Prof.

Pissarides PS1 - Solution

November 20, 2008

1 Question 1 - RBC Model Success

The following are statistics generated by the basic RBC model. Compare them
with the business cycle factsand evaluate the models successes and failures.

variable st. dev. relative st. dev. 1st order autoc cont. cor. with output
model data model data model data model data
Y 1:39 1:81 1:00 1:00 0:72 0:84 1:00 1:00
C 0:61 1:35 0:44 0:74 0:79 0:80 0:94 0:88
I 4:09 5:30 2:95 2:93 0:71 0:87 0:99 0:80
N 0:67 1:79 0:48 0:99 0:71 0:88 0:97 0:88
Y/N 0:75 1:02 0:54 0:56 0:76 0:74 0:98 0:55
w 0:75 0:68 0:54 0:38 0:76 0:66 0:98 0:12
r 0:05 0:30 0:04 0:16 0:71 0:60 0:95 0:35
A 0:94 0:98 0:68 0:54 0:72 0:74 1:00 0:78
Notation is standard and all variables are in logs (except for r): N is hours
per capita.
Data from http://www.nber.org/papers/w7534.pdf

1.1 Solution
Overall: even though the model fails in some dimension, it is surprising that such
a simple model captures so many features reasonably well. However, the model
is weak on internal propagation: most of the volatility comes from the volatility
of the technology shock and the serial correlation comes almost exclusively from
the persistence of the technology shock.

Remark 1 Model predicts too much consumption smoothing.

Remark 2 Model does pretty well in matching investment (three times as volatile
as output)

Remark 3 The model struggles to generate total hours worked that are as
volatile as output. Moreover, in the data, the variation in total hours is driven
by employment numbers (workers) rather than hours per worker.

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Remark 4 All aggregates exhibit large persistence: serial correlations of 0.9 in
annual time series are common But the model only generates these by giving
the technology shock the "right" autocorrelation. Typical for basic RBC, lacks
internal propagation mechanism.
Remark 5 The model predicts almost perfect contemporaneous correlation with
output while the data show a somewhat weaker correlation. The model does not
do well for wages. In the model, wages have an allocative role - in the data
there is less evidence of wages adjusting to clear the labour market (e.g. implicit
contracts).

2 Question 2 - Labour Supply Decisions

Suppose the period t utility function is given by
1
(1 lt )
ut = ln ct + b
1
b; >0
1. Consider a one-period problem. How does the supply of labour depend on
the wage?
2. Consider now a two-period problem. How does the relative demand for
leisure in the two periods depend on the relative wage and the interest
rate? Why does inuence these elasticities?
3. In view of your answer to (b), how do you think the performance of the
model in question 1 will be aected if we decrease the value of in the
basic model?

2.1 Solution
1. The budget constraint in the one-period problem is given by ct = wt :lt
and so the maximisation can simply be written as:
1
(1 lt )
max ln (wt :lt ) + b for t = 1
lt 1
The FOC is given by:
1
:wt = b: (1 lt )
wt :lt
1
= b: (1 lt ) (1)
lt

Equation (1) denes the level of l1 (implicitly), and it can be seen that in
the one-period problem the amount of labour supplied does not depend
on the real wage.

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2. In the two-period problem, the period budget constraints are:
c1 + s1 = w1 :l1
c2 = w2 :l2 + (1 + r) :s1
So the intertemporal budget constraint is:
c2 w2 :l2
c1 + = w1 :l1 +
1+r 1+r
Therefore the Lagrangian for this problem can be written as:
" #
1 1
(1 l1 ) (1 l2 )
max L = ln (c1 ) + b + ln (c2 ) + b
c1 ;c2 ;l1 ;l2 1 1
c2 w2 :l2
c1 + w1 :l1
1+r 1+r
and the FOCs are:
dL 1
= 0: =
dc1 c1
dL 1
= 0: : =
dc2 c2 1+r
dL
= 0 : b (1 l1 ) = :w1 (2)
dl1
dL w2
= 0 : :b (1 l2 ) = : (3)
dl2 1+r
The rst two equations will combine to give us the usual Euler equation for
consumption growth, but as we are interested in the behaviour of labour
supply, we can use equations (2) and (3). Eliminating from these two
equations yields:
b (1 l1 ) : (1 + r) :b (1 l2 )
=
w1 w2
1 l1 w1
= : (1 + r)
1 l2 w2
1
1 l2 w1
= : (1 + r) (4)
1 l1 w2

Equation (4) tells us the behaviour of relative labour supply as a function

of the relative wage, the interest rate and the discount factor.
w1
It shows that as w2 " (the real wage in period 1 is higher relative
to period 2), then 11 ll12 " which means that leisure in period 2
increases relative to period 1 (or alternatively, more labour is supplied
in period 1 to take advantage of the higher wage).

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 As the interest rate increases (1+r) ", more labour will be supplied in
period 1 - this is to take generate more labour income from which to
save and therefore take advantage of the high interest rate by saving.

