Lecture Notes 4: OLG Model

Chunyang Wang
Peking University PHBS

September 24, 2015

Chunyang Wang (Peking University PHBS)

September 24, 2015

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Diamond OLG Model

Agents live nite lives, for simplicity, two periods. Discrete time.
Lt individuals are born in period t. Population grows at rate n.
Lt = (1 + n)Lt +1
Denotes the two periods as young and old. Work only when young.
Consume at both periods. Save money to consume when old.
Supply 1 unit of labor when young inelastically.
Let C1t and C2t denote consumption in period t of young and old
individuals.
CRRA utility
Ut =

1
1
C1t
1 C2t
+1
+
,
1 1+ 1

Chunyang Wang (Peking University PHBS)

> 0, >

September 24, 2015

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Household Optimization
Production is same as before. Yt = F (Kt , At Lt ) satises the usual
conditions. At = (1 + g )At 1
rt = f 0 (kt ) and wt = f (kt )

kt f 0 (kt )

Initial situation: some initial capital K0 owned equally by the old

agents. At period 0, households consume their capital income and
existing wealth.
Second period consumption of an individual born at period t is
C2t +1 = (1 + rt +1 )(wt At

C1t )

Alternatively, the budget constraint is

C1t +

Chunyang Wang (Peking University PHBS)

1
C2t +1 = wt At
1 + rt +1

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Individual choose {C1t , C2t +1 g to max utility subject to budget

constraint.
Individuals maximization lagrangian
1
1
C1t
1 C2t
+1
L=
+
+ [wt At
1 1+ 1

(C1t +

1
C2t +1 )]
1 + rt +1

F.O.C.
C1t

1
C
=
1 + 2t +1

1 + rt +1

Euler equation
C2t +1
1 + rt +1 1/
=(
)
C1t
1+

Chunyang Wang (Peking University PHBS)

September 24, 2015

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Saving Rate

Combine Euler equation and budget constraint, we can have

C1t

= [1

s (r ) =

s (rt +1 )]At wt

(1 + r )(1 )/
(1 + )1/ + (1 + r )(1

)/

Rises of r has both an income and a substitution eect on saving.

s is increasing in r if < 1. (Proof)

Chunyang Wang (Peking University PHBS)

September 24, 2015

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Dynamics of the Economy

Key equation in OLG model

Kt +1 = s (rt +1 )Lt At wt
Since kt +1 = Kt +1 /(At +1 Lt +1 ),
kt +1 =

1
s (rt +1 )wt
(1 + n)(1 + g )
1
s (f 0 (kt +1 ))[f (kt )
(1 + n)(1 + g )

kt f 0 (kt )]

which denes the evolution of kt . kt +1 = k (kt )

Chunyang Wang (Peking University PHBS)

September 24, 2015

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Evolution of k
Pick = 1, f (k ) = k
kt +1 =

Chunyang Wang (Peking University PHBS)

1
1
(1
(1 + n)(1 + g ) 2 +

)kt

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A Fall in Discount Rate

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Speed of Convergence

Taylor series expansion

kt +1 ' k + (
Assume =

k )

dk t +1
dk t jkt =k

kt
and =

dkt +1
jk =k )(kt
dkt t

k ' t (k0

k )

dkt +1
dkt jkt =k

=
If = 1/3, convergence is about 2/3 toward k per period.

Chunyang Wang (Peking University PHBS)

September 24, 2015

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General Case
kt +1 =

1
f (kt ) kt f 0 (kt )
s (f 0 (kt +1 ))
f (kt )
(1 + n)(1 + g )
f (kt )

Chunyang Wang (Peking University PHBS)

September 24, 2015

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Dynamic Ine ciency

social planner problem: max something which is innite as individuals
are innitely more. impossible!
f 0 (kGR ) = n VS f 0 (k ) =

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1 (1 + n )(2 + )v

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Government in OLG
kt +1 =

1
1
[(1
(1 +n )(1 +g ) 2 +

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)kt

Gt ]

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