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Problem set 2: The short run during normal business cycles

Problem 3.1
Consider a household that makes consumption decisions for two periods, t = 1, 2. The household’s real
financial wealth at the beginning of period 1 amounts to 5,000 Euro; its real disposable income amounts to
25,000 Euro in period 1 and to 30,000 Euro in period 2. The household at the end of period 2 wishes to
have real financial wealth in the amount of 4,000 Euro. The real interest rate between period 1 and period
2 is r = 0.01. The household maximizes utility from consumption according to the objective function

U (C2 ) (C1 )1−κ 1 (C2 )1−κ

U (C1 ) + = +
1+ρ 1−κ 1+ρ 1−κ
where ρ = 0.02 denotes the subjective rate of discounting, and κ = 0.5 denotes a coefficient in the instanta-
neous utility function u(C).

a) Obtain the ratio at which this household wishes to consume in period 1 relative to period 2. Also
obtain this household’s optimal levels of consumption in periods 1 and 2.

b) How does your answer to (a) change if the household in period 1 had real disposable income amounting
to 30,000 Euro? What therefore is this household’s marginal propensity to consume?

c) How would your answer to (b) change if the household’s subjective rate of discounting increased?

d) How does your answer to (a) change if the real interest rate increased to r = 0.015? What does this
answer suggest concerning the relative strengths of the substitution and income effects?

Problem 3.2
Consider the aggregate consumption function:
C = C0 + Cy · (Y − T ) − Cr · r
a) Which parameter refers to the marginal propensity to consume? Assuming a strictly concave utility
function, set up the household’s consumption maximization problem and explain why the marginal propen-
sity to consume is assumed to be positive and smaller than one.

b) Using the terms substitution effect and income effect to explain how a consumer who inter-temporally
maximizes consumption reacts to an increase in the interest rate. Does it matter whether the consumer is a
creditor or a borrower? What is the reaction when the interest rate decreases?

c) Based on your reasoning in part b), explain why the parameter Cr in the aggregate consumption
function is assumed to be positive.

Problem 3.3
Suppose that the utility function of a representative household could be represented by: u(C) = log(C).
Assuming that households maximize their utility by smoothing between consumption now (C1 ), and con-
sumption in the future (C2 ).

a) Derive the Euler equation for this household and show that current consumption, C1 could be ex-
pressed as C1 = α · P V R.

b) Suppose that the subjective discount factor ρ = 0.02, r = 0.01, Y1 = Y2 = 10, 000, T1 = T2 = 2000,
determine the value of consumption now, and consumption in the future.

b) What is the effect of a decrease in PVR on C1 ?

c) Does it matter whether the decrease in PVR today results from a decrease in current and/or future
disposable income?
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d) Suppose the individual receives an announcement today that income in the future might be lower than
previously expected. What is the effect on consumption today?

Problem 3.4

A representative household maximizes its strictly concave utility by smoothing consumption between now
(C1 ), and the future (C2 ). Financial wealth at the beginning of period 1 is W1 , and at the end of period 2
is W2 . Its labor income in periods 1 and 2 are Y1 and Y2 respectively. It’s utility function is defined as:

1
U = u(C1 ) + 1+ρ u(C2 ),

where ρ is the subjective discounting factor, and the prevailing interest rate is r.

a) Setting up the household’s maximizing problem of smoothing consumption between periods 1 and 2.

b) Derive the impact of a change in the present value of resources on current consumption, C1 .
c) Derive the impact of a change in the interest rate on current consumption, C1 .

Problem 3.5

Assume a simple economy with only one representative household that owns a firm and that there is no
capital to begin with (in the metaphor of Robinson Crusoe, there are no trees on the island). The key
decision is: how much investment today (I1 ) (coconuts to plant). This will give rise to productive capital
tomorrow K2 = I1 . Let Yi denotes period i’s labor income, i =1,2, and r denotes the interest rate.

a) Define the budget constraint facing this household.

b) Formulate the maximization problem facing the household so that the present value of resources is
maximized.

Problem 3.6

Consider a firm that operates only for two periods, t = 1, 2. The firm produces output, Yt , with the
production function Yt = Alog(Kt ), t = 1, 2, where A is the level of technology, log denotes the natural
logarithm, and Kt the firm’s capital stock. Suppose that the firm’s revenue and cost in period 1 are given
by Revenue1 = Y 1, and Cost1 = p1 .I1 , where I1 is the firm’s investment in the physical capital stock of
period 2, and K1 is exogenously given. At the end of each period, a fraction δ of the firm’s capital stock
depreciates. The firm discounts future profits at the market rate of interest, denoted r.
a) Given investment I1 and capital stock K1 in period 1, what is the firm’s capital stock in period 2?
b) Determine for general parameter values the period 1 present value of revenue as well as period 1 present
value of cost, if the firm can sell its remaining capital after production in period 2 at real price p2 and if the
real interest rate between periods 1 and 2 is r.
c) Derive for general parameter values the condition for the firm’s optimal investment in period 1.

