ECON 322 (Intermediate Macroeconomic Theory, Instructor: Sang Min Lee)

Problem Set #4

Due: April 18th (Thursday) by the start of the class

• Late submissions will not be accepted and will result in a score of zero.
• Only physical copies are accepted.

Name:

Section:
(Section 001: TTh 10:05 am, Section 002: TTh 6:00 pm, Section 003: TTh 1:15 pm)

Instructions
• This problem set is divided into two parts:
o Part A: Short Answers (30 points)
▪ Please limit your response for each question to a maximum of five sentences.
o Part B: Analytical Problems (70 points)
▪ Show your work to receive partial credits.
▪ Feel free to use additional paper if needed.
• Note: Illegible submissions may result in a score of zero.

Part A: Short Answer (15 questions, 2 points each)

1. What is the definition of (real) interest rates? How does it relate to the price of current consumption in
terms of future consumption?

The real interest rate represents the return on an investment adjusted for inflation. It indicates the cost of
borrowing or the reward for saving. When the real interest rate is high, the cost of borrowing is high
relative to inflation-adjusted returns, encouraging saving over spending. Conversely, when the real
interest rate is low, borrowing becomes cheaper relative to potential returns, stimulating spending over
saving. This dynamic influences the price of current consumption compared to future consumption by
affecting borrowing and lending decisions in the economy.

2. What does the convexity of indifference curves for the consumer’s utility on current and future
consumption imply?

The convexity of indifference curves for consumer utility on current and future consumption implies
diminishing marginal utility. As consumption of one good increases, the additional utility gained from
consuming more of that good decreases. This convexity also reflects the consumer's willingness to
trade off between current and future consumption at varying rates. Generally, consumers prefer a
balanced allocation between current and future consumption, with the shape of the indifference
curve indicating their preferences for different combinations of the two.

1/9
 3. When examining how an increase in interest rates affects consumers' optimal choices for current and
future consumption, the direction of income effects varies based on whether a consumer is a borrower
or a lender. What is the reason behind this difference?
The reason behind the differing income effects for borrowers and lenders when interest rates
increase lies in their respective positions in the lending and borrowing relationship. For borrowers,
an increase in interest rates leads to higher borrowing costs, reducing their disposable income and
decreasing their ability to consume both in the present and the future. Conversely, for lenders,
higher interest rates result in increased returns on savings or investments, leading to higher
disposable income and potentially increasing their ability to consume both now and in the future.
Thus, the direction of income effects depends on whether an individual is net borrowing or lending
in the economy.

4. In the classroom model, where borrowing and lending interest rates are identical, how does increased
government borrowing affect the consumer's optimal choices on current consumption, future
consumption, and savings? Does the interest rate change in this scenario? Explain why or why not.

Increased government borrowing in a classroom model, where borrowing and lending rates are the
same, affects consumer choices by crowding out private investment, raising interest rates. This
discourages borrowing for current and future consumption, prompting consumers to save more. The
interest rate changes due to increased demand for funds by the government, altering consumer
behavior towards consumption and savings.

5. In practice, why are the interest rates faced by lenders and borrowers different?

In practice, interest rates faced by lenders and borrowers differ due to several factors, including the
lender's need to cover costs and make a profit, the borrower's credit risk, and market conditions
such as supply and demand for credit. Lenders charge higher rates to compensate for the risk of
default by borrowers and to cover administrative costs and profit margins. Additionally, market
conditions influence rates, with high demand for credit pushing rates up and vice versa. Overall, the
discrepancy arises from the lender's need to manage risk and expenses while also meeting market
demand.

6. (Continued from 5) In this case, how can government tax policy make a consumer better off?

Government tax policy can make a consumer better off by influencing disposable income and
consumption decisions. For instance, tax policies that reduce income taxes or provide tax credits for
certain expenditures can increase disposable income, allowing consumers to spend more on
current consumption or save for the future. Similarly, targeted tax incentives for savings or
investment can encourage consumers to allocate more resources towards future consumption,
potentially enhancing their long-term financial well-being. By adjusting tax policies, governments
can affect consumers' purchasing power and incentivize behaviors that align with their economic
objectives, ultimately improving consumer welfare.
2/9
 7. What is a pay-as-you-go social security system, and why does population growth matter for this type of
system?

A pay-as-you-go social security system is one where current workers' contributions fund benefits for
current retirees. In this system, there's no individual savings component; instead, contributions from
current workers are used to pay benefits to current retirees. Population growth matters for this
system because it affects the ratio of workers to retirees. When population growth is high, there are
more workers contributing to the system relative to retirees, making it easier to fund benefits.
However, if population growth slows or declines, there are fewer workers relative to retirees, putting
strain on the system as there may not be enough contributions to cover benefits, potentially leading
to financial instability or necessitating changes in the system's structure.

