Macro Prelim Solutions

Macro Prelim Solutions
Joseph Steinberg
May 25, 2009
Contents
1 Spring 2009, 8107 nal exam, question 1 (Perri, Ayagari) 2
2 Fall 2008, 8106 nal exam, question 1 (Chari, Asset allocation) 6
3 Fall 2008, 8106 nal exam, question 2 (Chari, cash-credit/Friedman rule) 9
4 Fall 2008, I.1 (Larry, labor-augmenting tech. change) 13
5 Fall 2008, I.2 (Chari, Search and R&D) 16
6 Fall 2008, I.4 (Perri, income uctuation problem) 20
7 Fall 2008, II.1 (Larry, TDCE with government spending in utility function) 22
8 Fall 2008. II.2 (Victor, externality) 26
9 Fall 2008, II.3 (Chari, cash-credit) 30
10 Spring 2008, I.1 (Larry, DP) 33
11 Spring 2008, I.2 (Chari, optimal asset allocation) 34
12 Spring 2008, I.3 (Victor, bargaining/monopolistic competition) 36
13 Spring 2008, I.4 (Perri, IFP) 38
14 Spring 2008, II.1 (Larry, DP) 41
15 Spring 2008, II.2 (Victor, recursive competitive equilibrium) 43
16 Spring 2008, II.3 (Chari, search and human capital) 46
17 Spring 2008, II.4 (Perri, Ayagari) 50
18 Fall 2007, I.1 (Larry, TDCE) 53
19 Fall 2007, I.2 (Perri, Ayagari) 55
20 Fall 2007, I.3 (Chari, optimal asset allocation) 57
21 Fall 2007, II.1 (Larry, durable goods) 57
22 Fall 2007. II.2 (Perri, IFP in small open economy) 63
23 Spring 2007, I.1 (Larry, dierent discount factors) 64
1
24 Spring 2007, I.2 (Victor, OLG) 66
25 Spring 2007, I.4 (Chari, on-the-job search) 69
26 Spring 2007 II.1 (T. Kehoe, DP) 72
27 Spring 2007 II.2 (Larry, TDCE with government spending in the utility function) 76
28 Fall 2006 I.1 (Larry, TDCE) 76
29 Fall 2006 I.4 (Chari, on the job search) 79
30 Fall 2006 II.1 (T. Kehoe, DP/guess & verify) 79
31 Fall 2006 II.2 (Larry, TDCE with government spending in the production function) 83
32 Spring 2006, I.1 (Larry, TDCE) 87
33 Spring 2006, I.3 (Chari, DP) 89
34 Fall 2005, II.4 (Chari, cash-credit) 91
35 UPenn prelim, fall 2007, industry equilibria 93
1 Spring 2009, 8107 nal exam, question 1 (Perri, Ayagari)
Thanks to Tayyar and Jan for their solution.
Part (a)
Let A = [ a, ) and let E = [ y, ). Several things to note: both sets are compact, A is the state space
for type 1, and AE is the state space for type 2. Let A E be a -algebra for AE. Let (AE, A E )
be a measurable space. Finally, let be the set of probability measures on (A E, A E ).
There are two ways to approach this problem. The rst way is to try to come up with a way to have a
stationary measure that includes both types of agents and have a Huggett economy where aggregate demand
for saving is zero. The other way is to have a stationary measure for just the type 2 agents and consider the
type 1 agents as the demand for borrowing (like the exogenous K(r) in Ayagaris paper). In order to avoid
trouble dening a measure over all the agents (we would have to have some way of dierentiating type 1
agents from type 2 agents that just happen to draw a shock of zero), I will use the second approach.
A stationary equilibrium in this economy is: Value functions V
1
: A R and V
2
: A E R; policy
functions g
1
a
: A A, g
1
c
: A R
+
, g
2
a
: A E A, and g
2
c
: A E R
+
; a stationary measure
;
and an interest rate r such that
(i) Given r, V
1
, g
1
a
, and g
1
c
solve type 1s problem:
V
1
(a) = max
(a
,c)
1
(a)
u(c) +V
1
(a
)
where
1
(a) = (a
, c) : c +a
= (1 +r)a + y, c 0, a
A.
(ii) Given r, V
2
, g
2
a
, g
2
c
solve type 2s problem:
V
2
(a, ) = max
(a
,c)
2
(a,)
_
u(c) +
_
E
V
2
(a
) dF(
)
_
where
2
(a, ) = (a
, c) : c +a
= (1 +r)a + y +, c 0, a
A.
2
(iii) The market for saving clears:
g
1
a
(a) + (1 )
_
AE
g
2
a
(a, ) d
(a, ) = 0.
Note that Walras law implies that the market for consumption goods will clear if the above equation
holds so we dont need to explicitly include a market-clearing condition for the goods market.
(iv)
is invariant, i.e., for all /c A E ,
(/c) =
_
AE
Q[(a, ), (/c)] d
(a, ),
where
Q[(a, ), (/c)] =
_
E
A
[g
2
a
(a, )] dF(
).
In other words, Q gives the probability that a type 2 agent starting with (a, ) will choose g
2
a
/ and
receive a shock
c. If the shocks were not independently distributed, we would replace dF(
) with
something like (, d
).
Part (b)
Autarky is not a stationary equilibrium. To see this, rst consider the type 1 agents Euler equation:
u
(c
1
t
) (1 +r)u
(c
1
t+1
).
Suppose that (1 +r) > 1. Dene M
t
= u
(c
1
t
)[(1 +r)]
t
. Then the Euler equation implies that
M
t
M
t+1
> 0.
Thus M
t
is a bounded sequence. Since [(1 +r)]
t
, it must be that u
(c
1
t
) 0. Inada conditions then
imply that c
1
t
. By iterating forward on the budget constraint from time t, we can express the type 1
agents budget constraint as
a
1
t
(1 +r) +
j=0
y
(1 +r)
j

j=0
c
1
t+j
(1 +r)
j
.
Since c
1
t
is unbounded, the sum on the RHS is also unbounded. But
j=0
y
(1+r)
j
is clearly bounded, so it
must be that a
1
t
. Thus autarky cannot be a stationary equilibrium when (1 +r) > 1.
Now suppose that (1 + r) < 1. For simplicity, consider the simple case in which a = 0. We will use
x (1 +r)a + y to represent the type 1 agents cash in hand. Then his problem is
V
1
(x) = max
c,a
u(c) +V
1
(x
)
s.t. x
= (1 +r)(x c) + y
a
= x c
a
0
The envelope condition for this problem is
V
1
x
(x) = u
c
(g
1
c
(x)).
Assuming that V
1
is twice-dierentiable, we get
V
1
xx
(x) = u
cc
(g
1
c
(x))
dg
1
c
(x)
dx
which implies
dg
1
c
(x)
dx
=
V
xx
(x)
u
cc
(g
1
c
(x))
> 0
3
since both u and V
1
are strictly concave. Thus type 1s consumption is increasing in cash-in-hand. If the
borrowing constraint is not binding, the FOC holds with equality. Using the envelope condition in the FOC,
we get
V
x
(x) = (1 +r)V
x
(x
) < V
x
(x
).
Thus x
< x, so cash-in-hand is decreasing over time when the borrowing constraint is not binding. Since
income is constant, this implies that a
1
t
is decreasing over time. Further, a
1
t
will hit the borrowing constraint
in nite time. Suppose not. Then cash-in-hand is greater than y for all t, i.e., x
t
> y, t. Then we have
0 < u
(c
1
t
) = lim
j
[(1 +r)]
j
u
(g
1
c
(x
t+j
)) lim
j
[(1 +r)]
j
u
(g
1
c
( y)) = 0.
Contradiction. Therefore it must be that cash-in-hand converges to y in nite time, i.e., T such that for all
t T, a
1
t
= 0 = a. This analysis yields a similar result when a < 0, so autarky cannot be a stationary
equilibrium when (1 +r) > 1.
So far we have shown that just considering the type 1 agents, the only viable candidate for parameter
values that are consistent with autarky is (1 + r) = 1. However, if (1 + r) = 1, type 2 agents will
accumulate assets. This is because the utility function is strictly concave and marginal utility is strictly
convex. Consider the Euler equation for type 2 agents when (1 +r) = 1:
u
(c) E[u
(c
)].
Since marginal utility is strictly convex, Jensens inequality implies that
E[u
(c
)] > u
(E[c
]).
Thus
u
(c) > u
(E[c
])
so type 2s consumption will tend to increase over time. This requires that type 2 agents have precautionary
saving. Thus when (1 + r) = 1, type 2 agents will tend to acucmulate assets over time, so (1 +r) = 1 is
not consistent with autarky either. Therefore there is no value of (1 + r) that is consistent with autarky,
so autarky cannot be a stationary equilibrium.
Part (c)
In part (b), we saw that (1 +r) = 1 cannot be not a stationary equilibrium because type 1 agents will hold
zero assets while type 2 agents will accumulate assets, so aggregate asset holdings would be greater than
zero, i.e., the market for saving would not clear. Further, if (1 +r) > 1, both types will accumulate assets,
so in a stationary equilibrium it must be that (1 +r) < 1.
In this case, type 1 agents will hit the borrowing constraint in nite time, so in stationary equilibrium,
all type 1 agents will have a
1
t
= a. Thus average assets holdings for type 1 agents is a and the variance
is zero.
Part (d)
Since g
1
a
(a) = a in stationary equilibrium, market clearing requires that
a + (1 )
_
AE
g
2
(a, ) d
(a, ) = 0
or
E[a
2
t
] =
_
A
g
2
(a, ) d
(a, ) =

1
a.
4
Part (e)
Since type 1 agents all have assets equal to a, their budget constraint implies that
c
1
t
= y r a
for all type 1 agents. Thus average consumption for type 1 agents is y r a and the variance is zero.
For type 2 agents, market clearing for goods implies that
( y r a) +
_
AE
g
2
c
(a, ) d
(a, ) = y.
Thus we get
E[c
2
t
] =
_
AE
g
2
c
(a, ) d
(a, ) = y +

1
r a.
Then average type 2 consumption is higher than average type 1 consumption if and only if
y +

1
r a > y r a.
Simplifying this expression, we get
r a > 0.
Thus
E[c
2
t
] > c
1
t
r a > 0.
If idiosyncratic risk of type 2 agents increases, they will want to save more. Since type 1 agents will still
be at the borrowing constraint (i.e., their assets will remain unchanged), the interest rate must go down in
order to clear the market for saving (since a lower interest rate will decrease the amount of saving done by
type 2 agents). Since
E[c
2
t
] c
1
t
= y +

1
r a y +r a
we have
(E[c
2
t
] c
1
t
)
r
=

1
a + a > 0.
Since r must decrease to clear the market for saving, the dierence in consumption of the two types will go
down. The graph below shows how the increase in idiosyncratic risk causes type 2 agents demand for saving
to increase and causes equilibrium interest rate to drop.
Include graph!
Part (f)
To answer this problem, we have to consider what happens during the transition from time zero to the
stationary equilibrium as well as the stationary equilibrium itself. Note that since has mean zero, the
expected present value of lifetime endowments is the same for both types:
y
1
. Further, the law of large
numbers implies that there is no aggregate uncertainty; the aggregate endowment in every period and state
is y.
If we had complete markets, the second welfare theorem implies that we could solve the planners problem
and use the Negiishi algorithm to calculate the planners problem weights that would give us the competitive
equilibrium allocations. Since both types have the same expected present value of lifetime endowments and
the same initial asset holdings, the correct weights would be the same for both types. This implies that the
complete markets CE would have each type consuming y in every period and state.
Since the utility function is strictly concave, the type 1 agents problem has a unique solution, so setting
c
t
= y is strictly better than every other aordable allocation for type 1 in the complete markets CE. Note
that consuming y in every period is still feasible for type 1 agents in our Ayagari economy with non-contingent
bonds only. Since the type 1 agents choose a dierent consumption stream in this economy, strict concavity
of the utility function implies that they are strictly better o in the Ayagari economy than in the complete
markets economy. Therefore the type 2 agents must be strictly worse o, so ex ante it would be better to
be a type 1 agent in this economy.
5
Part (g)
The market clearing condition is now
g
1
a
(a) + (1 )
_
AE
g
2
a
(a, ) d
(a, ) = 0.
Since type 1 agents will still be at the borrowing constraint and g
2
(a, ) has not changed, the increase in the
fraction of type 1 agents causes aggregate supply of lending to decrease (the curve (1 )A
2
shifts left to
(1 )A
2
in the graph below) and causes aggregate demand for borrowing to increase (from a to a in the
graph). In order for the market to clear, type 2 agents will have to save more on average so the equilibrium
interest rate will have to rise. See the graph below.
Part (h)
As 1, aggregate supply of lending will go to zero and demand for borrowing will go to a for all r such
that (1 +r) < 1. In order to clear the market for assets, the equilibrium interest rate will go to r = 1
1
at the limit, at which point the type 1 agents have no incentive to borrow or lend.
2 Fall 2008, 8106 nal exam, question 1 (Chari, Asset allocation)
Part (a)
I assume that the entrepreneur can consume his wealth as well as allocate it to capital and bonds. This
means that the problem is similar to Charis other asset allocation problem in which an agent allocates wealth
between consumption, a risky asset, and a safe asset. Here, the risky asset is the prot from entrepreneurial
activity. I also assume that the production function is CRS and the agent gets to choose labor input after
hi productivity and wage shocks are drawn.
To write the entrepreneurs problem as a dynamic program, rst note that in the nal period, the
entrepreneur will consume all of his wealth since he receives no benet from allocating any of it to capital
or bonds. Thus V
T
(W) = u(W). The entrepreneurs problem for t < T can be written as follows:
V
t
(W) = max
c,k,b
_
u(c) +
_
A
_
max
n
V
t+1
(W
) dF(A) dG()
_
s.t. c +k +b W
W
= AF(k, n) n +Rb
Substituting the second constraint into the functional equation gives us a more compact version:
V
t
(W) = max
c,k,b
_
u(c) +
_
A
_
max
n
V
t+1
[AF(k, n) n +Rb] dF(A) dG()
_
s.t. c +k +b W
If we let k = (W c) and b = (1 )(W c), we can write the problem in a dierent way:
V
t
(W) = max
c0
[0,1]
_
u(c) +
_
A
_
max
n
V
t+1
[AF((W c), n) n + R(1 )(W c)] dF(A) dG()
_
.
(1)
Part (b)
Given my interpretation of the question, I assume that we want to show that the entrepreneur allocates a
xed fraction of his after-consumption wealth W c to capital.
Proposition. For all t T, V
t
(W) = a
t
u(W) for some constant a
t
.
6
Proof. By induction. For period T, we have V
T
(W) = u(W), so the condition holds for period T with
a
T
= 1. Now suppose that V
t+1
(W) = a
t+1
u(W). We want to show that this implies that V
t
(W) = a
t
u(W).
Given the assumption about V
t+1
, we can write V
t
as
V
t
(W) = max
c0
[0,1]
_
u(c) +
_
A
_
max
n
a
t+1
u[AF((W c), n) n +R(1 )(W c)] dF(A) dG()
_
.
(2)
Take arbitrary k, b and x A, . Consider the general problem of the form
max
n
u[AF(k, n) n +Rb].
Since the utility function is strictly increasing, the agent will choose n to maximize prots. Thus the maximal
utility from this problem is equivalent to
u
_
max
n
AF(k, n) n +Rb
_
.
Let n
(A, k, ) denote the optimal choice of n given A, k, . Then we have

u
_
max
n
AF(k, n) n +Rb
_
= u [AF(k, n
(A, k, )) n
(A, k, ) +Rb] .
Since F is CRS, the optimal choice n
(A, k, ) will be a linear function of k, i.e., the ratio

n
(A,k,)
k
will be
equal to some constant function of the parameters A, . Suppose we multiply k and b by the same number
Q. Then this implies that
u [AF(Qk, n
(A, Qk, )) n
(A, Qk, ) +RQb] = u [AF(Qk, Qn
(A, k, )) Qn
(A, k, ) +RQb]
= u [AQF(k, n
(A, k, )) Qn
(A, k, ) +RQb]
= u [Q(AF(k, n
(A, k, )) n
(A, k, ) +Rb)]
Note that the specication of u implies that for any a, b, u(ab) = (1 )u(a)u(b). Given the above result,
this implies that
u [AF(Qk, n
(A, Qk, )) n
(A, Qk, ) +RQb] = (1 )u(Q)u(AF(k, n
(A, k, )) n
(A, k, ) +Rb).
Since n
is the maximizing value, we have

max
n
u [AF(Qk, n) n +RQb] = (1 )u(Q)u
_
max
n
AF(k, n) +Rb
_
. (3)
Plugging this result into (2), we get
V
t
(W) = max
c0
[0,1]
_
u(c) +
_
A
_
max
n
a
t+1
u[AF((W c), n) n +R(1 )(W c)] dF(A) dG()
_
= max
c0
[0,1]
_
u(c) +a
t+1
(1 )u(W c)
_
A
_
u
_
max
n
AF(, n) +R(1 )
_
dF(A) dG()
_
Since the term
_
A
_
u
_
max
n
AF(, n) +R(1 )
_
dF(A) dG()
does not depend on W or c, we can write our functional equation as
V
t
(W) = max
c0
_
u(c) +a
t+1
(1 )u(W c) max
[0,1]
__
A
_
u
_
max
n
AF(, n) +R(1 )
_
dF(A) dG()
__
.
7
Since u is strictly concave,
argmax
[0,1]
__
A
_
u
_
max
n
AF(, n) +R(1 )
_
dF(A) dG()
_
is unique. Let
denote the maximizing value, and note that
does not depend on c, W, or t. This

implies that if our induction proof goes through, the entrepreneur will always allocate the same fraction of
after-consumption income W c to capital.
Now we have
V
t
(W) = max
c0
_
u(c) +u(W c)a
t+1
(1 )
_
A
_
u
_
max
n
AF(
, n) +R(1
)
_
dF(A) dG()
_
.
(4)
Let J
t
denote
a
t+1
(1 )
_
A
_
u
_
max
n
AF(
, n) +R(1
)
_
dF(A) dG()
Then we can write this as simply
V
t
(W) = max
c0
u(c) +J
t
u(W c) . (5)
Since u is strictly increasing and strictly concave, the FOC is sucient to guarantee a maximum. The FOC
is
u
(c) = J
t
u
(W c).
Lets use the specication of u now. The FOC is
c
= J
t
(W c)
.
Solving for c, we get
c =
J
1/
t
W
1 +J
1/
t
=
W
1 +J
1/
t
.
Plugging this into (5), we have
V
t
(W) = u
_
W
1 +J
1/
t
_
+J
t
u
_
W
W
1 +J
1/
t
_
.
Using the fact that u(ab) = (1 )u(a)u(b) again, we have
V
t
(W) = u(W)(1 )
_
u
_
1
1 +J
1/
t
_
+ J
t
u
_
1
1
1 +J
1/
t
__
.
Let
a
t
= (1 )
_
u
_
1
1 +J
1/
t
_
+J
t
u
_
1
1
1 +J
1/
t
__
.
So now we have
V
t
(W) = a
t
u(W).
This completes the induction.
With our proposition veried, we can see that the entrepreneur indeed allocates a xed fraction of his
after-consumption wealth to capital.
8
3 Fall 2008, 8106 nal exam, question 2 (Chari, cash-credit/Friedman
rule)
Part (a): Constant money supply
A CE in this environment is
An allocation (z
1
, z
2
), where z
i
= c
i
1t
, c
i
2t
,
i
t
, M
i
t
, B
i
t
t=0
A price system P = p
t
, w
t
t=0
A policy =
B
t
,

M, R
t
t=0
(

M
t
=

M, t)
such that
1) Given (P, ),
z
i
argmax
{c
i
1t
,c
i
2t
,
i
t
,M
i
t
,B
i
t
}
t=0
t=0
t
u
i
(c
i
1t
, c
i
2t
,
i
t
)
s.t. M
i
t
+B
i
t
(M
i
t1
p
t1
c
i
t1
) +w
t1
i
t1
p
t1
c
i
2t1
+R
t1
B
i
t1
p
t
c
i
1t
M
i
t
0
i
t
1
non-negativity, no Ponzi, A
i
0
given
2) Given (P, ), (z
1
, z
2
) solves the rms problem
max
{c
1
1t
,c
2
1t
,c
1
2t
,c
2
2t
,
1
t
,
2
t
}
t=0
t=0
[p
t
(c
1
1t
+c
2
1t
+c
1
2t
+c
2
2t
) w
t
(
1
t
+
2
t
)]
s.t. c
1
1t
+c
2
1t
+c
1
2t
+c
2
2t
=
1
t
+
2
t
non-negativity
3) The governments budget balances:

B
t+1
= R
t

B
t
(since money supply is xed, money cancels out on
both sides)
4) The market clears for all t: B
1
t
+B
2
t
=

B
t
, M
1
t
+ M
2
t
=

M,
2
i=1
[c
i
1t
+ c
i
2t
] =
1
t
+
2
t
.
3.1 Part (b): Constant interest rate
A CE in this environment is
An allocation (z
1
, z
2
), where z
i
= c
i
1t
, c
i
2t
,
i
t
, M
i
t
, B
i
t
t=0
t
, w
t
t=0
A policy =
B
t
,

M
t
,

R
t=0
(R
t
=

R, t)
such that
1) Given (P, ),
z
i
argmax
{c
i
1t
,c
i
2t
,
i
t
,M
i
t
,B
i
t
}
t=0
t=0
t
u
i
(c
i
1t
, c
i
2t
,
i
t
)
s.t. M
i
t
+B
i
t
(M
i
t1
p
t1
c
i
t1
) +w
t1
i
t1
p
t1
c
i
2t1
+

RB
i
t1
p
t
c
i
1t
M
i
t
0
i
t
1
i
0
given
9
2) Given (P, ), (z
1
, z
2
max
{c
1
1t
,c
2
1t
,c
1
2t
,c
2
2t
,
1
t
,
2
t
}
t=0
t=0
[p
t
(c
1
1t
+c
2
1t
+c
1
2t
+c
2
2t
) w
t
(
1
t
+
2
t
)]
s.t. c
1
1t
+c
2
1t
+c
1
2t
+c
2
2t
=
1
t
+
2
t
non-negativity
3) The governments budget balances: (

M
t+1

M
t
) +

B
t+1
=

R

B
t
.
1
t
+B
2
t
=

B
t
, M
1
t
+ M
2
t
=

M,
2
i=1
[c
i
1t
+ c
i
2t
] =
1
t
+
2
t
.
Part (c): Friedman rule
I assume that utility for both agents is given by
u
1
(c
1
, c
2
, 1 ) = u
2
(c
1
, c
2
, 1 ) =
c
1
1
1
+
c
1
2
1
+v(1 ).
Let =
B
t
,

M
t
, R
t
t=0
denote a policy. Let be the set of all possible policies. To nd the optimal
policy, we solve the Ramsey problem:
max
t=0
2
i=1
i
u
i
(c
i
1t
(), c
i
2t
(),
i
t
())
_
,
where
i
is the planner weight for consumer i, subject to
(c
i
1t
(), c
i
2t
(),
i
t
(), M
i
t
(), B
i
t
())
2
i=1
t=0
is a competitive equilibrium allocation.
A competitive equilibrium in this environment (remember that labor is supplied inelastically)
An allocation (z
1
, z
2
), where z
i
= c
i
1t
, c
i
2t
,
i
t
, M
i
t
, B
i
t
t=0
t
, w
t
t=0
A policy =
B
t
,

M
t
, R
t
t=0
such that
1) Given (P, ),
z
i
argmax
{c
i
1t
,c
i
2t
,
i
t
,M
i
t
,B
i
t
}
t=0
t=0
t
u
i
(c
i
1t
, c
i
2t
, 1
i
t
)
s.t. M
i
t
+B
i
t
(M
i
t1
p
t1
c
i
t1
) +w
t1
i
t1
p
t1
c
i
2t1
+R
t1
B
i
t1
p
t
c
i
1t
M
i
t
0
i
t
1
i
0
given
2) Given (P, ), (z
1
, z
2
max
{c
1
1t
,c
2
1t
,c
1
2t
,c
2
2t
,
1
t
,
2
t
}
t=0
t=0
[p
t
(c
1
1t
+c
2
1t
+c
1
2t
+c
2
2t
) w
t
(
1
t
+
2
t
)]
s.t. c
1
1t
+c
2
1t
+c
1
2t
+c
2
2t
=
1
t
+
2
t
non-negativity
3) The governments budget balances: (

