Problem Set 5: OLG Model

– with answers –

Problem 1 - Depreciation
Consider the Diamond model. Assume that utility is logarithmic and production is
Cobb-Douglas, f (k) = Ak α , α ∈ (0, 1).

1. Describe how the following changes in parameters affect the capital accumulation
schedule kt+1 (kt ):
Answer: Each young consumer solves the problem
1
max U = ln(c1,t ) + ln(c2,t+1 ), ρ > −1
c1,t ,c2,t+1 1+ρ
st. c1,t = wt − st , c2,t+1 = (1 + rt+1 )st , c1,t ≥ 0, c2,t+1 ≥ 0

The problem is rewritten as

1  
max U = ln(wt − st ) + ln (1 + rt+1 )st
st 1+ρ
st. st ∈ [0, wt ]

Taking the first order condition yields

1 1 1
0=− + (1 + rt+1 ) ⇔
w t − st 1 + ρ (1 + rt+1 )st
(1 + ρ)st = wt − st ⇔
wt
st =
2+ρ
The problem of the representative firm is given by

max AKtα Lt1−α − wt Lt − rt Kt , α ∈ (0, 1)

Kt ≥0,Lt ≥0

Note that f (k) = Ak α ⇔ F (K, L) = AK α L1−α . Using the first order conditions,
rt and wt can be expressed as functions of kt .
∂πt (·)
= (1 − α)AKtα L−α
t − wt = 0 ⇔
∂Lt
wt = (1 − α)Aktα
∂πt (·)
= αAKtα−1 L1−α
t − rt = 0 ⇔
∂Kt
rt = αAktα−1

1
 The aggregate capital level at time t + 1 is given by
Lt+1
Kt+1 = st Lt = st ⇔
1+n
st
kt+1 =
1+n
In sum we thus have
st wt (1 − α)A
kt+1 = = = kα
1+n (2 + ρ)(1 + n) (2 + ρ)(1 + n) t
(a) An increase in the rate of population growth, n.
Answer:
∂kt+1 1 (1 − α)A α
=− k <0
∂n (1 + n) 2 + ρ t
2

(b) A fall in A.
Answer:
∂kt+1 1−α
= ktα > 0
∂A (1 + n)(1 − ρ)

(c) An increase in the share of capital in production, α.

Answer:
!
∂kt+1 ∂ (1 − α)A
= kα
∂α ∂α (1 + n)(2 + ρ) t
∂  
=B (1 − α)ktα
∂α   
= B −ktα + (1 − α) ln(kt )ktα = Bktα (1 − α) ln(kt ) − 1
A
where B ≡ (1+n)(1+ρ)
. Clearly, B > 0 and ktα > 0. Consequently, the sign of
∂kt+1
∂α
is determined by the expression: (1 − α) ln(kt ) − 1.
1 1
(1 − α) ln(kt ) > 1 ⇔ ln(kt ) > ⇔ kt > e 1−α
1−α
Hence
 1
 > 0 if kt > e 1−α
∂kt+1

 1
= 0 if kt = e 1−α
∂α   1
< 0 if kt < e 1−α


Introduce depreciation in the Diamond model such that δ is the rate at which capital
depreciates.

2
2. Does this affect the capital accumulation schedule kt+1 (kt )? How?
Answer: Let rtr be the rental rate of capital. Profit maximization of the firm
implies
rtr = f 0 (kt )
No-arbitrage now imply that the interest rate must be given by

rt = rtr − δ ⇔
rt = f 0 (kt ) − δ

Consumption as old thus is c2t+1 = (1 + rt+1 )st = (1 + f 0 (kt ) − δ)st . The old still
consume everything, and capital next-period is therefore only the savings of the
young

kt+1 (1 + n) = s(wt , rt+1 )

= s(w(kt ), r(kt+1 ))
= s(f (kt ) − kt f 0 (kt ), f 0 (kt+1 ) − δ)

Consequently the effect of depreciation on the capital accumulation schedule is

determined by how the saving saving rate responds to a change in the interest
rate,
∂s(wt , rt+1 ) ∂s(wt , rt+1 )
=−
∂δ ∂rt+1
Extra details: The saving function is determined implicitly by the Euler equa-
tion
1 + rt+1 0
u0 (wt − s(wt , rt+1 )) = u ((1 + rt+1 )s(wt , rt+1 ))
1+ρ
Total differentiation yields

