Advanced Macro I

Advanced Macroeconomics I
Volker Hahn
University of Konstanz
October 23, 2016
Hahn (U. Konstanz) Advanced Macroeconomics I October 23, 2016 1

Section 1
Introduction

My office hours: Wednesdays 8:45-9:45 a.m.
Tutorials
matlab (see ``MATLAB for Economics and Econometrics A Beginners
Guide'' by John Frain, available online)
no midterm exam, teams of at most three students have to hand in
problem sets every week, 20\% of the overall grade

The History of Macroeconomic Thought
Classical Economics
Keynesianism
Monetarism
Lucas Critique/Rational Expectations and Microeconomic Foundations
(New) Growth Theory
Real Business Cycles
New Keynesian Economics

Focus of this lecture
Building blocks of many current macroeconomic models:

Based on microeconomic foundations
Rational expectations
Representative agent
Uncertainty
How to solve dynamic optimization problems in discrete time?

Analytically?
Numerically?
Standard approaches in Dynamic Macroeconomics

Neoclassical Growth Theory
New Growth Theory
Real business cycles
Money
Search Theory
Money-in-the-utility-function approach
Cash-in-advance constraints

Literature
Lecture slides (can be obtained from ilias platform, password:
AdvMacI)
Acemoglu, `Ìntroduction to Modern Economic Growth''
Ljungqvist, Sargent, ``Recursive Macroeconomic Theory''
Walsh, ``Monetary Theory and Policy''
Romer, `Àdvanced Macroeconomics''
Dirk Kr\"uger, ``Macroeconomic Theory'', lecture notes, available online,

2007.
Per Krusell, Real Macroeconomic Theory, 2007, available online.
Simon and Blume, ``Mathematics for Economists''
Jerome Adda and Russell Cooper, ``Dynamic Economics: Quantitative

Methods and Applications''
Stokey, Lucas, ``Recursive Methods in Economic Dynamics'' (very

challenging)
Ljungqvist, Sargent, ``Recursive Macroeconomic Theory''

Table of contents (I)
1 Introduction
2 Solow Model
3 Dynamic Optimization
Cake-eating problem
Stationary dynamic programming
The Contraction Mapping Theorem and its applications
Generalizations of stationary dynamic programming

Table of contents (II)
4 Neoclassical Growth Theory
The social planner's solution
Different ways of computing the socially optimal solution
Competitive equilibrium
Balanced growth path
Transition dynamics
Log-linearization
Some background information on difference equations and
saddle-path stability
Additional material on difference equations and saddle-path stability
Implications of the Neoclassical Model
Cross-country differences
Solow model with human capital and physical capital
Growth accounting and level differences
5 Ricardian Equivalence

Table of contents (III)
6 AK model
Simplified AK model
Socially optimal solution
The role of policy
Summary
Possible extensions
7 RBC Models
Idea
Model
The social planner's problem
HP-filter
Assessment
Log-linearization
Critique of RBC models

Table of contents (IV)
8 Money
Money-in-the utility approach
Cash-in-advance models
Search theory and money
New Keynesian Economics
Where has money gone?
Time inconsistency

Section 2
Solow Model

Starting point
Kaldor identified the following stylized facts about growth:
Real GDP per worker and capital per worker roughly grow at a
constant rate in many developed countries (e.g. the US over the last
200 years)
Both grow at similar rates. As a result, the ratio between capital and
real GDP is approximately constant over time.
The real rate of return on capital and the real interest rate are
approximately constant over time.
The fraction of income that accrues to capital owners and workers is

constant over time
Solow built a simple model that reflects these stylized facts.

Sustained Growth
Source: Madison (2003)
Western Offshoots: US, Canada, New Zealand and Australia

Capital and Labor Share over Time
Source: Acemoglu (2007)
Capital and Labor Share in the U.S. GDP.

Solow Model (Assumptions)
One good (can be used as capital good or for consumption)
closed economy (no trade, no capital flows)
No government (e.g., no taxes)
All resources are used (e.g. no unemployment)
Time is discrete t = 0, 1, 2, ....

Aggregate Production Function
only effective labor At Lt and capital Kt are inputs to production
A is the efficiency of labor (the technology level) and L is the size of

the population
constant returns to scale (CRTS), F (xAL, xK) = xF (AL, K)

Thus a CRTS production function is homogeneous of degree 1.
CRTS: If one replicates a factory (all machines and workers), output is
twice as high as the output of a single factory.
F (AL, K) is increasing in both arguments
F (AL, K) is concave with respect to both arguments
The production function satisfies Inada conditions.
\mathrm{l}\mathrm{i}\mathrm{m} FK (At Lt , Kt ) = \infty \mathrm{l}\mathrm{i}\mathrm{m} FK (At Lt , Kt ) = 0

Kt \rightarrow 0 Kt \rightarrow \infty
\mathrm{l}\mathrm{i}\mathrm{m} FAL (At Lt , Kt ) = \infty \mathrm{l}\mathrm{i}\mathrm{m} FAL (At Lt , Kt ) = 0
At Lt \rightarrow 0 At Lt \rightarrow \infty

Example of a production function: Cobb-Douglas
Cobb-Douglas function: F (AL, K) = (AL)1 - \alpha K \alpha where 0 \leq \alpha \leq 1
It is straightforward to check that the Cobb-Douglas production
function satisfies our assumptions about F (AL, K).
\partial F (AL,K)
marginal product of effective labor:
\partial AL = (1 - \alpha ) F (AL,K)
AL
\partial F (AL,K)
marginal product of capital:
\partial K = \alpha F (AL,K)
K

Example of a production function: CES
CES production function (\gamma < 1, r > 0):
F (AL, K) = [\alpha K \gamma + (1 - \alpha )(AL)\gamma ]r/\gamma
For r = 1, the CES function involves CRTS.
For \gamma \rightarrow 0 and r = 1, the CES function converges to the

Cobb-Douglas function.

Intensive form of the production function
The intensive form makes it is easier to compute the solution of the

model, because the production function has only one argument rather
than two.
Because of CRTS output per effective labor can be written as:

Y /(AL) = F (1, K/(AL)).
Let f (x) := F (1, x). We obtain Y /(AL) = f (K/(AL)) (intensive
form)
With k := K/(AL) and y := Y /(AL) we obtain y = f (k).

Example: The Cobb-Douglas function in intensive form is given by
f (k) = k \alpha

Population Growth and Technological Progress
population growth rate n is constant
Nt+1 - Nt = nNt
Nt = N0 (1 + n)t
The efficiency of labor (or level of usable knowledge), At , grows at a
constant rate g
At = A0 (1 + g)t

Capital Accumulation
In a closed economy, I=S (investment = savings) must hold at each

point in time.
Simple assumption: S = sY , s constant over time
This implies that consumption equals C = (1 - s)Y

depreciation rate \delta is constant (0 < \delta < 1)
depreciation: machines cannot be used for an infinite amount of time,
at each point in time a constant fraction of capital, \delta , is lost.
We obtain Kt+1 = Kt + It - \delta Kt = Kt + sYt - \delta Kt

Capital accumulation: intensive form
If we divide both sides of the capital accumulation equation by At Lt

and use kt = Kt /(At Lt ), we obtain the capital accumulation equation
in intensive form:
(kt+1 - kt )(1 + n)(1 + g) = syt - \delta kt + (1 - (1 + n)(1 + g)) kt
Recall that for F (AL, K) = (AL)1 - \alpha K \alpha the production function in
intensive form
\alpha
is given by f (k) = k .
This implies
(kt+1 - kt )(1 + n)(1 + g) = s(kt )\alpha - (\delta + n + g + ng)kt

Break-even investment
(\delta + n + g + ng)kt is break-even investment.
At least the break-even investment has to be invested to prevent the

capital stock in intensive form from shrinking.
Otherwise the capital stock in intensive form would shrink because ...
...a fraction of the capital stock depreciates (\delta ).
...effective labor grows at rate (1 + n)(1 + g) - 1 = g + n + ng .
\alpha
If actual investment s(kt ) is equal to break-even investment, kt is
constant over time.

Definition
Balanced Growth Path: On the balanced growth path kt is constant.
The BGP (balanced growth path) capital stock is given by the solution
to sk \alpha = [\delta + g + n + ng] k
In the following, we will use X \ast to denote the value of X on the BGP.
\Bigl( \Bigr) 1
1 - \alpha
k \ast = s
n+g+ng+\delta

Properties of the balanced growth path
yt\ast = (k \ast )\alpha is constant.
c\ast t = (1 - s)yt\ast is constant.
In the following \widehat

X always denotes the per-capita value of X.
Per-capita output Y\widehat t\ast , per-capita capital \widehat \ast
K t and per-capita
consumption \widehat t\ast
C grow at rate g.
Output Yt\ast , capital Kt\ast and consumption Ct\ast grow at rate
g + n + gn \approx g + n for g, n \ll 1.
Yt\ast , Ct\ast and Kt\ast do not depend on the initial capital endowment.

Output, break-even and actual investment
(kt)
( + n + g + ng)kt
skt
kt

Phase diagram for k
kt+1 kt
kt

Adjustment to the BGP
If kt is below its BGP value k \ast , kt+1 - kt > 0.

If kt is above its BGP value k \ast , kt+1 - kt < 0.
The growth rate of Y\widehat t is higher than g for some time if kt < k \ast ,
eventually the growth rate converges to g.

Growth effects vs. level effects (I)
Per-capita income on the BGP is given by
\biggl( \biggr) \alpha

s 1 - \alpha
Y\widehat t\ast = (1 + g)t A0 (k \ast )\alpha = (1 + g)t A0
n + g + ng + \delta
It is important to distinguish between growth and level effects.

Growth effects vs. level effects (II)
a permanent increase in the saving rate s increases Y\widehat t\ast , but not its
growth rate g \Rightarrow level effect
a permanent decrease in the population growth rate n increases Y\widehat t\ast ,

but not its growth rate g \Rightarrow level effect
A permanent increase in the rate of technological growth increases the

long-run growth rate of per-capita income.
Note: a permanent increase in s increases the growth of per-capita

income in the short run

Section 3
Dynamic Optimization

3.1 Dynamic Optimization: Cake-eating problem

Cake-eating-problem
Consider an infinitely lived agent who has a divisible storable cake of

size s0 in period 0.
instantaneous utility function function in t: u(ct ) = \mathrm{l}\mathrm{n}(ct ), where ct is
cake consumption in t.
discount factor \beta with 0 < \beta < 1
The agent chooses a (feasible) consumption path
\sum \infty \{ ct \} \infty
t=0 to maximize
U0 = t
t=0 \beta u(ct ).
Which consumption path is optimal?

Discounting
The agent must be able to compare instantaneous utility across

different periods to compare consumption paths.
Assumption: If the agent can choose between ...

1 a specified increase \Delta u in utility in period t
2 and a specified increase \Delta u in utility in period t + 1, ...
...he will prefer the utility gain in period t.

Future utility is discounted at a constant factor \beta .
Thus utility \tau periods in the future is weighted by \beta \tau
1
The discount rate \rho > 0 is implicitly given by \beta = 1+\rho .

Feasible consumption paths
A consumption path is feasible if

ct \leq st \forall t with st+1 = st - ct
ct \geq 0 \forall t
The optimization problem can be stated as
\infty
\sum
V (s0 ) = \mathrm{m}\mathrm{a}\infty \mathrm{x} \beta t u(st - st+1 )
\{ st \} t=1
t=0
subject to
st+1 \in \Gamma (st ), \forall t \geq 0
\Gamma (st ) = [0, st ]

Dynamic Programming
Bellman's principle of optimality
Suppose you had already solved the problem from period t+1 on \Rightarrow
V (st+1 ).
Then the cake-eating problem in period t is
V (st ) = \mathrm{m}\mathrm{a}\mathrm{x} [u(st - st+1 ) + \beta V (st+1 )]

st+1 \in \Gamma (st )
The above functional equation is called Bellman equation.
The cake-eating problem can be written in this recursive formulation.

Solving the Bellman equation
First-order condition:
- u\prime (st - st+1 ) + \beta V \prime (st+1 ) = 0
Envelope theorem:
V \prime (st ) = u\prime (st - st+1 )
Combining yields the so-called Euler equation:
u\prime (st - st+1 ) = \beta u\prime (st+1 - st+2 )
In consumption levels:
u\prime (ct ) = \beta u\prime (ct+1 )

Optimal consumption path
Suppose u(ct ) = \mathrm{l}\mathrm{n}(ct ).

Then the optimal consumption path satisfies:
ct = \beta t c0
How can we determine the level of this consumption path or c0 ,

respectively?

3.2 Dynamic Optimization: Stationary dynamic
programming

Notation
Let X be the set of possible values that the state x can take.
Correspondence \Gamma : X \Rightarrow X describes the feasible set of next period's

states y, given that today's state is x.
Important restriction at this stage: \Gamma does not depend on time
explicitly.

Notation
A sequence of states \{ xt \} \infty

t=0 is a plan
The set of all feasible plans starting with xt \in X is
\bigl\{ \bigr\}
\Phi (xt ) := \{ xs \} \infty \prime
s=t : xs\prime +1 \in \Gamma (xs\prime )\forall s \geq t

Sequential problem (SP)
\infty
\sum
W (x0 ) = \mathrm{s}\mathrm{u}\mathrm{p} \beta t u(xt , xt+1 )
\bfx \in \Phi (x0 ) t=0
Functional equation (FE)
V (x) = \mathrm{s}\mathrm{u}\mathrm{p} \{ u(x, y) + \beta V (y)\} \forall x \in X

y\in \Gamma (x)

Questions
1 Under which conditions is a solution W to SP a solution to FE?
2 Under which conditions is a solution V to FE a solution to SP?
3 Under which conditions does a sequence \{ xt \} \infty

t=0 that attains the
supremum in SP satisfy a policy correspondence \pi that attains the
supremum to FE (xt+1 \in \pi (xt ) \forall t \geq 0)?
4 What can we say about the existence and uniqueness of values and
policy function \pi (x) in FE or path \bfx in SP?
5 Is V differentiable?

Summary of Results
Under mild assumptions, ...

... we obtain the equivalence of values, i.e. a solution W to SP is also
solution to FE and a solution V to FE attains the supremum in SP.
... a plan that attains the supremum in SP gives a policy function \pi (x)
that describes an optimal policy in FE. The optimal policy function in
FE describes a path that attains the supremum in SP.
Under somewhat more restrictive assumptions (for example \Gamma (x) must
not be an open interval (a, b) and should be bounded), we obtain
uniqueness and existence of solution V to FE and the existence of
policy functions that attain V.
Proof: By the contraction mapping theorem, yet to be introduced.
Other conditions ensure the concavity of V and the uniqueness of

policy functions.

More results...
Further conditions (e.g. u has to be differentiable and \Gamma has to be
continuous in some sense) imply that V is differentiable and the
gradient is
DV (x) = Dx u(x, \pi (x)).
(Envelope Theorem or somewhat more impressive:
Benveniste-Scheinkman formula)
\pi (x) is called the policy function and gives the optimal choice for a
given state x.
Suppose several assumptions hold. A sequence \bfx \in \Phi (x0 ) is optimal
for SP iff
Dy u(x, \pi (x)) + \beta Dx u(\pi (x), \pi (\pi (x))) = 0
and
\partial u(x\ast t , x\ast t+1 ) \ast
\mathrm{l}\mathrm{i}\mathrm{m} \beta t xt = 0.
t\rightarrow \infty \partial x
The first equations are the Euler equations.
The second equation is the transversality condition.
3.3 Dynamic Optimization: The Contraction Mapping
Theorem and its applications

Usefulness of the Contraction Mapping Theorem
It establishes uniqueness and existence of solution V to FE.
It implies an algorithm for computing the solution V to FE.

Functional equation
V (x) = \mathrm{s}\mathrm{u}\mathrm{p} \{ u(x, y) + \beta V (y)\}

y\in \Gamma (x)
Operator T
(T V )(x) := \mathrm{s}\mathrm{u}\mathrm{p} \{ u(x, y) + \beta V (y)\}
y\in \Gamma (x)
Operator T takes the function V as input and spits out a new function
TV .
A solution V \ast to the functional equation is a fixed point of the
operator T, i.e. satisfies
V \ast = T V \ast

Definition: Contraction Mapping
Let (S, d) be a metric space and T : S \rightarrow S be a function mapping S into
itself. The function T is a contraction mapping if there exists a number
\beta \in (0, 1) satisfying
d(T x, T y) \leq \beta d(x, y) for all x, y \in S
The number \beta is called the modulus of the contraction mapping.
Contraction Mapping Theorem

Let (S, d) be a complete metric space. Suppose that T : S \rightarrow S is a
contraction mapping with modulus \beta . Then
1 the operator T has exactly one fixed point v \ast \in S and
2 for any v0 \in S , and any n \in \BbbN we have
d(T v0 , v ) \leq \beta n d(v0 , v \ast ).

n \ast

Theorem: Blackwell's Sufficient Conditions
Let X \subseteq \BbbR L and B(X) be the space of bounded functions f : X \rightarrow \BbbR with
the metric d induced by the sup-norm. Let T : B(X) \rightarrow B(X) be an
operator satisfying
1 Monotonicity: If f, g \in B(X) such that f (x) \leq g(x) for all x \in X ,
then (T f )(x) \leq (T g)(x) for all x \in X .
2 Discounting: Let the function f + a, for f \in B(X) and a \in \BbbR + , be
defined as (f + a)(x) := f (x) + a. There exists \beta \in (0, 1) such that
for all f \in B(X), a \geq 0 and all x \in X
[T (f + a)](x) \leq [T f ](x) + \beta a
If these two conditions are satisfied, then the operator T is a

contraction with modulus \beta .

