Macroeconomic Theory and Analysis, (Spring 2020)

Midterm 1 Suggested Solutions

Felipe Camelo Andres Ghini
New York University
Economics (GSAS)

Problem 1

If the economy slips into recession, the government will likely have to use tax policy to stimulate
the economy. How does a reduction in the corporate income tax affect firm investment and output?
Consider the investment problem of a firm that operates for two periods. Output Y in period k = 1, 2
is given by,

Yk = Ak Kkα

with 0 < α < 1 and where capital K1 is given, but K2 depends on investment I, as follows

K2 = (1 − δ)K1 + I

The capital market is perfect and the firm faces the interest rate R, which it takes as given. The
firm chooses I to maximize the present discounted returns to shareholders. Assume the firm finances
investment with retained earnings. In this case discounted payouts to shareholders are given by,
 2
(1 − τ )Y1 − I − 2c KI1 K1 + (1−τ )Y2 +(1−δ)K
R
2

 2
c I
where the term 2 K1 K1 reflects adjustment costs, and τ is the corporate tax rate.

1. Derive the first order condition for investment I and rearrange to obtain an expression for the
firm’s optimal choice of investment in terms of Tobin’s Q.

2. How does a reduction in the corporate tax rate affect investment and period 2 output? Explain
how the effect is summarized in the behavior of Q.

Solution:

Question 1

The FOC is  
I
−1 − c +Q=0
K1
where
(1 − τ )A2 αK2α−1 + 1 − δ
Q≡
R

From the FOC, we get

I 1
= (Q − 1)
K1 c

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Question 2

Notice that a reduction in the corporate tax increases the Tobin’s Q. Doing so makes I
increase, and so Y2 will increase. R is the rate at which the firm discounts future profits (and
hence the rate at which it discounts the future marginal benefit of capital). A lower R makes
future profits more valuable, and so encourages higher investment.

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Problem 2.

There is increasing pessimism about the return to capital. What will be the impact on investment,
consumption and the U.S. current account deficit? Consider the issue in the following two period
small open economy model. Let Y ≡ output, K ≡ capital,A ≡ productivity,C ≡ consumption, I ≡
investment, R ≡gross real interest rate, N X ≡ net exports and F A ≡ foreign asset holdings. The
details of the model are then as follows:

Technology and resources constraints are given by

Yk = Ak (Kk )α , k = 1, 2

C1 = Y1 − I − N X

FA = NX

C2 = (1 − δ)K2 + Y2 + RF A

K2 = I + (1 − δ)K1

The household’s optimal choice of consumption versus saving satisfies

C1−σ = RβC2−σ

The firm’s optimal choice of investment (with no adjustment costs), satisfies

A2 K2α−1 + (1 − δ) = R

Finally, the interest rate equals the world interest rate R.w

R = Rw

1. Provide brief intuition for the household’s optimal consumption/saving choice and the firms’s
investment demand decision.

2. Construct a diagram for the capital market, where you portray household saving supply, firm
investment demand and the current account deficit (equal to minus net exports). Be clear where
the saving supply and investment demand curves come from. You may assume that the world
interest rate is below the rate that would arise if the economy was closed (i.e. did not participate
in the world capital market.)

3. Construct a diagram for the period 1 production possibility frontier. Be clear where it comes
from.

4. Now suppose there is an expected decline the return to capital, reflected by an expected rise
in A2 . What is the impact on I, C1 and the current deficit (−N X). You may answer using
diagrams.

Solution:

Question 1 The household’s optimal choice of consumption versus saving satisfies

C1−σ = RβC2−σ

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On the LHS we have the marginal cost of saving at time t: which equals the marginal utility
of consumption at time t,i.e. the marginal increment in the utility of the HH by incresing
consumption at time t.
On the RHS we have the marginal benefits of saving at time t, this is, saving one unit of
consumption at time t can buy R units of consumption at time t + 1, but since the HH is
impatient, its value is discounted by β.

The firm’s optimal choice of investment (with no adjustment costs), satisfies

A2 K2α−1 + (1 − δ) = R

Here, on the LFH we have the marginal benefits from investing at time t, that is, the increase
in production at t + 1 due to that new unit of capital i.e. marginal productivity of capital at
t + 1, plus the remainder of that new capital that will not depreciate at the end of t + 1.
On the RHS we have the marginal cost of investment at t: the interest rate.

