Macroeconomic Theory

Dirk Krueger1
Department of Economics
University of Pennsylvania

January 26, 2012

1
I am grateful to my teachers in Minnesota, V.V Chari, Timothy Kehoe and Ed-
ward Prescott, my ex-colleagues at Stanford, Robert Hall, Beatrix Paal and Tom
Sargent, my colleagues at UPenn Hal Cole, Jeremy Greenwood, Randy Wright and
Iourii Manovski and my co-authors Juan Carlos Conesa, Jesus Fernandez-Villaverde,
Felix Kubler and Fabrizio Perri as well as Victor Rios-Rull for helping me to learn
modern macroeconomic theory. These notes were tried out on numerous students at
Stanford, UPenn, Frankfurt and Mannheim, whose many useful comments I appreci-
ate. Kaiji Chen and Antonio Doblas-Madrid provided many important corrections to
these notes.
ii
Contents

1 Overview and Summary 1

2 A Simple Dynamic Economy 5

2.1 General Principles for Specifying a Model . . . . . . . . . . . . . 5
2.2 An Example Economy . . . . . . . . . . . . . . . . . . . . . . . . 6
2.2.1 DeÖnition of Competitive Equilibrium . . . . . . . . . . . 8
2.2.2 Solving for the Equilibrium . . . . . . . . . . . . . . . . . 9
2.2.3 Pareto Optimality and the First Welfare Theorem . . . . 11
2.2.4 Negishiís (1960) Method to Compute Equilibria . . . . . . 14
2.2.5 Sequential Markets Equilibrium . . . . . . . . . . . . . . . 18
2.3 Appendix: Some Facts about Utility Functions . . . . . . . . . . 24
2.3.1 Time Separability . . . . . . . . . . . . . . . . . . . . . . 24
2.3.2 Time Discounting . . . . . . . . . . . . . . . . . . . . . . 24
2.3.3 Standard Properties of the Period Utility Function . . . . 25
2.3.4 Constant Relative Risk Aversion (CRRA) Utility . . . . . 25
2.3.5 Homotheticity and Balanced Growth . . . . . . . . . . . . 28

3 The Neoclassical Growth Model in Discrete Time 31

3.1 Setup of the Model . . . . . . . . . . . . . . . . . . . . . . . . . . 31
3.2 Optimal Growth: Pareto Optimal Allocations . . . . . . . . . . . 32
3.2.1 Social Planner Problem in Sequential Formulation . . . . 33
3.2.2 Recursive Formulation of Social Planner Problem . . . . . 35
3.2.3 An Example . . . . . . . . . . . . . . . . . . . . . . . . . 37
3.2.4 The Euler Equation Approach and Transversality Condi-
tions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
3.2.5 Steady States and the ModiÖed Golden Rule . . . . . . . 52
3.2.6 A Remark About Balanced Growth . . . . . . . . . . . . 53
3.3 Competitive Equilibrium Growth . . . . . . . . . . . . . . . . . . 55
3.3.1 DeÖnition of Competitive Equilibrium . . . . . . . . . . . 56
3.3.2 Characterization of the Competitive Equilibrium and the
Welfare Theorems . . . . . . . . . . . . . . . . . . . . . . 58
3.3.3 Sequential Markets Equilibrium . . . . . . . . . . . . . . . 64
3.3.4 Recursive Competitive Equilibrium . . . . . . . . . . . . . 65
3.4 Mapping the Model to Data: Calibration . . . . . . . . . . . . . 67

iii
iv CONTENTS

4 Mathematical Preliminaries 71
4.1 Complete Metric Spaces . . . . . . . . . . . . . . . . . . . . . . . 72
4.2 Convergence of Sequences . . . . . . . . . . . . . . . . . . . . . . 73
4.3 The Contraction Mapping Theorem . . . . . . . . . . . . . . . . 77
4.4 The Theorem of the Maximum . . . . . . . . . . . . . . . . . . . 83

5 Dynamic Programming 85
5.1 The Principle of Optimality . . . . . . . . . . . . . . . . . . . . . 85
5.2 Dynamic Programming with Bounded Returns . . . . . . . . . . 92

6 Models with Risk 95

6.1 Basic Representation of Risk . . . . . . . . . . . . . . . . . . . . 95
6.2 DeÖnitions of Equilibrium . . . . . . . . . . . . . . . . . . . . . . 97
6.2.1 Arrow-Debreu Market Structure . . . . . . . . . . . . . . 98
6.2.2 Pareto E¢ciency . . . . . . . . . . . . . . . . . . . . . . . 100
6.2.3 Sequential Markets Market Structure . . . . . . . . . . . . 101
6.2.4 Equivalence between Market Structures . . . . . . . . . . 102
6.2.5 Asset Pricing . . . . . . . . . . . . . . . . . . . . . . . . . 102
6.3 Markov Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
6.4 Stochastic Neoclassical Growth Model . . . . . . . . . . . . . . . 106

7 The Two Welfare Theorems 109

7.1 What is an Economy? . . . . . . . . . . . . . . . . . . . . . . . . 109
7.2 Dual Spaces . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
7.3 DeÖnition of Competitive Equilibrium . . . . . . . . . . . . . . . 114
7.4 The Neoclassical Growth Model in Arrow-Debreu Language . . . 115
7.5 A Pure Exchange Economy in Arrow-Debreu Language . . . . . 117
7.6 The First Welfare Theorem . . . . . . . . . . . . . . . . . . . . . 119
7.7 The Second Welfare Theorem . . . . . . . . . . . . . . . . . . . . 120
7.8 Type Identical Allocations . . . . . . . . . . . . . . . . . . . . . . 128

8 The Overlapping Generations Model 129

8.1 A Simple Pure Exchange Overlapping Generations Model . . . . 130
8.1.1 Basic Setup of the Model . . . . . . . . . . . . . . . . . . 131
8.1.2 Analysis of the Model Using O§er Curves . . . . . . . . . 136
8.1.3 Ine¢cient Equilibria . . . . . . . . . . . . . . . . . . . . . 143
8.1.4 Positive Valuation of Outside Money . . . . . . . . . . . . 148
8.1.5 Productive Outside Assets . . . . . . . . . . . . . . . . . . 150
8.1.6 Endogenous Cycles . . . . . . . . . . . . . . . . . . . . . . 152
8.1.7 Social Security and Population Growth . . . . . . . . . . 154
8.2 The Ricardian Equivalence Hypothesis . . . . . . . . . . . . . . . 160
8.2.1 InÖnite Lifetime Horizon and Borrowing Constraints . . . 161
8.2.2 Finite Horizon and Operative Bequest Motives . . . . . . 170
8.3 Overlapping Generations Models with Production . . . . . . . . . 175
8.3.1 Basic Setup of the Model . . . . . . . . . . . . . . . . . . 175
8.3.2 Competitive Equilibrium . . . . . . . . . . . . . . . . . . 176
CONTENTS v

8.3.3 Optimality of Allocations . . . . . . . . . . . . . . . . . . 183

8.3.4 The Long-Run E§ects of Government Debt . . . . . . . . 187

9 Continuous Time Growth Theory 193

9.1 Stylized Growth and Development Facts . . . . . . . . . . . . . . 193
9.1.1 Kaldorís Growth Facts . . . . . . . . . . . . . . . . . . . . 194
9.1.2 Development Facts from the Summers-Heston Data Set . 194
9.2 The Solow Model and its Empirical Evaluation . . . . . . . . . . 199
9.2.1 The Model and its Implications . . . . . . . . . . . . . . . 202
9.2.2 Empirical Evaluation of the Model . . . . . . . . . . . . . 204
9.3 The Ramsey-Cass-Koopmans Model . . . . . . . . . . . . . . . . 215
9.3.1 Mathematical Preliminaries: Pontryaginís Maximum Prin-
ciple . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215
9.3.2 Setup of the Model . . . . . . . . . . . . . . . . . . . . . . 215
9.3.3 Social Planners Problem . . . . . . . . . . . . . . . . . . . 217
9.3.4 Decentralization . . . . . . . . . . . . . . . . . . . . . . . 226
9.4 Endogenous Growth Models . . . . . . . . . . . . . . . . . . . . . 231
9.4.1 The Basic AK-Model . . . . . . . . . . . . . . . . . . . . 231
9.4.2 Models with Externalities . . . . . . . . . . . . . . . . . . 235
9.4.3 Models of Technological Progress Based on Monopolistic
Competition: Variant of Romer (1990) . . . . . . . . . . . 248

10 Bewley Models 261

10.1 Some Stylized Facts about the Income and Wealth Distribution
in the U.S. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
10.1.1 Data Sources . . . . . . . . . . . . . . . . . . . . . . . . . 262
10.1.2 Main Stylized Facts . . . . . . . . . . . . . . . . . . . . . 263
10.2 The Classic Income Fluctuation Problem . . . . . . . . . . . . . 269
10.2.1 Deterministic Income . . . . . . . . . . . . . . . . . . . . 270
10.2.2 Stochastic Income and Borrowing Limits . . . . . . . . . . 278
10.3 Aggregation: Distributions as State Variables . . . . . . . . . . . 282
10.3.1 Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282
10.3.2 Numerical Results . . . . . . . . . . . . . . . . . . . . . . 289

11 Fiscal Policy 293

11.1 Positive Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . 293
11.2 Normative Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . 293
11.2.1 Optimal Policy with Commitment . . . . . . . . . . . . . 293
11.2.2 The Time Consistency Problem and Optimal Fiscal Policy
without Commitment . . . . . . . . . . . . . . . . . . . . 293

12 Political Economy and Macroeconomics 295

13 References 297
vi CONTENTS
Chapter 1

Overview and Summary

After a quick warm-up for dynamic general equilibrium models in the Örst part
of the course we will discuss the two workhorses of modern macroeconomics, the
neoclassical growth model with inÖnitely lived consumers and the Overlapping
Generations (OLG) model. This Örst part will focus on techniques rather than
issues; one Örst has to learn a language before composing poems.
I will Örst present a simple dynamic pure exchange economy with two in-
Önitely lived consumers engaging in intertemporal trade. In this model the
connection between competitive equilibria and Pareto optimal equilibria can be
easily demonstrated. Furthermore it will be demonstrated how this connec-
tion can exploited to compute equilibria by solving a particular social planners
problem, an approach developed Örst by Negishi (1960) and discussed nicely by
Kehoe (1989).
This model with then enriched by production (and simpliÖed by dropping
one of the two agents), to give rise to the neoclassical growth model. This
model will Örst be presented in discrete time to discuss discrete-time dynamic
programming techniques; both theoretical as well as computational in nature.
The main reference will be Stokey et al., chapters 2-4. As a Örst economic
application the model will be enriched by technology shocks to develop the
Real Business Cycle (RBC) theory of business cycles. Cooley and Prescott
(1995) are a good reference for this application. In order to formulate the
stochastic neoclassical growth model notation for dealing with uncertainty will
be developed.
This discussion will motivate the two welfare theorems, which will then be
presented for quite general economies in which the commodity space may be
inÖnite-dimensional. We will draw on Stokey et al., chapter 15ís discussion of
Debreu (1954).
The next two topics are logical extensions of the preceding material. We will
Örst discuss the OLG model, due to Samuelson (1958) and Diamond (1965).
The Örst main focus in this module will be the theoretical results that distinguish
the OLG model from the standard Arrow-Debreu model of general equilibrium:
in the OLG model equilibria may not be Pareto optimal, Öat money may have

1
2 CHAPTER 1. OVERVIEW AND SUMMARY

positive value, for a given economy there may be a continuum of equilibria

(and the core of the economy may be empty). All this could not happen in
the standard Arrow-Debreu model. References that explain these di§erences in
detail include Geanakoplos (1989) and Kehoe (1989). Our discussion of these
issues will largely consist of examples. One reason to develop the OLG model
was the uncomfortable assumption of inÖnitely lived agents in the standard
neoclassical growth model. Barro (1974) demonstrated under which conditions
(operative bequest motives) an OLG economy will be equivalent to an economy
with inÖnitely lived consumers. One main contribution of Barro was to provide
a formal justiÖcation for the assumption of inÖnite lives. As we will see this
methodological contribution has profound consequences for the macroeconomic
e§ects of government debt, reviving the Ricardian Equivalence proposition. As
a prelude we will brieáy discuss Diamondís (1965) analysis of government debt
in an OLG model.
In the next module we will discuss the neoclassical growth model in con-
tinuous time to develop continuous time optimization techniques. After having
learned the technique we will review the main developments in growth the-
ory and see how the various growth models fare when being contrasted with
the main empirical Öndings from the Summers-Heston panel data set. We will
brieáy discuss the Solow model and its empirical implications (using the arti-
cle by Mankiw et al. (1992) and Romer, chapter 2), then continue with the
Ramsey model (Intriligator, chapter 14 and 16, Blanchard and Fischer, chapter
2). In this model growth comes about by introducing exogenous technological
progress. We will then review the main contributions of endogenous growth the-
ory, Örst by discussing the early models based on externalities (Romer (1986),
Lucas (1988)), then models that explicitly try to model technological progress
(Romer (1990).
All the models discussed up to this point usually assumed that individuals
are identical within each generation (or that markets are complete), so that
without loss of generality we could assume a single representative consumer
(within each generation). This obviously makes life easy, but abstracts from a
lot of interesting questions involving distributional aspects of government policy.
In the next section we will discuss a model that is capable of addressing these
issues. There is a continuum of individuals. Individuals are ex-ante identical
(have the same stochastic income process), but receive di§erent income realiza-
tions ex post. These income shocks are assumed to be uninsurable (we therefore
depart from the Arrow-Debreu world), but people are allowed to self-insure by
borrowing and lending at a risk-free rate, subject to a borrowing limit. Deaton
(1991) discusses the optimal consumption-saving decision of a single individual
in this environment and Aiyagari (1994) incorporates Deatonís analysis into a
full-blown dynamic general equilibrium model. The state variable for this econ-
omy turns out to be a cross-sectional distribution of wealth across individuals.
This feature makes the model interesting as distributional aspects of all kinds
of government policies can be analyzed, but it also makes the state space very
big. A cross-sectional distribution as state variable requires new concepts (de-
veloped in measure theory) for deÖning and new computational techniques for
 3

computing equilibria. The early papers therefore restricted attention to steady

state equilibria (in which the cross-sectional wealth distribution remained con-
stant). Very recently techniques have been developed to handle economies with
distributions as state variables that feature aggregate shocks, so that the cross-
sectional wealth distribution itself varies over time. Krusell and Smith (1998)
is the key reference. Applications of their techniques to interesting policy ques-
tions could be very rewarding in the future. If time permits I will discuss such
an application due to Heathcote (1999).
For the next two topics we will likely not have time; and thus the corre-
sponding lecture notes are work in progress. So far we have not considered
how government policies a§ect equilibrium allocations and prices. In the next
modules this question is taken up. First we discuss Öscal policy and we start
with positive questions: how does the governmentsí decision to Önance a given
stream of expenditures (debt vs. taxes) a§ect macroeconomic aggregates (Barro
(1974), Ohanian (1997))?; how does government spending a§ect output (Baxter
and King (1993))? In this discussion government policy is taken as exogenously
given. The next question is of normative nature: how should a benevolent gov-
ernment carry out Öscal policy? The answer to this question depends crucially
on the assumption of whether the government can commit to its policy. A gov-
ernment that can commit to its future policies solves a classical Ramsey problem
(not to be confused with the Ramsey model); the main results on optimal Öscal
policy are reviewed in Chari and Kehoe (1999). Kydland and Prescott (1977)
pointed out the dilemma a government faces if it cannot commit to its policy
-this is the famous time consistency problem. How a benevolent government
that cannot commit should carry out Öscal policy is still very much an open
question. Klein and Rios-Rull (1999) have made substantial progress in an-
swering this question. Note that we throughout our discussion assume that the
government acts in the best interest of its citizens. What happens if policies are
instead chosen by votes of selÖsh individuals is discussed in the last part of the
course.
As discussed before we assumed so far that government policies were either
Öxed exogenously or set by a benevolent government (that can or canít commit).
Now we relax this assumption and discuss political-economic equilibria in which
people not only act rationally with respect to their economic decisions, but also
rationally with respect to their voting decisions that determine macroeconomic
policy. Obviously we Örst had to discuss models with heterogeneous agents since
with homogeneous agents there is no political conáict and hence no interesting
di§erences between the Ramsey problem and a political-economic equilibrium.
This area of research is not very far developed and we will only present two
examples (Krusell et al. (1997), Alesina and Rodrik (1994)) that deal with the
question of capital taxation in a dynamic general equilibrium model in which
the capital tax rate is decided upon by repeated voting.
4 CHAPTER 1. OVERVIEW AND SUMMARY
Chapter 2

A Simple Dynamic
Economy

2.1 General Principles for Specifying a Model

An economic model consists of di§erent types of entities that take decisions
subject to constraints. When writing down a model it is therefore crucial to
clearly state what the agents of the model are, which decisions they take, what
constraints they have and what information they possess when making their
decisions. Typically a model has (at most) three types of decision-makers

1. Households: We have to specify householdsí preferences over commodi-

ties and their endowments of these commodities. Households are as-
sumed to optimize their preferences over a constraint set that speciÖes
which combination of commodities a household can choose from. This set
usually depends on initial household endowments and on market prices.

2. Firms: We have to specify the production technology available to Örms,

describing how commodities (inputs) can be transformed into other com-
modities (outputs). Firms are assumed to maximize (expected) proÖts,
subject to their production plans being technologically feasible.

3. Government: We have to specify what policy instruments (taxes, money

supply etc.) the government controls. When discussing government policy
from a positive point of view we will take government polices as given
(of course requiring the government budget constraint(s) to be satisÖed),
when discussing government policy from a normative point of view we
will endow the government, as households and Örms, with an objective
function. The government will then maximize this objective function by
choosing policy, subject to the policies satisfying the government budget
constraint(s)).

5
6 CHAPTER 2. A SIMPLE DYNAMIC ECONOMY

In addition to specifying preferences, endowments, technology and policy,

we have to specify what information agents possess when making decisions.
This will become clearer once we discuss models with risk. Finally we have
to be precise about how agents interact with each other. Most of economics
focuses on market interaction between agents; this will be also the case in this
course. Therefore we have to specify our equilibrium concept, by making
assumptions about how agents perceive their power to a§ect market prices.
In this course we will focus on competitive equilibria, by assuming that all
agents in the model (apart from possibly the government) take market prices
as given and beyond their control when making their decisions. An alternative
assumption would be to allow for market power of Örms or households, which
induces strategic interactions between agents in the model. Equilibria involving
strategic interaction have to be analyzed using methods from modern game
theory.
To summarize, a description of any model in this course should always con-
tain the speciÖcation of the elements in bold letters: what commodities are
traded, preferences over and endowments of these commodities, technology, gov-
ernment policies, the information structure and the equilibrium concept.

2.2 An Example Economy

Time is discrete and indexed by t = 0; 1; 2; : : : There are 2 individuals that live
forever in this pure exchange economy.1 There are no Örms, and the govern-
ment is absent as well. In each period the two agents consume a nonstorable
consumption good. Hence there are (countably) inÖnite number of commodities,
namely consumption in periods t = 0; 1; 2; : : :

DeÖnition 1 An allocation is a sequence (c1 ; c2 ) = f(c1t ; c2t )g1

t=0 of consump-
tion in each period for each individual.

Individuals have preferences over consumption allocations that can be rep-

resented by the utility function
1
X
u(ci ) = ( t ln(cit ) (2.1)
t=0

with ( 2 (0; 1):

This utility function satisÖes some assumptions that we will often require in
this course. These are further discussed in the appendix to this chapter. Note
that both agents are assumed to have the same time discount factor (:
1 One may wonder how credible the assumption is that households take prices as given in

an economy with two households. To address this concern, let there be instead two classes
of households with equal size. Within each class, there are many households (if you want to
be really safe, a continuum) that are all identical and described as in the main text. This
economy has the same equilibria as the one described in the main text.
2.2. AN EXAMPLE ECONOMY 7

Agents have deterministic endowment streams ei = feit g1

t=0 of the consump-
tion goods given by

"
2 if t is even
e1t =
0 if t is odd
"
0 if t is even
e2t =
2 if t is odd

There is no risk in this model and both agents know their endowment pattern
perfectly in advance. All information is public, i.e. all agents know everything.
At period 0; before endowments are received and consumption takes place, the
two agents meet at a central market place and trade all commodities, i.e. trade
consumption for all future dates. Let pt denote the price, in period 0; of one
unit of consumption to be delivered in period t; in terms of an abstract unit
of account. We will see later that prices are only determined up to a constant,
so we can always normalize the price of one commodity to 1 and make it the
numeraire. Both agents are assumed to behave competitively in that they take
the sequence of prices fpt g1
t=0 as given and beyond their control when making
their consumption decisions.
After trade has occurred agents possess pieces of paper (one may call them
contracts) stating

in period 212 I, agent 1; will deliver 0.25 units of the consumption

good to agent 2 (and will eat the remaining 1.75 units)
in period 2525 I, agent 1; will receive one unit of the consumption
good from agent 2 (and eat it).

and so forth. In all future periods the only thing that happens is that agents
meet (at the market place again) and deliveries of the consumption goods they
agreed upon in period 0 takes place. Again, all trade takes place in period 0
and agents are committed in future periods to what they have agreed upon in
period 0: There is perfect enforcement of these contracts signed in period 0:2

2 A market structure in which agents trade only at period 0 will be called an Arrow-Debreu

market structure. We will show below that this market structure is equivalent to a market
structure in which trade in consumption and a particular asset takes place in each period, a
market structure that we will call sequential markets.
8 CHAPTER 2. A SIMPLE DYNAMIC ECONOMY

2.2.1 DeÖnition of Competitive Equilibrium

Given a sequence of prices fpt g1
t=0 households solve the following optimization
problem
1
X
max
i 1
( t ln(cit )
fct gt=0
t=0
s.t.
1
X X1
pt cit $ pt eit
t=0 t=0
cit % 0 for all t

Note that the budget constraint can be rewritten as

1
X
pt (eit & cit ) % 0
t=0

The quantity eit &cit is the net trade of consumption of agent i for period t which
may be positive or negative.
For arbitrary prices fpt g1t=0 it may be the case that total consumption in
the economy desired by both agents, c1t + c2t at these prices does not equal total
endowments e1t + e2t ' 2: We will call equilibrium a situation in which prices
are ìrightî in the sense that they induce agents to choose consumption so that
total consumption equals total endowment in each period. More precisely, we
have the following deÖnition

p t g1
DeÖnition 2 A (competitive) Arrow-Debreu equilibrium are prices f^ t=0 and
i 1
allocations (f^
ct gt=0 )i=1;2 such that

p t g1
1. Given f^ cit g1
t=0 ; for i = 1; 2; f^ t=0 solves

1
X
max
i 1
( t ln(cit ) (2.2)
fct gt=0
t=0
s.t.
1
X X1
p^t cit $ p^t eit (2.3)
t=0 t=0
cit % 0 for all t (2.4)

2.
c^1t + c^2t = e1t + e2t for all t (2.5)

The elements of an equilibrium are allocations and prices. Note that we

do not allow free disposal of goods, as the market clearing condition is stated
2.2. AN EXAMPLE ECONOMY 9

as an equality.3 Also note the ^ís in the appropriate places: the consumption
allocation has to satisfy the budget constraint (2:3) only at equilibrium prices
and it is the equilibrium consumption allocation that satisÖes the goods market
clearing condition (2:5): Since in this course we will usually talk about com-
petitive equilibria, we will henceforth take the adjective ìcompetitiveî as being
understood.

2.2.2 Solving for the Equilibrium

For arbitrary prices fpt g1 t=0 letís Örst solve the consumer problem. Attach
the Lagrange multiplier ,i to the budget constraint. The Örst order necessary
conditions for cit and cit+1 are then

(t
= , i pt (2.6)
cit
( t+1
= ,i pt+1 (2.7)
cit+1

and hence
pt+1 cit+1 = (pt cit for all t (2.8)
for i = 1; 2:
Equations (2:8); together with the budget constraint can be solved for the
optimal sequence of consumption of household i as a function of the inÖnite
sequence of prices (and of the endowments, of course)

cit = cit (fpt g1

t=0 )

In order to solve for the equilibrium prices fpt g1

t=0 one then uses the goods
market clearing conditions (2:5)

c1t (fpt g1 2 1 1 2
t=0 ) + ct (fpt gt=0 ) = et + et for all t

This is a system of inÖnite equations (for each t one) in an inÖnite number

of unknowns fpt g1t=0 which is in general hard to solve. Below we will discuss
Negishiís method that often proves helpful in solving for equilibria by reducing
the number of equations and unknowns to a smaller number.
For our particular simple example economy, however, we can solve for the
equilibrium directly. Sum (2:8) across agents to obtain
# $
pt+1 c1t+1 + c2t+1 = (pt (c1t + c2t )
3 Di§erent people have di§erent tastes as to whether one should allow free disposal or not.

Personally I think that if one wishes to allow free disposal, one should specify this as part of
technology (i.e. introduce a Örm that has available a technology that uses positive inputs to
produce zero output; obviously for such a Örm to be operative in equilibrium it has to be the
case that the price of the inputs are non-positive -think about goods that are actually bads
such as pollution).
10 CHAPTER 2. A SIMPLE DYNAMIC ECONOMY

Using the goods market clearing condition we Önd that

# $
pt+1 e1t+1 + e2t+1 = (pt (e1t + e2t )
and hence
pt+1 = (pt
and therefore equilibrium prices are of the form
pt = ( t p0
Without loss of generality we can set p0 = 1; i.e. make consumption at period
0 the numeraire.4 Then equilibrium prices have to satisfy
p^t = ( t
so that, since ( < 1, the period 0 price for period t consumption is lower than the
period 0 price for period 0 consumption. This fact just reáects the impatience
of both agents.
Using (2:8) we have that cit+1 = cit = ci0 for all t, i.e. consumption is
constant across time for both agents. This reáects the agentís desire to smooth
consumption over time, a consequence of the strict concavity of the period utility
function. Now observe that the budget constraint of both agents will hold with
equality since agentsí period utility function is strictly increasing. The left hand
side of the budget constraint becomes
1
X 1
X ci0
p^t cit = ci0 (t =
t=0 t=0
1&(

for i = 1; 2:
The two agents di§er only along one dimension: agent 1 is rich Örst, which,
given that prices are declining over time, is an advantage. For agent 1 the right
hand side of the budget constraint becomes
1
X 1
X 2
p^t e1t = 2 ( 2t =
t=0 t=0
1 & (2
and for agent 2 it becomes
1
X 1
X 2(
p^t e2t = 2( ( 2t =
t=0 t=0
1 & (2
The equilibrium allocation is then given by
2 2
c^1t = c^10 = (1 & () 2 = 1+( >1
1&(
2( 2(
c^2t = c^20 = (1 & () 2 = 1+( <1
1&(
4 Note that multiplying all prices by ! > 0 does not change the budget constraints of agents,

so that if prices fpt g1 i 1

t=0 and allocations (fct gt=0 )i21;2 are an AD equilibrium, so are prices
f!pt g1
t=0 and allocations (fc i g1 )
t t=0 i=1;2
2.2. AN EXAMPLE ECONOMY 11

which obviously satisÖes

c^1t + c^2t = 2 = e^1t + e^2t for all t

Therefore the mere fact that the Örst agent is rich Örst makes her consume
more in every period. Note that there is substantial trade going on; in each
2 2%
even period the Örst agent delivers 2 & 1+% = 1+% to the second agent and in
2%
all odd periods the second agent delivers 2 & 1+% to the Örst agent. Also note
that this trade is mutually beneÖcial, because without trade both agents receive
lifetime utility
u(eit ) = &1
whereas with trade they obtain
' (
1
X % & ln 2
2 1+%
c1 )
u(^ = ( t ln = >0
t=0
1+( 1&(
' (
1
X % & 2%
ln 1+%
2 t 2(
u(^
c ) = ( ln = <0
t=0
1+( 1&(

In the next section we will show that not only are both agents better o§ in
the competitive equilibrium than by just eating their endowment, but that, in
a sense to be made precise, the equilibrium consumption allocation is socially
optimal.

2.2.3 Pareto Optimality and the First Welfare Theorem

In this section we will demonstrate that for this economy a competitive equi-
librium is socially optimal. To do this we Örst have to deÖne what socially
optimal means. Our notion of optimality will be Pareto e¢ciency (also some-
times referred to as Pareto optimality). Loosely speaking, an allocation is Pareto
e¢cient if it is feasible and if there is no other feasible allocation that makes no
household worse o§ and at least one household strictly better o§. Let us now
make this precise.

DeÖnition 3 An allocation f(c1t ; c2t )g1

t=0 is feasible if

1.
cit % 0 for all t; for i = 1; 2

2.
c1t + c2t = e1t + e2t for all t

Feasibility requires that consumption is nonnegative and satisÖes the re-

source constraint for all periods t = 0; 1; : : :
12 CHAPTER 2. A SIMPLE DYNAMIC ECONOMY

DeÖnition 4 An allocation f(c1t ; c2t )g1t=0 is Pareto e¢cient if it is feasible and

c1t ; c~2t )g1
if there is no other feasible allocation f(~ t=0 such that

ci ) % u(ci ) for both i = 1; 2

u(~
ci ) > u(ci ) for at least one i = 1; 2
u(~
Note that Pareto e¢ciency has nothing to do with fairness in any sense: an
allocation in which agent 1 consumes everything in every period and agent 2
starves is Pareto e¢cient, since we can only make agent 2 better o§ by making
agent 1 worse o§.
We now prove that every competitive equilibrium allocation for the economy
described above is Pareto e¢cient. Note that we have solved for one equilibrium
above; this does not rule out that there is more than one equilibrium. One can,
in fact, show that for this economy the competitive equilibrium is unique, but
we will not pursue this here.
Proposition 5 Let (f^ cit g1
t=0 )i=1;2 be a competitive equilibrium allocation. Then
cit g1
(f^ )
t=0 i=1;2 is Pareto e¢cient.
Proof. The proof will be by contradiction; we will assume that (f^ cit g1
t=0 )i=1;2
is not Pareto e¢cient and derive a contradiction to this assumption.
cit g1
So suppose that (f^ t=0 )i=1;2 is not Pareto e¢cient. Then by the deÖnition
of Pareto e¢ciency there exists another feasible allocation (f~ cit g1
t=0 )i=1;2 such
that
ci ) % u(^
u(~ ci ) for both i = 1; 2
ci ) > u(^
u(~ ci ) for at least one i = 1; 2
Without loss of generality assume that the strict inequality holds for i = 1:
Step 1: Show that
X1 1
X
p^t c~1t > p^t c^1t
t=0 t=0

where pt g1
f^ t=0 cit g1
are the equilibrium prices associated with (f^ t=0 )i=1;2 : If not,
i.e. if
1
X 1
X
p^t c~1t $ p^t c^1t
t=0 t=0

then for agent 1 the ~-allocation is better (remember u(~ c1 ) > u(^c1 ) is assumed)
1 1
and not more expensive, which cannot be the case since f^ ct gt=0 is part of
a competitive equilibrium, i.e. maximizes agent 1ís utility given equilibrium
prices. Hence
X1 1
X
p^t c~1t > p^t c^1t (2.9)
t=0 t=0
Step 2: Show that
1
X 1
X
p^t c~2t % p^t c^2t
t=0 t=0
2.2. AN EXAMPLE ECONOMY 13

If not, then
1
X 1
X
p^t c~2t < p^t c^2t
t=0 t=0

But then there exists a / > 0 such that

1
X 1
X
p^t c~2t + / $ p^t c^2t
t=0 t=0

Remember that we normalized p^0 = 1: Now deÖne a new allocation for agent 2;
by

c22t = c~2t for all t % 1

c220 = c~20 + / for t = 0

Obviously
1
X 1
X 1
X
p^t c22t = p^t c~2t +/ $ p^t c^2t
t=0 t=0 t=0

and
c2 ) > u(~
u(2 c2 ) % u(^
c2 )

which canít be the case since f^c2t g1

t=0 is part of a competitive equilibrium, i.e.
maximizes agent 2ís utility given equilibrium prices. Hence
1
X 1
X
p^t c~2t % p^t c^2t (2.10)
t=0 t=0

Step 3: Now sum equations (2:9) and (2:10) to obtain

1
X 1
X
c1t + c~2t ) >
p^t (~ c1t + c^2t )
p^t (^
t=0 t=0

But since both allocations are feasible (the allocation (f^ cit g1
t=0 )i=1;2 because it is
an equilibrium allocation, the allocation (f~cit g1 )
t=0 i=1;2 by assumption) we have
that
c~1t + c~2t = e1t + e2t = c^1t + c^2t for all t

and thus
1
X 1
X
p^t (e1t + e2t ) > p^t (e1t + e2t );
t=0 t=0

our desired contradiction.

14 CHAPTER 2. A SIMPLE DYNAMIC ECONOMY

2.2.4 Negishiís (1960) Method to Compute Equilibria

In the example economy considered in this section it was straightforward to
compute the competitive equilibrium by hand. This is usually not the case for
dynamic general equilibrium models. Now we describe a method to compute
equilibria for economies in which the welfare theorem(s) hold. The main idea is
to compute Pareto-optimal allocations by solving an appropriate social planners
problem. This social planner problem is a simple optimization problem which
does not involve any prices (still inÖnite-dimensional, though) and hence much
easier to tackle in general than a full-blown equilibrium analysis which consists
of several optimization problems (one for each consumer) plus market clearing
and involves allocations and prices. If the Örst welfare theorem holds then we
know that competitive equilibrium allocations are Pareto optimal; by solving
for all Pareto optimal allocations we have then solved for all potential equilib-
rium allocations. Negishiís method provides an algorithm to compute all Pareto
optimal allocations and to isolate those who are in fact competitive equilibrium
allocations.
We will repeatedly apply this trick in this course: solve a simple social
planners problem and use the welfare theorems to argue that we have solved
for the allocations of competitive equilibria. Then Önd equilibrium prices that
support these allocations. The news is even better: usually we can read o§
the prices as Lagrange multipliers from the appropriate constraints of the social
planners problem. In later parts of the course we will discuss economies in which
the welfare theorems do not hold. We will see that these economies are much
harder to analyze exactly because there is no simple optimization problem that
completely characterizes the (set of) equilibria of these economies.
Consider the following social planner problem
max 0u(c1 ) + (1 & 0)u(c2 ) (2.11)
f(c1t ;c2t )g1
t=0
1
X ) *
= max 1
1 2
( t 0 ln(c1t ) + (1 & 0) ln(c2t )
f(ct ;ct )gt=0
t=0
s.t.
cit % 0 for all i; all t
c1t + c2t = e1t + e2t ' 2 for all t
for a Pareto weight 0 2 [0; 1]: The social planner maximizes the weighted sum of
utilities of the two agents, subject to the allocation being feasible. The weight 0
indicates how important agent 1ís utility is to the planner, relative to agent 2ís
utility. Note that the solution to this problem depends on the Pareto weights,
i.e. the optimal consumption choices are functions of 0
f(c1t ; c2t )g1 1 2 1
t=0 = f(ct (0); ct (0))gt=0

We have the following

Proposition 6 An allocation f(c1t ; c2t )g1
t=0 is Pareto e¢cient if and only if it
solves the social planners problem (2:11) for some 0 2 [0; 1]
2.2. AN EXAMPLE ECONOMY 15

Proof. Omitted (but a good exercise, or consult MasColell et al., chapter

16E).
This proposition states that we can characterize the set of all Pareto e¢-
cient allocations by varying 0 between 0 and 1 and solving the social planners
problem for all 0ís. As we will demonstrate, by choosing a particular 0; the asso-
ciated e¢cient allocation for that 0 turns out to be the competitive equilibrium
allocation.
Now let us solve the planners problem for arbitrary 0 2 (0; 1):5 Attach La-
grange multipliers &2t to the resource constraints (and ignore the non-negativity
constraints on cit since they never bind, due to the period utility function satis-
fying the Inada conditions). The reason why we divide the Lagrange multipliers
by 2 will become apparent in a moment.
The Örst order necessary conditions are
0( t 1t
=
c1t 2
(1 & 0)( t 1t
=
c2t 2
Combining yields
c1t 0
= (2.12)
c2t 1&0
0 2
c1t = c (2.13)
1&0 t
i.e. the ratio of consumption between the two agents equals the ratio of the
Pareto weights in every period t: A higher Pareto weight for agent 1 results in
this agent receiving more consumption in every period, relative to agent 2:
Using the resource constraint in conjunction with (2:13) yields
c1t + c2t = 2
0 2
c + c2t = 2
1&0 t
c2t = 2(1 & 0) = c2t (0)
c1t = 20 = c1t (0)
i.e. the social planner divides the total resources in every period according to the
Pareto weights. Note that the division is the same in every period, independent
of the agentsí endowments in that particular period. The Lagrange multipliers
are given by
20( t
1t = 1 = ( t
ct
(if we wouldnít have done the initial division by 2 we would have to carry the
1
2 around from now on; the results below wouldnít change at all, though).
5 Note that for % = 0 and % = 1 the solution to the problem is trivial. For % = 0 we have

c1t = 0 and c2t = 2 and for % = 1 we have the reverse.

16 CHAPTER 2. A SIMPLE DYNAMIC ECONOMY

Hence for this economy the set of Pareto e¢cient allocations is given by

P O = ff(c1t ; c2t )g1 1 2

t=0 : ct = 20 and ct = 2(1 & 0) for some 0 2 [0; 1]g

How does this help us in Önding the competitive equilibrium for this economy?
Compare the Örst order condition of the social planners problem for agent 1

0( t 1
= t
c1t 2
or
(t 1
1 = t
ct 20
with the Örst order condition from the competitive equilibrium above (see equation (2:6)):

(t
= , 1 pt
c1t
1
By picking ,1 = 2' and 1t = pt these Örst order conditions are identical. Sim-
1
ilarly, pick ,2 = 2(1$') and one sees that the same is true for agent 2: So for
appropriate choices of the individual Lagrange multipliers ,i and prices pt the
optimality conditions for the social plannersí problem and for the household
maximization problems coincide. Resource feasibility is required in the com-
petitive equilibrium as well as in the planners problem. Given that we found
a unique equilibrium above but a lot of Pareto e¢cient allocations (for each 0
one), there must be an additional requirement that a competitive equilibrium
imposes which the planners problem does not require.
In a competitive equilibrium householdsí choices are restricted by the budget
constraint; the planner is only concerned with resource balance. The last step
to single out competitive equilibrium allocations from the set of Pareto e¢cient
allocations is to ask which Pareto e¢cient allocations would be a§ordable for
all households if these households were to face as market prices the Lagrange
multipliers from the planners problem (that the Lagrange multipliers are the
appropriate prices is harder to establish, so letís proceed on faith for now).
DeÖne the transfer functions ti (0); i = 1; 2 by
X ) *
ti (0) = 1t cit (0) & eit
t

The number ti (0) is the amount of the numeraire good (we pick the period 0
consumption good) that agent i would need as transfer in order to be able to
a§ord the Pareto e¢cient allocation indexed by 0: One can show that the ti as
functions of the Pareto weights are homogeneous of degree one6 and sum to 0
(see HW 1).
6 In the sense that if one gives weight x% to agent 1 and x(1 # %) to agent 2, then the

corresponding required transfers are xt1 and xt2 :

2.2. AN EXAMPLE ECONOMY 17

Computing ti (0) for the current economy yields

X ) *
t1 (0) = 1t c1t (0) & e1t
t
X ) *
= ( t 20 & e1t
t
20 2
= &
1&( 1 & (2
2(1 & 0) 2(
t2 (0) = &
1&( 1 & (2
To Önd the competitive equilibrium allocation we now need to Önd the Pareto
weight 0 such that t1 (0) = t2 (0) = 0; i.e. the Pareto optimal allocation that
both agents can a§ord with zero transfers. This yields
20 2
0 = &
1&( 1 & (2
1
0 = 2 (0; 0:5)
1+(
and the corresponding allocations are
% &
1 1 2
ct =
1+( 1+(
% &
2 1 2(
ct =
1+( 1+(

Hence we have solved for the equilibrium allocations; equilibrium prices are
given by the Lagrange multipliers 1t = ( t (note that without the normalization
by 12 at the beginning we would have found the same allocations and equilibrium
t
prices pt = %2 which, given that equilibrium prices are homogeneous of degree
0; is perfectly Öne, too).
To summarize, to compute competitive equilibria using Negishiís method
one does the following

1. Solve the social planners problem for Pareto e¢cient allocations indexed
by the Pareto weights (0; 1 & 0):
2. Compute transfers, indexed by 0, necessary to make the e¢cient allocation
a§ordable. As prices use Lagrange multipliers on the resource constraints
in the plannersí problem.
3. Find the Pareto weight(s) 0
^ that makes the transfer functions 0:
4. The Pareto e¢cient allocations corresponding to 0 ^ are equilibrium allo-
cations; the supporting equilibrium prices are (multiples of) the Lagrange
multipliers from the planning problem
18 CHAPTER 2. A SIMPLE DYNAMIC ECONOMY

Remember from above that to solve for the equilibrium directly in general
involves solving an inÖnite number of equations in an inÖnite number of un-
knowns. The Negishi method reduces the computation of equilibrium to a Önite
number of equations in a Önite number of unknowns in step 3 above. For an
economy with two agents, it is just one equation in one unknown, for an economy
with N agents it is a system of N & 1 equations in N & 1 unknowns. This is why
the Negishi method (and methods relying on solving appropriate social plan-
ners problems in general) often signiÖcantly simpliÖes solving for competitive
equilibria.

2.2.5 Sequential Markets Equilibrium

The market structure of Arrow-Debreu equilibrium in which all agents meet only
once, at the beginning of time, to trade claims to future consumption may seem
empirically implausible. In this section we show that the same allocations as
in an Arrow-Debreu equilibrium would arise if we let agents trade consumption
and one-period bonds in each period. We will call a market structure in which
markets for consumption and assets open in each period Sequential Markets and
the corresponding equilibrium Sequential Markets (SM) equilibrium.7
Let rt+1 denote the interest rate on one period bonds from period t to period
t+1: A one period bond is a promise (contract) to pay 1 unit of the consumption
good in period t + 1 in exchange for 1+r1t+1 units of the consumption good in
period t: We can interpret qt ' 1+r1t+1 as the relative price of one unit of the
consumption good in period t + 1 in terms of the period t consumption good.
Let ait+1 denote the amount of such bonds purchased by agent i in period t
and carried over to period t + 1: If ait+1 < 0 we can interpret this as the agent
taking out a one-period loan at interest rate (between t and t + 1) given by rt+1 :
Household iís budget constraint in period t reads as
ait+1
cit + $ eit + ait (2.14)
(1 + rt+1 )
or
cit + qt ait+1 $ eit + ait
Agents start out their life with initial bond holdings ai0 (remember that period
0 bonds are claims to period 0 consumption). Mostly we will focus on the
situation in which ai0 = 0 for all i; but sometimes we want to start an agent o§
with initial wealth (ai0 > 0) or initial debt (ai0 < 0): Since there is no government
and
P2 only two agents in this economy the initial condition is required to satisfy
i
i=1 a0 = 0:
We then have the following deÖnition
# $
DeÖnition 7 A Sequential Markets equilibrium is allocations f c^it ; a ^it+1 i=1;2 g1
t=0 ;
1
interest rates f^
rt+1 gt=0 such that
7 In the simple model we consider in this section the restriction of assets traded to one-

period riskless bonds is without loss of generality. In more complicated economies (e.g. with
risk) it would not be. We will come back to this issue in later chapters.
2.2. AN EXAMPLE ECONOMY 19

rt+1 g1
1. For i = 1; 2; given interest rates f^ t=0 f^ ^it+1 g1
cit ; a t=0 solves

1
X
max 1
( t ln(cit ) (2.15)
fcit ;at+1 gt=0
i
t=0
s.t.
ait+1
cit + $ eit + ait (2.16)
(1 + r^t+1 )
cit % 0 for all t (2.17)
ait+1 % &A8i (2.18)

2. For all t % 0
2
X 2
X
c^it = eit
i=1 i=1
2
X
^it+1
a = 0
i=1

The constraint (2:18) on borrowing is necessary to guarantee existence of

equilibrium. Suppose that agents would not face any constraint as to how
much they can borrow, i.e. suppose #the constraint
$ (2:18) were absent. Suppose
^it+1 i=1;2 g1
there would exist a SM-equilibrium f c^it ; a rt+1 g1
t=1 ; f^ t=0 : Without con-
straint on borrowing agent i could always do better by setting
"
ci0 = c^i0 +
1 + r^1
cit = c^it for all t > 0
ai1 = a^i1 & "
ai2 = a^i2 & (1 + r^2 )"
Y t
ait+1 = a^it+1 & (1 + r^* +1 )"
* =1

i.e. by borrowing " > 0 more in period 0; consuming it and then rolling over the
additional debt forever, by borrowing more and more. Such a scheme is often
called a Ponzi scheme. Hence without a limit on borrowing no SM equilibrium
can exist because agents would run Ponzi schemes and augment their consump-
tion without bound. Note that the " > 0 in the above argument was arbitrarily
large.
In this section we are interested in specifying a borrowing limit that prevents
Ponzi schemes, yet is high enough so that households are never constrained
in the amount they can borrow (by this we mean that a household, knowing
that it can not run a Ponzi scheme, would always Önd it optimal to choose
ait+1 > &A8i ): In later chapters we will analyze economies in which agents face
20 CHAPTER 2. A SIMPLE DYNAMIC ECONOMY

borrowing constraints that are binding in certain situations. Not only are SM
equilibria for these economies quite di§erent from the ones to be studied here,
but also the equivalence between SM equilibria and AD equilibria will break
down when the borrowing constraints are occasionally binding.
We are now ready to state the equivalence theorem relating AD equilibria
and SM equilibria. Assume that ai0 = 0 for all i = 1; 2: Furthermore assume
that the endowment stream feit g1t=0 is bounded.
# $
Proposition 8 Let allocations f c^it i=1;2 g1 pt g1
t=0 and prices f^ t=0 form an Arrow-
Debreu equilibrium with

p^t+1
$ 9 < 1 for all t: (2.19)
p^t
# $
Then there exist A8i i=1;2 and a corresponding sequential markets equilibrium
# $
~it+1 i=1;2 g1
with allocations f c~it ; a rt+1 g1
t=0 and interest rates f~ t=0 such that

c~it = c^it for all i; all t

# $
^it+1 i=1;2 g1
Reversely, let allocations f c^it ; a rt+1 g1
t=0 and interest rates f^ t=0 form
a sequential markets equilibrium. Suppose that it satisÖes

^it+1
a > &A8i for all i; all t
r^t+1 % " > 0 for all t (2.20)
# $
for some ": Then there exists a corresponding Arrow-Debreu equilibrium f c~it i=1;2 g1
t=0 ;
pt g1
f~ t=0 such that
c^it = c~it for all i; all t:
That is, the set of equilibrium allocations under the AD and SM market struc-
tures coincide.8

Proof. We Örst show that any consumption allocation that satisÖes the
sequence of SM budget constraints is also in the AD budget set (step 1). From
this in fairly directly follows that AD equilibria can be made into SM equilibria.
The only complication is that we need to make sure that we can Önd a large
enough borrowing limit A8i such that the asset holdings required to implement
the AD consumption allocation as a SM equilibrium do not violate the no Ponzi
constraint. This is shown in step 2. Finally, in step 3 we argue that an SM
equilibrium can be made into an AD equilibrium.
Step 1: The key to the proof is to show the equivalence of the budget sets
for the Arrow-Debreu and the sequential markets structure. This step will then
8 The p
^
assumption on t+1 p
^t
and on r^t+1 can be completely relaxed if one introduces bor-
rowing constraints of slightly di§erent form in the SM equilibrium to prevent Ponzi schemes.
See Wright (Journal of Economic Theory, 1987). They are required here since I insisted on
making the A(i a Öxed number.
2.2. AN EXAMPLE ECONOMY 21

be used in the arguments below. Normalize p^0 = 1 (as we can always do) and
relate equilibrium prices and interest rates by
p^t
1 + r^t+1 = (2.21)
p^t+1
Now look at the sequence of sequential markets budget constraints and assume
that they hold with equality (which they do in equilibrium since lifetime utility
is strictly increasing in each of the consumption goods)

ai1
ci0 + = ei0 (2.22)
1 + r^1
ai2
ci1 + = ei1 + ai1 (2.23)
1 + r^2
..
.
ait+1
cit + = eit + ait (2.24)
1 + r^t+1

Substituting for ai1 from (2:23) in (2:22) one gets

ci1 ai2 ei1

ci0 + + = ei0 +
1 + r^1 (1 + r^1 ) (1 + r^2 ) (1 + r^1 )

and, repeating this exercise, yields9

T
X X T
cit ai eit
Qt + QT +1T +1 = Qt
t=0 j=1 (1 + r
^j ) j=1 (1 + r
^j ) t=0 j=1 (1 + r
^j )

Now note that (using the normalization p^0 = 1)

t
Y p^0 p^1 p^t$1 1
(1 + r^j ) = ) *** ) = (2.25)
j=1
p^1 p^2 p^t p^t

Taking limits with respect to t on both sides gives, using (2:25)

1
X X 1
ai
p^t cit + lim QT +1T +1 = p^t eit
T !1 (1 + r
^ )
t=0 j=1 j t=0

Given our assumptions on the equilibrium interest rates in (2:20) we have

ai &A8i
lim QT +1T +1 % lim QT +1 =0
T !1 ^j ) T !1 j=1 (1 + r^j )
j=1 (1 + r
9 We deÖne
0
Y
(1 + r^j ) = 1
j=1
22 CHAPTER 2. A SIMPLE DYNAMIC ECONOMY

QT +1
and since limT !1 j=1 (1 + r^j ) = 1 (due to the assumption that r^t+1 % " > 0
for all t), we have
1
X 1
X
p^t cit $ p^t eit :
t=0 t=0

Thus any allocation that satisÖes the SM budget constraints and the no Ponzi
conditions satisÖes the AD budget constraint when AD prices and SM interest
rates are related by (2:21): # $
Step 2: Now suppose we have an AD-equilibrium f c^it i=1;2 g1 pt g1
t=0 , f^ t=0 :
We want to show that there exist a SM equilibrium with same consumption
allocation, i.e.
c~it = c^it for all i; all t
# $
Obviously f c~it i=1;2 g1
t=0 satisÖes market clearing. DeÖne asset holdings as

1 # $
X p^t+* c^it+* & eit+*
~it+1
a = : (2.26)
* =1
p^t+1

Note that the consumption and asset allocation so constructed satisÖes the SM
p^t
budget constraints since, recalling 1 + r~t+1 = p^t+1 we have, plugging in from
(2:26):
1 # $ 1 # $
X p^t+* c^it+* & eit+* X p^t$1+* c^it$1+* & eit$1+*
i i
c^t + = et +
* =1
p^t+1 (1 + r~t+1 ) * =1
p^t
1 # i $ 1 # $
X p^t+* c^t+* & eit+* X p^t+* c^it+* & eit+*
i i
c^t + = et +
* =1
p^t * =0
p^t
# i $
p^t c^t & eit
c^it = eit + = c^it :
p^t

Next we show that we can Önd a borrowing limit A8i large enough so that the
no Ponzi condition is never binding with asset levels given by (2:26): Note that
(since by assumption pp^^t+#
t+1
$ 9 * $1 ) we have

1
X 1
X
p^t+* eit+*
~it+1 % &
a %& 9 * $1 eit+* > &1 (2.27)
* =1
p^t+1 * =1

so that we can take

1
X
A8i = 1 + sup 9 * $1 eit+* < 1 (2.28)
t
* =1

where the last inequality follows from the fact that 9 < 1 and the assumption
that the endowment stream is bounded. This borrowing limit A8i is so high that
agent i; knowing that she canít run a Ponzi scheme, will never hit it.
2.2. AN EXAMPLE ECONOMY 23
# $
It remains to argue that f c~it i=1;2 g1
t=0 maximizes lifetime utility, subject
to the sequential markets budget constraints and the borrowing constraints de-
Öned by A8i . Take any other allocation satisfying the SM budget constraints, at
interest rates given by (2:21). In step 1. we showed that then this allocation
would also satisfy the AD budget constraint and thus could have been cho-
sen at AD equilibrium prices. If this alternative allocation would yield higher
lifetime utility than the allocation f~cit = c^it g1
t=0 it would have been chosen as
part of an AD-equilibrium, which it wasnít. Hence f~ cit g1
t=0 must be optimal
within the set of allocations satisfying the SM budget constraints at interest
p^t
rates 1 + r~t+1 = p^t+1 :
# $
^it+1 i2I g1
Step 3: Now suppose f c^it ; a t=1 and f^ rt+1 g1t=0 form a sequential
markets equilibrium satisfying
^it+1
a > &A8i for all i; all t
r^t+1 > 0 for all t
We
# $want to show 1 that there exists a corresponding Arrow-Debreu equilibrium
f c~it i2I g1
t=0 ; f~
pt gt=0 with

c^it = c~it for all i; all t

# $
Again obviously f c~it i2I g1t=0 satisÖes market clearing and, as shown in step
1, the AD budget constraint. It remains to be shown that it maximizes utility
within the set of allocations satisfying the AD budget constraint, for prices
p~t
p~0 = 1 and p~t+1 = 1+^ rt+1 : For any other allocation satisfying the AD budget
constraint we could construct asset holdings (from equation 2.26) such that this
allocation together with the asset holdings satisÖes the SM-budget constraints.
The only complication is that in the SM household maximization problem there
is an additional constraint, the no-Ponzi constraints. Thus the set over which we
maximize in the AD case is larger, since the borrowing constraints are absent in
the AD formulation, and we need to rule out that allocations that would violate
the SM no Ponzi conditions are optimal choices in the AD household problem,
at the equilibrium prices. However, by assumption the no Ponzi conditions are
not binding at the SM equilibrium allocation, that is a ^it+1 > &A8i for all t:
But for maximization problems with concave objective and convex constraint
set (such as the SM household maximization problem) if in the presence of the
additional constraints a^it+1 % &A8i for a maximizing choice these constraints are
not binding, then this maximizer is also a maximizer of the relaxed problem
with the constraint removed.10 Hence f~ cit g1
t=0 is optimal for household i within
the set of allocations satisfying only the AD budget constraint.
1 0 This is a fundamental result in convex analysis. See e.g. the book Convex Analysis by

Rockafellar. Note that strictly speaking we cannot completely remove the constraint (because
then the household would run Ponzi schemes). But we can relax it to the level deÖned in
equation (2:28): No asset sequence implied by a consumption allocation that is contained in
the AD budget set violates this constraint.
Alternatively, we could have avoided these technicalities by stating the second part of the
proposition in terms of the exact borrowing limit deÖned in (2:28); rather than keeping it
arbitrary.
24 CHAPTER 2. A SIMPLE DYNAMIC ECONOMY

This proposition shows that the sequential markets and the Arrow-Debreu
market structures lead to identical equilibria, provided that we choose the no
Ponzi conditions appropriately (e.g. equal to the ones in (2:28)) and that the
equilibrium interest rates are su¢ciently high. Usually the analysis of our
economies is easier to carry out using AD language, but the SM formulation
has more empirical appeal. The preceding theorem shows that we can have the
best of both worlds.
For our example economy we Önd that the equilibrium interest rates in the
SM formulation are given by
pt 1
1 + rt+1 = =
pt+1 (
or
1
rt+1 = r = &1=:
(
i.e. the interest rate is constant and equal to the subjective time discount rate
: = %1 & 1:

2.3 Appendix: Some Facts about Utility Func-

tions
The utility function
1
X
i
u(c ) = ( t ln(cit ) (2.29)
t=0
described in the main text satisÖes the following assumptions that we will often
require in our models.

2.3.1 Time Separability

The utility function in (2:29) has the property that total utility from a con-
sumption allocation ci equals the discounted sum of period (or instantaneous)
utility U (cit ) = ln(cit ): Period utility U (cit ) at time t only depends on consump-
tion in period t and not on consumption in other periods. This formulation
rules out, among other things, habit persistence, where the period utility from
consumption cit would also depend on past consumption levels cit$* ; for < > 0:

2.3.2 Time Discounting

The fact that ( < 1 indicates that agents are impatient. The same amount
of consumption yields less utility if it comes at a later time in an agentsí life.
The parameter ( is often referred to as (subjective) time discount factor. The
1
subjective time discount rate : is deÖned by ( = 1+/ and is often, as we have
seen above, intimately related to the equilibrium interest rate in the economy
(because the interest rate is nothing else but the market time discount rate).
2.3. APPENDIX: SOME FACTS ABOUT UTILITY FUNCTIONS 25

2.3.3 Standard Properties of the Period Utility Function

The instantaneous utility function or felicity function U (c) = ln(c) is continuous,
twice continuously di§erentiable, strictly increasing (i.e. U 0 (c) > 0) and strictly
concave (i.e. U 00 (c) < 0) and satisÖes the Inada conditions

lim U 0 (c) = +1
c&0

lim U 0 (c) = 0
c%+1

These assumptions imply that more consumption is always better, but an ad-
ditional unit of consumption yields less and less additional utility. The Inada
conditions indicate that the Örst unit of consumption yields a lot of additional
utility but that as consumption goes to inÖnity, an additional unit is (almost)
worthless. The Inada conditions will guarantee that an agent always chooses
ct 2 (0; 1) for all t; and thus that corner solutions for consumption, ct = 0; can
be ignored in the analysis of our models.

2.3.4 Constant Relative Risk Aversion (CRRA) Utility

The felicity function U (c) = ln(c) is a member of the class of Constant Relative
Risk Aversion (CRRA) utility functions. These functions have the general form

c1$0 & 1
U (c) = (2.30)
1&=
where = % 0 is a parameter. For = ! 1; this utility function converges to
U (c) = ln(c); which can be easily shown taking the limit in (2:30) and applying
líHopitalís rule. CRRA utility functions have a number of important properties.
First, they satisfy the properties in the previous subsection.

Constant Coe¢cient of Relative Risk Aversion

00
DeÖne as =(c) = & UU 0(c)c
(c) the (Arrow-Pratt) coe¢cient of relative risk aversion.
Hence =(c) indicates a householdís attitude towards risk, with higher =(c) repre-
senting higher risk aversion, in a quantitatively meaningful way. The (relative)
risk premium measures the householdís willingness to pay (and thus reduce safe
consumption c8) to avoid a proportional consumption gamble in which a house-
hold can win, but also lose, a fraction of c8: See Ögure 2.1 for a depiction of the
risk premium.
Arrow-Prattís theorem states that this risk premium is proportional (up
to a Örst order approximation) to the coe¢cient of relative risk aversion =(8 c):
This coe¢cient is thus a quantitative measure of the willingness to pay to avoid
consumption gambles. Typically this willingness depends on the level of con-
sumption c8; but for a CRRA utility function it does not, in that =(c) is constant
for all c; and equal to the parameter =: For U (c) = ln(c) it is not only constant,
but equal to =(c) = = = 1: This explains the name of this class of period utility
functions.
26 CHAPTER 2. A SIMPLE DYNAMIC ECONOMY

u(4/3*c) u(.)
u(c)

0.5u(2/3*c)
+0.5u(4/3*c)
=u(c-p )

u(2/3*c)

Risk Premium p

2/3*c c-p c 4/3*c

Figure 2.1: The Risk Premium

Intertemporal Elasticity of Substitution

DeÖne the intertemporal elasticity of substitution (IES) as iest (ct+1 ; ct ) as
2 0 1 3$1
@u(c)
. ct+1
/ d@
@ct+1
A
d( ) 6 @u(c)
7
ct
ct+1 6 @ct
7
6 c
d t+1
( ) 7
iest (ct+1 ; ct ) = & 2 0 @u(c) 1 3 = & 6 7
ct ct
6 @u(c) 7
@ct+1
d@ @u(c) A 6 @ct+1 7
6 7 4 @u(c) 5
6 @u(c) 7
@ct @ct
ct+1
4 @c 5 ct
t+1
@u(c)
@ct

that is, as the inverse of the percentage change in the marginal rate of substi-
tution between consumption at t and t + 1 in response to a percentage change
in the consumption ratio ct+1
ct : For the CRRA utility function note that

@u(c) % &$0
@ct+1 ct+1
@u(c)
= M RS(ct+1 ; ct ) = (
ct
@ct
2.3. APPENDIX: SOME FACTS ABOUT UTILITY FUNCTIONS 27

and thus 2 ($0$1 3$1

'
ct+1
6 &=( 7
iest (ct+1 ; ct ) = & 6 7 = 1
ct
4 c t+1
%( c )
#' 5 =
t
ct+1
ct

and the intertemporal elasticity of substitution is constant, independent of the

level or growth rate of consumption, and equal to 1==. A simple plot of the
indi§erence map should convince you that the IES measures the curvature of
the utility function. If = = 0 consumption in two adjacent periods are per-
fect substitutes and the IES equals ies = 1: If = ! 1 the utility function
converges to a Leontie§ utility function, consumption in adjacent periods are
prefect complements and ies = 0:
The IES also has a nice behavioral interpretation. From the Örst order
conditions of the household problem we obtain
@u(c)
@ct+1 pt+1 1
@u(c)
= = (2.31)
pt 1 + rt+1
@ct

and thus the IES can alternatively be written as (in fact, some economists deÖne
the IES that way)
. ct+1 / . ct+1 /
d( c ) d( c )
t t
ct+1 ct+1
ct ct
iest (ct+1 ; ct ) = & 2 0
@u(c)
13 = &" % &#
@ct+1 d 1+r1
d@ @u(c) A t+1
6 7 1
6 @ct
7 1+rt+1
4 @u(c)
@ct+1
5
@u(c)
@ct

that is, the IES measures the percentage change in the consumption growth
rate in response to a percentage change in the gross real interest rate, the
intertemporal price of consumption.
Note that for the CRRA utility function the Euler equation reads as
% &$0
ct+1
(1 + rt+1 )( = 1:
ct

Taking logs on both sides and rearranging one obtains

ln(1 + rt+1 ) + log(() = = [ln(ct+1 ) & ln(ct )]

or
1 1
ln(ct+1 ) & ln(ct ) = ln(() + ln(1 + rt+1 ): (2.32)
= =
This equation forms the basis of all estimates of the IES; with time series data
on consumption growth and real interest rates the IES 01 can be estimated from
28 CHAPTER 2. A SIMPLE DYNAMIC ECONOMY

a regression of the former on the later.11

Note that with CRRA utility the attitude of a household towards risk (atem-
poral consumption gambles) measured by risk aversion = and the attitude to-
wards consumption smoothing over time measured by the intertemporal elas-
ticity of substitution 1== are determined by the same parameter, and varying
risk aversion necessarily implies varying the IES as well. In many applications,
and especially in consumption-based asset pricing theory this turns out to be an
undesirable restriction. A generalization of CRRA utility by Epstein and Zin
(1989, 1991(often also called recursive utility) introduces a (time non-separable)
utility function in which two parameters govern risk aversion and intertemporal
elasticity of substitution separately.

2.3.5 Homotheticity and Balanced Growth

Finally, deÖne the marginal rate of substitution between consumption at any
two dates t and t + s as
@u(c)
@ct+s
M RS(ct+s ; ct ) = @u(c)
@ct

The lifetime utility function u is said to be homothetic if M RS(ct+s ; ct ) =

M RS(,ct+s ; ,ct ) for all , > 0 and c:
It is easy to verify that for a period utility function U of CRRA variety the
lifetime utility function u is homothetic, since
$0 $0
( t+s (ct+s ) ( t+s (,ct+s )
M RS(ct+s ; ct ) = $0 = $0 = M RS(,ct+s ; ,ct ) (2.33)
( t (ct ) ( t (,ct )
With homothetic lifetime utility, if an agentís lifetime income doubles, optimal
consumption choices will double in each period (income expansion paths are
linear).12 It also means that consumption allocations are independent of the
units of measurement employed.
This property of the utility function is crucial for the existence of a bal-
anced growth in models with growth in endowments (or technological progress
in production models). DeÖne a balanced growth path as a situation in which
consumption grows at a constant rate, ct = (1 + g)t c0 and the real interest rate
is constant over time, rt+1 = r for all t:
Plugging in for a balanced growth path, equation (2:31) yields, for all t
@u(c)
@ct+1 1
@u(c)
= M RS(ct+1 ; ct ) = :
1+r
@ct
1 1 Note that in order to interpret (2:32) as a regression one needs a theory where the error

term comes from. In models with risk this error term can be linked to expectational errors,
and (2:32) with error term arises as a Örst order approximation to the stochastic version of
the Euler equation.
1 2 In the absense of borrowing constraints and other frictions that we will discuss later.
2.3. APPENDIX: SOME FACTS ABOUT UTILITY FUNCTIONS 29

But for this equation to hold for all t we require that

M RS(ct+1 ; ct ) = M RS((1 + g)t c1 ; (1 + g)t c0 ) = M RS(c1 ; c0 )

and thus that u is homothetic (where , = (1 + g)t in equation (2:33)). Thus ho-
mothetic lifetime utility is a necessary condition for the existence of a balanced
growth path in growth models. Above we showed that CRRA period utility im-
plies homotheticity of lifetime utility u: Without proof here we state that CRRA
utility is the only period utility function such that lifetime utility is homothetic.
Thus (at least in the class of time separable lifetime utility functions) CRRA
period utility is a necessary condition for the existence of a balanced growth
path, which in part explains why this utility function is used in a wide range of
macroeconomic applications.
30 CHAPTER 2. A SIMPLE DYNAMIC ECONOMY
Chapter 3

The Neoclassical Growth

Model in Discrete Time

3.1 Setup of the Model

The neoclassical growth model is arguably the single most important workhorse
in modern macroeconomics. It is widely used in growth theory, business cycle
theory and quantitative applications in public Önance.
Time is discrete and indexed by t = 0; 1; 2; : : : In each period there are three
goods that are traded, labor services nt ; capital services kt and a Önal output
good yt that can be either consumed, ct or invested, it : As usual for a complete
description of the economy we have to specify technology, preferences, endow-
ments and the information structure. Later, when looking at an equilibrium of
this economy we have to specify the equilibrium concept that we intend to use.

1. Technology: The Önal output good is produced using as inputs labor and
capital services, according to the aggregate production function F

yt = F (kt ; nt )

Note that I do not allow free disposal. If I want to allow free disposal, I
will specify this explicitly by deÖning an separate free disposal technology.
Output can be consumed or invested

yt = it + ct

Investment augments the capital stock which depreciates at a constant

rate / over time
kt+1 = (1 & /)kt + it
We can rewrite this equation as

it = kt+1 & kt + /kt

31
32CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

i.e. gross investment it equals net investment kt+1 & kt plus depreciation
/kt : We will require that kt+1 % 0; but not that it % 0: This assumes that
the existing capital stock can be dis-invested and eaten. Note that I have
been a bit sloppy: strictly speaking the capital stock and capital services
generated from this stock are di§erent things. We will assume (once we
specify the ownership structure of this economy in order to deÖne an equi-
librium) that households own the capital stock and make the investment
decision. They will rent out capital to the Örms. We denote both the
capital stock and the áow of capital services by kt : Implicitly this assumes
that there is some technology that transforms one unit of the capital stock
at period t into one unit of capital services at period t: We will ignore this
subtlety for the moment.

2. Preferences: There is a large number of identical, inÖnitely lived house-

holds. Since all households are identical and we will restrict ourselves to
type-identical allocations1 we can, without loss of generality assume that
there is a single representative household. Preferences of each household
are assumed to be representable by a time-separable utility function:
1
X
1
u (fct gt=0 ) = ( t U (ct )
t=0

3. Endowments: Each household has two types of endowments. At period 0

each household is born with endowments k80 of initial capital. Furthermore
each household is endowed with one unit of productive time in each period,
to be devoted either to leisure or to work.

4. Information: There is no risk in this economy and we assume that house-

holds and Örms have perfect foresight.

5. Equilibrium: We postpone the discussion of the equilibrium concept to a

later point as we will Örst be concerned with an optimal growth problem
where we solve for Pareto optimal allocations.

3.2 Optimal Growth: Pareto Optimal Alloca-

tions
Consider the problem of a social planner that wants to maximize the utility of
the representative agent, subject to the technological constraints of the economy.
Note that, as long as we restrict our attention to type-identical allocations, an
allocation that maximizes the utility of the representative agent, subject to the
technology constraint is a Pareto e¢cient allocation and every Pareto e¢cient
allocation solves the social planner problem below. Just as a reference we have
the following deÖnitions
1 Identical households receive the same allocation by assumption.
3.2. OPTIMAL GROWTH: PARETO OPTIMAL ALLOCATIONS 33

DeÖnition 9 An allocation fct ; kt ; nt g1

t=0 is feasible if for all t % 0

F (kt ; nt ) = ct + kt+1 & (1 & /)kt

ct % 0; kt % 0; 0 $ nt $ 1
k0 $ k80

DeÖnition 10 An allocation fct ; kt ; nt g1t=0 is Pareto e¢cient if it is feasible

and there is no other feasible allocation f^ct ; k^t ; n
^ t g1
t=0 such that

1
X 1
X
( t U (^
ct ) > ( t U (ct )
t=0 t=0

Note that in this deÖnition I have used the fact that all households are
identical.

3.2.1 Social Planner Problem in Sequential Formulation

The problem of the planner is
1
X
w(k80 ) = max 1 ( t U (ct )
fct ;kt ;nt gt=0
t=0
s:t: F (kt ; nt ) = ct + kt+1 & (1 & /)kt
ct % 0; kt % 0; 0 $ nt $ 1
k0 $ k80

The function w(k80 ) has the following interpretation: it gives the total lifetime
utility of the representative household if the social planner chooses fct ; kt ; nt g1
t=0
optimally and the initial capital stock in the economy is k80 : Under the assump-
tions made below the function w is strictly increasing, since a higher initial
capital stock yields higher production in the initial period and hence enables
more consumption or capital accumulation (or both) in the initial period.
We now make the following assumptions on preferences and technology.
Assumption 1: U is continuously di§erentiable, strictly increasing, strictly
concave and bounded. It satisÖes the Inada conditions limc&0 U 0 (c) = 1 and
limc!1 U 0 (c) = 0: The discount factor ( satisÖes ( 2 (0; 1)
Assumption 2: F is continuously di§erentiable and homogenous of degree
1; strictly increasing and strictly concave. Furthermore F (0; n) = F (k; 0) = 0
for all k; n > 0: Also F satisÖes the Inada conditions limk&0 Fk (k; 1) = 1 and
limk!1 Fk (k; 1) = 0: Also / 2 [0; 1]
From these assumptions two immediate consequences for optimal allocations
are that nt = 1 for all t since households do not value leisure in their utility
function. Also, since the production function is strictly increasing in capital,
k0 = k80 : To simplify notation we deÖne f (k) = F (k; 1) + (1 & /)k; for all k: The
function f gives the total amount of the Önal good available for consumption
or investment (again remember that the capital stock can be eaten). From
34CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

assumption 2 the following properties of f follow more or less directly: f is

continuously di§erentiable, strictly increasing and strictly concave, f (0) = 0;
f 0 (k) > 0 for all k; limk&0 f 0 (k) = 1 and limk!1 f 0 (k) = 1 & /:
Using the implications of the assumptions, and substituting for ct = f (kt ) &
kt+1 we can rewrite the social plannerís problem as

1
X
w(k80 ) = max1 ( t U (f (kt ) & kt+1 ) (3.1)
fkt+1 gt=0
t=0
0 $ kt+1 $ f (kt )
k0 = k80 > 0 given

The only choice that the planner faces is the choice between letting the consumer
eat today versus investing in the capital stock so that the consumer can eat more
*
tomorrow. Let the optimal sequence of capital stocks be denoted by fkt+1 g1
t=0 :
The two questions that we face when looking at this problem are

1. Why do we want to solve such a hypothetical problem of an even more hy-

pothetical social planner. The answer to this questions is that, by solving
this problem, we will have solved for competitive equilibrium allocations
of our model (of course we Örst have to deÖne what a competitive equilib-
rium is). The theoretical justiÖcation underlying this result are the two
welfare theorems, which hold in this model and in many others, too. We
will give a loose justiÖcation of the theorems a bit later, and postpone
a rigorous treatment of the two welfare theorems in inÖnite dimensional
spaces until chapter 7 of these notes.

2. How do we solve this problem?2 The answer is: dynamic programming.

The problem above is an inÖnite-dimensional optimization problem, i.e.
we have to Önd an optimal inÖnite sequence (k1 ; k2 ; : : :) solving the prob-
lem above. The idea of dynamic programing is to Önd a simpler maximiza-
tion problem by exploiting the stationarity of the economic environment
and then to demonstrate that the solution to the simpler maximization
problem solves the original maximization problem.

