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ECA5102: Lecture Notes

Topic 02: Ramsey-Cass-Koopmans Model


Aamir Raque Hashmi
National U of Singapore
August 22, 2014
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Why this model?
In Solow model households do not optimally choose consumption and
savings
In this model we shall explicitly model household economic behavior
This has become one of the main workhorse models of modern
macroeconomics
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Outline of the Lecture
Model assumptions
Behavior of the rm
Behavior of the household
Dynamics of the economy
Comparative dynamics
Rate of adjustment to steady state
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Assumptions
A large number of identical rms
Production function:
Y(t) = F[K(t), A(t)L(t)],
Usual restrictions on the production function (same as in Solows
model)
Competitive input and output markets
A is given and grows at an exogenously given rate g
Firms objective is to maximize prots
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Assumptions
A large number of identical households
The size of each household grows at rate n
Each member of the household supplies one unit of labor at every
point in time
Each household rents capital to rms
Initial capital stock per household is
Initial aggregate capital stock
number of households
=
K(0)
H
No depreciation
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Assumptions
The (representative) household divides income between consumption
and savings to maximize utility
Households utility is given by
U =

_
t=0
e
t
u[C(t)]
L(t)
H
dt (2.1)
C(t) = Consumption of each member of the household
u = Instantaneous utility function
L(t) = Total population in the economy
= Discount rate
_
e

=
1
e

-
1
1+
_
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Assumptions
The instantaneous utility function is
u[C(t)] =
C(t)
1
1
1
, > 0 and n (1 )g > 0. (2.2)
This utility function is called CRRA (constant relative risk aversion)
Risk aversion is related to the curvature of the utility function
Arrow-Pratt coecient of Absolute Risk Aversion: u
//
/u
/
Coecient of Relative Risk Aversion:
cu
//
/u
/
= c () c
1
/c

=
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Assumptions
is the inverse of the intertemporal elasticity of substitution
If is small (approaching zero), large swings in consumption are
acceptable to the consumers
If 1, u = ln C
Proof:
lim
1
C
1
1
1
= lim
1
C
1
1

(1)

= lim
1
C
1
ln C
1
= ln C. Q.E.D.
The rst equality follows from LHopitals rule.
n (1 )g > 0 is needed to ensure that life-time (which is
innite here) utility does not diverge
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Behavior of the rm
Firms problem is static so we suppress the time subscripts
The rm maximizes prots taking factor prices as given
max
L,K
F(K, AL) WL rK.
We have normalized the price of output to 1
The rst order conditions for this problem are
F
L
= W and
F
K
= r .
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Behavior of the rm
Since F is CRS,
Y = F(K, AL) = ALf (k),
where k =
K
AL
.
==
F
K
= f
/
(k) and
F
L
= A[f (k) f
/
(k)k].
The rst order conditions become
A[f (k) f
/
(k)k] = W (2.4) , and
f
/
(k) = r . (2.3)
The wage rate per eective unit of labor is
W
A
= w = f (k) f
/
(k) k (2.5)
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Behavior of the household
The household chooses a path of consumption to maximize its utility
taking timepaths of r and W as given
Dene R(t) =
t
_
=0
r ()d
This allows for time varying interest rate
If the interest rate is constant, say at r , then R(t) = r t
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Behavior of the household
The household budget constraint is

_
t=0
e
R(t)
C(t)
L(t)
H
dt _
K(0)
H
+

_
t=0
e
R(t)
W(t)
L(t)
H
dt (2.6)
==
K(0)
H
+

_
t=0
e
R(t)
[W(t) C(t)]
L(t)
H
dt _ 0 (2.7)
== lim
s
_
K(0)
H
+
s
_
t=0
e
R(t)
[W(t) C(t)]
L(t)
H
dt
_
_ 0 (2.8)
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Behavior of the household
The expression in square brackets in (2.8) is the present value of
capital holdings of the household at time s.
To see this, note that the capital holdings of the household at time s
are
K(s)
H
=
K(0)
H
e
R(s)
+
s
_
t=0
e
R(s)R(t)
[W(t) C(t)]
L(t)
H
dt. (2.9)
Taking the present value we get
K(s)
H
e
R(s)
=
K(0)
H
+
s
_
t=0
e
R(t)
[W(t) C(t)]
L(t)
H
dt.
The right-hand side of the last equation is the same as the bracketed
expression in (2.8)
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Behavior of the household
Substituting the last equation in (2.8) we get
lim
s
_
K(s)
H
e
R(s)
_
_ 0, (2.10)
which says that the present value of the household assets cannot be
negative in the limit
Using the household budget constraint in (2.6), we have derived a
boundary condition in (2.10).
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Behavior of the household
Before solving the household maximization problem it is instructive to
write the objective function and constraints in terms of variables per
eective unit of labor
Recall the utility function
U =

