Chapter 1

Question 1, Part A
Microeconomic foundations: Consider the neoclassical model from the lectures
in which consumers decide about allocations of consumption and leisure and
firms decide how much labour to hire. Suppose that consumers are subject
to a proportional income tax (τ ) but no lump-sum taxes. Suppose also that
labour is the only input into production and that firms have a linear production
function given by Y = zN D .

(a) What is a Pareto optimum and why does a proportional tax on labour
income lead to an inefficient economic outcome?

Answer:

An allocation is Pareto efficient if it maximises the utility of households subject

only to the physical constraints of an economy (independent of the institutions,
such as markets or governments, that implement that allocation). Note that
as all households are identical, there is no tradeoff of making some better off
without making others worse off.

Intuitively, Pareto optimality is reached when the rate at which households

are happy to substitute leisure for consumption equals the rate at which this
can be done physically. Economically speaking, it equates the marginal rate
of substitution between leisure and consumption to the marginal rate of trans-
formation which measures the technological possibility of converting one good
into another: the Pareto optimum thus requires M RSl,c = M RTl,c . In this
setup, M RTl,c = M PN .

With the proportional income tax, consumers’ optimality condition requires

that the marginal rate of substitution (relative value of leisure in terms of con-
sumption) is equal to the net wage rate: M RSl,c = (1 − τ )w. The marginal
rate of transformation is the slope of the production possibility frontier (M PN )
which is unaffected by the income tax. Firms’ optimum implies M PN = w.
Thus we have M RTl,c = w.

It follows that the competitive equilibrium implies M RSl,c ̸= M RTl,c , and so

the allocation is not optimal.

1
Intuitively, if consumers supplied one additional unit of labour, the marginal
product would be higher than the after-tax wage the consumer receives, and
this would raise utility in equilibrium. It would be socially optimal to supply
more labour, but the proportional tax scheme doesn’t motivate workers to do
so.

(b) Write down the firm’s profit function and the consumer’s budget con-
straint when there is a proportional income tax but no lump-sum taxes.

Answer:

The firm’s profit function is not directly affected by a proportional labour tax
and so profits are given by the usual formula: π = Y − wN d = (z − w)N d

However, the consumer’s budget constraint does change with the new tax. It
is now given by: C = w(1 − τ )(h − l) + π where N = (h − l)

(c) Show graphically how the labour supply and demand curves differ with
and without the proportional tax.

Answer:

The labour demand curve is perfectly elastic (horizontal) at z (when w = z,

firms make zero profits regardless of how much labour they demand). The
labour supply curve is given by the condition M RSl,c = (1 − τ )w. With the
(standard) assumption that the substitution effect on wage changes is larger
than the income effect, this curve is upward sloping. When we move from
τ = 0 to τ > 0, the curve will shift to the left - labour supply decreases for any
given wage.

Because the demand curve for labour is perfectly elastic, the equilibrium real
wage is always given by w = z. Note that the real wage (w) equals the marginal
product of labour in equilibrium - which, in this case, coincides with total factor
productivity (z). Note also that profits are zero in equilibrium (which is what
we would expect with perfect competition between firms).

2
 Figure 1: Labour supply and demand
w Ns′ Ns

z Nd

Question 1, Part B
The Laffer curve: Consider the same model as in Question 1, Part A and
suppose the only source of government revenue is labour income taxes. In this
case we can write total tax revenue as REV = τ w(h − l) where τ is the tax
rate and w(h − l) is referred to as the tax base. The Laffer curve describes the
relationship between total tax revenue and the tax rate.

(a) Explain why the Laffer curve is hump-shaped. How are the incentive
effects of income taxation important for the Laffer curve?

Answer:

The Laffer curve takes into account that higher proportional tax rates provide
less incentives for households to work (assuming the substitution effect dom-
inates the income effect of a change in the real wage). If we think about tax
revenues as tax rate × tax base, the government can increase the tax rate and
this will have a positive mechanical effect on total revenue but, at the same
time, labour supply will decrease because of the higher income taxes, which has
a negative incentive effect on total revenue because the tax base falls. These

3
two effects generates a “hump-shaped” Laffer curve. The Laffer curve implies
that there can be two different tax rates – a low tax rate (τ1 ) and a high tax
rate (τ2 ) – that generate the same tax revenue (G).

Figure 2: The Laffer curve

REV

REV ∗
tax revenue

τ1 τ∗ τ2 τ
tax rate

(b) Explain what happens when the economy is on the wrong side of the
Laffer curve and the income tax rate falls.

Answer:

If we are on the wrong side of the Laffer curve, the incentive effect becomes the
dominating factor. If the income tax rate falls, households will supply more
labour such that the tax base increase outweighs the reduction in the tax rate
and tax revenue will increase.

(c) U.S. President Reagan used the concept of the Laffer curve to justify his
tax cuts in 1981. Looking at the U.S. experience from both Reagan’s and

4
 George W. Bush’s tax reductions in 1981 and 2001 can we justify the
claims that the U.S. economy is on the “wrong side” of the curve?

Answer:

If the U.S. economy were indeed operating on the inefficient downward-sloping por-
tion of the Laffer curve in both 1981 and 2001, then we should be able to find evidence
in the data that federal income tax revenues increased following the enactment of
the tax cut bills. Looking at the evidence, this does not seem to be the case.

Question 1, Part C
Productivity shocks and the Laffer curve: Assume that the economy of Question
1, Part B is always in the low-tax-rate equilibrium on the good side of the Laffer
curve, and that the government wants to collect a constant amount of revenue.
Determine the effects of an increase in total factor productivity, z, on the Laffer
curve and on the tax rate. What is the combined effect (of higher TFP and of
a new tax rate) on equilibrium labour, leisure, consumption and welfare?

Answer:

Let’s first review optimality conditions with an income tax. The firm’s behaviour,
i.e. the labour demand (N d ) curve, is described by a horizontal line at w = z and
the consumer’s behaviour, i.e. consumption and labour supply N s , is characterised
by M RSl,C = (1 − τ )w. The budget constraint is: C = (1 − τ ) w (h − l) + π, where
π is dividend income of households.

Higher TFP z directly shifts up the labour demand curve, since labour demand is
perfectly elastic at w = z. The equilibrium outcome is a higher real wage and higher
employment. See point B in the left panel of Figure 3.

Higher w and N directly affect the government’s revenue for any tax rate: REV =
tax rate × tax base = τ × w × N . The Laffer curve shifts up in the right panel of
Figure 3. As the government holds its total spending and revenue fixed, it lowers
the tax rate τ .

This implies that demand for leisure decreases (N s shifts to the right). By con-
sequence, employment increases further to point C. Consumption here is simply
C = Y − G = zN − G. As both z and N have increased but G has stayed constant,

5
consumption has risen.

Finally welfare as measured by the consumer’s utility has increased, too. This is not
too obvious as leisure has fallen while consumption has increased. But note that
π = 0 in equilibrium, and so the only income source is wage income. The effective
wage the consumer receives has risen from z0 ∗ (1 − τ0 ) to z1 ∗ (1 − τ1 ), and so the
consumer’s budget set has increased. Utility must therefore be greater than before.

Figure 3: Endogenous tax response

w Ns Ns′ REV

B C
z′ Nd

z N0d
A G

N τ
τ1 τ0

6
Chapter 2
Question 2
The Malthusian growth model: In the Malthusian model:
(a) What are the key relationships and assumptions of the model? How would
you use the model to show what determines standards of living? Explain
intuitively.
Answer:

The key equations are

i. the production function Y = zF (L, N ),
ii. the population growth equation N ′ /N = g(C/N )
iii. and market clearing C = Y .
By using the CRS property of F and combining the equations we can obtain
N ′ = g [zF (L/N, 1)] N . We assume that this is a concave function of N (as
shown in the graph below). This concavity implies that there is a steady state
in N towards which the economy converges. The key assumption is that land
is in fixed supply.

When the population is low (below its steady state value) land per worker will
be high leading to high output per worker. High output per worker means high
consumption per worker: workers are well-off. Well-off workers will have more
children. This increases population which causes land per worker and output
per worker to decline. Lower output per worker leads to a lower rate of pop-
ulation growth. This process continues until output per worker is low enough
that there is no population growth. The opposite applies for population above
the steady state value: land per worker is low so output per worker is too low
to raise a high number of children (potentially leading to starvation). The
population will, therefore, decline.

With a steady state value of population (N ′ /N = 1), equation (ii.) uniquely

determines standards of living (consumption per head). Only external interven-
tions into this relationship, such as birth control or improvements in medicine
that lead to greater life expectancy, can produce a sustained change in stan-
dards of living.

7
 Figure 4: Convergence in the Malthusian Model

N
N′ = N

N ′ = g[zF (L/N, 1)]N

N∗

N
N∗

(b) Use the following functional forms to compute the steady state level
of population and consumption per capita. Assume z = 1:

Y = zF (L, N ) = Lα N 1−α
( ) ( )γ
C C
g =
N N

Answer:

Substitute (i) and (iii) into (ii) and use the given functional forms to write
( ) ( )γ ( )γ ( α 1−α )γ ( )αγ
N′ C C Y L N L
=g = = = =
N N N N N N

8
The steady state condition is N ′ /N = 1 so we have N ∗ = L. The production
function then implies that Y ∗ = Lα L1−α = L and from the market clearing
condition it follows that C ∗ = L and therefore C ∗ = N ∗ . Steady state con-
sumption per capita, C ∗ /N ∗ , is therefore equal to 1.

(c) Suppose that there is an epidemic disease which suddenly reduces the
level of the population. Show graphically what effects it has on the
long-run consumption per worker and explain your results. Can you
see the same conclusion in the algebraic solution you derived in part
(b)?

Answer:

After the population falls, consumption per worker increases at once: there is
more land available per worker and, by decreasing returns to labour, the surviv-
ing workers are able to produce more output per capita. Recall that population
growth responds to living standards (consumption per capita). Here, due to
the higher consumption per capita, the population starts expanding. The ex-
pansion continues until the marginal product of labour (and consumption per
worker) is the same as it was before the outbreak of the disease. There is no
long-run effect.

The same result follows from the solution above: steady state consumption per
capita c∗ = 1 and this is independent of the current population.

We can use the three main graphs of the Malthusian model to see the result
graphically. The production function and the population growth equation are
unchanged, so we will just observe expansions or contractions along the same
functions. Figure 1 illustrates the equilibrium path.

After the epidemic, land per worker l rises and we immediately move to l1 on
the right panel of the figure. Higher land per worker implies that production
and consumption per worker rise to c1 . In the left panel of the figure, the popu-
lation growth function implies that population growth N ′ /N is larger than one.

