Suppose That an Increase in Consumer Confidence

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Suppose That an Increase in Consumer Confidence Powered By Docstoc
					Macroeconomics I
Professor Javier Andrés

PROBLEM SET 2: The determinants of National Income. Long Run


1) Represent graphically the equilibrium in the labor and capital markets. Discuss the
   effect on the real wage and the rental cost of capital, employment and capital of an
   increase in the price level. Represent the aggregate supply curve of the economy.


2) Consider the following production function and the labor supply given by:
   Y= 20L-0.01L2
   Ls = 50(W/P).

   Obtain the labor demand schedule, the equilibrium real wage and the level of
   employment and output. How would you represent the effect on the aggregate
   supply curve of the economy of each of the following events?
   a) A larger number of immigrants enter the economy
   b) A technological advance that increases labor productivity.
   c) A 10% increase in the price level.


3) Suppose the production function is Cobb-Douglas with α=0.3.
   a) What fractions of income do capital and labor receive?
   b) Suppose that a wave of immigration increases the labor force by 10%, while the
      supply of capital is fixed. How do total output, the real rental price of capital and
      the real wage change? Give all your answers in percentages.
   c) Suppose that an inflow of capital from abroad raises the capital stock by 10%.
      Answer the same questions as in b) assuming that the labor supply is fixed.
   d) Suppose that a technological development raises the value of the parameter A by
      10%. Answer the same questions as in b).


4) If both the supply of labor and capital are fixed (inelastic) the aggregate supply of
   the economy will also be inelastic (vertical) regardless of whether wages and prices
   are flexible or sticky. Explain why you agree or disagree with the previous
   statement.


5) Consider that the technology of the economy is represented by the following
   production function:
   Y = K 1 / 4 L1 / 4 H 1 / 2
   Where K represents capital, L is unskilled labor and H is skilled labor.
   a) Derive an expression for the marginal product of unskilled labor and discuss
      how it changes if the supply of skilled labor increases.
   b) Derive an expression for the marginal product of skilled labor and discuss how it
      changes if the supply of skilled labor increases.
   c) Obtain the relative wage of both types of labor and discuss how this relative
      wage changes if the supply of skilled labor increases
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   d) Consider that the government increases the amount of resources spent in
      education increasing the proportion of skilled workers significantly. Do you
      think that this will reduce the wage differential among the two types of workers
      in this economy?


6) Consider an economy described by the following equations:
   Y=C+I+G
   Y=5,000
   G=1,000
   T=1,000
   C=250+0.75(Y-T)
   I=1,000-50r

   a)   Compute private saving, public saving and total saving.
   b)   Find the equilibrium interest rate.
   c)   Suppose that G rises to 1,250. Answer again question a).
   d)   Find the new equilibrium interest rate.


7) Suppose that an increase in consumer confidence raises consumer’s expectations of
   future income and thus the amount they want to consume today. This may be
   interpreted as an upward shift in the consumption function. How does this shift
   affect investment and the interest rate?



8) The government increases taxes by €100 billion. If the marginal propensity to
   consume is 0.6, what happens to the following magnitudes?
   a) Public saving.
   b) Private saving
   c) Total saving
   d) Investment



9) Use the model of the small open economy to predict how the trade balance of a
   country and the real exchange rate would respond to each of the following events.
   a) A fall in consumer confidence about the future that induces consumers to spend
      less and save more.
   b) The introduction of a stylish line of Toyotas that makes some consumers prefer
      foreign cars over domestic cars.
   c) The introduction of automatic teller machines that reduces the demand for
      money.


10) Consider an economy described by the following equations:
    Y = C+I+G+NX
    Y = 5,000
    G = 1,000
    T = 1,000
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   C = 250+0.75(Y-T)
   I = 1,000-50r
   NX = 500-500
   r = r* = 5
   In this economy, find the amount of national savings and investment, the trade
   balance and the equilibrium exchange rate.
   a) Suppose now that G is increased to 1,250. Find the new equilibrium values of
       these variables.
   b) Now suppose that the world interest rate rises from 5 to 10 percent. (G is again
       1,000). Find the new equilibrium values of these variables. Explain your results.


11) Suppose that business expectations improve in the US and Japan, so that investment
    in these countries increases.
    a) What happens to the world interest rate?
    b) What happens to investment in our small open economy?
    c) What happens to our trade balance?
    d) What happens to our real exchange rate?




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ADDITIONAL QUESTIONS

1) Income distribution in market economies is driven by the marginal productivity of
   labor (real wages or return on labor) and that of capital (real rental cost or return on
   capital). Due to the law of diminishing marginal returns, whenever the supply of a
   given factor increases, its return falls. This is the true dilemma of capitalism: factor
   growth is a necessary condition for growth but growth can never increase
   everybody’s incomes. Explain why you agree or disagree with the previous
   statement.


