� • I

· Ph.D. Comprehensiv� Exams

Study· Guide
 Exam#

PhD Macroeconomic Comprehensive Exam (February 2017) 1

Please make your answers neat and concise. Make whatever assumptions you need to answer
the questions. Be sure to state them clearly. Show your work.

1 Wealth Effects (30 points)

Consider a consumer that solves the following standard problem:
∞
X
max∞ E0 β t u(ct ),
{ct ,at+1 }t=0
t=0

1
u(c) = b1 ct − b2 c2t , b1 > 0, b2 > 0
2
s.t.

ct + at+1 = (1 + r)at + yt ,
a0 = 0, N o P onzi,

and faces an income process given by

yt = yt−1 + t ,
t → N (0, σ 2 ),

and an interest rate r satisfies

β(1 + r) = 1.

1. (15 pts) Derive the consumption function i.e., solve for current consumption ct as a
function of current wealth at and current income yt (show your calculations).

2. (15 pts) Suppose that from period t to period t + 1 the wealth of the consumer at
is reduced by x dollars due to an unexpected financial crash. How much does the
consumer reduces consumption? Suppose instead that due to a negative t , its income
falls by x dollars. How much is consumption reduced? Explain why the two shocks
have different quantitative effects on consumption.
 Exam#

PhD Macroeconomic Comprehensive Exam (February 2017) 2

2 Overlapping Generations Model (35 points)

Consider an overlapping generations (OLG) economy. A generation of equal measure is
born every year and lives for 60 periods. Without loss of generality, the total measure of
all generations is normalized to one. A superscript of a variable denotes the age of the
generation and a subscript denotes time. Agents in each generation work for their first 40
years. After 40 years, retirement is mandatory. Instantaneous utility is a function of both
consumption(c) and leisure (l):

(clγ )1−η − 1
u(c, l) =
1−η
Agents are born with 0 assets, and do not leave bequests. Agents receive income from capital
(k) and labor (n); and receive pensions b during retirement periods. Labor income is taxed
at rate τt . The representative firm produces the single good by employing labor and capital.
Capital depreciates at rate δ. Production Yt is characterized by constant returns to scale
and assumed to be Cobb-Douglas: Yt = Ktα Nt1−α . Lastly, the government uses the revenues
from taxing labor in order to finance its expenditures on social security b.

1. (15 pts) Define an equilibrium in a recursive representation for this economy.

2. (10 pts) Calculate the first-order conditions of working agents.

3. (10 pts) Now imagine that you are given the values of model parameters, such as
the values of β, δ, η, etc.; and compute the steady state that is characterized by a
constant distribution of the capital stock over generations using Matlab. Your first
step is to make initial guesses for the steady state values of the aggregate capital stock
and aggregate employment. Complete the algorithm. (hint: you need to compute the
values of w and r and τ to compute the optimal path for consumption, labor, and
savings for individual agents).
 Exam#

PhD Macroeconomic Comprehensive Exam (February 2017) 3

3 Search and Unemployment (25 points)

Consider the following infinite-horizon model. A worker who is employed begins each period
with a wage, w. The worker can either work at that wage or search and receive unemployment
benefits b in the current period. If the worker chooses to work, he is employed at wage w in the
following period with probability δ and unemployed with probability 1 − δ. An unemployed
worker who searches receives a wage offerPfrom a distribution F (w). Wage offers are i.i.d.
over time. The workers’s preferences are β t u(ct ) where ct denotes consumption and u is
an increasing function. Assume no borrowing or lending.

1. (10 pts) Set up the worker’s decision problem as a dynamic program.

2. (25 pts) Show that the solution to the worker’s problem is of the reservation wage
form. Characterize the reservation wage. Show that the reservation wage is increasing
in the level of the unemployment benefits.
 Exam#

PhD Macroeconomic Comprehensive Exam (February 2017) 4

4 Investment-Specific Technology Shocks (60 points)

Suppose the representative household has preferences given by
∞
X
E0 β t U (Ct , Nt ),
t=0

where
Nt1+ν
U (Ct , Nt ) := ln(Ct ) − .
1+ν
The household selects labor supply, consumption and investment to maximize expected util-
ity subject to
Ct + It ≤ Πt + Rt Kt + wt Nt ,
and
Kt+1 = (1 − δ)Kt + vt It .
vt represents an investment-specific technology shock and follows

ln vt = σv vt ,

where vt is an iid mean zero process with bounded support. The household takes {vt , wt , Rt , Πt }
and K0 as given. The representative firm chooses capital and labor to maximize profit

Πt := Ktα Nt1−α − wt Nt − Rt Kt ,

taking {wt , Rt } and given.

1. Write household’s Lagrangean, first-order conditions and transversality condition. (5

points)

2. Write down the firm’s first-order conditions. (5 points)

3. Solve for the steady state. (10 points)

4. Log-linearize and write the model in the format

AEt xt+1 = Bxt + C v̂t ,

 0
where xt = K̂t Ĉt , A is 2 × 2, B is 2 × 2 and C is 2 × 1. (17 points)

5. Suppose we have assigned parameter values, and attained the following for matrices
A, B and C:
     
−0.06 −1.95 0 −1.00 −1
A= ,B = ,C =
4.11 0 4.39 −1.91 0.41

with 
1.07 −0.46
−1
W := A B = ,
−0.03 0.53
 Exam#

PhD Macroeconomic Comprehensive Exam (February 2017) 5

Suppose the eigen values and vectors of W are

τ1 = 0.50, τ2 = 1.10,
   
0.63 0.99
p1 = and p2 =
0.77 −0.06
with    
τ1 0   −1 0.07 1.23
J := , P := p1 p2 and P =
0 τ2 0.96 −0.78
and 

−1 0.57
C̃ := P A C = .
0.05

Is our solution locally unique? Explain. Solve for K̂t+1 and Ĉt as a function of K̂t and
v̂t . (17 points)
6. Intuitively explain the response of K̂t+1 and Ĉt to the investment-specific technology
shock v̂t . (6 points)

5 Optimal Money Supply Rules (30 points)

Suppose we have the basic New Keynesian model with sticky prices (Calvo) and no cost-push
shocks with the standard non-policy block equations:
ỹt = Et ỹt+1 − (1/σ)[R̂t − r̂tn − Et π̂t+1 ],
π̂t = βEt π̂t+1 + κỹt .
Let mt = Mt /Pt be real money balances and assume log-linearized money demand is given
by
m̂t = Ŷt − η R̂t ,
Suppose steady state inflation is zero, the flexible price output is Pareto optimal and ỹt =
π̂t = 0 is Pareto optimal. Suppose the log of TFP (at := ln At ) follows an AR(1) process:
at+1 = ρat + et+1 ,
with 0 < ρ < 1 and Et [et+1 ] = 0. Let P−1 > 0 be an initial condition (the price index before
period 0). Output is produced by firms using linear technology:
Yt (j) = At Nt (j),
and preferences are standard with
C 1−σ N 1+χ
U (C, N ) := − .
1−σ 1+χ
A. Let m̂nt be the demand for real money balances in the Pareto efficient equilibrium with
ỹt = π̂t = 0. Write down this equilibrium value of m̂nt as a function of at (note: to do
this, you may simply assume Ŷtn = ψya at without solving for ψya ). [6 pts]
 Exam#

PhD Macroeconomic Comprehensive Exam (February 2017) 6

B. What is the equilibrium path for the optimal money supply? [6 pts]

C. Consider the following class of money growth rules:

m̂t = φπ π̂t + φy ỹt

where M̂t = ln Mt − ln M ∗ and M ∗ is the deterministic zero inflation steady state. Is this
class of rules capable of implementing the Pareto optimal allocation? Explain. [6 pts]

D. Consider the following class of money growth rules:

m̂t = m̂nt + φπ π̂t + φy ỹt .

Is this class of rules consistent with implementing the Pareto optimal allocation? When
φπ = φy = 0 is there local determinacy? Explain. [12 pts]
 Exam #

Microeconomic Theory Comprehensive Exam

August 25, 2016

Part I: Answer all questions.

1. For each statement, explain why it is true or false.
a. For a normal good and a price increase, the compensating variation is more
negative and less than the equivalent variation.
b. Because the Slutsky and Hicksian compensations have different purposes, they
generate different substitution matrices for a differential price change.

2. Suppose the production function is given by f(z1, z2) = z11/4 z21/4.

a. In the short run, z2 is fixed at k. Find the short-run cost function, c(w, q, k).
b. Find the long-run optimal k and long-run cost function, c(w, q).
c. Solve the cost minimization problem (CMP) and verify your answer in (b).
d. Using the long-run cost function, find the profit-maximizing output.

3. Suppose two firms sell differentiated products with zero marginal cost and no fixed costs.
Their demands are given by q1 = 24 – 5p1 + 2p2, and q2 = 24 – 5p2 + 2p1.
a. Find the Bertrand best-response functions, equilibrium prices, and profits.
b. Find the collusive prices and profits.
c. What is the optimal defection strategy from the cooperative agreement?
d. Suppose they compete in quantities. Find the Cournot outcome and compare to
(a). If time is a constraint, briefly describe how to solve for the equilibrium.

4. Consider a two-consumer, two-commodity exchange economy. The utility functions for

consumers 1 and 2 are given by u1(x1, y1) = x1y1, and u2(x2, y2) = min (2x2, y2). The
initial endowment for consumer 1 consists of 1 unit of y, w1 = (0, 1), and for consumer 2,
1 unit of x, w2 = (1, 0).
a. Define a competitive equilibrium for this economy.
b. Find the Pareto optimal allocations and graph in an Edgeworth box.
c. Calculate the equilibrium price vector and allocation.
 Exam #

Advanced Microeconomic Theory Ph.D. Comprehensive Exam.

August 25, 2016
Part II: Answer all four questions below.

1. Public Goods. Two players simultaneously and independently decide how much to
contribute to a public good. If player 1 contributes x1 and two contributes x2 then
the value of the public good is 2 (x1 + x2 + x1 x2 ) : Player 1 pays of cost of x21 for
contributing x1 ; so u1 = 2 (x1 + x2 + x1 x2 ) x21 and 2 pays a cost of tx22 so u1 =
2 (x1 + x2 + x1 x2 ) tx22 : The number t is private information to player 2. Player 1
only knows that t = 2 with probability 1=2 and t = 3 with probability 1=2:

(a) What is the appropriate equilibrium concept for solving this game? Explain why.
(b) Find the equilibrium contributions x1 and x2 of each player.

2. Credit, Collateral and Competition. Consider a market in which competitive

banks provide capital to entrepreneurs who each have a …xed type, either safe (type 1)
or risky (type 2). The entrepreneur’s type determines the probability pi ; i = 1; 2; that
the entrepreneur’s venture will succeed, where p1 > p2 : The venture is worth X > 0
dollars if it succeeds and 0 otherwise.
p The entrepreneur has an initial wealth W and
preference scaling function v(x) = x: However, the entrepreneur’s wealth is less than
the investment I necessary to …nance the venture. Banks are risk neutral and write
contracts of the form (R; C): The bank receives a payment R if the venture succeeds
and receives the collateral C if the venture fails. If the venture succeeds, the bank’s
pro…t is R I(1 + ); where is the rate at which the banks borrow on the capital
market, and the entrepreneur’s …nal wealth is W + X R: If the venture fails, the
bank’s pro…t is C I(1 + ); and the entrepreneur’s …nal wealth is W C:

(a) Assume that entrepreneur types are observable. Derive an equation for the bank’s
isopro…t line expressing the maximum payment R as a function of C that the
bank can receive from a type i entrepreneur in any competitive equilibrium, and
illustrate the 0 isopro…t lines in a diagram with R on the vertical axis and C on
horizontal axis. (Make sure you accurately re‡ect di¤erences in the intercept and
slope of each isopro…t).
(b) Derive the slope of a type i entrepreneur’s indi¤erence curve at any contract with
C = 0; and use a diagram to illustrate the contracts that would be o¤ered in a full
information competitive equilibrium and the corresponding indi¤erence curves for
each entrepreneur type.
(c) What would happen if these contracts were o¤ered under conditions of asymmetric
information in which banks cannot observe entrepreneur types?
(d) Suppose that a separating Nash equilibrium exists. Illustrate the separating Nash
equilibrium contracts in the diagram.
(e) Explain why collateral is an e¤ective screening device in this market.

1
 Exam #

3. Unpredictable Weather. Bob is a farmer who can plant either potatoes or corn.
Both crops are risky and Bob’s pro…t depends on the weather according to the following
table:
Pro…t from
Potatoes Corn
Cold $4000 $1000
Weather Normal $8000 $8000
Warm $6000 $11,000
There is a 1/4 probability that the weather will be cold, a 1=2 probability that the
weather will be normal, andpa 1/4 probability that the weather will be warm. Bob’s
utility function is u (w) = w and Bob has $2000 of income from other sources, so
his total income is $2000 plus crop pro…ts. Bob can plant a fraction of his land
with potatoes and the remaining fraction 1 with corn. Pro…ts will be earned in
proportion to the fraction of land planted with each crop (i.e. if = :3 then Bob’s
pro…t will be 30 percent of the potato pro…t plus 70 percent of the corn pro…t in the
table above, depending on which state of the world occurs).

(a) Express Bob’s decision as a lottery.

(b) What value of should Bob choose?

4. Pro…t Maximization with Unobserved E¤ort. A manufacturer supplies, at a

constant marginal cost of m = 50; a good to a risk-averse retailer who sells the good
on the …nal market. Demand in the …nal market depends upon the retailer’s e¤ort
e 2 f0; 1g; with high demand of P = 200 Q occurring with probability q(e) and
low demand P = 100 Q occurring with probability 1 q(e); where q (0) = 0:2 and
p
q (1) = 0:8: The retailer’s utility is u ( R ; e) = 2 R c (e) where R is the …nal
pro…t obtained by the retailer, c (0) = 0 and c (1) = 80: The manufacturer observes
…nal demand (either high or low), but not the retailer’s e¤ort level. The manufacturer
speci…es a pro…t split in which the manufacturer receives a payment t if high demand
is observed (in which case R = t where is the retailer’s pro…t which equals total
revenue less the 50Q paid to the manufacturer for the goods) and a payment t if low
demand is observed. The retailer chooses the market price after observing demand.

(a) Suppose that the retailer’s e¤ort is unobservable and that it is optimal for the
manufacturer to induce high e¤ort from the retailer. De…ne a residual claimant
contract (in particular, what is the relationship between t and t under a residual
claimant contract), and explain why such a contract is or is not feasible if the
retailer’s e¤ort is unobservable.
(b) Explain the monotone likelihood ratio condition and why it is important in set-
tings like the one described here.
(c) State the manufacturer’s optimization problem for the case of unobservable e¤ort.
Clearly explain any constraints.
(d) Solve for the optimal contract ft; tg o¤ered by the manufacturer.

2
 Exam#
PhD Macroeconomic Comprehensive Exam (June 2016) 1

Please make your answers neat and concise. Make whatever assumptions you need to answer
the questions. Be sure to state them clearly. Show your work.

Income Uncertainty [30 points]

Consider a small open economy inhabited by a continuum of infinitely lived agents with
common utility given by:
X∞
E0 β t u(ct ),
t=0

1
u(c) = − e−γc , γ > 0,
γ
where β < 1 is the discount factor and c is consumption. Assume each agent faces the
following intertemporal budget constraint

At+1 = (1 + r)(At + yt − ct ),

where A is wealth (assets), y is a stochastic endowment, r is the world interest rate. Assume
yt = y + t , where t is i.i.d. across time and agents and distributed normally with mean 0
and variance σ 2 . Assume that the world interest rate is such that β(1 + r) = 1. Answer the
following sub-questions.

1. Show that the consumption function,

r 1
ct = (At + yt + y) − π,
1+r r
where π is a constant which depends only on γ, r, σ 2 , implies
r
ct − ct−1 = ∆ct = (yt − y) + rπ.
1+r

2. Use your results in part (1) to show that the consumption function in part (1) satisfies
the agent’s intertemporal Euler equation, solve for the constant π and show that π > 0.
(Hint: remember that if  is normal with mean 0 and variance σ 2 , then e has mean
1
e 2 σ2 .)

3. Show that average income and cross-sectional income variance are stationary but av-
erage consumption and cross-sectional consumption variance are not.
 Exam#
PhD Macroeconomic Comprehensive Exam (June 2016) 2

Overlapping Generations Model [30 points]

Consider an overlapping generations economy in which there is one good in each period and
a continuum of measure 1 of two types of consumers in each generation, except the initial
ones, live for two periods. Both types of consumers in generation t, t = 1, 2, ... have the
utility function
log ci,t i,t
t + log ct+1 , i = 1, 2.

Consumers of type 1 have the endowment (e1,t 1,t

t , et+1 ) = (3, 1), while consumers of type 2
have the endowment (e2,t 2,t
t , et+1 ) = (1, 1). The two representative consumers in generation 0
(the initial ones) live only in period 1, prefer more to less, and have the endowment ei,0 1 = 1,
i = 1, 2. There is no outside money.

1. Define a sequential market equilibrium for this economy. Calculate the unique sequen-
tial market equilibrium.

2. In the equilibrium allocation, is it the case that c1,t

t = 3?
 Exam#
PhD Macroeconomic Comprehensive Exam (June 2016) 3

Deterministic Growth Model [30 points]

Consider an infinite-horizon economy
P with an equal measure of two types of agents. The
agents’ preferences are of the form t βit log(cit ), where 0 < β1 < β2 < 1. The households
are endowed with 1 unit of labor each. Type 1 households hold the entire initial capital
stock. The aggregate resource constraint is

ct + kt+1 = ktα lt1−α + (1 − δ)kt ,

where ct denotes period t aggregate consumption, kt the capital stock, lt labor, 0 < α < 1 a
parameter, and 0 < δ < 1 the depreciation rate.

1. Define an Arrow-Debreu competitive equilibrium for this economy.

c1t
2. What is limt→∞ c2t
in such an equilibrium?

