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14.462 Advanced Maroeconomics
Spring 2003

Problem Set 2
(due April 23)

Problem 1 (Human Capital and Incomplete Markets)

We introduce human capital in the model of Angeletos and Calvet (2002) that we discussed
in class. Households can now invest in two types of capital: Physical capital, denoted by
k at the individual level and K at the aggregate; and human capital, denoted by h at
the individual level and H at the aggregate. For simplity, we assume that the are no
financial assets other than the riskless bond; that there is no exogenous endowment; and
that preferences have expected­utility representation. There are a continuum of households.
The typical household faces the following problem:
∞
�
max E β t U (ct ) (1)
t=0

s.t. ct + θt+1 + kt+1 + ht+1 = wt (2)

˜t hγt + Rθt
wt = A˜t ktα + B (3)

where k denotes investment in physical capital, h denotes investment in human capital, θ

denotes investment in the riskless bond, A˜ denotes the productivity of physical capital, B
˜
denotes the productivity of human capital, and R denotes the (constant) riskless rate. The
utility is CARA,
1
U (c) = − exp(−Γc).
Γ
The productivity shocks à and B ˜ are jointly normally distributed and i.i.d. across time
and agents, and � � �� � � 2 ��
A˜ A¯ σA σAB
˜ ∼N ¯ ,
B B σAB σB2

1. Solve the consumers problem. How does investment in physical and human capital
depend on the variance and covariance of the shocks?

2. In the special case that σAB = 0 and α = γ = 1/2, solve explicitly for the optimal k
and h as functions of R and σA , σB .

3. Assume σAB = 0. Does the optimal k depends on σB ? Why, or why not?

1
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 4. Assume σAB = 0, σA = 0, σB > 0. What is the effect of a higher σB on the optimal
k and h, given R? Consider next the general equilibrium, where we endogenize R
through the Euler condition and let K = k, H = h. Discuss what is the general
equilibrium effect of σB on steady­state K, H, and R. (For this question, intuition is
enough, no maths are necessary.)

5. Assume again σAB = 0, σA = 0, σB > 0, but now let the cash on hand every period
be:
wt = Aktα Htη + B̃htγ + Rθt (4)
where Ht denotes the aggregate human capital stock. Interpret this new set­up.
Characterize the optimal k and h as functions of σB , R, and H. How does σB affect
the choice of k and h, given R and H? Consider next the general equilibrium, where
we endogenize R through the Euler condition and let K = k, H = h in equilibrium.
Discuss what is the general equilibrium effect of a higher σB on H and K. (For this
question, intuition is enough, no maths are necessariry.)

6. In the light of the above results, what is likely to be the effect of higher labor­income
risks on physical­capital accumulation in the presence of human­capital externalities?

Problem 2 (based on Kiyotaki and Moore (1997))

Consider an economy with an infinity of time periods and two types of continuum of agents:

farmers and gatherers. The population of farmers is equal to unity. There are also two

goods: an ordinary nondurable product, fruit, and a durable productive asset, land. The

¯ The farmer has a constant returns to scale technology:

total supply of land is equal to K.
he uses kt units of date t land to produce at+1 kt units of date t + 1 fruit. Each farmer
is always eager to expand (due to their great enjoyment of farming), but faces the credit
constraint, which implies the repayment of today’s debt (bt ) does not exceed the value of
land tomorrow:
Rbt ≤ qt+1 kt , (1)
where R is one plus real interest rate, and qt is land price in terms of fruit. The farmer
is also subject to the flow of funds constraint, which implies his investment expenditure is
financed by his output and net borrowing:
qt (kt − kt−1 ) = at kt−1 + bt − Rbt−1 . (2)
The gatherer’s production displays decreasing returns to scale; they use kt� units of date
t land to produce G(kt� ) units of date t + 1 fruit. The gatherer maximizes the expected
discounted consumption of fruit with discount factor R−1 < 1. This together with land
market equilibrium, implies that the residual supply of land to the farmers satisfies:
1 1 1
¯ − kt ) = αktη ,
qt − qt+1 = G� (K (3)
R R

2
where η > 0 is the elasticity of the residual supply of land with respect to the opportunity
cost of holding land, and α is a positive parameter.
1. Describe the steady state equilibrium of the above economy for at = a.

2. Suppose that the economy is at the steady state at date t − 1 for some value of a,
say a1 . Suppose that the value of a unanticipatedly increases to a2 > a1 permanently
from date t. Describe the equilibrium path of the economy.

Problem 3 (Savings with Incomplete Markets, General Exam 2001)

Consider the following OLG economy with incomplete markets. Each individual lives for

two periods. Population is constant. Each generation consists of a continuum of individuals.