To make the second point more concrete, note that we can rewrite the prob-

2 Just a caveat: inÖnite-dimensional maximization problems may not have a solution even

if the u and f are well-behaved. So the function w may not always be well-deÖned. In our
examples, with the assumptions that we made, everything is Öne, however.
3.2. OPTIMAL GROWTH: PARETO OPTIMAL ALLOCATIONS 35

lem above as
1
X
w(k0 ) = max ( t U (f (kt ) & kt+1 )
fkt+1 g1
t=0 s.t.
t=0
0+kt+1 +f (kt ); k0 given
( 1
)
X
t$1
= max U (f (k0 ) & k1 ) + ( ( U (f (kt ) & kt+1 )
fkt+1 g1
t=0 s.t.
t=1
0+kt+1 +f (kt ); k0 given
8 2 39
>
< 1 >
=
6 X 7
t$1
= max U (f (k0 ) & k1 ) + ( 4 max1 ( U (f (kt ) & kt+1 )5
k1 s.t. >
: fkt+1 gt=1 >
;
0+k1 +f (k0 ); k0 given t=1
0+kt+1 +f (kt ); k1 given
8 2 39
>
< X1 >
=
6 7
= max U (f (k0 ) & k1 ) + ( 4 max1 ( t U (f (kt+1 ) & kt+2 )5
k1 s.t. >
: fkt+2 gt=0 >
;
0+k1 +f (k0 ); k0 given t=0
0+kt+2 +f (kt+1 ); k1 given

Looking at the maximization problem inside the [ ]-brackets and comparing

to the original problem (3:1) we see that the [ ]-problem is that of a social
planner that, given initial capital stock k1 ; maximizes lifetime utility of the
representative agent from period 1 onwards. But agents donít age in our model,
the technology or the utility functions doesnít change over time; this suggests
that the optimal value of the problem in [ ]-brackets is equal to w(k1 ) and hence
the problem can be rewritten as

w(k0 ) = max fU (f (k0 ) & k1 ) + (w(k1 )g

0+k1 +f (k0 )
k0 given

Again two questions arise:

2.1 Under which conditions is this suggestive discussion formally correct? We

will come back to this in chapters 4-5. SpeciÖcally, moving from the 2nd to
the 3rd line of the above argument we replaced the maximization over the
entire sequence with two nested maximization problems, one with respect
to fkt+1 g1
t=1 ; conditional on k1 ; and one with respect to k1 : This is not
an innocuous move.
2.2 Is this progress? Of course, the maximization problem is much easier
since, instead of maximizing over inÖnite sequences we maximize over
just one number, k1 : But we canít really solve the maximization problem,
because the function w(:) appears on the right side, and we donít know
this function. The next section shows ways to overcome this problem.

3.2.2 Recursive Formulation of Social Planner Problem

The above formulation of the social planners problem with a function on the
left and right side of the maximization problem is called recursive formulation.
Now we want to study this recursive formulation of the planners problem. Since
36CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

the function w(:) is associated with the sequential formulation of the planner
problem, let us change notation and denote by v(:) the corresponding function
for the recursive formulation of the problem.
Remember the interpretation of v(k): it is the discounted lifetime utility of
the representative agent from the current period onwards if the social planner
is given capital stock k at the beginning of the current period and allocates
consumption across time optimally for the household. This function v (the
so-called value function) solves the following recursion

v(k) = max fU (f (k) & k 0 ) + (v(k 0 )g (3.2)

0+k0 +f (k)

Note again that v and w are two very di§erent functions; v is the value
function for the recursive formulation of the planners problem and w is the
corresponding function for the sequential problem. Of course below we want to
establish that v = w, but this is something that we have to prove rather than
something that we can assume to hold! The capital stock k that the planner
brings into the current period, result of past decisions, completely determines
what allocations are feasible from today onwards. Therefore it is called the
ìstate variableî: it completely summarizes the state of the economy today (i.e.
all future options that the planner has). The variable k 0 is decided (or controlled)
today by the social planner; it is therefore called the ìcontrol variableî, because
it can be controlled today by the planner.3
Equation (3:2) is a functional equation (the so-called Bellman equation): its
solution is a function, rather than a number or a vector. Fortunately the math-
ematical theory of functional equations is well-developed, so we can draw on
some fairly general results. The functional equation posits that the discounted
lifetime utility of the representative agent is given by the utility that this agent
receives today, U (f (k) & k 0 ), plus the discounted lifetime utility from tomorrow
onwards, (v(k 0 ): So this formulation makes clear the planners trade-o§: con-
sumption (and hence utility) today, versus a higher capital stock to work with
(and hence higher discounted future utility) from tomorrow onwards. Hence, for
a given k this maximization problem is much easier to solve than the problem of
picking an inÖnite sequence of capital stocks fkt+1 g1 t=0 from before. The only
problem is that we have to do this maximization for every possible capital stock
k; and this posits theoretical as well as computational problems. However, it will
turn out that the functional equation is much easier to solve than the sequential
problem (3:1) (apart from some very special cases). By solving the functional
equation we mean Önding a value function v solving (3:2) and an optimal policy
function k 0 = g(k) that describes the optimal k 0 from the maximization part in
(3:2); as a function of k; i.e. for each possible value that k can take. Again we
face several questions associated with equation (3:2):

1. Under what condition does a solution to the functional equation (3:2) exist
and, if it exists, is it unique?
3 These terms come from control theory, a Öeld in applied mathematics.
3.2. OPTIMAL GROWTH: PARETO OPTIMAL ALLOCATIONS 37

2. Is there a reliable algorithm that computes the solution (by reliable we

mean that it always converges to the correct solution, independent of the
initial guess for v?

3. Under what conditions can we solve (3:2) and be sure to have solved (3:1);
i.e. under what conditions do we have v = w and equivalence between the
optimal sequential allocation fkt+1 g1
t=0 and allocations generated by the
optimal recursive policy g(k)

4. Can we say something about the qualitative features of v and g?

The answers to these questions will be given in the next two chapters. The
answers to 1. and 2. will come from the Contraction Mapping Theorem, to
be discussed in Section 4.3. The answer to the third question makes up what
Richard Bellman called the Principle of Optimality and is discussed in Section
5.1. Finally, under more restrictive assumptions we can characterize the solution
to the functional equation (v; g) more precisely. This will be done in Section 5.2.
In the remaining parts of this section we will look at speciÖc examples where we
can solve the functional equation by hand. Then we will talk about competitive
equilibria and the way we can construct prices so that Pareto optimal alloca-
tions, together with these prices, form a competitive equilibrium. This will be
our versions of the Örst and second welfare theorem for the neoclassical growth
model.

3.2.3 An Example
Consider the following example. Let the period utility function be given by
U (c) = ln(c) and the aggregate production function be given by F (k; n) =
k ' n1$' and assume full depreciation, i.e. / = 1: Then f (k) = k ' and the
functional equation becomes

v(k) = max fln (k ' & k 0 ) + (v(k 0 )g

0+k0 +k*

Remember that the solution to this functional equation is an entire function

v(:): Now we will discuss several methods to solve this functional equation.

Guess and Verify (or Method of Undetermined Coe¢cients)

We will guess a particular functional form of a solution and then verify that the
solution has in fact this form (note that this does not rule out that the functional
equation has other solutions). This method works well for the example at hand,
but not so well for most other examples that we are concerned with. Let us
guess
v(k) = A + B ln(k)
where A and B are unknown coe¢cients that are to be determined. The method
consists of three steps:
38CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

1. Solve the maximization problem on the right hand side, given the guess
for v; i.e. solve

max fln (k a & k 0 ) + ( (A + B ln(k 0 ))g

0+k0 +k*

Obviously the constraints on k 0 never bind and the objective function is

strictly concave and the constraint set is compact in k 0 , for any given k:
Thus, the Örst order condition for k 0 is su¢cient for the unique solution.
The FOC yields
1 (B
=
k' & k0 k0
(Bk '
k0 = (3.3)
1 + (B

%Bk*
2. Evaluate the right hand side at the optimal solution k 0 = 1+%B : This
yields

RHS = ln (k a & k 0 ) + ( (A + B ln(k 0 ))

% & % &
k' (Bk '
= ln + (A + (B ln
1 + (B 1 + (B
% &
(B
= & ln(1 + (B) + 0 ln(k) + (A + (B ln + 0(B ln (k)
1 + (B

3. In order for our guess to solve the functional equation, the left hand side of
the functional equation, which we have guessed to equal LHS= A+B ln(k)
must equal the right hand side, which we just found, for all possible values
of k. If we can Önd coe¢cients A; B for which this is true, we have found
a solution to the functional equation. Equating LHS and RHS yields
% &
(B
A + B ln(k) = & ln(1 + (B) + 0 ln(k) + (A + (B ln + 0(B ln (k)
1 + (B
% &
(B
(B & 0(1 + (B)) ln(k) = &A & ln(1 + (B) + (A + (B ln (3.4)
1 + (B
But this equation has to hold for every capital stock k. The right hand
side of (3:4) does not depend on k but the left hand side does. Hence
the right hand side is a constant, and the only way to make the left hand
side a constant is to make B & 0(1 + (B) = 0: Solving this for B yields
' '
B = 1$'% : Since the left hand side of (3:4) equals to 0 for B = 1$'% ; the
right hand side better is, too. Therefore the constant A has to satisfy
% &
(B
0 = &A & ln(1 + (B) + (A + (B ln
1 + (B
% &
1 0(
= &A & ln + (A + ln(0()
1 & 0( 1 & 0(
3.2. OPTIMAL GROWTH: PARETO OPTIMAL ALLOCATIONS 39

Solving this mess for A yields

. /
1 0(
A= ln(0() + ln(1 & 0()
1 & ( 1 & 0(
We can also determine the optimal policy function k 0 = g(k) by plugging
'
in B = 1$'% into (3:3):

(Bk '
g(k) =
1 + (B
= 0(k '

Hence our guess was correct: the function v * (k) = A + B ln(k); with A; B as
determined above, solves the functional equation, with associated policy func-
tion g(k) = 0(k ' :
Note that for this speciÖc example the optimal policy of the social planner is
to save a constant fraction 0( of total output k ' as capital stock for tomorrow
and and let the household consume a constant fraction (1 & 0() of total output
today. The fact that these fractions do not depend on the level of k is very unique
to this example and not a property of the model in general. Also note that there
may be other solutions to the functional equation; we have just constructed one
(actually, for the speciÖc example there are no others, but this needs some
proving). Finally, it is straightforward to construct a sequence fkt+1 g1 t=0 from
our policy function g that will turn out to solve the sequential problem (3:1) (of
course for the speciÖc functional forms used in the example): start from k0 = k80
and then recursively
k1 = g(k0 ) = 0(k0'
2
k2 = g(k1 ) = 0(k1' = (0()1+' k0'
..
. Pt#1 j
' t
kt = (0() j=0 k0'
Obviously, since 0 < 0 < 1 we have that
1
lim kt = (0() 1#* = k *
t!1

for all initial conditions k0 > 0. Not surprisingly, k * is the unique solution to
the equation g(k) = k.

Value Function Iteration: Analytical Approach

In the last section we started with a clever guess, parameterized it and used the
method of undetermined coe¢cients (guess and verify) to solve for the solution
v * of the functional equation. For just about any other than the log-utility,
Cobb-Douglas production function, / = 1 case this method would not work;
even your most ingenious guesses would fail when trying to be veriÖed.
Consider instead the following iterative procedure for our previous example
40CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

1. Guess an arbitrary function v0 (k): For concreteness letís take v0 (k) = 0

for all

2. Proceed by solving

v1 (k) = max fln (k ' & k 0 ) + (v0 (k 0 )g

0+k0 +k*

Note that we can solve the maximization problem on the right hand side
since we know v0 (since we have guessed it). In particular, since v0 (k 0 ) = 0
for all k 0 we have as optimal solution to this problem

k 0 = g1 (k) = 0 for all k

Plugging this back in we get

v1 (k) = ln (k ' & 0) + (v0 (0) = ln k ' = 0 ln k

3. Now we can solve

v2 (k) = max fln (k ' & k 0 ) + (v1 (k 0 )g

0+k0 +k*

since we know v1 and so forth.

4. By iterating on the recursion

vn+1 (k) = max fln (k ' & k 0 ) + (vn (k 0 )g

0+k0 +k*

we obtain a sequence of value functions fvn g1 n=0 and policy functions

fgn g1 *
n=1 : Hopefully these sequences will converge to the solution v and
*
associated policy g of the functional equation. In fact, below we will state
and prove a very important theorem asserting exactly that (under certain
conditions) this iterative procedure converges for any initial guess v0 ; and
converges to the unique correct solution v * :

In the homework I let you carry out the Örst few iterations of this procedure.
Note however, that, in order to Önd the solution v * exactly you would have to
carry out step 3: above a lot of times (in fact, inÖnitely many times), which is, of
course, infeasible. Therefore one has to implement this procedure numerically
on a computer.

Value Function Iteration: Numerical Approach

Even a computer can carry out only a Önite number of calculation and can
only store Önite-dimensional objects. Hence the best we can hope for is a
numerical approximation of the true value function. The functional equa-
tion above is deÖned for all k % 0 (in fact there is an upper bound, but
letís ignore this for now). Because computer storage space is Önite, we will
3.2. OPTIMAL GROWTH: PARETO OPTIMAL ALLOCATIONS 41

approximate the value function for a Önite number of points only.4 For the
sake of the argument suppose that k and k 0 can only take values in K =
f0:04; 0:08; 0:12; 0:16; 0:2g: Note that the value function vn then consists of 5
numbers, (vn (0:04); vn (0:08); vn (0:12); vn (0:16); vn (0:2))
Now let us implement the above algorithm numerically. First we have to pick
concrete values for the parameters 0 and (: Let us pick 0 = 0:3 and ( = 0:6:

1. Make the initial guess v0 (k) = 0 for all k 2 K

2. Solve A # 0:3 $ B
v1 (k) = max
0 0:3
ln k & k 0 + 0:6 ) 0
0+k +k
k0 2K

This obviously yields as optimal policy k 0 (k) = g1 (k) = 0:04 for all k 2 K
(note that since k 0 2 K is required, k 0 = 0 is not allowed). Plugging this
back in yields

v1 (0:04) = ln(0:040:3 & 0:04) = &1:077

v1 (0:08) = ln(0:080:3 & 0:04) = &0:847
v1 (0:12) = ln(0:120:3 & 0:04) = &0:715
v1 (0:16) = ln(0:160:3 & 0:04) = &0:622
v1 (0:2) = ln(0:20:3 & 0:04) = &0:55

3. Letís do one more step by hand

8 9
>
< >
=
# 0:3 0
$ 0
v2 (k) = max ln k & k + 0:6v1 (k )
>
:0+k00 +k0:3 >
;
k 2K

Start with k = 0:04 :

A # $ B
v2 (0:04) = max
0 0:3
ln 0:040:3 & k 0 + 0:6v1 (k 0 )
0+k +0:04
k0 2K

Since 0:040:3 = 0:381 all k 0 2 K are possible. If the planner chooses

k 0 = 0:04; then
# $
v2 (0:04) = ln 0:040:3 & 0:04 + 0:6 ) (&1:077) = &1:723

If he chooses k 0 = 0:08; then

# $
v2 (0:04) = ln 0:040:3 & 0:08 + 0:6 ) (&0:847) = &1:710
4 In this course I will only discuss so-called Önite state-space methods, i.e. methods in

which the state variable (and the control variable) can take only a Önite number of values.
For a general treatment of computational methods in economics see the textbooks by Judd
(1998), Miranda and Fackler (2002) or Heer and Maussner (2009).
42CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

If he chooses k 0 = 0:12; then

# $
v2 (0:04) = ln 0:040:3 & 0:12 + 0:6 ) (&0:715) = &1:773

If k 0 = 0:16; then
# $
v2 (0:04) = ln 0:040:3 & 0:16 + 0:6 ) (&0:622) = &1:884

Finally, if k 0 = 0:2; then

# $
v2 (0:04) = ln 0:040:3 & 0:2 + 0:6 ) (&0:55) = &2:041

Hence for k = 0:04 the optimal choice is k 0 (0:04) = g2 (0:04) = 0:08 and
v2 (0:04) = &1:710: This we have to do for all k 2 K: One can already see
that this is quite tedious by hand, but also that a computer can do this
quite rapidly. Table 1 below shows the value of
# 0:3 $
k & k 0 + 0:6v1 (k 0 )

for di§erent values of k and k 0 : A ) in the column for k 0 that this k 0 is

the optimal choice for capital tomorrow, for the particular capital stock k
today

Table 1

k0
0:04 0:08 0:12 0:16 0:2
k
0:04 &1:7227 &1:7097* &1:7731 &1:8838 &2:0407
0:08 &1:4929 &1:4530* &1:4822 &1:5482 &1:6439
0:12 &1:3606 &1:3081* &1:3219 &1:3689 &1:4405
0:16 &1:2676 &1:2072* &1:2117 &1:2474 &1:3052
0:2 &1:1959 &1:1298 &1:1279* &1:1560 &1:2045

Hence the value function v2 and policy function g2 are given by

Table 2

k v2 (k) g2 (k)
0:04 &1:7097 0:08
0:08 &1:4530 0:08
0:12 &1:3081 0:08
0:16 &1:2072 0:08
0:2 &1:1279 0:12

In Figure 3.1 we plot the true value function v * (remember that for this exam-
ple we know to Önd v * analytically) and selected iterations from the numerical
3.2. OPTIMAL GROWTH: PARETO OPTIMAL ALLOCATIONS 43

Value Function: True and Approximated

0 Analytical
v0
v1
v2
-0.5 v10
Converged v
Value Function

-1

-1.5

-2

-2.5

0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2

Capital Stock k Today

Figure 3.1: True and Approximated Value Function

value function iteration procedure. In Figure 3.2 we have the corresponding

policy functions.
We see from Figure 3.1 that the numerical approximations of the value func-
tion converge rapidly to the true value function. After 20 iterations the approx-
imation and the truth are nearly indistinguishable with the naked eye (and they
are not distinguishable in the plot above). Looking at the policy functions we
see from Figure 2 that the approximating policy function do not converge to the
truth (more iterations donít help, and the step 10 and fully converged policy
functions lie exactly on top of each either). This is due to the fact that the
analytically correct value function was found by allowing k 0 = g(k) to take any
value in the real line, whereas for the approximations we restricted k 0 = gn (k)
to lie in K: The function g10 approximates the true policy function as good as
possible, subject to this restriction. Therefore the approximating value function
will not converge exactly to the truth, either. The fact that the value function
approximations come much closer is due to the fact that the utility and pro-
duction function induce ìcurvatureî into the value function, something that we
may make more precise later. Also note that we we plot the true value and
policy function only on K, with MATLAB interpolating between the points in
K, so that the true value and policy functions in the plots look piecewise linear.
44CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

Policy Function: True and Approximated

0.2
Analytical
g1
g2
g10
Policy Function 0.15 Converged g

0.1

0.05

0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2

Capital Stock k Today

Figure 3.2: True and Approximated Policy Function

3.2.4 The Euler Equation Approach and Transversality

Conditions

We now relate our example studied above with recursive techniques to the tra-
ditional approach of solving optimization problems. Note that this approach
also, as the guess and verify method, will only work in very simple examples,
but not in general, whereas the recursive numerical approach works for a wide
range of parameterizations of the neoclassical growth model. First let us look at
a Önite horizon social planners problem and then at the related inÖnite horizon
problem

The Finite Horizon Case

Let us consider the social planner problem for a situation in which the repre-
sentative consumer lives for T < 1 periods, after which she dies for sure and
3.2. OPTIMAL GROWTH: PARETO OPTIMAL ALLOCATIONS 45

the economy is over. The social planner problem for this case is given by
T
X
wT (k80 ) = max ( t U (f (kt ) & kt+1 )
fkt+1 gT
t=0 t=0
0 $ kt+1 $ f (kt )
k0 = k80 > 0 given

Obviously, since the world goes under after period T; kT +1 = 0. Also, given
our Inada assumptions on the utility function the constraints on kt+1 will never
be binding and we will disregard them henceforth. The Örst thing we note is
that, since we have a Önite-dimensional maximization problem and since the set
constraining the choices of fkt+1 gTt=0 is closed and bounded, by the Bolzano-
Weierstrass theorem a solution to the maximization problem exists, so that
wT (k80 ) is well-deÖned. Furthermore, since the constraint set is convex and
we assumed that U is strictly concave (and the Önite sum of strictly concave
functions is strictly concave), the solution to the maximization problem is unique
and the Örst order conditions are not only necessary, but also su¢cient.
Forming the Lagrangian yields

L = U (f (k0 )&k1 )+: : :+( t U (f (kt )&kt+1 )+( t+1 U (f (kt+1 )&kt+2 )+: : :+( T U (f (kT )&kT +1 )

and hence we can Önd the Örst order conditions as

@L
= &( t U 0 (f (kt )&kt+1 )+( t+1 U 0 (f (kt+1 )&kt+2 )f 0 (kt+1 ) = 0 for all t = 0; : : : ; T &1
@kt+1
or

U 0 (f (kt ) & kt+1 ) = (U 0 (f (kt+1 ) & kt+2 ) f 0 (kt+1 ) for all t = 0; : : : ; T & 1
| {z } | {z } | {z }
Utility cost Discounted Add. production
for saving add. utility possible with
= (3.5)
1 unit more from one more one more unit
capital for t + 1 unit of cons. of capital in t + 1

The interpretation of the optimality condition is easiest with a variational argu-

ment. Suppose the social planner in period t contemplates whether to save one
more unit of capital for tomorrow. One more unit saved reduces consumption by
one unit, at utility cost of U 0 (f (kt )&kt+1 ): On the other hand, there is one more
unit of capital for production to produce with tomorrow, yielding additional out-
put f 0 (kt+1 ): Each additional unit of production, when used for consumption,
is worth U 0 (f (kt+1 ) & kt+2 ) utils tomorrow, and hence (U 0 (f (kt+1 ) & kt+2 ) utils
today. At the optimum the net beneÖt of such a variation in allocations must
be zero, and the result is the Örst order condition above.
This Örst order condition some times is called an Euler equation (supposedly
because it is loosely linked to optimality conditions in continuous time calculus
of variations, developed by Euler). Equations (3:5) is second order di§erence
46CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

equation, a system of T equations in the T + 1 unknowns fkt+1 gTt=0 (with k0

predetermined). However, we have the terminal condition kT +1 = 0 and hence,
under appropriate conditions, can solve for the optimal fkt+1 gTt=0 uniquely. We
can demonstrate this for our example from above.
Again let U (c) = ln(c) and f (k) = k ' : Then (3:5) becomes
'$1
1 (0kt+1
=
kt' & kt+1 ' &k
kt+1 t+12
' '$1 '
kt+1 & kt+2 = 0(kt+1 (kt & kt+1 ) (3.6)
with k0 > 0 given and kT +1 = 0: A little trick will make our life easier. DeÖne
zt = kkt+1
* : The variable zt is the fraction of output in period t that is saved
t
as capital for tomorrow, so we can interpret zt as the saving rate of the social
'
planner. Dividing both sides of (3:6) by kt+1 we get
% &
0((kt' & kt+1 ) 1
1 & zt+1 = = 0( &1
kt+1 zt
0(
zt+1 = 1 + 0( &
zt
This is a Örst order di§erence equation. Since we have the boundary condi-
tion kT +1 = 0; this implies zT = 0; so we can solve this equation backwards.
Rewriting yields
0(
zt = (3.7)
1 + 0( & zt+1
We can now recursively solve backwards for the entire sequence fzt gTt=0 ; given
that we know zT = 0: We obtain as general formula (verify this by plugging it
into the Örst order di§erence equation (3:7) above)
T $t
1 & (0()
zt = 0( T $t+1
1 & (0()
and hence
T $t
1 & (0()
kt+1 = 0( k'
T $t+1 t
1 & (0()
1 & 0(
ct = k'
T $t+1 t
1 & (0()
One can also solve for the discounted future utility at time zero from the optimal
allocation to obtain
T T j
!
X j
X X i
T T $j
w (k0 ) = 0 ln(k0 ) (0() & ( ln (0()
j=0 j=1 i=0
T
"j$1 ( Pj$1 !)#
X X i (0()
i
T $j
+0( ( (0() ln(0() + ln Pi=0
j i
j=1 i=0 i=0 (0()
3.2. OPTIMAL GROWTH: PARETO OPTIMAL ALLOCATIONS 47

Note that the optimal policies and the discounted future utility are functions of
the time horizon that the social planner faces. Also note that for this speciÖc
example
T $t
1 & (0()
lim 0( k'
T $t+1 t
T !1 1 & (0()
= 0(kt'
and
. /
1 0( 0
lim wT (k0 ) = ln(0() + ln(1 & 0() + ln(k0 )
t!1 1 & ( 1 & 0( 1 & 0(
So is it the case that the optimal policy for the social planners problem with
inÖnite time horizon is the limit of the optimal policies for the T &horizon plan-
ning problem (and the same is true for the value of the planning problem)?
Our results from the guess and verify method seem to indicate this, and for this
example this is indeed true, but it is not true in general. We canít in general
interchange maximization and limit-taking: the limit of the Önite maximization
problems is often but not always equal to maximization of the problem in which
time goes to inÖnity.
In order to prepare for the discussion of the inÖnite horizon case let us
analyze the Örst order di§erence equation
0(
zt+1 = 1 + 0( &
zt
graphically. On the y-axis of Figure 3.3 we draw zt+1 against zt on the x-axis.
Since kt+1 % 0; we have that zt % 0 for all t: Furthermore, as zt approaches 0
from above, zt+1 approaches &1: As zt approaches +1; zt+1 approaches 1+0(
'%
from below asymptotically. The graph intersects the x-axis at z 0 = 1+'% : The
di§erence equation has two steady states where zt+1 = zt = z: This can be seen
by

0(
z = 1 + 0( &
z
z 2 & (1 + 0()z + 0( = 0
(z & 1)(z & 0() = 0
z = 1 or z = 0(
From Figure 3.3 we can also determine graphically the sequence of optimal
policies fzt gTt=0 : We start with zT = 0 on the y-axis, go to the zt+1 = 1+0( & '%
zt
curve to determine zT $1 and mirror it against the 45-degree line to obtain zT $1
on the y-axis. Repeating the argument one obtains the entire fzt gTt=0 sequence,
and hence the entire fkt+1 gTt=0 sequence. Note that going with t backwards to
zero, the zt ís approach 0(: Hence for large T and for small t (the optimal policies
for a Önite time horizon problem with long horizon, for the early periods) come
close to the optimal inÖnite time horizon policies solved for with the guess and
verify method.
48CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

z z =z
t+1 t+1 t

z =1+αβ-αβ/z
t+1 t

z
T-1
z
T
αβ 1 z
t

Figure 3.3: Dynamics of Savings Rate

The InÖnite Horizon Case

Now let us turn to the inÖnite horizon problem and letís see how far we can get
with the Euler equation approach. Remember that the problem was to solve
1
X
w(k80 ) = max1 ( t U (f (kt ) & kt+1 )
fkt+1 gt=0
t=0
0 $ kt+1 $ f (kt )
k0 = k80 > 0 given

Since the period utility function is strictly concave and the constraint set is
convex, the Örst order conditions constitute necessary conditions for an optimal
*
sequence fkt+1 g1t=0 (a proof of this is a formalization of the variational argu-
ment I spelled out when discussing the intuition for the Euler equation). As a
3.2. OPTIMAL GROWTH: PARETO OPTIMAL ALLOCATIONS 49

reminder, the Euler equations were

(U 0 (f (kt+1 )&kt+2 )f 0 (kt+1 ) = U 0 (f (kt )&kt+1 ) for all t = 0; : : : ; t; : : : (3.8)

Again this is a second order di§erence equation, but now we only have an initial
condition for k0 ; but no terminal condition since there is no terminal time period.
In a lot of applications, the transversality condition substitutes for the miss-
ing terminal condition. Let us Örst state and then interpret the TVC5

lim ( t U 0 (f (kt ) & kt+1 )f 0 (kt ) kt = 0

t!1 | {z } |{z}
value in discounted Total
utility terms of one Capital = 0
more unit of capital Stock

The transversality condition states that the value of the capital stock kt ; when
measured in terms of discounted utility, goes to zero as time goes to inÖnity.
Note that this condition does not require that the capital stock itself converges
to zero in the limit, only that the (shadow) value of the capital stock has to
converge to zero.
The transversality condition is a tricky beast, and you may spend some
more time on it as the semester progresses. For now we just state the following
theorem (see Stokey and Lucas, p. 98):

Theorem 11 Let U; ( and F (and hence f ) satisfy assumptions 1. and 2. Then

an allocation fkt+1 g1
t=0 that satisÖes the Euler equations and the transversality
condition solves the sequential social planners problem, for a given k0 :
5 Often one can Önd an alternative statement of the TVC in the literature:
lim /t kt+1 = 0
t!1

where /t is the Lagrange multiplier on the constraint

ct + kt+1 = f (kt )
in the social planner problem in which consumption is not yet substituted out in the objective
function. From the Örst order condition we have
1 t U 0 (ct ) = /t
t 0
1 U (f (kt ) # kt+1 ) = /t
Hence the TVC becomes
lim 1 t U 0 (f (kt ) # kt+1 )kt+1 = 0
t!1
This condition is equvalent to the condition given in the main text, as shown by the following
argument (which uses the Euler equation)
0 = lim 1 t U 0 (f (kt ) # kt+1 )kt+1
t!1

= lim 1 t%1 U 0 (f (kt%1 ) # kt )kt

t!1

= lim 1 t%1 1U 0 (f (kt ) # kt+1 )f 0 (kt )kt

t!1

= lim 1 t U 0 (f (kt ) # kt+1 )f 0 (kt )kt

t!1

which is the TVC in the main text.

50CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

This theorem states that under certain assumptions the Euler equations and
the transversality condition are jointly su¢cient for a solution to the social
planners problem in sequential formulation. Stokey et al., p. 98-99 prove this
theorem. Note that this theorem does not apply for the case in which the
utility function is logarithmic; however, the proof that Stokey et al. give can be
extended to the log-case. So although the Euler equations and the TVC may
not be su¢cient for every unbounded utility function, for the log-case they are.
Also note that we have said nothing about the necessity of the TVC. We
have (loosely) argued that the Euler equations are necessary conditions, but is
the TVC necessary, i.e. does every solution to the sequential planning problem
have to satisfy the TVC? This turns out to be a hard problem, and there is
not a very general result for this. However, for the log-case (with f 0 s satisfying
our assumptions), Ekelund and Scheinkman (1985) show that the TVC is in
fact a necessary condition. Refer to their paper and to the related results by
Peleg and Ryder (1972) and Weitzman (1973) for further details. From now on
we assert that the TVC is necessary and su¢cient for optimization under the
assumptions we made on f; U; but you should remember that these assertions
remain to be proved.
But now we take these theoretical results for granted and proceed with our
example of U (c) = ln(c); f (k) = k ' : For these particular functional forms, the
TVC becomes

lim ( t U 0 (f (kt ) & kt+1 )f 0 (kt )kt

t!1
0( t kt' 0( t
= lim = lim
t!1 kt' & kt+1 t!1 1 & kt+1
* kt

0( t
= lim
t!1 1 & zt

We also repeat the Örst order di§erence equation derived from the Euler equa-
tions
0(
zt+1 = 1 + 0( &
zt
We canít solve the Euler equations form fzt g1 t=0 backwards, but we can solve it
forwards, conditional on guessing an initial value for z0 : We show that only one
guess for z0 yields a sequence that does not violate the TVC or the nonnegativity
constraint on capital or consumption.

1. z0 < 0(: From Figure 3.3 we see that in Önite time zt < 0; violating the
nonnegativity constraint on capital

2. z0 > 0(: Then from Figure 3 we see that limt!1 zt = 1: (Note that, in
fact, every z0 > 1 violate the nonnegativity of consumption and hence is
not admissible as a starting value). We will argue that all these paths
violate the TVC.
3.2. OPTIMAL GROWTH: PARETO OPTIMAL ALLOCATIONS 51

3. z0 = 0(: Then zt = 0( for all t > 0: For this path (which obviously
satisÖes the Euler equations) we have that

0( t 0( t
lim = lim =0
t!1 1 & zt t!1 1 & 0(

and hence this sequence satisÖes the TVC. From the su¢ciency of the
Euler equation jointly with the TVC we conclude that the sequence fzt g1
t=0
given by zt = 0( is an optimal solution for the sequential social plan-
ners problem. Translating into capital sequences yields as optimal policy
kt+1 = 0(kt' ; with k0 given. But this is exactly the constant saving rate
policy that we derived as optimal in the recursive problem.

Now we pick up the unÖnished business from point 2. Note that we asserted
above (citing Ekelund and Scheinkman) that for our particular example the
TVC is also a necessary condition, i.e. any sequence fkt+1 g1t=0 that does not
satisfy the TVC canít be an optimal solution.
Since all sequences fzt g1
t=0 from case 2. above converge to 1; in the TVC
both the nominator and the denominator go to zero. Let us linearly approximate
zt+1 around the steady state z = 1: This gives
0(
zt+1 = 1 + 0( & := g(zt )
zt
zt+1 - g(1) + (zt & 1)g 0 (zt )jzt =1
% &
0(
= 1 + (zt & 1) jzt =1
zt2
= 1 + 0((zt & 1)
(1 & zt+1 ) - 0((1 & zt )
t$k+1
- (0() (1 & zk ) for all k

Hence
0( t+1 0( t+1
lim - lim t$k+1
t!1 1 & zt+1 t!1 (0() (1 & zk )
k
(
= lim =1
t!1 0t$k (1 & zk )
as long as 0 < 0 < 1: Hence non of the sequences contemplated in 2. can be
an optimal solution, and our solution found in 3. is indeed the unique optimal
solution to the inÖnite-dimensional social planner problem. Therefore in this
speciÖc case the Euler equation approach, augmented by the TVC works. But
as with the guess-and-verify method this is very unique to the speciÖc example
at hand. Therefore for the general case we canít rely on pencil and paper, but
have to resort to computational techniques.
To make sure that these techniques give the desired answer, we have to study
the general properties of the functional equation associated with the sequential
52CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

social planner problem and the relation of its solution to the solution of the
sequential problem. We will do this in chapters 4 and 5. Before this we will
show that, by solving the social planners problem we have, in e§ect, solved for
a (the) competitive equilibrium in this economy. But Örst we will analyze the
properties of the solution to the social planner problem a bit further.

3.2.5 Steady States and the ModiÖed Golden Rule

A steady state is deÖned as a social optimum or competitive equilibrium in
which allocations are constant over time, ct = c* and kt+1 = k * : In general, we
can only expect for a steady state to arise for the right initial condition, that
is, we need k0 = k * : Even if k0 6= k * ; the allocation may over time converge to
(c* ; k * ); in that case we call (c* ; k * ) an (asymptotically) stable steady steady
state. We can use our previous results to sharply characterize steady states.
The Euler equations for the social planner problem read as

(U 0 (f (kt+1 ) & kt+2 )f 0 (kt+1 ) = U 0 (f (kt ) & kt+1 ) or

(U 0 (ct+1 )f 0 (kt+1 ) = U 0 (ct ):

In a steady state ct = ct+1 = c* and thus

(f 0 (k * ) = 1
f 0 (k * ) = 1+:

where : is the time discount rate. Recalling the deÖnition of f 0 (k) = Fk (k; 1) +
1 & / we obtain the so-called modiÖed golden rule

Fk (k * ; 1) & / = :

that is, the social planner sets the marginal product of capital, net of deprecia-
tion, equal to the time discount rate. As we will see below, the net real interest
rate in a competitive equilibrium equals Fk (k; 1) & /; so the modiÖed golden
rule can be restated as equating the real interest rate and the time discount
rate. Note that we derived exactly the same result in our simple pure exchange
economy in chapter 2.
For our example above with log-utility, Cobb-Douglas production and / = 1
we Önd that
'$1 1
0 (k * ) = :+1=
(
1
k* = (0() 1#* :

One can also Önd the steady state level of capital by exploiting the optimal
policy function from the recursive solution of the problem, k 0 = 0(k ' : Setting
1
k 0 = k and solving we Önd again k * = (0() 1#* : Also note that from any initial
*
capital stock k0 > 0 the optimal sequence chosen by the social planner fkt+1 g
1
converges to k * = (0() 1#* : This is no accident: the unique steady state of the
3.2. OPTIMAL GROWTH: PARETO OPTIMAL ALLOCATIONS 53

neoclassical growth model is globally asymptotically stable in general. We will

show this in the continuous time version of the model in chapter 8.
Note that the name modiÖed golden rule comes from the following consid-
eration: the resource constraint reads as

ct = f (kt ) & kt+1

and in the steady state

c = f (k) & k:
The capital stock that maximizes consumption per capita, called the (original)
golden rule k g ; therefore satisÖes

f 0 (k g ) = 1 or
Fk (k g ; 1) & / = 0

Thus the social planner Önds it optimal to set capital k * < k g in the long run
because he respects the impatience of the representative household.

3.2.6 A Remark About Balanced Growth

So far we have abstracted both from population growth as well as technological
progress. As a consequence there is no long-run growth in aggregate and in per-
capita variables as the economy converges to its long-run steady state. Thus
the neoclassical growth model does not generate long-run growth.
Fortunately this shortcoming is easily Öxed. So now assume that the pop-
ulation is growing at rate n; so that at time t the size of the population is
Nt = (1 + n)t : Furthermore assume that there is labor-augmenting technologi-
cal progress, so that output at date t is produced according to the production
function
F (Kt ; Nt (1 + g)t )
where Kt is the total capital stock in the economy. In the model with population
growth there is some choice as to what the objective function of the social
planner (and the household in the competitive equilibrium) ought to be. Either
per capita lifetime utility
X1
( t U (ct ) (3.9)
t=0

or lifetime utility of the entire dynasty

1
X
Nt ( t U (ct ) (3.10)
t=0

is being maximized. We will go with the Örst formulation, but also give re-
sults for the second (nothing substantial changes, just some adjustments in the
algebra are required). The resource constraint reads as

(1 + n)t ct + Kt+1 = F (Kt ; (1 + n)t (1 + g)t ) + (1 & /)Kt :

54CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

Now we deÖne growth-adjusted per capita variables as

ct
c~t =
(1 + g)t
kt Kt
k~t = t
=
(1 + g) (1 + n)t (1 + g)t
and divide the resource constraint by (1 + n)t (1 + g)t to obtain
c~t + (1 + n)(1 + g)k~t+1 = F (k~t ; 1) + (1 & /)k~t : (3.11)
In order to be able to analyze this economy and to obtain a balanced growth path
1#'
we now assume that the period utility function is of CRRA form U (c) = c1$0 :
We can then rewrite the objective function (3:9) as
1
X 1
X
c1$0 ct (1 + g)t )1$0
(~
(t t
= (t
t=0
1&= t=0
1&=
1
X 1$0
= ~ t c~t
(
t=0
1&=

~ = ((1 + g)1$0 : Note that had we assumed (3:10) as our objective, only
where (
~ would change6 ; it would now read as (
our deÖnition of ( ~ = ((1 + n)(1 + g)1$0 :
Given these adjustments we can rewrite the growth-deáated social planner
problem as
' (1$0
X1 f (k~t ) & (1 + g)(1 + n)k~t+1
max ~t
(
fkt+1 g1
t=0
t=0
1&=
0 $ (1 + g)(1 + n)k~t+1 $ f (k~t )
k~0 = k0 given
and all the analysis from above goes through completely unchanged. In particu-
lar, all the recursive techniques apply and the Euler equation techniques remain
the same
A balanced growth path is a socially optimal allocation (or a competitive
equilibrium) where all variables grow at a constant rate (this rate may vary
across variables). Given our deáation above a balanced growth path in the
variables fct ; kt+1 g corresponds to constant steady state for f~ ct ; k~t+1 g: The Euler
equations associated with the social planner problem above is
h i
$0 ~ (~ $0
(1 + n)(1 + g) (~ct ) = ( ct+1 ) Fk (k~t+1 ; 1) + (1 & /) : (3.12)

Evaluated at the steady state this reads as

h i
(1 + n)(1 + g) = (~ Fk (k~* ; 1) + (1 & /)

~ < 1 which entails a joint assumption on the

6 In either case one must now assume 1

parameters 1; 4; g of the model.

3.3. COMPETITIVE EQUILIBRIUM GROWTH 55

~=
DeÖning ( 1
we have
1+~/

~) = Fk (k~* ; 1) + (1 & /)
(1 + n)(1 + g)(1 + :

or, as long as the terms ng; n~

:; g~
: are su¢ciently small, the new modiÖed golden
rule reads as
Fk (k~* ; 1) & / = n + g + :
~:
Note that the original golden rule in this growing economy is deÖned as maxi-
mizing, growth-deáated per capita consumption
~ & (1 + g)(1 + n)k~
c~ = f (k)

and thus (approximately)

Fk (k~g ; 1) & / = n + g:

Once the optimal growth-deáated variables f~ ct ; k~t+1 g1

t=0 have been determined,
the true variables of interest can trivially be computed as

ct = (1 + g)t c~t and kt+1 = (1 + g)t k~t+1

Ct = (1 + n)t (1 + g)t c~t and Kt+1 = (1 + n)t (1 + g)t k~t+1 :

Overall we conclude that the model with population growth and technolog-
ical progress is no harder to analyze than the benchmark model. All we have
to do is to redeÖne the time discount factor, deáate all per-capita variables by
technological progress, all aggregate variables in addition by population growth,
and pre-multiply e§ective capital tomorrow by (1 + n)(1 + g):

3.3 Competitive Equilibrium Growth

Suppose we have solved the social planners problem for a Pareto e¢cient al-
location fc*t ; kt+1
*
g1
t=0 : What we are genuinely interested in are allocations and
prices that arise when Örms and consumers interact in markets. In this section
we will discuss the connection between Pareto optimal allocations and alloca-
tions arising in a competitive equilibrium. For the discussion of Pareto optimal
allocations it did not matter who owns what in the economy, since the planner
was allowed to freely redistribute endowments across agents. For a competitive
equilibrium the question of ownership is crucial. We make the following assump-
tion on the ownership structure of the economy: we assume that consumers own
all factors of production (i.e. they own the capital stock at all times) and rent
it out to the Örms. We also assume that households own the Örms, i.e. are
claimants of the Örmsí proÖts.
Now we have to specify the equilibrium concept and the market structure.
We assume that the Önal goods market and the factor markets (for labor and
capital services) are perfectly competitive, which means that households as well
as Örms take prices are given and beyond their control. We assume that there is a
56CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

single market at time zero in which goods for all future periods are traded. After
this market closes, in all future periods the agents in the economy just carry out
the trades they agreed upon in period 0: We assume that all contracts are per-
fectly enforceable. This market is often called Arrow-Debreu market structure
and the corresponding competitive equilibrium an Arrow-Debreu equilibrium.
For each period there are three goods that are traded:

1. The Önal output good, yt that can be used for consumption ct or invest-
ment it purposes of the household. Let pt denote the price of the period
t Önal output good, quoted in period 0: We let the period 0 output good
be the numeraire and thus normalize p0 = 1:

2. Labor services nt : Let wt be the price of one unit of labor services delivered
in period t; quoted in period 0; in terms of the period t consumption
good. Hence wt is the real wage; it tells how many units of the period t
consumption goods one can buy for the receipts for one unit of labor. The
wage in terms of the numeraire, the period 0 output good is pt wt :

3. Capital services kt : Let rt be the rental price of one unit of capital services
delivered in period t; quoted in period 0; in terms of the period t consump-
tion good. Note that rt is the real rental rate of capital; the rental rate in
terms of the numeraire good is pt rt :

Figure 3.4 summarizes the áows of goods and payments in the economy (note
that, since all trade takes place in period 0; no payments are made after period
0).

3.3.1 DeÖnition of Competitive Equilibrium

Now we will deÖne a competitive equilibrium for this economy. Let us Örst look
at Örms. Without loss of generality assume that there is a single, representative
Örm that behaves competitively.7
The representative Örmís problem is, given a sequence of prices fpt ; wt ; rt g1
t=0 ;
to solve:
1
X
Q = max 1 pt (yt & rt kt & wt nt ) (3.13)
fyt ;kt ;nt gt=0
t=0
s:t: yt = F (kt ; nt ) for all t % 0
yt ; kt ; nt % 0

Hence Örms chose an inÖnite sequence of inputs fkt ; nt g to maximize total proÖts
Q: Since in each period all inputs are rented (the Örm does not make the capital
7 As we will show below this is an innocuous assumption as long as the technology features

constant returns to scale.

3.3. COMPETITIVE EQUILIBRIUM GROWTH 57

supply labor n ,capital k

t t
w,r
t t

Firms Households
y=F(k,n) Preferences u, β
Profits π
Endowments e

p
t

Sell output y
t

Figure 3.4: Flows of Goods and Payments in Neoclassical Growth Model

accumulation decision), there is nothing dynamic about the Örmís problem and
it will separate into an inÖnite number of static maximization problems.
Households instead face a fully dynamic problem in this economy. They own
the capital stock and hence have to decide how much labor and capital services
to supply, how much to consume and how much capital to accumulate. Taking
prices fpt ; wt ; rt g1
t=0 as given the representative consumer solves

1
X
max ( t U (ct ) (3.14)
fct ;it ;xt+1 ;kt ;nt g1
t=0
t=0
1
X 1
X
s:t: pt (ct + it ) $ pt (rt kt + wt nt ) + Q
t=0 t=0
xt+1 = (1 & /)xt + it all t % 0
0 $ nt $ 1; 0 $ kt $ xt all t % 0
ct ; xt+1 % 0 all t % 0
x0 given
58CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

A few remarks are in order. First, there is only one, time zero budget con-
straint, the so-called Arrow-Debreu budget constraint, as markets are only open
in period 0: Secondly we carefully distinguish between the capital stock xt and
capital services that households supply to the Örm. Capital services are traded
and hence have a price attached to them, the capital stock xt remains in the
possession of the household, is never traded and hence does not have a price
attached to it.8 We have implicitly assumed two things about technology: a)
the capital stock depreciates no matter whether it is rented out to the Örm or
not and b) there is a technology for households that transforms one unit of the
capital stock at time t into one unit of capital services at time t: The constraint
kt $ xt then states that households cannot provide more capital services than
the capital stock at their disposal produces. Also note that we only require the
capital stock to be nonnegative, but not investment. We are now ready to deÖne
a competitive equilibrium for this economy.

DeÖnition 12 A Competitive Equilibrium (Arrow-Debreu Equilibrium) con-

sists of prices fpt ; wt ; rt g1 d d 1
t=0 and allocations for the Örm fkt ; nt ; yt gt=0 and
s s 1
the household fct ; it ; xt+1 ; kt ; nt gt=0 such that

1. Given prices fpt ; wt ; rt g1 d d 1

t=0 ; the allocation of the representative Örm fkt ; nt ; yt gt=0
solves (3:13)

2. Given prices fpt ; wt ; rt g1 t=0 ; the allocation of the representative household

fct ; it ; xt+1 ; kts ; nst g1
t=0 solves (3:14)

3. Markets clear

yt = ct + it (Goods Market)
ndt = nst (Labor Market)
ktd = kts (Capital Services Market)

3.3.2 Characterization of the Competitive Equilibrium and

the Welfare Theorems
Firms
Let us start with a partial characterization of the competitive equilibrium. First
of all we simplify notation and denote by kt = ktd = kts the equilibrium demand
and supply of capital services. Similarly nt = ndt = nst : It is straightforward
to show that in any equilibrium pt > 0 for all t, since the utility function is
strictly increasing in consumption (and therefore consumption demand would
be inÖnite at a zero price). But then, since the production function exhibits
positive marginal products, rt ; wt > 0 in any competitive equilibrium because
otherwise factor demands would become unbounded.
8 This is not quite correct since we do not require investment i to be positive. If household
t
choose ct < #it < 0; households transform part of the capital stock back into Önal output
goods and sell it back to the Örm at price pt :
3.3. COMPETITIVE EQUILIBRIUM GROWTH 59

Now let us analyze the problem of the representative Örm. As stated earlier,
the Örms does not face a dynamic decision problem as the variables chosen at
period t; (yt ; kt ; nt ) do not a§ect the constraints nor returns (proÖts) at later
periods. The static proÖt maximization problem for the representative Örm is
given by
Q t = max pt (F (kt ; nt ) & rt kt & wt nt )
kt ;nt -0

Since the Örm take prices as given, the usual ìfactor price equals marginal
productî conditions arise

rt = Fk (kt ; nt )
wt = Fn (kt ; nt ) (3.15)

Substituting marginal products for factor prices in the expression for proÖts
implies that in equilibrium the proÖts the Örms earns in period t are equal to

Q t = pt (F (kt ; nt ) & Fk (kt ; nt )kt & Fn (kt ; nt )nt ) = 0

The fact that proÖts are equal to zero is a consequence of perfect compe-
tition (and the associated marginal product pricing conditions (3:15)) and the
assumption that the production function F exhibits constant returns to scale
(that is, it is homogeneous of degree 1):

F (,k; ,n) = ,F (k; n) for all , > 0

Eulerís theorem9 states that for any function that is homogeneous of degree 1
payments to production factors exhaust output, or formally:

F (kt ; nt ) = Fk (kt ; nt )kt + Fn (kt ; nt )nt

Therefore total proÖts of the representative Örm Q t are equal to zero in equi-
librium in every period, and thus overall proÖts Q = 0 in equilibrium as well.
9 Eulerís theorem states that for any function that is homogeneous of degree k and di§er-

entiable at x 2 RL we have
XL
@f (x)
kf (x) = xi
i=1
@xi
Proof. Since f is homogeneous of degree k we have for all / > 0
f (/x) = /k f (x)
Di§erentiating both sides with respect to / yields
L
X @f (/x)
xi = k/k%1 f (x)
i=1
@xi

Setting / = 1 yields
L
X @f (x)
xi = kf (x)
i=1
@xi
60CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

This result of course also implies that the owner of the Örm, the representative
household, will not receive any proÖts in equilibrium either.
We now return to the point that with a CRTS production technology the
assumption of having a single representative (competitively behaving) Örm is
innocuous. In fact, with CRTS the number of Örms is indeterminate in a com-
petitive equilibrium; it could be one Örm, two Örms each operating at half the
scale of the one Örm or 10 million Örms. To see this, Örst note that constant
returns to scale imply that the marginal products of labor and capital are ho-
mogeneous of degree 0: for all , > 0 we have10

Fk (,kt ; ,nt ) = Fk (kt ; nt )

Fk (,kt ; ,nt ) = Fk (kt ; nt ):

1
Taking , = n we obtain

Fk (k=n; 1) = Fk (k; n):

Therefore equation
rt = Fk (kt ; nt ) = Fk (kt =nt ; 1) (3.16)

implies that all Örms that we might assume to exist (the single representative
Örm or the 10 million Örms) in equilibrium would operate with exactly the
same capital-labor ratio determined by (3:16). Only that ratio is pinned down
by the marginal product pricing conditions11 , but not the scale of operation
of each Örm. So whether total output is produced by one representative (still
competitively behaving) Örm with output

F (kt ; nt ) = nt F (kt =nt ; 1)

or nt Örms, each with one worker and output F (kt =nt ; 1) is both indeterminate
and irrelevant for the equilibrium, and without loss of generality we can restrict
attention to a single representative Örm.
1 0 For any / > 0; since F has CRTS, we have:

F (/k; /n) = /F (k; n)

Di§erentiate this expression with respect to one of the inputs, say k; to obtain

/Fk (/k; /n) = /Fk (k; n)

Fk (/k; /n) = Fk (k; n)

and thus the marginal product of capital is homogeneous of degree 0 in its argument (of course
the same can be derived for the marginal product of labor).
1 1 Note that the other condition

wt = Fn (kt ; nt ) = Fn (kt =nt ; 1)

does not help here (but it does imply that rt and wt are inversely related in any competitive
equilibrium, since Fk is strictly decreasing in kt =nt and Fn is strictly increasing in it.
3.3. COMPETITIVE EQUILIBRIUM GROWTH 61

Households
Letís now turn to the representative household. Given that output and factor
prices have to be positive in equilibrium it is clear that the utility maximizing
choices of the household entail
nt = 1; kt = xt
it = kt+1 & (1 & /)kt
From the equilibrium condition in the goods market we also obtain
F (kt ; 1) = ct + kt+1 & (1 & /)kt
and thus
f (kt ) = ct + kt+1 :
Since utility is strictly increasing in consumption, we also can conclude that
the Arrow-Debreu budget constraint holds with equality in equilibrium. Using
these results we can rewrite the household problem as
1
X
max 1 ( t U (ct )
fct ;kt=1 gt=0
t=0
1
X 1
X
s:t: pt (ct + kt+1 & (1 & /)kt ) = pt (rt kt + wt )
t=0 t=0
ct ; kt+1 % 0 all t % 0
k0 given
Again the Örst order conditions are necessary for a solution to the household
optimization problem. Attaching 1 to the Arrow-Debreu budget constraint and
ignoring the nonnegativity constraints on consumption and capital stock we get
as Örst order conditions12 with respect to ct ; ct+1 and kt+1
( t U 0 (ct ) = 1pt
t+1
( U 0 (ct+1 ) = 1pt+1
1pt = 1(1 & / + rt+1 )pt+1
Combining yields the Euler equation
(U 0 (ct+1 ) pt+1 1
= =
U 0 (ct ) pt 1 + rt+1 & /
1 2 That the nonnegativity constraints on consumption do not bind follows directly from the

Inada conditions. The nonnegativity constraints on capital could potentially bind if we look
at the household problem in isolation. However, since from the production function kt = 0
implies F (0; 1) = 0 and Fk (0; 1) = 1: Thus in equilibrium rt would be bid up to the point
where kt > 0 is optimal for the household. Anticipating this we take the shortcut and ignore
the corners with respect to capital holdings. But you should be aware of the fact that we
did something here that was not very clean, we used equilibrium logic before carrying out the
maximization problem of the household. This is Öne here, but may lead to a lot of problems
when used in other circumstances.
62CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

and thus
(1 & / + rt+1 ) (U 0 (ct+1 )
=1
U 0 (ct )

Note that the net real interest rate in this economy is given by rt+1 & /. When
a household saves one unit of consumption for tomorrow, she can rent it out
tomorrow of a rental rate rt+1 ; but a fraction / of the one unit depreciates, so
the net return on her saving is rt+1 & /: In these lecture notes we sometimes let
rt+1 denote the net real interest rate, sometimes the real rental rate of capital;
the context will always make clear which of the two concepts rt+1 stands for.
Now we use the marginal pricing condition and the fact that we deÖned
f (kt ) = F (kt ; 1) + (1 & /)kt

rt = Fk (kt ; 1) = f 0 (kt ) & (1 & /)

and the market clearing condition from the goods market

ct = f (kt ) & kt+1

in the Euler equation to obtain

f 0 (kt+1 )(U 0 (f (kt+1 ) & kt+2 )

=1 (3.17)
U 0 (f (kt ) & kt+1 )

which is exactly the same Euler equation as in the social planners problem.
Also recall that for the social planner problem, in addition we needed to
make sure that the value of the capital stock the social planner chose converged
to zero in the limit: one version of the transversality condition we stated there
was
lim ,t kt+1 = 0
t!1

where ,t was the Lagrange multiplier (social shadow cost) on the resource con-
straint. The Euler equation and TVC were jointly su¢cient for a maximizing
sequence of capital stocks. The same is true here: in addition to the Euler
equation we need to make sure that in the limit the value of the capital stock
carried forward by the household converges to zero13 :

lim pt kt+1 = 0
t!1

1 3 We implictly assert here that for the assumptions we made on U; f the Euler conditions

with the TVC are jointly su¢cient and they are both necessary.
Note that Stokey et al. in Chapter 2.3, when they discuss the relation between the planning
problem and the competitive equilibrium allocation use the Önite horizon case, because for
this case, under the assumptions made the Euler equations are both necessary and su¢cient
for both the planning problem and the household optimization problem, so they donít have
to worry about the TVC.
3.3. COMPETITIVE EQUILIBRIUM GROWTH 63

But using the Örst order condition yields

1
lim pt kt+1 = lim ( t U 0 (ct )kt+1
t!1 1 t!1
1
= lim ( t$1 U 0 (ct$1 )kt
1 t!1
1
= lim ( t$1 (U 0 (ct )(1 & / + rt )kt
1 t!1
1
= lim ( t U 0 (f (kt ) & kt+1 )f 0 (kt )kt
1 t!1

where the Lagrange multiplier 1 on the Arrow-Debreu budget constraint is

positive since the budget constraint is strictly binding. Note that this is exactly
the same TVC as for the social planners problem (as stated in the main text).
Hence an allocation of capital fkt+1 g1t=0 satisÖes the necessary and su¢cient
conditions for being a Pareto optimal allocations if and only if it satisÖes the
necessary and su¢cient conditions for being part of a competitive equilibrium
(always subject to the caveat about the necessity of the TVC in both problems).
This last statement is our version of the fundamental theorems of welfare eco-
nomics for the particular economy that we consider. The Örst welfare theorem
states that a competitive equilibrium allocation is Pareto e¢cient (under very
general assumptions). The second welfare theorem states that any Pareto e¢-
cient allocation can be decentralized as a competitive equilibrium with transfers
(under much more restrictive assumptions), i.e. there exist prices and redis-
tributions of initial endowments such that the prices, together with the Pareto
e¢cient allocation is a competitive equilibrium for the economy with redistrib-
uted endowments.
In particular, when dealing with an economy with a representative agent (i.e.
when restricting attention to type-identical allocations), whenever the second
welfare theorem applies we can solve for Pareto e¢cient allocations by solving
a social planners problem and be sure that all Pareto e¢cient allocations are
competitive equilibrium allocations (since there is nobody to redistribute en-
dowments to/from). If, in addition, the Örst welfare theorem applies we can be
sure that we found all competitive equilibrium allocations.
Also note an important fact. The Örst welfare theorem is usually easy to
prove, whereas the second welfare theorem is substantially harder, in particular
in inÖnite-dimensional spaces. Suppose we have proved the Örst welfare theorem
and we have established that there exists a unique Pareto e¢cient allocation
(this in general requires representative agent economies and restrictions to type-
identical allocations, but in these environments boils down to showing that the
social planners problem has a unique solution). Then we have established that,
if there is a competitive equilibrium, its allocation has to equal the Pareto
e¢cient allocation. Of course we still need to prove existence of a competitive
equilibrium, but this is not surprising given the intimate link between the second
welfare theorem and the existence proof.
Back to our economy at hand. Once we have determined the equilibrium
64CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

sequence of capital stocks fkt+1 g1

t=0 we can construct the rest of the competitive
equilibrium. In particular equilibrium allocations are given by

ct = f (kt ) & kt+1

yt = F (kt ; 1)
it = yt & ct
nt = 1

for all t % 0: Finally we can construct factor equilibrium prices as

rt = Fk (kt ; 1)
wt = Fn (kt ; 1)

Finally, the prices of the Önal output good can be found as follows. We have
already normalized p0 = 1. From the Euler equations for the household in then
follows that
(U 0 (ct+1 )
pt+1 = pt
U 0 (ct )
pt+1 (U 0 (ct+1 ) 1
= =
pt U 0 (ct ) 1 + rt+1 & /
Y t
( t+1 U 0 (ct+1 ) 1
pt+1 = 0
=
U (c0 ) * =0
1 + r* +1 & /

and we have constructed a complete competitive equilibrium, conditional on

having found fkt+1 g1 t=0 :
To summarize, section 3.2 discussed how to solve for the optimal alloca-
tions of the social planner problem using recursive techniques (analytically for
an example, numerically for the general case). Chapters 4 and 5 will give the
theoretical-mathematical background for this discussion. In section 3.3 we then
discussed how to decentralize this allocation as a competitive (Arrow-Debreu)
equilibrium by demonstrating that the optimal allocation, together with appro-
priately chosen prices, satisfy all household and Örm optimality and all equilib-
rium conditions.

3.3.3 Sequential Markets Equilibrium

We now brieáy state the deÖnition of a sequential markets equilibrium for this
economy. This deÖnition is useful in its own right (given that the equivalence
between an Arrow Debreu equilibrium and a sequential markets equilibrium
continues to apply), but also prepares the deÖnition of a recursive competitive
equilibrium in the next subsection.
In a sequential markets equilibrium households (who own the capital stock)
take sequences of wages and interest rates as given and in every period chooses
consumption and capital to be brought into tomorrow. In every period the
3.3. COMPETITIVE EQUILIBRIUM GROWTH 65

consumption/investment good is the numeraire an its price normalized to 1.

Thus the representative household solves
1
X
max 1 ( t U (ct ) (3.18)
fct ;kt+1 gt=0
t=0
s.t.
ct + kt+1 & (1 & /)kt = wt + rt kt
ct ; kt+1 % 0
k0 given

Firms solve a sequence of static problems (since households, not Örms own the
capital stock). Taking wages and rental rates of capital as given the Örmís
problem is given as
max F (kt ; nt ) & wt nt & rt kt : (3.19)
kt ;nt -0

Thus we can deÖne a sequential markets equilibrium as

DeÖnition 13 A sequential markets equilibrium is a sequence of prices fwt ; rt g1 t=0 ;

s
allocations for the representative household fct ; kt+1 g1
t=0 and allocations for the
representative Örm fndt ; ktd g1
t=0 such that

1. Given k0 and fwt ; rt g1 s 1

t=0 ; allocations for the representative household fct ; kt+1 gt=0
solve the household maximization problem (3:18)
2. For each t % 0; given (wt ; rt ) the Örm allocation (ndt ; ktd ) solves the Örmsí
maximization problem (3:19):
3. Markets clear: for all t % 0

ndt = 1
ktd = kts
F (ktd ; ndt ) = ct + kt+1
s
& (1 & /)kts

Note that the notation implicitly uses that k0s = k0 : The characterization
of equilibrium allocations and prices is identical to that of the Arrow-Debreu
equilibrium.14 In particular, once we have solved for a Pareto-optimal allocation,
it can straightforwardly be decentralized as a SM equilibrium

3.3.4 Recursive Competitive Equilibrium

We have argued that in general the social planner problem needs to be solved
recursively. In models where the equilibrium is not Pareto-e¢cient and it is not
straightforward to solve in sequential or Arrow-Debreu formulation one often
proceeds as follows. First, one makes the dynamic decision problems (here only
1 4 Note that we have taken care of the need for a no Ponzi condition by requiring that

kt+1 & 0:
66CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

the household problem is dynamic) recursive and then deÖnes and computes a
Recursive Competitive Equilibrium. While this is not strictly necessary for the
neoclassical growth model (since we can obtain the equilibrium from the social
planner problem) we now want to show how to deÖne a recursive competitive
equilibrium in this economy.
A useful starting point is typically the sequential formulation of the problem.
The Örst question is what are the appropriate state variables for the household,
that is, what is the minimal information the household requires to solve its
dynamic decision problem from today on. Certainly the households own capital
stock at the beginning of the period, k: In addition, the household needs to
know w and r; which in turn are determined by the marginal products of the
aggregate production function, evaluated at the aggregate capital stock K and
labor supply N = 1. While it may seem redundant to distinguish k and K (they
are surely intimately related in equilibrium) it is absolutely crucial to do so in
order to avoid mistakes when solving the household recursive problem. Thus
the state variables of the household are given by (k; K) and the control variables
are todayís consumption c and the capital stock being brought into tomorrow,
k0 :
The Bellman equation characterizing the household problem is then given
by

v(k; K) = max fU (c) + (v(k 0 ; K 0 )g (3.20)

c;k0 -0
s.t.
0
c+k = w(K) + (1 + r(K) & /)k
K0 = H(K)

The last equation is called the aggregate law of motion: the (as of yet unknown)
function H describes how the aggregate capital stock evolves between today
and tomorrow, which the household needs to know, given that K 0 enters the
value function tomorrow. It now is clear why we need to distinguish k and K:
Without that distinction the household would perceive that by choosing k 0 it
would a§ect future prices w(k 0 ) and r(k 0 ): While this is true in equilibrium, by
our competitive behavior assumption it is exactly this ináuence the household
does not take into account when making decisions. To clarify this the (k; K)
notation is necessary. The solution of the household problem is given by a value
function v and two policy functions c = C(k; K) and k 0 = G(k; K):
On the Örm side we could certainly formulate the maximization problem and
deÖne optimal policy functions, but since there is nothing dynamic about the
Örm problem we will go ahead and use the Örmís Örst order conditions, evaluated
at the aggregate capital stock, to deÖne the wage and return functions

w(K) = Fl (K; 1) (3.21)

r(K) = Fk (K; 1): (3.22)

We then have the following deÖnition

3.4. MAPPING THE MODEL TO DATA: CALIBRATION 67

DeÖnition 14 A recursive competitive equilibrium is a value function v : R2+ !

R and policy functions C; G : R2+ ! R+ for the representative household,
pricing functions w; r : R+ ! R+ and an aggregate law of motion H : R+ !
R+ such that

1. Given the functions w; r and H; the value function v solves the Bellman
equation (3:20) and C; G are the associated policy functions.
2. The pricing functions satisfy (3:21)-(3:22):
3. Consistency
H(K) = G(K; K)

4. For all K 2 R+

c(K; K) + G(K; K) = F (K; 1) + (1 & /)K

The one condition that is not straightforward is the consistency condition

3. It simply states that the law of motion for the aggregate capital stock is
consistent with the household capital accumulation decision as the householdsí
individual asset holdings coincide with the aggregate capital stock.
As with the social planner problem we hope to prove that the recursive
formulation of the household problem is equivalent to the sequential formulation,
so that by solving the former (which is computationally feasible) we also have
solved the latter (which is the problem we are interested in, but can in general
not solve). But as before it requires a proof that asserting this equivalence is in
fact justiÖed. This equivalence result between the sequential and the recursive
problem is (again, as before) nothing else but the principle of optimality which
we discuss in generality in chapter 5.1.

3.4 Mapping the Model to Data: Calibration

So far we have studied the theoretical properties of the neoclassical growth
model and described how to solve for equilibria and socially e¢cient allocations
numerically, for given values of the parameters. In the Önal section of this
chapter we discuss a simple method to select (estimate) these parameters in
practice, so that the model can be used for a quantitative analysis of the real
world and for counterfactual analysis.
The method we describe is called calibration. The idea of this method is to
Örst choose a set of empirical facts that the model should match. The parameters
of the model are then selected so that the equilibrium allocations and prices
implied by the model matches these facts. Evidently the fact that the model
Öts these empirical observations cannot be treated as success of the model. To
argue that the model is useful requires the empirical evaluation of the model
predictions along dimensions the model was it not calibrated to.
Before choosing parameters we specify functional forms of the period utility
function and production function. We select a CRRA utility function to enable
68CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

the model to possess a balanced growth path and a Cobb-Douglas production

function for reasons clariÖed below.
c1$0 & 1
U (c) =
1&=
) *1$'
F (K; N ) = K ' (1 + g)t N
The model is then fully speciÖed by the technology parameters (0; /; g); the
demographics parameter n; and the preference parameters ((; =):
Since the neoclassical growth model is meant to explain long-run growth we
choose as empirical targets long run averages of particular variables in U.S. data
and choose the six parameters such that the long run equilibrium of the model
(the balanced growth path, BGP) matches these facts. In order to make this
procedure operational we Örst have to take a stance on how long a time period
lasts in the model. We choose the length of the period as one year.
The Örst set of parameters in the model can be chosen directly from the
data. In the model the long run population growth rate is (by assumption) n:
For U.S. the long run annual average population growth rate for the last century
is about 1:1%: Thus we choose n = 0:011: Similarly, in the BGP the growth rate
of output (GDP) per capita is given by g: In the data, per capita GDP has grown
at an average annual rate of about 1:8%: Consequently we select g = 0:018:
For the remaining parameters we use equilibrium relationships to inform
their choice. In equilibrium the wage equals the marginal product of labor,
) *1$'
wt = (1 & 0)Kt' Nt$' (1 + g)t
Thus the labor share of income is given by
wt Nt
= 1 & 0:
Yt
Note that this fact holds not only in the BGP, but in every period.15 In U.S.
the labor share of income has averaged about 2/3, and thus we choose 0 = 1=3:
In order to calibrate the depreciation rate / we use the relationship between
gross investment and the capital stock:
It = Kt+1 & (1 & /)Kt
= (1 + n)t+1 (1 + g)t+1 k~t+1 & (1 & /)(1 + n)t (1 + g)t k~t
= [(1 + n)(1 + g) & (1 & /)] (1 + n)t (1 + g)t k~
= [(1 + n)(1 + g) & (1 & /)] Kt
Thus the investment-capital ratio in the BGP is given by
It It =Yt
= = [(1 + n)(1 + g) & (1 & /)] - n + g + /
Kt Kt =Yt
1 5 Note that the only production function with CRTS that also has constant factor shares

(independent of the level of inputs) is the Cobb-Douglas production function which explains
both our choice as well as its frequent use. Also note that this production function has a
constant elasticity of substitution between capital and labor inputs, and that this elasticity
of substitution equals 1.
3.4. MAPPING THE MODEL TO DATA: CALIBRATION 69

In the data the share of investment in GDP averages about I=Y - 0:2 and
the capital-output ratio averages K=Y - 3: Using the selections g = 1:8% and
n = 1:1% from above then yields / - 4%:
Finally, to pin down the preference parameters we turn to the remaining key
equilibrium condition, the Euler equation for the representative household (see
(3:12)). With CRRA utility and growth it reads as
$0 ~ (~ $0
(1 + n)(1 + g) (~
ct ) = (1 + rt+1 & /)( ct+1 ) (3.23)

In the BGP

(1 + n)(1 + g) = (1 + r & /)((1 + g)1$0

1+n
((1 + g)$0 = (3.24)
1+r&/
Now we note that in the competitive equilibrium the rental rate on capital is
given by
) *1$' Yt
rt = 0Kt'$1 (1 + g)t Nt =0
Kt
We have already chosen 0 = 0:33 and targeted a capital-output ratio of K=Y =
3: The rental rate is then given by r = 0:33=3 = 0:11 and real interest rate by
r & / = 7%:
Given n = 1:1% and g = 1:8% and r & / = 7% equation (3:24) provides a
relationship between the preference parameters ( and =:

((1:018)$0 = 0:944:

First we note that in the absence of growth, g = 0; this relationship uniquely

pins down (; but contains no information about =: If g > 0, the parameters (
and = are only jointly determined. In models without risk the typical approach
to deal with this problem is to choose = based on information about the IES 01
outside the model.16
One can estimate an equation of the form (3:23); preferably after hav-
ing taken logs, with aggregate consumption data. Doing so Hall (1982) Önds
1
0 = 0:1: One could do the same using micro household data, which Attanasio
(and a large subsequent literature) has done with various coauthors in several
important papers (1993, 1995) and Önd a range 01 2 [0:3; 0:8]; and possibly
higher values for particular groups. Finally, Lucas argues that cross-country
di§erences in g are large, relative to cross-country di§erences in r & / (and n).
Thus, conditional on all countries sharing same preference parameters relation,
condition (3:24) suggests a value for the IES of 01 % 1: If we take = = 1 (log-
case), then ( = 0:961 (i.e. : = 3:9%). We summarize our preferred calibration
of the model in the following table.

1 6 In models with risk 4 is not only a measure of the IES, but also of risk aversion and return

(prices) of risky assets might provide additional information that helps to pin down 4 with
equilibrium relationships of the model.
70CHAPTER 3. THE NEOCLASSICAL GROWTH MODEL IN DISCRETE TIME

Calibration: Summary
Param. Value Target
g 1.8% g in Data
n 1.1% n in Data
0 0.33 wN
Y
I=Y
/ 4% K=Y
= 1 Outside Evid.
( 0.961 K=Y

The calibration approach to select parameter values is frequently used in

business cycle analysis. Once we have augmented the model with sources for
áuctuations (e.g. technology shocks) as we will do in chapter 6.4, the parameters
of the model are chosen such that the model replicates long run growth obser-
vations, as just discussed. It is then evaluated based on its ability to generate
business cycle áuctuations of plausible size and length, as well as the appropriate
co-movement of the economic variables of interest (e.g. productivity, output,
investment, consumption and hours worked).
Chapter 4

Mathematical Preliminaries

We want to study functional equations of the form

v(x) = max fF (x; y) + (v(y)g

y2,(x)

where r is the period return function (such as the utility function) and C is the
constraint set. Note that for the neoclassical growth model x = k; y = k 0 and
F (k; k 0 ) = U (f (k) & k 0 ) and C(k) = fk 0 2 R :0 $ k $ f (k)g
In order to so we deÖne the following operator T

(T v) (x) = max fF (x; y) + (v(y)g

y2,(x)

This operator T takes the function v as input and spits out a new function T v:
In this sense T is like a regular function, but it takes as inputs not scalars z 2 R
or vectors z 2 Rn ; but functions v from some subset of possible functions. A
solution to the functional equation is then a Öxed point of this operator, i.e. a
function v * such that
v* = T v*
We want to Önd out under what conditions the operator T has a Öxed point
(existence), under what conditions it is unique and under what conditions we
can start from an arbitrary function v and converge, by applying the operator T
1
repeatedly, to v * : More precisely, by deÖning the sequence of functions fvn gn=0
recursively by v0 = v and vn+1 = T vn we want to ask under what conditions
limn!1 vn = v * :
In order to make these questions (and the answers to them) precise we have
to deÖne the domain and range of the operator T and we have to deÖne what
we mean by lim : This requires the discussion of complete metric spaces. In the
next subsection I will Örst deÖne what a metric space is and then what makes
a metric space complete.
Then I will state and prove the contraction mapping theorem. This theorem
states that an operator T; deÖned on a metric space, has a unique Öxed point if

71
72 CHAPTER 4. MATHEMATICAL PRELIMINARIES

this operator T is a contraction (I will obviously Örst deÖne what a contraction

is). Furthermore it assures that from any starting guess v repeated applications
of the operator T will lead to its unique Öxed point.
Finally I will prove a theorem, Blackwellís theorem, that provides su¢cient
condition for an operator to be a contraction. We will use this theorem to prove
that for the neoclassical growth model the operator T is a contraction and hence
the functional equation of our interest has a unique solution.

4.1 Complete Metric Spaces

DeÖnition 15 A metric space is a set S and a function d : S 0 S ! R such
that for all x; y; z 2 S

1. d(x; y) % 0
2. d(x; y) = 0 if and only if x = y
3. d(x; y) = d(y; x)
4. d(x; z) $ d(x; y) + d(y; z)

The function d is called a metric and is used to measure the distance between
two elements in S: The second property is usually referred to as symmetry,
the third as triangle inequality (because of its geometric interpretation in R
Examples of metric spaces (S; d) include1

Example 16 S = R with metric d(x; y) = jx & yj

"
1 if x 6= y
Example 17 S = R with metric d(x; y) =
0 otherwise
1
Example 18 S = l1 = fx = fxgt=0 jxt 2 R; all t % 0 and supt jxt j < 1g with
metric d(x; y) = supt jxt & yt j

Example 19 Let X 1 Rl and S = C(X) be the set of all continuous and

bounded functions f : X ! R: DeÖne the metric d : C(X) 0 C(X) ! R as
d(f; g) = supx2X jf (x) & g(x)j: Then (S; d) is a metric space
1 A function f : X ! R is said to be bounded if there exists a constant K > 0 such that

jf (x)j < K for all x 2 X:

Let S be any subset of R: A number u 2 R is said to be an upper bound for the set S if
s ) u for all s 2 S: The supremum of S; sup(S) is the smallest upper bound of S:
Every set in R that has an upper bound has a supremum (imposed by the completeness
axiom). For sets that are unbounded above some people say that the supremum does not
exist, others write sup(S) = 1: We will follow the second convention.
Also note that sup(S) = max(S); whenever the latter exists. What the sup buys us is that
it always exists even when the max does not. A simle example
# $
1
S= # :n2N
n
For this example sup(S) = 0 whereas max(S) does not exist.
4.2. CONVERGENCE OF SEQUENCES 73

A few remarks: the space l1 (with corresponding norm) will be important

when we discuss the welfare theorems as naturally consumption allocations for
models with inÖnitely lived consumers are inÖnite sequences. Why we want to
require these sequences to be bounded will become clearer later.
The space C(X) with norm d as deÖned above will be used immediately as
we will deÖne the domain of our operator T to be C(X); i.e. T uses as inputs
continuous and bounded functions.
Let us prove that some of the examples are indeed metric spaces. For the
Örst example the result is trivial.
"
1 if x 6= y
Claim 20 S = R with metric d(x; y) = is a metric space
0 otherwise

Proof. We have to show that the function d satisÖes all three properties in
the deÖnition. The Örst three properties are obvious. For the forth property: if
x = z; the result follows immediately. So suppose x 6= z: Then d(x; z) = 1: But
then either y 6= x or y 6= z (or both), so that d(x; y) + d(y; z) % 1

Claim 21 l1 together with the sup-metric is a metric space

Proof. Take arbitrary x; y; z 2 l1 : From the basic triangle inequality on R

we have that jxt & yt j $ jxt j+jyt j: Hence, since supt jxt j < 1 and supt jyt j < 1;
we have that supt jxt & yt j < 1: Property 1 is obvious. If x = y (i.e. xt = yt for
all t), then jxt & yt j = 0 for all t; hence supt jxt & yt j = 0: Suppose x 6= y: Then
there exists T such that xT 6= yT ; hence jxT & yT j > 0; hence supt jxt & yt j > 0
Property 3 is obvious since jxt & yt j = jyt & xt j; all t: Finally for property 4.
we note that for all t

jxt & zt j $ jxt & yt j + jyt & zt j

Since this is true for all t; we can apply the sup to both sides to obtain the
result (note that the sup on both sides is Önite).

Claim 22 C(X) together with the sup-norm is a metric space

Proof. Take arbitrary f; g 2 C(X): f = g means that f (x) = g(x) for all
x 2 X: Since f; g are bounded, supx2X jf (x)j < 1 and supx2X jf (x)j < 1; so
supx2X jf (x) & g(x)j < 1: Property 1. through 3. are obvious and for property
4. we use the same argument as before, including the fact that f; g 2 C(X)
implies that supx2X jf (x) & g(x)j < 1:

4.2 Convergence of Sequences

The next deÖnition will make precise the meaning of statements of the form
limn!1 vn = v * : For an arbitrary metric space (S; d) we have the following
deÖnition.
74 CHAPTER 4. MATHEMATICAL PRELIMINARIES

DeÖnition 23 A sequence fxn g1 n=0 with xn 2 S for all n is said to converge

to x 2 S; if for every " > 0 there exists a N" 2 N such that d(xn ; x) < " for all
n % N" : In this case we write limn!1 xn = x:

This deÖnition basically says that a sequence fxn g1

n=0 converges to a point
if we, for every distance " > 0 we can Önd an index N" so that the sequence of
xn is not more than " away from x after the N" element of the sequence. Also
note that, in order to verify that a sequence converges, it is usually necessary
to know the x to which it converges in order to apply the deÖnition directly.
1
Example 24 Take S = R with d(x; y) = jx & yj: DeÖne fxn g1 n=0 by xn = n :
Then limn!1 xn = 0: This is straightforward to prove, using the deÖnition.
Take any " > 0: Then d(xn ; 0) = n1 : By taking N" = 2" we have that for n % N" ;
d(xn ; 0) = n1 $ N1" = 2" < " (if N" = 2" is not an integer, take the next biggest
integer).

For easy examples of sequences it is no problem to guess the limit. Note that
the limit of a sequence, if it exists, is always unique (you should prove this for
yourself). For not so easy examples this may not work. There is an alternative
criterion of convergence, due to Cauchy.2

DeÖnition 25 A sequence fxn g1 n=0 with xn 2 S for all n is said to be a Cauchy

sequence if for each " > 0 there exists a N" 2 N such that d(xn ; xm ) < " for all
n; m % N"

Hence a sequence fxn g1

n=0 is a Cauchy sequence if for every distance " > 0
we can Önd an index N" so that the elements of the sequence do not di§er by
more than by ":
1
Example 26 Take S = R with d(x; y) = jx & yj: DeÖne fxn g1 n=0 by xn = n :
This sequence is a Cauchy sequence. Again this is straightforward to prove. Fix
" > 0 and take any n; m 2 N: Without loss of generality assume that m > n:
Then d(xn ; xm ) = n1 & m
1
< n1 : Pick N" = 2" and we have that for n; m % N" ;
1 1 "
d(xn ; 0) < n $ N" = 2 < ": Hence the sequence is a Cauchy sequence.

So it turns out that the sequence in the last example both converges and is a
Cauchy sequence. This is not an accident. In fact, one can prove the following

Theorem 27 Suppose that (S; d) is a metric space and that the sequence fxn g1
n=0
converges to x 2 S: Then the sequence fxn g1
n=0 is a Cauchy sequence.

"
Proof. Since fxn g1 n=0 converges to x; there exists M 2 such that d(xn ; x) < 2
"

for all n % M 2 : Therefore if n; m % N" we have that d(xn ; xm ) $ d(xn ; x) +

"

d(xm ; x) < 2" + 2" = " (by the deÖnition of convergence and the triangle inequal-
ity). But then for any " > 0; pick N" = M 2" and it follows that for all n; m % N"
we have d(xn ; xm ) < "
2 Augustin-Louis Cauchy (1789-1857) was the founder of modern analysis. He wrote about

800 (!) mathematical papers during his scientiÖc life.

4.2. CONVERGENCE OF SEQUENCES 75
"
1 if x 6= y
Example 28 Take S = R with d(x; y) = : DeÖne fxn g1n=0 by
0 otherwise
xn = n1 . Obviously d(xn ; xm ) = 1 for all n; m 2 N: Therefore the sequence is
not a Cauchy sequence. It then follows from the preceding theorem (by taking
the contrapositive) that the sequence cannot converge. This example shows that,
whenever discussing a metric space, it is absolutely crucial to specify the metric.
This theorem tells us that every convergent sequence is a Cauchy sequence.
The reverse does not always hold, but it is such an important property that
when it holds, it is given a particular name.
DeÖnition 29 A metric space (S; d) is complete if every Cauchy sequence fxn g1
n=0
with xn 2 S for all n converges to some x 2 S:
Note that the deÖnition requires that the limit x has to lie within S: We are
interested in complete metric spaces since the Contraction Mapping Theorem
deals with operators T : S ! S; where (S; d) is required to be a complete metric
space. Also note that there are important examples of complete metric spaces,
but other examples where a metric space is not complete (and for which the
Contraction Mapping Theorem does not apply).
Example 30 Let S be the set of all continuous, strictly decreasing functions
on [1; 2] and let the metric on S be deÖned as d(f; g) = supx2[1;2] jf (x) & g(x)j:
I claim that (S; d) is not a complete metric space. This can be proved by an
example of a sequence of functions ffn g1
n=0 that is a Cauchy sequence, but does
1
not converge within S: DeÖne fn : [0; 1] ! R by fn (x) = nx : Obviously all fn
are continuous and strictly decreasing on [1; 2]; hence fn 2 S for all n: Let us
Örst prove that this sequence is a Cauchy sequence. Fix " > 0 and take N" = 2" :
Suppose that m; n % N" and without loss of generality assume that m > n: Then
K K
K 1 1 KK
d(fn ; fm ) = sup K K &
x2[1;2] nx mx K
1 1
= sup &
x2[1;2] nx mx
m&n
= sup
x2[1;2] mnx
n
m&n 1& m
= =
mn n
1 1 "
$ $ = <"
n N" 2
Hence the sequence is a Cauchy sequence. But since for all x 2 [1; 2]; limn!1 fn (x) =
0; the sequence converges to the function f; deÖned as f (x) = 0; for all x 2 [1; 2]:
But obviously, since f is not strictly decreasing, f 2= S: Hence (S; d) is not a
complete metric space. Note that if we choose S to be the set of all continu-
ous and decreasing (or increasing) functions on R; then S; together with the
sup-norm, is a complete metric space.
76 CHAPTER 4. MATHEMATICAL PRELIMINARIES
qP
L
Example 31 Let S = RL and d(x; y) = L l=1 jxl & yl jL : (S; d) is a complete
metric space. This is easily proved by proving the following three lemmata (which
is left to the reader).

1. Every Cauchy sequence fxn g1 L

n=0 in R is bounded

2. Every bounded sequence fxn g1 L 1

n=0 in R has a subsequence fxni gi=0 con-
L
verging to some x 2 R (Bolzano-Weierstrass Theorem)
3. For every Cauchy sequence fxn g1 L 1
n=0 in R ; if a subsequence fxni gi=0
L 1
converges to x 2 R ; then the entire sequence fxn gn=0 converges to x 2
RL :

Example 32 This last example is very important for the applications we are
interested in. Let X 1 RL and C(X) be the set of all bounded continuous
functions f : X ! R with d being the sup-norm. Then (C(X); d) is a complete
metric space.

Proof. (This follows SLP, pp. 48) We already proved that (C(X); d) is a
metric space. Now we want to prove that this space is complete. Let ffn g1 n=0
be an arbitrary sequence of functions in C(X) which is Cauchy. We need to
establish the existence of a function f 2 C(X) such that for all " > 0 there
exists N" satisfying supx2X jfn (x) & f (x)j < " for all n % N" :
We will proceed in three steps: a) Önd a candidate for f; b) establish that the
sequence ffn g1n=0 converges to f in the sup-norm and c) show that f 2 C(X):

1. Since ffn g1n=0 is Cauchy, for each " > 0 there exists M" such that supx2X jfn (x)&
fm (x)j < " for all n; m % M" : Now Öx a particular x 2 X: Then ffn (x)g1n=0
is just a sequence of numbers. Now

jfn (x) & fm (x)j $ sup jfn (y) & fm (y)j < "
y2X

Hence the sequence of numbers ffn (x)g1 n=0 is a Cauchy sequence in R:

Since R is a complete metric space, ffn (x)g1 n=0 converges to some number,
call it f (x): By repeating this argument for all x 2 X we derive our
candidate function f ; it is the pointwise limit of the sequence of functions
ffn g1
n=0 :

2. Now we want to show that ffn g1 n=0 converges to f as constructed above.

Hence we want to argue that d(fn ; f ) goes to zero as n goes to inÖnity.
Fix " > 0: Since ffn g1 n=0 is Cauchy, it follows that there exists N" such
that d(fn ; fm ) < " for all n; m % N" : Now Öx x 2 X: For any m % n % N"
we have (remember that the norm is the sup-norm)

jfn (x) & f (x)j $ jfn (x) & fm (x)j + jfm (x) & f (x)j
$ d(fn ; fm ) + jfm (x) & f (x)j
"
$ + jfm (x) & f (x)j
2
4.3. THE CONTRACTION MAPPING THEOREM 77

But since ffn g1

n=0 converges to f pointwise, we have that jfm (x)&f (x)j <
"
2 for all m % N " (x), where N" (x) is a number that may (and in general
does) depend on x. But then, since x 2 X was arbitrary, jfn (x)&f (x)j < "
for all n % N" (the key is that this N" does not depend on x). Therefore
supx2X jfn (x) & f (x)j = d(fn ; f ) $ " and hence the sequence ffn g1 n=0
converges to f:

3. Finally we want to show that f 2 C(X); i.e. that f is bounded and

continuous. Since ffn g1 n=0 lies in C(X); all fn are bounded, i.e. there is
a sequence of numbers fKn g1 n=0 such that supx2X jfn (x)j $ Kn : But by
the triangle inequality, for arbitrary n

sup jf (x)j = sup jf (x) & fn (x) + fn (x)j

x2X x2X
$ sup jf (x) & fn (x)j + sup jfn (x)j
x2X x2X
$ sup jf (x) & fn (x)j + Kn
x2X

But since ffn g1n=0 converges to f; there exists N" such that supx2X jf (x)&
fn (x)j < " for all n % N" : Fix an " and take K = KN" + 2": It is obvious
that supx2X jf (x)j $ K: Hence f is bounded. Finally we qprove continuity
L L
PL L
of f: Let us choose the metric on R to be jjx & yjj = l=1 jxl & yl j .
We need to show that for every " > 0 and every x 2 X there exists a
/("; x) > 0 such that if jjx & yjj < /("; x) then jf (x) & f (y)j < ", for
all x; y 2 X: Fix " and x: Pick a k large enough so that d(fk ; f ) < 3"
(which is possible as ffn g1 n=0 converges to f ): Choose /("; x) > 0 such
that jjx & yjj < /("; x) implies jfk (x) & fk (y)j < 3" : Since all fn 2 C(X);
fk is continuous and hence such a /("; x) > 0 exists. Now

jf (x) & f (y)j $ jf (x) & fk (x)j + jfk (x) & fk (y)j + jfk (y) & f (y)j
$ d(f; fk ) + jfk (x) & fk (y)j + d(fk ; f )
" " "
$ + + ="
3 3 3

4.3 The Contraction Mapping Theorem

Now we are ready to state the theorem that will give us the existence and
uniqueness of a Öxed point of the operator T; i.e. existence and uniqueness of
a function v * satisfying v * = T v * : Let (S; d) be a metric space. Just to clarify,
an operator T (or a mapping) is just a function that maps elements of S into
some other space. The operator that we are interested in maps functions into
functions, but the results in this section apply to any metric space. We start
with a deÖnition of what a contraction mapping is.
78 CHAPTER 4. MATHEMATICAL PRELIMINARIES

DeÖnition 33 Let (S; d) be a metric space and T : S ! S be a function map-

ping S into itself. The function T is a contraction mapping if there exists a
number ( 2 (0; 1) satisfying

d(T x; T y) $ (d(x; y) for all x; y 2 S

The number ( is called the modulus of the contraction mapping

A geometric example of a contraction mapping for S = [0; 1]; d(x; y) = jx&yj

is contained in SLP, p. 50. Note that a function that is a contraction mapping
is automatically a continuous function, as the next lemma shows

Lemma 34 Let (S; d) be a metric space and T : S ! S be a function mapping

S into itself. If T is a contraction mapping, then T is continuous.

Proof. Remember from the deÖnition of continuity we have to show that

for all s0 2 S and all " > 0 there exists a /("; s0 ) such that whenever s 2
S; d(s; s0 ) < /("; s0 ); then d(T s; T s0 ) < ": Fix an arbitrary s0 2 S and " > 0
and pick /("; s0 ) = ": Then

d(T s; T s0 ) $ (d(s; s0 ) $ (/("; s0 ) = (" < "

We now can state and prove the contraction mapping theorem. Let by
vn = T n v0 2 S denote the element in S that is obtained by applying the
operator T n-times to v0 ; i.e. the n-th element in the sequence starting with an
arbitrary v0 and deÖned recursively by vn = T vn$1 = T (T vn$2 ) = * * * = T n v0 :
Then we have

Theorem 35 Let (S; d) be a complete metric space and suppose that T : S ! S

is a contraction mapping with modulus (: Then a) the operator T has exactly
one Öxed point v * 2 S and b) for any v0 2 S; and any n 2 N we have

d(T n v0 ; v * ) $ ( n d(v0 ; v * )

A few remarks before the proof. Part a) of the theorem tells us that there
is a v * 2 S satisfying v * = T v * and that there is only one such v * 2 S: Part
b) asserts that from any starting guess v0 ; the sequence fvn g1 n=0 as deÖned
recursively above converges to v * at a geometric rate of (: This last part is
important for computational purposes as it makes sure that we, by repeatedly
applying T to any (as crazy as can be) initial guess v0 2 S, will eventually
converge to the unique Öxed point and it gives us a lower bound on the speed
of convergence. But now to the proof.
Proof. First we prove part a) Start with an arbitrary v0 : As our candidate
for a Öxed point we take v * = limn!1 vn : We Örst have to establish that the
sequence fvn g1 *
n=0 in fact converges to a function v : We then have to show that
this v * satisÖes v * = T v * and we then have to show that there is no other v^
that also satisÖes v^ = T v^
4.3. THE CONTRACTION MAPPING THEOREM 79

Since by assumption T is a contraction

d(vn+1 ; vn ) = d(T vn ; T vn$1 ) $ (d(vn ; vn$1 )

= (d(T vn$1 ; T vn$2 ) $ ( 2 d(vn$1 ; vn$2 )
= * * * = ( n d(v1 ; v0 )

where we used the way the sequence fvn g1n=0 was constructed, i.e. the fact that
vn+1 = T vn : For any m > n it then follows from the triangle inequality that

d(vm ; vn ) $ d(vm ; vm$1 ) + d(vm$1 ; vn )

$ d(vm ; vm$1 ) + d(vm$1 ; vm$2 ) + * * * + d(vn+1 ; vn )
$ ( m d(v1 ; v0 ) + ( m$1 d(v1 ; v0 ) + * * * ( n d(v1 ; v0 )
# $
= ( n ( m$n$1 + * * * + ( + 1 d(v1 ; v0 )
(n
$ d(v1 ; v0 )
1&(
By making n large we can make d(vm ; vn ) as small as we want. Hence the
sequence fvn g1
n=0 is a Cauchy sequence. Since (S; d) is a complete metric space,
the sequence converges in S and therefore v * = limn!1 vn is well-deÖned.
Now we establish that v * is a Öxed point of T; i.e. we need to show that
T v = v * : But
*
' (
T v * = T lim vn = lim T (vn ) = lim vn+1 = v *
n!1 n!1 n!1

Note that the fact that T (limn!1 vn ) = limn!1 T (vn ) follows from the conti-
nuity of T:3
Now we want to prove that the Öxed point of T is unique. Suppose there
exists another v^ 2 S such that v^ = T v^ and v^ 6= v * : Then there exists c > 0 such
that d(^v ; v * ) = a: But

v ; v * ) = d(T v^; T v * ) $ (d(^

0 < a = d(^ v ; v * ) = (a

a contradiction. Here the second equality follows from the fact that we assumed
that both v^; v * are Öxed points of T and the inequality follows from the fact
that T is a contraction.
We prove part b) by induction. For n = 0 (using the convention that T 0 v =
v) the claim automatically holds. Now suppose that

d(T k v0 ; v * ) $ ( k d(v0 ; v * )

We want to prove that

d(T k+1 v0 ; v * ) $ ( k+1 d(v0 ; v * )

3 Almost by deÖnition. Since T is continuous for every " > 0 there exists a A(") such that

d(vn #v & ) < A(") implies d(T (vn )#T (v & )) < ": Hence the sequence fT (vn )g1
n=0 converges and
limn!1 T (vn ) is well-deÖned. We showed that limn!1 vn = v & : Hence both limn!1 T (vn )
and limn!1 vn are well-deÖned. Then obviously limn!1 T (vn ) = T (v & ) = T (limn!1 vn ):
80 CHAPTER 4. MATHEMATICAL PRELIMINARIES

But
# $
d(T k+1 v0 ; v * ) = d(T T k v0 ; T v * ) $ (d(T k v0 ; v * ) $ ( k+1 d(v0 ; v * )

where the Örst inequality follows from the fact that T is a contraction and the
second follows from the induction hypothesis.
The following corollary, which I will state without proof, will be very useful
in establishing properties (such as continuity, monotonicity, concavity) of the
unique Öxed point v * and the associated policy correspondence.

Corollary 36 Let (S; :) be a complete metric space, and let T : S ! S be a

contraction mapping with Öxed point v 2 S: If S 0 is a closed subset of S and
T (S 0 ) 1 S 0 ; then v 2 S 0 : If in addition T (S 0 ) 1 S 00 1 S 0 ; then v 2 S 00 :

The Contraction Theorem is is extremely useful in order to establish that our

functional equation of interest has a unique Öxed point. It is, however, not very
operational as long as we donít know how to determine whether a given operator
is a contraction mapping. There is some good news, however. Blackwell, in 1965
provided su¢cient conditions for an operator to be a contraction mapping. It
turns out that these conditions can be easily checked in a lot of applications.
Since they are only su¢cient however, failure of these conditions does not imply
that the operator is not a contraction. In these cases we just have to look
somewhere else. Here is Blackwellís theorem.

Theorem 37 Let X 1 RL and B(X) be the space of bounded functions f :

X ! R with the d being the sup-norm. Let T : B(X) ! B(X) be an operator
satisfying

1. Monotonicity: If f; g 2 B(X) are such that f (x) $ g(x) for all x 2 X;

then (T f ) (x) $ (T g) (x) for all x 2 X:
2. Discounting: Let the function f + a; for f 2 B(X) and a 2 R+ be deÖned
by (f + a)(x) = f (x) + a (i.e. for all x the number a is added to f (x)).
There exists ( 2 (0; 1) such that for all f 2 B(X); a % 0 and all x 2 X

[T (f + a)](x) $ [T f ](x) + (a

If these two conditions are satisÖed, then the operator T is a contraction

with modulus (:

Proof. In terms of notation, if f; g 2 B(X) are such that f (x) $ g(x) for
all x 2 X; then we write f $ g: We want to show that if the operator T satisÖes
conditions 1. and 2. then there exists ( 2 (0; 1) such that for all f; g 2 B(X)
we have that d(T f; T g) $ (d(f; g):
Fix x 2 X: Then f (x) & g(x) $ supy2X jf (y) & g(y)j: But this is true for all
x 2 X: So using our notation we have that f $ g + d(f; g) (which means that for
any value of x 2 X; adding the constant d(f; g) to g(x) gives something bigger
than f (x):
4.3. THE CONTRACTION MAPPING THEOREM 81

But from f $ g + d(f; g) it follows by monotonicity that

Tf $ T [g + d(f; g)]
$ T g + (d(f; g)

where the last inequality comes from discounting. Hence we have

T f & T g $ (d(f; g)

Switching the roles of f and g around we get

&(T f & T g) $ (d(g; f ) = (d(f; g)

(by symmetry of the metric). Combining yields

(T f ) (x) & (T g) (x) $ (d(f; g) for all x 2 X

(T g) (x) & (T f ) (x) $ (d(f; g) for all x 2 X

Therefore
sup j(T f ) (x) & (T g) (x)j = d(T f; T g) $ (d(f; g)
x2X

and T is a contraction mapping with modulus (:

Note that do not require the functions in B(X) to be continuous. It is
straightforward to prove that (B(X); d) is a complete metric space once we
proved that (B(X); d) is a complete metric space. Also note that we could
restrict ourselves to continuous and bounded functions and Blackwellís theorem
obviously applies. Note however that Blackwells theorem requires the metric
space to be a space of functions, so we lose generality as compared to the
Contraction mapping theorem (which is valid for any complete metric space).
But for our purposes it is key that, once Blackwellís conditions are veriÖed we
can invoke the CMT to argue that our functional equation of interest has a
unique solution that can be obtained by repeated iterations on the operator T:
We can state an alternative version of Blackwellís theorem

Theorem 38 Let X 1 RL and B(X) be the space of bounded functions f :

X ! R with the d being the sup-norm. Let T : B(X) ! B(X) be an operator
satisfying

1. Monotonicity: If f; g 2 B(X) are such that f (x) $ g(x) for all x 2 X;

then (T f ) (x) % (T g) (x) for all x 2 X:
2. Discounting: Let the function f + a; for f 2 B(X) and a 2 R+ be deÖned
by (f + a)(x) = f (x) + a (i.e. for all x the number a is added to f (x)).
There exists ( 2 (0; 1) such that for all f 2 B(X); a % 0 and all x 2 X

[T (f & a)](x) $ [T f ](x) + (a

If these two conditions are satisÖed, then the operator T is a contraction

with modulus (:
82 CHAPTER 4. MATHEMATICAL PRELIMINARIES

The proof is identical to the Örst theorem and hence omitted.

As an application of the mathematical structure we developed let us look
back at the neoclassical growth model. The operator T corresponding to our
functional equation was

T v(k) = max fU (f (k) & k 0 ) + (v(k 0 )g

0+k0 +f (k)

DeÖne as our metric space (B[0; 1); d) the space of bounded functions on [0; 1)
with d being the sup-norm. We want to argue that this operator has a unique
Öxed point and we want to apply Blackwellís theorem and the CMT. So let us
verify that all the hypotheses for Blackwellís theorem are satisÖed.

1. First we have to verify that the operator T maps B[0; 1) into itself (this
is very often forgotten). So if we take v to be bounded, since we assumed
that U is bounded, then T v is bounded. Note that you may be in big
trouble here if U is not bounded.4

2. How about monotonicity. It is obvious that this is satisÖed. Suppose

v $ w: Let by gv (k) denote an optimal policy (need not be unique) corre-
sponding to v: Then for all k 2 (0; 1)

T v(k) = U (f (k) & gv (k)) + (v(gv (k))

$ U (f (k) & gv (k)) + (w(gv (k))
$ max
0
fU (f (k) & k 0 ) + (w(k 0 )g
0+k +f (k)

= T w(k)

Even by applying the policy gv (k) (which need not be optimal for the
situation in which the value function is w) gives higher T w(k) than T v(k):
Choosing the policy for w optimally does only improve the value (T v) (k):

3. Discounting. This also straightforward

T (v + a)(k) = max fU (f (k) & k 0 ) + ((v(k 0 ) + a)g

0+k0 +f (k)

= max fU (f (k) & k 0 ) + (v(k 0 )g + (a

0+k0 +f (k)

= T v(k) + (a
4 Somewhat surprisingly, in many applications the problem is that u is not bounded below;

unboundedness from above is sometimes easy to deal with.

We made the assumption that f 2 C 2 f 0 > 0; f 00 < 0; limk&0 f 0 (k) = 1 and
limk!1 f 0 (k) = 1 # A: Hence there exists a unique k ^ such that f (k)
^ = k:
^ Hence for all
kt > k^ we have kt+1 ) f (kt ) < kt : Therefore we can e§ectively restrict ourselves to capital
^ Hence, even if u is not bounded above we have that for all
stocks in the set [0; max(k0 ; k)]:
^ < 1; and hence by sticking a function
feasible paths policies u(f (k) # k0 ) ) u(f (max(k0 ; k))
v into the operator that is bounded above, we get a T v that is bounded above. Lack of
boundedness from below is a much harder problem in general.
4.4. THE THEOREM OF THE MAXIMUM 83

Hence the neoclassical growth model with bounded utility satisÖes the Su¢-
cient conditions for a contraction and there is a unique Öxed point to the func-
tional equation that can be computed from any starting guess v0 be repeated
application of the T -operator.
One can also prove some theoretical properties of the Howard improvement
algorithm using the Contraction Mapping Theorem and Blackwellís conditions.
Even though we could state the results in much generality, we will conÖne our
discussion to the neoclassical growth model. Remember that the Howard im-
provement algorithm iterates on feasible policies [TBC]

4.4 The Theorem of the Maximum

An important theorem is the theorem of the maximum. It will help us to
establish that, if we stick a continuous function f into our operator T; the
resulting function T f will also be continuous and the optimal policy function
will be continuous in an appropriate sense.
We are interested in problems of the form

h(x) = max ff (x; y)g

y2,(x)

The function h gives the value of the maximization problem, conditional on the
state x: We deÖne

G(x) = fy 2 C(x) : f (x; y) = h(x)g

Hence G is the set of all choices y that attain the maximum of f , given the state
x; i.e. G(x) is the set of argmaxíes. Note that G(x) need not be single-valued.
In the example that we study the function f will consist of the sum of the
current return function r and the continuation value v and the constraint set
describes the resource constraint. The theorem of the maximum is also widely
used in microeconomics. There, most frequently x consists of prices and income,
f is the (static) utility function, the function h is the indirect utility function, C
is the budget set and G is the set of consumption bundles that maximize utility
at x = (p; m):
Before stating the theorem we need a few deÖnitions. Let X; Y be arbitrary
sets (in what follows we will be mostly concerned with the situations in which
X and Y are subsets of Euclidean spaces. A correspondence C : X ) Y maps
each element x 2 X into a subset C(x) of Y: Hence the image of the point x
under C may consist of more than one point (in contrast to a function, in which
the image of x always consists of a singleton).

DeÖnition 39 A compact-valued correspondence C : X ) Y is upper-hemicontinuous

at a point x if C(x) 6= ? and if for all sequences fxn g in X converging to some
x 2 X and all sequences fyn g in Y such that yn 2 C(xn ) for all n; there exists a
convergent subsequence of fyn g that converges to some y 2 C(x): A correspon-
dence is upper-hemicontinuous if it is upper-hemicontinuous at all x 2 X:
84 CHAPTER 4. MATHEMATICAL PRELIMINARIES

A few remarks: by talking about convergence we have implicitly assumed

that X and Y (together with corresponding metrics) are metric spaces. Also,
a correspondence is compact-valued, if for all x 2 X; C(x) is a compact set.
Also this deÖnition requires C to be compact-valued. With this additional re-
quirement the deÖnition of upper hemicontinuity actually corresponds to the
deÖnition of a correspondence having a closed graph. See, e.g. Mas-Colell et al.
p. 949-950 for details.

DeÖnition 40 A correspondence C : X ) Y is lower-hemicontinuous at a

point x if C(x) 6= ? and if for every y 2 C(x) and every sequence fxn g in X
converging to x 2 X there exists N % 1 and a sequence fyn g in Y converging to
y such that yn 2 C(xn ) for all n % N: A correspondence is lower-hemicontinuous
if it is lower-hemicontinuous at all x 2 X:

DeÖnition 41 A correspondence C : X ) Y is continuous if it is both upper-

hemicontinuous and lower-hemicontinuous.

Note that a single-valued correspondence (i.e. a function) that is upper-

hemicontinuous is continuous. Now we can state the theorem of the maximum.

Theorem 42 Let X 1 RL and Y 1 RM ; let f : X 0 Y ! R be a contin-

uous function, and let C : X ) Y be a compact-valued and continuous cor-
respondence. Then h : X ! R is continuous and G : X ! Y is nonempty,
compact-valued and upper-hemicontinuous.

The proof is somewhat tedious and omitted here (you probably have done
it in micro anyway).
Chapter 5

Dynamic Programming

5.1 The Principle of Optimality

In the last section we showed that under certain conditions, the functional equa-
tion (F E)
v(x) = sup fF (x; y) + (v(y)g
y2,(x)

has a unique solution which is approached from any initial guess v0 at geometric
speed. What we were really interested in, however, was a problem of sequential
form (SP )
1
X
w(x0 ) = sup ( t F (xt ; xt+1 )
fxt+1 g1
t=0 t=0
s:t: xt+1 2 C(xt )
x0 2 X given

Note that I replaced max with sup since we have not made any assumptions
so far that would guarantee that the maximum in either the functional equation
or the sequential problem exists. In this section we want to Önd out under what
conditions the functions v and w are equal and under what conditions optimal
sequential policies fxt+1 g1 t=0 are equivalent to optimal policies y = g(x) from
the recursive problem, i.e. under what conditions the principle of optimality
holds. It turns out that these conditions are very mild.
In this section I will try to state the main results and make clear what they
mean; I will not prove the results. The interested reader is invited to consult
Stokey and Lucas or Bertsekas. Unfortunately, to make our results precise
additional notation is needed. Let X be the set of possible values that the state
x can take. X may be a subset of a Euclidean space, a set of functions or
something else; we need not be more speciÖc at this point. The correspondence
C : X ) X describes the feasible set of next periodís states y; given that todayís

85
86 CHAPTER 5. DYNAMIC PROGRAMMING

state is x: The graph of C, A is deÖned as

A = f(x; y) 2 X 0 X : y 2 C(x)g

The period return function F : A ! R maps the set of all feasible combinations
of todayís and tomorrowís state into the reals. So the fundamentals of our
analysis are (X; F; (; C): For the neoclassical growth model F and ( describe
preferences and X; C describe the technology.
We call any sequence of states fxt g1t=0 a plan. For a given initial condition
x0 ; the set of feasible plans E(x0 ) from x0 is deÖned as

E(x0 ) = ffxt g1
t=1 : xt+1 2 C(xt )g

Hence E(x0 ) is the set of sequences that, for a given initial condition, satisfy all
the feasibility constraints of the economy. We will denote by x 8 a generic element
of E(x0 ): The two assumptions that we need for the principle of optimality are
basically that for any initial condition x0 the social planner (or whoever solves
the problem) has at least one feasible plan and that the total return (the total
utility, say) from all feasible plans can be evaluated. Thatís it. More precisely
we have
Assumption 1: C(x) is nonempty for all x 2 X
Assumption 2: For all initial conditions x0 and all feasible plans x 8 2 E(x0 )
n
X
lim ( t F (xt ; xt+1 )
n!1
t=0

exists (although it may be +1 or &1).

Assumption 1 does not require much discussion: we donít want to deal
with an optimization problem in which the decision maker (at least for some
initial conditions) canít do anything. Assumption 2 is more subtle. There are
various ways to verify that assumption 2 is satisÖed, i.e. various sets of su¢cient
conditions for assumption 2 to hold. Assumption 2 holds if

1. F is bounded and ( 2 (0; 1): Note " that boundedness of F is not enough.
1 if t even
Suppose ( = 1 and F (xt ; xt+1 ) = Obviously F is bounded,
&1 if t odd
"
Pn 1 if n even
but since t=0 ( t F (xt ; xt+1 ) = ; the limit in assumption 2
0 if n odd
" n
Pn 1 & ( 2 + ( n if n even
does not exist. If ( 2 (0; 1) then t=0 ( t F (xt ; xt+1 ) = n
1 & ( 2 if n odd
Pn t
and therefore limn!1 t=0 ( F (xt ; xt+1 ) exists and equals 1: In general
the joint assumption
Pn that F is bounded and ( 2 (0; 1) implies that the
sequence yn = t=0 ( t F (xt ; xt+1 ) is Cauchy and hence converges. In this
case lim yn = y is obviously Önite.

2. DeÖne F + (x; y) = maxf0; F (x; y)g and F $ (x; y) = maxf0; &F (x; y)g:
5.1. THE PRINCIPLE OF OPTIMALITY 87

Then assumption 2 is satisÖed if for all x0 2 X; all x

8 2 E(x0 ); either
n
X
lim ( t F + (xt ; xt+1 ) < +1 or
n!1
t=0
n
X
lim ( t F $ (xt ; xt+1 ) < +1
n!1
t=0

or both. For example, if ( 2 (0; 1) and F is bounded above, then the Örst
condition is satisÖed, if ( 2 (0; 1) and F is bounded below then the second
condition is satisÖed.

3. Assumption 2 is satisÖed if for every x0 2 X and every x 8 2 E(x0 ) there

are numbers (possibly dependent on x0 ; x 8) ] 2 (0; %1 ) and 0 < c < +1
such that for all t
F (xt ; xt+1 ) $ c]t
Hence F need not be bounded in any direction for assumption 2 to be
satisÖed. As long as the returns from the sequences do not grow too fast
(at rate higher than %1 ) we are still Öne .

I would conclude that assumption 2 is rather weak (I canít think of any

interesting economic example where assumption1 is violated, but let me know
if you come up with one). A Önal piece of notation and we are ready to state
some theorems.
DeÖne the sequence of functions un : E(x0 ) ! R by
n
X
un (8
x) = ( t F (xt ; xt+1 )
t=0

For each feasible plan un gives the total discounted return (utility) up until
$
period n: If assumption 2 is satisÖed, then the function u : E(x0 ) ! R
n
X
u(8
x) = lim ( t F (xt ; xt+1 )
n!1
t=0

is also well-deÖned, since under assumption 2 the limit exists. The range of
$ the extended real line, i.e. R
u is R; $ = R [ f&1; +1g since we allowed the
limit to be plus or minus inÖnity. From the deÖnition of u it follows that under
assumption 2
w(x0 ) = sup u(8 x)
/20(x0 )
x

Note that by construction, whenever w exists, it is unique (since the supremum

of a set is always unique). Also note that the way I have deÖned w above only
makes sense under assumption 1. and 2., otherwise w is not well-deÖned.
We have the following theorem, stating the principle of optimality.
88 CHAPTER 5. DYNAMIC PROGRAMMING

Theorem 43 Suppose (X; C; F; () satisfy assumptions 1. and 2. Then

1. the function w satisÖes the functional equation (F E)

2. if for all x0 2 X and all x

8 2 E(x0 ) a solution v to the functional equation
(F E) satisÖes
lim ( n v(xn ) = 0 (5.1)
n!1

then v = w

I will skip the proof, but try to provide some intuition. The Örst result
states that the supremum function from the sequential problem (which is well-
deÖned under assumption 1. and 2.) solves the functional equation. This result,
although nice, is not particularly useful for us. We are interested in solving the
sequential problem and in the last section we made progress in solving the
functional equation (not the other way around).
But result 2. is really key. It states a condition under which a solution
to the functional equation (which we know how to compute) is a solution to
the sequential problem (the solution of which we desire). Note that the func-
tional equation (F E) may (or may not) have several solution. We havenít made
enough assumptions to use the CMT to argue uniqueness. However, only one
of these potential several solutions can satisfy (5:1) since if it does, the theo-
rem tells us that it has to equal the supremum function w (which is necessarily
unique). The condition (5:1) is somewhat hard to interpret (and SLP donít
even try), but think about the following. We saw in the Örst lecture that for
inÖnite-dimensional optimization problems like the one in (SP ) a transversality
condition was often necessary and (even more often) su¢cient (jointly with the
Euler equation). The transversality condition rules out as suboptimal plans that
postpone too much utility into the distant future. There is no equivalent condi-
tion for the recursive formulation (as this formulation is basically a two period
formulation, today vs. everything from tomorrow onwards). Condition (5:1)
basically requires that the continuation utility from date n onwards, discounted
to period 0; should vanish in the time limit. In other words, this puts an upper
limit on the growth rate of continuation utility, which seems to substitute for
the TVC. It is not clear to me how to make this intuition more rigorous, though.
A simple, but quite famous example, shows that the condition (5:1) has
some bite. Consider the following consumption problem of an inÖnitely lived
household. The household has initial wealth x0 2 X = R: He can borrow or
lend at a gross interest rate 1 + r = %1 > 1: So the price of a bond that pays o§
one unit of consumption is q = (: There are no borrowing constraints, so the
sequential budget constraint is

ct + (xt+1 $ xt

and the nonnegativity constraint on consumption, ct % 0: The household values

5.1. THE PRINCIPLE OF OPTIMALITY 89

discounted consumption, so that her maximization problem is

1
X
w(x0 ) = sup ( t ct
f(ct ;xt+1 )g1
t=0 t=0

s:t: 0 $ ct $ xt & (xt+1

x0 given

Since there are no borrowing constraint, the consumer can assure herself inÖnite
utility by just borrowing an inÖnite amount in period 0 and then rolling over the
debt by even borrowing more in the future. Such a strategy is called a Ponzi-
scheme -see the hand-out. Hence the supremum function equals w(x0 ) = +1
for all x0 2 X: Now consider the recursive formulation (we denote by x current
period wealth xt ; by y next periodís wealth and substitute out for consumption
ct = xt & (xt+1 (which is OK given monotonicity of preferences)

v(x) = sup fx & (y + (v(y)g

x
y+ 2

Obviously the function w(x) = +1 satisÖes this functional equation (just plug
in w on the right side, since for all x it is optimal to let y tend to &1 and hence
v(x) = +1: This should be the case from the Örst part of the previous theorem.
But the function v2(x) = x satisÖes the functional equation, too. Using it on the
right hand side gives, for an arbitrary x 2 X

sup fx & (y + (yg = sup x = x = v2(x)

x x
y+ 2 y+ 2

Note, however that the second part of the preceding theorem does not apply
for v2 since the sequence fxn g deÖned by xn = %xn0 is a feasible plan from x0 > 0
and
lim ( n v(xn ) = lim ( n xn = x0 > 0
n!1 n!1
Note however that the second part of the theorem gives only a su¢cient con-
dition for a solution v to the functional equation being equal to the supremum
function from (SP ); but not a necessary condition. Also w itself does not satisfy
the condition, but is evidently equal to the supremum function. So whenever
we can use the CMT (or something equivalent) we have to be aware of the fact
that there may be several solutions to the functional equation, but at most one
the several is the function that we look for.
Now we want to establish a similar equivalence between the sequential prob-
lem and the recursive problem with respect to the optimal policies/plans. The
Örst observation. Solving the functional equation gives us optimal policies
y = g(x) (note that g need not be a function, but could be a correspondence).
Such an optimal policy induces a feasible plan f^ xt+1 g1
t=0 in the following fash-
ion: x0 = x ^0 is an initial condition, x
^1 2 g(^
x0 ) and recursively x^t+1 = g(^xt ):
The basic question is how a plan constructed from a solution to the functional
equation relates to a plan that solves the sequential problem. We have the
following theorem.
90 CHAPTER 5. DYNAMIC PROGRAMMING

Theorem 44 Suppose (X; C; F; () satisfy assumptions 1. and 2.

1. Let x
8 2 E(x0 ) be a feasible plan that attains the supremum in the sequential
problem. Then for all t % 0

w(8
xt ) = F (8
xt ; x
8t+1 ) + (w(8
xt+1 )

2. Let x
^ 2 E(x0 ) be a feasible plan satisfying, for all t % 0

w(^
xt ) = F (^
xt ; x
^t+1 ) + (w(^
xt+1 )

and additionally1
lim sup ( t w(^
xt ) $ 0 (5.2)
t!1

Then x
^ attains the supremum in (SP ) for the initial condition x0 :

What does this result say? The Örst part says that any optimal plan in the
sequence problem, together with the supremum function w as value function
satisÖes the functional equation for all t: Loosely it says that any optimal plan
from the sequential problem is an optimal policy for the recursive problem (once
the value function is the right one).
Again the second part is more important. It says that, for the ìrightî
Öxed point of the functional equation w the corresponding policy g generates
a plan x^ that solves the sequential problem if it satisÖes the additional limit
condition. Again we can give this condition a loose interpretation as standing
in for a transversality condition. Note that for any plan f^ xt g generated from a
policy g associated with a value function v that satisÖes (5:1) condition (5:2) is
automatically satisÖed. From (5:1) we have

lim ( t v(xt ) = 0
t!1

for any feasible fxt g 2 E(x0 ); all x0 : Also from Theorem 32 v = w: So for any
plan f^
xt g generated from a policy g associated with v = w we have

w(^
xt ) = F (^
xt ; x
^t+1 ) + (w(^
xt+1 )

and since limt!1 ( t v(^

xt ) exists and equals to 0 (since v satisÖes (5:1)); we have

lim sup ( t v(^

xt ) = 0
t!1

and hence (5:2) is satisÖed. But Theorem 33.2 is obviously not redundant as
there may be situations in which Theorem 32.2 does not apply but 33.2 does.
1 The limit superior of a bounded sequence fx g is the inÖmum of the set V of real numbers
n
v such that only a Önite number of elements of the sequence strictly exceed v: Hence it is the
largest cluster point of the sequence fxn g:
5.1. THE PRINCIPLE OF OPTIMALITY 91

Let us look at the following example, a simple modiÖcation of the saving problem
from before. Now however we impose a borrowing constraint of zero.
1
X
w(x0 ) = max1 ( t (xt & (xt+1 )
fxt+1 gt=0
t=0
xt
s:t: 0 $ xt+1 $
(
x0 given

Writing out the objective function yields

w0 (x0 ) = (x0 & (x1 ) + (x1 & (x2 ) + : : :

= x0

Now consider the associated functional equation

v(x) = max
0 x
fx & (x0 + v(x0 )g
0+x + 2

Obviously one solution of this functional equation is v(x) = x and by Theorem

32.1 is rightly follows that w satisÖes the functional equation. However, for
v condition (5:1) fails, as the feasible plan deÖned by xt = x%0t shows. Hence
Theorem 32.2 does not apply and we canít conclude that v = w (although we
have veriÖed it directly, there may be other examples for which this is not so
straightforward). Still we can apply Theorem 33.2 to conclude that certain plans
are optimal plans. Let f^ xt g be deÖned by x
^0 = x0 ; x
^t = 0 all t > 0: Then

lim sup ( t w(^

xt ) = 0
t!1

and we can conclude by Theorem 33.2 that this plan is optimal for the sequential
problem. There are tons of other plans for which we can apply the same logic to
shop that they are optimal, too (which shows that we obviously canít make any
claim about uniqueness). To show that condition (5:2) has some bite consider
the plan deÖned by x^t = x%0t : Obviously this is a feasible plan satisfying

w(^
xt ) = F (^
xt ; x
^t+1 ) + (w(^
xt+1 )

but since for all x0 > 0

lim sup ( t w(^

xt ) = x0 > 0
t!1

Theorem 33.2 does not apply and we canít conclude that f^ xt g is optimal (as in
fact this plan is not optimal).
So basically we have a prescription what to do once we solved our functional
equation: pick the right Öxed point (if there are more than one, check the limit
condition to Önd the right one, if possible) and then construct a plan from the
92 CHAPTER 5. DYNAMIC PROGRAMMING

policy corresponding to this Öxed point. Check the limit condition to make sure
that the plan so constructed is indeed optimal for the sequential problem. Done.
Note, however, that so far we donít know anything about the number (unless
the CMT applies) and the shape of Öxed point to the functional equation. This
is not quite surprising given that we have put almost no structure onto our
economy. By making further assumptions one obtains sharper characterizations
of the Öxed point(s) of the functional equation and thus, in the light of the
preceding theorems, about the solution of the sequential problem.

5.2 Dynamic Programming with Bounded Re-

turns
Again we look at a functional equation of the form

v(x) = max fF (x; y) + (v(y)g

y2,(x)

We will now assume that F : X 0 X is bounded and ( 2 (0; 1): We will make
the following two assumptions throughout this section
Assumption 3: X is a convex subset of RL and the correspondence C :
X ) X is nonempty, compact-valued and continuous.
Assumption 4: The function F : A ! R is continuous and bounded, and
( 2 (0; 1)
We immediately get that assumptions 1. and 2. are satisÖed and hence
the theorems of the previous section apply. DeÖne the policy correspondence
connected to any solution to the functional equation as

G(x) = fy 2 C(x) : v(x) = F (x; y) + (v(y)g

and the operator T on C(X)

(T v) (x) = max fF (x; y) + (v(y)g

y2,(x)

Here C(X) is the space of bounded continuous functions on X and we use the
sup-metric as metric. Then we have the following

Theorem 45 Under Assumptions 3. and 4. the operator T maps C(X) into

itself. T has a unique Öxed point v and for all v0 2 C(X)

d(T n v0 ; v) $ ( n d(v0 ; v)

The policy correspondence G belonging to v is compact-valued and upper-hemicontinuous

Now we add further assumptions on the structure of the return function F;

with the result that we can characterize the unique Öxed point of T better.
Assumption 5: For Öxed y; F (:; y) is strictly increasing in each of its L
components.
5.2. DYNAMIC PROGRAMMING WITH BOUNDED RETURNS 93

Assumption 6: C is monotone in the sense that x $ x0 implies C(x) 1

C(x0 ):
The result we get out of these assumptions is strict monotonicity of the value
function.

Theorem 46 Under Assumptions 3. to 6. the unique Öxed point v of T is

strictly increasing.

We have a similar result in spirit if we make assumptions about the curvature

of the return function and the convexity of the constraint set.
Assumption 7: F is strictly concave, i.e. for all (x; y); (x0 ; y 0 ) 2 A and
] 2 (0; 1)

F [](x; y) + (1 & ])(x0 ; y 0 )] % ]F (x; y) + (1 & ])F (x0 ; y 0 )

and the inequality is strict if x 6= x0

Assumption 8: C is convex in the sense that for ] 2 [0; 1] and x; x0 2 X;
the fact y 2 C(x); y 0 2 C(x0 )

]y + (1 & ])y 0 2 C(]x + (1 & ])x0 )

Again we Önd that the properties assumed about F extend to the value function.

Theorem 47 Under Assumptions 3.-4. and 7.-8. the unique Öxed point of v
is strictly concave and the optimal policy is a single-valued continuous function,
call it g.

Finally we state a result about the di§erentiability of the value function,

the famous envelope theorem (some people call it the Benveniste-Scheinkman
theorem).
Assumption 9: F is continuously di§erentiable on the interior of A:

Theorem 48 Under assumptions 3.-4. and 7.-9. if x0 2 int(X) and g(x0 ) 2

int(C(x0 )); then the unique Öxed point of T; v is continuously di§erentiable at
x0 with
@v(x0 ) @F (x0 ; g(x0 ))
=
@xi @xi
where @v(x
@xi
0)
denotes the derivative of v with respect to its i-th component, eval-
uated at x0 :

This theorem gives us an easy way to derive Euler equations from the re-
cursive formulation of the neoclassical growth model. Remember the functional
equation
v(k) = max 0
U (f (k) & k 0 ) + (v(k 0 )
0+k +f (k)

Taking Örst order conditions with respect to k 0 (and ignoring corner solutions)
we get
U 0 (f (k) & k 0 ) = (v 0 (k 0 )
94 CHAPTER 5. DYNAMIC PROGRAMMING

Denote by k 0 = g(k) the optimal policy. The problem is that we donít know v 0 :
But now we can use Benveniste-Scheinkman to obtain

v 0 (k) = U 0 (f (k) & g(k))f 0 (k)

Using this in the Örst order condition we obtain

U 0 (f (k) & g(k)) = (v 0 (k) = (U 0 (f (k 0 ) & g(k 0 ))f 0 (k 0 )

= (f 0 (g(k))U 0 (f (g(k)) & g(g(k))

Denoting k = kt ; g(k) = kt+1 and g(g(k)) = kt+2 we obtain our usual Euler
equation
U 0 (f (kt ) & kt+1 ) = (f (kt+1 )U 0 (f (kt+1 ) & kt+2 )
Chapter 6

Models with Risk

In this section we will introduce a basic model with risk and complete Önan-
cial markets, in order to establish some notation and extend our discussion of
e¢cient economies to this important case. We will also derive two substantive
results, namely that risk will be perfectly shared across households (in a sense
to be made precise), and that for the pricing of assets the distribution of endow-
ments (incomes) across households is irrelevant. Then, as a Örst application, we
will look at the stochastic neoclassical growth model, which forms the basis for a
particular theory of business cycles, the so called ìReal Business Cycleî (RBC)
theory. In this section we will be a bit loose with our treatment of risk, in that
we will not explicitly discuss probability spaces that form the formal basis of
our representation of risk.

6.1 Basic Representation of Risk

The basic novelty of models with risk is the formal representation of this risk
and the ensuing description of the information structure that agents have. We
start with the notion of an event st 2 S: The set S = f^ 1 ; ; : : : ; ^ N g of possible
events that can happen in period t is assumed to be Önite and the same for all
periods t: If there is no room for confusion we use the notation st = 1 instead
of st = ^ 1 and so forth. For example S may consist of all weather conditions
than can happen in the economy, with st = 1 indicating sunshine in period
t, st = 2 indicating cloudy skies, st = 3 indicating rain and so forth.1 As
another example, consider the economy from Section 2, but now with random
endowments. In each period one of the two agents has endowment 0 and the
other has endowment 2; but who has what is random, with st = 1 indicating
that agent 1 has high endowment and st = 2 indicating that agent 2 has high
endowment at period t: The set of possible events for this example is given by
1 Technically speaking s is a random variable with respect to some underlying probability
t
space (8; A; P ); where 8 is some set of basis events with generic element !; A is a sigma
algebra on 8 and P is a probability measure.

95
96 CHAPTER 6. MODELS WITH RISK

S = f1; 2g
An event history st = (s0 ; s1 ; : : : st ) is a vector of length t + 1 summarizing
the realizations of all events up to period t: Formally (and with some abuse of
notation), with S t = S 0 S 0 : : : 0 S denoting the t + 1-fold product of S; event
history st 2 S t lies in the set of all possible event histories of length t:
By Q t (st ) let denote the probability of a particular event history. We assume
that Q t (st ) > 0 for all st 2 S t ; for all t: For our example economy, if s2 = (1; 1; 2)
then Q t (s2 ) is the probability that agent 1 has high endowment in period t = 0
and t = 1 and agent 2 has high endowment in period 2. Figure 6.1 summarizes
the concepts introduced so far, for the case in which S = f1; 2g is the set of
possible events that can happen in every period. Note that the sets S t of possible
event histories of length t become fairly big very rapidly even when the set of
events itself is small, which poses computational problems when dealing with
models with risk.

2
π(s =(2,2,2))
1
π(s =(2,2))
2
s =(2,2,2)
0 1
π(s =2) s =(2,2) 2
s =(2,2,1)

0 2
s =2 s =(2,1,2)
1
s =(2,1)
2
s =(2,1,1)

2
s =(1,2,2)
0 1 3
π(s =1) s =(1,2) 2 π(s =(1,12,2))
s =(1,2,1)
3
s =(1,1,2,2)
0 2
s =1 s =(1,1,2)
1 3
s =(1,1) s =(1,1,2,1)
2
s =(1,1,1)

t=0 t=1 t=2 t=3

Figure 6.1: Event Tree in Models with Risk

6.2. DEFINITIONS OF EQUILIBRIUM 97

All commodities of our economy, instead of being indexed by time t as before,

now also have to be indexed by event histories st : In particular, an allocation
for the example economy of Section 2, but now with risk, is given by

(c1 ; c2 ) = fc1t (st ); c2t (st )g1

t=0;st 2S t

with the interpretation that cit (st ) is consumption of agent i in period t if event
history st has occurred. Note that consumption in period t of agents are allowed
to (and in general will) vary with the history of events that have occurred in
the past.
Now we are ready to specify to remaining elements of the economy. With
respect to endowments, these also take the general form

(e1 ; e2 ) = fe1t (st ); e2t (st )g1

t=0;st 2S t

and for the particular example

"
2 if st = 1
e1t (st ) =
0 if st = 2
"
0 if st = 1
e2t (st ) =
2 if st = 2

i.e. for the particular example endowments in period t only depend on the
realization of the event st ; not on the entire history. Nothing, however, would
prevent us from specifying more general endowment patterns.
Now we specify preferences. We assume that households maximize expected
lifetime utility where E0 is the expectation operator at period 0; prior to any
realization of risk (in particular the risk with respect to s0 ). Given our notation
just established, assuming that preferences admit a von-Neumann Morgenstern
utility function representation we represent householdsí preferences by
1 X
X
u(ci ) = ( t Q t (st )U (cit (st ))
t=0 st 2S t

This completes our description of this simple stochastic endowment economy.

6.2 DeÖnitions of Equilibrium

Again there are two possible market structures that we can work with. The
Arrow-Debreu market structure turns out to be easier than the sequential mar-
kets market structure, so we will start with it. Again there is an equivalence
theorem that relates the equilibrium of the two markets structures, once we
allow the asset market structure for the sequential markets market structure to
be rich enough.
98 CHAPTER 6. MODELS WITH RISK

6.2.1 Arrow-Debreu Market Structure

As usual with Arrow-Debreu, trade takes place at period 0; before any risk has
been realized (in particular, before s0 has been realized). As with allocations,
Arrow-Debreu prices have to be indexed by event histories in addition to time,
so let pt (st ) denote the price of one unit of consumption, quoted at period 0;
delivered at period t if (and only if) event history st has been realized. Given
this notation, the deÖnition of an AD-equilibrium is identical to the case without
risk, with the exception that, since goods and prices are not only indexed by
time, but also by histories, we have to sum over both time and histories in the
individual householdsí budget constraint.

pt (st )g1
DeÖnition 49 A (competitive) Arrow-Debreu equilibrium are prices f^ t=0;st 2S t
i t 1
and allocations (f^
ct (s )gt=0;st 2S t )i=1;2 such that

pt (st )g1
1. Given f^ cit (st )g1
t=0;st 2S t ; for i = 1; 2; f^ t=0;st 2S t solves

1 X
X
max
1
( t Q t (st )U (cit (st ))
(6.1)
fcit (st )gt=0;st 2S t
t=0 st 2S t
s.t.
1 X
X X1 X
p^t (st )cit (st ) $ p^t (st )eit (st ) (6.2)
t=0 st 2S t t=0 st 2S t

cit (st ) % 0 for all t; all st 2 S t (6.3)

2.
c^1t (st ) + c^2t (st ) = e1t (st ) + e2t (st ) for all t; all st 2 S t (6.4)

Note that there is again only one budget constraint, and that the market
clearing condition has to hold date by date, event history by event history. Also
note that, when computing equilibria, one can normalize the price of only one
commodity to 1; and consumption at the same date, but for di§erent event
histories are di§erent commodities. That means that if we normalize p0 (s0 =
1) = 1 we canít also normalize p0 (s0 = 2) = 1: Finally, there are no probabilities
in the budget constraint. Equilibrium prices will reáect the probabilities of
di§erent event histories, but there is no scope for these probabilities in the
Arrow-Debreu budget constraint directly.
It is relatively straightforward to characterize equilibrium prices. Taking
Örst order conditions with respect to cit (st ) and ci0 (s0 ) yields

( t Q t (st )U 0 (cit (st )) = 1pt (st )

Q 0 (s0 )U 0 (ci0 (s0 )) = 1p0 (s0 )

and combining yields

pt (st ) Q t (st ) U 0 (cit (st ))

= (t (6.5)
p0 (s0 ) Q 0 (s0 ) U 0 (ci0 (s0 ))
6.2. DEFINITIONS OF EQUILIBRIUM 99

for all t; st and all agents i: This immediately implies that

U 0 (c1t (st )) U 0 (c2t (st ))

=
U 0 (c10 (s0 )) U 0 (c20 (s0 ))
or
U 0 (c2t (st )) U 0 (c20 (s0 ))
= for all st :
U 0 (c1t (st )) U 0 (c10 (s0 ))
for all st : That is, the ratio of marginal utilities between the two agents is
constant over time and across states of the world. In addition, if households
have CRRA period utility, the above equation implies that
% &$0 % &$0
c2t (st ) c20 (s0 )
=
c1t (st ) c10 (s0 )

that is, the ratio of consumption between the two agents is constant over time.
Denoting the aggregate endowment by
X
et (st ) = eit (st )
i

the resource constraint then implies that for both agents

cit (st ) = ]i et (st ) (6.6)

where ]i is the constant share of aggregate endowment household i consumes.

Using this result in equation (6:5) we Önd, after normalizing p0 (s0 ) = 1 for the
particular s0 we have chosen, that
% &$0
Q t (st ) cit (st )
pt (st ) = (t
Q 0 (s0 ) ci0 (s0 )
% &$0
Q t (st )
t et (st )
= ( : (6.7)
Q 0 (s0 ) e0 (s0 )

Thus the price of consumption at node st is declining with t because of dis-

counting, it is the higher the more likely node st is realized and is declining
in the availability of consumption at this node (as measured by the aggregate
endowment et (st )).2
Equations (6:6) and (6:7) have important implications. Turning to equation
(6:6); it implies that endowment risk is perfectly shared. The only endow-
ment risk that a§ects consumption of each household i is aggregate risk, that
is, áuctuations in the aggregate endowment et (st ): These shocks are born by
2 We have to be a bit careful with prices at initial nodes s ^0 6= s0 (because we can only
normalize one price to one). These prices are given by
% &
p0 (^
s0 ) H 0 (^ s0 ) %)
s0 ) e0 (^
= :
p0 (s0 ) H 0 (s0 ) e0 (s0 )
100 CHAPTER 6. MODELS WITH RISK

all households equally, in that consumption of all households falls by the same
fraction as the aggregate endowment plummets. In contrast, shocks to indi-
vidual endowments eit (st ) that do not a§ect the aggregate endowment (because
household i is small in the aggregate, or because endowments of households i
and j are perfectly negatively correlated) in turn do not impact individual con-
sumption since they are perfectly diversiÖed across households. In this sense,
the economy exhibits perfect risk sharing (of individual risks).
Equation (6:7) shows that Arrow Debreu equilibrium prices (and thus all
other asset prices, as discussed below) only depend the stochastic process for
the aggregate endowment et (st ); but not on how these endowments are dis-
tributed across households. This implies that if we consider an economy with
a representative household whose endowment process equals the aggregate en-
dowment process fet (st )g and who has CRRA risk aversion utility with the
same coe¢cient = as all the households in our economy, then the Arrow Debreu
prices (and thus all other asset prices) in the representative agent economy are
identical to the ones we have determined in our economy in (6:7): That is, for
asset pricing purposes we might as well study the representative agent economy
(whose equilibrium allocations are of course trivial to solve in an endowment
economy since the representative agent just eats her endowment in every pe-
riod).

6.2.2 Pareto E¢ciency

The deÖnition of Pareto e¢ciency is identical to that of the certainty case; the
Örst welfare theorem goes through without any changes (in particular, the proof
is identical, apart from changes in notation). We state both for completeness
DeÖnition 50 An allocation f(c1t (st ); c2t (st ))g1
t=0;st 2S t is feasible if

1.
cit (st ) % 0 for all t; all st 2 S t ; for i = 1; 2
2.
c1t (st ) + c2t (st ) = e1t (st ) + e2t (st ) for all t; all st 2 S t
DeÖnition 51 An allocation f(c1t (st ); c2t (st ))g1
t=0;st 2S t is Pareto e¢cient if it
is feasible and if there is no other feasible allocation f(~ c1t (st ); c~2t (st ))g1
t=0;st 2S t
such that
ci ) % u(ci ) for both i = 1; 2
u(~
ci ) > u(ci ) for at least one i = 1; 2
u(~
Proposition 52 Let (f^ cit (st )g1
t=0;st 2S t )i=1;2 be a competitive equilibrium allo-
i t 1
cation. Then (f^
ct (s )gt=0;st 2S t )i=1;2 is Pareto e¢cient.
Note that we could have obtained the above characterization of equilibrium
allocations and prices from following the Negishi approach, that is, by solv-
ing a social planner problem and using the transfer functions to compute the
appropriate welfare weights.
6.2. DEFINITIONS OF EQUILIBRIUM 101

6.2.3 Sequential Markets Market Structure

Now let trade take place sequentially in each period (more precisely, in each
period, event-history pair). Without risk we allowed trade in consumption and
in one-period IOUís. For the equivalence between Arrow-Debreu and sequential
markets with risk, this is not enough. We introduce one period contingent IOUís,
Önancial contracts bought in period t that pay out one unit of the consumption
good in t + 1 only for a particular realization of st+1 = j tomorrow.3 So let
qt (st ; st+1 = j) denote the price at period t of a contract that pays out one unit
of consumption in period t + 1 if (and only if) tomorrowís event is st+1 = j:
These contracts are often called Arrow securities, contingent claims or one-
period insurance contracts. Let ait+1 (st ; st+1 ) denote the quantities of these
Arrow securities bought (or sold) at period t by agent i:
The period t; event history st budget constraint of agent i is given by
X
cit (st ) + qt (st ; st+1 )ait+1 (st ; st+1 ) $ eit (st ) + ait (st )
st+1 2S

Note that agents purchase Arrow securities fait+1 (st ; st+1 )gst+12S for all contin-
gencies st+1 2 S that can happen tomorrow, but that, once st+1 is realized, only
the ait+1 (st+1 ) corresponding to the particular realization of st+1 becomes the
asset position that he starts the current period with. We assume that ai0 (s0 ) = 0
for all s0 2 S.
We then have the following

' A i B (
DeÖnition 53 A SM equilibrium is allocations f c^it (st ); a
^t+1 (st ; st+1 ) st+1 2S g1
t=0;st 2S t ;
i=1;2
qt (st ; st+1 )g1
and prices for Arrow securities f^ t=0;st 2S t ;st+1 2S such that

A i B
qt (st ; st+1 )g1
1. Given f^ t=0;st 2S t ;st+1 2S ; for all i; f^ ^t+1 (st ; st+1 ) s 2S g1
cit (st ); a t=0;st 2S t
t+1
solves

max u(ci )
fcit (st );fait+1 (st ;st+1 )g g1
t=0;st 2S t
st+1 2S

s.t.
X
cit (st ) + q^t (st ; st+1 )ait+1 (st ; st+1 ) $ eit (st ) + ait (st )
st+1 2S

cit (st ) % 0 for all t; st 2 S t

ait+1 (st ; st+1 ) % &A8i for all t; st 2 S t

3 A full set of one-period Arrow securities is su¢cient to make markets ìsequentially com-

pleteî, in the sense that any (nonnegative) consumption allocation is attainable with an appro-
priate sequence of Arrow security holdings fat+1 (st ; st+1 )g satisfying all sequential markets
budget constraints.
102 CHAPTER 6. MODELS WITH RISK

2. For all t % 0
2
X 2
X
c^it (st ) = eit (st ) for all t; st 2 S t
i=1 i=1
2
X
^it+1 (st ; st+1 )
a = 0 for all t; st 2 S t and all st+1 2 S
i=1

Note that we have a market clearing condition in the asset market for each
Arrow security being traded for period t + 1:

6.2.4 Equivalence between Market Structures

As before we can establish the equivalence, in terms of equilibrium outcomes,
between the Arrow-Debreu and the sequential markets structure. Without re-
peating the details (which are identical to the discussion in chapter 2, mutatis
mutandis), the key to the argument is the map between Arrow-Debreu prices
and prices for Arrow securities, given by
pt+1 (st+1 )
qt (st ; st+1 ) = (6.8)
pt (st )
pt (st ) = p0 (s0 ) ) q0 (s0 ; s1 ) ) : : : qt$1 (st$1 ; st ): (6.9)

6.2.5 Asset Pricing

With Arrow Debreu prices (and sequential market prices from (6:8)) in hand we
can now price any additional asset in this economy. Consider an arbitrary asset
j, deÖned by the dividends dj = fdjt (st )g it pays in each node st : The dividend
djt (st ) is simply a claim to djt (st ) units of the consumption good at node st of
the event tree. Thus the time zero (cum dividend) price of such an asset is given
by
X1 X
P0j (d) = pt (st )djt (st );
t=0 st
that is, it is the value of all consumption goods the asset delivers at all future
dates and states. The ex-dividend price of such an asset at node st ; expressed
in terms of period t consumption good is given by
P1 P * j *
j t * =t+1 s# jst p* (s )d* (s )
Pt (d; s ) =
pt (st )
that is, the value of all future dividends, translated into the node st consumption
good.
Most of asset pricing work with asset returns rather than asset prices. So
let us deÖne the one-period gross realized real return of an asset j between st
and st+1 as
j P j (d; st+1 ) + djt+1 (st+1 )
Rt+1 (st+1 ) = t+1
Ptj (d; st )
6.2. DEFINITIONS OF EQUILIBRIUM 103

Let us consider a few examples that make these deÖnitions clear.

Example 54 Consider an Arrow security from the Sequential Markets equilib-

rium above that is purchased in st and pays o§ one unit of consumption in state
s^t+1 and nothing in all other states st+1 (and nothing beyond period t+1). Then
its price at st is given by

st+1 )
pt+1 (^
PtA (d; st ) = = qt (st ; s^t+1 )
pt (st )

and the associated gross realized return between st and s^t+1 = (st ; s^t+1 ) is

A 0+1
Rt+1 st+1 )
(^ =
st+1 )=pt (st )
pt+1 (^
pt (st ) 1
= =
st+1 )
pt+1 (^ qt (st ; s^t+1 )
A
and Rt+1 (st+1 ) = 0 for all st+1 6= st+1 :

Example 55 Now consider a one period risk-free bond, that is, an asset that is
purchased at st and pays one unit of consumption at all events st+1 tomorrow.
Its price at st is given by
P t+1 X
t+1 pt+1 (s )
PtB (d; st ) = s t
= qt (st ; st+1 )
pt (s ) t+1 s

and its realized return is given by

B 1
Rt+1 (st+1 ) =
PtB (d; st )
1 B
= P t
= Rt+1 (st )
st+1 t (s ; st+1 )
q

which from the perspective of st is nonstochastic (since it does not depend on

st+1 ). Hence the name risk-free bond.

Example 56 A stock that pays as dividend the aggregate endowment in each

period (a so-called Lucas tree) has a price per share (if the total number of shares
outstanding is one) of:
P1 P * *
S t * =t+1 s# jst p* (s )e* (s )
Pt (d; s ) =
pt (st )

Example 57 An option to buy one share of the Lucas tree at time T (at all
nodes) for a price K has a price Ptcall (st ) at node st given by
X pT (sT ) A B
Ptcall (st ) = t
max PTS (d; sT ) & K; 0
T t
pt (s )
s js
104 CHAPTER 6. MODELS WITH RISK

Such an option is called a call option. A put option is the option to sell the
same asset, and its price given by
X pT (sT ) A B
Ptput (st ) = t)
max K & PTS (d; sT ); 0 :
T t
p t (s
s js

The price K is called the strike price (and easily could be made dependent on
sT ; too).