3. To what level does the aggregate capital stock converge?

 Exam#
PhD Macroeconomic Comprehensive Exam (June 2016) 4

Policy with Cost-Push Shocks and Inflation Persistence

[65 points]
Suppose now partial price indexation by firms (i.e., prices for firms that do not get to choose
a new price, moves with lagged inflation). In this model, we have the following dynamic IS
and New Keynesian Phillips curve (in logs):
1
xt = Et [xt+1 ] − [it − Et πt+1 − re ], (1)
σ
πt − γπt−1 = βEt [πt+1 − γπt ] + κxt + ut , (2)

where ut is iid mean zero cost-push shock with bounded support. xt is the welfare-relevant
output gap and re is the expected real interest rate under the efficient allocation (assume
constant). Assume π−1 = 0.The second-order approximation to welfare loss is given by
∞
1 X t
E0 β [αx x2t + (πt − γπt−1 )2 ].
2 t=0

A. Discretionary Policy. Policy is set sequentially each period taking future policy (and past
policy) as fixed. The single-period loss function is

(1/2)[(πt − γπt−1 )2 + αx x2t ].

1. Since future and past policies are taken as given, we can let

vt := γπt−1 + βEt πt+1 + ut .

Then our constraint can be written as

(1 + βγ)πt = κxt + vt .

Set up the Lagrangean for this single-period loss minimization. Take first-order con-
ditions and solve for optimal xt , πt as a function of vt and πt−1 .
2. Let zt := πt − γπt−1 . Show that πt = tj=0 γ j zt−j . Note that if we set zt = 0 for t < 0,
P
we can write ∞
X
πt = γ j zt−j .
j=0

3. Solve for the equilibrium {xt , πt , it } under the optimal discretionary policy as a func-
tion of cost push-shocks. Hint: use a change of variables and let zt := πt − γπt−1 in
the DIS equation and substitute for xt as a function of zt . You should get zt = Ψz ut
where Ψz is a function of underlying parameters.
4. Solve for an interest rate rule that will implement this optimal equilibrium without
commitment of the following form:

it = re + φπ πt + τπ πt−1 .
 Exam#
PhD Macroeconomic Comprehensive Exam (June 2016) 5

5. For this part only, assume σ = 1, γ = 0.5, κ = 0.5 and β = 1/2. Calculate the φπ and
τπ you derived in part 2.
Consider the following matrix form of the model (after using the interest rate rule
from part 2):    
xt xt+1
 πt  = AEt πt+1  + But ,
πt−1 πt
where A is 3 × 3 and B is 3 × 1. Suppose give the above parameters, the A matrix is
given by  
0.7143 0.4286 −0.2143
A=  0 0 1.0000 
−0.7143 −1.3500 2.7143
with eigenvalues 2.0636, 0.2993 and 1.0657. Do we have local determinacy with this
policy? Explain. Is this consistent or inconsistent with the Taylor principle? Explain.

B. Markovian Policy. Let zt : πt − γπt−1 . In period 0, the central bank chooses a policy of
the following form:

xt = ψx ut ,
zt = ψz ut

to minimize "∞ #
1 X
− E0 β t (zt2 + αx x2t ).
2 t=0

1. Solve for the optimal Markovian policy.

2. How does welfare under this policy compare to that in part A under discretion? Which
is better?
 Exam#
PhD Macroeconomic Comprehensive Exam (June 2016) 6

Classical Model [25 points]

Consider the following classical model (in logs):

ct = y t ,
yt = (1 − α)nt ,
−αnt = σct + φnt + zt ,
1
ct = Et ct+1 − {it − Et [πt+1 ] − ρ},
σ
with

it := rt + Et [πt+1 ]

where rt is the expected real interest rate which equals ρ + σEt [∆yt+1 ] and zt is a preference
shock (iid mean zero). Suppose that money demand is given by

mt − pt = yt − ηit + m
t ,

where em
t is a stochastic money demand shock with mean 0 and standard deviation σm .

A. Provide an interest rate rule that results in price stabilization πt = 0 for all t and solve
for equilibrium yt , nt , rt , mt and it . [15 points]

B. What makes this model “classical?” [5 points]

C. Provide a money growth rule that results in price stabilization πt = 0 for all t. How does
the money supply respond to a positive taste shock zt > 0? In addition to deriving this
response, provide some intuition. [10 points]
 Exam #

Microeconomic Theory Comprehensive Exam

June 30, 2016

Part I: Answer all questions.

1. For each statement, briefly explain why it is true or false.
a. In the Robinson Crusoe economy, the Walrasian equilibrium is always Pareto
optimal.
b. In the Dixit model, maintaining pre-entry capacity post entry is not a credible
threat.

2. Suppose a firm’s production function is given by q = f(z1, z2) = 4z11/4z21/4.

a. For the profit maximization problem (PMP), derive the first-order conditions and
check the second-order conditions.
b. Find the unconditional factor demand functions, supply function, and profit
function.
c. For the PMP, state and briefly describe the envelope theorem. Then apply it to
derive Hotelling’s lemma and verify your answers in (b).
d. Show how Hotelling’s lemma can be used to derive a law of supply.

3. Suppose the indirect utility function, v(p,w) = w/(p11/2p21/4p31/4).

a. Find the Walrasian demand functions.
b. Derive the utility function.
c. Find the Hicksian demand functions.
d. Suppose x3 is rationed at x3’. Find the Walrasian demand function for good 1.

4. Consider the following dynamic game of complete information. Player 1 moves first and
can move up (u) or down (d). If 1 moves u, player 2 can move up (U) with payoffs of 6
to player 1 and 2 to player 2, or move down (D) with payoffs of 2 to player 1 and 1 to
player 2. If 1 moves d, player 2 can move up (U) with payoffs of 4 to player 1 and 3 to
player 2, or move down (D) with payoffs of 7 to player 1 and 0 to player 2.
a. Draw the extensive form of this game.
b. What are players 1 and 2’s strategies? Summarize the game in normal form.
c. Explain and find the Nash equilibrium/equilibria. Are they plausible?
d. Explain and find the subgame perfect Nash equilibrium.
 Exam #

Microeconomics Ph.D. Comprehensive Examination

June 2016

Part II: Answer all four questions below.

1. An airline serves two di¤erent types of customers, business travelers and tourists. The
airline knows that business travelers are willing to pay more than tourists, and that
neither type likes to purchase a ticket in advance. In particular, the utility functions
of the two di¤erent traveler types are
2
UB = v B PB dB ;
2
UT = v T PT dT

where the subscript represents the customer’s type (B =business, and T =tourist),
0 < B < T (so that business travelers are willing to pay more than tourists), P is the
price of the ticket, and d is the number of days in advance of the ‡ight date that the
ticket is purchased. Both types can achieve a reservation utility of 0 by not purchasing
a ticket. The proportion of tourists in the air travel market is denoted ; and the cost
of transporting a passenger is c:

(a) Mathematically determine the slope of a type i consumer’s indi¤erence curve,

and illustrate the reservation indi¤erence curves of the two types of travelers in a
diagram with P on the vertical axis and d on the horizontal axis.
(b) Use the diagram to illustrate the pro…t maximizing contracts if the airline can
observe each customer’s type.
(c) Now suppose the airline cannot observe customer types. Formulate the airline’s
pro…t maximization problem assuming the airline can o¤er two di¤erent (P; d)
pairs, where a (P; d) pair speci…es a ticket price and the amount of time d in
advance of the departure date that the ticket must be purchased to get the cor-
responding price.
(d) Prove mathematically and illustrate in a diagram that under the optimal solution
one of the two types is just indi¤erent between buying a ticket and not traveling.
Clearly identify which type this is.
(e) Suppose that = 1=2; B = 1; T = 3; v = 600 and c = 1: Solve for the optimal
contracts and illustrate in a diagram.
(f) Is the solution derived in part (e) e¢ cient? Explain.
(g) Now suppose the air travel market is perfectly competitive. What equilibrium
will result? Explain why a pooling equilibrium will or will not occur.

1
 Exam #

2. Hazardous Waste
Two towns are bidding for a contract to house a hazardous waste dump within the
town boundaries. The disutility di for town i 2 f1; 2g from housing the hazardous
waste dump is a random variable uniformly distributed on the interval [0; 1]. Each
town knows its own disutility but does not know the disutility of the other town. Each
town submits a bid for the contract and the lowest bidder wins and is paid its bid to
house the dump. Other than the disutility di ; the cost of the dump to the town is 0:
Determine the symmetric equilibrium bidding strategy for each town.
3. Investing Under Uncertainty An individual is deciding how to invest $1000 in two
assets which generate random returns R1 and R2 : The expected return from investing
all $1000 in the …rst asset is 1 = $2000 and the expected return from investing all
$1000 in the second asset is 2 = $2500: The variance of the return for each asset is
2 2
1 = 30 and 2 = 80; and the covariance is cov (R1 ; R2 ) = 22: If the investor is highly
risk averse, would you recommend that she only invest in the less risky asset 1 or that
she diversify? Explain. Use a diagram in your answer.
4. Moral Hazard Consider the regular moral hazard model with a risk-neutral principal
and a risk-averse agent. The agent can choose between two e¤ort levels, ai 2 fa; ag
with associated cost ci 2 f0; cg with c > 0. The agent’s action generates one of
two possible pro…t levels, xi 2 fx; xg : Let p (a) = Pr (x = x j a = a) and p (a) =
Pr (x = x j a = a) ; and assume p (a) > p (a) (i:e:; the probability of the low outcome x
occurring is higher under low e¤ort a than under high e¤ort a): The utility function of
the agent is u (w; ci ) = ln w ci : The value of the agent’s outside option is normalized
to 0 and the principal is risk-neutral. Assume that the principal cannot observe the
agent’s e¤ort and that c is su¢ ciently small so that the principal always earns higher
pro…t by incenting the agent to choose high e¤ort.
(a) Can a residual claimant contract be used to generate the …rst-best (e¢ cient)
outcome? Explain.
(b) Fully characterize the principal-agent problem (mathematically) given the princi-
pal prefers the high e¤ort level a.
(c) Solve for the optimal wage schedule which implements the high e¤ort level a.
(d) Now consider the following extension to the problem. After the principal has
o¤ered a wage schedule and the agent has chosen and performed an e¤ort level,
but before x is revealed, the principal has the opportunity to o¤er a new contract
to the agent (to renegotiate). The agent can either accept or reject the new
contract o¤er. If he accepts the new contract, then it replaces the old contract,
if he rejects the new contract, then the old one remains in place. After the
renegotiation has concluded (and the new contract has either been accepted or
rejected), x is revealed and the payment speci…ed under the …nal accepted contract
is implemented. Show that there is no subgame perfect equilibrium under which
the agent chooses high e¤ort, i:e:; with renegotiation the principal cannot get
the agent to choose a = a: Hint: Consider the optimal contract after a has been
chosen but before x has been realized.

2
PhD Macroeconomic Comprehensive Exam (February 2016) Exam # 1

I. In part I, answer TWO sections of questions out of four A, B, C and D. Please make
your answers neat and concise. Make whatever assumptions you need to answer the
questions. Be sure to state them clearly.

A. Income Uncertainty: Consider a small open economy inhabited by a continuum of

infinitely lived agents with common utility given by:
∞
X
E0 β t u(ct ),
t=0

1
u(c) = − e−γe , γ > 0,
γ
where 0 < β < 1 is the discount factor and c is consumption. Assume each agent
faces the following intertemporal budget constraint

At+1 = (1 + r)(At + yt − ct ),

where A is wealth (assets), y is a stochastic endowment, r is the world interest

rate. Assume yt = y + t , where et is i.i.d. across time and agents and distributed
normally with mean 0 and variance σ 2 . Assume that the world interest rate is such
that β(1 + r) = 1. Answer the following sub-questions.
1. Show that the consumption function,
r 1
ct = (At + yt + y) − π,
1+r r
where π is a constant which depends only on γ, r, σ 2 ; and it eventually implies
r
ct − ct−1 = ∆ct = (yt − y) + rπ.
1+r
2. Use your results in part (I(A)1) to show that the consumption function in part
(I(A)1) satisfies the agent’s intertemporal Euler equation, solve for the constant
π and show that π > 0. (Hint: remember that if  is normal with mean 0 and
1
variance σ 2 , then e has mean e 2 σ2 .)
3. Show that average income and cross-sectional income variance are stationary but
average consumption and cross-sectional consumption variance are not.
PhD Macroeconomic Comprehensive Exam (February 2016) 2

B. Steady States and Taxation: Consider an infinite horizon, single sector, representa-
tive agent model with no technological change, and inelastic labor supply. Assume
that the government uses a constant tax, τ , applied to all (i.e., both labor and cap-
ital) income uniformly. Assume that the proceeds of this tax are used, balancing
the budget in every period, to purchase a stream of purchases of goods, gt . Make
the standard assumptions on preferences and production functions. Answer the
following sub-questions.
1. Define a TDCE (Tax Distorted Competitive Equilibrium) for this economy.
2. Characterize the steady state of this TDCE as a function of τ . Say as much as
you can about what happens to steady state k, c, and g as a function of τ .
3. Show that no matter what the initial capital stock is, and no matter what the τ
is, the equilibrium path of the economy converges to the steady state you derived
in part (I(B)2).
PhD Macroeconomic Comprehensive Exam (February 2016) 3

C. Dynamic Programming in an Economy with Leisure:

Consider the social planning problem of choosing sequences {ct , xt , lt , kt } to solve
∞
X
max β t (log ct + γ log xt ),
t=0

s.t. ct + kt+1 ≤ θktα lt1−α ,

xt + lt ≤ 1,
ct , xt , lt , kt ≥ 0,
k0 ≤ k0 .

Answer the following sub-questions.

1. Write down the Bellman equation for this problem.
2. Guessing that the value function V (k) has the form a0 + a1 log k and that the
policy function for labor l(k) is constant, find analytic solutions for the policy
function V (k) and the policy functions c(k), x(k), l(k), k 0 (k).
3. Describe a sequential market structure for this world. Define a sequential market
equilibrium. Use the answer to part (I(C)2) to calculate the unique sequential
market equilibrium.
4. Describe an Arrow-Debreu market structure for this world. Define an Arrow-
Debreu equilibrium. Use the answer to part (I(C)2) to calculate the Arrow-
Debreu equilibrium.
5. Show that the sequential market equilibrium is the same as the Arrow-Debreu
equilibrium and both are Pareto-optimal.
PhD Macroeconomic Comprehensive Exam (February 2016) 4

D. Growth and Inequality:

Consider an economy in which there is a continuum of non-altruistic, overlapping-
generation individuals indexed by i ∈ [0, 1]. Individuals of each generation are
assumed to live for two periods. Time in the model economy is discrete with an
infinite horizon. The utility of individual i in generation t is

Uti = cit − h(eit ),

where cit denotes individual i’s second period consumption (for simplicity, we assume
that individuals consume only when old), eit is the non-monetary effort incurred by
individual i when young and h(eit ) = At (eit )2 /2 denotes the non-monetary cost of
effort. The parameter At measures productivity on technology. The endowment
of individual i is taken to be an idiosyncratic proportion of average knowledge at
date t, that is, wti = it At . The production activity requires a fixed and indivisible
capital outlay equal to kti = φAt ; and conditional upon the required investment φAt
being made at date t, the output from investment in this technology is uncertain
and given by (
σAt with probability eit
yti =
0 with probability 1 − eit .

Answer the following sub-questions.

1. Consider the effort decision of an individual who does not need to borrow, that
is, wi ≥ φA. The problem she/he faces is maxe {eσA − Ae2 /2}. Find her/his
optimal level of effort.
2. Consider the same decision problem for an individual who needs to borrow an
amount bi = φA − wi in order to invest. Let r be the unit repayment rate. Write
down the problem she/he faces and find her/his optimal level of effort.
3. Interprete your answer in part (I(D)2). (Given r, what is the relationship between
effort and initial wealth?)
4. The growth rate of the economy is given by gt = log(yt /yt−1 ). Assume that there
is learning-by-doing, i.e., At = yt−1 . Write down the growth rate in terms of σ
and the distribution of efforts.
5. Based on your answer in part (I(D)4), suggest any suitable policy to boost the
growth rate. Briefly explain why.
PhD Macroeconomic Comprehensive Exam (February 2016) 5

II. Suppose a representative firm has a production function that is given by

1/2
Yt = F (Lt , Mt /Pt ) := Lt (Mt /Pt )1/2

where Lt is labor and Mt /Pt is real money balances. The firm hires labor at the rate
Wt and rents (borrows) money from the household at rate St . It seeks to maximize
profit
Πt := Pt F (Lt , Mt /Pt ) − Wt Lt − St Mt ,
by choice of Lt , Mt , taking Wt , Pt , St as given.
The representative household has preferences over consumption and labor given by
∞
X
E0 β t U (Ct , Lt ),
t=0

where
L2t
U (Ct , Lt ) := ln Ct − .
4
The household budget constraint is given by

Pt Ct + Qt Bt + Mt ≤ Wt Lt + St Mt + Mt−1 + Bt−1 + Tt .

The household seeks to maximize expected utility by choice of Ct , Bt , Mt , Lt taking as

given Pt , Qt , Wt , St , Tt (and initial conditions).
The government controls the money supply with a money growth rule:

Mt = Mt−1 exp{γ + et },

where γ > 0 and et is iid mean zero with bounded support so that γ + et > 0 always.
The money supply is adjusted via transfers Tt = Mt − Mt−1 .

A. Write down the household’s Lagrangean and first-order conditions.

B. Write down the firm’s first-order conditions for profit maximization.
C. Solve for the deterministic steady state. How does the steady state level of output
depend on γ? Explain the intuition for this.
D. Log-linearize the equilibrium conditions and derive a system of stochastic difference
equation in m̂t and m̂t+1 of the form

Et m̂t+1 = Γm̂t .

E. Are there any restrictions on γ to make the equilibrium (locally) unique, i.e., imply
local determinacy?
F. Under local determinacy, what is the equilibrium path for Ct , Lt , πt .
G. Does this impact of a money growth shock (et+1 ) on output Yt consistent with the
empirical monetary facts outlined by Galı́? Explain.
PhD Macroeconomic Comprehensive Exam (February 2016) 6

III. New Keynesian Model with Capital: This version has intermediate goods (produced
by monopolistically competitive firms) and a final good (produced by a representative
perfectly competitive firm).
The final good firm produces the final good Yt using the differentiated goods according
to the Dixit-Stiglitz aggregator:

Z 1  −1
−1
Yt = Yt (i)  di .
0

This firm purchases the inputs from the intermediate firms at given prices Pt (i) and
sells the output at given price Pt .
Intermediate firms j ∈ [0, 1] produce differentiated goods using both labor and capital
according to
Yt (j) := Kt (j)1/2 Lt (j)1/2 .
Capital is rented from the household at the nominal rate Rt and labor is hired at the
nominal wage Wt . Output prices are Calvo sticky. Demand for good j (by the final
good firm) is given by
Yt (j) = Yt (Pt /Pt (j)) .

