Macroeconomics - Quiz Solutions

Consider the Closed Economy One Period model studied. Assume that there is no Government.
The representative household has preferences over consumption, c, and hours of work N , repre-
sented by the utility function
u (c, N ) = c − 0.5N 2

The representative firm has a technology well described by

Y = zN α ,

(a) Compute the Pareto optimum (First Best) for this economy. Represent the solution graphically.
Resolution:
The Pareto optimum is attained by solving the planner problem. This is the problem of a particular
agent that has preferences identical to the representative household and whose choice is constrained
by the technology and the resources contraint. The last one in this case, with no government, is the
restriction that consumption cannot exceed production. Time here is not a constraint because leisure
does not belong to the decision variables. (In the back we should have a maximum h and to be sure
that any value for N will not be higher than that value)
Therefore the Pareto optimum should be the solution to:
Max U = c − 0.5N 2
Subjet to:

Y = zN α
Y = c

First order conditions:

∂U/∂N
− = ∂Y /∂N
∂U/∂c
Y = c = zN α

or

N = αzN α−1
c = zN α

or

1
 1
N = (αz) 2−α
2 α
Y = c = (z) 2−α (α) 2−α

α = 0.6 or α = 2/3.
(b) What is the Competitive General Equilibrium when z = 10?
Resolution:
Because the model studied has fundamentals that satisfy the conditions for the second welfare
theorem the solution for allocations obtained in a) will be the ones characterizing the competitive
general equilibrium (GE) solutions. To complete the GE we need to know which will be the equilibrium
price. As studied this price is the real wage w.
One way would be to use the first order condition from the firm problem, that is

w = ∂Y /∂N = αzN α−1

Using the value for N obtained in a) we know that

α−1 1
w = ∂Y /∂N = αz (αz) 2−α = (αz) 2−α

which we should join to

1
N = (αz) 2−α
2 α
Y = c = (z) 2−α (α) 2−α

Then
α = 0.6 or α = 2/3
and
z = 10 or z = 1.
(c) Comment: Given the fundamentals described above, fluctuations of z can explain why employ-
ment is procyclical.
Resolution:
The fundamentals are in this model the preferences (U) and the technology. So fluctuations of z
woud be changes in the fundamentals (technology), wich will lead to a new equilibrium. As shown
above

2
 1
N = (αz) 2−α
2 α
Y = c = (z) 2−α (α) 2−α

In the GE whatever the value of α < 1 we see that Y will comove (the same sign) with z as well
as N .
That is when z fluctuates over time, Y will fluctuate as we see in data and a positive correlation
between Y and N . Given the proposed preferences that are quasi-linear in consumption, there will
be no income effect in the labor. Therefore, due to the substitution effect there will be a positive
correlation in the model between output and employment conditional on technological shocks. There-
fore this model can explained with this fundamentals and technological shocks the procyclicality of
employment seen in data.

Figure 1: Graphical representation

Note that the graphical representation for question a) should have just one production function
(the one with lower z). Figure 1 represents already an increase in the parameter z.