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Note 5. One Period Model

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15 views22 pages

Note 5. One Period Model

Uploaded by

Pb H
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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Chapter 5.

A Closed-Economy One-Period
Macroeconomic Model

Jun Hee Kwak

Sogang University
Macroeconomics 1

September 27, 2024

Sogang University Macroeconomics 1 September 27, 2024 1 / 22


Key Questions

Define and construct a competitive equilibrium model for the


closed-economy one period model.

Show that allocations for the competitive equilibrium and the Pareto
optimum are the same.

Analyze and interpret the effects of changes in exogenous variables.

Decompose the effects of an increase in total factor productivity into


income and substitution effects.

Analyze the effects of a distorting labor income tax.

Sogang University Macroeconomics 1 September 27, 2024 2 / 22


Government
The government provides public goods such as national defense by
taxing the representative consumer.

We assume that the government purchases an exogenous amount of


G which is produced in the private sector.

▶ An exogenous variable is determined outside the model, while an


endogenous variable is determined by itself.

The government must respect the government budget constraint:

G =T (1)

This means that the government budget deficit G − T is always zero


in this one period model.

Sogang University Macroeconomics 1 September 27, 2024 3 / 22


Competitive Equilibrium 1

In a competitive equilibrium, all consumers and firms are


price-takers, and the economy is in equilibrium when the actions of all
consumers and firms are consistent.

When demand equals supply in all markets, we say that markets


clear.

Sogang University Macroeconomics 1 September 27, 2024 4 / 22


Competitive Equilibrium 2

Formally, a competitive equilibrium is a set of endogenous


quantities, C (consumption), N s (labor supply), N d (labor demand),
T (taxes), and Y (aggregate output), and an endogenous real wage
w , such that, given the exogenous variables G (government
spending), z (total factor productivity), and K (capital stock), the
following are satisfied:
1 The representative consumer chooses C and N s to make himself or
herself as well off as possible subject to his or her budget constraint,
given w , T , and 𝜋 (dividend income).
2 The representative firm chooses N d to maximize profits, with
maximized output Y = zF (K , N d ), and maximized profits
𝜋 = Y − wN d , taking z, K , and w as given.
3 The market for labor clears, that is N d = N s .
4 Thee government budget constraint is satisfied, G = T .

Sogang University Macroeconomics 1 September 27, 2024 5 / 22


Competitive Equilibrium 3
Recall the consumer’s budget constraint:

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 .

!"#$%&'()"#, !
−0."', = 23! = 245",$ = 240",$
C

9
D#6)EE,-,#7,
?
!∗ !%-F,

@
:∗ − 5 3-"6%7()"#
3"$$)8).)(),$
9-"#(),-
A
(<, <)
.∗ G
+,)$%-,, .
−>
B

Sogang University Macroeconomics 1 September 27, 2024 7 / 22


Pareto Optimality
Definition. A competitive equilibrium is Pareto optimal if there is
no way to rearrange production or to reallocate goods so that
someone is made better off without making someone else worse off.
To obtain the Pareto optimum, we find the solution to the social
planner’s problem which chooses C and l, given the technology for
converting l into C , to make the representative consumer as well off
as possible.
!"#$%&'()"#, !
−0."', = 23! = 245",$ = 240",$

C
Pareto Optimum D#6)EE,-,#7,
A
!∗ !%-F,

3-"6%7()"#
3"$$)8).)(),$
9-"#(),-
(<, <)
.∗ G
+,)$%-,, .
−>
B

Sogang University Macroeconomics 1 September 27, 2024 8 / 22


Fundamental Theorems of Welfare Economics
Both the competitive equilibrium and the Pareto optimum satisfy the
following condition:

MRSl ,C = MRTl ,C = MPN (7)

In this model, allocations in the competitive equilibrium and the


Pareto optimum are identical.

So, following two fundamental theorems hold:

▶ The first fundamental theorem of welfare economics: a


competitive equilibrium is Pareto optimal under certain conditions
(Adam Smith’s “invisible hand ").

▶ The second fundamental theorem of welfare economics: a Pareto


optimum is a competitive equilibrium under certain conditions.

Sogang University Macroeconomics 1 September 27, 2024 9 / 22


Sources of Social Inefficiencies
In reality, a competitive equilibrium fails to be Pareto optimal for the
following reasons:

▶ Externalities: any activity for which an individual firm or consumer


does not take account of all associated costs and benefits. ex) Pollution
(negative externality), attractive building (positive externality)

▶ Distorting taxes: a proportional wage income tax tends to discourage


work, driving a wedge between thee marginal rate of substitution and
the marginal product of labor

▶ Monopoly power: If a firm is large relative to market, it can use its


monopoly power to act strategically to restrict output, raise prices, and
increase profits.

The existence of market inefficiencies can justify various


government interventions in the market.

