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LSE Economics Department

EC210 Macroeconomic Principles 2014/2015


Michaelmas Term

Kevin Sheedy
32L.1.09, x5022
k.d.sheedy@lse.ac.uk

Problem Set 10: to be handed to class teachers in week 2 LT

1. Short question, 2012 Exam: Some economists have found a negative relationship
between the interest rate spread (the difference between the interest rates faced by
borrowers and savers) and investment. Use a simple model to explain this relationship and show how this might be relevant to the 2008/09 economic crisis. [10
marks]
Answer:
Consider a firm which lives for two periods. It has an initial endowment of capital K.
In period 1, it hires labour N at a wage w, produces, and invests I. Profits in the first
period are
= F (K, N ) wN I
In the second period, its new capital stock is its initial capital less depreciation plus
investment: K = (1 d)K + I. The firm hires labour N and produces. It then stops
operating and sells its remaining capital, (1 d)K , on the market. Profits in period 2
are then
= F (K , N ) w N + (1 d)K
The firm maximises the present value of profits. It discounts using the interest rate it
faces, which represents its opportunity cost of investing. In the presence of an interest
rate spread, this will be r for a saver and rl = r + x for a borrower, where r is the risk-free
rate and x the spread. The spread could be positive, for example, if firms occasionally
default on their loans. In this case a lender needs to charge every firm a premium to get
a return of r on a diversified portfolio of loans. Assume the firm is a borrower. Then its
problem is

N,N ,K
1+r+x
The optimality condition for investment is given by FOC with respect to K
max
+

M P K = r + x + d
As d and r are assumed to be fixed, an increase in x must lead to an increase in M P K .
With a diminishing MPK, this implies that K , and therefore investment I, has to decrease.
This theory might help to explain why the very large deterioration in lending conditions
to firms, including higher spreads, during the 2008/2009 has led to a fall in investment
and consequently a drop in GDP in many industrialised countries.
1

2. Some economists argue that the collapse of the housing market in the U.S. might
have contributed to the rise in unemployment during 2008/09 recession. Use the
equilibrium search model to provide a reason for their argument. [10 marks]
Answer:
The rise in unemployment in the US after 2008 was associated with a rightward shift in
the Beveridge curve. This is consistent with a fall in matching efficiency.
It is plausible that rapidly falling house prices have indeed led to a decrease in US matching efficiency. As we have seen previously in the course, housing is often used as collateral
for mortgage loans. When house prices fall, borrowing limits tighten and households have
to scale back current consumption, which reduces their utility. In practice, this tightening occurs when people move house. A household which stays in their current home
is often able to leave the mortgage under water. This means that the value of their
total borrowing exceeds the value of their home. By contrast, a household that wants to
move home typically needs to sell their current house, buy a new one, and refinance their
mortgage. In this case, they cannot avoid a reduction in their borrowing limit and the
associated utility loss.
Thus, a rapid fall in housing prices makes households with borrowing constraints more
reluctant to relocate. This leads to a fall in worker mobility, so that for the same number
of unemployed workers and vacancies in the country, fewer matches are formed. In the
search model, this can be captured by a decrease in the matching efficiency .
A fall in the matching efficiency has the following effects in the search model.
The Beveridge curve shifts to the right, since for every value of the tightness , the
probability of a match f = 1 falls.
At the same time, job creation decreases. Since the probability of filling a vacancy is
now lower, but creating one is costly, firms will want to post fewer vacancies. Thus,
tightness = v/u falls for any wage rate w.
The wage curve is unaffected. In equilibrium, both the wage and tightness fall.
The unemployment rate rises both because of the lower tightness and the shift in
the Beveridge curve. The equilibrium effect on vacancies v is ambiguous (but it is
plausible that fewer vacancies will be posted as well). See Figure 1.

