2 Ramsey Model PDF

Advanced Macroeconomics
The Ramsey Model
Michal Brzoza-Brzezina/Marcin Kolasa
Warsaw School of Economics
Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 1 / 47

Introduction
Authors: Frank Ramsey (1928), David Cass (1965) and Tjalling

Koopmans (1965)
Basically the Solow model with endogenous savings - explicit
consumer optimization
Probably the most important model in contemporaneous
macroeconomics, workhorse for many areas, including business cycle
theories

Basic setup
Closed economy
No government
One homogeneous final good
Price of the final good normalized to 1 in each period (all variables
expressed in real terms)
Two types of agents in the economy:
Firms
Households
Firms and households identical: one can focus on a representative
firm and a representative household, aggregation straightforward

Firms
Final output produced by competitive firms
Neoclassical production function with Harrod neutral technological
progress
Yt = F (Kt , At Lt ) (1)
Capital and labour inputs rented from households
Technology is available for free and grows at a constant rate g > 0:
At+1 = (1 + g )At
Maximization problem of firms:
max{F (Kt , At Lt ) − Wt Lt − RK ,t Kt }
Lt ,Kt
Firms maximize their profits, taking factor prices as given

(competitive factor markets)
First order conditions:
∂F ∂F
Wt = RK ,t = = f 0 (kt ) (2)
∂Lt ∂Kt
Households I
Own production factors (capital and labour), so earn income on

renting them to firms
Labour supplied inelastically, grows at a constant rate n > 0:
Lt+1 = (1 + n)Lt
Capital is accumulated from investment It and subject to depreciation:
Kt+1 = (1 − δ)Kt + It (3)
Total income of households can be split between consumption or

savings (equal to investment):
Wt Lt + RK ,t Kt = Ct + St = Ct + It (4)
Make optimal consumption-savings decisions

Households II
Households maximize the lifetime utility of their members (present

and future):
X∞
U0 = β t u(C̃t )Lt (5)
t=0
where:
Ct
C̃t = Lt - consumption per capita
β - discount factor (0 < β < 1)
u(Ct ) - instantaneous utility from consumption:
1−θ
C̃t
u(C̃t ) = (6)
1−θ
where:
θ>0
If θ = 1 then u(C̃t ) = ln C̃t

Households III
Remarks:
Literally: household members live forever
Justification: intergenerational transfers, people care about utility of
their offspring
Discounting: households are impatient
Remarks on the utility function:
u(C̃t ) is a constant relative risk aversion function (CRRA):
C̃t u 00 (C̃t )
− =θ
u 0 (C̃t )
u(C̃t ) is a constant intertemporal elasticity of substitution function:

˜
∂ ln CC˜1 1
2
− =
u 0 (C˜1 ) θ
∂ ln u0 (C˜ )
2
CRRA form essential for balanced growth (steady state)

Households IV
Households’ optimization problem: maximize (5) subject to the
model’s constraints:
Capital law of motion (capital is the only asset held by households),
incorporating income definition and savings-investment equality (4)
Transversality condition:
t
!
Y 1
lim Kt+1 =0 (7)
t→∞
s=1
1 + rs
where: rt = RK ,t − δ = f 0 (kt ) − δ is the market rate of return on
capital (real interest rate)
Interpretation of the transversality condition:
Analog of a terminal condition in a finite horizon
Non-negativity constraint on the terminal (net present) value of assets
held by households (capital)
No-Ponzi game condition: proper lifetime budget constraint on
households
Optimization by households implies (7) holds with equality
General equilibrium
Market clearing conditions:
Output produced by firms must be equal to households’ total
spending (on consumption and investment):
Yt = Ct + It (8)
Labour supplied by households must be equal to labour input

demanded by firms
Capital supplied by households must be equal to capital input
demanded by firms
Definition of competitive equilibrium

A sequence of {Kt , Yt , Ct , It , Wt , RK ,t }∞
t=0 for a given sequence of
{Lt , At }∞
t=0 and an initial capital stock K0 , such that (i) the representative
household maximizes its utility taking the time path of factor prices
{Wt , RK ,t }∞
t=0 as given; (ii) firms maximize profits taking the time path of
factor prices as given; (iii) factor prices are such that all markets clear.
Households’ optimization problem
Lifetime utility rewritten:

∞ 1−θ
t C̃t
X
U0 = β Lt =
1−θ
t=0
∞ 1−θ
X C̃t
= L0 β̃ t (9)
1−θ
t=0
where:
β̃ = β(1 + n) β(1 + g )1−θ (1 + n) < 1
the last inequality is assumed and ensures that utility is bounded

Households’ optimization problem II
Capital accumulation rewritten in per capita terms (using (4)):
1−δ 1
K̃t+1 = K̃t + (Wt + RK ,t K̃t − C̃t ) (10)
1+n 1+n
Capital accumulation rewritten in intensive form (using (4) and
defining wt = W
At ):
t
1−δ 1
kt+1 = kt + (wt + RK ,t kt − ct ) (11)
(1 + g )(1 + n) (1 + g )(1 + n)
Transversality condition rewritten in intensive form:

t
!
Y (1 + n)(1 + g )
lim kt+1 =0 (12)
t→∞ 1 + rs
s=1

Lagrange function and FOCs
Lagrange function (normalizing L0 ):

∞ !
C̃t1−θ

X (1 − δ)K̃t + Wt + RK ,t K̃t − C̃t −
LL = β̃ t + λt
1−θ −(1 + n)K̃t+1
t=0
First order conditions (FOCs):
∂LL
= 0 =⇒ C̃t−θ = λt (13)
∂ C̃t
∂LL
= 0 =⇒ β̃λt+1 (1 − δ + RK ,t+1 )) = (1 + n)λt (14)
∂ K̃t+1

Euler equation I
Equations (13) and (14) imply:

!θ
C̃t+1 RK ,t+1 + 1 − δ
= β̃ (15)
C̃t (1 + n)
Using the definition of β̃ and rewriting in intensive form:

θ
ct+1 RK ,t+1 + 1 − δ
=β (16)
ct (1 + g )θ
For consumption per capita, using also the definition of the interest
rate rt : !θ
ct+1 At+1 θ

C̃t+1
= = β (1 + rt+1 ) (17)
C̃t ct At

Euler equation II
Interpretation of the Euler equation (17):

For θ > 0: C̃t+1 > C̃t ⇐⇒ 1 + rt+1 > β −1
Interpretation: For (per capita) consumption to grow the (market)
interest rate must exceed households’ rate of time preference
Interpretation: It is optimal for households to postpone consumption
(i.e. save in the current period and consume more in the next period)
iff the related utility loss is more than offset by the rate of return on
savings
Role of θ:
The higher θ the less responsive consumption to changes in the interest
rate
In other words: The higher θ the stronger the consumption smoothing
motive (the lower intertemporal substitution)

Equilibrium dynamics in intensive form - summary
The equilibrium dynamics of the model at any time t can be

characterized by 3 equations: (16), (11) and (12). They are (after
some rewriting and using (4) and (8) in intensive form):
θ
f 0 (kt+1 ) + 1 − δ

ct+1
=β (18)
ct (1 + g )θ
kt+1 1−δ 1 f (kt ) − ct

= + (19)
kt (1 + g )(1 + n) (1 + g )(1 + n) kt
t
!
Y (1 + n)(1 + g )
lim kt+1 =0 (20)
t→∞ f 0 (kt+1 ) + 1 − δ
s=1
At t = 0 capital is fixed. For given initial k0 and c0 , equations (18)

and (19) describe the future evolution of these variables: kt and ct .
The transversality condition (20) pins down the initial level of
consumption c0 .
Steady state equilibrium I
In the steady state equilibrium kt and ct must be constant.

Using (18) and (19), the long-run solution to the Ramsey model:
(1 + g )θ
f 0 (k ∗ ) = −1+δ (21)
β
c ∗ = f (k ∗ ) − (n + g + δ + ng )k ∗ (22)

Steady state equilibrium II
Plotting (21) and (22) in the (k, c) space:
ct ct+1=ct
c*
kt+1=kt
k* kG kt

Modified golden rule I
How do we know that k ∗ < kG ?

