Eco 387: Macroeconomics

Problem Set 4
Due: Oct 7 2014
Julian Ludwig
UTID: j738
Problem 1
Dene a competitive equilibrium in which households can trade shares of rms from period to period.
Show that, for the right share prices, this is equivalent to the model where households are endowed with
shares and there is no trade.
Qualitative reasoning:
(i) Given technology with constant return to scale, rms can be represented with a single
rm in equilibrium. Hence, all rms have the same input-output ratio and same capital
to labor ratio in equilibrium. The prot per share is therefore the same for each rm in
each period. If in addition all households have same utility, there is no reason to trade.
(ii) In competitive equilibrium with constant return to scale technology, rms dont have
prots. Wage and return on capital are therefore the only income and shares neither
distribute dividends nor utility. Hence, there is no demand for shares and therefore no
trade.
Quantitative reasoning:
Based on a competitive equilibrium with households and rms, I show (ii) mathematically that
prots are equal to zero with constant returns to scale technology. This then implies that there is
no market for shares.
ADE consists of:
I.
_
p
ct
, p
xt
, r
t
, w
t
, ( p
h
x
jt
)
Jx
j=1
, ( p
h
c
jt
)
Jc
j=1
_

t=0
: Prices: consumption price, investment price,
rate of return on capital, wage, share prices for investment rms, and share prices for
consumption rms.
II.
_
c
i
t
, x
i
t
,

k
i
t+1
, n
i
t
,

l
i
t
, (

h
x
jit
,

x
jit+1
)
Jx
j=1
, (

h
c
jit
,

c
jit+1
)
Jc
j=1
_

t=0
, i: Households allocations: con-
sumption, investment, capital in t +1, labor, leisure, investment in and stock of shares of
investment rms, and investment in and stock of shares of consumption rms.
III. (

k
j
x,t
, n
j
c,t
, x
j
t
)

t=0
, j = 1, ..., J
x
: Investment rms allocations: capital, labor, and invest-
ment (=output),
(

k
j
c,t
, n
j
c,t
, x
j
t
)

t=0
, j = 1, ..., J
x
: Consumption rms allocations: capital, labor, and con-
sumption (=output).
IV. (
j
x,t
)

t=0
, j = 1, ..., J
x
: Investment rms prots,
(
j
c,t
)

t=0
, j = 1, ..., J
c
: Consumption rms prots
1
Eco 387: Macroeconomics
Problem Set 4
Julian Ludwig
UTID: j738
s.t.
1) Given I and IV, II solve i
max
( c, x,

k, n,

l)0,(

x
j
,

h
x
j
)
Jx
j=1
,(

c
j
,

h
c
j
)
Jc
j=1
)
U
i
( c,

l) (1)
s.t.

t=0
_

_
p
ct
c
t
+ p
xt
x
t
+
Jx

j=1
p
h
x
jt
h
x
jt
+
Jc

j=1
p
h
c
jt
h
c
jt
. .
new investment in shares
_

t=0
_

_
w
t
n
t
+ r
t
k
t
+
Jx

j=1

x
jt

j
x,t
+
Jc

j=1

c
jt

j
c,t
. .
dividends
_

_
,
(2)
k
t+1
= (1 )k
t
+x
t
, t (3)
l
t
+n
t
= n
i
t
, t (4)

x
jt+1
=
x
jt
+h
x
jt
, t, j (5)

c
jt+1
=
c
jt
+h
c
jt
, t, j (6)
given k
i
0
,
x
ji0
, and
c
ji0
, j, i.
2) Given I, III and IV solve j
max
( x, n,

k)

t=0
( p
xt
x
t
wtn
t
r
t
k
t
), (7)
s.t.
x
t
F
j
x
(k
t
, n
t
), (8)
where

j
x,t
= p
x,t
x
j
t
w
t
n
j
t
r
t

k
j
t
, (9)
and
max
( c, n,

k)