−u00 (c1t )dst = (1 + ρ)−1 [u0 (c2t+1 )drt+1 + (1 + rt+1 )u00 (c2t+1 )[(1 + rt+1 )dst + st drt+1 ]]

Re-arranging terms implies

ds (1 + ρ)−1 [u0 (c2t+1 ) + u00 (c2t+1 )c2t+1 ]
= − 00
drt+1 u (c1t ) + (1 + ρ)−1 u00 (c2t+1 )(1 + rt+1 )2
(1 + ρ)−1 u0 (c2t+1 )[σ(c2t+1 ) − 1]
= 00 R 0 for σ(c2t+1 ) Q 1
u (c1t ) + (1 + ρ)−1 u00 (c2t+1 )(1 + rt+1 )2
where
u00 (c2t+1 )c2t+1
σ(c2t+1 ) ≡
u0 (c2t+1 )
and the second order condition for the household problem implies
∂ 2U
= u00 (c1t ) + (1 + ρ)−1 u00 (c2t+1 )(1 + rt+1 )2 ≤ 0
∂ 2 st

3
 3. For the case with log-CobbDouglas and δ = 1, what is the capital accumulation
schedule kt+1 (kt )?
Answer: In the log-CobbDouglas case we have that the saving rate is independent
of the interest rate and therefore also the depreciation rate.

Problem 2 - Growth
Consider an OLG economy where individuals live for two periods. Total population
is constant, and households of the same cohort are homogeneous. Individuals born at
time t have exogenous endowments given by et when young and et (1 + g) when old at
time t + 1 (where g can either be positive or negative). Households can save investing in
a linear technology with rate of return 1 + r. An individuals born at time t maximizes
1
Ut = log c1t + log c2t+1 , ρ > −1
1+ρ
Finally, endowments evolve according to

et+1 = (1 + m)et

1. Find the consumption function of the young.

Answer: Each young consumer faces the problem
1
max U = ln(c1,t ) + ln(c2,t+1 ), ρ > −1
c1,t
,c 2,t+1 1+ρ
st. c1,t = et − st , c2,t+1 = (1 + g)et + (1 + r)st , c1,t ≥ 0, c2,t+1 ≥ 0

The problem can be rewritten as

1  
max U = ln(et − st ) + ln (1 + g)et + (1 + r)st
st 1+ρ
st. st ∈ [0, et ]

The first order condition is given by

1 1 1+r
0=− + ⇔
et − st 1 + ρ (1 + g)et + (1 + r)st
h i
et (1 + r) − (1 + ρ)(1 + g)
st =
(1 + r)(2 + ρ)

(a) Is there an wealth effect of interest rate changes?

Answer: Yes, we have logarithm utility implying that substitution and
income effects cancel, but we still have an effect of r on st . Note that the
effect disappears if g = −1 such that income as old is only due to saving.

4
 (b) What is the effect of an increase in g on the individual saving rate?
Answer: The savings rate is the ratio between individual saving as young
divided by individual income as young.
h i
et (1+r)−(1+ρ)(1+g)
st st (1+r)(2+ρ) (1 + r) − (1 + ρ)(1 + g)
= = =
yt et et (1 + r)(2 + ρ)
Taking the derivative with respect to g
 
st
∂ yt (1 + ρ)
=− <0
∂g (1 + r)(2 + ρ)
(c) What is the effect in m on aggregate net saving?
Answer: The aggregate net saving is the saving of the young minus the
saving of the old1 . The aggregate net saving of the economy is given by
h i
(1 + r) − (1 + ρ)(1 + g)
St = L(st − st−1 ) = (et − et−1 )L
(1 + r)(2 + ρ)
h i
(1 + r) − (1 + ρ)(1 + g)
= et−1 (1 + m − 1)L
(1 + r)(2 + ρ)
h i
(1 + r) − (1 + ρ)(1 + g)
= et−1 mL
(1 + r)(2 + ρ)
where L is the size of each generation2 . We would like to analyze how
a change in m affects aggregate net saving, when m is changed after the
realization of et−1 , i.e. we will take et−1 as given.
h i
∂St (1 + r) − (1 + ρ)(1 + g)
= et−1 L
∂m (1 + r)(2 + ρ)
Evaluating the sign of the derivative

