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Answer 1.1: C
Statements A and B: A one time only decrease in the price level or the money supply has
no effect on inflation or nominal interest rates. The change in the price level decreases the
nominal demand for money.
Statement C: A decrease in the nominal interest rate makes consumers less concerned
about investing their cash and more concerned about avoiding transaction costs. They
exchange bonds for money less frequently and hold larger average money balances.
Statement D: A decrease in consumption causes a decrease in the demand for money.
Statement E: A decrease in transaction costs causes consumers to exchange bonds for
money more frequently, leading to a decrease in average money balances.
Answer 1.2: C
The demand for money increases, since consumers want to avoid bank visits. For the
money market to remain in equilibrium, the real money supply must increase, so the price
level must decline. Money is neutral so it has no effect on real interest rates.
Answer 1.1: E
Leisure and consumption are economic goods with positive utility. If one point has more
leisure and more consumption than a second point, that point has greater utility.
Indifference curves show decreasing marginal utility along each axis. If the two axes are
Goods Y and Z, as we reduce Good Y, we need increasing amounts of Good Z to retain
the same utility.
! As we reduce Good Y, its marginal utility increases.
! As we increase Good Z, its marginal utility decreases.
Illustration: Three points lie on the same indifference curve: (L1, C1), (L2, C2), and (L3, C3),
with L1 < L2 < L3. (L is leisure; C is consumption.)
Both goods are valuable, so C1 > C2 > C3. As leisure increases along an indifference
curve, consumption decreases (and vice versa).
By decreasing marginal utility, (C2 C3) / (L3 L2) > (C1 C2) / (L2 L1). As leisure
increases, its marginal value decreases, so we need more consumption per unit of leisure
to have the same total utility.
Consider Points 1, 2, and 3.
! Point #1 has the highest leisure and the lowest consumption.
! Point #3 has the lowest leisure and the highest consumption.
We compare the ratios (C2 C3) / (L3 L2) and (C1 C2) / (L2 L1) in $000 per hour:
! (C2 C3) / (L3 L2): ($84,000 $92,000) / (16 hours 18 hours) = 4.000
! (C1 C2) / (L2 L1). ($80,000 $84,000) / (18 hours 20 hours) = 2.000
Decreasing marginal utility means that indifference curves are convex (concave upwards).
These three points on the same indifference curve imply that a consumer who has
~ 16 hours of leisure a day would pay $6,000 a year for two more hours of leisure a day.
~ 18 hours of leisure a day would pay $4,000 a year for two more hours of leisure a day.
We infer the following items about this indifference curve:
! The curve is convex between 18 and 20 hours of leisure a day. A consumer who has
19 hours of leisure must receive less than (or equal to) ($80,000 + $84,000) =
$82,000 to be on the same indifference curve.
! The curve is convex between 16 and 18 hours of leisure a day. A consumer who has
17 hours of leisure must receive less than (or equal to) ($84,000 + $92,000) =
$88,000 to be on the same indifference curve.
! The curve is convex between 14 and 16 hours of leisure a day. A consumer who has
14 hours of leisure must receive more than (or equal to) $92,000 + ($92,000 $84,000)
= $100,000 to be on the same indifference curve.
! The curve is convex between 20 and 22 hours of leisure a day. A consumer who has
22 hours of leisure must receive more than (or equal to) $80,000 ($84,000 $80,000)
= $76,000 to be on the same indifference curve.
The principle of economic goods eliminates Choices C and D.
! Point C has more leisure and more consumption than point #2, so it has higher utility.
! Point D has more leisure and more consumption than point #1, so it has higher utility.
The principle of decreasing marginal utility eliminates Choices A and B.
! Statement A: Points #1 and #2 imply that leisure is worth $2,000 an hour. As leisure
increases, it is worth less per hour. But Points A and #1 imply that leisure is worth
$2,500 an hour at a higher amount of leisure.
! Statement B: Points #2 and #3 imply that leisure is worth $4,000 an hour. As leisure
decreases, it is worth more per hour. But Points B and #3 imply that leisure is worth
$3,500 an hour at a lower amount of leisure.
Only point E can be on the same indifference curve as Points 1, 2, and 3.
This solution reviews more the concepts of indifference curves. Economics is a science of
choices: why consumers choose one situation over another. Much of this course deals with
preferences: do people work, consume, save, and invest more in one scenario or another?
Answer 1.2: E
Work is less important and leisure is more valuable to Joseph on July 3 than on July 1,
since he is richer on July 3.
~ If Joseph prefers leisure to work in some scenario on July 1, he surely prefers leisure
to work in that scenario on July 3.
~ If Joseph prefers work to leisure in some scenario on July 3, he surely prefers work to
leisure in that scenario on July 1.
Statement A says that Joseph is indifferent between an extra hour of work and an extra
$5,000 a year on July 1. We infer that Joseph might prefer the extra hour of leisure on July
3, which is Job j, not Job k.
