Dynamic Programming Methodology

Baseline Environment: There is a continuum of agents of measure one in this economy who are homogeneous and innitely lived. Agents derive utility from the consumption of a non durable good (e.g. food) and from leisure. The preferences are represented by the utility function

Preferences

t U (Ct , lt )
t=0

(0, 1) is the inter-temporal discount factor, Ct is the non-durable consumption good and lt is leisure. The period utility function is assumed to be strictly increasing and strictly concave satisfying Inada conditions in the arguments.

An aggregate production technology produces output in this economy. The technology uses capital stock Kt and labor supply nt to produce an output Yt . The production function is a standard constant returns to scale technology which satises the standard concavity conditions. The technology is given by
Y = F (Kt , nt )

Technology

Capital depreciates at rate . A single representative rm associated with the technology maximizes prot every period Competitive markets ensure that rms operate a constant returns to scale technology. Therefore, individual labor earnings wt nt are a product of individual labor supply and the marginal product of labor. Firms rent capital from households at the rate rt . At the beginning of each period, an agent has capital stock Kt and one unit of time endowment. The agent simultaneously chooses consumption Ct , capital for next period Kt+1 and labor supply nt or 1 lt . The dynamic programming problem for the agent with the value function V (Kt ) is stated as follows:
V (Kt ) =
Ct ,Kt+1 ,lt

Recursive representation

max {U (Ct , lt ) + V (Kt+1 )}

subject to Ct + Kt+1 wt (1 lt ) + rt Kt + Kt (1 )

Bellman equation and Euler conditions

The Bellman equation can be written as
lt ,Kt+1

V (Kt ) = max {U (wt (1 lt ) + rt Kt + Kt (1 ) Kt+1 , lt ) + V (Kt+1 )}

First order condition w.r.t. Kt+1

U1 (Ct , lt )(1) + V (Kt+1 ) = 0...........(1)

Using envelope theorem:

V (Kt ) = U1 (Ct , lt )[rt + 1 ]

Updating one period, we get

V (Kt+1 ) = U1 (Ct+1 , lt+1 )[rt+1 + 1 ]..........(2)

Putting (2) in (1), we get

U1 (Ct , lt ) = U1 (Ct+1 , lt+1 )[rt+1 + 1 ].........(3)

Equation (3) is the Euler condition for consumption in an innitely lived model. Intuitively, the LHS denotes the marginal utility from giving up one unit consumption today. RHS denotes the marginal utility from consumption in future discounted at the rate along with marginal capital gains in the future period. First order condition w.r.t. lt
U1 (Ct , lt )(wt ) + U2 (Ct , lt ) = 0 wt U1 (Ct , lt ) = U2 (Ct , lt )..........(4)

Equation (4) is the Euler condition for leisure. Looking back at a representative agent, one period economy, the condition is exactly the same. There are no inter-temporal features. , Kt Equations (3), (4) and the budget constraints solve for optimal Ct +1 , lt

A recursive competitive equilibrium is a set of decision rules, Ct (Kt ), lt (Kt ), Kt+1 (Kt ) and corresponding value function V (Kt ), aggregate capital Kt , labor nt , prices r and w, such that the following conditions hold: 1.
Given factor prices,the decision rules are optimal and solve:

Recursive Competitive Equilibrium

{Ct (Kt ), lt (Kt ), Kt+1 (Kt )}

for agents

V (Kt ) =

Ct ,Kt+1 ,lt

max {U (Ct , lt ) + V (Kt+1 )}

subject to Ct + Kt+1 wt (1 lt ) + rt Kt + Kt (1 )

2. Factor prices are competitively determined.

F1 (Kt , nt ) = rt F2 (Kt , nt ) = wt

3.

Market clearing conditions hold:

Capital Market clears : Goods Market clears:

Kt = Kt
where

Ct + It = F (Kt , nt )

It is investment.

Labor Market clears: nt =

n t or lt

= (1

n t)