Problem Set 2
Macroeconomics A
Due date: October 14, 2024, 3 PM
1 Optimal growth in discrete time
In the lecture notes, we have studied the consumption-savings problem of a household
that takes wages and interest rates as given.
In this exercise, instead, we consider the problem of a “social planner”. You can think of
the social planner as an all-knowing entity that allocates resources with the objective of
maximising the representative consumer’s welfare. In the economy considered in section 3.1
of the lecture notes, her problem is
+∞
V ( K0 ) = max ∑ βt u (Ct )
(C0 ,C1 ,C2 ,...) t=0
such that Kt+1 = (1 − δ) Kt + F (Kt , L) − Ct for every t,
K0 is given.
As this problem shows, the social planner is only bound by the resource constraints of
the economy: capital tomorrow is equal to the non-depreciated part of capital today plus
investment (i.e., non-consumed output). Note that we do not need a No-Ponzi-Scheme
condition for the Social Planner: as capital cannot become negative, the Social Planner
cannot run into debt.
Note that as our economy has perfect competition and no frictions, the social planner
allocation coincides with the market equilibrium. However, this result is not our focus here:
we will use this social planner problem to train your dynamic programming skills.
For simplicity, we assume throughout Lt = 1 and F (Kt , 1) = Ktα , with α ∈ (0, 1).
1. Write down the Bellman equation for the problem described in equation (1).
2. Compute the first-order condition for the optimal choice of Ct .
3. Use the envelope theorem to compute the derivative V ′ (Kt ), and deduce from this
the derivative V ′ (Kt+1 ).
4. Replace your result from question 4 into the first-order condition from question 3, to
obtain an Euler equation in Ct , Ct+1 and Kt+1 .
1
5. To make further progress, we impose two more simplifying assumptions: we assume
that utility is logarithmic (u (Ct ) = ln(Ct )) and that capital fully depreciates in
production (δ = 1). Using these assumptions, show that you can write the Euler
equation from question 5 as
1 αβKtα+−11
= .
Ct Ct+1
6. In class, we discussed a guess-and-verify approach for the value function (see section
3.1.3 in the lecture notes). Here, we use a similar approach, but this time, we directly
guess the policy function. Precisely, guess that
Ct = ϕKtα ,
where ϕ is a constant to be determined. Substituting this guess into the Euler equation,
find an expression for ϕ as a function of the model parameters.
7. Interpret the results. In this economy, what is the savings rate? Starting from an
arbitrary initial level K0 , how will capital evolve over time?
2 Consumption choices with logarithmic utility
Consider the dynamic programming problem
+∞
max ∑ βt ln (Ct )
(C0 ,C1 ,C2 ,...) t=0
such that Wt+1 = (1 + rt ) Wt + wt L − Ct for every t,
W0 is given, No-Ponzi-Scheme condition holds.
1. Write down the Bellman equation for this problem.
2. Proceeding as in the lecture (deriving the first-order condition, and then using the
envelope theorem), show that this problem leads to the Euler equation
Ct+1
= β (1 + r t +1 ) .
Ct
3. Write down the transversality condition for this problem.
4. Assume that the economy eventually reaches a steady state, in which output, capital,
interest rates and wages are constant. What can you say about the steady-state interest
rate r ∗ ?