0 if 1 + r > (1 + ρ)(1 + g)
>

∂St

= 0 if 1 + r = (1 + ρ)(1 + g)
∂m 

< 0 if 1 + r < (1 + ρ)(1 + g)
(d) Assume m = g. What is the effect of an increase in m on aggregate net
saving?
Answer: Now m = g. Consequently, aggregate net saving is given by
h i
(1 + r) − (1 + ρ)(1 + m)
St = et−1 mL
(1 + r)(2 + ρ)
1
The exercise can also be solved using aggregate gross saving, S̃t = Yt − Ct . The qualitative results
are the same.
2
Population growth is absent.

5
 The derivative of St with respect to m is given by
h i
(1 + r) − (1 + ρ)(1 + m)
!
∂St (1 + ρ)m
= − et−1 L
∂m (1 + r)(2 + ρ) (1 + r)(2 + ρ)
(1 + r) − (1 + ρ)(1 + m) − (1 + ρ)m
= et−1 L
(1 + r)(2 + ρ)
(1 + r) − (1 + ρ) − (1 + ρ)m − (1 + ρ)m
= et−1 L
(1 + r)(2 + ρ)
r − ρ − 2(1 + ρ)m
= et−1 L
(1 + r)(2 + ρ)
Evaluating the sign of the derivative

>
 0 if r > ρ + 2(1 + ρ)m
∂St

= 0 if r = ρ + 2(1 + ρ)m
∂m 

< 0 if r < ρ + 2(1 + ρ)m

2. Based on your answers analyze the theoretical validity of the following statement:
“In China, the high growth rate of output is the result of a high saving rate.”
Answer: This question could have been formulated more clearly. Three impor-
tant points are:
(a) In this problem, we have seen that higher growth (higher m) can both de-
crease or increase saving.
(b) In general a higher saving rate increase the kt+1 (kt ) schedule, which can give
a higher steady state level of capital and a higher growth rate towards steady
state.
(c) In the long-run the growth is determined by exogenous technology growth
(see next exercise).

Problem 3 - Balanced Growth

Consider the Diamond model and remember that the saving function of the young is
st = s(wt , rt+1 ). Add depreciation and technology growth to the model. The factor
prices implied by profit maximization then are
r(kt ) = f 0 (kt ) − δ
w(kt , Tt ) = [f (kt ) − f 0 (kt )kt ]Tt

where Tt = (1 + g)t is the technology level and we define

Kt
kt ≡
Tt Lt

6
Define the trend-adjusted real wage as

w̃(kt ) = f (kt ) − f 0 (kt )kt

1. Show that the law of motion of capital can be written as

s(w̃(kt )Tt , r(kt+1 ))
kt+1 =
Tt (1 + g)(1 + n)

Answer: We still have that the old consume everything and consequently next-
period capital is the saving of the young

Kt+1 = st Lt = s(wt , rt+1 )Lt = s(w̃(kt )Tt , r(kt+1 ))Lt ⇔

Lt
kt+1 = s(w̃(kt )Tt , r(kt+1 ))
Tt+1 Lt+1
1
= s(w̃(kt )Tt , r(kt+1 ))
Tt (1 + g)(1 + n)

Assume that the life-time utility function U is homothetic such that if life-time wealth
is multiplied by λ > 0 then the optimal choices of c1t and c2t also grows with a factor
of λ.

2. Show that we then for some function s̃ have

s(w̃(kt )Tt , r(kt+1 )) = s̃(r(kt+1 ))w̃(kt )Tt

resulting in the law of motion

s̃(r(kt+1 ))
kt+1 = w̃(kt )
(1 + g)(1 + n)

Answer: The budget constraints are

c1t + st = wt
c2t+1 = (1 + rt+1 )st

Assume that the optimal level of saving is multiplied with κ when life-time wealth
is multiplied by λ > 0. The assumption of homothetic preferences imply

c1t λ + st = wt λ
c2t+1 λ = (1 + rt+1 )st κ

This can only be true for λ = κ. Defining s̃(r(kt+1 )) = s(1, r(kt+1 )) thus implies
the required result.