Statement B is the inverse of Statement A; Joseph might prefer Job k, not Job j, on July 1.
Statement C: Joseph might prefer Job k on July 1 because he needs income. On July 3,
when he has less need f or income, he might prefer Job j.
Statement D: If Joseph prefers Job j on July 1, he surely prefers Job j on July 3.
Statement E is correct. Even when Joseph is wealthy (on July 3) he prefers the extra
$5,000 of income to the extra hour of leisure. When he is poor (on July 1), he surely
prefers the extra income to the extra leisure.
Jacob: Can we say that Joseph prefers Job k on July 1 and Job j on July 3?
Rachel: No. We dont know Josephs preference for leisure vs income.
! Perhaps Joseph has no use for leisure, and prefers Job k on both July 1 and July 3.
! Perhaps Joseph has great use for leisure, and prefers Job j on both July 1 and July 3.
If Josephs tastes are the same on July 1 and July 3 except for the effects of greater wealth
on July 3, we infer Statement E.
Answer 1.1: B
Growing corn requires much capital to buy tractors and harvesters. Capital does not help
growing mushrooms, since all work is done by hand.
The U.S. has more capital per worker, so it has a comparative advantage in growing corn.
U.S. farmers grow corn and exchange it for Mexican mushrooms.
Mexico has less capital per worker, so it has a comparative advantage in growing
mushrooms. Mexican farmers grow mushrooms and exchange them for U.S. corn.
U.S. farms already have all the capital they can use and more investment wont help. But
some Mexican farms may want to grow crops that require much capital. They are willing
to pay higher interest rates for the capital, so investors prefer to invest in Mexican farms.
The current-account deficit reflects national savings minus domestic investment.
! U.S. citizens save money and invest in Mexico.
" U.S. national savings exceeds domestic investment, so the U.S. runs a currentaccount surplus.
Private Investment
Interest Rates
rise
rise
fall
B
C
D
E
fall
no change
fall
rise
fall
fall
no change
rise
rise
rise
no change
no change
Answer 1.1: D
Increased government spending makes it harder for private firms to borrow and causes
people to consume and invest less.
If the government finances its spending with debt, interest rates rise, and private firms
invest less. Consumers expect to pay higher taxes in later years, so they spend less.
If the government finances its spending with higher taxes, consumers spend less and save
less. Interest rates rise, and private firms invest less.
A
B
C
D
E
Real GDP
Private Consumption
Private Investment
Interest Rates
fall
rise
fall
no change
rise
rise
fall
no change
fall
rise
rise
fall
fall
no change
rise
fall
rise
rise
no change
no change
Answer 1.2: D
Increased government spending makes it harder for private firms to borrow and causes
people to consume and invest less.
If the government finances its spending with debt, interest rates rise, and private firms
invest less. Consumers expect to pay higher taxes in later years, so they spend less.
If the government finances its spending with higher taxes, consumers spend less and save
less. Interest rates rise, and private firms invest less.
A
B
C
D
E
Answer 1.3: E
Private Consumption
Gross Domestic
Investment
Permanent Government
Expenditures
pro-cyclical
counter-cyclical
independent
counter-cyclical
pro-cyclical
pro-cyclical
counter-cyclical
counter-cyclical
independent
pro-cyclical
counter-cyclical
pro-cyclical
pro-cyclical
independent
independent
A
B
C
D
E
Private Consumption
Private Investment
Interest Rates
rise slightly
fall slightly
rise slightly
fall slightly
rise slightly
rise
fall
fall
rise
rise
fall
rise
rise
fall
no change
Answer 1.4: B
Increased government spending makes it harder for private firms to borrow and causes
people to consume and invest less.
If the government finances its spending with debt, interest rates rise, and private firms
invest less. Consumers expect to pay higher taxes in later years, so they spend less.
If the government finances its spending with higher taxes, consumers spend less and save
less. Interest rates rise, and private firms invest less.
Some exam problems test relations among the real wage rate, marginal product of labor,
nominal wage rate, price level, real demand for money, and nominal money supply. These
questions combined several course modules. Focus on
! the equilibrium relations, such as real demand for money equals the real money supply,
or the real wage rate equals the marginal product of labor
! the conversion of real values (real wage rate, real interest rate, real GDP) to nominal
values (nominal wage rate, nominal interest rate, nominal GDP)
A
B
Demand curve
moves right (increases)
moves right (increases)
Supply curve
moves right (increases)
no change
C
D
E
Answer 1.1: B
Suppose a worker could sew five shirts in an hour without the new sewing machine, and
firms would hire 1,000 workers at the going rate of $2 an hour. With the new sewing
machine, workers sew 10 shirts an hour, and firms want to hire more workers at the rate
of $2 an hour, so the demand curve shifts to the right.
