Alexandra Figueiredo Bento

Macroeconomics N: 13238 TCB30

Problem Set 4
1.
a) The present value is the amount of cash today that is equivalent in value to a payment
to be received in the future. So, if we consider different years and if we want to compare
their incomes and value of consumptions, we should convert all the values to a specific
year.
Taking a present value of the several consumptions/incomes over the years will give a
higher weight to the year 1 than the year 2, and a higher weight to the year 2 than the
year 3, and so on. The future values, when comparing to year 1, must be discounted
because the interest rate (i) is greater than zero and 1 dollar held as assets in year 1
becomes more than 1 dollar in year 2: we have to discount the year 2 to make them
comparable.
A unit of real income in the present is more valuable than a unit of real income next
year because if we receive the income this year we can hold the amount as assets and in
the next year that income (x) will become (1+i) x, however the real income next year will
just be x (assuming that price level and nominal income is fixed).
A unit of consumption next year is cheaper than a unit this year because the present
value of consumption in year 2 must be discounted by (1+i) to compare to the
consumption in year 1. If a household defers consumption from year 1 to year 2, it can
hold more assets (or borrow less) in year 1 and in the year 2 each unit of assets will have a
an extra value of the interest rate that will allow the households to have an extra source
of income which will lead to a cheaper consumption in the year 2.

b) Households must decide what they do with their income. They can use that value for
consumption or can use it to hold as assets and deviate the consumption to the next year.
The propensity to consume of and additional unit of income is given by the marginal
propensity to consume (MPC=C/Y). The factor that determine the value of the MPC is
the value of the interest rate: a higher interest rate can be an incentive for households to
hold that extra unit of income in order to have a higher consumption next year. A big
interest rate will mean that MPC will be close to zero (the variation of consumption will be
close to zero) because households would be willing to not consume today and save to the
next year because it will be cheaper to consume. On the other hand, a low interest rate
will not incentive households to save income (almost no return), and that extra unit will
be consumed in the current year (MPC close to 1).
The other factor that determiner the value of MPC is if we have an increase in income,
that increase is permanent or isolated. The propensity to consume in year 1 out of an
extra unit of year 1 income tends to be small when the extra income is temporary ( people
like to have similar levels of consumptions in the different years consumption
smoothing ). On the other side, MPC tend to be close to 1 when the extra income is
permanent (households dont save almost anything because they know that they also
have extra income in the next year).
The MPC cant be greater than one because we assume that household like to have
similar amounts of consumption in the different years, so the usually dont spent more at
consumption that their income.
2.

a) An increase at the interest rate (i) will have two separated effects:
1. Households have to decide how much to consume in one year compared to the other
years. An increase at the interest rate will have impact at this decision because the
household will save their income as assets instead of consuming (the higher the interest
rate the hire the reward to differing the consumption). Households will lower their
consumption today (C1) and raise the consumption at the next year because the cost of C 2
is lower. This effect is called the substitution effect.
2. On the other hand, an increase at the interest rate will bring more income to
householders. The assets in the form of bonds and capital will have a higher reward on the
next year which will increase the income and households will be more willing to consume
in year 1 because they know that they will have a higher income on year 2.
So, the increase in the interest rate will have a positive income effect, which motivates
the households to raise C1, but will also have an opposite effect that motivates the
households to reduce C1. The overall effect from an increase if i in C1 is uncertain.

b) A permanent increase in the wage income will allow households to increase their
consumption. In this case, households increase their consumptions (in years 1 and in the
next year) in many different ways according to the household multi-year budget
constraint: C1 + C2/(1 + i1) + C3/[(1 + i1).(1 + i2) ] + ... = (1+ i0).(B0/P+K0) + + (w/P)1.L +
(w/P)2.L/(1+ i1) + (w/P)3.L/[(1+i1).(1+i2) ] + ...
However, households like to have similar levels of consumptions in each year
(consumption smoothing), so the most logic way to predict their changes in consumption
is that they will increase their consumption in similar parts, at each year.
In each year the increase at the wage rate will promote an income increase. That
income can be divided by consumption on the current year or save that income as assets.
However, in this case the household does not need additional assets to provide the
consumption in the next years.
So, the effect in this years consumption (C1) is going to raise almost at the same
amount as the increase in the wage rate (MPC close to 1 )

c) A temporary change in the current real income (in order to satisfy the household multi-
year budget constraint and to respect the preference of households to have similar
amounts of consumption in each year- consumption smoothing) will increase the
consumption by similar amount in each year (C1,C2,C3). So, as households know that
this increase is isolated, they want to deviate that extra income also for the next years.
This means that the consumption in year 1 is going to increase just a little bit (when
comparing with the increase of the income). In this case MPC is going to be close to zero
because they will save practically the all amount for the next years.
d) An increase in future real wage income, but not at the current year wage income, will
raise every single consumptions over the years (including in the year 1). Although the
incomes of future years are higher that the income at the year 1 (does not change), the
household starts to react to the information of future incomes since the minute that he
knows it. So, the increase in the income from the future year is already reflected in a
higher C1 because the consumption will raise by similar amounts (consumption
smoothing).

