QUIZ 2: Macro Winter 2014 Name: __ANSWERS________ rida! a"m" rida! #"m" Sat$rda!

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Q$i% ass$m#tions: &'ese 'o(d )or *+&, -$estions 1 and 2 . When answering these questions, you should compare the initia( #osition of the economy to the ne. e-$i(i/ri$m in the economy (inclusive of both income and substitution effects). That means, we will assume the labor market will always clear. Additionally, $n(ess I te(( !o$ ot'er.ise0 all other e ogenous variables!! T"#, ta es, population, value of leisure, changes in wealth!! (and the capital stock) are held fi ed. Q$estion 1 12 #oints eac' 10 #oints tota(2 "or questions $a % $e, circ(e the answer that makes the question stem true. When answering the questions, you should only use the models developed in class (including assuming a &obb!'ouglas production function). "or each question stem, there is only one tr$e ans.er. a" A tem#orar! increase in & 3 1A2 .i((: i. (nambiguously shift the labor supply curve to the right. ii. (nambiguously shift the labor supply curve to the left. iii. (nambiguously have no effect on the labor supply. iv. The labor supply curve will shift to the right or the left depending on whether income effects are large or small compared to substitution effects.

)tart with the &obb 'ouglas production function* + , A-../0..1. Taking the partial derivative with respect to 0 gives us* 2#0 , ..1A(-30)../. As A increases, 2#0 increases. "irm optimi4ation results in 2#0 , W3# (this is our labor demand curve). "rom this identity, we can easily see that a temporary increase in A holding all else constant will shift the labor demand curve up (or to the right). (sing our labor market analysis, the temporary increase in T"# will result in a temporary increase in W3# (when workers are more productive they are more valuable to the firm). 5ecause this is a temporary wage increase, lifetime income will move but only by a small amount. As 6 said in the )upplemental 0otes, we equate very small income effects with no income effects. The 7abor )upply curve does not shift. /" A #ermanent increase in & 3 1A2 .i((: i. (nambiguously shift the labor supply curve to the right. ii. (nambiguously shift the labor supply curve to the left. iii. (nambiguously have no effect on the labor supply. iv. The labor supply curve will shift to the right or the left depending on whether income effects are large or small compared to substitution effects.

Again, start with the &obb 'ouglas production function* + , A- ../0..1. Taking the partial derivative with respect to 0 gives us* 2#0 , ..1A(-30)../. As A increases, 2#0 increases. Again, we can easily see that an increase in A holding all else constant will shift the labor demand curve up (or to the right). (sing our labor market analysis, the permanent increase in T"# will result in a permanent increase in W3# (when workers are more productive they are more valuable to the firm). As W3# permanently increases, the permanent value of lifetime resources (#879 increases), so there will be a second shift in the labor market. This second shift is a shift to the left of the labor supply curve:the income effect. As we are richer, the income effect on labor supply says we work less. (There is also a substitution effect which is the movement up the original labor supply curve that occurs as labor demand shifts out.) c" A tem#orar! dec(ine in (a/or income ta4es 1tn2 .i((: i. (nambiguously shift the labor supply curve to the right. ii. (nambiguously shift the labor supply curve to the left. iii. (nambiguously have no effect on the labor supply. iv. The labor supply curve will shift to the right or the left depending on whether income effects are large or small compared to substitution effects.

A temporary decrease in labor income ta es will shift the labor supply curve to the right because of a substitution effect (as ta es fall, leisure becomes more e pensive and we will substitute away from leisure). There is no income effect because the change is temporary. d" A #ermanent dec(ine in (a/or income ta4es 1tn2 .i((: i. (nambiguously shift the labor supply curve to the right. ii. (nambiguously shift the labor supply curve to the left. iii. (nambiguously have no effect on the labor supply. iv. The labor supply curve will shift to the right or the left depending on whether income effects are large or small compared to substitution effects.

A permanent decrease in labor income ta es will have both an income and a substitution effect on the labor supply curve. As we saw above, the labor supply curve will shift to the right because of a substitution effect (as ta es fall, leisure becomes more e pensive and we will substitute away from leisure). After ta wages will unambiguously increase because the government is taking less out of every paycheck. (5efore ta wages will decrease as 0 increases.) The increase in after ta wages will imply we are permanently richer. ;iven this, the income effect says we should work less. The income effect will shift in the labor supply curve. )o, the net effect on the labor supply curve is theoretically ambiguous.

Q$estion 1 1contin$ed2 e" A #ermanent decrease in t'e .or5ing age #o#$(ation: i. (nambiguously shift the labor supply curve to the right. ii. (nambiguously shift the labor supply curve to the left. iii. (nambiguously have no effect on the labor supply. iv. The labor supply curve will shift to the right or the left depending on whether income effects are large or small compared to substitution effects.

