Grinnell College Econ 282

Department of Economics Fall 2011

Economics 282: Macroeconomic Analysis

Problem Set 5
Due Friday, November 4, 2011

1. Consider North Country, a competitive economy that has the same quantities of labor and
capital ( ). Its output is described by the following production function:

/ /

a) Does this economy exhibit increasing, decreasing, or constant returns to scale? Show
your proof.
b) Derive an expression for the marginal product of labor. Does it exhibit increasing,
decreasing, or constant marginal product (explain your answer)? How does an increase in
the amount of capital affect the marginal product of labor?
c) The observed equilibrium real wage rate is 15, and the real output level is 20,000. What
is the quantity of labor in the economy? Show your calculations.
d) What is the labor share of income? Show your calculations.
A technological breakthrough raises the economy’s total factor productivity by 10 percent.
e) Show how this change affects the graphs of both the production function relating output
to labor and the production function relating output to labor.
Y Y

L K
f) Show how this change affects the real wage rate on a graph representing the labor market.

Answers:
/ /
a)
/ /
for 1 
/ / / /
      
/ /
      
      

The production function exhibits constant returns to scale.

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b)
As L is in the denominator of the above expression, therefore as L increases, MPL
decreases.
On the other hand, as K is in the numerator, as K increases, MPL increases.
c) Assume ,

 Î   Î 

/ / / /
,  Î  ,

,
d) Labor’s share of income  
, ,
e)

Y / /
Y / /

/ / / /

L K

f)
w

L
1,000
Labor Market

2. Consider a Cobb-Douglas production function with three inputs. K is physical capital (the
number of machines), L is labor (the number of workers), and H is human capital (the
number of college degrees among the workers). The production function is

/ / /
.

a) Derive an expression for the marginal product of labor. How does an increase in the
amount of human capital affect the marginal product of labor?

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b) Derive an expression for the marginal product of human capital. How does an increase in
the amount of human capital affect the marginal product of human capital?
c) What is the income share paid to labor? What is the income share paid to human capital?
In the national income accounts of this economy, what share of total income do you think
workers would appear to receive? [Hint: Consider where the return to human capital
shows up.)
d) An unskilled worker earns the marginal product of labor, whereas a skilled worker earns
the marginal product of labor plus the marginal product of human capital. Using your
answers to parts (a) and (b), find the ratio of the skilled wage to the unskilled wage. How
does an increase in the amount of human capital affect this ratio? Explain.
e) Some people advocate government funding of college scholarships as a way of creating a
more egalitarian society. Others argue that scholarships help only those who are able to
go to college. Do your answers to the preceding questions shed light on this debate?

Answers:
a)
An increase in human capital will increase the MPL because more human capital
makes all the existing labor more productive.
b)
An increase in human capital will decrease the MPH because there are diminishing
marginal returns.
/ / — /
c) Labor share / / /
/ / — /
Human capital share / / /
So labor gets one-third of the output, and human capital gets one-third of the
output. Since workers own their human capital (we hope!), it will appear that labor
gets two-thirds of output.
d) The ratio of the skilled wage to the unskilled wage is:

[Notice that the ratio is always greater than 1 because skilled workers get paid more
than unskilled workers. Also, when H increases this ratio falls because the
diminishing returns to human capital lower its return, while at the same time
increasing the marginal product of unskilled workers.]
e) If more college scholarships increase H, then it does lead to a more egalitarian
society. The policy lowers the returns to education, decreasing the gap between the
wages of more and less educated workers. More importantly, the policy even raises
the absolute wage of unskilled workers because their marginal product rises when
the number of skilled workers rises.

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3. Consider an economy described by the following equations:

5,000
1,000
1,000
250 0.75
1,000 50
a) In this economy, compute private saving, public saving, and national saving.
b) Find the equilibrium interest rate.
c) Now suppose that G rises to 1,250. Compute private saving, public saving, and national
saving.
d) Find the new equilibrium interest rate.
e) Suppose, instead of part c), the government increases taxes and government purchases by
the same amounts. What happens qualitatively to the interest rate and investment in
response to this balanced-budget change (i.e. do they increase, decrease, or stay
constant)? Explain your answer.

Answers:
a) Private saving is the amount of disposable income, Y – T, that is not consumed:

Public saving is the amount of taxes the government has heft over after it makes its
purchases:

National saving is the sum of private saving and public saving:

b) The equilibrium interest rate is the value of r that clears the market for loanable
funds. We already know that national saving is 750, so we just need to set it equal to
investment:

  . . %

c) When the government increases its spending, private saving remains the same as
before while government saving decreases:

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d) Once again the equilibrium interest rat clears the market for loanable funds:

  . . %
e) To determine the effect on investment of an equal increase in both taxes and
government spending, consider the national income accounts identity for national
saving:

                                            
                                     ∆  ∆  ∆ ∆ ∆
                                     ∆ ∆ ∆ ∆
∆

The above expression tells us that the impact on saving of an equal increase in T and
G depends on the size of the MPC. The closer the MPC is to 1, the smaller is the fall
in saving. For example, if the MPC equals 1, then the fall in consumption equals the
rise in government purchases, so national saving is unchanged. The closer the MPC
is to 0, the greater is the fall in saving. Because we assume that the MPC is less than
1, we expect that national saving falls in response to an equal increase in taxes and
government spending. The reduction in saving means that the supply of loanable
funds decreases. The real interest rate rises, and investment falls.