6.3 Markov Processes

So far we havenít speciÖed the exact stochastic structure of risk. In particular,
in no sense have we assumed that the random variables st and s* ; < > t are
independent over time or time-dependent in a simple way. Our theory is com-
pletely general along this dimension; to make it implementable (analytically or
numerically), however, one typically has to assume a particular structure of the
risk.
In particular, for the computation of equilibria or socially e¢cient allocations
using recursive techniques it is useful to assume that the st ís follow a discrete
time (time is discrete), discrete state (the number of values st can take is Önite)
time homogeneous Markov chain. Let by

Q(jji) = prob(st+1 = jjst = i)

denote the conditional probability that the state in t+1 equals j 2 S if the state
in period t equals st = i 2 S: Time homogeneity means that Q is not indexed
by time. Given that st+1 2 S and st 2 S and S is a Önite set, Q(:j:) can be
represented by an N 0 N -matrix of the form
0 1
..
B Q 11 Q 12 * * * . * * * Q 1N C
B .. .. C
B Q 21 . . C
B C
B .. .. .. C
B . . . C
Q=B C
B Q i1 * * * * * * Q ij * * * Q iN C
B C
B . .. .. C
B .. . . C
@ A
..
QN 1 * * * * * * . * * * QN N

with generic element Q ij = Q(jji) =prob(st+1 = jjst = i): Hence the i-th row
gives the probabilities of going from state i today to all the possible states
tomorrow, and the j-th column gives the probability of landing in state j to-
morrow
P conditional of being in an arbitrary state i today. Since Q ij % 0 and
Q
j ij = 1 for all i (for all states today, one has to go somewhere tomorrow),
the matrix Q is a so-called stochastic matrix.
Suppose the probability distribution over states today is given by the N -
dimensional column vector Pt = (p1t ; : : : ; pN T
t ) and risk is described by a Markov
6.3. MARKOV PROCESSES 105

P
chain of the from above. Note that i pit = 1: Then the probability of being in
state j tomorrow is given by
X
pjt+1 = Q ij pit
i

i.e. by the sum of the conditional probabilities of going to state j from state i;
weighted by the probabilities of starting out in state i today. More compactly
we can write
Pt+1 = Q T Pt
A stationary distribution E of the Markov chain Q satisÖes

E = QT E

i.e. if one starts out today with a distribution over states E then tomorrow one
ends up with the same distribution over states E: From the theory of stochastic
matrices we know that every Q has at least one such stationary distribution.
It is the eigenvector (normalized to length 1) associated with the eigenvalue
, = 1 of Q T : Note that every stochastic matrix has (at least) one eigenvalue
equal to 1: If there is only one such eigenvalue, then there is a unique stationary
distribution, if there are multiple eigenvalues of length 1; then there a multiple
stationary distributions (in fact a continuum of them).
Note that the Markov assumption restricts the conditional probability dis-
tribution of st+1 to depend only on the realization of st ; but not on realizations
of st$1 ; st$2 and so forth. This obviously is a severe restriction on the possible
randomness that we allow, but it also means that the nature of risk for period
t + 1 is completely described by the realization of st ; which is crucial when for-
mulating these economies recursively. We have to start the Markov process out
at period 0; so let by E(s0 ) denote the probability that the state in period 0 is
s0 : Given our Markov assumption the probability of a particular event history
can be written as

Q t+1 (st+1 ) = Q(st+1 jst ) ) Q(st jst$1 ) : : : ) Q(s1 js0 ) ) E(s0 )

Example 58 Suppose that N = 2: Let the transition matrix be symmetric, that

is % &
p 1&p
Q=
1&p p
for some p 2 (0; 1); then the unique invariant distribution is E(s) = 0:5 for both
s:

Example 59 Let % &

1 0
Q=
0 1
then any distribution over the two states is an invariant distribution.
106 CHAPTER 6. MODELS WITH RISK

6.4 Stochastic Neoclassical Growth Model

In this section we will brieáy consider a stochastic extension to the deterministic
neoclassical growth model. You will have fun with this model in the third
problem set. The stochastic neoclassical growth model is the workhorse for half
of modern business cycle theory; everybody doing real business cycle theory uses
it. I therefore think that it is useful to expose you to this model, even though
you may decide not to do RBC theory in your own research.
The economy is populated by a large number of identical households. For
convenience we normalize the number of households to 1: In each period three
goods are traded, labor services nt ; capital services kt and the Önal output good
yt ; which can be used for consumption ct or investment it :

1. Technology:
yt = ezt F (kt ; nt )
where zt is a technology shock. F is assumed to have the usual properties,
i.e. has constant returns to scale, positive but declining marginal products
and it satisÖes the INADA conditions. We assume that the technology
shock has unconditional mean 0 and follows a N -state Markov chain. Let
Z = fz1 ; z2 ; : : : zN g be the state space of the Markov chain, i.e. the
set of values that zt can take on. Let Q = (Q ij ) denote the Markov
transition matrix and E the stationary distribution of the chain (ignore
the fact that in some of our applications E will not be unique). Let
Q(z 0 jz) = prob(zt+1 = z 0 jzt = z): In most of the applications we will take
N = 2: The evolution of the capital stock is given by

kt+1 = (1 & /)kt + it

and the composition of output is given by

yt = ct + it

Note that the set Z takes the role of S in our general formulation of risk,
and z t corresponds to st .
2. Preferences:
1
X
E0 ( t u(ct ) with ( 2 (0; 1)
t=0
The period utility function is assumed to have the usual properties.
3. Endowment: each household has an initial endowment of capital, k0 and
one unit of time in each period. These endowments are not stochastic.
4. Information: The variable zt ; the only source of risk in this model, is
publicly observable. We assume that in period 0 z0 has not been realized,
but is drawn from the stationary distribution E: All agents are perfectly
informed that the technology shock follows the Markov chain Q with initial
distribution E:
6.4. STOCHASTIC NEOCLASSICAL GROWTH MODEL 107

A lot of the things that we did for the case without risk go through al-
most unchanged for the stochastic model. The only key di§erence is that now
commodities have to be indexed not only by time, but also by histories of pro-
ductivity shocks, since goods delivered at di§erent nodes of the event tree are
di§erent commodities, even though they have the same physical characteristics.
For a lucid discussion of this point see Chapter 7 of Debreuís (1959) Theory of
Value.
For the recursive formulation of the social planners problem, note that the
current state of the economy now not only includes the capital stock k that the
planner brings into the current period, but also the current state of the technol-
ogy z: This is due to the fact that current production depends on the current
technology shock, but also due to the fact that the probability distribution of
tomorrowís shocks Q(z 0 jz) depends on the current shock, due to the Markov
structure of the shocks. Also note that even if the social planner chooses capital
stock k 0 for tomorrow today, lifetime utility from tomorrow onwards is uncer-
tain, due to the risk of z 0 : These considerations, plus the usual observation that
nt = 1 is optimal, give rise to the following Bellman equation
( )
X
z 0 0 0 0
v(k; z) = 0 z
max U (e F (k; 1) + (1 & /)k & k ) + ( Q(z jz)v(k ; z ) :
0+k +e F (k;1)+(1$O)k
z0

Remark 60 This model is not quite yet a satisfactory business cycle model
since it does not permit áuctuations in labor input of the sort that characterize
business cycles in the real world. For this we require households to value leisure,
so that the period utility function becomes

U (ct ; lt ) = U (ct ; 1 & nt )

and the recursive formulation of the planner problem reads as

( )
X
z 0 0 0 0
v(k; z) = max U (e F (k; n) + (1 & /)k & k ; 1 & n) + ( Q(z jz)v(k ; z )
0+k0 +ez F (k;1)+(1$O)k
0+n+1 z0

The Örst order conditions for the maximization problem (assuming di§erentia-
bility of the value function) read as
U2 (c; 1 & n)
ez Fn (k; n) = (6.10)
U1 (c; 1 & n)
and X
U1 (c; 1 & n) = ( Q(z 0 jz)v 0 (k 0 ; z 0 ) (6.11)
z0

where U1 is the marginal utility of consumption, U2 is the marginal utility of

leisure and v 0 is the Örst derivative of the value function with respect to its Örst
argument. The envelope condition reads as

v 0 (k; z) = (ez Fk (k; n) + 1 & /) U1 (c; 1 & n): (6.12)

108 CHAPTER 6. MODELS WITH RISK

Using this in equation (6:11) we obtain

X
U1 (c; 1 & n) = ( Q(z 0 jz) (ez0 Fk (k 0 ; n0 ) + 1 & /) U1 (c0 ; 1 & n0 ): (6.13)
z0

Thus the key optimality conditions of the stochastic neoclassical growth model
with endogenous labor supply, often referred to as the real business cycle model,
are (6:10) and (6:13): Equation (6:10), the intratemporal optimality condition,
states that at the optimum the marginal rate of substitution between leisure and
consumption is equated to the marginal product of labor (the wage, in the de-
centralized equilibrium). Equation (6:13) is the standard intertemporal Euler
equation, now equating the marginal utility of consumption today to the expected
marginal utility of consumption tomorrow, adjusted by the time discount factor
( and the stochastic rate of return on capital, ez0 Fk (k 0 ; n0 ) + 1 & /; which in turn
equals the gross real interest rate in the competitive equilibrium.
Chapter 7

The Two Welfare Theorems

In this section we will present the two fundamental theorems of welfare eco-
nomics for economies in which the commodity space is a general (real) vector
space, which is not necessarily Önite dimensional. Since in macroeconomics we
often deal with agents or economies that live forever, usually a Önite dimen-
sional commodity space is not su¢cient for our analysis. The signiÖcance of the
welfare theorems, apart from providing a normative justiÖcation for studying
competitive equilibria is that planning problems characterizing Pareto optima
are usually easier to solve that equilibrium problems, the ultimate goal of our
theorizing.
Our discussion will follow Stokey et al. (1989), which in turn draws heavily
on results developed by Debreu (1954).

7.1 What is an Economy?

We Örst discuss how what an economy is in Arrow-Debreu language. An econ-
omy E = ((Xi ; ui )i2I ; (Yj )j2J ) consists of the following elements

1. A list of commodities, represented by the commodity space S: We require

S to be a normed (real) vector space with norm k:k.1
1 For completeness we state the following deÖnitions

DeÖnition 61 A real vector space is a set S (whose elements are called vectors) on which
are deÖned two operations
, Addition + : S - S ! S: For any x; y 2 S; x + y 2 S:
, Scalar Multiplication . : R - S ! S: For any % 2 R and any x 2 S; %x 2 S that satisfy
the following algebraic properties: for all x; y 2 S and all %; 1 2 R
(a) x+y =y+x
(b) (x + y) + z = x + (y + z)
(c) % . (x + y) = % . x + % . y
(d) (% + 1) . x = % . x + 1 . x
(e) (%1) . x = % . (1 . x)

109
110 CHAPTER 7. THE TWO WELFARE THEOREMS

2. A Önite set of people i 2 I: Abusing notation I will by I denote both the

set of people and the number of people in the economy.
3. Consumption sets Xi 1 S for all i 2 I: We will incorporate the restrictions
that households endowments place on the xi in the description of the
consumption sets Xi :
4. Preferences representable by utility functions ui : S ! R:
5. A Önite set of Örms j 2 J: The same remark about notation as above
applies.
6. Technology sets Yj 1 S for all j 2 J: Let by
8 9
X < X =
Y = Yj = y 2 S : 9(yj )j2J such that y = yj and yj 2 Yj for all j 2 J
: ;
j2J j2J

denote the aggregate production set.

A private ownership economy E ~ = ((Xi ; ui )i2I ; (Yj )j2J ; (]ij )i2I;j2J ) consists
of all the elements
P of an economy and a speciÖcation of ownership of the Örms
]ij % 0 with i2I ]ij = 1 for all j 2 J: The entity ]ij is interpreted as the share
of ownership of household d to Örm j; i.e. the fraction of total proÖts of Örm j
that household i is entitled to.
With our formalization of the economy we can also make precise what we
mean by an externality. An economy is said to exhibit an externality if household
iís consumption set Xi or Örm jís production set Yj is a§ected by the choice of
household kís consumption bundle xk or Örm mís production plan ym : Unless
otherwise stated we assume that we deal with an economy without externalities.

DeÖnition 63 An allocation is a tuple [(xi )i2I ; (yj )j2J ] 2 S I/J .

(f ) There exists a null element M 2 S such that
x+M = x
0.x = M
(g) 1 . x = x

DeÖnition 62 A normed vector space is a vector space is a vector space S together with a
norm k:k : S ! R such that for all x; y 2 S and % 2 R
(a) kxk & 0; with equality if and only if x = M
(b) k% . xk = j%j kxk
(c) kx + yk ) kxk + kyk

Note that in the Örst deÖnition the adjective real refers to the fact that scalar multiplication
is done with respect to a real number. Also note the intimate relation between a norm and a
metric deÖned above. A norm of a vector space S; k:k : S ! R induces a metric d : S - S ! R
by
d(x; y) = kx # yk
7.1. WHAT IS AN ECONOMY? 111

In the economy people supply factors of production and demand Önal output
goods. We follow Debreu and use the convention that negative components
of the xi ís denote factor inputs and positive components denote Önal goods.
Similarly negative components of the yj ís denote factor inputs of Örms and
positive components denote Önal output of Örms.

DeÖnition 64 An allocation [(xi )i2I ; (yj )j2J ] 2 S I/J is feasible if

1. xi 2 Xi for all i 2 I
2. yj 2 Yj for all j 2 J
3. (Resource Balance) X X
xi = yj
i2I j2J

Note that we require resource balance to hold with equality, ruling out free
disposal. If we want to allow free disposal we will specify this directly as part
of the description of technology.

DeÖnition 65 An allocation [(xi )i2I ; (yj )j2J ] is Pareto optimal if

1. it is feasible
2. there does not exist another feasible allocation [(x*i )i2I ; (yj* )j2J ] such that

ui (x*i ) % ui (xi ) for all i 2 I

ui (x*i ) > ui (xi ) for at least one i 2 I

Note that if I = J = 1 then2 for an allocation [x; y] resource balance requires

x = y, the allocation is feasible if x 2 X \Y; and the allocation is Pareto optimal
if
x 2 arg max u(z)
z2X\Y

Also note that the deÖnition of feasibility and Pareto optimality are identical for
economies E and private ownership economies E: ~ The di§erence comes in the
deÖnition of competitive equilibrium and there in particular in the formulation
of the resource constraint. The discussion of competitive equilibrium requires
a discussion of prices at which allocations are evaluated. Since we deal with
possibly inÖnite dimensional commodity spaces, prices in general cannot be
represented by a Önite dimensional vector. To discuss prices for our general
environment we need a more general notion of a price system. This is necessary
in order to state and prove the welfare theorems for inÖnitely lived economies
that we are interested in.
2 The assumption that J = 1 is not at all restrictive if we restrict our attention to constant

returns to scale technologies. Then, in any competitive equilibrium proÖts are zero and the
number of Örms is indeterminate in equilibrium; without loss of generality we then can restrict
attention to a single representative Örm. If we furthermore restrict attention to identical people
and type identical allocations, then de facto I = 1: Under which assumptions the restriction
to type identical allocations is justiÖed will be discussed below.
112 CHAPTER 7. THE TWO WELFARE THEOREMS

7.2 Dual Spaces

A price system attaches to every bundle of the commodity space S a real number
that indicates how much this bundle costs. If the commodity space is a Önite (say
k&) dimensional Euclidean space, then the natural thing to do is to represent a
price system by a k-dimensional vector p = (p1 ; : : : pk ); where pl is the price of
the l-th component of a commodity Pkvector. The price of an entire point of the
commodity space is then e(s) = l=1 sl pl : Note that every p 2 Rk represents
a function that maps S = Rk into R: Obviously, since for a given p and all
s; s0 2 S and all 0; ( 2 R
k
X k
X k
X
e(0s + (s0 ) = pl (0sl + (s0l ) = 0 pl sl + ( pl s0l = 0e(s) + (e(s0 )
l=1 l=1 l=1

the mapping associated with p is linear. We will take as a price system for an
arbitrary commodity space S a continuous linear functional deÖned on S: The
next deÖnition makes the notion of a continuous linear functional precise.

DeÖnition 66 A linear functional e on a normed vector space S (with asso-

ciated norm kkS ) is a function e : S ! R that maps S into the reals and
satisÖes

e(0s + (s0 ) = 0e(s) + (e(s0 ) for all s; s0 2 S; all 0; ( 2 R

The functional e is continuous if ksn & skS ! 0 implies je(sn ) & e(s)j ! 0 for
all fsn g1
n=0 2 S; s 2 S: The functional e is bounded if there exists a constant
M 2 R such that je(s)j $ M kskS for all s 2 S: For a bounded linear functional
e we deÖne its norm by
kekd = sup je(s)j
kskS +1

Fortunately it is rather easy to verify whether a linear functional is contin-

uous and bounded. Stokey et al. state and prove a theorem that states that a
linear functional is continuous if it is continuous at a particular point s 2 S and
that it is bounded if (and only if) it is continuous. Hence a linear functional is
bounded and continuous if it is continuous at a single point.
For any normed vector space S the space

S * = fe : e is a continuous linear functional on Sg

is called the (algebraic) dual (or conjugate) space of S: With addition and scalar
multiplication deÖned in the standard way S * is a vector space, and with the
norm kkd deÖned above S * is a normed vector space as well. Note (you should
prove this3 ) that even if S is not a complete space, S * is a complete space and
hence a Banach space (a complete normed vector space). Let us consider several
examples that will be of interest for our economic applications.
3 After you are done with this, check Kolmogorov and Fomin (1970), p. 187 (Theorem 1)

for their proof.

7.2. DUAL SPACES 113

Example 67 For each p 2 [1; 1) deÖne the space lp by

1
! p1
X p
lp = fx = fxt g1
t=0 : xt 2 R; for all t; kxkp = jxt j < 1g
t=0

with corresponding norm kxkp : For p = 1; the space l1 is deÖned correspond-

ingly, with norm kxk1 = supt jxt j: For any p 2 [1; 1) deÖne the conjugate
index q by
1 1
+ =1
p q
For p = 1 we deÖne q = 1: We have the important result that for any p 2 [1; 1)
the dual of lp is lq : This result can be proved by using the following theorem
(which in turn is proved by Luenberger (1969), p. 107.)

Theorem 68 Every continuous linear functional e on lp ; p 2 [1; 1); is repre-

sentable uniquely in the form
1
X
e(x) = xt yt (7.1)
t=0

where y = fyt g 2 lq : Furthermore, every element of lq deÖnes an element of the

dual of lp ; lp* in this way, and we have
(
P1 q 1
kekd = kykq = ( t=0 jyt j ) q if 1 < p < 1
supt jyt j if p = 1

Letís Örst understand what the theorem gives us. Take any space lp (note
that the theorem does NOT make any statements about l1 ): Then the theorem
states that its dual is lq : The Örst part of the theorem states that lq 1 lp* : Take
any element e 2 lp* : Then there exists y 2 lq such that e is representable by y: In
this sense e 2 lq : The second part states that any y 2 lq deÖnes a functional e on
lp by (7:1): Given its deÖnition, e is obviously continuous and hence bounded.
Finally the theorem assures that the norm of the functional e associated with
y is indeed the norm associated with lq : Hence lp* 1 lq :
As a result of the theorem, whenever we deal with lp ; p 2 [1; 1) as commod-
ity space we can restrict attention to price systems that can be represented by a
vector p = (p0 ; p1 ; : : : pt ; : : :) and hence have a straightforward economic inter-
pretation: pt is the price of the good at period t and the cost of a consumption
bundle x is just the sum of the cost of all its components.
For reasons that will become clearer later the most interesting commodity
space for inÖnitely lived economies, however, is l1 : And for this commodity
space the previous theorem does not make any statements. It would suggest
that the dual of l1 is l1 ; but this is not quite correct, as the next result shows.
*
Proposition 69 The dual of l1 contains l1 : There are e 2 l1 that are not
representable by an element y 2 l1
114 CHAPTER 7. THE TWO WELFARE THEOREMS

Proof. For the Örst part for any y 2 l1 deÖne e : l1 ! R by

1
X
e(x) = xt yt
t=0

We need to show that e is linear and continuous. Linearity is obvious. For

continuity we need to show that for any sequence fxn g 2 l1 and x 2 l1 ;
kxn & xk = supt jxntP & xt j ! 0 implies je(xn ) & e(x)j ! 0: Since y 2 l1 there
1
exists M such that t=0 jyt j < M: Since supt jxnt & xt j ! 0; for all / > 0 there
exists N (/) such that fro all n > N (/) we have supt jxnt & xt j < /: But then for
"
any " > 0; taking /(") = 2M and N (") = N (/(")); for all n > N (")
K1 K
KX 1
X K
n K n K
je(x ) & e(x)j = K xt yt & xt yt K
K K
t=0 t=0
1
X
$ jyt (xnt & xt )j
t=0
1
X
$ jyt j * jxnt & xt j
t=0
"
$ M /(e) = <"
2
The second part we prove via a counter example after we have proved the
second welfare theorem.
The second part of the proposition is somewhat discouraging in that it asserts
that, when dealing with l1 as commodity space we may require a price system
that does not have a natural economic interpretation. It is true that there is
a subspace of l1 for which l1 is its dual. DeÖne the space c0 (with associated
sup-norm) as
c0 = fx 2 l1 : lim xt = 0g
t!1
*
We can prove that l1 is the dual of c0 : Since c0 1 l1 and l1 1 l1 ; obviously
* *
l1 1 c0 : It remains to show that any e 2 c0 can be represented by a y 2 l1 : [TO
BE COMPLETED]

7.3 DeÖnition of Competitive Equilibrium

Corresponding to our two notions of an economy and a private ownership econ-
omy we have two deÖnitions of competitive equilibrium that di§er in their spec-
iÖcation of the individual budget constraints.

DeÖnition 70 A competitive equilibrium is an allocation [(x0i )i2I ; (yj0 )j2J ] and

a continuous linear functional e : S ! R such that

1. for all i 2 I; x0i solves max ui (x) subject to x 2 Xi and e(x) $ e(x0i )
7.4. THE NEOCLASSICAL GROWTH MODEL IN ARROW-DEBREU LANGUAGE115

2. for all j 2 J; yj0 solves max e(y) subject to y 2 Yj

P P
3. i2I x0i = j2J yj0

In this deÖnition we have obviously ignored ownership of Örms. If, however,

all Yj are convex cones, the technologies exhibit constant returns to scale, proÖts
are zero in equilibrium and this deÖnition of equilibrium is equivalent to the
deÖnition of equilibrium for a private ownership economy (under appropriate
assumptions on preferences such as local nonsatiation). Note that condition 1.
is equivalent to requiring that for all i 2 I, x 2 Xi and e(x) $ e(x0i ) implies
ui (x) $ ui (x0i ) which states that all bundles that are cheaper than x0i must not
yield higher utility. Again note that we made no reference to the value of an
individualsí endowment or Örm ownership.

DeÖnition 71 A competitive equilibrium for a private ownership economy is

an allocation [(x0i )i2I ; (yj0 )j2J ] and a continuous linear functional e : S ! R
such that
P
1. for all i 2 I; x0i solves max ui (x) subject to x 2 Xi and e(x) $ j2J ]ij e(yj0 )

2. for all j 2 J; yj0 solves max e(y) subject to y 2 Yj

P P
3. i2I x0i = j2J yj0
P
We can interpret j2J ]ij e(yj0 ) as the value of the ownership that household
i holds to all the Örms of the economy.

7.4 The Neoclassical Growth Model in Arrow-

Debreu Language
Let us look at the neoclassical growth model presented in Section 2. We will
adopt the notation so that it Öts into our general discussion. Remember that
in the economy the representative household owned the capital stock and the
representative Örm, supplied capital and labor services and bought Önal out-
put from the Örm. A helpful exercise would be to repeat this exercise under
the assumption that the Örm owns the capital stock. The household had unit
endowment of time and initial endowment of k80 of the capital stock. To make
our exercise more interesting we assume that the household values consumption
and leisure according to instantaneous utility function U (c; l); where c is con-
sumption and l is leisure. The technology is described by y = F (k; n) where F
exhibits constant returns to scale. For further details refer to Section 2. Let us
represent this economy in Arrow-Debreu language.

7 I = J = 1; ]ij = 1
116 CHAPTER 7. THE TWO WELFARE THEOREMS

7 Commodity Space S: since three goods are traded in each period (Önal
output, labor and capital services), time is discrete and extends to inÖnity,
3
a natural choice is S = l1 = l1 0 l1 0 l1 : That is, S consists of all three-
dimensional inÖnite sequences that are bounded in the sup-norm, or
K iK
S = fs = (s1 ; s2 ; s3 ) = f(s1t ; s2t ; s3t )g1 i K K
t=0 : st 2 R; sup max st < 1g
t i

Obviously S; together with the sup-norm, is a (real) normed vector space.

We use the convention that the Örst component of s denotes the output
good (and hence is required to be positive), whereas the second and third
components denote labor and capital services, respectively. Again follow-
ing the convention these inputs are required to be negative.

7 Consumption Set X :

X = ffx1t ; x2t ; x3t g 2 S : x30 % &k80 ; &1 $ x2t $ 0; x3t $ 0; x1t % 0; x1t &(1&/)x3t +x3t+1 % 0 for all tg

We do not distinguish between capital and capital services here; this can
be done by adding extra notation and is an optional homework. The
constraints indicate that the household cannot provide more capital in
the Örst period than the initial endowment, canít provide more than one
unit of labor in each period, holds nonnegative capital stock and is required
to have nonnegative consumption. Evidently X 1 S:

7 Utility function u : X ! R is deÖned by

1
X
u(x) = ( t U (x1t & (1 & /)x3t + x3t+1 ; 1 + x2t )
t=0

Again remember the convention than labor and capital (as inputs) are
negative.

7 Aggregate Production Set Y :

Y = ffyt1 ; yt2 ; yt3 g 2 S : yt1 % 0; yt2 $ 0; yt3 $ 0; yt1 = F (&yt3 ; &yt2 ) for all tg

Note that the aggregate production set reáects the technological con-
straints in the economy. It does not contain any constraints that have
to do with limited supply of factors, in particular &1 $ yt2 is not imposed.

7 An allocation is [x; y] with x; y 2 S: A feasible allocation is an allocation

such that x 2 X; y 2 Y and x = y: An allocation is Pareto optimal is
it is feasible and if there is no other feasible allocation [x* ; y * ] such that
u(x* ) > u(x):

7 A price system e is a continuous linear functional e : S ! R: If e

has inner product representation, we represent it by p = (p1 ; p2 ; p3 ) =
f(p1t ; p2t ; p3t )g1
t=0 :
7.5. A PURE EXCHANGE ECONOMY IN ARROW-DEBREU LANGUAGE117

7 A competitive equilibrium for this private ownership economy is an allo-

cation [x* ; y * ] and a continuous linear functional such that

1. y * maximizes e(y) subject to y 2 Y

2. x* maximizes u(x) subject to x 2 X and e(x) $ e(y * )
3. x* = y *

Note that with constant returns to scale e(y * ) = 0: With inner product
representation of the price system the budget constraint hence becomes
1 X
X 3
e(x) = p * x = pit xit $ 0
t=0 i=1

Remembering our sign convention for inputs and mapping p1t = pt ; p2t = pt wt ;
p3t = pt rt we obtain the same budget constraint as in Section 2.

7.5 A Pure Exchange Economy in Arrow-Debreu

Language
Suppose there are I individuals that live forever. There is one nonstorable
consumption good in each period. Individuals order consumption allocations
according to
1
X
ui (ci ) = ( ti U (cit )
t=0

They have deterministic endowment streams ei = feit g1

t=0 : Trade takes place at
period 0: The standard deÖnition of a competitive (Arrow-Debreu) equilibrium
would go like this:

DeÖnition 72 A competitive equilibrium are prices fpt g1

t=0 and allocations
cit g1
(f^ )
t=0 i2I such that

1. Given fpt g1 cit g1

t=0 ; for all i 2 I; f^ t=0 solves maxci -0 ui (ci ) subject to

1
X
pt (cit & eit ) $ 0
t=0

2. X X
cit = eit for all t
i2I i2I

We brieáy want to demonstrate that we can easily write this economy in our
formal language. What goes on is that the household sells his endowment of the
consumption good to the market and buys consumption goods from the market.
So even though there is a single good in each period we Önd it useful to have
118 CHAPTER 7. THE TWO WELFARE THEOREMS

two commodities in each period. We also introduce an artiÖcial technology

that transforms one unit of the endowment in period t into one unit of the
consumption good at period t: There is a single representative Örm that
P operates
this technology and each consumer owns share ]i of the Örm, with i2I ]i = 1:
We then have the following representation of this economy
2
7 S = l1 : We use the convention that the Örst good is the consumption
good to be consumed, the second good is the endowment to be sold as
input by consumers. Again we use the convention that Önal output is
positive, inputs are negative.
7 Xi = fx 2 S : x1t % 0; &eit $ x2t $ 0g
7 ui : Xi ! R deÖned by
1
X
ui (x) = ( ti U (x1t )
t=0

7 Aggregate production set

Y = fy 2 S : yt1 % 0; yt2 $ 0; yt1 = &yt2 g

7 Allocations, feasible allocations and Pareto e¢cient allocations are deÖned

as before.
7 A price system e is a continuous linear functional e : S ! R: If e has inner
product representation, we represent it by p = (p1 ; p2 ) = f(p1t ; p2t )g1
t=0 :

7 A competitive equilibrium [(xi* )i2I ; y; e] for this private ownership econ-

omy deÖned as before.
7 Note that with constant returns to scale in equilibrium we have e(y * ) = 0:
With inner product representation of the price system in equilibrium also
p1t = p2t = pt : The budget constraint hence becomes
1 X
X 2
e(x) = p * x = pit xit $ 0
t=0 i=1

Obviously (as long as pt > 0 for all t) the consumer will choose xi2t =
&eit , i.e. sell all his endowment. The budget constraint then takes the
familiar form
X1
pt (cit & eit ) $ 0
t=0

The purpose of this exercise was to demonstrate that, although in the re-
maining part of the course we will describe the economy and deÖne an equilib-
rium in the Örst way, whenever we desire to prove the welfare theorems we can
represent any pure exchange economy easily in our formal language and use the
machinery developed in this section (if applicable).
7.6. THE FIRST WELFARE THEOREM 119

7.6 The First Welfare Theorem

The Örst welfare theorem states that every competitive equilibrium allocation
is Pareto optimal. The only assumption that is required is that peopleís prefer-
ences be locally nonsatiated. The proof of the theorem is unchanged from the
one you should be familiar with from micro last quarter

Theorem 73 Suppose that for all i; all x 2 Xi there exists a sequence fxn g1 n=0
in Xi converging to x with u(xn ) > u(x) for all n (local nonsatiation). If an
allocation [(x0i )i2I ; (yj0 )j2J ] and a continuous linear functional e constitute a
competitive equilibrium, then the allocation [(x0i )i2I ; (yj0 )j2J ] is Pareto optimal.

Proof. The proof is by contradiction. Suppose [(x0i )i2I ; (yj0 )j2J ], e is a

competitive equilibrium.
Step 1: We show that for all i; all x 2 Xi ; u(x) % u(x0i ) implies e(x) % e(x0i ):
Suppose not, i.e. suppose there exists i and x 2 Xi with u(x) % u(x0i ) and
e(x) < e(x0i ): Let fxn g in Xi be a sequence converging to x with u(xn ) > u(x)
for all n: Such a sequence exists by our local nonsatiation assumption. By
continuity of e there exists an n such that u(xn ) > u(x) % u(x0i ) and e(xn ) <
e(x0i ); violating the fact that x0i is part of a competitive equilibrium.
Step 2: For all i; all x 2 Xi ; u(x) > u(x0i ) implies e(x) > e(x0i ): This follows
directly from the fact that x0i is part of a competitive equilibrium.
Step 3: Now suppose [(x0i )i2I ; (yj0 )j2J ] is not Pareto optimal. Then there
exists another feasible allocation [(x*i )i2I ; (yj* )j2J ] such that u(x*i ) % u(x0i ) for
all i and with strict inequality for some i: Since [(x0i )i2I ; (yj0 )j2J ] is a competitive
equilibrium allocation, by step 1 and 2 we have

e(x*i ) % e(x0i )

for all i; with strict inequality for some i: Summing up over all individuals yields
X X
e(x*i ) > e(x0i ) < 1
i2I i2I

The last inequality comes from the fact that the set of people I is Önite and
that for all i; e(x0i ) is Önite (otherwise the consumer maximization problem has
no solution). By linearity of e we have
! !
X X X X
* * 0 0
e xi = e(xi ) > e(xi ) = e xi
i2I i2I i2I i2I

Since both allocations are feasible we have that

X X
x0i = yj0
i2I j2J
X X
x*i = yj*
i2I j2J
120 CHAPTER 7. THE TWO WELFARE THEOREMS

and hence 0 1 0 1
X X
e@ yj* A > e @ yj0 A
j2J j2J

Again by linearity of e X X
e(yj* ) > e(yj0 )
j2J j2J

and hence for at least one j 2 J; e(yj* )

> e(yj0 ): But yj* 2 Yj and we ob-
tain a contradiction to the hypothesis that [(x0i )i2I ; (yj0 )j2J ] is a competitive
equilibrium allocation.
Several remarks are in order. It is crucial for the proof that the set of in-
dividuals is Önite, as will be seen in our discussion of overlapping generations
economies. Also our equilibrium deÖnition seems odd as it makes no reference
to endowments or ownership in the budget constraint. For the preceding the-
orem, however, this is not a shortcoming. Since we start with a competitive
equilibrium we know the value of each individualís consumption allocation. By
local nonsatiation each consumer exhausts her budget and hence we implicitly
know each individualís income (the value of endowments and Örm ownership, if
speciÖed in a private ownership economy).

7.7 The Second Welfare Theorem

The second welfare theorem provides a converse to the Örst welfare theorem.
Under suitable assumptions it states that for any Pareto-optimal allocation there
exists a price system such that the allocation together with the price system
form a competitive equilibrium. It may at Örst be surprising that the second
welfare theorem requires much more stringent assumptions than the Örst welfare
theorem. Remember, however, that in the Örst welfare theorem we start with a
competitive equilibrium whereas in the proof of the second welfare we have to
carry out an existence proof. Comparing the assumptions of the second welfare
theorem with those of existence theorems makes clear the intimate relation
between them.
As in micro we will use a separating hyperplane theorem to establish the
existence of a price system that decentralizes a given allocation [x; y]. The
price system is nothing else than a hyperplane that separates the aggregate
production set from the set of consumption allocations that are jointly preferred
by all consumers. Figure 6 illustrates this general principle.In lieu of Figure 6 it
is not surprising that several convexity assumptions have to be made to prove
the second welfare theorem. We will come back to this when we discuss each
speciÖc assumption. First we state the separating hyperplane that we will use
for our proof. Obviously we canít use the standard theorems commonly used
in micro4 since our commodity space in a general real vector space (possibly
inÖnite dimensional).
4 See MasColell et al., p. 948. This theorem is usually attributed to Minkowski.
7.7. THE SECOND WELFARE THEOREM 121

Separating Hyperplane: Set of jointly preferred consumption

Price System Φ allocations A

[x,y]

Aggregate Production Set Y

122 CHAPTER 7. THE TWO WELFARE THEOREMS

We will apply the geometric form of the Hahn-Banach theorem. For this we
need the following deÖnition

DeÖnition 74 Let S be a normed real vector space with norm kkS : DeÖne by

b(x; ") = fs 2 S : kx & skS < "g

the open ball of radius " around x: The interior of a set A 1 S; e is deÖned to
be
e = fx 2 A : 9" > 0 with b(x; ") 1 Ag

Hence the interior of a set A consists of all the points in A for which we can
Önd a open ball (no matter how small) around the point that lies entirely in A:
We then have the following

Theorem 75 (Geometric Form of the Hahn-Banach Theorem): Let A; Y 8 S

be convex sets and assume that

f = ;
either Y has an interior point and A \ Y
or S is Önite dimensional and A \ Y = ;

Then there exists a continuous linear functional e; not identically zero on S;

and a constant c such that

e(y) $ c $ e(x) for all x 2 A and all y 2 Y

For the proof of the Hahn-Banach theorem in its several forms see Luenberger
(1969), p. 111 and p. 133. For the case that S is Önite dimensional this theorem
is rather intuitive in light of Figure 6. But since we are interested in commodity
spaces with inÖnite dimensions (typically S = lp ; for p 2 [1; 1]), we usually
have to prove that the aggregate production set Y has an interior point in
order to apply the Hahn-Banach theorem. We will two things now: a) prove by
example that the requirement of an interior point is an assumption that cannot
be dispensed with if S is not Önite dimensional b) show that this assumption
de facto rules out using S = lp ; for p 2 [1; 1); as commodity space when one
wants to apply the second welfare theorem.
For the Örst part consider the following

Example 76 Consider as commodity space

1
X
S = ffxt g1
t=0 : xt 2 R for all t, kxkS = ( t jxt j < 1g
t=0

for some ( 2 (0; 1): Let A = f]g and

Y = fx 2 S : jxt j $ 1 for all tg

7.7. THE SECOND WELFARE THEOREM 123

Obviously A; B 8 S are convex sets. In some sense ] = (0; 0; : : : ; 0; : : :) lies in

the middle of Y; but it does not lie in the interior of Y: Suppose it did, then
there exists " > 0 such that for all x 2 S such that
1
X
kx & ]kS = ( t jxt j < "
t=0

ln( " )
we have x 2 Y: But for any " > 0; deÖne t(") = ln(%) 2
+1: Then x = (0; 0; : : : ; xt(") =
P1 t t(")
2; 0; : : :) 2
= Y satisÖes t=0 ( jxt j = 2( < ". Since this is true for all " > 0;
this shows that ] is not in the interior of Y; or A\Y= f ;: A very similar argu-
ment shows that no s 2 S is in the interior of Y; i.e. Y= f ;: Hence the only
hypothesis for the Hahn-Banach theorem that fails is that Y has an interior
point. We now show that the conclusion of the theorem fails. Suppose, to the
contrary, that there exists a continuous linear functional e on S with e(s) 6= 0
for some s8 2 S and
e(y) $ c $ e(]) for all y 2 Y
Obviously e(]) = e(0 * s8) = 0 by linearity of e: Hence it follows that for all
y 2 Y; e(y) $ 0: Now suppose there exists y8 2 Y such that e(8 y ) < 0: But since
&8y 2 Y; by linearity e(&8 y ) = &e(8
y ) > 0 a contradiction. Hence e(y) = 0 for
all y 2 Y: From this it follows that e(s) = 0 for all s 2 S (why?); contradicting
the conclusion of the theorem.
As we will see in the proof of the second welfare theorem, to apply the
Hahn-Banach theorem we have to assure that the aggregate production set has
nonempty interior. The aggregate production set in many application will be
(a subset) of the positive orthant of the commodity space. The problem with
taking lp ; p 2 [1; 1) as the commodity space is that, as the next proposition
shows, the positive orthant
lp+ = fx 2 lp : xt % 0 for all tg
has empty interior. The good thing about l1 is that is has a nonempty interior.
This justiÖes why we usually use it (or its k-fold product space) as commodity
space.
Proposition 77 The positive orthant of lp ; p 2 [0; 1) has an empty interior.
The positive orthant of l1 has nonempty interior.
Proof. For the Örst part suppose there exists x 2 lp+ and " > 0 such that
b(x; ") 1 lp+ : Since x 2 lp ; xt ! 0; i.e. xt < 2" for all t % T ("): Take any < > T (")
and deÖne z as "
xt if t 6= <
zt =
xt & 2" if t = <
= lp+ : But since
Evidently z* < 0 and hence z 2

1
! p1
X "
kx & zkp = jxt & zt jp = jx* & z* j = <"
t=0
2
124 CHAPTER 7. THE TWO WELFARE THEOREMS

we have z 2 b(x; "); a contradiction. Hence the interior of lp+ is empty, the
Hahn-Banach theorem doesnít apply and we canít use it to prove the second
welfare theorem.
+
For the second part it su¢ces to construct an interior point of l1 : Take
1 +
x = (1; 1; : : : ; 1; : : :) and " = 2 : We want to show that b(x; ") 1 l1 : Take any
z 2 b(x; "): Clearly zt % 12 % 0: Furthermore

1
sup jzt j $ 1 <1
t 2
+
Hence z 2 l1 :
Now let us proceed with the statement and the proof of the second welfare
theorem. We need the following assumptions

1. For each i 2 I; Xi is convex.

2. For each i 2 I; if x; x0 2 Xi and ui (x) > ui (x0 ); then for all , 2 (0; 1)

ui (,x + (1 & ,)x0 ) > ui (x0 )

3. For each i 2 I; ui is continuous.

4. The aggregate production set Y is convex

5. Either Y has an interior point or S is Önite-dimensional.

Note that the second assumption is sometimes referred to as strict quasi-

concavity5 of the utility functions. It implies that the upper contour sets

Aix = fz 2 Xi : ui (z) % ui (x)g

are convex, for all i; all x 2 Xi : Without the convexity assumption 1. assumption
2 would not be well-deÖned as without convex Xi ; ,x+(1&,)x0 2 = Xi is possible,
in which case ui (,x+(1&,)x0 ) is not well-deÖned. I mention this since otherwise
1. is not needed for the following theorem. Also note that it is assumption 5
that has no counterpart to the theorem in Önite dimensions. It only is required
to use the appropriate separating hyperplane theorem in the proof. With these
assumptions we can state the second welfare theorem

Theorem 78 Let [(x0i ); (yj0 )] be a Pareto optimal allocation and assume that
for some h 2 I there is a x
^h 2 Xh with uh (^ xh ) > uh (x0h ): Then there exists a
continuous linear functional e : S ! R; not identically zero on S; such that

1. for all j 2 J; yj0 2 arg maxy2Yj e(y)

2. for all i 2 I and all x 2 Xi ; ui (x) % ui (x0i ) implies e(x) % e(x0i )

5 To me it seems that quasi-concavity is enough for the theorem to hold as quasi-concavity

is equivalent to convex upper contour sets which all one needs in the proof.
7.7. THE SECOND WELFARE THEOREM 125

Several comments are in order. The theorem states that (under the assump-
tions of the theorem) any Pareto optimal allocation can be supported by a price
system as a quasi-equilibrium. By deÖnition of Pareto optimality the allocation
is feasible and hence satisÖes resource balance. The theorem also guarantees
proÖt maximization of Örms. For consumers, however, it only guarantees that
x0i minimizes the cost of attaining utility ui (x0i ); but not utility maximization
among the bundles that cost no more than e(x0i ); as would be required by a
competitive equilibrium. You also may be used to a version of this theorem
that shows that a Pareto optimal allocation can be made into an equilibrium
with transfers. Since here we havenít deÖned ownership and in the equilibrium
deÖnition make no reference to the value of endowments or Örm ownership (i.e.
do NOT require the budget constraint to hold), we can abstract from trans-
fers, too. The proof of the theorem is similar to the one for Önite dimensional
commodity spaces.
Proof. Let [(x0i ); (yj0 )] be a Pareto optimal allocation and Aix0 be the upper
i
contour sets (as deÖned above) with respect to x0i ; for all i 2 I: Also let qix0 to
i
be the interior of Aix0 ; i.e.
i

i
qx0i = fz 2 Xi : ui (z) > ui (x0i )g

By assumption 2. the Aix0 are convex and hence qix0 is convex. Furthermore
i i
x0i 2 Aix0 ; so the Aix0 are nonempty. By one of the hypotheses of the theorem
i i
there is some h 2 I there is a x xh ) > uh (x0h ): For that h; qhx0
^h 2 Xh with uh (^
h
is nonempty. DeÖne X
h
A = qx0h + Aix0
i
i6=h

A is the set of all aggregate consumption bundles that can be split in such a way
as to give every agent at least as much utility and agent h strictly more utility
than the Pareto optimal allocation [(x0i ); (yj0 )]: As A is the sum of nonempty
convex sets, so is A: Obviously A 8 S: By assumption Y is convex. Since
[(x0i ); (yj0 )] is a Pareto optimal allocation A \ Y = ;: Otherwise there is an
aggregate consumption bundle x* 2 A\Y that can be produced (as x* 2 Y ) and
Pareto dominates x0 (as x* 2 A), contradicting Pareto optimality of [(x0i ); (yj0 )]:
With assumption 5. we have all the assumptions we need to apply the Hahn-
Banach theorem. Hence there exists a continuous linear functional e on S; not
identically zero, and a number c such that

e(y) $ c $ e(x) for all x 2 A; all y 2 Y

It remains to be shown that [(x0i ); (yj0 )] together with e satisfy conclusions 1

and 2, i.e. constitute a quasi-equilibrium. P
First note that the closure of A is A8 = i2I Aix0 since by continuity of uh
i
(assumption 3.) the closure of qhx0 is Ahx0 : Therefore, since e is continuous,
P h h
c $ e(x) for all x 2 A8 = i2I Aix0 .
i
126 CHAPTER 7. THE TWO WELFARE THEOREMS

Second, note that, since [(x0i ); (yj0 )] is Pareto optimal, it is feasible and hence
0
y 2Y X X
x0 = x0i = yj0 = y 0
i2I j2J
0
Obviously x 2 A: 8 Therefore e(x0 ) = e(y 0 ) $ c $ e(x0 ) which implies e(x0 ) =
0
e(y ) = c:
To show conclusion 1 Öx j 2 J and suppose there exists y~jP2 Yj such that
e(~yj ) > e(yj0 ): For k 6= j deÖne y~k = yk0 : Obviously y~ = jy~j 2 Y and
e(~y ) > e(y 0 ) = c; a contradiction to the fact that e(y) $ c for all y 2 Y:
Therefore yj0 maximizes e(z) subject to z 2 Yj ; for all j 2 J:
To show conclusion 2 Öx i 2 I and suppose there exists x ~i 2 Xi with
Pui (~
xi ) %
ui (x0i ) and e(~
xi ) < e(x0i ): For l 6= i deÖne x
~l = x0l : Obviously x
~ = ix ~i 2 A8
and e(~ x) < e(x0 ) = c; a contradiction to the fact that e(x) % c for all x 2 A: 8
Therefore x0i minimizes e(z) subject to ui (z) % ui (x0i ); z 2 Xi :
We now want to provide a condition that assures that the quasi-equilibrium
in the previous theorem is in fact a competitive equilibrium, i.e. is not only cost
minimizing for the households, but also utility maximizing. This is done in the
following

Remark 79 Let the hypotheses of the second welfare theorem be satisÖed and
let e be a continuous linear functional that together with [(x0i ); (yj0 )] satisÖes the
conclusions of the second welfare theorem. Also suppose that for all i 2 I there
exists x0i 2 Xi such that
e(x0i ) < e(x0i )
Then [(x0i ); (yj0 ); e] constitutes a competitive equilibrium

Note that, in order to verify the additional condition -the existence of a

cheaper point in the consumption set for each i 2 I- we need a candidate price
system e that already passed the test of the second welfare theorem. It is
not, as the assumptions for the second welfare theorem, an assumptions on the
fundamentals of the economy alone.
Proof. We need to prove that for all i 2 I; all x 2 Xi ; e(x) $ e(x0i ) implies
ui (x) $ ui (x0i ): Pick an arbitrary i 2 I; x 2 Xi satisfying e(x) $ e(x0i ): DeÖne

xS = ,x0i + (1 & ,)x for all , 2 (0; 1)

Since by assumption e(x0i ) < e(x0i ) and e(x) $ e(x0i ) we have by linearity of e

e(xS ) = ,e(x0i ) + (1 & ,) e(x) < e(x0i ) for all , 2 (0; 1)

Since xi0 by assumption is part of a quasi-equilibrium and (by convexity of Xi

we have xS 2 Xi ), ui (xS ) % ui (x0i ) implies e(xS ) % e(x0i ); or by contraposition
e(xS ) < e(x0i ) implies ui (xS ) < ui (x0i ) for all , 2 (0; 1): But then by continuity
of ui we have ui (x) = limS!0 ui (xS ) $ ui (x0i ) as desired.
As shown by an example in Stokey et al. the assumption on the existence
of a cheaper point cannot be dispensed with when wanting to make sure that
7.7. THE SECOND WELFARE THEOREM 127

-p

0
B

Indifference Curves of A

E’

Indifference
Curves of B

0
A

a quasi-equilibrium is in fact a competitive equilibrium. In Figure 7 we draw

the Edgeworth box of a pure exchange economy. Consumer Bís consumption
set is the entire positive orthant, whereas consumer Aís consumption set is the
are above the line marked by &p; as indicated by the broken lines. Both con-
sumption sets are convex, the upper contour sets are convex and close as for
standard utility functions satisfying assumptions 2. and 3. Point E clearly rep-
resents a Pareto optimal allocation (since at E consumer Bís utility is globally
maximized subject to the allocation being feasible). Furthermore E represents
a quasi-equilibrium, since at prices p both consumers minimize costs subject
to attaining at least as much utility as with allocation E: However, at prices
p (obviously the only candidate for supporting E as competitive equilibrium
since tangent to consumer Bís indi§erence curve through E) agent A obtains
higher utility at allocation E 0 with the same cost as with E; hence [E; p] is not
a competitive equilibrium. The remark fails because at candidate prices p there
is no consumption allocation for A that is feasible (in XA ) and cheaper. This
demonstrates that the cheaper-point assumption cannot be dispensed with in
the remark. This concludes the discussion of the second welfare theorem.
128 CHAPTER 7. THE TWO WELFARE THEOREMS

The last thing we want to do in this section is to demonstrate that our choice
of l1 as commodity space is not without problems either. We argued earlier
that lp ; p 2 [1; 1) is not an attractive alternative. Now we use the second
welfare theorem to show that for certain economies the price system needed
(whose existence is guaranteed by the theorem) need not lie in l1 ; i.e. does not
have a representation as a vector p = (p0 ; p1 ; : : : ; pt ; : : :): This is bad in the sense
that then the price system we get from the theorem does not have a natural
economic interpretation. After presenting such a pathological example we will
brieáy discuss possible remedies.

Example 80 Let S = l1 : There is a single consumer and a single Örm. The

aggregate production set is given by

1
Y = fy 2 S : 0 $ yt $ 1 + ; for all tg
t

The consumption set is given by

X = fx 2 S : xt % 0 for all tg

The utility function u : X ! R is

u(x) = inf xt
t

[TO BE COMPLETED]

7.8 Type Identical Allocations

[TO BE COMPLETED]
Chapter 8

The Overlapping
Generations Model

In this section we will discuss the second major workhorse model of modern
macroeconomics, the Overlapping Generations (OLG) model, due to Allais
(1947), Samuelson (1958) and Diamond (1965). The structure of this section
will be as follows: we will Örst present a basic pure exchange version of the OLG
model, show how to analyze it and contrast its properties with those of a pure
exchange economy with inÖnitely lived agents. The basic di§erences are that in
the OLG model

7 competitive equilibria may be Pareto suboptimal

7 (outside) money may have positive value

7 there may exist a continuum of equilibria

We will demonstrate these properties in detail via examples. We will then

discuss the Ricardian Equivalence hypothesis (the notion that, given a stream of
government spending the Önancing method of the government -taxes or budget
deÖcits- does not ináuence macroeconomic aggregates) for both the inÖnitely
lived agent model as well as the OLG model. Finally we will introduce pro-
duction into the OLG model to discuss the notion of dynamic ine¢ciency. The
Örst part of this section will be based on Kehoe (1989), Geanakoplos (1989), the
second section on Barro (1974) and the third section on Diamond (1965). Other
good sources of information include Blanchard and Fischer (1989), chapter 3,
Sargent and Ljungquist, chapter 8 and Azariadis, chapter 11 and 12.

129
130 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

8.1 A Simple Pure Exchange Overlapping Gen-

erations Model
Letís start by repeating the inÖnitely lived agent model to which we will compare
the OLG model. Suppose there are I individuals that live forever. There is one
nonstorable consumption good in each period. Individuals order consumption
allocations according to
1
X
ui (ci ) = ( ti U (cit )
t=0

Agents have deterministic endowment streams ei = feit g1

t=0 : Trade takes place
at period 0: The standard deÖnition of an Arrow-Debreu equilibrium goes like
this:

DeÖnition 81 A competitive equilibrium are prices fpt g1

t=0 and allocations
cit g1
(f^ )
t=0 i2I such that

1. Given fpt g1 cit g1

t=0 ; for all i 2 I; f^ t=0 solves maxci -0 ui (ci ) subject to

1
X
pt (cit & eit ) $ 0
t=0

2. X X
c^it = eit for all t
i2I i2I

What are the main shortcomings of this model that have lead to the devel-
opment of the OLG model? The Örst criticism is that individuals apparently do
not live forever, so that a model with Önitely lived agents is needed. We will see
later that we can give the inÖnitely lived agent model an interpretation in which
individuals lived only for a Önite number of periods, but, by having an altruistic
bequest motive, act so as to maximize the utility of the entire dynasty, which
in e§ect makes the planning horizon of the agent inÖnite. So inÖnite lives in
itself are not as unsatisfactory as it may seem. But if people live forever, they
donít undergo a life cycle with low-income youth, high income middle ages and
retirement where labor income drops to zero. In the inÖnitely lived agent model
every period is like the next (which makes it so useful since this stationarity
renders dynamic programming techniques easily applicable). So in order to an-
alyze issues like social security, the e§ect of taxes on retirement decisions, the
distributive e§ects of taxes vs. government deÖcits, the e§ects of life-cycle sav-
ing on capital accumulation one needs a model in which agents experience a life
cycle and in which people of di§erent ages live at the same time in the economy.
This is why the OLG model is a very useful tool for applied policy analysis.
Because of its interesting (some say, pathological) theoretical properties, it is
also an area of intense study among economic theorists.
8.1. A SIMPLE PURE EXCHANGE OVERLAPPING GENERATIONS MODEL131

8.1.1 Basic Setup of the Model

Let us describe the model formally now. Time is discrete, t = 1; 2; 3; : : : and
the economy (but not its people) lives forever. In each period there is a sin-
gle, nonstorable consumption good. In each time period a new generation (of
measure 1) is born, which we index by its date of birth. People live for two
periods and then die. By (ett ; ett+1 ) we denote generation tís endowment of the
consumption good in the Örst and second period of their live and by (ctt ; ctt+1 )
we denote the consumption allocation of generation t: Hence in time t there are
two generations alive, one old generation t & 1 that has endowment et$1 t and
consumption ct$1t and one young generation t that has endowment ett and con-
sumption ctt : In addition, in period 1 there is an initial old generation 0 that has
endowment e01 and consumes c01 : In some of our applications we will endow the
initial generation with an amount of outside money1 m: We will NOT assume
m % 0: If m % 0; then m can be interpreted straightforwardly as Öat money,
if m < 0 one should envision the initial old people having borrowed from some
institution (which is, however, outside the model) and m is the amount to be
repaid.
In the next Table 1 we demonstrate the demographic structure of the econ-
omy. Note that there are both an inÖnite number of periods as well as well as
an inÖnite number of agents in this economy. This ìdouble inÖnityî has been
cited to be the major source of the theoretical peculiarities of the OLG model
(prominently by Karl Shell).
Table 1
Time
G 1 2 ::: t t+1
e 0 (c01 ; e01 )
n 1 (c11 ; e11 ) (c12 ; e12 )
.. ..
e . .
r t&1 (ct$1
t ; et$1
t )
t t
a t (ct ; et ) (ctt+1 ; ett+1 )
t. t+1 (ct+1 t+1
t+1 ; et+1 )

Preferences of individuals are assumed to be representable by an additively

separable utility function of the form

ut (c) = U (ctt ) + (U (ctt+1 )

and the preferences of the initial old generation is representable by

u0 (c) = U (c01 )
1 Money that is, on net, an asset of the private economy, is ìoutside moneyî. This includes

Öat currency issued by the government. In contrast, inside money (such as bank deposits) is
both an asset as well as a liability of the private sector (in the case of deposits an asset of the
deposit holder, a liability to the bank).
132 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

We shall assume that U is strictly increasing, strictly concave and twice contin-
uously di§erentiable. This completes the description of the economy. Note that
we can easily represent this economy in our formal Arrow-Debreu language from
Chapter 7 since it is a standard pure exchange economy with inÖnite number
of agents and the peculiar preference and endowment structure ets = 0 for all
s 6= t; t+1 and ut (c) only depending on ctt ; ctt+1 : You should complete the formal
representation as a useful homework exercise.
The following deÖnitions are straightforward

DeÖnition 82 An allocation is a sequence c01 ; fctt ; ctt+1 g1

t=1 : An allocation is
feasible if ct$1
t ; c t
t % 0 for all t % 1 and

ct$1
t + ctt = et$1
t + ett for all t % 1

An allocation c01 ; f(ctt ; ctt+1 )g1

t=1 is Pareto optimal if it is feasible and if there is
no other feasible allocation c^10 ; f(^ ctt ; c^tt+1 )g1
t=1 such that

ctt ; c^tt+1 ) % ut (ctt ; ctt+1 ) for all t % 1

ut (^
u0 (^ c01 ) % u0 (c01 )

with strict inequality for at least one t % 0:

We now deÖne an equilibrium for this economy in two di§erent ways, depend-
ing on the market structure. Let pt be the price of one unit of the consumption
good at period t: In the presence of money (i.e. m 6= 0) we will take money
to be the numeraire. This is important since we can only normalize the price
of one commoditiy to 1; so with money no further normalizations are admissi-
ble. Of course, without money we are free to normalize the price of one other
commodity. Keep this in mind for later. We now have the following

ctt ; c^tt+1 )g1

DeÖnition 83 Given m; an Arrow-Debreu equilibrium is an allocation c^01 ; f(^ t=1
1
and prices fpt gt=1 such that

1. Given fpt g1 ctt ; c^tt+1 ) solves

t=1 ; for each t % 1; (^

max ut (ctt ; ctt+1 ) (8.1)

(ctt ;ctt+1 )-0

s.t. pt ctt + pt+1 ctt+1 $ pt ett + pt+1 ett+1 (8.2)

2. Given p1 ; c^01 solves

max
0
u0 (c01 )
c1

s.t. p1 c01 $ p1 e01 + m (8.3)

3. For all t % 1 (Resource Balance or goods market clearing)

ct$1
t + ctt = et$1
t + ett for all t % 1
8.1. A SIMPLE PURE EXCHANGE OVERLAPPING GENERATIONS MODEL133

As usual within the Arrow-Debreu framework, trading takes place in a hy-

pothetical centralized market place at period 0 (even though the generations are
not born yet).2 There is an alternative deÖnition of equilibrium that assumes
sequential trading. Let rt+1 be the interest rate from period t to period t + 1
and stt be the savings of generation t from period t to period t + 1: We will
look at a slightly di§erent form of assets in this section. Previously we dealt
with one-period IOUís that had price qt in period t and paid out one unit of
the consumption good in t + 1 (so-called zero bonds). Now we consider assets
that cost one unit of consumption in period t and deliver 1 + rt+1 units tomor-
row. Equilibria with these two di§erent assets are obviously equivalent to each
other, but the latter speciÖcation is easier to interpret if the asset at hand is
Öat money.
We deÖne a Sequential Markets (SM) equilibrium as follows:

ctt ; c^tt+1 ; s^tt )g1

DeÖnition 84 Given m; a sequential markets equilibrium is an allocation c^01 ; f(^ t=1
1
and interest rates frt gt=1 such that

1. Given frt g1 ctt ; c^tt+1 ; s^tt ) solves

t=1 for each t % 1; (^

max ut (ctt ; ctt+1 )

(ctt ;ctt+1 )-0;stt

s.t. ctt + stt $ ett (8.4)

ctt+1 $ ett+1 + (1 + rt+1 )stt (8.5)

2. Given r1 ; c^01 solves

max
0
u0 (c01 )
c1

s.t. c01 $ e01 + (1 + r1 )m

3. For all t % 1 (Resource Balance or goods market clearing)

c^t$1
t + c^tt = et$1
t + ett for all t % 1 (8.6)

In this interpretation trade takes place sequentially in spot markets for con-
sumption goods that open in each period. In addition there is an asset market
through which individuals do their saving. Remember that when we wrote down
the sequential formulation of equilibrium for an inÖnitely lived consumer model
we had to add a shortsale constraint on borrowing (i.e. st % &A) in order to
prevent Ponzi schemes, the continuous rolling over of higher and higher debt.
This is not necessary in the OLG model as people live for a Önite (two) number
of periods (and we, as usual, assume perfect enforceability of contracts)
2 When naming this deÖnition after Arrow-Debreu I make reference to the market structure

that is envisioned under this deÖnition of equilibrium. Others, including Geanakoplos, refer
to a particular model when talking about Arrow-Debreu, the standard general equilibrium
model encountered in micro with Önite number of simultaneously living agents. I hope this
does not cause any confusion.
134 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

Given that the period utility function U is strictly increasing, the budget
constraints (8:4) and (8:5) hold with equality. Take budget constraint (8:5) for
generation t and (8:4) for generation t + 1 and sum them up to obtain

ctt+1 + ct+1 t+1 t t+1 t

t+1 + st+1 = et+1 + et+1 + (1 + rt+1 )st

Now use equation (8:6) to obtain

st+1 t
t+1 = (1 + rt+1 )st

Doing the same manipulations for generation 0 and 1 gives

s11 = (1 + r1 )m

and hence, using repeated substitution one obtains

stt = Et* =1 (1 + r* )m (8.7)

This is the market clearing condition for the asset market: the amount of saving
(in terms of the period t consumption good) has to equal the value of the outside
supply of assets, Et* =1 (1 + r* )m: Strictly speaking one should include condition
(8:7) in the deÖnition of equilibrium. By Walrasí law however, either the asset
market or the good market equilibrium condition is redundant.
There is an obvious sense in which equilibria for the Arrow-Debreu economy
(with trading at period 0) are equivalent to equilibria for the sequential markets
economy. For rt+1 > &1 combine (8:4) and (8:5) into

ctt+1 ett+1
ctt + = ett +
1 + rt+1 1 + rt+1

Divide (8:2) by pt > 0 to obtain

pt+1 t pt+1 t
ctt + ct+1 = ett + e
pt pt t+1

Furthermore divide (8:3) by p1 > 0 to obtain

m
c01 $ e01 +
p1
We then can straightforwardly prove the following proposition

ctt ; c^tt+1 )g1

Proposition 85 Let allocation c^01 ; f(^ 1
t=1 and prices fpt gt=1 constitute
an Arrow-Debreu equilibrium with pt > 0 for all t % 1: Then there exists a cor-
responding sequential market equilibrium with allocations c~01 ; f(~ ctt ; c~tt+1 ; s~tt )g1
t=1
1
and interest rates frt gt=1 with

c~t$1
t = c^t$1
t for all t % 1
c~tt = c^tt for all t % 1
8.1. A SIMPLE PURE EXCHANGE OVERLAPPING GENERATIONS MODEL135

ctt ; c^tt+1 ; s^tt )g1

Furthermore, let allocation c^01 ; f(^ 1
t=1 and interest rates frt gt=1 con-
stitute a sequential market equilibrium with rt > &1 for all t % 0: Then there ex-
ists a corresponding Arrow-Debreu equilibrium with allocations c~01 ; f(~ ctt ; c~tt+1 )g1
t=1
1
and prices fpt gt=1 such that

c~t$1
t = c^t$1
t for all t % 1
c~tt t
= c^t for all t % 1

Proof. The proof is similar to the inÖnite horizon counterpart. Given

equilibrium Arrow-Debreu prices fpt g1
t=1 deÖne interest rates as

pt
1 + rt+1 =
pt+1
1
1 + r1 =
p1

and savings
s~tt = ett & c^tt

It is straightforward to verify that the allocations and prices so constructed

constitute a sequential markets equilibrium.
Given equilibrium sequential markets interest rates frt g1
t=1 deÖne Arrow-
Debreu prices by

1
p1 =
1 + r1
pt
pt+1 =
1 + rt+1

Again it is straightforward to verify that the prices and allocations so con-

structed form an Arrow-Debreu equilibrium.
Note that the requirement on interest rates is weaker for the OLG version
of this proposition than for the inÖnite horizon counterpart. This is due to
the particular speciÖcation of the no-Ponzi condition used. A less stringent
condition still ruling out Ponzi schemes would lead to a weaker condtion in the
proposition for the inÖnite horizon economy also.
Also note that with this equivalence we have that
m
Et* =1 (1 + r* )m =
pt

so that the asset market clearing condition for the sequential markets economy
can be written as
pt stt = m

i.e. the demand for assets (saving) equals the outside supply of assets, m: Note
that the demanders of the assets are the currently young whereas the suppliers
136 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

are the currently old people. From the equivalence we can also see that the
return on the asset (to be interpreted as money) equals

pt 1
1 + rt+1 = =
pt+1 1 + Q t+1
(1 + rt+1 )(1 + Q t+1 ) = 1
rt+1 - &Q t+1

where Q t+1 is the ináation rate from period t to t + 1. As it should be, the real
return on money equals the negative of the ináation rate.

8.1.2 Analysis of the Model Using O§er Curves

Unless otherwise noted in this subsection we will focus on Arrow-Debreu equilib-
ria. Gale (1973) developed a nice way of analyzing the equilibria of a two-period
OLG economy graphically, using o§er curves. First let us assume that the econ-
omy is stationary in that ett = w1 and ett+1 = w2 ; i.e. the endowments are time
invariant. For given pt ; pt+1 > 0 let by ctt (pt ; pt+1 ) and ctt+1 (pt ; pt+1 ) denote
the solution to maximizing (8:1) subject to (8:2) for all t % 1: Given our as-
sumptions this solution is unique. Let the excess demand functions y and z be
deÖned by

y(pt ; pt+1 ) = ctt (pt ; pt+1 ) & ett

= ctt (pt ; pt+1 ) & w1
z(pt ; pt+1 ) = ctt+1 (pt ; pt+1 ) & w2

These two functions summarize, for given prices, all implications that consumer
optimization has for equilibrium allocations. Note that from the Arrow-Debreu
budget constraint it is obvious that y and z only depend on the ratio pt+1
pt ; but
not on pt and pt+1 separately (this is nothing else than saying that the excess
demand functions are homogeneous of degree zero in prices, as they should be).
Varying pt+1
pt between 0 and 1 (not inclusive) one obtains a locus of optimal
excess demands in (y; z) space, the so called o§er curve. Let us denote this
curve as
(y; f (y)) (8.8)
where it is understood that f can be a correspondence, i.e. multi-valued. A point
on the o§er curve is an optimal excess demand function for some pt+1 pt 2 (0; 1):
Also note that since ctt (pt ; pt+1 ) % 0 and ctt+1 (pt ; pt+1 ) % 0 the o§er curve
obviously satisÖes y(pt ; pt+1 ) % &w1 and z(pt ; pt+1 ) % &w2 : Furthermore, since
the optimal choices obviously satisfy the budget constraint, i.e.

pt y(pt ; pt+1 ) + pt+1 z(pt ; pt+1 ) = 0

z(pt ; pt+1 ) pt
= & (8.9)
y(pt ; pt+1 ) pt+1
8.1. A SIMPLE PURE EXCHANGE OVERLAPPING GENERATIONS MODEL137

Equation (8:9) is an equation in the two unknowns (pt ; pt+1 ) for a given t % 1:
Obviously (y; z) = (0; 0) is on the o§er curve, as for appropriate prices (which
we will determine later) no trade is the optimal trading strategy. Equation (8:9)
is very useful in that for a given point on the o§er curve (y(pt ; pt+1 ); z(pt ; pt+1 ))
in y-z space with y(pt ; pt+1 ) 6= 0 we can immediately read o§ the price ratio at
which these are the optimal demands. Draw a straight line through the point
pt
(y; z) and the origin; the slope of that line equals & pt+1 : One should also note
that if y(pt ; pt+1 ) is negative, then z(pt ; pt+1 ) is positive and vice versa. Letís
look at an example

Example 86 Let w1 = "; w2 = 1 & "; with " > 0: Also let U (c) = ln(c) and
( = 1: Then the Örst order conditions imply

pt ctt = pt+1 ctt+1 (8.10)

and the optimal consumption choices are

% &
t 1 pt+1
ct (pt ; pt+1 ) = "+ (1 & ") (8.11)
2 pt
% &
t 1 pt
ct+1 (pt ; pt+1 ) = " + (1 & ") (8.12)
2 pt+1

the excess demands are given by

% &
1 pt+1
y(pt ; pt+1 ) = (1 & ") & " (8.13)
2 pt
% &
1 pt
z(pt ; pt+1 ) = " & (1 & ") (8.14)
2 pt+1
pt+1 "
Note that as pt 2 (0; 1) varies, y varies between & 2 and 1 and z varies
between & (1$")
2 and 1: Solving z as a function of y by eliminating pt+1
pt yields

"(1 & ") 1 & " "

z= & for y 2 (& ; 1) (8.15)
4y + 2" 2 2

This is the o§er curve (y; z) = (y; f (y)): We draw the o§er curve in Figure 8

The discussion of the o§er curve takes care of the Örst part of the equilibrium
deÖnition, namely optimality. It is straightforward to express goods market
clearing in terms of excess demand functions as

y(pt ; pt+1 ) + z(pt$1 ; pt ) = 0 (8.16)

Also note that for the initial old generation the excess demand function is given
by
m
z0 (p1 ; m) =
p1
138 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

z(p ,p )
Offer Curve z(y) t t+1

-w y(p ,p )
1 t t+1

-w
2
8.1. A SIMPLE PURE EXCHANGE OVERLAPPING GENERATIONS MODEL139

so that the goods market equilibrium condition for the Örst period reads as

y(p1 ; p2 ) + z0 (p1 ; m) = 0 (8.17)

Graphically in (y; z)-space equations (8:16) and (8:17) are straight lines through
the origin with slope &1: All points on this line are resource feasible. We
therefore have the following procedure to Önd equilibria for this economy for a
given initial endowment of money m of the initial old generation, using the o§er
curve (8:8) and the resource feasibility constraints (8:16) and (8:17):

1. Pick an initial price p1 (note that this is NOT a normalization as in the

inÖnitely lived agent model since the value of p1 determines the real value
of money pm1 the initial old generation is endowed with; we have already
normailzed the price of money). Hence we know z0 (p1 ; m): From (8:17)
this determines y(p1 ; p2 ):
2. From the o§er curve (8:8) we determine z(p1 ; p2 ) 2 f (y(p1 ; p2 )): Note that
if f is a correspondence then there are multiple choices for z:
3. Once we know z(p1 ; p2 ); from (8:16) we can Önd y(p2 ; p3 ) and so forth. In
this way we determine the entire equilibrium consumption allocation

c01 = z0 (p1 ; m) + w2
ctt = y(pt ; pt+1 ) + w1
ctt+1 = z(pt ; pt+1 ) + w2

4. Equilibrium prices can then be found, given p1 from equation (8:9): Any
initial p1 that induces, in such a way, sequences c01 ; f(ctt ; ctt+1 ); pt g1
t=1 such
that the consumption sequence satisÖes ct$1 t ; c t
t % 0 is an equilibrium
for given money stock. This already indicates the possibility of a lot of
equilibria for this model, a fact that we will demonstrate below.

This algorithm can be demonstrated graphically using the o§er curve dia-
gram. We add the line representing goods market clearing, equation (8:16): In
the (y; z)-plane this is a straight line through the origin with slope &1: This line
intersects the o§er curve at least once, namely at the origin. Unless we have
the degenerate situation that the o§er curve has slope &1 at the origin, there is
(at least) one other intersection of the o§er curve with the goods clearing line.
These intersection will have special signiÖcance as they will represent stationary
equilibria. As we will see, there is a load of other equilibria as well. We will Örst
describe the graphical procedure in general and then look at some examples.
See Figure 9.
Given any m (for concreteness let m > 0) pick p1 > 0: This determines
z0 = pm1 > 0: Find this quantity on the z-axis, representing the excess demand
of the initial old generation. From this point on the z-axis go horizontally to
the goods market line, from there down to the y-axis. The point on the y-axis
represents the excess demand function of generation 1 when young. From this
140 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

Offer Curve z(y)

z(p ,p ), z(m,p )
t t+1 1

z
0
Slope=-p /p
1 2

z
1

z
2

z
3
y(p ,p )
t t+1
y y y
1 2 3

Resource constraint y+z=0

Slope=-1
8.1. A SIMPLE PURE EXCHANGE OVERLAPPING GENERATIONS MODEL141

point y1 = y(p1 ; p2 ) go vertically to the o§er curve, then horizontally to the

z-axis. The resulting point z1 = z(p1 ; p2 ) is the excess demand of generation 1
when old. Then back horizontally to the goods market clearing condition and
down yields y2 = y(p2 ; p3 ); the excess demand for the second generation and so
on. This way the entire equilibrium consumption allocation can be constructed.
Equilibrium prices are easily found from equilibrium allocations with (8:9), given
p1 : In such a way we construct an entire equilibrium graphically.
Letís now look at some example.

Example 87 Reconsider the example with isoelastic utility above. We found

the o§er curve to be

"(1 & ") 1 & " "

z= & for y 2 (& ; 1)
4y + 2" 2 2

The goods market equilibrium condition is

y+z =0

Now letís construct an equilibrium for the case m = 0; for zero supply of outside
money. Following the procedure outlined above we Örst Önd the excess demand
function for the initial old generation z0 (m; p1 ) = 0 for all p1 > 0: Then from
goods market y(p1 ; p2 ) = &z0 (m; p1 ) = 0: From the o§er curve

"(1 & ") 1&"

z(p1 ; p2 ) = &
4y(p1 ; p2 ) + 2" 2
"(1 & ") 1 & "
= &
2" 2
= 0

and continuing we Önd z(pt ; pt+1 ) = y(pt ; pt+1 ) = 0 for all t % 1: This implies
that the equilibrium allocation is ct$1
t = 1 & "; ctt = ": In this equilibrium every
consumer eats his endowment in each period and no trade between generations
takes place. We call this equilibrium the autarkic equilibrium. Obviously we
canít determine equilibrium prices from equation (8:9): However, the Örst order
conditions imply that
pt+1 ct "
= tt =
pt ct+1 1&"
For m = 0 we can, without loss of generality, normalize the price of the Örst
period consumption good p1 = 1: Note again that only for m = 0 this normaliza-
tion is innocuous, since it does not change the real value of the stock of outside
money that the initial old generation is endowed with. With this normalization
the sequence fpt g1
t=1 deÖned as

% &t$1
"
pt =
1&"
142 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

together with the autarkic allocation form an (Arrow-Debreu)-equilibrium. Ob-

viously any other price sequence f8 pt g with p8t = 0pt for any 0 > 1; is also
an equilibrium price sequence supporting the autarkic allocation as equilibrium.
This is not, however, what we mean by the possibility of a continuum of equilib-
ria in OLG-model, but rather the usual feature of standard competitive equilibria
that the equilibrium prices are only determined up to one normalization. In fact,
for this example with m = 0; the autarkic equilibrium is the unique equilibrium
for this economy.3 This is easily seen. Since the initial old generation has no
money, only its endowments 1&"; there is no way for them to consume more than
their endowments. Obviously they can always assure to consume at least their
endowments by not trading, and that is what they do for any p1 > 0 (obviously
p1 $ 0 is not possible in equilibrium). But then from the resource constraint
it follows that the Örst young generation must consume their endowments when
young. Since they havenít saved anything, the best they can do when old is to
consume their endowment again. But then the next young generation is forced
to consume their endowments and so forth. Trade breaks down completely. For
this allocation to be an equilibrium prices must be such that at these prices all
generations actually Önd it optimal not to trade, which yields the prices below.4

Note that in the picture the second intersection of the o§er curve with the
resource constraint (the Örst is at the origin) occurs in the forth orthant. This
need not be the case. If the slope of the o§er curve at the origin is less than one,
we obtain the picture above, if the slope is bigger than one, then the second
intersection occurs in the second orthant. Let us distinguish between these
two cases more carefully. In general, the price ratio supporting the autarkic
equilibrium satisÖes
pt U 0 (ett ) U 0 (w1 )
= =
pt+1 (U 0 (ett+1 ) (U 0 (w2 )
and this ratio represents the slope of the o§er curve at the origin. With this
in mind deÖne the autarkic interest rate (remember our equivalence result from
above) as
U 0 (w1 )
1 + r8 =
(u0 (w2 )
3 The fact that the autarkic is the only equilibrium is speciÖc to pure exchange OLG-models

with agents living for only two periods. Therefore Samuelson (1958) considered three-period
lived agents for most of his analysis.
4 If you look at Sargent and Ljungquist (1999), Chapter 8, you will see that they claim to

construct several equilibria for exactly this example. Note, however, that their equilibrium
deÖnition has as feasibility constraint
ct%1
t + ctt ) et%1
t + ett
and all the equilibria apart from the autarkic one constructed above have the feature that for
t=1
c01 + c11 < e01 + e11
which violate feasibility in the way we have deÖned it. Personally I Önd the free disposal
assumption not satisfactory; it makes, however, their life easier in some of the examples to
follow, whereas in my discussion I need more handwaving. Youíll see.
8.1. A SIMPLE PURE EXCHANGE OVERLAPPING GENERATIONS MODEL143

Gale (1973) has invented the following terminology: when r8 < 0 he calls this
the Samueson case, whereas when r8 % 0 he calls this the classical case.5 As it
will turn out and will be demonstrated below autarkic equilibria are not Pareto
optimal in the Samuelson case whereas they are in the classical case.

