Advanced Macroeconomics, ECON40002 Lawrence Uren

Semester 1, 2014 University of Melbourne

Assignment 2
This assignment is due in lecture on 17 April, 2014. You may work in groups of up to three people.
Please make sure you place the names of all group members and of your tutor on the assignment
that you hand in. Please hand directly to me or in my mailbox on the fourth oor of the FBE
building.
Q1. Innite Horizon Model.
Consider a continuous time, innite horizon Ramsey economy, similar to the one examined in
lectures. In particular, a social planner maximises the following objective function:

0
e
t
u(c(t)) dt
subject to a resource constraint

k = f(k) k c
and an initial value of capital stock k(0) given, c(t) 0, and k(t) 0.
a) Briey, explain in words, why if we are interested in the solution of a competitive equilibrium,
that the solution to a social planners problem is interesting.
b) What is the Hamiltonian associated with this problem? Write out the corresponding rst-order
conditions associated with this problem? Derive an equation for this problem that describes
the growth rate of consumption.
c) What is the transversality condition associated with this problem? Provide an interpretation
for this condition and display the phase-plane diagram associated with this problem.
Now consider the inclusion of government spending. Each period, the government spends a constant
g per unit of time to provide public goods. It funds this expenditure by taxing individuals using
lump-sum non-distortionary taxation. The evolution of capital stock in this environment is as
follows:

k = f(k) k c g
Assume that other aspects of the problem are unchanged. That is, the utility function and pro-
duction function are unchanged.
d) Explain how the phase-plane diagram presented in part (c) is changed by the introduction of
government spending.
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e) Suppose there is an anticipated decrease in government spending. That is, at time t
0
individuals
learn that at a future time, t
1
, that the government will reduce government expenditure.
Use a phase-plane diagram to illustrate the evolution of consumption and capital stock in
response to this shock. Dene the savings rate, s, as the ratio of savings to after-tax income.
What happens to the saving rate in this economy in response to the decrease in government
spending?
Q2. Consider the standard Overlapping Generations economy with technology growth at the rate
of g and population growth at the rate of n. Assume that workers have log preferences. That is a
worker born at time t maximises
U
t
(c
y,t
, c
o,t+1
) = log(c
y,t
) +
1
1 +
log(c
o,t+1
)
subject to the lifetime budget constraint,
w
t
= c
y,t
+
c
o,t+1
1 + r
t+1
Further, assume that the production function is our standard Cobb-Douglas specication. That is,
Y
t
= F(K
t
, A
t
L
t
) = K

t
(A
t
L
t
)
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and that factor markets are competitive.
(a) Set up the Lagrangian for the consumers problem. Derive the solution for the optimal con-
sumption choice when young, consumption when old, and saving choice (c
y,t
, c
o,t+1
, and a
t+1
)
as a function of wages, w
t
, and interest rates, r
t+1
.
(b) Use the fact that K
t+1
= a
t+1
L
t
and that wages and interest rates equal the marginal product
of labour and the marginal product of capital, respectively, to solve for a transition equation
that describes the evolution of capital per eective worker.
(c) Consider the case in which g = n = 0. That is, there is no growth in technology or the
population. Describe what happens in the steady state of this economy.
(d) Finally, consider the continuous time Solow-Swan model that we discussed in which = n =
g = 0. Describe in as much detail as possible, what happens to this economy as t .
Explain any dierences.
Q3. Optimal Cake Eating - revisited (or regurgitated)
Consider the following problem:
max
{c
t
}

t=1

t=1

t
u(c
t
) (1)
subject to the transition equation:
k
t+1
= k
t
c
t
(2)
and the constraint that k
t
0 for all t and that k
1
is given.
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(a) Write the associated Bellman Equation with the above problem;
(b) What is the associated rst order conditions;
(c) Consider the alternative case in which u = u(c
t
, c
t1
). Here, due to habit formation or durable
good consumption, the utility from consumption is dependent upon consumption today and
consumption yesterday. Write out the Bellman equation associated with this problem. For
this case, assume that c
0
and k
1
are given.
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