A QUICK REVIEW TO INTERTEMPORAL MAXIMIZATION PROBLEMS

1
1.1

A simple two period model

The intertemporal problem

The intertemporal consumption decision can be analyzed in a way very similar to an atemporal problem. The
consumer has to choose between consumption of the same good at dierent dates. He lives for two periods
and derives utility from his stream of consumption, as given by u (c0 , c1 ). The consumer takes the gross real
interest rate R as given. His budget at time 0 is given by y (expressed in terms of period 0 goods). Assume
that the only source of income in period 1 is the income from savings at time 0.
At date 0, the consumer chooses between the consumption level c0 and savings s0 . Savings are in the form of
consumption goods at date 0. The budget constraint at date 0 is
c0 + s0 y.

(1)

At date 1, the consumer chooses the consumption level c1 . The income in that period only comes from savings
in the previous period. Hence, the budget constraint is
c1 Rs0 .

(2)

The consumers maximization problem is thus:

max u (c0 , c1 )
s.t. (1) (2).
The dierence between this problem and an atemporal problem (choice between two dierent goods at the
same date) is that there are two budget constraints. This is artificial though, since assuming strictly increasing
utility, the two budget constraints will hold as equality and can be combined as follows:
1
c1 = y,
R

(3)

max u (c0 , c1 )

(P)

c0 +
so that the maximization problem is given by

s.t. (3).
This is similar to a standard utility maximization problem subject to a budget constraint, with the characteristic that the trade-o is between current and future consumption and the relative price of date 1 good to

date 0 good is 1/R (it is not equal to 1 even though the two goods have the same physical characteristics).
The consumer thus has the possibility of intertemporarily substituting consumption across time.
A special case (yet very common) for u (., .) is
u (c0 , c1 ) = U (c0 ) + U (c1 ) , 0 < < 1.
This intertemporal utility function assumes that the consumer derives utility from consumption in each period
and that intertemporal utility is a weighted sum of the utility levels in the two periods [time-additive utility
function]. is called the discount factor. Solving (P), we get
u1 /u2

= R

(4)

y c0 c1 /R = 0

(5)

Condition (4) equates the marginal rate of substitution (relative value of current consumption to future
consumption, i.e. the rate at which consumers are willing to trade one type of consumption for another)
with the marginal rate of transformation (i.e. the rate of substitution between the two types of consumption
available in the market).

1.2

The determinants of savings

There are three important determinants of savings: the income profile, the rate of return to savings (the
real interest rate) and the agents patience toward future consumption. We enrich the model by allowing
the household to have income at date 1 in addition to the income from savings (it could be labor income for
example). Then, the budget constraint at date 1 is
c1 Rs0 + y1 .
The households budget constraint at date 0 is (1) with y = y0 . The intertemporal constraint is then
c0 +

c1
y1
y0 + .
R
R

(6)

The level of savings is given by s0 = y0 c0 . The optimal c0 is given by (4). Since the intertemporal budget
constraint (6) binds, c1 = y1 + R (y0 c0 ). Substituting this and using time additivity of u, we get
U0
1.2.1

U 0 (c0 )
= R.
(y1 + R (y0 c0 ))

(7)

Income profile

By the income profile, we refer to the households income derived from human capital such as labor income,
not counting income derived from savings. Hence, the income profile is (y0 , y1 ). To illustrate how the income

profile aects savings, assume that R = 1 and that the household does not discount future utility ( = 1). In
that case, condition (7) becomes (assuming a strictly concave U (.))
c0 = y1 + R (y0 c0 ) .
The household achieves the same amount of consumption every period. This is due to the "consumptionsmoothing motive". In that simple case, we can explicitly solve for s0 ,
s0 =

y0 y1
.
2

If the household has a flat income profile (and (R, ) = (1, 1)), the optimal level of savings is 0; if the household
has an increasing income profile (y1 > y0 ), the optimal level of savings is negative and vice versa.
1.2.2

Real interest rate

Let us now look at the rate of return to savings, i.e. the real interest rate. To isolate its role, let us assume
again that = 1 and and, for the moment, that the household has a smooth income profile (y0 = y1 = y).
In that case, the optimal level of savings is 0 and the real interest rate R = 1. Assume, instead, that R > 1.
Condition (7) becomes
U 0 (c0 ) = RU 0 (y + R (y c0 ))
Unlike the previous case, the optimal consumption levels are dierent in the two periods. Given the smooth
income profile and no time discounting, a higher real rate entices the household to save more. The intertemporal substitution eect is due to the fact that an increase in the real interest rate eectively makes consumption
cheaper at date 1 than at date 0 (the real interest rate is the relative price of date 0 goods to date 1 goods).
The increase in the real interest rate can also induce an income eect on savings (which does not appear
in this example since, before the increase in R, households savings are 0). If instead, households had nonzero savings, then an increase in R will aect the households interest income from savings Rs0 , and change
future income. If the household has positive savings, an increase in the interest rate increases future income
relative to current income. Anticipating the rising income profile, the household reduces savings in order to
smooth consumption. On the other hand, if the household has negative savings, an increase in the interest rate
increases the households interest payment at date 1. In this case, future income falls relative to current income
and the household increases savings in order to smooth consumption. Therefore, income and intertemporal
substitution eects work in the same direction when the household has negative savings, but in opposite
directions when the household has positive savings.
A measure of the strength of intertemporal substitution is the elasticity of intertemporal substitution. Because
R is the relative price between goods at dierent dates, we can define the intertemporal elasticity as

dLn (c0 /c1 )

.
dLn (R)

0 /c1 )
Another way to compute the elasticity is dLn(c
d(u1 /u2 ) , which comes from substituting the first-order condition

F = u1 /u2 . For the time-additive utility function, with U (c) =

(the case where 1 corresponds to logarithmic utility).

c1 1
1 ,

the elasticity of substitution is 1/

Exercise: Suppose that U (c) = c 11 , where > 0. Hence, the elasticity of substitution is 1/. Assume
= 1, R 1, y0 > 0 and y1 > 0. Prove the following results:
(i) the optimal level of savings is
y0 R1/ y1
s0 =
.
R1/ + R
(ii) s0 0 always implies ds0 /dR > 0.
(iii) If R = 1 and y0 > y1 , then ds0 /dR > 0 if and only if < (y0 + y1 ) / (y0 y1 ).
Solution: (i) The households problem is to solve
c1
1 c1
1
0
+ 1
c0 ,c1 1
1

max

s.t. c0 +

c1
y1
= y0 + .
R
R

The first order conditions are

u1
u2
c
c0 + 1
R

c0
c1

= y0 +

= R,

y1
.
R

After some algebra, this results in

y0 R1/ y1
.
R1/ + R
(ii) From the above, once can compute ds0 /dR. After some algebra

s0 R + R1/ + 1 R1/ y0 +
ds0
=

2
dR
R + R1/
s0 = y0 c0 =

y1
R

Hence, if s0 0, ds0 /dR > 0.

(iii) When R = 1
2s0 + 1 (y0 + y1 )
(y0 y1 ) + 1 (y0 + y1 )
ds0
=
=
dR
4
4
1

Thus ds0 /dR > 0 if and only if (y0 y1 ) + (y0 + y1 ) > 0, i.e. when
<

y0 + y1
,
y0 y1

given that y0 > y1 . Notice that with an increasing income profile (y0 < y1 ), ds0 /dR > 0, for all .

What is the point of the exercise? We know the following:

As R
s0 0 s0 0
Subst. eect
s0
s0
Income eect
s0
s0
Question (ii) allowed us to check analytically that when savings are negative, an increase in the real interest
rate always induces an increase in savings, as both the income and substitution eects work in the (same)
direction of increasing savings. In question (iii), we assume a decreasing income profile and hence positive
savings (when R = 1). That is the case when the income and substitution eects work in opposite directions.
We established analytically, that for the substitution eect to dominate the income eect, it has to be that is
small enough and thus that the elasticity of substitution is high enough. The insight in this simple model will
be useful when we look at a more general one in the upcoming chapter on general equilibrium, real business
cycle models.
1.2.3

Impatience towards the future

The degree of impatience is measured by the discount factor. When is low, the household is more impatient.
For illustration, assume that the income profile is flat, the real interest rate is equal to 1, and that < 1.
Then condition (7) becomes
U 0 (c0 ) = U 0 (2y c0 ) ,
which implies that c0 > y. In fact, the lower , the higher c0 is. Let us illustrate in a dierent manner
how savings fall when the degree of impatience increases. Suppose the household chooses the same level of
consumption in the two periods, i.e. that c0 = c1 = y. Let the household reduce savings by a slightly positive
amount and increase consumption at date 0 by the same amount. Utility at date 0 is now approximately
U (y)+U 0 (y), while utility at date 1 is now approximately U (y)U 0 (y). Taking into account the discounting
implies that utility increases by (1 ) U 0 (y) > 0.

Chapter I
BUSINESS CYCLES

1
1.1

A General Real Business Cycle Model

The model

The idea is to view economic fluctuations as the result of external shocks hitting the economy. These shocks
can be of dierent sources. The real business cycle (RBC) literature focuses on shocks to the productive
capacity of the economy as the main source of fluctuations. Hence, the reference to real shocks, as opposed
to nominal or monetary shocks which had been the focus of previous literatures. In that sense, RBC models
are a very definite departure from previous models. They try to see how much of the fluctuations are normal
reactions to real shocks, in the absence of any market imperfections. The previous literatures tended to
assume some kind of market imperfections, and explain cycles with these imperfections.
The idea is to model an artificial competitive economy where aggregates determined in equilibrium (output,
investment, consumption, labor) are derived from agents maximizing behavior at the microeconomic level.
Instead of assuming relationships at the macroeconomic level, aggregates outcomes are derived from optimal
behavior of individual agents.
Agents:
Large number of identical households (of measure 1). Each household is small enough that it cannot influence
market outcomes through its behavior (competitive economy) and lives forever.
Large number of identical small firms.
Both types of agents are price takers, i.e. they believe they can buy or sell any quantity of the good or labor
but not aect price. Households are expected utility maximizers, while firms are profit maximizers.
The population size is assumed constant.
Technology:
Each period, households rent capital and provide labor to firms, at a wage rate wt and a rental rate rt ,
respectively. The production function is
Yt = ezt f (Ht , Kt )
(1)
where Yt , Ht , and Kt are output, labor and capital in period t, respectively. zt is a random shock to the
economys productive capacity. Assume that the stochastic process is characterized as follows:
zt+1 = zt + t+1

(2)

where 0 < < 1 and t N (0, 2 ). Each period, a new shock hits the economy. That shock is known
2
before any decision is to be taken. f is defined on R+
with values in R+ , and it is increasing, concave, and
continuously dierentiable in H and K. It is also homogenous of degree 1 (f (aH, aK) = af (H, K), i.e. if the
inputs of capital and labor are doubled, output is also doubled). In addition, f (H, 0) = f (0, K) = 0. Also,
f1 (H, K) + as H 0 and f2 (H, K) + as K 0.
Endowments:
2

Households are initially endowed with k0 and start every period with a new total time endowment equal to
1, to be allocated between labor and leisure.
Utility functions:
+
For the households, the utility derived from an infinite sequence of consumptions and labor choices, {ct }t=0
+
and {ht }t=0 is
+
i X
h
+
,
{h
}
t U (ct , 1 ht )
=
u {ct }+
t
t=0
t=0
t=0

where the discount factor satisfies 0 < < 1. The one period utility function U is defined from R+ to R and
is assumed to be increasing, strictly concave and continuously dierentiable in both arguments. Moreover,
lim U1 (c, 1 h) =

h1

lim U1 (c, 1 h) =

h0

lim U2 (c, 1 h) = +

c0

lim U2 (c, 1 h) = 0

c+

These restrictions, as well as the restrictions on the production function f ensure that there exists an interior
solution1 .
Resource constraint:
Each period capital depreciates at a rate . The resource constraint is
ct + it = ct + kt+1 (1 ) kt = wt ht + rt kt
where it is the households investment in period t. This constraint states that households need to allocate
their period income (from renting capital and working) between consumption and investment.
The problem has already been set up as a competitive equilibrium problem. It could also be solved as a social
planner problem, given that, in this particular case, they are equivalent. However, for the sake of generality,
we will solve the problem as an equilibrium problem. The method retained can also be used in cases where
the welfare theorems do not apply (distortions, externalities ...).
The concept used is called Recursive Competitive Equilibrium. We will solve the problem using dynamic
programming and start by defining the state variables, as well as the control variables.
Individual state variable: kt (capital owned by an individual household)
Aggregate state variables: zt , Kt (total capital in the economy)
Control variables: ct , ht , it
We will start by describing the maximization problems faced by the firms and the households.
Firms decision problem:
1 These

conditions are referred to as the Inada conditions.

Every period, the firm chooses capital and labor to maximize profits. The firm, as opposed to the worker,
faces a one period problem. Because it does not have any claim to either labor or capital, it does not have to
consider how its choices this period will aect its decision next period. Hence, the firms problem is
t, M axt = ezt f (ht , kt ) wt ht rt kt
ht ,kt

Dierentiating with respect to ht and kt , we obtain

ezt f1 (ht , kt ) = wt

(3)

ezt f2 (ht , kt ) = rt

(4)

These two equations define the individual demands, given factor prices. Remark that, since the production
functions is assumed to exhibit constant return to scale, firms make zero profits in equilibrium2 . The aggregate
variables Ht and Kt satisfy (3) and (4) if the number of firms is normalized to 1. Hence, (3) and (4) imply
that
wt = w
b (zt , Ht , Kt )
(5)
rt = rb (zt , Ht , Kt )

(6)

Equations (5)-(6) represent the market clearing conditions, pinning down prices.
Households decision problem:
Households are expected utility maximizers. Hence, they solve3
"+
#
X t
M axE
u (ct , 1 ht )
t=o

s.t. ct + kt+1 (1 ) kt = wt ht + rt kt , t
given stochastic processes for wt , rt and given k0
The households need to make expectations on the future behavior of variables relevant to their intertemporal
decision making. We will assume that households expect wage and capital rental rates to be functions of
zt , Kt and Ht , as indicated by the solution to the firms problem, and hence that they know (5) and (6)
(remember ht is a control variable, but not Ht ). Assuming that the other households also behave optimally,
the individuals also know, or make expectations on
Ht = H (zt , Kt )

(7)

Kt+1 = K (zt , Kt )

(8)

2 By

the application of Eulers theorem for homogenous functions of degree 1, f (h, k) = hf1 (h, k) + kf2 (h, k).
firms make zero profit in equilibrium, we do not need to add dividends from ownership of firms in the households
budget constraint.
3 Because

zt+1 = z (zt , t )

(9)

Using (7), the households expect the future wage and capital rental rates to be functions of the aggregate
state variables only
wt = w (zt , Kt )
(10)
rt = r (zt , Kt )

(11)

Once these expectations are taken, the households are able to solve their maximization problem for consumption, investment and labor supplied. Expectations are rational in the sense that Kt+1 = K (zt , Kt ),
zt+1 = z (zt , t ), wt = w (zt , Kt ), rt = r (zt , Kt ) are known by the agents. But be careful, what is known by
the agents is the rule of motion for Kt+1 and zt+1 , as well as factor prices as a function of aggregate state
variables, not the exact future sequences. The agents make exact predictions about these on average, but are
not assumed to be correct every period !
Due to the recursive nature of the problem, the individual households decision problem can be written as4 :
v (zt , kt , Kt ) = M ax {u (wt ht + rt kt + (1 ) kt kt+1 , 1 ht ) + E [v (zt+1 , kt+1 , Kt+1 ) | zt ]}
ht ,kt+1

(12)

where
wt

= w (zt , Kt )

rt

= r (zt , Kt )

Kt+1
zt+1

= K (zt , Kt )
= z (zt , t )
z0 , k0 , K0 are given

The solution to this problem is

ht

= h (zt , kt , Kt )

kt+1

= k (zt , kt , Kt )

DEFINITION: A recursive competitive equilibrium is a list of value function V (zt , kt , Kt ), individual decision
rules ht (zt , kt , Kt ), kt+1 (zt , kt , Kt ) for the representative household, aggregate laws of motion Ht (zt , Kt ),
Kt+1 (zt , Kt ), factor price functions wt (zt , Kt ) and rt (zt , Kt ) such that :
(i) the households problem is satisfied, i.e. ht (zt , kt , Kt ), and kt+1 (zt , kt , Kt ) solve (12)
(ii) the firms problem is satisfied and markets clear, i.e. ezt f1 (Ht , Kt ) = wt (zt , Kt )
and ezt f2 (Ht , Kt ) = rt (zt , Kt )
4 Because the budget constraint will always be binding, there are really only two decision variables: how much labor to supply
and how much to invest. Once investment is chosen, consumption is automatically given. Also, choosing investment is equivalent
to choosing how much capital to bring to the next period (kt+1 ).

(iii) consistency of individual and aggregate decisions5 , i.e. ht (zt , Kt , Kt ) = Ht (zt , Kt )

and kt+1 (zt , Kt , Kt ) = Kt+1 (zt , Kt )
(iv) aggregate resource constraint is satisfied, i.e. C(zt , Kt ) + I(zt , Kt ) = Y (zt , Kt )
The concept used to construct the equilibrium is illustrated in figure 1.
6

Expectations
optimization

?
Equilibrium

Behavior

mechanism/institution

Outcome

Figure 1: Recursive competitive equilibrium concept

1.2

Calibration

The concept presented above abstracts away from considerations of growth in the economy. Implicitly, we
only looked at fluctuations around a steady state growth path. However, this is not a problem because one
can always start from an economy that is allowed to grow along a steady state path and transform it into
a stationary economy and solve for the Recursive Competitive Equilibrium. Hence, the techniques outlined
can be used to study both how an economy grows over time and how it fluctuates around its growth trend.
We present below how the problem can be stationarized (in later applications, we will start directly from the
stationarized version of the economy).

Restriction on the production function

The steady state growth path is defined as the path where all rates of growth are constant, except for labor,
which is bounded above (by H). Assume that there is a permanent component to technological change Xt
5 This is because all households are identical. The typical household must be typical in equilibrium. However, it cannot
be imposed on the decision maker. Prices move to make it desirable to the household.

in addition to the temporary one zt . We restrict ourselves to the case where the permanent change is labor
augmenting 6 , that is, Xt aects the eciency of labor
f (Ht , Kt , Xt ) = f (Xt Ht , Kt )
Along the steady state growth path, Ht = H. Let us call the growth rates. Hence, X = Xt+1 /Xt ,
K = Kt+1 /Kt , C = Ct+1 /Ct , I = It+1 /It , Y = Yt+1 /Yt . Writing the resource constraint for any dates t
and t + 1 gives us that
Ct + It
c Ct + I It

= Yt
= Y Yt

and hence
c Ct + I It = Y Ct + Y It
Therefore, for all t
( C Y ) Ct + ( I Y ) It = 0
For that to hold for all t, it has to be the case that Ct and It grow at the same rate. If this were not the case,
the above equation cannot hold for all t, unless the two coecients are equal to zero, which was ruled out by
assumption. Hence it must be the case that C = I , which in turn implies that ( C Y ) (Ct + It ) = 0.
Thus C = Y .
We know that It = Kt+1 (1 )Kt . Therefore
K = 1 +

It
Kt

and thus It /Kt is constant for all t, and as a result K = I . Finally, Yt = f (Xt Ht , Kt ) = f (Xt H, Kt ).
Because of the constant returns to scale assumption on f

f X Xt H, K Kt
f Xt+1 H, Kt+1
Yt+1

=
=
Y =
Yt
f Xt H, Kt
f Xt H, Kt
The only way for this expression to be constant for all t, is that X = K . Hence7
X = I = Y = C = K
This matches the empirical observations that (i) real output grows at a more or less constant rate, (ii) the
stock of real capital grows at a more or less constant rate greater than the rate of growth of the labor input,
the growth rates of real output and the stock of capital tend to be about the same8 .
6 For

a steady state growth to be feasible, we need that the permanent technological change be labor augmenting.
a steady state growth path requires that the growth rates be constant. This is enough to conclude that they are not
only constant, but also equal.
8 Of course, there has been a marked break in the trend of productivity growth around 1973, a phenomenon for which a
satisfactory explanation still has to be found. Nevertheless, the facts mentioned still hold. The growth rates may have changed,
but the relationships between them are still valid.
7 Hence

Restriction on the utility function

The dynamic programing problem can be solved for a variety of utility functions. We would like to use the
data to restrict the class of utility functions to be considered. We will use the observation that the long-run
aggregate labor supply is constant to pick a particular class of utility function. A general treatment can be
found in King, Plosser & Rebelo (JME 1988). The question asked is: what kind of utility function do we
need to be consistent with balanced growth and a constant labor supply in the long run ?
Suppose you solve the following maximization problem:
V (kt ) =
s.t. ct + kt+1 (1 ) kt

M ax {u (ct , 1 ht ) + V (kt+1 )}

kt+1 ,ht

= f (Xt ht , kt )

You are interested in finding restrictions on the utility functions that are consistent with a steady state growth
path, where labor is constant at h and other variables grow at the same rate as the technological progress
Xt . The eciency conditions are:

u1 c, 1 h = f 2 + 1 u1 c, 1 h

t f 1 u1 c, 1 h = u2 c, 1 h

(13)
(14)

These are the standard eciency conditions. The marginal products of capital of labor (f 1 ) and capital
(f 2 ) are constant along the steady state growth path, due to the constant return to scale assumption on
the production function. Xt was normalized to t . By dierentiating (13) with respect to c and writing the
u11 (c,1h)
u11 (c,1h)
expression c u c,1h at ct = c and ct+1 = c, one can verify that c u c,1h must remain constant along the
)
)
1(
1(
SSGP as consumption increases (and equal to ). Solving the dierential equation, one gets that:
u (c, 1 h) = c1 a (1 h) + b (1 h)

if 6= 1

u (c, 1 h) = Ln (c) d (1 h) + e (1 h)

if = 1

Similarly, writing (14) at ct = c and ct+1 = c and using the functional form just found for u, one can verify
that one needs the restrictions that b0 (1 h) = 0 if 6= 1 and d0 (1 h) = 0 if = 1. Hence:
u (c, 1 h) = c1 a (1 h)

if 6= 1

u (c, 1 h) = Ln (c) + e (1 h)

if = 1

For a CRRA utility function, the income eect (h ) of an increase in wage cancels out the substitution eect
(h ), which matches the empirical result that the long-run aggregate supply of labor is constant, even though
real wages increased over time.
With this class of utility function, we can now compute the intertemporal elasticity of substitution (IES),
as well as the intratemporal elasticity of substitution (ES). Suppose you are solving the following standard
8

equilibrium problem. The households maximization problem is (state variable: kt , control variables: ht ,
kt+1 ):
M ax

+
X
t=0

t u (ct , 1 ht )

s.t. wt ht + rt kt = ct + kt+1 (1 ) kt
In dynamic programming terms, this can be rewritten as
V (kt ) = M ax {u (ct , 1 ht ) + V (kt+1 )}
kt+1 ,ht

This gives us the following first order conditions:

Uc w
Uct

= Ul

(15)

Uct+1

(1 + rt+1 )

(16)

Hence, the marginal rate of substitution between consumption this period and leisure this period is Ul /Uc = w,
and the marginal rate of substitution between consumption this period and consumption next period is
Uct /Uct+1 = 1 + rt+1 . We can now define the two elasticities as:
IES

ES

dLn (ct+1 /ct )

dLn M RSct ,ct+1

dLn (ct /lt )
dLn (M RSct ,lt )

c1 0
1 g (l).

With a CRRA utility function, Uc = c g(l) and Ul =

M RSct ,lt =

0
1 ct lt g (lt )
1 lt g(lt ) .

Hence, M RSct ,ct+1 =

Thus,

ct+1
ct

g(lt )
g(lt+1 )

and

= 1

IES

ES

Making the problem stationary

At
,except for Lt and Ht , which are not normalized (we know that
Now, for the variable At , define ast = X
t
all variables grow at the same rate along the steady state growth path). Since the utility function is CRRA,
we can rewrite the maximization problem as
M ax

+
X
t=0

s.t. Yt

Ct1
g (Lt )
1

= Ct + Kt+1 (1 ) Kt
9

and further
M ax

+
X

t=0

(cst X0 tx )
1

g (lts )

s
(1 ) kts
s.t. ezt f (hst , kts ) = cst + x kt+1

The Bellman equations are

V (kts , zt ) =
where

M ax

s
kt+1
,hst

= 1
x

1
s

(cst )
, zt+1
g (lts ) + E V kt+1
1

The problem thus redefined is stationary and can be solved using dynamic programing.
1.2.1

Choosing the parameters of the model

We can now start the calibration. Let us start by defining the capital and labor shares of output. Take a
production function
y = Zf (h, k)
Then by dierentiation, we obtain

y = Zf (h, k) + Zf1 (h, k)h + Zf2 (h, k)k

and thus

Zf1 (h, k)h h Zf2 (h, k)k k

y
Z
= +
+
y
Z
y
h
y
k

(17)

Zf1 (h, k)h and Zf2 (h, k)k are the labor and capital shares of output (income from production going to the
owner of labor and capital). Notice that because of the perfect competition assumption, Zf1 is the wage
received by the worker and Zf2 is the rental income to the owner of capital. By the constant returns to scale
and perfect competition assumptions, the two shares add up to 1. Since everything else is observable, one can
calculate time series for z, using (17).
It is found, looking at data, that capital and labor shares of output have been approximately constant over
time9 , even while their relative prices have changed. This suggests a Cobb-Douglas production function
f (ht , kt ) = ht kt1
To be consistent with observed values of labor and capital shares of output, 2/3.
We know that the utility function must be CRRA. The only parameter we have to choose is 1/ (intertemporal
elasticity of substitution). Most empirical studies point towards a value of between 1 and 2. As the artificial
9 This

is also true across countries.

10

economy is not very sensitive to the exact value of , a value of = 1 is generally chosen. Hence, the form
generally retained for the utility function is
u (c, 1 h) = (1 ) Ln (c) + Ln (1 h)
By solving for the first order conditions, we can obtain the deterministic steady state. The households
maximization problem is
"+
#
X
t
M axE
[(1 ) Ln (ct ) + Ln (1 ht )]
t=0

s.t. ct + kt+1 (1 ) kt = f (ht , kt ) , t

The first order conditions are

u1 (ct , 1 ht ) = V 0 (kt+1 )
f1 (ht , kt ) u1 (ct , 1 ht ) = u2 (ct , 1 ht )
and from the envelope theorem
V 0 (kt ) = u1 (ct , 1 ht ) [f2 (ht , kt ) + 1 ]
Hence
u1 (ct , 1 ht ) = u1 (ct+1 , 1 ht+1 ) [f2 (ht+1 , kt+1 ) + 1 ]
Given our assumptions on the production function, this implies that
1
k
1
=
h
c
!

1
h
+1
=
(1 )
c
k

1h
1
c
or

y 1
h c

y
1 = (1 ) + 1
k

1h
We also that know that in steady state

(18)
(19)

i = k
The depreciation rate is chosen to match the average investment to capital ratio in the economy. Using (19)
and the average value for the output to capital ratio, can be determined. Microeconomic evidence points
toward a value of h .3. Finally, given the average value for y/c, can be found using (18). As you can see,
11

calibrated values comes either from the requirement that the steady state values match the corresponding
average values in the economy or from independently conducted microeconomic studies.
To complete the calibration of the model, we need to determine values for and (see (2)). Using (1), we
see that
zt+1 zt = (LnYt+1 LnYt ) (LnHt+1 LnHt ) (1 ) (LnKt+1 LnKt )
(20)
From there, the series of {zt } observed in the economy can be calculated. The residuals calculated are quite
persistent, hence a very high value for is generally retained (typically = .95). Knowing , the standard
deviation of the error terms ( ) can be determined.

1.3

Defining and measuring the business cycle

Business cycles are generally considered as a deviation from a trend. The question is then to define the trend.
Once the trend is known, fluctuations can be easily calculated. Several method can be used (linear trend,
piecewise linear trend). Most authors use a technique known as the Hodrick-Prescott filter.
Consider the series of real output {yt } for example. It can be decomposed as the sum of a growth component
ytg and a cyclical component ytc . The problem is to choose a trend to minimize the cyclical component, while
still retaining a smooth trend. In other words, the problem is equivalent to
M in

T
X

(ytc )

t=0

s.t.

T
X
t=0

g

g 2
not too big
yt+1 ytg ytg yt1

Take 10 a parameter reflecting the relative variance of the growth component to the cyclical component.
Then the problem is to choose {ytg } to minimize the loss function
M gin
{yt }

T
X
t=0

(yt

2
ytg )

T
X
g

g 2
+
yt+1 ytg ytg yt1
t=0

The point of the exercise is to trade o the extent to which the growth component tracks the actual series
against the smoothness of the trend. Please notice that for = 0, ytg = yt and for +, the growth
component is a purely linear time trend. For quarterly data, a value of = 1, 600 is generally retained11 . Using
this method, we can get a smooth time varying trend. The rational behind that choice is that it eliminates
fluctuations at frequencies lower than eight years (business cycles are generally considered as fluctuations
around the growth path occurring at frequencies of three to five years).
1 0 Penalty
11

coecient.
= 400 for annual data.

12

The standard detrending procedure is the following. Let Xt be the series of interest. Take LnXt . HP-filter
LnXt . Take the standard deviation of filtered LnXt . This is the percentage standard deviation of Xt . The
relative percentage standard deviations are usually relative to the percentage standard deviation of GDP12 .
Once the U.S. time series have been detrended, business cycle facts can be presented. Several measures are
of interest. First, we can look at the amplitude of fluctuations in the data. Second, we can also measure
the correlation of aggregate variables with real GDP. That allows us to verify if a particular variable is proor countercyclical with respect to yt . Third, we can look at cross-correlation over time to see if one variable
tends to lead or lag another variable. Below is a table summarizing the U.S. business cycle data from 1954
to 1991.
Variable xt
GNP
Consumption:
Non-Durables & Services
Investment
Non-Farm Hours
Productivity13

Std Dev
1.72%

Corr (xt1 ,yt )

.85

Corr (xt ,yt )

1.00

Corr (xt+1 ,yt )

.85

.86%
5.34%
1.59%
.90%

.78
.82
.74
.33

.77
.90
.86
.41

.64
.81
.82
.19

The magnitude of fluctuations in output and hours are similar. This confirms the general consensus that
the eects of business cycles are most clearly felt in the labor market. Consumption is the smoothest of the
series14 . Investment fluctuates the most. Productivity is slightly procyclical, but varies less than output.
This can now be compared with the same measures as simulated with the model. The model has been
simulated 100 times, each simulation lasting for 150 period long (or the length of the observation period)15 .
The simulated data were HP-filtered to give the same representation as the U.S. data. The results of the
simulated economy are provided below:
1 2 Take

a series Xt = (1 + t ) Tt . Tt represents the trend component, while t represent the percentage deviation from trend.
Hence, after taking logs, LnXt = Ln (1 + t ) + LnTt . If one were to HP-filter LnXt , one would get a trend term and a deviation
term. What the procedure explained above amounts to, is to isolate the deviation term. By HP-filtering LnXt , one tries to pick
up Ln (1 + t ) t .
1 3 GNP/Hours
1 4 This should not be surprising given the concavity of the utility function.
1 5 For each simulation, the first observations have been discarded, in order to get rid of dependence on initial values. However,
the simulation still produced 150 observations.

13

Variable xt
GNP
Consumption:
Non-Durables & Services
Investment
Non-Farm Hours
Productivity16

Std Dev
1.35%

Corr (xt1 ,yt )

.70

Corr (xt ,yt )

1.00

Corr (xt+1 ,yt )

.70

.33%
5.95%
.77%
.61%

.72
.66
.65
.73

.84
.99
.99
.98

.50
.71
.72
.65

Performance of simulated model: One question can be answered using these simulations: assuming the economy is a perfectly competitive one, how much of the variations in output can be explained by optimal
adjustments to purely real shocks to the productive capacity of the economy ? This question is an interesting
one, because before the advent of RBC theory, all models assumed that the fluctuations were due to nominal (monetary) shocks, and fluctuations were how an economy with market imperfections reacted to these
nominal shocks. In that sense, RBC is a radical departure from previous literature. In the artificial economy,
output fluctuates less than in the U.S. economy, but still a large share of the fluctuations can be accounted
for, without assuming any kind of market imperfections. The investment time series is very volatile, both
in the U.S. and in the artificial economy. All times series are procyclical in the U.S. and this is reflected in
the model economy. This, however, is not surprising, given that there is only one source of uncertainty in
the economy, zt . The model does not perform as well, when looking at hours of work or productivity, which
suggests that some elements of the labor market are missing. Another point that the model is missing is the
fact that the consumption series is not volatile enough in the model economy.
Interpretation of the model: There are several channels through which a shock is propagated in the economy.
The shocks considered aect the productive capacity of the economy, and they are propagated by the manner
in which optimizing agents (at the micro level) react and alter their economic decisions (investment and
consumption). Because their utility functions are concave (they are risk averse), households smooth out their
consumption throughout their lifetime, so that a change in output will manifest itself partly through a change
in consumption and partly through a change in investment. As households try to avoid wide fluctuations in
consumption, it is not surprising to find in the model and in the data, that investment is more volatile than
consumption. Of course, variations in investment now, aect future output. Hence shocks are transmitted
through time. Finally, households substitute leisure across periods, in response to a rise/decrease in wages in
this period (due to a rise/decrease in zt , and thus in labor productivity).
It is interesting to point out the role of capital accumulation. Suppose, for the sake of argument, that
output is only a function of labor (i.e. abstract away from capital). Then the households problem becomes
static. Assume that a positive productivity shock hits the economy. Then, output yt and wage wt increase
proportionately and a change in zt has the same secular eect as a trend. Then, the income and substitution
eects cancel out and labor ht is constant (but consumption ct increases in proportion to wt ). With capital,
1 6 GNP/Hours

14

however, investment would increase and consumption would not increase as much. Thus, it is also ecient to
lower consumption and raise labor hours relative to the no-investment case.
Another point that is often stressed in the RBC literature is how the persistence of productivity shocks
aects the model. Suppose = 0. Assume a one-time (temporary) shock to the economy. The marginal
productivity of labor increases this period, and the representative household faces an unusually high opportunity cost of taking leisure this period. While there are osetting income and substitution eects, the models
preferences were chosen so that a permanent increase in the real wage generates exactly osetting income and
substitution eects, so that labor is left unchanged following such an increase. An implication is that labor
has to rise in response to a temporary productivity increase. With a temporary shock, there is a much smaller
income eect and there is great incentive to substitute intertemporally, since the current wage is high relative
to expected future wages. On net, the positive labor response amplifies the productivity shock. The agents
must decide what to do with this additional income. One possibility is to consume it all in one period. This
would be inecient, given that the marginal utility of consumption is decreasing, thus inducing a preference
for smooth consumption paths. It is optimal to increase consumption both today and tomorrow. When there
is serial correlation in the productivity shocks ( > 0), the same mechanism is at work, but the eects are
drawn out over time.
Conclusion: In conclusion, the artificial economy performs relatively well, but can be improved along certain
lines, particularly the labor market. Also, the model can be generalized by adding new sources of uncertainty,
such as government spending shocks or monetary shocks, or any other type of shock. We will look at how the
model can be improved by adding new shocks, how it performs when including monetary shocks, and how it
can be modified to capture essential aspects of the labor market. Although we will not study the case, RBC
theory can be used to study economies with heterogeneous agents17 . You should retain from this chapter that
RBC theory is really a rigorous methodology and is flexible enough to study a lot of problems.

1.4

An application of RBC theory

We present here a paper entitled Variance properties of Solows productivity residual and their cyclical
implications (Finn, JEDC 1995). It is intended first as an application of the methodology just learned, but
also to show the concept of RBC can be extended to very dierent situations. We will see other examples of
that later, when we study the labor market.
The question is what constitutes a technology shock?. Theoretically, it is any real shock that influences
the productive capacity of an economy, since it enters as a multiplicative factor in the production function.
When we compute the Solow residuals, we can obtain time series for the {zt }, but it does not tell us what
these zt stand for. Weather shocks may be considered as (negative) technology shocks (it decreases the
output produced given, a certain amount of labor and capital inputs). What else may constitute a temporary
1 7 Agents

characterized by age or skill, or subject to idiosyncratic shocks.

15

technology shock? The paper looks at how energy price shocks18 , which are not part of the standard model,
aect the economy.
The impetus for the paper is the observation that the correlation between the growth rates of the Solow
residual and oil prices is 0.55 and the correlation between the growth rates of the Solow residual and total
government spending is 0.09. It seems that the Solow residuals, as computed, may include more than pure
technology shocks and are influenced by such events as energy price shocks and to a lesser degree, government
spending shocks. The paper investigates if energy shocks influence economic outcomes, in a way that cannot
be captured by a production function, whose only inputs are labor and capital. The channel through which
energy prices influence the productive capacity of the economy is capital utilization. The capital rented by
firms can now be used more or less intensively. Energy costs (and depreciation) depend on how intensively
the machinery is being used. For example, one may expect that if energy prices increase, capital utilization
(hours of service per period or speed of utilization per hour) will decrease and hence output will decrease.
The model makes the standard assumptions that the economy is perfectly competitive, with a representative
firm, a representative household and a government. The production function exhibits constant returns to
scale, and labor augmenting technological change. The utility function has constant relative risk aversion
and unitary intertemporal elasticity of substitution. The defining characteristics of this model is variable
energy costs, as well as variable depreciation costs. Energy prices are exogenous (open economy). There is
endogenous capital utilization, that is it is left to the agent to optimally choose how intensively to use their
capital. The economy is hit by stochastic shocks to technology, energy prices and government spending.
Firms problem:
The production function is Cobb-Douglas in labor input (lt ) and capital services. Capital services is equal
to the physical capital rented (kt ) times the rate of capital utilization (ht ). Capital utilization is defined as
hours of service per period or speed of utilization per hour. Firms pay for what they use in production: lt and
(kt ht ). Hence, firms maximize profits, taking wage rates (wt ) and capital services rental rates (rt ) as given:
M ax yt wt lt rt (kt ht )

lt ,(kt ht )

where

yt = f (zt lt , kt ht ) = (zt lt ) (kt ht )1

Households problem:
The household maximizes its expected discounted lifetime utility, subject to its budget constraint. The novelty
is that energy costs and depreciation are functions of how intensively the capital is being used. In particular,
both energy costs and depreciation are increasing and convex functions of capital utilization. Higher rate of
utilization increases wear and tear and causes capital to depreciate faster. Using capital more intensively also
1 8 Oil

price shocks come in mind immediately.

16

increases energy costs. Because of wear and tear, the machinery is not as energy ecient, so that a higher
rate of capital utilization also increases energy usage faster. Hence, we have
kt+1

= [1 (ht )] kt + it
h
t
(ht ) =

1
This is the law of motion with endogenous depreciation (it is investment at date t). Energy costs per unit of
capital are given by
et
kt

= a (ht ) =

ht

Hence, the households maximization problem is

)
(+
X
t
(Lnct + Ln (1 lt ))
M axE0
t=0

s.t. wt lt + (1 ) rt kt ht = ct + it + xt + pt et
where ct is consumption, xt is a lump-sum tax and pt is the exogenous energy price. is a tax on capital
income.
Government:
The economy is subject to exogenous government purchases gt , and the government budget balances every
period:
gt = rt kt ht + xt
Stochastic nature of the economy:
Lnzt+1

= Lnzt + Lnz + uz,t+1

Lng t+1 = g Lng t + 1 g Lng + ug,t+1

Lnpt+1 = p Lnpt + 1 p Lnp + up,t+1

gt
gt =
zt
0 < g , p < 1

uz,t

ut = ug,t
up,t
E (ut ) = 0

17

Where u is governed by a Markov process (ut+1 | ut ). Hence Lnz is the mean growth of zt , Lng is the
mean of Lng t , and Lnp is the mean of Lnpt . Since zt is not stationary and g t is stationary, gt is also not
stationary (it grows with the size of the economy). Movements in zt generate permanent movements in gt ,
but movements in g t only generate temporary fluctuations in gt .
Defining the recursive competitive equilibrium:
The firms chooses lt and (kt ht ) such that:
wt = f1 (zt lt , kt ht )
rt = f2 (zt lt , kt ht )
Using dynamic programming to solve the households problem, we have to define the problems state and
control variables:
Individual state variables: kt
Aggregate control variables: Kt , ut
Control variables: lt , ht , kt+1
The Bellmanns equation can be written as:
V (kt , Kt , ut ) = M ax {u (ct , lt ) + Et [V (kt+1 , Kt+1 , ut+1 ) | ut ]}
lt ,ht ,kt+1

Definition: A recursive competitive equilibrium is a list of aggregate laws of motion Lt (Kt , ut ), Ht (Kt , ut ),
Kt+1 (Kt , ut ), individual decision rules lt (kt , Kt , ut ), ht (kt , Kt , ut ), kt+1 (kt , Kt , ut ), factor prices wt (Kt , ut ),
rt (Kt , ut ) and lump-sum taxes xt (Kt , ut ), such that:
1) Firms maximize and markets clear:
wt (Kt , ut ) = zt f1 (zt Lt (Kt , ut ), Kt Ht (Kt , ut ))
rt (Kt , ut ) = f2 (zt Lt (Kt , ut ), Kt Ht (Kt , ut ))
2) Household maximize, i.e. Bellmanns equation is satisfied by
lt (kt , Kt , ut ), ht (kt , Kt , ut ), kt+1 (kt , Kt , ut )
3) Consistency of individual and aggregate behavior:
lt (Kt , Kt , ut ) = Lt (Kt , ut )
ht (Kt , Kt , ut ) = Ht (Kt , ut )
kt+1 (Kt , Kt , ut ) = Kt+1 (Kt , ut )
4) The government budget balances, i.e.:
gt = xt (Kt , ut ) + rt (Kt , ut )Kt Ht (Kt , ut )
18

Once the equilibrium has been defined, one can look at the first order conditions. The first order condition
with respect to labor, lt , capital utilization ht , and kt+1 are:
wt u1 (ct , lt ) = u2 (ct , lt )

(FOC[lt ])

Marginal benefit of consumption = Marginal disutility of working 1 more hour

(1 ) rt kt
After-tax marginal return to an increase in ht

= 0 (ht ) kt + pt kt a0 (ht )

(FOC[ht ])

= Marginal depreciation+Marginal energy cost

u1 (ct , lt ) = Et {u1 (ct+1 , lt+1 ) [(1 ) rt+1 ht+1 + 1 (ht+1 ) pt+1 a (ht+1 )]}

(FOC[kt+1 ])

This last condition states that the marginal benefit of current consumption is equal to the marginal benefit of
consumption next period, with returns from delaying consumption. Remark that, in the usual case, the last
FOC would be: u1 (ct , lt ) = Et {u1 (ct+1 , lt+1 ) [(1 ) rt+1 + 1 ]}.
In summary, the equilibrium is defined by 13 equations:
1) Firms labor eciency condition
2) Firms capital services eciency condition
3) Households labor eciency condition
4) Households capital utilization eciency condition
5) Households capital accumulation eciency condition
6) Domestic resource constraint19
7) Production function equation
8) Law of motion of capital
9) Energy usage constraint
10) Government budget constraint
11) Stochastic equation governing technological shocks
12) Stochastic equation governing energy price shocks
13) Stochastic equation governing government spending shocks
Now that the equilibrium equations have been established, we can see how energy shocks are diused through
the economy. However, it is VERY IMPORTANT to recognize that, given the general equilibrium nature of
the model, all the eects of a particular type of shocks are taking place simultaneously. Hence, it may be
dicult to disentangle these eects. Nonetheless, it is interesting to figure out all the channels through which
a shock aects the economy. Ultimately, it will be necessary to simulate the model to account for
the general equilibrium eects.
Diusion of a positive energy price shock:
1 9 Obtained

by combining the households budget constraint and the governemnt budget constraint: yt pt et = ct + it + gt .

19

Assume that there is positive energy price shock, i.e. that:

pt
This creates a negative income eect (from the domestic resource constraint). Consumption and leisure being
normal goods, this implies that
ct

lt

The capital utilization eciency condition, and the fact that depreciation and energy costs are convex functions
of utilization, imply that
ht

Also, due to the fall in capital utilization, yt is reduced, which enhances the income eect20 . In that sense, a
positive energy price shock is equivalent, in a way, to a negative technology shock. In conclusion,
positive energy price shocks tend to reduce capital utilization.
Diusion of a positive government spending shock:
Assume a positive government spending shock.
gt
This again results in a negative income eect and
ct

lt

If labor increases, the marginal productivity of capital services increases and from the capital utilization
eciency condition and the convexity of depreciation and energy costs
ht
Finally, with ht and lt increasing, total output produced yt tends to increase, which has a counter-eect on
the negative shock due to increased government spending21 . In conclusion, positive government spending
shocks tend to increase capital utilization.
The objective of the project is to determine a true technology shock, i.e. a measure of an economys ability
to produce output from a given quantity of inputs, regardless of energy prices or government spending. The
usual calculations of Solow residuals would give us
LnSRt = [Lnyt Lnlt (1 ) Lnkt ] /

2 0 Notice that, due to the general equilibrium eects, the marginal productivity of labor diminishes and the households labor
eciency condition implies that households substitute labor for leisure, hence that lt tends to decrease (mitigating the increase
in lt previously mentioned).
2 1 Again to account for the general equilibrium eects, with labor increasing, the marginal productivity of labor decreases
(mitigated by increase in ht ) and from the substitution eect, lt decreases {wt is the price of leisure, os that if wt decreases,
leisure increases).

20

where kt is capital as reported in National and Income Product Accounts. This measure of capital is calculated
assuming constant depreciation. However, this does not fit with the model. To calculate a proper measure of
kt in accordance with the setup, we use the capital utilization eciency condition and the capital stock law
of motion to get series on ht and kt . Hence, the true technology shocks are given by
Lnzt = [Lnyt Lnlt (1 ) (Lnkt + Lnht )] /
When technology shocks are computed in this fashion, the correlation between the growth rates of the technology shocks and oil prices on the one hand and the correlation between the growth rates of the technology
shocks and total government spending on the other hand are very close to 0.22

Market imperfections and business cycles

2.1

The Lucas imperfect information model

We will now study an economy that has all the ingredients of a competitive economy (rationally behaving
agents, price taking behavior, market clearing), but has the characteristic that agents are imperfectly informed
about the state of the economy. There will be preference shocks (aecting the relative price between goods) and
monetary shocks. However, the monetary shocks are unobserved. In particular, producers, when observing
a change in the price for their product do not know whether it is a relative price increase (i.e. an increase in
the price of their product relative to the aggregate price level) or if it is a general price increase, reflected in
the aggregate price level. Hence, they will have to take production decisions, based on imperfect information.
In particular, they will need to take expectations about the overall price level, based on the only information
they get, that is the price of their commodity.
The treatment of the Lucas imperfect information model comes from the Romer textbook.
In order to focus on the central problem, which is to determine how agents take their decisions, when faced
with uncertainty about the relative demand for their product, the model will make a number of simplifying
assumptions. Agents use their own labor to produce a good indexed by i. They sell that good, taking the
market price as given. The agents production function is
Yi = Li
where Li is labor. The individual consumes his entire REAL income Pi Yi /P , where P is the aggregate price
level, or the price of a market basket of goods23 . His utility is determined by consumption and leisure24
Ui =

Pi Li
1
Li , > 1
P

2 2 And

statistically insignificant.
an index of prices of all goods.
2 4 This assumes constant marginal utility of consumption and increasing marginal disutility of work.
2 3 Or

21

2.1.1

The case of perfect information

For comparison, first suppose that the producer has perfect information on both the relative price Pi he faces
and also the aggregate price level P . Taking prices as given, the agent chooses Li to maximize his utility
Pi
=0
L1
i
P
Hence
Li =
Taking logarithms25
li =

Pi
P

1
1

1
(pi p)
1

(21)

This implies that production of good i increases with pi p, the relative price of good i. That determined the
individuals supply of good i. We now need to look at the demand side. It is assumed that the demand per
producer of good i depends on real income, the goods relative price and a random shock to preferences26 :
qi = y + zi (pi p)

(22)

where y is log aggregate real income, zi is a shock to the demand of good i27 , is the elasticity of demand
for each good, and qi is the demand per producer of good i28 . It is assumed that the zi s have zero mean
across sectors, i.e. that they are pure relative demand shocks (or preference shocks), hence E(zi ) = 0. It is
assumed that y = q i (average across goods of the qi s) and p = pi (the price index is defined as the average
across goods of the pi s). The aggregate demand is given by
y =mp

(23)

where m can be considered as the money in circulation29 .

The equilibrium in the market for good i requires that the market clears. Hence,

or

1
(pi p) = y + zi (pi p)
1
pi =

Averaging over the pi s, we get that30

1
(y + zi ) + p
1 + ( 1)
y=0

2 5 Lowercase

letters correspond to the natural logarithms of uppercase letters.

the particular functional form for utility function assumed, this is an approximation
2 7 This is a relative demand shock and can be interpreted as a preference shock.
2 8 Total (log) demand = LnN + y + z (p p)
i
i
2 9 See Romer p. 269, on interpreting y = m p, where m can be viewed as a generic variable aecting aggregate demand, not
necessarily money.
3 0 Do not gorget that y is log output.
2 6 For

22

and hence
m=p
So, in case of perfect information, changes in money supply are fully reflected in p and all relative prices pi
are proportionally increased. However, output is unchanged. Hence, not surprisingly, money is neutral in the
case of perfect information.
2.1.2

The case of imperfect information

Producers observe Pi , but not P . However, since their optimal decision depends on P , they need to make
inferences about the aggregate price level, solely based on the price of the good they produce and sell.
Define ri = pi p (relative price of good i). What matters to the individual is ri , but what he sees is pi .
From (21), we have
1
li =
(24)
E [ri ; pi ]
1

Notice that the maximization problem faced by the producer is

M axE [Ui ; Pi ]

given Pi and expectations of Pi /P

which gives
Li1 = E [Pi /P ; Pi ]
or
( 1) li = LnE [Pi /P ; Pi ]

(25)

This is dierent from (24) that states that ( 1) li = E [Ln (Pi /P ) ; Pi ]. We know that due to the concavity
of the logarithm function, these are not equal. However, Lucas showed that if one assumes that Ln(Pi /P ) =
E[Ln(Pi /P ); Pi ] + ui , where ui is normal with mean zero and a standard deviation that is independent of
Pi , then one can show that the labor supply defined in (24) and (25) only dier by a constant. In (24),
expectations are rational in the sense that the subjective probability of the distribution of the ri s given pi is
equal to its objective distribution.
We now look in detail at how producers take their expectations. It is assumed that the monetary shock m
and the relative demand shock zi are normally distributed and independent.
zi N (0, Vz )
m N (E [m] , Vm )
zi m

23

We will assume for now (but confirm later) that p and ri are normally distributed and independent.
p N (E (p) , Vp )
ri N (E (ri ) , Vri )
pri
Hence pi is also normally distributed.
pi N (E (pi ) , Vpi )
E (pi ) = E (p) + E (ri )
Vpi

= Vp + Vri

We will assume for now (but confirm later) that

E (p) = E (m)
E (ri ) = 0
Vp and Vri can be expressed as function of Vm and Vz
Since ri and pi are jointly normally distributed, the expectation of one conditional on the other is linear in the
conditioning variable. This can be seen as follows. Assume two random variables (X, Y ) are jointly normally
distributed. Hence their pdf is
fX,Y (x, y) =
q

1
p
e(q/2)
2 1 2 1 2
"

2 #
x 1
x 1
y 2
y 2
1
2
+
1 2
1
1
2
2

q can be rewritten as
q

1
1 2

where b = 2 +

yb
2

2
(x 1 )
1

x 1
1

Now, we can rewrite the joint pdf as

 
 
2  #
"
 # "
x1 2
yb

12
12
1
1
1
2
2 1

p
e
e
fX,Y (x, y) =

2 1
2 2 1 2

= fx (x) fY |X y|x

Hence, we see that the conditional pdf is given by the term in the second bracket. It is a normal distribution

2
fY |X y|x N 2 + (x 1 ) , 22 1 2
1
24

Applying this result, we get

E [ri ; pi ] = E (ri ) + ri ,pi

ri
(pi E (pi ))
pi

Since E(ri ) = 0 and E(pi ) = E(p), we have that

E [ri ; pi ] = ri ,pi
where ri ,pi =

cov(ri ,pi )
ri pi .

ri
(pi E (p))
pi

The covariance can be calculated:

cov (ri , pi ) = E [(ri E (ri )) (pi E (pi ))]
= E [ri (pi E (p))] = E [ri (ri + p E (p))]


= E ri2 + E [ri (p E (p))] = E ri2 = 2ri

Hence,

E [ri ; pi ] =
=

2ri ri
(pi E (p))
ri pi pi
2ri
(pi E (p))
2pi

Hence,
E [ri ; pi ] =

Vri
(pi E [p])
Vri + Vp

(26)

Equation (26) states that if the observed pi equals its mean, then the guessed ri also equals its mean, and
that the observed pi and the expected ri are always on the same side of their respective means. Finally, we
can see that if the variance in ri goes to zero, pi is a good expectation of p (E (p; pi ) = pi ) and if the variance
in p goes to zero, all the variation in pi is due to ri (E (p; pi ) = E (p)).
By substitution of (26) into (24), we get the individual labor supply:
li =

1
Vri
(pi E [p]) = b (pi E [p])
1 Vri + Vp

(27)

Hence, averaging across producers:

y = b (p E [p])

(28)

This is the famous Lucas supply curve. It implies, that in the aggregate, the deviation in output from its
average value (zero in model) increases with the surprise in the price level (p E[p]). If the price level where
perfectly known, every period, then there would not be any deviation in output (money neutrality). It is easy
to verify that the higher Vri , the higher the illusion eect and the higher Vp , the lower the illusion eect
(in fact, Vri / (Vri + Vp ) represent the variance in pi due to the variance in ri ). This gives a microfoundation
to the Phillips curve (negative relationship between inflation and unemployment).

25

We can now combine the aggregate supply curve with the aggregate demand curve to calculate the equilibrium
aggregate price level. From equations (23) and (28), we obtain:
m p = b (p E [p])
Hence
p =
y

1
b
m+
E [p]
b+1
b+1
b
(m E [p])
b+1

(29)
(30)

Assuming rational expectations, equation (29) implies that

E [p] =

1
b
E [m] +
E [p]
b+1
b+1

Hence
E [p] = E [m]
Rewriting (29) and (30), we get
p = E [m] +
y

1
(m E [m])
b+1

b
(m E [m])
b+1

(31)
(32)

We can interpret equations (31) and (32). The expected monetary disturbance - E[m] - only aects the
aggregate price level and has no eect on output. However, the unexpected portion of monetary policy (m E[m]) - aect both the aggregate price level and total output. When m E[m] 6= 0, producers attribute
part of the increase in the demand for their own good to there being more money in the economy, part to an
increase in the relative demand for their product. Hence, they increase output. However, when m increases,
while m E[m] remains constant, y is unaected. In that case, there is no money illusion and output is
unchanged.
We must now check the validity of some assumptions made along the way. We see from (31) that p is normal
Vm
((31) implies that E(p) = E(m) and Vp = (b+1)
2 ). Substituting (28) into (22), we get qi = b(p E[p]) + zi
(pi p). From equation (27), we have that li = b(pi p) + b(p E[p]). Equating supply for good i with
zi
demand for good i, we obtain that b(pi p) = zi (pi p) and hence that (pi p) = b+
. Hence, ri is normal,
Vz
E(ri ) = 0 and Vr = (b+)2 . One can see that p are ri are independent (since m and zi are independent). We
see then that b can be described only as a function of , , Vz , and Vm :

Vz
1

b=
1 Vz + (b+)22 Vm
(b+1)

It is easy to show that the above implicitly defined b increase in Vz and decreases in Vm . Notice that when
Vz = 0, Vr = 0 and E [p; pi ] = pi , and b = 0 (no illusion).
26

2.2

Coordination failures

We first present a very general framework where agents take actions which they cannot coordinate between
themselves. As a result of the lack of coordination, multiple equilibria may arise and the economy may be
stuck either in a good equilibrium (boom) or a bad equilibrium (recession). We will then study a particular
economy where dierent levels of unemployment may occur because of a lack of coordination between the
actions the agents take.
We want to look at situations where agents cannot coordinate their actions. Hence, the concept of Nash
equilibrium seems appropriate, since it assumes non-cooperative behavior among agents. This is not due to
their unwillingness to cooperate, but rather to their inability to do so. Agents cannot coordinate their actions
in a decentralized economy populated by many agents, even though they would benefit from doing so. We
first look at a general game that agents play. Assume that there are I agents31 who have to choose an action
ei from an interval [0, E]. The payo to agent i of action ei , taking the actions of other agents ei as given, is
equal to (ei , ei ). We assume that the payo functions have all the desired dierentiability and continuity
2
properties32 . In particular, assume that the payo functions are continuously dierentiable and that e2 < 0.
i
Denote the payo to agent i of action ei , when all other agents take action e, by V (ei , e). ei (e) is the optimal
response of agent i, when all other agents choose action e. Since we are only looking at symmetric Nash
equilibria (SNE), we need to have
ei (e) = e
Of course, there is the possibility of multiple SNE. Call S the set of all SNEs33 .
S = {e [0, E] , V1 (e, e) = 0 and V11 (e, e) < 0}
(assume that lim V1 (e, e) > 0 and lim V1 (e, e) < 0.)
e0

eE

Let us now define the set of ecient equilibria. We define symmetric cooperative equilibria (SCE) as actions
by all agents that maximize the welfare of the representative agent. The set Se of all SCE is given by34
Se = {e [0, E] , V1 (e, e) + V2 (e, e) = 0 and V11 (e, e) + 2V12 (e, e) + V22 (e, e) < 0}

Let us define the following:

If V2 (ei , e) > 0, the game exhibits positive spillovers

(33)

If V2 (ei , e) < 0, the game exhibits negative spillovers

(34)

If V12 (ei , e) > 0, the game exhibits stategic complementarity

(35)

If V12 (ei , e) < 0, the game exhibits stategic substitutability

(36)

3 1 We could look equivalently at I agents or I groups of agents. What matters is that agents have a non-negligible eect on
the payos of others and act strategically.
3 2 For all technical assumptions, see Cooper and John (QJE 1988).
3 3 Cooper and John (1988) make the appropriate assumptions for existence of an interior solution.
3 4 The authors ensure the existence of an interior solution by assuming that lim V (e, e) + V (e, e) > 0 and lim V (e, e) +
1
2
1
e0

V2 (e, e) < 0

27

eE

Equations (33) and (34) characterize positive or negative externalities present in the game. The action that
one agent takes may aect the other agents payos. The interactions are at the level of payos. The increase
in a players strategy aects other players payos. Equation (35) states that an increase in the action of
all other agents increase the marginal return to agent is actions. Hence, an increase in all the other agents
strategy (or an increase in e) causes an increase in agent is optimal strategy. The interactions are at the level
of strategies. Under strategic complementarity, one therefore expects ei (e) to be an increasing function of e
de
[from the implicit function theorem, dei = VV12
> 0].
11
Here are a few results about this game35 :
Proposition 1: Strategic complementarity is necessary for multiple SNE.
This is because, looking at figure 2 below, multiple solutions (intersections of the reaction function and the
45o line) can only arise if the slope of the reaction functions is positive on some range. Call s that slope. Then
V1 (ei (e), e) = 0, and sV11 (ei (e), e) + V12 (ei (e), e) = 0, which implies that s = V12 (ei (e), e) /V11 (ei (e), e).
If we have strategic complementarity on some range, s is positive
Proposition 2: If the game exhibits spillovers at e S, then e is inecient.
e This is because in an SNE, agents do not take
If V2 (e, e) 6= 0 (spillovers) and V1 (e, e) = 0 (e S), then e
/ S.
into account the fact that their actions aect others payos (externalities).
Proposition 3: Assume there are several SNE. Also assume positive spillovers for all e E. The SNEs can
be Pareto-ranked by the equilibrium action. Higher action SNEs are preferred.

By the Envelope Theorem, e

V (ei (e), e) = V2 (ei (e), e). If the game exhibits positive spillovers (globally),
d

then de V (ei (e), e) > 0. Agents is payos increase when everybody else increase their action. Equilibria with
higher actions are preferred by everybody. However, SNE with lower welfare for the representative agent are
also consistent with optimizing behavior. Such equilibria can be sustained because of the inability of agents
to coordinate their actions.
2.2.1

An example of coordination failure: the low skill trap

We can now look at a particular example of the general setup described above. As the focus is on the strategic
interactions between firms and workers, the important assumptions are with respect to how the labor market
functions. In particular, we do not assume that the labor market clears anymore (this anticipates the search
literature that we will explore in more details later). Rather, because of informational problems, finding a
firm (or a worker) to match and start production with, is a dicult and time consuming process. This can
come from several reasons. Because workers and firms do not know instantaneously where each other are,
they have to search and this takes time. Or even if they know where they are, they do not necessarily know
which ones are actively looking for a partner. Or even if they know where to locate a partner interested in
making a match, several workers may apply for a given position for example, and only one of them can get
3 5 Similar

(opposite) results can be obtained, if one considers negative spillovers or strategic substitutability.

28

ei (e)
6

45o line

(reaction function ei (e))

Figure 2: Reaction function

29

it. To represent all these possible frictions, it is assumed that matching opportunities come randomly for
searching workers or firms. The following model is derived from The Low Skill Trap (Burdett 1990s).
The paper tries to explain the following facts, relative to the English and the German economies:
(i) A greater proportion of the German labor force is skilled,
(ii) There are more skilled job vacancies in Germany than in the U.K.,
(iii) The expected return to training in the U.K. is no higher than in Germany,
(iv) The (long-run) unemployment/vacancy ratio is higher in the U.K. than in Germany.
Workers can be in two states, searching for a firm or matched and producing output. Similarly, firms can be
in two states, searching for a worker or matched. To find a worker, firms have to pay a vacancy cost c (per
period).
State variables:
workers: searching or matched
firms: searching or matched
Decision variables:
workers: accept a match or not, whether to train or not
firms: whether to post vacancies, accept a match or not
Types:
workers: trained or untrained
firms: same type
Technologies:
Production technology: X1 for trained workers and X2 for untrained workers (X1 > X2 )
Meeting technology: M (Ut , Vt ) (number of meetings per period, where Ut is the number of unemployed
workers and Vt is the number of vacancies). It is generally assumed that the meeting function is increasing
and concave in both arguments, and exhibits constant returns to scale.
Utility:
Linear utility for both workers and firms
Let t be the proportion of the unemployed workers who are trained (type 1), at t. All workers are born
untrained, and must take the decision whether to get training or not (and incur the costs), BEFORE entering
the labor market. For simplicity (but that should not alter the main message of the model), once a worker
and a firm have made contact, they start production and leave the labor market, that is these matches are
not subject to future breakdowns. Also denote by g the number of workers who enter the market at date t.
This is exogenously given. The number of firms entering the market, though, is endogenously determined. It

30

is because firms need to post a costly vacancy to attract a worker, and firms do so until the expected value
of posting a vacancy is driven down to zero. This is a free entry condition for firms.
Steady State Value functions:
S1 : value of search to the trained worker
S2 : value of search to the untrained worker
: value of posting a vacancy to the firm
The novelty is to assume that meetings between firms and workers only come randomly, Hence, workers and
firms face arrival rates of meetings. Call 1w and 2w the arrival rates of job oers in a given period, for
a trained and an untrained worker, respectively. These are arrival rates of firms willing to match with the
particular types of workers. Call f the arrival rate of meetings for the firms. Denote by w1 and w2 the wage
of trained and untrained workers. Assume that (to be checked later)
X1 > w1 > 0, X2 > w2 > 0, w1 > w2

LOOKING AT THE WORKERS AND THE FIRMS PROBLEMS

IN THE SEARCHING POOL FIRST:
When calculating his value of search, the worker takes the market wage wi and arrival rates of job oers as
given:
n
i
1 h 1
w1 o
S1 =
(37)
w M ax S1 ,
+ 1 1w S1
1+r
r
S1 is the discounted lifetime expected value of being a searching worker of type 1 (trained), and following an
optimal strategy. It says that (at the end of the period, hence the discounting), the worker has a probability
1w of meeting a firm, in which case he will follow the optimal strategy of accepting the match if the value
of doing so (w1 /r) is greater than the value of continuing search (S1 ). There is also a probability 1 1w
that the trained worker does not meet a firm in that period. The value of accepting the match is w1 /r, since
we assumed that matches lasted forever. Hence, the workers decision problem is simple: accept the job if
S1 wr1 and reject it otherwise.

This is equivalent to a Bellman equation. Remember that the only control variable (at this stage) for the
worker is whether to accept or not accept a matching opportunity, given a meeting took place. And the only
state variable for the worker is whether he is searching or matched. Hence, for a searching worker, (37) says
that the value derived from the state of search is that the worker gets oers that he optimally chooses from,
knowing that he can continue search in the next period if he chooses to. S1 is the discounted value of making
the optimal choice, given the opportunity arises.

31

The general form for a Bellman equation, the one you are used to is:
V (Statet ) = M ax [U (.) + EV (statet+1 )]
controlt

In the present case, the control variable is discrete: do you accept the match or not? Given the current state
is search for the worker, and since there is no utility received outside the match (U = 0), this becomes:
S1

1
E [M ax (value of search, value of a match)]
1+r
there is an expectation term, because the worker
may not have the opportunity to make a choice.

The value function for the untrained worker is similarly given by:
n
i
1 h 2
w2 o
S2 =
w M ax S2 ,
+ 1 2w S2
1+r
r

(38)

Hence, we have that:

S1

S2

n
1w
w1 o
M ax S1 ,
1
r + w
r
n
2
w
w2 o
M ax S2 ,
2
r + w
r

As w1 > 0 and w2 > 0, trained and untrained workers accept the first oer they receive (it is intuitive and
easy to show that assuming Si > wri leads to a contracdiction). Thus:
S1

S2

1w
r + 1w
2w
r + 2w

w1
r
w2
r

(39)
(40)

Taking wages, arrival rates and the proportion of skilled workers as given, the value of search for the firm is
given by:

X1 w1
X2 w2
1
=
f M ax ,
+ f (1 ) M ax ,
+ (1 f ) c
1+r
r
r
Hence:

X1 w1
X2 w2
(r + f ) = f M ax ,
+ f (1 ) M ax ,
c
r
r

As for the worker, the firms decision is straightforward: accept the match with a worker of type i if
and reject it otherwise.
LOOKING AT THE WORKERS AND THE FIRMS PROBLEMS
32

Xi wi
r

BEFORE THEY ENTER THE SEARCHING POOL:

Firms decision is the following: taking wages as given and taking expectations on the proportion of trained
workers36 , post vacancies until the value of doing so is driven down to zero, i.e. when = 0. At that stage,
firms have to have expectations over . This is the free entry condition. As Xi wi > 0, i = 1, 2, this implies
that:
X1 w1
X2 w2
c = f
+ f (1 )
(41)
r
r
Since employers with a vacancy oer a job to all workers met (Xi wi > 0, i = 1, 2), 1w = 2w = w . Hence,
S1

S2

w
r + w
w
r + w

w1
r
w2
r

Turning now to the training decision by the workers (that has to be taken before entering the labor market),
we see that the return from education is equal to S1 S2 , where:
= S1 S2 =

w w1 w2
r + w
r

(42)

Denote the cost of training to the worker by e. Then, the workers decision is (taking wages as given and
taking expectations on meeting rates):
Undertake training if

> e

Do not train if

< e

(if = e, the workers are indierent between training or not)

Flows:
In steady state, the flows into the labor market are equal to the flows outside the labor market (remember
that we assumed that the meeting probabilities were constant through time). Hence:
g = M (U, V )

(43)

The probability of a meeting to a worker (firm) is equal to the ratio of the number of meetings to the number
of searching workers (firms):

3 6 Of

M (U, V )
U
M (U, V )
V

ocourse, as the number of vacancies posted increases, f decreases.

33

(44)
(45)

Hence,
g = w U = f V

(46)

From (41), (42), and (46), we obtain that:

g X w
X2 w2
1
1
V () =

+ (1 )
c
r
r

g
w1 w2
(U ) =
g + rU
r

(47)
(48)

Conditional on w1 and w2 , a steady state equilibrium can take two forms. Denote by e the cost of education
(training). Either it is an interior solution or it is a corner solution. The interior solution (U , V , ) is given
by
g

= M (U , V )

(U ) = e
V

= V ( )

The corner solution is given by either

g

= M (U , V )

(U ) e
V

= V (0)

or by
g

= M (U , V )

(U ) e
V

= V (1)

We now investigate the possibility of multiple equilibria. Continue assuming that X1 w1 > X2 w2 (this
seems more appealing than the opposite assumption). From (47), we see that V (.) is linear and increasing in ,

2
1
such that V (0) = gc X2 w
and V (1) = gc X1 w
. Remark that the iso-matching curve g = M (U, V ) is
r
r
downward sloping, because of the assumptions on M . Define U0 , U1 such that M (U0 , V (0)) = M (U1 , V (1)) =
g. Please refer to the figure.
First assume that there is U [U1 , U0 ], such that (U ) = e. From the figure, one can check that this
corresponds to a unique interior equilibrium37 . Now looking at the two corner solutions, it is easy to see that
3 7 This

is not necessarily an interesting equilibrium, since it is unstable in the sense, that if more people decide somehow to
acquire more training ( ), then > e, and we would move towards the corner solution where = 1.