9
N ′ /N Figure 5: Epidemic disease in the Malthusian model

C/N
g(c)

1
c1 f (l)
c∗

c∗ c1 C/N l∗ l1 L/N

Once population rises, land per worker slowly moves back to its steady-state
level l∗ as is shown by the double arrow on the production function and, sim-
ilarly, consumption per worker returns back to c∗ . The double arrow on the
population growth function shows that population expansion slows down until
N ′ /N = 1 and we converge to the old c∗ and l∗ .

Question 3
Output Y is produced by firms according to the production function Y =
K α (BN )1−α , where K is the capital stock, N is the workforce (equal to the
population), B is the level of labour-augmenting technology, and α is a pa-
rameter that lies between 0 and 1. The population N is constant over time
(n = 0). Capital depreciates at rate d, so the evolution of the capital stock is
K ′ − K = I − dK, where K ′ is next year’s capital stock and I is the level of
investment. Investment is equal to saving sY , which is a constant fraction s
of income. Assume that technology B is constant.

(a) Show that output per person y = Y /N is given by y = B 1−α k α , where

k = K/N is capital per person, and that capital per person evolves over
time according to k ′ − k = sy − dk. Sketch the saving line sy and the

10
 depreciation line dk in a diagram, and explain why the economy has a
steady state for both k and y.

Answer:

• Dividing the production function Y = K α (BN )1−α by N to obtain an expres-

sion for output per person y = Y /N :
( )α
K α (BN )1−α B 1−α K α N 1−α 1−α K
y= = = B = B 1−α k α
N N α N 1−α N

where k = K/N is capital per person. Using I = sY and dividing both sides
of K ′ − K = I − dK by the constant N = N ′ leads to k ′ − k = sy − dk.
The saving line sy is sB 1−α k α , which is an increasing and concave function of
k because 0 < α < 1; The depreciation line dk is a straight line.

y
y∗
dk

sy

k∗ k

Given that the gradient of the line sy is diminishing as k increases, it must

intersect the depreciation line at a positive level of capital per person, where
since k ′ = k the economy has a steady-state level of capital per person, and also
a steady state for output per person. The existence of a steady state comes from
the concave shape of the production function and saving line, which reflects
the assumption of diminishing returns to capital.

(b) In January 2016, a slowdown in Chinese economic growth was widely reported
in the media. Some economists think of this as a natural outcome predicted
by the Solow model. Use your answer to part (a) to justify this claim.

11
Answer:
Chinese growth might have slowed down because it was initially accumulating capital
per capita (and thus catching up to the richer countries), shown in (a) as a move
from klow to k ∗ . Over time, as the returns to capital decreased, the economy attained
a steady state which was reflected by lower GDP growth rates. The key condition
for this to be true is that there is, indeed, a diminishing marginal product to capital,
i.e. α < 1 - otherwise we have no reason to believe a unique or, indeed, any steady
state exists in (a).

12
Chapter 3

Question 1
The Solow model: Consider an economy with an aggregate production function
Yt = BKtα N 1−α , where 0 < α < 1, Yt and Kt are output and the capital stock
at time t, N is the number of workers. Assume N and B are constants and
this is a closed economy. Let s be the saving rate and d be the depreciation
rate of capital.

a. Use the Solow model to show that the long run growth rate of this econ-
omy is zero and derive the steady-state level of capital per worker. Explain
the economic meaning of the equations and the graph that you used in
your answer.

Answer:
Solow model assumes that economy saves a constant fraction of output and,
as it is a closed economy, this equals investment:

It = sYt = sBKtα N 1−α

The capital accumulation equation states that

Kt+1 = (1 − d)Kt + It

With a constant number of workers, the per worker capital accumulation equa-
tion is
kt+1 − kt = sBktα − dkt
From this equation, we argue with help of Figure 1 why a unique1 steady state
level of capital per worker k ∗ exists and why the economy must converge to it.
Imposing the steady state on the equation itself, we obtain
( )1/1−α
∗ sB
k =
d

1
Strictly speaking another steady state exists where k ∗ = 0 - but it is not stable (the economy
never converges to it. It is also not very interesting for our analysis, as it implies no activity in the
economy - so we ignore it.

1
 Figure 1: Solow Convergence
dk

sf (k)

klow k∗ khigh k

b. Suppose the economy is in the steady state of part (a). There is a sudden
arrival of migrant workers of number M once and for all. Each immigrant
carries with them q units of capital per person. Suppose the migrant
workers settle down in the economy and adopt the same saving rate as
the local workers. What will happen to the growth rate and level of
output per worker in the short run and in the long run? Explain with the
equations and graph you used in part (a).

Answer:

We need to study three cases: q = k ∗ , q > k ∗ , q < k ∗ and study movement

along the saving curve for these three different cases.
If q = k ∗ , capital per worker does not change, so steady state stays the same,
hence output per worker and growth rate does not change in the short or long
run.
If q > k ∗ , capital per worker and output per worker increases to kq>k∗ in
Figure 2) (jump off the steady state) in the short run but starts decreasing
(because the saving curve is below the depreciation curve) until the economy
returns to the initial steady state. So, output per worker increases in the short
run but does not change in the long run, and growth rate of output per worker
is negative in the short run and 0 in the long run.
If q < k ∗ , capital per worker and output per worker decreases to kq<k∗ in
Figure 2) (jump off the steady state) in the short run, but starts increasing
(because the saving curve is above the depreciation curve) until the economy
returns to the initial steady state. So, output per worker decreases in the short

2
 run but does not change in the long run, and growth rate of output per worker
is positive in the short run and 0 in the long run.