7
 3. Show that if the model have a steady state then growth is balanced.
Answer: The assumption of a steady state implies that kt = k ∗ is constant.
Consequently, Kt = k ∗ Tt Lt grows by gT L ≡ (1 + g)(1 + n) − 1. This implies that
Yt = F (k ∗ Tt Lt , Tt Lt ) = F (k ∗ , 1)Tt Lt also grows with gT L . Total consumption
for the young equals (1 − s̃(r(k ∗ )))w̃(k ∗ )Tt Lt and thus grows with gT L . Total
consumption for the old equals (1 + r(k ∗ ))s̃(r(k ∗ ))w̃(k ∗ )Tt Lt−1 and thus grows
with a rate of gT L . All variables thus grows with a rate of gT L and we have
balanced growth.

Problem 4 - Pension system

Consider the Diamond OLG model where an individual born in period t has the fol-
lowing utility function
1
Ut = log c1t + log c2t+1 , ρ > −1
1+ρ

which is maximized subject to

c1t + st = wt
c2t+1 = (1 + rt+1 )st

Competitive firms produce according to the Cobb-Douglas production

Yt = F (Kt , Lt ) = Ktα Lt1−α , α ∈ (0, 1)

Kt
Defining capital per unit of labor, kt = Lt
, profit maximization implies

αktα−1 = rt
(1 − α)ktα = wt

1. Show that individual utility maximization implies

1
st = wt
2+ρ

Answer: Each young consumer solves the problem

1
max U = ln(c1,t ) + ln(c2,t+1 ), ρ > −1
c1,t
,c 2,t+1 1+ρ
st. c1,t = wt − st , c2,t+1 = (1 + rt+1 )st , c1,t ≥ 0, c2,t+1 ≥ 0

8
 The problem is rewritten as
1  
max U = ln(wt − st ) + ln (1 + rt+1 )st
s t 1+ρ
st. st ∈ [0, wt ]

Taking the first order condition yields

1 1 1
0=− + (1 + rt+1 ) ⇔
w t − st 1 + ρ (1 + rt+1 )st
(1 + ρ)st = wt − st ⇔
wt
st = ((1))
2+ρ
The problem of the representative firm is given by

max πt (Kt , Lt ) = Ktα Lt1−α − wt Lt − rt Kt , α ∈ (0, 1)

Kt ≥0,Lt ≥0

Kt
Using the first order conditions, rt and wt can be expressed as functions of kt ≡ Lt
.

(wt = (1 − α)ktα (2))

rt = αAktα−1 ((3))

The aggregate capital level at time t + 1 is given by

Lt+1
Kt+1 = Lt st = st ⇔
1+n
st
kt+1 = ((4))
1+n

2. Show that capita per unit of labor evolves according to

1 1
kt+1 = (1 − α)ktα
1+n2+ρ
and use the expression to graphically analyze the evolution of the economy, pro-
vided that capital is initially below the steady state value, k0 < k ∗ .
Answer: Substituting (1) and (2) into (4)
st wt 1−α
kt+1 = = = ktα ((5))
1+n (2 + ρ)(1 + n) (2 + ρ)(1 + n)

3. Briefly explain the problem to find an analytical solution that would arise without
the assumption that utility is logarithmic.
Answer: Then st would also be a function of rt+1 .

9
4. Show that it cannot be ruled out that the steady state is dynamically inefficient.
Explain how in this situation, the utility of all individuals could be increased if k
was decreased and explain why this is not in contradiction with the first welfare
theorem.
Answer: In steady state kt+1 = kt = k ∗ . Using (5)
" # 1
(1 − α) 1−α 1−α
k∗
k∗α ⇔ ∗
k = ((6))
(2 + ρ)(1 + n) (1 + n)(2 + ρ)

The interest rate in steady state can be computed using (3) and (6)

α(1 + n)(2 + ρ)
r∗ = αk ∗ α−1 = ((7))
1−α
Consumption in steady state is given by

c∗ = f (k ∗ ) − nk ∗

Taking the derivative with respect to k ∗ and using (7)


