EC303 - Economic Policy Analysis Problem Set 1

Michaelmas Term 2013

This problem set makes you go through some of the mathematical steps of deriving the RBC model seen in class. Problem 1 covers the basic case of constrained maximization and should be seen as a refresher in setting up the Lagrangian. Problem 2 then covers the consumers and the rms problem for the basic RBC model seen in class and in the lecture notes posted on the class website.

Problem 1: Constrained Maximization and Consumption

Consider a consumer who lives for two period and receives utility from consumption. Her utility function is given by U (c1 , c2 ) = ln (c1 ) + ln (c2 ) . In period one she receives an income y1 = 1. In period two she receives income yt = y . She can borrow and save freely at the interest rate r. 1. Write the consumers budget constraint both in its ow form and its net-present value form. 2. State the consumers maximization problem and set up the Lagrangian. 3. Derive the three necessary rst-order conditions for the variables (c1 , c2 , ) 4. Derive the Euler equation. How does the growth rate of consumption the discount factor ? 5. Solve for c1 and c2 in terms of y , r and .
c2 c1

depend on the interest rate r and on

Problem 2: Firms and consumers in the RBC model

Now consider the basic set-up of the RBC model. Consumers live for 2 periods and have preferences U (c1 , c2 , n1 , n2 ) = u (c1 , n1 ) + u (c2 , n2 ) , c1 n1+ . 1 Here, ct denotes consumption of the unique consumption good and nt denotes labor supply. Denote the price of the nal good at time t by pt and the wage by wt . Consumers can save and borrow at a nominal interest i, i.e. when they save b units of the numeraire in period 1, they receive (1 + i) b units of the numeraire in period 2. The nal good is produced by a representative rm, who produces according to a production function u (c, n) = y t = At n t with < 1. Here At denotes rm productivity and is a parameter, which parametrizes the returns to scale. The rm is owned by the consumers so that any prots, which the rm generates, accrue to the household. 1 where

2.1

Prot maximization

Let pt and wt denote the equilibrium price and wage rate at time t. Solve the rms prot-maximization problem. Derive the rms labor demand function as a function of At , pt , wt and . Also, show that rms prots are given by = (1 ) pt At n t.

2.2

Utility maximization

Now consider the consumer. 1. Write the consumers budget constraint both in its ow form and its net-present value form (remember that consumers receive the prots , which they take as given) 2. State the consumers maximization problem and set up the Lagrangian. 3. Derive the two optimality conditions seen in class, i.e. the intra temporal condition (i.e. the one linking the marginal utility of eort and the marginal utility of consumption within periods) and the inter temporal condition (the Euler equation linking the marginal utility of consumption across periods). 4. Consider the intra temporal condition. How does labor supply nt depend on (a) the wage wt , (b) price level pt and (c) the level of consumption ct . Provide an intuition. 5. Show that the labor supply elasticity is given by 1 nt wt = . (wt ) nt