Problem Set 3: More on The Ramsey

model

Problem 1 – Social Planner Problem

Consider the social planner problem for the Ramsey economy. Assume for simplicity
that there is no technological growth. Assume that population grows at rate n and
capital depreciates at rate δ. Thus the planner’s problem can be stated as
Z ∞
max e−(ρ−n)t u(c(t))dt
c(t) 0

subject to k̇(t) = f (k(t)) − (n + δ)k(t) − c(t)

k(0) given, NPG

where ρ > n
1. What are the control and state variables in the planner’s problem?
Answer: c(t) is the control variable, k(t) is the state variable.
2. Write the Hamiltonian for the optimization problem and apply the Maximum
Principle
Answer: The Hamiltonian is
H(t, c, k, λ) = e−(ρ−n)t u(c(t)) + λ(t) (f (k(t)) − (n + δ)k(t) − c(t))
The four conditions of the Maximum Principle are
∂H
= f (k(t)) − (n + δ)k(t) − c(t) = k̇(t) (1)
∂λ
∂H
= e−(ρ−n)t u0 (c(t)) − λ(t) = 0 (2)
∂c
∂H
= λ(t) (f 0 (k(t)) − (n + δ)) = −λ̇(t) (3)
∂k
TVC : lim k(t)λ(t) = 0 (4)
t→∞

3. Derive the Euler equation

Answer: We first use (2)
λ(t) = e−(ρ−n)t u0 (c(t)) ⇒ log(λ(t)) = −(ρ − n)t + log(u0 (c(t)))
We have
∂ log(λ(t)) λ̇(t) u00 (c(t))ċ(t)
= = −(ρ − n)
∂t λ(t) u0 (c(t))
ċ(t)
= −(ρ − n) − σ
c(t)

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 u00 (c(t))c(t)
using the definition σ = u0 (c(t))
. From (4) we then get
ċ(t)
−f 0 (k(t)) + (n + δ) = −(ρ − n) − σ
c(t)
ċ(t) 1
⇔ = (f 0 (k(t)) − δ − ρ)
c(t) σ

4. Characterize the steady state for this economy

Answer: The steady state values of consumption and capital per capita are found
by
ċ(t) = 0 ⇒ c∗ = 0 ∨ f 0 (k ∗ ) = ρ + δ
k̇(t) = 0 ⇒ c∗ = f (k ∗ ) − (n + δ)k ∗

5. Draw the phase diagram and show the model’s dynamics

Answer: The phase diagram is

The model dynamics are summarized by

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ċ(t) = (f 0 (k(t)) − δ − ρ)
σ(c(t))
k̇(t) = f (k(t)) − (n + δ)k(t) − c(t)

the TVC, and the initial stock of capital per capita, k(0).
The arrows in the phase diagram are due to
ċ(t) ≶ 0 ⇔ f 0 (k(t)) − δ − ρ ≶ 0 ⇔ k(t) ≷ k ∗
k̇(t) ≶ 0 ⇔ c(t) ≷ f (k(t)) − (n + δ)k(t)

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6. Explain, given k(0), how convergence to steady state come about
Answer: It comes about by consumption at time 0, c(0), being on the saddle-
path, and convergence to the steady state along the saddle-path afterwards. c(0)
below or above the saddle-path can be ruled out because it will result in move-
ments north-west or south-east, which can be ruled out by the TVC. For details
see lecture 5.

7. Assume that the economy is in a steady state and there is an unexpected per-
manent increase in the rate of depreciation δ. What is the best response to this
change? Does consumption initially increase or decrease?
Answer: An increase in δ moves the k̇ = 0 curve down, and the ċ = 0 curve to
the left. Consumption jumps to be on the new saddle-path.

(a) The downward movement of k̇ = 0 imply a downward jump in consumption

all else equal.
(b) The leftward movement of ċ = 0 imply an upward jump in consumption all
else equal
(c) Combined we cannot know the effect on consumption.

The diagram below show the case with a downward jump in consumption. It is
formally wrong because the saddle-path is above k̇ = 0 to the left of the new
steady state.