Let Ct and It represent consumption and investment of the homogenous final good that
is produced by the representative competitive firm.
The household budget constraint is

Pt Ct + Pt It + Qt Bt ≤ Bt−1 + Wt Nt + Rt Kt + Tt ,

where Pt is the price of the final good, Tt are nominal lump-sum transfers, Bt are bond
holdings and Qt is the discount price of the bond. Capital evolves according to

Kt+1 = (1 − δ)Kt + It ,

where 0 < δ ≤ 1 is the depreciation rate. Preferences are

∞
X
E0 βU (Ct , Lt )
t=0

with
L2t
U (Ct , Lt ) := ln Ct − .
4
PhD Macroeconomic Comprehensive Exam (February 2016) 7

A. Given Yt (j) derive the total cost function as a function of Wt , Rt and Yt (j) along
with marginal cost.
B. Derive an expression for total costs at time t + k for firm j that sets it price at time
t as a function of Pt (j), Pt+k , Yt+k , Wt+k and Rt+k .
C. Derive an expression for profit at time t + k for firm j that sets it price at time t as
a function of Pt (j), Pt+k , Yt+k , Wt+k and Rt+k .
D. Write down the optimization problem for a firm that gets to select its price at time
t and derive the first-order condition.
E. Substitute for It in the household’s budget contraint from the evolution of capital
equation. Using this new budget constraint, write down the household’s optimiza-
tion problem and FOCs. Let wt := Wt /Pt and rt := Rt /Pt .
F. Using market clearing in the labor and capital markets, along with factor inputs
and output demands derive the following aggregate demand for the factor inputs:

Nt = (rt /wt )1/2 Yt dt ,

Kt = (wt /rt )1/2 Yt dt ,

where dt is measure of price dispersion. Log-linearize these demands to express (up

to first-order) N̂t and K̂t as functions of ŵt , r̂t and Ŷt .
G. Use the log-linearized factor input demands to show that (up to first-order) we have

Ŷt = (1/2)K̂t + (1/2)N̂t .

H. Real aggregate total costs are given by

rt Kt + wt Nt .

Show that this implies that real aggregate cost is given by

tct = 2(wt rt )1/2 Yt dt ,

where dt is a measure of price dispersion. Show that (up to first-order), we have

log-linearized aggregate real marginal cost:

m̂ct = (1/2)ŵt + (1/2)r̂t .

I. Market clearing in the final goods market requires Ct + It = Yt or Ct + Kt+1 =

Yt + (1 − δ)Kt . Let SC := C/Y and SK := K/Y denote steady state ratios. Log-
linearize the latter expression for market clearing using Sc and SK as coefficients.
J. Use the log-linearized factor input demands, the aggregate production function and
household’s FOCs to solve (up to first order) for m̂ct as a function of Ĉt , Ŷt and K̂t .
PhD Macroeconomic Comprehensive Exam (February 2016) 8

K. Assume the flexible price equilibrium is efficient. Let

c̃t := ln Ct − ln Ctn ,
k̃t := ln Kt − ln Ktn ,
ỹt := ln Yt − ln Ytn .
Using the fact that the markup is constant in the flexible price equilibrium, show
that m̂ct can be expressed as a function of c̃t , k̃t and ỹt .
L. The firms’ FOCs can be transformed to the following:
π̂t = βEt π̂t+1 + λm̂ct .
Using the result in part K, derive the NKPC as a function of inflation and con-
sumption, capital and output gaps. You should get something of the form
π̂t = βEt π̂t+1 + λc c̃t + λy ỹt + λk k̃t .

M. Use the bond first-order condition to derive the dynamic IS curve as a function of
c̃t , c̃t+1 , R̂t := −Q̂t , π̂t+1 and r̂tn (the expected real interest rate in the flexible price
equilibrium).
N. Use the aggregated demand for capital along with the household’s labor supply and
the aggregate production function to express r̂t as a function of Ĉt , Ŷt and K̂t .
O. Use the capital FOC along with the expression for r̂t in part N (moved one period
ahead) to derive an intertemporal FOC in c̃t , c̃t+1 , k̃t+1 and ỹt+1 .
P. Using a Taylor rule of the form
R̂t = r̂tn + φπ π̂t + φy ỹt
and collecting our intertemporal conditions and final goods market clearing condi-
tion, we get the following system:
   
k̃t+1 k̃t
 ỹt+1   ỹt 
 c̃t+1  = M  c̃t 
Et    

π̂t+1 π̂t
where M is a 4×4 matrix. Given model parameters and policy parameters φπ = 1.5
and φy = 0.5, we get
 
0.9000 0.3053 −0.2053 0
 0.7906 1.4721 −0.3749 0.8793
M = 0.0970

0.6454 1.0485 0.4474
−0.0970 −0.1454 −0.0485 1.0526
with eigenvalues τ1 = 0.5652, τ2 = 1.3611 + 0.5416i, τ3 = 1.3611 − 0.5416i and
τ4 = 1.1859. Under this policy do we have local determinacy or local indeterminacy?
Explain. Is this policy Pareto optimal? Explain.
 Exam #3

Microeconomic Theory Comprehensive Exam

August 27, 2015

Part I: Answer all questions.

1. For each statement, explain why it is true or false.
a. A law of supply follows from the fact that the profit function is convex in p.
b. In the expenditure minimization problem, the envelope theorem can be used to
derive Shephard’s lemma.

2. Suppose three commodities, and that at the price vectors, p1 = (2, 1, 2), p2 = (2, 2, 1), and
p3 = (1, 2, 2), the respective choices are x1 = (1, 2, 2), x2 = (2, 1, 2), and x3 = (2, 2, 1).
a. Define the weak axiom of revealed preference (WA).
b. For the above example, show that any two pairs of choices satisfy WA.
c. Are the choices compatible with a preference-based theory of demand? Explain.
d. When is WA compatible with a preference-based theory of demand?

3. Suppose the cost function is given by c(w, q) = 3 (w1w2w3)1/3q.

a. Calculate the conditional factor demands, z(w, q).
b. Derive the production function.
c. Calculate the long-run conditional own-price elasticity for z1(w, q).
d. Suppose z3 is fixed in the short run. Derive the short-run conditional own-price
elasticity for z1(w, q).

4. Consider a Robinson Crusoe economy, in which yams (y) are produced using labor (L)
according to the production function y = L1/2. Robinson’s utility is given by u(y, 1 – L) =
y1/2 (1 - L)1/2, and normalize the price of yams, py = 1.
a. Define a competitive general equilibrium for this economy.
b. Find the labor demand, labor supply, and equilibrium wage, and the equilibrium
allocation of labor and yams.
c. Suppose Robinson agrees to provide Friday with a salary equal to 50% of the
profits. Find the new equilibrium wage, labor, and Robinson’s consumption of
yams.
 Microeconomics Ph.D. Comprehensive Examination
August 2015
Part II: Answer all three questions below.

1. Optimal Risk Bearing.

(a) Suppose a risk-averse consumer is deciding on purchases of contingent claims in

a world with three possible future states. State and explain the fundamental
theorem of risk-bearing for this case, and derive and explain conditions under
which the consumer will purchase contingent claims to eliminate all risk. Clearly
de…ne your notation.
(b) Write down a model for an asset market with three future states. Clearly de…ne
what an asset is in your answer, and clearly de…ne the asset prices and returns,
and how these di¤er from contingent claims prices and returns.
(c) Under what conditions is the asset market in part (b) equivalent to the contingent
claims market in part (a)? Explain.

2. Auctions with an Entry Fee. Consider the following private-value auction of a

single object, whose value to the seller is 0. There are two buyers, 1 and 2. The value
of the object for each buyer i 2 f1; 2g is vi so that if i buys the object at a price p; his
payo¤ is vi p; and if he does not buy the object, his payo¤ is 0. Assume that v1 and
v2 are independently and identically distributed uniformly on [v; 1] where 0 v < 1:
The seller uses a sealed-bid …rst-price auction to sell the item.

(a) Compute the symmetric Bayesian Nash equilibrium in linear strategies bi = a+cvi
(determine the values of a and c as a function of v), and compute the expected
utility of a buyer for whom the value of the object is v.
(b) Now assume that v1 and v2 are independently and identically distributed uni-
formly on [0; 1] (and vi is private information to buyer i): In addition, the seller
imposes an entry fee of 2 (0; 1) which a buyer must pay to submit a bid in the
auction. In the …rst period each buyer simultaneously decides whether to pay
to enter the auction. Each buyer’s decision is then observed by all players. In
the second period the seller runs the sealed-bid auction as in part (a) : If only one
player enters the auction then he wins with a bid of b = 0; while if both bidders
enter they auction, they use linear bidding strategies (as in part (a)). Compute
the symmetric sequential equilibrium of this game – determine the equilibrium
bidding strategies and the value of chosen by the seller. [Hint: In the entry
stage, there is a cuto¤ level v~ such that buyer i enters the auction if and only if
vi > v~: This cuto¤ v~ is then equivalent to v in part (a):]

1
3. Product Quality and Price Discrimination. A monopolist can produce a good in
di¤erent qualities. The cost of producing a unit of quality s is C (s) = s2 . Consumers
buy either one or zero units and have the utility function

s if one unit is consumed

u (sj ) =
0 if nothing is consumed

The monopolist decides on the quality levels it is going to produce and the price for
each di¤erent quality level. Consumers observe qualities and prices and decide which
quality to buy.

(a) Characterize the …rst-best solution (i.e. the quality level and price for a type
consumer when the monopolist observes ).
(b) In general, what condition is necessary for a monopolist to separate di¤erent
consumer types if cannot be observed? Is this condition satis…ed in this problem?
Explain.
(c) Suppose that the seller cannot observe , and suppose that

H with probability 1
=
L with probability

where H > L > 0: Assume the monopolist sells two products (two di¤erent
quality levels, sH and sL at prices pH and pL ; respectively). Characterize this
equilibrium mathematically (i.e., state and solve the monopolist’s maximization
problem), and use a diagram to illustrate.
(d) Is the outcome in part (c) e¢ cient? Explain why or why not.
Now suppose that many other …rms enter this industry, so that it is perfectly
competitive.
(e) Use a diagram to illustrate the competitive, separating equilibrium assuming one
exists.
(f) Is the reactive equilibrium concept helpful in the context of this problem? Explain
why or why not.

2
 Microeconomic Theory Comprehensive Exam
June 25, 2015
Part I: Answer all questions.
1. For each statement, briefly explain why it is true or false.
a. In the proof of the first welfare theorem, nonsatiation is needed to show that there
exists a separating hyperplane.
b. Because the Hicksian demand curve is flatter than the Walrasian demand curve
for an inferior good, the compensating variation is greater than the equivalent
variation.

2. Suppose the utility function is given by u = 2x11/2 + 4x21/2.

a. Solve the utility maximization problem to find the demand functions.
b. Find the Hicksian demand functions and verify Shephard’s lemma.
c. Find the indirect utility function and verify Roy’s identity.

3. Suppose a firm’s production function is given by q = f(z1, z2) = z12 z22.

a. For the profit maximization problem, calculate the first-order conditions (FOCs).
What does the second-order condition (SOC) indicate?
b. Solve the cost minimization problem to find the cost function.
c. Check if the cost function is well-behaved in that it is homogeneous of degree one
in w, nondecreasing in q, and concave in w.

4. Suppose there are two firms producing a homogeneous good, demand is given by
P = 260 – q, and each firm’s costs are given by c(q) = 20q.
a. For the static Bertrand game, find the equilibrium outputs, price, and profits.
b. Assuming equal division of output, find the cooperative outputs, price, and
profits. Given that firm 1 cooperates, what is firm 2’s optimal strategy?
c. In an infinitely-repeated Bertrand game with grim trigger strategies (play static
outcome if rival cheats), calculate the discount factor which supports the
cooperative outcome.
d. Suppose there are J firms. Recalculate the discount factor which supports
cooperation. What does it imply about the effect of more firms on achieving
cooperation?
e. In the infinitely-repeated Cournot game with grim trigger strategies and two
firms, calculate the discount factor which supports the cooperative outcome. Is it
easier to achieve cooperation in the Bertrand or Cournot game?
 Microeconomics Ph.D. Comprehensive Examination
June 2015

Part II: Answer all four questions below.

1. Investing Under Uncertainty An individual is deciding how to invest $1000 in two

assets which generate random returns R1 and R2 : The expected return from investing
all $1000 in the …rst asset is 1 = $2000 and the expected return from investing all
$1000 in the second asset is 2 = $2500: The variance of the return for each asset is
2 2
1 = 30 and 2 = 80; and the covariance is cov (R1 ; R2 ) = 22: If the investor is highly
risk averse, would you recommend that she only invest in the less risky asset 1 or that
she diversify? Explain. Use a diagram in your answer.

2. Labor Markets. Two players, a worker and a …rm, interact in a labor market. Player
one (the worker) is one of two types, H or L with equal probability. He can choose to
study (S) or play (P ): The cost of P is 0 regardless of the worker’s type. The cost of
S depends on the worker’s type with cH = 1 and cL = 3: Worker productivity, which
can be thought of as revenue R generated for the …rm by the worker, depends on the
worker’s type, with RH = 4 and RL = 1: The …rm must pay a wage of w to hire the
worker. Consider a game in which the worker chooses to either study or play in the
…rst period. The …rm observes this action (but cannot observe the worker’s type) and
then chooses to either hire or not hire the worker in the second period. If the …rm hires
the worker, then the …rm’s payo¤ is Ri w and the worker’s payo¤ is w ci where
i 2 fH; Lg : If the …rm does not hire the worker, then the …rm’s payo¤ is 0 and the
worker’s payo¤ is ci :

(a) Draw the extensive form (game tree) of this game. Clearly label players, strategies,
information sets, and payo¤s.
(b) Show that if w = 2; then there is a sequential equilibrium in which neither type
chooses to study and the …rm always hires the worker (a pooling equilibrium)
Your answer should include the updated beliefs (HjP ) and (HjS) about the
worker’s type and formally verify that the equilibrium is a sequential equilibrium.
(c) Now suppose the labor market is perfectly competitive with many …rms and work-
ers, and that 1/2 of the workers are type H. Does a separating equilibrium exist?
If yes, then determine the equilibrium contracts (wage paid to each type) and ex-
plain why separation of types is possible. If no, then explain why not and propose
an alternative equilibrium concept under which separation of types occurs, and
explain why separation of types is possible using this equilibrium concept.

1
3. Salesforce Compensation with Limited Liability A …rm hires salespeople who
can exert either a high or low level of e¤ort, e 2 fh; lg. The outcome of a salesperson’s
e¤ort is sales s of either 0 or 1: If e = h; then s = 1 with probability 1. If e = l; then
s = 1 with probability q and s = 0 with probability 1 q: The cost of low e¤ort is
cl = 0 and of high e¤ort is ch where 0 < ch < 1 q: Salespeople have a reservation
utility U A = 0: Both the …rm and the salespeople are all risk neutral.

(a) Determine the optimal contract (and e¤ort level) the …rm should o¤er if e¤ort
can be observed.
(b) Show that if e¤ort cannot be observed, then the optimal level of e¤ort can still
be achieved with a contract that imposes a negative wage on the agent if s = 0:
Characterize the equilibrium contract (wages paid when s = 1 and when s = 0)
and calculate the expected surplus of the …rm and of a salesperson.
(c) Now suppose there is a limited liability constraint under which the contract must
specify non-negative wages. Determine the optimal contract o¤ered by the …rm
and determine the expected surplus of the …rm and of a salesperson. Explain any
di¤erences in expected surplus from what you found in part (b).
(d) With unobservable e¤ort, can limited liability lead the …rm to prefer low e¤ort?
Demonstrate your answer formally and explain.

4. Public Goods and the Groves Mechanism. Suppose three individuals have
values v1 = 10; v2 = 20 and v3 = 30 for a public good. These values are private
information to each individual. The cost c to the government of providing the public
good is c = 52: If the good is provided, it can simultaneously be utilized by all three
individuals. Groves proposed the following mechanism to make decisions regarding
provision of a public good under asymmetric information. Each individual is asked to
report a value bi : If b1 + b2 + b3 c; then the good is provided and each individual is
assessed a fee fi equal to the cost c minus the reported values of the other individuals
(e:g:; f1 = c b2 b3 ): If fi < 0; then individual i pays 0.

(a) Is truth-telling a dominant strategy under the Groves mechanism? De…ne what it
means for a mechanism to be truthfully implementable and formally verify your
answer.
(b) Show that the Groves mechanism does not generally satisfy a balanced budget
condition –i:e:; the fees charged to the three individuals will not cover the cost
of providing the pubic good.
(c) Suppose the government covers the di¤erence between the sum of the fees and
the actual cost of the project. If the individuals can credibly collude with one
another, is truth telling still a dominant strategy? Explain with an example.

2
 Microeconomic Theory Comprehensive Exam
August 27, 2015

Part I: Answer all questions.

1. For each statement, explain why it is true or false.
a. A law of supply follows from the fact that the profit function is convex in p.
b. In the expenditure minimization problem, the envelope theorem can be used to
derive Shephard’s lemma.

2. Suppose three commodities, and that at the price vectors, p1 = (2, 1, 2), p2 = (2, 2, 1), and
p3 = (1, 2, 2), the respective choices are x1 = (1, 2, 2), x2 = (2, 1, 2), and x3 = (2, 2, 1).
a. Define the weak axiom of revealed preference (WA).
b. For the above example, show that any two pairs of choices satisfy WA.
c. Are the choices compatible with a preference-based theory of demand? Explain.
d. When is WA compatible with a preference-based theory of demand?

3. Suppose the cost function is given by c(w, q) = 3 (w1w2w3)1/3q.

a. Calculate the conditional factor demands, z(w, q).
b. Derive the production function.
c. Calculate the long-run conditional own-price elasticity for z1(w, q).
d. Suppose z3 is fixed in the short run. Derive the short-run conditional own-price
elasticity for z1(w, q).

4. Consider a Robinson Crusoe economy, in which yams (y) are produced using labor (L)
according to the production function y = L1/2. Robinson’s utility is given by u(y, 1 – L) =
y1/2 (1 - L)1/2, and normalize the price of yams, py = 1.
a. Define a competitive general equilibrium for this economy.
b. Find the labor demand, labor supply, and equilibrium wage, and the equilibrium
allocation of labor and yams.
c. Suppose Robinson agrees to provide Friday with a salary equal to 50% of the
profits. Find the new equilibrium wage, labor, and Robinson’s consumption of
yams.
 Microeconomics Ph.D. Comprehensive Examination
August 2015
Part II: Answer all three questions below.

