Maastricht University

Macroeconomics I

EBC4063

Replicating A model of unconventional

monetary policy by Gertler and Karadi
(2011)

Authors:
Supervisor:
Wiktor Owczarz (i6052598)
Lenard Lieb
Colin Tissen (i6064642)

January 19, 2017

Contents
1 Introduction 3

2 Model Description 5
2.1 Households . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.2 Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.3 Credit Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.4 Intermediate goods firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2.5 Capital Producing firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.6 Retail Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.7 Resource constraint and government policy . . . . . . . . . . . . . . . . . . 15

3 Log-linearization and the steady state relations 16

3.1 The Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3.1.1 Equilibrium equations . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3.2 Approximation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

4 Model Analysis 23
4.1 The parameters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
4.2 Model analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

5 Discussion 28
5.1 Impact of the Gertler and Karadi (2011) paper . . . . . . . . . . . . . . . . 28
5.2 Criticism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

6 Conclusion 29

7 Appendix: Taylor Approximations 31

7.1 Euler - optimal savings consumption . . . . . . . . . . . . . . . . . . . . . . 31
7.2 Stochastic Discount Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
7.3 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
7.4 Labour supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
7.5 Optimal leverage ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
7.6 Growth rate of banks net wealth . . . . . . . . . . . . . . . . . . . . . . . . 33
7.7 Optimal utilization rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
7.8 Production Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
7.9 Net capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

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7.10 Capital Accumulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
7.11 Fisher Relation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
7.12 Effective Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
7.13 Wages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

2
1 Introduction
In general, the Federal Reserve has three types of instruments in order to conduct monetary
policy: setting the discount rate, open market operations, and reserve requirements. The
goal of the monetary policy is to maintain stable prices, ultimately this leads to maximum
employment and stable economic growth. However, during an economic recession the gen-
eral tools are not effective enough to ensure that the Federal Reserve meets its goals. For
example, the Fed can lower its Federal Funds Rate to stimulate consumption and to slow
down savings. Figure 1 shows the Federal Funds Rate over the last ten years.

Figure 1: Effective Federal Funds Rate 1995-2015. Source: Federal Reserve Economic Data
(2016)

It is clear that the Fed lowered their interest rate substantially during the financial crisis
of 2008, nearly reaching its minimum rate of 0.0 percent. This shows that, at this point,
altering the discount rate was not effective anymore. The Fed needed to find another way
to reach their objectives. At the end of 2007, the Fed started to inject credit into private
markets (Gertler and Karadi (2011)). They also started to purchase securities in the open
market, next to the usual government bonds. These securities are mostly debt instruments
and include, for instance, mortgage backed securities. These actions are often referred to as
unconventional monetary policy. Its impact can be easily seen in Figure 2, this figure shows
the amount of securities held by the Fed, which increased substantially since the financial
crisis of 2008.

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Figure 2: Securities held by Federal Reserve. Source: Federal Reserve Economic Data(2016)

In the academic literature many authors have modelled conventional monetary policy, but
these models do not account for disruptions in financial markets, which ultimately would
lead to interventions by the Fed. Models that incorporate unconventional monetary policy
were only qualitative, until Gertler and Karadi (2011) published their model of unconven-
tional monetary policy. Their model includes financial intermediaries which are constrained
by an agency problem that limits their leverage ratios. However, the central bank in this
model is does not face this agency problem since its risk of defaulting is close to zero. The
central bank acts as an intermediary between savers and investors. Thus, during times of
financial crises, the central bank can support credit flows. This is exactly the kind of uncon-
ventional monetary policy that we want to investigate. Our goal in this paper is to replicate
the model of Gertler and Karadi (2011) and to give an elaborate overview of the way in
which this model works. Instead of showing the final results, we provide a step-by-step
overview of all the necessary calculations and derivations that lead to the ultimate model.
Our last objective is to explain the relevance and the impact that the paper of Gertler and
Karadi (2011) had.
First, we describe the model with separate sections for the different agents that play a
role in the model: households, financial intermediaries, intermediate goods firms, capital
producing firms, retail firms, and the government (including the central bank). Secondly,
we perform a Taylor approximation and import out model into Matlab. Thirdly, the model
is analysed and the results are given. Fourthly, the impact of the Gertler and Karadi (2011)

4
paper is examined. Lastly, the paper is concluded with some final remarks.

2 Model Description
This section will focus on explaining the setup of the model and includes a detailed de-
scription of the agents and their preference relations. The presented model is based on
the standard monetary DSGE models developed by Christiano et al. (2005) and Smets and
Wouters (2007), with addition of financial intermediaries. The inclusion of the financial
intermediaries allows for observing the effectiveness of government policy in times of crisis.

2.1 Households

Within each household there are two types of members: bankers and workers. Workers are
responsible for supplying labour, bankers are in charge of financial intermediaries. Both
workers and bankers transfer their earnings back to the household, which are either spend
on consumption or saved by lending to financial intermediaries or the government. As a
consequence, the household preference setting can be described as a standard allocation
problem; the choice between consumption, leisure and work.

h i
L1+
X
max Et i log(Ct+i hCt+i1 ) (1)
1 + t+1
i=0

Where:

Ct : consumption at time t
1 1+
1+ Lt : household supply of labour, characterised by constant elasticity of substi-
tution (CRRA utility)

t : discount rate

h: habit parameter, past consumption has an effect on present consumption, as a

result utility function is non monotone in the consumption at any given period

: relative utility weight of labour in preference relation

Household consumption is limited by their income and savings. Agents are awarded a
real wage (Wt ) for each unit of labour they supply. Furthermore, households receive net
payouts from ownership of both non-financial and financial firms (t ) and lump sum taxes
(Tt ). Financial intermediaries and the government supply short term debt (Bt ), that pays

5
gross return of Rt . As a result, the households budget constraint can be formulated as
follows:

Ct = Wt Lt + t + Tt + Rt Bt Bt+1 (2)

Maximizing household preference (1) over its budget constraint (2) we obtain the following
constrained maximisation problem:

h i
L1+
X
L : Et i log(Ct+t hCt+i1 ) (Ct Wt Lt t Tt Rt Bt + Bt+1 )
1 + t+1
i=0

L (1 + )
: 0 L + 0 t Wt = 0
Lt 1+ t
(3a)
0 t Wt = 0 Lt

L h 1 h i
: Et 0 t 1 =0
Ct Ct hCt1 ct+1 hCt

h 1 i h i
= Et Et [t ] Et 1 h(ct+1 hCt )1
Ct hCt1 (3b)
h i
%t = (Ct hCt1 )1 Et 1 h(Ct+1 hCt )1

= Marginal utility of consumption

Joining (3a) and (3b), provides the optimum labour supply (4):

t Wt = Lt (4)

In order to find the optimum savings/consumption relation (5), the problem is further
derived w.r.t. short term debt (Bt+1 ):

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 L h i
: Et 0 t + 1 t+1 Rt+1 = 0
Bt+1
h i
= Et [t ] + Et t+1 Rt+1

h %t+1 i (5)
1 = Et Rt+1 = Euler equation
%t

%t+1
where t,t+1
%t

Once all necessary equilibrium relations (5, 4) for the model household are established we
move to the financial intermediaries.

2.2 Financial Intermediaries

The financial intermediaries obtain deposits from households and lend these to non-financial
firms; so they make sure that the money flows from savers to investors. They hold long term
assets which are paid for with short term liabilities, these liabilities are larger than their
capital, so they create leverage. This leverage leads to agency costs, which is discussed later
on. Furthermore, investments banks as well as commercial banks are part of the financial
intermediaries
The intermediary balance sheet is given by:

Qt Sjt = Njt + Bjt+1 (6)

With:

Qt : relative price of each claim

Sjt : quantity of financial claims on non-financial firms that the intermediary holds

Njt : amount of wealth intermediary j has at the end of period t

Bjt+1 : deposits the intermediary obtains from the households

The intermediarys debt consist of all of the deposits from the households Bjt+1 , which pay
the real gross return Rt+1 . The amount of wealth of the intermediary Njt can be thought of
as their equity capital. Lastly, the financial intermediaries earn the stochastic return Rkt1

7
on their assets. The amount of wealth at period t + 1 equals the earnings on assets minus
the interest payments to the households.

N jt + 1 = Rkt+1 Qt Sjt Rt+1 Bjt+1 (7)

We rearrange (6) to obtain:

Bjt+1 = Qt Sjt Njt (8)

Combining (7) and (8) yields:

Njt+1 = Rkt+1 Qt Sjt Rt+1 (Qt Sjt Njt )

= Rkt+1 Qt Sjt Rt+1 Qt Sjt + Rt+1 Njt (9)

= (Rkt+1 Rt+1 )Qt Sjt + Rt+1 Njt

From 9 it can be concluded that the growth in equity, above the riskless return Rt+1 ,
depends on the risk premium Rkt+1 Rt+1 and the total amount of assets Qt Sjt .
The banker applies a stochastic discount at time t to earnings at time t + i, we denote
this discount by i t,t+i . The banker will only fund assets whenever the discounted return
is higher than the discounted cost of borrowing. Intermediary assets earn the stochastic
return Rkt+1 , and bankers pay Rt+1 to the households which is thus the cost of borrowing.
So,

Et i t,t+1+i Rkt+1+i i t,t+1+i Rt+1+i

Et i t,t+1+i Rkt+1+i i t,t+1+i Rt+1+i 0 (10)

Et i t,t+1+i (Rkt+1+i Rt+1+i ) 0

As long as 10 holds it is profitable for the banker to keep building assets. Ultimately, the
banker wants to maximise expected terminal wealth, which is given by:

X
Vjt = maxEt (1 )i i+1 t,t+1+i (Njt+1+i )
i=0

X
Vjt = maxEt (1 )i i+1 t,t+1+i [(Rkt+1+i Rt+1+i )Qt+i Sjt+i + Rt+1+i Njt+i (11)
i=0

The banker cannot keep on borrowing funds to increase his assets so we have to put a
limit on its borrowing ability. The following moral hazard problem is introduced: at the
beginning of the period the banker can divert the fraction of his available funds from the
project and transfer these back to his household. So it is possible for the depositors to force

8
the intermediary into bankruptcy and recover the remaining fraction of the assets, 1 .
For lenders to be willing to supply funds, the possible loss from diverting assets should be
bigger than the gain from diverting these assets:

Vjt Qt Sjt (12)

We can express Vjt as:

Vjt = t Qt Sjt + t Njt (13)

with

vt = Et [(1 )t,t+1 (Rkt+1 Rt+1 ) + t,t+1 xt,t+1 t+1 ]

t = Et [(1 ) + t,t+1 t,t+1 t+1 ]

With:
Qt+i Sjt+i
xt,t+1 = : gross growth rate in assets between t and t + i
Qt Sjt
Njt+i
zt,t+i = : gross growth rate of net worth
Njt
t : the expected discounted marginal gain to the banker of expanding assets Qt Sjt by
a unit, holding Njt constant

t : the expected discounted value of having another unit of Njt , holding Sjt constant
Financial intermediaries will keep on borrowing until the marginal gain of expanding assets,
t , becomes zero. However, the intermediary is constrained by the agency problem and the
amount that it can borrow is dependent on its equity capital. One of the most important
differences between the financial intermediaries and the central bank is that the central
bank is not constrained by this problem.
We can combine (12) and (13) to obtain:

t Njt + vt Qt Sjt Qt Sjt (14)

When this constraint is binding:

t Njt + vt Qt Sjt = Qt Sjt

t Njt + vt Qt Sjt Qt Sjt = 0

t Njt + Qt Sjt (vt ) = 0

Njt
Qt Sjt = Njt
vt

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 Qt Sjt = t Njt (15)

Where is the private leverage ratio, or the ratio of privately intermediated assets to equity.
(15) confirms that the borrowing capacity of the intermediary depends on its equity capital.
Furthermore, when Njt > 0, the constraint (14) is only binding if 0 < t < . Since t is
greater than zero, it is profitable for the intermediary to increase assets. As t increases, the
opportunity cost to the banker from the risk of defaulting increases. Thus, the households
will tolerate a higher leverage ratio whenever t increases.
Using (15), the evolution of the bankers net worth can be described as:

Njt+1 = (Rkt+1 Rt+1 )Qt Sjt + Rt+1 Njt

= (Rkt+1 Rt+1 )t Njt + Rt+1 Njt (16)

= Njt ((Rkt+1 Rt + 1)t + Rt+1 )

From this it follows that:

Njt+1
zt,t+1 = = (Rkt+1 Rt+1 )t + Rt+1 (17)
Njt

Qt+1 Sjt+1 t+1 Njt+1 t+1 Njt+1 t+1

xt,t+1 = = = = zt,t+1 (18)
Qt Sjt t Njt t Njt t
The components of t do not depend on firm-specific factors, j, so total intermediary
demand for assets can be determined by summing across individual demands, this gives:

Qt St = t Nt (19)

With:

St : aggregate quantity of intermediary assets

Nt : aggregate intermediary capital

During times of crisis the wealth of the intermediaries, Nt ,will sharply decline, this results
in a lower demand for assets. We can separate Nt into two parts; the net worth of existing
bankers, Net , and the net worth of new bankers, Nnt . So,

Nt = Net + Nnt (20)

Furthermore, only the fraction of bankers at t-1 survive until period t. From (16) it follows
that:

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 Net = [(Rkt Rt )t1 + Rt ]Nt1 (21)

Note that Net is most affected by fluctuations in Rkt and that the leverage ratio t increases
this impact on Net . In section 1, the households, it was mentioned that exiting bankers
provide start up capital to new bankers. This start up capital is equal to a fraction of
the asset value that the exiting banker intermediated in his final period. So, the start up
capital depends on the scale at which the exiting banker was operating. The total final
period assets of exiting bankers equals (1 )Qt St1 . Each period the household transfers

the fraction of this value to the new bankers. Summing these up gives:
(1 )

Nnt = Qt St1 (22)

Combining (20), (21), and (22) results in:

Nt = [(Rkt Ry )t1 + Rt ]Nt1 + Qt St1 (23)

QS
Note that the steady state leverage ratio, , is dependent on .
N

2.3 Credit Policy

The total value of intermediated assets consists of privately and governmental intermediated
assets:

Qt St = Qt Spt + Qt Sgt (24)

The central bank acts as an intermediary between the households and non-financial firms;
households can buy treasury bills or other types of government debt and obtain the riskless
rate Rt+1 as return. Non-financial firms can borrow money from the central bank and pay
interest, Rkt+1 . This intermediation by the government comes at a certain efficiency cost of
per unit. These costs emerge because the central bank has to search for valuable private
sector investments, for non-financial firms it is also a reflection of the costs of obtaining
funds through government debt. However, the government will always honor its debt and
government debt is thus risk-free. Therefore, there are no agency costs involved for the
operations of the central bank, unlike the financial intermediaries.
Suppose that the government is willing to fund a fraction t of intermediaries assets, thus:

Qt Sgt = t Qt St (25)

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In order to fund this, the government issues bonds Bg t, which equal t Qt St . The government
earns the difference between the riskless rate and the market lending rate. So, government
earnings are: (Rkt+1 Rt+1 )Bgt .
Using (19) and (25), (24) can be written as:

Qt St = t Nt + t Qt St

Qt St (1 t ) = Qt Nt
t Nt
Qt St = = ct Nt
1 t
With:

t : leverage ratio for privately intermediated funds (from equations 14 and 19)

ct : leverage ratio for total intermediated funds:

1
ct = t (26)
1 t

The higher the intensity of credit policy, denoted by t , the higher the leverage ratio ct .

2.4 Intermediate goods firms

Intermediate goods firms are non-financial firms that sell their goods to retail firms. These
firms work as follows: the firm acquires capital Kt+1 , that they need in order to produce, at
the end of period t.After production in the next period (t + 1) the firm can sell the capital
on the open market.
In order to produce the firm needs to acquire capital, it funds this capital acquisition by
borrowing from the intermediaries. The number of units of capital acquired Kt+1 equals
the amount of claims that the firm issues St . Each claim is priced at the price of a unit of
capital Qt . So, the value of capital acquired Qt Kt+1 equals the value of claims Qt St against
this capital, by arbitrage.
As we have seen, financial intermediaries face financial constraints. Just like the central
bank, the intermediate goods firms are not constrained and can freely obtain funds from
the financial intermediaries. However, because of the constraint for the intermediaries, the
required rate of return on capital that the intermediate goods firms must pay is higher than
the case in which there would be no constraints for all agents.
The production function of intermediate goods firms is given by:

Yt = At (Ut t Kt ) Lt1 (27)

Where:

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 At = total factor productivity

Ut = capital utilisation rate

t = quality of capital

t Kt = effective quantity of capital

The quality of capital, t , can be thought of as depreciation in this case and provides a
source of exogenous variation.
The profit function for the intermediate goods producing firms consists of the revenue,
costs, and the value of unused capital. As mentioned before, the firms can sell the capital
that is left from the production of last period on the open market. This value is equal to
(Qt (Ut ))t Kt . So the effective quantity of capital is multiplied by the price that the
firm can get for the capital minus the depreciation. The revenue is equal to the production
function multiplied by the price of the intermediate goods and the costs consist of labor
costs and the cost for the capital acquisition. Thus, intermediate goods producing firms
maximize the following profit function:

t = Pmt At (Ut t Kt ) L1
t (Wt Lt + Qt Kt+1 ) + (Qt (Ut ))t Kt ) (28)

Where (Qt (Ut ))t Kt is the value of unused capital that the firm sells.
By differentiating the profit function we can find the optimal labor demand and utilisation
rate:

t Yt
= (1 )Pmt = Wt
Lt Lt
t Yt (Ut )
= Pmt = t Kt
Ut Ut Ut

The stochastic return that the firm pays to the intermediaries is equal to (assuming zero
profits for the goods producer):

