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1
X
, t (1 + n)t u(ct )
t=0
subject to
Kt+1 # Kt = F (Kt ; Nt ) # Nt ct # .Kt ; Kt $ 0; K0 given.
Alternatively, we can express the constraints in the intensive form
kt+1 =
1
[f (kt ) + (1 # .)kt # ct ] ; kt $ 0; k0 given,
1+n
subject to
kt+1 =
T
X
, t (1 + n)t u(ct )
t=0
1
[f (kt ) + (1 # .)kt # ct ] ; (1 + n)kT +1 $ 0; k0 given.
1+n
Here, kT +1 is the capital left over after consumption in the last period, period
T; and it is dened as kT +1 = KT +1 =(1 + n)NT (since T is the last period
(1)
(2)
(4)
What is the intuition? The basic idea is that, if the consumption path is
optimal, the initial planner must be indierent between the two alternatives:
1. Consume a unit of output today, reaping the utility gain u0 (ct ):
2. Invest the output in capital instead, but consume the proceeds (including what is left of the initial amount invested) tomorrow. The proceeds
are 1 + f 0 (kt+1 ) # ., and their marginal utility value from the standpoint of date t is the product of (a) the discount factor ,(1 + n) and
(b) the marginal utility reaped by each member of generation t + 1,
u0 (ct+1 )=(1 + n): Thus, the marginal gain from this second alternative
is , [1 + f 0 (kt+1 ) # .] u0 (ct+1 ); the right-hand side of (4) above.
For the nite horizon problem, this equation completely determines the
optimal consumption/accumulation path, together with the initial condition
that k0 is given and the terminal condition that kT +1 = 0 (for optimality, all
capital is eaten when the economy ends).
Formally, if we stare at the two equations
u0 (ct ) = , [1 + f 0 (kt+1 ) # .] u0 (ct+1 );
(5)
1
[f (kt ) + (1 # .)kt # ct ] ;
1+n
and rewrite them (after some substitution) in the equivalent form
"
#
0
u
(c
)
t
#
$ 1
%
& ;
ct+1 = u0!1
0
, 1 + f 1+n [f (kt ) + (1 # .)kt # ct ] # .
kt+1 =
1
[f (kt ) + (1 # .)kt # ct ] ;
1+n
where u0!1 is the inverse of the function u0 (c), then we have a system of two
(generally nonlinear) dierence equations of the form
kt+1 =
ct+1 = /(ct ; kt );
kt+1 = 0(ct ; kt ):
(6)
c1! "
u(c) =
; 6 > 0,
1 # %1
where 6 is the elasticity of intertemporal substitution, then u0 (c) = c!1=% and
u0!1 (x) = x!% .
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In the preceding system (6), k is predetermined by the past history of accumulation, whereas c is a freely-chosen control variable. This type of system
is absolutely omnipresent in macroeconomics. In general, there are innitely
many solutions to the two preceding equations the family of solutions contains two free parameters but the two boundary conditions that k0 is given
and that kT +1 = 0 suce to yield the unique economically-relevant solution.
That is, k0 is a given explicitly and c0 is given implicitly by the condition
that, starting at (c0 ; k0 ), the equations in (6) land the economy at kT +1 = 0
in the nal period. In contrast, the Solow model could be reduced to a single
dierence (or dierential) equation in k with k0 providing the one boundary
condition needed to pin down the relevant solution path.
Innite-Horizon Case
The economys dynamic behavior in the innite horizon case is still governed by the equations in (5). Also, the predetermined variable k0 still provides one boundary condition for the system. But with an innite horizon
there clearly is no terminal condition on capital in the same simple sense
as in a nite-horizon economy.
The relevant terminal condition for the innite-horizon case, just as in
the nite-horizon case, can be derived, however, from eq. (3). Passing to the
limit, the latter condition becomes the transversality condition,
lim , T (1 + n)T u0 (cT )kT +1 = 0:
T !1
(7)
More detailed discussion of the necessity of this condition can be found elsewhere, for example, in the back of Barro and Sala-i-Martin or in the book
by Weitzman (op. cit.). Important point: While the nite-horizon version of
(7) normally implies that k = 0 when the economy ends, (7) itself assumes
that there is no end of time and therefore there is no implication that k ! 0
asymptotically in the innite-horizon case. More typically, c and k will both
converge to some steady values c1 and k1 in equilibrium, but (7) will hold true
nonetheless because ,(1 + n) < 1. (As we shall see, however, (7) can hold
also when no steady state exists.)
The intuition is also given by David Romer in his text. Imagine a path
along which consumption is falling and k is therefore growing very large.
Along such a path the product u0 (c)k would grow rapidly, probably causing
the limit in the last equation to be positive. Such a path could not be optimal,
however, because the economy is accumulating excessive hoards of capital,
5
0
'
1+n
)(
ct
kt
(8)
y~t+1 = X !1 M X y~t = 4~
yt :
This (vector) dierence equation is easy to solve as
y~t+1 = 4t+1 y~0 ;
where y~0 is an initial condition for the vector y~. We can then retrieve the
solution for y itself via the linear transformation
yt+1 = X4t+1 y~0 = X4t+1 X !1 y0 :
Finding a matrix X such that M X = X4 is standard linear algebra.
There are many such matrices, and all we need is one so lets restrict our
7
1
#9 ,+
1+n
Di +
,92
= 0:
1+n
and
1
9
x1i +
= D i:
1+n
1+n
For D 1 = 9,; the rst of the last two equations above is uninformative (it
holds for any x11 ), but the second requires that
#
x11 = 9 # (1 + n)9,:
For D 2 = 9=(1 + n), however, the rst of the two preceding equations dening
eigenvectors holds only for x12 = 0, whereas the second equation reduces to
the true relationship D 2 = 9=(1 + n) in that case. As a result, a viable matrix
X is given by
(
)
9 [1 # (1 + n),] 0
X=
:
1
1
We are almost there. Recall that we now want to transform the original
system by X !1 ; where
(
)
1
1
0
!1
X
=
9 [1 # (1 + n),] #1 9 [1 # (1 + n),]
"
#
1
0
'[1!(1+n))]
=
:
1
# '[1!(1+n))]
1
Thus,
X
giving us
!1
ct+1
kt+1
c~t+1
~
kt+1
=4
c~t
~
kt
(10)
Some of the roots could be complex. These give rise to oscillatory behavior.
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