Individuals within a generation t are indexed by h. Let cyt (h) and cot+1 (h) denote the
consumption of an individual h born in period t, when she is young and when she is old,
respectively. Preferences are given by:

Et Ut (h) = log cyt (h) + βEt [log cot+1 (h)], (1)

where β > 0 and Et denotes expectations. During her youth, an individual receives a fixed
endowment: yty (h) = 1. Part of this endowment is consumed and part is saved for the next
period. Let kt (h) denote savings. Therefore, the budget of an individual during youth is:

cyt (h) + kt (h) = 1. (2)

Each individual invests her savings either in a safe storage technology, or in a risky en­
trepreneurial project. If the individual specializes in the storage technology, her consump­
tion during retirement is:
cot+1 (h) = δkt (h) (3)
where δ > 0 is constant. If instead the individual chooses to specialize in the risky en­
trepreneurial project, her consumption during retirement is:

cot+1 (h) = Ãt+1 (h)kt (h). (4)

The return A˜t+1 (h) is specific to individual h. It is i.i.d. across individuals, i.i.d. across
time, and distributed as follows:
�
A + σ with probability 21
Ãt+1 (h) = Ã = (5)
A − σ with probability 12
˜ > δ > 0; and σ ≥ 0. Finally, define gt as the (gross) growth rate in the
where A = E[A]
consumption of generation t over her life cycle:
� o
c (h)dh
gt ≡ � t+1 . (6)
cyt (h)dh

3
 1. Use (1)–(4) to express Et Ut (h) as a function of kt (h), depending on whether h spe­
cializes in storage or the risky technology.

2. Define σ ˆ such that E(log

� �Ã) = �� ˆ What are the signs of ∂∂δσˆ and ∂A
log δ at σ = σ. ∂σ
ˆ
?
Next, define B = exp E log A˜ . What are the signs of ∂B ∂σ
and ∂B
∂A
? Specify the
values of B at σ = 0, at σ = σ,
ˆ and at σ = A; and draw a picture of B as σ varies in
(0, A). What is the interpretation of B and σ̂? When does individual h specialize in
the risky technology, and when in storage?

3. Suppose we allow a risk­free bond to be traded. Let then R denote the risk­free rate,
What is R when σ < σ?ˆ What is R when σ > σ? ˆ

4. What are the optimal savings, kt (h), for individual h? How does the saving rate
depend on R, B, and σ?

5. Derive g from (6). What is g at σ = 0? What is g at σ < σ

ˆ and at σ > σ?
ˆ

6. Drop (1) and suppose instead that preferences are given by

� � �� 1−θ
(cy
t)
1−θ
+ β Et (cot+1 )1−γ 1−γ . (7)

Then, redefine B as:

� � �� 1−γ
1
˜
B(σ) ≡ E (A)1−γ
;

and redefine σ
ˆ by B(ˆ
σ) = δ. Explain the following:

(a) What is the degree of relative risk aversion and the elasticity of intertemporal
substitution implied by (7)?
∂B
(b) How do the sign and the magnitude of ∂σ
depend on γ?
∂B ∂ σ̂
(c) What are the signs of ∂γ
and ∂γ
?
(d) How does the interest­sensitivity of the saving rate depend on θ?
∂g
(e) How do the sign and the magnitude of ∂σ
depend on γ and θ?

Problem 4 (Government and Growth in the Ramsey Model)

Consider a representative consumer who maximizes
� ∞
c1−θ − 1
max e−ρt dt (1)
0 1−θ
subject to
ȧ = (1 − τK )ra + (1 − τL )w − c + v (2)

4
where c denotes consumption, a denotes assets, r is the interest rate, w is the wage rate,
τK is the tax rate on capital income, τL the tax rate on labor income, and v a lump­sum
per capita transfer. The government spends g per capita in order to blow up Pacific islands
(i.e. g does not affect utility or production). The government budget is

g + v = τK ra + τL w

The market clearing for assets is

k=a
The production function is Cobb­Douglas, y = k α , implying r = αk α−1 and w = (1 − α)k α .

1. Write down the resource constraint of the economy.

2. Write down the FOCs for maximization of the consumer, taking all fiscal policy
variables as given.

3. Use a phase diagram in (k, c) to show how the paths of k and c change when the
government surprises people by permanently raising the values of τK and g. What
happens to the steady state value of k?

4. Redo part c.) for the case in which the government raises τL and g (without changing
τK ). What happens to the steady state value of k? Explain the differences from those
of part c.)

5. Redo part c.) for the case in which the government raises τL and v (without changing
τY and g). What happens to the steady state value of k? Explain the differences
from those of parts c.) and d.)

6. Finally, assume that τL = v = 0 so that g = τK y. Discuss the adjustment dynamics

due to the following change in fiscal policy: at time t = T1 , the government announces
that spending increases from g = 0 to g = g > 0 until t = T2 .

