EBIE222207: Macroeconomics 2

Problem Set 1
Suggested Solutions

1. (15 points) Explain why macroeconomists like to build models and why do they build models based on
microeconomic principles? Discuss.
Solution: In macroeconomics, in contrast to the natural sciences, for example, it is difficult or impossible
to run experiments 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.
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.
2. (15 points) Macroeconomists are interested in two types of phenomena: economic growth and business
cycles. Explain how macroeconomists utilize 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 component 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.
3. (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: When the government imposes a proportional tax on wage income, the consumer’s budget con-
straint 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

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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.

4. (25 points) Suppose that a consumer can earn a higher wage rate for working overtime. That is, for the
first q hours the consumer works, he/she receives a real wage rate of w1 , and for hours worked more than
q he/she receives w2 , where w2 > w1. Suppose that the consumer pays no taxes and receives no non-wage
income, and he/she is free to choose hours of work.
a. (15 points) Draw the consumer’s budget constraint, and show his/her optimal choice of consumption
and leisure. Hint: think of the slope of the budget constraint for levels of leisure less than h∗ − q (due
to higher overtime wage) and for levels of leisure higher than h∗ − q.
Solutions: The budget constraint is now EJG in the figure below. The budget constraint is steeper
for levels of leisure less than h − q, because of the higher overtime wage. The figure depicts possible
choices for two different consumers. Consumer 1 picks point A on her indifference curve, I1 . Consumer
2 picks point B on his indifference curve, I2 . Consumer 1 chooses to work overtime; consumer 2 does
not.

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 b. (10 points) Determine what happens if the overtime wage rate w2 increases. Explain your results in
terms of income and substitution efects. Hint: you must consider the case of a worker who initially
works overtime, and a worker who initially does not work overtime.

Solutions: An increase in the overtime wage steepens segment EJ of the budget constraint, but has
no effect on the segment JG. For an individual like consumer 2, the increase in the overtime wage has
no effect up until the point at which the increase is large enough to shift the individual to a point like
point A. Consumer 2 receives no income effect because the income effect arises out of a higher wage
rate on inframarginal units of work. An individual like consumer 1 has the traditional income and
substitution effects of a wage increase. Consumer 1 increases her consumption, but may either increase
or reduce hours of work according to whether the income effect outweighs the substitution effect.

5. (25 points) Suppose that the government announces a ban on hiring foreign domestic helpers. The
representative consumer now has to give up some of her leisure activities to spend more of her time doing
housework. Her preference toward the consumption bundle changes and she is now willing to consume less
for additional leisure time. Assuming that there has been no effect on real wage (w), taxes (T ), and dividend
income, how does this new policy affect the consumer’s choice of work and consumption? Draw a diagram
to explain your answer.

Solution: Given the same budget constraint, she cannot achieve a higher indifference curve. As she prefers
to have less consumption and more leisure time in the consumption bundle, a new indifference curve (l1 )
must be plotted. This new indifference curve crosses the indifference curve (I2 ) showing that her utility
level remains the same, but she prefers to give up more consumption for additional leisure time. Preference
changes. The new optimal consumption bundle is at point A where leisure rises from l2∗ to l1∗ . As she works
less, she earns less income at fixed wages, thereby reducing her consumption level from C2∗ to C1∗ .

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