Department of Applied Economics Johns Hopkins University

Economics 602
Macroeconomic Theory and Policy
Midterm Exam
Professor Sanjay Chugh
Spring 2009
March 9, 2009

NAME:

The Exam has a total of four (4) problems and pages numbered one (1) through twelve (12)
(followed by three blank pages for any scratch work). Each problem’s total number of points is
shown below. Your solutions should consist of some appropriate combination of mathematical
analysis, graphical analysis, logical analysis, and economic intuition, but in no case do solutions
need to be exceptionally long. Your solutions should get straight to the point – solutions with
irrelevant discussions and derivations will be penalized. You are to answer all questions in
the spaces provided.

You may use one page (double-sided) of notes. You may not use a calculator.

Problem 1 / 20
Problem 2 / 30
Problem 3 / 20
Problem 4 / 30
TOTAL / 100
Problem 1: Consumption and Savings in the Two-Period Economy (20 points). Consider a
two-period economy (with no government and hence no taxes), in which the representative
consumer has no control over his income. The lifetime utility function of the representative
consumer is u ( c1 , c2 ) = ln c1 + ln c2 , where ln stands for the natural logarithm. We will work
here in nominal terms: suppose the consumer’s present discounted value of ALL lifetime
NOMINAL income is 52.

For part a of this problem, suppose also the following:

1. The nominal interest rate between period 1 and period 2 is zero (i.e., i = 0, which is
roughly what the nominal Federal Funds interest rate is currently).
2. The consumer begins period 1 with zero net assets.
3. Nominal prices of consumption in the two periods are P1 = 2 and P2 = 2 .

a. (14 points) Set up the lifetime Lagrangian formulation of the consumer’s problem, in order
to answer the following: i) is it possible to numerically compute the consumer’s optimal
choice of consumption in period 1? If so, compute it; if not, explain why not. ii) is it
possible to numerically compute the consumer’s optimal choice of consumption in period 2?
If so, compute it; if not, explain why not. iii) is it possible to numerically compute the
consumer’s nominal asset position at the end of period 1? If so, compute it; if not, explain
why not.

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Problem 1a continued (if you need more space)

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Problem 1 continued.
b. (6 points) Now ignore all numerical values presented at the beginning of this problem
(that is, suppose you were given no numerical information whatsoever). To demonstrate how
important the concept of the real interest rate is in macroeconomics, an interpretation of it (in
addition to the couple of different interpretations we have already discussed in class) is that it
reflects the rate of consumption growth between two consecutive periods. Based on the
consumption-savings optimality condition for the given utility function u (c1 , c2 ) = ln c1 + ln c2 ,
briefly describe/discuss (rambling essays will not be rewarded) whether the real interest rate is
positively related to, negatively related to, or not at all related to the rate of consumption
growth between period one and period two. For your reference, the definition of the rate of
c
consumption growth rate between period 1 and period 2 is 2 − 1 (completely analogous to how
c1
we defined in class the rate of growth of prices between period 1 and period 2). (Note: No
mathematics are especially required for this problem; also note this part can be fully completed
even if you were unable to get all the way through part a).

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Problem 2: Government in the Two-Period Economy (30 points). Consider an economy that
lasts for two periods. Neither the representative consumer nor the government start their lives
with any assets (that is, both a0 = 0 and b0 = 0 ). All taxes that the government levies are lump-
sum. In each period, the government has positive government spending (i.e., both g1 > 0 and g2
> 0). Suppose that the real interest rate between period one and period two is zero (i.e., r = 0).
Finally, suppose that the government lives for the entire two periods, and, until parts d and e
below, so does the representative consumer.

a. (5 points) Briefly (in no more than two sentences/phrases) define/describe what a lump-sum
tax is.

b. (5 points) Suppose that the government is currently planning to collect t1 = 3 and t2 = 5 in

taxes in period one and period two, respectively. A policy change is proposed, however, that
would reduce period-one taxes to t1 = 2 without changing either g1 or g2. If this policy
change is enacted, is it possible to numerically compute the amount of tax collections that the
government will require in period two? If so, compute it; if not, explain why not.

c. (5 points) If the proposed policy change described in part b is enacted, how will it affect
consumers’ period-1 optimal choices of consumption? Specifically, will it increase period-1
consumption, decrease it, leave it unchanged, or is it impossible to tell? Briefly
discuss/explain.