e) In this case, as we can see in the households multi-year budget constraint, a one-time
windfall that raises the actual assets will increase not only the consumption on the current
year but also on the next year (income effect).
C1 + C2/(1 + i1) + C3/[(1 + i1).(1 + i2) ] + ... = (1+ i0).(B0/P+K0) + (w/P)1.L + (w/P)2.L/(1+ i1)
+ (w/P)3.L/[(1+i1).(1+i2) ] + ...
This increase at the actual assets will raise the consumption at the current year but also
at the next ones because households prefer to maintain a similar level of consumption all
over the years (consumption smoothing). So, the present consumption (C1) will increase
with the raise of assets (however, the increase on C1 comparing to the increase of initial
assets is going to be small, because households want to save part of the extra income for
the next years).

3.
a) A mathematical expression for permanent income evaluated at t = 1 would be the right
side of the household multi-year budget constraint (the sources of funds of the several
years). Assuming that the interest rate is constant for all the years, the permanent income
expression is:
Permanent income = (1+ i).(B0/P+K0) + (w/P)1.L + (w/P)2.L/(1+ i) + (w/P)3.L/[(1+i)2+

b) If we assume that permanent income is the constant income that has the same present
value as the households sources of funds, we can suppose that the permanent income is
going to be equal to the lifetime consumption. So, the variance of the lifetime
consumption will depend on the variation of the permanent income:
lifetime consumption= lifetime consumption
In this case of permanent income, the propensity to consume will be close to 1:
lifetime consumption/ lifetime consumption = 1

c) According to the multi-year household budget constraint and with the fact that the
permanent income is equal to the sources founds, we can also say that the permanent
income is also equal to the lifetime consumption:

Permanent income = (1+ i).(B0/P+K0) + (w/P)1.L + (w/P)2.L/(1+ i) + (w/P)3.L/[(1+i)2+=

C1 + C2/(1 + i1) + C3/[(1 + i1).(1 + i2) ] +
If we assume that the consumption (Ct) is equal for t=1,2,3 (And that the interest rate is
constant) the value of the permanent income will be
Permanent income= C1 + C2/(1 + i) + C3/[(1 + i).(1 + i) = C+ C/(1 + i) +C/[(1 + i).(1 + i)
= C+ C/(1 + i) +C/(1 + i)2+ = C[1+1/(1 + i)+ 1/(1 + i)2+
4.
a) If the household has a positive value of initial bonds, B0 > 0, it is a net saver. The real
value of the assets in form of bonds is B0/P, so if the price level (P) increase, the real value
of bonds will reduce. This decrease in assets will generate a reduction on the right side of
the multi-year household budget constraint (in the sources of bonds) and, as result, the
consumption will fall.
If the initial bond holdings are zero, there will be no effect on permanent income
resulting from a change in P. However, if bond holdings are negative, the household is a
net borrower, and the increase in the price level will reduce the real value of the debt of
households. That decrease on the real value of the debt will conduct to a higher income
and to a higher consumption.

b) Assuming that the initial bonds are zero (B0 = 0), we just need to pay attention to how
the interest rate affects the present value of labor income. An increase at the interest rate
by 1% will reduce the present value of the income and will reduce permanent income (as
we can see at the multi-year household budget constraint, the future incomes are divided
by (1+i)t, so if I increase, the present value of the future incomes will decrease).

6.
a) As we can see in the household multi-year budget constraint, the year 2 real wage
income (W/P)2Ls2 is discounted by (1+i1):
C1 + C2/(1 + i1) + C3/[(1 + i1).(1 + i2) ] + ... = (1+ i0).(B0/P+K0) + + (w/P)1.L +
(w/P)2.L/(1+ i1) + (w/P)3.L/[(1+i1).(1+i2) ] + ...
An increase in the interest rate of the year 1 (i1) will decrease the present value of the
year 2 real wage income. In this case, a higher interest rate will motivate households to
reduce their leisure time on the year 1, in order to increase their future leisure.
This is a an intertemporal-substitution effect on labor supply: households will increase
their work supply on year 1 (Ls1) and decrease their work supply on year 2 (Ls2) because
they want to have more leisure in the future, comparing to the present, because is
cheaper in year 2 (for an extra hour of leisure, they will decline lower their consumption
more in year 1 than in year 2)

