ECON20300 Elements of Economic Analysis IV Spring 2014

Problem Set 1
Yuan Tian

Due Thursday, April 10, 2014, in class

1 A Robinson Crusoe Economy

Robinson Crusoe lives on an island by himself. He generates utility from leisure and the consumption of
coconuts. Coconuts will not grow by themselves on this island so Crusoe has to work to grow coconuts. He
has one unit of time to allocate between working and resting. Crusoe consumes all the coconuts he grows.
If Crusoe decides to allocate l units of time to working, he will grow

y ⌘ f (l) = A · l

units of coconuts. If he consumes c units of coconuts and rests for r units of time, he will obtain utility

u(c, r) = c r1 .

Obviously, r + l ⌘ 1 with r 0 and l 0 and c = y. Crusoe makes his consumption and labor/leisure
decisions optimally to maximize his utility.

Exercises:

1. Set up Crusoe’s utility maximization problem.

2. Solve for his optimal choices c⇤ in consumption and r⇤ in leisure.

3. What does A represent?

4. How do r⇤ and c⇤ depend on A?

5. Explain the intuitions behind your answers to the previous part with income and substitution e↵ects.

For the rest of the problem, assume Crusoe’s utility is now given by
p
ũ(c, r) = 2 c + r

while the production function of coconuts stays the same.

Exercises:

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 6. Repeat exercises 1 and 2 with the new utility function.

7. Repeat exercise 4 with the new utility function.

8. Repeat exercise 5 with the new utility function.

2 A General Equilibrium Model with Lump-Sum Taxes

Consider the following variation to the model we introduced in class. The productive services generated by
the government expenditure is characterized by

1
Y g (G) = G , where 0 < < 1. (1)

The production technology of the private sector is given by

1 ↵
Y p (K) = K , where 0 < ↵ < 1.
↵

The government acts as a benevolent social planner who maximizes the household’s discounted utility over
its infinite lifetime, which is given by
1
X
t
u(Ct ).
t=0

As before, the economy-wide resource constraint is given by

1 ↵ 1
Yt = Ytp + Ytg = Ct + It + G = K + G ,
↵ t

with the law of motion for capital given by

Kt+1 = (1 )Kt + It .

Exercises:

1. Calculate the efficiency of government expenditure in terms of generating extra output. Does the
marginal product of government expenditure increase or decrease as G increases?

2. Combine the law of motion for capital with the economy-wide resource constraint in period t to obtain
a single constraint for this period.

3. Set up the benevolent social planner’s problem, taking the government expenditure G as given. What
are the choice variables? What are the parameters?

4. Calculate the first-order conditions with respect to the choice variables and solve for the Euler equation
of consumptions between periods t and t + 1.

5. Impose the steady state equilibrium in the economy and solve for steady state level of capital Kss . Is
government expenditure distortionary toward capital held by the private sector?

6. Solve for the steady state consumption Css and overall output Yss . Is government expenditure distor-
tionary toward Css and Yss ?

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 7. Rewrite G as function Yss . Use the economy-wide resource constraint you obtained in part 2 to solve
for Css as a function of Yss .

8. The traditional Keynesian theory conjectures that consumption C is a linear function of the aggregate
output. Does this model satisfy the Keynesian theory in the steady state?

9. According to your answer in part 6, what is the steady-state consumption maximizing government
expenditure—what level of G maximizes the discounted utility for the households in steady state?

10. What would your answer be to part 9 if the productive services of the government expenditure follows
the same pattern as we introduced in class:

Y g (G) = G, where 0 < < 1.

What lies behind the di↵erence, if there is any, between your answer here and that in part 9?
(Hint: You do not have to solve the first nine parts again to answer this question. Briefly justify why
you can use your answer in part 6 directly then proceed to answer the question raised in this part.)

3 Taxation of Labor Income

Consider the following scenario regarding the proportional tax on labor income and the election of officials
in public offices in one single period. There are three voters in this economy with their preferences over
consumption and labor/leisure given by
8 ✓ ◆2
>
> 1
>
> u1 (c1 , l1 ) = c1 l1 ;
>
> 3
>
>
>
>
>
>
>
< ✓ ◆2
1
u2 (c2 , l2 ) = c2 l2 ;
>
> 2
>
>
>
>
>
>
>
> ✓ ◆2
>
> 2
>
:u3 (c3 , l3 ) = c3 l3 ;
3

where ci and li stand for voter i’s consumption and labor supply and each voter has one unit of time to
allocate between working and resting. Voters’ only source of income is their wage. Wage rate is fixed at 1.
Wage income is subject to proportional income taxes. Let ⌧ represent a generic income tax rate. Voters’
objective is to maximize their own utility subject to their budget constraint.

Exercises:

1. Write down the budget constraint of each voter and solve for each voter’s optimal choices in consump-
tion c⇤i and labor supply li⇤ as functions of the income tax rate ⌧ .

2. Calculate each voter’s maximized utility as a function of ⌧ by plugging your answers to part 1 into the
corresponding utility function.

3. Calculate the tax payment by each voter as a function of ⌧ .

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 4. Calculate the total tax revenue collected from all voters. Does it exhibit a La↵er Curve?

