Macro Theory I Part 1 - Assignment 3

Solution suggested by Shang-Chieh Huang

October 29, 2021

Question 1
1. How do the steady state capital and consumption change as g increase?

Representative household’s optimization problem is:

1
X
t
max 1 u(ct )
{ct ,kt+1 }t=0
t=0
s.t. ct + kt+1 (1 )kt = f (kt ) g (1)

To solve Household’s problem, we form Lagrangian first:

1
X
t
L= {u(ct ) + t (f (kt ) g ct kt+1 + (1 )kt )}
t=0

Then we can have first order conditions:

[ct ] : u0 (ct ) = t (2)

0
[kt+1 ] : t = t+1 (f (kt+1 ) + (1 )) (3)

Combining Eq.(2) and Eq.(3) yields the Euler equation:

u0 (ct ) = u0 (ct+1 )[(f 0 (kt+1 ) + 1 )] (4)

At steady state, ct = ct+1 ⌘ c⇤ , kt = kt+1 ⌘ k ⇤ . Thus evaluating Eq.(1) and Eq.(4) at steady state

gives:

1
f 0 (k ⇤ ) = (1 )
1
k⇤ = f 0 1
( (1 ))

c⇤ = f (k ⇤ ) k⇤ g

How would k ⇤ and c⇤ be a↵ected by increasing g?

df 0 (k ⇤ )
=0
dg
dc⇤
= 1<0
dg
dk⇤
Since f 00 < 0, dg = 0.
In conclusion, As g increase, k ⇤ is una↵ected and c⇤ becomes smaller.

1
2. Draw Lk (k) and Lc (k) locus before and after the unexpected shock on the
k c diagram

From resource constraint Eq.(1), we have

kt+1 = f (kt ) + (1 )kt ct g

implying that

kt+1 = kt () ct = f (kt ) kt g ⌘ Lk (kt ) (5)

From Euler equation (Eq.(4)), we have

u0 (ct )
u0 (ct+1 ) =
[f 0 (kt+1 ) + 1 ]
u0 (ct )
=
[f 0 (f (kt ) + (1 )kt ct g) + 1 ]

implying that

1
ct+1 = ct () ct = f (kt ) + (1 )kt g f0 1
( (1 )) ⌘ Lc (kt ) (6)

In conclusion,

• From Eq.(5), we know that g decreases Lk (kt ). That is, Lk (kt ) shifts down as g increases.

• From Eq.(6), we know that g decreases Lc (kt ). That is, Lc (kt ) shifts down as g increases.

Our conclusion is also represented on the figure below.

oldsaddlepath

Vertical
I jump path
Newsaddle

Figure 1: increase of government expenditure

• As g increases, both Lk (kt ) and Lc (kt ) shift down.

2
 • There are two saddle paths in this figure. Before the shock, we have a original (old) saddle path.
After the shock, we have a new saddle path.

• Capital is a state variable and consumption is a choice variable. That is to say, suppose that

the shock happens at time T , the capital level at T is decided at T 1; for those households in
this economy, they only can decide their consumption. Also, they would decide to consume the
amount of goods on saddle path since it can maximize their utility.

• In this case, since the capital in old steady state and the capital in new steady state are the

same, their will be a vertical jump on consumption from old steady state to new steady state.

3. Plot the optimal path of capital and consumption from the old steady
state to the new steady state.

The first figure below is the optimal path of capital, and the second one is the optimal path of

consumption

Figure 2: increase of government expenditure

• Capital does not change.

• Consumption drops directly to the new steady state.

3
Question 2
1. How do the steady state capital and consumption change as ⌧ increase?

Representative household’s optimization problem is:

1
X
t
max 1 u(ct )
{ct ,kt+1 }t=0
t=0
s.t. ct + kt+1 (1 )kt = (1 ⌧ )f (kt ) + ⌧ y¯t (7)

To solve Household’s problem, we form Lagrangian first:

1
X
t
L= {u(ct ) + t ((1 ⌧ )f (kt ) + ⌧ y¯t ct kt+1 + (1 )kt )}
t=0

Then we can have first order conditions:

[ct ] : u0 (ct ) = t (8)

