ECON 214: Intermediate Macroeconomics

Chapter 2.3 - A Dynamic General Equilibrium Model

Andreas Pollak

Department of Economics
University of Saskatchewan

Winter 2020/21
Overview

Chapter 2.3 - A Dynamic General EquilibriumModel

An RBC-like model
consumption, investment, labour-leisure choice
social planner’s solution
graphical analysis
Changes in productivity: real business cycles (RBC)
Changes in expected productivity: expectations-driven business cycles

Readings
Williamson, Chapter 11 (all) and 13 (pp. 363-373)

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 2 / 30
The Model

two periods, representative household, representative firm,

government
combines the static labour/leisure choice model from chapter 1.3 with
the dynamic consumption model from chapter 2.2

period 1:
the firm produces output Y using K and N
the capital stock K is predetermined
the household chooses `, C , S P
the government chooses G , T
goods market: Y = C + I + G
using the household’s budget constraint Y − T = C + S P :
Y = (Y − T − S P ) + I + G ⇔
I = SP
|{z} + |T {z− G}
private saving public saving

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 3 / 30
The Model

period 2:
the firm produces output Y 0 using K 0 and N 0
K 0 = K − dK + I
the household chooses `0 and C 0 ; it consumes all available resources
the government chooses G 0 , T 0
goods market: Y 0 + (1 − d)K 0 = C 0 + G 0
To solve the model: characterize the household’s and the firm’s optimal
behaviour

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 4 / 30
The Household

The household’s budget constraints in the two periods are:

period 1: w (h − `) + π − T = C + S P
period 2: C 0 = w 0 (h − `0 ) + π 0 − T 0 + (1 + r )S P

Combining them to eliminate S P :

C0 w 0 (h − `0 ) + π 0 − T 0
C+ = w (h − `) + π − T +
1+r 1+r

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 5 / 30
The Household

The household optimally chooses C , C 0 , `, `0 under the intertemporal

budget constraint.
There are three optimality conditions:
1 work-leisure choice, period 1:
MRS`,C = w
2 work-leisure choice, period 2:
MRS`0 ,C 0 = w 0
3 intertemporal consumption choice:
MRSC ,C 0 = 1 + r

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 6 / 30
The Firm

The firm’s profit functions in the two periods are:

investment
z}|{
period 1: π = zF (K , N) − wN − I
period 2: π 0 = z 0 F (K 0 , N 0 ) − w 0 N 0 + (1 − d)K 0
| {z }
remaining capital
will be sold

capital in period 2: K 0 = K − dK + I

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 7 / 30
The Firm

There are three optimality conditions:

1 optimal employment, period 1:
MPN = w
2 optimal employment, period 2:
MPN0 = w 0
3 optimal investment:
MPK0 − d = r

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 8 / 30
The Government

The government can borrow or save. Its intertemporal budget constraint is:

G0 T0
G+ =T+
1+r 1+r

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 9 / 30
Equilibrium

By combining the household’s with the firm’s optimality conditions, we

arrive at three conditions that must hold in equilibrium:
1 MRS`,C = w = MPN = MRT`,C
same condition as in the static model of labour-leisure choice
2 MRS`0 ,C 0 = w 0 = MPN0 = MRT`0 ,C 0
same as above, but for the second period
3 MRSC ,C 0 = 1 + r = 1 + MPK0 − d
links intertemporal consumption choice to the marginal product of
capital
Since the First Welfare Theorem applies, we can use the social planner’s
approach to solve the model.

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 10 / 30
 ECON 214: Intermediate Macroeconomics
Chapter 2.3 - A Dynamic General Equilibrium Model

Changes in z: Real Business Cycles (RBC)

Business Cycles

Source: Williamson

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 12 / 30
Business Cycles

Source: Williamson

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 13 / 30
Business Cycles

Source: Williamson

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 14 / 30
Business Cycles

Procyclical variable x Countercyclical variable x

Source: Williamson

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 15 / 30
Business Cycles

Source: Williamson

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 16 / 30
Business Cycles

Source: Williamson

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 17 / 30
Business Cycles

Source: Williamson

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 18 / 30
Business Cycles

Source: Williamson

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 19 / 30
Business Cycles

Source: Williamson

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 20 / 30
The Real Business Cycle Model

what happens?
z ↑ → can increase C
problem: intertemporal optimization requires smooth consumption;
households therefore want higher C 0 , too
solution: increase investment
 I:
I ↑ → K0 ↑ → C0 ↑ 
help fulfill intertemporal optimality
I ↑ → K0 ↑ → r ↓
 condition for consumption
I ↑ → C↓
idea: to achieve better consumption smoothing, the economy carries
over part of the current productivity advantage to the next period by
increasing investment and thus the future capital stock
co-movement of variables:
z ↑: Y ↑, C ↑ (less than Y ), I ↑, N unclear

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 21 / 30
Business Cycles

Source: Kydland, Finn E and Prescott, Edward C, 1982. ”Time to Build and Aggregate Fluctuations,” Econometrica,
Econometric Society, vol. 50(6), pages 1345-70, November.