The supply curve is the same workers as before. At a rate of $2 an hour, the same number
of people want to work. If the real wage rate increases, more of these people take jobs
sewing shirts. That is a shift in the quantity supplied, not a shift in the supply curve.
A
B
increases
increases
increases
no change
C
D
E
increases
no change
no change
decreases
decreases
increases
Answer 1.2: A
The previous question says the demand curve moves to the right (increases) and the
supply curve does not change.
! The intersection of the supply and demand curves occurs further to the right.
! The supply curve is upward sloping, so a point further to the right is higher.
Farther to the right mean a higher quantity of workers. A higher point means a higher real
wage rate.
Demand for
Diamond W ork ers
Numb er of
Diamond W ork ers
Decreases
Increases
Increases
No change
Increases
Decreases
Increases
No change
No change
Decreases
No change
Increases
Increases
Decreases
Decreases
Decreases
No change
Decreases
Increases
No change
A
B
C
D
E
Answer 1.3: C
The supply of diamond workers is the number of workers who want to search for diamonds
at a given real wage rate. At a wage rate of $2 an hour for diamond workers
! When the harvest is bountiful, landowners pay more than $2 an hour for farm laborers.
Most workers find jobs on farms, and only 10,000 want to hunt for diamonds.
! When the harvest is poor, landowners pay less than $2 an hour for farm laborers. Few
workers find jobs on farms, and 50,000 workers want to hunt for diamonds.
Take heed: The demand for farm workers has changed, which affects the reservation wage
for diamond workers and the supply of diamond workers.
The demand for diamond workers has not changed. The owners of diamond search firms
pay a real wage rate based on the marginal product of labor. The market for diamonds has
not changed and the quality of diamond workers has not changed, so the demand curve
does not change.
The greater supply of diamond workers means the supply curve shifts to the right (shifts
down). The intersection of the supply and demand curves is at a higher quantity of labor
and a lower price for labor (real wage rate).
Answer 1.4: D
Statement A: Unskilled labor costs more after the increase in the minimum wage, so less
is demanded. A pizza shop may pay a teen-ager $6.00 an hour because the hours work
is worth $6.00. If the pizza shop must pay $8.50 an hour, it prefers to hire an older worker
with a higher marginal product of labor.
Statement C: Unskilled labor costs more, so firms look for substitutes. Instead of hiring
check-out clerks, supermarkets may install self-checkout lanes with machines (capital) for
reading the prices of goods.
Illustration: Many factories in France are highly automated: machines do the work, with few
human workers. The French say they are more intelligent that other nations, so they more
easily automate their factories. Economists say that restrictions on labor in France, such
as the 35 hour work week, the difficulty of firing unneeded workers, and the high benefits,
reduce the relative value of labor. Firms substitute capital for the high-priced labor.
Statement D: Many teenagers work at the minimum wage, since their marginal product of
labor is low.
! If demand for teen-age labor falls, the unemployment rate increases.
! If the minimum wage rises, more teen-agers leave school and seek jobs, further raising
the unemployment rate. Teen-agers who leave school suffer later on.
Statement E: The equilibrium real wage rate is the marginal product of labor. In a free
labor market, workers with a marginal product of labor of $7.00 an hour receive $7.00 an
hour in wages. If the minimum wage is $10.00 an hour, firms do not hire these workers.
The effects of minimum wage laws are grasped by a comparison with consumer products.
Suppose beef costs $5.00 a pound on free markets, and 40 farms produce 10,000 pounds
of beef apiece. Legislators fear that beef producers are not earning a living wage, so they
mandate that beef be sold for not less than $10.00 a pound.
Consumers substitute cheaper foods for beef. They eat more fowl and fish and less beef.
The quantity of beef demanded declines from 400,000 pounds to 100,000 pounds.
At the higher price, farmers are more willing to sell their cattle for beef. At $5.00 a pound,
farmers supply 400,000 pounds of beef. At $10.00 a pound, farmers are willing to supply
1,000,000 pounds of beef.
Of the 1,000,000 pounds that farmers supply, only 100,000 are bought. The other 900,000
pounds that farmers supply but can not sell are like unemployed labor: people who want
to work but no firm wants to hire them.
The real world is worse. Farm price supports in the U.S. and Western Europe give farmers
extra income through the tax system and transfer payments. Consumers pay more for
food and farmers produce too much, which is sold to third world countries. Farmers in third
world countries can not compete with government subsidized crops. Everyone loses
except the farmers in the U.S. and Western Europe.
Take heed: The terms differ among economists. The natural unemployment rate reflects
the time needed to search for jobs and workers. Some economists say the higher minimum
wage raises the unemployment rate above its natural level. Other economists (like Barro)
do not distinguish among causes of unemployment. The higher minimum wage reduces
the job finding rate and raises the natural unemployment rate.
Answer 1.5: A
Answer 1.6: E
! The demand curve increases because more customers want to eat in restaurants.
