Macro TB
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School
Wilfrid Laurier University *
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Course
EC 390
Subject
Economics
Date
Feb 20, 2024
Type
Pages
53
Uploaded by DukeJaguarMaster1027
Difficulty: moderate
Classification: application
AACSB: application of knowledge
37) As the quantity of labor increases, the marginal product of capital
A) is constant.
B) increases.
C) decreases.
D) may either increase or decrease.
Answer: B
LO: 4.5: List the properties of the production function, and explain why it is useful to assume
these properties.
Difficulty: difficult
Classification: application
AACSB: application of knowledge
38) The assumption that the marginal product of labor decreases as the labor input increases
implies that
A) output decreases as the labor input increases.
B) the wage increases as the labor input increases.
C) the production function is concave.
D) the production function shifts upward.
Answer: C
LO: 4.5: List the properties of the production function, and explain why it is useful to assume
these properties.
Difficulty: moderate
Classification: application
AACSB: application of knowledge
!39) The production function is concave in capital because
A) the contribution to production of each additional unit of capital decreases.
B) the marginal product of capital is increasing.
C) the marginal product of labor is decreasing.
D) the cost of loans increases with their quantity.
Answer: A
LO: 4.5: List the properties of the production function, and explain why it is useful to assume
these properties.
Difficulty: moderate
Classification: application
AACSB: application of knowledge
40) An increase in total factor productivity could be the result of
A) adverse weather.
B) the addition of new machinery.
C) new hires.
D) the introduction of new manufacturing methods.
Answer: D
LO: 4.5: List the properties of the production function, and explain why it is useful to assume
these properties.
Difficulty: easy
Classification: application
AACSB: analytical thinking
41) If the firm hires more labor, everything else held constant, then
A) the marginal product of labor falls.
B) output decreases.
C) there is an increase in the marginal product of labor.
D) total factor productivity falls.
Answer: A
LO: 4.5: List the properties of the production function, and explain why it is useful to assume
these properties.
Difficulty: moderate
Classification: application
42) An increase in total factor productivity
A) changes neither the slope nor the position of the production function.
B) changes the slope but not the position of the production function.
C) changes the position but not the slope of the production function.
D) changes both the slope and the position of the production function.
Answer: D
LO: 4.5: List the properties of the production function, and explain why it is useful to assume
these properties.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
43) The profit-maximizing quantity of labor equates the marginal product of labor with
A) total factor productivity.
B) the marginal product of capital.
C) the real wage.
D) the average product of labor.
Answer: C
LO: 4.6: Show how the representative firm optimizes given its production technology to
determine labor demand and output.
Difficulty: moderate
Classification: application
AACSB: application of knowledge
44) When the representative firm maximizes profits
A) production is at its maximum.
B) the slope of the production function is at its flattest.
C) labor costs are minimized.
D) the marginal product of labor equals the wage.
Answer: D
LO: 4.6: Show how the representative firm optimizes given its production technology to
determine labor demand and output.
Difficulty: moderate
Classification: application
AACSB: application of knowledge
45) Labor demand is decreasing in the wage because
A) the substitution effect is larger than the income effect.
B) the income effect is larger than the substitution effect.
C) the marginal product of labor is decreasing in labor.
D) the marginal product of labor is increasing in labor.
Answer: C
LO: 4.7: Determine the effects of changes in the representative firm's environment on its labor
demand and output choices.
Difficulty: easy
Classification: application
AACSB: analytical thinking
!4.2
True/False Questions
1) True or False: The consumer's indifference curves are concave.
Answer: FALSE
LO: 4.1: List the properties of the representative consumer's preferences, and explain why it is
useful to assume these properties.
Difficulty: moderate
Classification: application
AACSB: application of knowledge
2) True or False: For a consumer, more is always preferred to less.
Answer: TRUE
LO: 4.1: List the properties of the representative consumer's preferences, and explain why it is
useful to assume these properties.
Difficulty: easy
Classification: application
AACSB: application of knowledge
3) True or False: An indifference curve is downward sloping because of the consumer's
preference for diversity.
Answer: FALSE
LO: 4.1: List the properties of the representative consumer's preferences, and explain why it is
useful to assume these properties.
Difficulty: moderate
Classification: application
AACSB: application of knowledge
4) True or False: The consumer's budget constraint is bowed in toward the origin.
Answer: FALSE
LO: 4.2: Construct the representative consumer's budget constraint.
Difficulty: difficult
Classification: application
AACSB: application of knowledge
5) True or False: A lump sum tax is a tax that is independent of the consumer's actions.
Answer: TRUE
LO: 4.2: Construct the representative consumer's budget constraint.
Difficulty: moderate
Classification: application
AACSB: application of knowledge
6) True or False: Dividend income depends on the consumer's behavior.
Answer: FALSE
LO: 4.2: Construct the representative consumer's budget constraint.
Difficulty: moderate
Classification: application
AACSB: application of knowledge
7) True or False: The consumer chooses a consumption bundle that is as close as possible to
the
budget constraint, but not on it.
Answer: FALSE
LO: 4.3: Show how the consumer optimizes given his or her budget constraint to determine
labor supply and consumption.
Difficulty: easy
Classification: application
AACSB: analytical thinking
8) True or False: When the consumer optimizes, the marginal rate of substitution of leisure for
consumption equals the real wage rate.
Answer: TRUE
LO: 4.3: Show how the consumer optimizes given his or her budget constraint to determine
labor supply and consumption.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
9) True or False: Given our assumptions about consumer preferences, the consumer could be
indifferent between two or more consumption bundles when he or she is optimizing.
Answer: FALSE
LO: 4.3: Show how the consumer optimizes given his or her budget constraint to determine
labor supply and consumption.
AACSB: application of knowledge
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10) True or False: If taxes go down, then the consumer substitutes consumption for leisure.
Answer: FALSE
LO: 4.4: Determine the effects of changes in the representative consumer's environment on his
or her choices.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
11) True or False: If dividend income declines, then consumption and leisure fall.
Answer: TRUE
LO: 4.4: Determine the effects of changes in the representative consumer's environment on his
or her choices.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
!12) True or False: If the real wage decreases, then consumption rises and leisure must fall.
Answer: FALSE
LO: 4.4: Determine the effects of changes in the representative consumer's environment on his
or her choices.
Difficulty: easy
Classification: application
AACSB: analytical thinking
13) True or False: Increasing returns to scale means that, if both factors of production double,
then output more than doubles.
Answer: TRUE
LO: 4.5: List the properties of the production function, and explain why it is useful to assume
these properties.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
14) True or False: If the firm has more capital, this causes the marginal product of labor to
decline.
Answer: FALSE
LO: 4.5: List the properties of the production function, and explain why it is useful to assume
these properties.
Difficulty: difficult
Classification: application
AACSB: application of knowledge
15) True or False: As the labor input falls, holding constant the capital input, the marginal
product of labor increases.
Answer: TRUE
LO: 4.5: List the properties of the production function, and explain why it is useful to assume
these properties.
Difficulty: moderate
Classification: application
AACSB: application of knowledge
16) True or False: The firm maximizes the welfare of its workers.
Answer: FALSE
LO: 4.6: Show how the representative firm optimizes given its production technology to
determine labor demand and output.
Difficulty: moderate
Classification: application
AACSB: application of knowledge
!17) True or False: When the firm is optimizing, the marginal product of labor equals the market
real wage.
Answer: TRUE
LO: 4.6: Show how the representative firm optimizes given its production technology to
determine labor demand and output.
Difficulty: easy
Classification: application
AACSB: application of knowledge
18) True or False: If the firm pays a proportional tax on its profits, this causes the firm's output to
fall.
Answer: FALSE
LO: 4.7: Determine the effects of changes in the representative firm's environment on its labor
demand and output choices.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
19) True or False: If the firm faces a higher real wage rate, it hires less labor.
Answer: TRUE
LO: 4.7: Determine the effects of changes in the representative firm's environment on its labor
demand and output choices.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
20) True or False: If total factor productivity decreases, then profits must go down for the firm.
Answer: TRUE
LO: 4.7: Determine the effects of changes in the representative firm's environment on its labor
demand and output choices.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
!4.3
Essay Questions
1) Show the indifference curves for a consumer who has, respectively, perfect substitutes
preferences and perfect complements preferences. Comment on how each set of preferences
does
or does not satisfy standard properties that we assumed consumer preferences have.
Answer: Perfect substitutes preferences imply indifference cures that have constant marginal
rate of substitution — they are downward-sloping straight lines. These preferences satisfy more-
is-preferred to less, but do not satisfy preference for diversity, as the consumer does not care at
all about diversity in his or her consumption bundle. Perfect complements preferences are right
angles along a straight line from the origin. These preferences satisfy more-is-preferred to less.
With respect to preference for diversity, these preferences exhibit this property to an extreme.
Holding constant the consumption of one good and giving the consumer more of the other good
does not make him or her better off, but giving the consumer more of both goods always makes
him or her better off.
LO: 4.1: List the properties of the representative consumer's preferences, and explain why it is
useful to assume these properties.
Difficulty: moderate
Classification: application
AACSB: application of knowledge
2) Explain why we assume that taxes are lump sum in our consumer behavior model. Are there
taxes in the real world that are lump sum? Why or why not?
Answer: Lump sum taxes are assumed simply because it makes our life easier as macro
modelers to assume that taxes are independent of the consumer's actions. But doing so in
many
circumstances does not do much harm. In practice, essentially no taxes are lump sum. Sales
taxes
and income taxes, for example, are all affected by how we behave — how much goods and
services we buy, or how hard we work. There is always some lump sum tax that some
consumer
could not pay. And not being able to pay is determined by our actions. Thus, no tax can be lump
sum.
LO: 4.2: Construct the representative consumer's budget constraint.
Difficulty: difficult
Classification: application
3) Explain why optimization by the consumer should imply that the marginal rate of substitution
of leisure for consumption is equal to the market real wage.
Answer: The consumer optimizes by choosing the consumption bundle — the combination of
leisure and consumption goods — that makes him or her as well off as possible, while being
feasibility. Feasibility means that the consumption bundle must be inside the budget set, or on
the
budget constraint. But a consumption bundle within the budget set is not optimal, as more is
preferred to less. Therefore, the consumer must be optimizing by choosing a consumption
bundle
on the budget constraint. Suppose M is the marginal rate of substitution of leisure for
consumption and w is the real wage. If M > w, then the consumer could be better of by
consuming more leisure and less consumption goods, and if M < w, the consumer could be
better
off by consuming less leisure and more consumption goods. Therefore, the consumer optimizes
by choosing a consumption bundle on the budget constraint with M = w.
LO: 4.3: Show how the consumer optimizes given his or her budget constraint to determine
labor supply and consumption.
Difficulty: moderate
Classification: application
AACSB: application of knowledge
4) What will a consumer do if dividend income falls?
Answer: This shifts in the budget constraint — it's a pure income effect. As a result, given that
both goods are normal, the consumer chooses to consume less and to take less leisure — he or
she works more.
LO: 4.4: Determine the effects of changes in the representative consumer's environment on his
or her choices.
Difficulty: easy
Classification: application
AACSB: analytical thinking
5) What will a consumer do if the real wage falls?
Answer: The consumer's response entails income and substitution effects. The fall in the real
wage shifts in the budget constraint, which is a negative income effect for the consumer, so this
will cause both consumption and leisure to fall. But, the fall in the real wage makes leisure
cheaper relative to consumption goods, so the consumer will substitute leisure for consumption.
On net, consumption must fall, but leisure could rise or fall, depending on the strength of the
opposing income and substitution effects.
