Lucas Tree Models Financial Economics II

Yang-Ho Park

1. Consider and economy with a representative consumer with preferences t described by E0 t=0 u(ct ) where u(ct ) = ln(ct + ) where 0 and ct denotes consumption of the fruit in period t. The sole source of the single good is an everlasting tree that produces dt units of the consumption good in period t. The dividend process dt is Markov, with prob{dt+1 d |dt = d} = F (d , d). Assume the conditional density f (d , d) of F exists. There are competitive markets in the title of trees and in state-contingent claims. Let pt be the price at t of a title to all future dividends from the tree. (a) Prove that the equilibrium price pt satises

pt = (dt + )
j =1

t Et

di+j di+j +

Consumer optimizes the following household problem.

max E0
t=0

t u(ct )

Budget constraint: At+1 = Rt (At + yt ct ) where ct , yt , At , Rt indicate the consumption of an agent at time t, the agents labor income, the amount of a single asset valued in units of consumption good, and the real gross rate of return on the asset between time t and t+1. The Euler equation gives the following condition. u (ct ) = Et Rt u (ct+1 ) The above equation does not spell out complete general equilibrium setups. Lucass asset pricing model does use general equilibrium reasoning. Lucas model assumptions: 2

The labor income is zero. The durable good in the economy is only a set of trees. Representative agent assumption. The fruit is nonstorable. Recall ct = dt in a general equilibrium. pt+1 + dt+1 , the Euler equation will be : Letting Rt = pt u (ct+1 ) pt+1 + dt+1 Et =1 u (ct ) pt pt = Et u (ct+1 ) (pt+1 + dt+1 ) u (ct )

Using the equilibrium condition ct = dt . pt = Et Since u(ct ) = ln(ct + ), pt = Et (dt + ) (pt+1 + dt+1 ) (dt+1 + ) u (dt+1 ) (pt+1 + dt+1 ) u (dt )

The price at time t+1 is as follows: pt+1 = Et+1 (dt+1 + ) (pt+2 + dt+2 ) (dt+2 + )

By plugging pt+1 back into pt , pt = Et = Et (dt + ) (dt+1 + ) (pt+2 + dt+2 ) + dt+1 (dt+1 + ) (dt+2 + ) (dt + ) (dt + ) (dt + ) dt+1 + 2 dt+2 + 2 pt+2 (dt+1 + ) (dt+2 + ) (dt+2 + )

Recursively,

pt+1 = Et
j =1

(dt + ) (dt + ) dt+j + lim Et j pt+j j (dt+j + ) (dt+j + ) 3

Since limj Et j formula.

(dt + ) pt+j = 0, we obtain the nal pricing (dt+j + )

pt+1 = Et
j =1

(dt + ) dt+j (dt+j + )

(b) Find a formula for the risk-free one-period interest rate R1t . Prove that in the special case in which {dt } is independently and iden1 tically distributed, R1t is given by R1 t = k (dt + ), where k is a constant. Give a formula for k . We now suppose that there are markets in one- and two-period perfectly safe loans, which bear gross rates of return R1t and R2t . At the beginning of time t, the returns R1t and R2t are known with certainty and are risk free from the viewpoint of the agents. 1 That is, at time t, R1 t is the price of a perfectly sure claim to one 1 unit of consumption at time (t+1), and R2 t is the price of a perfectly sure claim to one unit of consumption at time (t+2). The representative agent solves the following optimization problem:
ct ,L1t+1 ,L2t+1

max

E0
t=0

t u(ct )

subject to the budget constraint: ct + L1t + L2t dt + L1t1 R1t1 + L2t2 R2t2 where Ljt is the amount lent for j periods at time t. Using the Lagrange Multiplier method,

L = E0
t=0

t (u(ct )+t (dt +L1t1 R1t1 +L2t2 R2t2 ct L1t L2t ))

By taking dierentiations with respect to {ct , L1t , L2t }. ct : E0 t (u (ct ) t ) = 0 L1t : E0 t (t+1 R1t t ) = 0 L2t : E0 t ( 2 t+2 R2t t ) = 0 4

Using the Markov property E0 = Et . ct : t = u (ct ) L1t : t = Et (t+1 R1t ) L2t : t = Et ( 2 t+2 R2t ) Combining the rst-order conditions gives: Et Et u (ct+1 ) R 1t u (ct ) u (ct+2 ) 2 R 2t u (ct ) =1 =1

Assuming the risk-free interest rates,

u (ct+1 ) u (ct ) u (ct+2 ) 2 u (ct )

Since u(ct ) = ln(ct + ),

ct + ct+1 + ct + 2 ct+2 +

Recall ct = dt in a general equilibrium.

dt + dt+1 + dt + 2 dt+2 +

By letting k1t = Et pressed as:

1 , the pricing formula can be exdt+1 +

(c) Find a formula for the risk-free two-period interest rate R2t . Prove that in the special case in which {dt } is independently and iden2 1 tically distributed, R2t is given by R2 t = k (dt + ), where k is the same constant you found in part (b). By letting k2t = Et pressed as:
2 1 R2 t = k2t (dt + )

1 , the pricing formula can be exdt+2 +

Let me show that k1t and k2t are identical. Since dt are identically distributed and follow the markov chain, k2t = Et 1 dt+2 + 1 = Et+1 dt+2 + = k 1t

2. Consider the following version of the Lucass tree economy. There are two kinds of trees. The rst kind is ugly and gives no direct utility to consumers, but yields a stream of fruit {d1t }, where d1t denotes a positive random process obeying a rst-order Markov process. The second tree is beautiful and yields utility on itself. This tree also yields a stream of the same kind of fruit d2t , where it happens that d2t = d1t = 1 dt t, so that the physical yields of the two kinds of trees are equal. 2 There is one of each tree for each N individuals in the economy. Trees last forever, but the fruit is not storable. Trees are the only source of fruit. Each of the N individuals in the economy has preferences described by