7. Redo part f.), but now assuming the following policy change: at time t = T1 , the
government announces that from t = T2 > T1 until t = T3 > T2 spending increases
from g = 0 to g = g > 0. What is different?

8. Discuss how your answers to all above parts would change if labor supply was en­
dogenous.

14.462 Advanced Maroeconomics

Spring 2003

Problem Set 2 Solution

Problem 1 (Human Capital and Incomplete Markets)

1. The Bellman equation is

V (w) = max � {U (c) + βE[V (w� )]}

c,k,h,w
˜ α + Bh
s.t. w� = Ak ˜ γ + R(w − c − k − h).

Notice that to simplify notation I do not give k and h a prime although they are next
period variables. A natural guess for the value function is
1
V (w) = − exp(−Γ(aw + b)).
aΓ
In order to perform the optimization we need to evaluate E[V (w]). We have
¯ α + Bh
E[w� ] = Ak ¯ γ + R(w − c − k − h),
Var[w� ] = σA2 k 2α + σB2 h2γ + 2σAB k α hγ .

Now

� �

� 1 �
E[V (w )] = E − exp(−Γ(aw + b))
aΓ
� �
1 � 1 2 2 �
= − exp −Γ(aE[w ] + b) + Γ a Var(w ) .
aΓ 2

Thus the objective in the Bellman equation can be written as

1 1 ¯ α + Bh
¯ γ + R(w − c − k − h)] − Γb
− exp(−Γc) − β exp − Γa[Ak
Γ aΓ

�
1
2 2 2 2α 2 2γ α γ
+ Γ a [σA k + σB h + 2σAB k h ]
2
The first order condition with respect to consumption is given by
�
exp(−Γc) = βR exp − Γa[Ak ¯ α + Bh
¯ γ + R(w − c − k − h)] − Γb
�
1 2 2 2 2α 2 2γ α γ
+ Γ a [σA k + σB h + 2σAB k h ]
2

1
The first order conditions with respect to k and h are
� �
R = αAk¯ α−1 − Γa ασ 2 k 2α−1 + ασAB k α−1 hγ ,
A
� �
R = γBh¯ γ−1 − Γa γσB2 h2γ−1 + γσAB g γ−1 k α .

Notice that the level of wealth does not appear in these equations, so the optimal
choice of k and h is independent of the state w. Denote the solutions to this system
of equations as k ∗ (a) and h∗ (a). Now define the function
�
φ(a, b) = −[Γ(1 + aR)]−1 · log(βR) − Γa[Ak ¯ ∗ (a)α + Bh
¯ ∗ (a)γ − R(k ∗ (a) + h∗ (a))]
1 �
− Γb + Γ2 a2 [σA2 k ∗ (a)2α + σB2 h∗ (a)2γ + 2σAB k ∗ (a)α h∗ (a)γ ]
2
Then the first order condition for consumption can be rewritten as

exp(−Γc) = exp(−ΓaR(w − c) − Γ(1 + aR)φ(a, b))

and so we obtain the consumption function

aR
c= w + φ(a, b).
1 + aR
Substituting into the objective we get
1 1
− exp(−Γc) − exp(−ΓaR(w − c) − Γ(1 + aR)φ(a, b))
Γ � �ΓaR
��

1 aR
= − exp −Γ w + φ(a, b)
Γ 1 + aR
� � � �
1 aR
− exp −ΓaR w − w − φ(a, b) − Γ(1 + aR)φ(a, b)
ΓaR 1 + aR

� � � � ��

1 1 aR
=− 1+ exp −Γ w + φ(a, b)
Γ aR 1 + aR
� � ��
1 aR
= − aR exp −Γ w + φ(a, b)
1+aR
Γ 1 + aR

For our guess to be correct this must be equal to − a1Γ exp(−Γ(aw + b)). Thus it must
be the case that
aR
a=
1 + aR
R−1
which implies a = R . It must also be the case that b = φ(a, b), which yields
�
−1
b = −[ΓaR] · log(βR) − Γa[Ak ¯ ∗ (a)α + Bh
¯ ∗ (a)γ − R(k ∗ (a) + h∗ (a))]
1 2 2 2 ∗ 2α �
2 ∗ 2γ ∗ α ∗ γ
+ Γ a [σA k (a) + σB h (a) + 2σAB k (a) h (a) ]
2

2
Note that the consumption function can now be written as c = aw + b.
Now let’s analyze how investment in physical and human captial depends on the
variance and covariance of shocks. Totally differentiating the first order condition for
physical capital yields
� �
¯ α−1 − Γa (2α − 1)ασA2 k 2α−1 + (α − 1)ασAB k α−1 hγ ] dk
0 = [(α − 1)αAk
k

− ΓaαγσAB k α−1 hγ−1 dh − Γaαk 2α−1 dσA2

− Γaαk α−1 hγ dσAB .

