Output Dynamics with Microfoundations

From Solow-Swan to Ramsey-Cass-Koopmans & OLG

Mausumi Das

Lecture 3, EC004, DSE

18 May, 2022

Das (Lecture 3, EC004, DSE) Solow to RCK & OLG 18 May, 2022 1 / 15
Utility Function in R-C-K Model: Some Explanations
In the last class we had speci…ed households’utility function in the
R-C-K model as follows:
∞
∑ βt u cth = u (c0 ) + βu (c1 ) + β2 u (c2 ) + β3 u (c3 ) + ......
t =0
We had also discussed one possible rationale behind this utility
function and provided the corresponding interpretaion of the
intertemporal discount factor β:
(1) Agents live forever:
Then the above utility function de…nes the present discounted value
of an agent’s ‘life-time’utility.
By this de…nition, β is to be interpreted as the agents’innate
preference for present vis-a-vis future (or their rate of time
preference) which is constant - independent of the calendar time.
The constancy of the discount factor also makes the preferences of
the household "time consistent".
Das (Lecture 3, EC004, DSE) Solow to RCK & OLG 18 May, 2022 2 / 15
Household’s Utility Function: Some Explanations (Contd.)

There can be an alternative explanation of the households’utility

function in the R-C-K model, which is described below:

(2) Each agent lives only for a single period, but in the next period an
exact replica is born who inherits the parent’s tastes and preferences:

Then the utility function de…nes the weighted sum of the dynastic
utility.
By this de…nition, β is to be interpreted as a measure of the degree
of intergenerational altruism.
This speci…cation is called a case of "imperfect altruism" where
parents do care about the utility of their children - but a little less
than their own utility.

Das (Lecture 3, EC004, DSE) Solow to RCK & OLG 18 May, 2022 3 / 15
Household’s Utility Function: Some Explanations (Contd.)
Yet another explanation of the households’utility function is as
follows:
(3) An agent can potentially live forever but in each period he faces an
exogenous mortality shock which is i.i.d. across time and happens
with probability p:
Then the utility function de…nes the "expected" life-time utility of an
agent.
By this de…nition, β (1 p ) is the constant probablity of
survival from one period to the next.
In our analysis, we shall ignore the third (‘expected’utility)
interpretation - since we want to stick to a deterministic set up and
stay clear of any ‘random shock’that might the households’decision
making process.
In fact, the second one ("dynastic" utility with imperfect altruism)
will be our preferred interpretation.
Das (Lecture 3, EC004, DSE) Solow to RCK & OLG 18 May, 2022 4 / 15
Household’s Problem: In…nite Horizon & No Borrowing

In the last class we had speci…ed household h’s optimization problem

in the absence of intra-household borrowing as:
∞

∞
Max. ∞ ∑ βt u cth ; u 0 > 0; u 00 < 0; 0 < β < 1 (1)
fcth gt =0 ,fath+1 gt =0 t =0

subject to

(i) cth 5 wt + rt ath + (1 δ)ath for all t = 0;

(ii) ath+1 = wt + rt ath cth + (1 δ)ath ; ath = 0 for all t = 0;

where a0h is historically given.

The atomistic household also treats wt and rt as exogenous.

Das (Lecture 3, EC004, DSE) Solow to RCK & OLG 18 May, 2022 5 / 15
Household’s Problem: In…nite Horizon & No Borrowing
(Contd.)

Note that that the household is solving this problem at time 0.

Therefore, in order to solve this problem the households would have
to have some idea about the entire time paths of wt and rt from
t = 0 to t ! ∞.
However recall that households’have rational expectations. In this
model with complete information and no uncertainty, rational
expectation is equivalent to perfect foresight. We shall use these two
terms here interchangeably.
By virtue of the assumption of rational expectations/perfect foresight,
the agents can correctly guess all the future values of the
market wage rate and rental rate.
But they still treat them as exogenous. As atomistic agents, they
believe that their action cannot in‡uence the values of these ‘market’
variables.
Das (Lecture 3, EC004, DSE) Solow to RCK & OLG 18 May, 2022 6 / 15
Household’s Problem: In…nite Horizon & No Borrowing
(Contd.)
We can always solve the household’s optimization problem using the
standard Lagrangean method.
The only problem is that there are now in…nite number of choice
variables as well as in…nite number of constraints (one for each time
period from t = 0, 1, 2....., ∞) and things can get quite intractable.
Instead, we shall employ a di¤erent method - called Dynamic
Programming - which simpli…es the solution process and reduces it
to a univariate problem.
Before we develop the formal mathematical tools of Dynammic
Programming, let us …rst discuss the idea behind the technique
intuitively in terms of a much simpler optimization problem for an
endowment economy.
Note that in an endowment economy without production, wt and rt
in each period are necessarily zero (which simpli…es the budget
constraint of the household).
Das (Lecture 3, EC004, DSE) Solow to RCK & OLG 18 May, 2022 7 / 15
Dynamic Optimization in Discrete Time: A Cake Eating
Problem
Imagine that the household/agent is given a …xed endowment (a
cake) of size W0 at the initial point of time. He does not receive any
fresh income/endowment thereafter.
The agent has to maintain his consumption over his lifetime from this
cake, size of which decreases with consumption in every period.
In the context of this simple example, I would also like to show you
how the logic behind dynamic programming is closely related to the
standard Lagrangean technique: so I will solve this dynamic
optimization problem using both methods..
However, manipulating in…nite number of variables and constraints in
a Lanrangean function is di¢ cult.
Hence, to begin with, we shall assume that the agent has a …nite life
time: he lives from period 0 to T , where T is a very large number.
Evetually we will allow T to go to in…nity.
Das (Lecture 3, EC004, DSE) Solow to RCK & OLG 18 May, 2022 8 / 15
Dynamic Optimization in Discrete Time: A Cake Eating
Problem (Contd.)
Let us also assume that the cake does not depreciate/spoil or grow.
Hence the size of the cake evolves over time according to the
following di¤erence equation:
Wt + 1 = Wt ct for all t = 0, 1, 2, ......., T . (2)
This is the ‡ow budget constraint of the agent in every period.
The life-time utility of the agent is given by:
T
∑ βt u (ct ) ; u 0 > 0; u 00 < 0; 0<β<1
t =0

In addition we assume: limc !0 u 0 (c ) = ∞ (No-stravation condition).

Neither consumption, nor the size of the cake can be negative in any
period, which implies the following set of nonegativity constraints:
ct > 0; Wt +1 > 0 for all t = 0, 1, 2, ....., T .
Das (Lecture 3, EC004, DSE) Solow to RCK & OLG 18 May, 2022 9 / 15
Cake Eating Problem: Direct Approach (Sequence
Problem)
Moreover the consumption in any period cannot exceed the size of
the cake in that period; i.e., ct 6 Wt for all t. This constitute the
feasible set for consumption in this problem.
How should the agent choose his optimal consumption path fct gTt=0 ?
One option is to solve the problem directly by using the standard
Lagrangean method.
Since the time horizon is …nite, the number of choice variables
(c0 , c1 , c2 ,....., cT ) as well as the number of constraints are also …nite.
Hence can combine all the ‡ow budget constraint to get the following
single resource contraint (lifetime budget constraint) of the agent:
T
∑ ct + WT +1 = W0 (3)
t =0

where W0 is exogenously speci…ed.

Das (Lecture 3, EC004, DSE) Solow to RCK & OLG 18 May, 2022 10 / 15
Cake Eating Problem: Direct Approach (Contd.)

