Lecture01 Exo

Growth Accounting
The Solow Model

Savings behaviour
The Ramsey Model
Growth Theory
Lecture 1, Exogenous Growth
Economic Policy in Development
February 2011
Lecture 1, Exogenous Growth 1/104 Economic Policy in Development

Growth Accounting
The Solow Model
Savings behaviour
The Ramsey Model
Outline
Growth Accounting
Growth Accounting: Objective and Technical Framework
TFP residual
Decomposing growth in GDP per worker
Results
The Solow Model

Model Setup
Steady state (simple case)
Balanced Growth (with popul. and prod. growth)
Savings behaviour
Preferences, Budget constraint, Optimal choice
Consumption smoothing
Intertemporal-substitution and wealth effects
Taxes in the two-period model
The Ramsey Model

Main Ingredients of the Model
Definition of Equilibrium
Characterizing Equilibrium Quantities
Steady state and Dynamics

Growth Accounting Growth Accounting: Objective and Technical Framework
The Solow Model TFP residual
Savings behaviour Decomposing growth in GDP per worker
The Ramsey Model Results
Growth Accounting: Objective 3
I Many factors play role to determine output in a country

I Certainly, size of the labour force and capital stock do
I But also, education, government regulation, weather,...
I Any theory of economic growth chooses which of these

factors to emphasize as
I sources of GDP growth within countries
I explanation for differences in levels/growth rates across
countries
I Growth accounting:
tool to evaluate relative importance of such factors →
Theory & Policy Implications
Technical framework 4
I Ignore the demand side for now

I Carefully specify the supply side
I Inputs: capital, K , and labour, L
I Output, Y
I State of technology, A

Technology, F 5
Y = F (K , AL) where
Y = output
K = capital (input / factor)
L = labour (input / factor)
A = state of technology
H = AL = effective labour
Assumptions
I Marginal products positive and diminishing
I Constant returns to scale

Marginal products 6
I Marginal product of labour

∂F
I
∂L = FL > 0 positive
2
∂ F
I
∂L2
= FLL < 0 and diminishing
I Marginal product of capital

∂F
I
∂K = FK > 0 positive
2
∂ F
I
∂K 2
= FKK < 0 and diminishing

Constant returns to scale (CRS) 7
F (λK , AλL) = λF (K , AL) for λ > 0
I Implications of CRS
I Size (of firms) does not matter → representative firm
I Euler’s theorem: Factor payments exhaust the output
I See example

Cobb-Douglas production function 8
F (K , AL) = K α (AL)1−α 1>α>0

I CRS?
F (λK , AλL) = (λK )α (AλL)1−α

= λα K α λ1−α (AL)1−α
= λα λ1−α K α (AL)1−α
= λK α (AL)1−α
= λF (K , AL)
Yes, Cobb-Douglas production function is CRS.

Cobb-Douglas production function 9
F (K , AL) = K α (AL)1−α 1>α>0

I CRS? Yes.
I Positive and diminishing MP?
FK (K , AL) = αK α−1 (AL)1−α > 0
FL (K , AL) = (1 − α)K α A1−α L−α > 0
FKK (K , AL) = α(α − 1)K α−2 (AL)1−α < 0
FLL (K , AL) = (1 − α)(−α)K α A1−α L−α−1 < 0
Yes, Cobb-Douglas production function has positive and

diminishing MPs.
Profit maximizing firm(s) 10
Π(K , AL) = F (K , AL) − rK − wL

I Firms take prices as given and choose inputs K and L
I First order conditions
∂Π
I
∂K = FK (K , AL) − r = 0
∂Π
I
∂L = FL (K , AL) − w = 0
I Firm picks K and L such that

I FK (K , AL) = r
I FL (K , AL) = w

Profit maximizing firms with CD production function 11
I With CD production function, FOCs become
FK (K , AL) = αK α−1 (AL)1−α = r

FL (K , AL) = (1 − α)K α A1−α L−α = w
I Or, rearranging
AL 1−α
FK (K , AL) = α =r
K
K α
FL (K , AL) = (1 − α)A =w
AL

Euler’s Theorem with CD production function 12
rK + wL = F (K , AL)
Factor payments exhaust production.
I We have
AL 1−α
r = FK (K , AL) = α
K
K α
w = FL (K , AL) = (1 − α)A
AL
I Therefore,
rK + wL = FK (K , AL)K + FL (K , AL)L

Euler’s Theorem with CD production function 13
I We had
rK + wL = FK (K , AL)K + FL (K , AL)L
I Therefore, substituting in functional forms for FK (K , AL)

and FL (K , AL) from the previous slide, we get:
h AL 1−α i h K α i
rK + wL = α K + (1 − α)A L
K AL
= αK α (AL)1−α + (1 − α)K α (AL)1−α
= K α (AL)1−α
= F (K , AL)

One large firm or many small firms 14
I Since firms take prices as given,

I and assuming A and α are the same for all firms
I from FOCs, we get
L 1−α
r = FK (Ki , ALi ) = αA1−α i
Ki
K α
i
w = FL (Ki , ALi ) = (1 − α)A1−α
Li
I Capital-labor ratio, k ∗ = KLii , chosen is the same for all firms