LO: 4.4: Determine the effects of changes in the representative consumer's environment on his
or her choices.
Difficulty: easy
Classification: application
AACSB: analytical thinking
!6) Suppose that the consumer receives a subsidy s for working, i.e. he or she gets s for each
hour
of work. What is the effect on consumption and leisure?
Answer: The subsidy implies that the consumer now has an effective wage of w+s instead of w.
As a result, the consumer's budget constraint shifts out, and becomes steeper. There is a
positive
income effect, which causes both consumption and leisure to increase. But consumption
becomes
cheaper relative to leisure, so the consumer substitutes from leisure to consumption.
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Consumption must go up, but leisure could rise or fall. The consumer may work more or less,
depending on whether the substitution effect is larger or smaller than the income effect.
LO: 4.4: Determine the effects of changes in the representative consumer's environment on his
or her choices.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
7) Suppose that the firm produces output only with labor (no capital), and there is constant
returns to scale. Draw the production function, and explain why it takes the form it does.
Answer: If output is produced only with labor, then the production function is Y = zN, where Y
is output, N is the labor input, and z is total factor productivity. Therefore, the production
function is a straight line, and the marginal product of labor is a constant, z.
LO: 4.5: List the properties of the production function, and explain why it is useful to assume
these properties.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
8) Suppose that the there is a proportional tax on the firm's profits. Determine the effects on the
firm's labor demand decision.
Answer: If the firm has to pay a proportional tax on profits, then profits are given by (1-t)
[F(K,N) — wN]. Therefore, the fact that the firm is taxed will not affect its labor demand
decision, as the firm still maximizes profits by hiring labor to the point where the marginal
product of labor is equal to the real wage.
LO: 4.7: Determine the effects of changes in the representative firm's environment on its labor
demand and output choices.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
9) What is the effect of a decrease in total factor productivity on the firm's labor demand
decision?
Answer: If total factor productivity falls, then the marginal product of labor falls for each
quantity of labor input. The marginal product of labor curve is the firm's labor demand curve, so
the decrease in total factor productivity causes labor demand to fall for each real wage.
LO: 4.7: Determine the effects of changes in the representative firm's environment on its labor
demand and output choices.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
10) Suppose that the firm receives a subsidy s for each unit of labor it hires. Determine the
effects on the firm's demand for labor.
Answer: This will work as if the wage fell to w - s from w. Since the firm's demand for labor
decreases when the real wage increases, the subsidy will increase the demand for labor for any
market real wage w.
LO: 4.7: Determine the effects of changes in the representative firm's environment on its labor
demand and output choices.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
Macroeconomics, 6e (Williamson)
Chapter 5
A Closed-Economy One-Period Macroeconomic Model
5.1
Multiple-Choice Questions
1) An economy that has no interaction with the rest of the world is called
A) an isolated economy.
B) a closed economy.
C) a parochial economy.
D) a rogue nation.
Answer: B
LO: 5.1: Define and construct a competitive equilibrium for the closed-economy one period
(CEOP) macroeconomic model.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
2) An economy that engages in international trade is called
A) a cooperative economy.
B) a modern economy.
C) an engaged economy.
D) an open economy.
Answer: D
LO: 5.1: Define and construct a competitive equilibrium for the closed-economy one period
3) In an economic model, an exogenous variable is
A) a stand-in for more complicated variables.
B) determined by the model itself.
C) determined outside the model.
D) a variable that has no effect on the workings of the model.
Answer: C
LO: 5.1: Define and construct a competitive equilibrium for the closed-economy one period
(CEOP) macroeconomic model.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
!4) In an economic model, an endogenous variable is
A) a stand-in for more complicated variables.
B) determined by the model itself.
C) determined outside the model.
D) a variable that has no effect on the workings of the model.
Answer: B
LO: 5.1: Define and construct a competitive equilibrium for the closed-economy one period
(CEOP) macroeconomic model.
Difficulty: easy
Classification: concept
AACSB: application of knowledge
5) In the one-period model,
A) government spending consists of transfers.
B) government spending is the construction of public infrastructure.
C) government spending is the acquisition of goods, which the government throws away.
D) government spending redistributes income.
Answer: C
LO: 5.1: Define and construct a competitive equilibrium for the closed-economy one period
(CEOP) macroeconomic model.
Difficulty: difficult
Classification: application
AACSB: application of knowledge
6) Which of the following relationships does not hold in the one-period model?
A) G=T
B) Y=C+G
C) Y=zF(K,N)
D) π=Y-wN-C
Answer: D
LO: 5.1: Define and construct a competitive equilibrium for the closed-economy one period
(CEOP) macroeconomic model.
Difficulty: moderate
Classification: application
AACSB: application of knowledge
7) Fiscal policy encompasses all of the following except
A) expenditures by the government.
B) monetary injection by the government.
C) taxation by the government.
D) borrowing by the government.
Answer: B
LO: 5.1: Define and construct a competitive equilibrium for the closed-economy one period
(CEOP) macroeconomic model.
Difficulty: moderate
Classification: concept
8) A competitive equilibrium is a state of affairs in which
A) markets clear, and output is maximized.
B) output is maximized, and all agents are equally well-off.
C) all agents are equally well-off and agents are price-takers.
D) economic agents are price takers and markets clear.
Answer: D
LO: 5.1: Define and construct a competitive equilibrium for the closed-economy one period
(CEOP) macroeconomic model.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
9) For a competitive equilibrium to occur, all of the following has to happen except
A) agents are price takers.
B) the government sets taxes at zero.
C) markets clear.
D) the actions of all agents are consistent.
Answer: B
LO: 5.1: Define and construct a competitive equilibrium for the closed-economy one period
(CEOP) macroeconomic model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
10) In a competitive equilibrium all these relationships hold but one. Which one?
A) Nd=Ns
B) Y=G+C
C) G=T
D) w=z
Answer: D
LO: 5.1: Define and construct a competitive equilibrium for the closed-economy one period
(CEOP) macroeconomic model.
Difficulty: easy
Classification: application
AACSB: application of knowledge
!11) In the one-period competitive model we have been studying
A) both consumption and total factor productivity are exogenous.
B) consumption is exogenous and total factor productivity is endogenous.
C) consumption is endogenous and total factor productivity is exogenous.
D) both consumption and total factor productivity are endogenous.
Answer: C
LO: 5.1: Define and construct a competitive equilibrium for the closed-economy one period
(CEOP) macroeconomic model.
Difficulty: difficult
Classification: application
AACSB: application of knowledge
12) The production possibilities frontier represents
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A) all combinations of consumption and leisure for fixed output.
B) all equally affordable combinations of consumption and leisure for a given wage.
C) all technologically feasible combinations of consumption and leisure.
D) all equally liked combinations of consumption and leisure.
Answer: C
LO: 5.1: Define and construct a competitive equilibrium for the closed-economy one period
(CEOP) macroeconomic model.
Difficulty: moderate
Classification: concept
AACSB: analytical thinking
13) The PPF determines
A) all possible outcomes for a given wage.
B) the set of feasible outcomes.
C) given leisure, how much consumption a household wants.
D) the share of consumption in output.
Answer: B
LO: 5.1: Define and construct a competitive equilibrium for the closed-economy one period
(CEOP) macroeconomic model.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
14) PPF is the
A) price parity formula.
B) possible production function.
C) producer's preferred frontier.
D) production possibilities frontier.
Answer: D
LO: 5.1: Define and construct a competitive equilibrium for the closed-economy one period
(CEOP) macroeconomic model.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
15) Points on the production possibilities frontier have the property that they
A) are inherently unattainable.
B) show the maximum amount of leisure that can be consumed for given amounts of goods
consumed.
C) show the maximum amount of goods that can be consumed for given amounts of
government
spending.
D) show the maximum amount of leisure that can be consumed for given amounts of hours
worked.
Answer: B
LO: 5.1: Define and construct a competitive equilibrium for the closed-economy one period
(CEOP) macroeconomic model.
Difficulty: easy
Classification: application
AACSB: analytical thinking
16) A competitive equilibrium has all of the following properties except
A) MPN = slope of PFF.
B) MRS1,C = MRT1,C.
C) MRT1,C = MPN.
D) MPN = w.
Answer: A
LO: 5.2: Show that the competitive equilibrium and the Pareto optimum for the CEOP model
are
the same thing.
Difficulty: difficult
Classification: concept
AACSB: application of knowledge
17) A Pareto optimum is a point that
A) a malevolent dictator would choose.
B) a cooperative coalition of some altruistic consumers would choose.
C) a cooperative coalition of some socially responsible firms would choose.
D) a social planner would choose.
Answer: D
LO: 5.2: Show that the competitive equilibrium and the Pareto optimum for the CEOP model
are
the same thing.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
18) Much of the writings of Adam Smith are in close agreement with
A) the necessity of trade restrictions.
B) the first fundamental theorem of welfare economics.
C) the second theorem of welfare economics.
D) both B and C above.
Answer: B
LO: 5.2: Show that the competitive equilibrium and the Pareto optimum for the CEOP model
are
the same thing.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
19) The first fundamental theorem of welfare economics states that
A) under certain conditions, a competitive equilibrium is Pareto optimal.
B) a competitive equilibrium is always Pareto optimal.
C) under certain conditions, a Pareto optimum is a competitive equilibrium.
D) a Pareto optimum is always a competitive equilibrium.
Answer: A
LO: 5.2: Show that the competitive equilibrium and the Pareto optimum for the CEOP model
are
the same thing.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
20) The concept of Pareto optimality is a
A) utopian concept.
B) useful concept because it guarantees economic equality.
C) useful concept because it defines economic efficiency.
D) useful concept that carefully balances a society's desires for equality and efficiency.
Answer: C
LO: 5.2: Show that the competitive equilibrium and the Pareto optimum for the CEOP model
are
the same thing.
Difficulty: easy
Classification: concept
AACSB: application of knowledge
21) A competitive equilibrium
A) is always economically efficient.
B) is efficient only if there is an externality.
C) is economically efficient only given some special conditions.
D) does not exist without government taxation.
Answer: C
LO: 5.2: Show that the competitive equilibrium and the Pareto optimum for the CEOP model
are
the same thing.
Difficulty: difficult
Classification: concept
AACSB: application of knowledge
22) A competitive equilibrium may fail to be Pareto optimal due to all of the following except
A) inequality.
B) externalities.
C) distorting taxes.
D) non-price-taking firms.
Answer: A
LO: 5.2: Show that the competitive equilibrium and the Pareto optimum for the CEOP model
are
the same thing.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
23) An externality is any activity for which an individual firm or consumer does not take into
account all
A) of the ramifications of its actions on others.
B) associated costs.
C) associated benefits.
D) associated costs and benefits.
Answer: D
LO: 5.2: Show that the competitive equilibrium and the Pareto optimum for the CEOP model
are
the same thing.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
24) Which of the following causes the competitive equilibrium to fail to be Pareto optimal?
A) lump sum taxation
B) competitive firms
C) proportional taxes on wages
D) consumers care about the dividends they receive from firms
Answer: C
LO: 5.2: Show that the competitive equilibrium and the Pareto optimum for the CEOP model
are
the same thing.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
!25) The presence of a distorting tax on wage income can result in
A) MPN < MRT1,C.
B) MRT1,C < MRS1,C.
C) MPN < w.
D) MRS1,C < MPN
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Answer: D
LO: 5.2: Show that the competitive equilibrium and the Pareto optimum for the CEOP model
are
the same thing.
Difficulty: easy
Classification: application
AACSB: analytical thinking
26) An increase in government spending shifts the PPF
A) upward, but does not change its slope.
