Intermediate Macroeconomics

Week 8 — Labor markets, wages and unemployment. Redistribution

Felipe Camêlo
October 20 2022, New York University

1
What are we doing today?

Valuation of human capital with finite lifetimes

Present discounted value of dividends

Bathtub model of unemployment and transition dynamics

Redistribution and Efficiency

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Valuation of human capital with
finite lifetimes
Valuation of human capital with finite lifetimes - Setup

In this question, you are asked to compute the present discounted value of (your) future income. The material is
closely related to Section 7.6 in the textbook.

Remember that the two most important aspects of the computation of the present discounted value of future
income are the growth rate g of your income, and the discount rate R used to discount future income to present
value. The discount rate corresponds to the interest rate on savings or borrowing.

In what follows, you are asked to derive both general formulas using the parameters g and R, as well as
numerical answers for particular values of g and R. Let us assume that the current year is t = 0.

3
Valuation of human capital with finite lifetimes - Question 2.1

Consider first a wage income w , paid out next year. What is the present discounted value (denote it pdv ) of
this income? Provide a general formula as well as a numerical answer for w = 100, R = 3%.

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Valuation of human capital with finite lifetimes - Question 2.2

What is the present discounted value of wage income w paid out in five years? Use the same numbers as in
Question 3.1.

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5
Valuation of human capital with finite lifetimes - Question 2.3

Now you have already figured out that incomes paid out further in the future are less valuable today (when
R > 0). Why is this economically sensible?

• The rate of interest represents the relative price of consumption between two periods

• Economically, the positive interest rate is a compensation for impatience of investors (which is a feature
of their preferences). People prefer consumption today to consumption further in the future

• Therefore, in order to provide incentives for investors to save, the borrowers must offer a positive rate of
interest on their saving

• The positive interest rate that we observe in the economy is thus a reward to savers for postponing
consumption, and reflects the impatience embedded in people’s preferences.

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Valuation of human capital with finite lifetimes - Question 2.4

Imagine now that the agent knows that he will receive wage income w in five years but he would like to use the
money to purchase consumption goods in the current year. He goes to the bank, borrows money at a rate of
interest R, and promises to repay w in five years.

How much money m can he borrow today so that his repayment in five years is exactly w ? Why is the answer
the same as for Question 3.2?
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Valuation of human capital with finite lifetimes - Question 2.5

From the previous questions, you have already figured out that the present discounted value of income paid in a
particular year in the future is a decreasing function of the time t when this income is paid out. Denote the
present discounted value of w paid out in t years as pdvt . Show that this is an exponential function of time.
Sketch the graph of this function.

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Valuation of human capital with finite lifetimes - Question 2.6
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We now want to compute the present discounted value of future income received over a longer horizon. Imagine
that the person receives his first paycheck in the amount of w this year (year zero, i.e., it is not discounted), and
his last paycheck in the amount of w in year T 1. He therefore receives T payments in total, each in the
amount of w .
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What is the present discounted value PDV of this income stream? Use the formula for the geometric sum to
obtain a convenient expression for this present discounted value (not as a long sum).

Using the convenient formula, answer this function for w = 100, R = 3%, and for the following values of the last
period when the person receives the wage income: T = 1, 2, 5, 10, 20, 40, 100.

Sketch the graph of the present discounted value PDV as a function of T .

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Valuation of human capital with finite lifetimes - Question 2.7
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What happens to PDV when T ! •? Take the limit in the general formula and then answer the numerical
exercise.

We typically use the assumption of T ! • as a convenient approximation that simplifies our algebra (observe
that the formula for T ! •) is much simpler than the one for the finite horizon T . How well does the result for
T ! • approximate the answer for a typical span of the worklife, say T = 40 years?

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Valuation of human capital with finite lifetimes - Question 2.8

Imagine now that the person does not receive his first paycheck this year (year 0) but in year 4. For instance, it
takes 4 years to get through college, so you will not receive any income in years 0, 1, 2 and 3. From that point
onward, he will work T years.