Figure 2: Convergence following inflow of migrant workers

dk

sf (k)

kq<k∗ kq=k∗ kq>k∗ k

Question 2
Output Y is produced by firms according to the production function Y =
K α (BN )1−α , where K is the capital stock, N is the workforce (equal to the
population), B is the level of labour-augmenting technology, and α is a pa-
rameter that lies between 0 and 1. The population N is constant over time
(n = 0). Capital depreciates at rate d, so the evolution of the capital stock is
K ′ − K = I − dK, where K ′ is next year’s capital stock and I is the level of
investment. Investment is equal to saving sY , which is a constant fraction s
of income.

Now assume there is a ‘learning-by-doing’ effect: new ideas (higher B) are

generated as a by-product of the production process, so an expansion of the
capital stock leads to the discovery of new ideas. Ideas are assumed to be a
public good (non-rival and non-excludable), hence suppose that the level of
technology B available to all firms depends on the economy-wide capital stock
K according to B = λK, where λ is a positive constant.
(a) Taking account of the learning-by-doing effect, derive the relationship between
y and k. Sketch the saving line sy and the depreciation line dk in a diagram.

3
 Answer:
Substituting the equation B = λK giving the learning-by-doing relationship
between knowledge B and aggregate capital K/ into the production function
Y = K α (BN )1−α :
Y = K α ((λK)N )1−α = K α λ1−α K 1−α N 1−α = λ1−α N 1−α K
Dividing both sides by N leads to y = λ1−α N 1−α k, which is linear in capital per
person k. This implies the saving line sy is now a straight line. The learning-
by-doing effect raises the aggregate return on capital to the point where the
marginal product of capital is no longer diminishing.
y

sy
dk

Since both the saving line and depreciation line are straight lines, they generally
do not intersect at any positive level of capital per person. This means the
economy does not have a steady state, and capital per person and income per
person can grow perpetually (endogenous long-run growth) if the saving line
is steeper than the depreciation line.
(b) Explain the effects of increasing the saving rate s. Will the higher saving rate
necessarily result in greater long-run consumption per person c = (1 − s)y than
would otherwise have been obtained?

Answer:
An increase in the saving rate shifts the saving line upwards. Since there is no
steady state, this means that the growth rate of capital per person and output
per person is permanently higher. As output per person y will diverge over
time ever further from the path it would otherwise have followed, eventually
c = (1 − s)y must become larger than it would otherwise have been because
there is only a one-off change to 1 − s.

4
 y

s2 y
s1 y
dk

It could be argued that even if there is a learning-by-doing effect, knowledge

might not increase exactly in proportion to the capital stock. Assume instead
that B = λK β , where β is a constant that lies between 0 and 1.

(c) How would this alternative assumption affect the results found in parts (a) and
(b)?

Answer:
Substituting the learning-by-doing equation B = λK β into the production
function:
(( ) )1−α
Y = K α λK β N
= K α λ1−α K (1−α)β N 1−α
= λ1−α N 1−α K α+β−αβ
= λ1−α N 1−α K 1−(1−α)(1−β)

Dividing both sides by N :

λ1−α N 1−α K 1−(1−α)(1−β)

y=
N (1−α)(1−β) N 1−(1−α)(1−β)
( )1−(1−α)(1−β)
1−α (1−α)(1−(1−β)) K
=λ N
N
= λ1−α N (1−α)β k 1−(1−α)(1−β)

This means sy is proportional to k 1−(1−α)(1−β) . Since α and β are both between

0 and 1, 1 − (1 − α)(1 − β) also lies strictly between 0 and 1, which means

5
that k 1−(1−α)(1−β) is an increasing and concave function of k. The saving line is
not a straight line unlike in part (a). Therefore, unlike part (a), it follows that
the economy would have a steady state for capital per person, which means
there is no endogenous long-run growth. Unlike part (b), an increase in the
saving rate does not necessarily raise long-run consumption per person because
the usual logic of the Golden rule applies. However, since k 1−(1−α)(1−β) is less
concave than k α , there is a greater range of saving rates for which higher saving
increases consumption in the long run.

6
Chapter 4

Question 1
Consider the Fisher model of consumption with two time periods. A household
cares about consumption C1 in the present and consumption C2 in the future. The
household receives income Y1 in the present time period and Y2 in the future (taxes
and transfers can be ignored in this question). Households can save or borrow at
real interest rate r.
Households have a diminishing marginal rate of substitution between present and
future consumption, and both C1 and C2 are normal goods.
(a) Derive the life-time budget constraint of the household. Using a diagram, show
how the household’s optimal choice of consumption plan (C1 , C2 ) is found.
Answer:
Let S = Y1 − C1 denote the household’s saving in the current period, where a
negative value denotes borrowing. Conditional on saving S, the household will have
future financial wealth (1 + r)S and can afford consumption C2 = Y2 + (1 + r)S.
Dividing both sides by 1 + r:
C2 Y2
= +S
1+r 1+r
Substituting S = Y1 − C1 and rearranging gives the lifetime budget constraint:
C2 Y2
C1 + = Y1 +
1+r 1+r
In the Fisher model diagram, this lifetime budget constraint is a straight line with
gradient −(1 + r) passing through the endowment point (Y1 , Y2 ).
C2

Y2

C2∗

1+r
1 C1
Y1 C1∗

1
 The optimal choice of consumption plan (C1∗ , C2∗ ) is at the tangency point between
the indifference curves and the lifetime budget constraint.

