December 25, 2016, Christopher D. Carroll Envelope

The Envelope Theorem and the Euler Equation

This handout shows how the Envelope theorem is used to derive the consumption Euler equation in a multiperiod optimization problem with geometric discounting and intertemporally separable utility.

The consumer’s goal from the perspective of date is to

| (1) |

subject to the dynamic budget constraint

The problem can be written in Bellman equation form as

The first order condition for (3) can be written as

and we can define a function that returns the that solves the max problem for any given . That is, for the first order condition (5) will hold so thatNow define a function

with partial derivatives and note that by definitionThe Chain Rule of differentiation tells us that

Here’s the key insight: The assumption that consumers are optimizing
means that we will always be evaluating the value function and its
derivatives at a that satisfies the first-order optimality condition
(6).^{1}
Thus we have from (8) that

Now notice that the RHS’s of (5) and (14) are identical, so we can equate the left hand sides,

and since a corresponding equation will hold in period we can rewrite (14) asThe general principle can be condensed into a rule of thumb by realizing that the Envelope theorem will always imply that the total derivative of a value function with respect to any choice variable must be equal to zero for optimizing consumers (because the first order condition holds). Thus we could have obtained the result immediately by treating as though it were a constant (that is, treating the problem as though ) and taking the derivative of Bellman’s equation with respect to directly. This leads immediately to the key result: