Alexandra Figueiredo Bento

Macroeconomics N: 13238 TCB30

Problem Set 10

1. The effect of an increase by 1 unit at the Government Expenditure (Gt) will depend
whether the increase is temporary or permanent. In both cases ( permanent and
temporary increases) an increase at the Government Expenditure by 1 unit will decrease
by 1 unit the real transfers net of real taxes (V-T), as we can see by the government
budget constraint: G+V=T V-T=-G.
The decrease in the real transfers net of real taxes will decrease the disposable
income of the households. If we look at the households budget constraint
(Ct+(1/P).Bt+Kt =(w/P)t.Lst+rt-1 .(Bt-1/P+Kt-1)+Vt-Tt ) and assume that everything else is
constant we will conclude that the decrease in the right side of the equation ( V-T) must
be followed by a decrease on the left side, which in this case will affect the consumption
(income effect) . In order to maintain the equation of the household budget constrain
(uses of funds = sources of found) consumption must also decrease.
If we think about a permanent increase at the government expenditure (G t) that
means that in each period Gt will rise by 1 unit which will generate a decrease at the real
transfers net of real taxes (V-T) and consequentially a decrease at consumption in each
period (income effect). In order to see if exists any other effect that affect consumption
we must look at the capital and labour market:
Capital Market: An increase at Gt does not shift the demand (doesnt affect MPK)
or supply curves (we assume that capital stock, K, is fixed at the short run and
the change at Gt wont affect the capital utilization rate, k,). So, the equilibrium
values of the capital market (kK* and (R/P)*) wont suffer any change.
In terms of real interest rate, since (R/P)* and the capital utilization rate, k,
doesnt change, r wont suffer any modification.
Labour Market: The increase at Gt doesnt have any effect on the demand
(doesnt change MPL) or supply curves (we assume that the Labour supply if
fixed). The equilibrium variables of the labour market ((w/P)* and L*) wont
suffer any change.
Since the effect is permanent and we dont consider any substitution effect
(intertemporal-r doesnt move- or intratemporal-real wage rate is the same) we
conclude that the consumption will decrease approximately by one unit at each period
(propensity to consume out of a permanent change in income is close to 1).
In terms of real GDP we can conclude that doesnt change (L*, kK* or A doesnt suffer
any movement). A permanent increase at Gt wont affect Gross Investment because
assuming that Y is unchanged, G rises by 1 unit and C decreases by 1 unit, that means
that Gross Investment wont be practically affected: Y=C+I+G (changes in C and G fully
offset each other).
On the other hand, if we face a temporary increase at the government expenditure
that means that in 1 period Gt will rise by one unit, but in the next years the values of
government will return to the original value. Like in the previous scenario, nothing will
move at the capital or labour market, which means that the equilibrium variables wont
move. Since r or w/P doesnt move (again), consumption will only count with the income
effect (no substitution effects). The income effect that results from the temporary
increase at G is caused by a rise by one unit at the real transfers net of real taxes (V-T),
but in this case, since is a temporary effect, the disposable income is reduced in the
present year but households will react by reducing their consumption in the present
year and also in the future years (consumption smoothing). So, in the present year the
consumption will decrease but by a much less than 1 (differ from the permanent effect).
Nothing will happens to real GDP ( L* or kK* doesnt change) but, in this case, gross
investment will have to decrease because assuming that Y doesnt change, G increase
by 1 unit and C decreases by much less than 1 unit, I will have to decrease by a large
value: Y=C+I+G ( in order to compensate the increase in G).
In terms of money market, in both cases, nothing will change in the side of the supply
(the fact of increasing G doesnt motive the central bank to print more money) and
nothing will change on the side of the real demand, L(Y,i), because the variables of real
GDP (Y) and nominal interest rate (i) doesnt suffer any change. Since the supply or the
real demand for money doesnt move that means that the price level P will remain the
same: Ms=P.L(Y,i).
In conclusion, the differences in a permanent and a temporary increase by 1 unit at
G is basically on consumption (big decrease in permanent and lower decrease in
temporary) and on Gross Investment (doesnt practically change in permanent and big
decrease in temporary).