Using the first order condition to simplify the coefficient for dk we get

0 = −[(1 − α)Rk −1 + Γaα2 σA

2 2(α−1)
k ]dk − ΓaαγσAB k α−1 hγ−1 dh
− Γaαk 2α−1 dσA2
− Γaαk α−1 hγ dσAB .

Dividing by Γaαk α−1 and rearranging we get

[ψk + ασA2 k α−1 ]dk + γσAB hγ−1 dh = −k α dσA2 − hγ dσAB .

2
where ψk = 1−α 1 1 R
α Γ kα R−1
> 0.
By symmetry

[ψh + γσB2 hγ−1 ]dh + ασAB k α−1 dk = −hγ dσB2 − k α dσAB .

2
where ψh = 1−γ 1 1 R
γ Γ kα R−1
> 0.
Writing this system in matrix form we have
� � � � � �
ψk + ασA2 k α−1 γσAB hγ−1 dk −k α dσA2 − hγ dσAB
· =
ασAB k α−1 ψh + γσB2 hγ−1 dh −hγ dσB2 − k α dσAB

Then
� �
dk 1
= 2 γ−1 2 α−1
dh ψk ψh + ψk γσB h + ψh ασA k + αk α−1 γhγ−1 [σA2 σB2 − σAB
2
]

� � � �

ψh + γσB2 hγ−1 −γσAB hγ−1 −k α dσA2

− hγ dσAB
· ·
−ασAB k α−1 ψk + ασA2 k α−1 −hγ dσB2
− k α dσAB
1
= 2 γ−1 2 α−1
ψk ψh + ψk γσB h + ψh ασA k + αk α−1 γhγ−1 [σA2 σB2 − σAB
2
]
� �
−(ψh + γσB2 hγ−1 )k α dσA2 + γσAB h2γ−1 dσB2 − (ψh hγ + γhγ−1 (σB2 hγ − σAB k α ))dσAB
·
−(ψk + ασA2 k α−1 )hγ dσB2 + ασAB k 2α−1 dσA2 − (ψk k α + αk α−1 (σA2 k α − σAB hγ ))dσAB

The term σA2 σB2 −σAB

2
is nonnegative as it is the determinant of the variance-covariance
matrix (Cauchy-Schwartz inequality). Thus the determinant is positive.
dk dh
We find that dσ 2 and dσ 2 are both negative. An increase in the riskiness of the own
A B

3
 return unambigously reduces investment. Notice that
dσdk2 and dσ dh
2 are positive if
B A
σAB > 0 and negative if σAB < 0. If human capital becomes more risky and the two
returns are positively correlated, then physical capital is relatively more attractive
and investment in physical capital increases. Now suppose that the correlation of
the returns is negative and human capital becomes more risky. Investment in human
capital shrinks. As human capital provides insurance for physical capital, the amount
of insurance of physical capital shrinks and so physical capital investment is reduced
as well.

2. With σAB = 0 and α = γ = 12 , the first order condition for k reduces to

� �
1 −1 R−1 1 2
R = Āk − Γ
2 σ
2 R 2 A
and solving for k we obtain

� �2

RA¯
k=
2R + (R − 1)ΓσA2
and by symmetry
� ¯ �2
RB
h=
2R + (R − 1)ΓσB2
3. When σAB = 0, investment in the two different capital stocks is independent.

4. From our previous calculations we know that if σAB = 0, σA = 0 and σB > 0, then an
increase in σB leaves investment in physical capital unaffected and reduces investment
in human capital.
To derive the Euler equation, first compute the envelope condition as V � (w) =
βRE[V � (w� )] and recall that the first order condition for consumption is U � (c) =
βRE[V � (w� )]. Combining these two equations we have V � (w) = U � (c) and thus

U � (c) = βRE[U � (c� )].

With our functional form for U this becomes

exp(−Γc) = βRE[exp(−Γc� )]

As c� = aw� + b it is normally distributed and so

� �
� 1 2 �
exp(−Γc) = βR exp −ΓE[c ] + Γ Var(c ) .
2

Taking logs and rearranging yields

log(βR) Γ

E[c� ] − c = + Var(c� ).
Γ 2

4
 Moreover Var(c� ) = Var(aw� + b) = a2 Var(w� ) and with σAB = 0 and σA = 0 we have
Var(w� ) = σB2 h2γ . Using these facts the Euler equation can be rewritten as
� �2
� log(βR) Γ R − 1
E[c ] − c = + σB2 h2γ .
Γ 2 R

Due to the linearity of the Euler equation in E[c� ] and c and the fact that all households
invest the same amount h = H we can aggregate across households to obtain
� �2
� log(βR) Γ R − 1
C −C = + σB2 H 2γ .
Γ 2 R
The expectation disappears as aggregate consumption is deterministic. In steady
state we must have
� �2

