Asset Price in Static Economies

Chapter B
Solutions to Exercises
1 Complete Contingent Claims
Question 1 Dene the set A = a R
I
: a
i
= u
i
(x
i
) u
i
(c
i
), x and
A
= a R
I
+
: a ,= 0.
We rst note that A
is empty by the Pareto optimality of the allocation

(c
1
, . . . , c
I
). Furthermore, A is a convex set by the concavity of the utility
functions. Thus, the Separating Hyperplane Theorem implies that there exists
a nonzero vector y z for each y A and each z A
. Since 0 A (by
Pareto optimality), 0.
Question 2 In a perfect foresight competitive equilibrium for this economy
(which is just a special case of the complete contingent claims equilibrium)
both consumers solve the problem:
max
c
i
1
,c
i
2
U
i
(c
i
1
) +U
i
(c
i
2
) s.t. c
i
1
+pc
i
2

1
+p
2
.
a) For individual a, construct the Lagrangian function as follows:
L =
(c
a
1
)
1
1
1
+
(c
a
2
)
1
1
1
+
a
[
1
+p
2
c
a
1
pc
a
2
].
The rst-order conditions are as follows:
L
c
a
1
= 0 (c
a
1
)
=
a
L
c
a
2
= 0 (c
a
2
)
=
a
p.
From the equations above, we obtain c
a
2
in terms of c
a
1
as:
c
a
2
= p
c
a
1
. (1.1)
1
2 Solutions to Exercises
The remaining rst-order condition, L/
a
= 0, gives us back the consumers
budget constraint:
1
+p
2
= c
a
1
+pc
a
2
.
If we substitute the value c
a
2
obtained from the equation (1.1) to the condition
above and then use the resulting expression in equation (1.1), we nd the
values of c
a
1
and c
a
2
as follows:
c
a
1
=

1
+p
2
1 +p
(1)/
, (1.2)
c
a
2
=
p
1/
(
1
+p
2
)
1 +p
(1)/
. (1.3)
For individual b, construct the Lagrangian function as follows:
L = log(c
b
1
) + log(c
b
2
) +
b
[
1
+p
2
c
b
1
pc
b
2
].
The rst-order conditions are as follows:
L
c
b
1
= 0
1
c
b
1
=
b
L
c
b
2
= 0
1
c
b
2
=
b
p.
From the equations above, we obtain c
b
1
in terms of c
b
2
as:
c
b
1
= pc
b
2
. (1.4)
The remaining rst-order condition L/
b
= 0 yields the budget constraint
for individual b as:
1
+p
2
= c
b
1
+pc
b
2
.
If we substitute the value c
b
1
obtained from the equation (1.4) to the condition
above and use the resulting expression in equation (1.4), we nd the values of
c
b
1
and c
b
2
as follows:
c
b
1
=

1
+p
2
2
(1.5)
c
b
2
=

1
+p
2
2p
. (1.6)
3
(b) Notice that if both individuals have logarithmic utility functions,
then the equilibrium price is given by p =
1
/
2
with r = 1/p 1. For the
more general case with > 1, p <
1
/
2
. To show this, we can use the
market-clearing conditions for periods 1 and 2, which are given by:
1
+p
2
1 +p
(1)/
+

1
+p
2
2
= 2
1
p
1/
(
1
+p
2
)
1 +p
(1)/
+

1
+p
2
2p
= 2
2
.
Expressing these conditions in terms of a common denominator and taking
their ratios yields:
p(3 +p
(1)/
)
3p
(1)/
+ 1
=

1
2
.
As 1, the left side of this equation goes to p and
p =

1
2
To show that p <
1
/
2
when > 1, assume the contrary that p =
1
/
2
.
Then the condition describing the equilibrium price (or real interest rate)
simplies as
3 +p
(1)/
= 3p
(1)/
+ 1 p
(1)/
= 1.
For > 1, the only solution is p = 1, contradicting the assumption that
p =
1
/
2
< 1. Henceforth, we assume that p <
1
/
2
. Since p < 1,
p
(1)/
< 1 holds,
c
a
1
=

1
+p
2
1 +p
(1)/
. .
<1
. .
<2
>

1
+p
2
2
= c
b
1
.
Similarly, if we use the expression for c
b
2
and multiply and divide it by
p
1/
, then we obtain;
c
a
2
=
p
1/
(
1
+p
2
)
1 +p
(1)/
. .
>2p
(1)/
<
p
1/
(
1
+p
2
)
2p
(1)/
= c
b
2
Thus, consumer a is compensated with high consumption in the bad state
which corresponds to date 1 when the endowment is low. Although the con-
sumption of both a and b increases in period 2, consumer b receives a higher
consumption than consumer a in period 2 as compensation for insuring con-
sumer a in period 1.
c) When we look at the consumption inequality,
c
a
1
c
b
1
=
(
1
+p
2
)
2(1 +p
(1)/
)
(1 p
(1)/
)
c
a
2
c
b
2
=
(
1
+p
2
)
2(1 +p
(1)/
)
_
p
(1)/
1
p
_
,
and since 0 < p < 1 and > 1,
[1 p
(1)/
[ <
p
(1)/
1
p
.
Therefore, we conclude that
c
a
1
c
b
1
<
c
a
2
c
b
2
.
In other words, consumer a has to give up more consumption in period 2
relative to consumer b than the additional consumption he received in period
1 relative to consumer b. In this framework, the cross-sectional variance of
consumption is increasing, but the increase is not proportional to endowment
growth.
Question 3
a) In the CCE, the consumer maximizes (1.52) subject to the budget
constraint:
p
0
c
i
0
+
S
s=1
p
s
c
i
s
p
0
i
0
+
S
s=1
p
s
i
s
. (1.7)
Without loss of generality, let us normalize p
0
= 1. The rst-order necessary
and sucient conditions for c
i
to be an optimal plan are:
U
i
(c
i
) =
i
, (1.8)
i
s
V
i
(c
i
) =
i
p
s
, s = 1, . . . , S, (1.9)
where
i
is a Lagrange multiplier. For any two states k and l, a consumer i
chooses consumption satisfying:
i
k
V
i
(c
i
k
)
i
l
V
i
(c
i
l
)
=
p
k
p
l
. (1.10)
This condition says that the ratio of the contingent claims prices for any two
states is equal to the ratio of the marginal utilities of consumption in those
states weighted by the probability of occurrence of those states. We can also
derive an expression for the price of a contingent claims contract that pays o
in state s as:
p
s
=

i
s
V
i
(c
i
s
)
U
i
(c
i
0
)
. (1.11)
5
b) Now consider the SME. Suppose that there are N S securities with
payos x
n,s
for n = 1, . . . , N and s = 1, . . . , S. Without loss of generality,
assume that the spot price of consumption is unity for each s 0, 1, . . . , S.
The budget constraints for the consumers problem are given by:
c
i
0
+
i
q
i
0
, (1.12)
c
i
s

i
s
+
i
x
s
, 1 s S. (1.13)
Let
i
0
and
i
s
, s = 1, . . . , S, denote the Lagrange multipliers for the con-
sumers budget constraints. The rst-order conditions with respect to c
i
0
, c
i
s
,
and
i
n
are:
U
i
(c
i
0
) =
i
0
, (1.14)
i
s
V
i
(c
i
s
) =
i
s
, s = 1, . . . , S, (1.15)
i
0
q
n
=
S
s=1
i
s
x
n,s
, n = 1, . . . , N. (1.16)
Assume that
i
s
=
s
for s = 1, . . . , S. Then, using these conditions, we can
express the price of the nth security as:
q
n
=
S
s=1
s
V
(c
i
s
)
U
(c
i
0
)
x
n,s
= E
_
V
i
(c
i
s
)x
n,s
U
i
(c
i
0
)
_
. (1.17)
Thus, the price of security price n is determined as the expected discounted
value of its future payo, where the discounting is doe by means of the in-
tertemporal marginal rate of substitution (MRS) between consumption in pe-
riod two versus period one. This expression says that the price of the security
will be high in equilibrium if consumption in future states s are lower in ex-
pectation that todays consumption.
c) We already showed that the SME can support the CCE if N = S and
the matrix of security payos has full rank. In this case, the consumer can
achieve the allocations of the CCE by trading in securities in the SME.
d) Notice that in the SME the stochastic discount factor is given by
V
(c
i
s
)
U
(c
i
0
)
s and i.
Since the SME can be used to support the CCE, the stochastic discount factor
also satises the CCE rst-order conditions:
V
(c
i
s
)
U
(c
i
0
)
= p
s
/
s
s and i.
Substitute for U() and V () in the above condition and re-write it as:
(c
i
s
)
= (c
i
0
)
(p
s
/
s
).
Now invert this condition and sum over both sides:
1
I
I
i=1
c
i
s
= (p
s
/
s
)
1/
1
I
I
i=1
c
i
0
.
Dene
c
0
=
1
I
I
i=1
c
i
0
, c
s
=
1
I
I
i=1
c
i
s
.
Then notice that
( c
s
)
= ( c
0
)
(p
s
/
s
),
which implies that
V
( c
s
)
U
( c
0
)
= p
s
/
s
.
Thus, in the asset pricing equation, we can replace the stochastic dicount
factor evaluated using individual consumtion data with the one evaluated using
average consumption. This is an example of exact aggregation results due to
Rubinstein [177], and constitute the basis for asset pricing models based on a
representative consumer approach.
7
2 Arbitrage and Asset Valuation
Question 1
a) Let the number of shares held in each stock equal
i
for i = 1, 2.
Since we wish the portfolio to yield $100 in each state, the set of equations
characterizing the portfolio shares is:
120
1
+ 160
2
= 100 (2.1)
80
1
+ 60
2
= 100 (2.2)
We can solve for the number of share holdings as:
=
_
25
14
5
7
_
.
Since
2
< 0 we short sell security 2 and purchase positive quantities of the
other security.
b) The price of the risk-free bond today is
p
f
=
1
80 +
2
88 =
25
14
80
5
7
88 = 80,
which implies that (net) risk-free rate is
r
f
1 =
100
p
f
1 = 25%.
c) The state prices satisfy the set of equations:
120
1
+ 80
2
= 80 (2.3)
160
1
+ 60
2
= 88. (2.4)
Solving these equations yields the result:
1
=
2
=
4
10
.
The risk neutral probabilities are found as
1
=
4/10
8/10
=
1
2
=
2
=
.
d) The put option will be exercised if the price of the second stock falls
below the exercise price of $80. Hence, the option pays o 0 in state 1 and $20
in state 2. We can easily price the option using state prices or equivalently,
the risk neutral probabilities. Using the latter method, we have
o
p
=
1
r
f
[
0 + (1
) 20]
=
1
1.25
(0.5)(20) = 8. (2.5)
Hence, the put option will sell for a price of $8 today.
Question 2
a) The portfolio of stocks does not allow investors to attain payos con-
tingent on each state. Let x
s
for s = 1, 2, 3 denote the payos on the portfolio.
Dene two call options written on the portfolio as follows:
o
1
=
_
x
s
x
1
if x
s
x
1
0 otherwise.
and
o
2
=
_
x
s
x
2
if x
s
x
2
0 otherwise.
Now we can write the payo matrix with 3 securities, 1 stock portfolio and
the 2 options, as:
_
_
x
1
x
2
x
3
0 x
2
x
1
x
3
x
1
0 0 x
3
x
2
_
_.
Provided this matrix has full rank, an investor can achieve any pattern of
payos across states by holding the portfolio of stocks and the two options
written on it. A similar argument can be made with put options, which gives
the right to sell a security at a given price called the exercise or strike price.
For our problem, the payo has the form:
_
_
5 8 15
0 3 10
0 0 7
_
_.
9
b) To insure against endowment risk, individuals will hold portfolios that
payo 1 in each state of the economy. Individual 1 receives the endowment
(1, 0, 1). Hence s/he would like to hold a portfolio that pays o 1 in state 2
and zero otherwise. Thus:
1
1
5 +
1
2
0 +
1
3
0 = 0 (2.6)
1
1
8 +
1
2
3 +
1
3
0 = 1 (2.7)
1
1
15 +
1
2
10 +
1
3
7 = 0. (2.8)
Solving this system yields
1
1
= 0,
1
2
= 0.3333 and
1
3
= 0.4762.
Individual 2 receives the endowment (1, 1, 0). Hence, s/he should hold a port-
folio that pays o 1 in state 3 and zero otherwise.
2
1
5 +
2
2
0 +
2
3
0 = 0 (2.9)
2
1
8 +
2
2
3 +
2
3
0 = 0 (2.10)
2
1
15 +
2
2
10 +
2
3
7 = 1. (2.11)
Solving this system yields
2
1
= 0.0,
2
2
= 0.0 and
2
3
= 0.1429.
c) Now there are 6 states of the economy. Hence we need 6 securities
to complete the market. Since the state index portfolio pays o only in the
aggregate states, we cannot write new options to insure against variation in the
individual states. Hence, the condition that we have given in part (a) appears
more stringent than rst assumed. In other words, unless we have a portfolio
that pays o dierent amounts depending on individual as well as aggregate
states, we cannot use options as we did in part (a) to complete the market.
Question 3
a) Provided x
j,s
> 0 for each j and s, the collateral constraint
j
x
j,s
+f
j
w
s
0
can be equivalently written as:
j

f
j
w
s
x
j,s
.
Under short sales,
j
< 0. Recall that the collateral constraint is less strict than
the short sales constraint. Hence, we choose the minimum value of f
j
w
s
/x
j,s
and restrict
j
, which is state independent as:
j
min
_
f
j
w
s
x
j,s
_
= b
j
.
b)
f
j
500
80
= 6.25f
j
f
j
1500
100
= 15f
j
f
j
5000
125
= 40f
j
.
The maximum amount of borrowing that the investor can engage in at date 0
is
min f
j
w
s
/x
j,s
= 6.25f
j
.
Question 4
a) The rst order conditions with respect to z
i
(1), z
i
(2) and z
i
(3) are:
p(1)
c
i
1
(1)
c
i
2
(1)
= 0
p(2)
c
i
1
(2)
c
i
2
(2)
= 0
p(3)
c
i
1
_
(1)
c
i
2
(1)
+
(2)
c
i
2
(2)
_
= 0 for i = 1, 2.
Notice that the last FOC can be rewritten as:
p(3) = p(1) +p(2)
The third claim is the redundant security into this economy, which gives 1 unit
of consumption in whichever state is realized. This asset is redundant since
one can easily reproduce it using existing claims in the economy. To prevent
arbitrage opportunities, the price of such a security should be equal to sum of
prices of all securities in the economy when countries are not subject to any
borrowing constraints (and any other frictions including incomplete markets).
This is just a re-statement of the law of one price.
11
Simplifying rst-order conditions imply the following:
c
i
2
(s) =
(s)c
i
1
p(s)
, for i = 1, 2, s = 1, 2 (2.12)
Dene the world output as
y
1
1
+y
2
1
= y
w
1
and y
1
2
(s) +y
2
2
(s) = y
w
2
(s)
The market clearing conditions are:
c
1
1
+c
2
1
= y
w
1
= 4
c
1
2
(s) +c
2
2
(s) = y
w
2
(s) = 4
Substituting the FOC in Eq. (2.12) into the market clearing condition yields:
c
1
2
(s) +c
2
2
(s) = (c
1
1
+c
2
1
)
(s)
p(s)

y
w
2
(s)
y
w
1
=
(s)
p(s)
= 1.
Then, the state price is given by:
p(s) = (s)
Taking the ratio of the rst-order conditions in the dierent states yields:
c
i
2
(2)
c
i
2
(1)
=
p(1)
p(2)
(2)
(1)
=
(1)
(2)
(2)
(1)
c
i
2
(1) = c
i
2
(2) for i = 1, 2.
Notice that the rst-order conditions in (2.12) together with the condition that
p(s) = (s) for s = 1, 2 imply that:
c
i
2
(s)
c
i
1
=
y
w
2
(s)
y
w
1
= 1 c
i
1
= c
i
2
(1) = c
i
2
(2) for i = 1, 2
Since countries are symmetric in their endowments and have identical pref-
erences, the optimal consumption allocations and Arrow-Debreu security po-
sitions are given by:
c
1
= (2, 2, 2), c
2
= (2, 2, 2)
z
1
= (2, 2, 0), z
2
= (2, 2, 0)
and equilibrium prices satisfy:
p(1) = p(2) =
3
8
, p(3) =
3
4
.
Thus, by trading in the contingent securities in the absence of any short
sales constraint, each consumer is able to achieve a perfectly smooth consump-
tion stream. Notice that the equilibrium holdings of the third security for both
consumers is zero. Hence, as argued before, the price of the third security in
equilibrium is equal to the sum of the other two securities.
b) Under the short sales constraint, since the optimal security holdings
will be on the boundary, the multiplier associated with the constraint will be
positive. Then, the rst-order conditions imply that:
p(1)
c
i
1
(1)
c
i
2
(1)
> 0
p(2)
c
i
1
(2)
c
i
2
(2)
> 0
p(3)
c
i
1
_
(1)
c
i
2
(1)
+
(2)
c
i
2
(2)
_
= 0 for i = 1, 2.
The last inequality follows from the fact that none of the countries need a
security that will pay in both states, so that the third security is not subject
to the short sales constraint. An equilibrium for this world economy is a
corner solution, where countries share the risk to the extent that the short
sales constraint allows:
c
1
= (2, 3, 1), c
2
= (2, 1, 3)
z
1
= (1, 1, 0), z
2
= (1, 1, 0).
Notice that the short sales constraint aects the consumption of consumer 1 in
state 2 and of consumer 2 in state 1. Substituting these equilibrium allocations
and the values for and given in the question into the rst-order conditions
for the state-contingent securities yields:
p(2) = p(1) >
(3/4)(1/2)2
1
=
3
4
.
Using the third rst-order condition, one can easily check that price of the
third asset is not equal to sum of p(1) and p(2). Since,
p(s)
c
i
1
>
(s)
c
i
2
(s)
for s = 1, 2
then,
p(1)
c
i
1
+
p(2)
c
i
1
>
_
(1)
c
i
2
(1)
+
(2)
c
i
2
(2)
_
=
p(3)
c
i
1
,
which implies
p(1) +p(2) > p(3)
so that the law of one price does not hold.
13
Question 5 We examine the value of the two portfolios at date T. Let S
T
denote the price of the stock at date T.
Value of A =
_
S
T
X +X = S
T
if S
T
> X
X if S
T
X
and
Value of B =
_
X S
T
+S
T
= X if S
T
< X
S
T
if S
T
X
Thus, both portfolios are worth max(S
T
, X) at the expiration date of the
options. Thus, if there is no arbitrage, then two portfolios must have identical
values today. This implies
c +Xr
(Tt)
= p +S
t
, (2.13)
This relation is known as put-call parity. It shows that the value of a European
call with a certain exercise price and date can be deduced from the value of
a European put option with the same exercise price and date, and vice versa.
If this relationship does not hold, then there exists an arbitrage opportunity.
Let us illustrate this with an example. Suppose this equality does not hold
such that:
p +S
t
> c +Xr
(Tt)
The inequality above says that Portfolio B is overpriced relative to Portfolio
A. Thus, the correct arbitrage strategy is to buy the relatively underpriced
security (which is the call in this case) and to short sell the one which is
relatively overpriced (the put and the stock). Such a strategy will generate a
current cash ow of p + S
t
c, which will grow to r
Tt
(p + S
t
c) in T t
periods if invested at the risk free return. At the expiration date, there are
two possible scenarios for this strategy:
if S
T
> X , then only the call will be exercised. The investor will buy
the stock at a price of X at time T and will close out the short position
with it.
if S
T
< X, then only the put will be exercised. The investor is obliged
to buy the stock at a price of X, at time T and will use this stock to
close his short position.
Therefore for both scenarios, r
Tt
(p + S
t
c) X is the net prot
at time T from this strategy. Since, we assumed that r
Tt
(p + S
t
) >
r
Tt
c + X , net prots from this strategy will be positive such that
r
Tt
(p + S
t
c) X > 0 . The table shows the cash ows associated
with such an investment strategy.
S
T
> X S
T
< X
Call c S
T
X 0
Put/stock p +S
t
S
T
S
T
(X S
T
)
Bond p +S
t
c (p +S
t
c)r
Tt
(p +S
t
c)r
Tt
Total 0 (p +S
t
c)r
Tt
X (p +S
t
c)r
Tt
X
Using the same steps described above, one can easily show that an ar-
bitrage strategy also exists when Portfolio A is overpriced relative to
Portfolio B.
15
3 Expected Utility
Question 1 Let L
1
= ((x
1
1
, . . . , x
1
m
),
1
) and L
2
= ((x
2
1
, . . . , x
2
n
),
2
) be two
lotteries and suppose that rewards are ordered such that x
i
1
_ . . . _ x
i
m
.
Choose x
h
such that it is preferred to both x
1
1
and x
2
1
and choose x
l
such
that x
1
m
and x
2
n
are preferred to it. For each x
i
j
compute q
i
j
such that x
i
j

((x
h
, x
l
), (q
i
j
, 1 q
i
j
)
). This can be done the continuity axiom. By the inde-

pendence axiom, L
i
((x
h
, x
l
), (Q
i
, 1 Q
i
)), where Q
i
=

q
i
j
i
j
. By the
dominance axiom, L
1
L
2
if and only if Q
1
> Q
2
.
Notice that q
i
j
is a valid utility measure for x
i
j
because by Axiom 3.6 x
i
j
x
i
k
if and only if q
i
j
> q
i
k
. This implies that q is increasing and by Axiom 3.5, it
is continuous.
Question 2
a) The rst-order condition with respect to x consists of
E[U(W
1
)]
x
= E
_
U(W
1
)
x
_
= E
_
U(W
1
)
W
1
W
1
x
_
= E
_
U
(W
1
)(r r
f
)W
0
_
= 0.
b) The rst-order condition is a nonlinear function of x, which enters
W
1
. To linearize it, we expand U
(W
1
)(r r
f
)W
0
around x = 0 as
E
_
U
(W
1
)(r r
f
)W
0
_
U
(W
0
(1 +r
f
))(r r
f
)W
0
+E
_
x(r r
f
)
2
W
2
0
U
(W
0
(1 +r
f
))
_
.
Solving for x
yields
x
=
_
U
W
0
U
W
2
0
_
_
E(r) r
f
E(r r
f
)
2
_
=
_
E(r) r
f
V ar(r) + [E(r) r
f
]
2
_
_
1
CRRA
_
(3.1)
where E(r r
f
)
2
= V ar(r) + [E(r) r
f
]
2
.
c) The fraction of wealth invested in the risky asset, x
,
varies positively with E(r) r
f
. The higher the expected return on the
risky asset relative to the risk-free, the larger is the fraction of wealth
held in the risky asset. If the risky asset is a fair gamble with E(r) = r
f
,
then x
= 0.
varies negatively with V ar(r).
varies negatively with CRRA, which shows the investors attitude to-
wards risk. As CRRA increases, the fraction of wealth held in the risky
asset decreases.
Question 3
a) Here, is practically useful for two things. First, it is dened in
units of consumption. Second, it summarizes behavior towards risk directly
such that a more risk-averse person is expected to have a higher certainty
equivalent of a particular set of state-contingent consumptions compared to a
less risk-averse person. In this case, the appropriate measure of risk is simply
the dierence between the certainty equivalent and expected consumption.
Since
E(u(c)) = U(c(s)) = u((c(s))),
it follows that
S
s=1
p(s)u(c(s)) =
S
s=1
p(s)u((c(s))) = u((c(s))).
Because u(.) is strictly increasing, it has an inverse so that we can solve for
the certainty equivalent:
(c(s)) = u
1
_
S
s=1
p(s)u(c(s))
_
= u
1
[E(u(c))].
b) Substituting the information we are given into the expected utility
yields:
2
s=1
p(s)u(c(s)) =
1
4
.0 +
3
4
.2 =
3
2
.
The inverse of the CRRA utility function is:
u
1
(x) = [1 + (1 )x]
1
1
= [1 + 0.5x]
2
,
where x = u(c). Then,
u
1
_
3
2
_
=
_
1 +
3
4
_
2
=
49
16
3
17
Question 4
a) i. The certainty eqivalent function can be found from the relation:
=
s
p(s)c(s)
+
_
1
1
_
.
Solving for
yields:
s
p(s)c(s)
.
ii. The certainty equivalent function satises the relation:
E(u(c)) = U(c) = u((c(s))).
Since the person is risk-averse,
u((c(s))) < u[E(c(s))] (c(s)) < E(c(s)),
or equivalently,
=
S
s=1
p(s)M[c(s), ] < E(c(s)).
We can write the right side of this equation as an expectation:
E[M(c(s), )] < E(c(s)).
We claim that M[E(c(s)), ] = E(c(s)). To show this, consider:
=
S
s=1
p(s)M[E(c(s)), ] =
s
p(s)E(c(s))
+
_
1
1
_
,
which implies that:
= E(c(s))
, or = E(c(s)).
It follows that E[M(c(s)), ] < E(c(s)) = M[E(c(s)), ]. But if this inequality
holds, then by Jensens inequality, the function M(.) is concave.
b) Substituting the risk aggregator M into the denition for the certainty
equivalent function yields:
(i) Weighted utility
=
s
p(s)
_
c(s)
+
+
_
1
c(s)
__
=

1
s
p(s)c(s)
+
+

1
s
p(s)c(s)
s
p(s)c(s)
+
z
p(z)c(z)
Notice that the probabilities placed on each outcome are weighted by the factor
z
p(z)c(z)
.
(ii) Disappointment aversion
=
s
p(s)
_
c(s)
+
_
1
1
_
+I[c(s) ]
(c(s)
1
)
_
=

1
s
p(s)c(s)
+
_
1
1
_
+
s
p(s)I[c(s) ]
(c(s)
1
)
Solving for
yields:
s
p(s)c(s)
s
p(s)I[c(s) ](c(s)
)
where I is an indicator function that equals 1 if c(s) and zero otherwise.
Notice that disappointment aversion places greater weight on outcomes that
are worse than the certainty equivalent.
Question 5
a) According to the max-min utility function, the expected utility from
owning security 1 is given by
min
s=1
s
c
s
= min
1
4
1
4
_
1
2

_
=
1
4
and the expected utility from owning security 2 is given by
min
s=1
s
c
s
= min
1
4
1
4
_
1
2
+
_
=
1
4
.
b) By contrast, when the probabilities of the 2 states are known to be
1
2
,
1
2
, then each security is worth 1/2. Thus, we nd that ambiguity about the
probability of a given state leads agents to value payos less than in a situation
where the probabilities are known for sure.
19
4 CAPM and APT
Question 1
a) The problem is to minimize V (r
p
) by choice of x. The rst-order
condition is
V (r
p
)
x
= 2x
2
1
2(1 x)
2
2
+ 2(1 2x)
12
= 0,
which has the solution
x
=

2
2

12
2
1
2
12
+
2
2
=
Cov(r
2
, r
2
r
1
)
V (r
2
r
1
)
. (4.1)
We can calculate the minimum value of the portfolio variance by substituting
for the optimal value of x into the expression for V (r
p
) as
V (r
p
) = x
2
V (r
1
) + (1 x)
2
V (r
2
) + 2x(1 x)
12
=
2
2
2x(
2
2

12
) +x
2
(
2
1
+
2
2
2
12
)
=
2
2
2
(
2
2

12
)
2
2
1
2
12
+
2
2
+
(
2
2

12
)
2
(
2
1
+
2
2
2
12
)
(
2
1
2
12
+
2
2
)
2
=

2
1
2
2

2
12
2
1
+
2
2
2
12
. (4.2)
b) We now consider the optimal solution under alternative covariance
structures for the risky assets. Figure A.1 shows the possible congurations.
- Perfectly positively correlated returns (
12
= 1). In this case,
12
=
1
2
and
x =

2
(
2
1
)
(
2
1
)
2
=

2
1
. (4.3)
Recall that we did not impose any restrictions on the value of x as part
of the optimization problem. Thus, x is not necessarily restricted to
be between zero and one. The above expression shows that when the
underlying risky assets are perfectly positively correlated, the optimal
strategy involves selling one asset (shorting it) and buying the other
asset. But this implies the presence of arbitrage opportunities. Suppose
that the variance on the rst asset is smaller than the variance of the
return for the second asset, i.e.,
1
<
2
, then the minimum variance
portfolio has the share of asset 1 given by
x =

2
1
> 1.
x

y
E(R)
E(R
y
)
E(R
x
)
= 1
= 1

Figure B.1: Eciency Locus with Dierent Values of
Thus, the minimum variance portfolio involves short selling the second
asset and buying the rst asset. Since a security that has a higher
variance will also typically have a higher mean, if the investor follows
this strategy, s/he can obtain a riskless return at zero outlay. Note that
for any x satisfying (4.3), the variance of r
p
is:
V (r
p
) =

