Review Questions for Macroeconomics Before the Great Depression

1. What assumption about the production technology allows us to conclude that the demand curve for labor is negatively sloped? Recall the definition of the demand curve for labor as the quantity of labor that should be hired to equate the marginal product of labor to the real wage, w/p. The demand curve slopes down because the marginal product of labor declines as the quantity of labor employed rises, with capital fixed. This property of the production function is known as the law of diminishing marginal productivity, or the law of variable proportions. Yet another way to answer the question is to note that the level of the demand curve -- the marginal product of labor -- is the slope of the production function when plotted againts labor. So, if we assume that the slope of the production function declines as employment rises, the demand curve for labor will has a negative slope. One way of saying this is that the production function is assumed to be concave. 2. Consider the production function Y=KL , where 0<<1. Does the marginal product of labor increase or decrease when the capital stock increases? Show the effect of an increase in the capital stock on employment and output.
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The direct way to approach this question is to differentiate Y with respect to L to get the marginal product of labor: dY/dL=MPL=(1)KL Now we want to know how this expression changes when the capital stock increases. To find this, just differentiate again, this time with respect to capital: d(MPL)/dK=d(dY/dL)/dK=d Y/(dLdK)=(1)KL
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which is greater than zero because 0<<1. Thus, the marginal product of labor increases when capital increases. This is equivalent to saying that the demand curve of labor shifting upward at every possible quantity of labor when capital is increased (see the answer to question 1). 3. If there is a sudden increase in the capital stock, what happens to the real rate of interest? This question requires you to link together the market for savings and investment with the production, or supply, side. We have seen in the answer to question 2 that an increase in the capital stock shifts the marginal product curve for labor upwards. It then follows that employment must rise (draw the effect of an increase in the capital stock in the labor market supply-demand diagram). Having now established that both the capital stock and employment has risen, there can be no doubt that total output also rises. We now turn to the savings-investment diagram. What happens to private savings if there is an increase in output? Output and income are one and the same thing, so income has risen. Intuitively, we expect that people will save more when income is higher, so the saving curve must shift to the right. But, if the saving curve shifts to the right, then the real rate of interest must be lower to induce firms to invest more. That is, an increase in the capital stock must cause a reduction in the real rate of interest. Moving beyond the question itself, note that there is a nice symmetry in the relationship between the capital stock and the real interest rate. If the capital stock rises, the real interest rate falls. But one could also ask the following

question: if the real interest rate falls, what happens to the capital stock? The answer depends on why the interest rate fell. Imagine that people start saving more (a rightward shift of the saving curve). Then investment must increase. But if investment increases, the capital stock rises.

4. In the classical model, explain the effect of a 10 percent increase in the money supply on a) the real rate of interest, b) the nominal wage rate. a) You should always start out answering a question such as this by asking the following question: what determines the real interest rate? The answer, of course, is that it results from the equilibration of savings and investment. So then, you should ask, is there anything on the investment side that is affected by the money supply? The answer is No: we assume in the classical model that investment depends only on the real interest rate. Then ask the same question about saving. National saving is given by S=Y-C(Y-t,r)G, and there is nothing in this equation that depends on the money supply (you must be sure to understand why Y does not change when the money supply changes). So, the real rate of interest is not affected by a change in the money supply. b) The labor market determines the real wage, w/p. Now, a 10 percent increase in the money supply raises prices by 10 perent (this is the central prediction of the quantity theory of money). But if w/p has already been determined, and p goes up by 10 percent, then w must go up also by 10 percent. For this answer to be complete, you should also establish that neither the labor supply curve nor the labor demand curve shifts when prices go up by 10 percent. Doing so ensures that the equilibrium w/p is unaffected by a change in the price level. 5. Why do we say that any measured unemployment can only be interpreted as voluntary unemployment in the classical model? Review the meaning of labor market equilibrium in the classical model: Firms are hiring the number of workers they want to hire at the prevailing wage. Workers are supplying the amount of labor they want to supply at the prevailing wage. The prevailing wage is at the level that ensures these two quantities are equal. It therefore follows that, given the wage, everyone who wants to work at that wage are employed. Put another way, if people are not working they have chosen not to because the wage is not high enough for them. Of course, a policy maker might not like the prevailing wage, or the quantity of employment at that wage, and so she may want to intervene. But this is not the same as saying there is involuntary employment. 6. Within the classical framework, show the effect on the price level of introducing an income tax to be paid by workers.

6. Within the classical framework, show the effect on the price level of introducing an income tax to be paid by workers. Let's start with the effect of the tax in the labor market. For any given w/p, the income tax reduces workers' incentives to supply labor. This shifts the labor supply curve to the left. The effect on the equilibrium is to raise w/p and lower the equilibrium level of employment. From the production function, we know that a reduction in equilibrium employment reduces output. This is a reduction in aggregate supply. Consider now the AS-AD model in the classical framework. The Aggregate Demand curve comes from the quantity theory of money: MV=PY . For any fixed policy choice for the money supply, we can write this as P=MV/Y, giving a negative relationship between P and Y (recall that V is assumed to be fixed in the quantity theory). Thus, if Y goes down because of

the labor market tax, the price level must go up. An intuitive way to think about this is to realize that for any given level of the money supply, a reduction in output means you have the same amount of money chasing fewer goods. Because goods have become scarcer relative to money, the price of goods must go up.

