International Monetary Economics

Summer Semester 2026

Problem Set 2 Solutions
Dr. Nicolas Syrichas
May 6, 2026

1. Intertemporal Choice and General Equilibrium

Households: Consider a representative agent with the following preferences over

consumption in periods t = 1, 2:

u(c1 , c2 ) = log(c1 ) + β log(c2 )

where 0 ≤ β ≤ 1 is a discount factor and c1 and c2 are the consumption levels in periods
1 and 2 respectively. The agent starts the first period with a given income y1 . The
income is measured in terms of the consumption good. In the first period, the agent
must decide how much to consume (c1 ) and how much to save in a. Savings are carried
over to the next period and are remunerated at a rate of r (in percent). In the second
period, the remunerated savings and given income y2 are allocated to consumption c2 .

The objective of the agent is then to choose c1 , c2 and a to maximize lifetime

utility.
(a) Write down the two budget constraints of the agent.
Solution:

• In the first period, she can decide how much to consume and how much to
save (or borrow) from the income y1 , and subsequently repay in the next
period from income y2 .

• The budget constraint for the first period is represented by the equation:

c1 + a = y 1

1
 • In the second period, the agent consumes c2 , which is funded by the income
y2 , any savings a, and any interest earned (1 + r). In the case of borrowing
(i.e., a < 0) in the first period, the agent must forgo some consumption in
c2 to repay the debt.

c2 = y2 + a(1 + r)

• To be precise, the agent might choose not to spend all of its income, so
the constraints can be written with weak inequalities. However, due to the
strict concavity of preferences, this situation will never happen so I write the
budget constraints with equality.

(b) Formulate the maximization problem of the agent in terms of an objective function
(i.e utility) and the intertemporal budget constraint.
Solution:

• Let us first derive the intertemporal budget constraint. In practice, this in-
volves combining the two budget constraints into one: the Lifetime Budget
Constraint.

a = y 1 − c1 , (1a)
a(1 + r) = c2 − y2 . (1b)

• Substitute equation (1a) into (1b):

(y1 − c1 )(1 + r) = c2 − y2 . (1c)

• Then rearrange:
c2 y2
c1 + = y1 + . (1d)
| {z 1 + r} | {z1 + r}
PV Consumption PV Income

• The term 1+r 1

represents the price of a period-2 good in terms of a period-1
good. This is because if you sell one period-1 good to the market, the market
is willing to exchange it for 1 + r period-2 goods.

• The right-hand side of equation (1d) is the Total Budget, indicating how
much the household can afford given the market price of 1 + r.

• Note that the concept of PV (Present Value) is used to express future quan-
tities in terms of the equivalent amount of present goods, relevant to market
1
prices. Here, the price at period 1 of consumption in period 2 is 1+r i.e
1
p1 = 1 and p2 = 1+r .

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 • The agent must choose c1 and c2 to maximize its lifetime utility s.t to the
lifetime budget constraint.

max log(c1 ) + β log(c2 )

c1 ,c2
c2 y2
s.t. c1 + = y1 +
1+r 1+r

• Notice that the agent will choose c1 and c2 to maximize his utility and she
takes y1 and y2 and 1 + r as given.

• In other words, she has no direct influence on his current and future income
and the interest rate. She can only decide how much to consume in period-1
(and implicitly save) and how much to consume in period-2 .

(c) Derive the Euler equation of the problem from the associated first order condi-
tions.
Solution:

• We start by defining the Lagrangian for this optimization problem:

 
c2 y2
L(c1 , c2 , λ) = log(c1 ) + β log(c2 ) − λ c1 + − y1 −
1+r 1+r

• Here, λ represents the Lagrange multiplier associated with the lifetime bud-
get constraint.

• The role of λ is to measure the increase in marginal utility for a unit relax-
ation of the budget constraint.

