Problem Set 3: The Static Closed Economy With Government

Professor: Isabel Horta Correia; TAs: Joana Figueira, Rui Ferreira

March 2020

Macroeconomics, Católica-Lisbon School of Business and Economics

1 Required Exercises

Exercise 1. In an economy, the preferences of a representative household are described by a utility

where θ > 0. Technology is described by

1−α
y ≤ zk α nd , (2)

where z > 0 and 0 < α < 1. The resource constraint is

c+g ≤y (3)

The household’s budget constraint can be written as

c + wl ≤ wh + π − T (4)

l≤h (5)

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where h is a time endowment. Labor supply, ns , is defined as

ns ≡ h − l. (6)

A representative firm chooses labor, nd , to maximize profits

π = y − wnd , (7)

subject to (2), given the real wage w and its endowment of capital, k. The government’s budget
constraint is
T = g. (8)

a) Define the competitive equilibrium for this economy.

b) Derive the conditions that characterize the competitive equilibrium, assuming that the solution to
the household’s problem is interior (see Exercise 11).

c) Show that one of the competitive equilibrium conditions derived in (b) is redundant.

d) Derive the conditions that characterize the competitive equilibrium allocation (c, l), and represent
them graphically. Interpret each of the conditions.

e) Write down and solve the first-best problem, i.e., the social planner’s problem. Is the competitive
equilibrium allocation (c, l) obtained in (d) a solution to this problem? Why/why not?

f) Suppose total factor productivity, z, increases.

i) Show that consumption, the real wage and leisure must increase. What if g = 0?

ii) Graphically illustrate the effects of this shock on the (c, l) space, decomposing them into
substitution and income effects.

iii) Graphically illustrate the effects of this shock on the labor market.

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 iv) Is this shock a plausible explanation for the observed business cycle co-movements?

Exercise 2. Consider the closed economy model described in Exercise 1. Suppose government expen-
ditures, g, increase.

a) Show that labor and output must increase and consumption must decrease. Illustrate your answer
graphically.

Solution. Suppose labor decreased. Then

c ↓ +g ↑= zF (k, h − l) ↓,

but
ul (c, l) ↓
= zFn (k, h − l) ↑,
uc (c, l) ↑

which would be inconsistent. In the same fashion, labor staying constant also provokes an incon-
sistency. Therefore, labor increases and

ul (c, l) ↑
= zFn (k, h − l) ↓,
uc (c, l) ↑↑

so consumption decreases. Since labor increases, output also increases. Graphically, the production
possibilities frontier shifts downwards. Hence, an increase in government expenditures causes an
negative income effect. However, since resources available for consumption are scarcer, the relative
price of consumption increases, and the equilibrium marginal rate of substitution decreases.

b) What are the effects of this shock on the labor market?

Solution. Nothing happens to the labor demand curve, as Total Factor Productivity does not
change. Since taxes increase, disposable income decreases, meaning that there is a a negative
income effect to the consumer. Therefore, the labor supply curve shifts to the right.

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 c) Is this shock a plausible explanation for the observed business cycle co-movements?

Solution. An increase in government expenditures causes an increase in output and employment,

Exercise 3. Consider a static closed economy model with endogenous labor. The preferences of a
representative household are described by a utility function

u (c, l) , (9)

satisfying all regular assumptions and ucl (c, l) = 0. Technology is described by

y ≡ c + g ≤ zF k, nd ,


(10)

where z > 0 and F (·) exhibits constant returns to scale. The household’s budget constraint can be
written as

c + (1 − τ n ) wl ≤ (1 − τ n ) wh + π

l≤h (11)

where h is a time endowment and τ n is a labor income tax. Labor supply, ns , is defined as

ns ≡ h − l. (12)

A representative firm chooses labor, nd , to maximize profits

π = y − wnd , (13)

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subject to (10), given the real wage w and its endowment of capital, k.

a) Write down the government’s budget constraint.

b) Derive the conditions that characterize the competitive equilibrium allocation (c, l). Is the com-
petitive equilibrium optimal? Why/why not? Illustrate your answer graphically.

c) Can the social planner choose the labor income tax, τ n , to implement the first-best allocation? If
so, under what conditions?

d) Suppose government expenditures, g, increase.

i) What must happen to the labor income tax?

ii) Abstracting from the increase in government expenditures, analyze the effects of the change
in the labor income tax on labor, consumption and on the real wage.

e) What is the total effect of the increase in government expenditures?