Sketch of the Proof of Existence and Uniqueness of V in FE
Consider the space of continuous (and bounded) functions on X,

C(X), together with the metric induced by the supremum norm
| | f | | := \mathrm{s}\mathrm{u}\mathrm{p}x\in X | f (x)| .
Together with this metric, C(X) forms a metric space.
T is well-defined, as it involves the maximization of a continuous

function over a compact set.
According to Berge's Maximum Theorem, the continuity of u and V

imply the continuity of TV .
Thus T maps C(X) into itself.
We have to check that T fulfills Blackwell's sufficient conditions:

Monotonicity
Discounting
T is a contraction mapping and has a unique fixed point V \ast .

Value Function Iteration
The contraction mapping theorem entails a very useful algorithm for
computing solutions to FE.
Algorithm
1 Start with some guess V0
2 Compute TV to obtain a new guess.
3 Repeat with the new guess.
The contraction mapping theorem implies
d(T n V0 , V \ast ) \leq \beta n d(V0 , V \ast )

In each step we are getting closer to the fixed point V \ast .
The smaller \beta , the more rapid the convergence.
The algorithm is stopped, when the additional improvement by a step

is small | | T n+1 V - T n V | | < \varepsilon , where \varepsilon is some given threshold level.
Note that an upper boundary for the distance from the fixed point can
be calculated in the following way:
| | V \ast - T n V | | \leq 1
1 - \beta | | T
n+1 V - T n V | | < \varepsilon
1 - \beta .
3.4 Dynamic Optimization: Generalizations of stationary
dynamic programming

Non-Stationary Infinite-Horizon Optimization
We have only considered stationary environments, i.e. \Gamma and u do not

depend on time directly.
This precludes optimization problems in dynamic general equilibria (at

least in general).
Similar theorems to the ones discussed before guarantee, in particular,

... the existence of solutions.
... the necessity and sufficiency of Euler equation and transversality
condition for a solution.

Stochastic Dynamic Programming
So far, we have not considered uncertainty.
Again, similar theorems exist that allow, in particular, the use of Euler
equation and transversality condition to characterize solutions.

Optimal control theory
Optimization problems can also be formulated in continuous time.
Example (cake-eating in continuous time): A household maximizes
\int \infty
e - \rho t u(c(t)) dt
t=0
subject to
\. = - c(t), s(t) \geq 0
s(t) \forall t \geq 0.
by choosing a consumption path c(t) for an initial cake size s(0) = 1 .
These problems can be tackled by optimal control theory.

Section 4
Neoclassical Growth Theory

Starting point
In the Solow-Model, the saving rate is assumed to be constant.
But: the saving/investment decision must be made by households.
Importantly, the savings/investment decision depends on the economic

environment and on the households' preferences. If the economic
environment changes, the saving rate may change.

Representative household
To model the behavior of households, economists often consider the

behavior of a single representative household.
One assumes that there are a very large number of identical

households and each household is too small to affect prices.
By abstracting from differences between households, the analysis is

much easier.
Obviously, distributional issues cannot be examined in such a model.
For additional information on the representative household see Section

5.2 in Acemoglu's book.

Differences between Solow and Ramsey, Cass, Koopmans
(RCK)
In the Solow model, the firm simply invests all available inputs (labor
and capital). In the RCK-Model, the firm chooses its inputs to
maximize profits.
In the Solow model, the household consumes a constant fraction of

output. In the RCK-Model, the household chooses an optimal path for
consumption and savings.
In the RCK-model, prices adjust such that the demand and supply of
labor and capital respectively are equal. In the Solow model, all
resources are used by assumption.
The Ramsey-Cass-Koopmans model is otherwise identical to the Solow

model.

4.1 Neoclassical Growth Theory: The social planner's
solution

Social Planner
Social Planner
A social planner is a hypothetical agent who can choose an arbitrary
feasible allocation (i.e. sequences of consumption and capital) to maximize
welfare (where welfare is just the utility of the representative household in
our case).
Why do we introduce this concept?
The allocation chosen by the social planner is the (socially) best

allocation that can be achieved.
If some other mechanism (like a competitive market) yields the same

allocation, this mechanism cannot be improved upon and is in this
sense optimal.
If the first theorem of welfare is known to hold, it may be easier to

compute the competitive equilibrium indirectly by computing the
social planner's problem.

The Environment
There is an infinitely lived household, growing at rate n in each period.
Endowment of labor: Nt = N0 (1 + n)t units per period.

The household has an instantaneous (or per-period) utility function
\widehat t )
u(C where \widehat t
C denotes consumption per capita.
u\prime () >0 (more consumption is always better)
u\prime \prime () <0 (decreasing marginal utility from consumption)

\widehat t )1 - \sigma - 1
In the following, we assume CRRA-utility: \widehat t ) =
u(C (C
, \sigma > 0,
1 - \sigma
for \widehat t ) = \mathrm{l}\mathrm{n}(C
\sigma = 1: u(C \widehat t )

Digression: CRRA-utility
\Bigl( relative
the coefficient of \Bigr) \Bigl(
risk \Bigr)
aversion is defined as
\widehat t u\prime \prime C
RRA = - C \widehat t /u\prime C
\widehat t
for a CRRA-utility function this coefficient is \sigma
The parameter \sigma measures the concavity of the CRRA-utility function.
For \sigma \rightarrow 0, the function becomes linear.
For very large values, the function becomes ``more concave''. The
household tends to smooth consumption over time.

Production technology
Production function with labor-augmenting technological progress:

F (Kt , At Lt ) with At+1 = (1 + g)At
The production function has constant returns to scale.
Positive and declining marginal productivity
The production function satisfies Inada conditions.
\mathrm{l}\mathrm{i}\mathrm{m} FK (Kt , At Lt ) = \infty \mathrm{l}\mathrm{i}\mathrm{m} FK (Kt , At Lt ) = 0

Kt \rightarrow 0 Kt \rightarrow \infty
\mathrm{l}\mathrm{i}\mathrm{m} FAL (Kt , At Lt ) = \infty \mathrm{l}\mathrm{i}\mathrm{m} FAL (Kt , At Lt ) = 0
At Lt \rightarrow 0 At Lt \rightarrow \infty
Example: Cobb-Douglas production function

F (Kt , At Lt ) = Kt\alpha (At Lt )1 - \alpha

Sequence of events
At the beginning of each period, output is produced, where the inputs

are labor Lt and the capital stock inherited from the previous period.
After production, a fraction \delta of the capital stock Kt depreciates.
Afterwards, the household consumes Ct . The remainder of goods form

the capital stock for the next period.

Social planner's problem
The social planner solves the recursive problem
\Bigl\{ \Bigr\}
V\~t (Kt ) = \mathrm{m}\mathrm{a}\mathrm{x} \widehat t ) + \beta V\~t+1 (Kt+1 )
u(C
\~ t (Kt )
Kt+1 \in \Gamma
s.t. \widehat t
Kt+1 = Kt (1 - \delta ) + F (Kt , At Nt ) - Ct , Ct /Nt = C
where
\~ t (Kt ) := [0, Kt (1 - \delta ) + F (Kt , At Nt )]
\Gamma
Note that Kt is not guaranteed to remain in a compact set over time.
Note that \~ t (Kt ) also depends on time because At depends on time.
\Gamma

Formulate the problem in intensive form (where kt := Kt /(At Nt ))
and set f (kt ) = kt\alpha
\Bigl\{ \Bigr\}
Vt (kt ) = \mathrm{m}\mathrm{a}\mathrm{x} \widehat t ) + \beta Vt+1 (kt+1 )
u(C
kt+1 \in \Gamma (kt )
where \widehat t = At [kt (1 - \delta ) + k \alpha - kt+1 (1 + n)(1 + g)]

C t
\Gamma (kt ) = [0, \{ (1 - \delta )kt + kt\alpha \} / \{ (1 + n)(1 + g)\} ]
kt is guaranteed to remain in a compact subset of \BbbR if
(1 - \delta )/((1 + g)(1 + n)) < 1.
\ast \infty
The optimal path \{ kt \} t=0 satisfies
1 Euler equation:
1
u\prime (C\^t\ast ) = \beta u\prime (C\^t+1
\ast
)(1 - \delta + f \prime (kt+1
\ast
)) \forall t \geq 0
(1 + n)
2 Transversality condition:
\partial u(C\^t\ast ) \ast

\mathrm{l}\mathrm{i}\mathrm{m} \beta t k = 0.
t\rightarrow \infty \partial kt\ast t
where
\bigl[ \bigr]
\widehat t\ast = At kt\ast (1 - \delta ) + f (kt\ast ) - kt+1
C \ast
(1 + n)(1 + g)
Special Case
Suppose u(C\^t ) = \mathrm{l}\mathrm{n} C\^t , f (kt ) = 0, \delta = 0, n = 0, g = 0.
Then the Euler equation is
1 1
= \beta \ast \forall t \geq 0
\^
Ct \ast \^
Ct+1
Hence per-capita consumption must be of the form
C\^t\ast = \beta t C\^0\ast

Capital evolves according to
\^ \ast \^ \ast \^ \ast

K t+1 = Kt - Ct
t - 1
\sum
\^ t\ast = K
K \^ 0 - C\^\tau \ast
\tau =0
It is straightforward to show that the transversality condition implies
C\^0\ast = (1 - \beta )K
\^ 0 .

Alternative Way of Deriving the Euler equation
The Euler equations can be obtained from setting up a Lagrangean to

the sequential problem.
For simplicity, assume that population and technology are constant.
For given K0 , choose \{ Ct \} \infty

t=0 and \{ Kt \} \infty
t=1 to maximize
\infty
\sum
\beta t u(Ct )
t=0
subject to
Kt+1 = Kt (1 - \delta ) + F (Kt ) - Ct t \geq 0

Alternative Way of Deriving the Euler equation (continued)
Lagrangean:
\infty
\sum \Bigl( \Bigl[ \Bigr] \Bigr)
\scrL = \beta t u(Ct ) - \lambda t Kt+1 - Kt (1 - \delta ) - F (Kt ) + Ct
t=0
First-order conditions:
\beta t u\prime (Ct ) = \beta t \lambda t \forall t \geq 0

\Bigl( \Bigr)
\beta t \lambda t (1 - \delta ) + F \prime (Kt ) - \beta t - 1 \lambda t - 1 = 0 \forall t \geq 1
Combining yields the Euler equation:
\Bigl( \Bigr)
\beta u\prime (Ct+1 ) (1 - \delta ) + F \prime (Kt+1 ) = u\prime (Ct )

4.2 Neoclassical Growth Theory: Different ways of
computing the socially optimal solution

Special case
We focus on the special case u(C\^t ) = \mathrm{l}\mathrm{n} Ct , \delta = 1, n = 0, g = 0,

f (k) = k \alpha .
The social planner's problem in recursive form is
\bigl\{ \bigr\}
V (k) = \mathrm{m}\mathrm{a}\mathrm{x} \mathrm{l}\mathrm{n}(f (k) - k + ) + \beta V (k + )
k+ \in [0,k\alpha ]

Different solution approaches
1 Euler equation and transversality condition
2 Value function iteration (analytical)
3 Value function iteration (numerical on a grid)
4 Guess a functional form for the value function and apply the method
of undetermined coefficients.

Solution Approach: Value Function Iteration (analytical)
We have already described the algorithm for Value Function Iteration.
The algorithm can be used analytically.
We start with V0 (k) = 0.

\mathrm{l}\mathrm{n}(f (k) - k + ) + \beta V0 (k + ) is maximized by k+ = 0
This yields V1 (k) = \mathrm{l}\mathrm{n} f (k).
\mathrm{l}\mathrm{n}(f (k) - k + ) + \beta V1 (k + ) = \mathrm{l}\mathrm{n}(f (k) - k + ) + \beta \mathrm{l}\mathrm{n} f (k + ) is maximized
by \alpha \beta /(1 + \alpha \beta )k
\alpha
....

Solution Approach: Value Function Iteration on a Grid
We have to define a grid for the state variable k \in \{ \kappa 1 , \kappa 2 , \kappa 3 , ..., \kappa n \}
with n distinct values.
Set Uij = u(f (\kappa i ) - \kappa j ) for all i, j . Set Uij to a ``very negative'' value
if f (\kappa i ) - \kappa j < 0.
\bigl\{ 0 \bigr\} n
Start with some vector Vi .
i=1
Entry i has the interpretation as the starting value of the value
function at \kappa i .
1
Compute Vi = \mathrm{m}\mathrm{a}\mathrm{x}j =1..n \{ Uij + \beta Vj \}
0
2
Compute Vi = \mathrm{m}\mathrm{a}\mathrm{x}j =1..n \{ Uij + \beta Vj \}
1
...
Repeat until the difference between two vectors Vs and V s+1 is lower
than some given \varepsilon (to compute the difference between the vectors, we
can use the maximum absolute difference for all pairs of corresponding
entries).
Note: The policy function in a particular step is given by the values
of j that yield the maximum value for different values of i.
4.3 Neoclassical Growth Theory: Competitive equilibrium

So far, we have considered the social planner's solution for the
Ramsey-Cass-Koopmans model.
Now we consider ``decentralization,'' i.e. how (and whether) this

allocation can be reached by competitive markets.

Markets and Institutions
For a competitive equilibrium, we have to specify exactly the

endowments of goods, labor and shares of firms.
All contracts can be enforced (for example, firms always pay back their
loans).
No information asymmetries.

Representative Household
The household owns the firm (it receives the firm's profits).
It has an endowment of Nt = N0 (1 + n)t units of labor per period.
The household can rent out one unit of the good (capital) from
period t to t + 1 to the firm and receives a compensation of rt+1 in
period t + 1.
rt : real interest rate
\Omega t : assets of the household, representing claims on the firm.
In period t = 0, the household has an initial endowment of assets from

the previous period \Omega 0 .
wt : wage of the household, per unit of labor
Each representative household is small, i.e., it cannot affect prices rt

and wt .

The household chooses a consumption path \widehat 0 , C

C \widehat 1 , ... that maximizes
\infty
\sum
\widehat 0 , C
U (C \widehat 1 , ...) = \widehat t )
\beta t u(C
t=0
subject to instantaneous budget constraints \forall t \geq 0

\Bigl[ \Bigr] 1
\widehat t (1 + rt ) - C
\Omega \widehat t + wt + profits of firm (per capita) \cdot \widehat t+1
= \Omega
1+n
and the No-Ponzi condition (to be discussed)
Note that the profits of the firm amount to zero in equilibrium.

1
The factor
1+n takes into account the fact that the household grows
at a rate n in each period.

No-Ponzi Condition
In addition to the per-period budget constraints, the household has to

satisfy the No-Ponzi condition.
\Biggl( \tau
\Biggr)
\prod 1
\mathrm{l}\mathrm{i}\mathrm{m} \Omega \tau \geq 0
\tau \rightarrow \infty 1 + r\tau \prime
\tau \prime =1
Combining the No-Ponzi condition with the per-period budget

constraints yields the intertemporal budget constraint
\infty
\Biggl( \tau
\Biggr)
\sum \prod 1
C\tau
1 + r\tau \prime
\tau =0 \tau \prime =1
\infty
\Biggl( \tau
\Biggr)
\sum \prod 1
\leq \Omega 0 (1 + r0 ) + [L\tau w\tau + profits of firm in \tau ]
1 + r\tau \prime

Representative firm
production function F (Kt , At Lt ) = Kt\alpha (At Lt )1 - \alpha with

At+1 - At = gAt
The firm's intertemporal optimization problem is equivalent to a
one-period problem.
firm employs labor and uses capital to maximize profits:
\mathrm{m}\mathrm{a}\mathrm{x} \{ F (Kt , At Lt ) - rt Kt - \delta Kt - wt Lt \}

Kt ,Lt
the firm takes prices rt and wt as given

Sequence of events in period t
1 Output Yt = Kt\alpha (At Lt )1 - \alpha is produced.
2 A fraction \delta of the capital stock Kt depreciates.
3 The firm pays rt \Omega t (in addition to the principal \Omega t ) to the household,
which is the owner of capital.
4 The firm pays wt Lt to the household, which has supplied its labor.
5 The household makes its consumption and savings decision, i.e. it

purchases bonds \Omega t+1 and hands over Kt+1 to the firm in return.
6 The household grows at a constant rate n.

