Matriculation Number:

Midterm, Advanced Macroeconomics 1, Part 1, WS 18/19

Hitoshi Tsujiyama, Ph.D.
Make your handwriting as clean as possbile.
You may lose points if your answer is not readable.
This handout must be returned after the exam.
Good luck!

Question 1
(6 points in total) Answer the following questions. [max 2 lines each]

1. (2p) Suppose an agent with a standard preference and positive asset holdings observes an
increase in the interest rate. Does she increase her current consumption? Why/why not?

2. (2p) What is the di¤erence between partial equilibria and general equilibria?

3. (2p) Suppose the utility is quadratic and hence does not exhibit prudence. Does the agent try
to smooth consumption when the income ‡uctuates? Why/why not?

Question 2
(17 points in total) Consider a two-period economy with constant income. The household solves
c11 c12
max 1
+ 1
c1 0;c2 0;a
s.t. c1 + a y
c2 (1 + r)a + y

where > 0, r 0 and (1 + r) 6= 1:

1. (2p) State the Euler equation. [No derivation is needed]

2. (4p) Derive the expression for the consumption growth, cc12 . Will the (positive or negative) slope
of this consumption pro…le become steeper or ‡atter when becomes lower? Interpret your
result, using the term "elasticity of intertemporal substitution".

3. (3p) Derive the natural borrowing constraint of this economy. Can that be binding? Why/why
not?

Suppose there is an exogenous borrowing constraint, a b. Consider the following algorithm for
solving the household problem. Denote the optimal consumption by (c1 ; c2 ):
Step 1: Solve the “relaxed problem”where the borrowing constraint is assumed not binding.
Step 2: Get the candidate solution (~ c1 ; c~2 ): Verify that c~1 < A :
Step 3: If veri…ed, (c1 ; c2 ) = (~
c1 ; c~2 ). If not, then c1 = B and hence c2 = C :

4. (3p) Complete the algorithm by …lling in the three boxes (A, B, C). [No derivation is needed]

5. (5p) Assume = 1; r = 0, < 1 and b = 0. Solve for c~1 and c1 :

1
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Lec1 (p.12 for Q2, p.14 for Q3, p.15 for Q4)

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Question 3
(11 points in total) A household solves

X
1
t
max E0 u(ct )
fct g1
t=0
t=0
s.t. at+1 = Rt (at ct ) , a0 given

The rate of return Rt is stochastic and is observed after ct is chosen. Throughout the question, ignore
the presence of the non-negativity constraint for consumption.

1. (2p) Explain why at+1 cannot be the control variable for period t?

2. (3p) Write down the Bellman equation when fRt g is i.i.d.

3. (2p) Write down the Bellman equation when fRt g is a …rst order Markov.

4. (4p) Suppose that at the beginning of period t the agent can purchase insurance, it 2 f0; 1g. If
he chooses it = 1, then he pays a constant premium p > 0 and the return at t becomes constant,
~ If he chooses it = 0, then he does not pay the premium but faces the stochastic return.
Rt = R:
Write down the Bellman equation when fRt g is i.i.d.

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Standard DP. See Lec2

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Question 4
(26 points in total) Consider an economy consisting of two in…nitely-lived agents. There is a
single non-storable consumption good. Type 1 agent receives the endowment stream fyt1 g1 t=0 =
2 1
f0; 1; 0; 1; 0; 1; g: Type 2 agent receives the endowment
P1 t stream fy g
t t=0 = f1; 0; 1; 0; 1; 0; g: Type
i
i 2 f1; 2g agent maximizes the life-time utility t=0 log ct :

1. (3p) An allocation is Pareto optimal if (i) it is feasible and (ii) there is no other feasible
allocation that Pareto-dominates it. State (i) and (ii) formally for this economy.

2. (5p) A social planner solves a planner’s problem putting weight on type 1 agent and weight
1 on type 2 agent. Write down and solve the planner’s problem.

3. (1p) Is the allocation in the previous question Pareto e¢ cient? Why/why not? [max 2 lines]

2
Suppose the agents trade Arrow-Debreu securities in the markets. Also consider one-time govern-
ment transfers T1 from type 2 agent to type 1 agent (and T2 T1 being transfers from type 1 agent
to type 2 agent). The agent i’s problem given the transfers is thus:
P
1
t
max
i 1
log cit
fct gt=0 t=0
P
1
s.t. qt0 (yti cit ) + Ti 0
t=0

where qt0 is the Arrow-Debreu price:

4. (3p) Does this economy admit aggregation? Why/why not? [max 2 lines]

5. (3p) De…ne an Arrow-Debreu equilibrium.

6. (4p) Show that the equilibrium consumption is constant over time, i.e., cit = ci for all t and i.

7. (2p) Solve for qt0 (Hint: normalize q00 by 1).

8. (5p) Solve for T1 as a function of that is necessary to implement the allocation in question 2
as an equilibrium.

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Mostly PS3Q1. Note T is one-time unlike PS3.

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