_
t=0
e
t
C(t)
1
1
L(t)
H
dt.
Dene c(t) =
C(t)
A(t)
==C(t) = c(t)A(t) = c(t)A(0)e
gt
.
Also recall L(t) = L(0)e
nt
. The utility can then be written as
U =

_
t=0
e
t
[c(t)A(0)e
gt
]
1
1
L(0)e
nt
H
dt.
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Behavior of the household
U =

_
t=0
e
t
[c(t)A(0)e
gt
]
1
1
L(0)e
nt
H
dt
=
[A(0)]
1
L(0)
H

_
t=0
e
[n(1)g ]t
c(t)
1
1
dt
= B

_
t=0
e
t
c(t)
1
1
dt, (2.12)
.
where B =
[A(0)]
1
L(0)
H
and = n (1 )g > 0.
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Behavior of the household
To rewrite the budget constraint, note that C(t)
L(t)
H
= c(t)
A(t)L(t)
H
,
W(t)
L(t)
H
= w(t)
A(t)L(t)
H
and
K(0)
H
= k(0)
A(0)L(0)
H
.
Substituting these in (2.6) we get

_
t=0
e
R(t)
c(t)
A(t)L(t)
H
dt _ k(0)
A(0)L(0)
H
+

_
t=0
e
R(t)
w(t)
A(t)L(t)
H
dt.
Using A(t)L(t) = A(0)L(0)e
(n+g )t
and dividing by
A(0)L(0)
H
we have

_
t=0
e
R(t)
c(t)e
(n+g )t
dt _ k(0) +

_
t=0
e
R(t)
w(t)e
(n+g )t
dt. (2.14)
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Behavior of the household
To rewrite (2.10), note that K(s) = k(s)A(s)L(s). Substituting this
in (2.10)
lim
s
_
k(s)
A(s)L(s)
H
e
R(s)
_
_ 0.
==
lim
s
_
A(0)L(0)
H
e
R(s)
e
(n+g )s
k(s)
_
_ 0.
Dividing by
A(0)L(0)
H
we have
lim
s
_
e
R(s)
e
(n+g )s
k(s)
_
_ 0. (2.15)
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Behavior of the household
The objective of the household is to choose c(t) to maximize (2.12)
subject to (2.14).
The Lagrangian for the problem is
L = B

_
t=0
e
t
c(t)
1
1
dt+

_
k(0) +

_
t=0
e
R(t)
w(t)e
(n+g )t
dt

_
t=0
e
R(t)
c(t)e
(n+g )t
dt
_
. (2.16)
The rst order condition with respect to c(t) is
Be
t
c(t)

= e
R(t)
e
(n+g )t
. (2.17)
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Behavior of the household
Take logs and use R(t) =
t
_
=0
r ()d
ln B t ln c(t) = ln
t
_
=0
r ()d + (n +g)t. (2.18)
Dierentiate with respect to time

c(t)
c(t)
= r (t) + (n +g). (2.19)
Substitute n (1 )g for and solve for
c(t)
c(t)
c(t)
c(t)
=
r (t) g

. (2.20)
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Behavior of the household
Recall C(t) = c(t)A(t). Take logs and dierentiate with respect to
time

C(t)
C(t)
=

A(t)
A(t)
+
c(t)
c(t)
Substitute (2.20) and g =

A(t)
A(t)
into the last equation

C(t)
C(t)
= g +
r (t) g

which simplies to

C(t)
C(t)
=
r (t)

. (2.21)
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Behavior of the household
If r (t) > , consumption is rising because people consume less (and
save more) now and consume more in future
If r (t) < , consumption is falling because people are impatient and
they want to consume more now
If is low, intertemporal elasticity of substitution is high. People
allow greater variation in consumption for a given dierence between
r (t) and
If , intertemporal elasticty of substitution approaches zero.
People want perfect consumption smoothing.
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Dynamics of the Economy
Recall
c(t)
c(t)
=
r (t)g

