Slides 2: Extending the RBC Model

Endogenous Labour Supply and Real

Rigidities

Bianca De Paoli

November 2009
1 The social planner's maximisation problem

In previous lectures presented the following problem:

8 0 19
<X1 1 =
max Et i @ Ct+i A
: 1 ;
i=0

s.t.

Yt+i = Ct+i + Kt+i (1 ) Kt+i 1;

Yt+i = Zt+iKt+i 1;
Zt+i = Z (1 )Z
t+i 1 exp ("t+i) :
Labour supply is xed at 1 for all t.
We solved for the decision rules (for all t):
n o
1
Ct = Et Ct+1 1 + Zt+1Kt ;

ZtKt 1 = Ct + Kt (1 ) Kt 1 ;
and derived the deterministic steady state
1
R= ;

0 1 1 0 1
1 1+ 1 1 1+ 1
K=@ A ;Y = @ A ;

0 1 1 0 1 0 1 1
1 1+ 1 1 1+ 1 1 1+ 1
I= @ A ;C = @ A @ A :
Endogenising labour supply -why?

A model with capital accumulation alone can only have an important

e ect on the dynamics of the economy when the underlying technology
shock is persistent;

Technology shocks do not have strong e ects on realised or expected

returns on capital (relating to obsereved low capital share in output);

Capital accumulation does not generate a short- or long-run multiplier

in the sense that the output response to an underlying shock is never
larger (in percentage terms) than the shock itself.

So we need to introduce an endogenous labour choice. This model is a

simple extension of the neoclassical model studied in the previous lectures.
The social planner's maximisation problem
The maximisation problem now becomes
8 9
<X1 =
max Et i U (C
: t+i; Nt+i);
i=0

s.t.

Yt+i = Ct+i + Kt+i (1 ) Kt+i 1;

(1 )
Yt+i = Zt+iKt+i 1Nt+i ;
Zt+i = Z (1 )Zt+i 1 exp ("t+i) :
We set up utility as follows
1 1+'
Ct+i Nt+i
U (Ct+i; Nt+i) = :
1 1+'
In this particular set up, the agent derives disutility from supplying
labour because doing so leaves less time to derive utility from leisure.

But this is not a universal formulation - e.g. other speci cations may
be nonadditively separable or may incorporate agents that derive utility
from leisure, rather than disutility from working.

Two new parameters: and ' represent the preference weight of

leisure in utility (used maily to calibrate the steady state value for N )
and the inverse of the Frisch elasticity of labour supply, respectively.
Solving for decision rules
The Lagrangean for this problem is
2 8 9
> 1 1+' >
1 > Ct+i Nt+i >
6X < =
max Et 6 i 1 1+'
4 > (1 ) >
> (1 ) Kt+i 1 + Ct+i >
i=0 : t+i Kt+i Zt+iKt+i 1Nt+i ;

Nt, Ct and Kt are now the planner's choice variables.

Zt and Kt 1 are again the state variables.

t is the Lagrange multiplier.

The rst order conditions to this problem for all t are as follows:

Ct : Ct = t:
( 1) (1 )
Kt : t = Et t+1 1 + Zt+1Kt Nt+1 :
'
Nt : Nt = t (1 ) ZtKt 1N a:
(1 )
t : ZtKt 1Nt = C t + Kt (1 ) Kt 1:
The last condition is the resource constraint. Combining the rst two
conditions, we obtain the familiar Euler equation (EE)
1 (1 )
Ct = Et Ct+1 1 + Zt+1Kt Nt+1 :

Combining the rst and third conditions we get

'
N t = Ct (1 ) ZtKt 1N :
We can express the previous condtion in terms of log deviations from mean

1h ^t 1
i
^t =
n z^t + k ^t
n c^t
'
which shows that:

" Marginal product of labour ( real wage) ! " Labour e ort;

" Ct (marginal utility# ) ! # Labour e ort;

We can think of these in terms of income and substitution e ects.

The System
Rearranging conditions above gives
1 (1 )
Ct =Et Ct+1 1 + Zt+1Kt Nt+1 ;

'
Nt
= (1 ) ZtKt 1N a;
Ct
These rst two equations of the system impose equality between mar-
ginal rates of substitution and transformation.

