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Christos Koulovatianos

University of Nottingham (CFCM, CPE)

and

Center for Financial Studies (Frankfurt)

e-mail: christos.koulovatianos@nottingham.ac.uk

March 6, 2010*

0

* These notes heve beneted from comments and corrections by Sebastian Schmidt and Leonid Silberman.

1

Assumptions and Description of the Model

Assumptions concerning Households

Time is discrete and the horizon is innite, i.e. t = 0, 1, .... The economy is populated by

a large number of identical innitely-lived households. All households own the same stock of

physical-capital claims in period 0, k

0

> 0 that they can sell in a free capital market. Each

household derives utility from the consumption of a single nal consumable good throughout

the innite horizon. All households have the same preference proles over potential innite

sequences of consumption, {c

t

}

t=0

, represented by the following utility function:

U ({c

t

}

t=0

) =

t=0

t

u(c

t

) , (1)

with (0, 1),

du

dc

u

1

> 0, and

d

2

u

dc

2

u

11

< 0, for all c > 0. Moreover, we impose the

Inada conditions on u (from the famous Japanese economist who rst suggested them),

lim

c0

u

1

(c) = , (2)

lim

c

u

1

(c) = 0 . (3)

Remark 1: the role of the Inada conditions

The rst Inada condition is placed in order to create a consumer-optimization tendency

towards interior solutions, by discouraging corner consumption choices where c

t

= 0

for some t {0, 1, ...}. The second Inada condition guarantees that the lowest bound of

marginal utility is zero. Thus, equalization of marginal utility with any strictly positive price

is guaranteed, helping to avoid the possibility of non-existence of competitive equilibria.

2

Remark 2: additive separability of momentary utility leads to path indepen-

dence of a single-periods marginal utility of consumption

The functional representation of household preferences that Ramsey, Cass, and Koop-

mans have used, is a discounted sum of additively-separable momentary utility functions

u, referring to the one-periods utility derived by one-periods consumption. Additive sep-

arability gives a key economic property to preferences: the marginal utility of any periods

consumption is path-independent, meaning that

U

_

{ c

t

}

t=0

t=

, c

_

c

=

U

_

{ c

t

}

t=0

t=

, c

_

c

u

1

(c

) , (4)

for all possible sequences { c

t

}

t=0

t=

, { c

t

}

t=0

t=

. Path independence of the marginal utility of a

certain periods consumption stems from the fact that the marginal utility of a single-periods

consumption is not aected by changes in any other periods consumption. In other words,

2

U ({c

t

}

t=0

)

c

i

c

j

= 0 for all i, j {0, 1, ...} , with i = j. (5)

Remark 3: (im)patience of households

The constant discount factor links geometrically momentary utilities in the households

utility function and imposes an exogenous and constant degree of (im)patience over time. In

particular, the assumption that (0, 1) means that consumers are impatient: they prefer

to consume a given quantity today, rather than consuming the same quantity in any other

future period.

To see why households are impatient, dene the rate of time-preference as:

d

1

=

1

1+

d

(

d

= rate of time-preference in discrete time). The condition that (0, 1) holds

if and only if

d

> 0. When a household considers a consumption plan where the same

3

quantity is consumed today and tomorrow, the rate of time preference

d

can be interpreted

as the percentage of utility loss one period ahead due to that the household has to wait for

one period. Impatience leads to the tendency for having the same good being cheaper next

period.

Assumptions concerning Firms and their technology

There is a very large number of small rms, each having the same size and operating the

same technology for producing the single consumable good. Production of a single rm is

achieved through a neoclassical production function with two inputs, physical capital and

labor, given by,

y = F (k, l) . (6)

A summary of its properties is:

Both factors of production are necessary in strictly positive amounts in order to achieve

strictly positive production quantities:

F (0, l) = F (k, 0) = 0, for all (k, l) R

2

+

. (7)

For all (k, l) R

2

+

, the marginal returns of each of the two inputs are positive, i.e.

F (k, l)

k

F

1

(k, l) > 0 , and

F (k, l)

l

F

2

(k, l) > 0 , (8)

and the law of diminishing marginal returns holds, so:

2

F (k, l)

k

2

F

11

(k, l) < 0 , and

2

F (k, l)

l

2

F

22

(k, l) < 0 . (9)

4

For all (k, l) R

2

+

, F () exhibits constant returns to scale, i.e.

F (k, l) = F (k, l) , for all > 0 . (10)

The marginal product of each productive input goes to innity (zero) as the same input

goes to zero (innity). These are the Inada conditions pertaining to production.

Specically,

lim

k0

F

1

(k, l) =lim

l0

F

2

(k, l) = (11)

and

lim

k

F

1

(k, l) =lim

l

F

2

(k, l) = 0 . (12)

Household- and rm-population normalization for simpler analysis

In order to simplify our analysis and to economize on notation, we can assume, without

loss of generality, that the total size of the very large number of households is equal to L

f

,

a xed total labor supply.