1. Optimal Risk Bearing.

(a) Suppose a risk-averse consumer is deciding on purchases of contingent claims in

a world with three possible future states. State and explain the fundamental
theorem of risk-bearing for this case, and derive and explain conditions under
which the consumer will purchase contingent claims to eliminate all risk. Clearly
de…ne your notation.
(b) Write down a model for an asset market with three future states. Clearly de…ne
what an asset is in your answer, and clearly de…ne the asset prices and returns,
and how these di¤er from contingent claims prices and returns.
(c) Under what conditions is the asset market in part (b) equivalent to the contingent
claims market in part (a)? Explain.

2. Auctions with an Entry Fee. Consider the following private-value auction of a

single object, whose value to the seller is 0. There are two buyers, 1 and 2. The value
of the object for each buyer i 2 f1; 2g is vi so that if i buys the object at a price p; his
payo¤ is vi p; and if he does not buy the object, his payo¤ is 0. Assume that v1 and
v2 are independently and identically distributed uniformly on [v; 1] where 0 v < 1:
The seller uses a sealed-bid …rst-price auction to sell the item.

(a) Compute the symmetric Bayesian Nash equilibrium in linear strategies bi = a+cvi
(determine the values of a and c as a function of v), and compute the expected
utility of a buyer for whom the value of the object is v.
(b) Now assume that v1 and v2 are independently and identically distributed uni-
formly on [0; 1] (and vi is private information to buyer i): In addition, the seller
imposes an entry fee of 2 (0; 1) which a buyer must pay to submit a bid in the
auction. In the …rst period each buyer simultaneously decides whether to pay
to enter the auction. Each buyer’s decision is then observed by all players. In
the second period the seller runs the sealed-bid auction as in part (a) : If only one
player enters the auction then he wins with a bid of b = 0; while if both bidders
enter they auction, they use linear bidding strategies (as in part (a)). Compute
the symmetric sequential equilibrium of this game – determine the equilibrium
bidding strategies and the value of chosen by the seller. [Hint: In the entry
stage, there is a cuto¤ level v~ such that buyer i enters the auction if and only if
vi > v~: This cuto¤ v~ is then equivalent to v in part (a):]

1
3. Product Quality and Price Discrimination. A monopolist can produce a good in
di¤erent qualities. The cost of producing a unit of quality s is C (s) = s2 . Consumers
buy either one or zero units and have the utility function

s if one unit is consumed

u (sj ) =
0 if nothing is consumed

The monopolist decides on the quality levels it is going to produce and the price for
each di¤erent quality level. Consumers observe qualities and prices and decide which
quality to buy.

(a) Characterize the …rst-best solution (i.e. the quality level and price for a type
consumer when the monopolist observes ).
(b) In general, what condition is necessary for a monopolist to separate di¤erent
consumer types if cannot be observed? Is this condition satis…ed in this problem?
Explain.
(c) Suppose that the seller cannot observe , and suppose that

H with probability 1
=
L with probability

where H > L > 0: Assume the monopolist sells two products (two di¤erent
quality levels, sH and sL at prices pH and pL ; respectively). Characterize this
equilibrium mathematically (i.e., state and solve the monopolist’s maximization
problem), and use a diagram to illustrate.
(d) Is the outcome in part (c) e¢ cient? Explain why or why not.
Now suppose that many other …rms enter this industry, so that it is perfectly
competitive.
(e) Use a diagram to illustrate the competitive, separating equilibrium assuming one
exists.
(f) Is the reactive equilibrium concept helpful in the context of this problem? Explain
why or why not.

2
PhD Macroeconomic Comprehensive Exam (February 2015) 1

Basic DSGE modeling [55 pts]

Consider the following set-up for a typical consumer optimization problem in DSGE models.
The consumer is “small” or atomistic in the sense that she/he takes all prices as given.
The representative consumer has preferences given by the utility index:
" #1−σ
Ct − hCt−1 − ψ
Lη+1
η+1 t
−1
 
U Ct , Lt =
1−σ
where Ct is consumption, h parametrizes the internal habit, Lt is the time spent working
and the parameters σ > 1, ψ > 0 and η > 0 shape the consumer’s preferences.
The consumer owns the stock of physical capital Kt which depreciates at a rate δ and
faces a convex investment-adjustment cost S(xt ). Following Christiano, Motto, and Rostagno
(2014) the convex cost is given by:
)
1
 h√ i h √ i
S(xt ) = exp S 00 (xt − x) + exp − S 00 (xt − x) − 2 , (1)
2
with xt := ζt It /It−1 , where ζt is an investment shock and It is the investment level. Note
that in steady state S(x) = S 0 (x) = 0 and S 00 (x) = S 00 , with S 00 > 0. To be clear, note that
every unit of additional investment produces 1 − S(xt ) units of additional capital. Finally,
capital takes one period to become productive, that is, at t the capital used in production is
Kt−1 .
In every period the consumer can issue a one-period bond bt to be repaid at t + 1 with
a gross interest rate Rt determined at t. The sources of resources for the consumer are: the
rental of capital at a rate zt , labor income with a wage rate wt , bonds and lump-sum transfers
that amount the firms’ profits (Πt ); the uses of resources are consumption, investment and
the repayment of bonds.
PhD Macroeconomic Comprehensive Exam (February 2015) 2

Instructions: Let β ∈ (0, 1) be the subjective discount factor, λt the Lagrange multiplier
of the budget constraint and let λt Qt be the Lagrange multiplier of the law of motion of
capital,

A. Formalize the consumer problem using a Lagrange function. In your answer, clearly list
the variables that the consumer chooses and which ones takes as given.

B. Obtain the first-order conditions.

C. Log-linearize the relevant f.o.c.’s to obtain the Euler equation for bonds in terms of λ
and discuss its economic interpretation—including the economic interpretation of λ.

D. Log-linearize the relevant f.o.c.’s to obtain the marginal Tobin’s Q. Discuss the economic
interpretation of Q and the key assumptions made in the model to obtain a dynamic
(marginal) Tobin’s Q.

E. Log-linearize the relevant f.o.c.’s to obtain the investment equation. Discuss the its
economic interpretation and the key assumptions made in the model to obtain a second-
order difference equation for investment.

F. Log-linearize the relevant f.o.c.’s to obtain the labor supply. Is there a wealth effect in
the labor supply? Discuss the dual role of h in this setting.
PhD Macroeconomic Comprehensive Exam (February 2015) 3

Method of undetermined coefficients [35 pts]

Instructions: solve the following system of linear rational expectations equations with the
method of undetermined coefficients.

zt = −0.4Kt−1 + At (2)
λt = 1.5Kt − 1.5Kt−1 − At (3)
λt = Et λt+1 + Et zt+1 (4)

with At ∼ N (0, 1).

A. Show the guess to solve the system with the method of undetermined coefficients.

B. Solve the system and:

• clearly show the quadratic equation associated to the solution method

• show both roots

C. Compute the unconditional variance of Kt

Short Answer [20 points]

A. We saw in the basic New Keynesian model with sticky prices that price stabilization is
optimal. However, we saw with the addition of sticky wages, price stabilization was no
longer optimal (in general). Explain why this is.

B. In a sticky wage model with two assumptions (1) separable utility

C 1−σ N 1+χ
U (C, N ) := −
1−σ 1+χ

and (2) complete asset markets, it can be shown in equilibrium that consumption is inde-
pendent of wage history, i.e., consumers will have the same consumption path indepen-
dent of when they last changed their wage. Explain (intuively) why these two assumptions
deliver this result and the signficance of this result in terms of model tractability.
PhD Macroeconomic Comprehensive Exam (February 2015) 4

Indexation and Backward-Looking Inflation [70 points]

The basic New Keynesian model along with its policy analysis was in a framework where
there is Calov pricing: some firms get to choose a new price and others must stick with
their old price (a simple type of pricing rule). One modification of the model to consider is
to allow a different type of pricing rule where subsequent prices do not stay fixed, but are
indexed to lagged inflation.
With probability 1 − θ, firm j gets to select a new price Pt (j)∗ . Let Pt,t (j) := Pt (j)∗ .
Now subsequent prices for firm j that selects a price Pt,t (j) are given by

Pt+k+1,t (j) = (Πt+k−1,t+k )ω Pt+k,t (j), for k = 0, 1, 2, . . . ,

where Πt+k−1,t+k := Pt+k /Pt+k−1 and ω ∈ [0, 1] is the degree of indexing. Note that ω = 0
gives the standard Calvo model. Solving this forward, we have
 ω
∗ Pt+k−1
ω
Pt+k,t (j) = Πt−1,t+k−1 Pt (j) ≡ Pt (j)∗ for k = 0, 1, 2, . . . .
Pt−1

Everything else in the model is the same. A CES Dixit-Stiglitz aggregator gives the usual
demand for firm j’s good:
 −
Pt+k,t (j)
Yt+k|t (j) := Ct+k ,
Pt+k

where Ct+k is aggregate demand. Assume that production for firm j is given by a constant
returns to scale production function

Yt (j) := At Nt (j),

where total factor productivity At is common to all firms and follows an exogenous AR(1)
process (in logs): Ât = ρa Ât−1 + et (et iid, mean 0 with bounded support). Assume standard
preferences for the household (expected discounted utility) with the single period utility
function
Ctσ N 1+χ
− t ,
1−σ 1+χ
with σ, χ > 0. For firm j that gets to select a price in period t, its pricing problem is to
∞
X
θk Et Qt,t+k πt+k|t (j)

max∗
Pt (j)
k=0

where Qt,t+k := β k (Ct+k /Ct )−σ (Pt /Pt+k ) is the standard stochastic discount factor and

πt+k|t (j) := Pt+k|t (j)Yt+k|t (j) − Wt+k Nt+k|t (j)d .

Suppose steady state 1 = Π∗ = Πt := Pt /Pt−1 .

PhD Macroeconomic Comprehensive Exam (February 2015) 5

A. (5 pts) The price level index is the same:

1
Z 1  1−
1−
Pt := Pt (i) di .
0

Derive a log-linear expression for the evolution of inflation πt := ln Pt −ln Pt−1 := pt −pt−1
as a function of lagged inflation and p̂∗t := p∗t − pt−1 where p∗t := ln Pt∗ is the log of the
common price set by firms that get to reoptimize prices at time t.
∂πt+k|t (j)
B. (5 pts) Derive an expression for marginal profit ∂Pt (j)∗
.

C. (7 pts) Show that the first-order condition with respect to Pt (j)∗ is equivalent to the
following
X∞
θk Et Qt,t+k Yt+k|t (j)[Πωt−1,t+k−1 Pt (j)∗ − µM Ct+k|t (j)] = 0,
k=0

where µ := /( − 1) is the mark-up.

D. (5 pts) Show that the price FOC can be written as

∞
X Pt (j)∗
(θ)k Et Qt,t+k Yt+k|t (j)[Πωt−1,t+k−1 − µmct+k|t (j)Πt−1,t+k ]. (5)
k=0
P t−1

where mct+k|t (j) := M Ct+k|t (j)/Pt+k .

ˆ∗
Pt (j)
E. (8 pts) Log-linearize (5) and solve for p̂∗t := Pt−1
:= ln Pt (j)∗ − ln Pt−1 .

F. (5 pts) Derive an expression for the economy-wide average real marginal cost m̂ct as a
function of the output gap ỹt . Does this expression depend on price dispersion? Explain.

G. (20 pts) Use your answers from above to obtain a new Keynesian Phillips curve. Hint:
it should be of the form
π̂t = γb π̂t−1 + γf Et π̂t+1 + λỹt .
Be sure to provide expressions for γb , γf and λ.
PhD Macroeconomic Comprehensive Exam (February 2015) 6

H. (5 pts) Policy: is price stabilization optimal in this model? Explain. You may assume
a production subsidy that corrects the distortion due to monopolistic competition and
that Π−1 = 1 so that firms at t=0 who do not get to optimally set P0 (j), set price to
P−1 (j) (no change).

I. (10 pts) The dynamic IS equation is unchanged in this model. Using a backward-looking
Taylor rule of the form
R̂t = r̂tn + φπ π̂t−1 , with φπ > 0,
put the system in the following format:
   
ỹt+1 ỹt
 π̂t+1 
 = B  π̂t  .
 
Et 
 π̂t  π̂t−1 
Ât+1 Ât

You may use the γf , γb and λ notation.

What property with regard to eigenvalues of the matrix B are needed for local determi-
nacy? Explain.
Why is local determinacy a desirable property for a monetary policy?

References
Christiano, L. J., R. Motto, and M. Rostagno (2014): “Risk Shocks,” American
Economic Review, 104(1), 27–65.
 Microeconomic Theory Comprehensive Exam
August 21, 2014

Part I: Answer all questions.

1. For each statement, briefly explain why it is true or false.
a. For two commodities, the Slutsky matrices from the choice-based approach and
the preference-based approach are negative semidefinite and symmetric for the
same reasons.
b. In the finitely-repeated prisoner’s dilemma game, the players never achieve
cooperation.

2. Suppose a consumer’s utility function is given by u(x1, x2) = (1/3) ln x1 + (2/3) ln x2.
a. For the utility maximization problem (UMP), find the Walrasian demand
functions and indirect utility function.
b. Check the second-order conditions.
c. For good 1, calculate the own-price Walrasian and Hicksian elasticities of
demand. What do they imply about the Walrasian and Hicksian demand curves?
d. For the UMP, use the envelope theorem to derive Roy’s identity.

3. Two firms compete in outputs and produce a homogeneous product. Each firm’s cost is
given by c(q) =10q. Market demand is given by p = 34 – q.
a. Find the static Cournot equilibrium quantities, price, and profits.
b. Graph each firm’s best-response function and indicate the Cournot equilibrium.
c. Assuming they equally share the market, find the collusive output, price, and
profits.
d. In an infinitely-repeated game with grim trigger strategies, calculate the discount
factor which supports the cooperative outcome.

4. Consider a Robinson Crusoe economy, in which yams (y) are produced using labor (L)
according to the production function y = L1/2. Robinson’s utility is given by u(y, 1 – L) =
y1/2 (1 - L)1/2, and normalize the price of yams, py = 1.
a. Define a competitive general equilibrium for this economy.
b. Find the labor demand, labor supply, and equilibrium wage, and the equilibrium
allocation of labor and yams.
c. Suppose Robinson’s wage income is taxed at a rate of 50% with collected tax
revenues returned to him in a lump sum payment, R. Find the equilibrium wage,
and the equilibrium allocation of labor and yams.
d. Is the equilibrium in part (c) Pareto optimal? Sketch a graph and explain.
Advanced Microeconomic Theory Ph.D. Comprehensive Exam.
Part II: Answer all three questions below.

1. Optimal Risk Bearing.

(a) Suppose a risk-averse consumer is deciding on purchases of contingent claims in a

world with three possible future states. State and explain the fundamental theo-
rem of risk-bearing, and derive and explain conditions under which the consumer
will purchase contingent claims to eliminate all risk. Clearly de…ne your notation.
(b) Write down a model for an asset market with three future states. Clearly de…ne
what an asset is in your answer, and clearly de…ne the asset prices and returns,
and how these di¤er from contingent claims prices and returns.
(c) Under what conditions is the asset market in part (b) equivalent to the contingent
claims market in part (a)? Explain.

2. Pro…t Maximization with Unobserved E¤ort. A manufacturer supplies, at a

constant marginal cost of m = 50; a good to a risk-averse retailer who sells the good
on the …nal market. Demand in the …nal market depends upon the retailer’s e¤ort
e 2 f0; 1g; with high demand of P = 200 Q occurring with probability q(e) and
low demand P = 100 Q occurring with probability 1 q(e); where q (0) = 0:2 and
p
q (1) = 0:8: The retailer’s utility is u ( R ; e) = 2 R c (e) where R is the …nal
pro…t obtained by the retailer, c (0) = 0 and c (1) = 80: The manufacturer observes
…nal demand (either high or low), but not the retailer’s e¤ort level. The manufacturer
speci…es a pro…t split in which the manufacturer receives a payment t if high demand
is observed (in which case R = t where is the retailer’s pro…t which equals total
revenue less the 50Q paid to the manufacturer for the goods) and a payment t if low
demand is observed. The retailer chooses the market price after observing demand.

(a) Clearly de…ne the concepts of moral hazard and adverse selection and explain how
they are relevant to this problem.
(b) Suppose that the retailer’s e¤ort is observable. Verify that the manufacturer
prefers that the retailer choose high e¤ort, and characterize the contract the man-
ufacturer should o¤er the retailer.
(c) Suppose that the retailer’s e¤ort is unobservable. De…ne a residual claimant
contract (in particular, what is the relationship between t and t under a residual
claimant contract), and explain why such a contract is or is not feasible if the
agent’s e¤ort is unobservable.
(d) Explain the monotone likelihood ratio condition and why it is important in set-
tings like the one described here.
(e) State the manufacturer’s optimization problem for the case of unobservable e¤ort.
Clearly explain any constraints.
(f) Solve for the optimal contract ft; tg o¤ered by the manufacturer.

1
3. Auctions. Consider an auction with n bidders with private valuations which are all
random draws from the uniform distribution on the interval [0; 1]:

(a) Describe the equilibrium bidding strategies in the English auction.

(b) Calculate the equilibrium bidding strategies in a sealed-bid, …rst-price auction.
Note that the expected value of the highest random draw from a sample of n
draws from the uniform distribution is n=(n + 1); and the expected value of the
second highest draw from a sample of n draws is (n 1)=(n + 1):
(c) Determine the expected winning bid in both of the auctions above and verify the
revenue equivalence theorem.
(d) Does the revenue equivalence theorem for auctions hold if the good has a common
value? Explain.

2
 Microeconomic Theory Comprehensive Exam
June 26, 2014
Part I: Answer all questions.
1. For each statement, briefly explain why it is true or false.
a. In the proof of the second welfare theorem, convexity is needed to show that there
exists an equilibrium allocation.
b. By the envelope theorem, the derivative of the value function in the expenditure
minimization problem equals the Walrasian demand function.

