Macroeconomics - Problem Set

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(5) An explanation that may explain the lower labor supply in Europe besides taxes is one that Europeans may place a higher weight on leisure relative to working in their preferences than their American counterparts. This would mean that the indifference curves lean more towards the leisure axis than they lean towards the consumption axis, as is the case in Figure 3. Thus, when the price of leisure falls (i.e. leisure becomes more affordable), Europeans are more willing to substitute out of consumption (and labor supply) and into leisure. Problem Set 2: Suggested Solutions 2 Taxes in the Real Intertemporal Model (40 Raw Points) Taxes in the Real Intertemporal Model This problem studies the effects of a permanent (lump sum) tax…show more content…
The effects of this change can be seen in the graph of the labor market in Figure 4(a). A decrease in lump-sum taxes increases the wealth of households and decreases the need to work. Thus, for a given real wage, the labor supply curve shifts in. In order to restore equilibrium in the labor market, the real wage increases from w1 to w2 and the equilibrium level of labor falls from N1 to N2 . Hence, a permanent tax cut yields lower employment in the labor market. As a consequence, the firm produces less output at fixed level of ¯ capital stock (K) and total factor productivity (z) . This effect is a movement along the production function in the downward direction, as seen in Figure 4(b). Tracing the change over to the aggregate output market shown in Figure 4(c), the aggregate supply curve shifts to the left for every r from Y1s to Y2s . The labor market and the aggregate output market are linked via the firms production function. Figure 4: The Real Intertemporal Model (a) The Labor Market (b) The Production Function 4 2 (c) The Aggregate Goods Market 3) Next, we study the effect of such a tax decrease on the intertemporal consumption choice in isolation; therefore, use the “consumption today – consumption tomorrow” diagram to illustrate the effects of a lump-sum tax decrease on the optimal consumption path, c and c . Make sure you illustrate income and substitution effects. To make your life simple, assume
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