Project - Macro III

Raffael Russo

22/12/2018

1 Introduction
The project proposed involves replicating a well-known paper in the literature and proposing a slight
modification to the model to improve on its qualitative or quantitative properties. The chosen paper is
”Resuscitating Real Business Cycles” by King and Rebelo (1999).
As written in section 8 of the paper the so-called ”High Substitution Economy” is an economy that
features both indivisible labour supply and variable capital utilization. We write, step-by-step, a model
that simulates this environment. The second section presents the model and explains the choice of the
parameters as well as the functions. The third section presents the equilibrium conditions, the log-
linearized equilibrium and the steady state. The fourth section explains the calibration chosen. The fifth
section shows the properties of the solution and is divided into a subsection with IRF’s for a technology
shock, a subsection with the steady state properties and a subsection for the dynamic properties of the
model. At the sixth section we introduce an additional feature to the model: exogenous government
spending financed by a lump-sum tax to the representative agent. In this section we do the same work as
in section 5 and analyze the responses to both technological and government spending shocks this time.
The seventh section concludes. The appendix shows the matrices that we used to write our Matlab code
for the model with government spendings. To solve the model we follow closely the ”Solve” class that
we had in the course and the basic Matlab code sent by the Professor. All the codes were sent by email
with this report.
To get the results of section 5 run the BasicModel Russo final.m file. To get the results of section 6 run
the GovernmentModel Russo final.m

2 The model
We follow the model proposed by King and Rebelo (1999) in which there is indivisible labour and variable
capital utilization with a general utility function. In our project we specify the functions and give an
argument for their choice.

2.1 Agents

First, to justify our choice for the utility function we follow the steps of Hansen (1985). As we have no
frictions in the economy, we could think of the problem as an optimization by a Central Planner.
As Hansen does, we model a continuum of mass 1 of agents, with no population growth. Then we assign
a probability pt for an agent to be employed at time t. If employed, the agent works ĥ hours, and zero
otherwise.
Also, set cet , cut as the consumption of the employed agent and the consumption of the unemployed
agent at time, respectively.

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We could then, divide the Central Planner’s Problem into two stages. Here, we will use just the first
stage of the central planner’s problem to justify our utility function. This said, the Central planner
solves:

max pt u(cet , 1 − ĥ) + (1 − pt )u(cut , 1)

{cut ,cet ,pt }

s.t. pt cet + (1 − pt )cut = Ct

Now for u(c, h) = ln(c) − α̂ln(1 − h), with α̂ being a parameter. We have that CT = cut = cet trivially.
Finally, take aggregate hours as Ht = pt ĥ and the expected utility of an agent will be:

pt u(cet , 1 − ĥ) + (1 − pt )u(cut , 1) = pt (ln(Ct ) + ˆ(α)ln(1 − ĥ)) + (1 − pt )(ln(Ct ) + α̂ln(1)) =

ln(1 − ĥ)
= ln(Ct ) + α̂ Ht = ln(Ct ) − BHt
| {zĥ }
≡−B<0

So our representative agent’s utility function is U (Ct , Ht ) = ln(Ct ) − BHt with B a positive constant,
and this will be our utility function for the rest of the problem.
Now for the variable capital utilization, we follow the Professor’s suggestion and define the depreciation
function as δ(Z) = δ0 + δ1 (Z − 1) + δ22 (Z − 1)2 , in which Z ∈ [0, 1] is the percentage of capital used.
So now, back to a decentralized model, as done in class, we can write the representative agent’s problem
as:
(∞ )
X
t
max E0 β (ln(Ct ) − BH)
{Ct ,Kt+1 ,Ht }t=∞
t=0 t=0

s.t. Ct + It = Wt Ht + Rtk Zt Kt , ∀t
Kt+1 = [1 − δ(Zt )]Kt + It ∀t

Substituting constraint (2) into constraint (1) and denoting the lagrange multiplier associated with the
new constraint by λt we have:
This takes us to the following FOC’s:

1
βt = λt (1)
Ct
CPO{Ct }
t
β B = λ t Wt (2)
CPO{Ht }
k
λt = λt+1 [1 − δ(Zt+1 ) + Rt+1 Zt+1 ] (3)
CPO{Kt+1 }
0
Rtk = δ (Zt ) (4)
CPO{Zt }

2
2.2 Firms

Firms follow a competitive market with full flexible prices in the economy. For the production function,
then, we follow King and Rebelo (1999) once again to write the firms problem, for all t:

max At (Zt Kt )α (Ht )1−α − Rtk Zt Kt − Wt Ht

{Kt ,Zt ,Ht }

with ln(At ) − ln(A) = ρa (ln(At−1 ) − ln(A)) + at , ∀t

In which A is the steady state value of At . Once again, we have the following FOC’s:
Yt
α = Rtk (5)
Kt Zt
CPO{Kt } = CPO{Zt }
Yt
(1 − α) = Wt (6)
Ht
CPO{Ht }

In which the First order condition w.r.t. Zt and w.r.t. Kt results in the same equations.

2.3 Market Clearing

The Market Clearing Condition is

Yt = Ct + It

3 Equilibrium Conditions
Getting rid of the multipliers from previous equations we arrive at the equilibrium equations:

Wt
B= (7)
Ct
Yt = Ct + It (8)
αYt
Rtk = (9)
Kt Zt
Rtk = δ 0 (Zt ) (10)
Yt
Wt = (1 − α) (11)
Ht
k Ct
1 = Et {β(1 − δ(Zt+1 ) + Rt+1 Zt+1 ) } (12)
Ct+1
Kt+1 = (1 − δ(Zt ))Kt + It (13)
ln(At ) − ln(A) = ρa (ln(At−1 ) − ln(A)) + at (14)
α 1−α
Yt = At (Zt Kt ) (Ht ) (15)
(16)

And the log-linearized equilibrium, for the steady state given in the next subsection:

3
 ŵt = ĉt (17)
Y ŷt = Cĉt + I ît (18)
r̂tk = ŷt − k̂t − ẑt (19)
00
δ (1)
r̂tk = ẑt (20)
δ 0 (1)
ŵt = ŷt − ĥt (21)
k k 0
0 = Et {β[R + ẑt+1 ) − δ (1)zt+1
(r̂t+1 ˆ ] + ĉt − ĉt+1 } (22)
k̂t+1 = (1 − δ(1))k̂t + δ(1)ît − δ 0 (1)(zˆt ) (23)
ât = ρa ât−1 + at (24)
ŷt = ât + α(k̂t + ẑt ) + (1 − α)ĥt (25)

In which, for a given variable x̂t = ln(Xt ) − ln(X) and X denotes the steady state of a variable Xt . In
(22) we used the fact that in steady state Rk + 1 − δ(1) = β1 . In (23) we used we used the fact that in
I
steady state K = δ(1).

3.1 Steady State

Now, we’re going to find the Steady State variables. There is no uncertainty, TFP is at its mean: A = 1
Z = 1, and all variables are constant, for example ct = ct+1 = c
From equation (12) we obtain:
1
Rk = − (1 − δ(1)) (26)
β

From equation (9) we obtain:

Y Rk
= (27)
K α
From the production function we obtain:
 1
 α−1
K Y
= (28)
H K

Again from the production function we obtain:

 α
Y K
= (29)
H H

From equation (13) we obtain:

I K
= δ(1) (30)
H H

From equation (8) we obtain:

Y C I
= + (31)
H H H

From equation (11) we obtain:

Y
W = (1 − α) (32)
H

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From equation (7) we obtain:
W
C
= BH (33)
H

and from this last one we obtain H and deduce all other variables

C Y
C= H, Y = H
H H

K I
K= H, I= H
H H

4 Calibration
To finish the model we need to calibrate the parameters α, β, ρa , σa , δ0 , δ1 and B.
For the calibration of α, β, rhoa and σa we follow the Professor’s notes which leads us to:

α = 0.37 (Capital share in production)

β = 0.995 (Discount Factor)
ρa = 0.986 (Persistency of Technology shock)
σa = 0.0086 (Standard deviation of Technology shock)