The reason that the labor supply curve shifts left is that there are fewer people working. 0otice, as we discussed in class, there is also an income effect (real wages go up and people are richer). This will further shift the labor supply curve to the left (the substitution effects are <ust movements along the curves). Q$estion 2 11 #oints eac' 6 #oints tota(2 "or questions =a % =g, circ(e all the true statements (this means multiple answers could be true). 6n essence, each question is a separate true3false question. W'en ans.ering t'e -$estions0 ass$me t'at s$/stit$tion e))ects on (a/or s$##(! are (arge re(ati7e to income e))ects" a. A permanent increase in T"# (A) will unambiguously increase output!per!worker (+30). + , A-../0..1 so +30 , A-../0!../. When the substitution effect dominates, both + and 0 increase. We know the ratio of +30 is proportional to the real wage (from class ..1 +30 , W3# > this <ust comes from the firm first order condition (2#0,W3#) and some algebra). Anytime W3# increases, we know +30 increases. b. A permanent increase in labor income ta es (tn) will unambiguously increase before ta real wages. A permanent increase in labor income ta es will shift the labor supply curve to the left because of the substitution effect (as ta es go up, leisure becomes cheaper and we will substitute towards leisure). After ta wages will fall because the government is taking more of every paycheck. The decline in after ta wages will imply we are poorer. ;iven this, the income effect says we should work more. The labor supply curve shifts right because of the income effect. 5ecause the substitution effect dominates, 0 will fall. As 0 falls, workers are scarce and before ta wages (W3#) will increase (because of diminishing marginal product of labor). 6n a world with a small income effect, 6 sometimes <ust assume there is no income effect. +ou should be able to draw the situation where there is no income effect. We did this in class. 6n this e ample, before ta real wages wen up when there was a decline in labor income ta es. c. A permanent decline in consumption ta es (tc) will unambiguously cause the unemployment rate to fall.

"alse. As we discussed in lecture and in several of the readings, unemployment results from a disequilibrium of the labor market. When the ta on consumption decreases ! the price of consumption decreases. As a result, households will want to switch toward consumption. As a result, they will choose to work more (leisure is relatively more e pensive compared with consumption) shifting the labor supply curve out. This is the substitution effect. The income effect says that as we are made permanently richer by the decline in consumption ta es, we will want to work less. The labor supply curve shifts in. 5ecause the substitution effect dominates, the permanent decrease in tc causes the labor supply curve to shift out more than the income effect causes it to shift in. ?ur labor market reaches a new equilibrium (not a disequilibrium) at a higher 0@ and lower real wages (W3#). There is no disequilibrium> therefore, there is no effect on unemployment as a result of this ta change. d. A permanent increase in labor income ta es (tn) will unambiguously cause the long run aggregate supply (79A)) curve to shift to the left. A permanent increase in labor income ta es will shift the labor supply curve to the left because of the substitution effect (as ta es go up, leisure becomes cheaper and we will substitute towards leisure). After ta wages will fall because the government is taking more of every paycheck. The decline in after ta wages will imply we are poorer. ;iven this, the income effect says we should work more. The labor supply curve shifts right because of the income effect. 5ecause the substitution effect dominates, 0@ will fall. We define the 79A) curve with our &obb 'ouglas production function* +@ , + , A-../0@..1. As 0@ falls, +@ falls and the 79A) shifts in. (0ote, the long run aggregate supply curve is 0?T the labor supply curve ! the long run aggregate supply curve is +@ ! make sure you know the difference between the two.) e. A permanent decline in labor income ta es (t n) will unambiguously shift the labor demand curve to the right. "alse. The permanent decline in t n will result in a shift of the labor supply curve. 6n equilibrium, it will result in a movement along the labor demand curve ! but, it will not shift the labor demand curve (the labor demand curve shifts only when A or - changes). f. A permanent increase in labor income ta es (tn) will unambiguously increase after ta real wages. "alse. A permanent increase in tn means the government is taking more out of every paycheck. Thus, after ta wages will unambiguously decrease as a result of this ta increase. This was the shock that started the whole process off. +ou should be able to prove this to yourself. g. A permanent increase in T"# (A) will unambiguously increase aggregate e penditure.

True. 9ecall, + , A-../0..1. As A increases, +@ increases. 0ote* + , output , aggregate e penditure , aggregate income (week $As lecture). Bven though 6 asked about aggregate e penditure, we know that aggregate e penditure , output. The rest of the course will be showing the mechanism by which this takes place. Q$estion 8 18 #oints2 This week, 6 had you read lots of articles3discussion surrounding the work by Carvard economists &armen 9einhart and -en 9ogoff. 6n one of the preliminary versions of a research paper they co!authored, they had a coding error in their data work. This coding error sparked a C(;B debate among politicians, economists and cable news networks. 6n their research, 9einhart39ogoff were e ploring the effect of one particular macroeconomic variable on a countryAs subsequent growth rate. What was the one macroeconomic variable that they were trying to relate to a countryAs growth rate in their research that sparked the controversyD (+our answer should be no more than $= words. 2y ideal answer is = words.) #ublic 'ebt. We will also take debt to ;'# ratio or government spending (or anything similar).