The rst means that the marginal rate of intertemporal substitution

in consumption equals the marginal product of capital net of depreci-
ation.

The second equates the marginal rate of substitution between lesiure

and consumption with the marginal product of labour.
 (1 )
ZtKt 1Nt = C t + Kt (1 ) Kt 1;

Zt+i = Z (1 )Z
t+i 1 exp ("t+i) :

The third equation is the resource constraint while the fourth is the
law of motion for productivity.

Other variables are de ned recursively:

(1 )
Output: Yt = ZtKt 1Nt
Investment: It = Kt (1 ) Kt 1
(1 )
Return on capital: Rtk = 1 + ZtKt 1Nt
Real wages: Wt = (1 ) ZtKt 1Nt
Solving the deterministic steady state (DSS)
The DSS for this model di ers slightly from that derived in the previous
lecture. We now set the steady state level of labour supply at 0.25
(as suggested in Cochrane (2001) - but Prescott (1996) suggest a higher
number as households alocate 1/3 of their time to market activities), so

N = 0:25:
(but Prescott (1996) suggest N = 0:33 as households allocate 1/3 of their
time to market activities)
The steady state gross return on capital and level of productivity are
1
R= ; Z = 1:
Using this in Rt we obtain
0 1 1
1 1+ 1
K
=@ A ;
N

We can express the other steady state values in terms of K or, indeed, the
N
deep parameters.

! 0 1
1 1+ 1
K
Y = N =N@ A
N
! 0 1 1
1 1+ 1
K
I = N = N@ A
N
 2 3
" ! !# 0 1 0 1 1
1 1+ 1 1 1+ 1
K K 6 7
C = N =N6
4
@ A @ A 7:
5
N N

However we still have a free paramater, : In steady state,

!
K
= N 'C (1 ) :
N
This expression can be expressed entirely in terms of deep paramaters, for
a given N ; so it can be calibrated.
The responses to a productivity shock:
n o
Ct = Et Ct+1 (Rt+1) ;

1 (1 )
Rt = 1 + ZtKt Nt ;
'
N t = Ct Wt ;

Wt = (1 ) ZtKt 1N a

(1 )
ZtKt 1Nt = C t + Kt (1 ) Kt 1;

Zt+i = Z (1 )Z
t+i 1 exp ("t+i) :
Varying the Frisch elasticity:
Calibration:
= 0:3; = 0:025; = 0 :5 :

We vary ' to see what happens to the responses.

' = [0:1; 0:5; 1:0; 1:5; 10]

Z 1.2 K 1 C 0.5
0.9 0.45
1
0.8 0.4

0.8
0.7 0.35
0.6 0.3
0.6 0.5 0.25
0.4 0.2
10
0.4
0.3 1.5
0.5 0.15
1.5 10
0.1
0.2
0.2 0.1 0.5
No Labour 0.1
1
No Labour 1
0.1
0.05
0 0
0
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75

H 10 1.5 1 Y 1.6 0.06

R
0.5 0.1 10
0.8 1.4 1.5 0.05
1 0.5

0.6 10 1.2 0.1 0.04

No Labour
1.5
Series2
0.5 0.03
0.4 0.1 1
No Labour
1 0.02
0.2 0.8
0.01
0 0.6
0
-0.2 0.4
-0.01
-0.4 0.2 -0.02

-0.6 0 -0.03
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75
U'(C) 0.1 C 0.5 I 6
0.45
-0.1 10 5
10 0.4 1.5
1.5 0.5
0.5 0.35 0.1 4
0.1 -0.3 NO L SIG 1.5
No L 1
1
0.3
3
-0.5 0.25
10 0.2 2
1.5
-0.7 0.5 0.15
0.1 1
NO L SIG 1.5 0.1
-0.9 1

0.05 0

-1.1 0
-1
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75

C_Y 0.2 I_Y 1 W 1.2

10 1.5

0 0.8 0.5 0.1

1

10 1

-0.2 1.5 0.6 0.8

0.5
0.1
No L
10 -0.4 1 0.4 0.6
1.5
0.5
0.1
NO L SIG 1.5 -0.6 0.2 0.4
1

-0.8 0 0.2

-1 -0.2 0
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75
Discussion
The red dotted line in each chart shows the response from the model
we discussed in the last session - i.e a model without labour and =
0 :5 :
When ' = 10, labour supply is inelastic. The respsonse of the econ-
omy is similar to that obtained from a model with an exogenous labour
supply.
We see that at high values of the Frisch elasticity (i.e when ' 1 is high,
so ' is low), labour supply initially increases sharply to take advantage
of higher productivity.
With labour supply higher, the capital stock is increased with sharp
increases in in investment. With higher labour and capital, output also
initially rises and we observe an output multiplier e ect.
To balance desired investment with savings the real interest rate rises.
Alternative discussion:

The initial increase in productivity raises both the marginal products

of capital and labour;

Therefore capital is gradually increased (as it cannot jump), while

labour supply (which can jump) increases sharply.

This results in higher output.

Both consumption and investment are higher, but investment more

so, as agents realise that the higher productivity environment is only
temporary.

Again, the interest rate adjusts to attract savings.

Income vs Substitution e ect.

Homework
Consider the case in which the utility function is given by:
(Ct+i(1 Nt+i)1 )1
U (Ct+i; Nt+i) =
1
-Calculate the equilibrium conditions and the steady state (which value of
is consistent with N = 0:25?)
- Simulate the impulse response to a productivity shock for di erent values
of and
- How does the responses compare with the case of separable labour
Real Rigidities:
Consumption Habits
Habits make agents very sensitive to small changes in consumption. They
increase agents' motivation to smooth (near) changes not levels. Techni-
cally, habits make the utility function temporally nonseparable.

Habits can be speci ed as di erences or as a ratio. We use the

di erence form
1
Cj;t+i Xj;t+i
U (Cj;t+i) = ;
1
in which Cj;t+i and Xj;t+i represent the consumption and habit levels
of an individual, or cohort, j at time t + i; respectively.

The parameter measures preference weight for reference level of

habit.
Habits can be Internal or External (\keeping up with the Joneses"),
and this is re ected by the way in which we specify Xj;t :
1
(Cj;t Cj;t 1 )
Habits are Internal if e.g. Xj;t = Cj;t 1 ! U (Cj;t+i) = 1 !
when optimising w.r.t.Cj;t; we would need to worry about 2nd term in
brackets, as in this case, Cj;t+i appears in consecutive time periods.
1
(Cj;t Ct 1 )
Habits are External if Xj;t = Ct 1 8j; t ! U (Cj;t+i) = 1 !
when optimising w.r.t.Cj;t; we would ignore 2nd term in brackets.

We use the di erence form and assume habits are external.

NB: we will have FOCs for individuals - need to derive aggregate

decision rules.
Capital adjustment costs

Adding capital adjustment costs to a model with habits ensures that

not only do agents care a lot about changes in consumption, they
are also prevented from easily smoothing through uctuations. Con-
sumers cannot costlessly adjust their production to see out bad states
of the world.

Many di erent speci cations for adjustment costs - could be in terms

of capital or investment.

Provide a formal framework for q theory of investment.

Often they are quadratic - implying it is: (i) increasingly costly to
change investment with size of change; and (ii) as costly to decumulate
as accumulate capital.

We use the following quadratic form:

(1 )
Yt+i = Zt+iKt+i 1Nt+i (Kt+i Kt+i 1)2 :
2
dictates how costly it is to change capital.
The social planner's maximisation problem (for an individual, j )
The maximisation problem incorporating both habits and adjustment costs
becomes
8 0 19
> 1 1+' >
<X1 Cj;t+i Xj;t+i Nj;t+i C=
max Et iB
@ A
>
:i=0 1 1+' > ;

s.t.
(1 ) 2
Zt+iKj;t+i 1Nj;t+i Kj;t+i Kj;t+i 1
2
= Cj;t+i + Kj;t+i (1 ) Kj;t+i 1;

(1 ) 2
Yj;t+i = Zt+iKj;t+i 1Nj;t+i Kj;t+i Kj;t+i 1 ;
2

Zt+i = Z (1 )Z
t+i 1 exp ("t+i) :
Solving for decision rules
The Lagrangean for this problem is
1 1+'
1
X Cj;t+i Xj;t+i Nj;t+i
max Et if
i=0 1 1+'
(1 )
j;t+i[Kj;t+i Zt+iKj;t+i 1Nj;t+i
2
(1 ) Kj;t+i 1 + Cj;t+i + Kj;t+i Kj;t+i 1 ]g:
2
As stated, we treat the habit as external ! so no need to optimise
w.r.t Xj;t+i

Nj;t, Cj;t and Kj;t are the planner's choice variables for the jth indi-
vidual.

j;t is the Lagrange multiplier for the jth individual.

