LSE Economics Department EC210 Macroeconomic Principles 2015/2016 Problem Set 10

LSE Economics Department Kevin SheedyEC210 Macroeconomic Principles 2015/2016 32L.1.09, x5022Problem Set 10: to be handed to class teachers in MT Week 111. [10 marks] Short question, 2014 Exam: Explain why the housing market collapsemight have played a role in the 2008/09 U.S. recession through its e§ect on aggregateconsumption.2. [10 marks] Short question, 2009 Exam: Explain the following statement: “Whenwages are flexible, and there are no other frictions, unemployment is always zeroin a full-information competitive labour market. It becomes positive when firmscannot observe their workers’ e§ort.”3. [40 marks] Long question, based on 2015 Exam: Consider an economy where eachgeneration lives for two time periods. Consumption of a particular generation whenyoung and old is denoted by c and c0 respectively. Assume there is no populationgrowth, so any time half of the population is young and half of the population isold. The young each receive labour income y (labour supply is inelastic). The oldare retired and receive no labour income. There is a credit market where anyonecan save and earn real interest rate r. The labour income of the young grows atrate g between generations (y0/y =1+ g).Suppose the government levies a proportional income tax t on the incomes of theyoung. The government also pays out pensions to the old that are a fraction b ofthe current young’s labour incomes (i.e. if the current young earn y, the current oldreceive by). Note that this says nothing about how these pensions are funded. Thepresent value of a generation’s lifetime after-tax income including pensions is:we = (1 ? t)y + by01 + rFirst suppose the government’s pensions system is fully funded, meaning that thetaxes collected from the young are invested and the proceeds are used to fund theirfuture pensions when old.(a) [5 marks] Assuming the government earns the same real return r as householdsdo on their savings, write down an equation linking t and b. Show that thisfully-funded pension system has no e§ect on households’ consumption plansand explain what impact it has on the saving s = (1 ? t)y ? c of the young.(b) [5 marks] Explain why your findings in part (a) are an illustration of the ‘Ricardianequivalence’ principle. Is it possible that your answers would be di§erentif households were unable to borrow?1Now suppose instead that the government has a ‘pay-as-you-go’ pensions system,meaning that taxes collected from the young are used to pay the pensions of thecurrent old.(c) [10 marks] Write down an equation linking t and b under this pension system,and use this to find an expression for life-time wealth we in terms of y, t, r,and g only.(d) [10 marks] Explain why the current old would gain from the introduction ofthe pay-as-you-go pension system, and find the condition for the current younggeneration to benefit from it as well. Assuming this condition is satisfied andthe system is introduced, find the e§ects on the consumption and saving of theyoung. Explain why the ‘Ricardian equivalence’ principle does not apply tothis type of pension system.(e) [10 marks] Now suppose that the growth rate g falls, but the condition derivedin part (d) continues to hold. Two options for reforming the pay-as-you-gopension system are: (i) maintaining contributions t and cutting benefits b; or(ii) increasing contributions t and maintaining benefits b. Compare the e§ectsof these two reforms on the current old and young generations. Is it possibleto say which reform is preferable?4. [40 marks] Consider the dynamic macroeconomic model from the lectures. For eachof the shocks below, find the e§ects on output, employment, the real interest rate,and the real wage (if an answer is ambiguous you should say so). Include wealthe§ects in your answers where appropriate.(a) The government temporarily increases its expenditure G (assume governmentspending has no direct benefits in terms of production or utility). [10 marks](b) There is good news about future total factor productivity z0 (with no changeto current total factor productivity z). [15 marks](c) The economy’s production processes become less capital intensive (interpretthis as raising the marginal product of labour MPN and reducing the marginalproduct of capital MP0K, ignoring any direct e§ect on what output is producedusing the initial supplies of capital and labour, and ignoring any wealth e§ects).[15 marks]



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