2.
a) In this situation households will have the information of a future increases at the
government expenditure on some random year. Since they expect this situation they
have the conscious that in that future year the real transfers net of real taxes (V-T) will
decrease by the same value as the increase in G (as we can see by the government
budget constraint: G+V=T V-T=-G). That decrease in (V-T) will generate a lower
disposable income and consequentially a lower consumption (income effect) in that
future year.
Since this shock is only temporary, the results will be close to the ones that were
mentioned on question 1 (for the temporary situation). In order to analyse the effect of
this anticipated information we should look to each market:
Labour Market: Nothing will move at the demand curve (the labours wont
become more productive) or the supply curve (we assume that workers supply a
fixed amount of labour) with that information. The equilibrium values will remain
constant (w/P and L*).
Capital Market: Nothing will also change (supply and demand) because the MPK
is the same (machines have the same amount of productivity) and the capital
utilization rate wont change with that information. The equilibrium values
doesnt move ( R/P and kK*)
Looking at the real interest rate, since nothing changes at R/P or k that means that r
doesnt change too (no arbitrage property). Since the values of L* or kK* are constant,
the real GDP wont suffer any change (Y=A.F(Y,i)).
In terms of money market, the central bank wont print more/less money (supply
doesnt change) which means that the amount of bonds in the economy will remain the
same (nominal interest rate tend to stay unchanged) and households wont have any
incentive to change their demand (Y or i are unchanged). Given those results (of M s and
L(Y,i)) the price level wont move.
The consumption will only be affected by the income effect (no substitution
effects). Since the effect is temporary (one isolated increase at G) and assuming that
households prefer to have similar levels of consumption in all years (consumption
smoothing) the households will decrease their consumption by a small amount in each
year, including in the present year. The small decrease at consumption will accompanied
by a small increase at the Gross Investment (more savings so that the consumption at
the future year wont be so affected) (assuming that Y is constant- Y=C+I+G).

b) One possible real world case scenario where households expect a future and
temporary increase at the government expenditure could be an announcement by the
government that there is going to exist a future investment at a certain infrastructure
(maybe roads) in which households dont know when the investment is going to be
made.

3.
a) Households may benefit from the public services in which the government invest.
The benefit that is provided by the government expenditure to households is
represented by G which means that for every unit of government expenditure (G) is
equivalent in utility to units of private consumption (C). The benefit in terms of utility
( units of C) can vary with the type of investment by the government.
In each of the categories of government expenditure that was presented in the
question we assume that all the categories provide a benefit for households (>0).
However, the benefit may vary from category to category and the attribution of a certain
value to to each category is a subjective process:
The categories of military spending and Police may be a case where <1 (less but
close to 1) because these mechanisms may not be a total substitution of private
securities.
In terms of highways and public transit we can assume that =1 (households can
use the public roads and have the exactly same amount of utility as if they had invested
in roads)
In environmental protection, research and development we can assume that the
government may give more benefits (units in C) in terms of utility for households than
the investment in G (>1) because the government have more resources than
households to deal with this investment which bring a lot of benefits to families.

