Question No 01

a) Immigration increases labor force:

According to the neoclassical theory of distribution, if a wave of immigration increases the
labor force:
Real Wage (w): Decreases
With more workers available, the marginal product of labor (MPL) decreases due to
diminishing returns, leading to lower wages.
Real Rental Price of Capital (r): Increases
The additional labor makes capital (e.g., machinery) more productive, increasing the marginal
product of capital (MPK) and raising its rental price.
b) Earthquake destroys capital stock:
According to the neoclassical theory of distribution, if an earthquake destroys part of the
capital stock:
Real Wage (w): Decreases
With less capital available, the marginal product of labor (MPL) decreases because workers
have fewer tools and resources to work with, leading to lower wages.
Real Rental Price of Capital (r): Increases
The remaining capital becomes more scarce and productive, increasing the marginal product of
capital (MPK) and raising its rental price.
c) Technological advance:
If a technological advance improves the production function:
1. Real Wage: Increases
o Technology makes labor more productive, increasing the marginal product of
labor (MPL), which raises wages.
2. Real Rental Price of Capital: Increases
o Technology also enhances the efficiency of capital, increasing the marginal
product of capital (MPK), which raises its rental price.

Question N0 02
a. A production function exhibits:
Decreasing Returns to Scale:
Output increases by less than inputs due to:
 Inefficiencies in management as scale grows.
 Resource constraints (e.g., limited land).
 Diminishing specialization beyond a point.
Increasing Returns to Scale:
Output increases more than inputs due to:
 Economies of scale (lower costs per unit).
 Improved specialization with a larger scale.
 Network effects in interconnected systems.

Question No 03
a. Fractions of income received by capital and labor
Given the Cobb–Douglas production function:
Y=AK α L 1-α:

where α=0.3
so:
Capital's share of income = α=0.3=30%
Labor's share of income = 1−α= 0.7=70%

b. Impact of a 10% increase in the labor force

When L increases by 10%, total output, rental price of capital, and real wage adjust as follows:
Total Output:
Using the Cobb-Douglas property, output increases by:

1. Rental Price of Capital (R/ P):

Since more labor makes capital more productive, the rental price of capital increases.
2. Real Wage (W/ P):
With more workers sharing the same amount of capital, the marginal product of labor
decreases, so real wages fall.
c. 10% Increase in Capital (K)
When KKK increases by 10%, the effects are:
1. Total Output:

1. Rental Price of Capital (R/P):

More capital reduces its marginal productivity, so the rental price of capital falls.
2. Real Wage (WP):
Additional capital makes labor more productive, so real wages increase.

d. Impact of a 10% increase in A (technological advance

d. Impact of a 10% increase in A (technological advance)

When technology improves by 10% (A increases by 10%), its impact is:
1. Total Output:
Output increases directly by the same percentage:
%ΔY=10%.
2. Rental Price of Capital (R/PR/P):
Technology increases capital productivity, so the rental price of capital increases.
3. Real Wage (W/P):
Technology also raises labor productivity, so real wages increase.

Question No 05
a. Real wage of farmers
According to the neoclassical theory, the real wage equals the worker's marginal productivity.
Since the productivity of farmers has risen substantially due to technological progress, their real
wage should have increased over time.

b. Units of the real wage in part (a)

The real wage of farmers is measured in terms of the amount of food they can produce (e.g.,
bushels of wheat per hour).

c. Real wage of barbers

Since the productivity of barbers has remained constant (no technological progress), their real
wage should have stayed the same over time.
d. Units of the real wage in part (c)
The real wage of barbers is measured in terms of the amount of haircuts they can perform
(e.g., haircuts per hour).

e. Wage equality through labor mobility

If workers can move freely between farming and barbering, wages in both professions must
eventually equalize. This implies that the real wage of farmers and barbers will be the same in
terms of what each can buy (e.g., food or haircuts).

f. Price of haircuts relative to food

As farmer productivity increases, food becomes cheaper (since more food is produced). In
contrast, barber productivity remains constant, so the price of haircuts remains the same. This
means the relative price of haircuts rises compared to food.

g. Who benefits from technological progress in farming?

Farmers: Benefit from higher productivity, which increases their real wages.
Consumers: Benefit from cheaper food due to increased food supply.
Barbers: Indirectly benefit because their wages rise (due to mobility) and they can buy cheaper
food, even though their productivity has not changed.