(indexed by i).
I Using the CRS assumption, total output by many firms can
be represented by output of one firm
Steps for growth accounting 15
I TFP residual, At , for K only production function

I TFP residual, At , across countries: K only
I TFP residual, At , including human capital
I TFP residual, At , across countries: K and H
I Decomposing growth in GDP per worker: K only
I Decomposing growth in GDP per worker: K and H
I Summary of results
I Critique

TFP, At , as residual for K only production function 16
I From the production function in year t

Yt = At Ktα L1−α
t
I Denoting “per worker” variables in lower case letters,

i.e., output per w. yt = YLtt and capital per w. kt = KLtt
I After dividing by Lt , we rewrote production function
Yt
Lt = At ( KLtt )α ( LLtt )1−α as yt = At ktα
I Hence, by rearranging we got
yt
At = ktα

TFP residual, At , across countries: K only 17
UK, South Korea and India

TFP
(Accounting for Physical Capital Only)
1400.00
1200.00
1000.00
800.00
U.K.
Korea
600.00 India
400.00
200.00
0.00
1960 1965 1970 1975 1980 1985 1990 1995

CRS production function with physical and human

capital 18
I Now include human capital (e.g., years of education) into

production function (Make sure production function is CRS
and positive and diminishing MP)
I We will use Yt = At F (Kt , Ht , Lt ) = At Ktα Htβ Lt1−α−β ,
with α, β ∈ [0, 1] (parameters)
I Note: At F (λKt , λHt , λLt ) = λAt F (Kt , Ht , Lt ) → CRS
I Homework: → Show that this production function is CRS
→ Check that MP of physical capital, K , human capital, Ht
and labor Lt are positive and diminishing

TFP as residual for production function with K and H

19
I From the production function in year t

Yt = At Ktα Htβ Lt1−α−β
I Denoting “per worker” variables in lower case letters,
i.e., output per w. yt = YLtt , phys. capital per w. kt = KLtt and
ht
human capital per w. ht = Lt
I After dividing by Lt , we can rewrite the production function
Yt Kt α Ht β Lt 1−α−β
Lt = A t ( Lt ) ( Lt ) ( Lt ) as yt = At ktα htβ
I Hence, by rearranging we get
At = αyt β
kt ht

Compare At for the 2 production functions 20
I Residual for production function with physical capital only

At = kyαt
t
I Residual for production function with human capital

At = αyt β
kt ht
I Difficult to measure β
I In data computations below, I used α = β = 0.3

TFP residual, At , across countries: K and H 21
TFP
(Accounting for Physical and Human Capital)
1400.00
1200.00
1000.00
800.00
U.K.
Korea
600.00 India
400.00
200.00
0.00
1960 1965 1970 1975 1980 1985 1990 1995

TFP residual, At , across countries: K only 22

TFP
1400.00
1200.00
1000.00
800.00
U.K.
Korea
600.00 India
400.00
200.00
0.00
1960 1965 1970 1975 1980 1985 1990 1995

TFP ratio: Korea and India relative to U.K. (K only) 23
TFP ratios
80%
70%
TFP Ratio Korea/UK (K only)
60% TFP Ratio India/UK (K only)
50%
40%
30%
20%
10%
0%
1960 1965 1970 1975 1980 1985 1990 1995

TFP ratio: Korea and India relative to U.K. (K and H)

24
TFP ratios
(Accounting for Physical and HumanCapital)
80%
TFP Ratio Korea/UK (K only)
70%
TFP Ratio India/UK (K only)
60% TFP Ratio Korea/UK (K and H)

TFP Ratio India/UK (K and H)
50%
40%
30%
20%
10%
0%
1960 1965 1970 1975 1980 1985 1990 1995

Decomposing GDP per worker growth: K only 25
I Now that we have a series for At , we want to decompose

growth in GDP per worker into growth in the capital stock
versus growth in productivity.
I Last time, we derived

log yt+1 − log yt = log At+1 − log At + α log kt+1 − log kt
log yt+1 −log yt log At+1 −log At log k −log k

t
log yt+1 −log yt = log yt+1 −log yt + α log yt+1
t+1 −log yt
log At+1 −log At log k −log k

t
1 = 100% = log yt+1 −log yt + α log yt+1
t+1 −log yt

UK, Korea and India 26
Growth Accounting with physical capital only

Decomposing GDP per worker growth: K and H 27
I Now that we have a series for At , we want to decompose

growth in GDP per worker into growth in the capital stock
versus growth in human capital versus growth in
productivity (TFP).
I Growth in output per worker is
yt+1 At+1 (kt+1 )α (ht+1 )β
yt = At (kt )α (ht+1 )β
yt+1 At+1 kt+1 α ht+1 β
yt = At ( kt ) ( ht )
I Next, as before we go to logs so we have a sum.