M
t+1

M
t
) +

B
t+1
= R
t

B
t
.
10
1
t
+B
2
t
=

B
t
, M
1
t
+ M
2
t
=

M,
2
i=1
[c
i
1t
+ c
i
2t
] =
2
i=1
i
t
.
The rms problem implies that w
t
= p
t
, t. Given our assumption, both consumers utilities are
strictly increasing and strictly concave. Then their securities market constraints will hold with equality.
Their constraint sets are convex, so FOCs are sucient to guarantee a maximum. The FOCs for consumer
i are:
c
i
1t
:
t
u
i
1
(t) = p
t
i
t+1
+p
t
t
(1)
c
i
2t
:
t
u
i
2
(t) = p
t
i
t+1
(2)
i
t
:
t
u
i
(t) = w
t
i
t+1
(3)
M
i
t
:
i
t
=
i
t+1
+
i
t
(4)
B
i
t
:
i
t
= R
t
i
t+1
(5)
i
t
: M
i
t
+B
i
t
= (M
i
t1
p
t1
c
i
t1
) +w
t1
i
t1
p
t1
c
i
2t1
+R
t1
B
i
t1
(6)
i
t
: p
t
c
i
1t
M
i
t
(7)
where
i
t
and
i
t
are the lagrange multipliers on the securities market and cash-in-advance constraints re-
spectively. Note that by using (1), (2), (4), and (5), we get
u
i
1
(t)
u
i
2
(t)
= R
t
. (8)
We can use these FOCs to get an implementability constraint for each consumer which we will use to solve
the Ramsey problem.
Start with (5), the securities market constraint:
M
i
t
+B
i
t
= (M
i
t1
p
t1
c
i
t1
) +w
t1
i
t1
p
t1
c
i
2t1
+R
t1
B
i
t1
.
Assume the CIA constraint holds with equality. Then p
t
c
i
1t
= M
i
t
, t.
M
i
t
+B
i
t
= w
t1
i
t1
p
t1
c
i
2t1
+R
t1
B
i
t1
.
Multiply by
i
t
:
i
t
M
i
t
+
i
t
B
i
t
=
i
t
w
t1
i
t1
i
t
p
t1
c
i
2t1
+
i
t
R
t1
B
i
t1
.
Use (2), (3), and (5):
i
t
M
i
t
+
i
t
B
i
t
=
t1
u
i
(t 1)
i
t1
t1
u
i
2
(t 1)c
i
2t1
+
i
t1
B
i
t1
.
Sum from period t = 1 to T:
T
t=1
[
i
t
M
i
t
+
i
t
B
i
t
] =
T
t=1
t1
[u
i
(t 1)
i
t1
+u
i
2
(t 1)c
i
2t1
] +
T
t=1
i
t1
B
i
t1
.
Reindex on the RHS:
T
t=1
[
i
t
M
i
t
+
i
t
B
i
t
] =
T1
t=0
t
[u
i
(t)
i
t
+u
i
2
(t)c
i
2t
] +
T1
t=0
i
t
B
i
t
.
Cancel out some of the bond terms:
T
t=1
i
t
M
i
t
+
i
T
B
i
T
=
T1
t=0
t
[u
i
(t)
i
t
+u
i
2
(t)c
i
2t
] +
i
0
B
i
0
.
Add
i
0
M
i
0
to both sides:
T1
t=0
i
t
M
i
t
+
i
T
[M
i
T
+B
i
T
] =
T1
t=0
t
[u
i
(t)
i
t
+u
i
2
(t)c
i
2t
] +
i
0
[M
i
0
+B
i
0
].
11
Use the fact that the CIA holds with equality again:
T1
t=0
i
t
p
t
c
i
1t
+
i
T
[M
i
T
+B
i
T
] =
T1
t=0
t
[u
i
(t)
i
t
+u
i
2
(t)c
i
2t
] +
i
0
[M
i
0
+B
i
0
].
Use (1) and (4) on
i
t
p
t
c
i
1t
and rearrange some terms:
T1
t=0
t
[u
i
1
(t)c
i
1t
+u
i
2
(t)c
i
2t
+u
i
(t)
i
t
] =
i
0
[M
i
0
+B
i
0
]
i
T
[M
i
T
+B
i
T
].
Take limits as T and apply the transversality condition lim
T
[M
i
T
+B
i
t
] = 0:
t=0
t
[u
i
1
(t)c
i
1t
+u
i
2
(t)c
i
2t
+u
i
(t)
i
t
] =
i
0
[M
i
0
+B
i
0
].
Finally, set p
0
= 1 and use (2):
t=0
t
[u
i
1
(t)c
i
1t
+u
i
2
(t)c
i
2t
+u
i
(t)
i
t
] = u
i
2
(0)[M
i
0
+B
i
0
].
WLOG, set M
i
0
+B
i
0
= 0. Thus our implementability constraint for consumer i is
t=0
t
[u
i
1
(t)c
i
1t
+u
i
2
(t)c
i
2t
+u
i
(t)
i
t
] = 0. (9)
The competitive equilibrium allocation is thus fully characterized by (8), (9), and the resource constraint.
Note that for the problem to be well-posed, we require that R
t
1, t. Therefore we can write the
Ramsey problem as
max
{(c
i
1t
,c
i
2t
,
i
t
)
2
i=1
}
t=0
_

t=0
2
i=1
i
u
i
(c
i
1t
, c
i
2t
,
i
t
)
_
s.t.
t=0
t
[u
i
1
(t)c
i
1t
+u
i
2
(t)c
i
2t
+u
i
(t)
i
t
] = 0, i = 1, 2
u
i
1
(t)
u
i
2
(t)
1, i = 1, 2, t
2
i=1
[c
i
1t
+c
i
2t
] =
2
i=1
i
t
, t
Consider the Ramsey problem with the second constraint dropped:
max
{(c
i
1t
,c
i
2t
,
i
t
)
2
i=1
}
t=0
_

t=0
2
i=1
i
u
i
(c
i
1t
, c
i
2t
,
i
t
)
_
s.t.
t=0
t
[u
i
1
(t)c
i
1t
+u
i
2
(t)c
i
2t
+u
i
(t)
i
t
] = 0, i = 1, 2
2
i=1
[c
i
1t
+c
i
2t
] =
2
i=1
i
t
, t
Let
i
be the multiplier on consumer is implementability constraint and let
t
be the multiplier on the
resource constraint. Given the assumption about the form of the utility function, the implentability constraint
for consumer i is
t=0
t
[(c
i
1t
)
1
+ (c
i
2t
)
1
+v
(1
i
t
)
i
t
] = 0.
12
Then the FOCs for c
i
1t
and c
i
2t
are
c
i
1t
:
i
t
(c
i
1t
)
=
t
i
(1 )(c
i
1t
)
+
t
c
i
2t
:
i
t
(c
i
2t
)
=
t
i
(1 )(c
i
2t
)
+
t
Combining the two conditions, we get
(c
i
1t
)
t
[
i
i
(1 )] = (c
i
2t
)
t
[
i
i
(1 )].
This implies that
u
i
1
(t)
u
i
2
(t)
=
(c
i
1t
)
(c
i
2t
)
= 1.
This satises the constraint we dropped, so it must be that
u
i
1
(t)
u
i
2
(t)
= 1
is optimal. Looking at (8), we see that this implies that R
t
= 1, t, i.e., the Friedman rule is optimal.
4 Fall 2008, I.1 (Larry, labor-augmenting tech. change)
Part (a)
Proposition. Assume the following conditions hold:
(i) F is continuous.
(ii) F has CRS.
(iii) F(0, ) = 0.
(iv)
k such that for all k [
k, ) and all n, F(k, n) + (1 )k k.

(v) u is a continuous function of the form
u(c, ) =
c
1
1
v().
(vi) 0 <
1
< 1.
Then the planners problem for the single-sector growth model with labor augmenting technological change
can be obtained by solving a stationary dynamic program.
Proof. Dene the following variables:
c
t
=
c
t
A
t
x
t
=
x
t
A
t
k
y
=
k
t
A
t
13
Using the assumption about the form of u, the planners problem becomes
max
{ ct,t,nt, xt,
kt}
t=0
t=0
t
(
t
c
t
)
1
1
v(
t
)
s.t.
t
c
t
+
t
x
t
F(
t
k
t
,
t
A
0
n
t
)
n
t
+
t
1
t+1
k
t+1
+ (1 )
t
k
t
+
t
x
t
k
0
=
k
0
A
0
given
non-negativity
Since F is CRS, this simplies to
max
{ ct,t,nt, xt,
kt}
t=0
t=0
t
c
1
t
1
v(
t
)
s.t. c
t
+ x
t
F(
k
t
, A
0
n
t
)
n
t
+
t
1
k
t+1
+ (1
k
t
+ x
t
k
0
=
k
0
A
0
given
non-negativity
where

=
1
, 1
=
1
, and =
1
. Since F and u are bounded on [0,
k] and 0 <

< 1, this problem
satises assumptions of the principle of optimality. Thus the supremum v
(k
0
) from the problem above is
the unique solution to the following stationary dynamic program:
v(
k) = max
c,,n, x,
_
c
1
1
v() +

v(
)
_
s.t. c + x F(
k, A
0
n)
n + 1
(1

)
k + x
c, x,
, n, non-negative
Part (b)
Proposition. Suppose that in addition to (i) - (vi) above, the following conditions hold:
(vii) F is strictly increasing.
(viii) F is strictly concave.
(xi) F is continously dierentiable.
(x) F satises Inada conditions.
(xi) v() is constant (labor is supplied inelastically).
Then for any k
0
,
kt+1
kt
.
14
Proof. Since labor is supplied inelastically and the utility function is strictly increasing, n = 1 and all
constraints hold with equality. Dene the function f as f(
k) = F(
k, A
0
) + (1

)
k. WLOG, assume that

v() = 1. Then we can write the Bellman equation above in a simpler form:
v(
k) = max
k)
_
1
1
[f(
k)
]
1
+

v(
)
_
where
(
k) = [0, f(
k)].
We already showed that assumptions 4.3 and 4.4 hold, so theorem 4.6 from SLP implies that v is continuous
and bounded. Since u and F are strictly increasing, the return function of the above Bellman equation
is strictly increasing and is monotone. Thus assumptions 4.5 and 4.6 are also satised, so theorem 4.7
implies that v is strictly increasing. Since u and F are strictly concave, f is also strictly concave, so the return
function is strictly concave as well, i.e., assumption 4.7 holds. Our conditions on u and F also guarantee
that is convex in the sense of assumption 4.8, so theorem 4.8 implies that v is strictly concave and the
policy correspondence is a single-valued function g. Finally, since u and F are continuously dierentiable,
assumption 4.9 holds, so theorem 4.11 implies that v is dierentiable for any

k > 0 such that g(
k)
_
(
k).
Thus the FOC and envelope condition fully characterize the solution to our dynamic programming problem.
We want to show that
kt+1
kt
. Since k
t
=
t
A
0
k
t
, it is equivalent to show that

kt+1
kt
1. By the
principle of optimality, the optimal sequence
k
t
t=0
in the sequence problem from part (a) is generated
by iteratively applying the policy function g to the initial value

k
0
. Thus it suces to show that g has a
positive, globally stable xed point.
The FOC for the Bellman equation is
[f(
k) g(
k)]
=

v
(g(
k)).
The envelope condition is
v
k) = [f(
k) g(
k)]
k).
Combining the two gives the Euler equation:
[f(
k) g(
k)]
=

[f(g(
k)) g(g(
k))]
(g(
k)).
Thus any xed point

k
of g must solve
[f(
=

[f(
)
which simplies to
=

f
).
Our conditions on F imply that f is continuously dierentiable, strictly concave, and satises Inada condi-
tions. Therefore there exists a unique positive solution to this equation, i.e., there exists a unique positive
xed point

k
of g.
First, we show that g is strictly increasing. Suppose not. Then there exists

k
1
<

k
2
such that g(
k
1
)
g(
k
2
). Since v is strictly concave, we have v
(g(
k
1
)) v
(g(
k
2
)). Then the FOC implies that
[f(
k
1
) g(
k
1
)]
[f(
k
2
) g(
k
2
)]
.
This in turn implies that
f(
k
1
) g(
k
1
) f(
k
2
) g(
k
2
).
Since g(
k
1
) g(
k
2
), we have
f(
k
1
) f(
k
2
).
But since f is strictly increasing by our conditions on F, this means that

k
1

k
2
. Contradiction. Therefore
g is strictly increasing.
15
Since v is concave, the following inequality must hold for all

k, with equality if and only if

k =

k
:
[v
(g(
k)) v
k)][g(
k)
k] 0.
Using the FOC and envelope condition to substitute for v
(g(
k)) and v
k) respectively, we get
_
[f(
k) g(
k)]
[f(
k) g(
k)]
k)
_
[g(
k)
k] 0.
Simplifying and using the fact that f
) =

we have
(f(
k) g(
k))
_
f
) f
k)
_
[g(
k)
k] 0.
Since the utility function is strictly increasing, marginal utility is always strictly positive. Therefore we can
simplify even further to get the following inequality, which again holds only for

k =

k
:
_
f
) f
k)
_
[g(
k)
k] 0. (*)
Suppose

k <

k
. Since f is strictly concave, f
) < f
k). Since (*) holds with equality only for
k =

k
, g(
k) >

k. Since g is strictly increasing, we know that g(
k) < g(
) =

k
. Thus for

k <

k
k < g(
k) <

k
.
Take

k
0
<

k
and dene the sequence
k
t
t=0
by

k
t+1
= g(
k
t
), t. Then the above argument implies that
k
0
<

k
1
<

k
2
< . . . <

k
t
<

k
t+1
<

k
, t.
Thus

k
t

k
.
Now suppose that

k >

k
. Again, since f is strictly increasing, f
) > f
k). Since (*) holds with

equality only for

k =

k
, g(
k) <

k. Since g is strictly increasing, we know that g(
k) > g(
) =

k
. Thus for
k >

k
k > g(
k) >

k
.
Take

k
0
>

k
and dene the sequence
k
t
t=0
as above. Now we have
k
0
>

k
1
>

k
2
> . . . >

k
t
>

k
t+1
>

k
, t.
Thus

k
t

k
.
So we have shown that for all possible values of

k
0
, the sequence
k
t
t=0
dened by iteratively applying
the policy function converges to

k
. Therefore

k
, the unique positive xed point of g, is globally stable. As

explained above, this implies that
kt+1
kt
.
5 Fall 2008, I.2 (Chari, Search and R&D)
Part (a)
The typical inventors problem can be written as a functional equation as:
V (z) = maxV
M
(z), V
I
(2.1)
where v
M
(z), the value of managing an invention, is
V
M
(z) = z +(1 p)V
M
(z) +pV
I
(2.2)
and v
I
, the value of inventing, is
V
I
= b +
_
V (z
)dF(z
). (2.3)
16
Part (b)
I assume that there exists a maximum invention quality z, the lowest invention quality is 0 (the invention
fails to meet government standards or some other reason for failure) and that 0 < < 1. Note that because
V
I
is constant, V
M
(z) is continuous and strictly increasing. We can write V
M
(z) as
V
M
(z) =
z +pV
I
1 (1 p)
.
Then we have
V (z) = max
_
z +pV
I
1 (1 p)
, V
I
_
so V is nondecreasing.
I assume that b 0 and 0 < < 1. Now suppose that the inventor chooses to sell a worthless product
than to invent a new one, i.e.,
V (0) = V
M
(0) V
I
.
Then
p
1 (1 p)
V
I
V
I
.
This implies that
p
1 (1 p)
1.
Rewriting, this is
1
1 (1 p)
0.
Since < 1 and (1 p) < 1, this is a contradiction, so it must be that the inventor chooses to invent, i.e.,
V (0) = V
I
> V
M
(0).
Now suppose that given an invention of the maximum quality, the inventor stil chooses to invent. Then
V ( z) = V
I
V
M
( z).
Since V is nondecreasing, V ( z) V (z
) for all z
[0, z]. Then

V ( z) b +V ( z).
Since b 0 and < 1, this is a contradiction. Then it must be that the worker chooses to manage:
V ( z) = V
M
( z) > V
I
.
Thus we have shown that
V
M
(0) =
pV
I
1 (1 p)
< V
I
and
V
M
( z) =
z + pV
I
1 (1 p)
> V
I
.
Since V
M
is continuous and strictly increasing, the Intermediate Value Theorem implies that that there
exists a unique z
such that
V
M
(z
) =
z
+pV
I
1 (1 p)
= V
I
. (2.4)
Therefore this dynamic program exhibits the reservation wage property, i.e.,
V (z) =
_
V
M
(z) z z
V
I
z z
.
17
We will now solve for the reservation invention quality in terms of the given parameters. We can rewrite
(2.4) as
z
+pV
I
= [1 (1 p)]V
I
.
Rearranging gives us
z
= (1 )V
I
. (2.5)
We know that for all z z
, we have
V (z) = z +[(1 p)V (z) +pV
I
]
=
z +pV
I
1 (1 p)
.
=
z
1 (1 p)
+
pz
[1 (1 p)](1 )
, z z
(2.6)
Similarly, since V (z) = V
I
for all z < z
, we can use (2.5) to get

V (z) =
z
1
, z z
(2.7)
Then by (2.5)-(2.7) we have
z
= b(1 ) +(1 )
_
z
0
V (z
)dF(z
)
= b(1 ) +(1 )
_
z
0
V (z
)dF(z
) +
_
z
z
V (z
)dF(z
)
= b(1 ) +
_
z
0
z
dF(z
) +
_
z
z
_
(1 )z
1 (1 p)
+
pz
1 (1 p)
_
dF(z
)
= b(1 ) +
_
z
0
z
dF(z
) +
_
z
z
_
(1 )z
1 (1 p)
+
[1 (1 p) (1 )]z
1 (1 p)
_
dF(z
)
= b(1 ) +
_
z
0
z
dF(z
) +
_
z
z
_
(1 )z
1 (1 p)

(1 )z
1 (1 p)
+z
_
dF(z
)
= b(1 ) +
_
z
0
z
dF(z
) +
_
z
z
_
(1 )(z
)
1 (1 p)
_
dF(z
) +
_
z
z
dF(z
)
= b(1 ) +
_
z
0
z
dF(z
) +
_
z
z
_
(1 )(z
)
1 (1 p)
_
dF(z
)
= b(1 ) +z
+
_
z
z
_
(1 )(z
)
1 (1 p)
_
dF(z
)
Then we have
z
(1 ) = b(1 ) +
_
z
z
_
(1 )(z
)
1 (1 p)
_
dF(z
)
which can be rewritten as
z
= b +

1 (1 p)
_
z
z
(z
)dF(z
). (2.8)
Let M
t
denote the fraction of inventors engaged in management in period t, and let I
t
denote the fraction
engaged in invention. Since this economy has a large number of inventors, we can express M
t+1
as a function
of M
t
and I
t
:
M
t+1
= (1 p)M
t
+ (1 F(z
))I
t
.
Since M
t
+I
t
= 1 t, we can rewrite this as a rst-order dierence equation in M
t
:
M
t+1
= (1 p)M
t
+ (1 F(z
))(1 M
t
).
18
Similarly, the fraction of inventors engaged in invention in period t + 1 is
I
t+1
= p(1 I
t
) +F(z
)I
t
.
A stationary equilibrium in this economy is (z
, I
) such that (2.8) holds and

I
= p(1 I
) +F(z
)I
. (2.9)
Rearranging (2.9) we get I
as a function of p and F(z
):
I
=
p
1 +p F(z
)
. (2.10)
Part (c)
Consider the following rearrangement of (2.8):
z

1 (1 p)
_
z
z
(z
)dF(z
) = b. (2.11)
If b falls, the RHS rises, so the LHS must also rise. Note that
_
z
z
(z
z)dF(z
)
is a decreasing function of z. This implies that
z

1 (1 p)
_
z
z
(z
z)dF(z
)
is a strictly increasing function of z. So if the LHS of (2.11) rises, then z
also rises. Thus z
rises when b
falls. This means that F(z
) will go up. Examining (2.10), we can see that this will cause I
, the fraction
of agents engaged in invention, to rise.
Part (d)
We can rewrite (2.8) as
z
[1 (1 p)] = b[1 (1 p)] +

_
_
z
z
(z
)dF(z
) +
_
z
0
(z
)dF(z
)
_
z
0
(z
)dF(z
)
_
= b[1 (1 p)] +
_
_
z
0
(z
)dF(z
)
_
z
0
(z
)dF(z
)
_
= b[1 (1 p)] +
_
E[z
] z
_
z
0
(z
)dF(z
)
_
.
Rearranging the last equation and applying integration by parts gives us
z
=
1 (1 p)
1 p
b +

1 p
E[z
] +

1 p
_
z
0
F(z
)dz
. (2.12)
Suppose that G is a mean-preserving spread of F. Then
_
z
0
G(z
) dz
_
z
0
F(z
) dz
, z [0, z].
19
For clarity, I will use z
F
and z
G
to denote the reservation invention qualities for distributions F and G.
Dene the functions h
F
and h
G
as
h
F
(z) =
1 (1 p)
1 p
b +

1 p
E[z
] +

1 p
_
z
0
F(z
)dz
h
G
(z) =
1 (1 p)
1 p
b +

1 p
E[z
] +

1 p
_
z
0
G(z
)dz
We can see from (2.12) that z
F
= h
F
(z
) and z
G
= h
G
(z
). Since G is a mean-preserving spread of F, we

can see that h
G
(z) h
F
(z), z [0, z]. This means z
F
z
G
. In other words, a mean-preserving increase
in risk will cause the reservation invention quality to rise. This may seem counterintuitive at rst, but it
actually makes sense. We can think of inventing as an option which will be exercised only when the draw
is above the reservation invention quality. Thus the higher incidence of very good draws increases the value
of inventing, while the higher incidence of very bad draws has little eect since the option will never be
exercised upon receiving such draws. So a mean-preserving increase in risk actually increases the value of
inventing, so the reservation invention quality has to rise.
However, the fact that z
G
z
F
does not necessarily imply that G(z
G
) F(z
F
) nor does it necessarily
imply that G(z
G
) F(z
F
). Thus the eect of a MPS on the fraction of agents engaged in invention is
ambiguous.
6 Fall 2008, I.4 (Perri, income uctuation problem)
Part (a)
The utility function is strictly concave and the constraint set is convex so FOCs are sucient for maximiza-
tion. Let
t
be the lagrange multiplier on the budget constraint. The FOCs are:
c
t
:
t
(b
1
2b
2
c
t
) =
t
a
t+1
:
t
= E
t
[(1 +r)
t+1
]
This implies that
(b
1
2b
2
c
t
) = E
t
[(1 +r)(b
1
2b
2
c
t+1
)]
which becomes
c
t
= E
t
[c
t+1
].
since (1 +r) = 1. Note that this implies that c
t
is a Martingale, i.e.,
c
t
= E
t
[c
t+j
], j 0. (1)
Starting from period t, multiply all the budget constraints by
_
1
1+r
_
j
, j 0. Add them up,
take expectations (keep in mind the law of iterated expectations!), and use the transversality condition
E
0
_
lim
t
_
1
1+r
_
t
a
t
_
= 0, we get
j=0
_
1
1 +r
_
j
E
t
[c
t+j
] =
j=0
_
1
1 +r
_
j
E
t
[y
t+j
] + (1 +r)a
t
.
Using (1), we get
j=0
_
1
1 +r
_
j
c
t
=
j=0
_
1
1 +r
_
j
E
t
[y
t+j
] + (1 +r)a
t
.
This simplies to
c
t
=
r
1 +r
_
_
j=0
_
1
1 +r
_
j
E
t
[y
t+j
]
_
_
+ra
t
. (2)
20
By (1), c
t
= c
t+1
E
t
[c
t+1
], which we can write as
c
t
= c
t+1
E
t
[c
t+1
] =
r
1 +r
_
_
j=0
_
1
1 +r
_
j
_
E
t+1
[y
t+1+j
] E
t
[y
t+1+j
]
_
_
_
+ra
t+1
E
t
[ra
t+1
].
Since a
t+1
is chosen at time t, the last part drops out and we simply have
c
t
=
r
1 +r
_
_
j=0
_
1
1 +r
_
j
_
E
t+1
[y
t+1+j
] E
t
[y
t+1+j
]
_
_
_
. (3)
Notice that
E
t+1
[y
t+1+j
] E
t
[y
t+1+j
] = E
t+1
[z
t+1+j
+
t+1+j
] E
t
[z
t+1+j
+
t+1+j
]
= z
t+1
z
t
= z
t
+
t+1
z
t
=
t+1
And for j = 0, we have
E
t+1
[y
t+1
] E
t
[y
t+1
] = y
t+1
E
t
[y
t+1
]
= z
t+1
+
t+1
z
t
= z
t
+
t+1
+
t+1
z
t
=
t+1
+
t+1
Thus
c
t
=
r
1 +r
_
_
j=0
_
1
1 +r
_
j
t+1
+
t+1
_
_
.
This simplies to
c
t
=
t+1
+
r
1 +r
t+1
. (4)
This is an intuitive result; it says that the agent will consume the entirety of the permanent shock
t+1
but
will only consume the annuity value of the temporary shock
t+1
.
The BC implies that
a
t+1
= y
t
+a
t
(1 +r) c
t
.
Thus
a
t
= a
t+1
a
t
= y
t
+a
t
(1 +r) = c
t
a
t
= y
t
+ra
t
c
t
.
Using (2), we have
a
t
= y
t
r
1 +r
_
_
j=0
_
1
1 +r
_
j
E
t
[y
t+j
]
_
_
. (5)
Since y
t
= z
t
+
t
and E
t
[y
t+j
] = z
t
for all j > 0, we have
a
t
= z
t
+
t
r
1 +r
(z
t
+
t
)
r
1 +r
_
_
j=1
_
1
1 +r
_
j
z
t
_
_
.
which simplies to
a
t
=
1
1 +r
t
. (6)
This is reasonable in light of (4).
21
Part (b)
The specication of the income process implies that
y
t
= z
t+1
+
t+1
z
t
t
= z
t
+
t+1
+
t+1
z
t

t
=
t+1
+
t+1

t
.
Then
E[y
t
] = 0.
Note that if x and y are independently distributed (like and are), E(xy) = E(x)E(y). Then since
E(
t+1
) = E(
t+1
) = E(
t
) = 0, for the variance of y
t
we get
var(y
t
) = E[(y
t
E[y
t
])
2
]
= E[(y
t
)
2
]
= E[(
t+1
+
t+1

t
)
2
]
= E[
2
t+1
+
2
t+1
+
2
t
]
=
2
+ 2
2
Note the formula for covariance:

cov(x, y) = E[(x E(x))(y E(y))]
= E[xy +E(x)E(y) E(x)y xE(y)]
= E(xy) +E(x)E(y) 2E(x)E(y)
= E(xy) E(x)E(y)
Then for the covariance of y
t
and c
t
we get
cov(y
t
, c
t
) = E[y
t
c
t
] E(y
t
)E(c
t
)
= E
_
(
t+1
+
t+1
t
)
_
t+1
+
r
1 +r
t+1
__
E[
t+1
+
t+1
t
]E
_
t+1
+
r
1 +r
t+1
_
= E(
2
t+1
) +
r
1 +r
E(
2
t+1
)
=
2
+
r
1 +r
Thus we have
0.2 =
cov(y
t
, c
t
)
var(y
t
)
=
+
r
1+r
+ 2
2
.
Rearranging stu a few times, we have
0.2[
2
+ 2
2
] =
2
+
r
1 +r
then
0.8
2
= [0.4
r
1 +r
]
2
so
=
_
0.4
r
1+r
0.8
.
7 Fall 2008, II.1 (Larry, TDCE with government spending in util-
ity function)
Part (a)
Given a xed sequence g
t
,
kt
,
nt
t=0
, a TDCE in this economy is:
22
household allocations x
t
= c
t
, x
t
, k
t+1
, n
t
, l
t
t=0
;
rm allocations y
t
= c
f
t
, x
f
t
, k
f
t+1
, n
f
t
, g
f
t
t=0
; and
prices p
t
, r
t
, w
t
t=0
such that given prices,
1. x
t
solves the households problem:
max
{ct,xt,kt+1,nt,lt}
t=0
t=0
t
u(c
t
, l
t
, g
t
)
s.t.
t=0
p
t
(c
t
+x
t
)
t=0
[w
t
(1
nt
)n
t
+r
t
(1
kt
)k
t
] +
k
t+1
(1 )k
t
+x
t
n
t
+l
t
n
k
0
given, all quantities non-negative
2. y
t
solves the rms problem:
max
{c
f
t
,x
f
t
,k
f
t+1
,n
f
t
,g
f
t
}
t=0
=
t=0
[p
t
(c
f
t
+x
f
t
+g
f
t
) w
t
n
f
t
r
t
k
f
t
]
s.t. c
f
t
+x
f
t
+g
f
t
F(k
f
t
, n
f
t
)
all quantities non-negative
3. The market clears: c
f
t
= c
t
, x
f
t
= x
t
, k
f
t
= k
t
, n
f
t
= n
t
, and g
f
t
= g
t
for all t.
4. The governments budget balances:
t=0
p
t
g
t
=
t=0
[r
t
kt
k
t
+w
t
nt
n
t
]
Part (b)
Without loss of generality, let n = 1. I assume that the utility function is strictly increasing and F has CRS.
Then the rst three of the households contraints hold with equality and = 0. I can then eliminate the
constraint on the law of motion for capital by replacing x
t
with k
t+1
(1 )k
t
in the budget constraint:
t=0
p
t
(c
t
+k
t+1
) =
t=0
[w
t
(1
nt
)n
t
+ [r
t
(1
kt
)k
t
+p
t
(1 )]k
t
]
I can also replace l
t
with 1 n
t
throughout. For simplicity, I will use the shorthand u
c
(t) to refer to
u
c
(c
t
, 1 n
t
, g
t
), etc. Let be the multiplier on the budget constraint. Then the FOCs for the household
are:
c
t
:
t
u
c
(t) = p
t
, t
k
t+1
: p
t
= r
t+1
(1
kt+1
) +p
t+1
(1 ), t
n
t
:
t
u
l
(t) = w
t
(1
nt
), t
Note that there is no FOC for g
t
. This is because the consumer does not choose g
t
; he takes it as given.
Since the market clears, we can replace c
f
t
with c
t
(and the same for the other quantities) in the rms
FOCs. Since the rm maximizes prots, it will not waste resources, i.e., c
t
+x
t
+g
t
= F(k
t
, n
t
). Therefore
we can eliminate the resource constraint in the rms problem by replacing c
t
+x
t
+g
t
with F(k
t
, n
t
) in the
rms objective function. The rms FOCs are:
k
t
: p
t
F
k
(t) = r
t
, t
n
t
: p
t
F
n
(t) = w
t
, t
23
WLOG, assume that p
0
= 1. Using the households FOC for c
t
, we get
p
t
=
t
u
c
(t)
u
c
(0)
.
Using the rms FOCs to substitute into the households FOCs, we obtain the following equations that
characterize the equilibrium allocations:
u
c
(t)
u
c
(t + 1)
= [(1
kt+1
)F
k
(t + 1) + 1 ], t
u
l
(t)
u
c
(t)
= (1
nt
)F
n
(t), t
Since F has CRS, the rms prots are zero, so
t=0
p
t
(c
t
+x
t
+g
t
) =
t=0
[r
t
k
t
+w
t
n
t
].
Subtracting the households budget constraint from this equation, we see that
t=0
p
t
(c
t
+x
t
+g
t
)
t=0
p
t
(c
t
x
t
) =
t=0
[r
t
k
t
+w
t
n
t
]
t=0
[r
t
(1
kt
)k
t
+w
t
(1
nt
)n
t
].
This implies that
t=0
p
t
g
t
=
t=0
[r
t
kt
k
t
+w
t
nt
n
t
]
so the governments budget constraint is satisifes. This shows that the governments budget constraint is
redundant.
With the above results, we have shown that given taxes and government spending, a TDCE in this
economy is a sequence of prices p
t
, r
t
, w
t
t=0
and a sequence of allocations allocations c
t
, k
t+1
, n
t
t=0
characterized by the following conditions:
p
t
=
t
u
c
(t)
u
c
(0)
, t (1)
r
t
= p
t
F
k
(t), t (2)
w
t
= p
t
F
n
(t), t (3)
u
c
(t)
u
c
(t + 1)
= [(1
kt+1
)F
k
(t + 1) + 1 ], t (4)
u
l
(t)
u
c
(t)
= (1
nt
)F
n
(t), t (5)
c
t
+k
t+1
+g
t
= F(k
t
, n
t
) + (1 )k
t
, t (6)
t=0
p
t
(c
t
+k
t+1
) =
t=0
[w
t
(1
nt
)n
t
+ [r
t
(1
kt
)k
t
+p
t
(1 )]k
t
] (7)
Part (c)
Rearrange (7) as follows:
t=0
[p
t
c
t
w
t
(1
nt
)n
t
] =
t=0
[r
t
(1
kt
)k
t
+p
t
(1 )k
t
p
t
k
t+1
].
Substituting (3), we get
t=0
[p
t
c
t
p
t
F
n
(t)(1
nt
)n
t
] =
t=0
[r
t+1
(1
kt
)k
t
+p
t
(1 )k
t
p
t
k
t+1
].
24
Pulling out some terms for period 0, we get
t=0
[p
t
c
t
p
t
F
n
(t)(1
nt
)n
t
] = F
k
(0)(1
k0
)k
0
+ (1 )k
0
+
t=0
[r
t+1
(1
kt+1
)k
t+1
+p
t+1
(1 )k
t+1
p
t
k
t+1
]
lim
T
p
T
k
T+1
.
From the households FOCs, we know that the second term on the RHS iz zero. I assume the transversality
condition holds. Then the third term is zero as well. Thus we have
t=0
[p
t
c
t
p
t
F
n
(t)(1
nt
)n
t
] = F
k
(0)(1
k0
)k
0
+ (1 )k
0
.
Substituting (1), we have
t=0
t
u
c
(0)
[u
c
(t)c
t
u
c
(t)F
n
(t)(1
nt
)n
t
] = F
k
(0)(1
k0
)k
0
+ (1 )k
0
.
Substituting (5) and moving u
c
(0) to the RHS, we get
t=0
t
[u
c
(t)c
t
u
l
(t)n
t
] = u
c
(0)k
0
[F
k
(0)(1
k0
) + (1 )]. (8)
This is the implementability constraint. Together with (6), it completely characterizes the set of TDCE
allocations. Given a sequence of allocations that satises (6) and (8), we can nd the prices and taxes with
which the sequence is a TDCE.
Dene the set
A
1
=
_
c
t
, n
t
t=0
: (g
t
,
kt
,
nt
), (p
t
, r
t
, w
t
), (c
t
, k
t
, n
t
)
t=0
is a TDCE
_
.
Thus the Ramsey Problem is:
max
{ct,nt}
t=0
t=0
u(c
t
, n
t
, g
0
) s.t. c
t
, n
t
t=0
A
1
.
A
1
can also be described as
A
1
=
_
c
t
, n
t
t=0
: c
t
, n
t
t=0
satises (6) and (8)
_
.
So we can also write the Ramsey problem as
max
{ct,kt,nt}
t=0
,
t=0
t
u(c
t
, n
t
, g
t
)
s.t. c
t
+k
t+1
+g
t
= F(k
t
, n
t
) + (1 )k
t
t=0
t
[u
c
(t)c
t
u
l
(t)n
t
] = u
c
(0)k
0
[F
k
(0)(1
k0
) + (1 )]
k
0
Let be the multiplier on the implementability constraint. Dene W
0
(c
0
, n
0
, g
0
; ) as
W(c
0
, n
0
, g
0
; ) = u(c
t
, n
t
, g
0
) +[u
c
(0)k
0
(F
k
(0)(1
k0
) + (1 )) (u
c
(t)c
t
u
l
(t)n
t
)], t = 0
25
and V (c
t
, n
t
, g
t
; ) as
V (c
t
, n
t
, g
t
; ) = u(c
t
, n
t
, g
t
) [u
c
(t)c
t
u
l
(t)n
t
], t > 0.
Thus we can rewrite the Ramsey Problem as
max
{ct,kt,nt}
t=0
,
W
0
(c
0
, n
0
, g
0
; ) +
t=1
t
V (c
t
, n
t
, g
t
; )
s.t. c
t
+k
t+1
+g
t
= F(k
t
, n
t
) + (1 )k
t
k
0
Let
t
be the multiplier in the resource constraint.As before, I will use the shorthand V
c
(t) to refer to
V
c
(c
t
, n
t
, g
t
; ). The FOCs for this problem for all t > 0 are:
c
t
:
t
V
c
(t) =
t
n
t
:
t
V
l
(t) =
t
F
n
(t)
k
t+1
:
t
=
t+1
[F
k
(t + 1) + (1 )]
Using the rst and last FOCs, we obtain the following Euler equation that characterizes the Ramsey alloca-
tion:
V
c
(t)
V
c
(t + 1)
= [F
k
(t + 1) + (1 )], t > 0.
Assume that the system converges to a steady state. Then c
t
c
, k
t
k
, etc. The Euler equation

then implies that
V
c
()
V
c
()
= [F
k
() + (1 )]
or
1 = [F
k
() + (1 )]. (9)
Recall the Euler equation used to characterize all TDCE allocations:
u
c
(t)
u
c
(t + 1)
= [(1
kt+1
)F
k
(t + 1) + 1 ], t.
Since the Ramsey allocation is a TDCE, it must also satisfy this equation. Steady state convergence implies
that
u
c
()
u
c
()
= [(1
)F
k
() + 1 ]
or
1 = [(1
k
)F
k
() + 1 ]. (10)
So both (9) and (10) must hold at the steady state level of capital. This is only possible if
k
= 0. Thus
kt
0, so the Chamley-Judd result holds.
8 Fall 2008. II.2 (Victor, externality)
Part (a)
TO BE COMPLETED.
26
Part (b)
Let h
t
(z
0
, . . . , z
t
) denote the history of shocks up to period t. Let H
t
be the set of all possible histories. The
commodity space is
L =
_
(
1
,
2
,
3
) :
i
= l
it
(h
t
)
tN,htHt
, l
it
(h
t
) R i, t, h
t
, sup
t,ht
[l
it
(h
t
)[ < i = 1, 2, 3
_
.
The consumption sets are
X
i
=
_
x
i
L : c
i
t
(h
t
), k
i
t
(h
t1
)
tN,htHt
such that :
c
i
t
(h
t
), k
i
t
(h
t1
) 0, t, h
t
c
i
t
(h
t
) +k
i
t+1
(h
t
) x
i
1t
(h
t
) + (1 )k
i
t
(h
t1
)
k
i
t
(h
t1
) x
i
2t
(h
t
) 0
1 x
i
3t
(h
t
) 0
k
i
0
=

k
i
0
_
, i = s, n
The production set is
Y =
_
y L : 0 y
1t
(h
t
) z
t
(h
t
)F(y
2t
(h
t
), y
3t
(h
t
)), t, h
t
_
.
An Arrow-Debreu equilibrium in this economy is (x
s
, x
n
, y
) X
s
X
n
Y , N
s

, and a
continuous linear functional
: L R such that
(i) For i = s, n, x
i
argmax
x
i
X
i
,
(x
i
)0
U
i
(x
i
)
(ii) y
argmax
yY

(y)
(iii)
s
x
s
+ (1
s
)x
n
= y
(iv) N
s
= x
s
3
where
U
s
= E
_

t=0
t
_
(c
s
t
(h
t
))
1
1
+
_
1 x
s
3t
(h
t
)
1 N
s
t
(h
t
)
_
1/2
__
and
U
s
= E
_

t=0
t
_
(c
n
t
(h
t
))
1
1
_
_
.
Part (c)
The rst welfare theorem will hold when
s
= 0, in which case there is no externality and all agents have
locally nonsatiated preferences. When
s
> 0, the sociable agents choices of x
s
3
(their labor) has an
externality eect on the other sociable agents, but these agents do not take this eect into account when
choosing x
s
3
. Thus the rst welfare theorem will not hold when
s
> 0.
Part (d)
We need to know how much capital each type holds in the aggregate to know prices in the future. Therefore
the aggregate state is (z, K
s
, K
n
). I will let the agents trade contingent claims on capital goods. This allows
27
us to use a cash-in-hand individual state variable rather than one each for capital and bonds (in the case of
contingent claims on consumption goods). The problem of an agent of type i is
v
i
(z, K
s
, K
n
, a; G, H) = max
c,n,y,
b(z
)
_
u
i
(c, n, N
s
) +
zz
v
i
(z
, K
s
, K
n
, y +
b(z
); G, H)
_
s.t. c +y +
Z
q(z, K
s
, K
n
, z
b(z
) = [1 +r(z, K
s
, K
n
, N)]a +w(z, K
s
, K
n
, N)n
K
i
(z
) = G
i
(z, K
s
, K
n
, z
)
N
s
= H
s
(z, K
s
, K
n
)
N = H
A
(z, K
s
, K
n
)
c 0, y 0,

b(z
b(z
), n [0, 1]
where u
i
is the period utility utility given in the problem.
A rational expectations RCE is: (v
i
, g
i
y
, g
i
b
, h
i
)
i=s,n
, r
, w
, q
, G
, H
such that
(i) For i = s, n, (v
i
, g
i
y
, g
i
b
, h
i
) solves type is problem shown above given r
, w
, q
, G
, H
.
(ii) Prices are set by a competitive, prot-maximizing rm:
r
(z, K
s
, K
n
, N) = zF
k
(
s
K
s
+ (1
s
)K
n
, N)
w
(z, K
s
, K
n
, N) = zF
n
(
s
K
s
+ (1
s
)K
n
, N)
(iii) Representative agent conditions hold:
G
i
(z, K
s
, K
n
, z
) = g
i
y
(z, K
s
, K
n
, K
i
) +g
i
b
(z, K
s
, K
n
, K
i
, z
), i = s, n
H
s
(z, K
s
, K
n
) = h
s
(z, K
s
, K
n
, K
s
)
H
A
(z, K
s
, K
n
) =
s
h
s
(z, K
s
, K
n
, K
s
) + (1
s
)
(iv) The market for contigent claims clears:
s
g
s
b
(z, K
s
, K
n
, K
s
, z
) + (1
s
)g
n
b
(z, K
s
, K
n
, K
n
, z
) = 0, z
Z.
(v) No arbitrage condition holds:
Z
q(z, K
s
, K
n
, z
) = 1, (z, K
n
, K
s
).
Part (e)
Without contingent claims, the agents no longer choose

b(z
). Therefore we no longer need the claim prices

q nor conditions (iv) and (v). This means that the aggregate capital stocks tomorrow are known today with
certainty. The agents problem simplies to
v
i
(z, K
s
, K
n
, a; G, H) = max
c,n,y
_
u
i
(c, n, N
s
) +
zz
v
i
(z
, K
s
, K
n
, y; G, H)
_
s.t. c +y = [1 +r(z, K
s
, K
n
, N)]a +w(z, K
s
, K
n
, N)n
K
i
= G
i
(z, K
s
, K
n
)
N
s
= H
s
(z, K
s
, K
n
)
N = H
A
(z, K
s
, K
n
)
c 0, y 0, n [0, 1]
A rational expectations RCE is now: (v
i
, g
i
y
, h
i
)
i=s,n
, r
, w
, G
, H
such that
28
(i) For i = s, n, (v
i
, g
i
y
, h
i
) solves type is problem shown above given r
, w
, G
, H
.
(ii) Prices are set by a competitive, prot-maximizing rm:
r
(z, K
s
, K
n
, N) = zF
k
(
s
K
s
+ (1
s
)K
n
, N)
w
(z, K
s
, K
n
, N) = zF
n
(
s
K
s
+ (1
s
)K
n
, N)
G
i
(z, K
s
, K
n
) = g
i
y
(z, K
s
, K
n
, K
i
), i = s, n
H
s
(z, K
s
, K
n
) = h
s
(z, K
s
, K
n
, K
s
)
H
A
(z, K
s
, K
n
) =
s
h
s
(z, K
s
, K
n
, K
s
) + (1
s
)
Part (f)
In this scenario, the rm now has a dynamic problem:
(z, K, k; G, H) = max
k
,n
_
zF(k, n) k
w(z, K, N)n +q(z, K)
zz
(z
, K
, k
; G, H)
_
s.t. K
= G(z, K)
N = H
A
(z, K)
Let g
f
(z, K, k) denote the policy function for capital for this problem. Let a denote the value of an agents
shares in rms. His problem is now
v
i
(z, K, a; G, H) = max
c,n,a
b(z
)
_
u
i
(c, n, N
s
) +
zz
v
i
(z
, K
, a
b(z
); G, H)
_
s.t. c +q(z, K)a
Z
q(z, K, z
b(z
) = a +w(z, K, N)n
K
= G(z, K)
N
s
= H
s
(z, K)
N = H
A
(z, K)
c 0, y 0, n [0, 1]
Let g
i
a
and g
i
b
denote the policy functions shares of rms and contingent claims respectively.
NOT SURE WHETHER WE NEED TO KEEP TRACK OF BOTH TYPES SHARES. WHAT IS THE
AGGREGATE STATE?
Part (g)
TO BE COMPLETED.
Part (h)
TO BE COMPLETED.
Part (i)
TO BE COMPLETED.
29
9 Fall 2008, II.3 (Chari, cash-credit)
Part (a)
A competitive equilibrium in this economy is:
Allocations c
1t
, c
2t
, M
t
, B
t
t=0
;
Prices p
t
t=0
; and
Policy M
t
, B
t
, R
t
, T
t
t=0
such that:
1. Given prices and policy, the allocation solves the households problem:
max
{c1t,c2t,Mt,Bt}
t=0
t=0
t
u(c
1t
, c
2t
)
s.t. p
t
c
1t
M
t
M
t
+B
t
= (M
t1
p
t1
c
1t1
) p
t1
c
2t1
+p
t1
y +R
t1
B
t1
+T
t1
initial nominal holdings given, all quantities non-negative, no ponzi schemes
2. The governments budget constraint is satised:
M
t+1
M
t
+B
t+1
= T
t
+R
t
B
t
, t.
3. Markets clear for all t: c
1t
+c
2t
= y, M
t
= M
t
, B
t
= B
t
.
Part (b)
Since u is strictly increasing and strictly concave, FOCs are sucient for maximization. Let
t
be the
multiplier on the cash-in-advance constraint and let
t
be the multiplier on the securities market constraint.
I will use the shorthand u
1
(t) to refer to u
1
(c
1t
, c
2t
) (and the same for the second variable). The households
FOCs are:
c
1t
:
t
u
1
(t) =
t
p
t
+
t+1
p
t
(1)
c
2t
:
t
u
2
t =
t+1
p
t
(2)
M
t
:
t
=
t
+
t+1
(3)
B
t
:
t
= R
t+1
(4)
Note that since R > 1, the CIA constraint will bind in every period. A sucient condition for the constraint
to bind is
t
> 0. Looking at (4), R > 1 implies that
t+1
t
> 1 for all t. Rearranging gives us 1
t+1
t
> 0.
Multiplying both sides by
t
, we have
t
t+1
> 0. Looking at (3), this means that
t
> 0 for all t, so the
CIA constraint binds in every period.
Combining (1) and (2), we see that
u
1
(t)
u
2
(t)
=

t
+
t+1
t+1
, t.
Using (3), we get
u
1
(t)
u
2
(t)
=

t
t+1
, t
and using (4), we get
u
1
(t)
u
2
(t)
=
R
t+1
t+1
, t.
30
Thus we get the following relationship between c
1t
and c
2t
:
u
1
(t)
u
2
(t)
= R, t. (5)
The resource constraint is
c
1t
+c
2t
= y, t. (6)
Looking at the resource constraint, we can write the equilibrium value of c
2t
in terms of c
1t
:
c
2t
= y c
1t
.
Using this substituting, we can rewrite (b.5) as a function of c
1t
only:
u
1
(c
1t
, y c
1t
)
u
2
(c
1t
, y c
1t
)
= R, t. (7)
This single equation fully characterizes the set of equilibrium real allocations. Call this set A
R
. Since R
and y are constant, the values of c
1t
that solve these equations are the same for every period. Then we can
express A
R
as
A
R
=
_
c
1
R
+
:
u
1
(c
1
, y c
1
)
u
2
(c
1
, y c
1
)
= R
_
.
Claim: A
R
is a singleton.
Proof: Suppose not. Then there exists c
1
, c
1
A
R
such that c
1
,= c
1
. Since (7) is a FOC and both c
1
and c
1
both satisfy it, it must be that both c
1
and c
1
maximize u(x, y x). In other words, u(c
1
, y c
1
) =
u(c
1
, y c
1
). But since u is strictly concave, any linear combination of (c
1
, y c
1
) and (c
1
, y c
1
) will give
strictly higher utility than (c
1
, y c
1
). This contradicts the fact that c
1
A
R
, so it must be that A
R
is a
singleton.
Now we want to characterize the equilibrium values of the nominal variables. We know that c
1t
=
c
1t+1
= c
1
and c
2t
= c
2t+1
= y c
1
for all t. Equality in the CIA constraint implies that
M
t+1
M
t
=
p
t+1
p
t
c
1
c
1
=
p
t+1
p
t
. (8)
Divide (2) for period t + 1 by (2) for period t:
u
2
(t + 1)
u
2
(t)
=

t+2
t+1
p
t+1
p
t
, t.
Using (4), we get
u
2
(t + 1)
u
2
(t)
=

t+2
R
t+2
p
t+1
p
t
, t.
Then
p
t+1
p
t
= R
u
2
(t + 1)
u
2
(t)
, t. (9)
Since equilibrium values of the consumption goods are constant, I will use u
1
and u
2
to refer to u
1
(c
1
, y c
1
)
and u
2
(c
1
, y c
1
) respectively. Then u
2
(t) = u
2
(t + 1) = u
2
for all t, so (9) becomes
p
t+1
p
t
= R
u
2
u
2
= R, t.
With (8) and the market clearing condition, this implies that
M
t+1
M
t
=
M
t+1
M
t
=
p
t+1
p
t
= R, t. (10)
So the growth rates of both money and prices are constant in equilibrium.
31
Given the results above, we can write the securities market constraint as
p
t
c
1
+B
t
= p
t1
y p
t1
(y c
1
) +R
t1
B
t1
+T
t1
.
This simplies to
p
t
c
1
+B
t
= p
t1
c
1
+R
t1
B
t1
+T
t1
. (11)
We can use (11) along with the government budget constraint to calculate the other nominal variables in
terms of p
0
.
Suppose M
t
, B
t
, p
t
, T
t
t=0
form an equilibrium with the unique equilibrium real allocation c
1
. Then
M
t
, B
t
, p
t
, T
t
t=0
satisfy (10), (11) and the GBC. Looking at these equations, we can see that for any > 0,
M
t
, B
t
, p
t
, T
t
t=0
also satisfy (10), (11) and the GBC. Therefore > 0, M
t
, B
t
, p
t
, T
t
t=0
also
form an equilibrium with c
1
, so the equilibrium is not unique.
Part (c1)
The same FOCs as in part (b) are valid here. They are rewritten below using the specied utility function:
c
1t
:

t
c
1t
=
t
p
t
+
t+1
p
t
(12)
c
2t
:

t
c
2t
=
t+1
p
t
(13)
M
t
:
t
=
t
+
t+1
(14)
B
t
:
t
= R
t
t+1
(15)
Note that in (15), the interest rate is no longer constant. By all 4 of the FOCs in part (c1), we know that
u
1
(t)
u
2
(t)
=
c
2t
c
1t
= R
t+1
. (16)
Divide (13) for period t + 1 by period t:
u
2
(t + 1)
u
2
(t)
=
c
2t
c
2t+1
=

t+2
t+1
p
t+1
p
t
, t.
Using (15), we get
u
2
(t + 1)
u
2
(t)
=
c
2t
c
2t+1
=

t+2
R
t+1
t+2
p
t+1
p
t
, t.
Rearranging, we get
R
t+1
=
1
u
2
(t)
u
2
(t + 1)
p
t+1
p
t
=
1
c
2t+1
c
2t
p
t+1
p
t
.
Assume the CIA constraint holds with equality. Using (16) in (17), we get
R
t+1
=
1
c
1t+1
c
1t
Mc
1t
Mc
1t+1
which simplies to
R
t+1
=
1
. (17)
c
1t
+c
2t
= y. (18)
So (16) - (19) characterize the equilibrium real allocations and interest rate given prices.
Since money supply is constant and the markets clear, M
t
= M for all t. Then the securities market
constraint becomes
B
t
= p
t1
c
1t1
p
t1
c
2t1
+p
t1
y +R
t1
B
t1
+T
t1
(19)
and the GBC is
B
t+1
= T
t
+R
t
B
t
. (20)
Equations (16) - (20) characterize the equilibrium.
32
Part (c2)
By (12),
t1
u
2
(t 1)
p
t1
=
t
.
By (13),
t
u
1
(t)
p
t
=
t+1
+
t
.
Using (14), we get
u
1
(t)
p
t
=
u
2
(t 1)
p
t1
.
Multiply both sides by

M:
u
1
(t)

M
p
t
=
u
2
(t 1)

M
p
t1
.
I assume the cash-in-advance constraint is binding for all t. Then p
t
c
1t
=

M, so the previous equation
becomes
u
1
(t)c
1t
= u
2
(t 1)c
1t1
.
As in the previous section, c
2t
= y c
1t
. Thus we have
u
1
(c
1t
, y c
1t
)c
1t
= u
2
(c
1t1
, y c
1t1
)c
1t1
.
The problem states that F(c
1
) = c
1
u
2
(c
1
, y c
1
) and G(c
1
) = c
1
u
1
(c
1
, y c
1
). So we can rewrite the last
equation as
F(c
1t
) = G(c
1t1
). (21)
Suppose the economy converges to a steady-state level c
1
. Then c
1
is characterized by
F(c
1
) = G(c
1
).
Take a rst-order Taylor expansion of (21) around c
1
:
F
(c
1
)(c
1t
c
1
) = G
(c
1
)(c
1t1
c
1
).
This can be rearranged as
c
1t
c
1
=
G
(c
1
)
F
(c
1
)
(c
1t1
c
1
). (22)
The problem states that
F
(c
1
)
G
(c
1
)
<
so
c
1t
c
1
< c
1t1
c
1
. (23)
Therefore c
1t
c
1
. This implies that the economy has a continuum of equilibria, each converging to c
1
,
indexed by c
10
. For each equilibrium, the sequence c
1t
t=0
is given by (22).
10 Spring 2008, I.1 (Larry, DP)
Since log c
t
is strictly increasing, the resource contraint will hold with equality. Since n
t
doesnt enter the
objective function, we know that n
t
= 1for all t. Then we can rewrite the set of 5 contraints as
c
t
= Ak
t
h
1
t
k
t+1
h
t+1
+k
t+1
(1
k
) +h
t+1
(1
h
) 0 (1)
(h
0
, k
0
) = (h, k) given (2)
33
Dene the feasibility correspondence : R
2
+
R
2
+
by
(h
t
, k
t
) = (h
t+1
, k
t+1
) R
2
+
: s.t. (1) holds.
Dene (h, k) as the set of feasible sequences given (h, k), i.e., (h
, k
) (h, k) if (h
0
, k
0
) = (h, k) and
(h
t+1
, k
t+1
) (h
t
, k
t
) for all t > 0. Then we can rewrite V (h, k) as
V (h, k) = sup
(h
,k
)(h,k)
t=0
t
log(c
t
)
where c
t
is given by (1) for all t.
Proposition. Suppose that (h
, k
) attains V (h, k). Then for > 0, (h
, k
) attains V (h, k).