! The supply curve does not change because no workers switch from other industries.
Restaurant meals cost more, and the real wage rate rises.
Restaurant meals cost more, and the real wage rate stays the same.
Restaurant meals cost the same, and the real wage rate rises.
Restaurant meals cost the same, and the real wage rate stays the same.
Restaurant meals cost more, and the real wage rate declines.
Answer 1.7: A
The supply curve is upward sloping. To induce employees to work more, owners must pay
them a higher real wage rate. The variable costs of restaurant meals increases, so the
price of the meals increases.
Answer 1.8: B
Statement A: Teen-age workers are now unemployed; they lose.
Statement B: Restaurant workers are paid more and work more. If they want, they could
work the same hours and be paid more, so they surely gain.
Statement C: Reduced competition hurts consumers.
Statement D: Pizza shop owners have to close and move to other cities; they lose.
Statement E: Income inequality has increased, since teen-age workers are unemployed
and restaurant workers earn more.
A
B
C
D
E
20X7
0.50%
4.50%
5.00%
9.00%
10.00%
20X8
0.25%
1.75%
2.00%
10.00%
12.50%
Answer 1.9: E
Use the following reasoning: Let
Z be the natural unemployment rate
F be the monthly job finding rate
S be the monthly job separation rate
! Workers finding jobs each month are F Z.
! Workers leaving jobs each month are S (1 Z).
In equilibrium, workers finding jobs just offset workers leaving jobs.
We solve for the natural unemployment rate before and after the new legislation:
! Before: 4.5 Z = 0.5 (1 Z) A 5Z = 0.5 A Z = 10%
! After: 1.75 Z = 0.25 (1 Z) A 2Z = 0.25 A Z = 12.5%
People sometimes speak of a lawof unintended consequences. Free markets are efficient,
in that they often maximize social welfare. Legislation that interferes with free markets to
help one party generally reduces total social welfare. All parties respond to the legislation
to maximize their own self-interests. Since the total pie is smaller, all parties may be worse
off, including the party that the legislation was designed to help.
The money supply increased 50%, and the marginal product of labor increased 25%
The money supply increased 25%, and the marginal product of labor increased 50%
The money supply decreased 50%, and the marginal product of labor decreased 25%
The money supply decreased 25%, and the marginal product of labor decreased 50%
The money supply increased 50%, and the marginal product of labor decreased 25%
Answer 1.10: A
Real GDP increases 25%, so the real demand for money increases 25% and the real
money supply increases 25%. The price level increases 20%, so the nominal money
supply increases 1.25 1.20 1 = 50.00%.
The nominal wage rate increases 50% and the price level increases 20%, so the real wage
rate increases 1.500 / 1.200 1 = 25.00%
The change in the price level reflects real GDP growth and money growth.
! 1% rise in money supply with no change in real GDP 1% rise in the price level
! 1% rise in real GDP with no change in money supply 1% rise in the price level
From the changes in real GDP and the price level, determine the change in the money
supply. The changes are large, so use a multiplicative model, not an additive model.
The real wage rate is the nominal wage rate divided by the price level. From the changes
in the nominal wage rate and the price level, determine the change in the real wage rate.
If the labor market is in equilibrium, the real wage rate equals the marginal product of labor.
Alternative problems:
give change in money supply; determine the change in the price level and then the change
in the real wage rate and the marginal product of labor.
The money supply increased 50%, and the marginal product of labor increased 25%
The money supply increased 25%, and the marginal product of labor increased 50%
The money supply decreased 50%, and the marginal product of labor decreased 25%
The money supply decreased 25%, and the marginal product of labor decreased 50%
The money supply increased 50%, and the marginal product of labor decreased 25%
Answer 1.11: A
Real GDP increases 25%, so the real demand for money increases 25% and the real
money supply increases 25%. The price level increases 20%, so the nominal money
supply increases 1.25 1.20 1 = 50.00%.
The nominal wage rate increases 50% and the price level increases 20%, so the real wage
rate increases 1.500 / 1.200 1 = 25.00%
The change in the price level reflects real GDP growth and money growth.
! 1% rise in money supply with no change in real GDP 1% rise in the price level
! 1% rise in real GDP with no change in money supply 1% rise in the price level
From the changes in real GDP and the price level, determine the change in the money
supply. The changes are large, so use a multiplicative model, not an additive model.
The real wage rate is the nominal wage rate divided by the price level. From the changes
in the nominal wage rate and the price level, determine the change in the real wage rate.
If the labor market is in equilibrium, the real wage rate equals the marginal product of labor.
Alternative problems:
give change in money supply; determine the change in the price level and then the change
in the real wage rate and the marginal product of labor.
