EP607: Ekonomika Makro III

Problem Set 2
Suggested Solutions

1. (10 points) In the one period model, list the requirements for a competitive equilibrium, and explain why
each is important.
Solution:
In a competitive equilibrium, the consumer consumption and leisure optimally given the market real wage
and dividend income, and the firm maximizes profits given the market wage by choosing the quantity of
labor input. In equilibrium, at the market real wage the consumer is willing to supply the quantity of labor
that the consumer demands. Optimization assures that everyone in this economy is doing the best they can
given their constraints, while market-clearing assures that those decisions are consistent. In a competitive
equilibrium all economic agents are price-takers who treat market prices as given.
2. (20 points) In the one-period model, education can be represented as time spent by the representative
consumer that is neither leisure time nor time applied to producing output. What the economy gains in the
future is that the representative consumer then has more time available, as measured in terms of effective
units of labor time (adjusted for skill level, or what economists call human capital).
a. Using the one-period model, show what effects additional education has in the present on consumption,
leisure, employment, aggregate output, and the real wage.
Solution:
If households dedicate a hours to education today, it reduces the hours available for leisure and work
to h − a. The PPF has to start from point (−G, h − a). Graphically, this corresponds to the figure in
the answer of question 3(b). The consequence is thus a reduction in consumption, leisure, employment,
and aggregate output, but an increase in the real wage.
b. Similarly, show the effects the additional education that people acquire today will have in the future
on consumption, leisure, employment, aggregate output, and the real wage.
Solution:
In the future, workers will be more efficient, which corresponds to an increase in total factor produc-
tivity. Thus we have the case described in Figure 5.9 of the textbook. There is an increase in future
consumption, aggregate output and the real wage. Changes in employment and leisure are ambiguous.
c. What does your analysis in parts (a) and (b) have to say about the trade-offs society makes between
the present and the future in investing in education?
Solution:
An increase in education leads to an immediate loss in welfare, as both leisure and consumption are
reduced. But this is compensated by an increase in future consumption, and possibly of leisure, too.
Whether this is worth doing depends on the preferences of households over current and future utility.

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3. (20 points) Suppose that government spending makes private firms more productive; for example, gov-
ernment spending on roads and bridges lowers the cost of transportation. This means that there are now
two efects of government spending, the first being the effects discussed in this chapter of an increase in G
and the second being similar to the efects of an increase in the nation’s capital stock K.
a. Show that an increase in government spending that is productive in this fashion could increase welfare
for the representative consumer.
Solution:
The increase in government spending in this example has two separate effects on the production possi-
bilities frontier. First, the increase in government spending from G1 to G2 implies a parallel downward
shift in the production possibilities frontier. Second, the productive nature of government spending
is equivalent to an increase in total factor productivity that shifts the production possibilities frontier
upward and increases its slope. The figure that follows draws the original production possibilities
frontier as P P F1 and the new production possibilities frontier as P P F2 . If the production-enhancing
aspects of the increase in government spending are large enough, representative consumer utility could
rise, as in this figure.

Add the graph here.

b. Show that the equilibrium efects on consumption and hours worked for an increase in government
spending of this type are ambiguous but that output increases. You must consider income and substi-
tution efects to show this.

Solution:
There are three effects at work in this example. First, there is a negative income effect from the
increase in taxes needed to pay for the increased government spending. This effect tends to lower
both consumption and leisure. Second, there is a substitution effect due to the productive effect of
the increase in G, which is drawn as the movement from point A to point D. This effect tends to
increase both consumption and leisure. Third, there is a positive income effect from the increase in G
on productivity. This effect tends to increase both consumption and leisure. In the figure above, the
movement from point D to point B is the net effect of the two income effects. In general, consumption
may rise or fall, and leisure may rise or fall. The overall effect on output is the same as in any increase
in total factor productivity. Output surely rises.

