ECON224 Macroeconomics II

Problem Set 6

Question 1: Chapter 6

Suppose your government reforms its unemployment insurance system. the duration of UI benefits
received by unemployed persons shortens from nine to six months. In addition, the government reduces the
taxes on labor income but not those on UI benefits. Examine the effects of this decision on the reservation
wage and long-term unemployment with the aid of the one-sided search model of unemployment.

Question 2: Chapter 6

Determine the effects of an increase in the separation rate, s, on the reservation wage amd on the
long-run unemployment rate in the on-sided search model of unemployment. Explain your results.

Question 3: Chapter 18

Risk averse and concave utility function

In the Diamond-Dybvig model, we assume that consumers are risk averse. The figure below presents
the relationship between risk perference and utility function. For the consumer who is risk averse, his
utility function is concave. That is,
u′′ (c) < 0.

Or for any c1 and c2 and any p ∈ (0, 1), we have

pu(c1 ) + (1 − p)u(c2 ) < u(pc1 + (1 − p)c2 ).

Check the following utility functions, are there risk averse, risk neutral or risk seeking?

ˆ u(c) = c

ˆ u(c) = c2

ˆ u(c) = ln c
1
ˆ u(c) = 1 − c− 2

Question 4: Chapter 18

This is a modification of the Diamond-Dybvig model. Suppose that there are two assets. One asset
is an illiquid asset that returns 1 + r units of consumption goods in period 2 for each unit invested in
period 0. The illiquid asset production technology cannot be interrupted in period 1. The other asset is

1
a liquid asset that returns one unit of consumption goods in period 1 for each unit invested in period 0.
At period 1, the consumption goods can be stored to consume in period 2.

The model is otherwise the same as the Diamond-Dybvig model. Assume there are total N = 100
consumers, and each consumer is endowned with 1 unit of goods in period 0. The probability of being
the earlier type of consumer is t = 0.4. Utility function is u(c) = 1 − c−1/2 and the rate of return r = 2.

(a) Determine a consumer’s lifetime budget constraint when there is no bank, show this in a diagram.
Determine the consumer’s optimal consumption (Autauky allocation).

(b) Determine a bank’s lifetime budget constraint, show this in your diagram, and determine the
optimal deposit contract for the bank in the diagram.

(c) Are consumers who deposit in the bank better of than in part (a)? Explain why or why not.

Figure 1: Risk Preference and Utility function