8.1.3 Ine¢cient Equilibria

The preceding example can also serve to demonstrate our Örst major feature of
OLG economies that sets it apart from the standard inÖnitely lived consumer
model with Önite number of agents: competitive equilibria may be not be Pareto
optimal. For economies like the one deÖned at the beginning of the section the
two welfare theorems were proved and hence equilibria are Pareto optimal. Now
letís see that the equilibrium constructed above for the OLG model may not be.
Note that in the economy above the aggregate endowment equals to 1 in
each period. Also note that then
P1 the value of the aggregate endowment at the
equilibrium prices, given by t=1 pt : Obviously, if " < 0:5; then this sum con-
verges and the value of the aggregate endowment is Önite, whereas if " % 0:5;
then the value of the aggregate endowment is inÖnite. Whether the value of the
aggregate endowment is inÖnite has profound implications for the welfare prop-
erties of the competitive equilibrium. In particular, using a similar argument
as in the standard proof of thePÖrst welfare theorem you can show (and will
1
do so in the homework) that if t=1 pt < 1; then the competitive equilibrium
allocation for this economy (and in general for any pure exchange OLG econ-
omy) is Pareto-e¢cient. If, however, the value of the aggregate endowment is
inÖnite (at the equilibrium prices), then the competitive equilibrium MAY not
be Pareto optimal. In our current example it turns out that if " > 0:5; then
the autarkic equilibrium is not Pareto e¢cient, whereas if " = 0:5 it is. Since
interest rates are deÖned as
pt
rt+1 = &1
pt+1
_
"<0:5 implies rt+1 = 1$" 1
" & 1 = " & 2: Hence " < 0:5 implies rt+1 > 0 (the
classical case) and " % 0:5 implies rt+1 < 0: (the Samuelson case). Ine¢ciency
is therefore associated with low (negative interest rates). In fact, Balasko and
Shell (1980) show that the autarkic equilibrium is Pareto optimal if and only if
1 Y
X t
(1 + r* +1 ) = +1
t=1 * =1
5 More generally, the Samuelson case is deÖned by the condition that savings of the young
generation be positive at an interest rate equal to the population growth rate n: So far we
have assumed n = 0; so the Samuelson case requires saving to be positive at zero interest rate.
We stated the condition as r( < 0: But if the interest rate at which the young donít save (the
autarkic allocation) is smaller than zero, then at the higher interest rate of zero they will save
a positive amount, so that we can deÖne the Samuelson case as in the text, provided that
savings are strictly increasing in the interest rate. This in turn requires the assumption that
Örst and second period consumption are strict gross substitutes, so that the o§er curve is not
backward-bending. In the homework you will encounter an example in which this assumption
is not satisÖed.
144 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

where frt+1 g is the sequence of autarkic equilibrium interest rates.6 Obviously

the above equation is satisÖed if and only if " $ 0:5:
Let us brieáy demonstrate the Örst claim (a more careful discussion is left
for the homework). To show that for " > 0:5 the autarkic allocation (which is
the unique equilibrium allocation) is not Pareto optimal it is su¢cient to Önd
another feasible allocation that Pareto-dominates it. Letís do this graphically in
Figure 10. The autarkic allocation is represented by the origin (excess demand
functions equal zero). Consider an alternative allocation represented by the
intersection of the o§er curve and the resource constraint. We want to argue
that this point Pareto dominates the autarkic allocation. First consider an
arbitrary generation t % 1: Note that the indi§erence curve through the origin
must lie to the outside of the o§er curve (they are equal at the origin, but
everywhere else the indi§erence curve lies below). Why: the autarkic point can
be chosen at all price ratios. Thus a point on the o§er curve was chosen when the
autarkic allocation was a§ordable, and therefore must represent a higher utility.
This demonstrates that the alternative point marked in the Ögure (which is both
on the o§er curve as well as the resource constraint, the line with slope -1) is at
least as good as the autarkic allocation for all generations t % 1: What about
the initial old generation? In the autarkic allocation it has c01 = 1 & "; or z0 = 0:
In the new allocation it has z0 > 0 as shown in the Ögure, so the initial old
generation is strictly better o§ in this new allocation. Hence the alternative
allocation Pareto-dominates the autarkic equilibrium allocation, which shows
that this allocation is not Pareto-optimal. In the homework you are asked to
make this argument rigorous by actually computing the alternative allocation
and then arguing that it Pareto-dominates the autarkic equilibrium.
6 Rather than a formal proof (which is quite involved), letís develop some intuition for why

low interest rates are associated with ine¢ciency. Take the autarkic allocation and try to
construct a Pareto improvement. In particular, give additional A 0 > 0 units of consumption
to the initial old generation. This obviously improves this generationís life. From resource
feasibilty this requires taking away A 0 from generation 1 in their Örst period of life. To make
them not worse of they have to recieve A 1 in additional consumption in their second period of
life, with A 1 satisfying
A 0 U 0 (e11 ) = A 1 1U 0 (e12 )
or
1U 0 (e12 )
A1 = A0
U 0 (e11 )
= A 0 (1 + r2 ) > 0

and in general
t
Y
At = A0 (1 + r* +1 )
* =1
are the required transfers in the second period of generation tís life to compensate for the
reduction of Örst period consumption. Obviously such a scheme does not work if the economy
ends at Öne time T since the last generation (that lives only through youth) is worse o§. But
as our economy extends forever, such an intergenerational transfer scheme is feasible provided
that the A t donít grow too fast, i.e. if interest rates are su¢ciently small. But if such a transfer
scheme is feasible, then we found a Pareto improvement over the original autarkic allocation,
and hence the autarkic equilibrium allocation is not Pareto e¢cient.
8.1. A SIMPLE PURE EXCHANGE OVERLAPPING GENERATIONS MODEL145

z(p ,p ), z(m,p )
Offer Curve z(y) t t+1 1

Pareto-dominating allocation z =z
0 t

Indifference Curve through dominating

allocation

Indifference Curve through autarkic allocation

Autarkic Allocation
y(p ,p )
t t+1
y =y
1 t

Resource constraint y+z=0

Slope=-1
146 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

What in our graphical argument hinges on the assumption that " > 0:5:
Remember that for " $ 0:5 we have said that the autarkic allocation is actually
Pareto optimal. It turns out that for " < 0:5; the intersection of the resource
constraint and the o§er curve lies in the fourth orthant instead of in the second
as in Figure 10. It is still the case that every generation t % 1 at least weakly
prefers the alternative to the autarkic allocation. Now, however, this alternative
allocation has z0 < 0; which makes the initial old generation worse o§ than in
the autarkic allocation, so that the argument does not work. Finally, for " = 0:5
we have the degenerate situation that the slope of the o§er curve at the origin is
&1, so that the o§er curve is tangent to the resource line and there is no second
intersection. Again the argument does not work and we canít argue that the
autarkic allocation is not Pareto optimal. It is an interesting optional exercise
to show that for " = 0:5 the autarkic allocation is Pareto optimal.
Now we want to demonstrate the second and third feature of OLG models
that set it apart from standard Arrow-Debreu economies, namely the possibility
of a continuum of equilibria and the fact that outside money may have positive
value. We will see that, given the way we have deÖned our equilibria, these
two issues are intimately linked. So now let us suppose that m 6= 0: In our
discussion we will assume that m > 0; the situation for m < 0 is symmetric. We
Örst want to argue that for m > 0 the economy has a continuum of equilibria,
not of the trivial sort that only prices di§er by a constant, but that allocations
di§er across equilibria. Let us Örst look at equilibria that are stationary in the
following sense:

pt+1
DeÖnition 88 An equilibrium is stationary if ct$1
t = co ; ctt = cy and pt = a;
where a is a constant.

Given that we made the assumption that each generation has the same en-
dowment structure a stationary equilibrium necessarily has to satisfy y(pt ; pt+1 ) =
y; z0 (m; p1 ) = z(pt ; pt+1 ) = z for all t % 1: From our o§er curve diagram the
only candidates are the autarkic equilibrium (the origin) and any other alloca-
tions represented by intersections of the o§er curve and the resource line. We
will discuss the possibility of an autarkic equilibrium with money later. With
respect to other stationary equilibria, they all have to have prices pt+1
pt = 1; with
m m
p1 such that ( p1 ; & p1 ) is on the o§er curve. For our previous example, for any
m 6= 0 we Önd the stationary equilibrium by solving for the intersection of o§er
curve and resource line

y+z = 0
"(1 & ") 1 & "
z = &
4y + 2" 2

This yields a second order polynomial in y

"(1 & ") 1 & "

&y = &
4y + 2" 2
8.1. A SIMPLE PURE EXCHANGE OVERLAPPING GENERATIONS MODEL147

whose one solution is y = 0 (the autarkic allocation) and the other solution is
y = 12 & "; so that z = & 12 + ": Hence the corresponding consumption allocation
has
1
ct$1
t = ctt = for all t % 1
2
In order for this to be an equilibrium we need
1 m
= c01 = (1 & ") +
2 p1
m
hence p1 = "$0:5 > 0: Therefore a stationary equilibrium (apart from autarky)
only exists for m > 0 and " > 0:5 or m < 0 and " < 0:5: Also note that
the choice of p1 is not a matter of normalization: any multiple of p1 will not
yield a stationary equilibrium. The equilibrium prices supporting the stationary
allocation have pt = p1 for all t % 1: Finally note that this equilibrium, since
it features pt+1
pt = 1; has an ináation rate of Q t+1 = &rt+1 = 0: It is exactly
this equilibrium allocation that we used to prove that, for " > 0:5; the autarkic
equilibrium is not Pareto-e¢cient.
How about the autarkic allocation? Obviously it is stationary as ct$1
t = 1&"
and ctt = " for all t % 1: But can it be made into an equilibrium if m 6= 0: If we
look at the sequential markets equilibrium deÖnition there is no problem: the
budget constraint of the initial old generation reads

c01 = 1 & " + (1 + r1 )m

So we need r1 = &1: For all other generations the same arguments as without
money apply and the interest sequence satisfying r1 = &1; rt+1 = 1$" " & 1
for all t % 1; together with the autarkic allocation forms a sequential market
equilibrium. In this equilibrium the stock of outside money, m; is not valued:
the initial old donít get any goods in exchange for it and future generations
are not willing to ever exchange goods for money, which results in the autarkic,
no-trade situation. To make autarky an Arrow-Debreu equilibrium is a bit more
problematic. Again from the budget constraint of the initial old we Önd
m
c01 = 1 & " +
p1
which, for autarky to be an equilibrium requires p1 = 1; i.e. the price level is
so high in the Örst period that the stock of money de facto has no value. Since
for all other periods we need pt+1 "
pt = 1$" to support the autarkic allocation, we
have the obscure requirement that we need price levels to be inÖnite with well-
deÖned Önite price ratios. This is unsatisfactory, but there is no way around it
unless we a) change the equilibrium deÖnition (see Sargent and Ljungquist) or
b) let the economy extend from the inÖnite past to the inÖnite future (instead
of starting with an initial old generation, see Geanakoplos) or c) treat money
somewhat as a residual, as something almost endogenous (see Kehoe) or d) make
some consumption good rather than money the numeraire (with nonmonetary
equilibria corresponding to situations in which money has a price of zero in terms
148 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

of real consumption goods). For now we will accept autarky as an equilibrium

even with money and we will treat it as identical to the autarkic equilibrium
without money (because indeed in the sequential markets formulation only r1
changes and in the Arrow Debreu formulation only p1 changes, although in an
unsatisfactory fashion).

8.1.4 Positive Valuation of Outside Money

In our construction of the nonautarkic stationary equilibrium we have already
demonstrated our second main result of OLG models: outside money may have
positive value. In that equilibrium the initial old had endowment 1 & " but
consumed c01 = 12 : If " > 12 ; then the stock of outside money, m; is valued in
equilibrium in that the old guys can exchange m pieces of intrinsically worthless
paper for pm1 > 0 units of period 1 consumption goods.7 The currently young
generation accepts to transfer some of their endowment to the old people for
pieces of paper because they expect (correctly so, in equilibrium) to exchange
these pieces of paper against consumption goods when they are old, and hence
to achieve an intertemporal allocation of consumption goods that dominates
the autarkic allocation. Without the outside asset, again, this economy can do
nothing else but remain in the possibly dismal state of autarky (imagine " = 1
and log-utility). This is why the social contrivance of money is so useful in this
economy. As we will see later, other institutions (for example a pay-as-you-go
social security system) may achieve the same as money.
Before we demonstrate that, apart from stationary equilibria (two in the
example, usually at least only a Önite number) there may be a continuum of
other, nonstationary equilibria we take a little digression to show for the general
inÖnitely lived agent endowment economies set out at the beginning of this
section money cannot have positive value in equilibrium.

Proposition 89 In pure exchange economies with a Önite number of inÖnitely

lived agents there cannot be an equilibrium in which outside money is valued.

Proof. Suppose, to the contrary, that there is an equilibrium cit )i2I g1

P f(^ p t g1
t=1 ; f^ t=1
i i
for initial endowments of outside money (m )i2I such that i2I m 6= 0: Given
the assumption of local nonsatiation each consumer in equilibrium satisÖes the
Arrow-Debreu budget constraint with equality
1
X X
p^t c^it = p^t eit + mi < 1
t=1 t=1

7 In Önance lingo money in this equilibrium is a ìbubbleî. The fundamental value of an

assets is the value of its dividends, evaluated at the equilibrium Arrow-Debreu prices. An
asset is (or has) a bubble if its price does not equal its fundamental value. Obviuosly, since
money doesnít pay dividends, its fundamental value is zero and the fact that it is valued
positively in equilibrium makes it a bubble.
8.1. A SIMPLE PURE EXCHANGE OVERLAPPING GENERATIONS MODEL149

Summing over all individuals i 2 I yields

1
X X# $ X i
p^t c^it & eit = m
t=1 i2I i2I
P # $
But resource feasibility requires i2I c^it & eit = 0 for all t % 1 and hence
X
mi = 0
i2I

a contradiction. This shows that there cannot exist an equilibrium in this type
of economy in which outside money is valued in equilibrium. Note that this
result applies to a much wider class of standard Arrow-Debreu economies than
just the pure exchange economies considered in this section.
Hence we have established the second major di§erence between the standard
Arrow-Debreu general equilibrium model and the OLG model.

Continuum of Equilibria
We will now go ahead and demonstrate the third major di§erence, the possibility
of a whole continuum of equilibria in OLG models. We will restrict ourselves to
the speciÖc example. Again suppose m > 0 and " > 0:5:8 For any p1 such that
m 1
p1 < " & 2 > 0 we can construct an equilibrium using our geometric method
before. From the picture it is clear that all these equilibria have the feature
that the equilibrium allocations over time converge to the autarkic allocation,
with z0 > z1 > z2 > : : : zt > 0 and limt!1 zt = 0 and 0 > yt > : : : y2 > y1 with
limt!1 yt = 0: We also see from the Ögure that, since the o§er curve lies below
the -450 -line for the part we are concerned with that pp12 < 1 and pt+1
pt
< pt#1
pt <
p1
: : : < p2 < 1; implying that prices are increasing with limt!1 pt = 1. Hence
all the nonstationary equilibria feature ináation, although the ináation rate is
bounded above by Q 1 = &r1 = 1 & 1$" 1
" = 2 & " > 0: The real value of money,
9
however, declines to zero in the limit. Note that, although all nonstationary
equilibria so constructed in the limit converge to the same allocation (autarky),
they di§er in the sense that at any Önite t; the consumption allocations and price
ratios (and levels) di§er across equilibria. Hence there is an entire continuum of
m
equilibria, indexed by p1 2 ( "$0:5 ; 1): These equilibria are arbitrarily close to
each other. This is again in stark contrast to standard Arrow-Debreu economies
where, generically, the set of equilibria is Önite and all equilibria are locally
unique.10 For details consult Debreu (1970) and the references therein.
8 You should verify that if " ) 0:5; then r ( & 0 and the only equilibrium with m > 0 is
the autarkic equilibrium in which money has no value. All other possible equilibrium paths
eventually violate nonnegativity of consumption.
9 But only in the limit. It is crucial that the real value of money is not zero at Önite t;

since with perfect foresight as in this model generation t would anticipate the fact that money
would lose all its value, would not accept it from generation t # 1 and all monetary equilibria
would unravel, with only the autarkic euqilibrium surviving.
1 0 Generically in this context means, for almost all endowments, i.e. the set of possible values

for the endowments for which this statement does not hold is of measure zero. Local uniquenes
150 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

Note that, if we are in the Samuelson case r8 < 0; then (and only then)
all these equilibria are Pareto-ranked.11 Let the equilibria be indexed by p1 :
One can show, by similar arguments that demonstrated that the autarkic equi-
librium is not Pareto optimal, that these equilibria are Pareto-ranked: let
m
p1 ; p^1 2 ( "$0:5 ; 1) with p1 > p^1 ; then the equilibrium corresponding to p^1
Pareto-dominates the equilibrium indexed by p1 : By the same token, the only
Pareto optimal equilibrium allocation is the nonautarkic stationary monetary
equilibrium.

8.1.5 Productive Outside Assets

We have seen that with a positive supply of an outside asset with no intrinsic
value, m > 0; then in the Samuelson case (for which the slope of the o§er curve
is smaller than one at the autarkic allocation) we have a continuum of equilibria.
Now suppose that, instead of being endowed with intrinsically useless pieces of
paper the initial old are endowed with a Lucas tree that yields dividends d > 0
in terms of the consumption good in each period. In a lot of ways this economy
seems a lot like the previous one with money. So it should have the same number
and types of equilibria!? The deÖnition of equilibrium (we will focus on Arrow-
Debreu equilibria) remains the same, apart from the resource constraint which
now reads
ct$1
t + ctt = et$1
t + ett + d
and the budget constraint of the initial old generation which now reads
1
X
p1 c01 $ p1 e01 + d pt
t=1

Letís analyze this economy using our standard techniques. The o§er curve
remains completely unchanged, but the resource line shifts to the right, now
goes through the points (y; z) = (d; 0) and (y; z) = (0; d): Letís look at Figure
11.
It appears that, as in the case with money m > 0 there are two stationary and
a continuum of nonstationary equilibria. The point (y1 ; z0 ) on the o§er curve
indeed represents a stationary equilibrium. Note that the constant equilibrium
pt
price ratio satisÖes pt+1 = 0 > 1 (just draw a ray through the origin and the
point and compare with the slope of the resource constraint which is &1). Hence
# $t$1
we have, after normalization of p1 = 1; pt = '1 and therefore the value of
the Lucas tree in the Örst period equals
X1 % &t$1
1
d <1
t=1
0

means that in for every equilibrium price vector there exists " such that any "-neighborhood
of the price vector does not contain another equilibrium price vector (apart from the trivial
ones involving a di§erent normalization).
1 1 Again we require the assumption that consumption in the Örst and the second period are

strict gross substitutes, ruling out backward-bending o§er curves.

8.1. A SIMPLE PURE EXCHANGE OVERLAPPING GENERATIONS MODEL151

Offer Curve z(y) z(p ,p ), z(m,p )

t t+1 1

z
0

Slope=-p /p
1 2

z’’
0

z’’
1

y’
1 y(p ,p )
t t+1
y y’’ y’’ z’
1 1 2 0

Resource constraint y+z=d

Slope=-1
152 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

How about the other intersection of the resource line with the o§er curve,
pt
(y10 ; z00 )? Note that in this hypothetical stationary equilibrium pt+1 = f < 1; so
' (t$1
that pt = U1 p1 : Hence the period 0 value of the Lucas tree is inÖnite and
the consumption of the initial old exceed the resources available in the economy
in period 1: This obviously cannot be an equilibrium. Similarly all equilibrium
paths starting at some point z000 converge to this stationary point, so for all
pt
hypothetical nonstationary equilibria we have pt+1 < 1 for t large enough and
again the value of the Lucas tree remains unbounded, and these paths cannot
be equilibrium paths either. We conclude that in this economy there exists a
unique equilibrium, which, by the way, is Pareto optimal.
This example demonstrates that it is not the existence of a long-lived outside
asset that is responsible for the existence of a continuum of equilibria. What is
the di§erence? In all monetary equilibria apart from the stationary nonautarkic
equilibrium (which exists for the Lucas tree economy, too) the price level goes
to inÖnity, as in the hypothetical Lucas tree equilibria that turned out not to
be equilibria. What is crucial is that money is intrinsically useless and does
not generate real stu§ so that it is possible in equilibrium that prices explode,
but the real value of the dividends remains bounded. Also note that we were
to introduce a Lucas tree with negative dividends (the initial old generation is
an eternal slave, say, of the government and has to come up with d in every
period to be used for government consumption), then the existence of the whole
continuum of equilibria is restored.12

8.1.6 Endogenous Cycles

Not only is there a possibility of a continuum of equilibria in the basic OLG-

model, but these equilibria need not take the monotonic form described above.
Instead, equilibria with cycles are possible. In Figure 12 we have drawn an o§er
curve that is backward bending. In the homework you will see an example of
preferences that yields such a backward bending o§er curve, for a rather normal
utility function.
Let m > 0 and let p1 be such that z0 = pm1 : Using our geometric approach
we Önd y1 = y(p1 ; p2 ) from the resource line, z1 = z(p1 ; p2 ) from the o§er
curve (ignore for the moment the fact that there are several z1 will do; this
merely indicates that the multiplicity of equilibria is of even higher order than
previously demonstrated). From the resource line we Önd y2 = y(p2 ; p3 ) and
from the o§er curve z2 = z(p2 ; p3 ) = z0 : After period t = 2 the economy repeats

1 2 Also note that the fact that in the unique equilibrium lim
t!1 pt = 0 has to be true
(otherwise the Lucas tree cannot have Önite value) implies that this equilibrium cannot be
made into a monetary equilibrium, since limt!1 pm = 1 and the real value of money would
t
eventually exceed the aggregate endowment of the economy for any m > 0:
8.1. A SIMPLE PURE EXCHANGE OVERLAPPING GENERATIONS MODEL153

-p /p
1 2 Offer Curve z(y)
z(p ,p ), z(m,p )
t t+1 1
Resource constraint y+z=0
Slope=-1

z
1
-p /p
2 3

z
0

y(p ,p )
t t+1
y y
2 1
154 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

the cycle from the Örst two periods. The equilibrium allocation is of the form
" ol
t$1 c = z0 & w2 for t odd
ct =
coh = z1 & w2 for t even
" yl
t c = y1 & w1 for t odd
ct =
cyh = y2 & w1 for t even

with col < coh ; cyl < cyh : Prices satisfy

" h
pt 0 for t odd
=
pt+1 0l for t even
" l
Q < 0 for t odd
Q t+1 = &rt+1 =
Q h > 0 for t even

Consumption of generations áuctuates in a two period cycle, with odd genera-

tions eating little when young and a lot when old and even generations having
the reverse pattern. Equilibrium returns on money (ináation rates) áuctuate,
too, with returns from odd to even periods being high (low ináation) and returns
being low (high ináation) from even to odd periods. Note that these cycles are
purely endogenous in the sense that the environment is completely stationary:
nothing distinguishes odd and even periods in terms of endowments, prefer-
ences of people alive or the number of people. It is not surprising that some
economists have taken this feature of OLG models to be the basis of a theory
of endogenous business cycles (see, for example, Grandmont (1985)). Also note
that it is not particularly di¢cult to construct cycles of length bigger than 2
periods.

8.1.7 Social Security and Population Growth

The pure exchange OLG model renders itself nicely to a discussion of a pay-
as-you-go social security system. It also prepares us for the more complicated
discussion of the same issue once we have introduced capital accumulation.
Consider the simple model without money (i.e. m = 0). Also now assume that
the population is growing at constant rate n; so that for each old person in a
given period there are (1 + n) young people around. DeÖnitions of equilibria
remain unchanged, apart from resource feasibility that now reads

ct$1
t + (1 + n)ctt = et$1
t + (1 + n)ett

or, in terms of excess demands

z(pt$1 ; pt ) + (1 + n)y(pt ; pt+1 ) = 0

This economy can be analyzed in exactly the same way as before with noticing
that in our o§er curve diagram the slope of the resource line is not &1 anymore,
but &(1 + n): We know from above that, without any government intervention,
the unique equilibrium in this case is the autarkic equilibrium. We now want
8.1. A SIMPLE PURE EXCHANGE OVERLAPPING GENERATIONS MODEL155

to analyze under what conditions the introduction of a pay-as-you-go social

security system in period 1 (or any other date) is welfare-improving. We again
assume stationary endowments ett = w1 and ett+1 = w2 for all t: The social
security system is modeled as follows: the young pay social security taxes of
< 2 [0; w1 ) and receive social security beneÖts b when old. We assume that the
social security system balances its budget in each period, so that beneÖts are
given by
b = < (1 + n)
Obviously the new unique competitive equilibrium is again autarkic with en-
dowments (w1 & < ; w2 + < (1 + n)) and equilibrium interest rates satisfy

U 0 (w1 & < )

1 + rt+1 = 1 + r =
(U 0 (w2 + < (1 + n))

Obviously for any < > 0; the initial old generation receives a windfall transfer
of < (1 + n) > 0 and hence unambiguously beneÖts from the introduction. For
all other generations, deÖne the equilibrium lifetime utility, as a function of the
social security system, as

V (< ) = U (w1 & < ) + (U (w2 + < (1 + n))

The introduction of a small social security system is welfare improving if and

only if V 0 (< ); evaluated at < = 0; is positive. But

V 0 (< ) = &U 0 (w1 & < ) + (U 0 (w2 + < (1 + n))(1 + n)

V 0 (0) = &U 0 (w1 ) + (U 0 (w2 )(1 + n)

Hence V 0 (0) > 0 if and only if

U 0 (w1 )
n> & 1 = r8
(U 0 (w2 )

where r8 is the autarkic interest rate. Hence the introduction of a (marginal)

pay-as-you-go social security system is welfare improving if and only if the pop-
ulation growth rate exceeds the equilibrium (autarkic) interest rate, or, to use
our previous terminology, if we are in the Samuelson case where autarky is not
a Pareto optimal allocation. Note that social security has the same function as
money in our economy: it is a social institution that transfers resources between
generations (backward in time) that do not trade among each other in equilib-
rium. In enhancing intergenerational exchange not provided by the market it
may generate allocations that are Pareto superior to the autarkic allocation, in
the case in which individuals private marginal rate of substitution 1 + r8 (at the
autarkic allocation) falls short of the social intertemporal rate of transformation
1 + n:
If n > r8 we can solve for optimal sizes of the social security system analyti-
cally in special cases. Remember that for the case with positive money supply
m > 0 but no social security system the unique Pareto optimal allocation was
156 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

the nonautarkic stationary allocation. Using similar arguments we can show

that the sizes of the social security system for which the resulting equilibrium
allocation is Pareto optimal is such that the resulting autarkic equilibrium in-
terest rate is at least equal to the population growth rate, or

U 0 (w1 & < )

1+n$
(U 0 (w2 + < (1 + n))

For the case in which the period utility function is of logarithmic form this yields

w2 + < (1 + n)
1+n $
((w1 & < )
( w2
< % w1 & = < * (w1 ; w2 ; n; ()
1+( (1 + ()(1 + n)

Note that < * is the unique size of the social security system that maximizes the
lifetime utility of the representative generation. For any smaller size we could
marginally increase the size and make the representative generation better o§
and increase the windfall transfers to the initial old. Note, however, that any
< > < * satisfying < $ w1 generates a Pareto optimal allocation, too: the repre-
sentative generation would be better o§ with a smaller system, but the initial old
generation would be worse o§. This again demonstrates the weak requirements
that Pareto optimality puts on an allocation. Also note that the ìoptimalî size
of social security is an increasing function of Örst period income w1 ; the popu-
lation growth rate n and the time discount factor (; and a decreasing function
of the second period income w2 :
So far we have assumed that the government sustains the social security
system by forcing people to participate.13 Now we brieáy describe how such
a system may come about if policy is determined endogenously. We make the
following assumptions. The initial old people can decide upon the size of the
social security system < 0 = < ** % 0: In each period t % 1 there is a majority
vote as to whether the current system is to be kept or abolished. If the majority
of the population in period t favors the abolishment of the system, then < t = 0
and no payroll taxes or social security beneÖts are paid. If the vote is in favor
of the system, then the young pay taxes < ** and the old receive (1 + n)< ** :
We assume that n > 0; so the current young generation determines current
policy. Since current voting behavior depends on expectations about voting
behavior of future generations we have to specify how expectations about the
voting behavior of future generations is determined. We assume the following
expectations mechanism (see Cooley and Soares (1999) for a more detailed dis-
cussion of justiÖcations as well as shortcomings for this speciÖcation of forming
expectations): " **
e < if < t = < **
< t+1 = (8.18)
0 otherwise
1 3 This section is not based on any reference, but rather my own thoughts. Please be aware

of this and read with caution.

8.1. A SIMPLE PURE EXCHANGE OVERLAPPING GENERATIONS MODEL157

that is, if young individuals at period t voted down the original social security
system then they expect that a newly proposed social security system will be
voted down tomorrow. Expectations are rational if < et = < t for all t: Let < =
f< t g1
t=0 be an arbitrary sequence of policies that is feasible (i.e. satisÖes < t 2
[0; w1 ))

DeÖnition 90 A rational expectations politico-economic equilibrium, given our

expectations mechanism is an allocation rule c^01 (< ); f(^
ctt (< ); c^tt+1 (< ))g; price rule
14
f^
pt (< )g and policies f^
< t g such that

1. for all t % 1; for all feasible < ; and given f^

pt (< )g;

ctt ; c^tt+1 )
(^ 2 arg max V (< t ; < t+1 ) = U (ctt ) + (U (ctt+1 )
(ctt ;ctt+1 )-0

s.t. pt ctt + pt+1 ctt+1 $ pt (w1 & < t ) + pt+1 (w2 + (1 + n)< t+1 )

2. for all feasible < ; and given f^

pt (< )g;

c^01 2 arg max

0
V (< 0 ; < 1 ) = U (c01 )
c1 -0

s.t. p1 c01 $ p1 (w2 + (1 + n)< 1 )

3.
ct$1
t + (1 + n)ctt = w2 + (1 + n)w1

4. For all t % 1
<^t 2 arg max V (]; < et+1 )
V2f0;* %% g

where < et+1 is determined according to (8:18)

5.
<^0 2 arg max V (]; <^1 )
V2[0;w1 )

6. For all t % 1
< et = <^t

Conditions 1-3 are the standard economic equilibrium conditions for any
arbitrary sequence of social security taxes. Condition 4 says that all agents of
generation t % 1 vote rationally and sincerely, given the expectations mechanism
speciÖed. Condition 5 says that the initial old generation implements the best
possible social security system (for themselves). Note the constraint that the
initial generation faces in its maximization: if it picks ] too high, the Örst regular
generation (see condition 4) may Önd it in its interest to vote the system down.
Finally the last condition requires rational expectations with respect to the
formation of policy expectations.
1 4 The dependence of allocations and prices on Q is implicit from now on.
158 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

Political equilibria are in general very hard to solve unless one makes the
economic equilibrium problem easy, assumes simple voting rules and simpliÖes
as much as possible the expectations formation process. I tried to do all of the
above for our discussion. So let Önd an (the!) political economic equilibrium.
First notice that for any policy the equilibrium allocation will be autarky since
there is no outside asset. Hence we have as equilibrium allocations and prices
for a given policy <

ct$1
t = w2 + (1 + n)< t
ctt = w1 & < t
p1 = 1
pt U 0 (w1 & < t )
=
pt+1 (U 0 (w2 + (1 + n)< t )
Therefore the only equilibrium element to determine are the optimal policies.
Given our expectations mechanism for any choice of < 0 = < ** ; when would
generation t vote the system < ** down when young? If it does, given the ex-
pectation mechanism, it would not receive beneÖts when old (a newly installed
system would be voted down right away, according to the generationsí expecta-
tion). Hence
V (0; < et+1 ) = V (0; 0) = U (w1 ) + (U (w2 )
Voting to keep the system in place yields

V (< ** ; < et+1 ) = V (< ** ; < ** ) = U (w1 & < ** ) + (U (w2 + (1 + n)< ** )

and a vote in favor requires

V (< ** ; < ** ) % V (0; 0) (8.19)

But this is true for all generations, including the Örst regular generation. Given
the assumption that we are in the Samuelson case with n > r8 there exists a
< ** > 0 such that the above inequality holds. Hence the initial old generation
can introduce a positive social security system with < 0 = < ** > 0 that is not
voted down by the next generation (and hence by no generation) and creates
positive transfers for itself. Obviously, then, the optimal choice is to maximize
< 0 = < ** subject to (8:19); and the equilibrium sequence of policies satisÖes
<^t = < ** where < ** > 0 satisÖes

U (w1 & < ** ) + (U (w2 + (1 + n)< ** ) = U (w1 ) + (U (w2 )

Note that since the o§er curve lies everywhere above the indi§erence curve
through the no-social security endowment point (w1 ; w2 ); we know that the in-
di§erence curve thorugh that point intersects the resource line to the north-west
of the intersection of resource line and o§er curve (in the Samuelson case). But
this implies that < ** > < * (which was deÖned as the level of social security that
maximizes lifetime utility of a typical generation). Consequently the politico-
equilibrium social security tax rate is bigger than the one maximizing welfare
8.1. A SIMPLE PURE EXCHANGE OVERLAPPING GENERATIONS MODEL159

for the typical generation: by having the right to set up the system Örst the
initial old can steer the economy to an equilibrium that is better for them (and
worse for all future generations) than the one implied by tax rate < * :
160 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

8.2 The Ricardian Equivalence Hypothesis

How should the government Önance a given stream of government expenditures,
say, for a war? There are two principal ways to levy revenues for a govern-
ment, namely to tax current generations or to issue government debt in the
form of government bonds the interest and principal of which has to be paid
later.15 The question then arise what the macroeconomic consequences of using
these di§erent instruments are, and which instrument is to be preferred from a
normative point of view. The Ricardian Equivalence Hypothesis claims that it
makes no di§erence, that a switch from one instrument to the other does not
change real allocations and prices in the economy. Therefore this hypothesis, is
also called Modigliani-Miller theorem of public Önance.16 Itís origin dates back
to the classical economist David Ricardo (1772-1823). He wrote about how
to Önance a war with annual expenditures of $20 millions and asked whether
it makes a di§erence to Önance the $20 millions via current taxes or to issue
government bonds with inÖnite maturity (so-called consols) and Önance the an-
nual interest payments of $1 million in all future years by future taxes (at an
assumed interest rate of 5%). His conclusion was (in ìFunding Systemî) that

in the point of the economy, there is no real di§erence in either

of the modes; for twenty millions in one payment [or] one million per
annum for ever ... are precisely of the same value

Here Ricardo formulates and explains the equivalence hypothesis, but im-
mediately makes clear that he is sceptical about its empirical validity

...but the people who pay the taxes never so estimate them, and
therefore do not manage their a§airs accordingly. We are too apt to
think, that the war is burdensome only in proportion to what we are
at the moment called to pay for it in taxes, without reáecting on the
probable duration of such taxes. It would be di¢cult to convince
a man possessed of $20; 000, or any other sum, that a perpetual
payment of $50 per annum was equally burdensome with a single
tax of $1; 000:

Ricardo doubts that agents are as rational as they should, according to ìin
the point of the economyî, or that they rationally believe not to live forever and
hence do not have to bear part of the burden of the debt. Since Ricardo didnít
believe in the empirical validity of the theorem, he has a strong opinion about
which Önancing instrument ought to be used to Önance the war

war-taxes, then, are more economical; for when they are paid, an
e§ort is made to save to the amount of the whole expenditure of the
1 5 I will restrict myself to a discussion of real economic models, in which Öat money is absent.

Hence the government cannot levy revenue via seignorage.

1 6 When we discuss a theoretical model, Ricardian equivalence will take the form of a theorem

that either holds or does not hold, depending on the assumptions we make. When discussing
whether Ricardian equivalence holds empirically, I will call it a hypothesis.
8.2. THE RICARDIAN EQUIVALENCE HYPOTHESIS 161

war; in the other case, an e§ort is only made to save to the amount
of the interest of such expenditure.

Ricardo thought of government debt as one of the prime tortures of mankind.

Not surprisingly he strongly advocates the use of current taxes. We will, after
having discussed the Ricardian equivalence hypothesis, brieáy look at the long-
run e§ects of government debt on economic growth, in order to evaluate whether
the phobia of Ricardo (and almost all other classical economists) about govern-
ment debt is in fact justiÖed from a theoretical point of view. Now letís turn to
a model-based discussion of Ricardian equivalence.

8.2.1 InÖnite Lifetime Horizon and Borrowing Constraints

The Ricardian Equivalence hypothesis is, in fact, a theorem that holds in a fairly
wide class of models. It is most easily demonstrated within the Arrow-Debreu
market structure of inÖnite horizon models. Consider the simple inÖnite horizon
pure exchange model discussed at the beginning of the section. Now introduce
a government that has to Önance a given exogenous stream of government ex-
penditures (in real terms) denoted by fGt g1t=1 : These government expenditures
do not yield any utility to the agents (this assumption is not at all restrictive
for the results to come). Let pt denote the Arrow-Debreu price at date 0 of
one unit of the consumption good delivered at period t: The government has
initial outstanding real debt17 of B1 that is held by the public. Let bi1 denote
the initial endowment of government bonds of agent i: Obviously we have the
restriction X
bi1 = B1
i2I

Note that bi1

is agent iís entitlement to period 1 consumption that the govern-
ment owes to the agent. In order to Önance the government expenditures the
government levies lump-sum taxes: let < it denote the taxes that agent i pays
in period t; denoted in terms of the period t consumption good. We deÖne an
Arrow-Debreu equilibrium with government as follows

DeÖnition 91 Given a sequence of government spending fGt g1 t=1 and initial

i
government
# $ debt B 1 and (b 1 )i2I an Arrow-Debreu
# i$ equilibrium are allocations
f c^it i2I g1
t=1 ; prices f^
p t g1
t=1 and taxes f < g 1
t i2I t=1 such that
# i$
p t g1
1. Given prices f^ 1
cit g1
t=1 and taxes f < t i2I gt=1 for all i 2 I; f^ t=1 solves

1
X
max
1
( t$1 U (cit ) (8.20)
fct gt=1
t=1
1
X 1
X
s.t. p^t (ct + < it ) $ p^t eit + p^1 bi1
t=1 t=1

1 7 I.e. the government owes real consumption goods to its citizens.

162 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

pt g1
2. Given prices f^ t=1 the tax policy satisÖes

1
X 1 X
X
p^t Gt + p^1 B1 = p^t < it
t=1 t=1 i2I

3. For all t % 1 X X
c^it + Gt = eit
i2I i2I

In an Arrow-Debreu deÖnition of equilibrium the government, as the agent,

faces a single intertemporal budget constraint which states that the total value
of tax receipts is su¢cient to Önance the value of all government purchases plus
the initial government debt. From the deÖnition it is clear that, with respect to
government
P1 tax policies, the only thing that matters is the total value of taxes
i
t=1 p
^ t < t that the individual has to pay, but not the timing of taxes. It is then
straightforward to prove the Ricardian Equivalence theorem for this economy.
1
Theorem 92 Take as given a sequence of government spending # i $ fG1 t gt=1 and
i
initial government debt B1 ; (b1 )i2I : Suppose that allocations f c^t i2I gt=1 ; prices
# i$ # i$
p t g1
f^ 1
t=1 and taxes f < t i2I gt=1 form an Arrow-Debreu equilibrium. Let f < ^t i2I g1
t=1
be an arbitrary alternative tax system satisfying
1
X 1
X
p^t < it = p^t <^it for all i 2 I
t=1 t=1
# $ # i$
Then f c^it i2I g1 pt g1
t=1 ; f^ ^t i2I g1
t=1 and f < t=1 form an Arrow-Debreu equilib-
rium.

There are two important elements of this theorem to mention. First, the
sequence of government expenditures is taken as Öxed and exogenously given.
Second, the condition in the theorem rules out redistribution among individuals.
It also requires that the new tax system has the same cost to each individual at
the old equilibrium prices (but not necessarily at alternative prices).
Proof. This is obvious. The budget constraint of individuals does not
change, hence the optimal consumption choice at the old equilibrium prices
does not change. Obviously resource feasibility is satisÖed. The government
budget constraint is satisÖed due to the assumption made in the theorem.
A shortcoming of the Arrow-Debreu equilibrium deÖnition and the preced-
ing theorem is that it does not make explicit the substitution between current
taxes
# $ and government # i $ deÖcits that may occur for two equivalent tax systems
f < it i2I g1 ^t i2I g1
t=1 and f < t=1 : Therefore we will now reformulate this economy
sequentially. This will also allow us to see that one of the main assumptions of
the theorem, the absence of borrowing constraints is crucial for the validity of
the theorem.
As usual with sequential markets we now assume that markets for the con-
sumption good and one-period loans open every period. We restrict ourselves to
8.2. THE RICARDIAN EQUIVALENCE HYPOTHESIS 163

government bonds and loans with one year maturity, which, in this environment
is without loss of generality (note that there is no risk) and will not distinguish
between borrowing and lending between two agents an agent an the government.
Let rt+1 denote the interest rate on one period loans from period t to period
t + 1: Given the tax system and initial bond holdings each agent i now faces a
sequence of budget constraints of the form
bit+1
cit + $ eit & < it + bit (8.21)
1 + rt+1
with bi1 given. In order to rule out Ponzi schemes we have to impose a no Ponzi
scheme condition of the form bit % &ait (r; ei ; < ) on the consumer, which, in
general may depend on the sequence of interest rates as well as the endowment
stream of the individual and the tax system. We will be more speciÖc about the
exact from of the constraint later. In fact, we will see that the exact speciÖcation
of the borrowing constraint is crucial for the validity of Ricardian equivalence.
The government faces a similar sequence of budget constraints of the form
X Bt+1
Gt + Bt = < it + (8.22)
1 + rt+1
i2I

with B1 given. We also impose a condition on the government that rules out
government policies that run a Ponzi scheme, or Bt % &At (r; G; < ): The deÖni-
tion of a sequential markets equilibrium is standard
DeÖnition 93 Given a sequence of government spending fGt g1 t=1 and initial' (
government debt B1 ; (bi1 )i2I a Sequential Markets equilibrium is allocations f c^it ; ^bit+1 g1
t=1 ;
# $ i2I
rt+1 g1
interest rates f^ i 1
t=1 and government policies f < t i2I ; Bt+1 gt=1 such that
# i$
1. Given interest rates f^ rt+1 g1 1
t=1 and taxes f < t i2I gt=1 for all i 2 I; f^ cit ; ^bit+1 g1
t=1
maximizes (8:20) subject to (8:21) and bit+1 % &ait (^ r; ei ; < ) for all t % 1:
rt+1 g1
2. Given interest rates f^ t=1 ; the government policy satisÖes (8:22) and
Bt+1 % &At (^r; G) for all t % 1
3. For all t % 1
X X
c^it + Gt = eit
i2I i2I
X
^bi = Bt+1
t+1
i2I

We will particularly concerned with two forms of borrowing constraints. The

Örst is the so called natural borrowing or debt limit: it is that amount that, at
given sequence of interest rates, the consumer can maximally repay, by setting
consumption to zero in each period. It is given by
1
X eit+* & < it+*
anit (^
r; e; < ) = Qt+* $1
* =1 j=t+1 (1 + r ^j+1 )
164 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

Qt
where we deÖne j=t+1 (1 + r^j+1 ) = 1: Similarly we set the borrowing limit of
the government at its natural limit
1 P
X i
i2I < t+*
Ant (^
r; < ) = Qt+* $1
* =1 j=t+1 (1 + r ^j+1 )

The other form is to prevent borrowing altogether, setting a0it (^ r; e) = 0 for all
i; t: Note that since there is positive supply of government bonds, such restriction
does not rule out saving of individuals in equilibrium. We can make full use
of the Ricardian equivalence theorem for Arrow-Debreu economies one we have
proved the following equivalence result

Proposition 94 Fix a sequence of government # ispending

$ fGt g1
t=1 and initial
i 1
pt g1
government debt B1 ; (b1 )i2I : Let allocations f c^t i2I gt=1 ; prices f^ t=1 and
# i$ 1
taxes f < t i2I gt=1 form an Arrow-Debreu equilibrium. Then there exists a cor-
' (
responding sequential markets equilibrium with the natural debt limits f c~it ; ~bit+1 g1
t=1 ;
# $ i2I
f~ 1 i ~ 1
rt gt=1 ; f <~t i2I ; Bt+1 gt=1 such that

c^it = c~it
< it = <~it for all i; all t
' (
Reversely, let allocations f c^it ; ^bit+1 g1 rt g1
t=1 ; interest rates f^ t=1 and govern-
# i$ 1
i2I
ment policies f < t i2I ; Bt+1 gt=1 form a sequential markets equilibrium with nat-
ural debt limits. Suppose that it satisÖes

r^t+1 > &1; for all t % 1

1
X eit & < it
Qt$1 < 1 for all i 2 I
t=1 j=1 (1 + r ^j+1 )
1 P
X i
i2I < t+*
Qt+* < 1
* =1 j=t+1 (1 + r ^j+1 )
# $
Then there exists a corresponding Arrow-Debreu equilibrium f c~it i2I g1 pt g1
t=1 ; f~ t=1 ,
# i$
f <~t i2I g1
t=1 such that

c^it = c~it
< it = <~it for all i; all t

Proof. The key to the proof is to show the equivalence of the budget sets
for the Arrow-Debreu and the sequential markets structure. Normalize p^1 = 1
and relate equilibrium prices and interest rates by

p^t
1 + r^t+1 = (8.23)
p^t+1
8.2. THE RICARDIAN EQUIVALENCE HYPOTHESIS 165

Now look at the sequence of budget constraints and assume that they hold with
equality (which they do in equilibrium, due to the nonsatiation assumption)

bi2
ci1 + = ei1 & < i1 + bi1 (8.24)
1 + r^2
bi3
ci2 + = ei2 & < i2 + bi2 (8.25)
1 + r^3
..
.
bit+1
cit + = eit & < it + bit (8.26)
1 + r^t+1

Substituting for bi2 from (8:25) in (8:24) one gets

ci2 + < i2 & ei2 bi3

ci1 + < i1 & ei1 + + = bi1
1 + r^2 (1 + r^2 )(1 + r^3 )
and in general
T
X ct & et bi
Qt$1 + QT T +1 = bi1
t=1 j=1 (1 + r
^ j+1 ) j=1 (1 + r
^ j+1 )

Taking limits on both sides gives, using (8:23)

1
X biT +1
p^t (cit + < it & eit ) + lim QT = bi1
T !1
t=1 j=1 (1 + r^j+1 )

Hence we obtain the Arrow-Debreu budget constraint if and only if

biT +1
lim QT = lim p^T +1 biT +1 % 0
T !1 T !1
j=1 (1 + r
^j+1 )

But from the natural debt constraint

1
X 1
X
eit+* & < it+*
p^T +1 biT +1 % &^
pT +1 Qt+* $1 =& p^t (ei* & < i* )
* =1 j=t+1 (1 + r^j+1 ) * =T +1
1
X T
X
= & p^t (ei* & < i* ) + p^t (ei* & < i* )
* =1 * =1

P1 ei $* it
Taking limits with respect to both sides and using that by assumption t=1
Qt#1t =
j=1 (1+^rj+1 )
P1
^t (ei* & < i* ) < 1 we have
t=1 p

lim p^T +1 biT +1 % 0

T !1

So at equilibrium prices, with natural debt limits and the restrictions posed
in the proposition a consumption allocation satisÖes the Arrow-Debreu budget
166 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

constraint (at equilibrium prices) if and only if it satisÖes the sequence of budget
constraints in sequential markets. A similar argument can be carried out for
the budget constraint(s) of the government. The remainder of the proof is
then straightforward and left to the reader. Note that, given an Arrow-Debreu
equilibrium consumption allocation, the corresponding bond holdings for the
sequential markets formulation are

X1
c^it+* + < it+* & eit+*
bit+1 = Qt+* $1
* =1 j=t+1 (1 + r^j+1 )

As a straightforward corollary of the last two results we obtain the Ricardian

equivalence theorem for sequential markets with natural debt limits (under the
weak requirements of the last proposition).18 Let us look at a few examples

Example 95 (Financing a war) Let the economy be populated by I = 1000

identical people, with U (c) = ln(c); ( = 0:5

eit = 1

and G1 = 500 (the war); Gt = 0 for all t > 1: Let b1 = B1 = 0: Consider two
tax policies. The Örst is a balanced budget requirement, i.e. < 1 = 0:5; < t = 0 for
all t > 1: The second is a tax policy that tries to smooth out the cost of the war,
i.e. sets < t = < = 13 for all t % 1: Let us look at the equilibrium for the Örst tax
policy. Obviously the equilibrium consumption allocation (we restrict ourselves
to type-identical allocations) has
"
i 0:5 for t = 1
c^t =
1 for t % 1

and the Arrow-Debreu equilibrium price sequence satisÖes (after normalization

of p1 = 1) p2 = 0:25 and pt = 0:25)0:5t$2 for all t > 2: The level of government
debt and the bond holdings of individuals in the sequential markets economy
satisfy
Bt = bt = 0 for all t
Interest rates are easily computed as r2 = 3; rt = 1 for t > 2: The budget con-
straint of the government and the agents are obviously satisÖed. Now consider
the second tax policy. Given resource constraint the previous equilibrium alloca-
tion and price sequences are the only candidate for an equilibrium under the new
policy. Letís check whether they satisfy the budget constraints of government and
1 8 An equivalence result with even less restrictive assumptions can be proved under the

speciÖcation of a bounded shortsale constraint

inf bit < 1

t

instead of the natural debt limit. See Huang and Werner (1998) for details.
8.2. THE RICARDIAN EQUIVALENCE HYPOTHESIS 167

individuals. For the government

1
X 1 X
X
p^t Gt + p^1 B1 = p^t < it
t=1 t=1 i2I
X1
1
500 = 1000^
pt
3 t=1
X1
1000
= (1 + 0:25 + 0:25 ) 0:5t$2 )
3 t=3
= 500

and for the individual

1
X 1
X
p^t (ct + < it ) $ p^t eit + p^1 bi1
t=1 t=1
1 1
5 4X X
+ p^t $ p^t
6 3 t=2 t=1
X1
1 1 1
p^t = $
3 t=2
6 6

Finally, for this tax policy the sequence of government debt and private bond
holdings are
2000 2
Bt = ; b2 = for all t % 2
3 3
i.e. the government runs a deÖcit to Önance the war and, in later periods,
uses taxes to pay interest on the accumulated debt. It never, in fact, retires the
debt. As proved in the theorem both tax policies are equivalent as the equilibrium
allocation and prices remain the same after a switch from tax to deÖcit Önance
of the war.

The Ricardian equivalence theorem rests on several important assumptions.

The Örst is that there are perfect capital markets. If consumers face binding
borrowing constraints (e.g. for the speciÖcation requiring bit+1 % 0), or if, with
risk, not a full set of contingent claims is available, then Ricardian equivalence
may fail. Secondly one has to require that all taxes are lump-sum. Non-lump
sum taxes may distort relative prices (e.g. labor income taxes distort the relative
price of leisure) and hence a change in the timing of taxes may have real e§ects.
All taxes on endowments, whatever form they take, are lump-sum, not, however
consumption taxes. Finally a change from one to another tax system is assumed
to not redistribute wealth among agents. This was a maintained assumption of
the theorem, which required that the total tax bill that each agent faces was
left unchanged by a change in the tax system. In a world with Önitely lived
overlapping generations this would mean that a change in the tax system is not
supposed to redistribute the tax burden among di§erent generations.
168 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

Now letís brieáy look at the e§ect of borrowing constraints. Suppose we

restrict agents from borrowing, i.e. impose bit+1 % 0; for all i; all t: For the
government we still impose the old restriction on debt, Bt % &Ant (^ r; < ): We
can still prove a limited Ricardian result
' (
Proposition 96 Let fGt g1 i
t=1 and B1 ; (b1 )i2I be given and let allocations f c ^it ; ^bit+1 g1
t=1 ;
# $ i2I
interest rates f^ rt+1 g1 i 1
t=1 and government policies f < t i2I ; Bt+1 gt=1 be a Se-
quential Markets equilibrium with no-borrowing constraints for which ^bit+1 > 0
# $
for all i; t: Let f <~i ;B~t+1 g1 be an alternative government policy such that
t i2I t=1

1
X
~bi c^i + <~i* & ei*
t+1 = Q* * %0 (8.27)
* =t+1 j=t+2 (1 + r ^j+1 )
X ~t+1
B
~t
Gt + B = <~it + for all t (8.28)
1 + r^t+1
i2I
~t+1
B % &Ant (^
r; < ) (8.29)
1
X X1
<~i* < i*
Q* $1 = Q* $1 (8.30)
* =1 j=1 (1 + r^j ) * =1 j=1 (1 + r ^j+1 )
' ( # i$
Then f c^it ; ~bit+1 g1 rt+1 g1
t=1 ; f^ t=1 and f <
~t+1 g1 is also a sequential
~t i2I ; B t=1
i2I
markets equilibrium with no-borrowing constraint.

The conditions that we need for this theorem are that the change in the tax
system is not redistributive (condition (8:30)), that the new government policies
satisfy the government budget constraint and debt limit (conditions (8:28) and
(8:29)) and that the new bond holdings of each individual that are required to
satisfy the budget constraints of the individual at old consumption allocations
do not violate the no-borrowing constraint (condition (8:27)).
Proof. This proposition to straightforward to prove so we will sketch it
here only. Budget constraints of the government and resource feasibility are
obviously satisÖed under the new policy. How about consumer optimization?
Given the equilibrium prices and under the imposed conditions both policies
induce the same budget set of individuals. Now suppose there is an i and
allocation f8 cit g 6= f^
cit g that dominates f^ cit g: Since f8
cit g was a§ordable with the
old policy, it must be the case that the associated bond holdings under the
old policy, f8bit+1 g violated one of the no-borrowing constraints. But then, by
continuity of the price functional and the utility function there is an allocation
cit g with associated bond holdings f2bit+1 g that is a§ordable under the old policy
f2
and satisÖes the no-borrowing constraint (take a convex combination of the
cit ; ^bit+1 g and the f8
f^ cit ; 8bit+1 g; with su¢cient weight on the f^ cit ; ^bit+1 g so as to
satisfy the no-borrowing constraints). Note that for this to work it is crucial that
the no-borrowing constraints are not binding under the old policy for f^ cit ; ^bit+1 g:
You should Öll in the mathematical details
8.2. THE RICARDIAN EQUIVALENCE HYPOTHESIS 169

Let us analyze an example in which, because of the borrowing constraints,

Ricardian equivalence fails.

Example 97 Consider an economy with 2 agents, U i = ln(c); ( i = 0:5; bi1 =

B1 = 0: Also Gt = 0 for all t and endowments are
"
1 2 if t odd
et =
1 if t even
"
2 1 if t odd
et =
2 if t even

As Örst tax system consider

"
0:5 if t odd
< 1t =
&0:5 if t even
"
&0:5 if t odd
e2t =
0:5 if t even

Obviously this tax system balances the budget. The equilibrium allocation with
no-borrowing constraints evidently is the autarkic (after-tax) allocation cit =
1:5; for all i; t: From the Örst order conditions we obtain, taking account the
nonnegativity constraint on bit+1 (here ,t % 0 is the Lagrange multiplier on
the budget constraint in period t and 1t+1 is the Lagrange multiplier on the
nonnegativity constraint for bit+1 )

( t$1 U 0 (cit ) = ,t
( t U (cit+1 ) = ,t+1
,t
= ,t+1 + 1t+1
1 + rt+1

Combining yields

U 0 (cit ) ,t (1 + rt )1t+1
= = 1 + rt+1 +
(U 0 (cit+1 ) ,t+1 ,t+1

Hence
U 0 (cit )
% 1 + rt+1
(U 0 (cit+1 )
= 1 + rt+1 if bit+1 > 0

The equilibrium interest rates are given as rt+1 $ 1; i.e. are indeterminate.
Both agents are allowed to save, and at rt+1 > 1 they would do so (which of
course canít happen in equilibrium as there is zero net supply of assets). For
any rt+1 $ 1 the agents would like to borrow, but are prevented from doing so by
the no-borrowing constraint, so any of these interest rates is Öne as equilibrium
170 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

interest rates. For concreteness letís take rt+1 = 1 for all t:19 Then the total
bill of taxes for the Örst consumer is 13 and & 13 for the second agent. Now lets
consider a second tax system that has < 11 = 13 ; < 21 = & 13 and < it = 0 for all
i; t % 2: Obviously now the equilibrium allocation changes to c1t = 53 ; c21 = 43 and
cit = eit for all i; t % 2: Obviously the new tax system satisÖes the government
budget constraint and does not redistribute among agents. However, equilibrium
3
allocations change. Furthermore, equilibrium interest rate change to r2 = 2:5
20
and rt = 0 for all t % 3: Ricardian equivalence fails.

8.2.2 Finite Horizon and Operative Bequest Motives

It should be clear from the above discussion that one only obtains a very limited
Ricardian equivalence theorem for OLG economies. Any change in the timing
of taxes that redistributes among generations is in general not neutral in the
Ricardian sense. If we insist on representative agents within one generation and
purely selÖsh, two-period lived individuals, then in fact any change in the timing
of taxes canít be neutral unless it is targeted towards a particular generation,
i.e. the tax change is such that it decreases taxes for the currently young only
and increases them for the old next period. Hence, with su¢cient generality
we can say that Ricardian equivalence does not hold for OLG economies with
purely selÖsh individuals.
Rather than to demonstrate this obvious point with another example we
now brieáy review Barroís (1974) argument that under certain conditions Ö-
nitely lived agents will behave as if they had inÖnite lifetime. As a consequence,
Ricardian equivalence is re-established. Barroís (1974) article ìAre Govern-
ment Bonds Net Wealth?î asks exactly the Ricardian question, namely does
an increase in government debt, Önanced by future taxes to pay the interest on
the debt increase the net wealth of the private sector? If yes, then current con-
sumption would increase, aggregate saving (private plus public) would decrease,
leading to an increase in interest rate and less capital accumulation. Depending
on the perspective, countercyclical Öscal policy21 is e§ective against the business
cycle (the Keynesian perspective) or harmful for long term growth (the classical
perspective). If, however, the value of government bonds if completely o§set by
the value of future higher taxes for each individual, then government bonds are
not net wealth of the private sector, and changes in Öscal policy are neutral.
Barro identiÖed two main sources for why future taxes are not exactly o§-
setting current tax cuts (increasing government deÖcits): a) Önite lives of agents
that lead to intergenerational redistribution caused by a change in the timing
1 9 These are the interest rates that would arise under natural debt limits, too.
2 0 In general it is very hard to solve for equilibria with no-borrowing constraints analytically,
even in partial equilibrium with Öxed exogenous interest rates, even more so in gneral equi-
librium. So if the above example seems cooked up, it is, since it is about the only example I
know how to solve without going to the computer. We will see this more explicitly once we
talk about Deatonís (1991) EC piece.
2 1 By Öscal policy in this section we mean the Önancing decision of the government for a

given exogenous path of government expenditures.

8.2. THE RICARDIAN EQUIVALENCE HYPOTHESIS 171

of taxes b) imperfect private capital markets. Barroís paper focuses on the Örst
source of nonneutrality.
Barroís key result is the following: in OLG-models Öniteness of lives does not
invalidate Ricardian equivalence as long as current generations are connected
to future generations by a chain of operational intergenerational, altruistically
motivated transfers. These may be transfers from old to young via bequests
or from young to old via social security programs. Let us look at his formal
model.22
Consider the standard pure exchange OLG model with two-period lived
agents. There is no population growth, so that each member of the old genera-
tion (whose size we normalize to 1) has exactly one child. Agents have endow-
ment ett = w when young and no endowment when old. There is a government
that, for simplicity, has 0 government expenditures but initial outstanding gov-
ernment debt B: This debt is denominated in terms of the period 1 (or any
other period) consumption good. The initial old generation is endowed with
these B units of government bonds. We assume that these government bonds
are zero coupon bonds with maturity of one period. Further we assume that
the government keeps its outstanding government debt constant and we assume
a constant one-period real interest rate r on these bonds.23 In order to Önance
the interest payments on government debt the government taxes the currently
young people. The government budget constraint gives

B
+< =B
1+r

The right hand side is the old debt that the government has to retire in the
current period. On the left hand side we have the revenue from issuing new
B 1
debt, 1+r (remember that we assume zero coupon bonds, so 1+r is the price of
one government bond today that pays 1 unit of the consumption good tomorrow)
and the tax revenue. With the assumption of constant government debt we Önd

rB
<=
1+r
rB
and we assume 1+r < w:
Now letís turn to the budget constraints of the individuals. Let by att denote
the savings of currently young people for the second period of their lives and by
att+1 denote the savings of the currently old people for the next generation, i.e.
the old peopleís bequests. We require bequests to be nonnegative, i.e. att+1 % 0.
In our previous OLG models obviously att+1 = 0 was the only optimal choice
since individuals were completely selÖsh. We will see below how to induce pos-
itive bequests when discussing individualsí preferences. The budget constraints
2 2 I will present a simpliÖed, pure exchange version of his model to more clearly isolate his

main point.
2 3 This assumption is justiÖed since the resulting equilibrium allocation (there is no money!)

is the autarkic allocation and hence the interest rate always equals the autarkic interest rate.
172 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

of a representative generation are then given by

att
ctt + = w&<
1+r
at
ctt+1 + t+1 = att + at$1
t
1+r
The budget constraint of the young are standard; one may just remember that
att
assets here are zero coupon bonds: spending 1+r on bonds in the current period
yields at units of consumption goods tomorrow. We do not require att to be
t

positive. When old the individuals have two sources of funds: their own savings
from the previous period and the bequests at$1t from the previous generation.
They use it to buy own consumption and bequests for the next generation.
att+1
The total expenditure for bequests of a currently old individual is 1+r and it
t
delivers funds to her child next period (that has then become old) of at+1 : We
can consolidate the two budget constraints to obtain
ctt+1 att+1 at$1
ctt + + 2 =w+ t &<
1 + r (1 + r) 1+r
Since the total lifetime resources available to generation t are given by et =
at#1
w + 1+r
t
& < ; the lifetime utility that this generation can attain is determined
by e: The budget constraint of the initial old generation is given by
a01
c01 + =B
1+r
With the formulation of preferences comes the crucial twist of Barro. He
assumes that individuals are altruistic and care about the well-being of their
descendant.24 Altruistic here means that the parents genuinely care about the
utility of their children and leave bequests for that reason; it is not that the
parents leave bequests in order to induce actions of the children that yield
utility to the parents.25 Preferences of generation t are represented by
ut (ctt ; ctt+1 ; att+1 ) = U (ctt ) + (U (ctt+1 ) + 0Vt+1 (et+1 )
where Vt+1 (et+1 ) is the maximal utility generation t + 1 can attain with lifetime
at
t+1
resources et+1 = w+ 1+r &< ; which are evidently a function of bequests att+1 from
26
generation t: We make no assumption about the size of 0 as compared to (;
2 4 Note that we only assume that the agent cares only about her immediate descendant, but
(possibly) not at all about grandchildren.
2 5 This strategic bequest motive does not necessarily help to reestablish Ricardian equiva-

lence, as Bernheim, Shleifer and Summers (1985) show.

2 6 To formulate the problem recurively we need separability of the utility function with

respect to time and utility of children. The argument goes through without this, but then
it canít be clariÖed using recursive methods. See Barroís original paper for a more general
discussion. Also note that he, in all likelihood, was not aware of the full power of recursive
techniques in 1974. Lucas (1972) seminal paper was probably the Örst to make full use of
recursive techiques in (macro) economics.
8.2. THE RICARDIAN EQUIVALENCE HYPOTHESIS 173

but assume 0 2 (0; 1): The initial old generation has preferences represented by

u0 (c01 ; a01 ) = (U (c01 ) + 0V1 (e1 )

The equilibrium conditions for the goods and the asset market are, respec-
tively

ct$1
t + ctt = w for all t % 1
t$1
at + att = B for all t % 1

Now let us look at the optimization problem of the initial old generation
A 0
B
V0 (B) = 0max 0
(U (c1 ) + 0V 1 (e1 )
c1 ;a1 -0

a01
s.t. c01 + = B
1+r
a01
e1 = w+ &<
1+r
Note that the two constraints can be consolidated to

c01 + e1 = w + B & < (8.31)

This yields optimal decision rules c01 (B) and a01 (B) (or e1 (B)): Now assume
that the bequest motive is operative, i.e. a01 (B) > 0 and consider the Ricar-
dian experiment of government: increase initial government debt marginally by
IB and repay this additional debt by levying higher taxes on the Örst young
generation. Clearly, in the OLG model without bequest motives such a change
in Öscal policy is not neutral: it increases resources available to the initial old
and reduces resources available to the Örst regular generation. This will change
consumption of both generations and interest rate. What happens in the Barro
economy? In order to repay the IB, from the government budget constraint
taxes for the young have to increase by

I< = IB

since by assumption government debt from the second period onwards remains
unchanged. How does this a§ect the optimal consumption and bequest choice
of the initial old generation? It is clear from (8:31) that the optimal choices for
c01 and e1 do not change as long as the bequest motive was operative before.27
The initial old generation receives additional transfers of bonds of magnitude
IB from the government and increases its bequests a01 by (1 + r)IB so that
lifetime resources available to their descendants (and hence their allocation) is
left unchanged. Altruistically motivated bequest motives just undo the change
in Öscal policy. Ricardian equivalence is restored.
2 7 If the bequest motive was not operative, i.e. if the constraint a0 & 0 was binding, then
1
by increasing B may result in an increase in c01 and a decrease in e1 :
174 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

This last result was just an example. Now letís show that Ricardian equiva-
lence holds in general with operational altruistic bequests. In doing so we will de
facto establish between Barroís OLG economy and an economy with inÖnitely
lived consumers and borrowing constraints. Again consider the problem of the
initial old generation (and remember that, for a given tax rate and wage there
is a one-to-one mapping between et+1 and att+1
A B
V0 (B) = max (U (c01 ) + 0V1 (a01 )
c01 ; a01 % 0
a01
c01 + 1+r =B
8 9
>
> >
>
>
> >
>
>
> >
>
>
> >
>
>
> >
>
< A B =
0 1 1 1
= max (U (c1 ) + 0 max U (c1 ) + (U (c2 ) + 0V2 (a2 )
c01 ; a01 % 0 >
> c11 ; c12 ; a12 % 0; a11 >
>
>
> >
>
0 a10 >
> 1 a1 1 >
>
c1 + 1+r = B > > c1 + 1+r = w & < >
>
>
> >
>
: 1 a 1
c2 + 1+r = a1 + a1
2 1 0 ;

But this maximization problem can be rewritten as

A B
max
0 0 1 1 1 1
(U (c01 ) + 0U (c11 ) + 0(U (c12 ) + 02 V2 (a12 )
c1 ;a1 ;c1 ;c2 ;a2 -0;a1

a01
s.t. c01 + = B
1+r
a1
c11 + 1 = w&<
1+r
a1
c12 + 2 = a11 + a01
1+r
or, repeating this procedure inÖnitely many times (which is a valid procedure
only for 0 < 1), we obtain as implied maximization problem of the initial old
generation
( 1
)
X # $
0 t t t
max (U (c1 ) + 0 U (ct + (U (ct+1 ))
f(ct#1
t ;ctt ;at#1
t )g1
t=1 -0 t=1
a0
s:t: c01 + 1 = B
1+r
c t
t+1 at
t+1 at$1
t
ctt + + = w&< +
1 + r (1 + r)2 1+r

i.e. the problem is equivalent to that of an inÖnitely lived consumer that faces a
no-borrowing constraint. This inÖnitely lived consumer is peculiar in the sense
that her periods are subdivided into two subperiods, she eats twice a period,
ctt in the Örst subperiod and ctt+1 in the second subperiod, and the relative
8.3. OVERLAPPING GENERATIONS MODELS WITH PRODUCTION 175

price of the consumption goods in the two subperiods is given by (1 + r): Apart
from these reinterpretations this is a standard inÖnitely lived consumer with
no-borrowing constraints imposed on her. Consequently one obtains a Ricar-
dian equivalence proposition similar to proposition 96, where the requirement
of ìoperative bequest motivesî is the equivalent to condition (8:27): More gen-
erally, this argument shows that an OLG economy with two period-lived agents
and operative bequest motives is formally equivalent to an inÖnitely lived agent
model.
Example 98 Suppose we carry out the Ricardian experiment and increase ini-
tial government debt by IB. Suppose the debt is never retired, but the required
interest payments are Önanced by permanently higher taxes. The tax increase
that is needed is (see above)
rIB
I< =
1+r
Suppose that for the initial debt level f(^ ct$1
t ^t$1
; c^tt ; at )g1
t=1 together with r
^ is an
t$1
equilibrium such that a ^t > 0 for all t: It is then straightforward to verify
ct$1
that f(^ t ~t$1
; c^tt ; at )g1
t=1 together with r
^ is an equilibrium for the new debt level,
where
~t$1
at =a^t$1
t + (1 + r^)IB for all t
i.e. in each period savings increase by the increased level of debt, plus the pro-
vision for the higher required tax payments. Obviously one can construct much
more complicated tax experiments that are neutral in the Ricardian sense, pro-
vided that for the original tax system the non-borrowing constraints never bind
(i.e. that bequest motives are always operative). Also note that Barro discussed
his result in the context of a production economy, an issue to which we turn
next.

8.3 Overlapping Generations Models with Pro-

duction
So far we have ignored production in our discussion of OLG-models. It may
be the case that some of the pathodologies of the OLG-model appear only in
pure exchange versions of the model. Since actual economies feature capital
accumulation and production, these pathodologies then are nothing to worry
about. However, we will Önd out that, for example, the possibility of ine¢cient
competitive equilibria extends to OLG models with production. The issues of
whether money may have positive value and whether there exists a continuum
of equilibria are not easy for production economies and will not be discussed in
these notes.

8.3.1 Basic Setup of the Model

As much as possible I will synchronize the discussion here with the discrete time
neoclassical growth model in Chapter 2 and the pure exchange OLG model in
176 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

previous subsections. The economy consists of individuals and Örms. Individu-

als live for two periods By Ntt denote the number of young people in period t;
by Ntt$1 denote the number of old people at period t: Normalize the size of the
initial old generation to 1; i.e. N00 = 1: We assume that people do not die early,
so Ntt = Nt+1
t
: Furthermore assume that the population grows at constant rate
n; so that Ntt = (1 + n)t N00 = (1 + n)t : The total population at period t is
therefore given by Ntt$1 + Ntt = (1 + n)t (1 + 1+n 1
):
The representative member of generation t has preferences over consumption
streams given by
u(ctt ; ctt+1 ) = U (ctt ) + (U (ctt+1 )
where U is strictly increasing, strictly concave, twice continuously di§erentiable
and satisÖes the Inada conditions. All individuals are assumed to be purely
selÖsh and have no bequest motives whatsoever. The initial old generation has
preferences
u(c01 ) = U (c01 )
Each individual of generation t % 1 has as endowments one unit of time to work
when young and no endowment when old. Hence the labor force in period t is
of size Ntt with maximal labor supply of 1 ) Ntt : Each member of the initial old
generation is endowed with capital stock (1 + n)k81 > 0:
Firms has access to a constant returns to scale technology that produces
output Yt using labor input Lt and capital input Kt rented from households
i.e. Yt = F (Kt ; Lt ): Since Örms face constant returns to scale, proÖts are zero
in equilibrium and we do not have to specify ownership of Örms. Also without
loss of generality we can assume that there is a single, representative Örm, that,
as usual, behaves competitively in that it takes as given the rental prices of
factor inputs (rt ; wt ) and the price for its output. DeÖning the capital-labor
ratio kt = KLt we have by constant returns to scale
t

% &
Yt F (Kt ; Lt ) Kt
yt = = =F ;1 = f (kt )
Lt Lt Lt

We assume that f is twice continuously di§erentiable, strictly concave and sat-

isÖes the Inada conditions.

8.3.2 Competitive Equilibrium

The timing of events for a given generation t is as follows

1. At the beginning of period t production takes place with labor of genera-

tion t and capital saved by the now old generation t & 1 from the previous
period. The young generation earns a wage wt

2. At the end of period t the young generation decides how much of the wage
income to consume, ctt ; and how much to save for tomorrow, stt : The saving
occurs in form of physical capital, which is the only asset in this economy
8.3. OVERLAPPING GENERATIONS MODELS WITH PRODUCTION 177

3. At the beginning of period t + 1 production takes place with labor of

generation t + 1 and the saved capital of the now old generation t: The
return on savings equals rt+1 & /; where again rt+1 is the rental rate of
capital and / is the rate of depreciation, so that rt+1 & / is the real interest
rate from period t to t + 1:
4. At the end of period t + 1 generation t consumes its savings plus interest
rate, i.e. ctt+1 = (1 + rt+1 & /)stt and then dies.

