Homework 1

Macroeconomics II - 2020

Deadline: March 24 (Tuesday), lecture time, 08:00am

You are encouraged to work in groups of up to three people. Please hand in only one solution in
hard copy with the names of all group members.

Problem 1a): Consumption Theory - calculations

1. Draw a chart of Fisher’s inter-temporal choice model showing:
• the inter-temporal budget constraint (put the meaning of the interception with each axis)
• the optimal consumption plan chosen (you will assume a utility curve with the same form
as the one showed during the lecture and seminar)
• explain in your case if the consumer is saving or borrowing the first period and show the
saving (or borrowing) quantity on the relevant axis
2. Derive the form for the inter-temporal budget constraint (detail each step). What is the ex-
∂C2
pression for its slope in the graph you previously drew? (Hint: ∂C1
) What is the economic in-
terpretation of the slope ?
3. Assume the consumer is borrowing in the first period. Show graphically what is the effect of
an increase in:
• (i) interest rate
• (ii) income in period 1 (Y1 )
on consumption in period 1 and consumption in period 2, when individuals have standard pref-
erences (meaning the utility has the same form as before). On your graph indicate on the hor-
izontal axis where Y1 and Y2 are situated. Explain what is the new consumption chosen in pe-
riod 1 and in period 2 based on the income and substitution effects.

4. Show graphically how things would differ if we were in the case of a person initially saving in
the first period.
5. Show graphically what is the effect of an increase in the interest rate on consumption in period
1 and period 2 when individuals are not willing to substitute between consumption in period 1
and consumption in period 2.1 How are consumption in period 1 and in period 2 affected ?

6. Now, forget about what we said until

√ now. Assume the utility function of a representative
household takes the form U (Ct ) = Ct .
• Form the Lagrangian, and solve for the optimal consumption in both periods.
• What happens for consumption in the first period if the preference for the present in-
creases?
1 You will assume here that the utility function has a ”L-shape”, if you don’t know that you will find a description

of utility functions in that case in the first chapters of the book of Michael Burda and Charles Wyplosz ”Macroeco-
nomics” available at the library.

1
 • Assume you observe the following characteristics for our representative consumer: Y1 =
200, Y2 = 250, r = 10% and β = 0.9 (beta being the preference for the future). Given
your precedent result, is our consumer a debtor or a saver? Support your answer with
calculations.

Problem 1b): Consumption Theory - reading

Please briefly read this paper (https://mpra.ub.uni-muenchen.de/49310/1/MPRA paper 49310.pdf)
that mostly focuses on the Keynes consumption theory (no need to go into the details and the econo-
metric part). Answer the following questions:

1. Among the main four theories we saw during the lectures (Keynes’ consumption theory, Fisher’s
inter-temporal approach, the LCH, and the permanent income hypothesis):

• Which one would you say is a priori the most relevant for a country such as Nigeria with
underdeveloped financial markets (explain)?
• What difference(s) would you expect in terms of consumption smoothing (the fact that
people borrow/save when they are young in order to smooth their consumption) relative
to a country such as Germany?

2. ”We found also that the APC did not vary systematically with income as conjectured by
Keynes”: why the fact that APC does not vary systematically with income is contradictory
with Keynes’ theory?
MP C
3. Explain what is the income elasticity of consumption and why the author states that it is AP C .

Problem 2: Investment - housing market

In the lecture, you have seen this figure showing the evolution of real residential house prices and
the number of newly started construction projects for residential housing in the Czech Republic in
recent years.

Source: FRED FED

1. Is this situation in line with the predictions of the simple residential model that was discussed
during the lecture and the seminar? Explain and show graphically. Focus on the figure show-
ing the supply of new housing.
PH
2. In the lecture we have simply assumed that residential investment was a function of P .

2
 • Does this mean that with a baby boom, the residential investment will increase at the
time of the baby boom or when the babies born under the baby boom become adults?
• Now imagine that residential investors take their decision in function of the expected
price of houses in 10 or 20 years. What would it change to the analysis for the previous
question? How would you describe what is going on with a graph in the spirit of the one
we took to explain residential investment?

Problem 3 (IS-LM model)

This problem asks you to derive the IS-LM model algebraically. You will assume that consumption
is related to disposable income in the following way:

C = a + b(Y − T ) (1)
where a > 0, 0 < b < 1. Suppose also that investment is a linear function of the interest rate:

I(r) = I¯ − dr
where d > 0.

First part: IS

1. The first questions are on investment:

– Does it make sense to assume that investment is related to the real interest rate? Why?
– (bonus question +0,5) Imagine a firm owns so much cash that it doesn’t need to borrow
to make any investment it wants. Does it still make sense to assume that the demand for
investment of this firm depends negatively on the interest rate? Why?
2. Derive the IS curve: solve for Y as a function of r, the exogenous policy variables G and T,
and the model parameters a, b, I,¯ and d.

3. What is the slope of the IS curve?

4. Without mentioning it explicitly, we actually assumed that taxes were ”lump-sum” here. What
does this mean?
5. Assume now that taxes are proportional to the real income. So, now, take the following:

T = T̄ + tY (2)

– Does this expression for taxes make sense? Why?

– Derive the IS curve taking into account the new form for taxes: solve for Y as a function
of r, the exogenous policy variables G, t and T̄ , and the model parameters a, b, , and d.
– What is now the slope of IS? how does the slope of the IS curve depend on the parameter
t?

Second part: LM

Now suppose the demand for real money balances is a linear function of income and the interest
rate:

L(r, Y ) = eY − f r
where e > 0 and f > 0.

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 1. Derive the LM curve: solve for r as a function of Y, M and P and the parameters e and f.
2. What is the slope of LM?
3. Based only on LM, what should happen to Y if r decreases for the money market to remain at
equilibrium? Why?

Third part: AD

1. Use your answers to questions 2 of the IS part and 3 of the LM part to derive an expression
for the aggregate demand curve. Your expression should show Y as a function of P, of exoge-
nous policy variables M, G, t and T, and the model’s parameters. This expression should not
contain r.
2. What is the slope of this AD curve? Is it upward or downward sloping?

3. In lecture 3 we simplified the analysis of AD. In Lecture 3, with the simple money demand we
had, we were saying that if P decreases, then real money supply increases (and thus becomes
higher that money demand) and then people will increase their expenditures. With the ag-
gregate demand curve you derived now, do we still have an increase in expenditures if P de-
creases? Based on your understanding, is it still a direct link as assumed in Lecture 3 or are
there other adjustment leading to this process now (detail them if there are some)?

Problem bonus (1 point bonus)

Check these two videos which are material for a class of Microeconomics at Harvard (for the 3rd
year of Bachelor)

- ”Part 10 savings 2 period savings problem”2

- ”Part 10 savings T period savings problem”
accessible by going on Edward Glaeser’s Harvard webpage (https://scholar.harvard.edu/glaeser/classes/economics-
1011a-intermediate-microeconomics-advanced/materials/course-videos), tab ”video” and open the
file.

1. (notice how the concepts are discussed. The actual class is not more mathematical than what
you see.)
2. How do the authors describe ”time consistency” in the context of consumption?
3. Taking the T periods model, explain why, if we take the data and utility function of Problem
1, question 6, we should expect consumption to decrease or increase over the life.

4. Taking again the data and utility function of Problem 1, question 6, express Ct as a function
of Ct−1 in the T periods model.

2 Note that he doesn’t solve with Lagrangian but with a simpler method.