4. When the government subsidizes investment, such as with an investment tax credit, the
subsidy often applies to only some types of investment. This question asks you to consider
the effect of such a change. Suppose there are two types of investment in the economy:
business investment and residential investment. And suppose that the government institutes
and investment tax credit only for business investment.
a) How does this policy affect the demand curve for business investment? The demand
curve for residential investment?
b) Draw the economy’s supply and demand for loanable funds. How does this policy affect
the supply and demand for loanable funds? What happens to the equilibrium interest rate?
c) Compare the old and the new equilibria. How does this policy affect the total quantity of
investment? The quantity of business investment? The quantity of residential investment?

Answers:
a) The demand curve for business investment shifts out to the right because the
subsidy increase the number of profitable investment opportunities for any given
interest rate. The demand curve for residential investment remains unchanged.

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b) The total demand curve for investment in the economy shifts out to the right since it
represents the sum of business investment (which shifts out to the right) and
residential investment. As a result, the real interest rate rises.

r
S

r2

r1

I2
I1

I,S

c) The total quantity of investment does not change because it is constrained by the
inelastic supply of savings. The investment tax credit leads to a rise in business
investment, but an offsetting fall in residential investment. That is, the higher
interest rate means that residential investment falls (a movement along the
residential investment curve), whereas the right ward shift of the business
investment curve leads business investment to rise by an equal amount.
r r

r2 r2

r1 r1

Ibusiness2
I1business1 Iresidential
Ibusiness Iresidential
                 

5. The Quantity Theory of Money and the Fisher Equation

a) According to the quantity theory of money, what causes inflation? How can inflation be
controlled? Explain your answers.
b) Based on the values taken from the statistical tables of the 2009 Economic Report of the
President, the percentage changes of the following variables over each decade are
calculated. What, if anything, can you conclude about the classical assumption
concerning the velocity of circulation of money ( ) from the data?

Real GDP GDP deflator M1

’75 – ‘85 40.4% 83.4% 115.9%
’85 – ‘95 32.7% 32.1% 81.9%
’95 – ‘05 36.8% 22.7% 490.7%

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c) Suppose V is constant, nominal money stock M is growing 100% per year, real output Y
is growing 2% per year, and the real interest rate r is 2%. What are the inflation rate and
the nominal interest rate i? [The Fed has more than doubled its balance sheet, or
monetary base, since the beginning of the financial crisis. Imagine how inflation will
behave once banks start to lend out all the excess reserves they have acquired!]

Answers:
a) The quantity theory of money argues that an increase in the money supply in excess
of the growth of real GDP causes a proportionate increase in the price level. To
control inflation, one needs to control the rate of growth of the money supply.
b) According to the quantity equation:
%∆ %∆ %∆ %∆ or %∆ %∆ %∆ %∆

Real GDP GDP deflator M1 %change in V

(using M1)
’75 – ‘85 40.4% 83.4% 115.9% 7.9%
’85 – ‘95 32.7% 32.1% 81.9% -17.1%
’95 – ‘05 36.8% 22.7% 490.7% -431.2%

The classical model assumes that V is constant (i.e. %∆ ). However, the

percentage change in V calculated above suggests that V is not constant. [One way to
interpret it is that the money demand function is not stable over time, or people’s
preference to hold monetary balances changes over time.]
c) According to the quantity equation:
%∆ %∆ %∆ %∆
100% + 0% = inflation rate + 2%
Inflation rate = 98%
According to the fisher equation:
 
i = 2% + 98% = 100%

6. Who are the winners and losers when the Board of Trustees of Grinnell College agrees to a 2
percent pay raise for its faculty, and during the same year prices unexpectedly fall by 1
percent? If the fall in prices persists, how would such continuing deflation affect employers
and employees in the economy as a whole?

Answer:
If the actual inflation is below expected inflation (the actual inflation is negative in
this case), the ex-post real wage rate will be higher than the ex-ante real wage rate,
meaning that the Grinnell faculty will be getting a higher than expected real pay raise. The
Grinnell faculty (including Professor Chan) will gain and the College will lose. If the fall in
prices persists, employers may re-negotiate wage contract with their employees by cutting
their wage rates and salary. However, there is usually downward rigidity to wage rate (or
resistance to pay cut). If that is the case, the College may implement a pay freeze and may
need to fire some employees.

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