From (22):
f 0 (kG ) = n + g + δ + ng
The transversality condition (20) written in the steady-state:

t
(1 + n)(1 + g )
lim k ∗ =0
t→∞ f 0 (k ∗ ) + 1 − δ
This implies:
f 0 (k ∗ ) > n + g + δ + ng
Since f 00 (k) < 0 for any k > 0
f 0 (k ∗ ) > f 0 (kG ) =⇒ k ∗ < kG (23)

Modified golden rule II
Equivalently, we can show that the steady-state savings rate s ∗ falls

short of the savings rate consistent with the golden rule:
From (22), the steady-state savings rate is:
c∗ k∗
s∗ = 1 − = (n + g + δ + ng )
f (k ∗ ) f (k ∗ )
Using (23):
k∗
s ∗ < f 0 (k ∗ ) = α(k ∗ )
f (k ∗ )
Intuitive explanation: households are impatient (β < 1) and smooth
consumption (θ > 0, relevant if g > 0).

The role of the discount factor
Higher β implies more patient consumers

From (21): if β goes up, f 0 (k ∗ ) goes down, which means that k ∗
goes up
The ct+1 = ct locus on the (k, c) chart shifts right
Steady-state consumption goes up
Intuition: if households are more patient, they save more, which
brings them closer to the standard golden rule

Phase diagram
From (18): k ≶ k ∗ =⇒ ∆c ≷ 0
From (19): c ≶ f (k) − (n + g + δ + ng )k =⇒ ∆k ≷ 0
ct ct+1=ct
c*
kt+1=kt
k* kt
Saddle path (stable arm)
Transversality condition (20) pins down the inital level of c0 for any
initial k0 , so that the system converges to the steady-state:
ct ct+1=ct
c*
kt+1=kt
c0
k0 k* kt
Uniqueness of equilibrium
How do we know that the saddle path is a unique equilibrium?

If the initial level of consumption were below c0 :
capital would eventually reach its maximal level k̄ > kG
this implies:
f 0 (k̄) < f 0 (kG ) = n + g + δ + ng
which violates the transversality condition (20) since:
t
(1 + n)(1 + g )
lim k̄ =∞
t→∞ f 0 (k̄) + 1 − δ
informally (but more intuitively): at the end of their planning horizon,

households would hold very valuable assets, which cannot be optimal
If the initial level of consumption were above c0 :
capital would eventually reach 0 but consumption would stay positive,
which is clearly not feasible

Speed of convergence
Compared to the Solow model, the speed of convergence in the

Ramsey model depends additionally on the behaviour of the savings
rate along the transition path
For very small time intervals, the following implications hold (see
Barro and Sala-i-Martin, 2004, ch. 2.6.4):
1
θ < s ∗ =⇒ st − s ∗ depends positively on kt − k ∗
1
θ = s ∗ =⇒ st = s ∗
1
θ > s ∗ =⇒ st − s ∗ depends negatively on kt − k ∗
Intuition (suppose the economy starts from k0 < k ∗ , so c0 < c ∗ ):
if households care much about consumption smoothing (θ is high),
they wll try to shift consumption from the future to the present
if households care little about consumption smoothing (θ is low), they
will try to postpone consumption to reach steady-state sooner
For standard parameter values 1θ > s ∗ , so the Ramsey model predicts
relatively fast pace of convergence
Wealth and consumption
Consider the lifetime budget constraint of the household
∞ ∞
X Ct X W t Lt
C0 + = (1 + r0 )K0 + W0 L0 + ≡ Ωt
Rt Rt
t=1 t=1
where Ωt is lifetime wealth. Substitute recursively from Euler
Ct+1 1
= (β (1 + rt )) θ (1 + n)
Ct
1 1
(β (1 + r1 )) θ (1 + n) β 2 (1 + r1 ) (1 + r2 ) θ (1 + n)2
C0 +C0 +C0 +. . . = Ωt
R1 R2

Wealth and consumption cont’d
so that
" ∞ 1 #−1
X (β t Rt ) θ (1 + n)t
C0 = Ωt 1+
Rt
t=1
For log utility this boils down to
C0 = [1 − β (1 + n)] Ωt
So current consumption depends on lifetime wealth. Current income

has a small impact on current consumption!