2 Recommended Exercises

Exercise 4. Consider the closed economy model described in Exercise 1, but with technology described


by the CRS production function zF k, nd . Show that the representative firm has positive profits in
equilibrium. Explain.

Exercise 5. Consider the closed economy model described in Exercise 1 with g = T = 0. Graphically
represent the conditions for the competitive equilibrium allocation (c, l) under the following specifications
for technology and preferences, and if possible, obtain an explicit solution for the competitive equilibrium
allocation.

a) u (c, l) = ln c + θ ln l and F (k, n) = zk α n1−α , with z, θ > 0 and 0 < α < 1.

b) u (c, l) = ln c + θ ln l and F (k, n) = zn, with z, θ > 0.

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 c) u (c, l) = ln (c + θ ln l) , and F (k, n) = zk α n1−α , with z, θ > 0 and 0 < α < 1.
1−σ
c1−γ −1

1−γ
+l −1
d) u (c, l) = 1−σ
, and F (k, n) = zk α n1−α , with z, γ, σ > 0, γ, σ 6= 1 and 0 < α < 1.

Exercise 6. For each of the functional specifications for technology and preferences in Exercise 5, show
the effects of an increase in z, discussing the existence and magnitude of income and substitution effects
in each case.

Exercise 7. In the model presented in Exercise 3, suppose that the government is also able to collect
revenue through a proportional consumption tax, τ c .

a) Write down the government’s budget constraint.

b) Derive the conditions that characterize the competitive equilibrium allocation (c, l).

c) Can the social planner choose proportional taxes, τ n and τ c , to implement the first-best allocation?
If so, how?

Exercise 8. Consider the closed economy model described in Exercise 1 with g = T = 0. Suppose,
furthermore, that preferences are described by U (c, l) = u (c) + θv (l), θ > 0.

a) Write the conditions that characterize the competitive equilibrium allocation.

b) Suppose θ increases.

i) How can you interpret such a shock?

ii) What must happen to consumption, leisure and output? Conduct both an analytical and
graphical analysis.

iii) What must happen to the real wage?

iv) Are such shocks likely causes for the observed business cycle co-movements?

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Exercise 9. In an economy, the preferences of a representative household are described by a utility
function
u (c, l) , (14)

satisfying all regular assumptions and ucl (c, l) = 0. Technology is described by

y ≤ zF k, nd ,


(15)

where z > 0 and F (·) exhibits constant returns to scale. The household’s budget constraint can be
written as

c + wl ≤ wh + π − T

l≤h (16)

where h is a time endowment. Labor supply, ns , is defined as

ns ≡ h − l. (17)

A representative firm chooses labor, nd , to maximize profits

π = y − wnd , (18)

subject to (15), given the real wage w and its endowment of capital, k. The government’s budget
constraint is
T z = g. (19)

a) Derive the resource constraint, and write down the conditions that characterize the competitive
equilibrium allocation (c, l).

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 b) Suppose total factor productivity increases. What are the effects on consumption, leisure and on
the real wage? Graphically illustrate your answer.

Exercise 10. Consider the closed economy model described in Exercise 1, but suppose now that the
technological restriction is described by

y ≤ zg γ k α n1−α ,

where z, γ > 0 and 0 < α < 1.

a) Write down the conditions that characterize the competitive equilibrium allocation (c, l).

b) What are the effects of an increase in government expenditures? (Hint: You may want to analyze
the effects of this shock first abstracting from its impact on the production function, and then
abstracting from its impact on aggregate demand). Can such a shock increase welfare?

3 Challenge Exercises

Exercise 11. Consider the closed economy model described in Exercise 1 with g = T = 0, but with
general preferences u (l, c) satisfying

uc (0, l) = ul (c, 0) = ∞

uc (∞, l) = ul (c, ∞) = 0

and technology described by the production function zF k, nd satisfying

F 0, nd = F nd , 0 = 0.

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a) Show that the conditions that characterize the solution to the household’s problem are

 
ul (l)
(h − l) − w = 0,
uc (c)

c + wl = wh + π,

l ≤ h,

ns = h − l,

b) Derive all competitive equilibrium conditions.

c) Show that l = h can never be a solution to the competitive equilibrium through the following
steps:

i) Show that l = h implies c = 0.

ii) Show that the problem of the household can be written as

 
1 π
max u − c + h + , c
c w w

iii) Show that at (l, c) = (h, 0) the household can always increase utility by marginally increasing
c.

iv) Use the above result to argue that (l, c) = (h, 0) cannot solve the utility-maximization prob-
lem.