Tutorial Problem Set 3 and

Preparation for Mid Exam

Macroeconomics 2

By Naufal Nurrohman and Saffanah Calista

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 Outline
● Discussion about material
○ Consumer and Firms Behaviour (Week 2)
○ A Closed-Economy One Period Macroeconomics Model (Week 3)
○ Search and Unemployment (Week 4)
○ A Two-Period Model: The Consumption-Savings Decision and Credit Market
(Week 5)
○ Credit Market Imperfections: Credit Frictions, Financial Crises, and Social
Security (Week 6)
○ A Real Intemporal Model With Investment (Week 7)
● Discussion about Problem Set 3

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 Consumer and Firms
Behaviour

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 The Assumption
1. One Time Period
a. They will make a static decision
b. How much consumer can spent in one day (exclude invest)
c. Consume goods = the cost, so the consumer will work hard and will enjoy
less leisure time or they will have a more leisure and will have less
consumption
d. For the firm, we focus on how the available technology (k) and labor (Nd)

2. Identic
a. Any consumers in the economy are identical with the other consumer
b. Consumer preference over consumption and leisure can be represented
using Indifference curve
c. Which is utility function U(c,l) c is consumption and l is leisure.

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 Indifference Curve
The indifference curve connects a set of points, with these points representing
consumption (u = f(c,l))
● Properties of an indifference curve
○ As indifference curves slopes downward because the
representative consumer’s
○ An indifference curve is convex (the consumer prefers diversity in
his or her consumption bundle)
○ Slope MRS (Marginal Rate Substitution) is function of Leisure and
Consumption

Consumer preference have 3 properties

○ More is always preferred to less
○ The consumers likes diversity in his/her consumption bundle
○ Consumption and leisure are normal goods

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 Budget Constraint
● When T < π Assumption of budget constraint ● When consumers
● Competitive choose not to work
● No money in the economy, only
goods
● There are only two goods,
consumption and time (leisure)
● Any trades happening in the
economy will affect labor time
and consumption goods, vice
versa

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 Indifference Curve
● Effect from real dividend and taxes ● Substitution and Income Effect when real
wage rises

Assumption: C and L are normal goods so ● Subs Effect: Consumers perceive that
increase dividends and decrease in taxes working more appealing than leisure. This
will affect the consumer to consumption occurs because the opportunity cost of
more and reduce the quantity of labor leisure time rises
supplied (work time spent) ● Income Effect: Enhance their purchasing
power without sacrificing their leisure time

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 Firm’s Production Function
● Marginal product of a factor
production, specifically capital
Production function will declines with the quantity

Total productivity = Total function of capital of capitals

and labor demand ○ The slope of the
production is the
● Goal of the firm is to maximize the profit marginal product of
capital.

● Will be maximum when

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 A Closed-Economy One Period
Macroeconomics Model

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 A Closed-Economy One Period Macroeconomic Model
Competitive Equilibrium
PPF (supply pov) → MRTlc; captures the trade-off between
leisure and consumption that the available production
technology makes available in the economy. MRT is the rate at
which leisure can be converted in the economy into
consumption through work.
IC (demand) → MRSlc; captures the trade-off between leisure
and consumption faced by consumers to allocate their income.
Budget Line → MPn = w

So, point J is the equilibrium point of supply and demand side

(alo the labor market)
Some conditions have to be satisfied to obtain a competitive equilibrium point:

- Representative consumer optimizes given market price – she maximizes

consumption and labor supply subject to her budget constraint, given wage, tax,
and dividend income
- Representative firms optimized given market prices – she chooses labor demand
to optimize profit
- The labor market clears, Nd = Ns
- The government budget constraint is satisfied, G = T
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 Search and Unemployment

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One-sided Model: The Reservation Wage & Determination of Unemployment
Rate
Reservation Wage Unemployment Rate

Reservation wage (at which worker makes decision to In the LR, we can extend the perspective to also look into the
work/not) determines the the welfare of employed & flows between the pool of employed and unemployed (have
unemployed. new job/separate from the job)