Problem 3.7

Suppose the following interest parity relationship holds:

1
1 + rt = · [1 + (1 − τ ∗ ) · rt∗ ] · ϵt+1
ϵt

where τ ∗ denotes the rate at which capital returns are taxed (for all financial investors, irrespective of their
nationality) in the foreign economy. Also suppose that purchasing power parity holds for the long-run ahead
value of the real exchange rate. Now consider an increase of τ ∗ . Derive algebraically the impact of this
increase. Provide a detailed economic rationale this has on the current value of the real exchange rate
between the domestic and the foreign currencies.
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Problem 3.8
Assume the economy can be described by the following system of linear equations:

C = C0 + Cy · (1 − t) · Y
I = I0 − Ir · r
G = G0
T B = T Bex · (1 − t∗ ) · Y ∗ − T Bim · (1 − t) · Y + T Bϵ · ϵ
ϵ = ϵ0 − ϵr · (r − r∗ )
a) Derive the Keynesian Multiplier.
b) If t = 0.25; Cy = 0.6, and T Bim = 0.25, What will be the effect on output Y if the government increases
its expenditure G by 5 billion? Explain the intuition behind your result.

Problem 3.9
Assume
Y = C + I + G + TB
with
C = C0 + Cy · (Y − T ) − Cr · r
I = I0 − Ir · r
G = G0 + Gy · (Ȳ − Y )
T B = T Bex · (1 − t∗ ) · Y ∗ − T Bim · (1 − t) · Y + T Bϵ · ϵ
ϵ = ϵ0 − ϵr · (r − r∗ )
a) Derive the Keynesian Multiplier in this framework.
b) Derive how the Multiplier depends on Cy , T Bim and Gy . What does it mean, if, respectively, Cy , T Bim
or Gy increase? Explain in each case why the Multiplier increases or decreases.

Problem 3.10
Assume the following specific functions for C, I , G and TB:

C = 100 + 0.7 · (1 − t) · Y
I = 80 − 500 · r
G = 200
T B = 0.2 · (1 − t ) · Y ∗ − 0.3 · (1 − t) · Y + 20 · ϵ
∗

Furthermore, assume that the interest rate equals 5%, the real exchange rate equals 2 and foreign income
equals 1,000. The tax rates t and t∗ are 0.2 and 0.1, respectively.
a) Derive the analytical expression of Desired Demand as a function of income.
b) Plot Desired Demand as a function of income. How do you interpret the slope?
c) Calculate the Goods Market Equilibrium.

Problem 3.11
The real sector of an economy under fixed prices (for which foreign variables are exogenous) is described by
the following relations:
Y = DD = C + I + G + T B;
C = C0 + Cy [(1 − t) · Y + GT ] ;
I = I0 − Ir · r;
G = G0 ;
T B = T B0 + T Bex · [(1 − t ) · Y + GT ∗ ] − T Bim · [(1 − t) · Y + GT ] + T Bϵ · ϵ;
∗ ∗

ϵ = ϵ0 − ϵr (r − r∗ )
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where t (t∗ ) denotes the domestic (foreign) rate of income taxation and GT (GT ∗ ) denotes transfer payments
by the domestic (foreign) government to domestic (foreign) private households; all other notation is as in
the lectures on the macroeconomy in the short run. When numerical answers are asked for, you may assume
the following parameter values: C0 = 1.45; Cy = 0.75; t = 0.15; GT = 0.25; I0 = 3.25; Ir = 15; r = 0.03; G0 =
2.8; T B = 0; T Bex = 0.15; t∗ = 0.1; Y ∗ = 11; GT ∗ = 0.05; T Bim = 0.15; T Bϵ = 1; ϵ0 = 1; ϵr = 1; r∗ = 0.03.
a) Derive (for general parameter values) the Keynesian multiplier describing how changes of the autonomous
component of aggregate output demand affect short-run output.
b) Derive (for general parameter values) the IS curve. Provide a detailed economic rationale as to how the
slope of the IS curve depends on (i) T Bim and (ii) ϵr
c) Compute the macroeconomic outcomes. d) Provide a detailed economic rationale as to how the size of
the Keynesian multiplier depends on (i) T Bim and (ii) T Bex .
e) Calculate and compare the short-run output effects of (a) an increase in domestic government transfer
payments to domestic private households, GT, by 0.1 with (b) an increase in domestic government expendi-
ture through an increase of G0 , also by 0.1. Provide a detailed economic rationale for your comparison.