1

If we denote the aggregate quantities of all variables with bold

upper-case characters, aggregation gives,

Y = yL

f

,

C = cL

f

,

K = kL

f

.

Yet, it is better to transform all aggregate variables into aggregates per-unit of labor, i.e. to

divide all variables by L

f

. So,

y

Y

L

f

= y ,

1

Assume, for simplicity, there is no population growth, even though an exogenously-driven constant-

population growth process can be easily incorporated in the analysis.

5

c

C

L

f

= c ,

k

K

L

f

= k .

Although variables denoted by lower-case bold characters are equal to our initially dened

individual variables, these two categories of variables are not the same. Variables denoted by

bold characters are still aggregate. Dividing by L

f

changed the total size of the households

from L

f

to 1. This normalization does not mean that the number of households is still not

very large. Without loss of generality, the population size of households in this economy

is equal to one. Our assumption of all households being identical means that the household

distribution is degenerate. Our assumption that the population number is quite large,

means that the size of any single household tends to zero. In other words, each household

is a drop in the ocean, enforcing a perfectly competitive behavior for households on the

demand side of the nal-good market. Therefore, households are price-takers.

We can move along the same lines with respect to the supply side of the nal good.

Aggregate production is given by,

Y = F

_

K, L

f

_

y =F

_

K

L

f

,1

_

.

Dening the univariate function f as,

f (x) = F (x, 1) ,

it is,

y =f (k) . (13)

Taking the partial derivatives of the aggregate production function expressed as L

f

F

_

K

L

f

,1

_

with respect to K and L

f

, we obtain,

Y

K

= F

1

_

K

L

f

,1

_

,

6

Y

L

f

= F

_

K

L

f

,1

_

F

1

_

K

L

f

,1

_

K

L

f

,

resulting to,

Y

K

=f

1

(k) and

Y

L

f

=f (k) f

1

(k) k . (14)

In this way, we have managed to eliminate variable L

f

fromboth the expression of production

and the expressions of marginal products that are necessary for determining equilibrium

prices. We have also managed to normalize the large number of rms. Without loss of

generality, the total population size of rms in this economy is equal to one. Our assumption

of all rms being the same means that the rm distribution is degenerate. Our assumption

that the number of rms is quite large, means that the size of any single rm tends to

zero. In other words, each rm is a drop in the ocean, enforcing a perfectly competitive

behavior for rms on the supply side of the nal-good market.

Whereas the small size of households is enough to rationalize their price-taking behavior,

the organization of rms in a competitive supply market is not straightforward. Technology

may generate tendencies for other organizational structures: for example, increasing returns

to scale can encourage mergers or monopolistic competition. The key assumption that ratio-

nalizes perfect competition among rms in this model is this of having a constant-returns-

to-scale technology. Constant returns to scale drive all rms to achieving zero maximum

prots and being price-takers. Moreover, production-input markets (these for capital and

labor) are perfectly competitive as well.

To summarize, we have managed to eliminate the labor variable from both the demand-

and the supply side. Also, the fact that the total measure of households and rms is equal

to one for both (degenerate) distributions allows us to use one of all identical households as

a representative household and one of all identical rms as a representative rm. We will

now see that one can also solve alternatively one of two a-priori dierent problems that give

7

the same result: (i) the general competitive-equilibrium problem; and (ii) the social-planner

problem. Of course, it is the rst and second welfare theorems that allow us to do so.

Competitive general equilibrium versus the social planners solution

Suppose that we have solved the competitive general-equilibrium problem. Remarks (i)

and (ii) help us see the link between the competitive general equilibrium and the social

planners solution.

(i) Preferences are convex. We know this, since the law of diminishing marginal utility

holds for the preferences of households. Moreover, production technology exhibits constant

returns to scale and there are no externalities. These are sucient conditions for the rst

welfare theorem to hold in general equilibrium. This means that any competitive

equilibrium resulting from this model is Pareto ecient.

(ii) Our assumption that all rms and households are identical, provides a symmetry

among all individual maximization problems of rms and households. This symmetry

means that the resulting competitive equilibrium is characterized by a degenerate

distribution of relative personal utilities among households.

Remarks (i) and (ii) lead us to the conclusion that the models unique competitive equi-

librium (we will take uniqueness as a granted property for the moment) is Pareto ecient

with a degenerate relative personal-utility distribution.

Now if we consider a social planner with an equi-weighted utilitarian social-welfare func-

tion, the symmetry among all households and rms will induce her to pick a Pareto-ecient

equilibrium with a degenerate relative personal-utility distribution. There is one more re-

mark to be made, even though a formal proof of this claim is beyond the scope of the present

8

analysis: that there is only one Pareto-ecient equilibrium corresponding to each possible

relative distribution of personal utilities. In other words, the correspondence mapping the

domain of relative personal utility distributions to Pareto ecient equilibria is a function.

