5.

The output gap is defined as the difference between the actual output level and the potential
output level. Define potential output as the efficient output level, that is, the output level that a
social planner would choose. In what direction and why does a decrease in total factor productivity
affect the output gap (i) in the real business cycle model, (ii) in the New Keynesian model, and (iii) in
the labour-market search model?

Answer: In the real business cycle model, actual output is always equal to the efficient output level,
so the output gap is always equal to zero. That is the first welfare theorem holds. So changes in
productivity do not affect the output gap. In the New Keynesian model, output is demand
determined because of sticky prices. A decrease in TFP leads to a decrease in the efficient level of
output. A reduction in TFP leads to an increase in marginal costs. This will increase prices if they are
flexible (intuitively, a TFP reduction is like a negative supply shock which put upward pressure on
prices). Sticky prices will limit the increase in prices, which means (since output is demand
determined in the NK model), that actual output will drop by less than it does when prices are
flexible. The following reasoning lead to the same answer. With monopolistic competition, the
markup of price over marginal costs means that actual output is below the efficient output level.
This markup becomes smaller when marginal costs increase and prices are sticky. Consequently, the
output gap, i.e., actual output minus efficient output, increase. If the Hosios condition holds, then
the first welfare theorem also holds in the labour-market search model and TFP would again have no
effect on the output gap. If real wages are constant, then the Hosios condition cannot always hold.
In particular, an increase in TFP will increase the share of the surplus that accrues to the
entrepreneur. This will increase the gap between the actual and the efficient output level if TFP
increases. If productivity shocks are i.i.d. and the household does not care about consumption
smoothing, then neither the actual output level nor the efficient output level will be affected. The
reason is that expected future profits determine job creation.

6. Consider the following overlapping generations model without money. Each agent lives for two
periods. The young use capital to produce and this capital is rented from the old at rate rt. The
representative young faces the following maximization problem:

max c y ,t ,co ,t 1 ,k y ,t ,ko ,t 1 U c y ,t   U co ,t 1 

s.t.
c y ,t  k o ,t 1  Ak y ,t  rt k y ,t
co ,t 1  rt 1  1   k o ,t 1

A) Give a complete set of conditions that a solution of this optimization has to satisfy (the first-order
conditions).

Answer:
 Ak y ,t 1  rt
U (c y ,t ) U (co ,t 1 )
 rt 1  1   
c y ,t co ,t 1

c y ,t  k o ,t 1  Ak y ,t  rt k y ,t
co ,t 1  rt 1  1   k o ,t 1

Population growth is equal n. That is,

N y ,t 1  1  nN y ,t  (1  n) No,t 1 ,

Where Ny,t and No,t denote the number of young in period t and the number of old in period t,
respectively.

B) What is the market clearing condition for capital in period t+1?

Answer: In period t+1, there are Ny,t+1 young persons. They are all the same and each demands ky,t+1
units of capital. Total demand for capital is, thus equal to Ny,t+1ky,t+1. In period t+1, there are No,t+1 old
persons, and each old person owns ko,t+1 units of capital. Setting total supply of capital is thus equal to
No,t+1ko,t+1. Equilibrium is thus given by

N o ,t 1 k o ,t 1  N y ,t 1 k y ,t 1
or
N o ,t 1 k o ,t 1  (1  n) N y ,t k y ,t 1
or
N o ,t 1 k o ,t 1  (1  n) N o ,t 1 k y ,t 1
or
k o ,t 1  (1  n)k y ,t 1

C) Rates of return have been low for quite some time; they were already low before the financial crisis.
Use this model to explain why low rates of return can be due to low population growth.

Answer: If we plug the answer to part b in the first-order condition for ky,t+1, we get

Ak y ,t 11  rt 1

or
 1
k 
A 0,t 1   rt 1
 1 n 

This equation shows that a decrease in n, increases the amount of capital per young worker (keeping
ko,t+1 constant), which lowers the rental rate of capital and thus the rate of return. This is not the
complete story, since ko,t+1 may be lower when n and r are lower. Depending on the magnitude of
the substitution and income effect, ko,t+1 may increase or decrease. But a reduction in ko,t+1 induced
by a reduction in r cannot overturn the reduction in r because then ko,t+1 should not become smller in
the first place.
7. In the US, cyclical fluctuations in the job separation rate have little effect on the unemployment
rate. Describe the characteristics of these cyclical fluctuations in the job separation rate and explain
why they have little effect on the unemployment rate.

