14.

02 Principles of Macroeconomics
Fall 2009


Quiz 1
Thursday, October 8
th

7:30 PM 9 PM


Please, answer the following questions. Write your answers directly on the quiz. You
can achieve a total of 100 points. There are 5 multiple-choice questions, followed by
2 free response questions. You should read all of the questions first.
Good luck!


NAME: ________________________________________________


MIT ID NUMBER: ________________________________________________


TA: ________________________________________________


CLASS TIME: ________________________________________________


EMAIL: ________________________________________________


(Table is for corrector use only)
1 2 3 4 5 6 7 8 Total
Multiple
Choice
Questions



Long
Question 1


Long
Question 2

Total

1 Multiple Choice (30 points)
Answer the following questions. You DO NOT need to justify your answer.
1. (6 Points) Consider an economy with two goods and two periods. Data are
Good 1
p
1
t
= 1
p
1
t+1
= 1
q
1
t
= 1
q
1
t+1
= 1:1
Good 2
p
2
t
= 1
p
2
t+1
= 1:4
q
2
t
= 1
q
2
t+1
= 1:3
where q
1
t
stands for the quantity of good 1 produced in period t; q
2
t
stands for the quantity of
good 2 produced in period t; p
1
t
stands for the price of good 1 in period t and p
2
t
stands for the
price of good 2 in period t:
The oce of national accounts wants to calculate the real GDP growth rate in this economy
using the chain index and they hire you to do so. What is the correct growth rate you should
report to the oce of national accounts?
(a) 19.7%
(b) 20.8%
(c) 20.1%
2. (6 Points) When we characterize labor supply as an upward sloping relationship between hours
worked and wages, we assume that
(a) the substitution eect dominates the income eect.
(b) the income eect dominates the substitution eect.
(c) the income and the substitution eect cancel out making the relationship between hours
worked and wages unambiguous.
1
3. (6 Points) According to the Solow growth model, which of the following statements is FALSE?
(a) A country which experiences higher population growth than another will have a lower
output per worker in steady state.
(b) Steady state consumption in a country which saves more will always be higher than steady
state consumption of a country with a lower savings rate.
(c) Capital accumulation alone can not sustain long run growth in capital per worker.
4. (6 Points) Consider a consumer who follows a PIH consumption rule and who is a saver in the
rst period (i.e., in the rst period he consumes less than his current income). Which of the
following statements is TRUE?
(a) An increase in the interest rate in the rst period will have no eect in the rst periods
consumption since current consumption only depends on current income.
(b) An increase in the interest rate will make the price of the rst periods consumption
compared to the second periods consumption more expensive, which means that the rst
periods consumption will decrease unambiguously.
(c) An increase in the interest rate makes the price of the rst periods consumption com-
pared to the second periods consumption more expensive but makes the consumer richer,
hence the eect of the rst periods consumption after an increase in the interest rate is
ambiguous.
5. (6 Points) The relationship between investment and the interest rate will be negative:
(a) Only for rms who nance investment through borrowing.
(b) Because the interest rate determines the opportunity cost of investing, and is a component
of the user cost of capital.
(c) Because the interest rate decreases the marginal product of capital making rms want to
install less capital.
2
2 Consumption with Borrowing Constraints (35 points)
Consider a PIH consumer, Anna, who receives an income of $4 when she is young and an income of
$10 when old. Anna is born with no assets, so a = 0: The real interest rate that Anna faces for
borrowing and saving is equal to r:
1. (7 points) Write down Annas intertemporal budget constraint, i:e: the budget constraint that
relates Annas lifetime income with Annas lifetime consumption. Explain briey what this
budget constraint tells us.
3
2. (7 points) Assume that preferences are logarithmic, that is U(c
y
; c
o
) = lnc
y
+ lnc
o
, where
2 [0; 1]. Use Annas optimality condition, c
o
= (1 + r)c
y
; and the budget constraint you
found in part 1 to nd Annas consumption when young and old as a function of the discount
factor, ; the real interest rate, r; the income in period 1 and the income in period 2. Calculate
Annas savings (or borrowing) when young. Under what condition will Anna be a borrower in
the rst period? Explain briey how Annas consumption when young diers from an agent
who follows a Keynesian consumption rule, where consumption at time t is equal to c
t
= 0:9Y
t
;
where Y
t
is income at time t:
4
3. (7 points) Suppose that Annas income when young increases by " but her income when old
remains constant. Calculate the increase in Annas consumption when young, c
y
; and
calculate Annas marginal propensity to consume when young (c
y
=y
y
): Compare this to
the marginal propensity to consume of a Keynesian consumer and briey comment on the
dierential response of the two consumers to transitory shocks.
5
4. (7 points) Now suppose that Anna faces liquidity constraints, which means Anna can save but
is unable to borrow when she is young. Draw the budget constraint in the c
y
; c
o
axis. Using the
same income stream as above and setting r = 0; = 1, calculate Annas optimal consumption
decision when young. Explain briey how this compares to the consumption when Anna is
young and faces no liquidity constraints.
6
5. (7 points) Suppose as above that Anna faces liquidity constraints when young and her income
when young increases by " but her income when old remains constant. Calculate the increase
in Annas consumption when young, c
y
and calculate Annas marginal propensity to consume
when young (c
y
=y
y
): How does Annas marginal propensity to consume compares to the
marginal propensity to consume of a Keynesian consumer? Comment.
7
3 Technological Change and the Labor Market (35 points)
In country B there is a rm that produces the unique good of the economy using the following
production function:
Y = F(L
s
; L
u
) =

