Technical University of Lisbon

ISEG (School of Economics and Management)

Macroeconomics
M.Sc. in Economics
M.Sc. in Monetary and Financial Economics

A Few Notes for Chapter III

by Lus F. Costa
This version: 1.2 (2011/02/21)

1. Introduction
Chapter III Real Business Cycles (RBC), uses a simple classroom model to
introduce dynamic general equilibrium models to M.Sc. students. The notes presented
here follow Romer (2006), p. 168-216, very closely. However, there are some
differences that should be taken into account:
I assume the rates of growth of labour efficiency (g) and of the population (n)
are both zero. Therefore, we can interpret variables in detrended per capita
terms. The trend can be reintroduced afterwards.
I use the usual discount and growth factors in discrete time. Therefore, the
discounted utility is given by [(1 + )- t].ut.
The flow utility function is given by
Ct1 1 Z 1 1
ut b. t ,
1 1
where Zt = 1 - Lt represents leisure, and 0 and 0. Notice the model in
Romer (2006) is a special case where = = 1.
Costa (2007b) is a companion spreadsheet that uses the model developed here.

2. The Economy
This is a closed economy composed by H identical households. We normalise the
number of households to one (H = 1), without loss of generality, as we did in the
Ramsey model. There is no technical progress, i.e. g = 0, and population is fixed, i.e.
n = 0.

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Also, we normalise the initial values of key variables in order to have A0 = N0 = 1.
Thus, variables in levels have exactly the same value then their value per unit of
steady-state efficiency per capita, e.g.
Ct .H C Ct
ct * t * Ct .
A0 . 1 g .N 0 . 1 n
* t t
At At .N t

Notice it is easy to recover the true values for the variables in levels if we multiply
the values produced by the model by A0.(1 + g)t.N0.(1 + g)t > 1.

3. Households
We can use a representative household to study the aggregate behaviour of the H
households. This representative household maximises an inter-temporal expected
utility function given by
1
t Ct 1 Z 1 1
max E 1 . b. t , (1)
Ct , Lt , K t 1
t 1 1

where Ct 0 represents aggregate consumption in period t, 0 Zt 1 stands for

leisure in period t, and Kt 0 is the capital stock held by the household at the
beginning of period t.
Since we normalised the time endowment to one, leisure is given by Zt = 1 Lt, where
Lt represents the labour supplied.
The parameter > 0 represents the discount rate, 1/ > 0 is the elasticity of inter-
temporal substitution in consumption, and 1/ > 0 stands is the elasticity of inter-
temporal substitution in leisure. Also, we have b 0.
The inter-temporal budget constraint expressed in terms of units of the aggregate good
is given by
K t 1 K t wt .Lt Rt .K t t Tt Ct .K t , (2)
where wt stands for the wage rate, Rt is the rental price of capital, t corresponds to
profits income, Tt is a lump-sum tax levied on households, and 0 1 is a fixed
depreciation rate. All profits are assumed to be distributed to households.
We now define a current-value Hamiltonian to the stochastic problem in order to find
the optimal paths for consumption, labour supply, and the capital stock:
C 1 1 Z 1 1
H t Et t b. t t . wt .Lt Rt .K t t Tt Ct .K t (3)
1 1
and the first-order conditions are given by
H t C1 1
Et t E t t .Ct 0 , (4)
Ct Ct 1 Ct
1 Lt 1 E .w .L 0 ,
1
H t
E t b. (5)
Lt Lt 1 Lt
t t t t

2
 H t
E t t . Rt E t t t 1 Et .t 1 , (6)
K t
H t
E t wt .Lt Rt .Kt t Tt Ct .Kt Et K t 1 Kt , (7)
t

limE .K 1 0 . (8)

First, let us assume the probability of Ct being equal to C does not depend on the
latter and also its probability distribution is stable overtime. Thus, we can conclude
that:
C 1 1 Ct1 1
Et t Et Et Ct .
Ct 1 Ct 1
Furthermore, the values of both Ct and t are perfectly known by the household. Thus,
equation (4) can be written as
Ct t 0 . (4)b
The optimal value for the capital stock is regulated by equation (6). However, at time
t the decision is to be made upon Kt+1, since Kt is a pre-determined variable. Thus,
equation (6) has to be written in the following way:
E t t 1. Rt 1 E t t 1 1 .t . (9)a

