Intertemporal macroeconomics questions

1) Explain the model of consumption behind the Ricardian Equivalence

proposition. Why might this theory of consumption be unrealistic?
One of the main ways of considering the effects of a budget deficit is the
Ricardian paradigm. Here, generations are linked through intergenerational utility
transfers. The equivalence means that because deficits merely change the
payment of taxes to future generations, dynastic resources are unaffected, and
so deficits do not affect the economy significantly. This is because deficits are
merely a postponement of taxes, and a rational household/ individual would be
able to see this, and make an intertemporal calculation that lower taxes now will
lead to higher taxes/ lower spending in the future. Once the household has
factored that in, they will realise that the present discounted value of taxes does
not depend on the timing of the tax. Therefore, temporary and permanent
budget deficits do not affect the consumption pattern of households this is
related to Says law for deficits the demand for bonds will rise to match
government borrowing, so for example a budget deficit financed through tax cuts
will result in households spending their increase in current income purely on
government bonds i.e. saving all of the increase in income. Therefore budget
deficits have no real effects.
This proposition relies on many strict assumptions: that successive generations
are linked through intergenerational utility, or intergenerational resource
transfers; perfect capital markets (or failure in specific ways); rational, nonmyopic consumers; lump sum taxation; non redistributionary taxation; deficits
cannot add to value within the economy; deficit financing do not alter the
political system.
These assumptions are highly unrealistic, and do not match the empirical data
available to us. Moreover, because households comprise of more than one
person, humanity will be linked in a very complicated fashion, with links between
one family and the other. Because of these extra links forming a large, global
network of families we cannot represent one household as a representative,
single, utility-maximising agent, even if their utility is solely derived from their
own utility and their childrens. Ricardian equivalence, or Barros result, would
lead to the result that all government transfers, taxes, and the price system are
irrelevant under this global family network as shown by Bernheim and Bagwell.
This is best illustrated with the example of two couples with one child each. If the
children marry, these two families that initially did not care about each other will
now affect each others utility through their children, and would have to initially
spot this and somehow coordinate their actions to transfer resources to offset the
effects of budget deficits now, which seems highly unlikely. The Ricardian
assumption that consumers are infinite-lived is highly unrealistic.
2) Explain how, in an RBC model, the economy responds to a one-off and
permanent increase in the level of technology.

Within an RBC model we set up a neoclassical model of the economy. The

economy is populated by identical agents who live forever. Their utility at a
specific moment in time will be dependent on their consumption in that time
period, the amount of leisure consumed in that time period, multiplied by a
discount factor, assumed to be constant. We include leisure because work effort
can vary in the short run and explains fluctuations. The utility function is
assumed to be concave, and twice continuously differentiable.
Production: there is a single final good, Y, produced, captured by a constant
returns to scale production technology, so Y=Qt F(Kt,Nt) where Kt is the capital
stock will be determined by the period preceding this current time period. Qt is
the temporary shift factor that influences the total factor productivity, or the
technology. The produced good can be consumed or invested. This production
function is also concave, and twice continuously differentiable.
Capital accumulation: the invest Y becomes part of the capital stock for the next
period, t+1. Therefore, the capital stock in the next time period will be 1 minus
the depreciation rate multiplied by the capital stock in the current time period,
plus the gross investment of Y in the current time period.
Resource constraints: Agents cannot have their labour supplied and leisure
consumed add up to more than 1, and consumption and investment of good Y
must be less than or equal to the amount of good Y produced. We have
normalised time endowment so that 1 represents the total time available to
workers. L, C, N, K are all nonnegative.
Because we assume that all individuals are the same, we can model a
representative agent to determine the optimal level of consumption, investment,
work effort over time. If we set up a Lagrangian from the logarithmic utility
function for the representative consumer, where utility is equal to the log of
consumption, minus a variable X times leisure. If we then assume that the
economy follows a Cobb-Douglas production function, and that changes in
technology are computed using a Solow model, following a logarithmic random
walk for optimal decisions (approximately) we can then go on conclude what
happens following a one-off shift to the level of technology.
An increase in the technology factor, due to total factor productivity increasing,
would lead to wages increase in the wage paid to labour according the
production function increasing by the factor of productivity increase. We would
also see an increase in the wages for the future time period, which would lead to
an increase in the labour supply. However, this would be offset in future time
periods as the change in labour supply quickly decreases, before becoming
negative and leading to the constant level of labour supply.
We would expect to see an increase in the output level because of the production
function increasing by the productivity factor increase. However, households
would want to smooth consumption over their lifetime (assumed to be infinite)
which would mean that savings would have to increase to ensure this happens.
As well as this, the marginal product of capital will have increased due to

