Lecture 2

Dynamic Equilibrium Models : Finite Periods

1. Introduction

In macroeconomics, we study the behavior of economy-wide aggregates – e.g. GDP,

savings, investment, employment and so on - and their interrelations. The behavior of
aggregates and their interrelations are results of decisions and interactions of consumers
and firms in different markets – goods market, labor market, and asset market. In addition,
most of the issues in macroeconomics are inherently dynamic. In growth we are concerned
with behavior of output, investment, and consumption over long run. Business cycle
relates to short-run movements in a number of variables e.g. GDP, employment, real
wage, inflation, investment. Savings involve foregoing current consumption for the sake
of higher future consumption. Investment decision requires comparison of current costs
with expected future returns. Thus in macroeconomics, we are concerned with behavior
of agents across time and markets i.e. macroeconomics is about dynamics and general
equilibrium.
In order to analyze macroeconomics issues, we need a framework which can handle
both general equilibrium and dynamics. Dynamic general equilibrium (DGE) mod-
els provide one such framework. These models ensure that aggregate or economy-wide
variables are consistent with the decisions and interactions of individual agents, and the
decisions of individual agents are optimal given aggregate variables and other parameters.
In this lecture, we will develop a basic framework of these models and study some of
its applications. DGE models generally have following building blocks:

(1) Description of the Economy/ Environment: This section gives details about
number and types of goods and agents, preferences (objective functions) of agents,
their endowments, technology, structure of markets, trading processes, information
structure, timing of events, time period, and sources of shocks. It is extremely impor-
tant to clearly describe the economy. Basically this section lays out the structure of
the economy and all the assumptions a modeler makes.
(2) Optimal Decisions of Agents: This section analyzes optimal behavior of agents
subject to given constraints e.g. consumers maximize utility subject to their budget
constraint, firms maximize profit. This is partial equilibrium analysis. At this stage,
it is very important to differentiate between what variables are choice variables of the
agents and what variables they take as given.
There are two types of variables - endogenous variables and exogenous variables.
Endogenous variables are variables whose solution we are seeking. Exogenous vari-
ables are variables given from outside. Endogenous variables are also of two types :
(i) individual choice variables, which individual agents choose; and (ii) aggregate or
economy-wide endogenous variables, which are not chosen by individual agents, but
are the outcomes of their interactions. For example, in the competitive market con-
sumption by a consumer or production by a firm is individual choice variable, but the

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 prices are aggregate endogenous variables. Individual agents while making decisions
take exogenous and aggregate endogenous variables as given.
(3) Definition of Equilibrium: This section tells us what constitutes an equilibrium.
Usually equilibrium consists of system of prices and allocations which are consistent
with optimizing behavior of agents given the market structure and feasibility con-
straints (coming from endowments, technology etc.).
(4) Solution: Ultimately, we are interested in the solutions of the model, which involves
expressing endogenous variables solely as functions of exogenous variables. The op-
timal decisions of agents together with the definition of equilibrium allow us to find
solutions of the model.

To illustrate these elements, we will solve many examples. But first we are going
to analyze some partial equilibrium models. We will assume that agents while making
decisions take market prices as given.

1. Partial Equilibrium Models

Example 1

Suppose that the utility function of a consumer is U (c1 , c2 ), where c1 and c2 are
consumption of good 1 and good 2 respectively. The utility function is an increasing
and concave function of consumption of both goods. The budget constraint faced by the
consumer is p1 c1 + p2 c2 = Y , where p1 , p2 , and Y are prices of good 1 and good 2 and
income respectively. We want to find out the optimal choices of c1 and c2 (consumption
bundle) given prices and income.
The consumer’s problem is

max U (c1 , c2 )
c1 ,c2

subject to

p1 c1 + p2 c2 = Y. (1.1)
The easiest way to solve this problem is to put the budget constraint in the utility
function (or the objective function). This way we convert the constrained optimization
problem in an unconstrained optimization problem. Then, we have
Y p1
max U (c1 , − c1 ). (1.2)
c1 p2 p2
The first order condition is
p1
U1 = U2 (1.3)
p2
which can be rewritten as

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 U1 p1
= . (1.4)
U2 p2
(1.4) equates the marginal rate substitution between the two goods to the ratio of their
prices. Using equations (1.1) and (1.4) we can derive consumption functions c1 (p1 , p2 , Y )
and c2 (p1 , p2 , Y ).
Let us take an specific example. Suppose that U (c1 , c2 ) = ln c1 + ln c2 . Then from
(1.4) we have

p1 c1 = p2 c2 . (1.5)
1 Y
Putting (1.5) in the budget constraint we have c1 = 2 p1 . Then (1.5) implies that
c2 = 12 pY2 .

