Growth Model with Consumer

Optimization

THE RAMSEY MODEL

 Introduction

• Authors: Frank Ramsey (1928), David Cass (1965) and Tjalling

Koopmans (1965)

• The Solow model with endogenous savings - explicit consumer

optimization
 Assumptions of the Model

• Closed economy
• No government
• One homogeneous final good
• Price of the final good normalized to 1 in each period (all variables
expressed in real terms)
• Two types of agents in the economy: Firms and Households
• Firms and households are identical: i.e., we assume one
representative firm and one representative household.
 Households
• They provide labor for wages
• Save by accumulation assets
• They are identical (same wages, same preferences, equally
productive)
• Same initial conditions in terms of assets
• Same rate of population growth
• Dynasty, Infinite Horizon, Immortal Extended Family
• Altruism
 Households
• The growth rate of population is n.

• We neglect migration.

• We normalize the initial number of adults to 1

• The family size at time t is

• C(t) is total consumption

• I is consumption per adult person.

 Households-Utility Maximization
• Each household wants to maximize overall utility u

• u(c) is increasing and concave, u’(c)>0 and u’’(c)<0

• It satisfies the Inada

 Households-Utility Maximization
• Each household wants to maximize overall lifetime utility u of their members (present and future)

• Rate of time preference, ρ>0

• ρ>n equation , i.e., 2.1 is bounded if c is constant over time

• c is per capita consumption.

 Households
• Household hold assets

• We distinguish between, loans and capital, but as they are perfect

substitutes they pay the same rate of return r(t)

• We denote the assets of the household by a(t)

• Households provide 1 unit of labor, we assume no unemployment, they

provide inelastically

• Wage is denoted by w(t)

 Households
• The budget constraint of the household is given by

Upon manipulation we obtain

No Ponzi-game/scheme assumption
 Households Optimizations

• The household optimization problem is to maximize U (eq. 2.1) st the budget constraint (2.3), the stock of
initial assets, a(0) and the limitation in borrowing (2.4)

• We maximize the present-value Hamiltonian

 Households-Optimization
• FOC’s

• The transversality condition is given by

• Interpretation of the transversality condition:

• Analog of a terminal condition in a finite horizon
• Non-negativity constraint on the terminal (net present) value of assets held by households (capital)
• No-Ponzi game condition: proper lifetime budget constraint on households
 Households-Euler Equation

• We differentiate equation 2.6 with respect to time and substitute for v from its equation and for from
equation 2.7 to obtain the Euler equation

• Interpretation: It is optimal for households to postpone consumption (i.e. save in the current period and
consume more in the next period) iff the related utility loss is more than offset by the rate of return on
saving.
 Households-CIES Utility
• From 2.9 using CIES utility functional form

Where θ>0 and σ=1/θ

I obtain:
 Households-CIES Utility

• Interpretation:
• For (per capita) consumption to grow the (market) interest rate must exceed households’ rate of time preference
Interpretation: It is optimal for households to postpone consumption (i.e. save in the current period and consume
more in the next period) iff the related utility loss is more than offset by the rate of return on savings

• Role of θ: The higher θ the less responsive consumption to changes in the interest rate In other words: The higher θ
the stronger the consumption smoothing motive (the lower intertemporal substitution)
 Households-CIES Utility
• The transversality condition

• Where if I substitute for v(t) into 2.8 the TVC

 FIRMS
• Firms produce goods, pay wages and make rental payments for capital

• We assume that technology T grows at an exogenous rate x>=0

• We normalize the initial level of technology T(0) to 1

• Where F is a neoclassical production function.

• Effective labor
 FIRMS
• R(t) is the rental rate of a unit of capital

• δ>=0, thus the net rate of return to a household that owns a unit of capital is R-δ=r

• Firms want to maximize profits

• Multiply and divide with to get

• Doing the maximation wrt k-hat

 FIRMS
• Doing the maximation wrt k-hat
 STEADY STATE EQUILIBRIUM
• Competitive households face a given interest rate r and wage rate w.
• Firms face given values of r and w.
• We combine the behavior of households and firms to analyse the structure of a competitive market
equilibrium.
• Since the economy is closed, the assets per adult person a, equal the capital per worker, k.
• From e.q 2.3 we obtain

• Using and using 2.22 and 2.23

 STEADY STATE EQUILIBRIUM
• The and in steady state will grow at zero rate.