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Problem 2 continued

For the remainder of this problem, suppose that instead of living for two periods, each consumer
only lives for one period in the two-period economy. Specifically, there is a set of consumers
that comes into existence at the beginning of period one, knowing that at the end of period one
they will cease to exist. At the beginning of period two, there is a completely different set of
consumers that comes into existence, knowing that at the end of period two they (and the entire
economy) will cease to exist. The consumers in period two have no relation to the
consumers in period one, and the consumers in period one do not care at all about the
consumers in period two. The government, however, continues to exist for the entire two
periods. Continue to suppose that taxes are lump-sum (and, furthermore, there are no credit
constraints).

d. (5 points) If the proposed policy change described in part b is enacted, is it possible to

numerically compute the amount of tax collections that the government will require in period
two? If so, compute it; if not, explain why not. Carefully explain your logic.

e. (10 points – Harder) If the proposed policy change described in part b is enacted, how will
it affect consumers’ period-1 optimal choices of consumption? Specifically, will it increase
period-1 consumption, decrease it, leave it unchanged, or is it impossible to tell? Carefully
explain your logic. (Hint: The analysis here is nearly entirely purely logical.)

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Problem 2e continued (if you need more space)

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Problem 3: Mortgage-Backed Securities and Stock Prices (20 points). Much of the recent
problems in financial markets have stemmed from a particular type of stock called “mortgage
backed securities” (abbreviated MBS). Briefly, an MBS is a type of stock that indirectly entitles
holders of that stock to the mortgage payments made by a great many homeowners to their
respective mortgage companies.

Suppose there are two “types” of stock: MBS stock and “regular stock” (i.e., “regular stock” is
all stock besides those that are specifically MBS stock). In the context of the infinite-period
framework, denote by atREG−1 the representative consumer’s holdings of regular stock at the
beginning of period t and by atMBS
−1 the representative consumer’s holdings of MBS stock at the
beginning of period t.

The nominal prices of the two different types of stock are, during period t, StREG and StMBS . The
nominal dividend payments of the two different types of stock are, during period t, DtREG and
DtMBS . Analogous notation describes prices and dividends in periods t+1, t+2, etc. Finally,
suppose, as usual, that the representative consumer’s consumption during period t is ct and the
nominal price of consumption during period t is Pt. Again, analogous notation describes
consumption and consumption prices in periods t+1, t+2, etc.

The only institutional detail regarding the MBS market that is relevant for the question at hand
here is the following: all mortgage payments made by homeowners to their respective
mortgage companies are reflected in the dividend DtMBS . For example, if many people stop
paying their home mortgage payments in period t, the dividend DtMBS will decline.

The Lagrangian for the representative consumer’s utility-maximization problem (starting from
the perspective of the beginning of period t) is

u (ct ) + β u (ct +1 ) + β 2u (ct + 2 ) + β 3u (ct +3 ) + ....

+ λt ⎡⎣Yt + ( StREG + DtREG )atREG
−1 + ( St
MBS
+ DtMBS )atMBS
−1 − Pc
t t − St at − StMBS atMBS ⎤⎦
REG REG

+ βλt +1 ⎡⎣Yt +1 + ( StREG

+1 + Dt +1 ) at
REG REG
+ ( StMBS
+1 + Dt +1 ) at
MBS MBS
− Pt +1ct +1 − StREG ⎤
+1 at +1 − St +1 at +1 ⎦
REG MBS MBS

+ β 2 λt + 2 ⎡⎣Yt + 2 + ( StREG MBS MBS MBS REG REG MBS MBS

⎤
+ 2 + Dt + 2 ) at +1 + ( St + 2 + Dt + 2 ) at +1 − Pt + 2 ct + 2 − St + 2 at + 2 − St + 2 at + 2 ⎦
REG REG

+...

As usual, β is a number between zero and one that measures the degree of consumer impatience,
and u(.) is the consumer’s utility function in any period.

(OVER)

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Problem 3 continued
a. (4 points) Compute the first-order conditions of the Lagrangian above with respect to both
atREG and atMBS . (Note: there is no need to compute first-order conditions with respect to
any other variables.)

b. (6 points) Using the first-order conditions you computed in parts a and b, construct two
distinct stock-pricing equations for period t, one for the price of MBS stock in period t and
one for the price of regular stock in period t. Your final expressions should be of the form
StREG = ... and StMBS = ... (Note: It’s fine if your expressions here contain Lagrange
multipliers in them.)

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Problem 3 continued
c. (10 points – Harder) Suppose that in period t, it comes to be known that beginning in
period t+1, all homeowners will stop making their mortgage payments forever. That is,
from period t+1 onwards, nobody will ever make their mortgage payments again (i.e.,
all homeowners will default on their mortgages starting in period t+1).

Using your stock-pricing expression from part b, answer three questions based on this new
information; in all cases, carefully explain your logic.
i) What will happen to dividend payments on MBS stock starting from period t+1 onwards
(will they increase, decrease, or remain unchanged)?
ii) What happens to the stock price of MBS stock in period t (does it increase, decrease, or
remain unchanged?)
iii) What happens to the stock price of regular stock in period t (does it increase, decrease,
or remain unchanged?)

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Problem 4: Forty-Hour Workweeks and Labor Income Taxes in the Consumption-Leisure
Framework (30 points). In this question, you will use only the simple (one-period)
consumption-leisure framework to consider some labor-market issues.

Suppose the representative consumer has the following utility function over consumption and
leisure,
u (c, l ) = ln c + ln l ,
where, as usual, c denotes consumption and l denotes the number of hours of leisure the
consumer takes. In this utility function, ln(⋅) is the natural log function. Suppose the budget
constraint the individual faces is simply c = (1 − t ) ⋅ w ⋅ n , where t is the labor tax rate, w is the
real hourly wage rate, and n is the number of hours the individual works. (Notice that this
budget constraint is expressed in real terms, rather than in nominal terms.)

Throughout this analysis, assume that the real wage is w = 1. Also, recall that in one week there
are 168 hours, hence n + l = 168 must always be true.

a. (12 points) Suppose the labor income tax rate is 20 percent (i.e., t = 0.20). Setting up an
appropriate Lagrangian, compute numerically the representative consumer’s optimal
choice of labor. Show all important steps/logic.

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Problem 4 continued.
b. (8 points) Because of the nature of most employment contracts, most individuals have a
fixed workweek. Forty hours per week is the most common number of hours specified by
many employment contracts.

The diagram below depicts the budget line in the consumption-leisure framework; as usual,
it has slope -(1-t)w. In this diagram, clearly sketch two points: the individual’s optimal
choice you found in part a, and the individual’s choice of consumption and leisure under a
40-hours-per-week restriction.

Your sketch should show the numerical values of leisure under the two different cases (no
need to quantify consumption in the diagram), and show appropriate indifference curves on
which the two points lie. Briefly justify the logic behind your sketch.

Also, briefly explain whether the 40-hours-per-week restriction makes the individual better
off or worse off (in terms of utility), and why.
consumption

168 leisure

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Problem 4 continued.
c. (10 points) Now suppose again there is no restriction on the number of hours an individual
can work. If fiscal policy makers (i.e., Congress and the White House) would like to
encourage more work (i.e., they would like to increase people’s labor supply), can they do
so by lowering the labor income tax rate? Your analysis should be based on all of the
information given at the beginning of this problem, and the reference point for the analysis
here is what you found in part a (that is, the question is, can policy makers increase
people’s labor supply compared to what you found in part a). Explain carefully. (Note:
there is no need for a very mathematical solution here if you think one is not needed.)

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END OF EXAM

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