Problem 3.12
Consider two central banks that both use the following Taylor rule to set their monetary policy rate:
 
Y − Ȳ
RM P = r̄M P + ϕy
Ȳ
Suppose the parameter ϕy is larger for the first of these two central banks than for the second one. Provide
a detailed economic rationale as to how the two central banks’ monetary policy rate decisions differ when
(i) Y > Ȳ and (ii) Y < Ȳ .

Problem 3.13
Consider the real interest rate prediction of the model of commercial bank lending considered in the lectures:
rM P − ν · ALo
r=
1 + ν · Lor
where
V ar(lrp) · χ
ν=
Eq
How does the real interest rate respond to a decrease of Eq? Derive this effect algebraically. (Hint: Calculate
the partial derivative of r with respect to Eq, and then re-write this partial derivative in such form that
you can invoke the condition that the loan demand must be strictly positive.) Provide a detailed economic
rationale for your result.

Problem 3.14
Consider the ISTR model and an economy for which

A (Cr + Ir + T Bϵ · ϵr )
Y = − ·r
1 − (Cy − T Bim − Gy ) 1 − (Cy − T Bim − Gy )
 
Y − Ȳ
r = rM P + rRP = r̄M P + ϕy + r̄RP
Ȳ
with A = 10, cy = 0.7, T Bim = 0.1, Gy = 0.1, Ir = 15, Cr = 4, T Bϵ = 1, ϵr = 1, r̄M P = 0 : 02, r̄RP = 0 : 02,
ϕy = 0.5, Ȳ = 16.
(a) Determine the goods market equilibrium for r = 0.05.
(b) Determine the money market equilibrium for Y = 15.
(c) Determine the overall short run macroeconomic equilibrium. What are the values for Y and r?

Problem 3.15
In the standard IS-TR model presented in the subsection 3.7.5, suppose that A = 9.63, Cy = 0.6, Gy = 0.1,
T Bim = 0.1, T Bex = 0.1, Cr = 4, Ir = 16, Ȳ = 15, r̄M P = 0.02, r̄RP = 0.01, ϕy = 1, T Bϵ = 1, ϵr = 1.
a) Determine the values of r and Y using the parameter values.
b) Determine the impact of an increase in foreign income by 5, i.e. ∆Y ∗ = 5.
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Problem 3.16
On the IS - TR model: An economy under fixed prices (for which foreign variables are exogenous) is described
by the following model:
Y = DD = C + I + G + T B;
C = C0 + Cy · (Y − T ) − Cr · r;
I = I0 − Ir · r;
G = G0 − Gr · r;
T B = T B0 + T Bex · (Y ∗ − T ∗ ) − T Bim · (Y − T ) + T Bϵ · ϵ;
ϵ = ϵ0 - ϵr · (r − r∗)
 
r = r̄M P + ϕy · Y Ȳ−Ȳ + r̄RP .

When numerical calculations are asked for, assume the following parameter values: C0 = 1.6; Cy = 0.55; Cr =
3; T = 2.5; I0 = 3.25; Ir = 15; G0 = 2.8; Gr = 1; T B0 = 0; T Bex = 0.1; Y ∗ = 10; T ∗ = 3; T Bim = 0.15; T Bϵ =
1; ϵ0 = 1; ϵr = 1; r∗ = 0.03; r̄M P = 0.02; ϕy = 1; Ȳ = 15; r̄RP = 0.01.
a) Derive (for general parameter values) the IS - curve. Provide an economic rationale as to how the slope
of the IS - curve depends on the model parameters.
b) What is the value of output in the short-run macroeconomic outcome?
c) Calculate the effects on domestic short-run output of a decrease in the foreign interest rate, r∗ , by 0.01?
Decompose the overall output effects into its components (that is, the Keynesian multiplier induced effect
and the domestic interest rate induced crowding out-in effects). Make sure to provide, in addition to numer-
ical results, a detailed economic rationale as to how the various effects arise.

Problem 3.17
In 2001, then U.S. President George W. Bush was concerned about the sluggish U.S. economy. To help
stimulate the U.S. economy, President Bush proposed a tax cut (suppose for this question that this tax cut
would occur in the form of an income tax cut). Using the IS - TR model, derive graphically the effects
on short-run U.S. output of the policy President Bush proposed. Make sure to provide, in addition to the
graphical analysis, a detailed economic rationale as to how the output effects arise.