t=0
( p
ct
c
t
wtn
t
r
t
k
t
), (10)
s.t.
c
t
F
j
c
(k
t
, n
t
), (11)
where

j
c,t
= p
c,t
c
j
t
w
t
n
j
t
r
t

k
j
t
. (12)
3) Markets clear t
(i) Market for consumption goods
I

i=1
c
i
t
=
Jc

j=1
c
j
t
(13)
(ii) Market for investment goods
I

i=1
x
i
t
=
Jx

j=1
x
j
t
(14)
2
Eco 387: Macroeconomics
Problem Set 4
Julian Ludwig
UTID: j738
(iii) Labor market
I

i=1
n
i
t
=
Jx

j=1
n
j
t
+
Jc

j=1
n
j
t
(15)
(iv) Capital market
I

i=1

k
i
t
=
Jx

j=1

k
j
t
+
Jc

j=1

k
j
t
(16)
(v) Shares market
I

i=1

h
x
jit
= 0, j = 1, ..., J
x
(17)
I

i=1

h
c
jit
= 0, j = 1, ..., J
c
(18)
I

i=1

x
jit
= 1, j = 1, ..., J
x
(19)
I

i=1

c
jit
= 1, j = 1, ..., J
c
(20)
Now it is shown that prots are zero in equilibrium. In order to maximize prots, rms do not
waste output, hence, constraints holds with equality. The investment rms rst order condition
is given with x
t
= F
j
x
(k
t
, n
t
) as
[k
t
] : p
x,t
F
j
x
(k
t
, n
t
)
k
t
r
t
= 0, (21)
[n
t
] : p
x,t
F
j
n
(k
t
, n
t
)
n
t
w
t
= 0, (22)
so that with positive demands
r
t
= p
x,t
F
j
x
(

k
t
, n
t
)
k
t
, (23)
w
t
= p
x,t
F
j
n
(

k
t
, n
t
)
n
t
. (24)
By Eulers Homogeneous Function Theorem (see mathworld.wolfram.com), a homogeneous func-
tion of order n can be written as
n g(y
1
, ..., y
K
) =
K

k=1
y
k
g(y
1
, ..., y
K
)
y
k
. (25)
Assuming constant return to scale (CRS) technology (as for example Cobb-Douglas), rms pro-
duction function is homogeneous of degree 1. Hence, with Eulers Homogeneous Function Theorem
one gets
F
j
n
(k
t
, n
t
) = n
t
F
j
n
(k
t
, n
t
)
n
t
+k
t
F
j
k
(k
t
, n
t
)
k
t
. (26)
Combining investment rms prot function (9) with the above equations 23, 24, and 26, it is
obvious that rms have no prots:

j
x,t
= p
x,t
F
j
n
(

k
t
, n
t
) w
t
n
j
t
r
t

k
j
t
, (27)
3
Eco 387: Macroeconomics
Problem Set 4
Julian Ludwig
UTID: j738
inserting 23 and 24

j
x,t
= p
x,t
F
j
n
(

k
t
, n
t
) p
x,t
F
j
n
(

k
t
, n
t
)
n
t
. .
wt
n
j
t
p
x,t
F
j
x
(

k
t
, n
t
)
k
t
. .
rt

k
j
t
, (28)

j
x,t
= p
x,t
_
F
j
n
(

k
t
, n
t
)
F
j
n
(

k
t
, n
t
)
n
t
n
j
t

F
j
x
(

k
t
, n
t
)
k
t

k
j
t
_
, (29)
inserting 26

j
x,t
= p
x,t
__
F
j
n
(

k
t
, n
t
)
n
t
n
j
t
+
F
j
x
(

k
t
, n
t
)
k
t

k
j
t
_

F
j
n
(

k
t
, n
t
)
n
t
n
j
t

F
j
x
(

k
t
, n
t
)
k
t

k
j
t
_
= 0 (30)
The same holds for rms that produce consumption goods.
Problem 2
In the CE we dened in class, show that we could have instead had rms maximize prots period by
period rather than the discounted sum and would have gotten the same equilibrium.
The maximization problem as discounted sum of prots (
j
xt
) of investment rm j {1, ..., J
x
} is
max

