Economics 3307
Study Questions for Exam I
Sample
Questions from Chapter 3:
1. Using the model developed in Chapter 3 of the
textbook, explain the effects of the following exogenous events on the level of
aggregate output, the real wage rate, and the real rental price of
capital. Provide a separate answer for
each part of this question. (HINT: Use the appropriate graph, shift the
appropriate line in the appropriate direction, and see what happens to the
variables on the axes.)
a. The
labor force increases because of a large increase in the labor force
participation rate of adult women.
b. The
capital stock increases, and this in turn increases the marginal product of
labor.
c. A
war destroys much of an economy's capital stock but causes only a small
decrease in the country's total population.
2. Suppose that in an economy Y is temporarily
larger than (C+I+G). Will the real
interest rate (r) tend to rise or to fall?
Explain in 2 or 3 sentences.
3. Problem #5 on page 75 of the Mankiw textbook.
4. Suppose that over a period of time, the
following things occur in an economy:
(i) the real wage rate (W/P) increases, (ii) aggregate output (Y)
increases, and (iii) the real rental price of capital (R/P) decreases. Describe a set of exogenous changes, and the
resulting curve shifts in the labor market and capital market graphs, that can
explain these occurrences.
5. Suppose that Congress reduces the US federal
budget deficit.
a. Use
the loan market graph (from Chapter 3) to determine the effect of this change
on the equilibrium real interest rate in the economy.
b. Describe
how the reduction in the US federal budget deficit affects the elements of the
equation Y = C + I + G. Which elements
increase? Which decrease? Which are
unchanged? (NOTE: Your answer should be based on analysis in
Chapter 3; you should not refer to the growth models in Chapter 4.)
1. a. The labor supply curve
shifts right, which lowers the real wage and increases the quantity of labor
employed. The increase in L raises the
marginal product of capital (assuming labor and capital are complements in the
aggregate), which shifts the demand curve for capital to the right. This increases the real rental price of
capital, but does not change the quantity of capital. Because Y = F(K,L), with K unchanged and a rise in L, Y also
rises.
b. The
rise in K shifts the capital supply curve to the right, which reduces the
equilibrium real rental price of capital (R/P) and increases the equilibrium
quantity of capital. Because the rise
in K increases MPL, the labor demand curve shifts right. This causes the equilibrium real wage (W/P)
to increase, but has no effect on the equilibrium quantity of labor employed
(because the labor supply curve is vertical).
Because Y = F(K,L), with L unchanged and a rise in K, Y also rises.
c. The
decrease in K shifts the capital supply curve to the left, which decreases
equilibrium K and increases equilibrium R/P.
If capital and labor are complements, the fall in K causes a decline in
MPL, so the labor demand curve shifts left.
This reduces the equilibrium (W/P) and has no effect on L. Because Y = F(K,L), with L unchanged and a
fall in K, Y also falls.
2. Y > C+I+G implies that S > I, which
means that there is an excess supply of loans in the economy. The excess supply of loans means that r will
fall. When r falls, I = I[r] rises, and
eventually C+I+G rises to equal Y.
3. More consumption at any given (Y-T) means
less savings at any given (Y-T). This shifts the savings schedule (the vertical
line we have been interpreting as loan supply) to the left. The real interest rate rises, which reduces
investment.
4. These facts could be explained by an increase
in the capital stock (K) when capital and labor are complements -- that is, the
rise in K increases the marginal product of labor (MPL). In the market for K, the rise in K reduces
(R/P). In the labor market, the rise in
the MPL shifts the labor demand curve to the right and increases (W/P). Given Y = F(K,L), the rise in K causes Y to
increase.
5. a. A
reduced federal budget deficit increases government saving (T-G), which
increases total saving (S). In our
“loan market” graph, the vertical savings line shifts right, which makes the
real interest rate decrease.
b. Suppose
the deficit decreases because of a decrease in G. Thus G falls. The fall in
r causes I = I[r] to increase. Y =
F(K,L) is unchanged because K and L are unchanged. C = C(Y-T) is unchanged because Y and T are unchanged. Thus the rise in I exactly offsets the fall
in G.
If the deficit decreases because of
a rise in T, then G is unchanged. The
fall in r causes I = I[r] to increase.
Y = F(K, L) is unchanged because K and L are unchanged. When T rises and Y is unchanged, (Y-T)
falls. The fall in (Y-T) causes C =
C(Y-T) to decrease. Thus the increase
in I exactly offsets the decrease in C.
1. Consider two economies, economy A and economy
B. Suppose that over long periods of
time, the average rate of Real GDP growth is higher in economy A than in
economy B. Briefly (one sentence for
each explanation) describe two (2) possible explanations for the fact that
average Real GDP growth is higher in economy A than in economy B.