B) upward, and also changes its slope.
C) downward, but does not change its slope.
D) downward, and also changes its slope.
Answer: C
LO: 5.3 Analyze and interpret the effects of changes in exogenous variables in the CEOP
model.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
27) An increase in government spending
A) increases consumption, increases hours worked, and increases the real wage.
B) reduces consumption, increases hours worked, and increases the real wage.
C) reduces consumption, increases hours worked, and reduces the real wage.
D) reduces consumption, reduces hours worked, and reduces the real wage.
Answer: C
LO: 5.3 Analyze and interpret the effects of changes in exogenous variables in the CEOP
model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
!28) Changes in government spending are not likely causes of business cycles because
changes in
government spending predict
A) countercyclical real wages.
B) procyclical real wages.
C) countercyclical employment.
D) procyclical employment.
Answer: A
LO: 5.3 Analyze and interpret the effects of changes in exogenous variables in the CEOP
model.
29) Changes in government spending are not likely causes of business cycles because changes
in
government spending predict
A) countercyclical consumption.
B) procyclical consumption.
C) countercyclical employment.
D) procyclical employment.
Answer: A
LO: 5.3 Analyze and interpret the effects of changes in exogenous variables in the CEOP
model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
30) An increase in total factor productivity shifts the PPF
A) upward, but does not change its slope.
B) upward, and also changes its slope.
C) downward, but does not change its slope.
D) downward, and also changes its slope.
Answer: B
LO: 5.3 Analyze and interpret the effects of changes in exogenous variables in the CEOP
model.
Difficulty: easy
Classification: application
AACSB: analytical thinking
!31) An increase in total factor productivity
A) increases consumption, increases output, and increases the real wage.
B) reduces consumption, increases output, and increases the real wage.
C) reduces consumption, increases output and reduces the real wage.
D) reduces consumption, reduces output, and reduces the real wage.
Answer: A
LO: 5.4: Decompose the effects of an increase in total factor productivity in the CEOP model
into income and substitution effects.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
32) In response to an increase in total factor productivity
A) both the substitution effect and the income effect suggest that hours worked should increase.
B) the substitution effect suggests that hours worked should increase, while the income effect
suggests that hours worked should decrease.
C) the substitution effect suggests that hours worked should decrease, while the income effect
suggests that hours worked should increase.
D) both the substitution effect and the income effect suggest that hours worked should
decrease.
Answer: B
LO: 5.4: Decompose the effects of an increase in total factor productivity in the CEOP model
into income and substitution effects.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
33) Changes in total factor productivity are plausible causes of business cycles because
productivity-induced business cycles correctly predict
A) real wages and total hours must be procyclical.
B) real wages and consumption must be procyclical.
C) total hours worked and consumption must be procyclical.
D) consumption and government spending must be procyclical.
Answer: B
LO: 5.4: Decompose the effects of an increase in total factor productivity in the CEOP model
into income and substitution effects.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
!34) Real business cycle theory argues that the primary cause of business cycles is fluctuations
in
A) preferences.
B) government spending.
C) the importance of externalities.
D) total factor productivity.
Answer: D
LO: 5.4: Decompose the effects of an increase in total factor productivity in the CEOP model
into income and substitution effects.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
35) The variable G considered in the model encompasses
A) government expenses on goods.
B) government expenses on goods and services.
C) government expenses on goods and services as well as transfers.
D) government expenses on goods and services as well as transfers and public debt service.
Answer: B
LO: 5.3 Analyze and interpret the effects of changes in exogenous variables in the CEOP
model.
Difficulty: easy
Classification: concept
AACSB: application of knowledge
36) If the government replaces a lump sum tax with a proportional labor income tax, then
A) employment and output increase.
B) employment increases and output decreases.
C) employment decreases and output increases.
D) employment and output decrease.
Answer: D
LO: 5.5: Analyze the effects of a distorting labor income tax in the simplified CEOP model.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
37) Proportional income taxation is distorting because
A) people do all they can to avoid paying taxes.
B) the competitive equilibrium is not Pareto optimal.
C) firms do all they can to avoid paying taxes.
D) the government budget constraint does not hold.
Answer: B
LO: 5.5: Analyze the effects of a distorting labor income tax in the simplified CEOP model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
!38) How does an increase in the proportional labor income tax modify the consumer's budget
constraint?
A) a parallel move up
B) a parallel move down
C) the slope decreases (constraint gets steeper)
D) the slope increases (constraint gets flatter)
Answer: D
LO: 5.5: Analyze the effects of a distorting labor income tax in the simplified CEOP model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
39) At the competitive equilibrium with a positive proportional labor income tax
A) the real wage after tax exceeds the marginal product of labor.
B) the real wage after tax equals the marginal product of labor.
C) the real wage after tax is lower than the marginal product of labor.
D) We cannot say.
Answer: C
LO: 5.5: Analyze the effects of a distorting labor income tax in the simplified CEOP model.
Difficulty: moderate
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Classification: application
AACSB: analytical thinking
40) The tax base is
A) the average tax rate.
B) the tax rate for the base year.
C) the object being taxed.
D) the lowest tax rate.
Answer: C
LO: 5.5: Analyze the effects of a distorting labor income tax in the simplified CEOP model.
Difficulty: easy
Classification: concept
AACSB: application of knowledge
41) When the tax rate increases, the tax revenue
A) always increases.
B) does not change.
C) always decreases.
D) may increase or decrease.
Answer: D
LO: 5.5: Analyze the effects of a distorting labor income tax in the simplified CEOP model.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
!42) If, with proportional taxes on labor income, there is an equilibrium with a high tax rate, and
an equilibrium with a low tax rate,
A) the economy cannot function.
B) the government should always choose the lower tax rate, as this makes the consumer better
off.
C) the government should always choose the higher tax rate, as this makes the consumer better
off.
D) it is irrelevant what tax rate the government chooses.
Answer: D
LO: 5.5: Analyze the effects of a distorting labor income tax in the simplified CEOP model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
43) In the model of public goods
A) government spending is pure waste.
B) private consumption and government spending are equal.
C) consumers benefit from private goods and public goods.
D) the government provides goods at no cost to the public.
Answer: C
LO: 5.6: Analyze the determinants of the size of government and private consumption.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
44) In the model of public goods, when the government chooses public goods provision
optimally
A) there is no public goods production.
B) public goods are provided in an amount equal to private goods.
C) the marginal rate of substitution of private goods for public goods equals the marginal rate of
transformation.
D) GDP is maximized.
Answer: C
45) If GDP increases in the model of public goods
A) people are richer, so they need less public goods.
B) there is substitution from private goods to public goods.
C) if the government provides public goods optimally, public and private goods production both
increase.
D) all of the increase in GDP goes into public goods.
Answer: C
LO: 5.6: Analyze the determinants of the size of government and private consumption.
Difficulty: easy
Classification: application
AACSB: analytical thinking
5.2
True/False Questions
1) True or False: In the one-period model, consumption is exogenous.
Answer: FALSE
LO: 5.1: Define and construct a competitive equilibrium for the closed-economy one period
(CEOP) macroeconomic model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
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2) True or False: In the one-period model, consumers and firms optimize given prices.
Answer: TRUE
LO: 5.1: Define and construct a competitive equilibrium for the closed-economy one period
(CEOP) macroeconomic model.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
3) True or False: In the one-period model, the income-expenditure identity does not hold in
equilibrium.
Answer: FALSE
LO: 5.1: Define and construct a competitive equilibrium for the closed-economy one period
(CEOP) macroeconomic model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
4) True or False: In the one-period model, externalities imply that the competitive equilibrium is
not Pareto optimal.
Answer: FALSE
LO: 5.2: Show that the competitive equilibrium and the Pareto optimum for the CEOP model
are
the same thing.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
5) True or False: In the one-period model, the marginal rate of substitution of leisure for
consumption is equal to the marginal product of labor at the Pareto optimum.
Answer: TRUE
LO: 5.2: Show that the competitive equilibrium and the Pareto optimum for the CEOP model
are
the same thing.
Difficulty: easy
Classification: application
AACSB: analytical thinking
6) True or False: If taxes distort, this can cause the first welfare theorem to fail.
Answer: TRUE
LO: 5.2: Show that the competitive equilibrium and the Pareto optimum for the CEOP model
are
the same thing.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
7) True or False: In the one-period model, a decrease in government spending causes
consumption to fall.
Answer: FALSE
LO: 5.3 Analyze and interpret the effects of changes in exogenous variables in the CEOP
model.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
8) True or False: In the one-period model, an increase in government spending reduces the real
wage.
Answer: TRUE
LO: 5.3 Analyze and interpret the effects of changes in exogenous variables in the CEOP
model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
9) True or False: In the one-period model, a decrease in government spending causes the
representative consumer to work harder.
Answer: FALSE
LO: 5.3 Analyze and interpret the effects of changes in exogenous variables in the CEOP
model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
!10) True or False: In the one-period model, when total factor productivity declines, consumption
may increase or decrease, due to opposing income and substitution effects.
Answer: FALSE
LO: 5.4: Decompose the effects of an increase in total factor productivity in the CEOP model
into income and substitution effects.
Difficulty: easy
Classification: application
AACSB: analytical thinking
11) True or False: In the one-period model, to determine the income effect, we need to first
determine the substitution effect, which is a movement along an indifference curve in response
to
a change in the slope of the production possibilities frontier.
Answer: TRUE
LO: 5.4: Decompose the effects of an increase in total factor productivity in the CEOP model
into income and substitution effects.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
12) True or False: In the one-period model, if government spending falls, the substitution effect
is for the consumer to choose more consumption goods and less leisure.
Answer: FALSE
LO: 5.4: Decompose the effects of an increase in total factor productivity in the CEOP model
into income and substitution effects.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
13) True or False: In the one-period model, if total factor productivity declines there is a positive
income effect on consumption and on leisure.
Answer: FALSE
14) True or False: In the simplified one period model with a distorting tax on wage income, there
is always only one equilibrium.
Answer: FALSE
LO: 5.5: Analyze the effects of a distorting labor income tax in the simplified CEOP model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
!15) True or False: In the simplified one period model with a distorting tax on wage income, the
Laffer curve describes how government tax revenue depends on the income tax rate.
Answer: TRUE
LO: 5.5: Analyze the effects of a distorting labor income tax in the simplified CEOP model.
Difficulty: easy
Classification: application
AACSB: analytical thinking
16) True or False: In the simplified one period model with a distorting tax on wage income, an
equilibrium with a lower tax rate always implies higher welfare than a high-tax-rate equilibrium.
Answer: TRUE
LO: 5.5: Analyze the effects of a distorting labor income tax in the simplified CEOP model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
17) True or False: In the simplified one period model with a distorting tax on wage income, the
competitive equilibrium is Pareto optimal.
Answer: FALSE
LO: 5.5: Analyze the effects of a distorting labor income tax in the simplified CEOP model.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
18) True or False: In the model of public goods, the government does not act in the interest of
private consumers.
Answer: FALSE
LO: 5.6: Analyze the determinants of the size of government and private consumption.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
19) True or False: In the model of public goods, an increase in real GDP causes government
spending to increase.
Answer: TRUE
LO: 5.6: Analyze the determinants of the size of government and private consumption.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
20) True or False: In the model of public goods, if the government becomes less efficient,
private
consumption will certainly increase.
Answer: FALSE
LO: 5.6: Analyze the determinants of the size of government and private consumption.
Difficulty: easy
Classification: application
AACSB: analytical thinkin
5.3
Essay Questions
1) In the one period model, list the requirements for a competitive equilibrium, and explain why
each is important.
Answer: In a competitive equilibrium, the consumer consumption and leisure optimally given
the market real wage and dividend income, and the firm maximizes profits given the market
wage by choosing the quantity of labor input. In equilibrium, at the market real wage the
consumer is willing to supply the quantity of labor that the consumer demands. Optimization
assures that everyone in this economy is doing the best they can given their constraints, while
market-clearing assures that those decisions are consistent. In a competitive equilibrium all
economic agents are price-takers who treat market prices as given.
LO: 5.1: Define and construct a competitive equilibrium for the closed-economy one period
(CEOP) macroeconomic model.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
2) List three reasons why a competitive equilibrium could fail to be equilibrium, and briefly
explain why in each case.
Answer: First, a competitive equilibrium could fail to be Pareto optimal because of externalities.
For example, pollution is a negative externality which could result in too much production of
pollution-causing products in a competitive equilibrium relative to the Pareto optimum. Second,
distorting taxes can lead to a situation where, for example, the marginal rate of substitution of
two goods is not equal to their marginal rate of transformation, so Pareto optimality fails. Third,
there may be monopoly power, in which case a firm with monopoly power will tend to produce
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to little compared to the Pareto optimum.
LO: 5.2: Show that the competitive equilibrium and the Pareto optimum for the CEOP model
are
the same thing.
Difficulty: easy
Classification: application
AACSB: analytical thinking
3) Explain how crowding out works, using the one-period model as an example.
Answer: In the one-period model, if government spending increases, this leads to a decrease in
consumption and leisure, and an increase in real GDP. The reduction in consumption, which
works through a negative income effect is crowding out. That is, government spending partially
crowds out private spending.
LO: 5.3 Analyze and interpret the effects of changes in exogenous variables in the CEOP
model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
!4) Suppose, in the one period model, that there is a decrease in government spending, and that
government spending is also productive, so that this also works as a decline in total factor
productivity. Explain what the effect is on employment, and explain why we get this effect.
Answer: If there were only a decrease in government spending, without the effect on
productivity, then leisure would fall, due to the pure income effect, so employment would
increase. If there were only a decrease in total factor productivity, the effect on employment
would be ambiguous, due to opposing income and substitution effects. The negative income
effect makes employment go up, but the substitution effect makes employment go down. Thus,
on net the effect on employment is ambiguous.
LO: 5.3 Analyze and interpret the effects of changes in exogenous variables in the CEOP
model.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
5) Explain why, in the one-period model, a decrease in total factor productivity has income and
substitution effects.
Answer: In determining the effect of a decrease in TFP, we treat the production possibilities
frontier (PPF) like the budget constraint for an individual consumer, in solving the problem. A
decrease in TFP shifts the PPF in, which is a negative income effect for the consumer, which
reduces consumption and leisure for the consumer, since both are normal goods. But, the PPF
also becomes less steep, which is effectively like making leisure cheaper relative to
consumption
goods. This causes substitution from consumption to leisure
LO: 5.4: Decompose the effects of an increase in total factor productivity in the CEOP model
into income and substitution effects.
Difficulty: easy
Classification: application
AACSB: analytical thinking
6) If total factor productivity rises in the one-period model, explain what happens to the real
wage in equilibrium, and why.
Answer: The increase in TFP shifts the production possibilities frontier (PPF) out, and makes it
steeper. There is an income effect, that increases consumption and leisure, and the substitution
effect causes leisure to decrease and consumption to increase. So, consumption must rise, but
leisure may rise or fall. The substitution effect is a movement along an indifference curve from
the initial equilibrium point, up the indifference curve — the indifference curve becomes steeper.
The income effect results in a movement down the new PPF — the PPF gets steeper. Thus, the
indifference curve that is tangent to the PPF at the new equilibrium point must be steeper than
the indifference curve tangent to the initial PPF at the initial equilibrium point. Therefore the real
wage must increase.
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LO: 5.4: Decompose the effects of an increase in total factor productivity in the CEOP model
into income and substitution effects.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
!7) Explain what the Laffer curve is, and what its practical importance is.
Answer: The Laffer curve describes the revenue that can be collected as a function of the tax
rate. In the case of the simplified one period model with a distorting tax on wage income, the tax
is the labor income tax, and the Laffer curve shows the revenue collected as a function of the
labor income tax rate. The curve is increasing and then decreasing, so there can be two tax
rates
that generated the same revenue for the government — a high tax rate and a low tax rate. In
principle, the government could be on the bad side of the Laffer curve — the side in which
revenue is a decreasing function of the tax rate. Therefore, if the economy is on the bad side of
the Laffer curve and the tax rate increases, government revenue actually falls.
LO: 5.5: Analyze the effects of a distorting labor income tax in the simplified CEOP model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
8) In the simplified one period model with a distorting tax on wage income, explain what the
government would do if it is trying to set the income tax rate so as to make the consumer as well
off as possible.
Answer: In the simplified one period model with a distorting tax on wage income, there can be a
situation in which the government needs to collect a given quantity of revenue to finance
government spending. But there are two tax rates, a high one and a low one, which will both
finance government spending. However, if the government chooses the low tax rate, welfare is
higher for the consumer than if the government chooses the high tax rate. So, the government
always chooses the lower tax rate.
LO: 5.5: Analyze the effects of a distorting labor income tax in the simplified CEOP model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
9) In the model of public goods, describe how the government determines public spending, and
explain what happens if the quantity of GDP goes up.
Answer: In the model of public goods, it is assumed that private consumption and public goods
are chosen jointly — effectively income is split between private consumption and public goods
through the political process, in a way that makes the consumer as well off as possible. The
nation then faces a linear production possibilities frontier (PPF). When GDP goes up, this shifts
out the PPF, implying a pure income effect. Private consumption and public goods both go up,
so
a country with higher GDP will tend to have a larger government. Whether public goods
increase
more or less than in proportion to the increase in income depends on whether or not public
goods
are luxury goods.
LO: 5.6: Analyze the determinants of the size of government and private consumption.
Difficulty: moderate
Classification: application
!10) In the model of public goods, explain what happens if public goods and private
consumption
are perfect substitutes for the consumer, and if more than one unit of private consumption must
be sacrificed if one more unit of public goods is to be produced.
Answer: This implies that indifference curves are straight lines, and that the production
possibilities frontier is steeper than are the indifference curves. Therefore, in equilibrium private
consumption will equal income and no public goods will be produced, as this would be
inefficient.
LO: 5.6: Analyze the determinants of the size of government and private consumption.
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Difficulty: moderate
Classification: application
AACSB: analytical thinking
Macroeconomics, 6e (Williamson)
Chapter 6
Search and Unemployment
6.1
Multiple-Choice Questions
1) If N is the working-age population, Q is the labor force, and U is the number of unemployed,
then the unemployment rate is measured as
A) U/N
B) U/Q
C) U/(N-Q)
D) Q/N
Answer: B
LO: 6.1: List the key labor market facts concerning the unemployment rate, the participation
rate, and the employment/population ratio.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
2) If N is the working-age population, Q is the labor force, and U is the number of unemployed,
then the participation rate is measured as
A) U/N
B) Q/U
C) Q/N
D) (Q-U)/N
Answer: C
LO: 6.1: List the key labor market facts concerning the unemployment rate, the participation
rate, and the employment/population ratio.
Difficulty: difficult
Classification: concept
AACSB: application of knowledge
3) If N is the working-age population, Q is the labor force, and U is the number of unemployed,
then the employment/population ratio is measured as
A) N/Q
B) U/Q
C) (Q-U)/N
D) Q/N
Answer: C
LO: 6.1: List the key labor market facts concerning the unemployment rate, the participation
rate, and the employment/population ratio.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
!4) A key determinant of the unemployment rate is
A) labour market unrest.
B) nominal interest rates.
C) aggregate consumption.
D) aggregate economic activity
Answer: D
LO: 6.1: List the key labor market facts concerning the unemployment rate, the participation
rate, and the employment/population ratio.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
5) Percentage deviations from trend in unemployment are
A) procyclical and have been larger than the percentage deviations from trend in real GDP.
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B) procyclical and have been smaller than the percentage deviations from trend in real GDP.
C) countercyclical and have been larger than the percentage deviations from trend in real GDP.
D) countercyclical and have been smaller than the percentage deviations from trend in real
GDP.
Answer: D
LO: 6.1: List the key labor market facts concerning the unemployment rate, the participation
rate, and the employment/population ratio.
Difficulty: easy
Classification: concept
AACSB: application of knowledge
6) If N is the working-age population, Q is the labor force, and U is the number of unemployed,
then the employment/population ratio is measured as
A) N/Q
B) U/Q
C) (Q-U)/N
D) Q/N
Answer: C
LO: 6.1: List the key labor market facts concerning the unemployment rate, the participation
rate, and the employment/population ratio.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
!7) The unemployment rate is
A) countercyclical
B) procyclical
C) a leading variable
D) smooth
Answer: A
LO: 6.1: List the key labor market facts concerning the unemployment rate, the participation
rate, and the employment/population ratio.
Difficulty: difficult
Classification: concept
AACSB: application of knowledge
8) In the 1948-2012 data, the unemployment rate was highest in
A) 2009
B) 1991
C) 1975
D) 1982
Answer: D
LO: 6.1: List the key labor market facts concerning the unemployment rate, the participation
rate, and the employment/population ratio.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
9) The average unemployment rate was lowest during what period?
A) 1980-1990
B) 1950-1970
C) 2000-2010
D) 1980-2000
Answer: B
LO: 6.1: List the key labor market facts concerning the unemployment rate, the participation
10) The participation rate is
A) countercyclical.
B) more variable than GDP.
C) procyclical.
D) a leading variable.
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Answer: C
LO: 6.1: List the key labor market facts concerning the unemployment rate, the participation
rate, and the employment/population ratio.
Difficulty: easy
Classification: concept
AACSB: application of knowledge
11) The participation rate was higher in 2012 than in 1948 because
A) the labor force was larger in 2012 than in 1948.
B) the unemployment rate became less variable over time.
C) of the Great Moderation.
D) the participation rate of women rose between 1948 to 2012.
Answer: D
LO: 6.1: List the key labor market facts concerning the unemployment rate, the participation
rate, and the employment/population ratio.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
12) The employment/population ratio is
A) more volatile than the participation rate.
B) roughly constant over time.
C) less volatile than the participation rate.
D) smaller in 2012 than in 1970.
Answer: A
LO: 6.1: List the key labor market facts concerning the unemployment rate, the participation
rate, and the employment/population ratio.
Difficulty: difficult
Classification: concept
AACSB: application of knowledge
13) Government intervention influences the unemployment rate through
A) its monetary policies.
B) its tax policies.
C) its regulations.
D) unemployment insurance.
Answer: D
LO: 6.1: List the key labor market facts concerning the unemployment rate, the participation
rate, and the employment/population ratio.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
14) Which of the following best describes mismatch that can increase the unemployment rate?
A) a decrease in the availability of information for firms about the skills of workers
B) firms move production to Mexico
C) an increase in the availability of information for firms about the skills of workers
D) an overall decrease in the available skills of the labour force
Answer: A
LO: 6.2 Describe the Beveridge curve, and explain its importance.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
15) Sectoral shifts influences the unemployment rate through
A) a shift away from services industries and toward manufacturing industries.
B) a shift away from manufacturing industries and toward services industries.
C) a shift away from blue collar jobs and toward services industries.
D) a shift way from white collar jobs and toward blue collar jobs.