AL
1=2
s
+ L
1=2
u

2
where A is a technological parameter; L
s
is the number of hours of skilled workers the rm hires
monthly, and L
u
is the number of hours of unskilled workers the rm hires monthly.
There are two groups of agents in the economy, one group is composed of skilled agents and
the other group is composed of unskilled agents. Both groups are equally sized (N
S
= N
U
= N)
and have the same preferences over consumption and leisure which are represented by the following
utility function
U(c; l) = lnc + lnl
where is a positive constant. The only source of income of the consumers is their wage income,
and the two groups of consumers only dier in the wage they receive, which is w
S
for skilled workers
and w
U
for unskilled workers. The monthly time endowment of a worker is T: Both the rm and
the consumers are price takers, meaning they take the wages, w
S
; w
U
; and the price of the nal good,
P; as given.
1. (3 points) Show that the production function satises constant returns to scale in the two labor
types.
8
2. (5 points) Using the rms optimality condition we have seen in class, and using the fact that
the marginal product of worker of type s is
AL
1=2
s

AL
1=2
s
+ L
1=2
u

and the marginal product of labor of a worker of type u is

AL
1=2
s
+ L
1=2
u

;
nd the relative demand of skilled workers to unskilled workers (L
S
=L
U
) as a function of the
relative wage (w
S
=w
U
) and the technological parameter.
9
3. (4 points) Using the time constraint T = n + l; where n is number of hours worked,write the
budget constraint of a consumer of type s and the budget constraint of a consumer of type u
as a function of leisure, consumption, the wage rate of the type, the price P; and T:
10
4. (5 points) Using the time constraint T = n+l; the budget constraint, and the fact the marginal
utility of consumption and the marginal utility of leisure are given by
MU(c) = 1=c
MU(l) = =l;
nd the optimal labor supply of individuals and the optimal demand of the nal good for
skilled and unskilled consumers.
11
5. (5 points) Using the labor supplies for the two groups of consumer and the relative labor
demand of the rm, nd the equilibrium relative wage (w
S
=w
U
).
12
6. (5 points) What is the eect of a technological increase (an increase in A) in the wage gap
between skilled and unskilled workers? Explain briey what happens to the labor demand of
the two types of workers.
13
7. (4 points) Now imagine that as a result of a national trend, more and more people go to college
so the ratio of skilled to unskilled workers rises (a rise in N
s
=N
u
). What will happen to the
relative wage between skilled and unskilled workers as a result of this national trend?
14
8. (4 points) Finally assume that the current technological level, A; is endogenous and is a function
of the ratio between skilled and unskilled workers. In particular, assume A = (N
s
=N
u
)

; > 0.
What will happen to the wage ratio as a result of the national trend mentioned before?
15
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14.02 Principles of Macroeconomics
Fall 2009
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