34

if all workers decide to acquire training ( = 1), the number of vacancies increases to V (1). As this happens,
unemployment decreases. Consequently, the return to education exceeds its cost e, because workers have a
higher chance to reap benefits from their training. So, firms post more vacancies since the chance of making a
higher profit match increases. But also, workers have more incentive to acquire training. since there are more
vacancies (job opportunities). Now assume that all workers decide to remain untrained. Then, by the same
token, the number of vacancies decreases and workers have no incentive to acquire education. The strategic
interaction between workers and firms decisions is clear. This is the low skill trap alluded to in the title.
Workers do not acquire training because there are not enough job vacancies, where they can enjoy the fruits
of their training. And firms do not post many vacancies, since the chances of making a high profit match are
low, because there are few high skilled workers around. Please note that the expectations are rational in these
equilibria. It is easy to see that the high skill equilibrium Pareto dominates the low skill equilibrium. Please
remark that if the training costs are low enough or high enough, there is a unique corner solution (either every
worker trains or none trains)38 .
Equilibrium wages:
Finally, we need to verify what we assumed along the way: X1 > w1 > 0, X2 > w2 > 0, w1 > w2 , and
X2 w2 > X1 w1 . The match between the worker and the firm creates a local surplus between the two,
which is due to the fact that the combined value of the match between the two entities is greater than the total
value of search (between both of them): agents do search because they enjoy utility once matched (due to the
division of output), but they do not enjoy any income during search. So, matching creates some gain from
trade that has to be divided between the two parties. That is when we make the assumption that wages (or
the division of output) are negotiated between the two parties. And for an equilibrium, we require that
negotiated wages are equal to market wages. The division of gains from trade has long been a topic
of great theoretic interest. The most common approach in equilibrium models is to use the Nash bargaining
solution, as derived in Nash (1950). This bargaining solution is explained in detail below. Remember that,
when negotiating, the two parties take their values of search and values of being matched as given. Applying
the Nash bargaining solution, the resulting negotiated wage has to be equal to the market wage.
The Nash bargaining solution:
This is referred to the axiomatic approach to bargaining. The reason is that Nash was interested in
finding a solution with particular properties to a bargaining problem. Let us first define the problem and the
properties that the solution must have. There are two agents39 , j = 1, 2, with utility functions uj . There is
an arbitrary set of outcomes A. D is the outcome in case the agents cannot reach an agreement (disagreement
or threat point). Define S = {(u1 (a) , u2 (a)) , a A} and d = (d1 , d2 ), where dj = uj (D). Suppose that S is
compact and convex and that d S. Also assume that s S, such that sj > dj , j = 1, 2.
(S, d) is the bargaining problem
f
3 8 It
3 9 In

(S, d) S is a solution to (S, d)

can be shown that if X1 w1 X2 w2 , there is always a unique equilibrium.

what follows, we are only interested in situations where two agents bargain.

35

Nash was looking for a solution with the following properties:

(A1) Invariance to utility choices:
Given (S, d) and (S 0 , d0 ) defined by s0j = j sj + j and d0j = j dj + j , then fj (S 0 , d0 ) = j fj (S, d) + j
(A2) Symmetry:
If d1 = d2 and (s1 , s2 ) S (s2 , s1 ) S, then f1 (S, d) = f2 (S, d)
(A3) Independence of irrelevant alternatives:
If (S, d) and (S 0 , d) satisfy S S 0 and f (S 0 , d) S, then f (S, d) = f (S 0 , d)
(A4) Pareto eciency:
Given (S, d), if s S and s0 S and s0j > sj , j = 1, 2, then f (S, d) 6= s
Nash (1950) showed that the unique solution to this problem is40 :
f (S, d) = Arg max (s1 d1 ) (s2 d2 )

(49)

s1 d1 ,s2 d2

To sketch the proof, it will be useful to draw a graph. By (A1), one can choose the set of possible outcome
S1 , such that d = (0, 0) (normalization of the utility functions). Denote by S2 the intersection of S1 and
the positive quadrant. Let (u1 , u2 ) = Arg maxu1 u2 . By assumption, S2 is non-empty, compact and convex,
sS2

which guarantees existence of the maximizers. Uniqueness is obtained from the convexity assumption. By
(A1), choose u1 , u2 such that (u1 , u2 ) = (u , u ) lies on the 45o line (normalization of the utility functions).
Notice that every point of S2 is such that u1 + u2 2u41 . Let B be a square, symmetric relative to the 45o
line, one side of which is supported by u1 + u2 = 2u , that includes S (of course, it is not unique). It exists
since S is bounded. Then by (A2), f (B, O) is located on the 45o line. By (A4), f (B, O) = (u , u ). By (A3),
f (S, O) = f (B, O). Hence, given the normalizations performed, f (S, d) is located at (u , u ). Remarkably,
it can be proved that uniqueness of the bargaining solution cannot be obtained with a proper subset of these
four axioms.
Final remark: we need to check that X1 > w1 > 0, X2 > w2 > 0, w1 > w2 , and X2 w2 > X1 w1 . The
Nash bargained wage wi satisfies:

w
X w
i
i
i
M ax
Si

wi
r
r
4 0 Remark

that if requirement (A2) were dropped, then there is a continuum of solutions:

f (S, d) =

Arg max (s1 d1 ) (s2 d2 )(1)

s1 d1 ,s2 d2

4 1 Suppose that there exists a point M = (u , u ) S such that u + u > 2u . Then, there exists a point between M and
1
2
2
1
2
N = (u , u ) that belongs to S, for which u1 u2 > u2 (by convexity of S2 ).

36

U2

@
@

@
@
@

U1

Figure 3: Graphical transformation used in Nashs proof

The first order condition implies (one can easily check the second order condition):
Xi wi
wi
Si =

r
r
since Si and are taken as given, by the negotiating parties. As = 0 and Si is given by (39)-(40), we
have that:
r + w
wi =
Xi
2r + w
One can then check that X1 > w1 > 0, X2 > w2 > 0, w1 > w2 , and X2 w2 > X1 w1 .
Conclusion: this simple model can be used to shed some light on the remarks made at the beginning: consider
that England is in the low skill equilibrium while Germany is in a high skill equilibrium. Then: (i) Germanys
workforce would be more skilled than Englands workforce, (ii) there are more skilled job vacancies in Germany
than in England, (iii) the expected return to education is lower in England, (iv) the unemployment to vacancy
ratio is higher in the U.K. than in Germany.

37

Chapter II
ECONOMIC GROWTH

In this chapter, instead of trying to explain why economic variables uctuate, we are focusing our attention
on the levels of economic aggregates and their growth rates. In particular, some empirical facts need to be
explained1 :

Observed growth facts

1) There is a great wealth disparity between countries. In 1985, average per-capita incomes in the richest 5%
of countries and the poorest 5% of countries diered by a factor of 29. The wealth distribution has shifted
up. But the disparities tend to persist in both levels of income per capita and growth rates.
2) There has been development miracles and disasters.
3) Barro (QJE 1991) tries to nd relationships between growth rates, initial per capita output, and initial
human capital levels (proxied by school enrollment rates). The Solow growth model predicts that if countries
have the same preference and technology parameters, one should expect convergence - poor countries grow
faster than rich ones. However, the data show almost zero correlation between initial capital output (GDP602 )
and subsequent growth rates (GR60853 ). However, dierent countries have dierent levels of human capital.
So, he performs the following regression
GR6085

=
<

+
0;

GDP 60 +

SEC60 +

P RIM 60

> 0; > 0 (and all highly statistically signicant)

where SEC60 and PRIM60 are secondary and primary enrollment rates in 1960, respectively, which are
proxies for initial human capital levels.
< 0 implies that with constant human capital levels, there is a
strong negative relationship between initial wealth and subsequent growth rates. Since > 0 and > 0, initial
human capital levels and subsequent growth rates are positively related, holding other variables constant. This
seems to support endogenous growth models, which suggest that a large stock of human capital promotes
growth, because it makes physical capital more productive and/or it makes it easier to develop or absorb new
ideas, products and technologies4 .
Notice that having < 0 and corr(gy ; initialGDP )
also had a low SEC60 and P RIM 60.

0 can be reconciled, if countries with low GDP 60

4) Barro (1991) also nds that growth rates are positively related with measures of political stability.
5) This comes in addition to the facts mentioned in your rst semester class: persistent dierences in Y =N
and gY =N across countries, low correlation between Y and gY =N across countries, stable and similar growth
rates in rich countries, unstable and diverse growth rates in poor countries.
1 Facts

(1) and (2) come from Prescott and Parente (FRB Minneapolis Quarterly Review, Spring 1993).
per capita GDP.
3 Average growth rate from 1960-1985.
4 Remark though that there is a possible problem with this regression, since the schooling decision is potentially endogenous.
2 1960

Welfare costs: growth vs. uctuations

In the Jahnsson Lectures Series (1987), Lucas argued that business cycles in the post-war involved very
small welfare losses, challenging the presumption that stabilizing the cyclical uctuations was desirable. In
particular, he showed that removing all the empirical volatility observed in U.S. times series - regardless of
feasibility, would bring small welfare gains, in particular relatively to gains from increasing trend growth rates.
Here is how he proceeded.
The argument involved does not necessitate developing and solving a full economic model. Rather, we
just examine and compare expected welfare from given streams of consumption. We can thus evaluate welfare
gains/losses from removing volatility from the stream of consumption or increasing trend components. Hence,
no particular policy is examined. Rather, we try to determine how much can be gained from a hypothetical
policy removing all volatility, for example. In essence, we are asking the representative household for his
attitudes towards some purely hypothetical consumption streams.
The only things we need to carry out that exercise is parameters describing (i ) preferences (from consumption) and (ii ) the stochastic consumption process. Assume households have utility from consumption
dened by
)
(+1
X
1
t
c1t
1 ;
(1)
U =E
1
t=0
where 2 (0; 1) is a constant discount factor and
Let us represent consumption as

> 0 is the constant coe cient of relative risk aversion.

ct = (1 + ) (1 + )

1
2

2
z

zt ; t = 0; ::: + 1;

(2)

where fzt g is a stationary stochastic process with a stationary distribution given by

ln (zt ) ~N 0;
1

2
z

Then, we have that E(e 2 z zt ) = 1, so that mean consumption is given by (1 + )(1 + )t . At this point
is just a normalizing constant, whose reason for being will be evident soon.
What are empirically reasonable values for
and 2z ? For the U.S., the annual growth rate in total
consumption is about 3 percent, so that = 0:03. For the post-war period in the U.S., the standard deviation
of the log of consumption about trend is about 0:013, so that 2z = (0:013)2 . Thus, we may take (2) with
; ; 2z = 0; 0:03; (0:013)2 . Given any choice of ; ; 2z , we could simply calculate the value of (1) under
(2) and call the indirect utility function so dened U ; ; 2z . Instead, we will use compensating variations
in to evaluate various and 2z .
To evaluate changes in the growth rate , dene f ( ;
U f( ;

0) ;

2
z

0)

by

= U 0;

0;

2
z

so that f ( ; 0 ) is the percentage change in consumption, uniform across all dates and values of the shocks,
required to leave the consumer indierent between the growth rates and 0 .5 One nds that
f( ;

0)

Taking = 0:95 and with a base growth rate

cost of reducing growth from 0 to :

1+
1+

1:

= 0:03, one can generate the following table, evaluating the

f( ;
0.01
0.02
0.03
0.04
0.05
0.06

0)

0.45
0.20
0.00
-0.17
-0.31
-0.42

The table says that consumers would require a 20 percent across the board consumption increase to accept
voluntarily a reduction in the consumption growth rate from 0:03 to 0:02 percent.
The costs of economic instability can be measured in a way which is identical. Dene g
U g

2
z

; ;

2
z

2
z

by

= U (0; ; 0) .

Thus g 2z is the percent increase in consumption, uniform across all dates and values of the shocks, required
to leave the consumer indierent between consumption instability of 2z and a perfectly smooth consumption
path. One nds that g is given by6
1
2
g 2z '
z:
2
Here again, one can evaluate the cost of consumption instability, as in the table below:
g
1
5
10

2
z

0.00008
0.00042
0.00084

The table says that eliminating all aggregate consumption variability of this magnitude would be the equivalent
in utility terms of an increase in average consumption of less than one tenth of a percent. Just as a reference,
total U.S. consumption in 1983 was $2 trillion, so one tenth of a percent is $2 billion or $8.50 per person.
This is a relatively small number, especially compared to the welfare gains from increasing growth trends.
5 With

CRRA preferences, 2z does not appear as an argument of f .

ln (1 + ) as .

6 Approximating

Of course, this calculation entailed some simplications. Yet at the least, this implies that the welfare
consequences of increasing growth rates are larger than those of policies targeting business cycles. Interestingly,
this paper has spurred a great interest in better assessing the welfare gains from policies aimed at reducing
consumption volatility. Some directions of research include recognizing that not all households are identical
and incorporating imperfection in capital markets.

The Solow model: a quick refresher

There is a representative household and an aggregate production function: yt = f (ht ; kt ) (CRS, increasing
and concave in both arguments). The law of motion for capital is given by: kt+1 (1
) kt = yt , which
assumes that households are saving at a constant exogenous rate . Assume that households supply labor
inelastically (ht = 1). Rewrite F (k) = f (1; k) (then F 0 > 0, F 00 < 0, F (0) = 0, F 0 (0) = +1, F 0 (1) = 0).
Hence, kt+1 = (1
) kt + F (kt ) g (kt ). Given k0 , the above relation gives the time paths of kt , ct and yt .
We look at the steady state, i.e. a solution to g (k ) = k . By assumption, g (0) = 0, g 0 (0) > 1, g 00 (k) < 0,
g 0 (+1) < 1, guaranteeing two steady states (including a degenerate one at k = 0). It is straightforward to
show that we have monotonic convergence to k and slower growth as k increases.
t

To actually obtain persistent growth, assume: yt = f (1 + ) ht ; kt .

Then, kt+1 = (1

) kt +

1
Then: e
kt+1 = 1 e e
kt + eF e
kt , where 1 e = 1+
and e = 1+ .
We are back to the previous setup, and hence e
kt converges to e
kt . Hence, asymptotically, kt grows at rate
1 + (and so do ct and yt ).
t
f (1 + ) ; kt . Call e
kt =

kt
.
(1+ )t

The Cass-Koopmans optimal growth model

We will start by refreshing your memories and quickly lay out the standard Cass-Koopmans exogenous growth
model. All individuals have the same preferences represented by the utility function u(ct ) = ct = . As leisure
does not enter the utility function, agents devote all their time endowment to labor. The production technology
is given by f (kt ) = A1t kt 7 . Looking for the optimal solution, we have to maximize the lifetime discounted
utility from consumption of the representative agent:
M ax

fkt+1 ;ct g

s:t: f (kt )

= kt+1

+1
X

u (ct )

(3)

t=0

(1

) kt + ct

k0 given
Notice that the problem is deterministic. The state variable is kt and the only control variable is kt+1 8 .
Assume that At = (1 + )t A0 , or that the technological progress component grows at a rate . To render the
7 This
8 Or

implies that At , the technological progress, is labor augmenting.

equivalently ct .

problem stationary, we need to redene the variables. Hence:

kt

ct

yt

kt
At
ct
At
yt
At

We can now rewrite (3) as:

+1
X

M ax

fkt+1 ;ct g t=0

s:t: (kt )

( (1 + ) ) u (ct )

(1 + ) kt+1

(1

) kt + ct

(4)

The value function is thus:

V (kt ) = M ax u kt + (1

) kt

kt+1

(1 + ) kt+1 +

(1 + ) V kt+1

The rst order condition (on kt+1 ) is:

(1 + ) u0 kt + (1

) kt

(1 + ) V 0 kt+1 = 0

(1 + ) kt+1 +

MC of savings = MB of savings
Using the envelope theorem:
V 0 (kt ) =

kt

1)

+ (1

) u0 kt + (1

) kt

(1 + ) kt+1

Hence:
u0 kt + (1

) kt

Since u0 (ct ) = ct

(1 + ) kt+1 =

1)

+ (1

) u0 kt+1 + (1

1)

+ (1

(1 + )

kt+1

(1 + )

kt+1

) kt+1

(1 + ) kt+2

(ct )

ct+1

(5)

We want to look at the steady state balanced growth path, i.e. when the normalized variables (c ; k ) are
constant. Of course, this implies that ct , kt grow at the same rate as the deterministic technological progress.
From (4) and (5), we have that:
k

=
1

( + )k + c
(1 + )

We have a system of two equations in c and k . Then:

"
1
1
k =
(1 + )
c

= k

= k

( + )k

(6)
k

1)

+1

1+

!#

(7)

1
1

Notice that, in this model, growth rates are only dependent on the rate at which technology increases ( ).
However, the levels of consumption, investment and output also depend on structural parameters such as
production technology ( ), preferences ( ) and discount rates ( )9 . On the steady state balanced growth
path, kt = At k . At is the same for all countries. k depends on , , , ,and . Any cross-country
dierence, in this model, comes from dierences in , ,
or . If you assume that technology is not
restricted by borders ( , ) and that households are the same across countries ( and ), this basic model
cannot explain cross-country dierences. Fortunately, there are many alternatives to explaining the various
growth experiences in the dierent countries. Next chapter introduces you to some of the possible directions.

What do we need to generate economic growth?

5.1

A basic framework to determine what is needed to generate economic growth

What did we learn from the previous two models? So far, growth was only generated exogenously through
labor augmenting technological progress. This is clearly not satisfying. Let us a look at a more general
approach.
Suppose the economy has a constant population of a large number of identical agents with preferences
dened as
+1
P

t=0
1

with u (c)

u (ct ) ;
1

> 0:

For the discussion, the production function will take the form
F (Kt ; Xt )
bt
where K

b t );
= Xt f (K
Kt
Xt

The function F (:) will have the usual properties (monotonicity, diminishing marginal returns, constant returns
to scale, Inada conditions), which implies that
b
lim f 0 (K)

= 1;

F1 (K; X)

F2 (K; X)

b !0
K

lim

b = 0;
f 0 (K)

b !+1
K

@Xf (K=X)
b
= f 0 (K)
@K
@Xf (K=X)
b
b K
b
= f (K)
f 0 (K)
@X

(8)
(9)

. The input Kt is physical capital, while the input Xt captures the contribution of labor (we will be more
precise soon).
9 And

of course the depreciation rate, which has no reason to dier across country.

We are looking for additional technological assumptions to generate a balanced growth path, where consumption grows at rate . In a competitive equilibrium, the payment to capital is given by
b t ):
rt = F1 (Kt ; Xt ) = f 0 (K

(10)

Households maximize lifetime utility subject to a budget constraint:

M ax

+1
P

u (ct )

t=0

s:t: ct + kt+1
where

(1

) kt = rt kt +

stands for labor income (we will be more precise soon). The rst order condition is
u0 (ct ) = u0 (ct+1 ) [rt+1 + 1

Combining (10) and (11), we get

ct+1
ct

b t+1 ) + 1
f 0 (K

]:

(11)

(12)

b Again,
In conclusion, a constant consumption growth rate must come from a constant rate of return on K.
capital accumulation cannot by itself sustain long-term growth when the other input Xt is constant over time
(for example,. if Xt is purely labor. Xt = L). The Solow and Cass-Koopmans model took care of that
problem by assuming an exogenous, labor-augmenting technological progress. These two model assumed that
b t along the balanced growth path. Notice that
Xt = At L, with At+1 = (1 + ) At , implying a constant K
b
= F1 (Kt ; Xt ) = f 0 (K);
h
i
dXt
b
b K
b At ;
= f (K)
f 0 (K)
wt = F2 (Kt ; Xt )
dL
which implies that capital is paid a constant rate along the BGP, but payments to labor increase with the
technological progress.
rt

5.2
5.2.1

Some possible extensions

Externality from spillovers

The externality considered here is that technology grows because of aggregate spillovers coming from rms
production activities (this section is inspired by Arrow (1962) [learning by doing] and Romer (1986)). Here,
technological advancement is external to rms. Assume that rms faced a xed labor productivity, which
is proportional to the current economy-wide average of physical capital per worker10 . In particular, assume
that
Kt
:
Xt = K t L; where K t =
L
1 0 Arrow considers that learning from experience is embodied in capital goods. Romer considers that the spillovers come from
rmsinvestment in knowledge (aggregate stock of knowledge).

b t = 1 and, hence, (12) becomes

The rental rate of capital is given by (10). Of course, we have that K
ct+1
ct

[f 0 (1) + 1

Not surprisingly, it turns out that the competitive equilibrium is not Pareto optimal. The social rate of return
on capital is given by
dF Kt ; KLt L
= F1 (Kt ; Kt ) + F2 (Kt ; Kt ) = f (1)
dKt
where the last equality comes from (8)-(9). Inserting this rate of return into the Planners problem gives us
a higher growth rate
ct+1
= [f (1) + 1
]
ct
a fact that is shown by (9).
5.2.2

All factors reproducible - one-sector model

An alternative approach to generating endogenous growth is to assume that all factors of production are
reproducible. In particular, assume that human capital Xt can also be produced and depreciates at rate X
( K for physical capital). The competitive wage is given by
wt = F2 (Kt ; Xt ) :
Households maximize
M ax

+1
P

u (ct )

t=0

s:t: ct + kt+1

(1

K ) kt

+ xt+1

(1

X ) xt

= rt kt + wt xt :

The rst order condition with respect to human capital xt+1 is

u0 (ct ) = u0 (ct+1 ) [wt+1 + 1

X] :

(13)

Since households are investing in both human and physical capital (equations (11) and (13)), the two returns
must be equal,
F1 (Kt+1 ; Xt+1 )
K = F2 (Kt+1 ; Xt+1 )
X;
which, using (8)-(9), implies that
X

b t+1 )
= f (K

i
b t+1 f 0 (K
b t+1 ):
1+K

(14)

b =K
b . One can solve (14) for f 0 (K
b ) and insert it
This last equation pins down a time invariant value for K
in (12) to get
"
#
b )
b
ct+1
f (K
X + KK
=
+1
:
b
b
ct
1+K
1+K
9

Miscellaneous: An empirical investigation: why does not capital

ow from rich to poor countries ?

This is derived from a paper by Lucas (same title, AER 1990).

The paper starts from the observation that physical capital does not ow from rich to poor countries, where
presumably it would earn a higher return. This is puzzling if one considers the basic assumptions on production
technology and free trade between countries. Let us take a look at these standard assumptions. If you consider
that countries share the same production function (technology spreads across borders)
Y = AK N 1

(15)

and that physical capital can be traded between countries without restrictions. Dierences in output per
Y
=
worker that are observed across countries must come from dierences in the capital to labor ratio [ N
A K
]. But then the higher return to capital in one country should cause capital to go where the return is
N
the higher. That is why one would expect capital to move from rich to poor countries (if one believes in this
simple model). Let us take an example to illustrate this. It is observed that output per person in the U.S. is
15 times higher than in India. Taking the Cobb-Douglas production function in (15), denote by y the output
per worker and k the capital per worker. Then
y = Ak
and the return to capital r = dY =dK is given by
r = Ak
Using

= A y

= 0:4 (average of U.S. and Indian capital shares)

rI
rU:S:

yI
yU:S:

1:5

58

Thus if capital ows were not restricted, one would expect capital movements from the U.S. to India. Hence,
this very basic framework needs to be altered. We will look below at several possible modications of the
neoclassical framework to address this issue.
Human capital in the production function:
This is equivalent to considering that labor quality or eectiveness enters the labor input. Two workers
producing for the same number of hours may produce dierent amounts of output. The production function
becomes
1
Y = AK (hN )

10

where h is e ciency units of labor, or human capital. In that case, denoting the output per eective worker
(Y =hN ) and capital per eective worker (K=hN ) by y and k, respectively, and the return to capital by r, we
have that
y

= Ak

= A k

= A y

Lucas reports that, if each country had the same physical capital endowment per worker, an Indian worker
1
would produce 38% of what his American counterpart would11 . Hence (hI =hU:S: )
= :38, or hI =hU:S: 0:2.
This would result in
1

rI
rU:S:

yI
yU S

per capita income ratio (India to U:S:)

hU:S:
hI

1:5

5:2

Of course, this is an improvement over the previous version that did not include human capital. The ratio
rI =rU S is lower because higher human capital in the U.S. increases rU S . But the puzzle remains partially
unexplained.
Human capital with externalities:
Assume that:
1

Y = AK (hN )

ha

where ha is the average level of human capital in the economy and > 0. Hence, output depends on the
average level of human capital in the economy (and not only the eective labor used as input). Of course,
when taking their decision of investing in human capital, agents do not take into account the fact that their
decisions aect ha in equilibrium. Rather, they take ha as given. The accumulation of human capital therefore
brings a positive externality on the economy. The idea is that the more people around are skilled, the more
productive one is. For a complete treatment, see Lucas (JME 1988).
Again denoting y and k as income per eective worker and capital per eective worker, we have that:
y

= Ak ha

A y

ha

Remark that this is equivalent to having a growing technology component. Lucas estimates the parameter
= 0:36. With this parameter, one nds that rI =rU:S:
1 (the parameter is actually estimated and not
1 1 This

comes from Krueger (Economic Journal 1968). A bit more precisely, she estimates how (age/sector mix/education)
aects productivity in the U.S. (from earnings information). She then uses this information to compute the productivity of an
Indian worker (with a dierent mix of age/sector/education). That allows her to estimate per capita income in the two countries,
if each countries had the same physical capital per worker. The estimate is:
[Y =N ]I
[Y =N ]U:S:

Hence,

hI
hU:S:

A(K=N ) hI

A(K=N ) hU:S:

hI
hU:S:

= :38.

= :2.

11

calibrated to obtain the ratio of 1!). However, notice that it was assumed the external benets of human
capital accumulation in the U.S. did not aect productivity in India, hence that there was no knowledge
spillover across borders. If that was the case, the nal result would not hold so strongly12 . The previous
intuition applies, with the eect of human capital on r even stronger.

Miscellaneous: can policy dierences explain the wide disparity

in income levels?

Can policy dierences explain the wide disparity observed in income per capita across countries? To answer
this question, let us consider a simple neoclassical, exogenous growth model. In principle, policy dierences
can dier in a lot of ways. One can think of the relative price of capital goods as reecting distortions arising
from taxes, corruption or other import substitutions. Jones (1995) shows that a high price of investment goods
relative to consumption goods is associated with low growth rates over the postwar period. More generally,
we will introduce policy dierences as dierential tax rates on investment.
Suppose that all countries have access to the same technology given by
Yj = Kj1
The capital accumulation is given by Ij;t = Kj;t+1
with preferences dened by

Cj1
1

(AHj ) :
(1

(16)

) Kj;t . Households maximize their lifetime utility,

. The budget constraint is dierent in each country. In particular,

(1 +

j ) Ij

+ Cj = Ij :

Here, j , which can be interpreted as a tax on investment, varies across countries, for example because of
policies or dierences in institution/property rights enforcement. Notice that 1 + j is also the relative price
of investment goods (relative to consumption goods): one unit of consumption goods can only be transformed
into 1=(1 + j ) units of investment goods.13
Attacking the problem as an equilibrium problem, the solution to the households problem is given by
V (kt ) = max fu (ct ) + V (kt+1 )g
kt+1

s:t: (1 +

j ) [kt+1

(1

) kt ] + ct = wt h + rt kt

The rst order condition is

(1 +
1 2 The

j) u

(ct ) =

[rt+1 + (1 +

j ) (1

)] u0 (ct+1 ) :

human capital accumulation in the U.S. would also increase r in India.

that, implicitly, j Ij is wasted, rather than redistributed to agents in the economy.

1 3 Note

12

Ah
k

Prot maximization by rms imply that r = (1

)
get that
1
ct+1
=
ct
1+

. Using the functional form we have for u (:), we

At+1 h
kt+1

+1

(along the steady state growth path, Ah=k is constant.)

When the growth rate of technological progress gA is set to 0, the above equation gives us that
"

1
k=
1+

1
1+

#1

Ah;

(17)

implying that those distortions negatively aect capital accumulation and, thus, the respective income levels.
However, can simple dierences in policies (as represented by ) be enough to explain wide discrepancies in
income per capita across countries? Continue assuming that gA = 0 for simplicity. From equations (16)-(17),
one can see that the ratio of per capita income between countries i and j is given by
1

Y ( i)
1+
=
Y ( j)
1+

(18)

Taking a value for the capital share of income of 1=3 (i.e. = 2=3). Data suggest that there is a large amount
of variation in the relative price of investment goods: countries with the highest such price have approximately
eight times as high a value as countries with the lowest relative price of investment goods. Using the value
= 2=3, equation (18) implies that the output gap between two such countries should be approximately
1=2
3 ' (8) . Therefore, dierences in capital-output ratio or capital-labor ratios caused by taxes or distortions
cannot account for the large income dierences observed.

Endogenous technological change

With this section, we start a very dierent approach. The two previous chapters were based on some modied
version of the neoclassical model. Here, we look at a model, based on Romer (JPE 1990), where technology
is both input in a production function of a nal good and the output of a research sector. Hence, technology
is endogenously determined.
Technological change is dened as improvement in our ability to use inputs. In this sense, the output of
the research sector is new blueprints on how to use labor and capital to create goods. One fundamental
characteristics of technological change is that, once the costs of creating better ways to produce goods have
been incurred, the technological changes can be repeatedly implemented at no cost.
The distinguishing feature of technology as an input is that it is neither a conventional good nor a public
good; it is a non-rival, partially excludable good. (A good is a rival good if its use by one agent precludes its
use by another; a good is excludable if the owner can prevent others from using it, possibly through the legal
13

system; conventional goods are both rival and excludable; public goods are non-rival and non-excludable).
Technology is non-rival since a blueprint or set of instructions can be used simultaneously by several agents
within a rm, and can be used repeatedly at no extra cost. Because of patents, it is partially excludable,
and hence there is an incentive to incur the costs of creating new technology. Here it is important to see how
technology (the ability to use inputs to produce output) diers from human capital (the e ciency of labor):
technology is a non-rival good, while human capital is a rival good. Since human capital is both a rival and
an excludable good, it can be traded in competitive markets.
Technology, as a non-rival good, can be accumulated without any limit (per capita) and remains forever,
once the costs of creating it have been incurred. The non-rival aspect of technology has very important
consequences on the nature of the market for technology production.
Temporarily assume that there are two sectors: (i) sector A, which produces R&D and (ii) sector B which
uses R&D as one of its inputs. Denote by F (N; R), the production function in sector B, where N are the
non-rival inputs and R the rival inputs, then 8m, F (N; mR) = mF (N; R). To be convinced, think of N as
technology (blueprints) and R as the rival inputs of capital and labor. Then given a certain know-how N ,
output can be doubled by doubling capital and labor. This is because technology does not have to be doubled.
By that argument, F is homogenous of degree 1 in R and hence F (N; R) = RFR (N; R). We will see that
this situation is not compatible with competitive markets. Assume perfectly competitive markets for
now:
- First, if we were to assume that a rm using a non-rival good N as an input, is a price taker in all inputs
and output markets, rents these inputs and pays marginal product to all of them, then this rm could not
survive since then prots would be negative: F (N; R) RFR (N; R) N FN (N; R) < 0.
- Second, in sector A, since the marginal cost of supplying the blueprint to an additional user is zero
(once the discovery has been made), then, in a competitive market, the rental price of the blueprint should
be zero. But, then the rm in sector A would not have engaged in research.
- Hence, it is necessary to move away from the assumption of perfectly competitive markets.
Instead, we need to account for the fact that technology is a non-rival and (partially excludable) input and
only needs to be purchased once. In what will follow soon, because the R&D rm will be able to sell a patent
and assign the right to the technology to a particular rm, it will do so and sell the patent to the highest
bidder. In turn, we will assume that the rm in sector B owning the patent is a monopolist in the production
of its good (whose production requires the patent). That rm will incur the cost of purchasing the patent
once. Because of its monopoly situation, it will be able to sell above marginal cost and recoup its initial
cost. Because rms in sector B have to bid for the patent, the discounted value of the stream of prots will
be equal to the price of the patent (like a free entry condition). Keep all of this in mind. It will justify the
assumption we will make later that intermediate goods producers (who use the blueprints) are monopolists
in the production of their own good.
There are three sectors: A research sector, an intermediate good sector and a nal good sector. We will look

14

at each one in turn. For simplicity, total population and labor supply are assumed constant. Total human
capital is also assumed constant and the proportion allocated to the market is xed.
Research Sector:
Inputs in the research sector are human capital and the existence technology (stock of knowledge). The output
is new knowledge, in the form of new designs for the intermediate good sector. When a new design has been
produced, the R&D rm obtains a patent for its invention. It is assumed that if a researcher with human
capital h has access to the cumulative number of designs invented up to that time A, his rate of production
of new designs is a = hA. Summing across researchers, the aggregate rate of design production is
A = HA A

(19)

where HA is aggregate human capital devoted to the R&D sector.14 Equation (19) assumes that (i) more
human capital in the R&D sector implies higher rate of inventions, (ii) more designs already invented leads to
higher productivity of new designs, (iii) the rate of production of new designs is linear in HA and A. We will
discuss assumption (iii) later in more detail. Notice that the creation of new designs has thus two eects: it
increases productivity in the nal goods sector, but also future productivity in the R&D sector. By holding
a patent, an inventor has property rights over its use in the intermediate goods sector, but not in the R&D
sector.
The R&D rms maximization problem (per unit of time) is
M axPA A
HA

wA HA

This implies that:

wA = PA A
where wA is the wage rate paid per unit of human capital provided in the research sector and PA is the price
of new designs.
Final Goods Sector:
Inputs are labor, human capital and producer durables (the ones that have been invented to this point).
Labor is measured by the number of people working. Human capital reects the accumulation of education
and work experience. The output can be either consumed or saved as new capital (capital is measured in
units of consumption goods). In that sector, the production function is15
F (Hy ; L; x) = Hy L

+1
X

xi1

i=1

1 4 Remark

that if we were assuming that the rate of production of new designs was only a function of human capital, we could
not generate continued growth.
1 5 This implicitly assumes that all types of capital are not perfect substitutes for each other. An additional unit of x has no
i
eect on the marginal productivity of xj .

15

where Hy is the human capital allocated to the nal goods sector, L is labor services and fxi g are the set of
producer durables produced to this point. Because each durable is derived from a new design, for any given t,
there exists A (t) such that xi = 0 for i > A (t). Since the designs last forever, A (t) is an increasing function.
Because F (Hy ; L; x) exhibits constant returns to scale, the nal goods sector can be considered as made of
one single representative price taking rm. The rms maximization problem is
M ax

HY ;L;fxi gA
1

Hy L

A
X

xi1

wH Hy

wL L

i=1

A
X

pi xi

i=1

where pi is price of durable i. The rst order conditions are:

wH

= M PH

wL

= M PL

pi

(1

) xi

( + )

Hy L

(20)

Intermediate Goods Sector:

Inputs are the designs provided by the research sector and forgone output (forgone consumption in order to
accumulate capital). The output is producer durables to be used by the nal goods sector. There is one rm
i for each producer durable xi . That rm purchases the design for its product and converts units of nal
output into one unit of xi 16 . It rents the product it manufactures at a rental rate pi . Since the rm has
a monopoly for its own product, it faces a downward demand curve for its product, and maximizes prots
accordingly. Taking L and Hy as given, the intermediate goods rm producing durable xi knows that the
demand it faces for its product is given by (20). Having already incurred the one time cost of purchasing the
technology, the rms maximization problem is to maximize prots (x). Remember that the cost can be
recovered because of the rms monopoly position.
M ax (x) = p (x) x
x

r x

(21)

where p(x) is dened by (20) and r x represents the costs of producing x units ( x units of nal good needed
to produce 1 unit of x, rented at the interest rate r). The rst order condition for this problem is
2

(1

) Hy L xi

( + )

=r

which implies a price p (from (20)), and a prot :

p

1 6 To

r
1
= px ( + )
=

be precise, the foregone consumption is actually never manufactured. Instead, the resources are used to produce capital

goods.

16

where x is the output determined by the aggregate demand curve.

