Homework 5

1. Use the social security model developed in this chapter to answer this question. Suppose that the
government establishes a social security program in period 𝑇𝑇, which provides a social security
benefit of 𝑏𝑏 (in terms of consumption goods) for each old person forever. In period T the
government finances the benefits to the current old by issuing debt. This debt is then paid off in
period 𝑇𝑇 + 1 through lump-sum taxes on the young. In periods 𝑇𝑇 + 1 and later, lump-sum taxes
on the young finance social security payments to the old.

a. Show, using diagrams, that the young and old alive at time 𝑇𝑇 all benefit from the social
security program under any circumstances.

When the program is first instituted, the current old receive b in benefits and pay
nothing. The effect on the current old is as in Figure 10.12 in the text. The current young
receive b in benefits when they are old. This effect is also captured by the shift from BA
to FD in the text’s Figure 10.13. The current young also lend 𝑏𝑏𝑏𝑏 to the government in
period T and receive (1 + 𝑟𝑟)𝑏𝑏𝑏𝑏 in principal and interest when they are old. In per capita
𝑏𝑏𝑏𝑏 𝑏𝑏 (1+𝑟𝑟)𝑏𝑏𝑏𝑏 (1+𝑟𝑟)𝑏𝑏
terms, these amounts are (1+𝑛𝑛)𝑁𝑁 = and (1+𝑛𝑛)𝑁𝑁
= respectively. However, this
1+𝑛𝑛 1+𝑛𝑛
borrowing and lending are represented in Figure 10.13 as movements along the budget
line. Unless there is a change in the real interest rate, there is no additional shift in the
budget line. Therefore, both these generations unambiguously benefit from the program.

b. What is the effect of the social security program on consumers born in periods 𝑇𝑇 + 1 and
later? How does this depend on the real interest rate and the population growth rate?

Once the program is running, it is identical to the pay-as-you-go system in the text. This
program benefits a typical cohort as long as n > r, as is depicted in textbook Figure 10.13.
A special circumstance applies to the cohort born in period T + 1. These individuals each
receive a benefit per capita of b/(1 + r) in present value terms. However, they pay taxes
to support two generations’ worth of benefits. They pay taxes to retire the principal and
interest on debt incurred in period T. The per capita share of principal and interest on
their grandparents’ benefits is equal to (1 + r)b/(1 + n)2. The per capita share of their
parents’ benefits is equal to b/(1 + n). This generation can only benefit if:
1 + 𝑟𝑟 (1 + 𝑟𝑟)2
1> +
1 + 𝑛𝑛 (1 + 𝑛𝑛)2
This requirement is obviously more stringent than 𝑛𝑛 > 𝑟𝑟.
2. Use the social security model developed in this chapter to answer this question. Suppose that a
government pay-as-you-go social security system has been in place for a long time, providing a
social security payment to each old person of 𝑏𝑏 units of consumption. Now, in period 𝑇𝑇, suppose
that the government notice that 𝑟𝑟 > 𝑛𝑛, and decides to eliminate this system. During period 𝑇𝑇,
the government reduces the tax of each young person to zero, but still pays a social security
benefit of 𝑏𝑏 to each old person alive in period 𝑇𝑇. The government issues enough one-period
government bonds, 𝐷𝐷𝑇𝑇 , to finance the social security payments in period 𝑇𝑇. (Hint: It is sold to
young generation at T. Interest rate is r.) Then, in period 𝑇𝑇 + 1, to pay off the principal and
interest on the bonds issued in period 𝑇𝑇, the government taxes the old currently alive, and issues
new one-period bonds 𝐷𝐷𝑇𝑇+1. (Hint: To payback the bond, the government uses both tax on old
and issue bond to young.) The taxes on the old in period 𝑇𝑇 + 1 are just large enough that the
quantity of debt per old person stays constant; that is, 𝐷𝐷𝑇𝑇+1 = (1 + 𝑛𝑛)𝐷𝐷𝑇𝑇 . Then, the same thing
is done in periods 𝑇𝑇 + 2, 𝑇𝑇 + 3, ... , so that the government debt per old person stays constant
forever.

a. Are the consumers born in periods 𝑇𝑇, 𝑇𝑇 + 1, 𝑇𝑇 + 2, ... better or worse off than they
would have been if the pay-as-you-go social security program had stayed in place?
Explain using diagrams.

Refer to the note at the end.

b. Suppose that the government follows the same financing scheme as above, but replaces
the pay-as-you-go system with a fully funded system in period 𝑇𝑇. Are consumers better
off or worse off than they would have been with pay-as-you-go? Explain using diagrams.

3. What is the effect of an increase in d, the depreciation rate, on the representative firm's
investment decision, and on its optimal investment schedule? Explain your results carefully.

