Problem Set 3
(Due Date: October 21, 11:59 pm)
* QUESTION 1 - submission through the e-campus
Intermediate Macroeconomics (Fall 2025)
Professor: Wonmun Shin
1 Robinson Crusoe Economy with Concave Production Function
In class, we assumed that Robinson receives a constant wage. This is a realistic assumption if there are
no diminishing returns to his work (that is, if the amount of sh he gets for working one hour is the same
regardless of the amount of hours he works). More realistically, he faces diminishing returns (that is, the more
√
he works, the harder he gets additional sh). Imagine that his budget constraint is C = A L where L is the
amount of work and C is consumption.
(a) Plot the budget constraint in the C -L space.
Imagine that Robinson's preferences are normal (that is, increasing in C , decreasing in L and convex).
(b) Plot the indierence curve in the C -L space (Note: recall that L is labor, not leisure).
(c) Find graphically the optimal amount of work eort and consumption.
(d) Imagine that Robinson wins the lottery. That is, without having to work, he can now enjoy 10,000 sh for
free. Display Robinson's new budget constraint and his new likely behavior. Make sure you explain Robinson's
behavior in terms of income and substitution eects.
(e) Imagine instead that Robinson's economy experiences a positive productivity shock which is a technological
improvement (that is, A in the production function increases). Plot the new budget constraint and describe
the new optimal choice for Robinson. Make sure you explain Robinson's behavior in terms of income and
substitution eects.
(f) What are dierences between your answers in (d) and (e)? Explain.
2 Constant Wage Model with Taxes and Transfers
Suppose that a worker receives a wage rate w and works L hours. The government imposes taxes on his income
at the constant rate τ . He spends all his income in sh so his budget constraint is C = wL (1 − τ ). The worker
has normal preferences over leisure and sh (represented by the usual indierence curves).
(a) Draw the budget constraint of this individual.
(b) Display graphically what is the optimal consumption-labor choice for this worker.
(c) Imagine that the government increases this worker's tax rate from τ to τ ′ . What is the new budget constraint?
In the new optimum, is he going to consume more or less? Is he going to work more or less? Explain your
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answers in terms of income and substitution eects.
Suppose now that, on top of being taxed by the government, the workers also received a transfer, which we call
S , from the government. The transfer is not related to how much he works (that is, this transfer is lump-sum
transfer). Hence, the guy's total revenue is his income (after tax) plus the transfer.
(d) Write down an equation for the budget constraint.
(e) Draw the budget constraint of this individual.
(f) Display graphically what is the optimal consumption-labor choice for this worker.
(g) Imagine that the government increases this worker's tax rate from τ to τ ′ . At the same time, it increases
the transfer from S to S ′ , so as to achieve the same quantity of consumption and leisure that the worker had
previous to the increase of tax rate. What is the new budget constraint? In the new optimum, is he going to
consume more or less? Is he going to work more or less? Is your answer dierent from (c)? If so, why? Explain
your answers in terms of income and substitution eects.
3 Ricardian Equivalence
Consider a consumer who receives incomes Y1 and Y2 in period 1 and 2 respectively. Imagine that there is a
government who levies a tax on this individual. The total taxes paid in period 1 and 2 are T1 and T2 respectively.
The individual has access to banks so he can borrow and lend any amount he desires at the interest rate r.
Imagine that the amount of bonds he inherits when he start is zero (B0 = 0) and he want to leave no assets
when he dies after period 2 (B2 = 0). The individual needs to choose the amount of consumption in period 1
and 2 (C1 and C2 , respectively) that maximizes his utility subject to a budget constraint.
(a) Write the dynamic budget constraint (DBC) for period 1 and 2. (Note: Keep in mind that part of his
expenditure are now taxes).
(b) Write the intertemporal budget constraint (IBC). Provide an interpretation.
(c) Draw the budget constraint in a diagram that has C1 and C2 in the axes.
(d) Imagine that the individual likes to smooth consumption. How would his indierence curves look like?
Why?
(e) Display his optimal choice given the after-tax endowment, where he becomes a borrower at period 1.
(f) Suppose that the government decreases the tax rates in period 1, T1 , and in period 2, T2 , both by the same
amount (i.e. △T1 = △T2 = △T < 0). Would his consumption in period 1 change? By how much?
(g) Suppose that the government decreases the tax rates in period 1, T1 , and T2 remains the same (i.e. △T1 < 0,
△T2 = 0). Would his consumption in period 1 change? By how much?
(h) Suppose that the government decreases the tax rates in period 1, T2 , and keeps T1 (i.e. △T1 = 0, △T2 < 0).
Would his consumption in period 1 change? By how much?
(i) Imagine that the government decreases T1 by △T < 0 and increases T2 by (1 + r)△T > 0. Would his
consumption in period 1 change? By how much?
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4 Dierent Rates for Borrowing and Lending
In class, we considered the case in which the consumer can borrow and lend freely and the interest rate r.
Consider now the more realistic case in which the interest rate charged by the bank for borrowing is larger than
the interest rate by the bank consumer for the amount they deposit in the bank. In other words, the consumer
can save at the interest rate rs (s for saving) and can borrow at the rate rb (b for borrowing) with rb > rs . The
individual receives Y1 and Y2 in period 1 and 2 respectively as usual.
(a) What is the consumer's budget constraint in the case in which he consumes less than his income in period
1? Answer in the form of equation.
(b) What is the consumer's budget constraint in the case in which he consumes more than his income in period
1? Answer in the form of equation.
(c) Graph the budget constraint for the individual (on a single graph). (Hint: The budget constraint would be
a kinked line and still pass through the endowment point.)
(d) Add to your graph the consumer's indierence curves. Show graphically three possible outcomes: one in
which the consumer saves, one in which he borrows, and one in which he neither borrow nor saves.
(e) Consider the case in which the consumer does not borrow or save. How does consumption in period 1 change
when the interest rate rb increases a little bit? How does consumption in period 1 change when the interest
rate rs increases a little bit?