For the parameters α̂ and ĥ we follow Hansen (1985) and set α̂ = 2 and ĥ = 0.53, which implies

B = 3.21

For the parameters δ0 , δ1 and δ1 we use equation (26) that leads us to Rk = β1 − (1 − δ0 ) and equation
(10) applied to the steady state, that lead us to Rk = δ1 . Finally using the Professor’s calibration we
define δ0 = 0.02. The parameter δ2 is free, so we’ll test different calibrations. By solving this system,
and choosing a value for δ2 we get:

δ0 = 0.02
δ1 = 0.025
δ2 = 0.1

5 Properties of The Solution

Here we present the properties of the solution. Subsection 5.1 presents the impulse response functions
(IRFs) from a technology shock and section 5.2 presents the steady state properties. In both subsections
we do two exercises in order to study the robustness of our findings and some comparative statics: first
we change some of the parameters as explained in the each subsection; second we compare the basic and
the new model with the standard model sent by the Professor.

5
5.1 Technology Shock

Using the calibration previously mentioned, for a first period technology shock, the impulse response
function is shown in Figure 1.

Productivity Output Consumption

1 2 1

0.5 1 0.5

0 0 0
0 50 100 0 50 100 0 50 100
Investment Hours Capital
6 1.5
1
4 1
0.5
2 0.5
0
0 0
0 50 100 0 50 100 0 50 100
Wage Rental Rate of Capital Capital utilization
1 2 0.4

1 0.2
0.5

0 0
0
0 50 100 0 50 100 0 50 100

Figure 1: IRFs for a technology shock - basic calibration

By the definition of our depreciation function we can see that the higher δ2 the more close to the basic
RBC model we are (without variable capital utilization). So now we set δ2 = 100 and compare the
results. Figure 2 shows the results to this new calibration.

Productivity Output Consumption

1 2 1

0.5 1 0.5

0 0 0
0 50 100 0 50 100 0 50 100
Investment Hours Capital
1.5
4 1
1
2 0.5
0.5

0 0 0
0 50 100 0 50 100 0 50 100
Wage Rental Rate of Capital Capital
10 -4 utilization
1 2 4

1 2
0.5

0 0
0
0 50 100 0 50 100 0 50 100

Figure 2: IRFs for a technology shock - δ2 = 100

We can see that with higher δ2 (e.g. higher cost of utilization) investment and hours don’t go up as much
as in the case with lower δ2 . This makes output also go up by less. As we have separable preferences,

6
consumption is not affected. So investment goes up significantly more when we have variable capital
utilization.
Finally, Figure 3 shows the IRFs for a technology shock in the standard model sent by the Professor.

Productivity Output Consumption

1 1.5 1

1
0.5 0.5
0.5

0 0 0
0 50 100 0 50 100 0 50 100
Investment Hours Capital
3 0.4
1
2
0.2
0.5
1

0 0 0
0 50 100 0 50 100 0 50 100
Wage Rental Rate of Capital
1
1

0.5 0.5

0
0
0 50 100 0 50 100

Figure 3: IRFs for a technology shock - standard model

Comparing Figure 3 with Figure 2 we can finally see the role of indivisible labour supply. With indivisible
labour supply hours and investment go up by more after a technology shock than in the standard divisible
labour supply model, this leads to higher output growth also.

5.2 Steady State Properties

As δ2 does not appear in ant steady state equation, for this subsection we do the following exercise:
change the parameter δ0 from 0.2 to 0.025 (a value also largely used in the literature). This implies
δ1 = 0.03. Table 1 shows the steady state for the basic calibration of our model. Table 2 shows the
steady state for δ0 = 0.025 and δ1 = 0.03. Table 3 shows the steady state for the standard model with
the output trend equal to one, as in our model. With this last assumption we isolate the effect of our
high substitution economy.