Since both the social-planners equilibrium and the competitive equilibrium are unique

and Pareto ecient both implying a degenerate relative personal-utility distribution, the two

problems are equivalent, i.e., their unique solutions coincide. This result gives us substantial

practical facility with respect to solving the model, especially on the computer: a-priori, we

can pick the social planners problem, which is easier, in order to solve for the competitive

equilibrium of the model. Historically, this facility has been a major breakthrough at a time

when computational power was low. For the purposes of this note we will characterize the

social planners solution analytically, knowing that we are characterizing the competitive

equilibrium at the same time.

The General Two-period Neoclassical Growth Model

In order to comprehend the key dynamic properties of the neoclassical growth model, it

is better to have a chance to draw some graphs that remind us of the typical microeconomics

we know so far. This purpose is met by studying the two-period model rst, i.e. we will

restrict attention to the case of t = 0, 1. One key feature that we can see through the

two-period-model analysis is the fact that in a nite-horizon neoclassical world production

possibilities are given solely by the initial conditions k

0

> 0, i.e. the initial physical capital by

which the economy is endowed. Thus, the problem of growth in the neoclassical model is one

of optimal resource management and not of growth-enhancing strategies via technological

investments. Another key result is that the general-equilibrium conditions resulting from

9

the two-period model are the same as these of the innite-horizon model. So, the two-period

model provides the backbone for a neoclassical general-equilibrium analysis in the long-run.

Commodity space and the production possibility frontier

Once more for simplicity, assume that labor is exogenous. In other words, independently

of how prices may evolve over time, households provide a xed fraction of their time endow-

ment as labor services, because (by assumption) they do not value leisure. Denote this xed

level of labor supply with L

f

= 1. This takes us to using equations (13) and (14).

By having households not valuing leisure, we have restricted the commodity space into a

two-dimensional one, since there are only two goods: (a) consumption of a single composite

good in period 0, c

0

; and (b) consumption of the same good in period 1, c

1

. Time is what

makes the same good be valued dierently by consumers.

There are two boundary conditions concerning the capital stock in this economy: (a) in

period 0, the available capital stock is positive, i.e. k

0

> 0; and (b) after the end of period 1,

i.e. at the beginning of period 2, the representative household cannot owe physical-capital

claims, i.e. it cannot die in debt, so k

2

0. With respect to boundary condition (b),

even though the household can borrow resources in order to consume more in period 0,

this condition secures that it has enough time to pay o its debt before it dies. Ecient

utilization of resources implies that households will exhaust their available capital (since

providing it to the rms gives back interest income to them). Therefore, condition k

2

0

will bind, i.e. it will become k

2

= 0.

Consumption and capital goods have the same price within the same time period.

2

The

2

Notice that this assumption of xing an exogenous intra-temporal price between consumable goods and

capital dominates all existing growth literature: both the neoclassical-growth literature, and new growth

theory.

10

one type of good can be transformed into the same number of units of the other type of

good at no cost. The economy-resource constraints are given by,

c

t

+i

t

= y

t

, t = 0, 1. (15)

The two constraints given by (15) represent the expenditure identity in the national accounts

of a closed economy without a public sector. Now observe that i

0

= k

1

(1 ) k

0

, where

[0, 1] is the capital depreciation rate, and also i

1

= (1 ) k

1

, since k

2

= 0, as

explained above. Substituting these last two equations into the two relationships given by

(15) and taking into account that y

t

= f (k

t

), we obtain,

c

0

+k

1

= f (k

0

) + (1 ) k

0

, (16)

c

1

= f (k

1

) + (1 ) k

1

. (17)

Solving (16) for k

1

and substituting into (17), we have,

c

1

= f

_

f (k

0

) + (1 ) k

0

c

0

_

+ (1 )

_

f (k

0

) + (1 ) k

0

c

0

_

. (18)

Equation (18) fully describes the production-possibility frontier (PPF). The latter is the set

of all possible bundles (c

0

, c

1

) under the constraint that production resources are utilized

eciently. The PPF is given by the curve drawn in Figure 1. Some simple calculus validates

the shape of the PPF as in Figure 1. In particular,

dc

1

dc

0

= f

1

_

f (k

0

) + (1 ) k

0

c

0

_

(1 ) < 0 , (19)

d

2

c

1

dc

2

0

= f

11

_

f (k

0

) + (1 ) k

0

c

0

_

< 0 . (20)

An important remark is that the PPF reects the decentralized-equilibrium production

possibilities under perfect competition. This is due to the fact that production exhibits

11

constant returns to scale. Therefore, competitive pricing of the productive inputs leads,

through Eulers theorem, to zero prots. Notice that our discussion above about the equiv-

alence between the social planners problem and the problem of nding competitive general

equilibrium applies here, too.

0

Production Possibility

Frontier (PPF)

C

0

C

1

f(f(K

0

)+(1) K

0

)+

+ (1- ) [f(K

0

)+(1- ) K

0

]

f(K

0

)+(1- ) K

0

Figure 1 The Production Possibility Frontier in the 2-period Neoclassical growth

model

12

The Social Planners Problem

Households have preferences over the consumption of two periods given by additively-

separable momentary utility functions as:

U (c

0

, c

1

) = u(c

0

) +u(c

1

) ,

with (0, 1) and

du

dc

u

1

> 0 and

d

2

u

dc

2

u

11

< 0. At time t = 0, households own

physical-capital claims (assets) equal to K

0

> 0.