Proof. First note that
A(k
t
)
(h
t
)
1
= Ak
t
h
1
t
.
Then the resource constraint is homogeneous of degree one in (h, k), so is also homogeneous of degree one
in (h, k). This implies that (h
, k
) (h, k).
Suppose for contradiction that (h
, k
) does not attain V (h, k). Then (h
, k
) (h, k) such
that
t=0
t
log(c
t
) >
t=0
t
log(c
t
).
Since (h
, k
) (h, k), homogeneity of implies that

_
h
,
k
_
(h, k). Note that log(c
t
) = log() +
log(c
t
). This implies that log(c
t
) is homothetic, i.e., log(x) = log(y) log(x) = log(y). Then
t=0
t
log
_
c
_
>
t=0
t
log(c
t
).
But this is a contradiction since (h
, k
) attains V (h, k). Therefore it must be that (h
, k
) attains
V (h, k).
The above proposition implies that we can express V (h, k) as
V (h, k) = sup
(h
,k
)(h,k)
t=0
t
log(c
t
)
where c
t
is given by (1). Since log(c
t
) = log() + log(c
t
), this can be rewritten as
V (h, k) = sup
(h
,k
)(h,k)
log()
1
+
t=0
t
log(c
t
)
=
log()
1
+ sup
(h
,k
)(h,k)
t=0
t
log(c
t
)
=
log()
1
+V (h, k)
= B() +V (h, k)
11 Spring 2008, I.2 (Chari, optimal asset allocation)
Part (a)
Since the agents lifetime ends after period T, we know that he will consume all of his wealth in that period,
i.e.,
V
T
(W
T
) = u(W
T
).
34
For all t < T, the dynamic program representing the agents decision can be written as
V
t
(W
t
) = max
ct+xt+ytWt
_
u(c
t
) +E[V
t+1
(Rx
t
+R
f
y
t
)]
_
Part (b)
We can express x
t
and y
t
as
t
W
t
and (1
t
)W
t
respectively, where
t
[0, 1]. Then we can rewrite the
DP as
V
t
(W
t
) = max
ctWt, t[0,1]
_
u(c
t
) +E[V
t+1
((W
t
c
t
)(
t
R + (1
t
)R
f
))]
_
Proposition. V
t
(W
t
) = a
t
u(W
t
) for all t T, and the optimal choice
t
does not depend on t, i.e.,
t
=
for all t.
Proof. We know that V
T
(W
T
) = u(W
T
), so a
T
= 1. Now suppose that V
t+1
= a
t+1
u(W
t+1
) for some unique
a
t+1
that is independent of W
t+1
. Then
V
t
(W
t
) = max
ctWt, t[0,1]
_
u(c
t
) +E[a
t+1
u((W
t
c
t
)(
t
R + (1
t
)R
f
))]
_
Note that given the specication of the utility function, u(ab) = (1 )u(a)u(b). Then
V
t
(W
t
) = max
ctWt, t[0,1]
_
u(c
t
) +u(W
t
c
t
)(1 )a
t+1
E[u(
t
R + (1
t
)R
f
)]
_
Since E[u(
t
R + (1
t
)R
f
)] does not depend on W
t
, we can rewrite this as
V
t
(W
t
) = max
ctWt
_
u(c
t
) +u(W
t
c
t
)(1 )a
t+1
max
t[0,1]
_
E[u(
t
R + (1
t
)R
f
)]
_
_
Let
Q
t
= (1 )a
t+1
max
t[0,1]
_
E[u(
t
R + (1
t
)R
f
)]
_
Then
V
t
(W
t
) = max
ctWt
_
u(c
t
) +u(W
t
c
t
)Q
t
_
The utility function is strictly increasing and strictly concave and the constraint set is compact and convex,
so rst-order conditions are sucient for a maximum. The FOC for c
t
is
u
(c
t
) = u
(W
t
c
t
)Q
t
Plugging in the specication of the utility function, this is
c
t
= (W
t
c
t
)
Q
t
or
c
t
= (W
t
c
t
)Q
1/
t
Solving for c
t
, we get
c
t
=
Q
1/
t
W
t
1 +Q
1/
t
=
W
t
1 +Q
1/
t
Plugging this solution into the last expression of the dynamic program, we have
V
t
(W
t
) = u
_
W
t
1 +Q
1/
t
_
+u
_
W
t

W
t
1 +Q
1/
t
_
Q
t
_
35
Using homotheticity of the utility function again, we can rewrite this as
V
t
(W
t
) = u(W
t
)
_
u
_
1
1 +Q
1/
t
_
+u
_
1
1
1 +Q
1/
t
__
Q
t
Let
a
t
=
_
u
_
1
1 +Q
1/
t
_
+u
_
1
1
1 +Q
1/
t
__
Q
t
Then we have
V
t
(W
t
) = a
t
u(W
t
)
Recall that
Q
t
= (1 )a
t+1
max
t[0,1]
_
E[u(
t
R + (1
t
)R
f
)]
_
Since R is i.i.d., the value of max
t[0,1]
_
E[u(
t
R + (1
t
)R
f
)]
_
is the same for all t, and the solution
will be the same for all t as well. Then we can write
Q
t
= (1 )a
t+1
max
[0,1]
_
E[u(R + (1 )R
f
)]
_
Since u is strictly concave, there is a unique
such that
argmax
[0,1]
_
E[u(R + (1 )R
f
)]
_
Then
Q
t
= (1 )a
t+1
E[u(
R + (1
)R
f
)]
Therefore the agent will always allocate the same portion of his disposable wealth (W
t
c
t
) to the risky
asset. In other words, his portfolio allocation is constant for all t < T.
12 Spring 2008, I.3 (Victor, bargaining/monopolistic competi-
tion)
Part (a)
I dont really see what he is asking. I will assume that there are only ten periods, so once those ten periods
is up, everyone dies. The worker either takes the oer and works for 10 periods earning w, or rejects the
oer and gets 0.1 per period plus 0.5 in each of the rst 5 periods. I assume that a zero interest rate implies
a discount rate of 1. Then the value of taking the oer is
V
E
(w) = 10w
and the value of rejecting the oer is
V
U
= 0.1(10) + 0.5(5) = 3.5.
The minimum wage w
that the worker would take solves

V
E
(w
) = V
u
10w
= 3.5 w
= 0.35.
Part (b)
The value of the rm is
(w) = 10 10w.
The rm gets nothing if it doesnt hire the worker, so the rms threat point is 0. The workers threat point
is V
U
. Thus the Nash bargaining solution with the worker having twice the weight of the rm is
w = argmax
w
(10 10w)
1/3
(V
E
(w) V
U
)
2/3
= argmax
w
(10 10w)
1/3
(10w 3.5)
2/3
36
Part (c)
Let W denote the representative consumers wealth. His utility functions strictly increasing in all goods, so
the budget constraint will hold with equality. Then his problem is
max
{c(i)}
i[0,A]
_
_
A
0
c(i)
di
_
1/
s.t.
_
A
0
p(i)c(i) di = W.
The FOCs for this problem are
c(i) : U
1/1
c(i)
1
= p(i)
:
_
A
0
p(i)c(i) di = W
where
U =
_
A
0
c(i)
di.
This implies that
p(i)
p(j)
=
c(i)
1
c(j)
1
, i, j [0, A].
or
p(i)c(i) =
p(j)c(i)
c(j)
1
, i, j [0, A].
Integrating over i, we get
M =
_
A
0
p(i)c(i) di =
p(j)
c(j)
1
_
A
0
c(i)
= U
p(j)
c(j)
1
, j [0, A].
Thus
p(j) =
W
U
c(j)
1
, j [0, A]. (1)
Each rm solves
(i) = max
p(i),c(i)
p(i)c(i) c(i).
Plugging in the result we got above about the consumers demand, this problem becomes
(i) = max
c(i)
W
U
c(i)
c(i).
The FOC of this problem is
W
U
c(i)
1
= .
Plugging in our formula for p(i) in (1) above, we get
p(i) =

.
Rearranging the FOC a bit, we have
U
W
c(i) = c(i)
.
If we integrate, we get
U
W
c =
_
A
0
c(i) di =
_
A
0
c(i)
= U.
37
Then we have an expression for industry output:
c =
W
.
If the rms are owned by the workers, the representative consumers problem is now
max
{c(i)}
i[0,A]
_
_
A
0
c(i)
di
_
1/
s.t.
_
A
0
p(i)c(i) di = W +
_
A
0
(i) di.
The consumer takes prots as given, so the analysis above. . . TO BE COMPLETED.
13 Spring 2008, I.4 (Perri, IFP)
Part (a)
Both utility functions are strictly concave and the constraint sets are convex, so FOCs are sucient for
maximization. The FOCs for consumer 1 are
c
1
t
:
t
(b
1
2b
2
c
1
t
) =
1
t
a
1
t+1
:
1
t
= E
t
[(1 +r)
1
t+1
]
This implies that
b
1
2b
2
c
1
t
= (1 +r)E
t
[b
1
2b
2
c
1
t+1
or simply
c
1
t
= (1 +r)E
t
[c
1
t+1
].
Since (1 +r) = 1, we have
c
1
t
= E
t
[c
1
t+1
].
This implies that
c
1
t
= E
t
[c
1
t+j
], j 0. (1)
In other words, c
1
t
is a martingale. Iterating on consumer 1s budget constraint starting with period t, taking
expectations, and using the transversaility condition
E
0
_
lim
t
_
1
1 +r
_
t
a
1
t
_
= 0,
we have
j=0
_
1
1 + r
_
j
E
t
[c
1
t+j
] =
j=0
_
1
1 +r
_
j
E
t
[y
1
t+j
] + (1 +r)a
1
t
.
Using (1), we have
j=0
_
1
1 +r
_
j
c
1
t
=
j=0
_
1
1 +r
_
j
E
t
[y
1
t+j
] + (1 +r)a
1
t
.
This simplies to
c
1
t
=
r
1 +r
_
_
j=0
_
1
1 +r
_
j
E
t
[y
1
t+j
]
_
_
+ra
1
t
. (2)
We know that for all j > 0, E
t
[y
1
t+j
] = y. Thus
c
1
t
= y +
r
1 +r
1
t
+ra
1
t
. (3)
38
For consumer 2, the form of the utility function will implies that c
2
t
will not be a martingale. Instead
we will use guess and verify method on the dynamic program
V (a, y) = max
c,a
u(c) +E[V (a
, y
)]
s.t. c 0
c +a
= (1 +r)a +y
I assume V is strictly concave and dierentiable at x. The FOCs are
c : u
(c) =
a
: E[V
1
(a
, y
)] =
This implies the rst order condition
u
(c) = E[V
1
(a
, y
)]. (4)
The envelope condition for a is
V
1
(a, y) = (1 +r)
or
V
1
(a, y) = (1 +r)E[V
1
(a
, y
).
Since (1 +r) = 1, this becomes
V
1
(a, y) = E[V
1
(a
, y
)]. (5)
Combining (4) and (5) gives
u
(c) = (1 +r)V
1
(a, y). (6)
Guess that
V (a, y) =
1
r
e
r(a+By+D)
Then
V
1
(a, y) = e
r(a+By+D)
.
Using this in (6) gives
e
c
= e
r(a+By+D)
.
Taking logs, we have
c = r(a +By +D) log(1 +r).
Thus our candidate policy function for consumption is
c = r
_
a +By +D +
1
r
log(1 +r)
_
. (7)
Looking back at (5), if we plug in the guess and do some substitutions, we get
e
r(a+By+D)
= E
_
e
r(a
+By
+D)
_
= E
_
e
r((1+r)a+yc+B y+B
+D)
_
= e
r((1+r)a+yc+B y+D)
E
_
e
rB
_
Then we have
e
rc
= e
r(ra+(1B)y+B y)
E
_
e
rB
_
.
We can solve this for c:
c = r
_
a +
1 B
r
y +
B
r
y
1
r
log
_
E
_
e
rB
__
_
. (8)
39
Comparing with (7), we see that B =
1
1+r
and
D =
B
r
y
1
r
log
_
E
_
e
rB
__
1
r
log(1 +r).
This veries the guess. Thus our consumption policy function for type 2 is
c = r
_
a +
1
1 +r
y +
1
r(1 +r)
y
1
r
log
_
E
_
e
r
1+r
__
_
.
Note that
E[e
r
1+r
] = e
2
r
2
2
2(1+r)
2
.
Then type 2s consumption is
c = r
_
a +
1
1 +r
y +
1
r(1 +r)
y
r
2
2(1 +r)
2
_
. (9)
Lets rewrite (9) a little bit:
c =
r
1 +r
y +
1
1 +r
y +ra
r
2
2(1 +r)
2
.
Since y = y +, we have
c =
r
1 +r
( y +) +
1
1 +r
y +ra
r
2
2(1 +r)
2
.
This simplies to
c = y +
r
1 +r
+ra
r
2
2(1 +r)
2
.
Adding time subscripts and denoting consumer 2s consumption by c
2
t
, we have
c
2
t
= y +
r
1 +r
2
t
+ra
2
t

r
2
2(1 +r)
2
. (10)
Comparing (10) to (3), we can see that if we assume that a
1
t
= a
2
t
and
1
t
=
2
t
, consumer 2s consumption is
lower by exactly
r
2
2(1+r)
2
.
Part (b)
Note that if consumer 1 starts with zero assets and receives a shock of zero in every period, (3) implies that
c
1
t
= y, t. Let denote
r
2
2(1+r)
2
. If consumer 2 also starts with zero assets and receives a shock of zero in
every period, (10) implies that his consumption and asset paths are as follows:
t c
2
t
a
2
t
0 y 0
1 y +r
2 y + 2r 2
.
.
.
.
.
.
.
.
.
t y +tr t
and so on. Thus c
2
t
starts out below c
1
t
, but once t is large enough so that tr > , c
2
t
will be larger than
c
1
t
. This is because (1 + r) = 1 implies that both consumers value consumption in all periods equally (so
they have no incentive to borrow), but the uncertainty in type 2s income causes precuationary saving so
that type 2s assets go to innity.
40
14 Spring 2008, II.1 (Larry, DP)
Part (a)
Let C(X) be the set of continuous, bounded, real-valued functions dened on X. We know that C(X) is
a Banach space. Since C
(X) is a closed subset of C(X), C
(X) can be viewed as a Banach space itself.

In order to show that T
has a xed point, we need to show that T
and T
satisfy Blackwells suciency

conditions. Let f, g C
(X) such that f(k) g(k) for all k X. Then for any k X,
max
k
(k)
g(k
) max
k
(k)
f(k
).
Thus T
g(k) T
f(k) and T
g(k) T
f(k). Therefore T
and T
both satisfy monotonicity. I assume that

,

(0, 1). Then T
satises discounting since

T
(f +a)(k) = max
k
(k)
u(F(k) k
) +[f(k) +a]
= max
k
(k)
u(F(k) k
) +f(k) +a
= max
k
(k)
u(F(k) k
) +f(k) +a
= T
(f)(k) +a
Similarly, T
(f +a) = T
(f)+

a, so T
satises discounting as well. Thus both operators satisfy Blackwells

suciency conditions, so both are contractions. Since C
(X) is a Banach space, the Contraction Mapping

Theorem implies that T
and T
each have a unique xed point in C
(X).
Part (b)
Since v
(; ) is the xed point for T
,
v
(k; ) = max
k
(k)
u(F(k) k
) +v
(k
; ).
g
(; ) is the policy function associated with v
(; ), so
g
(k; ) argmax
k
(k)
u(F(k) k
) +v
(k
; ).
Thus g
(k; ) must satisfy the FOC:

u
(F(k) g
(k; )) = v
(g
(k; ); ).. (1)

Part (c)
Given the initial guess v
(k, ), we have
v
1
(k;

) = T
(v
(k; )) = max
k
(k)
u(F(k) k
) +

v
(k; ).
g
1
(;

) is the policy function associated with v
1
(;

), so
g
1
(k;

) argmax
k
(k)
u(F(k) k
) +

v
(k
; ).
Thus g
1
(k;

) must satisfy the FOC:
u
(F(k) g
1
(k;

)) =

v
(g
1
(k;

); ).. (2)
41
Part (d)
I assume that u is strictly concave. Suppose for contradiction that k such that g
1
(k;

) g
(k; ). Then
strict concavity of u implies
u
(F(k) g
(k; )) u
(F(k) g
1
(k;

)).
By (1) and (2), we have
v
(g
(k; ); )

v
(g
1
(k;

); ).
Since v
(; ) is weakly concave,
v
(g
(k; ); ) v
(g
1
(k;

); ).
Since <

,
v
(g
(k; ); ) <

v
(g
1
(k;

); ).
This is a contradiction, so it just be that g
1
(k;

) > g
(k; ) for all k X.

Part (e)
Since v
(; ) and v
1
(;

) are dierentiable and weakly concave, we obtain the following envelope conditions
(see Th 4.10 in SLP; weak concavity is sucient for the envelope condition to hold):
v
(k; ) = u
(F(k) g
(k; ))F
(k) (3)
v
1
(k;

) = u
(F(k) g
1
(k;

))F
(k) (4)
By part (d), g
1
(k;

) > g
(k; ). Then by strict concavity of u,

u
(F(k) g
(k; )) < u
(F(k) g
1
(k;

))
so (3) and (4) imply that v
(k; ) < v
1
(k;

) for all k X.
Part (f)
Proposition. g
n
(k;

) > g
(k; ) and v
n
(k;

) > v
(k; ), k X, n N.
Proof. By induction. By part (d) we have g
1
(k;

) > g
(k; ), k X. By part (e), v
(k; ) < v
1
(k;

), k
X. Thus the conditions hold for n = 1. Now suppose that g
n1
(k;

) > g
(k; ) and v
n1
(k;

) > v
(k; )
for all k X. We have the following FOC and envelope condition for v
n
(;

) and g
n
(;

):
u
(F(k) g
n
(k;

)) =

v
n1
(g
n
(k;

);

) (5)
v
n
(k;

) = u
(F(k) g
n
(k;

))F
(k) (6)
Suppose for contradiction that k X such that g
n
(k;

) g
(k; ). By strict concavity of u,

u
(F(k) g
n
(k;

)) u
(F(k) g
(k; )).
Then by (1) and (5),
n1
(g
n
(k;

);

) v
(g
(k; ); ).
Since

> , this implies that
v
n1
(g
n
(k;

);

) < v
(g
(k; ); ).
Since g
n
(k;

) g
(k; ) and v
is weakly concave,
v
(g
(k; ); ) v
(g
n
(k;

); ).
But then we have
v
n1
(g
n
(k;

);

) < v
(g
n
(k;

); )
42
which contradicts the assumption of the induction. Therefore it must be that g
n
(k;

) > g
(k; ) for all

k X. Then by strict concavity of u,
u
(F(k) g
(k; )) < u
(F(k) g
n
(k;

)), k X.
By (3) and (6), we have
v
(k; ) < v
n
(k;

), k X.
Since the conditions hold for n = 1 and arbitrary n given that they hold for n 1, induction implies
that g
n
(k;

) > g
(k; ) and v
n
(k;

) > v
(k; ), k X, n N.
15 Spring 2008, II.2 (Victor, recursive competitive equilibrium)
Part (a)
The utility function is locally nonsatiated so the rst welfare theorem will hold. Therefore we can just use
the FOCs from the planners problem to get the following three equations that characterize the steady state
equilibrium:
AF
K
(K
, N
A
) = 1
0.5(1 N
A
N
B
)
0.5
= AF
N
(K
, N
A
)
0.5(1 N
A
N
B
)
0.5
= (C
We can use the second two equations to get the following condition:
AF
N
(K
, N
A
) = 1.
So if we want to have N
A
= N
B
= 0.5, we just have to solve the system
AF
K
(K
, 0.5) = 1
AF
N
(K
, 0.5) = 1
Since we have two equations and two unknowns we will be able to get the answer.
Part (b)
The commodity space is
L =
_
(
1
,
2
,
3
) :
i
= l
it
(h
t
)
tN,htHt
, l
it
(h
t
) R i, t, h
t
, sup
t,ht
[l
it
(h
t
)[ < i = 1, 2, 3
_
.
The consumption sets are
X =
_
x L : (c
i
t
(h
t
), k
i
t
(h
t1
), n
i
t
(h
t
))
i=A,B
tN,htHt
such that :
c
i
t
(h
t
), k
i
t
(h
t1
), n
i
t
(h
t
) 0, t, h
t
, i
c
A
t
(h
t
) +k
A
t+1
(h
t
) x
1t
(h
t
)
c
B
t
(h
t
) +k
B
t+1
(h
t
) = n
B
t
(h
t
)
k
A
t
(h
t1
) k
B
t
(h
t1
) x
2t
(h
t
) 0
n
A
t
(h
t
) = x
i
3t
(h
t
)
0 n
A
t
(h
t
) +n
B
t
(h
t
) 1
k
i
0
=

k
i
0
_
, i = s, n
43
The production set is
Y =
_
y L : 0 y
1t
(h
t
) z
t
(h
t
)AF(y
2t
(h
t
), y
3t
(h
t
)), t, h
t
_
.
An Arrow-Debreu equilibrium without reworks is (x
, y
) X Y and a continuous linear functional
such that
(i) x
argmax
xX,
(x)0
U(x)
(ii) y
argmax
yY

(y)
(iii) x
= y
where U(x) is the consumers lifetime utility.

Part (c)
We can write the consumers problem in recursive form as
V (z, K, a; G, H
A
) = max
c,n
A
,n
B
,a
_
u(c, n
A
+n
B
, 0) +
zz
V (z
, K
; G, H
A
)
_
s.t. c +a
= r(z, K, N
A
)a +w(z, K, N
A
)n
A
+n
B
n
A
+n
B
1
K
= G(z, K)
N
A
= H
A
(z, K)
non-negativity
where u(c, n, P) is the consumers period utility.
A rational expectations RCE is: (V
, g
, h
A
, h
B
), r
, w
, G
, H
A
such that:
(i) (V
, g
, h
A
, h
B
) solves the consumers problem shown above given r
, w
, G
, H
A
(ii) r
and w
are marginal products of a prot-maximizing rm:

r
(z, K, N
A
) = zAF
K
(K, N
A
)
w
(z, K, N
A
) = zAF
N
(K, N
A
)
G
(z, K) = g
(z, K, K)
H
A
(z, K) = h
(z, K, K)
Part (d)
TO BE COMPLETED.
Part (e)
I assume home production is not counted in GDP. Then we want
P
= 0.1AF(K
, H
(1, K
))
where all starred variables are steady-state values. We are going to tax all income, so we have
P
= [r
(1, K
, H
A
(1, K
))K
+w
(1, K
, H
A
(1, K
))H
A
(1, K
)].
44
I assume that F is homogeneous of degree one in (K, N
A
). Then by Eulers theorem,
AF
K
(K, N
A
)K + AF
N
(K, N
A
)N
A
= AF(K, N
A
).
Since r
and w
are marginal products, this implies that

P
= AF(K
, H
(1, K
)).
Thus = 0.1.
Part (f)
Now we are just taxing labor income. Then
P
= w
(1, K
, H
A
(1, K
))H
A
(1, K
) = AF
N
(K
, H(1, K
)).
This means that
= 0.1
AF(K
, H
(1, K
))
AF
N
(K
, H(1, K
))
.
Part (g)
If sector B becomes a market activity, then the equilibrium wage must be the same in both sectors. Let
H
B
(z, K) denote h
B
(z, K, K). Assuming that we still are not counting sector B in GDP, we have
P
= 0.1AF(K
, H
(1, K
))
and
P
= w
(1, K
, H
A
(1, K
))[H
A
(1, K
) +H
B
(1, K
)].
Thus
= 0.1
AF(K
, H
(1, K
))
w
(1, K
, H
A
(1, K
))[H
A
(1, K
) +H
B
(1, K
)]
.
If we count sector B in GDP, then this changes to
P
= 0.1[AF(K
, H
(1, K
)) +H
B
(1, K
)]
P
= w
(1, K
, H
A
(1, K
))[H
A
(1, K
) +H
B
(1, K
)]
= 0.1
AF(K
, H
(1, K
)) +H
B
(1, K
)
w
(1, K
, H
A
(1, K
))[H
A
(1, K
) +H
B
(1, K
)]
Part (h)
Lump-sum taxes are nondistortionary so I would choose to fully nance the reworks with a lump-sum tax
of 10% of GDP, i.e.,
T = 0.1AF(K
, H
A
(1, K
))
or
T = 0.1[AF(K
, H
A
(1, K
)) +H
B
(1, K
)]
depending on whether we could sector be as part of GDP.
45
Part (i)
Since sector B is now intermediated by rms, we can simplify the consumers labor choice so that he just
chooses his total amount of labor. Again, the wages in both sectors have to be the same in equilibrium. The
consumers problem in recursive form as
V (z, K, B, a, b; G, H
A
, H
B
, ,

P,
t) = max
c,n
A
,n
B
,y,b
_
u(c, n, P) +
zz
V (z
, K
, b
; G, H
A
, H
B
, ,

P,
t)
_
s.t. c +y +b = (1 )[r(z, K, B)(a +b) + w(z, K, B)n]
n 1
K
= G(z, K, B)
P =

P(z, K, B)
= (z, K, B)
non-negativity
where u(c, n, P) is the consumers period utility.
A rational expectations RCE is: (V
, g
a
, g
b
, h
), r
, w
, G
, H
A
, H
B
,
,

P
, such that:
(i) (V
, g
a
, g
b
, h
) solves the consumers problem shown above given r
, w
, G
, H
A
, H
B
,
,

P
(ii) r
and w
are marginal products of a prot-maximizing rm:

r
(z, K, B) = zAF
K
(K, H
A
(z, K, B))
w
(z, K, B) = zAF
N
(K, H
A
(z, K, B))
G
(z, K, B) = g
a
(z, K, B, K, B)
H
A
(z, K, B) +H
B
(z, K, B) = h
(z, K, B, K, B)
(z, K, B) = g
b
(z, K, B)
(iv) The governments budget constraint holds:
r
(z, K, B)B+

P
(z, K, B) = (z, K, B)[r
(z, K, B)(K+B)+w(z, K, B)(H

A
(z, K, B)+H
B
(z, K, B))]+
(z, K, B)
where
P(z, K, B) =
0.5
_
(1 )(z, K, B)[r
(z, K, B)(K +B) +w(z, K, B)(H

A
(z, K, B) +H
B
(z, K, B))] G
(z, K, B)
(z, K, B)
_
.
16 Spring 2008, II.3 (Chari, search and human capital)
Part (a)
Given human capital h and an oer of z, the value of the choice faced by the worker is
V (z, h) = maxV
E
(zh), V
U
(h)
where
V
E
(zh) = (zh)
+(1 )V
E
(zh) +V
U
(zh)
represents the value of becoming employed, and
V
U
(h) =
_
1
0
V (h, z
)dz
46
represents the value of searching. We can also represent the workers problem with a single functional
equation:
V (h, z) = max
_
(zh)
+(1 )V (zh, 1) +
2
_
1
0
V (zh, z
)dz
,
_
1
0
V (h, z
)dz
_
Two notes about this formulation: (1) I have allowed the worker to quit his job (although he will never quit
a job he has already accepted); (2) We can use of dz
instead of dF(z
) since z is uniformly distributed and

i.i.d.
Part (b)
There are two primary issues facing us in solving this problem using dynamic programming. First, the return
function (zh)
is unbounded. We cannot reasonably restrict the state space so that the set of possible values
of h is bounded since > 1; a worker who is never red will have human capital that goes to innity. Thus
we must nd another method of working around this problem. Second, we would like to be able to show that
the value function is homogeneous of degree in order to make part (c) easy. Fortunately, we can apply the
principles of dynamic programming to the space of continuous, homogeneous functions (without requiring
them to be bounded in the usual sense) to handle both issues simultaneously. See Stokey (1996) for a full
treatment.
I assume 0 < < 1, 0 < < 1, and
1
>
. Let X = R
+
and Z = [0, 1]. Dene H
(X Z) as the
space of functions f : X Z R that are continuous, homogeneous of degree in h, and bounded in the
norm
|f| = sup
x=1,xX
zZ
[f(x, z)[
Equipped with this norm, H
(X Z) is a Banach space. This is because there is a continuous, one-to-one

relationship (homeomorphism) between H
and the space of continuous and bounded functions dened on

1 Z (which we know is a Banach space when endowed with the usual sup norm). Completeness is a
topological property, so completeness of the latter space implies completeness of the former. Note that in
this problem, X is one-dimensional, so our norm is equivalent to
|f| = sup
zZ
[f(1, z)[
Dene the operator T as
Tf(h, z) = max
_
(zh)
+(1 )f(zh, 1) +
2
_
1
0
f(zh, z
)dz
,
_
1
0
f(h, z
)dz
_
Let f H
. Then
Tf(h, z) = max
_
h
+h
(1 )f(z, 1) +h
_
1
0
f(z, z
)dz
, h
_
1
0
f(1, z
)dz
_
= h
max
_
z
+(1 )f(z, 1) +
2
_
1
0
f(z, z
)dz
,
_
1
0
f(1, z
)dz
_
= h
Tf(1, z)
Since z
is bounded by 1, T : H
. We want to show that T satises a slightly modied version of

Blackwells Suciency Conditions:
(i) Monotonicity: If f(h, z) g(h, z), (h, z), then Tf(h, z) Tg(h, z), (h, z).
(ii) Discounting: (0, 1) such that T(f +a)(h, z) Tf(h, z) +ah
, where (f +a)(h, z) is dened as

(f +a)(h, z) = f(h, z) +a|h|
, or in this case simply (f +a)(h, z) = f(h, z) +ah
since X = R
+
.
47
Let f, g H
such that f(h, z) g(h, z) for all h, z X Z. Then it is clear that Tf(h, z) Tg(h, z) for
all h, z X Z, so T satises monotonicity. Note that this is exactly the same monotonicity condition as
in the standard Suciency Conditions. T also satises discounting:
T(f +a)(h, z) = T(f(h, z) +ah
)
= T(h
(f(1, z) +a))
= h
T(f(1, z) +a)
= h
max
_
z
+(1 )(f(z, 1) +a) +

2
_
1
0
(f(1, z
) +a)dz
,
_
1
0
(f(1, z
) +a)dz
_
= h
max
_
z
+(1 )f(z, 1) +
2
_
1
0
f(1, z
)dz
+a[(1 ) +],
_
1
0
f(1, z
)dz
+a
_
h
max
_
z
+(1 )f(z, 1) +
2
_
1
0
f(1, z
)dz
,
_
1
0
f(1, z
)dz
_
+ah
= h
Tf(1, z) +ah
= Tf(h, z) +ah
To see that these modied conditions imply that T is a contraction of modulus , rst note that for any
f, g H
,
f(h, z) = g(h, z) + [f(h, z) g(h, z)] g(h, z) +h
|f g|, (h, z).

