Dynamic Macro HistoryversusExpectations Summer2016 1

202: Dynamic Macroeconomic Theory
History versus Expectations:

Murphy-Shleifer-Vishny; Krugman
Mausumi Das
Lecture Notes, DSE
Oct 20-Nov 10; 2016
Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 1 / 71
History vis-a-vis Expectations in the Process of
Development:
The growth/development literature in general attributes observed

dierences in the growth trajectories of dierent countries to various
historical factors.
History shows up either in terms of an initial condition (e.g., initial
capotal stock, initial distribution of wealth) or in terms of an
institutional set up that the eceonomy has inherited (e.g., nature of
the nancial or political institutions).
There is however a third strand of the litearture which focuses on the
role of expectations in determining the development trajectory of an
economy.
It has been observed that countries with similar history sometimes
follow divergent growth paths. This latter strand of the literature
attempts to explain these cases.
Role of Expectations in the Process of Development:
The basic theoretical underpinning of this literature is the

coordination failure models which result in multiple (Nash) equilibria.
The basic idea here is that even with a given history, an economy may
face multiple possible growth trajectories due to existence of strategic
complementarity among the choice variable of agents.
Among the many possible equilibrium trajectories, which one will be
chosen depends crucially on agents expectations - what one believes
about others choice of action.
Even with favouarble historical conditions, an economy mail fail to
take o simply because agents in this economy failed to coordinate on
their actions.
Such cases highlight a special role of the government in terms of
coordinating the actions of various agents to generate an outcome
that is pareto e cient.
Role of Expectations in the Process of Development:
(Contd.)
We shall discuss two papers that look at the process of development

as a coordination game:
Murphy, Shleifer, Vishny: Industrialization and the Big Push (Journal
of Political Economy, 1989)
Krugman: History Versus Expectations (Quaterly Journal of
Economics, 1991)
The Murphy-Shleifer-Vishny paper explores a static model of
coordination failure.
The Krugman paper starts with a static model and then extends it to
a dynamic framework which allows us to precisely charaterise the role
of history vis-a-vis expectations.
We shall strat with the Murphy-Shleifer-Vishny model.
Role of Expectations in the Process of Industrilization:
Murphy-Shleifer-Vishny
The basic idea is as follows:

Suppose the economy has access to two types of technologies: an IRS
modern technology and a CRS cottage technology.
The rst technology is more productive - but it also entails a xed
cost. Thus a rm will adopt this technology only if there is su cient
demand.
The level of aggregate demand on the other hand depends on the
actions of other rms:
if all rms adopt the modern technology together then that generates
income which in turn creates demand for each of the products to make
the adoption of the modern technolgy viable;
if no other rms adopt the modern technology, then there is no
incentive for a single rm to adopt the technology alone - since the
resulting demand will not be su cient to cover the xed cost.
Murphy-Shleifer-Vishny: (Contd)
Existence of such demand complementarities across rms thus

generates possibilities of mutiple equilibria and the consequent role of
self-fullling (rational) expectations:
If each rm expects that others will adopt the modern technology, then
it adopts the modern technology too - hence the economy embarks on
the path of industriazation
If each rm expects that others will not adopt the modern technology,
then it does not adopt the modern technology either - hence the
economy remains stuck wit home production.
However, Murphy-Shleifer-Vishny shows that presence of such
strategic complementarities (in this case working through demand) is
necessary but not su cient to generate multiple equilibria.
In fact they construct two similar models - one of which exhibits
multiple, the other does not.
Murphy-Shleifer-Vishny: Model I
Consider a static (one period) closed economy.

The economy consists of a continuum of population of measure 1,
represented by the unit interval [0, 1] .
All agents/households in this economy are identical; so we can talk in
terms of a representative agent. (Note that since total population has
a measure of unity, average and aggregate values in this economy
would be identical).
There exists a variety of nal goods, represented by the continuum
[0, 1] , such that each variety is represented by an index q 2 [0, 1] .
The representative agents preference over all these varieties of nal
goods is dened by a Dixit-Stiglitz Love for Varietyutility function:
Z1
U= log xq dq
0
Murphy-Shleifer-Vishny: Model I (Contd.)
Notice that this Love for Varietyutility function has similal features
as the Love for Varityproduction funvtion that we have seen bafore.
U 1 2 U 1
In particular, for any variety q, = > 0; = < 0.
xq xq xq2
(xq )2
Morever, as xq ! 0, x U
q
! .
These two features will ensure that as long as the varieties are
associated with nite prices, the agent will consume all the varieties.
Also, if the same price is charged for all the varieties then the agent
will spread his income equally over all the varieties and consume equal
amount of each.
In general, if the agent has income y , then the optimization problem
of the representative agent is given by:
Z1 Z1
Max. log xq dq subject to pq xq dq = y .
0 0
Model I: Production Side Story
Production on any nal commodi requires only labour - no capital