Answer: The separation rate decreases during a boom and increases during a recession. The
separation rate consists of two components: layoffs and quits. Layoffs are countercyclical, but quits
are procyclical. The fact that these two components move in opposite directions, reduces the volatility
of the separation rate. Nevertheless, there is still quite a bit of movement in the separation rate.
Although recessions start with a burst of layoffs, that is, an increase in the separation rate, the average
job finding rate is quite high in the US, so these people find a job quickly. The latter is key in the
“Shimer exercise,” which shows that fluctuations in the separation rate are not that important for
fluctuations in the unemployment rate. Note that it is not correct to say that fluctuations in the
separation rate are not that important for fluctuations in the unemployment rate because the job
finding rate is (much) higher than the separation rate. That is true in every country, since – fortunately
– workers get out of unemployment quicker than out of employment. Also, not that small changes in
the separation rate have a big effect on the number of unemployed, because it affects more people
(namely all the employed) than changes in the job finding rate. What matters is that in the US the
average job finding rate is exceptionally high. Although the job finding rate is lower during recessions
it is still quite high, which means that the bursts of layoffs observed during workers do not have a long-
lasting effect on the number of unemployed. Note that this wasn’t quite true during the financial crisis,
when the US also experienced quite a bit of long-term unemployment.

8. In the course slides, the law of motion of the debt to GDP ratio, dt, is given by the following
equation

dt 1  1  r  g dt  st ,

Where r is the interest rate, g is the growth rate of GDP, and st is the primary surplus.

A) Is r < g a sufficient condition to ensure that the debt to GDP ratio is sustainable?

Answer: If r < g, then the debt to GDP ratio will converge towards a finite number. If st<0, then this is
a positive number. Depending on the values of st, r, and g this could be a very high number and it
could be so high that it is not sustainable, that is the interest payments are so high that it becomes
tempting for the government to default.

B) What are the assumptions underlying this law of motion? Also, concisely explain why austerity
programs, that is, programs that increase st, could lead to a deterioration of the debt to GDP ratio,
whereas this equation suggests that the opposite should hold.

Answer:

Key assumptions:

 One-period debt. This means that all debt is the same. In particular, there is no debt that
was issued a long time ago. If a country has debt that was issued in the past with fixed
nominal interest rates, then it could reduce the real interest rate by increasing inflation.
 Values of r and g constant and in particular not affected by either st or dt

If austerity is bad for the real economy, then an increase in st would decrease g which negatively
affects the debt to GDP ratio. Moreover, if the debt to GDP ratio does indeed go up, then this could
lead to an increase in r, which would lead to a further increase in the debt to GDP ratio.
11. Consider an economy with the following characteristics.

 All firms are identical. Each firm has one worker who receives a wage rate equal to wt. The
firm also has a manager who makes decisions that are best for the firm’s owner. This manager
is the same person as the entrepreneur that created the firm. The owner is the
(representative) household who provided the financing for the creation of the firm.
 Output of the representative firm, qt, is given by
qt  exp zt kt ,


where kt is the amount of capital used by the representative firm.

 Existing firms rent capital on a competitive market at rate rt.
 Revenues of the firm after capital rental costs are given by
yt  exp zt kt  rt kt .


This amount is divided by the worker and the owner. The worker’s share is equal to  and
the owner’s share is equal to 1-. These shares are fixed.
 The entrepreneur chooses kt to maximize the amount of income that the owner receives.
 The law of motion for zt is given by zt  zt 1   t , where t is an i.i.d. random variable with
mean zero and 0    1.
 There is a unit mass of workers. A fraction nt is employed and a fraction 1-nt is unemployed.
Every period, a fixed fraction  of employed workers quit.
 New firms are created on a matching market where entrepreneurs and unemployed workers
meet. The number of matches is given by mt  0vt
1
1  nt 1 , where vt is the number of
1

vacancies. The cost of posting one vacancy is equal to .