Yt+1
Pt + (Qt (Ut+1 ))t+1
t Kt+1
= = Rkt+1
Kt+1 Qt

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2.5 Capital Producing firms

The role of capital producing companies is to create and sell capital to the intermediate
goods producing firms at price Qt . Capital producing firms also purchase depreciated cap-
ital and repair it.
In the presented model, contrary to the standard DSGE models, next to the normal in-
vestment cost, capital producing firms incur additional costs: investment adjustment cost,
which adds rigidities to the capital accumulation. Now, companies cannot make instan-
taneous investments to adjust capital stock. The stock is adjusted gradually over time as
investments are smoothed. Furthermore, this model focuses only on the net capital created
Int = It (Ut )t Kt , to make investment decisions independent of the market price.
After taking all of the constraints into account, the discounted capital producing firms profit
function is given by:

h  I +I  i
n ss
X
max Et t t, (Q 1)In f (In Iss ) (29)
=t
In 1 + Iss

s.t. Int = It (Ut )t Kt

Companies want to set price at the profit maximising level, therefore:

h h Int1 + Iss  I + I i
nt ss
: Et 0 t,t Qt 1 f 0 () (I nt + Iss ) f
Int (Int1 + Iss )2 Int1 + Iss
h
0 Int+1 + Iss ii
+ t,t+1 f () (Int+1 + Iss )
(Int + Iss )2
Int + Iss  I +I 
nt ss
h h I
nt+1 + Iss
ii
Qt = 1 + f 0 () +f Et t,t+1 f 0 ()
Int1 + Iss Int1 + Iss Int + Iss )

This gives the optimum value of capital for capital producing firms.

2.6 Retail Firms

The analysed model presents a classical setup of retail firms: a continuum of imperfectly
competitive companies that produce a continuum of differentiated products, using inter-
mediate products as the only input. Therefore, the final output of all retail firms can be
described as follows: hZ 1 i(1)/
(1)/
Yt = Yf t df (30)
0

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Further, output of the individual company is derived from the household optimum con-
sumption expenditure allocation problem. Assuming that the market clears (Ct = Yt ), the
demand (Yf t ) of the individual company (f ) is given by:
 P 
ft
Yf t = Yt (31)
Pt
Where P is the optimum (profit maximising) price that would be set by imperfectly com-
petitive companies in an equilibrium without any frictions.
As a result, the aggregate price level is given by assumption as:
hZ 1 i1/(1)
Pt = Pf1
t df (32)
0

Finally, the retail firms profit maximisation problem with nominal rigidities is constructed.
Nominal rigidities introduce constraints on price adjustment (sticky prices), now only a
fraction of firms (1 ) can adjust its prices from period to period.

Inflation adj.
Discount factor z }| {
i
z }| { h Pt i
(1 + t+k1 )P Pmt+i Yf t+i
X Y
max Et i i t,t+i Yf t+i (33)
P
| t+i{z }
| {z }
i=0 k=1
Total Cost
Aggregate demand

Last, the optimum price level, with nominal rigidities is given by:
P
Y 1
1
Pt = [(1 )(P ) ) + ( Pt1 )1 )] 1 (34)
t1

2.7 Resource constraint and government policy

The economys output is constrained by consumption, investments (including investment

adjustment costs), government expenditures 1 and cost of servicing government debt inter-
mediation:
 I +I 
n,t ss
Yt = Ct + It + f (In,t + Iss ) + G + t Qt Kt+1 (35)
In,t1 + Iss
Furthermore, capital is considered to evolve as noted in the section 5 equation (2.5):

Kt+1 = t Kt + Int (36)

1
Government expenditure is assumed to remain constant at G = 0.2

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As a result the government budget (expenditure and cost of government intermediation)
is financed by the inflow from lump sum taxes and government bonds purchases by the
households and non-financial firms:

G + t Qt Kt+1 = Tt + (Rkt Rt )Bg,t1 (37)

Gertler and Karadi (2011) assume that the central bank policy can be described by a simple
Taylor rule, which states that nominal interest rate (it ) should respond to divergence in
inflation rate () and output(Yt ), compared to their optimal levels. Additionally, the
smoothing parameter , is included to explain how monetary policy works by affecting
future expectations about the level of short term interest rates.

it = (1 )[i + t + y (logYT logYt )] + it1 + t (38)

Finally, the main point of the paper is to analyse the effectiveness of unconventional mone-
tary policy in times of crisis. Therefore, the model describes a crisis as a situation where the
return spread increases compared to its steady state value (39). Moreover, it is assumed that
in times of crisis the central bank abandons unreasonable interest rate smoothing behaviour
and sets the smoothing parameter = 0.

t = + vEt [(logRkt+1 logRt1 ) (logRk logR)] (39)

3 Log-linearization and the steady state relations

The above model gives us a system of mostly non-linear difference equations that we want
to solve. Because it is extremely complicated to solve such a system, we will first try to
linearize them in such a way that it allows us to simulate the model. Since we want to
examine fluctuations in our macro-economic model, it is important that we have some kind
of basis on which the variables fluctuate. This basis is the general trend, which is assumed
to be constant, and is called the steady state. To quantitatively examine the model we
look at percentage deviations from this steady state, in general:

xt x
x
t =
x
Where x is the steady state value.
We continue our research in the following way. First, we determine which equations from
our model constitute the equilibrium. Second, we log-transfrom these equations. Third,
we apply a first order Taylor expansion on the log-tranformed equations. Lastly, we sum

16
up our linearized model and transform them into matrices which are ultimately used to
simulate the model.

3.1 The Equilibrium

The previous sections focused on modeling the behaviour of specific sectors/agents in the
model. However, in order to analyse the impact of the economic growth, monetary policy
or business cycle fluctuations on the modeled economy, all agents need to be aggregated
in an equilibrium. As a result, we try to connect the actions of individual households and
companies with each other to establish equilibrium relationships. The important and most
difficult part is to realise which of the equations from our model are important for the
equilibrium, these are the equations that need to be transformed. According to Gertler and
Karadi (2011), and our understanding of the model, the following equations are part of the
equilibrium.

