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Economics 210

Prof. Michelle Connolly


Duke University
Spring 2016
Problem Set II
Due: February 8, 2016

I encourage you to work in study groups. This will be especially helpful as the difficulty of
problem sets increases over the term. My only warning is to be sure that every member is
contributing to the group, and that each person answer questions in their own words. Be sure to
write your section on your problem set when you turn it in.
On problem sets, as on exams, the explanations for the answer you give matter more than the
answer itself. A correct answer without any explanations will not receive full credit. Still, try to
be concise. It is usually possible to fully answer a question in only a couple of sentences if you
truly understand the concept under consideration. Each week, it is possible that only an
unannounced subset of the problems will be graded.

Problem 1
Suppose you only live two periods and there is a credit market in place, allowing you to buy or
sell bonds between both periods. At the start of your analysis, before any decisions are taken,
you receive news that you have just received an inheritance.
a) Will this event induce any form of substitution effects, either intra-temporal or inter-temporal?
Explain.
b) What will be the impact of this event (if any) over consumption and labor effort in both
periods? What about savings? Explain.
c) Imagine now that, because of the financial crisis, you find some difficulties in accessing the
credit market. More exactly, some limits are imposed on the amount of lending you can make
between the first and the second period. Will your initial decisions be affected by this? Under
which conditions could they stay the same? Explain. For simplicity assume you cannot hold
money.

Problem 2

Consider the behavior of a representative household integrated in a two period economy, with a
commodity and a credit market, and holding no initial assets (bonds or money). Assume that, for
some exogenous reason, the price level decreases at the beginning of period one, but then
remains constant.
a) Would you expect real output demand to be affected by this change? Explain.
b) Imagine now that the household may inherit bonds (that is, b0 can be either positive or
negative). In case the price change is unexpected, should there be any impact over
consumption and labor effort in each period? Explain.

Problem 3
Consider a two period Fisher Model with an endowment economy. Our consumer has utility U
(c1, c2), endowment income (y1, y2), and faces a given interest rate, r.

a) Set up the Lagrangian for this consumer that will allow him to choose his intertemporal
consumption pattern optimally.
b) Derive the first order conditions.
c) Using your FOCs, find an expression relating c1 to c2. What does this expression represent?
Use a Fisher Diagram. Explain intuitively this expression.

Problem 4

Suppose the government decides to decrease the level of labor taxes. Discuss (and
explain) the effects of the following policies over consumption and work effort, both
current and future.
a

A temporary unexpected decrease in the labor tax, effective today.

A temporary decrease in the labor tax, announced today, but effective only
tomorrow.

A permanent decrease in the labor tax, effective today.

Problem 5
Suppose a household lives two periods, holds no assets at the beginning of the first
period, but is allowed to buy or sell bonds between both periods. Choices are made
with regard to the optimal consumption and work effort levels in both periods.
a) Imagine that at the end of the first period a negative technological shock occurs,
shifting the production function downwards, in a proportional way. Explain how the
households choices are affected by this event.
b) What if the shock had instead been anticipated at the beginning of the first
period? Would this make any difference upon the previous answer? Explain.

Problem 6

a) Suppose the economy consists only of two people and assume the interest rate is
8 %. Fill out the following table (using the excel file). Specifically, fill in the
consumption of each person (and the aggregate economy) for each period and
calculate the present value of consumption and income for all four periods.
Calculate the bond holdings, and the present value of the bond holdings, of each
person (and the aggregate economy) as well.

b) Consider the households budget constraint in real terms over an infinite horizon,

y1 y2 /(1 R) b0 (1 R) / P c1 c2 /(1 R)

Using this condition, what is the

wealth effect of an increase in the interest rate, R, for a household that has
and initially has

ct yt

in each period.

b0 0

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