Sogang University Macroeconomics 1 September 27, 2024 10 / 22


An Increase in Government Spending 1
When the government spending increases, from G1 to G2 , the
production possibilities frontier moves from PPF1 to PPF2 .
G = T implies an increase in taxes and a reduction in nonwage
disposable income.

!"#$%&'()"#, !

C
!&
A D&
!'
D' 339'

339&
(<, <)
.' .& G
+,)$%-,, .
−>&
−>'

Sogang University Macroeconomics 1 September 27, 2024 11 / 22


An Increase in Government Spending 2
Because consumption and leisure are normal goods, C and l decrease.
Employment must rise because N = h − l, which means that output Y
should increase.
Recall the income-expenditure identity:

Y =C +G (8)

Rewriting the above equation,

ΔC = ΔY − ΔG (9)

We have ΔC < 0, ΔY > 0, and ΔG > 0, where private consumption is


crowded out by government purchases.
However, |ΔC | < |ΔG |, meaning that consumption is not completely
crowded out as a result of the increase in output.
Real wage w falls, as labor supply increases.
Sogang University Macroeconomics 1 September 27, 2024 12 / 22
An Increase in Government Spending 3

In sum, this model predicts that in response to an increase in


government spending, output and employment increases, while
consumption and the real wage fall.

This prediction is consistent with business cycle facts observed in data


in that employment is procyclical (moving in tandem with output).

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.

Sogang University Macroeconomics 1 September 27, 2024 13 / 22


An Increase in Total Factor Productivity 1
When total factor productivity increases, from z1 to z2 , the production
possibilities frontier pivots outward around point A.
With the same amount of labor, output increases, meaning that
consumption increases given C = Y − G where G is constant.

!"#$%&'()"#, !

@
B
!'
A D'
9 ! = H' 9 I, G − . − >
!&
D&
! = H& 9 I, G − . − >
(<, <)
.& G
+,)$%-,, .

−> C
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.
!"#$%&'()"#, !

B
!'
@
D'
9 ! = H' 9 I, G − . − >
!&
D&
! = H& 9 I, G − . − >
(<, <)
.& G
+,)$%-,, .

−> C
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.

▶ There have been many important technological innovations since World


War 2, and aggregate output, consumption, and real wage has
increased, while hours worked per employed has remained roughly
constant.

This model also can explain short-run aggregate fluctuations in


macroeconomic variables.

▶ The model is consistent with procyclical consumption, and real wages


observed in data.

▶ However, this model may or may not explain procyclical employment.

▶ To do so, substitution effects should dominate income effects so that


labor supply increases in response to a positive shock to productivity.
Sogang University Macroeconomics 1 September 27, 2024 16 / 22
Proportional Income Taxation 1
For the purpose of simple analysis here, assume that labor is only
input in the production function.

Y = zN d (10)

In an equilibrium, labor demand equals labor supply:

Nd = Ns = h − l (11)

To get the production possibilities frontier, substitute for Y in the


expenditure-income identity C + G = Y :

C = z(h − l) − G (12)

Sogang University Macroeconomics 1 September 27, 2024 17 / 22


Proportional Income Taxation 2
We can draw the production possibilities frontier as follows.
Note that the equilibrium point should be on this frontier, as the
expenditure-income identity should be always satisfied.

!"#$%&'()"#, !
C
HG − >

A
(<, <)
G − >/H G
+,)$%-,, .
−>

Sogang University Macroeconomics 1 September 27, 2024 18 / 22


Proportional Income Taxation 3
Labor demand of firms is infinitely elastic at w = z.
▶ Firm’s profit is given by
𝜋 = Y − wN d = (z − w )N d
▶ If w > z, there is no incentive to hire labor (N d = 0).
▶ If w < z, N d is infinite.
▶ if w = z, N d can be any values, as the firm is indifferent among any
values of labor.
KLM,, N

O((N)
H

+L8"- @,&L#6, O(
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.
!"#$%&'()"#, !

C
HG − >

P
@
H Q−( G

D&
B D'
A 9
(<, <)
G − >/H G
+,)$%-,, .
−>

Sogang University Macroeconomics 1 September 27, 2024 20 / 22


Laffer Curve 1
Tax revenue is collected from the labor income tax wN s with w = z
and N s = h − l:

REV = tz[h − l(t)]


Here, labor supply l is a function of a tax rate t.
l increases with t if substitution effects dominate income effects.
We can draw tax revenue REV against the tax rate t.
5LR 4,F,#%,

4PS∗

>

C A
T (& (∗ (' Q
5LR -L(,, (
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 .
!"#$%&'()"#, !

HG − > C
H Q − (& G

9
H Q − (' G

D&
B D'
A
(<, <)
G − >/H G
+,)$%-,, .
−>

Sogang University Macroeconomics 1 September 27, 2024 22 / 22

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