Definition of a competitive equilibrium
Definition
For given K0 = \Omega 0 and r0 , a competitive equilibrium is a path of
consumption, assets, capital, labor, real wages, and real interest rates for
all periods t = 0, 1, 2, ... such that
The representative household chooses a path of consumption, assets,

\sum \infty \widehat t ), subject to its
t u(C
and labor to maximize its utility t=0 \beta
instantaneous budget constraints in all periods t = 0, 1, 2, ... and the
no-Ponzi-condition, taking all current and future prices as well as its
initial assets as given.
The representative firm chooses labor and capital to maximize its

profits (subject to technical feasibility), taking all prices (real interest
rates on one-period bonds and real wages) as given.
All markets clear for all periods (labor markets, goods markets, capital
markets).

Household maximization
Because the household has no disutility from labor, it always supplies

all of its labor.
The utility maximization problem leads to the following Euler

equations
\widehat t ) = 1 + rt+1 \cdot \beta u \widehat (C

uC\widehat (C \widehat t+1 )
1+n C
Interpretation: In equilibrium the household's utility must not increase

if it
1 consumes a marginal unit of consumption good less in period t
2 and saves it and consumes more in period t+1
Note that a household optimum requires also that a particular
transversality condition holds and that the household does not violate
the no-Ponzi condition (to be considered later).

Representative firm
First-order conditions:
\partial F (Kt , At Lt )
= rt + \delta , \forall t \geq 1,
\partial Kt
= wt , \forall t \geq 0
\partial Lt

Competitive equilibrium: market clearing conditions
In equilibrium, all markets must clear:
labor market: Lt = N0 (1 + n)t

capital \widehat t Nt = Kt
market: \Omega
good market: \widehat t Nt + (Kt+1 - Kt ) + \delta Kt = F (Kt , At Lt )

C

Comparison with Social Planner's problem
The firm's optimization problem led to
= rt + \delta
\partial Kt
or, equivalently
\partial f (kt )
= rt + \delta
\partial kt
Combining with the household's Euler equation yields:
\prime
\widehat t ) = 1 + f (kt+1 ) - \delta \cdot \beta u \widehat (C
1+n C
This is the same condition that we obtained for the social planner's
problem!

No-Ponzi Condition and Transversality Condition
In an optimum, the No-Ponzi condition holds with equality (in

addition to the Euler equations).
\Biggl( \tau
\Biggr)
\prod 1
\mathrm{l}\mathrm{i}\mathrm{m} \Omega \tau = 0
\tau \prime =1
Using \widehat t ) = 1+f \prime (kt+1 ) - \delta \cdot \beta u \widehat (C

rt = f \prime (kt ) - \delta , uC\widehat (C \widehat t+1 ), and
1+n C
\Omega t = Kt , we can show that the above condition is equivalent to the
transversality condition in the social planner's problem:
\bigl[ \bigr]
\mathrm{l}\mathrm{i}\mathrm{m} \beta t u\prime (C\^t )At 1 - \delta + f \prime (kt ) kt = 0.
t\rightarrow \infty

First welfare theorem
Definition
An allocation is Pareto-efficient if it is not possible to raise the utility of
one agent without lowering the utility of at least one other agent.
Implication: If there is just one household, Pareto-efficiency implies that

the household's utility is maximal.
Theorem (First theorem of welfare)

If some assumptions are fulfilled (e.g. no externalities, local non-satiation
of preferences), a competitive equilibrium yields a Pareto efficient outcome.
Neoclassical Growth Model

In the Neoclassical Growth Model (Ramsey-Cass-Koopmans model), the
first theorem of welfare holds.
Note: The second theorem of welfare holds, too.

Labor and capital income
\partial Yt
recall that wt = \partial Lt = (1 - \alpha ) LYtt and rt = \partial Yt
\partial Kt
Yt
- \delta = \alpha K t
- \delta
Thus 1 - \alpha corresponds to the fraction of total income Yt that accrues
to labor
\alpha is the fraction of (gross) total income Yt that accrues to capital

(\alpha Yt - \delta Kt is paid to the household, \delta Kt has depreciated)
Because of constant returns to scale, the firm makes zero profits in a
competitive equilibrium
Our findings are in line with Kaldor's growth facts about income
shares.
We can calibrate \alpha using empirical income shares.

4.4 Neoclassical Growth Theory: Balanced growth path

Balanced growth path (I)
Definition
On the BGP Yt , Ct and Kt grow at constant rates.
Note that such a BGP, if it exists, will be in line with Kaldor's growth
facts.
Note that such a BGP, if it exists, may be only one possible solution.

For CRRA utility, we have u\prime (C\^t ) = (C\^t ) - \sigma .
In a competitive equilibrium, the consumption Euler equation gives
\widehat t+1 \biggl( 1 + f \prime (kt+1 ) - \delta \biggr) 1/\sigma

C
= \beta
C\^t 1+n
Together with C\^t = At ct , we obtain
\biggl( \biggr)
ct+1 1 1 + f \prime (kt+1 ) - \delta 1/\sigma
= \beta
ct 1+g 1+n
kt+1 (1 + n)(1 + g) = kt (1 - \delta ) + f (kt ) - ct

On the BGP, all variables in intensive form are constant (note that the
left-hand side of the Euler equation is constant on the BGP).
If (1 + g)\sigma (1 + n) > \beta (1 - \delta ), (1 + g)\sigma (1 + n) = \beta (1 + f \prime (k) - \delta ) has
a unique solution for k (due to the Inada conditions and because f (k)
\prime
is monotonically decreasing and continuous)
Consumption is given by
\bigl[ \bigr]
\widehat \ast = At c\ast = At k \ast (1 - \delta ) + f (k \ast ) - k \ast (1 + n)(1 + g)
C t t t t t+1
The social planner's transversality condition on the BGP is
\bigl[ \bigr]
\mathrm{l}\mathrm{i}\mathrm{m} \beta t u\prime (C\^t\ast )At 1 - \delta + f \prime (kt\ast ) kt\ast = 0.
t\rightarrow \infty
\Bigl( \Bigr) - \sigma
Due to u\prime (C\^t ) = C\^t and C\^t\ast = At c\ast = (1 + g)t A0 c\ast , the
transversality condition holds iff \beta (1 + g)1 - \sigma < 1.

Saving rate on the balanced growth path (I)
Because c and k (and thus y) are constant on the BGP, the saving
rate on the BGP path is constant (like in the Solow model).
Now we can determine the saving rate on the BGP for y = k \alpha
c = (1 - s)y , y = k \alpha , c = ((1 - \delta ) - (1 + n)(1 + g)) k + f (k), and
(1 + g)\sigma (1 + n) = \beta (1 + f \prime (k) - \delta ) yield
(1 + n)(1 + g) - 1 + \delta
s = \alpha 1 \sigma
\beta (1 + n)(1 + g) - 1 + \delta
Due to \beta (1 + g)1 - \sigma < 1 and (1 + n)(1 + g) - 1 + \delta > 0, s \in (0, 1).
difference between Ramsey-Cass-Koopmans model and Solow model
1 Solow model
saving rate is assumed to be constant
2 Ramsey-Cass-Koopmans model
saving rate is derived from household's optimization and a function of
the model's parameters
the saving rate is constant (on the BGP!)
4.5 Neoclassical Growth Theory: Transition dynamics

How do the general dynamics of (ct , kt ) look like? (we have only
examined the BGP!)
We have already shown that
\biggl( \biggr)
ct+1 1 1 + f \prime (kt+1 ) - \delta 1/\sigma
= \beta
ct 1+g 1+n
For given (ct , kt ), these equations specify values for (ct+1 , kt+1 ).

Figure: Dynamics of the capital stock, capital stock evolves according to

\Bigl( \prime
\Bigr) 1/\sigma
ct+1
Figure: Consumption dynamics governed by
ct = 1
1+g \beta 1+f (kt+1 ) - \delta
1+n

Figure: Both figures combined.

Difference between c and k
Note that there is an important difference between c and k

c is a jump variable whose initial value has to be determined
endogenously.
k is a state variable whose initial value is exogenously given.

kt is pre-determined in t.

Figure: Different paths of consumption for different initial values of consumption.

Figure: The saddle path.

The path for which the household's No-Ponzi-Condition holds with
equality (and the social planner's transversality condition holds) is
called the saddle path.
In the long run, the system converges along the saddle path to the
BGP, irrespective of the initial value of k.
The initial value of
the state variable k (k0 ) is exogenously given.
the jump variable c (c0 ) is determined by the only value of c0 that
allows for convergence to the BGP along the saddle path.

Figure: An increase in the discount factor.

4.6 Neoclassical Growth Theory: Log-linearization

Approximate Solution
The dynamics of ct and kt are difficult to describe in general.
Main idea: Assess the approximate evolution of ct and kt for small

relative deviations from the BGP (log-linear approximation).
A system of log-linear difference equations can be solved easily.
For additional information, consult Uhlig (1995), `À Toolkit for

Analyzing Nonlinear Dynamic Stochastic Models Easily''
Log-linear approximation:
\biggl( \biggr)
xt - x\ast xt - x\ast
\~t = \mathrm{l}\mathrm{n}(xt ) - \mathrm{l}\mathrm{n}(x\ast ) = \mathrm{l}\mathrm{n}(xt /x\ast ) = \mathrm{l}\mathrm{n} 1 +
x \approx
x\ast x\ast
\~t )x\ast \approx xt

\Rightarrow (1 + x

Approximate Solution
Let's write ct = (1 + c\~t )c\ast and kt = (1 + k\~t )k \ast .

Assume, for simplicity n = 0, g = 0, \sigma = 1, and f (k) = k \alpha .
Then consumption and capital evolve according to
kt+1 = kt (1 - \delta ) + kt\alpha - ct

ct+1 \alpha - 1
= \beta (1 + \alpha kt+1 - \delta )
ct
We transform these equations into (approximately equivalent) linear
equations in c\~t , c\~t+1 , k\~t , and k\~t+1

The log-linearized system
Note that for small x, y
\alpha
(1 + x) \approx 1 + \alpha x
1
1+x \approx 1 - x
(1 + x)(1 + y) \approx 1 + x + y
We obtain a log-linearized resource constraint and Euler equation:
1 \~ c\ast
k\~t+1 = kt - \ast c\~t
\beta k
c\~t+1 - c\~t = - \beta (1 - \alpha )\alpha (k \ast )\alpha - 1 k\~t+1
This system can be solved by the method of undetermined coefficients:
k\~t+1 = ak k\~t
c\~t = ac k\~t
k\~t+1 and c\~t are expressed as functions of the only state variable k\~t
ln(ct+1 )ln(ct )=0
ln(c)
A
ln(kt+1 )ln(kt )=0

B
E
ln(k ) ln(k)
Figure: The phase diagram for the log-linearized system.

4.7 Neoclassical Growth Theory: Some background
information on difference equations and saddle-path
stability

We have already derived:
1 \~ c\ast
k\~t+1 = kt - \ast c\~t
\beta k
c\~t+1 - c\~t = - \beta (1 - \alpha )\alpha (k \ast )\alpha - 1 k\~t+1
This can be transformed into a second-order difference equation for k\~t :
k\~t+2 + ak\~t+1 + bk\~t = 0,
where k\~0 is given by an initial condition
In the following we discuss how such a second-order difference

equation can be solved.

Rewriting with the help of the lag operator
With \scrL (the lag operator), which is defined by
\scrL k\~t := k\~t - 1
the second-order differential equation can be re-written as
k\~ + a\scrL k\~ + b\scrL 2 k\~ = 0

(1 - \lambda 1 \scrL ) (1 - \lambda 2 \scrL ) k\~ = 0,
where the second equation ``factorizes'' the first one
\lambda 1 and \lambda 2 can be determined by noting that

\bigl( \bigr)
1 - (\lambda 1 + \lambda 2 )\scrL + \lambda 1 \lambda 2 \scrL 2 k\~ = 0
and comparing coefficients implies
a = - (\lambda 1 + \lambda 2 )
b = \lambda 1 \lambda 2
The characteristic equation
Re-arranging yields
\biggl( \biggr)
b
a = - \lambda 1 +
\lambda 1
a\lambda 1 = - \lambda 21 - b
and thus
\lambda 21 + a\lambda 1 + b = 0
Similarly, \lambda 2 also fulfills
\lambda 22 + a\lambda 2 + b = 0
The equation
\lambda 2 + a\lambda + b = 0
is called the characteristic equation of (1 + a\scrL + b\scrL 2 )k\~ = 0.

General solution
For \lambda 1 \not = \lambda 2 , the general solution to
(1 - \lambda 1 \scrL ) (1 - \lambda 2 \scrL ) k\~ = 0
is
k\~t = \alpha 1 \lambda t1 + \alpha 2 \lambda t2 ,
where \alpha 1 and \alpha 2 are coefficients that are yet to be determined
We can verify that k\~t = \alpha 1 \lambda t1 + \alpha 2 \lambda t2 is a solution by observing
(1 - \lambda 1 \scrL ) \lambda t1 = 0

(1 - \lambda 2 \scrL ) \lambda t2 = 0
Note: all solutions can be written in the above form.

Determining the initial conditions
How can \alpha 1 and \alpha 2 be determined?
There is one initial condition: k\~0

The initial condition implies
\alpha 1 + \alpha 2 = k\~0
Can we pin down \alpha 1 and \alpha 2 exactly?
We are only interested in solutions that converge to zero:
\mathrm{l}\mathrm{i}\mathrm{m} k\~t = 0
t\rightarrow \infty

Three cases can be distinguished (we assume that both roots are real)
1 \lambda 1 and \lambda 2 have an absolute value smaller than one
two unknowns \alpha 1 and \alpha 2 and one initial condition k\~0
infinitely many solutions exist
2 only one of the roots has an absolute value smaller than one
w.l.o.g.: | \lambda 1 | \geq 1, | \lambda 2 | < 1
we conclude \alpha 1 = 0, which implies \alpha 2 = k\~0
3 both roots have an absolute value weakly larger than one
in general, no solutions converging to zero can be found
only if k\~0 = 0 does the system remain at k\~t = 0 forever.

4.8 Neoclassical Growth Theory: Additional material on
difference equations and saddle-path stability

Transforming the second-order difference equation into a
system of two first-order difference equations
We want to solve
k\~t+2 + ak\~t+1 + bk\~t = 0,
where k\~0 is given by an initial condition
Trick: we introduce the variable \~
lt := k\~t - 1 and obtain:
k\~t+1 + ak\~t + b\~lt = 0
\~lt+1 = k\~t
This system of first-order difference equations can be written in matrix

notation as:
\biggl( \biggr) \biggl( \biggr) \biggl( \biggr) \biggl( \biggr)
k\~t+1 k\~ k\~t t k0
\~
\~lt+1 = A \~t , \~lt = A \~l0 ,
lt
where \biggl( \biggr)
- a - b
A=
0 1
Using the Jordan normal form of A
Let J be the Jordan normal form of A with invertible transformation

matrix T (| \lambda 1 | \geq | \lambda 2 | )
J = T - 1 AT
- 1
A = T
\biggl( JT \biggr)
\lambda 1 \cdot
J =
0 \lambda 2
Using J we can rewrite the system as
\biggl( \biggr) \biggl( \biggr)

- 1 k\~t+1 - 1 kt
\~
T \~lt+1 = JT \~lt
\underbrace{} \underbrace{} \underbrace{} \underbrace{}
vt+1 vt
vt+1 = Jvt , vt = J t v0

The evolution of the Transformed system
We assume that J is diagonal (similar arguments also hold for

non-diagonal J ).
Then the transformed variables evolve according to
v1,t = \lambda t1 v1,0

v2,t = \lambda t2 v2,0
k\~t and \~
lt evolve according to
\biggl( \biggr) \biggl( \biggr) \biggl( t \biggr)
k\~t v1,t t \lambda 1 v1,0
\~lt = T v2,t = T J v0 = T \lambda t2 v2,0

Determining the initial conditions
How can v1,0 and v2,0 be determined?
There is one initial condition: k\~0

We are only interested in solutions that converge to zero:
\mathrm{l}\mathrm{i}\mathrm{m} k\~t = 0 (and \mathrm{l}\mathrm{i}\mathrm{m} \~lt = 0)

t\rightarrow \infty t\rightarrow \infty

Three cases can be distinguished
1 \lambda 1 and \lambda 2 have an absolute value smaller than one
two unknowns v1,0 , v2,0 and one initial condition k\~0
infinitely many solutions exist
2 only one of the eigenvalues has an absolute value smaller than one
| \lambda 1 | \geq 1
pick \~ l0 such that v1,0 = 0
3 both eigenvalues have an absolute value weakly larger than one
in general, no solutions converging to zero can be found

4.9 Neoclassical Growth Theory: Implications of the
Neoclassical Model

Neoclassical Model and Kaldor's Stylized Facts
Implications of the Neoclassical Model
On the BGP, output per capita grows at constant rate g.