2
1
2
2

2
12
2
1
+
2
2
2
12
=

2
1
2
2

2
1
2
2
2
1
+
2
2
2
12
= 0,
To evaluate its mean, suppose E(r
1
) = 6, E(r
2
) = 10,
1
= 4 and
2
= 8.
Then,
x =
8
8 4
= 2 or 200%,
and
E(r
p
) = 2(6) 10 = 2.
Since such arbitrage is inconsistent with individual optimization and
market equilibrium, we typically rule out the case of perfectly positively
correlated assets.
21
- Perfectly negatively correlated returns (
12
= 1). In this case,
12
=
2
and
x =

2
(
2
+
1
)
(
2
+
1
)
2
=

2
2
+
1
, (4.4)
and V (r
p
) = 0. In this case, the investor holds positive amounts of both
assets. Perfect negative correlation implies that when one asset has a
return above average, the other asset has a return below average. Thus,
by holding both assets in the proportions described above, the investor
can obtain a positive expected return with no risk.
- Uncorrelated returns (
12
= 0). In this case,
x =

2
1
2
2
+
2
1
, (4.5)
and
V (r
p
) =

2
1
2
2
2
2
+
2
1
. (4.6)
Question 2
a) Dene l to be the n 1 vector of ones, i.e., l = (1, 1, . . . , 1)
. Hence,
we can write the investors end-of-period wealth as
W
t+1
= W
t
_
x
t
(l +r
t+1
) + (1 x
t
l)(1 +r
f
t+1
)
_
= W
t
_
x
t
l +x
t
r
t+1
+ 1 x
t
l +r
f
t+1
x
t
lr
f
t+1
_
= W
t
_
1 +x
t
r
t+1
lr
f
t+1
+r
f
t+1
_
= W
t
(1 +r
p
t+1
).
b) We assume that the consumer maximizes the expected utility of next
periods wealth E
t
[U(W
t+1
)]. As before, we expand E
t
[U(W
t+1
)] around
E
t
(r
p
t+1
). It follows that
E
t
[U(W
t+1
)] = E
t
_
U
_
W
t
(1 +r
p
t+1
)
_
E
t
_
U
_
W
t
(1 +E
t
r
p
t+1
)
+W
t
(r
p
t+1
E
t
r
p
t+1
)U
+
1
2
W
2
t
(r
p
t+1
E
t
(r
p
t+1
))
2
U
_
= U
_
W
t
(1 +E
t
r
p
t+1
)
+
1
2
W
2
t
V
t
(r
p
t+1
)U
= F
_
E
t
(r
p
t+1
), V
t
(r
p
t+1
)
_
, (4.7)
where F > 0, F
1
= F/E
t
(r
p
t+1
) > 0, F
2
= F/V
t
(r
p
t+1
) 0, and F
2
/F
1
=
(W
t
U
)/(2U
). Thus, we have that maximizing expected utility is equivalent

to maximizing a function of expected return and the variance of returns, where
the two are traded o.
Using the denition of r
p
t+1
, we have that
E
t
(r
p
t+1
) = x
t
E
t
(r
t+1
) + (1 x
t
l)r
f
t+1
(4.8)
and
V
t
(r
p
t+1
) = x
t
E
t
_
(r
t+1
E
t
(r
t+1
))(r
t+1
E
t
(r
t+1
))
x
t
= x
t
V
t
(r
t+1
)x
t
. (4.9)
Hence, the investor can choose to invest nothing in the risky assets (by setting
x
t
= 0) and obtain a zero variance on the portfolio V
t
(r
p
t+1
) = 0 and the sure
portfolio return r
p
t+1
= r
f
t+1
, or s/he can invest in both the risk-free and the
risky assets and obtain a portfolio return that is greater than the risk-free
return E
t
(r
p
t+1
) > r
f
t+1
and a positive portfolio variance V
t
(r
p
t+1
) > 0.
c) Consider the problem
max
x
t
F
_
E
t
(r
p
t+1
), V
t
(r
p
t+1
)
_
subject to
r
p
t+1
= x
t
(r
t+1
lr
f
t+1
) +r
f
t+1
and V
t
(r
p
t+1
) = x
t
V
t
(r
t+1
)x
t
.
The rst-order conditions with respect to x
t
are
F
x
t
= F
1
_
E
t
(r
p
t+1
)
x
t
_
+F
2
_
V
t
(r
p
t+1
)
x
t
_
= F
1
_
E
t
(r
t+1
) lr
f
t+1
_
+F
2
2V
t
(r
t+1
)x
t
= 0.
d) We can manipulate the rst-order conditions to show that:
E
t
(r
t+1
) lr
f
t+1
=
_
2
F
2
F
1
_
V
t
(r
t+1
)x
t
=
t
V
t
(r
t+1
)x
t
, (4.10)
23
where
t
= W
t
U
/U
= 2F
2
/F
1
= CRRA. Pre-multiply both sides of
the expression in (4.10) by x
t
. Thus, at the consumers optimum, the excess
return on the optimal portfolio relative to the risk-free return is given by
E
t
(r
p
t+1
) r
f
t+1
= x
t
(E
t
(r
t+1
) lr
f
t+1
)
=
t
x
t
V
t
(r
t+1
)x
t
=
t
V
t
(r
p
t+1
). (4.11)
We can use this expression to solve for
t
as
t
=
E
t
(r
p
t+1
) r
f
t+1
V
t
(r
p
t+1
)
. (4.12)
Eliminating
t
from (4.11) using the expression in (4.12) yields
E
t
(r
t+1
) lr
f
t+1
= [E
t
r
p
t+1
r
f
t+1
]
V
t
(r
t+1
)x
t
V
t
(r
p
t+1
)
.
e) Notice that this relation holds at each consumers optimum, regardless
of her/his attitude towards risk. If all market investors have identical beliefs,
then in equilibrium the return on the portfolio r
p
will be the market return
r
m
, too. Thus, in equilibrium the return on each risky asset relative to the
risk-free asset is given by
E
t
(r
t+1
) lr
f
t+1
= [E
t
r
m
t+1
r
f
t+1
]
V
t
(r
t+1
)x
t
V
t
(r
m
t+1
)
,
or
E
t
(r
p
t+1
) r
f
t+1
= [E
t
r
m
t+1
r
f
t+1
]
x
t
V
t
(r
t+1
)x
t
V
t
(r
m
t+1
)
= [E
t
r
m
t+1
r
f
t+1
]
V
t
(r
p
t+1
)
V
t
(r
m
t+1
)
. (4.13)
The relationship in (4.13) is an equilibrium relation which provides a linear
representation for the risk and return on ecient portfolios. It represents the
mean-variance portfolio frontier in the presence of a risk-free asset. This is
known as the Capital Market Line (CML). The CML is graphed in Figure A.2
below.
The picture depicts investment opportunity (or feasible) set with nitely
many risky assets. The point on the left side of the set, denoted by + sign
is the minimum variance portfolio, which is the portfolio with the smallest
risk and maximum expected return. The point, where the line is tangent to
the mean-variance frontier denotes the market (tangency) portfolio, where the
Capital Market Line (CML) is tangent to the frontier. The portfolio provides
the largest slope for the line drawn from a given expected risk-free return.
In other words, the market portfolio, when combined with a risk-free asset
provides highest return per risk.
Market
Portfolio
Minimum
Variance
Portfolio
CML
E(R
f
)
E(R)
Figure B.2: Capital Market Line (CML)
Question 3
a) This follows directly from part (e) of Exercise 2 above by noting that
V (r
t+1
)x
t
= Cov
t
(r
t+1
, r
p
t+1
).
Substituting for r
p
t+1
= r
m
t+1
and evaluating Cov
t
(r
t+1
, r
m
t+1
) for a single asset
yields the result in the text.
b) The market beta shows the covariance of the return on asset i with
the market return. The quantity [E
t
(r
m
t+1
) r
f
t+1
] is referred to as the price of
risk, and the quantity of risk is the beta for asset i,
it
. The linear relationship
between the excess expected return on asset i relative to the risk-free asset,
on the one hand, and the price and quantity of risk, on the other, is referred
to as the Capital Asset Pricing Model.
c) The beta of a risk-free asset is 0:
Cov
t
(r
f
t+1
, r
m
t+1
)
V ar
t
(r
m
t+1
)
= 0.
25
d) The beta of the market return is 1:
Cov
t
(r
m
t+1
, r
m
t+1
)
V ar
t
(r
m
t+1
)
= 1.
Question 4 Let us begin with writing the rst-order condition given below
once more:
q
l
= E
_
U
_
N
n=1
i
n
x
n
_
x
l
_
.
Since, this rst-order condition is valid for all securities, we can write it for
the riskless security, too:
q
f
= E
_
U
_
N
n=1
i
n
x
n
_
x
f
_
Equating the s and arranging the resulting equation we obtain:
E
_
U
_
N
n=1
i
n
x
n
__
x
l
q
l
x
f
q
f
__
= 0
Since, R
n
= x
n
/q
n
n = 1, 2, ..., N, we can write this equation as:
E
_
U
_
N
n=1
i
n
x
n
_
(R
l
r
f
)
_
= 0
or
E
_
U
_
N
n=1
W
i
_
(R
l
r
f
)
_
= 0
where we make use of the denition of next periods wealth: W
i
s
=

N
n=1
i
n
x
n
.
Let us apply the covariance decomposition in order to rewrite the above equa-
tion as:
Cov
_
U
_
N
n=1
W
i
_
, (R
l
r
f
)
_
= E(R
l
r
f
)E
_
U
_
N
n=1
W
i
__
Now, we can use the lemma given in the question on the left side of this
equation:
E[U
(W
i
)]Cov
_
W
i
, (R
l
r
f
)
_
= E(R
l
r
f
)E
_
U
_
N
n=1
W
i
__
Substituting the denitions of w
i
n
and R
n,s
, we can write the next periods
wealth in terms of w
i
n
, R
n,s
and W
i
0
as follows:
W
i
= W
i
0
N
n=1
w
i
n
R
n
Substituting this denition into the equation yields:
E(R
l
r
f
)E[U
(W
i
)] = E[U
(W
i
)]Cov
_
W
i
0
N
n=1
w
i
n
R
n
, (R
l
r
f
)
_
= E[U
(W
i
)]W
i
0
Cov
_
N
n=1
w
i
n
R
n
, (R
l
r
f
)
_
Rearranging yields:
E(R
l
r
f
)E[U
(W
i
)]
E[U
(W
i
)]W
i
0
= Cov
_
N
n=1
w
i
n
R
n
, (R
l
r
f
)
_
E(R
l
r
f
)
A(W
i
)W
i
0
= Cov
_
N
n=1
w
i
n
R
n
, (R
l
r
f
)
_
where A(W
i
) is the coecient of absolute risk aversion evaluated at W
i
. Now,
we can sum the left and right sides of this equation over individuals:
E(R
l
r
f
)
I
i=1
_
1
A(W
i
)W
i
0
_
=
I
i=1
Cov
_
N
n=1
w
i
n
R
n
, (R
l
r
f
)
_
= Cov
_
I
i=1
N
n=1
w
i
n
R
n
, (R
l
r
f
)
_
Since R
W
s

I
i=1
N
n=1
w
i
n
R
n,s
and the return to the market portfolio and to
the riskless asset are uncorrelated, this reduces to
E(R
l
r
f
)
I
i=1
_
1
A(W
i
)W
i
0
_
= Cov(R
l
, R
W
) (4.14)
Since Eq.(4.14) is valid for all assets, we can write it for the market portfolio,
too:
E(R
W
r
f
)
I
i=1
_
1
A(W
i
)W
i
0
_
= Cov(R
W
, R
W
) = V ar(R
W
) (4.15)
Dividing Eq.(4.14) to Eq.(4.15) yields the CAPM representation:
E(R
l
r
f
) = E(R
W
r
f
)
Cov(R
l
, R
W
)
V ar(R
W
)
.
27
5 Consumption and Saving
Question 1 Under certainty, we solve the following problem:
max U(c
1
) +U(c
2
)
with respect to
c
1
+S y
1
c
2
y
2
+ (1 +r)S.
If we substitute the values of c
1
and c
2
, then we obtain
max U(y
1
S) +U[y
2
+ (1 +r)S] .
The F.O.C is given by:
U
(c
1
) = (1 +r)U
(c
2
). (5.1)
Since our utility function is quadratic, then U
(c
1
) = a bc
1
and U
(c
2
) =
a bc
2
. If we substitute these values into the equation (5.1), and solve for c
2
,
we obtain the value of c
2
under certainty as following;
c
2
=
a[(1 +r) 1] +bc
1
b(1 +r)
. (5.2)
On the other hand, when we look at the solution under uncertainty, we
solve the following problem:
max E U(c
1
) +U(c
2
)
with respect to
c
1
+S y
1
c
2
y
2
+ (1 +r)S.
If we also substitute the values of c
1
and c
2
, then we obtain
max E U(y
1
S) +U[y
2
+ (1 +r)S] .
The F.O.C is given by:
E
_
U
(c
1
)
= E
_
(1 +r)U
(c
2
)
. (5.3)
If we substitute values of c
1
and c
2
associated with the quadratic utility func-
tion into the equation (5.3), and solve for c
2
, we obtain the value of c
2
under
uncertainty as follows:
E[c
2
] =
a[(1 +r) 1] +bE(c
1
)
b(1 +r)
. (5.4)
Thus, we nd that the solution under uncertainty is equal to the expectation
of the solution under certainty. This is known as the certainty equivalent
property. It is worth noting that the quadratic utility function is the only
utility function for which this property holds.
Question 2 To solve this problem, we construct the Lagrange function as
follows;
L =
i=0
_
i
log(c
t+i
) +
t
[y
t
+S
t
(1 +r) c
t
S
t+1
]
_
.
The F.O.Cs are
L
c
t
= 0

t
c
t
=
t
L
c
t+1
= 0

t+1
c
t+1
=
t+1
L
S
t+1
= 0

t
t+1
= 1 +r.
a) The stochastic discount factor is
m
t+1
=
U
(c
t+1
)
U
(c
t
)
=
c
t
c
t+1
.
b) The price of the wealth portfolio is calculated as:
P
W
t
= E
t
j=1
j
U
(c
t+j
)
U
(c
t
)
c
t+j
= E
t
j=1
j
c
t
c
t+j
c
t+j
= E
t
j=1
j
c
t
,
which implies
P
W
t
= E
t
j=1
j
c
t
= E
t
c
t
( +
2
+
3
+...)
= E
t
c
t
1
= c
t
1
.
c) Finally the return on the wealth portfolio is dened as:
R
W
t+1
=
P
W
t+1
+c
t+1
P
W
t
=
c
t+1
1
+c
t+1
c
t
1
=
c
t+1
c
t
,
which implies that
1
R
W
t+1
=
c
t
c
t+1
= m
t+1
.
29
Hence, the inverse of the return on the wealth portfolio is equal to the stochas-
tic discount factor, which is strictly positive. Thus, the log utility CAPM
provides a way to obtain a atrictly positive discount factor that is based on
(the inverse of) the return on the wealth portfolio.
Question 3 This is an example of a dynamic optimization problem with a
quadratic utility function and a present-value form of the budget constraint.
Let the single-period utility function be given by U(c
t
) = a (b/2)c
2
t
. The
problem is:
max
{c
t
,b
t+1
}
E
0
_

t=0
U(c
t
)
_
subject to
b
t+1
+y
t
= c
t
+i
t
+g
t
+ (1 +r)b
t
, t 0,
given b
0
. It is straightforward to show that the intertemporal Euler equation
is:
(1 +r)E
t
[c
t+s
] =
a[(1 +r) 1]
b
+E
t
[c
t+s1
]
= B +E
t
[c
t+s1
], s 1, (5.5)
where B = a[(1 +r) 1]/b.
a) To express the solution for consumption in terms of national cash ows
nf
t
, solve the budget constraint forward at time t, imposing the transversality
condition that
lim
h
E
t
_
b
t+h+1
(1 +r)
t+h
_
0.
This yields:
s=0
c
t+s
(1 +r)
s
=
s=0
y
t+s
i
t+s
g
t+s
(1 +r)
s
(1 +r)b
t
=
s=0
nf
t+s
(1 +r)
s
(1 +r)b
t
.
Now take expectations of both sides of the present-value budget constraint
and substitute recursively for E
t
[c
t+s
] using the rst-order condition:
c
t
+
s=1
c
t
s
(1 +r)
2s
+
B
(1 +r)
2
_
_
1
1
1
(1+r)
_
_
2
=
s=0
E
t
_
nf
t+s
(1 +r)
s
_
(1 +r)b
t
.
Ignoring the constant term and simplifying yields:
c
t
=
r
__
1
1 +r
E
t
s=0
nf
t+s
(1 +r)
s
_
b
t
_
,
where
=
(1 +r)r
(1 +r)
2
1
.
This result shows that predicted consumption is proportional (r/) to net
productive wealth, which is dened as the present value of expected national
cash ows, net of the stock of foreign debt today.
The parameter is known as the consumption-tilting parameter. Consider
3 cases:
= 1. This corresponds to the permanent income theory. In this case,
the consumption-smoothing level of consumption is equal to permanent
net cash ow or the countrys wealth, and the country is neither accu-
mulating nor decumulating foreign assets.
< 1. Using the denition of , we have that
(1 +r)r
(1 +r)
2
1
< 1 (1 +r) > 1.
Hence, the country is initially consuming more than its permanent na-
tional cash ow by running current account decits and then decreasing
its consumption to meet its intertemporal solvency constraint. This oc-
curs because > (1 + r)
1
, which means that the subjective discount
factor is greater than the discount factor oered by world capital mar-
kets. Equivalently, the rate of return from deferring consumption is lower
than the rate of return oered by world capital markets.
> 1. In this case, < (1 +r)
1
and the country is initially consuming
less than its permanent net cash ow and gradually increasing its con-
sumption to satisfy its intertemporal constraint. In this case, the return
from deferring consumption is greater than the rate of return oered by
world capital markets, and the country accumulates foreign assets by
running current account surpluses.
b) The optimal consumption-smoothing current account CA
t
is evalu-
ated at the optimal value for consumption with = 1. In this case, no con-
sumption tilting occurs. To nd CA
t
, use the denition of the current account
31
and substitute for the optimal consumption evaluated at = 1, c
t
:
CA
t
= nf
t
c
t
rb
t
= nf
t
r
_
1
1 +r
E
t
s=0
nf
t+s
(1 +r)
s
b
t
_
rb
t
= nf
t
r
1 +r
E
t
_

s=0
nf
t+s
(1 +r)
s
_
=
nf
t
1 +r

r
1 +r
E
t
_

s=1
nf
t+s
(1 +r)
s
_
= E
t
_
nf
t+1
1 +r
+
nf
t+1
(1 +r)
2
_
r
1 +r
E
t
_

s=2
nf
t+s
(1 +r)
s
_
= E
t
_
nf
t+1
1 +r

nf
t+2
(1 +r)
2
+
nf
t+2
(1 +r)
3
_
r
1 +r
E
t
_

s=3
nf
t+s
(1 +r)
s
_
= E
t
_

s=1
nf
t+s
(1 +r)
s
_
.
The last relation shows that the consumption-smoothing component of the
current account is the negative of the present discounted value of expected
changes in national cash ow. The current account is in decit when the
present discounted value of expected changes in national cash ow is positive.
The current account is in surplus in the opposite case.
c) By this argument, permanent increases in real output (y
t+s
for all s)
have no eect on the current account since optimal consumption also increases
by the same amount, leaving the current account unchanged. For the same rea-
son, permanent decreases in investment or government expenditures result in
equal increase in consumption; hence, the current account remains unchanged.
Note, however, that a permanent positive shock to investment may worsen the
current account, if the investment shock is expected to increase output in the
future.
On the other hand, any temporary shock will have an eect on the cur-
rent account. If there is a temporary increase in investment or government
spending, a temporary decrease in national cash ow occurs. Therefore, the
current account decit increases and the economy increases its foreign liabil-
ities. For the opposite case, any temporary positive shock to real output or
a temporary decrease in investment improves the current account, hence the
economy increases its foreign assets. For these reasons, we can say that the
current account plays a role of buer to smooth consumption in the presence
of temporary shocks.
Question 4
a) Eliminate l
t
using the time constraint. The problem is
max
{c
t
,n
t
,S
t+1
}
t=0
t
U(c
t
, 1 n
t
) +
t
[w
t
n
t
+ (1 +r)S
t
c
t
S
t+1
] .
The rst-order conditions are
U
1
(c
t
, 1 n
t
) =
t
, (5.6)
U
2
(c
t
, 1 n
t
) =
t
w
t
, (5.7)
t
=
t+1
(1 +r). (5.8)
Eliminate
t
in the rst two equations to obtain
U
2
(c
t
, 1 n
t
) U
1
(c
t
, 1 n
t
)w
t
= 0. (5.9)
Dierentiate with respect to n
t
to show that the left side is monotonically
increasing in n
t
, assuming both consumption and leisure are normal goods.
We can express n
t
as a function of (c
t
, w
t
), using the inverse function theorem.
Hence,
n
t
= H(c
t
, w
t
).
Totally dierentiate (5.9) with respect to c
t
after substituting in the function
H,
H
c
t
=
U
21
U
11
w
t
U
22
U
12
w
t
< 0.
Hence the higher consumption, the lower is labor supply or the higher is leisure.
Totally dierentiate with respect to w
t
,
H
w
t
=
U
1
U
22
+U
12
w
t
> 0.
Hence the higher wages, the more agents work (no surprise). Next substitute
the solution into the rst-order condition (5.8). This yields the intertemporal
Euler equation:
1 =
U
1
(c
t+1
, 1 H(c
t+1
, w
t+1
))(1 +r)
U
1
(c
t
, 1 H(c
t
, w
t
))
. (5.10)
Using this equation along with the budget constraint results in a second-order
nonlinear dierence equation in savings (specically solve the budget con-
straint for c
t
and substitute into (5.10)).
33
b) Under this assumption,
U
1
(c
t
, 1 H(c
t
, w
t
)) = U
1
(c
t+1
, 1 H(c
t+1
, w
t+1
)), (5.11)
so that the marginal utility of consumption is constant over time. If utility
were a function of consumption only, then this implies that consumption is
constant since the utility function is concave. Let K denote the constant
marginal utility of consumption. We know then that the pair (c
t
, n
t
) that
solve the rst-order conditions is
U
1
(c
t
, 1 H(c
t
, w
t
)) = K.
Totally dierentiate with respect to c
t
,
U
11
U
12
H
c
t
= U
11
U
12
_
U
21
U
11
w
t
U
22
U
12
w
t
_
=
U
11
U
22
U
2
12
U
22
U
12
w
t
> 0
Since the left side is increasing in c
t
, there exists a unique solution, given K,
c
t
= g(c
t
, K).
The problem now is to nd K such that the lifetime budget constraint holds.
That step is explained later.
c) The rst-order conditions imply that
2
1 n
t
=

1
w
t
c
t
c
t+1
c
t
= (1 +r)
Under the assumption (1 +r) = 1, the system can be rewritten as
n
t
= 1

2
c
t
1
w
t
,
c
t
= c
t+1
.
Under this preference assumption, specically that the utility function is sepa-
rable in c
t
, l
t
, and the assumption that (1+r) = 1, consumption is a constant;
call it c. Substitute this into the rst-order condition,
n
t
= 1 c

2
1
w
t
. (5.12)
Notice that labor supply does uctuate in response to uctuations in the wage
rate. We need to nd the lifetime budget constraint. Solve the initial budget
constraint for S
0
,
S
0
=
1
1 +r
[c
0
+S
1
w
0
n
0
]
Now solve this forward to obtain
S
0
+
t=1
_
1
(1 +r)
_
t
w
t
n
t
= c
t=1
_
1
(1 +r)
_
t
, (5.13)
assuming c is constant. Substitute for n
t
using (5.12) and simplify to obtain
S
0
+
t=1
_
1
(1 +r)
_
t
_
w
t
c
1
_
=
c
r
or
S
0
+
t=1
_
1
(1 +r)
_
t
w
t
=
c
r
_
1 +

2
1
_
.
Given S
0
and the wage sequence, c can be determined from the equation above.
d) If we assume the logarithmic utility function above, then consumption
will be a constant. When wages are high, labor will be high and labor is low
when wages are low. This can be veried from the labor function above.
Specically,
n
l
= 1 c

2
1
w
l
< n
h
1 c

2
1
w
h
.
35
6 Dynamic Programming
Question 1
a) Write the Bellman equation as follows:
V (y) = max
c,k
_
U(c) +V (f(k
)
_
subject to c + k
= y = k. Since the technology shock is deterministic, we

can dene ()
1
= .
1
Now try to make a guess about the form of the value
function. For instance:
V (y) = G+F
_
y
1
1
_
where F and G are undetermined constants. Use the rst-order condition:
U
(c) =
V (y
)
k
and substitute our guess into this condition to obtain:

c
= (y k
= (k k
= F(y
= F(k
.
Then, the values of next periods capital stock and consumption are given by:
k
=
k
1 + (F)
1/
,
c =
k[(F)
1/
]
1 + (F)
1/
.
Now use the envelope condition V
(k) = U
(c)f
(k) together with the expres-

sion for the value function to obtain:
F
1/
=
[(F)
1/
]
1 + (F)
1/
,
which implies that
(
1
F)
1/
= ()
1/
1.
Substituting this result back into the decision rules for capital and consumption
yields:
c = g(y) = y
y
()
1/
,
k
= h(y) =
y
()
1/
.
1
We note that the solution to the problem with {
t
}
t=0
i.i.d. will be the same provided
we dene

= E(
)
1
and take expectations of the future value function.
b) We follow the approach in the text to generate a solution.
t=T:
The value function at the terminal date again has the form:
max
k
T+1
V (k
T
) =
c
1
T
1
+V (k
T+1
)
If we are at time t = T, next periods utility will be 0, so that V (k
T+1
) = 0.
The Bellman equation at time t = T reduces to:
max
k
T+1
V (k
T
) =
c
1
T
1
=
[k
T
k
T+1
]
1
1
.
Obviously, solution to this maximization problem is k
T+1
= 0. The value
function at time T is:
V (k
T
) =
[k
T
]
1
1
,
and the optimal consumption level is c
T
= k
T
.
t=T-1:
The social planner solves
max
k
T
V (k
T1
) =
c
1
T1
1
+V (k
T
).
Substituting for V (k
T
) and feasibility constraints yields:
max
k
T
V (k
T1
) =
[k
T1
k
T
]
1
1
+
(k
T
)
1
1
.
The rst-order condition with respect to k
T
is:
(k
T1
k
T
)
= (k
T
)
.
Letting F
T
= (
1
)
1/
, the solution for k
T
is:
k
T
=

1 +F
T
k
T1
.
Using the law of motion for capital and the feasibility constraint, one can show
that the optimal consumption is:
c
T1
=
F
T
1 +F
T
k
T1
.
Now we need to re-write the value function at time T 1 in terms of k
T1
:
V (k
T1
) =
_
_
F
T
1+F
T
_
1
+
_

2
1+F
T
_
1
_
1
k
1
T1
.
37
t=T-2:
Dene
R
T1
=
_
_
F
T
1 +F
T
_
1
+
F
T
(1 +F
T
)
1
_
.
The Bellman equation for time T 2 is:
max
k
T1
V (k
T2
) =
[k
T2
k
T1
]
1
1
+
R
T1
(k
T1
)
1
1
.
Taking the derivative with respect to k
T1
yields:
(k
T2
k
T1
)
=
1
R
T1
k
T1
.
Solving for k
T1
and c
T2
yields:
k
T1
=

1 + (
1
R
T1
)
1/
k
T2
(6.14)
c
T2
=
(
1
R
T1
)
1/
1 + (
1
R
T1
)
1/
k
T2
. (6.15)
Let
F
T1
= (
1
R
T1
)
1/
.
As before, we can re-write the value function at time T 2 in terms of
k
T2
as:
V (k
T2
) =
_
_
F
T1
1+F
T1
_
1
+R
T1
_

2
1+F
T1
_
1
_
1
k
1
T2
.
Let
R
T2
=
_
_
F
T1
1 +F
T1
_
1
+
F
T1
(1 +F
T1
)
1
_
.
t=T-3: We can now observe a pattern for the optimal policy functions.
Using the same steps, one can show that
k
T2
=

1 + (
1
R
T2
)
1/
k
T3
c
T3
=
(
1
R
T2
)
1/
1 + (
1
R
T2
)
1/
k
T3
.
Let
F
T2
= (
1
R
T2
)
1/
.
These results yield a pattern for the evolution of optimal capital and consump-
tion for t = 0, . . . , T as
k
t
=