We now can deÖne a sequential markets equilibrium for this economy

DeÖnition 99 Given k81 ; a sequential markets equilibrium is allocations for

ctt ; c^tt+1 ; s^tt )g1
households c^01 ; f(^ ^ ^ 1
t=1 ; allocations for the Örm f(Kt ; Lt )gt=1 and prices
1
f(^
rt ; w
^t )gt=1 such that

1. For all t % 1; given (w ctt ; c^tt+1 ; s^tt ) solves

^t ; r^t+1 ); (^

max U (ctt ) + (U (ctt+1 )

ctt ;ctt+1 -0;stt

s.t. ctt + stt $ w^t

ctt+1 $ (1 + r^t+1 & /)stt

2. Given k81 and r^1 ; c^01 solves

max
0
U (c01 )
c1 -0

s.t. c01 $ (1 + r^1 & /)k81

3. For all t % 1; given (^

rt ; w ^ t; L
^t ); (K ^ t ) solves

max F (Kt ; Lt ) & r^t Kt & w

^t Lt
Kt ;Lt -0

4. For all t % 1

(a) (Goods Market)

Ntt c^tt + Ntt$1 c^t$1

t
^ t+1 & (1 & /)K
+K ^ t = F (K
^ t; L
^t)

(b) (Asset Market)

^ t+1
Ntt s^tt = K
(c) (Labor Market)
^t
Ntt = L

The Örst two points in the equilibrium deÖnition are completely standard,
apart from the change in the timing convention for the interest rate. For Örm
maximization we used the fact that, given that the Örm is renting inputs in
each period, the Örms intertemporal maximization problem separates into a
178 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

sequence of static proÖt maximization problems. The goods market equilibrium

condition is standard: total consumption plus gross investment equals output.
The labor market equilibrium condition is obvious. The asset or capital market
equilibrium condition requires a bit more thought: it states that total saving
of the currently young generation makes up the capital stock for tomorrow,
since physical capital is the only asset in this economy. Alternatively think of
it as equating the total supply of capital in form the saving done by the now
young, tomorrow old generation and the total demand for capital by Örms next
period.28 It will be useful to single out particular equilibria and attach a certain
name to them.

DeÖnition 100 A steady state (or stationary equilibrium) is (k; 8 s8; c81 ; c82 ; r8; w)
8
0
such that the sequences c^1 ; f(^t t t 1 ^ ^ 1
ct ; c^t+1 ; s^t )gt=1 ; f(Kt ; Lt )gt=1 and f(^rt ; w ^t )g1 t=1 ;
deÖned by

c^tt = c81
c^t$1
t = c82
s^tt = s8
r^t = r8
w
^t = w8
^
Kt = 8
k ) Ntt
^t
L = Ntt

are an equilibrium, for given initial condition k81 = k:

8

In other words, a steady state is an equilibrium for which the allocation

(per capita) is constant over time, given that the initial condition for the initial
capital stock is exactly right. Alternatively it is allocations and prices that
satisfy all the equilibrium conditions apart from possibly obeying the initial
condition.
We can use the goods and asset market equilibrium to derive an equation
that equates saving to investment. By deÖnition gross investment equals K ^ t+1 &
^
(1 & /)Kt ; whereas savings equals that part of income that is not consumed, or
# $
^ t+1 & (1 & /)K
K ^ t = F (K
^ t; L
^ t ) & Ntt c^tt + Ntt$1 c^t$1
t

But what is total saving equal to? The currently young save Ntt s^tt ; the currently
old dissave s^t$1 t$1 ^
t$1 Nt$1 = (1 & /)Kt (they sell whatever capital stock they have

2 8 To deÖne an Arrow-Debreu equilibrium is quite standard here. Let p the price of the
t
consumption good at period t, rt pt the nominal rental price of capital and wt pt the nominal
wage. Then the household and the Örms problems are in the neoclassical growth model, in
the household problem taking into account that agents only live for two periods.
8.3. OVERLAPPING GENERATIONS MODELS WITH PRODUCTION 179

left).29 Hence setting investment equal to saving yields

^ t+1 & (1 & /)K
K ^ t = Ntt s^tt & (1 & /)K
^t

or our asset market equilibrium condition

^ t+1
Ntt s^tt = K

Now let us start to characterize the equilibrium It will turn out that we can
describe the equilibrium completely by a Örst order di§erence equation in the
capital-labor ratio kt : Unfortunately it will have a rather nasty form in general,
so that we can characterize analytic properties of the competitive equilibrium
only very partially. Also note that, as we will see later, the welfare theorems
do not apply so that there is no social planner problem that will make our lives
easier, as was the case in the inÖnitely lived consumer model (which I dubbed
the discrete-time neoclassical growth model in Section 3).
From now on we will omit the hats above the variables indicating equilibrium
elements as it is understood that the following analysis applies to equilibrium
sequences. From the optimization condition for capital for the Örm we obtain
% &
Kt
rt = FK (Kt ; Lt ) = FK ; 1 = f 0 (kt )
Lt

because partial derivatives of functions that are homogeneous of degree 1 are

homogeneous of degree zero. Since we have zero proÖts in equilibrium we Önd
that
wt Lt = F (Kt ; Lt ) & rt Kt
and dividing by Lt we obtain

wt = f (kt ) & f 0 (kt )kt

i.e. factor prices are completely determined by the capital-labor ratio. Investi-
gating the households problem we see that its solution is completely character-
ized by a saving function (note that given our assumptions on preferences the
optimal choice for savings exists and is unique)

stt = s (wt ; rt+1 )

= s (f (kt ) & f 0 (kt )kt ; f 0 (kt+1 ))

so optimal savings are a function of this and next periodís capital stock. Ob-
viously, once we know stt we know ctt and ctt+1 from the householdís budget
2 9 By deÖnition the saving of the old is their total income minus their total consumption.

Their income consists of returns on their assets and hence their total saving is
h i
(rt st%1 t%1
t%1 # ct
t%1
Nt%1

= #(1 # A)st%1 t%1

t%1 Nt%1 = #(1 # A)Kt
180 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

constraint. From Walras law one of the market clearing conditions is redun-
dant. Equilibrium in the labor market is straightforward as

Lt = Ntt = (1 + n)t

So letís drop the goods market equilibrium condition.30 Then the only con-
dition left to exploit is the asset market equilibrium condition

stt Ntt = Kt+1

t+1
Kt+1 Nt+1 Kt+1
stt = t = t t+1
Nt Nt Nt+1
Kt+1
= (1 + n)
Lt+1
= (1 + n)kt+1

Substituting in the savings function yields our Örst order di§erence equation
s (f (kt ) & f 0 (kt )kt ; f 0 (kt+1 ))
kt+1 = (8.32)
1+n
where the exact form of the saving function obviously depends on the functional
form of the utility function U: As starting value for the capital-labor ratio we
(1+n)k/1
have K L1 =
1
N11
= k81 : So in principle we could put equation (8:32) on a
computer and solve for the entire sequence of fkt+1 g1t=1 and hence for the entire
equilibrium. Note, however, that equation (8:32) gives kt+1 only as an implicit
function of kt as kt+1 appears on the right hand side of the equation as well. So
let us make an attempt to obtain analytical properties of this equation. Before,
letís solve an example.

Example 101 Let U (c) = ln(c); n = 0; ( = 1 and f (k) = k ' ; with 0 2 (0; 1):
The choice of log-utility is particularly convenient as the income and substitution
e§ects of an interest change cancel each other out; saving is independent of rt+1 :
As we will see later it is crucial whether the income or substitution e§ect for an
interest change dominates in the saving decision, i.e. whether

srt+1 (wt ; rt+1 ) Q 0

But letís proceed. The saving function for the example is given by
1
s(wt ; rt+1 ) = wt
2
1 '
= (k & 0kt' )
2 t
1&0 '
= kt
2
3 0 In the homework you are asked to do the analysis with dropping the asset market instead

of the goods market equilibrium condition. Keep the present analysis in mind when doing
this question.
8.3. OVERLAPPING GENERATIONS MODELS WITH PRODUCTION 181

so that the di§erence equation characterizing the dynamic equilibrium is given

by
1&0 '
kt+1 = kt
2
There are two steady states for this di§erential equation, k0 = 0 and k * =
# 1$' $ 1#*
1

2 : The Örst obviously is not an equilibrium as interest rates are inÖnite

and no solution to the consumer problem exists. From now on we will ignore this
steady state, not only for the example, but in general. Hence there is a unique
steady state equilibrium associated with k * : From any initial condition k81 > 0;
there is a unique dynamic equilibrium fkt+1 g1 *
t=1 converging to k described by
the Örst order di§erence equation above.

Unfortunately things are not always that easy. Let us return to the general
Örst order di§erence equation (8:32) and discuss properties of the saving func-
tion. Let, us for simplicity, assume that the saving function s is di§erentiable
in both arguments (wt ; rt+1 ):31 Since the saving function satisÖes the Örst order
condition

U 0 (wt & s(wt ; rt+1 )) = (U 0 ((1 + rt+1 & /)s(wt ; rt+1 )) ) (1 + rt+1 & /)

we use the Implicit Function Theorem (which is applicable in this case) to obtain
U 00 (wt & s(wt ; rt+1 ))
swt (wt ; rt+1 ) = 2 (0; 1)
U 00 (wt & s(wt ; rt+1 )) + (U 00 ((1 + rt+1 & /)s(wt ; rt+1 ))(1 + rt+1 & /)2
&(U 0 ((1 + rt+1 & /)s(:; :)) & (U 00 ((1 + rt+1 & /)s(:; :))(1 + rt+1 & /)s(:; :)
srt+1 (wt ; rt+1 ) = R0
U 00 (wt & s(:; :)) + (U 00 ((1 + rt+1 & /)s(:; :))(1 + rt+1 & /)2
Given our assumptions optimal saving increases in Örst period income wt , but
it may increase or decrease in the interest rate. You may verify from the above
formula that indeed for the log-case srt+1 (wt ; rt+1 ) = 0: A lot of theoretical work
focused on the case in which the saving function increases with the interest rate,
which is equivalent to saying that the substitution e§ect dominates the income
e§ect (and equivalent to assuming that consumption in the two periods are strict
gross substitutes).
Equation (8:32) traces out a graph in (kt ; kt+1 ) space whose shape we want to
characterize. Di§erentiating both sides of (8:32) with respect to kt we obtain32

dkt+1 &swt (wt ; rt+1 )f 00 (kt )kt + srt+1 (wt ; rt+1 )f 0 (kt+1 ) dkdkt+1
t
=
dkt 1+n
or rewriting
dkt+1 &swt (wt ; rt+1 )f 00 (kt )kt
=
dkt 1 + n & srt+1 (wt ; rt+1 )f 00 (kt+1 )
3 1 One has to invoke the implicit function theorem (and check its conditions) on the Örst

order condition to insure di§erentiability of the savings function. See Mas-Colell et al. p.
940-942 for details.
3 2 Again we appeal to the Implicit function theorem that guarantees that k
t+1 is a di§eren-
tiable function of kt with derivative given below.
182 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

Given our assumptions on f the nominator of the above expression is strictly

positive for all kt > 0: If we assume that srt+1 % 0, then the (kt ; kt+1 )-locus is
upward sloping. If we allow srt+1 < 0; then it may be downward sloping.

k
t+1

Case C

45-degree line

Case B

Case A

k* k* k** k
B C B t

Figure 13 shows possible shapes of the (kt ; kt+1 )-locus under the assump-
tion that srt+1 % 0: We see that even this assumption does not place a lot
of restrictions on the dynamic behavior of our economy. Without further as-
sumptions it may be the case that, as in case A there is no steady state with
positive capital-labor ratio. Starting from any initial capital-per worker level
the economy converges to a situation with no production over time. It may be
*
that, as in case C, there is a unique positive steady state kC and this steady
state is globally stable (for state space excluding 0): Or it is possible that there
*
are multiple steady states which alternate in being locally stable (as kB ) and
**
unstable (as kB ) as in case B. Just about any dynamic behavior is possible and
in order to deduce further qualitative properties we must either specify special
functional forms or make assumptions about endogenous variables, something
that one should avoid, if possible.
8.3. OVERLAPPING GENERATIONS MODELS WITH PRODUCTION 183

We will proceed however, doing exactly this. For now letís assume that there
exists a unique positive steady state. Under what conditions is this steady state
locally stable? As suggested by Figure 13 stability requires that the saving
locus intersects the 450 -line from above, provided the locus is upward sloping.
A necessary and su¢cient condition for local stability at the assumed unique
steady state k * is that
K K
K &swt (w(k * ); r(k * ))f 00 (k * )k * K
K K
K 1 + n & sr (w(k * ); r(k * ))f 00 (k * ) K < 1
t+1

If srt+1 < 0 it may be possible that the slope of the saving locus is negative.
Under the condition above the steady state is still locally stable, but it exhibits
oscillatory dynamics. If we require that the unique steady state is locally stable
and that the dynamic equilibrium is characterized by monotonic adjustment to
the unique steady state we need as necessary and su¢cient condition

&swt (w(k * ); r(k * ))f 00 (k * )k *

0< <1
1 + n & srt+1 (w(k * ); r(k * ))f 00 (k * )

The procedure to make su¢cient assumptions that guarantee the existence of

a well-behaved dynamic equilibrium and then use exactly these assumption to
deduce qualitative comparative statics results (how does the steady state change
as we change /; n or the like) is called Samuelsonís correspondence principle,
as often exactly the assumptions that guarantee monotonic local stability are
su¢cient to draw qualitative comparative statics conclusions. Diamond (1965)
uses Samuelsonís correspondence principle extensively and we will do so, too,
assuming from now on that above inequalities hold.

8.3.3 Optimality of Allocations

Before turning to Diamondís (1965) analysis of the e§ect of public debt let us
discuss the dynamic optimality properties of competitive equilibria. Consider
Örst steady state equilibria. Let c*1 ; c*2 be the steady state consumption levels
when young and old, respectively, and k * be the steady state capital labor ratio.
Consider the goods market clearing (or resource constraint)

Ntt c^tt + Ntt$1 c^t$1

t
^ t+1 & (1 & /)K
+K ^ t = F (K
^ t; L
^t)

^ t to obtain
Divide by Ntt = L

c^t$1
c^tt + t
+ (1 + n)k^t+1 & (1 & /)k^t = f (kt ) (8.33)
1+n
and use the steady state allocations to obtain

c*2
c*1 + + (1 + n)k * & (1 & /)k * = f (k * )
1+n
184 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

c%
DeÖne c* = c*1 + 2
1+n to be total (per worker) consumption in the steady state.
We have that
c* = f (k * ) & (n + /)k *
Now suppose that the steady state equilibrium satisÖes
f 0 (k * ) & / < n (8.34)
something that may or may not hold, depending on functional forms and pa-
rameter values. We claim that this steady state is not Pareto optimal. The
intuition is as follows. Suppose that (8:34) holds. Then it is possible to de-
crease the capital stock per worker marginally, and the e§ect on per capita
consumption is
dc*
= f 0 (k * ) & (n + /) < 0
dk *
so that a marginal decrease of the capital stock leads to higher available over-
all consumption. The capital stock is ine¢ciently high; it is so high that its
marginal productivity f 0 (k * ) is outweighed by the cost of replacing depreciated
capital, /k * and provide newborns with the steady state level of capital per
worker, nk * : In this situation we can again pull the Gamov trick to construct a
Pareto superior allocation. Suppose the economy is in the steady state at some
arbitrary date t and suppose that the steady state satisÖes (8:34): Now consider
the alternative allocation: at date t reduce the capital stock per worker to be
saved to the next period, kt+1 ; by a marginal Ik * < 0 to k ** = k * + Ik * and
keep it at k ** forever. From (8:33) we obtain
ct = f (kt ) + (1 & /)kt & (1 + n)kt+1
The e§ect on per capita consumption from period t onwards is
Ict = &(1 + n)Ik * > 0
Ict+* = f 0 (k * )Ik * + [1 & / & (1 + n)]Ik *
= [f 0 (k * ) & (/ + n)] Ik * > 0
In this way we can increase total per capita consumption in every period. Now
we just divide the additional consumption between the two generations alive in
a given period in such a way that make both generations better o§, which is
straightforward to do, given that we have extra consumption goods to distribute
in every period. Note again that for the Gamov trick to work it is crucial to
have an inÖnite hotel, i.e. that time extends to the inÖnite future. If there
is a last generation, it surely will dislike losing some of its Önal period capital
(which we assume is eatable as we are in a one sector economy where the good is
a consumption as well as investment good). A construction of a Pareto superior
allocation wouldnít be possible. The previous discussion can be summarized in
the following proposition
Proposition 102 Suppose a competitive equilibrium converges to a steady state
satisfying (8:34): Then the equilibrium allocation is not Pareto e¢cient, or, as
often called, the equilibrium is dynamically ine¢cient.
8.3. OVERLAPPING GENERATIONS MODELS WITH PRODUCTION 185

When comparing this result to the pure exchange model we see the direct
parallel: an allocation is ine¢cient if the interest rate (in the steady state) is
smaller than the population growth rate, i.e. if we are in the Samuelson case.
In fact, we repeat a much stronger result by Balasko and Shell that we quoted
earlier, but that also applies to production economies. A feasible allocation is
an allocation c01 ; fctt ; ctt+1 ; kt+1 g1
t=1 that satisÖes all negativity constraints and
the resource constraint (8:33): Obviously from the allocation we can reconstruct
stt and Kt : Let rt = f 0 (kt ) denote the marginal products of capital per worker.
Maintain all assumptions made on U and f and let nt be the population growth
rate from period t & 1 to t: We have the following result

Theorem 103 Cass (1972)33 , Balasko and Shell (1980). A feasible allocation
is Pareto optimal if and only if

X1 Y t
(1 + r* +1 & /)
= +1
t=1 * =1
(1 + n* +1 )

As an obvious corollary, alluded to before we have that a steady state equi-

librium is Pareto optimal (or dynamically e¢cient) if and only if f 0 (k * ) & / % n:
That dynamic ine¢ciency is not purely an academic matter is demonstrated
by the following example

Example 104 Consider the previous example with log utility, but now with
population growth n and time discounting (: It is straightforward to compute
the steady state unique steady state as
. / 1#*
1

* ((1 & 0)
k =
(1 + ()(1 + n)

so that
0(1 + ()(1 + n)
r* =
((1 & 0)
and the economy is dynamically ine¢cient if and only if

0(1 + ()(1 + n)
&/ <n
((1 & 0)

Letís pick some reasonable numbers. We have a 2-period OLG model, so let us
interpret one period as 30 years. 0 corresponds to the capital share of income,
so 0 = :3 is a commonly used value in macroeconomics. The current yearly
population growth rate in the US is about 1%; so lets pick (1 + n) = (1 +
0:01)30 : Suppose that capital depreciates at around 6% per year, so choose (1 &
/) = 0:9430 : This yields n = 0:35 and / = 0:843: Then for a yearly subjective
discount factor ( y % 0:998; the economy is dynamically ine¢cient. Dynamic
ine¢ciency therefore is deÖnitely more than just a theoretical curiousum. If the
3 3 The Örst reference of this theorem is in fact Cass (1972), Theorem 3.
186 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

economy features technological progress of rate g, then the condition for dynamic
ine¢ciency becomes (approximately) f 0 (k * ) < n + / + g: If we assume a yearly
rate of technological progress of 2%; then with the same parameter values for
( y % 0:971 we obtain dynamic ine¢ciency. Note that there is a more immediate
way to check for dynamic ine¢ciency in an actual economy: since in the model
f 0 (k * ) & / is the real interest rate and g + n is the growth rate of real GDP, one
may just check whether the real interest rate is smaller than the growth rate in
long-run averages.

If the competitive equilibrium of the economy features dynamic ine¢ciency

its citizens save more than is socially optimal. Hence government programs
that reduce national saving are called for. We already have discussed such
a government program, namely an unfunded, or pay-as-you-go social security
system. Letís brieáy see how such a program can reduce the capital stock of
an economy and hence leads to a Pareto-superior allocation, provided that the
initial allocation without the system was dynamically ine¢cient.
Suppose the government introduces a social security system that taxes people
the amount < when young and pays beneÖts of b = (1 + n)< when old. For
simplicity we assume balanced budget for the social security system as well as
lump-sum taxation. The budget constraints of the representative individual
change to

ctt + stt = wt & <

ctt+1 = (1 + rt+1 & /)stt + (1 + n)<

We will repeat our previous analysis and Örst check how individual savings react
to a change in the size of the social security system. The Örst order condition
for consumer maximization is

U 0 (wt & < & stt ) = (U 0 ((1 + rt+1 & /)stt + (1 + n)< ) ) (1 + rt+1 & /)

which implicitly deÖnes the optimal saving function stt = s(wt ; rt+1 ; < ): Again
invoking the implicit function theorem we Önd that
% &
00 ds
&U (wt & < & s(:; :; :)) 1 &
d<
% &
00 ds
= (U ((1 + rt+1 & /)s(:; :; :) + (1 + n)< ) ) (1 + rt+1 & /) ) (1 + rt+1 & /) +1+n
d<
or
ds U 00 () + (1 + n)(U 00 (:)(1 + rt+1 & /)
= s* = <0
d< U 00 (:) + (U 00 (:)(1 + rt+1 & /)2
Therefore the bigger the pay-as-you-go social security system, the smaller is the
private savings of individuals, holding factor prices constant. This however, is
only the partial equilibrium e§ect of social security. Now letís use the asset
8.3. OVERLAPPING GENERATIONS MODELS WITH PRODUCTION 187

market equilibrium condition

s(wt ; rt+1 ; < )

kt+1 =
1+n
s (f (kt ) & f 0 (kt )kt ; f 0 (kt+1 ; < )
=
1+n
Now let us investigate how the equilibrium (kt ; kt+1 )-locus changes as < changes.
For Öxed kt ; how does kt+1 (kt ) changes as < changes. Again using the implicit
function theorem yields

dkt+1 sr f 00 (kt+1 ) dkd*

t+1
+ s*
= t+1
d< 1+n
and hence
dkt+1 s*
=
d< 1 + n & srt+1 f 00 (kt+1 )
The nominator is negative as shown above; the denominator is positive by our
assumption of monotonic local stability (this is our Örst application of Samuel-
sonís correspondence principle). Hence dkd* t+1
< 0; the locus (always under the
maintained monotonic stability assumption) tilts downwards, as shown in Figure
14.
We can conduct the following thought experiment. Suppose the economy
converged to its old steady state k * and suddenly, at period T; the government
unanticipatedly announces the introduction of a (marginal) pay-as-you go sys-
tem. The saving locus shifts down, the new steady state capital labor ratio
declines and the economy, over time, converges to its new steady state. Note
that over time the interest rate increases and the wage rate declines. Is the intro-
duction of a marginal pay-as-you-go social security system welfare improving?
It depends on whether the old steady state capital-labor ratio was ine¢ciently
high, i.e. it depends on whether f 0 (k * ) & / < n or not. Our conclusions about
the desirability of social security remain unchanged from the pure exchange
model.

8.3.4 The Long-Run E§ects of Government Debt

Diamond (1965) discusses the e§ects of government debt on long run capital
accumulation. He distinguishes between government debt that is held by for-
eigners, so-called external debt, and government debt that is held by domestic
citizens, so-called internal debt. Note that the second case is identical to Barroís
analysis if we abstract from capital accumulation and allow altruistic bequest
motives. In fact, in Diamondís environment with production, but altruistic
and operative bequests a similar Ricardian equivalence result as before applies.
In this sense Barroís neutrality result provides the benchmark for Diamondís
analysis of the internal debt case, and we will see how the absence of operative
bequests leads to real consequences of di§erent levels of internal debt.
188 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

k
t+1

τ up

45-degree line

k’* k* k
t

External Debt

Suppose the government has initial outstanding debt, denoted in real terms, of
B1 : Denote by bt = B Bt
Lt = Ntt the debt-labor ratio. All government bonds have
t

maturity of one period, and the government issues new bonds34 so as to keep
the debt-labor ratio constant at bt = b over time. Bonds that are issued in
period t & 1; Bt ; are required to pay the same gross interest as domestic capital,
namely 1 + rt & /; in period t when they become due. The government taxes
the current young generation in order to Önance the required interest payments
on the debt. Taxes are lump sum and are denoted by < : The budget constraint
of the government is then

Bt (1 + rt & /) = Bt+1 + Ntt <

3 4 As Diamond (1965) let us specify these bonds as interest-bearing bonds (in contrast to

zero-coupon bonds). A bond bought in period t pays (interst plus principal) 1 + rt+1 # A in
period t + 1:
8.3. OVERLAPPING GENERATIONS MODELS WITH PRODUCTION 189

or, dividing by Ntt ; we get, under the assumption of a constant debt-labor ratio,

< = (rt & / & n)b

For the previous discussion of the model nothing but the budget constraint of
young individuals changes, namely to

ctt + stt = wt & <

= wt & (rt & / & n)b

In particular the asset market equilibrium condition does not change as the
outstanding debt is held exclusively by foreigners, by assumption. As before
we obtain a saving function s(wt & (rt & / & n)b; rt+1 ) as solution to the house-
holds optimization problem, and the asset market equilibrium condition reads
as before
s(wt & (rt & / & n)b; rt+1 )
kt+1 =
1+n
Our objective is to determine how a change in the external debt-labor ratio
changes the steady state capital stock and the interest rate. This can be an-
swered by examining s(): Again we will apply Samuelsonís correspondence prin-
ciple. Assuming monotonic local stability of the unique steady state is equivalent
to assuming
dkt+1 &swt (:; :)f 00 (kt )(kt + b)
= 2 (0; 1) (8.35)
dkt 1 + n & srt+1 (:; :)f 00 (kt+1 )

In order to determine how the saving locus in (kt ; kt+1 ) space shifts we apply
the Implicit Function Theorem to the asset equilibrium condition to Önd

dkt+1 &swt (:; :) (f 0 (kt ) & / & n)

=
db 1 + n & srt+1 (:; :)f 00 (kt+1 )

so the sign of dkdb

t+1
equals the negative of the sign of f 0 (kt ) & / & n under
the maintained assumption of monotonic local stability. Suppose we are at
a steady state k * corresponding to external debt to labor ratio b* : Now the
government marginally increases the debt-labor ratio. If the old steady state
was not dynamically ine¢cient, i.e. f 0 (k * ) % / + n; then the saving locus shifts
down and the new steady state capital stock is lower than the old one. Diamond
goes on to show that in this case such an increase in government debt leads to
a reduction in the utility level of a generation that lives in the new rather
than the old steady state. Note however that, because of transition generations
this does not necessarily mean that marginally increasing external debt leads
to a Pareto-inferior allocation. For the case in which the old equilibrium is
dynamically ine¢cient an increase in government debt shifts the saving locus
upward and hence increases the steady state capital stock per worker. Again
Diamond shows that now the e§ects on steady state utility are indeterminate.
190 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL

Internal Debt
Now we assume that government debt is held exclusively by own citizens. The
tax payments required to Önance the interest payments on the outstanding debt
take the same form as before. Letís assume that the government issues new
government debt so as to keep the debt-labor ratio B ~
Lt constant over time at b:
t

Hence the required tax payments are given by

< = (rt & / & n)~b

Again denote the new saving function derived from consumer optimization by
s(wt & (rt & / & n)~b; rt+1 ): Now, however, the equilibrium asset market condition
changes as the savings of the young not only have to absorb the supply of the
physical capital stock, but also the supply of government bonds newly issued.
Hence the equilibrium condition becomes

Ntt s(wt & (rt & / & n)~b; rt+1 ) = Kt+1 + Bt+1

or, dividing by Ntt = Lt ; we obtain

s(wt & (rt & / & n)~b; rt+1 ) ~

kt+1 = &b
1+n
Stability and monotonic convergence to the unique (assumed) steady state re-
quire that (8:35) holds. To determine the shift in the saving locus in (kt ; kt+1 )
we again implicitly di§erentiate to obtain

dkt+1 &swt (:; :)(rt & / & n) + srt+1 f 00 (kt+1 ) dkdt+1

~
b
= &1
db~ 1 + n
and hence
dkt+1 & [swt (:; :)(f 0 (kt ) & / & n)]
= & (1 + n) < &n < 0
d~b 1 + n & srt+1 (:; :)f 00 (kt+1 )

where the Örst inequality uses (8:35): The curve unambiguously shifts down,
leading to a decline in the steady state capital stock per worker. Diamond,
again only comparing steady state utilities, shows that if the initial steady state
was dynamically e¢cient, then an increase in internal debt leads to a reduc-
tion in steady state welfare, whereas if the initial steady state was dynamically
ine¢cient, then an increase in internal government debt leads to a increase in
steady state welfare. Here the intuition is again clear: if the economy has accu-
mulated too much capital, then increasing the supply of alternative assets leads
to a interest-driven ìcrowding outî of demand for physical capital, which is a
good thing given that the economy possesses too much capital. In the e¢cient
case the reverse logic applies. In comparison with the external debt case we
obtain clearer welfare conclusions for the dynamically ine¢cient case. For ex-
ternal debt an increase in debt is not necessarily good even in the dynamically
8.3. OVERLAPPING GENERATIONS MODELS WITH PRODUCTION 191

ine¢cient case because it requires higher tax payments, which, in contrast to

internal debt, leave the country and therefore reduce the available resources to
be consumed (or invested). This negative e§ect balances against the positive
e§ect of reducing the ine¢ciently high capital stock, so that the overall e§ects
are indeterminate. In comparison to Barro (1974) we see that without operative
bequests the level of outstanding government bonds ináuences real equilibrium
allocations: Ricardian equivalence breaks down.
192 CHAPTER 8. THE OVERLAPPING GENERATIONS MODEL
Chapter 9

Continuous Time Growth

Theory

I do not see how one can look at Ögures like these without seeing
them as representing possibilities. Is there some action a govern-
ment could take that would lead the Indian economy to grow like
Indonesiaís or Egyptís? If so, what exactly? If not, what is it about
the nature of India that makes it so? The consequences for human
welfare involved in questions like these are simply staggering: Once
one starts to think about them, it is hard to think about anything
else. [Lucas 1988, p. 5]

So much for motivation. We are doing growth in continuous time since I

think you should know how to deal with continuous time models as a signiÖcant
fraction of the economic literature employs continuous time, partly because in
certain instances the mathematics becomes easier. In continuous time, variables
are functions of time and one can use calculus to analyze how they change over
time.

9.1 Stylized Growth and Development Facts

Data! Data! Data! I canít make bricks without clay. [Sherlock
Holmes]

In this part we will brieáy review the main stylized facts characterizing
economic growth of the now industrialized countries and the main facts charac-
terizing the level and change of economic development of not yet industrialized
countries.

193
194 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

9.1.1 Kaldorís Growth Facts

The British economist Nicholas Kaldor pointed out the following stylized growth
facts (empirical regularities of the growth process) for the US and for most other
industrialized countries.

1. Output (real GDP) per worker y = YL and capital per worker k = K L grow
over time at relatively constant and positive rate. See Figure 9.1.1.
2. They grow at similar rates, so that the ratio between capital and output,
K
Y is relatively constant over time

3. The real return to capital r (and the real interest rate r & /) is relatively
constant over time.
4. The capital and labor shares are roughly constant over time. The capital
share 0 is the fraction of GDP that is devoted to interest payments on
capital, 0 = rK
Y : The labor share 1 & 0 is the fraction of GDP that is
devoted to the payments to labor inputs; i.e. to wages and salaries and
other compensations: 1 & 0 = wLY : Here w is the real wage.

These stylized facts motivated the development of the neoclassical growth

model, the Solow growth model, to be discussed below. The Solow model has
spectacular success in explaining the stylized growth facts by Kaldor.

9.1.2 Development Facts from the Summers-Heston Data

Set
In addition to the growth facts we will be concerned with how income (per
worker) levels and growth rates vary across countries in di§erent stages of their
development process. The true test of the Solow model is to what extent it can
explain di§erences in income levels and growth rates across countries, the so
called development facts. As we will see in our discussion of Mankiw, Romer
and Weil (1992) the verdict is mixed.
Now we summarize the most important facts from the Summers and Hestonís
panel data set. This data set follows about 100 countries for 30 years and
has data on income (production) levels and growth rates as well as population
and labor force data. In what follows we focus on the variable income per
worker. This is due to two considerations: a) our theory (the Solow model)
will make predictions about exactly this variable b) although other variables
are also important determinants for the standard of living in a country, income
per worker (or income per capita) may be the most important variable (for
the economist anyway) and other determinants of well-being tend to be highly
positively correlated with income per worker.
Before looking at the data we have to think about an important measurement
issue. Income is measured as GDP, and GDP of a particular country is measured
in the currency of that particular country. In order to compare income between
countries we have to convert these income measures into a common unit. One
9.1. STYLIZED GROWTH AND DEVELOPMENT FACTS 195

Real GDP in the United States 1967-1999

9

8.9

8.8

8.7

8.6
Log of real GDP

Trend
8.5

GDP
8.4

8.3

8.2

8.1

8
1965 1970 1975 1980 1985 1990 1995 2000
Year

option would be exchange rates. These, however, tend to be rather volatile and
reactive to events on world Önancial markets. Economists which study growth
and development tend to use PPP-based exchange rates, where PPP stands for
Purchasing Power Parity. All income numbers used by Summers and Heston
(and used in these notes) are converted to $US via PPP-based exchange rates.
Here are the most important facts from the Summers and Heston data set:
1. Enormous variation of per capita income across countries: the poorest
countries have about 5% of per capita GDP of US per capita GDP. This
fact makes a statement about dispersion in income levels. When we look at
Figure 1, we see that out of the 104 countries in the data set, 37 in 1990 and
38 in 1960 had per worker incomes of less than 10% of the US level. The
richest countries in 1990, in terms of per worker income, are Luxembourg,
the US, Canada and Switzerland with over $30,000, the poorest countries,
without exceptions, are in Africa. Mali, Uganda, Chad, Central African
Republic, Burundi, Burkina Faso all have income per worker of less than
$1000. Not only are most countries extremely poor compared to the US,
196 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

Distribution of Relative Per Worker Income

40
1960
1990

35

30

25
Number of Countries

20

15

10

0
0 0.2 0.4 0.6 0.8 1 1.2 1.4
Income Per Worker Relative to US

but most of the worldís population is poor relative to the US.

2. Enormous variation in growth rates of per worker income. This fact makes
a statement about changes of levels in per capita income. Figure 2 shows
the distribution of average yearly growth rates from 1960 to 1990. The ma-
jority of countries grew at average rates of between 1% and 3% (these are
growth rates for real GDP per worker ). Note that some countries posted
average growth rates in excess of 6% (Singapore, Hong Kong, Japan, Tai-
wan, South Korea) whereas other countries actually shrunk, i.e. had nega-
tive growth rates (Venezuela, Nicaragua, Guyana, Zambia, Benin, Ghana,
Mauretania, Madagascar, Mozambique, Malawi, Uganda, Mali). We will
sometimes call the Örst group growth miracles, the second group growth
disasters. Note that not only did the disastersí relative position worsen,
but that these countries experienced absolute declines in living standards.
The US, in terms of its growth experience in the last 30 years, was in the
middle of the pack with a growth rate of real per worker GDP of 1.4%
between 1960 and 1990.
9.1. STYLIZED GROWTH AND DEVELOPMENT FACTS 197

Distribution of Average Grow th Rates (Real GDP) Betw een 1960 and 1990
25

20
Number of Countries

15

10

0
-0.03 -0.02 -0.01 0 0.01 0.02 0.03 0.04 0.05 0.06
Average Grow th Rate

3. Growth rates determine economic fate of a country over longer periods of

time. How long does it take for a country to double its per capita GDP
if it grows at average rate of g% per year? A good rule of thumb: 70=g
years (this rule of thumb is due to Nobel Price winner Robert E. Lucas
(1988)).1 Growth rates are not constant over time for a given country.
1 Let y denote GDP per capita in period T and y denote period 0 GDP per capita in a
T 0
particular country. Suppose the growth rate of GDP per capita is constant at g; i.e. 100 0 g%:
Then
yT = y0 egT
Suppose we want to double GDP per capita in T years. Then
yT
2= = egT
y0
or
ln(2) = gT
& ln(2) 100 0 ln(2)
T = =
g g(in %)
Since 100 0 ln(2) 1 70; the rule of thumb follows.
198 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

This can easily be demonstrated for the US. GDP per worker in 1990
was $36,810. If GDP would always have grown at 1.4%, then for the US
GDP per worker would have been about $9,000 in 1900, $2,300 in 1800,
$570 in 1700, $140 in 1600, $35 in 1500 and so forth. Economic historians
(and common sense) tells us that nobody can survive on $35 per year
(estimates are that about $300 are necessary as minimum income level
for survival). This indicates that the US (or any other country) cannot
have experienced sustained positive growth for the last millennium or so.
In fact, prior to the era of modern economic growth, which started in
England in the late 1800th century, per worker income levels have been
almost constant at subsistence levels. This can be seen from Figure 3,
which compiles data from various historical sources. The start of modern

GDP per Capita (in 1985 US $): Western Europe

and its Offsprings
16000
14000
12000
10000
8000 GDP per Capita
6000
4000
2000
0
0
0

00
00
10
20
70
13
50
73
89
50
10
14
16
18
18
19
19
19
19

Tim e

economic growth is sometimes referred to as the Industrial Revolution.

It is the single most signiÖcant economic event in history and has, like
no other event, changed the economic circumstances in which we live.
Hence modern economic growth is a quite recent phenomenon, and so
far has occurred only in Western Europe and its o§springs (US, Canada,
Australia and New Zealand) as well as recently in East Asia.
4. Countries change their relative position in the (international) income dis-
tribution. Growth disasters fall, growth miracles rise, in the relative cross-
country income distribution. A classical example of a growth disaster is
Argentina. At the turn of the century Argentina had a per-worker income
that was comparable to that in the US. In 1990 the per-worker income
of Argentina was only on a level of one third of the US, due to a healthy
growth experience of the US and a disastrous growth performance of Ar-
gentina. Countries that dramatically moved up in the relative income
distribution include Italy, Spain, Hong Kong, Japan, Taiwan and South
9.2. THE SOLOW MODEL AND ITS EMPIRICAL EVALUATION 199

Korea, countries that moved down are New Zealand, Venezuela, Iran,
Nicaragua, Peru and Trinidad&Tobago.

In the next section we have two tasks: to construct a model, the Solow
model, that a) can successfully explain the stylized growth facts b) investigate
to which extent the Solow model can explain the development facts.

9.2 The Solow Model and its Empirical Evalua-

tion
The basic assumptions of the Solow model are that there is a single good pro-
duced in our economy and that there is no international trade, i.e. the economy
is closed to international goods and factor áows. Also there is no government.
It is also assumed that all factors of production (labor, capital) are fully em-
ployed in the production process. We assume that the labor force, L(t) grows
at constant rate n > 0; so that, by normalizing L(0) = 1 we have that

L(t) = ent L(0) = ent

The model consists of two basic equations, the neoclassical aggregate production
function and a capital accumulation equation.

1. Neoclassical aggregate production function

Y (t) = F (K(t); A(t)L(t))

We assume that F has constant returns to scale, is strictly concave and

strictly increasing, twice continuously di§erentiable, F (0; :) = F (:; 0) = 0
and satisÖes the Inada conditions. Here Y (t) is total output, K(t) is the
capital stock at time t and A(t) is the level of technology at time t: We
normalize A(0) = 1; so that a worker in period t provides the same labor
input as A(t) workers in period 0: We call A(t)L(t) labor input in labor
e¢ciency units (rather than in raw number of bodies) or e§ective labor at
date t: We assume that
A(t) = egt
i.e. the level of technology increases at continuous rate g > 0: We interpret
this as technological progress: due to the invention of new technologies or
ìideasî workers get more productive over time. This exogenous techno-
logical progress, which is not explained within the model is the key driving
force of economic growth in the Solow model. One of the main criticisms
of the Solow model is that it does not provide an endogenous explana-
tion for why technological progress, the driving force of growth, arises.
Romer (1990) and Jones (1995) pick up exactly this point. We model
technological progress as making labor more e§ective in the production
process. This form of technological progress is called labor augmenting
200 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

or Harrod-neutral technological progress.2 In order to analyze the model

we seek a representation in variables that remain stationary over time,
so that we can talk about steady states and dynamics around the steady
state. Obviously, since the number of workers as well as technology grows
exponentially, total output and capital (even per capita or per worker)
will tend to grow. However, expressing all variables of the model in per
e§ective labor units there is hope to arrive at a representation of the model
in which the endogenous variables are stationary. Hence we divide both
sides of the production function by the e§ective labor input A(t)L(t) to
obtain (using the constant returns to scale assumption)3
% &
Y (t) F (K(t); A(t)L(t)) K(t)
9(t) = = =F ; 1 = f (h(t))
A(t)L(t) A(t)L(t) A(t)L(t)
(9.1)
Y (t) K(t)
where 9(t) = A(t)L(t) is output per e§ective labor input and h(t) = A(t)L(t)
is the capital stock perfect labor input. From the assumptions made on
F it follows that f is strictly increasing, strictly concave, twice continu-
ously di§erentiable, f (0) = 0 and satisÖes the Inada condition. Equation
(9:1) summarizes our assumptions about the production technology of the
economy.

2. Capital accumulation equation and resource constraint

_
K(t) = sY (t) & /K(t) (9.2)
_
K(t) + /K(t) = Y (t) & C(t) (9.3)

_
The change of the capital stock in period t, K(t) is given by gross invest-
ment in period t; sY (t) minus the depreciation of the old capital stock
/K(t): We assume / % 0: Since we have a closed economy model gross
investment is equal to national saving (which is equal to saving of the
private sector, since there is no government). Here s is the fraction of
total output (income) in period t that is saved, i.e. not consumed. The
important assumption implicit in equation (9:2) is that households save a
constant fraction s of output (income), regardless of the level of income.
This is a strong assumption about the behavior of households that is not
endogenously derived from within a model of utility-maximizing agents
(and the Cass-Koopmans-Ramsey model relaxes exactly this assumption).

2 Alternative speciÖcations of the production functions are F (AK; L) in which case tech-

nological progress is called capital augmenting or Solow neutral technological progress, and
AF (K; L) in which case it is called Hicks neutral technological progress. For the way we will
deÖne a balanced growth path below it is only Harrod-neutral technological progress (at least
for general production functions) that guarantees the existence of a balanced growth path in
the Solow model.
3 In terms of notation I will use uppercase variables for aggregate variables, lowercase for

per-worker variables and the corresponding greek letter for variables per e§ective labor units.
Since there is no greek y I use V for per capita output
9.2. THE SOLOW MODEL AND ITS EMPIRICAL EVALUATION 201

Remember that the discrete time counterpart of this equation was

Kt+1 & Kt = sYt & /Kt

Kt+1 & (1 & /)Kt = Yt & Ct

Now we can divide both sides of equation (9:2) by A(t)L(t) to obtain

_
K(t)
= s9(t) & /h(t) (9.4)
A(t)L(t)
Expanding the left hand side of equation (9:4) gives
_
K(t) _
K(t) K(t) _
K(t)
= = h(t) (9.5)
A(t)L(t) K(t) A(t)L(t) K(t)
But
h(t)
_ _
K(t) _
L(t) _
A(t) _
K(t)
= & & = &n&g
h(t) K(t) L(t) A(t) K(t)
Hence
_
K(t) h(t)
_
= +n+g (9.6)
K(t) h(t)
Combining equations (9:5) and (9:6) with (9:4) yields
_ _ % &
K(t) K(t) h(t)
_
= h(t) = + n + g h(t) (9.7)
A(t)L(t) K(t) h(t)
h(t)
_ + h(t)(n + g) = s9(t) & /h(t) (9.8)
h(t)
_ = s9(t) & (n + g + /)h(t) (9.9)

This is the capital accumulation equation in per-e§ective worker terms. Combin-

ing this equation with the production function gives the fundamental di§erential
equation of the Solow model

h(t)
_ = sf (h(t)) & (n + g + /)h(t) (9.10)

Technically speaking this is a Örst order nonlinear ordinary di§erential equation,

and it completely characterizes the evolution of the economy for any initial
condition h(0) = K(0): Once we have solved the di§erential equation for the
capital per e§ective labor path h(t)t2[0;1) the rest of the endogenous variables
are simply given by

k(t) = h(t)A(t) = egt h(t)

K(t) = e(n+g)t h(t)
y(t) = egt f (h(t))
Y (t) = e(n+g)t f (h(t))
C(t) = (1 & s)e(n+g)t f (h(t))
c(t) = (1 & s)egt f (h(t))
202 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

9.2.1 The Model and its Implications

Analyzing the qualitative properties of the model amounts to analyzing the dif-
ferential equation (9:10): Unfortunately this di§erential equation is nonlinear,
so there is no general method to explicitly solve for the function h(t): We can,
however, analyze the di§erential equation graphically. Before doing this, how-
ever, let us look at a (I think the only) particular example for which we actually
can solve the equation analytically

Example 105 Let f (h) = h' (i.e. F (K; AL) = K ' (AL)1$' ). The fundamen-
tal di§erential equation becomes

h(t)
_ = sh(t)' & (n + g + /)h(t) (9.11)

with h(0) > 0 given. A steady state of this equation is given by h(t) = h* for
which h(t)
_ = 0 for all t: There are two steady states, the trivial one at h = 0
(which we will ignore from now on, as it is only reached if h(0) = 0) and the
' ( 1#*
1
s
unique positive steady state h* = n+g+O : Now letís solve the di§erential
equation. This equation is, in fact, a special case of the so-called Bernoulli
equation. Letís do the following substitution of variables. DeÖne v(t) = h(t)1$' :
Then
(1 & 0)h(t)
_
v(t)
_ = (1 & 0)h(t)$' ) h(t)
_ =
h(t)'
Y(t)*
Dividing both sides of (9:11) by 1$' yields

(1 & 0)h(t)
_
'
= (1 & 0)s & (1 & 0)(n + g + /)h(t)1$'
h(t)
and now making the substitution of variables

v(t)
_ = (1 & 0)s & (1 & 0)(n + g + /)v(t)

which is a linear ordinary Örst order (nonhomogeneous) di§erential equation,

which we know how to solve.4 The general solution to the homogeneous equation
takes the form
vg (t) = Ce$(1$')(n+g+O)t
where C is an arbitrary constant. A particular solution to the nonhomogeneous
equation is
s 1$'
vp (t) = = v * = (h* )
n+g+/
Hence all solutions to the di§erential equation take the form

v(t) = vg (t) + vp (t)

= v * + Ce$(1$')(n+g+O)t
4 An excellent reference for economists is Gandolfo, G. ìEconomic Dynamics: Methods and

Modelsî. There are thousands of math books on di§erential equations, e.g. Boyce, W. and
DiPrima, R. ìElementary Di§erential Equations and Boundary Value Problemsî
9.2. THE SOLOW MODEL AND ITS EMPIRICAL EVALUATION 203

Now we use the initial condition v(0) = h(0)1$' to determine the constant C

v(0) = v * + C
C = v(0) & v *

Hence the solution to the initial value problem is

v(t) = v * + (v(0) & v * ) e$(1$')(n+g+O)t

and substituting back h for v we obtain

' (
1$' 1$'
h(t)1$' = (h* ) + h(0)1$' & (h* ) e$(1$')(n+g+O)t

and hence
. % & / 1#*
1
s s
h(t) = + h(0)1$' & e$(1$')(n+g+O)t
n+g+/ n+g+/

h i 1#*
1
s
Note that limt!1 h(t) = n+g+O = h* regardless of the value of h(0) > 0:
In other words the unique steady state capital per labor e¢ciency unit is locally
(globally if one restricts attention to strictly positive capital stocks) asymptoti-
cally stable

For a general production function one canít solve the di§erential equation
explicitly and has to resort to graphical analysis. In Figure 9.2.1 we plot the
two functions (n + / + g)h(t) and sf (h(t)) against h(t): Given the properties
of f it is clear that both curves intersect twice, once at the origin and once
at a unique positive h* and (n + / + g)h(t) < sf (h(t)) for all h(t) < h* and
(n + / + g)h(t) > sf (h(t)) for all h(t) > h* : The steady state solves

sf (h* )
=n+/+g
k*

Since the change in h is given by the di§erence of the two curves, for h(t) < h*
h increases, for h(t) > h* it decreases over time and for h(t) = h* it remains
constant. Hence, as for the example above, also in the general case there exists
a unique positive steady state level of the capital-labor-e¢ciency ratio that is
locally asymptotically stable. Hence in the long run h settles down at h* for any
initial condition h(0) > 0: Once the economy has settled down at h* ; output,
consumption and capital per worker grow at constant rates g and total output,
capital and consumption grow at constant rates g + n: A situation in which the
endogenous variables of the model grow at constant (not necessarily the same)
rates is called a Balanced Growth Path (henceforth BGP). A steady state is a
balanced growth path with growth rate of 0:
204 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

(n+g+δ)κ(t)

sf(κ(t))

.
κ(0)

κ(0) κ* κ(t)

9.2.2 Empirical Evaluation of the Model

Kaldorís Growth Facts

Can the Solow model reproduce the stylized growth facts? The prediction of
the model is that in the long run output per worker and capital per worker both
grow at positive and constant rate g; the growth rate of technology. Therefore
the capital-labor ratio k is constant, as observed by Kaldor. The other two
stylized facts have to do with factor prices. Suppose that output is produced by
a single competitive Örm that faces a rental rate of capital r(t) and wage rate
w(t) for one unit of raw labor (i.e. not labor in e¢ciency units). The Örm rents
both input at each instant in time and solves

max F (K(t); A(t)L(t)) & r(t)K(t) & w(t)L(t)

K(t);L(t)-0
9.2. THE SOLOW MODEL AND ITS EMPIRICAL EVALUATION 205

ProÖt maximization requires

r(t) = FK (K(t); A(t)L(t))

w(t) = A(t)FL (K(t); A(t)L(t))

Given that F is homogenous of degree 1; FK and FL are homogeneous of degree

zero, i.e.
% &
K(t)
r(t) = FK ;1
A(t)L(t)
% &
K(t)
w(t) = A(t)FL ;1
A(t)L(t)

K(t)
In a balanced grow path A(t)L(t) = h(t) = h* is constant, so the real rental rate
of capital is constant and hence the real interest rate is constant. The wage
rate increases at the rate of technological progress, g: Finally we can compute
capital and labor shares. The capital share is given as

r(t)K(t)
0=
Y (t)

which is constant in a balanced growth path since the rental rate of capital
is constant and Y (t) and K(t) grow at the same rate g + n: Hence the unique
balanced growth path of the Solow model, to which the economy converges from
any initial condition, reproduces all four stylized facts reported by Kaldor. In
this dimension the Solow model is a big success and Solow won the Nobel price
for it in 1989.

The Summers-Heston Development Facts

How can we explain the large di§erence in per capita income levels across coun-
tries? Assume Örst that all countries have access to the same production tech-
nology, face the same population growth rate and have the same saving rate.
Then the Solow model predicts that all countries over time converge to the same
balanced growth path represented by h* : All countriesí per capita income con-
verges to the path y(t) = A(t)h* , equal for all countries under the assumption
of the same technology, i.e. same A(t) process. Hence, so the prediction of the
model, eventually per worker income (GDP) is equalized internationally. The
fact that we observe large di§erences in per worker incomes across countries in
the data must then be due to di§erent initial conditions for the capital stock,
so that countries di§er with respect to their relative distance to the common
BGP. Poorer countries are just further away from the BGP because they started
with lesser capital stock, but will eventually catch up. This implies that poorer
countries temporarily should grow faster than richer countries, according to the
model. To see this, note that the growth rate of output per worker f y (t) is given
206 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

by
y(t)
_ f 0 (h(t))h(t)
_
f y (t) = =g+
y(t) f (h(t))
f 0 (h(t))
= g+ (sf (h(t)) & (n + / + g)h(t))
f (h(t))
0
Since ff (Y(t))
(Y(t))
is positive and decreasing in h(t) and (sf (h(t)) & (n + / + g)h(t))
is decreasing in h(t) for two countries with h1 (t) < h2 (t) < h* we have f 1y (t) >
f 2y (t) > 0; i.e. countries that a further away from the balanced growth path
grow more rapidly. The hypothesis that all countriesí per worker income even-
tually converges to the same balanced growth path, or the somewhat weaker
hypothesis that initially poorer countries grow faster than initially richer coun-
tries is called absolute convergence. If one imposes the assumptions of equality
of technology and savings rates across countries, then the Solow model predicts
absolute convergence. This implication of the model has been tested empirically
by several authors. The data one needs is a measure of ìinitially poor vs. richî
and data on growth rates from ìinitiallyî until now. As measure of ìinitially
poor vs. richî the income per worker (in $US) of di§erent countries at some
initial year has been used.
In Figure 9.2.2 we use data for a long time horizon for 16 now industrialized
countries. Clearly the level of GDP per capita in 1885 is negatively correlated
with the growth rate of GDP per capita over the last 100 years across coun-
tries. So this Ögure lends support to the convergence hypothesis. We get the
same qualitative picture when we use more recent data for 22 industrialized
countries: the level of GDP per worker in 1960 is negatively correlated with the
growth rate between 1960 and 1990 across this group of countries, as Figure
9.2.2 shows. This result, however, may be due to the way we selected coun-
tries: the very fact that these countries are industrialized countries means that
they must have caught up with the leading country (otherwise they wouldnít
be called industrialized countries now). This important point was raised by
Bradford deLong (1988)
Let us take deLongs point seriously and look at the correlation between initial
income levels and subsequent growth rates for the whole cross-sectional sample
of Summers-Heston. Figure 9.2.2 doesnít seem to support the convergence hy-
pothesis: for the whole sample initial levels of GDP per worker are pretty much
uncorrelated with consequent growth rates. In particular, it doesnít seem to
be the case that most of the very poor countries, in particular in Africa, are
catching up with the rest of the world, at least not until 1990 (or until 2002 for
that matter).
So does Figure 9.2.2 constitute the big failure of the Solow model? After
all, for the big sample of countries it didnít seem to be the case that poor
countries grow faster than rich countries. But isnít that what the Solow model
predicts? Not exactly: the Solow model predicts that countries that are further
away from their balanced growth path grow faster than countries that are closer
to their balanced growth path (always assuming that the rate of technological
9.2. THE SOLOW MODEL AND ITS EMPIRICAL EVALUATION 207

Growth Rate Vers us Initial Per Capita GDP

3
JPN
Growth Rate of Per Capita GDP, 1885-1994

2.5
NOR
FIN

ITL CAN
DNK
2 GER
SWE
AUT
FRA USA

BEL
1.5 NLD GBR

AUS
NZL

1
0 1000 2000 3000 4000 5000

Per Capita GDP, 1885

progress is the same across countries). This hypothesis is called conditional con-
vergence. The ìconditionalî means that we have to condition on characteristics
of countries that may make them have di§erent steady states h* (s; n; /) (they
still should grow at the same rate eventually, after having converged to their
steady states) to determine which countries should grow faster than others. So
the fact that poor African countries grow slowly even though they are poor may
be, according to the conditional convergence hypothesis, due to the fact that
they have a low balanced growth path and are already close to it, whereas some
richer countries grow fast since they have a high balanced growth path and are
still far from reaching it.
To test the conditional convergence hypothesis economists basically do the
following: they compute the steady state output per worker5 that a country
should possess in a given initial period, say 1960, given n; s; / measured in
this countryís data. Then they measure the actual GDP per worker in this
5 Which is proportional to the balanced growth path for output per worker (just multiply

it by the constant A(1960)):

208 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

Growth Rate Vers us Initial Per Capita GDP

JPN
5

GRC
POR
4
Growth Rate of Per Capita GDP, 1960-1990

ESP

IRL ITL
TUR
3 FRA
AUT
BEL
FIN
GER NOR
NLD
GBR
2
CAN
DNK
SWE CHE
AUS USA
1

NZL

0
0 0.5 1 1.5 2 2.5
4
Per Worker GDP, 1960 x 10

period and build the di§erence. This di§erence indicates how far away this
particular country is away from its balanced growth path. This variable, the
di§erence between hypothetical steady state and actual GDP per worker is then
plotted against the growth rate of GDP per worker from the initial period to
the current period. If the hypothesis of conditional convergence were true, these
two variables should be negatively correlated across countries: countries that
are further away from their from their balanced growth path should grow faster.
Jonesí (1998) Figure 3.8 provides such a plot. In contrast to Figure 9.2.2 he
Önds that, once one conditions on country-speciÖc steady states, poor (relative
to their steady) tend to grow faster than rich countries. So again, the Solow
model is quite successful qualitatively.
Now we want to go one step further and ask whether the Solow model can
predict the magnitude of cross-country income di§erences once we allow para-
meters that determine the steady state to vary across countries. Such a quanti-
tative exercise was carried out in the ináuential paper by Mankiw, Romer and
Weil (1992). The authors ìwant to take Robert Solow seriouslyî, i.e. inves-
9.2. THE SOLOW MODEL AND ITS EMPIRICAL EVALUATION 209

Growth Rate Vers us Initial Per Capita GDP

6 KOR
HKG
OAN SGP
JPN
SYC CYP
LSO THA PRTGRC
4 ESP
Growth Rate of Per Capita GDP, 1960-1990

MYS
IDN ITA
JOR SYR
TUR
EGY IRL
YUG ISRAUTFIN FRA BEL
CHN BOL PRYECU BRA GER LUX
GINTUN
CMR NAMCOL DZA NOR NLD CAN
2 PNG ISL GBR
GAB PAN MUS MEX
BGD CSK DNK CHE USA
ZAF FJI
DOM SWEAUS
NGA GTM CIVHND
LKA
GNB PHL COM CRI
SLV CHL
MAR URY
IND CIV COG JAM NZL
CAF SEN
ZMB ZWE PER IRN
0 KEN TTO
GMBBEN
TGO GHA
MOZ TCD
RWA NIC
MLI VEN
MRT
UGA
MLIMDG CAF
MWI
BFA
BDI LSO
-2 BFA
MOZ GUY
PAK

-4
0 0.5 1 1.5 2 2.5
4
Per Worker GDP, 1960 x 10

tigate whether the quantitative predictions of his model are in line with the
data. More speciÖcally they ask whether the model can explain the enormous
cross-country variation of income per worker. For example in 1985 per worker
income of the US was 31 times as high as in Ethiopia.
There is an obvious way in which the Solow model can account for this
number. Suppose we constrain ourselves to balanced growth paths (i.e. ignore
the convergence discussion that relies on the assumptions that countries have
not yet reached their BGPís). Then, by denoting y U S (t) as per worker income
in the US and y ET H (t) as per worker income in Ethiopia in time t we Önd that
along BGPís, with assumed Cobb-Douglas production function
' ( 1#*
*
sU S
US US
y (t) A (t) nU S +g U S +O U S
ET H
= ET H )' ( 1#*
* (9.12)
y (t) A (t) sET H
nET H +g ET H +O ET H

One easy way to get the income di§erential is to assume large enough di§erences
210 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

US
in levels of technology AAET H(t)
(t)
: One fraction of the literature has gone this route;
the hard part is to justify the large di§erences in levels of technology when
technology transfer is relatively easy between a lot of countries.6 The other
fraction, instead of attributing the large income di§erences to di§erences in A
attributes the di§erence to variation in savings (investment) and population
growth rates. Mankiw et al. take this view. They assume that there is in
fact no di§erence across countries in the production technologies used, so that
AU S (t) = AET H (t) = A(0)egt ; g ET H = g U S and / ET H = / U S : Assuming
balanced growth paths and Cobb-Douglas production we can write
% & 1#*
*

i gt si
y (t) = A(0)e i
n +/+g

where i indexes a country. Taking natural logs on both sides we get

0 0
ln(y i (t)) = ln(A(0)) + gt + ln(si ) & ln(ni + / + g)
1&0 1&0
Given this linear relationship derived from the theoretical model it very tempting
to run this as a regression on cross-country data. For this, however, we need a
stochastic error term which is nowhere to be detected in the model. Mankiw et
al. use the following assumption

ln(A(0)) = a + "i (9.13)

where a is a constant (common across countries) and "i is a country speciÖc

random shock to the (initial) level of technology that may, according to the
authors, represent not only variations in production technologies used, but also
climate, institutions, endowments with natural resources and the like. Using
this and assuming that the time period for the cross sectional data on which the
regression is run is t = 0 (if t = T that only changes the constant7 ) we obtain
the following linear regression
0 0
ln(y i ) = a+ ln(si ) & ln(ni + / + g) + "i
1&0 1&0
ln(y i ) = a + b1 ln(si ) + b2 ln(ni + / + g) + "i (9.14)

Note that the variation in "i across countries, according to the underlying model,
are attributed to variations in technology. Hence the regression results will tell
us how much of the variation in cross-country per-worker income is due to vari-
ations in investment and population growth rates, and how much is due to
random di§erences in the level of technology. This is, if we take (9:13) literally,
how the regression results have to be interpreted. If we want to estimate (9:14)
by OLS, the identifying assumption is that the "i are uncorrelated with the
6 See, e.g. Parente and Prescott (1994, 1999).
7 Note that we do not use the time series dimension of the data, only the cross-sectional,
i.e. cross-country dimension.
9.2. THE SOLOW MODEL AND ITS EMPIRICAL EVALUATION 211

other variables on the right hand side, in particular the investment and popu-
lation growth rate. Given the interpretation the authors o§ered for "i I invite
you all to contemplate whether this is a good assumption or not. Note that the
regression equation also implies restrictions on the parameters to be estimated:
if the speciÖcation is correct, then one expects the estimated ^b1 = &^b2 : One
may also impose this constraint a priori on the parameter values and do con-
strained OLS. Apparently the results donít change much from the unrestricted
estimation. Also, given that the production function is Cobb-Douglas, 0 has the
interpretation as capital share, which is observable in the data and is thought to
be around .25-0.5 for most countries, one would expect ^b1 2 [ 13 ; 1] a priori. This
is an important test for whether the speciÖcation of the regression is correct.
With respect to data, y i is taken to be real GDP divided by working age
population in 1985, ni is the average growth rate of the working-age population8
from 1960 & 85 and s is the average share of real investment9 from real GDP
between 1960 & 85: Finally they assume that g + / = 0:05 for all countries.
Table 2 reports their results for the unrestricted OLS-estimated regression
on a sample of 98 countries (see their data appendix for the countries in the
sample)

Table 2

a
^ ^b1 ^b2 82
R
5:48 1:42 &1:48
0:59
(1:59) (0:14) (0:12)

The basic results supporting the Solow model are that the ^bi have the right
sign, are highly statistically signiÖcant and are of similar size. Most impor-
tantly, a major fraction of the cross-country variation in per-worker incomes,
namely about 60% is accounted for by the variations in the explanatory vari-
ables, namely investment rates and population growth rates. The rest, given the
assumptions about where the stochastic error term comes from, is attributed to
random variations in the level of technology employed in particular countries.
That seems like a fairly big success of the Solow model. However, the size
of the estimates ^bi indicates that the implied required capital shares on aver-
age have to lie around 23 rather than 13 usually observed in the data. This
is both problematic for the success of the model and points to a direction of
improvement of the model.
Letís Örst understand where the high coe¢cients come from. Assume that
nU S = nET H = n (variation in population growth rates is too small to make
a signiÖcant di§erence) and rewrite (9:12) as (using the assumption of same
technology, the di§erences are assumed to be of stochastic nature)
% U S & 1#*
*
y U S (t) s
=
y ET H (t) sET H
8 This implicitly assumes a constant labor force participation rate from 1960 # 85:
9 Private as well as government (gross) investment.
212 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

To generate a spread of incomes of 31; for 0 = 13 one needs a ratio of investment

rates of 961 which is obviously absurdly high. But for 0 = 23 one only requires
a ratio of 5:5: In the data, the measured ratio is about 3:9 for the US versus
Ethiopia. This comes pretty close (population growth di§erentials would almost
do the rest). Obviously this is a back of the envelope calculation involving only
two countries, but it demonstrates the core of the problem: there is substantial
variation in investment and population growth rates across countries, but if
the importance of capital in the production process is as low as the commonly
believed 0 = 13 , then these variations are nowhere nearly high enough to generate
the large income di§erentials that we observe in the data. Hence the regression
forces the estimated 0 up to two thirds to make the variations in si (and ni )
matter su¢ciently much.
So if we canít change the data to give us a higher capital share and canít
force the model to deliver the cross-country spread in incomes given reasonable
capital shares, how can we rescue the model? Mankiw, Romer and Weil do
a combination of both. Suppose you reinterpret the capital stock as broadly
containing not only the physical capital stock, but also the stock of human
capital and you interpret part of labor income as return to not just raw physical
labor, but as returns to human capital such as education, then possibly a capital
share of two thirds is reasonable. In order to do this reinterpretation on the data,
one better Örst augments the model to incorporate human capital as well.
So now let the aggregate production function be given by

1$'$%
Y (t) = K(t)' H(t)% (A(t)L(t))

where H(t) is the stock of human capital. We assume 0 + ( < 1; since if

0 + ( = 1; there are constant returns to scale in accumulable factors alone,
which prevents the existence of a balanced growth path (the model basically
becomes an AK-model to be discussed below. We will specify below how to
measure human capital (or better: investment into human capital) in the data.
The capital accumulation equations are now given by

_
K(t) = sk Y (t) & /K(t)
_
H(t) = sh Y (t) & /H(t)

H(t)
Expressing all equations in per-e§ective labor units yields (where ^(t) = A(t)L(t)

9(t) = h(t)a ^(t)%

h(t)
_ = sk 9(t) & (n + / + g)h(t)
^(t)
_ = sh 9(t) & (n + / + g)^(t)
9.2. THE SOLOW MODEL AND ITS EMPIRICAL EVALUATION 213

Obviously a unique positive steady state exists which can be computed as before
! 1#*#2
1

* s1$%
k s%h
h =
n+/+g
% 1$' & 1#*#2
1

* s'
k sh
^ =
n+/+g
' %
9* = (h* ) (^ * )

and the associated balanced growth path has

y(t) = A(0)egt 9 *
! 1#*#2
*
% & 1#*#2
2

gt s1$%
k s%h s' 1$'
k sh
= A(0)e
n+/+g n+/+g

Taking logs yields

ln(y(t)) = ln(A(0)) + gt + b1 ln(sk ) + b2 ln(sh ) + b3 ln(n + / + g)

' % '+%
where b1 = 1$'$% ; b2 = 1$'$% and b3 = & 1$'$% : Making the same assump-
tions about how to bring a stochastic component into the completely determin-
istic model yields the regression equation

ln(y i ) = a + b1 ln(sik ) + b2 ln(sih ) + b3 ln(ni + / + g) + "i

The main problem in estimating this regression (apart from the validity of the
orthogonality assumption of errors and instruments) is to construct reasonable
data for the savings rate of human capital. Ideally we would measure all the
resources áowing into investment that increases the stock of human capital,
including investment into education, health and so forth. For now letís limit
attention to investment into education. Mankiw et al.ís measure of the invest-
ment rate of education is the fraction of the total working age population that
goes to secondary school, as found in data collected by the UNESCO, i.e.

S
sh =
L
where S is the number of people in the labor force that go to school (and forgo
wages as unskilled workers) and L is the total labor force. Why may this be
a good proxy for the investment share of output into education? Investment
expenditures for education include new buildings of the universities, salaries
of teachers, and most signiÖcantly, the forgone wages of the students in school.
Letís assume that forgone wages are the only input for human capital investment
(if the other inputs are proportional to this measure, the argument goes through
unchanged). Let the people in school forgo wages wL as unskilled workers. Total
forgone earnings are then wL S and the investment share of output into human
214 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

capital is wYL S : But the wage of an unskilled worker is given (under perfect
competition) by its marginal product

wL = (1 & 0 & ()K(t)' H(t)% A(t)1$'$% L(t)$'$%

so that
wL S wL LS S
= = (1 & 0 & () = (1 & 0 & ()sh
Y YL L
so that the measure that the authors employ is proportional to a ìtheoretically
more idealî measure of the human capital savings rate. Noting that ln((1 & 0 &
()sh ) = ln(1 & 0 & () + ln(sh ) one immediately see that the proportionality
factor will only a§ect the estimate of the constant, but not the estimates of the
bi :
The results of estimating the augmented regression by OLS are given in
Table 3

Table 3

a
^ ^b1 ^b2 ^b3 82
R
6:89 0:69 0:66 &1:73
0:78
(1:17) (0:13) (0:07) (0:41)

The results are quite remarkable. First of all, almost 80% of the variation of
cross-country income di§erences is explained by di§erences in savings rates in
physical and human capital This is a huge number for cross-sectional regressions.
Second, all parameter estimates are highly signiÖcant and have the right sign.
In addition we (i.e. Mankiw, Romer and Weil) seem to have found a remedy
for the excessively high implied estimates for 0: Now the estimates for bi imply
almost precisely 0 = ( = 13 and the one overidentifying restriction on the b0i s
canít be rejected at standard conÖdence levels (although ^b3 is a bit high). The
Önal verdict is that with respect to explaining cross-country income di§erences
an augmented version of the Solow model does remarkably well. This is, as
usual subject to the standard quarrels that there may be big problems with
data quality and that their method is not applicable for non-Cobb-Douglas
technology. On a more fundamental level the Solow model has methodological
problems and Mankiw et al.ís analysis leaves several questions wide open:

1. The assumption of a constant saving rate is a strong behavioral assumption

that is not derived from any underlying utility maximization problem of
rational agents. Our next topic, the discussion of the Cass-Koopmans-
Ramsey model will remedy exactly this shortcoming

2. The driving force of economic growth, technological progress, is model-

exogenous; it is assumed, rather than endogenously derived. We will pick
this up in our discussion of endogenous growth models.
9.3. THE RAMSEY-CASS-KOOPMANS MODEL 215

3. The cross-country variation of per-worker income is attributed to varia-

tions in investment rates, which are taken to be exogenous. What is then
needed is a theory of why investment rates di§er across countries. I can
provide you with interesting references that deal with this problem, but
we will not talk about this in detail in class.

But now letís turn to the Örst of these points, the introduction of endogenous
determination of householdís saving rates.

9.3 The Ramsey-Cass-Koopmans Model

In this section we discuss the Örst logical extension of the Solow model. Instead
of assuming that households save at a Öxed, exogenously given rate s we will
analyze a model in which agents actually make economic decisions; in particu-
lar they make the decision how much of their income to consume in the current
period and how much to save for later. This model was Örst analyzed by the
British mathematician and economist Frank Ramsey. He died in 1930 at age
29 from tuberculosis, not before he wrote two of the most ináuential economics
papers ever to be written. We will discuss a second pathbreaking idea of his
in our section on optimal Öscal policy. Ramseyís ideas were taken up indepen-
dently by David Cass and Tjelling Koopmans in 1965 and have now become the
second major workhorse model in modern macroeconomics, besides the OLG
model discussed previously. In fact, in Section 3 of these notes we discussed
the discrete-time version of this model and named it the neoclassical growth
model. Now we will in fact incorporate economic growth into the model, which
is somewhat more elegant to do in continuous time, although there is nothing
conceptually di¢cult about introducing growth into the discrete-time version-
a useful exercise.

9.3.1 Mathematical Preliminaries: Pontryaginís Maximum

Principle
Intriligator, Chapter 14

9.3.2 Setup of the Model

Our basic assumptions made in the previous section are carried over. There is
a representative, inÖnitely lived family (dynasty) in our economy that grows at
population growth rate n > 0 over time, so that, by normalizing the size of the
population at time 0 to 1 we have that L(t) = ent is the size of the family (or
population) at date t: We will treat this dynasty as a single economic agent.
There is no risk in this economy and all agents are assumed to have perfect
foresight.
Production takes place with a constant returns to scale production function

Y (t) = F (K(t); A(t)L(t))

216 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

where the level of technology grows at constant rate g > 0; so that, normalizing
A(0) = 1 we Önd that the level of technology at date t is given by A(t) = egt :
The aggregate capital stock evolves according to

_
K(t) = F (K(t); A(t)L(t)) & /K(t) & C(t) (9.15)

i.e. the net change in the capital stock is given by that fraction of output that
is not consumed by households, C(t) or by depreciation /K(t): Alternatively,
this equation can be written as

_
K(t) + /K(t) = F (K(t); A(t)L(t)) & C(t)

_
which simply says that aggregate gross investment K(t)+/K(t) equals aggregate
saving F (K(t); A(t)L(t))&C(t) (note that the economy is closed and there is no
government). As before this equation can be expressed in labor-intensive form:
deÖne c(t) = C(t) C(t)
L(t) as consumption per capita (or worker) and i(t) = A(t)L(t)
as consumption per labor e¢ciency unit (the Greek symbol is called a ìzetaî).
Then we can rewrite (9:3:3) as, using the same manipulations as before

h(t)
_ = f (h(t)) & i(t) & (n + / + g)h(t) (9.16)

Again f is assumed to have all the properties as in the previous section. We

assume that the initial endowment of capital is given by K(0) = h(0) = h0 > 0
So far we just discussed the technology side of the economy. Now we want
to describe the preferences of the representative family. We assume that the
family values streams of per-capita consumption c(t)t2[0;1) by
Z 1
u(c) = e$/t U (c(t))dt
0

where : > 0 is a time discount factor. Note that this implicitly discounts utility
of agents that are born at later periods. Ramsey found this to be unethical
and hence assumed : = 0: Here U (c) is the instantaneous utility or felicity
function.10 In most of our discussion we will assume that the period utility
function is of constant relative risk aversion (CRRA) form, i.e.
" c1#'
if = 6= 1
U (c) = 1$0
ln(c) if = = 1

1 0 An alternative, so-called Benthamite (after British philosopher Jeremy Bentham) felicity

function would read as L(t)U (c(t)): Since L(t) = ent we immediately see

e%.t L(t)U (c(t))

= e%(.%n)t U (c(t))

and hence we would have the same problem with adjusted time discount factor, and we would
need to make the additional assumption that W > n:
9.3. THE RAMSEY-CASS-KOOPMANS MODEL 217

Under our assumption of CRRA11 we can rewrite

c(t)1$0
e$/t U (c(t)) = e$/t
1&=
1$0
(i(t)egt )
= e$/t
1&=
i(t)1$0
= e$(/$g(1$0))t
1&=

and we assume : > g(1 & =): DeÖne : ^ = : & g(1 & =): We therefore can rewrite
the utility function of the dynasty as
Z 1
i(t)1$0
u(i) = e$^/t dt (9.17)
0 1&=
Z 1
= e$^/t U (i(t))dt (9.18)
0

where = = 1 is understood to be the log-case. As before note that, once we

know the variables h(t) and i(t) we can immediately determine per capita con-
sumption c(t) = i(t)egt and the per capita capital stock k(t) = h(t)egt and
output y(t) = egt f (h(t)): Aggregate consumption, output and capital stock can
be deduced similarly.
This completes the description of the environment. We will now, in turn, de-
scribe Pareto optimal and competitive equilibrium allocations and argue (heuris-
tically) that they coincide.

