Problem Set 4 Answer Key

Question 1 1. The Hamiltonian is H (c, k, , t) = c (t)1 t e + [rk (t) c (t)] 1

First, we derive the conditions that characterize the solution of the individual problem. Hc = c (t) et (t) = 0 (1) (t) Hk = (t) r = (2) (t) H = rk (t) c (t) = k The transversality condition is (T ) k (T ) = 0 which derives from k (T ) erT = 0 (1) implies that (2) implies that (t) c (t) = c (t) (t) (t) = r (t)

Thus, we get the growth rate of consumption over time. c (t) r = c (t) 2. The optimal consumption over the life cycle is c (t) = c (0) e
r t

, t [0, T ]

We need to obtain the optimal level of c (0). Using the budget constraint, one obtains T k (0) = c (s) ers ds
0

That is, the discounted value of consumption as of age 0 must equal the initial amount of assets (the only source of income!). Plugging the optimal consumption path, we get k (0) = c (0) = c (0) Let
r T 0 T 0

r s

ers ds

r e( r)s ds

r, then k (0) = c (0) eT 1 k (0) es ds

This implies that c (0) =

k (0) = eT 1

T 0

When increases, if r > , decreases; if r < , increases. Why? Because k (0) is xed, and d
T 0 T 0

es ds = d

T 0

ses ds > 0
k(0)
T 0

es ds increases (decreases) with . Therefore, c (0) =

es ds

decreases

with . Hence, if r > , consumption at the start of life increases with . If r < , consumption at the start of life decreases with . If r = , consumption at the start of the life-cycle remains unchanged. 2

Question 2 1. The Hamiltonian is H (c, k, , t) = [log (c) + log (h)] et + [rk (t) + w (1 h (t)) c (t)] First, we derive the conditions that characterize the solution of the individual problem. 1 t e (t) = 0 (3) Hc = c (t) t Hh = e w (t) = 0 (4) h (t) (t) Hk = (t) r = (t) H = rk (t) + w (1 h (t)) c (t) = k The transversality condition is (T ) k (T ) = 0 which derives from k (T ) erT = 0 (3) implies that (4) implies that (5) implies that (t) c (t) = c (t) (t) (t) (t) h = h (t) (t) (t) = r (t) c (t) =r c (t) (t) h =r h (t) 3 (5)

Thus, we get the growth rate of consumption and leisure over time

2. If r > , the growth rate of leisure is positive. So, the individual has more and more leisure as he/she ages. Thus, the individual works more at the start of his economic life relative to the end (labor declines over time). If r < , individual labor hours grow over time. If r = , labor hours are of course constant. Question 3 1. Since the evolution of k is determined by technology rather than . Because c preferences, enters the equation for c but not the one for k =0 when f (k ) = + g + a permanent decrease in the elasticity of intertemporal substitution (increase = 0 curve is unchanged. Therefore, in ) shifts the c = 0 line to the left. the k the dynamic eect is that the economy moves from A to A at the time of change, and then moves gradually towards the new steady state B long the new saddle path. Thus, consumption rst increases, then gradually decreases. The capital stock per-eective worker decreases towards the new steady state level. Insert g 1 here 2. Because c = 0 when f (k ) = + g + =0 a permanent increase in TFP shifts the c = 0 line to the right. Because k when c (t) = f (k ) (n + g + ) k = 0 curve shifts up at the increase in TFP. the k a) If the shift in c = 0 curve is relative big, the dynamic eect is that the economy moves from A to A at the time of change, and then moves gradually towards the new steady state B long the new saddle path. Accordingly, consumption level rst drops, and then increases gradually toward the new steady state level. The capital stock per-eective worker increases gradually to the new steady state level. Insert g 2 here 4

 = 0 curve is relative big, the dynamic eect is that the b) If the shift in k economy moves from A to A at the time of change, and then moves gradually towards the new steady state B long the new saddle path. Accordingly, consumption level rst increases a little, and then increases gradually toward the new steady state level. The capital stock per-eective worker increases gradually to the new steady state level. Insert g 3 here Question 4 1.Because c = 0 when f (k ) = + g + population growth rate n does not enters the equation for c . Therefore, c =0 = 0 when curve is unchanged. Because k c (t) = f (k ) (n + g + ) k = 0 curve shifts down at the increase in population growth rate. Therethe k fore, the new steady state capital to output ratio is unchanged. Insert g 4 here 2. Because c = 0 when f (k ) = + g + an increase in the growth rate of labor eciency g shifts the c = 0 curve to the left. (This can be shown in the following gure: the intersection of f (k ) and ( + g ) k changes from a to b) Insert g 5 here Therefore, the new steady state capital to output ratio decreases. 3. The saving rate s is given by (n + g + ) 5 k = s y

For a Cobb-Douglas production function with capital share , f (k/y ) = Therefore, the c = 0 curve is = + g + k/y then, + g + k/y = Thus, s = Because n+g+ + g +
1

. k/y

+ n s = g ( + g + )2

+ If n , higher rate of augmenting technical progress implies lower aggre+ + gate saving rates. If < n , higher rate of augmenting technical progress + implies higher aggregate saving rates. Because s 1 = >0 n + g +

higher rate of population growth implies higher aggregate saving rates.

c`=0

A B

k`=0

k*

Figure 1

c`=0 B

k`=0

k*

Figure 2

c`=0 B

A A

k`=0

k*

Figure 3

c`=0

k`=0

k`=0

k*

Figure 4

f(k)

a b

Figure 5