1 +F
t
k
t1
(6.16)
c
t1
=
F
t
1 +F
t
k
t1
, (6.17)
where
F
t
= (
1
)
1/
F
t+1
1 +F
t+1
, given F
T
= (
1
)
1/
.
c) We will write the solution to nite horizon problem in terms of the
terminal period T:
c
F
t
=
F
t
1 +F
t
k
t
=
(
1
)
1/
F
t+1
1+F
t+1
1 + (
1
)
1/
F
t+1
1+F
t+1
k
t
=
(
1
)
1/
F
t+1
1 +F
t+1
+ (
1
)
1/
F
t+1
k
t
=
(
1
)
1/
1 + (
1
)
1/
+
1
F
t+1
k
t
If we substitute for F
t+1
recursively, we see that the consumption can be
written as:
c
F
t
=
(
1
)
(Tt)/
Tt
i=0
(
1
)
i/
+F
1
T
k
t
=
(
1
)
(Tt)/
1(
1
)
(Tt+1)/
1(
1
)
1/
+
1
()
1/
k
t
In order to take the limit of this expression, we can use LHospital Rule and
take the derivative of the numerator and the denominator with respect to T
to obtain:
lim
T
c
F
t
=
lim
T
(
1
)
(Tt)/
ln(
1
)(
1
)
lim
T
(
1
)
(Tt+1)/
ln(
1
)(
1
)
1(
1
)
1/
k
t
= (
1
)
1/
[1 (
1
)
1/
]k
t
= y
t
(
1
)
1/
y
t
= c
I
t
.
So, in the limit, the optimal consumption we found for the nite horizon
case will converge to the deterministic version of the solution for the innite
horizon.
39
Question 2
a) Let Prob(
t
=
h
) = G(
h
) for h = 1, . . . , k. Then,
l
i,j
= Prob(X
t+1
= X
j
[X
t
= X
i
, u
t
= u
l
)
=
k
h=1
G(
h
)f(X
t
= X
i
, u
t
= u
l
,
t
=
h
).
b) Since the shock
t
is i.i.d. and the law of motion for X
t
depends only
on its past value, the state variable for the problem consists of X
t
. Thus, the
value function may be expressed as:
V (X
t
) = max
u
t
_
v(X
t
, u
t
) +
r
h=1
V (X
t+1
)G(
h
)
_
.
However, using our answer to part a) and the notation dened in the problem,
we can simplify this expression as
V
i
= max
l
_
_
_
v
i,l
+
r
j=1
l
i,j
V
j
_
_
_
(TV )
i
,
for i = 1, . . . , r.
c) Using the notation in the problem, we can stack the values of V
i
eval-
uated at the optimal solution U
i
as:
_
_
V
1
V
2
.
.
.
V
r
_
_
=
_
_
S
1
S
2
.
.
.
S
s
_
_
+
_
11

12
. . .
1r
21

22
. . .
2r
.
.
.
.
.
. . . .
.
.
.
r1

r2
. . .
rr
_
_
_
_
V
1
V
2
.
.
.
V
r
_
_
,
which can be re-written as:
V = S +V V = (1 )
1
S.
This shows that the solution for the value function at every possible current
state X
i
is equal to the current evaluated at the optimal policy for that state,
v(X
i
, U
i
), plus expected discounted value of the future value, conditional on
the current state, X
i
, and the control variable that is optimal conditional on
that state, U
i
.
d) To do value iteration, guess that the initial value function for any
state X
j
is 0, V
0
j
= 0. Then
V
1
i
= (TV
0
)
i
= max
l
v
i,l
, i = 1, . . . , n
which says that the value function at the next iteration is just equal to the
value of the current return v(X
i
, u
l
) maximized with respect to the control
variable u
l
for l = 1, . . . , m. Now proceed in this way and use V
1
in the next
iteration as:
V
2
i
= (TV
1
)
i
= (T
2
V
0
)
i
= max
l
_
_
_
v
i,l
+
n
j=1
l
i,j
V
1
j
_
_
_
,
for i = 1, . . . , m. We continue in this way until max
h
[V
n+1
h
V
n
h
[ , where
> 0 is some small number.
e) To understand how policy function iteration is implemented, start
with V
0
= 0. Then
U
1
i
= |V
0
i
= max
l
v
i,l
, i = 1, . . . , r
S
1
i
= v(X
i
, U
1
i
), i = 1, . . . , r.
To nd
1
i,j
, choose the value of
l
i,j
that corresponds to the optimal control
at stage 1, namely, U
1
i
. Once
1
is determined, the value function at the next
stage can be determined as
V
1
= (1
1
)
1
S
1
,
where we have stacked all the relevant variables in vectors and matrices. We
continue to iterate in this way until max
l
[U
n+1
l
U
n
l
[ , where > 0 is some
small number.
The dierence between value iteration and policy function iteration is that
we seek convergence in terms of the optimal policy function instead of the
value function. However, at each stage of the policy function iteration, we also
update the value function according to the new policy function and the new
probabilities of the future state, conditional on the new control variable.
Question 3 Notice that
|V
n
V
| |V
n
V
n+1
| +|V
n+1
V
|.
41
But
|V
n+1
V
| = |TV
n
TV
| |V
n
V
|
since V
satises TV
= V
and T is a contraction. Combining these results

yields
|V
n
V
| |V
n+1
V
n
| +|V
n
V
|,
which implies that
|V
n
V
|
1
1
|V
n+1
V
n
|.
b) We can use this result to bound the error in approximating the true value
function by V
n
since the result in part a) says that for any n, this error is
(1 )
1
of the distance between the value function at the n
th
and (n + 1)
th
iterations.
7 Intertemporal Risk Sharing
Question 1
a) Let R
+
denote the positive real numbers. The commodity space is the
space of sequences c
i
R
TS
+
.
b) To answer this question, you need to solve for the competitive equi-
librium. Agent i solves
max
T
t=1
s
t
S
t
t
U(c
i
(s
t
))
t
(s
t
)
+
i
T
t=1
s
t
p
t
(s
t
)[w
i
(s
t
) c
i
(s
t
)].
Denote
p(s
t
)
p
t
(s
t
)
t
(s
t
)
.
Suppose we are looking for a stationary solution. This means that for any
state s
t
, agent i has the consumption c
i
(s
t
), regardless of the time period.
U
(c
i
(s
t
))
i
= p(s
t
). (7.18)
The right side is the same for all agents i = 1, . . . , I. Dene the inverse function
for marginal utility as G = (U
)
1
, or if U
(c) = x then c = G(x). It follows

that
c
i
(s
t
) = G( p(s
t
)
i
).
These functions are known as the Frisch demands, which express consumption
allocations in terms of the marginal utility-weighted prices.
The feasibility condition is
I
i=1
w
i
(s
t
) =
I
i=1
c
i
(s
t
) =
I
i=1
G( p(s
t
)
i
). (7.19)
For each agent, his lifetime budget constraint must hold, or
T
t=1
s
t
t
(s
t
) p(s
t
)[w
i
(s
t
) G( p(s
t
)
i
)] (7.20)
where the only unknown is
i
, given prices. Hence there are I equations in the
unknown
i
. For each s
j
S there are S equations of the form (7.19). Hence
the solution is a system of I +S equations.
43
Now to answer the original question: observe that the consumption allo-
cation for an agent depends on his
i
and prices, where
i
is invariant with
respect to s
t
or t. The budget constraint does not require, for a given time
path of realizations s
t
, that
T
t=1
p
t
( s
t
)[w
i
( s
t
) c
i
( s
t
)] = 0.
Hence an agent may expire with a surplus or a decit along a particular sample
path. What the budget constraint does require is that the weighted average
equals zero over all possible time paths, where the weights are the prices.
c) Observe that feasibility requires the sum of all endowments at a point
in time equal the sum of consumption for any s
t
. If we take the equation
above, the budget constraint along a sample path, and sum over all agents,
I
i=1
T
t=1
p
t
( s
t
)
_
I
i=1
[w
i
( s
t
) c
i
( s
t
)]
_
= 0 (7.21)
where the equality follows because
T
t=1
p
t
( s
t
)
_
I
i=1
[w
i
( s
t
) c
i
( s
t
)]
_
= 0 (7.22)
where the term in brackets must equal 0 by feasibility. Hence if some agent i
dies in debt then there is some agent j that dies in a surplus.
d) Let M(s
t+1
) U
(c
i
(s
t+1
))/U
(c
i
(s
t
)). Observe that M is not a func-
tion of i since the intertemporal marginal rate of substitution is equal across
agents. To see this, observe for agent i
t
U
(c
i
(s
t
))
t
(s
t
)
p
t
(s
t
)
=
i
=

t+1
U
(c
i
(s
t+1
))
t+1
(s
t+1
)
p
t+1
(s
t+1
)
so that
(s
t+1
, s
t
)U
(c
i
(s
t+1
)
U
(c
i
(s
t
))
=
p
t+1
(s
t+1
)
p
t
(s
t
)
.
which can be rewritten as
p
t+1
(s
t+1
) = M(s
t+1
)(s
t+1
, s
t
)p
t
(s
t
).
Since units of the price are arbitrary set p
0
(s
0
) = 1. Now the discounted
expected present value of total wealth is
T
t=1
s
t
p
t
(s
t
)w(s
t
)
which is equal to
T
t=0
s
t
_
_
t
j=0
M(s
j
)
_
_
t
(s
t
)w(s
t
). (7.23)
Observe that M(s
j
) converges to a constant and
t
is decreasing as t increases
while w(s
t
) is positive and nite for all s
t
. Hence the expected discounted
present value of total resources is nite. This isnt always true for innite
horizon economies.
Question 2 The feasibility condition for the economy at any point in time
and for any history is
I
i=1
w
i
(s
t
)
I
i=1
c
i
(s
t
).
The central planner solves
I
i=1
T
t=1
s
t
i
U(c
i
(s
t
))
t
(s
t
) +
T
t=1
s
t
t
(s
t
)
_
I
i=1
[w
i
(s
t
) c
i
(s
t
)
_
.
i
U
(c
i
(s
t
))
t
(s
t
) =
t
(s
t
). (7.24)
Observe for each i,
c
i
(s
t
) = G
_

t
(s
t
)
t
(s
t
)
i
_
, G = (U
)
1
. (7.25)
Recall that the
i
are known so that feasibility requires
I
i=1
_
w
i
(s
t
) G
_

t
(s
t
)
t
(s
t
)
i
__
= 0. (7.26)
The solution is a value of
t
(s
t
) solving the equation above. In both the contin-
gent claims equilibrium and social planning problem, the optimal consumption
allocations are given by a function of marginal utilities.
45
Question 3
a) For the time-zero trading model, the intertemporal marginal rate of
substitution is
U
(c
i
(s
t+1
)
U
(c
i
(s
t
))
=
p
t+1
(s
t+1
)
p
t
(s
t
)(s
t+1
, s
t
)
.
Hence we require
q
t
(s
t+1
, s
t
) =
p
t+1
(s
t+1
)
p
t
(s
t
)(s
t+1
, s
t
)
,
which can be rewritten as
p
t+1
(s
t+1
) = q
t
(s
t+1
, s
t
)p
t
(s
t
)(s
t+1
, s
t
).
If the prices for the two versions of the model are related as above, then the
two solutions are equivalent.
b) We will just use the contingent claims solution above. Solve the
agents budget constraint with respect to z
t1
(s
t
):
z
t1
(s
t
) = c
i
(s
t
) w
i
(s
t
) +
t+1
q(s
t+1
, s
t
)z
t
(s
t+1
)
In period 1, assume that z
0
(s
1
) = 0. Starting from time period 1, for which
there are S possible realizations of the rst period state, solve the equation
above forward in time for z
t
(s
t+1
) to obtain
0 =
s
1
q(s
1
, s
0
)[c
i
(s
1
) w
i
(s
1
) +
s
2
q(s
2
, s
1
)[c
i
(s
2
) w
i
(s
2
)
+
s
3
q(s
3
, s
2
)[c
i
(s
3
) w
i
(s
3
) +. . .
=
T
t=1
s
t
t
j=1
q(s
j
, s
j1
)[c
i
(s
t
) w
i
(s
t
)],
so that the expected discounted present value of lifetime consumption is just
equal to the expected discounted present value of lifetime wealth. Observe
that the discount factor is the product of the one-period ahead contingent
claims price.
c) For the sum to converge in (7.27), we require that the product
t
j=1
q(s
j
, s
j1
)
tend to zero when averaged over all states, as t . The price q is just the
intertemporal marginal rate of substitution (IMRS). Hence the IMRS must
be less than one on average for the sum to converge - this is equivalent to
the requirement that the one-period interest rate be positive on average. The
no-Ponzi scheme condition is that debt at some future date t + N must tend
to zero in expected present value as N .
Question 4 This problem can be set up as in the previous question. We
will write down the sequential equilibrium but realize that the problem can
be correctly solved in other ways. We will use notation developed earlier for
convenience (so there are other correct ways of setting this up.) Let s
t
be
an exogenous Markov process such that y
t
= y(s
t
) and x
t
= x(s
t
), so that
the state of the system can be easily described. Let (s
t+1
[ s
t
) denote the
probability of moving to state s
t+1
from state s
t
in one period. Let q(s
t+1
, s
t
)
denote the period t price of one unit of consumption delivered at time t + 1.
Let z
a
(s
t
, s
t1
) denote the contingent claims purchased by type A at time t1
and z
b
(s
t
, s
t1
) denote the claims purchased by type B.
a) The type A consumer solves
V (s
t
, z
a
(s
t
)) = max
c
a
t
,z
a
(s
t+1
,s
t
)
[U(c
a
t
) +E
t
V (s
t+1
, z
a
(s
t+1
))]
subject to
y(s
t
) +z
a
(s
t
, s
t1
) c
a
t
+
s
t+1
q(s
t+1
, s
t
)z
a
(s
t+1
, s
t
).
Let
a
t
denote the Lagrange multiplier. The rst-order conditions are
(s
t+1
, s
t
)V
a
(s
t+1
, z
a
(s
t+1
)) =
a
t
q(s
t+1
, s
t
) (7.27)
a
t
= U
(c
a
t
). (7.28)
A similar expression can be derived for the type B agent. The rst-order
conditions are
(s
t+1
, s
t
)V
b
(s
t+1
, z
b
(s
t+1
)) =
b
t
q(s
t+1
, s
t
) (7.29)
b
t
= U
(c
b
t
). (7.30)
For each state, in equilibrium
z
a
(s
t+1
, s
t
) +z
b
(s
t+1
, s
t
) = 0.
47
Market clearing requires that
y(s
t
) +x(s
t
) = c
a
t
+c
b
t
.
Let y(s
t
) = y(s
t
) +x(s
t
). Solve the rst-order conditions for q for each agent,
equate and rewrite to obtain
q(s
t+1
, s
t
)
(s
t+1
, s
t
)
=
V
a
(s
t+1
, z
a
(s
t+1
))
U
(c
a
t
)
=
V
b
(s
t+1
, z
b
(s
t+1
))
U
(c
b
t
)
. (7.31)
A property of complete markets is that, for every state, the ratio of marginal
utilities for dierent agents is equal to a constant, or
U
(c
a
t
)
U
(c
b
t
)
=
or
U
( y(s
t
) c
b
t
)
U
(c
b
t
)
= .
Let c
b
t
= g( y(s
t
), ) The result for permanent income becomes clearer if all
trading is done at time 0. Let s
t
= (s
0
, s
1
, . . . , s
t
) denote the history of the
system up to time t and let
t
(s
t
) denote the probability of s
t
. Finally, let
q
t
(s
t
) denote the time 0 price of a unit of consumption delivered at time t in
state s
t
. The type Bs lifetime budget constraint is
s
t
q
t
(s
t
)[x(s
t
) g( y(s
t
), )] = 0.
A similar expression holds for type A. Substitute the solution to obtain
s
t
q
t
(s
t
)[g( y(s
t
), ) x(s
t
)] = 0.
There exists a unique solving this equation.
b) Under complete markets, the ratio of the marginal utilities is equal
to a constant, so that although the aggregate endowment is random and con-
sumption of each type of agent is uctuating, the aggregate risk is shared. If
the two endowments are negatively correlated, then large transfers would take
place from the high endowment agent to the low endowment agent. If there
is no aggregate and only idiosyncratic risk, then the consumption of the two
agents would be constant and there would be a large volume of trade providing
complete insurance against idiosyncratic risk.
c) Suppose in an extreme case, that the endowments were always equal.
Then there would be no trade because the agents are identical. If the endow-
ments are positively but imperfectly correlated, there may be some scope for
trade, but there is little insurance value in the trade.
d) This question is trickier than you might at rst guess. The reason
is that we need to look at what happens to the price q
t
(s
t
). Suppose that
aggregate output is low, so that the marginal utility of consumption is high
for each type of agent. Then the contingent claims price is high. If one
agent has most of the endowment during that period, then the value of the
endowment will be high. Hence we can compute the unconditional mean of the
two processes x, y, and determine which one is higher. But permanent income
depends on the expected value of the endowment and so it is possible for the
agent with the lower average endowment to have higher permanent income.
49
8 Consumption and Asset Pricing
Question 1 The asset pricing function satises the relation:
U
(c
t
)q
e
t
= E
t
_
U
(c
t+1
)(q
e
t+1
+y
t+1
)
.
Since the consumer is risk neutral, marginal utility of consumption is a con-
stant. Furthermore, output equals consumption in equilibrium. Hence, we
obtain the relation:
q
e
t
= E
t
_
q
e
t+1
+y
t+1
. (8.1)
Since y
t
follows a rst-order autoregressive process, the state variable is the
current level of output, y
t
. Furthermore, y
t
is a stationary stochastic process
since [[ < 1. Therefore, for any bounded continuous function q
e
(y), notice
that the right-hand side of the above equation maps the space of bounded,
continuous functions into itself. We can dene an operator from the right-side
of this equations as:
(T q
e
)(y) = E
y
_
(q
e
)
+y
.
Since 0 < < 1, T is a contraction and its xed point can be found by
iterating on equation (8.1) as follows:
q
e
t
= E
t
_
q
e
t+1
+y
t+1
= E
t
_
y
t+1
+E
t+1
_
q
e
t+2
+y
t+2
_
=
.
.
.
=
s=0
s
E
t
[y
t+s
].
But
E
t
[y
t+1
] = E
t
[y
t
+
t+1
] = y
t
since
t
is i.i.d.
Likewise,
E
t
[y
t+2
] = E
t
E
t+1
[y
t+1
+
t+2
] = E
t
[y
t+1
] =
2
y
t
.
Iterating in this way, we nd that
E
t
[y
t+s
] =
s
y
t
.
Substituting this result into the solution for q
e
t
yields:
q
e
t
=
s=1
s
y
t
=

1
y
t
.
To interpret these results, we note:
- Under risk neutrality, the equity price is just equal to the discounted
value of expected dividends, the discounting being done with the con-
stant rate of subjective time preference r = 1/ 1, which also equals
the real interest rate for this economy.
- The autoregressive parameter shows the impact of future dividends
on the current stock price. If is small, then current output has little
eect in predicting future dividends. Hence, the response of the current
equity price to current output is small. By contrast, if is large, then
the impact of current output on future dividends decays slowly. In this
case, the equity price shows a large response to changes in current output
because changes in current y
t
are a good predictor of changes in y
t+s
for
s 0.
Question 2
a) The price-dividend ratio satises the relation
q
e
t
y
t
= E
t
_
1
t+1
_
1 +
q
e
t+1
y
t+1
__
.
In the text, we showed that the equation describing q
e
t
/y
t
satises a contraction
and has unique xed which can be found by iterating on this equation as
q
e
t
y
t
= E
t
_
1
t+1
+
1
t+1
1
t+2
_
1 +
q
e
t+2
y
t+2
___
= E
t
_
_
i=1
i
_
_
i
j=1
1
t+j
_
_
_
_
.
b) If dividend growth satises
t
= exp( +
t
),
t
i.i.d, N(0,
2
),
then
E
t
_
_
_
_
i
j=1
1
t+j
_
_
_
_
=
i
j=1
E
t
(
1
t+j
)
=
i
j=1
exp[(1 ) + (1 )
2
(
2
/2)]
= exp
_
i((1 ) + (1 )
2
(
2
/2))
_
.
51
Substituting into the expression for the price-dividend ratio yields
q
e
t
y
t
=
i=1
i
exp
_
i((1 ) + (1 )
2
(
2
/2))
_
=
i=0
i
=

1
,
where
= exp[(1 ) + (1 )
2
(
2
/2)].
c) In the version of the model with a growing endowment, a sucient con-
dition for a recursive competitive equilibrium to exist is that E
s
[(s
)
1
] < 1.
Evaluating this condition under the distributional assumptions for
t
yields
the condition < 1.
Question 3
a) Let and
2
be a function of an underlying parameter . To keep
E(
t
) constant while increasing V ar(
t
), we require that:
()/ = (
2
()/2)/.
b) The price-dividend ratio has the form:
q
e
t
y
t
=

1
,
where = exp[(1 ) + (1 )
2
(
2
/2)]. Consider a change in q
e
/y as a
function of :
(q
e
/y)
=
_

1
+

(1 )
2
_

=

(1 )
2
_
(1 )
+ (1 )
2
(
2
/2)
_
=

(1 )
2
[(1 )(1 1 +)]

=

(1 )
2
[(1 )]

.
Hence, we see that the price-dividend ratio decreases with a mean-preserving
spread in the distribution for
t
if > 1 and increases otherwise. Since
denotes the coecient of relative risk aversion, we note that if consumers are
relatively more risk averse an increase in risk reduces the price-dividend ratio
and increases it otherwise.
Question 4 Consider a period coupon bond that is issued at date t. At
date t the consumers budget constraint satises
c
t
+b
t+1
Q
c,t
y
t
.
Consider the strategy of purchasing the bond at t +s 1 that is s periods
from maturity for 0 s 1, and holding it for one period. At t + s,
the consumer receives the coupon and also the price at date t + s of a bond.
Hence, its budget constraint satises:
c
t+s
+b
t+s+1
Q
s
c,t+s
y
t+s
+b
t+s
(c +Q
r
c,t+s
), 0 s 1, r = s + 1.
The condition characterizing the optimal choice of b
s+t+1
is:
U
(c
t
)Q
s
c,t
= E
t
_
U
(c
t+1
)(c +Q
s1
c,t+1
)
_
, 0 s 1,
where Q
0
c,t
= 1.
Dene m
t+s
= U
(c
t+s+1
)/U
(c
t+s
) for s 1. Substituting into the
above condition and solving this equation forward subject to the condition
that Q
0
t+s
= 1, we obtain:
Q
c,t
= E
t
_
m
t+1
(c +Q
1
c,t+1
)
_
= E
t
_
m
t+1
c +m
t+1
_
m
t+2
(c +Q
2
c,t+2
)
__
= E
t
_
_
_
1
i=1
_
_
i
j=1
m
t+j
_
_
c +
j=1
m
t+j
_
_
_
=
1
i=1
E
t
(m
t,i
)c +E
t
(m
t,
)
=
1
i=1
Q
i
t
c +Q
t
,
where m
t,i
=
i
U
(y
t+i
)/U
(y
t
) and Q
i
t
is the price of a pure discount bond
with maturity i for i = 1, . . . , .
53
Question 5 The delivery price must satisfy
0 = E
t
_
m
t,n
(q
e
(s
t+n
)

S)
,
where m
t,n
=
n
U
(y
t+n
)/U
(y
y
). Otherwise, there would exist an arbitrage
opportunity. Solving for

S equals
S =
1
E
t
(m
t,n
)
E
t
[m
t,n
q
e
(s
t+n
)]
= r
n
t
E
t
[m
t,n
q
e
(s
t+n
)].
Question 6 We will compute the price of a -period bond for each model.
Consider the rst time series model and suppose that = 1. The price of a
one-period bond satises
Q
1
t
= E
t
_
_
y
t+1
y
t
_
_
.
Substituting the expression for output using the representation yields
Q
1
t
= E
t
exp[(
1
+
t+1
t
)]
= exp(
1
)E
t
exp[((
2
1)
t
+e
t+1
)]
= exp(
1
+
2
2
e
/2) exp[(1
2
)
t
]
= A
1
exp(a
1
t
).
Now let = 2. Then
Q
2
t
=
2
E
t
exp[(2
1
+
t+2
t
)]
=
2
E
t
exp[2
1
(
2
t+1
+e
t+2
t
)]
=
2
exp((1
2
2
)
t
)E
t
[exp(2
1
(
2
e
t+1
+e
t+2
)]
= A
1
exp[
1
+ (a
1
)
2
2
e
/2] exp(a
1
(1 +
2
)
t
).
More generally, for any , we have
Q
t
= A
exp(a
t
),
where
a
1
= (1
2
), a
= a
1
1
i=0
i
2
,
A
1
= exp[
1
+
2
2
e
/2],
A
= A
1
exp[
1
+ (a
1
)
2
(
2
e
/2)].
Next, we derive the price of a -period bond for the second time series
model. In this case, we use the version of the model with a growing endowment.
The expression for a one-period bond is given by:
Q
1
t
= E
t
(
t+1
).
Using the representation for log(
t
), we have
Q
1
t
= E
t
exp[(
0
+
1
log(
t
) +u
t
)]
= exp[
0
+
2
2
u
/2] exp(
1
log(
t
))
= B
1
b
1
t
.
For = 2, we have
Q
2
t
=
2
E
t
(
t+2
t+1
)
=
2
E
t
exp[(2
0
+
1
(log(
t+1
) + log(
t
)) +u
t+2
+u
t+1
)]
=
2
E
t
[exp((2
0
+
1
0
+
1
(1 +
1
) log(
t
) + (1 +
1
)u
t+1
+u
t+2
)]
=
2
exp((
0
+
0
(1 +
1
))] exp[
2
2
u
/2 + (1 +
2
1
)
2
2
u
/2]
1
(1+
1
)
t
.
More generally,
Q
t
= B
t
,
where
b
1
=
1
, b
= b
1
i=1
i1
1
,
B
1
= exp[
0
+
2
2
u
/2],
B
= B
1
exp[(b
1
)
0
+ (b
2
1
+
2
)
2
u
/2].
Question 7 Recall that the price of a put option satises
P
p
t
= E
t
[m
t,1
. max(0, q q
e
t+1
)].
Assuming that preferences are CRRA, we can rewrite the price as follows
P
p
t
= E
t
_
_
c
t+1
c
t
_
max(0, q q
e
t+1
)
_
(8.2)
Using the assumptions that ln(q
e
t+1
) and ln(c
t+1
/c
t
) are lognormally distributed
with covariance matrix given in the text, we can rewrite the equation in (8.2)
as
P
p
t
= q
e
_

_
ln( q/q
e
)
( q/q
e
exp(z)) exp(y)f(z, y)dzdy,
55
where f(z, y) is the joint density function for z = ln[(q
e
)
/q
e
] and y = ln[(c
/c)
].
This last equation can be expressed as the sum of two integrals:
P
p
t
= q
_

_
ln( q/q
e
)
exp(y)f(z, y)dzdy q
e
_

_
ln( q/q
e
)
exp(z +y)f(z, y)dzdy.

