Reetika Garg
Department of Economics
Delhi School of Economics
Course 004: Macroeconomic Theory
15th April 2025
Problem Set 2
1. Consider an individual who lives for two periods and whose utility is given by
1−𝜃 1−𝜃
𝐶1𝑡 1 𝐶2𝑡+1
𝑈𝑡 = + , 𝜃 > 0, 𝜌 > −1
1−𝜃 1+𝜌1−𝜃
Let P1 and P2 denote the prices of consumption in the two periods, and let W denote the
value of the individual’s lifetime income; thus the budget constraint is
𝑃1 𝐶1𝑡 + 𝑃2 𝐶2𝑡+1 = 𝑊
a. What are the individual’s utility-maximizing choices of C1t and C2t+1, given P1, P2, and W?
b. The elasticity of substitution between consumption in the two periods is
− ∂ln((𝐶1𝑡 /𝐶2𝑡+1 )/𝜕𝑙𝑛(𝑃1 /𝑃2 )
Show that with the utility function given above, the elasticity of substitution between
C1t and C2t+1 is 1/θ.
2. Consider the Diamond’s two period overlapping generations model where all agents have
identical preferences. Each representative agent born in period t, supplies 1 unit of labour
when he is young and divides the resulting labour income, 𝑤𝑡 𝐴𝑡 , between first period
consumption (𝐶1𝑡 ) and saving (𝑆𝑡 ). In the second period t+1, the individual simply
consumes the saving and any interest he or she expects to earn (savings in period t gets
converted into capital stock in t+1, which generates interest income in t+1).
𝑒
Agents have perfect foresight so 𝑟𝑡+1 = 𝑟𝑡+1 . Moreover, the agents neither inherit anything
from their parents, nor do they leave bequests.
Suppose the representative agent of generation t has the following lifetime utility function.
1
𝑈𝑡 = log(𝐶1𝑡 ) + log(𝐶2𝑡+1 ) , 𝜌 > −1
1+𝜌
Aggregate production function in the economy is Cobb- Douglas with labour productivity
𝐴𝑡 growing at the rate g
𝑌𝑡 = 𝐾𝑡𝛼 (𝐴𝑡 𝐿𝑡 )1−𝛼 ; 0 < 𝛼 < 1
Population grows at a constant rate n and there is no depreciation of capital stock.
a. Write down the optimization problem of the representative agent of generation t
subject to his lifetime budget constraint.
b. Derive the optimal values of 𝐶1𝑡 , 𝑆𝑡 𝑎𝑛𝑑 𝐶2𝑡+1 as a function of current wage rate 𝑤𝑡 and
future interest rate 𝑟𝑡+1 .
c. In period t, each young person earns 𝑤𝑡 𝐴𝑡 , saves 𝑆𝑡 out of it and consumes the rest
𝐶1𝑡 . Aggregate savings of all the young people in period t , 𝑆𝑡 𝐿𝑡 , forms capital stock of
the economy in the next period 𝐾𝑡+1 . The old people in period t, consume interest
income from capital stock invested in period t-1. Derive the aggregate consumption of
all young and all old people in the economy for period t. From this identify the
Reetika Garg
Department of Economics
Delhi School of Economics
aggregate savings of all the agents in the economy (savings of all young + dissavings of
all old) in period t.
d. Derive the dynamic equation representing the evolution of capital per unit of effective
labour (𝑘𝑡 = 𝐾𝑡 /𝐴𝑡 𝐿𝑡 ) for this economy. Draw the corresponding phase diagram 𝑘𝑡+1
as a function of 𝑘𝑡 . Production function can be written in terms of output per unit of
effective labour 𝑦𝑡 as a function of capital per unit of effective labour i.e.
𝑦𝑡 = 𝑘𝑡𝛼 ; 0 < 𝛼 < 1
e. Based on the phase diagram argue that there exists a unique nontrivial balanced growth
path level of 𝑘 denoted as 𝑘 ∗ which is stable.
f. Calculate the precise value of 𝑘 ∗ in terms of the parameters
g. Describe how each of the following effects 𝑘𝑡+1 as a function of 𝑘𝑡 :
i. A rise in n.
ii. A downward shift of the production function (that is, production function takes
the form 𝑦𝑡 = 𝐵𝑘𝑡𝛼 and B falls).
iii. Relax the assumption of no depreciation of capital stock (𝛿 = 0) and allow for
positive depreciation rates (0 < 𝛿 < 1).
h. Linearise 𝑘𝑡+1 as a function of 𝑘𝑡 around 𝑘 ∗ , and obtain the speed of convergence
towards the balanced growth path (𝑘 ∗ ).
i. Assuming that labour productivity 𝐴𝑡 is constant i.e. 𝑔 = 0 and 𝐴𝑡+1 = 𝐴𝑡 = 𝐴0 = 1,
derive the general expression for golden rule value of capital –labour ratio 𝑘𝑔 . [Hint:
Write wage rates and rental rates as a function of steady state level of capital labour
ratio. Using this, calculate the steady state level of per capita consumption as a function
of steady state capital labour ratio. ]
j. Calculate the precise golden rule value of capital –labour ratio 𝑘𝑔 and steady state value
of capital labour ratio, in terms of the parameters. Is the steady state dynamically
efficient?
3. Consider the Diamond economy in question 2 where g is zero, production is Cobb Douglas,
and utility is logarithmic.
a. Pay-as-you-go social security. Suppose the government taxes each young individual an
amount T and uses the proceeds to pay benefits to old individuals; thus, each old person
receives (1 + 𝑛)𝑇
i. How, if at all, does this change affect equation giving 𝑘𝑡+1 as a function of 𝑘𝑡
1 1
𝑘𝑡+1 = (1 − 𝛼)𝑘𝑡𝛼
(1 + 𝑛) 2 + 𝜌
ii. How, if at all, does this change affect the balanced-growth-path value of k?
iii. If the economy is initially on a balanced growth path that is dynamically
efficient, how does a marginal increase in T affect the welfare of current and
future generations? What happens if the initial balanced growth path is
dynamically inefficient?
Reetika Garg
Department of Economics
Delhi School of Economics
b. Fully funded social security. Suppose the government taxes each young person an
amount T and uses the proceeds to purchase capital. Individuals born at t therefore
receive (1 + 𝑟𝑡+1 )𝑇 when they are old.
i. How, if at all, does this change affect equation giving 𝑘𝑡+1 as a function of 𝑘𝑡 ?
1 1
𝑘𝑡+1 = (1 − 𝛼)𝑘𝑡𝛼
(1 + 𝑛) 2 + 𝜌
ii. How, if at all, does this change affect the balanced-growth-path value of k?