∗ >
 0 if r∗ > n ⇔ k ∗ < kGR
∂c 
= f 0 (k ∗ ) − n = r∗ − n = αk ∗ α−1 − n = 0 if r∗ = n ⇔ k ∗ = kGR
∂k ∗
< 0 if r∗ < n k ∗ > kGR


⇔

When k ∗ > kGR the economy will be dynamically inefficient. Clearly, the economy
is dynamically inefficient when

α(1 + n)(2 + ρ)
<n⇔
1−α
2α + ρα + 2nα + ρnα < n − αn ⇔
2α + ρα < n(1 − 3α − ρα) ⇔
(2 + ρ)α
n>
1 − α(3 + ρ)

The equation can be true for certain parameter values. Consequently, dynamic
inefficiency cannot be ruled out.
Assume that in period t0 a fully funded pension system is introduced according
to which a fraction, τ ∈ (0, 1), of wage income is collected from each young
individual. The contribution is invested in physical capital, thereby earning a
rate of return equal to the interest rate, and the contribution including interest
is paid as a pension when the individual get old.

5. Analyze and explain how this will affect consumption, savings and capital accu-
mulation in the economy.

10
 Answer: The problem of the young is now given by
1
max U = ln(c1,t ) + ln(c2,t+1 ), ρ > −1
c1,t ,c2,t+1 1+ρ
st. c1,t = wt (1 − τ ) − st , c2,t+1 = (1 + rt+1 )(st + wt τ ), c1,t ≥ 0, c2,t+1 ≥ 0
The problem is rewritten as
1  
max U = ln(wt (1 − τ ) − st ) + ln (1 + rt+1 )(st + wt τ )
st 1+ρ
st. st ∈ [−wt τ, wt (1 − τ )]
Taking the first order condition yields
1 1 1
0=− + (1 + rt+1 ) ⇔
wt (1 − τ ) − st 1 + ρ (1 + rt+1 )(st + wt τ )
(1 + ρ)(st + wt τ ) = wt (1 − τ ) − st ⇔
wt
st = − wt τ
2+ρ

Assume instead that the revenue from the wage income tax is used to finance public
consumption (with the primary public budget being kept balanced in all periods).

3. Solve the individual utility maximization problem and show that after the intro-
duction of the tax, individual consumption of the young is
1+ρ
c1t = (1 − τ )wt
2+ρ

Answer: The problem of the young is now given by

1  
max U = ln(wt (1 − τ ) − st ) + ln (1 + rt+1 )st
st 1+ρ
st. st ∈ [−wt τ, wt (1 − τ )]
Taking the first order condition
1 1 1
0=− + (1 + rt+1 ) ⇔
wt (1 − τ ) − st 1 + ρ (1 + rt+1 )st
wt (1 − τ )
st = ((8))
2+ρ
Use (8) to compute c1,t
wt (1 − τ ) 2+ρ−1
 
c1,t = wt (1 − τ ) − st = wt (1 − τ ) − = wt (1 − τ )
2+ρ 2+ρ
1+ρ
= wt (1 − τ ) ((9))
2+ρ

11
 Using (2), (4) and (8)
(1 − α)(1 − τ ) α
kt+1 = k ((10))
(1 + n)(2 + ρ) t

After the introduction of the tax, capital will be evolving according to

1 1
kt+1 = (1 − τ )(1 − α)ktα
1+n2+ρ

4. Analyze how the tax affect capital, the wage per unit of labor, the interest rate,
consumption of the young and of the old from the period when the tax is intro-
duced and afterwards.
Answer: From (5) and (10) it is clear that k will fall. Consequently, the real
interest rate will increase according to (3), the real wage rate will fall according
to (2), and consumption of the young will fall according to (9). The question is,
what happens to consumption of the old for t > t0 ?
 
c2,t+1 = st (1 + rt+1 ) = (1 − τ )wt − c1,t (1 + rt+1 )
!
1+ρ
= (1 − τ )(1 − α)ktα
− (1 − τ )(1 − α)ktα (1 + αkt+1
α−1
)
2+ρ
!
α α−1 1
= (1 − τ )(1 − α)kt (1 + αkt+1 )
2+ρ
! " #α−1 
1 (1 − α)(1 − τ ) α
= (1 − τ )(1 − α)ktα 1 + α k 
2+ρ (1 + n)(2 + ρ) t
! !α α−1
1 1 1

2
= (1 − τ )(1 − α)ktα + (1 − τ )α (1 − α)α α ktα
2+ρ 2+ρ 1+n

Clearly, c2,t+1 is increasing in kt and decreasing in τ . Hence, the consumption of

the old will fall when the tax, τ , is introduced.