3. Long question, 2007 Exam: Consider a two-period economy in which the representative consumer maximizes the utility function U (c1 , c2 ) = ln(c1 ) + ln(c2 ) subject
to the life-time budget constraint c1 + c2 /R = W , where 0 < < 1, ci is consumption in period i = 1 or 2, W is the present value of after-tax life-time income and
R = 1 + r, where r is the interest rate.
(a) Derive the level of optimal consumption in the two periods. Provide economic
intuition for your derivations. [10 marks]
2

vacancies v

wages w

Figure 1: Mismatch in the equilibrium search model

(JC)

(BC)

(WC)

A
A

tightness

unemployment u

Answer:
To provide intuition, we maximize a general utility function subject to an inter-temporal
budget constraint. First, substitute the budget constraint into the objective function to
eliminate c2 and then maximize with respect to c1 :
max u(c1 ) + u [R (W c1 )]
Using the chain rule, the first-order condition for c1 is
u (c1 ) u [R (W c1 )] R = 0
Note that the expression in the squared bracket is simply c2 , so we can rewrite it as:
u (c1 ) = R u (c2 )
We can express this condition in terms of the marginal rate of substitution:
M RS =

u (c1 )
=R
u (c2 )

which says that consumer maximize their utility when the internal relative value of c1 in
terms of c2 equals to the market exchange value of these goods.
Using the utility function u(c) = ln(c), we have
R
1
=
c1
c2
or c2 = R c1 . Finally, using this condition along with the budget constraint, we can
RW
W
derive c1 = 1+
and c2 = 1+
.
(b) Suppose the consumer receives Y1 and Y2 and pays taxes T1 and T2 in periods
1 and 2. Use this model to explain the Ricardian equivalence on the timing of
taxes. For simplicity assume that the number of consumers N = 1. [10 marks]
3

Answer:
The governments budget constraint is
T1 +

G2
T2
= G1 +
R
R

and the consumers life-time income




T2
Y2
T1 +
W = Y1 +
R
R
If the present value of government spending (G1 + G2 )/R remains constant then any
change of taxes in the current period must be compensated by a proportional change of
taxes in the future period to satisfy the governments budget constraint.
Therefore consumers life-time wealth W is unaffected by the change in taxes. We showed
in part (a) that the optimal consumption levels are a function of the present discounted
value of wealth, so they will also be unaffected.
Therefore, the timing of taxes does not matter if the present value of government spending
remains the same.
Mathematically, this can be seen by combining the above two equations to show that the
consumers budget constraint does not depend on taxes:


G2
Y2
G1 +
W = Y1 +
R
R
(c) Suppose the consumer cannot borrow, show that what you derive in part (b)
might not hold. [10 marks]
Answer:
We have to distinguish two cases. First, if the consumer from part (a) is a lender (i.e.
c1 Y1 T1 ) then a borrowing limit doesnt affect her consumption choice and Ricardian
equivalence still holds.
Second, if the consumer wants to consumer more than his net income in period 1, then
this is not feasible anymore. She will consume as much as possible without borrowing in
period 1, so her consumption choices will be c1 = Y1 T1 and c2 = Y2 T2 . A tax increase
today will reduce current consumption even if the consumer knows that future taxes will
fall, so the timing of taxes matters and Ricardian Equivalence doesnt hold. Both cases
are depicted in Figure 2.
(d) Another proposed reason why the Ricardian equivalence might not hold is that
consumers have different life horizon than the government. How can you use
the two-period model to show this? [10 marks]
4

Figure 2: Ricardian equivalence and credit constraints


c
IC1

IC1
IC2

BC

BC
c

Answer:
This can be illustrated by having two different consumers living in each period (consumer
1 is alive only in period 1 and consumer 2 only in period 2) and a single government
with a planning horizon that spans over the two periods. Assume that there are also no
inheritances so consumer 1 doesnt care about consumer 2 at all.
The utility function for the consumer alive in period i will be U = u(ci ). Because the
consumer has no reason to save for after his death and will not be allowed to borrow at
a repayment date after his death, the budget constraint will simply be ci = Yi Ti .
In this case, each consumer will consume everything in the period in which they are alive.
A tax cut in period 1 will increase consumption in period 1 even if there is no borrowing
constraint.
The consumer living in period 1 doesnt internalise the greater tax burden that falls on
the consumer living in period 2, whose consumption will decrease.
4. Use appropriate graphs and equations in your answers.
(a) Consider the equilibrium search model.
i. Explain which properties of the matching function are important for the
Beveridge curve to be downward-sloping. [10 marks]
Answer:
The matching function M (u, v) takes as its arguments the number of unemployed people
(which equals the unemployment rate if we normalise the size of the labour force to one)
and the number of vacancies. It has the same properties as a neoclassical production
function: constant returns to scale and positive but diminishing marginal products.