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 22 / 30
The Real Business Cycle Model

RBC models:
explain well the responses of macro variables to the business cycle
there is no scope for welfare-improving stabilization policy
ignore frictions in the economy (unemployment, sticky prices)
are quite popular, are the basis for most business cycle models today
(including “New Keynesian” monetary models)

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 23 / 30
 ECON 214: Intermediate Macroeconomics
Chapter 2.3 - A Dynamic General Equilibrium Model

Changes in z 0 : News about the business cycle

News about the Business Cycle
Some people believe that business cycles are not just driven by
contemporaneous changes in productivities.
Often, business cycles seem to be about anticipated events, about
expectations and uncertainty.
One example that is sometimes given is the dot-com bubble of the late
1990s. Back then, lots of firms invested in IT and communications
technology, in particular things related to the internet. Allegedly they did
this not because they believed it would immediately generate profits; they
believed that such investments would be very profitable in the future.
Apparently, the full anticipated productivity improvement never
materialized, and the investment-driven dot-com boom ended in a bust.
Question: Does such a story make sense? Does our model support the
idea that booms and recessions can be caused by expectations only?
There has been some work on “news about the business cycle” or
“expectation-driven business cycles” since that dot-com bubble.
ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 25 / 30
Business Cycles
US real GDP growth (annualized %)
8

-2
1995 1996 1997 1998 1999 2000 2001 2002 2003

Stock Prices
5000 2500
NASDAQ
4000 S&P 500 2000

3000 1500

2000 1000

1000 500

0 0
1995 1996 1997 1998 1999 2000 2001 2002 2003

Data sources: quarterly GDP: OECD; stock prices: Yahoo Finance

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 26 / 30
News about the Business Cycle

what happens?
z 0 ↑ → can increase C 0 , r increases
two scenarios:
scenario I: intertemporal consumption substitution difficult (MRSC ,C 0
increases more than r )
problem: intertemporal optimization requires smooth consumption;
households therefore want higher C or higher r
solution: reduce investmentI :
I ↓ → K0 ↓ → C0 ↓ 
help fulfill intertemporal optimality
I ↓ → K0 ↓ → r ↑
 condition for consumption
I ↓ → C↑
idea: households know they will be richer tomorrow, so they start
consuming today (C and `)

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 27 / 30
News about the Business Cycle

two scenarios:
scenario II: intertemporal consumption substitution easy (MRSC ,C 0
increases less than r )
problem: to take advantage of high interest rates, households want to
shift even more consumption to the future (higher C 0 or lower r )
solution: increase investment
 I:
I ↑ → K0 ↑ → C0 ↑ 
help fulfill intertemporal optimality
I ↑ → K0 ↑ → r ↓
 condition for consumption
I ↑ → C↓
idea: economy more productive tomorrow; invest today, to take
advantage of that
co-movement of variables:
problem: I and C always move in opposite directions: inconsistent
with business cycle observations
⇒ Our model suggests the business cycles we observe are not
primarily driven by expectations.

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 28 / 30
Business Cycles
US real GDP: shares of components compared to their 1995-2002 means
0.03

0.02 C (64.7%)
I (21.4%)
0.01 G (16.5%)
NX (-2.6%)
0

-0.01

-0.02

-0.03
1995 1996 1997 1998 1999 2000 2001 2002 2003

Stock Prices
5000 2500
NASDAQ
4000 S&P 500 2000

3000 1500

2000 1000

1000 500

0 0
1995 1996 1997 1998 1999 2000 2001 2002 2003

Data sources: quarterly GDP data: OECD; stock prices: Yahoo Finance

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 29 / 30
Business Cycles
Growth Accounting: US
7
TFP
6 K
N
5

-1

-2

-3

-4
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Data sources: GDP: OECD; capital stock (fixed nonresidential assets): BEA; civilian employment: St. Louis FED

ECON 214: Intermediate Macro 2.3 - A Dynamic General Equilibrium Model Winter 2020/21 30 / 30