The rst order conditions, for the jth individual, and treating the habit as
external, are as follows (for all t) :

Cj;t : Cj;t Xj;t = j;t:

h i
Kj;t : j;t 1 + Kj;t Kj;t 1
n h io
1 1
= Et j;t+1 1 + Zt+1Kj;t Nj;t+1 + Kj;t+1 Kj;t :
'
Nj;t : Nj;t = j;t (1 ) ZtKj;t 1Nj;t :
(1 ) 2
j;t : ZtKj;t 1Nj;t Kj;t+i Kj;t+i 1 = Cj;t + Kj;t (1 )K
2
Marginal utility now depends on how far the agent is from his or her
habit level.
Aggregate Decision Rules
To return to the representative agent framework we have to aggregate each
decision rule and express it in per capita terms. De ning
n
X n
X
1 1
Ct = Cj;t , t = j;t , Kt = , Yt = :::etc
j=1 n j=1 n
and writing the habit level as

Xj;t = Ct 1 8j; t
we can aggregate the rst FOC to give

(Ct Ct 1) = t:
We can aggregate the other conditions in similar fashion:

(Ct Ct 1) = t:

t [1n+ ( Kt
h
Kt 1)]
io
1 1
= Et t+1 1 + Zt+1 Kt Nt+1 + (Kt+1 Kt )

'
Nt = t (1 ) ZtKt 1Nt :

(1 )
ZtKt 1Nt (Kt+i Kt+i 1)2 = Ct + Kt (1 ) Kt 1 :
2
Zt, Kt 1 and additionally Ct 1 are now the state variables.
Combining the rst two conditions, we obtain an Euler equation (EE)
which is still equating M RS = M RT

(Ct Ct 1)
8 h i9
< 1 1
(Ct+1 Ct) 1 + Zt+1Kt Nt+1 + (Kt+1 Kt ) =
= Et
: [1 + (Kt Kt 1)] ;

Labour supply condition from 1st and 3rd condition (very similar to
last week's condition)
" #1
(1 )h i '
Nt = (C t Ct 1) ZtKt 1Nt :
Resource constraint (written as net output) and law of motion for
productivity are written as

(1 )
ZtKt 1Nt (Kt+i Kt+i 1)2 = Ct + Kt (1 ) Kt 1 ;
2

Zt+i = Z (1 )Z
t+i 1 exp ("t+i) :

Capital adjustment costs leave less resources available for consump-

tion/investment.
The recursive de nitions for other variables are now
(1 )
(Net) Output : Yt = ZtKt 1Nt (Kt+i Kt+i 1)2
2
Investment : It = Kt (1 ) Kt 1
h i
1 1
k
1 + Z t+1 K t Nt+1 + (Kt+1 Kt )
Return on capital : Rt+1 =
[1 + (Kt Kt 1)]
Real wages : Wt = (1 ) ZtKt 1Nt
Solving the deterministic steady state (DSS)
In steady state we know that Kt = Kt 18t & Ct = Ct 18t , therefore
the adjustment cost terms disappear from the expressions above and the
DSS in this model is the same as in a model without adjustment costs or
habits.
N = 0:25:
The steady state gross return on capital and level of productivity are
1
R= ; Z = 1:

Using this in Rt we obtain

0 1 1
1 1+ 1
K
=@ A ;
N
We can express the other steady state values in terms of K or, indeed, the
N
deep parameters.

0 1 1
1 1+ 1
1 K
N = 0:25; R = ; Z = 1; =@ A ;
N
! 0 1 1
! 0 1
1 1+ 1 1 1+ 1
K K
I = N = N@ A ; Y =N =N@ A ;
N N
2 3
" ! !# 0 1 0 1 1
1 1+ 1 1 1+ 1
K K 6 7
C = N =N6
4
@ A @ A 7:
5
N N
We still have a free paramater, : In steady state,
!
K
=N ' (1 )C (1 ) :
N
This expression can be expressed entirely in terms of deep paramaters, for
a given N ; so it can be calibrated.
The responses to a productivity shock:
Varying the habit weight (in a model without capital adjustment costs)
Calibration:
= 0:3; = 0:025; = 0:5; ' = 0:5

We vary to see what happens to the responses.