 All agents in this economy are part of a representative household. The household’s
optimization problem can be represented by the following Bellman equation
1
Ct  1
v( K t ; nt , z t )  max Ct , Kt 1  E t v( K t 1 ; nt 1 , z t 1 )
1 
s.t.
Ct  K t 1  wt nt  rt K t  1   K t  xt ,
where Ct is aggregate consumption, Kt is the aggregate capital stock, and xt denotes firm
profits. Note that the household takes the values of employment, nt, as given.
 Equilibrium in the market for capital is given by nt kt  K t

A) Give the first-order conditions of the household’s maximization problem and use the
envelope condition to eliminate the derivative of the value function.
Answer:

Ct  t
 v( K t 1 ; nt 1 , zt 1 ) 
t  E t  
 K t 1 
Ct  K t 1  wt nt  rt K t  1   K t  xt ,
Note that the budget constraint is also part of the set of first-order conditions unless you
have substituted out capital.
v( K t ; nt , z t )
 t rt  1   ) 
K t
 Leading this expression and substituting it in the first-order condition for capital gives
t  E t t 1 rt 1  1   
B) Explain why Kt, nt, and zt are state variables. Why is xt not a state variable?
Answer: State variables need to be either exogenously given or predetermined. Profits, xt, are
not exogenous and not predetermined. Kt is a state variable because it affects the wealth of
the household, the firms’ output level, and the capital rental rate. nt is a state variable because
it affects household resources and activity in the matching market. zt is a state variable
because it affects firm productivity and, thus, the wage rate and firm profits. It also helps to
predict future values of zt+1.
C) Write down the optimization problem that characterizes the entrepreneur’s choice of capital
and give the first-order condition. Is this choice also the best choice for the worker?
Answer: The question states that the manager makes decisions that are best for the firm’s
owner. The wellbeing of the firm’s owner is given by a discounted sum of expected utility
levels. The firm’s capital decision is a static decision, however, which means that the firm
manager should choose the capital level in period t that maximizes period t profits. Thus

max kt 1    exp zt kt  rt kt . 
The worker’s payment is simply /(1-) times the amount the owner receives, so this choice
also maximizes the amount the worker receives.
D) Give an expression that indicates the period-t value of a firm that will still have its worker in
period t+1 after wages and dividends have been paid. Denote this value as Vt.
Answer:
 | C 
  
Vt  E t  t 1 1    exp z t 1 k t1  rt 1 k t 1  1   Vt 1  .
 Ct 
From part C, we get that the capital choice has to satisfy
 exp zt kt 1  rt .
This equation could be used to substitute out kt+1 in the expression for Vt.
E) This model generates a negative co-movement between the unemployment rate and the
number of vacancies, that it, it is consistent with the observed Beveridge curve. Intuitively
explain why this is the case.
Answer: In this model, fluctuations are caused by changes in the random variable, firm
productivity, zt. Since zt is persistent, and increase in zt leads to an increase in the expected
value of future levels of zt and, thus, to an increase in Vt. This will lead to an increase in
vacancies, which in turn will lead to an increase in the number of matches and a decrease in
the unemployment rate. The reason the number of vacancies increases is the following. The
matching market is characterized by free entry. That means that the cost of positing a vacancy,
, has to equal the expected payoff. Thus,
1 1
0vt  1  nt 1 
1 1
v 
 Vt  0  t  Vt .
vt  ut 
In period t, the value of ut is predetermined, which implies that an increase in Vt must lead to
an increase in vt. This will continue in subsequent periods but the mechanism will be weaker
as Vt and ut begin to decrease making posting vacancies less attractive.
F) As productivity falls and rises, this model generates a counter clockwise movement in the
space with the unemployment rate on the x-axis and the number of vacancies on the y-axis.
Explain why this is the case.
 Answer: Suppose (to simplify the exposition of the argument) that the economy has had low
productivity shocks for many periods and reached a low-activity steady state. Now
productivity unexpectedly increases. This will lead to an instantaneous increase in vacancies.
It will also lead to a decrease in the unemployment rate, but this will occur later because of
the matching friction. Thus, in the beginning there is a vertical movement upwards, which is
followed by a negative comovement if productivity remains high. Similarly, if the economy
suddenly receives some bad shocks, vacancies will move first, leading now to a vertical
downward movement. This means that the movements in the (ut,vt) space are not along one
curve. Instead, the movement of increasing vacancies and decreasing unemployment occurs
along a curve that is above the curve characterising the economy on a downward trajectory.
G) Suppose that the wage rate is not a fixed fraction of revenues minus capital rental costs, but
a constant number, that is, wages are sticky and do not respond to an increase in productivity,
zt. How would this affect the volatility of profits, vacancies, and employment?
Answer: In the setup above, profits, wages, and revenues net of capital rental costs are all
equally volatile (when scaled by their mean values). If wages do not increase in response to
an increase in productivity, then profits (again scaled by its mean) will become more volatile.
This will also make the expected discounted value of the future profit stream more volatile as
long as productivity is persistent. The free-entry condition then directly implies that the
matching probability will be more volatile, which in turn implies that vacancies will be more
volatile. The transition equation for employment, then implies that employment will be more
volatile as well.
H) During the financial crisis, the unemployment rate increased and the Beveridge curve shifted
to the right in several developed economies. Use the framework of this question to discuss
possible factors that explain these two empirical findings. (Hint: think of shocks and changes
in parameter values.) Are there any other factors that are not part of the framework of this
question that might be relevant for these two observations in countries like France, Italy, and
Spain. Answer concisely using bullet points. Points will be subtracted for wrong and irrelevant
remarks.
Answer: Part f of this question focused on the counter clockwise movement. One can also
think of this as a shift, that is, the Beveridge curve of the recovery is to the right and above of
the Beveridge curve of the downturn. But we usually think of this as still being part of the
same Beveridge curve. To think of a real shift in the Beveridge curve, some of the parameters
would have to change (that is, the answer cannot be that there is a change in productivity).
 One simple way to get a shift is to increase the persistence of productivity shocks.
 A reduction in matching efficiency, for example, a reduction in 0, would also induce
a shift in the Beveridge curve as it would mean that less jobs are created for the same
number of vacancies.
 Also, an increase in the exogenous separation rate would mean that a higher
unemployment rate is associated with the same number of vacancies.
 Finally, an increased desire to smooth consumption would induce a shift, because it
lowers the marginal rate of substitution. That is,

