ECON 20200/5: Problem Set 2

Due April 29, 2019

Josh Morris-Levenson

1 The Two-Period Labor Model Decentralized (25 points)

Consider a two period model inhabited by a continuum of households on the unit interval
and a single representative firm.(In other words treat this as a problem with one agent
and one firm). The households live for two periods and then die and wish to maximize
their lifetime utility which is given as:
U (c1 , ns1 , c2 , ns2 ) = ln c1 + ln(1 − ns1 ) + β ln c2 + ln(1 − ns2 )
 

The individual buys the consumption good c from the firm at a price of one and sells
its labor in each period, nst , at wage wt . In addition the household is able to buy and
sell bonds, b1 , with other households in period one at a price of 1 and receives (1 + r) in
interest from it’s holdings in period two. The household also owns the firm from which
it receives profits πt as dividends. The household takes the profits of the firm and the
wage rate as given. The representative firm, buys labor ndt in the labor market from the
household and produces output with production function f (ndt ) = At (ndt )α , for A > 0 and
α ∈ (0, 1).
1. Define the competitive equilibrium of the economy.
2. Write out the household’s period by period budget constraint, combine these into a
lifetime budget constraint. How does this compare to the budget constraint in the
social planner’s problem?
3. Set up the Lagrangean for the household’s problem.
4. Obtain and interpret the optimality conditions.
5. Find the solution to c∗1 , n∗1 , n∗2 and c∗2 . You may leave these in terms of the prices r
and wt , πt .
6. Set up the representative firm’s problem. Is the problem dynamic?
7. Obtain the optimality condition to the firm’s problem. Are the firm’s profits zero
at the optimum?
8. Show that the competitive equilibrium provides the same solution as the social plan-
ner’s problem.

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2 A Bond Market with Heterogeneous Households (25 points)

Consider an economy that lasts for two periods and contains two types of households.
Type E households have elastic preferences:

U (c1E , c2E ) = c1E + βc2E

Type I households have inelastic preferences:

V (c1I , c2I ) = log cI1 + β log c2I

Both types of households have the same discount factor β between 0 and 1. Both house-
holds receive identical endowments y1 in period 1 and y2 in period 2. The households have
access to a credit market where they can trade one-period bonds. A quantity b1 of bonds
purchased in period 1 will pay (1 + r)b1 units of the consumption good in period 2.
1. Write the intertemporal budget constraint for the type-I household.
2. State the type-I household’s optimization problem. Compute the optimal choices
c∗1I , c∗2I , and b∗1I in terms of the interest rate.
3. Write the intertemporal budget constraint for the type-E household.
4. Compute the optimal choices c∗1E , c∗2E , and b∗1E in terms of the interest rate. (Hint
1: The standard approach using the Euler equation will produce a nonsensical result.
Instead, consider three cases separately: β(1 + r) > 1, β(1 + r) = 1, and β(1 + r) <
1. Hint 2: Replace c2E in the utility function using the intertemporal budget
constraint, and then consider how utility responds to changes in c1E in each of the
three cases.)
5. Why does the Euler equation approach fail in this case?
6. State the market clearing condition in the bond market.
y2
In parts 7-9 we will use a guess and verify method to figure out conditions on y1
and β so that β(1 + r) is either greater, less than, or equal to 1.
7. Guess that β(1 + r) > 1 (*). With this guess, plug in b∗1E into the bond-market
clearing condition. Use the bond-market clearing condition to solve for 1+r. Finally,
find a condition on yy12 and β so that β(1 + r) > 1 (i.e., take your solution for 1 + r
and substitute it into (*)).
8. Guess that β(1 + r) < 1 (**). With this guess, plug in b∗1E into the bond-market
clearing condition. Use the bond-market clearing condition to solve for 1+r. Finally,
find a condition on yy12 and β so that β(1 + r) < 1 (i.e., take your solution for 1 + r
and substitute it into (**)).

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 9. Under what condition on yy12 and β is β(1 + r) equal to 1? (Hint: It will be when
β(1 + r) is neither greater than 1 nor less than 1. Use your answers to parts 7 and
8.)
10. Suppose that yy21 and β are such that β(1 + r) = 1. Plug (1 + r) = β1 into the
expression for b∗1I . Use the bond-market clearing condition to solve for b∗1E .
y2
11. Under what conditions on y1 and β is the elastic household borrowing in period 1?
Lending?
12. Suppose that yy12 and β are such that β(1+r) > 1. Use your answer to part 7 to solve
for c∗1I and c∗2I . Plug these values into V (c1I , c2I ) to find the utility of the inelastic
household.
13. Now consider a world in which the elastic household does not exist. Since there
is only one type of households, agents will neither borrow nor lend. In this case,
utility will be V (y1 , y2 ). What does the difference between V (c∗1I , c∗2I ) and V (y1 , y2 )
represent? (Hint: V (c∗1I , c∗2I ) − V (y1 , y2 ) > 0.)