When awarding the new designs to competing bidders, the price PA will be bid up until it is equal to the
discounted value of future prots attributable to that new design. This is equivalent to a free entry condition
for the intermediate goods producers. Hence
r

= PA

(22)

Preferences:
1
Preferences are assumed to be CRRA in consumption, that is u (c) = c 1 1 . This implies a growth rate of
consumption gc :
r
c
=
(23)
gc =
c
where r is the interest rate and is the rate of time preference. This can be quickly veried. Consider that
households choose a stream of consumptions fc (t)g. Suppose that at date t, households reduce consumption
by a small amount dc that they save and instead increase consumption at date t + dt (using the incremental
investment made at date t). The marginal impact on lifetime utility must be zero, since households are assumed
to maximize lifetime utility. The utility loss at t is e t u0 (c (t)) dc = e t c (t) dc. Consumption at date
t + dt is increased by erdt dc. The marginal utility of consumption at t + dt is c (t + dt)
= c (t) egc dt
.
t
(t+dt) rdt
gc dt
t
Hence, we must have that e c (t) dc = e
e dc c (t) e
. Eliminating e c (t) dc on each
side, we have that gc = r .
Equilibrium:
An equilibrium is a path for prices and quantities, such that:
- consumers make consumption and savings decisions, taking interest rates as given,
- workers allocate their human capital in the dierent sectors, taking A, PA , and wH as given,
- nal goods producers choose labor, human capital, and durables taking prices as given,
- intermediate goods producers set prices to maximize prots, taking interest rates and the downward
sloping demand curve it faces as given,
- rms trying to enter a new durable good sector take PA as given,
- R&D rms sell their new designs to the highest bidder,
- markets clear.
Solving for equilibrium:
Use (20) to establish that
xi = x; 81

Because it takes x units of forgone consumption to produce x units of a durable, K =

A
P

xi and because

i=1

of symmetry
K = Ax

17

(24)

and therefore
F (Hy ; L; x) = Hy L Ax1

(AHY ) (AL) K 1

(25)

That implicit production function is CRS in (AHY ), (AL) and K. This is equivalent to labor and human
capital augmenting technological progress. As A increases, K, (AHY ), and (AL) will grow at the same rate,
ensuring sustained growth. This is to be compared with the standard result from the Solow model that,
because of diminishing returns to physical capital (and a constant labor force), growth rates are eventually
nil, without some exogenous technological progress. Hence, here we have endogenizedtechnological progress
(it is a result of R&D activity), and with A as an impliedinput in the production function. we do not have
the problems due to diminishing marginal returns to physical capital.
Hence, the number of intermediate goods increases (more diversity in intermediate goods) and Y (composite output) grows at rate gA .
Calculating growth rates in this economy:
We are looking for an equilibrium where A, K, C and Y grow at a constant rate. For the same kind of reasons
as in Chapter 1, K and A will grow at the same rate along the balance growth path, and so does Y (A is
labor augmenting in the bounded inputs and the implicit production function is CRS). If this is the case,
the economy is said to be on its balanced growth path.
a) For gA to be constant, HA and therefore HY must remain constant, since gA = HA .
b) With K and A growing at the same rate, x is constant.
c) The wage to human capital in the nal good sector grows with A (wH = Hy 1 L Ax1
wage to human capital in the R&D sector grows with A, if PA is constant (wA = PA A).
d) Hence, Hy and HA are constant if PA is constant.
e) PA = r is constant since p, x and r are constant (r is constant since gc = r ).

), while the

From (22), we know that:

+
=
(1
) Hy L x1
r
r
It must also be the case that wages paid to human capital in the research and the nal goods sectors are
equal, otherwise either HY or HA would be equal to zero. Hence:
PA =

wA = PA A = wH = Hy

L Ax1

Given the expression for PA above:

HY
HA

( + ) (1
= H HY

18

(26)
(27)

Since L, HY are constant, (25) shows that Y grows at the same rate as A. The capital accumulation condition
Y = C + K implies that17
C
=1
Y

KK
KY

Hence C and Y grow at the same rate. As (19) implies that

A
A

= HA , we have that:

g = gc = gy = gk = gA = HA
Given the expression for HA above,
g= H
Denote

( + )(1

by . Since g = gc =

( + ) (1

, r can be calculated and:

g=

H
1+

Note that g does not depend on L. This is because an increase in L increases the returns to human capital
in both research and manufacturing sectors (as the author outlines, however, this is not robust to a change
in the functional forms).
Notice that when computing equilibrium values for HA and HY , we should take into account the constraint
that HA > 0. For (26) and (27) to hold, one needs that H > r= . If H < r= , HA = 0 and g = 0. For
strictly positive growth, one needs H > = . Hence, we get the enclosed graph plotting g and HA against
H.
This shows that contrary to an increase in L, an increase in H has a (positive) eect on g. Figure 1 also
shows that if there is not enough total human capital in an economy, that economy may stay trapped at a
zero growth rate.
Highlighting some important assumptions:
(a) The R&D sector is the engine of growth. It is therefore important to notice that the current stock of
knowledge aects both current and future productivity in that sector. More on that point below.
(b) The introduction of new intermediary goods does not aect the marginal product of existing intermediary
goods.
(c) The introduction of new intermediary goods allows the economy to grow forever even though each intermediary good taken separately is subject to diminishing marginal returns.
(d) It is important to notice that the non-reproducible input (labor) is not required in the R&D sector
production function.
1 7 This

implicitly assumes no depreciation for the capital. However, with depreciation at rate

C + K + K. We would still have that C and Y must grow at the same rate.

19

, then we have that Y =

g; HA
6

Figure 1: g = HA as a function of H;

=1

Related contributions:
These endogenous growth models have started a new line of literature. An interesting contribution is by
Jones (JPE 1995). The author starts by noticing that Romer (and othersmodels as well) nd a scale eect,
that is that growth rates increase when the human capital allocated to R&D increases. Jones argues that
this is not empirically veried. For example, the number of scientists in most developed have increased a lot,
but average growth rates have been constant at best. He suggests a model where growth rates depend on
the growth rate of invention, but not on the level of human capital devoted to R&D. Remember that Romer
assumes the rate at which designs are invented follows:
A =
gA

HA A or

HA

Jonesmain contribution is to alter this law of motion of technology, while keeping the rest of Romers model
untouched. In particular, the discovery of new ideas is assumed to depend on the number of people in the
R&D sector LA , and the rate at which these scientists discover new ideas . That is18 :
A=

LA

For a given number of scientists in the economy, one would expect to depend on the amount of knowledge
already created A. Hence, it is assumed that
= A . No restriction is taken on (notice that Romer
1 8 Remark that Jones does not make a dierence between labor and human capital, the way Romer does. However, this does
not really aects the argument.

20

xes it at = 1). Rather, > 0 if there are positive spillovers. That is, the work done by predecessors
make current researchers more productive. Or as Einstein said, I have been able to achieve what I did,
because I was standing on the shoulders of giants(or something to that eect ...). Alternatively, < 0 if one
assumes that there is some xed number of inventions, and therefore the probability of discovering a new idea
decreases with the stock of knowledge19 (this is reminiscent of the idea of shing out, where ones shing
in a pond with limited number of sh decreases everyone elses likelihood of catching sh, hence imposing
a negative externality). These two eects are externalities across time. Also consider the possible waste of
research eort due to the fact that two scientists may nd an invention at the same time. This would reduce
the total number of new inventions at a particular point in time, so that LA ; 0 <
1 rather than LA enters
the equation (this is referred to as a duplication externality, or stepping on toes eect). Hence
a = lA A LA

where lA is the individuals allocation of time to the R&D sector, and a the individuals output. In equilibrium,
of course, we must have that lA = LA , so that, on aggregate:
A = LA A

(28)

One can see that, in this framework, Romers model is a very specic case ( = 1;
be assumed to be strictly less than one.

= 1). In the rest,

will

With no such specic restrictions on and , one can derive steady state growth, even in the presence of a
growing labor force. Equation (28) implies that:
g = gA =

LA
A1

By dierentiating, one obtains:

g=

n
(1

(29)

where n is the growth rate of the labor force (along the steady state growth path, labor is allocated in xed
proportion between R&D and production).
The results from Romer and Jones can be compared along a few lines. First, in Jones, the level of resources
allocated to R&D does not aect growth, whereas with Romer it does (which is counterfactual as noticed).
Second, in Jones, population growth (n) induces growth in per capita variables, which a lot of economists
take as counterfactual.

Production technology and growth

In this section, we are focusing on the nature of the production technology to explain some patterns observed
across countries. In particular, we will see that a production function with a high degree of complementarity
1 9 Maybe

that is why the average duration of a Ph.D. seems to be increasing !

21

between all the tasks necessary to produce the nal output helps explain large income dierences between
countries, smaller rms in poor countries and other observations. The analysis is based on Kremer (1993).
The production of a good generally requires several steps or tasks that are typically performed by dierent
individuals. The value of the nal good being produced depends on how successful each task was performed.
When workers are heterogeneous with respect to their skills, the rm is confronted with the decision of having
to choose the skill level of the workers it employs. Hiring higher skill workers on average increases the value
of nal output, but these workers, presumably, are also paid higher wages. Hence, we can see that the nature
of the production technology has the potential to aect the assignment of workers to tasks.
The production of one unit of good consists of n tasks. Every task needs one person only devoted to this
particular task. Hence one high skill worker cannot be substituted for several low skill workers. It is assumed
that each task in the production process must be successfully completed for the nal product to have its
maximum value. Here, skill q is dened as the probability that the task will be successfully completed (hence,
it is a number between 0 and 1), or equivalently, the expected percentage of maximum value the nal good
retains if the worker performs the task. Since the probability of making a mistake is independent across tasks,
the production function is dened as:
!
n
Y
E(y) = k
qi nB
i=1

where k is capital, and B is a normalizing constant (output per worker with a single unit of capital, when all
tasks are performed perfectly, qi = 1; 8i = 1:::n).
Suppose that there is a xed supply of capital k and a given distribution of skill in the labor force (q).
Assume that leisure does not enter workers utility and that they supply labor inelastically. We look for a
competitive equilibrium, that is an allocation of workers to rms, a wage schedule w (q), and a rental rate of
capital r, such that rms maximize prots and all markets clear. In this case, the workersdecision problem
is trivial since they supply labor inelastically. The markets in consideration are the market for capital and
the market for workers of each skill level. Since rms are risk neutral, we can replace E (y) by y and obtain
the rms maximization problem20 :
!
n
n
Y
X
M ax
k
qi nB
w (qi ) rk
(30)
n
k;fqi gi=1

i=1

i=1

Firms have to choose capital and a skill level for the ith task, so as to maximize prots, given market prices.
2 0 The wage schedule is taken as given, but rms can still perform marginal analysis and look at how output and the wage bill
increase when the required skill level is increased at a particular task.

22

The n + 1 rst order conditions are:

0
k @

n
Y

j=1;j6=i

qj A nB
n
Y

qi

i=1

w0 (qi )

nB

0; 8i = 1:::n

Note that the inputs in that production function are complementary, since:

dqi d

d2 y
Q

>0

j6=i qj

Hence, the derivative of the marginal product of the ith worker with respect to the skill of all other workers
is strictly positive. That is the (marginal) product of one worker is positively related with the skill levels of
ALL other workers. Hence, rms with high skill workers in the n 1 rst tasks prefer a high skill worker in
the nth task, since the marginal product of all the rst n 1 workers depends positively on the skill of that
last worker. It is in that sense that skill levels are very complementary in the production function.
In fact, equilibria can be restricted to the case where all workers in a rm have the same skill level q. Indeed,
using the rst order conditions for the ith and the jth tasks, one gets:
Y
nBk
ql = w0 (qi )
l6=i

nBk

qm

= w0 (qj )

m6=j

By taking the ratio of these two expressions, one obtains that:

qj
w0 (qi )
; 8 (i; j) 2 f1:::ng
= 0
qi
w (qj )
Hence:
qi w0 (qi ) = qj w0 (qj ) , 8 (i; j) 2 f1:::ng
It will be checked later that qw0 (q) is strictly monotonic. Consequently, qi = qj = q, 8 (i; j) 2 f1:::ng.
The rst order conditions become:
k qn
k

nB

1 n

q nB

= w0 (q)
= r

This implies that:

k=

q n nB
r
23

1
1

(31)

This is the demand for capital of the individual rm hiring at skill level q, as a function of rental price r.
Rewriting the individual rms production function equation y = k q n nB as q n nB = ky and the rst order
condition for capital k 1 q n nB = r as q n nB = k r 1 , one gets that ky = k r 1 , or
rk = y

(32)

This implies that a proportion of output goes to the payment of capital. Of course, this is true at the
individual rm level, and on aggregate.
In equilibrium, the market for capital clears, or
k =

Z1

q n nB
r

1
1

1
d (q)
n

(33)

The density of rms hiring qworkers is n1 times the density of such workers. This is the sum of individual
demands. One can get r from there. (remember that k is individual capital, while k is aggregate capital.)
The rst order condition on q, k q n

nB = w0 (q), can be rewritten as

nB
r

w0 (q) =
Integrating, one gets
w (q) = (1

h ni1
r

nBq 1

B1

q1

q n nB
r

i1

qn

nB = w0 (q) or:
(34)

+c

(35)

Using the rst order condition on capital, rn 1 = k (q n B) 1 , this wage schedule implies that the total
wage bill, nw (q) = n (1
) k Bq n + nc = (1
) y + nc. Therefore, total prots are equal to y (1
)y
nc
y = nc. Prots cannot be negative, hence c = 0. Since rms make zero prot in equilibrium, rms
are indierent as to the skill level of their employees, as long as they are of homogenous skill. Since c = 0, we
have that:
h ni1
1
n
w (q) = (1
)
B1 q1
(36)
r
Thus, we have what we were looking for: an expression for the wage that only depends on q (and model
parameters) and an expression for r that only depends on model parameters.
It is important to understand what we just did in order to derive the wage schedule w (q). First, of course,
w (q) must be dened for all values of q. So, taking w (q) and r as given, rms choose q and k to satisfy the two
rst order conditions. Then, knowing how k is related to q and r (equation (31)), we can get a relationship,
at all levels of q between w0 (q), q and r (which is given and has been previously calculated in equation (33)).
We can then integrate for w (q) and get (35). By integrating, we nd the functional form for w (q) that allows
rms to possibly satisfy their rst order condition for any q.
24

Applications:
This production technology may help explain some empirical facts observed across countries.
a) Income and productivity dierentials.
There are enormous income per capita dierentials between the poorest and the richest countries in the world.
Lucas (1990) suggests a few explanations, primarily including human capital in the production function (with
or without externalities). Hence, dierent levels in human capital across countries may account for some of
the great variability in income observed.
With the production technology used in this paper however, small dierences in skill distribution result in
large dierence in wages or incomes. This is because the production function exhibits a high degree of
complementarity in its inputs, the workersskills. Indeed, one can see from (35) that w (q) is strictly convex
in q. Therefore a small increase in q results in a large increase in w (q). It is interesting to also notice that
the derivative of the marginal product of capital with respect to the skill of all workers is strictly positive,
d2 y
Q
>0
dkd ( i qi )

and hence, that capital and skills are complementarity inputs in the production technology. Therefore more
capital will be used with higher skill workers, explaining why ows of capital from rich to poor countries are
relatively limited: higher skill workers are less likely to waste the rental value of capital.
b) Firms hire workers of dierent skill levels and produce goods of dierent quality.
Within a given industry, there are rms producing high quality goods with skilled workers and rms that
produce low quality goods with unskilled workers. However, both types of rms can survive (prots are zero,
for all q). This is can also be observed across economies, where some countries tend to specialize in high
quality goods while others specialize in low quality goods.
c) There is a positive correlation among the wages of workers in dierent occupations within rms.
This is because the equilibrium allocation of skills is that rms hire workers of homogenous skills. Simply
put, high-q secretaries work with high-q lawyers and bankers.
d) For a given symmetric distribution of skill q, the distribution of income w is skewed to the right and the
distribution of log income Logw is distributed symmetrically. This is what is observed empirically.
w (q) is strictly increasing and convex in q. For the sake of argument, assume that q is uniformly distributed.
Denote the mean and the median of the skill distribution by E (q) and M D (q) respectively. Because of
the uniform distribution, we have that E (q) = M D (q) . Since w (q) is strictly monotonic, M D (w (q)) =

25

w (M D (q)). By Jensens inequality and the strict convexity of w (q), E (w (q))

M D (w (q)). Hence, the distribution of income is skewed to the right.

w (E (q)) = w (M D (q)) =

The distribution of Logw is symmetric, because so is the distribution of Logq (Logw (q) =

n
1

Logq+constant).

Endogenizing the choice of technology:

Consider that rms have the choice of how complex a production technology they can choose to implement,
as well as what kind of workers they can hire. In particular, a complex technology is one with a high n, i.e.
with multiple tasks, and hence more possibilities to commit mistakes. For simplicity, capital is not necessary
for production and all tasks require the same amount of labor. The production function is given by:
!
n
Y
y=
qi nB (n)
i=1

where n is the number of tasks to be performed to complete the production process and B (n) is the value
of output per task if all tasks are performed correctly. It is assumed that increasing the complexity of the
technology increases the value of nal output, if all tasks are performed correctly, but that these benets
diminish as technology become more and more complex. In other words,
B 0 (n) > 0
B 00 (n) < 0
Hence, the rmsmaximization problem is, taking w (q) as given:
!
n
n
X
Y
w (qi )
qi nB (n)
M ax
n;fqi g

i=1

i=1

Again, equilibria can be restricted to cases where the qi s are all equal. So, the rms problem becomes
M axq n nB (n)

nw (q)

n;q

The rst order conditions are

nq n
n

B (n)
0

(Logq) q nB (n) + q B (n) + q nB (n)

w0 (q)

w (q)

The rst order condition on q implies that w (q) = q n B (n) + c. To ensure non-negative prots, c must be
equal to 0. Thus,
w (q) = q n B (n)
The rst order condition on n can be simplied as
(Logq) B (n) + B 0 (n) = 0
26

This implies that:

Logq =

B 0 (n)
B (n)

(37)

Equation (37) implicitly denes n as a function of q. The left-hand side increases with q, while the righthand side increases in n. As a result, the implicitly dened n is an increasing function of q. Therefore rms
choosing a complex production technology (high n) will also choose highly skilled workers (high q). Because
mistakes are more costly with a highly sophisticated technology, rms prefer to hire workers who are expected
to commit fewer mistakes.
Applications:
Even though we are not fully solving for the equilibrium in this case, we can still make use of what was just
established.
e) Rich countries specialize in complicated products and rms are larger in rich countries.
Rich countries, with high skilled workers, specialize in complex products, i.e. with high n.
f) Within a single country, there is a positive correlation between wage and rm size.

27

Chapter III
SOME LABOR MARKET MODELS

Some refinements of the standard RBC model applied to the

labor market

As we saw, RBC theory is fundamentally a methodology for the study of business cycles. You may also
remember that the basic RBC model does not perform very well for the labor market. The point of this
chapter is to modify the structure of the basic model, in order to replicate some characteristics that are
peculiar to the labor market.
In particular, we want to improve the basic RBC model along the following lines:
(i) the labor input in the U.S. economy fluctuates roughly twice as much as it does in the model,
(ii) hours of work and productivity basically show zero correlation in reality, but they tend to move together
in the artificial economy,
(iii) total hours worked fluctuate more than productivity in the U.S.
These points are illustrated in the table below:
TABLE 1
U.S. time series
Standard model

1.1

h / y
.78
.49

h /prod
1.37
.94

corr (h, prod)

.07
.93

What seems to be the problem ?

One problem with the basic RBC model is that it relies on only one type of shock to generate fluctuations. It is
therefore not too surprising that, in general, variables would tend to be highly correlated. In the case of hours
of work and productivity, for example, a positive technology shock increasing productivity would also increase
hours, as wages would also increase (remember that in the neoclassical framework, average productivity is


equal to hy = z hk and marginal productivity or wage is equal to (1 ) z hk ).

The fact that hours vary more than productivity in the U.S. means that the implied short run labor supply
elasticity is relatively high. In other words, in the model, households are not suciently willing to substitute
leisure across periods, in response to a given shock. The first two adjustments to the model considered will
therefore attempt to generate higher response of hours to a given shock.

The fact that hours and productivity are too highly positively correlated in the model is due to the fact that
fluctuations are driven by a single shock. Think of a positive technology shock as a shift of labor demand with
no alteration to labor supply. It is then not surprising to find that real wage and hours are highly correlated.
Hence, the last two adjustments to the model will introduce additional shocks to the model.
2

But first, let us quickly consider the baseline model, from which we will consider the various adjustments.

1.2

Baseline model

Agents:
Homogenous households
Firms
Preferences:
Defined over consumption and leisure: u (c, l) = Log (c) + ALog (l) = Log (c) + ALog (1 h)
Discounting at rate
Endowments:
Unit endowment of leisure (lt ) and work hours (ht ) every period. Hence, ht + lt = 1.
Households start every period with their capital kt .
Technology:
yt = ezt f (ht , kt ) = ezt h1
kt , where zt is a technology shock observed by agents at the beginning of the
t
period, before decisions are to be taken.
The shocks zt follow a random process: zt+1 = zt + t .
Skipping a few steps along the way, and solving the problem as a social planner problem (the problem does
not have distortions), we have the following maximization problem:
M ax

{ct },{ht }

+
X
t=0

t u (ct , 1 ht )

s.t. ct + kt+1 (1 ) kt = ezt ht1 kt

Using standard dynamic programming techniques, it is possible to get decision rules ct = ct (zt , kt ) and
ht = ht (zt , kt ), and from there, all the values of interest (it ...). One can then simulate the model for a
high number of periods, do so a number of times, average the statistics over the number of simulations and
generate the statistics of interest. The results are provided in table 1 above (with the same statistics for the
dierent variants).

1.3

First adjustment: non-separable leisure

Consider that the utility from leisure does not only depend on leisure this period, but also on past leisure.
More precisely, it depends on a weighted average of past leisure. In this case, leisure in one period is a good
substitute for leisure in nearby periods. Hence, the agent may be more willing to reduce leisure (that is
increase hours of work) when the technology shock is high, if he derives utility not only from leisure this
period, but also from past periods. With this type of utility functions, it is possible to reduce leisure a lot
more in a good period, since the marginal utility of leisure at very low values of leisure is not necessarily
infinite anymore. In particular, assume the following utility function:
+
!
X
Log (ct ) + ALogLt = Log (ct ) + ALog
ai lti
i=0

where

+
X

ai

= 1

i=0

and ai+1

= (1 ) ai , i 1

0 < <1

This implies, of course, that ai = (1 )i1 a1 , for i 1. Remark that the number of free parameters in the
utility function is actually limited to two ( and a0 ). Noticing that a0 + a1 = 1, one can rewrite Lt as:
Lt

= a0 (1 ht ) + a1
= a0 (1 ht ) +

+
X
i=1

Bt =

+
X
i=1

(1 hti )

+
X
a1
i1
(1 )
hti
a1

i=1

= 1 a0 ht (1 a0 )

Define Bt as

i1

(1 )

+
X
i=1

(1 )i1 hti

(1 )i1 hti

This new variable Bt should be viewed as the contribution of past leisure to Lt . With a simple manipulation,
it can be shown that:
Bt+1 = (1 ) Bt + ht

Thus we have that:

Lt
Bt+1

= 1 a0 ht (1 a0 ) Bt
= (1 ) Bt + ht

The problem then becomes:

M axE

{kt+1 },{ht }

(+
X
t=0

[Log (ct ) + ALog (1 a0 ht (1 a0 ) Bt )]

s.t. ct + kt+1 (1 ) kt = ezt ht1 kt

Bt+1 = (1 ) Bt + ht 1
zt+1 = zt + t
This problem can be solved using standard dynamic programing (notice that Bt is a state variable)2 . As
the focus is on assessing whether the adjustment considered improves the standard model along the lines
mentioned, we look at the table provided below.
TABLE 2
U.S. time series

h /y
.78

h / prod
1.37

corr (h, prod)

.07

Standard model

.49

.94

.93

Non-separable utility
Indivisible leisure
Government shocks
Home production

.65
.76
.55
.75

1.63
2.63
.90
1.92

.80
.76
.49
.49

It looks like considering non-separable utility improves the standard model. As expected, hours are more
volatile because agents are more willing to substitute leisure across time.
1 It

is a law of motion for the state variable Bt .

time goes back indefinitely, there is no such thing for which Bt would not be properly defined. To solve, assume that
you start at Bt = B0 (for some t = 0). B0 is a given parameter of the problem, and you can solve the problem using dynamic
programming. You thus get decision rules and find a steady state that is independent of B0 . In fact, when you simulate, you
would use approximation around a steady state (see Cooley, ch. 2).
2 Since

1.4

Second adjustment: indivisible labor

In addition to the facts already mentioned, it is observed that most fluctuations in aggregate hours worked is
due to fluctuations in the number employed rather than in fluctuations in hours per employed worker. The
second adjustment attempts to also address this issue. The treatment is based on Hansen (JME 1985).
A non-convexity is introduced in the model: workers can either work zero hours or a constant number of
hours e
h. This non-convexity is taken as given. In practice, it may arise from the costs of going to work or
from the fact that individuals need warm up time every day before becoming fully productive. This is not
specified here. The important point is that the choice of hours is discrete.
As illustrated in Rogerson (JME 1988), the competitive equilibrium in an economy with non-convex choice
sets (because of indivisible labor), may involve dierent agents choosing dierent allocations of consumption
and hours of work (as long as agents are indierent between the two bundles). Also, there are allocations
involving lotteries over employment that dominate the competitive equilibrium allocation3 (such allocation
would be of the type every agents consume c and work with some probability [0, 1] and would dominate
the equilibrium allocation where a fraction of agents consume c1 and work e
h and the rest consume c2 and
work zero hours). Hence, realizing the optimal allocation in these economies involves such lotteries to decide
which agents do work and which agents do not work. You may think of these lotteries as convexifying the
choice set in the problem. This may look very dierent from the choice sets you are used to. The next
paragraph explains in more detail how these lotteries function.
Every period, a lottery is held determining which agents work or do not work. Agents are only paid if they
do work. Also assume that agents can buy unemployment insurance in case they do not work. Here is
how the economy works each period. First, the technology shock zt is realized. Then, households choose
a probability t of working, rather than hours of work, in the form of a contract with the firm. They
may also purchase privately provided unemployment compensation yt at a price p (t ) and they decide on
consumption cst and investment ist , contingent on whether the household works or not (s = 1 indicating that
the household is working and s = 2 indicating that it is not). [Notice that it does not make sense to choose
c and i, independently of the outcome of the lottery. In fact, agents choose c and i after realization of the
lottery and after insurance payments. But when you choose , you are aware that you will have to make that
contingent choice.]. Their problem is the following (it is very convenient to denote next period value by a
prime):

3 Assuming

that agents are expected utility maximizers.

o
V (k, K, z) = M ax u c1 , 1 e
h + E [V (k10 , K 0 , z 0 )] + (1 ) {u (c2 , 1) + E [V (k20 , K 0 , z 0 )]}
,y,cs ,is

s.t. c1 + i1 = w (K, z) e
h + r (K, z) k p () y
c2 + i2 = y + r (K, z) k p () y
ks0 = (1 ) k + is , s = 1, 2

The insurance company maximizes expected profits p () y (1 ) y. Suppose that competition in the
insurance industry forces profits to zero. Then, p () = (1 ). In that case, the insurance is actuarially fair.
The problem can be rewritten as:
n

o
V (k, K, z) =
M ax 0 u w (K, z) e
h + r (K, z) k (1 ) y k10 + (1 ) k, 1 e
h + E [V (k10 , K 0 , z 0 )]
,y,cs ,ks

+ (1 ) {u (y + r (K, z) k (1 ) y k20 + (1 ) k, 1) + E [V (k20 , K 0 , z 0 )]}

The first order conditions with regards to ks0 and y are:

h
= E [V1 (k10 , K 0 , z 0 )]
u1 c1 , 1 e
u (c , 1) = E [V1 (k20 , K 0 , z 0 )]
1 2
u1 c1 , 1 e
h
= u1 (c2 , 1)

We assumed preferences that are additively separable in consumption and leisure (as well as strictly concave).
Notice that this drastically simplifies the problem. However, this is equivalent to assuming a constant relative
risk aversion coecient of 1, which is in the range of estimates for that coecient. Hence:
c1 = c2
In turn, this implies that:
k10

= k20

i1

= i2

The first line is obtained from combining the first two first order conditions above, and the second line is
0
due to the fact that is = ks (1 ) k. This means that the two budget constraints are the same. Hence,
y = w (K, z) e
h

We have the usual result that the insurance is actuarially fair and agents are fully insured. All agents facing
the same problem implies that k = K (everybody has same capital holdings, which was not obvious from the

start, since agents have dierent stochastic employment histories). In summary, the agents problem can be
greatly simplified as:
o
n

0
0 0
e
V (k, K, z) = M ax
,
K
,
z
)]
u
c,
1

h
+
(1

)
u
(c,
1)
+
E
[V
(k
0
,k

Since the utility function is (Log-Log) additively separable, it can be further simplified as:

o
n
V (kt , Kt , zt ) = M ax Log (ct ) + t ALog 1 e
h + E [V (kt+1 , Kt+1 , zt+1 )]
t ,kt+1

s.t. ct + kt+1 (1 ) kt = w (Kt , zt ) t e

h + r (Kt , zt ) kt

The new budget constraint reads as if agents were paid according to expected hours. This gives us two first
order conditions:

1
w (Kt , zt ) e
h + ALog 1 e
h
= 0
c

t
1
1
(r (Kt+1 , zt+1 ) + 1 )
=
E
ct+1
ct
Notice that the main result in the end, for our purpose, is that the problem has been reduced to a usual
representative agent problem with the following utility function:

Log (c) + ALog 1 e

h

Of course, the agent now chooses kt+1 and t , rather than kt+1 and ht .4
Notice that the probability t is given by:5
t

where, ht

ht
e
h
per-capita hours

Hence, the utility function in the problem is of the following form (up to a constant term):

where B

Log (ct ) Bht

ALog 1 e
h
>0
=
e
h

e K and
firms problem is standard. Simply, firm optimization and market clearing imply that: w (z, K) = f1 H,

e K .
r (z, K) = f2 H,
4 The

5 When

looking at data, t is to be interpreted as

ht
e .
h

It is linear in leisure. Hence, even though we have the usual utility function for the households, the problem
can be made into a problem with a representative agent that has a utility function that is linear in leisure. You
may remember that the problem with the standard model was that households were not suciently willing
to substitute leisure across periods. With a utility that is not concave in leisure anymore, the representative
agent is not attempting to smooth out his intertemporal pattern of leisure and this may result in more
substitution of leisure across periods in response to a given technology shock. This can be verified in table
2. h / y in the indivisible labor economy is almost the same as in the data. In fact, one could argue that
this adjustment has generated too much volatility of hours, when looking at h / prod which is much higher
than in the U.S. However, if one also allowed for adjustments along the number of hours per worker, this
may reduce the volatility. Finally, corr (h, prod) is still too high. Actually, indivisible labor was not trying to
improve the standard model along that particular line. For that, one needs to add a new type of shock. This
is the object of the next two paragraphs.

1.5

Third adjustment: an economy with government spending shocks

Assume that there is a government and that government expenditures gt are financed through non-distortionary
lump-sum taxation Tt . Assume the following functional form for the random shock to government spending:
Log (gt+1 ) = (1 ) Log (g) + Log (gt ) + t

t N 0, 2
t

zt

The value of reflects how persistent ( = 1) or temporary ( = 0) these shocks are expected to be6 .
Temporary shocks have a smaller wealth eect (the average of ygtt is used to get g). The government shocks
are supposed to be independent of the technology shocks. The utility function is still given by:
u (c, l) = Log (c) + ALog (1 h)
which implies that g does not enter the utility function. Other functional forms could have been chosen, that
would have included g 7 . With this assumption, the government expenditures are just a drain on resources,
since they do not provide any utility to the households, but rather reduce their budget available to allocate
between consumption and investment8 . This is equivalent to a wealth eect, and tends to reduce leisure and,
6 If = 1, Lng

t+1 = Lngt + t . Hence gt+1 = gt e t and E [gt+1 |gt ] = gt E [e t ], hence the persistence of shocks. If = 0,
Lngt+1 = Lng + t , and gt+1 = get and E [gt+1 |gt ] = gE [et ], hence the temporary nature of shocks.
7 For example, u (c, l) = Log (C) + ALog (l), where: (i) C = c + g (c and g are perfect substitutes) or (ii) C =
1

c + (1 ) g .
8 If, instead, private consumption c and g were perfect substitutes, households would clearly derive the same utility than if
there was no government expenditure. They would just reduce c by the amount of government expenditures g. Consider the
following: Problem A [u = u (c + g, 1 h) and g > 0] and Problem B [ u = u (c, 1 h) and g = 0].

hence, increase labor. Remember that there is a second source of uncertainty in the economy: the uncorrelated
technology shock. This shock will aect both productivity and hours of work. Since hours of work are also
aected by the government shock, it is possible that productivity and labor may exhibit low correlation, if
the eect of the two shocks work in opposite directions on the labor hours.
The maximization problem is the following:
M axE

"+
X
t=0

u (ct , 1 ht )

kt
s.t. ct + kt+1 (1 ) kt + gt = ezt h1
t
gt = Tt
zt+1 = zt + t
Log (gt+1 ) = (1 ) Log (g) + Log (gt ) + t
Remark that if we had set this up as a competitive equilibrium problem (even though there are no distortions),
we would have had the following problem to solve. Denote the random shocks by xt = (zt , gt ):
V (kt , Kt , xt ) = M ax {u (ct , 1 ht ) + E [V (kt+1 , Kt+1 , xt+1 )]}
kt+1 ,ht

wt (Kt , xt ) ht + rt (Kt , xt ) kt = ct + it + Tt
zt+1 = zt + t
Problem A:
Max {u (c + g, 1 h) + E [V (kt+1 , Kt+1 , xt+1 )]}
h,k0

s.t. wh + rk = c + k0 (1 ) k + T
and g = T (gvt budget constraint)
The FOCs are:
u1 (c + g, 1 h) = E [(r0 + 1 ) u1 (c0 + g 0 , 1 h0 )]
wu1 (c + g, 1 h) = u2 (c + g, 1 h)
Problem B:
Max {u (c, 1 h) + E [V (kt+1 , Kt+1 , xt+1 )]}
h,k0

s.t. wh + rk = c + k0 (1 ) k
The FOCs are:
u1 (c, 1 h) = E [(r0 + 1 ) u1 (c0 , 1 h0 )]
wu1 (c, 1 h) = u2 (c, 1 h)
Looking at the various FOCs, one can check that [c + g]A = cB or cA = cB g. If c and g are perfect substitutes, g substitutes
for some consumption. The agents would not mind the government expenditures.

10

Log (gt+1 ) = (1 ) Log (g) + Log (gt ) + t

Given the first order conditions for the firm,

wt (Kt , xt ) = (1 ) ezt h
t kt

rt (Kt , xt ) = ezt h1
kt1
t

the two maximization problems are equivalent.

Intuitively, the shock to government expenditures can be seen as aecting labor supply, while the shock to
technology can be seen as aecting labor demand. The first one would tend to produce a negative relationship
between hours and productivity, while the second one would tend to produce the opposite. Hence, there is
a potential for the two shocks together to produce low correlation between hours of work and productivity,
as illustrated in the figures below. Of course, this can be resolved by calibrating and simulating the model.
The results from table 2 show that, indeed, the correlation between hours and productivity decreased, once
we introduced government expenditures shocks. It is still a little too high, but constitutes an improvement.
It did not improve the volatility of hours (but was not really expected to do so)

11

Real Wage 6

Labor Supply

@
@

@Labor Demand

@
@
@

Corr(Prod,Hrs) < 0

Labor
Figure 1: Eect of a positive government shock

Real Wage 6

Corr(Prod,Hrs) > 0

@
@

Labor Supply

@
@
@

@
@

@
@
@
@

@Labor Demand
-

@
@
@

Labor
Figure 2: Eect of a positive technology shock

12

1.6

Fourth adjustment: Home production

Home production is essentially defined as any activity out of discretionary time, that is not included in market
production (i.e. production with a firm) and leisure. This would include activities such as maintaining the
household, taking care of children, home improvements, etc. Studies report that:
- a typical married couple spends 25% of discretionary time to home production and 33% to paid activities
(market production).
- in the postwar period, investment in household capital (consumer durables and residential structures), exceed
investment in market capital (producer durables and non residential structures) by 15%.
- Estimates of output from home production range from 20% to 50% of measured (market) GNP.
All these facts should convince you of the importance to include home production in our basic RBC model.
In addition, it may help us address some of the issues we mentioned at the beginning. Since home production
is likely to be aected by dierent shocks than the market production, this allows us to have a second type
of shocks in the economy.
Agents have preferences over consumption and leisure defined by u (c, l) = Log (c) + ALog (l). However, the
consumption good is now a composite of the market produced and the home produced output:
1

ct = [aceMt + (1 a) ceHt ] e
where cMt is consumption of the market produced good and cHt is the consumption of the home produced
good. This functional form implies an elasticity of substitution of 1/ (1 e) between the two goods. The unit
time endowment has to be allocated between three activities: leisure, production in the market sector and
production in the home sector:9
lt + hMt + hHt = 1
The technology is characterized by a market good production function and a home good production function.
Because the capital used in production has to be allocated between the two sectors, we have that:
kt = kMt + kHt
The production functions are defined by:

9 Since

yMt

= f (zMt , kMt , hMt ) = ezMt kMt

h1
Mt

yHt

= g (zHt , kHt , hHt ) = ezHt kHt

h1
Ht

lt + hM t + hHt = 1, the two types of work are perfect substitutes.

13

where:
zM,t+1

= zMt + M t

zH,t+1

= zHt + Ht

N 0, 2M

N 0, 2H

Mt
Ht

= corr (Mt , Ht )

Output has to divided between consumption and investment. The latter is defined as usual:
it = kt+1 (1 ) kt
Since the composite consumption good is a function of cMt and cHt , it is necessary to define each term:
cMt + it

= f (zMt , kMt , hMt )

cHt

= g (zHt , kHt , hHt )

This implies that investment is only derived from market activities, while the home produced good is entirely
for consumption.
The state variables are: kt , xt = (zM t , zHt )
The control variables are: kMt , hMt , hHt , kt+1
Once kM t is chosen, kHt is automatically determined. Similarly, once hHt and hMt are chosen, lt is the leftover
discretionary time. The maximization problem can be written as:
V (kt , xt ) =

M ax

kMt ,hMt ,hHt ,kt+1

{u (ct , 1 hMt hHt ) + E [V (kt+1 , xt+1 )]}

1

s.t. ct = [aceM t + (1 a) ceHt ] e

kt = kMt + kHt
cM t + kt+1 (1 ) kt
cHt

= ezMt kMt
hMt

= ezHt kHt
h1
Ht

zM,t+1

= zMt + M t

zH,t+1

= zHt + Ht

14

Looking at table 2, adding home production into the model, improves the baseline model. Indeed, it makes
hours more volatile and reduces the correlation between work hours and productivity (it is to be mentioned,
though, that the simulation results depend, to some degree, on the values of e and 10 ). The intuition
for these results is that now, in addition to market production and leisure, agents can allocate their time
to home production. Hence, they can adjust their time spent in the market, in response to a technology
shock, without changing their leisure time too much. A low implies more divergence between zH and zM
and more opportunities to specialize. In fact, this model would improve the volatility of work hours, even
with deterministic home production, because there would still be productivity dierentials between the two
sectors.11 The ability of the home production model to decrease the corr (h, prod) is that two types of shocks
aect this economy, as in the previous adjustment. Hence, the ability of the model to replicate U.S. time
series along these lines depend critically on the nature of the shocks to home production.

2.1

Matching models of the labor market

Baseline model

The treatment below comes from Pissarides (1990). It develops the basic framework for matching models of
the labor market and is the building block for many applications.
The central idea is that the labor market does not clear at all instant, as in the neoclassical framework, but
that finding a partner (worker or firm) is a time consuming, uncoordinated and costly activity. The number of
matches between workers and firms looking for each other, are determined by a matching function M (U, V ).
The function M (., .) gives the number of matches formed per unit of time, as a function of its two arguments
U , the number of unemployed and searching workers and V , the number of vacant and searching firms. It is
assumed to be increasing and concave in both arguments, and to exhibit constant returns to scale12 .
Consider that the labor force is made of two states: a worker is either employed or looking for a job13 . Assume
1 0 This is because results depend on the willingness to substitute home consumption for market consumption (e) and on the
incentive to switch production between the home sector and the market sector ().
1 1 The paper mentions that the results are not "too" sensitive to . The average values for time spent at home and at work
come from time studies.
1 2 You probably noticed that the neoclassical production function and the matching function are assumed to have the same
properties. The assumptions on the matching function are made to ensure that on a balanced growth path, the unemployment
rate is constant.
1 3 This implies that workers cannot be out of the labor force (OLF). In statistics, such as in the Current Population Survey,
workers can actually be in three states: (i) employed, (ii) unemployed and looking for a job, or (iii) out of the labor force, i.e.
unemployed and not looking for a job. For simplicity, we do not consider that option. In ocial statistics, the unemployment

15

that the labor force is comprised of L workers. Firms have to post vacancies to find workers. Hence, jobs can
also be in two states: vacant or matched and producing. Denote by u the unemployment rate, by v the job
vacancy rate, and by m the matching rate. Thus:
U

= uL

(1)

= vL

(2)

M (U, V ) = mL

The activity in the labor market can be represented as follows:

rate is in fact defined as the the proportion of job seekers [(ii)] over the labor force [(i)+(ii)].

16

(3)

Matched Pool

PRODUCTION

New matches

Match

forming

Breakdowns

Searching pool

SEARCH

Free entry of firms

Let = uv be the market tightness. Denote the workers and the firms probability of matching (per unit of
time) by pw and pf , respectively. Because of random matching, they are the same for each worker and each
firm, and:
pw

pf

M (U, V )
U
M (U, V )
V

(4)
(5)

Given the nature of the matching technology:

pf

pw

M (U, V )
1
=M
, 1 = q ()
V

M (U, V )
= M (1, ) = q ()
U

(6)
(7)

This implies (and this is important for the rest of the analysis) that the matching probabilities are only
functions of the market tightness. Because of the assumptions on M , pf is decreasing in and pw is increasing
in . That is, firms have more diculties matching when there are a lot of vacancies per unemployed workers.
Similarly, when this is the case, it is easier for workers to find a firm.
We just looked at transitions from unemployment (search pool) into employment (matched pool). Tran17

sitions into unemployment are given by a job-specific separation rate s14 . The origin of the shocks is not
made explicit, but they can be associated with structural shifts of demand for the firms product.
Since transitions are stochastic and derived from Poisson processes, it is possible to compute the average
time before the Poisson event, that is the average employment/unemployment duration for a worker and the
average employment/vacancy duration for a firm. As you know, for Poisson processes, these average times
are given by the inverse of the Poisson rate:
Average Unemployment Duration =
Average Employment Duration =
Average Vacancy Duration =

1
q ()
1
s
1
q ()

(8)
(9)
(10)

The flows into and out of unemployment have to be equal in steady state, resulting in a constant unemployment
rate. Hence:
sdt [L U ] = q () dtU
or
s (1 u) = q () u
or
u=

s
s + q ()

(11)
(12)

Remark that this allows us to decompose the unemployment rate into its two components: unemployment
duration (how long, on average, one stays unemployed) and unemployment incidence (how often, on average,
1
one becomes unemployed). Duration is given by q()
and incidence is given by 1s . Decomposing unemployment
this way carries more information than just knowing the unemployment rate. Indeed, a given unemployment
rate can be the result of many dierent combinations of unemployment duration and unemployment incidence.
Firms problem:
S f : value of a vacancy to a firm
M f : value of being matched to a firm
r: discount rate
c: cost of posting a vacancy (per unit of time)
1 4 That

is, shocks are idiosyncratic and not aggregate shocks.

18

Time is continuous. In that case, the value function equations are generally given in flow terms. In papers,
the flow equations are rarely explicitly derived. That is because they tend to take the same general form and
because, most times, they are actually written in steady state. The flow of value from being in a particular
state is generally equal to the instantaneous utility received from being in that state plus the instantaneous
probability of changing state times the resulting gain/loss in value from that change. Let us see why in this
particular example:

1
cdt + (q ( (t)) dt) M f (t + dt) + [1 q ( (t)) dt] S f (t + dt)
1 + rdt
As dt 0, we have that:
S f (t) =

f
f
f
f
(1 + rdt) S (t) = cdt + (q ( (t)) dt) M (t) + dtM (t) + [1 q ( (t)) dt] S (t) + dtS (t)
f

(13)

Taking S f (t) out on both sides, dividing through by dt and with dt 0, one gets:

In steady state, this becomes:

rS f (t) = c + q ( (t)) M f (t) S f (t) + S f (t)

rS f = c + q () M f S f

(14)

This can be interpreted as follows. A vacancy is like an asset. The cost of holding that asset (rS f ) is equal
to the return on that asset (carrying cost c plus the probability q () of changing state times the net return
of doing so M f S f ).
Notice that we assumed in (13) that given the choice, firms always prefer to match than remain vacant. That
can be checked, in equilibrium. Since firms post vacancies until the value of doing so is driven down to zero,
it is enough to verify that M f 0. Intuitively, it is impossible that firms would post costly vacancies and, at
the same time, refuse to match.
The free entry condition implies that:

c
(15)
q ()
In equilibrium, the expected value of a filled vacancy is equal to its expected cost, i.e. the cost of posting it
per period of time times the average duration of a vacancy.
Mf =

Given that match output is y and the firm pays wage w, the value of a match to the firm is given by15 :

(16)
rM f = y w + s S f M f = y w sM f

(y w (t)) dt + (sdt) (0) + [1 sdt] M f (t + dt)

= (1 + rdt) M f (t) = (y w (t)) dt + [1 sdt] M f (t) + dtM f (t)

15 Mf

(t) =

1
1+rdt

= rM f (t) = y w (t) sM f (t) + M f (t)

= rM f = y w sM f

19

In flow terms, the value of a filled position is equal to instantaneous net output plus the instantaneous
probability of a separation times the resulting loss. Combining (15) and (16), this can be rewritten as:
c
yw
=
r+s
q ()

(17)

Workers problem:
S w : value of search to worker (value of being unemployed)
M w : value of employment to worker
b: workers income during search (home production, unemployment benefits, value of leisure)
In flow terms16 :

rS w
rM w

= b + q () [M w S w ]
= w + s [S w M w ]

(18)
(19)

In flow terms, the value of search is equal to income during search plus the probability of changing states
times the net gain (again, it is rightly assumed that workers prefer the state of employment to the state of
unemployment). Likewise, the value of employment is the wage received plus the probability of separation
times the associated net loss.
(18) and (19) can be solved to get:
rS w

rM w

(r + s) b + q () w
r + s + q ()
sb + (r + q ()) w
r + s + q ()

1 6 Value

of search:
1
S w (t) = 1+rdt
{bdt + (q () dt) M w (t + dt) + [1 q () dt] S w (t + dt)}

= (1 + rdt) S w (t) = bdt + (q () dt) M w (t) + dtM w (t) + [1 q () dt] S w (t) + dtS w (t)

= rS w (t) = b + q () [M w (t) S w (t)] + S w (t)

= rS w = b + q () [M w S w ]
Value of employment:
1
M w (t) = 1+rdt
{w (t) dt + (sdt) S w (t + dt) + [1 sdt] M w (t + dt)}

= (1 + rdt) M w (t) = w (t) dt + (sdt) S w (t) + dtS w (t) + [1 sdt] M w (t) + dtM w (t)

= rM w (t) = w (t) + s [S w (t) M w (t)] + M w (t)

= rM w = w + s [S w M w ]

20

To guarantee that, indeed, a worker prefers working than being unemployed, we need that w b.
Wage determination:
Since the total value of matching (to a worker/firm pair) is greater than the total value of search (to that
same pair), matching creates a surplus, whose split is determined by bargaining between the worker and the
firm. Again, we use the Nash bargaining solution to obtain the negotiated wage. In the negotiations, the
market wage is taken as given by the two parties (since all matches are similar, in equilibrium, all must be
characterized by the same wage). In equilibrium, the negotiated wage must be equal to the market wage.
Conditional on the negotiated wage wn , the value to the firm of being matched and paying the worker wn is
given by rMnf = y wn sMnf , while the value of the same match to the worker is rMnw = wn + s [S w Mnw ].
Notice that S w depends on the market wage, since it is the expected return to the worker from search. Hence,
wn must maximize the Nash product, where is the workers bargaining power:

(1)
M ax (Mnw S w ) Mnf S f
wn

The maximum is achieved when:

Mnf S f = (1 ) [Mnw S w ]

Hence17 :

(20)

(y wn ) = (1 ) (wn rSw )
or:
wn = y + (1 ) rSw

(21)

Remark that the wage is a convex combination of match output and the workers value of search or his threat
point (it should be clear that, in this type of models, wage is not equal to the workers marginal product). It
is easy to see from there that any parameter increasing the value of search also increases the wage of employed
workers. One such example would be unemployment benefits. The wage can be rewritten as:
wn = rSw + (y rSw )

(22)

This can be interpreted as follows. The worker receives his reservation wage (rSw ), i.e. the minimum wage he
must get for him to accept the match plus a proportion of the net surplus created by accepting the match
(y rSw ).
(15) and (20) imply that M w S w =

c
b + q () 1
q() = b +

1 c.

f
1 M

c
1 q() .

From (18), it results that rSw = b+q () [M w S w ] =

Using (21), w = y + (1 ) (b +

1 c)

w = (1 ) b + [y + c]
1 7 Comes

from (16) and (19), and the above equation.

21

and:

(23)

Equilibrium:
The equilibrium is given by the triplet (u, v, w) satisfying (12) [steady state], (17) [free entry] and (23) [wage
determination].
We can perform a little comparative static exercise. In particular, it is interesting to look at the eect of
changes in productivity (y) and workers search income (b) on the equilibrium values of unemployment and
wages. Combining (17) and (23), one gets:
(1 ) (y b) = c + (r + s)

c
q ()

(24)

As the right-hand side of (24) is increasing in , an increase in search income b results in a decrease in the
equilibrium value of eq . Looking at (12), it is clear that ueq increases. By totally dierentiating (11), we
see that veq decreases. Finally, by dierentiating (23) [and using the expression for d
db ], one gets that weq
increases with b. From (24), an increase in productivity y increases eq and veq , while it decreases ueq . From
(23), we see that weq also increases.
The intuition is the following: by increasing the value of search to the worker, hence his threat point, an
increase in b results in increased market wages (w ). That reduces match profitability to firms who post less
vacancies (v ). In steady state, there is an inverse relationship between u and v. Hence, u . The case of
an increase in y is dierent. In that case, both the value of search to the worker and the value of the match
increase (matches are more productive, and hence, search has also higher value). So, the increase in y accrues
to both the worker and the firm. Thus, we have that both wages and vacancies increase (w , v ).

2.2

Application to the study of job creation and job destruction

Up to now, the rate of job destruction s was exogenously given. The purpose of this application is to endogenize
it. The treatment is based on Mortensen & Pissarides (Restud 1994). But, first let us look at some empirical
facts. These facts come from Davis & Haltiwanger (QJE 1992).
The paper looks at employment changes at the plant level, rather than at the aggregate level. The authors
look at the U.S. manufacturing sector data between 1972 and 1986. The establishments considered are 5
employees or more (99% of the population). An establishment is defined as a plant (physical location rather
than firm). In particular, the authors have data on the number of jobs at a given plant over a long period.
They are thus able to look at the patterns of job creation and destruction within a firm. The frequency of
observation is one year.

22

Here is some notation:

- Employment at date t, Et : number of workers on the payroll at date t,
- Job Creation, JCt : (net) employment gains at plants that expanded between t 1 and t within a sector,
- Job Destruction, JDt : (net) employment losses at establishments that shrank between t 1 and t within a
sector.
Hence:
Et = Et1 + JCt JDt
To get the measures in terms of rates (JCRt , JDRt ), divide JCt and JDt by the average sector size
1
2 [Et1 + Et ].
- Job Reallocation Rate: SU Mt = JCRt + JDRt
- Net Employment Growth Rate: N ETt = JCRt JDRt
The main results are reported below along two dimensions:
Magnitudes:
There is a relatively high amount of simultaneous job creation and job destruction at every phase of the
business cycle: between 1972 and 1986, M ean (JCRt ) = .092, M in (JCRt ) = .064, and M ean (JDRt ) = .113,
M in (JDRt ) = .061.
Cyclicality:
The job creation and job destruction rates are negatively correlated, Corr (JCRt , JDRt ) = .864.
The authors also make the point that the patterns of job destruction and job creation cannot be explained by
sectorial shifts, that is shocks to particular industries, with labor being reallocated across industries following
these shocks. If this were the case, one would observe some industries with high levels of job destruction,
while others would experience high levels of job destruction. After narrowing their observations by focusing
on specific industries, the authors report that this pattern is not observed. This seems to indicate that the
high levels of both job destruction and job creation may be better explained by idiosyncratic shocks to active
jobs.
We can now extend the basic Pissarides model and add a job destruction decision (that is endogenize s).
The productivity of job/worker pairs is now idiosyncratic. Denote the instantaneous match output by:
y =p+

23

where p is the deterministic component of the value of the product and its idiosyncratic random component
( can be considered as a productivity shock or a preference shock aecting the product relative price).
Nature of the random shocks:
The arrival of shocks follows a Poisson process with arrival rate . Conditional on a new shock, is drawn
from a distribution F (z) with finite upper support u . This specification is chosen for two reasons. First,
assuming a Poisson process maintains tractability. Second, it brings positive persistence to firm size (the
lower , the more persistent firm size).
Assume that newly created jobs start at the highest productivity p + u . This can be supported by the observation that most job creation comes from existing firms, which have better information about the profitability
of new products within their sectors. Of course, this is an extreme assumption. For our purpose, it is not
going to change the results of the model. An area where it may matter is, if we were interested in looking
at wages. For example, it would mean that wages in a given occupation always decrease before increasing,
which would be inconsistent with the typical wage tenures observed.
Because of the shocks, there is now a new decision variable for firms and workers. Since matches start at the
highest productivity level u , neither firm, nor worker will want to separate. However, upon arrival of a new
shock , the two parties have to decide whether to break the match down or to continue production. This is
how the job destruction decision is endogenized. Whether production will stop now depends on the current
value of , instead of being exogenously given.
Decision variables:
Firms: (i) how many vacancies to post, (ii) when to break the match down.
Workers: (i) when to break a match down
(as usual the decision to accept a match is trivial, hence is not included).

Value functions:
Since matches are characterized by their idiosyncratic productivity, the value functions when matched must
have as an argument. However, ex-ante, all vacancies and unemployed workers are identical. Therefore, the
values of search do not depend on . We have that:

rS f = c + q () M f (u ) S f
(25)
rS w

= b + q () [M w (u ) S w ]
Z
w
rM () = w () + [M ax {M w (z) , S w } M w ()] dF (z)
Z

M ax M f (z) , S f M f () dF (z)
rM f () = p + w () +
24

(26)

(27)
(28)

(27) and (28) can be intuitively explained as follows. In flow terms, the value to the worker of being in a
match of productivity is equal to the instantaneous wage received w () plus the option value of being
hit by a new idiosyncratic shock z and taking the optimal decision of staying in the match at the new value
of productivity (M w (z)) or breaking the match down and returning to the state of search (S w ). A similar
reasoning holds for (28)18 .
Wage determination:
As before, wages are negotiated. Given productivity , the workers surplus from the match is given by
M w () S w and the firms surplus is given by M f () S f . Hence, total match surplus T () is M w () +
M f () S w S f . Because of the free entry condition for firms, in equilibrium,
Sf = 0

(29)

As usual, the worker retains a proportion (equal to his bargaining power) of the total surplus.19 Hence:
M w () S w

= [M w () + M w () S w ] = T ()

M f () = (1 ) [M w () + M w () S w ] = (1 ) T ()

(30)
(31)

Thus, we can rewrite (27) and (28) as:

rM w () = w () +

[M ax {T (z) , 0} T ()] dF (z)

Z
f
rM () = p + w () + (1 ) [M ax {T (z) , 0} T ()] dF (z)

By combining (26), (32) and (33), one gets [adding (32) and (33) and using the equation for rS w ]:
Z
rT () = p + + [M ax {T (z) , 0} T ()] dF (z) b q () T (u )

(32)
(33)

Max {M w (z; t + dt) , S w (t + dt)} dF (z) + (1 dt) M w (; t + dt)

R
= (1 + rdt) M w (; t) = w (; t) dt+dt [Max {M w (z; t + dt) , S w (t + dt)} M w (; t + dt)] dF (z)+M w (; t)+dtM w (; t)

R
= rM w (; t) = w (; t) + [Max {M w (z; t + dt) , S w (t + dt)} M w (; t + dt)] dF (z) + M w (; t)
The terms in dt in the integral are negligible as dt 0, thus:

R
rM w (; t) = w (; t) + [Max {M w (z; t) , S w (t)} M w (; t)] dF (z) + M w (; t)
In steady state,
R
rM w () = w () + [Max {M w (z) , S w } M w ()] dF (z)
1 9 The Nash bargaining solution is given by:

1
.
max (M w S w ) M f S f
18 Mw

(; t) =

1
1+rdt

w (; t) dt + dt

wn

25

or
(r + ) T () = p + b +

M ax {T (z) , 0} dF (z) q () T (u )

(34)

We can see from (34) that T () is increasing in .

Notice that due to the nature of the bargaining procedure retained, breakdowns are privately ecient. Workers
decide to break a match down when M w () < S w and firms decide to do so when M f () < 0. But these
situations arise at the same time, since M w () S w and M f () always have the same sign (that of T ()).
Hence, workers and firms always agree whether to stay in the match or to separate. This implies that matches
are (bilaterally) broken down when the total surplus, given the match current productivity, is negative. Since
T () is increasing in , we have a reservation property. Matches break down when the idiosyncratic shock
falls below a certain value r , such that T (r ) = 0. The reservation shock is defined as:
T (r ) = 0

(35)

(34) can be rewritten as:

(r + ) T () = p + b +

Zu

T (z) dF (z) q () T (u )

Integrating by parts, the integral can be rewritten as follows20 :

Zu

T (z) dF (z) = [T (z) F

(z)]ur

= T (u )
=

Zu

F (z) T (z) dz

1
r+

Hence:

2 0 Assuming

F (z) T (z) dz

T (z) [1 F (z)] dz
Zu

(r + ) T () = p + b +

Zu

Zu

r+

(1 F (z)) dz

Zu

the cdf is well behaved.

26

(1 F (z)) dz q () T (u )

From (25), (31) and (35), we get that21 :

p + r = b +
c
1
r+

Zu

(1 F (z)) dz

(36)

Using (25), (26), (30) and (31), notice that (36) can be rewritten as:
rS w = p + r +

r+

Zu

(1 F (z)) dz

(37)

Remark that this last expression is not necessarily very "intuitive". Instead, one can use the integration by
parts above to rewrite it as:
Zu
w
(38)
rS = p + r + T (z) dF (z)
r

This states that, at the reservation shock, the opportunity cost from matching (rS w ) is equal to the opportunity cost of search (instantaneous output p + r plus the option value of being hit by a higher shock,
appropriately discounted to account for the match impermanence). At r , agents are indierent between
search and production.
Condition (36) [or (37), or (38)] is often referred to as the Job Destruction Condition, because it defines
r the reservation shock, for a given . It can be interpreted as follows. The left hand-side of (36) is the
lowest acceptable price to firms to stay in the job. The first term in the right-hand side is the opportunity
cost from matching. The second term is the extent to which a firm is willing to occur a current loss in
expectation of future increases in the productivity of the match. Hence, firms hoard labor, that is they retain
some workers, even though current output is below the opportunity cost of employment, in expectation of
future improvement in match productivity. Firms do that, because finding a worker is a costly process.
Now that we defined the threshold level at which jobs are destroyed (notice that this is equivalent to endogenizing the job destruction rate), we want to look at the job creation condition. As already mentioned, this is
given by the free entry condition. Rewriting (34) for and r , we get that:
T () =

r
r+

(39)

Using (25) and (31), we get that:

c
u r
= (1 )
q ()
r+

(40)

Condition (40) states that the expected vacancy costs (c/q ()) are equal to the return from posting a vacancy
(firms share of the surplus times the surplus at job creation).
2 1 rS w

1
= b + q () [M w (u ) S w ] = b + q () T (u ) = b + q () 1
M f (u ) = b + q ()

27

c
1 q()

=b+

c
1

6
@
@
@

JD

@
@

@
@

JC @

Figure 3: Job creation and destruction curves

The equilibrium is characterized graphically by a job creation curve (JC) and a job destruction curve (JD),
as follows:

(JC) is a downward sloping curve reflecting the fact that a low incidence of match breakdown (low r ) induces
firms to post more vacancies (high ). (JD) is an upward sloping curve reflecting the fact that the joint value
of the match increases with match idiosyncratic productivity, while the joint value of breakdown (or value of
search) increases with market tightness. Hence, the reservation shock, where the joint value of continuation
equals the joint value of breakdown, increases with market tightness.
Remark that once the equilibrium values of and r are known, employment duration and unemployment
duration are also known (and, hence, the unemployment rate):
Employment duration :
Unemployment duration :
Unemployment rate :

1
F (eq
r )
1
eq q (eq )
F (eq
r )
eq
F (r ) + eq q (eq )

Let us assume for simplicity that the matching function is Cobb-Douglas in U and V . This functional form
satisfies the assumptions made at the beginning of the paper. That is:
M (U, V ) = U V 1
28

Hence:
q () =

(41)

Using (41) and (40), one can rewrite (36) with only eq
r , and by totally dierentiating, obtain that:
d eq

dp r
d eq

dp

< 0

(42)

> 0

(43)

In conclusion, we can use the model to explain the two main facts laid out at the beginning of the chapter.
These facts were the following: (i) there is a relatively high amount of simultaneous job creation and job
destruction at every phase of the business cycle, (ii) the job creation and job destruction rates are negatively
correlated.
First, because of the idiosyncratic nature of the shocks, there is always a high level of job creation and job
destruction. Hence, we defined a steady state equilibrium, where some jobs are created and others destroyed,
these two phenomena occurring at all times.
Second, we can look at the economy at dierent phases of the business cycle. For that, we can consider that p
can take two values p2 > p1 . Changes in p can be considered as aggregate shocks to the economy. We want
to use the above model to look at the eect of an aggregate shock on job destruction and job creation. The
above model characterized the steady state equilibrium values of and r , taking p as a model parameter.
Carrying out a comparative exercise, we were able to look at the eect of a change in the parameter p on
eq and eq
r . These are the results we are going to use to answer the question of how job creation and job
destruction are varying over the business cycle (that is when p changes). One should realize however, that
this is somewhat of a simplification. By allowing for changes in p, we are not only changing one of the models
exogenous parameters, but also the entire structure of the economy. Comparative statics exercises usually
involve looking at how a change in an exogenous parameter aects equilibrium values. Here, by allowing
for aggregate shocks, we actually change the problem faced by the agents. Such shocks are now part of the
problem to solve, and should be anticipated by the agents. By looking at an economy where no aggregate
shock has been built into the model, and letting p vary, we are looking at what happens to the steady state
of an economy with no anticipated aggregate shock, when there is a new value of p?. It is dierent from
looking at what happens to job destruction and job creation when an aggregate shock hits an economy
where agents anticipate the possibility of aggregate shocks taking place?. Mortensen & Pissarides (1994)
actually do look at the two cases: (i) they carry out the comparative static exercise based on a model with no
anticipated aggregate shock, and (ii) alter their model to account for the possibility of aggregate shocks hitting
the economy at a Poisson rate . It turns out that, even though one method is superior, the qualitative results
do not change22 . Using (42) and (43) and assuming that p decreases from p2 to p1 , we see that eq
r increases,
2 2 One

may argue that the methodological bias from using the first method is not as much of a problem, when one considers

29

hence job destruction increases (immediately, i.e. all the current matches between r (p2 ) and r (p1 )), and
that eq decreases, hence job creation decreases (and u increases). Looking at the case where p increases from
p1 to p2 yields the opposite results (except that the impact on job destruction is not immediate anymore).
Hence, job destruction and job creation move in opposite directions over the business cycle.

2.3

2.3.1

Application to the study of labor market policies

Some facts

Labor market policies

Labor market policies in place in European countries are very dierent from the ones in the U.S. There are
policies designed for income security, such as unemployment insurance (UI) and minimum wage. Unemployment insurance varies between the two economies by its replacement rate (percentage of previous wage
received as benefits), the length of the benefits (the replacement rate may also depend on the length of the
unemployment spell), benefit ceilings, and eligibility criteria. In addition, the U.S. unemployment insurance
system is experience rated, which means that the firms contribution to the unemployment insurance system is proportional to the number of layos the firm initiated (this is implicitly a form of firing costs). In
some European countries, the minimum wage is increased annually, while, in the U.S., it is only increased by
Congress, at much longer intervals.
There also are employment protection policies (EP), which are designed to reduce unemployment by imposing firing costs to firms for terminating an employee. There are four basic types of protection measures:
severance pay, advance notice, administrative and procedural costs, and legal costs. The severance pay regulation dictates how much compensation the fired worker is to receive. It is a fraction of the workers current
wage which generally increases with the length of tenure. The advance notice regulation stipulates a period
before which a firing is to take place and during which the worker is still employed. This also varies with the
tenure, but generally not to the same extent as severance pay does. Administrative and legal costs are dicult
to quantify. These two sets of costs are due to record keeping requirements, and the obligation to inform and
consult with worker representatives and/or a third party. These regulations primarily take place in Europe,
while in the U.S. these types of costs are essentially nil23 . Also bear in mind a very important distinction
one-time shocks, or infrequent shocks ...
2 3 It would be dicult to describe all the firing regulations in the dierent countries. As an example, French employment
protection policies are described below in more detail. In France, dismissals can be either for economic reasons or for cause.
Terminations for cause can be for serious reason or for very serious misconduct. Firing for very serious misconduct exempts
the employer of any cost. For all other reasons, the employer must give advance notice and provide severance payments to
the terminated employee. The laws dier slightly, depending on whether the dismissal is individual or collective. However, in

30

between the dierent firing costs imposed on the firm. Some regulations, such as severance payments and
advance notice, impose costs that are proportional to the dismissed workers wage and hence proportional to
his or her skill. Also, they are transfers from the firm to the worker. Other regulations, such as administrative,
procedural and legal ones, impose costs that are essentially fixed, i.e. the same regardless of the dismissed
workers wage. They also have the characteristic of being incurred by the firm, but to not be received by the
worker.
It is very important to mention that these requirements are the legal minimum requirements and that in many
cases, additional protection is in place at the firm or industry level. Finally, keep in mind that, typically,
these regulations do not come into eect before a certain tenure with the firm.

Empirical facts
The empirical evidence on the eects of EP policies is somewhat inconclusive. Using the number of months of
severance payment for blue-collar workers with ten years of tenure as a measure of strictness of employment
protection policies, Lazear (QJE 1990) finds a small positive eect of severance pay regulations on the unemployment rate, for a sample of 22 countries over 29 years. However, depending on the specification adopted,
the evidence presented is not always statistically significant. For example, regressing the unemployment rate
on country means over the entire period for the severance pay proxy, the coecient becomes statistically
insignificant. In addition, he also recognizes in introduction that unmeasured factors (such as other labor
market institutions) dier across countries. Among ten European countries and the U.S., Bertola (EER 1990)
finds no strong correlation between the long-term unemployment rate and a general ranking of strictness of
employment protection policies - including all form of firing restrictions, not only severance pay. This seems
to point out toward the need for a detailed modelization of the dierent forms of employment protection
policies. From a dierent perspective, looking at the eect of firing regulations on wages, Friesen (ILRR,
1996) studies the wages of workers covered by advance notice and severance pay regulations. Using wage data
from the dierent Canadian provinces, hence subject to dierent regulations, and controlling for education,
tenure, firm size, occupation and industry, she was able to determine that incumbent workers, protected by
regulations, extract higher wages than workers not protected by these laws and, also, that starting wages (for
non-union workers) appear to fall to oset subsequent wage increases.

both cases, the employee must be notified of the reason for termination. The Ministry of Labor must also be informed of the
termination, even though the request is rarely denied, as long as the procedures have been respected. A retraining program for
the dismissed worker may be oered. This entire procedure takes up to three weeks. For collective dismissals, the employer must
also consult with the union. For collective dismissals of more than ten employees, the regulations require that the firm establish
a social plan, including steps designed to facilitate the re-employment of the dismissed work force. For all terminations, workers
between six months and two years of tenure are to be given a one month notice, and, in case of a longer tenure, a two month
notice. The notice must be three month for engineers, professionals and managers. The legal minimum severance payment is one
tenth of the monthly wage per year of seniority. An additional 1/15 of the monthly wage must be added for every year of tenure
beyond 10 years of service.

31

There is less controversy about the eects of UI policies on unemployment. Layard & al (1991)24 find that
cross-country unemployment rates are positively associated with the generosity of UI benefits.
Looking at dierences between the U.S. and European labor markets, the following facts emerge. First, unemployment in Europe are characterized by less frequent, but longer unemployment spells than in the U.S.
(less skilled workers suer higher unemployment in Europe, primarily because of higher duration). Second,
the following facts are known regarding the unemployment rate time series over the past 35 five years: unemployment has not shown any long-term trend in the U.S., while it trended upwards in Europe. In fact, within
country relative changes in the unemployment rates, measured by the percentage dierence between average
rates in the last half of the 80s and the last half of the 70s, are positively correlated across countries with
both the generosity of UI benefits and the aggressiveness of EP policies25 .

