Lecture 8

Dynamic General Equilibrium

Noah Williams
University of Wisconsin - Madison
Economics 312

Williams

Economics 312

Dynamic Equilibrium

We learned how to think about a household that makes

dynamic decisions.
We learned how to think about the intertemporal choice of
government.
Now we want to introduce investment and capital
accumulation.
With these, and our previous static considerations on the
labor market, we put everything together in a definition of
Dynamic General Equilibrium.

Williams

Economics 312

Consumption-Leisure-Savings Decision

A representative household maximizes u(c, l) + u(c, l 0 )

Its preferences satisfy the usual assumptions.
It faces two intertemporal budget constraints:
c + s = w(h l) + T
c 0 = w 0 (h l 0 ) + 0 T 0 + (1 + r)s
As before, we can combine these into PV budget constraint:
c+

w 0 (h l 0 )
0
T0
c0
= w(h l) +
++
T
1+r
1+r
1+r
1+r

Williams

Economics 312

The Households Problem

We can write the choice problem as a Lagrangian:
L = u(c, l) + u(c 0 , l 0 )+
w 0 (h l 0 )
0
T0
c0
w(h l)+
++
T
c
1+r
1+r
1+r
1+r
There are four first order conditions:
c:

uc (c, l) = 0

ul (c, l) w = 0

uc (c 0 , l 0 )
= 0
1+r
w 0
ul (c 0 , l 0 )
= 0
1+r
l:

c0 :
l0 :

Williams

Economics 312

Household Problem II
First order conditions for c and l imply
MRSl,c =

ul (c, l)
=w
uc (c, l)

First order conditions for C 0 and l 0 imply

MRSl 0 ,c0 =

ul (c 0 , l 0 )
= w0
uc (c 0 , l 0 )

First order conditions for c and c 0 imply Euler equation:

MRSc,c0 =

uc (c, l)
= (1 + r)
uc (c 0 , l 0 )

Combining these equations gives

MRSl,c MRSc,c0
w
= MRSl,l 0 = 0 (1 + r)
MRSl 0 ,c0
w
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Economics 312

Determinants of current labor supply N = h l

MRSl,l 0 =

w
(1 + r)
w0

Higher current wage w raises labor supply.

Higher future wage w 0 lowers labor supply.
Higher interest rate r raises labor supply.
Higher lifetime wealth reduces labor supply.
The labor supply curve is the relationship between w and
N , and so is upward sloping.
The other factors shift the labor supply curve.

Williams

Economics 312

Figure 9.2 An Increase in the Real

Interest Rate Shifts the Current Labor
Supply Curve to the Right

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Williams

Economics 312

Determinants of current consumption c

MRSc,c0 = (1 + r)
Higher interest rates reduce consumption.
Higher current (wage or profit) income raises consumption.
Higher future (wage or profit) income raises consumption.
The consumption demand curve plots aggregate
consumption as a function of current aggregate income,
and so is upward sloping.
The other factors shift the consumption demand curve.

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Economics 312

Figure 9.6 An Increase in Lifetime

Wealth for the Consumer Shifts Up the
Demand for Consumption Goods.

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Economics 312

Investment
Well treat firm investment slightly differently from how we
previously did it, to be closer to the textbook. The
implications are nearly identical.
In each period, the firm has a production function:
Y = zF (K , N ) and Y 0 = z 0 F (K 0 , N 0 )
In the first period, the firm chooses how much labor to hire
N and how much to invest I (measured in units of the
consumption good):
= zF (K , N ) wN I
The investment yields capital in the following period:
K 0 = (1 d)K + I , where d is the depreciation rate.
Williams

Economics 312

In the second period, the firm chooses how much labor to

hire N 0 and then sells its un-depreciated capital:
0 = z 0 F (K 0 , N 0 ) w 0 N 0 + (1 d)K 0
A representative firm chooses N , N 0 , I , and K 0 to maximize
V =+

0
,
1+r

the present value of its profits, where

= zF (K , N ) wN I
0 = z 0 F (K 0 , N 0 ) w 0 N 0 + (1 d)K 0
K 0 = (1 d)K + I

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Economics 312

The Firms Problem

Write the Lagrangian:
z 0 F (K 0 , N 0 ) w 0 N 0 + (1 d)K 0
1+r
+((1 d)K + I K 0 )

L = zF (K , N ) wN I +

The choice of N involves only static considerations.

zFN (K , N ) = w.
Equivalently, N is chosen to maximize .
The choice of N 0 is similarly static.
z 0 FN (K 0 , N 0 ) w 0
= 0 z 0 FN (K 0 , N 0 ) = w 0 .
1+r
Equivalently, N 0 is chosen to maximize 0 .
Williams

Economics 312

z 0 F (K 0 , N 0 ) w 0 N 0 + (1 d)K 0
1+r
+((1 d)K + I K 0 )

L = zF (K , N ) wN I +

The choice of I and K 0 is dynamic:

I
K

=1
z 0 FK (K 0 , N 0 ) + (1 d)
:
=0
1+r
z 0 FK (K 0 , N 0 ) d = r
:

The net marginal product of capital equals the interest

rate.