Now to side of the politics. Two candidates are running for the public office that determines the income tax
rate. Each candidate has to propose a tax rate as his/her running platform and must implement his/her
proposed tax rate if elected. Winner in the election is determined by the simple majority voting rule. Specif-
ically, in this model, whichever candidate wins at least two votes wins the election. The first candidate Alice
proposes a tax rate of ⌧1 = 11/24 and the second candidate Bob proposes ⌧2 = 7/12. Each voter votes for
his/her preferred candidate based on whose tax rate results in a higher utility for him/her if implemented1 .
In addition, assume that when any voter is indi↵erent between the two candidates, he/she votes for Bob.

Exercises:

5. Who (Alice or Bob) will voter 1 vote for? What about voters 2 and 3? Who wins the election?

6. Now, suppose Alice still proposes ⌧1 = 11/24 but Bob becomes forward looking before the election and
is reconsidering his running platform. Bob knows that Alice will not change her platform. He also
really wants to win the election. In what range, within the interval [0, 1], can Bob propose a tax rate
⌧2 and beat Alice in the election?

7. Suppose all the tax revenue goes to the winner of the election. Instead of being a good public servant
and having the voters’ interest in mind, Bob simply wants to maximize the tax revenue he can collect.
Of course, he will not be able to collect any tax revenue if he loses the election to Alice. Based on your
answers in part 6, what tax rate ⌧2 will Bob propose?

1 It may not be optimal for voters to “vote according to their heart” in general when there are more than three candidates

involved and voters act strategically, according a Nobel-winning result in mechanism design discovered by Kenneth Arrow.
However, honestly voting for his/her preferred candidate is optimal for any voter in this model.

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 ECON20300 Elements of Economic Analysis IV Spring 2014

Problem Set 2
Yuan Tian

Due Thursday, April 17, 2014, in class

1 Income Inequality
Consider an economy populated by a measure 1 of consumers. Each consumer has 1 unit of time to allocate
between working and resting. Consumers have to work to obtain income so that they can purchase consump-
tion goods. The price of consumption goods is normalized to 1. Consumers di↵er in the wage rate they can
get when working. Among the measure 1 of consumers, an ↵ share of them are skilled workers with wage
rate wa and the rest 1 ↵ share are unskilled ones with wage rate 0 < wb < wa . Consumers care about
consumption and leisure/labor according to the following utility function,
8
<u (c, l) = c a (1 l)1 a
;
a
where 0 < a, b < 1.
:u (c, l) = c b (1 l) 1 b
;
b

(Do you expect a > b or the exact opposite?) We start this problem with some understanding of a widely
used basic measure of income inequality, namely the Gini coefficient. The Gini coefficient is a real number
between 0 and 1, with 0 representing perfect equality and 1 representing all wealth belongs to the richest
consumer/worker. The Gini coefficient is based on a graphical representation of cumulative income made by
the lower income population called the Lorenz curve. We will build up the Lorenz curve for this model step
by step but we first have to characterize the optimal behaviors of the consumers.

Exercises:

1. Set the utility maximization problems and solve for the optimal choices of the skilled ((c⇤a , la⇤ )) and
unskilled ((c⇤b , lb⇤ )) workers.

2. How much wage income is each unskilled worker making? How about each skilled worker?

3. What condition must a, b, wa , and wb jointly satisfy so that an average skilled worker is making
more income than an average unskilled worker?

4. What fraction of the total wage income in the entire economy is made by the unskilled workers?

Assume from now on, a = b = . Notice that this condition would not violate the condition you
characterized above in part 3, if you answered that part correctly. We are now ready the characterize the
Lorenz curve. Let L(s) represent the share of the total income made by the lowest-income s fraction of the

1
entire population. In other words, if we identify all workers by the income they individually make in an
increasing order, with worker 0 being the worker that makes the least income and worker 1 the most, L(s)
will be the quotient between the total income made by workers 0 through s and the total income made by
the entire population. Note that, by definition,

L(0) = 0 and L(1) = 1.

Exercises:

5. What is the total wage income made in this economy?

6. Calculate L(s) as a function of wa , wb , ↵, and . You may not see all the parameters in your answer
and your answer may be a piecewise function.

7. Plot L(s) as a function of s, putting s on the horizontal axis and the value of L(s) on the vertical axis.
The curve you just plotted is the Lorenz curve for our very simple model. What would the Lorenz
curve look like if wa = wb ?

8. Calculate the area below the Lorenz curve between 0 and 1. You can either do this by integrating
the cumulative income share function L(s) or geometrically by segmenting the area below the Lorenz
curve into di↵erent regions and adding up the areas of these regions. Let B to represent this area.

The Gini coefficient G of an economy is defined as

0.5 B
G(B) ⌘ =1 2B.
0.5

In the U.S., according to the report compiled by the Congressional Budget Office in 2010, the before-tax
Gini coefficient is roughly 50%, increasing from roughly 45% in 1985.

Exercises:

9. What is the Gini coefficient of our simple economy in this model when ↵ = 1/2?

10. How does the ratio between the wage rates of the skilled and unskilled workers wa /wb depend on ↵ so
that our simply model results in a Gini coefficient of 50%?

11. How does the Gini coefficient in our simple economy depend on the ratio wa /wb , holding ↵ constant?

12. Based on your answers to the previous two parts, comment on whether the Gini coefficient is a good
measure of income inequality in an economy. (There is no single correct answer to this part. The
merits of your answer will be based on the argument you make to support your conclusions.)