b) Supposing that the households benefit from public services, we should add the term
G to the both sides of the household budget constraint because they receive some
utility by the public services (left side-uses of funds) and they gain an implicit value with
the free or subsidized public services (right side- sources of funds). So, the new H.B.C
will be: Ct+ G +(1/P).Bt+Kt =(w/P)t.Lst+rt-1 .(Bt-1/P+Kt-1)+Vt-Tt + G.
The permanent increase at G by 1 unit will decrease the real transfers net of real
taxes (V-T) (by the government budget constraint, V-T=-G) and consequentially the
effective real disposable income (right side) will decrease by 1- . The variation of the
consumption created by the rise of G by 1 unit at the HBC will be: C+ G= (Vt-Tt) +
G C+= -1+ C=-1. This result means that a permanent increase at G by 1
unit crowds out private consumption (C) at each period.
Looking at the labour market and capital market we can conclude that this extra
government expenditure wont change any of the supply or demand curves (MPK and
MPL dont change) which means that the equilibrium variables wont suffer any change
( (R/P)*, kK*, (w/P)*, L* and r*). Since none of the variables kK* and L* change the real
GDP will remain the same (Y).
 The private consumption will decrease by approximately 1 unit at each period
(permanent effect) because we only consider the income effect which means that in
terms of goods, each household will decrease their effective consumption (Ct+ G ) by
1- at each period. The Gross Investment wont suffer any change because the decrease
in C balances with the decrease in G by 1 unit.
In the money market nothing will happen on the supply side or in the demand side
which means that the price level (P) will remain the same.

c) A temporary increase at the government expenditure by 1 unit will lead to a

decrease at the real transfers net of real taxes (V-T) which means that the effective real
disposable income (right side) will decrease by 1- (as we can see by the new HBC: Ct+G
+(1/P).Bt+Kt =(w/P)t.Lst+rt-1 .(Bt-1/P+Kt-1)+Vt-Tt + G). The decrease at the real
disposable income will lead to a decrease at private consumption by 1 unit at the current
year: C+ G= (Vt-Tt) + G C+= -1+ C=-1 (as we already seen at the
previous scenario). However, households like to keep constant levels of private
consumption through the years (consumption smoothing) which means that households
will make a small decrease at C in the present but also in the future.
In this case the equilibrium levels of the capital and labour markets will also remain
unchanged, which means that the real GDP wont suffer any change.
Assuming that doesnt exist any substitution effect, the private consumption will
decrease by much less than 1 unit at each period which means that the effective
consumption will increase by approximately (what households gain with public
services). The gross Investment will have to decrease by approximately 1 unit at the
present year in order to compensate the increase at G (Y=C+I+G).
To conclude the analysis, we should look at the money market: since nothing
changes at the supply side (government wont print more/less money) or demand side
(households dont have any incentive to change the amount of money demanded) the
price level will remain unchanged.

d) The results at the 2 previous questions will depend on the size of the coefficient
. A higher value of the coefficient means that households will be happier when the
government expand G (because they know that they will have a higher increase at the
consumption of public goods that corresponds in utility to more units of private
consumption).
On the scenario where the increase is permanent we know that the effective
consumption of households will decrease by 1- at each year. If the value of is 1 that
means that the effective consumption wont suffer any change. However, if the value of
is higher than one that means that the effective consumption will increase and on the
other hand, if <1 the effective consumption will suffer a decrease.
When the increase at G is temporary, the change in effective consumption is
given by which means that the value of the effective consumption will change
accordantly with the magnitude of (usually is always higher than zero, which means
that the effective consumption tends to be positive in this case).
 4. In some cases, the government can provide public services that are useful for
households. In this particular situation, the government provides public police that are
just as efficient as the private guards. Since the utility for firms of public police is equal
to the utility provided by the private guards, firms will decrease their demand for
private guards which means that the quantity of Labour input is lower (assuming that
nothing changes on the labour supply). However, government will demand a bigger
amount of guards which means that the overall effect is that the amount of labour
demanded is unchanged which means that L maintains that same value.
Considering the assumption that the government expenditure is a input at the
production function, Y=F(kK,L,G) and that L is unchanged, the increase at the
government expenditure will increase, which means that the real GDP (Y) will also
increase. However, the change from private guards to public police by the firms is being
associated with a higher production, which is not true (problem of double counting).
A way to avoid this double counting problem could be make a distinction between G
that is not used in production and G that will be used at production and we should only
consider the last one as an input (and not at the moment of purchase). However, this
measure is really hard to apply on the real world because its extremely difficult to make
this distinction between expenditure that will be a input and expenditure that wont.

5.
a) A rise in the tax rate on labour income (w) can generate an income effect. That
income effect exists because we can assume that the increase at the tax rate on labour
income will increase the revenues of the government and that extra revenue will pay for
a possible increase at the government expenditure. As we know, an increase at the
government expenditure will lead to a decrease by the same amount at the real
transfers net of real taxes (V-T) which we can prove with the government budget
constraint: G+V=T V-T=-G.
If we now look at the Household budget constraint, that decrease in (V-T) will
consequentially decrease the effective real disposable income: Ct+(1/P).Bt+Kt
=(w/P)t.Lst+rt-1 .(Bt-1/P+Kt-1)+Vt-Tt. In this situation households will lower their
consumption because they have a lower income (income effect).
However, in the first part of our analysis we dont include that income effect
because we assume that the government expenditure is constant, which means that the
real transfers net of real taxes (V-T) should also be constant (for example, the
government can adjust other taxes to keep the total real taxes collected unchanged).
So, if (V-T) is unchanged that means that the households will have the same amount of
income which means that they wont have to reduce their consumption (no income
effect).

b) An increase at government expenditure that is financed by a rise in the tax on the

labour income (w) will have several implications at the labour supply.
If the tax on the labour income increase (w) that means that the for the same
labour income that households receive they will have to pay a higher tax which means
that the after tax real wage rate ((1- w).(w/P)) will be lower. Since households have a
lower wage for each hour that means that the opportunity cost of leisure is lower
(cheaper). Households tend to choose the cheaper option which means that they will
increase their leisure and decrease the amount of labour supplied (substitution effect).
Another effect at the labour supply is a negative income effect because an
increase at G requires a decrease at (V-T) which will decline the real disposable income
of the households. In response to this decrease at the real disposable income,
households will increase the amount of labour supplied.
The overall effect on the labour supplied will be uncertain because we dont
know which the effect (income effect or substitution effect) is stronger.

c) An increase in the tax rate of labour income (w) could reduce the real tax revenue
if the substitution effect that results from that increase is super strong.
The increase in w will result in a decrease of the after tax real wage rate ((1-
w).(w/P)) that households receive which means that for each hour that individuals work
they will receive a lower income. Since the opportunity cost of leisure is the income that
they get when they are working (consequentially the amount of goods that they can get)
and if now the income that they get is lower that means that leisure time is cheaper.
Assuming that households choose the cheaper option, they will decrease the quantity
of labour supplied Ls.
If we imagine a scenario where the government increases by a lot the tax rate of
labour income (w) that will implicate a much lower income for each hour of labour
which means that the leisure time will become super cheaper. In that particular case,
households may have an incentive decrease abruptly the amount of labour supplied
which may lead to a decrease at the revenue (the higher w wont be enough to
compensate the decrease at Ls).

6.
a) Household Budget Constraint:
Ct+Tt +(1/P).Bt+Kt =(w/P)t.Lst+rt-1 .(Bt-1/P+Kt-1)+Vt

b) A permanent increase at the tax rate on consumption (c) means that for the same
amount of income households will consume a lower amount of goods because for each
good the individuals will have to pay more (higher tax). With an increase at c will be
motivated to decrease the amount of goods that they consume (because they are more
expensive) which means that they can decrease the quantity of labour supplied and
enjoy more leisure time (leisure become cheaper when comparing to consumption).
Those final results in which we predict that with a higher tax rate on consumption
households will decrease the amount of labour supplied matches with the final results
of the scenario where the tax rate of labour income increase. In both cases (increases in
c or in w) households tend to work less and enjoy more leisure time.