technology increasing the future time period as the level of savings increases in
the current time period, meaning that savings and investment will fluctuate
heavily within this model.
3) Explain how a Keynesian economist might construct a theory of a business
cycle coming from fluctuations in aggregate demand
A Keynesian economist would construct a theory of the business cycle by using
sticky prices to model the economy using aggregate demand and short run
aggregate supply. Aggregate demand might change for a variety of reasons, for
example due to a change in the level of government spending. When business
are not confident about the future they will cut back on investments, leading to a
fall in aggregate demand. According to the IS-LM model, an inward shift of the IS
curve would lead to a fall in the level of output and a fall in the real interest rate,
and at the current price level we would see a lower level of output. Due to the
multiplier and accelerator effects we would see a much larger fall in output as
business would see the fall in output of the previous period, and respond by
cutting output and investment further in the expectation that they will see lower
income. Eventually investment decreases will bottom out and we will see the
rate at which output falls decrease, which will lead to investment rising in the
next time period as business grow confident of an upturn, leading to accelerator
and multiplier effects in the opposite direction.
4) How much of the disagreement between Keynesian and Real Business
Cycle theory has to do with differing views about what shocks hit the
economy rather than different views about how the economy reacts?
As discussed above, it is clear how aggregate demand would affect the economy
in the short run according to a Keynesian economist; fluctuations in aggregate
demand affect output due to sticky prices. However, within RBC we will see
intertemporal substitution of goods and leisure within the goods market. Because
of higher government spending, there is increased demand for good Y. In order to
achieve equilibrium within the goods market, the interest rate must increase,
leading to a fall in consumption and investment. Moreover, this increase in the
real interest rate would lead to individuals working harder, because working hard
today is now more attractive (make hay while the sun is shining). Income in the
current time period has a higher present value, and future income has a lower
value, relative and absolute. Therefore, labour supply increases, leading to a
higher equilibrium output and labour employment. The Keynesian analysis does
not include any role for the labour market through the real interest rate
employment and output do increase, but only because those unemployed now
find jobs due to higher aggregate demand. We see labour markets in excess
supply, whereas within the neoclassical model of the economy within the RBC
model, we cannot explain involuntary employment output and employment
increasing due to real interest rate must happen due to another mechanism.
However, both of the models predict the same effect due to a change in
government spending, and so have the same explanatory power when it comes

to aggregate demand shocks perhaps this might depend on whether the labour
market is working properly within the economy being modelled.
However, for technological disturbances we are unlikely to see the same analysis
from Keynesian business cycles and RBC models. RBC models would be unlikely
to model recessions using aggregate demand analyses as it would not be able to
generate a procyclical real wage that would explain why labour and consumption
move in opposite directions during a recession (the real wage being the relative
price of working compared to leisure). If we had the same production function,
the diminishing marginal returns to labour would mean that we get counter
cyclical real wages. Therefore, for recessions the RBC model points towards
technological changes rather than aggregate demand chocks, both of the
nominal and real kind, towards which Keynesian and monetarist accounts point
as explaining recessions.
Keynesian economists will point towards the fact that supply and demand will not
equate due to sticky prices, whereas RBC theorists will point towards negative
technological shocks within recessions. However, RBC theorists can still model
demand shocks by simply adapting the parameters within the model set up
preferences can be adjusted accordingly, for example. However, as explained
with the example of government spending, we would see this manifested in
supply shocks as real interest rates affect the labour market by expanding labour
supply and capital stock, thus shifting supply outwards.