2 Taxation and Transfer

In the same setup as in the previous question, let ↵ = 1/2. Also, assume the skilled and unskilled workers
share the same preferences, in other words, a = b = .
To achieve some distributional objective, which will be clarified shortly, the government decides to tax
the labor income of the skilled workers with a proportional tax with rate ⌧ and transfer the tax revenue

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directly to the unskilled workers in a lump sum. The government must balance its own budget, so the
total amount of lump sum transfers to the unskilled workers must be equal to the total tax revenue col-
lected from the skilled workers. Let v be the lump sum transfer received by a representative unskilled worker.

Exercises:

1. Set up the utility maximization problem of a representative skilled worker and solve for her optimal
consumption c⇤a and labor supply la⇤ as functions of wa and ⌧ and the parameters.

2. How much tax is a representative skilled worker paying, given the tax rate being ⌧ ? What is her
maximized utility? Let µa denote this maximized level of utility (as a function of ⌧ and wa and the
parameters). What is the value of µa when ⌧ = 0? Call this value µ̄a .

3. Set up the utility maximization problem of a representative unskilled worker and solve for her optimal
consumption c⇤b and labor supply lb⇤ as functions of wb and v and the parameters.

4. What is the maximized utility of a representative unskilled worker given the lump sum transfer v? Let
µb denote this maximized level of utility (as a function of v and wb and the parameters). What is the
value of µb when v = 0? Call this value µ̄b .

Suppose the government’s objective is to maximize the following composite welfare of the entire economy:

U = ↵ ln(µa ) + (1 ↵) ln(µb ).

U , as a sum of concave functions of individual utilities is often referred to as the Nash collective utility.

Exercises:

5. Write down the constraint the government is facing to balance the budget.

6. Set up the government’s problem and solve for the optimal tax rate ⌧ ⇤ that maximizes the Nash
collective utility of the consumers. (This part may be quite algebraically involving... but considerably
less so if you know which part of the problem to focus on...)

7. Calculate the after-tax incomes of the skilled and unskilled workers under ⌧ ⇤ .

8. What is the Gini coefficient in this economy after the tax-and-transfer program is implemented? That
is, what is the Gini coefficient when the after-tax (for the skilled workers) and after-transfer (for the
unskilled worker) incomes are used in the calculation?

3 Social Security
In this problem, we consider and compare two social security systems in an Overlapping Generation model.
Consider an economy where all consumers live for two periods. All consumers only work and receive
income in the first period of their lives. For simplicity, we assume the income of the workers are exogenously
given. Each consumer’s income depends on the generation she is in. For someone born in period t, we refer
to her as being in generation t 0. Each consumer of generation t receives income yt in period t.

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 Consumers of generation t generate utility from consumptions in periods t and t + 1. We assume a
natural-logarithmic form for the period utility function for all consumers. All consumers, regardless of
generation, discount the second period with respect to the first at rate . We use the symbol cts to denote
the consumption of a representative consumer of generation t in period s. Naturally, s can only be either t
or t + 1. In short, for a representative consumer of generation t who consumes ctt and ctt+1 ,

ut ctt , ctt+1 = ln ctt + ln ctt+1 .

To capture some of the fundamental features of the processes of output and population in reality, we
assume consumers’ income grows at a constant rate g from one generation to another. That is

yt+1 = (1 + g)yt .

Similarly, assume population grows at a constant rate n, i.e.

Nt+1 = (1 + n)Nt .

n is mostly likely di↵erent from g. The income and population of generation zero (y0 and N0 ) are exogenously
given. All consumers can access a credit market where they can save or loan at a constant interest rate r.

Exercises:

1. Set up the utility maximization problem of a representative consumer of generation t and solve for her
optimal consumptions ctt and ctt+1 . Calculate her maximized utility. Call this utility level v1 .

At first, the government proposes a fully-funded social security system which works as follows. The govern-
ment taxes all consumers their income at a constant rate ⌧ in the first period of their lives. It then invests
the tax revenue in the credit market and return all proceed back to the same consumers when they are in
the second period of their lives. Specifically, consider a representative consumer of generation t. If she pays
the tax of amount Tt in period t, she will get back (1 + r)Tt in period t + 1. All consumers still have access
to the credit market where they can save or loan at the same interest rate r.

Exercises:

2. Set up the utility maximization problem of a representative consumer of generation t and solve for her
optimal consumptions ctt and ctt+1 .

3. How much does a representative consumer save in a fully-funded social security system? This amount
is what we call the private savings. For what rate ⌧ is the private savings zero? Explain the intuitions.

Suppose, instead, the government is considering an alternative pay-as-you-go social security system that
works as follows. In any period t + 1, the government taxes the incomes of consumers of generation t + 1
at rate ⌧ and distribute the tax revenue equally among the consumers of generation t who are now in the
second period of their lives. Notice that with this system, all consumers have some income in the second
period of their lives even if they do not have any savings in the first period. This is a model that is supposed
to mimic the actual social security system in reality where the young workers (consumers in the first period

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of their lives in our model) support the old retirees (consumers of an earlier generation now in their second
period). Moreover, the government must balance its budget in every period. In period t + 1, the tax revenue
to be collected will amount to
⌧ · yt+1 · Nt+1 .

Therefore, a representative consumer of generation t will receive

⌧ · yt+1 · Nt+1
Nt

in period t + 1 from the government. All consumers still have access to the credit market where they can
save or loan as they will.