Therefore, the household problem is stated as:

max

c

0

,c

1

u(c

0

) +u(c

1

)

subject to:

c

0

+k

1

= f (k

0

) + (1 ) k

0

, (21)

c

1

= f (k

1

) + (1 ) k

1

, (22)

given k

0

> 0.

The Lagrangian is given by,

L = u(c

0

) +u(c

1

) +

0

[f (k

0

) + (1 ) k

0

c

0

k

1

] +

1

[f (k

1

) + (1 ) k

1

c

1

]

and the rst-order conditions are,

L

c

0

= 0 : u

1

(c

0

) =

0

(23)

L

c

1

= 0 : u

1

(c

1

) =

1

(24)

L

k

1

= 0 :

0

= [1 +f

K

(k

1

) ]

1

(25)

L

0

= 0 : c

0

+k

1

= f (k

0

) + (1 ) k

0

(26)

L

1

= 0 : c

1

= f (k

1

) + (1 ) k

1

(27)

13

Using (23)-(25), it is straightforward that the general equilibrium conditions are given by:

u

1

(c

0

)

u

1

(c

1

)

= 1 +f

1

(k

1

) , (28)

and (26) and (27). Obviously, the indierence curve is tangent on the PPF, as it would

be the case in a static model. As it is clear from Figure 2, the general-equilibrium point is

interior, with the (negative value of the) gross-eective interest rate of the second period,

1 +R

1

, being equal to the slope of the tangent line passing from both the PPF and the

indierence curve.

PPF

C

0

C

1

0

C

0

C

1

K

1

U

max

slope=-(1+R

1

-)

Figure 2 General equilibrium in the 2-period Neoclassical growth model

14

The Two-period Model with CES utility and production functions and = 1

Consider the following functional forms for the two-period model,

Momentary utility:

U (c

0

, c

1

) =

c

1

1

0

1

1

1

+

c

1

1

1

1

1

1

,

with > 0.

Consumable/capital goods production function:

y =

_

k

1

1

+ (1 ) L

1

1

_

1

,

with labor being supplied exogenously with L = 1.

Under the assumption that = 1, by direct application of (26)-(28), it is straightforward

to show that,

c

0

=

1

1 + ()

f (k

0

) ,

and

k

1

=

()

1 + ()

f (k

0

) ,

which comprise the solution to the two-period problem.

15

The General Innite-horizon Neoclassical Model

First-order conditions using a Lagrangian

The social planners problem can be described as:

max

{ct,k

t+1

}

t=0

t=0

t

u(c

t

)

subject to:

k

t+1

+c

t

f (k

t

) + (1 ) k

t

given k

0

> 0 ,

lim

t

k

t+1

t

j=0

(1 +R

j

)

= 0 ,

where 1+R

j

is the gross-eective interest rate in period j {0, 1, ...}. The last boundary

constraint means that the present discounted value of aggregate capital as time goes to

innity must be zero. In other words, eventually the economy should not have debt. This

is rather straightforward in this economy, since homogeneity among households means that

there are no net borrowers and lenders, and, as non-negative amounts of capital are necessary

for production, the economy will never be in debt. Since all variables are normalized so that

the total population- and household-measure is equal to one, and since all rms are identical,

it is k = k and c = c. We can therefore use the above structure of the optimization problem,

after having imposed these aggregation rules, i.e. we can use a representative household

and a representative rm solving the social planners problem. We do so, for forming the

Lagrangian.

L =

t=0

t

u(c

t

) +

t=0

t

[f (k

t

) + (1 ) k

t

c

t

k

t+1

]

16

The rst-order conditions are:

L

c

t

= 0

t

u

1

(c

t

) =

t

, (29)

L

k

t+1

= 0

t

= [f

1

(k

t+1

) + 1 ]

t+1

, (30)

L

t

= 0 c

t

+k

t+1

= f (k

t

) + (1 ) k

t

. (31)

Combining (29) and (30) we can eliminate the Lagrange multipliers and obtain,

u

1

(c

t

) = [f

1

(k

t+1

) + 1 ] u

1

(c

t+1

) . (32)

Equations (31) and (32) together with the two terminal conditions k

0

> 0 and lim

t

k

t+1

t

j=0

(1+R

j

)

=

0, constitute the necessary conditions for a maximum. We will refer to other arguments for

showing that these conditions are also sucient for a maximum in a later section. In brief,

equation (32) says that the necessary condition for a maximum sets the marginal rate of

substitution between any two subsequent periods equal to the gross eective interest rate

linking these two periods, f

1

(k

t+1

) + 1 . On the other hand, equation (31) says that the

budget constraint is never slack; it is always met with equality.

