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# III: Labor Supply in Two Periods

## Dynamic Macroeconomic Analysis

Universidad Auto
onoma de Madrid

Fall 2012

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 1 / 37
1 Outline

## 2 The representative agent in two periods

Budget constraint
Preferencias
The Individual Problem

## 3 The Complete Solution

Optimal Consumption Decisions (for given x)
Optimal Labor Supply
Elasticity of Intertemporal Substititution of Labor
Complete solution
Consumption levels
Optimal labor supply

4 Concluding remarks
Hechos Estilizados (EE.UU.)
Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 2 / 37
Summary

## In the first theme we analyzed labor-leisure decisions in a static

framework
Next, we analyzed consumption and savings decisions in a two-period
setting with inelastic labor supply
The logical next step is to endogenize the labor-leisure decisions in
this two-period setting with endogenous saving.
For the moment we will take the salaries, denoted by wt , as given.
Agents will sacrifice leisure in periods with relatively high wages and
they use the credit market to smooth consumption.
The endogenous determination of salaries is explained in Theme 4.

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 2 / 37
Budget constraints

## Denoting the salaries in period 1 and 2 by w1 and w2 , respectively, we can

write the one-period budget constraints as:

c1 + b1 = w1 l1 ,
c2 = w2 l2 + (1 + R )b1 .

The only difference w.r.t. the previous lecture is that income is now
endogenous as yt = wt lt . The corresponding life-time budget constraint is
given by:
c2 w2 l2
c1 + = w1 l1 +
1+R 1+R

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 3 / 37
Preferences

## To complete the description we need to specify the agents

preferences over consumption and leisure in the two periods.
Like before we assume time-separable preferences. In addition we
assume that preferences are additive in consumption and leisure.
Formally,

## where ct denotes consumption and 1 lt leisure.

Note that future consumption and leisure are discounted at the
common rate .
Finally, utility is strictly concave in consumption and leisure.

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 4 / 37
The optimization problem

## max u (c1 ) + v (1 l1 ) + [u (c2 ) + v (1 l2 )]

c1 ,c2 ,l1 ,l2
1 1
s.t. c1 + c2 = w1 l1 + w2 l2
1+R 1+R
The Lagrangian associated to the above maximization problem is:

## L = max {u (c1 ) + v (1 l1 ) + [u (c2 ) + v (1 l2 )]

c1 ,c2 ,l1 ,l2
1 1
+ [w1 l1 + w2 l2 c1 c2 ]}, (1)
1+R 1+R
where is the multiplier.

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 5 / 37
FOCs

## There are four FOCs:

c1 : u 0 (c1 ) = 0,

1
c2 : u 0 (c2 ) = 0,
1+R

l1 : v 0 (1 l1 ) + w1 = 0,

w2
l2 : v 0 (1 l2 ) + = 0.
1+R

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 6 / 37
Intertemporal consumption decisions

Combining the first ( = u 0 (c1 )) and second FOC yields the standard
Consumption Euler eqn.:

u 0 (c1 ) = u 0 (c2 ) (1 + R ),
| {z } | {z }
MC MB

## Once again, therefore, the agent will choose a constant consumption

stream when (1 + R ) = 1.

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 7 / 37
Labor supply
With the use of the first FOC we can rewrite the FOC associated with
l1 in the following manner:

L
= v 0 (1 l1 ) + w1 = 0
l1
v 0 (1 l1 ) = u 0 (c1 ) w1
| {z } | {z }
MC MC

The above condition equalizes the marginal cost in utility terms from
the loss of leisure to the marginal gain from additional consumption.
Similarly, since = u 0 (c1 ) and u 0 (c1 ) = (1 + R )u 0 (c2 ):

L w2
= v 0 (1 l2 ) + =0
l2 1+R
( )v 0 (1 l2 ) = ( )u 0 (c2 )w2
| {z } | {z }
MC MB

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 8 / 37
Intertemporal Labor Supply

To obtain the equilibrium levels of labor supply we solve the FOCs for l1
and l2 in terms of :
L
= v 0 (1 l1 ) + w1 = 0 =
l1
v 0 (1 l1 )
=
w1
L w2
= v 0 (1 l2 ) + = 0 =
l2 1+R
v 0 (1 l2 ) (1 + R )
= .
w2

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 9 / 37
Intertemporal labor supply

## Equalizing the right-hand sides of both conditions yields

v 0 (1 l1 ) v 0 (1 l2 ) (1 + R )
= ..
w1 w2
This condition can be rewritten as
v 0 (1 l1 ) w1
= (1 + R ) .
v 0 (1 l2 ) w2

The above condition implicitly defines the ratio of labor supply (l1 /l2 )
as an increasing function of the wage ratio (w1 /w2 ).