9.3.3 Social Planners Problem

The Örst question is how a social planner would allocate consumption and saving
over time. Note that in this economy there is a single agent, so the problem of
the social planner is reduced from the OLG model to only intertemporal (and
not also intergenerational) allocation of consumption. An allocation is a pair of
functions h(t) : [0; 1) ! R and i(t) : [0; 1) ! R:

DeÖnition 106 An allocation (h; i) is feasible if it satisÖes h(0) = h0 , h(t); i(t) %

0 and (9:16) for all t 2 [0; 1):

DeÖnition 107 An allocation (h* ; i * ) is Pareto optimal if it is feasible and if

there is no other feasible allocation (^ ^ such that u(i)
h; i) ^ > u(i * ):

1 1 Some of the subsequent analysis could be carried out with more general assumptions on

the period utility functions. However for the existence of a balanced growth path one has to
assume CRRA, so I donít see much of a point in higher degree of generality that in some point
of the argument has to be dispensed with anyway.
For an extensive discussion of the properties of the CRRA utility function see the appendix
to Chapter 2 and HW1.
218 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

It is obvious that (h* ; i * ) is Pareto optimal, if and only if it solves the social
planner problem
Z 1
max e$^/t U (i(t))dt (9.19)
(Y;\)-0 0
s.t. h(t)
_ = f (h(t)) & i(t) & (n + / + g)h(t)
h(0) = h0
This problem can be solved using Pontryaginís maximum principle. The
state variable in this problem is h(t) and the control variable is i(t): Let by ,(t)
denote the co-state variable corresponding to h(t): Forming the present value
Hamiltonian and ignoring nonnegativity constraints12 yields
H(t; h; i; ,) = e$^/t U (i(t)) + ,(t) [f (h(t)) & i(t) & (n + / + g)h(t)]
Su¢cient conditions for an optimal solution to the planners problem (9:19) are13
@H(t; h; i; ,)
= 0
@i(t)
_ @H(t; h; i; ,)
,(t) = &
@h(t)
lim ,(t)h(t) = 0
t!1

The last condition is the so-called transversality condition (TVC). This yields
e$^/t U 0 (i(t)) = ,(t) (9.20)
_
,(t) = & (f 0 (h(t)) & (n + / + g)) ,(t) (9.21)
lim ,(t)h(t) = 0 (9.22)
t!1

plus the constraint

h(t)
_ = f (h(t)) & i(t) & (n + / + g)h(t) (9.23)
Now we eliminate the co-state variable from this system. Di§erentiating (9:20)
with respect to time yields
00
_
,(t) _ &:
= e$^/t U (i(t))i(t) ^e$^/t U 0 (i(t))
or, using (9:20)
00
_
,(t) _
i(t)U (i(t))
= &:
^ (9.24)
,(t) U 0 (i(t))
Combining (9:24) with (9:21) yields
00
_
i(t)U (i(t))
= & (f 0 (h(t)) & (n + / + g + :
^)) (9.25)
U 0 (i(t))
1 2 Giventhe functional form assumptions this is unproblematic.
13 I
use present value Hamiltonians. You should do the same derivation using current value
Hamiltonians, as, e.g. in Intriligator, Chapter 16.
9.3. THE RAMSEY-CASS-KOOPMANS MODEL 219

or multiplying both sides by i(t) yields

00

_ i(t)U (i(t)) = & (f 0 (h(t)) & (n + / + g + :

i(t) ^)) i(t)
U 0 (i(t))
\ 1#'
Using our functional form assumption on the utility function U (i) = 1$0 we
00
obtain for the coe¢cient of relative risk aversion & \(t)U (\(t))
U 0 (\(t)) = = and hence

_ 1
i(t) = (f 0 (h(t)) & (n + / + g + :
^)) i(t)
=
Note that for the isoelastic case (= = 1) we have that :
^ = : and hence the
equation becomes
_
i(t) = (f 0 (h(t)) & (n + / + g + :)) i(t)

The transversality condition can be written as

lim ,(t)h(t) = lim e$^/t U 0 (i(t))h(t) = 0

t!1 t!1

Hence any allocation (h; i) that satisÖes the system of nonlinear ordinary dif-
ferential equations

_ 1 0
i(t) = (f (h(t)) & (n + / + g + :
^)) i(t) (9.26)
=
h(t)
_ = f (h(t)) & i(t) & (n + / + g)h(t) (9.27)

with the initial condition h(0) = h0 and terminal condition (TVC)

lim e$^/t U 0 (i(t))h(t) = 0

t!1

is a Pareto optimal allocation. We now want to analyze the dynamic system

(9:26) & (9:27) in more detail.

Steady State Analysis

Before analyzing the full dynamics of the system we look at the steady state
_
of the optimal allocation. A steady state satisÖes i(t) = h(t)
_ = 0: Hence from
14
equation (9:26) we have , denoting steady state capital and consumption per
e¢ciency units by i * and h*

f 0 (h* ) = (n + / + g + :
^) (9.28)

The unique capital stock h* satisfying this equation is called the modiÖed golden
rule capital stock.
1 4 There is the trivial steady state X& = Y & = 0: We will ignore this steady state from now

on, as it only is optimal when X(0) = X0 :

220 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

The ìmodiÖedî comes from the following consideration. Suppose there is

no technological progress, then the modiÖed golden rule capital stock h* = k *
satisÖes
f 0 (k * ) = (n + / + :) (9.29)
The golden rule capital stock is that capital stock per worker k g that maxi-
mizes per-capita consumption. The steady state capital accumulation condition
(without technological progress) is (see (9:27))

c = f (k) & (n + /)k

Hence the original golden rule capital stock satisÖes15

f 0 (k g ) = n + /

and hence k * < k g : The social planner optimally chooses a capital stock per
worker k * below the one that would maximize consumption per capita. So even
though the planner could increase every personís steady state consumption by
increasing the capital stock, taking into account the impatience of individuals
the planner Önds it optimal not to do so.
Equation (9:28) or (9:29) indicate that the exogenous parameters governing
individual time preference, population and technology growth determine the
interest rate and the marginal product of capital. The production technology
then determines the unique steady state capital stock and the unique steady
state consumption from (9:27) as

i * = f (h* ) & (n + / + g)h*

The Phase Diagram

It is in general impossible to solve the two-dimensional system of di§erential
equations analytically, even for the simple example for which we obtain an
analytical solution in the Solow model. A powerful tool when analyzing the
dynamics of continuous time economies turn out to be so-called phase diagrams.
Again, the dynamic system to be analyzed is

_ 1 0
i(t) = (f (h(t)) & (n + / + g + :
^)) i(t)
=
h(t)
_ = f (h(t)) & i(t) & (n + / + g)h(t)

with initial condition h(0) = h0 and terminal transversality condition limt!1 e$^/t U 0 (i(t))h(t) =
0: We will analyze the dynamics of this system in (h; i) space. For any given
value of the pair (h; i) % 0 the dynamic system above indicates the change of
the variables h(t) and i(t) over time. Let us start with the Örst equation.
_
The locus of values for (h; i) for which i(t) = 0 is called an isocline; it is the
_
collection of all points (h; i) for which i(t) = 0: Apart from the trivial steady
1 5 Note that the golden rule capital stock had special signiÖcance in OLG economies. In

particular, any steady state equilibrium with capital stock above the golden rule was shown
to be dynamically ine¢cient.
9.3. THE RAMSEY-CASS-KOOPMANS MODEL 221

_
state we have i(t) = 0 if and only if h(t) satisÖes f 0 (h(t)) & (n + / + g + :^) = 0;
or h(t) = h : Hence in the (h; i) plane the isocline is a vertical line at h(t) = h* :
*

Whenever h(t) > h* (and i(t) > 0), then i(t) _ < 0; i.e. i(t) declines. We
indicate this in Figure 9.3.3 with vertical arrows downwards at all points (h; i)
for which h < h* : Reversely, whenever h < h* we have that i(t) _ > 0; i.e. i(t)
increases. We indicate this with vertical arrows upwards at all points (h; i) at
which h < h* : Similarly we determine the isocline corresponding to the equation
h(t)
_ = f (h(t)) & i(t) & (n + / + g)h(t): Setting h(t)_ = 0 we obtain all points in
(h; i)-plane for which h(t)
_ = 0; or i(t) = f (h(t)) & (n + / + g)h(t): Obviously for
h(t) = 0 we have i(t) = 0: The curve is strictly concave in h(t) (as f is strictly
concave), has its maximum at hg > h* solving f 0 (hg ) = (n + / + g) and again
intersects the horizontal axis for h(t) > hg solving f (h(t)) = (n + / + g)h(t):
Hence the isocline corresponding to h(t) _ = 0 is hump-shaped with peak at hg :
For all (h; i) combinations above the isocline we have i(t) > f (h(t)) & (n +
/ + g)h(t); hence h(t)
_ < 0 and hence h(t) is decreasing. This is indicated by
horizontal arrows pointing to the left in Figure 9.3.3. Correspondingly, for all
(h; i) combinations below the isocline we have i(t) < f (h(t)) & (n + / + g)h(t)
and hence h(t)
_ > 0; i.e. h(t) is increasing, which is indicated by arrows pointing
to the right.
Note that we have one initial condition for the dynamic system, h(0) = h0 :
The arrows indicate the direction of the dynamics, starting from h(0): However,
one initial condition is generally not enough to pin down the behavior of the
dynamic system over time, i.e. there may be several time paths of (h(t); i(t))
that are an optimal solution to the social planners problem. The question is,
basically, how the social planner should choose i(0): Once this choice is made
the dynamic system as described by the phase diagram uniquely determines the
optimal path of capital and consumption. Possible such paths are traced out in
Figure 9.3.3.
We now want to argue two things: a) for a given h(0) > 0 any choice i(0) of
the planner leading to a path not converging to the steady state (h* ; i * ) cannot
be an optimal solution and b) there is a unique stable path leading to the steady
state. The second property is called-saddle-path stability of the steady state and
the unique stable path is often called a saddle path (or a one-dimensional stable
manifold).
Let us start with the Örst point. There are three possibilities for any path
starting with arbitrary h(0) > 0; they either go to the unique steady state, they
lead to the point E (as trajectories starting from points A or C); or they go to
points with h = 0 such as trajectories starting at B or D: Obviously trajectories
like A and C that donít converge to E violate the nonnegativity of consumption
i(t) = 0 in Önite amount of time. But a trajectory converging asymptotically
to E violates the transversality condition

lim e$^/t U 0 (i(t))h(t) = 0

t!1

8 > hg > h* > 0 and from

As the trajectory converges to E, h(t) converges to a h
222 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

ζ (t)

.
ζ (t)=0

ζ*
.
κ(t)=0

κ* κ(t)

dU 0 (\(t)) _ 00
(9:25) we have, since dt = i(t)U (i(t))
dU 0 (\(t))
dt
= &f 0 (h(t)) + (n + / + g + :
^) > :
^>0
U 0 (i(t))

i.e. the growth rate of marginal utility of consumption is bigger than : ^ as

the trajectory approaches A: Given that h approaches h 8 it is clear that the
transversality condition is violated for all those trajectories.
Now consider trajectories like B or D: If, in Önite amount of time, the
trajectory hits the i-axis, then h(t) = i(t) = 0 from that time onwards, which,
given the Inada conditions imposed on the utility function canít be optimal. It
may, however, be possible that these trajectories asymptotically go to (h; i) =
(0; 1): That this canít happen can be shown as follows. From (9:27) we have

h(t)
_ = f (h(t)) & i(t) & (n + / + g)h(t)

which is negative for all h(t) < h* : Di§erentiating both sides with respect to
9.3. THE RAMSEY-CASS-KOOPMANS MODEL 223

ζ (t) D

.
ζ (t)=0
C

Saddle path

ζ*
.
κ(t)=0

Saddle path

ζ (0)

B
A
E

κ(0) κ* κ(t)

time yields

dh(t)
_ d2 h(t) _
= = (f 0 (h(t)) & (n + / + g)) h(t)
_ & i(t) <0
dt dt2

since along a possible asymptotic path i(t) _ > 0: So not only does h(t) decline,
but it declines at increasing pace. Asymptotic convergence to the i-axis, how-
ever, would require h(t) to decline at a decreasing pace. Hence all paths like B
or D have to reach h(t) = 0 at Önite time and therefore canít be optimal. These
arguments show that only trajectories that lead to the unique positive steady
state (h* ; i * ) can be optimal solutions to the planner problem
In order to prove the second claim that there is a unique such path for
each possible initial condition h(0) we have to analyze the dynamics around the
steady state.
224 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

Dynamics around the Steady State

We canít solve the system of di§erential equations explicitly even for simple
examples. But from the theory of linear approximations we know that in a
neighborhood of the steady state the dynamic behavior of the nonlinear system
is characterized by the behavior of the linearized system around the steady state.
Remember that the Örst order Taylor expansion of a function f : Rn ! R
around a point x* 2 Rn is given by

f (x) = f (x* ) + rf (x* ) * (x & x* )

where rf (x* ) 2 Rn is the gradient (vector of partial derivatives) of f at x* : In

our case we have x* = (h* ; i * ); and two functions f; g deÖned as

_ 1 0
i(t) = f (h(t); i(t)) = (f (h(t)) & (n + / + g + :
^)) i(t)
=
h(t)
_ = g(h(t); i(t)) = f (h(t)) & i(t) & (n + / + g)h(t)

Obviously we have f (h* ; i * ) = g(h* ; i * ) = 0 since (h* ; i * ) is a steady state.

Hence the linear approximation around the steady state takes the form
% & % 1 0 &K %
_
i(t) (f (h(t)) & (n + / + g + : ^)) 1 00
f (h(t))i(t) K i(t) & i
- 0 0 K *
h(t)
_ &1 f 0
(h(t)) & (n + / + g) K h(t) &h
(\(t);Y(t))=(\ % ;Y% )
% & % &
0 1 00 * *
0 f (h )i i(t) & i *
= * (9
&1 :
^ h(t) & h*

This two-dimensional linear di§erence equation can now be solved analyti-

cally. It is easiest to obtain the qualitative properties of this system by reducing
it two a single second order di§erential equation. Di§erentiate the second equa-
tion with respect to time to obtain

h _ +:
J (t) = &i(t) ^h(t)
_
_
DeÖning ( = & 01 f 00 (h* )i * > 0 and substituting in from (9:30) for i(t) yields

h
J (t) = ( (h(t) & h* ) + :
^h(t)
_
*
h
J (t) & :
^h(t)
_ & (h(t) = &(h (9.31)

We know how to solve this second order di§erential equation; we just have to
Önd the general solution to the homogeneous equation and a particular solution
to the nonhomogeneous equation, i.e.

h(t) = hg (t) + hp (t)

It is straightforward to verify that a particular solution to the nonhomogeneous

equation is given by hp (t) = h* : With respect to the general solution to the
homogeneous equation we know that its general form is given by

hg (t) = C1 eS1 t + C2 eS2 t

9.3. THE RAMSEY-CASS-KOOPMANS MODEL 225

where C1 ; C2 are two constants and ,1 ; ,2 are the two roots of the characteristic
equation

,2 & :
^, & ( = 0
s
:
^ ^2
:
,1;2 = < (+
2 4
We see that the two roots are real, distinct and one is bigger than zero and one
is less than zero. Let ,1 be the smaller and ,2 be the bigger root. The fact that
one of the roots is bigger, one is smaller than one implies that locally around
the steady state the dynamic system is saddle-path stable, i.e. there is a unique
stable manifold (path) leading to the steady state. For any value other than
C2 = 0 we will have limt!1 h(t) = 1 (or &1) which violates feasibility. Hence
we have that
h(t) = h* + C1 eS1 t
(remember that ,1 < 0). Finally C1 is determined by the initial condition
h(0) = h0 since

h(0) = h* + C1
C1 = h(0) & h*

and hence the solution for h is

h(t) = h* + (h(0) & h* ) eS1 t

and the corresponding solution for i can be found from

h(t)
_ = &i(t) + i * + :
^ (h(t) & h* )
i(t) = i* + :
^ (h(t) & h* ) & h(t)
_

by simply using the solution for h(t): Hence for any given h(0) there is a
unique optimal path (h(t); i(t)) which converges to the steady state (h* ; i * ):
Note
K that the speed of convergence
K to the steady state is determined by j,1 j =
K /^ q 1 2K
K & & f 00 (h* )i + K which is increasing in & 1 and decreasing in :
* /
^
^: The
K2 0 4 K 0
higher the intertemporal elasticity of substitution, the more are individuals will-
ing to forgo early consumption for later consumption an the more rapid does
capital accumulation towards the steady state occur. The higher the e§ective
time discount rate : ^; the more impatient are households and the stronger they
prefer current over future consumption, inducing a lower rate of capital accu-
mulation.
So far what have we showed? That only paths converging to the unique
steady state can be optimal solutions and that locally, around the steady state
this path is unique, and therefore was referred to as saddle path. This also means
that any potentially optimal path must hit the saddle path in Önite time.
Hence there is a unique solution to the social planners problem that is graph-
ically given as follows. The initial condition h0 determines the starting point
226 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

of the optimal path h(0): The planner then optimally chooses i(0) such as to
jump on the saddle path. From then on the optimal sequences (h(t); i(t))t2[0;1)
are just given by the segment of the saddle path from h(0) to the steady state.
Convergence to the steady state is asymptotic, monotonic (the path does not
jump over the steady state) and exponential. This indicates that eventually,
once the steady state is reached, per capita variables grow at constant rates g
and aggregate variables grow at constant rates g + n:
c(t) = egt i *
k(t) = egt h*
y(t) = egt f (h* )
C(t) = e(n+g)t i *
K(t) = e(n+g)t h*
Y (t) = e(n+g)t f (h* )
Hence the long-run behavior of this model is identical to that of the Solow model;
it predicts that the economy converges to a balanced growth path at which all
per capita variables grow at rate g and all aggregate variables grow at rate g +n:
In this sense we can understand the Cass-Koopmans-Ramsey model as a micro
foundation of the Solow model, with predictions that are quite similar.

9.3.4 Decentralization
In this subsection we want to demonstrate that the solution to the social plan-
ners problem does correspond to the (unique) competitive equilibrium allocation
and we want to Önd prices supporting the Pareto optimal allocation as a com-
petitive equilibrium.
In the decentralized economy there is a single representative Örm that rents
capital and labor services to produce output. As usual, whenever the Örm
does not own the capital stock its intertemporal proÖt maximization problem is
equivalent to a continuum of static maximization problems
max F (K(t); A(t) + (t)) & r(t)K(t) & w(t)L(t) (9.32)
K(t);L(t)-0

taking w(t) and r(t); the real wage rate and rental rate of capital, respectively,
as given.
The representative household (dynasty) maximizes the familyís utility by
choosing per capita consumption and per capita asset holding at each instant
in time. Remember that preferences were given as
Z 1
u(c) = e$/t U (c(t))dt (9.33)
0

The only asset in this economy is physical capital16 on which the return is
r(t) & /: As before we could introduce notation for the real interest rate i(t) =
1 6 Introducing a second asset, say government bonds, is straightforward and you should do

it as an exercise.
9.3. THE RAMSEY-CASS-KOOPMANS MODEL 227

r(t)&/ but we will take a shortcut and use r(t)&/ in the period household budget
constraint. This budget constraint (in per capita terms, with the consumption
good being the numeraire) is given by

c(t) + a(t)
_ + na(t) = w(t) + (r(t) & /) a(t) (9.34)

where a(t) = A(t)

L(t) are per capita asset holdings, with a(0) = h0 given. Note that
the term na(t) enters because of population growth: in order to, say, keep the
per-capita assets constant, the household has to spend na(t) units to account for
its growing size.17 As with discrete time we have to impose a condition on the
household that rules out Ponzi schemes. At the same time we do not prevent
the household from temporarily borrowing (for the households a is perceived as
an arbitrary asset, not necessarily physical capital). A standard condition that
is widely used is to require that the household debt holdings in the limit do no
grow at a faster rate than the interest rate, or alternatively put, that the time
zero value of household debt has to be nonnegative in the limit.
Rt
lim a(t)e$ 0
(r(* )$O$n)d*
%0 (9.35)
t!1

Note that with a path of interest rates r(t) & /; the value of one unit of the
consumption
Rt good at time t in units of the period consumption good is given
by e$ 0 (r(* )$O)d* : We immediately have the following deÖnition of equilibrium

DeÖnition 108 A sequential markets equilibrium are allocations for the house-
hold (c(t); a(t))t2[0;1) ; allocations for the Örm (K(t); L(t))t2[0;1) and prices
(r(t); w(t))t2[0;1) such that

1. Given prices (r(t); w(t))t2[0;1) and h0 ; the allocation (c(t); a(t))t2[0;1)

maximizes (9:33) subject to (9:34); for all t; and (9:35) and c(t) % 0:

2. Given prices (r(t); w(t))t2[0;1) ; the allocation (K(t); L(t))t2[0;1) solves

(9:32)

3.

L(t) = ent
L(t)a(t) = K(t)
_
L(t)c(t) + K(t) + /K(t) = F (K(t); L(t))
1 7 The householdís budget constraint in aggregate (not per capita) terms is
_
C(t) + A(t) = L(t)w(t) + (r(t) # A) A(t)

Dividing by L(t) yields

_
A(t)
c(t) + = w(t) + (r(t) # A) a(t)
L(t)
_
A(t)
and expanding L(t)
gives the result in the main text.
228 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

This deÖnition is completely standard; the three market clearing conditions

are for the labor market, the capital market and the goods market, respec-
tively. Note that we can, as for the discrete time case, deÖne an Arrow-Debreu
equilibrium and show equivalence between Arrow-Debreu equilibria and sequen-
tial market equilibria under the imposition of the no Ponzi condition (9:35): A
heuristic argument will do here. Rewrite (9:34) as

c(t) = w(t) + (r(t) & /) a(t) & a(t)

_ & na(t)
Rt
then multiply both sides by e$ 0 (r(* )$n$O)d* and integrate from t = 0 to t = T
to get
Z T R
Z T Rt
$ 0t (r(* )$n$O)d*
c(t)e dt = w(t)e$ 0 (r(* )$n$O)d* dt (9.36)
0 0
Z T Rt
& _ & (r(t) & n & /) a(t)] e$
[a(t) 0
(r(* )$n$O)d*
dt
0

But if we deÖne Rt
F (t) = a(t)e$ 0
(r(* )$n$O)d*

then
Rt Rt
F 0 (t) = a(t)e
_ $ 0
(r(* )$n$O)d*
dt & a(t)e$ 0
(r(* )$n$O)d*
[r(t) & / & n]
Rt
$ (r(* )$n$O)d*
= [a(t)
_ & (r(t) & n & /) a(t)] e 0

so that (9:36) becomes

Z T Rt
Z T Rt
c(t)e$ 0 (r(* )$n$O)d* dt = w(t)e$ 0
(r(* )$n$O)d*
dt + F (0) & F (T )
0 0
Z T Rt RT
= w(t)e$ 0
(r(* )$n$O)d*
dt + a(0) & a(T )e$ 0
(r(* )$n$O)d*
0

Now taking limits with respect to T and using (9:35) yields

Z 1 Rt
Z 1 Rt
c(t)e$ 0 (r(* )$n$O)d* dt = w(t)e$ 0 (r(* )$n$O)d* dt + a(0)
0 0
Rt
or deÖning Arrow-Debreu prices as p(t) = e$ 0 (r(* )$O)d* we have
Z 1 Z 1
p(t)C(t)dt = p(t)L(t)w(t)dt + a(0)L(0)
0 0

where C(t) = L(t)c(t) and we used the fact that L(0) = 1: But this is a stan-
dard Arrow-Debreu budget constraint. Hence by imposing the correct no Ponzi
condition we have shown that the collection of sequential budget constraints is
equivalent to the Arrow Debreu budget constraint with appropriate prices
Rt
p(t) = e$ 0
(r(* )$O)d*
9.3. THE RAMSEY-CASS-KOOPMANS MODEL 229

The rest of the proof that the set of Arrow-Debreu equilibrium allocations equals
the set of sequential markets equilibrium allocations is obvious.18
We now want to characterize the equilibrium; in particular we want to show
that the resulting dynamic system is identical to that arising for the social
planner problem, suggesting that the welfare theorems hold for this economy.
From the Örmís problem we obtain
% &
K(t)
r(t) = FK (K(t); A(t)L(t)) = FK ;1 (9.37)
A(t)L(t)
= f 0 (h(t))

and by zero proÖts in equilibrium

w(t)L(t) = F (K(t); A(t)L(t)) & r(t)K(t) (9.38)

w(t)
!(t) = = f (h(t)) & f 0 (h(t))h(t)
A(t)
w(t) = A(t) (f (h(t)) & f 0 (h(t))h(t))

From the goods market equilibrium condition we Önd as before (by dividing by
A(t)L(t))
_
L(t)c(t) + K(t) + /K(t) = F (K(t); L(t))
h(t)
_ = f (h(t)) & (n + / + n)h(t) & i(t) (9.39)

Now we analyze the householdís decision problem. First we rewrite the utility
function and the householdís budget constraint in intensive form. Making the
assumption that the period utility is of CRRA form we again obtain (9:17):
With respect to the individual budget constraint we obtain (again by dividing
by A(t))

c(t) + a(t)
_ + na(t) = w(t) + (r(t) & /) a(t)
0(t)
_ = !(t) + (r(t) & (/ + n + g)) 0(t) & i(t)
a(t)
where 0(t) = A(t) : The individual state variable is the per-capita asset holdings
in intensive form 0(t) and the individual control variable is i(t): Forming the
Hamiltonian yields

H(t; 0; i; ,) = e$^/t U (i(t)) + ,(t) [!(t) + (r(t) & (/ + n + g)) 0(t) & i(t)]

The Örst order condition yields

e$^/t U 0 (i(t)) = ,(t) (9.40)

1 8 Note that no equilbrium can exist for prices satisfying
Rt
lim p(t)L(t) = lim e% 0 (r(* )%1%n)d* >0
t!1 t!1

because otherwise labor income of the family is unbounded.

230 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

and the time derivative of the Lagrange multiplier is given by

_
,(t) = & [r(t) & (/ + n + g)] ,(t) (9.41)

The transversality condition is given by

lim ,(t)0(t) = 0
t!1

Now we proceed as in the social planners case. We Örst di§erentiate (9:40) with
respect to time to obtain

_ &:
e$^/t U 00 (i(t))i(t) _
^e$^/t U 0 (i(t)) = ,(t)

and use this and (9:40) to substitute out for the costate variable in (9:41) to
obtain
_
,(t)
= & [r(t) & (/ + n + g)]
,(t)
_
U 00 (i(t))i(t)
= &^
:+ 0
U (i(t))
_i(t)
= &^
:&=
i(t)
or
_ 1
i(t) = [r(t) & (/ + n + g + :
^)] i(t)
=
Note that this condition has an intuitive interpretation: if the interest rate is
higher than the e§ective subjective time discount factor, the individual values
consumption tomorrow relatively higher than the market and hence i(t) _ > 0;
i.e. consumption is increasing over time.
Finally we use the proÖt maximization conditions of the Örm to substitute
r(t) = f 0 (h(t)) to obtain

_ 1
i(t) = [f 0 (h(t)) & (/ + n + g + :
^)] i(t)
=
Combining this with the resource constraint (9:39) gives us the same dynamic
system as for the social planners problem, with the same initial condition h(0) =
h0 : And given that the capital market clearing condition reads L(t)a(t) = K(t)
or 0(t) = h(t) the transversality condition is identical to that of the social
planners problem. Obviously the competitive equilibrium allocation coincides
with the (unique) Pareto optimal allocation; in particular it also possesses the
saddle path property. Competitive equilibrium prices are simply given by

r(t) = f 0 (h(t))
w(t) = A(t) (f (h(t)) & f 0 (h(t))h(t))
9.4. ENDOGENOUS GROWTH MODELS 231

Note in particular that real wages are growing at the rate of technological
progress along the balanced growth path. This argument shows that in con-
trast to the OLG economies considered before here the welfare theorems apply.
In fact, this section should be quite familiar to you; it is nothing else but a
repetition of Chapter 3 in continuous time, executed to make you familiar with
continuous time optimization techniques. In terms of economics, the current
model provides a micro foundation of the basic Solow model. It removes the
problem of a constant, exogenous saving rate. However the engine of growth
is, as in the Solow model, exogenously given technological progress. The next
step in our analysis is to develop models that do not assume economic growth,
but rather derive it as an equilibrium phenomenon. These models are therefore
called endogenous growth models (as opposed to exogenous growth models).

9.4 Endogenous Growth Models

The second main problem of the Solow model, which is shared with the Cass-
Koopmans model of growth is that growth is exogenous: without exogenous
technological progress there is no sustained growth in per capita income and
consumption. In this sense growth in these models is more assumed rather
than derived endogenously as an equilibrium phenomenon. The key assumption
driving the result, that, absent technological progress the economy will converge
to a no-growth steady state is the assumption of diminishing marginal product
to the production factor that is accumulated, namely capital. As economies
grow they accumulate more and more capital, which, with decreasing marginal
products, yields lower and lower returns. Absent technological progress this
force drives the economy to the steady state. Hence the key to derive sustained
growth without assuming it being created by exogenous technological progress
is to pose production technologies in which marginal products to accumulable
factors are not driven down as the economy accumulates these factors.
We will start our discussion of these models with a stylized version of the
so called AK-model, then turn to models with externalities as in Romer (1986)
and Lucas (1988) and Önally look at Romerís (1990) model of endogenous tech-
nological progress.

9.4.1 The Basic AK-Model

Even though the basic AK-model may seem unrealistic it is a good Örst step to
analyze the basic properties of most one-sector competitive endogenous growth
models. The basic structure of the economy is very similar to the Cass-Koopmans
model. Assume that there is no technological progress. The representative
household again grows in size at population growth rate n > 0 and its prefer-
ences are given by
Z 1
c(t)1$0
U (c) = e$/t dt
0 1&=
232 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

Its budget constraint is again given by

c(t) + a(t)
_ + na(t) = w(t) + (r(t) & /) a(t)

with initial condition a(0) = k0 : We impose the same condition to rule out Ponzi
schemes as before Rt
lim a(t)e$ 0 (r(* )$O$n)d* % 0
t!1

The main di§erence to the previous model comes from the speciÖcation of tech-
nology. We assume that output is produced by a constant returns to scale
technology only using capital

Y (t) = AK(t)

The aggregate resource constraint is, as before, given by

_
K(t) + /K(t) + C(t) = Y (t)

This completes the description of the model. The deÖnition of equilibrium is

completely standard and hence omitted. Also note that this economy does not
feature externalities, tax distortions or the like that would invalidate the welfare
theorems. So we could, in principle, solve a social planners problem to obtain
equilibrium allocations and then Önd supporting prices. Given that for this
economy the competitive equilibrium itself is straightforward to characterize we
will take a shot at it directly.
Letís Örst consider the household problem. Forming the Hamiltonian and
carrying out the same manipulations as for the Cass-Koopmans model yields as
Euler equation (note that there is no technological progress here)

1
c(t)
_ = [r(t) & (n + / + :)] c(t)
=
c(t)
_ 1
f c (t) = = [r(t) & (n + / + :)]
c(t) =

The transversality condition is given as

lim ,(t)a(t) = lim e$/t c(t)$0 a(t) (9.42)

t!1 t!1

The representative Örmís problem is as before

max AK(t) & r(t)K(t) & w(t)L(t)

K(t);L(t)-0

and yields as marginal cost pricing conditions

r(t) = A
w(t) = 0
9.4. ENDOGENOUS GROWTH MODELS 233

Hence the marginal product of capital and therefore the real interest rate are
constant across time, independent of the level of capital accumulated in the
economy. Plugging into the consumption Euler equation yields

c(t)
_ 1
f c (t) = = [A & (n + / + :)]
c(t) =

i.e. the consumption growth rate is constant (always, not only along a balanced
growth path) and equal to A & (n + / + :): Integrating both sides with respect
to time, say, until time t yields
1
c(t) = c(0)e ' [A$(n+O+/)]t (9.43)

where c(0) is an endogenous variable that yet needs to be determined. We now

make the following assumptions on parameters

[A & (n + / + :)] > 0 (9.44)

. /
1&= :
A & (n + /) & = e<0 (9.45)
= 1&=

The Örst assumption, requiring that the interest rate exceeds the population
growth rate plus the time discount rate, will guarantee positive growth of per
capita consumption. It basically requires that the production technology is pro-
ductive enough to generate sustained growth. The second assumption assures
that utility from a consumption stream satisfying (9:43) remains bounded since
Z 1 Z 1 1#'
c(t)1$0 c(0)1$0 e ' [A$(n+O+/)]t
e$/t dt = e$/t dt
0 1&= 0 1&=
Z
c(0)1$0 1 [ 1#' <
= e ' [A$(n+O)$ 1#' ]]t dt
1&= 0
. /
1&= :
< 1 if and only if A & (n + /) & <0
= 1&=

From the aggregate resource constraint we have

_
K(t) + /K(t) + C(t) = AK(t)
_
c(t) + k(t) = Ak(t) & (n + /)k(t) (9.46)

Dividing both sides by k(t) yields

_
k(t) c(t)
f k (t) = = A & (n + /) &
k(t) k(t)

In a balanced growth path f k (t) is constant over time, and hence k(t) is pro-
portional to c(t); which implies that along a balanced growth path

f k (t) = f c (t) = A & (n + / + :)

234 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

i.e. not only do consumption and capital grow at constant rates (this is by
deÖnition of a balanced growth path), but they grow at the same rate A & (n +
/ + :): We already saw that consumption always grows at a constant rate in
this model. We will now argue that capital does, too, right away from t = 0: In
other words, we will show that transition to the (unique) balanced growth path
is immediate.
Plugging in for c(t) in equation (9:46) yields
1
_
k(t) = &c(0)e ' [A$(n+O+/)]t + Ak(t) & (n + /)k(t)

which is a Örst order nonhomogeneous di§erential equation. The general solution

to the homogeneous equation is

kg (t) = C1 e(A$n$O)t

A particular solution to the nonhomogeneous equation is (verify this by plugging

into the di§erential equation)
1
&c(0)e ' [A$(n+O+/)]t
kp (t) =
e
Hence the general solution to the di§erential equation is given by
c(0) 1 [A$(n+O+/)]t
k(t) = C1 e(A$n$O)t & e'
e
h i
/
where e = 1$0
0 A & (n + /) & 1$0 < 0: Now we use that in equilibrium a(t) =
k(t): From the transversality condition we have that, using (9:43)
. /
$/t $0 $/t $0 $[A$(n+O+/)]t (A$n$O)t c(0) 1 [A$(n+O+/)]t
lim e c(t) k(t) = lim e c(0) e C1 e & e '
t!1 t!1 e
.
c(0)
lim e[$/$A+n+O+/+ ' [A$(n+O+/)
1
= c(0)$0 C1 lim e[$/$A+n+O+/+A$n$O]t &
t!1 e t!1
. /
c(0) 1#' <
= c(0)$0 C1 & lim e ' [A$(n+O)$ 1#' ] = 0 if and only if C1 = 0
e t!1
because of the assumed inequality in (9:45): Hence
c(0) 1 [A$(n+O+/)]t c(t)
k(t) = & e' =&
e e
i.e. the capital stock is proportional to consumption. Since we already found
that consumption always grows at a constant rate f c = A & (n + / + :); so does
k(t): The initial condition k(0) = k0 determines the level of capital, consump-
tion c(0) = &ek(0) and output y(0) = Ak(0) that the economy starts from;
subsequently all variables grow at constant rate f c = f k = f y : Note that in this
model the transition to a balanced growth path from any initial condition k(0)
is immediate.
9.4. ENDOGENOUS GROWTH MODELS 235

In this simple model we can explicitly compute the saving rate for any point
in time. It is given by

Y (t) & C(t) Ak(t) & c(t) e

s(t) = = = 1 + = s 2 (0; 1)
Y (t) Ak(t) A

i.e. the saving rate is constant over time (as in the original Solow model and
in contrast to the Cass-Koopmans model where the saving rate is only constant
along a balanced growth path).
In the Solow and Cass-Koopmans model the growth rate of the economy was
given by f c = f k = f y = g; the growth rate of technological progress. In particu-
lar, savings rates, population growth rates, depreciation and the subjective time
discount rate a§ect per capita income levels, but not growth rates. In contrast,
in the basic AK-model the growth rate of the economy is a§ected positively by
the parameter governing the productivity of capital, A and negatively by para-
meters reducing the willingness to save, namely the e§ective depreciation rate
/ + n and the degree of impatience :: Any policy a§ecting these parameters in
the Solow or Cass-Koopmans model have only level, but no growth rate e§ects,
but have growth rate e§ects in the AK-model. Hence the former models are
sometimes referred to as ìincome level modelsî whereas the others are referred
to as ìgrowth rate modelsî.
With respect to their empirical predictions, the AK-model does not predict
convergence. Suppose all countries share the same characteristics in terms of
technology and preferences, and only di§er in terms of their initial capital stock.
The Solow and Cass-Koopmans model then predict absolute convergence in in-
come levels and higher growth rates in poorer countries, whereas the AK-model
predicts no convergence whatsoever. In fact, since all countries share the same
growth rate and all economies are on the balanced growth path immediately,
initial di§erences in per capita capital and hence per capita income and con-
sumption persist forever and completely. The absence of decreasing marginal
products of capital prevents richer countries to slow down in their growth process
as compared to poor countries. If countries di§er with respect to their charac-
teristics, the Solow and Cass-Koopmans model predict conditional convergence.
The AK-model predicts that di§erent countries grow at di§erent rates. Hence
it may be possible that the gap between rich and poor countries widen or that
poor countries take over rich countries. Hence one important test of these two
competing theories of growth is an empirical exercise to determine whether we
in fact see absolute and/or conditional convergence. Note that we discuss the
predictions of the basic AK-model with respect to convergence at length here
because the following, more sophisticated models will share the qualitative fea-
tures of the simple model.

9.4.2 Models with Externalities

The main assumption generating sustained growth in the last chapter was the
presence of constant returns to scale with respect to production factors that
236 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

are, in contrast to raw labor, accumulable. Otherwise eventually decreasing

marginal products set in and bring the growth process to a halt. One obvious
unsatisfactory element of the previous model was that labor was not needed
for production and that therefore the capital share equals one. Even if one
interprets capital broadly as including physical capital, this assumption may be
rather unrealistic. We, i.e. the growth theorist faces the following dilemma:
on the one hand we want constant returns to scale to accumulable factors, on
the other hand we want labor to claim a share of income, on the third hand
we canít deal with increasing returns to scale on the Örm level as this destroys
existence of competitive equilibrium. (At least) two ways out of this problem
have been proposed: a) there may be increasing returns to scale on the Örm
level, but the Örm does not perceive it this way because part of its inputs come
from positive externalities beyond the control of the Örm b) a departure from
perfect competition towards monopolistic competition. We will discuss the main
contributions in both of these proposed resolutions.

Romer (1986)
We consider a simpliÖed version of Romerís (1986) model. This model is very
similar in spirit and qualitative results to the one in the previous section. How-
ever, the production technology is modiÖed in the following form. Firms are
indexed by i 2 [0; 1]; i.e. there is a continuum of Örms of measure 1 that behave
competitively. Each Örm produces output according to the production function

yi (t) = F (ki (t); li (t)K(t))

where kiR(t) and li (t) are labor and capital input of Örm i; respectively, and
K(t) = ki (t)di is the average capital stock in the economy at time t: We
assume that Örm i; when choosing capital input ki (t), does not take into account
the e§ect of ki (t) on K(t):19 We make the usual assumption on F : constant
returns to scale with respect to the two inputs ki (t) and li (t)K(t); positive but
decreasing marginal products (we will denote by F1 the partial derivative with
respect to the Örst, by F2 the partial derivative with respect to the second
argument), and Inada conditions.
Note that F exhibits increasing returns to scale with respect to all three
factors of production

F (,ki (t); ,li (t),K(t)) = F (,ki (t); ,2 li (t)K(t)) > ,F (ki (t); li (t)K(t)) for all , > 1
F (,ki (t); , [li (t)K(t)]) = ,F (ki (t); li (t)K(t))

but since the Örm does not realize its impact on K(t); a competitive equilibrium
will exist in this economy. It will, however, in general not be Pareto optimal.
1 9 Since we assume that there is a continuum of Örms this assumption is completely rigourous
as Z 1 Z 1
ki (t)di = ~i (t)di
k
0 0
~i (t) for all but countably many agents.
as long as ki (t) = k
9.4. ENDOGENOUS GROWTH MODELS 237

This is due to the externality in the production technology of the Örm: a higher
aggregate capital stock makes individual Örmís workers more productive, but
Örms do not internalize this e§ect of the capital input decision on the aggregate
capital stock. As we will see, this will lead to less investment and a lower capital
stock than socially optimal.
The household sector is described as before, with standard preferences and
initial capital endowments k(0) > 0. For simplicity we abstract from population
growth (you should work out the model with population growth). However we
assume that the representative household in the economy has a size of L identical
people (we will only look at type identical allocations). We do this in order to
discuss ìscale e§ectsî, i.e. the dependence of income levels and growth rates on
the size of the economy.
Since this economy is not quite as standard as before we deÖne a competitive
equilibrium

DeÖnition 109 A competitive equilibrium are allocations (^ c(t); a

^(t))t2[0;1) for
^ ^
the representative household, allocations (ki (t); li (t))t2[0;1);i2[0;1] for Örms, an
^ t2[0;1) and prices (^
aggregate capital stock K(t) r(t); w(t))
^ t2[0;1) such that

1. Given (^
r(t); w(t))
^ t2[0;1) (^
c(t); a
^(t))t2[0;1) solve
Z 1
c(t)1$0
max e$/t dt
(c(t);a(t))t2[0;1) 0 1&=
s.t. c(t) + a(t)
_ = w(t)
^ + (^
r(t) & /) a(t) with a(0) = k(0) given
c(t) % 0
Rt
lim a(t)e$ 0
(^
r (* )$O)d*
% 0
t!1

2. Given r^(t); w(t)

^ ^
and K(t) for all t and all i; k^i (t); ^li (t) solve

max ^
F (ki (t); li (t)K(t)) & r^(t)ki (t) & w(t)l
^ i (t)
ki (t);li (t)-0

3. For all t
Z 1
L^ b_
c(t) + K(t) ^
+ K(t)/(t) = F (k^i (t); ^li (t)K(t))di
^
0
Z 1
^li (t)di = L
0
Z 1
k^i (t)di = L^
a(t)
0

4. For all t
Z 1
k^i (t)di = K(t)
^
0
238 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

The Örst element of the equilibrium deÖnition is completely standard. In

the Örmís maximization problem the important feature is that the equilibrium
average capital stock is taken as given by individual Örms. The market clearing
conditions for goods, labor and capital are straightforward. Finally the last
condition imposes rational expectations: what individual Örms perceive to be
the average capital stock in equilibrium is the average capital stock, given the
Örmsí behavior, i.e. equilibrium capital demand.

Given that all L households are identical it is straightforward to deÖne a

Pareto optimal allocation and it is easy to see that it must solve the following
9.4. ENDOGENOUS GROWTH MODELS 239

social planners problem20

Z 1
c(t)1$0
max e$/t dt
(c(t);K(t))t2[0;1) -0 0 1&=
_
s.t. Lc(t) + K(t) + /K(t) = F (K(t); K(t)L) with K(0) = Lk(0) given

Note that the social planner, in contrast to the competitively behaving Örms,
internalizes the e§ect of the average (aggregate) capital stock on labor produc-
tivity. Let us start with this social planners problem. Forming the Hamiltonian
and manipulation the optimality conditions yields as socially optimal growth
2 0 The social planner has the power to dictate how much each Örm produces and how much

inputs to allocate to that Örm. Since production has no intertemporal links it is obvious
that the planners maximization problem can solved in two steps: Örst the planner decides on
aggregate variables c(t) and K(t) and then she decides how to allocate aggregate inputs L
and K(t) between Örms. The second stage of this problem is therefore
Z 1 % *Z 1 +&
max F ki (t); li (t) kj (t)dj di
li (t);ki (t)(0 0 0
Z 1
s.t. ki (t) = K(t)
0
Z 1
li (t) = L(t)
0

i.e. given the aggregate amount of capital chosen the planner decides how to best allocate it.
Let ! and / denote the Lagrange multipliers on the two constraints.
First order conditions with respect to li (t) imply that

F2 (ki (t); li (t)K(t)) K(t) = /

or, since F2 is homogeneous of degree zero

% &
ki (t)
F2 ; K(t) K(t) = /
li (t)
which indicates that the planner allocates inputs so that each Örm has the same capital labor
ratio. Denote this common ratio by
ki (t)
\ = for all i 2 [0; 1]
li (t)
K(t)
=
L
But then total output becomes
Z 1 % *Z 1 +& Z 1 K(t)
F ki (t); li (t) kj (t)dj di = ki (t)F (1; )di
0 0 0 \
K(t)
= F (1; )K(t)
\
F (K(t); K(t)L)

How much production the planner allocates to each Örm hence does not matter; the only
important thing is that she equalizes capital-labor ratios across Örms. Once she does, the
production possibilies for any given choice of K(t) are given by F (K(t); K(t)L):
240 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

rate for consumption

c(t)
_ 1
f SP
c (t) = = [F1 (K(t); K(t)L) + F2 (K(t); K(t)L)L & (/ + :)]
c(t) =
Note that, since F is homogeneous of degree one, the partial derivatives are
homogeneous of degree zero and hence
K(t)L K(t)L
F1 (K(t); K(t)L) + F2 (K(t); K(t)L)L = F1 (1; ) + F2 (1; )L
K(t) K(t)
= F1 (1; L) + F2 (1; L)L

and hence the growth rate of consumption

c(t)
_ 1
= [F1 (1; L) + F2 (1; L)L & (/ + :)]
c(t) =
is constant over time. By dividing the aggregate resource constraint by K(t) we
Önd that
c(t) _
K(t)
L + + / = F (1; L)
K(t) K(t)
and hence along a balanced growth path f SP SP SP
K = f k = f c : As before the tran-
sition to the balanced growth path is immediate, which can be shown invoking
the transversality condition as before.
Now letís turn to the competitive equilibrium. From the household problem
we immediately obtain as Euler equation
c(t)
_ 1
f CE
c (t) = = [r(t) & (/ + :)]
c(t) =
The Örmís proÖt maximization condition implies

r(t) = F1 (ki (t); li (t)K(t))

But since all Örms are identical and hence choose the same allocations21 we have
that
Z 1
ki (t) = k(t) = k(t)di = K(t)
0
li (t) = L

and hence
r(t) = F1 (K(t); K(t)L) = F1 (1; L)
Hence the growth rate of per capita consumption in the competitive equilibrium
is given by
c(t)
_ 1
f CE
c (t) = = [F1 (1; L) & (/ + :)]
c(t) =
2 1 This is without loss of generality. As long as Örms choose the same capital-labor ratio

(which they have to in equilibrium), the scale of operation of any particular Örm is irrelevant.
9.4. ENDOGENOUS GROWTH MODELS 241

and is constant over time, not only in the steady state. Doing the same ma-
nipulation with resource constraint we see that along a balanced growth path
the growth rate of capital has to equal the growth rate of consumption, i.e.
f CE
K = fk
CE
= f CE
c : Again, in order to obtain sustained endogenous growth we
have to assume that the technology is su¢ciently productive, or

F1 (1; L) & (/ + :) > 0

Using arguments similar to the ones above we can show that in this economy
transition to the balanced growth path is immediate, i.e. there are no transition
dynamics.
Comparing the growth rates of the competitive equilibrium with the socially
optimal growth rates we see that, since F2 (1; L)L > 0 the competitive economy
grows ine¢ciently slow, i.e. f CE
c < f SP
c : This is due to the fact that competi-
tive Örms do not internalize the productivity-enhancing e§ect of higher average
capital and hence under-employ capital, compared to the social optimum. Put
otherwise, the private returns to investment (saving) are too low, giving rise to
underinvestment and slow capital accumulation. Compared to the competitive
equilibrium the planner chooses lower period zero consumption and higher in-
vestment, which generates a higher growth rate. Obviously welfare is higher in
the socially optimal allocation than under the competitive equilibrium alloca-
tion (since the planner can always choose the competitive equilibrium allocation,
but does not Önd it optimal in general to do so). In fact, under special func-
tional form assumptions on F we could derive both competitive and socially
optimal allocations directly and compare welfare, showing that the lower initial
consumption level that the social planner dictates is more than o§set by the
subsequently higher consumption growth.
An obvious next question is what type of policies would be able to remove
the ine¢ciency of the competitive equilibrium? The answer is obvious once we
realize the source of the ine¢ciency. Firms do not take into account the exter-
nality of a higher aggregate capital stock, because at the equilibrium interest
rate it is optimal to choose exactly as much capital input as they do in a com-
petitive equilibrium. The private return to capital (i.e. the private marginal
product of capital in equilibrium equals F1 (1; L) whereas the social return equals
F1 (1; L) + F2 (1; L)L: One way for the Örms to internalize the social returns in
their private decisions is to pay them a subsidy of F2 (1; L)L for each unit of
capital hired. The Örm would then face an e§ective rental rate of capital of

r(t) & F2 (1; L)L

per unit of capital hired and would hire more capital. Since all factor payments
go to private households, total capital income from a given Örm is given by
[r(t) + F2 (1; L)L] ki (t); i.e. given by the (now lower) return on capital plus the
subsidy. The higher return on capital will induce the household to consume less
and save more, providing the necessary funds for higher capital accumulation.
These subsidies have to be Önanced, however. In order to reproduce the so-
cial optimum as a competitive equilibrium with subsidies it is important not to
242 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

introduce further distortions of private decisions. A lump sum tax on the repre-
sentative household in each period will do the trick, not however a consumption
tax (at least not in general) or a tax that taxes factor income at di§erent rates.
The empirical predictions of the Romer model with respect to the conver-
gence discussion are similar to the predictions of the basic AK-model and hence
not further discussed. An interesting property of the Romer model and a whole
class of models following this model is the presence of scale e§ects. Realiz-
ing that F1 (1; L) = F1 ( L1 ; 1) and F1 (1; L) + F2 (1; L)L = F (1; L) (by Eulerís
theorem) we Önd that

@f CE
c 1
= & F11 (1; L) > 0
@L =L2
@f SP
c F2 (1; L)
= >0
@L =
i.e. that the growth rate of a country should grow with its size (more precisely,
with the size of its labor force). This result is basically due to the fact that the
higher the number of workers, the more workers beneÖt form the externality of
the aggregate (average) capital stock. Note that this scale e§ect would vanish if,
instead of the aggregate capital stock K the aggregate capital stock per worker
K
L would generate the externality. The prediction of the model that countries
with a bigger labor force are predicted to grow faster has led some people to
dismiss this type of endogenous models as empirically relevant. Others have
tried, with some, but not big success, to Önd evidence for a scale e§ect in the
data. The question seems unsettled for now, but I am sceptical whether this
prediction of the model(s) can be identiÖed in the data.

Lucas (1988)
Whereas Romer (1986) stresses the externalities generated by a high economy-
wide capital stock, Lucas (1988) focuses on the e§ect of externalities generated
by human capital. You will write a good thesis because you are around a
bunch of smart colleagues with high average human capital from which you can
learn. In other respects Lucasí model is very similar in spirit to Romer (1986),
unfortunately much harder to analyze. Hence we will only sketch the main
elements here.
The economy is populated by a continuum of identical, inÖnitely lived house-
holds that are indexed by i 2 [0; 1]: They value consumption according to stan-
dard CRRA utility. There is a single consumption good in each period. Individ-
uals are endowed with hi (0) = h0 units of human capital and ki (0) = k0 units
of physical capital. In each period the households make the following decisions

7 what fraction of their time to spend in the production of the consumption

good, 1 & si (t) and what fraction to spend on the accumulation of new
human capital, si (t): A household that spends 1 & si (t) units of time in
the production of the consumption good and has a level of human capital
9.4. ENDOGENOUS GROWTH MODELS 243

of hi (t) supplies (1 & si (t))hi (t) units of e§ective labor, and hence total
labor income is given by (1 & si (t))hi (t)w(t)

7 how much of the current labor income to consume and how much to save
for tomorrow

The budget constraint of the household is then given as

ci (t) + a_ i (t) = (r(t) & /)ai (t) + (1 & si (t))hi (t)w(t)

Human capital is assumed to accumulate according to the accumulation equa-

tion
h_ i (t) = ]hi (t)si (t) & /hi (t)

where ] > 0 is a productivity parameter for the human capital production

function. Note that this formulation implies that the time cost needed to acquire
an extra 1% of human capital is constant, independent of the level of human
capital already acquired. Also note that for human capital to the engine of
sustained endogenous economic growth it is absolutely crucial that there are no
decreasing marginal products of h in the production of human capital; if there
were then eventually the growth in human capital would cease and the growth
in the economy would stall.
A household then maximizes utility by choosing consumption ci (t); time al-
location si (t) and asset levels ai (t) as well as human capital levels hi (t); subject
to the budget constraint, the human capital accumulation equation, a standard
no-Ponzi scheme condition and nonnegativity constraints on consumption as
well as human capital, and the constraint si (t) 2 [0; 1]: There is a single repre-
sentative Örm that hires labor L(t) and capital K(t) for rental rates r(t) and
w(t) and produces output according to the technology

Y (t) = AK(t)' L(t)1$' H(t)%

where 0 2 (0; 1); ( > 0: Note that the Örm faces a production externality in that
R1
the average level of human capital in the economy, H(t) = 0 hi (t)di enters the
production function positively. The Örm acts competitive and treats the average
(or aggregate) level of human capital as exogenously given. Hence the Örmís
problem is completely standard. Note, however, that because of the externality
in production (which is beyond the control of the Örm and not internalized
by individual households, although higher average human capital means higher
wages) this economy again will feature ine¢ciency of competitive equilibrium
allocations; in particular it is to be expected that the competitive equilibrium
features underinvestment in human capital.
The market clearing conditions for the goods market, labor market and
244 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

capital market are

Z 1
_
ci (t)di + K(t) + /K(t) = AK(t)' L(t)1$' H(t)%
0
Z 1
(1 & si (t)hi (t)) di = L(t)
0
Z 1
ai (t)di = K(t)
0

Rational expectations require that the average level of human capital that is
expected by Örms and households coincides with the level that households in
fact choose, i.e.
Z 1
hi (t)di = H(t)
0

The deÖnition of equilibrium is then straightforward as is the deÖnition of a

Pareto optimal allocation (if, since all agents are ex ante identical, we conÖne
ourselves to type-identical allocations, i.e. all individuals have the same welfare
weights in the objective function of the social planner). The social planners
problem that solves for Pareto optimal allocations is given as
Z 1
c(t)1$0
max e$/t dt
(c(t);s(t);H(t);K(t))t2[0;1) -0 0 1&=
_
s.t. c(t) + K(t) + /K(t) = AK(t)' ((1 & s(t)H(t))1$' H(t)% with K(0) = k0 given
_
H(t) = ]H(t)s(t) & /H(t) with H(0) = h0 given
s(t) 2 [0; 1]

This model is already so complex that we canít do much more than simply
determine growth rates of the competitive equilibrium and a Pareto optimum,
compare them and discuss potential policies that may remove the ine¢ciency
of the competitive equilibrium. In this economy a balanced growth path is an
allocation (competitive equilibrium or social planners) such that consumption,
physical and human capital and output grow at constant rates (which need not
equal each other) and the time spent in human capital accumulation is constant
over time.
Letís start with the social plannerís problem. In this model we have two
state variables, namely K(t) and H(t); and two control variables, namely s(t)
and c(t): Obviously we need two co-state variables and the whole dynamical
system becomes more messy. Let ,(t) be the co-state variable for K(t) and 1(t)
the co-state variable for H(t): The Hamiltonian is 1_

H(c(t); s(t); K(t); H(t); ,(t); 1(t); t)

c(t)1$0 h i
1$'
= e$/t + ,(t) AK(t)' ((1 & s(t)H(t)) H(t)% & /K(t) & c(t)
1&=
+1(t) []H(t)s(t) & /H(t)]
9.4. ENDOGENOUS GROWTH MODELS 245

The Örst order conditions are

e$/t c(t)$0 = ,(t) (9.47)

" #
' 1$' %
AK(t) ((1 & s(t)H(t)) H(t)
1(t)]H(t) = ,(t)(1 & 0) (9.48)
(1 & s(t))

The co-state equations are

" #
' 1$'
_,(t) = &,(t)0 AK(t) ((1 & s(t)H(t)) H(t)%
&/ (9.49)
K(t)
" #
1$'
AK(t)' ((1 & s(t)H(t)) H(t)%
1(t)
_ = &,(t)(1 & 0 + () & 1(t) []s(t) & /]
H(t)
(9.50)
1$'
DeÖne Y (t) = AK(t)' ((1 & s(t)H(t)) H(t)% : Along a balanced growth path
we have

Y_ (t)
= f Y (t) = f Y
Y (t)
c(t)
_
= f c (t) = f c
c(t)
_
K(t)
= f K (t) = f K
K(t)
_
H(t)
= f H (t) = f H
H(t)
_
,(t)
= f S (t) = f S
,(t)
1(t)
_
= f & (t) = f &
1(t)
s(t) = s

Letís focus on BGPís. From the deÖnition of Y (t) we have (by log-di§erentiating)

f Y = af K + (1 & 0 + ()f H (9.51)

From the human capital accumulation equation we have

f H = ]s & / (9.52)

From the Euler equation we have

. /
1 Y (t)
fc = 0 & (/ + :) (9.53)
= K(t)
246 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

and hence
fY = fK (9.54)
From the resource constraint it then follows that

fc = fY = fK (9.55)

and therefore
1&0+(
fK = fH (9.56)
1&0
From the Örst order conditions we have

fS = &: & =f c (9.57)

f& = fS + fY & fH (9.58)

S(t)
Divide (9:47) by 1(t) and isolate &(t) to obtain

,(t) ]H(t)(1 & s(t))

=
1(t) (1 & 0)Y (t)

Do the same with (9:50) to obtain

,(t) # $ H(t)
= & f& + fH
1(t) (1 & 0 + ()Y (t)

Equating the last two equations yields

# $
f& + fH ](1 & s)
& =
(1 & 0 + () (1 & 0)

Using (9:58) and (9:55) and (9:52) and (9:56) we Önally arrive at
. /
1 (] & /)(1 & 0 + ()
fc = &:
= 1&0

The other growth rates and the time spent with the accumulation of human
capital can then be easily deduced form the above equations. Be aware of the
algebra.
In general, due to the externality the competitive equilibrium will not be
Pareto optimal; in particular, agents may underinvest into human capital. From
the Örms problem we obtain the standard conditions (from now on we leave out
the i index for households
Y (t)
r(t) = 0
K(t)
Y (t) Y (t)
w(t) = (1 & 0) = (1 & 0)
L(t) (1 & s(t))h(t)
9.4. ENDOGENOUS GROWTH MODELS 247

Form the Lagrangian for the representative household with state variables
a(t); h(t) and control variables s(t); c(t)
c(t)1$0
H = e$/t + ,(t) [(r(t) & /) a(t) + (1 & s(t))h(t)w(t) & c(t)]
1&=
+1(t) []h(t)s(t) & /h(t)]
The Örst order conditions are
e$/t c(t)$0 = ,(t) (9.59)
,(t)h(t)w(t) = 1(t)]h(t) (9.60)
and the derivatives of the co-state variables are given by
_
,(t) = &,(t)(r(t) & /) (9.61)
1(t)
_ = &,(t)(1 & s(t))w(t) & 1(t)(]s(t) & /) (9.62)
Imposing balanced growth path conditions gives
1
fc = (&f S & :)
=
fS = f& & fw = f& & fY + fh
fc = fY = fK
1&0
fh = f
1&0+( Y
Hence % &
(
fS = f& & fc
1&0+(
Using (9:60) and (9:62) we Önd
f& = / & ]
and hence
% &
1 (
fc = (] & f c & (: + :))
= 1&0+(
1
f CE
c = %
(] & (: + :))
= + 1$'+%
Compare this to the growth rate a social planner would choose
. /
SP 1 (] & /)(1 & 0 + ()
fc = &:
= 1&0
We note that if ( = 0 (no externality), then both growth rates are identical ((as
they should since then the welfare theorems apply). If, however ( > 0 and the
externality from human capital is present, then if both growth rates are positive,
tedious algebra can show that f CE c < f SP
c : The competitive economy grows
slower than optimal since the private returns to human capital accumulation are
lower than the social returns (agents donít take the externality into account) and
hence accumulate to little human capital, lowering the growth rate of human
capital.
248 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

9.4.3 Models of Technological Progress Based on Monop-

olistic Competition: Variant of Romer (1990)
In this section we will present a model in which technological progress, and hence
economic growth, is the result of a conscious e§ort of proÖt maximizing agents
to invent new ideas and sell them to other producers, in order to recover their
costs for invention.22 We envision a world in which competitive software Örms
hire factor inputs to produce new software, which is then sold to intermediate
goods producers who use it in the production of a new intermediate good, which
in turn is needed for the production of a Önal good which is sold to consumers.
In this sense the Romer model (and its followers, in particular Jones (1995))
are sometimes referred to as endogenous growth models, whereas the previous
growth models are sometimes called only semi-endogenous growth models.

Setup of the Model

Production in the economy is composed of three sectors. There is a Önal goods
producing sector in which all Örms behave perfectly competitive. These Örms
have the following production technology
Z ! 1#=
*
A(t)
Y (t) = L(t)1$' xi (t)1$& di
0

where Y (t) is output, L(t) is labor input of the Önal goods sector and xi (t) is
the input of intermediate good i in the production of Önal goods. &1 is elasticity
of substitution between two inputs (i.e. measures the slope of isoquants), with
1 = 0 being the special case in which intermediate inputs are perfect substi-
tutes. For 1 ! 1 we approach the Leontie§ technology. Evidently this is a
constant returns to scale technology, and hence, without loss of generality we
can normalize the number of Önal goods producers to 1.
At time t there is a continuum of di§erentiated intermediate goods indexed
by i 2 [0; A(t)]; where A(t) will evolve endogenously as described below. Let
A0 > 0 be the initial level of technology. Technological progress in this model
takes the form of an increase in the variety of intermediate goods. For 0 < 1 < 1
this will expand the production possibility frontier (see below). We will assume
this restriction on 1 to hold.
Each di§erentiated product is produced by a single, monopolistically com-
petitive Örm. This Örm has bought the patent for producing good i and is the
only Örm that is entitled to produce good i: The fact, however, that the in-
termediate goods are substitutes in production limits the market power of this
Örm. Each intermediate goods Örm has the following constant returns to scale
production function to produce the intermediate good
xi (t) = ali (t)
2 2 I changed and simpliÖed the model a bit, in order to obtain analytic solutions and make

results coparable to previous sections. The model is basically a continuous time version of the
model described in Jones and Manuelli (1998), section 6.
9.4. ENDOGENOUS GROWTH MODELS 249

where li (t) is the labor input of intermediate goods producer i at date t and
a > 0 is a technology parameter, common across Örms, that measures labor
productivity in the intermediate goods sector. We assume that the intermediate
goods producers act competitively in the labor market
Finally there is a sector producing new ìideasî, patents to new intermediate
products. The technology for this sector is described by
_
A(t) = bX(t)
Note that this technology faces constant returns to scale in the production of
new ideas in that X(t) is the only input in the production of new ideas. The
parameter b measures the productivity of the production of new ideas: if the
ideas producers buy X(t) units of the Önal good for their production of new
ideas, they generate bX(t) new ideas.

Plannerís Problem
Before we go ahead and more fully describe the equilibrium concept for this
economy we Örst want to solve for Pareto-optimal allocations. As usual we
specify consumer preferences as
Z 1
c(t)1$0
u(c) = e$/t dt
0 1&=
The social planner then solves23
Z 1
c(t)1$0
max e$/t dt
c(t);li (t);xi (t);A(t);L(t);X(t)-0 0 1&=
Z ! 1#=
*
A(t)
s.t. c(t) + X(t) = L(t)1$' xi (t)1$& di
0
Z A(t)
L(t) + li (t)di = 1
0
xi (t) = ali (t) for all i 2 [0; A(t)]
_
A(t) = bX(t)
This problem can be simpliÖed substantially. Since 1 2 (0; 1) it is obvious
that xi (t) = xj (t) = x(t) for all i; j 2 [0; A(t)] and li (t) = lj (t) = l(t) for
all i; j 2 [0; A(t)]:24 . Also use the fact that L(t) = 1 & A(t)l(t) to obtain the
2 3 Note that there is no physical capital in this model. Romer (1990) assumes that inter-

mediate goods producers produce a durable intermediate good that they then rent out every
period. This makes the intermediate goods capital goods, which slightly complicates the
analysis of the model. See the original article for further details.
2 4 Suppose there are only two intermediate goods and one wants to

2
! 1#=
*
X
max ali (t)1%4
l1 (t);l2 (t)(0
i=1
s.t. l1 (t) + l2 (t) = L
250 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

constraint set
Z ! 1#=
*
A(t)
1$' 1$&
c(t) + X(t) = L(t) xi (t) di
0
Z ! 1#=
*
A(t)
1$' 1$&
= L(t) (al(t)) di
0
% &1$& ! 1#=
*

1$' 1 & L(t)

= L(t) A(t) a
A(t)
*=
'
= a' L(t)1$' (1 & L(t)) A(t) 1#=
_
A(t) = bX(t)
Finally we note that the optimal allocation of labor solves the static problem of
'
max L(t)1$' (1 & L(t))
L(t)2[0;1]

with solution L(t) = 1 & 0: So Önally we can write the social planners problem
as
Z 1
c(t)1$0
u(c) = e$/t dt
0 1&=
_
A(t)
s.t. c(t) + = CA(t)^ (9.63)
b
'&
where C = aa (1 & 0)1$' 0' and ^ = 1$& > 0 and with A(0) = A0 given. Note
that if 0 < 1 < 1; this model boils down to the standard Cass-Koopmans model,
whereas if ^ = 1 we obtain the basic AK-model. Finally, if ^ > 1 the model
will exhibit accelerating growth. Forming the Hamiltonian and manipulating
the Örst order conditions yields
1) *
f c (t) = b^CA(t)^$1 & :
=
Hence along a balanced growth path A(t)^$1 has to remain constant over time.
From the ideas accumulation equation we Önd
_
A(t) bX(t)
=
A(t) A(t)
For ! 2 (0; 1) the isoquant
2
! 1#=
*
X
1%4
ali (t) =C>0
i=1
is strictly convex, with slope strictly bigger than one in absolute value. Given the above con-
straint, the maximum is interior and the Örst order conditions imply l1 (t) = l2 (t) immediately.
The same logic applies to the integral, where, strictly speaking, we have to add an ìalmost
everywhereî (since sets of Lebesgue measure zero leave the integral unchanged). Note that
for ! ) 0 the above argument doesnít work as we have corner solutions.
9.4. ENDOGENOUS GROWTH MODELS 251

which implies that along a balanced growth path X and A grow at the same
rate. Dividing () by A(t) yields

c(t) _
A(t)
+ = CA(t)^$1
A(t) bA(t)

which implies that c grows at the same rate as A and X:

We see that for ^ < 1 the economy behaves like the neoclassical growth
model: from A(0) = A0 the level of technology converges to the steady state A*
satisfying

b^C
1$^ = :
(A* )
X* = 0
^
c* = C (A* )

Without exogenous technological progress sustained economic growth in per

capita income and consumption is infeasible; the economy is saddle path stable
as the Cass-Koopmans model.
If ^ = 1; then the balanced growth path growth rate is
1
f c (t) = [b^C & :] > 0
=
provided that the technology producing new ideas, manifested in the parameter
b, is productive enough to sustain positive growth. Now the model behaves as
the AK-model, with constant positive growth possible and immediate conver-
gence to the balanced growth path. Note that a condition equivalent to (9:45)
is needed to ensure convergence of the utility generated by the consumption
stream. Finally, for ^ > 1 (and A0 > 1) we can show that the growth rate of
'&
consumption (and income) increases over time. Remember again that ^ = 1$& ;
which, a priori, does not indicate the size of ^: What empirical predictions the
model has therefore crucially depends on the magnitudes of the capital share 0
and the intratemporal elasticity of substitution between inputs, 1:

Decentralization
We have in mind the following market structure. There is a single representative
Önal goods producing Örm that faces the constant returns to scale production
technology as discussed above. The Örm sells Önal output at time t for price p(t)
and hires labor L(t) for a (nominal) wage w(t): It also buys intermediate goods
of all varieties for prices pi (t) per unit. The Önal goods Örm acts competitively
in all markets. The Önal goods producer makes zero proÖts in equilibrium (re-
member CRTS). The representative producer of new ideas in each period buys
Önal goods X(t) as inputs for price p(t) and sells a new idea to a new interme-
diate goods producer for price h(t): The idea producer behaves competitively
and makes zero proÖts in equilibrium (remember CRTS). There is free entry
252 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

in the intermediate goods producing sector. Each new intermediate goods pro-
ducer has to pay the Öxed cost h(t) for the idea and will earn subsequent proÖts
Q(< ); < % t since he is a monopolistic competition, by hiring labor li (t) for
wage w(t) and selling output xi (t) for price pi (t): Each intermediate producer
takes as given the entire demand schedule of the Önal producer xdi (&
!p (t)); where
!
& !
&
p = (p; w; (pi )i2[0;A(t)] : We denote by p $1 all prices but the price of inter-
mediate good i: Free entry drives net proÖts to zero, i.e. equates h(t) and the
(appropriately discounted) stream of future proÖts. Now letís deÖne a mar-
ket equilibrium (note that we canít call it a competitive equilibrium anymore
because the intermediate goods producers are monopolistic competitors).

DeÖnition 110 A market equilibrium is prices (^ p(t); h

^ (t); p^i (t)i2[0;A(t) ; w(t))
^ t2[0;1) ;
allocations for the household c^(t)t2[0;1) ; demands for the Önal goods producer
^ &
(L( ! ^di (&
p (t)); x !
p (t))i2[0;A(t)] )t2[0;1) ; allocations for the intermediate goods pro-
xi (t); ^li (t))i2[0;A(t) )t=[0;1) and allocations for the idea producer (A(t);
ducers ((^ s ^ ^
X(t)) t=[0;1)
such that

1. Given h
^ (0); (^
p(t); w(t))
^ t2[0;1) ; c
^(t)t2[0;1) solves
Z 1
c(t)1$0
max e$/t dt
c(t)-0 0 1&=
Z 1 Z 1
s.t. p(t)c(t)dt = w(t)dt + h
^ (0)A0
0 0

!
&
2. For each i; t; given p^ $i (t); w(t);
^ ^di (&
and x ! xsi (t); ^li (t); p^i (t)) solves
p (t); (^
!
&
Q
^ i (t) = max pi (t)xdi ( p^ (t)) & w(t)li (t)
xi (t);li (t);pi (t)-0
!
&
s.t. xi (t) = xdi ( p^ (t))
xi (t) = ali (t)

3. For each t; and each !

& ^ &
p % 0; (L(! ^di (&
p (t)); x !
p (t)) solves

Z ^
! 1#=
*
Z ^
A(t) A(t)
1$' 1$&
max p^(t)L(t) xi (t) di &w(t)L(t)&
^ p^i (t)xi (t)di
L(t);xi (t)-0 0 0

4. Given (^ ^
p(t); c^(t))t2[0;1 ; (A(t); ^
X(t))t=[0;1) solves

Z 1 Z 1
max _ &
c(t)A(t) p(t)X(t)dt
0 0
_
s.t. A(t) = bX(t) with A(0) = A0 given
9.4. ENDOGENOUS GROWTH MODELS 253

5. For all t

Z ^
! 1#=
*
A(t)
^ !
L(
&
p^ (t))1$'
&
!
^di ( p^ (t))1$& di
x ^ + c^(t)
= X(t)
0
!
& ^
^si (t)
x ^di ( p^ (t)) for all i 2 [0; A(t)]
= x
Z ^
A(t)
^ +
L(t) ^li (t)di = 1
0

^
6. For all t; all i 2 A(t)

Z 1
h
^ (t) = Q
^ i (< )d<
t

Several remarks are in order. First, note that in this model there is no phys-
ical capital. Hence the household only receives income from labor and from
selling initial ideas (of course we could make the idea producers own the ini-
tial ideas and transfer the proÖts from selling them to the household). The
key equilibrium condition involves the intermediate goods producers. They, by
assumption, are monopolistic competitors and hence can set prices, taking as
given the entire demand schedule of the Önal goods producer. Since the inter-
mediate goods are substitutes in production, the demand for intermediate good
i depends on all intermediate goods prices. Note that the intermediate goods
producer can only set quantity or price, the other is dictated by the demand of
the Önal goods producer. The required labor input follows from the production
technology. Since we require the entire demand schedule for the intermediate
goods producers we require the Önal goods producer to solve its maximization
problem for all conceivable (positive) prices. The proÖt maximization require-
ment for the ideas producer is standard (remember that he behave perfectly
competitive by assumption). The equilibrium conditions for Önal goods, inter-
mediate goods and labor market are straightforward. The Önal condition is
the zero proÖt condition for new entrants into intermediate goods production,
stating that the price of the pattern must equal to future proÖts.
It is in general very hard to solve for an equilibrium explicitly in these type
of models. However, parts of the equilibrium can be characterized quite sharply;
in particular optimal pricing policies of the intermediate goods producers. Since
the di§erentiated product model is widely used, not only in growth, but also
in monetary economics and particularly in trade, we want to analyze it more
carefully.
254 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

Letís start with the Önal goods producer. First order conditions with respect
to L(t) and xi (t) entail25
Z A(t) ! 1#=
*

(1 & 0)p(t)Y (t)

w(t) = (1 & 0)p(t)L(t)$' xi (t)1$& di = (9.64)
0 L(t)
Z ! 1#=
*
$1
A(t)
pi (t) = 0p(t)L(t)1$' xi (t)1$& di xi (t)$& (9.65)
0

or
Z ! 1#=
*
$1
A(t)
& 1$' 1$&
xi (t) pi (t) = 0p(t)L(t) xi (t) di for all i 2 [0; A(t)]
0

0p(t)Y (t)
= R A(t)
0
xi (t)1$& di
Hence the demand for input xi (t) is given by
% & =1 ! =1
p(t) 0Y (t)
xi (t) = R A(t) (9.66)
pi (t) xi (t)1$& di
0
% & =1
p(t) =+*#1 (1#=)(1#*)
= 0Y (t) *= L(t) *= (9.67)
pi (t)
As it should be, demand for intermediate input i is decreasing in its relative
price pp(t)
i (t)
: Now we proceed to the proÖt maximization problem of the typical
intermediate goods Örm. Taking as given the demand schedule derived above,
the Örm solves (using the fact that xi (t) = ali (t)
w(t)xi (t)
max pi (t)xi (t) &
pi (t) a
% &
w(t)
= xi (t) pi (t) &
a
The Örst order condition reads (note that pi (t) enters xi (t) as shown in (9:67)
% &
1 w(t)
xi (t) & xi (t) pi (t) & =0
1pi (t) a
and hence
1 w(t)
1 = &
1 1api (t)
w(t)
pi (t) = (9.68)
a(1 & 1)
2 5 Strictly speaking we should worry about corners. However, by assumption ! 2 (0; 1) will

assure that for equilibrium prices corners donít occur

9.4. ENDOGENOUS GROWTH MODELS 255

A perfectly competitive Örm would have price pi (t) equal marginal cost w(t) a :
The pricing rule of the monopolistic competitor is very simple, he charges a
1
constant markup 1$& > 1 over marginal cost. Note that the markup is the
lower the lower 1: For the special case in which the intermediate goods are
perfect substitutes in production, 1 = 0 and there is no markup over marginal
cost. Perfect substitutability of inputs forces the monopolistic competitor to
behave as under perfect competition. On the other hand, the closer 1 gets to
1 (in which case the inputs are complements), the higher the markup the Örms
can charge. Note that this pricing policy is valid not only in a balanced growth
path. indicating that
Another important implication is that all Örms charge the same price, and
therefore have the same scale of production. So let x(t) denote this common
w(t)
output of Örms and p~(t) = a(1$&) the common price of intermediate producers.
ProÖts of every monopolistic competitor are given by

w(t)x(t)
Q(t) = p~(t)x(t) &
a
= 1x(t)~
p(t)
10p(t)Y (t)
= (9.69)
A(t)

We see that in the case of perfect substitutes proÖts are zero, whereas proÖts
increase with declining degree of substitutability between intermediate goods.26
Using the above results in equations (9:64) and (9:66) yields

w(t)L(t) = (1 & 0)p(t)Y (t) (9.70)

A(t)x(t)~
p(t) = 0p(t)Y (t) (9.71)

We see that for the Önal goods producer factor payments to labor, w(t)L(t) and
to intermediate goods, A(t)x(t)~p(t); exhaust the value of production p(t)Y (t)
so that proÖts are zero as they should be for a perfectly competitive Örm with
constant returns to scale. From the labor market equilibrium condition we Önd

A(t)x(t)
L(t) = 1 & (9.72)
a
and output is given from the production function as
*
Y (t) = L(t)1$' x(t)' A(t) 1#= (9.73)

and is used for consumption and investment into new ideas

Y (t) = c(t) + X(t) (9.74)

2 6 This is not a precise argument. One has to consider the general equilibrium e§ects of

changes in ! on p(t); Y (t); A(t) which is, in fact, quite tricky.

256 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

We assumed that the ideas producer is perfectly competitive. Then it follows

immediately, given the technology

_
A(t) = bX(t)
Z t
A(t) = A(0) + X(< )d< (9.75)
0

that
p(t)
h(t) = (9.76)
b
The zero proÖt-free entry condition then reads (using (9:69))
Z 1
p(t) p(< )Y (< )
= 10 d< (9.77)
h t A(< )

Finally, let us look at the household maximization problem. Note that, in

the absence of physical capital or any other long-lived asset household problem
does not have any state variable. Hence the household problem is a standard
maximization problem, subject to a single budget constraint. Let , be the
Lagrange multiplier associated with this constraint. The Örst order condition
reads
e$/t c(t)$0 = ,p(t)

Di§erentiating this condition with respect to time yields

&=e$/t c(t)$0$1 c(t)

_ & :e$/t c(t)$0 = ,p(t)
_

and hence % &

c(t)
_ 1 p(t)
_
= & &: (9.78)
c(t) = p(t)
i.e. the growth rate of consumption equals the rate of deáation minus the time
discount rate. In summary, the entire market equilibrium is characterized by the
10 equations (9:68) and (9:70) to (9:78) in the 10 variables x(t); c(t); X(t); Y (t);
L(t); A(t); h(t); p(t); w(t); p~(t); with initial condition A(0) = A0 : Since it is, in
principle, extremely hard to solve this entire system we restrict ourselves to a
few more interesting results.
First we want to solve for the fraction of labor devoted to the production of
Önal goods, L(t): Remember that the social planner allocated a fraction 1 & 0 of
all labor to this sector. From (9:72) we have that L(t) = 1 & A(t)x(t) a : Dividing
(9:71) by (9:70) yields

0 A(t)x(t)~
p(t) A(t)x(t)
= =
1&0 w(t)L(t) aL(t)(1 & 1)
A(t)x(t) 0(1 & 1)L(t)
=
a 1&0
9.4. ENDOGENOUS GROWTH MODELS 257

and hence

A(t)x(t) 0(1 & 1)L(t)

L(t) = 1& =1&
a 1&0
1&0
L(t) = >1&0
1 & 01

Hence in the market equilibrium more workers work in the Önal goods sector
and less in the intermediate goods sector than socially optimal. The intuition
for this is simple: since the intermediate goods sector is monopolistically com-
petitive, prices are higher than optimal (than social shadow prices) and output
is lower than optimal; di§erently put, Önal goods producers substitute away
from expensive intermediate goods into labor. Obviously labor input in the
intermediate goods sector is lower than in the social optimum and hence

AM E (t)xM E (t) < ASP (t)xSP (t)

Again these relationships hold always, not just in the balanced growth path.
Now letís focus on a balanced growth path where all variables grow at con-
1$'
stant, possibly di§erent rate. Obviously, since L(t) = 1$'& we have that gL = 0:
From the labor market equilibrium gA = &gx : From constant markup pricing we
have gw = gp~: From (9:75) we have gA = gX and from the resource constraint
(9:74) we have gA = gX = gc = gY : Then from (9:70) and (9:71) we have that

gw = gY + gP
gp~ = gY + gP

From the production function we Önd that

0
gY = 0gx + gA
1&1
01
= gA
1&1

'&
Hence a balanced growth path exists if and only if gY = 0 or ^ = 1$& = 1:
The Örst case corresponds to the standard Solow or Cass-Koopmans model: if
^ < 1 the model behaves as the neoclassical growth model with asymptotic
convergence to the no-growth steady state (unless there is exogenous techno-
logical progress). The case ^ = 1 delivers (as in the social planners problem)
a balanced growth path with sustained positive growth, whereas ^ > 1 yields
explosive growth (for the appropriate initial conditions).
Y (t)
Letís assume ^ = 1 for the moment. Then gY = gA and hence A(t) =
Y (0)
A0 =constant. The no entry-zero proÖt condition in the BGP can be written
258 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY

as, since p(< ) = p(t)egp (* $t) for all < % t

Z
p(t) Y (0) 1
= 10 p(t)gp (* $t) d<
b A0 t
Y (0)
1 = &b10
A0 gp
% &
p(t)
_ Y (0)
gp = = & b10 <0
p(t) A0
Finally, from the consumption Euler equation
% &
1 Y (0)
gc = b10 &:
= A0
But now note that
*
Y (0) = L(0)1$' x(0)' A(0) 1#=
*=
'
= L(0)1$' (x(0)A(0)) A(0) 1#=
'
= L(0)1$' (x(0)A(0)) A(0)
under the assumption that ^ = 1: Hence, using (9:72)
Y (0) '
= L(0)1$' (x(0)A(0))
A0
'
= L(0)1$' (a(1 & L(0))
= L(0)a'
1&0 a
= a
1 & 01
Therefore Önally
% &
1 1&0
gc = gY = gA = baa 10 &:
= 1 & 01
is the competitive equilibrium growth rate in the balanced growth path under
the assumption that ^ = 1: Comparing this to the growth rate that the social
planner would choose
1) a *
f c (t) = ba (1 & 0)1$' 0' & :
=
We see that for 10 $ 1 the social planner would choose a higher balanced
growth path growth rate than the market equilibrium BGP growth rate. The
market power of the intermediate goods producers leads to lower production of
intermediate goods and hence less resources for consumption and new inventions,
which drive growth in this model.27
2 7 Note however that there is an e§ect of market power in the opposite direction. Since in the

market equilibrium the intermediate goods producers make proÖts due to their (competitive)
monopoly position, and the ideas inventors can extract these proÖts by selling new designs,
due to the free entry condition, they have too big an incentive to invent new intermediate
goods, relative to the social optimum. For big ! and big % this may, in fact, lead to an
ine¢ciently high growth rate in the market equilibrium.
9.4. ENDOGENOUS GROWTH MODELS 259

This completes our discussion of endogenous growth theory. The Romer-type

model discussed last can, appropriately interpreted, nest the standard Solow-
Cass-Koopmans type neoclassical growth models as well as the early AK-type
growth models. In addition it achieves to make the growth rate of the economy
truly endogenous: the economy grows because inventors of new ideas consciously
expend resources to develop new ideas and sell them to intermediate producers
that use them in the production of a new product.
260 CHAPTER 9. CONTINUOUS TIME GROWTH THEORY
Chapter 10

Bewley Models

In this section we will look at a class of models that take a Örst step at explain-
ing the distribution of wealth in actual economies. So far our models abstracted
from distributional aspects. As standard in macro up until the early 90ís our
models had representative agents, that all faced the same preferences, endow-
ments and choices, and hence received the same allocations. Obviously, in such
environments one cannot talk meaningfully about the income distribution, the
wealth distribution or the consumption distribution. One exception was the
OLG model, where, at a given point of time we had agents that di§ered by age,
and hence di§ered in their consumption and savings decisions. However, with
only two (groups of) agents the cross sectional distribution of consumption and
wealth looks rather sparse, containing only two points at any time period.
We want to accomplish two things in this section. First, we want to summa-
rize the main empirical facts about the current U.S. income and wealth distrib-
ution. Second we want to build a class of models which are both tractable and
whose equilibria feature a nontrivial distribution of wealth across agents. The
basic idea is the following. The is a continuum of agents that are ex ante iden-
tical and all have a stochastic endowment process that follow a Markov chain.
Then endowments are realized in each period, and it so happens that some
agents are lucky and get good endowment realizations, others are unlucky and
get bad endowment realizations. The aggregate endowment is constant across
time. If there was a complete set of Arrow-Debreu contingent claims, then peo-
ple would simple insure each other against the endowment shocks and we would
be back at the standard representative agent model. We will assume that peo-
ple cannot insure against these shocks (for reasons exogenous from the model),
in that we close down all insurance markets. The only Önancial instrument
that agents, by assumption, can use to hedge against endowment uncertainty
are one period bonds (or IOUís) that yield a riskless return r: In other words,
agents can only self -insure by borrowing and lending at a risk free rate r: In
addition, we impose tight limits on how much people can borrow (otherwise,
it turns out, self-insurance (almost) as good as insuring with Arrow-Debreu
claims). As a result, agents will accumulate wealth, in the form of bonds, to

261
262 CHAPTER 10. BEWLEY MODELS

hedge against endowment uncertainty. Those agents with a sequence of good

endowment shocks will have a lot of wealth, those with a sequence of bad shocks
will have low wealth (or even debt). Hence the model will use as input an ex-
ogenously speciÖed stochastic endowment (income) process, and will deliver as
output an endogenously derived wealth distribution.
To analyze these models we will need to keep track of the characteristics of
each agent at a given point of time, which, in most cases, is at least the current
endowment realization and the current wealth position. Since these di§er across
agents, we need an entire distribution (measure) to keep track of the state of the
economy. Hence the richness of the model with respect to distributional aspects
comes at a cost: we need to deal with entire distributions as state variables,
instead of just numbers as the capital stock. Therefore the preparation with
respect to measure theory in recitation

10.1 Some Stylized Facts about the Income and

Wealth Distribution in the U.S.
In this section we describe the main stylized facts characterizing the U.S. income
and wealth distribution.1 For data on the income and wealth distribution we
have to look beyond the national income and product accounts (NIPA) data,
since NIPA only contains aggregated data. What we need are data on income
and wealth of a sample of individual families.

10.1.1 Data Sources

For the U.S. there are three main data sets

7 the Survey of Consumer Finances (SCF). The SCF is conducted in three

year intervals; the four available surveys are for the years 1989, 1992,
1995 and 1998. It is conducted by the National Opinion Research cen-
ter at the University of Chicago and sponsored by the Federal Reserve
system. It contains rich information about U.S. householdsí income and
wealth. In each survey about 4,000 households are asked detailed ques-
tions about their labor earnings, income and wealth. One part of the
sample is representative of the U.S. population, to give an accurate de-
scription of the entire population. The second part oversamples rich house-
holds, to get a more precise idea about the precise composition of this
groupsí income and wealth composition. As we will see, this group ac-
counts for the majority of total household wealth, and hence it is partic-
ularly important to have good information about this group. The main
advantage of the SCF is the level of detail of information about income
and wealth. The main disadvantage is that it is not a panel data set,
i.e. households are not followed over time. Hence dynamics of income
1 This section summarizes the basic Öndings of Diaz-Gimenez, Quadrini and Rios-Rull

(1997).
10.1. SOME STYLIZED FACTS ABOUT THE INCOME AND WEALTH DISTRIBUTION IN THE U.S.263

and wealth accumulation cannot be documented on the household level

with this data set. For further information and some of the data see
http://www.federalreserve.gov/pubs/oss/oss2/98/scf98home.html

7 the Panel Study of Income Dynamics (PSID). It is conducted by the Sur-

vey Research Center of the University of Michigan and mainly sponsored
by the National Science Foundation. The PSID is a panel data set that
started with a national sample of 5,000 U.S. households in 1968. The
same sample individuals are followed over the years, barring attrition due
to death or nonresponse. New households are added to the sample on
a consistent basis, making the total sample size of the PSID about 8700
households. The income and wealth data are not as detailed as for the
SCF, but its panel dimension allows to construct measures of income and
wealth dynamics, since the same households are interviewed year after
year. Also the PSID contains data on consumption expenditures, al-
beit only food consumption. In addition, in 1990, a representative na-
tional sample of 2,000 Latinos, di§erentially sampled to provide adequate
numbers of Puerto Rican, Mexican-American, and Cuban-Americans, was
added to the PSID database. This provides a host of information for stud-
ies on discrimination. For further information and the complete data set
see http://www.isr.umich.edu/src/psid/index.html

7 the Consumer Expenditure Survey (CEX) or (CES). The CEX is con-

ducted by the U.S. Bureau of the Census and sponsored by the Bureau
of Labor statistics. The Örst year the survey was carried out was 1980.
The CEX is a so-called rotating panel: each household in the sample is
interviewed for four consecutive quarters and then rotated out of the sur-
vey. Hence in each quarter 20% of all households is rotated out of the
sample and replaced by new households. In each quarter about 3000 to
5000 households are in the sample, and the sample is representative of
the U.S. population. The main advantage of the CEX is that it contains
very detailed information about consumption expenditures. Information
about income and wealth is inferior to the SCF and PSID, also the panel
dimension is signiÖcantly shorter than for the PSID (one household is only
followed for 4 quarters). Given our focus on income and wealth we will
not use the CEX here, but anyone writing a paper about consumption will
Önd the CEX an extremely useful data set. For further information and
the complete data set see http://www.stats.bls.gov/csxhome.htm.

10.1.2 Main Stylized Facts

We will look at facts for three variables, earnings, income and wealth. Letís Örst
deÖne how we measure these variables in the data.

DeÖnition 111 We deÖne the following variables as

264 CHAPTER 10. BEWLEY MODELS

1. Earnings: Wages, Salaries of all kinds, plus a fraction 0.864 of business

income (such as income from professional practices, business and farm
sources)
2. Income: All kinds of household revenues before taxes, including: wages
and salaries, a fraction of business income (as above), interest income,
dividends, gains or losses from the sale of stocks, bonds, and real es-
tate, rent, trust income and royalties from any other investment or busi-
ness, unemployment and worker compensation, child support and alimony,
aid to dependent children, aid to families with dependent children, food
stamps and other forms of welfare and assistance, income form social
security and other pensions, annuities, compensation for disabilities and
retirement programs, income from all other sources including settlements,
prizes, scholarships and grants, inheritances, gifts and so forth.
3. Wealth: Net worth of households, deÖned as the value of all real and Ö-
nancial assets of all kinds net of all the kinds of debts. Assets considered
are: residences and other real estate, farms and other businesses, checking
accounts, certiÖcates of deposit, and other bank accounts, IRA/Keogh ac-
counts, money market accounts, mutual funds, bonds and stocks, cash and
call money at the stock brokerage, all annuities, trusts and managed in-
vestment accounts, vehicles, the cash value of term life insurance policies,
money owed by friends, relatives and businesses, pension plans accumu-
lated in accounts.
So, roughly, earnings correspond to labor income before taxes, income corre-
sponds to household income before taxes and wealth corresponds to marketable
assets. Now turn to some stylized facts about the distribution of these variables
across U.S. households

Measures of Concentration
In this section we use data from the SCF. We measure the dispersion of the
earnings, income and wealth distribution in a cross section of households by
several measures. Let the sample of size n, assumed to be representative of the
population, be given by fx1 ; x2 ; : : : xn g; where x is the variable of interest (i.e.
earnings, income or wealth). DeÖne by
n
1X
x
8 = xi
n i=1
v
u n
u1 X
= t
2
std(x) (xi & x
8)
n i=1

the mean and the standard deviation. A commonly reported measure of disper-
sion is the coe¢cient of variation cv(x)
std(x)
cv(x) =
x8
10.1. SOME STYLIZED FACTS ABOUT THE INCOME AND WEALTH DISTRIBUTION IN THE U.S.265

A second commonly used measure is the Gini coe¢cient and the associated
Lorenz curve. To derive the Lorenz curve we do the following. We Örst order
fx1 ; x2 ; : : : xn g by size in ascending order, yielding
P
fy1 ; y2 ; : : : yn g: The Lorenz
i
i yj
curve then plots Pj=1
n; i 2 f1; 2 : : : ng against zi = n
j=1 yj : In other words, it plots
the percentile of households against the fraction of total wealth (if x measures
wealth) that this percentile of households holds. For example, if n = 100 then
i = 5 corresponds to the 5 percentile of households. Note that, since the yi
are ordered ascendingly, zi $ 1; zi+1 % zi and that zn = 1: The closer the
Lorenz curve is to the 45 degree line, the more equal is x distributed. The Gini
coe¢cient is two times the area between the Lorenz curve and the 45 degree
line. If x % 0; then the Gini coe¢cient falls between zero and 1; with higher Gini
coe¢cients indicating bigger concentration of earnings, income or wealth. As
extremes, for complete equality of x the Gini coe¢cient is zero and for complete
concentration (the richest person has all earnings, income, wealth) the Gini
coe¢cient is 1:2 .
Figure 26 and Table 4 summarize the main stylized facts with respect to the
concentration of earnings, income and wealth from the 1992 SCF

Table 4
Top 1% M ean
Variable Mean Gini cv Bottom 40% Loc. of Mean M edian
Earnings $ 33; 074 0:63 4:19 211 65% 1:65
Income $ 45; 924 0:57 3:86 84 71% 1:72
Wealth $ 184; 308 0:78 6:09 875 80% 3:61

We observe the following stylized facts

7 There is substantial variability in earnings, income and wealth across U.S.

households. The standard deviation of earnings, for example, is about $
140; 000. The top 1% of earners on average earn 21; 100% more than the
bottom 40%; the corresponding number for income is still 8; 400%:

7 Wealth is by far the most concentrated of the three variables, followed

by earnings and income. That income is most equally distributed across
households makes sense as income includes payments from government
insurance programs. The distribution would be even less dispersed if we
would look at income after taxes, due to the progressivity of the tax code.
Since wealth is accumulated past income minus consumption, it also makes
intuitive sense that it is most most concentrated. For example, the top
1% households of the wealth distribution hold about 30% of total wealth.

7 The distribution of all three variables is skewed. If the distributions were

symmetric, the median would equal the mean and the mean would be
2 Strictly speaking it approaches 1; as n ! 1 with complete concentration.
266 CHAPTER 10. BEWLEY MODELS

Lorenz Curves for Earnings , Incom e and Wealth for the US in 1992
100

80
% of Earnings, Income, Wealth Held

60

40

Wealth

20
Earnings

Incom e

-20
0 10 20 30 40 50 60 70 80 90 100
% of Hous eholds
10.1. SOME STYLIZED FACTS ABOUT THE INCOME AND WEALTH DISTRIBUTION IN THE U.S.267

located at the 50-percentile of the distribution. For all three variables the
mean is substantially higher than the median, which indicates skewness
to the right. In accordance with the last stylized fact, the distribution of
wealth is most skewed, followed by the distribution of earnings and the
distribution of income.

It is also instructive to look at the correlation between earnings, income and

wealth. In Table 5 we compute the pairwise correlation coe¢cients between
earnings, income and wealth. Remember that the correlation coe¢cient between
two variables x; y is given by

cov(x; y)
:(x; y) =
std(x) ) std(y)
1
Pn
(xi & x
8)(yi & y8)
= q P n i=1 q P
1 n n
n 8)2 ) n1 i=1 (yi & y8)2
i=1 (xi & x

Table 5

Variables :(x; y)
Earnings and Income 0:928
Earnings and Wealth 0:230
Income and Wealth 0:321

We see that earnings and income as almost perfectly correlated, which is

natural since the largest fraction of household income consists of earnings. The
almost perfect correlation indicates that transfer payments and capital income,
at least on average, do not constitute a major component of household income.
In fact, on average 72% of total income is accounted for by earnings in the
sample. On the other hand, wealth is only weakly positively correlated with
income and earnings. Wealth is the consequence of past income, and only to
the extent that current and past income and earnings are positively correlated
should wealth and earnings (income) by naturally positively correlated.3

Measures of Mobility
Not only is there a lot of variability in earnings, income and wealth across
households, but also a lot of dynamics within the corresponding distribution.
Some poor households get rich, some rich households get poor over time. In
Table 6 we report mobility matrices for earnings, income and wealth. The
tables are read as follows: a particular row indicates the probability of moving
from a particular quintile in 1984 to a particular quintile in 1989. Note that
for these matrices we used data from the PSID since the SCF does not have a
3 Wealth is measured as stock at the end of the period, so current income (earnings) con-

tibute to wealth accumulation during the period).

268 CHAPTER 10. BEWLEY MODELS

panel dimension and hence does not contain information about households at
two di§erent points of time, which is obviously necessary for studies of income,
earnings and wealth mobility.

Table 6

1984 1989 Quintile

Measure Quintile 1st 2nd 3rd 4th 5th
Earnings 1st 85.5% 11.6% 1.4% 0.6% 0.5%
2nd 16.8% 40.9% 30.0% 7.1% 3.4%
3rd 7.1% 12.0% 47.0% 26.2% 7.6%
4th 7.5% 6.8% 17.5% 46.5% 21.7%
5th 5.8% 4.1% 5.5% 18.3% 66.3%

Income 1st 71.0% 17.9% 7.0% 2.9% 1.3%

2nd 19.5% 43.8% 22.9% 10.1% 3.7%
3rd 5.1% 25.5% 37.2% 24.9% 7.3%
4th 2.5% 10.7% 23.4% 42.5% 20.8%
5th 1.9% 2.1% 9.5% 20.3% 66.3%

Wealth 1st 66.7% 23.4% 6.6% 2.9% 0.4%

2nd 25.4% 46.6% 20.4% 5.4% 2.3%
3rd 5.8% 24.4% 44.9% 20.5% 4.6%
4th 1.8% 4.6% 22.4% 49.6% 21.6%
5th 0.7% 0.8% 5.7% 21.6% 71.2%

In Table 7 we condition the sample on two factors. The Örst matrix computes
transition probabilities of earnings for people with positive earnings in both 1984
and 1989, i.e. Ölters out households all of which members are either retired
or unemployed in either of the years. This is done to get a clearer look at
earnings mobility of those actually working. The second matrix shows transition
probabilities for households with heads of so-called prime age, age between 35-
45.

Table 7
10.2. THE CLASSIC INCOME FLUCTUATION PROBLEM 269

1984 1989 Quintile

Type of Household Quintile 1st 2nd 3rd 4th 5th
with positive 1st 58.8% 25.1% 9.0% 5.1% 2.0%
earnings in 2nd 20.2% 45.6% 21.6% 8.6% 4.0%
both 1984 and 1989 3rd 9.7% 20.2% 40.4% 21.9% 7.8%
4th 7.7% 6.1% 20.0% 45.9% 20.4%
5th 3.6% 2.9% 9.0% 18.4% 66.1%

with heads 1st 63.3% 27.2% 4.0% 3.3% 2.3%

35-45 years old 2nd 23.6% 44.3% 22.3% 7.3% 2.4%
3rd 4.7% 16.7% 47.0% 25.1% 6.6%
4th 6.9% 8.1% 20.2% 44.6% 20.1%
5th 1.1% 4.0% 6.4% 19.1% 69.3%

We Önd the following stylized facts

7 There is substantial persistence of labor earnings, in particular at the

lowest and highest quintile. For the lowest quintile this may be due to
retirees and long-term unemployed. Stratifying the sample as in Table 7
indicates that this may be part of the explanation that 85:8% of all the
households that were in the lowest earnings quintile in 1984 are in the
lowest earnings quintile in 1989. But even looking at Table 7 there seems
to be substantial persistence of earnings at the low and high end, with
persistence being even more accentuated for prime-age households.

7 The persistence properties of income are similar to those of earnings, which

is understandable given the high correlation between income and earnings

7 Wealth seems to be more persistent than income and earnings.

Now let us start building a model that tries to explain the U.S. wealth
distribution, taking as given the earnings distribution, i.e. treating the earnings
distribution as an input in the model.

10.2 The Classic Income Fluctuation Problem

Bewley models study economies where a large number of agents face the classic
income áuctuation problem: they face a stochastic, exogenously given income
and interest rate process and decide how to allocate consumption over time,
i.e. how much of current income to consume and how much to save. So before
discussing the full-blown general equilibrium dynamics of the model, letís review
the basic results on the partial equilibrium income áuctuation problem.
270 CHAPTER 10. BEWLEY MODELS

The problem is to
T
X
max E0 ( t u(ct ) (10.1)
fct ;at+1 gT
t=0 t=0
s.t. ct + at+1 = yt + (1 + rt )at
at+1 % &b; ct % 0
a0 given
aT +1 = 0 if T Önite
Here fyt gTt=0 and frt gTt=0 are stochastic processes, b is a constant borrowing
constraint and T is the life horizon of the agent, where T = 1 corresponds to
the standard inÖnitely lived agent model. We will make the assumptions that
u is strictly increasing, strictly concave and satisÖes the Inada conditions. Note
that we will have to make further assumptions on the processes fyt g and frt g
to assure that the above problem has a solution.
Given that this section is thought of as a preparation for the general equilib-
rium of the Bewley model, and given that we will have to constrain ourselves to
stationary equilibria, we will from now on assume that frt gTt=0 is deterministic
and constant sequence, i.e. rt = r 2 (&1; 1); for all t:

10.2.1 Deterministic Income

Suppose that the income stream is deterministic, with yt % 0 for all t and yt > 0
for some t: Also assume that r > 0 and
T
X yt
+ (1 + r)a0 < 1
t=0
(1 + r)t

This constraint is obviously satisÖed if T is Önite. If T is inÖnite this constraint is

satisÖed whenever the sequence fyt g1 t=0 is bounded and r > 0; although weaker
restrictions are su¢cient, too.4
Note that under this assumption we can consolidate the budget constraints
to one Arrow-Debreu budget constraint
T
X X T
yt ct
a0 + t+1
=
t=0
(1 + r) t=0
(1 + r)t+1

and the implicit asset holdings at period t + 1 are (by summing up the budget
constraints from period t + 1 onwards)
T
X XT
c* y*
at+1 = * $t
&
* =t+1
(1 + r) * =t+1
(1 + r)* $t
4 For example, that y grows at a rate lower than the interest rate. Note that our assump-
t
tions serve two purposes, to make sure that the income áuctuation problem has a solution
and that it can be derived from the Arrow Debreu budget constraint. One can weaken the
assumptions if one is only interested in one of these purposes.
10.2. THE CLASSIC INCOME FLUCTUATION PROBLEM 271

Natural Debt Limit

Let the borrowing constraint be speciÖed as follows
T
X y*
b = & sup <1
t
* =t+1
(1 + r)* $t

where the last inequality follows from our assumptions made above.5 The key of
specifying the borrowing constraint in this form is that the borrowing constraint
will never be binding. Suppose it would at some date T . Then cT +* = 0 for
all < > 0; since the household has to spend all his income on repaying his debt
and servicing the interest payments, which obviously cannot be optimal, given
the assumed Inada conditions. Hence the optimal consumption allocation is
completely characterized by the Euler equations

u0 (ct ) = ((1 + r)u0 (ct+1 )

and the Arrow-Debreu budget constraint

T
X X T
yt ct
a0 + t+1
=
t=0
(1 + r) t=0
(1 + r)t+1
PT yt
DeÖne discounted lifetime income as Y = a0 + t=0 (1+r)t+1 ; then the optimal
consumption choices take the form

ct = ft (r; Y )

i.e. only depend on the interest rate and discounted lifetime income, and partic-
ular do not depend on the timing of income. This is the simplest statement of the
permanent income-life cycle (PILCH) hypothesis by Friedman and Modigliani
(and Ando and Brumberg). Obviously, since we discuss a model here the hy-
pothesis takes the form of a theorem.
1#'
For example, take u(c) = c1$0 ; then the Örst order condition becomes

c$0
t = ((1 + r)c$0
t+1
1
ct+1 = [((1 + r)] ' ct

and hence t
ct = [((1 + r)] ' c0
1
[%(1+r)] '
Provided that a = 1+r < 1 (which we will assume from now on)6 we Önd
5 For Önite T it would make sense to deÖne time-speciÖc borrowing limits b
t+1 : This ex-
tension is straightforward and hence omitted.
6 We also need to assume that
1
1 [b(1 + r)] ' < 1
to assure that the sum of utilities converges for T = 1: Obviously, for Önite T both assump-
tions are not necessary for the following analysis.
272 CHAPTER 10. BEWLEY MODELS

that
(1 + r)(1 & a)
c0 = Y
1 & aT +1
= f0;T Y
(1 + r)(1 & a) t
ct = T +1
[((1 + r)] ' Y
1&a
= ft;T Y

where ft;T is the marginal propensity to consume out of lifetime income in

period t if the lifetime horizon is T: We observe the following

1. If T > T~ then ft;T < ft;T~ : A longer lifetime horizon reduces the mar-
ginal propensity to consume out of lifetime income for a given lifetime
income. This is obvious in that consumption over a longer horizon has to
be Önanced with given resources.

2. If 1 + r < %1 then consumption is decreasing over time. If 1 + r > %1 then

consumption is increasing over time. If 1 + r = %1 then consumption is
constant over time. The more patient the agent is, the higher the growth
rate of consumption. Also, the higher the interest rate the higher the
growth rate of consumption.

3. If 1 + r = %1 then ft;T = fT , i.e. the marginal propensity to consume is

constant for all time periods.

4. If in addition = = 1 (iso-elastic utility) and T = 1, then f1 = r; i.e.

the household consumes the annuity value of discounted lifetime income:
ct = rY for all t % 0: This is probably the most familiar statement of the
PILCH hypothesis: agents should consume permanent income rY in each
period.

Potentially Binding Borrowing Limits

Let us make the same assumptions as before, but now assume that the borrowing
constraint is tighter than the natural borrowing limit. For simplicity assume
that the consumer is prevented from borrowing completely, i.e. assume b =
0, and assume that yt > 0 for all t % 0: We also assume that the sequence
fyt gTt=0 is constant at yt = y: Now in the optimization problem we have to take
the borrowing constraints into account explicitly. Forming the Lagrangian and
denoting by ,t the Lagrange multiplier for the budget constraint at time t and
by 1t the Lagrange multiplier for the non-negativity constraint for at+1 we have,
ignoring non-negativity constraints for consumption

T
X
L= ( t u(ct ) + ,t (yt + (1 + r)at & at+1 & ct ) + 1t at+1
t=0
10.2. THE CLASSIC INCOME FLUCTUATION PROBLEM 273

The Örst order conditions are

( t u0 (ct ) = ,t
t+1 0
( u (ct+1 ) = ,t+1
&,t + 1t + (1 + r),t+1 = 0

and the complementary slackness conditions are

at+1 1t = 0

or equivalently
at+1 > 0 implies 1t = 0

Combining the Örst order conditions yields

u0 (ct ) % ((1 + r)u0 (ct+1 )

= if at+1 > 0

Now suppose that ((1 + r) < 1: We will show that in Bewley models in general
equilibrium the endogenous interest rate r indeed satisÖes this restriction. We
distinguish two situations

1. The household is not borrowing-constrained in the current period, i.e.

at+1 > 0: Then under the assumption made about the interest rate ct+1 <
ct ; i.e. consumption is declining.

2. The household is borrowing constrained, i.e. at+1 = 0: He would like

to borrow and have higher consumption today, at the expense of lower
consumption tomorrow, but canít transfer income from tomorrow to today
because of the imposed constraint.

To deduce further properties of the optimal consumption-asset accumula-

tion decision we now make the income áuctuation problem recursive. For the
deterministic problem this may seem more complicated, but it turns out to be
useful and also a good preparation for the stochastic case. The Örst question
always is what the correct state variable of the problem is. At a given point of
time the past history of income is completely described by the current wealth
level at that the agents brings into the period. In addition what matters for his
current consumption choice is his current income yt : So we pose the following
functional equation(s)7

vt (at ; y) = max fu(ct ) + (vt+1 (at+1 ; y)g

at+1 ;ct -0

s.t. ct + at+1 = y + (1 + r)at

7 In the case of Önite T these are T distinct functional equations.
274 CHAPTER 10. BEWLEY MODELS

with a0 given. If the agentís time horizon is Önite and equal to T , we take
vT +1 (aT +1 ; y) ' 0: If T = 1; then we can skip the dependence of the value
functions and the resulting policy functions on time.8
The next steps would be to show the following

1. Show that the principle of optimality applies, i.e. that a solution to the
functional equation(s) one indeed solves the sequential problem deÖned in
(10:1):

2. Show that there exists a unique (sequence) of solution to the functional

equation.

3. Prove qualitative properties of the unique solution to the functional equa-

tion, such as v (or the vt ) being strictly increasing in both arguments,
strictly concave and di§erentiable in its Örst argument.

We will skip this here; most of the arguments are relatively straightforward
and follow from material in Chapter 3 of these notes.9 Instead we will assert
these propositions to be true and look at some results that they buy us. First we
observe that at and y only enter as sum in the dynamic programming problem.
Hence we can deÖne a variable xt = (1 + r)at + y; which we call, after Deaton
(1991) ìcash at handî, i.e. the total resources of the agent available for con-
sumption or capital accumulation at time t: The we can rewrite the functional
equation as

vt (xt ) = max fu(ct ) + (vt+1 (xt+1 )g

ct ;at+1 -0
s.t. ct + at+1 = xt
xt+1 = (1 + r)at+1 + y

or more compactly

vt (xt ) = max fu(xt & at+1 ) + (vt+1 ((1 + r)at+1 + y)g

0+at+1 +xt

8 For the Önite lifetime case, we could have assumed deterministically áucuating endow-

ments fyt gT t=0 , since we index value and policy function by time. For T = 1 in order to have
the value function independent of time we need stationarity in the underlying environment,
i.e. a constant income (in fact, with the introduction of further state variables we can handle
deterministic cycles in endowments).
9 What is not straightforward is to demonstrate that we have a bounded dynamic program-

ming problem, which obviously isnít a problem for Önite T; but may be for T = 1 since we
have not assumed u to be bounded. One trick that is often used is to put bounds on the
state space for (y; at ) and then show that the solution to the functional equation with the
additional bounds does satisfy the original functional equation. Obviously for yt = y we have
already assumed boundedness, but for the endogenous choices at we have to verify that is is
innocuous. It is relatively easy to show that there is an upper bound for a; say a ( such that
if at > a(; then at+1 < at for arbitrary yt : This will bound the value function(s) from above.
To prove boundedness from below is substantially more di¢cult since one has to bound con-
sumption ct away from zero even for at = 0: Obviously for this we need the assumption that
y > 0.
10.2. THE CLASSIC INCOME FLUCTUATION PROBLEM 275

The advantage of this formulation is that we have reduced the problem to one
state variable. As it will turn out, the same trick works when the exogenous
income process is stochastic and i:i:d over time. If, however, the stochastic
income process follows a Markov chain with nonzero autocorrelation we will
have to add back current income as one of the state variables, since current
income contains information about expected future income.
It is straightforward to show that the value function(s) for the reformulated
problem has the same properties as the value function for the original problem.
Again we invite the reader to Öll in the details. We now want to show some
properties of the optimal policies. We denote by at+1 (xt ) the optimal asset
accumulation and by ct (xt ) the optimal consumption policy for period t in
the Önite horizon case (note that, strictly speaking, we also have to index these
policies by the lifetime horizon T , but we keep T Öxed for now) and by a0 (x); c(x)
the optimal policies in the inÖnite horizon case. Note again that the inÖnite
horizon model is signiÖcantly simpler than the Önite horizon case. As long as
the results for the Önite and inÖnite horizon problem to be stated below are
identical, it is understood that the results both apply to the Önite
From the Örst order condition, ignoring the nonnegativity constraint on con-
sumption we get

u0 (ct (xt )) % ((1 + r)vt+1

0
((1 + r)at+1 (xt ) + y) (10.2)
= if at+1 (xt ) > 0

and the envelope condition reads

vt0 (xt ) = u0 (ct (xt )) (10.3)

The Örst result is straightforward and intuitive

Proposition 112 Consumption is strictly increasing in cash at hand, or c0t (xt ) >
0: There exists an x 8t and a0t+1 (xt ) > 0
8t such that at+1 (xt ) = 0 for all xt $ x
for all xt > x 8t : It is understood that x8t may be +1: Finally c0t (x) $ 1 and
0
at+1 (xt ) < 1:

Proof. For the Örst part di§erentiate the envelope condition with respect
to xt to obtain
vt00 (xt ) = u00 (ct (xt )) ) c0t (xt )
and hence
vt00 (xt )
c0t (xt ) = 00
>0
u (ct (xt ))
since the value function is strictly concave.10
1 0 Note that we implicitly assumed that the value function is twice di§erentiable and the

policy function is di§erentiable. For general condition under which this is true, see Santos
(1991). I strongly encourage students interested in these issues to take Mordecai Kurzís Econ
284.
276 CHAPTER 10. BEWLEY MODELS

Suppose the borrowing constraint is not binding, then from di§erentiating

the Örst order condition with respect to xt we get
u00 (ct (xt )) ) c0 (xt ) = ((1 + r)2 vt+1
00
((1 + r)at+1 (xt ) + yt+1 ) ) a0t+1 (xt )
and hence
u00 (ct (xt )) ) c0 (xt )
a0t+1 (xt ) = 2 00 ((1 + r)a >0
((1 + r) vt+1 t+1 (xt ) + yt+1 )
Now suppose that at+1 (8 xt ) = 0: We want to show that if xt < x 8t ; then
at+1 (xt ) = 0: Suppose not, i.e. suppose that at+1 (xt ) > at+1 (8
xt ) = 0: From the
Örst order condition
u0 (ct (xt )) = ((1 + r)vt+1
0
((1 + r)at+1 (xt ) + yt+1 )
0 0
u (ct (8xt )) % ((1 + r)vt+1 ((1 + r)at+1 (8
xt ) + yt+1 )
0
But since vt+1 is strictly decreasing (as vt+1 is strictly concave) we have
0 0
((1 + r)vt+1 ((1 + r)at+1 (xt ) + yt+1 ) < ((1 + r)vt+1 ((1 + r)at+1 (8
xt ) + yt+1 )
and on the other hand, since we already showed that ct (xt ) is strictly increasing
ct (xt ) < ct (8
xt )
and hence
u0 (ct (xt )) > u0 (ct (8
xt ))
Combining we Önd
u0 (ct (xt )) > u0 (ct (8 0
xt )) % ((1 + r)vt+1 ((1 + r)at+1 (8
xt ) + yt+1 )
> ((1 + r)vt+1 ((1 + r)at+1 (xt ) + yt+1 ) = u0 (ct (xt ))
0

a contradiction since u0 is positive.

Finally, to show that c0t (xt ) $ 1 and a0t+1 (xt ) < 1 we di§erentiate the identity
in the region xt > x8t
ct (xt ) + at+1 (xt ) = xt
with respect to xt to obtain
c0t (xt ) + a0t+1 (xt ) = 1
and since both function are strictly increasing, the desired result follows (Note
8t we have a0t+1 (xt ) = 0 and c0t (xt ) = 1).
that for xt $ x
The last result basically state that the more cash at hand an agent has,
coming into the period, the more he consumes and the higher his asset accumu-
lation, provided that the borrowing constraint is not binding. It also states that
there is a cut-o§ level for cash at hand below which the borrowing constraint
is always binding. Obviously for all xt $ x 8t we have ct (xt ) = xt ; i.e. the agent
consumes all his income (current income plus accumulated assets plus interest
rate).
For the inÖnite lifetime case we can say more.
10.2. THE CLASSIC INCOME FLUCTUATION PROBLEM 277

Proposition 113 Let T = 1: If a0 (x) > 0 then x0 < x: a0 (y) = 0: There exists
8 > y such that a0 (x) = 0 for all x $ x
ax 8

Proof. If a0 (x) > 0 then from envelope and FOC

v 0 (x) = (1 + r)(v 0 (x0 )

< v 0 (x0 )

since (1 + r)( < 1 by our maintained assumption. Since v is strictly concave we

have x > x0 :
For second part, suppose that a0 (y) > 0: Then from the Örst order condition
and strict concavity of the value function

v 0 (y) = (1 + r)(v 0 ((1 + r)a0 (y) + y)

< v 0 ((1 + r)a0 (y) + y)
< v 0 (y)

a contradiction. Hence a0 (y) = 0 and c(y) = y:

The last part we also prove by contradiction. Suppose a0 (x) > 0 for all
x > y: Pick arbitrary such x and deÖne the sequence fxt g1
t=0 recursively by

x0 = x
xt = (1 + r)a0 (xt$1 ) + y % y

If there exists a smallest T such that xT = y then we found a contradiction,

since then a0 (xT $1 ) = 0 and xT $1 > 0: So suppose that xt > y for all t: But
then a0 (xt ) > 0 by assumption. Hence

v 0 (x0 ) = (1 + r)(v 0 (x1 )

= [(1 + r)(]t v 0 (xt )
< [(1 + r)(]t v 0 (y)
= [(1 + r)(]t u0 (y)

where the inequality follows from the fact that xt > y and the strict concavity of
v: the last equality follows from the envelope theorem and the fact that a0 (y) = 0
so that c(y) = y:
But since v 0 (x0 ) > 0 and u0 (y) > 0 and (1 + r)( < 1; we have that there
exists Önite t such that v 0 (x0 ) > [(1 + r)(]t u0 (y); a contradiction.
This last result bounds the optimal asset holdings (and hence cash at hand)
from above for T = 1: Since computational techniques usually rely on the
Öniteness of the state space we want to make sure that for our theory the
state space can be bounded from above. For the Önite lifetime case there is no
problem. The most an agent can save is by consuming 0 in each period and
hence
X t
at+1 (xt ) $ xt $ (1 + r)t+1 a0 + (1 + r)j y
j=0
278 CHAPTER 10. BEWLEY MODELS

which is bounded for any Önite lifetime horizon T < 1:

The last theorem says that cash at hand declines over time or is constant at
y; in the case the borrowing constraint binds. The theorem also shows that the
agent eventually becomes credit-constrained: there exists a Önite < such that
the agent consumes his endowment in all periods following < : This follows from
the fact that marginal utility of consumption has to decline at geometric rate
((1 + r) if the agent is unconstrained and from the fact that once he is credit-
constrained, he remains credit constrained forever. This can be seen as follows.
First x % y by the credit constraint. Suppose that a0 (x) = 0 but a0 (x0 ) > 0:
Since x0 = a0 (x)+y = y we have that x0 $ x: Thus from the previous proposition
a0 (x0 ) $ a0 (x) = 0 and hence the agent remains credit-constrained forever.
For the inÖnite lifetime horizon, under deterministic and constant income
we have a full qualitative characterization of the allocation: If a0 = 0 then the
consumer consumes his income forever from time 0: If a0 > 0; then cash at hand
and hence consumption is declining over time, and there exists a time < (a0 ) such
that for all t > < (a0 ) the consumer consumes his income forever from thereon,
and consequently does not save anything.

10.2.2 Stochastic Income and Borrowing Limits

Now we discuss the income áuctuation problem that the typical consumer in
our Bewley economy faces. We assume that T = 1 and (1 + r)( < 1: The
consumer is assumed to have a stochastic income process fyt g1 t=0 . We assume
that yt 2 Y = fy1 ; : : : yN g; i.e. the income can take only a Önite number of
values. We will Örst assume that yt is i:i:d over time, with
E(yj ) = prob(yt = yj )
We will then extend our discussion to the case where the endowment process
follows a Markov chain with transition function Q
Q ij = prob(yt+1 = yj if yt = yi )
In this case we will assume that the transition matrix has a unique stationary
measure11 associated with it, which we will denote by E and we will assume
that the agent at period t = 0 draws the initial income from E: We continue to
assume that the borrowing limit is at b = 0 and that ((1 + r) < 1:
For the i:i:d case the dynamic programming problem takes the form (we will
focus on inÖnite horizon from now on)
8 9
< X =
0 0
v(x) = max u(x & a ) + ( E(y j )v((1 + r)a + y j )
0+a0 +x : ;
j

1 1 Remember that a stationary measure A (distribution) associated with Markov transition

matrix H is an N - 1 vector that satisÖes
A0 H = A0
Given that H is a stochastic matix it has a (not necessarily unique) stationary distribution
associated with it.
10.2. THE CLASSIC INCOME FLUCTUATION PROBLEM 279

with Örst order condition

X
u0 (x & a0 (x)) % ((1 + r) E(yj )v 0 ((1 + r)a0 (x) + yj )
j
0
= if a (x) > 0

and envelope condition

v 0 (x) = u0 (x & a0 (x)) = u0 (c(x))

Denote by X
E(yj )v 0 ((1 + r)a0 (x) + yj ) = Ev 0 (x0 )
j

Note that we need the expectation operator since, even though a0 (x) is a de-
terministic choice, y 0 is stochastic and hence x0 is stochastic. Again taking for
granted that we can show the value function to be strictly increasing, strictly
concave and twice di§erentiable we go ahead and characterize the optimal poli-
cies. The proof of the following proposition is identical to the deterministic
case.

Proposition 114 Consumption is strictly increasing in cash at hand, i.e. c0 (x) 2

(0; 1]: Optimal asset holdings are either constant at the borrowing limit or strictly
0
increasing in cash at hand, i.e. a0 (x) = 0 or dadx(x) 2 (0; 1)

It is obvious that a0 (x) % 0 and hence x0 (x; y 0 ) = (1 + r)a0 (x) + y 0 % y1 so

we have y1 > 0 as a lower bound on the state space for x: We now show that
there is a level x
8 > y1 for cash at hand such that for all x $ x 8 we have that
c(x) = x and a0 (x) = 0

Proposition 115 There exists x

8 % y1 such that for all x $ x
8 we have c(x) = x
and a0 (x) = 0

Proof. Suppose, to the contrary, that a0 (x) > 0 for all x % y1 : Then, using
the Örst order condition and the envelope condition we have for all x % y1

v(x) = ((1 + r)Ev 0 (x0 ) $ ((1 + r)v 0 (y1 ) < v 0 (y1 )

Picking x = y1 yields a contradiction.

Hence there is a cuto§ level for cash at hand below which the consumer
consumes all cash at hand and above which he consumes less than cash at hand
and saves a0 (x) > 0: So far the results are strikingly similar to the deterministic
case. Unfortunately here it basically ends, and therefore our analytical ability to
characterize the optimal policies. In particular, the very important proposition
showing that there exists x ~ such that if x % x~ then x0 < x~ does not go through
anymore, which is obviously quite problematic for computational considerations.
In fact we state, without a proof, a result due to Schechtman and Escudero
(1977)
280 CHAPTER 10. BEWLEY MODELS

Proposition 116 Suppose the period utility function is of constant absolute

risk aversion form u(c) = &e$c ; then for the inÖnite life income áuctuation
problem, if E(y = 0) > 0 we have xt ! +1 almost surely, i.e. for almost every
sample path fy0 (!); y2 (!); : : :g of the stochastic income process.

Proof. See Schechtman and Escudero (1977), Lemma 3.6 and Theorem 3.7

Fortunately there are fairly general conditions under which one can, in fact,
prove the existence of an upper bound for the state space. Again we will refer to
Schechtman and Escudero for the proof of the following results. Intuitively why
would cash at hand go o§ to inÖnity even if the agents are impatient relative to
the market interest rate, i.e. even if ((1 + r) < 1? If agents are very risk averse,
face borrowing constraints and a positive probability of having very low income
for a long time, they may Önd it optimal to accumulated unbounded funds over
time to self-insure against the eventuality of this unlikely, but very bad event
to happen. It turns out that if one assumes that the risk aversion of the agent
is su¢ciently bounded, then one can rule this out.

Proposition 117 Suppose that the marginal utility function has the property
that there exist Önite eu0 such that

lim (logc u0 (c)) = eu0

c!1

~ such that x0 = (1 + r)a0 (x) + yN $ x for all x % x

Then there exists a x ~:

Proof. See Schechtman and Escudero (1977), Theorems 3.8 and 3.9
The number eu0 is called the asymptotic exponent of u0 : Note that if the
utility function is of CRRA form with risk aversion parameter =; then since

logc c$0 = &= logc c = &=

we have eu0 = &= and hence for these utility function the previous proposition
applies. Also note that for CARA utility function
c
logc e$c = &c logc e = &
ln(c)
c
& lim = &1
c!1 ln(c)

and hence the proposition does not apply.

So under the proposition of the previous theorem we have the result that
~].12 Consumption equals cash
cash at hand stays in the bounded set X = [y1 ; x
at hand for x $ x
8 and is lower than x for x > x8; with the rest being spent on
capital accumulation a0 (x) > 0: Figure 27 shows the situation.
Finally consider the case where income is correlated over time and follows
a Markov chain with transition Q: Now the trick of reducing the state to the
1 2 If x0 = (1 + r)a0 + y0 happens to be bigger than x ~ 0 = x0 :
~; then pick x
10.2. THE CLASSIC INCOME FLUCTUATION PROBLEM 281

45 degree line

c(x)

a’(x)

45 degree line

x’=a’(x)+y
N

x’=a’(x)+y
1

y
N

y
1

_ ~
y x x x
1
282 CHAPTER 10. BEWLEY MODELS

single variable cash at hand does not work anymore. This was only possible since
current income y and past saving (1 + r)a entered additively in the constraint
set of the Bellman equation, but neither variable appeared separately. With
serially correlated income, however, current income ináuences the probability
distribution of future income. There are several possibilities of choosing the
state space for the Bellman equation. One can use cash at hand and current
income, (x; y); or asset holdings and current income (a; y): Obviously both ways
are equivalent and I opted for the later variant, which leads to the functional
equation
8 9
< X =
0 0 0
v(a; y) = max u(c) + ( Q(y jy)v(a ; y )
c;a0 -0 : 0
;
y 2Y
0
s.t. c + a = y + (1 + r)a

What can we say in general about the properties of the optimal policy functions
a0 (a; y) and c(a; y): Huggett (1993) proves a proposition similar to the ones
above showing that c(a; y) is strictly increasing in a and that a0 (a; y) is constant
at the borrowing limit or strictly increasing (which implies a cuto§ a 8(y) as
before, which now will depend on current income y). What turns out to be very
di¢cult to prove is the existence of an upper bound of the state space, a ~ such
that a0 (a; y) $ a if a % a
~. Huggett proves this result for the special case that
N = 2; assumptions on the Markov transition function and CRRA utility. See
his Lemmata 1-3 in the appendix. I am not aware of any more general result for
the non-iid case. With respect to computation in more general cases, we have
to cross our Öngers and hope that a0 (a; y) eventually (i.e. for Önite a) crosses
the 450 -line for all y:
Until now we basically have described the dynamic properties of the optimal
decision rules of a single agent. The next task is to explicitly describe our
Bewley economy, aggregate the decisions of all individuals in the economy and
Önd the equilibrium interest rate for this economy.

10.3 Aggregation: Distributions as State Vari-

ables
10.3.1 Theory
Now let us proceed with the aggregation across individuals. First we describe
the economy formally. We consider a pure exchange economy with a continuum
of agents of measure 1: Each individual has the same stochastic endowment
process fyt g1t=0 where yt 2 Y = fy1 ; y2 ; : : : yN g: The endowment process is
Markov. Let Q(y 0 jy) denote the probability that tomorrowís endowment takes
the value y 0 if todayís endowment takes the value y: We assume a law of large
numbers to hold: not only is Q(y 0 jy) the probability of a particular agent of
a transition form y to y 0 but also the deterministic fraction of the population
10.3. AGGREGATION: DISTRIBUTIONS AS STATE VARIABLES 283

that has this particular transition.13 Let E denote the stationary distribution
associated with Q; assumed to be unique. We assume that at period 0 the
income of all agents, y0 ; is given, and that the distribution of incomes across
the population is given by E: Given our assumptions, then, the distribution of
income in all future periods is also given by E: In particular, the total income
(endowment) in the economy is given by
X
y8 = yE(y)
y

Hence, although there is substantial idiosyncratic uncertainty about a particular

individualís income, the aggregate income in the economy is constant over time,
i.e. there is no aggregate uncertainty.
Each agentís preferences over stochastic consumption processes are given by
1
X
u(c) = E0 ( t u(ct )
t=0

with ( 2 (0; 1): In period t the agent can purchase one period bonds that pay
net real interest rate rt+1 tomorrow. Hence an agent that buys one bond today,
at the cost of one unit of todayís consumption good, receives (1 + rt+1 ) units of
consumption goods for sure tomorrow. Hence his budget constraint at period t
reads as
ct + at+1 = yt + (1 + rt )at
We impose an exogenous borrowing constraint on bond holdings: at+1 % &b:
The agent starts out with initial conditions (a0 ; y0 ): Let L0 (a0 ; y0 ) denote the
initial distribution over (a0 ; y0 ) across households. In accordance with our pre-
vious assumption the marginal distribution of L0 with respect to y0 is assumed
to be E: We assume that there is no government, no physical capital or no
supply or demand of bonds from abroad. Hence the net supply of assets in this
economy is zero.
At each point of time an agent is characterized by her current asset position
at and her current income yt : These are her individual state variables. What
describes the aggregate state of the economy is the cross-sectional distribution
over individual characteristics Lt (at ; yt ): We are now ready to deÖne an equi-
librium. We could deÖne a sequential markets equilibrium and it is a good
exercise to do so, but instead let us deÖne a recursive competitive equilibrium.
We have already conjectured what the correct state space is for our economy,
with (a; y) being the individual state variables and L(a; y) being the aggregate
state variable.
First we need to deÖne an appropriate measurable space on which the mea-
sures L are deÖned. DeÖne the set A = [&b; 1) of possible asset holdings and
by Y the set of possible income realizations. DeÖne by P(Y ) the power set
1 3 Whether and under what conditions we can assume such a law of large numbers created

a heated discussion among theorists. See Judd (1985), Feldman and Gilles (1985) and Uhlig
(1996) for further references.
284 CHAPTER 10. BEWLEY MODELS

of Y (i.e. the set of all subsets of Y ) and by B(A) the Borel =-algebra of A:
Let Z = A 0 Y and B(Z) = P(Y ) 0 B(A): Finally deÖne by M the set of all
probability measures on the measurable space M = (Z; B(Z)). Why all this?
Because our measures L will be required to elements of M: Now we are ready
to deÖne a recursive competitive equilibrium. At the heart of any RCE is the
recursive formulation of the household problem. Note that we have to include
all state variables in the household problem, in particular the aggregate state
variable, since the interest rate r will depend on L: Hence the household problem
in recursive formulation is
X
v(a; y; L) = max0
u(c) + ( Q(y 0 jy)v(a0 ; y 0 ; L0 )
c-0;a -$b
y 0 2Y
0
s.t. c + a = y + (1 + r(L))
L0 = H(L)
The function H : M ! M is called the aggregate ìlaw of motionî. Now let us
proceed to the equilibrium deÖnition.
DeÖnition 118 A recursive competitive equilibrium is a value function v : Z 0
M ! R, policy functions a0 : Z 0 M ! R and c : Z 0 M ! R, a pricing
function r : M ! R and an aggregate law of motion H : M ! M such that
1. v; a0 ; c are measurable with respect to B(Z); v satisÖes the householdís
Bellman equation and a0 ; c are the associated policy functions, given r():
2. For all L 2 M
Z Z
c(a; y; L)dL = ydL
Z
a0 (a; y; L)dL = 0

3. The aggregate law of motion H is generated by the exogenous Markov

process Q and the policy function a0 (as described below)
Several remarks are in order. Condition 2: requires that asset and goods
markets clear for all possible measures L 2 M. Similarly for the requirements
in 1: As usual, one of the two market clearing conditions is redundant by Walrasí
law. Also note that the zero on the right hand side of the asset market clearing
condition indicates that bonds are in zero net supply in this economy: whenever
somebody borrows, another private household holds the loan.
Now let us specify what it means that H is generated by Q and a0 : H basically
tells us how a current measure over (a; y) translates into a measure L0 tomorrow.
So H has to summarize how individuals move within the distribution over assets
and income from one period to the next. But this is exactly what a transition
function tells us. So deÖne the transition function Q : Z 0 B(Z) ! [0; 1] by14
X " Q(y 0 jy) if a0 (a; y) 2 A
Q((a; y); (A; Y)) =
0
0 else
y 2Y
1 4 Note that, since a0 is also a function of B; Q is implicitly a function of B; too.
10.3. AGGREGATION: DISTRIBUTIONS AS STATE VARIABLES 285

for all (a; y) 2 Z and all (A; Y) 2 B(Z): Q((a; y); (A; Y)) is the probability that
an agent with current assets a and current income y ends up with assets a0 in
A tomorrow and income y 0 in Y tomorrow. Suppose that Y is a singleton, say
Y = fy1 g: The probability that tomorrowís income is y 0 = y1 ; given todayís
income is Q(y 0 jy): The transition of assets is non-stochastic as tomorrows assets
are chosen today according to the function a0 (a; y): So either a0 (a; y) falls into
A or it does not. Hence the probability of transition from (a; y) to fy1 g 0 A is
Q(y 0 jy) if a0 (a; y) falls into A and zero if it does not fall into A. If Y contains
more than one element, then one has to sum over the appropriate Q(y 0 jy):
How does the function Q help us to determine tomorrowís measure over
(a; y) from todayís measure? Suppose Q where a Markov transition matrix for
a Önite state Markov chain and Lt would be the distribution today. Then to
Ögure out the distribution Lt tomorrow we would just multiply Q by Lt ; or

Lt+1 = QT Lt

But a transition function is just a generalization of a Markov transition matrix

to uncountable state spaces. For the Önite state space we use sums
N
X
Lj;t+1 = QTij Li;t
i=1

in our case we use the same idea, but integrals

Z
L0 (A; Y) = (H(L)) (A; Y) = Q((a; y); (A; Y))L(da 0 dy)

The fraction of people with income in Y and assets in A is that fraction of

people today, as measured by L; that transit to (A; Y); as measured by Q:
In general there no presumption that tomorrowís measure L0 equals todayís
measure, since we posed an arbitrary initial distribution over types, L0 : If the
sequence of measures fLt g generated by L0 and H is not constant, then obvi-
ously interest rates rt = r(Lt ) are not constant, decision rules are not constant
over time and the computation of equilibria is di¢cult in general. Therefore we
are frequently interested in stationary RCEís:

DeÖnition 119 A stationary RCE is a value function v : Z ! R, policy func-

tions a0 : Z ! R and c : Z ! R, an interest rate r* and a probability measure
L* such that

1. v; a0 ; c are measurable with respect to B(Z); v satisÖes the householdís

Bellman equation and a0 ; c are the associated policy functions, given r*
2.
Z Z
*
c(a; y)dL = ydL*
Z
a0 (a; y)dL* = 0
286 CHAPTER 10. BEWLEY MODELS

3. For all (A; Y) 2 B(Z)

Z
*
L (A; Y) = Q((a; y); (A; Y))dL* (10.4)

where Q is the transition function induced by Q and a0 as described above

Note the big simpliÖcation: value functions, policy functions and prices are
not any longer indexed by measures L; all conditions have to be satisÖed only for
the equilibrium measure L* : The last requirement states that the measure L*
reproduces itself: starting with distribution over incomes and assets L* today
generates the same distribution tomorrow. In this sense a stationary RCE is
the equivalent of a steady state, only that the entity characterizing the steady
state is not longer a number (the aggregate capital stock, say) but a rather
complicated inÖnite-dimensional object, namely a measure.
What can we do theoretically about such an economy? Ideally one would like
to prove existence and uniqueness of a stationary RCE. This is pretty hard and
we will not go into the details. Instead I will outline of an algorithm to compute
such an equilibrium and indicate where the crucial steps in proving existence
are. In the last homework some (optional) questions guide you through an
implementation of this algorithm.
Finding a stationary RCE really amounts to Önding an interest rate r* that
clears the asset market. I propose the following algorithm

1. Fix an r 2 (&1; %1 & 1): For a Öxed r we can solve the householdís recursive
problem (e.g. by value function iteration). This yields a value function vr
and decision rules a0r ; cr ; which obviously depend on the r we picked.

2. The policy function a0r and Q induce a Markov transition function Qr :

Compute the unique stationary measure Lr associated with this transition
function from (10:4): The existence of such unique measure needs proving;
here the property of a0r that for su¢ciently large a; a0 (a; y) $ a is crucial.
Otherwise assets of individuals wander o§ to inÖnity over time and a
stationary measure over (a; y) does not exist.

3. Compute average net asset demand

Z
Ear = a0r (a; y)dLr

Note that Ear is just a number. If this number happens to equal zero, we
are done and have found a stationary RCE. If not we update our guess for
r and start from 1: anew.

So the key steps, apart from proving the existence and uniqueness of a sta-
tionary measure in proving the existence of an RCE is to show that, as a function
of r; Ear is continuous in r; negative for small r and positive for large r: If one
also wants to prove uniqueness of a stationary RCE, one in addition has to
10.3. AGGREGATION: DISTRIBUTIONS AS STATE VARIABLES 287

show that Ear is strictly increasing in r; i.e. that households want to save more
the higher the interest rate. Continuity of Ear is quite technical, but basically
requires to show that a0r is continuous in r; proving strict monotonicity of Ear
requires proving monotonicity of a0r with respect to r: I will spare you the de-
tails, some of which are not so well-understood yet (in particular if income is
Markov rather than i:i:d). That Ear is negative for r = &1: If r = &1; agents
can borrow without repaying anything, and obviously all agents will borrow up
to the borrowing limit. Hence Ea$1 = &b < 0
On the other hand, as r approaches : = %1 & 1 from below, Ear goes to +1:
The result that for r = : asset holdings wander o§ to inÖnity almost surely was
proved by Chamberlain and Wilson (1984) using the martingale convergence
theorem; this is well beyond this course. Letís give a heuristic argument for the
case in which income is i:i:d: In this case the Örst order condition and envelope
condition reads
X
u0 (c(a; y))) % Q(y 0 )v 0 (a0 (a; y); y 0 )
y0

= if a0 (a; y) > &b

v 0 (a; y) = u0 (c(a; y))

Suppose there exists an amax such that a0 (amax ; y) $ a for all y 2 Y: But then
X
v 0 (amax ; ymax ) % Q(y 0 )v 0 (a0 (amax ; ymax ); y 0 )
y0
X
> Q(y 0 )v 0 (amax ; y 0 )
y0
X
> Q(y 0 )v 0 (amax ; ymax )
y0
0
= v (amax ; ymax )

a contradiction. The inequalities follow from strict concavity of the value func-
tion in its Örst argument and the fact that higher income makes the marginal
utility form wealth decline. Hence asset holdings wander o§ to inÖnity almost
surely and Ear = 1: What goes on is that without uncertainty and ((1+r) = 1
the consumer wants to keep a constant proÖle of marginal utility over time. With
uncertainty, since there is a positive probability of getting a su¢ciently long se-
quence of bad income, this requires arbitrarily high asset holdings.15 Figure 28
summarizes the results.
The average asset demand curve, as a function of the interest rate, is up-
ward sloping, is equal to &b for su¢ciently low r; asymptotes towards 1 as r
1 5 This argument was loose in the sense that if a0 (a; y) does not cross the 45 degree line,

then no stationary asset distribution exists and, strictly speaking, Ear is not well-deÖned.
What one can show, however, is that in the income áuctuation problem with 1(1 + r) = 1 for
each agent at+1 ! 1 almost surely, meaning that in the limit asset holdings become inÖnite.
If we understand this time limit as the stationary situation, then Ear = 1 for r = W:
288 CHAPTER 10. BEWLEY MODELS

r*

-b 0
Ea
r
10.3. AGGREGATION: DISTRIBUTIONS AS STATE VARIABLES 289

approaches : = %1 & 1 from below. The Ear curve intersects the zero-line at a
unique r* ; the unique stationary equilibrium interest rate.
This completes our description of the theoretical features of the Bewley
models. Now we will turn to the quantitative results that applications of these
models have delivered.

10.3.2 Numerical Results

In this subsection we report results obtained from numerical simulations of the

model described above. In order to execute these simulations we Örst have to
pick the exogenous parameters characterizing the economy. The parameters in-
clude the parameters specifying preferences, (=; () (we assume constant relative
risk aversion utility function), the exogenous borrowing limit b and the parame-
ters specifying the income process, i.e. the transition matrix Q and the states
that the income process can take, Y:
We envision the model period as 1 year, so we choose ( = 0:97: As coe¢cient
of relative risk aversion we choose = = 2: As borrowing limit we choose b = 1:
We will normalize the income process so that average (aggregate) income in the
economy is 1: Hence the borrowing constraint permits borrowing up to 100% of
average yearly income. For the income process we do the following. We follow
the labor literature and assume that log-income follows an AR(1) process

1
log yt = : log yt$1 + =(1 & :2 ) 2 "t

where "t is distributed normally with mean zero and variance 1.16 We then
use the procedure by Tauchen and Hussey to discretize this continuous state
space process into a discrete Markov chain.17 For : and = " we used numbers
estimated by Heaton and Lucas (1996) who found : = 0:53 and = " = 0:296: We
picked the number of states to be N = 5. The resulting income process looks

1 6 For the process spaeciÖed above W is the autocrooelation of the process

cov(log yt ; log yt%1 )

W=
var(log yt )

and 4 " is the unconditional standard deviation of the process

p
4" = var(log yt ))

The numbers were estimated from PSID data.

1 7 The details of this rather standard approach in applied work are not that important here.

Aiyagariís working paper version of the paper has a very good description of the procedure;
see me if you would like a copy.
290 CHAPTER 10. BEWLEY MODELS

Stationary As set Distribution

0.1

0.09

0.08

0.07
Percent of the Population

0.06

0.05

0.04

0.03

0.02

0.01

0
-2 0 2 4 6 8 10
Am ount of Ass ets (as Fraction of Average Yearly Incom e)

as follows.
0 1
0:27 0:55 0:17 0:01 0:00
B 0:07 0:45 0:41 0:06 0:00 C
B C
Q = B
B 0:01 0:22 0:53 0:22 0:01 C
C
@ 0:00 0:06 0:41 0:45 0:07 A
0:00 0:01 0:17 0:55 0:27
Y = f0:40; 0:63; 0:94; 1:40; 2:19g
E = [0:03; 0:24; 0:45; 0:24; 0:03]
Remember that E is the stationary distribution associated with Q:
What are the key endogenous variables of interest. First, the interest rate
in this economy is computed to be r & 0:5%: Second, the model delivers an
endogenous distribution over asset holdings. This distribution is shown in Figure
29.We see that the richest (in terms of wealth) people in this economy hold
about six times average income, whereas the poorest people are pushed to the
borrowing constraint. About 6% of the population appears to be borrowing
10.3. AGGREGATION: DISTRIBUTIONS AS STATE VARIABLES 291

constrained. How does this economy compare to the data. First, the average
level of wealth in the economy is zero, by construction, since the net supply of
assets is zero. This is obviously unrealistic, and we will come back to this below.
How about the dispersion of wealth. The Lorenz curve and the Gini coe¢cient
do not make much sense here, since too many people hold negative wealth by
construction. The standard deviation is about 0:93: Since average assets are
zero, we canít compute the coe¢cient of variation of wealth. However, since
average income is 1; the ratio of the standard deviation of wealth to average
income is 0:93; whereas in the data it is 33 (where we used earnings instead of
income). Hence the model underachieves in terms of wealth dispersion. This is
mostly due to two reasons, one that has to do with the model and one that has to
do with our parameterization. How much dispersion in income did we stick into
the model? The coe¢cient of variation of the income process that we used in the
model is 0:355 instead of 4:19 in the data (again we used earnings for the data).
So we didnít we use a more dispersed income process, or in other words, why did
Heaton and Lucas Önd the numbers in the data that we used? Remember that
in our model all people are ex ante identical and income di§erences result in
ex-post di§erences of luck. In the data earnings of people di§er not only because
of chance, but because of observable di§erences. Heaton and Lucas Öltered out
di§erences in income that have to do with deterministic factors like age, sex,
race etc.18 Why do we use their numbers? Because they Ölter out exactly those
components of income dispersion that our model abstracts from.
Even if one would rig the income numbers to be more dispersed, the model
would fail to reproduce the amount of wealth dispersion, largely because it fails
to generate the fat upper tail of the wealth distribution. There have been several
suggestions to cure this failure; for example to introduce potential entrepreneurs
that have to accumulate a lot of wealth before Önancing investment projects, A
somewhat successful strategy has been to introduce stochastic discount factors;
let ( follow a Markov chain with persistence. Some days people wake up and
are really impatient, other days they are patient. This seems to do the trick.
Instead of picking up these extensions we want to study how the model reacts
to changes in parameter values. Most interestingly, what happens if we loosen
the borrowing constraint? Suppose we increase the borrowing limit from 1 years
average income to 2 years average income. Then people can borrow more and
some previously constrained people will do so. On the other hand agents can
always freely save. Hence for a given interest rate the net demand for bonds, or
net saving should go down, the Ear -curve shifts to the left and the equilibrium
interest rate should increase. The new equilibrium interest rate is r = 1:7%:
Now about 1:5% of population is borrowing constrained. The richest people
hold about eight times average income as wealth. The ratio of the standard
deviation of wealth to average income is 1:65 now, increased from 0:93 with a
borrowing limit of b = 1: Figure 30 shows the equilibrium asset distribution.

1 8 The details of their procedure are more appropriately discussed by the econometricians

of the department than by me, so I punt here.

292 CHAPTER 10. BEWLEY MODELS

Stationary As set Distribution

0.1

0.09

0.08

0.07
Percent of the Population

0.06

0.05

0.04

0.03

0.02

0.01

0
-2 0 2 4 6 8 10
Am ount of Ass ets (as Fraction of Average Yearly Incom e)
Chapter 11

Fiscal Policy

11.1 Positive Fiscal Policy

11.2 Normative Fiscal Policy
11.2.1 Optimal Policy with Commitment
11.2.2 The Time Consistency Problem and Optimal Fiscal
Policy without Commitment
[To Be Written]

293
294 CHAPTER 11. FISCAL POLICY
Chapter 12

Political Economy and

Macroeconomics

[To Be Written]

295
296 CHAPTER 12. POLITICAL ECONOMY AND MACROECONOMICS
Chapter 13

References

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5. Discrete Time Dynamic Programming

297
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ment and Social Security,î NBER Working Paper 7117.
7 Persson and Tabellini (1994): ìIs Inequality Harmful for Growth?,î
American Economic Review, 84, 600-619.