Econ 712, Fall 2017 - Final

December 15, 2017, 9:15am-11:15am.

Discrete time on the job wage search (80 points)

Consider an infinitely lived worker who maximizes the discounted stream of future utility of income and
search choices. The discount factor is 0 < β < 1. The search decision is a choice of the probability that the
worker gets a job offer with a wage drawn from the cumulative wage offer distribution F (·) that has support
[0, 1]. Assume F (·) is continuously differentiable. Specifically, in a given period, the worker receives a single
draw from F (·) with probability λ or no offer with probability 1 − λ. If given an offer, the worker then starts
the next period with the better of the two options of either staying in his/her current job or accepting the
new job, that is he/she is choosing the max of the two options. Given current wage income w and a choice
of λ, the worker’s per period utility is u(w, λ) = w − c(λ). c(λ) is strictly increasing, strictly convex, and
twice differentiable. Furthermore, c(0) = c0 (0) = 0 and limλ→1 c(λ) = ∞. The worker makes the period t
search choice λt knowing the current income wt . The worker can quit from one job P to another. Otherwise,
∞
jobs last indefinitely. Given period 0 wage w0 the worker’s objective is to maximize t=0 β t u(wt , λt ) where
wt follows the stochastic process dictated by the worker’s search choices.
1. State the functional equation for the worker’s dynamic problem. Denote by V (w) the value of current
employment at wage w, where w ∈ [0, 1].

2. Prove existence and uniqueness of V (w) as a solution to the functional equation set out in problem 1.
Adopt a proof strategy that utilizes the contraction mapping theorem.
3. Prove that V (w) is strictly increasing in w for any w ∈ [0, 1].
4. Prove that λ(w) is (weakly) decreasing in w for any w ∈ [0, 1]. Feel free to use differentiability of V (w)
here, if you should so desire.

5. Is V (w) convex or concave? Prove it. Feel free to use differentiability of V (w) here, if you should so
desire.

Stochastic income (20 points)

Consider the Aiyagari/Huggett model with constant interest rate r and a discrete income process yt ∈ Y =
{z1 , z2 , z3 }, where 0 < z1 < z2 < z3 < ∞. It is Markov with transition matrix,
 1 1

2 2 0
π =  0 1 − 2ε 2ε  .
0 ε 1−ε

1. Denote by p∗ = (p∗1 , p∗2 , p∗3 ) a stationary distribution defined by, p∗ = π T p∗ . Show the stationary
distribution(s) for the process.
2. If a worker’s initial income is y0 = z3 , what is the worker’s natural debt limit?