Dynamic Macro Basic Macro Frameworks Summer 2016 1

202: Dynamic Macroeconomics
Two Basic Dynamic Macro Frameworks: Innite Horizon & OLG
Mausumi Das
Delhi School of Economics
July-August, 2016
Das (Delhi School of Economics) Dynamic Macro July-August, 2016 1 / 90

Dynamic Macro Models with Optimizing Agents:
All models that we shall consider in this course would entail a

dynamic micro-founded macro framework, where rational agents
would maximise their life-time utility dened over more than one time
period.
There are two macro frameworks which allow for optimizing
consumption/savings behaviour by households over time:
1 The Ramsey-Cass-Koopmans Ininite Horizon Framework (henceforth
R-C-K);
2 The Samuelson-Diamond Overlapping Generations Framework
(henceforth OLG).
The basic dierence between the two is that in the R-C-K model
agents optimize over innite horizon; while in the OLG model, agents
optimize over a nite time horizon (usually 2 periods).

Neoclassical Growth with Optimizing Agents: The R-C-K
Model (in Continuous Time)
We start with the R-C-K model.
You have already seen the discrete time version of the R-C-K model
in the compulsory macro. Here we provide the continous time counter
part. (Intuitions would be exactly the same; only the mathematical
technique diers)
As before, the economy starts with a given stock of capital (Kt ) and
a given level of population (Nt ) at time t. (We are ignoring
technological progress for now).
Since the production side story is identical to Solow, we know that
the rm-specic production functions can be aggregated to generate
an aggregate production function:Yt = F (Kt , Nt ).
And at every point of time the market clearing wage rate and the
rental rate of capital are given by:
wt = FN (Kt , Nt ); rt = FK (Kt , Nt ).
The R-C-K Model: The Household Side Story
There are H identical households indexed by h.

Each household consists of a single innitely lived member to begin
with (at t = 0). However population within a household increases
over time at a constant rate n. (And each newly born member is
innitely lived too!) This implies that total population also increases
at the rate n.
At any point of time t, the total capital stock and the total labour
force in the economy are equally distributed across all the households,
which are supplied inelastically to the market at the market wage rate
wt and the market rental rate rt .
Thus total earning of a household at time t: wt Nth + rt Kth .
Corresponding per member earning: yth = wt + rt kth ,
where kth is the per member capital stock in household h,
which is also the per capita capital stock (or the capital-labour
ratio, kt ) in the economy.
The Household Side Story (Contd.):
In every time period, the instantaneous utility of the household

depends on its per member consumption:
ut = u cth ; u 0 > 0; u 00 < 0; lim u 0 (c h ) = ; lim u 0 (c h ) = 0.

c h !0 c h !
The household at time 0 chooses its entire consumption prole

cth t =0 so as to maximise the discounted sum of its life-time utility:
Z
U0h = u cth exp t
dt; > 0,
t =0
subject to the households budget constraint in every time period.

Notice that identical households implied that per member
consumption (cth ) of any household is also equal to the per capita
consumption (ct ) in the economy at time t.
Interpretation of the Discount Rate:
Notice that the objective function of the household is an integral

dened over innite horizon, where future utilities are discounted at a
constant rate . The discount rate () may have three possible
interpretations.
We have already seen the discrete time counterpart of the above
objective function:
u c1h u c2h
U0h ' u c0h + + + .........
1+ (1 + )2
1. One interpretation of the above ininte horizon utility function is that

agents are immortal (live for ever), but they have an innate
(psychological) tendency to prefer current consumption over future
consumption; hence they discount utilities from consumption that
happen in future dates. In this case is interpreted as the "pure"
rate of time preference of an agent.
Interpretation of the Discount Rate (Contd.):
2. Another interpretation of the discount rate follows if we read the

innite horizon utility function of the household as the sum of utilities
of successive generations of agents who themselves are nitely lived,
but who care for their future generations.
To understand the idea better, suppose each member of the

household lives exactly for one period. But in every successive period
(1 + n ) proprtion of new members are born (also with a life-time of
exactly one period), each of whom are an exact replica of the previous
set of agents (i.e, have identical tastes and preferences).
Each agent cares for the utility of her child, who in turn cares for the
utility of her child and so on....In other words, the agents are altruistic
towards their children. But the altruism is imperfectin the sense
that they care a little less for their children than they do for
themselves.

By this denition then, utlity of an agent belonging to genertaion t :

1
U t = u ( ct ) + Ut + 1 .
1+
If we now expand the successive values of Ut , then we shall get back
the utility function of an agent belonging to generation 0 as:
1 1
U 0 = u ( ct ) + u ( ct + 1 ) + u (ct +2 ) + ........
1+ (1 + )2
In other words, we shall get back the innite horizon utility function
as had been dened earlier, except that the term now measures the
degree of parental altruism.
The lower is , the higher is the parental altruism.
When = 0, there is perfectaltruism (i.e., parents care as much for
their children as they care for themselves).
3. A third interpretation of the discount rate follows if we allow each

agent to potentially live forever, but introduce a constant
(age-independent) mortality risk at every time period.
Suppose an agent lives for sure in the rst period of his life (when he
is born); but at every subsequent period he faces a constant
probablility of dealth, denoted by 1 p. Thus his survival probability
in any period (contingent on the fact that he has survived in all the
previous periods) is p.
This implies the the conditional probability of his surviving upto
period t > 0 is: (p )t
If the agent is alive in any time period t, then he can enjoy utility
from consumption at that point of time, given by u (ct ). But if he
dies then he gets zero utility.

Thus beginning at time 0, the expected life-time utility of the agent

will be given by:
U0 = u (ct ) + pu (ct +1 ) + p 2 u (ct +2 ) + ........
1
Without any loss of generality, replace p by and we shall get
1+
back the innite horizon utility function as had been dened earlier.

The R-C-K Model: Centralized Version (Optimal Growth)
We now discuss the continuous time R-C-K model for the central
planner, referred to as the optimal growthproblem.
It is assumed that there exists an omniscient, omnipotent,
benevolent social planner who wants to maximise the citizens
welfare.
Since all households are identical, the objective function of the social
planner is identical to that of the households:
Z
t
U0 = u (ct ) exp dt. (1)
t =0

The R-C-K Model: Centralized Version (Contd.)
The social planner maximises (1) subject to the planners budget

constraint in every period.
Notice that in a centrally planned economy there are no markets
(hence no market wage rate or market rental rate), and there is no
private ownership of assets (capital) and no personalized income.
The social planner employs the existing capital stock in the economy
(either collectively owned or owned by the government) and the
existing labour force to produce the nal output -using the aggregate
production technology.
After production it distributes a part of the total output among its
citizens for consumption puoposes and invests the rest.
Thus the budget constraint faced by the planner in period t is
nothing but the aggregate resource constraint:
Ct + It = Yt = F (Kt , Nt ).