Other elements that can explain a high unemployment rate and a rightward shift in the
Beveridge curve are

 Keynesian type of unemployment, for example, because of sticky prices and/or sticky
nominal wages.
 Austerity policies.
 Damaged financial sector, which hampers supply of credit.
 High interest rates and instability because of sovereign debt problems.
 Monetary policy that is restricted by (i) the zero-lower-bound and (ii) the fact that not
all countries in the Eurozone are as deeply hit as these countries (and not as willing to
pursue aggressive unconventional policy).
 Drops in house prices, since these will push some mortgage holders into negative
equity and will make it more difficult for unemployed workers to accept jobs which
would require moving.
 Sectoral mismatch (although one could argue that these are captured by the matching
friction). That is, the crisis made it clear that the economy needed to move workers
out of some sectors (like finance and construction) and into other sectors.
12. Consider an economy with the following characteristics.

 Aggregate output, y, is determined by the following Phillips curve: y  y  b  E ,
where  is the inflation rate, E[] is the expected inflation rate, and y is the efficient or natural
output level.

 The government’s loss function is given by

1
2
 2

1
 
y  k y  a    * , where * is the ideal
2
2

inflation rate (for a given level of y), and a>0 and k>1.
 The timing is as follows. First, the private sector forms expectations of inflation. Second, the
government chooses the inflation rate . The ideal inflation rate, *, is fixed.

A) What does k represent and what factors are behind the assumption that k is bigger than 1?

Answer: k is the factor that represents the government’s preference for output stimulus and a value
of k bigger than 1 means that the government would  for a given inflation rate  to see output
somewhat about the efficient output level (for example because the desire to win elections makes it
short-sighted).

B) Write down the optimization problem of the government for a given value of E[]. Also, give the
first-order condition(s) and give expressions for the optimal choice of  and the corresponding
outcome for y.

Answer:

1
 2

1

2
min y ,  y  k y  a    *  
2 2 
s.t.
y  y  b  E 
FOC :
  
b 1 - k  y  b  E   a    *  0

bk  1 y  a *  b 2 E 

a  b2
 bk  1 y  a *  b 2 E  
y  y  b  E  

 a  b 2

C) Suppose that E[]=*. What would be the outcomes for inflation and output? Explain why this
cannot be an equilibrium outcome if agents have rational expectations. What is the equilibrium
outcome if agents have rational expectations?

Answer:

bk  1 y
 *  *
ab 2

 b2 
y  y1  k  1  y
 ab
2

There are stochastic shocks that could push actual inflation away from its expected value.
Consequently, if agents have rational expectations then it must be the case that  = E[].

D) How does the outcome in part C compare with the case when the government can and does commit
to a certain inflation rate before the private sector forms its expectation of inflation?

Answer: If the government can does commit, then  = E[] (even if agents are not rational and simply
believe the government’s promise). Consequently, y  y which implies that  = *. Thus, in the full
commitment case, the government is not tempted to fool the private sector (after they have formed
their expectations) and both output and inflation are equal to their efficient level.

E) Explain why it could be beneficial to appoint a central banker who dislikes inflation more than the
government even if the central banker has the same k as the government.