Efficiency of equilibrium
A very important question in economics: are markets efficient?

What does it mean? If markets are efficient the equilibrium allocation
maximizes households welfare.
Then government intervention is pointless (see Adam Smith’s invisible
hand)
But we know many situations where markest fail. E.g.:
externalities
imperfect information
principal-agent problem
How about the Ramsey model?

Social planer’s problem
Imagine a social planer - allocates resources and wishes to maximize

household welfare
Constrained by technology and available resources
For simplicity consider a model without labor or technology growth
∞
X
max U0 = β t u(ct ) (24)
ct ,kt+1 ,yt
t=0
subject to
yt = f (kt )
and
ct + kt+1 = yt + (1 − δ)kt

Lagrangean and FOC
∞
X ∞
X
t
L= β u(ct ) − λt [ct + kt+1 − f (kt ) − (1 − δ)kt ] (25)
t=0 t=0
FOC:
ct : β t uc,t = λt
kt+1 : −λt + λt+1 f 0 (kt+1 ) + 1 − δ = 0

TVC (imposed) : lim λt kt+1 = 0

t→∞

Optimal allocation
The optimal alocation is given by
uc,t
= f 0 (kt+1 ) + 1 − δ
βuc,t+1
TVC : lim β t uc,t kt+1 = 0

t→∞
yt = f (kt )
ct + kt+1 = yt − (1 − δ)kt

Comparison to decentralized (competitive) equilibrium
The competitive equilibrium is given by (16), (11) and (12), which

after ignoring labor and population growth become:
uc,t
= β (RK ,t+1 + 1 − δ)
uc,t+1
kt+1 = (1 − δ) kt + (wt + RK ,t kt − ct )
t
!
Y 1
lim kt+1 =0
t→∞ 1 + rs
s=1

Competitive equilibrium cont’d
Use zero profit condition:
kt+1 = (1 − δ) kt + yt − ct
Note that
uc,t+1
= β(1 + rt+1 )
uc,t
so that
t
Y 1 βuc,1 βuc,2 βuc,t β t uc,t
= ··· =
1 + rs uc,0 uc,1 uc,t−1 uc,0
s=1
Hence TVC condition is equivalent to
lim β t uc,t kt+1 = 0

t→∞

Welfare theorems
Hence, social planner’s and competitive allocations are equal. Ramsey

economy reflects two fundamental welfare theorems.
1 First welfare theorem: every competitive equilibrium is efficient.

2 Second welfare theorem: any efficient allocation can be supported as
a competitive equilibrium (possibly with lump-sum transfers).
First states that resources are not wasted in a competitve economy

(Adam Smith would like it).
Second gives the equivalence beween an efficient and competitive
allocation and thus, the possibility to solve the (simpler) planners
problem.

The government
In modern economies governments are big players

G
Y is 40-50% (once all government expenditure is accounted for)
Some problems worth analysing:
difference/ similarity between tax and debt financing of gov.
expenditure
reaction of economy to government shocks (spending, taxes)

Ricardian equivalence
In the Ramsey model Ricardian equivalence holds:

Government plans sustainable - initial debt plus net present value of
expenditures equals net present value of revenues
∞ ∞
X Tt X Gt
T0 + = (1 + r0 )B0 + G0 +
Rt Rt
t=1 t=1
where
t
Y
Rt ≡ (1 + ri )
i=1

Ricardian equivalence cont’d
Household lifetime budget (with government)
∞ ∞ ∞
X Ct X Wt Lt X Tt
C0 + = (1 + r0 )K0 + (1 + r0 )B0 + W0 L0 + − T0 −
Rt Rt Rt
t=1 t=1 t=1
P∞ Tt
Substitute from government budget for t=1 Rt
∞ ∞ ∞
X Ct X Wt Lt X Gt
C0 + = (1 + r0 )K0 + W0 L0 + − G0 −
Rt Rt Rt
t=1 t=1 t=1
What matters for the household is the present value of expenditures

Financing expenditures with lump-sum taxes equivalent to financing
expenditures with debt
Ricardian equivalence in practice
Empirical research shows that Ricardian equivalence holds partly