Decomposing GDP per worker growth: K and H 28
log yt+1 − log yt =

log At+1 − log At + α log kt+1 − log kt + β log ht+1 − log ht
log yt+1 −log yt log At+1 −log At log k −log k

t log h t −log h
log yt+1 −log yt = log yt+1 −log yt + α log yt+1
t+1 −log yt
t+1
+ β log yt+1 −log yt
log At+1 −log At log k t−log k log ht −log h

1 = 100% = log yt+1 −log yt + α log yt+1
t+1 −log yt
t+1
+ β log yt+1 −log yt

UK, Korea and India 29
Growth Accounting with physical and human capital

Summary of Results 30
I TFP in the UK > TFP Korea AND India

→ For given inputs output in the UK is higher than in Korea
and India
I When accounting for higher educational attainment,
differences in TFP are smaller
→ Adding H as input shows that India is not that much less
productive than the UK; educational attainment (on
average) is lower

Summary of Results 31
I GDP growth accounting:

increase in human capital (average years of education)
accounts for a major part of growth in India
I Hence, omitting human capital in growth accounting can
lead to erroneous conclusions

Critique 32
I Interpretation of TFP?
I Technological change?
I Deregulation?
I Regulation??
I Why did trend change?
I Other factors
I Human capital? → Done
I Capital-skill complementarities?
I Quality of capital?

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
From Growth Accounting to the Solow Model 33
I In growth accounting
→ link of inputs in period t to output in period t
→ no link of inputs or output across periods (t versus t + 1)
I Solow model links
→ population/labor force, productivity and, in particular,
capital stock in year t
to
→ labor force, productivity and capital stock in year t + 1
I Solow (1956), Solow (1957) and Solow (1960)

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
From Growth Accounting to the Solow Model 34
I Solow’s story about how the capital stock evolves over time
I Households save → investment
I Households save a (constant) fraction s ∈ [0, 1] of their
income every period/year
I Households consume the rest, i.e., fraction (1 − s) of
income
I Aggregate income : Yt
I Aggregate investment = It = sYt
I Law of motion of aggregate capital (δ ∈ [0, 1])

Kt+1 = (1 − δ)Kt + It

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Kaldor facts: Stylized facts of economic growth 35
1. The labor share and the capital share are almost constant
over time.
2. The ratio of aggregate capital to output is almost constant
over time.
3. The return to capital is almost constant over time.
4. Output per capita and capital per worker grow at a roughly
constant and positive rate.
5. Different countries and regions within a country that start
out with a different level of income per capita tend to
converge over time.

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Understanding growth differences across time and

across countries 36
I Why do (developed) countries grow?

I Will developing countries catch up to developed countries?
I Solow model:
a first attempt to explain the mechanics of growth
I Implications of Solow’s theory:
differences in initial condition, effectiveness of labor and
population growth matter

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Assumptions of the Solow model 37
I Assumptions
I Inputs: capital, Kt and labor Lt
I Production function: neo-classical production function
I Depreciation:
capital depreciates at rate δ ∈ [0, 1] from t to t + 1
I Evolution of technology:
At+1 = (1 + g)At ,
I Evolution of population (labor force*):
Lt+1 = (1 + n)Lt
I where δ, g and n are exogenously given parameters

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Assumptions of the Solow model 38
I Last Assumption
I Consumption and savings:
consumers save a constant fraction s of their income, yt ,
consume fraction (1 − s) (s parameter)
I Per person income is: yt = rt kt + wt `t
I Labor is supplied inelastically & normalized to `t = 1
I Savings per person are: syt

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Aggregating consumers 39
I Savings per person are: syt = rt kt + wt

I Multiplying by the number of people in period t
Aggregate Savings/Investment
= It = Lt syt = Lt s(rt kt + wt ) = s(rt Kt + wt Lt )

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Firm’s problem (see above) 40
h i
max Π(Kt , At Lt ) = max F (Kt , ALt ) − rt Kt − wt Lt
I Firms take prices as given and choose inputs K and L
I First order conditions
∂Πt
I
∂Kt = FK (Kt , At Lt ) − rt = 0
∂Πt
I
∂Lt = FL (Kt , At Lt ) − wt = 0
I Firm picks Kt and Lt such that

I FK (Kt , At Lt ) = rt
I FL (Kt , At Lt ) = wt

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Law of motion of aggregate capital stock 41
I Using the solution to the firm’s problem, we showed that

rt Kt + wt Lt = F (Kt , At Lt ) = Yt (lecture 2)
I Using the aggregation over consumers, we saw earlier
It = s(rt Kt + wt Lt )
I Therefore, It = sYt = sF (Kt , At Lt )
I Law of motion of aggregate capital
Kt+1 = (1 − δ)Kt + It
I Consider Kt+1 as a function of Kt

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Law of motion: simple case n = 0 and g = 0 42
I Consider Kt+1 as a function of Kt :

Kt+1 = (1 − δ)Kt + It
Kt+1 = (1 − δ)Kt + sYt
Kt+1 = (1 − δ)Kt + sF (Kt , ĀL̄)
I Since marginal product of K positive,
→ law of motion: increasing function
I Since marginal product of K diminishing
→ law of motion: concave function

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Solow’s law of motion 43
50
45
40
35
30
K_t+1
25
20
Kt+1 = Kt (45 degree line)
15
10
Kt+1 = (1-delta) Kt + s F(Kt,AL)
0
0 10 20 K_t 30 40 50

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Solow’s law of motion 44
50
45
40
35
30
K_t+1
25
20
15
10
0
0 10 20 K_t 30 40 50

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Steady state 45
The state variable of this economy is capital Kt

