325_PS1_Soln - Department of Economics University of...

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Department of Economics University of Maryland Economics 325 Intermediate Macroeconomic Analysis Problem Set 1 Suggested Solutions Professor Sanjay Chugh Spring 2011 Instructions : Written (typed is strongly preferred, but not required) solutions must be submitted no later than 11:00am on the date listed above. You must submit your own independently-written solutions. You are permitted (in fact, encouraged) to work in groups to think through issues and ideas, but you must submit your own independently-written solutions. Under no circumstances will multiple verbatim identical solutions be considered acceptable. Your solutions, which likely require some combination of mathematical derivations, economic reasoning, graphical analysis, and pure logic, should be clearly, logically, and thoroughly presented; they should not leave the reader (i.e., your TAs and I) guessing about what you actually meant. Your method of argument(s) and approach to problems is as important as, if not more important than, your “final answer.” Throughout, your analysis should be based on the frameworks, concepts, and methods developed in class. There are a total of three problems, each with multiple subparts.
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2 Problem 1: Consumption, Labor, and Unemployment: Fiscal Policy Choices in a Search Framework (50 points). The 2010 Nobel Prize in Economics was awarded to Peter Diamond, Dale Mortensen, and Christopher Pissarides for their development (during the 1970s and 1980s) of search theory. Search theory is a framework especially suited for studying labor market issues. The search framework builds on, but is richer than, the basic theory of supply and demand. Search theory can be applied to both the supply side of the labor market (building on the analysis of Chapter 2) as well as the demand side of the labor market (building on the analysis of Chapter 6, which we will study later in the course). In what follows, you will study the application of search theory to the supply side of the labor market. There are three basic ideas underlying search theory. First, search theory incorporates into basic supply-and-demand analysis the fact that when an individual wants to work (i.e., “supplies labor”), there is a chance that employment may not be found. That is, an individual “searching” for a job has a probability less than one that a suitable “match” will be found. Second, as a direct consequence of the probabilistic nature of successfully finding a job, there is a probability larger than zero that an individual might end up “unemployed” – that is, having searched for work but not found anything. In this case, he/she receives “unemployment benefits” from the government. Third, search theory makes explicit the costs associated with search activity. As is realistic, when an individual wants a job, he/she does not simply “go to the market” as in basic supply-and-demand analysis. Rather, the individual must expend resources searching for a job (think of these costs as due to the time spent looking at recruiting
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325_PS1_Soln - Department of Economics University of...

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