Key Decisions: Flow from employment to unemployment → s(1-U); consists of

- Ve(w) >= Vu if w>w* → worker will accept the separation rate and employment components
job offering
- Ve(w) < Vu if w<w* → will turn down the offer Flow from unemployment to employment → UpH(w);
Because worker’s decision to accept/reject job offer depends on
When a worker decide to turn down a job offer, it will wage offer and reservation wage.
affect the unemployment rate or the flow from
unemployment to employment (UpH(w*)) It consists of H(w); a fraction of unemployed receiving a wage
offer larger than w* , p; fraction of unemployed receive a job
offer, and U; proportion of unemployed. Interpretation: only
some of workers who get job offering that receive wage offer
greater than the reservation wage. They are the ones who will
transition to employment

Thee equilibrium in the long run is

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One-sided Model: The Reservation Wage & Determination of Unemployment
Rate

Step 1 determine the level of w* or reservation rate.

Level of reservation wage will influence the welfare of employed/unemployed, which then determines whether a
worker accept a job offer (unemployed → employed)
Step 2 with the w*, we can decide the long run unemployment rate
After we get information about flow from unemployed to employment (UpH(w*)) from the determination of
reservation wage, it helps us to decide the unemployment rate, that also takes into account the analysis of flow
employment to unemployment

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Two-Sided Model: Demand & Supply Perspective

We assume that a firm keeps posting vacancies and It is assumed that a is a fraction of worker’s surplus:
a worker keeps looking for a job. When a firm is 0<a<1
matched with worker, they can produce output z.
However, how do they decide/determine the level Thus, worker’s surplus can be written as: w-b =a(z-b)
of wage in the economy? And we can get wage equation from equation above that
is w = az + (1-a)b
Nash bargaining solutions
Two individuals strike a bargain that depends on By substituting the wage wage equation in the firm and
what each person faces as an alternatives. It is consumer equations, we get:
adopted as a notion of surplus: worker surplus, firm
surplus and total surplus.
Worker’s surplus: w-b; wage income minus
unemployed benefits
Firm’s surplus : z-w; value of total output minus
wage
That solve for the endogenous j (labor market
Total surplus: z-b: value of total output minus
tightness) and Q(labor force)
unemployed benefits

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Two-Sided Model: Demand & Supply Perspective

worker
Step 1 (b) the ratio of the cost of posting a vacancy to the
firm’s surplus from a successful match determines the labor
market tightness
Decision firm to post vacancies will determines the match success, which
then determines the labor market tightness (j). If a change doesn’t affect the
cost of job posting, the demand curve will shift. If it changes the cost of job
posting, it will move along the curve.
Step 2 (a) the labor market tightness determines the size of
labor force
Then, the latest labor market tightness will determine the labor force. A
factor change also be analyzed on how it affects the worker’s decision
firm
*To determine how a factor influences each side, use these equation as a
direction

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 A Two-Period Model: The
Consumption-Savings Decision
and Credit Market

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Dynamic Consumption-Saving Decision

The type of Consumer’s Choices Assumption

1. The consumer can consume all his current income 1. Large number of consumers (m)
today and all his future income in the future (no 2. Lowercase letters = individual var
borrowing no savings) 3. Uppercase letters = aggregate var
2. By saving, the consumer gives up consumption 4. Y = real income in the current period, Y’ = future
today for assets, which will be exchanged for period
consumption in the future 5. T = lump sum taxes current period. T’ = Future
3. By borrowing, or negative savings, the consumer period
can consume more today but has to sacrifice
consumption tomorrow to repay the loan

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 Type of Budget Constraint
1. Current period 2. Future period
c+s = y-t c’ = y’ - t’ + (1+r)s
● s = consumers savings in the current period ● s = consumers savings in the previous period
● If s > 0, the consumer is saving a lender on the ● If s > 0, the consumer is redeems his bonds on the
credit market credit market for consumption goods
● If s < 0, the consumer is dissaving a borrower ● If s < 0, the consumer is retire the bonds issued in
on the credit market the previous period out of disposable income (y’-t’)

3. Lifetime Budget Constraint 4. Consumer’s Lifetime Wealth (we)

The real rate of interest (r) at which a consumer can ● The intercept of the budget constraint is (1+r)we
lend is the same as the real rate of interest at which a ● The slope of the budget constraint is -(1+r)
consumer can borrow.