Let us now define a real interest rate as rt Rt - and use the previous equation to
determine the equilibrium value of t, that is equal to Ett+1.(1 + rt + 1)/(1 + ). By
substituting this value in (4)b, taking into account that Ett+1 = EtCt+1-, we obtain the
Euler equation for consumption under uncertainty:
1
Ct .Et Ct 1 . 1 rt 1 . (10)
1

Using t = Ct- , derived in equation (4)b, in equation (5) we can obtain an inter-
temporal relationship between Lt and Ct that are both known at period t. Thus, a
pseudo-labour-supply equation can be derived1:
1

C .wt
Lt 1 t . (11)
b

4. Government
Considering the household is infinitely living Ricardian equivalence holds in this
model. Therefore, nothing is lost if we ignore debt financing. Since there is no money

1
In fact, both (10) and (11) represent substitution effects (inter-temporal and intra-temporal), but not
the income effects that are given by the budget constraint.

3
in the model, money financing is also ignored2. Thus, the level of taxes is the one
needed to finance government expenditure:
Tt = Gt , (12)
where Gt denotes government consumption, assumed to be an exogenous variable.

5. Firms
We assume there is a large number of identical firms that produce a homogeneous
aggregate good using labour and capital supplied by households as inputs. Firms are
price takers in the good and factor markets. Consequently, we can also assume there is
a single representative firm in a competitive market that maximises its profits:
max t Yt wt .Lt Rt .K t . (13)
Yt , Lt , Kt

Notice there is no uncertainty for firms as they decide how much to produce and how
much labour and capital services to rent after the shocks are revealed in period t.
The production technology is given by a constant-returns-to-scale Cobb-Douglas
production function:
Yt K t . At .Lt
1
, (14)

where 0 < < 1. By substituting (14) in (13) we obtain a new profit function that
depends only on demand for inputs and we can maximise it obtaining the first-order
condition that lead us to the following conditions equalising the real prices of inputs
to their marginal products:

K
wt 1 . At 1
. t , (15)
Lt
1
K
rt . t . (16)
At .Lt
If we substitute these two equations and the production function in the profits
definition we conclude t = 0. In fact, this is the expected result considering there is
perfect competition and constant returns to scale3.

6. The macroeconomic equilibrium

Considering (12), (14), (15), and (16), we obtain the fundamental identity of national
accounting that is given by substituting the previous equations in (7):
K t 1 Kt Yt Ct Gt .K t . (17)
Notice the expected-value operator disappears because: Kt is a pre-determined
variable in period t and Kt+1 is the decision variable for the representative household at
period t, i.e. the household knows its exact value in the same way it knows Ct or Lt.

2
RBC models with money produce results that are not quantitatively different from the one presented
here.
3
See Costa (2007a) for a more general demonstration using the Euler theorem.

4
 7. Shocks to the balanced-growth path
We assume there are two sources of shocks that may drive the economy away from its
balanced-growth path in the short run: technological shocks and fiscal shocks. Both
types of shocks are assumed to be uncorrelated.
Firstly, we assume the stochastic process that drives the technology parameter At is
given by

At At* .e At , (18)
where the steady-state deterministic process for technical progress is the usual one
given by At* = A0.(1 + g)t, a constant with our initial assumption (g = 0) At* = A0. The
shock is given by a AR(1) process:
At A . At 1 A,t , (19)

where A,t N(0, A2) are independent and identically distributed (i.i.d.) and 0 < A <
1.
Finally, we assume the stochastic process that drives government consumption Gt is
given by

Gt Gt* .eGt , (20)
where the steady-state deterministic process for technical progress is the usual one
given by Gt* = G0.[(1 + g).(1 + n)]t, a constant with our initial assumption (g = n = 0)
Gt* = G0. The shock is given by a AR(1) process:
G t G .G t 1 G ,t , (21)

where G,t N(0, G2) are i.i.d. and 0 < G < 1.

8. The initial steady-state equilibrium

Our dynamic general equilibrium stochastic system is given by the following ten
equations:
The consumption Euler equation - (10).
The (pseudo-)labour-supply function (11).
The (pseudo-)labour-demand function (15).
The (pseudo-)capital-demand function (16).
The capital-accumulation equation - (17).
The aggregate production function - (14).
The log version of (18): ln At ln A0 At .
The stochastic process for the technological shocks - (19).
The log version of (20): ln Gt ln G0 G t .
The stochastic process for the fiscal shocks - (21).