Answer: B
LO: 6.2 Describe the Beveridge curve, and explain its importance.
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Difficulty: easy
Classification: application
AACSB: analytical thinking
16) If A is the number of job vacancies in the aggregate, Q is the labor force, and U is the
number
of unemployed, then the vacancy rate is measured by
A) A/(A+Q-U)
B) A/(Q
C) A/(A+Q+U)
D) U/(A+Q-U)
Answer: A
LO: 6.2 Describe the Beveridge curve, and explain its importance.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
17) The negative correlation between the vacancy rate and the unemployment rate is called
A) The Laffer curve.
B) The Phillips curve.
C) The Fisher relation.
D) The Beveridge curve.
Answer: D
LO: 6.2 Describe the Beveridge curve, and explain its importance.
Difficulty: difficult
Classification: concept
AACSB: application of knowledge
18) From 2009 to 2012
A) The Beveridge curve became flat.
B) The Beveridge curve shifted to the right.
C) The Beveridge curve cannot be discerned in the data.
D) The Beveridge curve shifted to the left.
Answer: B
LO: 6.2 Describe the Beveridge curve, and explain its importance.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
!19) In the one-sided search model, the welfare of an employed worker
A) is convex in the real wage.
B) decreases with the real wage.
C) is a concave function of the real wage.
D) increases with employment insurance benefits.
Answer: C
LO: 6.3: In the one-sided search model, explain how the reservation wage is determined.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
20) In the one-sided search model, an increase in the separation rate
A) reduces the welfare of an employed worker.
B) increases the welfare of an unemployed worker.
C) reduces wages.
D) increases the employment insurance benefit.
Answer: A
LO: 6.3: In the one-sided search model, explain how the reservation wage is determined.
Difficulty: easy
Classification: application
AACSB: analytical thinking
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21) In the one-sided search model, the welfare of an unemployed worker
A) is independent of employment insurance benefits.
B) increases with the size of the employment insurance benefit.
C) decreases as market wages increase.
D) depends only on government intervention in labor markets.
Answer: B
LO: 6.3: In the one-sided search model, explain how the reservation wage is determined.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
22) In the one-sided search model, a decrease in the fraction of the unemployed receiving job
offers
A) increases the welfare of the employed.
B) reduces the welfare of the employed.
C) reduces the welfare of the unemployed.
D) increases the welfare of the unemployed.
Answer: C
LO: 6.3: In the one-sided search model, explain how the reservation wage is determined.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
!23) The reservation wage
A) is the wage paid to the reserve army of the unemployed.
B) cannot be higher than the employment insurance benefit.
C) should be the same as the employment insurance benefit, if employment insurance is to be
efficient.
D) is the wage at which an unemployed worker is just indifferent to accepting a job and turning it
down.
Answer: D
LO: 6.3: In the one-sided search model, explain how the reservation wage is determined.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
24) In the one-sided search model, if an unemployed worker turns down a job offer,
A) he or she continues to search.
B) he or she is not behaving optimally.
C) he or she foregoes employment insurance.
D) he or she quits searching and drops out of the labor force.
Answer: A
LO: 6.3: In the one-sided search model, explain how the reservation wage is determined.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
25) In the one-sided search model, if the employment insurance benefit goes down,
A) the reservation wage goes down.
B) the reservation wage goes up.
C) the welfare of the unemployed goes up.
D) the government sector shrinks.
Answer: B
LO: 6.3: In the one-sided search model, explain how the reservation wage is determined.
Difficulty: easy
Classification: application
AACSB: analytical thinking
26) In the one-sided search model, if the employment insurance benefit goes down,
A) the reservation wage goes up and long-run unemployment goes down.
B) the reservation wage goes down and long-run unemployment goes down.
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C) the reservation wage and long-run unemployment are unchanged.
D) the reservation wage goes up and long-run unemployment goes up
Answer: B
LO: 6.4: Show how the one-sided search model determines the unemployment rate.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
!27) In the one-sided search model, if the job offer rate goes down,
A) the reservation wage goes down and the effect on long-run unemployment is ambiguous.
B) the reservation wage goes up and long-run unemployment goes down.
C) the reservation wage and long-run unemployment are unchanged.
D) the reservation wage goes up and long-run unemployment goes up
Answer: A
LO: 6.5: Use the one-sided search model to determine the effects of changes in the labor
market
on the reservation wage and the unemployment rate.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
28) In the two-sided search model,
A) There are N firms, Q is the labor force, and N-Q is the vacancy rate.
B) There are N consumers, Q is the labor force, and N+Q is the number of consumers choosing
home production.
C) There are Q consumers, N is the labor force, and N-Q is the number of consumers choosing
home production.
D) There are N consumers, Q is the labor force, and N-Q is the number of consumers choosing
home production.
Answer: D
LO: 6.6: Construct an equilibrium in the two-sided search model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
29) In the two-sided search model, there
A) is a single representative agent.
B) is an exogenously fixed number of firms.
C) are N total consumers and N total firms.
D) are N total consumers
Answer: D
LO: 6.6: Construct an equilibrium in the two-sided search model.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
30) In the two-sided search model, the number of firms is
A) endogenous.
B) neither endogenous nor exogenous.
C) fixed.
D) exogenous.
Answer: A
LO: 6.6: Construct an equilibrium in the two-sided search model.
Difficulty: easy
Classification: application
AACSB: analytical thinking
31) In the two-sided search model,
A) each consumer decides between searching for work and home production.
B) each consumer decides whether or not to accept a job.
C) each consumer decides whether to start a new business or to seek employment as a worker.
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D) each consumer decides whether to stay in his or her existing job or search for a new job.
Answer: A
LO: 6.6: Construct an equilibrium in the two-sided search model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
32) The matching function captures the difficulties in
A) matching heterogeneous firms with heterogenous workers.
B) matching capital with labour.
C) matching heterogenous firms with homogeneous workers.
D) matching homogeneous firms with heterogeneous workers.
Answer: A
LO: 6.6: Construct an equilibrium in the two-sided search model.
Difficulty: difficult
Classification: concept
AACSB: application of knowledge
33) In the two-sided search model,
A) firms maximize profits.
B) firms determine how much effort they should put into filling job vacancies.
C) firms decide whether or not to enter the labor market by posting vacancies.
D) firms decide whether or not to retain or fire workers.
Answer: C
LO: 6.6: Construct an equilibrium in the two-sided search model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
34) The matching function exhibits all of the following properties except
A) diminishing marginal product of labor.
B) constant returns to scale.
C) increasing in matching efficiency.
D) increasing in inputs of searching consumers and firms.
Answer: A
LO: 6.6: Construct an equilibrium in the two-sided search model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
!35) The matching function captures the idea that
A) consumers have to be paid to work.
B) supply and demand for labor determine the market wage.
C) it is costly and time-consuming to get firms and workers together to produce output.
D) firms are profit-maximizing.
Answer: C
LO: 6.6: Construct an equilibrium in the two-sided search model.
Difficulty: easy
Classification: concept
AACSB: application of knowledge
36) An important feature of the two-sided search model is that
A) would-be workers care not just about the market wage, but about the chances of finding
work.
B) firms can fire workers.
C) workers can choose to shirk on the job.
D) firms maximize revenue.
Answer: A
LO: 6.6: Construct an equilibrium in the two-sided search model.
Difficulty: moderate
Classification: application
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AACSB: analytical thinking
37) Labour market tightness in the two-sided search model is defined b
A) the number of firms divided by the number of consumers searching for work.
B) the number of firms multiplied by the number of consumers searching for work.
C) the number of consumers searching for work divided by the number of firms.
D) the number of employed consumers divided by the number of firms.
Answer: A
LO: 6.6: Construct an equilibrium in the two-sided search model.
Difficulty: difficult
Classification: concept
AACSB: application of knowledge
38) In the two-sided search model
A) the market wage is equal to the marginal product of labor.
B) the market wage is equal to the marginal rate of substitution of leisure for consumption.
C) the wage is equal to the marginal rate of transformation.
D) the wage is determined by bargaining between the firm and the worker.
Answer: D
LO: 6.6: Construct an equilibrium in the two-sided search model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
!39) In the two-sided search model
A) the firm threatens the worker with separation and takes all the surplus from the match.
B) the firm's surplus from a match is equal to a constant fraction of total surplus.
C) the firm earns zero profits in a match.
D) when a match occurs, the firm is indifferent between continuing with the match and letting
the worker go.
Answer: B
LO: 6.6: Construct an equilibrium in the two-sided search model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
40) In the two-sided search model, a decrease in the unemployment insurance benefit
A) increases the unemployment rate.
B) reduces labor market tightness.
C) reduces the unemployment rate.
D) reduces the vacancy rate.
Answer: C
LO: 6.7: Use the two-sided search model to explain how shocks to the labor market change
labor force participation, unemployment, vacancies, aggregate output, and labor market
tightness.
Difficulty: easy
Classification: application
AACSB: analytical thinking
41) In the two-sided search model, an increase in the unemployment insurance benefit does
not,
under any circumstances
A) increase the vacancy rate.
B) increase the unemployment rate.
C) reduce labor market tightness.
D) reduce the size of the labor force.
Answer: A
LO: 6.7: Use the two-sided search model to explain how shocks to the labor market change
labor force participation, unemployment, vacancies, aggregate output, and labor market
tightness.
Difficulty: moderate
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Classification: application
AACSB: analytical thinking
!42) In the two-sided search model, a decrease in productivity
A) decreases the unemployment rate.
B) reduces the vacancy rate.
C) increases the unemployment rate.
D) increases the size of the labor force.
Answer: C
LO: 6.7: Use the two-sided search model to explain how shocks to the labor market change
labor force participation, unemployment, vacancies, aggregate output, and labor market
tightness.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
43) In the two-sided search model, an increase in productivity does not
A) reduce the unemployment rate.
B) increase the vacancy rate.
C) increase labor market tightness.
D) increase the size of the labor force.
Answer: D
LO: 6.7: Use the two-sided search model to explain how shocks to the labor market change
labor force participation, unemployment, vacancies, aggregate output, and labor market
tightness.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
44) A decrease in matching efficiency
A) can never happen.
B) is due to a change in the productivity of firms.
C) is not related to sectoral shocks.
D) can explain the shift in the Beveridge curve.
Answer: D
LO: 6.7: Use the two-sided search model to explain how shocks to the labor market change
labor force participation, unemployment, vacancies, aggregate output, and labor market
tightness.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
!45) In the two-sided search model, a decrease in matching efficiency
A) has no effect on vacancies.
B) reduces the unemployment rate.
C) increases labor market tightness.
D) increases the size of the labor force.
Answer: D
LO: 6.7: Use the two-sided search model to explain how shocks to the labor market change
labor force participation, unemployment, vacancies, aggregate output, and labor market
tightness.
Difficulty: easy
Classification: application
AACSB: analytical thinking
6.2
True/False Questions
1) True or False: The labor force participation rate was higher in 2015 than in 1950 because the
labor force participation of men rose.
Answer: FALSE
LO: 6.1: List the key labor market facts concerning the unemployment rate, the participation
rate, and the employment/population ratio.
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Difficulty: difficult
Classification: application
AACSB: analytical thinking
2) True or False: If the number of unemployed rises and the size of the labor force falls, the
unemployment rate rises.
Answer: TRUE
LO: 6.1: List the key labor market facts concerning the unemployment rate, the participation
rate, and the employment/population ratio.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
3) True or False: If people exit the labor force, and the ratio of employed to unemployed is
constant, the unemployment rate falls.
Answer: FALSE
LO: 6.1: List the key labor market facts concerning the unemployment rate, the participation
rate, and the employment/population ratio.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
!4) True or False: The Beveridge curve reflects a positive correlation between the
unemployment
rate and the vacancy rate.
Answer: FALSE
LO: 6.2 Describe the Beveridge curve, and explain its importance.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
5) True or False: Since the 2008-2009 recession, the Beveridge curve in the United States has
shifted to the right.
Answer: TRUE
LO: 6.2 Describe the Beveridge curve, and explain its importance.
Difficulty: easy
Classification: application
AACSB: analytical thinking
6) True or False: In the one-sided search model, an increase in the unemployment insurance
benefit increases the welfare of the employed.
Answer: FALSE
LO: 6.3: In the one-sided search model, explain how the reservation wage is determined.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
7) True or False: In the one-sided search model, if unemployed workers receive job offers with
greater frequency, this increases the welfare of the unemployed.
Answer: TRUE
LO: 6.3: In the one-sided search model, explain how the reservation wage is determined.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
8) True or False: In the one-sided search model, a reduction in the unemployment insurance
benefit will reduce the reservation wage.
Answer: TRUE
LO: 6.3: In the one-sided search model, explain how the reservation wage is determined.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
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9) True or False: In the one-sided search model, a decrease in the separation rate increases the
reservation wage.
Answer: FALSE
LO: 6.3: In the one-sided search model, explain how the reservation wage is determined.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
10) True or False: In the one-sided search model, in the long run the number of people who are
separated from their jobs each period equals the number who accept job offers of employment.
Answer: TRUE
LO: 6.4: Show how the one-sided search model determines the unemployment rate.
Difficulty: easy
Classification: application
AACSB: analytical thinking
11) True or False: In the one-sided search model, anything that increases the reservation wage
reduces the unemployment rate.
Answer: FALSE
LO: 6.4: Show how the one-sided search model determines the unemployment rate.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
12) True or False: In the one-sided search model, a decrease in the unemployment insurance
benefit increases the reservation wage and increases the unemployment rate.
Answer: TRUE
LO: 6.5: Use the one-sided search model to determine the effects of changes in the labor
market
on the reservation wage and the unemployment rate.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
13) True or False: In the one-sided search model, an increase in the separation rate increases
the
separation rate and lowers the unemployment rate.
Answer: FALSE
LO: 6.5: Use the one-sided search model to determine the effects of changes in the labor
market
on the reservation wage and the unemployment rate.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
14) True or False: In the two-sided search model, an increase in the unemployment insurance
benefit increases the expected benefit to a consumer of searching for a job.
Answer: TRUE
LO: 6.5: Use the one-sided search model to determine the effects of changes in the labor
market
on the reservation wage and the unemployment rate.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
!15) True or False: In the two-sided search model, there is a fixed number of firms.
Answer: FALSE
LO: 6.6: Construct an equilibrium in the two-sided search model.
Difficulty: easy
Classification: application
AACSB: analytical thinking
16) True or False: In the two-sided search model, there is a labor force participation decision.
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Answer: TRUE
LO: 6.6: Construct an equilibrium in the two-sided search model.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
17) True or False: In the two-sided search model, a reduction in total factor productivity reduces
labor market tightness.
Answer: TRUE
LO: 6.7: Use the two-sided search model to explain how shocks to the labor market change
labor force participation, unemployment, vacancies, aggregate output, and labor market
tightness.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
18) True or False: In the two-sided search model, an increase in total factor productivity reduces
the size of the labor force.
Answer: FALSE
LO: 6.7: Use the two-sided search model to explain how shocks to the labor market change
labor force participation, unemployment, vacancies, aggregate output, and labor market
tightness.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
19) True or False: In the two-sided search model, shocks to matching efficiency explain why the
Beveridge curve is downward-sloping.
Answer: FALSE
LO: 6.7: Use the two-sided search model to explain how shocks to the labor market change
labor force participation, unemployment, vacancies, aggregate output, and labor market
tightness.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
!20) True or False: In the two-sided search model, an increase in matching efficiency increases
the size of the labor force.
Answer: TRUE
LO: 6.7: Use the two-sided search model to explain how shocks to the labor market change
labor force participation, unemployment, vacancies, aggregate output, and labor market
tightness.
Difficulty: easy
Classification: application
AACSB: analytical thinking
6.3
Essay Questions
1) Discuss how labor force participation has evolved in the United States since 1948, in terms of
total labor force participation and the participation of men and women.
Answer: Since 1948, the total labor force participation rate has increased, though there has
been
a decrease since about 2000. The increase in labor force participation from 1948 was due to the
increased participation of women, since the participation rate of men has fallen steadily from
1948 to 2015. Since 2000, the labor force participation rates of both men and women have
fallen.
LO: 6.1: List the key labor market facts concerning the unemployment rate, the participation
rate, and the employment/population ratio.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
2) Explain what has happened to the Beveridge curve since the beginning of the 2008-2009
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recession, and discuss a reason for this.
Answer: The Beveridge curve is a negative relationship between the vacancy rate and the
unemployment rate, observable in the U.S. data. Since the 2008-2009 recession, the Beveridge
curve has shifted out. That is, for a given vacancy rate, the unemployment rate has tended to be
higher after the recession. A possible reason for this, which we can use the two-sided search
model to understand, is that matching efficiency has decreased. That is, there is a poorer match
between the skills that firms desire and the skills possessed by would-be workers. This
increases
friction in the labor market, and results in higher unemployment for a given number of vacancies
posted by firms.
LO: 6.2 Describe the Beveridge curve, and explain its importance.
Difficulty: moderate
Classification: application
AACSB: analytical thinkin
3) Explain how the reservation wage is determined in the one-sided search model.
Answer: To determine the reservation wage, we assume that the welfare of unemployed
workers
is a concave function of the wage they earn, and also depends on the separation rate. The
welfare
of unemployed workers depends on the unemployment insurance benefit and how frequently an
unemployed worker receives job offers. An unemployed worker will search until he or she
receives a wage offer that implies that, if he or she accepts it, his or her welfare will be higher
than it would if he or she remained unemployed and continued searching. Therefore, the
reservation wage is determined by the point at which the welfare of the employed worker, as
function of the wage, is equal to the welfare of being unemployed. An unemployed worker will
accept any job offer at the reservation wage or above, and will decline everything else.
LO: 6.3: In the one-sided search model, explain how the reservation wage is determined.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
4) Explain how the unemployment rate is determined in the one-sided search model.
Answer: The one-sided search model determines the long-run unemployment rate, which is
consistent with equal employment-to-unemployment and unemployment-to-employment flows
in the labor market, given the reservation wage. That is, if the unemployment rate is U, then the
flow from fraction of the population moving from employment to unemployment is (1-U)s,
where s is the separation rate. The flow from unemployment to employment is UpH(w*), where
p is the probability of receiving a job offer for an unemployed worker, and H(w*) is the fraction
of the unemployed who receive a wage offer above the reservation wage w* or above,
conditional on receiving a wage offer. Then, the unemployment rate is determined by the
equation (1-U)s = UpH(w*), given the reservation wage.
LO: 6.4: Show how the one-sided search model determines the unemployment rate.
Difficulty: easy
Classification: application
AACSB: analytical thinking
5) Determine what happens to the unemployment rate and the reservation wage in the
one-sided
search model if the separation rate decreases.
Answer: The decrease in the separation rate increases the welfare of the employed, and thus
serves to reduce the reservation wage — work becomes more attractive, so unemployed
workers
are less picky about what they will accept. Then the decrease in the separation rate reduces the
flow of workers from employment to unemployment. The reduction in the reservation wage also
increases the flow of workers form unemployment to employment. Therefore, on net the
unemployment rate will fall in the long run.
LO: 6.5: Use the one-sided search model to determine the effects of changes in the labor
market
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on the reservation wage and the unemployment rate.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
!6) Suppose that all jobs pay a lower wage. In the one-sided search model, determine what
happens to the reservation wage and the unemployment rate, and explain.
Answer: If all jobs pay a lower wage, this shifts down the welfare function of the employed,
which increases the reservation wage. The fact that all wages are lower implies that the function
H(w) shifts down. There are therefore two effects on the flow of workers from unemployment to
employment UpH(w*). Since H(w) is lower for each w, and w* is higher, both effects serve to
reduce the flow of workers from unemployment to employment. As a result, long-term
unemployment must increase.
LO: 6.5: Use the one-sided search model to determine the effects of changes in the labor
market
on the reservation wage and the unemployment rate.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
7) In the two-sided search model, explain what decisions firms make, and how they make them.
Answer: Would-be firms make a decision as to whether they should post a vacancy in an
attempt
to hire a worker — to be an active firm — or to remain idle. Posting a vacancy costs the firm k in
recruiting costs. If the firm successfully matches with a worker, it receives the output from
production, z, minus the wage it pays to the worker w. But, the chances of matching with a
Chapter 9
A Two-Period Model: The Consumption-Savings Decision and Credit Markets
9.1
Multiple-Choice Questions
1) Consumption smoothing refers to
A) the tendency of all consumers to choose the same amount of current consumption.
B) the tendency of consumers to seek a consumption path over time that is smoother than
income.
C) the tendency of consumers to seek an income path over time that is smoother than
consumption.
D) consumer's concerns about going heavily into debt.
Answer: B
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
2) The desire to smooth consumption is reflected in
A) the consumer's budget constraint.
B) the curvature in a consumer's indifference curves.
C) choice between present and future.
D) the production possibilities frontier.
Answer: B
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: difficult
Classification: application
AACSB: analytical thinking
3) In the basic two-period model,
A) credit markets have frictions.
B) the government borrows at a lower interest rate than do consumers.
C) some consumers will always default on their debts.
D) consumers do not default on their debts.
Answer: B
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
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Difficulty: moderate
Classification: concept
AACSB: application of knowledge
!4) The simplest device to analyze dynamic decisions is a
A) one-period model.
B) two-period model.
C) model that includes only the number of years of a typical consumer's lifetime.
D) continuous time model.
Answer: B
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
5) We use a two-period model because
A) the business cycle has two phases: contraction and recovery.
B) it is the simplest dynamic model.
C) we want to make a distinction between young and old households.
D) this is the horizon of the politicians that formulate policy.
Answer: B
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: easy
Classification: concept
AACSB: application of knowledge
6) Lifetime wealth is
A) the quantity of assets the consumer has in the current period.
B) current income plus future income.
C) current income minus discounted future taxes.
D) the present value of disposable income.
Answer: D
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
7) Why don't consumers work in the two-period model?
A) It's a convenient simplification.
B) It would make no difference to the model if consumers could work.
C) People who participate in real-world credit markets do not work.
D) We don't know how to include workers in the model.
Answer: A
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: difficult
Classification: application
AACSB: analytical thinking
!8) Savings in our model are
A) durable consumption.
B) non-durable consumption.
C) postponed consumption.
D) money.
Answer: C
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
9) The consumer's lifetime budget constraint states that
A) the present value of lifetime consumption must be equal to the present value of lifetime gross
income.
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B) the present value of lifetime consumption must be equal to the present value of lifetime
disposable income.
C) the present value of lifetime consumption plus the present value of lifetime taxes to be paid
must be equal to the present value of lifetime income.
D) the present value of lifetime taxes to be paid by the consumer must be equal to the present
value of government spending.
Answer: B
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
10) The endowment point is the consumption bundle in which
A) first-period consumption is equal to zero.
B) second-period consumption is equal to zero.
C) the consumer finds the most utility.
D) consumption is equal to disposable income in each period.
