[Math] Deriving Stochastic Euler Equation

economicsself-learning

If a consumer has utility function
\begin{equation*}
u(c_t) = ac_t – \cfrac{b}{2}c_t^2
\end{equation*}

and present value budget constraint

\begin{equation*}
\sum_{j=0}^\infty E_t[\beta^jc_{t+j}] = \sum_{j=0}^\infty E_t [\beta^j y_{t+j}]
\end{equation*}

Then how does it follow that the Euler equation is

\begin{equation*}
E_t[c_{t+k}] = c_t,\quad k\geq 1
\end{equation*}

I tried to find it as follows, but without success (especially I don't see why there is $c_{t+k}$ in the Expectation operator $E_t$)

\begin{equation*}
\max_{c_t} u(c_t) \quad \textrm{s.t.}\quad \sum_{j=0}^\infty E_t[\beta^jc_{t+j}] = \sum_{j=0}^\infty E_t [\beta^j y_{t+j}]
\end{equation*}
The Lagrangian is
\begin{equation*}
L = u(c_t) + \lambda\left[ \sum_{j=0}^\infty E_t[\beta^jc_{t+j}] – \sum_{j=0}^\infty E_t [\beta^j y_{t+j}] \right]
\end{equation*}
The First Order Condition gives
\begin{equation*}
b c_t = E_t[\beta^jc_t]
\end{equation*}

Best Answer

The consumer maximizes intertemporal utility over the whole stream of consumption (and I suspect income is exogenous here). Also for the result to pass through, the discount rate for utility must be identical with the discount rate for consumption-income (usually they aren't, the first being related to pure time preference, the second to interest rates). But assume they are identical. Then we have

\begin{equation*} \max_{\{c_{t+j}\}|_{j=0}^{\infty}} \sum_{j=0}^{\infty}E_t[b^ju(c_{t+j})] \quad \textrm{s.t.}\quad \sum_{j=0}^\infty E_t[\beta^jc_{t+j}] = \sum_{j=0}^\infty E_t [\beta^j y_{t+j}] \end{equation*} Since the budget constraint is written in present-value form, then we have one lagrange multiplier for all periods, so the Langrangean is

\begin{equation*} L =\sum_{j=0}^{\infty}E_t[\beta^ju(c_{t+j})] + \lambda\left[ \sum_{j=0}^\infty E_t[\beta^jc_{t+j}] - \sum_{j=0}^\infty E_t [\beta^j y_{t+j}] \right] \end{equation*}

The consumer solves this problem for $j=0,1,...$. For $j=0$ the expectations operator goes away and the first order condition is

$$j=0\qquad u'(c_t) + \lambda = 0 \Rightarrow a - bc_t = \lambda \Rightarrow c_t = \frac {a+\lambda}{b}$$

For $j=k$ we have

$$j=k\qquad E_t[\beta^ku'(c_{t+k})] + \lambda\beta^k = 0 \Rightarrow \beta^k\left(a - bE_t[c_{t+k}]\right) = \lambda\beta^k \Rightarrow E_t[c_{t+k}] = \frac {a+\lambda}{b}$$

So

$$E_t[c_{t+k}] = c_t$$

Intuitively, this happens because essentially the consumer solves a static problem, although in an intertemporal guise. Decision-making becomes truly dynamic when there exist factors that can be accumulated, creating the trade-off between present and future.

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