Indian Institute of Foreign Trade

Macroeconomic Theory (M.A. Economics)

Summer Semester 2022-23

Problem Set 1

1. Explain the following

a) Random Walk Model of Consumption
b) Consumption CAPM

2. Assuming no assets and zero interest rate in an economy, compare the behaviour of
consumption under certainty and uncertainty.

3. What is certainty equivalence? Can you derive and explain this using a simple model?

4. Discuss and derive the Equity Premium Puzzle.

5. Suppose that an individual has the following CRRA utility function:

𝐶𝑡1−𝜃
𝑈(𝐶𝑡 ) = , 𝜃 > 0.
1−𝜃
a) Given the usual budget constraint under certainty with real interest and discount
rates set to zero, what will be the solution for the consumption path?
b) Now assume that the real interest rate, r, is constant but not necessarily equal to the
discount rate, 𝜌, what is the Euler equation relating 𝐶𝑡 to expectations concerning
𝐶𝑡+1 .

6. Consider the intertemporal consumption-savings decision. Suppose that the government

initially raises revenue only by taxing interest income. Thus, the individual’s budget
𝐶2 𝑌2
constraint is 𝐶1 + [1+(1−𝜏)𝑟] ≤ 𝑌1 + [1+(1−𝜏)𝑟] where 𝜏 is the tax rate. The government’s
revenue is 0 in period 1 and 𝜏𝑟(𝑌1 − 𝐶10 ) in period 2, where 𝐶10 is the individual’s choice
of 𝐶1 given this tax rate. Now suppose the government eliminates the taxation of interest
income and instead institutes a lump-sum taxes of amounts 𝑇1 and 𝑇2 in the two periods.
𝐶 (𝑌2 −𝑇2 )
Thus, the individual’s budget constraint is now 𝐶1 + [1+𝑟]
2
≤ (𝑌1 − 𝑇1 ) + [1+𝑟]
. Assume
that 𝑌1 , 𝑌2 and r are exogenous.
a) What condition must the new taxes satisfy so that the change does not affect the
present value of government revenues?
b) If the new taxes satisfy the condition in part a), is the old consumption bundle
(𝐶10 , 𝐶20 ), not affordable, just affordable or affordable with room to spare?
c) If the new taxes satisfy the condition in part a), does the first-period consumption rise,
fall or stay the same?

7. In a dynamic model for investment, derive the conditions for optimal investment under
a) Discrete Time

1
 b) Continuous Time

Are these conditions similar? Compare.

8. In the Tobin’s q model for investment, what would be the impact of the following changes?

a) A permanent change in the rate of interest

b) A permanent increase in the output