Suggested Solutions to Homework #4

Econ 511b (Part I), Spring 2004

1. Consider a neoclassical growth model with valued leisure. The (represen-
tative) consumer values streams of consumption and leisure according to
P

t=0

t
U (c
t
, l
t
), where l
t
is hours of leisure in period t. The felicity function
U is strictly concave and strictly increasing in both of its arguments. Out-
put is produced according to y
t
= F(k
t
, n
t
), where n
t
= Ll
t
is hours of labor
supply in period t (F is the total number of hours available for either leisure
or work in period t) and F exhibits constant returns to scale. Output in
period t can be used for either consumption c
t
or investment i
t
and capital
accumulates according to k
t+1
= (1 ) k
t
+ i
t
.
(a) Display Bellmans equation for the problem faced by the social plan-
ner in this economy. Identify clearly the state and control (or choice)
variable(s).
The recursive formulation for the planning problem is
v

= max
n
c,l,k
0
o
U

c, l

+ v

k
0

s.t.
c + k
0
= F(k, L l) + (1 )k
or
v

= max
{
l,k
0
}
U

F(k, L l) + (1 )k k
0
, l

+ v

k
0

From the way we write it, we can see that the state variable is k, and control
variables are l, k
0
.
(b) Derive the rst-order and envelope conditions for the planning problem.
The F.O.C. is

: U
1

c, l

F
2
(k, L l) = U
2

c, l

n
k
0
o
: U
1

c, l

= v
0

k
0

From Envelope Theorem, we have

v
0

k

= U
1

c, l

F
1
(k, L l) + (1 )

Iterate forward for one period, it becomes

v
0

k
0

= U
1

c
0
, l
0

F
1
(k
0
, L l
0
) + (1 )

Plug it into F.O.C., we get the nal optimality conditions:

l
t

: U
1

c
t
, l
t

F
2
(k
t
, L l
t
) = U
2

c
t
, l
t

k
t+1

: U
1

c
t
, l
t

= U
1

c
t+1
, l
t+1

F
1
(k
t+1
, L l
t+1
) + (1 )

1
(c) Use the conditions from part (b) to determine the economys steady
state. Show how the steady state depends on primitives and compare
your results to those for a growth model without valued leisure.
In steady state, the optimality condition becomes
n
l

o
: U
1

, l

F
2
(k

, L l

) = U
2

, l

n
k

o
: F
1
(k

, L l

) =
1

(1 )
where c

= F(k

, L l

) k

. We can see that k

and l

depends on both , ,
production techonology F(k
t
, n
t
), and utility function U (c
t
, l
t
).
In a growth model without valued leisure, the steady state is determined by the
equation
F
1
(k

, L) =
1

(1 )
which does not depend on the utility function U (c
t
, l
t
).
Now lets compare two models. First, in the model with leisure choice we add an
additional equation which states that the marginal rate of substitution between
consumption and leisure must equal to the marginal rate of transformation. Sec-
ond, the equation about k

is the same, except that the level of steady-state

leisure is dierent. Third, for the equation F
1
(k

, L l

) =
1

(1 ), due to
the dierence in the steady-state leisure level, the steady-state capital stock is
also dierent. For example, if F
12
> 0 as in the case of Cobb-Douglas produc-
tion function, the capital stock in the model with leisure will be lower than that
without leisure choice (since L l

< L).
(d) Let F (k, n) = k

n
(1)
and U (c, l) = log (c) + (1 ) log (l), where 0 <
< 1 and 0 < < 1. Solve explicitly for the steady state in terms of
parameters.
With F (k, n) = k

n
(1)
and U (c, l) = log (c)+(1 ) log (l) , the steady-state
condition becomes
n
l

o
:
_
_
_

k

L l

(1)
k

_
_
_
(1 )

L l

=
1
l

n
k

o
:

L l

!
1
=
1

(1 )
which leads to
_

_
n

=
1
1

(1)
!
+1
L
l

= L n

=

1

(1)

1
1
n

= k

(n

)
(1)
k

2
2. (a) Carefully dene a recursive competitive equilibrium for the neoclassical
growth model with valued leisure. (Hint: You need two functions to
describe the behavior of the aggregate economy.)
A recursive competitive equilibrium for the neoclassical growth model with valued
leisure is a set of functions:
price function : r