Using monotonicity and discounting, we have
Tf(h, z) T(g(h, z) +h
|f g|) Tg(h, z) +h
|f g|.
Similarly, since
g(h, z) = f(h, z) + [g(h, z) f(h, z)] f(h, z) +h
|f g|, (h, z),

our modied suciency conditions imply
Tg(h, z) Tf(h, z) +h
|f g|.
Thus
[Tf(h, z) Tg(h, z)[ h
|f g|
By homogeneity of f and g (and the fact that h 0),
h
[Tf(1, z) Tg(1, z)[ h
|f g|
Cancelling out h
on both sides, we nd that for all z Z,

[Tf(1, z) Tg(1, z)[ |f g|.
Thus
sup
zZ
[Tf(1, z) Tg(1, z)[ |f g|.
Going back to the denition of our norm, we see that this is equivalent to
|Tf Tg| |f g|.
Thus T is a contraction of modulus .
Since H
is a Banach space, the Contraction Mapping Theorem implies that T has a xed point V H
.
Therefore V as dened in part (a) is continous and homogeneous of degree . Now suppose that f is weakly
increasing in (h, z). Since (zh)
is increasing in (h, z), so is Tf. By the rst Corollary to the Contraction

Mapping Theorem, V is also weakly increasing in (h, z). Finally, note that V (0, z) = 0 for all z Z, since
the worker will always produce nothing when he chooses to work regardless of the state and there are no
unemployment benets.
48
We will prove that V has the reservation wage property by contradiction. Fix h 0. First, suppose for
contradiction that given an oer of 0, the worker chooses to work, i.e.,
V (h, 0) = (1 )V (0, 1) +
2
_
1
0
V (0, z
)dz
>
_
1
0
V (h, z
)dz
.
Then by the above observation that V (0, z) = 0 for all z Z,
0 >
_
1
0
V (h, z
)dz
.
This contradicts the fact that V is weakly increasing in h, so it must be that the worker chooses to search:
V (h, 0) =
_
1
0
V (h, z
)dz
(1 )V (0, 1) +
2
_
1
0
V (0, z
)dz
,
i.e., V (h, 0) = V
U
(h).
Now suppose for contradiction that given an oer of 1, the worker chooses to search rather than work,
i.e.,
V (h, 1) =
_
1
0
V (h, z
)dz
+(1 )V (h, 1) +
2
_
1
0
V (h, z
)dz
.
Note that since V is weakly increasing in z,
_
1
0
V (h, z
)dz
V (h, 1). Then

V (h, 1) V (h, 1) < V (h, 1)
Contradiction. Therefore
V (h, 1) = h
+(1 )V (h, 1) +
2
_
1
0
V (h, z
)dz
>
_
1
0
V (h, z
)dz
,
i.e., V (h, 1) = V
E
(h).
Since V is continuous, the Intermediate Value Theorem implies that z
(h) such that

(z
(h)h)
+(1 )V (z
(h)h, 1) +
2
_
1
0
V (z
(h)h, z
)dz
=
_
1
0
V (h, z
)dz
.
Since
(zh)
+(1 )V (zh, 1) +
2
_
1
0
V (zh, z
)dz
is strictly increasing in z while
_
1
0
V (h, z
)dz
.
is constant with respect to z, z
(h) is unique for each h X. In other words, we can express V (h, z) as

V (h, z) =
_
(zh)
+(1 )V (zh, 1) +
2
_
1
0
V (zh, z
)dz
if z z
(h)
_
1
0
V (h, z
)dz
if z z
(h)
Thus V has the reservation wage property.
Part (c)
Fix h X. Then at z
(h),
V (h, z
(h)) = (z
(h)h)
+(1 )V (z
(h)h, 1) +
2
_
1
0
V (z
(h)h, z
)dz
=
_
1
0
V (h, z
)dz
49
By homogeneity of V ,
h
V (1, z
(h)) = h
_
(z
(h))
+(1 )V (z
(h), 1) +
2
_
1
0
V (z
(h), z
)dz
_
= h
_
1
0
V (1, z
)dz
_
So
(z
(h))
+(1 )V (z
(h), 1) +
2
_
1
0
V (z
(h), z
)dz
=
_
1
0
V (1, z
)dz
Thus we have characterized z
(h) by an equation that is independent of the value of h. Therefore z
(h) = z
,
i.e., the reservation wage does not depend on h.
For an in-depth discussion of DP with homogeneous functions, see:
Stokey, Nancy. A Note on Dynamic Programming with Homogeneous Functions. Discussion Paper
109. Federal Reserve Bank of Minneapolis. March 1996.
17 Spring 2008, II.4 (Perri, Ayagari)
Part (a)
A CE in this economy is
allocations z
A
= c
At
, b
At
t=0
and z
B
= c
Bt
, k
t
, b
Bt
t=0
prices r
bt
, r
kt
, w
t
t=0
i) z
A
solves the artists problem:
max
{cAt,bAt}
t=0
t=0
t
log(c
At
)
s.t. b
At
(1 +r
bt
) +w
t
= c
At
+b
At+1
b
At+1
0
b
A0
= 0
ii) z
B
solves the bankers problem:
max
{cBt,kBt,bBt}
t=0
t=0
t
log(c
Bt
)
s.t. b
At
(1 +r
bt
) +k
t
(1 +r
kt
) = c
Bt
+b
Bt+1
+k
t+1
b
Bt+1
0
b
B0
= 0, k
0
given
iii) The rm chooses l
t
and k
t
to maximize prots, i.e., w
t
and r
kt
equal marginal products of capital
and labor respectively: w
t
= (1 )k
t
and r
kt
= k
1
t
.
iv) Markets clear: c
At
+c
Bt
+k
t+1
= k
t
, t and b
At
+b
Bt
= 0, t.
Since the consumers utility functions are strictly increasing and strictly concave and their constraint sets
are convex, FOCs are necessary and sucient for maximization. Let
it
and
it
be the lagrange multipliers
on type is budget and borrowing constraints respectively (i = A, B). For the artist, FOCs are
c
At
:

t
c
At
=
At
, t (1)
b
At+1
:
At
= (1 +r
bt
)
At+1
+
At
, t (2)
At
: b
At
(1 +r
bt
) +w
t
= c
At
+b
At+1
, t (3)
At
: b
At+1
0, t (4)
50
For the banker, the FOCs are
c
Bt
:

t
c
Bt
=
Bt
, t (5)
k
t+1
:
Bt
= (1 +r
kt
)
Bt+1
, t (6)
b
Bt+1
:
Bt
= (1 +r
bt
)
Bt+1
+
Bt
, t (7)
Bt
: b
At
(1 +r
bt
) +k
t
(1 +r
kt
) = c
Bt
+b
Bt+1
+k
t+1
, t (8)
Bt
: b
Bt+1
0, t (9)
The market clearing conditions are
c
At
+c
Bt
+k
t+1
= k
t
, t (10)
b
At
+b
Bt
= 0, t (11)
Equations (1) - (11) characterize the equilibrium.
Part (b)
Since the economy is closed, the market clearing condition dictates that in a steady state equilibrium,
aggregate saving must be zero, i.e., b
A
+b
B
= 0. Therefore a steady state equilibrium in which b
A
> 0 and
b
B
> 0 does not exist. Another way to look at this is to see that if the borrowing constraints for both the
artist and the banker are not binding,
At
=
Bt
= 0 for all t. Thus (2) and (7) imply that
At
= (1 +r
bt
)
At+1
,
Bt
= (1 +r
bt
)
Bt+1
Using (1) and (5) plus the fact that in a steady state equilibrium, c
it
= c
it+1
= c
i
, t, i = A, B, this gives
us
t
c
A
= (1 +r
bt
)
t+1
c
A
,
t
c
B
= (1 +r
bt
)
t+1
c
B
or
1 = (1 +r
bt
) = (1 +r
bt
).
This contradicts the fact that > . Note that this logic applies even when the borrowing constraint is
relaxed so that
b < 0; regardless of how stringent the constraint is, there can be no stationary equilibrium
in which the borrowing constraint does not bind for both agents.
Part (c)
Because the nor borrowing constraint means that neither the artist nor the banker can borrow, market
clearing dictates that
b
A
= b
B
= 0. (12)
Using (5) and (6) and the fact that c
Bt
= c
Bt+1
= c
B
in a steady state, we have
1 +r
k
=
1
which implies that

r
k
=
1
. (13)
51
We already know from (iii) that r
k
= k
1
and w = (1 )k
. Thus we know k and thus w as well:

k =
_
1
_ 1
1
. (14)
Then
w = (1 )
_
1
_
1
. (15)
Given (12), the bankers budget constraint in the steady state is
c
B
= r
k
k = k
.
Using (14) gives us
c
B
=
_
1
_
1
. (16)
Market clearing implies that
c
A
= k
k c
B
.
Using (14) and (16), we have
c
A
= (1 )
_
1
_
1
_
1
_ 1
1
. (17)
Finally, note that (6) and (7) imply that
r
b
r
k
. (18)
Equations (12) - (18) give the equilibrium variables in terms of the structural parameters.
Part (d)
Note that (13) - (15) still hold in the new steady state. By the second argument in part (b), we know that
we cannot have b
A
>
b and b
B
>
b. Therefore it must be that either b

A
=
b or b
B
=

b.
If b
B
=
b then b
A
=

b by market clearing. Since the artists borrowing constraint is not binding, (1) -
(2) impliy that
r
b
=
1
.
But this implies that r
b
> r
k
, which contradicts (18).
Thus in the new steady state it must be that b
A
=
b and b
B
=

b. Since the bankers borrowing
constraint is not binding, (5) - (7) imply that r
b
= r
k
. Then the bankers budget constraint says that
c
B
= r
k
k +r
b
b > r
k
k. (19)
This implies that c
B
is higher in the new steady state. Since k is the same in both steady states, this implies
that c
A
is lower. Since utilities are strictly increasing, the bankers welfare is higher while the artists is
lower.
Part (e)
Let T be the period in which liberalization occurs. Since we know that both w and r
k
are the same in both
steady states, guessing that w
t
and r
kt
stay at the initial steady state levels is the same as saying that they
are constant for all t T. Looking at (5) and (6), this means that
1 +r
k
=

Bt
Bt+1
=
c
Bt+1
c
Bt
, t T.
52
We know from part (c) that
1 +r
k
=
1
, t T.
This implies that c
Bt
= c
Bt+1
, t T. But this is a contradiction since we know that the bankers
consumption is higher in the new steady state than the initial one. Therefore it cannot be that w
t
, r
kt
, and
r
bt
are constant at the initial steady state levels throughout the transition.
Part (f)
We know that the bankers consumption is higher in the new steady state than the initial one, so the bankers
consumption must rise during the transition as it converges to the new level. Looking at the the answer for
part (e), this implies that r
kt
must decrease during the transition. Since it must eventually converge to the
smae value as in the initial steady state, this implies that r
kt
must jump up above
1
at the beginning of
the transition and converge downward towards that value. Since
k
t
=
_
r
kt
_ 1
1
and < 1, this implies that k
t
must jump downward at the beginning of the transition and converge upward
towards its steady state value (which must be the same in both steady states since r
k
is the same). Since
w
t
= (1 )k
t
, w
t
must also jump down at the beginning of the transition and converge upward. FInally,
since we know that r
b
r
k
in any steady state and r
b
= r
k
in the new steady state, r
b
must weakly rise
(wont go down) during the transition.
Part (g)
The statement is false. We know that in the new steady state the artist is worse o, so the only way the
artist could be better of after capital liberalization is that he has higher welfare during the transition. Since
w
t
drops at the beginning of the transition, the artists constraint set is not necessarily larger during the
transition than it was at the initial steady state.
18 Fall 2007, I.1 (Larry, TDCE)
Part (a)
Let consumer allocation c
t
, x
t
, k
t
t=0
and rm allocation c
f
t
, x
f
t
, k
f
t
t=0
form a TDCE with prices p
t
, r
t
t=0
and taxes implies by scal policy 1. Suppose for contradiction that there exists another feasible set of
allocations
( c
t
, x
t
,
k
t+1
t=0
, c
f
t
, x
f
t
,
k
f
t+1
t=0
)
such that
t=0
t
u( c
t
) >
t=0
t
u(c
t
)
I assume that the consumers utility function is strictly increasing. Then hus budget constraint will hold
with equality in any TDCE. Thus it must be that c
t
, x
t
,
k
t+1
t=0
is unaordable given prices p
t
, r
t
t=0
,
i.e.,
t=0
p
t
( c
t
+ x
t
) >
t=1
r
t
k
t
+r
0
(1
2
k0
)
k
0
+T
2
0
Given the specication of
2
k0
and T
2
0
, this is equivalent to
t=0
p
t
( c
t
+ x
t
) >
t=1
r
t
k
t
+r
0
(1
2
k0
)
k
0
+r
0
2
k0
k
0
=
t=0
r
t
k
t
(1)
53
Consider the rms problem:
max
{c
f
t
,x
f
t
,k
f
t
}
t=0
t=0
[p
t
(c
f
t
+x
f
t
) r
t
k
f
t
] s.t. c
f
t
+ x
f
t
Ak
f
t
The production technology has constant returns to scale, so prots will be zero in equilibrium. Thus
t=0
p
t
(c
f
t
+x
f
t
) =
t=0
r
t
k
f
t
Prot maximization requires
c
f
t
+x
f
t
= Ak
f
t
, t
The rm allocation c
f
t
, x
f
t
,
k
f
t+1
t=0
cannot yield higher prots than the TDCE rm allocation, so it must
be that
t=0
p
t
( c
f
t
+ x
f
t
)
t=0
r
t
k
f
t
Feasibility requires that

k
t
=

k
f
t
for all t. Thus
t=0
r
t

k
t
=
t=0
r
t
k
f
t
Then
t=0
p
t
( c
f
t
+ x
f
t
)
t=0
r
t
k
t
Combined with (1), this implies that
t=0
p
t
( c
t
+ x
t
) >
t=0
p
t
( c
f
t
+ x
f
t
)
But feasibility requires that c
t
= c
f
t
and x
t
= x
f
t
for all t, so this is a contradiction. Therefore
(c
t
, x
t
, k
t
t=0
, c
f
t
, x
f
t
, k
f
t
t=0
)
is Pareto optimal given the specied TDCE prices.
Part (b)
We know that the following Euler equation will hold for all t in any CE allocation under scal policy i:
u
(c
i
t
) = u
(c
i
t+1
)[(1
i
kt+1
)A + 1 ]
Given the specication of the utility function, this is written as
(c
i
t
)
= (c
i
t+1
)
[(1
i
kt+1
)A + 1 ]
Solving for c
i
t+1
, we get
c
i
t+1
= c
i
t
([(1
i
kt+1
)A + 1 ])
1
Given the specications of the tax policies, we get the following two policy-specic equations:
c
1
t+1
= c
1
t
([(1
1
k
)A + 1 ])
1
and
c
2
t+1
= c
2
t
([A + 1 ])
1
54
Thus the growth rates of consumption are
1
= ([(1
1
kt+1
)A + 1 ])
1
and
2
= ([A + 1 ])
1
Since
1
k
< 0 for all t,
1
>
2
.
The above dierence equations imply that c
i
t
= (
i
)
t
c
i
0
. Thus
c
1
t
= c
1
0
([(1
1
k
)A + 1 ])
t
and
c
2
t
= c
2
0
([A + 1 ])
t
Then we get the following ratio:

c
1
t
c
2
t
=
c
1
0
c
2
0
[(1
1
k
)A + 1 ]
t
[A + 1 ]
t
Part (c)
Suppose that c
1
0
c
2
0
. Since
1
>
2
, this implies that c
1
t
c
2
t
for all t, with strict inequality for all t > 0.
Then
t=0
t
u(c
1
t
) >
t=0
t
u(c
2
t
)
The resource constraint is the same under both scal policies, so the TDCE allocation under FP1 is feasible
under FP2. This contradicts the fact that the TDCE allocation under FP2 is Pareto optimal. Therefore it
must be that c
2
0
> c
1
0
.
19 Fall 2007, I.2 (Perri, Ayagari)
Part (a)
Assume that a maximum level of asset holdings a
max
exists. Let A = [0, a
max
], let Y = 1, 1+, and let
S = A Y . Let B denote the borel -algebra for S. A stationary competitive equilibrium in this economy
is
a value function v : S R
policy functions a
: S A and c : S R
+
demand for savings K(r) = 0 for all r
interest rate r
stationary measure
such that given r,

i) For the dynamic program below, a
and c solve the dynamic program and v is the associated value

function:
v(a, y;
) = max
c,a
u(c) +E [v(a
, y
)]
s.t. c +a
= (1 +r)a +y
a
0
55
ii) The asset market clears:
_
AY
a
(a, y) d
(a, y) = K(r) = 0.
Note that we do not need to explicitly include a market-clearing condition for the consumption good since
Walras law guarantees that the market for consumption will clear if the markets for all the other goods
clear.
iii) For all A Y B,
satises
(A Y ) =
_
AY
Q((a, y), A Y ) d
(a, y)
where Q is a transition function dened as
Q((a, y), A Y ) =
Y
Ia
(a, y) A(y
, y).
Note that (y
, y) = 1/2 for all y, y
Y .
Since no agent can borrow, market clearing implies that a
(a, y) = 0 for all a, y S. Thus we can write

the policy function for consumption as a simple function of the endowment: c(a, y) c(y). Let y
L
and y
H
denote 1 and 1 + respectively. The budget constraint implies that c(y
L
) = y
L
and c(y
H
) = y
H
.
I assume that v is strictly concave and dierentiable. Since u is strictly increasing and strictly concave
and the constraint set is convex, FOCs are necessary and sucient for maximization. The FOCs are:
c : u
(c) =
a
: = E[v
a
(a
, y
)] +
where and are the multipliers on the budget and borrowing constraints respectively. We can put these
together to get
u
(c) E[v
a
(a
, y
)]. (1)
v
a
(a, y;
) = (1 +r)
or
v
a
(a, y;
) = (1 +r)u
(c). (2)
Combining (1) and (2) yields
u
(c) (1 +r)E[u
(c
)]. (3)
Given that Y = y
L
, y
H
, (y
, y) = 1/2, y, y
Y , and c(y
i
) = y
i
, i = L, H, we can write (3) as
u
(c)
(1 +r)
2
[u
(y
L
) +u
(y
H
)] .
Using the specication of the utility function, we have
c
(1 +r)
2
_
y
L
+y
.
Note that this must hold for all possible values of c, i.e., y
L
and y
H
. Since y
H
> y
L
, y
H
< y
L
. Thus the
more restrictive condition is
y
H

(1 +r)
2
_
y
L
+y
.
This implies that
1 +r
2y
H
(y
L
+y
H
)
.
Therefore
r
=
2y
H
(y
L
+y
H
)
1.
Looks like this implies that any interest rate belonging to (, r
] is consistent with stationary equilibrium,

not [r
, ). Must be a mistake in the question.

56
Part (b)
(Draw the usual Ayagari graph, show where r
is and why it has to go up for aggregate demand for saving

to be positive.)
In period t, the government wants to borrow g, so supply of saving is K(r) = g in period t. In order for
the market to clear, we need aggregate demand for saving to be positive, i.e.,
_
AY
a
(a, y) d
(a, y) = g.
Since no consumers will save when r r
, it must be that r
t
> r
in order to induce some consumers to

save (loan the government money). This implies that aggregate consumption in period t is lower than in the
previous periods, i.e., c
t
< 1 (the continuum of agents has a measure of 1, so aggregate consumption under
autarky is 1).
In period t+1, the government pays back its bonds, so the agents who bought the bonds will have higher
income than in the normal steady state. This means that they will have higher demand for saving at every
interest rate, so in order for aggregate demand for saving to be zero, we need the interest rate to be lower
than r
, the maximum steady state interest rate in when no agent has extra income. Thus r
t+1
< r
. Since
aggregate saving is zero but aggregate income is more than 1 due to the extra income some consumers get
from the government bonds, it must be that c
t+1
> 1.
Is this right or should the interest rates be shifted forward by one period?
Part (c)
Suppose r
t
is not high enough to induce agents with low income to buy bonds, so only agents with high
income buy the bonds. Since autarky is still an option for all agents but the high-income agents now choose
to buy bonds in period t, those agents must be strictly better o. However, agents with low income are still
in autarky so the economy with government investment only weakly Pareto dominates the economy without
the investment.
It is possible though that if the investment is large enough, it will require r
t
to be high enough so as
to induce all consumers to buy bonds. In this case, all agents are strictly better o in the economy with
government investment, so the Pareto dominance is strict.
20 Fall 2007, I.3 (Chari, optimal asset allocation)
See Spring 2008, I.2
21 Fall 2007, II.1 (Larry, durable goods)
Part (a)
Proposition. Since u
1
and u
2
are strictly increasing, we can write the specied problem as
max
{dt+1}
t=0
t=0
t
F(d
t
, d
t+1
)
s.t.
_
d
t+1
(d
t
) R
+
d
0
given
Proof. Since u
1
and u
2
are strictly increasing, the rst two constraints will hold with equality. Then we can
express c
t
as a function of d
t
, d
t+1
and the parameter w:
c
t
= w d
xt
= w + (1 )d
t
d
t+1
57
Then the objective function is
t=0
t
u
1
(w + (1 )d
t
d
t+1
) +u
2
(d
t
)
Dene F : R
2
R by
F(d
t
, d
t+1
) = u
1
(w + (1 )d
t
d
t+1
) +u
2
(d
t
)
Then the objective function can be rewritten again as
t=0
t
F(d
t
, d
t+1
)
Dene : R
+
R
+
by
(d
t
) = d
t+1
R
+
: w + (1 )d
t
d
t+1
0
Note that this ignores the constraint that d
xt
= d
t+1
(1 )d
t
0. So the rst two constraints can be
replaced with the constraint that d
t+1
(d
t
). Thus the sequence problem is
max
{dt+1}
t=0
t=0
t
F(d
t
, d
t+1
)
s.t.
_
d
t+1
(d
t
) R
+
d
0
given
Part (b)
The Bellman equation for this problem is
v(d) = max
d
(d)
F(d, d
) +v(d
)
where
F(d, d
) = u
1
(w + (1 )d d
) +u
2
(d)
Part (c)
Let C(X) be the set of continuous and bounded functions dened on X = R
+
. Let S
C(X) be the subset

of weak;y increasing, weakly concave functions, and let S
be the subset of strictly increasing, strictly

concave functions.
Proposition. Suppose u
1
, u
2
S
. Then v S
.
Proof. We want to show that Assumptions 4.3-4.8 in SLP are satised.
A4.3 X is a convex subset of R and the correspondence : X X is nonempty, compact-valued and
continuous.
A4.4 F : X
2
X is continuous and bounded, and 0 < < 1.
A4.5 For each d
, F(, d
) is strictly increasing in its rst argument.

A4.6 is monotone in the sense that if x, x
X such that x
x, then (x) (x
).
A4.7 F is strictly concave, i.e., for any z, z
in the graph of and any (0, 1), F(z + (1 )z
) >
F(z) + (1 )F(z
).
58
A4.8 is convex in the sense that if x, x
X and [0, 1], then for all y (x) and all y
(x
),
y + (1 )y
(x + (1 )x
).
R
+
is a convex subset of R. We can write (d) as [0, w + (1 )d]. Since w + (1 )d is a continuous
function of d, (d) is continuous. Thus A4.3 is satised.
Since S
C(X), all elements of S
are continuous and bounded. Then u

1
and u
2
are continuous and
bounded, so F is continuous and bounded. I assume 0 < < 1. Then A4.4 is satised.
u
1
and u
2
are strictly increasing since they are both elements of S
. Then F is strictly increasing in its

rst argument. Then A4.5 is satised.
Let x, x
X such that x x
. Then w+(1)x
w+(1)x, so [0, w+(1)x] [0, w+(1)x
].
Then (x) (x
), so A4.6 is satised.
u
1
and u
2
are strictly concave since they are both elements of S
. In particular, this implies that

u
1
(w + (1 )d d
) is strictly concave in both d and d
. Then F is strictly concave in (d, d
), so A4.7 is
satised.
Let x, x
X, let y (x) and y
(x
), and let [0, 1]. Then

0 y w + (1 )x
and
0 y
+ (1 )x
Multiplying the rst inequality by , the second by 1 and combining, we have

0 y + (1 )y
(w + (1 )x) + (1 )(w + (1 )x
) = w + (1 )(x + (1 )x
)
Thus y + (1 )y
(x + (1 )x
), so is convex. Then A4.8 is satised.

Dene T as
Tf(x) = max
y(x)
F(x, y) +f(y)
Let f C(X). Then since A4.3 holds, F is continuous and is nonempty, compact-valued and continuous.
Then by the Theorem of the Maximum, Tf is contonuous. f is bounded by assumption and F is bounded
since A4.3 holds. Then Tf is bounded, so Tf C(X). Thus T : C(X) C(X).
Let f, g C(X) such that f(x) g(x) for all x X. Then Tf(x) Tg(x). Dene (f + a)(x) as
f(x) +a. Then
T(f +a)(x) = max
y(x)
F(x, y) +(f +a)(y)
= max
y(x)
F(x, y) +[f(y) +a]
= max
y(x)
F(x, y) +f(y) +a
= Tf(x) +a
Thus Blackwells suciency conditions are satised, so T is a contraction of modulus . recall that C(X) is
a Banach space with the norm |f| = sup
xX
[f(x)[. Then the Contraction Mapping Theorem implies that
T has a xed point v C(X), so v is continuous and bounded. Moreover, the theorem of the maximum
implies that the policy correspondence
G(x) = argmax
y(x)
F(x, y) +v(y)
is nonempty-valued, compact-valued and upper hemicontinuous.
Let f S
. Then f is continous, bounded, weakly increasing and weakly concave. Let x, x
X such
that x
> x. Then f(x
) f(x). By A4.5, F(x
, y) > F(x, y). Let y (x) attain Tf(x) and let y
(x
)
attain Tf(x
). By A4.6, y (x
). Thus
Tf(x
) = F(x
, y
) +f(y
)
F(x
, y) +f(y)
> F(x, y) +f(y)
= Tf(x)
59
where the second line comes from the fact that y (x
) and y
G(x
). Therefore Tf is strictly increasing.