(simplication).
Each nal good sector - producing a particular variety q has access
to two types of technologies:
(i) A modern, highly productive, IRS mass-production technology -
which entails a xed set up cost of F units of labour. Once this set
up cost has been incurred, every additional unit of labour emplyed in
this sector generates units of nal output of variety q, where > 1.
(Why is the modern technology IRS?)
(ii) A traditional, less productive, CRS cottage technology - which
does not ential any xed cost. Every unit of labour employed in this
sector generates 1 unit of nal output of variety q.
Model I: Market Structure
Each of the modern technology is operated by a monopolist rm who

sets its own price (given the demand) so as maximise prot.
However houselds hold ownership shares of these rms so that a part
of the monopoly prot is distributed to the households in the form of
dividends.
The cottage technologies can either be operated by competitive rms
of can be produced at home using own labour.
We shall assume the latter.
Model I: Wages & Prices
When a variety is produced at home using the cottage technology, a
unit of the nal commdity is produced by a unit of labour. Thus
implicit wage rate in the cottage sector (in tems of the nal
commodity) is equal to 1.
Let us take labour as the numaraire: w = 1.
Then implicit price of each variety under cottage production is also
eqaul to unity: pq = 1.
The monopolist rm in each sector on the other hand sets its price by
looking at the demand.
Notice that given the utlity function of the agent, the demand for any
variety q is derived from the following equation:
1
= pq for all q
xq
1
) pq xq = for all q

Model I: Wages & Prices (Contd.)
Plugging this in the budget equation of the agent:
Z1
1 1
dq = y ) = y

0
Thus the representation agents demand for a variety q is given by:
pq xq = y
Since the total measure of households is equal to unity, the total

demand for each variety is also represented by the same equation:
y
xq = (1)
pq
Notice that the price elasticity of demand of each variety is unity; so a
monopolist would like to charge an arbitrarily high price level (close to
innity) (Why?)
Model I: Wages & Prices (Contd.)
However because of the presence of the cottage sector, it cannot
charge anything other than a price equal to 1. (Otherwise nobody will
buy from the monopolist.)
On the other hand, the monopolist being a price-taker in the factor
(labour) market will pay the same cottage wage rate of w = 1.
This implies that irrespective of whether a variety is produced by a
monopolist using the modern technology, or under cottage
production, the corresponding wage rate and the prices would be the
same, given by:
w = 1;
pq = 1 for all q.
However, since the cottage sector is less productive, the level of
income would dier in the two cases. The higher is the proportion of
varieties that are produced by the monopolists, the higher would be
the aggregate output.
Model I: Demand-Prot Interlinkage
But there is an additional constraint as well: given that the
monopolist has to incur a xed cost, will he always operate?
The answer is: No.
Given the xed cost, a monopolist will operate if and only if the total
revenue is enough not only to cover the variable cost, but also the
xed cost.
To put it dierently, a monopolist would operate if and only if his net
prot is non-negative.
His prot depends on the level of demand - which in turn depends on
the level of income of the households.
Recall that xq denotes the consumption of each variety by a
household. Since the measure of total households is unity, xq also
denotes the aggregate consumption demand for variety q.
Accordingly, prot of a monopolist operating in sector q is given by:
1
q = xq xq F

Model I: Demand-Prot Interlinkage (Contd.)
Now from the solution of the householdsoptimization exercise
(equation (1)) we know that for each variety q 2 [0, 1]:
xq = y (since pq = 1)
Simplifying, we get the following relationship between y and q :
1
q = 1 y F

1
= ay F where a < 1. (2)

A monopolist would operate if and only if
F
q = 0 ) y =
.
a
Thus for a monopolist to operate in any sector, the corresponding
demand (y ) has to be su ciently high. (Recall that if the monopolist
in any sector abstains from production then the correspoding demand
is served by the cottage sector.)
Model I: Prot-Demand Interlinkage
Notice however that there is a reverse linkage from prot to demand

working though the distributed prots.
Let us assume that households are the shareholders of the
monopolists rms, which gives them access to the prots earned by
the monopolist rms.
Since a part of the prot income goes back to the households in the
form of dividends, the householdsincome consists of the total wage
bill plus the share of prot that is distributed.
Let be the share of prot that is distributed back to the households.
Then aggregate household income (which is also the income of the
representative household) is the given by:
y = W +
This circular linkage from Income ! Demand ! Prot ! Income

creates the potential of multiple equilibria here.
Model I: Prot-Demand Interlinkage & Keynesian Demand
Shortage
Note that the possibility of a Keynesian aggregate demand shortage

