University College London, 2023-2024

Econ 0039 – Advanced Macro – Franck Portier

Problem set 2: Business Cycles

Version 1.0 - 12/01/2024
Partial Solution

I – Real Business Cycles in the UV Model

his problem takes you through the solving of the RBC model in the UV setting of Lecture 4 on Business Cycles.
T The economy features a representative firm and a representative household. The representative household owns
the firm, and receives its profits π. There is a unique good (numéraire) that can be used for consumption c and
investment x Technology is y = c + x = Aℓα with 0 < α < 1. y is total output.
The representative household utility is of the UV form, and is given by

U (c, ℓ) + V (x, θ) = γ ln c − Bℓ + θ ln x

and the household budget constraint is

c + x = wℓ + π

1 – Write the profit maximization problem of the firm and derive the first order condition to this maximization.
max π = AF (ℓ) − wℓ for given w. FOC is AF ′ (ℓ) = αAℓα−1 = w, where w is the real wage. This FOC determines
labor demand
2 – Write the utility maximization problem of the household and derive the two first order conditions to this
maximization.
Utility maximisation can be written, using the budget constraint to substitute away c:

max γ ln (wℓ + π − x) − Bℓ + θ ln x
ℓ,x

for w and π given.

γw
- FOC wrt ℓ: c = B.
γ
- FOC wrt x: c = xθ .

3 – Define the general equilibrium of this economy in terms of quantities c, ℓ, x, wage w and profit π.
General equilibrium is given by quantities c, ℓ, x, wage w and profit π such that

1. for given w and π, quantities maximize utility and profits, and therefore satisfy the FOCs

αAℓα−1 = w, (RBC.1)
γw
= B, (RBC.2)
c
γ θ
= , (RBC.3)
c x
and the budget constraint (RBC.0);
2. labour market clears (ℓ is the same for the representative firm and household), good market clears

c + x = Aℓα , (RBC.4)

and profits are given by

π = Aℓα − wℓ. (RBC.5)

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4 – Use the equilibrium definition to compute the equilibrium levels of c, ℓ, x and y.
(RBC.3) gives
γ
c = x, (RBC.6)
θ
 1
 α−1
B
(RBC.1) and (RBC.2) give ℓ = αγA c . Substitute c by its expression in (RBC.6) to get

 1
 α−1
B
ℓ= x (RBC.7)
αAθ

Now replace c and ℓ in (RBC.4) using (RBC.5) and (RBC.6) to obtain an equation in which x is the only unknown:
 α
1
γ  B  α−1 
x +x = A  x
 
θ αAθ

|{z}  
| {z }
c ℓ

This last equation can be solve for x (divide both sides by x) and the solution is
 
θ α α


x=A (γ+θ)1−α B

We can use the above equation in (RBC.5) and (RBC.6) to obtain the equilibrium values of c and ℓ.
 
γ α α


c=A (γ+θ)1−α B

α(γ+θ)
ℓ= B

Finally, using y = Aℓα , we obtain

 α
α(γ+θ)
y=A B

∂v
5 – For each variable v ∈ {c, ℓ, x, y} and each exogenous variable z ∈ {A, θ, B, γ}, compute ∂z and its sign.
This is simple algebra. One should obtain:

∂c ∂ℓ ∂x ∂y
∂A > 0 + 0 + +
∂θ > 0 - + + +
∂B > 0 - - - -
∂γ > 0 + + - +

6 – Interpret each shock ∂z and the response of the economy.

See Lecture 4 slides.
7 – How good is that model as a theory of Business Cycles comovements?
See Lecture 4 slides.

II – Gains From Trade Cycles in the UV Model

his problem takes you through the solving of the RBC model in the UV setting of Lecture 4 on Business Cycles.
T The economy produces two goods, a consumption good c (the numéraire) and an investment good x. There
c
are two firms, each one being the representative firm of its sector. Technology is c = Aℓ in the consumption sector
(price 1) and x = Aℓ in the investment sector (price q). Wages are w and w and profits are π c = Aℓc − wc ℓc and
x c x

π x = qAℓx − wx ℓx . Total profits in the economy are denoted π. GDP is given by y = c = q x.

There are two households; a representative consumption-worker and a representative investment-worker. Each
household works only in one of the two sectors. They both have UV preferences, that are given by ln cc − B c ℓc + θ ln xc
for the c-worker and ln(cx − B x ℓx ) + θ ln xx for the x-worker.

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 The c-worker receives a fraction ν c of total profits and the x-worker a fraction (1 − ν c ). The households budget
constraints are cc + qxc = wc ℓc + ν c π for the c-worker and cx + qxx = wx ℓx + (1 − ν c )π for the x-worker.
1 – Write the profit maximization problem of each firms and derive the first order condition to this maximization.
Show that profits will be null in equilibrium.
Profits are π c = Aℓc − wc ℓc and π x = qAℓx − wx ℓx First order conditions imply that for an interior equilibrium
(production being neither zero or infinite), one must have

wc = A (GFT.1)

wx = q A (GFT.2)
Therefore, because of perfect competition and constant returns, firms will make zero profitin equilibrium.
2 – Write the utility maximization problem of each household and derive the two first order conditions to this
maximization.
Substituting consumption away in the utility using the budget constraint, the utility maximization problem of the
two households can be written as:
- c-worker:
max
c c
ln(wc ℓc − qxc ) − B c ℓc + θ ln xc
ℓ ,x

- x-worker:  
x x x x x 2
max ln w ℓ − qx − B (ℓ ) + θ ln xx
ℓx ,xx

First Order Conditions are:

- c-worker:
- wrt ℓc :
wc
= Bc (GFT.5)
cc
- wrt xc :
q θ
= c (GFT.6)
cc x
- x-worker:
- wrt ℓx :
wx − 2B x ℓx
=0 (GFT.7)
cx − B x (ℓx)2
- wrt xx :
q θ
= x (GFT.8)
cx − B x (ℓx)2 x

3 – Define the general equilibrium of this economy in terms of quantities c, x, ℓ,cc , xc , ℓc , cx , xx , ℓx and prices wc , wx , q
General equilibrium of the GFT model is given by quantities c, x, ℓ,cc , xc , ℓc , cx , xx , ℓx and prices wc , wx , q such
that
1. given prices the quantities maximize utility and profits, and therefore satisfy the FOCs (GFT.1), (GFT.2) and
(GFT.5) to (GFT.8), together with budget constraints (GFT.3) and (GFT.4)

2. prices are such that markets clear, namely labor markets (ℓc and ℓx are the same for firms and households),
consumption and investment market clear:

cc + cx = c = Aℓc , (GFT.9)

xc + xx = x = Aℓx . (GFT.10)

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4 – Show that the amount of trade between the two agents will be given by q xc = cx . Interpret that equation.
First, note that in equilibrium, wc ℓc = Aℓc = c. Using the budget constraint of the c-worker (GFT.3) and the
defintion of c in (GFT.9), we obtain cc + q xc = c = cc + cx , which gives

q xc = cx (GFT.11)

This is a key equation that shows the amount of trade between the c− and x− workers. The x−worker is producing
x, but wants to invest and consume. She is therefore trading a part of her production q xc against some consumption
goods cx . This is agreed by the c−worker that would like not only to consume, but also to invest. Equation (GFT.11)
show that trade is balanced between the two workers
5 – Use the equilibrium definition to compute the equilibrium levels of c, x, ℓ, q and y.
A
Using (GFT.1) and (GFT.1), we replace everywhere wc with A and wx with q A. (GFT.5) writes cc = Bc , which
c c θA
is the equilibrium value for c . (GFT.6) rewrites q x = Bc , so that (GFT.11) gives the equilibrium value of cx :
θA (1+θ A(1+θ
cx = Bc . Using the equilibrium values of cx and cc , (GFT.9) gives ℓc = Bc . As c = Aℓc , we have c = Bc .
(GFT.8) can be rewritten
q xc = θcx − θB x (ℓx )2 (GF T.12)
(GFT.4) implies q xc = q Aℓx − cx , which we can put in (GFT.12) to obtain

qAℓx + θB x (ℓx )2 = (1 + θ)cx (GF T.13)