On the BGP, the real interest rate is constant.
The fraction of income that accrues to capital owners is given by \alpha

and is constant.
The labor share amounts to 1 - \alpha

Conclusion: The Neoclassical model can explain Kaldor's stylized facts
quite well.

Implications
For g = 0, the model cannot explain persistent growth in income per

capita.
Capital accumulation alone cannot explain long-run growth.

Reason: diminishing marginal product of capital
If a country's capital is below its BGP value, the country experiences a

period of comparably high growth. This might explain comparably
high growth rates in Germany and Japan after WW II.

4.10 Neoclassical Growth Theory: Cross-country differences

Differences in per-capita incomes
per-capita income varies extremely across countries, e.g. income per

capita in the richest countries (like Switzerland) is roughly 30 times
higher compared to the poorest countries (like Uganda)
Growth rates are also very different across countries (even over a long
period of time)
Can the neoclassical growth model explain these differences?

1 differences in per-capita incomes
2 differences in growth rates

Distribution of incomes

Distribution of Growth Rates

NCG Model and Differences in Per-Capita Incomes (I)
Suppose all countries had the same level of A at a point in time
Can differences in per-capita endowment explain differences in income

per capita?
Y\^ = A1 - \alpha K
\^ \alpha
For \alpha \approx 1/3, per-capita income differences of a factor ten can be
explained by capital per capita differences of 103 = 1000 \Rightarrow
implausible

NCG Model and Differences in Per-Capita Incomes (II)
Implications of per-capita income differences of a factor 10 for real

interest rates:
1 - \alpha
1 1 A \alpha
r = \alpha - \delta = \alpha 1 - \alpha - \delta = \alpha 1 - \alpha - \delta
k 1 - \alpha y \alpha Y\^ \alpha
1 - \alpha
As
\alpha =2 for \alpha = 1/3, the rates of return to capital r differ by a
factor of more
2
than 10 = 100 \Rightarrow implausible
Possible conclusions
1 A is different across countries
2 more fundamental change to the model required (like different
production function)

Predictions of the NCG Model on Growth Rates
Two countries with the same values for s, n, \delta , \alpha and the same
technology level At should eventually converge to the same value of
per capita income
GDP per capita in all countries on the BGP grows at rate g

A country with a GDP per capita below its BGP level has a higher
growth rate of GDP per capita.
Is there convergence in per-capita GDPs in the data?

Absolute and conditional convergence
Absolute convergence
All countries converge to the same BGP. A country with lower output
per-capita thus has a higher growth rate of per-capita GDP (for some
time).
Conditional convergence
All countries converge to different BGPs. The BGP values depend on (are
conditional on) the country's values for n, s and the technology level.

Source: Dirk Kr\"uger



Absolute and Conditional Convergence (II)
Absolute convergence cannot be found in the data.
Conditional convergence: If we take into account that n, s and the

level of technology may be different across countries, can the Solow
model explain differences in per-capita incomes?
Some empirical support for conditional convergence

Mankiw, Romer, Weil Estimates (I)
Assume all countries are on their BGPs.

\Bigl( \Bigr) \alpha
(k \ast )\alpha s 1 - \alpha

Recall that Yt /Lt = yAt = At = A0 (1 + g)t n+g+ng+\delta
for small n and g we obtain
\biggl( \biggr) \alpha

t s 1 - \alpha
Yt /Lt = A0 (1 + g)
n + g + \delta

MRW Estimates (II)
estimate an equation of the form:
\alpha \alpha
\mathrm{l}\mathrm{n}(Y /L)it = \mathrm{l}\mathrm{n}(Ai ) + gt + \mathrm{l}\mathrm{n}(si ) - \mathrm{l}\mathrm{n}(ni + \delta + g)
1 - \alpha 1 - \alpha
countries are indexed by i.
Assumptions on technology:
The level of technology may differ across countries.
The growth rate of technology is the same.
Data fits surprisingly well.

2
However, data seems to indicate \alpha \approx 3 , which does not correspond to
1
the income share of capital \alpha = 3.

Estimates for the Basic Solow Model

Introduction of human capital
integration of human capital into the model mitigates the problem

that \alpha is estimated to be too large (Mankiw/Romer/Weil (1992))
Next subsection: extended Solow model, with human capital

4.11 Neoclassical Growth Theory: Solow model with
human capital and physical capital

Differences to Solow model
We consider the Solow model with two types of capital.
Physical capital: K, human capital H.

Production function: Yt = Kt\alpha Ht\beta (At Lt )1 - \alpha - \beta , \alpha , \beta > 0, \alpha + \beta < 1.
There are two saving rates sH (0 < sH ) for human capital and sK
(0 < sK ) for physical capital (sH + sK \leq 1)
The saving rates could be endogenized by considering household's

saving decisions.

Capital Accumulation
Kt+1 = Kt + sK Yt - \delta K Kt
Ht+1 = Ht + sH Yt - \delta H Ht
\delta H and \delta K are the respective depreciation rates.
For simplicity, we assume \delta := \delta H = \delta K .

Formulation in Intensive Values
production function: yt = kt\alpha h\beta t

physical capital accumulation:
(kt+1 - kt )(1 + n)(1 + g) = sK (kt )\alpha (ht )\beta - (\delta K + n + g + ng)kt
human capital accumulation:
(ht+1 - ht )(1 + n)(1 + g) = sH (kt )\alpha (ht )\beta - (\delta H + n + g + ng)ht

Dynamics of Human and Physical Capital
k
h_{t+1}h_t=0
k_{t+1}k_t=0
Balanced Growth Path

Balanced Growth Path (I)
On the BGP, kt and ht are constant.
sK (k \ast )\alpha (h\ast )\beta = (\delta K + n + g + ng)k \ast

sH (k \ast )\alpha (h\ast )\beta = (\delta H + n + g + ng)h\ast
k\ast sK
Combining these equations yields:
h\ast = sH
Now it is straightforward to show
\Biggl( \Biggr) 1
s\beta H s1 - \beta 1 - \alpha - \beta
k \ast = K
\delta + n + g + ng
\Biggl( \Biggr) 1
s\alpha K s1 - \alpha 1 - \alpha - \beta
h\ast = H
\delta + n + g + ng

Balanced Growth Path (II)
On the BGP, Kt and Ht grow at rate (1 + n)(1 + g) - 1.

On the BGP, \widehat t , H
K \widehat t , and Y\widehat t grow at rate g .
An increase in sH or sK , increases the levels of \widehat t
K and \widehat t
H (and Y\widehat t ) in
the long run, but not their growth rates.
\beta can be estimated by comparing the wages for unskilled workers and
the average wage.
1
typical values are \alpha \approx \beta \approx 3.

MRW: Estimation with Human Capital
estimate an equation of the form:
\alpha
\mathrm{l}\mathrm{n}(Y /L)it = \mathrm{l}\mathrm{n}(Ai ) + gt + \mathrm{l}\mathrm{n}(sK,i )
1 - \alpha - \beta
\beta \alpha + \beta
+ \mathrm{l}\mathrm{n}(sH,i ) - \mathrm{l}\mathrm{n}(ni + \delta + g)
1 - \alpha - \beta 1 - \alpha - \beta
Note: Ai is the level of TFP in country i.

MRW: Estimates for the Solow Model with Human Capital

Summary: Solow Model with Human Capital
Comparably small differences in saving rates and population growth

rates can explain comparably large differences in output per capita.
The difference in the marginal products of capital between rich and

poor countries that is required to explain per-capita income differences
is much smaller than in the Solow model without human capital and
1
\alpha = 3.
MRW estimates lead to reasonable values of \alpha and \beta .

4.12 Neoclassical Growth Theory: Growth accounting and
level differences

Growth accounting (I)
How can we measure technological progress?
Y = AN 1 - \alpha K \alpha where A = Total factor productivity (TFP); \alpha \approx 1/3,
corresponds to the share of income that accrues to capital owners
dY = (dA)N 1 - \alpha K \alpha + A(1 - \alpha )(dN )N - \alpha K \alpha + AN 1 - \alpha \alpha (dK)K \alpha - 1
Y
Divide by and introduce growth rates dY /Y = gY , dN/N = gN ,
dA/A = gA and dK/K = gK
We obtain gY = gA + (1 - \alpha )gN + \alpha gK
By computing this equation for a country, we can decompose a
country's output growth into growth induced by technological change
and growth that is a consequence of capital accumulation and
population growth

Growth accounting (II)

Section 5
Ricardian Equivalence

Bond Financing vs. Debt Financing
Consider the Ramsey-Cass-Koopmans model and introduce a new

agent, the government
For simplicity, suppose n=0 and g = 0.

The government has to finance an exogenously given stream of public
goods \{ Gt \} \infty
t=0 .
The government raises lump-sum taxes Tt .
It can also issue bonds, the total stock at the beginning of period t
being Bt .
Given an initial debt level B0 , the government chooses paths \{ Tt \} \infty
t=0
and \{ Bt \} \infty
t=1 .

Government's budget constraint
On bonds, the government has to pay an interest rate of rt .

This leads to the following per-period budget constraints
Bt+1 + Tt = (1 + rt )Bt + Gt
The government also has to obey a No-Ponzi condition
\Biggl( \tau
\Biggr)
\prod 1
\mathrm{l}\mathrm{i}\mathrm{m} B\tau \leq 0
\tau \prime =1

If the No-Ponzi condition holds with equality, we obtain the
government's intertemporal budget constraint:
\infty
\Biggl( \tau
\Biggr)
\sum \prod 1
B0 (1 + r0 ) + G\tau
1 + r\tau \prime
\infty
\Biggl( \tau
\Biggr)
\sum \prod 1
= T\tau
1 + r\tau \prime
B0 is an initial stock of government debt.
Now take a look at the household's intertemporal budget constraint
\infty
\Biggl( \tau
\Biggr)
\sum \prod 1
[C\tau + T\tau ]
1 + r\tau \prime
\infty
\Biggl( \tau
\Biggr)
\sum \prod 1
\leq \Omega 0 (1 + r0 ) + [L\tau w\tau + profits of firm in \tau ]
1 + r\tau \prime

Competitive Equilibrium
Definition (Competitive Equilibrium)

Given an initial stock of government debt B0 , an initial stock of capital
K0 , and a path of Gt and Tt for which the government's intertemporal
budget constraint holds with equality, a competitive equilibrium is a path of
consumption, savings, labor, wages, and real interest rates such that
\sum \infty \widehat t ), by
t u(C
The representative household maximizes its utility t=0 \beta
choosing a path of consumption, savings and labor, subject to its flow
budget constraints for all periods and the no-Ponzi condition, taking
all prices and taxes as given.
The representative firm maximizes its profits by choosing how much

capital to rent and labor to employ (subject to technical feasibility),
taking all prices as given.
All markets clear (labor markets, goods markets, capital markets) for
all periods.

Note that the household's budget constraint does not depend on the
exact timing of Tt .
It only depends on the present value of tax liabilities
\infty
\Biggl( \tau
\Biggr)
\sum \prod 1
T\tau
1 + r\tau \prime
Theorem (Ricardian Equivalence)

For a given initial stock of government debt B0 and a given path \{ Gt \} \infty
t=0 ,
all paths \{ Tt \} \infty
t=0 for which the intertemporal budget constraint of the
government holds lead to the same competitive equilibrium, i.e.
consumption, capital, wages and interest rates do not depend on \{ Tt \} \infty
t=0 .
In particular, it doesn't matter whether the government finances its

expenditures by taxes now or by debt and thus taxes later.
`Àre government bonds net wealth?'' - No. (Barro 1974, JPE)

Why Ricardian Equivalence Might Not Hold
distortionary taxes
finite lifetime
agents not fully rational
credit constraints

Section 6
AK model

Neoclassical Growth Theory: At , the source of growth, grows at a
constant rate that is exogenous
What determines the size of At ?

How can a country achieve a higher level of At ?
We need a model that `èxplains'' At ! \Rightarrow Endogenous Growth Theory
or New Growth Theory

Different Approaches
AK (constant returns to accumulable resources)
Romer (1986) (knowledge accumulation as a byproduct of capital

accumulation by private firms; positive externalities of knowledge)
Lucas (1988) (human capital accumulation and positive externalities)
Romer (1990) (monopolistic competition, research of private firms and

positive externalities)
Aghion Howitt (1992) (Schumpeterian, creative destruction)

6.1 AK model: Simplified AK model

Introduction
Neoclassical Growth Theory: No endogenous growth because of

diminishing marginal product of capital
Increasing returns to scale incommensurate with competitive

equilibrium
AK-Model: Constant returns to scale for capital (or, more generally,

accumulable resources)

Simplified Version
Like in the Solow model, suppose the saving rate s is exogenous and
constant
production function: Yt = AKt

Capital Kt can be understood in the broadest sense, i.e. it comprises
both human and physical capital.
A is constant
Kt+1 = Kt - \delta Kt + sYt = (1 - \delta + sA)Kt

Kt = (1 - \delta + sA)t K0
\Bigl( \Bigr) t
Output per capita: Y\widehat t = 1 - \delta +sA
1+n
\widehat 0
AK
Thus the growth rate of per-capita output is given by:
1 - \delta +sA
gY\widehat = 1+n - 1

Implications
endogenous growth
the saving rate affects the growth rate
economy always grows at a constant rate (no adjustment to BGP like

in the Solow model)
initial capital endowment matters, no convergence of countries with

different initial capital endowments

The Role of Returns to Capital
Solow Model: capital evolves according to
(kt+1 - kt )(1 + n)(1 + g) = s(kt )\alpha - (\delta + n + g + ng)kt
AK Model: capital evolves according to
\widehat t+1 - K
(K \widehat t )(1 + n) = sAK
\widehat t - (\delta + n)K
\widehat t

Illustration: Solow model
(kt)
( + n + g + ng)kt
skt
kt

Illustration: AK model
d
AKt
d
sAKt
d
( + n)Kt
d
Kt
6.2 AK model: Socially optimal solution

Problem of the social planner
For a given initial value K0 , the social planner faces the problem:
\mathrm{m}\mathrm{a}\mathrm{x} \widehat t , C
U (C \widehat t+1 , ...)
C
\widehat 0 ,C
\widehat 1 ,...,K1 ,K2 ,...
subject to: Kt+1 = (1 - \delta )Kt + AKt - C\^t Nt

Bellman equation
Let W (Kt ) denote the respective value function, i.e. the value of
\widehat
U ( Ct , C \widehat t+1 , ...) for an optimally chosen path of consumption.
The Bellman equation is given by:
\Bigl( \Bigr)
\widehat t ) + \beta W (Kt+1 )
W (Kt ) = \mathrm{m}\mathrm{a}\mathrm{x} u(C
Kt+1
where \widehat t
C is given by \widehat t
Kt+1 = (1 - \delta )Kt + AKt - Nt C
The per-period \widehat
utility function u(Ct ) is assumed to be of the CRRA
type.
Notes:
Kt is guaranteed to remain in a compact set only if 1 - \delta + A \leq 1 (this
parameter region is not very relevant).
\~ t :=
K1
By using
(1 - \delta +A)t Kt , the maximization problem can be
transformed into a maximization problem where ``the
functional-equation operator'' is a contraction mapping for
\Bigl( \Bigr) 1 - \sigma
1+A - \delta
\beta
1+n <1 and the state variable can be restricted to a
compact set.

Optimal path of consumption
The Euler equation is
\Bigl( \Bigr) \Bigl( \Bigr)

uC\widehat C \widehat t = \beta 1 - \delta + A u \widehat C \widehat t+1
1+n C
Thus we obtain
\widehat t+1 \biggl( \beta (1 - \delta + A) \biggr) \sigma
1
C
=
C \widehat t (1 + n)
\Bigl( \Bigr) 1
\beta (1+A - \delta ) \sigma
With \chi := (1+n) , we obtain
\widehat t = \chi t C
C \widehat 0

Evolution of capital
Now we can compute the associated path of the capital stock
We define \kappa := 1+A - \delta

1+n
\Bigl( \Bigr)
\widehat t+1
K \widehat
= \kappa Kt - 1+A - \delta 1 \widehat t
C
\widehat t
K can be written as
t - 1
\sum
\widehat t = \kappa t K
\widehat 0 - 1 \prime
\widehat t\prime
K \kappa t - t C
1 + A - \delta \prime
t =0
\bigl( \bigr) t
t \widehat \kappa t 1 - \chi \kappa \widehat
= \kappa K0 - \cdot C0
1 + A - \delta 1 - \chi \kappa

Transversality condition
To pin down the initial value of per-capita consumption, \widehat 0 ,
C we have
to consider the transversality condition:
\Bigl[ \Bigr]
\mathrm{l}\mathrm{i}\mathrm{m} \beta t u\prime (C\^t )(1 + A - \delta )K \widehat t = 0
t\rightarrow \infty
\Bigl( \Bigr) 1 - \sigma
For \chi < \kappa , which is equivalent to \beta 1+A - \delta 1+n < 1, it is
straightforward to show that the transversality condition implies
C\^0 = (1 + A - \delta )(1 - \chi /\kappa )K

\^ 0
For \chi \geq \kappa , the TVC cannot be fulfilled.
Hence, capital evolves according to
\^ t = \chi t K
K \^ 0
It is now immediate to compute the saving rate
st = (AKt - Ct )/(AKt ).
As Kt and Ct grow at the same rate, the saving rate is constant (it
will be computed later).

