3505: Macro 1

Fall semester 2017

January 2, 2018, 09:00 - 13:00

Exam
]

• If you think the provided information is insufficient, then add the additional information which
you believe is necessary to answer a given question and then continue based on your additional
assumptions.

• Please write your answers clearly. Arguments should be complete and careful.

• You should write your answers in English.

• The exam contains 3 problems which are weighted differently. Questions within a given problem
are weighted equally.

Problem 1. (30%)
Consider a neoclassical growth model of a closed economy where the government provides a public good
to the households. There is no population growth, no technological progress, and the population’s and
household’s size have been normalized to L = H = 1. The household’s utility function is:

ˆ∞ h i
U ({c (t) , g (t)}∞
t=0 ) = e−ρt ln c (t)1−γ g (t)γ dt,
t=0

where ln [·] denotes the natural logarithm, c (t) is private consumption, g (t) is the provision of the public
good (the public good can be thought of as publicly provided private (rival) good like health care),
γ ∈ (0, 1), and ρ > 0. Hence, there is an utility effect of the public good, implying that the government
can choose an optimal path for this public good. Total output in the economy, y (t), is produced according
to:
y (t) = f (k (t)) ,

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3505: Macro 1 Fall 2017

where f (k (t)) is a standard neoclassical production function. The capital stock in the economy, k (t),
depreciates at a rate δ > 0, so the economy-wide resource constraint takes the form:

k̇ (t) = f (k (t)) − c (t) − δk (t) − g (t) .

The initial level of the capital stock is given and equal to k (0) = k0 > 0.

a) Set up the allocation problem faced by a benevolent planner for the choices of private and public
consumption, and solve for the optimality conditions. (Hint: There are two control/jump variables,
c (t) and g (t), and therefore two first-order conditions. As there is only one state variable, k (t),
there is only one Euler equation and one transversality condition.)

b) Show that the Euler equation can be written as:

ċ (t) ġ (t)
= = f 0 (k (t)) − δ − ρ.
c (t) g (t)

(Hint: Show first that the optimality conditions imply that c (t) and g (t) should always be propor-
tional to each other, and use this result to derive the Euler equations for c (t) and g (t) in the usual
fashion.)

c) Show that the steady state equilibrium requires that c (t), g (t), and k (t) grow at the same rate.
Determine this common rate of steady state equilibrium growth.

d) How could a permanent increase in public consumption, g (t), be modeled in this framework? (Hint:
g (t) is not an exogenous variable but an endogenous variable determined by the social planner.
What type of change in the household’s utility function could then imply a permanently higher level
of g (t)?)

e) Using a phase diagram in the (k, c) −plane, show how a change that leads to a permanently higher
level of g (t) affects the economy in the long run. (Hint: Use the property that g (t) is proportional
to c (t) to rewrite the aggregate resource constraint just in terms of c (t) and k (t).)

f) Discuss under which conditions the answers in a)-c) could describe the equilibrium of a decentralized
market economy with taxation. (Hint: What kind of taxation can be used for the decentralized
equilibrium to coincide with the social planning solution? Does it matter whether the government
budget is balanced in every period or whether some debt finance is used?)

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3505: Macro 1 Fall 2017

Problem 2. (40%)
Consider a representative consumer who lives for only two periods denoted by t = 1, 2. The consumer
is born in period 1 without any financial assets. He leaves no bequests nor debt at the end of period 2.
The consumer’s labor income is wt ≥ 0 in each period, and her preferences over consumption can be
represented by the lifetime utility function:

U (c1 , c2 ) = u (c1 ) + βu (c2 ) ,

where β ∈ (0, 1) is the subjective discount factor, and the per-period utility function is given by:
 1−θ
 ct −1 , θ =
6 1
1−θ
u (ct ) =
ln c , θ = 1,
t

and θ > 0. For the moment, let us abstract from the production side of the economy and simply assume
that the consumer can borrow and lend consumption across periods at the given real interest rate, r > 0.

a) Write down the consumer’s net present value budget constraint, and derive the optimal consumption
and savings over the life cycle.

b) Assume that the consumer has a considerably lower labor income in period 2 than that of period
1, i.e., w2 < w1 (you can think of period 2 as the old-age period of the agent). To avoid old-age
poverty, the government considers establishing a compulsory pension scheme. The pension scheme
is supposed to be fully funded, i.e., in period 1 the agent contributes D > 0 to the pension system
and receives B = (1 + r) D in period 2. Will the introduction of the pension scheme affect the
agent’s consumption behavior?

c) Suppose that the contribution to the mandatory pension system is still D > 0, while the pension
received in the old-age is B = (1 + r̃) D, where r̃ reflects the growth rate of the population, n,
i.e., r̃ = n, where n is sometimes referred to as the biological interest rate. Suppose that the
population growth is relatively high, n > r. Does the introduction of this pension system increase
the agent’s welfare? What kind of pension scheme indeed features a biological interest rate?