may arise here if (and only if) < 1.
This is because aggregate production under full employment would be
given by
Y W +
On the other hand, aggregate consumption demand (for all varieties
taken together and across all households) will be given by:
0 1
Z1 Z1
C = @ y dq A dh = y = W +
0 0
To the extent that < 1, C will fall short of Y creating a shortage of

demand leading to Keynesian unemplyement.
Model I: Prot-Demand Interlinkage & Keynesian Demand
Shortage (Contd.)
In a dynamic model with capital, this aggregate demand problem
could be taken care of by assuming that the retained prots of rms
are automatically invested.
This would ensure that aggregate demand is always equal to
aggregate supply:
C + I = W + + (1 ) = W + = Y
But in the absence of investment, (1 ) will constitute a leakage
that would lead to perpetual demand shortage.
To avoid this problem, we assume that = 1, i.e., the entire prot
income is distributed back to the households in the form of dividends.
This once again ensures that there is no aggregate demand shortage;
whatever is produced is always demanded:
C = y = W + = Y
Model I: Prot-Demand Interlinkage (Contd.)
Let each agent be endowed with L units of labour, which he supplies
inelastically to the market.
Recall that each unit of labour earns a wage rate of w = 1,
irrespcetive of whether it is employed in cottage production of
modern production.
Then
W = L.
Also let n proportion of the sectors be operated by the respective
monopolist producers. (The exact value of n will evetually be
determined endogeneously within the model).
Then
= n q
Putting these together, we get another relationship between y and
q :
y = L + n q (3)
Model I: Prot as a function of no. of modern sectors in
operation
From (2) and (3), we can write aggregate demand as a function of n

(the proportion of sectors which are mordernised):
y = L + n (ay F)
L nF
) y (n ) = (A)
1 na
Corresponding prot of each of the monopolist in operation:
q = ay (n) F
L nF
) q (n ) = a F
1 na

aL F
) q (n ) = (B)
1 na
Model I: Prot as a function of no. of modern sectors in
operation (Contd.)
Equation (B) above shows that the prot of each potential
monopolist in operation depends on the proportion of modern rms
which are under operation.
Notice however that the denominator of the RHS is always positive.
Thus the nature of the relationship depends crucially on the
numerator.
In particular:
d q (n )
1 when aL F > 0, > 0;
dn
d q (n )
2 when aL F < 0, < 0.
dn
Thus there is an externality from one modern rm to another: as the
proportion of modernised rms goes up, the prot of each modernised
rm is aected.
Model I: No. of Modern Sectors in Operation in
Equilibrium
How many sectors will be modernised in equilibrium?

Recall that a monopolist will operate as long as he earns a
non-negative prot.
Now there are two cases here:
In Case 1, aL F > 0.
d q (n )
We already know that in this case, > 0.
dn
aL F
Moreover, q (0) = aL F > 0 and q (1) = > 0.
1 a
Thus a monopolist will always be willing operate, quite independent of
what value n takes.
Therefore in equilibrium, n = 1.
Model I: No. of Modern Sectors in Operation in
Equilibrium (Contd.)
In Case 2, aL F < 0.
d q (n )
We already know that in this case, < 0.
dn
aL F
Moreover, q (0) = aL F < 0 and q (1) = < 0.
1 a
Thus a monopolist will stay away from operating, quite independent of
what value n takes.
Therefore in equilibrium, n = 0.
Note that multiple equilibria would have been realized in Case 1 if we
aL F
had q (0) = aL F < 0 while q (1) = > 0. But obviously
1 a
that cannot happen here.
Also note that multiple equilibria can neven happen in Case 2, even
aL F
when q (0) = aL F > 0 and q (1) = < 0. (Why?)
1 a
Model I: Limitations
Thus we see even when there are prot interlikages bewteen rms
working through demand externalities, that may not be su cient to
generate multiple equilibria.
Depending on the parametric conditions, we get two dierent
equilibrium values of n. But the equilibrium value is unique.
Each monpolist rm will decide either to operate or not operate -
quite independent of what others are doing.
Thus there is no role of expecations here. Neither is there any scope
for coordination-driven multiple equilibria.
This is because here the demand externality works only through the
prot channel: if prot is positive to begin with, that creates more
demand and therefore even higher prot - eventually leading to
n = 1. On the other hand, if prot is negative to begin with, that
creates less demand and therefore even lesser prot - eventually
leading to n = 0.
Model I: Limitations (Contd.)
This tells us that for the multiple equilibria story to operate we need
an additional channel of demand externality that works independent
of the prot channel.
Murphy-Shleifer-Vishny builds a second model, where this additional
channel is provided by a demand externality that works through the
wages.
For this purpose the rst model is modied to incorporate a wage
premium for the modern sector workers.
We now discuss the details of the second model.
Model II: Introducing Factory Wage Premium
Let us assume that working in factories under modern production has
certain disutilities associated with it (due to displacement cost,
impersonal non-family environment etc.).
The utility function of the representative agent is now given as follow:
8
>
> R1
>
< log xq dq if he works in cottage sector;
U= 0
>
> R1
>
: log xq dq V if he works in modern sector.
0
As before, under cottage production:
w = 1;
pq = 1 for all q.
Under modern production, once again pq = 1 (for the same reason as
before). However, the wage rate in the moden sector can no longer
be the same as that of the cottage sector. The modern sector must
oer a wage premium to compensate for the associated disutility.
Model II: Factory Wage Premium
Let w denote the wage rate in the modern sector. What is its value in
equilibrium?
Notice that at this wage rate, an agent should be indierent between
working in the cottage sector and working in the modern sector.
Now the indirect utility of any agent who is working in cottage
production and earning a wage income of L in given by:
Z1
Uc = = log L.
log Ldq
0
On the other hand, the indirect utility of any agent who is working in
modern production and earning a wage income of w L in given by:
Z1
Uc =
log w Ldq V = log w L V.
0
Model II: Factory Wage Premium (Contd.)
Now an agent will be indierent bewteen working in the modern