6.3 AK model: Competitive equilibrium

Competitive Equilibrium
Now we turn to the competitive equilibrium.
Markets and institutions identical to the ones in the neoclassical

growth model (however, the labor market is absent)
In equilibrium
a representative firm maximizes its profits (subject to technological
feasibility) by choosing the amount of capital used in production in all
periods t \geq 1.
a representative household maximizes its utility (subject to its flow
budget constraints for all periods t \geq 0 and the no-Ponzi condition).
the goods and capital markets clear in all periods t \geq 0.

Sequence of events in period t
1 Output Yt = AKt is produced.

2 The \widehat t to the household
firm pays rt K that has rented \widehat t
K goods to the
firm
3 A fraction \delta of the capital stock depreciates.
4 The household makes its consumption and savings decision.
5 Each household grows at a constant rate n.

Representative Firm
production function: Yt = AKt

profits in period t: \pi t = AKt - rt Kt - \delta Kt = (A - rt - \delta )Kt
Thus the real rate of interest is rt = A - \delta
rt is constant

Given initial assets \Omega 0 and paths of real interest

\sum \infty rates rt , the household
chooses paths of \^ \^ t \widehat
\Omega t and Ct to maximize t=0 \beta u(Ct ) subject to
the per-period budget constraints
\widehat t+1 = ((1 + rt )\Omega

\widehat t - C
\widehat t ) 1
\Omega , \forall t \geq 0,
1+n
and
the no-Ponzi condition

\biggl( \biggr) t
1
\mathrm{l}\mathrm{i}\mathrm{m} \Omega t \geq 0.
t\rightarrow \infty 1+r
(note that the \Omega t has no ``hat'')

Consumption Euler equation (I)
The consumption Euler equation is
\widehat t ) = 1 + r \cdot \beta u \widehat (C

1+n C
Interpretation: In equilibrium the household's utility must not increase

if it
1 consumes a marginal unit of consumption good less in period t
2 and saves it and consumes more in period t+1

Consumption Euler equation (II)
\Bigl( \Bigr) - \sigma \widehat t )1 - \sigma

marginal utility: \widehat t ) = C
uC\widehat (C \widehat t for \widehat t ) =
u(C (C
1 - \sigma
the consumption Euler equation can be written as
\biggl( \biggr) 1
\widehat t+1 = \beta (1 + r) \sigma
\widehat t
C C
1+n
Because r = A - \delta , we obtain
\biggl( \biggr) 1
\widehat t+1 = \beta (1 + A - \delta ) \sigma
\widehat t
C C
(1 + n)

Evolution of household wealth
\Bigl( \Bigr) 1
\beta (1+A - \delta ) \sigma 1+A - \delta
Let us introduce \chi := (1+n) and \kappa := 1+n
C \widehat t = \chi t C
\widehat 0
\Bigl( \Bigr)
\widehat t+1 = \kappa \Omega
\Omega \widehat t - 1 \widehat
1+A - \delta Ct
\widehat t
\Omega can be written as
t - 1
\sum
\widehat t = \kappa t \Omega
\widehat 0 - 1 \prime
\widehat t\prime
\Omega \kappa t - t C
1 + A - \delta \prime
t =0
\bigl( \bigr) t
t \widehat \kappa t 1 - \chi \kappa \widehat
= \kappa \Omega 0 - \cdot C0
1 + A - \delta 1 - \chi \kappa

Initial condition
Two constants: \widehat 0

C and \widehat 0
\Omega
\widehat 0
\Omega is given by the initial capital endowment.
C \widehat 0 will be determined by the No-Ponzi condition.

No-Ponzi condition
The No-Ponzi condition holds with equality if
\biggl( \biggr) t \biggl( \biggr) t

1 1 \^ t Nt
\mathrm{l}\mathrm{i}\mathrm{m} \Omega t = \mathrm{l}\mathrm{i}\mathrm{m} \Omega
t\rightarrow \infty 1+r t\rightarrow \infty 1 + A - \delta
\Biggl[ \bigl( \chi \bigr) t \Biggr]
\widehat 0 - 1 1 - \kappa \widehat 0 = 0
= \mathrm{l}\mathrm{i}\mathrm{m} \Omega C
t\rightarrow \infty 1 + A - \delta 1 - \chi \kappa
\chi
Assume
\kappa <1 (as before).
\bigl[ \chi \bigr]
\widehat 0 = \Omega
C \widehat 0 1 - + A - \delta )
\kappa (1
Inserting into \widehat t = \chi t C
C \widehat 0 gives
\Bigl[ \Bigr]
\widehat 0 1 - \chi (1 + A - \delta )
\widehat t = \chi t \Omega
C
\kappa

Evolution of capital
Now we can compute the value of the capital stock over time
Because the capital market must clear at each point in time \widehat t = \Omega
K \widehat t
\forall t \geq 0.
K \widehat t = \chi t \Omega
\widehat 0
Because Y\widehat t = AK
\widehat t = \chi t A\Omega
\widehat 0
Thus the growth rate of per-capita output is
\Bigl( \Bigr) 1
\beta (1+A - \delta ) \sigma
gY\widehat = \chi - 1 = 1+n - 1
The growth rate is endogenously determined

saving rate in equilibrium
it is interesting to compute the saving rate
Y\widehat t - C \widehat t
st :=
Y\widehat t
1 \Bigl[ \chi \Bigr]
= 1 - 1 - (1 + A - \delta )
A \Biggl[ \kappa \Biggr]
\biggl( \biggr) 1 - \sigma
1 1 + A - \delta \sigma 1
= 1 - 1 - \beta \sigma (1 + A - \delta )
A 1+n
Thus the saving rate is constant

\chi
Because of our assumption
\kappa < 1, s < 1 holds

Comparative Statics
An increase in \beta (households become more patient) increases the

saving rate and thus the growth of per capita-income (even in the long
run, in contrast with Solow model).
An increase in n decreases the saving rate and the growth of per

capita-income (even in the long run, in contrast with Solow model).

Social optimum - competitive equilibrium
The socially optimal solution is identical to the competitive

equilibrium.
This is in accordance with the first theorem of welfare.

6.4 AK model: The role of policy

Tax on Capital Income
Assume that there is a tax \tau on capital income.
The government simply consumes the revenues.
The household obtains a net income of r(1 - \tau ) per unit of savings.

Tax on Capital Income
It is straightforward to show that the growth rate of per-capita output

is
\biggl( \biggr) 1
(1 + (A - \delta )(1 - \tau ))\beta \sigma
gY\widehat = - 1
(1 + n)
Similarly, the saving rate is (note that \^ t = \tau (A - \delta )K
G \^ t )
Y\^t - C\^t - G
\^ t
st =
Y\^t
1
1 - \delta [\beta (1 + (A - \delta )(1 - \tau ))] \sigma
= - + 1 - \sigma
A A(1 + n) \sigma
An increase in the tax rate lowers the growth rate and the saving rate.
By contrast, policies never affect the per-capita growth rate of output

in the neoclassical growth model.

6.5 AK model: Summary

Summary and Implications
Constant returns with respect to accumulable inputs makes

endogenous growth possible.
Growth is the result of the accumulation of capital.
An increase in the saving rate has a long-run impact on the level and
growth rate of per-capita output
Policies have growth effects (neoclassical growth model: different

policies have level effects)
Thus even small differences in policies can potentially explain large

differences in output per capita between countries.
Inconsistent with important role of technology, which is suggested, for

example, by growth accounting.
All national income accrues to capital (inconsistent with data).

6.6 AK model: Possible extensions

AK model with human capital and physical capital
It is straightforward to incorporate human capital into the AK model.
Production function: Yt = A(Kt )\mu (Ht )1 - \mu

production function has constant returns to scale with respect to
accumulable resources.
Again there are two alternatives:

constant saving rates for Kt and Ht
endogenous saving decisions from household optimization
Findings: very similar to simple AK model, endogenous growth,

changes in saving rates affect growth rates, policies have an impact on
growth.

Rebelo (1991)
Simple AK model: capital is the only production factor; all national

incomes accrue to capital (questionable).
Possible Extension: Two sector model

1 First sector: Consumption goods; with Cobb-Douglas production
function and inputs labor and capital.
2 Second sector: Investment goods; produced by linear technology,
capital is sole production factor.
Hence there are constant returns to accumulable resources only in the

second sector.

Rebelo (1991)
Implication: Endogenous growth, strong effects of policies.
Implication: Positive fraction of income accrues to labor, wages grow

exponentially.
Implication: Capital deepening, i.e. capital grows at a larger rate than

output (plausible?)

Section 7
RBC Models

7.1 RBC Models: Idea

Real business cycle (RBC) models' purpose is to explain business
cycles.
They are ``real'' in the sense that nominal rigidities do not play a role.
Business cycles are caused by exogenous productivity shocks.
School was founded by Finn Kydland and Edward Prescott.
RBC models are examples/precursors of DSGE models (dynamic

stochastic general equilibrium models)

RBC models can be calibrated using
microeconomic data
by trying to match specific moments of aggregate data
RBC models then make predictions on the variances and covariances

of (other) economic aggregates.
These predictions can be compared to the variances and covariances of

real-life macroeconomic data.
If a RBC model matches the data, its quantitative policy implications

appear more reliable.
If discrepancies arise, one can think of modifying the model to improve

the fit.

We will also use a basic RBC model to study the evolution of the
economy after a shock (so-called impulse responses).
The dynamic response of a DSGE economy after a shock can be ...

... used to check whether the behavior corresponds to priors about how
the economy behaves.
... compared to the impulse responses implied by estimated VAR
models.
Important policy implication of RBC models:

The first welfare theorem holds.
Thus stabilization policy (even if it were effective) would be
unnecessary at best or socially harmful otherwise.

7.2 RBC Models: Model

Overview
The RBC model we consider here is identical to the

Ramsey-Cass-Koopmans model except for the following differences:
The efficiency of labor is stochastic.
There is no trend growth in the efficiency of labor (could be easily

relaxed and would yield the stochastic neoclassical growth model).
There is disutility from labor.
The size of the population is constant.
For simplicity, we set the depreciation rate \delta to one (together with the
particular form of the utility function we employ, this will allow for an
analytical solution).

Details
The initial capital stock K0 is given.
In each period, the household is endowed with one unit of labor.
Instantaneous utility function
u(Ct , Lt ) = \mathrm{l}\mathrm{n} Ct + b \mathrm{l}\mathrm{n}(1 - Lt ) where b>0
The household's intertemporal utility function:
\Biggl[ \infty \Biggr]

\sum
U = \BbbE 0 \beta t u(Ct , Lt ) (where 0 < \beta < 1)
t=0
Capital evolves according to (recall that \delta = 1)
Kt+1 = Kt (1 - \delta ) + Yt - Ct = Yt - Ct

Details: Production Technology
Output is produced according to
Yt = Kt\alpha (At Lt )1 - \alpha
The efficiency of labor is given by
\mathrm{l}\mathrm{n} At = A\~t ,
where
A\~t = \rho A\~t - 1 + \varepsilon t .
Note that A\~t follows a Markov process, which allows for a recursive
representation of the social planner's problem and for a recursive
competitive equilibrium.
We assume
- 1 < \rho < 1
\varepsilon t are i.i.d and N (0, \sigma \varepsilon 2 ), where \sigma \varepsilon > 0
A\~0 is exogenously given (like K0 )
7.3 RBC Models: The social planner's problem

Sequential version
The social planner's problem (sequential version)

The social planner chooses (state-contingent) plans
\{ Ct \} \infty \infty \infty \infty
t=0 , \{ Yt \} t=0 , \{ Kt \} t=1 , \{ Lt \} t=0 to maximize
\Biggl[ \infty \Biggr]
\sum
U = \BbbE 0 \beta t u(Ct , Lt )
t=0
subject to
\mathrm{l}\mathrm{n} At = A\~t \forall t \geq 0

A\~t = \rho A\~t - 1 + \varepsilon t \forall t \geq 0, A\~ - 1 given
Kt+1 = Yt - Ct \forall t \geq 0, K0 given
Yt = Kt\alpha (At Lt )1 - \alpha \forall t \geq 0

0 \leq Lt \leq 1, 0 \leq Ct \leq Yt \forall t \geq 0

Recursive version
Abusing notation, we define
\bigl( \bigr)
u(Kt , Kt+1 , Lt , At ) := u Kt\alpha (At Lt )1 - \alpha - Kt+1 , Lt , i.e. we plug
Ct = Kt\alpha (At Lt )1 - \alpha - Kt+1 into u(Ct , Lt )
The social planner's problem (recursive version)

\biggl\{ \biggr\}
V (At , Kt ) = \mathrm{m}\mathrm{a}\mathrm{x} u(Kt , Kt+1 , Lt , At ) + \beta \BbbE t V (At+1 , Kt+1 )
(Kt+1 ,Lt )\in \Gamma (At ,Kt )
subject to
\mathrm{l}\mathrm{n} At+1 = A\~t+1

A\~t+1 = \rho A\~t + \varepsilon t+1
\Bigl\{ \bigm|
\bigm|
\Gamma (At , Kt ) = (Kt+1 , Lt )\bigm| Lt \geq 0, Lt \leq 1, Kt+1 \geq 0,
\Bigr\}
Kt+1 \leq Kt\alpha (At Lt )1 - \alpha
Social planner's solution
Euler equation for capital:
\biggl[ \biggr]
\partial u (Kt , Kt+1 , Lt , At ) \partial u (Kt+1 , Kt+2 , Lt+1 , At+1 )
+ \beta \BbbE t = 0,
\partial Kt+1 \partial Kt+1
`Èuler equation'' for labor
\partial u (Kt , Kt+1 , Lt , At )

= 0,
\partial Lt
Transversality condition
\biggl[ \biggl\{ \biggr\} \biggr]

t \partial u (Kt , Kt+1 , Lt , At )
\BbbE 0 \mathrm{l}\mathrm{i}\mathrm{m} \beta Kt =0
t\rightarrow \infty \partial Kt

1 The Euler equation for capital yields
\biggl[ \biggr]
1 1 \alpha - 1
= \beta \BbbE t \cdot (At+1 Lt+1 )1 - \alpha \alpha Kt+1
Ct Ct+1
2 The first-order condition (`Èuler equation'') with respect to labor yields
1 b
(1 - \alpha )L - \alpha
t At
1 - \alpha \alpha
Kt \cdot =
Ct 1 - Lt
3 We have already specified the economy's resource constraint
Kt+1 = (At Lt )1 - \alpha Kt\alpha - Ct
Now we have to solve this system of difference equations (and the

transversality condition).

Using Yt = (At Lt )1 - \alpha Kt\alpha gives
\biggl[ \biggr]
1 1 Yt+1
= \alpha \beta \BbbE t \cdot
Ct Ct+1 Kt+1
Yt 1 b
(1 - \alpha ) =
Ct Lt 1 - Lt
Kt+1 = Yt - Ct
Using the third equation to replace Kt+1 in the first equation yields
the following system of difference equations:
\biggl[ \biggr]
Yt - Ct Yt+1
= \alpha \beta \BbbE t
Ct Ct+1
Yt 1 b
(1 - \alpha ) =
Ct Lt 1 - Lt

The system of difference equations
\biggl[ \biggr]
Yt - Ct Yt+1
= \alpha \beta \BbbE t
Ct Ct+1
Yt 1 b
(1 - \alpha ) =
Ct Lt 1 - Lt
fortunately has a rather simple solution.
The solution involves a constant saving rate and constant labor (not
only in the steady state!)
Yt - Ct
st = = \alpha \beta
Yt
1 - \alpha
Lt =
1 - \alpha + b(1 - \alpha \beta )

Interpretation
1 Why is the saving rate constant (in the social planner's solution)?
An increase in productivity A\~t induces

a substitution effect and
an income effect
for the choice of current consumption vs. future consumption.
For log-utility, these effects cancel each other.
2 Why is labor constant (in the social planner's solution)?
An increase in productivity A\~t induces similar income and substitution

effects for the choice between leisure and consumption.
A higher A\~t makes working attractive because of the high marginal
productivity of labor.
A higher A\~t makes agents wealthier (in a competitive equilibrium) and
thus makes them choose a higher level of leisure.
For \delta = 1 and log-utility, these effects exactly cancel each other.