Γ2 R − 1
0 = log(βR) + σB2 H 2γ

2 R
This together with the first order equation for human capital

¯ γ−1 − Γ R − 1 γσ 2 − R
0 = γBH B
R
determines R and H in steady state. We want to know how this depends on σB2 . Note
that σB2 enters these equations in two places. In the Euler equation idiosyncratic risk
in human capital investment creates a precautionary savings effect. In the first order
condition for human capital in exerts a direct negative investment effect.
The effect of σB2 on R and H is ambiguous. Let’s consider the scenario which An-
geletos and Calvet would consider the most likely. So suppose from now on that in
the Euler equation the direct effect precautionary savings effect of σB2 on R wins out
and R is decreasing in σB2 . From the first oder equation for human capital we can
˜
write H = H(R, σB2 ). The direct investment effect tends to reduce investment. But
through the precautionary savings effect σB2 reduces the interest rate which tends to
increase investment in human capital. Investment in human capital will fall if the
investment effect dominates. Investment in physical captial will increase with the
reduction in the interest rate caused by the precautionary savings effect, so the gen­
eral equilbrium effect of an increase in the idiosyncratic risk in human capital is to
increase investment in physical capital.

5. The human capital externality affects the first order condition for capital investment,
which now becomes

R = αAH¯
η k α−1

Maintaining our assumptions about which effects dominate from the previous part,
an increase in σB2 reduces both R and H. Thus we have two opposing effects on

5
 investment in physical capital. The precautionary savings effect tends to increase
investment in physical capital, but the reduction in human capital investment tends
to reduce physical capital investment through the externality.

6. If labor income risk corresponds to riskiness in human capital investments, and if

human capital externalities are strong, then physical capital accumulation is likely to
be reduced.

Problem 2 (based on Kiyotaki and Moore (1997))

1. Before solving the problem we’ll discuss where equation (3) comes from. If a gatherer
buys a unit of land, he pays qt today. His output tomorrow increases by G� (kt� ) and
the unit of land can be resold for qt+1 . As the discount factor is R−1 , we get the
condition
G� (kt� ) + qt+1
qt =
R
Now using the market clearing condition kt + kt� = K ¯ to replace k � and rearraning
t
slightly yields the first equality of equation (3). The second equality is simply a
convenient functional form assumption. Farmers are always eager to expand, so the
borrowing constraint will always be binding unless there are surprises. In particular
the borrowing constraint will be binding in steady state. The steady state versions
of (1),(2) and (3) are

Rb = qk
0 = ak + b − Rb
1 1
q− q = αk η
R
qk
The first equation gives b = R
. Substituting into the second equation yields

R−1
ak = qk,
R
R
so the steady state price of land is q ∗ = a R−1 . Substituting this result into the third
equation yields
1
a = αk
η
� �η
so steady state land holdings of farmers are k ∗ = αa . Plugging these results into
the first equation yields
q∗k∗ 1 R � a �η 1
b∗ = = a = a1+η α−η .
R RR−1 α R−1

6
2. Let k1∗ , q1∗ and b∗1 be the steady state corresponding to a1 . Similarly let k2∗ , q2∗ and b2∗
be the steady state corresponding to a2 .
Consider some date t ≥ s. As farmers are eager to expand and their are no more
surprises the borrowing constraint will always be binding:

Rbs = qs+1 ks .

Substituing into the flow of funds constraint of farmers we get

qs+1 ks
qs (ks − ks−1 ) = as ks−1 + − Rbs−1
R
or slightly rearranged
� qs+1 �
qs − ks = (as + qs )ks−1 − Rbs−1 .
R
qs+1
Substituting for qs − R
from equation (3) we get
1
αksη ks = (as + qs )ks−1 − Rbs−1

or equivalently
� � 1+η
η
(as + qs )ks−1 − Rbs−1
ks = .
α
At time t this equation becomes
� � 1+η
η
(a2 + qt )k1∗ − Rb∗1
kt = .
α

and as Rb∗1 = q1∗ k1∗ this can also be written as

� � 1+η
η
(a2 + qt − q1∗ )k1∗
kt = .
α

For s ≥ t + 1 the borrowing constraint was also binding in the previous period, so
� � 1+η
η
(a2 + qs )ks−1 − qs ks−1
ks =
α
� � 1+η
η
a2 ks−1
=
α

