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variable st. dev. relative st. dev. 1st order autoc cont. cor. with output
model data model data model data model data
Y 1:39 1:81 1:00 1:00 0:72 0:84 1:00 1:00
C 0:61 1:35 0:44 0:74 0:79 0:80 0:94 0:88
I 4:09 5:30 2:95 2:93 0:71 0:87 0:99 0:80
N 0:67 1:79 0:48 0:99 0:71 0:88 0:97 0:88
Y/N 0:75 1:02 0:54 0:56 0:76 0:74 0:98 0:55
w 0:75 0:68 0:54 0:38 0:76 0:66 0:98 0:12
r 0:05 0:30 0:04 0:16 0:71 0:60 0:95 0:35
A 0:94 0:98 0:68 0:54 0:72 0:74 1:00 0:78
Notation is standard and all variables are in logs (except for r): N is hours
per capita.
Data from http://www.nber.org/papers/w7534.pdf
1.1 Solution
Overall: even though the model fails in some dimension, it is surprising that such
a simple model captures so many features reasonably well. However, the model
is weak on internal propagation: most of the volatility comes from the volatility
of the technology shock and the serial correlation comes almost exclusively from
the persistence of the technology shock.
Remark 2 Model does pretty well in matching investment (three times as volatile
as output)
Remark 3 The model struggles to generate total hours worked that are as
volatile as output. Moreover, in the data, the variation in total hours is driven
by employment numbers (workers) rather than hours per worker.
1
Remark 4 All aggregates exhibit large persistence: serial correlations of 0.9 in
annual time series are common But the model only generates these by giving
the technology shock the "right" autocorrelation. Typical for basic RBC, lacks
internal propagation mechanism.
Remark 5 The model predicts almost perfect contemporaneous correlation with
output while the data show a somewhat weaker correlation. The model does not
do well for wages. In the model, wages have an allocative role - in the data
there is less evidence of wages adjusting to clear the labour market (e.g. implicit
contracts).
2.1 Solution
1. The budget constraint in the one-period problem is given by ct = wt :lt
and so the maximisation can simply be written as:
1
(1 lt )
max ln (wt :lt ) + b for t = 1
lt 1
The FOC is given by:
1
:wt = b: (1 lt )
wt :lt
1
= b: (1 lt ) (1)
lt
Equation (1) denes the level of l1 (implicitly), and it can be seen that in
the one-period problem the amount of labour supplied does not depend
on the real wage.
2
2. In the two-period problem, the period budget constraints are:
c1 + s1 = w1 :l1
c2 = w2 :l2 + (1 + r) :s1
So the intertemporal budget constraint is:
c2 w2 :l2
c1 + = w1 :l1 +
1+r 1+r
Therefore the Lagrangian for this problem can be written as:
" #
1 1
(1 l1 ) (1 l2 )
max L = ln (c1 ) + b + ln (c2 ) + b
c1 ;c2 ;l1 ;l2 1 1
c2 w2 :l2
c1 + w1 :l1
1+r 1+r
and the FOCs are:
dL 1
= 0: =
dc1 c1
dL 1
= 0: : =
dc2 c2 1+r
dL
= 0 : b (1 l1 ) = :w1 (2)
dl1
dL w2
= 0 : :b (1 l2 ) = : (3)
dl2 1+r
The rst two equations will combine to give us the usual Euler equation for
consumption growth, but as we are interested in the behaviour of labour
supply, we can use equations (2) and (3). Eliminating from these two
equations yields:
b (1 l1 ) : (1 + r) :b (1 l2 )
=
w1 w2
1 l1 w1
= : (1 + r)
1 l2 w2
1
1 l2 w1
= : (1 + r) (4)
1 l1 w2
3
As the interest rate increases (1+r) ", more labour will be supplied in
period 1 - this is to take generate more labour income from which to
save and therefore take advantage of the high interest rate by saving.
3. In terms of elasticities, we can show that the key determinant is the para-
meter : We can write the elasticity of relative labour supply with respect
to relative wages as:
1 l2 w1 w1
d 1 l1 w2 1 w1 1
1
1 w2
: = [ : (1 + r)] : :
d w1 1 l2 w2 1 l2
w2 1 l1 1 l1
1
1 w1 1
= : (1 + r) :h i1
w2
: (1 + r) w
w2
1
1
=
And the elasticity of relative labour supply with respect to the interest
rate is:
1 l2 1
d 1 l1 (1 + r) 1 w1 1 (1 + r)
1
: = : : (1 + r) :
d (1 + r) 1 l2 w2 1 l2
1 l1 1 l1
1
=
1 l2 1 w1
log = log( ) + log : (1 + r) + log
1 l1 w2
1 l2
d log 1 l1 1
=
w1
d log w2
1 l2
d log 1 l1 1
=
d log (1 + r)
4
3 Question 3 - Interest Rate Uncertainty
1
Suppose an individual lives for two periods and has utility E1 ln C1 + (1 + ) ln C2 :
1. Labour income is Y1 in the rst period and 0 in the second. The rate of
return on savings, r; is potentially random.