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 Type of Budget Constraint

● If income in the current period

increases from y1 to y2, the budget
● Vertical intercept (we(1+r)) = consumed Consumer optimization for lender For borrower constraint will shifts to the right by ∆y
tomorrow if nothing were consumed ● The consumer will choose the ● Now the endowment bundle = y2 - y1

today ● Increase c, c’, and s savings

best bundle that is budget feasible point E
● Horizontal intercept (we) = consumed ● Optimization implies setting ● c* > y-t implies that s < 0
today if nothing were consumed MRSc,c’ = (1+r)
tomorrow ● Point A = the rate at which the
● The slope of the line BA is -(1+r) consumer is willing to trade
● Consumer have his/her endowment current consumption for the
point bundle at point E if savings are future consumption in terms of
exactly zero = 0 future consumption (1+r)
● BE = the consumer must be a lender ● c* < y-t implies that s > 0
(s>0)
● EA = the consumer must be a borrower ● Increase c, and c’ but
decrease s savings
(s<0)

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 Increase in the Real Interest Rate
Lender Borrower

Substitution Effect: Substitution Effect:

● Increase in the market real interest rate
● The substitution effect is the ● The substitution effect is the
decreases the relative price of future
movement from A to D movement from A to D
consumption goods in terms of current ● Since the relative price of future
● As before, since the relative
consumption goods consumption is lower:
price of future consumption is
● Income Effect: is the change in the ● c decreases | c′ increases | s
lower:
consumption of goods by consumers increases
● c decreases | c′ increases | s
based on their income. * Income Effect
increases
● Substitution effect happens when ● Since the consumer is richer
Income Effect
consumers replace cheaper items with and goods are normal:
● c decreases | c′ decreases | s
more expensive ones when their financial ● c increases | c′ increases | s
increases
conditions change decreases

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 Gov’t Intertemporal Choice
2. Future period

● Government spending G′ is an exogenous variable ◮

Total taxes collected T ′ = mt′
1. Current period
● The government has to pay interest and principal on
G = T+B debt issued yesterday (1 + r)B
● Government spending G is an exogenous ● Note: if B < 0, the government is a net lender in the
variable first period and collects (1 + r)B from private agents in
● Total taxes collected T = mt, as each of the m the second period
consumers pay lump-sum taxes t
● The government can borrow by issuing riskless 3 Present Value
bonds B
● The current-period budget deficit T − G is
financed by issuing bonds
● The equation says, the present value of government
purchases must equal the present value of taxes.
● Or, that the government must eventually pay off all of its
debt by taxing its citizens.

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 Ricardian Equivalence
The Ricardian Equivalence Ricardian Equivalence with a Cut in Ricardian Equivalence with a Cut in
Current Taxes for a Borrower Current Taxes for a Borrower
Theorem Holding current and future government spending constant, a change in
current taxes with an equal and opposite change in the present value of future taxes
leaves the equilibrium interest rate and the consumptions of individuals unchanged

● This theorem suggests that under certain conditions the timing of taxes
does not matter
● What matters is the present value of tax liabilities
● Key: consumers realize that a tax break today is not free: taxes tomorrow
will be higher, so they save the tax break

● The original endowment is at point ● The original endowment is at

E1, and the consumer chooses point E1, and the consumer
bundle A chooses bundle A
● When current taxes fall and future
● When current taxes fall and
taxes increase, the endowment
point moves to E2
future taxes increase, the
● Since the change in taxes does not endowment point moves to E2
affect wealth, the budget constraint ● Since the change in taxes does
does not change and bundle A is still not affect wealth, the budget
optimal constraint does not change and
● The consumer simply saves all the bundle A is still optimal
current tax cut to pay higher taxes
● The consumer simply saves all
tomorrow
the current tax cut to pay higher
taxes tomorrow

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 Why Might Ricardian Equivalence Fall in Practice? / How Burden the debt is
shared

Redistributional effects of taxes: tax changes affect the wealth of different consumers differently: All individuals may
not pay the same taxes, changing the tax burden across individuals
● We assumed that ∆t ′ = −(1 + r)∆t for all individuals
● If some consumers received higher tax cuts than others, they would change their consumption and the interest
rate would change as well
● In practice, the government can redistribute wealth through tax policy

