Macroeconomics I

Problem Set 7
Marti Mestieri
UPF and BSE
March 2023

This problem set consists on characterizing a BGP equilibrium in an economy similar to the
one in Ngai-Pissarides-07.

Set-up

The economy consists of three different sectors: agriculture, manufacturing, and services, in-
dexed by i = {a, m, s}. Output yit of each sector can be used for final consumption cit . Only
output from manufacturing, ymt , can be used for final investment xmt . An infinitely-lived rep-
resentative households rents capital kt and labor (normalized to one) to firms and chooses how
much of each good to buy for consumption and investment satisfying the standard budget con-
straint:
X
wt + rt kt = pit cit + pmt xmt (1)
i={a,m,s}

where pit is the price of output of sector i at time t, wt is the wage rate, and rt is the rental rate
of capital. Capital accumulates with the standard law of motion

kt+1 = (1 − δ) kt + xt (2)

where 0 < δ < 1 is a constant depreciation rate, and xt = xmt . The period utility function u(ct )
is defined over a consumption basket ct ≡ C(cat , cmt , cst ) that aggregates goods from the three
sectors. We will use a standard CRRA utility function,

ct1−σ − 1
u(ct ) = (3)
1−σ
and specify standard (potentially) non-homothetic CES aggregators for consumption:
 1
ρ

(θic )1−ρ cρi 

X
C(ca , cm , cs ) =  (4)
i∈{a,m,s}

with ρ < 1, 0 < θic < 1 and c

P
i∈{a,m,s} θi = 1 for i = a, m, s.
 Macroeconomics I, Problem Set

There is a representative firm in each sector i combining capital kit and labor lit to produce
the amount yit of the good i. The production functions are Cobb-Douglas with equal capital
shares and different technology levels Bit :

α
yit = kit (Bit lit )1−α

1 Problem Set

1. Write down the Lagrangian that represents the HH’s dynamic problem and find the first
order conditions (FOC)

2. Use the FOC for each good i (together with the tricks from the notes) to get an expression
for the FOC of the consumption good ct of the form:

c−σ
t = λt pct (5)

where pct is the implicit price of the consumption basket defined as:
  ρ−1
ρ
X ρ
pct ≡  θic pit
ρ−1  (6)
i=a,m,s

3. Use equation 15 together with the FOC for xt and kt+1 to solve for the Euler equation.
Provide the intuition

4. Use the FOC with respect to each of the goods i to provide and expression for:

pit cit
(7)
pjt cjt
What are the drives of structural transformation in this economy? What is the main
parameter that determines the extent of structural transformation?

5. Solve for the firms’ problem. Find the implied FOC

6. Characterize relative prices as a function of relative productivities

7. Provide an expression for the interest rate of the economy in terms of the relative price of
manufacturing m, its TFP, and the aggregate stock of capital. HINT (Use the fact that
the capital-labor ratio is the same across sectors)

8. Define a competitive equilibrium

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 Macroeconomics I, Problem Set

9. Define a BGP in terms of the evolution of the interest rate of the economy that you solved
for in (7). How should the aggregate stock of capital kt evolve?

10. Assume that pmt = pxt = 1 ∀t. Define the productivity with which consumption goods
are produced as:

1
Bct = (8)
pct

11. Use this definition together with the assumption you made in (10) to re-write the Euler
equation

12. Consider the following resource constraint:

1−α α
kt+1 = (1 − δ)kt + Bmt kt − pct ct (9)

This equation, together with the Euler equation, represents the dynamic system of the
kt ct
economy. Re-write this system in terms of k̂t = Bmt and ĉt = Bct

13. Find the conditions (in terms of values of parameters) under which there is BGP

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 Macroeconomics I, Problem Set

Solution

2 Households

2.1 Households’ problem

With all these elements in place the optimal household plan is the sequence of consumption and
investment choices that maximizes the discounted infinite sum of utilities. We can write the
Lagrangian as,

∞
( )
X h X i h i
t
β u (ct ) + λt wt + rt kt − pit cit − pmt xmt + ηt (1 − δk ) kt + xmt − kt+1
t=0 i

where λt and ηt are the shadow values at time t of the budget constraint and the law of motion
of capital respectively. Taking prices as given, the standard first order conditions with respect
to goods cit and xit are:

∂ct
cit : u′ (ct ) = λt pit i ∈ {a, m, s} (10)
∂cit
∂xt
xmt : ηt = λt pmt (11)
∂xmt

while the FOC for capital kt+1 is given by,

kt+1 : ηt = β λt+1 rt+1 + β ηt+1 (1 − δ) (12)

2.1.1 Consumption choices: consumption basket and the price index

Using the utility function in equation (3) and the consumption aggregator in equation (4), the
FOC of each good i described by equation (10) can be rewritten as:
 1−ρ
ct
c−σ
t θac = λt pat
cat
 1−ρ
c ct
c−σ
t θ m = λt pmt
cmt
 1−ρ
c ct
c−σ
t θ s = λt pas
cst

1−ρ
θac cmt

pat
c c
= (13)
θm at pmt
 c   ρ
pmt cmt θm pat 1−ρ
= (14)
pat cat θac pmt

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 Macroeconomics I, Problem Set

Manipulating these equations (see Appendix A):

c−σ
t = λt pct (15)

where pct is the implicit price of the consumption basket defined as:
  ρ−1
ρ
X ρ
pct ≡  θic pit
ρ−1  (16)
i=a,m,s

Plugging equation 16 into each FOC and summing them up (see Appendix A):

X
pit cit = pct ct
i=a,m,s

which states that total expenditure in consumption goods is equal to the value of the consump-
tion basket minus the market value of the non-homothetic components. Using the ratio of the
FOC’s given by equation (10) we obtain the expenditures shares relative to the consumption
basket

  ρ
pit cit pct 1−ρ
= θic (17)
pct ct pit
and relative to total consumption expenditure
  ρ
pit cit pct 1−ρ
P = θic
j=a,m,s p jt cjt pit

2.1.2 Investment choices: Investment basket and the price index

Given that manufacturing is the only good that can be used for investment, equation 11 becomes

ηt = λt pxt (18)

where

pxt = pmt (19)

and the total expenditure:

pmt xmt = pxt xt

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 Macroeconomics I, Problem Set

2.1.3 Inter-temporal condition:

In order to get the Euler equation (see Appendix B), we plug equations (15) and (18) into (12):

 
pct pxt+1 rt+1
c−σ
t = β c−σ
t+1 + (1 − δ) (20)
pxt pct+1 pxt+1

This equation states that the value of one unit of consumption today must equal the value of
transforming that unit into capital, renting the capital to firms, and consuming the proceeds
next period. The term in square brackets in the right-hand-side is the investment return in units
of the investment good. When divided by the increase in the relative price of consumption it
becomes the investment returns in units of the consumption good, which is the relevant one for
the Euler equation.

3 Production side of the economy

There is a representative firm in each sector i combining capital kit and labor lit to produce the
amount yit of the good i. The production functions are Cobb-Douglas with equal capital shares
and different technology levels Bit :

α
yit = kit (Bit lit )1−α

The objective function of each firm is given by,

max {pit yit − rt kit − wt lit }

kit ,lit

Leading to the standard FOC,

kit α−1
 
rt = α pit
Bit lit
kit α
 
wt = (1 − α) Bit pit
Bit lit

which has the implications that (see Appendix C),

kit kjt α wt
kt = = = (21)
lit ljt 1 − α rt

and that  1−α

pit Bjt
= (22)
pjt Bit
Plugging equation (21) into the first FOC of sector i and using equation (21):

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 Macroeconomics I, Problem Set

rt = αpit Bit1−α ktα−1 (23)

So the interest rate of the economy can be written in terms of the relative price of any interme-
diate good i, its TFP, and the aggregate stock of capital.

4 Equilibrium

An equilibrium for this economy is a sequence of exogenous productivity paths {Bit }∞

t=1 where i ∈
{a, m, s}; a sequence of aggregate allocations {ct , xt , yt , kt }∞
t=1 ; a sequence of sectoral allocations
{kit , lit , yit , xmt , cit }∞ ∞
t=1 ; and a sequence of equilibrium prices {rt , wt , pit , pct , pxt }t=1 such that

• Households optimize: equations (10), (11) and (12) hold

• Firms optimize: equations (21), (21) hold

• All markets clear:

P P
i=a,m,s kit = kt , i=a,m,s lit = 1, yit = cit for all i = a, s, ymt =
cmt + xmt

5 Aggregates and sectoral composition

Feasibility conditions imply:

yat = cat (24)

ymt = cmt + xmt (25)
yst = cst (26)

Let’s define GDP in terms of the manufacturing (investment) good as:

yt = pat yat + ymt + pst yst (27)

Using the production functions:

α
yt = pat kat (Bat lat )1−α + kmt
α
(Bat lmt )1−α + pst kst
α
(Bst lst )1−α
 α  α  α
kat 1−α kmt 1−α kst 1−α
yt = pat Bat lat + Bmt lmt + pst Bst lst
lat lmt lst

Given that capital-output ratios are the same across sectors:

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 Macroeconomics I, Problem Set

 α  α  α
kt 1−α kt 1−α kt 1−α
yt = pat Bat lat + Bmt lmt + pst Bst lst
lt lt lt

Given equation (22) on relative prices across sectors:

kt α
   α  α
1−α 1−α kt 1−α kt
yt = Bmt lat + Bmt lmt + Bat
lt lt lt
 α
1−α kt
yt = Bmt [lat + lmt + lst ]
lt

And given that lt = 1:

1−α α
yt = Bmt kt (28)

So GDP in terms of the manufacturing good can be written in terms of its TFP and the aggregate
stock of capital.

Alternative definition of GDP:

X X
yt = pxt xt + pit cit = pmt xt + pct ct − pit c̄i (29)
i=a,m,s i=a,m,s

In terms of the manufacturing good:

yt pct 1 X
= xt + ct − pit c̄i (30)
pmt pmt pmt
i=a,m,s

6 Characterization of prices

Given our normalization pmt = 1 we have the following equation for prices (from equations 16,
19):

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 Macroeconomics I, Problem Set

pxt = pmt = 1
 ρ ρ ρ
 ρ−1
ρ
ρ−1 c ρ−1 c ρ−1 c
pct = pat θa + pmt θm + pst θs
 1−α
Bmt
pat =
Bat
 1−α
Bmt
pst =
Bst

7 Balanced Growth Path: definition

We define a balanced growth path as a sequence of equilibria where the interest rate measured
in units of the manufacturing good:

rt 1−α α−1
= αBmt kt (31)
pmt

is constant over time. This implies that:

 1−α  α−1
rt+1 /pm,t+1 Bm,t+1 kt+1 Bm,t+1 kt+1
= =1⇒ = (32)
rt /pm,t Bm,t kt Bm,t kt
Then, under a balanced growth path, it has to be the case that

kt
k̂t ≡ (33)
Bmt
is constant over time.

8 Balanced Growth Path: existence

The dynamic system of this economy is given by the Euler equation and the aggregate resource
constraint. The Euler equation is given by

 
pct pxt+1 rt+1
c−σ
t = β c−σ
t+1 + (1 − δ)
pxt pct+1 pxt+1

which becomes:

 σ
ct+1 pct
= β [rt+1 + (1 − δ)]
ct pct+1

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 Macroeconomics I, Problem Set

Let’s define Bct , the productivity with which consumption goods are produced, as:

 ρ ρ ρ
 1−ρ 1
ρ 1−α
c (1−α) 1−ρ c (1−α) 1−ρ c (1−α) 1−ρ
Bct ≡ θa Bat + θm Bmt + θs Bst (34)

Then, the Euler equation can be written as:

 σ
ct+1 Bct+1
= β [rt+1 + (1 − δ)]
ct Bct

And the aggregate resource constraint is given by:

X
1−α α
kt+1 = (1 − δ)kt + Bmt kt − pct ct + pit c̄i (35)
i=a,m,s

Autonomous System: Let’s re-write the system in terms of variables that, in case BGP
ct
exists, will be constant over time: ĉt ≡ Bct and k̂t

 σ  σ−1  h
ĉt+1 Bct Bmt α−1
i
= αk̂t+1 + (1 − δ) (36)
ĉt Bct+1 Bmt+1
 
k̂t+1 Bmt+1 ĉt 1 1 1 1
= (1 − δ) + k̂tα−1 − + c̄a + c̄m + c̄s (37)
k̂t Bmt k̂t k̂t Bat Bmt Bst

Does a BGP exists? Here we will consider the set of assumptions that are made in two
papers NP and KRX in order for the model to deliver BGP.

Kongsamut, Rebelo and Xie (2001): They make the following assumptions:

Bat+1 Bmt+1 Bst+1

1. Product. growth in all sectors is constant and symmetric: Bat = Bmt = Bst = (1+γ)
Bct+1
2. This implies that Bct = (1 + γ) as well

3. c̄m = 0
1
4. Bat c̄a = − B1st c̄s

Then the dynamic system becomes:

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 Macroeconomics I, Problem Set

 σ
ĉt+1 h
α−1
i
= (1 + γ)σ αk̂t+1 + (1 − δ) (38)
ĉt
k̂t+1 ĉt
(1 + γ) = (1 − δ) + k̂tα−1 − (39)
k̂t k̂t

which defines a system of two equations with two unknowns and is identical to the one delivered
by the one sector Ramsey model.

