Chapter 3

Ramsey Model – Discrete Time Analysis

This chapter1 introduces the reader to the most basic dynamic model: the Ramsey
Model.2 The first goes through the representative agent’s constraint and total utility.
Then, it covers the agent’s optimizing problem. The result is the Intertemporal
Efficiency Condition3. Its implications on the steady state and the Golden Rule
Accumulation follow. The analysis is extended by setting parameters on the utility
function and the production function.

I. Intertemporal Efficiency Condition (IEC)

Suppose the following notations hold.

1. Ct = consumption per capita at time t; total consumption / total population.

2. It = investment per capita at time t; total investment / total population.
3. Kt = capital per capita at time t; total capital stock / total population; capital-labor ratio.
4. n = population growth rate.
5. Nt = population or labor supply at time t.
6. rt = rent on capital at time t.
7. U(Ct) = utility function or satisfaction from consumption at time t.
8. Yt = income at time t.
9.  = 1/(1+) = present value factor.
10.  = rate of depreciation, where 0    1.
11.  = rate of time preference.

Assume the following.

1. n = 0 or zero population growth.

2. Transversality condition (TVC) holds.
3. The production function follows the Inada (1964) conditions. This means that production is
zero if capital is zero, increases with capital regardless of amount of capital, and increases
at decreasing rate.
4. No-Ponzi Game condition holds. In other words, consumers may not borrow
infinitesimally to consinuously expand their budget constraint to the extent that budget
becomes unlimited.

The TVC condition can be expressed as

1
Last revision: 28 October 2010.

2
Some call this the Keynes-Ramsey Model, still others call this the Ramsey-Cass-Koopmans Model.

3
Others refer to this as the Keynes-Ramsey Intertemporal Efficiency Condition.

Dumlao: Notes in Macroeconomics, 2011.

 (1) lim t Kt 1  0.
t 

The value of capital stock at terminal date or at the end of time is zero. Agents invest in their
time, less for their immediate descendants and then less for their indirect descendants, and so on
until they invest for those least related to them. Thus, they invest only up to some terminal date.
In this model, the terminal date is infinity. That means they invest for themselves and their
descendants to the infinitesimal future. Assume that the Inada conditions hold, then

(2) f (0)  0, f '( K )  0, & f "( K )  0 K.

Figure 1 shows the graphical translation.

Figure 1

f(Kt)

Kt

During a specific period, t, a planner takes its existing capital stock, Kt, as given. It also
adds new investment, It. The sum of the two makes up for the future capital stock, Kt+1. Thus

(3) Kt 1  Kt  It  It  Kt 1  Kt .

More realistically, depreciation must be taken into account. The existing capital stock depreciates
from t to t+1 at a rate of . Thus, future capital stock is less by Kt. This means

(4) Kt 1  Kt  It   Kt  It  Kt 1  (1   ) Kt .

Take note that investment, It, does not depreciate yet because it is brand new capital. Also,
investment is the future capital stock (Kt+1) less the left over of present capital [(1-)Kt]. Since the
preceding is in per capita terms, the total is obtained by factoring in total population. Thus

(5) Nt It  Nt 1Kt 1  (1   ) Nt Kt .

Current income depends on total capital and labor. The mathematical representation is 4

4
The more conventional notation of the production function is Yt = F(Kt,Nt), where K is total capital. In this
work, K is expressed as capital labor ratio. Thus, total capital is NK.

28 Chapter 3: Ramsey Model in Discrete Time

 (6) Yt  F ( Nt Kt , Nt ).

This is consistent with classical models such as the Cobb-Douglas production function such that

(7) Yt  F ( Nt Kt , Nt )  ( Nt Kt ) Nt1 .

The planner expends current income by either consuming today or investing for new capital.
Mathematically

(8) Yt  F ( Nt Kt , Nt )  Nt Ct  Nt I t .