Real GDP decreases 25%, and the marginal product of labor increases 25%
Real GDP decreases 20%, and the marginal product of labor increases 20%
Real GDP decreases 5%, and the marginal product of labor decreases 25%
Real GDP does not change, and the marginal product of labor increases 5%
Real GDP increases 4%, and the marginal product of labor increases 25%
Answer 1.12: E
The real demand for money equals the real money supply. The nominal money supply
increases 25% and the price level increases 20%, so the real money supply increases
1.250 / 1.200 1 = 4.17%.
The real money supply equals the real demand for money, so the real demand for money
increases 4.17%.
The real demand for money is proportional to real GDP, so real GDP increases 4.17%.
The nominal wage rate increases 50% and the price level increases 20%, so the real wage
rate increases 1.500 / 1.200 1 = 25.00%
A
B
C
D
E
Marginal Product of
a W ork er
Marginal Product of
a Machine
7%
3%
7%
3%
5%
$14
$14
$8
$8
$8
$16
$16
$22
$22
$22
Answer 1.13: B
The country has more machines (more capital) in 2049. Think of labor as farm workers and
machines as tractors.
If the country has only a few tractors, each one is used on productive land, so its marginal
product is high.
If the country has many tractors, all farms have tractors. The marginal product is the value
added by an additional tractor. Adding another tractor doesnt do as much as the first
tractors, so the marginal product of a machine declines.
The real interest rate is the marginal value of capital. If farms dont need more tractors, no
one buys more machines, so no one has incentive to produce more machines. Firms dont
borrow money to produce machines, so the interest rate falls.
A
B
C
D
E
Marginal
Product of
Capital
Real Rental
Price
Marginal
Product of
Lab or
Real W age
Rate
Key:
! = the variable increases
! = the variable decreases
Use the following reasoning:
! What is the relation of the capital per worker ratio to the marginal product of capital and
the marginal product of labor?
! What is the relation of the real rental price to the marginal product of capital? The real
rental price equals the real interest rate.
! What is the relation of the real wage rate to the marginal product of labor?
Answer 1.14: B
The capital per worker increases, so the marginal product of labor and the real wage rate
increase and the marginal product of capital and the real rental price decrease/
A
B
C
D(g, y)
>0
<0
>0
D(g, y*)
>0
<0
0
D
E
>0
<0
<0
>0
You may think of the question as: If y increases with no change in y* (or vice versa) does
g increase or decrease?
Answer 1.1: E
Take heed: The text uses plus and minus signs to show the sign of the partial derivative.
Exam problems may use partial derivatives, correlations, or plus/minus signs.
Current Output
W
Y
Z
20,000
30,000
30,500
28,000
40,000
31,000
Which country has the highest growth rate in 20X6 and which has the greatest output level
at 12/31/20X6?
A
B
C
D
E
W
Y
Y
W
W
W
Y
Z
Y
Z
Answer 1.2: D
We compute the growth rates in 20X6 and the output level at 12/31/20X6.
Country
Current Output
Steady State
Output
Growth rate
12/31/20X6
Output Level
W
Y
Z
20,000
30,000
30,500
28,000
40,000
31,000
4.00%
3.33%
0.16%
20,800
31,000
30,550
Labor moves easily across U.S. states but not between African countries.
U.S. states have similar legal and court systems; African countries do not.
U.S. states have the same currency and federal taxes; African countries do not.
U.S. states have similar public education systems; African countries do not.
U.S. states have never had large economic differences; African wars caused large
differences that convergence could not overcome.
Answer 1.4: E
The civil war in the U.S. was as severe (for its time) as most African wars. Europe has also
had absolute convergence, though its world wars were more severe than African wars.
GDP falls in Europe and the U.S. and it rises in China and India.
Employment falls in Europe and the U.S. and it rises in China and India.
GDP rises everywhere, but more in Europe and the U.S. than in China and India.
GDP rises everywhere, but less in Europe and the U.S. than in China and India.
Employment rises everywhere, but more in Europe and the U.S. than China and India.
Answer 1.5: D
The steady state income per worker of China and India is the same as that of the U.S. and
Europe, so they show absolute convergence. They have lower current income per worker,
so their income per worker rises faster than that of the U.S. and Europe.
International trade helps all parties, as countries make the goods and services for which
they have comparative advantages.
A
B
C
D
E
20X7
20%
40%
20%
40%
20%
20X8
40%
50%
50%
40%
60%
Answer 1.1: C
20X7: For a flat tax of 20%, the marginal tax rate is the tax rate of 20%.
20X8: For a flat tax of 40%, the marginal tax rate is the tax rate of 40%. Workers also
return the tax refund of $10,000 linearly as 10% of their income. The combination is a 50%
flat tax rate.
The marginal tax rate is the slope of the graph, where the horizontal axis is pre-tax income
and the vertical axis is the tax liability. In 20X8, the tax liability is
$10,000 Y / $100,000 + Y 40% = 50% Y
Intuition: A person earning $0 gets a tax credit of $10,000, and a person earning $100,000
get no tax credit. The tax credit has a 10% tax for all taxpayers.