(b) In which of the following cases is the household more likely to choose to be a
borrower, all else equal: (i) when Y1 is low relative to Y2 , (ii) when Y2 is low relative
to Y1 , or (iii) when both Y1 and Y2 are low?
Answer:

The household wants to smooth consumption over time, which means choosing
a consumption plan where C1∗ does not differ too much from C2∗ , or geometrically,
where the optimal consumption plan is far from the points where the lifetime budget
constraint intersects the horizontal and vertical axes. Case (i), where current income
Y1 is low relative to future income Y2 , is depicted in the diagram from part (a) above.
Here, the endowment point is relatively close to the top-left section of the lifetime
budget constraint, and the optimal consumption plan is further along to the right,
making the household a borrower.
Case (ii), where future income Y2 is low relative to current income Y1 , is depicted
in the diagram below.

C2

C2∗

Y2

C1
C1∗ Y1

Since the household wants to smooth consumption, it is more likely the household
will choose a consumption plan to the left of the endowment point here, making the
household a saver, compared to case (i). Case (iii), where both current and future
incomes are low, is depicted below.

2
 C2

Y2
C2∗
C1
C1∗Y1

The lifetime budget constraint has shifted inwards relative to cases (i) and (ii),
but this does not mean it is any more likely that the household will be a borrower
rather than a saver. This is because borrowing does not help the household smooth
consumption if both Y1 and Y2 are low. Therefore, it is more likely a given household
will be a borrower in case (i) compared to cases (ii) and (iii).

In what follows, assume the household chooses to be a borrower. Suppose now that
there is a rise in the real interest rate r.

(c) With reference to income and substitution effects, carefully analyse the effect of
a higher real interest rate r on the borrower’s optimal choice of current consumption
C1 .
Answer:

The higher real interest r makes the lifetime budget constraint steeper, pivoting it
around the endowment point. Making a hypothetical parallel shift of this budget
constraint to ensure the household can remain on the original indifference curve, the
new tangency point of the steeper budget constraint with that original indifference
curve has lower current consumption and higher future consumption. This is the
substitution effect, labelled ‘Se’ in the diagram below.

3
 C2

Y2

Ie Se
C1
Y1 C1∗ ′ C1∗

Removing the hypothetical shift of the budget constraint means shifting it back
to the left because the original consumption plan is no longer affordable by the
borrower at a higher rate of interest. This leftward parallel shift reduces both
current and future consumption because they are both normal goods. This is the
income effect, labelled ‘Ie’ in the diagram.
Overall, current consumption unambiguously falls from C1∗ to C1∗ ′ for the borrower
because income and substitution effects are reinforcing.

(d) Would the effect of higher r on savers’ current consumption simply be the op-
posite of what you have found for borrowers in part (c)? Explain.
Answer:

The substitution effect (‘Se’) would reduce current consumption for savers by the
same logic as in part (c). But higher interest rates r allow savers to afford better
consumption plans than before, so the income effect (‘Ie’) goes in the direction of
boosting consumption.

4
 C2

Ie
Y2

Se
C1
C1∗ Y1
C1∗ ′

The overall effect is ambiguous, so the response of savers is not simply the opposite
of borrowers. The income effects of r on the two groups go in opposite directions,
but the substitution effect leads both to adjust consumption in the same direction.
The diagram above shows the special case where income and substitution effects
exactly cancel out for a saver and current consumption remains at C1∗ (C1∗ ′ = C1∗ ).

Question 2
Use the dynamic macroeconomic model from the lectures to analyse the likely
effects on the real interest rate of the developments listed below. Explain which
curves shift in which direction, including wealth effects in your answer where
appropriate.

(a) An anticipated slowdown in the pace of technological discoveries (interpret

this as the expected level of future TFP z ′ being lower than previously
thought)

Answer:
A lower value of future TFP z ′ reduces the future marginal product of capital, low-
ering investment demand and shifting the output demand curve to the left.

Lower z ′ is also a negative wealth effect because lifetime incomes are expected to be
lower than previously thought.

5
This wealth effect reduces consumption, shifting the output demand curve further
to the left.

The wealth effect also reduces demand for leisure, resulting in a greater supply of
labour that would raise employment and output. This shifts the output supply curve
to the right (note that current TFP is not affected).

Since the output demand curve shifts to the left and the output supply curve to the
right, the real interest rate unambiguously falls.

(b) An increase in uncertainty about the future leads households to raise the
amount they want to save. In the dynamic macroeconomic model from
the lectures, interpret this as a reduction in consumption demand and an
increase in labour supply at each level of interest rates and wages. Analyse
the effects on interest rates, output, wages, employment, consumption,
and investment. If any effects are ambiguous you should say so.

Answer:

The reduction in consumption demand as households increase desired saving shifts

the output demand curve to the left.

6
The increase in desired saving also increases desired labour supply at each wage and
interest rate. The rightward shift of the labour supply curve increases employment
all else equal, which implies a rightward shift of the output supply curve increases
employment all else equal, which implies a rightward shift of the output supply curve.
w r
N2s (r2 ) Y1s
N1s (r1 ) Y2s
N2s (r1 ) r1
w2
w1
r2

Nd Y2d Y1d
N Y
N2N1 Y2 Y1

The leftward shift of output demand and the rightward shift of output supply imply
that the real interest rate must fall, though the effect on output is ambiguous.

