Macroeconomics II Tutorial 4 Real Business Cycles Theory

22.10.2008

RBC Theory
Rational expectations + self-clearing markets

Fluctuations in output are explained by the changes to production function (technology) and thus potential output (not a difference between potential and real output) output is always on its potential level
Robinson Crusoe Economy
Intertemporal budget constraint (between two periods) Intratemporal budget constraint (between consumption and leisure)

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Macroeconomics II Tutorial 4

Intertemporal BC (2 periods)
PV of C = PV of Y + W
c1 c2 y y1 2 W 1+ r 1 r

Intersections?
axis x axis y
B c2 y2

Slope?

c1

y1

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Macroeconomics II Tutorial 4

Exercise 1 - Liquidity constraints

1. Graphically show the intertemporal budget constraint for two periods for an individual under fill liquidity constraint (cannot borrow in first period) 2. Which combinations of c1 and c2 she can choose (indifference curves for different cases) 3. How the budget constraint changes if the liquidity constraint is eliminated?
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Solution 1.1

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Solution 1.2

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Solution 1.3

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Macroeconomics II Tutorial 4

Exercise 2 Saving vs. borrowing

1. Show the intertemporal budget constraint for two periods for an individual under partial liquidity constraint (save for rD, borrow for rc, rD < rC). 2. Show the combinations of C1 and C2 (show indifference curves for different cases). 3. Show how the BC change for a consumer neither saving nor borrowing if rD increases to rC. Show the different possibilities in relation to utility (increase/decrease/constant).
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Solution 2.1

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Solution 2.2

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Solution 2.3

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Exercise 3 preferential saving

1. Show the intertemporal BC for 2 periods if one can borrow for rC, save up to S1 < Y1 for the same rate and above S1 for rd < rC. 2. Show how the BC changes if this preferential interest rate is eliminated (save only for rd). 3. How the utility change for
a) a net debtor b) a net creditor c) one who consumed exactly the endowment
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Solution 3.1

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Solution 3.2

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Solution 3.3

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Exercise 4 minimum investment

1. Show the BC if one can save for r and borrow for the same rate but the loan must be higher than minimal level D. It is not possible to use only a port of loan and save the rest (if ones takes the loan, he must consume the whole endowment and whole loan in first period). 2. Show how the BC changes if the D is decreaded to D. 3. Show how the utility changes for:

a) a net debtor b) a net creditor c) one who consumes exactly his endowment
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Solution 4.1

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Solution 4.2

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Solution 4.3

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Solution 4.4

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Solution 4.5

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Exercise 5
Derive the relation for intertemporal household BC for more than 3 periods

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Intratemporal Substitution
Substitution between consumption (c) and leisure (L)- L=1-l (l work)
IC f(l)

Intratemporal Substitution
Parallel shift to production function Proportional shift to f(l) (income effect) (division between income&substitution effect)
c IC2 IC1
c f3(l) f2(l) f1(l) c1

f2(l) f1(l)

l1

MPL does not change

MPL is l same; c,l;

MPL changes Division to two changes (rotation substitution vs. shift income)

Pure substitution effect effect

Intratemporal Substitution- Proportional shift

IC2 IC1
IC3 IC2 IC1

Division between income&substitution

c f3(l) f2(l)

f2(l) f1(l)

f1(l)

l
Income effect c, l Substitution eff. c, l Total effect c, ? l

MPL lc, l;

Total effect- different possibilities

Intratemporal Substitution- Proportional shift

f3(l)

f1(l) c1

l1
Income effect c, l Substitution eff. c, l Total effect c, ? l