b) A permanent increase in the wage rate (w/P) will generate two effects in the quantity
of labor supplied (Ls):
The first one is a substitution effect, which we can see by the household budget
constraint (C1+ (B1)/P + K = (w/P)1.L+ i0(B0/P+K0)), that a raise in the wage rate (higher
income) will lead to an higher consumption. So, the household gets a better deal by
working more because it gets more consumption (the goal of households). This increase in
consumption will make leisure time more expensive (the household sacrifices more
consumption for every unit of leisure) which will lead to an increase the labor supply (Ls)
(because households choose the cheapest alternative: in this case, increase consumption).
The second effect will be an income effect that says that households tend to respond to
a higher real wage rate by consuming more each year. In this case, we have a permanent
increase in the wage rate, which generates a large income effect (people tend to consume
a big part of the increase that they get in the wage rate). This income effect will make
households choose to work less because the increase on the wage rate allows them to
consume as much as they did before and have more leisure time (they will choose the
alternative that maximize their utility function: more consumption and more leisure). So,
this effect will lead to a lower Ls1
Valuing the two effects, we cant decide which one of them is more powerful
(substitution or income effect) and we wont be able to realize if the permanent increase
in the wage rate will increase or decrease Ls1.

c) A temporary increase in the wage rate (w/P) will generate (like in the previous
question) two effects in the quantity of labor supplied.
The substitution effect tells us that a raise in the wage rate will lead to a higher
consumption. The household will get a better deal by increasing their work time because
he/she can get more consumption. The increase in the consumption level will make
leisure more expensive (the household sacrifices more consumption for every unit of
leisure) which will make the household to choose the cheapest alternative (more
consumption) that will lead to an increase in Ls1.
As the increase in the wage rate is only temporary, the income effect will be small
(households want to extent that extra income for the next years, so the increase in each
year will be really small). With the extra income that households will get an incentive to
work less, so this effect will lead to a decrease (very small) in L s1.
If we compare the two results, we can conclude that the income effect will be weaker
than the substitution effects and that a temporary increase in the wage rate (w/P) will
lead to an increase in the quantity of the labor supplied (Ls1).

d) As we can see by the household budget constraint (C1+ (B1)/P + K = (w/P)1.L+

i0(B0/P+K0), if we have a one time windfall that raises the initial assets could lead to a
higher consumption (income effect).
However, the objective of households is to maximize their utility function, which
depends on the level of consumption and leisure. For households, the more consumption
of goods and leisure they can get, the better for them. In this case, they can continue to
consume the much amount of goods as they did before ( because they have another
sources of funds with capital) and work less (increasing their leisure time). So, households
will decrease the quantity of labor supplied (L s1) in order to have more leisure and
improve their utility function.

8.
a) A one-time decrease in population possibly caused by an onset of disease or a
sudden out-migration will make a reduction on the labor supply, as we can see on the
previous diagram: the curve the supply (S) will move to the left, which represents a
decrease on the quantity of labor supplied for every single wage rate (S2).
With this decrease on supply, and if we consider the previous wage rate that clears the
labor market (W1), the quantity of labor demanded is going to be superior to the quantity
of labor supplied. In order to clearing the labor market (LD=Ls) it will have to exist some
adjustments.
So, with a decrease in supply, the households that own the business, and control the
demand of labor, will compete to other households for the workers that exist. In order to
attract more labors, the households that own the business will increase the wage rate for
to W2 (we assume a perfect competition market, and every single owner of business will
increase the wage rate for W2).
As the wage rate goes up to W2, the quantity of labors that will work this equilibrium
(L1) will be lower than the previous one (L2) because with a higher wage rate the owners
of the business wont be able to have the same number of labors that they did before.
This decrease of labor supply shock will lead for a new level of market clearing that has
a higher age rate (W2), but a lower quantity of labor (L2).