Ngai and Pissarides (2007): They make the following assumptions:

1. c̄a = c̄m = c̄s = 0

2. σ = 1

Then, the dynamic system becomes

 
ĉt+1 h
α−1
i
= (1 + γBm )σ αk̂t+1 + (1 − δ) (40)
ĉt
k̂t+1 ĉt
(1 + γBm ) = (1 − δ) + k̂tα−1 − (41)
k̂t k̂t

which defines a system of two equations with two unknowns and is identical to the one delivered
by the one sector Ramsey model.

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 Macroeconomics I, Problem Set

A Intra-temporal choices

Price Index: Raise each FOC to the power of ρ/(ρ − 1):

" ρ
1−ρ # ρ−1
ρ ct ρ  ρ −ρ c −ρ ρ
c−σ θac = [λt pat ] ρ−1 ⇒ c−σ ct (θa ) (cat + c̄a )ρ = [λt pat ] ρ−1
  
ρ−1 ρ−1
t t
cat + c̄a
 ρ −ρ c 1−ρ ρ
⇒ c−σ (cat + c̄a )ρ = [λt pat ] ρ−1 θac

t
ρ−1
ct (θa )

Then we have:

 −σ  ρ −ρ c 1−ρ ρ
ct ρ−1 ct (θa ) (cat + c̄a )ρ = [λt pat ] ρ−1 θac (A.1)
 −σ  ρ −ρ c 1−ρ ρ
ct ρ−1 ct (θm ) (cmt + c̄m )ρ = [λt pmt ] ρ−1 θm c
(A.2)
 −σ  ρ −ρ c 1−ρ ρ
ct ρ−1 ct (θs ) (cst + c̄s )ρ = [λt pst ] ρ−1 θsc (A.3)

Sum across these FOCs

ρ
 ρ ρ ρ

 −σ  ρ −ρ h c 1−ρ ρ c 1−ρ ρ c 1−ρ ρ
i
ρ−1 ρ−1 c ρ−1 c ρ−1 c
⇒ ct ρ−1
ct (θa ) (cat + c̄a ) + (θm ) (cat + c̄a ) + (θs ) cst = λt pat θa + pmt θm + pst θs
| {z }
cρt

⇒ c−σ
t = λt pct (A.4)

where:

 ρ ρ ρ
 ρ−1
ρ
ρ−1 c ρ−1 c ρ−1 c
pct = pat θa + pmt θm + pst θs

Consumption expenditure: Plugging A.4 into the (original) FOCs:

 1−ρ
ct
c−σ
t θac = c−σ −1
t pct pat
cat + c̄a
pct ct c−ρ c 1−ρ
t (θa ) (c̄a + cat )ρ−1 = pat
pct ct c−ρ c 1−ρ
t (θa ) (c̄a + cat )ρ cat = pat cat (c̄a + cat )

Then we have:

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 Macroeconomics I, Problem Set

pct ct c−ρ c 1−ρ

t (θa ) (c̄a + cat )ρ = pat (c̄a + cat ) (A.5)
pct ct c−ρ c 1−ρ
t (θm ) (c̄m + cmt )ρ = pmt (c̄m + cmt ) (A.6)
pct ct c−ρ c 1−ρ
t (θs ) (c̄s + cst )ρ = pst (c̄s + cst ) (A.7)

Summing across these FOCs:

h i
pct ct c−ρ
t (θ c 1−ρ
a ) (cat + c̄a ) ρ
+ (θ c 1−ρ
m ) (cmt + c̄m )ρ
+ (θ c 1−ρ
s ) (cst + c̄s ) ρ
=
| {z }
cρt
pat cat + pmt cmt + pst cst + pat c̄a + pmt c̄m + pst c̄s
X X
⇒ pct ct = pit cit + pit c̄i (A.8)
i=a,m,s i=a,m,s

Relative consumption: Divide one of the original FOCs by another:

∂ct
∂cit pit
∂ct
=
∂cjt
pjt

which implies:

 ρ−1
cit +c̄i
(θic )1−ρ ct pit
ρ−1 =
pjt

cjt +c̄j
(θjc )1−ρ ct
!1−ρ  ρ−1
θic cit + c̄i pit
=
θjc cjt + c̄j pjt
ρ−1 !ρ−1
θic

cit + c̄i pit
= c
cjt + c̄j θj pjt
1
θic pit ρ−1
 
cit + c̄i
=
cjt + c̄j θjc pjt
  ρ
pit (cit + c̄i ) θic pjt 1−ρ
=
pjt (cjt + c̄j ) θjc pit

Basket value consumption share: This last expression, and given the fact that consump-
tion expenditure equals the value of the consumption basket minus the market value of non-
homothecities:

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 Macroeconomics I, Problem Set

ρ
θc
 
X X pjt 1−ρ X
pit cit = pjt (cjt + c̄j ) ic − pit c̄i
θj pit
i=a,m,s i=a,m,s i=a,m,s
ρ
θc
 
X X X pjt 1−ρ
pit cit + pit c̄i = pjt (cjt + c̄j ) ic
θj pit
i=a,m,s i=a,m,s i=a,m,s
  ρ
X θic pjt 1−ρ
pct ct = pjt (cjt + c̄j ) c
θj pit
i=a,m,s
ρ ρ
1 1−ρ X c ρ−1
pct ct = pjt (cjt + c̄j ) c pjt θi pit
θj
i=a,m,s
| {z }
ρ
ρ−1
pct

  ρ
pjt cjt pct 1−ρ cjt
= θjc (A.9)
pct ct pjt cjt + c̄j

Consumption expenditure share:

X X
pit cit + pit c̄i = pct ct
i=a,m,s i=a,m,s

  ρ
pjt cjt pct 1−ρ cjt
P P = θjc
i=a,m,s pit cit + i=a,m,s pit c̄i pjt cjt + c̄j
 
  ρ
X X pct 1−ρ cjt
pjt cjt =  pit cit + pit c̄i  θjc
pjt cjt + c̄j
i=a,m,s i=a,m,s
P 
ρ
P
i=a,m,s pit cit + i=a,m,s pit c̄i
 
p c cjt pct 1−ρ
P jt jt = P θjc
i=a,m,s pit cit p
i=a,m,s it itc c jt + c̄j pjt
P !   ρ
pjt cjt i=a,m,s pit c̄i pct 1−ρ cjt
P = 1+ P θjc
i=a,m,s pit cit i=a,m,s pit cit pjt cjt + c̄j
P !   ρ
p (c + c̄j ) i=a,m,s pit c̄i pct 1−ρ
Pjt jt = 1+ P θjc
i=a,m,s pit cit i=a,m,s pit cit pjt
P !   ρ
pjt cjt i=a,m,s pit c̄i pct 1−ρ pjt c̄j
P = 1+ P θjc −P
i=a,m,s pit cit i=a,m,s pit cit pjt i=a,m,s pit cit

B Euler Equation

The Euler equation: The FOC with respect to capital is

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 Macroeconomics I, Problem Set

ηt = β λt+1 rt+1 + β ηt+1 (1 − δ)

We use the FOC for the composite consumption good and investment good:

c−σ
t = λt pct
ηt = λt pxt

The FOC with respect to capital becomes:

pxt 1 pxt+1
c−σ
t = β c−σ
t+1 rt+1 + β c−σ
t+1 (1 − δ)
pct pct+1 pct+1
p xt 1
c−σ
t = β c−σ
t+1 [rt+1 + pxt+1 (1 − δ)]
pct pct+1

Multiply and divide the right hand side of the equation by pxt+1 :

 
pxt pxt+1 rt+1
c−σ
t = β c−σ
t+1 + (1 − δ)
pct pct+1 pxt+1
pxt
And bringing pct to the right hand side:

 
pct pxt+1 rt+1
c−σ
t = β c−σ
t+1 + (1 − δ)
pxt pct+1 pxt+1

C Production side

These are the FOC for the representative firm producing good i:

kit α−1
 
rt = α pit
Bit lit
kit α
 
wt = (1 − α) Bit pit
Bit lit

Implication number # 1: Same capital-labor ratio across sectors

Divide one FOC by the other:

kit kjt α wt
= = (C.1)
lit ljt 1 − α rt
which also means that:

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 Macroeconomics I, Problem Set

kit kt
= = kt
lit lt

Implication number # 2: Relative price and relative TFP

Divide the capital FOC of sector i by that of sector j:

 α−1  1−α
pit Bjt pit Bjt
1= ⇒ = (C.2)
pjt Bit pjt Bit

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