t=0

j
xt
(1)
= max
(xt,nt,kt)

t=0

t=0

t
( p
xt
x
t
w
t
n
t
r
t
k
t
) (2)
s.t.
x
t
F
j
xt
(k
t
, n
t
) t (3)
Assuming there is no free disposal of investment one gets an equality constraint and x
t
can be
replaced with F
j
xt
(k
t
, n
t
) in the maximization problem
max
(xt,nt,kt)

t=0

t=0

t
_
p
xt
F
j
xt
(k
t
, n
t
) w
t
n
t
r
t
k
t

. (4)
All rst order conditions have the form
t
[...] = 0. Hence, the discount factors
t
can be reduced
and therefore play no role for choosing the optimum allocation. A period by period maximization
problem (see equation below) therefore gives the same rst order conditions as the maximization
over all periods with discounted sum.
max
(xt,nt,kt)
p
xt
F
j
xt
(k
t
, n
t
) w
t
n
t
r
t
k
t
, t {0, ..., }. (5)
The same applies for consumption producing rm i {1, ..., J
c
}, which faces the following analo-
gous period by period problem:
max
(ct,nt,kt)
p
ct
F
i
ct
(k
t
, n
t
) w
t
n
t
r
t
k
t
, t {0, ..., }. (6)
4
Eco 387: Macroeconomics
Problem Set 4
Julian Ludwig
UTID: j738
Problem 3
Dene a CE with sequential markets and argue that the equilibrium allocation would be identical to
those from the time-zero equilibrium we dened in class.
Here I set up the whole SME model and compare its the rst order conditions (FOCs) with the
FOCs of the ADE model.
SME consists of:
I. ( p
ct
, p
xt
, r
t
, w
t
)

t=0
: Prices: consumption price, investment price, rate of return on capital,
and wage.
II.
_
c
i
t
, x
i
t
,

k
i
t+1
, n
i
t
,

l
i
t
_

t=0
, i: Households allocations: consumption, investment, capital in
t + 1, labor, and leisure.
III. (

k
j
x,t
, n
j
c,t
, x
j
t
)

t=0
, j = 1, ..., J
x
: Investment rms allocations: capital, labor, and invest-
ment (=output),
(

k
j
c,t
, n
j
c,t
, x
j
t
)

t=0
, j = 1, ..., J
x
: Consumption rms allocations: capital, labor, and con-
sumption (=output).
IV. (
j
x,t
)

t=0
, j = 1, ..., J
x
: Investment rms prots,
(
j
c,t
)

t=0
, j = 1, ..., J
c
: Consumption rms prots
s.t.
1) Given I and IV, II solve i in every t
max
(cs, xs,ks,ns,ls)

s=t
0

s=t

st
u
i
(c
s
, l
s
) (1)
s.t.
p
s
c
s
+ p
s
x
s
= w
s
n
s
+ r
s
k
s
, s t (2)
k
s+1
= (1 )k
s
+x
s
, s t (3)
l
s
+n
s
= n
i
s
, s t (4)
given k
i
0
, i.
2) Given I, III and IV solve j in every t
max
(xs,ns,ks)

s=t

s=t
( p
xs
x
s
w
s
n
s
r
s
k
s
), (5)
s.t.
x
s
F
j
x
(k
s
, n
s
), s t (6)
and
max
(cs,ns,ks)

s=t

s=t
( p
cs
c
s
w
s
n
s
r
s
k
s
), (7)
s.t.
c
s
F
j
c
(k
s
, n
s
), s t (8)
5
Eco 387: Macroeconomics
Problem Set 4
Julian Ludwig
UTID: j738
3) Markets clear t
(i) Market for consumption goods
I

i=1
c
i
t
=
Jc

j=1
c
j
t
(9)
(ii) Market for investment goods
I

i=1
x
i
t
=
Jx

j=1
x
j
t
(10)
(iii) Labor market
I

i=1
n
i
t
=
Jx

j=1
n
j
t
+
Jc

j=1
n
j
t
(11)
(iv) Capital market
I

i=1

k
i
t
=
Jx

j=1

k
j
t
+
Jc

j=1

k
j
t
(12)
The maximization problems of the rms do not dier between ADE and SME, since the op-
timization can be rewritten to a period by period problem (see problem 2). The only thing that
diers is the maximization of the household. Based on rst order conditions, I now argue why
ADE and SME equilibrium allocations are identical.
The ADE from problem 1 without shares produces the following Lagrangian for the household:
L
ADE
=

t=0

t
u
i
(c
t
, 1 n
t
) +
_

t=0
[ w
t
n
t
+ r
t
k
t
p
c,t
c
t
p
x,t
x
t
]
_
+

t=0
[
t
((1 )k
t
+x
t
k
t+1
)] . (13)
with rst order conditions with respect to investment and capital
[ADE : x
t
] : p
x,t
+
t
= 0 (14)
[ADE : x
t+1
] : p
x,t+1
+
t+1
= 0 (15)
[ADE : k
t+1
] :
t
+ r
t+1
+
t+1
(1 ) = 0. (16)
Replacing
p
x,t
+ r
t+1
+ p
x,t+1
(1 ) = 0, (17)
divide by and solve for p
x,t
p
x,t
= r
t+1
+ p
x,t+1
(1 ). (18)
The SME produces the following Lagrangian for the household:
L
SME
=

s=t
_

st
u
i
(c
s
, 1 n
s
) +( w
s
n
s
+ r
s
k
s
p
c,s
c
s
p
x,s
x
s
) +
s
((1 )k
s
+x
s
k
s+1
)

, (19)
which rst order conditions produce the same interest rate to price relationship as in ADE:
p
x,t
= r
t+1
+ p
x,t+1
(1 ). (20)
ADE and SME therefore produce the same equilibrium prices and allocations.
6
Eco 387: Macroeconomics
Problem Set 4
Julian Ludwig
UTID: j738
Problem 4
Solve for the steady state in the following problem:
max
(ct,zt,kt+1,nt,lt)

t=0

t=0

t
[logc
t
+logl
t
] (1)
s.t.
c
t
+x
t
= Ak

t
n
1
t
(2)
k
t+1
= (1 )k
t
+x
t
(3)
l
t
+n
t
= 1 (4)
Find the change in labor and consumption in response to a change in TFP A.
I assume all parameters to be positive and < 1, < 1, 1.
Qualitative reasoning: An increase in TFP (A) increases output per labor. Hence, forgoing
a unit of leisure increases consumption by more with higher A than before. Hence, leisure gets
more costly relative to consumption. Or, consumption gets cheaper relative to leisure time. I thus
predict a substitution eect: some of leisure will be substituted with consumption. However, an
increase in A also increases total output. The household earns therefore more income and spends
it on goods and leisure. This phenomenon is called income eect. I therefore predict an increase
in consumption, since its relative price to leisure time decreases (substitution eect) and because
overall income increases (income eect). Whether leisure time increases or decreases depends on
the size of the substitution eect (negative eect) relative to the income eect (positive eect) on
leisure.
Quantitative reasoning:
The number of budget constraints can be reduced to one. Equation 4 allows for dening l
t
as
(1 n
t
). Solving equation 2 for investment x
t
and plugging it into equation 3 so that
c
t
+k
t+1
= (1 )k
t
+Ak

