Macroeconomics

Lecture 7

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 Lucas’s Model of Asset Prices

• This model uses the general

equilibrium concept.
• It assumes that there are a large
number of identical agents solving
problem (1) – (2) , in which yt = 0 for
all t.

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 Lucas’s Model of Asset Prices

• The only durable good in the economy is a

set of trees which are in equal number to
the number of people in the economy.
• Each period, each tree yields dividends in
the amount dt to its owner at the beginning
of period t.
• Let pt be the price of a tree in period t,
measured in units of consumption goods
per tree.

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 From the Euler equation (6) that
 p + d  U ' ( ct +1 )
1 = β Et  t +1 t +1  (10 )
 pt  U ' ( ct )
In equilibrium, we must have ct = dt , substituting it int o (10),
U ' ( dt +1 )
pt Et β ( pt +1 + dt +1 ) (11)
U ' ( dt )
U ' ( dt +1 )  U ' ( dt +1 ) 
or , pt Et β  pt +1  + Et β  dt +1  ,
 U ' ( dt )   U ' ( dt ) 
U ' ( dt +1 )  U ' ( dt + 2 )  U ' ( dt + 2 )  
= Et β   Et +1β  pt + 2  + Et +1β  dt + 2  
 U ' ( dt )   U ' ( dt +1 )   U ' ( dt +1 )  
U ' ( dt +1 ) 
+ Et β  dt +1 
 U ' ( dt ) 
U sin g resursion on (11) and the law of iterated exp ectations, we find that
∞  j −1 U ' ( dt + s +1 ) 
pt = Et ∑ β ∏ j
 dt + j , or
j =1  s =0 U ' ( dt + s ) 
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 ∞ U ' ( dt + j ) U ' ( dt + j −1 ) U ' ( dt + j − 2 ) U ' ( dt + 2 ) U ' ( dt +1 ) 
pt = Et ∑ β  j
......  dt + j ,
j =1 U ' ( dt + j −1 ) U ' ( dt + j − 2 ) U ' ( dt + j −3 ) U ' ( dt +1 ) U ' ( dt ) 

or ,
∞ U ' ( dt + j )
pt = Et ∑ β j
dt + j ,
j =1 U ' ( dt )
∞ U ' ( dt + j ) 
= ∑ β Et  j
dt + j  , (12 )
j =1  U ' ( dt ) 

Eq. (12 ) is a generlization of (9) in which the share price is

an exp ected discounted stream of dividends but with
 U ' ( dt + j ) 
time − var ying and stochastic discount rates  or , .
 U ' ( dt ) 
 
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Let U ( ct ) = ln ct (13)
Re call (12),
∞ U ' ( dt + j )
pt = Et ∑ β j
dt + j
j =1 U ' ( dt )
Substituting (13), with ct = dt , the above equation,
∞  dt  ∞ ∞  ∞ j
pt Et ∑ β =

j
t ∑ β ( dt )
 dt + j E=
j
∑
= β Et ( dt ) dt  ∑ β 
j

j 1  dt + j = j 1 =j 1 = j1 
β
pt = dt (14 )
1− β
Eq (14) is an asset − pricing function, a mapping of
state of the economy, dt , int o the price of a capital asset at t.
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 Lucas’s Asset-pricing function

dt is assumed to be governed by a
Markov process with a time-
invariant transition probability
distribution function given by
x'
prob ( dt +1 ≤ x | dt =
'
x) =
F ( x , x) =
'
∫ f ( s, x ) ds
0

The conditional expectation in the

Euler equation (10) is defined with
respect to this transition probability.

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 Lucas’s Asset-pricing function

• Because all consumers have the same

preference and endowment pattern, there can
be no gains from trade.
• Each household problem, given that st=st+1=1, is
∞
max E0 ∑ β tU ( ct )
t =0

s.t. ct ≤ dt
• The solution is to set ct = dt

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 Lucas’s Asset-pricing function

• At the beginning of period t, the owner of

the tree receives dt and has the right to
sell the tree at price pt. The consumer’s
consumption at t is constrained by

ct + pt st +1 ≤ ( pt + dt ) st (15)

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 Lucas’s Asset-pricing function

• Eq (15) states that during the time t to t+1,

consumer’s consumption at t and the value
of his/her asset at the beginning period t+1
must not exceed the value of his/her asset
at the beginning period t plus the dividend
that will be realized at the beginning
period t.
• (Note that the shock on dt will be observed
at the beginning period t)

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 Lucas’s Asset-pricing function

• The household is to maximize

∞
E0 ∑ β tU ( ct ) (16 )
t =0

• subject to (15).
• We need a law of motion for the stock price pt
to fully spell out constraint (15) for all t, and to
make sure that the conditional expectation in
(16) is well specified.

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 Lucas’s Asset-pricing function

• From eq. (14), we have that the asset price pt

can be expressed as a function of state
variable at t.
• So, let the price function be

pt = h ( dt ) (17 )

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 Lucas’s Asset-pricing function

• where h is continuous, bounded function

defined on the current state dt.
• Eq (17) and the transition law F (d′, d)
defines the perceived law of motion for
asset price pt .
• Let V (s [ h (x) + x]) be the value function
for the problem when the consumer
initially owns s trees, when the current
dividend equal x, and when the current
price of trees is h (x).