Question No 06
a. Marginal Product of Labor (MPL)
The Cobb-Douglas production function is:

The marginal product of labor (MPL) is the partial derivative of Y with respect to L:

Effect of an increase in human capital (HHH):

Since HHH appears in MPL as H1/3, an increase in HHH raises the marginal product of labor. This
means that a more educated workforce makes each worker more productive.

b. Marginal Product of Human Capital (MPH)

The marginal product of human capital (MPH) is the partial derivative of Y with respect to H:
Effect of an increase in human capital (HHH):
Since HHH appears in MPH as H−2/3, an increase in HHH reduces MPH. This is due to diminishing
returns to human capital—each additional college degree has less of an impact as the total
number of degrees increases.

c. Income shares of labor and human capital

In a Cobb-Douglas production function, each input’s income share equals its
respective exponent:
 Labor’s income share: 1/3
 Human capital’s income share: 1/3
Share of total income appearing as workers’ earnings:
 Labor’s income includes both the returns to labor (MPL) and human capital
(MPH) because workers "own" their human capital.
 Therefore, workers receive 2/3 of total income: 1/3 from labor and 1/3
from human capital.
d. Ratio of skilled to unskilled wages

 Unskilled worker’s wage: MPL.

 Skilled worker’s wage: MPL+MPH.

Substituting MPL and MPH:

Effect of an increase in H:
As H increases, the ratio L/H decreases, which reduces the gap between skilled and unskilled
wages. This implies that a more educated workforce leads to greater wage equality between
skilled and unskilled workers.

e. Scholarships and inequality

Government scholarships increase H (human capital) by enabling more people to attend
college. Based on the results:
1. Positive impact on equality:
 o Increasing H reduces the skilled-to-unskilled wage ratio (1+L/H) narrowing the
wage gap and promoting income equality.
2. Targeted benefits:
o Scholarships directly benefit individuals who gain access to college, allowing
them to earn higher wages by accessing both MPL and MPH.
Conclusion: Scholarships help create a more egalitarian society by reducing income inequality
between skilled and unskilled workers while also directly benefiting those who gain higher
education.

Question No 07
The marginal propensity to consume (MPC=0.6) helps determine how changes in taxes affect
savings and investment.

a. Public Saving
Public saving is defined as:
Public Saving=T−G,
where T is tax revenue and G is government spending.
 Since taxes increase by $100 billion, and government spending (G) is unchanged, public
saving rises by $100 billion.

b. Private Saving
Private saving is defined as:
Private Saving=Y−T,
where Y is income, T is taxes, and C is consumption.
 Taxes increase by $100 billion, which reduces disposable income (Y−T) by $100 billion.
 With MPC=0.6MPC = 0.6MPC=0.6, consumption falls by:
ΔC=MPC×ΔDisposable Income=0.6×100=60 billion
Private saving increases by the remainder of the reduction in disposable income:
ΔPrivate Saving=100−60=40billion.
Private saving rises by $40 billion.
c. National Saving
National saving is the sum of public and private saving:
National Saving=Public Saving+Private Saving.
 Public saving increases by $100 billion.
 Private saving increases by $40 billion.
Thus:
ΔNational Saving=100+40=140billion.
National saving rises by $140 billion.

d. Investment
In a closed economy, investment equals national saving:
I=National Saving.
Since national saving rises by $140 billion, investment also rises by $140 billion.

Question No 08
When consumer confidence increases, leading to higher current consumption, the
following effects occur in a closed economy:
1. Impact on National Saving:
o The consumption function shifts upward, meaning consumers spend
more of their current income.
o Since saving is the portion of income not spent on consumption,
private saving decreases.
o A decrease in private saving reduces national saving (since national
saving equals private saving plus public saving, and public saving is
unaffected here).
2. Impact on Investment:
o In a closed economy, investment is determined by national saving
because: I=S.I = S.
 o As national saving decreases, there is less available to finance
investment. Investment decreases.
3. Impact on the Interest Rate:
o The reduction in national saving shifts the supply curve of loanable
funds to the left in the loanable funds market.
o This causes the interest rate to rise, as the price (interest rate) adjusts
to balance the reduced supply of savings with the demand for loanable
funds.
o Higher interest rates further discourage investment.

Summary of Effects:
 National Saving: Decreases due to reduced private saving.
 Investment: Falls because of less available saving.
 Interest Rate: Increases as saving supply contracts in the loanable funds
market.

Question NO 09
We are given the following equations for an economy:
(a) Compute Private Saving, Public Saving, and National Saving
1. Compute Consumption (C)

y
2. Compute Private Saving (Private)

3. Compute Public Saving (Public)

4. Compute National Saving (national)

(b) Find the Equilibrium Interest Rate

In equilibrium, national saving equals investment:
(c) Compute Private Saving, Public Saving, and National Saving When
GGG Rises to 1,250
1. Compute New Public Saving

2. Compute Private Saving (Unchanged)

3. Compute New National Saving

(d) Find the New Equilibrium Interest Rate Using the equilibrium
condition

Question No 10

When the government increases taxes and government spending by equal amounts, the effects
on interest rates and investment depend on how consumption and national saving are affected.