E0
t=0

t u(ct , s2t )

(1)

where u(ct , s2t ) = ln ct + ln(s2t ) where 0, ct denotes consumption of the fruit in period t and s2t is the stock of beautiful trees owned at the beginning of the period t. The owner of a tree of either kind i at the start of the period receives the fruit dit produced by the tree during 6

that period. Let pit be the price of a tree of type i (where i = 1, 2) during period t. Let Rit be the gross rate of returns of tree i during that period held from period t to t + 1. (a) Write down the consumer optimization problem in sequential and recursive form. Consumer optimization in a recursive form The Bellmans equation is given by v (dt , s1t , s2t ) =
{ct ,s1t+1 ,s2t+1 }

max

(ln(ct ) + ln(s2t ) + Et v (dt , s1t+1 , s2t+1 ))

where ct + p1t s1t+1 + p2t s2t+1 (d1t + p1t )s1t + (d2t + p2t )s2t . Consumer optimization in a sequential form The sequential form is given by
{ct ,s1t+1 ,s2t+1 }

max

E0
t=0

t (ln(ct ) + ln(s2t ))

where ct + p1t s1t+1 + p2t s2t+1 (d1t + p1t )s1t + (d2t + p2t )s2t . (b) Dene a rational expectations equilibrium. Denition The following is called the market clear condition
I I

ci t =
i=1 I i=1 I

di t

(2)

si 1t
i=1 I

=
i=1 I

si 10 = I si 20 = I
i=1

si 2t =
i=1

i where si 10 and s20 are each agents number of trees at initial time.

Denition A sequential household problem is dened by each agents utility optimization problem:
{ct ,s1t+1 ,s2t+1 }

max

E0
t=0

t (ln(ct ) + ln(s2t ))

where ct + p1t s1t+1 + p2t s2t+1 (d1t + p1t )s1t + (d2t + p2t )s2t . Denition A rational competitive equilibrium is an allocation, i I i I {{ci t }t=0 }i=1 , {{s1t , s2t }t=0 }i=1 , and a price system, {p1t , p2t }t=0 , such that the allocation solves each household problem and satises the market clear condition.

(c) Find the pricing functions mapping the state of the economy at t unto p1t and p2t (give precise formulas). [Hint: You should be able to directly derive p1t from the example seen in class, then since pricing function have to be linear you can guess a pricing function p2t = kdt and solve for k parameter using Euler equation of the second stock.] I am going to use the sequential form to nd a solution. Using the Lagrange Multiplier,

L = E0
t=0

t ((ln(ct ) + ln(s2t ))

+ t ((d1t + p1t )s1t + (d2t + p2t )s2t ct p1t s1t+1 p2t s2t+1 )) By taking dierentiations with respect to {ct , s1t+1 , s2t+1 }. ct : E0 t ( s1t+1 1 t ) = 0 ct : E0 t (t+1 (d1t+1 + p1t+1 ) t p1t ) = 0 s2t+1 =0

s2t+1 : E0 t t+1 (d2t+1 + p2t+1 ) t p2t +

Using the Markov property E0 = Et . ct : 1 = t ct

s1t+1 : p1t = Et s2t+1

t+1 (d1t+1 + p1t+1 ) t t+1 (d2t+1 + p2t+1 ) + : p2t = Et t s2t+1 t

Combining the rst-order conditions, we can obtain the pricing formula. p1t = Et p 2t (d1t+1 + p1t+1 ) ct+1 ct ct = Et (d2t+1 + p2t+1 ) + ct+1 s2t+1 ct

Recall ct = dt in a general equilibrium. p1t = Et p 2t dt (d1t+1 + p1t+1 ) dt+1 dt dt (d2t+1 + p2t+1 ) + = Et dt+1 s2t+1

Let us assume the linear form of the rst trees pricing function. p1t = k1t dt Next apply the above linear form to the Euler equation. k1t dt = Et k 1t dt (d1t+1 + k1t+1 dt+1 ) dt+1 d1t+1 = Et k1t+1 + Et dt+1

Recursively we obtain k1t .

k1t = Et
j =1

d1t+j dt+j

d. Since we are given d1t = 1 2 t k 1t 1 = Et 2 =

j
j =1

2(1 )

Let us assume the linear form of the second trees pricing function. p2t = k2t dt Next apply the above linear form to the Euler equation. k2t dt = Et k2t dt dt (d2t+1 + k2t+1 dt+1 ) + dt+1 s2t+1 d2t+1 = Et k2t+1 + Et + dt+1 s2t+1

Recursively we obtain k2t .

k2t = Et
j =1

d2t+j + dt+j s2t+1

d and s2t+1 = 1 in equilibrium. Since we are given d2t = 1 2 t

k2t = Et
j =1

1 + 2 1

1 + 2

Finally, we have got the pricing equations. p 1t = p 2t = dt 2(1 ) 1 + 2 1

dt

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(d) Prove that if > 0, then R1t > R2t t The returns R1t , R2t are dened as: R 1t = R 2t = p1t+1 + d1t+1 p 1t p2t+1 + d2t+1 p 2t

From the derived pricing equations, 1 2 1 dt+1 + dt+1 1 2 1 dt 2 1 1 1 + dt+1 + dt+1 2 1 2 1 + dt 2 1

R 1t =

R 2t =

By rearranging the equations, R 1t R 2t = If > 0, then R 1t > R 2t 1 1 1 + 2 1 dt+1 dt

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