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 Bellman ' s equation is
( ) { ( ) ( )
 h ( x ) + x  max U s  h ( x ) + x  − h ( x ) s ' + β ∫ V s '  h ( x ') + x ' dF ( x ', x )
V s=
s'
}
A prime denotes next − period values. Euler equation is

( ) (
∂U s  h ( x ) + x  − h ( x ) s ' ∂ s  h ( x ) + x  − h ( x ) s ' )
(
∂ s  h ( x ) + x  − h ( x ) s ' ) ∂s '

+β∫
( ) (
∂V s '  h ( x ') + x ' ∂ s '  h ( x ') + x ' )
dF ( x ', x ) = 0
(
∂ s '  h ( x ') + x ' ) ∂ s '

h ( x)
(
∂U s  h ( x ) + x  − h ( x ) s '
= β ∫  h ( x ') + x '
) (
∂V s '  h ( x ') + x '
dF ( x ', x )
)
(
∂ s  h ( x ) + x  − h ( x ) s ' ) (
∂ s '  h ( x ') + x ' )
Differentiating Bellman equation w.r.t. state var iable, one has
(
∂V s  h ( x ) + x 
=
) ( ) ( )
∂U s  h ( x ) + x  − h ( x ) s ' ∂ s  h ( x ) + x  − h ( x ) s ' ∂U ( c )
=
(
∂ s  h ( x ) + x  ) (
∂ s  h ( x ) + x  − h ( x ) s ' ) (
∂ s  h ( x ) + x  ) ∂c

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 Since U ( x ) is known, once w ( x ) has been det er min ed ,
w( x)
h ( x ) can be computed from h ( x) =
∂U ( x )
∂x
Lucas assume U ( 0 ) = 0 and U ( c ) is concave and is bounded by B.
∂U ( x )
The implication is that x is bounded by B. It follows that
∂x
∂U ( x ')
g ( x) ≡ β ∫ x ' dF ( x ', x ) ≤ β B
∂x '
g ( x ) is continuous and bounded function.
Eq (19) can be rewritten as
w( x) β ∫ w ( x ') dF ( x ', x ) + g ( x ) ( 20 )
Eq (20) has a unique continuous and bounded solution.
The solution of the functional equation ( 20 ) is approached by iteration
on w j ( x ) defined by

16
j +1
wArayah β ∫ w j ( x ') dF ( x ', x ) + g ( x )
( x )Preechametta ( 21) 11/19/2018
 Starting from any initial continuous and bounded function w0 ( x ) .
Once the lim iting function w ( x ) is known, the price function h ( x )
w( x)
can be calculated as .
∂U ( x )
∂x
Eq ( 21) can be rewritten as
∂U ( x ) ∂U ( x ')
h j +1
( x) β ∫ h ( x ')
j
dF ( x ', x ) + g ( x ) ( 22 )
∂x ∂x '
 Eq (22) shows a mapping of a perceived pricing function h j
(x) into an actual pricing function hj+1(x).
 A rational expectations equilibrium is a fixed point of this
mapping from perceived pricing functions to actual pricing
functions.

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 ∂U ( x ') ∂x '
h j +1
( x ) = β ∫ h ( x ')
j
dF ( x ', x )
∂U ( x ) ∂x
∂U ( x ') ∂x '
+ β∫ x' dF ( x ', x )
∂U ( x ) ∂x
 ∂U ( x ') ∂x ' 
h ( x ) β ∫ {h ( x ') + x '} 
= j +1 j
 dF ( x ', x ) ( 23)
 ∂U ( x ) ∂x 
Eq ( 23) is in the form as Eq (11) ,
  ∂U ( x ') ∂x '  
pt β Et { pt +1 + dt +1}   | dt 
  ∂U ( x ) ∂x  
=
 pt h ( xt ) ≅ h j +1 ( x ) and F ( x ', x ) together define the
perceived law of motion for the tree prices, h j ( x ') .

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 Rational Expectation Equilibrium

• A rational expectations equilibrium is a fixed point of the

mapping from perceived pricing functions, hj(x)[∂U(x)/∂x], to
actual pricing functions, hj+1(x)[∂U(x’)/∂x’]. (See Brouwer fixed-
point theorem from Varian (1992) p.320-322)

hj+1(x) .[∂U(x)/∂x]

0 hj(x’). [∂U(x’)/∂x’]
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 Finite-State Version of Lucas’s
Model
• Suppose that there are only 2 states in each
period t.
• Dividends have 2 possible values [σ1, σ2]
• Transition probability distribution is
• prob {dt+1=σλ | dt=σk} = Pkλ > 0.
λ,k=1,2.
 P11 P12 
P= 
 21
P P22  k ×l = 2×2

P11 + P12 =1
P21 + P22 =
1

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 Finite-State Version of Lucas’s
Model
t=0 t=1 t=2 Transition Probability Distribution

σ1 P11

+ = 1
σ1
σ2 P12
σ
σ1 P21
σ2 + = 1
σ2 P22
Dividends
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 From Eq (11),
∂U ( dt ) ∂U ( dt +1 ) ∂U ( dt +1 )
=
pt β Et pt +1 + β Et dt +1 ( 24 )
∂dt ∂dt +1 ∂dt +1
∴ At=t 1, and=
k 1
∂U (σ 1 )   ∂U (σ 1 )   ∂U (σ 2 )  
p (σ 1 )
= β  P11  p (σ 1 )  + P12  p (σ 2 ) 
∂σ 1   ∂σ 1   ∂σ 2  
  ∂U (σ 1 )   ∂U (σ 2 )  
+ β  P11 σ 1  + P12 σ 2 
  ∂σ 1   ∂σ 2  
=
At t 1,= and k 2
∂U (σ 2 )   ∂U (σ 1 )   ∂U (σ 2 )  
p (σ 2 )
= β  P21  p (σ 1 )  + P22  p (σ 2 ) 
∂σ 2   ∂σ 1   ∂σ 2  

  ∂U (σ 1 )   ∂U (σ 2 )  
+ β  P21 σ 1  + P22 σ 2 
  ∂σ 1   ∂σ 2  
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