2021 Exam 1

Macroeconomics 1 – Examination 1 – PUC-Rio – 2021
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Exercise 1 [3.5 points] Equilibrium with Complete Markets
Consider an economy with two consumers, i = 1, 2. Markets are complete.

The endowment of consumer 1 is e1 = 1 − st and the endowment of consumer 2
is e2t = st , where st denotes a stochastic event. We assume st follows a Markov
chain with states s̄1 = 0, s̄2 = 1, and s̄3 = 0.5, and transition matrix
 
1 0 0
P = 0 1 0 .
1/3 2/3 0
The economy starts in state s̄3 . Thus, in time 0 there is uncertainty about
which will be the state in time 1, but after time 1 there is no longer any
uncertainty. Preferences are given by
XX
β t ln[cit (st )] Prob[st ], β ∈ (0, 1).
t=0 st
a. Define the Arrow-Debreu equilibrium.

b. Compute the Arrow-Debreu equilibrium.
c. Compute the consumption of consumer 1 when β → 0 and β → 1. Give
some intuition for the behavior of this consumption relative to β.
d. Compute the implied wealth Yi = ∞ τ t i t i t
P P
t=τ st |sτ qt (s )[ct (s ) − yt (s )] of con-
sumer 1 at time 1 in the case where state 1 occurred. This means the economy
stays in state 1 forever, ie consumer 1 receives the entire aggregate endow-
ment each period, and consumer 2 receives nothing. We showed in class that
if markets reopened, there would be no trades. But isn’t consumer 1 unhappy
with the situation, as she would prefer to keep all the future endowment for
herself, now that the uncertainty has disappeared? Explain why this situa-
tion does not contradict the proposition seen in class.
Exercise 2 [4 points] Neoclassical Growth
Consider the following simplified neoclassical growth model. There is a con-

stant population of infinitely-lived households. The representative household
has preferences
X∞
Et β t u(Ct ), β ∈ (0, 1).
t=0
1
The flow utility function is u(Ct ) = Ct − λCt2 , with λ > 0. Assume that C is
such that u0 (C) is always positive.
Output is produced as a linear function of capital plus an additive exogenous
disturbance
Yt = rKt + zt ,
where r is the interest rate. Assume r = β −1 − 1. There is no depreciation, so
capital accumulates according to Kt+1 = Kt + Yt − Ct . Finally, the disturbance
follows a first-order autoregressive process zt = ρzt−1 + εt , where −1 < ρ < 1
and εt is a zero-mean i.i.d. shock.
a. Set up the problem of the household by writing a Bellman equation.

b. Solve the problem of the household and obtain the Euler equation. Com-
ment on the behavior of consumption.
c. Guess that consumption takes the form Ct = A + BKt + Dzt . Given this
guess, what is Kt+1 as a function of Kt and zt ?
d. What values must the parameters A, B, and D have for the first-order
condition derived in b to be satisfied for all values of Kt and zt ?
e. Suppose that up until period t the shock εt = 0. Then in period t, there is
a one-time positive realization of εt = 1 − ρ + r. From period t + 1 onward,
εt = 0 again. What are the effects of the shock on the dynamics of output,
consumption, and capital? Provide some intuition.
Exercise 3 [2.5 points] Demand Shocks and Real Business Cycles
Consider the standard real business cycle model with endogenous labor sup-
ply. The population is constant and normalized to one. Preferences of the
representative agent are
∞
Ct1−σ N 1+ϕ
X
Et t
β ξt − t ,
t=0
1−σ 1+ϕ
where Ct is consumption, Nt is hours worked, β ∈ (0, 1) is the discount factor,

σ > 0 and ϕ > 0 are parameters, and ξt is an exogenous shock.
a. Interpret the variable ξt .

b. What is the effect of a temporary unexpected increase in ξt on output,
consumption, investment, and hours worked? Describe the mechanisms and
provide some intuition.
c. Are these dynamics consistent with actual business cycles? Justify.
d. What do you think is missing in the model for demand shocks to have
aggregate demand effects?

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Macroeconomics 1 – Examination 1 – PUC-Rio – 2021

Exercise 1 [3.5 points] Equilibrium with Complete Markets

Consider an economy with two consumers, i = 1, 2. Markets are complete.

a. Define the Arrow-Debreu equilibrium.

Exercise 2 [4 points] Neoclassical Growth

Consider the following simplified neoclassical growth model. There is a con-

a. Set up the problem of the household by writing a Bellman equation.

Exercise 3 [2.5 points] Demand Shocks and Real Business Cycles

where Ct is consumption, Nt is hours worked, β ∈ (0, 1) is the discount factor,

a. Interpret the variable ξt .

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