Universidad San Francisco de Quito

Advanced Macroeconomics
Problem Set 1
Due Date: Friday, September 7, before Matlab lab.
Max Grade: 25 points.

Question 1. (The Cake Eating Problem) Suppose that you have a cake of size A that you need
to eat during the following 5 days. The size of the portion you decide to eat in a given period is
given by xt and you discount time using a subjective discount factor . Eating cake makes you
happy (or at least, used to make you happy until you run into this problem –ha ha), and you can
measure that happiness daily using the following utility function
5
X
U ({xt }5t=1 ) = t 1
log(xt ).
t=1

Obviously, you cannot bake a new cake in the process, so the equivalent to your budget
constraint can be written as

yt+1 = yt xt ,

where yt+1 is the leftover cake that you will eat the following day. Since you only have one cake,
it is clear that y1 = A, you cannot eat negative values of cake, and you cannot leave negative
leftovers for the following day.

(i) (2 points) Write the optimization problem that you need to solve in order to eat your cake
optimally. Remember to include all the restrictions. Keep in mind that all the cake goes to
waste after five days, and you cannot allow for any cake to be thrown away!

(ii) (2 points) Write the bellman equation associated to this problem and find the first order
conditions assuming an interior solution. With this, find the Euler equation (you will need
the envelope theorem for this).

(iii) (3 points) Find the optimal portion sizes for the five days by backward induction. How does
each portion changes when the cake gets bigger?

Question 2. Consider a household that receives a stream of income during three periods: y1 =
0.8, y2 = 1.0 and y3 = 0.1. Each period the household chooses how much to consume and how
much to save given their preferences, that can be written as
2
U (c1 , c2 , c3 ) = log(c1 ) + log(c2 ) + log(c3 ),

where = 0.9 is the subjective discount factor. Suppose further that the interest rate in the
economy is r = 0.1. Solve the exercise using only two decimal points.

(i) (2 points) Suppose that the household do not inherit anything a1 = 0 and they do not
leave any bequest a4 = 0. Based on this, write the budget constraint for each period (three
constraints in total).

1
 (ii) (2 points) Write the maximization problem for the household. Then, state the full La-
grangian (i.e. you will need three Lagrange multipliers).

(iii) (2 points) Find the first order conditions associated to the Lagrangian. How many unknowns
and how many equations do you have? Find the Euler equation.

(iv) (2 points) Rewrite the maximization problem using the Bellman equation. Write down the
first order condition to the problem and find the Euler equation (you will need the envelope
theorem to do this).

(v) (3 points) Solve the problem by backward induction using the Bellman equation. That is,
find the consumption and savings stream that solves the maximization of the household.
Compare the consumption optimal stream with the income path; what can you say about
smoothing consumption in this household?

(vi) (3 points) (Hard) Use your findings in this question to compute the stream of Lagrange
multipliers 1 , 2 and 3 . Interpret this result.

Question 3. (The Role of Boundary Conditions) Consider again the optimization problem
discussed in the previous question.

(i) (2 points) Suppose now that, although the household do not leave any bequest, they inherit
some assets a1 = 2.0. Solve the problem again (i.e. write down the Bellman equation
and solve the problem by backward induction). Compare the consumption stream with the
solution you found in question 2 and explain the results.

(ii) (2 points) Now suppose that the household do not inherit (a1 = 0), but then can choose
optimally how much to leave as a bequest. Solve the problem again and comparte this result
to the results you found in part (i).