Investment (net of depreciation) augments next periods capital
dK
stock: = It Kt .
dt
Thus the budget constraint faced by the planner in period t is given
dK
by: Ct + = F (Kt , Nt ) Kt .
dt
Writing in per capita terms:
dk
ct + = f (kt ) kt nkt .
dt
Thus the dynamic optimization problem of the social planner is:
Z
t
u (ct ) exp dt (I)
t =0
subject to
dk
= f (kt ) ( + n)kt ct ; kt = 0 for all t; k0 given.
dt
A Digression: Dynamic Optimization in Continuous Time
(Optimal Control)
Consider the following optimization problem which is dened over a

nite time horizon from 0 to T :
ZT
W = F (ut , xt , t ) dt (2)
t =0
subject to
dx
= g (ut , xt , t ); ut 2 U; x0 given.
(i)
dt
Here ut is called the control variable; xt is called the state variable; F
represents the instantaneous payo function, or the felicity function.
(i) species the evolution of the state variable as a function of the
state and control variables.
It is called the equation of motion or the state transition equation.
Optimal Control (Contd.):
The objective function here is an integral, and our task is to nd out

a time path of the time dependent variable u from the corresponding
choice set U, (i.e., to choose a u 2 U for each point of time t starting
from 0 to T ) such that the value of this integral is maximized.
But our choice is not unconstrained. (Had it been so, a simple
point-by-point static optimization exercise would have given us the
required solution path).
Note that the F function depends not only on u but also on another
time dependent variable x. And our choice of u at each point of time
aects the next periods value of x through the given dierential
equation.
Thus our choice of u aects the objective function directly, as well as
indirectly through x.

ut is called the control variable because we choosing its value directly.

Once the value of ut is chosen in any time period t, the value of the
state variable evolves automatically through the state transistion
equation.
Notice that when we are considering the problem at time 0, the initial
value of the state variable is given to us, but not that of the control
variable.
The initial value of the control variable will also be optimally
chosen, along with all its subsequent values.

Optimal Control: Pontryagins Maximum Principle
Let ut be a solution path to the problem specied in (2), and let xt

be the associated path for the state variable, where ut is a piece-wise
continuous function of t and xt is a strictly continuous but piece-wise
dierentiable in t. Then there exist a strictly continuous and
piece-wise dierentiable variable t , and a function H dened as:
H (u, x, , t ) F (ut , xt , t ) + t g (ut , xt , t ) ,
such that
1 H is maximized with respect to u at ut for all t 2 [0, T ] ;
H d
2 = ;
x (u ,x ,,t ) dt
t t
H dx
3 = ;
(u ,x ,,t ) dt
t t
4 T = 0

The function H is called the Hamiltonian Function associated with

the given dynamic optimizations problem.
The newly introduced time dependent variable t is called the
co-state variable associated with the state variable xt .
The co-state variable t measures the change in the value of the
objective function W associated with an innitesimal change in the
dx
state variable x at time t (which is the same a change in the
dt
function or the constraint function.
If there were an exogenous tiny increment to the state variable at
time t, and if the problem were modied optimally thereafter, then
the increment in the total value of the objective would be t . Thus it
is the marginal valuation of an incremental change in the state
variable at time t
t is therefore often referred to as the shadow price of the state
variable at time t.
Pontryagins Maximum Principle gives us four rst order necessary
conditions for the optimization problem dened in (2).
These necessary conditions are also su cient if additionally the
following conditions (due to Mangasarian) hold:
the functions F and f are concave in (u, x );
t = 0 for all t whenever f is nonlinear in either u or x.
The rst three F.O.N.Cs are dened in terms of the Hamiltonian
function.
Note that if the Hamiltonian function is non-linear in u, then (1) can
be replaced by the condition
H
= 0,
u (u t ,xt ,,t )
provided the second order check is veried.

The last condition of the Maximum Principle, which species a
terminal condition for t , is called the Transversality Condition.
Sometimes depending on the specication of the problem the

transversality condition may change.
In the above problem we are given an initial condition about the state
state variable, but nothing has be specied about the terminal value
of the state. This type of problems are called problems with a free
terminal state, and the relevant transversality condition for this set
of problems are given by (4).
Alternatively you may have an optimization problem where not only
the initial state value, but the terminal value of the state is also
given: xT = x (given).
This is a problem with a xed terminal state. In this case the rst
three F.O.N.C.s will again be given by (1) (3). Only condition (4)
will be replaced by a new transversality condition now, given by
xT = x.


Yet another type of problem species a terminal condition on the

state variable in the form of an inequality. These are problems with a
truncated vertical terminal line. : xT = x (given).
In this case once again the rst three F.O.N.C.s will again be given by
(1) (3). But condition (4) will be replaced by a new transversality
condition now, given by the following Complementray Slackness
condition:
T = 0; xT = x; T (xT x ) = 0.
When the optimal control problem is dened over innite time, all the
above conditions go through, except that now the Transversality
condition is dened as a limit condition (which is to hold as t ! ).

The R-C-K Model Revisited:
Let us now go back to the centralized version of the R-C-K model.
Recall that the social planners problem is given by:
Z
t
u (ct ) exp dt (I)
t =0
subject to
dk
= f (kt ) ( + n)kt ct ; kt = 0 for all t; k0 given.
dt
Notice that the choice set for the control variable is: ct 2 R+ .
Also the terminal condition on the state variable can be written as:
limt ! kt = 0.
Corresponding Hamiltonian Function:
t
Ht = u (ct ) exp +t [f (kt ) ( + n)kt ct ]
The Corresponding FONCs (which are also su cient in this case):
H
H is maximixed with respect to ct ) = 0 for all t; (i)
ct
2 H
verify: 2 < 0
ct
H d
= ; (ii)
kt dt
H dk
= ; (iii)
t dt
TVC: lim t kt = 0. (iv)

t !