These properties1 ensure that the resulting Beveridge curve is downward-sloping. First,
the CRS property means that we can write the job-finding probability as
M (u, v)
= M (1, ) f ()
u
where = v/u is the job market tightness. Since M has positive marginal products,
df /d > 0. Next, the steady-state unemployment rate is given by
u=

s
s + f ()

Since f is increasing in , u is decreasing in : du/d < 0. As = v/u we have that is


an increasing function of v
d
1
= >0
dv
u
So, a higher v will lead to a higher which, as we have already established, will decrease
unemployment.
ii. Using the Beveridge curve, explain why lower labor market tightness is
associated with higher unemployment. [5 marks]
Answer:
Intuitively, the labour market becomes slack ( is low) when there are fewer vacancies
per unemployed worker in the economy. This means that each unemployed worker has a
lower chance of finding a job. The flow out of unemployment f ()u becomes smaller and
unemployment begins to rise. As fewer workers are employed, the inflow into unemployment s(1 u) mechanically becomes smaller as well. The economy quickly settles to a
new equilibrium in which the inflows and outflows are again equal but the unemployment
rate is at a higher level.
iii. Explain why higher unemployment benefits can lead to a higher unemployment rate. [10 marks]
Answer:
In this model higher unemployment benefits affect unemployment through the wage rate.
The wage is determined by bargaining between firms and workers. When a firm and a
worker are matched, each side enjoys a surplus from creating a job: the workers income
increases as long as the wage w is higher than the unemployment benefits b, and the firm
earns a profit as long as the wage is lower than the value added of the worker y plus the
opportunity cost of creating a new vacancy, cy. This surplus is divided according to the
relative bargaining powers of each party. To be precise, the wage is given by
w = (1 )b + (y + cy)
1

In fact, positive marginal products alone are sufficient.

where is the relative bargaining power of the worker.


The wage is increasing in b. Higher benefits improve the workers outside option: if firms
offer a wage that is too low, it is less painful for workers to walk away and stay unemployed
instead. As a result, their bargaining position improves and they can secure a higher wage.
For similar reasons, the wage is increasing in . Here, the firms outside option worsens:
a higher a means the opportunity cost of creating a vacancy is higher. So if the worker
demands too high a wage, it is less easy for the firm to reject it and advertise another
vacancy to fill the position. Its bargaining position is weaker and workers can negotiate
higher wages. This defines an upward-sloping wage curve (WC) curve in the left-hand
graph of Figure 3. The equilibrium wage and tightness are determined as the intersection
of (WC) and the job creation curve (JC). The latter defines an inverse relationship between the wage and tightness, since higher wages make it less profitable for firms to post
vacancies.
Now, when benefits b increase, the (WC) curve shifts up while the (JC) curve remains
unchanged. Wages increase and the labour market slackens. In the Beveridge curve, a
lower tightness translates into higher unemployment. See Figure 3.

(JC)

(WC)

vacancies v

wages w

Figure 3: Increase in unemployment benefits

(BC)

C
A

A
C

tightness

unemployment u

(b) Show that alternative unemployment theories based on the ideas of effciency
wages and reservation wages can also predict that higher benefits lead to higher
unemployment. [10 marks]
Answer:
In the efficiency wage model, it can be argued that an increase in unemployment benefits
reduces the amount of effort provided by workers at any wage level, since they have less
income loss in the event of being discovered as shirking on the job. The effort function
can therefore shift down. The analysis is then as in Problem Set 5, Question 1c: The

efficiency wage rises and unemployment increases.


In the one-sided search model, an increase in unemployment benefits raises the value of
being unemployed relative to that of being employed, raises the reservation wage, and
increases unemployment. The analysis is as in Problem Set 9, Question 3b.

(c) What data would you look at to argue in favour of equilibrium search theory
against the two other alternatives? [5 marks]
Answer:
The key empirical fact that the search model can match better than the other two theories
is the behaviour of vacancies. We have seen in the lecture that a plot of unemployment
against vacancies over time delivers a robust negative relationship, the Beveridge curve,
just as in the equilibrium search model. By contrast, the efficiency wage model cannot account for both vacancies and unemployment: either supply exceeds demand in the labour
market, leading to zero vacancies, or demand exceeds supply, leading to zero unemployment. The one-sided search model also cannot capture the behaviour of vacancies since
the behaviour of firms is entirely exogenous.