LSE Economics Department EC210 Macroeconomic Principles 2013/2014 Michaelmas Term

Kevin Sheedy 32L.1.09, x5022 k.d.sheedy@lse.ac.uk

Problem Set 8: The Dynamic Macro Model

1. Temporary productivity shocks in the dynamic macro model : Consider a two-period macroeconomic model with a representative consumer and a representative rm. The representative consumer makes consumption-saving and labour supply decisions. The representative rm makes labour demand and investment decisions. (a) Dene the competitive equilibrium of this economy by stating the optimality conditions from the consumers and the rms optimization problems, and the market clearing conditions for equilibrium wages and the real interest rate. Answer: The consumers optimal labour supply requires that the marginal rate of substitution between leisure and consumption is equal to the relative price, which is the real wage (M RSl,c = w). A similar condition holds for labour supply in period 2. The consumers optimal consumption-saving decision requires that the marginal rate of substitution between todays and tomorrows consumption is equal to the relative price, which is one plus the real interest rate (M RSc,c = 1 + r). Combining this with M RSl,c , we also have the condition for intertemporal substitution in labour (or leisure) M RSl,l = (1 + r)w/w . The rms optimal labour demand satises M PN = w, so that the marginal product of labour is equal to the marginal cost of hiring one unit of labour. The rms optimal investment decision satises M PK = r + d, so that the future marginal product of capital is equal to the user cost of capital. Finally, the market clearing conditions state that the real wage and interest rate have to be such that labour supply is equal to labour demand and that output demand is equal to output supply, N d = N s and Y = C + I + G.

b. Analyse the eects of a temporary positive shock to total factor productivity (TFP) on output, employment, consumption, investment, the real wage and the real interest rate. Assume that the shock is suciently short-lived so that wealth eects can be ignored here.

Figure 1: Temporary positive TFP shock

w Nd C r B A A C Ns r Yd Ys

N Y B C Y = zF (K, N )

Answer: This analysis is typical of the kind that we will see throughout the course. It is important to familiarise yourself with the logic. A temporary TFP shock has the following direct eects (see Figure 1): It increases the marginal product of labour: labour demand N d shifts right. It directly shifts up the production function. Any positive TFP shock also leads to a positive wealth eect, which increases consumption and leisure. But when the shock is short-lived, the wealth eect will be comparatively small, which is why you are asked to ignore it here. It is important rst to work out the eects on the Ys curve. This curve is determined by the production function together with the labour market equilibrium at each possible interest rate. The shift in N d raises equilibrium employment. This, together with the upward shift in the production function, increases output at any interest rate. At a given 2

interest rate, the economy moves from point A to B, which means that the Y s curve shifts to the right. From here, we can work out the indirect eects that ensure the economy readjusts to equilibrium: We always start rst with the output market. Here, the shift in Y s implies that the interest rate r falls. Equilibrium output Y unambiguously increases. The new equilibrium is at point C. As we move along the Y d curve, consumption C increases because of the substitution eect of the interest rate, as does investment I because lower r reduces the user cost of capital. Next, we turn back to the labour market. The thing to note here (and the reason why we analyse the markets in this order) is that as the interest rate change causes a substitution eect on labour supply. It is now less valuable for households to work today as they earn less interest on labour income that they save. Therefore, as we move down the new Y s curve, labour supply N s shifts to the left. The real wage unambiguously increases. If we assume (as we will often do) that the direct eect on labour demand outweighs the intertemporal substitution eect on labour supply, employment N is still above its initial level at the new interest rate, and the equilibrium is at point C. (Note that this argument supposes that the intertemporal substitution eect on labour is relatively weak, which is probably reasonable, but is an additional assumption.)

2. Expansionary austerity? : Consider the same two-period macroeconomic model from question 1. Use the model to study the eects on current aggregate output, employment, investment and consumption in the following scenarios: (a) The government announces a decrease in future government spending, with lower taxes in the future (take account of wealth eects in your answer). Answer: One might at rst think that the main eect to consider here is that lower government spending decreases output demand. However, here we consider a fall in future spending, so only future output demand is aected by this. Since the question is asking about the current eects of the policy, we do not analyse the future output market directly. The main eect of this future change is through the budget constraints. Remember that the consumers intertemporal budget constraint is: C+ w N + T C = wN + T + 1+r 1+r

where = Y wN I and = Y w N + (1 d)K , and the government needs to satisfy: T G =T+ G+ 1+r 1+r 3

From the governments budget constraint it follows that lower G allows a reduction in taxes, (which could happen either today or in the future, or both). This is a positive wealth eect for consumers (it slackens the intertemporal budget constraint). Direct eects: A positive wealth eect implies that current consumption increases and labour supply decreases. Thus, Y d shifts to the right and N s shifts to the left. Eect on Y s : Lower labour supply at any interest rate decreases employment and hence output through the production function. Y s shifts to the left. New equilibrium: In the goods market, the interest rate rises, but the eect on current output is ambiguous as demand and supply have shifted in opposite directions. If we assume that the wealth eect on labour supply is relatively minor compared to the wealth eect on consumption, current output increases slightly.1 Investment is governed by M P K = r + d. A higher interest rate implies that the user cost of investment increases, therefore investment falls. The rise in r also induces a substitution eect that tends to reduce consumption, tending to oset the wealth eect, but would probably not reverse it. Therefore, consumption is still likely to rise. In the labour market, the intertemporal substitution eect and the wealth eect on labour supply work in opposite directions, so the equilibrium outcome is a priori unclear. But note that the assumptions we made earlier in answering the question led us to conclude that output would rise. As the production function is unchanged, it must be that equilibrium employment has risen too in that case. In order for our analysis to be consistent, it must be the case that the intertemporal substitution eect dominates over the wealth eect for labour supply. The analysis is summarised in Figure 2.
Output would decrease if it were the other way around, that is, were the wealth eect on labour supply stronger than that on consumption - ultimately, this depends on household preferences.
1