Sometimes instead of the Hamiltonian Function, we use the
Current-value Hamiltonian Function, dened as:
H t = Ht expt
= u (ct ) + t [f (kt ) ( + n)kt ct ] ,
where t = t expt is called the Current-value co-state variable.
FONCs in terms of the Current-value Hamiltonian:
H
H is maximixed with respect to ct ) = 0 for all t; (i)
ct
H d
= + ; (ii)
kt dt
H dk
= ; (iii)
t dt
t
TVC: lim t exp kt = 0. (iv)
t !
Interpretation of the Optimality Conditions:
FONC (i):
H
= 0 ) u 0 (ct ) = t for all t
ct
implies that the marginal utility from consumption at every point of
time must be equal to the shadow price of capital (i.e., the
incremental utility associated with a unit increase in capital stock).
FONC (ii):
H d 1 d
= + t ) f 0 (kt ) n + =
kt dt t dt
implies that the netrate of return (inclusive of capital gains/losses)

on savings must be equal to the minimum compensation required to
induce people to forego a unit of current consumption for the sake of
tomorrow (i.e., the agentssubjective rate of time preference).

Interpretation of the Optimality Conditions (Contd.):
FONC (iii):
H dk dk
= ) = f (kt ) ( + n)kt ct
t dt dt
denotes the per capita budget constraint of the social planner.
Finally, the Transversality Condition:
t
lim t exp kt = 0
t !
implies that at the terminal time
if the shadow price of capital is positive, no capital stock should be left
unused (unconsumed) and the economy must end up with zero capital
stock (T > 0 ) kT = 0);
on the other hand, if some capital stock is indeed left unused then it
must be the case that the corresponding shadow price is zero (i.e.,
consuming further generates no utility value) (kT > 0 ) T = 0).
Needless to say in this innite horizon problem, the above conditions
hold in a limiting sense.
Interpretation of the Current Value Hamiltonian Function:
The Current-value Hamiltonian Function:
H t = u (ct ) + [f (kt ) ( + n )kt
t ct ]
measures the utility valuation of the per capita GDP at any point of
time t.
Note that the per capita output at any time period f (kt ) can be used
for two purposes: to be enjoyed as consumption (ct ) and to augment
dk
the capital stock .
dt
The part that is consumed generates direct utility given by u (ct ) .
That part that is used for investment generates potential future
consumption and associated with an utility valuation of t .
Thus the Current Value Hamiltonian measures the direct as well as
the indirect utility associated with the per capita output at any time
period t.
The Hamitonian (or the Present-value Hamiltonian), Ht , measures
the present discounted utility value of the per capita output at time t.
R-C-K Model (Centralized Version): Characterization of
the Optimal Path
To summarise, the optimal trajectories of ct , kt and t must satisfy
the following set of equations at every point of time t:
u 0 ( ct ) = t ; (i)
1 d
= f 0 (kt ) n ; (ii)
t dt
dk
= f (kt ) ( + n)kt ct ; (iii)
dt
t
lim t exp kt = 0. (iv)
t !
Notice that even though we have three time-dependent variables (ct ,

kt and t ), ct and t are always tied to each other by virtue of
equation (i); hence their dynamic paths are also inter-dependent.
Thus we can eliminate one of them to get a system of dierential
equations either in (ct and kt ) or in (kt and t ).
Characterization of the Optimal Path (Contd.):
Here we shall eliminate t and work with ct .

(Verify that you reach the same conclusions when you eliminate
ct and work with t instead).
Log-dierentiating (i), and using (ii):
u 00 (ct ) dc 1 d
= = f 0 (kt ) n
u 0 (ct ) dt t dt
dc ct
) = f 0 (kt ) n . (v)
dt ct u 00 (ct )
u 0 (c t)
We also know:
dk
= f (kt ) ( + n)kt ct . (iii)
dt
Equations (iii) & (v) represent a 2 2 system of dierential equations
which along with the Transversality Condition characterize the
optimal path of the economy under the centralized R-C-K model.
Intertemporal Elasticity of Substitution:
Notice that in equation (v), there is a term:
ct u 00 (ct )
( ct ) .
u 0 ( ct )
This term has multiple interpretations.
1 The most obvious interpretation is that it is the elasticity of

marginal utility with respect to consumption.
2 In choices under uncertainty, (ct ) coincides with the Arrow-Pratt
measure of relative risk aversion.
3 The (ct ) terms is also the inverse of the elasticity of
substitution between current and future consumption.

Intertemporal Elasticity of Substitution (Contd.):
Note that elasticity of substitution between consumption at date t

and consumption at date t + t is dened as
ct ct
d ct +t / ct +t
e= .
u 0 (c t ) u 0 (c t )
d u 0 (ct +t )
/ u 0 (ct +t )
It can be shown that as t ! 0, e ! 1 . (Verify this.)

It is sometimes convenient to work with utility functions where (ct )
is a constant.
Examples:
Log utility function: u (ct ) = log ct
(ct )1
CRRA utility function: u (ct ) = ; 6= 1.
1
For the time being, however, we shall work with a general utility
function where (ct ) need not be a constant.
Characterization of the Optimal Path (Contd.):
The 2 2 non-linear and autonomous system of equations for the

centralized economy are given by:
dc ct
= f 0 (kt ) n ; (v)
dt ( ct )
and
dk
= f (kt ) ( + n)kt ct . (iii)
dt
Both (iii) and (v) are non-linear dierential equations; so we have to
use phase diagram technique to qualitatively characterize the optimal
path.

R-C-K Model (Centralized Version): Steady State(s)
First let us identify the possible staedy state(s) of the dynamic system.
The steady state is now dened as pair of values (k, c ) such that
neither values change over time.
In other words, the steady states are dened by the following two
equation:
ct
f 0 (kt ) n = 0;
( ct )
f (kt ) ( + n )kt ct = 0.
Notice that (ct ) > 0. Hence from the above equations we can
identify three possbile steady states of the system:
Trivial steady state : c = 0; k = 0;
Semi-trivial steady state : c = 0; k = k such that f (k ) = + n;
Non-trivial steady state: c = c > 0; k = k > 0 such that
0
f (k ) = + n + ; c = f (k ) ( + n )k .
R-C-K Model (Centralized Version): Constrcution of the
Phase Diagram
From equation (v):
dc
T 0 according as
dt
either ct = 0 or f 0 (kt ) T + n + .
On the other hand, from equation (iii):
dk
T 0 according as
dt
ct S f (kt ) ( + n )kt .
dc dk
Now we can trace the level curves = 0 and = 0 in the (kt , ct )
dt dt
plane and draw the coresponding directional arrows to get the
corresponding phase diagram.
(How should the Phase Diagram look?)
R-C-K Model (Centralized Version): Phase Diagram

the Optimal Path (Contd.)
Notice that any pair of directional arrows in the phase diagram satisfy
(by construction) the dynamic equations (iii) and (v) and therefore
satisfy the rst three FONCs of the given dynamic optimization
problem .
Also note that k0 is given, but c0 is not. In fact our choice of c0
would generate multiple possible time paths of ct and kt - all
satisfying the rst three FONCs.
One can classify these multiple trajectories in three broad categories:
Category I: Trajectories that move towards the horizontal axis over
0) as t ! ;
time and eventually approach the point (k,
Category II: Trajectories that approach the vertical axis over time;
Category III: A unique trajectory that represents the stable arm of
the saddle point (k , c ) and approaches the non-trivial steady state
point (k , c ) over time.
Which one of these is the optimal trajectory?
Here the transversility condition comes to our rescue.
the Optimal Path (Contd.)
Recall that the TVC is part of the necessary (and su cinet)

conditions for optimality.
So among all these trajectories, the one which satises the TVC will
indeed be the optimal path. (What if there are multiple such
trajectories?)
As it turns out, only the unique trajectory belonging to Category III
(represented by the line SS 0 in the diagram) satises all the four
FONCs including the transversility condition.
We now provide heuristic arguments as to why trajectories belonging
to the other two categories cannot be optimal.

