Econ 387L: Macro II

Spring 2008, University of Texas

Instructor: Dean Corbae
Problem Set #2- Due 1/29/08
Consider a stochastic growth model with the following specification.
• Preferences:
³ h 1−η
i´1−ψ
Ct + λt (1−H1−ηt) −1
−1
U (Ct , Ht , λt ) =
1−ψ
where
λt = (1 − γ)−1 λt−1 εt , λ−1 = 1. (1)
and log εt is i.i.d. N (0, σ ε ). Agents discount the future at rate β < 1.
• Technology:
¡ ¢1−θ
Yt = Ktθ (1 + g)t Ht (2)
where K0 is given, 1 ≥ Ht ≥ 0 .
• Information: Households must choose Ht before knowing the shock to preferences λt
but choose Kt+1 after its realization.

1) Derive the stochastic Euler equation for the savings choice.

2) Derive the equation describing the labor/leisure choice.
3) Along a possible balanced growth path, assume that εt is constant and equal to its
expected value of 1. Under what conditions on parameters might a balanced growth path
where Kt , Ct , Yt all grow at rate κ while Ht remains constant exist? Is the set empty?
4) Is there a zero likelihood problem in the labor\leisure choice problem? In particular,
if you had data on Ct , Ht , Yt and Kt , could the first order condition describing the
labor\leisure choice hold or is the likelihood of it holding zero? Explain why or why not.
Hint: think about timing.
5) Show that the Euler equation for labor can be written as a simple function relating
log(1 − Ht ) to log(w) and other variables. Interpret in terms of a labor supply curve.
6) Calibrate the above model (find the parameter vector (β, g, η, ψ, θ, δ, γ, σ ε )) to the
hypothetical economy Tejas using the following “moments”:
1. a. The capital-output ratio has averaged 2 per year with minor fluctuation.
b. Experiments have shown that the coefficient of relative risk aversion is 2.
c. Experiments have also shown that the preference shock process satisfies the following
regression
log λt = 0.0296 + log λt−1 + ut
d. The estimated variance of the error term from the last regression is 0.04
e. The investment-output ratio in Tejas have been around 0.2 on an annual basis.

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f. The capital share of output is 2/3.
g. Labor economists have found the following “moments” from a regression of Tejanos’
leisure hours growth rate on a constant, and the real wages growth rate is given by
µ ¶
1 − Ht+1 1 wt+1
log( ) = 0.0148 + − log + et .
1 − Ht 2 wt