= [0:2; 0:4; 0:8]

Z 1.2 K 0.8 1 C 0.5
0.2
0.9 0.45
1 0.4 0.8
0.8 0.4
0.4
No_habits

0.7 0.2 0.35

0.8 No Habits
0.6 0.3

0.6 0.5 0.25

0.4 0.2
0.4 0.3 0.15
0.2 0.1
0.2 0.1 0.05
0 0
0 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75

H 0.8 0.5 Y 1.4 R 0.05

0.4

0.2 0.4 0.8

1.2 0.4
0.04
No Habits

0.3 0.8 0.2

0.4
1 No habits 0.03
0.2 0.2

No Habits 0.8 0.02

0.1
0.6 0.01
0
0.4 0
-0.1
0.2 -0.01
-0.2

-0.3 0
-0.02
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75
I 5
W 1 U'(C) 0.2
0.9
0.8 4 0.8
0.4 0.8 0
0.4
0.2
3 0.2 0.7
No Habits
No Habits -0.2
0.6
2 0.5
-0.4
0.4
1 0.8
0.3 -0.6
No Habits

0 0.2 0.2

0.1
0.4 -0.8

-1 0
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 -1
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75

I_Y 1 K_Y 6 C_Y 0.2

4
0.8 0
2
0.8
0
0.4
0.6 -0.2
0.2 0.8
-2
No Habits
0.4 0.4
-4 -0.4
0.2 0.8 0.4
NO Habits -6
0.2 0.2 No Habits -0.6
-8

0 -10
-0.8
-12
-0.2 -14 -1
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75
Varying the cost of adjusting capital (in a model with habits):
Calibration:

= 0:3; = 0:025; = 0:5; ' = 0:5; = 0 :8

Now we vary to see what happens to the responses.

= [1; 5; 10; 20]

We also show responses from (1) a model without habits or adjustment

costs; and (2) a model with habits, but no adjustment costs.
Z 0.012 K 20 1 C 0.6
1
5 0.9
0.01 10 20 0.5
No_habits 0.8 1
Hab_No_ACosts 10
5
0.008 0.7 No Habits 0.4
Hab_No_Ac
0.6
0.006 0.5 0.3
0.4
0.004 0.2
0.3

0.002 0.2
0.1
0.1
0 0 0
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75

H 20 0.6 Y 1.4 R 0.1

1
10
5 0.4
No Habits 1.2 0.05
Hab_No_Ac
0.2
20
1 1 0
0 10
5

-0.2
No Habits
Hab_No_ac
0.8 -0.05

-0.4 0.6
20
-0.1
1
-0.6 10
0.4 5 -0.15
-0.8 No habits
Hab_No_Ac
0.2 -0.2
-1

-1.2 0
-0.25
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75
I 5
W 1.6 U'(C) 0.2

20 4 1.4
20
1
1
10
10 1.2
-0.3
5
5
No Habits 3 No Habits
Hab_No_Ac
Hab_No_Ac 1
-0.8
2 0.8

0.6 -1.3
1 20
No Habits
0.4 5
10
0 1 -1.8
0.2 Hab_No_Ac

-1 0
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 -2.3
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75

I_Y 1 K_Y 6 C_Y 0.2

4
0.8 0
2
20
0
1 0.6 -0.2
10
5 20 -2
No Habits 1
Hab_No_Ac 0.4 10 -4 20 -0.4
5
1
NO Habits
hab_no_Ac -6 10
5
0.2 No Habits -0.6
-8 Habits_no adj costs

0 -10
-0.8
-12
-0.2 -14 -1
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75
Discussion - a model with habits

The black dotted line in each chart shows the response obtained from a
model without habits or adjustment costs, while the brown dotted line
shows the responses from a model with habits, but still no adjustment
costs.

Habits, in isolation, do not seem to have a great e ect on the re-

sponses.