The representative agent’s budget constraint can be derived through

(9) Yt  F ( Nt Kt , Nt )  Nt Ct  [ Nt 1Kt 1  (1   ) Nt Kt ].
Yt NK N  NC N K (1   ) Nt Kt
 F  t t , t   t t  t 1 t 1 
(10) Nt  Nt Nt  Nt Nt Nt
 yt  f ( Kt )  Ct  (1  n) Kt 1  (1   ) Kt .
(11) yt  f ( Kt )  Ct  Kt 1  (1   ) Kt .

The first line inserts (5) into the previous equation. The second line divides the aggregate
production function by population. The result is representative agent’s budget constraint. It is also
simplified for notational convenience. The third line assumes no population growth. The result is
the representative agent’s budget constraint if there is no population growth.

From this, the discussion turns to the dynamic utility function. It can be derived from

(12) U (C0 )  U (C1 )  U (C2 )  U (C3 )  ...  U (C ).

U (C1 ) U (C2 ) U (C3 ) U (C )
(13) U (C0 )     ...  .
1   (1   ) (1   )
2 3
(1   )
U (C0 )  U (C1 )   2U (C2 )   3U (C3 )  ...   U (C )
(14)   0U (C0 )   1U (C1 )   2U (C2 )   3U (C3 )  ...   U (C )

   tU (Ct )
t 0

The total satisfaction individuals get out of consumption is the sum of all present and future
satisfaction for consuming, thus the first line. However, consumers value time of consumption
differently. Thus, a more accurate perspective of total satisfaction factors in the present value, and
thus the second line. Since  = 1/(1+), then the third line results. The third line is the
representative agent’s total satisfaction.

The planner’s objective is to maximize lifetime utility (14) subject to the budget constraint
(11). Therefore, the Present Value Lagrangean is

Dumlao: Notes in Macroeconomics, 2011. 29

  
L    U (Ct )   t [ f ( Kt )  Ct  Kt 1  (1   ) Kt ].
P t

(15) t 0 t 0

For beginners, it is worthy to look at the extended version which is

LP   tU (Ct )   t 1U (Ct 1 )   t  2U (Ct  2 )  ...   U (C ) 

t [ f ( Kt )  Ct  K t 1  (1   ) K t ]  t 1[ f ( K t 1 )  Ct 1  K t  2  (1   ) K t 1 ] 
(16)
t  2 [ f ( Kt  2 )  Ct  2  Kt 3  (1   ) Kt  2 ]  ...   [ f ( K  )  C  K 1  (1   ) K  ].

The planner determines how much to consume today (Ct or C0) and how much to invest today [It
= Kt+1 – (1-)Kt or I0 = K1 – (1-)K0]. Since current capital stock (Kt or K0) is already given, the
planner determines investment by determining next period’s capital stock (Kt+1 or K1).

The first order conditions are

LP
(17)   tU '(Ct )  t  0.
Ct
LP
(18)  t  t 1[ f '( Kt 1 )  1   ]  0.
Kt 1
LP
(19)  f ( Kt )  Ct  Kt 1  (1   ) Kt  0.
t

The first two may rearrange to

(20) t   tU '(Ct ).
(21) t  t 1[ f '( Kt 1 )  1   ].

The first of the above implies

(22) t 1   t 1U '(Ct 1 )  t n   t nU '(Ct n ).

Relations (20) and (22) indicate that the present value Lagrange multiplier  is the costate
variable. That is, t equals the present value of marginal utility of consumption at a specific
period. More so, inserting (20) into the TVC in (1) yields

(23) lim  tU '(Ct ) Kt 1  0.

t 

Because of consumers’ impatience, as one defers consumption longer, satisfaction decreases. As

one defers to time infinity, satisfaction approaches zero. This holds true for individuals who live
an infinite life. By inserting the individuals’ degree of altruism, agents derive satisfaction in

30 Chapter 3: Ramsey Model in Discrete Time

consuming her own income by herself, her children, her grandchildren, her great grandchildren,
and so on. As generation furthers, the relation furthers; the individual cares less; satisfaction of
future consumption decreases; and the value approaches zero. This is basically the essence of the
TVC.

