Ramsey Rule: Alternative Formulation (Gollier 2008)1

Given a ‘utilitarian’ welfare function

𝑇

𝑊 = ∑ 𝑒 −𝜌𝑡 𝑢 (𝑐𝑡 ) (1)

𝑡=0

let ct denote consumption at date t. Consider a marginal risk-free investment at date 0

which generates a single benefit 𝑒 𝑟𝑡 at date t per dollar invested at date 0. At the margin,
investing in this project has the following impact on welfare:
Δ𝑊 = 𝑒 −𝜌𝑡 𝑒 𝑟𝑡 𝑢 ′ (𝑐𝑡 ) − 𝑢 ′ (𝑐0 ) (2)

The first term on the right-hand side is the welfare benefit that such investment yields.
Consumption at date t is increased by 𝑒 𝑟𝑡 which must be discounted at rate 𝛿 to take
account of the delay. Solve for the critical rate of return r such that Δ𝑊 = 0

Δ𝑊 = 𝑒 −𝜌𝑡 𝑒 𝑟𝑡 𝑢 ′ (𝑐𝑡 ) − 𝑢 ′ (𝑐0 ) = 0

−𝜌𝑡 𝑟𝑡
𝑢 ′ (𝑐0 )
⇒ 𝑒 𝑒 = ′
𝑢 (𝑐𝑡 )

𝑢 ′ (𝑐0 )
−𝜌𝑡 + 𝑟𝑡 = ln ( ′ )
𝑢 (𝑐𝑡 )

𝑢 ′ (𝑐𝑡 )
𝜌𝑡 − 𝑟𝑡 = ln ( )
𝑢 ′ (𝑐0 )

1 𝑢 ′ (𝑐𝑡 )
⇒ 𝑟 = 𝜌 − ln ( ′ ) (3)
𝑡 𝑢 (𝑐0 )

For a CIES (constant intertemporal elasticity of substitution) utility function

𝑐𝑡 1−𝜂 −𝜂
𝑢(𝑐𝑡 ) = and 𝑢 ′ (𝑐𝑡 ) = 𝑐𝑡
1−𝜂

Let 𝑋𝑡 = ln 𝑐𝑡 − ln 𝑐0 → growth in log consumption between period 0 and t.

𝑐
𝑋𝑡 = ln ( 𝑡 ) ⇒ 𝑐𝑡 = 𝑐0 𝑒 𝑋𝑡
𝑐0

−𝜂
𝑢 ′ (𝑐𝑡 ) 𝑐𝑡 −𝜂 (𝑐0 𝑒 𝑋𝑡 )−𝜂 𝑐0 𝑒 −𝜂𝑋𝑡
= −𝜂 = −𝜂 = −𝜂 = 𝑒 −𝜂𝑋𝑡
𝑢 ′ (𝑐0 ) 𝑐0 𝑐0 𝑐0

1
Gollier (2008). “Discounting with fat tailed economic growth,” Journal of Risk and Uncertainty 37:171-186.
Substituting in (3)
1
𝑟= 𝜌− ln(𝑒 −𝜂𝑋𝑡 )
𝑡
𝜂𝑋𝑡
𝑟= 𝜌+
𝑡
1 𝑐 𝑋𝑡
𝑔𝑡 = 𝑙𝑛 ( 𝑡 ) = → annualised growth of log consumption between years 0 and t.
𝑡 𝑐0 𝑡

𝑟 = 𝜌 + 𝜂𝑔𝑡
 Ramsey rule under uncertainty (Gollier 2008)

Consider the utilitarian welfare function

𝑇
𝑊 = ∑ 𝑒−𝜌𝑡 𝐸𝑢(𝑐𝑡 ) (1)
𝑡=0

Consider a risk free investment at date 0 with rate of return r. Investing in this project has the
following impact on welfare,

Δ𝑊 = 𝑒 −𝜌𝑡 𝑒 𝑟𝑡 𝐸𝑢′ (𝑐𝑡 ) − 𝑢′ (𝑐0 ) (2)

[investment increases consumption at date t by 𝑒 𝑟𝑡 , which increases expected utility by

𝐸𝑢′ (𝑐𝑡 ) 𝑒 𝑟𝑡 𝑒 −𝜌𝑡 ; however, higher consumption comes at the cost of reduced consumption
today, reducing welfare by 𝑢′ (𝑐0 )]

Solve for the critical rate of return r such that Δ𝑊 = 0

Δ𝑊 = 𝑒 −𝜌𝑡 𝑒 𝑟𝑡𝑡 𝐸𝑢′ (𝑐𝑡 ) − 𝑢′ (𝑐0 ) = 0

𝑢′ (𝑐0 )
⇒ 𝑒 −𝜌𝑡 𝑒 𝑟𝑡𝑡 =
𝐸𝑢′ (𝑐𝑡 )

Taking natural logs,

𝑢′ (𝑐0 )
−𝜌𝑡 + 𝑟𝑡 𝑡 = ln ( ′ )
𝐸𝑢 (𝑐𝑡 )

Or,
𝐸𝑢′ (𝑐𝑡 )
𝜌𝑡 − 𝑟𝑡 𝑡 = ln ( ′ )
𝑢 (𝑐0 )

1 𝐸𝑢′ (𝑐𝑡 )
⇒ 𝑟𝑡 = 𝜌 − ln ( ′ ) (3)
𝑡 𝑢 (𝑐0 )

