EXGA 2101 - Advance Macroeconomics

Lecture 2
The ( n + g + ) k line has a slope of ( n + g + )

( n + g + ) k
f (k)
sf ( k )

( )

f ' k < ( n + g + )

<0
s
f (k)

( n + g + ) k
sf ( k )

( ) > ( n + g + )

f' k

>0
s
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f (k)

( n + g + ) k
sf ( k )

( )

f ' k = ( n + g + )
marginal in s no effect on c
consumption is at maximum along the balanced growth path.
This k is the golden rule of capital stock.

Impact On Output (Long Run)

y
k
=f' k
where k = f ( s,n,g, )
s
s

( )

y
k
to determine
we need to first determine
s
s

2/2

on the balanced growth path

k=0

( )

sf k = ( n + g + ) k
Derive both sides

k
k

sf ' k
+ f k = ( n + g + )
s
s

k
f k = ( n + g + )
sf ' k
s
s

k
f k =
n + g + ) sf ' k
(

( )

( )

( )

( )

( )

( )

( )

f k
k

=
s ( n + g + ) sf ' k

( )

y
Substitute this into the expression for
above,
s

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y
k
=f' k
s
s

( )

( )

f k
y

=f' k
s
( n + g + ) sf ' k

( )

( )

1. Multiply both sides with

s
to convert LHS to an elasticity of
y

income w.r.t. savings

( )

2. Use sf k = ( n + g + ) k to substitute for s

( )

f k
s y s

= f' k
( n + g + ) sf ' k
y s y

( )

s y
=
y s

( )
( n + g + ) k f '( k )

( )

( n + g + ) k f ' k

f k ( n + g + )

f
k

( )

( )

cancel ( n + g + ) from numerator and denominator

( )

k f ' k

( )

f k
s y
=
y s k f ' k
1
f k

( )

( )

( )
( )

K k
s y
=
y s 1 K k

( )=

where K k

( )

k f ' k

( )

f k

elasticity of output wrt capital at k = k is balanced growth path.

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If markets are competitive and there are no externalities, capital earns its
marginal product.

( )

Amount received by capital = k f ' k

Share of capital income out of total =

( )

In most countries K k =

( ) = k
( )
f (k )

k f ' k

1
3

( )
( )

1
K k
s y
3 =1

=
=
2
y s 1 K k 1 1
3

if savings rate 10%, output per worker 5%.

2/5

Speed of Convergence

Focus on k rather than y for simplicity. Determine speed k approaches k

k = k ( k ) i.e. k is determined by k.

When k = k , k is zero.
Using a first order Taylor series approximation,

k(k)
k

k
k
=

kk

( )

Recall that k = sf k ( n + g + ) k

k (k)

( n + g + )
= sf ' k
k k = k

( )

n + g + ) k
(
since s =

( )

f k

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k (k)
n + g + ) k
(
f ' k ( n + g + )
=

k k = k
f k

( )
( )
k f '( k )
=
1 ( n + g + )
f ( k )

= ( ( k ) 1) ( n + g + )

Substitute this into the equation for k

( )) ( n + g + ) ( k ( t ) k )

k ( t )  1 K k

In the area of the balanced growth path, capital per unit effective labor
converges towards k at a speed distance from k

( )) ( n + g + ) the path of k is

Using  1 K k
k(t) k  e

k ( 0 ) k

2/7

y approaches y at the same rate as k approaches k

y(t) y  e

y( 0 ) y

Calibration using examples:

If ( n + g + ) 6% p.a. and 1

( ) ) ( n + g + ) = (1 13 ) ( 6) = 4%

1 K k

k & y move 4% of the remaining distance towards k and y each year.

It takes 18 years to get halfway to their balanced growth path values.
Overall impact of a is savings rate is modest and occurs relatively
slowly.

2/8

Key Issues In Growth Theory

Variations in output per worker is possibly due to

1. differences in K

2. differences in A (effectiveness of labor)

Finding that only growth in A can lead to permanent growth in output per
worker because:
1. if in output attribute solely to capital, then required difference in
capital is too large. Actual difference in k is much smaller.
2. if A is ignored then this implies large variation in rate of return on
capital No evidence of such difference in rates of return.

2/9

Chapter 2
Infinite-Horizon Model
Ramsey-Cass-Koopmans
Similar to Solow
But dynamics of macro variables determined by decisions at the

microeconomic level
Saving rate is endogenous
Firms rent capital and hire labor
Households sumpply L, hold K, consume & save

Assumptions:

Firms Y=F(K,AL)
Competitive factor markets
Competitive output markets
A is exogenous and grows at rate g
Firms maximize and owned by households

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Households:
Large numbers
Size of households grows at rate n
Each member of households supplies 1 uynit of laor at every point in

time
Initial capital holdings

K (0)
where K(0) initial amount of capital, H
H

number of households
Assume no depreciation = 0
Households divide income between C & S to maximize utility
Household utility function
U = t =0 e t u ( C ( t ) )

L(t)
dt
H

2/11

C(t): consumption of each member of household

u(0): instantaneous utility function gives each members utility at a

given date

L(t): number of household

u (C ( t ))

L(t)
is the households total instantaneous utility at t
H

= discount rate
Instantaneous utility function
C( t )
u (C( t )) =
1
> 0, n (1 ) > 0
1

Also known as the CRRA utility

2/12

Or Constant Relative Risk Aversion

= coefficient of relative risk aversion
= determines households willingness to shift consumption between
different periods. The smaller the the more willing the household is
to allow consumption to vary over time
if 0, large swings in C to take advantage of small difference
between discount rate and the rate of return.

The Behaviours Of Households And Firms

Firms: Employ Capital & Labor

Pay them their marginal products sell the output
Production function has constant returns
Firms earn zero profits
f '( k ) =

F ( K,AL )
= marginal product of capital
K

real rate of return on capital equals its earnings per unit of time

r ( t ) = f '( k ( t ))
real wage per unit effective labor equals marginal product of effective

labor w ( t ) = f ( k ( t ) ) k ( t ) f ' ( k ( t ) )
marginal product of labor (as opposed to effective labor) is A(t)w(t)
representative a household takes the path of r and w as given

2/13

Households Maximization Problem

Budget constraint is that the present value (PV) of its lifetime

consumption cannot exceed its initial wealth plus the PV of its lifetime
labor income.

R(t) = the real interest rate at time t

R may vary over time
R ( t ) = =0 r ( )d
t

household has

L(t)
members
H

Labor income = A ( t ) w ( t )

L(t)
H

Consumption expenditure = C ( t )

L(t)
H

2/14

Household Budget Constraint

L(t)
K ( 0 ) R( t )
L(t)
dt
A(t)w (t)
dt
+ t =0 e
H
H
H
lifetime consumption initial labor income

t =0 e

R( t )

C( t )

wealth

Budget Constraint is rewritten :

t =0 e

R( t )

c ( t ) e( n +g )t dt K ( 0 ) + t =0 e R ( t ) w ( t ) e( n +g )t dt

small c
consumption per unit
effective labor

2/15

this expression may be simplified.

If K ( s ) = capital holdings at time s
Then

lim R (s ) K ( s )
e
0
s
H

Which states that the PV of household asset holding cannot be negative in

the limit.

Households objective function is reduced to

c( t)
dt
1
1

U = Bt =0 e

where

B A (0)

L ( 0)
H

and
n (1 ) g
= discount rate
n = labor growth
= coefficient of relative risk aversion
g = technical growth

2/16

Household Behaviour

Household must choose path of c(t) to maximize lifetime utility subject to

budget constraint combining he objective function & budget constraint,
set up the Langrange:

c( t )

L = Bt =0 e
dt + k ( 0 ) + t =0 e R ( t )e ( n +g )t w ( t )dt t =0 e R ( t )e( n +g )t c ( t )dt

1
Utility Function
income
consumption

2/17

Solving leads to:

c( t ) r ( t ) n g
=
c( t )

c( t ) r ( t )
=
c( t )

This is the Euler equation for the maximization problem.

2/18