We can make use of Rubinsteins double integration formula to show that
q
_

_
ln( q/q
e
)
exp(y)f(z, y)dzdy = q exp(

c
+
2
c
/2)
_
ln( q/q
e
)
q
c
_
and
q
e
_

_
ln( q/q
e
)
exp(z +y)f(z, y)dzdy

= q
e
exp
_
q
+
c
+
_
2
q
+2
q
c
+
2
c
2
__
_
ln( q/q
e
)
q
q
_
Notice that we made use of the relation 1 (x) = (x). Under the pricing
equations of C-CAPM and the distributional assumptions, one can easily show
that
P
p
t
= q(r
f
)
1
(A) q
e
(A
q
).
9 Nonseparable Preferences
Question 1
a) Substituting the budget constraint into the problem yields:
max
W
s
U
_
W
0
s=1
p
s
W
s
_
+
S
s=1
s
U(W
s
)
Now, substitute the exponential utility function given in the question:
max
W
s
Aexp
_
S
s=1
p
s
W
s
W
0
A
_
A
S
s=1
s
exp
_
W
s
A
_
The rst-order condition is given by:
s
exp
_
W
s
A
_
p
s
exp
_
S
s=1
p
s
W
s
W
0
A
_
= 0
Simplifying this equation yields:
log(
s
/p
s
) =
S
s=1
p
s
W
s
W
0
+W
s
A
Then,
W
s
= Alog(
s
/p
s
) +W
0
s=1
p
s
W
s
= Alog(
s
/p
s
) +c
0
. (9.1)
Multiplying both sides of the last relation by p
s
and summing over s yields:
S
s=1
p
s
W
s
= A
S
s=1
p
s
log(
s
/p
s
) +c
0
S
s=1
p
s
= W
0
c
0
where the second equality is derived using the budget constraint. Solving for
c
0
yields:
c
0
=
W
0
A
S
s=1
p
s
log(
s
/p
s
)
1 +
S
s=1
p
s
(9.2)
One can derive next periods state contingent wealth using Eq. (9.1):
W
s
= Alog(
s
/p
s
) +
W
0
A
S
s=1
p
s
log(
s
/p
s
)
1 +
S
s=1
p
s
(9.3)
57
Dividing and multiplying the rst term in Eq. (9.3) by

S
s=1
p
s
log(
s
/p
s
)
and the second term by

S
s=1
p
s
yields:
W
s
=
1
S
s=1
p
s
_
S
s=1
p
s
W
0
A
S
s=1
p
s
log(
s
/p
s
)
1 +
S
s=1
p
s
_
+
log(
s
/p
s
)
S
s=1
p
s
log(
s
/p
s
)
_
A
S
s=1
p
s
log(
s
/p
s
)
_
Dene = 1 +

S
s=1
p
s
and 1 + r
f
(
S
s=1
p
s
)
1
and substitute into the
equation above:
W
s
= (1 +r
f
)
_
( 1)W
0
A
S
s=1
p
s
log(
s
/p
s
)
_
+
log(
s
/p
s
)
S
s=1
p
s
log(
s
/p
s
)
_
A
S
s=1
p
s
log(
s
/p
s
)
_
One can argue that buying state-contingent wealth is like investing into a risk-
free and a risky asset. The terms in braces show how much of current wealth is
invested into each asset and the terms before the braces give the gross return
on each asset.
b) Notice that the rst term in braces using Eq. (9.2) equals:
S
s=1
p
s
W
0
A
S
s=1
p
s
log(
s
/p
s
)
1 +
S
s=1
p
s
= c
0
S
s=1
p
s
In part (a) in Eq. (9.2), we showed that:
A
S
s=1
p
s
log(
s
/p
s
) +c
0
S
s=1
p
s
= W
0
c
0
So, we showed that terms in braces sum to the amount of current wealth net
of current consumption, invested into a risk free and a risky asset, where the
gross return to the risk free asset is 1/
S
s=1
p
s
and the return to the risky
asset is log(
s
/p
s
)/
S
s=1
p
s
log(
s
/p
s
). Notice that the risk-free asset is
given by the ratio of one sure amount of next periods wealth divided by the
sum of all contingent prices. Hence, the consumer divides her wealth net of
consumption between the risk-free asset and a risky asset. This is known
as the portfolio separation property, and it characterizes the class of HARA
preferences described in Chapter 3.
Question 2
a) The state variables for the consumers problem are given by W
t
and
c
t1
. The value function is given by:
V (W
t
, c
t1
) = max
c
t
U(c
t
) +V (W
t+1
, c
t
)
subject to
c
t
= c
t
hc
t1
, 0 < h < 1,
W
t
= (W
t1
c
t1
)R.
b) The rst-order and envelope conditions are given by:
(c
t
hc
t1
)
= RV
W
(W
t+1
, c
t
) V
C
(W
t+1
, c
t
)
V
W
(W
t
, c
t1
) = RV
W
(W
t+1
, c
t
)
V
C
(W
t
, c
t1
) = h(c
t
hc
t1
)
.
Since we know that the value function is a function of W
t
and c
t1
and since
there is a linear relationship between W
t
and c
t1
, we can guess that the value
function has the form:
V (W
t
, c
t1
) =
1
1
(AW
t
+Fc
t1
)
1
.
Let X
t
= AW
t
+ Fc
t1
. Substituting our guess into rst-order and envelope
conditions yield:
(c
t
hc
t1
)
= (RAF)X
t+1
(9.4)
X
t
= RX
t+1
(9.5)
FX
t
= h(c
t
hc
t1
)
. (9.6)
Solving equations (9.4) and (9.6) together yields:
(RAF)X
t+1
=
F
h
X
t
.
Solve the resulting equation together with Eq. (9.5) to obtain:
F =
hRA
h R
A =
F(h R)
hR
Use Eq. (9.5) again to obtain:
X
t+1
= (R)
1/
X
t
.
59
Notice the value function can be written in the form:
(AW
t
+Fc
t1
)
1
1
= max
c
t
_
(c
t
hc
t1
)
1
1
+
(AW
t+1
+Fc
t
)
1
1
_
subject to
W
t+1
= (W
t
c
t
)R.
Substituting for X
t
= AW
t
+Fc
t1
, the value function can be written:
X
1
t
= max
c
t
_
(c
t
hc
t1
)
1
+X
1
t+1
_
.
Substituting for X
t+1
into the value function, the following should hold:
X
1
t
= (c
t
hc
t1
)
1
+[(R)
1/
X
t
]
1
= (c
t
hc
t1
)
1
+(R)
(1)/
X
1
t
,
X
1
t
[1 (R)
(1)/
] = (c
t
hc
t1
)
1
.
Solving for X
t
:
X
t
=
(c
t
hc
t1
)
[1 (R)
(1)/
]
/(1)
Now, equate this to Eq. (9.6) to obtain:
h
F
=
h(R h)
hRA
= [1 (R)
(1)/
]
/(1)
.
Therefore,
A = R
1
(R h)[1 (R)
(1)/
]
/(1)
,
F = h[1 (R)
(1)/
]
/(1)
.
Note that since h[1 (R)
(1)/
]
/(1)
is a common term for F and A,
we can write the value function as follows:
V (W
t
, c
t1
) =
K
1
_
W
t
hR
(R h)
c
t1
_
1
.
With some further algebra, we can show that
K = h[1 (R)
(1)/
]
= (R h)
1
R
21
_
R (R)
1/
_
.
Substituting for these coecients in the expression for the value function
and the rst-order condition for consumption implies the solution:
c
t
=
_
R (R)
1/
_
(R h)R
2
W
t
+ (R)
1/
hR
1
c
t1
,
V (W
t
, c
t1
) =
K
1
_
W
t
hRc
t1
R h
_
1
.
c) We can solve for the time path of consumption from the rst-order
condition directly. Iterating the envelope conditions one period forward and
substituting in the rst-order condition yields:
U
(c
t
) (R)
2
V
W
(W
t+2
, c
t+1
) hU
(c
t+1
) = 0.
By the rst-order condition for period t + 1, we have that
RV
W
(W
t+2
, c
t+1
) = U
(c
t+1
) hU
(c
t+2
).
Dene x
t+i
(c
t+i
hc
t+i1
)
. Therefore, the rst-order condition can be

written as:
x
t
hx
t+1
= R[x
t+1
hx
t+2
] .
Collecting terms, we can re-write this as:
2
Rhx
t+2
(R +h)x
t+1
+x
t
= 0.
Notice that this is a second-order homogeneous dierence equation in x
t+2
.
Dividing through by
2
Rh and using lag operator notation, we have:
_
1 (R
1
)L
_ _
1 (h)
1
L
_
x
t+2
= 0.
Recall that 1/h > 1. Hence, we solve the rst root backward and the second
root forward as:
_
(h)
1
L
_ _
1 (R)
1
L
_ _
1 hL
1
_
x
t+2
= 0,
or
x
t+1
= (R)
1
x
t
.
Substituting for the denition of x
t+1
and x
t
yields:
(c
t+1
hc
t
)
= (R)
1
(c
t
hc
t1
)
.
Inverting this equation and simplifying yields:
c
t+1
_
h + (R)
1/
_
c
t
+h(R)
1/
c
t1
= 0. (9.7)
To solve this equation and nd the steady state consumption, dene z
t+1

c
t+1
hc
t
. Then we can write Eq. (9.7) as:
_
1 (R)
1/
L
_
z
t+1
= 0,
which has the solution:
z
t+1
= (R)
(t+1)/
z
0
.
61
Substituting for the denition of z
t+1
and z
0
, we obtain:
c
t+1
hc
t
= (R)
(t+1)/
(c
0
hc
1
).
Iterating on this condition, we obtain:
c
t+1
= h
t+1
c
0
+ (R)
(t+1)/
(c
0
hc
1
)
+
_
h(R)
t/
) +h
2
(R)
(t1)
. . . +h
t
(R)
1/
_
(c
0
hc
1
)
= h
t+1
c
0
+ (R)
(t+1)/
(c
0
hc
1
)
+h(R)
t/
_
1 +
h
(R)
1/
+. . . +
h
t1
(R)
(t1)/
_
(c
0
hc
1
)
= h
t+1
c
0
+ (R)
(t+1)/
(c
0
hc
1
)
+h(R)
t/
_
(R)
1/
(R)
1/
h

h
t
(R)
t/
(R)
1/
(R)
1/
h
_
(c
0
hc
1
)
=
1
(R)
1/
h
_
h
t+2
c
0
+h
t+2
(R)
1/
c
1
+ (R)
(t+2)/
(c
0
hc
1
)
_
.
Simplifying the last expression and using the solution for period t implies:
c
t
=
_
c
0
hc
1
(R)
1/
h
_
(R)
(t+1)/
+
_
(R)
1/
c
1
c
0
(R)
1/
h
_
h
t+1
.
Since (R)
1/
> 1 and 0 < h < 1, the rst term dominates the second term.
Hence, c
t
/c
t1
(R)
1/
and c
t1
/W
t
(R)
1/
R
1
as t .
d) The coecient of relative risk aversion (CRRA) is dened as:
CRRA =
W
t
V
WW
V
W
=

1 hRc
t1
/(R h)W
t
=

1 h[R(R)
1/
1]/(R h)
(in the steady state)
Since 1 < (R)
1/
< R,
CRRA

1 h(R 1)/(R h)
.
Thus we nd that the coecient of relative risk aversion diers from to the
extent that the habit persistence parameter diers from zero. However, even
for large values of h, the upper bound on the CRRA is close to . Hence,
in approximate terms, we can take CRRA = and this approximation is not
sensitive to the value of h.
e) The elasticity of consumption with respect to the interest rate is given
by

1
c
t
c
t
ln(r)
=
_
(R)
1/
c
t1
/c
t
h(R)
1/
c
t2
/c
t1
_
/
=
_
1 h(R)
1/
_
/ (in the steady state).
In contrast to the CRRA, the consumption elasticity is sensitive to the value
of h. If R)
1/
1, then (1 h)/, which varies signicantly with h.
f ) The product of the coecient of relative risk aversion and consumption
elasticity is given by
CRRA = 1 hR
1
.
This product equals one if there is no habit persistence; in the presence of
habit persistence, this product may be substantially below one. Thus, we nd
that habit persistence drives a wedge between CRRA and the intertemporal
elasticity of substitution in consumption.
Question 3
a) In order to solve this problem with the Weil specication, we will use
the transformation of Epstein and Zin. Notice that the Weil utility function
can be rewritten as:
u
t
= [1 + (1 )(1 )U
t
]
1/(1)
So, u
t
is a monotonic transformation of the original utility function U
t
. Thus
the consumption stream that solves the transformed problem will also be the
solution to the original maximization problem. Remember the Epstein-Zin
specication in the text:
u
t
=
_
(1 )c
t
+(E
t
u
t+1
)
/
_
1/
,
where = 1 1/ and = 1 . The consumers problem can be formulated
as a dynamic programming problem as follows:
V (A
t
, R
t
) max
c
t
_
(1 )c
t
+[E
t
V (A
t+1
, R
t+1
)
_1
subject to
A
t+1
= R
t
(A
t
c
t
).
63
Since R
t
is distributed i.i.d, we can dene V (A
t
, R
t
) = V (A
t
) A
t
and
c
t
= A
t
. We can rewrite the Bellman equation as follows:
A
t
max
c
t
_
(1 )c
t
+[E
t
(A
t+1
)
_1
subject to
A
t+1
= R
t
(A
t
c
t
).
The rst-order condition with respect to c
t
is:
(1 )c
1
t

[(ER
t
)
1/
]
(A
t
c
t
)
1
= 0.
Let

R
t
= (ER
t
)
1/
. Substituting for c
t
= A
t
yields:
(1 )
(

R
t
)
=
_
1
1
_
1
(1 )
_
1
1
_
1
t
=
. (9.8)
We know that the value function calculated at the optimal consumption
level should satisfy:
A
t
=
_
(1 )c
t
+[E
t
(A
t+1
)
_1
(A
t
)
= (1 )c
t
+[E
t
(A
t+1
)
= (1 )c
t
+ (1 )c
1
t
(A
t
c
t
)
= (1 )c
1
t
A
t
= (1 )
1
A
= (1 )
1
(9.9)
Equating this expression to the expression that we found for
in Eq. (9.8)
yields:
(1 )
1
=

R
t
= 1 (

R
t
)
/(1)
.
Substituting for

R
t
and using the denition for and gives the expression
for in the text:
= 1
_
(E(R
1
t
)
1/(1)
_
(11/)
.
To solve for , notice that
= (1 )
1
=
_
(1 )
1
_
1/(11/)
,
or
= [(1 )
1/
]
/(1)
.
Finally, to derive the form of the value function given in the question, notice
that
u
t
= [1 + (1 )(1 )U
t
]
1/(1)
,
which implies that
U
t
=
u
1
t
1
(1 )(1 )
=
(A
t
)
1
1
(1 )(1 )
as claimed.
b) The coecient of relative risk aversion can be obtained as:
WV
(W)
V (W)
=
(W)
1
2
W
(W)
= .
Thus, the coecient of relative risk aversion for this class of preferences diers
from the elasticity of intertemporal substitution in consumption, .
Question 4
a) The state variables for the consumers problem consist of
h
t
(c
t1
, . . . , c
tm
, k
t1
, b
0t
, . . . , b
N1,t
)
.
The value function can be expressed as
V (h
t
) = max
c
t
,d
t
,{b
j,t+1
}
N
j=0
U(c
t
, d
t
) +V (h
t+1
)
subject to (9.71), (9.72), (9.73), and (9.75).
b) The rst-order conditions are given by:
t
= MU(c
t
), (9.10)
t
p
d,t
= MU(d
t
), (9.11)
t
Q
j
t
= E
t
(
t+1
Q
j1
t+1
), j = 1, . . . , N. (9.12)
where MU(c
t
) and MU(d
t
) denote the marginal utility from nondurable and
durable consumption goods.
65
c) The holding return on the three investment strategies are
h
1
t,1
=
1
Q
1
t
,
h
2
t,3
=
1
Q
3
t
or h
2
t,3
=
Q
3
t+3
Q
6
t
,
h
3
t,3
=
_
2
i=0
1
Q
1
t+i
_
.
Using Equations (9.10) and (9.12), these holding returns satisfy the relation:
n
E
t
_
MU(c
t+n
)
MU(c
t
)
h
k
t,n
_
= 1, k = 1, , K. (9.13)
Equations (9.10) and (9.11) yield an expression for the price of durable good
p
d,t
as:
p
d,t
=
MU(d
t
)
MU(c
t
)
. (9.14)
d) To evaluate expression (9.13) and (9.14), we need expressions for
MU(c
t
) and MU(d
t
). Notice that MU(d
t
) depends on the expected, innite
sum of marginal utility from current durable goods acquisitions. To see this,
substitute sequentially in the expression for d
t
to obtain in the expression for
d
t
yields:
d
t
= k
t1
+d
t
=
j=0
(1 )
j
d
tj
.
Hence,
MU(d
t
) =
j=0
(1 )
j
MU(d
t
).
However, if consumers can trade in consumption services, then the price of
services from durable consumption goods expressed in units of the numeraire
good must equal the ratio of the marginal utility of services from durable
consumption goods and the marginal utility of nondurable consumption goods
acquisitions:
MU(d
t
) = p
d,t
MU(c
t
), (9.15)
where MU(d
t
) denotes the marginal utility with respect to d
t
.
Using the utility function dened above, notice that:
MU(c
t
) = E
t
_
_
m
j=0
t+j
c
1
t+j
d
(1)
t+j
_
_
,
MU(d
t
) = (1 )
t
c
t
d
(1)1
t
.
In order to evaluate Equation (9.15), we need an observable counterpart for
p
d,t
. But,
p
d,t
=
1
_
p
d,t
(1 )E
t
_
MU(c
t+1
)
MU(c
t
)
p
d,t+1
__
.
Using these results and scaling the resulting expressions by c
1
t
d
(1)
t
, we
obtain the following relations:
E
t
_
_
_
_
_
m
j=0
j
(c
1
t+j
d
(1)
t+j
)
_
_
n
_
_
_
_
m
j=0
j
(c
1
t+j+n
d
(1)
t+j+n
)
_
_
h
k
t,n
_
_
/[c
1
t
d
(1)
t
]
_
_
_
= 0,
for k = 1, . . . , K. Likewise,
E
t
_
_
_
_
_
(1 (1 )L
1
)[p
d,t
m
j=0
j
c
1
t+j
d
(1)
t+j
]
(1 )(c
t
d
(1)1)
t
)
_
/[c
1
t
d
(1)
t
]
_
= 0.
These conditions are used to generate orthogonality condition estimators
in Dunn and Singletons application.
67
10 Economies with Production
Question 1
a) The household takes as given the wage and rental rate. The factor
prices are themselves functions of aggregate capital and aggregate labor
N
t
, or w(
t
, N
t
,
t
) and r(, N
t
,
t
). Dene the vector of state variables as
S
t
= (k
t
,
t
,
t
, N
t
, g
t
)
. The household solves

V (S
t
) = max
c
t
,i
t
,n
t
[U(c
t
+g
t
, 1 n
t
) +E
t
V (S
t+1
)]
subject to
c
t
+i
t
r
t
k
t
+n
t
w
t
+
t
w
t
n
t
(r
t
)k
t
,
where k
t+1
= (1)k
t
+i
t
. Alternatively, you can write the Bellman equation
taking the wage and rental rate sequences as given. Rewrite the constraint as
c
t
+k
t+1
= r
t
(1 )k
t
+n
t
w
t
(1 ) +
t
+ (1 (1 ))k
t
. (10.1)
Let
t
denote the Lagrange multiplier for the budget constraint. The rst-
order conditions and envelope condition are
U
1
=
t
, (10.2)
U
2
=
t
w
t
(1 ), (10.3)
t
= E
t
[V
1
(S
t+1
)], (10.4)
V
1
(S
t
) =
t
[r
t
(1 ) + (1 (1 ))]. (10.5)
We can use the denition of the utility function to re-write these conditions
as:
(c
t
+g
t
) = (1 )w
t
,
1
c
t
+g
t
= E
t
_
1
c
t+1
+g
t+1
(r
t
(1 ) + (1 (1 ))
_
.
Notice that the income tax rate reduces the after-tax wage and the capital
tax reduces the after-tax rental rate. Since the capital tax is assessed on the
rental rate of capital net of depreciation, the eective depeciation rate also
falls. Since utility is linear in hours of work, the income tax rate aects labor
supply only through an income eect on consumption. Finally, with > 0,
an increase in government consumption reduces private consumption through
a negative wealth eect.
b) The rm solves
t
= max
k
t
,n
t
[
t
k
t
n
(1)
t
r
t
k
t
w
t
n
t
]. (10.6)
The rst-order conditions are:
t
k
1
t
n
1
t
= r
t
, (10.7)
t
(1 )k
t
n
t
= w
t
. (10.8)
c) The aggregate state vector is
t
, N
t
,
t
, g
t
. The rst two variables are
state variables because they help to determine the factor prices taken as given
by the representative household and rm. The last two variables are state
variables if they help predict future
t+1
, g
t+1
.
Feasibility requires that g
t
+ c
t
+ i
t
=
t
k
t
n
(1)
t
+ (1 )k
t
. This is also
the goods market-clearing condition. The capital market and the labor market
must also clear. What this means is that n
t
= N
t
and k
t
=
t
. The reason is
that individual rms and households determine their supply and demand for
each factor at the given wage and rental rate and then markets are required
to clear.
d) First of all, as specied, no closed-form solution can be derived. To
do so requires the additional assumption that = 1. Under the assumptions
for the utility function and parameter values above, the rst-order conditions
simplify to
1
c
t
=
t
, (10.9)
=
t
w
t
, (10.10)
t
= E
t
[V
1
(S
t+1
)], (10.11)
V
1
(S
t
) =
t
r
t
. (10.12)
Whenever you see a logarithmic structure like this, think make a clever
guess. Try this: suppose that
k
t+1
= A
t
k
t
n
1
t
,
where 0 < A < 1. From the resource constraint c
t
= (1 A)
t
k
t
n
1
t
. Then
the rst-order condition for (c
t
, n
t
) simplify to:
t
(1 )k
t
n
t
(1 A)
t
k
t
n
1
t
= , n
t
=
1
(1 A)
.
69
Next, use the envelope condition in the rst-order condition for capital to
obtain
1
(1 A)
t
k
t
n
1
t
= E
t
_

t+1
k
1
t+1
n
1
t+1
(1 A)
t+1
k
t+1
n
1
t+1
_
. (10.13)
Notice that this simplies to k
t+1
=
t
k
t
n
1
t
so that A = .
e) If the taxes are equal, then in the agents budget constraint
c
t
+k
t+1
= (1 )[r
t
k
t
+n
t
w
t
] +
t
+ (1 (1 ))k
t
]
= (1 )
t
k
t
n
1
t
+
t
+ (1 (1 ))k
t
].
The rst-order conditions and envelope condition are
U
1
=
t
, (10.14)
U
2
=
t
w
t
(1 ), (10.15)
t
= E
t
[V
1
(S
t+1
)], (10.16)
V
1
(S
t
) =
t
[r
t
(1 ) + (1 (1 ))]. (10.17)
We can derive the intratemporal and intertemporal conditions characterizing
the optimal choice of c
t
, n
t
and k
t+1
as:
c
t
= (1 )w
t
,
1
c
t
= E
t
_
1
c
t+1
(r
t
(1 ) + (1 (1 ))
_
.
In contrast to the version of the model in which > 0 and ,= , the tax
rate aects both the return to labor and the return to capital. Furthermore,
unlike the model in part a), there is no exogenous government consumption,
implying that labor varies only in response to a shock to productivity.
Question 2
a) Lets start with constructing the problem under the assumption that
the rm does not issue any equities:
max
{c
t
,b
t+1
}
t=0
E
0
_

t=0
t
U(c
t
)
_
subject to
c
t
+b
t+1
w
t
l
t
+ (1 +r
t
)b
t
.
t
= U
(c
t
), (10.18)
t
= E
t
[
t+1
(1 +r
t+1
)]. (10.19)
The rms gross prots are distributed as:
t
= RE
t
+ (1 +r
t
)b
t
and the net investment is nanced such that the equation holds:
k
t+1
(1 )k
t
= b
t+1
+RE
t
.
Using the denition of net cash ows and equations above we can rewrite it
as follows:
N
t
= (1 +r
t
)b
t
b
t+1
.
Now, we know that the rms value is given by: W
e
t
= b
t+1
. Using the (10.18)
and (10.19) we can write the rm value as:
W
e
t
= E
t
[m
t+1
(1 +r
t+1
)b
t+1
]
Add and subtract b
t+2
from the right hand side of this equation to obtain:
W
e
t
= E
t
[m
t+1
(W
e
t+1
+N
t+1
)]
and
t+1
=
1
m
t+1
1.
We showed that
t+1
= m
t+1
. We can also obtain the cost of debt by using
(10.19) as follows:
b
t+1
= E
t
[m
t+1
(1 +r
t+1
)b
t+1
]
The right-side of this equation tells us that when the interest plus the face value
of debt is discounted with m
t+1
, we get the present value of debt. Since there
are no distortions such as taxes, the discount factor continues to be dened as
the consumers intertemporal MRS. Another way of understanding this result
is in terms of Modigliani-Miller Theorem: in the absence of any distortions,
rms are indierent between all-debt nancing, all-equity nancing or any
combination of the two.
71
b) This time, we will take the taxes into account:
max
{c
t
,b
t+1
}
t=0
E
0
_

t=0
t
U(c
t
)
_
subject to
c
t
+b
t+1
(1
y
)[w
t
l
t
+r
t
b
t
] +b
t
t
= U
(c
t
), (10.20)
t
= E
t
[
t+1
(1 +r
t+1
(1
y
))]. (10.21)
The rms gross prots are distributed as:
(1 )
t
= RE
t
+ (1 +r
t
)b
t
p
r
t
b
t
and the net investment is nanced such that the equation holds:
k
t+1
(1 )k
t
= b
t+1
+RE
t
.
Using the denition of net cash ows and equations above we can re-write it
as follows:
N
t
= (1 +r
t
)b
t
b
t+1
p
r
t
b
t
The only source of nancing for the rm is still through debt, so that W
e
t
=
b
t+1
. Using the (10.21), we obtain:
W
e
t
= E
t
m
t+1
[1 +r
t+1
(1
y
)]b
t+1
.
Again, by adding and subtracting b
t+2
from the equation above and simplifying
we obtain:
W
e
t
= E
t
_
m
t+1
[(
p
y
)r
t+1
b
t+1
+N
t+1
+W
e
t+1
]
_
.
Substitute for b
t+1
with W
e
t
and use the condition E
t
(m
t+1
r
t+1
) = [1
E
t
(m
t+1
)]/(1
y
) to obtain the rm cost of capital as:
t+1
=
_
_
m
t+1
1 +
(
y
p
)
1
y
(1 E
t
(m
t+1
))
_
_
.
Then,
t+1
=
1
m
t+1
_
1 +
(
y

p
)
1
y
(1 E
t
(m
t+1
))
_
1.
The eect of the tax on the cost of capital depends on the sign of the term
[(
y

p
)/(1
y
)](1 E
t
(m
t+1
)) or equivalently, on (
y

p
)E
t
(m
t+1
r
t+1
).
Provided (
y

p
) > 0 (which is generally the case) and cov(m
t+1
, r
t+1
) > 0,
then the presence of the income tax will decrease the cost of capital relative
to the case in part a).
c) The problem is the same for households. However, the rms prots
are now distributed as:
(1
p
)
t
= RE
t
+ (1 +r
t
)b
t
,
where the rm is no longer allowed to deduct the interest payments from tax
it pays and net cash ows are given by:
N
t
= (1 +r
t
)b
t
b
t+1
.
Using the same approach, we can obtain the rm value as:
W
e
t
= E
t
_
m
t+1
[
y
r
t+1
b
t+1
+N
t+1
+W
e
t+1
]
_
.
Using the condition b
t+1
= W
e
t
we can write the
t+1
as:
t+1
=
_
m
t+1
1 +

p
1
y
(1 E
t
(m
t+1
))
_
=
_
m
t+1
1 +
y
E
t
(m
t+1
r
t+1
)
_
.
In order to obtain the cost of debt, dene:
b
t+1
= E
t
[
t+1
(1 +r
t+1
)b
t+1
],
where
t+1
is the cost of debt. Using the equation in (10.21), we can write:
b
t+1
= E
t
[m
t+1
(1 +r
t+1
(1
y
))b
t+1
]
and a simple derivation shows that:
t+1
=
_
m
t+1
1 +
y
E
t
(m
t+1
r
t+1
)
_
.
This shows us that when the rm cannot deduct its interest payments from
the tax it pays, the cost of capital will be equal to the cost of debt. This is
not surprising because the cost of debt is no longer calculated after tax, which
means that the cost of debt for the rm equals what debt holders demand
from the rm. Notice that as long as our assumptions cov(m
t+1
, r
t+1
) > 0 and
(
y
p
) > 0 hold, the discount factor for capital given in (b) is lower (the cost
of capital is higher) than we have found above. This follows from the fact that
the deduction of interest payments decreases the net cash ows from the rm
to households.
In order to understand the dierence, suppose there are two rms with the
same present value, the rst one decreases its interest payments through the
tax and the second rm does not. Since the rst rm will have lower amount
of future cash ows to discount, in order to obtain the same present value for
both rms, we need to discount the rst one with a lower cost of capital.
73
Question 3
a) The rst-order conditions with respect to c
t
, b
t+1
, z
c
t+1
, z
p
t+1
are :
t
= U
(c
t
), (10.22)
t
= E
t
[
t+1
(1 +r
t+1
(1
y
)] (10.23)
q
c
t
t
= E
t
[
t+1
(q
c
t+1
+ (1
y
)d
c
t+1
)] (10.24)
q
p
t
t
= E
t
[q
p
t+1
], (10.25)
where
t
is the Lagrange multiplier on the consumers budget constraint.
b) Begin with dening the distribution of the gross prots of the rm:
(1
p
)
t
= RE
t
+d
c
t
z
c
t
+ (1 +r
t
)b
t
p
r
t
b
t
.
We also know that the rm nances its investment by issuing new bonds, equity
shares and retained earnings so that k
t+1
(1 )k
t
= b
t+1
+ (z
c
t+1
z
c
t
)q
c
t
+
(z
p
t+1
z
p
t
)q
p
t
+ RE
t
holds. The net cash ows from the rm to households is
given by:
N
t
=
t
k
t+1
+ (1 )k
t
,
or using the expression for k
t+1
(1 )k
t
:
N
t
= (1 +r
t
)b
t
b
t+1
p
r
t
b
t
+ (z
c
t+1
z
c
t
)q
c
t
+ (z
p
t+1
z
p
t
)q
p
t
+d
c
t
z
c
t
.
We can dene the ex-dividend value of the rm as:
W
e
t
= q
c
t
z
c
t+1
+q
p
t
z
p
t+1
+b
t+1
.
Using the rst-order conditions we can re-write the value of the rm as:
W
e
t
= E
t
_
m
t+1
[q
p
t+1
z
p
t+1
+ (q
c
t+1
+ (1
y
)d
c
t+1
)z
c
t+1
+(1 +r
t+1
(1
y
))b
t+1
] .
By adding and subtracting b
t+2
, q
p
t+1
z
p
t+2
and q
c
t+1
z
c
t+2
from the right-side of
the equation for net cash ows N
t
and using the denitions for W
e
t+1
and N
t+1
we obtain:
W
e
t
= E
t
_
m
t+1
[(
p
y
)r
t+1
b
t+1
y
d
c
t+1
z
c
t+1
+N
t+1
+W
e
t+1
]
_
.
Notice that this is the equation we have found in the text for the case when
the only security issued by the rm was the common stock.
c) We can use the condition E
t
(m
t+1
r
t+1
) = [1 E
t
(m
t+1
)]/(1
y
) in
the equation (10.23) to rewrite the ex-dividend value of the rm as follows:
W
e
t
=
(
p
y
)
1
y
[1 E
t
(m
t+1
)] b
t+1
+E
t
_
m
t+1
[
y
d
c
t+1
z
c
t+1
+N
t+1
+W
e
t+1
]
_
.
Dene
B
t
b
t+1
/(q
c
t
z
c
t+1
+q
p
t
z
p
t+1
+b
t+1
),
C
t
q
c
t
z
c
t+1
/(q
c
t
z
c
t+1
+q
p
t
z
p
t+1
+b
t+1
)
as the share of debt in the rms value and the share of common equity in
the rms value, respectively. Also for simplicity dene
t+1
d
c
t+1
/q
c
t
as the
dividend-price ratio. Re-write the above equation for the ex-dividend value of
the rm:
W
e
t
=
(
p
y
)
1
y
[1 E
t
(m
t+1
)]W
e
t
B
t
+E
t
_
m
t+1
[
y
t+1
W
e
t
C
t
+N
t+1
+W
e
t+1
]
_
. (10.26)
We can dene the value of the rm as the discounted value of next periods net
cash ows plus future expected ex-dividend value W
e
t
= [
t+1
(N
t+1
+W
e
t+1
)].
To derive an expression for
t+1
, divide both sides of (10.26) by W
e
t
to obtain:
1 =
(
p
y
)
1
y
[1 E
t
(m
t+1
)]B
t
+E
t
_
m
t+1
_
t+1
C
t
+
N
t+1
+W
e
t+1
W
e
t
__
,
or
1 +
(
y

p
)
1
y
(1 E
t
(m
t+1
))B
t
+E
t
[m
t+1
(
y
t+1
C
t
)] =
E
t
_
m
t+1
_
N
t+1
+W
e
t+1
W
e
t
__
.
Multiplying through by W
e
t
and simplifying yields
W
e
t
= E
t
_
_
m
t+1
(N
t+1
+W
e
t+1
)
1 +
(
y
p
)
1
y
[1 E
t
(m
t+1
)]B
t
+E
t
[m
t+1
(
y
t+1
C
t
)]
_
_
.
So, applying the denition in equation (10.26) to the equation for ex-dividend
value above, we can write the discount factor of the rm as:
t+1
=
m
t+1
1 +
(
y
p
)
1
y
(1 E
t
(m
t+1
))B
t
+E
t
[m
t+1
t+1
]
y
C
t
.
75
Compare the result above with the one found in the text when there is only
one type of equity issued. Notice that if C
t
= 1 B
t
, then the discount factor
that we derived above is equivalent to one in the text. The result above says
that the cost of capital of the rm is determined by the shares of debt, common
and preferred equity in the rms value. Lets write the cost of capital to the
rm dened as = 1/ 1:
t+1
=
1
m
t+1
_
1 +
(
y

p
)
1
y
[1 E
t
(m
t+1
)]B
t
+E
t
[m
t+1
t+1
]
y
C
t
_
1.
d) Lets solve the problem given in part (a) under the extra tax levied
on households through the capital gains on preferred shares they hold. Begin
by re-writing the budget constraint as:
c
t
+q
c
t
z
c
t+1
+q
p
t
z
p
t+1
+b
t+1

(1
y
)[w
t
l
t
+r
t
b
t
+z
c
t
d
c
t
] +b
t
+z
c
t
q
c
t
+ (1
c
)z
p
t
q
p
t
The rst-order conditions with respect to c
t
, b
t+1
, z
c
t+1
, z
p
t+1
are :
t
= U
(c
t
), (10.27)
t
= E
t
[
t+1
(1 +r
t+1
(1
y
)], (10.28)
q
c
t
t
= E
t
[
t+1
(q
c
t+1
+ (1
y
)d
c
t+1
)], (10.29)
q
p
t
t
= E
t
[(1
c
)q
p
t+1
]. (10.30)
Using the rst-order conditions we can write the ex-dividend value of the rm
as:
W
e
t
= E
t
m
t+1
[(1
c
)q
p
t+1
z
p
t+1
+ (q
c
t+1
+ (1
y
)d
c
t+1
)z
c
t+1
+(1 +r
t+1
(1
y
))b
t+1
].
By adding and subtracting b
t+2
, q
p
t+1
z
p
t+2
and q
c
t+1
z
c
t+2
from the right hand side
of the equation we obtain:
W
e
t
= E
t
_
m
t+1
[(
p
y
)r
t+1
b
t+1
y
d
c
t+1
z
c
t+1
c
q
p
t+1
z
p
t+1
+N
t+1
+W
e
t+1
]
_
.
Notice that the capital gains tax levied on households decreases the rm value.
Using the same steps we used in part (c), we can write the rm value as:
W
e
t
=
(
p
y
)
1
y
[1 E
t
(m
t+1
)]W
e
t
B
t
+E
t
m
t+1
[
c
(1 B
t
C
t
)W
e
t
t+1
W
e
t
C
t
+N
t+1
+W
e
t+1
]
_
.
Dene
t
as
t
=
(
y

p
)
1
y
(1 E
t
(m
t+1
))B
t
+E
t
[m
t+1
(
t+1
y
C
t
)].
Then the discount factor for the rm is given by:
t+1
=
m
t+1
1 +
t
+E
t
[m
t+1
(
c
(1 B
t
C
t
)]
.
and the rms cost of capital becomes:
t+1
=
1
m
t+1
[1 +
t
+E
t
[m
t+1
(
c
(1 B
t
C
t
)] 1.
Notice that if E
t
[m
t+1
(1 B
t
C
t
)] > 0, then the rms cost of capital will
increase with the capital gains tax. One sucient condition for this to hold is
the covariance between the intertemporal MRS and the share of the preferred
stock in rm value, which is given by (1 B
t
C
t
), is positive.
Question 4 The Bellman equation and constraints are as follows:
V (K
t
, H
t
) = max
c
t
,K
t+1
,s
t
_
c
1
t
1
+V (K
t+1
, H
t+1
)
_
subject to
c
t
+K
t+1
(1 )K
t
= AK
t
((1 s
t
)H
t
)
1
,
H
t+1
= H
t
s
t
+ (1 )H
t
.
Assume that
t
is the Lagrange multiplier associated with the rst con-
straint. Substitute for H
t+1
by using the second constraint. The rst-order
conditions with respect to c
t
, K
t+1
and s
t
are as follows:
(c
t
)
=
t
, (10.31)
V
1
(K
t+1
, H
t+1
) =
t
, (10.32)
V
2
(K
t+1
, H
t+1
) =
t
(1 )AK
t
(1 s
t
)
t
. (10.33)
The envelope conditions with respect to K
t
and H
t
are:
V
1
(K
t
, H
t
) =
t
_
(1 )AK
1
t
((1 s
t
)H
t
_
1
+ 1 ), (10.34)
V
2
(K
t
, H
t
) =
t
(1 )AK
t
(1 s
t
)
1
H
t
(10.35)
+V
2
(K
t+1
, H
t+1
)(s
t
+ 1 ).
By (10.31) the growth rate of c
t
denoted
c
can be found as:
t+1
t
=
_
c
t+1
c
t
_
= (1 +
c
)
.
77
By (10.33) and (10.35):
V
2
(K
t
, H
t
) =
t
(1 )AK
t
(1 s
t
)
1
H
t
+
(s
t
+ 1 )

t
(1 )AK
t
(1 s
t
)
t
=
t
(1 )AK
t
(1 s
t
)
t
_
1 s
t
+
(s
t
+ 1 )
_
.
Iterating one period forward and substituting in (10.33) yields:
t+1
(1 )AK
t+1
(1 s
t+1
)
t+1
( + 1 )
=
t
(1 )AK
t
(1 s
t
)
t
.
Dene the steady state values of
K
t
H
t
= and s
t
= s. Imposing these
conditions into the above equation yields:
(1 +
c
) = (( + 1 ))
1
.
By (10.32) and (10.34) we can nd:
(1 +
c
)
(A
1
(1 s)
1
+ 1 ) = 1.
Substituting for (1 +
c
)
we can nd as follows:
=
_

A(1 s)
1
_ 1
1
.
By the resource constraint:
c
t
H
t
+
K
t+1
H
t+1
H
t+1
H
t
(1 )
K
t
H
t
= A
_
K
t
H
t
_
(1 s
t
)
1
.
Imposing the steady state conditions we end up with:
c
t
H
t
+(s + 1 ) (1 ) = A
(1 s)
1
.
Substituting for and re-arranging yields:
C =
c
t
H
t
=
_

A
_ 1
1
(1 s)
_
s
_
,
and
c
t
K
t
=
C
s.
By the resource constraint;
c
t
K
t
+
K
t+1
K
t
(1 ) = A()
1
(1 s)
1
.
But this implies
K
= s . Likewise,
H
t+1
H
t
= s + (1 ) = 1 +
H
,
which implies
H
= s . Also
Y
t
= AK
t
(1 s
t
)
1
H
1
t
t.
Therefore,
Y
t+1
Y
t
=
_
K
t+1
K
t
_
_
H
t+1
H
t
_
1
= (1 +s )
(1 +s )
1
= 1 +s .
Therefore,
H
=
C
=
K
= s .
79
11 Investment
Question 1
a) The Bellman equation is
V (k
t
) = max
{c
t
,k
t+1
}
[U(c
t
) +V (k
t+1
)]
subject to
k
t
n
1
t
+ (1 )k
t
c
t
k
t+1
0
k
t+1
(1 )k
t
.
Let
t
and
t
denote the Lagrange multipliers associated with two constraints.
The rst-order conditions and envelope condition are
U
(c
t
) =
t
(11.1)
t
=
t
+V
(k
t+1
) (11.2)
V
(k
t
) =
t
[k
1
t
n
1
t
+ (1 )]
t
(1 ) (11.3)
Observe that when
t
> 0, k
t+1
= (1)k
t
and c
t
= k
t
n
1
t
= k
t
since n
t
= 1
in equilibrium.
b) When investment is not constrained to be non-negative,
t
= 0 always.
Hence, the rst-order and envelope conditions simplify as:
U
(c
t
) =
t
(11.4)
t
= V
(k
t+1
) (11.5)
V
(k
t
) =
t
[k
1
t
n
1
t
+ (1 )], (11.6)
with c
t
+ i
t
k
t
n
1
t
. In this case, the optimal choice of capital satises the
condition
U
(c
t
) =
_
U
(c
t+1
)[f
(k
t+1
,
t+1
) + (1 )]
_
(11.7)
subject to c
t
+k
t+1
(1 )k
t
k
t
in equilibrium.
Question 2
a) The rms cash ow is dened as:
N
t
f(k
t
)
t
+p
k,t
(1 )k
t
w
t
n
t
i
d
t
p
k,t
k
d
t
.
The rm maximizes
W(k
t
,
t
) = N
t
+E
t
[m
t+1
W(k
t+1
,
t
)] (11.8)
subject to i
d
t
0 and given k
t
by choosing n
t
, k
d
t
, i
d
t
.
b) The rst-order conditions are:
w
t
= f(k
t
)
t
f
(k
t
)
t
, (11.9)
p
k,t
= E
t
[m
t+1
W
1
(k
t+1
,
t+1
)], (11.10)
1 =
t
+E
t
[m
t+1
W
1
(k
t+1
,
t+1
)], (11.11)
The envelope condition is:
W
1
(k
t
,
t
) = f
(k
t
)
t
+ (1 )(p
k,t
t
). (11.12)
where
t
denotes the Lagrange multiplier on the nonnegativity constraint i
d
t

0.
c) In this model, the replacement cost of new capital equals to the price
of output (which equals unity in this model). Hence, marginal Q = p
kt
.
We consider the case of
t
= 0 rst. In this case, investment i
d
t
is strictly
positive so that Equation (11.11) implies 1 = p
k,t
or equivalently, Q
t
= 1.
Now suppose that
t
> 0 so that i
d
t
= 0 in Equation (11.11); then we have
that p
kt
= E
t
[m
t+1
W
1
(k
t+1
,
t+1
)] < 1, or equivalently, Q
t
< 1.
d) To understand Sargents statement, we note that Q
t
itself is deter-
mined as a function of the rms capital stock, which is endogenous. To solve
for the equilibrium capital stock, we can make use of the social planners
problem in Section 9.2.3. Notice that with a representative consumer and a
representative rm, the aggregate per capita capital stock equals the rms
capital stock, K
t+1
= k
t+1
. Hence, we can use the problem in Section 9.2.3
to solve for K
t+1
and evaluate Q using the relations in Section 9.2.4. This
will yield relations that change as a function of the exogenous variables in the
model, in this case, the technology shock,
t
. Thus, while we can deduce a
relation between the investment-capital stock ratio i
t
/k
t
and Q in this model,
we cannot use this relation directly to make inferences, say, about the impact
of changes in technology on the investment-capital stock ratio because such a
change will aect both i
t
/k
t
and Q.
Question 3
a) Net cash ows of the rm is given by the equation:
N
t
= S
t
K
t
I
d
t
p
k,t
K
d
t
+p
k,t
(1 )K
t
, (11.13)
and the present value of the rm is just the discounted sum of future cash
ows given by:
W
t
=
i=0
m
t,i
N
t+i
81
=
i=0
m
t+i
_
S
t+i
K
t+i
I
d
t+i
p
k,t+i
K
d
t+i
+p
k,t+i
(1 )K
t+i
_
b) When there is time-to-build in investment, the state variables for the
rm consist of the unnished capital stocks s
j,t
plus the existing stock of capital
K
t
. Dene h
t
(K
t
, s
1,t
, . . . , s
J,t1
)
. Thus, the rms problem can be written

in a dynamic programming form as:
W(h
t
) = max
s
J,t
,K
d
t
N
t
+E
t
[m
t,t+1
W(h
t+1
)]
subject to
K
t+1
= K
d
t
+s
1,t
,
s
j,t+1
= s
j+1,t
, j = 1, . . . , J 1,
given s
j,0
, j = 1, ..., J 1 and K
0
.
c) Substituting for the laws of motion for the capital stocks, the rst-
order conditions are given by:
J
= E
t
[m
t,t+1
W
J1
(h
t+1
)],
p
k,t
= E
t
[m
1t,t+1
W
K
(h
t+1
)],
and the envelope conditions are
W
j1
(h
t
) =
j1
+E
t
[m
t,t+1
W
j2
(h
t+1
)], 2 j J
W
K
(h
t
) = S
t
+p
k,t
(1 ).
Now use the envelope conditions recursively to write the rst-order condition
corresponding to s
J,t
as:
E
t
[m
t,t+j
W
K
(h
t+J
)]
= E
t
[
J
+m
t,t+1
J1
+m
t,t+2
J2
+... +m
t,t+J1
1
].
The left-side of this equation denotes the discounted marginal benet of one
unit of s
J,t
that will be realized in J periods when it becomes a part of the
production process whereas the right side is simply the sum of discounted
payments made for this project during the last J periods.
We can rewrite the rst-order condition corresponding to the choice of K
d
t
as follows:
p
k,t+J1
= E
t+J1
[m
t+J1,t+J
W
K
(h
t+J
)],
which implies that
E
t
[m
t,t+J1
p
k,t+J1
] = E
t
m
t,t+J1
E
t+J1
[m
t+J1,t+J
W
K
(h
t+J
)]
= E
t
[m
t,t+J
W
K
(h
t+J
)],
where we used the law of iterated expectations together with the fact that
m
t,t+J1
m
t+J1,t+J
= m
t,t+J
to obtain the last line. Substituting this into
the Eq. (11.14) yields:
E
t
[m
t,t+J1
p
k,t+J1
]
= E
t
[
J
+m
t,t+1
J1
+m
t,t+2
J2
+... +m
t,t+J1
1
]
The expected discounted market price of the project is equal to its total cost,
or total investment into the project during its life. In other words, the repre-
sentative rm invests into projects to the point that the new project that will
be completed in J periods and used capital that can be purchased J periods
later have the same expected value. This is a no-arbitrage condition that re-
lates the value of new and used capital and that also takes into account the
time-to-build feature in investment. Demers, Demers, and Altug [149] also
describe how to incorporate irreversibility into the time-to-build model.
83
12 Business Cycles
Question 1
a) Utility in each period is given by:
U
t
= exp(u
t
) ln(c
t
) h
t
.
By using the denition of transformed variables we can write:
c
t
= ln(c
t
/
t
) = ln(c
t
) ln(
t
) ln(c
t
) = c
t
+ ln(
t
) (12.1)
and
h
t
= ln(h
t
) h
t
= exp(h
t
). (12.2)
Substitute (12.1) and (12.2) into the period utility function:
U
t
= exp(u
t
)[c
t
+ ln(
t
)] exp(h
t
)
= exp(u
t
)c
t
+ exp(u
t
) ln(
t
) exp(h
t
).
The original feasibility condition is given by:
c
t
+k
t+1
(1 )k
t
f(
t
, h
t
, k
t
) = (
t
h
t
)
1
k
t
. (12.3)
Dene original variables in terms of transformed variables:
c
t
= exp(c
t
)
t
,
k
t+1
= exp(k
t+1
)
t+1
= exp(k
t+1
)
t
exp(
t+1
),
k
t
= exp(k
t
)
t
.
So the left-hand side of the inequality in (12.1) can be rewritten as:
t
[exp(c
t
) + exp(k
t+1
) exp(
t+1
) (1 ) exp(k
t
)] (12.4)
Since, h
t
= exp(h
t
) and k
t
= exp(k
t
)
t
the right hand-side can be written
as:
[
t
exp(h
t
)]
1
[exp(k
t
)
t
]
=
t
[exp(h
t
)
1
exp(k
t
)
]. (12.5)
Combining (12.4) and (12.5):
exp(c
t
) + exp(k
t+1
) exp(
t+1
) (1 ) exp(k
t
)
exp(h
t
)
1
exp(k
t
)
. (12.6)
b) Rewrite the problem in terms of transformed variables:
max
c
t
,k
t
,k
t+1
E
0
t=0
t
[exp(u
t
)(c
t
+ ln(
t
)) exp(h
t
)]
subject to (12.6).
The Bellman equation can be written as:
V (k
t
,
t
) = max
c
t
,k
t
,k
t+1
[exp(u
t
)(c
t
+ ln(
t
)) exp(h
t
)
+E
t
V (k
t+1
,
t+1
)]
subject to (12.6). Let
t
denote the Lagrange multiplier for the constraint.
The rst-order conditions with respect to c
t
, h
t
and k
t+1
are:
exp(u
t
) =
t
exp(c
t
), (12.7)
exp(h
t
) =
t
(1 ) exp(h
t
)
exp(k
t
)
, (12.8)
E
t
V
1
(k
t+1
,
t+1
) =
t
exp(
t+1
) exp(k
t+1
). (12.9)
The envelope condition is given by:
V
1
(k
t
,
t
) =
t
[exp(h
t
)
1
exp(k
t
)
+ (1 ) exp(k
t
)].
Increase the time subscript by 1 unit in the envelope condition and substitute
the resulting expression into (12.9) to simplify:
E
t
_
_
_
exp(u
t+1
)
exp(c
t+1
)
_
_
_
exp(h
t+1
)
exp(k
t+1
)
_
1
+ (1 )
_
_
_
_
_
=
exp(u
t
)
exp(c
t
)
exp(
t+1
)). (12.10)
The rst and second conditions yield the intratemporal marginal rate of sub-
stitution between consumption and leisure as:
exp(u
t
)
exp(c
t
)
_
exp(k
t
)
exp(h
t
)
_
=

1
. (12.11)
If we substitute equation (12.11) into the equation (12.10) and simplify, we
obtain:
E
t
_

1
exp(h
t+1
)
exp(k
t+1
)
+ (1 )
_
=

1
_
exp(h
t
)
exp(k
t
)
_
exp(
t+1
).
85
Question 2
a) The state variables for Crusoes problem consist of output and tech-
nology shocks in each sector S
t
(y
1t
, y
2t
)
and the control variables are given

by u
t
(c
it
, n
it
, k
i1t
, k
i2t
)
for i = 1, 2. Dene
t
(
1t
,
2t
)
as the vector of
shocks in the two sectors. Bellmans equation is given by:
V (S
t
,
t
) = max
u
t
1
ln(c
1t
) +
2
ln(c
2t
) +
3
ln(l
t
) +E[V (S
t+1
,
t
)[
t
]
subject to
y
i,t+1
=
i,t+1
n
i
it
k
i1
i1t
k
i2
i2t
c
jt
+
2
i=1
k
ijt
y
jt
,
for i, j = 1, 2 and the time constraint:
n
1t
+n
2t
+l
t
= 1.
b) We guess that the value function has the form:
V (S
t
,
t
) =
2
i=1
i
ln(y
it
) +J(
t
) +C,
where
i
for i = 1, 2 and C are constants to be determined and J(
t
) is an
unknown function in
t
. Let
it
denote the Lagrange multipliers on the two
sector constraints and
t
denote the Lagrange multiplier on the time constraint.
The rst-order conditions are given by:
i
c
it
=
it
, i = 1, 2, (12.12)
3
l
t
=
t
, (12.13)
1t
= E
t
_
i1
i,t+1
n
i
it
k
i1
1
i1t
k
i2
i2t
y
it+1
_
, i = 1, 2, (12.14)
2t
= E
t
_
i2
i,t+1
n
i
it
k
i1
i1t
k
i2
1
i2t
y
it+1
_
, i = 1, 2, (12.15)
t
= E
t
_
i,t+1
n
i
1
it
k
i1
i1t
k
i2
i2t
y
it+1
_
, (12.16)
for i = 1, 2. The envelope conditions are as follows:
V
i
(S
t
,
t
) =

i
y
it
=
it
, i = 1, 2. (12.17)
Using this result in the condition determining optimal consumption yields
c
it
=

i
i
y
it
, i = 1, 2. (12.18)
Likewise, multiplying the next two conditions by k
i1t
and k
i2t
and substituting
for
it
using the envelope condition, we can solve for the optimal quantity of
capital of type j allocated to sector i as:
k
ijt
=
_
ij
j
_
y
jt
, i, j = 1, 2. (12.19)
Using the same approach, we can solve for the inputs of labor in the two sectors
as a function of leisure time as follows:
n
it
=

i
3
l
t
.
Using the rst-order condition for leisure time l
t
together with these conditions,
we can solve for l
t
as:
l
t
= 1 n
1t
n
2t
= 1
_
3
+

2
3
_
l
t
.
which implies that
l
t
=
3
_
3
+
2
i=1
i
_
1
. (12.20)
Substituting back into the expressions for n
it
yields:
n
it
=
i
i
_
3
+
2
i=1
i
_
1
, i = 1, 2. (12.21)
c) Now substitute for the optimal policy functions to nd the coecients
of the value function. We have that
2
i=1
i
ln(y
it
) +J(
t
) +C
=
2
i=1
i
ln(c
it
) +
3
ln(l
t
) +E [ln(y
i,t+1
) +J(
t+1
) +C[
t
]
=
2
i=1
i
ln(
i
y
it
/
i
) +
3
ln(
3
[
3
+
1
1
+
2
2
]
1
)
+
_
2
i=1
i
_
E[ln(
i,t+1
)[
t
] +
i
ln(
i
i
[
3
+
1
1
+
2
2
]
1
)
+
i1
ln (
i
i1
y
1t
/
1
) +
i2
ln (
i
i2
y
2t
/
2
)] +E[J(
t+1
)[
t
] +C .
87
Ignoring the constant term and equating the coecients in y
it
and the terms
involving
t
yields:
j
=
j
+
2
i=1
ij
, j = 1, 2,
J(
t
) = E
_
2
i=1
i
ln(
i,t+1
) +J(
t+1
)[
t
_
.
Let us discuss some properties of this solution. Notice that if output in a
given sector is high at some date, say y
it
, then the inputs of that commodity
in all of its productive uses, will also be high. This property of the solution
results in comovement and persistence of output shocks because a given output
shock is propagated both over time and across sectors. Next note that Cru-
soes labor/leisure allocation is constant and independent of S
t
. In general,
the labor allocation decision involves comparisons of the substitutability of la-
bor with capital in production with the substitutability of commodity/leisure
and present/future substitutability of consumption. In this example, all of
these elasticities are unity! This arises from the logarithmic, time-separable
specication in preferences and the Cobb-Douglas production functions. Pro-
cyclicality of the labor input, a phenomenon that is widely observed in the
data, requires that such substitution elasticities dier in consumption versus
production.
d) We already derived the equilibrium allocations in part b). The equi-
librium prices (in utility-denominated terms) are obtained as follows:
p
it
=
V (S
t
)
y
it
=

i
y
it
, i = 1, 2,
w
t
=
u(c
t
, l
t
)
l
t
=
3
+
2
i=1
i
.
Both the equilibrium allocations and the equilibrium prices for commodity i
reect the impact of the total quantity of output for commodity i as well as
the inuence of the preference and production parameters. Thus, for example,
consumption of commodity i is higher (relative to other commodities), the
higher is (i) output of commodity i, y
it
; (ii) the preference for commodity i
(
i
); or (iii) its productivity
ij
. Likewise, the higher the price of commodity
i relative to other prices, (i) the greater its scarcity; (ii) the preference for
commodity i (
i
); or (iii) its productivity
ij
. Denominated in terms of some
commodity h, the real wage is higher, the greater (i) the preference for leisure
(
3
); (ii) productivity of labor (
i
); and the current value of the numeraire
output (y
ht
). We also observe that the real wage and output move together.
Finally, the real interest rate (denominated in commodity h) satises
E[V (S
t+1
)/y
h,t+1
[S
t
]
V (S
t
)/y
ht
= E
__
y
ht
y
h,t+1
_
[S
t
_
=
1
1 +r
ht
.
This is our standard formula for the real interest rate. In this case, we make
use of the form of the value function. We leave it for the reader to show that
if y
ht
is lognormally distributed given S
t
, then the real interest rate varies ap-
proximately positively with the rate of time preference () and the growth rate
of commodity h (
h
) and negatively through a precautionary saving motive
on the variance of commodity h (
2
h
).
Question 4
a) The autocovariance function for these processes can be found using
the Yule-Walker equations.
Beginning with the AR(1) model, notice rst that
E(y
t
) = a
0
+a
1
E(y
t1
) +E(
t
) E(y
t
) =
a
0
1 a
1
= ,
V ar(y
t
) = a
2
1
V ar(y
t1
) +V ar(
t
) V ar(y
t
) =