For the CRRA utility function

𝑐𝑡 1−𝜂
𝑢(𝑐𝑡 ) =
1−𝜂
−𝜂
𝑢′ (𝑐𝑡 ) = 𝑐𝑡

If 𝑋𝑡 denotes growth rate of consumption = ln 𝑐𝑡 − ln 𝑐0

1
 − (𝑋𝑡 − 𝜇)2
1
(where 𝑋𝑡 ~ 𝑁 ( 𝜇, 𝜎 2 )1 𝑖. 𝑒., 𝑓(𝑋𝑡 ) = 𝑒 2𝜎2 )
𝜎√2𝜋

𝑐𝑡
𝑋𝑡 = ln ( )
𝑐0

⇒ 𝑐𝑡 = 𝑐0 𝑒 𝑋𝑡

Further,
−𝜂
𝐸𝑢′ (𝑐𝑡 ) 𝐸𝑐𝑡 −𝜂 𝐸(𝑐0 𝑒 𝑋𝑡 )−𝜂 𝑐0 𝐸𝑒 −𝜂𝑋𝑡
= −𝜂 = −𝜂 = −𝜂 = 𝐸𝑒 −𝜂𝑋𝑡
𝑢′ (𝑐0 ) 𝑐0 𝑐0 𝑐0

1 − (𝑋𝑡 − 𝜇)2
−𝜂𝑋𝑡 −𝜂𝑋𝑡
𝐸𝑒 = ∫𝑒 𝑒 2𝜎2 𝑑𝑡
𝜎√2𝜋

1 −(𝑋𝑡 −𝜇)2
= ∫ 𝑒 2𝜎2 𝑒 −𝜂𝑋𝑡 𝑑𝑡
𝜎√2𝜋
𝑋 2 + 𝜇 2 − 2𝑋𝑡 𝜇
1 −( 𝜂𝑋𝑡 + 𝑡 )
2𝜎2
= ∫𝑒 𝑑𝑡
𝜎√2𝜋
2𝜎2 𝜂𝑋𝑡 + 𝑋𝑡2 + 𝜇 2 − 2𝑋𝑡 𝜇
1 −(
2𝜎2
)
= ∫𝑒 𝑑𝑡
𝜎√2𝜋

Adding and subtracting 𝜂2 𝜎 4 and 2𝜂𝜇𝜎 2

1 −
1
(𝑋 2 + 𝜇 2 + 𝜂 2 𝜎4 − 2𝜂𝜇𝜎2 − 2𝑋𝑡 𝜇+2𝑋𝑡 𝜂𝜎2 +2𝜂𝜇𝜎2 − 𝜂 2 𝜎4 )
= ∫𝑒 2𝜎2 𝑡 𝑑𝑡
𝜎√2𝜋

−( 2𝜂𝜇𝜎2 −𝜂 2 𝜎4 ) 1 −1 2
(𝑋𝑡 − (𝜇−𝜂𝜎2 ))
= 𝑒 2𝜎2 [ ∫ 𝑒 2𝜎2 𝑑𝑡 ]
𝜎√2𝜋
−1 2
1 (𝑋𝑡 − (𝜇−𝜂𝜎2 ))
𝜎√2𝜋
∫ 𝑒 2𝜎2 is the pdf of a random variable which is normally distributed with
mean (𝜇 − 𝜂𝜎 2 ) and variance 𝜎 2 . Thus,

1 −1
(𝑋𝑡 − (𝜇−𝜂𝜎2 ))
2
∫ 𝑒 2𝜎2 𝑑𝑡 = 1
𝜎√2𝜋

1
𝑋𝑡 can be alternatively assumed to be a Brownian motion (where 𝑋𝑡 ~ 𝑁(0, 𝑡) for each 𝑡 ∈ (0, ∞))
or an AR(1) process, which have differing implications for the rate of return. It can be shown that for
a Brownian motion process, 𝐸𝑋𝑡 = 𝜇𝑡 and 𝑉𝑎𝑟(𝑋𝑡 ) = 𝜎 2 𝑡 yielding a time independent growth rate
of consumption (𝑔𝑡 ) and critical rate of return (𝑟𝑡 ).

2
Thus,
𝐸𝑢′ (𝑐𝑡 ) −𝜂𝜇+
𝜂2 𝜎2
= 𝑒 2
𝑢′ (𝑐0 )

i.e.,
𝐸𝑢′ (𝑐𝑡 )
= 𝑒 −𝜂(𝐸𝑋𝑡− 0.5𝜂 𝑉𝑎𝑟(𝑋𝑡))
𝑢′ (𝑐0 )

Substituting in (3),

1
𝑟𝑡 = 𝜌 − (−𝜂(𝐸𝑋𝑡 − 0.5𝜂 𝑉𝑎𝑟(𝑋𝑡 ))
𝑡
Or,
𝜂𝐸𝑋𝑡 𝑉𝑎𝑟(𝑋𝑡 )
𝑟𝑡 = 𝜌 + − 0.5𝜂2 (4)
𝑡 𝑡
Or,

𝜇 𝜎2
𝑟𝑡 = 𝜌 + 𝜂 − 0.5𝜂2
𝑡 𝑡
Or equivalently,

𝑉𝑎𝑟(𝑋𝑡 )
𝑟𝑡 = 𝜌 + 𝜂𝑔𝑡 − 0.5𝜂 (𝜂 + 1) (5)
𝑡

1 𝐸𝑐𝑡 𝐸𝑋𝑡 + 0.5 𝑉𝑎𝑟(𝑋𝑡 )

(where 𝑔𝑡 = 𝑙𝑛 ( ) = ( ))
𝑡 𝑐0 𝑡