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If a steady-state equilibrium exists, variables are stationary4, i.e. we observe Kt+1 = Kt
= K*, EtCt+1 = Ct = C*, Etrt+1 = rt = r*, and At G t 0 , i.e. A* = A0 and G* = G0, where
asterisks stand for steady-state levels for the variables. Of course this also the case for
variables that only present static relationships like Lt = L*, wt = w*, and Yt = Y*.
The first steady-state solution is obtained from (10): r* = , i.e. the steady-state
equilibrium vale for the real interest rate is given by the average discount rate in the
economy. Of course this leads also to a real steady-state rental price of capital given
by R* = + .
Now, if we use equation (17) we obtain the usual steady-state product-market
equilibrium condition, i.e. Y* = C* + I* + G*, where I* = K*. We can substitute all
the other variables, using the remaining equations in order to obtain a single equation
in L*:
h L* 0 , (22)

where h(L*) Y* - C* - .K* - G0, i.e. the following function:

1

1

1 1 1
h L A0 . .L 1 L . G
1
*
. * *

. A0 .
b
0


Despite the large number of parameters, this is a very simple increasing function of
L*, as
1
1 1 Y * .K * C * G0
A0 . . A0
. 0
L* L*
Furthermore, we can observe that h(0) < 0 and h(1) > h(0). Therefore, if an
equilibrium exists, it is unique and given by 0 < L* < 1 such that h(L*) = 0. Notice this
equilibrium always exists for 0 G0 A0.[/( + )]/(1 - ) - . A0.[/( + )]1/(1 - ) .
In the case of Romer (2006) there is a closed-form solution for (22) as = = 1
transforms h() into a linear function. This is also the case for any = > 0. For other
special cases that transform h() into a polynomial of the order 4 or below (e.g. =
2.), there is also an algebraic solution. However, there is no general closed-form
solution for (22) and it may have to be solved using numerical approximations that are
available in many computer programs5.

9. An approximate system
Since we face a non-linear system, that cannot be explicitly solved, we opted for using
a first-order Taylor approximation to this system. Therefore, we will ignore second-
order moments, i.e. we do not take into account: i) the deterministic second-order (and
higher-order) terms in the series and ii) the second-order moments of the distributions
(variances and covariances).

4
The steady state is a balanced-growth path when we consider g > 0 and n > 0, and stationary means
levels grow at n + g + n.g per period, i.e. variables per unit of efficiency per capita are stationary.
5
Including the Solver add-in in Excel.

6
However, instead of simply using the direct linearization, we transform the first-order
approximations to the equations in order to use (small) log-deviations from the
steady-state path for the variables, i.e. proportional instead of level deviations. Thus,
for a general equation
y t f x t ,

we define the log-deviation of x(t) from the steady-state path value [x*(t)] as
dx t
x t .
x* t
The first-order Taylor approximation can be written as
df *
dy t x t .dx t y t y , x x* t .x t ,
dx
df * x* t
where y , x x t . * is the elasticity of y with respect to x evaluated at the
dx y t
steady-state equilibrium for time t. Additionally, notice that the values for the steady-
state variables are constant overtime in our model given our assumptions.6
Therefore, our approximate system is given by
From (10) E t Ct 1 Ct e1.E t rt 1 , (23)

where e1 0 , due to the fact that r* = .
1 .
From (11) Lt e2 .w t e3 .Ct , (24)

1 L* 1
where e2 . 0 and e3 = .e2 > 0.
L*

From (15)
w t 1 . At . K t Lt . (25)

From (16)
rt e4 . At Lt K t . (26)

where e4 . 1 0 .

From (17)
Yt .K t 1 . At Lt . (27)

From (14) K t 1 1 .K t e5 .Yt ee .Ct e7 .G t , (28)

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Romer (2006) follows a different, though equivalent strategy. He notices that:

x t x t x* t x t x* t
ln * ln 1 x t .
x t x* t x* t
We can also notice that dx(t)/x*(t) = dlnx(t) lnx(t) lnx*(t) = ln[x(t)/x*(t)].

7
 Y* C* G*
where e5 *
0 , e6 e5 . *
0 , and e7 e5 . *
0 .7 Notice that we know that
K Y Y
R*.K*/Y* = , therefore e5 = ( + )/.
Finally, the last four equations remain the same.