7
Collecting equations we have

� � η
(a2 + qt − q1∗ )k1∗ 1+η
kt = ,
α
� � η
a2 ks−1 1+η
ks = ∀ s ≥ t + 1,
α
1 1
qs = qs+1 + αksη ∀ s ≥ t.
R
The next step is to log-linearize around the new steady state. For a variable xs define
x̌s = log(xs ) − log(x2 ). Also define Δ = log(a2 ) − log(a1 ). Let’s begin with the first
� � η
equation. Using the identity k2∗ = aα2 k2∗ 1+η we can write it as
� � 1+η
η
kt a2 + qt − q1∗ k1∗
=
k2∗ a2 k2∗
or � �1+ η1 � �
kt qt − q1∗ k1∗
= 1+
k2∗ a2 k2∗
� �η
k1∗
Taking logs, noting that k2∗
= aa12 we get that approximately
� �
1 qt − q1∗
1+ kˇt = − ηΔ
η a2
q2∗
R
Using the facts that q2∗ = a2 R−1 and q1∗
=
aa21 we have that approximately

� �
qt − q1∗ R qt − q2∗ q2∗ − q1∗ R
= + = (q̌t + Δ).
a2 R−1 q2∗ q2∗ R−1

Thus the log-linearized version of the first equation is given by

� � � �
1 ˇ R R
1+ kt = q̌t + − η Δ.
η R−1 R−1

For the second equation we simply get

η ˇ
kˇs = ks−1 ∀ s ≥ t + 1.
1+η
1
1 ∗
Using the identity q2∗ = q
R 2
+ α(k2∗ ) η the third equation can be rewritten as

� 1 �

qs − q2∗ 1 qs+1 − q2∗ 1 η ∗ η1

= + ∗ α ks − (k2 ) .

q2∗ R q2∗ q2

8
and so approximately

� �
1 1 1 1 ks − k2∗
q̌s = q̌s+1 + ∗ α (k2∗ ) η
R q2 η
k2∗
1
Using the facts that q2∗ = R
a
R−1 2
and (k2∗ ) η =
aα2 we see that the log-linearized version
of the third equation is
1 1R−1
q̌s = q̌s+1 + ǩs ∀ s ≥ t.
R η R
Collecting our results, the log-linearized system is
� � � �
1 ˇ R R
1+ kt = q̌t + − η Δ,
η R−1 R−1
η ˇ
kˇs = ks−1 ∀ s ≥ t + 1,
1+η
1 1R−1
q̌s = q̌s+1 + ǩs ∀ s ≥ t.
R η R
By induction we obtain from the second equation that
� �s−t
η
ǩs = kˇt
1+η

and iterating the third equation imposing lims→∞ R−(s−t) q̌s = 0 yields
�∞ � �
1 1 R − 1ˇ
q̌t = s−t
ks .
s=t
R η R

Combining the last two results gives

1 R−1
kˇt .
η R
q̌t = η
1 − R1 1+η

Together with the first equation of the log-linearized system we now have two equa­
tions in the two unknowns qˇt and qˆt . To solve, rewrite the last equation as
� � � �
1 η 1 R−1 1 ˇ
1− q̌t = 1+ kt .
R1+η 1+η R η

Substituting from the first equation of the log-linearized system this becomes
� � � � � �
1 η 1 R−1
1− q̌t = q̌t + 1 − η Δ
R1+η 1+η R

9
 This can be rewritten as
� �
R−1 η 1 R−1
q̌t = 1− η Δ
R 1+η 1+η R

and so we get
� �

R 1
q̌t = −1 Δ
R−1η
and consequently
� �� �
R 1 η R 1
ǩt = η 1− −1 Δ
R−1 R1+η R−1η
� �� �
η R 1 R 1
= (1 + η) − η −1 Δ
1+η R−1 R−1 R−1η
� �� �
η R R 1
= +η −1 Δ
1+η R−1 R−1η

R
Notice that there will be overshooting if R−1
> η, i.e. if the residual supply of land
to farmers is not very elastic.

Problem 3 (Savings with Incomplete Markets, General Exam 2001)

1. If individual h specializes in storage, then

Et Ut (h) = log(1 − kt (h)) + βEt [log(δkt (h))]

= log(1 − kt (h)) + β log(kt (h)) + β log(δ).

If instead the individual specializes in the risky technology, then

Et Ut (h) = log(1 − kt (h)) + βEt [log(Ãt+1 (h)kt (h))]

� �
1 1
= log(1 − kt (h)) + β log(kt (h)) + β log(A + σ) + log(A − σ) .
2 2

2. In words, σ̂ is the counterfactual riskiness of the risky project that makes the cer­
tainty equivalent of the return to the risky project equal to the return of the storage
technology. If we had σ = σ, ˆ
then the individual would be indifferent between the
risky project and the storage technology. So σ ˆ
is implicitly defined by the equation
1 1
log(A + σ)
ˆ + log(A − σ)
ˆ = log(δ).
2 2

