Topics in Macroeconomics 2

Econ 2004
Practice Questions for Master Class 3 on Friday, March 6, 2009

MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers
the question.
1) D
2) C
3) C
4) D
5) D
6) C
7) C
8) B
9) A
10) D
11) C
12) C
13) C
14) A
15) B
16) B
17) C
18) B
19) C
20) B
21) B
22) D
23) A
24) C
25) B
26) A
27) D
28) A
29) A
30) C
31) C
32) A
33) B
34) A
35)C
SHORT Problems
36) Consider a static macroeconomic model discussed in class which has the following
features.
The representative consumer: chooses consumption C and leisure l; takes as given
taxes T, dividends , the wage rate w, and her endowment of time h.
The representative firm: chooses the demand for labour Nd to maximise profits; uses
a standard production function zF(K,Nd) where z denotes TFP and K is the given
stock of capital; takes as given the wage rate w.
The government: consumes G and collects lump-sum taxes T; runs a balanced
budget.
The wage rate adjusts to clear all the markets in the economy.
(a) Graphically represent the equilibrium in terms of indifference curves and the PPF
as well as in terms of the demand and supply of labour. Explain.

Draw the PPF tangent to indifference curve. Draw the slope at point of tangency and
indicate that it is w.

(b) Suppose there is a reduction in the price of oil that increases Total Factor
Productivity, z. Determine the effects on aggregate output, consumption,
employment, and the real wage, with reference to income and substitution effects.
How does this compare to business cycle comovements as observed in the data?

Output, consumption and real wage increase. The effect on hours

worked/employment is ambiguous. It inacreases if in the short-run the substitution
effect dominates the income effect. In this case, all variables display the same
comovements as observed in the data.

(c) How does this compare to facts about long-run growth as observed in the data?

Output, consumption and real wage increase. The effect on hours

worked/employment is ambiguous. It remains stable if in the long-run the
substitution effect and the income effect cancel out. In this case, all variables display
the same movements as observed in the long run data.
37) Suppose that the government decides to reduce taxes. In the model used in Question
36, i.e. Chapter 5, determine the effects this has on aggregate output, consumption,
employment, and the real wage, and explain your results.

In a one-period model, taxes must be exactly equal to government spending. A

reduction in taxes is, therefore, equivalent to a reduction in government spending.
The result is exactly opposite of the case of an increase in government spending that
is presented in the text. A reduction in government spending induces a pure income
effect that induces the consumer to consume more and work less. At lower
employment, the equilibrium real wage is higher because the marginal product of
labour rises when employment falls. Output falls, consumption rises, employment
falls and the real wage rises.

38) Suppose that there is a natural disaster that destroys part of the nation's capital stock.
Determine the effects on aggregate output, consumption, employment, and the real
wage, with reference to income and substitution effects, and explain your results.

The only effect of this disturbance is to lower the capital stock. Therefore, the
production possibility frontier shifts down and the marginal product of labour falls
(the PPF is flatter). The reduction in the capital stock is depicted in Figure 5.1. The
economy starts at point A on PPF1. The reduction in the capital stock shifts the
production possibilities frontier to PPF2. Because PPF2 is flatter, there is a substitution
effect that moves the consumer to point D. The consumer consumes less of the
consumption good and consumes more leisure. Less leisure also means that the
consumer works more. Because the production possibilities frontier shifts down,
there is also an income effect. The income effect implies less consumption and less
leisure (more work). On net, consumption must fall, but leisure could decrease,
remain the same, or increase, depending on the relative strengths of the income and
substitution effect. The real wage must also fall. To see this, we must remember that,
in equilibrium, the real wage must equal the marginal rate of substitution. The
substitution effect implies a lower marginal rate of substitution. The income effect is a
parallel shift in the production possibilities frontier. As the income effect increases the
amount of employment, marginal product of labour must fall from point D to point B.
This reinforces the reduction in the marginal rate of substitution from point A to point
D.
 C

PPF1
A
D I1
PPF2
B I2
l
h

-G

Figure 5.1

39) Suppose that the representative consumer's preferences change, in that his or her
marginal rate of substitution of leisure for consumption increases for any quantities
of consumption and leisure.
(a) Explain what this change in preferences means in more intuitive language.
(b) What effects does this have on the equilibrium real wage, hours worked, output,
and consumption?

a.) At the margin, the consumer decides that leisure is more preferred to
consumption. That is, the consumer now requires a bigger increase in
consumption to willingly work more and consume less leisure.
C
I2
I1

A
B

l
h

-G

b.) To work out the effects of this change in tastes, we refer to Figure 5.5. The
production possibility frontier in this example is unchanged. The consumer
now picks a new point at which one of the steeper indifference curves is
tangent to the production possibilities frontier. That is, equilibrium will
shift from point A to point B. Consumption falls and leisure rises.
Therefore, the consumer works less and produces less. Because
employment has fallen, it also must be the case that the real wage increases
.