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 10 / 37
Logarithmic utility

## max {ln c1 + ln(1 l1 ) + (ln c2 + ln(1 l2 ))

c1 ,c2 ,l1 ,l2
1 1
+ [wl1 + wl2 c1 c2 ]}.
1+R 1+R
The associated FOCs are:
1
c1 : = 0, (2)
c1

1 1
c2 : = 0, (3)
c2 1+R
1
l1 : + w1 = 0, (4)
1 l1
1 w2
l2 : + = 0. (5)
1 l2 1+R
Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 11 / 37
The Optimal Consumption Decisions (given x)

## Combining the first two FOCs (corresponding to c1 and c2 ) we obtain

the Consumption Euler eqn. in levels that we have seen before:

c1 = c2 (1 + R ),
Similarly, like before agents save a fixed proportion 1/(1 + ) of their
lifetime resources x = w1 l1 + 1w+2 lR2

x
c1 =
1+

c2 = x (1 + R )
1+

## Hence, if we were to take x as given, the consumption decisions

would be the same as before. But x is NOT exogenous.

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 12 / 37
Optimal labor supply

Relative labor supply is again a function of the wage ratio w1 /w2 , but this
time we obtain a condition in levels.
In a first step we solve the FOCs for l1 and l2 in terms of :

L 1
= + w1 = 0
l1 1 l1
1
=
w1 (1 l1 )
L 1 w2
= + =0
l2 1 l2 1+R
(1 + R )
= .
w2 (1 l2 )

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 13 / 37
Optimal labor supply

## Equalizing the right hand sides of both conditions we obtain the

following expression

1 (1 + R )
= ,
w1 (1 l1 ) w2 (1 l2 )

## which can be rewritten as:

1 l1 1 w2
= .
1 l2 (1 + R ) w1
This arbitrage condition is key for the determination of labor supply in
both periods.

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 14 / 37
Optimal Labor Supply

## First of all, note that  

1l1
1l2
  > 0.
w2
w1

w2 1l1
Hence, an increase in the relative wage w1 leads to a rise in 1l2 or
equivalently a fall in ll12 .
The agent decides to consume less leisure in the second period to
benefit from the rise in the relative wage. Below we will see that the
agent will use the credit market to consume part of the rise in w2 l2 in
the first period.
Formally, the real wage wt is a measure of the opportunity cost of
leisure in period t. Following an increase in w2 /w1 leisure in the
second (first) period is therefore relatively more expensive (cheaper).

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 15 / 37
Optimal Labor Supply

## It is also important to note that

 
11 l1
l2
< 0.
(1 + R )

After an increase in the real interest rate the agents demand relatively
more leisure in the second period of life.
First explanation: the higher interest rate reduces the cost of future
consumption and raises the return to saving. This is an incentive to
work more and save more in the first period of life.
Second explanation: The rise in R is equivalent to a fall in the present
value of future wages, 1w+2R . This reduces the opportunity cost of
leisure in the second period.

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 16 / 37
Elasticity of Intertemporal Substitution of Labor

## This elasticity measures the percentage change in the ratio of leisure

1l1 w2
1l2 per percent change in the wage ratio w1 .
h i
1l1
1l2 h i  

1l1
 1l1 w2
1l2
1l2 w1
h i
w
= h i  ,
w2 w2 1l1
 1 w1 1l2
w2
w1

## When this elasticity is high, agents are willing to substitute a

relatively large amount of current leisure for future leisure in response
to a rise in the wage ratio w2 /w1 .

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 17 / 37
Example: log utility
Previously, we have seen that
1 l1 1 w2
= .
1 l2 (1 + R ) w1

Hence, h i
1 l1
1 l2 1
h i = ,
w2 (1 + R )
w1

and so,
h i    
1l1 w2 w2
1l2 w1 1 w1
h i   = 1 w2 = 1.
w2 1l1 (1 + R ) ( 1 + R ) w1
w1 1l2

In 
other words, the elasticity is equal to 1 and so a x percent increase
in w 2
w1 leads to a x % rise in 11 l1
l2 .

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 18 / 37
Optimal consumption levels

## Combining the FOCs for l1 and c1

1
+ w1 = 0.
1 l1
1
= ,
c1
we obtain the following equality
1 1
= w1 .
1 l1 c1
Hence,
c1 = w1 w1 l1 = w1 l1 = w1 c1 .

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 19 / 37
Optimal Consumption Levels
Similarly, combining the FOC for l2
1 w2
+ = 0.
1 l2 1+R
1
and the condition that = c1 , we obtain:

1 1 w2
= .
1 l2 c1 1 + R
Hence,
c1 (1 + R ) = w2 w2 l2 ,
and so:
w2 l2 w2
w2 l2 = w2 c1 (1 + R ) = = c1 .
1+R 1+R

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 20 / 37
Optimal consumption levels
Since

w1 l1 = w1 c1
w2 l2 w2
= c1 .
1+R 1+R
we get
w2 l2
x = w1 l1 +
1+R
w2
= w1 c1 + c1 .
1+R
x
Using the fact that c1 = 1+ , we can therefore write:

w2
(1 + )c1 = w1 c1 + c1 ,
1+R

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 21 / 37
Solutions for c1 and c2

## The final solutions:

 
1 w2
= c1 w1 + .
2(1 + ) (1 + R )
 
1 w2
c2 = c1 (1 + R ) = (1 + R ) w1 +
2(1 + ) (1 + R )

