Professor Mark Gertler

Intermediate Macroeconomic Theory

Midterm 1

Answer each of the following Each is worth 33 1/3 points.

Problem 1
If the economy slips into recession, the government will likely have to use tax policy to stimulate the
economy. How does a reduction in the corporate income tax a¤ect …rm investment and output? Consider
the investment problem of a …rm that operates for two periods. Output Y in period k = 1; 2 is given by,

Yk = Ak Kk

with 0 < < 1 and where capital K1 is given, but K2 depends on investment I, as follows

K2 = (1 )K1 + I

The capital market is perfect and the …rm faces the interest rate R, which it takes as given. The …rm
chooses I to maximize the present discounted returns to shareholders. Assume the …rm …nances investment
with retained earnings. In this case discounted payouts to shareholders are given by,
2
c I (1 )Y2 +(1 )K2
(1 )Y1 I 2 K1 K1 + R

2
c I
where the term 2 K1 K1 re‡ects adjustment costs, and is the corporate tax rate.

1. Derive the …rst order condition for investment I and rearrange to obtain an expression for the …rm’s
optimal choice of investment in terms of Tobin’s Q.

2. How does a reduction in the corporate tax rate a¤ect investment and period 2 output? Explain how
the e¤ect is summarized in the behavior of Q.

1
 Problem 2.
There is increasing pessimism about the return to capital. What will be the impact on investment,
consumption and the U.S. current account de…cit? Consider the issue in the following two period small
open economy model. Let Y output, K capital,A productivity,C consumption, I investment,
R gross real interest rate, N X net exports and F A foreign asset holdings. The details of the model
are then as follows:
Technology and resources constraints are given by

Yk = Ak (Kk ) ; k = 1; 2
C1 = Y1 I NX
FA = NX
C2 = (1 )K2 + Y2 + RF A
K2 = I + (1 )K1

The household’s optimal choice of consumption versus saving satis…es

C1 = R C2

The …rm’s optimal choice of investment (with no adjustment costs), satis…es

1
A2 K2 + (1 )=R

Finally, the interest rate equals the world interest rate R:w

R = Rw

1. Provide brief intuition for the household’s optimal consumption/saving choice and the …rms’s invest-
ment demand decision.

2. Construct a diagram for the capital market, where you portray household saving supply, …rm investment
demand and the current account de…cit (equal to minus net exports). Be clear where the saving supply
and investment demand curves come from. You may assume that the world interest rate is below the
rate that would arise if the economy was closed (i.e. did not participate in the world capital market.)

3. Construct a diagram for the period 1 production possibility frontier. Be clear where it comes from.

4. Now suppose there is an expected decline the return to capital, re‡ected by an expected rise in A2 :
What is the impact on I; C1 and the current de…cit ( N X). You may answer using diagrams.

2
 Problem 3
After World War II, for a period both Japan and Germany grew much faster than the U.S., before
eventually slowing down to a growth rate in the region of the U.S. growth rate. One hypothesis is that
the high post-war growth was the result of much of the physical capital in these economies being destroyed
during the war. Analyze this issue in the context of the following simple competitive equilibrium growth
model.
Suppose there is a representative household whose optimal consumption/saving decision is given by

1 1
Ct = Rt+1 Ct+1

1
where Ct is consumption, Ct is the marginal utility of consumption, Rt+1 is the gross return to capital
(the return to saving) and (0; 1) is the households’subjective discount factor. The household supplies
labor Nt exogenously.
Output Yt is the following function of capital Kt , productivity At and labor:

Yt = Kt (At Nt )1

with 0 < < 1. The resource constraint and law of motion for capital are given by

Yt = Ct + It
Kt+1 = (1 )Kt + It

In the competitive equilibrium, the gross interest rate equals the gross marginal return to capital
1
Kt+1
At+1 Nt+1 +1 = Rt+1

Labor and productivity grow exogenously at the rates n and a respectively, implying:
At+1 Nt+1
At Nt =1+a+n

1. Consider the economy’s balanced growth path equilibrium where the quantity variables C; Y; I and
K all grow at the same rate as labor in e¢ ciency units, AN , and where R is constant. First derive
K Y Y I C
the three equations that determine R; AN ; and AN : Then given AN , show how AN and AN are
determined.

2. Now suppose that a large fraction of the economy’s capital stock is suddenly destroyed (e.g. due to a
Kt K
war), so that falls well below its balanced growth path value .
At Nt AN
(a) What will be true about the interest rate relative to the balanced growth path?

(b) Explain how this economy will converge back to the balanced growth path equilibrium

(c) Explain why along the way it will grow faster than in the balance growth path.