• k and c will grow at the rate x in the steady state

• K and C will growth at the rate x+n

• Using 2.11 and as well as yields

• I now want to solve the set of differential equations wrt k-hat and c-hat
 STEADY STATE EQUILIBRIUM

• I now want to solve the set of differential equations wrt k-hat and c-hat

and the TVC

To solve the system, I show that the growth rates of k-hat and c-hat in the steady state are zero.
 STEADY STATE EQUILIBRIUM

• From setting eq. 2.25 equal to zero

• Using k* in eq.2.24 I obtain

 STEADY STATE EQUILIBRIUM
• Plotting (2.24) and (2.25) in the (k, c) space we obtain
 MODIFIED GOLDEN RULE
• From the TVC (2.26) and given that k-hat is constant in the steady state, the
condition and exceeds the steady-state growth rate, x+n/

• From (2.29) we can write this condition as

ρ>n+(1-θ)x (2.31)
 MODIFIED GOLDEN RULE
• Note in the graph above that we draw k* to the left of KG. How do we know
that k*<KG?

• The steady state value is determined from . The Golden Rule

value comes from .

• From 2.31 we know that ρ+θx>x+n and thus

• The result follows from

 MODIFIED GOLDEN RULE
• Implications of the modified golden rule:
• Inefficient oversaving cannot occur in an optimizing framework (recall that it could arise
in the Solow model with an arbitrary, constant saving rate).

• If the infinitely lived household were oversaving, it would realize that it is not optimizing.
The reason for this is that it would not satisfy the transversality condition.

• As a result it would shift to a path that entails less saving.

• The optimizing household does not save enough to attain the golden-rule value .

• The reason is that impatience, as captured by the effective discount rate, ρ+θχ, make it
not worthwhile to sacrifice more of current consumption to reach the maxim of c-hat,
i.e., the golden rule value, , in the steady state.
 STEADY STATE-THE OTHER VARIABLES
• The steady state growth rate does not depend on parameters that describe
the production function or on the preference parameters, ρ and θ.

• These parameters have long-run effects on the level of variables.

• In the plot, an increased willingness to save, represented by a reduction in ρ
or θ, shifts the schedule to the rights and leave the schedule
unchanged.
• These shifts lead to higher values of and thus to a higher value of
 STEADY STATE-THE OTHER VARIABLES
• In a similar fashion, an upword shift of the production function or a reduction
of the depreciation rate, δ, moves the curve up and moves the
schedule to the right. These shifts increase .

** EXCERICSE: Show, graphically and mathematically, and discuss what happens

when a decrease in x takes place as well as a change in n.
PHASE DIAGRAMME-CONSUMPTION
 PHASE DIAGRAMME-CONSUMPTION
• To study how c behaves we need to set . From this equation we
obtain a value for k-hat, . Whenever k-hat> we get > .

• Thus, for high values of k-hat, c-hat will go down (and vice versa).

• We can illustrate this motion to the left and the right of the locus.
PHASE DIAGRAMME-CAPITAL
 PHASE DIAGRAMME-CAPITAL
• To study how k-hat behaves we need to set .

• Below this locus, k-hat increases

• Above this locus, k-hat decreases

PHASE DIAGRAMME
 PHASE DIAGRAMME-STEADY STATE
• The two loci intersect three times. The origin, the steady state and one with
positive k-hat and zro consumption.

• The steady state takes place at the intersection of the two loci.

• This equilibrium is the unique stable and meaningful equilibrium. It is called a

saddlepoint.

• This can occur only for a unique initial condition. The path to the stable
steady state is called saddle-path.