Interestingly, even though the output response is little changed from

a model without habits, there is a compositional di erence - look at
the investment- and consumption to output ratios.
Discussion - adding capital adjustment costs
Immediately we see that the investment and capital responses are
muted. The greater the value of ; the less pronounced are the
responses of these two variables.
The positive output response is also lower.
We nd that even though there is a substitution towards investment
from current consumption, it is not as dramatic as in a model without
adjustment costs. And the more costly it is to change capital, the
lower the substituion towards investment.
The productivity shock enables agents to consume more without hav-
ing to supply extra labour. In fact, as the capital stock rises and
remains above steady state for a prolonged period, agents can achieve
higher than steady state level of consumption by working less - i.e. the
income e ect dominates.
Importantly, we see that marginal utility is far more volatile when
adjustment costs are added to a habits model. This will lead to
increased volatility in the stochastic discount factor, which is one of
the prerequisites for producing a plausible risk premium in these kinds
of models.
2 Centralised and decentralised representations

Three equivalent representations:

Social planner problem: benevolent social planner allocates capital and

labour to ensure maximum utility

Rental model: households own factors of production and pay the costs
associated with them. They rent these to rms in rental markets and
get capital and labour income in return to use to nance consumption.

\Capital ownership" model: rms own their own capital and pay capital
adjustment costs. They issue shares which entitle holders to whatever
dividends are paid. Households get wage income and rms' pro ts.

These are all exactly equivalent!

Some important assumptions:

Perfectly competitive goods markets and rental markets for factors of

production.

No distortions from, eg, taxes.

Closed economy.
The rental model

Social planner: total production output directed to consumption. One

agent consumes, sleeps, works, invests.

Rental version: total production output divided into rental streams

(c.f. National Accounts). \Firms" demand factors and \households"
rent them to rms.
Firms' maximisation problem
Assume that a large number of rms seeks to maximise period-by-period
pro ts, subject to technology constraints and rental rates for labour and
capital:
max Ya;t+i Wt+iNa;t+i k K
rt+i a;t+i 1

s.t.
(1 )
Ya;t+i = Zt+i Ka;t+i 1 Na;t+i
and
Zt+i = Z (1 )Z
t+i 1 exp ("t+i) :

Ka;t+i 1 and Na;t+i represent the demand by rm for capital and

labour, respectively, at the real capital rental rate k and real wage
rt+i
rate Wt+i .
The rm chooses capital and labour - the FOC's (for rm a) are
Ya;t
rtk =
Ka;t 1

Ya;t
Wt = (1 )
Na;t
Households' maximisation problem
The maximand for this problem is the same as previously:
8 0 1
19
>
> 1 1+! > >
<X1 Cj;t+i Xj;t+i Nj;t+i C=
max Et iB
B C :
@
>
>
:i=0 1 1 1 + ! A>>
;

k K
Bj;t+i + Kj;t+i + Cj;t+i = (1 + rt+i) Bj;t+i 1 + Wt+iNj;t+i + rt+i j;t+i 1
2
+ (1 ) Kj;t+i 1 Kj;t+i Kj;t+i 1 :
2
Bj;t represent consumer j 0s holdings of real (private) consumption
bonds at time t: These are not government bonds { in aggregate they
are in zero net supply.
Note that it is the household that nds it costly to adjust the capital
stock { it maintains the capital stock.
Euler's Theorem on Homogenous functions tells us that

Y = F (K; N ) = FK (K; N ) K + FL (K; N ) N

if the function F ( ) is homogenous of degree one - i.e.

F (aK; aN ) = aF (K; N ) 8a

This is necessary in order to have the competitive equilibrium solution

identical to the social planner's version of the economy. This holds in our
set up.
Household budget constrain in centralized model
(1 )
Yj;t+i = Zt+iKj;t+i 1Nj;t+i = Cj;t+i + Bj;t+i + Kj;t+i
2
(1 ) Kj;t+i 1 (1 + rt+i) Bj;t+i 1 + Kj;t+i Kj;t+i 1
2
Household budget constrain in decentralized model
k K
Wt+iNj;t+i + rt+i j;t+i 1 = Bj;t+i + Kj;t+i + Cj;t+i (1 ) Kj;t+i 1
2
(1 + rt+i) Bj;t+i 1 + Kj;t+i Kj;t+i 1
2
Equivalents, given that