Answer: The “definition” of a conservative banker is someone who really dislikes inflation, that is,
someone with a high a value. The answer to part C makes clear that a high a value will push both
output and inflation towards their efficient values.

Now consider a two-period version of the model above. In particular, suppose that the economy is
characterized by the following equations

y  y  b  E ,

y 1  y  b 1  E 1  1 
1
 2
 1
 y  k y  a   * 2
 

min y , , y1  2 2 
 1
 2
 2

1

  y 1  k y  a  1  
2
* 2


Expectations of the private sector are formed as follows

E    *
E 1  1   

Note that the expectation of inflation in the second period is equal to realized inflation in the first
period. Also note that +1 is not a choice variable; unknown to the private sector, the government
knows that +1 has to be set equal to ˆ <* for reasons that are not part of the model.

F) In models like the ones considered in this question, realized inflation is typically above * since
governments with a value of k that exceeds 1 would like to push inflation up to create a positive output
gap. However, it can be shown that the optimal choice for  is less than *. Explain intuitively why the
usual outcome doesn’t happen in the two-period version considered here.

Answer: In this setup, the government faces a trade-off. It could increase output above y in the first
period by setting inflation above its expected value, that is,   E    *. However, if inflation is
above * in the first period, then actual inflation, i.e.  1  ˆ , must be below its expected value in the
second period, since  1  ˆ   * . This argument just makes clear that there is a trade-off. Suppose
that ˆ   * . Then, the two effects exactly offset each other and it would be optimal to set    * .
However, if ˆ   * , then setting    * means that the loss in the second period is bigger than the
gain in the first period. If the government would push inflation above *, then the difference would
only get bigger (given the quadratic loss function).

G) According to the Phillips curve of this economy, an increase in the inflation rate increases the output
gap if expected inflation stays the same or increases by less than the increase in the inflation rate.
However, an equal increase in inflation and expected inflation does not affect the output gap. Explain
why it makes sense to assume that an increase in inflation that is accompanied by an equivalent
increase in expected inflation of equal magnitude leaves the output gap unchanged.

Answer: One story behind the expectations-augmented Phillips curve is that real activity will be high
when real wages are low, which could happen if actual inflation is lower than expected because
nominal wages are set in advance and based on expected inflation. The story in the New Keynesian
model is more subtle. In the version discussed in class, the quadratic inflation cost function is such
that there is only a deviation from the flexible price case if there is an asymmetry between the cost of
changes prices this period relative to the cost of changing the prices (back) next period.

H) Describe the behaviour of inflation during the financial crisis in developed countries and the factors
behind this behaviour. Discuss whether the behaviour of inflation has been consistent with the Phillips
curve. Also discuss the outlook for inflation in the UK and the US. You do not have to make forecasts,
but discuss relevant factors that can reasonably be expected to put upward pressure on inflation and
relevant factors that can reasonably be expected to put downward pressure on inflation. Answer
concisely using bullet points. Points will be subtracted for wrong and irrelevant remarks.

Answer:

 Even though we have seen massive drops in output and in the output gap the drops in inflation
have been relatively moderate.
 This is especially remarkable given the extremely loose monetary policy.
 One important factor is that decades of monetary policy focusing on low inflation have
anchored inflation expectations tightly to low numbers.
 Another possibility is that firms may find it difficult to lower the prices of their products unless
they know that their suppliers (and workers) are willing to lower their prices. The reason is
that a producer that lowers its prices without a similar reduction in nominal costs may lose
money. That is, there is a coordination problem.
 Of course, large output losses without large drops in inflation could be consistent with the
expectations-augmented Phillips curve if the drop in real activity is due to a decrease in the
efficient level of output, but that does not seem plausible.
 Central banks have pumped lots of liquidity into the economy. At this point, this is inactive
(mainly held by banks as reserves). In principle, this could unleash lots of buying potential and,
 thus, inflation. On the other hand, one could argue that this will not happen unless there is a
strong recovery which will match this additional buying potential with increased supply.
 The latest news is that the recovery in the US and the UK is slowing down, which is likely to
reduce pressure on inflation.
 Wage pressure has been remarkably low in the UK. The question is what will happen if the
economy recovers. Will there be a catch-up effect with an associated upward pressure on
inflation?
 Similarly, the proposed increases in the UK national living wage could put upward pressure on
inflation.
 A big conundrum in the UK is the low productivity observed during the recession. If this is
temporary then there is probably still quite a bit of slack in the economy and little reason to
worry about inflation if the recovery accelerates. However, if this is permanent, then the risk
of inflation is higher.