NEW YORK UNIVERSITY

M.A. IN ECONOMICS

MACROECONOMICS I G31.1005-01/02

PROBLEM SET #1 10/05/2010

Instructors: Stefano Eusepi Andrea Ferrero

INSTRUCTIONS: The problem set is due no later than 7PM on Tuesday, 10/12/2010. If you plan to hand in a hard copy of your solutions, please place it in the TAs (Bledi Taska) mailbox located in the NYU Economics Department, 19 W. 4th Street, 6th . If you plan to submit your solutions by e-mail, please send the le(s) to bt540@nyu.edu. Either way, please dont forget to include your Name and NYU ID with your answers. Please, be concise and straight to the point in your answers. You can work in groups up to four people but all members of the group should submit their own solution.

EXERCISE 1: Household Problem with Non-Separable Preferences Consider a representative household endowed with the following preferences over consumption Ct and labor Lt 1 X 1 t (Ct Lt ) , (1) u (Ct , 1 Lt ) = 1 t=0

where (0, 1), > 0 and > 1. The representative household faces the ow budget constraint At + Ct = Wt Lt + (1 + rt )At1 ,

where At represents assets, Wt the prevailing market wage and rt the prevailing market interest rates. All quantities and prices are expressed in real terms. 1. Assume the real interest rate is constant and equal to the inverse of the discount factor in every period (rt = 1 1 t). Derive the intertemporal budget constraint, showing and carefully explaining every step of your calculations. 2. Consider the limiting case in which 1 and assume for simplicity that the amount . Calculate the Euler equation for consumption and of labor supplied is xed at Lt = L combine it with the intertemporal budget constraint to obtain the optimal consumption decision. [Hint : You may nd simpler to take the limit for 1 after deriving the Euler equation.] = 1/3. Assume further that Wt+j = 1 for j 0. 3. Assume that At1 = 0 and L . Calculate the optimal consumption Ct 4. Assume now that the wage is permanently increased by 5%, that is Wt+j = 1.05 for increases? j 0. How much does Ct 5. Assume now that the wage is temporarily increased by 5%, such that Wt = 1.05 and
increases? What is the for j 1. Suppose = 0.9 and = 0.99. How much does Ct intuition for the dierent answer compared to the previous question?

Wt+j = Wt+j 1 ,

. Derive the optimal choice of labor (labor 6. Next, relax the assumption that Lt = L supply curve). 7. a. What is the change in hours that the representative household is willing to supply in response to a change in the real wage? b. Assume that the representative agents non-labor income increases but at the same time the real wage stays unchanged. What are the eects on the labor supply? Compare your answer with the case of the alternative utility function 1 X L t Ct t , (2) U (Ct , 1 Lt ) = 1 t=0 where > 1. How do you explain the dierences? [Hint : Think about how the two dierent utility functions imply dierent income and substitution eects.] 2

8. Consider a representative rm with prots t = Yt Wt Lt Rt Kt and production function

Lt , Yt = Zt Kt

where Yt represents total output, Rt the rental rate and Kt capital. Set up the rm optimization problem and compute the rms labor demand. What happens to labor demand if Zt increases? Why? 9. Assume for simplicity that Kt = 1. Calculate the wage and hours that guarantee equilibrium in the labor market, using the labor supply derived in your answer to question 2. What economic variable(s) do they depend on? 10. What happens to equilibrium hours and wages if Zt increases? Compare the response of hours and wages to an increase in Zt in two economies. In one is very close to 1 and in the other is considerably higher than 1. Compare the responses graphically using demand and supply and explain the economic intuition for your answer.

EXERCISE 2: Transaction Costs and Asset Substitutability Consider a representative household endowed with preferences U (Ct ) = who faces the ow budget constraint At + BL,t + Ct = Wt + (1 + rt1,t )At1 + (1 + rtL,t ) BtL , where Wt represents labor income (labor supply is inelastic and, for simplicity, normalized to 1). The household can invest in two assets: a one-period bond At , which pays a net real return rt1,t , and a long-term bond Bt , which pays a net real return rtL,t . 1. Derive the optimality conditions for the household. In particular, explain how the introduction of the long-term asset changes the households problem. 2. Show that no arbitrage implies that the relation between the returns on the two assets is L Y (1 + rt+j 1,t+j ) . 1 + rt,t+L =
j =1 X j =0

1 Ct 1

Provide the intuition behind the result. 3. Now assume that the representative household needs to pay a transaction cost t per unit of long-term asset purchased. How does the budget constraint change? How does the rst order condition change? What does no arbitrage imply now? 4. The expectation theory of the term structure maintains that long term rates are just an average of short term rates. Does the expectation theory hold in the absence of transaction costs (i.e. with t = 0 t)? What if transaction costs are instead present (i.e. with t 6= 0)? Explain. 5. Departures from the expectation theory of the term structure are called term premia, that is, households are remunerated for holding long term securities over short term securities. The introduction of transaction costs can explain the existence of term premia. Does it also have implications for the evolution of aggregate consumption? Explain why or why not. 6. Now suppose the economy consists of two types of households. A fraction is unrestricted (u) and can trade both short term and long term assets. The representative unrestricted household does pay the transaction cost t to purchase long term securities. A fraction 1 is restricted (r) and can only trade long term assets. The representative restricted household does not pay transaction costs. What are the optimality conditions for the two representative households?
u ) (C r )1 . What is the aggregate Euler 7. Dene aggregate consumption as Ct (Ct t equation for long term bonds?

8. Eliminate transaction costs from the result in 7. using the expression for the term premium. Show that the aggregate Euler equation relates the growth rate of consumption between t and t + L to a weighted average of (i) the average short term interest rate and (ii) the long term rate. Contrast this result with your answer to 5. 9. Suppose the government has full control of the real interest rate. In this model, if short term interest rates are at their minimum level, under which conditions would the government be able to provide additional stimulus to consumption growth via long term interest rates?