Solutions

Alexander Rubin
December 2019

Problem 3
1) Expectation of y˜1 is just an average:
1 1
Ey˜1 = · 20 + · 0 = 10
2 2

2) Remember that now we need to maximize expected consumption and a function can be differntiated under
the expectation. First-order conditions are:
1
−λ=0
c0
" #
1
E −λ=0
c1
Then Keynes-Ramsey Rule: " #
1 1
=E
c0 c1
Substitute c1 = y0 y˜1 − c0 and find expectation:
1 1 1 1 1
= +
c0 2 10 + 20 − c0 2 10 + 0 − c0
Solve this equation and get two roots: √
c0 = 15 + 10 3
Therefore, yp < c0 .

Problem 4
1) Take derivatives of production function and installation costs function and check whether they satisfy as-
sumptions:
F 0 (K) = 1 − k > 0, F 00 (K) = −1 < 0
C 0 (I) = I > 0, C 00 (I) = 1 > 0, C(0) = 0
2) Dynamic equations:
q̇ = rq − F 0 (K)
q = 1 + C 0 (I)
Steady-state corresponds to q̇ = 0 and K̇ = I = 0. Therefore:
q=1
F 0 (K) = r =⇒ K = 1 − r
3) Long-term relationship between interest rate and capital stock:
K =1−r
Intuitively, the larger the interest rate the smaller the optimal level of capital.