(GFT.7) implies qA = 2B x ℓx . Substituting in (GFT.13) and using the equilibrium value for cx , we obtain the equilib-
q q
(1+θ)θA (1+θ)θA3
rium level of ℓx : ℓx = (2+θ)B x
x B c . Then given x = Aℓ , we obtain equilibrium total investment x = (2+θ)B x B c .
q
(1+θ)θA
Total hours worked are ℓ = ℓc + ℓx , so that ℓ = 1+θ
Bc + (2+θ)B x B c . The relative price of investment is obtained from

x x
q x
(GFT.7): q = 2BA ℓ , so that, using equilibrium value for ℓx , we obtain q = 4(1+θ)θB
(2+θ)AB c . Finally, GDP is y = c + q x,

A(1+θ 2(1+θ)θA
which gives y = Bc + (2+θ)B x .

∂v
6 – For each variable v ∈ {c, x, ℓ, q, y} and each exogenous variable z ∈ {A, θ}, compute ∂z .
This is simple algebra. One should obtain:

∂c ∂x ∂ℓc ∂ℓx ∂ℓ ∂q ∂y
∂A > 0 + + 0 + + - +
∂θ > 0 + + + + + + +

7 – Interpret each shock ∂z and the response of the economy.

See Lecture 4 slides.
8 – How good is that model as a theory of Business Cycles comovements?
See Lecture 4 slides.

III – Monetary Policy and Sticky Prices in a “UV” model

This problem considers a monetary model in the UV setting of Lecture 4 on Business Cycles. The economy features
a representative firm, a representative household and a Central Bank. The representative household owns the firm
and receives its profits π. There is a unique produced good that can be used for consumption c and investment x. Its
price is p. Money is the numéraire good. It is supplied in quantity m by the Central Bank and is distributed to the
housholds.
The representative household utility is of the UV form, and is given by
   
m m
U c, ℓ, + V (x, θ) = ln c − Bℓ + ν ln + θ ln x,
p p
m
where m is the money demand of the household, ℓ is labour. Agents demand money because p brings some utility.
The household budget constraint is
pc + px + m ≤ wℓ + m + π

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where w is the nominal wage.
The representative firm produces a single good according to the technology y = Aℓα with 0 < α < 1. y is split into
consumption c and investment x.
Finally, all markets are competitive.

Assume first that prices are flexible.

1 – Write the profit maximization problem of the firm and the first order conditions to this maximization. Derive
good supply y, labour demand ℓd and profit π as a function of w, p and parameters.
The representative firm solves the problem:
max π = py − wℓ = pAℓα − wℓ,
ℓ

and first order condition is

αpAℓα−1 − w = 0,
 −1
 1−α  −α
 1−α
1
1 w
from which we obtain ℓd = αA p and y = A 1−α α1 wp .
α 1 1 −α
The expression for profit is then π = (1 − α)α 1−α A 1−α p 1−α w 1−α .
2 – Write the utility maximization problem of the household and the four first order conditions to this maximization,
with respect to c, x, ℓ and m. Derive consumption demand c, investment demand x, money demand m and labour
supply ℓs as a function of w, p, π, m and parameters.
The representative household solves the problem:
 
m
max ln c − Bℓ + ν ln + θ ln x,
c,ℓ,m,x p
subject to the budget constraint
pc + px + m ≤ wℓ + m + π (λ).
First order conditions are
1
= λp (1)
c
B = λw (2)
ν
= λ (3)
m
θ
= λp (4)
x
m 1 w w
(1) and (3) give pc = ν . (1) and (4) imply x = θc. Putting all together, we obtain c = B p, md = ν B and
θ w 1+θ w
x= B p. Total good demand is then c + x = B p. Plugging those three expressions in the budget constraint, we
(1+θ+ν) (m+π)
obtain ℓs = B − w .

