EC201 Intermediate Macroeconomics EC201 Intermediate Macroeconomics Problem set 12

2012/2013

1) (Rational Expectations and Monetary Policy Ineffectiveness) Consider the following AD-AS model in log linear form: AD yt = mt p t (you can derive this from the quantity theory by assuming that the velocity of money is normalised to 1) e AS yt = y + ( pt pt ) Where y t is output in period t, mt is the money supply, p t is the price level, y is the natural level of output, pt is the expected price and > 0 is a constant. Suppose that expectations are rational. Suppose that mt = m + t , where
e

t ~ WN (0, 2 ) is a random variable while m is a deterministic constant.

(a) Derive the equilibrium levels of aggregate output and aggregate prices at time t for this economy. (b) Find the expression of the expected price level under rational expectations. (c) Find the effect of monetary policy under the assumption of rational expectations. Explain. 2) (Intertemporal Substitution of Labour Supply, Lucas and Rapping (1969)) An individual lives for only two periods and has preferences given by the following intertemporal utility function: U = ln(c1 ) + ln(1 h1 ) + [ln(c 2 ) + ln(1 h2 )] where c1 , c 2 denote consumption in period 1 and period 2 respectively. h1 , h2 denote the labour supply (hours worked) in period 1 and 2 respectively. Therefore 1 h1 is the amount of leisure time in period 1 for example (we have normalised the amount of time available to the individual in each period to be 1). The term > 0 is the discount factor. The problem of the individual at period 1 is to choose consumption in both periods and labour supply in both periods subject to the following budget constraints: c1 + s = w1h1 and c 2 = w2 h2 + (1 + r ) s , where s denotes saving, w denotes the wage and r denotes the interest rate. (a) Provide an economic interpretation of the two budget constraints written above. (b) Combine the two budget constraints written above (using the fact that they have a common element, that is the saving) to derive the following c wh intertemporal budget constraint: c1 + 2 = w1 h1 + 2 2 . Provide an 1+ r 1+ r economic interpretation for the intertemporal budget constraint. (c) The Lagrangean function for this intertemporal optimisation problem is given by: wh c L = ln(c1 ) + ln(1 h1 ) + [ln(c 2 ) + ln(1 h2 )] + w1 h1 + 2 2 c1 2 1+ r 1+ r Where is the multiplier. Find the first order conditions with respect to L L h1 , h2 , that is: = 0, = 0. h1 h2

(d) Divide the two first order conditions you found in (c) to get rid of the multiplier. You should obtain an expression that tells you how the relative labour supply between period 1 and period 2 depends on the relative wage. What happens to the relative labour supply if there is an increase in the interest rate? What happens to the relative labour supply if there is an increase in the period 2 wage relative to the period 1 wage? Comments on your results. (e) Using the same Lagrangean as in (c) find the first order conditions with respect to consumption in both periods. Divide those two first order conditions to get rid of the multiplier. Explain what happens to the relative consumption when there is an increase of the interest rate. What about an increase in the discount factor?