10. Solving the approximate system

First, let us reduce the dynamic system to a two-dimensional system keeping C as a
jump (co-state) variable and K (state) variable. We can do that in the following way:
1. by substituting equations (24) to (27) in (23) and (28);
2. to find the value of E t rt 1 we have to use (26) written in expected value for
t+1;
3. since E t rt 1 now depends on the values of E t Lt 1 , we also need to use (24)
and (25) to determine the expected log-deviation of employment from its
steady-state level;
4. E t rt 1 depends on the values of E t K t 1 and the latter is a decision variable that
is equal to K ; t 1

5. finally, E t rt 1 depends on the value of E t At 1 E t G t 1 , and it is obtained
using the stochastic process, i.e. it is given by A . At G .G t .
Therefore, the reduced system is given by
E t Ct 1 a11 a12 Ct b11 b12 At
. . , (29)
K t 1 a21 a22 Kt b21 b22 Gt
where the elements of matrices A and B are given by
e1 .e3 .e4 .e5 . 1
1 .e2 e1.e4 .e6
1 .e2 1 a12 .a21
a11 0 ,
1 .e2 e1.e3 .e4 a22

e1.e4 . 1 . 1 .e2 e5 . . 1 e2 1 . 0
a12 ,
1 .e2 . 1 .e2 e1.e3 .e4 1 .e2 .
C*
. 1 . .e2 *
. 1 .e2
e3 .e5 . 1 e6 . 1 .e2 Y
a21 0 ,
1 .e2 . 1 .e2

7
Had we considered the steady-state values of Y, K, C, and G grow overtime at rate g + n + g.n > 0, the
rate that is compatible an endogenous-labour Ramsey deterministic model with population growing at
rate n and labour efficiency growing at rate g, the ratios e5, e6, and e7 would also be constant.

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 a22
1 .1 .e2 e5 . . 1 e2 1 .1 e2 e2 . . 1 0 ,
1 .e2 1 .e2

e1.e4 . 1 e2 . 1 .e2 . A e5 . 1
b11
1 .e2 e1.e3 .e4
,
. 1 . 1 e2 . A . . 1 .e2 1 .

1 .e2 . . .1 e2 . . 1
. 1
2
e1.e4 .e7 G*
b12 . * 0 ,

1 .e2 e1.e3 .e4 . . 1 e2 . . 1 Y
b21
1 e2 .e5 . 1 1 e2 . . 1 0 ,
1 .e2 . 1 .e2

G*
b22 e7 . 0 .
Y*
The stability of the system depends on the values for the trace and determinant of
matrix A, the Jacobian. Thus, we have to obtain the eigenvalues of A that are given by
the solution to the characteristic equation |A - .I| = 0.8 The roots of the system are
given by:

a11 a22 a11 a22 4.a12 .a21 a11 a22 a11 a22 4.a12 .a21
2 2

1 ; 2 .
2 2
In this case the determinant is simply given by |A| = 1 + > 1. Thus, we know the
product of the systems eigenvalues is positive and larger than one, as |A| = 1.2.
Therefore, both eigenvalues exhibit the same sign, i.e. they are either both positive or
both negative.
Furthermore, the trace of the Jacobian is also positive, as Tr(A) = a11 + a22 > 0, i.e. the
sum of the pair of eigenvalues is positive, as Tr(A) = 1 + 2. Thus, we can conclude
both eigenvalues are positive.
Additionally, we can rule out the existence of endogenous fluctuations in this model,
as we can conclude both eigenvalues are real. But how can we rule out complex
eigenvalues? Simply by noticing the discriminant of the characteristic polynomial is
always positive, i.e. (a11 a22)2 + 4.a12.a21 > 0.
However, we know that, in this case, the steady-state equilibrium is strictly stable if
both eigenvalues are within the unit circle (i.e. |Re(i)| 1), it is strictly unstable if
both roots are outside the unit circle (i.e. |Re(i)| > 1), and it is a saddle point if one of
the s is inside and the other lies outside the unit circle.