, w

policy function : k
0
= g
k

k, k

, l = g
l

k, k

value function : v

k, k

aggregate state : k
0
= G

, l = l(k)
such that:
(1) Given k
0
= G

, k
0
= g
k

k, k

, l = g
l

k, k

and v

k, k

solves consumers
problem:
v

k, k

= max
{c,l,k
0
}
U (c, l) + v

k
0
, k
0

s.t.
c + k
0
= r

k + (1 ) k + w

(L l)
k
0
= G

(2) Price is competitively determined:

r

= F
1

k, L l(k)

= F
2

k, L l(k)

(3) Consistency:
G

= g
k

k, k

l(k) = g
l

k, k

(b) Find the (functional) rst-order conditions of a typical consumer who

takes as given the economys aggregate laws of motion.
Solve a typical consumers problem
v

k, k

= max
{
l,k
0
}
U

r

k + (1 ) k + w

(L l) k
0
, l

+ v

k
0
, k
0

s.t.
k
0
= G

We get the F.O.C. as

{l} : U
1
(c, l) w

= U
2
(c, l)
n
k
0
o
: U
1
(c, l) = v
1

k
0
, k
0

3
Use the envelope condition
v
1

k, k

= U
1
(c, l)

+ (1 )

We get the optimality condition:

{l
t
} : U
1
(c
t
, l
t
) w

k
t

= U
2
(c
t
, l
t
)
{k
t+1
} : U
1
(c
t
, l
t
) = U
1
(c
t+1
, l
t+1
)

k
t+1

+ (1 )

Correspondingly, the functional F.O.C. is

{l
t
} : U
1

c
t
, g
l

k
t
, k
t

k
t

= U
2

c
t
, g
l

k
t
, k
t

{k
t+1
} : U
1

c
t
, g
l

k
t
, k
t

= U
1

c
t+1
, g
l

k
t+1
, k
t+1

r

k
t

+ (1 )

where c
t
= r

k
t

k
t
+ (1 ) k
t
+ w

k
t

L g
l

k
t
, k
t

g
k

k
t
, k
t

, r

=
F
1

k, L l

= F
1

k, L g
l

k, k

, and w

= F
2

k, L l

= F
2

k, L g
l

k, k

.
(c) Impose equilibrium conditions on the rst-order conditions from part
(b) and verify that the resulting equations are identical to the rst-
order conditions associated with the planning problemfor this economy.
Impose the equilibrium conditions k
t
= k
t
, l
t
= l
t
, we have
{l
t
} : U
1

c
t
, l
t

F
2

k
t
, L l
t

= U
2

c
t
, l
t

{k
t+1
} : U
1

c
t
, l
t

= U
1

c
t+1
, l
t+1

F
1

k
t
, L l
t

+ (1 )

where
c
t
= F
1

k
t
, L l
t

k
t
+ (1 ) k
t
+ F
2

k
t
, L l
t

L l
t

k
t+1
= F

k
t
, L l
t

+ (1 ) k
t
k
t+1
which are identical to the rst-order conditions associated with the planning prob-
lem for this economy.
3. Consider a competitive equilibriumone-sector growth model without valued
leisure in which consumers own capital and labor and rent their services to
rms. There is no uncertainty and the felicity function of a typical consumer
has constant elasticity of intertemporal substitution
1
.
(a) Show that the decision rule of a typical consumer takes the form:
k
0
=

k
where the functions and satisfy the following pair of functional
equations (i.e., these two equations must hold for all values of k):

+
w

k
0

k
0

k
0

k
0
=
w

4
and
1
r

k
0
=
_
_

k
0

k
0

_
_

,
where k
0
=

k. In these equations, k is the individuals

holdings of capital, k is aggregate capital, r

is the rental rate of

capital plus one minus the depreciation rate, and w

is the wage
rate. (Hint: Obtain the Euler equation for a typical consumer, guess
that the consumers decision rule takes the conjectured form, and then
nd restrictions that the coecients

and

must satisfy in
order for the Euler equation to hold for all values of k and k.)
A recursive competitive equilibrium for this economy is a set of functions:
price function : r