k K Yj;t+i Yj;t+i
Wt+iNj;t+i+rt+i j;t+i 1 = (1 ) Nj;t+i+ Kj;t+i 1 = Yj;t+i
Nj;t+i Kj;t+i 1
The Lagrangean for households is
2 8 9
>
> 1 1 1+!
Nj;t+i >
>
6 >
>
>
(Cj;t+i Xj;t+i) >
>
>
6 >
> 1 1 1+! >
>
61 >
< 0 1 >
=
6X i
max Et 6
6
Bj;t+i + Kj;t+i + Cj;t+i
6i=0 >
> B 2 C >
6 >
> B + K K (1 + r ) B C >
>
>
4 >
> j;t+i @ 2 j;t+i j;t+i 1 t+i j;t+i 1 A >
>
>
> k K >
>
: Wt+iNj;t+i rt+i (1 ) K ;
j;t+i 1 j;t+i 1

Cj;t, Kj;t, Nj;t and also Bj;t are the choice variables for the j th indi-
vidual.
The rst order conditions, for the jth individual, treating the habit as
external, are as follows (for all t) :
1
Cj;t : Cj;t Xj;t = j;t:
8 h i9
< k
1 + rt+1 + Kj;t+1 Kj;t =
Kj;t : j;t = Et h i :
: j;t+1 1+ Kj;t Kj;t 1 ;

Nj;t : ! =
Nj;t j;t Wt:
n o
Bj;t : j;t = Et j;t+1 (1 + rt+1) :
2 3
Bj;t + Kj;t + Cj;t = (1 + rt 1) Bj;t 1 + WtNj;t
j;t : 4 2 5
k
+rt Kj;t 1 + (1 ) Kj;t 1 2 Kj;t Kj;t 1 :
The FOC w.r.t Cj;t and Nj;t are identical to the conditions obtained
from a social planner's version.

The FOC w.r.t Kj;t looks di erent, but we will show later that it
implies the same consumption Euler equation as before.

The FOC w.r.t Bj;t implies that at an optimum the consumer equates
the marginal cost of consuming a bit less today with the discounted
marginal bene t of saving today and consuming a bit more tommorow.
In a deterministic model (which eliminates the expectation operator
from the above system), return on bonds equal's return on capital.
Dividing the 2nd condition by the 4th gives
h i
k
1 + rt+1 + Kj;t+1 Kj;t
Rt+1 = (1 + rt+1) = h i :
1+ Kj;t Kj;t 1
and in steady state
R 1 = r = rk
Aggregate Decision Rules
Again, we have to aggregate each decision rule and express it in per capita
terms. De ning
n
X n
X
1 1
Ct = Cj;t , t = j;t , Kt = , Yt = :::etc:
j=1 n j=1 n
Also in aggregate,
Bt = 08t:

NB The conditions and recursive de nitions are exactly the same as

those obtained from a social planner's model.

In steady state we know that Kt = Kt 18t & Ct = Ct 18t , therefore

the adjustment cost terms disappear from the expressions above and
the DSS in this model is the same as in the social planner's version
The capital ownership model

Rental version: total production output divided into rental streams

(c.f. National Accounts). Firms demand factors and households rent
them to rms.

Capital ownership: rms own capital - they invest and face adjust-
ment costs. Shares, representing claims on production, are issued to
households, who still supply labour at the real wage rate.

We can now explicitly solve for the value of equity issued by rms.

We will show that in terms of aggregate dynamics, this version of the

model is also identical to the social planner's version.
Firms' maximisation problem

Large number of rms seek to maximise the sum of discounted lifetime

dividends, subject to a period-by-period resource constraint.

The `value of the rm' is normally assumed to be the sum of discounted

lifetime dividends - so we can think that each rm wishes to maximise
its own value.
1
X
max Et i
a;t+i Da;t+i
i=0

Da;t+i = Ya;t+i Wt+iNa;t+i Ia;t+i

(1 ) 2
Ya;t+i = Zt+iKa;t+i 1Na;t+i Ka;t+i Ka;t+i 1
2
Ia;t+i = Ka;t+i (1 ) Ka;t+i 1
Na;t+i represents labour used by rm a at real wage rate Wt+i .
Da;t+i represents dividends paid by rm a - they are the di erence be-
tween output (= revenue) and outlays on total wages and investment.

a;t+i can be thought of as the shadow value of capital.