sector vis-a-vis the cottage sector i:
log w L V = log L
) log w L log L = V
) log (w ) = V
) w = expV > 1
Without any loss of generality, let us write
w = 1 + v
where v is the wage premium associated with factory production.
Model II: Demand-Prot Interlinkage
Once again the demand for any variety q is given by the aggregate
household income y . (Notice however that now income across agents
may dier depending on which sector they are working in, although
their utilities would be the same).
Let Y denote the aggegate demand for any variety q coming from all
the households.
The prot of a monopolist operating in sector q is given by:
1
q = Y (1 + v ) Y +F

(1 + v )
= 1 Y (1 + v )F (4)

We shall assume the the modern sector is productive enough so that
> 1 + v.
Model II: Prot-Demand Interlinkage
Once again the aggregate income is the given by the sum of the wage
bills and the distributed prot :
Y = Wc + Wm +
Let n proportion of the sectors be operated by the respective
monopolist producers.
Then
1
Wm = n ( 1 + v ) Y +F

1
Wc = L n Y +F

while
= n q .
Thus
1 1
Y = n (1 + v ) Y + F + L n Y +F + n q . (5)

Model II: Prot as a function of no. of modern sectors in
operation
From (4) and (5), we can write aggregate demand as a function of n

(the proportion of sectors which are mordernised):
L nF
Y (n ) = (A0 )
1
1 n

Corresponding prot of each of the monopolist in operation:

(1 +v )
[L nF ]
q (n ) = (1 + v )F (B0 )
1
1 n

Model II: Existence of Multiple Equilibria:
From the q (n ) expression derived above, it is easy to verify that

d q (n ) 1
whenever aL F > 0, > 0 (where a ).
dn
Thus as before, there exists a positive externality from one rm to
another working through the demand channel (under suitable
parameter restrictions).
Does that generate multiple equilibria in the current scenario? The
answer is yes and no.
It still does not gaurantee the existence of multiple equilibria for all
possible cases.
However, it is easy to construct examples (with specic parameter
values) which would generate multiple equilibria in the current
scenario.
Model II: Existence of Multiple Equilibria - An Example
Multiple equilibria will exist under current scenario if the following

two conditions are met :
(1 + v )
L < (1 + v )F

and
[ (1 + v )] [L F ] > (1 + v )F
(Construct such an example. Note that in addition, you have two
more conditions, namely, aL F > 0 and > 1 + v )
It is easy to verify that for this specic example,
d q (n )
> 0; q (0) < 0; q (1) > 0.
dn
(Contd.)
In terms of diagram:
Thus indeed there are two nash equilibria given by n = 0 and

n = 1.(Notice that n is not a nash equilibrium.)
(Contd.)
Which of these two equilibria the economy will end up at?