Adjust the general formulas for nite horizons and infinite horizons to reflect this change. How do your answers
to the previous questions change?

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Present discounted value of
dividends
Present discounted value of dividends - Setup

The formulas you used for the valuation of human capital can be applied to a broad variety of problems. In this
case, we will derive a formula for the value of a firm by computing the present discounted value of the dividends
that the firm is paying.

It will turn out that the formula is (almost) the same as the formula for the price-dividend ratio that we derived
in the chapter on investment (Chapter 17 in the textbook).

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Present discounted value of dividends - Question 3.1

What is a firm worth? From the perspective of a stockholder, it is the present discounted value of future
dividends.

• Consider a rm that pays a dividend of $10 per share every year, forever. The discount rate used to
discount future dividends is 8%. What should be the price of the share?
• Consider a firm that pays a dividend of $10 this year, and dividends grow at 2% per year. Using the same
discount rate, what should be the price of the share?
• Observe that you can write the results in the form of a formula for the price-dividend ratio. Are these
formulas similar to those you obtained in Chapter 17?

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Present discounted value of dividends - Question 3.2

One statistic of the U.S. stock market that is of interest to economists is the so called price-dividend ratio. It is
the ratio of the value of the stock market (say, the value of all rms included in the S&P500 index) to the total
dividend these firms pay out in a year. fi
Assume that this price-dividend ratio is 15, and dividends grow at 2% per year, forever. If investors value stocks
using the present discounted value formula we used in class, what discount rate are they using?

Notice that in order to solve this problem, you do not need to know they current valuation of the stock market
or the current dividend. The ratio of these two quantities is sufficient. Why?

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Bathtub model of unemployment
and transition dynamics
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Bathtub model of unemployment and transition dynamics

Consider the bathtub model of unemployment discussed in class, described by two equations. Labor force L̄ is
divided into employed and unemployed people
L̄ = Et + Ut
and the inflow into unemployment is
Ut+1 = s̄Et f¯Ut (1.1)
Extra Question. How do we solve for the steady state in this model?

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Bathtub model of unemployment and transition dynamics

Consider the bathtub model of unemployment, described by two equations. Labor force L̄ is divided into
employed and unemployed people
L̄ = Et + Ut
and the inflow into unemployment is
Ut+1 = s̄Et f¯Ut (1.1)
Question 1.1. What do the parameters s̄ and f¯ capture?

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finding rate
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Bathtub model of unemployment and transition dynamics - Question 1.2

Consider a government policy that severely limits the ability of firms to fire workers — for instance, by
instituting that the firm has to pay very high severance payments to the fired worker. Which parameter of the
model changes? Show that, other things equal, this decreases the steady state level of unemployment in our
bathtub model.

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Bathtub model of unemployment and transition dynamics - Question 1.3

⑥
Is this a plausible result? What happens if, if response to this policy, firms become more reluctant to hire new
workers because they are worried that they will not be able to fire the worker if he turns out to be unproductive
or economic conditions worsen? Which parameter would then change and what impact this would have on the
steady state level of unemployment?

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Bathtub model of unemployment and transition dynamics - Question 1.4

What do your answers to the preceding two questions imply about the usefulness of the parameters s and f for
conducting policy experiments?

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Bathtub model of unemployment and transition dynamics - Question 1.5

Suggest some government policies that may decrease the parameter s̄ without decreasing the parameter f¯.

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Bathtub model of unemployment and transition dynamics - Question 1.5

Notice that you can rewrite equation (1) as

Uniu ¯
Ut+1 Ut = s̄Et f¯Ut = s̄(L̄ Ut ) f Ut (2)
and thus
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Ut+1 = Ut + s̄(L̄≠Ut )≠f¯Ut (3)
Assume that the economy starts in the steady state and the parameter s̄ decreases. What happens to the
steady state level of unemployment? By analyzing the equation above, sketch the transition path (in a graph
with time on the horizontal axis) for the transition from the old to the new steady state.