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 22 / 37
Solution for l1

To obtain the value for l1 , we substitute the expression for c1 into the
condition w1 l1 = w1 c1 ,

w1 l1 = w1 c1
 
1 w2
= w1 w1 +
2(1 + ) (1 + R )
 
1 1 w2
w1 l1 = w1 1
2(1 + ) 2(1 + ) (1 + R )
Hence,
1 + 2 1 1 w2
l1 = .
2 ( 1 + ) 2 ( 1 + ) 1 + R w1

## Comparative statics: l1 /w1 > 0 ; l1 /w2 < 0 ; l1 /R > 0

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 23 / 37
Solution for l2

## Similarly, since wl2 = w c1 (1 + R ),

w2 l2 = w2 c1 (1 + R )
 
(1 + R ) w2
= w2 w1 +
2(1 + ) (1 + R )
(1 + R ) 1 (1 + R )
= w2 [ 1 ] w1 .
2(1 + ) 1 + R 2(1 + )

So,
2+ (1 + R ) w1
l2 = .
2(1 + ) 2(1 + ) w2

## Comparative statics: l2 /w1 < 0 ; l2 /w2 > 0 ; l2 /R < 0

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 24 / 37
A special case
Suppose for the moment that = 1 and R = 0.
The constant consumption level satisfies:
 
1 w2 1
c1 = w1 + = [w1 + w2 ] = c2 ,
2(1 + ) (1 + R ) 4

## while the solutions for l1 and l2 reduce to:

1 + 2 1 1 w2
l1 =
2(1 + ) 2(1 + ) 1 + R w1
3 1 w2
=
4 4 w1
2+ ( 1 + R ) w1
l2 =
2(1 + ) 2 ( 1 + ) w2
3 1 w1
= .
4 4 w2

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 25 / 37
A special case
Given the optimal choices for lt , total labor income satisfies

x = w1 l1 + w2 l2
   
3 1 w2 3 1 w1
= w1 + w2
4 4 w1 4 4 w2
3 1 3 1
= w1 w2 + w2 w1
4 4 4 4
1
= (w1 + w2 )
2
and the agent consumes half of x in each period.
Finally, if w2 = w1 , then
1
l1 = l2 = .
2
Hence, the agent works half time in both periods and consumes his or
her entire labor income, so b1 = 0.
Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 26 / 37
Concluding remarks

## In this section we have analyzed labor supply and consumption

decisions in a two-period setting with exogenous prices.
For given labor supply choices, the consumption decisions are the
same as before, but labor supply is endogenous and we need to solve
the jointly optimal consumption and labor supply decisions
The optimizing agents will concentrate their labor supply in periods
with a relatively high wage rate and they will use the credit market to
smooth consumption over time.
The elasticity of intertemporal substitution of labor measures the
responsiveness of labor-leisure choices to changes in the relative
wages w2 /w1 .
Suppose, realistically, that wages are high in booms and low in
recessions. This would lead to pro-cyclical fluctuations in labor supply.

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 27 / 37
Horas Trabajadas (USA 2000)

50 40
W eek ly hours w ork ed
20 3010

20 30 40 50 60
Age

Men Women

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 28 / 37
Salario Medio por Hora (USA 2000)

25 20
H ourly W age
15 10
5

20 30 40 50 60
Age

Men Women

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 29 / 37
Horas Trabajadas y Salario Medio por Hora (USA 2000)

Male Female

50
25

40
20
H ourly W age

30
15

20
10

10
5

20 30 40 50 60 20 30 40 50 60
Age
Hourly wage Weeklyhours worked
Graphs by Sex

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 30 / 37
Horas Trabajadas y Salario Medio por Hora (Mujeres-USA
2000)

## Never married Ever married

25

40
35
20
H ourly W age

30
15

25
10

20
15
5

20 30 40 50 60 20 30 40 50 60
Age
Hourly wage Weeklyhours worked
Graphs by evermar

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 31 / 37
Salario horario por Nivel de Educacion (USA 2000)

35 30
(m e a n ) h o u rw a g e
15 20 10 25

20 30 40 50 60
Age

Less HS HS
Some college College +

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 32 / 37
Horas Trabajadas por Nivel de Educacion (USA 2000)

45
40
(m e a n ) u h rs w o rk
25 30 20 35

20 30 40 50 60
Age

Less HS HS
Some college College +

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 33 / 37
Salario y Horas Trabajadas por Nivel de Educacion (USA
2000)

Less HS HS
40

20 25 30 35 40 45
30
20
M e a n h o u ly wa g e
10

## Some College College +

40

20 25 30 35 40 45
30
20
10

20 30 40 50 60 20 30 40 50 60
Age
Hourly Wage Weekly Hours of work
Graphs by educ

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 34 / 37
Horas Trabajadas y Salario Medio (Historico Anual)

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 35 / 37
Tendencias en Horas Trabajadas
Cambio Porcentual 1970-2002

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 36 / 37
Participacion Femenina y Trabajo Domestico

Dynamic Macroeconomic Analysis (UAM) III: Labor Supply in Two Periods Fall 2012 37 / 37