Exercises:

4. Set up the utility maximization problem of a representative consumer of generation t and solve for her
optimal consumptions ctt and ctt+1 . Calculate her maximized utility. Call this utility level v2 .

5. Compare the maximized utility level you obtain above in 6.4 (v2 ) to the one in 6.1 (v1 ). Under what
condition, in terms of g, n, and r, is v2 v1 ?

5
 ECON20300 Elements of Economic Analysis IV Spring 2014

Problem Set 3
Yuan Tian

Due Thursday, April 24, 2014, in class

1 Optimal Taxation in an Overlapping Generation Model

Consider a simple overlapping generation model with a measure Nt of young agents being born in period
t 1. The young population grows at a constant rate n, i.e. Nt+1 = (1 + n)Nt where n > 1. All agents
live for two periods (generation t live in periods t and t + 1) and only care about consumptions in the periods
they are alive. Agents’ preferences are identical, regardless of what generation they are in, and given by (for
an agent in generation t, for instance)

U ctt , ctt+1 = u ctt + u ctt+1 ,

where the period utility function u(·) is strictly increasing and strict concave in consumption. Agents only
make a fixed income y when they are young and have access to a perfect capital market where they can save
and borrow at a constant interest rate r.
The government provides a pay-as-you-go social security program which all agents must participate. In
particular, the government taxes the income of all young agents at a constant rate ⌧ 2 [0, 1] and equally
distribute all the tax revenue among all the agents in the same period.

Exercises:

1. Write down the budget constraint of a young agent in period t.

2. Write down the budget constraint of an old agent in period t.

3. Write down the inter-temporal budget constraint of an agent in generation t.

4. Set up the utility maximization problem of an agent in generation t and calculate the optimality
conditions. Notice that we have not assumed any functional form for the utility functions so your
answers may include u0 (·).

5. Briefly explain why the optimal choices made by an agent in generation t will be the same as those
made by an agent in generation t + 1.

For the rest of the problem, assume (1 + r) = 1.

Exercises:

1
 6. Solve for the optimal consumptions ct⇤ t⇤
t and ct+1 of an agent in generation t. This should be particularly
straightforward given your answers to parts 3 and 4.

7. A utilitarian government will try to maximize, in period t,

Nt u ct⇤
t + Nt 1 u ct⇤
t+1 .

A government with a Nash collective utility function as a social welfare function will try to maximize

Nt log u ct⇤
t + Nt 1 log u ct⇤
t+1 .

Meanwhile, a Rawlsian government will try to maximize

min u ct⇤
t , u ct⇤
t+1 .

Solve for the optimal tax rate ⌧ ⇤ that maximizes the government’s objective in each case. Do you see
anything surprising? What is the key assumption that drives your answers?

2 A Two-period Model of Government Expenditures

Consider a two-period model on financing government expenditures. The government has predetermined
expenditures G1 and G2 to fund through taxation and debt. At the beginning of period 1, the government
does not have any debt left over from period 0. Let Bt be the amount of debt the government takes on in
period t. The debt taken on in period t must be paid back in period t + 1. In addition, let Tt be the amount
of tax revenue it collects in period t.
There is one single consumer in this economy who lives for two periods and only cares about her con-
sumption in these two periods. Her utility as a function of the consumptions is given by

u(c1 , c2 ) = log(c1 ) + log(c2 ).

The consumer has incomes y1 and y2 , exogenously given, in the two periods. Both the government and
consumer has access to the same capital market where the interest rate is exogenously given as r. The
consumer does not have any savings at the beginning of period 1 and let s represent the savings the consumer
makes in the first period.

Exercises:

1. Write down the government’s budget constraint in period 1.

2. Suppose the government collapses at the end of the second period hence cannot have any running debt
when it collapses. What does this imply about the debt it can take on in period 2? Write down the
government’s budget constraint in the second period.

3. Combine your answers above to obtain the government’s lifetime budget constraint.

We will now consider di↵erent taxation plans to fund the government expenditures. In addition to balance its
lifetime budget, the government also aims to maximize the consumer’s welfare. For the rest of the problem,

2
do not worry about whether the government can balance its budget even if it collects all the income from
the economy—assume that the economy is large enough in capacity to satisfy the government expenditures.
The simplest of all is lump-sum taxes in both periods.

Exercises:

4. Set up and solve the consumer’s utility maximization problem under the lump-sum taxes T1 and T2 .

5. Set up the government’s optimization problem and characterize the optimal lump-sum taxes T1⇤ and
T2⇤ . Does the Richardian Equivalence hold under lump-sum taxes?

Now suppose instead of lump-sum taxes, the government decides to fund its expenditures with income taxes.
Particularly, let ⌧t be the income tax rate in period t.

Exercises:

6. Set up and solve the consumer’s utility maximization problem under income taxes ⌧1 and ⌧2 .

7. Set up the government’s optimization problem and characterize the optimal proportional income
taxes ⌧1⇤ and ⌧2⇤ . Does the Richardian Equivalence hold under the proportional income taxes?

The third format of taxation we consider is proportional consumption taxes in both periods. Let ⌧ct be the
consumption tax rate in period t. This means that, in period t, for one unit of consumption, the consumer
has to pay 1 + ⌧ct . For the rest of the problem, you may find using the following notations convenient:
8
> y2
>
> Y = y1 + ;
>
< 1 +r
where G < Y.
>
>
>
> G2
: G = G1 + ;
1+r

Exercises:

8. Set up and solve the consumer’s utility maximization problem under consumption taxes ⌧c1 and ⌧c2 .

9. Set up the government’s optimization problem and solve for the optimal proportional consumption
⇤ ⇤
taxes ⌧c1 and ⌧c2 . Does the Richardian Equivalence hold under the proportional consumption taxes?