3.1.1 Equilibrium equations

1. Household

(a) Marginal utility of consumption

h i
%t = (Ct hCt1 )1 Et 1 h(Ct+1 hCt )1
(b) Euler equation
h %t+1 i
1 = Et Rt+1
%t
(c) Stochastic discount rate
%t+1
t,t+1
%t
(d) Arbitrage
Et i t+1 Rkt+1 = i t+1 Rt+1
(e) Labour market equilibrium
Yt
t Wt = Lt with (1 )Pmt = Wt
Lt
2. Financial Intermediaries

(a) Value of banks capital

t = Et [(1 )t,t+1 (Rkt+1 Rt+1 ) + t,t+1 xt,t+1 t+1 ]
(b) Value of banks net wealth
t = Et [(1 ) + t,t+1 t,t+1 t+1 ]
(c) Optimal leverage
t 1
t = t 1t

17
 (d) Growth rate of banks net wealth
t+1
xt,t+1 = zt,t+1
t
3. Final goods producer

(a) Return to capital

Yt+1
[Pmt+1 +Qt+1 (Ut+1 )]t+1
t+1 Kt+1
Rkt+1 = Qt

(b) Production function

Yt = At (Ut t Kt ) L1
t

4. Capital goods producer

(a) Optimal investment decision

Int + Iss  I +I 
nt ss
h h I
nt+1 + Iss
ii
Qt = 1 + f 0 () +f Et t,t+1 f 0 ()
Int1 + Iss Int1 + Iss Int + Iss )
(b) Depreciation rate 2
c+b
(1+)U 1+

(c) Optimal capacity utilization rate

Pmt UYtt = 0 (Ut )t Kt
(d) Net investment
Int = It (Ut )t Kt
(e) Capital accumulation
Kt+1 = t Kt + Int
(f) Government consumption
G = Gss g

5. Equilibrium

(a) Aggregate resource constraint

 I +I 
n,t ss
Yt = Ct + It + f (In,t + Iss ) + G + t Qt Kt+1
In,t1 + Iss
(b) Markup
1
11/

(c) Price index

R1
Pt = [ 0 Pf1
t df ]
1/(1)

2
Gertler and Karadi (2011) do not specify the meaning of the c + b subscript. Furthermore, , the
elasticity of marginal depreciation with respect to utilization rate, is not specified in the article nor the code

18
 (d) Fisher equation
1 + it = Rt+1 Et PPtt+1
(e) Interest rate rule
it = (1 )[i + t + y (logYt logYt )] + it1 + t
(f) Credit policy rule
t = + vEt [(logRkt+1 logRt1 ) (logRk logR)]

6. Shocks

(a) Credit policy shock (Shock to short term interest rate)

t = t1 + t
(b) Total factor productivity shock
At = At1 + t
(c) Capital quality shock
t = t1 + t
(d) Government consumption shock
gt = gt1 + t

3.2 Approximation

The log-transformations and the first-order Taylor expansions can be found in the appendix.
The end results are summarized in the next box.

19
 t+1 +
t+1 + Et
(41) Et R t = 0

=0
(42) %t+1 + %t t,t+1

t+1 + Et R
(43) Et kt+1
t+1 R
t+1 = 0

t + W
(44) t L
t = 0

(45)t = t

t 1 t

xt,t+1 = t+1 + zt,t+1 t

(46)

(47) Pmt + Yt U t ) t K
t 0 (U t = 0

t t K
(48) Yt At U t (1 )L
t = 0

(U )
(49) Int I
In I t + In (Ut ) + In t + K
In Kt =0

t In t1 = 0
(50) K K t1 K Int1 K

t+1 Et Pt+1 + Pt = 0
(51) it R

(52 t + K
t = 0

t Pm Yt + L
(53) W t = 0

(6a) t = t1 + t

(6b) At = At1 + t

(6c) t = t1 + t

(6d) gt = gt1 + t 20
In order to implement this system and simulate it using Matlab, we need to rewrite it as a
multivariate stochastic difference equation. We write the system in matrix form using the
following equation:

0 = AEt Xt+1 + BXt + CXt1 + DEt t+1 + E t

+ F t1 + GEt At+1 + H At + I At1 + JEt t+1 (40)
+ K t + Lt1 + M Et gt+1 + N gt + O
gt1

In our case: Xt = [Yt , Int , It , U

t , K
t, L
t , Pt , R
t, R t , it , t , %t ,
kt , W t,
t , t , t , t , t , x
t , zt ] is
a 21 x 1 row vector. B and C are parameter matrices of dimension 21 x 13.
Note that (Ut ) is also part of our equations, but Gertler and Karadi (2011) do not specify
this depreciation function. Thus, we continue without (Ut ) in our Xt row vector. Further-
more, the system of equations is not complete because we were not able to approximate all
of them. The reason for this is that we need the function of (Ut ) in order to solve them.
Although it is not totally correct, we will continue only with the equations that we were
able to approximate. Using (40) the following matrices are constructed:

0 0 0 0 0 0 0 1 0 0 0 0 0 1 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0 0 0 0 1 0 1 0 0 0 0 0 0


0
0 0 0 0 0 0 1 1 0 0 0 0 0 0 0 0 0 0 0 0

0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

0
0 0 0 0 0 0 0 0 0 0 0 0 0 0 1 1 1 0 0

0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1 0 0 0 1 1

A = 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0


0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0


0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0


0 0 0 0 0 0 1 1 0 0 0 0 0 0 0 0 0 0 0 0 0

0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

21

0 0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 1 0 0
0 0 0 0 0 0 0 0 0 0 0 0 1 0 1 0 0 0 0 0 0


0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0


0
0 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0


0
0 0 0 0 0 0 0 0 0 0 0 0 0 0 1 0 0 0 1 1
B= 1 0 0 1 1 0 1 0 0 0 0 1 0 0 0 0 0 0 0 0 0


1
0 0 (1 ) 0 0 0 0 0 0 0 0 0 0 0 0 0 0

1 IIn K

0 0 In 0 0 0 0 0 0 In 0 0 0 0 0 0 0 0 0

0 0 0 0 1 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0


0
0 0 0 0 0 1 0 0 0 1 1 0 0 0 0 0 0 0 0 0
0 0 0 0 1 0 0 0 0 0 0 1 0 0 0 0 0 0 0 0 0