There are two effects of an increase in the depreciation rate. First, there is the direct effect,
′
which implies that, given the marginal product of capital in period two, MPK , the net marginal
′
product of capital, MPK − d , will decrease when the depreciation rate increases. For any given
real interest rate, this effect lowers investment demand, and so the investment demand schedule
shifts to the left. This direct effect is the result of the fact that a higher depreciation rate implies
that the scrap value of the capital the firm invests in will be lower at the end of period two.

In addition to this direct effect, there is also an indirect effect of the depreciation rate on
investment. Since K' =− (1 d )K + I , given the initial capital stock, K, the quantity of capital in
period two will be smaller, for any I, if the depreciation rate is higher. Therefore, when d
increases, the investment schedule shifts to the right. The direct and indirect effects work in
opposite directions, and so, given the real rate of interest, investment may either rise or fall with
an increase in the depreciation rate.
4. Determine how the following affects the slope of the output demand curve, and explain
your results:

(a) The marginal propensity to consume increases.

A reduction in the real interest rate increases consumption and investment spending. This is the
primary reason for the downward slope of the output demand curve. However, as output rises,
there is a further increase in consumption spending according to the size of the marginal
propensity to consume. The larger the marginal propensity to consume, the flatter is the
aggregate demand curve.

(b) The intertemporal substitution effect of the real interest rate on current consumption
increases.

The intertemporal substitution effect on consumption is one of the primary reasons that demand
rises at lower interest rates. The larger the sensitivity of consumption spending to the real rate of
interest, the flatter is the output demand curve.

(c) The demand for investment goods becomes less responsive to the real interest rate.

The responsiveness of investment demand to the real rate of interest is one of the primary
reasons that demand rises at lower interest rates. The larger the responsiveness of investment
demand to the real rate of interest, the flatter is the output demand curve.

5. The government decreases current taxes, while holding government spending in the present and
the future constant.

(a) Using diagrams, determine the equilibrium effects on consumption, investment, the real
interest rate, aggregate output, employment, and the real wage. What is the multiplier, and how
does it differ from the government expenditure multiplier?

As government expenses are unchanged, future taxes need to increase to satisfy the
intertemporal budget constraint of the government. We are therefore in the context of the
Ricardian equivalence. Thus, neither the real interest rate, aggregate output, employment, nor
the real wage is affected.
(b) Now suppose that there are credit market imperfections in the market for consumer credit,
for example, due to asymmetric information in the credit market. Repeat part (a), and explain
any differences in your answers in parts (a) and (b).

We are now violating the conditions of the Ricardian equivalence. There is potentially an impact.
Indeed, the endowment point is moving towards the right, and some borrowers now become
lenders, and thus face a lower interest rate. This leads to a positive income effect (and thus an
increase in current consumption demand and a decrease in labor supply) and a substitution
effect that increases demand for current goods. In the end, consumption demand increases and
labor supply decreases.
6. Suppose that a country experiences destruction of part of its capital stock. Suppose also that the
capital stock plays a role as collateral in credit contracts, so that the destruction of capital
increases credit market frictions.

(a) Determine how the net effects on macroeconomic variables differ from what is depicted in
Figure 11.24.

(b) Is there a government policy that can mitigate the effects of this capital destruction? What is
it? Explain how it works.

This shock combines Figure 11.23 (a reduction in the capital stock) with Figure 11.28 (an increase
in credit market frictions). The net effects on most macroeconomic variables are ambiguous, but
we can say that, relative to Figure 11.23, accounting for the effect of a reduction in collateral will
give an additional reduction in aggregate output, a decrease in the real interest rate, and a
reduction in employment. The increase in credit market frictions produces a scarcity of safe
assets, reflected in the decrease in the real interest rate, and under these conditions Ricardian
equivalence does not hold. Therefore, a tax cut coupled with an increase in government debt will
act to shift the output demand curve to the right, increase aggregate output, increase the real
interest rate, and increase economic welfare.

7. A macroeconomist suggests that, since aggregate output and employment have decreased the
government should increase expenditures on goods and services to increase both output and
employment. Suppose that output and employment fell because of a sectoral shock.

(a) Determine, using diagrams, what the net effects on output, employment, consumption,
investment, the real interest rate, and the real wage would be of such a policy, combined with
the sectoral shock.

(b) Do you think such a policy is appropriate? Why or why not?

This combines Figure 11.30 with Figure 11.22. A sectoral shock occurs which reduces output and
employment and increases the real interest rate. The government intervenes by increasing
government spending, which acts to increase aggregate output, increase employment, and
increase the real interest rate. The government can indeed offset the effects of the sectoral shock
on aggregate output, but as a result of the government intervention consumption and
investment are lower than they would otherwise be. There is no reason to think that there is an
inefficiency implied by the sectoral shock to the economy that the government is equipped to
correct.