Analytical solution for log deviations
We define
the steady-state level of capital Kt : K
the log deviation of capital from its steady-state level
\~ t := \mathrm{l}\mathrm{n} Kt - \mathrm{l}\mathrm{n} K
K
By applying our previous results (s = \alpha \beta and L constant) to the

economy's resource constraint (Kt = sYt - 1 ) and using
\alpha (A
Yt - 1 = Kt - 1 1 - \alpha ,
t - 1 Lt - 1 ) we can show
1
K = s 1 - \alpha L, (s and L have been computed already)
Kt = \alpha Kt - 1 + (1 - \alpha )A\~t - 1

\~ \~

Analytical solution for log deviations
A\~t = \rho A\~t - 1 + \varepsilon t

A\~t = \rho \scrL A\~t + \varepsilon t \scrL = lag operator: \scrL A\~t := A\~t - 1
A\~t = (1 - \rho \scrL ) - 1 \varepsilon t
\~ t - 1 + (1 - \alpha )(1 - \rho \scrL ) - 1 \scrL \varepsilon t
\~ t = \alpha K
K
The last equation can be re-arranged as
\~ t = (1 - \alpha )(1 - \rho \scrL ) - 1 \scrL \varepsilon t

(1 - \alpha \scrL )K

This equation can be written as:
\~ t = 1
K (1 - \alpha )\scrL \varepsilon t
(1 - \alpha \scrL )(1 - \rho \scrL )
1 \alpha - \alpha \rho \scrL + \alpha \rho \scrL - \rho
= (1 - \alpha )\scrL \varepsilon t
\alpha - \rho (1 - \alpha \scrL )(1 - \rho \scrL )
\biggl( \biggr)
1 \alpha \rho
= - (1 - \alpha )\scrL \varepsilon t
\alpha - \rho 1 - \alpha \scrL 1 - \rho \scrL
The (a?) solution is
\infty
\sum
\~ t = (1 - \alpha ) \alpha i+1 - \rho i+1
K \varepsilon t - 1 - i
\alpha - \rho
i=0
It is straightforward to show that Y\~t has to fulfill

Y\~t = \alpha Y\~t - 1 + (1 - \alpha )A\~t and thus
\infty
\sum \alpha i+1 - \rho i+1
Y\~t = (1 - \alpha ) \varepsilon t - i
\alpha - \rho
i=0

Impulse responses
Impulse response: How does the economy (the socially optimal
allocation) respond to a one-time (unexpected) shock \varepsilon 0 = 1 under
the assumption that \varepsilon t = 0 \forall t \not = 0?
The effectiveness of labor evolves according to
\Biggl\{
0 for t<0
A\~t =
\rho t for t \geq 0
The impulse response function for output is
\Biggl\{
0 for t<0
Y\~t = t+1 t+1
(1 - \alpha ) \alpha \alpha - \rho
- \rho for t \geq 0
Note: We will see that the first theorem of welfare holds. Hence the
dynamic response of the economy in the competitive equilibrium will
be the same.

Impulse response to a technology shock
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
0 1 2 3 4 5 6 7 8 9
Figure: blue line: A\~t , red line: Y\~t , green line: \~ t .

K Parameters: \alpha = 0.3, \rho = 0.9.

Impulse response to a technology shock
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
0 1 2 3 4 5 6 7 8 9
Figure: blue line: A\~t , red line: Y\~t , green line: \~ t .

K Parameters: \alpha = 0.3, \rho = 0.0.

7.4 RBC Models: HP-filter

How can we find empirical equivalents to Y\~t
Suppose we had data on log GDP for t = 1, ...T , i.e. time series data
Y1+ , Y2+ , Y3+ , ... YT+ .
How can we decompose this time series into
1 a trend component (equivalent to steady-state levels in our model) and
2 a cyclical component (deviation from the trend, equivalent to the
variables with `` \sim '')?
One very popular approach is the HP filter (Hodrick-Prescott).

Identify a new time series that minimizes the weighted average of
the sum of quadratic deviations from the data (weighted by one) and
the sum of its own second-order differences (weighted by some \lambda > 0).
The weight on the second sum is typically \lambda = 1600 for quarterly data.
This new time series is the trend component.
The difference between this new time series and the original data is the
deviation from trend.

7.5 RBC Models: Competitive equilibrium

Recursive Competitive Equilibrium
A Recursive Competitive Equilibrium is a set of price functions r(At , \bfK t ),
w(At , \bfK t ), and state-dependent policy functions (in particular,
\pi (At , \Omega t , \bfK t ) gives the household's savings) such that
The household's policy functions solve
\Bigl\{
V (At , \Omega t , \bfK t ) = \mathrm{m}\mathrm{a}\mathrm{x} \mathrm{l}\mathrm{n} Ct + b \mathrm{l}\mathrm{n}(1 - Lt )
\Omega t+1 ,Lt
\Bigr\}
+\beta \BbbE t V (At+1 , \Omega t+1 , \bfK t+1 )
subject to the borrowing constraints,
\mathrm{l}\mathrm{n} At+1 = A\~t+1 , A\~t+1 = \rho A\~t + \varepsilon t+1 ,

\bfK t+1 = \pi (At , \bfK t , \bfK t ),
\Omega t+1 = (1 + r(At , \bfK t ))\Omega t + w(At , \bfK t )Lt - Ct .
Note: ``solves'' means that, for example, \pi (At , \Omega t , \bfK t ) is given by the
optimal choice of \Omega t+1 in the above Bellman equation.
...
Recursive Competitive Equilibrium (continued)
...
The representative firm chooses Kt+1 and Ldt to maximize its profits,
taking the price functions r(At , \bfK t ), w(At , \bfK t ) as given.
All markets clear, e.g. \bfK t = \bfOmega t .
Note: Bold variables are aggregates:
Because individual agents are small, they cannot affect bold variables.
In equilibrium, the bold variables correspond to the individual variables

for a representative-agent economy, i.e. \Omega t = \bfOmega t or Kt = \bfK t .

Profit maximization
Profit maximization leads to the following conditions:
w(At , \bfK t ) =
\partial Lt
r(At , \bfK t ) + \delta = , where \delta = 1.
\partial Kt

Utility maximization
Consumption Euler equation
\biggl( \biggr)
\partial ut \bigl( \bigr) \partial ut+1
0= - \Delta C + \beta \BbbE t (1 + r(At+1 , \bfK t+1 )) \Delta C
\partial Ct \partial Ct+1
\biggl( \biggr)
1 1
= \beta \BbbE t (1 + r(At+1 , \bfK t+1 ))
Ct Ct+1
Household's optimal choice of labor
\partial ut \partial ut
\Delta L + \Delta Lw(At , \bfK t ) = 0
\partial Lt \partial Ct
b 1
= \cdot w(At , \bfK t )
1 - Lt Ct

First theorem of welfare
Combining these conditions for optimal behavior of households and

firms with the market-clearing conditions yields the same conditions
that we derived for the social planner's solution.
Thus we conclude
Proposition
The first theorem of welfare holds for the RBC model.

7.6 RBC Models: Assessment

Properties of the RBC model that we have considered:
employment constant (acyclical)

real wage and labor productivity procyclical
consumption procyclical
investment and saving procyclical
autocorr. of output growth slightly positive
In real-life data ...

consumption is only weakly procyclical (less volatile than output).
investment is more strongly procyclical (more volatile than output).
labor is procyclical.
real wages are only moderately procyclical.
autocorr. of output growth \approx 0.3
The finding that employment is constant over the business cycle can
be overturned if we assume less than full depreciation \Rightarrow labor
procyclical.

7.7 RBC Models: Log-linearization

In the general case with 1 > \delta > 0, the model cannot be solved
analytically.
Thus we rely on a log-linear approximation around the steady state (or

the non-stochastic balanced ``growth'' path)

There are two state variables in each period t in the social planner's
problem:
The capital stock Kt inherited from the previous period.
Current productivity At
log deviations of the state variables from their steady-state values can
be written as:
K\~ t = \mathrm{l}\mathrm{n} Kt - \mathrm{l}\mathrm{n} K \approx Kt - K

K
A\~t = \mathrm{l}\mathrm{n} At - \mathrm{l}\mathrm{n} A \approx At - 1, where A=1
The choice variables are Ct , Kt+1 , and Lt .

Log deviations of these can be written as
C\~t = aCK K\~ t + aCA A\~t

L\~ t = aLK K
\~ t + aLA A\~t
\~ t+1 = aKK K
K \~ t + aKA A\~t ,
where the a\prime s are coefficients left to be determined.

Log-Linearization
As a next step, all equations describing the dynamics of the system are
log-linearized.
As an example, consider the consumption Euler equation
\Biggl( \Biggl( \biggl( \biggr) 1 - \alpha \Biggr) \Biggr)

1 1 At+1 Lt+1
= \beta \BbbE t 1 - \delta + \alpha
Ct Ct+1 Kt+1
Replace all variables Xt by \~ t )

X(1 + X

Use
1 \~ t
\approx 1 - X
1+X\~ t
\Bigl( \Bigr)
f (Xt , Yt , Zt ) = f X(1 + X \~ t ), Y (1 + Y\~t ), Z(1 + Z\~t )
\bigl( \bigr) \bigl( \bigr)
\approx f X, Y , Z + fX X, Y , Z X X \~ t
\bigl( \bigr) \bigl( \bigr)
+fY X, Y , Z Y Y\~t + fZ X, Y , Z Z Z\~t
and the Euler equation for steady-state levels X

\Biggl( \biggl( \biggr) 1 - \alpha \Biggr)
1 1 AL
= \beta 1 - \delta + \alpha
C C K
to transform the consumption Euler equation into its log-linearized

form, a linear equation in C\~t and expected values of C\~t+1 , L
\~ t+1 ,
A\~t+1 , and \~ t+1 .
K

Derive log-linearized versions of the other equations.
Use the method of undetermined coefficients to determine the

coefficients a.
Choose the non-explosive solution to ensure that the system converges
to the steady-state in the long-run, which ensures that the
transversality condition is fulfilled.

7.8 RBC Models: Critique of RBC models

Difficult to find independent evidence for aggregate technology shocks
that correspond to the shocks driving the business cycle in RBC
models.
Difficult to interpret recessions.
In the RBC model, fluctuations in employment are the result of

intertemporal substitution of labor. Most empirical studies do not
support a strong willingness to substitute labor intertemporally.
There are only real shocks and no nominal rigidities.

There are empirical studies suggesting that monetary policy has
short-term effects on real output.
It is not clear whether it is a useful feature if a (RBC) model can

explain certain moments of macroeconomic data well.
Heterogeneity is disregarded.

Digression: A Skeptical View on Stabilization Policy
Thought-provoking article by Lucas (2003, ``Macroeconomic

Priorities,'' AER P\&P)
Consider a representative consumer

1 2
The consumer has a stochastic consumption stream ct = Ae\mu t e - 2 \sigma \varepsilon \epsilon t
\mathrm{l}\mathrm{o}\mathrm{g}\Bigl[ \epsilon t is normally distributed with mean 0 and variance \sigma \varepsilon (\Rightarrow
2
1 2
\Bigr]
\BbbE e - 2 \sigma \varepsilon \epsilon t = 1)
\Bigl[ \sum 1 - \sigma \Bigr]
\infty
\beta t ct
Intertemporal utility: \BbbE t=0 1 - \sigma where \sigma > 0 is the coefficient
of relative risk aversion and \beta is the discount factor.

Thought experiment
Suppose stabilization policy (some combination of monetary policy or

fiscal policy) could be used to completely eliminate the variance of the
consumption stream.
What is the size of the factor (1 + \lambda ) with which the stochastic
consumption stream would have to be multiplied for the agent to be
indifferent between
the perfectly safe consumption stream, engineered by monetary policy
the stochastic consumption stream, multiplied by (1 + \lambda )
\lambda is a measure of the maximum welfare gains that could be achieved
by stabilization policy.

Finding
Lucas' estimate of \lambda : \lambda = 0.0005

Even perfect stabilization policy would not improve welfare much.
Central banks should not aim at stabilizing the economy in the short
run.
Governments should not attempt to stabilize the economy by
countercyclical fiscal policy.

Section 8
Money

Money in Microfounded Models
money today is ``fiat money,'' i.e. intrinsically useless
Why do people hold money at all?
Functions of Money
unit of account
store of value
medium of exchange
How can a model be developed in which people hold positive

quantities of money, in particular when alternative assets with higher
returns are available?

1 Money delivers utility directly (``Money in the Utility'' or MIU
approach), Sidrauski (1967)
2 Shopping time models (purchasing goods requires time, the required

time decreases with real money holdings).
3 Money is required for certain transactions (Cash-in-Advance or CIA

constraint), see (Clower (1967))
4 Money as a store of value in Overlapping Generations Models (OLG

models), Samuelson (1958)
5 Search Theory, money alleviates the problem of double coincidence of

wants

8.1 Money: Money-in-the utility approach

Purpose of this section
demonstrate the MIU approach
examine socially optimal inflation rate
no uncertainty (for simplicity)

The MIU utility function
Notation in this section:

small letters denote real variables
capital letters denote nominal variables
Instantaneous utility: u(c, m)

c: consumption
m: real money holdings
Ad hoc assumption: money delivers liquidity services that yield utility

directly.
This is a shortcut for a more detailed model in which money allows for
economizing on transaction costs.

Assumptions on the utility function
u(c, m) is additively separable in consumption and money balances,

i.e. it can be written as
u(c, m) = v(c) + \phi (m)
\mathrm{l}\mathrm{i}\mathrm{m}m\rightarrow 0 \phi m (c, m) = \infty

\mathrm{l}\mathrm{i}\mathrm{m}m\rightarrow 0 \phi m (c, m)m exists and is positive.
\phi (m) is strictly increasing and concave in m for m < m, where m is

some level with m > 0.
\phi m (m) = 0 \forall m > m
v(c) is strictly increasing and concave.

Three groups of agents
households, rent out capital to firms, endowed with one unit of labor
per period; labor is supplied inelastically
firms, rent capital from households, acquire labor
state, issues money, pays transfers

An MIU Model
The household's intertemporal utility function
\infty
\sum
\beta t u(ct , mt ), 0 < \beta < 1
t=0
Budget constraint in nominal terms:
Pt \omega t = Tt + Wt + Mt - 1 + It - 1 Bt - 1
\geq Pt ct + Mt + Bt
The state has to satisfy a budget constraint as well (Tt lump-sum

transfers, Mt nominal money stock):
Tt = Mt - Mt - 1
\mu , the gross money growth rate is exogenously given and constant
(\mu \geq 1).

Variables
Pt price of the good
\omega t real wealth of the agent
Bt - 1 number of bonds acquired in period t - 1
It gross nominal return on bonds
held from period t to period t+1
Tt lump-sum transfer by the government
Wt nominal wage
Mt money held from period t to period t+1
\delta depreciation rate on capital
kt real stock of capital
l labor employed by the firm
f (k, l) production function
\beta discount factor
u(ct , mt ) instantaneous utility
ct consumption in t

The firm's optimization problem
Firms employ labor and capital to maximize profits.
The production function f (k, l) satisfies the usual conditions.
The firms issue bonds Bt that pay a gross nominal rate of return It
(gross real rate: Rt ) to finance capital purchases.
The firm's optimization problem leads to
fk (kt , lt ) + 1 - \delta = Rt
and
fl (kt , lt ) = Wt /Pt

In real terms, the household's budget constraint is
mt - 1 + It - 1 bt - 1
\omega t = wt + \tau t + \geq ct + mt + bt
\Pi t
where
m, b, \tau , w: analogous to M , B , T , w, but in real terms
\Pi t : gross rate of inflation, \Pi t := 1 + \pi t = PPt - 1
t
In period t + 1, the household's wealth is
mt + It bt
\omega t+1 = wt+1 + \tau t+1 +
\Pi t+1
Eliminating, bt , the household's real wealth in period t+1 is
mt
\omega t+1 \leq \tau t+1 + wt+1 + + Rt (\omega t - ct - mt )
\Pi t+1
It
where Rt := \Pi t+1 is the gross real rate of return.