Example 2

Let us take another example with the labor-leisure choice. Suppose that the utility
function of the consumer is U (c, 1 − l) where l is the amount of time worked (1 − l is the
leisure). Assume that utility function is an increasing and concave function of consumption
and leisure. Let P and W be the price of the consumption good and wage respectively.
What will be the optimal choices of consumption and leisure (labor supply) given prices?
The consumer’s problem is

max U (c, 1 − l)
c,l

subject to

P c = W l. (1.6)
Putting (1.6) in the objective function we have

max U (W l/P, 1 − l). (1.7)

l

The first order condition is

U2 W
= (1.8)
U1 P
which equates the MRS between consumption and leisure to the real wage. Using (1.6) and
(1.8) we can derive the individual demand function c(W, P ) and the labor supply function
l(W, p).

Example 3

Let us now take a two-period model where consumers face consumption-savings choi-
ces. Suppose that the utility function of a consumer is U (c1 , c2 ), where c1 and c2 are

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consumption in time period 1 and 2 respectively. The consumer can save in terms of
financial instrument at the net rate of interest r. Let Y be the income in the first period.
What will be the optimal choices of consumption and savings given the rate of interest?
The consumer’s problem is

max U (c1 , c2 )
c1 ,c2 ,s

subject to

c1 + s = Y & (1.9)

c2 = (1 + r)s (1.10)
where s is amount of saving in period 1.
By putting (1.9) and (1.10) in the objective function we have

max U (Y − s, (1 + r)s).
s

The first order condition is

U1
=1+r (1.11)
U2
which equates the MRS between consumption in two periods to the gross rate of interest.
Using (1.11) and the budget constraints, we can derive consumption functions c1 (r, Y )
and c2 (r, Y ) and savings function s(r, Y ).

Example 4

Let us modify the previous problem as follows. Suppose that the consumer also has
access to production technology which converts k units investment in period one to f (k)
units of goods in the second period. The production technology is an increasing and
concave function of k. Now the consumer faces a portfolio-choice problem. It can
enhance second period consumption by savings in the financial instrument or it can invest.
What will be the optimal portfolio?
The consumer’s problem is

max U (c1 , c2 )
c1 ,c2 ,s,k

subject to

c1 + s + k = Y & (1.12)

c2 = (1 + r)s + f (k). (1.13)

By putting (1.12) and (1.13) in the objective function we have

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 max U (Y − s − k, (1 + r)s + f (k)). (1.14)
s,k

The first order conditions are

U1
s: =1+r & (1.15)
U2
U1
k: = fk (k). (1.16)
U2
Combining (1.15) and (1.16), we have

fk (k) = 1 + r (1.17)
which equates the marginal product of capital to the gross rate of interest. Since the
consumer now has two instruments of savings, at the optimum it must be indifferent
between the two. Using (1.12)-(1.16) one can derive the consumption functions c1 (r, Y )
and c2 (r, Y ) and savings s(r, Y ) and investment functions k(r, Y ) .

Example 5

Suppose that there is a firm. The production depends on investment, k, and labor
input, l. More specifically, the production function, f (k, l) is an increasing and concave
function of investment and labor input. Let w, r, and δ be the real wage, the net rate of
interest, and the rate of depreciation respectively. What would be the optimal choices of
k and l?
The objective of the representative firms is to choose k and l in order to maximize the
profit

P R ≡ f (k, l) + (1 − δ)k − (1 + r)k − wl = f (k, l) − (δ + r)k − wl. (1.18)

The first order conditions are

M P K ≡ fk (k, l) = r + δ & (1.19)

M P L ≡ fl (k, l) = w. (1.20)
Using (1.19) and (1.20) we can derive the input demand functions k(w, r) and l(w, r).
So far we have analyzed several partial equilibrium models. Let us now turn to general
equilibrium models.

2. General Equilibrium Models

Let us begin with a two-period representative agent economy with production. By

assumption, consumers in the economy have identical preferences and identical wealth
levels.

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 Example 6

Environment

(a) Economy lasts for two periods.

(b) Single commodity.
(c) Large number (unit measure) of identical consumers and identical firms.
(d) Consumers own all firms equally.
(e) In the first period each consumer is endowed with y units of good, which they can
consume and save. They have zero endowment in the second period.
(f) The preference of the ‘representative consumer’ is given by

U = ln c1 + β ln c2 (2.1)

where ci is the consumption at time i and β ∈ (0, 1) is the discount rate.

(g) The ‘representative firm’ possesses a technology which converts k units investment in
period one to k α units of goods in the second period. Let δ be the rate of depreciation.
(h) Tradings between consumers and firms take place in a competitive market.

Consumer Optimization

Let us first state the budget constraint of the representative consumer. The first
period budget constraint is given by

c1 + s = y (2.2)
where s is the saving. The second period constraint is given by

c2 = s(1 + r) + P R (2.3)
where r is the real rate of interest (taken as given by consumers) and P R is the profit
repatriated by the representative firm to the representative consumer. We will define P R
below. We can combine (2.2) and (2.3) and get inter-temporal budget constraint of the
consumer given by

c2 PR
c1 + =y+ . (2.4)
1+r 1+r
The consumer problem is

max U = ln c1 + β ln c2 (2.5)
c1 ,c2

subject to the inter-temporal budget constraint in (2.4). Let λ be the Langrangian multi-
plier associated with (2.4), then the first order conditions are

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 1
c1 : M U1 ≡ =λ (2.6)
c1

β λ
c2 : M U2 ≡ = . (2.7)
c2 1+r
Combining (2.6) and (2.7), we have

M U1 dc2 c2
≡ M RS ≡ − ≡ =1+r (2.8)
M U2 dc1 βc1
where MRS is the marginal rate of substitution. (2.8) together with the budget constraint
gives the consumption functions:
· ¸
1 PR
c1 = y+ (2.9)
1+β 1+r
· ¸
β(1 + r) PR
c2 = y+ . (2.10)
1+β 1+r
(2.9) and (2.10) show that the current consumption is a function of the life-time income
and not only the current income. This illustrates the permanent income hypothesis.
Savings/borrowings allow a consumer to consume more or less than the current income in
a given period.

Firm Optimization

The objective of the representative firms is to choose k in order to maximize the profit

P R ≡ k α + (1 − δ)k − (1 + r)k = k α − (δ + r)k. (2.11)

To simplify the problem, we will assume that δ = 1 (100% depreciation). The first order
condition yields

M P K ≡ αk α−1 = 1 + r (2.12)

Definition of The Equilibrium

Competitive Equilibrium: A competitive equilibrium is the price (real rate of

interest) r and allocation {c1 , c2 , k} such that:
(a) consumers maximize their utilities given prices and subject to their budget con-
straints;
(b) firms maximize profits given prices and technology; and
(c) supply equals demand for each good:

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 c1 + k = y, c2 = k α . (2.13)
The last part of the definition pins down the equilibrium level of real rate of interest,
r. In order to get equilibrium allocation and prices, use (2.8), (2.12), and market clearing
condition (2.13). After some work, you can show that the equilibrium allocation and the
real rate of interest satisfy:

αβy
k= (2.14)
1 + αβ
1
c1 = y (2.15)
1 + αβ
· ¸α
αβy
c2 = (2.16)
1 + αβ
· ¸1−α
1 + αβ
r=α − 1. (2.17)
αβy

Example 7
Heterogeneity: A Model of Private Debt/Credit

In the previous example, we assumed that all agents are alike. Let us now introduce
heterogeneity. Agents can be heterogeneous in terms of their preferences, endowments,
information etc. We will consider a simple model in which agents are heterogenous in terms
of their endowment pattern. This will allows us to examine the issue of the circulation
credit and debt.
Suppose that there are two types of individuals: borrowers, with no endowment in the
first period and endowment y in the second period, and lenders with endowment y in the
first period and no endowment in the second period. With this structure of endowment,
borrowers would like to borrow in the first period while lenders would like to lend in order
to finance their consumption in the second period.
Preferences and Constraints of Lenders
Let c1,l , c2,l , and l denote the first-period consumption, second-period consumption,
and the amount of lending of a lender respectively. The first-period budget constraint for
a lender is

c1,l + l = y. (2.18)
The second-period budget constraint is

c2,l = (1 + r)l. (2.19)