2.3.2

The model

The framework developed below comes from Millard & Mortensen26 . It is the standard Mortensen & Pissarides
model adapted to the study of various labor market policies.
The notation is essentially the same as before. However, we introduce three dierent policies:
Firing costs:
When a match breaks down, the firm incurs firing costs. To follow the dichotomy developed above, we will
consider two types of costs. First, there is a severance payment T that the firm has to pay to the worker.
Second, there is a pure firing tax t paid by the firm, but not received by the worker. Notice that, in fact, the
severance payment should be proportional to wage, as per the regulations. Accounting for that fact would
change the outcome of the bargaining process, as firm would have to take into account that the severance
payments they may have to pay in the future, depends on the wage they are currently negotiating. Instead,
we assume that it is fixed (T ), since it is not central to our purpose, but simplifies the analysis. Although
Millard & Mortensen do not make a dierence between the two types of firing costs, we will see it is important
to dierentiate between the two.
Unemployment benefits:
2 4 Unemployment:

Macroeconomic Performance and the Labor Market, by Layard, Nickell and Jackman, Oxford University
Press, 1991.
2 5 For a ranking of strictness of EP policies in OECD countries, see OECD Job Study 1994.
2 6 Millard S. and Mortensen D. (1997): The unemployment and welfare eects of labour market policy: A comparison of
the U.S. and U.K. in D. Snower and G. de la Dehesa (eds.), Unemployment Policy: How Should Governments Respond to
Unemployment? Oxford: Oxford University Press

32

While unemployed, a worker receives a proportion of his/her wage. To keep the recursive nature of the
problem, we assume that these benefits are received as long as the worker remains unemployed.
Subsidizing vacancy posting:
A subsidy to hiring can be interpreted as government assistance in the job/worker matching process or as
a tax credit per worker hired paid to employers. In our model, this is equivalent to reducing the vacancy
posting costs c.
For simplicity, assume that output is entirely stochastic (p = 0). Using notations previously developed, we
have that, in flow terms:
Z
rM w () = w () + [M ax {M w (z) , S w + T } M w ()] dF (z)
(44)
Z

rM f () = w () +
M ax M f (z) , T t M f () dF (z)
(45)
rS w
rS

= b + w + q () [M w (u ) S w ]

= c + q () M f (u ) S f

(46)

(47)

The flow equations should look familiar. The only dierence between (27) and (44) is that, upon a breakdown,
the worker now receives a severance payment T . The only dierence between (28) and (45) is that the firm
has to pay T + t after a breakdown. The value function equations imply that all breakdowns are followed
by payments of T and t, regardless of who initiated the breakdown. As per the regulations, only layos are
supposed to require payments of T and t (by the firm). Since breakdowns are privately ecient, it is not clear
which party initiated the breakdown. We take the stand that firms always decide to separate, and thus that
they are responsible for paying T and t27 . Finally, in (46), the unemployed worker receives unemployment
benefits equal to times the average wage w (it now makes sense to view b as value of leisure and home
production only). It is assumed that unemployment benefits are based on the average wage and not the wage
before the breakdown, to avoid heterogeneity among workers, due to their labor market history.
Define the match surplus as:

T () = M w () (S w + T ) + M f () S f T t = M w () + M f () S w + t

It is clear that severance payments do not aect the total match surplus, since they are a transfer within the
match. Firing taxes, for the opposite reason, do influence the match surplus.
Proceeding as previously, we can derive a job destruction equation. This condition will have the property
2 7 We

could add quits to the model (at a rate ) and assume that these quits do not require payments by the firm. That would
lessen the eects of firing costs, since these payments would be less likely for the firm.

33

that, at the reservation productivity, the value of a match will be equal to the value of search. Since
M w () S w T

= T ()

(48)

M () + T + t = (1 ) T ()

(49)

we can rewrite (44) and (45) as:

rM w () = w () +

[M ax {T (z) , 0} T ()] dF (z)

Z
f
rM () = w () + (1 ) [M ax {T (z) , 0} T ()] dF (z)

Adding up the two equations, we get:

r [T () + S w t] = +
or
(r + ) T () = +

[M ax {T (z) , 0} T ()] dF (z)

M ax {T (z) , 0} dF (z) r (S w t)

(50)

Again, we see that the model exhibits a reservation property. Define the reservation productivity shock r
such that T (r ) = 0. Then, rewriting (50) at and r and subtracting the two, one gets that:
T () =

r
r+

(51)

We see that (51) is actually the same equation as (39). Both say that the total surplus at is the value of
output above the reservation productivity, discounted to take into account the match impermanence (r + ,
not r). Of course the value of r is not the same in the two models.
Inserting (51) into (50), we get:
r +

Zu

z r
dF (z) r (S w t) = 0
r+

Integrating by parts, this is equivalent to:

r (S t) = r +
r+
w

Zu

(1 F (z)) dz = r +

Zu

T (z) dF (z)

(52)

(52) is similar to (37). The left hand-side is the opportunity cost of a match, while the right-hand side is the
opportunity cost of search (at r ). With firing costs, the (total) opportunity cost of a match must reflect the
fact that by remaining in the match, the firm avoids the payment of the firing tax (t). The severance payment
34

(T ) does not enter the equation, because it does not aect the total opportunity cost. So, only t aects the
breakdown decision. It will become clear, however, that both T and t aect wages.
We can now look at the job creation condition. Because of the free entry condition, firms post vacancies until
the value of doing so is driven to zero. Hence:
c + q () M f (u ) = 0
or

u r
c
= (1 ) T (u ) T t = (1 )
T t
q ()
r+

(53)

The dierence between (40) and (53) is that (53) reflects the fact that the two types of firing costs adversely
aect the firms surplus. Firms anticipate to have to pay firing costs in the future and that decreases their
surplus at match formation. Notice that contrarily to the job destruction condition (52), where only t
enters,both T and t enter in (53), because they aect the threat points and hence, wage formation.
Since we can expect the firing regulations to have eects on both unemployment, but also wages, it is interesting
to determine w ()28 . The calculations are provided in the footnotes. We obtain the following expression for
the wage:
w () = + (1 ) rS w + r (T + t)
(54)
Comparing the wage in (54) with the expression (21) obtained in the baseline (Pissarides) model, one would
think that the wage is higher when firing costs are present. Indeed, firing costs enhance the workers bargaining
position (by increasing his/her threat point), and adversely aect the firms bargaining position, and this may

(48) and (49), we know that M f () + T + t = (1 ) [M w () S w T ]. Equations (44) and (45) imply

u
R
that (r + ) M w () = w () + F (r ) (S w + T ) + M w (z) dF (z) and (r + ) M f () = w () + F (r ) (T t) +
2 8 From

Ru

Mf

(z) dF (z).

Therefore, (r +

) (M w

()

Sw

T ) = w () + (F (r ) r ) (S w + T ) +

Ru

(r + ) M f () + T + t = w () + (F (r ) r ) (T t) + M f (z) dF (z).

(T (z) + S w + T ) dF (z) and

Ru

M f (z) dF (z) =

By

inserting

(F (r ) r

these

) (S w

integrals

+ T ) +

into

Ru

Ru

the

above

equations,

Ru

we

)) (S w

(1

M w (z) dF (z) =

(r + ) (M w () S w T )

+ T ) and (r + ) M f () + T + t
=
get

that

w () +

w () +

T (z) dF (z) + (1 F (r )) (T t) This simplifies as (r + ) (M w () S w T ) =

Ru
T (z) dF (z) and (r + ) M f () + T + t = w () r (T t) + (1 ) T (z) dF (z) Usr

ing the top equation in this footnote, one gets that w () r (T t) + (1 )

) r (S w

Ru

((1 ) T (z) T t) dF (z).

T (z) dF (z) + (1 F (r

(F (r ) r ) (T t) + (1 )
w () r (S w + T ) +

Ru

M w (z) dF (z) and

We have that

Ru

Ru

+ T ) + (1 )

Ru

T (z) dF (z) Hence, w () = + (1

35

) rS w

+ r (T + t).

Ru

T (z) dF (z) = (1 ) w ()

result in higher wages. In other terms, during wage negotiations, the worker is able to extract the rent
associated with the avoidance of firing costs by firms. However, one has to be careful since, firing costs
also aect the value of search S w , which is endogenously determined and depends on market tightness. In
particular, firing costs make vacancy posting less desirable to firms, which decreases market tightness and
therefore the value of search to workers.
We can look at the eect of firing regulations on labor market outcomes (unemployment and wages). In
particular, we can do some preliminary graphical analysis using a job creation/job destruction graph, as with
the Mortensen/Pissarides model. Combining (46), (48), (51) and (52) one gets the following job destruction
condition29 :

Zu
u r

(1 F (z)) dz
(55)
b + w + q ()
+ T rt = r +
r+
r+
r

And from (53):

c
u r
= (1 )
T t
q ()
r+

(56)

Using the model:

Using a JC/JD graph, we can look separately at what happens if T > 0, t = 0 or T = 0, t > 0 [starting from
t = 0 and t = 0].
0) Notice, that because w is endogenous, and because we do not know the eect of T and t on w, the model
should really be simulated. Nonetheless, let us try to preview the eects of the various policies.
1) First, as severance payments (only) are introduced in the model (T > 0, t = 0), we can easily see that both
the job destruction and job creation curves shift to the left. This results in lower , but has an inconclusive
2 9 Assume

that the economy is in steady state, and that total steady state employment is E. The change in total wage bill
per period dt is equal to wE (1 dt)wE = dtwE, since only a proportion dt of existing matches are subject to a new
shock. Over the same period, this change in total wage bill is due to (i) newly formed matches at w (u ), for an amount equal
to (dt) EF (r )w (u ) since only a proportion F (r ) of matches hit by a new shock are broken down and re-created in steady

Ru
state, and to (ii) continuing matches hit by new shocks (higher than r ) for an amount equal to dtE w(x)dF (x). Hence, in
r

steady state:

or,

dtwE = Edt F (r )w (u ) +

w = F (r )w (u ) +

Zu

36

Zu

w(x)dF (x)

w(x)dF (x)

eect on r . This implies a higher unemployment duration, while the eect on unemployment incidence cannot
be resolved qualitatively. This makes it dicult to relate that to the empirical facts from the motivation.
2) Second, as firing taxes (only) are introduced in the model (T = 0, t > 0), we can see that, again, the job
creation curve shifts left. The eect on the job destruction curve is a shift down (one should keep in mind
that ignoring the possible eects on w might be significant in this case, since t only comes in as rt in the
job destruction condition (and thus represents a small change)). Hence, no clear conclusion can be drawn.
3) Third, one can look at the eect of firing regulations (t, T ) on wages. From (54), one can see that firing
regulations may increase wages, since during the wage negotiations, workers are able to take advantage of the
fact that firms want to avoid paying these costs. However, looking at (54), whether or not wages are increased
depends also on the value of search. If the regulations have a strong enough negative eect on firmss vacancy
posting, S w might decrease and wages as well. This is why the model needs to be simulated to be able to
draw any conclusion.
4) In conclusion, this version of the model is not very satisfying since (i) one cannot fully determine the eects
of T and t on unemployment and wages and (ii) one does not get any implication on the wage profile from the
model. Notice however, that this model delivers a clear eect on job creation. Firms, being forward looking,
expect to have to pay these costs in the future. This reduces their lifetime discounted match value. Therefore,
firms post less vacancies.
5) What can be done to remedy these problems? Notice that, implicitly, regulations were assumed to come
into place at the very beginning of the match, or at match formation. We are presenting next a model,
where regulations do not come into eect before a certain tenure with the firm.

2.3.3

Tenure dependent policies

We are going to account for the fact that typically, employment protection policies do not come into eect
before a certain tenure with the firm. In particular, it is assumed that severance payments are not due before
the first idiosyncratic shock hits the match. This assumption is made for analytical tractability, but is designed
to replicate the fact that severance pay T is not required in the early parts of the tenure with the firm30 . Also,
regulations about unfair dismissals do not take eect until completion of a trial period, whose length varies
from a few months to two years, depending on the country. Hence, it will also be assumed that the fixed
cost t only comes into consideration after the first shock hits. These assumptions are made to reflect the fact
that, in general, firing costs only come into eect, after a certain tenure with the firm. This is an important
consideration, as it aects wage formation. Alternatively, it could be assumed that the regulations come into
3 0 In France, for example, no severance payment is due until the worker has been with the firm for two years (8 quarters).
Compare that with a Poisson arrival rate for idiosyncratic shocks = 0.1 (as calibrated in Mortensen (JEDC 1994)). Such a
value for implies an average time before arrival of the first shock of 10 quarters.

37

eect, following a Poisson process with a dierent rate 2 than the rate at which idiosyncratic shocks arrive.
That way, the artificial link between the arrival of shocks and the arrival of policy eects would be broken.
However, assuming the same rate does not aect the main fact we want to illustrate, which is that the firms
bargaining position at match formation is not altered by the regulations, while it is once these are in place.
Because of these assumptions, it is necessary to define (i) the value of a match (to the worker or the firm) at
match formation (indexed by zero), or before regulations come into eect, and (ii) the value of a match after
the regulations come into eect, hereafter called a continuing match.

rM0w

= w0 +

rM0f = u w0 +

Z h
i

M ax M f (z) , S f T t M0f dF (z)

rM w () = w () +
f

[M ax {M w (z) , S w + T } M0w ] dF (z)

rM () = w () +

[M ax {M w (z) , S w + T } M w ()] dF (z)

M ax M f (z) , S f T t M f () dF (z)

rS w = b + w + q () [M0w S w ]
h
i
rS f = c + q () M0f S f

(57)
(58)
(59)
(60)

(61)
(62)

The flow equations can be interpreted in the usual manner. Notice that the option values in (57) and (59) on
the one hand, and (58) and (60) on the other hand do not dier, since by assumption, once the first shock
has hit, the regulations come into eect. The dierence comes from the fact that w0 is negotiated when the
regulations are not in place, while w () is negotiated once these are in place. And firing costs do aect wage
formation, because they negatively aect the firms bargaining position (through the threat point).
Wage formation
At match formation:
Surplus to the wor ker :
Surplus to the f irm :
T otal surplus

M0w S w

M0f S f = M0f

T0 = M0w + M0f S w

Applying the Nash bargaining solution:

(1)
M ax M0f
(M0w S w )
w0

s.t. M0f 0, M0w S w

38

which implies that:

M0w S w

= T0

M0f

= (1 ) T0

For continuing matches:

Surplus to the wor ker :
Surplus to the f irm :
T otal surplus

M w () S w T

M f () S f T t = M f () + T + t
T () = M w () + M f () S w + t

Applying the Nash bargaining solution:

(1)

(M w () S w T )
M ax M f () + T + t
w0

s.t. M w () S w + T, M f () T t

which implies that:

M w () S w T

= T ()

M () + T + t = (1 ) T ()
Since we have already gone through the algebra, and because the calculations do not add much to the
economics, the results are summarized below. As expected in a search and matching model, the decision
whether to stay matched or resume search, follows a reservation property (of course, the cuto productivity
r will depend on T and t!). The surplus from the match is the output above the reservation productivity
discounted to take into account the match impermanence:
T () =

r
r+

The job destruction condition is similar to the one we previously derived:

r (S t) = r +
r+
w

Zu

(1 F (z)) dz

(63)

This should not come as a surprise, since it states that, at the reservation productivity r , the total opportunity
cost of search (right-hand side) is equal to the total opportunity cost of a match (r (S w + T ) to the worker
and r (T t) to the firm).

39

We can compute the total surplus at match formation, T0 . Writing (59)-(60) at = u , we get that
R
(r + ) M w (u ) = w (u ) + M ax {M w (z) , S w + T } dF (z) and (r + ) M f (u ) = u w (u )
f

R
+ M ax M (z) , T t dF (z). Adding these up, we get that (r + ) [T (u ) t + S w ] = u +

R
R
M ax {M w (z) , S w + T } dF (z) + M ax M f (z) , T t dF (z). By the same token, using (57)-(58),

R
R
we get that (r + ) M0w = w0 + M ax {M w (z) , S w + T } dF (z) and (r + ) M0f = u w0 + M ax M f (z) , T t dF (z

R
R
Adding these up again, one gets that (r + ) (T0 + S w ) = u + M ax {M w (z) , S w + T } dF (z)+ M ax M f (z) , T t d
Comparing the two expression, we get that T (u ) t = T0 , or
T0 =

u r
t
r+

(64)

and wages are given by31 :

w () = + (1 ) rS w + r (T + t)
w0

= u + (1 ) rS (T + t)

(65)
(66)

To determine the job creation equation, we use again the free entry condition. The dierence with the above
model is that the surplus at match formation, which is what firms are considering when posting vacancies,
has a dierent expression. We get:

c
u r
= (1 )
t
(67)
q ()
r+
We can now use the model to look at the eect of firing regulations on unemployment and wages. Combining
(61) and (63) and using (67), we get:

r +
r+

Zu

(1 F (z)) dz
c
q ()

u r
= b + w + q ()
t rt
r+

u r
= (1 )
t
r+

Eect of firing taxes on unemployment:

Assume t > 0 and T = 0. When t > 0, the surplus at match formation decreases, hence firms post less
vacancies and decreases (for a given r ). This corresponds to a shift down of the JC curve.
Looking at the JD condition, we see that the term w is also influenced by t. First, not taking into account
the eect of t on w, we see that for a given r , increases as t increases. This implies that the JD curve
shifts down in reaction to an increase in t, which means that firing taxes have the (partial) eect of reducing
3 1 The

calculations for w0 are very similar to the one we carried out previously for w ().

40

job destruction. A calibration and simulation of the model reveals that the eect of t on w is to reduce w a
little, confirming the shift down of the JD curve.
The combined eect of the two shifts is to decrease r , that is to make job separation less frequent. The
eect on eq is qualitatively inconclusive. However, calibration shows that a higher t results in both higher
unemployment duration and a lower incidence of unemployment.
Eect of severance payments on unemployment:
Assume t = 0 and T > 0. We see that the JC condition is unaected by T . This is because (i) severance
payments are transfers within the match, and (ii) they do not enter the firms or the workers threat point
when the wage is initially negotiated at match formation. Also, the severance payments do not enter the JD
condition, again because they are transfers within the match (for the same reason as above, w is not very
dependent on T ). Hence, since neither job creation, nor job destruction is much aected by T , it does not
have much eect on the unemployment rate either.
Eect of T and t on wages and the wage profile:
As in the previous version of the model, wages of continuing matches are increased by firing regulations,
relative to w0 . As seen from (66), wages initially are reduced by the firing regulations (comparing w0 at
productivity u and w (u ) for a continuing match, one can see that w (u ) w0 = (r + ) (T + t) > 0).
In order to get the firms to accept to match, the wage w0 has to be low enough, in anticipation of possible
future firing costs. When bargaining at match formation, the firm fully expects that once the regulations
come into play, its bargaining position will be weaker than what it is now (i.e. its threat point will be lower).
Anticipating this, and given its current bargaining position before the regulations come into play, the firm is
able to retain more of the match output. The worker has to concede more of the output at first, knowing
that, later in the match, he or she will be able to extract more from the match output, since the firm will try
to avoid paying the firing costs. Hence, we have a steeper wage profile, in the presence of firing regulations.
In conclusion, this extended version of the basic Mortensen-Pissarides model delivers the following results:
- Firing taxes t tend to reduce job separation, but still result in longer unemployment,
- Severance payments have little eect on unemployment,
- Firing regulations (T or t) result in a steeper wage profile.
A very important consideration when studying firing regulations is to recognize that the dierent types of
firing costs have various eects on unemployment. It is necessary to dierentiate between transfer payments
and costs that are incurred by only one party to the match32 . However, much of the debate in the literature
focuses on whether adjustment costs are linear or quadratic. Also, when firing costs are considered, empirical
studies tend to only include severance payments or advance notice regulations, or a composite index of
3 2 And

between policies that impose fixed costs and policies that impose costs proportional to the workers skill, as these policies
have dierent eects on heterogeneous workers. But this would require a model with heterogeneous workers, of course.

41

strictness of regulations. Of course, procedural costs are hard to quantify. Nevertheless, this model shows
that they play an important role in the total eect of firing regulations. Also, the literature tends to focus on
the eect of firing costs on unemployment. However, we saw that there are potential eects on wages.
Another potential application of this type of model is to explain why, despite higher firing costs in Europe than
in the U.S., job destruction rates are of relatively similar magnitude in these economies. This can be explained
by the fact that generous unemployment benefits have the opposite eect on unemployment incidence than
firing costs do. While firing costs tend to reduce unemployment incidence, generous unemployment benefits
(i.e. higher benefit replacement rates) tend to increase unemployment incidence. Since the countries with
high firing costs (i.e. Europe) are also the countries with the more generous unemployment benefits, that can
qualitatively explain similar magnitudes of job destruction rates in Europe and the U.S.

Eciency wage models

The literature on eciency wage models is concerned with one question in particular: Given unemployment is observed in real economies, why dont firms cut their wages, in the face of excess
supply?. Of course, in the neoclassical model, this is not an issue, since firms are price takers and we know
that there will not be any involuntary unemployment in equilibrium, exactly because of market clearing. However, it seems like the neoclassical model is missing something and that market clearing, as an assumption, is
not necessarily appropriate when studying the labor market.
The eciency wage models are an attempt to justify why it may not be in firms best interest
to cut wages. In this framework, firms are wage setters, yet they may not want to cut wages anyway.
There are actually several types of eciency wage models. Their common characteristic is that the workers
productivity is a function of wage. As a result, setting a lower wage induces lower workers productivity and
may negatively aect profits. Hence, in equilibrium, wages may be above the market clearing level.
We first look at a general model, where productivity depends on wages, without stating through which
channel. We then look at an eciency wage model, where the relationship between wage and productivity is
not assumed, but rather derived.

3.1

Wage setting when productivity depends on wages

Suppose the firms production function is given by:

y = sF (e (w) L)
42

L is the number of workers it employs, e (w) is an eort function and s is a random component. The production
function F satisfies the usual conditions:
F 0 (L) > 0
F 00 (L) < 0
The eort function satisfies:
e0 (w) > 0
e00 (w) < 0

The firm is a wage setter, thus chooses wages and labor to maximize profits. That is, its problem is to:
M axsF (e (w) L) wL
w,L

where s, e (.) are given

The first order conditions are:

sF 0 (e (w) L) e0 (w) L L = 0
sF 0 (e (w) L) e (w) w

Hence:

= 0

e0 [w (s)] w (s)
=1
e [w (s)]

Inspection of that condition reveals that the wage is actually independent of the shock s. That is, we have
complete wage rigidity! The wage is such that the elasticity of eort with respect to wage is equal to 1 at the
optimal wage. Once wage is determined, labor is given by the fact that firms hire until the marginal product
of labor is equal to wage:
dy
(w , L ) = w
dL
Given the fact that eort (which is an indirect input in the production function) depends on wage, firms
do not reduce wage below w , because doing so would reduce profits.

3.2

Eciency wages: the moral hazard case

43

This is in fact the most commonly cited reference for eciency wage models. It comes from Shapiro &
Stiglitz (AER 1984). The moral hazard comes from the fact that firms and workers have to engage into an
employment contract, determining the wage the worker will receive. However, the firm can only imperfectly
monitor the workers actions, or work eort, once the contract is in place. So, the firm wants to make sure
that the employee does not shirk, that is, it wants to make sure that the worker puts in a high work eort.
But how can the firm do that, if it cannot monitor its employees easily?
The economy is described below:
Agents:
N identical workers
M identical (wage setting) firms
Preferences:
Workers utility function: U (c, e), where c is consumption and e represents work eort. The worker has the
choice between two eort levels:
e

{0, e}

where e > 0
The worker gets to consume his or her wage if employed and receives unemployment benefits, if not employed.
That is:
c = w, if employed at w
c = b, if not employed
Of course, U is increasing in c and decreasing in e. It is also assumed that U is separable in c and e. Hence:
U (c, e) = c e
Firms are profit maximizers.
Flows:
- The is an exogenous (separation) rate s at which worker/firm matches are broken down.
- There is an (imperfect) monitoring technology, that allows the firm to see if the worker shirks or not.
However, it can only detect shirking, given it is taking place, with probability f , per unit of time. In that
case, the worker is fired.
- The rate a at which workers find jobs is endogenously determined.
State variables:
For workers: employed or unemployed
44

Control variables:
Work eort e {0, e}
Value functions:
Vu : Value to worker of being unemployed (expected lifetime value)
Ves : Value to employed worker of shirking
Ven : Value to employed worker of not shirking
Workers problem:
In order to make his or her decision, the worker has to take the wage wi at firm i as given, as well as the value
of his alternative state (state of unemployment) Vu . In flow terms, the value function equations are given
by33 :
rVes = wi + (s + f ) (Vu Ves )
(68)
This equation says that the flow of utility from shirking while employed is the instantaneous wage received,
not reduced by any work eort, plus the probability (s + f ) of becoming unemployed, in which case, the
workers expected lifetime value goes from Ves to Vu .
Similarly, the value of not shirking is:
rVen = wi e + s (Vu Ven )

(69)

This equation states that the flow of utility from not shirking is the instantaneous wage received minus the
disutility from eort, plus the probability s of becoming unemployed, due to an exogenous random event, in
which case, the workers expected lifetime value goes from Ven to Vu .
3 3 In

papers, the flow equations are rarely explicitly derived. That is because they tend to take the same general form and
because, most times, they are actually written in steady state. The flow of value from being in a particular state is generally
equal to the instantaneous utility received from being in that state plus the instantaneous probability of changing state times
the resulting gain/loss in value from that change. Let us see why in this particular example:
1
{w (t) dt + (sdt) Vu (t + dt) + (1 sdt) [(f dt) Vu (t + dt) + (1 f dt) Ves (t + dt)]}
1 + rdt
As dt 0, we have that:
Ves (t) =

(1 + rdt) Ves (t) = w (t) dt + (sdt) Vu (t) + dtVu (t) + (1 sdt) (f dt) Vu (t) + dtVu (t) + (1 f dt) Ves (t) + dtVes (t)
Taking Ves (t) out on both sides, dividing through by dt and with dt 0, one gets:

rVes (t) = w (t) + (s + f ) [Vu (t) Ves (t)] + Ves (t)

In steady state, this becomes:
rVes = w + (s + f ) [Vu Ves ]

45

Equations (68) and (69) can be solved for Ves and Ven as functions of the wage wi at firm i and the value of
being unemployed Vu .
Ves

Ven

wi + (s + f ) Vu
r+s+f
wi e + sVu
r+s

Remember that the employed workers decision is whether to shirk or not. Given wi and Vu , the worker
prefers to work hard if:
Ven Ves
which is equivalent to:
wi rVu +

r+s+f
e
f

(70)

This condition is generally referred to as the no-shirking condition (NSC). Note that the wage necessary
to deter shirking increases with Vu , the value of the state the worker goes to, if caught. It increases with e,
the eort level corresponding to no shirking. Finally, the no-shirking wage decreases with the probability of
being caught f . If being fired becomes more likely, the incentive the firm has to give the employee to work
hard does not have to be as big.
Firms problem:
Technology:
When firm is employment is Li , its eective employment li is the number of its workers who are not shirking.
Since shirkers are contributing zero eort, their eective labor input is also zero. Then, firm is production is
given by:
yi = F (li )
where F (.) is strictly increasing and concave.
Each firm must find it optimal to fire shirking workers, since the other alternative, a wage reduction, would
only induce him or her to shirk (remember that, unless a worker chooses eort level e, no output is produced).
The firm cannot pay a shirking worker anything else than 0, since a shirkers output is zero. It finds it better
to pay the no-shirking wage and get output from the worker. Remember that firms are wage setters. Taking
Vu as given, they can just set their wage to the point where the worker is just indierent between shirking
and not. Hence, they choose to hire at the no-shirking wage. Hence, firm i sets its wage w
ei , such that:
w
ei = rVu +

r+s+f
e
f

46

The employment choice Li by firm i has to be such that the marginal product of labor in firm i is equal to
the wage set:
0
F (Li ) = w
ei

Equilibrium:
Up to now, Vu and the market wage w were taken as given. Of course, these are determined in equilibrium.
We are looking for an equilibrium where the wage wi set by firm i is equal to the market wage w.
The value of unemployment is given by:
rVu = b + a (Ve Vu )

(71)

Remember that the firm sets the wage so that workers are just indierent between shirking or not shirking.
Hence:
Ves = Ven = Ve
Equation (71) has the same interpretation as the other value function equations. In flow terms, the value
of being unemployed is equal to the utility received while unemployed (which may include unemployment
benefits, value of leisure, home production) plus the option value of changing state (U to E). Solving for
equilibrium values of Ve and Vu , we get34 :
rVe

rVu

(r + a) (w e) + sb
r+s+a
a (w e) + (r + s) b
r+s+a

Knowing that, in equilibrium, all firms set the same wage (w

ei = w), this allows us to rewrite the NSC condition
as:
r+a+s
w =b+e+
e
(72)
f
As previously mentioned, the rate out of unemployment a is endogenously determined. In steady state, every
period, the flow out of employment (number of workers losing their jobs) is equal to the flow into employment
(number of workers finding a job). Calling L the aggregate employment, this steady state condition can be
written as:
sL

a (N L)
sL
= a =
N L

L
Let u = NN
be the unemployment rate. Thus, L/N = 1 u and a = s 1u
u . Therefore, w = b + e + (e/f ) (r +
s(1u)
+ s) and we can further rewrite the NSC condition as:
u
eh
si
w =b+e+
r+
(73)
f
u
3 4 Remark

that we could use either (68) or (69) to compute Ve .

47

No-Shirking Condition

Wage w
6

Labor Demand

Employment L

Figure 4: Equilibrium wage and employment

At this point, the unemployment rate u has not been determined yet. In fact, the market wage and employment
level are given by two conditions. First, the firm, given L, sets the wage just equal to the no-shirking wage,
as given by the NSC condition (73). Then, the firm, given w, chooses how many workers to hire to the point
where the marginal productivity of labor equals w. Given that all firms are homogeneous and hence have
same employment, this results in:

0
L
F
=w
(74)
M
This gives us two curves in (L, w) space. The equilibrium wage and employment level is the intersection of
these two curves.

The equilibrium wage and employment levels are the intersection of two curves.

48

One is the NSC condition. There has to be a certain relationship between the wage set by the firm and the
employment level:wN SC is increasing in L. This is because the firm uses the wage to entice the worker to
produce full eort: the higher the employment level, and therefore the lower the unemployment rate, the
higher the firm has to set the wage to make shirking costly. Notice that, of course, the threat of firing the
worker is eective only if there is a certain level of (involuntary) unemployment. The unemployed would
prefer to work at or even below the equilibrium wage35 , but cannot make a credible promise to produce full
eort at that wage.
Also, notice that the no-shirking wage w increases with the income received during search b. This is because
a higher b implies that the cost of becoming unemployed is less, and hence that being fired is relatively less
costly. Also, the higher the eort level e, the more the firm has to pay the worker to guarantee hard work.
And finally, the more dicult its is to monitor the worker (low f ), the higher the wage. If being caught is
unlikely, you have to increase the cost of being caught to deter low eort.
The other relationship is the usual labor demand equation. Given the wage, the firm sets employment such
that the marginal product of labor is equal to the wage. Because firms choose to raise wages as an enforcement
mechanism, the quantity of labor demanded decreases, resulting in unemployment.

An introduction to implicit contracts

The implicit contract literature is also interested in looking at why wages seem to be relatively stable (or
rigid). If one considers that firms and workers are engaged in long-term relationships, then wages may
reflect the terms of an implicit contract entered in voluntarily by the worker and the firm, rather than
ensure that the labor market is cleared every period.
The basic feature of implicit contract theory is that workers are risk averse and have limited access to capital
markets. This can be justified by considering that workers only capital is their human capital, that cannot
be used as collateral (especially firm-specific human capital). Since they are risk averse, they would like
to obtain some kind of insurance against income fluctuations, but cannot get this from private insurance
companies. The employers, however, are less risk averse and have access to capital markets. For simplicity,
one may assume that employers are risk neutral36 . Because workers and employers have dierent attitudes
towards risk, there is room for employers to provide some form of insurance to the workers. Hence, employers
implicitly provide wages and insurance to their workers as part of an employment package. The implicit
contract should be interpreted in the as if sense of an explicit one, as a mutual understanding between
worker and employer that the invisible handshake implies, as in commercial contracts. In other words, by
3 5 Notice

that: r (r + s + a) (Ve Vu ) = r (w b e) > 0. Hence, Ve Vu > 0.

the firms owner is risk neutral or because firms have access to capital markets.

3 6 Because

49

providing insurance to risk averse workers, the risk neutral firm is able to attract workers at a lower expected
wage, than they would if they were not providing insurance.
First assume that workers are risk averse and cannot insure themselves, either through direct insurance or
through savings accumulation. Consider that the productivity of a worker is determined, in part, by a random
variable s. The shock s can reflect demand uncertainty and/or a productivity shock. The firm oers an optimal
contract to the worker, in the form of wage and work hours, as a function of s, {W (s) , H (s)}sS .
The workers maximize expected utility:
E [V (C (s) , 1 H (s))]
s.t. C (s) = W (s) H (s)
The constraint reflects the fact that the workers do not have access to credit markets, so that labor is their
only source of income.
Firms are risk neutral and maximize expected profits:
E [sF (H (s)) W (s) H (s)]
What if the labor market were characterized by the usual competitive market?:
Let us first look at what would happen in a spot competitive market. Denote by F (L) the firms production
function:
0
00
F (L) > 0, F (L) < 0
In a competitive spot market, firms and workers, after realization of s, take W (s) as given, and maximize
current utility, and firms maximize expected profits. Hence, the firms FOC is given by:
0

sF (H (s)) = W (s)

(75)

W (s) V1 [W (s) H (s) , 1 H (s)] V2 [W (s) H (s) , 1 H (s)] = 0

(76)

while the workers FOC is:

In such a market, both wage and employment respond to a change in s.

Now assume the relationship between a worker and a firm are characterized by a long-term contract:
Consider that firms set wages, and in particular oer a contract to workers. In fact, the contract can be
determined in terms of {C (s) , H (s)} instead of {W (s) , H (s)}. The contract specifies a value for consumption
and labor hours as a function of s (before the realization of s, of course).

50

Since the firm is risk neutral, it can oer a contract that transfers income across states. The contract maximizes
expected profits, given expected utility. The contract must maximize:
M ax

E [sF (H (s)) C (s)] + E [V (C (s) , 1 H (s))]

{C(s),H(s)}

(77)

The constant can be seen as a measure of bargaining strength of the worker (the higher , the higher the
weight on the workers expected utility in the maximization problem)37 . Notice that this results in an optimal
contract, by construction. By varying , one describes the set of optimal contracts. Since workers are risk
averse, while firms are risk neutral, one can see that a contract derived from this maximization problem will
shift some of the risk from workers to firms, hence increasing the objective function.
(Writing the maximization problem in these terms is equivalent to writing in the form:
M ax

E [sF (H (s)) C (s)]

{C(s),H(s)}

s.t. E [V (C (s) , 1 H (s))] V0

where V0 is some reservation value to the worker. The contract has to make the worker as least as well o as
V0 , which can be seen as reflecting some outside option to the worker.)
[The outside option can be viewed as what the worker would get in a spot market.]
We can maximize with respect to C and H in each state s38 , and get:
1 + V1 [C (s) , 1 H (s)] = 0

(78)

sF [H (s)] V2 [C (s) , 1 H (s)] = 0

(79)

We get, by dierentiating (78) and (79):

0

Hence:

V11 [C (s) , 1 H (s)] C (s) V12 [C (s) , 1 H (s)] H (s) = 0

h
i 0
0
00
0
V12 [C (s) , 1 H (s)] C (s) + V22 [C (s) , 1 H (s)] + sF [H (s)] H (s) = F (H (s))
0

F V12

0
0
F V11
H (s) =

2
00
V11 V22 sF V11
where = V12
0

C (s) =

3 7 Notice

(80)
(81)

that this has nothing to do with the bargaining power in the Nash bargaining solution.
of the expected value of an objective function, with given weights. We can just maximize the objective function

3 8 Maximization

at every s.