The household's value function satisfies
\bigl\{ \bigr\}
V (\omega t ) = \mathrm{m}\mathrm{a}\mathrm{x} u(ct , mt ) + \beta V (\omega t+1 )
ct ,mt
mt
s.t. \omega t+1 = \tau t+1 + wt+1 + + Rt (\omega t - ct - mt )
\Pi t+1
With the help of the above expressions for \omega t+1 , the first-order
conditions can be stated as:
uc (ct , mt ) - \beta Rt V\omega (\omega t+1 ) = 0 deriv. w.r.t ct

\Bigl( 1 \Bigr)
um (ct , mt ) + \beta - Rt V\omega (\omega t+1 ) = 0 deriv. w.r.t mt
\Pi t+1

The Benveniste-Scheinkman formula yields
V\omega (\omega t ) = \beta Rt V\omega (\omega t+1 )
Combining this equation with the first of the first-order conditions

yields
V\omega (\omega t ) = uc (ct , mt )
Inserting into the other first-order condition entails
1
um (ct , mt ) + \beta uc (ct+1 , mt+1 ) = uc (ct , mt )
\Pi t+1
Using the two equations at the top of the slide, we can also write
um (ct , mt ) It - 1
=
uc (ct , mt ) It

Steady State
The Steady State is an equilibrium in which all real variables are

constant.
V\omega (\omega ss ) = V\omega (\omega t ) = \beta Rt V\omega (\omega t+1 ) = V\omega (\omega ss ) \Rightarrow \beta Rss = 1.
The steady-state capital stock can be computed with the help of:
1
fk (k ss ) + 1 - \delta = Rss =
\beta
The steady-state real wage is given by
fl (k ss , 1) = wss

Steady State
If the stock of real money is constant (and positive), the gross

nominal growth rate of money \mu to the gross inflation rate \Pi ss
Mt+1
\mu = = \Pi ss .
Mt
As Tt = Mt - Mt - 1 and \tau t = Tt /Pt , real transfers in the steady state
are \biggl( \biggr)
ss ss 1
\tau = m 1 -
\mu

Steady State
The firm issues bonds to finance purchases of capital, which means in

equilibrium
bss = k ss
1
As Rss = \beta , I ss = \Pi ss Rss , we obtain
\mu
I ss =
\beta

Steady State
The household's budget constraint in the steady-state is
mss + I ss bss
\tau ss + wss + = css + mss + bss
\Pi ss
\Bigl( \Bigr)
With the help of \tau ss = mss 1 - \mu 1 , bss = k ss , \Pi ss = \mu , and
I ss /\Pi ss = Rss the budget constraint becomes
(Rss - 1)k ss + wss = css
For a constant-returns-to-scale technology
fk (k ss , 1)k ss + fl (k ss , 1)lss = f (k ss , 1)
Thus the household's budget constraint in the steady state is

equivalent to the economy's resource constraint.
css = f (k ss ) - \delta k ss
Existence and Uniqueness of Steady State
In addition, steady-state money holdings are implicitly given by
\biggl( \biggr)
\beta
um (css , mss ) = 1 - uc (css , mss )
\mu
Does a steady state exist?

For an additively separable utility function, we have
u(c, m) = v(c) + \phi (m) and thus
\biggl( \biggr)
ss \beta
\phi m (m ) = 1 - vc (css )
\mu
Our assumptions on \phi and v guarantee that this equation has a unique
solution.

Convergence towards the Steady State
Recall that
1
um (ct , mt ) + \beta uc (ct+1 , mt+1 ) = uc (ct , mt )
\Pi t+1
Suppose that consumption is at its steady-state level
\beta
vc (css ) = vc (css , mt ) - \phi m (mt )
\Pi t+1
Multiplying through by mt and noting that mt /\Pi t+1 = mt+1 /\mu yields
\beta vc (css )mt+1 /\mu = (vc (css ) - \phi m (mt ))mt
or, equivalently
\mu
mt+1 = (vc (css ) - \phi m (mt ))mt
\beta vc (css )

Convergence to the steady state
Let us consider the properties of

\mu ss
g(mt ) := \beta vc (css ) (vc (c ) - \phi m (mt ))mt
Recall that \mathrm{l}\mathrm{i}\mathrm{m}m\rightarrow 0 \phi m (c, m)m exists and is positive.
Thus g(mt ) < 0 for very small mt .

g(mt ) is strictly decreasing for mt < m
\~ for some m
\~ > 0.
For mt > m
\~ , it is strictly increasing.
For mt \rightarrow \infty , g \prime (mt ) > \mu /\beta > 1.

Neutrality of Money
Definition (Neutrality)
Money is neutral if the real steady-state levels of consumption, capital,
labor, and output do not depend on the level of money.
The MIU economy displays neutrality of money.
This is plausible because only real money holdings enter into the utility
function.

Superneutrality of Money
Definition (Superneutrality)
Money is superneutral if the real steady-state levels of consumption, capital,
labor, and output do not depend on the gross growth rate of money \mu .
Superneutrality holds.
However, I ss , \Pi ss , and mss depend on \mu .

Optimal growth rate of money
Now the optimal money growth rate \mu can be determined as the value
of \mu that maximizes the household's utility in the steady state.
As consumption does not depend on \mu , the optimal value of \mu satisfies:
du(css , mss ) dmss

= um (css , mss ) \Rightarrow um (css , mss ) = 0
d\mu d\mu
Thus mss = m \Bigl( \Bigr)

1
Recall that um (ct , mt ) + \beta \Pi t+1 - Rt V\omega (\omega t+1 ) = 0
This implies um (css , mss ) = 0 if \Pi ss Rss = 1, i.e. I ss = 1 or iss = 0,
respectively (where i
ss = I ss - 1).

Friedman Rule
Friedman Rule
The so-called Friedman rule is optimal, i.e. a constant negative growth rate
of money such that iss = 0.
Under the Friedman Rule, the opportunity costs of holding money

vanish.
It implies deflation (1 = Rss \Pi ss = 1/\beta \cdot \Pi ss ) \Rightarrow \Pi ss = \beta < 1.
\mu ss = \Pi ss < 1, i.e. the nominal stock of money is declining.

Welfare Costs of Inflation
The money demand function follows from
um (ct , mt ) It - 1
=
uc (ct , mt ) It
The welfare costs of inflation can be measured by the computing the

area under the money demand function
recall that, in line with superneutrality, the steady-state level of

consumption is unaffected by the steady-state inflation rate.
According to Lucas (1994), the welfare loss arising from a steady-state

level of i = 10\% would correspond 1\% of aggregate consumption.
However, there might be also benefits of inflation, e.g. seigniorage (if

there are no non-distortionary taxes available)

Seigniorage
Definition (Seigniorage)
The revenues from printing money are seigniorage.
Recall that the transfers are

\biggl( \biggr)
ss ss 1
\tau =m 1 -
\mu
These transfers are zero for \mu = 1.

Because of
\phi m (mss ) I ss - 1
=
uc (css ) I ss
1
and I ss = \mu \cdot ss
\beta ,m is declining in \mu

Dynamics
The model can be used to study the dynamic response to shocks.
Assume that
log deviations of TFP from its long run level
deviations of the nominal money growth rate from the long-run
money-growth rate.
are given by AR(1) processes, for example.
All equilibrium conditions are log-linearized.
The resulting system of linear difference equations with rational

expectations can be solved.
Impulse responses to money growth and TFP shocks can be studied.

8.2 Money: Cash-in-advance models

Cash-in-Advance (CIA) Models
Consider a model with capital accumulation and money

\sum \infty t u(c ), where
A household maximizes: t=0 \beta t 0 < \beta < 1
In nominal terms, the budget constraint is:
Pt \omega t = Tt + Mt - 1 + It - 1 Bt - 1
\geq Pt ct + Mt + Bt + Pt kt
The government's budget constraint is
Tt \leq Mt - Mt - 1
Tt are lump-sum transfers.

Cash-In-Advance Constraint
Cash-In-Advance Constraint
An agent can only acquire goods in a particular period if he has acquired a
sufficient quantity of money in the previous period.
In addition to the budget constraint, the household has to respect the

CIA constraint
Mt - 1 mt - 1
ct \leq + \tau t = + \tau t
Pt \Pi t

The value function is
\bigl\{ \bigr\}
V (\omega t , mt - 1 ) = \mathrm{m}\mathrm{a}\mathrm{x} u(ct ) + \beta V (\omega t+1 , mt )
ct ,mt
s.t. the budget constraint and the CIA constraint
Like in the MIU model, the real budget constraint in t+1 can be
written as
mt
\omega t+1 \leq \tau t+1 + + Rt (\omega t - ct - mt )
\Pi t+1
Recall that the CIA constraint is
Mt - 1 mt - 1
ct \leq + \tau t = + \tau t
Pt \Pi t

Let \mu t be the Lagrange multiplier associated with the CIA constraint
Using the above expression for \omega t+1 , we can write the first-order
conditions as:
uc (ct ) - \beta Rt V\omega (\omega t+1 , mt ) - \mu t = 0 deriv. w.r.t ct

\Bigl( 1 \Bigr)
\beta - Rt V\omega (\omega t+1 , mt ) + \beta Vm (\omega t+1 , mt ) = 0 deriv. w.r.t. mt
\Pi t+1

The envelope theorem gives
V\omega (\omega t , mt - 1 ) = \beta Rt V\omega (\omega t+1 , mt )

1
Vm (\omega t , mt - 1 ) = \mu t
\Pi t
Introducing \lambda t := V\omega (\omega t , mt - 1 ), we can write
uc (ct ) = \lambda t + \mu t

It
Analogously, with Rt := \Pi t+1 , we obtain:
\lambda t = \beta Rt \lambda t+1

The second first-order condition can be rewritten as
\Bigl( \lambda \mu t+1 \Bigr)

t+1
\lambda t = \beta +
\Pi t+1 \Pi t+1
Dividing by Pt yields
\lambda t \Bigl( \lambda \mu t+1 \Bigr)

t+1
= \beta +
Pt Pt+1 Pt+1
Iterating yields
\infty
\sum \mu t+i /Pt+i
1
= \beta i
Pt \lambda t
i=1

Combining with
\partial V (\omega t+i , mt+i - 1 ) \partial mt+i - 1

= Vm (\omega t+i , mt+i - 1 )
\partial Mt+i - 1 \partial Mt+i - 1
= Vm (\omega t+i , mt+i - 1 )/Pt+i - 1
= \mu t+i /Pt+i
yields
\infty \partial V (\omega t+i ,mt+i - 1 )
1 \sum \partial Mt+i - 1
= \beta i
Pt \lambda t
i=1
The nominal interest rate is
\mu t+1
it = It - 1 =
\lambda t+1

Steady State
In the steady state:
1
Rss =
\beta
1
iss \approx - 1 + \pi ss
\beta
The steady-state capital stock is implicitly given by
1
fk (k ss ) = R - 1 + \delta = - 1 + \delta
\beta
Money is superneutral.
In addition
\beta Vm i
=
uc 1+i
Inflation equals the growth rate of the nominal money stock
Mt - Mt - 1
\Theta ss := Mt - 1
\pi ss = \Theta ss
Extensions
One could also introduce uncertainty.
Then, in some states, the cash-advance constraint will not bind.

8.3 Money: Search theory and money

Model
continuum of infinitely lived agents, number normalized to 1, a

fraction M (0 \leq M < 1) has an indivisible unit of money, the
remainder has one indivisible unit of goods.
No agent can consume his own good.
The probability of an agent being able to consume another agent's

good is x, 0 < x < 1.
If an agent consumes another agent's good, he obtains utility U
(U > 0). Otherwise the agent obtains no utility. Having consumed,
the agent produces a good, which he obtains at the end of the same
period.
Trading a good is costly, the receiver of a good incurs fixed costs \epsilon
(\epsilon < U ).
In each period t = 0, 1, 2, ... the agents meet pairwise and randomly.
Only agents who meet can trade.

Different constellations in meetings
agent 1\setminus agent 2 good cons. good non-cons. money
good cons. trade no trade ?

good non-cons. no trade no trade no trade
money ? no trade no trade
cons. = consumable means that the good can be consumed by the

other agent.
Non-cons. = con-consumable means that the good cannot be

consumed by the other agent.

There are two different states of agents: g (has a good in stock), m
(has one unit of money)
The value function depends on this state variable (V (g) and V (m))
Let \pi be the probability of a particular agent in state g being willing
to trade his good for money.
He takes \Pi , the respective probability for the other agents, as given
\beta : discount factor
Bellman equations:
V (g) = (1 - M )x2 (U - \epsilon + \beta V (g))

+M x\beta \mathrm{m}\mathrm{a}\mathrm{x} \{ \pi V (m) + (1 - \pi )V (g)\}
\pi \in [0,1]
\bigl[ \bigr]
+ 1 - (1 - M )x2 - M x \beta V (g)
V (m) = (1 - M )x\Pi (U - \epsilon + \beta V (g)) + (1 - (1 - M )x\Pi ) \beta V (m)

We are looking for symmetric and stationary equilibria.
From the Bellman equations, we obtain the best-response

correspondence \pi (\Pi )
\left\{
0 for \Pi < x
\pi (\Pi ) = 1 for \Pi > x
[0;1] for \Pi = x
Intuition: The more likely it is that the other agents will accept my
money in the future (the higher \Pi is), the more attractive is it for me
to accept money in a transaction.

The equilibrium is given by a fixed point of the best-response
correspondence: \Pi = \pi (\Pi ).
There are three equilibria
1 An equilibrium with \Pi = 1 (money is commonly accepted)
2 An equilibrium with \Pi = x (money is accepted partially)
3 An equilibrium with \Pi = 0 (money is never accepted)
Welfare ranking: first equilibrium > second equilibrium > third
equilibrium

8.4 Money: New Keynesian Economics

New Keynesian Models: Phillips Curve
The Phillips curve is derived from the optimal price setting decisions
of monopolistically competitive firms
Crucial assumptions: Prices are not perfectly flexible.
Different approaches
Taylor-price setting: overlapping prices (Taylor 1979, 1980)
Pre-determined prices
Calvo-price-setting: in each period, a firm may adjust the price of its
output only with probability \lambda (Calvo 1983).
Rotemberg (1982): quadratic costs of price adjustment
Stickiness may concern the prices of goods or wages (or both).

Let pt be the (log) price level and yt the log output gap in t.
Up to a first-order approximation, monopolistically competitive firms
choose prices according to
p\ast t = pt + \alpha yt
where \alpha > 0.

Intuition:
Firms choose prices as a markup of nominal marginal costs.
Real marginal costs are proportional to yt .

Each firm may adjust its price with probability \lambda (0 < \lambda < 1).
\lambda is a measure of the flexibility of prices
\lambda = 1 \Rightarrow prices are fully flexible
\lambda = 0 \Rightarrow prices are completely sticky
Suppose a firm that may adjust its price xt in the following way
\infty
\sum
xt = (1 - (1 - \lambda )\beta ) (1 - \lambda )j \beta j Et p\ast t+j
j=0
where we have taken into account that the price xt will remain
unchanged until period t+j with probability (1 - \lambda )j .
The factor 1 - \sum
(1 - \lambda )\beta is a normalization,
(1 - (1 - \lambda )\beta ) \infty j j
j=0 (1 - \lambda ) \beta = 1

Rearranging...
\infty
\sum
xt = (1 - (1 - \lambda )\beta ) (1 - \lambda )j \beta j Et p\ast t+j
j=0
\infty
\sum
= (1 - (1 - \lambda )\beta )p\ast t + \lambda (1 - \beta ) (1 - \lambda )j \beta j Et p\ast t+j
j=1
\infty
\sum
= (1 - (1 - \lambda )\beta )p\ast t + \lambda (1 - \beta )(1 - \lambda )\beta (1 - \lambda )j \beta j Et p\ast t+j+1
j=0
= (1 - (1 - \lambda )\beta )p\ast t + (1 - \lambda )\beta \BbbE t xt+1
The price chosen by a firm in period t is an expected average of the price

that it is optimal currently an the price that it expects to choose one
period ahead.

Aggregate Price Level
The price level in t can be computed as follows:

A firm that has updated its price i periods ago charges price xt - i
The probability of a firm having updated its price i periods ago is
\lambda (1 - \lambda )i .
The price level (the average price) is
\infty
\sum
pt = \lambda (1 - \lambda )i xt - i
i=0

Rearranging...
\infty
\sum
pt = \lambda (1 - \lambda )i xt - i
i=0
\infty
\sum
= \lambda (1 - \lambda )i xt - i + \lambda xt
i=1
\infty
\sum
= \lambda (1 - \lambda ) (1 - \lambda )i xt - i - 1 + \lambda xt
i=0
= (1 - \lambda )pt - 1 + \lambda xt
The current price level equals a weighted average of the previous period's
price level and the prices set by the firms who updated their prices.

Using
pt - (1 - \lambda )pt - 1
xt = ,
\lambda
we obtain
xt = \lambda p\ast t + (1 - \lambda )Et xt+1

\biggl[ \biggr]
pt - (1 - \lambda )pt - 1 \ast pt+1 - (1 - \lambda )pt
= \lambda pt + (1 - \lambda )Et
\lambda \lambda
1 \Bigl[ \pi \Bigr]
t+1
\pi t + pt - 1 = \lambda (pt + \alpha yt ) + (1 - \lambda )Et + (1 - \lambda )pt
\lambda \lambda
\lambda 2
\pi t = \alpha yt + Et [\pi t+1 ] ,
1 - \lambda
where we have utilized \pi t := pt - pt - 1 .