The life-time budget constraint is given by

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 c2,l
c1,l + = y. (2.20)
1+r
The lender chooses c1,l , c2,l , l in order to maximize

U (c1,l , c2,l ) (2.21)

subject to its budget constraints.
Optimal Choices of Lender
Putting (2.18) and (2.19) in (2.21), we have

max U (y − l, (1 + r)l). (2.22)

l

The first order condition is

U1 (c1,l , c2,l )
= 1 + r. (2.23)
U2 (c1,l , c2,l )
(2.23) equates the marginal rate of substitution between the current and the future
consumption to the rate of interest. Using this equation, we can derive the amount lent,
l, as a function of interest rate r, l(r). Normally we assume that utility function is such
that lending, l, is an increasing function of the real interest rate, r, i.e., l1 (r) > 0. Using
(2.18), (2.19), and (2.23), we can derive c1,l , c2,l , l as a function of interest rate r.
Preferences and Constraints of Borrowers
Let c1,b , c2,b , and b denote the first-period consumption, second-period consumption,
and the amount of borrowing of a borrower. Let r be the net rate of interest. The first-
period budget constraint for a borrower is

c1,b = b. (2.24)
The second-period budget constraint is

c2,b = y − (1 + r)b. (2.25)

The life-time budget constraint is given by
c2,b y
c1,b + = . (2.26)
r 1+r
The borrower chooses c1,b , c2,b , b in order to maximize

U (c1,b , c2,b ) (2.27)

subject to its budget constraints.
Optimal Choices of Borrower
Putting (2.24) and (2.25) in (2.27), we have

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 max U (b, y − (1 + r)b). (2.28)
l

The first order condition is

U1 (c1,b , c2,b )
= 1 + r. (2.29)
U2 (c1,b , c2,b )
(2.29) equates the marginal rate of substitution between the current and the future
consumption to the real rate of interest. Using this equation, we can derive the amount
borrowed, b, as a function of the real interest rate r, b(r). Normally we assume that utility
function is such that the borrowing, b, is a decreasing function of the interest rate, r, i.e.,
b1 (r) < 0. Using (2.24), (2.25), and (2.29), we can derive c1,b , c2,b , b as a function of interest
rate r.
Note that (2.23) and (2.29) equates the MRS of lenders and borrowers:

U1 (c1,l , c2,l ) U1 (c1,b , c2,b )

= = 1 + r. (2.30)
U2 (c1,l , c2,l ) U2 (c1,b , c2,b )

Definition of The Equilibrium

Competitive Equilibrium: A competitive equilibrium is the price (real rate of

interest) r and allocations {c1,l , c2,l , c1,b , c2,b , b, & l} such that:
(a) the representative lender maximizes its utility given prices and subject to its
budget constraints;
(b) the representative borrower maximizes its utility given prices and subject to its
budget constraints; and
(c) markets clear:

c1,l + c1,b = y, c2,l + c2,b = y, & l(r) = b(r). (2.31)

The condition that l(r) = b(r) allows us to pin down the equilibrium rate of interest.
Once we have determined the equilibrium real rate of interest, we can derive the allocations
c1,l , c2,l , l, c1,b , c2,b , b, l.

3. The Social Planner Problem

For policy formulation, it is important to know whether the allocations made by the
market are efficient and maximize social welfare (in some sense). If market allocations are
not efficient or social welfare maximizing, then what are the options available to policy
makers/ government/ social planner?
In order to know whether a particular allocation is social welfare maximizing we need
to have some kind of social preference which reflects preferences of individual agents. In
general, ways to aggregate preferences of individual agents are subject to debate because of

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differing utilities. But in the case of representative agent economy, deriving social welfare
maximizing allocation is particularly simple because every agent is identical. The socially
optimal allocation maximizes the representative consumer’s utility subject to the resource
constraint. In the production economy, this allocation satisfies the condition that

M RS = M RT (3.1)
where MRT is the marginal rate of transformation given by f 0 (k) + (1 − δ).