To continue, it can be shown that

 t  t U '(Ct )   t 1[f '(K t 1 )  1  ]

(24)
 t U '(Ct )  [t 1U '(Ct 1 )][f '(K t 1 )  1  ].
(25) U '(Ct )  U '(Ct 1 )[ f '( Kt 1 )  1   ].

The first of the above combines the first order conditions with respect to consumption (20) and
future capital (21). It also inserts (22). The second is the simplification and it is what is referred to
as the Intertemporal Efficiency Condition (IEC). The left side is the foregone consumption today
or sacrificed satisfaction from consuming today. U’(Ct+1) is the present value of next period’s
marginal utility of consumption.

In equilibrium, the marginal productivity of capital less depreciation equals the real rate of
return or interest to investment. Thus

(26) f '( Kt 1 )  1    1  [ f '( Kt 1 )   ]  1  r.

[f’(Kt+1)+1-] represents the gross return from investment. Multiplying this by U’(Ct+1) results
to the right side of the IEC. Thus, the right side is the present value of tomorrow’s gain by saving
today’s satisfaction from consumption. In sum, foregone consumption today equals the present
value of future gain from saving.

Although the above derives the IEC via Present Value Lagrangean, the Current Value
Lagrangean is an alternative route to solving and analyzing the model. That is, instead of solving
for the solution via (15), one may solve via


(27) L    t U (Ct )  t  f ( Kt )  Ct  Kt 1  (1   ) Kt .
C

t 0

Here, consumers determine current consumption (Ct) and new capital (Kt+1), but not used capital
because it is given and determined in the past. The first order conditions are

LC
(28)   tU '(Ct )   t t  0.
Ct
LC
(29)    t t   t 1t 1[ f '( Kt 1 )  1   ]  0.
Kt 1
LC
(30)   t [ f ( Kt )  Ct  Kt 1  (1   ) Kt ]  0.
t

Dumlao: Notes in Macroeconomics, 2011. 31

Rearranging the first of the above yields and implies

(31)  tU '(Ct )   t t  U '(Ct )  t  U '(Ct n )  t n n.

Thus, the current value Lagrange multiplier t is the current value of the marginal utility of
consuming in period t. This is distinct from the present value Lagrange multiplier  as expressed
in (22).

Further manipulation gives

(32)  t t   t 1t 1[ f '( Kt 1 )  1   ].

(33)  tU '(Ct )   t 1t 1[ f '( Kt 1 )  1   ].
(34)  tU '(Ct )   t 1[U '(Ct 1 )][ f '( Kt 1 )  1   ].

The first equation rearranges (29). The second equation combines the first with (31). The third
equation inserts (31). Simplifying results to the IEC expressed in (25).

Another question that arises is whether the result will be the same if the economy is one
that is decentralized. Specifically, the one presented above is one that is centralized as the
economic planner figures the optimal amount of consumption and stock of capital. What if there
are individual agents and firms, each deciding his or her consumption and investment? The
answer follows. As far as the individual agent is concerned, he or she earns income by wage (wt)
and returns to investment on capital (rKt), and expends this by either consuming (Ct) or saving
(St). In this sense, the budget constraint is

(35) wt  rt Kt  Ct  St .

In a perfectly competitive market, the representative firm derives total revenue from production
[f(Kt)], and total cost from wage (wt) and cost of capital (rtKt). Also economic profit is total
revenue less total cost, which is zero. Thus

(36)   f ( Kt )  wt  rt Kt  0  wt  f ( Kt )  rt Kt .

The budget constraints of the representative consumer and representative firm can be combined
by inserting the above into the previous equation. This gives

(37) [ f ( Kt )  rt Kt ]  rt Kt  Ct  St  f ( Kt )  Ct  St .

For the household, total saving is

(38) St  Kt 1  Kt .
St  Kt 1  Kt   Kt
(39)
 Kt 1  (1   ) Kt .

32 Chapter 3: Ramsey Model in Discrete Time

The first indicates that savings is the change in the stock of capital. Like the case of the
centralized economy, capital is also subject to depreciation, thus the second equation. Inserting
into (37) gives results to the representative agent’s budget constraint, which is identical to (11).
The same is true with the representative household’s utility function that is identical to (14). The
only difference is that the rate of time preference in a decentralized economy is the actual rate of
time preference of the representative household, while that in a centralized economy is the
economic planner’s estimation. With identical budget constraint and essentially the same utility
function, the result will be the same.