3. In terms of elasticities, we can show that the key determinant is the para-
meter : We can write the elasticity of relative labour supply with respect
to relative wages as:
1 l2 w1 w1
d 1 l1 w2 1 w1 1
1
1 w2
: = [ : (1 + r)] : :
d w1 1 l2 w2 1 l2
w2 1 l1 1 l1
1
1 w1 1
= : (1 + r) :h i1
w2
: (1 + r) w
w2
1

1
=

And the elasticity of relative labour supply with respect to the interest
rate is:
1 l2 1
d 1 l1 (1 + r) 1 w1 1 (1 + r)
1
: = : : (1 + r) :
d (1 + r) 1 l2 w2 1 l2
1 l1 1 l1
1
=

Therefore, the smaller is , the larger is 1 , the more responsive is labour

supply to the relative wage. This means that the issue of matching the
volatility of hours worked relies on choosing a low value for (often =1
which yields log preferences over leisure), but microeconomic evidence on
labour supply suggests much lower elasticities of intertemporal substitu-
tion (higher ) and so the success of the RBC model in predicting the
behaviour of hours should be questioned.
An alternatvie way of getting the same answer is to take log of equation
(4)

1 l2 1 w1
log = log( ) + log : (1 + r) + log
1 l1 w2
1 l2
d log 1 l1 1
=
w1
d log w2

1 l2
d log 1 l1 1
=
d log (1 + r)

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3 Question 3 - Interest Rate Uncertainty
1
Suppose an individual lives for two periods and has utility E1 ln C1 + (1 + ) ln C2 :

1. Labour income is Y1 in the rst period and 0 in the second. The rate of
return on savings, r; is potentially random.

(a) Find the optimal C1 .

(b) How does uncertainty in r inuence this choice? Show this by calcu-
lating rst C1 for a certain r and then for a random r that satises
E(r) = r:

2. Let now labour income be 0 in the rst period and Y2 in the second. Y2
is certain

(a) Find C1 :
(b) Derive the impact of uncertainty about r on C1 :

3.1 Solution
1. Labour income is received in the rst period. Thus the budget constraint
is C1 + S1 = Y1 in period 1, and C2 = (1 + r):S1 in period 2. The
C2
intertemporal budget constraint is C1 + (1+r) = Y1 :
The maximisation for this problem can therefore be written as (substitut-
ing out for C2 = (1 + r) (Y1 C1 )):

1
maxE1 ln C1 + ln [(1 + r) (Y1 C1 )]
C1 (1 + )

And, noting that all variables are known with certainty except r (which
may or may not be subject to uncertainty)1 , the FOC is given by:

1 1 (1 + r)
E1 = 0
C1 (1 + ) (1 + r) (Y1 C1 )
1 1 1
E1 = E1
C1 (1 + ) (Y1 C1 )
(1 + )
C1 = :Y1 (5)
(2 + )

Equation (5) gives the optimal value of C1 and it is clear from this equation
that the value of r does not aect the choice of rst period consumption -
1 If 1 1
X is known with certainty, E1 [X] = X and E1 X
= X
:

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 it will however aect the level of period 2 consumption which is given by:

C2 = (1 + r) (Y1 C1 )
(1 + )
= (1 + r) Y1 :Y1
(2 + )
1
= (1 + r):Y1 :
(2 + )

2. Now labour income is received in the second period and therefore the
consumer must borrow to consume in the rst period.Thus the budget
constraint is C1 = S1 in period 1, and C2 = Y2 (1 + r):S1 in period 2.
The intertemporal budget constraint is (1 + r):C1 + C2 = Y2 :
The maximisation for this problem can therefore be written as (substitut-
ing out for C2 = Y2 (1 + r)C1 ):

1
maxE1 ln C1 + ln (Y2 (1 + r)C1 )
C1 (1 + )

And the FOC is given by:

1 1 (1 + r)
E1 =0 (6)
C1 (1 + ) Y2 (1 + r)C1
h i
Y2 Y2
If r is certain - i.e. E [r] = r in every period, E1 (1+r) = (1+r) , then we
can write
(1 + r)
E1 [Y2 (1 + r)C1 ] = E1 C1
(1 + )
2+ ) Y2
E1 C1 = E1
1+ ) (1 + r)
(1 + ) Y2
C1 = :E1 (7)
(2 + ) (1 + r)

which becomes:
(1 + ) Y2
C1 = :
(2 + ) (1 + r)

If r is uncertain - i.e. E [r] = r + " in every period, we will need to use

Jensens inequality and the results for covariance As an aside, Jensens
inequality tells us that:

1 1
E1 >
X E1 [X]

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 Starting with the FOC (equation (6)):

1 1 (1 + r)
E1 = 0
C1 (1 + ) Y2 (1 + r)C1
(1 + ) 1
E1 = E1 (1 + r)
C1 C2
(1 + ) 1 1
= E1 E1 [(1 + r)] + Cov ; (1 + r)
C1 C2 C2
1
Then since is a convex function of C2 we can apply Jensens inequality
C2h i
and obtain E1 C12 > E1 [C 1
2]
; and since the covariance term is positive
(higher r means that the individual pays more interest and therefore con-
sumes less in period 2), then we can write:

(1 + ) 1
> E1 [(1 + r)]
C1 E1 [C2 ]
(1 + ) 1
> E1 [(1 + r)]
C1 E1 [Y2 (1 + r)C1 ]
(1 + ) [Y2 E1 [1 + r] C1 ] > C1 :E1 [1 + r]
(1 + )Y2 > C1 :E1 [1 + r] (1 + (1 + ))
(1 + )Y2 > C1 :E1 [1 + r] (2 + )
(1 + ) Y2
C1 <
(2 + ) E1 [1 + r]

Therefore, we can write see that:

(1 + ) Y2
C1uncertatiny < : = C1certatiny
(2 + ) (1 + r)

Therefore, uncertainty about r will lower the amount of consumption in

period 1 - they will be more cautious about how much they borrow since
they may end up paying back lots more than expected in period 2 when
they get their income..

Remark 6 This savings behaviour is called prudence. It happens when the 3rd
derivative of the utility function is positive: U = ln (C) ; U 0 = C1 > 0; U 00 =
1
C2 ; U
000
= C23 > 0
The reason is that marginal utility U 0 = C1 is convex. This implies that as
uncertainty about C2 goes up, even though the mean is unchanged, E [U 0 (C2 )]
goes up. But since the euler equation has to hold U 0 (C1 ) has to increase as well,
i.e. C1 has to fall.