c) As we already conclude at the previous question, an increase at the tax rate on

consumption will motivate households to work less and to increase the leisure time.
Given those results on the labour market we can analyse the effects on the capital
market. Since the quantity of labours decrease that means that is going to exist a
smaller number of labours for each machine, which means that each machine will
become less productive. A lower productivity of each machine is associated with a
lower MPK which means that the demand for rental price is going to be lower (demand
curve shifts to the left). Nothing changes at the side of the supply and we can conclude
that the equilibrium values ((R/P)* and kK) will both decrease because the firms want
to reduce the n of machines ( less workers) and each machine is less valuable.

d) Supposing that c falls in year 1 but remains unchanged at the future years will
generate a substitution effect. This effect happens because consuming today cheaper
than consuming in the future years (households have to pay more taxes in the next
years) which motivates households to differ their consumption from the next years to
the present year in order to consume more. So, a fall in c will lead to a higher
consumption on the present year a decrease in the consumption of the future years.
If the tax rate on asset income increase (r) that wont generate any alteration in
labour or demand curve at the capital market which means that the real rental price and
the supply capital services are unchanged. However, if we look at the after tax rate of
return: (1- r).r=(1- r).[(R/P).k- (k)] we can see that an increase in r lowers the after
tax interest rate which will develop an intertemporal substitution effect on
consumption. Due to this effect, households will raise the present consumption and
decrease future consumption.
The similarity between the 2 cases is that households will increase their present
consumption and decrease future consumptions. However, the cases also have
differences and one of them is in terms of the real GDP:
When c falls in year 1 that will motivate households to work more which means
that the labour supply will increase. Since the labour demand doesnt move, the effect
will be and increase at the quantity of labour of equilibrium. The increase in L means
that each machine is more productive (MPK increases) and the labor demand curve
increases, the result in the capital market will be a higher kK*. The increase in L* and
kK* will increase the real GDP (Y=A.F(L,kK)).
On the other side, an increase at r wont change the supply (we assume that K
is fixed at the short run and k doesnt change with r) or demand curve which means
that the arent any effect at the labour market. Since nothing changes at the equilibrium
variables (kK* and L*) the real GDP will remain unchanged.

7.
 a) After-tax real interest rate on bonds: (1- r).(B/P)r

b) Considering that the money growth and the price level rises at the same rate (=
), a permanent and unanticipated increase at the money growth rate from to will
generate an increase at the inflation rate. The increase at the inflation rate will have the
same dimension that the increase at .

c) After-tax return on capital: (1- r)([(R/P).k- (k)]K)

The increase at the money growth rate will increase the inflation rate by the same
amount (as we already conclude) and also an increase at the nominal interest rate.
Assuming that i=r+ and that an increase at doesnt change the real interest rate, that
means that the only way of maintain the equality of the equation when the inflation rise
is to increase the nominal interest rate (i). Since the nominal interest rate increase that
means that the real demand for money, L(Y,i) will decrease and the only way to maintain
the equilibrium of the money (Ms=P.L(Y,i)) is a jump at the price level (P).
Since those shocks dont affect the capital supply or the capital demand that means
that the equilibrium values of the capital market will remain the same. Therefore, if k
and (R/P) are unchanged that means that the rate of return on ownership of capital
([(R/P).k- (k)]) will also remain unchanged. Given this result, and assuming that the
amount of capital stock (K) is fixed at the short run and that r does not change we can
conclude that the after-tax return on capital will remain unchanged

d) After-tax real interest rate on bonds: (1- r).(B/P)r

The no arbitrage property claims that the rate of return on bonds is equal to the
rate of return on ownership of capital (r=(R/P).k- (k)). If we look at the previous
question we conclude that the rate of return on ownership of capital is unchanged when
the rises which means that the rate of return on bonds (r) will also remain unchanged
(no arbitrage property). Since r and r that means that the after-tax real interest rate on
bonds will also remain unchanged.
In terms of the nominal interest rate, we know that before the shock the nominal
interest rate was given by i=r+ and after the shock i is given by I=r+ . The variation
in the nominal interest rate during the shock at is: i=i-i= r+ -(r+)= - which
means that the increase at the nominal interest rate moves proportionately with and
consequentially with .