The most complicated tax format in this problem will be a combination of consumption tax in the first
period and a tax on the interest income in the second. In particular, let ⌧c be the consumption tax rate in
the first period and ⌧i be the tax rate on the interest income collected in the second period. That is, for any
one dollar of interest the consumer collects in the second period, she has to pay ⌧i to the government. To
eliminate negative tax payment, assume y2 = 0 ) y1 = Y > G.

Exercises:

10. Write down the consumer’s inter-temporal budget constraint in the first period.

11. Write down the consumer’s inter-temporal budget constraint in the second period.

12. Set up and solve the consumer’s utility maximization problem under the consumption and interest
income taxes ⌧c and ⌧i . How much does she consume in the two periods and how much does she save?

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 13. How much tax revenue does the government collect in the first period? The second?

14. Set up the government’s optimization problem and solve for the optimal consumption and interest
income tax rates. Compare this tax system to the one with only consumption taxes in both periods?

3 Path of Government Debt

According to the argument for tax smoothing, the ratio between the government’s tax revenue to the output
of the economy should be constant over time. In this problem, we will look at the evolution of government
debt with constantly increasing government debt.
In period t, the government’s inter-temporal budget constraint is

Gt + (1 + r)Bt 1 = Tt + Bt ,

where Bt is the amount of government debt in period t. From various previous exercises, we have concluded
that, for infinitely lived governments, the present discounted value of the tax revenue stream must be equal
to that of the government expenditure stream. We will utilize this piece of information along with the
argument that the tax rate must be constant over time to calculate the process of government debt. Suppose
the government’s expenditure is given by

G0 = 1, G1 = 2, G2 = 3, · · ·

In other words, Gt = t + 1 for all t. Moreover, assume that the tax revenue must be constant over time. Call
this constant tax revenue T̄ . Let interest rate be r > 0. Also, assume B 1 = 0.

Exercises:

1. Derive the government’s lifetime budget constraint. Your answer should be in terms of T̄ and the
interest rate r.

2. Calculate T̄ . Calculate B0 according to the following transformation of the government’s period-0

inter-temporal budget constraint,

B0 = G0 + (1 + r)B 1 T̄ .

3. Calculate B1 through B3 with the relationship that

Bt = Gt + (1 + r)Bt 1 T̄ .

Do you see any pattern? Conjecture the process of government debt after period 3 and graphically
represent your conjecture with time on the horizontal axis and government debt on the vertical axis.

4. Prove your conjecture in the previous part, rigorously!

4
 ECON20300 Elements of Economic Analysis IV Spring 2014

Problem Set 4
Yuan Tian

Due Tuesday, May 13, 2014, in class

1 Ramsey Taxation of a Simple Economy

Consider a one-period simple economy with one single representative consumer who cares about consumption
and leisure. The consumer has to work and make labor income at wage rate w to fund her consumption,
the price of which is normalized to 1. The consumer’s utility, as a function of her consumption c and labor
supply l, is given by
u(c, l) = ↵ ln c + (1 ↵) ln(1 l).

The government, acting as a benevolent social planner, has an expenditure of G to fund through three types
of taxes—a lump-sum tax T , a proportional labor income tax ⌧l , and a proportional consumption tax ⌧c .
We will try to characterize the optimal combination of these taxes with the inverse mechanics in calculation
we introduced in class. The parameters in this problem are ↵, w, and G where w > G T > 0.

Exercises:

1. Set up and solve the consumer’s utility maximization problem. In particular, solve for her optimal
consumption c⇤ and labor supply l⇤ as functions of the taxes and the parameters of the problem.

2. Using the consumer’s optimal labor supply, obtain an expression of ⌧l as a function of l⇤ , the lump-sum
tax T , and the parameters of the problem.

3. Similarly, using the consumer’s optimal consumption, obtain an expression of ⌧c as a function of c⇤ ,

l⇤ , T , and the parameters of the problem.

4. Write down the government’s budget constraint. Using your answers so far, rewrite the government’s
budget constraint in terms of c⇤ , l⇤ , T , and the parameters of the problem.

5. Recall that the government’s objective is to maximize the consumer’s optimized utility subject to its
own budget constraint. Set up and solve the government’s problem. Let c̃ and ˜l represent the solutions.
Your answer should be in terms of T and the parameters of the problem only.

A pair of⌘tax rates ⌧l⇤ and ⌧c⇤ are optimal when the consumer’s choices in c⇤ and l⇤ coincide with those
6. ⇣
c̃ and ˜l made for them by the government. Equate your answers in parts 1 and 5 and solve for the
optimal tax rates ⌧c⇤ and ⌧l⇤ as functions of T and the parameters of the problem.

1
 7. State a relationship between ⌧l⇤ and ⌧c⇤ that must be satisfied for any T . Does your answer coincide
with the conclusion we drew in class?