Example 8

Let us derive the socially optimal allocation in the economy considered in example 6.

max U = ln c1 + β ln c2 (3.2)
c1 ,c2 ,k

subject to

c1 + k = y (3.3)

c2 = k α (3.4)
As is evident, the social planner problem is identical to the representative consumer prob-
lem considered in example 6. Thus, the social optimal allocations will be identical to
market allocations.
Why social optimal allocations coincide with market allocations? From microeco-
nomics, we know that socially optimal allocations are also Pareto optimal or efficient.
An allocation (in our case {c1 c2 k}) is Pareto optimal or Pareto efficient if production
and distribution cannot be reorganized to increase the utility of one or more individuals
without decreasing utility of others.
From the first and second fundamental theorems of welfare economics we
know that competitive allocations are Pareto optimal (under certain conditions) and op-
timal allocations can be supported as competitive equilibria (under more restrictive con-
ditions). Our example (actually all examples considered so far) satisfies conditions under
which fundamental theorems apply and thus market allocation coincides with social opti-
mal allocation.
In the competitive economies where the second fundamental theorem of welfare ap-
plies, usually it is easier to compute competitive equilibrium by solving the social planner
problem, rather than going through the consumers and firms optimization problem and
imposing the market clearing conditions. Steps involved in computing competitive equi-
librium through this method are as follows:
(a) Compute the socially optimal allocation.
(b) Derive the real rate of interest by equating it to either MRS or MRT and evaluating
derivatives at the optimal allocation:

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 M U1
M RS ≡ = M RT ≡ M P K = 1 + r. (3.5)
M U2

(c) Other prices such as wages can be computed by evaluating the relevant MRS at the
socially optimal allocation.

We can use the above method to compute the competitive equilibrium in economies
which satisfy conditions of second fundamental theorem of welfare. However, there are
many economies which do not satisfy these conditions. In such economies, the social
planner allocations normally diverge from the market allocations. Such divergence raises
interesting policy issues, e.g. whether policy interventions can improve market alloca-
tions. The examples of such economies are economies with distortionary taxes, imperfect
competition, increasing returns, externalities, OLG economies etc.

Example 9

Let us derive the socially optimal allocation in the economy considered in example
7. Since, there is heterogeneity we have think about how to aggregate the preferences of
lenders and borrowers i.e. aggregate the individual preferences into one social preference.
One reasonable way is to assume that the social preference is represented by the weighted
average of the individual preferences (utilitarian social welfare function). Let us
suppose that the social planner puts weight λ ∈ (0, 1) on the utility of the lender and 1 − λ
on the utility of the borrowers. Thus, the social planner maximizes

max λU (c1,l , c2,l ) + (1 − λ)U (c1,b , c2,b ) (3.6)

c1,l ,c2,l ,c1,b ,c2,b

subject to resource constraints:

c1,l + c1,b = y & (3.7)

c2,l + c2,b = y. (3.8)

Using first order conditions, you can show that

U1 (c1,l , c2,l ) U1 (c1,b , c2,b )

= (3.9)
U2 (c1,l , c2,l ) U2 (c1,b , c2,b )
just as in the market economy.

4. Uncertainty and Expectations

So far we have been dealing with economies without uncertainty. But the real world is
full of uncertainty. In this section, we introduce uncertainty in two-period economies. We
will assume that exogenous variables (technology, endowments, preferences, taxes, money
supply etc.) can take more than one values in the second period. We will also assume

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that uncertainty about the values of exogenous variables can be expressed in terms of their
probability distributions and all agents in the economy know these distributions. The
question we are going to ask is: how allocations and prices are determined in economies
in which agents face uncertainty about exogenous variables in the second period (no un-
certainty in the first period)? The DGE model with uncertainty is known as Dynamic
Stochastic General Equilibrium (DSGE) model.

Example 10

We begin with an example. Let us modify the environment example 6 by assuming

that there is uncertainty about production function in the next period. Let the new
production be Ak α where A is a random variable which can take values Ah and Al with
probabilities ph and pl respectively (ph + pl = 1). Consider h to be high state and l to be
low state in the sense that Ah > Al . We continue to assume that the depreciation rate
δ = 1. Now we want to find out allocations and prices in this economy. Before we proceed,
let us define the expectation operator E. The expected value of A is given by