! Pre-tax income is a uniform distribution from $10,000 to $110,000.
! The tax rate is 50%, not 40%.
A
B
C
D
E
Joseph
Benjamin
Ephraim
more
more
more
fewer
fewer
more
same
fewer
same
fewer
more
fewer
fewer
more
fewer
Answer 1.2: E
For all three workers, the marginal tax rate increases, so each one works fewer hours.
Jacob pays less tax in 20X7; Rachel may pay more or less
Rachel pays more tax in 20X7; Jacob may pay more or less
Both Jacob and Rachel pay less tax in 20X7
Jacob pays less tax in 20X7; Rachel pays more tax
Both Jacob and Rachel may pay more or less tax in 20X7
Answer 1.3: A
Jacob pays less tax in 20X7; Rachel may pay more or less
To solve this problem, we determine
! The total tax each person would pay if he/she worked the same amount.
! Whether each person works more or less in 20X8 than in 20X7.
We reason through each scenario.
! If the same work leads to less tax and the person works less in 20X8, he/she surely
pays less tax.
! If the same work leads to more tax and the person works less in 20X8, he/she may pay
more or less tax.
! If the same work leads to more tax and the person works more in 20X8, he/she surely
pays more tax.
! If the same work leads to less tax and the person works more in 20X8, he/she may pay
more or less tax.
A higher marginal tax rates induces a person to work less, though we dont know how
much less. Raising the marginal tax rate from 20% to 40% may induce a person to work
one hour less or not to work at all at the 40% marginal tax rate. For example,
! Raising the tax rate from 1% to 2% has a small effect on the hours worked.
! Raising the tax rate from 50% to 100% causes the person to stop working.
The marginal tax rate increases for both Jacob and Rachel, so both work less in 20X7.
The decrease in work lowers pre-tax income. One is tempted to reason that:
! If the marginal value of leisure is small, the decrease in work is small, and the pre-tax
income declines little.
! If the marginal value of leisure is large, the decrease in work effort is large, and the pretax income declines much.
This reasoning is a good way to start, but it is not well worded. At equilibrium, the marginal
value of leisure equals the marginal variance of the work income. Raising the marginal tax
rate reduces the marginal variance of work income. To determine how much less the
person works, we examine the slopes of the value of leisure and work income.
! If the value of leisure and of work are relatively flat (the marginal value varies little by
amount of work or leisure), a decrease in the after-tax wage causes a large decrease
in work effort.
! If the value of leisure and of work are relatively steep (the marginal value varies greatly
by amount of work or leisure), a decrease in the after-tax wage causes a small
decrease in work effort.
Take heed: For the final exam, focus on the intuition. The exam problems do not compute
the exact amount by which work effort increases or declines.
We also consider the income effect.
If Jacobs work hours do not change, his after-tax income is
! 20X7: $35,000 (1 20%) = $28,000
! 20X8: $35,000 40% ($35,000 $20,000) = $29,000
Jacob has more income in 20X8, so the income effect induces him to work less.
If Rachels work hours do not change, her after-tax income is
! 20X7: $45,000 (1 20%) = $36,000
! 20X8: $45,000 40% ($45,000 $20,000) = $35,000
Rachel has less income in 20X8, so the income effect induces her to work more.
The substitution effect causes Rachel to work less. We dont know which effect is stronger,
so we dont know if she works more or less.
Take heed: Some exam problems separate the income effect from the substitution effect,
giving easier problems. For your exam preparation, first examine each effect separately.
The exam problems are not intricate, and they do not test mathematical ability. If you
understand the concepts and review the practice problems, you can solve exam problems.
For this exam problem, interpret low tax rates as a tax rate that approaches zero and high
tax rates as a tax rate that approaches one. The actual demarcation point depends on
other characteristics of the economy and the workers. Barro believes the dividing point is
somewhere between 50% and 75%
Answer 1.4: D
We use the following reasoning:
! At a zero tax rate, the total tax revenue is zero, so an increase in the tax rate increases
the total tax revenue.
! At a 100% tax rate, people dont work, since they keep none of their earnings, and total
tax revenue is zero. A decrease in the tax rate induces some people to work, so total
tax revenue increases.
Illustration: Suppose workers earn $10 an hour. If the tax rate is zero, people work 2,000
hours a year. If the tax rate is Z%, people work (1 Z%) 2,000 hours a year.
~ If the tax rate is 10%, people work 90% 2,000 = 1,800 hours a year. Total tax
revenue is 10% $10 1,800 = $1,800.00 per worker.
~ If the tax rate is 11%, people work 89% 2,000 = 1,780 hours a year. Total tax
revenue is 11% $10 1,780 = $1,958.00 per worker.
At low tax rates, total tax revenue increases as the tax rate increases.
