Volker Hahn, Fuzhen Wang University of Konstanz

Advanced Macroeconomics I, WT 2013/14

Exam
Date: 16 April 2014, 10:00 - 11:30

You may answer in English only.

The duration of the exam is 90 minutes.
Please use only the designated white sheets for your answers.
You must not use any books, notes, etc.
If you use mathematical formulae, define the respective vari-
ables (unless the variables have been defined in the question).
Problem #1:
Various issues (17.5 points)
(a) Name three of Kaldors stylized facts. How well can the neo-
classical growth model capture these stylized facts? Explain
your response briefly. (3 points)
(b) Define the terms absolute convergence and conditional con-
vergence. Does the AK model discussed in the lecture imply
any of them? Explain. (3 points)
(c) Show that the Cobb-Douglas production function F (AL, K) =
K (AL)1 satisfies the Inada conditions. (1 point)
(d) The Hodrick-Prescott filter is very popular in macroeconomic
analysis. What is it used for? Explain intuitively how it works.
(2 points)
(e) (Ricardian Equivalence) Consider a two-period pure exchange
economy inhabited by a representative household and a gov-
ernment. The household is endowed with yt units of goods
in period t, (t = 1, 2). The government finances its spending
{G1 , G2 } by issuing bonds B in the first period and/or raising
lump-sum taxes t from the household in periods t = 1, 2. We
assume that there is no government debt at the beginning of
period 1. The household chooses a consumption path {C1 , C2 }
and the amount of government bonds b so as to maximize its
lifetime utility u(C1 , C2 ) = ln C1 + ln C2 with 0 < < 1,
subject to its per-period budget constraints:
C1 + b y1 1 ,
C2 y2 + b(1 + r) 2
The government must honor its budget constraints
G1 1 + B,
G2 2 B(1 + r),
where r is the real interest rate between period 1 and period 2.

(i) Derive the intertemporal budget constraints for the house-

hold and the government, respectively. (2 points)
(ii) Write down the goods market clearing conditions in each
period. (1 point)

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 (iii) State the households optimization problem using the in-
tertemporal budget constraint you have just obtained.
(1 point)
(iv) Derive the households first-order condition. (1 point)
(v) Now consider two government policy plans P 1 : {B =
1, 1 = 0, 2 = 1 + r} and P 2 : {B = 0, 1 = 1, 2 = 0}.
Solve for the optimal consumption path under each pol-
icy strategy. How is your finding related to the Ricardian
equivalence? (3.5 points)

Problem #2:
Consider the simplified real-business-cycle model discussed in the
lecture. The model economy consists of an infinitely-lived repre-
sentative household and a representative firm. In each period, the
household is endowed with one unit of labor. The instantaneous
utility function is log-linear: u(Ct , Lt ) = ln Ct + b ln(1 Lt ), b > 0.
Output is produced according to Yt = Kt (At Lt )1 , 0 < < 1.
The logarithm of the efficiency of labor, ln At , follows an AR(1)
process ln At = ln At1 + t where 1 < < 1 and the t s
are serially uncorrelated random shocks with mean zero. We as-
sume full depreciation for capital, thus capital evolves according to
Kt+1 = Yt Ct . (0, 1) is the discount factor; A0 , K0 are exoge-
nously given. (Note that we abstract from population growth and
technological progress.) (18.5 points)
(a) Define the value function V () for the social planner as a func-
tion of the capital stock Kt and the level of technology At .
Write down the associated Bellman equation. Explain intu-
itively why V () must satisfy the Bellman equation. (3 points)
(b) Derive the Euler equation for capital and the first-order con-
dition with respect to labor. Explain the first-order condition
for labor intuitively. (3 points)
(c) Let us guess that V () takes the form V (Kt , At ) = 0 +
K ln Kt + A ln At , where the values of the s are to be deter-
mined using the method of undetermined coefficients. Substi-
tuting this conjectured form and the facts that Kt+1 = Yt Ct

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 and Et [ln At+1 ] = ln At into the Bellman equation yields:

V (Kt , At ) = max [ln Ct + b ln(1 Lt )]
Ct ,Lt

+ [0 + K ln(Yt Ct ) + A ln At ]

Derive the first-order condition for Ct . Show that it implies

that CYtt does not depend on Kt or At . (1 point)
(d) Derive the first-order condition for Lt . Use this result and the
result from the previous part to show that Lt does not depend
on Kt or At . (1.5 points)
(e) Substitute the production function and the results from parts
(e) and (f) for the optimal Ct and Lt into the equation
above, and show that the resulting expression has the form
V (Kt , At ) = 00 + 0K ln Kt + 0A ln At . (2.5 point)
(f) Use 0K = K and 0A = A to determine K and A . (1 point)
(g) Explain how 0 could be determined. (2 points)
(h) In practice, dynamic stochastic general equilibrium models can
rarely be solved analytically. Instead, we often have to re-
sort to numerical methods such as the value function iteration
method. Please describe in detail the algorithm of value func-
tion iteration method for the social planners problem above.
For simplicity, we now assume that At is constant. How can
you be sure that the algorithm will converge to the actual value
function? Explain in detail. (4.5 points)