• The first-order conditions (FOCs) of this problem are:

1
− λ = 0, (2a)
c1
1 1
β −λ = 0, (2b)
c2 1+r
c2 y2
−c1 − + y1 + = 0. (2c)
1+r 1+r
Solving equation (2a) for λ and substituting into equation (2b) yields the
“Euler equation”:
1 1
= β(1 + r) . (3)
c1 c2
• Equation (3) explains how the agent balances present and future consump-
tion.

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 • Deciding on the allocation of an additional unit of wealth involves weighing
the marginal utility of consuming today, u′ (c1 ) = c11 , against the compounded
future value and utility of saving it. If saved, this unit accrues to (1 + r)
units in the future, with each unit offering a marginal utility of u′ (c2 ) =
1
c2
, discounted by the factor β which reflects the agent’s time preference
(impatience).

• At the margin, the household is indifferent between consuming more today

or saving for the future.

(d) Under what condition is consumption in period 2 bigger than in period 1? [Hint:
Look at 1 + r and β]
Solution:

• Start by reformulating equation (3) as follows:

c2 = β(1 + r)c1 (4)

• Consider the scenario where β = 1+r

1
. In this case, c1 = c2 , indicating that
consumption remains constant over time.

• Next, explore the situation where β > 1+r 1

. This implies that β(1 + r) > 1.
Consequently, equation (4) simplifies to:
c2
= β(1 + r) > 1
c1
leading to c2 > c1 .

• Lastly, evaluate the case where β < 1+r

1
, which means β(1 + r) < 1. Under
this condition, equation (4) becomes:
c2
= β(1 + r) < 1
c1
resulting in c1 > c2 .

• Therefore, the necessary condition for consumption in period 2 to exceed

1
that in period 1 is β > 1+r .

(e) Solve for the optimal allocation (c∗1 , c∗2 ) in terms of the parameters and the given
(i.e exogenous) variables of the model.
Solution:

• First let me explain the distinction between endogenous and exogenous

variables in the model.

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 • An exogenous variable is one whose measure is determined outside the model
and is imposed on the model. In this model the exogeonous variables are y1
and y2 that are given.

• An endogenous variable is a variable whose measure is determined by the

model and in this case by the the consumer. In problem the endogenous
variables are c1 and c2 and a since their quantities are directly influenced by
the choices of consumer.

• In this sub-question we need to solve the (partial) equilibrium outcomes of c∗1

and c∗2 as a function of the exogenous variables and prices. To do so we use
the Euler equation from equation (4) and the budget constraint from (2c).

c2 = β(1 + r)c1 (5a)

c2 = (y1 − c1 )(1 + r) + y2 (5b)

• Plug (5a) into (5b) and solve for c1

β(1 + r)c1 = (y1 − c1 )(1 + r) + y2 (5c)

∗ 1  y2 
c1 = + y1 (5d)
1+β 1+r

• and c∗2

β  
c∗2 = y2 + y1 (1 + r) (5e)
1+β

(f) What is the amount of a∗ that yields this allocation?

Solution:
(g) Plug equation (5d) into the c1 + a = y1 and solve for a

∗ βy1 1  y2 
a = − (6)
1+β 1+β 1+r

Firms: Consider two types of representative firms owned by households. That

means if firms make any profits Π=ΠP + ΠI , those profits would go back to the
households. The first one is the production firm and in each period t = 1, 2 the firm
solves the maximization problem .

ΠPt = max AKtα − (r + δ)Kt

Kt

where A is the productivity level and 0 < α < 1.

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 The second firm is a representative investment firm that carries out all investment.
This firm buys the (1 − δ)K1 units of unused capital and adds I units of investment.
The law of motion for capital accumulation is then given as:

K2 = (1 − δ)K1 + I1

A clear distinction is that the production firm then rents out the K2 units of capital
at a rate rK , whereas the investment firm owns the capital and decides how much
to invest.
Solution:

• This section aims to clarify several concepts that were not explained in the
lecture notes.