I We say that the economy is at a steady state if the state
variable remains constant.
I That is capital is constant at K ∗ ,
K ∗ = Kt = Kt+1
I Using the C-D production function, we get
Kt+1 = (1 − δ)Kt + sKtα (ĀL̄)1−α
K ∗ = (1 − δ)K ∗ + s(K ∗ )α (ĀL̄)1−α
I Solving this equation for K ∗ yields*
1
K ∗ = ( sδ ) 1−α AL̄

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Comparative statics 46
1
K ∗ = ( sδ ) 1−α ĀL̄
I If s increases, → K ∗ increases *
I If δ increases, → K ∗ decreases*
I If A increases, → K ∗ increases*
I If L increases, → K ∗ increases*

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Comparative dynamics 47
I Suppose the level of the capital stock in some economy
(country) at time t is at its steady state level
1
Kt = K ∗ = ( sδ ) 1−α ĀL̄
I That is, there is no more growth, i.e. Kt+1 = Kt .
I In t + 1, s suddenly increases to s0 > s,
→ sF (Kt , AL) increases to s0 F (Kt , AL)
0
→ K ∗ increases to K ∗ > K ∗
I On the graph, we can see that now, the economy starts
growing again, i.e. Kt+2 > Kt+1
0
I ...until the capital stock reaches the new steady state...K ∗
Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Homework 48
I Derive the same reasoning for *

I If δ decreases or increases
I If A decreases or increases
I If N decreases or increases*

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Balanced growth: n 6= 0 and g 6= 0 49
At+1 = (1 + g)At ,
I Evolution of population (labour force*):
Lt+1 = (1 + n)Lt
I Law of motion of aggregate capital
Kt+1 = (1 − δ)Kt + sF (Kt , At Lt )
Kt
I Want to find growth rate of capital per worker, kt = Lt and
Yt
GDP per capita yt = Lt

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Balanced Growth: Steady state in units of effective

labour 50
I Let
Yt
ŷt = At Lt output per unit of effective labour
Kt
k̂t = At Lt capital per unit of effective labour
I Then we can write
ŷt At Lt = Yt
k̂t At Lt = Kt
I Law of motion becomes
Kt+1 = (1 − δ)Kt + sYt or,
k̂t+1 At+1 Lt+1 = (1 − δ)k̂t At Lt + sŷt At Lt

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
→ Law of Motion 51
I Law of motion becomes
Kt+1 = (1 − δ)Kt + sYt or,
k̂t+1 At+1 Lt+1 = (1 − δ)k̂t At Lt + sŷt At Lt or,
k̂t+1 (1 + g)At (1 + n)Lt = (1 − δ)k̂t At Lt + sŷt At Lt
k̂t+1 (1 + g)(1 + n) = (1 − δ)k̂t + sŷt

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
→ Law of Motion 52
I Law of motion for capital per unit of effective labour

h i
1
k̂t+1 = (1+g)(1+n) (1 − δ)k̂t + sŷt
Yt F (Kt ,At Lt )
I Note that ŷt = At Lt = At Lt = k̂tα

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Steady state in detrended variables

(i.e. per unit of effective labour) 53
I Using ŷt = k̂tα , law of motion for k̂t

h i
k̂t+1 = 1
(1+g)(1+n) (1 − δ)k̂t + sk̂tα
I Show that k̂t+1 is an increasing and concave function of k̂t

if α, δ ∈ [0, 1], g, n ∈ [−1, 1]

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Solow’s law of motion (capital per u. of eff. labour) 54
50
45
40
35
30
K_t+1
25
20
15
10
0
0 10 20 K_t 30 40 50

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Balanced Growth: Per capita/worker var’s 55

I Steady state ito capital per u. of eff. labour
h i
1
k̂t+1 = (1+g)(1+n) (1 − δ)k̂t + sk̂tα
I This again can be solved for k̂ ∗ , the value for which capital
per unit of effective labour does not change anymore, i.e.
k̂t = k̂t+1 = k̂ ∗
1
s 1−α
* k̂ ∗ = g+n+ng+δ
I Higher population growth implies lower level of capital
stock per unit of effective labor in the long run, but growth
rate of per capita variables unaffected

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Capital per worker and GDP per capita 56
I When the capital stock per unit of effective labour, k̂t ,

reaches its steady state level k̂ ∗ , we get:
I Growth rate of capital per worker:
Kt +1 At +1 Kt +1
kt+1 Lt +1 At +1 Lt +1 At+1 k̂ ∗
= Kt
= At Kt
= = (1 + g)
kt Lt At Lt At k̂ ∗
I Growth rate of output per capita:
1−α
yt+1 k α At+1 k α A 1−α
t+1 t+1
= t+1 1−α
= = (1 + g)α (1 + g)1−α
yt ktα At kt At
= (1 + g)

Growth Accounting
Model Setup
The Solow Model
Savings behaviour
The Ramsey Model
Balanced Growth: Wage and rental rate of capital 57
I Growth rate of wages
α (A
(1 − α)Kt+1 −α A
wt+1 F (t + 1) t+1 Lt+1 ) t+1
= K =
wt FK (t) (1 − α)Ktα (At Lt )−α At
k̂ ∗ α A
t+1
=
k̂ ∗ A t
= (1 + g)
I Show that the rental rate on capital, rt ,

is constant along the BGP

Growth Accounting Preferences, Budget constraint, Optimal choice
The Solow Model Consumption smoothing
Savings behaviour Intertemporal-substitution and wealth effects
The Ramsey Model Taxes in the two-period model
Solow model and Savings Behaviour 58
Recall that in the Solow model

I the savings rate was an exogenous constant (parameter)
I therefore aggregate investment was a constant fraction of
output/aggregate income
Suppose you know that whatever you save, the government will
tax at 100% next year. How much would you save versus
consume this year? About nothing – unless you can hide it
really well...
Hence questions such as: What is the effect of capital gains
taxes? cannot seriously be addressed in the Solow model.
However, the Solow model DID teach us that the savings rate is
important for growth.
The Model 59
Income
I Consider a household that receives an exogenous flow of

income in each period of time
I We restrict the number of periods to be 2: t and t + 1
I Denote income in each period by yt and yt+1
I Assume there are perfect financial markets where the
household can freely borrow and lend by holding assets or
debt, at+1 , at an interest rate r

The Model 60
Preferences
I Preferences of the household are defined over sequences
of consumption {ct , ct+1 }
I We assume that instantaneous utility can be represented
by a standard utility function: u(c) [i.e. u(.) is increasing,
twice differentiable, concave and satisfies Inada
conditions*]
I Life-time utility is the discounted sum of instantaneous
utilities → The agent has a subjective rate of time
preference ρ so that the discount factor is 1/(1 + ρ) < 1
→ high ρ means impatient
→ low ρ means patient

The Model 61
Preferences
I Life-time utility is
1
V (ct , ct+1 ) = u(ct ) + u(ct+1 )
1+ρ
1
I Sometimes we will define β ≡ 1+ρ and write utility as
V (ct , ct+1 ) = u(ct) + βu(ct + 1)
β is the discount factor

The Model 62
Budget constraint
I The agent faces two period-by-period constraints
ct + at+1 = yt
ct+1 = yt+1 + (1 + r )at+1
I The assumption of perfect financial markets means that
consumption is not restricted to equal income
I Agent can allocate consumption in many different ways
I In fact, he faces a single constraint:
the intertemporal budget constraint
I It follows from aggregating over time as follows:
1 1
ct + 1+r ct+1 = yt + 1+r yt+1
The Model 63
Budget constraint
I It follows from aggregating over time that:
1 1
ct + 1+r ct+1 = yt + 1+r yt+1
I In other words, the present value of consumption cannot
exceed the present value of income (or wealth)
I This can be represented graphically*
I Only at the point corresponding to the endowment, saving
(borrowing (-) or lending (+)) is zero

Household’s optimization problem 64
Given yt , yt+1 and r
max u(ct ) + βu(ct+1 )

ct ,ct+1
1 1
s.t. ct + ct+1 = yt + yt+1
1+r 1+r
or, equivalently,

ct ,ct+1
s.t. ct + at+1 = yt
ct+1 = (1 + r )at+1 + yt+1

Solution to the optimization problem 65
Graphical solution*
I Using the first formulation, the problem and the solution

can be represented in the typical indifference-curve
diagram on the (ct , ct+1 ) - space
I The optimal choice is characterized by the allocation where
the intertemporal budget constraint (with slope −(1 + r )) is
tangent to an indifference curve

Solution to the optimization problem 66
Analytical solution
I This solution is characterized by a FOC and the budget

constraint (2 equations for 2 unknowns (ct , ct+1 ))
I The FOC reads,
1+r 0
u 0 (ct ) = u (ct+1 )
1+ρ
= β(1 + r )u 0 (ct+1 )
I This is called the Euler equation

Consumption smoothing 67
I The FOC implies that the change in consumption over time

depends entirely on the form of the utility function, u(.), ρ
and r
I The time-profile of income does not matter for the
time-profile of consumption (holding present value of
life-time income fixed)
I The present value of income is only important in
determining the level consumption in the two periods, but
not the steepness of the consumption path

Consumption smoothing 68
I Consider in particular the situation where interest rate

equals the rate of time preference: r = ρ
I In this case, consumption is the same in the two periods
even if income is not
I This captures the implication of concave utility functions for
consumption: agents tend to prefer smooth consumption
paths
I They can do that because they can borrow and lend
I To see more specifically how the interest rate can alter the
optimal path of consumption, it proves convenient to use a
specific yet fairly general form for the utility function...
Constant-elasticity-of-substitution utility 69
I We use the following,
c 1−σ
u(c) = if σ 6= 1
1−σ
= log c if σ = 1
I It turns out that σ determines the household’s willingness

to shift consumption across periods:
→ the smaller is σ,
→ the more slowly marginal utility ↓ as consumption ↑
→ the more willing is the household to allow its
consumption to vary over time (if r differs from ρ)

I This can be seen from the FOC,

1+r 0
u 0 (ct ) = u (ct+1 )
1+ρ
I Using the CES utility function*,

ct+1 1 + r σ1
=
ct 1+ρ
I If σ is close to zero, then utility is close to linear and the

household is willing to accept large swings in consumption
to take advantage of small differences between ρ and r
I In fact the intertemporal elasticity of substitution, IES, is

closely related to σ
I The IES is defined as
(c) 0
θ(c) = − uu00 (c)c
I This is essentially a measure of the curvature of the utility

functions and, therefore, of the willingness to accept
swings in consumption over time
I With the CES utility function, the IES becomes*
(c) 0
θ(c) = − uu00 (c)c = 1/σ

