Macroeconomics - Problem Set
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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 decrease on macroeconomic variables such as
This problem studies the effects of a permanent (lump sum) tax decrease on macroeconomic variables such as employemployment, output, consumption, investment, interest rates, and real wages. This problem is particularly ment, output, consumption, investment, interest rates and real wages. good preparation for the midterm!
1) First, we study the effect of such a tax decrease on the consumption-leisure choice in isolation; therefore, use the consumption-leisure diagram to illustrate the effects of a lump-sum tax decrease on the optimal consumption and leisure choice. Make sure you illustrate income and substituion effects. (10)
We analyze the effect of a lump-sum tax cut from T1 to T2 on the consumption-leisure choice in isolation. Figure 3 shows that a permanent tax cut increases a consumers lifetime wealth, shifting the consumers budget set up by the amount of the tax decrease (i.e. by T1 − T2 ). Since the (lump-sum) tax cut does not change the real wage directly, the slope of the new budget constraint is fixed. As a result, there is no substitution effect. The tax cut, however, yields a pure income effect. Both current consumption and leisure increase as they are considered normal
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 decrease on macroeconomic variables such as
This problem studies the effects of a permanent (lump sum) tax decrease on macroeconomic variables such as employemployment, output, consumption, investment, interest rates, and real wages. This problem is particularly ment, output, consumption, investment, interest rates and real wages. good preparation for the midterm!
1) First, we study the effect of such a tax decrease on the consumption-leisure choice in isolation; therefore, use the consumption-leisure diagram to illustrate the effects of a lump-sum tax decrease on the optimal consumption and leisure choice. Make sure you illustrate income and substituion effects. (10)
We analyze the effect of a lump-sum tax cut from T1 to T2 on the consumption-leisure choice in isolation. Figure 3 shows that a permanent tax cut increases a consumers lifetime wealth, shifting the consumers budget set up by the amount of the tax decrease (i.e. by T1 − T2 ). Since the (lump-sum) tax cut does not change the real wage directly, the slope of the new budget constraint is fixed. As a result, there is no substitution effect. The tax cut, however, yields a pure income effect. Both current consumption and leisure increase as they are considered normal