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2020 Exam 1

The document is an exam with questions about optimal taxation, competitive equilibrium, and real business cycles. Question 1 asks to show that the optimal tax rate in a Ramsey plan is a constant value given exogenous government spending. Question 2 asks about the Pareto problem and optimal allocations. Question 3 asks about interpreting labor shocks in a real business cycle model and the effects on macroeconomic variables.

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30 views2 pages

2020 Exam 1

The document is an exam with questions about optimal taxation, competitive equilibrium, and real business cycles. Question 1 asks to show that the optimal tax rate in a Ramsey plan is a constant value given exogenous government spending. Question 2 asks about the Pareto problem and optimal allocations. Question 3 asks about interpreting labor shocks in a real business cycle model and the effects on macroeconomic variables.

Uploaded by

manuzipeixoto
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Macroeconomics 1 – Examination 1 – PUC-Rio – 2020

Please send me your sheets precisely three and a half hours after you receive this doc-
ument. Make sure you keep some time at the end for scanning. Good luck!

Exercise 1 [4 points] Optimal Taxation

Consider the following optimal taxation problem. There is no uncertainty. There is one
good that is produced by labor 1 − xt of the representative household, and that can be
divided among private consumption ct and government consumption gt subject to

ct + gt = 1 − xt .

The good is produced by zero-profit competitive firms that pay the worker a pretax
wage of 1 per unit of 1 − xt , ie the wage is tied down by the linear technology. A
representative consumer maximizes
∞
X
β t u(ct , xt ), (1)
t=0

subject to the sequence of budget constraints

ct + qt bt+1 ≤ (1 − τt )(1 − xt ) + bt , (2)

where ct is consumption, xt is leisure, qt is the price of consumption at t + 1 in units of


time t consumption, and bt is a stock of one-period bonds owned by the household and
falling due at time t. Also, τt is a flat-rate tax on the household’s labor supply 1 − xt .
Assume that u(c, x) = c − 0.5(1 − x)2 .

a. Argue that in a competitive equilibrium, qt = β and xt = τt .


b. Argue that in a competitive equilibrium with b0 = 0 and limt→∞ β t bt = 0, the se-
quence of budget constraints (2) imply the following single intertemporal constraint
∞
X
β t [ct − (1 − xt )(1 − τt )] = 0.
t=0

Given an exogenous sequence of government purchases {gt }∞


t=0 , a government wants
to maximize (1) subject both to the budget constraint
∞
X
β t [gt − τt (1 − xt )] = 0,
t=0

and to the household’s first-order condition

xt = τ t .

c. Consider the following government expenditure process defined for t ≥ 0


(
0 if t is even;
gt =
0.2 if t is odd.

1
Solve the Ramsey plan. Show that the optimal tax rate is given by
τt = τ̄ for all t ≥ 0.
Please compute the value for τ̄ when β = 0.95.
d. Consider the following government expenditure process defined for t ≥ 0
(
0.2 if t is even;
gt =
0 if t is odd.
Show that τt = τ̄ for all t ≥ 0. Compute τ̄ and comment on whether it is larger or
smaller than the value you computed in part c.
e. Interpret your results in parts c and d in terms of ”tax-smoothing.”
f. Under what circumstances, if any, would τ̄ = 0?

Exercise 2 [3 points] Competitive Equilibrium


Suppose consumers 1 and 2 have one-period utility functions u(c1 ) and w(c2 ), respec-
tively, where u and w are both increasing, strictly concave, twice differentiable functions
of consumption. Let c > 0 be the total amount of the single consumption good avail-
able to be allocated between consumers 1 and 2. Let γ ∈ (0, 1) be a Pareto weight, and
consider the Pareto problem
vγ (c) = max [γu(c1 ) + (1 − γ)w(c2 )],
{c1 ,c2 }

subject to the constraint c1 + c2 = c.


a. Solve the Pareto problem.
b. Show that the solution of this problem has the form of a utility function vγ (c), which
depends on the Pareto weight γ. Where {c1 (c, γ), c2 (c, γ)} is a Pareto optimal allocation,
show that vγ0 (c) = γu0 [c1 (c, γ)] = (1 − γ)w0 [c2 (c, γ)].
c. Is vγ (c) convex or concave? What can you conclude about the function vγ (c), in par-
ticular whose utility does it represent?

Exercise 3 [3 points] Labor Shocks and Real Business Cycles


Consider the standard real business cycle model with endogenous labor supply. The
population is constant and normalized to one. Preferences of the representative agent
are ∞
L1+ϕ
X  
t t
β ln Ct − νt ,
t=0
1+ϕ
where β ∈ (0, 1) is the discount factor, ϕ > 0 is a parameter, Ct is consumption, Lt is
hours worked, and νt is an exogenous shock.
a. Interpret the variable νt .
b. What is the effect of a sudden unexpected increase in νt on output, consumption,
investment, and hours worked? Describe the mechanisms and provide some intuition
without doing any computation.
c. Are these dynamics consistent with actual business cycles?
d. Could the current Covid-19 crisis be described by such a shock?

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