2. Suppose that at the price vector p = (p1 = 2, p2 = 1), a consumer chooses bundle x consisting of
(x1 = 10, x2 = 20).
a. Define the weak axiom (WA) in terms of the Walrasian demand function, x(p, w).
b. Suppose the price vector changes to p’ = (4, 1). What, if any, restrictions does WA place
on the consumer’s choice (label as x’) and what does it illustrate about demand? Explain
and graph the budget sets and the chosen bundles.
c. Suppose the consumer is given the Slutsky wealth compensation. Define and illustrate in
your graph. After the compensation, what, if any, restrictions does WA place on the
consumer’s choice (label as x”) and what does it illustrate about demand?

3. Suppose the production function is given by f(z) = z1/4.

a. Solve the profit maximization problem and check the second-order condition.
Find the unconditional factor demand, supply, and profit functions.
b. Use Hotelling’s lemma to verify your answers in (a).
c. For this profit function, show that the matrix D2π(p, w) is positive semidefinite.
d. Find the cost function and show that it is concave in w.
e. Maximize profit using the cost function and verify your answer in (a).

4. Suppose there are two firms producing a homogeneous good, demand is given by
P = 80 – q, and each firm’s costs are given by c(q) = 8q.
a. For the static Cournot game, find the equilibrium outputs, price, and profits.
b. For the static Bertrand game, find the equilibrium outputs, price, and profits.
c. Assuming equal division of output, find the cooperative outputs, price, and
profits. For each static game, given that firm 1 cooperates, what is firm 2’s
optimal strategy?
d. In an infinitely-repeated version of the Bertrand game with grim trigger strategies,
calculate the discount factor which supports the cooperative outcome.
e. In a finitely-repeated version of the Cournot game with periods, t = 0, 1, …, T
with complete information, explain how to determine the subgame perfect Nash
equilibrium.
f. In a finitely-repeated version of the Bertrand game with incomplete information,
suppose that each firm is “crazy” with probability α and cooperates so long as its
rival has cooperated up to that point; otherwise, it plays the static outcome for the
rest of the game. Let the discount factor be 1. Show that cooperation dominates
cheating at time t = 0.
Part II: Answer all three questions below.

1. Quantity Discounts. Consider a monopolist that sells its product in a market with
two di¤erent types of consumers, i = 1; 2. The utility of a type i consumer is

ui = iV (q) T

where q is the number of units consumed and T is the amount paid by the consumer.
Assume V (0) = 0; V 0 (q) > 0 and V 00 (q) < 0 so the marginal utility of consumption is
positive but decreasing. Furthermore, 2 > 1 ; so the marginal utility of consumption
is strictly greater for the type 2 consumers. The fraction of type 1 consumers in the
market is and the fraction of type 2 consumers is 1 : The monopolist produces
units of the good at a constant marginal cost c:

(a) Mathematically characterize the optimal contracts o¤ered by the monopolist to

each type when consumer types are observable.
(b) Use a diagram with T on the vertical axis and q on the horizontal axis to illustrate
the reservation indi¤erence curves for each consumer (assume that the consumer
can always choose not to purchase, so the reservation utility is 0) and to illustrate
the full-information contracts (T1 ; q1 ) and (T2 ; q2 ) be o¤ered to each type when
consumer types can be observed. Also include isopro…t lines for the monopolist
in your diagram. Clearly label each curve and contract.
(c) Mathematically characterize the monopolist’s optimization problem when the
types cannot be observed. In particular, assume the monopolist chooses two
contracts (T1 ; q1 ) and (T2 ; q2 ) in order to maximize pro…ts. Provide a brief expla-
nation for any constraints that must be satis…ed.
(d) Use a diagram to illustrate the pro…t maximizing contracts o¤ered by the mo-
nopolist when consumer types cannot be observed. Brie‡y explain how these
contracts are derived. Does the monopolist o¤er a quantity discount?
(e) Mathematically demonstrate that when types cannot be observed, the …rm’s prob-
lem can be restated as an unconstrained problem in terms of the quantities q1 and
q2 : Use this problem to verify that the quantity q2 sold to the type 2 consumers is
e¢ cient while the quantity q1 consumed by the type 1 consumers is not. Brie‡y
explain why.
(f) What happens as the fraction of type 1 consumers becomes very small? Use a
diagram to illustrate your answer. Include a discussion of how the pro…t generated
by the contract o¤ered to each consumer type changes as decreases.
(g) Now suppose the market is perfectly competitive with many …rms producing the
product at a constant marginal cost of c: Does the Wilson equilibrium di¤er from
the Nash equlibrium? Explain (clearly de…ne the Wilson equilibrium concept in
your answer). Use a diagram to illustrate your answer.

2. Salesforce Compensation A …rm hires salespeople who can exert either a high or
low level of e¤ort. if the agent’s e¤ort level is high, then he gets a large sale with

1
 probability .7, and the low sale with probability 0.3, while if his e¤ort level is low, the
probabilities are 0.2 and 0.8, respectively. A large sale generates revenue of $20,000
for the …rm and a low sale generates $5000. Exerting high e¤ort imposes a cost of
cH = 50 on the agent, while exerting low e¤ort imposes no cost –cL = 0: Salespeople
have a reservation utility U A = 25 which can be achieved by working in a di¤erent
industry. The …rm is risk-neutral with utility uP = S w; where S is the value of the
sale generated by the salesperson
p and w is the wage, and the salesperson’s Bernoulli
utility function is uA = w c:

(a) Determine the optimal contract for the …rm to o¤er salespeople if e¤ort can be
observed.
(b) If the salesperson’s e¤ort level cannot be observed, is a residual claimant contract
optimal? Explain. Your answer should de…ne a residual claimant contract.
(c) Suppose e¤ort cannot be observed. Write the principal’s maximization problem
and clearly explain each constraint. Solve the maximization problem for the pro…t
maximizing contract o¤ered by the …rm.

3. Patent Race. Consider the following patent race problem. Three …rms, i = 1; 2; 3;
compete to develop a new product. The time T (xi ) at which a given …rm i discovers
the product is a function of research spending xi , where T 0 (x) < 0: The …rst …rm to
make the discovery (the winner of the patent race) captures the entire value V of the
innovation and earns a pro…t of V xi : The other two …rms lose their R&D expenditure.
Firms compete in the value xi of R&D spending.

(a) Argue that there is no pure strategy Nash equilibrium to the patent race problem
with three …rms.
(b) Based on your answer to part (a) we can conclude that each …rm must adopt a
mixed strategy in equilibrium. Prove that the minimum expenditure x in each
…rm’s equilibrium mixed strategy must be x = 0 and that the maximum ex-
penditure x must be x = V: Hint: what must each …rm’s expected pro…t be in
equilibrium?
(c) Find the symmetric mixed strategy equilibrium with three …rms. Your equilibrium
strategy should specify an equilibrium cumulative distribution function G(x) such
that G(x) = Pr(xi x) for 0 x V:
(d) Note that because there is no discounting, the socially optimal level of R&D
spending is " ! 0: It is socially optimal to have the smallest possible level of
R&D spending by only one …rm because this R&D investment will (eventually)
generate an innovation worth V for a total surplus of V " which is maximized
as " ! 0: Given this fact use your solution found in part (c) to comment on
the social bene…ts of increased competition in R&D races (at least for the very
simplistic market structure de…ned by this game).

2
PhD Macroeconomic Comprehensive Exam (June 2013) 1

The exam is worth 180 points. Parts I and II are equally weighted (90 points
each).

Part I
I. Please answer the following short questions. (18 points)

A. Write down an example of GHH preferences in consumption Ct and

labor Lt . Explain the implications of such preferences in the la-
bor supply. For your discussion consider the relevant elements of
the budget constraint (wage wt ) and denote with λt the Lagrange
multiplier of the budget constraint. Derive the Labor supply. (6
points)
B. Write down the law of motion of capital Kt in a model with quadratic
investment-adjustment costs and variable capital utilization (ut ),
where the depreciation rate is increasing in the utilization rate δ(ut ).
Discuss the role of the convex costs and the variable capital utiliza-
tion in the model. (6 points)
C. Log-linearize the following first-oder condition with respect to con-
sumption:
" #−σ
1
(C) λt = Ct − Lψ+1
ψ+1 t

denote with x̄ the steady-state of x and with x̂t the linearized version
of x. (6 points)
PhD Macroeconomic Comprehensive Exam (June 2013) 2

II. Solve the following DSGE model. Consider a real business cycle econ-
omy with capital. (72 points, each part is equally weighted)

Consumer
The consumer derives utility from consumption ct and disutility from
labor Lt according to the preferences
!1−σ
ω
ct − η+1
(Lt )η+1 −1
U (ct , Lt ) =
1−σ
with ω > 0, η > 0, σ > 0, her budget constraint is

wt Lt + zt Kt−1 + Πt = ct + It (1)

the sources of resources are labor income with a wage rate wt , rents
from capital with a rental rate of zt and lump-sum transfer from the
firm, the uses of resources are consumption and investment It . The law
of motion of capita Kt is
 
Kt = 1 − δ Kt−1 + It (2)

where δ is the depreciation rate.

The consumer chooses ct , Lt , Kt , It , to maximize
∞
X
E0 β t U (ct , Lt ), (3)
t=0

where β ∈ (0, 1] is the subjective discount factor, subject to the budget

constraint (1) and the law of motion of capital (2).

Producer
The producer uses labor and capital to produce the consumption/investment
good with a technology

Yt = At (Kt−1 )α (Lt )(1−α)

PhD Macroeconomic Comprehensive Exam (June 2013) 3

Table 1: Calibrated Values

η=2 β=1 σ=1
δ=1 ω = 1/4 α = 1/2
ρ = 1/2 A = 1

where At is a technology shock that follows an AR(1) process in log-

linear terms:
Ât = ρÂt−1 + ˆt
with ˆ ∼ N (0, 1).
The producer choose Lt and Kt−1 to maximize profits subject to the
technology.

A. Formally define an equilibrium in this economy.

B. Let λt be the Lagrange multiplier of the budget constraint and Qt
the Lagrange multiplier of the law of motion of capital and construct
a Lagrange function to solve the consumer problem.
C. Obtain the first-order conditions for the consumer problem. Make
sure that you obtain all first order conditions (ct , Lt , Kt , It , λt &
Qt ) .
D. Obtain the first-order conditions for the producer problem. (Lt ,
Kt−1 and also the technology function itself). Together this is a
system of 9 equation in 9 variables: (Ct , Lt , Kt , It , λt , Qt , wt , zt ,
Yt ).
E. Qt can be rationalized as the shadow price of capital. From your
first order condition with respect to Kt discuss why.
F. Use the steady-state values in Table 1 to find the steady-state. Hint:
these values are chosen so that in steady-state L = 1, w = 1/4,
Y = 1/2, λ = 6, and the remaining values are easy to compute.
G. Log-linearize the system of equations around the steady-state. Af-
ter this point the variables below correspond to the log-linearized
version (I’ll omit the hat to save notation).
H. To reduce the system, first use the producer’s f.o.c. with respect to
labor ((1 − α)Y /L = w) together with the consumer’s f.o.c. with
PhD Macroeconomic Comprehensive Exam (June 2013) 4

respect to labor (ωLη = w) to obtain

Lt = 1/5Kt−1 + 2/5At (4)

I. Use the technology with the f.o.c. with respect to λ in equilibrium

(i.e. Y=C+I ) and the f.o.c. with respect to Q (i.e. law of motion
of capital) together with the result above to obtain

Ct = (1 + 1/5)Kt−1 − Kt + 2(1 + 1/5)At (5)

J. Use the f.o.c. of the producer with respect to K (i.e. αY /K = z)

with the result (4) to obtain

zt = −1/2 × (1 − 1/5)Kt−1 + (1 + 1/5)At = −0.4Kt−1 + 1.2At . (6)

K. Use 4 and 5 in the f.o.c. with respect to consumption to obtain

λt = 6/4Kt − 6/4Kt−1 − 3At . (7)

L. Finally using the consumer’s f.o.c.s with respect to I and K

λt = Et λt+1 + Et zt+1

together with 7 and 6 to obtain second order stochastic difference

equation in K.
M. Write the guess for the method of undetermined coefficients to solve
the equation
N. Calculate and show both roots for the endogenous state variable
O. Is the system stationary? Discuss.
P. Show the impulse responses of consumption and investment to the
technology shock.
Q. Calculate the variance of consumption and investment.
PhD Macroeconomic Comprehensive Exam (June 2013) 5

Part II
I. Short Answer: (12 points)

A. The basic New Keynesian model has both monopolistic competition

and sticky prices. Discuss the importance of both of these features
for the model. Be sure to discuss how the model performs when
only one of these features is included. (6 points)
B. Why is the New Keynesian model considered a better model for
guiding monetary policy than Classical models? Be sure to discuss
how money affects (or doesn’t affect) real variables in both types of
models. (6 points)
PhD Macroeconomic Comprehensive Exam (June 2013) 6

II. Monetary Policy in a Basic New Keynesian Model with Noisy Data.
(42 points)
Preferences are given by
∞
X
E0 β t U (Ct , Nt ),
t=0

where
Ct1−σ N 1+φ
U (Ct , Nt ) := − t
1−σ 1+φ
with σ, φ > 0. Nt is labor and Ct is the consumption of a composite
good given by a CES aggregator:
Z 1 
 −1
−1
Ct = ct (j)  dj
0

Pt is the price index

1
Z 1  1−
1−
Pt := pt (j) dj
0

where  > 0 and ct (j) is the amount of good j with nominal price pt (j).
Output by firm j is produced according to yt (j) = Nt (j)α . The model
is parameterized according to α = 1/2,  = 2, β = 0.5, σ = 1, φ = 2,
θ = 0.5.
Suppose we have the standard dynamic IS curve
1 n

ỹt = Et ỹt+1 − R̂t − Et π̂t+1 − r̂t
σ
and the New Keynesian Phillips curve
π̂t = βEt π̂t+1 + κỹt .
Suppose the natural rate is constant so r̂tn = 0. The monetary authority
measures inflation π̂tm with error:
π̂tm := π̂t + νt ,
where νt is iid mean zero with bounded support. Monetary policy fol-
lows a Taylor rule based on measured inflation:
R̂t = φπ π̂tm .
PhD Macroeconomic Comprehensive Exam (June 2013) 7

A. Confirm that κ = 1.5. (3 points)

B. State necessary and sufficient conditions for local determinacy (as-
suming φπ > 0). No need to derive this condition (you may assume
it holds for remaining parts). Why is local determinacy an impor-
tant consideration for monetary policy design? (3 points)
C. Solve for the equilibrium π̂t and ỹt . Explain intuitively how these
variable depend on νt . (10 points)
D. As φπ approaches infinity, what happens to equilibrium π̂t and ỹt ?
How does this differ from the standard model where νt = 0 (no
measurement error)? Explain. (10 points)
E. What value of φπ minimizes the variance of inflation and the output
gap? Again, how does this differ from the standard model where
νt = 0 (no measurement error)? Explain. (10 points)
F. True or False: It might be welfare improving (in terms of expected
utility) for the monetary authority to adopt a Taylor rule as written
above with φπ = 0. Explain. (6 points)
PhD Macroeconomic Comprehensive Exam (June 2013) 8

III. Cash-in-Advance: (36 points)

Suppose we have preferences give by
∞
X
E0 β t V (C1t , C2t , Nt ),
t=0

where
N 1+χ
V (C1 , C2 , N ) := ln C1 + ln C2 −
1+χ
with χ > 0 and 0 < β < 1. Technology is Yt = Nt . The household’s
budget constraints are

Pt C1t ≤ Mt−1 + Tt , (8)

Mt + Qt Bt ≤ Mt−1 + Bt−1 + Wt Nt + Πt + Tt − Pt (C1t + C2t ), (9)

where Bt is nominal bond holding, Wt is the nominal wage, Πt is nominal

profit, Tt is lump-sum transfer from the government (exogenous) and
Pt is the nominal price of the consumption goods. Suppose monetary
policy follows:
Mt+1 = Γt+1 Mt ,
where
Γ̂t+1 = τ Γ̂t+1 + et+1 ,
where |τ | < 1, et+1 is iid mean zero, variance σe2 with bounded support.
The government set Bt = 0 for all t and set Tt := Mt − Mt−1 .
Suppose β = 7/9, τ = 1/2, Γ̄ = 1 (steady state Γ) and χ = 1.

A. Define a rational expectations competitive equilibrium for this model.

(3 points)
B. Write down the equilibrium conditions for this model (FOCs and
market clearing). (10 points)
C. Solve for the steady state. (10 points)
D. Log-linearize the equilibrium conditions and solve for the equilib-
rium m̂t as a function of Γ̂t . (10 points)
E. Solve for the optimal monetary policy as a growth rule. Explain
intuitively why this rule is optimal. (3 points)
 Microeconomic Theory Comprehensive Exam
June 27, 2013

Part I: Answer all questions.

1. For each statement, briefly explain why it is true or false.
a. The Slutsky substitution matrix derived from the choice-based approach is
negative semidefinite.
b. In the proof of the second welfare theorem, the separating hyperplane represents
the Pareto optimal allocation.

2. Suppose the cost function is given by c(w,q) = (w1 1/2 + w21/2)2 q.

a. Find the conditional factor demands and the production function.
b. Show the cost function is concave in w by calculating the Hessian matrix.
c. State the envelope theorem and apply it to the cost minimization problem.

3. Consider a Robinson Crusoe economy, in which yams (y) are produced using labor (L)
according to the production function y = L1/2. Robinson’s utility is given by u(y, 1 – L) =
y1/2 (1 - L)1/2, and normalize the price of yams, py = 1.
a. Define a competitive general equilibrium for this economy.
b. Find the labor demand, labor supply, and equilibrium allocation of labor and
yams.
c. Suppose Robinson’s wage income is taxed at a rate of 50%, with collected
revenues returned in a lump sum payment, R. Recalculate the equilibrium
allocation of labor and yams.

4. Suppose there are two firms producing a homogeneous good, demand is given by
P = 58 – q, and each firm’s costs are given by c(q) = 10q.
a. Find the static Cournot equilibrium outputs, price, and profits.
b. Find the cooperative outputs, price, and profits, assuming equal sharing of output.
c. In an infinitely-repeated game with grim trigger strategies (cooperate; if rival
cheats, play static outcome for rest of game), calculate the discount factor which
supports the cooperative outcome.
d. For the Bertrand model, recalculate the discount factor which supports the
cooperative outcome.
Part II: Answer all four questions below.
1. Expected Utility. Suppose a risk-averse consumer is deciding on purchases of con-
tingent claims c1 and c2 at price p1 and p2 in a world with two possible future states
which occur with probability and 1 ; respectively. The consumer spends his entire
wealth w on contingent claims. Let u ( ) denote the utility of …nal wealth.

