Fall 2013. UdeM.

Example:
Suppose that individuals choose fc
t
g
1
t=0
in order to maximize
1

t=0
_
1
1 + j
_
t
(c
c
t
) (1)
where j, 0 subject to the budget constraint
a
t+1
a
t
= n
t
+ r
t
a
t
c
t
(2)
and the no-Ponzi game condition
lim
n!1
a
t
_
t1

s=1
1
(1 + r
s
)
_
0
We let a
t
denote the stock of accumulated asset (debt if negative) at time t, while c
t
is consumption.
Initial a
0
is given; n
t
denotes the wage, the net interest rate is r
t
. The consumer inelastically supplies
one unit of labor. Per-period utility in (1) is known as CARA (constant absolute risk aversion) utility.
1. Write the Euler condition. Write the transversality condition of the problem.
The Euler Equation of each individual is
c
c
t
=
(1 + r
t+1
)
1 + j
c
c
t+1
Taking log, you can write
c
t+1
c
t
= 1 +
1
c
t
1

ln(
1 + r
t+1
1 + j
)
Then the consumption of the rich (high c
t
) grows at a slower pace if r
t+1
j. To explain why the
rich have dierent saving behavior, rst note that the absolute coecient of risk aversion is constant
and equal to .
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Then, CARA implies increasing relative risk aversion (hence, decreasing elasticity of
intertemporal substitution). The higher incentive to keep a smooth consumption prole for the rich
explains why consumption growth of the rich is lower when r
t+1
j. The higher elasticity of substitution
of the poor implies that they consume less to enjoy higher consumption tomorrow. Things are opposite
when r
t+1
< j: the consumption of the rich (high c
t
) grows at a higher pace
The transversality condition takes the form
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lim
t!1
,
t
(1 + r
t
)n
0
(c
t
)a
t
= 0
The transversality condition (TVC) requires that the product between (1) the derivative of the per-
period utility n((1+r
t
)a
t
+n
t
a
t+1
) with respect to the current state variable and (2) the state variable
should not increase as t goes to 1 at a rate faster or equal than 1,,.
Why do we need the transversality condition? Wouldnt it be enough to impose that the Euler
Equations are satised at all t in order to nd the optimal consumption path? The answer is no. When
the horizon is nite (see Problem 1) in addition to the Euler equations, we also need a terminal condition:
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The coecient of absolute risk aversion is
u
00
(c)
u
0
(c)
:
2
See Appendix at the end.
1
a
T+1
= 0. That is, the individual does not save in the last period. When T = 1 the TVC substitutes
for the missing terminal condition.
The transversality condition states that the value of a
t
, when measured in terms of discounted utility,
goes to zero asymptotically. It is important to note that we do not require that a
t
itself converges to
zero, only the (shadow) value of a
t
has to converge to zero. The TVC ensures that individuals are not
accumulating too many assets and postponing consumption for ever.
There is no unique representation of the TVC condition. The TCV can be written in many forms. A
second formulation, using the EE n
0
(c
t1
) = ,n
0
(c
t
)(1 + r
t
) is
lim
t!1
,
t1
n
0
(c
t1
)a
t
= 0 (3)
Changing the timing, write as:
lim
t!1
,
t
n
0
(c
t
)a
t+1
= 0 (4)
The TVC is sometimes written this way because ,
t
n
0
(c
t
) is equal to the multiplier associated to the budget
constraint.
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Then, we can write
lim
t!1
`
t
a
t+1
= 0 (5)
which says, once again, that the limiting value of assets from the perspective of time zero (this is given
by the price at time zero in utility terms multiplied by the quantity a
t+1
) converges to 0.
Lets see a third way of writing the TCV. Using the Euler equation to substitute for n
0
(c
t1
) in (3)
we obtain
lim
t!1
,
t1
1
(1 + r
t1
) ,
n
0
(c
t2
)a
t
= 0 (6)
Using the EE at t 2, we substitute for n
0
(c
t2
). We keep substituting backwards and, after dropping
the constant term n
0
(c
0
) 0, one can write the transversality condition as:
lim
t!1
a
t
_
t1

s=1
1
(1 + r
s
)
_
= 0 (7)
Notice how (7) relates to the No-Ponzi game constraint. There is, however, an important dierence.
Expression (7) is an optimality condition: it is the innite horizon analogue to the terminal condition
a
T+1
= 0. The No-Ponzi game is not an optimality condition: it is instead a constraint imposed by the
markets. It says that the present value of assets must be asymptotically nonnegative: in other terms,
individuals should pay the debt asymptotically and should not be able to increase consumption by taking
loans to nance the payments of the interests. The debt cannot grow as fast as r
t
. Acemoglu, Section
8.1.2 shows that by using the no-Ponzi-game condition with equality, we can write the intertemporal
budget constraint, which states that the present value of consumption and present value of incomes are
equal. Financial markets impose a proper lifetime budget constraint on consumers. If not (for instance,
if consumers could run a Ponzi scheme), consumers would consume more than their incomes and nancial
markets would eventually loose money. A nal remark: in Appendix A we used the no-Ponzi constraint
with equality. If we used the no-Ponzi constraint with inequality, you would obtain that the present value
of consumption is weakly less than the present value of incomes. This is also ne: nancial markets would
not loose money in this case either. In Appendix A we used the no-Ponzi constraint with equality because
we integrated the fact (by using the transversality condition) that in equilibrium consumers would not
accumulate positive assets for ever.
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Dene the Lagrangian
L =
1
X
t=0

t
u(c
t
) +
t
[(1 + r
t
)a
t
+ w
t
c
t
)]
From the rst order condition,
t
u
0
(c
t
) =
t
. That is, the Lagrange multiplier is the marginal utility of consumption (a
measure of how much another unit of consumption at time t is worth from the perspective of time zero)
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Appendix: Given a general sequential problem
max
fx
t+1
g
1
t=0
1

t=0
,
t
1(r
t
, r
t+1
) ()
:n/,cct to r
t+1
2 (r
t
), r
0
is given
:A ! A is the correspondence describing the feasibility constraints. (r
t
) is the set of feasible
values for the state variable next period if today the state is r
t
2 A. 1 : ! A is the one-period return
function. r
t
is the current state, while r
t+1
is the state next period. The state (can be a vector) is a
complete description of the current position of the system. We just need to know r
t
to know what the
agent will do. Knowing past values of r
j
, , < t does not add information.
In the neoclassical growth model we have that r
t
= /
t
and r
t+1
= /
t+1
; while 1(r
t
, r
t+1
) = n()(/
t
)
/
t+1
) and (r
t
) = [0, )(/
t
)].
Denition The path fr
t+1
g
1
t=0
satises the Transversality Condition if
lim
t!1
,
t
1
x
(r
t
, r
t+1
)r
t
= 0
1
1
is the vector of marginal returns from increases in the current state variable r: we will see, for
example, that 1
1
is related to the vector of capital goods prices. Then 1
x
(., .)r
t
is the value of capital
stock at time t. ). Therefore, with the TVC we require that the present discounted value of capital stock
goes to zero as t ! 1. Clearly, in general we do not demand that the capital itself goes to zero. Basically,
we do not want to postpone too much utility in the distant future.
We write down the TVC for the growth model.
lim
t!1
,
t
n
0
()(/
t
) /
t+1
))
0
(/
t
)
. .
Value of one extra unit
of capital in disc. util. terms.
/
t
..
Total cap. stock
= 0
In other words, the TVC condition requires that the value of the capital stock, when it is measured in
discounted utility terms, goes to zero as t ! 1.
For more on this, see equation (6.32) at page 203 of the book by Acemoglu for a general formulation.
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