1.Effect on Consumption and National Saving

 Higher taxes reduce disposable income, leading to lower consumption.
 Higher government spending directly increases demand.
 The overall impact on national saving depends on the marginal propensity to consume
(MPC):
 A higher MPC means consumers reduce saving significantly, lowering national saving.
 A lower MPC means consumers cut spending more, which offsets the decline in national
saving.

2.Effect on Interest Rate and Investment

 If national saving falls (which happens if the reduction in private saving exceeds the
increase in public saving), the supply of loanable funds decreases.
 A lower supply of loanable funds raises the interest rate.
 Higher interest rates discourage investment, leading to a decline in investment.

3.Impact on Investment and Interest Rate

 In the loanable funds market, investment equals national saving (I=SI = SI=S).
  The reduction in national saving shifts the supply of loanable funds to the left.
 As a result:
 The interest rate rises, because the supply of savings decreases.
 Investment decreases, since a higher interest rate discourages borrowing for
investment

4.Dependence on MPC:
Yes, the outcome depends on MPC:
 A higher MPC means a larger reduction in consumption and private saving, leading
to a greater decrease in national saving.
 As a result, the rise in the interest rate and the decline in investment would be more
significant with a higher MPC.

Question No 11
(a) Effect on Demand for Business and Residential Investment
 The investment tax credit makes business investment more attractive by reducing its
effective cost.
 This shifts the demand curve for business investment to the right (higher demand at any
given interest rate).
 However, since the policy does not apply to residential investment, higher interest rates
(from increased demand for funds) make residential investment less attractive, shifting
its demand curve to the left.

(b) Effect on Loanable Funds Market and Interest Rate

 Supply of loanable funds (national saving) remains unchanged (unless households
change their savings behavior).
 Demand for loanable funds increases due to higher business investment.
 This raises the equilibrium interest rate, as more funds are needed to finance increased
business investment.

(c) Effect on Total, Business, and Residential Investment

 Total investment: May increase because the rise in business investment could outweigh
the decline in residential investment.
 Business investment: Increases due to the tax credit.
 Residential investment: Falls due to higher interest rates making borrowing more
expensive.
Question No 12
If consumption depended on the interest rate, it would introduce an additional feedback
effect in the loanable funds market, affecting the conclusions about fiscal policy in the
following ways:
1. Crowding-Out Effect Becomes Weaker or Stronger
 Higher interest rates reduce consumption, as borrowing becomes more expensive.
 This means an increase in government spending (which raises interest rates) could
reduce consumption, further lowering private demand.
 The reduction in private demand could offset some of the decline in investment,
weakening the crowding-out effect.
2. Tax Changes Have a Stronger Effect on Aggregate Demand
 When taxes rise, disposable income falls, reducing consumption.
 But if higher interest rates also reduce consumption, tax increases would have a
stronger negative effect on aggregate demand than in a model where consumption is
fixed.
3. Loanable Funds Market Adjusts Differently

 In standard models, higher interest rates reduce only investment.

 If consumption also responds, national saving may increase, reducing
the pressure on interest rates.
 This could make fiscal expansion less inflationary and fiscal contraction
less recessionary.

Question No 13
(a) Fluctuating Supply of Loanable Funds, Stable Demand
 Causes of Supply Fluctuations:
o Changes in private saving behavior (e.g., shifts in consumer confidence).
o Changes in government saving (e.g., budget deficits/surpluses).
o Changes in foreign capital inflows.
 Effect on Correlation:
o As supply shifts right (more saving), interest rates fall, and investment rises.
o As supply shifts left (less saving), interest rates rise, and investment falls.
o Investment and interest rates are negatively correlated in this case.

(b) Fluctuating Demand for Loanable Funds, Stable Supply

 Causes of Demand Fluctuations:
 o Changes in business confidence and expected profitability.
o Changes in technological advancements requiring investment.
o Government policies affecting investment, like tax credits.
 Effect on Correlation:
o If demand shifts right (higher investment demand), both investment and interest
rates rise.
o If demand shifts left (lower investment demand), both investment and interest
rates fall.
o Investment and interest rates are positively correlated in this case.

(c) Fluctuating Supply and Demand

 If both supply and demand fluctuate, the correlation between investment and
interest rates becomes weak or inconsistent.
 A scatterplot would show a weak or no clear relationship because sometimes
interest rates and investment move together, while other times they move in
opposite directions.
(d) Most Realistic Case
 Case (c) is the most realistic because both supply and demand for loanable funds
fluctuate due to various economic factors.
 This explains why macroeconomic data do not show a strong correlation between
investment and interest rates—the relationship is obscured by simultaneous shifts in
both curves.