Macroeconomic Theory: Assignment 6

Exercise 1. (AK Model) Consider the in…nite horizon growth model.

An in…nitely-lived representative household values consumption in each period
1
using the period utility is u (c) = c1 , > 0, and the subjective discount factor
2 (0; 1). Production only requires the input of capital and takes the following
functional form yt = Akt with A > 0. The accumulation of capital follows
kt+1 = Akt ct
and the initial capital stock is k0 > 0. Then the sequential problem is
1
X
t c1t
max 1
fct ;kt+1 gt=0
t=0
1
subject to Akt = kt+1 + ct .
1. (a) Write down the functional equation of the associated time t value
function
(b) Conjecture that the value function takes the form
k1
v (k) = E , (1)
1
where E > 0 is an undetermined coe¢ cient. Solve for E.
(c) Solve for the policy function h such that kt+1 = h(kt ).
Exercise 2. (Habit Persistence) Consider an in…nite horizon growth
model. The household’s utility function takes the form
ln ct + ln ct 1,

where > 0, and the capital accumulation follows

ct + kt+1 = Akt .
Then the sequential problem is
1
X
t
max 1 [ln(ct ) + ln(ct 1 )]
fct ;kt+1 gt=0
t=0
subject to Akt = kt+1 + ct .
Write down functional equation for the associated time t value function.

1
1. Write down the functional equation of the associated time t value function
(Hint: the state variables include the current capital stock kt and the
previous consumption ct 1 )
2. We guess that the time t value function takes the following form

v(kt ; ct 1) = E + F ln kt + G ln ct 1

Where E; F; G are undetermined coe¢ cients. Use guess and verify to solve
for the value function v(kt ; ct 1 ) and the policy function kt+1 = h(kt ; ct 1 )