Advanced Macroeconomics

Full-time Students 2017

Professor Hartwell

Homework Set

Instructions

1. Please do NOT forget to put your name on your assignment.

2. Please do ALL the questions. If no attempt is made, I will not give any partial credit.
3. Do your own work and submit your own answers.You may work in groups, but if the
explanations are the same on two (or more) assignments, you ALL will fail.
4. Make sure the assignment is handed in (hard copy only) at the start of class onNovember
16th, 2017. Late assignments will face a penalty, and very late assignments will not be
accepted.

Multiple Choice[2 points each]

1. Using the expenditure approach, investment includes:

a. household residential expenditures
b. firm structures, equipment, and inventories
c. fixed firm and household structures, equipment, and inventories
d. government and firm equipment expenditures
e. government defense and firm equipment expenditures

2. Real GDP is the ________ of all goods and services produced in a period of time
using ________ prices.
a. summation; current
b. value; 1945
c. value; base year
d. projection; base year
e. value; 1970

3. Consider two countries, labeled 1 and 2. Each has the production function
̅ , i = 1 or 2. If the only difference between the two countries is that A1>
A2,
a. Country 2 will not produce anything, ceteris paribus.
b. Country 2 will produce more than Country 1, ceteris paribus.
c. Country 1 will produce more than Country 2, ceteris paribus.
 d. Each will produce the same amount, ceteris paribus.
e. Not enough information is given.

4. The equation MPK = r* yields:

a. the amount of capital in an economy
b. the optimal amount of capital, K*, a firm fires
c. the optimal amount of labor, L*, a firm hires
d. the quantity of capital a firm wants to hire at any rental rate of capital
e. None of these answers are correct.

5. The Solow model describes:

a. how saving rates are determined
b. the static relationship between capital and output
c. how savings, population growth, and technological change affect output over
the long-run
d. how savings, population growth, and technological change affect output in a
single period
e. what constitutes technological change

6. In the equation (Y-T-C) + (T-G) + (EX-IM) = I, the term (Y-T-C) is ________ and
(T-G) is ________.
a. aggregate saving; tax revenues
b. private saving; government saving
c. foreign saving; private saving
d. the government debt; investment
e. the trade balance; the financial account

7. Which of the following is an exogenous variable in the Solow model?

a. Productivity
b. the initial capital stock
c. depreciation rate
d. saving rate
e. All of these answers are correct.

8. Consider the two production functions in Figure 1 below, representing two countries. Which
of the following is true?

i. At points a and b, each country has the same per capita capital stock but different factor
productivity.
ii. Points a and c represent the same country but with different factor productivity.
iii. Points b and d represent the same country but with different stock of per capita capital.
a. i and iii
b. iii only
c. i only
d. i and ii
e. ii only
 Figure 1: Production Functions

9. In a closed-economy model of the loanable funds market, reductions in savings lead

directly to:
a. An increase in the real interest rate
b. An increase in investment
c. A decrease in consumption
d. A decrease in the real interest rate
e. An increase in government spending

10. An economy’s ________ is equal to its ________.

a. consumption; income
b. expenditure on goods and services; output
c. expenditure on goods; expenditure on services
d. investment; government expenditures
e. taxes; net exports

Testing Your Understanding

11. [5 points] True or False? For the profit-maximizing firm, if the real interest rate is less
than the marginal product of capital, the firm should invest in more capital. Explain
your answer.
True.
If the real interest rate is lower than the marginal product of capital, then the
cost of investing is lower than the return from additional capital therefore the
firm should invest more capita.
 [5 points] True or False? In the Solow model, the addition of effective workers lowers
the amount of capital needed for the break-even point.
False
The addition of effective workers will reduce the capital per worker so a larger
amount of capital will be required in order to reach break-even point.

[5 points] True or False? If the marginal product of labor equals wages, firms should
hire more workers.
False.
The marginal revenue productivity theory states that a profit maximizing
firm will not hire workers once the marginal product of labor equals the
wages because it is not reasonable for the firm to pay its workers more than
revenues from them.

12. [15 points] Suppose the production function in medieval Europe is Y = K0.5L0.5, where K
is the amount of land and L is the amount of labor. The economy begins with 100 units of
land and 100 units of labor. Find a numerical answer to each of the following questions.
a. How much output does the economy produce?
Y= F(K,L)
100^0.5 * 100^0.5= 100

b. What are the wage and the rental price of land?

Wage = F( K, L+1) - F(K,L)= (100^0.5* 101^0.5)- (100^0.5*100^0.5)= 0.50
Rental Price = F(K+1,L)- F(K,L) = (101^0.5*100^0.5)-( 100^0.5*100^0.5)= 0.50

c. If a plague kills half the population, what is the new level of output?
Y= F(K,L)= 100^0.5 (100/2^0.5)=70.71

d. What is the new wage and rental price of land?

Wage = F( K, L+1) - F(K,L)= (100^0.5* 51^0.5)- (100^0.5*50^0.5)= 0.70
Rental Price= F(K+1,L)- F(K,L) = (101^0.5*50^0.5)-( 100^0.5*50^0.5)= 0.35

13. [15 points] Use the model of the small open economy to predict what would
happen to the trade balance, the real exchange rate, and the nominal exchange rate
in response to each of the following events.

a. A fall in consumer confidence about the future induces consumers to spend less
and save more.
As a result of the fall in consumer confidence, the consumers will spend less
leading to an increase in savings which results in a higher supply of money to
be invested abroad. This leads to a fall in the real exchange rate. Since the
exchange rate goes down, the exports increase and imports decrease and this
results in trade balance increase. The nominal exchange rate also falls due to
no change in prices.
 b. The introduction of a stylish line of BMWs makes some consumers prefer foreign
cars overdomestic cars.
The above situation leads to a rise in imports because more people want to
buy cars from abroad rather than locally leading to a shift in the Net exports
curve. Trade balance does not change because neither do savings change and
nor does investment. The real exchange rate decreases to ensure the net
exports= savings - investment .Since prices do not change the nominal
exchange rate follows the real exchange rate and both of them fall.

c. The introduction of bankomats (ATMs) reduces the demand for money.

The introduction of ATM has no effect on variables. The price level changes in
order to bring equilibrium between demand and supply. As a result of price
level increase, the nominal exchange rate drops while the real exchange rate
remains the same. Trade balance is not affected.

14. [15 points] Use the neoclassical model of investment to explain the impact of each of the
following events on three things: the rental price of capital, the cost of capital, and
investment

d. An alien invasion destroys part of the capital stock.

Rental price of capital: As per diminishing marginal returns principle, as the
capital stock decreases due to the alien invasion, the marginal product of
capital and the rental price of capital increases.
Cost of capital: Remains the same
Investment: Due to increase in marginal product of capital as opposed to a
constant cost of capital, firms will prefer to invest to be more profitable. So,
investment increases.

e. Monetary tightening results in a higher real interest rate.

Rental price of capital: Marginal product of capital does not change and
therefore the rental price of capital does not change either
Cost of capital: Rise in real interest rate results in an increase in the cost of
capital
Investment: Due to increase in cost of capital, it is not profitable for the
company to invest any further and thus, investments reduce

f. A sudden influx of refugees increases the size of the labor force.

Rental price of capital: An increase in labor force will increase the marginal
product of capital and an increase in the rental price of capital.
Cost of capital: Remains the same
Investment: Due to increase in marginal product of capital as opposed to a
constant cost of capital, firms will prefer to invest to be more profitable. So,
investment increases.
2. [30 points] In class we discussed conditional and unconditional convergence, a
crucial issue in growth and macroeconomics.

a. [5 points] What is the theoretical basis for unconditional convergence, using the
Solow growth model?
The idea of convergence in economics is based on the theory that the
poorer countries grow at a rate higher than the richer economies. This is due to
the fact that the diminishing returns are not as high as that of developed
economies. Unconditional convergence exists when the growth rate reduces
due to approaching steady state. Lower GDP in the beginning leads to a higher
growth rate thus implying that the poverty would soon disappear on its own.

b. [5 points] What are some reasons that unconditional convergence has not been
observed in the real world, apart for a small sample of OECD countries over a
short time span?
The theory is based on many assumptions that do not hold true in the real
world. The theory assumes that technology and capital are freely available in
the poorer countries. However, in reality capital is limited in these countries
and the best technology is too expensive. When the smaller economies acquire
all the existent knowledge base of the developed countries over a period of
time, they can no longer catch up with the growth of developed nations. The
population growth of countries is different too. Thus, we notice that
unconditional convergence has not been observed in the real world apart from
a small sample of OECD countries over a short span of time.

c. [20 points] Summarize Mankiw, Romer, and Weil’s (1992) findings on

conditional convergence. What do their findings also suggest about the impact of
population growth on economic growth?
Mankiw, Romer and Weil in their 1993 paper study the two basic implications
of the Solow model being the savings rate and the population growth rate on
steady state income levels and find that even though the results in terms of
direction are same as that seen in the Solow Model, the impact they have has
been highly underrated. They also found that more than half of the cross
country variation in income per capita can be explained by savings rate and
population growth rate. Thus, maintaining the assumption of diminishing
returns to capital, they augment the Solow model by adding a variable which is
human capital. The exclusion of human capital from the Solow model explains
why the influence of savings and population growth rate was too large. Higher
savings or lower population growth rate leads to a higher level of income and
therefore a higher level of human capital. Human capital was described to be
correlated with savings rate and population growth rate which implied that
omitting the same resulted in a bias of the coefficients attached with s and
n.They re-measure the coefficients for s and n and all these changes lead
to the new model being able to explain 80% of the cross country variations.
Mankiw, Romer and Weil show that based on savings rate, population growth
rate and human capital we can find negative correlation between growth rate
and initial income per capita. Mankiw, Romer and Weil suggest that the
international differences in per capita income can be best understood using the
augmented Solow Model. The conclusions arrived upon in their paper were-
1) It was found that even in the absence of externalities, physical stock has a
larger impact on income per capita than Solow Model suggests. Higher savings
rate increases the income steady state. Solow model suggests that the
elasticity of income with respect to savings rate is 0.5 while Augmented Solow
Model suggests that it is 1.
2) The elasticity of income with respect to the physical capital stock is roughly
the same as capital's share in income.
3)Population growth also has a higher impact on per capita income than
indicated by the Solow Model. Higher population growth leads to the
distribution of income more thinly over population of workers in the
Augmented Solow Model due to consideration of human capital. Solow model
measures elasticity of income with respect to population growth as -0.5 as o
pposed to Augmented Solow model which states elasticity to be -2.
4)The Augmented Solow Model points out that countries with similar
technology and rates of accumulation and population growth should converge
in income per capita. However, it suggests this happens more slowly than what
the Solow Model suggests. The traditional Solow model states that an e
economy reaches halfway to steady state in 17 years whereas the Augmented
Solow Model states 35 years.