Ct

Zt :::::

Stationarizing transformation ct =

b
(1 ) yt
=
T Ht
ct Ht
1=

yt+1

ct
Et (1 +
)
(1 + )
kt+1 ct+1

(1 + ) kt+1
yt

= (1 )kt + yt ct
= kt (At Ht )1

lim E0 [t

t !0

Stochastic Structure: ln At = ln At

kt+1
]=0
ct
1

+ "t "t

N (0; 2 )

Solution: Policy Functions

ct = c(kt ; at )

yt = y(kt ; at )

kt+1 = k(kt ; at )

Ht = H(kt ; at )

No general closed form solution. Instead search for approximate solutions.

De ne hat variables as percentage deviations from steady state.
b
ct =

ct c
c

kt k
b
kt =
k

yt y
y

ybt =

b t = Ht H
H
H

Find linear policy functions which solve a linearization of the rst order
conditions.
Linearizations of FOC
H b
b t b
Ht = ybt H
ct
T H

b
ct = Et

ybt+1 b
kt+1 b
ct+1
k (1 + )

(1 + ) b
kt+1
ybt

y
c
= (1 )b
kt + ybt b
ct
k
k
bt
= b
kt + (1 )at + (1 )H

lim E0 [t b
kt+1 b
ct ] = 0

t !0

 Solutions

kt + pCA at
= pCK b
= pHK b
kt + pHA at
kt + pKA at
= pKK b
b
= pY K kt + pY A at

cbt
bt
H

b
kt+1
ybt

Method of Undetermined Coe cients. Linearized model puts restrictions

on these coe cients.
ybt = b
k + (1 )at + (1 )pHK b
kt + (1 )pHA at
t

= + (1 )pHK
= (1 ) + (1 )pHA

pY K
pY A

H
H
pHK b
kt +
pHA at
T H
T H

T
pHK
T H

T
pHA
T H
b
kt+1

pKK

pKA

= pY K b
kt + pY A at pHK b
kt pHA at pCK b
kt pCA at

= pY K pCK
= pY A pCA

y
(1 ) b
y
c
c
kt + pY K b
kt + pY A at pCK b
kt pCA at
(1 + )
k
k
k
k
(1 ) y
c
+ pY K pCK
(1 + ) k
k
y
c
pY A pCA
k
k

pCK b
kt pCA at

= Et

(pY K 1) b
kt+1 + pY A at+1 pCK b
kt pCA at+1
k (1 + )

Et [at+1 ] = at

y
pCK b
kt pCA at = Et
(pY K 1) b
kt+1 + pY A at pCK b
kt+1 pCA at
k (1 + )

h
i
ky (1+
pCK
) pY A (1 )pCA
i
ob
i
ob
kt + nh
at
Et b
kt+1
= nh

y
ky (1+
(p
1)
p

(p
1)
p
Y
K
CK
Y
K
CK
)
k (1+ )
pKK

pKA

nh

nh

y
k (1+ )

pCK

i
o
(pY K 1) pCK

y
k (1+ ) pY A (1
y
k (1+ )

(pY K

)pCA
i
o
1) pCK

3
Consumption
Investment
Employment
Output

2.5

%Deviation from Balanced Growth

1.5

0.5

0
0

Period

Figure 1:
8 equations and 8 unkinowns. Unfortunately, coe cients are complicated
functions of the parameters so it is di cult to get insight from these parameters.
Choose numerical parameters and model the response of the model to a
technology shock
= :025

= :99

= :004

= :36

= :95

= :007

Show the dynamic response to a 1 standard deviation technology shock

Another real shock to consider are scal shocks: i.e. shocks to government
tax and spending policies. Government scal policy complicates the use
of the social planner's problem to solve for equilibrium. In the absence
3

0.7
Wages
1+r
0.6

0.5

0.4

0.3

0.2

0.1

0
0

Figure 2:

of household utility from goverment spending, the social optimum is zero

government spending and zero distortionary taxation. However, the social
planner's problem is easily modi ed to account for government shocks.
Two often used ways of understanding the impact of government shocks
are to examine the extreme cases of an exogenous government spending
level nanced by lump sum taxes.
Market Equilibrium
max

