Macroeconomics Intertemporal Problem

In the first period, the representative agent is endowed with ht units of time, which he can spend either working
(h) for real wage (w) or engaging in leisure activities (L).

In the first period, the agent splits his disposable income between consuming a basket of goods (c1) and saving
(s) which earns an interest (r).

In the second period, he retires from work and consumes all of his gross interest income from saving, net of
taxes.

The government imposes a lump-sum tax on labor or wage income in the first period (T1). Total government
spending in the first and second period is given by G1 and G2, respectively. In order to finance its budget deficit in
the first period, the government borrows from the agent by floating a one period bond (B).

The lifetime discounted utility is given by:

U = ln c1 + γ ln (ht - h) + β ln c2

1. Form the intertemporal budget constraint of the agent and of the government
2. Form the agent’s time constraint in every period
3. Set up the maximization problem
4. Set up the Lagrange equation.
5. Derive the first-order conditions for an interior solution
6. Derive the consumption-Euler equation and interpret this condition.
7. Solve for the optimal allocation
8. Suppose that the real interest rate increases. Show how savings will respond. Explain in terms of
income, substitution and PV effects.
9. Suppose instead that real wage rate increases. Show how labor hours will respond. Explain in terms of
the income and substation effects of a change in wage.
10. Suppose that the government raises first period taxes. Show what happens to c1, c2 and s.
11. Suppose instead that the government permanently raises taxes such that dT1 = dT2. Show what
happens to c1, c2 and s. Does Ricardian Equivalence hold in this instance?