Intergenerational redistribution: debt issued by the government today is paid off by future generations: Debt may not
be paid off during the lifetime of all individuals who were alive when it was issued
● Tax cuts could benefit currently old individuals and higher taxes in the future could be paid by the current young
● This scenario involves an intergenerational redistribution of wealth

Taxes are not lump sum; they cause distortions: Lump-sum taxes are not used in practice
● As we have seen, proportional wage taxation causes inefficiencies and changes in behaviour
● The same is true if the government taxes the return to savings

Credit market frictions: Credit market may not be perfect

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 Credit Market Imperfections:
Credit Frictions, Financial
Crises, and Social Security

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 Credit Market Frictions Facing different lending and borrowing rates

Two types of credit market frictions

1. Asymmetric Information
Some market participants know his/her
creditworthiness than do potential lenders

2. Limited commitment
Impossible for a market participant to
commit in advance to some future action

Effect of Tax Cut with Credit market Imperfections

● For such a consumer, entire tax cut will be
spent on current consumption
○ But in this case with no credit market
imperfections, the consumer will
save the entire tax cut to pay higher
future taxes

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 Credit Market Frictions
Limited Commitment and Credit Market
Asymmetric Information ● Example
● Each borrower know whether he is good or bad and ○ House is collateral for a mortgage loan
bank cannot ○ Mortgages are used not only to finance the
● All good borrowers identical purchase of homes but also to finance
consumption
Default Premium ○ When price of houses fall, the quantity of lending
● When α < 1, default premium increase when α
in the economy as a whole drops, and the
decreases - credit market imperfections becomes
current aggregate consumption decreases.
more severe

Effect of a Decrease in the fraction in Creditworthy Borrowers

● Default premium increases
● Budget constraint shifts in
● Consumption falls for all borrowers
● Matches obs from the current financial crisis
○ Increase credit market uncertainty, reduction in
lending, decrease in consumption expenditures

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 Credit Market Frictions
Social Security Programs
● Taxes on the working population pay for social security
transfers to the retired each period

Example
● The young pay social security taxes t, the old receive social
security benefits b.
● Assume that the social security has no effect on the market
real interest rate, r.
● A given consumer receives income y when young and
income y′ when old.
● Assume that government spending is zero in all periods.

Which implies, current period consumption can be no greater

than current disposable income plus the amount that can be
borrowed by the consumer by pledging the future value of the
house as collateral.

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 Credit Market Frictions

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 A Real Intemporal Model With
Investment

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 Introduction
Investment represents a trade-off between present and future consumption. In the present time, one can
allocate his endowment to current consumption or investment.

A firm makes decisions regarding investment. When a firm invests, it forgoes current profits to achieve higher
level of productivity in the future, as it aims to have higher future capital stock.

Higher real interest rate implies higher opportunity cost of investment, so investment becomes less
attractive. However, investment decisions also depend on credit market risk. Firms hardly borrow to fund its
projects if lenders are risky.

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 The Representative Firm’s Investment Decision

A firm’s motive is to optimize profit by Optimal investment decision : MC(I) = MB(I)

determining production, labor demand, and
investment level. MC(I) = 1
Investing one unit of investment reduces current
Current Profit : π = Y - wN - I profit by one unit.
Its current profit depends on production level (+),
cost of labor (-), and investment(-). More firm’s MB(I) = MPK’ + 1 - d/1+r
investment meaning that firm has to allocate its In the future, investment will result in (i) an
current resource to the future and potentially
additional unit to future capital stock (K’) so firm
leads to lower level of current profit
can produce more output, and the additional
Future Profit : π’ = Y’ - w’N’ + (1-d)K’ output produced is equal to firm’s future marginal
In the future, firm will be benefit by investment it’s product of capital (ii) at the end of future period,
done in the past by (1-d)K’, equals to level of there will be (1-d) more future capital
future capital minus depreciation
Optimal Decision:
Present Value of Profits : V= π + π’/(1+r)
(MPK’ + 1 - d)/1+r = 1

Can be written as : MPK’ - d = r

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 Two Types of Shifts in the Optimal Investment Schedule

1. The optimal investment schedule shifts to the right if future TFP (z’) increases

If a firm expects the future TFP to be higher, increases in the future marginal productivity of capital and
future output, firm is more willing to invest more during current period to optimize future production
capacity, to obtain the optimal profit in the future period

2. The optimal investment schedule shifts to the left if the current capital stock (K) is higher.

A higher capital stock at the beginning of current period implies that at given level of current
investment (I), capital stock (K’) is already high. That is, if current capital stock (K) is higher, there will
be more depreciated capitals that can be used in the future. Thus, it implies MPK’ will decrease for
each level of investment and the optimal investment schedule to shift to the left.