t
n
1
t
. (5)
Using Lagrangian, the rst order conditions are
[c
t
] :
t
1
c
t

t
= 0 (6)
[n
t
] :
t

1 n
t
+
t
(1 )Ak

t
n

t
= 0 (7)
[k
t+1
] :
t
+
t+1
(1 +Ak
1
t
n
1
t
) = 0 (8)
Solving equation 6 for
t
, and plugging it with its t + 1 equivalence into equation 8 one gets the
Euler equation
1
c
t
=
1
c
t+1
(1 + Ak
1
t
n
1
t
. .
marginal return on capital
) (9)
Inserting equation 6 into equation 7 then gives the consumption vs. leisure relationship
c
1
t
(1 )Ak

t
n

t
. .
marginal return on labor
= (1 n
t
. .
leisure
)
1
(10)
In steady state, all time indices can be dropped so that the Euler equation can be solved for
7
Eco 387: Macroeconomics
Problem Set 4
Julian Ludwig
UTID: j738
marginal return on capital
1 = (1 +Ak
1
n
1
)
Ak
1
n
1
. .
marginal return on capital
=
1
1 + (11)
Steady state equations of the consumption vs. leisure relationship is the following
c
1
(1 )Ak

. .
marginal return on labor
= (1 n
. .
leisure
)
1
(12)
Now solve equations 11 and 12 for
k
n
:
k
n
=
_
(A)
1
(
1
1 +)
1
1
. .
B
(13)
k
n
=
_
(1 )
1
A
1
c(1 n)
1
1

(14)
so that combined
B =
_
(1 )
1
A
1
c(1 n)
1
1

(15)
and now solve equation 15 for leisure (1 n) with respect to consumption c
(1 n) = B

(1 )
1
A
1
c. (16)
Now using budget constraint in steady state:
c +k = Ak

n
1
. (17)
and solving for n, given
k
n
= B and k = nB:
c
k
= AB
1

c
nB
= (AB
1
)
n = c(AB

B)
1
(18)
And then inserting equation 18 into equation 16
1 c(AB

B)
1
= B

(1 )
1
A
1
c
1 c
1
(AB

B) = B

(1 )A
1
c
1
c (AB

B) = B

(1 )A
1
c = B

(1 )A
1
+AB

B (19)
From equation 13 one can see the relationship between A and B:
B = A
1
1
_

1
(
1
1 +)
1
1
. .
D
(20)
Hence, combining equation 19 and 20
c = (A
1
1
D)

(1 )A
1
+A(A
1
1
)

A
1
1
8
Eco 387: Macroeconomics
Problem Set 4
Julian Ludwig
UTID: j738
c = D

(1 )
1
A
1
1
+A
1
1
A
1
1
c =
_
D

(1 )
1
+ 1
_
A
1
1
(21)
Inserting D:
c =
_
_

1
(
1
1 +)

1
(1 )
1
+ 1
_
A
1
1
(22)
Given positive parameters and 1, < 1 and < 1, the term in front of A is positive. Since
A
1
1
is positively related to A, there is a positive eect of A on consumption c.
For leisure I use equation 18 with B divided into D > 0 and A (see equation 20)
n = c
_
A(A
1
1
D)

(A
1
1
D)
_
1
n = c
_
D

A
1
1
DA
1
1
_
1
(23)
And now with c in terms of parameters and D and A (see equation 21):
n =
_
_
D

(1 )
1
+ 1
_
A
1
1
__
D

A
1
1
DA
1
1
_
1
, (24)
The expression A
1
1
can be cancelled so that labor input n
t
gets
n =
_
D

(1 )
1
+ 1
_
(D

D)
1
, (25)
whereas leisure is
1 n
. .
leisure
= 1
_
D

(1 )
1
+ 1
_
(D

D)
1
. (26)
Hence, a change in TFP (A) has no impact on leisure whatsoever. The income eect on leisure
seems to be equally big as the substitution eect of increased TFP.
9