Steady state(s)

In the steady state the growth rate of all variables is constant. A good conjecture for

the steady-state growth rate of variables in the neoclassical model may come from what we

know from the Solow model: given that the function f (k

t

) is strictly concave, the Solow

model says that in the steady state the growth rate of all variables equals 0. Is this the case

here? Does such a steady state exist?

As we do with linear dierence-equation systems, we check if there is a particular solution,

17

with,

k

t+1

= k

t

and c

t+1

= c

t

for all t {, + 1, ...} for some {0, 1, ...} .

We denote the equilibrium part that corresponds to the particular solution as (k

ss

, c

ss

), the

steady-state. The two equations in the steady state become,

c

ss

= f (k

ss

) k

ss

, (33)

f

1

(k

ss

) =

1

+ . (34)

k

t

0

c

t

( ) c f k k =

k

k f

ss

=

+

1

1

1

c

ss

( ) k f

*

=

1

1

ss

> 0

Equation (34) comes from imposing the condition that c

ss

t+1

= c

ss

t

. With the Inada

conditions f

1

(0) = and f () = 0, there should be only one possible non-zero and

18

bounded value for k

ss

, as f

1

(k) is a strictly decreasing function and 0 = f () <

1

+

< f (0) = . So, the intermediate-value theorem guarantees existence of a k

ss

with

0 < k

ss

< , and strict monotonicity the uniqueness of this k

ss

. In particular,

k

ss

= f

1

1

. (35)

Equation (33) comes from imposing the condition that k

ss

t+1

= k

ss

t

. To see that c

ss

> 0,

observe that the Inada condition f

1

(0) = together with (33) imply that there is a value

0,

c = f (k) k is drawn over the interval

0,

function k

0,

is given by: k

= f

1

1

(). Since f

1

is strictly decreasing and because

f

1

1

preserves the monotonicity of f

1

, it is,

1

+ > f

1

1

< f

1

1

() k

ss

< k

. (36)

This property is known as the dynamic ineciency of the optimal solution to the neoclas-

sical model, as c

ss

< f (k

) k

consumption. As it can be seen from (36), the reason for this ineciency is the impatience

of households, namely that < 1. Since k

ss

(0, k

0,

ss

< .

Figure 3 summarizes this argument graphically. In other words, there is a unique steady

state (k

ss

, c

ss

) with 0 < k

ss

, c

ss

< .

19

Stability Analysis of the Dynamic System

We can rst focus on the 2-equation, 2-unknown rst-order non-linear dynamic system

given by equations (31) and (32), of the form:

h(k

t+1

, c

t+1

) = (k

t

, c

t

) ,

where h : R

2

+

R

2

, : R

2

+

R

2

with:

h

1

(k

t+1

, c

t+1

)

h

2

(k

t+1

, c

t+1

)

k

t+1

[f

1

(k

t+1

) + 1 ] u

1

(c

t+1

)

=

=

f (k

t

) + (1 ) k

t

c

t

u

1

(c

t

)

1

(k

t

, c

t

)

2

(k

t

, c

t

)

Stability properties of the system

Now we will prove that the linearized dynamic system given by equations (31) and (32)

within a neighborhood (open ball) around the point (k

ss

, c

ss

) with an arbitrary radius > 0

is a saddle, rather than a sink or a source. We can take a rst-order Taylor expansion of

functions h and around (k

ss

, c

ss

). The linearized system will look like:

J

h

(k

ss

, c

ss

)

k

t+1

k

ss

c

t+1

c

ss

= J

(k

ss

, c

ss

)

k

t

k

ss

c

t

c

ss

,

where J

h

(k

ss

, c

ss

) and J

(k

ss

, c

ss

) are the Jacobian matrices of functions h and evaluated

at point (k

ss

, c

ss

), with,

J

h

(k

ss

, c

ss

) =

1 0

f

11

(k

ss

) u

1

(c

ss

) u

11

(c

ss

)

,

and

J

(k

ss

, c

ss

) =

1

0 u

11

(c

ss

)

.

20

In order to characterize the system for stability, we should focus on the linear system of

equations:

k

t+1

k

ss

c

t+1

c

ss

= J

1

h

(k

ss

, c

ss

) J

(k

ss

, c

ss

)

k

t

k

ss

c

t

c

ss

k

t+1

k

ss

c

t+1

c

ss

f

11

(k

ss

)u

1

(c

ss

)

u

11

(c

ss

)

f

11

(k

ss

)u

1

(c

ss

)

u

11

(c

ss

)

+ 1

k

t

k

ss

c

t

c

ss

.

