Programmation Dynamic 1

Econ 714: Macroeconomic Theory II 1
Discussion Section 2
1 Labor Search-Matching Model: Minimum Wage

Consider the standard labor search-matching model discussed in class.
• The economy is populated by infinitely lived firms and workers who discount the future at rate r. Firms
post vacancies at a flow cost c. The unemployment income of workers is z.
• The aggregate matching function is homogeneous of degree one. Hence, job seekers meet firms at rate
θq(θ), where θ = v/u is market tightness.
• Each firm employs only one worker. Once a firm and worker are matched, they start to produce. All jobs
have the same productivity p. Finally, jobs are destroyed at Poisson rate λ.
(a) Derive the job creation curve using the asset equations for vacancies, filled jobs, and the free entry condition.
Derive the wage curve using the solution of the Nash bargaining problem.
(b) The government imposes a minimum wage wm on firms. Obviously, if wm is too low it has no effect (w),
and if it is too high firms do not open vacancies (w). Characterize these two bounds [w, w] and plot the interval
in (θ, w) space using the job creation and wage curves. What is the impact of the minimum wage on θ and u?
(c) What is the impact of wm on the aggregate flow of workers who leave the unemployment pool?
(d) Consider the case where the cost of posting a vacancy is proportional to p, so that c = Φp. Also assume that
the flow income of workers when unemployed is proportional to w, so that z = Ψw. What is the new expression
for the equilibrium wage?
(e) What is the impact of a change in p on wages, market tightness, and unemployment?
(f) Assume that there is technological progress so that p(t) is an increasing function of time. What happens as t
goes to infinity if the minimum wage grows at a rate slower than p(t)? What happens as t goes to infinity if the
minimum wage grows at a rate faster than p(t)? Conclude.
1 Week 2, 2/3/2012, UW-Madison; TA Scott Swisher.
1
2 Labor Search-Matching Model: Short Answer
Consider the standard labor search-matching model discussed in class.
2.1 Bargaining power

“Eliminating unemployment is a simple matter of reducing workers’ bargaining power.” Discuss this claim using
the labor search-matching model, then analyze the outcome of the model when firms have no bargaining power.
Contrast the two cases.
2.2 Rejecting job offers

Unemployed workers sometimes turn down job offers. Ignoring the firm side, use the labor search-matching model
to address the following claim: “By setting unemployment insurance income to zero, the government can ensure
that workers will accept all job offers.” Given your answer, discuss the effects of a government labor market
policy that would force unemployed workers to accept any job offer over a certain level after 100 days of drawing
unemployment insurance.
2.3 Beveridge curve

Using the labor search-matching model, what type of exogenous shocks would generate a shift in the Beveridge
curve to the right? Discuss the impact of these shocks on the equilibrium wage, labor market tightness, and
unemployment.
2
3 Dynamic Programming: Cake Eating Problem
Consider a cake of initial size w0 = w0 , so wt is the size of the cake at date t. Each period t = 0, 1, . . . , T you
can choose to eat some of the cake and save the remainder for tomorrow. Let ct denote consumption of the cake
in period t, so the amount that remains for next period is given by wt+1 = wt − ct , the law of motion for wt . You
only enjoy your slice of cake in the period that you eat it, and eating cake is your only source of utility, so utility
in period t is u(ct ). As usual, assume that u(.) does not vary across time, is real-valued, differentiable, strictly
increasing, and strictly concave. Also assume Inada conditions
lim u0 (c) = ∞ , lim u0 (c) = 0

c→0 c→∞
which are standard. Your discounted lifetime utility is given by

T
X
β t u(ct )
t=0
with discount factor β ∈ (0, 1).
Consider the finite horizon version of the problem with T < ∞.
(a) Iterate the law of motion for wt forward to consolidate the sequence of two-period constraints into one lifetime
constraint. Interpret.
(b) Write down the sequence problem (SP) for this constrained optimization problem. Your statement of the
SP should contain the objective, constraint, nonnegativity constraints, the initial condition, and the terminal
condition. The solution to the SP is a sequence {ct }Tt=0 .
(c) Solve the SP by setting up the Lagrangian and taking first-order conditions. Derive the consumption Euler
equation.
(d) Using your solution to the SP, describe how you would use the consumption Euler equation, in combination
with the initial and terminal conditions, to solve for the entire sequence of ct ’s and wt ’s.
(e) Now take a dynamic programming approach and set up the functional problem (FP). Your statement of the
FP should contain a list of the state variables, a list of the control variables, the constraint set for the control
variables given the state variables, the Bellman equations, and the laws of motion for the state variables. The
solution to the FP is a function c(w) or w0 (w).
Now consider the infinite horizon version of the problem with T = ∞.
(f) Repeat part (e) for the infinite horizon case (this should actually make the problem easier to state).
(g) From the infinite horizon Bellman equation, take first-order conditions (one for each control variable) and
envelope conditions (one for each state variable). Derive the consumption Euler equation.
(h) Given today’s state variables, the policy function returns the optimal choices for the control variables (mapping
states into controls). Define the policy function for the infinite horizon problem. Write out the policy function.
(i) Assume that u(c) = ln(c). Under this functional form assumption, rewrite the consumption Euler equation
and the policy function. With log utility, there is no wealth effect in the policy function. Using this information,
guess and verify that the value function is of the form
V (w) = A + B ln(w)
and solve for unknown coefficients A and B.
(j) Repeat parts (f) - (i) with the cake depreciating at rate δ each period.

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Econ 714: Macroeconomic Theory II 1

1 Labor Search-Matching Model: Minimum Wage

1 Week 2, 2/3/2012, UW-Madison; TA Scott Swisher.

2.1 Bargaining power

2.2 Rejecting job offers

2.3 Beveridge curve

lim u0 (c) = ∞ , lim u0 (c) = 0

which are standard. Your discounted lifetime utility is given by

with discount factor β ∈ (0, 1).

Consider the finite horizon version of the problem with T < ∞.

Now consider the infinite horizon version of the problem with T = ∞.

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