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Problem 2 – Shocks
Consider the Ramsey model summarized in
1 0
ċ(t) = (f (k(t)) − δ − ρ − σg)c(t)
σ
k̇(t) = f (k(t)) − (n + g + δ)k(t) − c(t)

1. Assume that economy is in steady state at time t0 . Show what happens to K(t),
L(t), Y (t), r(t) and w(t) if respectively

(a) L(t) suddenly drops discretely at time t0 (epidemic disease)

Answer: A discrete jump down in L(t) imply a discrete upward jump in
K(t)
k(t) = A(t)L(t) at time t0 because A(t) and K(t) are given. We then have
∗
k(t) > k . Convergence is as in question 6 to Problem 1 with k(t) returning
to k ∗ from above. Remember

r(t) = f 0 (k(t)) − δ
w(t) = [f (k(t)) − f 0 (k(t))k(t)]A(t))
Y (t) = f (k(t))A(t)L(t)

The upward jump in k(t) imply that r(t) decrease and w(t) increase because
∂r(t) ∂(f 0 (k(t)) − δ)
= = f 00 (k(t)) < 0
∂k(t) ∂k(t)
∂w(t) ∂([f (k(t)) − f 0 (k(t))k(t)]A(t))
= = −k(t)f 00 (k(t))A(t) > 0
∂k(t) ∂k(t)
From Y (t) = F (K(t), A(t)L(t)) we see that Y (t) also decrease on impact.
During the convergence r(t) increase again back to its steady state value.
During convergence Y (t) grow slower than g + n and w(t) slower than g
because k(t) is decreasing.
(b) K(t) suddenly drops discretely at time t0 (natural disaster)
Answer: A discrete jump down in K(t) imply a discrete downward jump
K(t)
in k(t) = A(t)L(t) at time t0 because A(t) and L(t) are given. Otherwise the
opposite of question a.
(c) n suddenly decreases permanently to n0 < n at time t0
Answer: This implies that the k̇ = 0 curve shifts upward. The new steady
state E 0 is directly above the old one, E. Convergence is immediate with a
jump upward in c(t) at time t0 . Neither K(t), L(t), Y (t), r(t) nor w(t) react
on impact, but K(t), L(t) and Y (t) grows less afterwards.
(d) n decrease to n0 < n at time t0 , but is known to return to n at time t1
Answer: Temporary shocks needs to be analyzed backwards:

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 i. For t → ∞ we must end up in E (as the change is temporary).
ii. At time t1 when there is no more changes we must be on the saddle-path
around E.
iii. From time t0 to t1 the model dynamics are governed by E 0 because the
change is then in effect.
iv. At time t0 capital per capita is fixed, but c(t) jump to ensure that we
end up exactly on the required saddle-path. (We cannot have expected
jumps in c(t) due to the Euler equation).
v. t0 : c(t) jump to a point A between E and E 0
vi. t ∈ (t0 , t1 ): c(t) move south-east.
vii. t = t1 : c(t) exactly reach a point B north-east of E on its saddle-path.
viii. Other jumps in c(t) can be ruled out due to the TVC.

(Given the time path of k(t) the time path of K(t), L(t), Y (t), r(t) and w(t)
can simply be derived using the formulas from question a)
(e) n is known to decrease to n0 < n at time t1
Answer: Expected shocks needs to be analyzed backwards:
i. For t → ∞ we must end up in E 0 (as the change is permanent).
ii. At time t1 when there is no more changes we must be on the saddle-path
around E 0 .
iii. From time t0 to t1 the model dynamics are governed by E because the
change is not in effect yet.
iv. At time t0 capital per capita is fixed, but c(t) jump to ensure that we
end up exactly on the required saddle-path. (We cannot have expected
jumps in c(t) due to the Euler equation).
v. t0 : c(t) jump to a point A between E and E 0 .

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 vi. t ∈ (t0 , t1 ): c(t) move north-west.
vii. t = t1 : c(t) exactly reach a point B south-west of E 0 on its saddle-path.
viii. Other jumps in c(t) can be ruled out due to the TVC.