1
X
t=1

t [log Ct + b log(T Ht )]

= (1 )Kt + Wt Ht + Rt Kt Ct Gt

s:t:Kt+1

max Kt Ht1

Wt Ht Rt Kt

Note - Since there are no distortionary taxes, there will be no pro ts.
Kt Ht1

= Wt Ht + Rt Kt

Can solve for second best optimum using the social planner's problem
max

1
X
t=1

t [log Ct + b log(T Ht )]

= (1 )Kt + Kt Ht1

s:t:Kt+1

Ct Gt

Distortionary Taxes - Government Selects a distoritionary tax rate, t ,

and spends the remainder.Market Equilibrium
max

1
X
t=1

s:t:Kt+1

t [log Ct + b log(T Ht )]

= (1 )Kt + (1 t ) [Wt Ht + Rt Kt ] Ct

max Kt Ht1

Wt Ht Rt Kt

First order conditions.

b
(1 t ) (1 ) Yt
=
Ct Ht
T Ht

1
1
(1 t ) Yt+1
= Et
1 +
Ct
Ct+1
Kt+1
5

1.5

0.5

Consumption
Investment
Employment
Output

-0.5

-1

-1.5
0

Figure 3:

0.1

-0.1
Real Wages
Return to Capital
-0.2

-0.3

-0.4

-0.5

-0.6
0

Figure 4:

Kt+1 = (1 )Kt + (1 t ) [Yt ] Ct

Yt = Kt Ht1

Stability - Reduce the set of linearized rst order conditions into two
dynamic linear equations in b
kt ; at ; b
ct :
H b
Ht
T H
bt
H

bt
H
ybt

ybt

ybt

ybt

b t b
b t b
= ybt H
ct = b
kt + (1 )at H
ct

H
T H

(1 )
1
b
kt + H
at H
b
ct
+

T H
T H +

= DHK b
kt + DHA at + DHC b
ct
b
bt
= kt + (1 )at + (1 )H
h
i
= b
kt + (1 )at + (1 ) DHK b
kt + DHA at + DHC b
ct

= [ + (1 )DHK ] b
kt + (1 ) [1 + DHA ] at + (1 )DHC b
ct
= DY K b
kt + DY A at + DY C b
ct

y
ybt+1 b
kt+1 b
ct+1
= Et
k (1 + )
h
i
= Et (DY K 1) b
kt+1 + ( DY C 1) b
ct+1

b
ct

DY A at b
ct
(1 + ) b
kt+1

c
y
= (1 )b
kt +
DY K b
kt + DY A at + DY C b
ct b
ct
k
k i
h
i
i
h
h
y
y
c
y
kt + DY A at + DY C b
ct
(1 ) + DY K b
k
k
k
k

Matrix equation

(1 + )
0
(DY K 1) ( DY C 1)
y

c
(1 ) + ky DY K
k DY C k
=
0
1
y

k DY A
=
DY A

b
kt
=
ct
b

A =
B
C
xt

First order stochastic linear di erence equation

A Et [xt+1 ] = B [xt ] + C at
Et [xt+1 ] = A 1 B [xt ] + A
Et [xt+1 ] = M [xt ] + D zt
8

C at

1. For any matrix of endogenous x, we can break the variables into two
parts, the jump variables, pt , and the pre-determined state variables,
st and exogenous state variables
= M [xt ] + A
xt =

C at

st
pt

Solution for
st
zt
= Gst + Hzt
= F

pt
st+1

2. If the number of eigenvalues of M that are greater than 1 (in absolute

value) is exactly equal to the number of rows of pt then there is a
unique, stable solution to these variables. If the number of unstable
eigenvalues is less than the number of rows of pt , there are multiple
stable solutions. If the number of unstable eigenvalues is greater than
the number of rows of pt .