~ If the tax rate is 90%, people work 10% 2,000 = 200 hours a year. Total tax revenue
is 90% $10 200 = $180.00 per worker.
~ If the tax rate is 91%, people work 9% 2,000 = 180 hours a year. Total tax revenue
is 91% $10 180 = $162.00 per worker.
At low tax rates, total tax revenue decreases as the tax rate increases.
Intuition: At a 0% tax rate, total tax revenue is zero. At a 100% tax rate, people do no
work, since they keep nothing of what they earn, and total tax revenue is again zero. At
rates between 0% and 100%, people do some work, so total tax revenue is positive. We
infer that at low tax rates, total tax revenue increases from zero to a positive amount, and
at high tax rates, total tax revenue decreases from a positive amount to zero.
Algebra: In the example here, people work 2,000 (1 Z) hours, where Z is the tax rate.
The total tax revenue is 2,000 (1 Z) Z. The partial derivative with respect to Z is
2,000 (1 2Z).
~ If Z < 50%, the partial derivative is positive and total tax revenue increases.
~ If Z = 50%, the partial derivative is zero and total tax revenue stays the same.
~ If Z < 50%, the partial derivative is negative and total tax revenue decreases.
The incentive effects are stronger when the tax rate is progressive. This illustration uses
flat tax rates, with weaker but still evident effects.
In countries with high marginal tax rates, such as Switzerland, total tax revenue decreases,
because people have less incentive to work. If the tax rate were lower, the government
would have more tax revenue and the workers would have more after-tax income.
Jacob: If reducing the tax rate causes people to work more and raises total tax revenue,
the government has more money for social programs. Why would anyone oppose a tax
reduction?
! Conservatives want to reduce the tax rate.
! Progressives want more total tax revenue for social programs.
Rachel: Progressive tax rates reduce income inequality. Many people dont like inequality.
They would like everyone to be wealthy. But if not everyone can be wealthy, they prefer
everyone to be poorer if it reduces economic differences.
Substitution Effect
Fewer Hours
More Hours
More Hours
Fewer Hours
Fewer Hours
Fewer Hours
More Hours
More Hours
No Change
Fewer Hours
Answer 1.5: E
Abigail has pre-tax income of $33,333 in 20X7.
! 20X7: The tax liability is 20% $33,333 = $6,667
! 20X8: The net tax liability is 50% $33,333 $10,000 = $6,667
As worked out above, a tax refund that decline from $10,000 to $0 is like a tax refund of
$10,000 and an extra 10% tax rate.
If Abigail works the same hours in 20X8, her net tax liability is the same as in 20X7, so the
income effect is zero.
If the substitution effect is zero, the income effect by worker is
! A worker who earns less than $33,333 pays less tax and works fewer hours.
! A worker who earns more than $33,333 pays more tax and works more hours.
The marginal tax rate is higher in 20X8 than in 20X7 for all workers. The substitution effect
causes all workers to work fewer hours.
Substitution Effect
Fewer Hours
More Hours
More Hours
Fewer Hours
Fewer Hours
Fewer Hours
More Hours
More Hours
No Change
Fewer Hours
Answer 1.6: B
Abigail has pre-tax income of $33,333 in 20X7.
! 20X7: The tax liability is 20% $33,333 = $6,667
! 20X8: The net tax liability is 50% $33,333 $10,000 = $6,667
The marginal tax rate is higher in 20X8 than in 20X7 for all workers. The substitution effect
causes all workers to work fewer hours.
Because of the substitution effect, Abigail works fewer hours in 20X8. Her net tax liability
is smaller than in 20X7, so her after-tax income is lower and the income effect makes her
work more hours.
Rebecca
Leah
Fewer
Fewer
Fewer
More
More
Fewer
Fewer
More
More
Fewer
No Change
More
More
No Change
Fewer
Answer 1.7: C
Consider Rebecca, who earns $40,000 in 20X7.
! In 20X7, she pays tax of 20% $40,000 = $8,000.
! In 20X8, she keeps 1 40% = 60% of the tax refund. She pays tax of 40% $40,000
= $16,000. Her net tax liability is $16,000 $6,000 = $10,000.
! She has less after-tax income in 20X8. By the income effect, she works more hours.
Similar analysis for Sarah and Leah give Choice C for the answer.
Rebecca
Leah
Fewer
Fewer
Fewer
More
More
Fewer
Fewer
More
More
Fewer
No Change
More
More
No Change
Fewer
Answer 1.8: A
The marginal tax rate increases from 20% to 50% for all workers, so all workers work fewer
hours by the substitution effect.
A
B
C
D
E
Country W
Country Z
20%
20%
20%
40%
40%
15%
30%
60%
30%
60%
Answer 1.9: B
Let Y be the pre-tax income.
In Country W:
! The tax is 20% Y.
! The marginal tax rate is M(20% Y)/MY = 20%.
The marginal tax rate equals the tax rate for all workers.
In Country Z:
! The tax rate is 30% Y / $100,000.
! The tax is Y 30% Y / $100,000 = 30% Y2 / $100,000.
! The marginal tax rate is M(30% Y2 / $100,000)/MY = 60% Y / $100,000.
For a person earning $50,000, the marginal tax rate is 60% $50,000 / $100,000 = 30%.
A
B
C
D
E
Country W
Country Z
20%
20%
20%
10%
10%
10%
20%
30%
10%
20%
Answer 1.10: B
Country W: The tax rate is 20% for all workers.
Country Z: To simplify the mathematics, we use units of $100,000. The pre-tax income is
Y, which ranges from 0 ($0) to 1 ($100,000).
! The tax rate is 30% Y.
! The tax is Y 30% Y = 30% Y2.
We integrate the tax over the uniform distribution from 0 to 1 to get total tax revenue:
I 30% Y2 MY = 30% a Y3 from 0 to 1 = 10%.
The average pre-tax income is $50,000, or 0.5 in units of $100,000.
The average tax rate is 10% / 0.5 = 20%.
A
B
C
D
E
Country W
Country W
Country Z
Country Z
Country W
Country W
Country Z
Country W
Country Z
Equal
Answer 1.11: A
If people do not change their work hours because of the tax, the two countries have the
same pre-tax income, the same average tax rate, the same total tax revenue, and the
same after-tax income.
We group workers by pre-tax income:
For the average tax per capita, assume one taxpayer. We use units of $100,000
The total tax revenue is number of workers times 10,000 in Country W and Country Z.
The marginal tax rates are 20% in Country W and 60% y in Country Z,
Answer 1.1: A
For the Cobb-Douglas production function, the marginal product of capital equals
MPK = MY / MK
= " AK -1 L 1-
= " AK K -1 L 1-
= " AK L 1- (1/K)
= " (Y/ K)
The elasticity of income with respect to capital is MY / MK (K / Y) = (MPK K) / Y
= " (Y/ K) K / Y = " (see equation 3.20 on page 67)
MPK is the effect on Y from a change in K, holding A and L fixed:
Take heed: The elasticity of income with respect to capital is the percentage change in
income from a percentage change in capital. If " = 40%, a 5% increase in capital raises
income 5% 40% = 2%.
The microeconomics and regression analysis courses have full modules on elasticity. If you
have difficulty with elasticities, review the practice problems from microeconomics.
! The derivative of income with respect to capital is MY / MK.
! The elasticity of income with respect to capital is (MY/Y) / (MK/K) = MY / MK (K/Y).
As each of these parameters increases (holding other parameters constant), does the
growth rate of capital per worker increase, decrease, or remain the same?
k
A
B
C
D
E
_
`
`
`
_
*
`
`
`
`
_
_
`
`
`
`
_
_
`
_
_
_
_
_
`
_
rate *, and it supplies funds for further growth in capital per worker. As the capital per
worker grows, the savings needed to support depreciation and population growth is larger.
When capital is large enough that savings just offsets depreciation and population growth
the economy is in its steady state.
Savings and population growth differ by country. They are (in part) culturally determined.
Some cultures place more stress on large families than others do, or they are more
opposed to birth control, family planning, and abortion. Contrast the large families in the
Middle East and Latin America with small families in Western Europe, Canada, and China.
We do not know if economic growth in the Middle East and Latin America will reduce the
population growth rate to European levels or if Islamic and Catholic cultures will continue
with large families.
Some cultures have higher savings rates than others. Japan and other Asian countries
have higher savings rates than North America and Western Europe.
! An economy with a high population growth rate and a low savings rate may be near its
steady state capital per worker even at a low capital level (Nigeria, Congo).
! An economy with a low population growth rate and a high savings rate may be below
its steady state capital per worker even at a high capital level (Japan).
The countries above in parentheses are illustrations to help you understand the concepts.
Take heed: Distinguish between capital and the technology level. A higher technology level
raises the marginal product of capital and leads to more capital per worker. To remember
this, think of two workers:
! Jacob lives in a shepherd culture, with no knowledge of industrial society (A is low). The
only capital is knives, jars, and tents.
! Jacques lives in Paris and works in an information-age society (A is high). He uses cellphones and laptop computers (high capital).
Take heed: Some exam problems specify the Solow growth model. Unless specified
otherwise, the exam problems use the Solow growth model.
The Solow growth model has several forms: fixed values for A, s, and n; exogenous and
endogenous changes in the parameters. The type of model should be clear from the
context of the exam problem.
Quantity
Price
20X8
Bread
W ine
Bread
W ine
26000
4
5000
10
32000
5
4000
20
Use the average prices in 20X7 and 20X8 as base prices (the chain-link method).
A.
B.
C.
D.
E.
F.
G.