Y 1.3556
C 0.95472
I 0.40084
H 0.27866
K 20.0422
W 3.0647
Rk 0.025025
A 1

Table 1: Steady State - basic calibration

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 Y 1.2398
C 0.85786
I 0.38196
H 0.28365
K 15.2782
W 2.7537
Rk 0.030025
A 1

Table 2: Steady State - δ0 = 0.025 and δ1 = 0.03

Comparing Table 1 with Table 2 we see that the higher the cost of utilization the lower the capital and
investment in steady state. Hours are higher with more capital cost as the marginal utility of labour is
higher with lower capital. The economy overall has a lower steady state value for output. As the steady
state interest rate depends only on β and δ0 we have that it increases with δ0 .

Y 1.1996
C 0.84486
I 0.35472
H 0.2466
K 17.7358
W 3.0647
Rk 0.025025
A 1

Table 3: Steady State - standard model with output-trend equal to one

As in the basic calibration and in the standard model we use the same value for δ0 = 0.02 it’s better to
compare these two in order to highlight the effects of our high substitution economy. Despite habing the
same steady-state value for the interest rate our economy features higher values for output, consumption,
investment and capital.

5.3 Dynamic Properties

Here we present the dynamic properties of the model, such as first order autocorrelation and standard
deviation of the main variables. We briefly compare the results with the standard model presented in
class.

First Order Autocorrelation Std Deviation

Variable
Basic Model Standard Model Basic Model Standard Model
Output 0.87051 0.88964 9.5622 1.2404
Consumption 0.87891 0.91702 4.5823 0.49525
Investment 0.87209 0.87534 41.1449 3.1568
Hours 0.87263 0.86602 14.0702 0.40738
Wage 0.87891 0.89972 4.5823 0.85211

Table 4: Dynamic Properties of the main variables

As we can see only for hours the first order autocorrelation is higher in the basic model. With respect
to the Standard Deviation we can say that because of our calibration standard deviations in the basic
model are much higher than in the standard model, but what we should account for is the ratio of the
standard deviation of a specific variable and the standard deviation of output. By looking at that we
see that w.r.t output, investment is much more volatile in the basic model than in the standard model.

8
6 Modification to the Model
As a modification to the model we introduce exogenous government spending financed by a lump-sum
tax to the representative agent. Now agent solves:

∞
( )
X
t
max E0 β (ln(Ct ) − BH + ν(Gt ))
{Ct ,Kt+1 ,Ht }t=∞
t=0 t=0

s.t. Ct + It = Wt Ht + Rtk Zt Kt −Tt , ∀t

Kt+1 = [1 − δ(Zt )]Kt + It ∀t

As seen in the class notes this leads to the same First Order Conditions for the agent as Gt is exogenous
and Tt adjusts to balance the government spendings. This said, the government spendings follows an
AR(1) and the steady state value o Gt is such that:

ln(Gt ) − ln(G) = ρa (ln(Gt−1 ) − ln(G)) + at , ∀t (34)

G = ηY (35)
Tt = Gt (36)
(37)

Firms face the same problem as in subsection 2.2. Finally, the new market clearing condition is

Yt = Ct + It + Gt (38)

6.1 Equilibrium Conditions

The equilibrium conditions are the same as in section 3, with:

• Replace (8) for (38)
• add (34)
We summarize them here again:

Wt
B=
Ct
Yt = Ct + It + Gt
αYt
Rtk =
Kt Zt
Rtk = δ 0 (Zt )
Yt
Wt = (1 − α)
Ht
k Ct
1 = Et {β(1 − δ(Zt+1 ) + Rt+1 Zt+1 ) }
Ct+1
Kt+1 = (1 − δ(Zt ))Kt + It
ln(At ) − ln(A) = ρa (ln(At−1 ) − ln(A)) + at
Yt = At (Zt Kt )α (Ht )1−α
ln(Gt ) − ln(G) = ρa (ln(Gt−1 ) − ln(G)) + at

9
and for the log-linearized equilibrium:

ŵt = ĉt
Y ŷt = Cĉt + I ît + ηY ĝt
r̂tk = ŷt − k̂t − ẑt
δ 00 (1)
r̂tk = ẑt
δ 0 (1)
ŵt = ŷt − ĥt
0 = Et {β[Rk (r̂t+1
k
+ ẑt+1 ) − δ 0 (1)zt+1
ˆ ] + ĉt − ĉt+1 }
k̂t+1 = (1 − δ(1))k̂t + δ(1)ît − δ (1)(zˆt )
0

