Problem Set #2 - Econ 2220 A,B

“Harry” Haishi Li, Antony Cheung, Yulin Wang

September 22, 2023

This problem set is due at 9:30am on Oct 9. Please submit an electronic copy on Moodle.1

You may work in groups of up to five. Please form groups on Moodle and have one group member
make the submission. Please write the names of your group-mates on the problem set. Late prob-
lem sets will not be accepted.

Question 1: Labor Supply and Labor Demand How would each of the following affects the
equilibrium wage and employment? Explain using a figure with labor demand and supply curves.

1. Due to an increase in foreign investment, the amount of capital stock increases.

2. Oil price increases temporarily, which worsens total factor productivity.

3. There is a large influx of immigrants.

Question 2: Labor Supply by You and by Elon Musk Your friend is saying that he wants
to quit his job if he becomes rich. In fact, some people seem to dream about quitting their jobs
after becoming rich. However, many people who have high income do not quit their jobs even after
becoming rich (i.e. accumulating wealth) (Think about famous entrepreneurs.). Can you make
sense of both observations? Explain using what we have learned in class about substitution and
income effects (Max. 10 sentences).

Question 3: Labor Supply with Government The labor market model that we studied in
class is called a Classical model in the sense that all markets have been assumed to be competitive
and we have assumed that no “market failures” exist.

We studied the effects of productivity changes or tax changes in the Classical model. In this ques-
tion, we explore the implication of fiscal stimulus – i.e., increases in government purchases – on
labor, output and consumption in this Classical model. Later in the class, we will study fiscal
stimulus in a Keynesian model.

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Special thanks to Robert Jackman, Rafael Lopes de Melo, John Grigsby, Xiaoxuan Meng, Wataru Miyamoto for
sharing questions upon which this problem set is based.

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Problem Set #2 Econ 2220 - Fall 2023

Suppose there is only one person again (Robinson) and his utility function is given by:
log(C) + β log(1 − N ) + θ log(G),
where G is government purchases, C is consumption and N is labor (0 ≤ N < 1). Here we
entertain the possibility that Robinson may value the things that the government purchases, so
G shows up in the utility function. θ governs how much Robinson values G. Suppose Robinson’s
budget constraint is given by C = wN − T where T is the lump sum tax. Also, assume for
simplicity that the government runs a balanced budget, G = T . The resource constraint in the
economy is Y = C + G, i.e., consumption plus government purchases cannot exceed the amount of
output produced Y . In this model, we will treat N, Y, C as endogenous variables and the rest are
exogenous.
1. Derive Robinson’s labor supply curve (Express N as a function of w and T ). Is labor supply
increasing/decreasing in wage? Is income effect or substitution effect stronger? (Hint: Since
G is exogenous, Robinson treats it as a constant.)
2. Suppose the production function is Y = AN , and thus the wage is given by w = A (This
is actually the labor demand curve.). Use this equation and labor supply curve, resource
constraint and/or the balanced budget equation to solve for equilibrium labor in terms of
only G, A, β. Comment on how an increase in government purchases affects labor.
3. Solve for output in terms of only G, A, β. The government purchase multiplier is defined as
the number of dollars that output rises by when government purchases rise by a dollar. What
is the government purchase multiplier in this economy? If β > 0, what is the range of values
that the government purchase multiplier can take?
4. Solve for consumption in terms of only G, A, β. Comment on how an increase in government
purchases affects consumption.
5. In a few sentences, discuss whether an increase in government purchases makes Robinson
better or worse off. In particular, comment on whether Robinson is made better off in the
case where he does not value the things the government purchases, i.e. θ = 0.

Question 4: An Unsophisticated Consumption Decision Consider unsophisticated Robin-

son’s consumption decision. His consumption today (period 1) is determined by disposable income
today as follows.
C1 = C̄ + M P C × (Y1 − T1 ),
where C1 is consumption today, Y1 is income today, T1 is a lump-sum tax today, C̄ is the min-
imum level of consumption Robinson needs and M P C is the marginal propensity to consume
(0 < M P C ≤ 1).
1. What is the effect of increase in the lump-sum tax today on Robinson’s consumption today?
How much does consumption today change when the lump-sum tax T1 increases by one unit?
2. What is the effect of increase in a lump-sum tax tomorrow (say, in period 2) on Robinson’s
consumption today? Discuss the difference between your answer to this question (2) and
question (1). Based on your answer, do you see any problem with this consumption function?
Explain the problem if there is any.

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Problem Set #2 Econ 2220 - Fall 2023

Question 5: A Sophisticated Consumption Decision Consider sophisticated Robinson’s

two-period consumption decision problem. The notations of variables are the same as those in the
lecture slides. His life time utility is given by:

U (C1 , C2 ) = log(C1 ) + log(C2 ),

Here we assume a discount rate β = 1 implicitly. Budget constraints are given by:

C1 + B = Y1 − T1
C2 = Y2 − T2 + B,

in period 1 and 2 respectively. So, we assume the interest rate is zero (r = 0) implicitly. T1 , and
T2 are lump-sum taxes in period 1 and period 2 respectively.