[kt+1 ] : t = t+1 [(1 ⌧ )f 0 (kt+1 ) + (1 )] (9)

Combining Eq.(8) and Eq.(9) yields the Euler equation:

u0 (ct ) = u0 (ct+1 )[(1 ⌧ )(f 0 (kt+1 ) + 1 )] (10)

At steady state, ct = ct+1 ⌘ c⇤ , kt = kt+1 ⌘ k ⇤ . Also, y¯t = N y ⇤ = y ⇤ = f (k ⇤ ), where N is population

and assume that N = 1 (since households are mass one).
Thus evaluating Eq.(7) and Eq.(10) at steady state gives:
1
(1 )
f 0 (k ⇤ ) =
1 ⌧
1
(1 )
k⇤ = f 0 1
( )
1 ⌧
c⇤ = f (k ⇤ ) k⇤

How would k ⇤ and c⇤ be a↵ected by increasing ⌧ ?

1
df 0 (k ⇤ ) (1 )
= 2
>0
d⌧ (1 ⌧ )
dc⇤ dk ⇤
= [f 0 (k ⇤ ) ]
d⌧ d⌧
1+
+ ⌧ dk ⇤
=
1 ⌧ d⌧
dk⇤ dc⇤
Since f 00 < 0, we can conclude that d⌧ < 0 and d⌧ < 0.

In conclusion, As ⌧ increase, both k ⇤ and c⇤ would decrease.

4
2. Draw Lk (k) and Lc (k) locus before and after the unexpected shock on the
k c diagram

From resource constraint Eq.(7), we have

kt+1 = (1 ⌧ )f (kt ) + (1 )kt ct + ⌧ y¯t

Since y¯t = N yt = yt = f (kt ), the equation can be rewritten as

kt+1 = f (kt ) + (1 )kt ct

implying that

kt+1 = kt () ct = f (kt ) kt ⌘ Lk (kt ) (11)

From Euler equation (Eq.(10)), we have

u0 (ct )
u0 (ct+1 ) =
[(1 ⌧ )f 0 (kt+1 ) + 1 ]
u0 (ct )
=
[(1 ⌧ )f 0 (f (kt ) + (1 )kt ct ) + 1 ]

implying that
1
(1 )
ct+1 = ct () ct = f (kt ) + (1 )kt f0 1
( ) ⌘ Lc (kt ) (12)
1 ⌧

In conclusion,

• From Eq.(11), we know that Lk (kt ) is una↵ected as ⌧ increases. That is, Lk (kt ) does not shift

to anywhere as ⌧ increases.
1
(1 )
• From Eq.(12), we know that increasing ⌧ would a↵ect on f 0 1
( 1 ⌧ ). Since f 0 is decreasing
1
(1 )
(f 00 < 0), we can know that f 0 1
is decreasing, too. Thus f 0 1
( 1 ⌧ ) becomes smaller as ⌧

become larger, leading to the increase of Lc (kt ). That is, Lc (kt ) shifts up as ⌧ increases.

Note:
1 1
(1 ) (1 )
⌧ increases ! 1 ⌧ decreases ! 1 ⌧ increases ! f0 1
( 1 ⌧ ) decreases ! Lc (kt ) in-

creases.
Our conclusion is also represented on the figure below.

• As ⌧ increases, only Lc (kt ) shifts up.

• In this case, when the shock happens (time T ), their will be a vertical jump on consumption
from old steady state to new saddle path. Then it gradually converge to new steady state.

• Note that the capital level remains the same as old steady state at time T , then it goes to new
saddle path at T + 1. Finally, it gradually converge to new steady state.

5
 t fhiss

Figure 3: increase of tax rate

3. Plot the optimal path of capital and consumption from the old steady
state to the new steady state.

The first figure below is the optimal path of capital, and the second one is the optimal path of
consumption

Figure 4: increase of tax rate

• Both capital and consumption adjust to the new steady state with time.

Note: All figures in this document are plotted with utility function c = ln(c), production function
f (k) = k ↵ , and parameters: = 0.25, = 0.98, ↵ = 0.3, g increases from 0 to 0.4, and ⌧ increases
from 0 to 0.3.