(b) The government decreases its current spending temporarily (assume the wealth eect is negligible) and reduces current lump-sum taxes. Answer: Direct eects: Lower government expenditure directly shifts output demand to the left. It would also induce a small positive wealth eect, which we are asked to ignore here for simplicity (the analysis of that wealth eect would be as in part (a) if we were required to take account of it). Eect on Y s : none. New equilibrium: In the goods market, output and the interest rate fall. Investment and consumption rise, due to lower opportunity costs of investing and a lower return on savings, respectively. In the labour market, the intertemporal substitution eect lowers labour supply. Equilibrium employment falls. See Figure 3. (c) Same as in (b), but now the government cuts proportional wage income taxes in the current period. Answer: Unlike lump-sum taxes, proportional wage income taxes have a direct eect on the relative price of leisure in terms of consumption, namely the post-tax real wage (1 t)w, which households equate their marginal rate of substitution between consumption and leisure to. When the government cuts these distortionary taxes, it becomes more attractive to work, i.e. to substitute away from leisure and towards consumption (cf. Problem Set 2 of Michaelmas term). Thus, the direct eect to add here is that both labour supply and consumption demand increase: N s and Y d shift to the right. The former induces a rightward shift in Y s as well. Whether or not these two eects are sucient to overturn the conclusion from part (b) that output falls depends on how much households shift from leisure to consumption in response to the tax break. Figure 4 depicts a situation in which output is unchanged in response to the opposing eects. This is possible because G has fallen, but C has increased due to the tax break, and C and I have both increased due to lower interest rates. In the labour market, the substitution eect from lower interest rates and the one from the tax break must now oset each other in order for employment to stay constant, which is necessary for output to be unchanged. 5

Figure 2: Decrease in future government spending

w Nd Ns r A C B
wealth wealth

r Yd Ys

C A

Figure 3: Decrease in current government spending

w Nd Ns r
G

r Yd Ys

B A A B

Figure 4: Decrease in current spending with reduction in distortionary taxes

w Nd Ns
tax break

r Yd Ys

r A,C B
G tax break

A C

(d) Based on this analysis, would you say that austerity (i.e. lower government spending) can be expansionary for the economy? Answer: Dening expansionary as an increase in output, it is dicult to argue that lower government spending can be expansionary. First, we have seen in part (a) that the announcement of future cuts can be expansionary in the present, but only if the eect of increased private consumption is suciently strong. Second, at the time when the cuts are implemented, they decrease output mechanically through the identity Y = C + I + G, as we have seen in part (b). If the spending cuts are accompanied by tax breaks, the the fall in output is mitigated to the extent that this removes disincentives to produce (e.g. by encouraging labour supply as in part (c)). However, for output to actually rise in this case, the incentive distortion must be quite strong in the rst place. It is nevertheless possible that, although output does not rise when government expenditure actually falls, private consumption and investment do rise. We have seen this in part (b). Here, austerity crowds in private investment and consumption. We will talk more about the eects of scal policy on the economy in the last topic of this term. 3. Future productivity shocks in the dynamic macro model : Consider again the dynamic macro model from question 1. (NB: For the purpose of this exercise treat all wealth eects as negligible.) (a) Use the model to explain the eects of an expected fall in future total factor productivity (TFP) on the wage, real interest rate, employment, investment and output in the current period. Answer: Direct eects: A fall in future TFP implies that future M PK falls. This shifts the investment demand curve to the left, which shifts output demand Y d to the left. Wealth eects of the TFP shock are ignored as indicated in the question. Eect on Y s : none. New equilibrium (see Figure 3): In the output market, the real interest rate decreases, as does output. Investment decreases. Note that as we abstract from wealth eects, consumption actually increases here as by the substitution eect of a lower interest rate. The lower real interest rate shifts the current labour supply to the left due to the inter-temporal substitution of leisure, so the real wage increases. Employment N falls. 7

Figure 5: Decrease in future TFP w Nd r B A I A B Ns r Yd Ys

N Y Y = zF (K, N ) B A

N Note that the initial decrease in investment is partly oset by the fall in the interest rate. (b) Suppose two economists agree that TFP will be lower in the future. They are arguing about whether the current observed fall in output is also due to a current fall in TFP. Which variables should they look at to determine whose view is correct? Answer: We can think of the eects of the sum of several shocks as the sum of the eects of the shocks. A fall in TFP in the current period is just the opposite of what we saw in Question 1, so we know the eects of it already. We can just sum up the eects of the current and future TFP shock in Table 1. When both current and future TFP fall, the overall eect on the real interest rate is likely to be small, as the shocks from current and future TFP work in opposite directions. This is clearly dierent from the eect of a decrease in future TFP only where we saw that the real interest rate decreases in equilibrium. The same applies to the labour market, in which the response of the real wage to a fall in current and future TFP has opposing 8

Table 1: A fall in current and future TFP Variable Fall in current TFP Y r C I N w fall in future TFP

eects, and to consumption (but where our results are more sensitive to the exclusion of wealth eects). For the debate, it is thus possible to look at whether the real wage rises and the interest rate and consumption fall with output to determine which scenario applies to the economy.