Problem 5 - Pay-as-you-go
Consider an economy where individuals live for two periods, and population is constant.
Utility for young individuals born in period t is
1
Ut = log c1t + log c2+1 , ρ > −1
1+ρ
where c1t is consumption when young, and c2t+1 is consumption when old. Young agents
work a unit of time (i.e. their labor income is equal to the wage they receive). Old
agents do not work and must provide consumption through saving (in capital and/or

12
government debt, if this exists). Production for firm i that hires labor and capital is
given by
Yti = A(Kti )α (Kt Nti )1−α
where A > 0, K is the aggregate capital stock in the economy, K i and N i are the
amounts of capital and labor hired by the firm (since there is no population growth,
take the aggregate amount of labor, N , to be normalized to one). Markets for factors
are competitive resulting in factors being rewarded their marginal products, r and w.
Suppose that the government runs a pay-as-you-go social security system in which the
young contribute an amount d that is received by the old.

1. Show that rt is independent of the capital stock, and that wt = (1 − σ)AKt .

Answer: Firms are indexed i ∈ {1, 2, 3, ..., I} (alternatively we could have a
continuum of firms indexed i ∈ [0, I]). Each firm solves the problem

max πti (Kti , Nti ) = A(Kti )α (Kt Nti )1−α − wt Nti − rt Kti , α ∈ (0, 1), A>0
Kti ≥0,Lit ≥0

taking the aggregate capital stock Kt and factor prices as given. Taking the first
order condition with respect to Kti

rt = Aα(Kti )α−1 Kt1−α (Nti )1−α = AαKtα−1 I 1−α Kt1−α Nt1−α I α−1 = Aα ((1))

where Nt has been normalized to one and where it is used that Kti I = Kt and
Nti I = Nt in equilibrium3 . Using the same procedure, the real wage rate is given
by

wt = (1 − α)AKt = (1 − α)Akt (2)

2. Find saving and capital accumulation for the steady state.

Answer: The problem of the young can be rewritten as
" #
1   d
max Ut = ln(wt − st − d) + ln (1 + rt+1 )st + d st. st ∈ − ; wt − d
st 1+ρ 1 + rt+1
Using the first order condition, individual saving of the young can be expressed
as
wt 2 + rt+1 + ρ
st = −d (3)
2+ρ (1 + rt+1 )(2 + ρ)
Note that since population growth is absent kt+1 = st . Consequently, it follows
directly from (1), (2) and (3)
(1 − α)Akt 2 + Aα + ρ
kt+1 = −d (4)
2+ρ (1 + Aα)(2 + ρ)
3
Since all firms are identical

13
 In steady state
2 + Aα + ρ
k∗ = d    (5)
1 + Aα (1 − α)A − (2 + ρ)

Assume that (1 − α)A > 2 + ρ, such that the economy will not end-up in kt = 0
for t < ∞for all k0 > 0.

Suppose now that at t0 , the government decides to eliminate the social security system,
and makes the following announcement: In period t0 the old receive d, but the young
make contributions only for γd with γ ∈ [0, 1]. The difference, (1 − γ)d, is financed
by issuing debt. From period t0 + 1 onward the government collect no social security
contributions nor makes payments. It keeps the debt at a constant level (1 − γ)d
financing interest payment through a lump sum tax on the young.