Apriori we cannot say. Depends on agentsexpectations.
Notice that n = 1 is a betterequilibrium than n = 0 in the sense
that the aggregate income is higher in the former. But the agents
may not reach this equilibrium on their own.
Moreover, two economies which are exactly identical otherwise (in
terms of history and institutions) may end up with completely
dierent economic outcomes simply because agentsexpectations
diered in the two cases.
The existence of multiple equilibria where one equilibrium is better
than the other justies any kind of governement intervention that
nudges an economy from the bad equilibrium to the good equilibrium.
Limitation of the Murphy-Shleifer-Vishny Framework:
While the M-S-V model draws attention to a a-historical mechanism

which can explain the observed divergence in economic outcomes in
apparently similar countries, its biggest drawback is that it is a static
model. There is no dynamics here. Hence it cannot explain growth.
More importantly, being static, it also cannot explain the relative
importance of history vis-a-vis expectations in the development
process.
Notice that history can be captured in the model by the amount of
total labour available: L
Let us allow for population growth at a constant exogenous rate so
the the economy starts with a given labour force of L at the initial
point of time, but it grows over time.
Limitation of the Murphy-Shleifer-Vishny Framework:
(Contd.)
Let us take our earlier example with multiple equilibria, but now allow
L to increase over time.
It is easy to verify that as L increases, the prot line shifts up and
eventully it moves entirely above the horizontal axis. From that point
onwards, expectations ceases to play any role and we are back to a
world where history dominates.
However Murphy-Shleifer-Vishny do not explore the possible
interaction between history and expectations.
From Murphy-Shleifer-Vishny to Krugman:
This issue in fact has been explored by Krugman (1991).

Krugman also develops a static model of multiple equilibria which is
very similar to M-S-V.
But Krugman subsequently brings in a dynamic mechanism to
chracterise the dynamic paths of the economy.
In the process he precisely identies the relative role of history
vis-a-vis expectations.
We now turn to the Krugman model.
Krugman: A Short Run (Static) Model of Multiple
Equilibria
There are two nal goods (C and X ) that are produced using a single
factor (labour, L):
C , a good produced with constant returns;
X , a good whose production is subject to an externality resulting in
increasing returns (which is internal to the industry, but external to the
rms).Assume that the larger is the labour force engaged in X
production (LX ), the higher is labour productivity in that sector:
= (LX ) ; 0 > 0. (1)
Small open economy:

The economy is able to sell both C and X at xed prices on world
markets. Normalize these world prices to unity.
Technology
In the C sector productivity is constant.

one unit of labour produces one unit of C : YC = LC
the value of that unit is one.
) Real wage rate in the C sector is unity.
In the X sector productivity depends on industry employment:
YX = (LX )LX
Since the economies of scale are external, each rm treats labour
productivity as constant.
) Perceived marginal product = average product.
) Real wage rate in the X sector is equal to the average product:
w = ( LX ) . (2)
Total Lebour supply in the economy is given at L such that

LC + LX = L
Existence of Multiple Equilibria
Assumption: (0) < 1, and (L ) > 1.
Existence of Multiple Equilibria:
1. EC : Nobody is employed in X (LX = 0)

2. EX : Everyone is employed in the X sector (LX = L)
Expectation or History? Speed of Adjustment Matters
Which equilibrium does the economy go to? Apriori we do not know.

Depends on workersexpectations.
Notice that history will come back to play a crucial role if labour
adjustment across sectors is gradual and not instantaneous.
How?
Suppose the economy starts with a given initial allocation of labour
between the two sectors (LX (0) given).
Labour moves over time to the sector that oers higher wage through
the following dynamic adjustment process: L X = f (w 1); f (0) = 0;
f 0 > 0.
Note that LX in Figure 1 now represents a steady state - but it is an
unstable one.
If the initial employment in X sector is greater than LX , i.e.,
LX (0) > LX , then the economy in the long run moves to EX .
If the initial employment in X sector is smaller than LX , i.e.,
LX (0) < LX , then the economy in the long run moves to EC .
Crucial Question: Why Labour Adjusts Gradually?
If there is no cost of moving labour across sectors, then adjustments
should be instantaneous.
In that case there is no reason why the initial allocation of labor
should matter.
Thus, in the absence of some cost of shifting labour, we would be
back to the multiple equilibria story: either equilibrium can be
obtained as a self-fullling prophecy, irrespective of the initial
position.
To make the initial position matter, or to justify why the labour
adjustment process is gradual, it is then necessary to introduce some
cost of adjustment in shifting labour between sectors.
But if there is cost of adjusting labour and it happens gradually over
time, then when we should look at not just the current wage
dierential, but in fact the entire future stream of benets coming
from such labour adjustments. In other words, we should have a fully
developed dynamic optimization model.
A Dynamic Model: Interaction Bewteen History &
Expectation
Assume that the economy is populated by a continuum [0, 1] of

innitely lived agents who are identical in every respect - so we can
talk in terms of a representative agent.
At each point of time, the representative agent has a xed
endowment of labour, L, which he allocates between the two sectors:
X and M. Initial allocation (LX (0)) is given.
Cost of moving labour across sectors depends on how much labour is
being moved in or out of sector X :
1 2
F (L X ) = LX ,
2
L X
) The marginal cost of labour re-allocation: F 0 (L X ) = .