b) In order to see the impact of the decrease in population in the capital market we must
look at the results of the previous question about the effect of in the labor market. The
decrease in population was the cause why the new quantitiy of labor decline. So, if we
think about the production, the companies need the inputs (capital and labor) to produce
goods, this decrease in the quantity of labor will make an effect on the capital market.
Less quantity of labor will mean that even if we introduce more machines in the factories,
the production wont be able to increase because the factory also need labors that can
work with the machines. That situation means that the MPK (marginal productivity of
capital) will decrease, so the demand curve will also decrease (as we can see at the
graphic).
That decrease in the demand of capital will dictate a new equilibrium, where the
quantity of capital will decrease (factories doesnt need as much machines as they did
before because they dont have enough labors to work with them) and the capital price
(R/P) will also decrease because the value that factories are willing to give for an extra
machine will be lower and the households that rent the capital want to rent as much as
possible, even if that means a lower profit. The interest rate it will decrease because, we
know that i=(R/P) and assuming that is constant, the interest rate will have the same
behavior as the real rental Price (R/P), so, it will decrease.
c) As the result of all the changes at the labor and capital market, the level of output (Y)
will decrease because both of the inputs suffer a reduction caused by the diminution of
population. The level of consumption will decrease due to a reduction in the permanent
income (the quantity of labor decrease and the quantity and rate of capital also decrease).
The level of investment will decrease due to a lower interest rate (theres no point in
saving and invest if we have a low return). The capital stock will also decrease because the
demand for capital is lower and the rental price is also lower, so households wouldnt
want to own as much capital as they did before (its less profitable).

9.
a) A decrease in the capital stock that was possibly caused by a natural disaster or an act
of war will lower the supply of capital (the number of machines available in the market
will going to decrease) which is translated on the diagram by supply curve that moved to
the left ( market supply (2)).
In order to produce, factories need inputs (capital and labor), and with this massive
decrease of capital input (assuming that labor stays the equal) the households that owns
the business will have more difficult to get machines.
Assuming a competitive market, each business owner will compete for the amount of
machines that they need and they will raise amount of rent capital that they are willing to
give (every households do the same because they take the prices as given-they dont have
the power to change all by themselves). This increase on the rental price will lead the to a
new equilibrium where the quantity of capital will be lower ( because the supply is lower)
but with an higher rental price (R/P) because the existence of less machines will add value
to the machines in the market because they are really necessary to produce. The interest
rate it will increase because, we know that i=(R/P) and assuming that is constant, the
interest rate will have the same behavior as the real rental Price (R/P), so, it will increase.
b) Thinking about the factories, they need inputs (capital and labor) to produce goods,
and as we already see in the previous answer, the decrease in the capital stock caused an
impact at the capital market: a lower quantity of capital and a higher capital rent (K/P).
With a lower quantity of capital, factories doesnt need as much labors as they did
before they will not have enough machines to work. This means that each labor wont be
able to increase the production as they did before the decrease of the capital stock: the
MPL (marginal productivity of labor) is going to decrease which is represented by a
decrease of the demand curve (also visible at the graphic).
A lower demand of labor will make the quantities decrease, because factories doesnt
need as much workers as they did before, but it also going to decrease the wage rate
(W/P) because an additional worker have a less value to the companies and because the
households are willing to work by a lower wage (they are competing to another
households that do exactly the same in order to get a job).
c) The decrease at the capital stock caused some the changes at the labor and capital
market, that result in a decrease at the level of output (Y) because both of the inputs
suffer a reduction. The level of consumption will decrease due to a reduction in the
permanent income (the quantity of capital decrease and the quantity of labor and the real
wage rate also decrease).
The level of investment suffer an increase due to a higher interest rate (the reward of
saving and invest is higher). The capital stock will also increase because the real rental
price is higher, so households would want to invest in capital in order to increase their
income.

10.
a) If households change their preferences and want to consume more and save less at the
current year that wont make any impact at the demand but it will change the labor
supply: A lower saving rate will generate an excess supply of bonds available at the market
which will raise the interest rate. The opportunity cost of current leisure is going to
increase and the supply of labor is going to increase (households raise the quantity of
labor supplied, and thereby raise the real wage income that will increase the
consumption)
We can see that impact at the graphic, where the curve of labor supply increase ( goes
to the right), that means that for every real wage rate, the labors are willing to work more
in order to get an higher income ( to get more consumption). The results of this change is
going to be a higher quantity of labor at a lower wage rate (because the extra value in
output of the additional workers that enter in the factories is going to get lower and
lower-diminishing marginal productivity of labor).
b) If we consider the previous result at the labor market in which the quantity of labors
increased that means that input of labor in the factories also increase.
With more labors, the factories also need more capital (machines) in order to maximize
the production. So, the marginal productivity of capital (MPK) is going to increase because
the value added to the output will be higher than before. That result will be translated by
a higher demand (the curve moved to the right). With the increase of the demand, the
rental price is going to increase because factories will give more value to every additional
unit of capital (because MPK has increase).
The interest rate is going to increase because a higher saving rate will create an excess
of bonds at the market.

c) The changes at the labor and capital market increase the production (the quantities of
input became higher) and the consumption (that was the main goal to the households).
On the other side, the investment will suffer a decrease because households prefer to
consume. This lower rate of investment will cause a slow down or even a decrease at the
variation of capital stock (households want the money to consume, not to invest in
capital).