Econ7010, Macroeconomics Midterm Exam, 18 October 2010

1. (20 points) For each of the following statements, indicate whether it is true, false or uncertain and explain your choice. No points will be given for an answer without an explanation. (a) In measuring gross domestic product, consumption in the expenditure approach equals to the market value of newly produced nal goods minus the unsold goods in the product approach. False. The consumption of the expenditure approach counts only purchases by the households. The newly produced nal goods also include goods purchased by the government and nal goods used as capital and therefore counted as investment. (b) A negative current account balance means that investment must be higher than saving. True. S = I + CA. When saving is lower than investment, the dierence is made up by borrowing from abroad. (c) Negative slope of the labor demand curve is a direct consequence of the diminishing marginal product of capital. False. Negative slope of the labor demand is the consequence of the diminishing marginal product of labor. Labor demand curve is given by the marginal product of labor, which equals to the slope of the production function when capital is held constant. The slope of the production function is atter for higher values of L, which means that the real wage will be lower for higher values of L. Thus the negative slope of the labor demand. (d) According to the permanent income hypothesis, a prevalent economic model of consumption, an increase in the current income will cause an equal increase in consumption. Uncertain. According to the PIH, consumption depends only on the permanent income. So, if the increase in current income is permanent, then consumption will rise by the same amount. Otherwise, it will rise by a fraction of that amount. (e) A rise in productivity causes labor demand curve to shift up and right. True. A rise in productivity shifts the production function up. This also means that for every value of labor the slope of the production function will be steeper, which, in turn, means that the real wage will be higher for every quantity of labor. 1

2. (20 points) Dene each of the following terms and write relevant equations if any: (a) Real interest rate. Return of an asset in real (or purchasing power) terms. It is calculated by eliminating the eect of change in price level from the nominal interest rate: r = i . (b) Expected ination. The rate of ination in the future; normally, in the next time period. (c) Structural unemployment. Unemployment due to mismatch in labor skills. Mostly in case of low-skilled labor, shrinking industry, depressed regions, etc. (d) GDP deator. A price index that measures overall price level of goods and services included in GDP. (e) Marginal propensity of consumption. The fraction of additional income that is consumed. 3. (20 points) Suppose that an economy has a production function Y = AK .25 N .75 , where Y is total output, A productivity, K capital stock and N labor. Marginal productivity of labor equals to M P N = Y /N = .75A(K/N ).25 . Assume that A = 1 and K = 4096. Labor supply for the economy is given by w = .005N . (a) Draw labor demand and supply on the same graph and label them accordingly. See the graph below. There three labor demand curves for dierent values of A and K, and the labor supply curve. (b) Assuming that the labor market is in the equilibrium, calculate the amount of labor employed, real wage and the amount of output. In equilibrium, labor supply equals labor demand: .75(4096/N ).25 = .005N . From this, we get N = 12001/1.25 = 290.6. Real wage: w = M P N = .75(4096/290.6).25 = .005N = 1.45. Output: Y = 4096.25 290.6.75 = 563.1 (c) Suppose that productivity increases by 20%. Describe what happens in the economy and calculate new values of the variables that change, if any. Indicate this change on the graph. There are two eects of the increase in the productivity. First, it directly increases output through the production function. Second, the increase in productivity shifts the labor demand up. Labor supply remains the same. This moves the labor market to a new equilibrium with higher real wage and labor. This increase in labor additional increase in output. New labor market equilibrium: 1.2 .75(4096/N ). 25 = .005N N = 336.3 Real wage: w = M P N = 1.2 .75(4096/336.3).25 = .005N = 1.68. Output:Y = 4096.25 336.3.75 = 753.9 2

(d) What would have happened if, instead of productivity, capital increased by 20%? New labor market equilibrium: .75(1.2 4096/N ). 25 = .005N N = 301.4 Real wage: w = M P N = 1.2 .75(4096/301.4).25 = .005N = 1.51. Output:Y = (1.2 4096).25 301.4.75 = 605.7 (e) What can you say about the eect on output of changes in capital and productivity? Changes in both capital and productivity have similar eect on output. Both aect it directly, through the production function, and indirectly, through the labor market. The two eects, however, are stronger in the case of a productivity change.