Following the stability analysis by Azariadis (1993, Ch. 7) for 2 2 linear dynamic systems,

we should calculate the trace and determinant of matrix J

1

h

(k

ss

, c

ss

) J

(k

ss

, c

ss

). The reason

is that, for 2 2 systems, the trace equals the sum of the systems eigenvalues and the

determinant equals the product of the two eigenvalues.. By comparing them to certain key

values, we can reach a concrete conclusion about whether the eigenvalues are positive or

negative, and greater or less than 1 in absolute value. So, let

T = tr

J

1

h

(k

ss

, c

ss

) J

(k

ss

, c

ss

)

= 1 +

1

+

f

11

(k

ss

) u

1

(c

ss

)

u

11

(c

ss

)

> 2 ,

and

D =

J

1

h

(k

ss

, c

ss

) J

(k

ss

, c

ss

)

=

1

> 1 .

The positive sign of the determinant implies that the two eigenvalues have the same sign,

and since their sum is greater than zero, we know they should be both positive. At the

same time we can see that the two eigenvalues are both real, since the discriminant of the

characteristic polynomial equation

2

T +D = 0 ,

is,

= T

2

4D >

1 +

1

1

1

2

> 0 .

21

But we can be more specic about the eigenvalues. In order to nd out whether both

eigenvalues are greater than 1 or if it is only one of the two, we can set = 1 in the

polynomial equation and observe its sign. In other words,

2

T +D

=1

= 1 T +D

2

T +D

=1

=

f

11

(k

ss

) u

1

(c

ss

)

u

11

(c

ss

)

2

T +D

=1

< 0 .

Given that the sign of the factor multiplying

2

is positive, the fact that the value of the

polynomial is negative at = 1, means that 1 lies between the two real eigenvalues,

1

and

2

. In brief,

0 <

1

< 1 <

2

.

Therefore we know that the linearized system around the steady state can behave so that

the steady state is a saddle, i.e. it can be either a sink or a source. The conclusion that

the steady state can be either a sink or a source is drawn from equations (31) and (32), i.e.

only from a subset of the necessary conditions: the two boundary conditions, the initial

conditions and the transversality condition, have been ignored so far. If we impose the

transversality condition, then, (i) for any initial condition k

0

> 0, the steady state is a sink,

and (ii) it can be proved that there can be only one stable path. We will take statements

(i) and (ii) as granted for the moment, since their proofs are advanced for the scope of this

introductory note.

A heuristic analysis through the construction of a phase diagram can help us see the

position of a stable part of the decision correspondence c

t

= C (k

t

) in the planar eld (k

t

, c

t

).

A formal analysis is more involved. So, we will proceed with a characterization of the

22

equilibrium path with the aid of a phase diagram.

Building the phase diagram

A 2 2 dynamic system like this given by equations (31) and (32) is often hard to

characterize by naked eye. A useful device for characterizing the period-by-period motion

of the systems two variables is the phase diagram. Its goal is to dene and depict areas

of combinations of the systems two variables in an arbitrary (current) period t {0, 1, ...}

with clear-cut dynamic properties: such areas should point out distinct directions of these

two variables in the next period. So, the phase diagram for a system consisting of rst-

order dierence equations is a picture of key information about the systems period-by-period

mechanics.

One of the easiest ways to build a phase diagram in a 2-dimensional Euclidean vector

space is to isolate the motion of each variable in the 2-dimensional Cartesian plane. The idea

of motion is easy to comprehend and even easier to depict on the phase diagram. Given that

we work on a 2-dimensional Cartesian plane, we can view it in two ways: (i) as a planar eld,

that gives us the position of the two variables in a certain arbitrary period t {0, 1, ...}; and

(ii) as a vector eld, where we can use vectors of motion in the planar eld, referring to the

direction of change of each variable in the next period.

3

In this way, in a given Cartesian

plane, we can blend two planar elds in one graph: one referring to period t {0, 1, ...},

and one referring to period t + 1. If we think of the Cartesian plane of variables k and c,

ordered as (k, c), the one-period transition from a point (k

t

, c

t

) to the point (k

t+1

, c

t+1

), can

3

The planar eld of all the Cartesian ordered pairs (k, c) is straightforward. On the other hand, the denition

of the vector eld rests upon equations (31) and (32). You can nd a denition of a vector eld in any real

analysis book, (a introductory text is this of Lang (1983), and the denition is on page 332). It is a map

from (k, c) to R

2

in the case we examine here, and the interpretation of the two numbers can be (k, c),

the change in two subsequent periods.

23

be depicted by drawing an arrow with the tip of the arrowhead at point (k

t+1

, c

t+1

) and the

end of its tail at point (k

t

, c

t

).

Meeting our goal through a phase diagram means to nd areas in the planar eld of

(k

t

, c

t

) with clear-cut period-by-period dynamics for k and c. This means that we should

nd areas where the direction of the arrows is qualitatively similar. In order to do so in

a two-dimensional planar eld, it is easier to search through the motion of each variable

in isolation. In particular, we should identify areas where the system given by equations

(31) and (32) dictates that c > 0 (perpendicular vectors pointing upwards), or c < 0

(perpendicular vectors pointing downwards), or c = 0 (usually a phase curve instead of a

whole area). Then we can identify areas where the systemdrives k in isolation so that k > 0

(at vectors pointing to the right), or k < 0 (at vectors pointing to the left), or k = 0

(usually a phase curve instead of a whole area). At the end we can put our conclusions

together in one graph, combining qualitatively the directions of the perpendicular and at

vectors in areas where the combined vector directions are unambiguous. In this way we

can locate areas where choices of the control variable (c), make the system unambiguously

unstable, rening in this way areas for candidate solutions. This is what we will do in the

following subsections.