AgentsDynamic Optimization Problem:
Let us assume that the labour-movement cost has to be incurred

upfront, before the labour movement has actually taken place.
Consider a household which starts with a historically given initial
distribution of labour across the two sectors, given by LX (0) and
L LX (0) respectively.
It it wants to shift its labour from one sector to the other by a
magnitude L X (equivalent of 4LX in continuous time) then it has to
incur a cost of F (L X ) in the current period itself. This will result in a
new allocation of labour in the next period.
Hence for any given LX (t ), the net income available for consumption,
after incurring the labour re-allocation cost, is given by:
1 2
Y t = wt LX (t ) + (L LX (t )) LX . (3)
2
AgentsDynamic Optimization Problem: (Contd.)
The objective of the agent is to maximize the present discounted

value of his life time utility, where instantaneous utility is linear in
consumption, Z
t
U= Ct e dt. (4)
0
If there were no borrowing, then Y t Ct in every period.

Then the dynamic optimization problem of the household would be to
maximise (4) subject to (3).
AgentsDynamic Optimization Problem: (Contd.)
Alternatively, we can assume that individuals are able to borrow or

lend freely in the world market at a given world interest rate r .
Since the agent is allowed to borrow/lend at the given interest rate r ,
his ow budget constraint in every period is given by:
dB
= Ct Y t + rBt ,
dt
where Bt denotes the existing stock of (un-repaid) loans.
Now there are two state variables: LX (t ) and B (t )
Note that with a linear utility function, and facing a given world rate
of interest, an agent will have non-zero consumption in every period if
and only if r = . Otherwise he will always frontload all his
consumption at the initial point (if > r ); or will concentrate all his
consumption at the end point (if < r ). So we shall assume from
now on that r .
No Ponzi Game Condition:
Obviously, the moment we allow for borrowing, the possibility of
Ponzi-nancing arises.
We rule that out by imposing the following No-Ponzi-Game (NPG)
Condition:
rt
lim Bt e = 0.
t !
Note that the ow budget constraint can be easily converted into the
following life-time budget constraint (multiplying both sides by exp rt
and intergrating over 0 to ):
dB
e rt
rBt e rt
= Ct e rt
Y t e rt
dt
d (Be rt
)
) = Ct e rt
Y t e rt
Z dt Z Z
) d Be rt
= Ct e rt
dt Y t e rt
dt
0 0 0
No Ponzi Game Condition (contd.):
In other words,
Z Z
lim Bt e rt
B0 = Ct e rt
dt Y t e rt
dt.
t ! 0 0
Using the NPG Condition and assuming that the agent does not start
with any inherited debt (i.e., B0 = 0), the life-time budget constraint
implies, Z Z
rt
Ct e dt = Y t e rt dt.
0 0
This implies that even when we allow for borrowing, as long as the
NPG
R condition satised, choosing a consumption path that maximises
C e rt dt is equivalent to choosing a net income path that
t
0 R
maximises 0 Y t e rt dt. (The maximized values would be the same).
AgentsOptimization Problem Re-written:
Thus we can equivalently write the optimization problem of the agent

as
Z
Maximize Y t e rt
dt.
fY t g 0
Also note that (3) can be written as,

q
L X = 2 w LX + (L LX ) Y t , (i)
where the term w LX + (L LX ) Y t measures (in absolute

terms) the suplus income that would arise after allowing for
consumption, and the entire term on the RHS then tells us how much
labour can actually be moved with this suplus income, given the cost
function.
AgentsOptimization Problem Re-written (contd.):
The corresponding dynamic optimization problem:

Z
Maximize Y t e rt
dt
fY t g 0
subject to q
L X = 2 wt LX + (L LX ) Y t .
Control variable: Y t
State variable: LX
LX (0) given
First Order Conditions:
Current value Hamiltonian:

q
H = Y t + qt 2 wt LX + (L LX ) Y t
qt : the shadow price (in terms of income) of placing an additional

unit of labor in the X rather than the C sector.
The rst-order conditions are:
H
= 0, (i)
Y t
H
= rqt q,
(ii)
LX
q
L X = 2 wt LX + (L LX ) Y t , (iii)
rt
lim qt e LX (t ) = 0. (iv)
t !
Simplifying the FONCs:
(i) implies
qt
1 p = 0.
2 [wt LX + (L LX ) Yt ]
Using (iii), this gives