I With the CES utility function, the IES becomes*

(c) 0
θ(c) = − uu00 (c)c = 1/σ
I That is σ is the inverse of θ: θ = 1/σ
I Since σ is constant, θ is constant and u(.) is said to be of
CES type
I Note that with uncertainty σ characterizes the degree of
risk-aversion and this type of utility functions are also
known as constant-relative-risk-aversion (CRRA) utility
functions (see that later)
I Clearly, θ = 1/σ determines the responsiveness of the
slope of the consumption path to changes in the interest
rate
Intertemporal-substitution and wealth effects 73
Intertemporal substitution and r

I θ = 1/σ determines the responsiveness of the slope of the
consumption path to changes in the interest rate
I Higher r implies that optimal consumption grows faster
over time
I This does not depend on the time path of income
I This is the intertemporal-substitution effect of a change in
the interest rate → (1 + r ) is just the relative price of ct in
terms of ct+1

Intertemporal substitution and r

I Thus intertemporal substitution is the standard substitution
effect when the relative price of two commodities changes
I This effect of an increase in r tends to increase saving
a = yt − ct

Wealth effect and r

I But, as usual, there is also a wealth effect
I Here, it is useful to draw the indifference-curve diagram
I If initially saving is zero, then the wealth effect is nil and the
substitution effect dictates an increase in saving
I If initially the household is borrowing, both the wealth and
substitution effects go in the direction of increasing saving
(or reducing borrowing)
I If the household is initially saving, then the wealth effect
tends to reduce saving and the net effect is ambiguous
I Follow graphical analysis and discussion in D.Romer
(1996,p325-327)].
Savings is a = yt − ct
Suppose r increases
I Substitution effect ⇒ a ↑
I Income effect ⇒ a ?
I If initially a = 0, no wealth effect ⇒ a ↑
I If initially a > 0, positive wealth effect ⇒ a ?
I If initially a < 0, negative wealth effect ⇒ a ↑

Capital gains taxes in the two-period model 77
Budget constraint
I The agent faces two period-by-period constraints
ct + at+1 = yt
ct+1 = yt+1 + (1 + r (1 − τ ))at+1
I The intertemporal budget constraint
1 1
ct + 1+r (1−τ ) ct+1 = yt + 1+r (1−τ ) yt+1
Note: preferences unchanged → optimal choice may change

because the budget set and relative price of consumption in t
versus t + 1 changes.

Household’s optimization problem with taxes 78
Given yt , yt+1 , r and τ

ct ,ct+1
1 1
s.t. ct + ct+1 = yt + yt+1
1 + (1 − τ )r 1 + (1 − τ )r

Euler equation with taxes 79
Euler equation with capital-gains tax
ct+1 1 + r (1 − τ ) σ1
=
ct 1+ρ
Let r̂ = (1 − τ )r denote the after tax interest rate

(effective interest rate)
→ Higher tax rate, τ , implies lower effective interest rate, r̂
→ Increasing taxes affects consumers in the same way as
a decrease in the interest rate
(substitution of consumption from t + 1 to t & wealth effect)
Side question: In light of the Solow model for example, should
we increase or decrease taxes?
Growth Accounting Main Ingredients of the Model
The Solow Model Definition of Equilibrium
Savings behaviour Characterizing Equilibrium Quantities
The Ramsey Model Steady state and Dynamics
The Ramsey Model 80
Main Ingredients
I Neoclassical model of the firm
I Consumption-savings choice for consumers
I “Solow model + incentives to save”

(recall example with taxes)

The Model 81
Markets and ownership

Agents
I Firms produce goods, hire labor and rent capital
I Households own labor and assets (capital),
receive wages and rental payments, consume and save
Markets
I Inputs: competitive wage rates, w , and rental rate, R
I Assets: free borrowing and lending at interest rate, r
I Output: competitive market for consumption good

The Model 82
Firms / Representative Firm

Seeks to maximize profits
Profit = F (K , L) − RK − wL
The FOCs for this problem deliver
∂F ∂F
=R =w
∂K ∂L
In per unit of labor terms, let f (k) ≡ F (k, 1)
f 0 (k) = R f (k) − kf 0 (k) = w
Recall Euler’s Theorem: factor payments exhaust output

The Model 83
Households / Representative household

Preferences
∞
X
U0 = β t u(ct )
t=0
Budget constraint
ct + at+1 = wt + (1 + r )at ,
for all t = 0, 1, 2, ...
a0 given
Note: labor supplied inelastically, lt = 1

The Model 84
Households / Representative household

Intertemporal version of budget constraint
t
∞ Y t
∞ Y
X 1 X 1
ct = a0 + wt
1 + rs 1 + rs
t=0 s=0 t=0 s=0
We rule out that debt explodes (no Ponzi games)
at+1 ≥ −B for some B big, but finite
More compactly, PDV (c) = a(0) + PDV (w )

The Model 85
Household’s problem
∞
X
max β t u(ct )
(at+1 ,ct )∞
t=0 t=0
s.t.
ct + at+1 = wt + (1 + r )at , for all t = 0, 1, 2, ...
at+1 = −B for some B big, but finite
a0 given