2
1 a
2
1
,
where we have made use of the stationarity of y
t
to equate the unconditional
moments to each other. Next calculate
E[(y
t
)(y
t1
)] = a
1
E[(y
t1
)(y
t1
)] +E[
t
(y
t1
)]
= a
1
E[(y
t1
)(y
t1
)]
=
a
1
2
1 a
2
1
.
Dene
s
= E[(y
t
)(y
ts
)] = E[(y
tk
)(y
tks
)] by stationarity.
Notice that
E[(y
t
)(y
ts
)] = a
1
E[(y
t1
)(y
ts
)] +E[
t
(y
ts
)]
= a
1
E[(y
t1
)(y
ts
)]
= a
1
s1
=
a
s
1
2
1 a
2
1
.
Hence, the autocovariance function for an AR(1) process will decay as the lag
s increases since [a
1
[ < 1.
89
Next consider the MA(1) process.
E(y
t
) = b
0
+E(
t
) +b
1
E(
t1
), E(y
t
) = b
0
= ,
V ar(y
t
) = V ar(
t
) +b
2
1
V ar(
t1
) V ar(y
t
) =
2
(1 +b
2
1
),
The Yule-Walker equations are given by:
E[(y
t
)(y
t1
)] = b
1
E[
t1
(y
t1
)] +E[
t
(y
t1
)]
= b
1
2
,
and
E[(y
t
)(y
ts
)] = b
1
E[
t1
(y
ts
)] +E[
t
(y
ts
)]
= 0 s 1.
More generally, the autocovariance function for a nite MA(q) process will be
zero after lag q.
Finally, consider the ARMA(1,1) process.
E(y
t
) = a
0
+a
1
E(y
t1
) +E(
t
) +b
1
E(
t1
), E(y
t
) =
a
0
1 a
1
= ,
The Yule-Walker equations are given by:
E[(y
t
)(y
t
)] = a
2
1
E[(y
t1
)(y
t1
)] + 2a
1
b
1
E[
t1
(y
t1
)]
+E[
t
t
] +b
2
1
E[
t1
t1
]
E[(y
t
)(y
t1
)] = a
1
E[(y
t1
)(y
t1
)] +b
1
E[
t1
(y
t1
)]
+E[
t
(y
t1
)].
Solving these equations jointly for V ar(y
t
) and E[(y
t
)(y
t1
)] yields
V ar(y
t
) =
1 +b
2
1
+ 2a
1
b
1
1 a
2
1
2
E[(y
t
)(y
t1
)] =
(1 +a
1
b
1
)(a
1
+b
1
)
1 a
2
1
2
.
and
E[(y
t
)(y
ts
)] = a
1
E[(y
t1
)(y
ts
)] +b
1
E[
t1
(y
ts
)]
+E[
t
(y
ts
)]
= a
1
s1
s 2.
b) Notice that we can write all of the above proceses in the form:
y
t
=
j=0
c
j
tj
,
t
i.i.d.
= c(L)
t
,
where C(L) = c
0
+ c
1
L + c
2
L
2
+ . . . is a lag polynomial in positive powers of
L.
The covariance generating function for y
t
is denoted
g
y
(z) =
k=
y
(k)z
k
,
where
y
(k) = E [(y
t
Ey
t
)(y
tk
Ey
tk
)] .
Using the above representation,
y
(k) = E
_
_
j=0
c
j
tj
h=0
c
h
tkh
_
_
=
2
j=0
c
j
c
jk
,
since E(
tj
thk
) ,= 0 is h = j k. Substituting this result into the expres-
sion for g
y
(z) yields
g
y
(z) =
k=
z
k
j=
c
j
c
jk
, c
j
= 0 for j < 0
=
j=
h=
c
j
c
h
z
jh
=
j=
c
j
z
j
h=
c
h
z
h
= c(z)c(z
1
).
b) The spectrum of a stationary stochastic process is
S
y
() =
k=
y
(k)e
ik
, < < .
91
0
50
100
Sy(w)
w /2 0
5
9
w /2
Sy(w)
0
5
9
w /2
Sy(w)
Figure B.3: Spectra for AR(1), MA(1), and ARMA(1,1) Processes
Using the representation for the autocovariance functon that we derived earlier,
the spectrum can be expressed as follows:
S
y
() = c(e
i
)c(e
i
).
Now consider the AR(1) process. Since [a
1
[ < 1, we have that
c(L) =
1
1 a
1
L
.
Therefore, the spectrum of the AR(1) process is:
S
y
() =
_
1
1 a
1
e
i
__
1
1 a
1
e
i
_
.
Likewise, the MA(1) process has the specturm:
S
y
() =
_
b
0
+b
1
e
i
_ _
b
0
+b
1
e
i
_
.
Finally we can nd the spectrum for an ARMA(1,1) by combining these results
as:
S
y
() =
_
b
0
+b
1
e
i
1 a
1
e
i
__
b
0
+b
1
e
i
1 a
1
e
i
_
.
Figure B.3 shows the spectra for the the AR(1), MA(1) and ARMA(1,1)
processes.
c) We calculate the cross-covariagram for the rst two series and leave
the rest as an exercise. To begin,
E[(y
t
y
)(z
t
z
)] = E[(a
0
+a
1
y
t1
+
t
y
)(z
t
z
)]
= a
1
E[y
t1
(z
t
z
)] +E[
t
(z
t
z
)]
= a
1
E[y
t1
(
t
+b
1
t1
)] +E[
t
(
t
+b
1
t1
)]
= a
1
b
1
2
+
2
= (1 +a
1
b
1
)
2
.
Next,
E[(y
t
y
)(z
t1
z
)] = a
1
E[y
t1
(z
t1
z
)] +E[
t
(z
t1
z
)]
= a
1
E[y
t1
(
t1
+b
1
t2
) +E[
t
(
t1
+b
1
t2
)]
= a
1
2
Also,
E[(y
t
y
)(z
ts
z
)] = a
1
E[y
t1
(z
ts
z
)] +E[
t
(z
ts
z
)]
= a
1
E[y
t1
(
ts
+b
1
ts1
) +E[
t
(
ts
+b
1
ts1
)]
= 0, s 2.
We also have that
E[(y
t1
y
)(z
t
z
)] = a
1
E[y
t2
(z
t
z
)] +E[
t1
(z
t
z
)]
= a
1
E[y
t2
(
t
+b
1
t1
) +E[
t1
(
t
+b
1
t1
)]
= b
1
2
,
and
E[(y
ts
y
)(z
t
z
)] = a
1
E[y
ts1
(z
t
z
)] +E[
ts
(z
t
z
)]
= a
1
E[y
ts1
(
t
+b
1
t1
) +E[
ts
(
t
+b
1
t1
)]
= 0, s 2.
Hence,
C
yz
() =
r=
R
yz
(r)e
ir
= b
1
2
e
i
+ (1 +a
1
b
1
)
2
+a
1
2
e
i
.
Figure B.4 shows the cross spectrum between the AR(1) and MA(1) pro-
cesses for dierent values of
2
.
d) The spectrum and cross-spectrum are useful for business cycle analysis
because they show us the pattern of auto- and cross-correlation in terms of a
frequency domain decomposition. A series which has power at low frequencies
is typcally a persistent series whereas which has power at high frequencies has
more cyclical movements. Notice that the AR(1) process has most of its power
concentrated at the frequencies near zero. By contrast, the MA(1) process also
has power at higher frequencies. The cross specturm, in turn, tells us at which
frequencies two series are correlated. We notice that the coherence between
the two processes increases as
2
increases.
93
w /2
C
yz
(w)
2
= 0.30
2
= 0.15
2
= 0.05
Figure B.4: The Cross Spectrum
13 Models with Cash-in-Advance Constraints
Question 1 Dene B as the space of bounded, continuous functions on
++
S Z H such that sup
y,s,z,h
[V (y, s, z, h)/y
1
[ < . For V B,
dene the operator T:
(TV )(y, s, z, h) = max
_
U(c) +
_
S
V (y
, s
, z
, h
)d(s
)
_
,
subject to the constraints
m
d
t
+q
e
t
z
t
+Q
t
b
t
h
t
+q
e
t
z
t1
,
p
t
c
t
m
d
t
,
where
h
t

1
(s
t
)
[p
t1
y
t1
z
t1
+b
t1
+m
d
t1
p
t1
c
t1
+ (
t
1)],
and m
d
/, z
Z, and b
B.
First, we need to show that the operator T maps the space of bounded,
continuous functions with the -norm into itself. This requires that for any
V B, TV is bounded (so that |(TV )|
< ) and that it is jointly continuous

in its arguments.
From the budget constraint, notice that
(m
d
)
p(s, y)y
+
q
e
(s, y)
p(s, y)y
z
+
Q(s)
p(s, y)y
b
h
p(s, y)y
+
q
e
(s, y)
p(s, y)y
z,
and
c
p(s, y)y

(m
d
)
p(s, y)y
where
h
p(s, y)y

1
(s)
[z +
b
p(s, y)y
+
m
d
p(s, y)y

c
y
+
( 1)
p(s, y)y
],
We have restricted m
d
/, b
B, z
Z, h H and feasible c such that

0 c y. For any c such that 0 c y, current utility (which is continuous
in c) is also -bounded and continuous. If V B, then E
s
[V (y
, s
, z
, h
)] is
-bounded because
(y)
(y)
_
S
(y
)
V (y
, s
, z
, h
)
(y
)
d(s
)
= (y)
_
S
(s
)
1
V (y
, s
, z
, h
)
(y
)
(y)

B
_
S
(s
)
1
d(s
) (y)

B
since V is -bounded and
_
S
(s
)
1
d(s
) < 1. Furthermore, the func-

tion E
s
[V (y
, s
, z
, h
)] is continuous since V is continuous and the transition

function has the Feller property. Hence, TV involves maximizing a continuous
function over a compact set so that it is well dened; that is, a maximum ex-
ists and it is bounded, and by the Theorem of the Maximum, it is continuous.
Thus, T : B B.
Next, notice that T is monotone. Given any two functions u w, it is
straightforward to verify that Tu Tw. Furthermore, for any constant a > 0,
(TV +a)(y, s, z, h) max
c,m
d
,z
,b
_
y
1
_
c
1
1
y
1
(1 )
+
_
S
(s
)
1
V (y
, s
, z
, h
) +a(y
)
(y
)
d(s
)
__
(TV )(y, z, s, h) +a(y),
where =
_
S
(s
)
1
d(s
) < 1 so that T discounts. Finally, notice that

T(0) B since U is -bounded and continuous for 0 c y. Hence, T
satises the conditions for a weighted contraction mapping and has a unique
xed point V
B.
95
Question 2
a) The representative agent solves the dynamic programming problem:
V (s, z, b, h) = max
c,m
d
,z
,b
_
U(c) +E
s
V (s
, z
, b
, h
)
_
subject to (13.123) and (13.124).
b) The market clearing conditions are given by y = c, m
d
= 1, z
= 1
and b
= 0. Let (s) denote the multiplier on the cash-in-advance constraint

and (s) the multiplier on the wealth constraint. The rst-order conditions
with respect to c, m
d
, z
, b are
U
(c) = (s)p(s) +(s)p(s)

(s)(s) = E
s
V
h
(s
, z
, b
, h
)
(s)q
e
(s) = E
s
V
z
(s
, z
, b
, h
)
(s)(s)Q(s) = E
s
V
b
(s
, z
, b
, h
).
The envelope conditions are given by:
V
z
(s, z, b, h) = (s)[q
e
(s) +p(s)d(s)] (13.22)
V
b
(s, z, b, h) = (s), (13.23)
V
h
(s, z, b, h) = (s) +(s). (13.24)
Substituting the envelope conditions into the rst-order conditions and impos-
ing the market-clearing conditions yields:
U
(c) = (s)p(s) +(s)p(s) (13.25)

(s)(s) = E
s
[(s
) +(s
)] (13.26)
(s)q
e
(s) = E
s
[(s
)(q
e
(s
) +p(s
)y(s
))] (13.27)
(s)(s)Q(s) = E
s
[(s
)]. (13.28)
c) Using the rst-order conditions with respect to money balances and
bond holdings, the bond price satises
Q(s) = E
s
_
(s
)
(s)(s)
_
= E
s
_
(s
)
E
s
((s
) +(s
))
_
=
E
s
((s
))
E
s
((s
) +(s
))
.
Notice that if (s
) > 0, then the cash-in-advance constraint is binding. But

the nominal interest rate is positive whenever E
s
[(s
)] > 0. Thus, the con-

ditions which the nominal interest rate is positive are less restrictive than the
conditions under which the cash-in-advance constraint is binding. The rea-
son is that agents determine their money holdings to be carried into period
t + 1 before they know the nominal price that will prevail at t + 1. Thus,
they are willing to hold nominal money balances at a positive nominal interest
rate if, based on their period t information, they expect the cash-in-advance
constraint to be binding in period t + 1.
Question 3
a) By using rst-order conditions in equations (13.87) and (13.89) in the
text, we can get:
U
1
(c
t
, l
t
)
p(s
t
)
= (s
t
) (13.29)
By using equations (13.88) and (13.90) we can get:
U
2
(c
t
, l
t
)
w(s
t
)p(s
t
)(1 (s
t
))
= (s
t
)Q(s
t
) (13.30)
Combining the results in equations (13.29) and (13.30) one can get:
U
1
(c
t
, l
t
)
p(s
t
)
Q(s
t
) =
U
2
(c
t
, l
t
)
w(s
t
)p(s
t
)(1 (s
t
))
(13.31)
By using the utility specication given in the question we can nd:
U
1
(c
t
, l
t
) =
(c
t
l
1
t
)
c
t
U
2
(c
t
, l
t
) = (1 )
(c
t
l
1
t
)
l
t
.
Substituting these into (13.31) we get:
_
l
t
c
t
_
a
=
1
1
Q(s
t
)w(s
t
)(1 (s
t
))
. (13.32)
where a is an index representing part a).
97
b) If we drop the cash-in-advance constraint then we can nd the rst-
order conditions of the new model by substituting (s
t
) = 0 into (13.87)
(13.91). Using arguments similar to part (a), we get :
U
1
(c
t
, l
t
)
p(s
t
)
= (s
t
). (13.33)
Likewise, we nd that Q(s
t
) = 1 in the new model. Hence,
U
2
(c
t
, l
t
)
w(s
t
)p(s
t
)(1 (s
t
))
= (s
t
). (13.34)
Combining (13.33) and (13.34) :
U
1
(c
t
, l
t
)
p(s
t
)
=
U
2
(c
t
, l
t
)
w(s
t
)p(s
t
)(1 (s
t
))
(13.35)
Substituting U
1
(c
t
, l
t
) =
(c
t
l
1
t
)
c
t
and U
2
(c
t
, l
t
) = (1 )
(c
t
l
1
t
)
l
t
_
l
t
c
t
_
b
=
1
1
w(s
t
)(1 (s
t
))
(13.36)
where b is an index representing part b).
As a result, in both parts of the question, as (s
t
)
l
t
c
t
. Since Q(s
t
) 1
always then
_
l
t
c
t
_
b
_
l
t
c
t
_
a
,
implying that without any cash-in-advance constraint agents consume less
leisure and more work eort.
Question 4
a) The rms problem is to maximize current prots each period or
max
x
t
t
x
t
x
t
w
t
.
Prots are returned to shareholders as dividends. The rst-order condition is:
t
x
1
t
w
t
= 0,
so that the equilibrium real wage is
w
t
=
t
x
1
t
.
Substitute for the real wage in the expression for prots to yield equilibrium
dividends as
d
t
=
t
x
t
x
t
t
x
1
t
= (1 )
t
x
t
.
b) We can solve the households problem by setting it up as dynamic
programming problem:
V (h
t
, z
t
, b
t
, k
t
, s
t
,
t
) = max
{c
t
,z
t+1
,b
t+1
,x
t
}
t
ln(c
t
)
+E
t
V (h
t+1
, z
t+1
, b
t+1
, k
t+1
, s
t+1
,
t+1
)
subject to
k
t+1
= (s
t+1
)(k
t
x
t
),
k
t
x
t
0,
(s
t
)h
t+1
= [h
t
p
t
c
t
+b
t
+ (q
e
t
+p
t
d
t
)z
t
q
e
t
z
t+1
+w
t
p
t
x
t
+(s
t
) 1]
Q
t
(s
t
)b
t+1
p
t
c
t
h
t
.
c) Let
t
denote the multiplier for the cash-in-advance constraint, let
kt
denote the multiplier on the nonnegativity constraint for capital, and
t
denote the multiplier on the asset market constraint. Given the price functions
p
t
, q
e
t
, Q
t
, w
t
, the rst-order conditions with respect to c
t
, h
t+1
, z
t+1
, b
t+1
, and
x
t
are:
t
c
t
= p
t
(
t
+
t
), (13.37)
(s
t
)
t
= E
t
[V
h
(h
t+1
, z
t+1
, b
t+1
, k
t+1
, s
t+1
,
t+1
)], (13.38)
t
q
e
t
= E
t
[V
z
(h
t+1
, z
t+1
, b
t+1
, k
t+1
, s
t+1
),
t+1
], (13.39)
t
Q
t
= E
t
[V
b
(h
t+1
, z
t+1
, b
t+1
, k
t+1
, s
t+1
),
t+1
], (13.40)
p
t
w
t
t
=
kt
+E
t
[(s
t+1
)V
k
(h
t+1
, z
t+1
, b
t+1
, k
t+1
, s
t+1
,
t+1
)]. (13.41)
The envelope conditions are:
V
h
(h
t
, z
t
, b
t
, k
t
, s
t
,
t
) =
t
+
t
,
V
z
(h
t
, z
t
, b
t
, k
t
, s
t
,
t
) =
t
(q
e
t
+p
t
d
t
),
V
b
(h
t
, z
t
, b
t
, k
t
, s
t
,
t
) =
t
,
V
k
(h
t
, z
t
, b
t
, k
t
, s
t
,
t
) =
t
w
t
p
t
.
Substituting the envelope conditions into the rst-order conditions yields:
t
c
t
= p
t
(
t
+
t
), (13.42)
99
(s
t
)
t
= E
t
[
t+1
+
t+1
], (13.43)
t
q
e
t
= E
t
[
t+1
(q
e
t+1
+p
t+1
d
t+1
)], (13.44)
t
Q
t
= E
t
[
t+1
], (13.45)
p
t
w
t
t
=
kt
+E
t
[(s
t+1
)
t+1
p
t+1
w
t+1
]. (13.46)
The equilibrium conditions are c
t
= y
t
, w
t
=
t
x
1
t
, h
t+1
= 1, z
t+1
= 1,
b
t+1
= 0 and k
t
=
t
. We also have the conditions:
(p
t
c
t
1)
t
= 0,
(k
t
x
t
)
kt
= 0.
d) Let x(s, ) be a xed policy that satises the nonnegativity constraint
for capital. Then, output produced under this policy is given by
y(s, ) = x(s, )
.
If the cash-in-advance constraint were always binding, we would have p
t
c
t
= 1.
If this assumption is not imposed, then dene a function such that
p(s, ) =
1
y(s, )(s, )
.
Now substitute (13.42) into (13.43) to obtain
(s
t
,
t
) =

(s
t
)
E
t
_

t+1
p(s
t+1
,
t+1
)c
t+1
_
,
which can be expressed as
(s
t
,
t
) =

(s
t
)
E
t
[
t+1
(s
t+1
,
t+1
)] . (13.47)
Use (13.42) to solve for (s
t
,
t
). Substituting the expression that we have
derived above for (s
t
,
t
) yields
(s
t
,
t
) =
t
(s
t
,
t
) E
t
_
t+1
(s
t+1
,
t+1
)
(s
t
)
_
.
If (s
t
,
t
) = 0, then
(s
t
,
t
) = E
t
_
t+1
t
(s
t+1
,
t+1
)
(s
t
)
_
.
If (s
t
,
t
) > 0, then (s
t
,
t
) = 1. This yields the mapping
(s, ) = max
_
1, E
s
_
(s
)
(s)
__
. (13.48)
e) This is a functional equation in the unknown function . Notice that
the information set at the beginning of the period includes the current capital
stock k but it does not include the current output level y. Hence, the functional
equation can be solved independently from the problem of determining the
optimal x.
To further analyze the functional equation in (13.48), we assume that the
money growth is independent of the economy-wide capital stock . Now we
can follow the approach in Section 13.2.2 to show the existence of a xed point
that is a function only of the current exogenous state s.

f ) We now focus on the rst-order condition for the supply of the inter-
mediate good. Thus, use (13.46). Solving this condition for the multiplier
kt
yields
k
(s
t
,
t
) = p
t
w
t
t
E
t
[(s
t+1
)
t+1
p
t+1
w
t+1
].
First substitute for
t
using the condition in (13.47) and then for p
t
= 1/(c
t
t
)
to obtain:
kt
= E
t
_
t+1
t+1
p
t
w
t
t
_
E
t
_
t+2
t+2
p
t+1
w
t+1
t+1
_
= E
t
_
t+1
t+1
w
t
t
c
t
t
_
E
t
_
t+2
t+2
w
t+1
t+1
c
t+1
t+1
_
.
In equilibrium y
t
= c
t
= w
t
x
t
. Thus,
kt
= E
t
_
t+1
t+1
w
t
t
x
t
t
_
E
t
_
t+2
t+2
w
t+1
t+1
x
t+1
t+1
_
.
Using the denition for (s
t+1
, s
t
), we can express
k
(s
t
,
t
)
= E
t
_
(s
t+1
, s
t
)
x(s
t
,
t
)
_
E
t
_
(s
t+2
, s
t+1
)(s
t+1
)
x(s
t+1
,
t+1
)
_
. (13.49)
as claimed.
g) First observe that the operator dened by (13.48) has the property
that if

>

then T

T

. In fact, the mapping satises Blackwells
sucient conditions for a contraction mapping, so we need only examine the
unique xed point. If, as assumed, E
s
[
/(s)] < 1, then observe whenever

(s
) = 1, then (s, ) = 1 under the assumption and the properties of the

operator T. Assume that

(s, ) < 1 is a xed point, then that T(s, ) = 1,
which is a contradiction. Hence under the assumption, there is a unique xed
point and the constraint is always binding.
101
h) Under the assumption that E
t
[
t+1
/
t
t
] < 1, we have just shown
that the cash-in-advance constraint is always binding. It follows then that
(s
t+1
, s
t
)
_

t+1
(s
t
)
_
,
so that
k
(s
t
,
t
)
= E
t
_

t+1
(s
t
)x(s
t
,
t
)
_
E
t
_

t+2
(s
t+1
)
t+1
x(s
t+1
,
t+1
)
_
. (13.50)
Assume that the constraint is binding. Then x(s
t
,
t
) =
t
. It then follows
that
t+1
= 0
and the second term on the right side tends to , which is a contradiction.
Hence the constraint must be nonbinding. It then follows that
E
t
_

t+1
(s
t
)x(s
t
,
t
)
_
= E
t
_

t+2
(s
t+1
)
t+1
x(s
t+1
,
t+1
)
_
(13.51)
By assumption,
E
t
(
t+1
) =
a
exp(
1
2
)
and E
t
(
t+2
) = E
t
(E
t+1
t+2
) so that
E
t
_
E
t+1
(
t+2
)(s
t+1
)
t+1
x(s
t+1
,
t+1
)
_
= E
t
_
a
t+1
exp(
1
2
)(s
t+1
)
t+1
x(s
t+1
,
t+1
)
_
.
If (13.51) is to hold for all x
t
, then x
t+1
must vary with x
t
. Moreover, notice
that
t
x
t
varies inversely with the conditional expectation on the right side of
(13.51) so an initial guess that
t+1
x
t+1
= Ax
t
t+1
b
t+1
where A, b are to be determined is reasonable. Substitute the guess into (13.51)
E
t
_

t+1
(s
t
)x(s
t
,
t
)
_
= E
t
_

t+2
(s
t+1
)
Ax
t
t+1
b
t+1
_
(13.52)
Simplify the expression above to obtain
E
t
(
t+1
) = E
t
_
E
t+1
(
t+2
)
A
b
t+1
_
= E
t
_
E
t+1
(
a
t+1
)
A
b
t+1
_
so that A = exp(
1
2
) and b = a 1. Hence the closed form solution is

x
t+1
= exp(
1
2
)

t
t+1
a1
t+1

t+1
.
Question 5 Using the rst-order condition in (13.45), the price of a nominal
bond satises
Q
t
= E
t
_
t+1
t
_
=
E
t
[
t+2
t+2
t
]
E
t
[
t+1
t+1
t+1
]
.
Notice that the current storage decision does not aect the bond prices unless
the aggregate capital stock aects the current money supply rule. But we rule
this out by assumption in part e). Under the assumption that the cash-in-
advance constraint always binds,
Q
t
=
E
t
[
t+2
t
]
E
t
[
t+1
t+1
]
=
exp(2a ln(
t
) + (1 +a
2
)
2
) exp( ln(
t
) +
2
u
/2)
t
exp(a ln(
t
) +
2
)
.
Question 6 The households problem now becomes:
V (z
t
, b
t
, k
t
, s
t
) = max
c
t
,z
t+1
,b
t+1
,x
t
t
ln(c
t
) +E
t
V (z
t+1
, b
t+1
, k
t+1
, s
t+1
)
subject to
k
t+1
= (s
t+1
)(k
t
x
t
)
k
t
x
t
0
c
t
+q
e
t
z
t+1
+w
t
x
t
+Q
t
b
t+1
b
t
+ (q
e
t
+d
t
)z
t
.
The rst-order conditions with the envelope conditions substituted become:
t
c
t
=
t
(13.53)
t
q
e
t
= E
t
[
t+1
(q
e
t+1
+d
t+1
)] (13.54)
t
Q
t
= E
t
[
t+1
] (13.55)
w
t
t
=
kt
+E
t
[(s
t+1
)
t+1
w
t+1
]. (13.56)
The factor wage does not change, and the equity and bond prices satisfy the
relations in a standard real model with productions. What changes is the
condition determining the optimal accumulation of the factor. Notice that the
multiplier can be expressed as:
n
kt
= w
t
t
E
t
[(s
t+1
)
t+1
w
t+1
]
= w
t
t
c
t
E
t
_
(s
t+1
)w
t+1
t+1
c
t+1
_
.
103
Substituting for w
t
/c
t
= /x
t
yields
kt
=

t
x
t
E
t
_
(s
t+1
)
t+1
x
t+1
_
.
If the constraint on the accumulation of the asset does not bind, then we
obtain:
1
x
t
= E
t
_
(s
t+1
)

t+1
t
x
t+1
_
.
The dierence between the monetary and real models arises from the presence
of the money growth rates in the former.
Question 7
a) For any h, z, b, s, let (h, z, b, s) denote the set (c
1
, c
2
, z
, b
, m
) such
that c
1
, c
2
, z
, b
, m
0 satisfying Equations (13.130), (13.131), and (13.132).

Because there is one equity share outstanding, z
t
will equal exactly one in
equilibrium and so, for convenience, dene an interval Z [, z] where > 0
and z > 1 such that z
t
Z. One-period nominal bonds are assumed to be
in zero net supply so that, in equilibrium, b
t
will equal zero and so, without
loss of generality, dene an interval B [b, b] where b > 0 such that b
t
B.
Finally, we know that in equilibrium, h = 1 (the agents post transfer money
holdings as a ratio of the current money supply). We can dene any nite
upper bound

h > 1 but because we permit the money supply to contract, the
lower bound must be chosen so that if the agent has post transfer balances of
h, he can choose end-of-period balances so that, for any shock s
next period,
his beginning-of-period balances are at least h.
2
If p(s), (s), and Q(s) are strictly positive, then the correspondence is
compact-valued. It is also convex valued and is continuous in h. If p and q are
continuous, then under Assumption 13.7, is continuous in s.
The household chooses (c
1
, c
2
, z
, m
, b
) (h, z, b, s) to solve:
V (h, z, b, s) = max
_
U(c
1
, c
2
)+
_
S
V
_
h
, z
, b
, s
_
F(s, ds
)
_
.
Let ( be the space of bounded, continuous, real-valued functions on HS with
the norm |f| = sup
h,s
[f(h, s)[. Under Assumptions 13.1, 13.7, and 13.11(i),
there exists a unique value function V ( such that V is strictly increasing,
strictly concave, and continuously dierentiable. This follows as an application
of Proposition 6.1 from Chapter 6.
3
2
This implies that h < [p(s)y(s) + (s
) 1 + h]/(s
). If (s) > 1 for all s, then let

h = 0; otherwise set the lower bound h to satisfy min
s
[y(s)p(s)] > (1 )(1 h). Let
H = [h,
h] such that h
t
H.
3
The remainder of the proof for the existence of equilibrium is identical to the proof for
the consumption-leisure model. Equivalently, we refer the reader to Lucas and Stokey [325].
b) Let c(s) and y(s) c(s) denote the equilibrium quantities of good 1
and good 2. Let (s) and (s) be the multipliers associated with the cash-in-
advance constraint and the wealth constraint when markets clear. Substituting
the envelope conditions, the rst-order conditions with market clearing are:
0 = U
1
[c(s), y(s) c(s)] p(s)[(s) +(s)], (13.57)
0 = U
2
[c(s), y(s) c(s)] p(s)(s), (13.58)
(s) = E
s
_
((s
) +(s
, (13.59)
(s)q
e
(s) = E
s
_
(s
)[p(s
)y(s
) +q
e
(s
)]
_
, (13.60)
(s)Q(s) = E
s
_
(s
)/(s
. (13.61)
We also have the slackness conditions associated with the two constraints:
0 = (s)[y(s)p(s) +q
e
(s)]z +mp(s)c
1
+
(s)
1
b p(s)c
2
h
q
e
(s)z
Q(s)b
,
0 = (s)[p(s)c(s) 1].
c) The rst-order condition for nominal bonds is
Q(s) = E
s
_
(s
)
(s)(s
)
_
. (13.62)
If we assume that the cash-in-advance constraint is always binding, then the
bond price is:
Q
t
= E
t
_
U
2,t+1
U
2,t
p
t
t+1
p
t+1
_
,
which is the intertemporal MRS in the purchasing power of money for the
credit good. The nominal bond depends on the marginal utility of credit
goods divided by the price level. The close link between the nominal interest
rate and velocity has been severed in this model. To see this, suppose that the
cash-in-advance constraint is binding. Consumption velocity v
t
satises:
h
t
v
t
= p
t
(c
1,t
+c
2,t
) = 1 +
c
2,t
c
1,t
=
y
c
and, hence, consumption velocity varies as the proportion of credit to cash
goods varies.
105
d) The equity price function satises:
(s)q
e
(s) = E
s
_
(s
)[y(s
)p(s
) +q
e
(s
)]
_
.
For discussions sake, suppose that the cash-in-advance constraint is always
binding. In that case,
(s) = U
2
[c(s), y(s) c(s)]/p(s).
Dene U
2,t
U
2
[c(s
t
), y(s
t
) c(s
t
)] and let p
t
= p(s
t
). Using time subscripts,
the real equity price satises the relation:
q
e
t
p
t
= E
t
_
U
2,t+1
U
2,t
_
y
t+1
+
q
e
t+1
p
t+1
_
_
. (13.63)
Solving this forward:
q
e
t
p
t
= E
t
_

i=1
i
U
2,t+i
U
2,t
y
t+i
_
. (13.64)
This formula for the real equity price is similar to the present-value formula
we derived in Chapter 6 in an economy without money. This formula says that
the real equity price is formed by discounting real dividends in period t +i by
the marginal rate of substitution for consumption between t and t + i. But
notice that in this model, the relevant MRS is the MRS for consumption of
credit goods. Since cash goods and credit goods are not perfect substitutes in
consumption, the MRS for consumption of credit goods will be aected by the
existence of the cash-in-advance constraint on cash goods, thus dierentiating
this model from the real, representative consumer asset pricing model with a
single consumption good.
14 International Asset Markets
Question 1 The consumers state variables consist of his initial wealth h,
his share holdings z
i
for i = 1, 2, and the current exogenous shock s. Given
the price functions , e and q
e
i
and p
i
for i = 1, 2, the resident of each country
chooses (c
1
, c
2
, m
1
, m
2
, z
1
, z
2
) to solve:
V (h, z
1
, z
2
, s) = max
_
U(c
1
, c
2
) +E
s
[V (h
, z
1
, z
2
, s
)]
_
(14.65)
subject to the asset market constraint (Equation 14.21), the law of motion
for posttransfer real balances (Equation 14.22), and the cash-in-advance con-
straints (Equations 14.23 and 14.24). The normalized budget constraint in the
asset market can be written as:
q
e
1,t
z
j
1,t
+
t
q
e
2,t
z
j
2,t
+m
j
1,t
+
t
m
j
2,t

h
j
t
+q
e
1,t
z
j
1,t1
+
t
q
e
2,t
z
j
2,t1
, (14.66)
where
h
j
t
=
1,t
(m
j
1,t1
c
j
1,t1
) +
t
2,t
(m
j
2,t1
c
j
2,t1
)
+
1,t
y
1,t1
z
j
1,t1
+
t
2,t
y
2,t1
z
j
2,t1
+
j
1,t
+
t
j
2,t
, (14.67)
Likewise, we divide the cash-in-advance constraints in Equations (14.23)
and (14.24) by p
1,t
to obtain:
c
j
1,t
m
j
1,t
, (14.68)
t
c
j
2,t

t
m
j
2,t
. (14.69)
Let (s) denote the multiplier on the normalized budget constraint and
i
(s) the multipliers on the cash-in-advance constraints. The rst-order con-
ditions with respect to c
1
, c
2
, m
1
, m
2
, z
1
, z
2
are
U(c
1
, c
2
)
c
1
=
1
(s) +E
s
_
V (h
, z
1
, z
2
, s
)
h

1
(s
)
_
,
U(c
1
, c
2
)
c
2
= (s)
1
(s) +E
s
_
V (h
, z
1
, z
2
, s
)
h
(s)
2
(s
)
_
,
(s) =
1
(s) +E
s
_
V (h
, z
1
, z
2
, s
)
h

1
(s
)
_
,
(s)(s) =
2
(s) +E
s
_
V (h
, z
1
, z
2
, s
)
h
(s)
2
(s
)
_
,
q
e
1
(s)(s) = E
s
_
V (h
, z
1
, z
2
, s
)
z
1
_
,
(s)q
e
2
(s)(s) = E
s
_
V (h
, z
1
, z
2
, s
)
z
2
_
.
107
V (h, z
1
, z
2
, s)
h
= (s),
V (h, z
1
, z
2
, s)
z
1
= (s)[q
e
1
(s) +
1
(s)y
1
(s)],
V (h, z
1
, z
2
, s)
z
2
= (s)(s)[q
e
1
(s) +
1
(s)y
1
(s)].
Since the equilibrium requires that z
1
= 0.5, z
2
= 0.5, c
1
i
= c
2
i
= 0.5y
i
and h =
0.5[(M
1
/p 1) +(M
2
/p
2
)], it is easy to see that the rst-order and envelope
conditions evaluated at these quantities are equal to Equations (14.30) through
(14.35).
Question 2
a) Let e
t
be the nominal exchange rate quoted as the quantity of British
pounds per US dollar, and let e
t
be the quantity of US dollars per British
pound. Likewise, let G
t,k
and

G
t,k
denote the forward rate associated with
these exchange rates. As we showed in the text, if the covariance between the
future spot rate and the ratio of the purchasing powers of money is nonzero,
then the forward rate is an unbiased predictor of the future spot rate:
G
t,k
= E
t
(e
t+k
).
Now consider the relationship between e
t+k
and

G
t,k
. We know that e
t+k
=
1/e
t
and

G
t,k
= 1/G
t,k
. However, by Jensens Inequality,
E
_
1
x
_
>
1
[E(x)]
.
Hence, we have that
G
t,k
=
1
G
t,k
=
1
E
t
(e
t+k
)
< E
_
1
e
t+k
_
.
Thus, we nd that the unbiasedness hypothesis does not hold if the exchange
rate is quoted as the inverse of the original exchange rate.
b) Under risk neutrality, the relationship between the forward rate and
the expected future spot rate can be written as
G
t,k
=
k
E
t
(
1,t+k
e
t+k
) R
1
t,k
= E
t
(e
t+k
) +
k
Cov
t
(
1,t+k
, e
t+k
) R
1
t,k
,
where R
1
t,k
= 1/Q
1
t,k
= 1/
k
E
t
[
t+k
]. In this case, not only is there a term
arising from Jensens Inequality between

G
t,k
and e
t+k
but also from the co-
variance of changes in the nominal price of goods and the future exchange
rate. Even if the covariance between the future spot rate and the ratio of the
purchasing powers of money is zero for the original exchange rate, this need
not be the case for the inverse exchange rate.
Question 3 Let country 1 be the domestic country, let good 1 be the nu-
meraire good and dene
t
=
e
t
p
2,t
p
1,t
. Agents are assumed to hold the two types
of currencies to nance consumption purchases in the next period. For con-
venience, assume that currency is stationary in levels. The Bellman equation
for a representative agent in country i is
V
i
(H
i
1,t
, H
i
2,t
, s
t
, z
i
1,t
, z
i
2,t
, B
i
1,t
, B
i
2,t
) =
max[U(c
i
1,t
, c
i
2,t
) +E
t
V
i
(H
i
1,t+1
, H
i
2,t+1
, s
t+1
, z
i
1,t+1
, z
i
2,t+1
, B
i
1,t+1
, B
i
2,t+1
)]
subject to
H
i
1,t
p
1,t
= c
i
1,t
t
H
i
2,t
p
2,t
=
t
c
i
2,t
_
d
1,t
+
Q
e
1,t
p
1,t
_
z
i
1,t
+
t
[d
2,t
+
Q
e
2,t
p
2,t
]z
i
2,t
+
H
i
1,t
p
1,t
c
i
1,t
+
t
[
H
i
2,t
p
2,t
c
i
2,t
]
+
B
i
1,t
p
1,t
+
t
B
i
2,t
p
2,t
+
J
i
1,t
p
1,t
+
t
J
i
2,t
p
2,t
H
i
1,t+1
p
1,t
+
t
H
i
2,t+1
p
2,t
+
Q
e
1,t
p
1,t
z
i
1,t+1
+
t
Q
e
2,t
p
2,t
z
i
2,t+1
+
Q
1,t
B
i
1,t+1
p
1,t
+
t
Q
2,t
B
i
2,t+1
p
2,t
Let
i
j,t
denote the Lagrange multiplier on the cash-in-advance constraint for
agent i with currency j and let
i
t
denote the Lagrange multiplier for the asset
constraint. The rst-order conditions and envelope conditions with respect to
c
i
1,t
, c
i
2,t
, H
i
1,t+1
, H
i
2,t+1
, z
i
1,t+1
, z
i
2,t+1
, B
i
1,t+1
, B
i
2,t+1
, are
U
1
(c
i
1,t
, c
i
2,t
) =
i
1,t
+
i
t
,
U
2
(c
i
1,t
, c
i
2,t
) =
t
[
i
2,t
+
i
t
],
i
t
p
1,t
= E
t
V
i
1,t+1
,
109
i
t
p
2,t
= E
t
V
i
2,t+1
,
Q
e
1,t
i
t
p
1,t
= E
t
V
i
4,t+1
,
t
Q
e
2,t
i
t
p
2,t
= E
t
V
i
5,t+1
,
Q
1,t
i
t
p
1,t
= E
t
V
i
6,t+1
,
t
Q
2,t
i
t
p
2,t
= E
t
V
i
7,t+1
.
The envelope conditions are
V
i
1,t
=
i
1,t
+
i
t
p
1,t
,
V
i
2,t
=
t
[
i
2,t
+
i
t
]
p
2,t
,
V
i
4,t
=
i
t
_
d
1,t
+
Q
e
1,t
p
1,t
_
,
V
i
5,t
=
i
t
t
_
d
2,t
+
Q
e
2,t
p
2,t
_
,
V
i
6,t
=

i
t
p
1,t
,
V
i
7,t
=

i
t
t
p
2,t
.
The system simplies to
U
1
(c
i
1,t
, c
i
2,t
) =
i
1,t
+
i
t
, (14.70)
U
2
(c
i
1,t
, c
i
2,t
) =
t
[
i
2,t
+
i
t
], (14.71)
i
t
p
1,t
= E
t
_
U
1
(c
i
1,t+1
, c
i
2,t+1
)
p
1,t+1
_
, (14.72)
t
p
2,t
= E
t
_
U
2
(c
1,t+1
, c
2,t+1
)
p
2,t+1
_
, (14.73)
i
t
Q
1,t
p
1,t
= E
t
_

i
t+1
p
1,t+1
_
, (14.74)
i
t
Q
2,t
p
2,t
= E
t
_
t+1
i
t+1
p
2,t+1
_
, (14.75)
Q
e
1,t
i
t
p
1,t
= E
t
_
i
t+1
_
d
1,t+1
+
Q
e
1,t+1
p
1,t+1
__
, (14.76)
t
Q
e
2,t
i
t
p
2,t
= E
t
_
i
t+1
t+1
_
d
2,t+1
+
Q
e
2,t+1
p
2,t+1
__
. (14.77)
Notice that 14.72-14.73 can be solved for
i
t
to obtain
t
=
E
t
U
2,t+1
2,t+1
E
t
U
2,t+1
1,t+1
(14.78)
where
j,t+1

p
j,t
p
j,t+1
. From (14.70-14.71), observe also that
t
=
U
i
1,t
i
1,t
U
i
2,t
i
2,t
If neither cash-in-advance constraint is binding (
1
=
2
= 0) then
t
is
equal to the ratio of marginal utilities for the two goods, as in the Lucas
model. When the cash-in-advance constraint is binding in this model, there
is a wedge between the marginal rate of substitution across goods created by
the constraint. Let
j,t
be dened as
p
j,t
j,t
=
M
j,t
y
j,t
such that
j,t
= 1 if the cash-in-advance constraint is binding. As in the Lucas
model studied in the text, the function satises the following equation
j,t
= max
_
1, E
t
U
j,t+1
U
j,t
M
j,t
M
j,t+1
y
j,t+1
y
j,t
j,t+1
_
(14.79)
To determine the forward price, let G
t,k
denote the country 1 price at date
t of 1 unit of foreign currency (currency of country 2) at date t + k. The
spot exchange rate at the date the contract is delivered is denoted e
t+k
. Let
z
g
t,k
denote the contracts to be delivered (a decision variable). The rst-order
condition is
0 =
k
E
t
_
U
1,t+k
U
1,t
p
1,t+k
p
1,t
[e
t+k
G
t,k
]
_
(14.80)
111
Since G
t,k
is known at time t,
G
t,k
=
_
k
E
t
U
1,t+k
U
1,t
p
1,t+k
p
1,t
e
t+k
_ _
k
E
t
U
1,t+k
U
1,t
p
1,t+k
p
1,t
_
1
Let Q
t,k
denote the time t price of a nominal bond paying 1 unit of the domestic
currency at time t+k. The risk premium associated with the forward contract
is
E
t
e
t+k
G
t,k
=
1
Q
t,k
Cov
t
_
k
U
1,t+k
U
1,t
p
1,t+k
p
1,k
, e
t+k
_
(14.81)
The futures price can be determined as follows. Let F
t,k
denote the price
at time t of a contract that delivers at time t +k. Under marking to market,
if the price next period is F
t+1,k1
, the amount F
t+1,k1
F
t,k
per contract
is credited to the party in the long position and debited from the short party.
Let z
f
t,k
denote the number of futures contracts (a decision variable). The
rst-order condition with respect to z
f
t,k
is
0 = E
t
_
U
1,t+1
U
1,t
1,t+1
(F
t+1,k1
F
t,k
)
_
Since F
t,k
is known at time t, the price is
F
t,k
=

Q
t,1
E
t
_
U
1,t+1
U
1,t
1,t+1
F
t+1,k1
_
. (14.82)
The solution for the function
j
can be used to determine the properties of
using equation (14.72). Once this is determined, the equity price equations
(14.76)14.77) are linear stochastic dierence equations in the variable
Q
e
j,t
t
p
j,t
and can be solved using standard methods.
Question 4 The cash-in-advance constraints and asset market constraints
are modied as
H
i
1,t
p
1,t
= c
i
1,t
t

H
i
2,t
p
2,t
=

t
c
i
2,t
_
d
1,t
+
Q
e
1,t
p
1,t
_
z
i
1,t
+
t
[d
2,t
+
Q
e
2,t
p
2,t
]z
i
2,t
+
H
i
1,t
p
1,t
c
i
1,t
+
t
[
H
i
2,t
p
2,t
c
i
2,t
]
+
B
i
1,t
p
1,t
+
t
B
i
2,t
p
2,t
+
J
i
1,t
p
1,t
+
t
J
i
2,t
p
2,t
H
i
1,t+1
p
1,t
+
t
H
i
2,t+1
p
2,t
+
Q
e
1,t
p
1,t
z
i
1,t+1
+
t
Q
e
2,t
p
2,t
z
i
2,t+1
+
Q
1,t
B
i
1,t+1
p
1,t
+
t
Q
2,t
B
i
2,t+1
p
2,t
where

t

e
t
p
1,t
p
2,t
There is also the additional constraint, which can be written
as
H
1,t
p
1,t
+

t
H
2,t
p
2,t

i,t
H
1,t
p
1,t
+

2,t
H
2,t
p
2,t
.
Let
i
t
denote the Lagrange multiplier for this constraint. The rst-order
conditions for H
j,t+1
and

H
j,t
are
t
p
1,t
= E
t
(V
1,t+1
),
1,t
t
p
1,t
=

t
+
1,t
p
1,t
,
t
p
2,t
= E
t
(V
2,t+1
),
2,t
t
p
2,t
=

t
t
+

2,t
p
2,t
,
V
1
=

t
p
1,t
,
V
2
=
t
p
2,t
.
From the rst-order conditions for consumption, observe that
t
=
U
1,t
p
1,t
If
t
,=

t
, then e
t
,= e
t
. In that case, agents will have an incentive to adjust
relative holdings of domestic and foreign currency until e = e (notice that the
same information sets are available in the two markets). We can use the same
argument - the elimination of arbitrage prots - to show that
1
=
2
= 1. As
a result,
t
=
t
+
1,t
=
t
+
2,t
,
and hence
1
=
2
. This result is intuitive, because if one cash-in-advance
constraint is more binding than the other, then agents will adjust their relative
holdings of currencies to carry out consumption purchases. This also implies
that either both cash-in-advance constraints are binding or neither is. At
this point, the function can be determined using the , methods in the rst
question. The various prices can be solved for as in the previous question.
113
Question 5 The rst mechanism is identical to the standard cash-in-advance
model studied in the text. To study the second mechanism, let y
h,t
denote
the output in the home country at date t and let y
f,t
denote the output in
the foreign country. Let x
h
h,t
denote the output sold by domestic owners to
domestic households and x
h
f,t
denote the sales of output by domestic suppliers
to foreign households. Then
x
h
h,t
+x
h
f,t
= y
h,t
.
Assume that the revenue from sales
p
h,t
x
h
h,t
+e
t
p
f,t
x
h
f,t
isnt available for spending until the next time period. The cash-in-advance
constraint is
M
h,t
p
h,t
c
h,t
.
The law of motion for holdings of domestic currency is
H
h,t+1
= p
h,t
x
h
h,t
+e
t
p
f,t
x
h
f,t
+M
h,t
p
h,t
c
h,t
,
and the asset market constraint, assuming money is the only asset is
H
h,t
M
h,t
.
Agents have no use for the foreign currency, under the assumption that all
purchases are made in the buyers home currency. Hence, domestic suppliers
receiving the foreign currency will convert it into domestic currency for use
next period in the goods market. Without any way to borrow or lend and with
no motive to hold the currency issued by the foreign country, there will be no
trade and y
h,t
= c
h,t
. If this were not true, then the asset market constraint
and cash-in-advance constraint would not be binding. Hence, to answer the
question we need to introduce an asset that allows borrowing and lending. Let
B
h
f,t
denote the holdings by domestic residents of the foreign bond. The asset
market constraint is
H
h,t
+e
t
B
h
f,t1
+B
h
h,t1
M
h,t
+e
t
Q
f,t
B
h
f,t
+Q
h,t
B
h
h,t
,
and the cash-in-advance constraint is
M
h,t
p
h,t
c
h,t
U
1
(c
h,t
) =
h,t
+E
t
_
h,t+1
p
h,t+1
_
,
h,t
p
h,t
=

h,t
p
h,t
+E
t
_
h,t+1
p
h,t+1
_
,
h,t
Q
h,t
p
h,t
= E
t
_
h,t+1
p
h,t+1
_
,
h,t
e
t
Q
f,t
p
h,t
= E
t
_
h,t+1
p
h,t+1
_
.
A similar set of rst-order conditions can be derived for the foreign resident.
At this point, the problem can be solved using the approach described in the
text. This model results in a close link between positive nominal interest rates
and the binding cash-in-advance constraint that is typically displayed in the
standard Lucas model. One key idea emerging from the model is the notion
that the holding of domestic currency by foreigners is linked with the cash-in-
advance constraint and that, if that constraint is binding, then another asset
such as a government bond is required for borrowing and lending to occur.
Question 6
a) The real exchage rate is given by expression
(s) =
U
2
(s)
U
1
(s)
, (14.83)
and the nominal exchange rate satises
e(s, M) =
U
2
(s)
U
1
(s)
2
(s)
1
(s)
M
1
y
2
(s)
M
2
y
1
(s)
, (14.84)
where
i
(s) denotes the inverse velocity function. Using the specication of
preferences and the fact that c
i
1
= c
i
2
= 0.5y
i
(s), the real exchange rate can be
written as
(s) =
_
c
2
c
1
_
,
or
ln((s)) = [ln(y
2
(s)) ln(y
1
(s))].
Likewise, under the assumption that
i
(s) = 1 for all s, the nominal exchange
rate can be written as
e(s, M) =
_
c
2
c
1
_
M
1
y
2
(s)
M
2
y
1
(s)
,
or
ln(e(s, M)) = (1 )[ln(y
2
(s)) ln(y
1
(s))] [ln(M
2
) ln(M
1
)].
115
Notice that the variance of is
V ar((s)) =
2
[V ar(ln(y
2
) ln(y
1
))] .
Likewise,
V ar(e(s, M)) = (1 )
2
[V ar(ln(y
2
) ln(y
1
))]
+[V ar(ln(M
2
) ln(M
1
))]
2(1 )Cov [ln(y
2
(s)) ln(y
1
(s))][ln(M
2
) ln(M
1
)] .
Finally,
Cov((s), e(s, M)) = (1 ) [V ar(ln(y
2
) ln(y
1
))]
Cov [ln(y
2
(s)) ln(y
1
(s))][ln(M
2
) ln(M
1
)] .
If V ar((s)) V ar(e(s, M)), then
(1 2) [V ar(ln(y
2
) ln(y
1
))] + [V ar(ln(M
2
) ln(M
1
))]
Cov [ln(y
2
(s)) ln(y
1
(s))][ln(M
2
) ln(M
1
)] = 0,
which implies that
(1 2) [V ar(ln(y
2
) ln(y
1
))] + [V ar(ln(M
2
) ln(M
1
))]
Cov((s), e(s, M)) +(1 ) [V ar(ln(y
2
) ln(y
1
))] = 0,
Cov((s), e(s, M)) = (1
2
) [V ar(ln(y
2
) ln(y
1
))] + [V ar(ln(M
2
) ln(M
1
))] .
Since 0, for Cov((s), e(s, M)) positive and large, it must be the case that
monetary shocks are more variable than real shocks, that is, V ar(ln(M
2
)
ln(M
1
)) > V ar(ln(y
2
) ln(y
1
)).
Question 7 Let x
i
j,t
denote the claims held by type i agent to the transfer
of currency j at time t and let Q
m
j,t
denote the price of a claim measured in
units of currency j. Agent i holds nominal balances
[H
i
t
= M
i
1,t1
p
1,t1
c
i
1,t1
+e
t
[M
i
2,t1
p
2,t1
c
i
2,t1
] +p
1,t1
y
1,t1
z
i
1,t1
+e
t
[p
2,t1
y
2,t1
z
i
2,t1
] +x
i
1,t1
T
1,t
+e
t
x
i
2,t1
T
2,t
at the beginning of period t when the asset market opens. The asset market
constraint is
H
i
t
+Q
e
1,t
z
i
1,t1
+e
t
Q
e
2,t
z
i
2,t1
+Q
m
1,t
x
i
1,t1
+e
t
Q
m
2,t
x
i
2,t1

Q
e
1,t
z
i
1,t
+e
t
Q
e
2,t
z
i
2,t
+M
i
1,t
+e
t
M
i
2,t
+Q
m
1,t
x
i
1,t
+e
t
Q
m
2,t
x
i
2,t
The rst-order conditions for the shares to money transfers are
U
1,t
Q
m
1,t
p
1,t
= E
t
_
U
1,t+1
p
1,t+1
(T
1,t+1
+Q
m
1,t+1
)
_
,
U
2,t
t
Q
m
2,t
p
2,t
= E
t
_
U
2,t+1
t+1
p
2,t+1
(T
2,t+1
+Q
m
2,t+1
)
_
.
Observe that the rst-order conditions are linear stochastic dierence equa-
tions in a transformed variable. A pooled equilibrium that the shares of equity
z
1
j,t
= z
2
j,t
and money transfer shares x
1
j,t
= x
2
j,t
are equalized so that there is
a single representative agent in the world economy.
117
15 Asset Pricing with Frictions
Question 1
a) Since the shocks are i.i.d., we can look for stationary solutions for
prices and the allocations. Specically, suppose that q(s
t
) = q(s
t
) and let
consumption and the leisure allocations be functions only of the current state
s
t
. Each consumer i solves the problem:
max
c
i
(s
t
),l
i
(s
t
)
E
0
_
2
t=1
[ln(c
i
(s
t
)) l
i
(s
t
))
_
subject to
2
t=1
sS
q(s
t
)[c
i
(s
t
) w
i
(s
t
)l
i
(s
t
)],
where w
i
(s
t
) denotes the random productivity of agent i.
Let
i
denote the Lagrange multiplier on the individuals life-time budget
constraint. The rst-order conditions are:
s
c
i
(s
t
)
=
i
q(s
t
), (15.1)
s
=
i
w
i
(s
t
)q(s
t
), (15.2)
for s
t
S and t = 1, 2. Notice that the rst-order conditions simplify as:
c
i
(s
t
) = w
i
(s
t
), s
t
S, t = 1, 2.
But this says that agents supply labor inelastically each period and consume
their own labor income or endowment. Since the idiosyncratic productivity
shocks are time-independent, individuals consumption is constant across time
but varies across states.
b) Clearly the autarkic allocations are identical to the complete contin-
gent claims allocations. In an economy in which all agents have the same
logarithmic utility functions and supply labor inelastically, the perfect risk
sharing allocations can be achieved in autarky.
c) An econometrician who tries to make inferences about the underlying
economy based on the behavior of aggregate consumption would be unable
to identify an economy with a full set of contingent claims from an autarkic
economy.
Question 2
a) The rst-order condition with respect to is E(RU
(c)) = 0 which
can be written as
(1 +)U
() U
((1 )) = 0.
Under the assumption that the utility function is CRRA, the rst-order con-
dition can be written:
(1 +)
= ((1 ))
,
or
= (1 )
1.
Hence the risk premium increases with the size of the aggregate shock:
= (1 )
1
> 0.
b) This implies that in the good state, which occurs with probability
1/2, the agent consumes and the portfolio pays 1 + . In the bad state
the portfolio pays 1 and his consumption is with probability 1 and
(1 /) with probability . As goes to , the aggregate shock becomes
concentrated on a few individuals whose consumption goes to zero.
i. The rst-order condition is given by:
(1 +)U
() (1 )U
() U
((1 /)) = 0.
ii. The premium is now given by:
=
_
(U
[(1 /))] U
[])/U
[]
_
.
Thus, the premium depends not only on the size of the aggregate shock
() but also its distribution within the population ().
iii. Under CRRA preferences, the premium can be written as:
=
_
((1 /))
)/
_
.
To see the eect of the concentration of shocks on the equity premium,
consider:
=
_
((1 /))
)/
(/)((1 /))
1
/
_
.
119
We can nd the sign of this expression by noting that
=
_
1/)
U
[(1 /)] +U
[Z] dZ
U
[]
.
If U
> 0, then the integral is negative over the range of integration.