New Keynesian Phillips Curve
\lambda 2
\pi t = \alpha yt + Et [\pi t+1 ]
1 - \lambda
Important characteristics:
A higher output raises marginal costs and thus inflation.
Expected future inflation has a positive impact on current inflation.

Iterating recursively reveals
\infty \biggl(
\sum \biggr) j
\lambda 2
\pi t = \alpha Et [yt+j ]
1 - \lambda
j=0
Current inflation depends only on current and future output gaps.

Impulse responses to change in money
Suppose the quantity equation holds: mt + vt = yt + pt

Suppose, in addition, that vt = const
Thought experiment: Suppose the central bank increases mt once and
for all unexpectedly.
How do output and prices evolve over time?

Figure: Source: Woodford, `Ìnterest and Prices''

Empirical Evidence:
The New Keynesian model implies that the price level is given by the
previous period's price level and the expected marginal costs in this
and future periods.
Sbordone (2002) approximates these marginal costs by unit labor

costs, i.e. the costs of labor per unit of output. Expected future ULC
are computed by a VAR model.
Prediction of a neoclassical model without price rigidities: The price

level depends only on current ULC; the ratio of the price level to
current ULC is constant.

ULC/P for flexible prices
Figure: Source: Sbordone (2002,JME)

ULC/P for sticky prices

Inflation forecast generated by flexible-price model

Inflation forecast generated by sticky-price model

IS Curve in the New Keynesian Model
In the MIU model, we have derived
uc (ct , mt ) = Et [\beta Rt uc (ct+1 , m+1 )]
Suppose the utility function is additively separable.
uc (ct ) = Et [\beta Rt uc (ct+1 )]
Introducing rt+1 := Rt - 1 yields
uc (ct ) = Et [\beta (1 + rt+1 )uc (ct+1 )]
Write ct = css (1 + c\~t ), where c\~t is the relative deviation of

consumption from its steady-state level css . Analogously, set
1 - \beta
r\~t+1 := rt+1 - \beta .
We obtain
uc (css (1 + c\~t )) = Et [\beta (1 + rss + r\~t+1 )uc (css (1 + c\~t+1 ))]

If the system is close to its steady state, a linear approximation can be
used
uc (css ) + ucc (css ) css c\~t

\approx Et [\beta (1 + rss + r\~t+1 ) \{ uc (css ) + ucc (css ) css c\~t+1 \} ]
With the help of ct+1 r\~t+1 ] \approx 0

Et [\~ and 1 = \beta (1 + rss ), we obtain
ucc (css ) css c\~t \approx \beta Et [\~

rt+1 ] uc (css ) + ucc (css ) css Et [\~
ct+1 ]
uc (css )
c\~t \approx \beta Et [\~
rt+1 ] + Et [\~
ct+1 ]
ucc (css ) css

ss
With the definition \gamma := - \beta uccu(c
c (c )
ss )c ,
ss
we obtain
c\~t = - \gamma Et [\~

rt+1 ] + Et [\~
ct+1 ]
Decreasing marginal utility from consumption implies \gamma > 0.

Interpretation:
Current consumption depends on expected future consumption.
Households want to smooth consumption.
A higher real interest rate makes saving more attractive and reduces
consumption (substitution effect dominates).

For a constant capital stock yt = c\~t (we omit the \~ with regard to y for
simplicity).
Together with the Fisher equation rt+1 ] = it - Et [\pi t+1 ],

Et [\~ we obtain
IS curve
yt = - \gamma (it - Et [\pi t+1 ]) + Et [yt+1 ]
The IS curve is similar to the one in the IS-LM model in that output is
a monotonically decreasing function of the real interest rate.
Iterating recursively gives
\Biggl[ \infty
\Biggr]
\sum
yt = - \gamma Et (it+i - \pi t+i+1 )
i=0
Current output depends on expected future real interest rates. \rightarrow

future monetary policy is crucial!

IS curve and Phillips curve
The most important equations are the following:
yt = - \gamma (it - Et [\pi t+1 ]) + Et [yt+1 ] + \sigma t

\pi t = \kappa yt + Et [\pi t+1 ] + \xi t
We have added shocks \sigma t and \xi t .

We assume
\sigma t =\rho \sigma \sigma t - 1 + \varepsilon t \varepsilon \sim N (0, \sigma \varepsilon 2 )
\xi t =\rho \xi \xi t - 1 + \mu t \mu \sim N (0, \sigma \mu 2 )
\sigma t is a demand shocks, e.g. due to fluctuations in government

expenditures.
\xi t are cost-push shocks, affecting marginal costs

Taylor Principle
In response to an increase in inflation expectations, the central bank should

engineer a more-than-one-to-one increase in its short-term interest rate
(\alpha > 1).
Intuition:
An increase in inflation expectations requires an increase in real

interest rates.
Due to the Fisher equation, this calls for a more than one-to-one
increase in nominal interest rates in response to an increase in inflation
expectations.

Taylor Rule
The following rule was introduced by Taylor (1993)
i = \pi + r + aT R (\pi - \pi \ast ) + bT R y
with positive coefficients aT R , bT R and an inflation target of \pi \ast

y is the output gap and r the natural real rate of interest
Due to aT R > 0, it satisfies the Taylor principle.
It seems to describe the policy actually conducted by central banks

rather well.
Sometimes the Taylor rule is claimed to have normative implications:

Central banks should set their policy in line with a specific Taylor rule.
Assuming monetary policy can be described by Taylor rule is a

convenient assumption for computer models.

Figure: Source Taylor (1993), ``Discretion versus policy rules in practice''

Interest-Rate Smoothing
Some empirical evaluation shows that central banks also seem to put
some weight on their previous interest-rate decisions.
This raises the following questions:

Do central banks have implicit interest-rate smoothing objectives?
If so, what is the rationale for smoothing interest rates?
Uncertainty about the functioning of the economy may require cautious
small steps (?)
Quick interest-rate changes may be harmful to financial-market stability
(?)

8.5 Money: Where has money gone?

Money in New Keynesian Models
so far, there was no money in the New Keynesian model
money is unimportant for the transmission of monetary policy in most

New Keynesian models
the central bank ``sets'' short-term nominal interest rates
the short-term interest rate is determined by the central bank's choice
of the supply of reserves.
current short-term interest rates and expectations of future short-term
interest rates determine long rates and thus economic activity
the demand for monetary aggregates is affected by interest-rates, but
these quantities play no independent role for economic activity

The Role of Money in Monetary Policy
By assuming a MIU utility function, it is also possible to derive a

log-linear money demand mt - pt = yt - \nu it .
Money demand is not particularly important for central bank policy.
Monetary policy has an impact on output and inflation only via the
interest rate.
Monetary economics/monetary policy can do without money!
Policy implication: If money demand shocks cannot be predicted with

high precision, it's preferable to choose interest rates rather than
monetary aggregates as monetary-policy instruments.

IS-LM vs. New Keynesian models
The absence/irrelevance of money is one major difference between the

IS-LM model and (standard) New Keynesian models.
That central banks choose interest rates rather than the money supply
is more realistic (exception: quantitative easing?)
Why can central banks choose nominal interest rates?
Hint: They are the monopoly supplier of currency and reserves (base
money).
New Keynesian models have microeconomic foundations.

Central bank loss function
Loss function of the central bank:
\infty
\sum \bigl[ \bigr]
Lt = Et (\pi t+j )2 + a(yt+j )2
j=0
Two objectives
1 stabilize inflation around 0
2 stabilize output gap
The relative significance of both objectives is given by parameter a

(a > 0).

Optimal Policy under Discretion
Discretionary policy: In each period, the central bank chooses \pi t and
yt , subject to the Phillips curve, taking expectations about its own
future policy as given.
This leads to the first-order condition:
\pi t \kappa + ayt = 0
Inserting into the Phillips curve yields:
\kappa 2
\pi t = - \pi t + Et [\pi t+1 ] + \xi t
a
1
\pi t = 2 [Et [\pi t+1 ] + \xi t ]
1 + \kappa a

Iterating recursively:
\infty
\Biggl( \Biggr) j
1 \sum 1
\pi t = \kappa 2 \kappa 2
Et [\xi t+j ]
1+ a j=0 1+ a
\infty
\Biggl( \Biggr) j
1 \sum 1
= \kappa 2 2 (\rho \xi )j \xi t
1+ a j=0 1 + \kappa a
\Bigl( 2
\Bigr)
1 1 + \kappa a
= \Bigl( \Bigr) \Bigl( \Bigr) \xi t
\kappa 2 \kappa 2
1+ a 1+ a - \rho \xi
a
= \xi t
a(1 - \rho \xi ) + \kappa 2
This implies:
\kappa \kappa
yt = - \pi t = - \xi t
a a(1 - \rho \xi ) + \kappa 2

Efficient Frontier
Figure: Inflation-Output Trade-off (Efficient Frontier)

Tinbergen's Rule
Tinbergen's Rule: To achieve a number of targets, at least as many

instruments are necessary
Here:
two targets: output and inflation
one instrument: interest rate
In the presence of supply shocks, both targets cannot be achieved at

the same time.
Intuition:
A supply shock drives inflation up and output down (or vice versa).
Monetary policy can only shift inflation and output into the same
direction (lower interest rates, e.g., raise output and inflation)
Hence the central bank cannot stabilize supply shocks perfectly.

Properties of Optimal Policy
In the presence of cost-push shocks \xi t , there is a short-run tradeoff

between output stabilization and inflation stabilization \rightarrow efficient
frontier
demand shocks (shocks to the IS curve) can be fully stabilized.
Inserting \pi t \kappa + ayt = 0 into the IS curve, applying the Phillips curve
and re-arranging, yields
it = f1 Et [\pi t+1 ] + f2 \sigma t
with f2 > 0
Optimal policy can be described by a forward-looking Taylor rule.
f1 > 1: Taylor Principle

It is easy to show
\biggl[ \biggr]
a j
\mathrm{l}\mathrm{i}\mathrm{m} Et [\pi t+j ] = \mathrm{l}\mathrm{i}\mathrm{m} (\rho \xi ) \xi t = 0
j\rightarrow \infty j\rightarrow \infty a(1 - \rho \xi ) + \kappa 2
Optimal monetary policy implies flexible inflation targeting, i.e.

expected future inflation has to converge towards zero.
Strict inflation targeting, i.e. a policy where Et [\pi t+j ] = 0 \forall j \geq 1 is
not optimal in general because it leads to a high output variance.

Experiment: Impulse Responses to a Monetary Shock
Figure: From Woodford (2003): `Ìnterest and Prices''

8.6 Money: Time inconsistency

Committing to a rule can improve monetary-policy performance (lower
social losses).
Intuition
If inflation expectations are high, this will lead to high inflation today.
The central bank should promise that inflation will be low in the future.
If this announcement is credible, the central bank will be better able to
stabilize current inflation.
In the future, the central bank has an incentive to renege on its
promise.
Optimal monetary policy is not time-consistent \rightarrow importance of

credibility and rules for monetary policy

Traditional time inconsistency problem
Central bank loss function :
\infty
\sum \bigl[ \bigr]
Lt = Et (\pi t+j )2 + a(yt+j - \Delta )2
j=0
Difference to previously assumed loss function:

The central bank targets a positive level of the output gap: \Delta > 0
Discretionary monetary policy yields
\pi t \kappa + a(yt - \Delta ) = 0

Inserting into the Phillips curve yields:
\kappa 2
\pi t = - \pi t + \kappa \Delta + Et [\pi t+1 ] + \xi t
a
1
\pi t = 2 [\kappa \Delta + Et [\pi t+1 ] + \xi t ]
1 + \kappa a
Iterating recursively
a a
\pi t = 2
\xi t + \Delta
a(1 - \rho \xi ) + \kappa \kappa
\kappa
yt = - \xi t
a(1 - \rho \xi ) + \kappa 2
For \Delta = 0, this solution coincides with the solution previously derived.
a
For positive \Delta , inflation is systematically higher and equal to
\kappa \Delta \Rightarrow
inflation bias
There are no systematic output gains.
Welfare could be improved if monetary policy would be same as in the

case \Delta = 0 \Rightarrow However, this policy is not time-consistent!

Solutions to the traditional time-inconsistency problem
Delegation of monetary-policy to a conservative central banker (i.e. a

person with a low a). Tradeoff:
a conservative central banker alleviates the inflation bias (good!)
a conservative central banker stabilizes output insufficiently (bad!)
reputation building
Rules and transparency (for example, by implementing inflation

targeting)

Extensions
Empirical finding: inflation inertia

Solution: indexation rather than sticky prices
sticky wages
capital and investment
zero lower bound

Advanced Macro I

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Advanced Macroeconomics I

October 23, 2016

Hahn (U. Konstanz) Advanced Macroeconomics I October 23, 2016 1

Hahn (U. Konstanz) Advanced Macroeconomics I October 23, 2016 2

Hahn (U. Konstanz) Advanced Macroeconomics I October 23, 2016 3

Lucas Critique/Rational Expectations and Microeconomic Foundations

(New) Growth Theory

Real Business Cycles

New Keynesian Economics

Hahn (U. Konstanz) Advanced Macroeconomics I October 23, 2016 4

Building blocks of many current macroeconomic models:

How to solve dynamic optimization problems in discrete time?

Standard approaches in Dynamic Macroeconomics

Hahn (U. Konstanz) Advanced Macroeconomics I October 23, 2016 5

Acemoglu, ``Introduction to Modern Economic Growth''

Ljungqvist, Sargent, ``Recursive Macroeconomic Theory''

Walsh, ``Monetary Theory and Policy''

Romer, ``Advanced Macroeconomics''

Dirk Kr\"uger, ``Macroeconomic Theory'', lecture notes, available online,

Per Krusell, Real Macroeconomic Theory, 2007, available online.

Simon and Blume, ``Mathematics for Economists''

Jerome Adda and Russell Cooper, ``Dynamic Economics: Quantitative

Stokey, Lucas, ``Recursive Methods in Economic Dynamics'' (very

Ljungqvist, Sargent, ``Recursive Macroeconomic Theory''

Hahn (U. Konstanz) Advanced Macroeconomics I October 23, 2016 6

Hahn (U. Konstanz) Advanced Macroeconomics I October 23, 2016 7

Hahn (U. Konstanz) Advanced Macroeconomics I October 23, 2016 8

Hahn (U. Konstanz) Advanced Macroeconomics I October 23, 2016 9

Hahn (U. Konstanz) Advanced Macroeconomics I October 23, 2016 10

Hahn (U. Konstanz) Advanced Macroeconomics I October 23, 2016 11

Kaldor identified the following stylized facts about growth:

The fraction of income that accrues to capital owners and workers is

Solow built a simple model that reflects these stylized facts.

Hahn (U. Konstanz) Advanced Macroeconomics I October 23, 2016 12

Source: Madison (2003)

Western Offshoots: US, Canada, New Zealand and Australia

Source: Acemoglu (2007)

Capital and Labor Share in the U.S. GDP.

Hahn (U. Konstanz) Advanced Macroeconomics I October 23, 2016 14

One good (can be used as capital good or for consumption)

closed economy (no trade, no capital flows)

No government (e.g., no taxes)

All resources are used (e.g. no unemployment)

Time is discrete t = 0, 1, 2, ....

Hahn (U. Konstanz) Advanced Macroeconomics I October 23, 2016 15

A is the efficiency of labor (the technology level) and L is the size of

constant returns to scale (CRTS), F (xAL, xK) = xF (AL, K)

F (AL, K) is increasing in both arguments

F (AL, K) is concave with respect to both arguments

The production function satisfies Inada conditions.

\mathrm{l}\mathrm{i}\mathrm{m} FK (At Lt , Kt ) = \infty \mathrm{l}\mathrm{i}\mathrm{m} FK (At Lt , Kt ) = 0

Hahn (U. Konstanz) Advanced Macroeconomics I October 23, 2016 16

Hahn (U. Konstanz) Advanced Macroeconomics I October 23, 2016 17

CES production function (\gamma < 1, r > 0):

F (AL, K) = [\alpha K \gamma + (1 - \alpha )(AL)\gamma ]r/\gamma

For r = 1, the CES function involves CRTS.

For \gamma \rightarrow 0 and r = 1, the CES function converges to the

Hahn (U. Konstanz) Advanced Macroeconomics I October 23, 2016 18

The intensive form makes it is easier to compute the solution of the

Because of CRTS output per effective labor can be written as:

With k := K/(AL) and y := Y /(AL) we obtain y = f (k).

Hahn (U. Konstanz) Advanced Macroeconomics I October 23, 2016 19

population growth rate n is constant