Two INTERMEDIATE MACROECONOMICS Questions. Need it in 2 and half hours!!!!

Problem Set 2 Econ W3213

Intermediate Macroeconomics Spring 2013

Due at the beginning of class Thursday February 21nd

(or in mailbox 20 in IAB 1022 before that point) 1. Fiscal Stimulus in a Neoclassical Model. The economic model that we have been developing up until now in the course has been “Neoclassical” in the sense that all markets have been assumed to be competitive and we have abstracted from all “market failures.” In this question, we explore the implications of fiscal stimulus – i.e., increases in government purchases – on output and consumption in this Neoclassical model.1 Later in the class, we will study fiscal stimulus in a Keynesian model. Consider a Robinson Crusoe economy (i.e., an economy populated by a large number of identical households). In such an economy, all households will do the same thing since everyone is identical. We can therefore represent the whole household side of the economy by one “representative consumer,” which we refer to as Robinson Crusoe. One somewhat tricky aspect of writing the model this way is that we will be using the same symbols to represent both individual variables and the corresponding aggregate variables. For example, we will use the symbol to represent individual consumption but also to represent aggregate consumption.2 The same will be true for hours worked , government spending and taxes . It is important to keep in mind when solving the problem that from the individual’s point of view certain variables are exogenous – i.e., taken as given. For example, each household doesn’t take into account how a change in consumption and hours worked will affect taxes and government spending because from its perspective any change in its behavior has a trivial effect on the aggregate and thus a trivial effect on taxes and government spending. Suppose Robinson Crusoe’s preferences can be represented by the following utility function:

log log 1 log .

Here denotes consumption and denotes hours worked as in the models we have seen earlier in the class. The new element is , which represents government purchases. We entertain the possibility that Robinson Crusoe may value the things that the government purchases. This is why shows up in Robinson Crusoe’s utility function. The degree to which Robinson Crusoe

1 Notice, that here I am careful to talk about government purchases as opposed to government spending. Government spending includes transfers. Here we are focusing on purchases of goods and services by the government, not transfers. Economists and others are not always careful to make this distinction. Sometimes they will use the term government spending when they in fact mean to say government purchases. This distinction is important since fiscal stimulus in the form of transfers can have very different effects on output and consumption than purchases of goods and services by the government. 2 Formally, the idea here is that there are a continuum of identical households of length one (i.e., one household on each point on the interval from zero to one). Each one makes the same consumption choice (since they are identical) and so the aggregate is equal to the individual choice times the “number of households” which is represented by the length of the interval and for simplicity is equal to 1 (as opposed to in the last problem set).

values government purchases is governed by the parameter . Suppose Robinson Crusoe’s budget constraint is , where denotes the wage rate and denotes lump sum taxes paid by Robinson Crusoe. Assume for simplicity that the government runs a balanced budget, i.e., that . Notice, also, that the resource constraint in this economy implies that

, i.e., consumption plus government purchases cannot exceed the amount of output produced . In this model, we will treat , , and as endogenous variables. All other variables – including

and – are considered exogenous. a) (10 points) Derive Robinson Crusoe’s labor supply curve. (Hint: Since is exogenous, Robinson Crusoe treats it as a constant.) b) (20 points) Suppose the production function in the economy is and the wage is thus given by as in Problem Set 1. Use this equation, Robinson Crusoe’s labor supply curve, the economy’s resource constraint and/or the balanced budget equation to solve for output in terms of only , , and . c) (10 points) The government purchases multiplier is defined as the number of dollars that output rises by when government purchases rise by one dollar. (You can assume for simplicity that all the endogenous variables are denoted in dollars.) What is the government purchases multiplier in this economy? If 0, what is the range of values that the government purchases multiplier can take? d) (10 points) Solve for consumption in terms of only , , and . Briefly comment on how an increase in government purchases affects consumption. e) (10 points) In one paragraph, discuss whether an increase in government purchases makes Robinson Crusoe better or worse off. In particular, comment on whether Robinson Crusoe is made better off in the case where he does not value the things the government purchases, i.e., if

0. 2. Ricardian Equivalence. In this question, we explore the consequences of different ways of financing government purchases. In particular, we study the difference between tax financing and debt financing of government purchases. The question we ask is, Is the stimulative effect of the increase in government purchases greater or less when the government finances the stimulus by an increase in taxes today as oppose to by debt? An important qualifier is that we study this question under the simplifying assumption that the government can impose lump sum taxes. The answer to this question is different if the government needs to impose distortionary taxes (i.e., labor income taxes or consumption taxes). Suppose that Robinson Crusoe lives for two periods and that his utility from consumption is

log log .

Here we abstract for simplicity from endogenous labor supply and from the utility that Robinson Crusoe receives from government spending. This turns out not t0 matter for the analysis at hand. Robinson Crusoe’s budget constraints are

in period 1 and

1

in period 2. Here and denote Robinson Crusoe’s exogenous income in periods 1 and 2, respectively, and denote lump sum taxes imposed by the government in periods 1 and 2, respectively, and denotes the amount of bonds purchased by Robinson Crusoe in period 1. denotes the exogenous interest rate on bonds. Suppose that Robinson Crusoe can borrow from “abroad,” i.e., that there is a world bond market in which Robinson Crusoe (and the government) can borrow and lend at the interest rate . This assumption implies that the amount of bonds that Robinson Crusoe purchases need not equal the amount of bonds that the government issues. a) (10 points) Derive Robinson Crusoe’s consumption Euler equation. I.e., derive a condition that describes the optimal trade-off between consuming in period 1 versus saving and consuming in period 2. b) (10 points) Use the consumption Euler equation and the budget constraints to solve for consumption in periods 1 and 2 in terms of only exogenous variables and parameters (i.e., , ,

, , , and ). c) (10 points) Now suppose there is a war in period 1 and the government decides to spend to purchase goods and services. The government needs to finance this spending. We consider two polar extreme options. The first option is to raise in taxes in period 1 and thus pay for the entire spending contemporaneously. The second option is to issue debt in period 1 and raise enough taxes in period 2 to pay back the debt. If the government chooses the second option, how high do taxes need to be in period 2? d) (10 points) Use your results from parts (b) and (c) to answer the question, How does the choice of the government between financing the government purchases by contemporaneous taxes or debt affect consumption in periods 1 and 2. Comment briefly on the intuition for your result. e) For extra credit: Show that this same conclusion holds even if we allow for endogenous labor supply with disutility of labor of the form used in question 1. (Hint: When maximizing with respect to many variables, you take the partial derivative of the objective function with respect to each and set these to zero. I.e., you maximize with respect to each endogenous variable separately holding the other endogenous variables fixed.)