ât = ρa ât−1 + at

ŷt = ât + α(k̂t + ẑt ) + (1 − α)ĥt
ĝt = ρg ĝt−1 + gt

6.2 New Steady State

Following the same steps of subsection 3.1 we arrive at the new Steady State equations:

1
Rk = − (1 − δ(1))
β
Y Rk
=
K α
  α−1 1
K Y
=
H K
 α
Y K
=
H H
I K
= δ(1)
H H
C Y I
= (1 − η) −
H H H
Y
W = (1 − α)
H
W
C
= BH
H

and from this last one we obtain H and deduce all other variables

C Y
C= H, Y = H
H H

K I
K= H, I= H
H H

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6.3 New Calibration

Calibration is the same as in section 4 with the added parameters following from class:

η = 0.207
ρg = 0.95

6.4 New Properties of the Solution

As in section 5 we present the properties of the solution. Subsection 6.4.1 presents the impulse response
functions (IRFs) from a technology shock alone, from a government spending shock alone and from both
shocks at the same time. Subsection 6.4.2 presents the steady state properties. Subsection 6.4.3 presents
dynamic properties such as the autocorrelation of the variables. In all subsections we compare the results
with the model of section 2 (the basic high substitution economy model), when possible.

6.4.1 Response to shocks

Figure 4 shows the IRFs for a technology shock in the model with government. Comparing to Figure 1
we see that even with gt = g∀t (e.g. no government spending shocks) we have that hours and output
don’t raise by as much as in the basic model. As the share of investment in the output is now lower
because of the government spending we have that capital and the rental rate of don’t go up by much as
much as in the basic model (the peak of capital is lower in the latter model). Consumption goes up by
more because people spend in consumption rather than in capital accumulation, and in our model wage
has a linear relation with consumption.

Productivity Government Spending Output

1 1 2

0.5 0 1

0 -1 0
0 50 100 0 50 100 0 50 100
Consumption Investment Hours
5 1
1
0.5
0.5
0
0 0
0 50 100 0 50 100 0 50 100
Capital Wage Rental Rate of Capital
1 1
1
0.5 0.5 0.5
0
0 0
0 50 100 0 50 100 0 50 100
Capital utilization
0.3
0.2
0.1
0
0 50 100

Figure 4: IRFs for a technology shock - model with government

Figure 5 shows the IRFs w.r.t a government spending shock. The results are in line with the literature
and what we saw in class. It’s noticeable that a positive government spending shock, alone, lowers
consumption and raises output.

11
 Productivity Government Spending Output
1 1 0.2

0 0.5 0.1

-1 0 0
0 50 100 0 50 100 0 50 100
Consumption 10-3Investment Hours
0
0 0.2

-10 0.1
-0.05
-20
0
0 50 100 0 50 100 0 50 100
Capital Wage Rental Rate of Capital
0 0
0.1
-0.005
-0.05 0.05
-0.01
0
0 50 100 0 50 100 0 50 100
Capital utilization
0.04

0.02

0
0 50 100

Figure 5: IRFs for a government spending shock - model with government

Figure 6 Figure 5 shows the IRFs w.r.t to both shocks at the same time. Here we have a mix of the effects
shown in Figure 4 and Figure 5. So comparing to Figure 1, we can notice that with our calibration,
in our model with government hours and output still raises less than in the basic model. The peak of
capital is still lower in the latter model, rental rate of capital raises by less, and consumption raises more
in the latter model than in the basic model.

Productivity Government Spending Output

1 1 2

0.5 0.5 1

0 0 0
0 50 100 0 50 100 0 50 100
Consumption Investment Hours
1 5
1

0.5 0.5
0
0 0
0 50 100 0 50 100 0 50 100
Capital Wage Rental Rate of Capital
1 1
1
0.5 0.5 0.5
0
0 0
0 50 100 0 50 100 0 50 100
Capital utilization
0.3
0.2
0.1
0
0 50 100

Figure 6: IRFs for both technology and government spending shocks - model with government

6.4.2 New Dynamic Properties

As in subsection 5.3 we present some dynamic properties of the main variables. We compare the model
with government spendings that features both shocks ate the same time with the basic model of section
2.