8. Comment on the role of the lump-sum tax T . What would happen if no lump-sum tax is levied?

2 The Baumol-Tobin Model (Review)

In this problem, we review one of the first models on consumer’s demand for cash developed independently by
William Baumol and James Tobin1 —this entire problem should be a review for the relevant materials in your
ECON202. Consider the cash holding problem of some representative consumer in a bounded continuous
timeframe between 0 and 1. At any instant between 0 and 1, the consumer must consume C to stay alive
and the price of consumption goods is P . The consumer has enough fund in her savings account to finance
her consumptions between 0 and 1. Any fund left in the consumer’s savings account generates interest for
her in a simple manner at a constant rate R—there is no compounding on the interest income. For instance,
keeping $1 in the savings account for a time length of l will simply generate an interest income of $lR.
Vendors of consumption goods only accept payments in cash. Hence, to purchase consumption goods,
the consumer must hold some cash in hand. On the other hand, she also wants to keep as much fund in the
savings account as possible to accumulate interest. Hence, the consumer must go to the bank to withdraw
cash from time to time to finance her consumption. It costs the consumer every time she goes to the
bank—consider this as the potential income she could be making were she not making the trip to the bank
or simply the transaction costs of dealing with the ATMs. Every time she goes to the bank, the consumer
will withdraw just enough money to fund her consumptions until the next time she goes to the bank. For
simplicity, the consumer decides to go to the bank at a constant frequency. Thus, the consumer’s problem
is to choose the optimal number of trips to the bank during the time interval between 0 and 1 to minimize
the total cost including the transaction cost and the foregone interest income.

Exercises:

1. Let n represent the number of trips to the bank, how much cash does the consumer have to withdraw
each time she goes to the bank?

2. If the consumer makes n trips to the bank, what is the average amount of cash she holds in her hand
during the time interval between 0 and 1?

3. If the consumer makes n trips to the bank, what is the total cost of such a cash withdrawing/holding
plan as a function of C, R, , P , and n?

4. Solve for the optimal number of trips to the bank n⇤ by minimizing the cost you characterized above.
Ignore the restriction that n⇤ must be a natural number—we simply consider n⇤ as a proxy of the
frequency of trips to the bank hence any real number is admissible.
How often does the consumer go to the bank—that is, what is the amount of time T ⇤ between two
subsequent trips she makes to the bank?

5. What is the average amount of cash the consumer holds in the time interval between 0 and 1 if she
chooses n optimally? Let M represent her average cash holdings during the unit time interval.
1 Both original papers are available on Chalk—simply look for them by the authors’ names if you are interested.

2
 6. Does the consumer’s average cash holding depend on C, R, P , and positively or negatively? Provide
some intuitions for your answers.

7. The elasticity of the consumer’s average cash holding with respect to parameter X is defined to be the
percentage change in M for a one-percent change in parameter X. Calculate the elasticities of M with
respect to C, R, P , and .

3 Readings
Please read the paper The End of Four Big Inflations by Thomas Sargent uploaded on Chalk under “Sargent
(1982)” and answer the following questions in a succinct manner—several sentences will do for each part.

1. What are the two di↵erent views/explanations on the reason for persistent inflations? What is the
common factor in these two di↵erent views and what is the di↵erence in the interpretation of this
common factor according these two views?

2. Which of the two aforementioned views does Sargent think better explain the end of the four big
inflations after World War I?

3. What is the di↵erence between “isolated actions” and “strategy regimes”?

4. In terms of the governments’ fiscal status, what are some important and common features of the four
countries that potentially lead to the hyper-inflations?

5. Name a common feature of these countries’ currencies (particularly, those of Austria, Hungary, and
Germany) that also exacerbated the hyper-inflations.

6. Some economists argue that the coexistence of price stability and sharply increased money supply
violates the quantity theory of money. Does Sargent agree? What is his argument for or against it?
Feel free to focus on one country in your answer.

7. List at least three protocols put in place, not necessarily in the same country, by the League of Nations
to control and mitigate the hyper-inflations.

8. Did the end of the hyper-inflations have any e↵ect on the real sector (in particular, unemployment) of
these countries? If any, are the e↵ects mostly positive or negative?

9. According to Sargent, what are the essential measures that ended the four hyper-inflations?

10. According to Sargent, did the increase in money supply singlehandedly cause the hyper-inflations?
What other factors, if any, are also at play?

3
 ECON20300 Elements of Economic Analysis IV Spring 2014

Problem Set 5
Yuan Tian

Due Tuesday, May 20, 2014, in class

1 Cagan’s Model without Perfect Foresights

Consider the Cagan’s model with expectations on future inflations instead of perfect foresights. Let the
operator Et (·) represent the expectation formed in time period t. For any variable X, the expectation
formed in period t of the value of X is represented by

Et (X).

For example, since Xt —the value of X in period t—is already known in period t, Et (Xt ) = Xt . Moreover,
for any variable X̃ and s > 0, the expectation formed in period t of the expectation formed in period t + s
of X̃ should simply be equal to the expectation formed in period t of X̃. That is
h ⇣ ⌘i ⇣ ⌘
Et Et+s X̃ = Et X̃ . (1)

In other words, the current expectation of the future expectation should simply be equal to the current
expectation. Now, consider the stochastic version of the Cagan’s model:

mt pt = ⌘Et (pt+1 pt ) .

Exercise:

1. Using recursive substitution as we did in class and (1), show that

"1 ✓ ◆s #
1 X ⌘
pt = · Et (mt+s ) .
1 + ⌘ s=0 1 + ⌘

What is the transversality condition that you implicitly imposed?