2. Explain briefly (2 or 3 sentences) why you
agree or disagree with the following quotation:
"If the people of Japan began to save
a lower fraction of their incomes, this would reduce the rate of Real GDP
growth in Japan."
3. Suppose that the actual level of capital per
worker in an economy (k) is greater than the steady state equilibrium level
(k*) -- that is, k > k*. As the same time suppose that the steady
state equilibrium level of capital per worker
is less than the golden rule level:
k* < k*GOLD .
a. In
the absence of any government policy to change the savings rate, will the
actual level of capital per worker (k) tend to rise or fall in coming
years? Explain in 1 or 2 sentences.
b. Explain
what happens to the level of consumption per capita (c) as the economy moves to
the steady-state equilibrium.
4. Consider two countries that are similar in
all respects except one: Country A has
a much higher rate of population growth than country B. Which country probably has the higher
standard of living? Explain in 3 or 4
sentences, using a graph if you find it helpful to do so.
5. Consider two countries that are similar today
in all respects except one: Country C
has a much lower stock of capital per worker (k = K/L) than country D. Which country is likely to have the more
rapid rate of growth in output in coming years? Explain in 3 or 4 sentences, using a graph if you find it helpful
to do so.
6. In his 1994 television addresses, US
presidential candidate Ross Perot emphasized repeatedly that rate of
improvement in the standard of living in the US has slowed considerably since
the mid-1970s. He argued that the way
to restore rapid growth in the standard of living was to balance the government
budget -- that is, to reduce the deficit to zero. Were his arguments correct?
Answer in 3 or 4 sentences, using a graph if you find it helpful to do
so.
7. After listening to Ross Perot's speech, an
economist argues that a better way to increase the rate of economic growth is
for the government to implement a very large increase in spending on basic
research, even if doing so increases the federal budget deficit. Use the model developed in Chapter 4 to
critically evaluate this argument. Is
this policy better or worse than the Perot policy? Explain why. NOTE: You may need to make some assumptions to
answer this question. If so, be
explicit about what you assume.
8. Describe three (3) reasons why in any
particular year one country could have a higher level of Real GDP per capita
than another.
1. I’ll give three reasons. (i) Country A has a higher rate of
population growth (n). (ii) Country A
has a higher rate of technological progress (g). (iii) Country A starts with a much lower level of k relative to
k* than Country B.
2. A lower savings rate reduces the steady state
level of output per worker (y*). Real
GDP growth would slow down, but only during the transition to the new steady
state equilibrium. The statement is
true temporarily but not permanently.
3. a. When
k < k*, then investment is less than deprecation and k falls.
b. It
depends on whether k is greater than or less than k*GOLD . If k < k*GOLD , then as k falls
it will move farther away from k*GOLD and consumption per capita
will decrease. If k > k*GOLD
, then as k falls toward k*GOLD consumption will rise. k will continue to fall, however, because k*
< k*GOLD , and k will fall until k = k*. Thus consumption will rise on net if the
increase when k falls toward k*GOLD
is bigger than the decrease when k moves away from k*GOLD
. Consumption falls on net if the
increase when k falls toward k*GOLD
is smaller than the decrease when k moves away from k*GOLD .
4. A higher rate of population growth (n) means
a lower steady state equilibrium level of output per capita (y*). If output per capita measures standard of
living and both countries are in steady state equilibrium, then country A will
have the lower standard of living than country B. [QUESTION: What if
“standard of living” is consumption
per capita????]
5. In country C k is probably well below k*
while in country D k is probably close to k*.
Thus in country C k will rise toward k*, which means that Y will rise
faster than the rate [n+g]. In country
D, Y will rise at about the rate [n+g].
Thus country C will have the faster growth rate. Remember that the Solow model predicts that
“poor countries should grow faster than rich countries.”
6. Reducing the budget deficit increases
government savings [by reducing dissaving], which in turn increases the
economy’s savings rate [s]. A rise in
the savings rate increases the steady state equilibrium level of capital per
effective worker [y*]. Y will grow at a
faster rate, but only during the
transition to the new equilibrium.
Once in the new equilibrium, it will again growth at rate [n+g].
7. The Chapter 4 model, strictly interpreted,
does not support this policy. A higher
government deficit means a lower savings rate [s], which reduces y* permanently
and temporarily reduces the growth rate of Y.
From that perspective it is worse than the Perot policy.
One might argue, as do proponents of
this policy, that the right kinds of government “investment” in infrastructure
and research could increase the economy’s rate of technological progress
[g]. If this is the case, then the
policy would be better than the Perot policy.
8. In steady state equilibrium, a country could
have higher Real GDP per capita because of (i) a higher savings rate [s], (ii)
a lower population growth rate [n], or (iii) a lower depreciation rate [d]. It is also possible that a rise in AD could have output
temporarily above the long-run equilibrium value.