(2.20).
Since r (t) = f
/
[k(t)] we can write (2.20) as
c(t)
c(t)
=
f
/
[k(t)] g

. (2.24)
c(t) = 0 if f
/
[k(t)] = + g. Let us call the unique k(t) that
satises this equation k
+
.
c(t) > 0 if f
/
[k(t)] > + g i.e. k(t) < k
+
.
c(t) < 0 if f
/
[k(t)] < + g i.e. k(t) > k
+
.
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Dynamics of the Economy
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Dynamics of the Economy
For k note that

k(t) = f [k(t)] c(t)


. .
actual investment
(n +g)k(t).
. .
replacement investment
(2.25)

k(t) = 0, if c(t) = f [k(t)] (n +g)k(t).

k(t) > 0, if c(t) < f [k(t)] (n +g)k(t).

k(t) < 0, if c(t) > f [k(t)] (n +g)k(t).


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Dynamics of the Economy
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Dynamics of the Economy
Let k
G
be the value of k corresponding to the maximum c in Figure
(2.2)
Before combining the two graphs to study the dynamics, we need to
know whether k
+
is less than, equal to or greater than k
G
.
Claim: k
G
> k
+
Proof: Showing k
G
> k
+
is equivalent to showing that
f
/
(k
G
) < f
/
(k
+
) because f
//
(k) < 0
f
/
(k
+
) = + g (from (2.24) when c(t) = 0)
f
/
(k
G
) = n +g (from (2.25) when

k(t) = 0)
Then f
/
(k
G
) < f
/
(k
+
) requires
n +g < + g == n (1 )g = > 0,
Which is true by assumption. Q.E.D.
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Dynamics of the Economy
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Dynamics of the Economy
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Dynamics of the Economy
In Figure (2.4), points above F will lead to c = 0 and k = 0
Points below F will lead to
k > k
G
==f
/
(k) < (n +g) ==e
R(s)
e
(n+g )s
is rising and so is
k(s)
== lim
s
_
e
R(s)
e
(n+g )s
k(s)
_
= ,
which implies that the PV of lifetime income minus the PV of lifetime
consumption is innity.
Hence the household can increase utility by increasing consumption at
each point in time.
Starting from F, the system follows the Saddle Path to point E.
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Dynamics of the Economy
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Balanced Growth Path
At point E: c, y and k are constant
s =
y c
y
is also constant
K (= ALk) and Y (= ALy) grow at rate n +g
K
L
,
Y
L
and C (= Ac) grow at rate g
Unlike Solow model, in this model k > k
G
is not possible on the BGP
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Welfare
In the absence of externalities and distortionary taxes, a competitive
equilibrium will generate Pareto-ecient allocations and welfare will
be maximized.
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Comparative Dynamics (1)
We shall study the dynamics after an unexpected drop in discount
rate
As drops, people value future more.
This is equivalent to an increase in the saving rate in Solow model.
The dynamic system consists of
c(t)
c(t)
=
f
/
[k(t)]g

. (2.24)

k(t) = f [k(t)] c(t) (n +g)k(t). (2.25)


appears in (2.24) only so only c = 0 line will be aected
As drops k
+
increases
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Comparative Dynamics (1)
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Comparative Dynamics (2)
Now we add government to the model and study the dynamics after a
change in government expenditures (G)
Assume that
an increase in G does not aect utility from private consumption
it does not aect future output
it is nanced by lumpsum taxes
the governments budget is always balanced
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Comparative Dynamics (2)
With the government in the model, (2.25) changes to

k(t) = f [k(t)] c(t) G(t) (n +g)k(t). (2.40)


And (2.14) changes to

_
t=0
e
R(t)
c(t)e
(n+g )t
dt
_ k(0) +

_
t=0
e
R(t)
[w(t) G(t)]e
(n+g )t
dt. (2.41)
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Comparative Dynamics (2)
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Comparative Dynamics (2)
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Slope of the Saddle Path
We shall focus on the Saddle Path in the neighborhood of the
steady-state
To do so, we shall linearize the system around the steady-state
Recall the rst-order Taylor approximation formula in case of one
function
f (x) f (x
+
) + f
/
(x
+
)[x x
+
].
In case of two functions and two variables it extends to
_
f (x, y)
g(x, y)
_