Proof that Trajectories of Type I cannot be Optimal:
Recall that the Transversality condition for the central planners

problem is specied as:
t
TVC: lim t exp kt = 0. (iv)
t !
Also noting that along the optimal path, t = u 0 (ct ), we can write
the TVC as:
TVC: lim u 0 (ct ) exp t kt = 0. (iv0)
t !
Now let us check whether trajectories belonging to Category I satisfy

condition (iv0).
Notice that along a trajectory of type I, limt ! kt = k > 0.
Hence condition (iv0 ) will be satised along these trajectories if and
only if
TVC: lim u 0 (ct ) exp t = 0. (iv00 )
t !

(Contd.)
Now along a trajectory of type I, limt ! ct = 0 which implies that
limt ! u 0 (ct ) ! .
At the same time, limt ! exp t = 0.
Thus it is not immediately clear whether condition (iv0 ) will be
satised or not.
It depends on whether in the neighbourhood of (k, 0), u 0 (ct ) is
increasing at a faster/slower rate than the rate of fall of exp t .
The exponential term exp t is of course decreasing at a constant
rate .
On the other hand, the u 0 (ct ) term is increasing at the rate
[(n + f 0 (k )) + ] .
In the neighbourhood of (k, 0), [(n + f 0 (k )) + ] > . (Why?)
0
Thus u (ct ) is increasing at a faster rate than the rate of fall of
exp t .
(Contd.)
Therefore along any trajectory of type I,
lim u 0 (ct ) exp t

! ,
t !
which violates the TVC (iv00 ).

Hence trajectories of type I cannot be optimal.

Proof that Trajectories of Type II cannot be Optimal:
The trajectories of type II approach the vertical axis over time.
If they approach the vertical axis asympototically (never actually
hitting it at any nite point of time) then indeed the TVC (iv) will be
satised and such trajectories would be optimal.
However we now argue that this is not possible. Indeed every
trajectory belonging to category II actually hit the vertical axis
within a nite point of time.
We prove this by contradiction.
Suppose, if possible, that trajectories of type II approach but do not
hit the vertical axis within nite time.
In other words, suppose, if possible, that trajectories of type II are
asymptotic either to the vertical axis or some line parallel to the
vertical axis.
If that is true then starting form any given nite initial value, k0 ,
lim kt = M (where M is a non-negative constant < k0 ).
t !

(Contd.)
Now from FONC (iii), we know that,
dk
= f (kt ) ( + n)kt ct .
dt
Therefore,
Zt
kt = k0 + [ f (k ) ( + n )k c ] d .
0
Hence
Z
lim kt = k0 + [ f (k ) ( + n )k c ] d = M.
t !
0

(Contd.)
Rearranging terms:
Z
[ c f f (k ) ( + n)k g] d = k0 M N (a nite constant).
0
We now argue that along any trajectory of type II, the integral
dened by the LHS above will diverge away to + and therefore can
never converge to nite constant N.
(Prove this yourself. Hint: A necessary condition for an innite
R da
integral I a d to converge is that < 0. Dene
0 d
a [c ff (k ) ( + n )k g] here and show that along any
trajectory of type II this necessary condition is violated.)
Hence there is a contradiction.
(Contd.)
We have just proved that any trajectory belonging to category II
cannot be asymptotic to the vertical axis; it must hit the
vertical axis within a nite period of time.
Now take any such trajectory. Can it still be optimal?
The answer is "No".
The reason is as follows:
Suppose the trajectory hits the vertical axis precisely at time T .
then exactly at time T , kt reaches zero;
Consequently, ct falls from a nite value to zero (since a positive value
of consumption cannot be sustained with zero capital stock);
This implies that precisely at time T , t jumps from a nite value to
innity.
Such a discrete jump of t violates FONC (ii) - which presupposes
continuity of t .
Hence trajectories of type II cannot be optimal.
R-C-K Model (Continuous Time): Identication of the
Optimal Trajectory
We have now seen that trejectories belonging to either category I or
category II cannot be optimal because they violate one of the FONCs
(i)-(iv).
That leaves the unique trajectory beloging to category III, which is
the stable arm of the saddle point (k , c ) and represented by the line
SS 0 in the diagram.
Along this trajectory, as t ! , ct and kt approach c and k
respectively.
It is easy to verify that this trajectory satises all the four FONCs,
including the Transversality Condition.
Hence this is the unique optimal trajectory for the social planners
problem.
Thus, given k0 , it is optimal for the social planner to choose the
corresponding c0 that lies on trajectory III and then let the economy
evolve according to the two dynamic equations (iii) & (v).
R-C-K Model (Continuous Time): Growth Implications
In the centralized version of the R-C-K model in continuous time, the

growth predictions are exactly the same as the discrete time version.
once again the economy goes to a steady state in the long run, where
per capita income becomes constant.
So there is no long run growth of per capita income; aggreagte
income in the long run grows at the constant rate n.
Thus the growth conclusions of the centralized R-C-K model are
exactly identical to that of the Solow model (without technical
progress).
Moreover, as long as > 0, k < kg , which means at steady state
economy always lies in the dynamically e cient region.

