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Tutorial 2

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rashiagarwal2308
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TUTORIAL QUESTIONS 2

TOPICS IN MACROECONOMICS
WINTER 2022
UNIVERSITY OF EDINBURGH

INSTRUCTOR: RAFAEL LOPES DE MELO

1. Labor Force Participation


Consider an economy where the individuals have the same preferences and resources as the one
described in Lectures 1b and 2a. Individuals have a time endowment of T and can work for a
hourly wage w. The dierence now is that we have a population of individuals, each one with
their own value of vi (the non-labor income), where i indexes individuals. We assume that vi is
distributed Uniformly on support [0, v] , where v is signicantly higher than wT . For the purpose
of this question you can use the optimal choice of labor and consumption derived in lecture.
(a) Derive the reservation wage of a generic individual i.
(b) Compute the labor force participation rate in the economy.
(c) Compute total hours per person (THP) in this economy.
(d) Demonstrate what happens to labor force participation and THP when the wages increase
(keeping everything else xed).

2. Business Cycles and Labor Supply


Take an individual that lives for two periods. He supplies labor in each period (h1 and h2 ) and
then earns income from the government in the later period, which can be seen as retirement income
or a government transfer. Denote the wage rate on the rst period by w1 and the wage rate in
the second period by w2 . The transfer on the second period is proportional to the wages during
that period G = γw2 .1 He can borrow and save using capital markets: saving s1 at date 1 yields
s1 (1 + r2 ) at date 2. Let l1 = T − h1 and l2 = T − h2 denote leisure respectively in each period.
His preferences over consumption and leisure are given by

u(c1 , c2 , l1 , l2 ) = log (c1 ) + log (l1 ) + β [log (c2 ) + log (l2 )]


(a) Interpret the preference parameter β
(b) Write down this consumer's problem, rst using one budget constraint per period, expressing
the variables that he takes as given and the ones he optimize. Write the consolidated budget
constraint for this consumer.
(c) Solve the consumer problem, assuming that β = 1+r 1
2
.
1e.g.the transfer is nanced by a tax on period 2 workers. We assume that w2 implicitly includes that tax, so that
we do not have to consider it explicitly into the problem.
1
TUTORIAL QUESTIONS 2 TOPICS IN MACROECONOMICS WINTER 2022 UNIVERSITY OF EDINBURGH 2

(d) What happens to hours worked if w1 and w2 are increased proportionally by the same amount
(i.e. w1 = (1 + g) w1 and w2 = (1 + g) w2 ). What happens to consumption? Relate this to
0 0

the income and substitution eects with respect to growth we saw in class.
(e) Assume that w1 = w2 = w. Plot the long-run labor supply curve in this economy. (I want
a qualitative plot of hours worked as a function of w). Is this consistent with the empirical
evidence that we saw in class?
(f) We saw in class that the wage rate is pro-cyclical. Start from a situation where w1 = w2 = w.
Suppose that at date 1 there is an unexpected boom that only lasts for 1 period such that
w1 > w1 . What happens to labor supply on that period? What if it was a recession? Is this
0

consistent with the pattern of THP over the business cycle?


(g) Plot the short-run labor supply curve in this economy. (I want a qualitative plot of hours
worked as a function of w1 ). Reconcile these results with the results in (c) and (d).

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