Macroeconomics I

Problem Set # 3

This is due Thursday, February 3rd .

Exercise # 1 CRRA utility function

(a) Show that the CRRA utility function, u(c) = c1−θ , converges to log-utility when
1−θ

θ = 1. (Take the limit θ → 1 and use L’Hospital’s rule).

Consider the following inter-temporal maximization problem:

max u(ct ) + βu(ct+1 )

ct ,ct+1
ct+1
s.t. ct + = w̄
R

(b) Using the optimality conditions, write down the Euler Equation and interpret it.
Think what the consumer would do if the equation didn’t hold with equality.

(c) Rewrite the Euler Equation for the CRRA utility case. calculate the inter-temporal
elasticity of substitution (IES). What is the intuition of a higher/lower IES?

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Exercise # 2 The Ramsey Model

In the lecture, we solved the Ramsey model for the decentralized economy. We are now
going to solve the Social Planner (SP) problem.

(a) Why the SP problem is equivalent to the decentralized economy problem?

Consider the case where households grow at rate n and without technological growth.
Assume that ρ > n. The SP problem is:
∞
max ∫ u(ct )e−(ρ−n)t dt
{c }∞
t t=00

subject to the resource constraint

K̇t = Yt − Ct − δKt = F (Kt , Lt ) − Ct − δKt

where F (Kt , Lt ) is a neoclassical production function.

(b) Write the resource constraint in per capita terms.

(c) Write the current-value Hamiltonian.

(d) Write the FOCs.

(e) Using the FOCs, write the Euler equation (the equation that determines cċ .
HINTS:

• use the FOC w.r.t. k to find an expression for λλ̇ .

• time differentiate the FOC w.r.t. c, and divide this expression by the FOC
′ (c)
w.r.t. c. Define σ ≡ − uu′′ (c)c .

(f) What conditions k̇k and ċc satisfy on the BGP? What are the two expressions that
determine capital and consumption on the BGP?

(g) How does capital per capita on the BGP compares to the golden rule capital per
capita of the Solow model? Discuss.

(h) Plot the phase diagram of the system in (k, c) space. For a given initial level of
capital, k0 , below the BGP level, discuss the possible initial levels of consumption
that are not in the saddle path and the associated trajectories of capital and con-
sumption. What conditions do they violate?

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(i) What is the effect on the BGP and on impact of an (unexpected) decrease in the
discount rate, ρ?

(j) Linearize the system around the BGP. (Do a first-order Taylor expansion of k̇ and
ċ around the steady-state).