The Model 86
Euler equation
In general,
u 0 (ct ) = β(1 + rt+1 )u 0 (ct+1 )
c 1−σ
From here on, CES utility, u(c) = 1−σ , Euler eqn. becomes,
σ
ct+1
= β(1 + rt+1 )
ct

The Model 87
Transversality condition
HH do not want to “end up” with positive values of assets
lim β t u 0 (ct )at ≥ 0

t→∞
HH cannot think they can borrow at the “end of their life”
lim β t u 0 (ct )at ≤ 0

t→∞
Hence,
lim β t u 0 (ct )at = 0

t→∞
Definition of Equilibrium 88
A competitive equilibrium is defined by sequences of quantities

of consumption, {ct }, capital, {kt }, and output, {yt }, and
sequences of prices, {wt } and {rt }, such that
I Firms maximize profits
I Households maximize U0 subject to their constraints
I Goods, labour and asset markets clear

Characterizing Equilibrium Quantities* 89
kt+1 + ct = f (kt ) + (1 − δ)kt
ct+1
= [β(1 + f 0 (kt+1 ) − δ)]1/σ
ct
lim β t u 0 (ct )kt = 0

t→∞
k0 > 0

From the equilibrium conditions derived before, we find:

I There cannot be arbitrage opportunities in equilibrium
Rt − δ = rt
In equilibrium it does not pay to invest in capital directly.

The riskless asset and capital have the same payoff.

From the equilibrium conditions derived before, we find:

I Substituting out all the prices leads to the following set of
necessary and sufficient conditions for an equilibrium in
terms of quantities only.
kt+1 + ct = f (kt ) + (1 − δ)kt
ct+1
= [β(1 + f 0 (kt+1 ) − δ)]1/σ
ct
lim β t u 0 (ct )kt = 0

t→∞
k0 > 0
Prices can be determined from the firm’s problems FOCs.
Benevolent planner’s problem* 92
What is the allocation of resources that an economy should

feature in order to attain the highest feasible level of utility?
Central Planner’s optimal choice problem
∞
X
max∞ β t u(ct )
(kt+1 ,ct )t=0
t=0
s.t.
ct + kt+1 = f (kt ) + (1 − δ)kt , for all t = 0, 1, 2, ...
k0 > 0 given

Benevolent planner’s problem 93
Welfare
Socially optimal allocation coincides with the equilibrium

allocation.
The competitive equilibrium leads to the social optimum.
Not surprising: no distortions or externalities

→ Welfare Theorems hold

Notes: simplifying features* 94
I We are considering an economy without population growth.

I There is no exogenous technological change, either.
We include these two at the end of these notes.

Steady state* 95
Definition
A balanced growth path (BGP) is a situation in which output,
capital and consumption grow at a constant rate.
If this constant rate is zero, it is called a steady state.
We can usually redefine the state variable so that the latter is

constant (i.e. the growth rate is zero)
Recall from the Solow model:

capital per unit of labor for (n > 0, g = 0)
capital per unit of effective labor for (n > 0, g > 0)

Steady state 96
From the Euler equation,

ct+1
= [β(1 + f 0 (kt+1 ) − δ)]1/σ , for all t
ct
If consumption grows at a constant rate (BGP), say γ
1 + γ = [β(1 + f 0 (kt+1 ) − δ)]1/σ , for all t
Thus RHS must be constant

→ kt+1 = kt = k ∗ must be constant along the BGP

Steady state 97
But then, from the resource constraint with kt = kt+1 = k ∗ :
ct + kt+1 = f (kt ) + (1 − δ)kt , for all t
i.e.,
ct = f (k ∗ ) − δk ∗
ct+1 = f (k ∗ ) − δk ∗
We find that consumption must be constant along the BGP,
→ ct+1 = ct = c ∗ or γ = 0
Hence we have a steady state in per capita variables.

Steady state* 98
Hence from the Euler equation
1 + γ = 1 = [β(1 + f 0 (k ∗ ) − δ)]1/σ
or, simplified
1
f 0 (k ∗ ) = − (1 − δ) = ρ + δ
β
we can solve for k ∗ and from the (simplified) resource constraint
c ∗ = f (k ∗ ) − δk ∗
we can solve for c ∗

Modified golden rule* 99
The capital stock that maximizes utility in steady state is called

the modified golden rule level of capital
f 0 (k ∗ ) = ρ + δ
Using f (k) = k α , we get

1
∗ MGR α 1−α
k =k =
ρ+δ
Compare to golden rule level of capital(max conso in st. st.)
hαi 1
1−α
k GR =
δ
(see Problem set 1, Q 3.3, assume A = 1 and set s = α (from Q 3.4))
Modified golden rule 100
Since ρ > 0 and α ∈ (0, 1),

1
1
MGR α 1−α hαi
1−α
k = < = k GR
ρ+δ δ
This result reflects the impatience of agents.

As long as ρ > 0, they’d always prefer to consume earlier rather
than later, thereby reducing investments for next period and
hence the steady state level of capital (and consumption)!
One of Ramsey’s points was that this is the steady state that we
should aim at because it makes people the happiest - not the
one that maximizes consumption per se.