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3 Endogenous Labor Supply with Technological Progress
(25 points)

Consider a model with an infinite time horizon containing a representative household and
firm. The household supplies labor to the firm at a wage wt and purchases consumption
goods at a price pt normalized to 1 (you can interpret the wage as the real wage). The
household enjoys consumption and dislikes work. The household has access to one-period
bonds. A quantity of bonds bt purchased in period t will return (1 + rt+1 )bt units of the
consumption good in period t + 1.
The household has CRRA utility over consumption and leisure and discounts future peri-
ods at rate β between 0 and 1. Its lifetime utility is given by

∞  c1−σ
X (1 − nt )1−φ 
βt t
+
1−σ 1−φ
t=0

The household owns the representative firm, so all profits Πt are remitted to the household.
The household’s budget constraint for a generic period t is given by,

ct + bt = wt nt + (1 + rt )bt−1 + Πt

The representative firm has a linear production technology yt = At nt . Technology im-

proves over time at an exogenous rate g. Given an initial level of productivity A0 , we have
At = (1 + g)t A0 .
1. Write down the household’s utility maximization problem. You may write the budget
constraint for a generic period t.
2. Write the household’s Lagrangean. Express the budget constraint for each period
separately and include a Lagrange multiplier for each.
3. Compute the household’s FOCs with respect to ct , nt , and bt .
4. Combine the household’s FOCs to find the Euler equation and intratemporal labor-
leisure condition. Your results should be in terms of ct , nt , prices, and parameters.
5. Write the firm’s profit maximization problem. Is this problem dynamic?
6. Derive the firm’s FOC. Substitute the result into the profit function. What is the
level of profits in equilibrium?
7. Define the competitive equilibrium for this economy.
For the remainder of the question, assume φ = σ and σ > 1.
8. Solve for the household’s optimal labor supply decision. Express your answer in
terms of parameters. Does nt change over time? If so, is it increasing, decreasing, or
something else? (Hint: You should use the time-t goods market clearing condition,

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 the firm’s FOC, and the household’s intratemporal optimality condition. The result
should be a function of A0 and g only.)
9. Solve for the household’s optimal consumption, ct .
10. Solve for the interest rate using the Euler equation. Express your result in terms of
parameters. Is the interest rate increasing or decreasing over time?
ct
11. Let’s analyze the long-run behavior of the model. Note that limt→∞ ct+1 = (1 +
g)−1/σ . Compute r̄ = limt→∞ rt . How does r̄ change as σ increases? Explain
intuitively.

4 Decentralized Infinite Horizon Model (25 points)

Suppose we have an economy populated by a representative household who wishes to

maximize their lifetime utility, taking as given their initial wealth, b0 , capital stock k1 ,
and prices. Their lifetime utility is given by the expression:
∞
X
β t−1 u(ct ) + v(nt )
 
U=
t=1

subject to their individual period budget constraint:

wt nt + qt kt + (1 + rt−1 )bt−1 + πt = ct + it + bt

for t = 1, 2, 3... with k1 and b0 given. Where wt is the wage on time t labor services, qt is
the rental rate of capital at time t, and rt is the time t interest rate, it is investment in
time t, and bt is the household’s choice of bonds in time t. In addition the capital stock
owned by the household evolves according to the following law of motion:

kt+1 = (1 − δ)kt + it

1. Combine the law of motion for capital with the resource constraint. Set up the
household’s Lagrangian, using their per period budget constraints. In a generic time
period t what is the household choosing?
2. Find the period-t first order condition for the household and combine to make an
intertemporal equation with respect to the return to capital, an intratemporal equa-
tion with respect to the labor consumption trade off, and an intertemporal equation
with respect to the interest rate rt . All of these should be left in terms of the prices,
wt , qt , rt .
3. Explain intuitively the three optimality conditions. Suppose one side of the equa-
tion is larger than the other; what does that mean about the agent’s optimal choice?
What will happen as they respond?

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 The Representative firm’s problem is to choose labor and capital to maximize profits.
The available technology is:
yt = At F (nt , kt )
Where the usual conditions that Fn , Fk > 0, Fnn , Fkk , < 0 and Fnk > 0.
4. Set up the firm’s problem. What are they choosing in each period? Is the firm’s
problem dynamic? Why or why not?
5. Find the first order conditions for the firm, and explain intuitively what the firm is
doing in regards to these first order conditions?
6. Suppose the firm’s production function is :

At F (nt , kt ) = At nαt kt1−α

What will profits be at the optimum allocations?

7. Define the competitive equilibrium
8. Show that the Euler equations for the household combined with the firm’s optimality
conditions will give us the social planner’s optimum.
9. For now assume that

v(nt ) = 0
u(ct ) = ln(ct )

Assume there is some constant value for A. What will be the steady state values
of capital, labor (hint: they don’t care about leisure), consumption and bonds as
functions of α, β, δ and A.