Why? Some explanations can be given within our modeling
framework.
finite horizon of households
different interest rates
credit constrained households
distortionary taxes
Good to know the theoretical benchmark where Ricardian equivalence
holds
For instance to be able to construct models where gov. deficits have
macro effects

Distortionary taxation
The government is assumed to run a balanced budget each period:
Gt = Vt +τw Wt Lt +τk (RK ,t − δ) Kt +τc Ct +τi It +τf (Yt − Wt Lt − δKt )

(26)
where:
Gt - government purchases (exogenous)
τw , τk , τc , τi , τf - proportional tax rates on wage income, capital
income, consumption, investment and firms’ taxable profits,
respectively (all exogenous)
Vt - lump-sum taxes (net of lump-sum transfers) from households,
adjusted so that the balanced budget constraint (26) holds

Modified firms’ problem
Maximization problem of firms:
max{F (Kt , At Lt ) − Wt Lt − RK ,t Kt − τf (F (Kt , At Lt ) − Wt Lt − δKt )}

Lt ,Kt
First order conditions (using definition rt = RK ,t − δ):
∂F rt ∂F
Wt = +δ = = f 0 (kt )
∂Lt 1 − τf ∂Kt
Firms are competitive so earn zero profits:
Yt = Wt Lt + RK ,t Kt + τf (Yt − Wt Lt − δKt ) (27)
Market clearing on the product market:
Yt = Ct + It + Gt (28)

Modified households’ problem
We assume that government actions do not affect utility directly, so

households’ lifetime utility is still given by (5)
Households’ budget constraint (4) becomes:
Wt Lt +RK ,t Kt −τw Wt Lt −τk (RK ,t − δ) Kt −Vt = (1+τc )Ct +(1+τi )It

(29)
Note that, by (27), households’ factor income is no longer equal to
output
Modified transversality condition:
t
!
Y 1
lim Kt+1 =0 (30)
t→∞ 1 + (1 − τk )rs
s=1

Modified households’ optimization problem
Lifetime utility (identical to (9)):

∞
X C̃t1−θ
U0 = L0 β̃ t (31)
1−θ
t=0
Capital accumulation (substituting for investment from (29)):

1−δ 1
K̃t+1 = K̃t +
1+g (1 + g )(1 + τi )

(1 − τw )Wt + (1 − τk )RK ,t K̃t + τk δ K̃t
(32)
−(1 + τc )C̃t − Ṽt
Transversality condition:
t
!
Y 1+n
lim K̃t+1 =0 (33)
t→∞ 1 + (1 − τk )rs
s=1

Equilibrium dynamics
The equilibrium dynamics of the model at any time t is given by the
following equations:
Euler equation (maximizing (31), subject to (32) and using firms’
FOC):
ct+1 θ 1 + τi (1 − δ) + (1 − τk )(1 − τf )(f 0 (kt+1 ) − δ)

=β (34)
ct (1 + g )θ (1 + τi )
Capital accumulation equation (32) (merged with government budget

constraint (26) and firms’ zero profit condition (27), with gt = AGt Lt t ):
kt+1 1−δ 1 f (kt ) − ct − gt
= + (35)
kt (1 + g )(1 + n) (1 + g )(1 + n) kt
Transversality condition (33):
t
!
Y (1 + n)(1 + g )
lim kt+1 0 (k
=0 (36)
t→∞
s=1
f t+1 ) + 1 − δ

Simplified variant - only capital tax
Euler equation becomes:

θ
1 + (1 − τk )(f 0 (kt+1 ) − δ)

ct+1
=β
ct (1 + g )θ
Capital accumulation equation:
kt+1 1−δ 1 f (kt ) − ct − gt

= +
kt (1 + g )(1 + n) (1 + g )(1 + n) kt
Steady state:
(1 + g )θ − β
f 0 (k ∗ ) = +δ
β(1 − τk )
c ∗ = f (k ∗ ) − (n + g + δ + ng )k ∗ − g ∗

Simplified variant - simulate shocks
Permanent increase in government expenditure (financed with

lump-sum taxes)
Temporary increase in government expenditure (financed with
lump-sum taxes)
Permanent increase in capital tax