Answer: D
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: easy
Classification: concept
AACSB: application of knowledge
11) The endowment point is the consumption bundle in which
A) households maximize utility.
B) households are indifferent to interest rate changes.
C) permanent income is maximized.
D) savings are zero.
Answer: D
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
12) At the endowment point, we have the property that
A) c = c'
B) c = y - t
C) y - t = y' - t'
D) y = y'
Answer: B
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: difficult
Classification: concept
AACSB: application of knowledge
13) If we represents a two-period consumer's lifetime wealth and r denotes the real rate of
interest, the horizontal (current consumption) intercept of the consumer's budget line is equal to
A) we
B) (1 + r)we
C)D)
Answer: A
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
14) If we represents a two-period consumer's lifetime wealth and r denotes the real rate of
interest, the slope of the consumer's budget line is equal to
A) r × we
B) -
C) -
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D) - (1 + r).
Answer: D
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
!15) In the two-period model, r denotes
A) real income.
B) the nominal interest rate.
C) the real interest rate.
D) current taxes.
Answer: C
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: easy
Classification: concept
AACSB: application of knowledge
16) To assure a well-defined solution to the consumers' intertemporal choice problems, we must
assume that consumers' preferences exhibit the properties that
A) consumers are all identical and that more is always preferred to less.
B) more is preferred to less and that consumers prefer diversity.
C) consumers like diversity and that more is sometimes preferred to less.
D) more is sometimes preferred to less and that first-period consumption and second-period
consumption are both normal goods.
Answer: B
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: moderate
Classification: application
AACSB: analytical thinking
17) Why is it important that consumers respond differently to temporary and permanent
increases
in their incomes?
A) This implies that consumption will be highly sensitive to temporary changes in income.
B) This implies that a temporary tax cut will have a larger effect than a permanent one on
current
consumption.
C) This tells us that the timing of income increases for consumers is irrelevant.
D) This has implications for the relative effects of temporary and permanent tax cuts.
Answer: D
LO: 9.2: Show how the consumer responds to changes in his or her current income, future
income, and the market real interest rate.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
!18) The property of diminishing marginal rate of substitution follows from the property that the
indifference curves are
A) downward sloping
B) upward sloping.
C) bowed in toward the origin.
D) bowed out from the origin.
Answer: C
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: moderate
Classification: application
AACSB: analytical thinking
19) A consumer is a borrower if
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A) optimum current consumption is less than current disposable income.
B) optimum current consumption is greater than current disposable income.
C) future disposable income is greater than current disposable income.
D) the consumer's indifference curves are relatively steep.
Answer: B
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
20) A consumer is a lender if
A) optimum current consumption is less than current disposable income.
B) optimum current consumption is greater than current disposable income.
C) current disposable income is greater than future disposable income.
D) the consumer's indifference curves are relatively flat.
Answer: A
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: easy
Classification: concept
AACSB: application of knowledge
21) For a lender in a (c,c') graph, the optimal consumption bundle is
A) to the left of the endowment point.
B) to the right of the endowment point.
C) on the endowment point.
D) dependent on other factors.
Answer: A
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: moderate
Classification: application
AACSB: analytical thinking
!22) For a household in a (c,c') graph, the optimal consumption bundle is
A) to the left of the endowment point.
B) to the right of the endowment point.
C) on the endowment point.
D) dependent on other factors.
Answer: D
LO: 9.1: Construct a consumer's lifetime budget constraint and preferences in the
Difficulty: difficult
Classification: application
AACSB: analytical thinking
23) With higher future taxes
A) current consumption declines.
B) current consumption stays the same.
C) current consumption increases.
D) current consumption depends on other factors.
Answer: A
LO: 9.2: Show how the consumer responds to changes in his or her current income, future
income, and the market real interest rate.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
24) A temporary increase in income today leads to
A) a small increase in current consumption.
B) a large increase in current consumption.
C) a small decrease in future consumption.
D) a large decrease in future consumption.
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Answer: A
LO: 9.2: Show how the consumer responds to changes in his or her current income, future
income, and the market real interest rate.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
25) A permanent decrease in taxes leads to
A) a small increase in current consumption.
B) a large increase in current consumption.
C) a small decrease in future consumption.
D) a large decrease in future consumption.
Answer: B
LO: 9.2: Show how the consumer responds to changes in his or her current income, future
income, and the market real interest rate.
Difficulty: easy
Classification: application
AACSB: analytical thinking
26) A temporary decrease in taxes leads to
A) a small increase in current consumption.
B) a large increase in current consumption.
C) a small decrease in future consumption.
D) a large decrease in future consumption.
Answer: A
LO: 9.2: Show how the consumer responds to changes in his or her current income, future
income, and the market real interest rate.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
27) A good proxy for the flow of consumption services would be
A) aggregate consumption.
B) consumption of services and consumption of durables.
C) consumption of durables and consumption of nondurables.
D) consumption of nondurables and consumption of services.
Answer: D
LO: 9.2: Show how the consumer responds to changes in his or her current income, future
income, and the market real interest rate.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
28) In the data, which of the following is most volatile?
A) real GDP
B) consumption of durables
C) consumption of nondurables
D) consumption of services
Answer: B
LO: 9.2: Show how the consumer responds to changes in his or her current income, future
income, and the market real interest rate.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
29) The two primary explanations for the excess volatility of consumption are
A) consumers' limited life spans and credit market imperfections.
B) credit market imperfections and changes in market prices.
C) changes in market prices and distorting taxes.
D) distorting taxes and consumers' limited life spans.
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Answer: B
LO: 9.2: Show how the consumer responds to changes in his or her current income, future
income, and the market real interest rate.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
30) An increase in second-period income results in
A) an increase in first-period consumption, an increase in second-period consumption, and an
increase in saving.
B) an increase in first-period consumption, a decrease in second-period consumption, and an
increase in saving.
C) a decrease in first-period consumption, an increase in second-period consumption, and an
increase in saving.
D) an increase in first-period consumption, an increase in second-period consumption, and a
decrease in saving.
Answer: D
LO: 9.2: Show how the consumer responds to changes in his or her current income, future
income, and the market real interest rate.
Difficulty: easy
Classification: application
AACSB: analytical thinking
31) An increase in the real interest rate is an example of a
A) pure substitution effect.
B) substitution effect and a positive income effect.
C) substitution effect and a negative income effect.
D) substitution effect and an income effect whose sign depends on whether the consumer is
initially a borrower or a lender.
Answer: D
LO: 9.2: Show how the consumer responds to changes in his or her current income, future
income, and the market real interest rate.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
32) An increase in the real interest rate
A) increases savings for both borrowers and lenders.
B) increases savings for borrowers, but has an uncertain effect on the savings of lenders.
C) increases savings for lenders, but has an uncertain effect on the savings of borrowers.
D) has an uncertain effect on the savings of both borrowers and lenders.
Answer: B
LO: 9.2: Show how the consumer responds to changes in his or her current income, future
income, and the market real interest rate.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
!33) For a lender, an increase in the real interest rate
A) definitely reduces current consumption and increases future consumption.
B) reduces current consumption and has an uncertain effect on future consumption.
C) has an uncertain effect on current consumption and increases future consumption.
D) has an uncertain effect on both current and future consumption.
Answer: C
LO: 9.2: Show how the consumer responds to changes in his or her current income, future
income, and the market real interest rate.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
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34) For a borrower, an increase in the real interest rate
A) definitely reduces current consumption and increases future consumption.
B) reduces current consumption and has an uncertain effect on future consumption.
C) has an uncertain effect on current consumption and increases future consumption.
D) has an uncertain effect on both current and future consumption.
Answer: B
LO: 9.2: Show how the consumer responds to changes in his or her current income, future
income, and the market real interest rate.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
35) In a two-period model, government spending is financed through
A) taxes and transfer payments.
B) taxes and issuing debt.
C) taxes and redeeming debt.
D) taxes only.
Answer: B
LO: 9.3: Construct the government's present-value budget constraint.
Difficulty: easy
Classification: application
AACSB: analytical thinking
36) The government's present value budget constraint states that
A) taxes must equal government spending in each period.
B) the present value of government spending must be equal to the present value of consumers'
disposable incomes.
C) the present value of government spending must be equal to the present value of taxes.
D) the government may run deficits each and every year, as long as the deficits are sufficiently
small.
Answer: C
LO: 9.3: Construct the government's present-value budget constraint.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
37) The Ricardian equivalence theorem implies that
A) government debt policy must be handled correctly for the economy to prosper.
B) the amounts of government spending are neutral.
C) an increase in government spending has no effect on the economy, as long as there is an
equal
change in taxes.
D) the timing of taxes collected by the government is neutral.
Answer: D
LO: 9.5: Explain the Ricardian equivalence theorem.
Difficulty: difficult
Classification: concept
AACSB: application of knowledge
38) If government spending is held constant and Ricardian equivalence holds,
A) an increase in the government budget deficit is always matched by a reduction in private
savings.
B) an increase in government savings is always matched by an increase in the government
budget deficit.
C) an increase in government savings is always matched by an equal increase in private
savings.
D) an increase in government savings is always matched by an equal reduction in private
savings.
Answer: D
LO: 9.5: Explain the Ricardian equivalence theorem.
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Difficulty: moderate
Classification: application
AACSB: analytical thinkin
39) Ricardian equivalence implies
A) that when the government borrows more, the market real interest rate goes up.
B) that if the government saves less, then the nation saves less.
C) that when taxes are cut people consume more.
D) that consumers will save their tax cuts to pay their future taxes.
Answer: D
LO: 9.5: Explain the Ricardian equivalence theorem.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
40) The Ricardian equivalence theorem says
A) whatever the level of government expenses, consumption is the same.
B) whatever the timing of taxes, consumption is the same.
C) higher government expenses reduce consumption.
D) an increase in current consumption has to lead to a decrease in future consumption.
Answer: B
LO: 9.5: Explain the Ricardian equivalence theorem.
Difficulty: easy
Classification: concept
AACSB: application of knowledge
41) Which of the following is not a reason for the Ricardian equivalence theorem to fail to hold?
A) tax distortions
B) people can borrow from the government.
C) finite-lived people.
D) credit market imperfections.
Answer: B
LO: 9.6: Discuss how the Ricardian equivalence theorem helps us understand the burden of
the
government debt.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
42) Which condition would generate a violation of the Ricardian Equivalence?
A) downward sloping labor supply curve
B) underdeveloped credit markets
C) inflationary monetary policy
D) deflationary monetary policy
Answer: B
LO: 9.6: Discuss how the Ricardian equivalence theorem helps us understand the burden of
the
government debt.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
43) Supposing Ricardian equivalence holds, an increase in current taxes
A) increases current aggregate consumption.
B) reduces current aggregate consumption.
C) reduces current saving.
D) increases government spending.
Answer: C
LO: 9.5: Explain the Ricardian equivalence theorem.
Difficulty: moderate
Classification: application
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AACSB: analytical thinking
44) If people are finite-lived, Ricardian equivalence can fail because
A) lifetime wealth will change for those currently alive.
B) people cannot predict the future.
C) this implies taxes must be distorting.
D) there is intragenerational redistribution.
Answer: A
45) The permanent income hypothesis and the Ricardian equivalence theorem
A) are the same thing.
B) are related, but the first relates to the behavior of a single consumer while the second relates
to the behavior of the whole economy.
C) are related, but the first relates to the behavior of the whole economy, while the second
relates
to the behavior of a single consumer.
D) are completely unrelated.
Answer: B
LO: 9.5: Explain the Ricardian equivalence theorem.