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 Investment with Asymmetric Information and the Financial Crises

The implication of asymmetric information in the credit market is different rates faced by the borrower and
lender, to compensate the risk that banks face because banks have limited information and ability to
differentiate and choose the borrower/lender with less risks. So, economy has to suffer from a default
premium.

Real interest rate for lenders : r

Real interest rate for borrowers: rl = r + x
X is equal to default premium

So, the opportunity cost of investment for a borrowing firm is r + x

The optimal investment schedule for the firm: MPK’ - d = r + x
If a bank perceives more bad borrowing firms, the default premium will increase (x1 to x2). As a result,
optimal investment schedule for the firms shifts down and the firm chooses to invest less.

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 The Equilibrium Effects of a Decrease in the Current Capital Stock

A decrease in the current capital stock (K) will affect the supply and demand side for the output

Output Supply
A decline in the K decreases marginal productivity of labor (MPL), which shifts the current demand for labor
curve to the left (lower Nd). Then, the output supply decreases and shifts to the left

Output Demand (C + I + G)
A decline in K increases investment by the firm, because the future marginal product of capital will be higher,
so it shifts the output demand curve to the right.

The real interest rate must rise, but the effect on current aggregate output is ambiguous, depending on the
power of output demand/supply. However, because there is a higher interest rate, investment must fall, yet
the effect is contradicting to the effect from a decline in K. So, the impact on investment is ambiguous, but it
must increase, because less capital would cause ever-decreasing investment, which would be inconsistent
with statement that MPK rises as quantity of capital falls.

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 Problem Set 3

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 Number 1

Borrower
When the interest rate increases from r1 to r2, the lifetime wealth will change from we1 to
we2, causing the borrower consumer to choose the optimum point B after the interest
rate increase. Two effects occur when the interest rate rises.
● Substitution effect: The optimal point changes from point A to point D when the
interest rate increases. It can be concluded that when the interest rate rises,
current consumption decreases, but future consumption increases, and savings
increase when the substitution effect dominates.
● Income effect: Then, from the income effect side, the optimal point changes from
point D to point B in response to the increase in interest rates. This occurs
because it is assumed that consumers are poorer and the goods are normal
goods. Therefore, current consumption decreases, future consumption
decreases, but savings increase.

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 Number 1

Lender
When there's an increase in the real interest rate, the optimal point for lenders will change from the
initial point A to point B. Additionally, the graph of the WE axis becomes steeper compared to
before the increase in the real interest rate. This increase in the interest rate results in two types of
effects on lenders, which are as follows:
● Substitution Effect: The increase in the interest rate will cause the optimal consumer point
to change from point A to point D. When the relative price of future consumption is lower,
current consumption will decrease, future consumption will increase, and savings will
increase if the substitution effect dominates.
● Income Effect: When the income effect dominates, the change in the optimal point occurs
from point D to point B. It is assumed that when consumers are richer and goods are
normal, current consumption will increase, future consumption will increase, but savings
will decrease.

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 Number 2

Explanation of the question above:

The government wants to collect taxes from consumers through two options of tax collection:
1. Proportional tax on savings: This tax will be imposed on the amount of money consumers save each year (per unit of savings), expressed as tax =
s(y-c).
2. Proportional consumption tax: This tax will be imposed on the amount of consumption both currently and in the future.

Explain why consumers prefer option 2 over option 1. Note that consumers may have the possibility to choose the same consumption bundle under the
consumption tax as they choose under the savings tax. However, with the consumption tax, consumers will be better off because they will have more
income.
Answer:
To demonstrate that option (ii) is preferred over option (i) if the government wants to maximize consumer welfare, we can use the following argument:

Consider a consumer who chooses their consumption bundle under option (i). This consumer will face a budget constraint

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 Number 2

Now, consider the same consumer under option (ii). This consumer will face a budget constraint:

Where c' represents future consumption and u represents the proportional tax rate on consumption.

Now, we can show that the consumption bundle chosen by the consumer under option (i) could be chosen based on option (ii), but it turns out not to be.
This is because we can always find a value for u such that the two budget constraints are equivalent.

To see this, we can set two equal budget constraints to each other and solve for u:

This indicates that we can always find a value for u such that the two budget constraints are equivalent. However, consumers under option (ii) will choose a
consumption bundle that maximizes their utility, within the budget constraint. This means consumers under option (ii) will choose a consumption bundle that
is at least as good as the one they would choose under option (i).

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 Number 2

Therefore, option (ii) is preferred over option (i) if the government aims to maximize consumer welfare.

Why is this the case?

Option (ii) is preferred over option (i) because it allows consumers to smooth their consumption over time. This is
because the tax rate on consumption is the same in both the current and future periods. Conversely, in option (i), the
tax rate on savings differs from the tax rate on consumption. This may discourage savings, leading to lower
consumption in the future.

By enabling consumers to smooth their consumption over time, option (ii) makes them better off. This is because
consumers can avoid excessive consumption in the present and inadequate consumption in the future.

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 Number 3

a. An increase in the tax rate will result in a change in the optimal choice of consumption and saving, considering whether the substitution effect dominates over the
income effect, or vice versa.

From the borrowers' perspective, an increase in the tax rate will lead to a decrease in current consumption, savings, and an increase in borrowing. On the other hand,
for lenders, the response to an increase in the tax rate is to increase current consumption, increase savings, and decrease the amount of loans they borrow at present.

The increase in the tax rate will change the slope of the curve to become kinked because there is a decrease in income by (1-x) r.

b. The increase in the tax rate will affect the optimal points of consumption and savings for consumers, but the magnitude and direction of the change depend on
whether the substitution or income effect dominates for consumers.

Borrowers:
- Have no effect.

Lenders:
● Income effect: This will result in an increase in after-tax returns, which will increase consumers' real income. Therefore, lenders will experience an increase
in consumption in the current period and a decrease in consumption in the future, but there will be an increase in savings.
● Substitution effect: Due to the high after-tax value, lenders will respond by increasing savings and decreasing borrowing. In terms of consumption, lenders
will experience an increase in current consumption but a decrease in future consumption.

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 Number 4

● If asymmetric information occurs in the credit market, it will lead to an increase in bad borrowers who are at
high risk of default. This is because there is an information imbalance where one or some parties have more
information than others.
● The presence of asymmetric information also explains why there are differences in loan interest rates and
savings interest rates. Thus, the statement from Ricardian Equivalence does not apply because of market
crashes or unclear markets.
● A market crash will also result in the budget constraint pivoting at the endowment point, causing the slope to
change. The slope changes inward, resulting in a decrease in current and future consumption.
● The presence of asymmetric information can explain the occurrence of financial crises because there is a
dramatic increase in the interest rate spread, which is the difference between the interest rates of risky
borrowers and non-risky borrowers. The greater the quantity of asymmetric information, especially during
financial crises, will increase loan interest rates, leading consumers to reduce borrowing and consumption,
ultimately resulting in an economic recession.

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 Nomor 5

Suppose there are two groups of consumers in a population, constrained and

unconstrained, with equal number of each. The constrained consumers look like the
ones in Figure 10.5, while the unconstrained consumers do not have sufficient
collaterizable wealth to support the amount of borrowing they would like to do. The
government decides that it will tax each constrained consumer by an equal amount
in the current period and distribute the tax revenue equally among the
unconstrained consumers as transfers.

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 Nomor 5 Part A
Take the market real interest rate as given and determine the effect of the redistribution by the
government on the total demand for consumption goods in the current period and in the future period.
(Only determine the net effects on the demand for consumption goods, given the real interest rate.)

Assuming the total of transfer (t, t’) is equal to

total tax collection (t, t’). Yet, the effect of tax
collection to consumption is negative and the
effect of transfer is positive.

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 Nomor 5 Part B
What do your results tell you about a fiscal policy aimed at redistributing income toward those who
will tend to spend more of it?

The fiscal policy, in this case, is very restrictive as it does not help constrained consumers
who are already affected by collateralized wealth. In a situation where the constrained consumers
and unconstrained consumers have similar behavior in spending, the declining aggregate demand
of the constrained consumers will cancel off the positive effect on aggregate demand from the
transfer policy. Thus, the tax fiscal policy does not increase the general economic welfare.

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 Nomor 5 Part C
Determine an efficient tax policy. This will be the tax policy that relaxes the limited commitment
constraint for consumers.

An efficient tax policy would be a tax cut for the constrained consumer at the same rate of
interest. The constrained consumer goes back to the initial consumption bundle with the amount of
the tax cut.

Note that the constrained consumers have already collateralized their wealth, and a tax will reduce their lifetime wealth
even more, thus reducing their overall lifetime wealth. The budget constraint moves further left. The total demand for
the constraint consumers will fall. This means that the current period consumption can be no greater than the current
disposable income plus the amount that resulted after the collateralized wealth plus the tax.

In the case of unconstrained consumers, there are no subjects of collateralized wealth and they are also given the
redistribution in the future period. Their lifetime wealth increases and the demand for consumption goods also
increases. This means that the future period consumption is greater than the disposable income with the redistribution
of the tax, meaning saving for the unconstrained consumer.

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 Nomor 6
Consider a pay-as-you-go social security system where social security is funded by a proportional tax
on the age of the young (less before the age of 40, more after 40). In other words, the tax collected by
the government is sc, where s is the tax rate and c is the consumption of the young. Retirement benefits
are provided as a fixed amount b to each old consumer. Can social security improve lifetime wealth for
everyone in this situation? Use diagrams in your answer.
Under this regime, the disposable income for the young is y, but the price for
current consumption is (1+s).
Thus, in equilibrium, the intertemporal budget constraint is:
sc(1 + n) = b
It can be written as :
sc = b/(1+n)
That is tax on young depends on population growth(n). The higher the
population growth rate is, the lower tax burden on each individual

Over time, when talking about the young, regardless of age, the tax will be the
same when taken in general.
This implies that the intertemporal budget constraint is:
y + y’ + b = c(1 + s) + c’ = c +c’ + sc(tax collected by govt to fund social security)

If n > r, then social security increases the welfare of old people. However, there
is also a substitution effect coming from the change in relative price between c
and c’. This substitution comes in no welfare to the young.

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 Nomor 6
Consider a pay-as-you-go social security system where social security is funded by a proportional tax
on the age of the young (less before the age of 40, more after 40). In other words, the tax collected by
the government is sc, where s is the tax rate and c is the consumption of the young. Retirement benefits
are provided as a fixed amount b to each old consumer. Can social security improve lifetime wealth for
everyone in this situation? Use diagrams in your answer.
Situation: the young population has to finance social security transfers (b) to the old population by paying taxes. The
total collected tax is equal to social security transfers for all receivers. It is assumed that the burden of tax is
distributed evenly to all younger people (<40 year-old), so individual tax burden will depend on the number of young
people. Also, the tax collection will be conducted before period T, while the social security will be distributed at
period T. Prior to period T, there will be no social security distributed.

Thus, the impact of social security on lifetime wealth will depend on the number of population (population growth),
tax, and benefit of the social security.

Thus, we have that total security benefits equal to taxes on young:

Nb = N’t

Where the total social security benefits are equal to collected tax on young. To get an equation of individual tax
burden, the social security benefit has to be divided/distributed to all populations.

And the relationship between tax, population growth, and benefits :

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 Nomor 6
The initial budget line is AB with the endowment point at
E1 and slope is -(1-r). However, because there is a tax to
fund social security, the younger generation ‘s disposable
income becomes y-t.

The impact of social benefit and tax on disposable

income can be broken down into two situations: when
the individuals are young and have to pay taxes and
when the individuals are old and receive the social
benefits.

The disposable income when individuals are young

Substituting with the t equation above, the disposable
income when they are young can be written as:
Finally, the final impact on disposable income will depend on the n di = y - t
(population growth) and r (interest rate). Social security makes t = b/(1+n)
everyone better off only if the population growth is greater than the y-t = y - (b/1+n)
real interest rate n>r. It is because it determines how large a tax
burden is for the young population. The smaller the tax burden for The disposable income when individuals are old
each young person, the higher is the ratio of social security benefits di = y’ + b
in old age to the tax paid to support social security when young.

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 Thank You

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