2) The long-run aggregate supply curve is vertical, which means that firms in an
   economy are not willing to produce more when the aggregate price rises. The
   explanation of this behavior is that the supply of productive factors is fixed, and
   then it is impossible for all firms to increase their production at the same time, even
   if consumers are willing to pay a higher price for them. Explain why you agree or
   disagree with the previous statement.


3) Aggregate economic profits and the production function are given by:
   π = Y = −( W ) L − ( R ) K
              P         P

    Y = F ( K , L) = K α L β
    Show that if α =1/3 and β =2/3 profits must be zero. Would you conclude the same
    if α=1/3 and β=1?

4) Suppose that a significant proportion of the labor force migrates from country B to
   country A. Say which one of the following statements is true in the long run:
   a) Output (Y), the real wage (W/P) and the rental cost of capital (R/P) increase in
      both countries.
   b) Output and the real wage increase in both countries but the rental cost of capital
      will falls in A and B.
   c) None.
   d) Justify your answer, with a short argument.


5) Economic growth in Spain has been favored by immigration and the availability of a
   low paid workforce. Some economists argue that productivity improvement based
   growth would have been preferable. However this debate is irrelevant since the
   impact on output, employment and the distribution of income is very similar
   regardless of whether growth has been caused by immigration or by improvements
   in technology. Explain why you agree or disagree with the previous statement.


6) Suppose that the government increases taxes and spending by equal amounts. What
   happens to the interest rate and investment in response to this balanced budget
   change?
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7) An increase in public spending reduces domestic savings; this always leads to a fall
   in private investment in the long run, regardless of whether the economy is closed or
   open. Explain why you agree or disagree with the previous statement.

8) Switzerland is a small open economy. Suppose that due to a sudden change in
   preferences worldwide, Swiss exports fall.
   a) What happens in Switzerland to savings, investment, net exports, the interest
      rate, and the exchange rate?
   b) The citizens of Switzerland like to travel abroad. How will this change in the
      exchange rate affect them?
   c) The Swiss fiscal authorities want to adjust taxes to maintain the exchange rate at
      its previous level. What should they do? If they do this, what are the overall
      effects on saving, investment, net exports, and the interest rate?

9) In 1995, President Clinton considered placing a 100 percent tariff on the import of
   Japanese luxury cars. Discuss the economics and politics of such a policy. In
   particular, how would the policy affect the US trade deficit? How would it affect the
   exchange rate? Who would be hurt by such policy? Who would benefit?

10) Describe the long-run effect of the following policies in a small open economy:
    a) A reduction in domestic public spending.
    b) A reduction in the level of foreign public spending (the level of public spending
       diminishes abroad but remains unchanged in the domestic country).

11) Consider an open economy in which prices are flexible (long run), represented by
    the following equations:
    Y=7,500
    G=2,000
    T=2,000
    C=500+0.8 (Y-T)
    I=2,500-50 r
    NX=1,000-500 ε
    r=r*=5
    a) Obtain the equilibrium levels of national savings, investment, the trade balance
        and the exchange rate. Use graphs.
    b) Assume now that there is a tax cut so that new taxes fall to 1,500. Obtain the
        new equilibrium levels of national savings, investment, the trade balance and the
        exchange rate. Use graphs.
    c) Suppose now that due to political and social turmoil the economy shuts its
        markets to the rest of the world and that foreign trade in goods and assets is
        banned. Do you think that this, now closed, economy can maintain the
        investment levels obtained in a) and b). Solve the equilibrium and explain your
        results.
    d) Suppose that due to the social disorder firm’s expectations about future profits
        worsen in this (closed) economy. Describe, using graphs, how the real interest
        rate, national savings and investment will be affected by this change.



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12) In 2005 public saving in Spain was close to zero (T≈G). Thus, private investment
    had to be much lower than private savings (S>I) since some of these private savings
    were needed to finance the enormous trade deficit of the Spanish economy with the
    rest of the world (NX<0). Explain why you agree or disagree with the previous
    statement.


13) Some economists downplay the growing concerns about huge (foreign) trade
    deficits in some advanced countries. They rather claim that these deficits are
    symptoms of future prosperity since they can only be due to high investment rates.
    Explain why you agree or disagree with the previous statement.


14) In an open economy the fall in private savings always leads, in the long run, to a fall
    in private investment, unless the government reduces its budget deficit. Explain why
    you agree or disagree with the previous statement.




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