In the labour market, there is no shift of the labour demand curve. The labour sup-
ply curve shifts rightwards because of greater desired saving, but also to the left as
the interest rate declines, which reduces the return to saving more. The overall shift
of labour supply is unclear, so the effects on employment and wages are ambiguous
(but employment must go in the same direction as output, and wages in the opposite
direction).

Investment increases because the real interest rate is lower, which reduces the op-
portunity cost of investing more.

The effect on consumption is ambiguous. The direct effect of more desired saving is
lower consumption, but the fall in the real interest rate boosts consumption demand
through the substitution effect.

(c) Climate change, with a greater risk of natural disasters destroying some of
the economy’s capital stock (interpret this as an increase in the expected
depreciation rate d of capital in the future, but with no loss of capital at
the current time)

7
Answer:
Since investment demand is determined by r = MPK ′ − d, an increase in the depre-
ciation rate d (of the future capital stock) will reduce current investment demand.
This shifts the output demand curve to the left.

By reducing the resale value of the capital stock in the future, it also lowers the
present discounted value of firms’ profits. This is a negative wealth effect.

The wealth effect implies lower consumption demand, shifting the output demand
curve to the left.

The wealth effect implies an increase in labour supply (lower leisure demand), which
shifts the output supply curve to the right.

Since the output demand curve shifts to the left and the output supply curve to the
right, the real interest rate unambiguously falls.

8
Chatper 5

Question 1
Credit market imperfections. A consumer receives income y in the current
period, income y ′ in the future period, and pays taxes of t and t′ in the current
and future periods, respectively. The consumer can borrow or lend at the real
interest rate r.

(a) This consumer faces a constraint on how much she can borrow, much like
the credit limit typically placed on a credit card account. That is, she
cannot borrow more than x, where x < we − y + t, with we denoting
lifetime wealth. Use diagrams to determine the effects on the consumer’s
current consumption, future consumption, and savings of an increase in
x.

Answer:
The consumer faces a borrowing constraint that places a ceiling on the level of cur-
rent consumption. The consumer may consume more than the current endowment,
y − t, but less than her lifetime wealth, we. The consumer’s budget constraint is
shown in Figure 2. It becomes vertical at c = y − t + x, which is the maximum
amount she can consume today. One possibility is that the borrowing constraint
is non-binding as in the left panel of Figure 2. The consumer chooses point H. An
increase in the level of x has no effect on such a consumer.

Alternatively, the consumer depicted in the right panel of Figure 2 originally chooses
the corner solution, point B, and achieves a level of utility corresponding to indif-
ference curve I1 . An increase in x expands the budget constraint and the consumer
now chooses, say, point G. The new equilibrium allocation consists of higher current
consumption, lower current saving (higher debt) and lower future consumption. This
consumer is able to improve her level of utility to that corresponding to indifference
curve I2 . Notice that this also illustrates a case where Ricardian Equivalence would
fail and a change in lump-sum taxes can have real effects on consumption.

(b) Alternatively, the consumer is given an option to borrow an unlimited

amount at the interest r∗ , where r∗ > r. Use a diagram to determine
which option the consumer chooses.
Answer:

1
 Figure 1: The effect of a relaxation in credit constraints
′
c c′

I1

H
I0

B B G
I2

c c

This problem contrasts two alternative forms of credit market imperfections. Un-
der one imperfection, consumers may borrow and lend at the same real interest
rate, but face a ceiling on their borrowing (this is sometimes called a ”hard credit
constraint”). The alternative option allows unlimited borrowing, but the interest
rate paid on borrowing exceeds the interest rate earned from lending (a ”soft credit
constraint”). Clearly, consumers who choose to be lenders are unaffected by such
constraints. We therefore only need to be concerned about the behaviour of borrow-
ers.

The choice of constraint depends on the consumer’s preference between current and
future consumption. In Figure 3, both constraints are depicted, with Z denoting the
endowment point net of taxes, (y − t, y ′ − t′ ). The left panel depicts the case of a
consumer who prefers to pay the higher interest rate on borrowing. This consumer
picks point G, a point that is preferred to any of the points along the kinked budget
line. Her preferences are such that she puts higher value on current consumption.
Her indifference curve at the kink point is relatively steep.

The right panel depicts the case of a consumer who prefers the maximum borrowing
constraint because here preferences are more evenly spread over current and future
consumption. Her indifference curve at the kink point is relatively flat. She will pick
point H.

2
 Figure 2: Different types of credit rationing
′
c c′

Z
Z
H

c c

Question 2
PAYG Pensions: Consider the two-period model of consumption. An individ-
ual receives income y in the current time period, but will retire in the future
time period and receive no more non-financial income (y ′ = 0). The individ-
ual can borrow or save at real interest rate r. Assume that r is fixed in this
question.
The government is worried people are not saving enough for their retirement.
It forces everyone to contribute an amount t to a pension system in the first
period of their lives, which pays benefits b in the second time period. The
pension system is fully funded, so b = (1 + r)t.

(a) What are the effects of this policy on consumption and individuals’ own
private saving? Relate your answer to the concept of Ricardian equiva-
lence.

Answer:

The position of the life-time budget constraint is determined by the present dis-
counted value of income after taxes and transfers. This is y + y ′ /(1 + r) before the
public pension system is established. The government forces everyone to contribute t

3
while young, and pays benefits b = (1+r)t when they are old. The present discounted
value of income after taxes and transfers is now:
y′ + b y′ (1 + r)t y′ y′
(y − t) + =y−t+ + =y+ −t+t=y+
1+r 1+r 1+r 1+r 1+r
This leaves the life-time budget constraint unchanged, so in the absence of credit-
market imperfections, there is no change to consumption, and private saving falls by
t.