The lifetime budget constraint (3) is derived from the ‡ow budget
constraints in the following way:
We have T + 1 ‡ow budget constarints, one for every t = 0, 1, 2, ..., T :

W1 = W0 c0 : Period 0 ‡ow budget constraint

W2 = W1 c1 : Period 1 ‡ow budget constraint
W3 = W2 c2 : Period 2 ‡ow budget constraint
...
WT = WT 1 cT 1 : Period T 1 ‡ow budget constraint
WT + 1 = WT cT : Period T ‡ow budget constraint

Adding all the equations and eliminating W1 , W2 , ...., WT from both

sides we get:
T
∑ ct + WT +1 = W0
t =0

Das (Lecture 3, EC004, DSE) Solow to RCK & OLG 18 May, 2022 11 / 15
A Cake Eating Problem: Direct Approach (Contd.)
The nonnegativity constraints are now given by:
ct > 0 for all t = 0, 1, 2, ....., T ; and WT +1 > 0.
Taking into account the life-time resource constraint and the
non-negativity on WT +1 (we ignore the non-negativity constraints on
ct because of the assumption that limc !0 u 0 (c ) = ∞), we can write
the corresponding Lagrangean as:
" #
T T
L= ∑ β t u ( ct ) + λ W0 ∑ ct WT +1 + φWT +1
t =0 t =0

From the FONCs:

∂L
= 0 ) β t u 0 ( ct ) = λ for all t = 0, 1, 2, ....., T ;
∂ct
∂L
= 0 ) λ = φ; φWT +1 = 0 (with complementary slackness)
∂WT +1
Das (Lecture 3, EC004, DSE) Solow to RCK & OLG 18 May, 2022 12 / 15
A Cake Eating Problem: Direct Approach (Contd.)
Combining the …rst set of equations, we obtain an expression that
links consumption across any two time periods:

βt u 0 (ct ) = λ = βt +1 u 0 (ct +1 ) ) u 0 (ct ) = βu 0 (ct +1 ) (4)

This optimality condition is referred to in the literature as Euler

equation.
The Euler equation has a very simple and intuitive interpretation:

u 0 ( ct ) = βu 0 (ct +1 )
| {z } | {z }
Current utility loss from saving Future utility gain from saving
one marginal unit of cake one marginal unit of cake
at time t at time t

Along the optimal path, the marginal gain and the marginal loss
(opportunity cost) from savings must be exactly equal at every point
of time t.
Das (Lecture 3, EC004, DSE) Solow to RCK & OLG 18 May, 2022 13 / 15
A Cake Eating Problem: Direct Approach (Contd.)

The second FONC, in particular, the following complementary

slackness condition also plays an important role in this problem:

φWT +1 = 0

Note that using the result βt u 0 (ct ) = λ = φ, we can write the above
complementary slackness condition as follows:

βt u 0 (ct ) WT +1 = 0 (5)

This condition (which is a part of the FONCs) is referred to in the

literature as the Transversality condition.
Note further that since βt u 0 (ct ) > 0 for all t = 0, 1, 2, ....., T , the
Transversality condition for this problem reduces to the following
terminal condition:

WT +1 = 0 (due to complementary slackness).

Das (Lecture 3, EC004, DSE) Solow to RCK & OLG 18 May, 2022 14 / 15
A Cake Eating Problem: Direct Approach (Contd.)

This reduced form transversality condition also has an intuitive

interpretation: it implies that the no part of the cake remains beyond
period T .
Any consumption path that leaves part of the cake unconsumed
beyond period T would clearly be suboptimal. Since marginal utility
from consumption is postive in all time periods, the agent is better o¤
consuming the entire cake within his lifetime.
The transversality condition indeed ensures that such wastage does
not happen along the optimal path.
Reference for the Cake Eating Problem:
Jerome Adda and Russell Cooper: "Dynamic Economics:
Quantitative Methods and Applications", Chapter 2 (upto
section 2.4.2).

Das (Lecture 3, EC004, DSE) Solow to RCK & OLG 18 May, 2022 15 / 15