L X = qt . (5)
Simplifying the FONCs: (Contd.)
(ii) implies
qt [wt 1]
rqt q = p
2 [wt LX + (L LX ) Yt ]
Using (iii) and (5)], we get
q = rqt wt + 1.
H
Notice that In calculating , atomistic agents do not internalize the
LX
increasing returns to scale present in X production and therefore they
take wt as exogeneously given.
However, under the assumption of perfect foresight, their guesses are
always correct so that w = (LX ) .
Using this information in the above equation, we get:
q = rq (LX ) + 1. (6)
Dynamic Equations & their interpretations:
Equations (5) and (6) are the two dynamic equations that are
generated from the FONCs. These along with the initial condition
and the TVC will determine the optimal trajectories for the economy.
Equation (5) can be re-written as :
L X
= qt

where,
the LHS denotes that marginal cost of moving one unt of labour from
L
C to X ( X ), and

the RHS represents the marginal benet (valuation at the margin, or
shadow price) of such a movement (qt ).
Equation (5) says that along an optimal trajectory, the marginal cost
must be equal to the corresponding marginal benet.
Interpretations (contd.):
Equation (6) can be re-written as :
( 1) + q
r=
q
where,
the LHS denotes that international rate of return (r ), and
the RHS is the domestice rate of return of shifting labour from sector
C to sector X (plus the associated capital gains)
Equation (6) says that along an optimal trajectory, the two rates of
return must be equal.
Phase Diagram:
The dynamic system is represented by the following two eqautions:
L X = qt ;
q = rqt (LX ) + 1,
where LX (0) is given. Moreover, the optimal trajectory has to satisfy the
Transversility condition:
limt ! qt e rt LX (t ) = 0.
In drawing the phase diagram in the (LX , q ) plane, notice that
L X = 0 ).q = 0.
Thus in the phase diagram the L X = 0 locus co-incides with the
horizontal axis.
Whenever q is positive (i.e., in the postive quadrant), LX is rising.
Whenever q is negative (i.e., in the negative quadrant), LX is falling.
Phase Diagram (Contd.):
1
On the other hand, q = 0 ) q = [ (LX ) 1] .
r
Thus in the phase plane, the q = 0 locus is represented by an
1
upward-sloping line, which takes negative value [ (0) 1] when
r
1
LX = 0, and takes a positive value [ (L )
1] .when LX = L.
r
For any given LX , higher value of q means higher q;hence

At all points above the q = 0 line , q is rising.
At all points below the q = 0 line , q is falling.
Phase Diagram (Contd.):
Characterization of Steady States:
The two lines, L X = 0 and q = 0, intersect at LX = LX - which is an

unstable steady state.
There are, two other quasi-steady-states in this model: one
illustrated by EC ; the other illustrated by EX .
Both satisfy the transversality condition (Verify)
Thus
any trajectory that takes the economy to one of these two points would
stay there.
These two are the possible long run equlibria of the model - which
satisfy the optimality criteria.
Optimal Trajectories:
Starting from a given LX (0), what are the corresponding optimal

trajectories for the economy? Two possibilities:
(a) The trajectories approach EC or EX monotonically.
Happens when the characteristic roots associated with the unstable
steady state (q = 0; LX = LX ) are both real and positive.
(b) The trajectories approach EC or EX in a cyclical fashion.
Happens when the characteristic roots associated with the unstable
steady state (q = 0; LX = LX ) are both complex with positive real
parts.
Characterization of the Optimal Trajectory: Case (a)
In case (a) history is decisive; no role for expectations:

If LX (0) > LX , then the economy would gradually move to EX ;
If LX (0) < LX , then the economy would gradually converge to EC .
Characterization of the Optimal Trajectory: Case (b)
In case(b), the exists a range of LX values in the neighbourhood of

LX (an overlap of the two trajectories) from which either of EC or EX
can be reached.
Within the overlap, history is no longer decisive; expectations
play a role: For the same value of LX (0);there exist multiple optimal
trajectories within the overlap
Precise Role of Expectation in Case (b)
How does expectation enter the picture in case (b)?

Recall that qt is a jump variable: its value is not historically given. In
fact solving the dierental eqaution
q = rqt ( LX ) + 1
and using the steady state condition that in the long run limt ! qt !
some constant q,
one can show that at any point of time t,
Z
qt = ( 1) e r d .
t
R
Thus, the intial choice of q is given by: q0 = 0 ( 1) e r d .
Precise Role of Expectation in Case (b) (contd.)
What initial q0 one chooses depends crucially on what (LX ) value

