Economics 210

Prof. Michelle Connolly

Duke University
Fall 2016
Problem Set 2
September 13, 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.
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.
This problem set is due in class Tuesday, September 20
Problem 1
The production function for a closed economy can be expressed by Y = Lw and the
utility function is defined by U = C(1-L), where C is consumption, L is labor, and Y
is output.
a.
b.
c.
d.

Set up the Lagrangean and find the first order conditions.

Derive the optimal solution for consumption, output and labor.
Does the wealth effect or substitution effect on labor dominate?
Is there a type of utility function which delivers a different answer to c.?

Problem 2
Consider the behavior of a representative household 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 any real effect from this change? More exactly, should real
output demand be affected? Explain.
b. Now, consider a household who took out a loan in period zero, which must be
paid back in period one. Should there be any impact over this households
consumption and labor effort in periods one and two?
c. Now, suppose the economy is comprised of individuals like the one
considered in part (b) as well as individuals who were lenders in period zero.
Will there be any real effects in the aggregate economy?

Problem 3
Fill out the table in the excel file assuming the economy consists only of two people
and the interest rate is 8 %. 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.
Problem 4
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 Lagrangean 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 c 1 to c2. What does this
expression represent? Use a Fisher Diagram. Explain intuitively this
expression (i.e. explain to your very intelligent grandmother).
Problem 5
Suppose that you live in a two period endowment (that is, there is no labor-leisure
decision) economy and there is a credit market in place, allowing you to buy or sell
bonds between the two periods. At the beginning of the period, before any decisions
are taken, you receive news that it has just received an inheritance.
a. What will be the impact of this event (if any) over consumption in both
periods? What about savings? Explain.
b. 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.
Problem 6
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 positive technological shock
occurs, shifting the production function up, 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.