2 Inflations with an Inflation Fighting Central Bank

According to the Cagan’s model with perfect foresights and unit semi-elasticity,

mt pt = pt+1 + pt . (2)

1
Suppose the central bank really cares about price stability and reacts immediately after observing inflation
or deflation—think of these central bankers as having really sensitive nerves when it comes to price stability,
for example. Specifically, at the end of period t, the money supply in period t + 1—mt+1 —is chosen as

5 5
mt+1 = mt + pt 1 pt . (3)
4 4

Time starts in period 0.

Exercises:

1. Describe, in words, the central bank’s monetary policy in terms of its reactions to inflations/deflations.

2. Suppose m0 = 5, p0 = 10, and p 1 = 4—notice that since all the levels are measured in terms of
natural logarithm here, we do not have to worry about them being negative. Use (2) and (3) to solve
for pt and mt for t = 1, 2, and 3. Conjecture—you do not have to prove—a pattern for pt and mt
for any generic t. Does the pattern you conjectured satisfy the transversality condition we introduced
class? In other words, does the following equation hold?
✓ ◆z
1
lim pz = 0.
z!1 2

3. Repeat the previous part when m0 = 5, p0 = 2, and p 1 = 4.

4. Plot the processes of pt and mt you obtained in the previous two parts with time t on the horizontal
axis and pt and mt on the horizontal axis. Compare and contrast your results in the previous two
parts. What, do you think, is the key factor that drives these potentially vastly di↵erent results?

3 Friedman on the Role of Monetary Policy

Read Friedman(1968) and answer the following questions:

1. What is “liquidity preference” or “liquidity trap?”

2. What is Friedman’s view on the role played by monetary policy of causing the Great Depression?

3. Why can’t the Fed control the rate of interest for a long period?

4. Why is it better to look at the rate of change of the quantity of money, rather than interest rates, to
gage how tight or easy monetary policy is?

5. What is the “Phillips Curve?” Why is Friedman skeptical about the long run relationship between
unemployment and inflation?

6. This speech was given in December 1967. What happened to the US economy in the 1970s? Was
Friedman’s prediction about the Phillips Curve right?

2
4 Time Inconsistency in Monetary Policy
Read the speech on credibility and commitment by Charles Plosser and answer the following questions:

1. How is patent used to illustrate the main argument of this paper?

2. What about living in the desert?

3. What is the time-inconsistency problem that the monetary authority faces?

4. What are some commitment devices that Plosser talks about?

5. Should monetary policy be conducted by rule or discretion?

5 Monetary Neutrality according to Romer and Romer (1989)

Read the paper“Does Monetary Policy Matter?” by Romer and Romer and answer the following questions:

1. What is the danger of narrative approach to the authors? In particular, what is their criticism toward
the work of Friedman and Schwartz?

2. What is the criteria that the authors used to identify monetary shocks? Why wasn’t the tightening
episode of 1966 not used?

3. What did the authors try to show by running univariate autoregressive estimation? What are their
results?

4. Can we replicate their identification procedure after the 1990s? Why or why not?

6 Reading: U.S. Monetary Policy in Practice

This question refers to the document “U.S. Monetary Policy: An Introduction” (Federal Reserve Bank of
San Francisco (2004)) which is available on Chalk. The document was written by the sta↵ at the Federal
Reserve Bank of San Francisco, and describes some practical issues about conducting monetary policy in the
United States. Read the document and briefly answer the questions below.

1. What are the most important rules that make the Federal Reserve independent of the government?

2. What types of inflation costs do you consider most important and why?

3. The document discusses the issue of stock market bubbles and whether Fed policy should mitigate
them. How does this apply to the recent large increase and subsequent sudden drop in the housing
prices?

4. How does the sterilization of a foreign currency operation work?

5. The document describes a period during which the maximum sustainable growth rate of output likely
grew at a faster rate than usual, and another period during which it grew at a slower than usual rate.
Which periods are these? What happened during these periods? Why can’t we say for sure that the
maximum sustainable growth rate during these periods was indeed higher or lower than usual?

3
 ECON20300 Elements of Economic Analysis IV Spring 2014

Problem Set 6
Yuan Tian

Due Tuesday, May 27, 2014, in class

1 Optimal Monetary Policy with Adaptive Expectations

In this problem, we will look at the long-run trend of the inflation and unemployment rates in the economy
when consumers form their expectations adaptively. Following the set up in class, let

ut u⇤ = k (⇡t ⇡te )

where ut , ⇡t , and ⇡te are the unemployment rate, the inflation rate, and the expected inflation rate in time
period t, respectively. Consumers update their expectations for inflation adaptively, namely,

⇡te = ⇡t 1.

Exercises:

1. Suppose the central bank minimizes the total cost of inflation and unemployment in period t given by

u2t + ⇡t2

period by period. Solve for the optimal inflation rate ⇡t⇤ to be chosen by the central bank as a function
of ⇡t 1, u⇤ , and k.

2. Assume ⇡ 1 = 0. Given your answer above and using recursive substitutions, solve for ⇡t⇤ as a function
of t, u⇤ , and k. What is the limit of ⇡t⇤ as t ! 1?