• First, the term r represents the real interest rate, which is defined as the
interest rate expressed in terms of goods rather than monetary units such as
euros.

• Later in the course will will learn to convert the real interest rate into a
monetary-based rate (i.e., nominal interest rate). To do so it is essential to
consider the changes in prices between two periods, Period 1 and Period 2.

• The variable rk , representing the rental return on capital, can be expressed

as rK = r + δ. To illustrate this, consider the scenario where you possess
one unit of a good you wish to save. You have two options:

1. Convert the consumption good into physical capital K and lease it out.
In the next period, you receive a rental income of rK × 1 plus the
depreciated value of the capital, (1 − δ). The total return would be
[rK + (1 − δ)] × 1 unit of good.
2. Alternatively, invest the good in the capital markets to obtain a return
of (1 + r) × 1 unit of good in the next period.
3. To ensure no arbitrage opportunities-meaning the returns from both
strategies should be equal-the following condition must be satisfied:

rK + (1 − δ) = 1 + r =⇒ rK − δ = r

(h) Solve the static maximization problem of the production firm in period 2.
Solution:

• In this problem the firm asks, given the available capital Kt in the economy
how much of it should I employ in order to produce Y that maximize my
period t = 1, 2 profits. The profit here is ΠP . Since K1 is fixed firm only
choose K2 .

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 • Take the FOC with respect to K2

+ δ} = αAK2α−1
r| {z
| {z }
MC MR

• The standard optimality condition MR from employing an additional unit

of capital=MC

(i) Now formulate the maximization problem of the investment firm in terms of the
NPV.
Solution:

• In this case the firms make an investment decision. How much should I invest
in period-2 to maximize my profits from sales.

• Why will the firm invest at the first place? Because without investment I1
no new K2 can be generated that will result in higher sales of Y2 . In other
words, it acts as a representative investment firm and the profit is denoted
as ΠI

• Capital K1 is fixed. K2 can change only through investment I1 through

equation K2 = (1 − δ)K1 + I1 .
ΠI2
• The investment firm’s intertemporal profits are ΠI = ΠI1 + 1+r
.

• The profits ΠI1 in the first period are sales Y1 minus investment costs I1 , so
Π1 = AK1α −I1 .
| {z }
Y1

• The profits in the second period are the sales Y2 plus the revenues from
selling any remaining net capital (1 − δ)K2 (recall that the world is over
after t = 2 so therefore a firm will always want to sell its entire capital stock
before dying) and the profits are Π2 = AK2α + (1 − δ)K2 . Finally, since Π2
is in the future so its today value is discounted by 1 + r

• The firm’s problem can by summarized as:

 AK2α + (1 − δ)K2 
W = max AK1α − (1 − δ)K1 − K2 + (7)
K2 | {z } 1+r
I1

(j) Solve the maximization problem and derive the optimally condition. Do you observe
any similarities with (g).
Solution:

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 • Take the FOC wtr to K2

αAK2α−1 + (1 − δ)
−1 + =0
1+r

• and rearrange

αAK2α−1 = r + δ (8)

• The two equations are identical. In (g) we were computing the optimal level
of rk for a given level of investment. Here we are asking the reverse, i.e for
a given level of rk , what will be the level of capital stock.

• The level of the capital stock must be such that the rental rate of capital
rk makes the present value of the representative investment project equal to
zero. For a graphical illustration see the chart in slide 24.

(k) Solve for the optimal allocation K2∗ and I1∗ in terms of the parameters and the given
(i.e exogenous) variables of this model.
Solution:

• It is trivial form equation(8) that:

1
 r + δ  α−1
K2∗ = (9)
aA

• and using the fact that I1 = K2 − (1 − δ)K1

1
 r + δ  α−1
I1∗ = − (1 − δ)K1 (10)
aA

(l) Define and characterize the competitive equilibrium of this economy.

Solution: Given an initial K1 , a competitive equilibrium for this economy consist
of:

1. An allocation {c1 , c2 , K2 , I1 , y1 , y2 , Y1 , Y2 }.

2. Prices {r}.

such that:

1. {c1 , c2 } solve the household’s problem, taking prices as given.

2. {K2 , I1 } solve the firms problem taking prices and K1 as given.

3. Markets clear in all periods

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 • Goods market: Y1 = c1 + I1 , Y2 = c2
• Capital Market: K2 = (1 − δ)K1 + I1

Characterize equilibrium: See next exercise.

2. Dynamic General Equilibrium with Capital Accumulation

Firms have production functions Yt = At Kt . Capital evolves as

K2 = I1 + (1 − δ)K1

but δ = 1. K2 = I1 . Firm profits are then Π1 = Y1 − I1 , Π2 = Y2 . Firms maximize the

present value of profits which is then given by
 
A2 K2
W = max A1 K1 − K2 + (11)
K2 1 + r1

The household has utility function

U (C1 ) + βU (C2 ) (12)

where
1− 1
C σ −1
U (Ct ) = t (13)
1 − σ1
Households maximize utility subject to the budget constraint
C2
C1 + =W (14)
1 + r1
where W is the present value of the firms (11) owned by households and r1 is the real
interest rate between periods one and two. The resource constraints of the economy are

C1 + I1 = Y1 , C2 = Y2 (15)

(a) Show that the Euler equation can be expressed as:

C2
= [β(1 + r1 )]σ (16)
C1

Solution:

• Let us form the Lagrangian

h C2 i
L(c1 , c2 , λ) = U (C1 ) + βU (C2 ) − λ C1 + −W
1+r

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 • The FOC are

U ′ (C1 ) − λ = 0 (17a)
1
βU ′ (C2 ) − λ =0 (17b)
1+r
(17c)

• The corresponding Euler equation is

−1/σ
U ′ (C1 ) C
′
= 1−1/σ = 1 + r1
βU (C2 ) βC2
or
C2
= [β(1 + r1 )]σ (18)
C1
• The intertemporal elasticity of substitution, σ, therefore governs the respon-
siveness of the growth rate of consumption to changes in the interest rate
and discount factor. For instance, a low IES means that households dis-
like intertemporal substitution, i.e. want to smooth consumption which is
reflected in C2 /C1 not being very responsive to β(1 + r1 ).
(b) Show that the equilibrium of this economy takes the form:
 σ
1
βA2
A2
C1 =  σ A 1 K1
1 + βA1 2 A2
A2
C2 =  σ A 1 K1
1
1+ βA2
A2
1
I1 =  σ A 1 K1 (19)
1
1+ βA2
A2
Y1 = A1 K1
A2
Y2 =  σ A 1 K1
1
1+ βA2
A2
1 + r1 = A2

Solution:
• The Euler equation (18) together with the budget constraint (14) imply that
consumption demands are
 σ
1
β(1+r1 )
(1 + r1 ) 1 + r1
C1 =   σ W, C2 =  σ W (20)
1 1
1 + β(1+r1 ) (1 + r1 ) 1 + β(1+r1 ) (1 + r1 )

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 • The first order condition from the firm’s profits maximization problem (11)
gives an expression for the real interest rate 1 + r1 = A2 . Hence the value of
a firm is W = A1 K1 . Substituting into (20) gives the expressions for C1 and
C2 .

• The expression for I1 = K2 is found from C2 = Y2 and hence K2 = C2 /A2 .