3. For the case γ = 0, find the partial equilibrium effects (i.e. assuming wages and
interest rate remain constant) on saving and capital accumulation in period t0
and t0 + 1. Is capital accumulation lower or higher than found in question 2?
Does the reform have political support at time t0 ? (look at the change in welfare
of the young and old at that time)
Answer: The problem will first be solved for the general case. The problem of
the young at time t = t0
1
max Ut0 = ln(c1,t0 ) + ln(c2,t0 +1 ), ρ > −1
c1,t0 ,c2,t0 +1 1+ρ
st. c1,t0 = wt0 − st0 − γd, c2,t0 +1 = (1 + rt0 +1 )st0 , c1,t0 ≥ 0, c2,t0 +1 ≥ 0

The problem is rewritten as

1
   
max Ut0 = ln wt0 − st0 − γd + ln (1 + rt0 +1 )st0
st 0 1+ρ

14
Solving the problem yields
wt0 − γd
st0 = ((6))
2+ρ
The problem for the young at time t = t0 + 1
1
max Ut0 +1 = ln(c1,t0 +1 ) + ln(c2,t0 +2 ), ρ > −1
c1,t0 +1 ,c2,t0 +2 1+ρ
st. c1,t0 +1 = wt0 +1 − st0 +1 − (1 − γ)drt0 +1 ,
c2,t0 +2 = (1 + rt0 +2 )st0 +1 , c1,t0 +1 ≥ 0, c2,t0 +2 ≥ 0

The problem is rewritten as

1
   
max Ut0 = ln wt0 +1 − st0 +1 − (1 − γ)drt0 +1 + ln (1 + rt0 +2 )st0 +1
st0 +1 1+ρ
Solving the problem yields
wt0 +1 − (1 − γ)drt0 +1
st0 +1 = ((7))
2+ρ
For γ = 0 it follows directly from (6) and (7) that
wt0 wt0 +1 − drt0 +1
st0 = and st0 +1 =
2+ρ 2+ρ
Saving of the young will increase in t = t0 and saving of the young for t > t0 will
2 2
increase (decrease) for rt+1 < 2 + ρ (rt+1 > 2 + ρ). This is clear since
wt0 +1 − drt0 +1 wt 2 + rt+1 + ρ
> −d ⇔
2+ρ 2+ρ (1 + rt+1 )(2 + ρ)
2 + rt0 +1 + ρ
rt0 +1 < ⇔
1 + rt0 +1
2
rt+1 <2+ρ

Assuming that the entire transfer is financed by foreign investors st = kt+1 for
t ≥ t0 . If it is assumed that the entire transfer is financed by domestic investors
st 6= kt+1 for t ≥ t0 . Instead st = kt+1 + bt+1 where b is bonds. Due to arbitrage
the return to bonds must equal the return to capital holdings, i.e. the return to
bonds will be equal to r. Capital in t = t0 and t = t0 + 1 are given by
wt0 wt +1 − drt0 +1
kt0 +1 = st0 − bt0 +1 = − d and kt0 +2 = st0 +1 − bt0 +2 = 0 −d
2+ρ 2+ρ
Comparing with (3), it can be shown that kt0 +1 will increase if ρ < −1 and kt0 +2
will increase if 2 + rt0 +2 + ρ < 0. Both expressions are false by definition (we have
assumed that ρ > −1 and r > −1). Consequently, the capital level will decrease.

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 4. Repeat the previous analysis when γ = 1.
Answer: For γ = 1 it follows directly from (6) and (7) that

wt0 − d wt0 +1
st0 = and st0 +1 =
2+ρ 2+ρ
Saving of the young will increase for all t ≥ t0 . It is clear that st for t > t0 will
increase. Comparing the expression for st0 +1 with (3)

d d(2 + rt+1 + ρ)
< ⇔
2+ρ (1 + rt+1 )(2 + ρ)
2 + rt+1 + ρ
1< ⇔
(1 + rt+1 )
ρ > −1 [true by assumption]

it is clear that saving of the young must increase in t = t0 .

5. For the case of question 4) what are the general equilibrium effects?
Answer: Assume that the economy is initially in steady state. Since aggregate
saving is increased in t = t0 , the economy will be knocked out of the steady state
equilibrium and there will be a positive growth rate in kt . The growth rate in kt
will accelerate in t = t0 + 1. After t = t0 + 1, wt , c1,t , c2,t and kt will grow with
the same constant growth rate.

Problem 6 - Labor supply

Consider figure 5.3 in G5.2. Explain the substitution, income and wealth effects of a
change in the real wage.
Answer: The short answer is

16
• A → B: Substitution effect

• B → C: Pure income effect

• C → D: Wealth effect

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