Exam of Macro 2.

SGPE
WITH ANSWERS!!!
February 2010
The exam consist of ve short questions (that require of a SHORT answer)
and one problem.
Write clear, short answers. Go to the point: you will be penalized if it is
considered that you are talking about tangencial issues.
In the problem, explain briey your results with words. Provide with clear
answers.
In the short questions, brevity and clarity are a big plus. You can use
diagrams if you want, but do not overdo... they are not essays!
1 Problem
Assets and the reservation wage.
This part is worth 60% of the exam.
Consider a generic utility function l (c) that is concave.
The agent lives for two periods (called t = 0 and t = 1), and then dies. The
discount rate and the interest rate are both equal to zero (r = c = 0).
At the begining of time 0 (before any decision is taken) the agent has an
amount of assets
0
.
Before death she consumes anything available to her.
Let
1
denote her asserts at the begining of period 1. Also, let j
0
and j
1
denote respectively labor income in periods 0 and 1. Finally denote by c
0
and
c
1
the consumption in each of the periods.
Individuals take consumption decisions every period after knowing their cur-
rent period income.
1. Write down the dynamic budget constraint at period 0.

1
=
0
+ j
0
c
0
2. Write down the intertemporal budget constraint
c
1
=
1
+ j
1
c
1
=
0
+ j
0
c
0
+ j
1
c
1
+ c
0
=
0
+ j
0
+ j
1
1
3. Write down his value function
\ (
0
) = max
c0
fl (c
0
) + 1 [l (
0
+ j
0
c
0
+ j
1
)]g
4. Write down the Euler equation:
l
0
(c
0
) = 1 [l
0
(
0
+ j
0
c
0
+ j
1
)]
5. Explain what does it mean
The Euler equation is the FOC of the maximization problem, it sa-
tates that the marginial utility obtained from current consumption
must equal the value in utility terms (from the point of view of today)
of the consumption obtained tomorrow if we sacrice a marginal unit
of consumption today.
6. Assume that there is no uncertainty and the agent knows that his la-
bor income in both periods equals n (i.e., j
0
= j
1
= n). What is his
consumption in the rst period?
c
0
= c
1
=

0
2
+ n
7. Why? What is the role of life-time income?
Because they want to equalize consumption due to the curvature of the
utility function and the fact that the interest rate equals the discount.
The only thing that matters is lifetime income
8. Call now / to their rst period income (j
0
= /), and assume that second
period income is stochastic and normally distributed:
j
1


j, o
2

Assume also that theuitlity function is

l (c) = 1 c
c
This is, it has constant absolute prudence.
Notice that if r

j, o
2

, then 1 (c
x
) = c
+

2
2
Write down the Euler equation.
expfc
0
g = 1 (expfc
1
g)
expfc
0
g = 1 (expf[
0
+ / c
0
+ j
1
]g)
expfc
0
g = exp

0
+ / c
0
+ j
o
2
2

2
9. What is the optimal consumption at t = 0?
c
0
=
0
+ / c
0
+ j
o
2
2
c
0
=
1
2
[
0
+ / + j]
o
2
4
10. How does the consumption depend on j and expected lifetime income.
why?
The more expected life time incomeincome, the more consumtion.
Lifetime income is
1
2
[
0
+ / + j]
11. What is the level of assets at the begining of t = 1?

1
=
1
2
[
0
+ /]
1
2

j
o
2
2

12. How does

1
depend on the expected income j?Why?
The more expected income in the future, the less I need to save today.
13. How does
1
depend on the variance of income o
2
?Why?
The agent is prudent, so it has precautionary savings. The more risk
in future income, the less consumption in the present, and the more
assets for the future.
14. What is the value of expected consumption at t = 1 , c
1
? Notice that I
am not asking about c
c1
but about the consumption, c
1
.
c
1
=
1
+ j
1
c
1
=
1
2
[
0
+ /]
1
2

j
o
2
2

+ j
1
c
1


1
2
[
0
+ / + j] +
1
2
o
2
2
, o
2

1 (c
1
) =
1
2
[
0
+ / + j] +
o
2
4
15. Is it larger, smaller or equal to c
0
?Why?
It is larger than half of expected lifetime resources because the agent
is going to eat it all, and in the rst period she eats less than half the
expected resources, because she is scared of bad things happening in
the second period.
Thus, in the second period she expectes to eat more even if this means
that she does not expect to equalize consumption in both periods.
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16. Does the dierence between c
0
and c
1
has anything to do with liquidity
constraints?
No, it is a reection of precautionary savings.
17. Call \
u
to the value of the agent at t = 0,
\
u
(
0
) = max
c0
fl (c
0
) + 1 [l (
0
+ j
0
c
0
+ j
1
)]g
calculate \
u
(
0
).
\
u
(
0
) = 1 expfc
0
g + 1 1 (expfc
1
g)
= 1 exp

