EKO2111: Macroeconomics II

Problem Set 2
Suggested Solution

1. (10 points) In the one period model, list the requirements for a competitive equilibrium, and
explain why each is important.
Solution:
1) Consumer optimizes consumption and labor supply given his or her budget constraint,
which is determined by the real wage, taxes, and the profits that the consumer receives
from the firm as dividend income.
2) Firm optimizes the quantity of labor demanded given total factor productivity, its capital
stock, and the market real wage.
3) The quantity of labor that the representative firm wants to hire is equal to the quantity of
labor the representative consumer wants to supply (markets clear).
4) The government budget constraint is satisfied, that is, G = T.

These conditions ensure that each economic agent optimizes their choices with the constraints
that they face. While market clear conditions ensure that economic agents are consistent with
their decisions.

2. (20 points) In the one-period model, education can be represented as time spent by the
representative consumer that is neither leisure time nor time applied to producing output. What
the economy gains in the future is that the representative consumer then has more time available,
as measured in terms of effective units of labor time (adjusted for skill level, or what economists
call human capital).
a. Using the one-period model, show what effects additional education has in the present on
consumption, leisure, employment, aggregate output, and the real wage.
Solution:
Studying is not categorized as time spent on work or leisure. Thus, in the short run, the allocation
of time for education will reduce the level of consumption and also leisure. A decrease in the
time spent on work will also reduce the amount of labor in the market, which will result in a
decrease in aggregate output. Meanwhile, real wages will increase.

b. Similarly, show the effects the additional education that people acquire today will have in the
future on consumption, leisure, employment, aggregate output, and the real wage.
Solution:
In the future, the accumulation of human capital gained from education will result in an increase
in total factor productivity (z). To find out the impact on consumption, leisure, employment,
aggregate output, and real wages, we can analyze curve 5.9.

Curve 5.9

The curve illustrates that an increase in total factor productivity will cause the PPF curve to
rotate from AB to AD. This also results in a change in the indifference curve from I1 to I2. Thus,
the equilibrium point also moves from point F to H.

Then, from the analysis of curve 5.9, we can also confirm that real wages will increase. That is
because we know that in the pareto optimum condition, the real wage is minus the slope of the
PPF and minus the slope of the indifference curve. Since in the new PPF, point H is steeper than
point F, we can say that the real wage is higher than before.

It can be seen from the curve below that the change from point F to H also means that there is an
increase in consumption. This also results in an increase in aggregate output (Y = C + G).

Meanwhile, in this case the number of workers is ambiguous as the amount of time allocated to
work depends on the leisure allocation made by the individual (N = h - l).

Finally, the impact of an increase in total factor productivity on the level of leisure is ambiguous.
This can be explained by curve 5.10 below.
Curve 5.10

● Substitution Effect: PPF 1 (A) to PPF 3 (D)

Consumption rises and leisure falls

● Income Effect : PPF 3 (D) to PPF 2 (B)

Consumption and leisure levels rises

Thus, the leisure rate will rise or fall depending on which effect is more dominant (substitution
effect or income effect).

c. What does your analysis in parts (a) and (b) have to say about the trade-offs society makes
between the present and the future in investing in education?
Solution:
In the short run, an increase in time allocated to education leads to a decrease in welfare. This is
due to the reduction in leisure time and consumption. However, in the long run, it compensates
with an increase in future consumption, and possibly leisure time. Whether or not this is possible
depends on the household's preferences for current and future utility.

3. (20 points) Suppose that government spending makes private firms more productive; for
example, government spending on roads and bridges lowers the cost of transportation. This
means that there are now two effects of government spending, the first being the effects
discussed in this chapter of an increase in G and the second being similar to the effects of an
increase in the nation’s capital stock K.
a. Show that an increase in government spending that is productive in this fashion could increase
welfare for the representative consumer.
Solution:
Scenario 1:
When government spending is unproductive, it causes individual welfare to decrease. This
happens because individuals finance the government spending through taxes. An increase in the
amount of tax paid will result in a reduction in disposable income. Under the assumption that
consumption and leisure are normal goods, a reduction in disposable income will reduce both
consumption and leisure levels.

Graph 1

Scenario 2:
If government spending is effective in enhancing total factor productivity, the PPF curve will
shift upward. An upward shift in the PPF 1 to PPF 2 curve indicates an increase in individual
welfare, as seen from the increase in consumption and leisure levels.
Graph 2

b. Show that the equilibrium effects on consumption and hours worked for an increase in
government spending of this type are ambiguous but that output increases. You must consider
income and substitution effects to show this.
Solution:
An increase in government spending will have three effects on individuals:
1) Negative Income Effect : Caused by taxes that reduce disposable income. It can be
seen from the shift of point A to B in graph 1.
2) Substitution Effect : Increases the level of consumption and tends to increase
leisure. This can be seen from the shift of point A to D in graph 2.
3) Positive Income Effect : Increases the level of consumption and leisure. This can
be seen from the shift of point D to B in graph 2.

From the three effects above, it can be concluded that government spending has an ambiguous
effect on consumption and leisure. However, the appropriate amount of government spending
will increase total factor productivity and thus increase aggregate output.
4. (10 points) Explain how the reservation wage is determined in the one-sided search model.
Solution:

Welfare of employed workers (𝑉𝑒(𝑊)) is a concave

function of wages which also depends on the separation
rate. This concave form arises because workers experience
diminishing marginal utility from jobs with high wages.
The reservation wage (w*) is determined when the welfare
of employed workers (𝑉𝑒(𝑊)) equals the welfare of
unemployed workers (𝑉𝑢) or when those two intersect.
This indicates that the unemployed worker will continue
to look for a job with wage that will make his welfare
higher than when the worker is unemployed. For this
reason, workers will only accept job offers with wages equal to or greater than the reservation
wage.

5. (20 points) Determine the effects of an increase in the separation rate, s, on the reservation
wage and on the long-run unemployment rate in the one sided search model of unemployment.
Explain your results.
Solution

An increase in the separation rate will shift the

welfare employed workers curve (𝑉𝑒(𝑊)) to the
right because jobs are now worth less so that the
opportunity for workers to be separated from their
job will be greater. This will make the reservation
wage (w*) increase because workers tend to be more
selective about the job.
 Furthermore, an increase in the reservation wage
will make the option of being unemployed is
more attractive than working so that the
probability that the worker accepts the job offer
will decrease or 𝐻(𝑤 *) will decrease. This
condition is depicted in the curve on the side with
a downward shift of 𝐻(𝑤 *) and upward
𝑠(1 − 𝑈).

Thus, it can be concluded that first, workers are separated from work at a higher rate causing a
higher flow from employment to unemployment, and the unemployed are accepting jobs at a
lower rate, creating a lower flow from unemployment to employment. Both of these effects will
increase the unemployment rate.

6. (20 points) Suppose the government’s goal is to reduce the unemployment rate. Some
legislators propose that the government should give subsidies to any firm that hires a worker.
Some other legislators argue that it would be more effective to simply pay consumers to stay
home rather than searching for work; that is, anyone who chooses not to participate in the labor
force should receive a payment q. Which policy is more effective in achieving the government’s
goal? Explain using the two-sided search model, with the aid of diagrams. [In your answer, do
not concern yourself with how the subsidies from the government are financed.]
Solution:
In the two-sided-search model, the supply side of the labor market is given by
𝑃(𝑄) = 𝑏 + 𝑒𝑚(1, 𝑗)𝑎(𝑧 + 𝑠 − 𝑏)
And on the demand side of the market, the equation determining j is
𝑘
(1−𝑎)(𝑧+𝑠−𝑏)
= 𝑒𝑚 ( 1
𝑗 )
, 1
If the government decides to provide subsidies, when s > 0, labor market tightness (j) will
increase causing labor force to increase (Q). Providing subsidies will make more companies look
for workers. As a result, it will be easier for workers to find jobs. In addition, subsidies will
increase wages which also increase work incentives. Therefore, when there is an increase in j, the
unemployment rate will also decrease (1 − 𝑒𝑚(1, 𝑗))
.
If the government pays would-be workers to stay out of the labor m```arket, this has no effect on
the demand side. However, the supply side of the labor market is now characterized by the eq
𝑞 + 𝑃(𝑄) = 𝑏 + 𝑒𝑚(1, 𝑗)𝑎(𝑧 + 𝑠 − 𝑏)
Therefore, when q > 0, this shifts the curve in the upper panel of the figure below to the right.
There is no effect on labor market tightness, j, and therefore no effect on the unemployment rate.
However, Q falls. Since j does not change, this implies that A falls as well, since j = (A/Q).
Therefore, this policy has the effect not only of reducing the number of would-be workers
looking for work, but it reduces the number of firms searching for workers. The policy has an
unintended side effect and has no effect on the unemployment rate.

Panel 1. With Subsidy Panel 2. Without Subsidy