This is a special case of Ricardian equivalence because the pension contributions act
as a tax, but leave the government with additional assets, allowing transfers to be
made in the future of the same present value.

Since investment returns r are low, the government decides to operate a pay-as-
you-go pension system instead. The current benefits b paid to old individuals
(in the second period of their lives) are financed from the current contributions
t of young individuals (in the first period of their lives). There are N ′ young
people and N old people alive at the same time. With total contributions equal
to total benefits, the budget constraint of the pension system is N ′ t = N b. The
population grows at rate n, so N ′ = (1 + n)N .

(b) Derive an equation for b in terms of t and n.

4
Answer:

Dividing both sides of the equation N ′ t = N b by N implies b = (N ′ /N )t. Using the

population growth equation it follows that N ′ /N = 1 + n, therefore b = (1 + n)t.

(c) By analysing the effect of the pay-as-you-go pension system on the life-
time budget constraint of a young individual, explain why the pay-as-you-
go pension system is able to make all generations better off if n > r.

Answer:

The pay-as-you-go system clearly benefits the first old generation when it is intro-
duced, who receive benefits but make no contributions. The effect on subsequent
generations can be studied by considering the effect on the present discounted value
of income. After the system is introduced, this is:

y′ + b
y−t+
1+r
Substituting b = (1 + n)t from part (b) and grouping terms in t:
( ) ( ) ( ) ( )
y′ (1 + n)t y′ 1+n y′ n−r
y −t+ + = y+ + −1 t= y+ + t
1+r 1+r 1+r 1+r 1+r 1+r

If n > r, the final term is positive for t > 0, so the present discounted value of income
after taxes and transfers is greater than y + y ′ /(1 + r) for all subsequent generations.
It follows that all generations are made better off by the pay-as-you-go system when
n > r.

5
 The government wants to boost aggregate consumption spending. It cuts the
pay-as-you-go pension contributions t, but leaves benefits b unchanged. To
do this, it must borrow by issuing bonds that pay real interest rate r. The
government’s budget constraint is:

N ′ d′ = (1 + r)N d + N b − N ′ t

where d denotes the amount of government debt there is to repay per old person
in the current time period, and d′ the amount of debt per old person there will
be in the next time period.
(d) Derive an equation for d′ in terms of d, t, b, r, and n.

Answer:

Divide both sides of the government budget constraint by N ′ and use N/N ′ = 1/(1 +
n) implied by the population growth equation:
( )
′ 1+r b
d = d+ −t
1+n 1+n
(e) Assume n > r. If the government makes the cut in pension contributions
t permanent, show there exists a steady-state level of government debt
d = d′ .

6
Answer:

Using the equation derived in part (d), a steady-state d′ = d for government debt
must satisfy:
( ) ( )
1+r b n−r b
d= d+ −t ⇔ d= −t
1+n 1+n 1+n 1+n

Solving this equation for d in the case n > r leads to:

( )
1+n b
d= −t
n−r 1+n

which is a finite positive number after the permanent cut in contributions t.

(f) Would the cut in contributions t succeed in boosting aggregate consump-

tion spending in the economy? Does Ricardian equivalence hold? Explain
your answer.

Answer:

The cut in t with no change in b implies an increase in the present discounted value
of income after taxes and transfers y − t + (y ′ + b)/(1 + r). This raises consumption
of the current young, but has no effect on the consumption of the current old, so
aggregate consumption must rise. Ricardian equivalence does not hold because the
generations that benefit from the lower contributions never have to face higher taxes
to repay the government debt.

(g) Using your answer to part (d), plot d′ against d in a diagram that also
includes the 45◦ line. By comparing the cases n > r and n < r, explain
why your answer to part (f) would be different if n < r.

Answer:

The equation for d′ in terms of d is a straight line with gradient (1 + r)/(1 + n). In
the case n > r, the line is flatter than the 45◦ line and intersects it at the steady
state found in part (e).

7
In the case n < r, the line is steeper than the 45◦ line and there is no intersection
point because it is above it for all positive d. Hence, with n < r, any attempt to lower
t starting from (1 + n)t = b would lead to explosive growth in d, so the permanent
cut in t is not possible because eventually there would be too much debt for the next
generation to hold.

8
Question 1
The efficiency wage model:

(a) Assume that the production function is given by Y = F (K, E), where E
stands for effective units of labour E = e(w)N . Derive and interpret the
optimal condition for the efficiency wage: e′ (w) = e(w)/w.

Answer:

Firms do not take wages as given in this model. Instead, they set wages to maximise
their profits by increasing workers’ effort:
w
max F (K, E) − wN = max F (K, E) − E
w,N,E w,E e(w)

Here, we have replaced labour N by effective labour E. It is useful to think of E as

the input to production function - the “effective wage” becomes w/e(w); the wage
per unit of effort. It is then clear that whichever level of effective labour E the firm
chooses, w will be set to minimise this effective wage:
w
min
w e(w)

Mathematically, the first order condition is

e(w) − e′ (w)w e(w)

= 0 ⇔ = e′ (w)
e(w)2 w

Graphically (see Figure 1) the optimal wage is given by the point on e(w) where a
ray from the origin to that point (which has the slope e(w)/w) is exactly tangent to
the function (which has the slope e′ (w) at that point).