10
 As A > δ we know that σ̂ > 0 by Jensen’s inequality. Totally differentiating yields
� � � �
1 1 1 1 1 1 dδ
− dσ̂ + + dA =
2 A+σ ˆ A−σ ˆ 2 A+σ ˆ A−σ ˆ δ
which can be rewritten as

σ A dδ
− dˆ
σ+ dA = .
(A + σ)(A
ˆ − σ)
ˆ (A + σ)(A
ˆ − σ)
ˆ δ
Thus
∂ σ̂ (A + σ
ˆ )(A − σ)
ˆ
=− <0
∂δ δσˆ
and
∂ σ̂ A
= > 0.
∂A σ̂
If the storage technology has a better return, then the risky project must become
less risky to keep the individual indifferent. If the average return of the risky project
increases, then it must become more risky to keep the individual indifferent.
The definition of the certainty equivalent is
� �
1 1 �
B = exp(E(log Ã)) = exp log(A + σ) + log(A − σ) = (A + σ)(A − σ).
2 2

Clearly ∂B
∂σ
< 0 and ∂B ∂A
> 0. Making the project more risky reduces the certainty
equivalent of its return. Increasing the average return of the project increases the

certainty equivalent.

Now consider B as a function of σ, writing B(σ). Then B(0) = A, B(ˆ

σ) = δ and
B(A) = 0.
The individual specializes in the risky technology if σ < σˆ and in storage if σ > σ,
ˆ
being indifferent if σ = σ.ˆ
Let’s assume that the risky project is chosen in the case
of indifference.

I think
3. The ideathat thequestion
of this idea of this
was question was to
to get at what get
risk at whatreal
adjusted thereturn
risk adjusted real return
in the economy, and
in the
that economy,
would be and that would be

R = max[B(σ), δ],

so R = B(σ) for σ < σ ˆ and R = δ for σ > σ.ˆ

But if we really allow a risk-free bond to be traded, then things are a bit more
complicated. While it was impossible to invest in both the storage technology and
the risky project at the same time, it would now be possible to invest in the riskless
asset and the risky project at the same time.
Let’s compute the equilibrium real interest rate under the assumption that individuals

11
invest in the risky project but not in storage, but may want to invest in the riskless
asset. The equilibrium real interest rate must make the demand for the riskless asset
equal to zero because the asset is in zero net supply.
The problem of the individual is to choose the risky investment kt (h) and investment
in the riskless asset bt (h) to maximize
log(1 − kt (h) − bt (h))
� �
1 1
+β log((A + σ)kt (h) + Rbt (h)) + log((A − σ)kt (h) + Rbt (h))
2 2
The first order conditions are
� �
1 β A+σ A−σ
= +
1 − kt (h) − bt (h) 2 (A + σ)kt (h) + Rbt (h) (A − σ)kt (h) + Rbt (h)
� �
1 β R R
= +
1 − kt (h) − bt (h) 2 (A + σ)kt (h) + Rbt (h) (A − σ)kt (h) + Rbt (h)
We can combine them to obtain
A+σ−R A−σ−R
+ =0
(A + σ)kt (h) + Rbt (h) (A − σ)kt (h) + Rbt (h)
Now in equilibrium it must be the case that bt (h) = 0, so this condition reduces to
A+σ−R A−σ−R
+ =0
(A + σ) (A − σ)
Solving this for R and expressing the result as a function of σ we get
(A + σ)(A − σ)
R(σ) = .
A
Notice that R(σ) < B(σ). This makes a lot of sense. If the interest rate where B(σ),
then a risk adjusted return of B(σ) could be achieved simply by putting everything
into the riskless asset. But by combining the risky project with some of the riskless
asset, it would be possible to do strictly better then B(σ). But with the interest rate
R(σ) above, it is undesirable to put anything into the riskless asset, and then the risk
adjusted return is one again B(σ). Once again this is an equilibrium only if B(σ) ≥ δ
or equivalently σ ≤ σ̂, because otherwise given the interest rate R(σ) it would be
optimal to put all savings into the storage technology (using the riskless asset would
be inferior as B(σ) ≥ δ implies R(σ) < δ).
Now suppose that σ > σ̂. Is it an equilibrium for all individuals to invest in storage?
If so, then the interest rate must be R = δ. But if the interest rate is δ, then an
individual could get a risk adjusted return higher then δ by combining the riskless
asset and a little bit of the risky project. So investing in storage can never be an
equilibrium, and consequently an equilibrium does not exist if σ > σ̂.
So from now on let’s just consider R(σ) = max[B(σ), δ].

12
4. Substituting the optimal decision between risky project and storage into the objective,
the problem reduces to the maximization of

log(1 − kt (h)) + β log(R(σ)kt (h))

and the solution

β
kt (h) =
1 + β

is independent of R(σ).