1 0 0 0 0 1 1 0 0 1 0 0 0 0 0 0 0 0 0 0 0

0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0


0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0


0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0


0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

C = 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0


0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0


0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

In
0
K 0 0 1 0 0 0 0 0 0 K 0 0 0 0 0 0 0 0 0

0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

These matrices contain the parameter and some fractions which are related to steady
state values ( IIn , IKn , In , IKn , K ). In order to implement our model in Matlab, these fractions
need to be expressed in actual values. We know that,

Int = Kt+1 t Kt = It (Ut )t Kt

22
Furthermore,
Int Kt+1 Pmt UYtt
Kt = = 0
t (Ut )t Kt
The problem is that all of these equations, and all of the fractions that we need to solve,
are dependent on (Ut ), and we do not know what this (Ut ) looks like. Thus, we were not
able to solve these expressions.
Finally, to analyse the behaviour of the model, there are four types of shocks (AR(1) pro-
cesses) that we are interested in investigating: a 1% decrease in total factor productivity
A, a 0.25% increase in short term interest rate i (monetary shock), a 1% decrease in in-
termediary wealth Nj t (wealth shock), and a shock to the quality of capital (financial
crisis).
Obviously; D, F, G, I, J, M, O are just vectors of zeroes. The other shock matrices are as
follows:
h i
E= 0 0 0 0 1 0 0 0 0 0 0 0 0

h i
H= 0 0 0 0 0 0 0 1 0 0 0 0 0

h i
K= 0 0 0 0 0 0 1 1 1 0 0 1 0

h i
L= 0 0 0 0 0 0 0 0 0 1 0 0 0

h i
N= 0 0 0 0 1 0 0 0 0 0 0 0 0 3

4 Model Analysis
4.1 The parameters

We take the parameter values that Gertler and Karadi (2011) used in their research. These
are given in Table 1. Out of the 18 parameters, fifteen are conventional, and therefore
conventional values are used. However, Gertler and Karadi (2011) introduce three new
parameters , , and . They calibrated these parameters in such a way that the model hits
the following three targets: a steady state interest rate spread of 100 basis points, a steady
3
Logically, g should impact the intermediary capital Nt (wealth). Therefore, the shock affecting Nt should
lead to the fluctuations of assets demanded by intermediary. However, in the paper of Gertler and Karadi
(2011) g was not part of any of the presented equations.

23
state leverage ratio of four, and an average horizon of bankers of a decade. Note that the
value for is quite large, this is caused by the target leverage ratio being rather low.

Table 1: Parameters

Parameter Value Explanation

Households
0.990 Discount rate
h 0.815 Habit parameter
3.409 Relative utility weight of labor
0.276 Inverse Frisch elasticity of labor supply
Financial Intermediaries
0.381 Fraction of capital that can be diverted
0.002 Proportional transfer to the entering bankers
0.972 Survival rate of the bankers
Intermediate good firms
0.330 Effective capital share
U 1.000 Steady state capital utilization rate
(U ) 0.025 Steady state depreciation rate
7.200 Elasticity of marginal depreciation with respect to utilisation rate
Capital producing firms
i 1.728 Inverse elasticity of net investment to the price of capital
Retail firms
 4.167 Elasticity of substitution
0.779 Probability of keeping prices fixed
P 0.241 Measure of price indexation
Government
1.500 Inflation coefficient of the Taylor rule
y 0.50/4 Output gap coefficient of the Taylor rule
%i 0.800 Smoothing parameter of the Taylor rule
G
Y 0.200 Steady state proportion of government expenditures

24
4.2 Model analysis

Since were not able to completely solve the model by ourselves we used the code of Gertler
and Karadi (2011) and the Dynare toolkit to run the model in Matlab. In this section we
will look how the model of the economy reacts to four different disturbances (6a - 6d). Each
disturbance is modeled as an auto-regressive process of order one.

Figure 3: Responses to Technology shock. Source: Gertler and Karadi (2011) code.

The unexpected technological shock leads to a decrease in output and investment, which
negatively impacts asset prices. This decrease of prices of financial assets has an impact on
the financial intermediaries. The assumption of imperfect capital markets allows intermedi-
aries to operate with a risk adjusted premium that is higher than zero. In times of crisis, the
ability of the financial intermediary to obtain funds is limited even more, therefore an even
higher premium is demanded. The increase in the risk adjusted premium further decreases
the demand for capital and investment. All those factors constitute to the crisis that can
be observed in Figure 3 (solid black line). However, in case of the standard DSGE model
(red line) there is no amplification effect because perfect capital markets are assumed, as
a result the premium Rk R = 0. Nevertheless,the modeled economy still experiences a
crisis, but it is milder.

Figure 4: Responses to Monetary shock. Source: Gertler and Karadi (2011) code

A sudden drop in interest rates by 0.25% again negatively impacts the financial intermedi-
ates, leading to similar conclusions that were mentioned above. However, due to assumed

25
irrationality in Central Bank behaviour (interest rate smoothing) the crisis can have a more
persistent impact. So, compared to the technology shock, the economy is hit harder by a
monetary shock, this can be seen in the figures.

Figure 5: Responses to Wealth shock. Source: Gertler and Karadi (2011) code

Lastly, a decrease in intermediary wealth (Figure 5) has no effect in the standard DSGE
model (dashed red line) because it does not include premiums. As a result, a wealth decrease
sets a redistribution in motion from the financial intermediary to the household. However,
once the financial frictions are introduced as in the case of the presented model, the risk
adjusted premium increases. The demand for capital and investment drops, repeating the
crisis due to the shocks in technology and monetary policy.

Figure 6: Responses to Capital quality shock. Source: Gertler and Karadi (2011) code

The first three presented cases were somehow standard to the general equilibrium analy-
sis. Our main interest lies in evaluating unconventional monetary policy response on the
example of the 2007/2008 crisis. Therefore, Gertler and Karadi (2011)s model introduces
shocks related to the decrease in the quality of capital, which serves the purpose to simulate

26
a sub-prime mortgage crisis, where the quality of financial assets rapidly decreased. This
decrease in quality of capital mainly affects the balance sheet of the financial intermediaries,
decreasing their net worth due to a higher leverage ratio.
A comparison of the impulse response between the standard DSGE and the Gertler and
Karadi (2011) model with additional frictions in financial market, shows that a sudden de-
crease in the quality of capital leads to a recession, which is much more severe in the latter
model. The amplification effect is again similar to the already mentioned cases. Financial
intermediaries have a high leverage and a poor quality of capital, which leads to an increase
in risk premium. This causes a decrease in output and investments.