8
Notice this has nothing to do with the Hamilton multiplier in equation (3).

9
Thus, we can re-write equation (29) in the following way:
E t Ct 1 Ct a11 1 a12 Ct b11 b12 At
. . , (29)a
t 1
K K t a 21 a 22 1 t
K b21 b22 Gt
and analyse the determinant of the matrix A I, as we know the eigenvalues obtained
here are 1 1 and 2 1. It is easy to see that | A I | = - (a11 + a22), but we do not
know what is the sign of this determinant without some laborious and extremely
boring algebra. At last, we obtain this determinant:
C*
.1 .
2
*
.e2 2. . . 1 .e2 . . 1 . . 1 . 1 .
.
AI Y 0
a22 . . . 1 .e2

Finally, we can conclude 1 1 < 0 and 2 1 > 0, i.e. the steady-state equilibrium is
a saddle point.
However, we have not used the transversality condition given by (8), that implies:
limE C .K 1 0 . (8)a

By imposing this condition we rule out steady-state solutions that imply either an
infinite amount of steady-state capital stock, but also C* = 0. Therefore, we eliminate
the unstable trajectories that would lead to such solutions after an unexpected shock
has hit the economy at its steady state. Consequently, the steady-state equilibrium is
saddle-point stable and we can ignore the unstable root given by 2. We will return to
this point in the next section.

11. A recursive solution

We know that an equilibrium exists, if G0 is not absurdly large, it is unique and
saddle-point stable. Therefore, we can postulate a recursive linear solution and try to
obtain the relevant parameters by using an indeterminate-coefficients method.
First, let us impose a linear recursive solution of the following type:
Ct aCK aCA aCG At
.K t . . (30)
K t 1 bKK bKG bKG G t

If this is the true solution, then we know that

E t Ct 1 aCK .Et K t 1 aCA .E t At 1 aCG .E t G t 1
.
a .K a . . A a . .G
CK t 1 CA A t CG A t

By substituting the value of K t 1 obtained in (29) in the previous equation we obtain

E t Ct 1 aCK . a21.Ct a22 K t b21. At b22 .G t aCA . A . At aCG . A .G t .

We can now substitute the value of Ct in (30) here and obtain

E t C t 1 aCK . a21. aCK .K t aCA . At aCG .G t a22 K t b21. At b22 .G t aCA . A . At aCG . A .G t

. (31)

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We can also substitute the solution for Ct in (30) in the equation for E t Ct 1 in (29)
and obtain

Et Ct 1 a11. aCK .K t aCA . At aCG .G t a12 .K t b11. At b12 .G t . (32)

Thus, by comparing both, we know that the parameter for K t has to be the same, i.e.
we can obtain an equation that relates the reduced-form parameters in the log-
linearised model with parameters in the solution proposed:
aCK . a21.aCK a22 a11.aCK a12 . (33)
The remaining 5 equations of this indeterminate-coefficient method are given by
using the same procedure for At and G t with equations (31) and (32), but also using
the same strategy for the two equations in K . Thus, we can obtain the remaining
t 1
coefficients recursively, assuming we know the value of aCK:
bKG a21.aCG b22
bKA a21.aCA b21
bKK a21.aCK a22 .
b12 aCK .b22
aCG
a21.aCK G a11
b11 aCK .b21
aCA
a21.aCK A a11
Nevertheless, we apparently have two solutions for the value of aCK in (33), as it is a
second-degree polynomial given by a21.aCK2 + (a22 a11).aCK a12 = 0. A closer
inspection to this equation reveals there is a connection between this equation and the
characteristic equation that allows us to calculate the eigenvalues: 2 - (a22 + a11). +
(a11.a22 - a12.a21) = 0. Therefore, we can easily notice that aCK = ( - a22)/a21, i.e. there
is a pair of solutions for aCK, as long as there is a pair of solutions for . In our case,
with the transversality condition ruling out the unstable eigenvalue, we obtain a
unique solution for the parameters in equation (30):
1 a22
aCK .
a21

12. Using the solution for simulation

The values for the reduced-form parameters in (30) can be obtained from the values of
the elements in matrices A and B in equation (29), as we saw in the previous section.
We also obtained these values from the log-linearization parameters ei (i = 1, , 7)
and the later are functions of the fundamental parameters ( ).
Therefore, we can obtain the series for all the variables by knowing the initial position
( K 1 K * 0 ) and the series of technological and fiscal shocks.

References
Costa, L. (2007). Macroeconomics: A Few Notes for Chapter V. Mimeo

11
 ISEG/TULisbon.

Costa, L. (2010) Real Business Cycles Simulation Program for Excel. ISEG/
TULisbon, Lisboa.

Romer, D. (2006). Advanced Macroeconomics, 3rd edn . McGraw-Hill, New York.

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