1. Derive the intertemporal budget constraint for Robinson (Hint: Combine two budget con-
straints to eliminate B.). Provide the interpretation of the intertemporal budget constraint
(i.e. what does the intertemporal budget constraint imply?).

2. Solve the utility maximization problem and derive the optimal level of consumption in each
period, C1 and C2 (i.e. Express C1 and C2 in terms of Y1 , Y2 , T1 , and T2 .).

3. Now suppose Robinson cannot borrow. He can only save. Namely, B ≥ 0. What is the
optimal level of consumption in each period? Answer this question in each of the following
two cases.

(a) Y1 − T1 ≥ Y2 − T2 (i.e. his disposable income is larger in period 1)

(b) Y1 − T1 < Y2 − T2 (i.e. his disposable income is smaller in period 1)

Provide intuition for your answer. (Hint: With the optimal level of consumption you find
in question (2), what is the implied borrowing B? Does it satisfy the borrowing constraint
B ≥ 0? If not, what is the best for Robinson to do? Is it optimal to set B = 0, namely
consuming everything you have in period 1?)

4. Robinson still cannot borrow. Suppose the government plans to cut the lump-sum tax in
period 1 by increasing the lump-sum tax in period 2, keeping the present value of lump-sum
tax constant (i.e. T1 goes down while T2 goes up by the same amount so there is no change
in T1 + T2 .). What is the effect of this policy on the optimal level of consumption? Again,
answer this question in each of the following two cases.

(a) Y1 − T1 ≥ Y2 − T2 (i.e. his disposable income is larger in period 1)

(b) Y1 − T1 < Y2 − T2 (i.e. his disposable income is smaller in period 1)

Does this policy increase or decrease Robinson’s utility in each case? Explain your answer.

5. Does Ricardian equivalence proposition hold in each case? Provide intuition for your answer.
(Hint: Ricardian equivalence proposition says the timing of lump-sum taxes does not affect
a consumption plan. Does it hold in each case in question (4)?)

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Problem Set #2 Econ 2220 - Fall 2023

Question 6: Saving-investment Diagram How would each of the following affects equilibrium
saving, investment, and the real interest rate? Explain using the saving-investment diagram. State
your assumptions if necessary.
1. Income is expected to rise in the future.
2. Productivity is expected to drop next year.

Question 7: Finding the Goods Market Equilibrium A closed economy has full-employment
output of 6000. Government purchases are 1400. Desired consumption and desired investment are
given by:

Cd = 4000 − 2000r + 0.01Y

Id = 1000 − 3000r,
where Y denotes output and r is the expected real interest rate.
1. Find the real interest rate that clears the goods market. Assume that output equals full
employment output.
2. Calculate the amount of saving, investment, and consumption in equilibrium.
3. If a shock to wealth causes desired consumption to decline by 200 (so that the new equation
for desired consumption is Cd = 3800 − 2000r + 0.01Y ), find the equilibrium real interest rate,
saving, investment, and consumption.

Question 8: Intertemporal Consumption Decisions Consider an agent (Anna) with pref-

erences over two periods,

U (x1 , x2 ) = u(x1 ) + βu(x2 )

Anna is endowed with 1 unit of x1 , and 0 units of x2 . Anna faces some interest rate, r, which she
takes as given.
1. What is Anna’s budget constraint in period 1, given that she may save or borrow? What is
her budget constraint in period 2, given that she may save or borrow?
2. Combine these two budget constraints: what is Anna’s lifetime budget constraint?
3. Specify the problem that Anna will solve to maximize lifetime utility? What are the first
order conditions?
4. What is her Euler Equation? Please offer a short interpretation of this Euler Equation.

Now, suppose that Anna lives for T > 2 periods. She is endowed with 1 unit of the good in
period 1, and 0 units of the good in all other periods. Her preferences are described as
T
X
U (x1 , ..., x2 ) = β t−1 u(xt )
t=1

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Problem Set #2 Econ 2220 - Fall 2023

5. State Anna’s budget constraint. If you are stuck, consider using the same method that you
used for the two period model, and extend that to 3 periods. Do you notice a pattern?

6. Derive a first order condition. Show the Euler Equation. Is it any different than the two
period case? What if we considered the relationship of consumption that was two periods
apart? Is there an analogy to the Euler Equation for this relationship?
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7. Define β ≡ 1+ρ . We call ρ the discount rate. Suppose ρ > r. Does Anna’s consumption of
the good increase over time or decrease? What if ρ < r?

Question 9: Intertemporal Consumption Decisions and Production Consider the same

framework (and endowment) as the previous question. However, Anna can no longer save or
borrow. Instead, she may convert her endowment into capital, k, at a rate of 1:1 (e.g. one unit of
the consumption good can be converted into one unit of capital). She gets period 2 goods based
on this investment in capital. The production function is

x2 = Ak α , α ∈ (0, 1)

1. Derive Anna’s lifetime budget constraint.

2. How much of Anna’s endowment of x1 does she choose to convert into k?