Now let x, x
X and let [0, 1]. Let y (x) attain Tf(x) and let y
(x
) attain Tf(x
). Let
x
= x + (1 )x
and y
= y + (1 )y
. Since f is weakly concave,

f(y
) f(y) + (1 )f(y
).
By A4.7, F is strictly concave. Then
F(x
, y
) > F(x, y) + (1 )F(x
, y
).
A4.8 implies that y
(x
). Then
Tf(x
) F(x
, y
) +f(y
)
> [F(x, y) +f(y)] + (1 )[F(x
, y
) +f(y
)]
= Tf(x) + (1 )Tf(x
)
where the rst line comes from the denition of T and the fact that y
(x
). Therefore Tf is strictly
concave.
Thus we have Tf(S
) S
. Recall that the sets of weakly increasing and weakly concave functions are
closed subsets of C(X). Then the intersection of those two sets, the set of weakly increasing and weakly
concave functions, is also closed. Thus S
is a closed subset of C(X). Then by the rst corollary to the

Contraction Mapping Theorem, the xed point of T is an element of S
. In other words, v is strictly

increasing and strictly concave.
Part (d)
Since u
1
and u
2
are continuously dierentiable on the interior of X, so is F. Since Theorem 4.8s assumptions
(A4.3-4.4, A4.7-4.8) hold, the solution to the Bellman equation in part (b) is single-valued. Denote this policy
function by g
(d). The envelope condition for this problem is given by

v
(d) = F
1
(d, g
(d)).
Substituting the denition of F from part (b), this can be written as
v
(d) = u
1
(w + (1 )d g
(d))(1 ) +u
2
(d).
The FOC for this problem is
F
2
(d, g
(d)) = v
(g
(d))
or
u
1
(w + (1 )d g
(d)) = v
(g
(d)).
Part (e)
Combining the envelope and rst-order conditions, we get the following Euler equation:
u
1
(w + (1 )d g
(d)) = [u
1
(w + (1 )g
(d) g
(g
(d)))(1 ) +u
2
(g
(d))].
In a steady state, d
= g
(d
). Thus any potential steady states are characterized by

u
1
(w d
) = [u
1
(w d
)(1 ) +u
2
(d
)].
This is equivalent to
[1 (1 )]u
1
(w d
) = u
2
(d
). (*)
Dene h by
h(d) = [1 (1 )]u
1
(w d) u
2
(d).
60
Recall that both u
1
and u
2
satisfy Inada conditions. Then
lim
d0
u
2
(d) = .
Since w (0, ) and u
1
is strictly increasing, 0 < u
1
(w) < . Then
lim
d0
h(d) = < 0.
Similarly,
lim
dw/
u
1
(w d) = .
Since w/ (0, ) and u
2
is strictly increasing, 0 < u
2
(w/) < . Thus
lim
dw/
h(d) = > 0.
Both u
1
and u
2
are continuous, so h is also continuous. The Intermediate Value Theorem implies that there
exists d
(0, w/) such that h(d
) = 0. In other words, a steady state exists.

Suppose for contradiction that there exist two steady state values d
1
and d
2
such that g
(d
1
) = d
1
,
g
(d
2
) = d
2
, and d
1
,= d
2
. WLOG, let d
1
< d
2
. Then we have
g
(d
1
) = d
1
< d
2
= g(d
2
.)
Since d
1
< d
2
and v is strictly concave,
v
(g
(d
1
)) = v
(d
1
) > v
(d
2
) = v
(g
(d
2
).)
Combining this with the FOC,
u
1
(w d
1
) > u
1
(w d
2
.)
Since u
1
is strictly concave, w d
1
< w d
2
. Since X = R
+
, this implies that d
1
> d
2
. This is a
contradiction, so it must be that the steady state is unique.
Now suppose for contradiction that the steady state is d
= 0. Then g
(0) = 0. By (*), we have

[1 (1 )]u
1
(w) = u
2
(0).
But since w < and u
1
and u
2
satisfy Inada conditions, the LHS is nite while the RHS is innite.
Contradiction. Therefore the unique steady state is positive.
Part (f)
Let d, d
X such that d < d
. Suppose for contradiction that g
(d) g
(d
). Then since v is strictly

concave, v
(g
(d)) v
(g
(d
)). By the FOC, we have

u
1
(w + (1 )d g
(d)) u
1
(w + (1 )d
(d
)).
Since u
1
is strictly concave,
w + (1 )d g
(d) w + (1 )d
(d
).
Because g
(d) g
(d
), this implies that d d
. This is a contradiction, so g
(d) < g
(d
), i.e., g
is strictly
increasing.
We can write c
as
c
(d) = w + (1 )d g
(d)
Since g
(d) < g
(d
), strict concavity of v implies that v
(g
(d)) > v
(g
(d
)). By the FOC,

u
1
(w + (1 )d g
(d)) > u
1
(w + (1 )d
(d
)).
By strict concavity of u
1
,
c
(d) = w + (1 )d g
(d) < w + (1 )d
(d
) = c
(d
).
Thus c
(d) is strictly increasing.

61
Part (g)
Let d < d
. Since u
1
and u
2
are strictly concave, (*) implies that
[1 (1 )]u
1
(w d) < [1 (1 )]u
1
(w d
) = u
2
(d
) < u
2
(d). (#)
Suppose for contradiction that g
(d) d. Since v is strictly concave, v
(g
(d)) v
(d). Then by the FOC

and the envelope condition,
1
u
1
(w + (1 )d g
(d)) = v
(g
(d))
. .
FOC
v
(d) = u
1
(w + (1 )d g
(d))(1 ) +u
2
(d)
. .
Envelope condition
.
If we multiply both sides by and rearrange some terms, we get
[1 (1 )]u
(w (1 d)) u
2
(d).
This contradicts (#), so it must be that g
(d) > d.
Let d
0
< d
and dene d
t
t=1
by d
t+1
= g
(d
t
). In part (f) we showed that g
is strictly increasing in
d, so for any d < d
, we have g(d) < g(d
) = d
. Then by the above results,

d
0
< g
(d
0
) = d
1
< d
.
If d
t
< d
, then these results imply that

d
t
< g
(d
t
) = d
t+1
< d
.
Thus if d
0
< d
, we have shown that d

t
< d
t+1
< d
for all t 0. Thus the sequence d

t
converges
monotonically to d
.
Now let d > d
. Since u
1
and u
2
are strictly concave,
[1 (1 )]u
1
(w d) > [1 (1 )]u
1
(w d
) = u
2
(d
) > u
2
(d). (@)
Suppose for contradiction that g
(d) d. Since v is strictly concave, v
(g
(d)) v
(d). Then by the FOC

and the envelope condition,
1
u
1
(w + (1 )d g
(d)) = v
(g
(d))
. .
FOC
v
(d) = u
1
(w + (1 )d g
(d))(1 ) +u
2
(d)
. .
Envelope condition
.
If we multiply both sides by and rearrange some terms, we get
[1 (1 )]u
(w (1 d)) u
2
(d).
This contradicts (@), so it must be that g
(d) < d.
Let d
0
> d
and dene d
t
t=1
as above. Again, g
is strictly increasing in d, so for any d > d
, we have
g(d) > g(d
) = d
. Then by the above results,

d
0
> g
(d
0
) = d
1
> d
.
If d
t
> d
, then these results imply that

d
t
> g
(d
t
) = d
t+1
> d
.
So if d
0
> d
, we have shown that d

t
> d
t+1
> d
for all t 0. Thus the sequence d

t
converges
monotonically to d
.
If d
0
= d
, then by denition of d
, d
t
= d
for all t. Thus we have shown that for all d

0
X, d
t
converges monotonically to d
. Therefore d
is globally stable.
62
22 Fall 2007. II.2 (Perri, IFP in small open economy)
Part (a)
If consumption is given by
c
t
=
r
1 +r
_
A
t
+ y
t
+
1
r
y
_
then
c
t
c
t1
=
r
1 +r
[A
t
+y
t
A
t1
y
t1
]
=
r
1 +r
[(1 +r)(A
t1
+y
t1
c
t1
) +y
t
A
t1
y
t1
]
=
r
1 +r
_
r(A
t1
+y
t1
) r
_
A
t1
+y
t1
+
1
r
y
_
(1 +r) +y
t
_
=
r
1 +r
[y
t
y + (1 +r)]
=
r
1 +r
(y
t
y) +r
Part (b)
Since there is no borrowing constraint, and (1 +r) = 1, the Euler equation is
u
(c
t
) = E
t
[u
(c
t+1
)]
or
e
ct
= E
t
[e
ct+1
].
We can write this as
1 = E
t
_
e
ct+1
e
ct
_
= E
t
_
e
(ct+1ct)
_
= E
t
_
e
(
r
1+r
(yt+1 y)+r)
_
= E
t
_
e
(
r
1+r
t+1+r)
_
= E
t
_
e
(
r
1+r
t+1)
e
r
_
Thus we have
e
r
= E
t
_
e
(
r
1+r
t+1)
_
.
Using the hint, we have
e
r
= e
2
r
2
2
2(1+r)
2
.
Taking logs, we get
r =

2
r
2
2
2(1 +r)
2
or
=
r
2
2(1 +r)
2
.
63
Part (c)
Since the continuum of consumers has measure one and has a mean of zero, the law of large numbers
implies that average income is
_
y
i
t
di =
_
y di +
_

t
t
di
= y +
_

t
t
di
= y
Cross-sectional variance of income is
var(y
i
t
) = var( y +
i
t
) = var( y) +var(
i
t
) =
2
.
Thus average and cross-sectional variance of income are stationary.
We can write individual assets as
A
i
t
= (1 +r)(A
i
t1
+y
i
t1
c
i
t1
)
= (1 +r)(A
i
t1
+y
i
t1
) rA
i
t1
ry
i
t
y + (1 +r)
= A
i
t1
+y
i
t1
y + (1 +r)
= A
i
t1
+
i
t1
+ (1 +r)
Thus individual assets are a random walk with positive drift. Therefore the distribution of assets is spreading
out over time. Given our formula for c
i
t
, this implies that the distribution of consumption is also spreading out,
so the cross-sectional variance in consumption is nonstationary. Let c
t
and

A
t
denote average consumption
and asset holdings at time t. Then
A
t
=
_
A
i
t
di
=
_
[A
i
t1
+
i
t1
+ (1 +r)] di
=

A
t1
+ (1 +r)
So average assets are nonstationary. In particular, since > 0, average asset holdings are increasing over
time. Average consumption is
c
t
=
_
c
i
t
di
_ _
r
1 +r
_
A
t
+y
t
+
1
r
y
_

_
di
=
1
1 +r
A
t
+ y
which is also nonstationary. Since average assets are increasing over time, so is average consumption.
Aggregate output is constant, so the ratio of consumption to output in the economy is rising over time.
23 Spring 2007, I.1 (Larry, dierent discount factors)
Proposition. c
1
0
< c
2
0
.
Proof. Let K
t
denote aggregate capital in period t. The rms problem can be written as
max
Kt
p
t
AK
t
r
t
K
t
.
64
Then in equilibrium, we have p
t
A = r
t
. Consider the budget constraint for consumer i:
t=0
p
t
(c
i
t
+k
i
t+1
)
t=0
r
t
k
i
t
+p
t
(1 )k
i
t
.
Using the above result, this is equivalent to
t=0
p
t
(c
i
t
+k
i
t+1
)
t=0
p
t
k
i
t
[A + (1 )].
Thus consumer is equilibrium allocations will solve
max
{c
i
t
,k
i
t
}
t=0
t=0
t
i
(c
i
t
)
1
1
s.t.
t=0
p
t
(c
i
t
+k
i
t+1
)
t=0
p
t
k
i
t
[A + (1 )]
k
i
0
=

k
0
given
non-negativity
Since both consumers utility functions are strictly increasing and strictly concave and their budget sets
are convex, FOCs are sucient for maximization. Taking the FOCs w.r.t. c
i
t
and k
i
t+1
gives
c
i
t
:
t
i
(c
i
t
)
=
i
p
t
k
i
t+1
: p
t
= p
t+1
[A + 1 ]
where
i
is the multiplier on consumer is budget constraint. The rst FOC implies that
i
_
c
i
t+1
c
i
t
_
=
p
t+1
p
t
.
The second FOC implies that
p
t+1
p
t
= [A + 1 ]
1
.
Thus we have
i
c
i
t+1
c
i
t
= [
i
(A + 1 )]
1/
.
Applying this formula iteratively, we nd that
c
i
t
= c
i
0
[
i
(A + 1 )]
t/
.
Suppose for contradiction that c
1
0
c
2
0
. Then since
1
>
2
, c
1
t
> c
2
t
for all t.
WLOG normalize p
0
= 1. Looking at the FOCs again, we can get the following expression:
p
t
c
i
t
=
t
i
_
c
i
t
c
i
0
_
c
i
t
=

t
i
(c
i
t
)
1
(c
i
0
)
.
Thus we can rewrite consumer is BC as
t=0
t
i
(c
i
t
)
1
(c
i
0
)
t=0
[p
t
k
i
t
[A+ (1 )] p
t
k
t+1
].
Pulling out time-zero terms from the RHS, we get
t=0
t
i
(c
i
t
)
1
(c
i
0
)
= k
i
0
[A+ (1 )] +
t=0
[p
t+1
k
i
t+1
[A + (1 )] p
t
k
i
t+1
] lim
T
p
T
k
i
T+1
.
65
We know from the consumers FOCs that p
t
= [A + 1 ]p
t+1
, so the summation on the RHS drops out.
Imposing the transversality condition causes the last term on the RHS to drop out. Therefore we are left
with
t=0
t
i
(c
i
t
)
1
= (c
i
0
)
k
i
0
[A + (1 )], i = 1, 2.
By our assumption that c
1
0
c
2
0
,
(c
1
0
)
k
1
0
[A+ (1 )] (c
1
0
)
k
2
0
[A + (1 )].
But since
1
>
2
and c
1
t
> c
2
t
for all t,
t=0
t
1
(c
1
t
)
1
>
t=0
t
2
(c
2
t
)
1
.
This is a contradiction, so it must be that c
1
0
< c
2
0
.
24 Spring 2007, I.2 (Victor, OLG)
Part (a)
An ADE in this economy is a price system p = p
t
t=0
and an allocation z = (z
0
, z
t
t=1
), where z
0
= c
0
1
and z
t
= (c
t
, c
t
t+1
), such that
(i) Given p, z
t
solves the problem of the agent born at period t for all t > 0:
max
c
t
t
,c
t
t+1
log c
t
t
+c
t
t+1
s.t. p
t
c
t
t
+p
t+1
c
t
t+1
p
t
w
t
t
+p
t+1
w
t
t+1
(ii) Given p, z
0
solves the problem of the agent born in period 0:
max
c
0
1
c
0
1
s.t. p
1
c
0
1
p
1
w
0
1
(iii) In every period the allocation is feasible:
c
t1
t
+c
t
t
= w
t1
t
+w
t
t
= 4.
We can establish the ADE equilibrium by induction. Note that since all consumers have strictly increas-
ing utilities, their budget constraints will all hold with equality. The assumptions about the consumer born
in period 0 imply that c
0
1
= w
0
1
= 2. Feasibility for period 1 implies that c
1
1
= 2, and the budget constraint
for the consumer born in period 1 implies that c
1
2
= 2 as well.
Now suppose that for arbitrary t that c
t
t
= c
t
t+1
= 2. Then feasibility for period t + 1 implies that
c
t+1
t+1
= 2, and the budget constraint of the consumer born in period t + 1 implies that c
t+1
t+2
= 2. Therefore
the induction shows that the ADE allocation is c
0
1
= c
t
t
= c
t
t+1
= 2, t > 0.
This result implies that the solution to the consumers problem is interior, so FOCs are sucient for
maximization. The FOCs for the consumer born in period t are:
c
t
t
:
1
c
t
t
= p
t
t
c
t
t+1
: 1 = p
t+1
t
where
t
is the lagrange multiplier on the budget constraint. This implies that
p
t+1
p
t
= c
t
t
= 2.
66
Part (b)
A sequential markets equilibrium in this economy is a price system q = q
t
t=0
and an allocation z =
(z
0
, z
t
t=1
), where z
0
= (c
0
1
, b
0
1
) and z
t
= (c
t
, c
t
t+1
, b
t
t
, b
t
t+1
), such that
(i) Given q, z
t
max
c
t
t
,c
t
t+1
,b
t
t
,b
t
t+1
log c
t
t
+c
t
t+1
s.t. c
t
t
+q
t
b
t
t
w
t
t
c
t
t+1
+q
t+1
b
t
t+1
b
t
t
+w
t
t+1
(ii) Given p, z
0
max
c
0
1
,b
0
1
c
0
1
s.t. c
0
1
+q
1
b
0
1
w
0
1
(iii) In every period the allocation is feasibile and the market for bonds clears:
c
t1
t
+c
t
t
= w
t1
t
+w
t
t
= 4
and
b
t
t
+b
t1
t
= 0.
Again, we can establish the SME allocation by induction. Again, strictly increasing utilities imply that
all budget constraints will hold with equality. The consumer born in period 0 has no incentive to buy bonds
since he prefers more consumption to less, and no one will buy bonds from him since they will never be paid
back. Thus c
0
1
= 2 and b
0
1
= 0. Then bond market clearing and feasibility imply that c
1
1
= 2 and b
1
1
= 0.
Since this consumer dies after period 1, no one will buy bonds from him, so his second budget constraint
implies that c
1
2
= 2 and b
1
2
= 0.
Now suppose that b
t
t
= b
t
t+1
= 0 and c
t
t
= c
t
t+1
= 2. Bond market clearing for period t implies that
b
t+1
t+1
= 0 and feasibility implies that c
t+1
t+1
= 2. By the same logic as above, no one will buy bonds from
generation t +1 in period t +2, so b
t+1
t+2
= 0 and c
t+1
t+1
= 2. Thus the induction shows that the ADE allocation
is c
0
1
= c
t
t
= c
t
t+1
= 2, t > 0 and b
0
1
= b
t
t
= b
t
t+1
= 0, t > 0.
Again, interiority of the solution w.r.t. consumption lets us use FOCs to nd prices. The FOCs of
generation t are
c
t
t
:
1
c
t
t
=
t
t
c
t
t+1
:
t
t+1
= 1
b
t
t
: q
t
t
t
=
t
t+1
where
t
is generation ts lagrange multiplier on his period budget constraint. This implies that
q
t
=

t
t+1
t
t
= c
t
t
= 2.
Part (c)
An allocation (c
0
1
, c
t
t
, c
t
t+1
t=0
) is Pareto ecient if it is feasible, i.e.,
c
t1
t
+c
t
t
= w
t1
t
+w
t
t
, t > 0,
and another feasible allocation ( c
0
1
, c
t
t
, c
t
t+1
t=0
) such that
(i) c
0
1
c
0
1
and log c
t
t
+ c
t
t+1
log c
t
t
+c
t
t+1
for all t > 0.
67
(ii) Either c
0
1
> c
0
1
or > 0 such that log c
+ c
+1
> log c
+c
+1
.
Consider the allocation ( c
0
1
, c
t
t
, c
t
t+1
t=0
) dened as
c
t
t
= 1, t > 0
c
t1
t
= 3, t > 0
Clearly this allocation is feasible. Note that
c
0
1
= 3 > c
0
1
= 2
and
log c
t
t
+ c
t
t+1
= log 1 + 3 > log c
t
t
+ c
t
t+1
= log 2 + 2.
Thus ( c
0
1
, c
t
t
, c
t
t+1
t=0
) Pareto dominates the equilibrium allocation, so the equilibrium is not Pareto ecient.
Part (d)
A sequential markets equilibrium in this economy is a price system q = q
t
t=0
and an allocation z =
(z
0
, z
t
t=1
), where z
0
= (c
0
1
, s
0
1
, b
0
1
) and z
t
= (c
t
, c
t
t+1
, s
t
t
, s
t
t+1
, b
t
t
, b
t
t+1
), such that
(i) Given q, z
t
max
c
t
t
,c
t
t+1
,b
t
t
,b
t
t+1
,s
t
t
,s
t
t+1
log c
t
t
+c
t
t+1
s.t. c
t
t
+s
t
t
+q
t
b
t
t
w
t
t
c
t
t+1
+s
t
t+1
+q
t+1
b
t
t+1
b
t
t
+w
t
t+1
+s
t
t
s
t
0, = t, t + 1
(ii) Given p, z
0
max
c
0
1
,b
0
1
,s
0
1
c
0
1
s.t. c
0
1
+s
0
1
+q
1
b
0
1
w
0
1
, s
0
1
0
(iii) In every period the allocation is feasibile and the market for bonds clears:
c
t1
t
+c
t
t
+s
t1
t
+s
t
t
= w
t1
t
+w
t
t
= 4
and
b
t
t
+b
t1
t
= 0.
Since utility is strictly increasing, s
t
t+1
= 0, t 0. By the argument employed above about no one
buying bonds from a generation in the last period of its life, b
t
t+1
= 0, t 0 as well. If s
t
t
= 0 for t > 0,
then the equilibrium is the same as in part (b). Otherwise, c
t
t+1
> 2. In either case, we have an interior
solution w.r.t. consumption. The FOCs for generation t are
c
t
t
:
1
c
t
t
=
t
t
c
t
t+1
:
t
t+1
= 1
b
t
t
: q
t
t
t
=
t
t+1
s
t
t
:
t
=
t
t

t
t+1
where
t
is generation ts lagrange multiplier on his period budget constraint and

t
is the multiplier on
the non-negativity constraint for s
t
t
. Thus the storage technology will not be used if
t
> 0, i.e.,
t
t
>
t
t+1
.
Again, if storage is not used, b
t
t
= 0 and c
t
t
= 2. Using this with the rst and second equations above, we
have
1
c
t
t
=
1
2
> .
This the storage technology will only be used if 1/2.
68
25 Spring 2007, I.4 (Chari, on-the-job search)
Part (a)
I assume that the set from which wages are drawn for both distributions is a closed interval [0, w]. Let V (w)
represent the value of holding an oer w. Given such an oer, the worker chooses to accept the oer or
search. Let V
E
(w) represent the value of accepting the oer, and let V
U
represent the value of searching.
Then we can write V (w) as
V (w) = maxV
E
(w), V
U
.
If the worker chooses to accept the oer, he receives utility from his wages in that period plus the discounted
expected value for the following period. The realization of the following periods value depends on whether
or not he loses his job. If he does not lose his job, he will choose between remaining employed at his current
wage or taking the oer he receives from F. If he loses his job, the following periods value is simply V
U
.
Thus we can write V
E
(w) as
V
E
(w) = u(w) +(1 )
_
w
0
maxV
E
(w), V
E
(w
)dF(w
) +V
U
.
The value of searching for a new job (whether by choice or due to job loss) is the utility from one periods
unemployment benets plus the discounted expected value for the following period:
V
U
= u(b) +
_
w
0
V (w
)dG(w
).
Given these expressions, we can rewrite V (w) as
V (w) = max
_
u(w) +(1 )
_
w
0
maxV (w), V (w
)dF(w
) +
_
u(b) +
_
w
0
V (w
)dG(w
)
_
,
u(b) +
_
w
0
V (w
)dG(w
)
_
Note that I have replaced V
E
with V in the rst argument of the maximization. I can do this because
the second argument is a constant, so if the worker accepts an oer of w once, he will never quit that job
voluntarily.
Part (b)
I assume that u is continuous and strictly increasing, u(0) = 0, u(w) > 0, 0 < < 1, and G rst-order
stochastically dominates F, i.e., for every weakly increasing function f,
_
w
0
f(w
)dF(w
)
_
w
0
f(w
)dG(w
).
Let X = [0, w], and let C(X) be the space of continuous, real-valued functions dened on X. Since X is
compact, all elements of C(X) are bounded. Thus C(X) is a Banach space with the sup norm. Dene the
operator T by
Tf(w) = max
_
u(w) +(1 )
_
w
0
maxf(w), f(w
)dF(w
) +
_
u(b) +
_
w
0
f(w
)dG(w
)
_
,
u(b) +
_
w
0
f(w
)dG(w
)
_
Let f C(X). Then since u(w) is continuous, it is bounded on X. Then Tf is also continuous and bounded,
so T : C(X) C(X).
69
Let f, g C such that f(w) g(w) for all w X. Then Tf(w) Tg(w) for all x X, so T satised
monotonicity. Now, note that
T(f +a)(w) = max
_
u(w) + (1 )
_
w
0
max(f +a)(w), (f +a)(w
)dF(w
) +
_
u(b) +
_
w
0
(f +a)(w
)dG(w
)
_
,
u(b) +
_
w
0
(f +a)(w
)dG(w
)
_
= max
_
u(w) + (1 )
_
w
0
maxf(w) +a, f(w
) +adF(w
) +
_
u(b) +
_
w
0
[f(w
) +a]dG(w
)
_
,
u(b) +
_
w
0
[f(w
) +a]dG(w
)
_
= max
_
u(w) + (1 )
_
w
0
maxf(w), f(w
)dF(w
) +
_
u(b) +
_
w
0
f(w
)dG(w
)
_
+(1 +)a,
u(b) +
_
w
0
f(w
)dG(w
) +a
_
max
_
u(w) + (1 )
_
w
0
maxf(w), f(w
)dF(w
) +
_
u(b) +
_
w
0
f(w
)dG(w
)
_
,
u(b) +
_
w
0
f(w
)dG(w
)
_
+a
= Tf(w) +a
so T satises discounting. Then T satises Blackwells Suciency Conditions and is therefore a contraction.
Since C(X) is a Banach space, the Contraction Mapping Theorem implies that T has a unique xed point
V C(X).
Let S
C(X) be the subset of weakly increasing functions dened on X. Then S
is closed. Let f S
.
Since u is strictly increasing, Tf is also weakly increasing. Thus T(S
) S
, so the rst corollary to the

Contraction Mapping Theorem implies that V S
. In other words V (w) is weakly increasing.

We have shown thus far that V is continuous and weakly increasing. It remains to be shown that V has
the reservation wage property. First, suppose for contradiction that
V (0) = V
E
(0) > V
U
.
Then
(1 )
_
w
0
maxV (0), V (w
)dF(w
) +
_
u(b) +
_
w
0
V (w
)dG(w
)
_
> u(b) +
_
w
0
V (w
)dG(w
).
Since V is weakly increasing, V (w
) V (0) for all w
X. Thus we have
(1 )
_
w
0
V (w
)dF(w
) +
_
u(b) +
_
w
0
V (w
)dG(w
)
_
> u(b) +
_
w
0
V (w
)dG(w
).
Since G rst-order stochastically dominates F,
(1 )
_
w
0
V (w
)dG(w
) +
_
u(b) +
_
w
0
V (w
)dG(w
)
_
> u(b) +
_
w
0
V (w
)dG(w
).
This simplies to
u(b) +(1 +)
_
w
0
V (w
)dG(w
) > u(b) +
_
w
0
V (w
)dG(w
).
70
This is a contradiction since < 1 and (1 +) < . Therefore it must be that
(1 )
_
w
0
maxV (0), V (w
)dF(w
) +
_
u(b) +
_
w
0
V (w
)dG(w
)
_
u(b) +
_
w
0
V (w
)dG(w
),
i.e., V (0) = V
U
V
E
(0).
Second, suppose for contradiction that V (w) = V
U
> V
E
(w). Then
V (w) > u(w) + (1 )
_
w
0
maxV (w), V (w
)dF(w
) +V (w).
Since V is weakly increasing, V (w) V (w
) for all w
X. Then
V (w) > u(w) +(1 )V (w) +V (w) = u(w) +V (w).
This implies that u(w) > 0 which is a contradiction. Then it must be that V (w) = V
E
(w) > V
U
.
Thus we have shown that V
E
(0) V
U
and V
E
(w) V
U
. Since V is continuous and X is a closed
interval, the Intermediate Value Theorem implies that there exists w
X such that V
E
(w
) = V
U
, i.e.,
V (w
) = u(w
) +(1 )
_
w
0
maxV (w
), V (w
)dF(w
) +
_
u(b) +
_
w
0
V (w
)dG(w
)
_
= u(b) +
_
w
0
V (w
)dG(w
)
Then V has the reservation wage property. Since V is weakly increasing, we can write V as
V (w) =
_
u(w) +(1 )
_
w
0
maxV (w), V (w
)dF(w
) +
_
u(b) +
_
w
0
V (w
)dG(w
)
_
if w w
u(b) +
_
w
0
V (w
)dG(w
) if w w
Part (c)
We can now write V as
V (w) = max
_
u(w) +(1 )
_
w
0
maxV (w), V (w
)dF(w
) +
2
_
w
0
V (w
)dF(w
),
_
w
0
V (w
)dF(w
)
_
Suppose the worker has an oer of 0. Then his value function is
V (0) = max
_
(1 )
_
w
0
maxV (0), V (w
)dF(w
) +
2
_
w
0
V (w
)dF(w
),
_
w
0
V (w
)dF(w
)
_
Since V is weakly increasing and V (0) V (w
) for all w
X, this is equivalent to
V (0) = max
_
(1 +)
_
w
0
V (w
)dF(w
),
_
w
0
V (w
)dF(w
)
_
Since (1 +) < ,
V (0) =
_
w
0
V (w
)dF(w
) > (1 +)
_
w
0
V (w
)dF(w
).
71
Thus the reservation wage is higher than 0. The intuition here is that if the worker accepts the job, he has a
chance of being red, so the expected amount of time until he gets a new oer is longer than if he chooses to
search. However, note that if we had = 0 (so that the worker is never red), then V
E
(0) = V
U
, i.e., w
= 0.
This makes sense since the value of the option that the ability to search represents is the same regardless of
whether the worker is employed or unemployed when = 0, and since there are no unemployment benets,
an unemployed worker receives the same one-period compensation as a worker with a wage of zero.
The reservation wage w
is characterized by
u(w
) +(1 )
_
w
0
maxV (w
), V (w
)dF(w
) +
2
_
w
0
V (w
)dF(w
) =
_
w
0
V (w
)dF(w
).
Thus the worker will reject all jobs such that
u(w) +(1 )
_
w
0
maxV (w), V (w
)dF(w
) +
2
_
w
0
V (w
)dF(w
) <
_
w
0
V (w
)dF(w
).
It is implicit in this formulation that the employed worker who is not red will reject any on-the-job oer
that is worse than his current wage. Thus one might say that the reservation wage for on-the-job search is
w
(w) = w.
26 Spring 2007 II.1 (T. Kehoe, DP)
Part (a)
I will normalize the endowment of time to 1. The Bellman equation for this dynamic program is:
v(k) =max
c,k
,l
log c + (1 ) log(1 l) +v(k
)
s.t. c +k
l
1
0 l 1
k
0
given
Part (b)
First, guess that l
t
=

l for all t. Substitute k
l
1
k
for c. Then we can rewrite the Bellman equation as

v(k) = max
k
(k)
log(k
l
1
k
) + (1 ) log(1 l) +v(k
)
where the feasibility correspondence is dened as
(k) = k
R
+
: 0 k
l
1
.
Next, we guess that v(k) = a
0
+a
1
log k. Then
a
0
+a
1
log k = max
k
(k)
log(k
l
1
k
) + (1 ) log(1 l) +[a
0
+a
1
log k
]. (1)
To solve this dynamic program, I would rst use the FOC to characterize g(k), the optimal value of k
given
k, in terms of a
0
, a
1
,

l and k. Note that since the utility function is strictly increasing and strictly concave
and is convex-valued, the FOC is sucient for a maximum.
Since g(k) is optimal, we know that
v(k) = log(k
l
1
g(k)) + (1 ) log(1 l) +v(g(k)).
So we would now plug in our expression for g(k), leaving us with
a
0
+a
1
log k = log(k
l
1
g(k)) + (1 ) log(1 l) +[a
0
+a
1
log(g(k))]. (1)
72
This equation would contain only a
0
, a
1
,

l, k and the parameters of the model, so we can solve for the a
0
and a
1
that satisfy the equation. This veries the guess.
In order to double-check our solution for a
1
, we can use our expression for g(k) (in terms of a
1
as well
as parameters) in the envelope condition. The envelope condition says that
v
(k) =
k
1
l
1
k
l
1
g(k)
.
Using our guess for the form of v(k), this implies that
a
1
k
=
k
1
l
1
k
l
1
g(k)
.
Now we can plug in our expression for g(k) and verify once again that our solution for a
1
is in fact correct.
Part (c)
An Arrow-Debreu equilibrium in this economy is
a consumer allocation z
c
= c
t
, k
t
, x
t
, l
t
t=0
a rm allocation z
f
= c
f
t
, k
f
t
, l
f
t
t=0
prices p
t
, r
t
, w
t
t=0
1. z
c
solves
max
{ct,kt,xt,lt}
t=0
t=0
t
log(c
t
) + (1 ) log(1 l
t
)
s.t.
t=0
p
t
(c
t
+k
t+1
)
t=0
w
t
l
t
+r
t
k
t
0 l
t
1, x
t
= 1 l
t
k
0
given
non-negativity
2. z
f
solves for all t
max
c
f
t
,k
f
t
,l
f
t
p
t
(c
f
t
+k
f
t+1
) w
t
l
f
t
r
t
k
f
t
s.t. c
f
t
+k
f
t+1
(k
f
t
)
(l
f
t
)
1
non-negativity
3. Markets clear: c
t
= c
f
t
, k
t
= k
f
t
, and l
t
= l
f
t
for all t.
With our solution in part (b), we can use the policy function to calculate the entire sequence c
t
, k
t
, x
t
, l
t
t=0
that solves the sequence problem posed in the question given the initial level of capital k
0
. This sequence
problem is the social planners problem - maximizing the representative agents lifetime utility subject to
feasibility. The rst welfare theorem implies that any CE allocation is Pareto optimal, i.e., the solution to a
planners problem. Since there is only one representative agent, there is only one planners problem, so any
CE allocation must be equal to the sequence obtained above. An ADE is a CE, so the ADE allocation must
be equal to that sequence. All that remains to be found is the sequence of ADE prices p
t
, r
t
, w
t
t=0
.
I will normalize p
0
to 1. Taking the FOC w.r.t. c
t
for the consumers problem, we get
t

c
t
= p
t
73
where is the Lagrange multiplier on the budget constraint. This implies that
p
t
=
t
c
0
c
t
. (2)
Taking FOCs for the rms problem, we get
c
t
: p
t
=
t
k
t+1
: r
t+1
+
t
= p
t
+
t+1
k
1
t+1
l
1
t+1
l
t
: w
t
=
t
(1 )k
t
l
t
where
t
is the multiplier on the rms production constraint. Notice that I have substituted in the consumers
equilibrium allocations for the rms via market clearing. These equations can be combined to give us
r
t
= p
t
k
1
t
l
1
t
(3)
w
t
= p
t
(1 )k
t
l
t
(4)
Given that we have our ADE allocations already, (2), (3) and (4) characterize the prices. Thus we have all
the information we need to calculate the ADE.
Part (d)
A sequential markets equilibrium in this economy is
c
= c
t
, k
t
, x
t
, l
t
, A
t
t=0
a rm allocation z
f
= c
f
t
, k
f
t
, l
f
t
t=0
prices q
t
, r
t
, w
t
t=0
1. z
c
solves
max
{ct,kt,xt,lt,At}
t=0
t=0
t
log(c
t
) + (1 ) log(1 l
t
)
s.t. c
t
+k
t+1
+q
t
A
t+1
w
t
l
t
+r
t
k
t
+A
t
, t
0 l
t
1, x
t
= 1 l
t
k
0
, A
0
given
no Ponzi schemes non-negativity
2. z
f
solves for all t
max
c
f
t
,k
f
t
,l
f
t
c
f
t
+k
f
t+1
w
t
l
f
t
r
t
k
f
t
s.t. c
f
t
+k
f
t+1
(k
f
t
)
(l
f
t
)
1
non-negativity
3. Markets clear: c
t
= c
f
t
, k
t
= k
f
t
, and l
t
= l
f
t
for all t.
A SME is a competitive equilibrium, so the FWT holds again, implying that the SME allocations are
again equal to those given by the policy function in part (b). All we need is to characterize the prices. We
will again use FOCs to do this. Useful FOCs for the consumers problem are
c
t
:
t

c
t
=
t
A
t+1
: q
t
t
=
t+1
74
where
t
is the multiplier on the securities market constraint in period t. This gives us
q
t
=
c
t
c
t+1
. (5)
Useful FOCs from the rms problem:
c
t
:
t
= 1
k
t+1
: r
t+1
+
t
= 1 +
t+1
k
1
t+1
l
1
t+1
l
t
: w
t
=
t
(1 )k
t
l
t
where
t
is the multiplier on the resource constraint. This gives us
r
t
= k
1
t+1
l
1
t+1
(6)
w
t
= (1 )k
t
l
t
(7)
So (5), (6) and (7) characterize our prices in terms of the allocations.
Part (e)
An ADE in this economy is
consumer allocations z
i
= c
i
t
, k
i
t
, x
i
t
, l
i
t
t=0
, i = 1, 2
a rm allocation z
f
= c
f
t
, k
f
t
, l
f
t
t=0
prices p
t
, r
t
, w
t
t=0
1. For each i = 1, 2 z
i
solves
max
{c
i
t
,k
i
t
,x
i
t
,l
i
t
}
t=0
t=0
t
log(c
i
t
) + (1 ) log(1 l
i
t
)
s.t.
t=0
p
t
(c
i
t
+k
i
t+1
)
t=0
w
t
l
i
t
+r
t
k
i
t
0 l
i
t

l
i
, x
i
t
=

l
i
l
i
t
k
i
0
given
non-negativity
2. z
f
solves for all t
max
c
f
t
,k
f
t
,l
f
t
p
t
(c
f
t
+k
f
t+1
) w
t
l
f
t
r
t
k
f
t
s.t. c
f
t
+k
f
t+1
(k
f
t
)
(l
f
t
)
1
non-negativity
3. Markets clear: c
1
t
+c
2
t
= c
f
t
, k
1
t
+k
2
t
= k
f
t
, and l
1
t
+l
2
t
= l
f
t
for all t.
A SME in this economy is
i
= c
i
t
, k
i
t
, x
i
t
, l
i
t
, A
i
t
t=0
a rm allocation z
f
= c
f
t
, k
f
t
, l
f
t
t=0
prices q
t
, r
t
, w
t
t=0
75
1. For each i = 1, 2 z
i
solves
max
{c
i
t
,k
i
t
,x
i
t
,l
i
t
,A
i
t
}
t=0
t=0
t
log(c
t
) + (1 ) log(1 l
t
)
s.t. c
i
t
+k
i
t+1
+q
t
A
i
t+1
w
t
l
i
t
+r
t
k
i
t
+A
i
t
, t
0 l
t

l
i
, x
i
t
=

l
i
l
i
t
k
i
0
, A
i
0
given
2. z
f
solves for all t
max
c
f
t
,k
f
t
,l
f
t
c
f
t
+k
f
t+1
w
t
l
f
t
r
t
k
f
t
s.t. c
f
t
+k
f
t+1
(k
f
t
)
(l
f
t
)
1
non-negativity
3. Markets clear: c
1
t
+c
2
t
= c
f
t
, k
1
t
+k
2
t
= k
f
t
, and l
1
t
+l
2
t
= l
f
t
for all t.
Part (f)
I assume the question means, Does the equilibrium in part (e) solve a dynamic programming problem...
The answer is yes. By the Second Welfare Theorem, every Pareto optimal allocation is a CE allocation
with some level of transfers. In particular, there exists some welfare weight so that the weighted planners
problem
max
{c
1
t
,c
2
t
,k
1
t
,k
2
t
,x
1
t
,x
2
t
,l
1
t
,l
2
t
}
t=0
t=0
t
[
1
log c
1
t
+ (1
1
) log(1 l
1
t
)] +
t
(1 )[
2
log c
2
t
+ (1
2
) log(1 l
2
t
)]
s.t. c
1
t
+c
2
t
(k
1
t
+k
2
t
)
(l
1
t
+l
2
t
)
1
k
1
0
, k
2
0
given
non-negativity
Thus the Bellman equation for this dynamic program is
v(k) = max
c
1
,c
2
,k
,l
1
,l
2
[
1
log c
1
+ (1
1
) log(1 l
1
)] + (1 )[
2
log c
2
+ (1
2
) log(1 l
2
)] +v(k
)
s.t. c
1
+c
2
+k
(k
1
+k
2
)
(l
1
+l
2
)
1
k
1
0
, k
2
0
given
non-negativity
In fact, we could use the Negiishi algorithm to nd the correct welfare weights given the two agents initial
capital stocks.
27 Spring 2007 II.2 (Larry, TDCE with government spending in
the utility function)
See Fall 2008, II.1.
28 Fall 2006 I.1 (Larry, TDCE)
Given taxes and government spending g
t
t=0
, A TDCE in this economy is:
76
consumer allocations c
t
, k
t
, x
t
, l
t
, n
t
t=0
rm allocations c
f
t
, k
f
t
, n
f
t
, g
f
t
t=0
prices p
t
, r
t
, w
t
t=0
1. c
t
, k
t
, x
t
, l
t
, n
t
t=0
solves
max
{ct,kt,xt,lt,nt}
t=0
t=0
t
u(c
t
, l
t
)
s.t.
t=0
p
t
(c
t
+x
t
)
t=0
[w
t
n
t
+r
t
k
t
] +
k
t+1
x
t
+ (1 )k
t
n
t
+l
t
= n
k
0
given
non-negativity
2. c
f
t
, k
f
t
, n
f
t
, g
f
t
t=0
solves
max
{c
f
t
,k
f
t
,n
f
t
,g
f
t
}
t=0
t=0
(1 )p
t
(c
f
t
+x
f
t
+g
f
t
) w
t
n
f
t
r
t
k
f
t
s.t. c
f
t
+x
f
t
+g
f
t
F(k
f
t
, n
f
t
), t
non-negativity
3. Markets clear: c
f
t
= c
t
, k
f
t
= k
t
, x
f
t
= x
t
, n
f
t
= n
t
, g
f
t
= g
t
for all t.
4. The governments budget constraint is satised:
t=0
p
t
g
t
=
t=0
p
t
(c
f
t
+x
f
t
+g
f
t
).
I assume that 1) the consumers utility function is strictly increasing and dierentiable, and 2) F is CRS
and dierentiable. Then = 0 and all of the consumers constraints will hold with equality. Then we can
substitute x
t
= k
t+1
(1 )k
t
in the budget constraint. For simplicity of syntax, I let n = 1. Then we can
also substitute l
t
= 1 n
t
. Let be the multiplier on the budget constraint. I will use the notation u
c
(t)
to denote u
c
(c
t
, 1 n
t
) (similar notation will be used for the derivatives of the production function). First
order conditions for the consumers problem are:
c
t
:
t
u
c
(t) = p
t
k
t+1
: p
t
= r
t+1
+p
t+1
(1 )
n
t
:
t
u
l
(t) = w
t
These can be combined to get
u
l
(t)
u
c
(t)
=
w
t
p
t
u
c
(t)
u
c
(t + 1)
=
p
t
p
t+1
=
r
t+1
p
t+1
+ 1
Prot maximization requires that c
f
t
+x
f
t
+g
f
t
= F(k
f
t
, n
f
t
) for all t, so we can just substitute the rms
resource constraint into its objective function. FOCs for the rms problem are:
k
f
t
: (1 )p
t
F
k
(t) = r
t
n
f
t
: (1 )p
t
F
n
(t) = w
t
77
Combining the FOCs from both problems and using market clearing, we get the following three equations
that characterize the TDCE allocations:
u
l
(t)
u
c
(t)
= (1 )F
n
(t) (1)
u
c
(t)
u
c
(t + 1)
= [(1 )F
k
(t + 1) + 1 ] (2)
c
t
+k
t+1
+g
t
= F(k
t
, n
t
) + (1 )k
t
(3)
Proposition. The allocations in this TDCE are the same as the TDCE allocations in the model in which
the government taxes labor and capital income at the tax rate (the same from the rst model).
Proof. The consumers problem is now
max
{ct,kt,xt,lt,nt}
t=0
t=0
t
u(c
t
, l
t
)
s.t.
t=0
p
t
(c
t
+x
t
)
t=0
(1 )w
t
n
t
+ (1 tau)r
t
k
t
k
t+1
x
t
+ (1 )k
t
n
t
+l
t
= n
k
0
given
non-negativity
First order conditions for this problem are:
c
t
:
t
u
c
(t) = p
t
k
t+1
: p
t
= (1 )r
t+1
+p
t+1
(1 )
n
t
:
t
u
l
(t) = (1 )w
t
These can be combined to get
u
l
(t)
u
c
(t)
=
(1 )w
t
p
t
u
c
(t)
u
c
(t + 1)
=
p
t
p
t+1
=
(1 )r
t+1
p
t+1
+ 1
The rms problem is now
max
{c
f
t
,k
f
t
,n
f
t
,g
f
t
}
t=0
t=0
p
t
(c
f
t
+x
f
t
+g
f
t
) w
t
n
f
t
r
t
k
f
t
s.t. c
f
t
+x
f
t
+g
f
t
F(k
f
t
, n
f
t
), t
non-negativity
The rms FOCs are now
k
f
t
: p
t
F
k
(t) = r
t
n
f
t
: p
t
F
n
(t) = w
t
Combining the FOCs from both problems and using market clearing, we get the following three equations
that characterize the TDCE allocations:
u
l
(t)
u
c
(t)
= (1 )F
n
(t) (1)
u
c
(t)
u
c
(t + 1)
= [(1 )F
k
(t + 1) + 1 ] (2)
c
t
+k
t+1
+g
t
= F(k
t
, n
t
) + (1 )k
t
(3)
78
Clearly, (1) - (3) are the same as (1) - (2). Thus the TDCE allocations are the same in both models.
To verify that the governments BC balances in both models, recall that since F is CRS, the rms
TDCE prot must be zero. In the rst model, the GBC is
t=0
p
t
g
t
=
t=0
p
t
(c
t
+x
t
+g
t
).
In the second, zero prots implies that p
t
(c
t
+x
t
+g
t
) = r
t
k
t
+w
t
n
t
. Thus the GBC in the second model is
t=0
p
t
g
t
=
t=0
(r
t
k
t
+w
t
n
t
) =
t=0
p
t
(c
t
+x
t
+g
t
).
Note: Price levels are the same in both models, but wages and interest rates are not. To see that price
levels are the same, note that that if we let p
0
= 1 WLOG, the FOC w.r.t. c
t
in gives prices as a function
of allocations:
p
t
=
t
u
c
(t)
u
c
(0)
.
Since this equation results from the FOCs regardless of which of the two tax structures is chosen, price levels
are the same in both models. Given that allocations prices are the same, the fact that wages and interest
rates are dierent is clear from examination of the rms rst order conditions.
29 Fall 2006 I.4 (Chari, on the job search)
See Spring 2007, I.4
30 Fall 2006 II.1 (T. Kehoe, DP/guess & verify)
Part (a)
The Bellman equation for this dynamic program is
v(k) = max
c,x,l,k
log c + log x +(v(k
)
s.t. c +k
l
1
x +l 1
k
0
given
non-negativity
Part (b)
Since the utility function is strictly increasing the rst two constraint will bind, so we can substitute k
l
1
for c and 1 l for x. Plugging in the guess, we have

a
0
+a
1
log k = max
k
(k)
log(k
l
1
k
) + log(1 l) +[a
0
+a
1
log k
]
where is dened as
(k) = k
R
+
: 0 k
l
1
.
The utility function is strictly increasing and strictly concave, and is convex-valued, so FOCs are sucient
for maximization. The FOC w.r.t. k
is
1
k
l
1
k
=
a
1
k
.
79
This implies that
k
=
a
1
k
l
1
1 +a
1
.
v
(k) = u
(k
l
1
k
) =
k
1
l
1
k
l
1
k
.
Plugging in the guess in the RHS and the above equation for k
gives
a
1
k
=
k
1
l
1
k
l
1
a1k
l
1
1+a1
.
This implies that
a
1
=
k
l
1
k
l
1
a1k
l
1
1+a1
=

1
a1
1+a1
= (1 +a
1
)
=

1
So our policy function for k
is
g(k) =

1
k
l
1
1 +

1
= k
l
1
Since c = k
l
1
k
, our policy function for c is

c(k) = k
l
1
g(k)
= (1 )k
l
1
So far, our expression for the value function is
a
0
+a
1
log k = a
0
+

1
log k = log((1 )k
l
1
) + log(1 l) +
_
a
0
+

1
log(k
l
1
)
_
.
Rearranging, we get
a
0
+

1
log k = log((1 )l
1
) +log k + log(1 l) +a
0
+

1
log(l
1
) +

2
1
log k
=
_
a
0
+ log((1 )l
1
) + log(1 l) +

1
log(l
1
)
_
+

1
log k
So
a
0
= a
0
+ log((1 )l
1
) + log(1 l) +

1
log(l
1
)
=
1
1
_
log((1 )l
1
) + log(1 l) +

1
log(l
1
)
_
Now we just need to nd the optimal value l. Plugging in our policy functions above, we have
a
0
+a
1
log k = max
0l1
log((1 )k
l
1
) + log(1 l) +
_
a
0
+

1
log(k
l
1
)
_
.
80
The FOC for l is
(1 )(1 )k
(1 )k
l
1

1 l
+

1
(1 )k
l
1
= 0.
Simpling in several steps, we get
1
l
+

1
1
l
=

1 l
1
(1 )l
=

1 l
(1 )(1 l) = (1 )l
l =
1
+ 1
Thus our policy functions for l and x are
l(k) = x(k) =
1
+ 1
.
We can plug this result back into g(k) and c(k) to get policy functions for those variables in terms of only
the state (k) and the model parameters.
To summarize, we have found analytic solutions for v(k) and the policy functions g(k), c(k), x(k) and
l(k) given the guess v(k) = a
0
+a
1
log k. The solutions are:
v(k) =
1
1
_
log((1 )l
1
) + log(1 l) +

1
log(l
1
)
_
+

1
log k (1)
g(k) = k
l
1
(2)
c(k) = (1 )k
l
1
(3)
l(k) = x(k) = l =
1
+ 1
(4)
Part (c)
A sequential markets structure is a model of an economy in which consumers maximize utility subject to a
securities market constraint in every period. This constraint allows consumers to buy or sell claims on the
goods produced in the next period in order to smooth their consumption across time. In this economy, a
sequential markets equilibrium is:
c
= c
t
, k
t
, x
t
, l
t
, A
t
t=0
a rm allocation z
f
= c
f
t
, k
f
t
, l
f
t
t=0
prices q
t
, r
t
, w
t
t=0
1. z
c
solves
max
{ct,kt,xt,lt,At}
t=0
t=0
t
log(c
t
) +) log x
t
s.t. c
t
+k
t+1
+q
t
A
t+1
w
t
l
t
+r
t
k
t
+A
t
, t
x
t
+l
t
1
k
0
, A
0
given
81
2. z
f
solves for all t
max
c
f
t
,k
f
t
,l
f
t
c
f
t
+k
f
t+1
w
t
l
f
t
r
t
k
f
t
s.t. c
f
t
+k
f
t+1
(k
f
t
)
(l
f
t
)
1
non-negativity
3. Markets clear: c
t
= c
f
t
, k
t
= k
f
t
, and l
t
= l
f
t
for all t.
A SME is a competitive equilibrium, so by the FWT the SME allocation must be Pareto optimal. All
consumers are identical in this economy so there is only one representative agent. Since the utility function is
strictly concave, there is only one Pareto optimal allocation. The dynamic program in part (b) is the social
planners problem for this economy, so the sequence generated by iterating the policy functions starting with
k
0
is the Pareto optimal allocation. Formally, this sequence is c
t
, k
t
, x
t
, l
t
, A
t
t=0
such that given k
0
=

k
0
,
k
t+1
= g(k
t
), c
t
= c(k
t
), l
t
= l(k
t
) and x
t
= x(k
t
) for all t, and A
t
is given by the securities market constraint
c
t
+k
t+1
+q
t
A
t+1
w
t
l
t
+r
t
k
t
+A
t
.
To nish solving for the equilibrium, we just need to nd the prices. We will use FOCs to do this. Useful
FOCs for the consumers problem are
c
t
:
t

c
t
=
t
A
t+1
: q
t
t
=
t+1
where
t
is the multiplier on the securities market constraint in period t. This gives us
q
t
=
c
t
c
t+1
. (5)
Useful FOCs from the rms problem:
c
t
:
t
= 1
k
t+1
: r
t+1
+
t
= 1 +
t+1
k
1
t+1
l
1
t+1
l
t
: w
t
=
t
(1 )k
t
l
t
where
t
is the multiplier on the resource constraint. This gives us
r
t
= k
1
t+1
l
1
t+1
(6)
w
t
= (1 )k
t
l
t
(7)
So (5), (6) and (7) characterize our prices in terms of the allocations. This gives us all the information we
need to calculate the SME.
Part (d)
An Arrow-Debreu market structure is a model of an economy in which consumers trade all claims to fu-
ture consumption at time zero. This is represented using a lifetime budget constraint. An Arrow-Debreu
equilibrium in this economy is
c
= c
t
, k
t
, x
t
, l
t
t=0
a rm allocation z
f
= c
f
t
, k
f
t
, l
f
t
t=0
prices p
t
, r
t
, w
t
t=0
82
1. z
c
solves
max
{ct,kt,xt,lt}
t=0
t=0
t
log(c
t
) + (1 ) log(1 l
t
)
s.t.
t=0
p
t
(c
t
+k
t+1
)
t=0
w
t
l
t
+r
t
k
t
0 l
t
1, x
t
= 1 l
t
k
0
given
non-negativity
2. z
f
solves for all t
max
c
f
t
,k
f
t
,l
f
t
p
t
(c
f
t
+k
f
t+1
) w
t
l
f
t
r
t
k
f
t
s.t. c
f
t
+k
f
t+1
(k
f
t
)
(l
f
t
)
1
non-negativity
3. Markets clear: c
t
= c
f
t
, k
t
= k
f
t
, and l
t
= l
f
t
for all t.
A ADE is also a competitive equilibrium, so by the FWT the ADE allocation must be Pareto optimal.
The same reasoning as in part (c) applies here as well, so the ADE allocation is the same as the one described
there. Again, we just need to nd prices. I will normalize p
0
to 1. Taking the FOC w.r.t. c
t
for the consumers
problem, we get
t