Question 3
a) We wish to show that /
a
for the two utility functions listed in
the text.
Beginning with (i), notice that
/
i
=
(c
i,t+1
i
)
(c
it
i
)
,
which implies that
(c
i,t+1
i
)
_
_
1/
(c
it
i
).
Now aggregate over all consumers i and invert back as:
i
(c
i,t+1
i
)
_
_
1/
i
(c
it
i
)
(c
a,t+1
a
)
(c
at
a
)
.
A similar procedure applies to the utility function in (ii).
/
i
=
exp((c
i,t+1
i
))
exp((c
it
i
))
,
which implies
(c
i,t+1
i
) ln(/) (c
it
i
).
Sum both sides over i and invert:
i
(c
i,t+1
i
) ln(/)
i
(c
it
i
)
exp((c
a,t+1
a
))
exp((c
at
a
))
.
a) We wish to show that /
a
=
a
, where
a
is given in the text.
We know that /
i
=
i
holds, or
/
i
=
c
i,t+1
c
it
=
i
c
i,t+1
= (/)
1/
(
i
)
1/
c
it
.
Summing over i and inverting yields:
i
c
i,t+1
= (/)
1/
i
(
i
)
1/
(c
it
/c
at
)c
at
c
a,t+1
c
at
=
i
(
i
)
1/
(c
it
/c
at
).
121
16 Borrowing Constraints
Question 1
a) Now let us characterize the complete markets equilibrium. Let
i
denote the Lagrange multiplier associated with the budget constraint for a
type i agent. The rst-order conditions with respect to c
i,t
and
i,t
for an
agent of type i are
t
U
(c
i,t
) =
i
p
t
, (16.1)
t
=
i
i,t
p
t
. (16.2)
When
i,t
= 1, the rst-order conditions for agent i imply that
i
=
t
/p
t
,
and U
(c
i,t
) = 1. Dene the function g as
g(x) = (U
)
1
(x),
which is well-dened because marginal utility is strictly concave. Dene c as
c g(1). The consumption of an agent i with
i,t
= 1 (a productive agent)
equals c. When s
t
= i, the price satises p
t
=
t
/
i
. Notice that
i
does not
vary over time or over realizations s.
An unproductive agent (one with
j,t
= 0) chooses
j,t
= 0 and sets con-
sumption to satisfy
t
U
(c
j,t
) =
j
p
t
. Substituting in the price p
t
, which we
related earlier to the multiplier for the productive agent
i
, we have
t
U
(c
j,t
) =
t
j
/
i
, (16.3)
so that the consumption of the unproductive agent satises
c
j,t
= g(
j
/
i
). (16.4)
We now look at the marketclearing conditions. For any t such that
1,t
=
1,
c
1,t
+ (1 )c
2,t
= g(1) + (1 )g(
2
/
1
)
=
1,t
. (16.5)
For any t such that
2,t
= 2, market-clearing requires
c
1,t
+ (1 )c
2,t
= g(
1
/
2
) + (1 )g(1)
= (1 )
2,t
. (16.6)
b) The expected present value of lifetime earnings of a type 1 agent are
t=0
s
t
S
p
t
1,t
1,t
=
1
1
1
,
where we have substituted p
t
=
t
/
1
for t 0. The expected present value
of the type 1 agents consumption stream is
t=0
s
t
S
p
t
c
1,t
=
1
1
g(1)
1
+
1
1
_
(1 )
2
g(
1
/
2
)
_
.
Equating the two expressions and using the market-clearing condition (16.5)
to solve for
1
g(1), we have
_
1
_
g
_
1
_
=
_
1
__
2
_
g
_
2
_
. (16.7)
We can repeat the same steps for a type 2 agent; this results in
_

1
_
g
_
2
_
=
_

1
_

2
1
g
_
1
_
.
Dene x
1
/
2
; then the equilibrium condition (16.7) becomes
_
1
_
g
_
1
x
_
=
_
1
_
xg(x). (16.8)
c) (i) Suppose that = 1/2 and that = 1/2. Then each period half
of the agents are productive and each type of agent expects to be productive
with the same probability as any other agent. Under these assumptions, a
stationary solution is
1
=
2
= 1. In this case, individual a consumes a
constant amount equal to c at all dates and in all states. Output is constant
and equal to 2 c. Prices are also constant and the real interest rate r satises
E
t
_
p
t+1
p
t
_
=
1
1 +r
= .
This is the case of complete insurance in which the opportunities to pool
risks enable all agents to consume a xed amount regardless of the particular
realization which determines their earnings stream.
(ii) Suppose now that = 2/3 but retain the assumption that = 1/2.
Then each period, one half of the agents are productive just as before. But
now notice that the expected present value of the lifetime earnings for a type
1 agent is greater than that of a type 2 agent. Equation (16.8) now becomes
1
2
g(x)x = g
_
1
x
_
. (16.9)
123
Suppose utility displays constant relative risk aversion so that U
(c) = c
.
Then the solution is x = (
1
2
)
2
. The real interest rate r
1
when type 1 agents
are productive (s
t
() = 1) is
1
1 +r
1
= +(1 )x,
and the real interest rate r
2
when type 2 agents are productive ( s
t
() = 2) is
1
1 +r
2
= x +(1 ).
Hence both agents experience uctuations in consumption over time, depend-
ing on the realization of the random variable. The economy experiences aggre-
gate uctuations in output, prices and real interest rates because agents are
no longer indentical in expected present value of expected lifetime earnings.
There is no market incompleteness here and risks are pooled.
When agents have the same discounted present value of labor income, then
they can borrow and lend to smooth consumption to an extent that the agents
consumption is no longer dependent on the particular time path of his wealth.
When agents are no longer identical in expected present value, the ability of
each agent to smooth consumption is aected. When = 2/3, agent 1 is
better o with uctuating consumption than in the case where consumption
is constant at c. The same result would hold if = 1/2 and ,= 1/2. In that
case, although any individual agent expects to be productive with the same
probability as any other agent, the proportion of agents that are productive
varies so that aggregate output uctuates because of the concentration of the
productivity shock.
Question 2
a) Let x
i,t
denote the holdings of the asset by the representative type i
agent at the beginning of time t.
The supply of the asset is xed at unity. Thus, market-clearing requires
that
x
1,t
+ (1 )x
2,t
= 1 (16.10)
We can determine x
2
if we know x
1
so that we need only keep track of
the per-capita asset holdings of one type of agent. We will nd it convenient
later on to let x be the vector (x
1
, x
2
) and to let the state of the system be
described by the pair (x, s).
The representative type i agent, for i = 1, 2 chooses stochastic sequences
c
i,t
,
i,t
to maximize
E
0
_

t=0
t
[U(c
i,t
)
i,t
]
_
, (16.11)
subject to the set of constraints
z
i,t+1
z
i,t
= (y
i,t
c
i,t
)/q
t
, (16.12)
y
i,t
=
i
(s
t
)
i,t
, (16.13)
i,t
0, c
i,t
0, (16.14)
and given the initial distribution of the asset, which satises
1 = x
1,0
+ (1 )x
2,0
.
We will assume that all agents of the same type are identical so that in equi-
librium z
a
= x
1
if a is a type 1 agent and z
a
= x
2
otherwise. We allow z and
x to be negative; this can be interpreted as a debt (or borrowing). Let
i,t
be the multiplier associated with the constraint. The state variables clearly
consist of s and the vector x. The state of an individual agent depends on his
asset holdings z
a
and the system state variables, (x, s).
We now set this up as a dynamic programming problem. The problem is
V
i
(z, x, s) = max
{c,,z
}
[U(c) +
_
S
V
i
(z
, x
, s
)F(s, ds
)] (16.15)
subject to the constraints (16.12)(16.14) and the law of motion for x. We
assume that z Z = [ z, z] where 1 < z < , [0, L] where L < ,
and c [0,

Y ] where

Y < . The upper bound

Y can be justied by setting
Y = 2L which is the maximum possible output that could be attained. Also

assume that x
i
Z for i = 1, 2. Dene o Z S. Let Q be the set of
functions q : o
+
such that q : 0 < q(x, s) < , (x, s) o.
Notice that if q(x, s) is strictly positive, then the set of values c, , z
satisfying (16.12 16.14) can be denoted (z, x, s); this set is compact and
convex-valued. If q is continuous, then is continuous in s. Let 1 be the
space of bounded, continuous, real-valued functions V
i
(z, x, s) on Z o with
the norm |V
i
| = sup [V
i
(z, x, s)[. Given any continuous, strictly positive price,
it is straightforward to show that there exists a unique value function satisfying
(16.15).
b) The equilibrium rst-order conditions for the representative type i
agent are
U
(c
i
(x, s)) =

i
(x
i
, s)
q(x, s)
(16.16)
1 =

i
(s)
i
(x
i
, s)
q(x, s)
(16.17)
i
(x
i
, s) = E
s
[V
i
(x
i
, s
)]. (16.18)
125
The envelope condition is V
i
(x
i
, s) = U
(c
i
(x
i
, s))q(x, s).
If
i
(s) = 1, then
i
(x
i
, s)/q(x, s) = 1 and c
i
(x
i
, s) = c, where c was dened
earlier. Suppose that agents of type i are productive while type j agents are
not. Then the rst-order condition for the representative type j agent is
U
(c
j
(x
j
, s)) =
j
(x
j
, s)/q(x, s) =

j
(x
j
, s)
i
(x
i
, s)
,
where we have substituted q(x, s) =
i
(x
i
, s). It becomes apparent when we
compare the rst-order conditions for the sequential equilibrium with the con-
tingent claims equilibrium, that
i
=
i
and that the price of the asset equals
the Lagrange multiplier for the productive agent, which is independent over
dates and alternative states of the economy.
17 Overlapping Generations Models
Question 1 The budget constraint of the old akive at time 0 is:
p(s
1
)c
0
1
p(s
1
)w(s
1
) +M
0
.
a) The budget constraints for the young agent born at time t are as
follows:
p(s
t
)c
t
t
+M
t
t
w
1
(s
t
)p(s
t
) (1
st
period)
p(s
t+1
)c
t
t+1
w
2
(s
t+1
)p(s
t+1
) +M
t
t
(2
nd
period).
If we combine these two budget constraints, we obtain the intertemporal bud-
get constraint:
p(s
t+1
)c
t
t+1
w
2
(s
t+1
)p(s
t+1
) +w
1
(s
t
)p(s
t
) p(s
t
)c
t
t
.
b) The problem of the current young is to solve
max
c
t
t
,c
t
t+1
U(c
t
t
) +
(s
t+1
[s
t
)V (c
t
t+1
)
subject to
p(s
t+1
)c
t
t+1
w
2
(s
t+1
)p(s
t+1
) +w
1
(s
t
)p(s
t
) p(s
t
)c
t
t
.
The Lagrangian is given by:
L = U(c
t
t
) +
s
t+1
(s
t+1
[s
t
)V (c
t
t+1
)
+(s
t
)
_
w
2
(s
t+1
)p(s
t+1
) +w
1
(s
t
)p(s
t
) p(s
t
)c
t
t
p(s
t+1
)c
t
t+1
_
.
U
(c
t
t
) = (s
t
)p(s
t
)
(s
t+1
[s
t
)V
(c
t
t+1
) = (s
t
)p(s
t+1
).
Dividing the second condition by the rst yields:
p(s
t+1
) = (s
t+1
[s
t
)
V
(c
t
t+1
)
U
(c
t
t
)
p(s
t
).
Using the market-clearing conditions and assuming that the solution for con-
sumption is stationary, we obtain:
c
t
t
= c(s
t
)
c
t
t+1
= w
1
(s
t+1
) +w
2
(s
t+1
) c(s
t+1
)
= w(s
t+1
) c(s
t+1
),
127
Substituting this into the rst-order condition yields:
p(s
t+1
) = (s
t+1
[s
t
)
V
(w(s
t+1
) c(s
t+1
))
U
(c(s
t
))
p(s
t
), (17.1)
given the initial condition:
p(s
1
) = (s
1
[s
0
)V
_
w
2
(s
1
) +
M
0
p(s
1
)
_
.
Substituting recursively for p(s
t
), we obtain:
p(s
t+1
) = (s
t+1
)
t
i=0
V
(w(s
i+1
) c(s
i+1
))
U
(c(s
i
))
V
_
w
2
(s
1
) +
M
0
p(s
1
)
_
.
Recall that the economy is dynamically ecient if
V
_
w
2
(s
1
) +
M
0
p(s
1
)
_
is nite and if
t
i=0
V
(w(s
i+1
) c(s
i+1
))
U
(c(s
i
))
< 1.
But this is just the condition to ensure that the price level is nite, i.e.,
lim
t
p(s
t+1
) 0
for any s
t+1
S.
c) To determine whether the allocations with money satisfy conditional
and equal-treatment Pareto optimality, consider the MRS across agents alive
at a point in time evaluated at the stationary allocations:
V
(w(s
t
) c(s
t
))
U
(c(s
t
))
=
(s
t1
)
(s
t
[s
t1
)(s
t
)
.
Notice that the right-side varies with s
t
and hence, the allocations are condi-
tionally Pareto optimal.
d) If the money supply is stochastic, then we can dene M
t+1
(s
t+1
) =
z(s
t+1
)M
t
(s
t
) where z(s
t+1
) > 0. So the intertemporal budget constraint turns
out to be:
p(s
t+1
)c
t
t+1
w
2
(s
t+1
)p(s
t+1
) +z(s
t+1
)[w
1
(s
t
) p(s
t
)c
t
t
].
The objective function does not change; therefore our Lagrangian is as follows:
L = U(c
t
t
) +
s
t+1
(s
t+1
[s
t
)V (c
t
t+1
)
+(s
t
)
_
w
2
(s
t+1
)p(s
t+1
) +z(s
t+1
)[w
1
(s
t
) p(s
t
)c
t
t
] p(s
t+1
)c
t
t+1
_
.
c
t
t
: U
(c
t
t
) = (s
t
)z(s
t+1
)p(s
t
), (17.2)
c
t
t+1
: (s
t+1
[s
t
)V
(c
t
t+1
) = (s
t
)p(s
t+1
). (17.3)
Divide the second condition by the rst:
p(s
t+1
)
p(s
t
)
= z(s
t+1
)(s
t+1
[s
t
)
V
(w(s
t
) c(s
t
))
U
(c(s
t
))
.
Solving as before, we can express p(s
t+1
) as:
p(s
t+1
) = (s
t+1
)
t
i=0
z(s
i+1
)
V
(w(s
i+1
) c(s
i+1
))
U
(c(s
i
))
V
_
w
2
(s
1
) +
M
0
p(s
1
)
_
.
Recall that the economy is dynamically ecient if
V
_
w
2
(s
1
) +
M
0
p(s
1
)
_
is nite and if
t
i=0
z(s
i+1
)
V
(w(s
i+1
) c(s
i+1
))
U
(c(s
i
))
< 1.
In this case, dynamic eciency or Pareto optimality requires that the weighted
MRS be less than one, where the weighting is done by the money growth rate.
Question 2
a) The problem of the current young is to solve:
max
c
t
t
,I
t
U(c
t
t
) +E
t
_
V (c
t
t+1
)
_
subject to
w
t
= c
t
t
+
I
t
N
t
c
t
t+1
= R
t+1
I
t
N
t
=
a
t+1
I
t
N
1
t+1
N
t
.
129
We can form the Lagrangian as:
L = U(c
t
t
) +E
t
_
V
_
a
t+1
I
t
N
1
t+1
N
t
__
+
t
t
_
w
t
c
t
t
I
t
N
t
_
.
c
t
t
: U
1
(c
t
t
) =
t
t
I
t
: E
t
_
V
1
(c
t
t+1
)
a
t+1
2
I
1
t
N
1
t+1
N
t
_
=

t
t
N
t
.
Combining these two conditions we have:
E
t
_
V
1
(c
t
t+1
)
a
t+1
I
1
t
N
1
t+1
U
1
(c
t
t
)
_
= 1. (17.4)
b) The conditions are identical because of the extra in this condition
as:
E
t
_
V
1
(c
t
t+1
)
a
t+1
k
t+1
U
1
(c
t
t
)
_
= E
t
_
V
1
(c
t
t+1
)
a
t+1
I
1
t
N
1
t+1
U
1
(c
t
t
)
_
= 1.
So if 0 < < 1 then under the assumption of the existence of the solution
we can say that c
t
t+1
and I
t
are lower in the model of this question. So c
t
t
is
higher in this model compared to the model in the text since c
t
t
= w
t
I
t
N
t
.
Question 3
a) The Lagrangian is given by:
max
c
1,t
,c
2,t+1
,n
t
[a ln c
1,t
+b ln(1 n
t
) +a lnc
2,t+1
]
+
t
t
_
w
t
n
t
(1 ) c
1,t
1
r
t+1
(c
2,t+1
S
t+1
)
_
.
c
1,t
:
a
c
1,t
=
t
t
, (17.5)
c
2,t+1
:
a
c
2,t+1
=

t
t
r
t+1
, (17.6)
n
t
:
b
1 n
t
=
t
t
w
t
(1 ). . (17.7)
By (17.5) and (17.6),
a
c
2,t+1
=
a
c
1,t
r
t+1
c
2,t+1
= c
1,t
r
t+1
.
By (17.5) and (17.7),
b
1 n
t
=
a
c
1,t
w
t
(1 ) n
t
=
aw
t
(1 ) bc
1,t
aw
t
(1 )
.
b) Substitute what we have found above for c
2,t+1
and n
t
into budget
constraint of the young agent to nd c
1,t
. After making the substitution it
turns out that:
c
1,t
=
a [r
t+1
w
t
(1 ) +S
t+1
]
(b +a +a)r
t+1
.
In order to determine savings we can use the following 1
st
period budget
constraint of the young agent:
c
1,t
+saving
t+1
= w
t
n
t
(1 ).
As a result,
saving
t+1
= w
t
(1 )
[r
t+1
w
t
(1 ) +S
t+1
] (a +b)
(a +b +a)r
t+1
.
c) We evaluate the steady state capital stocks under the following two
systems.
(i) Pay-as-you go system:
c
1,t
+k
t+1
= w
t
n
t
(1 ) (1
st
period)
c
2,t+1
= (1 +r
t+1
)k
t+1
+w
t
n
t
(2
nd
period).
Combining these two budget constraints:
c
2,t+1
= (1 +r
t+1
)(w
t
n
t
(1 ) c
1,t
) +w
t
n
t
.
The optimization problem of the young agent is thus as follows:
max
c
1,t
,c
2,t+1
,n
t
[a ln c
1,t
+b ln(1 n
t
) +a lnc
2,t+1
]
subject to
(1 +r
t+1
)(w
t
n
t
(1 ) c
1,t
) +w
t
n
t
c
2,t+1
= 0.
L = a ln c
1,t
+b ln(1 n
t
) +a ln c
2,t+1
+
t
t
[(1 +r
t+1
)(w
t
n
t
(1 ) c
1,t
) +w
t
n
t
c
2,t+1
] .
131
c
1,t
:
a
c
1,t
= (1 +r
t+1
)
t
t
, (17.8)
c
2,t+1
:
a
c
2,t+1
=
t
t
, (17.9)
n
t
:
b
1 n
t
=
t
t
[(1 +r
t+1
)w
t
(1 ) +w
t
]. (17.10)
By (17.8) and (17.10),
b
1 n
t
=
a
c
1,t
(1 +r
t+1
)
[(1 +r
t+1
)w
t
(1 ) +w
t
]
n
t
=
aw
t
[(1 +r
t+1
)(1 ) +] bc
1,t
(1 +r
t+1
)
aw
t
[(1 +r
t+1
)(1 ) +]
.
By (17.8) and (17.9),
c
2,t+1
= (1 +r
t+1
)c
1,t
.
By substituting n
t
and c
2,t+1
we can nd c
1,t
:
c
1,t
=
w
t
[1 +r
t+1
(1 )]
(1 +r
t+1
)
_
b
a
+ + 1
_.
Since k
t+1
= w
t
n
t
(1 ) c
1,t
then substituting for n
t
and c
1,t
we can nd:
k
t+1
=
(1 )(1 +r
t+1
)a a
(1 +r
t+1
)(a +b +)
. (17.11)
(ii) Fully Funded System:
c
1,t
+k
t+1
= w
t
n
t
(1 ) (1
st
period)
c
2,t+1
= (1 +r
t+1
)k
t+1
+w
t
n
t
(1 +r
t+1
) (2
nd
period).
Combining the two budget constraints we can get:
c
2,t+1
= (1 +r
t+1
)(w
t
n
t
c
1,t
).
The problem is:
max
c
1,t
,c
2,t+1
,n
t
[a ln c
1,t
+b ln(1 n
t
) +a lnc
2,t+1
]
subject to
c
2,t+1
= (1 +r
t+1
)(w
t
n
t
c
1,t
).
L = a ln c
1,t
+b ln(1 n
t
) +a ln c
2,t+1
+
t
t
[(1 +r
t+1
)(w
t
n
t
c
1,t
) c
2,t+1
] .
c
1,t
:
a
c
1,t
=
t
t
(1 +r
t+1
) (17.12)
c
2,t+1
:
a
c
2,t+1
=
t
t
(17.13)
n
t
:
b
1 n
t
=
t
t
(1 +r
t+1
)w
t
. (17.14)
By (17.12) and (17.13) we can get
c
2,t+1
= (1 +r
t+1
)c
1,t
.
By (17.12) and (17.14) we can get
n
t
=
aw
t
bc
1,t
aw
t
.
Substituting these in the budget constraint we can nd
c
1,t
=
w
t
b
a
+ + 1
.
Since k
t+1
= w
t
n
t
(1 ) c
1,t
then substituting for n
t
and c
1,t
we can nd:
k
t+1
= aw
t
_
(1 )( + 1) 1
a +b +a
_
. (17.15)
d) As a result under pay-as-you go system:
k
t+1
=
(1 )(1 +r
t+1
)a a
(1 +r
t+1
)(a +b +)
.
As a result under fully-funded system:
k
t+1
= aw
t
_
(1 )( + 1) 1
a +b +a
_
.
In both systems distortionary tax decreases the capital stock since zero tax
implies higher capital stock.
133
Question 4 First lets note that g(y) > w(y) and c(y, K) w(y) where
g(y) B
1
. Therefore g(y)w(y) > 0 which in turn implies g(y)c(y, K) > 0.
So there exists a > 0 such that g(y) c(y, K) > . As a result we can say
g(y)c(y, K) [, B
1
] y Y. In order to use Brouwers Fixed Point Theorem
we need prove that K belongs to a compact, convex set and T is continuous
on this set. Consider the relation:
K = TK =
_
Y
V
(g(y
) c(y
, K))(g(y
) c(y
, K))dF(y
). (17.16)
The right-side of (17.16) is nonnegative for K 0 and for g(y
) = c(y
, K),
K 0. If g(y
) c(y
, K) then V
(g(y
) c(y
, K)) = 0 so K 0
again. Therefore 0 is a lower bound for (17.16). Denote the set that K
belongs as . So inf exists by the inmum principle. Now we need to nd
an upper bound to (17.16) in order to show that K belongs to a compact
set. Dene V
() = B
2
which is an upper bound for V
and we already know

g(y) c(y, K) B
1
y Y. So these two with Y being compact implies that
_
Y
V
(g(y
) c(y
, K))(g(y
) c(y
, K))dF(y
) is bounded above. So sup

also exists. As a result K belongs to a compact set on R which is necessarily
convex.
Now we need to show that T is continuous in K. Continuity of T follows
from the Dominated Convergence Theorem (Feller (1971),p.111). But intu-
itively we can perceive the continuity as follows: we already know V
(g(y
)
c(y
, K)) is continuous since V is continously dierentiable. Moreover g(y
)
c(y
, K) is a constant for given y
. Therefore the product of these two is also

continuous. Think of the integral as a summation operator. Indeed what we
are doing is then summing some continuous functions which is again continu-
ous.
As a result by the Brouwers Fixed Point Theorem we can say that there
exists a xed point of T. Now we need to prove uniqueness.
Dene (y, K) = g(y) c(y, K) and re-write
T
(K) =
_
Y
_
[V
((y
, K))(y
, K) +V
((y
, K))]
2
(y
, K)
_
dF(y
).
Now if T
(K) < 1 or T
(K) < 0 then T will cut the 45 degree line only once
which implies uniqueness.
Note that
2
(y
, K) > 0 since c(y
, K) decreases with K. If
V
((y
, K))(y
, K) +V
((y
, K)) < 0,
then T
(K) < 0 so uniqueness follows immediately. If

V
((y
, K))(y
, K) +V
((y
, K)) > 0,
then divide the integral in two parts where rst part is (V
())
2
< 0 and the
second part is V
()
2
> 0. If we can show that V
()
2
< 1 then T
(K) < 1
or T
(K) < 0.
Since g(y) > w(y) and U
(c(y, K))(w(y) c(y, K)) = K then

U
(c(y, K))(g(y) c(y, K)) K. (17.17)

Dierentiate (17.17) with respect to K then we get:
U
(c(y, K))c
(y, K) +U
(c(y, K))
2
1.
Since U
(c(y, K))c
(y, K) > 0 then U
(c(y, K))
2
1. Using this:
_
Y
V
()
2
dF(y
)
_
Y
V
()
1
U
(c(y, K))
dF(y
).
Now using U
(c(y, K))(w(y) c(y, K)) = K substitute for U
(c(y, K)) :
_
Y
V
()
1
U
(c(y, K))
dF(y
) =
1
K
_
Y
V
()(w(y
) c(y
, K))dF(y
) 1.
So K is unique.
Question 5
a) We can combine the two budget constraints as follows:
x(s) +R(s)h(s) +p
x
(s)z
x
(s
) +p
h
(s)z
h
(s
)
z
x
(s) [
x
(s) +p
x
(s)] +z
h
(s)
_
h
(s) +p
h
(s)
_
+r(s)K + (s).
Now lets write the Bellman equation:
v(w, s, z
x
(s), z
h
(s)) = max
x,h,z
x
,z
h
_
U(x(s), h(s)) +E(v(w
, s
, z
x
(s
), z
h
(s
)))
_
+(s)
_
z
x
(s) [
x
(s) +p
x
(s)] +z
h
(s)
_
h
(s) +p
h
(s)
_
+r(s)K + (s)
x(s) R(s)h(s) p
x
(s)z
x
(s
) p
h
(s)z
h
(s
)
_
.
The rst-order conditions with respect to x, h, z
x
(s
), z
h
(s
) are given by:

U
1
(x(s), h(s)) = (s) (17.18)
U
2
(x(s), h(s)) = (s)R(s) (17.19)
(s)p
x
(s) = E[v
1
(w
, s
, z
x
(s
), z
h
(s
))] (17.20)
(s)p
h
(s) = E[v
2
(w
, s
, z
x
(s
), z
h
(s
))]. (17.21)
v
1
(w, s, z
x
(s), z
h
(s)) = (s) [
x
(s) +p
x
(s)] (17.22)
v
2
(w, s, z
x
(s), z
h
(s)) = (s)
_
h
(s) +p
h
(s)
_
. (17.23)
135
To obtain an expression for the rental rate on housing, divide (17.19) by
(17.18):
U
2
(x(s), h(s))
U
1
(x(s), h(s))
= R(s).
This says that the rental rate on housing is dened in terms of the marginal
rate of substitution of housing relative to consumption goods.
a) Lets rst solve the maximization problem of the rms in the two
sectors.
Consumption goods sector
x
(s) = max
x
[x(s) (1 +T(s))r(s)f(x(s))] ,
which has the rst-order condition
1 = [1 +T(s)] r(s)f
(x(s)). (17.24)
Housing sector
h
(s) = max
h
[R(s)h(s) r(s)g(h(s))] ,
with the rst-order condition
R(s) = r(s)g
(h(s)). (17.25)
If the economy is in a high tax state, then compared to the low tax state
f
(x(s)) will decrease because of the condition in (17.24) and the fact that
none of the rms can aect r(s) in competitive equilibrium. Since f
(x(s))
decreases, this implies a decrease in x(s). So x(0) > x(). This follows since
f
xx
> 0.
So shiftable factor capital will shift to the housing sector. This implies an
increase in g(h(s)). As a result, h(0) < h().
By part a),
R(s) =
U
2
(x(s), h(s))
U
1
(x(s), h(s))
.
In this expression numerator decreases and denominator increases so R(s) will
decrease in the high tax state compared to the low tax state, R() < R(0).
The gure above illustrates this situation.
A
B
Housing
services (h)
Consumption
good (x)
x
0
x
h
0
h
Slope = R
0
Slope = R
Figure B.5: The impact of a tax on optimal consumption and housing choices
c) By using the rst-order condition R(s) = r(s)g
(h(s)) together with

R() < R(0) and h() > h(0), we can say that g
(h()) > g
(h(0)) since
g
hh
> 0. So r(0) > r().
Recalling the denition of
x
and substituting the rst-order condition
(17.24) into this expression yields:
x
(s) = x(s)
f(x(s))
f
(x(s))
.
Dierentiating, we obtain:
x
(s)
x(s)
=
f(x(s))f
(x(s))
f
(x(s))
> 0,
which implies that
x
(s) changes positively with output. Since x() < x(0),
we also have that
x
() <
x
(0).
d) By (17.20),
p
x
(s) =

s
P
ss
U
1
(x(s
), h(s
)) [
x
(s
) +p
x
(s
)]
U
1
(x(s), h(s))
.
For s = 0 this becomes:
p
x
(0) = P
0
U
1
(x(), h()) [
x
() +p
x
()]
+P
00
U
1
(x(0), h(0)) [
x
(0) +p
x
(0)] /U
1
(x(0), h(0)).
137
For s = this becomes:
p
x
() = P
0
U
1
(x(0), h(0)) [
x
(0) +p
x
(0)]
+P
U
1
(x(), h()) [
x
() +p
x
()] /U
1
(x(), h()).
Substituting P
00
= P
= P and P
0
= P
0
= 1 P in these expressions and
solving for p
x
(0) and p
x
() yields the expressions given in the question.
e) Since x(0) > x() and h() > h(0), then U
1
(0) < U
1
(). Since we dened
the parameter as the ratio of the marginal utility of consumption in the high
versus low tax state, then > 1. Also dene k
x
=
x
(0)/
x
() and note that
k
x
> 1
We can write
p
x
(0)
p
x
()
=
[k
x
(P (2P 1) +(1 P)]
k
x
(1 P) +[P (2P 2)]
.
Now if < k
x
then lower bound for p
x
(0)/p
x
() is
[(P (2P 1) +(1 P)]
(1 P) +[P (2P 2)]
= > 1.
If > k
x
then lower bound is k
x
> 1. So in any case p
x
(0)/p
x
() > 1.
So p
x
(0) > p
x
() as claimed.

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Chapter B

is empty by the Pareto optimality of the allocation

). This can be done the continuity axiom. By the inde-

). Thus, we have that maximizing expected utility is equivalent

= y = k. Since the technology shock is deterministic, we

and substitute our guess into this condition to obtain:

(k) together with the expres-

and T is a contraction. Combining these results

(c) = x then c = G(x). It follows

exp(z +y)f(z, y)dzdy.

exp(y)f(z, y)dzdy = q exp(

exp(z +y)f(z, y)dzdy

. Therefore, the rst-order condition can be

. The household solves

. Thus, the rms problem can be written

and the control variables are given

< ) and that it is jointly continuous

Z, h H and feasible c such that

) < 1. Furthermore, the func-

)] is continuous since V is continuous and the transition

) < 1 so that T discounts. Finally, notice that

= 0. Let (s) denote the multiplier on the cash-in-advance constraint

(c) = (s)p(s) +(s)p(s)

(c) = (s)p(s) +(s)p(s) (13.25)

) > 0, then the cash-in-advance constraint is binding. But

)] > 0. Thus, the con-

that is a function only of the current exogenous state s.

/(s)] < 1, then observe whenever

) = 1, then (s, ) = 1 under the assumption and the properties of the

) and b = a 1. Hence the closed form solution is

0 satisfying Equations (13.130), (13.131), and (13.132).

). If (s) > 1 for all s, then let

> 0, then the integral is negative over the range of integration.

Y = 2L which is the maximum possible output that could be attained. Also

and we already know

) is bounded above. So sup

, K)) is continuous since V is continously dierentiable. Moreover g(y

, K) is a constant for given y

. Therefore the product of these two is also

, K) > 0 since c(y

(K) < 0 so uniqueness follows immediately. If

(c(y, K))(w(y) c(y, K)) = K then

(c(y, K))(g(y) c(y, K)) K. (17.17)

(y, K) > 0 then U

(c(y, K))(w(y) c(y, K)) = K substitute for U

) are given by:

(h(s)) together with

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