7. Within the classical framework, show the complete effects on the macroeconomy of introducing a payroll tax to be paid by employers. 8. The government decides to impose a tax on the interest earnings of savers. Show the immediate effect of the new policy on a) the savings-investment equilibrium, b) on employment. c) What will be the long term effects on employment? a) A tax on interest income earned from saving reduces the incentive to save at any given market interest rate. This implies a leftward shift of the saving function. The equilibrium interest rate rises, and both investment and saving are reduced. b) The effect on employment depends on the time horizon one considers. Consider first the immediate effect. At any point in time, the capital stock is fixed, resulting from past investment decisions. Given a fixed capital stock, labor market equilibrium requires that the marginal product of labor equals the real wage. But nothing here depends on the interest rate, so employment is not immediately affected by the tax on saving. c) Now consider the longer term. Investment has declined, so we know that the capital stock will decline. And (check the answer to question 3 for an increase in the capital stock) a reduction in the capital stock will cause employment to decline. So, once one takes a long enough time horizon to allow for changes in the capital stock, the classical model predicts that a tax on saving will reduce employment.

9. What circumstances make it more likely that an increase in the marginal income tax rate will reduce rather than increase government revenue? This one is straight out of the transparencies. Check the section on supply side economics (it depends on the responsiveness of labor supply and demand to changes in the effective real wage-- i.e. it depends on the slopes of the labor supply and demand curves). 10. How does the classical model make a theory of inflation out of an accounting identity? This one is straight out of the transparencies. Check the section on the classical money market. The identity is MV=PY, which is true by definition. The classical model turns this into a theory by making assumptions about various components of the identity. First, the classical model assumes that Y is determined in the labor market. Then, it assumes that V is fixed. Thus, the identity is converted into a theory that relates the supply of money to the price level. This theory is testable in several ways. First, one could test whether M and P are in fact related as the theory predicts (we looked at a couple of graphs regarding this issue). Second, we see if V is indeed constant. Third, we could test whether Y is in fact unrelated to M or P.

11. What is an accounting identity? Provide some examples from material we have studied so far. Distinguish an accounting identity from a behavioral equation.

12. Economists in Cambridge, England, thought that the quantity theory of money was a too mechanical as an explanation of money demand. Explain their version of the money demand equation. This one is straight out of the transparencies. Check the section on the classical money market. 13. The quantity theory of money assumes that the velocity of circulation can safely be assumed to be constant at all points in time. Is it reasonable to assume constant velocity even through booms and recession? If velocity is not constant, what implication does this have for the classical theory of inflation?

The implication of the assumption of a constant velocity of circulation of money is that people spend money out of their checking accounts at the same rate regardless of the state of the economy. This does not seem reasonable. For example, in a recession some people will become unemployed. It is pretty obvious that many people cut back on their expenditures (eat at home, no visits to the movie theater, etc) after losing a job. But this implies that they spend their money less rapidly, and hence that velocity declines. Conversely, in a boom, it is more reasonable to assume that velocity rises. So what implications does this have for the theory of inflation? The basic classical theory is that inflation is caused by fluctuations in the money supply, because P and M have a proportional relationship to each other. Booms and recessions are caused by fluctuations in Y, which themselves are caused by shocks in the labor market (so the classical theory goes). Now consider the quantity theory equation, MV=PY. Rearrange this to get P=(V/Y)M. In a recession, V goes down as we have argued. But Y also goes down, so the ratio V/Y may go up, down, or stay more or less the same. If the movements in V and Y are more or less the same magnitude, then the proportional relationship between M and P is preserved even in booms and recessions. In practice, however, we would not expect movements in V and Y to always cancel each other out, so the quantity theory of money can only be expected to be an approximate theory of inflation.
14. Explain the concept of crowding out. This one is straight out of the transparencies. Remember that an increase in government expenditure forces down either consumption or investment, or both. The balance between the reduction in consumption and the reduction in investment depends on their relative sensitivities to the real rate of interest. Although a loss of consumption may also be viewed as bad, remember that the term "crowding out" has been reserved for the question of how much investment goes down when government expenditure goes up. 15. How would one go about evaluating how important crowding out is? What difficulties might one encounter? We would simply want to see how investment is related to changes in government expenditure. The main difficulty is dealing with the identification problem. For example, the government might increase spending every time investment falls to prevent a recession (this is the Keynesian prescription as we shall see). Thus, rising government expenditure will be associated with falling investment even if the former does not directly cause the latter. 16. "It does not matter whether government expenditure crowds out investment or not. In either case, less government expenditure is good." Explain, from the perspective of the classical model. In the transparencies, there is a page referring to two anti-government positions implied by the classical model of crowding out. If there is no crowding out (of investment) then private consumption is reduced by an increase in government expenditure. A common political position has been that old chestnut "private individuals know how to spend their money better than the government does." Second, if there is crowding out, rising government expenditures reduces further output (as in question 1 of problem set 2). 17. What causes of economic fluctuations are consistent with the classical model?

This one is straight out of the transparencies. Remember that the only causes that are consistent with the classical model relates to shocks to labor supply, labor demand, or the production function. 18. In what way did the classical model fail to provide an adequate explanation of the Great Depression?