c
t
= p
t
where is the Lagrange multiplier on the budget constraint. This implies that
p
t
=
t
c
0
c
t
. (8)
Taking FOCs for the rms problem, we get
c
t
: p
t
=
t
k
t+1
: r
t+1
+
t
= p
t
+
t+1
k
1
t+1
l
1
t+1
l
t
: w
t
=
t
(1 )k
t
l
t
where
t
is the multiplier on the rms production constraint. Notice that I have substituted in the consumers
equilibrium allocations for the rms via market clearing. These equations can be combined to give us
r
t
= p
t
k
1
t
l
1
t
(9)
w
t
= p
t
(1 )k
t
l
t
(10)
Given that we have our ADE allocations already, (8), (9) and (10) characterize the prices. Thus we have all
the information we need to calculate the ADE.
31 Fall 2006 II.2 (Larry, TDCE with government spending in the
production function)
Part (a)
The optimum for this economy is given by the solution to the social planners problem, which has no
distortionary taxes, just the feasibility constraint. The SPP is:
max
{ct,kt,gt}
t=0
t=0
c
1
t
1
s.t. c
t
+k
t+1
+g
t+1
Ak
t
g
1
t
83
The utility function is strictly increasing so the feasibility constraint holds with equality. Strict concavity
and convexity of the constraint set means FOCs are sucient for a maximum. Let
t
be the multiplier on
the feasibility constraint. The FOCs are (for all t):
c
t
:
t
c
t
=
t
k
t+1
:
t
=
t+1
Ak
1
t+1
g
1
t+1
g
t+1
:
t
=
t+1
(1 )Ak
t+1
g
t+1
t
: c
t
+k
t+1
+g
t+1
= Ak
t
g
1
t
The second two conditions imply that
Ak
1
t+1
g
1
t+1
= (1 )Ak
t+1
g
t+1
, t
which simplies to
g
t
k
t
=
1
, t. (1)
We can use all three FOCs to obtain
c
t+1
c
t
=
1
c
t+1
Ak
1
t+1
g
1
t+1
=
Ag
1
t+1
k
1
t+1
= A
_
1
_
1
This means that we have constant consumption growth:
c
=
c
t+1
c
t
=
_
A
_
1
_
1
_1
. (2)
So the the optimum is characterized by (1) and (2).
Part (b)
Lump-sum taxes are non-distortionary, so the planner would get the optimum allocation by simply setting
the lump sum tax in every period equal to the cost of g
t
. In the competitive equilibrium, consumers face a
lifetime budget constraint so the timing of the LS taxes does not aect the CE allocation.
Part (c)
Given g
t
and
kt
t=0
, the TDCE in this economy is:
consumer allocation z
c
= c
t
, k
t
t=0
rm allocation z
f
= c
f
t
, k
f
t
t=0
prices p
t
, r
t
t=0
1. z
c
solves
max
{ct,kt}
t=0
t=0
c
1
t
1
s.t.
t=0
p
t
(c
t
+k
t+1
)
t=0
(1
kt
)r
t
k
t
+
t
k
0
given
non-negativity
84
2. z
f
solves
max
{c
f
t
,k
f
t
}
t=0
t=0
p
t
(c
f
t
+k
f
t+1
+g
t+1
) r
t
k
t
s.t. c
f
t
+k
f
t+1
+g
f
t+1
Ak
t
g
1
t
, t
non-negativity
3. Markets clear: c
f
t
= c
t
, k
f
t
= k
t
for all t.
4. The governments budget balances:
t=0
p
t
g
t
=
t=0
kt
r
t
k
t
.
FOCs for the consumers problem are:
c
t
:
t
c
t
= p
t
k
t+1
: p
t
= (1
kt+1
)r
t+1
:
t=0
p
t
(c
t
+k
t+1
)
t=0
(1
kt
)r
t
k
t
+
t
Prot maximization requires the rm to use all of its production capacity, so we can substitute the rms
constraint into its objective function. The FOC for the rms problem is:
k
t
: p
t
Ak
t
g
1
t
k
t
= r
t
This implies that
Ak
t
g
1
t
= r
t
k
t
so the rm pays out
t
= (1 )Ak
t
g
1
t
as prots. Combining the rms FOC with the consumers, we
get an Euler equation:
c
t
= c
t+1
p
t
p
t+1
= c
t+1
(1
kt+1
)r
t+1
p
t+1
= c
t+1
(1
kt+1
)
Ak
t+1
g
1
t+1
k
t+1
For simplicity, let F
k
(t + 1) denote
Ak
t+1
g
1
t+1
kt+1
. Then the Euler equation can be written as
1 =
c
t+1
c
t
(1
kt+1
)F
k
(t + 1). (3)
The TDCE allocation is characterized by (3) and the resource constraint
c
t
+k
t+1
+g
t+1
Ak
t
g
1
t
. (4)
Normalizing prices so p
0
= 1, TDCE prices are given by
p
t
=
t
c
t
c
0
(5)
and
p
t
Ak
t
g
1
t
k
t
= r
t
.. (6)
Finally, the budget constraint is
t=0
p
t
(c
t
+k
t+1
)
t=0
(1
kt
)r
t
k
t
+
t
. (7)
Thus the TDCE is characterized by (3) - (7).
85
Part (d)
We can write the budget constraint as
t=0
p
t
c
t
=
t=0
(1
kt
)r
t
k
t
p
t
k
t+1
+
t=0
t
.
Using (5) (with a general utility form for now) this is
t=0
t
u
(c
t
)
u
(c
0
)
c
t
=
t=0
(1
kt
)r
t
k
t
p
t
k
t+1
+
t=0
t
.
Pulling out some terms for period 0, we have
t=0
t
u
(c
t
)
u
(c
0
)
c
t
= (1
k0
)r
0
k
0
+
t=0
[(1
kt+1
)r
t+1
k
t+1
p
t
k
t+1
] lim
T
p
T
k
T+1
+
t=0
t
.
The consumers FOC tells us that p
t
= (1
kt+1
)r
t+1
, so the rst summation on the RHS is zero. The
transversality condition implies that lim
T
p
T
k
T+1
= 0, so we have
t=0
t
u
(c
t
)
u
(c
0
)
c
t
= (1
k0
)r
0
k
0
+
t=0
t
.
Plugging in (6) (with a simpler syntax) and our equation for prots, we have our implementability constraint:
t=0
t
u
(c
t
)c
t
= u
(c
0
)(1
k0
)F
k
(0)k
0
+u
(c
0
)(1 )
t=0
Ak
t
g
1
t
. (7)
Part (e)
The Ramsey Problem is:
max
{ct,kt,gt}
t=0
t=0
u(c
t
)
s.t. c
t
+k
t+1
+g
t+1
Ak
t
g
1
t
t=0
t
u
(c
t
)c
t
= u
(c
0
)(1
k0
)F
k
(0)k
0
+u
(c
0
)(1 )
t=0
Ak
t
g
1
t
k
0
given
non-negativity
Let be the multiplier on the implementability constraint. Dene V
0
and W(c
t
, k
t
, g
t
; ) as
V
0
= u(c
0
) +[u
(c
0
)(1
k0
)F
k
(0)k
0
+u
(c
0
)(1 )Ak
0
g
1
0
u
(c
0
)c
0
]
and
W(c
t
, k
t
, g
t
; ) = u(c
t
) +[u(c
0
)(1 )Ak
t
g
1
t
u
(c
t
)c
t
].
Then the Ramsey Problem can be rewritten as
max
{ct,kt,gt}
t=0
V
0
+
t=1
t
W(c
t
, k
t
, g
t
; )
s.t. c
t
+k
t+1
+g
t+1
Ak
t
g
1
t
k
0
given
non-negativity
86
Let
t
be the multiplier on the resource constraint. FOCs w.r.t. c
t
and k
t+1
for t 1 are
c
t
:
t
W
c
(t) =
t
k
t+1
:
t+1
W
k
(t + 1) +
t+1
F
k
(t + 1) =
t
This gives us the following Euler equation:
W
c
(t) = [W
k
(t + 1) +W
c
(t + 1)F
k
(t + 1)], t 1.
Moving W
c
(t) to the RHS, this is
1 =
_
W
k
(t + 1)
W
c
(t)
+
W
c
(t + 1)F
k
(t + 1)
W
c
(t)
_
, t 1. (8)
Recall from part (c) the Euler equation that must hold in any TDCE:
1 =
u
(t + 1)
u
(t)
(1
kt+1
)F
k
(t + 1), t 0.
We know that u
(t) = c
t
. We dened W(c
t
, k
t
, g
t
; ) as
W(c
t
, k
t
, g
t
; ) = u(c
t
) +[u(c
0
)(1 )Ak
t
g
1
t
u
(c
t
)c
t
].
Plugging in the utility function specied in the problem, we have
W(c
t
, k
t
, g
t
; ) =
c
1
t
1
+[c
0
(1 )Ak
t
g
1
t
c
1
t
]
so
W
c
(t) = c
t
(1 )c
t
= c
t
(1 (1 )).
This means that
u
(t + 1)
u
(t)
=
W
c
(t + 1)
W
c
(t)
.
Thus in any TDCE,
1 =
W
c
(t + 1)
W
c
(t)
(1
kt+1
)F
k
(t + 1), t 0.
Suppose the economy converges to a steady state. Then in any TDCE,
Wc(t+1)
Wc(t)
1. So
1 = lim
t
(1
kt+1
)F
k
(t + 1).
But the RP Euler equation (8) implies that
1 = lim
t
_
W
k
(t + 1)
W
c
(t)
+F
k
(t + 1)
_
.
So
kt
0 only if
W
k
(t+1)
Wc(t)
0.
32 Spring 2006, I.1 (Larry, TDCE)
Part (a)
I assume that each rm can produce consumption, investment or government spending using the same
technology F
j
. Then all three goods will have the same price. Given taxes
ct
,
nt
,
kt
,
xt
, (T
i
t
)
I
i=1
t=0
and
government spending g
t
t=0
, a TDCE is
Household allocations z
ih
= c
ih
t
, n
ih
t
, x
ih
t
, k
ih
t+1
t=0
, i = 1, . . . , I;
87
Firm allocations z
jf
= y
jf
t
, n
jf
t
, k
jf
t

t=0
, j = 1, . . . , J; and
Prices p
t
, w
t
, r
t
t=0
1) For all i = 1, . . . , I, z
i
c
solves
max
{c
ih
t
,n
ih
t
,x
ih
t
,k
ih
t+1
}
t=0
t=0
t
u
i
(c
ih
t
, 1 n
ih
t
)
s.t.
t=0
p
t
[(1 +
ct
)c
ih
t
+ (1 +
xt
)x
ih
t
]
t=0
[r
t
(1
kt
)k
ih
t
+w
t
(1
nt
)n
ih
t
+T
i
t
] +
J
j=1
i
j
j
k
ih
t+1
x
ih
t
+ (1 )k
ih
t
0 n
ih
t
n
i
k
ih
0
,
i
j
given
non-negativity
2) For all j = 1, . . . , J, z
j
f
solves
max
{y
jf
t
,n
jf
t
,k
jf
t
}
t=0
j
=
t=0
[p
t
y
jf
t
r
t
k
jf
t
w
t
n
jf
t
]
s.t. y
jf
F
j
(k
jf
t
, n
jf
t
), t
non-negativity
3) The allocation is feasible, i.e., for all t, the markets clear:
iI
[c
ih
t
+x
ih
t
] +g
t
=
jJ
F
j
(k
jf
t
, n
jf
t
)
iI
k
ih
t
=
jJ
k
jf
t
iI
n
ih
t
=
jJ
n
jf
t
4) The governments budget balances:
t=0
p
t
g
t
=
t=0
I
i=1
_
p
t
_
ct
c
ih
t
+
xt
x
ih
t
_
+r
t
kt
k
ih
t
+w
t
nt
n
ih
t
T
i
t
.
Part (b)
Since each consumers BC holds with equality, if we add up the budget constraints for all consumers we then
have
t=0
I
i=1
p
t
[(1 +
ct
)c
ih
t
+ (1 +
xt
)x
ih
t
] =
t=0
I
i=1
[r
t
(1
kt
)k
ih
t
+w
t
(1
nt
)n
ih
t
+T
i
t
] +
I
i=1
J
j=1
i
j
j
.
Since the total shares of each rm add up to 1 and the markets clear in every period, we can rewrite this as
t=0
I
i=1
p
t
[(1 +
ct
)c
ih
t
+ (1 +
xt
)x
ih
t
] =
t=0
I
i=1
[r
t
(1
kt
)k
ih
t
+w
t
(1
nt
)n
ih
t
+T
i
t
] +
J
j=1
j
.
88
Subtituting in for
j
from the rms problems, we have
t=0
I
i=1
p
t
[(1 +
ct
)c
ih
t
+ (1 +
xt
)x
ih
t
] =
t=0
I
i=1
[r
t
(1
kt
)k
ih
t
+w
t
(1
nt
)n
ih
t
+T
i
t
]
+
t=0
J
j=1
[p
t
y
jf
t
r
t
k
jf
t
w
t
n
jf
t
].
Since the rms resource constraints hold with equality, this is the same as
t=0
I
i=1
p
t
[(1 +
ct
)c
ih
t
+ (1 +
xt
)x
ih
t
] =
t=0
I
i=1
[r
t
(1
kt
)k
ih
t
+w
t
(1
nt
)n
ih
t
+T
i
t
]
+
t=0
J
j=1
[p
t
F
j
(k
jf
t
, n
jf
t
) r
t
k
jf
t
w
t
n
jf
t
].
Using the market clearing conditions for capital and labor, we have
t=0
I
i=1
p
t
[(1 +
ct
)c
ih
t
+ (1 +
xt
)x
ih
t
] =
t=0
I
i=1
[r
t
(1
kt
)k
ih
t
+w
t
(1
nt
)n
ih
t
+T
i
t
]
+
t=0
J
j=1
p
t
F
j
(k
jf
t
, n
jf
t
)
t=0
iI
[r
t
k
ih
t
+w
t
n
ih
t
].
Cancelling out terms on the RHS and rearranging, we have
t=0
I
i=1
[p
t
((1 +
ct
)c
ih
t
+ (1 +
xt
)x
ih
t
) T
i
t
]
t=0
J
j=1
p
t
F
j
(k
jf
t
, n
jf
t
) =
t=0
I
i=1
[r
t
kt
k
ih
t
+w
t
nt
n
ih
t
]
Multiplying both sides by (-1) gives us
t=0
J
j=1
p
t
F
j
(k
jf
t
, n
jf
t
)
t=0
I
i=1
[p
t
((1 +
ct
)c
ih
t
+ (1 +
xt
)x
ih
t
) +T
i
t
] =
t=0
I
i=1
[r
t
kt
k
ih
t
+w
t
nt
n
ih
t
]
Using market clearing for goods, we get
t=0
p
t
g
t
t=0
I
i=1
[p
t
(
ct
c
ih
t
+
xt
x
ih
t
) +T
i
t
] =
t=0
I
i=1
[r
t
kt
k
ih
t
+w
t
nt
n
ih
t
]
Rearranging, we have
t=0
p
t
g
t
=
t=0
I
i=1
[p
t
(
ct
c
ih
t
+
xt
x
ih
t
) +r
t
kt
k
ih
t
+w
t
nt
n
ih
t
T
i
t
]
Therefore the GBC is automatically satised under the assumptions of the problem.
33 Spring 2006, I.3 (Chari, DP)
I make the following assumptions:
(i). 0 < < 1.
(ii). The production function F is continuous and strictly increasing.
89
(iii). F(0) = 0, and a maximum sustainable level of capital

k such that k

k k F(k) +(1 )k and
k

k k F(k) + (1 )k.
(iv). The utility function u is continuous and strictly increasing.
Assumption (iii) implies that the capital stock will never go above

k, so we can restrict our attention to
the interval X = [0,
k]. Dene the correspondence : X X by

(k) = [0, F(k) + (1 )k] X.
Note that for all k X, 0 (k) and (k) is compact. Further, (ii) implies that F(k) + (1 )k is
continuous, so (k) is continuous. This implies that is a nonempty-valued, compact-valued, continuous
correspondence. Our assumptions also imply that the map (k, k
) u[F(k) + (1 )k k
] is continuous
and bounded on the relevent interval. Thus A4.3-A4.4 in SLP are satised, so the principle of optimality
implies that value of the sequence problem solves the following functional equation:
v(k) = max
k
(k)
u[F(k) + (1 )k k
] +v(k
).
Let C
0
(X) denote the set of continuous, real-valued functions dened on X. Note that since X is
compact, every element of C
0
(X) is bounded. This implies that C
0
(X) is a Banach space. Dene the
operator T as
Tf(k) = max
k
(k)
u[F(k) + (1 )k k
] +f(k
).
Let f C
0
(X). By our continuity assumptions, u[F(k) + (1 )k k
] is bounded on X. Then Tf(k)

is also bounded. Our continuity assumptions and the above facts about imply that Tf(k) satises the
assumptions of the theorem of the maximum. Therefore Tf(k) is continuous. Thus T : C
0
(X) C
0
(X).
To show that T is a contraction, it suces to show that T satises Blackwells suciency conditions.
First, let f, g C
0
such that f(k) g(k) for all k R
+
. Then for all k k,
Tg(k) Tf(k) =
_
max
k
(k)
u[F(k) + (1 )k k
] +g(k
)
_
_
max
k
(k)
u[F(k) + (1 )k k
] +f(k
)
_
= max
k
(k)
(g(k) f(k))
0
Thus Tf(k) Tg(k) for all k k, so T satises the monotonicity condition. Next, let f C
0
. Then
T(f +a)(k) = max
k
(k)
u[F(k) + (1 )k k
] +[(f +a)(k)]
= max
k
(k)
u[F(k) + (1 )k k
] +f(k) +a
= Tf(k) +a
Since (i) implies that 0 < < 1, T satises the discounting condition. Therefore T satises Blackwells
suciency conditions and is thus a contraction. Since C
0
(X) is a Banach space, the contraction mapping
theorem implies that T has a unique xed point v C
0
(X), i.e., there exists a unique continuous and
bounded function v such that
v(k) = max
k
(k)
u[F(k) + (1 )k k
] +v(k
).
Let S
C
0
(X) be the subset of weakly increasing functions and let S
be the subset of strictly

increasing functions. Note that S
is a closed subset of C
0
(X). To prove that v is strictly increasing, by
the corollary to the CMT it suces to show that T(S
) S
. Let f S
. Then f is weakly increasing.

Since u and F are both strictly increasing, u[F(k) + (1 )k k
] is strictly increasing in k. Let k

1
, k
2

R
+
such that k
1
< k
2
. Let k
1
(k
1
) attain Tf(k
1
). Note that (k) = [0, F(k
1
) + (1 )k
1
] and
90
(k
) = [0, F(k
2
) + (1 )k
2
]. Since F is strictly increasing, (k
1
) (k
2
). Then k
1
(k
2
). Since
u[F(k) +(1 )k k
] is strictly increasing in k, u[F(k

2
) +(1 )k
2
k
1
] > u[F(k
1
) +(1 )k
1
k
1
]. Then
Tf(k
2
) u[F(k
2
) + (1 )k
2
k
1
] +f(k
2
)
> u[F(k
1
) + (1 )k
1
k
1
] +f(k
1
)
= Tf(k
1
)
Then Tf(k) is also strictly increasing, i.e., Tf S
. This implies that T(S
) S
, so by the corollary to
the CMT, v S
. QED.
34 Fall 2005, II.4 (Chari, cash-credit)
Part (a)
A competitive equilibrium in this economy is a household allocation z
h
= c
1t
, c
2t
, n
t
, M
t
, B
t
t=0
, a rm
allocation z
f
= y
t
, n
f
t
t=0
, a price system p = p
t
, w
t
t=0
, and a policy =
B
t
,

M
t
, T
t
, R
t
t=0
such that
(i) Given p, z
h
solves the consumers problem, i.e.,
z
h
argmax
{c1t,c2t,nt,Mt,Bt}
t=0
t=0
t
[log c
1t
+log c
2t
+ log(1 n
t
)]
s.t. M
t
+B
t
(M
t1
p
t1
c
1t1
) p
t1
c
2t1
+w
t1
n
t1
+R
t1
B
t1
T
t
, t
p
t
c
1t
M
t
, t
non-negativity, no Ponzi, M
0
, B
0
given
(i) Given p, z
f
solves the rms problem, i.e.,
z
f
argmax
{yt,n
f
t
}
t=0
t=0
[p
t
y
t
w
t
n
f
t
]
s.t. y
t
n
f
t
, t
non-negativity
(iii) The governments budget balances:
M
t+1

M
t
+

B
t+1
= T
t
+R
t

B
t
, t.
(iv) The markets clear: for all t, y
t
= c
1t
+c
2t
, n
t
= n
f
t
, M
t
=

M
t
, and B
t
=

B
t
.
Part (b)
The consumers utility function is strictly increasing so the securities market constraint will hold with
equality. The utility function is also strictly concave, dierentiable, and satises Inada conditions, so the
solution is unique, interior, and given by the following FOCs:
c
1t
:
t
1
c
1t
=
t+1
p
t
+
t
p
t
(1)
c
2t
:
t
1
c
2t
=
t+1
p
t
(2)
n
t
:
t
1
1 n
t
=
t+1
w
t
(3)
M
t
:
t
=
t+1
+
t
(4)
B
t
:
t
= R
t
t+1
(5)
t
: M
t
+B
t
= (M
t1
p
t1
c
1t1
) p
t1
c
2t1
+w
t1
n
t1
+R
t1
B
t1
T
t
(6)
t
: p
t
c
1t
M
t
(7)
91
Using (1), (2), (4), and (5), we get
c
2t
c
1t
= R
t
. (8)
The rms production technology has constant returns to scale so its prot will be zero. A prot-maximzing
rm will always use all of its resources, so its resource constraint hold withy equality. Thus the rms FOC
is w
t
= p
t
. Then we can use (2) and (3) to get
c
2t
(1 n
t
)
= 1. (9)
c
1t
+c
2t
= n
t
. (10)
Equations (8) - (10) characterize the real allocations in equilibrium.
Note that these FOCs hold for any given policy . Given the constant interest rate policy, (8) implies
that
c
2t
c
1t
= R, t.
Given (9) and (10), this means that in equilibrium the real variables will be constant over time, i.e., c
1t
= c
1
,
c
2t
= c
2
, and n
t
= n.
Suppose there exists some R
> R such that n
n. Then from (9), c
2
c
2
. By (8), this means that
c
1
c
1
. But using n
> n and c
2
c
2
in (10) implies that we should have c
1
> c
1
. This is a contradiction.
Therefore it must be n is strictly decreasing in R.
Part (c)
We have the following three equations:
c
2t
c
1t
= R
t
c
2t
(1 n
t
)
= 1
c
1t
+c
2t
= n
t
The rst one gives us c
1t
as a function of c
2t
:
c
1t
=
c
2t
R
t
.
Plug this into the third equation:
c
2t
R
t
+c
2t
= n
t
.
The second equation gives us c
2t
in terms of n
t
:
c
2t
=
(1 n
t
)
.
Plug this into the previous equation:
(1nt)
R
t
+
(1 n
t
)
= n
t
.
Simplifying, we have
(1 n
t
)
_
1 +R
t
R
t
_
= n
t
.
Solving for n
t
, we have
n
t
=
1+Rt
Rt
1
1+Rt
Rt
=
1 +R
t
1 + ( + )R
t
.
92
This implies that
c
2t
=
R
t
1 + ( +)R
t
c
1t
=
1
1 + ( +)R
t
The equations above characterize the real variables in terms of the model parameters and the interest rate
(either R
0
or R
1
).
To get an expression for money growth, take the raio of (2) in periods t and t + 1:
c
2t
c
2t+1
=

t+2
p
t+1
t+1
p
t
.
Using (5), we have
c
2t
c
2t+1
=
p
t+1
R
t+1
p
t
.
Assume the CIA constraint is binding in all periods and substitute for the prices:
c
2t
c
1t+1
c
2t+1
c
1t
=
M
t+1
R
t+1
M
t
.
Finally, use (1) to cancel out all the consumption good allocations:
R
t+1
=
M
t+1
M
t
.
This gives the growth rate of the money supply between periods t and t + 1. Since the odd-period interest
rate R
1
is higher than the even-period interest rate R
0
, the money supply grows faster from an even to an
odd period than from an odd to an even period.
35 UPenn prelim, fall 2007, industry equilibria
Part (a): The rms problem
Let be the distribution from which entering rms draw their productivity. The value of entering the
industry is
V
E
= +
_
(s, 0)(s).
The value of an incumbent rm is
(s, n
; p) = max
_
(0, n
), max
n
_
psf(n) wn (n, n
) +
1
1 +r
ss
(s
, n; p)
__
.
We can also use d to denote the rms binary decision to stay or leave. In that case,
(s, n
; p) = max
d{0,1}
_
(1 d)(0, n
) +d max
n
_
psf(n) wn (n, n
) +
1
1 +r
ss
(s
, n; p)
__
.
Part (b): Transition function
The assumptions of the problem imply that is monotone, so the incumbent rms problem has a reservation
productivity, i.e., s
(n
; p) such that
d
(s, n
; p) =
_
1 s s
(n
; p)
0 s < s
(n
; p)
93
I assume that the rms choice of the amount of labor to hire must be in a compact set N = [0, n]. Let
S N be the Borel sigma algebra of S N. Then (S N, S N is a measurable space. Let o ^
denote an element of S N .
Let x be the measure of the rms in the industry. Dene Q as
Q((s, n
), (o ^) =
S
I(n(s, n
; p) ^
ss
.
To check that Q is indeed a transition function, we want to verify that
(i) For all (s, n
) S N, Q((s, n
), ) is a probability measure.
(ii) For all o ^ S N , Q(, (o ^)) is a measurable function.
Take (s, n
) S N. Clearly, Q((s, n
), ) = 0 and Q((s, n
), (o ^) 0, o ^ S N . By
construction, for any disjoint sequence of subsets of S N , the measure of the union is equal to the sum of
the measures. Finally, Q((s, n
), (S N) = 1 by construction. Thus (i) holds. Now take o ^ S N .

Since Q(, (o ^)) is the weighted sum of indicator functions, it is measurable. Thus (ii) holds. Therefore
Q is a transition function.
Part (c):
When there are no adjustment costs, the reservation productivity s
(n
; p) will be lower. This means that

the distribution of rms in such an industry will have a larger support. Further, the lack of adjustment
costs will induce rms to hire more labor because there is no cost associated with ring workers due to a
bad shock in the future. This implies that rms will be larger on average and thus aggregate output will be
higher at any given price. In econ 101 terms, getting rid of adjustment costs will cause aggregate supply to
shift outward, so equilibrium price will be lower as aggregate supply will intersect demand at a lower price.
Part (d): Stationary equilibrium
A stationary equilibrium is: functions
, n
, d
, s
, a measure x
, a price p
, and a scalar
such that:
(i)
, n
, d
solve the incumbent rms problem given p
.
(ii) s
(n
) is the reservation productivity as described above, i.e.,

d
(s, n
; p) =
_
1 s s
(n
; p)
0 s < s
(n
; p)
.
(iii) =
sS
(s, 0; p
)(s) (no free entry).

(iv) For all o ^ S N ,
x
(o ^)
t
=
sS
_
N
Q[(s, n
), ((o s
(n
(s, n
; p
)), . . . , s
5
) ^)]
x
(s, dn
t
+

(S{s
(0;p
),...,s
5
})
I0 ^(s
)
(v) Supply equals demand in every period:
t
(1 p
) =
sS
_
N
sf(n
(s, n
; p
))x
(s, dn
).
94

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is invariant, i.e., for all /c A E ,

c. If the shocks were not independently distributed, we would replace dF(

(A, k, ) denote the optimal choice of n given A, k, . Then we have

(A, k, ) will be a linear function of k, i.e., the ratio

(A, Qk, ) +RQb] = u [AF(Qk, Qn

(A, Qk, ) +RQb] = (1 )u(Q)u(AF(k, n

is the maximizing value, we have

denote the maximizing value, and note that

does not depend on c, W, or t. This

k such that for all k [

k, ) and all n, F(k, n) + (1 )k k.

. Since F and u are bounded on [0,

k. WLOG, assume that

. Since f is strictly concave, f

k). Since (*) holds with equality only for

and dene the sequence

. Again, since f is strictly increasing, f

k). Since (*) holds with

and dene the sequence

, the unique positive xed point of g, is globally stable. As

[0, z]. Then

, we can use (2.5) to get

) such that (2.8) holds and

as a function of p and F(z

also rises. Thus z

[1 (1 p)] = b[1 (1 p)] +

We can see from (2.12) that z

). Since G is a mean-preserving spread of F, we

Note the formula for covariance:

, etc. The Euler equation

). Therefore we no longer need the claim prices

w(z, K, N)n +q(z, K)

) attains V (h, k). Then for > 0, (h

) attains V (h, k).

) does not attain V (h, k). Then (h

) (h, k), homogeneity of implies that

) attains V (h, k). Therefore it must be that (h

that the worker would take solves

(X) is a closed subset of C(X), C

(X) can be viewed as a Banach space itself.

has a xed point, we need to show that T

satisfy Blackwells suciency

both satisfy monotonicity. I assume that

satises discounting since

satises discounting as well. Thus both operators satisfy Blackwells

(X) is a Banach space, the Contraction Mapping

each have a unique xed point in C

(; ) is the xed point for T

(; ) is the policy function associated with v

(k; ) must satisfy the FOC:

(k; ); ).. (1)

(k; ) for all k X.

(k; ). Then by strict concavity of u,

(k; ), k X. By part (e), v

(k; ). By strict concavity of u,

(k; ) for all

) X Y and a continuous linear functional

where U(x) is the consumers lifetime utility.

are marginal products of a prot-maximizing rm:

are marginal products, this implies that

) solves the consumers problem shown above given r

are marginal products of a prot-maximizing rm: