ECON 385 – Intermediate Macroeconomic Theory II Term Test 2
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ECON 385 – Intermediate Macroeconomic Theory II
Term Test 2
2021
There are 3 questions to this test, which is 60 minutes long (50 minutes to write the test and 10 minutes to submit). You must submit your test in one pdf file via eclass (under Term Test 2). A 1 percent deduction will be applied for every minute the test is late.
Show all your steps and work when answering questions to receive full marks. Write legibly (if I cannot read your work/steps, a mark of zero will be assigned for each question). The test is ‘open book’, but you must follow the Code of Student Behaviour. Any suspicion of plagiarism will be immediately reported.
1. Consider a standard closed economy one-period macroeconomic model developed in class. The representative consumer maximizes utility subject to her budget constraint C = wNs +π 一T, where π 一T > 0. The time constraint is h = Ns +l. The capital stock, K > 0, is fixed and a representative firm maximizes profits, π = zF (K, Nd ) 一 wNd , by choosing labour Nd . Government spending is G and is financed with lump-sum taxes T.
a. (6 marks) In a diagram draw the production possibility frontier (PPF) of consump- tion and leisure for this economy. Show the equilibrium levels of consumption, output, labour supply and leisure.
b. (7 marks) Now assume productivity z falls due to the Covid-19 pandemic. Using a separate diagram, explain the impact of this on consumption, output, labour supply and leisure. Assume the substitution effect dominates.
c. (8 marks) Now instead of affecting z, assume the Covid-19 pandemic causes h to fall. Using a separate diagram, explain the impact of this on consumption, output, labour supply and leisure.
2. Consider the two-period model of consumption/savings. The budget constraint
of the consumer in the current period is c + s = y 一 t while in the future period is c′ = y′ 一 t′ + (1 + r)s. The present value life time budget constraint is c + 
= we, where we = y 一 t +1(y′)
a. (10 marks) In a diagram, show the impact of a decrease in the interest rate r on savings, and first and second period consumption for a borrower. Explain what hap- pens to savings, and first and second period consumption. You can assume whether the income or substitution effect dominates but clearly state your assumption. Pro- vide intuition for the impact the substitution and income effect have on first period consumption.
3. Consider the Pay-as-you-go social security model (taxes on young are used to fund pension income of the old). Assume the population grows at n╱i.e. 
= 1 + n、, where N and N′ represent the number of people who are old and young, respectively. A young person earns y and pays a lump-sum tax t. An old person earns y′ and receives pension income b. The government runs a balanced budget every period such that pension paid to the old is equal to the taxes collected from the young. The tax is t = b/(1 + n). Assume the interest rate is r > 0.
a. (4 marks) Suppose n = r. Draw a young person’s budget constraint with and without the pension system (label the endowment points and intercepts for each case).
2022-03-14