II. Implications: The Steady State, the Golden Rule, and Population

The IEC has much to say about macroeconomic theory, particularly on Steady State and
the Golden Rule, and implication of population. On steady state, the condition holds when total
output, total capital and total consumption grow just enough so that per capita output, capital-
labor ratio and per capita consumption are constant or steady. Thus

(40) Ct  C & Kt  K t.

With this, the budget constraint (11) becomes

(41) f ( K )  C  K  (1   ) K  C  f ( K )   K.

In the Golden Rule, the principle is to maximize human welfare by the amount of consumption.
Thus, the planner maximizes consumption by finding the right amount of capital. Mathematically

dC
(42)  f '( K )    0  f '( K )   .
dK

Under steady state, the planner maximizes consumption by investing on capital accumulation just
enough so that the marginal product of capital equals the rate of depreciation. Intuitively, the
planner budgets just enough capital to offset depreciation. The rest goes for consumption. This is
the traditional implication of the Steady State and Golden Rule.

To see the implication under the Ramsey model, inserting (40) into the IEC (25) yields

(43) U '(C )  U '(C )[ f '( K )  1   ].

Since =1/(1+), then

1
(44) U '(C )  U '(C )[ f '( K )  1   ]  f '( K )    .
1 

The above presents the Modified Golden Rule (MGR) of accumulation. Under steady state, the
planner maximizes satisfaction from consumption by investing on capital accumulation just
enough so that the marginal product of capital equals the sum of rate of depreciation and rate of

Dumlao: Notes in Macroeconomics, 2011. 33

time preference. Intuitively, the planner budgets just enough capital to offset depreciation and
consumer’s impatience. The rest goes for consumption.

Notice the distinction between GR and MGR. While the former seeks to maximize
consumption, the latter seeks to maximize utility of consumption. Since utility is affected by
when consumption takes place, the MGR investment does not just offset depreciation, but also the
rate of time preference. Figure 2 represents this graphically. The vertical axis is per capita output
of capital and the horizontal axis is the amount of capital. The production function is f(K) and the
marginal productivity of capital [f’(K)] is the slope of the production function. For the GR, the
optimal point of capital lies where the production function parallels the K line where the slope
equals . For the MGR, the optimal point of capital lies where the production function parallels
the (+)K line where the slope is (+).5

Figure 2

f(K) (+)K K
f(K)

KMGR KGR K

Note that capital in MGR is less than that in GR. As  decreases, the slope of (+)K
decreases; ultimately, KMGR increases towards KGR. Intuitively, as consumers become more
patient, they increase savings; investment increases; and then capital accumulation increases.
When capital accumulation increases, long run consumption increases. This implies that long run
consumption in the MGR is less than that in the GR. Although the representative agent can
consume more in a steady state GR capital stock, the impatience reflected in the rate of time
preference means that people are not as satisfied to reduce current consumption in order to reach
a higher long run GR consumption. Therefore, planners invest less to consume more today, but to
consume less in the long run.

So now the debate opens. Should planners invest more to maximize long run consumption or
invest less to maximize satisfaction from consumption? For the GR, consumption is certainly a
legitimate measurement of welfare. So to maximize long run consumption, planners ask people to
sacrifice more than they are willing by having them spend less than they wish. 6 Enough time
passes, planners hope that economic agents appreciate the intention to increase capital
accumulation and long term consumption. For the MGR, the better measurement of welfare is
human satisfaction. So to maximize human satisfaction, planners have people sacrifice just
enough as they are willing.