The rm chooses capital and labour - the FOC's (for rm a;and for
all t) are
Ya;t
Na;t : Wt = (1 )
Na;t
8 2 39
>
> Ya;t+1 >
< + (1 )+ Ka;t+1 Ka;t 7>
=
a;t+1 6
6 Ka;t 7
Ka;t : 1 = Et 4 5>
>
> a;t 1+ Ka;t Ka;t 1 >
: ;
( )
t+1 k
= Et Rt+1
t
Households' maximisation problem
The maximand for this problem is the same as previously:
8 0 1
19
>
> 1 1+! >
<X1
iB
Cj;t+i Xj;t+i Nj;t+i C>
=
max Et B C :
@
>
>
:i=0 1 1 1 + ! A>>
;

The budget constraint now takes account of equity share holdings and lack
of investment decisions,

Bj;t+i + Cj;t+i + Vt+iSj;t+i = (1 + rt+i) Bj;t+i 1 + Wt+iNj;t+i

+(Vt+i + Dt+i)Sj;t+i 1

Vt+i and Sj;t+i represent the value and quantity of shares. Dt+i are
the dividends earned from holding shares.
 y V +D
We de ne the total return from holding a share as Rt+1 = t+1 V t+1 i.e
t
it is the sum of the capital gain from holding the share and its dividend
yield.

Private bonds are again in zero net supply.

The rst order conditions are as follows (for all t) :
1
Cj;t : Cj;t = j;t:
Xj;t
( )
(Vt+1 + Dt+1) n o
y
Sj;t : j;t = Et j;t+1 = Et j;t+1 Rt+1 :
Vt
Nj;t : ! =
Nj;t j;t Wt:
n o
Bj;t : j;t = Et j;t+1 (1 + rt+1) :
h
j;t : Bj;t+i + Cj;t+i + Vt+iSt+i = (1 + rt+i) Bj;t+i 1 + Wt+iNj;t+i
The FOCs w.r.t Cj;t ,Nj;t and Bj;t are identical to the conditions
obtained from the rental model - see last lecture for intuition.
The additional FOC w.r.t Sj;t implies that at an optimum the con-
sumer equates the marginal cost of consuming a bit less today with
the discounted marginal bene t of holding an equity claim today, and
selling it and consuming its proceeds tommorow.
Aggregate Decision Rules
We aggregate as before (please see previous notes) but with the additional
condition that share holdings of all j households must sum to 1.
1
X
Sj;t = 18t
j=1

Additionally because the households collectively own the rms

t+1 t+1
=
t t
the FOCs of the rm with respect to capita, and households FOCs for
Bj;t and Sj;t imply that
n o n o n o
k y
Et j;t+1 Rt+1 = Et j;t+1 Rt+1 = Et j;t+1 Rt+1 :
Again, in a deterministic setting,
ky
Rt+1 = Rt+1 = Rt+1
The Value of the Firm
So, in a deterministic setting
Vt+1 + Dt+1 Vt+1 + Dt+1
Vt = y =
Rt+1 (1 + rt+1)

Iterating this forward -e.g.

1 1 1 1 1
Vt = Vt+2+ Dt+1+ Dt+2
(1 + rt+1) (1 + rt+2) (1 + rt+1) (1 + rt+1) (1 + rt+2)

We can therefore write

0 !1
1
X s
Y
@
1 A Ds
Vt =
s=t+1 j=t+1 1 + rj
Now in steady state
D=Y K W N:
From last week's session: Euler's Theorem tells us that

Y = rk K + W N ;
and in steady state that
rk = r + :
So,
D = (r + ) K + W N K W N = rK:
Therefore
1
X s
1
V = rK
s=1 1 + r
Expanding this gives
V =K
Asset pricing:
We have equities and bonds in the model above, so have a candidate asset
pricing model
( )
t+1
1 = Et Rt+1
t

( )
t+1 y
1 = Et Rt+1
t

If we assume that these bonds are risk-free - i.e. they deliver a unity of
consumption in each period, the rst equation can be written as:
( )
t+1
1 = Rt+1Et
t
Rt+1is known in period t

So, can we compute the equity risk premium?

Let's use our numerical solution (Note: have to advise the program
that Rt+1is known in period t- how?)

What will be the outcome? Homework