Isolating the motion of consumption (the control variable)

Consider the Cartesian plane of variables k

t

and c

t

, ordered as (k

t

, c

t

) at any t {0, 1, ...}.

A perpendicular vector with upwards direction and with the starting point of its tail po-

sitioned at the point (k

t

, c

t

), means that, at this point, c

t

c

t+1

c

t

> 0 (equivalently,

a perpendicular vector starting from this point showing downwards direction means that

24

c

t

< 0).

Because we are interested in the two-period motion of c

t

, we will focus on equation (32),

which is a rst-order dierence equation of c. At this point of our analysis there is no use

in examining equation (31), since this is a rst-order dierence equation of k.

k

t

0

c

t

( ) ( ) ( )

( ) = = + =

+

+

k c c c f f k k c

t t t t t t t

,

1 1

1

1

( ) ( ) ( ) ( ) k f f k k ,0 1

1

1

+ =

+

phase curve 1

area A ( ) ( ) ( ) ( ) = + >

+ >

+

k c f f k k c c c

t t t t t t t

,

1 1

1

1

area B ( ) ( ) ( ) ( ) = + <

+ <

+

k c f f k k c c c

t t t t t t t

,

1 1

1

1

( ) ( ) 0

1

1

, c f c =

+

c

t

> 0

c

t

< 0

Figure 4 Diagrammatic analysis of the motion of the control variable c in two arbitrary

subsequent periods, t, t + 1, where t {0, 1, ...}

In order to identify clear-cut areas where c

t

> 0 or c

t

< 0, we should start from

the set of points (k

t

, c

t

) for which c

t

= 0. Therefore, we start by imposing the condition

c

t

= 0 c

t

= c

t+1

on equation (32), which gives,

f

1

(f (k

t

) + (1 ) k

t

c

t

) =

1

+ .

25

So, the rst phase curve (phase curve 1) is dened as,

phase curve 1 =

(k

t

, c

t

)

c

t

= c

t+1

f

1

(f (k

t

) + (1 ) k

t

c

t

) =

1

, (37)

and it is depicted in Figure 4. We can see that phase curve 1 divides the planar eld (k

t

, c

t

)

in two areas, one on the left (area A) and one on the right (area B) as shown in Figure

4. Taking into account that f

11

< 0, we can dene the two areas as,

area A =

(k

t

, c

t

)

f

1

(f (k

t

) + (1 ) k

t

c

t

) >

1

, (38)

and

area B =

(k

t

, c

t

)

f

1

(f (k

t

) + (1 ) k

t

c

t

) <

1

. (39)

Now lets examine the sign of c

t

in area A.

f

1

(f (k

t

) + (1 ) k

t

c

t

) >

1

+ [1 + f

1

(k

t+1

) ] > 1

(32) [1 + f

1

(k

t+1

) ] =

u

1

(c

t

)

u

1

(c

t+1

)

u

1

>0

=

u

1

>0

= u

1

(c

t

) > u

1

(c

t+1

)

u

11

<0

= c

t

< c

t+1

c

t

> 0 .

Therefore, in area Ait is c

t

> 0, which justies the perpendicular arrowpointing upwards in

Figure 4. Similarly, we can showthat in area Bit is c

t

< 0, which justies the corresponding

perpendicular arrow pointing downwards in Figure 4.

A last remark about Figure 4 and the motion of variable c pertains to points (k

t

, c

t

) that

are on the phase curve 1. We have shown that if (k

t

, c

t

) phase curve 1 at an arbitrary

point in time t {0, 1, ...}, it is indeed the case that c

t

= c

t+1

. However, it is not necessarily

the case that c

t+1

= c

t+2

, unless (k

t

, c

t

) = (k

ss

, c

ss

). It is important to remember that Figure

4 provides information on the motion of c

t

only for one period ahead. This happens because

Figure 4 was derived by a rst-order dierence equation.

26

Isolating the motion of capital (the state variable)

Consider again the Cartesian plane of variables k

t

and c

t

, ordered as (k

t

, c

t

) at any

t {0, 1, ...}. A at vector starting from point (k

t

, c

t

) with direction to the right, means

that k

t

> 0.

Because we are interested in the two-period motion of k

t

, we will focus on equation (31),

which is a rst-order dierence equation of k. There is no use in examining equation (32),

since this is a rst-order dierence equation of c.

In order to identify clear-cut areas where k

t

> 0 or k

t

< 0, we should start from

the set of points (k

t

, c

t

) for which k

t

= 0. Therefore, we start by imposing the condition

k

t

= 0 k

t

= k

t+1

on equation (31), which gives,

c

t

= f (k

t

) k

t

.