5
Usually, consumers have greater pleasure for consuming their income soon rather than later. Thus, >0.
Thus, +>.

6
In less democratic countries, “force the people” occurs more often than “ask the people”.

34 Chapter 3: Ramsey Model in Discrete Time

 Another factor that affects the analysis is population. When including such, a more realistic
budget constraint is (10). Thus, the Present Value Lagangean becomes

 
(45) LP    tU (Ct )   t [ f ( Kt )  Ct  (1  n) Kt 1  (1   ) Kt ].
t 0 t 0

The first order conditions are

LP
(46)   tU '(Ct )  t  0  t   tU '(Ct ).
Ct
LP  f '( Kt 1 )  1   
(47)  t (1  n)  t 1[ f '( Kt 1 )  1   ]  0  t  t 1  .
Kt 1  1 n 
LP
(48)  f ( Kt )  Ct  (1  n) Kt 1  (1   ) Kt  0.
t

Combining the first two yields

 f '( Kt 1 )  1   
(49) t   tU '(Ct )  t 1  .
 1 n 

Note that (46) implies

(50) t 1   t 1U '(Ct 1 ).

Then the IEC is

 f '( Kt 1 )  1   
 tU '(Ct )  [  t 1U '(Ct 1 )]  
 1 n 
(51)
 f '( Kt 1 )  1   
 U '(Ct )  U '(Ct 1 )  .
 1 n 

Following the steady state conditions given in (40), the above is

 f '( K )  1   
(52) U '(C )  U '(C )   .
 1 n

Since  is 1/(1+), then

 1   f '( K )  1   
(53) U '(C )   U '(C )    f '( K )      n   n.
 1    1 n

Dumlao: Notes in Macroeconomics, 2011. 35

The above is the MGR of accumulation taking population growth into account. The marginal
productivity of capital if there is population growth is greater than that if there is no population
growth as in (44). Via the law of diminishing marginal productivity, the total product of capital if
there is population growth is less than that if there is no population growth. This implies that
capital accumulation is less if there is population growth. Intuitively, greater population translates
to lower capital labor ratio. More so, greater population means more “impatient” people require
immediate consumption, and this translates to less capital accumulation.

To compare with the GR, the steady state condition (40) is imposed on 10 so that

(54) f ( K )  C  (1  n) K  (1   ) K  C  f ( K )  (1  n) K  (1   ) K.

In finding the optimal capital that maximizes consumption

dC
(55)  f '( K )  (1  n)  (1   )  0  f '( K )    n.
dK

The above is the GR of accumulation, taking population growth into account. The marginal
productivity of capital if there is population growth is greater than that if there is no population
growth (42). Via the law of diminishing marginal productivity, capital accumulation is less.
Intuitively, greater population translates to lower capital labor ratio. Finally, the capital
accumulation is less in MGR than in GR, the same way when there is no population growth.

III. Parametric Model

The following provides a parametric example of the Ramsey model. Assume the following.

1. U(Ct) = Ln(Ct). Therefore, U’(Ct) = 1/Ct.

2. f(Kt)=AKt such that 0<<1. This also implies that f’(Kt)= AKt-1.
3.  = 1. Thus, past capital totally and fully depreciates.

Because of the assumed parameters set, the IEC (25) becomes

 1  1 
   [ f '( K t 1 )  1   ]
 Ct
  Ct 1 
1 1
  [( A K t11 )  1   ]
Ct Ct 1
(56)
1 1
  [ A K t11  1  (1)]
Ct Ct 1
K t 1 K
  A t 1 .
Ct Ct 1

36 Chapter 3: Ramsey Model in Discrete Time

The first inserts the parametric value of marginal utility of consumption. The second inserts the
parametric value of the marginal productivity of capital. The third inserts the parametric value of
depreciation. The fourth rearranges the third equation.

Because of the assumed parameters set, the budget constraint (11) becomes

( AKt )  Ct  Kt 1  (1   ) Kt
(57)  AKt  Ct  K t 1  [1  (1)]K t
Ct  K t 1
 Kt  .
A

The first inserts the parametric value of the total productivity of capital. The second inserts the
parametric value of depreciation. The third simplifies and rearranges the second equation. This is
the budget constraint. The budget constraint implies that

Ct 1  Kt  2
(58) Kt1  .
A

Combining the above on the IEC (56) gives

 Ct 1  Kt  2 
 
 A   
Kt 1 A Kt 1 K
(59)     t  2 .
Ct Ct 1 Ct Ct 1

One can now apply the method of undetermined coefficients. Conjecture that the relevant
determinant of Kt+1/Ct is a constant . Then

Kt 1
(60)   t.
Ct

Inserting the above into the previous equation gives


(61)         .
1  

Therefore (60) is

Kt 1 
(62)  .
Ct 1  

To extend the analysis, the above is rearranged two ways – the first isolates capital and the
second consumption. Thus

Dumlao: Notes in Macroeconomics, 2011. 37

 
(63) Kt 1  Ct &
1  
1  
(64) Ct  Kt 1.