one expects to prevail today, tomorrow and all points of time in
future.
For example, if you expect everyone else will stay in the C sector
forever so that your expected (LX ) 1 value is negative, then you
would choose a q0 < 0.
On the other hand if you expect everyone else will stay in the X sector
so that your expected (LX ) 1 value is positive, then you would
choose a q0 > 0.
Moreover, midway along any trajectory you could suddenly change
your expectation, and start moving along a dierent trajectory, which
will again be self-fullling (since all other agents will also behave
symmetrically).
Parameters Determining the Existence of an Overlap:
If there is no overlap, then history is always decisive in this model.
If there is an overlap, then
history determines the outcomes if LX lies outside the overlap, but
expectations decide the outcome if LX lies inside.
Overlap exists if and only if the characteristic roots associated with
the unstable steady state are complex.
Recall that the dynamic system is reprented by:
q = rq (LX ) + 1
LX = q
Linearizing the system around the unstable steady state
(q = 0; LX = LX ):
q = rq (LX LX )
LX = q
where = 0 (LX ): a constant.
Parameters Determining the Existence of an Overlap
(contd.):
Corresponding coe cient matrix:
r
A=
0
Characteristic roots:
p
r r2 4
1 ; 2 = .
2
Roots are real and positive if r 2 = 4
Roots are complex (with postive real parts) if r 2 < 4
(contd.):
Whether an overlap exists or not depends crucially on whether

r 2 < 4 or not.
r : the interest/discount rate
: represents the degree of the externalities
: measures the degree of responsiveness of cost to labour relocation
(higher implies lower cost responsiveness which in turn implies that
labour can be relocated very fast without much increment in cost)
(contd.):
1. If r is su ciently large, then there will be no overlap, and history will

dominate expectations.
r is su ciently large ) the future icome is heavily discounted,
) individuals will not care much about future gains to be generated by
adjusting labour across sectors in a coordinated manner (based on
beliefs about others peoples action).
(contd.):
2. A small also eliminates the possibility of self-fullling expectations.

small ) degree of externality is relatively small.
) there is not enough future gain in by adjusting labour across sectors in
a coordinated manner (based on beliefs about others peoples action).
(contd.):
3. Finally, if is small, then again history is always decisive.

small ) cost increases very fast in response to labour relocation,
) it is not protable enough to majorly relocate labour in coordination
with other agents (based on beliefs about others peoples action).

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202: Dynamic Macroeconomic Theory

History versus Expectations:

Lecture Notes, DSE

Oct 20-Nov 10; 2016

The growth/development literature in general attributes observed

The basic theoretical underpinning of this literature is the

We shall discuss two papers that look at the process of development

The basic idea is as follows:

Existence of such demand complementarities across rms thus

Consider a static (one period) closed economy.

Production on any nal commodi requires only labour - no capital

Each of the modern technology is operated by a monopolist rm who

Thus the representation agents demand for a variety q is given by:

Since the total measure of households is equal to unity, the total

Notice however that there is a reverse linkage from prot to demand

This circular linkage from Income ! Demand ! Prot ! Income

Note that the possibility of a Keynesian aggregate demand shortage

To the extent that < 1, C will fall short of Y creating a shortage of

From (2) and (3), we can write aggregate demand as a function of n

How many sectors will be modernised in equilibrium?

Now an agent will be indierent bewteen working in the modern

Without any loss of generality, let us write

where v is the wage premium associated with factory production.

From (4) and (5), we can write aggregate demand as a function of n

Corresponding prot of each of the monopolist in operation:

From the q (n ) expression derived above, it is easy to verify that

Multiple equilibria will exist under current scenario if the following

Thus indeed there are two nash equilibria given by n = 0 and

Which of these two equilibria the economy will end up at?

While the M-S-V model draws attention to a a-historical mechanism

This issue in fact has been explored by Krugman (1991).

= (LX ) ; 0 > 0. (1)

Small open economy:

In the C sector productivity is constant.

Total Lebour supply in the economy is given at L such that

Which equilibrium does the economy go to? Apriori we do not know.

Assume that the economy is populated by a continuum [0, 1] of

Let us assume that the labour-movement cost has to be incurred

The objective of the agent is to maximize the present discounted

If there were no borrowing, then Y t Ct in every period.

Alternatively, we can assume that individuals are able to borrow or

Thus we can equivalently write the optimization problem of the agent

Also note that (3) can be written as,

where the term w LX + (L LX ) Y t measures (in absolute

The corresponding dynamic optimization problem:

Current value Hamiltonian:

qt : the shadow price (in terms of income) of placing an additional

Using (iii), this gives

Equation (6) can be re-written as :

The dynamic system is represented by the following two eqautions:

The two lines, L X = 0 and q = 0, intersect at LX = LX - which is an

Starting from a given LX (0), what are the corresponding optimal

In case (a) history is decisive; no role for expectations:

In case(b), the exists a range of LX values in the neighbourhood of

How does expectation enter the picture in case (b)?

What initial q0 one chooses depends crucially on what (LX ) value

Corresponding coe cient matrix:

Whether an overlap exists or not depends crucially on whether

1. If r is su ciently large, then there will be no overlap, and history will

2. A small also eliminates the possibility of self-fullling expectations.

3. Finally, if is small, then again history is always decisive.

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