Suppose the central bank realized that, after the exercises it carried out in the previous problem set exploded,
it might be a better idea to optimize over its infinite lifetime instead of period by period, its cost of inflation
and unemployment over its lifetime now becomes
1
X
t
u2t + ⇡t2 .
t=0

1
The central bank clearly still faces the following constraint for all time periods

ut = u⇤ k(⇡t ⇡t 1 ).

For simplicity, assume u⇤ = 0 and k = 1.

Exercises:

3. Set up the central bank’s optimization problem and take the first-order conditions with respect to
the choice variables—feel free to choose between Lagrangian and substitutions according to your own
personal preferences over these two methods.
⇤
4. Based on the first-order conditions you obtained above, solve for the optimal choice of ⇡t+1 (the optimal
inflation in period t + 1) as a function of , ⇡t⇤ (the optimal inflation in period t), and ⇡t⇤ 1 (the optimal
inflation in period t 1).

5. Assume the following initial conditions,

p p
3 3
=p and ⇡ 1 =p .
3+1 3 1

Suppose the central bankers were advised to choose ⇡0⇤ = 1, calculate the optimal inflations for periods
1, 2, and 3 (or as soon as you see a pattern). What is the limit of ⇡t⇤ as t ! 1?

Now, consider the scenario where consumers update their expectations adaptively but take into account of
the two previous periods. That is,
1
⇡te = (⇡t 1 + ⇡t 2) .
2
Suppose the central bank now switches back to the scheme where it only minimizes the loss of inflation and
p
unemployment period by period. We still assume that u⇤ = 0 while we now let k = 1/2.

Exercises

6. Set up and solve the central bank’s problem and express the optimal inflation ⇡t⇤ in period t in terms
of ⇡t 1 and ⇡t 2.

7. Suppose ⇡ 2 = 4 and ⇡ 1 = 2, solve for the optimal inflations in periods 0, 1, and 2. What is the
long-run trend of the optimal inflation?

8. Suppose ⇡ 2 = 9 and ⇡ 1 = 3, solve for the optimal inflations in periods 0, 1, and 2. What is the
long-run trend of the optimal inflation?

2 International Trade with Trade Barriers

Suppose there are only two economies in the world, the U.S. and the E.U. Both economies have 100 units
of labor to be divided between the production of two types of consumption goods A and B. Both countries
gain utilities from the consumption of these two goods but maybe in di↵erent ways. Specifically, let CJi be
the consumption of good J 2 {A, B} by economy i 2 {U, E} (U for the U.S. and E the E.U.),

2
 8 1 1
>
> U
Û CA U
, CB U
= ln CA U
+ ln CB ,
>
< 2 2
>
>
>
:Ũ C E , C E = 1 ln C E + 1 ln C E .
A B A B
2 2
The productivities of the two economies in the two consumptions goods are summarized in the following
table, where the number in each cell represents the number of units of labor required to produce one unit of
the corresponding good in the corresponding economy.

Good A Good B

U.S. 1 1

E.U. 2 1/2

In this problem, we will go directly to the scenario where there exist some trade barriers between the
two economies. Suppose both the U.S. and the E.U. impose a proportional tari↵ of ⌧ > 0 on the goods they
import. That is to say, for example, if the E.U. is importing good A from the U.S. and if the world price of
good A is pA , the E.U. is paying (1 + ⌧ )pA for each unit of A it imports. However, the U.S. is only getting
pA for each unit it exports. Moreover, the tax revenue from the tari↵ belongs to the E.U. in this case and
it can freely spend this revenue on the purchase of the consumption goods. Let pA denote the world price
of good A and pB that of good B and let T i be the tari↵ revenue for country i. Assume from now on that
both economies specialize in producing the goods they have comparative advantage in.

Exercises:

1. Which economy has the comparative advantage in producing good A?

2. Which good does the U.S. specialize in producing? Set up and solve the utility maximization problem
U U
of the U.S. and obtain the optimal consumptions by the U.S. Your answer should include CA and CB
as functions of pA , pB , ⌧ , and T U .

3. Which good does the E.U. specialize in producing? Set up and solve the utility maximization problem
E E
of the E.U. and obtain the optimal consumptions by the E.U. Your answer should include CA and CB
as functions of pA , pB , ⌧ , and T E .

4. What is T U in terms of CA
U U
and/or CB , the tari↵ rate, and the prices? What about T E ? You are not
supposed to use your answers so far—your answers should only depend on the definition of tari↵s.
U
5. Using your answers to parts 2 and 4, solve for CB in terms of pA , pB , and ⌧ .
U
6. Using your answers to parts 2, 4, and 5, solve for CA in terms of pA , pB , and ⌧ .
E
7. Using your answers to parts 3 and 4, solve for CA in terms of pA , pB , and ⌧ .
E
8. Using your answers to parts 3, 4, and 7, solve for CB in terms of pA , pB , and ⌧ .

9. Using your answers so far, solve for the equilibrium relative price between A and B (pA /pB ) by clearing
the market for good B.

3
10. Using your answers so far, solve for the equilibrium relative price between A and B by clearing the
market for good A. Does your answer coincide with that in the previous part?

11. Does the equilibrium relative price you obtained above support the specialization in production we
have assumed so far? How did you reach your conclusion?

12. Calculate the optimized utilities of the U.S. and the E.U. based on all the answers you have obtained
so far. Your answers should only be in terms of the tax rate ⌧ . Maximize these optimized utilities with
respect to the tax rate ⌧ . Does your answer favor free trade or protectionism?