ECON 2123 Problem Set 2

Instructor: Prof. Wenwen Zhang

TA: Mr. Ding Dong

Due at 15:00 on Monday, April 9th, 2018

Important Notes:
1. This problem set is due at 15:00 on Monday, April 9th. You should submit a
hard-copy of your solutions to the Drop-box on 6th floor of LSK outside ECON
Office. No late submission will be accepted.
2. Please write the course code (ECON2123), your name, your student ID and your
email on the top of first page of your paper.

Question 1: The natural rate of unemployment

Suppose that the markup of goods prices over marginal cost is 5%, and that the
wage-setting equation is
W = P (1 − u)
where u is the unemployment rate.
a. What is the real wage, as determined by the price-setting equation?
b. What is the natural rate of unemployment?
c. Suppose that the markup of prices over costs increases to 10%. What happens
to the natural rate of unemployment? Explain the logic behind your answer.

Question 2: Demand shocks and demand management

Assume that the economy starts at the natural level of output. Now suppose there
is a decline in business confidence, so that investment demand falls for any interest
rate.
a. In an AS-AD diagram, show what happens to output and the price level in the
short run and the medium run.
b. What happens to the unemployment rate in the short run? in the medium run?
Suppose that the Federal Reserve decides to respond immediately to the decline in
business confidence in the short run. In particular, suppose that the Fed wants to

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prevent the unemployment rate from changing in the short run after the decline in
business confidence.
c. What should the Fed do? Show how the Feds action, combined with the decline
in business confidence, affects the AS-AD diagram in the short run and the medium
run.
d. How do short-run output and the short-run price level compare to your answers
from part (a)?
e. How do the short-run and medium-run unemployment rates compare to your
answers from part (b)?

Question 3.
Suppose that the interest rate has no effect on investment.
a. Can you think of a situation in which this may happen?
b. What does this imply for the slope of the IS curve?
c. What does this imply for the slope of the LM curve?
d. What does this imply for the slope of the AD curve?
Continue to assume that the interest rate has no effect on investment. Assume that
the economy starts at the natural level of output. Suppose there is a shock to the
variable z, so that the AS curve shifts up.
e. What is the short-run effect on output and the price level? Explain in words.
f. What happens to output and the price level over time? Explain in words.

Question 4.
Consider the production function
Y = K + 2N
a. Suppose that K = 10 and N = 20. What is the value of Y?
b. Suppose that K and N triple. What happens to Y?
c. How would you qualify the returns to scale for this function?
d. Write this function as a relation between output per worker and capital per
worker.
e. Suppose K/N = 2. What is the value of Y/N? What happens to Y/N if K/N is

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doubled?
f. Does the relation between output per worker and capital per worker exhibit the
same returns to scale as the above production function?
g. What is the difference between the two functions?
h. Plot the relation between output per worker and capital per worker. How does
the shape of the relationship between the two compare with Figure 10.4?

Question 5: The Cobb-Douglas production function and the steady state

This problem is based on the material in the chapter appendix. Suppose that the
economy’s production function is given by:
Y = K α N 1−α
and assume that α = 1/3.
a. Is this production function characterized by constant returns to scale? Explain.
b. Are there decreasing returns to capital?
c. Are there decreasing returns to labor?
d. Transform the production function into a relation between output per worker
and capital per worker.
e. For a given saving rate, s, and deprecation rate, δ, give an expression for capital
per worker in the steady state.
f. Give an expression for output per worker in the steady state.
g. Solve for the steady-state level of output per worker when s = 0.32 and δ = 0.08.
h. Suppose that the depreciation rate remains constant at δ = 0.08, while the saving
rate is reduced by half, to s = 0.16. What is the new steady-state output per worker?

THIS IS THE END OF PROBLEM SET 2.