51

2
We can see that H (s) has the opposite sign of . Since workers are risk averse, V12
V11 V22 < 0 and V11 < 0.
We also know that the production function itself is concave. Therefore < 0 and:
0

H (s) > 0
It results from inspection of (80) that:
0

C (s) > 0 V12 (C, 1 H) < 0

The implicit contract specifies that workers always work more in good times (high s). There is no ambiguity
due to opposing income and substitution eects (remember that in a competitive spot market, the income
0
and substitution eects of a increase in productivity, work in opposite directions). The positivity of H (s)
is basically a result of the substitution eect only. By providing insurance (income transfers) to the worker,
the firm removes the income eect, and workers substitute leisure for labor when productivity is high. A bad
productivity draw does not carry any income eect. Hence, the worker will work more when the marginal
product of labor is larger and redistributes consumption by insurance. If indeed the economy is characterized
by long-term implicit contracts between workers and firms, the fact that these contracts emphasize substitution
eects gives more support to RBC models that rely on high degree of substitution of labor hours in response
to productivity shocks.
Remark that implicit contracts do not insure ex-post utility. In fact, from (78), we see that the eect of
insurance is to smooth out marginal utility of consumption, but not utility. Define ex-post utility as
u (s) = V (C (s) , 1 H (s))
Then:

F V12
F V11
u (s) = C V1 H V2 =
V1
V2

Hence, u (s) has the sign of V11 V2 V12 V1 . We have that39 :

Utility is fully insured
This is the case if V (C, 1 H)

V11 V2 V12 V1 = 0
v (C + (1 H))

Notice that C (s) can take any sign. However, we have the following:
Consumption is completely smoothed when the utility function
is additively separable in consumption and leisure
Consumption and labor are positively correlated only when
3 9 Notice

that, in that case, employment is the same in the spot and the contract economies.

52

V12 (C, 1 H) < 0

Comparing the FOCs for the spot competitive market and the contract economy, we can see that:

Spot Market Economy:

V2
V1
V2
V1

= sF and sF = W
Contract Economy:
0
1
= sF and V1 =

We can see that in the two economies, the same eciency condition on hours holds. However, in the contract
economy, insurance ensures that the marginal utility of consumption is constant across states.

53

Miscellaneous issues
in
search and matching

First generation of search models: wage posting

The treatment comes from Rogerson, Shimer and Wright (JEL 2005).
We start the course with the rst generation of search models to have an idea of how the literature
evolved. One of the early questions was to try understanding how unemployment can arise and how can
similar workers earn dierent wages. For that of course, one has to move away from Walrasian models
towards models with frictions. To address these questions, we look at the rst generation of search models
(as opposed to matching models). The rst attempt was to study the problem of a worker facing a
distribution of wages and deciding whether to accept a wage oer. For now, the distribution of wages itself is
exogenous. We will think of endogenizing this distribution later in the course.

1.1

Innitely lived matches

Discrete time:
P+1
Consider a worker seeking to maximize his expected lifetime income E t=0 t xt , where xt is his income
at date t. This income can either be a wage wt if employed or unemployment income b. The unemployed
worker samples every period over a known distribution of oered wages F (w). The worker can either accept
or reject the sampled wage. If accepted, he starts working. If refused, the worker waits a period and gets to
sample again from the same distribution. Start by assuming that if the wage is accepted, the worker stays
employed indenitely. We thus have two value functions
(
R +1
U = b + 0 maxfU; W (w)gdF (w);
W (w0 ) = w0 + W (w0 ):
It is immediate that W (w0 ) = w0 =(1
) is increasing in w0 and therefore there exists a reservation wage wr
that will make the unemployed worker indierent between accepting and rejecting a wage oer. By denition,
W (wr ) = U:
How do we derive that reservation wage wr ? It must be that
R +1
U = W (wr ) = 1wr = b + 0 maxfW (wr ); W (w)gdF (w);
R +1
=) 1wr = b + 0 maxf 1wr ; 1 w )gdF (w);
R +1
=) wr = b(1
) + 0 maxfwr ; wgdF (w):

That can be rewritten as

wr (1
) = b(1
=) wr = b + 1

)+

R +1
0

R +1

maxf0; w wr gdF (w);

maxf0; w wr gdF (w):
0

This is one of the standard ways to express the reservation wage equation in a wage posting model. The
other one is derived as
R +1
wr = b + 1
maxf0; w wr gdF (w);
0 R
+1
=) wr = b + 1
(w wr )dF (w);
r
Rw+1
=) wr = b + 1
(1 F (w))dw;
wr
1

where the last expression is obtained by integrating by parts.

Continuous time:
We re-derive the results in continuous time. The discount rate is 1=(1 + rdt) and the probability to get
an oer per period dt is given by dt Then the value functions can be rewritten as
(
R +1
1
dt 0 maxfU; W (w)gdF (w) + (1
U = bdt + 1+rdt
dt) U ;
W (w0 ) = w0 dt +

1
0
1+rdt W (w ):

With the usual algebra, we obtain that

(
R +1
rU = b +
maxf0; W (w)
0
0
0
rW (w ) = w :

U gdF (w);

We can see the similarity with the discrete time case. The dierence is that the value functions just above
are expressed in terms of ow. By the same argument, we can prove the existence of a reservation wage wr
above which oers are accepted, W (wr ) = U . Algebra implies that this reservation wage can be expressed as
8
R +1
>
< wr = b + r wr (w wr )dF (w);
or
>
R +1
:
wr = b + r wr (1 F (w))dw:
What do we get out of that very simple model? This generates unemployment. Because not all oers
are accepted, the model predict some unemployment (of course, remember that a very important of that
unemployment is the distribution F which is still exogenous...) The model also generates a distribution G(w)
of accepted wages (which may be dierent from the distribution of oered wages). Also we can do some
comparative static exercises. Here are the results summarized:1
Unemployment duration:
U:D: = 1=H, where H = [1

F (wr )]:

H is called the hazard rate (why?).

Also,
Distribution of accepted (observed) wages:
G(w) = F (wjw wr ):
Also,

dwr
db
dwr
d

> 0 =) dH
db < 0 =) higher b implies longer unemployment spells,
> 0, but possibly ambiguous eect on H. dH
d > 0 under log-concavity.

Notice that the rst eect is the one obtained in standard matching models, but for dierent reasons (why?).
1 The probability that a worker has not found a job after a spell of duration
R
average unemployment duration is equal to 0+1 ue Hu Hdu = 1=H.

is equal to (1

Hdt) dt

. Thus the

1.2

Finitely lived matches

So far, we have assumed that once a worker accepted a job, he works for the rm for ever. This is clearly
empirically invalid since as we already know there are relatively high levels of job destruction at every phases
of the cycle.
We thus start by assuming that matches end exogenously at a Poisson rate . The value of unemployment
is unchanged. However, the value of employment must be rewritten as
rW (w) = w + [U

W (w)]:

The nature of the workers decision is still the same so that we still have a reservation wage property and
U = W (wr ), which leads to
Z +1
(1 F (w))dw:
wr = b +
r+
wr
It is the same as the reservation wage equation above, except that possible match breakdowns in the future
have the eect of reducing the discount rate. Unemployment duration is still given by 1=H and employment
duration is equal to 1= .

1.3

Finitely lived matches with on-the-job search

The problem with the above formulation is that the separation rate is exogenous, which makes it impractical
for a lot of applications. We thus introduce on-the-job search in the model in order to obtain job-to-job
transitions. This is empirically a very important feature of labor markets (see work by Nagypal among others
documenting that fact). We will see models of on-the-job search several times over the course of the semester.
Suppose new oers arrive at rate 0 while unemployed and at rate 1 while employed. In each case,
workers get to sample from the same distribution. The value functions become
(
R +1
rU = b + 0 wr [W (w) U ]dF (w);
R +1
rW (w0 ) = w0 + 1 0 maxf0; W (w) W (w0 )gdF (w) + [U W (w0 )]:

The second term in the LHS accounts for the fact that the employed worker can improve on his current situation
without going back to unemployment. Again we have a reservation wage property for the unemployed worker.
The employed workers reservation wage property is very simple: accept if w > w0 . After some algebra, we
get that
Z
+1

wr = b + (

1)

(W (w)

W (wr ))dF (w):

wr

Notice that wr 7 b ()

(why?). Again, this reservation wage property can be rewritten as

wr = b + (

1)

+1

wr

r+

1
+

F (w)
dw:
F (w)]
1 [1

We still have that dwr =db > 0, but here that also implies that turnover is reduced by unemployment insurance.

This simple framework delivers a lot of predictions about turnover that are empirically valid:2
8
>
< Time since last unemployed is positively correlated with wage,
Separation are negatively correlated with wages,
>
:
Negative correlation between job tenure and separation rates.

We will use a variant of this model later in the course (Ljungqvist and Sargent 1998)

2 One

can again compute a number of things. In steady state, (1

u=

o (1

u) = u
F (wr ))

o (1

F (wr )), thus

We can also compute the distribution of observed wages G(w). Consider the interval [wr ; w]. Flows into that interval are coming
from unemployed workers. Flows out of that interval are going either to unemployment or to higher wages (see graph ). Thus in
steady state, it must be that
u

0 [F (w)

F (wr )] = (1

u)G(w) + (1

u)G(w)

which combined with the expression for u above implies that

G(w) =

[F (w) F (wr )]
:
F (wr )][ + 1 (1 F (w))]

[1

Finally, the job-to-job transition rate is given by

1

+1

(1

F (w))dG(w):

wr

1 (1

F (w));

E ciency in matching models: the Hosios condition

Matching models are characterized by search externalities: searching rms make it harder for other rms to
match and make it easier for workers to match. The question is: when is e ciency achieved? Hosios (Restud
1990) answers that question.
We look at a simplied version of a matching model, but the argument carries through to a more general
setup. Since the decision being studied is: how are vacancy decisions taken? (and thus how are matching
probabilities determined?), we look at a simple model where an individual rm has the option to post costly
vacancies and faces a matching probability which is determined by rms behavior. The rm takes market
tightness = uv as given and posts a vacancy if the value of doing so is positive. Thus, free entry ensures that
c = q( )M f ;
Prices are determined once a meeting takes place, by Nash bargaining. Suppose output is y and the outside
options of both sides are 0. Then the wage is determined as
arg max w

(y

w)1

=) w = y =) M f = (1

)y:

Thus equilibrium vacancy posting is determined by

c = q( )(1

)y:

(1)

The social planners problem is to choose the number of vacancies to maximize aggregate output net of
vacancy costs, i.e. to
max m(u; v) y cv:
v

Thus optimal vacancy posting is determined by

c = m2 (u; v)y:

(2)

The equilibrium and optimal solutions coincide when

c = q( )(1
Denote by
when

)y = m2 (u; v)y =) 1

v:m2 (u; v)
:
m(u; v)

the elasticity of the matching function with respect to vacancies. The equilibrium is optimal
1

v;

(3)

in other words, when the rms bargaining power is equal to the elasticity of the matching function with
respect to vacancies. Notice that with constant returns to scale in the matching function, this is equivalent to

requiring that the workers bargaining power is equal to the elasticity of the matching function with respect
to unemployment. This is known as the Hosios condition.1
Notice two things. First, optimality holds only under very specic conditions. Generically, the equilibrium
is not e cient. Second, the intuition behind the Hosios condition is that to obtain an e cient allocation in
equilibrium, the rm must keep a su cient share of the surplus to compensate appropriately for posting a
(1
)y, the individual matching
costly vacancy. The private marginal return to a vacancy is equal to m(u;v)
v
probability times the share of surplus. The social marginal return to a vacancy is equal to m2 (u; v)y, the
product of the marginal increment in the number of matches from posting the vacancy times the output
produced in a match. The Hosios condition equates the two marginal returns.

E ciency with an investment decision and holdup of investment

We have just established that e ciency basically does not hold in random matching models. We now investigate the question of e ciency of investment decisions (by rms). We will see that even if the Hosios condition
holds, investment by rms may not be socially optimal. To help understand the issues at hand, we consider
two cases: investment prior to matching and investment after matching.

2.1

Investment costs incurred before matching - holdup

Firms take market tightness as given. Prior to looking for a worker, the individual rm can acquire capital
k at a cost c(k) to increase productivity y(k). The value of search conditional on the investment decision k is
S f (k) =

c(k) + q( )(y(k)

w(k));

where w(k) is the solution to

max w
w

(y(k)

w)1

thus w(k) = y(k). The investment choice is determined by maxk S f (k), where q( ) is taken parametrically.
In equilibrium, the free entry must also hold. Thus we have a system [dS f (k)=dk = 0; S f (k) = 0] to solve
which comes to
( 0
c (k)
)q( );
y 0 (k) = (1
(4)
C + c(k) = (1
)q( )y(k):
The social planners problem is to choose the number of vacancies and the investment level to maximize
aggregate output net of vacancy and investment costs, i.e. to
max m(u; v) y(k)
k;v

1 With

a Cobb-Douglas matching function (m(u; v) = Au v 1

(C + c(k))v:
), optimality of equilibrium requires that

= .

The optimal solution is characterized by2

(

c0 (k)
y 0 (k)

= q( );

C + c(k) =

v q(

(5)

)y(k):

The equilibrium and optimal allocations coincide when

= 0 and

= 1.

(6)

In that case, the Hosios condition is necessary, but not su cient. It must also be that the rm has all the
bargaining power. There is a holdup problem, since the rms investment decision is taken prior to matching
potential workers. When the worker and rm negotiate, the investment is already realized and unless the
rm has all the bargaining power, the worker will share in the returns from investing. This holdup problem
leads to underinvestment by the rm. We can see from (4) that the rm anticipates the upcoming holdup of
its investment and recognizes that its marginal return from investment is only q( )(1
)y 0 (k) rather than
0
q( )y (k).
We show below that the investment ine ciency is really coming from the fact that the investment is carried
out before matching. We consider a model where investments are realized after matching and see that the
Hosios condition is again necessary and su cient for optimality.

2.2

Investment costs incurred after matching - no holdup

The value of search is

S f (k) =

C + q( )(y(k)

c(k));

c(k))1

where wage and investment are the solutions to

max w
k;w

(y(k)

The negotiated wage and investment are given by

( 0
c (k)
y 0 (k)

= 1;

w = (y(k)

c(k)):

Free entry requires that S f (k) = 0. The equilibrium allocation is such that
( 0
c (k)
y 0 (k) = 1;
C = q( )(1

2 Notice

that m2 (u; v) = q( )

)(y(k)

v.

c(k)):

(7)

The social planners problem is to choose the number of vacancies and the investment level to maximize
aggregate output net of vacancy and investment costs, i.e. to
max m(u; v) (y(k)
k;v

The optimal solution is characterized by

(

c0 (k)
y 0 (k)

c(k))

Cv:

= 1;

C = q( )

v (y(k)

c(k)):

(8)

The Hosios condition guarantees optimality of equilibrium. Because the rms investment is not held upby
the worker during the negotiations - the private and social marginal returns to investment are both equal to
y 0 (k), we have e ciency of the investment decision and only need the Hosios condition to hold for e ciency.

Chapter IV
OPTIMAL TAXATION

Optimal taxation with commitment

We are interested in looking at the problem a government faces in financing its own expenditures. We will treat
it as a dynamic problem, where a government has to raise distortionary taxes, to finance a given exogenous
stream of government expenditures.

1.1

Competitive equilibrium

Households:
The problem is deterministic. There is an infinitely lived representative household. Its preferences are given
by a utility function u (ct , lt ), where ct is consumption of the single good and lt is leisure. The utility function
has the usual properties. It is increasing and concave in ct and lt . The representative household discounts
the future at rate .
The household is endowed every period with one unit of time, so that:
ht + lt = 1
so that the household has to divide its time between leisure and labor ht .
Firms:
To produce output, firms use a technology characterized by a production function f (ht , kt ). They rent labor
and capital from households, paying the capital rental rate rt and wage rate wt . The function f is assumed
to be increasing in both arguments, concave and to exhibit constant returns to scale.
Aggregate resource constraint:
The output produced in period t can be consumed by households, used by the government or used to augment
the capital stock, which otherwise depreciates at rate :
ct + kt+1 (1 ) kt + gt = f (ht , kt )

(1)

Notice that {gt }t=0..+ is taken as given.

Government:
The government can raise flat-rate, time-varying taxes on capital ( kt ) and labor income ( ht ). It can also
trade one-period bonds, which can accomplish any intertemporal trade in a deterministic economy. Denote

by bt the government indebtedness. bt is denominated in time t goods and mature at the beginning of period
t. Hence, the government budget constraint is given by:
gt = kt rt kt + ht wt ht +

bt+1
bt
Rt

(2)

where Rt is the gross rate of return of the one-period bonds held from t to t + 1 (interest earnings are assumed
to be tax-exempt).
Optimization:
The firms problem is standard. Profit maximization implies that factor prices are equal to their marginal
products:
wt

= f1 (ht , kt )

rt

= f2 (ht , kt )

The representative household maximizes the following objective function:

M ax

+
X
t=0

s.t. ct + kt+1 (1 ) kt +

t u (ct , 1 ht )

bt+1
= 1 ht wt ht + 1 kt rt kt + bt
Rt

We will use dynamic programming to solve the households problem. The state variables are the capital stock
kt and the initial bond holdings bt . The control variables are investment kt+1 , labor supply ht , and the bond
holdings to bring to the next period bt+1 . We can thus rewrite the households problem as:
V (kt , bt ) =

M ax

kt+1 ,ht ,bt+1

s.t. ct + kt+1 (1 ) kt +

{u (ct , 1 ht ) + V (kt+1 , bt+1 )}

bt+1
= 1 ht wt ht + 1 kt rt kt + bt
Rt

The first order condition with respect to investment is:

u1 (ct , 1 ht ) = V1 (kt+1 , bt+1 )
which, combined with the envelope condition on kt ,

V1 (kt , bt ) = 1 kt rt + 1 u1 (ct , 1 ht )
results in:

u1 (ct , 1 ht ) = u1 (ct+1 , 1 ht+1 )

3

1 kt+1 rt+1 + 1

(3)

The first order condition with respect to labor supply is given by:

1 ht wt u1 (ct , 1 ht ) = u2 (ct , 1 ht )

(4)

Finally, the first order condition with respect to bond holdings is:
1
u1 (ct , 1 ht ) = V2 (kt+1 , bt+1 )
Rt
which combined with the envelope condition on bt ,
V2 (kt , bt ) = u1 (ct , 1 ht )
gives us
1
u1 (ct , 1 ht ) = u1 (ct+1 , 1 ht+1 )
Rt

(5)

Combining (3) and (5), we find that:

Rt = 1 kt+1 rt+1 + 1

(6)

This condition, which does not involve any quantities that the household is free to adjust, constitutes an
arbitrage condition. Since only one type of financial asset is needed to accomplish all intertemporal trades in
a deterministic economy, (6) ensures that the two assets available (capital and bonds) oer the same rate of
return1 .

Competitive equilibrium (for a given government policy):

A competitive equilibrium is an allocation [{ct } , {kt } , {ht } , . {gt }]t=0...+ ,
1 If

we write the household budget constraint for two consecutive periods, and eliminate bt+1 which appears in both, we get:
ct+1
kt+2
bt+2
+
+
Rt
Rt
Rt Rt+1
"
#

1 kt+1 rt+1 + 1
1 h
t+1 wt+1 ht+1
h
1 t wt ht +
+
1 kt+1 + 1 kt rt kt + (1 ) kt + bt
Rt
Rt
ct +

If the term multiplying kt+1 were not zero, the household could make its budget set unbounded by buying or selling an
arbitrarily large kt+1 and entering the bond market (depending on the sign of the expression). Hence, to ensure the existence of
a competitive eqiulibrium with bounded budget sets, the arbitrage condition must hold.

a price system [{wt } , {rt } , {Rt }]t=0...+ and a government policy {gt } , kt , ht , {bt } t=0...+ , such that:

(a) Given prices and government policies, firms and households satisfy their respective optimization problems,
(b) The aggregate resource constraint (1) is satisfied for all t,
(c) Given allocations and prices, government policies satisfy the government resource constraint (2), for all t.

Of course, the competitive allocation depends on the (exogenous) government policy. This motivates our
interest in the following so-called Ramsey problem. In the Ramsey problem, the governments goal is
to maximize the representative households welfare, subject to raising given revenues through distortionary
taxation. The government knows how people react to a given set of taxes and can therefore use that reaction
function to design optimal taxes.
Ramsey problem: Given k0 and b0 , choose a competitive equilibrium that maximizes the discounted lifetime
utility of the representative household.

1.2

The Ramsey problem

The government tax revenues are kt rt kt + ht wt ht . Denote net after-tax capital and labor rental rates as

ret = 1 kt rt and w
et = 1 ht wt , respectively. Hence, government tax revenues can be rewritten as:
tax revenues

= (rt ret ) kt + (wt w

et ) ht
= f (ht , kt ) ret kt w
et ht

Inserting this expression in the government budget constraint, we get:

gt = f (ht , kt ) ret kt w
et ht +

bt+1
bt
Rt

We thus incorporated the firms first order conditions into the government budget constraint. The government
policy choice is also restricted by the aggregate resource constraint and the households problem first order
conditions.

We know that the government is interested in designing a tax path ht , kt to maximize consumers welfare.
It must first choose (once and for all) these taxes - and commit to them, then the competitive equilibrium
determines how households react to these taxes, in each period. Thus, the firms and the representative
households first order conditions, as well as the usual resource constraints, must be constraints in the governments problem. The diculty is that the control variables in the households problem are only implicitly
defined through the first order conditions. We must therefore treat the problem as a Lagrangian one, where
the government chooses taxes and the households control variables (from section 1.1), with the restriction
that the variables in the households problem satisfy the first order conditions.

Hence, the governments problem can be written as:

u (ct , 1 ht )

h
i

bt+1

,
k
)

r
e
k

w
e
h
+

g
f
(h
+
t
t
t
t
t
t
t
t
t
+

R
t
X t

+t [f (ht , kt ) ct kt+1 + (1 ) kt gt ]
ax
k
hM

t=0
t , t

+1t [u2 (ct , 1 ht ) w

et u1 (ct , 1 ht )]

{kt+1 } , {ht } , {bt+1 } , {ct }

+2t [u1 (ct , 1 ht ) u1 (ct+1 , 1 ht+1 ) [e
rt+1 + 1 ]]
where Rt = ret+1 + 1

Since the point we want to make does not require fully solving for the governments problem, we only look at
one of the optimizing condition, namely, the first-order condition with respect to kt+1 :
{t+1 [f2 (ht+1 , kt+1 ) ret+1 ] + t+1 [f2 (ht+1 , kt+1 ) + 1 ]} t = 0

(7)

Suppose that the government expenditures remain constant after some period (gt = g, t T ) and that the
solution to the Ramsey problem converges to a steady state. Then, from (7), we have that:

From (3), we have, in steady state:

{ [r re] + [r + 1 ]} =
1 = [e
r + 1 ]

which, plugged in the above equation, gives us:

( + ) [r re] = 0

(8)

One can easily show that the multipliers on the aggregate and government resource constraints must be
positive. Therefore, (8) implies that rt = ret , and thus we obtain the celebrated result that:
kt = 0

Hence, if the equilibrium has a steady state, then the optimal policy is to eventually set the tax rate on capital
to zero! Of course, the same conclusion does not hold for the labor income tax. It is important to notice that
this conclusion is robust to several changes. In particular, it holds whether the government can issue debt (as
in the present model) or must run a balanced budget (in which case, one could follow the same proof and just
set bt = bt+1 = 0 in the Lagrangian problem). Also, notice that this strong result is not due to some eciency
considerations, as we did not consider lump-sum taxes. In fact, the only strong assumption of the model
is that the government can commit to future tax rates, at time zero. Notice that taxing the (inelastically
supplied) capital stock at date 0 amounts to lump-sum taxation and hence disposes of distortionary taxes.
Thus, a government without a commitment technology may be tempted in future periods to renege on its
6

premises and levy a confiscatory tax on capital. But, of course, households would anticipate that possibility
and all the reasoning above would unravel. This leads us in the territory of time-inconsistent policies, and
of reputation. Can an announced fiscal policy be sustained in an equilibrium because the government wants
to preserve its reputation (rather than because one assumes that the government commits to the announced
policy once and for all)?

Chapter V

TIME INCONSISTENCY
OF
GOVERNMENT POLICY
AND
OTHER CONSIDERATIONS

General considerations on the recursive nature of various problems

1.1

The standard competitive equilibrium has a recursive formulation

Consider the typical problem of1

max E0

nX

o
t u (zt , st , dt ) ,

where zt are state variables chosen by nature and follow a law of motion
zt+1 = f (zt , t ).
The term t is an innovation vector, thus zt is our usual exogenous stochastic state vector. Think of st as (a
vector of) state variables under partial control of the decision maker. Each period, he selects (a vector) of
decision variables dt . There is a fixed technology describing the motion of st given the actions dt by the agent
and actions zt by nature
st+1 = g(zt , st , dt ).
The agents decision rule is
dt = h(zt , st ).
We know that, under suitable conditions, these types of problems have a recursive formulation. Intuitively,
that property is due to two characteristics of the maximization problem, (i) that the criterion function
[expected lifetime discounted utility] is additively separable and (ii) that decisions at time t only influences
the returns dated t and later. This influence occurs directly on u(zt , st , dt ) and indirectly on u(zt0 , st0 , dt0 ),
t0 > t. Taken together, these features of the problem impart to it a sequential character which permits it to
be solved via a recursive procedure.
In particular, consider a finite time horizon T . To solve, one would start by solving the constrained
optimization problem at the last period for given {zT , sT }, thus generating a decision rule hT (zT , sT ) [since
we are not looking at an infinite horizon problem at this point, decision rules must be indexed by time]. Armed
with that result, one could solve the agents problem in period T 1 using the decision rule hT , generating
a decision rule hT 1 (zT 1 , sT 1 ). One could thus proceed recursively back to the current period. The agent
can solve his problem now, knowing the decision rule he will use in any future period. It should be clear that
once period , 0 < T , is actually reached, the agent has no reason to use a dierent decision rule than
the one originally prescribed. In fact, the preceding argument shows that if a sequence of policy functions
{ht , 0 t T } is optimal, then the tail end of the plan {ht , s t T } is optimal for the remainder of the
problem at s > 0. This property is known as Bellmans principle of optimality and is due to two features of
our problem, (i) that the criterion function is additively separable and (ii) because of the sequential nature of
the problem. When the horizon is infinite, we know that we can drop the time indices and that the decision
1 The

problem can either have a finite or an infinite horizon.

rule will be independent of time. In that case too, agents have no reason to deviate from the decision rule in
future periods.

1.2

Early applications to macroeconomic policy - The Lucas Critique

The insight of optimal control theory have been applied in the 1970s to the design of macroeconomic policy.
We will see in this section the flaws associated with that approach, essentially an argument similar in spirit
to the famous Lucas critique.
Recall the problem
max E0
{dt }

s.t.

+
P

u (zt , st , dt ) ,

t=0

zt+1 = f (zt , t ),
st+1 = g(zt , st , dt ),

where the optimization is over control laws of the form dt = h(zt , st ). In applications of this setup to
determining macroeconomic policy rules, {dt } was interpreted as a vector of policy instruments, such as tax
rates, government expenditures, money supply, etc. {st } was considered to be a set of endogenous variables,
such a output, labor, etc. Finally, the function g was an econometric model of the economy. The function
h was the optimal law for the macroeconomic policy variables. The idea was to implement this setup in the
context of particular concrete econometric models g to make quantitative statements about optimal fiscal and
monetary policy rules.
These applications view the policymaking problem as a game against nature. That is, the problem
assumes that the functions f and g are both fixed and independent of the policymakers choice of h. But
recall that st+1 = g(zt , st , dt ) constitute an econometric model of private agents behavior. Included in
the policymakers g are the decision functions of private agents, who themselves face dynamic optimization
problems. The assumption that g is independent of the governments choice of its h is inconsistent with the
notion that private agents are solving their optimization problems properly. This is the essence of the Lucas
critique. Widely used macroeconometric models should recognize that private agents decision rules are not
invariant to government policies. Thus one cannot use a given assumed macroeconometric model g to analyze
the eect of government policy on macroeconomic aggregates.

1.3

Modeling both governments and private agents decisions and their interactions

These observations suggest that the single-agent decision theory outlined above is inadequate for fully analyzing the mutual interaction of the governments and private agents decisions. For that, we need to set up
a game featuring two agents, agent 1 and agent 2. We will think of agent 1 as the government and agent 2 as

being the public or the private agent.2 The technology is now defined as
st+1 = g(zt , st , d1t , d2t ),

(1)

where dit is the control variable now set by agent i. We retain that
zt+1 = f (zt , t ).

(2)

Consider a finite horizon T . Agent 1s problem is to

)
( T
X
t
1 u1 (zt , st , d1t , d2t ) ,
max E0

(3)

t=0

while agent 2s problem is to

max E0

( T
X

t2 u2 (zt , st , d1t , d2t ) .

t=0

(4)

We assume that at each t, each agent observes {st , zt }. The maximization problem is over decision rules of
the form dit = hit (zt , st ), i = 1, 2 and 0 t T . One can define the game played in one of two ways, as a
Nash equilibrium or a Stackelberg or dominant-player equilibrium.
1.3.1

Nash equilibrium

In the Nash equilibrium, agent i is supposed to maximize his criterion function (3) or (4) subject to (1)-(2)
and knowledge of the sequence of the decision rules hi,t , t = 0...T , of the other agent. The maximization is
carried out taking as given the hi,t of the other agent, so that agent i assumes that his choice of the sequence
of functions hit has no eect on the decision rules hi,t , t = 0...T . A Nash equilibrium is a pair of sequences
of functions {h1t },{h2t }, t = 0...T such that h1t maximizes
( T
)
X t

1 u1 zt , st , d1t , h2t (zt , st ) ,

(5)
E0
t=0

s.t.

while h2t maximizes

E0

st+1 = g(zt , st , d1t , h2t (zt , st )),

d1t = h1t (zt , st ),
zt+1 = f (zt , t ),

( T
X
t=0

2 In

t2 u2 zt , st , h1t (zt , st ), d2t ,

(6)

many problems, we would like a single government, agent 1, to face a large collection of private agents who act approximately competitively. For this purpose, we would use an N-agent game in which agents 2, ..., N are the private agents. Equation
(1) would be replaced by st+1 = ge(zt , st , d1t , ..., dN t ) and (3)-(4) would be modified accordingly. For the N-agent setup, most of
the remarks we make about the two-agent setup game would apply.

s.t.

st+1 = g(zt , st , h1t (zt , st ), d2t ),

d2t = h2t (zt , st ),
zt+1 = f (zt , t ).

The Nash equilibrium of this game is known to have the property that the principle of optimality applies
to the maximization problem of each player. This can be verified by noticing that problem (5) or (6) is a
version of the single-agent maximization problem studied in section 1.1. This means in particular that one can
use recursive methods to compute the Nash equilibrium decision rules. The fact that in a Nash equilibrium,
each agents problem satisfies the principle of optimality means that each agent has an incentive to adhere to
the sequence of decision rules that he initially chooses. This is true so long as the assumptions about each
agents perception of the independence of the other agents decision from his own decisions remain valid.
1.3.2

Stackelberg equilibrium

A second concept is the Stackelberg or dominant-player equilibrium. The leader, player 1, say the government,
is assumed to take into account the mapping between its current and future policies at a given time t, h1s ,
s t and the followers (private agent 2) response at date t, i.e. the government anticipates that

h2t = Tt h1s , s t .

Thus, the government chooses h1t , t = 0...T to maximize

E0

T
X
t=0

t1 u1 zt , st , h1t (zt , st ) , Tt h1s , s t (zt , st ) ,

(7)

st+1 = g(zt , st , h1t (zt , st ), Tt h1s , s t (zt , st )),

(8)
zt+1 = f (zt , t ).

This expresses the fact that the government is choosing the sequence of h1t taking into account the eect
of this choice on the private agents sequence of decisions. The private agent is behaving in the same fashion
as described for the Nash equilibrium. That is, he is solving his maximization problem taking the sequence
of functions {h1t } as given.
s.t.

A dominant-player or Stackelberg equilibrium is a pair of sequences {h1t , t = 0...T } and {h2t , t = 0...T }
such that {h2t , t = 0...T } maximizes the followers criterion function (6) given the sequence {h1t } and such that

{h1t , t = 0...T } maximizes the leaders criterion (7) subject to (8) and given the mappings h2t = Tt h1s , s t .

In the dominant-player equilibrium, the followers problem is readily shown to satisfy the principle of
optimality. However, the leaders problem does not satisfy the principle of optimality. The reason is that
via the mappings Tt , the functions h1t influence the returns of agent 1 for dates earlier than t. This means
that the problem ceases to be a sequential one to which the principle of optimality applies. The reason that
the principle of optimality fails to hold for the leaders problem is the appearance of future values of his own
5

policy functions h1s in the current return or utility function at date t < s. Future h1s s appear in current

utility through the mappings h2t = Tt h1s , s t , which summarize the influence of the leaders current and
future policy functions h1s on the followers current decision rules. In essence, the principle of optimality fails
to hold for the leaders problem because he is taking account of the fact that he is playing a dynamic game
against an intelligent agent who is reacting in systematic ways to his own choice of h1s . In particular, in
choosing the policy functions h1s , the leader takes into account the influence of his choice on the followers
choices in earlier periods.
One consequence is the following. Suppose that a particular sequence of functions {h1t } is optimal for
the problem (7) starting at date t. It is not in general true that the tail end of the plan is optimal for
the remainder of the problem, starting at s > t. This means that in general, at future points in time, the
leader has an incentive to depart from a previously planned sequence of policy functions. Some authors, in
particular Kydland and Prescott (JPE 1977) which we are studying in section 2, refer to this situation as the
time inconsistency of optimal plans. At future points in time, the leader has an incentive to depart from a
previously planned optimal strategy h1t and to employ some dierent sequence of policy functions for the tail
of the problem. However, if a leader actually gives in to the temptation to abandon the initially optimal rules
h1t in favor of new rules, this invalidates the assumptions used by the follower in solving his problem. Once
the follower catches on to this fact, the follower has an incentive not to behave as originally predicted, leading
to a breakdown in an ability either to predict the behavior of the follower or to make an analytic statement
about optimal government policy. In other terms, all hell breaks loose!
This section was meant as an introduction to issues of time inconsistency. The next section is developing
models where time inconsistency arises.

Time inconsistent policies: some examples from the literature

2.1

Rules rather than discretion: the inconsistency of optimal plans

The model is derived from a celebrated paper from Kydland and Prescott (JPE 1977). I am reporting here
just the basic points. The paper itself reports some applications. The point of the paper is to show that a
time-consistent plan is typically sub-optimal. What does this mean? We first need to set up some notation,
as well as the definition of optimal (which is standard) and time consistent (which is new).
Let us start by quoting the abstract form Kydland and Prescott:

Even if there is an agreed-upon, fixed social objective function and policymakers know the timing
and magnitude of the eects of their actions, discretionary policy, namely, the selection of that
decision which is best, given the current situation and a correct evaluation of the end-of-period
position, does not result in the social objective function being maximized. The reason for this

apparent paradox is that economic planning is not a game against nature but, rather, a game
against rational economic agents. We conclude that there is no way control theory can be made
applicable to economic planning when expectations are rational.
We illustrate that point by defining optimal and time-consistent policies and showing on a simple example
why the two notions do not coincide. Take a time horizon T N {+}.3 Let = (1 , ..., T ) be a sequence
of policies for periods 1 to T and x = (x1 , ..., xT ) be the corresponding sequence of economic agents decisions.
An agreed-upon social objective function
S (x1 , ..., xT , 1 , ..., T ) ,

(9)

is assumed to exist. Agents decisions in period t depend upon all policy decisions and their past decisions,
xt = Xt (x1 , ..., xt1 , 1 , ..., T ) , t = 1, ..., T.

(10)

Definition 1 An optimal policy, if it exists, is that feasible which maximizes (9) subject to constraints (10).
Thus for the optimal policy, the government chooses its policy once and for all.
Definition 2 A policy is time-consistent if, for each time period t, t maximizes (9), taking as given
previous decisions, x1 , ..., xt1 , and that future policy decisions (s for s > t) are similarly selected.
In that case, policies are chosen sequentially.
The inconsistency of the optimal plan is easily demonstrated by a two-period example. The second-period
policy of the optimal plan is determined by
max S (x1 , x2 , 1 , 2 ) ,
2

s.t.

x1 = X1 (1 , 2 ) ,
x2 = X2 (x1 , 1 , 2 ) .

Assuming dierentiability and an interior solution, this gives us the following first order condition

S X1
S X2 X1 X2
S
+
+
= 0,
+
x1 2
x2 x1 2
2
2
which rearranged gives us

S X2
S
X1 S
S X2
= 0.

+
+
+

x2 2
2
2 x1
x2 x1
3 The definition of time consistency presented will really only apply to the finite horizon case. However, the paper by Kydland
and Prescott presents an extension of the concept to the infinite horizon case. It basically requires that it be best to use now the
same policy expected to be used in the future.

The second-period policy of the time-consistent plan is determined by

max S (x1 , x2 , 1 , 2 ) ,
2

given

(x1 , 1 ) ,
x2 = X2 (x1 , 1 , 2 ) .

The first order condition is given by

S
S X2

+
= 0,
x2 2
2
S
S X2
1
which typically gives a dierent solution than the optimal problem unless either X
2 = 0 or x1 + x2 x1 = 0,
i.e. unless 2 has no eect on x1 or the combined eect of a change of x1 on S is nil. It should be apparent
from the two maximization problems that the time-consistent policy ignores the eect of 2 on x1 .4

We thus see that the use of discretion (as opposed to rules) in setting policies can lead to suboptimal
outcomes. This indicates that access to a commitment technology (following a rule) that binds the government
not to choose sequentially has value. As explained by Kydland and Prescott, the reason that such timeconsistent policies are suboptimal is not due to myopia. The eect of this decision upon the entire future is
taken into consideration. Rather, the suboptimality arises because there is no mechanism to induce future
policymakers to take into consideration the eect of their policy, via the expectations mechanism, upon current
decisions of agents. It is also another illustration that using standard dynamic programming techniques is
not appropriate in the context of optimal policy design. The intuition is that we use the standard dynamic
programming techniques in situations where current outcomes and the movement of the state variables depend
only upon current and past policy decisions and the current states. But it cannot be used when agents
decisions also depend on their expectations of future policies.5

2.2

Inflationary bias of monetary policy

The material presented comes from Shouyong Shis course notes. See his notes attached to the back.

2.3

A tax example

This subsection is building from Barro (1989).6 Let us start by presenting a simple model. We will then
sketch a generalization of the results from that simple model.
4 The

two maximization problems for the first period policy 1 are the same
max S (x1 , x2 , 1 , 2 ) ,
1

s.t.

x1 = X1 (1 , 2 ) ,
x2 = X2 (x1 , 1 , 2 ) .

5 Notice

that the argument does not require that agents perfectly forecast future policies, only that they realize that the
government has the option of changing policy in the future.
6 Modern Business Cycle Theories, edited by R. Barro. Chapter 7, Time consistency and policy.

Consider an economy with a large number of identical consumers and a government. There is a linear
production technology for the marginal product of capital is a constant R > 1 and the marginal product of
labor is 1. Consumers make decisions at two distinct points in time, the first-stage and the second-stage.
They make consumption-investment decisions at the first stage and consumption-labor supply decision at the
second stage. At the first stage, consumers are endowed with units of the consumption good from which
they consume c1 and save k. At the second stage, they consume c2 and work l units. Second-stage income,
net of taxes is (1 k )Rk + (1 h )l, where k and h denote the tax rates on capital and labor respectively.
For simplicity, we assume that first-stage consumption is a perfect substitute for second-stage consumption.
A consumer, confronted with tax rates k and h , chooses (c1 , k; c2 , l) to solve
max U (c1 + c2 , l)
s.t.

(11)

c1 + k ,
c2 (1 k ) Rk + (1 h ) l.

If the tax rate on capital k is set so that (1 k ) R = 1, the consumer is indierent about the timing of
consumption. In such a case, the consumer saves his entire endowment.
The government sets proportional tax rates on capital and labor income to finance an exogenously given
amount of second-stage per capita government spending G. The governments budget constraint is thus
G k RK + h L,

(12)

where as usually uppercase symbols represent aggregate values. Assume that G > R so that even if consumers
save their entire endowments and the tax on capital is set equal to one, the government still needs to tax
labor.
Capital taxation with commitment:
In an economy with commitment, the government sets tax rates before private agents make their decisions.
Let x1 = (c1 , k) and x2 = (c2 , l) denote an individual consumers first- and second-stage allocations. Let
= ( k , h ) denote government policy.
Definition 3 A competitive equilibrium (X, ) is an individual allocation (x1 , x2 ), an aggregate allocation
(X1 , X2 ) and a tax policy that satisfy
1. Given the tax policy , the individual allocations solve the consumer problem (11),
2. At the aggregate allocation (X1 , X2 ), the policy satisfies the government budget constraint (12),
3. The individual and aggregate allocations coincide, (x1 , x2 ) = (X1 , X2 ).
Let E denote the set of policies for which an equilibrium exists. Assume that for each in E, there is a
unique equilibrium allocation X(). Let S(, X()) denote the equilibrium value of utility under the policy
so that
S(, X()) = U (C1 () + C2 () , L ()) .
9

A pair (, X) is a Ramsey equilibrium if solves

max S (, X ())
E

and X = X () .
Proposition 4 The Ramsey equilibrium (, X) has first-stage allocation C1 = 0 and K = and a capital
tax rate k = (R 1)/R.
Proof. If the tax on capital is such that (1 k )R 1, then consumers save their entire endowments,
while if (1 k )R < 1, then they save nothing. The tax on capital acts like a lump-sum tax when it is selected
at any level less than or equal to (R 1)/R. Thus it is optimal to raise as much revenue as possible from this
tax. Since G > R, government spending is greater than the maximum possible revenues from this capital
tax, so it is optimal to set k = (R 1)/R. Consumers thus save their entire endowments. The tax rate on
labor h is then set at a level sucient to raise the rest of the revenues needed to finance G.
Capital taxation without commitment:
The lack of commitment is modeled by assuming that the government does not set policy until after consumers
have made their decisions. The timing is (i) consumers make first-stage decisions, (ii) the government sets
tax policy, and (iii) consumers make second-stage decisions. Thus, government tax rates depend on the
aggregate first-stage decisions. A government policy is no longer a pair of tax rates, but a specification of tax
rates for every possible X1 , (X1 ) = [ k (X1 ), h (X1 )]. Each consumers second-stage decisions depend on
the first-stage decisions x1 (and X1 ) and the tax policy selected. These second-stage decisions are described
by a pair of functions f2 (x1 , X1 , ) = [c2 (x1 , X1 , ), l(x1 , X1 , )].
An equilibrium in this environment is defined recursively. First, a second-stage competitive equilibrium is
defined, given the history of past decisions by consumers and the government. We consider symmetric histories
so that x1 = X1 . The resulting allocations are used to define the problem faced by the government. Next,
the first-stage competitive equilibrium is defined. Combining all of these gives a time-consistent equilibrium.
Second-stage equilibrium:
A competitive equilibrium at the second stage, given the history (x1 , X1 , ) is a set of allocation rules
f2 (x1 , X1 , ) that satisfy
1. Given the history (x1 , X1 , ), the individual allocation solves
max U (c1 + c2 , l) ,
c2 ,l

s.t. c2 (1 k ) Rk + (1 h ) l.
2. Equality of individual and aggregate allocations.

Governments problem:
10

Given the past aggregate decisions X1 and knowing the future decisions are selected according to a rule f2
(or F2 ) derived from the above problem, the government selects a policy = (X1 ) that maximizes consumer
welfare. The governments objective function is U (C1 + C2 (X1 , ), L(X1 , )), subject to its own budget
constraint.
First-stage equilibrium:
Each consumer chooses an allocation for the first stage x1 = (c1 , k), together with an allocation rule
f2 (x1 , X1 , ) for actions in the second stage. Each consumer takes as given X1 and that future policy is
set according to the plan . The definition of the first-stage equilibrium is analogous to the definition of the
second-stage equilibrium.
We have thus defined a time-consistent equilibrium, with sequential rationality built in both the private
agents and the government.

Proposition 5 The time-consistent equilibrium has first-stage allocations C1 = and K = 0 and a capital
tax plan k (X1 ) = 1.
Proof. Consider the policy plan . For any X1 = (C1 , K), it is optimal for the government to raise as
much revenue as possible from taxing the given amount of capital. By assumption G > R so even if all
the endowments are saved and the resulting capital is fully taxed, the revenues fall short of total spending.
Thus k (X1 ) = 1. Faced with such a tax, it is optimal for consumers to save nothing and consume all their
endowments. The dierence with the previous proof is now that X1 is taken as given, the incentive is to tax
capital fully, regardless of its level.

Proposition 6 The utility level in the time-consistent equilibrium is strictly lower than in the Ramsey equilibrium.
Proof. Let us compare the second stages of the Ramsey and the time-consistent equilibria. We already
established that in the Ramsey equilibrium, c1 = 0, k = and k = (R 1)/R. Thus the second-stage
Ramsey allocations (c2 , l) and h solve
max U (c2 , l) ,
c2 + (1 h ) l,
Ul
s.t. U
= 1 h,
c
G (R 1) + h l.
The government chooses the tax rate to maximize the consumers welfare, subject to its own budget constraint,
with the additional constraints that (c2 , l) must satisfy the consumers first order conditions.

11

We also established that the first-stage time-consistent allocation is c1 = and k = 1. Then the governments
problem in the time-consistent case is to set h and l to solve
max U ( + (1 h ) l, l) ,
Ul
= 1 h,
U
c
s.t.
G h l.
The maximization problems for the time-consistent and the Ramsey second-stage allocations are essentially
the same, except that the former has an implicit higher level of government expenditures, G as opposed to
G (R 1). So, the resulting allocations should bring more utility in the Ramsey than the time-consistent
allocations.

2.4

Can we improve from the time-consistent equilibrium?

Here we will only briefly sketch an argument of how, even without commitment technology, one can improve
from the time-consistent equilibrium seen in section 2.3. This is based on Chari and Kehoe (1977).7
Our notion of sustainable plans is that policies be sequentially rational. That is, the policy rules must
maximize the social welfare function at each date given that agents behave optimally. Likewise, optimality
on the part of private agents requires that they forecast future policies as being sequentially rational for
society. One can also allow for allocations and policies to depend on the entire history of past decisions by
governments as well as on past allocations. Thus, policies and allocations are history-contingent functions.
When we impose sequential rationality, both government and consumers must be able to predict how current
decisions aect future outcomes. Allowing for history dependence solves this forecasting problem.
For finite-horizon models, one can use backwards induction. It turns out that there is a unique timeconsistent equilibrium, which is the sequence of the single-period time-consistent equilibrium. Of course, one
cannot use backwards induction with infinite horizon models. There is actually a large set of time-consistent
equilibria. These equilibria are based on trigger strategies. Define autarky as playing the single-period timeconsistent plan defined in section 2.3, regardless of past history, i.e. reverting forever to it. In fact, autarky
is the worst time-consistent equilibrium. The trigger strategy equilibria specify playing a pair of sequences
(, X) as long as these have been played in the past, and to revert to autarky if one of the parties has deviated.
Of course, a few conditions are attached to the type of sequences that can be so sustained. In particular,
(, X) must be a competitive equilibrium. However, it can be shown that for high enough discount factor,
even the Ramsey allocation can be supported. The idea is that the players will stick to an established pattern
of behavior, even without commitment technology, because deviating from that pattern would be too costly,
returning to autarky. A credible policy is thus one that is in the governments own interest to maintain.

7 Sustainable

Plans, JPE 1977.

12

88

Chapter 8
A POSITIVE THEORY OF INFLATION
We now turn to the issue of ination. As discussed in Chapter 1, ination rates dier
remarkably across countries and across dierent periods of the same country. The
presence of high ination in the 1970s pressed many industrialized countries to make
ination control as one of the most important policy targets in the past decade. Most
countries succeeded but many believe that the success came with a high price tag. For
example, many people in Canada think that loosening the monetary policy to allow
moderate ination in Canada can stimulate output. In this and next few chapters,
we will see how expectations and policies interact to aect ination and why there is
some temptation to allow ination to rise.
8.1

Active Monetary Policies

The starting point of our analysis is the theory that anticipated changes in the money
supply are neutral but unanticipated changes in the money supply may not be neutral.
Thus, a government may have the incentive to surprise the private market by active
monetary policies. How eective these active policies are in real terms depends on
the degree to which the policies are unanticipated. On the other hand, the degree to
which the private sector anticipates the government policies depends in turn on the
government's actions. Thus, there is a two way relation between the government's
policy and the private sector's expectations.
To rule out wild cases, we will assume that the government is benevolent in
the sense that it tries to maximize the welfare of the agents in the economy (so as to
get elected?). That is, the government's and the private agents' objective functions
are the same. Even in this case, the government may pursue active monetary policies
for various reasons.
Dierence in assessment. The government may disagree with the private sector
on certain things. For example, the government may believe that the potential

90

A Positive Theory of Ination

GDP is too low, or the natural rate of unemployment is too high. In this
case, the government may want to surprise the private sector by increasing the
money supply in order to raise employment and output (at least temporarily).
This dierence in assessment is realistic. As examined in the last few chapters,
the unemployment rate in Canada has been about 9:5% for a number of years.
Since there have been no major structural changes or shocks during this period,
one may think that this unemployment rate is close to the natural rate. The
government clearly thinks that this rate is too high.
Credibility constraint. Certain policies may be time-inconsistent and thus incredible. A zero ination target can be such a policy.
Example 1 To understand this concept, consider an example where a parent tries to
advise an obese child not to overeat. Here both the parent and the child have the same
objective. Let us suppose that the child just had a full meal but he still craves for the
chocolate ice-cream in the refrigerator. For the well-being of the child, it is best for
the parent to use reasonable means to prevent the child from eating that ice-cream.
Suppose that the parent in this example uses the following threat: \If you eat that icecream, you will not have anything to eat in the next ve days." This extreme threat
is desirable ex ante (although it may be illegal): If it prevents the child from eating
the ice-cream now, it improves the child's well-being. The problem is, it is not time
consistent and hence not credible. To nd why it is not credible, let us try to answer
the following question: If the child cannot resist the craving and somehow manages
to get the ice-cream and eat it, is it optimal ex post to carry out the action in the
threat? The answer is clearly No. The child already ate the ice-cream and his health
might have been harmed by that. If the parent prevented him from regular meals in the
next ve days, the child would suer even more. Thus, the parent loses the incentive
to carry out the threat once the undesirable action takes place. The ex post incentive
diers from the ex ante incentive, which makes the threat incredible.
The same time-inconsistency problem exists in policy making and in particular
in monetary policy making. Let us suppose that zero ination is desirable to the
society and so the government announces that it intends to achieve such a target. In
response to this announcement, wage contracts are made in the private sector. Since
the ination rate is expected to be zero, the real wage rate equals the nominal wage
rate. Now given the wage contracts being made with a zero expected ination, does

91

Active Monetary Policies

the government want to carry out the zero ination policy? The answer is likely No.
By increasing the ination rate above zero, the government can reduce the real wage
rate and stimulate output (temporarily). The private sector anticipates this ex post
incentive of the government and so would not believe the zero-ination target in the
rst place.
To illustrate such a time-inconsistency problem in a slightly more formal way,
let us utilize the Phillips curve which argues for a negative relationship between
unemployment and the ination rate. That is, the employment level is positively
related to the ination rate. It is well known that the Phillips curve is not stable and
shifts when the expectations on ination change. We augment the Phillips curve by
incorporating ination expectations. Let x be the employment level, be the actual
ination rate and e be the expected ination rate (all in logarithmic terms). The
augmented Phillips curve, which we should term the Lucas supply curve, is
x = x + ( e ):

(8.1)

The number x is the natural level of employment and so (1 x ) can be understood

as the natural rate of unemployment. The Lucas supply curve states that the actual
employment level equals the natural level if the expected ination equals the actual
ination. If > e , employment can be increased beyond the natural level.
The government in this economy tries to minimize ination and achieve a
socially optimal employment level, x0 . To make the examination interesting, we
will assume that this socially optimal level of employment exceeds the natural level
of employment x , for the reason described above. If the actual employment level
diers from the socially optimal level, the economy suers a social loss. (Why would
it involve a social loss if x > x0?) If there is ination, there is also a social loss. The
total welfare loss is captured by the following loss function:
L(; x) = 2 + (x x0)2 :

(8.2)

The parameter > 0 describes the government's relative attitude towards employment. In the extreme case ! 0, the government does not care about the employment level and only cares about the cost of ination.
The government tries to set the ination rate to minimize the social welfare
loss L. The government's performance depends on the private sector's expectation
on ination. This is because the actual employment level x depends on the expected
ination e (see (8.1)). The government can inuence the private sector's expectations

92

A Positive Theory of Ination

by choosing a particular ination policy but it cannot directly control the expected
ination rate. Thus, the government tries to minimize the social loss by the policy
, taking the expected ination e as given. Loosely speaking, the policy will be a
function of the expected ination rate, say, = f (e ).
The expectations cannot be arbitrary either. They must be rational. In the
current case where no uncertainty exists, the rational expectations hypothesis requires
that the expectation ination rate be equal to the actual ination rate, i.e., e = .
The two-way relationship between the government's policy and the private sector's
expectations e forms a standard game and the equilibrium ination rate is a Nash
solution to the game.
Before getting into the details of the game, let us nd the socially optimal
policies, the rst-best policies. Since > 0, the two terms in the loss function are
both non-negative. The minimum value of the loss function is thus zero, which can be
achieved by the rst best policy = 0 and x = x0 . Unfortunately, this combination
of ination and employment is infeasible under rational expectations. If = 0 and
x = x0, (8.1) would imply e = x x0 < 0. That is, the expected ination rate would
have to be below the actual ination rate, which violates the rational expectations
requirement. Since the rst-best cannot be achieved, the best we can hope for is a
second-best.
8.2

Second-Best Monetary Policy: Commitment

The second best policy induces zero ination but generates an employment level that
is lower than the socially optimal level x0. In this section we show that a government
can achieve zero ination if it has the technology to commit to such a policy.
Example 2 To illustrate the important of commitment, let us rst re-consider the
ice-cream example and allow the parent to have a commitment \technology". After
making the threat explicit, suppose that the parent can program a robot to lock up all
the food for ve days if the child eats the ice-cream. The program cannot be changed
once is programmed and so the parent is commit to carrying out the threat. In this
case, if the child happens to eat the ice-cream, the parent will have the desire not to
carry out the threat, as before. However, the matter is not in the parent's hand but
in the robot's and the threat will be carried out anyway. Now, will the child eat the
ice-cream? If he regards ve days without food being a severe punishment, it is likely
that he will not eat the ice-cream. Thus, using the commitment technology makes the
commitment successful and improves the welfare of both the parent and the child.

Third-Best Policy: Discretion

93

Now consider the monetary policy. An example of the commitment technology

is law. That is, the government can make the zero ination target as a law and allow
an independent branch to enforce it (the enforcement must be independent, otherwise
the government would have the incentive to change it ex post). Let us see how zero
ination can be achieved with this new commitment technology. The policy game
between the private sector and the government takes three stages:
Stage 1: The government announces an ination rate a AND writes it into
law;
Stage 2: The private sector forms rational expectations e and writes wage
contracts;
Stage 3: The law is enforced independently.
Since the announced policy will be enforced, the actual ination rate will be
equal to the announced ination rate: = a . The target is credible and the private
sector expects e = a = 0. With these expectations, the private sector makes wage
contracts which, by the Lucas supply curve, yield an employment level x = x. That
is, the employment level equals the natural level of employment and is below the
socially optimal level of employment. The welfare loss is
L(0; x ) = (x x0 )2 > 0 = L(0; x0 ):
Since the welfare loss under the rst-best policy is L(0; x0 ), the current policy (; x) =
(0; x) yields a higher welfare loss than the rst-best policy does and hence is a second
best. Nevertheless, it does produce a zero ination rate.
A distinguished feature of the equilibrium under commitment is that the actual
ination rate always equals the announced ination rate. This is true because the
announced target is made credible by the commitment technology. Without the
commitment technology, the government can still promise to commit to the zero
ination target but no one would believe it, because everyone knows that there is an
incentive for the government to change the policy ex post. We examine this incentive
in the next section.
8.3

Third-Best Policy: Discretion

Suppose that the commitment technology is not available and so the policy enforcement is left to the discretion of the same government who makes the policy. We

94

A Positive Theory of Ination

show that there is an ex post gain for the government to deviate from a zero ination
target, which renders its zero ination target incredible in the rst place and leads
to a third-best outcome. This third best outcome is > 0 and x = x .
Again, consider the three stages of the game played between the private sector
and the government:
Stage 1: The government announces an ination rate a ;
Stage 2: The private sector forms rational expectations e and writes wage
contracts;
Stage 3: The government chooses the actual ination rate and implements it.
The dierence between this game and the one with commitment is that in
stage 3 the government does not have to implement the policy announced in Stage
1. That is, the actual ination rate does not have to be equal to a . Instead, the
government will review the economic conditions in Stage 3 and implement the policy
that is best in that stage. The only economic condition that has changed between
stages 1 and 3 is that wage contracts are written in Stage 2. The way the expectations
are formed can provide ex post incentives for the government to deviate from its own
announced policy.
To see the ex post incentives, let us check whether the second best policy
(; x) = (0; x) is optimal in Stage 3, if somehow the private sector believes this
policy. Start with the announcement a = 0. If the private sector believes such a
zero-ination target, then e = 0. Under the Lucas supply curve (which relies on the
wage contracts being written with the expectation e ), the actual employment level
is
x = x + e = x + :
The employment level is an increasing function of the ination rate. This is why the
government has ex post incentive to inate. By deviating from the announced zero
ination target, the government can increase the employment level and so reduce the
welfare loss.
To be precise, substitute the employment level into the welfare loss function:
L = 2 + ( + x x0 )2:

95

Third-Best Policy: Discretion

In Stage 3, the government chooses the ination rate to be such that minimizes the
above welfare loss. The rst-order condition is
+ ( + x x0 ) = 0:
Solving for , we have

(x0 x):
1+
Since the socially optimal employment level x0 is higher than the natural employment
level, the ination rate is positive. That is, in Stage 3, the government nds it
attractive to deviate from the announced zero ination rate to a higher ination rate.
By such deviation, the government increases the employment level from x in the
case of the second-best policy to a higher level x + . The welfare loss is reduced
from (x0 x )2 in the case of the second-best policy to
=

1
(x0 x )2 .
1+
The possible gains in employment and welfare from a positive ination rate in
Stage 3 come from the assumption that the private sector is tricked by the government
to believe the announced zero ination target. Of course, the private sector cannot
be so easily tricked. Knowing that the government will have an incentive to deviate
to a higher ination rate ex post, the private sector will never believe the announced
zero ination target in the rst place. That is, the zero ination policy is not credible
when there is no commitment technology. In fact, rational agents will believe that the
ination rate is positive and so the equilibrium will be > 0 and x = x , resulting
in a welfare loss that is even larger than under the second-best policy.
There is a two-way relationship between the government's policy and private
agents' expectations. The actual ination rate which the government nds optimal
in Stage 3 depends on the expected ination rate e . In turn, to make rational
expectations on the ination rate, e , private agents must look forward and check
what ination rate the government would like to have in Stage 3. To nd the
equilibrium policy, it is proper to solve the problem backward from Stage 3. The
steps are detailed below.
Step 1. For given expectations e formed in Stage 2, nd the best policy for
the government in Stage 3.
For given expectations e , the employment level is x = x + e . Substitute
this employment level into the welfare loss function:
2 + ( + x x0)2 =

L = 2 + ( + x e x0 )2 :

96

A Positive Theory of Ination

The government chooses an ination rate to minimizing this welfare loss. The rstorder condition is
+ ( + x e x0 ) = 0:
Solving for , we have:

(x0 x + e ):
(8.3)
1+
This is the reaction function of the government to the private sector's expectations.
The chosen ination rate in Stage 3 is an increasing function of the expected
ination rate. The explanation is as follows. If the private sector expects a high
ination rate, the wage contracts are written to be indexed to this expected ination
rate. The real wage is high and the employment level is low (see the Lucas supply
curve). To increase the employment level, the government must indeed pick a high
ination rate.
Step 2. Knowing the government's incentive to inate in Stage 3, the private
sector makes rational expectations on the ination rate.
Since there is no uncertainty in this model, the expectations must coincide
with the actual ination rate. That is,
=

e = :

(8.4)

This is the private sector's reaction function to the government's policy. Not surprisingly, the higher the ination rate, the higher the expected ination rate. Note
also that we do not set the expected ination rate to any announced rate but to the
actual rate, since not all of the announced rates are credible.
Step 3. Equilibrium ination rate and expected ination rate are joint solutions to the reaction functions (8.3) and (8.4).
We solve (; e ) jointly from the two reaction functions. Substitute e from
(8.4) to (8.3):

=
(x0 x + ):
1+
Solving for and using (8.4), we have
e = = (x0 x ) > 0:

(8.5)

This is a Nash equilibrium of the game. That is, (i) given the government's
strategy = (x0 x ), the rational (best) response of the private sector is e =
(x0 x ), and (ii) given the private sector's expectations e = (x0 x ), the best

97

Third-Best Policy: Discretion

response by the government is = (x0 x ). Part (i) is obvious, because any

expectations that do not coincide with the actual ination rate are not rational in
the current case without uncertainty. To verify part (ii), it is sucient to show that,
when e = (x0 x), the choice = (x0 x ) minimizes the welfare loss. This can
be established immediately after substituting e = (x0 x ) into (8.3).
A Digression: Let us try a dierent way to solve for the ination rate. Since
rational expectations require e = , let us substitute this expected ination rate into
the Lucas supply curve to obtain x = x + e = x . Substituting this employment
level into the welfare loss function, we have L = 2 + (x0 x )2. Choosing the
ination rate to minimize the welfare loss, we have = 0. Why does this procedure
lead to a dierent solution? Why isn't it a proper solution procedure for the current
game? Note also that this dierent solution method yields the second best policy
examined in the last section.

The ination rate given by (8.5) is the only one which is credible in the absence
of commitment. Therefore, the only credible announcement is a = (x0 x ). This
equilibrium ination rate is positive, in contrast to the zero ination rate under
commitment. The employment level under this positive ination rate is x = x,
the same as under commitment. The higher ination rate does not generate higher
employment because it is fully expected and hence taken into consideration when the
wage contracts are made. Since the equilibrium has a higher ination rate than under
commitment but the same employment level, the welfare loss is larger than that with
commitment, resulting in a third best. Substitute the ination rate in (8.5) into the
loss function, we have:
L = [(x0 x)]2 + (x0 x )2

= (1 + )(x0 x )2 > (x0 x )2 ;

where (x0 x )2 is the welfare loss under commitment.

We have a situation that resembles the prisoners' dilemma. Before the expectations are formed, the pair = e = 0 is clearly more desirable than the pair
= e = (x0 x ). That is, both the government and the private sector wish
to have a zero ination ex ante. However, if the private sector actually believes a

98

A Positive Theory of Ination

zero ination policy, the government nds it attractive to deviate from it. This incentive to make deviation renders the zero ination policy incredible and economy
achieves a higher ination rate = (x0 x ) and a worse outcome than under zero
ination. Thus, the monetary policy under discretion is inferior to the policy under
commitment.
The exercise illustrates why it is sometime dicult to achieve a low ination
target. Countries may fail in their attempt to control ination, not because low
ination is not desirable ex ante but because it is not credible without sucient
commitment power. What makes it incredible is the government's temptation to
inate. How strong the temptation is depends on how much a government likes to
use ination ex post to raise employment. Evidence suggests that a conservative
government is less likely to use ination to achieve employment target than a liberal
government. For example, Great Britain achieved a low ination rate under the
conservative government and so did Canada. The above simple model can be used to
conrm that a conservative government is more likely to achieve low ination rates.
To illustrate, recall that the welfare loss function incorporates the government's concern of both ination and low employment. The relative weight given to
ination is 1=. The lower the parameter , the more the government worries about
ination. We can then associate a low parameter with a conservative government.
Since the equilibrium ination rate is = (x0 x ), a conservative government is
able to achieve a lower ination rate than a liberal government. It should be emphasized that the employment level is the same (x ) under both conservative and liberal
monetary policies.

A Quick Introduction to Simulation Methods

General formulation

The typical maximization problem can be written in the following general form
v (z, s) = max {u (z, s, d) + E [v (z 0 , s0 ) | z]}
s.t.

z 0 = A (z) + 0
,
s0 = B (z, s, d)

where V (z, s) is the optimal value function, z is a vector of exogenous state variables (such as technology
shocks, for example), s is a vector of endogenous state variables (capital stock, for example), d is a vector of
decision variables and u (z, s, d) is the "return" function for the problem. The two constraints describe the
evolution of the state variables.

Two approaches

2.1

Operating on the value functions

It basically consists of defining an operator which maps the space of continuous bounded functions into itself,
so that the value function is the unique fixed point. Given the approximation to the true v (.), the decision
rules follow immediately.
For any g X, the state of continuous bounded functions, define the operator T as follows
T g (z, s) =

max

s0 B(z,s,d)

[u (z, s, d) + E (g (s0 , z 0 ) | z)] .

This consists in searching for a fixed point of the operator T . One approach is to actually solve the problem
with the computer, one can simplify the state space by restricting the domain of definition to be a grid.
Another approach is to find a linear quadratic approximation around the steady state equilibrium path.

2.2

Operating on the decision rules

The second approach consists obtains the decision rules, directly from the first order conditions. To illustrate
that, assume that the economy is characterized by one simple intertemporal decision, say investment. The
equilibrium can be described as a function I (z, s) that satisfies an integral equation of the form
Z
h [I (z, s) , z, s] = J [I (z 0 , s0 ) , z 0 , s0 ] dg (z 0 , z) .

The endogenous state variable s in that case is k and k0 = (1 ) k + I (z, k). We can define an operator
T : I (z, k) T I (z, k), where T I (z, k) satisfies the conditions
Z
arg min | h [T I (z, k) , z, k] + J [I (z 0 , k 0 ) , z 0 , k 0 ] dg (z 0 , z) |,
and k 0 = (1 ) k + I (z, k). We need to find a fixed point of that operator. As in the previous section, the
operator cannot be exactly replicated numerically. One approach is to discretize the state space. Another
possibility is a linear approximation to the first order conditions characterizing equilibrium.

An example

In this section, we give the example of a method that operates on the value functions and use linear quadratic
approximations. Such a structure is one with a quadratic objective, linear constraints and exogenous disturbances generated by a first-order, linear, vector-autoregressive process. The particular quadratic objective
used is the second order Taylor series expansion of the "return" function, evaluated around the steady state.
It turns out to imply that the decision rules are linear, which is not too much of a problem, since there is
little evidence of major non-linearities in aggregate data.
Let us look at a case where we can use a social planner approach and describe in general terms how to
solve numerically. Remember that the problem can be formulated as
v (z, s) = max {u (z, s, d) + E [v (z 0 , s0 ) | z]}
s.t.

z 0 = A (z) + 0
,
s0 = B (z, s, d)

where A (.) and B (.) are linear. To ensure that B (.) be linear, it may be necessary to substitute any non-linear
constraints into the return function. The method described applies to quadratic return functions. Hence, we
first need to approximate a general return function by a quadratic one. The advantage of solving a linearquadratic planning problem is that it delivers a linear policy function dt = d (zt , st ), which when substituted
yields a linear law of motion st+1 = s (zt , st ). The quadratic approximation of u corresponds to the first three

terms of a Taylor series expansion around the steady state values for (z, s, d) denoted z, s, d [z is the solution
to z = A (z)]. Let y be the stacked vector (z, s, d)and a superscript T denote the transpose of a vector. The
Taylor series expansion of u (y) at the steady state y is
T

u
e (y) = u (y) + Du (y) (y y) +

1
T
(y y) D2 u (y) (y y) ,
2

where Du (y) is the (y) x1 vector of first partial derivatives of ru and D2 u is the (y) x (y) matrix of second
partial derivatives of u. In practice, the derivatives are approximated numerically.1 It can be shown that re (y)
can be written as
u
e (y) = y T Qy,
1 For

h.
example, Di u (y) = u y + hi u y hi /e

where Q is a symmetric (y) x (y) matrix. Hence, the problem can be written in matrix form as
v (z, s) = max

y Qy + E [v (z 0 , s0 ) | z]
z 0 = A (z) + 0
.
s0 = B (z, s, d)

s.t.

It can be shown that the optimal value function is identical, save for a constant for any covariance matrix
of . As a result, the optimal policy function is independent of this covariance matrix and we can solve the
programming problem for the certainty case, when the covariance matrix has been set to zero. In other words,
we solve the problem by dropping the expectations operator and 0 is replaced by its mean of zero.
The general idea is to generate a sequence of approximations to v (.) which will converge to the optimal
value function. An initial value V0 is selected (matrix of dimension (z, s) x (z, s)). The standard Bellman
mapping is then used to obtain the sequence of approximations. Given the nth element of the sequence, the
(n + 1)th element is obtained as follows

v n+1 (z, s) = max y T Qy + v n (z 0 , s0 )

X
s.t. [z 0 , s0 ]i =
Bij yj
f or i = 1, ..., (z, s) .
j(y)

The notation implies that

v n (z, s) = [z s] . V n .

"

z
s

What follows describes in very general lines how the algorithm proceeds. For more details, the reader
should refer to Cooleys "Frontiers of Business Cycles Research", chapter 2:
- Define by x the stacked vector (z, s, d, z 0 , s0 ),
- Construct the matrix R[(x)] (dimension (x)),
"
#
Q
0
R[(x)] =
.
0 V n
- The maximization problem can be rewritten as:
max xT R[(x)] x
d

- Use the constraints to eliminate one by one all the elements of (z 0 , s0 ) from the above formulation. We
get a problem formulated as above, max xT R[(z,s,d)] x, except that the last (z 0 , s0 ) elements of x are zeros
d

and R[(z,s,d)] is still of dimension (x), but the last (x) (z 0 , s0 ) rows and columns are zeros.
- Use the FOCs to eliminate one by one the next (d) variables. We have max xT R[j] x and the first order
d

conditions is R[j] x = 0. That allows us to eliminated the elements of d from the formulation, one by one.

- In the end, we are left with a formulation max xT R[(z,s)] x. Set that R matrix equal to V n+1 .
d

- Compare V n+1 V n to some required degree of precision. Stop iterating when V n+1 is close enough to
V n.
-Use the first order conditions from the last iteration to get the policy functions.