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Macro assignment

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9 views

Assignment 1 Updated

Macro assignment

Uploaded by

Pradeep Joshi
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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1) Consider a Cobb-Douglas production function with three inputs.

K is capital (the number of


machines), L is labor (the number of workers), and H is human capital (the number of college
degrees among the workers). The production function is:

Y =K 1/ 2 L1/ 4 H 1/ 4
a. Derive an expression for the marginal product of labor. How does an increase in the
amount of human capital affect the marginal product of labor?

Δ y 1 1/2 -3/4 1/4


MPL= = K L H
ΔL 4
and obviously an increase of the amount of human capital H increases the
marginal product of labor as well.

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

Δ y 1 1/2 1/4 -3/4


MP H= = K L H
ΔH 4

We can see that Increase in human capital lowers MPH.

c. What is the income share paid to labor? What is the income share paid to human capital?
In the national income accounts of this economy, what share of total income do you think
workers would appear to receive? (Hint: Consider who owns the return to human capital.)

MPL∗L 1
Labor Share = =
Y 4
MPL∗H 1
Human Capital Share = = =
Y 4
Since, workers own the return to human capital as well as labor, the share of total income
workers receive will be 1/2.
d. An unskilled worker earns the marginal product of labor, whereas a skilled worker earns
the marginal product of labor plus the marginal product of human capital. Using your
answers to parts (a) and (b), find the ratio of the skilled wage to the unskilled wage. How
does an increase in the amount of human capital affect this ratio? Explain.

The ratio of the skilled wage to the unskilled wage is:


W skilled MPL+ MPH
=
W unskilled MPL
1 1
K 1/2 L−3/ 4 H 1 /4+ K 1/2 L 1/4 H −3/4
4 4
=
1
K 1 /2 L−3 /4 H 1/4
4
L
=1+
H
When H increases, this ratio falls because the diminishing returns to human
capital lower its return, while at the same time increasing the marginal product of
unskilled workers.

e. Some people advocate government funding of college scholarships as a way of creating a


more egalitarian society. Others argue that scholarships help only those who are able to
go to college. Do your answers to the preceding questions shed light on this debate?

If more college scholarships increase H, then it does lead to a more egalitarian society.
The policy lowers the returns to education, decreasing the gap between the wages of
more and less educated workers. More importantly, the policy even raises the absolute
wage of unskilled workers because their marginal product rises when the number of
skilled workers rises.

2. Consider an economy described by the following equations:


Y=C+I+G
Y = 5, 000
G = 800
T = 1, 000
C = 400 + 0.6(Y − T)
I = 1, 500 − 100r
a. In this economy, compute private savings, public savings, and national savings.
–S private = Y − T − C
= 5, 000 − 1, 000 − 400 + 0.6(5, 000 − 1, 000)
= 1200

S public = T − G
= 1, 000 – 800
= 200
National savings:
S = S private + S public
= 1200 + 200
= 1400
b. Find the equilibrium interest rate.
Since
S = I,
then
1400 = 1, 500 − 100r.
Solving for r, we get that r = 1

c. Now suppose that G rises to 1,250. Compute private savings, public savings, and national
savings.

S private = 1200
S public = T − G
= 1, 000 − 200
= 1000
S = S private + S public = 1200 - 200 = 1000
d. Find the new equilibrium interest rate and use figure to illustrate.
S=I
1000 = 1, 500 − 100r
Solving for r, we get that r = 5
So, an increase in G, increases the real interest rate

3. Suppose that the money demand function takes the form


(M/P)d=L(i, Y)=Y/5i
(A) If output grows at rate g, at what rate will the demand for real balances grow
(assuming constant nominal interest rates)?
(B) What is the velocity of money in this economy?
(C) If inflation and nominal interest rates are constant, at what rate, if any, will velocity
grow?
(D) How will a permanent (once-and-for-all) increase the level of interest rates affect the
level of velocity? How will it affect the subsequent growth rate of velocity?

(a) If output Y grows at rate g, then real money balances (M/P)d must also grow at rate g,
given that the nominal interest rate ⅈ is a constant.
(b) According to the quantity equation MV=PY, the velocity of money:
Y Y
V= = =5 ⅈ
M / P Y ∕ 5ⅈ

c. If the nominal interest rate is constant, then the velocity of money must be constant.
d. A one- time increase in the nominal interest rate will cause one-time increase in the
velocity of money. There will be no further changes in the velocity of money.
4. Suppose the consumption depends on the level of real money balances (on the grounds that
real money balances are part of wealth). Show that if real money balance depend on the nominal
interest rate, then an increase in the rate of money growth affects consumption, investment and
real interest rate. Does the nominal interest rate adjust more than one-for-one or less than one-
for-one to expected inflation?

This deviation from the classical dichotomy and Fisher effect is called Mundell-Tobin effect.
How might you decide whether the Mundell-Tobin effect is important in practice?
An increase in the rate of money growth leads to an increase in the rate of inflation. Inflation, in
turn, causes the nominal interest rate to rise, which means that the opportunity cost of holding
money increases. As a result, real money balances fall. Since money is part of wealth, real wealth
also falls. A fall in wealth reduces consumption, and, therefore, increases saving. The increase in
saving leads to an outward shift of the saving schedule, as in Figure 4.1. This leads to a lower
real interest rate.

Figure 4.1

The classical dichotomy states that a change in a nominal variable such as inflation does not
affect real variables. In this case, the classical dichotomy does not hold; the increase in the rate
of inflation leads to a decrease in the real interest rate. The Fisher effect states that i = r + π. In
this case, since the real interest rate r falls, a 1- percent increase in inflation increases the
nominal interest rate i by less than 1 percent. Most economists believe that this Mundell–Tobin
effect is not important because real money balances are a small fraction of wealth. Hence, the
impact on saving as illustrated in Figure 4.1 is small.

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