Note 5. One Period Model
Note 5. One Period Model
A Closed-Economy One-Period
Macroeconomic Model
Sogang University
Macroeconomics 1
Show that allocations for the competitive equilibrium and the Pareto
optimum are the same.
G =T (1)
C = wN s + 𝜋 − T (2)
In equilibrium, dividend income is equal to the firm’s maximized
profits:
𝜋 = Y − wN d (3)
Also, the government budget constraint is satisfied.
T =G (4)
The labor market clears:
Ns = Nd (5)
By combining the above equations, we have the income-expenditure
identity:
Y =C +G (6)
Note that I = 0, NX = 0 in this one period model.
Sogang University Macroeconomics 1 September 27, 2024 6 / 22
Competitive Equilibrium in Graph
Point J represents the equilibrium consumption bundle.
The line ADB is the budget constraint faced by the consumer in
equilibrium, with the slope of AD equal to −w .
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Y =C +G (8)
ΔC = ΔY − ΔG (9)
However, the model says consumption and the real wage are
countercyclical (moving in the direction opposite to the change in
output), which is inconsistent with data.
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Sogang University Macroeconomics 1 September 27, 2024 14 / 22
An Increase in Total Factor Productivity 2
Consumption should increase, but the change in leisure is
ambiguous.
We need to look at substitution and income effects.
▶ Substitution effect: F → D (C ↑, l ↓)
▶ Income effect: D → H (C ↑, l ↑, both are normal goods)
Real wage w should be higher at H than F , because labor demand
of firms increases when z rises from F to D, and labor supply
decreases (l increases) from D to H.
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Sogang University Macroeconomics 1 September 27, 2024 15 / 22
An Increase in Total Factor Productivity 3
This model explains long-term economic effects of long-run
improvements in technology.
Y = zN d (10)
Nd = Ns = h − l (11)
C = z(h − l) − G (12)
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Sogang University Macroeconomics 1 September 27, 2024 19 / 22
Proportional Income Taxation 4
Pareto optimum is point E .
A competitive equilibrium with a proportional income tax is point H.
The income tax distorts private decisions on labor supply, and thus the
competitive equilibrium is not socially efficient.
Note that consumption and output is higher, and leisure is lower at E
than H.
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Sogang University Macroeconomics 1 September 27, 2024 21 / 22
Laffer Curve 2
Given that the government can collect the same amount of taxes G ,
the benevolent government should not choose t2 instead of t1 .
With a higher tax rate, consumers become worse off at point H,
compared to F .
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