Figure 7: Impulse responses to the capital quality shock with zero lower bound and with
and without credit policy. Source: Gertler and Karadi (2011) code

Finally, we can consider the credit interventions by the central bank, the credit policy
response. Figure 7 presents a comparison between the baseline credit policy (black solid
line) with feedback parameter v = 10 and no credit market intervention (dashed line). On
first sight it is obvious that the credit policy moderates the contraction and reduces the
spread/ premium increases, which would lead to the investment decline. Unfortunately,
we are not able to show the aggressive credit intervention when the feedback parameter
is v = 100. The aggressive credit policy turns out to be the optimal and reduces the

27
contraction caused by the drop in capital quality more than the baseline model.

5 Discussion
5.1 Impact of the Gertler and Karadi (2011) paper

Gertler and Karadi (2011) are the first researchers that published a quantitative model of
unconventional monetary policy. It is clear that their paper has had a substantial impact
on the academic world; their paper was cited more than 1240 times, since it was published
in 2011 (Figure 3).

Figure 8: Citations per year of the Gertler and Karadi paper, 2011. Source: Google Scholar
(2016)

Going through all these citations is outside the scope of this paper. However, in the papers
that we checked, the contribution of the Gertler and Karadi (2011) paper seemed to be a
minor part of the new literature (Arajo et al. (2015); Brunnermeier and Sannikov (2014);
Curdia and Woodford (2011); Curdia and Woodford (2009)4 ; Gertler and Kiyotaki (2010);
Gilchrist et al. (2014); Gertler and Kiyotaki (2012); Mishkin (2011); Woodford (2010)).

5.2 Criticism

Cole (2011) wrote a discussion of Gertler and Karadi (2011) for the Journal of Monetary
4
Gertler and Karadi published their working paper in 2009.

28
Economics. Although he calls it a clear and tractable quantitative model, he has some
criticisim on the assumptions that Gertler and Karadi made. First, in the model the
intermediate goods producers cannot use retained earnings to acquire their capital, thus
they have to refinance themselves each period. This lowers the expected profits of the firms
since the cost of funds is higher. Cole (2011) notes that in the real world, according to the
data, these types of firms are not cash constrained. Hence, the mechanics that Gertler and
Karadi (2011) use are not exactly representative of the real world.
Second, concerning financial intermediaries, it is noted that the model seems to be consistent
with the real world if we look at risk spreads and the volume of lending. However, banks
do not appear to be constrained in their lending and investment activities as much as in
the model. An important part of this constraint is that funds can be withdrawn from the
banking system by households. When examining the data related to the financial crisis of
2008, it becomes clear that households did not withdraw their cash as much as expected.
Cash deposits actually increased by 5% in 2008 compared to 2007 (Cole, 2011).
Lastly, in the model the financial intermediaries do not efficiently hedge their risk, this is
consistent with models in classic academic articles (Bernanke et al. (1999); Carlstrom and
Fuerst (1997)). Cole (2011) comments that including a form of risk hedging could severely
dampen the impact of the shocks that appeared in the Gertler and Karadi (2011) model.
All in all, the impact would come closer to the perfect capital markets model. Furthermore,
Cole (2011) adds that frictions in the financial markets in the model come from stealing by
financial intermediaries rather than excessive risk taking (as in the real world).

6 Conclusion
Gertler and Karadi (2011) were the first to come up with a quantitative macro-economic
DSGE model that can examine unconventional monetary policy in times of crisis. They do
this by including financial intermediaries in their model which leverage ratios are constrained
because of an agency problem. However, the central bank does not face this constraint,
making it possible for the central bank to intervene in times of crisis (when the financial
intermediary faces its constraint).
In this paper we tried to replicate and explain the model of Gertler and Karadi (2011) as
thoroughly as possible. By linearizing the system of equations and by usage of a first-order
Taylor expansion we attempted to implement the model in Matlab. Unfortunately, we were
not able to completely solve the model with the information that was available to us. So, we
used the code of Gertler and Karadi (2011) to simulate the economy. This led to the figures
in part 4.2 (Model Analysis). It can be concluded that for a technology shock, monetary

29
shock, and a wealth shock, investments and total output decrease, as expected. However,
these decreases in investment and output were more apparent in this model (with financial
frictions) than in the standard DSGE model.
To simulate an actual crisis we shocked the capital quality, similar to a sub-prime mortgage
crisis. In both models the shock to capital quality results in a recession, but the effect is
much more pronounced in the new model. This is caused by the amplification effect. Lastly,
it can also be concluded that an unconventional monetary policy moderates the effect of a
crisis on the economy, compared to no credit market intervention. This is a very important
result; it shows that unconventional monetary policy is effective in times of crisis.
The paper of Gertler and Karadi (2011) was cited for more than 1240 times by other
academics. This proves that their paper was very influential. However, a short investigation
showed that the citations only had a minor part in the examined papers. Since we only
glanced at a fraction of their citations, we cannot draw any general conclusions about this.
The fact that they were the first to quantitatively examine unconventional monetary policy
must have provided researchers with many new ideas for their own research.
To conclude, Gertler and Karadi (2011) came up with a very impressive macro-economic
model which proved the effectiveness of unconventional monetary policy in times of crisis.
The model could be expanded or improved by including a form of risk hedging for the finan-
cial intermediaries (Cole (2011)). Moreover, future research could attempt to endogenize
the steady state leverage ratio since it was determined exogenously in this model. Lastly,
this paper only focused on one crisis and future research could focus on an exogenous rare
disaster instead of an endogenous crisis.