(a) State the consumer’s expected utility maximization problem, then derive condi-
tions under which the consumer will purchase contingent claims to eliminate all
risk. Show all work.
(b) Interpret the condition found in part (a) –in particular, why would the consumer
choose not to eliminate all risk if this condition is not satis…ed?
p
2. Moral Hazard. Suppose an agent has a preference scaling function v = w c where
the cost of e¤ort is c1 = 0 or c2 = 2 and the agent’s reservation utility level is U = 4.
The principal is risk-neutral. Output can take one of two values, 49, or 100. The
principal observes output, but cannot observe the agent’s e¤ort level. The probability
of each output level as a function of e¤ort is de…ned in the following table:
49 100
E¤ort = 1 :4 :6
E¤ort = 2 :2 :8

(a) Can a residual claimant contract be used to e¢ ciently solve the moral hazard
problem? Explain.
(b) Explain the monotone likelihood ratio condition and determine whether it is sat-
is…ed for the table above.
(c) Assuming e¤ort = 2 is optimal for the principal, solve for the optimal contract
o¤ered by the principal if the agent’s e¤ort level cannot be observed.

3. The All-Pay Auction. Consider a variation of the sealed bid, …rst price auction in
which the highest bidder wins and all bidders pay their bids (whether they win or not).
In addition assume that each bidder has an identical valuation v for the object and
that all bidders know this. There are 2 bidders competing to win the object.

(a) Is it possible for bidders to adopt pure bidding strategies in this auction? Explain.
(b) Find the symmetric Nash equilibrium bidding strategies as a function of v: Hint:
Let G (b) denote the equilibrium bid distribution function and g (b) denote the
corresponding density function. Solve for G (b) (note, you will …rst …nd g (b)) as
a function of v; and also determine the support (minimum and maximum bids)
of the equilibrium bid distribution function.
Now suppose that there are only two bidders, that each bidder’s valuation is one of
two values vh or vl where 0 < vl < vh and Pr (v = vh ) = : Each bidder knows his
own valuation but not that of the competing bidder. Assume that in equilibrium
it is optimal for a type vh bidder to adopt a strategy that ensures he will always
beat a type vl bidder.

1
 (c) Derive the Bayesian-Nash equilibrium bidding strategies for each bidder type (the
equilibrium bid distribution functions and minimum and maximum bids for each
type). Hint: …rst …nd the equilibrium bid distribution function for type l following
the process in part (b), then solve for type h:
(d) Describe a social choice function that can truthfully implement the equilibrium
found in part (c).

4. Quantity Discounts? Consider a monopolist that sells its product in a market with
two di¤erent types of consumers, i = 1; 2. The utility of a type i consumer is

ui = iV (q) T

where q is the number of units consumed and T is the amount paid by the consumer.
Assume V (0) = 0; V 0 (q) > 0 and V 00 (q) < 0 so the marginal utility of consumption is
positive but decreasing. Furthermore, 2 > 1 ; so the marginal utility of consumption
is strictly greater for the type 2 consumers. The fraction of type 1 consumers in the
market is and the fraction of type 2 consumers is 1 : The monopolist produces
units of the good at a constant marginal cost c:

(a) Mathematically characterize the monopolist’s optimization problem de…ning the

optimal contract for the type i consumers as a function of Ti and qi when types
are observable. Derive and interpret the …rst-order condition determining the
optimal quantity qi sold to each type.
(b) Argue that the contracts o¤ered in part (a) cannot be implemented if the monop-
olist is unable to observe each consumer’s type.
(c) Mathematically characterize the monopolist’s optimization problem when the
types cannot be observed. In particular, assume the monopolist chooses two
contracts (T1 ; q1 ) and (T2 ; q2 ) in order to maximize pro…ts. Provide a brief expla-
nation for any constraints that must be satis…ed.
(d) Use the constraints from the monopolist’s problem in part (c) to restate this prob-
lem as an unconstrained problem that is a function of q1 and q2 only. Derive the
…rst-order conditions and use them to determine whether either of the quanti-
ties q1 or q2 is economically e¢ cient. Provide economic intuition for why these
quantities are or are not e¢ cient.
(e) Use a diagram with T on the vertical axis and q on the horizontal axis to illustrate
the results found in part (d). Include isopro…t lines in your diagram. Does the
monopolist o¤er a quantity discount? Explain why the monopolist is or is not
able to separate the two types.
(f) Suppose that instead of a monopolist, there are many competing sellers. Would
a separating equilibrium exist? Explain.

2
 Microeconomic Theory Comprehensive Exam
January 3, 2013

Part I: Answer all questions.

1. For each statement, briefly explain why it is true or false.
a. The choice-based and preference-based approaches are equivalent in that
preferences can be recovered from the demand function.
b. In a Robinson Crusoe economy, the Walrasian equilibrium is Pareto optimal, even
if Robinson Crusoe’s wage income is taxed.

2. Suppose the cost function is given by c(w, q) = q2 (1/w1 + 1/w2)-1.

a. Find the conditional factor demands, z(w, q).
b. For input z1, calculate the long-run conditional own-price elasticity.
c. Find the production function.
d. For input z1, calculate the long-run unconditional own-price elasticity. How does
it compare to the elasticity in part (b)?

3. Suppose consumers have quasilinear utility functions, ui(mi, xi) = mi + ln (xi), where
consumer i’s consumption of the numeraire is mi (with price pm) and of good l is xi (with
price px).
a. Find the Walrasian demand functions.
b. Calculate the income and substitution effects for each good.
c. In a partial equilibrium analysis of a competitive market for good l, why is
quasilinear utility appropriate?

4. Consider the following prisoners’ dilemma game. If the two prisoners cooperate with
each other, they each receive a 2 year prison sentence (payoff -2). If one prisoner defects
and the other prisoner cooperates, they receive payoffs of -1 and -8, respectively. If they
both defect, they each receive -5.
a. Write the normal form and find the Nash equilibrium.
b. In a finitely repeated version of this game with periods t = 0, 1, ...,T, what is the
subgame perfect Nash equilibrium? Explain.
c. Next, consider the infinitely repeated game with grim trigger strategies. To
achieve cooperation, what is the necessary condition on the discount factor, δ?
d. Suppose the game is finite with incomplete information about prisoner types.
With probability α, a player is “crazy” and cooperates so long as his partner has
cooperated up to that point; otherwise, he defects. Let the discount factor be 1.
Show that cooperation dominates defecting at t = 0 for T sufficiently long. What
is likely to occur near the end of the game?

Exam #10
Part II: Answer any three (3) of the following four (4) questions.

1. Consider a moral hazard model with a risk-neutral principal and a risk-averse agent.
The agent can choose between two e¤ort levels ai 2 fa; ag with associated costs of
ci 2 fc; cg = f0; cg with c > 0: The e¤ort level randomly results in one of two pro…t
levels (not including wage payments). In particular, 2 fx; xg ; and, letting p =
Pr ( = x j ai = a) and p = Pr ( = x j ai = a) ; assume p > p (i.e., the low pro…t is
more likely to occur if the agent chooses the low e¤ort level – also note that this
notation implies Pr ( = x j ai = a) = 1 p and Pr ( = x j ai = a) = (1 p)). The
agent’s utility function is
u (w; ci ) = ln w ci :
The agent’s outside option has a value of 0: (The principal’s net pro…t is x w):

(a) Carefully describe the principal-agent problem when the principal wishes to im-
plement the high e¤ort level a:
(b) Solve for the optimal wage schedule to be o¤ered the agent assuming the principal
prefers ai = a: Show all work.

2. The owner of a small …rm is contemplating selling all or part of his …rm to outside
investors. The pro…ts from the …rm are risky and the owner is risk averse. The owner’s
preferences over the fraction x of the …rm the owner retains, and the price p per-share
paid by outside investors is given by

u (x; ; p) = x x2 + p (1 x) ;

where is the value of the …rm. (The x2 term re‡ects the owner’s risk-aversion.) The
outside investors are risk-neutral and the return to the outside investor who pays the
owner a price p per share to purchase a fraction (1 x) of the …rm is

( p) (1 x) :

There are many outside investors. The owner …rst chooses the fraction (1 x) of the
…rm to sell and the outside investors then make an o¤er of the price p per share they
are willing to pay. Shares are sold to the investor making the highest o¤er.

(a) Suppose is public information. What fraction of the …rm will the owner sell,
and how much will he receive for it?
(b) Suppose now that is privately known by the owner. The outside investors have
common beliefs assigning probability 2 (0; 1) to = 1 > 0 and probability
1 to = 2 > 1 : Characterize the separating (perfect Bayesian) equilibrium.
(c) Are there any other perfect Bayesian equilibria? Explain.

1
3. Consider a risk averse consumer purchasing contingent claims c1 and c2 to consumption
in two possible future states. State 1 occurs with probability 1 ; and state 2 occurs with
probability 2 where 2 > 1 . The prices at which contingent claims to consumption
in either state can be purchased are p1 and p2 ; respectively, and the consumer’s utility
from consumption in either state is u (c) :

(a) Under what conditions, if any, will a highly risk averse consumer choose c1 > c2 ?
Show your answer mathematically and intuitively explain.
(b) Is this contingent claims market the same as an asset market? Clearly explain
why or why not.

4. A corrupt politician decides to conduct a “bribe” auction to determine which of two

construction companies will be awarded a lucrative building contract. Each construc-
tion company has a private, independent value v for the project, and values are uni-
formly distributed over the interval from $0 to $1 million. Each company knows its
own value, but doesn’t know its rival’s value. In a bribe auction, each pays cash (simul-
taneously) to the politician. The politician awards the contract to the …rm submitting
the highest bribe and keeps all of the cash.

(a) Consider a sealed-bid, …rst-price auction. Suppose that you conjecture that your
rival will bid according to the strategy b (v) = av 2 : Construct your pro…t maxi-
mization problem and derive your optimal bidding function given your valuation
v1 .
(b) Determine the (symmetric) equilibrium value of a:
(c) Explain what it means for a mechanism to be truthfully implementable in dom-
inant strategies, and discuss whether the auction derived above is truthfully im-
plementable.

2
PhD Macroeconomic Comprehensive Exam (January 2013) 1

I. Consider a real business cycle economy with capital technology that

allows for variable capital utilization. That is, from the productive
capital stock Kt−1 the consumer chooses a utilization rate ut ∈ [0, 1]
and rents the the effective capital ut Kt−1 to the producer at a rental
rate zt . The trade off for the consumer is that the higher the utilization
rate the higher the depreciation rate is. That is, the depreciation rate
increases with the utilization rate.

Consumer
The consumer derives utility from consumption ct and disutility from
labor Lt according to the preferences
!1−σ
1
Ω ct − η+1
Lη+1 −1
U (ct , Lt ) =
1−σ
with Ω > 0, η > 0, σ > 1, her budget constraint is

wt Lt + zt ut Kt−1 = ct + It (1)

the sources of resources are labor income with a wage rate wt and rents
from capital with a rental rate of zt and utilization rate ut , the uses
of resources are consumption and investment It . The law of motion of
capita Kt is  
Kt = 1 − δ(ut ) Kt−1 + It (2)
where
δc
δ(ut ) = δa + δb (ut ) + (ut )2
2
with δs defined below.
The consumer chooses ct , Lt , Kt , It , ut to maximize
∞
X
E0 β t U (ct , Lt ), (3)
t=0

where β ∈ (0, 1] is the subjective discount factor, subject to the budget

constraint (1), law of motion of capital (2), and depreciation function.

Exam # 15
PhD Macroeconomic Comprehensive Exam (January 2013) 2

Table 1: Calibrated Values

w=1 u=1 K=4
η=2 β=1 σ=1
δa = 1/4 δb = 0 δc = 1/2 (⇒ δ = 1/2)
Ω = 2/3 (⇒ λ = 1)
ρw = 1/2

To simplify the model, we close the economy by assuming that the

rental rate of capital responds to changes in investment and the wage
rate according to the process

ln(zt ) = Γ − ln(It ) + ln(wt ) (4)

and the wage rate is given by:

ln(wt ) = (1 − ρw ) ln(w) + ρw ln(wt−1 ) + ln(w

t ) (5)

with ln(w
t ) ∼ N (0, 1). Note that Γ is just to ensures that w and z can
have different steady-state values (which they will).

A. Let λt be the Lagrange multiplier of the budget constraint and Qt

the Lagrange multiplier of the law of motion of capital. Construct
a Lagrange function to solve the consumer problem.
B. Obtain the first-order conditions for the consumer problem. Make
sure that you obtain all seven first order conditions (ct , Lt , Kt , It ,
ut , λt & Qt ).
C. Briefly discuss the role of GHH preferences in the labor supply – con-
trast it for example against a utility index separable in consumption
and labor.
D. Qt can be rationalized as the shadow price of capital. From your
first order condition with respect to Kt discuss why.
E. Use the steady-state values in Table 1 to find the steady-state for the
remaining variables. Hint: these values are chosen so that δ = 1/2,
c = λ = 1 and the remaining values are easy to compute.

Exam # 15
PhD Macroeconomic Comprehensive Exam (January 2013) 3

F. Using the steady-state values show that using (4), (5) and the first-
order condition with respect to (ut ) we obtain

ŵt = ρw ŵt−1 + ˆw

t
ˆ
ẑt = ŵt − It
ût = ŵt − Iˆt

G. Use the first-order condition with respect to Qt and the facts δb +

δc + δ = 1, δ = 1/2 and δb + δc = 1/2 to obtain

K̂t = 1/2K̂t−1 − 1/2ŵt + Iˆt

H. From the first-order condition with respect to Lt show

L̂t = 1/2ŵt

I. From the first-order condition with respect to λt show

Ĉt = −6K̂t + 5K̂t−1 + 5/2ŵt (6)

J. From the first-order condition with respect to Kt , and using the fact
(z − δb − δc ) = 0 – so that ut drops – show:

Q̂t =Et Q̂t+1 + 1/2ŵt+1 − 1/2Iˆt+1



K. From the first-order condition of Ct show (use the previously found

results λt = Qt , Ω = 2/3, λ = 1 and others):

Q̂t = −3/2Ĉt + 3/4ŵt

L. Use the last two results to show


−3/2Ĉt + ŵt = Et − 3/2Ĉt+1 + 5/4ŵt+1 − 1/2K̂t+1 + 1/4K̂t
(7)

M. Use (6) in (7) to reduce the system to one equation in one endoge-
nous variable and one exogenous variable.

Exam # 15
PhD Macroeconomic Comprehensive Exam (January 2013) 4

N. Write the guess for the method of undetermined coefficients to solve

the equation
O. Calculate and show both roots for the endogenous state variable.
P. Is the system stationary? Discuss.
Q. Show the impulse responses of consumption and capital to one shock
to wages.
R. Intuitively discuss the effects of variable capital utilization in the
dynamics of investment.
S. (bonus 5 pts) Calculate the variance of consumption .

Exam # 15
PhD Macroeconomic Comprehensive Exam (January 2013) 5

II. Short Answer:

A. Policy in the Basic New Keynesian Model: the basic new Keynesian
model has two sources of suboptimality. Discuss what these are and
why they lead to suboptimal outcomes. Also discuss how policy
can be used to correct these two distortions and lead to an efficient
allocation.
B. Why are reduced-form VARs (unidentified) not useful for under-
standing how monetary policy affects the macroeconomy?

Exam # 15
PhD Macroeconomic Comprehensive Exam (January 2013) 6

III. Preference Shocks in the Basic New Keynesian Model: Preferences are
given by
∞
X
E0 β t U (Ct , Nt , Mt /Pt ),
t=0

where
Ct1−σ ψt Nt1+χ (Mt /Pt )1−ν
U (Ct , Nt , Mt /Pt ) := − +
1−σ 1+χ 1−ν
with σ, χ, ν > 0. Mt is money, Nt is labor, Ct is the consumption of a
composite good given by a CES aggregator:

Z 1  1−
−1
Ct = ct (j)  dj
0

Pt is the price index

1
Z 1  1−
Pt := pt (j)1− dj
0

where  > 0 and ct (j) is the amount of good j with nominal price pt (j).
ψt is a preference shock that affects the disutility of working. Assume
it follows a stationary AR(1) process:

ψ̂t = ρψ ψ̂t−1 + ut ,

where ut is iid mean zero with bounded support.

Firm j produces good j using labor according to

yt (j) = At Nt (j),

where Nt (j) is labor used by firm j and At is total factor productivity

(common to all firms). TFP follows an AR(1) process

Ât = ρA Ât−1 + et .

where 0 < ρA < 1 and et is iid with mean zero and bounded support.
Firms get to set prices in each period with probability 1 − θ. In the
event that firm j gets to select a price at period t, call this pt (j). This

Exam # 15
PhD Macroeconomic Comprehensive Exam (January 2013) 7

price remains fixed until the next reoptimization and firms must satisfy
demand. You may assume that price dispersion has no impact on output
(up-to first-order, as in lecture). You may also assume that monetary
policy is implemented so that inflation is zero in the deterministic steady
state and in terms of optimal policy, the impact on welfare due to real
money balances may be ignored.

A. Write down the household’s optimization problem for optimally choos-

ing {Ct , Nt , Mt , Bt } assuming competitive price-taking behavior. Let
Qt be the nominal discount price of the one-period nominal risk-free
bond. Derive the first-order conditions for a solution to this prob-
lem.
B. Derive log-linear labor supply from the first-order conditions. How
does labor supply respond to a preference shock? Explain.
C. Write down the demand for firm j output at time t + k for a firm
that selects its price pt (j) at time t. Call this expression yt+k|t (j).
Note: this will be a function of pt (j), Pt+k and Yt+k .
D. Write down firm j total nominal revenue and total nominal cost at
time t + k for a firm that selects price at time t. Denote these by
j j
T Rt+k|t and T Ct+k|t . Total revenue will be a function of pt (j), Pt+k
and Yt+k . Total cost will be a function of Wt (nominal wage), At ,
pt (j), Pt+k and Yt+i .
E. The firm’s FOC for profit maximization is the following:
∞
X
0= θk Et {Qt,t+k yt+k|t (j)[pt (j) − µM Ct+k|t (j)]},
k=0

where
β k UCt+k Pt
Qt,t+k := .
UCt Pt+k
Use this expression to argue that in the flexible price case (θ = 0),
the mark-up is constant in equilibrium.
j
F. Derive an expression for nominal marginal costs M Ct+k|t at time
t + k for firm j that set its price at time t. Substitute this expression
for nominal marginal costs into the first-order condition for profit
maximization stated above.