E(A) = ph Ah + pl Al . (4.1)
Notice that there are two states in the second period: high state and low state.
Corresponding to these two states, there will be two consumption levels ch2 and cl2 in the
second period. Thus, in this economy the objects of interest are c1 , k, ch2 , cl2 , r. In order
to solve for these variables, let us setup the representative agent problem:

max U = ln c1 + β[ph ln ch2 + pl ln cl2 ] ≡ ln c1 + βE ln c2 (4.2)

c1 ,ch l
2 ,c2 ,k

subject to

c1 + k = y (4.3)

ch2 = Ah k α (4.4)

cl2 = Al k α . (4.5)
We have two constraints on the second period consumption corresponding to two
states. Ultimately, only one of these will end up binding. Putting the budget constraints
in the objective function, we have

max U = ln(y − k) + β[ph ln(Ah k α ) + pl ln(Al k α )] ≡ ln c1 + βE ln c2 (4.6)

k

The first order condition is given by

1 αβ
= . (4.7)
y−k k

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(4.7) is an example of the Euler equation. The solution for optimal k is
αβ
k= y (4.8)
1 + αβ
The optimal consumption plan is given by
· ¸α
1 i i αβ
c1 = y, c2 = A y for i = h, l. (4.9)
1 + αβ 1 + αβ
Now we have solved for optimal allocations. We can solve for the real rate of interests
by using M P K. The real rate of interest will satisfy

r = E(Aαk α−1 ) − 1. (4.10)

We have characterized allocations and prices for this particular example. Let us do it
for a more general case.

Example 11

Suppose that the period utility is u(c) with u0 (c) > 0 and u00 (c) < 0. The production
function is y = Af (k) with f (0) = 0, f 0 (k) > 0 and f 00 (k) < 0. Suppose that f (k) satisfies
Inada Conditions: f 0 (0) = ∞ and f 0 (∞) = 0. As before δ = 1.
The representative agent problem is

max U = u(c1 ) + β[ph u(ch2 ) + pl u(cl2 )] ≡ u(c1 ) + βE(u(c2 )) (4.11)

c1 ,ch l
2 ,c2 ,k

subject to

c1 + k = y (4.12)

ch2 = Ah f (k) (4.13)

cl2 = Al f (k). (4.14)

We can plug these constraints in the objective function (4.11) and get unconstrained max-
imization problem:

max U = u(y − k) + β[ph u(Ah f (k)) + pl u(Al f (k))] ≡ u(y − k) + βE(u(Af (k))). (4.15)
k

The first order condition satisfies

£ ¤
u0 (c1 ) = β ph u0 (ch2 )Ah f 0 (k) + pl u0 (cl2 )Al f 0 (k) . (4.16)
Using the expectation operator defined in (4.1), we can write (4.16) as

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 u0 (c1 ) = βE [u0 (c2 )Af 0 (k)] . (4.17)

Equations like (4.17) are known as Euler equation. It has straight forward inter-
pretation. At the optimal level of k, the marginal cost of k (LHS) equals the expected
marginal benefit from k (RHS). The marginal cost of investment is simply equal to the
marginal utility of consumption forgone in the current period u0 (c). What is the gain
from one unit of investment? One unit of investment produces Af 0 (k) units of goods next
period. In terms of utility this benefit is simply equal to u0 (c2 )Af 0 (k). Since, this utility
occurs next period, we need to discount it in order to make it comparable to the current
utility, and thus the expected marginal benefit from investment is given by the RHS of
(4.17). Using this Euler equation together with the resource constraints we can derive
optimal allocations. Once we get optimal allocations, using M P K we can get the real
rates of interest.

Exercise: Show that the production function y = Ak α satisfies Inada conditions. Let
u(c) = ln c. Using the Euler equation (4.17) and resource constraints show that optimal
allocations and prices satisfy (4.8), (4.9), and (4.10).

5. Government Expenditure and Ricardian Equivalence

So far, we have considered economies without government expenditure. Suppose that

there is a government which consumes quantity g1 and g2 in period 1 and 2 respectively.
It can finance its expenditure through lump-sump taxation and issuing one period bond.
Let b1 be the bond issued in period 1 and let t1 and t2 be lump sum taxes in the first and
the second period respectively. Let r be the net rate of interest.
The period budget constraints of the government are:

g1 = t1 + b1 & (5.1)

g2 = t2 − (1 + r)b1 . (5.2)