1
2
[
0
+ /]
1
2

j
o
2
2

+1 exp

1
2
[
0
+ /] +
1
2

j
o
2
2

j +
o
2
2

= 2

1 exp

1
2
[
0
+ /]
1
2

j
o
2
2

18. Imagine now that the income in both periods where n (which is not sto-
chastic). Call the value in this case \
e
(
0
) . Calculate it.
\
e
(
0
) = 2

1 exp

0
2
+ n

19. Imagine that there is an unemployed worker with utility function l (c) =
1 c
c
who is going to live two periods, t = 0 and t = 1. If he remains
unemployed he gets / at t = 0 and his income at t = 1 is stochastic, it
depends on the wages that he will be oered at t = 1, the distribution of
these wages is

j, o
2

. At t = 0 he is oered a job that pays n, but

this precludes him to nding another job at t = 1. This is, if he accepts
the oer his income will be n in both periods. He has assets
0
at the
begining of period 0. Call the value of accepting the job \
e
(
0
),. and the
value of not doing so \
u
(
0
)
Write down the condition on \
e
(
0
) and \
u
(
0
) for hiom to accept the
job.
\
e
(
0
) \
u
(
0
)

1 exp

0
2
+ n

1 exp

1
2
[
0
+ /]
1
2

j
o
2
2

20. Determine the wage level n = n

R
that lets him indierent between ac-
cepting the job or not.
n
R
=
/
2
+
1
2

j
o
2
2

4
21. How does n
R
depend on /. Why?
The better you are unemployed, the more picky you are at choosing
a job. You need to get paid more in order to accept the job.
22. How does n
R
depend on j. Why?
The better the jobs that you expect to nd tomorrow, the more you
sacrice today by accepting the job, so the more the job has to pay in
order to be accepted.
23. How does n
R
depend on o
2
. Why?
The more uncertain future income is, the more willing I am to accept
a low paying job today.
24. How does n
R
depend on
0
. Why?
It does not depend on
0
.The reason is that with CARA the amount
of precautionary savings is not aected by the asset level: you save
the same as a consequence of future risk irrespectively of your nan-
cial wealth. Wealth aects you happiness the same if here is no risk
(employment) or if there is (unemployment)
25. How should n
R
depend on
0
. Why? How it would happen?
It is just reasonable to assume that richer people would be pickier
in the jobs they accept. This would happen if the agents had CRRA
utility. In such a case the amount of precautionary savings would
decrease with the asset level. Thus, the eect of uncertainty (which
aects you only if you choose to keep searching) would be smaller if
you are richer, and richer people would have larger reservation wages.
2 Short Questions
They require of a coherent, brief and clear answer. If you do not go to the point
you will get a lower mark. Explain the essence of the issue, this is NOT an
essay... In most cases one, at most two paragraphs should suce.
Answer all the questions. They are worth a 40% of the exam.
1. Explain the role of lifetime income determining current consumption.
If the agent has access to properly working capital markets, it should
determine its consumption much more than current income. Actually
in such a case the only other thing that can aect consumption is the
ampount of risk that the agent faces.
If there were liquidity constraints binding, then curren income is more
of a critical component.
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2. Imagine that if a rm saw catched a worker cheating it could place a
tatoo in his forefront where it said "cheater". What would be the eect
of introducing this on employment and wages?
There would be an equilibrium where cheating workers are punished
not only by the current rm, but by any other rm. It would be
much more painful to cheat, there would be lower wages and less
unemployment
3. What would you expect that would be the eect of a reduction of taxes
on the prots of rms on the vacancy unemplyment ratio.
There value of rms with workers would be larger for any level of
productivity. Thus, there would be less destruction (as rms with
less productivity would still be valuable enough) and there would be
more willingness to create rms, as they are more protable when
they produce. There would be more vacancies up to the point where
the value of a vacancy is zero. The vacancy unemplyment ratio would
increase.
4. Explain the reasons why you may save more if you may be subject to
liquidity constraints and how does it relate to the degree of risk, risk
aversion and persistency of income shocks.
You save more, the more risk there is, the more risk averse you are
and the more persistant are the shocks in your income process.
The more risk there is, the larger you want a buer stock in order
to minimize the chance of getting liquidity constrained.
The more risk averse you are, the less you like the idea of be-
coming liquidity constrained (which is a bad state, as it implies
very large marginal utility, low consumption). You try to get way
from it by saving more.
The more persistant income shocks are, the more complicated is
to make sure you are far away form the constraint, so you save
more in order to minimize the chance of hitting it.
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