4. (10 points) Explain how the reservation wage is determined in the one-sided search model.
Solution:

To determine the reservation wage, we assume that the welfare of unemployed workers is a concave function
of the wage they earn, and also depends on the separation rate. The welfare of unemployed workers depends
on the unemployment insurance benefit and how frequently an unemployed worker receives job offers. An
unemployed worker will search until he or she receives a wage offer that implies that, if he or she accepts it,
his or her welfare will be higher than it would if he or she remained unemployed and continued searching.
Therefore, the reservation wage is determined by the point at which the welfare of the employed worker, as
function of the wage, is equal to the welfare of being unemployed. An unemployed worker will accept any
job offer at the reservation wage or above, and will decline everything else.
5. (20 points) Determine the efects of an increase in the separation rate, s, on the reservation wage and on
the long-run unemployment rate in the onesided search model of unemployment. Explain your results.

Solution:

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If the separation rate s increases, this has two effects. In Figure 6.14, this shifts down the curve Ve (w), as
a job is now worth less–a worker has a greater chance of being separated from the job at any wage. As a
result, the reservation wage w∗ will increase, as the consumer becomes more picky about the jobs he or she
will take. That is, unemployment is more attractive relative to working. So, H(w∗ ), which is the chances of
receiving a job offer that is acceptable, falls. So in the second panel of Figure 6.14, U pH(w∗ ) shifts down,
and s(1 − U ) shifts up. Therefore, on net, the long-term unemployment rate must rise. That is, workers are
being separated from jobs at a higher rate, causing a higher flow from employment to unemployment, and
the unemployed are accepting jobs at a lower rate, creating a lower flow from unemployment to employment.
These two effects both work to increase the unemployment rate.
6. (20 points) Suppose the government’s goal is to reduce the unemployment rate. Some legislators propose
that the government should give a subsidy s to any firm that hires a worker. Some other legislators argue
that it would be more effective to simply pay consumers to stay home rather than searching for work; that
is, anyone who chooses not to participate in the labor force should receive a payment q. Which policy is
more effective in achieving the government’s goal? Explain using the two-sided search model, with the aid
of diagrams. [In your answer, do not concern yourself with how the subsidies from the government are
financed.]

Solution:
With a subsidy s to hiring a worker, for a successful match, the surplus of the firm is z + s − w, the surplus of
the worker is w − b, total surplus is z + s − b, and the wage (from Nash bargaining) is w = a(z + s) + (1 − a)b.
Then, on the supply side of the labor market, the equation determining the curve in panel (a) of Figure 6.2
is given by
v(Q) = b + em(1, j)a(z + s − b),
and on the demand side of the market, the equation determining j is

(k/((1 − a)(z + s − b))) = em((1/j), 1).

Then, in Figure 6.2, comparing the equilibrium when s = 0 to one with s > 0, the subsidy acts to increase
labor market tightness, j, and to increase the labor force, Q. The subsidy acts to induce more firms to enter
the labor market to search for workers, which makes j = (A/Q) higher. This in turn acts to make search
more attractive for workers, as it is now easier to find a job. As well, the subsidy increases the wage, which
further increases the incentive to search for work. The unemployment rate is 1 − em(1, j), which falls when
j increases, so the subsidy reduces the unemployment rate.
If the government pays would-be workers to stay out of the labor market, this has no effect on the demand
side (firms’ behavior). However, the supply side of the labor market is now characterized by the equation

q + v(Q) = b + em(1, j)a(z + s − b),

Therefore, when q > 0, this shifts the curve in the upper panel of the figure below to the right. There is
no effect on labor market tightness, j, and therefore no effect on the unemployment rate. However, Q falls.
Since j does not change, this implies that A falls as well, since j = (A/Q). Therefore, this policy has the
effect not only of reducing the number of would-be workers looking for work, but it reduces the number of
firms searching for workers. The policy has an unintended side effect and has no effect on the unemployment
rate.

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