Macroeconomics II

Tutorial 2
Topic 3

Martin Luther University of Halle-Wittenberg

Chair of Economic Growth and Development

Teacher: Prof. Wolf-Heimo Grieben - Tutor: Adeel Ahmad Dar - Date: May 26, 2023

Questions

1. The idea of this exercise is to show formally why consumption fluctuates less than some other macroe-
conomic variables. The model has only 2 periods. Assume the following utility function, also known as
1
logarithmic preferences: 𝑈 = log⁡(𝑐1 ) + ⁡ 1+𝜌 ⁡log⁡(𝑐2 ). Here, 𝑈 denotes utility, 𝑐1 denotes consumption in
period 1, 𝑐2 consumption in period 2. Furthermore, the degree of impatience (= rate of time preference =
𝑐2 𝑦2
discount rate) “rho” 𝜌 ≥ 0. The budget constraint can be written as: 𝑐1 + = 𝑦1 + (see lecture
1+𝑟 1+𝑟
slide III-42) with 𝑦1 ⁡denoting income in period 1 and⁡𝑦2 income in period 2.

a) Derive the optimal level of consumption in periods 1 and 2: 𝑐1 ∗ and 𝑐2 ∗ . This optimization problem
can be solved by setting up a Lagrangian function.

b) What happens to consumption in both periods if income decreases in period 1? Evaluate your ex-
pressions for 𝑐1 ∗ and 𝑐2 ∗ .

2. The profit function of a representative bank is given by:

rLS  r p  LS  D  e 
2
 LS 
  1   . (i)
e 2  e 

Here, r denotes the lending rate of the bank, rp the exogenously given policy rate of the central bank (and
at the same time the interest rate on the interbank lending market), LS is the credit supply of the bank, D
are the deposits of the private sector at the bank, e is the equity of the bank, and the term  LS e  measures
2

the risk of the bank as a function of the leverage LS e . The investment demand, that is, the credit demand
LD of the private sector is given by:

LD  I  r , (ii)
2

where I denotes the autonomous (interest-independent) investments. Assume that the given representa-
tive bank operates under perfect competition.

1
 a) Explain briefly the meaning of perfect competition for the representative bank in this model. What
would be different under imperfect competition (in the extreme case: the bank is a monopoly bank,
that is, the only credit supplier to the private sector)?

b) Provide an intuitive explanation for the expression r p  LS  D  e  in the numerator of the first term in
equation (i). Why does this term enter negatively in the profit function (i)?

c) Determine the optimal (= profit maximizing) credit supply LS of the bank.

d) Derive formally the lending rate r in equilibrium.

e) Provide an economic interpretation for your result from d). On which parameters does the equilibrium
lending rate r depend in which way? What are intuitive reasons for this?

3. Considering the below figure, begin at point Aʹ for the credit-constrained households and at point Aʹʹ for
the consumption smoothing (unconstrained) households.

a) For each household type, explain the relationship between the change in income and the change in
consumption when income returns to normal after the temporary decline.

b) Based on this analysis, explain the predicted relationship between temporary changes in income and
consumption for an economy with a mixture of the two household types.