Question 2
From the FOC of the HH we derive the Savings curve (supply of funds in the capital market)
and from the FOC of the firm we get the Investment curve (demand for funds in the capital
market).
The graph would be:

Question 3
From the aggregate resource constraint we obtain the following graph:

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Question 4
An increase in A2 will raise the marginal productivity of capital in period two and so firms
are willing to invest more at time t, so investment goes up. More investment in the first
period implies more capital at period two and so more production at time 2, so Y2 goes
up. The HH will then save less and consume more in period one, then C1 goes up. Finally,
since Y1 is fixed, from the aggregate resource constraint we get that the current deficit has
to increase as well:

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Problem 3

After World War II, for a period both Japan and Germany grew much faster than the U.S., before
eventually slowing down to a growth rate in the region of the U.S. growth rate. One hypothesis
is that the high post-war growth was the result of much of the physical capital in these economies
being destroyed during the war. Analyze this issue in the context of the following simple competitive
equilibrium growth model.

Suppose there is a representative household whose optimal consumption/saving decision is given by

Ct−1 = Rt+1 βCt+1

−1

where Ct is consumption, Ct−1 is the marginal utility of consumption, Rt+1 is the gross return to capital
(the return to saving) and β  (0, 1) is the households’ subjective discount factor. The household
supplies labor Nt exogenously.

Output Yt is the following function of capital Kt , productivity At and labor:

Yt = Ktα (At Nt )1−α

with 0 < α < 1. The resource constraint and law of motion for capital are given by

Yt = Ct + It

Kt+1 = (1 − δ)Kt + It

In the competitive equilibrium, the gross interest rate equals the gross marginal return to capital
 α−1
Kt+1
α At+1 Nt+1 + 1 − δ = Rt+1

Labor and productivity grow exogenously at the rates n and a respectively, implying:
At+1 Nt+1
At N t =1+a+n

1. Consider the economy’s balanced growth path equilibrium where the quantity variables C, Y, I
and K all grow at the same rate as labor in efficiency units, AN , and where R is constant. First
K Y Y I
derive the three equations that determine R, AN , and AN . Then given AN , show how AN and
C
AN are determined.

2. Now suppose that a large fraction of the economy’s capital stock is suddenly destroyed (e.g. due
Kt K
to a war), so that falls well below its balanced growth path value .
At Nt AN
(a) What will be true about the interest rate relative to the balanced growth path?

(b) Explain how this economy will converge back to the balanced growth path equilibrium

(c) Explain why along the way it will grow faster than in the balance growth path.

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Solution:

Question 1

From the Euler equation, we get

Ct+1 C
Ct+1 = βRCt =⇒ = βR
At Nt AN

Then multiplying and dividing the LHS by At+1 Nt+1 gives

At+1 Nt+1 Ct+1 C C C

= βR =⇒ (1 + a + n) = βR
At+1 Nt+1 At Nt AN AN AN

With some cancellation and rearranging, we obtain

1
R= (1 + a + n)
β

Then, from the firm’s FOC, we get

 α−1
K
α +1−δ =R
AN

And from the production function, we get

K α
 
Y
=
AN AN

where we make use of the fact that

At Nt = (At Nt )α (At Nt )1−α

The final two equations are from the resource constraint and LOM for capital. The resource
constraint is simply obtained by diving through by At Nt :

Y C I
= +
AN AN AN

For the LOM for capital, we divide both sides by At Nt to get

Kt+1 K I
= (1 − δ) +
At N t AN AN

Then again multiplying and dividing the LHS by At+1 Nt+1 gives

K K I
(1 + a + n) = (1 − δ) +
AN AN AN

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which, after some rearranging, gives

I K
= (a + n + δ) (0.1)
AN AN

These five equations in five unknowns constitute an equilibrium in the economy.

Question 2

2.a) When the fraction of capital stock is destroyed, it is the case that:

Kt K
<
At Nt AN

from the firm first order condition/marginal product of capital equation, we can see that:

Rt+1 > R

From the household first order condition, we can see that this implies that

Ct+1 C0
>
Ct C

This then implies that the saving rate increases. This in turn implies that there is increased
Kt
capital accumulation, meaning that along the transition path, At Nt must be increasing to-
K
wards AN .

2.b) Growth in the stable balanced growth path is given by a+n. Growth along the transition
Kt
path will be higher than this because of the growth in capital stock At Nt (up until it reaches
K
the balanced growth path ratio: AN ).

2.c) Along the transition path, Rt+1 > R. That is, the marginal return to capital will be
higher than along the balanced growth path, and this is due to diminishing returns to capital
in the production function.