• Note in particular that the solution takes the form of a constant saving rate
s(A2 ) out of current output, Y1 , i.e. we can write
1
I1 = s(A2 )Y1 , C1 = [1 − s(A2 )]Y1 , s(A2 ) =  σ (21)
1
1+ βA2
A2

3. CRRA Utility Function (Not examinable)

In the lecture 2, I introduce the iso-elastic power utility function. In this exercise we
will learn about its nice properties:
( 1−σ
c −1
1−σ
for σ ̸= 1
u(c) = (22)
ln(c) for σ = 1.
for concavity parameter σ ≥ 0.
(a) Show that for the representation in equation (22),
u(c) → ln(c) for σ → 1. (23)
[Hint: Evaluate the limits of numerator and denominator separately and then apply
l’Hopital’s rule to get the result].
Solution:

• L’Hopital rule states that for two functions, f and g that are differentiable
and f (a) = g(a) = 0 or f (a) = g(a) = ±∞ then

f (c) f ′ (c)
lim = lim ′
c→a g(c) c→a g (c)

• Write f (c) = c1−σ − 1 and g(c) = 1 − σ

f (c) 0
U (c) = lim =
σ→1 g(c) 0

• Also notice that if y = ax then this can be written as ln(y) = xln(a). The
′
derivative of this is yy = ln(a) =⇒ y ′ = ax ln(a).
1−σ)
c1−σ − 1 eln(c −1 e(1−σ)ln(c) − 1
U (c) = lim = lim = lim
σ→1 1 − σ σ→1 1−σ σ→1 1−σ

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 • Apply L’Hopitals rule, taking derivatives of the numerator and denominator:

c1−σ − 1 e(1−σ)[ln(c)] × (−ln(c)) e(0)ln(c) [−ln(c)]

U (c) = lim = lim = = ln(c)
σ→1 1 − σ σ→1 −1 −1
Let’s concentrate on the case σ ̸= 1. Suppose, we look at utility of an agent who
lives for two periods, hence
c1−σ
1 c1−σ
u(c) = +β 2 , (24)
1−σ 1−σ
where 0 < β < 1 is the discount factor. Assume that the agent intertemproral
budget constraint is given as:
c2 y2
c1 + = y1 + (25)
1+r 1+r
(b) Derive and show that the Intertemproral Elasticity of Substitution (IES) is equal
to σ1 . Hint use the expression below:
d ln(ci /cj )
ϵi,j = −
d ln(M RSi,j )
Solution:
c1−σ u′ (ci ) c−σ
• First, let us write i
1−σ
and M RSi,j = βu′ (cj )
= i
βc−σ
j

• Also notice that d [u′ (ci )/u′ (cj )] = −σc−σ−1

i /c−σ−1
j × d (ci /cj )

d ln(c1 /c2 ) d ln(c1 /c2 ) u′ (c1 )/βu′ (c2 ) d [c1 /c2 ]

ϵ1,2 =− =− ′ (c ) ) = − ×
d ln(M RS1,2 ) u
d ln( ′ 1 c1 /c2 d [u (c1 )/βu′ (c2 )]
′
βu (c2 )
c−σ −σ
1 /c2 d [c1 /c2 ] 1
=− × −σ−1 −σ−1 =
c1 /c2 −σc1 /c2 d (c1 /c2 ) σ

1. Definition of Elasticity of Intertemporal Substitution (EIS):

The EIS measures the percentage change in consumption growth for
each percentage increase in the net interest rate. This is justified as the
marginal rate of substitution (MRS) between consumption in periods 1
and 2 equals the relative price ratio, which is expressed as 1 + r.
2. Impact of a Rise in Real Interest Rate: An increase in the real
interest rate can have a dual impact on current consumption. On one
hand, it might lead to a decrease in period 1 consumption as individ-
uals opt to save more, attracted by higher returns (subsitution effect).
On the other hand, it might increase consumption in period 1 if house-
holds feel wealthier and decide to consume more immediately. The
overall effect on current consumption is determined by the elasticity of
intertemporal substitution.

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3. Logarithmic Utility and Elasticity: With a logarithmic utility func-
tion, the elasticity of substitution (σ) is equal to 1, implying an elastic-
ity of intertemporal substitution (EIS) of 1. In this particular case, the
income and substitution effect exactly offset each other for period 1 con-
sumption. This indicates a one-to-one responsiveness of consumption
growth to changes in the net interest rate.

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