The Setting
An agent undertakes the investment only if
where . In this setting only lenders are taxed. For a lender born at t, he is taxed at t+1 for a portion (
) of his wealth. The tax proceeds are then transferred to the borrowers born at t, as a fraction ( ) of their
capital income. Agents takes as given. In a small open economy . Simplifying:
The borrowing constraint is
Define . Note that
(1) and (2) then can be summarized as follows:
,
where is defined by or . Rewriting,
Note that and , where is defined implicitly as in Matsuyama (2004) by
. Also, is increasing in , and for .
Government budget is balanced in equilibrium:
where is the amount of borrowers at t. Rearranging:
Thus in equilibrium the subsidy rate varies with the tax rate, prevailing interest rate, capital formation of t+1
and the prior period.
The Small Open Economy
If not all agents choose to invest, in equilibrium , therefore it is of utmost importance to analyze the
equation under , and . [from which is implicitly
defined.] In the following it is assumed that . Consider . From , after rearranging,
we have:
In the following, we show that there exists a function implicitly defined by (1) if we impose
the Inada conditions (which, to my knowledge, are not assumed by Matsuyama (2004)). But first, note that if
, (1) reduces to , which implies or .
From (1), define , where , and
. Note that if we impose the Inada condition ,
This implies is positive for large values of . Also . So for small
values of , is necessarily negative. As is continuous in , there exists a
such that , which is to be shown as unique.
Hereafter, any particular value of that satisfies is denoted by . Thus given ,
we have:
, or
Differentiating with respect to and then evaluating at )1:
Consequently, for any , the derivative is positive. Now, suppose is not unique. Then, since
is positive for large values of , for at least one , which is a contradiction.
Indeed, there exist only one satisfying for .
It follows that there exists a continuously differentiable function which satisfies, for
, . Note that
and, the derivative is given by
1
Note that , with ambiguous sign.
,
which implies is monotonic increasing. From the definition of , we have , or
Rearranging:
(3) implies or . As
2
, , i.e., is unbounded from above. (2)
can also be rewritten as follows:
2
This is true as long as the Inada condition is imposed.
.
From (4), it is necessary that , or . Since is monotonic increasing and
bounded from below, it admits a limit . By defining , is
3
hereafter redefined over . Note that satisfies . The function is increasing
and continuous on , and satisfies over the same interval.
3
Informally, this is true because 0 would be within the neighborhood of arbitrarily close to 0, upon which defines
and is an identity. Please refer to de la Croix and Michel (2002, p.28)
It follows that given , and thus , there exists such that . Given
, by induction, there exists a sequence satisfying .
There exists at least one such that
Note that for , , which implies
4
. If , , or .
Therefore, for , the equilibrium locus tilts upwards around (0, )5. But the locus no
longer levels off at ; it is monotonically increasing:
Since for any and,
4
Please refer to (6) in Matsuyama (2004). and are defined in Matsuyama (2004, p.864).
5
Please refer to Fig. 2 in Matsuyama (2004).
Small Open Economy
From (3), implies or .
implies
An agent undertakes the investment only if
where . An income tax applies to both borrowers and lenders. Tax collected from the younger
generation of t is solely be lent to local or foreign borrowers at the prevailing interest rate. The repayment and
interest income are rebated to borrowers of the aforementioned generation at t+1, as a fraction ( ) of capital
income. Every agent takes as given. In a small open economy .
Simplifying:
The borrowing constraint is:
Government budget is balanced in equilibrium:
where is the amount of borrowers at t. Rearranging:
Thus in equilibrium the subsidy rate varies with the tax rate, prevailing interest rate, capital formation of t+1
and the prior period.
Rewriting (1) and (2):
Define implicitly by . Note that is decreasing in and increasing in .
(4) and (5) can then be summarized by
For the time being, let us focus on the case in a small open economy. If not all agents choose to
invest, in equilibrium . Thus, from (6), we have:
For and any positive ( ), , or . Since
and ,
, and
where by (A2) in Matsuyama (2004).
Now consider . From (6):
For and any positive ( ), , or
. If , , or . Since
, and
,
.
Consequently, , i.e., greater compared to Matsuyama (2004), in which case , if and
only if .
Note that for , we have . Differentiating the left hand side: