Problem Set 5: Ramsey Model

IDEC8002, Semester 2

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1. Consider a closed economy in which the representative e¤ective con-

sumer/worker maximises
Z 1
c1
U= e t t dt (1)
0 1
where c refers to private consumption expenditure per e¤ective worker.
Labour is supplied inelastically. In the same manner as in Romer’s
text, appears because of the transformation from a household util-
ity maximising problem to that shown above, where variables are in
e¤ective worker terms; = n (1 )g, where is the house-
hold’s discount rate, and g is the rate of technological progress. For
simplicity, the depreciation rate on physical capital is zero. There is no
government in this economy.

Ans a: Write down the budget constraint faced by the household at

time t and justify the equation of motion for k, capital per e¤ective
worker. The representative household:

supplies 1 unit of labor at every t (inelastic labor supply)

holds the only asset, physical capital

takes the paths of r and w as given

has perfect foresight

and faces the Budget Constraint:

CL + K_ = W L + rK (2a)
K_ = (W C)L + rK (2b)

where, for convenience, C denotes consumption per worker and K denotes

capital. The LHS and RHS of (2a) reveal uses of income and sources of
income, respectively. The LHS of (2b) gives the change in family wealth, the
RHS is savings plus interest on capital holdings. Divide both sides of (2b) by

1
 _ + (n + g))K to obtain the budget constraint,
AL and substitute for K_ = (k=k
in per e¤ective worker terms:

c + k_ + (n + g)k = w + rk (3)

Given constant returns to scale and perfect competition, by Euler’s Theorem,

f (k) = w + rk, yielding the equation of motion for k :

k_ = f (k) c (n + g)k (4)

Ans b: The Euler equation for consumption is:

c_ 1 0
= [f (k) ( + n + g)]
c
1 0
= [f (k) g)] (5)

so that along the optimal path the growth in consumption per worker is
given by:
C_ 1
= [r ]
C
meaning the optimising household equates the rate of returns on savings
and consumption, respectively:

C_
r= + (6)
C

Ans c: Draw (and justify) a diagram in (c; k) space in which you show the
locus for c_ = 0 and k_ = 0. Show the saddlepath for out-of-steady-state
adjustment.Plot k_ = f (k) c (n+g)k = 0 and c_ = 1 [f 0 (k) g)]c =
0 in (c; k) space. See diagram in lectures.

2. E¤ect of an increase in : c isocline shifts left. Household discounts future

consumption more heavily, so saves less, accumulates less k. Economy
converges to balanced growth path with lower c and k. At time of in-
crease in discount rate, k instantaneously …xed, but c can jump discon-
tinuously. Along saddlepath, c and k growing. c_ = 1 [f 0 (k) g)]c >
0 and k_ = f (k) c (n + g)k > 0. Consider the e¤ect of a higher on
the saddlepath. Household will be less inclined to postpone consumption
until tomorrow and will save (invest) less today. For given k(0), c(0)
will be higher, so stable arm will be closer to k isocline.