(Given the time path of k(t) the time path of K(t), L(t), Y (t), r(t) and w(t)
can simply be derived using the formulas from question a)

Problem 3 – Endogenous Growth

1. What is endogenous growth?
Answer: A model generates endogenous growth if it it implies growth even
without exogenous growth in technology and/or in population (g = n = 0).

2. Is there endogenous growth in the Solow or Ramsey model?

Answer: In the Solow-model both saving and growth is exogenously determined.
In the Ramsey-model saving is endogenously determined, and in that sense the
growth while converging to the state steady is endogenous. The long-run growth
in the Ramsey model is, however, completely exogenous. If g = n = 0 there is no
long-run growth in the Ramsey model.

Problem 4 – Government and Taxes

Consider a Ramsey model where population grows at the rate n, and physical capital
depreciates at the rate δ. Suppose that capital income is taxed at the constant rate τ .
This implies that the representative household faces the real after tax interest income

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(1 − τ )r . Assume further that the government return the tax revenue to the household
through lump-sum transfers.

1. Find the household’s Euler equation

Answer: The Hamiltonian is

H(t, c, a, λ) =u(c(t)) · e−(ρ−n)t

− λ(t) [a(t) (r(t)(1 − τ ) − n) + w(t) − c(t) + x(t)]

The Maximum Principle implies

∂H
= ȧ(t) = w(t) − c(t) + a(t) [r(t)(1 − τ ) − n] + x(t) (H1)
∂λ
∂H
= e−(ρ−n)t · u0 (c(t)) − λ(t) = 0 (H2)
∂C
∂H
= λ(t) (r(t)(1 − τ ) − n) = −λ̇(t) (H3)
∂a
lim a(t)λ(t) (T V C)
t→∞

From H2

λ(t) = e−(ρ−n)t · u0 (c(t)) ⇔

ln(λ(t)) = −(ρ − n)t + ln(u0 (c(t)))

λ̇(t) ∂ ln(λ(t)) 1
= = −(ρ − n) + 0 · u00 (c(t)) · ċ(t)
λ(t) ∂t u (c(t))
λ̇(t) ċ(t)
⇒ = −(ρ − n) − σ ·
λ(t) c(t)
00
with σ = − uu0 (c(t))
(c(t))

Using H3

λ̇(t)
= −(r(t)(1 − τ ) − n) ⇔
λ(t)
ċ(t)
−(ρ − n) − σ · = −(r(t)(1 − τ ) − n) ⇔
c(t)
ċ(t)
σ· − (ρ − n) + (r(t)(1 − τ ) − n) ⇔
c(t)
ċ(t) r(t)(1 − τ ) − ρ
=
c(t) σ

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2. Construct the phase diagram of the model dynamics
Answer: The factor prices in the Ramsey model are

r(t) = f 0 (k(t)) − δ (F1)

0
w(t) = f (k(t)) − k(t)f (k(t)) (F2)

Therefore
1
ċ(t) = c(t) · ((f 0 (k(t)) − δ) (1 − τ ) − ρ)
σ
This implies that the ċ = 0 curve is
ρ
ċ(t) = 0 ⇒ c∗ = 0 ∨ f 0 (k ∗ ) = +δ
1−τ

Increasing τ thus move the ċ = 0 curve to the left because f 00 < 0.

In equilibrium we have a(t) = k(t) and x(t) = τ r(t)k(t). The budget constraint
of the households consequently implies

ȧ(t) = w(t) − c(t) + a(t) (r(t)(1 − τ ) − n) + x(t) ⇔

k̇(t) = f (k(t)) − k(t) · f 0 (k(t)) − c(t) + k(t) ((f 0 (k(t)) − δ)(1 − τ ) − n)
+ (f 0 (k(t)) − δ) · τ · k(t)
= f (k(t)) − k(t) · f 0 (k(t)) − c(t) + k(t) · f 0 (k(t)) − k(t) · f 0 (k(t)) · τ
− k(t) · δ · (1 − τ ) + τ · f 0 (k(t)) · k(t) − τ · δ · k(t) − k(t) · n
= f (k(t)) − n · k(t) − c(t) − k(t) · δ
= f (k(t)) − (n + δ) · k(t) − c(t)

i.e. the standard differential equation for k̇(t).