Off steady state dynamics* 101
Off the steady state, consumption and capital adjust to reach

the steady state eventually.
To analyze these dynamics, consider the movements of c and k

separately.
Let ∆c = ct+1 − ct and ∆k = kt+1 − kt . See graphical analysis.

Off steady state dynamics* 102
I Consider the set of points such that ∆c = 0, then from the

Euler eqn, the optimal k satisfies f 0 (k) = ρ + δ
→ draw vertical line at k ∗ (< k GR )
To the left: kt < k ∗ ⇒ f 0 (kt ) > f 0 (k ∗ ) ⇒ ∆c > 0 ⇒ c ↑
To the right: kt > k ∗ ⇒ f 0 (kt ) < f 0 (k ∗ ) ⇒ ∆c < 0 ⇒ c ↓
I Consider the set of points such that ∆k = 0, then from the
Resource cstrt, the optimal c satisfies c = f (k) − δk
→ draw hump-shaped line from origin, maximized at k GR
cross 0 again for k such that f (k) = δk
Above: ct > f (kt ) − δkt ⇒ ∆k = f (kt ) − δkt − ct < 0 ⇒ k ↓
Below: ct < f (kt ) − δkt ⇒ ∆k = f (kt ) − δkt − ct > 0 ⇒ k ↑

Adding population and productivity growth 103
At+1 = (1 + g)At ,
I Evolution of population (labour force*):
Lt+1 = (1 + n)Lt
I Resource constraint in units of effective labour
ĉt + (1 + n)(1 + g)k̂t+1 = (1 − δ)k̂t + f (k̂t )
I Euler equation in units of effective labour becomes
1
ĉt+1 [β(1+f 0 (k̂t+1 )−δ)] σ
ĉ
= (1+n)(1+g)
t

Balanced Growth: St. state in units of effective labour

104
I In steady state:
ĉt+1 k̂t+1
ĉt
= 1 and =1
k̂t
I Solving the Euler Equation for k̂ ∗ gives

∗ βα
k̂ =
((1 + n)(1 + g))σ − (1 − δ)β
decreasing in population growth rate. But long run growth
rates of per capita variables are independent of n
I Thus, in terms of population growth rates, Ramsey model
gives same conclusions as Solow model.

Lecture01 Exo

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Growth Accounting

The Solow Model

Economic Policy in Development

Lecture 1, Exogenous Growth 1/104 Economic Policy in Development

The Solow Model

The Ramsey Model

Lecture 1, Exogenous Growth 2/104 Economic Policy in Development

Growth Accounting: Objective 3

I Many factors play role to determine output in a country

I Any theory of economic growth chooses which of these

I Ignore the demand side for now

Lecture 1, Exogenous Growth 4/104 Economic Policy in Development

Lecture 1, Exogenous Growth 5/104 Economic Policy in Development

I Marginal product of labour

I Marginal product of capital

Lecture 1, Exogenous Growth 6/104 Economic Policy in Development

Constant returns to scale (CRS) 7

F (λK , AλL) = λF (K , AL) for λ > 0

Lecture 1, Exogenous Growth 7/104 Economic Policy in Development

Cobb-Douglas production function 8

F (K , AL) = K α (AL)1−α 1>α>0

F (λK , AλL) = (λK )α (AλL)1−α

Yes, Cobb-Douglas production function is CRS.

Cobb-Douglas production function 9

F (K , AL) = K α (AL)1−α 1>α>0

Yes, Cobb-Douglas production function has positive and

Profit maximizing firm(s) 10

Π(K , AL) = F (K , AL) − rK − wL

I Firm picks K and L such that

Lecture 1, Exogenous Growth 10/104 Economic Policy in Development

Profit maximizing firms with CD production function 11

I With CD production function, FOCs become

FK (K , AL) = αK α−1 (AL)1−α = r

Lecture 1, Exogenous Growth 11/104 Economic Policy in Development

Euler’s Theorem with CD production function 12

Lecture 1, Exogenous Growth 12/104 Economic Policy in Development

Euler’s Theorem with CD production function 13

I Therefore, substituting in functional forms for FK (K , AL)

Lecture 1, Exogenous Growth 13/104 Economic Policy in Development

One large firm or many small firms 14

I Since firms take prices as given,

I Capital-labor ratio, k ∗ = KLii , chosen is the same for all firms

Steps for growth accounting 15

I TFP residual, At , for K only production function

Lecture 1, Exogenous Growth 15/104 Economic Policy in Development

TFP, At , as residual for K only production function 16

I From the production function in year t

I Denoting “per worker” variables in lower case letters,

Lecture 1, Exogenous Growth 16/104 Economic Policy in Development

TFP residual, At , across countries: K only 17

UK, South Korea and India

Lecture 1, Exogenous Growth 17/104 Economic Policy in Development

CRS production function with physical and human

I Now include human capital (e.g., years of education) into

Lecture 1, Exogenous Growth 18/104 Economic Policy in Development

TFP as residual for production function with K and H

I From the production function in year t

Lecture 1, Exogenous Growth 19/104 Economic Policy in Development

Compare At for the 2 production functions 20

I Residual for production function with physical capital only

I Residual for production function with human capital

Lecture 1, Exogenous Growth 20/104 Economic Policy in Development

log yt+1 − log yt =