R-C-K Model (Continuous Time):Equivalence between
Planned and Market Solutions
Let us now look at the decentralized market economy solution, where
each household h undertakes a similar dynamic optimization exercis
eon its own, treating the market wages and the market returns for
capital as exogenously given.
The household at time 0 chooses its entire consumption prole

cth t =0 so as to maximise the discounted sum of its life-time utility:
Z
U0h = u cth exp t
dt; > 0,
t =0
subject to the households budget constraint in every time period.
Let us ignore intra-household borrowing here. Then household hs
budget constraint (in aggregate terms) would be given by:
dKth
Cth + Ith = wt Nth + rt Kth , where = Ith Kth .
dt
R-C-K Model (De-centralized Version): Household Side
Story
Since the population in every household is also growing at the
constant rate n, in per member terms, household hs budget
constraint becomes:
dkth
= wt + rt kth (n + )kth cth .
dt
Thus the optimization problem of the representative household h is
given by:
Z
Max.
U0h = u cth exp t
dt; > 0,
fcth gt =0 t =0
subject to
dkth
= wt + rt kth (n + )kth cth ; kth = 0 for all t = 0; k0h given,
dt
where cth is the control variable and kth is the state variable.
R-C-K Model (De-centralized Version): Household Side
Story (Contd.)
Notice that in order to solve this problem the households would have
to have some expectation about the entire time paths of wt and rt .
We shall assume that householdshave perfect foresight. So they
can correctly guess all the future values of the market wage rate and
rental rate, even though they do not know the exact values of these
variables.
To put it dierently, in their optimization exercise, the households will
treat wt and rt as exogenous, but since their guesses are always
correct, in the solution to the householdsoptimal path,we can plug
back the actual values of wt and rt .

Households Problem: FONCs in terms of Hamiltonian
The Hamiltonian Function:

h i
Ht = u cth exp t
+t wt + rt kth (n + )kth cth
Corresponding FONCs:
H
H is maximixed with respect to cth ) = 0 for all t
cth
i.e., u 0 cth exp t
= t (i)
H d
=
kth dt
d
i.e., = t [ rt n ] (ii)
dt

Households Problem: FONCs in terms of Hamiltonian
(Contd.)
H dkth
=
t dt
dah
i.e., t = wt + rt kth (n + )kth cth (iii)
dt
TVC: lim t kth = 0. (iv)

t !

Households Problem: Optimal Solutions
From FONCs (i)-(iii) of the households optimization problem we get

the following dynamic equations:
dcth cth
= [rt n ] (1)
dt (cth )
dkth
= wt + rt kth (n + )kth cth (2)
dt
When the households are identical, we can directly replace kth and cth
in equations (1) and (2) by kt and ct respectively.

De-centralized R-C-K Model: Solution Paths for the
Aggregate Economy (Contd.)
Thus,
dct ct
= [rt n ] (10 )
dt ( ct )
dkt
= wt + rkt (n + )kt ct (20 )
dt
Finally noting that in a competitive market economy:
wt = f (kt ) kt f 0 (kt ) and rt = f 0 (kt ), we get dynamics of average
consumption and per capita capita stock for the aggregate economy
as:
dct ct
= f 0 (kt ) n (3)
dt ( ct )
dkt
= f (kt ) (n + )kt ct (4)
dt
R-C-K Model: Equivalence between Centralized and
De-centralized Economy
Compare equations (3) and (4) with the dynamic equations derived
for the social planner earlier. Observe that they are exactly
identical!
This implies that even for the continuous time the R-C-K model, the
optimal trajectories for the decentralized market economy and
the centralized planning economy would be identical.
Since we have already proved that the steady state for the social
planners problem would be dynamically e cient, so would be the
steady state for the market economy.

Equivalence between Centralized and De-centralized
Economy (Contd.)
Needless to say, in deriving this strong equivalence result, we have

assumed the households are identical in every respect.
In fact with identical household allowing for intra-household borrowing
and the consequent NPG condition become superuous because one
side of the lending/borrowing market will be always missing!
A more interesting question is: will this strong equivalence result hold
even when households are heterogenous?
The answer is "yes", provided the utility function satises the CRRA
properties. (Verify yourself)

R-C-K Model in Continuous Time: References
Reference for the R-C-K Model in continuous time (Centralized

& De-centralized versions):
Barro & Sala-i-Martin, Economic Growth (2nd Edition), Chapter 2
D. Acemoglu: Introduction to Modern Economic Growth, Chapter 5.
Reference for Dynamic Optimization Technique in Continuous
Time (for students who are interested in diggging deeper in terms of
technique):
A.C. Chiang: Elements of Dynamic Optimization, Chapters 7,8 & 9
M. Kamien & N. Schwartz: Dynamic Optimization, Part II, Sections
1-9.
(The second book is more rigorous, but also more terse. Consult at
your own risk!)

Samuelson-Diamond Overlapping Generations Model
We have so far analysed optimizing savings behaviour by the
households in the context of the ininite horizon R-C-K framework.
We now turn to an alternative framework, where agents optimize over
a nite time horizon.
This framework was rst developed by Samuelson (1958) in the
context of an exchange economy, which was later extended to a
production economy by Peter Diamond (1965).
Each agent now lives exactly for T periods. For convenience, we shall
assume that T = 2.
We shall denote these two periods of an agents life time by youth
and old-agerespectively.
The agent works only in the rst period of his life (when young) and
is retired in the second period (when old).
Thus he has to make provisions for his old-age consumption from his
rst period wage income itself (through savings).
The agent optimally decides about his consumption prole by
maximizing his life-time utility (to be specied later).
OLG Model: Production Side Story
Once again, the production side story in the OLG model is identical
to that of Solow.
Thus the economy starts with a given stock of capital (Kt ) and a
given stock of labour force (Nt ) at time t.
Notice that since people do not work during their oldage, the current
labour force consist only of the current youth.
We also assume that all rms have access to an identical production
technology - which satises all standard neoclassical properties.
The rm-specic production functions can be aggregated to generate
an aggregate production function such that :
Yt = F (Kt , Nt ).
At every point of time the market clearing wage rate and the rental
rate of capital are given by:
wt = FN (Kt , Nt ); rt = FK (Kt , Nt ).
OLG Model: Household Side Story
There are H households or dynasties in the economy. In every
household, at any point of time t, there are two cohorts of agents -
those who are born in period t (generation t- who are currently
young) and those who were born in the previous period (generation
t 1- who are currently old): hence the name overlapping
generations.
Thus at any point of time t, total population consists of two
successive generations of people:
Lt = Nt + Nt 1.
(Notice that although total population is Lt , total labour force at

time t in only Nt .)
We shall assume that population in successive generations grows at a
constant rate n :
Nt +1 = (1 + n )Nt .
Hence total population in the economy (Lt ) also grows at the same
constant rate n.
Life Cycle of a Representative Member of Generation t:
All agents within a generation are identical. So we can talk in terms

of a representative agent belonging to generation t.
The agent is born at the beginning of period t with an endowment of
one unit of labour.
All agents in this model are selsh - they care only about their own
consumption/utility and not about their childrensutility. Hence they
do not leave any bequest.
No bequest implies that the young agent has only labour endowment
and no capital endowment.
The young agent in period t supplies his labour inelastically to the
labour market in period t to earn a wage income wt .
Out of this wage income, the agent consumes a part and saves the
rest - which becomes his capital stock in the next period and allows
him to earn a rental income in the next period.