Exam # 15
PhD Macroeconomic Comprehensive Exam (January 2013) 8

G. Is the first-order condition for firm j stated above stationary? If

not, how would you make it stationary?
H. Derive expressions for real marginal costs mct+k|t (j) and average
real marginal costs in the aggregate mct+k and log-linearize these
expressions.
I. Derive an expression for the flexible price equilibrium level of output
(“natural level of output”) Ŷtn and the expected natural rate of
return r̂tn (these are log deviations from steady state values).
J. Do preference shocks affect Ŷtn and r̂tn ? If yes, explain how and
why. Does the sign of ρψ (positive or negative) matter? Explain
intuitively.
K. Let \
pt (j)
:= ln pt (j) − ln Pt .
Pt
Using the definition of the aggregate price index, derive an expres-
\
sion for ptP(j)
t
as a function of π̂t .
L. The log-linearized pricing equation for firm j is as in lecture:
∞
pd
t (j)
X
= (1 − βθ) (βθ)k Et [m̂ct+k|t (j) + π̂t,t+k ].
Pt k=0

After substituting for m̂ct+k|t (j) with an expression involving aggre-

gate average marginal cost, we can write this expression as

pd
t (j) p\
t+1 (j)
= (1 − βθ)m̂ct + βθEt π̂t,t+1 + βθEt .
Pt Pt+1

Use the expression for ptP(j) as a function of π̂t that you found above
d
t
to derive the following (show your work):
π̂t−1,t = λm̂ct + βEt π̂t,t+1 . (8)
Write down the expression for λ.
M. Use your expression for equilibrium m̂ct to derive the New-Keynesian
Phillips curve for this model. Recall that ỹt := ln Yt − ln Ytn . Do the
preference shocks ψt show up in the NKPC as a cost-push shock?
Why or why not?

Exam # 15
PhD Macroeconomic Comprehensive Exam (January 2013) 9

N. The dynamic IS curve is unchanged from lecture:

1
ỹt = Et ỹt+1 − (R̂t − Et π̂t+1 − r̂tn ).
σ
What nominal interest rate rule (Taylor rule) would be optimal?
How would the optimal nominal interest rate respond to TFP and
preference shocks? Explain why the interest rate rule is optimal
and discuss any issues related to local determinacy that might be
relevant. There is no need to explicitly compute eigenvalues.
Provide a money supply rule that would implement the optimal path
for output and inflation. How does the money supply respond to
TFP and preference shocks? Are there any local determinacy issues
that should be considered? Explain. Again, there is no need to
explicitly compute eigenvalues.
O. Suppose the model is parameterized so that we get the following
equilibrium restrictions:
    
ỹt+1 2.5408 0.4898 0 0 ỹt
 π̂t+1  −2.0816 1.0204 0 0   π̂t 
 
Et  =
Ât+1  

0 0 0.9 0  Ât 
ψ̂t+1 0 0 0 0.5 ψ̂t

Is the rational expectations equilbrium locally unique? Explain.

How do ỹt and π̂t respond to shocks to TFP and preferences? Ex-
plain.

Exam # 15
PhD Macroeconomic Comprehensive Exam (June 2012) 1

I. Consider an overlapping generations model where population growths at rate n. Each

agent lives for two periods and is endowed with one unit of time when young. The
initial old are each endowed with k0 units of capital. The production function is

F (Kt , At Lt ) = Ktα (At Lt )1−α

At is exogenous labor productivity. Capital accumulates according to Kt+1 = It (so

there is full depreciation). The young at time t buy the capital stock (Kt+1 ) and then
rent it at time t + 1 to competitive firms at the rental rate rt+1 . Agents preferences
over consumption streams are:

u(cyt , cot+1 ) = log cyt + β log cot+1 . (1)

The government levies lump sum taxes Tt on each young and issues Nt bt+1 one period
bonds. All markets are perfectly competitive.

A. Define a competitive equilibrium for this economy.

B. Solve for the household’s optimal consumption and saving rules.
C. Find the equation that describes the dynamics of the capital stock per capita (NOT
per young person).
D. For the case in which labor productivity, taxes and bond emissions are constant
(At = A, Tt = T, bt+1 = b) determine the expression that defines the steady state
level of capital per capita.
E. Draw the law of motion for capital in (kt+1 , kt ) space. Be precise about the details
of the graph, in particular the points at which the curves cut the different axes.
How many steady states does this economy exhibit? How many are stable?
F. Assume that initially the economy is in the highest stable steady state. Then the
economy experiences a productivity based recession, that is A falls permanently
from A0 to A1 (A1 < A0 ). What happens with the steady state level of capital and
output?
G. Suppose that the government wants to increase the steady state level of output.
1. Can the government achieve its goal by reducing taxes and increasing bond
emissions in the same amount (4b = −4T )?
2. What is the economic reason?
3. Do you think this is a realistic prediction?
4. What feature of the model is behind this result?
PhD Macroeconomic Comprehensive Exam (June 2012) 2

II. Consider a real economy where the representative consumer supplies labor, consumes
and can issue a real bond. The consumer preferences feature habit in labor (but not
in consumption), that is labor disutility depends on the average past labor. The repre-
sentative firm hires labor to produce the consumption good. There is no government,
no money and no physical capital in this real economy. The only source of economic
fluctuations is a technology shock.
The representative consumer has preferences given by the utility index:
" #1−σ
1

ψ+1
Ct − ψ+1 Lt − hL̃t−1 −1
 
U Ct , Lt =
1−σ

where Ct is consumption, Lt is amount of time spent in labor activities and L̃t is the
average time spend in labor activities, which is taken as given by the consumer; the
parameters ψ > 0 and σ ≥ 1 shape the consumer’s preferences.
The consumer can issue a real bond bt that pays a gross interest rate Rt . The sources of
income at time t are: labor income at a wage rate wt (1 − τ ) with τ ∈ [0, 1) borrowings
and lump-sum transfers of the firms’ profits (Πt ). Per-unit labor income received by
the consumer wt (1 − τ ) differs from the wage paid by the producer wt because workers
pay a the tax τ to a union. The union tax is just a device to simplify the steady-state
but plays no role in the dynamics of the model. The uses of resources are consumption
and the repayment of the borrowings with interests. The budget constraint is

wt Lt (1 − τ ) + bt + Πt = Ct + bt−1 Rt−1 . (2)

The consumer chooses consumption, labor and bonds taking wages, interests and past
average labor as given to maximize
∞
X  
t
β U Ct , Lt , (3)
t=0

where β ∈ (0, 1) is a subjective discount factor, subject to the budget constraint.

The producer chooses labor to maximize profits Yt − wt Lt subject to the production
function
Yt = At (Lt ) (4)
where At is a technology shock. The exogenous technology shock follows the AR(1)
process:
ln(At ) = ρ ln(At−1 ) + ln(t )
where ln(t ) ∼ N (0, 1) is a log-normal i.i.d. innovation.
Please answer the following questions. Note that each question has approximately the
same weight.
PhD Macroeconomic Comprehensive Exam (June 2012) 3

A. Define a competitive equilibrium in this economy.

B. Let λt be the Lagrange multiplier and construct a Lagrange function to solve the
consumer problem.
C. Obtain the first-order conditions for the consumer’s problem
D. Recall that the Frisch elasticity measures the response in labor to wages keeping
income constant. What is the short-term Frisch elasticity (on impact)? What is
the long-term Frisch elasticity? Briefly discuss. Hint: use **only** the first-order
conditions to answer this problem—that is a partial equilibrium approach.
E. Obtain the first-order conditions for the producer’s problem
F. What are the endogenous and exogenous state variables in the model?
G. Calibrate the model as follows. A = 1, ρ = 0, σ = 1,ψ = 2, h = τ = 1/2, this
implies in steady-state Y = C = L = w = 1 and to simplify further we use the
approximation λ ≈ 1. Reduce the system and log-linearize the first-order conditions
and equilibrium conditions around steady-state.
H. Write the guess to solve the model with the method of undetermined coefficients.
I. Solve the model with the method of undetermined coefficients. Clearly show the
laws of motion of Y , C, L, b and R. In particular show that

Rt = 0.5Rt−1 + 0.5At−1 + 1.25At

J. Discuss the main quadratic equation in the solution of the model and its implications
for existence and uniqueness of the solution.
K. Graph the impulse responses for C, L, b and R to a positive technology innovation
of 1 standard deviation.
L. Explain the economic intuition of the effects of a positive technological innovation
in consumption and labor decisions and the dynamics of interest rates.
M. Bonus: Find the variance and autocorrelation of consumption.
 Exam # 1

Microeconomic Theory Comprehensive Exam

June 28, 2012

Part I: Answer all questions.

I.A.1 For each statement, briefly explain why it is true or false.
a. The compensated law of demand follows from Roy’s identity.
b. To prove the second welfare theorem, concavity must be assumed to apply the
separating hyperplane theorem (find a quasiequilibrium price vector).

I.A.2 Suppose the indirect utility function is given by v(p, w) = ½ (p1 p2)-1/2 w.
a. Find the Walrasian demands.
b. Derive the utility function.
c. Solve the expenditure minimization problem.
d. For good 1, calculate the substitution effect directly and indirectly using the
Slutsky equation.

I.A.3 Consider a Robinson Crusoe economy, in which yams (y) are produced using labor (L)
according to the production function y = L1/2. Robinson’s utility is given by u(y, 1 – L) =
y1/2 (1 - L)1/2, and normalize the price of yams, py = 1.
a. Define a competitive general equilibrium for this economy.
b. Find the labor demand, labor supply, and equilibrium allocation of labor and
yams.
c. Suppose Robinson’s wage income is taxed at a rate of 50%. What happens to the
equilibrium wage, the equilibrium allocation of labor and yams, and Robinson’s
consumption of yams?

I.A.4 Suppose there are two firms producing a homogeneous good, demand is given by
P = 100 – q, and each firm’s costs are given by c(q) = 20q.
a. For the static Bertrand game, find the equilibrium outputs, price, and profits.
b. Assuming equal division of output, find the cooperative outputs, price, and
profits. Given that firm 1 cooperates, what is firm 2’s optimal strategy?
c. In an infinitely-repeated Bertrand game with grim trigger strategies (play static
outcome if rival cheats), calculate the discount factor which supports the
cooperative outcome.
d. In a finitely-repeated Bertrand game (t = 0 to t = T) with complete information,
explain how one determines the subgame perfect Nash equilibrium.
e. In a finitely-repeated Bertrand game with incomplete information, suppose that
each firm with probability α is “crazy” and cooperates so long as its rival has
cooperated up to that point; otherwise, it plays the static outcome for the rest of
the game. Let the discount factor be 1. Show that cooperation dominates
cheating at time t = 0.
 Exam # 1

Part II.A: Answer each of the following three questions.

II.A.1 What is the revelation principle, and why is it important in models with asymmetric
information?

II.A.2 Consider a risk averse consumer purchasing contingent claims c1 and c2 to consumption
in two possible future states. State 1 occurs with probability 1 ; and state 2 occurs
with probability 2 . The prices at which contingent claims to consumption in either
state can be purchased are p1 and p2 ; respectively, and the consumer’s utility from
consumption in either state is u (c) :

(a) Under what conditions, if any, will a highly risk averse consumer choose c1 > c2 ?
Explain.
(b) Is this contingent claims market the same as an asset market? Explain why or
why not.

II.A.3 Consider a …rst-price, sealed-bid auction between two bidders with independent private
values for the object being sold. Before this auction, each bidder i (for i = 1; 2) observes
a random variable xi that is independently drawn from a uniform distribution over the
interval [0, 1]. The value of the object to bidder i is vi = xi + 0:5: Each bidder submits
a sealed bid bi 2 [0; 1): Is there an equilibrium in which each bidder adopts a bidding
strategy of the form bi = xi + ? If so, …nd the equilibrium values of and : If not,
explain why not.

1
 Exam # 1

Part II.B: Answer one of the following two questions.

II.B.1 A monopolist can produce a good in di¤erent qualities. The cost of producing a unit
of quality s is C (s) = s2 . Consumers buy either one or zero units and have the utility
function
s if one unit is consumed
u (sj ) =
0 if nothing is consumed
The monopolist decides on the quality (or the qualities) it is going to produce and
the price for each di¤erent quality level. Consumers observe qualities and prices and
decide which quality to buy.

(a) Characterize the …rst-best solution (i.e. the quality level and price for a type
consumer when the monopolist observes ).
(b) In general, what condition is necessary for a monopolist to separate di¤erent
consumer types if cannot be observed? Is this condition satis…ed in this problem?
Explain.
(c) Suppose that the seller cannot observe , and suppose that

H with probability 1
=
L with probability

where H > L > 0: Assume the monopolist sells two products (two di¤erent
quality levels, sH and sL at prices pH and pL ; respectively). Characterize this
equilibrium mathematically (i.e., state and solve the monopolist’s maximization
problem), and use a diagram to illustrate.
(d) Is the outcome in part (c) e¢ cient? Explain why or why not.
(e) Is it possible that the monopolist would ever choose to o¤er only one quality level?
If so, state the mathematical condition under which this would occur and explain.
If not, explain.
Now suppose that many other …rms enter this industry, so that it is perfectly
competitive.
(f) Use a diagram to illustrate the competitive, separating equilibrium assuming one
exists.
(g) Are there conditions under which a pooling Wilson equilibrium exists? Explain
why or why not.

2
 Exam # 1

II.B.2 A …rm has recognized a potentially valuable investment project, but it must be man-
aged by an agent who is subject to moral-hazard temptations. The project requires an
initial investment of I = 15: The project’s return will be some R > 0 if it is successful
but will be 0 if unsuccessful. The probability of success is p = 0:6 if the agent behaves
well but is p = 0:2 if the agent misbehaves. The agent’s outside option is v = 0; and
the agent’s private bene…t from misbehavior is B = 8: The agent’s wage can depend
on whether the project is a success. The agent is risk neutral but cannot be paid less
than 0 (limited liability, no punishment). The …rm wants to maximize its expected net
pro…t.

(a) Derive the optimal wage plan for minimizing the …rm’s expected wage cost while
giving the agent an incentive to participate and behave well in managing this
project. Clearly explain all constraints used in your answer.
(b) Find the lowest return R for which the …rm should invest in the project and pay
the agent to behave well.
(c) How would your answers to (a) and (b) change if the agent has assets worth
A = 3 that he can invest in the project, but only if he can get an expected
wage that is worth at least this amount? In particular, this would allow for
the wage wL in the unsuccessful state to be negative as long as the expected
wage payment is at least 3: Note that the agent’s only form of payment is the
wage (wH ; or wL , depending on the state) : The agent does not receive any other
return on his investment, so the principal keeps the full amount R if the project
is successful.
(d) Does the ability to invest make the agent better or worse o¤? Explain.
Now suppose that the …rm has two similar project opportunities. Successes in
the two projects are independent events, but each depends in the same way on
the behavior of the managing agent. The …rm is considering a plan in which, if
the …rst project succeeds then it would invest in the second project and put the
same agent in charge of it, with all wage payments deferred until the end of the
second project. Assume the agent has no assets to invest (so A = 0):
(e) Describe an optimal wage plan for minimizing the expected cost of paying the
agent while giving the agent an incentive to participate and behave well both in
managing the …rst project and in managing the second project if it is undertaken.
Note that the solution from part (a) is still relevant because the …rm must create
an incentive for the agent to behave in the second period (while working on
the second project), which is simply the same as the problem faced in part (a).
However, you must now also consider the additional amount the agent will be
paid if the …rst project succeeds or fails.
(f) What is the lowest return R for which the …rm should be willing to do this? Note
that the …rm must earn a non-negative expected return at the beginning of the
process while assuming the agent will behave in both periods.
(g) Consider the case of R = 25: Would the …rm choose to undertake the project
initially? After the result of the …rst project is determined, would the …rm still
choose to continue with the second project? Explain.

3
PhD Macroeconomic Comprehensive Exam (February 2012) 1

1. Consider an overlapping generations model where agents live for three periods. At
each date N households are born. When young in period t-1, a household borrows an
amount dt−1 at the market rate of return to acquire human capital, ht , according to
1−ρ
ht = ht−1 dρt−1 with 0 < ρ < 1, (1)

where ht−1 is the average human capital of period t-1 middle-aged agents. When
middle-aged, the household repays the debt accumulated, earns labor income wt ht
(where wt is the wage rate), consumes c1t , and saves st . When old the household does
not work and consumes c2t+1 .
Preferences are given by:

U (c1t , c2t+1 ) = log c1t + β log c2t+1 . (2)

The production function F (Kt , Lt ) is

F (Kt , Lt ) = Ktα L1−α

t .

Capital accumulates according to Kt+1 = It (so there is full depreciation) and Lt =

N ht .

(a) Write the life-cycle optimization problem for an agent born in period t-1 and
derive the corresponding first-order conditions.
(b) Define a competitive equilibrium for this economy.
(c) Write an agent’s savings, st , and debt, dt−1 , as a function of variables exogenous
to the agent.
(d) Write down a system of equations that determines the dynamics of aggregate
physical and human capital.
(e) Write down a system of equations determining the physical to human capital ratio
and the growth rate of output along the balanced growth path. Calculate these
constants.

Exam # 15
PhD Macroeconomic Comprehensive Exam (February 2012) 2

2. Consider a real economy where the representative consumer supplies labor, consumes
and can issue a real bond. The representative firm hires labor to produce the con-
sumption good. There is no government, no money and no physical capital in this real
economy. The only source of economic fluctuations is a technology shock.
The representative consumer has preferences given by the utility index:
" #1−σ
Ct − hC̃t−1 − 1
Lψ+1
ψ+1 t
−1
 
U Ct , C̃t , Lt =
1−σ

where Ct is consumption, C̃t is the average consumption in the economy and Lt is

amount of time spent in labor activities; the parameters ψ > 0, σ > 1 and h ∈ [0, 1)
shape the consumer’s preferences. As you know from ECON812 this type of utility
function (GHH preferences) was proposed first by Greenwood et al. (1988) and it
has the property of eliminating the wealth effect on the labor supply as discussed for
example in Jaimovich and Rebelo (2009). Moreover it allows for external consumption
habit in the sense that the consumption utility depends on past average consumption
(i.e. the consumer takes C̃t−1 as given).
The consumer can issue a real bond bt that pays a gross interest rate Rt . The sources
of income at time t are: labor income at a wage rate wt , borrowings and lump-sum
transfers of the firms’ profits (Πt ); the uses of resources are consumption and the
repayment of the borrowings with interests. The budget constraint is

wt Lt + bt + Πt = Ct + bt−1 Rt−1 . (3)

The consumer chooses consumption, labor and bonds taking wages, interests and av-
erage consumption as given to maximize
∞
X  
t
β U Ct , C̃t , Lt , (4)
t=0

where β ∈ (0, 1) is a subjective discount factor, subject to the budget constraint.

