Econ 714 Midterm

Wednesday, February 16, 2005. You have 75 minutes to answer all the questions. A total of 30 points are at stake. See the last page for Assumptions AF.

Deterministic dynamic programming

Let the sequence problem (SP) be:

w(x0 ) = s.t. sup
{xt+1 } t=0 t=0

t F (xt , xt+1 ) t.

(1)

xt+1 (xt ),

Then, we can write down the corresponding functional equation (FE) as:
v(x) = sup F (x, y) + v(y),
y(x)

x X.

(2)

1. (3 points) Is the following statement true or false? Justify your answer. If Assumptions C and D are satised, there exists at least one solution to the FE. 2. (3 points) Is the following statement true or false? Justify your answer. Lets assume that Assumptions C and D are satised, and that v is a solution to the FE. If, for a feasible plan x (x0 ), n limn v (n ) > 0, then v is not a solution to the original SP. x 3. (3 points) Is the following statement true or false? Justify your answer. When Assumptions A, B, E and F are satised, it follows that the optimal policy correspondence G(x) = {y (x) | v(x) = F (x, y) + v(y)} is a single-valued function. 4. (5 points) In Mondays class, we computed the steady state of a system by studying the rst-order conditions of the sequence problem. In particular, 1

1 when F (x, y) = x y and (x) = [0, x ], we have x = () 1 . This result comes from the fact that the steady state x satises:

Fy (x , x ) + Fx (x , x ) = 0,

(3)

where Fx and Fy denote dierentiation with regard to the rst and second argument of F , respectively. Now, show that you can derive Equation (3) from the functional equation as well. Start by taking the rst-order condition of Equation (2). You do not have to prove the dierentiability of v.

II

Finite-horizon neoclassical growth model

T

Think of the following nite-horizon neoclassical growth model.

wT (k0 ) = s.t.
{ct ,kt+1 }T t=0

max

t u(ct )
t=0

(4) t. (5)

0 ct + kt+1 f (kt ),

In addition, f (k) = k , and , (0, 1). Finally, k0 (0, 1). 1. (5 points) Is the following FE a correct recursive representation of the original SP? Why or why not?
v(k) =
0k k

max u(k k ) + v(k )

(6)

III

Consumption smoothing under uncertainty

A consumer wants to maximize his expected utility over an innite horizon. His income every period (yt ) is stochastic, and governed by a Markov chain. In particular, his income could be either low (yL ) or high (yH ) in any given period. If todays income is yL , the probability that his income will be low tomorrow is LL . Therefore, conditioning on yL today, the probability that his income will be yH tomorrow is 1 LL . Likewise, P r(yt+1 = yH |yt = yH ) = HH and P r(yt+1 = yL |yt = yH ) = 1 HH . Although he can save, he cannot borrow at all. The prevailing net interest rate is r, with (1 + r) < 1. Plus, there is an ad hoc restriction capping his asset 2

H holdings at aM ax = yr . He has no asset holdings in the beginning; that is, a0 = 0. Finally, his income in the initial period (y0 ) is yL . The sequential problem can be written as follows.

U (c)

= s.t.

{ct (st ),at+1 (st )} t=0

max

t (st )u(ct (st ))

t=0 st

at+1 (st ) yt + at (st1 ), 1+r a0 = 0 and y0 = yL given. ct (st ) +

0 at aM ax ,

The history up to t is denoted by st . One possible example of the history up to t = 4 (s4 ) is (y0 , y1 , y2 , y3 , y4 ) = (yL , yL , yH , yH , yL ). (st ) is the probability of a particular history being realized. In our example, (s4 = (yL , yL , yH , yH , yL )) = LL (1 LL )HH (1 HH ). Note that now the consumer must make a consumption-savings decision for each period, and for each possible history realization (st ). 1. (1 point) Briey explain why it is not easy to solve the sequence problem as it is. In particular, mention the dimension of the consumers choice variables. 2. (3 points) If you want to transform the SP into an FE, what will be your state variable(s)? Justify your choice. What will be the relevant state space, then? 3. (5 points) Write down the functional equation for this problem. Do not use the expectation operator (E). Instead, explicitly write out the probabilities given above. 4. (1 point) In the neoclassical growth model, the optimal decision rule g maps todays capital stock (k) to tomorrows capital stock (k ). In your setup of the consumption smoothing problem, what are the input and output of the consumers optimal decision rule? 5. (1 point) Describe how you would go about solving the FE numerically in practice. Do not go into too much detail. It suces to write down an outline.

Assumption A: For each y, F (, y) is strictly increasing in each of its rst l arguments. Assumption B: is convex in the sense that for any 0 1, and x, x X, y (x) and y (x ) implies y + (1 )y [x + (1 )x ]. Assumption C: For all x0 X and x (x0 ), limn (although it may be plus or minus innity). Assumption D: (x) is nonempty, for all x X. Assumption E: The function F : Gr() R is bounded and continuous, and 0 < < 1. Assumption F: X is a convex subset of Rl , and the correspondence : X X is nonempty, convex-valued, and continuous.
n t=0

t F (xt , xt+1 ) exists