Timeline of Events:

Representative Agents Utility Function:
Notice that since the agent would not be working in the next period,
the savings and the consequent ownership of capital is the only source
of income for him in the next period.
Thus an agent is a worker in the rst period of his life and becomes a
capitalist (capital-owner) in the second period of his life.
The young agent in period t optimally decides on his current
consumption (ct1 ) and current savings (st ) (or equivalently, his current
(period 1) consumption (ct1 ) and future (period 2) consumption (ct2 ))
so as to maximise his lifetime utility:
U (ct1 , ct2 ) u (ct1 ) + u (ct2 ); 0 < < 1, (3)
where u 0 > 0; u 00 < 0; lim u 0 (c ) = ; lim u 0 (c ) = 0.

c !0 c !
is the standard discount factor, which can be thought of as
1
where represents the pure rate of time preference.
1+
Representative Agents Budget Constraints:
The rst period budget constraint of the agent:
ct1 + st = wt .
The second period budget constraint of the agent:
ct2 = (1 + rte+1 ) st .
Combining, we get the life-time budget constraint of the agent as:
ct2
ct1 + = wt . (4)
(1 + rte+1 )
The agent decides on his optimal consumption in the two periods by
maximising (1) subject to (2).
Since the agent is taking his savings decision in the rst period, when
second periods market interest rate is not yet known, he must
optimize on the basis of some expected value of the rt +1 .
As before, we shall assume that agents have perfect
foresight/rational expectations such that rte+1 = rt +1 for all t.
Representative Agents Optimal Consumption & Savings:
From the FONC of the optimization exercise:
u 0 (ct1 )
= (1 + rt +1 ). (5)
u 0 (ct2 )
From the FONC and the life-time budget constraint, we can derive
the optimal solutions as:
ct1 = (wt , rt +1 );
ct2 = (wt , rt +1 ).
Corresponding optimal savings:
st = wt (wt , rt +1 ) (wt , rt +1 ).
Before we proceed further, it is useful to note the signs of the partial

derivatives sw and sr .
Representative Agents Optimal Consumption & Savings
(Contd.):
Notice that
(wt , rt +1 ) (wt , rt +1 ) ct1
sw =1 =1 .
wt wt wt
From the life-time budget constraint of the agent:
ct1 1 ct2
+ = 1.
wt (1 + rt +1 ) wt
Under the assumption that both ct1 and ct2 are normal goods, a unit
increase in the wage rate wt ceteris paribus must increase both ct1
c 1 c 2
and ct2+1 . Thus 0 < t , t < 1.
wt wt
This in turn implies that
0 < sw < 1.
(Contd.):
The sign of sr however is ambiguous.

Notice that
(wt , rt +1 ) (wt , rt +1 ) ct1
sr = = .
rt +1 rt +1 rt +1
So the sign of sr depends on how rst period consumption responds

to a unit change in rt +1 .
1
Recall however that is the relative price of ct2+1 in terms
1 + rt +1
of ct1 .
Thus a unit increase in rt +1 ceteris paribus reduces the relative price
of future consumption in terms of current consumption.

(Contd.):
Any such price change will be associated with two eects:
a substitution eect () consumption should move in favour of the
relatively cheaper good);
an income eect () the budget set of the consumer expands, which
increases consumption of both goods)
Thus due to an increase in rt +1 ceteris paribus
ct1 should decrease due to the substitution eect, while
ct1 should increase due to the income eect of a price change.
ct1
The sign of depends on which eect dominates.
rt +1
This in turn implies that
sr R 0
according as, substitution eect R income eect.
Aggregate Consumption & Savings:
Let us now turn our attention to the aggregate economy.

Recall that in every period the total output is distributed as wage
income and capital income:
Yt = wt Nt + rt Kt . (6)
The entire wage income goes to the current young generation. Each
of them saves a part of the wage income (st ) and consume the rest.
Thus,
wt Nt = ct1 Nt + st Nt .
On the other hand, the entire interest income goes to the current old
generation. Each of them consume not only the interest earnings but
the left over capital stock as well. Thus,
ct2 1 Nt 1 = rt Kt + (1 )Kt .

Aggregate Consumption & Savings (Contd.):
Thus aggregate consumption in this economy at time t :
Ct = ct1 Nt + ct2 1 Nt 1
= [wt Nt st Nt ] + [rt Kt + (1 )Kt ]
= wt Nt + rt Kt [st Nt (1 )Kt ] (7)
| {z }
St
Notice that aggregate savings St has two components:

1 The positive savings by the young (st Nt );
2 The negative savings by the old ( (1 )Kt ).
As before, from the demand-supply equality for the aggregate
economy:
Ct + I t = Yt , where It Kt +1 (1 )Kt
) Kt +1 = st Nt .

Dynamics of Capital-Labour Ratio:
Since we know that labour force in this economy is growing at the
rate n, i.e., Nt +1 = (1 + n )Nt , we can derive the dynamic of
capital-labour ratio (kt ) as:
st (wt , rt +1 )
kt +1 = = . (8)
(1 + n ) (1 + n )
Again, from the production side of the story, we already know that
wt = f (kt ) kt f 0 (kt );
rt + 1 = f 0 (kt +1 ).
Thus we can write (4) as:
(wt (kt ), rt +1 (kt +1 ))
kt +1 = = (kt , kt +1 ). (9)
(1 + n )
Equation (7) is the basic dynamic equation of the OLG model, which
implicitly denes kt +1 as a function of kt . Given k0 , we should be able
to trace the evolution of the capital-labour ratio over time.
Existence of a Unique Perfect Foresight path:
Let us look at dynamic equation (7). Notice that it is an implicit

dierence equation with kt +1 entering on both sides.
In fact this implicit nature of the function arises precisely due to
assumption of perfect foresight. (Verify that with static expectation
the dierence equation is explicit and well-dened).
The implicit function on the RHS poses a problem: for every kt do we
neceassrily get a unique kt +1 that satisfy the dynamic equation (7)?
In other words, for any given initial value of k0 , does a unique
perfect foresight path exist?
Notice that uniqueness is important because otherwise the future
trajectory of the economy will become indeterminate.

