ECON6323 Macroeconomic Theory
Problem Set #2
Due: Mar. 11 in class
1. (Factor Prices) A firm produces goods through a CRS technology F(·, ·) with aggregate cap-
ital and aggregate labor as factor inputs. F is strictly increasing in each argument, concave,
twice continuously differentiable and homogeneous of degree one. Since there is no dynam-
ics in the firm’s decision, the firm maximizes a period-by-period profit:
max F(Kt , Nt ) − rt Kt − wt Nt (1)
Kt ,Nt
(a) Explain the reason that there is no need for the dividend income to be added in the
household’s budget constraint.
(b) Show that the firm’s FOCs can be written as
rt = f ′ (kt ) (2)
wt = f (kt ) − kt f ′ (kt ) (3)
where kt = Kt /Nt is capital-labor ratio and define f (kt ) ≡ F(Kt /Nt , 1).
2. There are ex-ante identical unit-mass households and firms. Capital is owned by the house-
hold and rented out to firms. There are four markets open for each commodity: consumption
goods, capital, government bond, and labor. The representative household maximizes the
present discounted utility
∞
max ∑ β t (v(ct ) − e(nt )) (4)
t=0
s.t.
(1 + τ c )ct + xt + bt+1 ≤ (1 − τ n )wt nt + rt kt + Rt bt + Tt (5)
kt+1 ≤ (1 − δ )kt + xt (6)
k0 > 0 and b0 given (7)
(ct , xt , kt+1 ) ≥ (0, 0, 0) (8)
0 ≤ nt ≤ 1 (9)
where wt is the wage rate and rt is the rental price of existing capital, τ n , τ c and Tt are a
flat rate labor income tax, a flat rate consumption tax, and a lump-sum transfer, respectively.
The utility for consumption v is increasing, strictly concave, and twice differentiable, and the
disutility from working is strictly convex, increasing and differentiable.
A representative firm produces goods through a technology F(·) with capital and labor as
input factors. F is strictly increasing in each argument, concave, twice continuously differ-
entiable and homogeneous of degree one. The technology exogenously evolves by z. The
firm maximizes a period-by-period profit:
max zF(kt , nt ) − rt kt − wt nt , ∀t ≥ 0 (10)
kt ,nt
1
An aggregate resource feasibility in this economy is
ct + xt + gt ≤ zF(kt , nt ), ∀t ≥ 0 (11)
and the government budget balances when
τ c ct + τ n wt nt + bt+1 = gt + Rt bt + Tt , ∀t ≥ 0 (12)
where LHS indicates government revenues and RHS indicates government outlays (expendi-
ture).
(a) Define a competitive equilibrium.
(b) Write down Lagrangian equation and FOCs for the household’s problem and firm’s
problem.
(c) Write down the present value of household budget constraint. That is, instead of having
infinite number of household budget constraint, sum them up and have just one life-time
budget constraint.
(d) With the present value budget constraint, set up a Lagrangian equation for the household
problem and show that the FOCs are identical to the FOCs in (b). (Remember, in
constructing the present value budget constraint, some of the FOCs are already used.)
(e) Assume that τ n = 0 and τ c = 0. With no distortionary taxes, the First and Second
Welfare Theorems hold for this problem. Explain why. Set up a planner’s problem with
government spending so that the competitive equilibrium allocations are Pareto optimal.
(f) Now assume that τ n > 0 and τ c = 0. When there is an increase in labor income tax,
what is the effect on capital and labor supply in the steady state?
(g) Now assume that τ n = 0 and τ c > 0. When there is an increase in consumption tax,
what is the effect on capital and labor supply in the steady state?
(h) Now assume that τ n = 0 and τ c = 0. When there is an increase in lump-sum tax Tt > 0,
what is the effect on capital and labor supply in the steady state?