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Redistribution and Efficiency
Redistribution and Efficiency - Setup

In this question, we will analyze the tradeoff between efficiency and equality. Imagine the following situation.
There are two people in the economy. Person 1 can produce up to one unit of output and consume it. On the
other hand, person 2 cannot produce, and so he can only rely on what he receives through redistribution.

The government has the ability to tax person 1 and redistribute the tax revenue to person 2. Through this
redistribution, the government can lower the inequality between the two people in the economy.

However, the taxation is not costless. When the government taxes person 1, it lowers the person’s incentive to
produce, and thus the person produces less. Therefore, the attempt of the government to tax person 1
decreases total output in the economy.

We will study what allocations of consumption between person 1 and person 2 can the government achieve
through this redistribution.

Denote Y the output produced by person 1, and C1 and C2 the amount received and consumed by person 1 and
2, respectively, after redistribution occurs (I denote it C as consumption). In our case without taxation, Y = 1.

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Redistribution and Efficiency - Question 4.1

Write down the condition that describes the set of Pareto optimal allocations. These are the allocations of
consumption between person 1 and person 2 that could be achieved if taxation was costless, i.e., if it were not
decreasing the incentive of person 1 to produce.

Hint: this condition is the same as the feasibility condition that states that the sum of consumption of the two
agents equals output.

Plot the set of these allocations into a graph with C1 on the horizontal axis and C2 on the vertical axis. Depict
the initial allocation (the one without redistribution).

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Redistribution and Efficiency - Question 4.2

Assume now that the government cannot redistribute output in a non-distortionary way but must use
distortionary taxation. In particular, it can impose a tax on person 1. Person 1 then produces
Y (t) = 1 at
where a > 0 is a parameter that controls how discouraging the taxation is for agent 1. Notice that if a = 0, then
there is no discouragement and discouragement rises with a. 1

When the government uses tax rate t 0, then person 1 receives his after-tax income, C1 = (1 t) Y (t), while
person 2 receives the tax revenue, C2 = tY (t).

Question 1.2 Show that when a = 0, the government can achieve any Pareto optimal allocation.

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Redistribution and Efficiency - Question 4.3 - Part 1

Consider the cases a = 0.5 and a = 1. Fill in the following table for the two cases.

t Y (t) C1 = (1 t) Y (t) C2 = tY (t)

0
0.25
0.50
0.75
1

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Redistribution and Efficiency - Question 4.3 - Part 2

Use the graphs with C1 on the horizontal axis and C2 on the vertical axis to plot the curve that represents the
set of allocations that can be achieved through redistribution with distortionary taxation (one curve for a = 0.5,
one curve for a = 1).

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Redistribution and Efficiency - Question 4.4

It is obvious from the previous question that when tax rates are too high, an increase in the tax rate can make
both agents worse off. Show this region of excessive taxation in the graph for the previous question, for a = 0.5
and a = 1.

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Redistribution and Efficiency - Question 4.5

We want to make the argument from the previous question somewhat more formal. For a given parameter a,
what is the marginal effect of an increase in the tax rate on consumption of person 1 and person 2?

In particular, show that consumption of person 1 is a decreasing function of the tax rate, while the effect on the
consumption of person 2 is ambiguous.

Hint: You are asked to compute the derivative of C1 and C2 with respect to t.

30
Redistribution and Efficiency - Question 4.6
dC2
Observe that when t is close to zero, we certainly have > 0, so that as the tax rate increases, person 1
dt
receives less consumption but person 2 receives more consumption. When a is a given parameter, at what tax
rate t̄ will consumption of person 2 stop growing as the tax rate increases? For which values of a is this a
concern when we restrict tax rates to the interval t 2 [0, 1]?

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Redistribution and Efficiency - Question 4.7

Argue that setting t > t̄ does not make any economic sense, regardless what is your normative preference for
redistribution.

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