Inserting (63) into the budget constraint (57) gives

  
Ct   Ct 
(65) Kt   1     C  (1   ) AK  .
t t
A

The above presents the Optimal Consumption Rule. As income (AKt) increases, consumption
increases by (1-). Hence, (1-) is the marginal propensity to consume (MPC). Noting that the
scale of capital () is between zero and one, and the time factor () is almost always between
zero and one, then multiplying the two results to a number between zero and one. Finally,
deducting this to one results to the MPC that is between zero and one. For example, typical
lectures assume that the capital elasticity of output is one-third, or =0.33. Assume that the rate
of time preference is =0.1 then the discount factor is =1/(1+0.1). This calculates to 0.30
and an MPC of 0.7 which is close to its assumed value in typical lectures of the Keynesian
consumption function.

This agrees with intuition. Inserting (64) into the budget constraint (57) gives

 1   
  Kt 1   Kt 1
(66) Kt     Kt 1   AKt .
A

The above presents the Optimal Accumulation Rule. As income (AKt) increases, capital
accumulation increases by . Hence,  is the marginal propensity to save (MPS). As noted
above, the MPS () is between zero and one and this agrees with intuition. Note also that the
sum of MPC and MPS is one. Thus, all of income is accounted for. That is income is either
consumed or invested. Note the steady state level of capital. Since at steady state (40) holds, then

(67) K   AK   K  ( A )1/(1 )  K *.

Figure 3 shows the graphical implication of the previous two equations. The figure is
consistent with the convergence hypothesis. A stock of capital that is less than the steady state
level eventually increases capital level to the steady state. A stock of capital that is greater than
steady state level does just the opposite. Also, note the following. As technology improves, steady
state capital increases. As the scale of capital () increases, the return to capital increases, agents
invest more on capital, and steady state capital increases. Finally, as the representative consumer
becomes more patient, the rate of time preference () decreases,  increases, and steady state
capital increases.

38 Chapter 3: Ramsey Model in Discrete Time

 Figure 3

Kt+1 45 degree
f(K)

K2

K1

K0 K1 K2 K* Kt

Summary

The Ramsey model maximizes the representative agent’s utility subject to constraint. Ultimately,
the sacrificed utility from consuming today equals the present value of tomorrow’s total gain for
saving. At steady state, the marginal product of capital exactly equals the sum of the rate of time
preference and the rate of depreciation. Due to the rate of time preference, the Ramsey model
results to a lower capital accumulation than that of the Golden Rule.

Guide Problems

1. Derive and explain intuitively the representative agent’s total utility.

2. Derive and explain intuitively the representative agent’s budget constraint.
3. Explain intuitively the notion of transversality condition.
4. Given the representative agent’s total utility and budget constraint, derive and explain
intuitively the optimal solution.
5. Derive the Current Value Lagrangean and show how it resolves to the same solution as the
Present Value Lagrangean.
6. Derive the decentralized economy’s Present Value Lagrangean and show that it resolves to
the same solution as the centralized economy.
7. Derive and explain intuitively the implication of the steady state.
8. Derive and explain intuitively the capital accumulation difference between the Golden Rule
and the Modified Golden Rule.
9. Derive and explain intuitively the effect of including population growth in the Ramsey
model.
10. Use the parametric example to derive mathematically and graphically, and explain intuitively
how capital accumulation settles at a steady state level.

Dumlao: Notes in Macroeconomics, 2011. 39

40 Chapter 3: Ramsey Model in Discrete Time