The producer chooses labor to maximize profits Yt − wt Lt subject to the production
function
Yt = At (Lt )α
where α ∈ (0, 1) and At is a technological shock. The exogenous technology shock
follows the AR(1) process:

ln(At ) = ρ ln(At−1 ) + ln(t )

where ln(t ) ∼ N (0, 1) is a log-normal i.i.d. innovation.

Exam # 15
PhD Macroeconomic Comprehensive Exam (February 2012) 3

Please answer the following questions. Note that each question has approximately the
same weight.

(a) Define a competitive equilibrium in this economy.

(b) Let λt be the Lagrange multiplier and construct a Lagrange function to solve the
consumer problem.
(c) Obtain the first-order conditions for the consumer’s problem.
(d) Briefly discuss the role of GHH preferences in the labor supply—contrast it for
example against a utility index separable in consumption and labor.
(e) Obtain the first-order conditions for the producer’s problem
(f) What are the endogenous and exogenous state variables in the model?
(g) In steady-state A = 1, find the steady-state for Y , C, L and R and b.
(h) Log-linearize the first-order conditions around the steady state.
(i) Solve the model. Clearly show the laws of motion of Y , C, L, b and R.
Hint: It is straight forward to obtain the solution of labor, after that consumption
and production are also straightforward; the only hard-to-get solution is the one
for R, but don’t get stuck on this if you run out of time.
(j) Graph the impulse responses for C, L, b and R to a positive technology innovation
of 1 standard deviation.
(k) Explain the economic intuition of the effects of a positive technological innovation
in consumption and labor decisions and the dynamics of interest rates.
(l) Find the variance and autocorrelation of consumption.

Exam # 15
PhD Macroeconomic Comprehensive Exam (February 2012) 4

3. Ireland (2004) presents a three-equation New Keynesian model able to empirically

explain the patterns of GDP, inflation and interest rates in the US economy. The
micro-founded DSGE model is summarized in an Euler equation of consumption, a
Phillips curve and a Taylor Rule. To make the empirical analysis feasible Ireland
(2004) allows for habit in consumption, indexation and a persistent interest rate rule.
Consider a simplified version of Ireland’s model with only monetary innovations and
without the mentioned frictions:
 
yt = Et yt+1 − rt − πt+1 (5)
πt = βEt πt+1 + ψyt (6)
rt = ρπt + t (7)

where y is output, r is the nominal interest rate, π is inflation and the parameters
β ∈ (0, 1) , ψ > 0 and ρ > 1 come from the underlying microeconomic structure of the
model. In the interest rate rule t ∼ N (0, 1) represents monetary innovations induced
exogenously by the Central Bank.
Please answer the following questions. Note that each question has approximately the
same weight.
(a) Summarize the business cycles properties of key macroeconomic variables for the
US economy as discussed in Ireland (2004) or Smets and Wouters (2007). Add
the bibliographic references that you consider necessary.
(b) What is the role of the frictions in Ireland (2004)? More specifically, how do those
frictions change the statistical properties of the model to fit the US data?
(c) Use the method of undetermined coefficients to solve the model above. Hint:
the only state variable is t and since Et t+1 = 0, the undetermined coefficients
simplify very nicely.
(d) In the New Keynesian model above, if the Central Bank increases the nominal
interest rate, what happens with output and inflation? Explain the economic
intuition.

References
Greenwood, J., Hercowitz, Z., Huffman, G. W., June 1988. Investment, capacity utilization,
and the real business cycle. American Economic Review 78 (3), 402–17.
Ireland, P. N., 01 2004. Technology shocks in the new keynesian model. The Review of
Economics and Statistics 86 (4), 923–936.
Jaimovich, N., Rebelo, S., 2009. Can news about the future drive the business cycle? Amer-
ican Economic Review 99 (4), 1097–1118.
Smets, F., Wouters, R., 2007. Shocks and frictions in us business cycles: A bayesian dsge
approach. American Economic Review 97 (3), 586–606.

Exam # 15
 Exam #14

Microeconomic Theory Comprehensive Exam

January 5, 2012

Part I: Answer all questions.

I.A.1 For each statement, briefly explain why it is true or false.
a. If the weak axiom is satisfied, the Slutsky substitution matrix must be negative
semi-definite.
b. To prove the first welfare theorem, we must assume that preferences are convex.

I.A.2 Suppose the utility function is given by u (x1, x2) = x11/2 + 2x21/2.
a. Solve the utility maximization problem, and find the Walrasian demands.
b. Check the second-order condition.
c. Verify Roy’s identity.

I.A.3 Consider a two-consumer, two-commodity exchange economy. Suppose consumer i’s

utility function is given by ui(xi, yi) = xiα yi1 – α, with initial endowments,
w1 = (x1 = 2, y1 = 3), w2 = (3, 2).
a. Define a competitive equilibrium for this economy.
b. Calculate the equilibrium price vector and allocation.
c. Draw the Edgeworth box for α = 1/2. Is the equilibrium Pareto optimal? Explain.

I.A.4 Suppose there are two firms producing a homogeneous good, demand is given by
P = 60 – q, and each firm’s costs are given by c(q) = 12q.
a. For the static Cournot game, find each firm’s best response function.
b. Show that successively eliminating strictly dominated strategies leads to a unique
predicted outcome.
c. Calculate the static Cournot equilibrium outputs, price, and profits.
d. Assuming equal division of output, find the cooperative outputs, price, and
profits. Given that firm 1 cooperates, what is firm 2’s optimal strategy?
e. In an infinitely-repeated game with grim trigger strategies, calculate the discount
factor which supports the cooperative outcome.
f. In a finitely-repeated game (t = 0 to t = T) with complete information, explain
how one determines the subgame perfect Nash equilibrium.
g. In a finitely-repeated game with incomplete information, suppose that each firm
with probability α is “crazy” and cooperates so long as its rival has cooperated up
to that point; otherwise, it plays the static outcome for the rest of the game. Let
the discount factor be 1. Show that cooperation dominates cheating at time t = 0.
 Exam #14

Microeconomic Theory Comprehensive Exam

January 5, 2012

Part II: Answer all three of the questions below

II.A.1 Uncertainty and Unemployment. Consider a competitive market for a homogeneous
good. Identical …rms all have the same cost function of c (x) = x2 where x isp
the amount
of output the …rm produces. The …rm’s utility from pro…t is u ( (x)) = 4 (x):

(a) Suppose there is no uncertainty about prices. In particular, the …rm knows the
competitive market price is p = 50: Determine the optimal output for the …rm.

Now suppose that demand for the product is uncertain. The …rm knows that on
average the price will be 50; but in reality the price will be either 40 or 60: Each
occurs with probability 1/2.
(b) Write down the lottery the …rm faces as a function of the output choice x.
(c) Determine the optimal output of the …rm in the market with uncertainty. Assum-
ing it takes 100 workers to produce each unit of output, does uncertainty increase
or reduce the unemployment rate?
(d) Explain the role of risk-preferences in determining unemployement in this prob-
lem.

II.A.2 Consider an auction with n bidders with independent private values vi ordered so that
v1 > v2 > > vn : A seller uses an auction in which each bidder reports a bid bi : The
seller then computes a new bid ~bi = bi+1 + (bi 2bi+1 ) for each bidder i and awards the
item to the buyer with the highest computed bid ~bi at a price of ~bi :

(a) De…ne what it means for a social choice function to be implementable in dominant
strategies.
(b) Is this auction truthfully implementable? Explain.
(c) Suppose instead that there are only two buyers and the seller utilizes a Dutch
auction. Both v1 and v2 are common knowledge (i.e., there is full information).
Characterize the equilibrium bidding strategies. Clearly show all work.

1
 Exam #14

II.A.3 A risk neutral company o¤ers insurance against the risk of a car accident. There are
two types of agents, characterized by the probability they have an accident. Careful
drivers (G) face a low probability of accident G while risky drivers (B) are more
likely to have an accident with probabilty B > G : Denote the proportion of G type
agents with q. If no accident occurs, the value of the car is v N A = w, while if an
accident occurs the value of the damaged car is v A = w d: Agents are risk averse
with von Neumann – Morgenstern utility u ( ) : Agents pay a premium 1 = pz and
receive a payment of z from the insurance company in case of an accident. Denote the
net payment by the agent in the case of an accident by 2 = pz z; and de…ne an
insurance contract as the pair ( 1 ; 2 ) specifying the net payment from the agent to
the insurance company in each state of the world.

(a) Brie‡y de…ne the concepts of adverse selection and moral hazard and comment
on the relevance of each to this setting.
(b) What is the expected utility of each agent i = G; B when o¤ered insurance? What
is the expected pro…t of the …rm?
i i
(c) Solve for the …rst best (complete information) insurance contracts ( 1 ; 2 ) for
each agent i = G; B:
(d) Describe the situation graphically in the contingent claims space (v A ; v N A ). Clearly
identify the full information contracts in your diagram, and explain why these con-
tracts would be chosen by the monopoly insurance company to maximize pro…t.
(e) Can the full information contracts be implemented if the insurance company can-
not identify each agent’s type? Explain.

Now assume there are n 2 insurance companies competing for agents.

(f) Show that …rms must earn 0 pro…t in any Nash equilibrium.
(g) Can a pooling Nash equilibrium contract exist? Why or why not? Use a diagram
in your answer.
G G B B
(h) Consider a separating equilibrium candidate set of contracts 1; 2 ; 1; 2 :
i. Argue that in any equilibrium B 1; 2
B
= B B
1 ; 2 ; i:e:; that the sepa-
rating equilibrium contract o¤ered to the bad types is the same as the full
information contract o¤ered to the bad types.
B G G
ii. Argue that u w 1 = (1 B) u w 1 + Bu w d 2 must hold
in equilibrium.
(i) Show graphically (in the contingent claims space used in part (d) or, if you pre-
fer, in an alternative space appropriately de…ned using the parameters w; d; p;
and z) conditions under which a separating equilibrium does exist. What role
does q play? Hint: insurance companies earn zero pro…t at the no insurance
point (w d; w) in the contingent claims space, and the separating equilibrium
contracts must be actuarially fair.

2
 Microeconomic Theory Comprehensive Exam
January 5, 2012

Part II: Answer all three of the questions below

II.A.1 Uncertainty and Unemployment. Consider a competitive market for a homogeneous
good. Identical …rms all have the same cost function of c (x) = x2 where x isp
the amount
of output the …rm produces. The …rm’s utility from pro…t is u ( (x)) = 4 (x):

(a) Suppose there is no uncertainty about prices. In particular, the …rm knows the
competitive market price is p = 50: Determine the optimal output for the …rm.

Now suppose that demand for the product is uncertain. The …rm knows that on
average the price will be 50; but in reality the price will be either 40 or 60: Each
occurs with probability 1/2.
(b) Write down the lottery the …rm faces as a function of the output choice x.
(c) Determine the optimal output of the …rm in the market with uncertainty. Assum-
ing it takes 100 workers to produce each unit of output, does uncertainty increase
or reduce the unemployment rate?
(d) Explain the role of risk-preferences in determining unemployement in this prob-
lem.

II.A.2 Consider an auction with n bidders with independent private values vi ordered so that
v1 > v2 > > vn : A seller uses an auction in which each bidder reports a bid bi : The
seller then computes a new bid ~bi = bi+1 + (bi 2bi+1 ) for each bidder i and awards the
item to the buyer with the highest computed bid ~bi at a price of ~bi :

(a) De…ne what it means for a social choice function to be implementable in dominant
strategies.
(b) Is this auction truthfully implementable? Explain.
(c) Suppose instead that there are only two buyers and the seller utilizes a Dutch
auction. Both v1 and v2 are common knowledge (i.e., there is full information).
Characterize the equilibrium bidding strategies. Clearly show all work.

1
II.A.3 A risk neutral company o¤ers insurance against the risk of a car accident. There are
two types of agents, characterized by the probability they have an accident. Careful
drivers (G) face a low probability of accident G while risky drivers (B) are more
likely to have an accident with probabilty B > G : Denote the proportion of G type
agents with q. If no accident occurs, the value of the car is v N A = w, while if an
accident occurs the value of the damaged car is v A = w d: Agents are risk averse
with von Neumann – Morgenstern utility u ( ) : Agents pay a premium 1 = pz and
receive a payment of z from the insurance company in case of an accident. Denote the
net payment by the agent in the case of an accident by 2 = pz z; and de…ne an
insurance contract as the pair ( 1 ; 2 ) specifying the net payment from the agent to
the insurance company in each state of the world.

(a) Brie‡y de…ne the concepts of adverse selection and moral hazard and comment
on the relevance of each to this setting.
(b) What is the expected utility of each agent i = G; B when o¤ered insurance? What
is the expected pro…t of the …rm?
i i
(c) Solve for the …rst best (complete information) insurance contracts ( 1 ; 2 ) for
each agent i = G; B:
(d) Describe the situation graphically in the contingent claims space (v A ; v N A ). Clearly
identify the full information contracts in your diagram, and explain why these con-
tracts would be chosen by the monopoly insurance company to maximize pro…t.
(e) Can the full information contracts be implemented if the insurance company can-
not identify each agent’s type? Explain.

Now assume there are n 2 insurance companies competing for agents.

(f) Show that …rms must earn 0 pro…t in any Nash equilibrium.
(g) Can a pooling Nash equilibrium contract exist? Why or why not? Use a diagram
in your answer.
G G B B
(h) Consider a separating equilibrium candidate set of contracts 1; 2 ; 1; 2 :
i. Argue that in any equilibrium B 1; 2
B
= B B
1 ; 2 ; i:e:; that the sepa-
rating equilibrium contract o¤ered to the bad types is the same as the full
information contract o¤ered to the bad types.
B G G
ii. Argue that u w 1 = (1 B) u w 1 + Bu w d 2 must hold
in equilibrium.
(i) Show graphically (in the contingent claims space used in part (d) or, if you pre-
fer, in an alternative space appropriately de…ned using the parameters w; d; p;
and z) conditions under which a separating equilibrium does exist. What role
does q play? Hint: insurance companies earn zero pro…t at the no insurance
point (w d; w) in the contingent claims space, and the separating equilibrium
contracts must be actuarially fair.

2
DEPARTMENT OF ECONOMICS June 29, 2011

GRADUATE PHD COMPREHENSIVE MACROECONOMICS EXAMINATION

READ THESE INSTRUCTIONS CAREFULLY

WRITE YOUR NAME AND CODEWORD BELOW.

YOUR NAME ______________________________

YOUR CODEWORD ______________________________

DO NOT WRITE YOUR NAME ON THE EXAM JUST YOUR CODEWORD.

WRITE YOUR CODEWORD ON EACH PAGE OF THE EXAM.

DO THIS NOW!

Read the questions carefully.

Make sure you explain all your answers clearly.

1
1. John Taylor has been very critical of recent policy actions: both monetary and …scal actions.

(a) He has argued that the stimulus package that the Obama administration supported when
Obama came into o¢ ce in 2009 would do little to help the economy. Describe how this
position is consistent with a Classical theory. Explain also why carrying out the stimulus
package is consistent with Keynesian theory.
(b) Taylor has also been upset with the Fed. He has argued that the Fed has not been
following the ‘Taylor Rule”in recent years. In a recent paper he presented the following
graph.

From the perspective of having a ‘rule-based’ policy, what are the implications of not
following the rule? Why would Taylor be so concerned that the Taylor rule is not being
followed?

2
2. Consider an economy with overlapping generations of consumers who live for two periods.
Young consumers are born with zero assets and are endowed with one unit of labor. Old
consumers are endowed with units of labor, where 0 < < 1. There is no population
growth. Output Y is produced by a competitive …rm according to

Y = K N1 ; (1)

where K is the aggregate capital stock and N is the aggregate supply of labor. Capital
depreciates fully in one period. Consumers do not value leisure; the preferences of a young
consumer born in period t are given by:

log(c1;t ) + log(c2;t+1 ); (2)

where c1;t is his consumption when young and c2;t+1 is his consumption when old.

(a) Setup the individual’s problem and derive the corresponding optimality conditions.
(b) De…ne a competitive equilibrium.
(c) Find the equilibrium law of motion of the aggregate capital stock.
(d) Show that the steady-state of this economy is dynamically e¢ cient (for all and )
provided that is greater than some “cuto¤”value ^ 2 (0; 1). (You do not need to …nd
an explicit expression for ^ .) Give an intuitive explanation for this result.

3
3. Consider a neoclassical growth model in which the government has constant government
expenditures equal to G for every period t. The government …nances these expenditures by
levying a proportional tax on labor income, lt , and a proportional tax on consumption, c;t ,
in every period. The government balances its budget in every period: for all t, expenditures
are chosen so that the revenue raised by the taxes the tax rates lt and c;t is exactly equal
to that period’s expenditures.
The economy is populated by a continuum (of measure one) of identical consumers. Each
consumer has preferences
1
X
t
u(ct ; lt ); (3)
t=0

where ct is period-t consumption, lt is period-t leisure, and 2 (0; 1). Consumers do not
value government expenditures, so that government expenditures are a pure drain on output.
In this economy: the aggregate resource constraint is

Yt = Ct + It + G; (4)

where Yt is aggregate output in period t, Ct is aggregate consumption in period t, and It is

aggregate investment in period t.
Each consumer is endowed with k0 units of capital in period 0 and with one unit of time
in each period. In each period, consumers rent the services of capital and labor to …rms in
competitive markets. Firms maximize pro…ts and produce output according to:

Y = K N1 ; (5)

where Y is aggregate output, K is aggregate capital, and N is aggregate labor supply; the
parameter 2 (0; 1). Finally, aggregate capital accumulates according to

Kt+1 = (1 )Kt + It ; (6)

where 2 (0; 1].

(a) Describe the representative consumer’s recursive problem.

(b) Derive the …rst order conditions, and the Euler equation for the consumer’s problem.
(c) Based on your previous calculations, explain the impact of each type of taxation on the
consumer’s decisions.
(d) Carefully de…ne a recursive competitive equilibrium for this economy.

Assume that
u(ct ; lt ) = log(ct ) + A log(lt ) (7)