Williams

Economics 312

Investment Demand

Since K 0 = (1 d)K + I , investment must satisfy

z 0 FN ((1 d)K + I , N 0 ) = w 0
0

and

z FK ((1 d)K + I , N ) d = r.
Since FKK < 0, I is decreasing in r. This is the investment
demand curve.
Alternatively, since FKN > 0, I is increasing in w 0 .
An increase in (1 d)K reduces I one-for-one.
An increase in z 0 raises K 0 , hence I .

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Economics 312

Figure 9.10 The Optimal Investment Schedule

Shifts to the Right if Current Capital Decreases
or Future Total Factor Productivity Is Expected
to Increase

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Economics 312

More on Investment

As before, factor prices equal marginal products, but now

expected future net marginal product of capital determines
investment.
Alternative explanation: Firm trades off the cost of
additional capital with the benefit.
Benefit: addition to future output = MPK 0 .
Cost: r + d. Interest cost due to forgone current profit,
depreciation costs due to wearing out of capital stock.
User cost (uc) of capital= r + d, total cost of use of capital
for one period. To determine K 0 firm equates user cost to
expected MPK 0 .

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Economics 312

Changes in Investment/Capital Stock

Changes in either uc or MPK 0 affect the firms capital
stock. Decrease in r or d lowers uc, doesnt change MPK 0 ,
leads to higher capital stock. To get higher K 0 , increase I .
Positive change in expected future technology z 0
increases MPK 0 , leading to higher desired K 0 and so higher
I . Increases in labor N 0 have the same effect, since each
unit of K more productive.
Capital revenue taxation implies (1 )MPK 0 = uc, so can
define tax-adjusted user cost =uc/(1 ).
Examples: investment tax credits, depreciation allowances.
Same effects as r and d.
Complications: firm profit is taxed, not firm revenue. Since
depreciation allowances decrease profits, lead to lower
taxes. Investment tax credits reduce tax.
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Economics 312

More on Investment

Same capital stock calculations apply for inventories and

housing as for physical capital.
Some capital can be constructed easily, others (new
buildings) may take years. So investment needed to
increase the capital stock may be spread out over time
Costs of adjustment: often assume that a company has a
fixed business plan and to increase capital has a cost due to
reorganization. Larger changes may entail more than
proportional increases in costs.
Explains lags in investment: may be able to double build
plant size in a week if pay enough (high cost of
adjustment), but more likely will be spread out over time.

Williams

Economics 312

Competitive Equilibrium
Add government with PV Budget Constraint:
G+

G0
T0
=T+
1+r
1+r

In a competitive equilibrium, households choose

consumption and leisure (c, c 0 , l and l 0 ) to maximize utility
given wages and interest rates (w, w 0 , and r).
Firms choose employment and investment (N , N 0 , and I )
to maximize value given wages and interest rates (w, w 0 , r).
The labor market clears in both periods,
N + l = N 0 + l 0 = h.
The goods market clears in both periods,
zF (K , N ) = C +I +G

and

z 0 F (K 0 , N 0 )+(1d)K 0 = C 0 +G 0

Note that the credit market clears by Walras law.

Williams

Economics 312

Labor Market Equilibrium

Labor supply: increasing in the real wage.

Substitution effect dominates income effect.
Labor demand: decreasing in real wage.
Equate marginal product of labor to the real wage.
An increase in the interest rate directly and indirectly
reduces future wages, raising current labor supply.
Direct effect: PDV of wages is
Indirect effect:

w0
1+r .

r = z 0 FK (K 0 , N 0 ) d, decreasing in K 0 /N 0 .
So higher r reduces K 0 /N 0 .
w 0 = z 0 FN (K 0 , N 0 ), increasing in K 0 /N 0 .
So lower K 0 /N 0 reduces future wages w 0 .

Both work through intertemporal substitution of leisure.

Williams

Economics 312

Figure 9.11
Determination
of Equilibrium
in the Labor
Market Given
the Real
Interest Rate r

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Economics 312

Goods Market Equilibrium

Output supply: increasing in real interest rate

An increase in the interest rate raises current labor supply.
This increases employment, raising output.
Output demand: decreasing in real interest rate.
Higher real interest rates reduce investment.
Higher real interest rates reduce consumption.

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Economics 312

Figure 9.12 Construction of the

Output Supply Curve

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Economics 312

Figure 9.14 An Increase in Current Total

Factor Productivity Shifts the Ys Curve

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Economics 312

Figure 9.16 Construction of the

Output Demand Curve

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Economics 312

Figure 9.18 The Complete Real

Intertemporal Model

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Economics 312