3 – Define the general equilibrium of this economy. Find the equilibrium levels of quantities cE , ℓE , xE , y E and mE ,
wage wE and price pE .
A general equilibrium is a collection of prices and quantities such that, (i) given wage wE and price pE , quantities
c , ℓ , xE , y E and mE maximise utility and profits, (ii) good, labour and money markets clear.
E E

The table below gives the expressions for demand and supply on the three markets, as obtained above.

Supply Demand
 −α
 1−α
1 (1+θ) w
1 w
Good market: y = A 1−α α p c+x= B p

 −1
 1−α
(1+θ+ν) (m+π) 1 w
Labour market: ℓs = B − w ℓd = αA p

w
Money market: m md = ν B

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 α 1 1 −α
where π = (1 − α)α 1−α A 1−α p 1−α w 1−α .
 1−α
wE B
To solve for the equilibrium, y = c + x implies pE
= αα A 1+θ . Then labour demand gives ℓE = α 1+θ
B . Using

−α −α
B B
the demands c and x, one gets cE = αα A (1+θ)1−α and xE = θαα A (1+θ)1−α . From the production function, the
1−α α
1+θ α
Using money demand with md = m, we obtain pE = m (1+θ) B


expression for ℓE implies y E = αα A B . αα Aν .
B
Finally, using the expressions for the equilibrium real wage and for the equilibrium price, we obtain wE = ν m.
Note that money supply m does not affect real quantities, and increases linearly pE and wE . Money is neutral.
4 – Can a technology shock (∂A > 0), an investment demand shock (∂θ > 0) or a monetary policy shock (∂m > 0)
create business cycles comovements? Discuss.
It is easy to check that shocks have the following effect:

∂cE ∂xE ∂y E ∂ℓE

∂A > 0 + + + 0
∂θ > 0 - + + +
∂m > 0 0 0 0 0

As we can see, money is neutral and monetary shocks do not generate business cycles. An investment demand shock
does increase x, but not c, which is counterfactual as consumption and investment are procyclical in the data. A
technology shock does increase all quantities. It leaves employment constant, but as discussed in class, it is possible to
obtain an increase in employment if we change the utility function so that wealth and substitution effect do not exactly
compensate (at the cost of less tractability). But in the data, technological shocks are not procyclical. Therefore, the
flex price model does not propose a realistic theory of the business cycle.

Assume now that the price of the good is fixed at a level pF > pE .
Let’s consider a fix-price “equilibrium” in which the money market clears, but the good and labour market may not.
We assume voluntary exchange, meaning that households are not forced to work or spend more than what is optimal
for them, neither are firms forced to hire or produce more that what is optimal for them.
Because pF > pE , the structure of the equilibrium will be as follows. Money market will be in equilibrium, which
will determine equilibrium wage wF . Output y F will be determined by good demand cF + xF . To that level of output
will correspond a demand for labour ℓF . That level of labour demand will be the equilibrium employment.
5 – Find the fix-price equilibrium values cF , ℓF , xF , y F , mF and wF .
Demand and supplies have the same expression as before and pF is given. Clearing the money market gives
B wF wE wE
mF = m and wF = νm = wE . The real wage is therefore pF
= pF
> pE
because pF > pE . Output is determined
1 m θ m
by good demand, so that y F = cF + xF . Using the demands for c and x, we obtain cF = ν pF , xF = ν pF and
  α1
1+θ m 1+θ m
yF = ν pF . Employment is then obtained using the production function: ℓF = Aν pF .

6 – Can a technology shock (∂A > 0), an investment demand shock (∂θ > 0) or a monetary policy shock (∂m > 0)
create business cycles comovements in that fix-price economy? Discuss.
It is easy to check that shocks have the following effect:

∂cF ∂xF ∂y F ∂ℓF

∂A > 0 0 0 0 -
∂θ > 0 0 + + +
∂m > 0 + + + +

Clearly, a technological shock cannot create business cycle movements, as output and employment are demand deter-
mined. The investment demand shock θ could be a candidate as it increase all variables without strictly decreasing
any. The monetary shock, as in IS-LM, is here expansionary and create business cycles like movements.