We now turn from the behavior of the representative consumer to the economy as a whole. Suppose that
this economy is populated by an infinite sequence of overlapping generations that live for two periods.
Each generation is of the same size L, and the income of individuals in their old age is assumed to be
zero, w2 = 0. There is no pension scheme, but the remaining specification of the model (utility function)

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3505: Macro 1 Fall 2017

is as outlined above. There is a production sector that combines aggregate physical capital, Kt , and
aggregate labor supplied inelastically by the young generations, L, according to:

Yt = F (Kt , L) = Ktα L1−α , 0<α<1

to produce aggregate output Yt . Markets are competitive such that the wage rate and the rental rate of
capital are given by their marginal products:
 α
Kt
wt = (1 − α) ,
L
 α−1
Kt
rt = α .
L

Young agents save by buying or selling next-period’s capital stock. Capital market clearing requires that
the total savings of today’s young people correspond to the next periods physical capital stock:

st L = St = Kt+1 ,

where st denotes per capita savings of the current young people, and St the aggregate savings in the
economy. In what follows, assume that the depreciation rate of physical capital is set to δ = 0, such that
the real interest rate and the rental rate of capital are the same, and denoted by rt .

d) Use this market clearing condition and your results in a) to characterize the future capital stock
Kt+1 as a function of the interest rate rt+1 and the current capital stock, Kt . Note that the
savings in period t yield their return in period t + 1.

e) Assume that θ = 1. Plot a transition diagram in the (Kt , Kt+1 )-plane, and compute the stable
steady state capital stock of this economy.

f) Suppose that the economy is resting in its stable steady state. Using the transition diagram from
e), sketch the dynamics of the aggregate capital stock caused in response to an unexpected and
permanent increase in the cohort size by ∆L.

Let us now assume that the number of individuals born (young) at time t is:

Lt+1 = (1 + n) Lt , L0 > 0

where n > 0 is the population growth rate. Let At denote the labor efficiency which is assumed to evolve

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3505: Macro 1 Fall 2017

according to:

At+1 = (1 + g) At , A0 > 0

where g > 0 is the growth rate of labor’s efficiency. The aggregate output in the economy is now produced
according to:
Yt = Ktα (At Lt )1−α , 0 < α < 1.

Kt
g) Derive the law of motion for the capital stock per efficiency unit, kt = At Lt .

h) Suppose the economy is in the stable steady state. Plot a transition diagram in the (kt , kt+1 )-plane,
and use it to sketch the dynamics of the capital stock per efficiency unit caused in response to
an unexpected increase in the cohort size at time t = τ by ∆L. What are the implied dynamics
for the aggregate capital stock? (Hint: Continue to assume that θ = 1. After the shock, which
increases Lτ to L0τ = Lτ + ∆L, the population dynamics continues to follow the general law
Lτ +1 = (1 + n) L0τ , so the one-time increase has a persistent effect. For the second part of the
question, draw a plot in the (t, ln Kt ) −plane.)

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3505: Macro 1 Fall 2017

Problem 3. (30%)
Answer each of the following short questions by stating whether they are True/False AND then give a
short but instructive explanation. You can write, calculate, or draw to explain your answer. You only get
points if you have stated the correct short answer True/False AND provided a correct explanation for the
question.

a) Consider an economy where firms have monopolistic power. Then, unexpected changes in nominal
variables have real effects. True or false?

b) In the long run, taxes levied on corporate income reduce the optimal level of investment undertaken
by firms. True or false?

c) Consider the capital accumulation of the neoclassical growth model with exogenous technology
growth and constant population size:

Kt Ct
k̇ (t) = k (t)α − c (t) − (δ + g) k (t) , kt ≡ , ct ≡ ,
At L At L

where Kt is the aggregate capital stock, At is the level of labor efficiency, L is the constant size of
the population, Ct is aggregate consumption, α ∈ (0, 1) is the capital income share in the economy,
δ > 0 is the depreciation rate of physical capital, and g ≥ 0 is the net growth rate of technology.
The Golden Rule level of capital stock per efficiency unit is given by:
  1
GR αδ 1−α
k = .
δ+g

True or false?

d) Business cycles are socially optimal responses to economic shocks according to the Real Business
Cycle (RBC) model. True or false?

e) Consider the canonical New-Keynesian model studied in class (a hat on top of a variable denotes

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3505: Macro 1 Fall 2017

deviations from its deterministic steady state):

1 
ŷt = Et [ŷt+1 ] − ît − Et [π̂t+1 ]
σ
π̂t = κŷt + βEt [π̂t+1 ]
ît = +χπ π̂t + χy ŷt + νt
νt = ρν νt−1 + σν εν,t

where β ∈ (0, 1), κ > 0, χπ > 1, χy > 0, σ > 1, ρν ∈ [0, 1], σν > 0, and εν,t ∼ i.i.dN (0, 1).
Then, a contractionary monetary policy (i.e. an unexpected increase in the nominal interest rate
by the central bank) unambiguously leads to higher effective nominal and real interest rates. True
or false?

f) Under the assumption of a quadratic utility function (e.g. u (Ct ) = αCt − γ2 Ct2 , with α > 0 and
γ > 0), higher uncertainty about future income growth (higher variance) leads to higher expected
consumption growth. True or false?

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