Conclusions from model with government
In the Ramsey model:

Ricardian equivalence holds as long as taxes are nondistortionary
Taxes on capital, investment and firm profits are distortionary (change
the equilibrium allocation)
Taxes on consumption and labor income are nondistortionary (but only
as long as labor supply is exogeneous)
Government expenditure crowds out private consumption one-to-one
but does not affect capital or output (if financed by nondistortionary
taxes)

Some simulations with the Ramsey model
Several interesting numerical simulations can be done with the

Ramsey model
find initial consumption for given k0 that fulfils the equilibrium
conditions
simulate convergence from c0 , k0 to steady state
simulate a change (temporary or permanent) of:
rate of time preference
government expenditure
capital tax

Main implications of the Ramsey model
As in the Solow model, long-run growth (of output per capita)

possible only with technological progress (exogenous in both models)
We should observe conditional, but not necessarily unconditional,
convergence (in line with the data)
Shows several important (though ratehr benchmark) features
Ricardian equivalence
Key role of permanent income (lifetime wealth) in driving consuption
Compared to the Solow model:
Explicit optimality criterion - households’ utility
If there is no distortionary taxation (i.e. if there is no government or all
taxes are lump-sum), allocations are Pareto optimal: decentralized
equilibrium coincides with allocations dictated by a benevolent social
planer (markets are competitive and complete, so the first welfare
theorem applies)
Savings rate endogenous and in the long-run always lower than implied
by the golden rule

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Advanced Macroeconomics

The Ramsey Model

Michal Brzoza-Brzezina/Marcin Kolasa

Warsaw School of Economics

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 1 / 47

Authors: Frank Ramsey (1928), David Cass (1965) and Tjalling

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 2 / 47

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 3 / 47

Firms maximize their profits, taking factor prices as given

Own production factors (capital and labour), so earn income on

Capital is accumulated from investment It and subject to depreciation:

Kt+1 = (1 − δ)Kt + It (3)

Total income of households can be split between consumption or

Make optimal consumption-savings decisions

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 5 / 47

Households maximize the lifetime utility of their members (present

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 6 / 47

CRRA form essential for balanced growth (steady state)

Labour supplied by households must be equal to labour input

Definition of competitive equilibrium

Lifetime utility rewritten:

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 10 / 47

Capital accumulation rewritten in per capita terms (using (4)):

Transversality condition rewritten in intensive form:

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 11 / 47

Lagrange function (normalizing L0 ):

First order conditions (FOCs):

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 12 / 47

Equations (13) and (14) imply:

Using the definition of β̃ and rewriting in intensive form:

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 13 / 47

Interpretation of the Euler equation (17):

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 14 / 47

The equilibrium dynamics of the model at any time t can be

kt+1 1−δ 1 f (kt ) − ct

At t = 0 capital is fixed. For given initial k0 and c0 , equations (18)

In the steady state equilibrium kt and ct must be constant.

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 16 / 47

Plotting (21) and (22) in the (k, c) space:

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 17 / 47

How do we know that k ∗ < kG ?

The transversality condition (20) written in the steady-state:

f 0 (k ∗ ) > f 0 (kG ) =⇒ k ∗ < kG (23)

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 18 / 47

Equivalently, we can show that the steady-state savings rate s ∗ falls

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 19 / 47

Higher β implies more patient consumers

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 20 / 47

How do we know that the saddle path is a unique equilibrium?

informally (but more intuitively): at the end of their planning horizon,

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 23 / 47

Compared to the Solow model, the speed of convergence in the

Consider the lifetime budget constraint of the household

where Ωt is lifetime wealth. Substitute recursively from Euler

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 25 / 47

For log utility this boils down to

So current consumption depends on lifetime wealth. Current income

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 26 / 47

A very important question in economics: are markets efficient?

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 27 / 47

Imagine a social planer - allocates resources and wishes to maximize

Michal Brzoza-Brzezina/Marcin Kolasa (WSE) Ad. Macro - Ramsey model 28 / 47

kt+1 : −λt + λt+1 f 0 (kt+1 ) + 1 − δ = 0