The Diamond Model: Overlapping Generations 47

 Barro’s JME paper (4th paper of week) is discussed on Romer’s pp. 75–77 and looks at
behavior of interest rates during English wars from 1729 to 1918.

The Diamond Model: Overlapping Generations

Differences from the Ramsey model
 Discrete time
 Finite (two-period) lifetimes
 Distinct phases of life (work and retirement)

Similarities to Ramsey model

 Same basic idea of consumption/saving
 Same production and growth dynamics

Dynamic assumptions
 Lifetime assumptions
o Individual lives two periods
o No links to earlier or later generations
o Works first period and lives off saving (with interest) second period
o Old gradually sell off capital to the young throughout the old-age period
o Young save by buying capital from old, then diverting output from consumption
to create additional new capital as desired
 Size of population
o Lt = number of young in year t
 They are the only workers
o L t 1  1  n  L t
 Labor force and population grow at annually compounded rate n
 Consumption notation
o C1,t  consumption per person by young in period t
o C2,t  consumption per person by old in period t

Utility
 Period felicity function is again CRRA
 Consumption choices by person who is young in t
o Consumes C1,t when young and C2,t1 when old
48 The Diamond Model: Overlapping Generations

C1,1
1
1 C 2,t 1
Utility is U 
t
  , with  > 0 and  > 0.
1  1  1 
o Utility is discounted at annually compounded rate 

Production and dynamics

 Y t  F  K t , At L t  with constant returns to scale and usual marginal product conditions
o y t  f  k t  as before
o rt  f   k t  (assume no depreciation)
o w t  f  k t   k t f   k t  = wage of each effective labor unit

 At wt = wage per worker

 At wt Lt  total wages earned in economy (= income of young)
 All capital is owned by the old at the beginning of each period
 K t 1  Lt  wt At  C1,t 
o Expression in parentheses is saving by each young person, which consists of
buying up capital from oldies plus perhaps diverting some new production to
further capital.
o Multiply by number of young people to get total capital put away for next period

Budget constraint and utility maximization

C 2,t 1
 Budget constraint over lifetime is C1,t   At wt
1  rt 1

o 
Or C2,t 1  1  rt 1  wt At  C1,t 
 Individual maximization problem:
 C 1 1 C 2,t 1 
1
C
max  1,t   , subject to C1,t  2,t 1  At wt
C1,t ,C 2,t 1 1   1   1    1  rt 1

 Can do this as a Lagrangean, but just as easy to solve and substitute for C2,t1 :
 1 1  rt 1   wt At  C1,t   
1
C 1  
o max  1, t
 
C1,t  1   1  1  
 
dU
 First-order conditions for this maximization come from 0
dC1,t
1
C 2,t 1  1  rt 1  
o  
C 1,t  1  
The Diamond Model: Overlapping Generations 49

o Budget constraint: C2,t 1  1  rt 1  wt At  C1,t  

o Note similarity of first condition to Euler equation in Ramsey model:
 C increases or decreases over time as r >  or r < 
 Sensitivity of consumption path to r depends on 1/
 Plugging the budget constraint back into the other first-order condition yields
1
1    
C1,t  1 1
At w t  1  s  rt 1   At w t
1      1  rt 1  
o Note that numerator and denominator terms are always positive and that the
denominator is always larger
o If  ≈ r then we consume about ½ of income in first period and ½ in second,
which is consistent with basic consumption smoothing
1

 We can show that s   rt 1  

1  rt 1  
1 1
 0 iff  < 1
1      1  rt 1  

o Change in r has income and substitution effects

 Reward to saving is higher if r↑
 Don’t need to save as much for retirement if r↑
o Remember that 1/ is elasticity of intertemporal substitution
 If 1/ is large, then substitution effect is strong and s > 0
 If 1/ is small, then income effect dominates and s < 0
o Intermediate case  = 1 has s = 0 and saving rate does not depend on interest rate
 Recall that the CRRA utility function approaches u = ln(c) as  → 1.
1
 If  = 1, then s  = constant
2
 We shall use log utility as a special case because it is simple
 What does this mean in terms of indifference curves?
50 The Diamond Model: Overlapping Generations

C2,t + 1 slope = – (1 + rt + 1)

Income and substitution effects cancel

out as C1,t is the same after increase in
rt + 1 steepens the budget constraint.

