EP607: Ekonomika Makro III

Problem Set 1
Suggested Solution

1. (10 points) Explain why macroeconomists like to build models.

Solution:
In macroeconomics, in contrast to the natural sciences, for example, it is difficult or impossible to run exper-
iments to test theories. As an alternative, macroeconomists find it useful to construct artificial apparatuses–
models–on which they can run artificial experiments. The basic idea is to build the model, fit it to the data
in some sense, and then ask how the model responds to changes that mimic the real-world experiments we
would actually like to run.
2. (10 points) Explain why macroeconomists like to build models and why do macroeconomists build models
based on microeconomic principles? Discuss.

Solution:
In part macroeconomists are interested in understanding the consequences of changes in government pol-
icy. But, when government policy changes, the behavior of individuals changes in response to the policy.
Therefore, we cannot accurately predict the results of a policy change just from looking at historical macroe-
conomic relationships. That is, the Lucas critique comes into play. If we build up macroeconomic models
from microeconomic behavior, we have the structure we need to accurately predict the results of changes in
policy.
3. (10 points) Macroeconomists are interested in two types of phenomena: economic growth and business
cycles. Explain how macroeconomists manipulate economic data in order to study these two problems.

Solution:
A typical approach macroeconomists take is to separate the trend component from the business cycle com-
ponent in macroeconomic time series data. For example, suppose that we are interested in the trend and
cyclical components of real GDP per capita. First, we would take the natural logarithm of the time series.
Then, we would fit a trend to the natural logarithm, and measure the cyclical component of real GDP per
capita as the deviation of the actual time series from the trend. This then gives us some idea of the trend
growth component and the business cycle component of real GDP per capita that we want to understand.
4. (20 points) Suppose that the government imposes a proportional income tax on the representative con-
sumer’s wage income. That is, the consumer’s wage income is w(1 − t)(h − l) where t is the tax rate. What
effect does the income tax have on consumption and labor supply? Explain your results in terms of income
and substitution effects.

Solution:

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When the government imposes a proportional tax on wage income, the consumer’s budget constraint is now
given by:
C = w(1 − t)(h − l) + π − T,
where t is the tax rate on wage income. In the figure below, the budget constraint for t = 0 is F GH. When
t > 0, the budget constraint is EGH. The slope of the original budget line is –w, while the slope of the
new budget line is −(1 − t)w. Initially the consumer picks the point A on the original budget line. After
the tax has been imposed, the consumer picks point B. The substitution effect of the imposition of the tax
is to move the consumer from point A to point D on the original indifference curve. The point D is at the
tangent point of indifference curve, I1 , with a line segment that is parallel to EG. The pure substitution
effect induces the consumer to reduce consumption and increase leisure (work less). The tax also makes
the consumer worse off, in that he or she can no longer be on indifference curve, I1 , but must move to the
less preferred indifference curve, I2 . This pure income effect moves the consumer to point B, which has less
consumption and less leisure than point D, because both consumption and leisure are normal goods. The
net effect of the tax is to reduce consumption, but the direction of the net effect on leisure is ambiguous.
The figure shows the case in which the substitution effect on leisure dominates the income effect. In this
case, leisure increases and hours worked fall. Although consumption must fall, hours worked may rise, fall,
or remain the same.

5. (25 points) Suppose that a consumer cannot vary hours of work as he or she chooses. In particular, he
or she must choose between working q hours and not working at all, where q > 0. Suppose that dividend
income is zero, and that the consumer pays a tax T if he or she works, and receives a benefit b when not
working, interpreted as an unemployment insurance payment.
a. If the wage rate increases, how does this affect the consumer’s hours of work? What does this have to
say about what we would observe about the behavior of actual consumers when wages change?
Solution:
Think of the economy as consisting of many consumers, some of whom are in a situation as in the
Figure 2.1 and some as in Figure 2.2. Some consumers do not work, and some choose to work. If the
wage goes up, then that will make working preferable for some consumers who formerly did not choose
to work. An increase in the wage will not discourage anyone from working, but those who were working
already will not choose to vary hours of work (they cannot). But total employment in the economy
will increase, as now more people are working. With the constraint on hours of work, there are no
issues related to income and substitution effects. A higher wage always increases the total quantity of
labor supplied.

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 Figure 2.1

Figure 2.2

b. Suppose that the unemployment insurance benefit increases. How will this affect hours of work?
Explain the implications of this for unemployment insurance programs.
Solution:
Similar to part (a), if the unemployment insurance benefit increases, this will make not working prefer-
able to some consumers who were formerly working, and employment will fall. An increase in the
unemployment insurance benefit unequivocally reduces the quantity of labor supplied.

6. (25 points) To control pollution, assume that your government tightens regulations on one hand and
provides a lump-sum subsidy (S) to firms that use clean technology on the other. Now, a representative
firm decides to use clean technology throughout the production process, thereby improving its total factor
productivity. How will this government policy affect the profit-maximizing firm’s choice of labor input and
labor demand curve?
Solution:
Initially, the profit for the firm is π = zF (K, N d ) − wN d , where the production function (or revenue
function) is zF (K, N d ) and the cost function is wN d . To maximize the profits, the firm chooses the quantity
of labor where the slope of the revenue function equals the slope of the cost function, i.e., zM PN = w.
After receiving the lump-sum subsidy and improving its productivity, the firm’s profit function becomes
π = z 0 F (K, N d ) + S − wN d , where z 0 > z and S is the lump-sum subsidy. The production function shifts

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upward as shown in the diagram. The firm’s demand for labor curve is the marginal product of labor
schedule. To maximize profits, the firm chooses the quantity of labor input where the slope of the new
production function is equal to the cost function, i.e., z 0 M PN = w. Given w, as z 0 > z, z 0 M PN > w. To
maintain z 0 M PN = w, M PN has to be lower. Thus, higher demand for labor input is required (as the law of
diminishing marginal labor product applies). As shown in Figure 5.1, the demand for labor input increases
from N1d to N2d . Now the firm hires more workers at a given wage, shifting the labor demand curve to the
0
right, from N d to N d , as shown in Diagram 2.