8. How can a financial crisis happen? Explain it through the two mechanisms: (i) asymmetric information
and (ii) limited commitment.

A financial crisis can stem from asymmetric information and limited commitment. Asymmetric
information occurs when one party possesses more information than the other, leading to risky loans
and defaults. Limited commitment refers to parties' inability to commit to future actions, potentially
resulting in debt defaults. Both issues can trigger a financial crisis by eroding trust and sparking a
chain of defaults.

Questions 9 to 12 refer to the two-period model with the representative consumer, the representative firm,
and the government.
9. Name at least two factors that can shift the labor demand curve to the right. Explain how each factor
affects the curve.

Two factors that can shift the labor demand curve to the right are technological advancements and
an increase in the demand for goods and services produced by labor. Technological advancements
increase the productivity of labor, making it more valuable to firms, thus shifting the demand curve to
the right. Similarly, an increase in the demand for goods and services leads firms to hire more
workers to meet the higher production levels, also shifting the labor demand curve to the right.

10. Name at least three factors that can shift the labor supply curve to the right. Explain how each factor
affects the curve.

Three factors that can shift the labor supply curve to the right are an increase in population, an
increase in immigration, and government policies promoting workforce participation. An increase in
population or immigration expands the pool of available workers, increasing the overall labor supply.
Government policies such as subsidies for childcare or education can incentivize more individuals to
join the workforce, further increasing the labor supply.

3/9
 11. Name at least four factors that can shift the output demand curve to the right. Explain how each factor
affects the curve.

Four factors that can shift the output demand curve to the right include an increase in consumer
confidence, expansionary monetary policy, fiscal stimulus measures, and technological
advancements. Higher consumer confidence leads to increased spending on goods and services,
boosting demand. Expansionary monetary policy, such as lowering interest rates, encourages
borrowing and spending, stimulating demand. Fiscal stimulus measures, like increased government
spending or tax cuts, also boost demand. Additionally, technological advancements can create new
products or improve existing ones, increasing demand for output.

12. Name at least three factors that can shift the output supply curve to the right. Explain how each factor
affects the curve.
Three factors that can shift the output supply curve to the right are technological
advancements, an increase in the labor force, and improvements in productivity.
Technological advancements enhance production processes, allowing firms to produce more
output with the same inputs, shifting the supply curve to the right. An increase in the labor
force, either through population growth or immigration, provides firms with more workers,
increasing their capacity to produce output. Improvements in productivity, such as better
training or investment in capital equipment, also increase the efficiency of production,
leading to a rightward shift in the output supply curve.
For questions 13 to 14, read the article on the Great Recession (2008 Financial Crisis).
(https://www.federalreservehistory.org/essays/great-recession-and-its-aftermath)
13. What caused the Great Recession? Explain it with the economic terms we learned in class.
The Great Recession was primarily caused by a combination of factors, including the
burst of the housing bubble, financial market turmoil, and the subsequent collapse of
major financial institutions. This led to a severe contraction in economic activity,
widespread unemployment, and a decline in consumer spending. In economic terms,
we can describe this as a demand shock, where a sudden decrease in consumer and
investor confidence led to a sharp decline in aggregate demand. Additionally, the crisis
exposed systemic risks within the financial system, such as excessive leverage and
reliance on complex financial instruments, which exacerbated the downturn.

14. Why and how did the Federal Reserve decrease the interest rate? Explain it with the economic terms
we learned in class.

To combat the economic downturn during the Great Recession, the Federal Reserve
employed expansionary monetary policy measures, including reducing the federal
funds rate—the interest rate at which banks lend to each other overnight. By lowering
interest rates, the Fed aimed to stimulate borrowing and spending, thereby increasing
aggregate demand and promoting economic growth. This policy action is consistent
with the Keynesian economic theory, which suggests that during periods of economic
downturns, monetary authorities should lower interest rates to encourage investment
and consumption, thereby stimulating economic activity and reducing unemployment.

4/9
For question 15, read the article on artificial intelligence (AI) and macroeconomics.
(https://www.imf.org/en/Publications/fandd/issues/2023/12/Macroeconomics-of-artificial-intelligence-
Brynjolfsson-Unger)
15. This article discusses the significant potential impact of AI, such as ChatGPT, on the economy. Based on
the key points highlighted in the article, explain how AI might personally affect you.

AI, such as ChatGPT, could impact me personally in a few ways. It might

make tasks easier and more efficient, offer personalized experiences, and
potentially change job opportunities in the future. However, there could also
be concerns about privacy and security with the increased use of AI. Overall,
it's an area that's likely to have both positive and negative effects on
individuals like me.

5/9