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 First Order Autocorrelation Std Deviation
Variable
Model with Basic Model Model with Basic Model
Government Government
Spendings Spendings
Output 0.87086 0.87051 9.7372 9.5622
Consumption 0.87595 0.87891 4.7336 4.5823
Investment 0.87147 0.87209 40.7092 41.1449
Hours 0.87227 0.87263 14.4398 14.0702
Wage 0.87595 0.87891 4.7336 4.5823

Table 5: Dynamic Properties of the main variables

As we can see, this specif dynamic properties don’t vary significantly between the two models since in
both models we have a technology shock and for the common parameters the same calibration.

7 Conclusion
In the present project we chose King and Rebelo (1999) to replicate and add some new features. First we
presented the model and the problems faced by a representative agent and firms. We set up the market
clearing conditions and showed the equilibrium equations as well as the log-linearized equilibrium and
the steady state equations. We, then, explained how to calibrate the model and for the so-called basic
model we showed the properties of the solution: from the IRFs to the steady state properties and
some dynamic properties. In this exercise we also compared the robustness of the findings to different
calibrations and also compared the model to a standard model presented in Class by the Professor.After
that we introduced exogenous government spending financed by a lump-sum tax to the representative
agent and re-did all the exercises of the previous sections. Our findings were in line with the literature.
Finally we wrote a Matlab code for obtaining the IRFs.

References
Gary D. Hansen. Indivisible labour and the business cycle. Journal of Monetary Economics, 16:309–327,
1985.
Robert G. King and Sergio T. Rebelo. Resuscitating real business cycles. Handbook of Macroeconomics,
1, 1999.

13
A Solution for Matlab
Here we present the matrices used in the latex code for the ”model with government spendings”. From
the equations here and using the ”Solve” class, it is straightforward to get the solution presented in the
code.
Section 6.1 presented the log-linearized equilibrium. From there we see that we have 10 equations for 10
variables and that:
• There are 3 state variables k̂t ,ât , ĝt ;
• There are 7 control variables ĥt , ŷt , ît , ŵt , r̂tk , ĉt , ẑt in which
– 6 of them are static ĥt , ŷt , ît , ŵt , r̂tk , ẑt ;
– 1 of them is forward-looking (jumper): ĉt .
So we can write the system as:


ĥt  
 ŷt  k̂t
 
 ît  ât 
ŵt  = M 2 ĝt 
M1     (39)
 
 r̂k  ĉt
t
ẑt
   
    ĥt+1 ĥt
k̂t+1 k̂t  ŷt+1   ŷt 
   
ât+1  ât   ît+1   ît 
M3 
  + M 4   = M 5   + M 6   + M 7[at+1 ] + M 8[g ] (40)
t+1
ĝt+1  ĝt  ŵ
 t+1 
 ŵt 
 
ĉt+1 ĉt k
 r̂  k
 r̂ 
t+1 t
ẑt+1 ẑt

In which:

   
1 −1 0 1 0 0 0 0 0 0

 0 Y −I 0 0 0 

0
 0 ηY C
−(1 − α) 1 0 0 0 −α α 1 0 0
M1 =   M2 =  

 0 0 0 1 0 0 

0
 0 0 1
 0 1 0 0 −1 −1  1 0 0 0
δ2
0 0 0 0 −1 δ1 0 0 0 0
   
0 0 0 1 0 0 0 −1
1 0 0 0 −(1 − δ0 ) 0 0 0
M3 =   M4 =  
0 1 0 0  0 −ρa 0 0
0 0 1 0 0 0 −ρg 0
0 βRk β(Rk − δ1 )
   
0 0 0 0 0 0 0 0 0
0 0 0 0 0 0  0 0 δ0 0 0 −δ1 
M5 =   M6 = 
0 0 0 0 0

0 0 0 0 0 0  0 
0 0 0 0 0 0 0 0 0 0 0 0
 0  0
M7 = 0 0 1 0 M8 = 0 0 0 1

14