International Monetary Economics

Summer Semester 2025

Problem Set 1
Dr. Nicolas Syrichas
April 24, 2026

1. Utility Maximization
Our economic agent Ian consumes two goods labelled 1 and 2 in quantities x1 and x2 .
His preferences are represented by a utility function:

√ √
U (x1 , x2 ) = x1 + x 2 (1)
The price of good x1 is p1 and the price of good x2 is p2 . We denote income by M, as
usual, with M > [Link] function is well-defined for x1 > 0 and for x2 > 0. Assume
x1 > 0 and x2 > 0.
(a) Compute ∂u/∂x1 and ∂ 2 u/∂ 2 x1 . Is the utility function increasing in x1 ? Is the
utility function concave in x1 ? Explain.
(b) The consumer maximizes utility subject to a budget constraint. Write down the
maximization problem of the consumer with respect to x1 x2 and M . Explain briefly
why the budget constraint is satisfied with equality. (Hint: you can use the answer
in point 1)
(c) Write down the Lagrangean function and write down the first order conditions for
this problem with respect to x1 , x2 , and λ.
(d) Solve explicitly for x1 ∗ and x2 ∗ as a function of p1 ,p2 , and M

2. Marginal returns of capital/labor

Consider a single representative firm that chooses Capital K and Labor L to maximize
profits Π .The cost for each unit of Capital is r and for each unit of Labor is w. Suppose
the production function of output Y is Cobb-Douglas:
Y = F (K, L) = AK α L1−α

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 Assume that A > 0 is the constant productivity and that 0 < α < 1.
(a) Write down the maximization problem of the firm with respect to K and L
(b) Derive the marginal product of capital and the marginal product of labor (by taking
the respective partial derivatives of the production function).
(c) Derive output elasticities to capital and labor using the formula

∂Y /Y ∂Y x
ϵx = =
∂x/x ∂x Y

i.e. by how many percents output Y changes in response to 1% change in input

factor x.

3. A static consumption-leisure choice

Our economic agent Ian is endowed with 1 unit of time and has preferences over con-
sumption c and leisure l denoted as:

U (c, l) = u(c) + u(l) (2)

He has to allocate his time optimally (i.e full time vs part time work) in order to maximize
his utility. His budget constraint is given as:

c = w(1 − l) (3)
(a) Write down the Lagrangian for this maximization problem
(b) Write down and solve the first-order conditions.
(c) Show that MRS which is the ratio of marginal utilities is equal with the price ratio.
Provide an interpretation about the trade-off Ian is facing.
(d) Draw an algebraic representation of the consumption leisure decision in terms of
the budget constraint and indifference curves.

4. Existence of Representative Firm (Advanced)

In this problem we want to show that under the perfect capital markets assumption
the maximazation problem of many firms N yields the same solution as with the a single
representative firm.
Consider an economy with N number of firms. Each firm is denoted as i = 1, , , , , N . A
firm i hires labor ni and and capital ki to produce output yi . Each firm i faces the same
maximization problem:
Π = max f (ki , ni ) − W ni − Rki (4)
ki ,ni

where R is the rental rate of capital and W is the wage.

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(a) Write down the first-order conditions with respect to capital and labor for firm i
and firm j.
(b) Show that the Marginal product of capital and labor of firm i and firm j are
equalized.
Now consider that the firms problem is solved by a fictitious social planner who can
allocate aggregate endowments of capital and labor K and N across firms P by choosing
N
each individual firm’s ki and ni subject to the Resource Constraints: i ki = K
PN
and i ni = N .
The planner’s problem is:
N
X N
X N
X
F (K, L) = max f (ki , ni ) s.t ki = K and ni = N (5)
{ki ,ni }N
i=i i i i

(a) Write down the Langrangian denoting the Lagrange multipliers on the planner’s
resource constraints by R and W .
(b) Take the first-order conditions with respect to ki and ni . Do you notice any simi-
larities with the solution in (b).

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