Combining (5.1) and (5.2), we can write inter-temporal budget constraint of the govern-
ment:

t2 g2
t1 + = g1 + . (5.3)
1+r 1+r
The left hand side of (5.3) is the present value of revenue of the government and the right
hand side is the present value of expenditure.
Let us now consider how government expenditure and financing of its expenditure
affects decisions of the private agents and market allocations. Let u(c1 , c2 ) be the utility
function of the representative consumer. Also suppose that the representative consumer
has endowments y1 , y2 . Now the period budget constraints for the representative consumer
are:

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 c1 = y1 − b1 − t1 & (5.4)

c2 = y2 − t2 + (1 + r)b1 . (5.5)
Combining (5.4) and (5.5), we can write inter-temporal budget constraint of the represen-
tative consumer:
c2 y2 t2
c1 + = y1 + − t1 − ≡W (5.6)
1+r 1+r 1+r
where W is the present value of his net life-time income or wealth. The left hand
side of (5.6) is the present value of expenditure of the representative consumer. The
representative consumer chooses c1 and c2 to maximize his utility subject to (5.6). Using
the maximization problem one can derive c1 and c2 as a function of W .
Note that W is just a function of taxes and endowments. It is independent of bonds,
b1 . Thus changes in b1 or deficit financing does not affect net wealth of the representative
consumer. In that sense, the government bonds are not net wealth – they signal deferred
taxes and do not affect lifetime budget constraints in the private sector. If we combine
(5.3) and (5.6), we have
c2 y2 g2
c1 + = y1 + − g1 − ≡ W. (5.7)
1+r 1+r 1+r
(5.7) shows that in equilibrium W depends on endowments and government expenditure. In
essence, in this economy the representative consumer maximizes his utility subject to (5.7).
Immediate consequence is that the mode of financing government expenditure (whether
through taxes or government bonds) does not affect market allocations and prices. Timing
of taxes and government budget deficits do not affect market allocations and prices. In
that sense, financing government expenditure through either taxes or budget deficit is
equivalent.
The result that taxes and budget deficit are equivalent ways of financing government
expenditure is known as the Ricardian Equivalence. Note that Ricardian equivalence
does not say that government expenditure does not affect market allocations and prices.
From (5.7) it is clear that any change in government expenditure affects wealth of repre-
sentative consumer and thus market allocations and prices.
The Ricardian equivalence result is quite striking. However, it depends on a number of
special assumptions such as : (i) no uncertainty (ii) lump-sum taxes (iii) no heterogeneity
and (iv) perfect capital market. If we relax these assumptions, in general, Ricardian
equivalence will not hold and timing of taxes and government budget deficits would matter.

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 Additional Exercises

(1.) Labor Supply: Suppose that the representative consumer maximizes following objective
function:

max ln c1 + ln(1 − n1 ) + β ln c2 + β ln(1 − n2 )

c1 ,n1 ,c2 ,n2

subject to
c2 w2 n2
c1 + = w1 n1 + .
1+r 1+r
The consumer takes w1 , w2 and r as given. Solve for c1 , n1 , c2 , n2 in terms of prices.
What happens to the labor supply when prices change ?

(2.) Labor Supply and Taxes: Suppose that the inter-temporal budget constraint is now
given by

c2 w2 (1 − t2 )n2
c1 + = w1 (1 − t1 )n1 +
1+r 1+r
where t1 , t2 are taxes in periods 1 and 2. Solve for c1 , n1 , c2 , n2 in terms of prices.
What happens to the labor supply when taxes change?

(3.) Suppose that the representative consumer has endowment of good y in the first period
and endowment n = 1 of labor in the second period. Suppose that the second period
production function is k α n1−α , where k is the investment made in the first period.
Suppose that the depreciation rate is 100 %. The objective function of the consumer
is

ln c1 + β ln c2 .
Define competitive equilibrium and find out equilibrium allocations and prices.

(4.) Government Expenditure: Suppose that there is a government which consumes quan-
tity {g1 , g2 }. It can finance its expenditure through through imposing lump-sum
taxes and issuing bonds. The representative consumer has endowments {y1 , y2 }. The
utility function of the representative consumer is

ln c1 + β ln c2 .
(a.) Write down the inter-temporal budget constraints of the government and the repre-
sentative consumer.
(c.) Define the competitive equilibrium.
(c.) Solve for c1 , c2 and r.
(d.) Does the Ricardian Equivalence hold in this economy?

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