β
ˆ then cot+1 (h) = Ãt+1 (h) 1+β
5. If σ ≤ σ, and taking the average across individuals we
� o β y 1
get ct+1 (h)dh = A 1+β and as ct (h) = 1+β for all individuals we get gt = βA. On
β
the other hand, if σ > σ,ˆ then for all individuals cot+1 (h) = δ 1+β
and consequently
gt = βδ. Thus as a function of σ we have

�
βA for σ ≤ σ̂,
g(σ) =
βδ for σ > σ̂.

1
6. (a) The coefficient of relative risk aversion is γ and θ
is the elasticity of intertemporal
substitution.
(b) As
� � 1−γ
1
1 1
B(σ) = (A + σ)1−γ + (A − σ)1−γ
2
2
we have
∂B 1
= B(σ)γ [(A + σ)−γ − (A − σ)−γ ] < 0.
∂σ 2
We would expect B to me more responsive to changes in σ if γ is large.
(c) We would expect an increase in the coefficient of relative risk aversion to reduce
the risk adjusted return, that is ∂B
∂γ
< 0. Recall that σ
ˆ is implicitly defined by
B(ˆσ) = δ. Increasing γ reduces the left hand side, so σ ˆ must fall to restore
∂ σ̂
equalitiy, i.e. ∂γ < 0.
(d) Now savings are chosen by maximizing

(1 − kt (h))1−θ + β(R(σ)kt (h))1−θ

and the solution is

β
θ R(σ)( θ −1)
1 1

kt (h) = .

1 + β
θ R(σ)( θ −1)
1 1

Of course the saving rate is not at all sensitive to the interest rate if θ = 1. For
θ close to zero it is quite sensitive and it is somewhat sensitve for large θ.

13
 β θ R(σ)( θ )
1 1 −1

(e) If σ ≤ σ,
ˆ then cot+1 (h) = Ãt+1 (h) and taking the average across
1+β θ R(σ)( )
1 1 −1
θ

� o β θ R(σ)( θ )
1 1 −1

individuals we get ct+1 (h)dh = A and as c

yt (h) = 1
1 (
1+β θ R(σ) θ
1 −1
) 1+β θ R(σ)( θ )
1 1 −1

for all individuals we get gt = Aβ θ R(σ)( θ −1) . On the other hand, if σ > σ̂, then
1 1

gt = β
θ δ ( θ −1) δ. Thus as a function of σ we have
1 1

�
Aβ
θ R(σ)( θ −1) for σ ≤ σ̂,
1 1

g(σ) = 1
(βδ) θ for σ > σ̂.

The growth rate of consumption varies with σ only as long as σ < σ̂. If θ < 1,
then an increase in σ will reduce R(σ) and thus consumption growth. If θ > 1,
then consumption growth is increasing in σ. Of course in both cases there is
still a downward jump at σ. ˆ An increase in γ shortens the intervall [0, σ] ˆ in
which g(σ) varies with σ, and the counterpart of this is that within this intervall
consumption growth becomes more sensitive to changes in σ

Problem 4 (Government and Growth in the Ramsey Model)

Consider a representative consumer who maximizes
� ∞
c1−θ − 1
max e−ρt dt (1)
0 1−θ
subject to
ȧ = (1 − τK )ra + (1 − τL )w − c + v (2)
where c denotes consumption, a denotes assets, r is the interest rate, w is the wage rate,
τK is the tax rate on capital income, τL the tax rate on labor income, and v a lump-sum
per capita transfer. The government spends g per capita in order to blow up Pacific islands
(i.e. g does not affect utility or production). The government budget is

g + v = τK ra + τL w

The market clearing for assets is

k=a
The production function is Cobb-Douglas, y = k α , implying r = αk α−1 and w = (1 − α)k α .

1. Write down the resource constraint of the economy.

2. Write down the FOCs for maximization of the consumer, taking all fiscal policy
variables as given.

14
3. Use a phase diagram in (k, c) to show how the paths of k and c change when the
government surprises people by permanently raising the values of τK and g. What
happens to the steady state value of k?

4. Redo part c.) for the case in which the government raises τL and g (without changing
τK ). What happens to the steady state value of k? Explain the differences from those
of part c.)

5. Redo part c.) for the case in which the government raises τL and v (without changing
τY and g). What happens to the steady state value of k? Explain the differences
from those of parts c.) and d.)

6. Finally, assume that τL = v = 0 so that g = τK y. Discuss the adjustment dynamics

due to the following change in fiscal policy: at time t = T1 , the government announces
that spending increases from g = 0 to g = g > 0 until t = T2 .

7. Redo part f.), but now assuming the following policy change: at time t = T1 , the
government announces that from t = T2 > T1 until t = T3 > T2 spending increases
from g = 0 to g = g > 0. What is different?

8. Discuss how your answers to all above parts would change if labor supply was en­
dogenous.

15