Welfare effects of controlling labor supply: an application of the stochastic Ramsey model

In this paper we extend Merton's (Rev. Econom. Stud. 42 (1975) 375) classic stochastic version of the Ramsey model by allowing the government to control the expected growth rate of the labor supply. We characterize the solution to this control problem for general time-separable preferences, and derive an analytical solution for the CRRA case. The results show to what extent the planner, or government, increases consumption and welfare by taking an active role in controlling the economy. We also explore the implications of government control of labor growth for the term structure of interest rates and the effects of taxes on capital.