Advanced Macroeconomics I, UPF

Professor Andrea Caggese

PROBLEM SET 3 - 2018
(Due Thursday 15 February at 10.30)
NOTE: You should try to solve all questions.
You only need to hand in questions 3, 4, 5 and 6.
All questions will be solved in the practice class.

Solow model with government. What are the effects of taxes on the economy?
Question 1) Consider a Solow economy with government. The government taxes households
and consumes all of the tax revenue (Government consumption is equal to G).
Households consume a constant fraction c of their disposable income Y-T, where T is taxes
paid to the government.
Show that national savings Y-C-G (savings by households and the government), where G
denotes government consumption, is equal to (1-c)(Y-T).

Question 2) How does, therefore, an increase in taxes affect output per worker in the short
and in the long run? (HINT: you first need to determine the effect of taxes on 𝑘 in the balance
growth path. Also, assume there is no technological progress and that the economy is on a
T
balanced growth path when taxes are increased. Moreover, assume that is small enough so
Y
that you don’t need to worry about multiple (or inexistent) steady states).

Again on the dynamics of the Solow model

Question 3) Consider a Solow-type economy with production function F(K,AL)=𝐾 # 𝐴𝐿 &'# ,

depreciation rate δ, saving rate s, where labor supply L grows at the rate n>0 and
efficiency A grows at the rate a>0. Also assume that 𝑘 > 1.
a) Write the equilibrium dynamic equation that shows the growth rate of capital per
+
efficiency worker as a function of its level 𝑘. Then derive the value of 𝑘 in the
+
balanced growth path.
+
b) Show graphically the equation that determines (indicating what the curves
+
+
represent, what is , and what is the balanced growth path value to which 𝑘
+
converges).
c) Now suppose that at time t₀ α increases permanently. Show graphically the
evolution over time of: i) the logarithm of capital per efficiency worker log(𝑘); ii)
the logarithm of capital per worker log(k); iii) the interest rate r.

1
Question 4) Repeat point (c), of the previous question, this time assuming that α decreases
permanently at time t₀.

Changes in output per worker and output (income) per capita due to changes in the
participation rate (the fraction of the population that is working).
Consider a Solow economy without technological progress that is on its balanced growth
path. Suppose that a fraction 0 < p < 1 of the population works, i.e. L = p P , where P is the
size of the population of the country and L is the number of workers.

Question 5) Suppose now that the participation rate p increases. What happens to output per
worker and income per capita in the short and in the long run? Why?

Question 6) And what happens when the participation rate p decreases? What, then, does the
Solow model predict will happen to output per worker in a society where the participation rate
falls because of an increase in the share of older people?

Taxation, Consumption and Ricardian Equivalence

Question 7) Consider a two-period consumption allocation problem as seen in class. For

simplicity, assume that the discount rate β is equal to 1 and the interest rate r are both equal to
zero. The household maximizes U C0 + U C& subject to its intertemporal budget constraint:

𝑆 = 𝐿𝑤0 − 𝐶0

𝐶& = 𝐿𝑤& + 𝑆

Extend the budget constraint to include lump-sum taxes 𝑇0 and 𝑇& , to be paid respectively in
period 0 and 1. Therefore Disposable income in period 0 is 𝐿𝑤0 − 𝑇0 , and in period 1 is
𝐿𝑤& − 𝑇& .
Derive the reaction of the household's consumption in the first period with respect to an
increase in taxes. Distinguish the two cases in which the household either believes that the tax
increase is temporary (taxes increase only in period 0) and the case in which the tax increase
is assumed to be permanent (taxes increase in the first period and will remain high in the
second period).

Question 8) Consider the same model as in question A, and extend it by considering the
government's budget constraint. Assume that the government has to cover a predetermined
path of expenditures (𝐺0 , 𝐺& ).
The government may decide to run a budget deficit (if 𝐺0 > 𝑇0 ) or a surplus (if 𝐺0 < 𝑇0 ) in
period 0, but these have to be repaid in the second period. So for example if 𝐺0 > 𝑇0 , then in
period 1 taxes 𝑇& have to repay both 𝐺& and the difference 𝐺0 − 𝑇0 .
Write down the government's intertemporal budget restriction. How does the consumer now
react to a first-period tax cut if she takes into account that the government has to balance its
budget intertemporally? Why?