Existence of a Unique Perfect Foresight Path (Contd.):
from (7) we shall have a
Notice that for any given value of kt ,say k,
unique solution for kt +1 if and only if the curve representing
(k, kt +1 ) has a unique point of intersection with the 45o line in the
positive quadrant.
A su cient condition for this to happen is (k, kt +1 ) is either a at
line or is downward sloping with respect to kt +1 , i.e.,
kt +1 )
(k,
5 0 for all k 2 (0, ).
kt +1

Existence of a Unique Perfect Foresight Path (Contd.):
Notice that
kt + 1 )
(k, 1 (wt , rt +1 )
=
kt +1 (1 + n ) kt +1
1 (wt , rt +1 ) drt +1
=
(1 + n ) rt +1 dkt +1
1
= sr f 00 (kt +1 ).
(1 + n )
Thus a su cient condition for the existence of a unique perfect
foresight path is: sr = 0.
Henceforth we shall assume that this condition is satised (i.e., the
utility function is such that the substitution eect of price change
dominates the income eect).

Dynamics of Capital-Labour Ratio (Contd.):
Having established that the dierence equation given by (7) is
well-dened, let us now characterise the evolution of kt over time.
Since (kt , kt +1 ) is a nonlinear function of kt and kt +1 , we shall
have to use the phase diagram technique to qualitatively characterise
the dynamics.
In drawing the phase diagram, rst note that the slope of the phase
line can be determined by total dientiating (7):
dwt drt +1
(1 + n)dkt +1 = sw dkt + sr dkt +1
dkt dkt +1
dkt +1 sw [ kt f 00 (kt )]
i.e., = .
dkt (1 + n) sr f 00 (kt +1 )
Under the assumption that sr = 0, the slope of the phase line is
necessarily positive.
But even when the slope is positive, the curvature is not necessarily
concave - since it would involve the third derivative of the utility
function and the f (k ) function - whose signs are not known.
Dynamics of Capital-Labour Ratio (Contd.):
Hence anything is possible: we may have situations of no steady
state; unique stable steady state; unique unstable steady state;
multiple steady states (some stable, some unstable).

Stability & Dynamic E ciency in the OLG Model:
In other words, the nice result of the Solow model of a unique and
globally stable steady state is no longer gauranteed - despite the
production function satifying all the standard neoclassical
properties - including diminishing returns and the Inada
conditions!
What about dynamic e ciency?
Even that is not gauranteed any more!
Below we provide an example - with specic functional forms - to
show that dynamic e ciency is not necessarily gauranteed under the
OLG model - despite optimizing savings behaviour by the agents.

Golden Rule & Dynamic E ciency in the OLG Model:
Before we turn to the specic functional forms, let us rst dene the
golden rule in the context of the OLG model.
As before let us dene the golden ruleas that particular steady state
which maximises the steady state level of per capita (average)
consumption.
Notice however that now there are two sets of people at any point of
time t - current young (Nt ) and current old (Nt 1 ).
Hence per capita (average) consumption at any point of time t would
be dened as:
ct1 Nt + ct2 1 Nt 1 ct1 Nt + ct2 1 Nt 1 (1 + n)ct1 + ct2 1
ct = = = .
Lt Nt + Nt 1 1 + (1 + n )
In other words, the per capita consumption in period t is the

weighted average of the consumption of the current young and that
of the current old.
Characterization of the Steady State in OLG Model:
So what would be the steady state value of per capita consumption?
Recall that the basic dynamic equation is the OLG model is given by:
st (w (kt ), r (kt +1 ))
kt +1 = =
(1 + n ) (1 + n )
Accordingly, the steady state(s) of the OLG model is dened as:
s (w (k ), r (k ))
k = =
(1 + n ) (1 + n )
) s = (1 + n )k (10)
On the other hand, from the optimal solutions of c 1 and c 2 , we know

that at steady state:
c1 = (w (k ), r (k )) = w (k ) s ; (11)
2
c = (w (k ), r (k )) = [1 + r (k ) ] s . (12)

Steady State Per Capita Consumption in the OLG Model:
Hence from (1), (2) & (3) steady state per capita consumption:
(1 + n ) c 1 + c 2
c =
1 + (1 + n )
(1 + n) [w (k ) s ] + [(1 + r (k ) )] s
=
1 + (1 + n )
(1 + n)w (k ) + [r (k ) n)] s
=
1 + (1 + n )
(1 + n) [fw (k ) + r (k )k g (n + )k ]
=
1 + (1 + n )
1+n
= [f (k ) (n + )k ] .
1 + (1 + n )
Maximizing c with respect to k , we would still get the golden rule
condition as:
kg : f 0 (k ) = (n + )
Alternative Denition of Golden Rule:
An alternative denition of the golden rulein the context of the
OLG model can be as follows: it is that particular steady state which
maximises the steady state level of utility of any agent.
When the economy is at a steady state both w and r become
constants. Thus for any agent belonging to any generation (t 1 or t
or t + 1), the life-time consumption prole look exactly the same:
ct1 1 = ct1 = ct1+1 = (w (k ), r (k )) c1 ;
ct2 = ct2+1 = ct2+2 = (w (k ), r (k )) c 2
.
Hence steady state utility of any generation is given by:
U( c1 , c2 ) u( c 1 ) + u ( c 2 ).
It is easy to check that the k that maximises U ( c 1 , c2 ) is still
given by:
kg : f 0 (k ) = (n + ).
Thus the two denitions of the golden rule are equivalent. (Verify.)
OLG Model with Specic Functional Forms:
Let us now assume specic functional forms.

Let
U (ct1 , ct2 ) log ct1 + log ct2 ;
f (kt ) = (kt ) ; 0 < < 1.
Also let the rate of depreciation be 100%, i.e., = 1.
Thus the life-time budget constraint of the representative agent of
generation t is given by:
ct2
ct1 + = wt .
rt +1
The corresponding FONC:
ct2
= rt +1 . (13)
ct1

OLG Model: Specic Functional Forms (Contd.)
From the FONC and the life-time budget constraint, we can derive
the optimal solutions as:
1
ct1 = wt ;
1+

st = wt ;
1+
1
ct2 = rt +1 wt .
1+
Corresponding dynamic equation:
st 1
kt +1 = = wt .
(1 + n ) 1+n 1+
Finally, given the production function,
wt = (1 ) (kt )
OLG Model: Dynamics with Specic Functional Forms
Thus the dynamics of this specic case is simple:
1
kt +1 = (1 ) (kt ) .
1+n 1+
It is easy to see that the above phase line will generate a unique
non-trivial steady state which is globally stable.
The corresponding steady state solution is dened as:
1
k = (1 ) (k )
1+n 1+
1
1 1
i.e., k = (1 ) .
1+n 1+
Is this steady state dynamically e cient? Not necessarily!

OLG Model: Dynamic Ine ciency
Notice that given the specic functional form, the golden rulevalue
of the capital-labour ratio can be derived as:
kg : f 0 (k ) = (n + )
1
i.e., kg : (k ) = 1+n
1
1
i.e., kg = .
1+n
It is easy to verify that the steady state under this specic example
will be dynamically ine cient whenever

> .
1+ 1
1 1
Example: = ; = .
2 5
Reason for Dynamic Ine ciency in the OLG Model:
Thus we see that dynamic ine ciency may arise in the OLG model -
despite optimizing savings behaviour by households.
This apparently paradoxical result stems from the fact that agents are
selshin the OLG model; they do not care for their childrens
utility/consumption.
Thus when they optimise they equate the MRS with (the discounted
value of) the actual future return (rt +1 + 1 ):
u 0 (ct1 )
= ( rt + 1 + 1 ).
u 0 (ct2 )
Now notice that

u 0 ct1
T 1 ) u 0 ct1 T u 0 ct2 ) ct1 S ct2 .
u 0 (ct2 )

Reason for Dynamic Ine ciency in OLG Model (Contd.)
This implies that in the OLG framework, ct1 S ct1 i.e, consumption of
generation t would rise, fall or remain unchanged over time if the
corresponding (future) return, measured by (rt +1 + 1 ) is greater,
1
equal to or less than the subjective cost (1 + ), ie. according as

rt +1 R .
Recall that in the R-C-K model the corresponding equation was given
by:
dc ct
= [ rt n ] .
dt ( ct )
dc
Thus in the R-C-K framework, R 0 i.e, consumption would rise,
dt
fall or remain unchanged over time if the corresponding
population-adjusted (future) return, measured by (rt n ) is
greater, equal to or less than the subjective cost measured by .
Reason for Dynamic Ine ciency in OLG Model (Contd.)
Notice that both in the OLG model and the R-C-K model, households
will stop saving whenever their percieved return is less than the
subjective cost .
But due to presence of intergenerational altrauism, in the R-C-K
model the percieved return is adjusted for popultion growth and is
given by r n, whereas in the OLG model this return is just r
This implies that in the R-C-K model households will necessarily stop
saving when the (net) marginal product has fallen below the
population growth rate (rt n < 0).
But there is no reason why in the OLG model, households would stop
saving in this scenario, because even though the net gross marginal
product (rt +1 ) has fallen below n - it might still greater than the
subjective cost .
Thus there is a tendency to oversave (compared to the R-C-K model),
which persists even when the economy has moved into a dynamically
ine cient region (i.e., rt +1 < + n ).
Dynamic Ine ciency & Scope for Government Intervention
in the OLG Model:
Since under the OLG framework, the steady state of the decentralized
market economy may be dynamically ine cient (despite rational
expectations on part of the agents), this again justies a role of
government in improving e ciency.
Thus the conclusions of the OLG model are diametrically opposite of
that of the R-C-K model - even though both are based on strictly
neoclassical production function and optimizing agents.
The dierence arises primarily due to the absence of parental altruism
in the OLG framework.
It can be shown that if we introduce parental altruism in the OLG
model (by incorporating a bequest term that each parent leaves to his
child at the end of his life time), then the OLG framework will be very
similar to the R-C-K framework.

OLG Model: Summary
Even though the production function is Neoclassical in the OLG

model, the strong stability result of Solow (as well as R-C-K model)
does not hold:
a steady state may not exists;
even if it exists it may not be unique;
even if it is unique, it may not be stable.
So the growth conclusions of the Solow model do not hold either.
Moreover the dynamic ine ciency problem may reappear here- even
though each agent is optimally determining his savings behaviour.
Thus in this model there is scope for government intervention in
terms of improving e ciency.
Since the OLG model does not obey the growth properties of the
Solow/R-C-K model, we do not identify this structure with the
Neoclassical Growth Model" (even though the production structure
here is identical to Solow/R-C-K).
References:
Reference for the OLG Model:

D. Acemoglu: Introduction to Modern Economic Growth, Chapter 9,
Sections 9.2,9.3, 9.4 (Pages 329-339).
O.Galor & H. Ryder (1989): "Existence, uniqueness, and stability of
equilibrium in an overlapping-generations model with productive
capital,", Journal of Economic Theory, pp.360375.

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202: Dynamic Macroeconomics

Two Basic Dynamic Macro Frameworks: Innite Horizon & OLG

Delhi School of Economics

Das (Delhi School of Economics) Dynamic Macro July-August, 2016 1 / 90

All models that we shall consider in this course would entail a

Das (Delhi School of Economics) Dynamic Macro July-August, 2016 2 / 90

There are H identical households indexed by h.

In every time period, the instantaneous utility of the household

ut = u cth ; u 0 > 0; u 00 < 0; lim u 0 (c h ) = ; lim u 0 (c h ) = 0.

The household at time 0 chooses its entire consumption prole

subject to the households budget constraint in every time period.

Notice that the objective function of the household is an integral

1. One interpretation of the above ininte horizon utility function is that

2. Another interpretation of the discount rate follows if we read the

To understand the idea better, suppose each member of the

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By this denition then, utlity of an agent belonging to genertaion t :

3. A third interpretation of the discount rate follows if we allow each

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Thus beginning at time 0, the expected life-time utility of the agent

U0 = u (ct ) + pu (ct +1 ) + p 2 u (ct +2 ) + ........

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The social planner maximises (1) subject to the planners budget

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Consider the following optimization problem which is dened over a

The objective function here is an integral, and our task is to nd out

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ut is called the control variable because we choosing its value directly.

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Let ut be a solution path to the problem specied in (2), and let xt

H (u, x, , t ) F (ut , xt , t ) + t g (ut , xt , t ) ,

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The function H is called the Hamiltonian Function associated with

provided the second order check is veried.

Sometimes depending on the specication of the problem the

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Yet another type of problem species a terminal condition on the

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The Corresponding FONCs (which are also su cient in this case):

TVC: lim t kt = 0. (iv)

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implies that the netrate of return (inclusive of capital gains/losses)

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Notice that even though we have three time-dependent variables (ct ,

Here we shall eliminate t and work with ct .

Notice that in equation (v), there is a term:

This term has multiple interpretations.

1 The most obvious interpretation is that it is the elasticity of

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Note that elasticity of substitution between consumption at date t

It can be shown that as t ! 0, e ! 1 . (Verify this.)

The 2 2 non-linear and autonomous system of equations for the

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Recall that the TVC is part of the necessary (and su cinet)

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Recall that the Transversality condition for the central planners

Now let us check whether trajectories belonging to Category I satisfy