30
7 Appendix: Taylor Approximations
7.1 Euler - optimal savings consumption

h t+1 i
1 = Et Rt+1
t

0 = log() + Et log(Rt+1 ) + Et log(t+1 ) + Et log(t )

1 1 1
0 = log() + log(R) + Et (Rt R) + log() + Et (t+1 ) + log() + (t )
R

So,
t+1 +
t+1 + Et
0 = Et R t (41)

7.2 Stochastic Discount Rate

%t+1
t,t+1
%t

log(%t+1 ) log(%t ) = log(t,t+1 )

1 1 1
log(%) + (%t+1 %) log(%) + (%t %) = log() + (t,t+1 )
% %

In steady state:
log(%) log(%) = log()

Therefore,

%t+1 + %t = t,t+1 (42)

31
7.3 Arbitrage

Et i t+1 Rkt+1 = i t+1 Rt+1

log( i ) + Et log(t+1 ) + Et log(Rkt+1 ) = log( i ) + log(t+1 ) + log(Rt+1 )

1 1
log( i ) + log() + Et (t+1 ) + log(Rk ) + Et (Rkt+1 Rk )
Rk
1 1
=log( i ) + log() + (t+1 ) + log(R) + (Rt+1 R)
R

In the steady state:

log( i ) + log() + log(Rk ) = log( i ) + log() + log(Rt )

So,
t+1 + Et R
Et kt+1 =
t+1 + R
t+1 (43)

7.4 Labour supply

t Wt = Lt

log(t ) + log(Wt ) = log() + log(Lt )

1 1 1
log() + (t ) + log(W ) + (Wt W ) = log() + log(L) + (Lt L)
W L
Thus,
t + W
t = L
t (44)

7.5 Optimal leverage ratio

t 1
t =
t 1 t

log(t ) = log(t ) log( t ) + log(1) log(1 T )

1 1 1 1
log() + ( + t ) = log() + (t ) log( ) (t ) log(1 ) + (t )
1

32
In the steady state:
log() = log() log( ) log(1 )

So,

t = t t t (45)
1

7.6 Growth rate of banks net wealth

t+1
xt,t+1 = zt,t+1
t

log(xt,t+1 ) = log(t+1 ) + log(zt,t+1 ) log(t )

1 1 1 1
log(x) + (xt,t+1 x) = log() + (t+1 ) + log(z) + (zt,t+1 z) log() (t )
x z
In the steady state:

log(x) = log() + log(z) log()log(x) = log(z)

So,

t,t+1 = t+1 + zt,t+1 t

x (46)

7.7 Optimal utilization rate

Yt
Pmt = 0 (Ut )t Kt
Ut

log() + log(Pmt ) + log(Yt ) log(Ut ) = log( 0 (Ut )) + log(t ) + log(Kt )

1 1 1
log() + log(Pm ) + (Pmt P ) + log(Y ) + (Yt Y ) log(U ) (Ut U ) =
Pm Y U

1 1
log( 0 (U )) + 00 (Ut )(Ut U ) + log() + (t ) + log(K) + (Kt K)
K
In the steady state:

log() + log(Pm ) + log(Y ) log(U ) = log( 0 (U )) + log() + log(K)

So,
Pmt + Yt U t ) + t + K
t = 0 (U t (47)

33
7.8 Production Function

Yt = At (Ut t Kt ) L1
t

log(Yt ) = log(At ) + log(Ut ) + log(t ) + log(Kt ) + (1 )log(Lt )

1 1
log(Y ) + (Yt Y ) = log(A) + (At A) + log(U ) + (Ut U ) + log()+
Y A U

1
(t ) + log(K) + (Kt K) + (1 )log(L) + (Lt L)
K L
In the steady state:

log(Y ) + log(A) + log(U ) + log() + log(K) + (1 )log(L)

So,
t + t + K
Yt = At + U t + (1 )L
t (48)

7.9 Net capital

Int = It (Ut )t Kt

log(Int ) = log(It (Ut )t Kt )

1 I
Int = log(I (U )K) + (It I)
I (U )K I

1 (U )
((Ut ) (U )) (K)
I (U )K (U )

1
(t ) ((U )K)
I (U )K

1 K
(Kt K) ((U ))
I (U )K K

I (U ) t) K
Int = It (U t t
K
I (U )K I (U )K I (U )K I (U )K
In the steady state: Int = I (U )K
Thus,
I (U ) K
Int = It (Ut ) t Kt (49)
Int Int Int Int

34
7.10 Capital Accumulation

Kt+1 = t Kt + Int

log(Kt ) = log(t1 Kt1 + Int1 )

1 1
(Kt K) + log(K) = log(t1 Kt1 Int1 ) + (t1 )+
K K + In

1 1
(Kt1 K) + (Int1 In )
K + In K + In

K In
t =
K t1 + tt 1 +
K Int1
K + In K + In K + In
In the steady state: K = K + In
Then,
t = t1 + In Int1 + K
K t1 (50)
K K

7.11 Fisher Relation

Et Pt+1
1 + it = Rt+1
Pt

log(1 + it ) = log(Rt+1 ) + Et log(Pt+1 ) log(Pt )

1 1 1 1
log(1 + i) + (it i) = log(R) + (Rt+1 R) + log(P ) + Et (Pt+1 P ) log(P ) (Pt P )
i R P P

In the steady state: log(1 + i) = log(R) + log(P ) log(P ). So, log(i) = log(R).
Thus,
t+1 + Et Pt+1 Pt
it = R (51)

7.12 Effective Capital

log(Kef f ) = log(t ) + log(Kt )

1 1
log(Kef f ) = log() + (t ) + log(K) + (Kt K)
K
In the steady state: log(Kef f ) = log() + log(K).
So,
t + K
t = 0 (52)

35
7.13 Wages

Yt
Wt = Pmt (1 )
Lt

log(Wt ) = log(Pmt ) + log(1 ) + log(Yt ) log(Lt )

1 1
log(W ) + (Wt W ) = log(Pm ) + (Pmt P )+
W Pm

1 1
log(1 ) + log(Y ) + (Yt Y ) log(L) (Lt L)
Y L
In the steady state: log(W ) = log(Pm ) + log(1 ) + log(Y ) log(L)
So,
t = Pm + Yt L
W t (53)

36
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