, w

policy function : k
0
= g

k, k

value function : v

k, k

transition function : k
0
= G

such that:
(1) k
0
= g

k, k

and v

k, k

solves consumers problem:

v

k, k

= max
{c,k
0
}
c
1
1
+ v

k
0
, k
0

s.t.
c + k
0
= r

k + w

k
0
= G

(2) Price is competitively determined:

r

= F
1

k, 1

+ 1
w

= F
2

k, 1

(3) Consistency:
G

= g(k, k)
By taking F.O.C. and using envelope condition, we can get the Euler equation as
u
0
(c
t+1
)
u
0
(c
t
)
r

k
t+1

= 1

c
t+1
c
t

k
t+1

= 1
c
t+1
=

r

k
t+1

c
t
r

k
t+1

k
t+1
+ w

k
t+1

k
t+2
=

r

k
t+1

k
t

k
t
+ w

k
t

k
t+1

5
Since this is a second-order linear dierence equation in k
t
, we conjecture the
solution form as
k
0
=

k
Plug back into Euler equation, we get
LHS = r

k
t+1

k
t+1
+ w

k
t+1

k
t+2
= r

k
t+1

k
t

k
t

k
t

+ w

k
t+1

k
t+1

k
t+1

k
t

k
t

k
t

=

r

k
t+1

k
t+1

k
t

k
t
+

k
t

r

k
t+1

k
t+1

+ w

k
t+1

k
t+1

and
RHS =

r

k
t+1

k
t

k
t
+ w

k
t

k
t

k
t

k
t

=

r

k
t+1

k
t

k
t

k
t
+

k
t

k
t

To make LHS and RHS equate for every k

t
and k
t+1
, we must have
(1) :

r

k
t+1

k
t+1

k
t

=

r

k
t+1

k
t

k
t

(2) :

k
t

r

k
t+1

k
t+1

+ w

k
t+1

k
t+1

=

r

k
t+1

k
t

k
t

i.e.
(1)
1
r

k
0
=
_
_

k
0

k
0

_
_

(2)

+
w

k
0

k
0

k
0

k
0
=
h
r

k
0
i1

k
0

k
0

+
w

k
0

k
0

k
0

k
0
=
_
_

k
0

k
0

_
_
w

k
0

k
0

+
w

k
0

k
0

k
0

k
0
=
w

This nishes the proof.

(b) Suppose now that there are two (types of) consumers in the economy
who dier only in their initial capital holdings. Each consumer repre-
sents half of the economys population. Use the result from part (a)
to argue that a redistribution of capital (holding aggregate capital con-
stant) across the two consumers at time 0 has no eect on equilibrium
interest rates and wages.
6
To prove the result, we need to see what is the dierence between a representative
agent economy and heterogeneous agent economy. So we rst clearly dene a
recursive competitive equilibrium for heterogeneous agent economy.
A recursive competitive equilibrium for the economy with two types of agents is
a set of functions:
price function : r

, w

policy function : k
0
i
= g
i

k
i
, k
1
, k
2

value function : v
i

k
i
, k
1
, k
2

transition function : k
0
i
= G
i

k
1
, k
2

where k =
1
2
(k
1
+ k
2
), such that:
(1) Given G
1

k
1
, k
2

and G
2

k
1
, k
2

, k
0
i
= g
i

k
i
, k
1
, k
2

and v
i

k
i
, k
1
, k
2

solve
consumers problem:
v
i

k
i
, k
1
, k
2

= max
{
c
i
,k
0
i
}
u
i
(c
i
) + v
i

k
0
i
, k
0
1
, k
0
2

s.t.
c
i
+ k
0
i
= r

k
i
+ w

k
0
1
= G
1

k
1
, k
2

k
0
2
= G
2

k
1
, k
2

(2) Price is competitively determined:

r

= F
1

k, 1

+ 1
w

= F
2

k, 1

(3) Consistency:
G
i

k
1
, k
2

= g
i
(k
i
, k
1
, k
2
)
Notice the dierence between the denition of recursive competitive equilibrium
we met before: in heterogeneous agent economy, normally the whole distribution
of state variable counts.
Now we start to prove the result. Due to the special preference relation here,
rst we assume that only average capital level matters for the evolution of the
economy, i.e. k
0
= G

. Then the result from part (a) tells us that in recursive

competitive equilibrium we will have
k
0
i
=

k
i
Therefore, we have
k
0
=
1
2

k
0
1
+ k
0
2

k
7
Therefore, indeed the evolution of average capital stock does not depend on the
distribution of capital. In other words, this veries our guess that k
0
= G

.
Since equilibrium interest rates and wages depend only on the aggregate average
capital stock (remember that r

= F
1

k, 1

+ 1 and w

= F
2

k, 1

),
a redistribution of capital (holding aggregate capital constant) across the two
consumers at time 0 has no eect on equilibrium interest rates and wages.
8