So, the second phase curve (phase curve 2) is dened as,

phase curve 2 = {(k

t

, c

t

) |k

t

= k

t+1

c

t

= f (k

t

) k

t

} , (40)

and it is depicted in gure 5. We can see that phase curve 2 divides the planar eld (k

t

, c

t

)

in two areas, one above (area C) and one below (area D) as shown in Figure 5.

It is straightforward to dene the two areas as,

area C = {(k

t

, c

t

) |c

t

> f (k

t

) k

t

} , (41)

and

area D = {(k

t

, c

t

) |c

t

< f (k

t

) k

t

} , (42)

Now lets examine the sign of k

t

in area C.

c

t

> f (k

t

) k

t

(31) c

t

= f (k

t

) + (1 ) k

t

k

t+1

k

t

> k

t+1

k

t

< 0 .

27

Therefore, in area C it is k

t

< 0, which justies the at arrow pointing to the left in Figure

5. Similarly, we can show that in area D it is k

t

> 0, which justies the corresponding at

arrow pointing to the right in Figure 5.

k

t

0

c

t

( ) ( ) { }

= = =

+

k c k k c f k k

t t t t t t t

,

1

phase curve 2

area C ( ) ( ) { } = > <

+

k c c f k k k k

t t t t t t t

,

1

area D ( ) ( ) { } = < >

+

k c c f k k k k

t t t t t t t

,

1

k

t

< 0

k

t

> 0

Figure 5 Diagrammatic analysis of the motion of the state variable, k, in two arbitrary

subsequent periods, t, t + 1, where t {0, 1, ...}

Again, it is important to remember that, since Figure 5 was derived by a rst-order

dierence equation (equation (31)), Figure 5 provides information on the motion of k

t

only

for one period ahead. This means that although (k

t

, c

t

) phase curve 2 at an arbitrary

point in time t {0, 1, ...} implies k

t

= k

t+1

, it is not necessarily the case that k

t+1

= k

t+2

,

unless (k

t

, c

t

) = (k

ss

, c

ss

). Yet, we will see that when we set up the whole phase diagram we

28

can characterize the long-run behavior of the model. This is the task we will deal with in

the following section.

The complete phase diagram

In our analysis above, we showed that in a neighborhood around the steady state, the

system can behave in a way that the steady state can be a sink or a source. We also

mentioned (without proof) that if the transversality condition is imposed, then the steady

state will become a sink, and in particular, with a unique, globally stable equilibrium path,

that we call stable arm. Although the phase diagram neither provides a formal proof of

stability, nor it provides a proof of uniqueness of an equilibrium path, the phase diagram

can point out the areas in which the stable arm may lie.

By putting Figures 4 and 5 together in a single diagram, we can see in Figure 6 that the

two phase curves (1 and 2) intersect at one point only. By the denition of the phase curves,

their intersection point is the steady state (k

ss

, c

ss

).

The planar eld (k

t

, c

t

) is divided into four areas (denoted by Latin numbers) with specic

vector-eld directions for both variables pertaining to the motion for one-period ahead only.

The vector-eld directions of motion are depicted in Figure 6.

If we consider any initial conditions k

0

> 0 and start examining alternative initial equi-

librium levels of consumption c

0

> 0, then the only areas that could guarantee that, in a

repeated, recursive fashion, an equilibrium path could lead to the steady state, are the areas

II (northeast) and IV (southwest) of the phase diagram. In Figure 6 we can see a candidate

placement of the stable arm.

29

k

t

0

c

t

c

ss

( ) : f k

ss

1

1

=

+

k

ss

I

IV

II

III

Stable arm

Figure 6 The complete phase diagram and the stable arm

The economic intuition stemming from this phase diagram is direct and substantial. First

of all, the stable arm is a decision rule for consumption, a function of the form c

t

= C (k

t

).

Given that the production function y

t

= f (k

t

) bonds capital and income tightly together,

the stable arm can be viewed and interpreted as a consumption function as well. Although

all households take into account their long-run income in order to decide how much to

consume in this model (permanent-income considerations), intuitively, when agents are poor,

then they consume less. The study of issues such as how big is the average and marginal

propensity to consume while starting as richer or poorer (higher or lower k

0

) is not easy to

undertake analytically for such a general setting. Some analytical results are possible for

30

specic parametric functional forms for u and f, but these results are known only for the

continuous-time version of the neoclassical model. For the discrete-time neoclassical model,

Figures 7-9 provide some numerical results for u(c) =

c

1

1

/ (1 ) and f (k) = Ak

,

(the numerical values used are, = 0.34, = 0.96, = 0.05, A = 1), conducting also a

sensitivity analysis with respect to varying the values of , with {0.5, 1, 2, 3, 5}.

REFERENCES

Azariadis, C. (1993), Intertemporal Macroeconomics, Blackwell Publishing.

Lang, S. (1983), Undergraduate Analysis, rst edition, Springer, Undergraduate

Texts in Mathematics.

31

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