_
f (x
+
, y
+
) + f
1
(x
+
, y
+
)[x x
+
] +f
2
(x
+
, y
+
)[y y
+
]
g(x
+
, y
+
) + g
1
(x
+
, y
+
)[x x
+
] +g
2
(x
+
, y
+
)[y y
+
]
_
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Slope of the Saddle Path
The dynamic system that we want to linearize consists of
c(t) =
f
/
[k(t)]g

c(t). (2.24)

k(t) = f [k(t)] c(t) (n +g)k(t). (2.25)


Compared to the general case in the previous slide the variables of
interest are c and k (instead of x and y) and the relevant functions
are c(c, k) and

k(c, k) (instead of f (x, y) and g(x, y))
We take rst-order Taylor approximation around k = k
+
and c = c
+
c [ c]
c=c
+
k=k
+
+
_
c
c
_
c=c
+
k=k
+
[c c
+
] +
_
c
k
_
c=c
+
k=k
+
[k k
+
], (2.26)

k
_

c=c
+
k=k
+
+
_

k
c
_
c=c
+
k=k
+
[c c
+
] +
_

k
k
_
c=c
+
k=k
+
[k k
+
]. (2.27)
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Slope of the Saddle Path
To simplify the notation, note that in the steady-state, c =

k = 0.
Dene c = c c
+
,

k = k k
+
,

c = c and

k =

k

c
_
c
c
_
c=c
+
k=k
+
c +
_
c
k
_
c=c
+
k=k
+

k (2.28)

k
_

k
c
_
c=c
+
k=k
+
c +
_

k
k
_
c=c
+
k=k
+

k (2.29)
There are four partial derivatives that we need to nd and evaluate at
the steady state values of c and k
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Slope of the Saddle Path
Recall
c(t) =
f
/
[k(t)] g

c(t) (2.24).
_
c
c
_
c=c
+
k=k
+
=
_
f
/
[k(t)] g

_
c=c
+
k=k
+
= 0,
because f
/
(k
+
) = + g.
_
c
k
_
c=c
+
k=k
+
=
_
c (t)
f
//
[k(t)]

_
c=c
+
k=k
+
= c
+
f
//
[k
+
]

.
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Slope of the Saddle Path
Recall

k(t) = f [k(t)] c(t) (n +g)k(t). (2.25).


_

k
c
_
c=c
+
k=k
+
= 1.
_

k
k
_
c=c
+
k=k
+
= [f
/
[k(t)] (n +g)]
c=c
+
k=k
+
= f
/
[k
+
] (n +g)
= + g (n +g)
=
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Slope of the Saddle Path
Substituting these derivatives in (2.28) and (2.29)

c
c
+
f
//
[k
+
]

k (2.30)

k c (2.31)
Dividing (2.30) by c and (2.31) by

k

c
c

c
+
f
//
[k
+
]

k
c
(2.32)

k

c

k
(2.33)
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Slope of the Saddle Path
For simplicity, we assume

c
c
=

k
= . (2.32) becomes
=
c
+
f
//
[k
+
]

k
c
.
==
c

k
=
c
+
f
//
[k
+
]

. (2.34)
Substitute (2.34) in (2.33)

c
+
f
//
[k
+
]

. (2.35)
==

2
+
c
+
f
//
[k
+
]

= 0. (2.36)
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Slope of the Saddle Path
The two roots of (2.36) are

1
,
2
=

_

2
4
c
+
f
//
[k
+
]

2
.
Since
c
+
f
//
[k
+
]

< 0, one root


_

2
_
is less than zero (the other is
greater than zero and implies a divergent path). Let us call this root

1
.
To be on the linearized saddle path, at time zero c must be equal to
c
+
+
c
+
f
//
[k
+
]

1
(k k
+
).
. .
(cc
+
) from (2.34)
From there,
k(t) = k
+
+e

1
t
[k(0) k
+
] = k
+
+e

1
[k(t 1) k
+
]
c(t) = c
+
+e

1
t
[c(0) c
+
] = c
+
+e

1
[c(t 1) c
+
]
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Speed of Adjustment
Assume f (k) = k

==f
//
(k) = ( 1)k
+(2)
From (2.24) k
+
=
_

+g
_ 1
1
From (2.25) c
+
= k
+
(n +g)k
+
Parameters: =
1
3
, = 0.04, n = 0.02, g = 0.01 and = 1
Using the above functional form and parameter values we get

1
= 5.4%
It means each period both c and k cover 5.4% of their current
distance from c
+
and k
+
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