2. Let now labour income be 0 in the rst period and Y2 in the second. Y2
is certain
(a) Find C1 :
(b) Derive the impact of uncertainty about r on C1 :
3.1 Solution
1. Labour income is received in the rst period. Thus the budget constraint
is C1 + S1 = Y1 in period 1, and C2 = (1 + r):S1 in period 2. The
C2
intertemporal budget constraint is C1 + (1+r) = Y1 :
The maximisation for this problem can therefore be written as (substitut-
ing out for C2 = (1 + r) (Y1 C1 )):
1
maxE1 ln C1 + ln [(1 + r) (Y1 C1 )]
C1 (1 + )
And, noting that all variables are known with certainty except r (which
may or may not be subject to uncertainty)1 , the FOC is given by:
1 1 (1 + r)
E1 = 0
C1 (1 + ) (1 + r) (Y1 C1 )
1 1 1
E1 = E1
C1 (1 + ) (Y1 C1 )
(1 + )
C1 = :Y1 (5)
(2 + )
Equation (5) gives the optimal value of C1 and it is clear from this equation
that the value of r does not aect the choice of rst period consumption -
1 If 1 1
X is known with certainty, E1 [X] = X and E1 X
= X
:
5
it will however aect the level of period 2 consumption which is given by:
C2 = (1 + r) (Y1 C1 )
(1 + )
= (1 + r) Y1 :Y1
(2 + )
1
= (1 + r):Y1 :
(2 + )
2. Now labour income is received in the second period and therefore the
consumer must borrow to consume in the rst period.Thus the budget
constraint is C1 = S1 in period 1, and C2 = Y2 (1 + r):S1 in period 2.
The intertemporal budget constraint is (1 + r):C1 + C2 = Y2 :
The maximisation for this problem can therefore be written as (substitut-
ing out for C2 = Y2 (1 + r)C1 ):
1
maxE1 ln C1 + ln (Y2 (1 + r)C1 )
C1 (1 + )
1 1 (1 + r)
E1 =0 (6)
C1 (1 + ) Y2 (1 + r)C1
h i
Y2 Y2
If r is certain - i.e. E [r] = r in every period, E1 (1+r) = (1+r) , then we
can write
(1 + r)
E1 [Y2 (1 + r)C1 ] = E1 C1
(1 + )
2+ ) Y2
E1 C1 = E1
1+ ) (1 + r)
(1 + ) Y2
C1 = :E1 (7)
(2 + ) (1 + r)
which becomes:
(1 + ) Y2
C1 = :
(2 + ) (1 + r)
1 1
E1 >
X E1 [X]
6
Starting with the FOC (equation (6)):
1 1 (1 + r)
E1 = 0
C1 (1 + ) Y2 (1 + r)C1
(1 + ) 1
E1 = E1 (1 + r)
C1 C2
(1 + ) 1 1
= E1 E1 [(1 + r)] + Cov ; (1 + r)
C1 C2 C2
1
Then since is a convex function of C2 we can apply Jensens inequality
C2h i
and obtain E1 C12 > E1 [C 1
2]
; and since the covariance term is positive
(higher r means that the individual pays more interest and therefore con-
sumes less in period 2), then we can write:
(1 + ) 1
> E1 [(1 + r)]
C1 E1 [C2 ]
(1 + ) 1
> E1 [(1 + r)]
C1 E1 [Y2 (1 + r)C1 ]
(1 + ) [Y2 E1 [1 + r] C1 ] > C1 :E1 [1 + r]
(1 + )Y2 > C1 :E1 [1 + r] (1 + (1 + ))
(1 + )Y2 > C1 :E1 [1 + r] (2 + )
(1 + ) Y2
C1 <
(2 + ) E1 [1 + r]
(1 + ) Y2
C1uncertatiny < : = C1certatiny
(2 + ) (1 + r)
Remark 6 This savings behaviour is called prudence. It happens when the 3rd
derivative of the utility function is positive: U = ln (C) ; U 0 = C1 > 0; U 00 =
1
C2 ; U
000
= C23 > 0
The reason is that marginal utility U 0 = C1 is convex. This implies that as
uncertainty about C2 goes up, even though the mean is unchanged, E [U 0 (C2 )]
goes up. But since the euler equation has to hold U 0 (C1 ) has to increase as well,
i.e. C1 has to fall.