Atwt C1,t
Analysis of the Diamond Model 51

Analysis of the Diamond Model

Dynamics
 The basic equation of motion of this model is K t  1  s  rt  1  L t At w t
 We want to translate this into kt + 1 :
K t 1 Aw L
kt 1   s  rt 1  t t t
At 1 Lt 1 At 1 Lt 1
wt f  kt   kt f   kt 
 s  rt 1   s  f   kt 1  
Lt 1 At 1
 1  n 1  g 
Lt At
o This equation gives kt + 1 implicitly as a function of kt, but it can’t be solved in the
general case.
 Steady-state condition
o What would correspond to k  0 ?
o kt 1  kt 1  kt  0 would be the equivalent in discrete time
o Setting kt 1  0 (or kt 1  kt  k * ) gives the steady-state condition:
s  f   k *    f  k *   k * f   k *  
k*   , which implicitly defines k* the steady-
1  n 1  g 
state value of k.
o This equation is difficult to work with because we don’t know the form of f and
we don’t even know the sign of s.
o Depending on the forms of s and f, the function on the right can have a variety of
shapes.
 Special case:  = 1 (log utility) and Cobb-Douglas production function y = k
1
o In this case, s  r   , f   k    k  1 , w  1    k  .
2

o kt 1 
1    kt  Dkt with positive constant D
 2   1  n 1  g 
o In this case, we can graph kt 1 as a function of k t and know its basic shape:
52 Analysis of the Diamond Model

kt + 1 = kt
kt + 1
e
k*

k0 k1 k* kt
1
o In this case, if we start at k0, we will converge to k *  D 1 by the “cobweb” path
shown
o Note effects of parameters:
 ↑  D↓
 n↑  D↓
 g↑  D↓
 Effects are similar to Ramsey (and Solow) model

Properties of Diamond Steady State

 In steady-state equilibrium
o k and y are stable
o Y/L grows at g
o Y, K grow at n + g
 Speed of convergence:
o k t 1  k t    k t  k * 
o  ≈ 1/3, so economy moves 1/3 of way to equilibrium in each “period”
 Note that “period” is half a lifetime, so this is not so different from
Solow/Ramsey result

Diamond Model General Case?

 If we abandon the comfortable home of log utility and Cobb-Douglas we admit to
strange possibilities:
Analysis of the Diamond Model 53

o Can have multiple equilibria

kt + 1 = kt
kt + 1
e kt + 1 = g(kt)
k*

k* kt

o Can have no non-zero equilibrium at all

kt + 1 = kt
kt + 1
e
k*

kt + 1 = g(kt)

k* kt

Dynamic Inefficiency in Diamond Model

 Equilibrium in Ramsey model was Pareto efficient
 Diamond model admits the possibility of inefficiency
o It is possible that k* is greater than Golden Rule k
54 Analysis of the Diamond Model

o Why? Because survival in old age depends on saving lots of income regardless of
rate of return.
o It is possible that the saving rate that is optimal for an individual might be higher
than the saving rate that leads to Golden Rule level of k*
 Suppose that k* > kGR
o Suppose that there was another (than capital) way of transferring money from
youth to old age (Social Security) so that saving could go down
o Young would be better off because they could consume more
o Future generations would be better off because k*↓ means higher steady-state c*
o Everyone is made better off and no one worse off, so original equilibrium must
not have been Pareto optimal
 How can model by inefficient? Where is the market failure?
o No externalities, but an absent market: no way for current generation to trade
effectively with future generations
o Only way to provide for retirement is through saving, even if rate of return is
zero or negative
o From social standpoint, it is desirable to avoid low- or negative-return investment,
but for individual facing retirement this is only choice
o If benevolent government were to establish transfer scheme from young to old
(like Social Security), then they would not need to accumulate useless capital in
order to eat in retirement
o You will do a problem this week looking at the effect of alternative Social
Security regimes in the Diamond model
 Is this empirically relevant?
o k > kGR means that f   k     g  n
o Are interest rates lower than the GDP growth rate?
 Probably not in U.S. steady state