(b) Suppose that it becomes more difficult for firms to observe worker effort
(perhaps because the cost of monitoring rises). Show in diagrams the
effect on the effort function e(w), the efficiency wage and unemployment.

Answer:

1
 Figure 1: Greater difficulty in observing worker ability

e(w) w
Nd Ns
w2
A
w1
B

w1 w2 w N2 N1
N

If it becomes more harder for firms to observe effort then workers, knowing they are
less likely to be caught if they do not do their work properly, will put in less effort
for a given wage as effort is costly. The effort function therefore shifts down (note
that it still passes through the origin though). In response, firms will likely increase
the efficiency wage in order to increase workers’ effort. A higher efficiency wage then
leads to higher unemployment (as the gap between labour supply and labour demand
becomes wider). See Figure 1.

Question 2
The equilibrium search model. Consider the two-sided search model of unemploy-
ment. Matches (m) between job vacancies (v) and the unemployed (u) are deter-
mined by the Cobb-Douglas matching function:

m = µuη v 1−η

where 0 < η < 1. The job-finding rate is f = m/u = µθ1−η , where θ = v/u denotes
labour-market tightness (the ratio of vacancies to the number of unemployed). The
rate at which vacancies are filled is q = m/v = µθ−η . Workers leave jobs and become
unemployed at an exogenous rate s. The labour market is in equilibrium when inflows
are equal to outflows:
s(1 − u) = f u

2
 (a) Show that the equilibrium unemployment rate is u = s/(s + f ), and use this
to demonstrate that there is a negative relationship between vacancies v and
unemployment u (the Beveridge curve).

Answer:
The equation for inflows and outflows to be in balance is:

s(1 − u) = f u

Collecting terms in u on one side leads to (s + f )u = s, and hence the equilibrium

unemployment rate given the job-separation rate s and the job-finding rate f is:
s
u=
s+f
The job-separation rate s is exogenous. The job-finding rate is f = µθ1−η , where
θ = v/u is market tightness. The job-finding rate is increasing in market tightness
θ, and unemployment u is decreasing in the job-finding rate. This shows that higher
market tightness θ = v/u is associated with lower equilibrium unemployment u.
Geometrically in a diagram with vacancies v on the vertical axis and unemployment
on the horizontal axis, market tightness θ = v/u is the slope of a ray from the origin.
The negative relationship between θ and u thus traces out a negative relationship
between v and u 1 . This is the Beveridge curve.

1 s
Note that for completeness, we could multiply both sides of the equation u = s+f by θ to show
θs
that v = s+f (θ) . Since the derivative of this expression with respect to θ is positive, this tells us
that when θ increases, it is also the case that v increases.

3
The ongoing cost to firms of having a vacancy open is k, and the average time taken
to fill the vacancy is 1/q. When the vacancy is filled, the worker will produce y units
of output and be paid wage w until the worker leaves the job. Firms are willing to
create new jobs up to the point where:
k
y − w = (r + s) (JC)
q
Wages w are set by bargaining between the worker and the firm:

w = (1 − γ)b + γ(y + θk) (WC)

where b denotes unemployment benefits and γ is the bargaining power of the worker
(0 ≤ γ ≤ 1).

(b) Using a diagram with market tightness θ on the horizontal axis and wages
w on the vertical axis, explain why the equation (JC) implies a downward-
sloping job-creation curve and the equation (WC) implies an upward-sloping
wage curve (it is not necessary to derive the equations given above).

Answer:
Using the expression q = µθ−η for the vacancy filling rate, the equation (JC) implies
the wage w is related to market tightness θ according to:

(r + s)k (r + s)k η
w=y− −η
=y− θ
µθ µ
The wage consistent with job creation for a given level of market tightness is de-
creasing in market tightness, so the job-creation curve (JC) is downward sloping.
In the equation (WC), the wage w is linearly related to market tightness θ with a
positive coefficient. The wage curve (WC) is thus an upward sloping straight line.

4
 (c) Assume that workers have no bargaining power (γ = 0). If there is a decline in
workers’ productivity y, what are the effects on the job-creation curve and/or
wage curve? What are the responses of wages and market tightness to the
productivity shock and what are the implications for vacancies and unemploy-
ment?

Answer:
If the bargaining power of workers is zero (γ = 0) then w = b and the wage curve
becomes flat and the height of the wage curve is independent of productivity y. A
decrease in productivity shifts down the job-creation curve by exactly the fall in
y. Wages are unchanged in equilibrium (equal to workers’ outside option b), and all
adjustment to the new equilibrium is through a reduction in market tightness θ. The
movement down the Beveridge curve leads to a rise in unemployment and a fall in
vacancies.

5
 (d) Now assume that workers have some bargaining power (γ > 0). Repeat the
analysis of part (c) and use your results to comment on what assumptions on
bargaining power are required for productivity shocks to have large effects on
unemployment.

Answer:
With γ > 0, the wage curve is upward sloping and it also shifts down when pro-
ductivity decreases. The shape and shift of the job-creation curve is the same as
in part (c). Both (WC) being upward sloping and shifting down when y falls lead
to a smaller effect on market tightness θ in equilibrium. This means the movement
along the Beveridge curve is smaller, so unemployment and vacancies are affected
less by productivity shocks . For the model to predict that productivity shocks have
a large effect on unemployment, it is therefore necessary that the bargaining power
of workers is not too high.

6
7