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3. Assume that initially the economy is in steady state with no capital taxation.
How does the economy react to the unexpected introduction the tax? How does
capital and consumption instantaneously respond to the introduction of the tax,
and how does the new steady state compare to the situation without taxation?
Answer: The ċ = 0 loci move to the left. Consumption jump up to be on the
new stabble-path. Capital per capita can not jump. The new steady state has
less capital. The intuition is that the value of capital falls with the introduction
of capital taxation implying that the households wants to dis-save.
y ∗ −c∗
4. Show that the saving rate on the balanced growth path, s∗ = y∗
is decreasing
in τ
Answer: We have
y ∗ − c∗ f (k ∗ ) − c∗
s= =
y∗ f (k ∗ )
f (k ∗ ) − f (k ∗ ) + (n + δ)k ∗ k ∗ (n + δ)
= =
f (k ∗ ) f (k ∗ )

∂k∗ ∂f ∂k∗
∂s ∂τ
· (n + δ) · f (k ∗ ) − k ∗ (n + δ) · ∂k∗
· ∂τ
=
∂τ (f (k ∗ ))2
 
∂k∗
∂τ
· (n + δ) 
f (k ∗ ) − k ∗ · f 0 (k ∗ ) < 0,
 ∂k ∗
= da <0
(f (k ∗ ))2  | {z } ∂τ
=w(t)>0

5. How would your answers to the questions 1-4 change if the government purchased
goods, G(t), with the tax proceeds instead of making lump-sum transfers? Assume
that
c(t)1−σ
u(c(t), G(t)) = + h(G(t))
1−σ
for an arbitrary C 1 function h.
Answer: The basic point of this exercise is that the Euler equation is unchanged
(neither of the conditions of the Maximum Principle are affected) but that differ-
ential equation for k̇(t) is affected because (see question 2)

k̇(t) =f (k(t)) − k(t) · f 0 (k(t)) − c(t) + k(t) [(f 0 (k(t)) − δ)(1 − τ ) − n]

=f (k(t)) − n · k(t) − δ · k(t) − c(t) − τ · k(t) · (f 0 (k(t)) − δ)
=f (k(t)) − (n + δ) · k(t) − c(t) − τ (k(t) · (f 0 (k(t)) − δ)
=f (k(t)) − (n + (1 − τ )δ) · k(t) − c(t) − τ k(t)f 0 (k(t))

The remaining analysis features some unforeseen and uninteresting complications,

so forget about it.

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6. Answer question 3 again assuming that the introduction of the capital income tax
is announced some time before it is implemented (and as before the tax revenue
will be rebated lump sum).
Answer: The steady state E1 (old) and E2 (new) are the same as in question 3.
Expected shocks needs to be analyzed backwards:

(a) For t → ∞ we must end up in E2 (as the change is permanent).

(b) At time t1 when there is no more changes we must be on the saddle-path
around E2 .
(c) From time t0 to t1 the model dynamics are governed by E1 because the
change is not in effect yet.
(d) At time t0 capital per capita is fixed, but c(t) jump to ensure that we end
up exactly on the required saddle-path. (We cannot have expected jumps in
c(t) due to the Euler equation).
(e) t0 : c(t) jump to a point A directly above E1 .
(f) t ∈ (t0 , t1 ): c(t) move north-west.
(g) t = t1 : c(t) exactly reach a point B north-east of E2 on its saddle-path.
(h) Other jumps in c(t) can be ruled out due to the TVC.

Consumption jumps less upwards than in question 3, but then increase as the
introduction of the tax approaches. The intuition for the smaller jump is that the
effect of the tax reform is smaller because it takes affect later. When consumption
jumps up capital per capita begins to decrease putting upward pressure on the
interest rate implying positive growth in consumption. When the tax reform
comes into place, the effect interest rates fall implying negative consumption
growth.

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