Difficulty: easy
Classification: application
AACSB: analytical thinking
Chap 11
44) A decrease in credit market frictions does not
A) reduce the real interest rate.
B) increase output.
C) increase employment.
D) reduce the real wage.
Answer: A
LO: 11.7: Use the real intertemporal model to explain the effects of particular shocks to the
economy.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
45) In general equilibrium
A) supply equals demand for all goods in all periods.
B) supply equals demand for most goods in all periods.
C) supply equals demand in present value, but not in all periods.
D) prices are exogenous.
Answer: A
LO: 11.6: Show how a competitive equilibrium is determined in the real intertemporal model.
Difficulty: easy
Classification: concept
AACSB: application of knowledge
11.2
True/False Questions
1) True or False: In the real intertemporal model, the representative consumer does not care
about future leisure.
Answer: FALSE
LO: 11.1: Explain the decisions made by the representative consumer in the real intertemporal
model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
2) True or False: In the real intertemporal model, the representative consumer chooses current
and future consumption, and current and future hours of work.
Answer: TRUE
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LO: 11.1: Explain the decisions made by the representative consumer in the real intertemporal
model.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
3) True or False: In the real intertemporal model, the representative firm maximizes profits in the
current period.
Answer: FALSE
LO: 11.2: Explain the decisions made by the representative firm in the real intertemporal model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
4) True or False: In the real intertemporal model, the representative firm chooses the current
and
future labor inputs, and investment in the current period.
Answer: TRUE
LO: 11.2: Explain the decisions made by the representative firm in the real intertemporal model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
5) True or False: In the real intertemporal model, the representative firm chooses investment so
as to maximize its capital stock in the future.
Answer: FALSE
LO: 11.3: Show how the firm's investment decision is structured, and determine how changes in
the environment faced by the firm affect investment.
Difficulty: easy
Classification: application
AACSB: analytical thinking
6) True or False: In the real intertemporal model, the representative firm increases investment if
the real interest rate falls.
Answer: TRUE
LO: 11.3: Show how the firm's investment decision is structured, and determine how changes in
the environment faced by the firm affect investment.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
7) True or False: In the real intertemporal model, if the representative firm expects the marginal
product of capital will be lower in the future than it would otherwise have been, investment will
increase.
Answer: FALSE
LO: 11.3: Show how the firm's investment decision is structured, and determine how changes in
the environment faced by the firm affect investment.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
8) True or False: The output supply curve shifts to the left if some of the nation's capital stock is
destroyed.
Answer: TRUE
LO: 11.4: Construct the output supply curve.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
9) True or False: The output supply curve slopes upward because of the effect of total factor
productivity on production.
Answer: FALSE
LO: 11.4: Construct the output supply curve.
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Difficulty: moderate
Classification: application
AACSB: analytical thinking
10) True or False: The output demand curve shifts to the right if the marginal product of capital
is expected to be higher in the future.
Answer: TRUE
LO: 11.5: Construct the output demand curve.
Difficulty: easy
Classification: application
AACSB: analytical thinking
!11) True or False: The output demand curve slopes upward because of the negative effect of
the
real interest rate on consumption and investment.
Answer: FALSE
LO: 11.5: Construct the output demand curve.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
12) True or False: In the real intertemporal model, markets clear in the goods market and the
money market.
Answer: FALSE
LO: 11.6: Show how a competitive equilibrium is determined in the real intertemporal model.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
13) True or False: In the real intertemporal model, if government spending increases, the real
interest rate goes up.
Answer: TRUE
LO: 11.7: Use the real intertemporal model to explain the effects of particular shocks to the
economy.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
14) In the real intertemporal model, if government spending increases, then in equilibrium output
increases one-for-one with the increase in government spending.
Answer: FALSE
LO: 11.7: Use the real intertemporal model to explain the effects of particular shocks to the
economy.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
15) True or False: In the real intertemporal model, if some of the nation's capital is destroyed,
then employment must fall.
Answer: FALSE
LO: 11.7: Use the real intertemporal model to explain the effects of particular shocks to the
economy.
Difficulty: easy
Classification: application
AACSB: analytical thinking
!16) True or False: In the real intertemporal model, if economic agents receive bad news about
future total factor productivity, then employment rises in the current period.
Answer: FALSE
LO: 11.7: Use the real intertemporal model to explain the effects of particular shocks to the
economy.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
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17) True or False: In the real intertemporal model, if current total factor productivity falls, then
the real wage falls.
Answer: TRUE
LO: 11.7: Use the real intertemporal model to explain the effects of particular shocks to the
economy.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
18) True or False: In the real intertemporal model, if current total factor productivity rises,
investment must fall.
Answer: FALSE
LO: 11.7: Use the real intertemporal model to explain the effects of particular shocks to the
economy.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
19) True or False: In the real intertemporal model, if there are less severe credit market frictions
then the real interest rate rises.
Answer: TRUE
LO: 11.7: Use the real intertemporal model to explain the effects of particular shocks to the
economy.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
20) True or False: In the real intertemporal model, a sectoral shock will reduce the market real
wage.
Answer: TRUE
LO: 11.7: Use the real intertemporal model to explain the effects of particular shocks to the
economy.
Difficulty: easy
Classification: application
AACSB: analytical thinking
!11.3
Essay Questions
1) In the real intertemporal model, what effect does a decrease in the firm's initial capital stock
have on the firm's investment decision? Explain.
Answer: If the firm's initial capital stock is lower, this implies that, for a given level of current
investment, the firm's future capital stock will be lower. This implies that the future marginal
product of capital will be higher for the firm, increasing the marginal benefit of investment. This
shifts the firm's optimal investment schedule to the right. Given the real interest rate, the firm
will invest more.
LO: 11.3: Show how the firm's investment decision is structured, and determine how changes in
the environment faced by the firm affect investment.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
2) Describe how a firm makes its investment decision in the real intertemporal model.
Answer: The firm will invest to the point where the marginal cost of investment is equal to the
marginal benefit. Marginal costs and benefits are measured in terms of the present value of
profits for the firm. The marginal cost of one unit of investment is one unit of profit. On the
benefit side, one unit of investment implies that the firm will have 1 - d units of capital left at the
end of the future period, where d is the depreciation rate, and the firm also uses the capital in
the
future period to produce an extra MPK units of output, where MPK is the future marginal product
of capital. So, the marginal benefit of investment is (MPK + 1 - d) /(1+r), where r is the real
interest rate. Therefore the firm invests to the point where MPK - d = r, that is until the future
marginal product of capital, net of depreciation, is equal to the real rate of interest. Here, the real
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rate of interest represents the opportunity cost of investment to the firm.
LO: 11.3: Show how the firm's investment decision is structured, and determine how changes in
the environment faced by the firm affect investment.
Difficulty: easy
Classification: application
AACSB: analytical thinking
3) Suppose that the output supply curve becomes steeper. Why would this occur? Explain.
Answer: The output supply curve is constructed by varying the real interest rate, and
determining how much output would be produced given that interest rate. That is, the real
interest rate affects labor supply. A higher real interest rate causes the consumer to substitute
future leisure for current leisure, so the consumer works harder in the present. The larger this
effect — which is an intertemporal substitution effect — the larger is the effect on employment,
and the larger is the effect on output. A large intertemporal substitution effect then implies a flat
upward-sloping output supply curve. So, if the output supply curve gets steeper, this implies that
the size of the intertemporal substitution effect has fallen.
LO: 11.4: Construct the output supply curve.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
4) Suppose that the output demand curve gets less steep. Why would this occur? Explain.
Answer: The output demand curve is constructed by determining, for alternative real interest
rates, what the total demand for output would be, given the effect of the real interest rate on the
demand for consumption goods and investment goods. A higher real interest rate causes
consumers to substitute future consumption for current consumption, so the current demand for
consumption goods falls. As well, a higher real interest rate implies that the demand for
investment goods falls. Therefore, if the real interest rate is higher, the total demand for goods
falls, which is why the output demand curve is downward sloping, and its slope will thus depend
on how sensitive demand is to the real interest rate — the size of the intertemporal substitution
effect on consumption, and the response of investment to the real interest rate. A flat output
demand curve is the result of a large response of demand to the real interest rate. Thus, if the
output demand curve becomes less steep, this is because output demand is less responsive to
the
real interest rate.
LO: 11.5: Construct the output demand curve.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
5) Suppose that current government spending increases. What are the effects on the economy,
using the real intertemporal model? Explain.
Answer: The increase in government spending implies an increase in the present value of taxes
equal to the increase in government spending. Taking account of the effect of the tax change on
consumption, the output demand curve shifts to the right by the amount of the increase in
government spending. The increase in taxes is also a negative wealth effect on labor supply, so
the output supply curve shifts to the right, but by a relatively small amount. Taking account of
the real interest rate effect on labor supply, on net employment increases, the real wage falls,
the
real interest rate rises, consumption falls, investment falls, and output rises.
LO: 11.7: Use the real intertemporal model to explain the effects of particular shocks to the
economy.
Difficulty: easy
Classification: application
AACSB: analytical thinking
6) Suppose that there are two countries, which are identical except that country A has a higher
capital stock than does country B. What does the real intertemporal model tell us about how
these countries will look different? Explain.
Answer: In the real intertemporal model, if there is a fall in the capital stock, then the output
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supply curve shifts to the left, and the output demand curve shifts to the right. The real interest
rate must rise, and the real wage must fall. But employment may rise or fall, and output may rise
or fall. Therefore, we can say conclusively that country A will have a lower real interest rate and
a higher real wage than will country B. But we cannot determine how output and employment
will compare in the two countries.
LO: 11.7: Use the real intertemporal model to explain the effects of particular shocks to the
economy.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
7) Suppose that current total factor productivity falls. Determine the equilibrium effects in the
real intertemporal model, and explain.
Answer: The shock shifts the labor demand curve to the left, and also shifts the output supply
curve to the left. The real interest rate rises, and output falls. As a result of the increase in the
real
interest rate, the labor supply curve shifts to the right by a small amount. On net, employment
falls, the real wage falls, consumption falls, and investment falls.
LO: 11.7: Use the real intertemporal model to explain the effects of particular shocks to the
economy.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
8) If there is a news that future total factor productivity will be lower, what are the equilibrium
effects in the real intertemporal model? Explain.
Answer: This shock shifts the output demand curve to the left, because of the negative effect on
the demand for investment goods. The real interest rate falls, and output falls. As well, because
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the real interest rate falls, labor supply falls, so that the real wage rises and employment falls. In
equilibrium consumption may be higher or lower, but investment falls.
LO: 11.7: Use the real intertemporal model to explain the effects of particular shocks to the
economy.
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Difficulty: moderate
Classification: application
AACSB: analytical thinking
9) Suppose, in the real intertemporal model, that there is lower friction in credit markets. What
are the equilibrium effects? Explain.
Answer: There is a positive effect on output demand, so the output demand curve shifts right,
but there is a negative effect on labor supply, so the output supply curve shifts left. The real
interest rate rises, and in principle output could rise or fall, though the output supply effect
should be small, so that output rises. Employment must move in the same direction as output.
LO: 11.7: Use the real intertemporal model to explain the effects of particular shocks to the
economy.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
10) Suppose, in the real intertemporal model, that there is a sectoral shock. Determine the
equilibrium effects, and explain.
Answer: The shock acts to reduce both labor demand and labor supply, given the real wage.
The
output supply curve shifts to the left. Therefore output falls, consumption falls, investment falls,
and employment falls. The real interest rate rises, and the real wage may rise or fall.
LO: 11.7: Use the real intertemporal model to explain the effects of particular shocks to the
economy.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
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