Economics Review and Practice Questions

In the Solow model, how does the rate of population growth affect the steady-state level of income? How doe sit affect the steady-state rate of growth?

A higher population growth rate leads to lower steady-state capital per worker and thus lower steady-state income per worker. To see why, consider A higher population growth rate decreases the incentive to accumulate capital and results in lower steady-state capital per worker. In a model with no technological change, the steady-state growth rate of total income is n, so a higher population growth rate gives a higher steady-state rate of growth. Income per worker, however, is constant in a steady state.

In the Solow model, how does the saving rate affect the steady-state level of income? How does it affect the steady-state rate of growth?

In the Solow growth model, a higher saving rate leads to a larger steady-state capital stock and a higher level of steady-state output. Increasing the saving rate leads to faster economic growth only in the short run, as the economy converges to the new steady state. In a steady state, the growth rate of output (or income) is independent of the saving rate.

In the Solow model, what determines the steady-state rate of growth of income per worker?

In the Solow model, we find that only technological progress can affect the steady-state rate of growth of income per worker. Growth in the capital stock (through saving) has no effect on the steady-state growth rate of income per worker, and neither does population growth. Technological progress, rather than factor accumulation, leads to sustained growth in income per worker.

Give an example of an institutional difference between countries that might explain the differences in income per person.

The legal system is an example of an institutional difference between countries that might explain differences in income per person. Countries that have adopted the English-style common law system tend to have better-developed capital markets, and this leads to more rapid growth through more efficient financing of investment projects. The quality of government is also important. Countries with more government corruption tend to have lower levels of income per person.

The residents of a certain dormitory have collected the following data: people who live in the dorm can be classified as either involved in a relationship or uninvolved. Among people involved, 10% experience a breakup of their relationship every month. Among uninvolved people, 5% enter into a relationship every month. What is the steady-state fraction of residents who are uninvolved?

We can reinterpret the formula for the natural rate of unemployment: U/L = s/(s + f ). Let U/L be the steady-state fraction of residents who are uninvolved, let s = 0.1 be the rate at which involved residents break up, and let f = 0.05 be the rate at which uninvolved residents enter into relationships. The steady-state fraction of residents who are uninvolved is then U/L = s/(s + f ) = 0.1/(0.1 + 0.05) = 2/3.

When the real GDP declines during a recession, what typically happens to consumption, investment, and the unemployment rate?

When real GDP declines during a recession, consumption and investment typically decline also, and the unemployment rate typically rises.

In any city at any time, some of the stock of usable office space is vacant. This vacant office space is unemployed capital. How would you explain this phenomenon? In particular, which approach to explaining unemployed labor applies best to unemployed capital? Do you think unemployed capital is a societal problem?

The vacant office space problem is similar to the unemployment problem, so we can apply the same concepts we used in analyzing unemployment to analyze office vacancies. There is a rate of office separation: firms that occupy offices leave, either to move to different offices or because they go out of business. There is a rate of office finding: firms that need office space (either to start up or expand) find empty offices. Different types of firms want spaces with different attributes, so it takes time to match firms with available office space. This is analogous to frictional unemployment.

How can policymakers influence a nation's saving rate?

Economic policy can influence the saving rate by either increasing public saving or providing incentives to stimulate private saving. Public saving is the difference between government revenue and government spending. Public saving can be increased by reducing government expenditure or raising taxes. A variety of government policies affect private saving. The decision by a household to save may depend on the rate of return to saving; the greater the return, the greater the incentive to save. Tax incentives such as tax-exempt retirement accounts for individuals and investment tax credits for corporations increase the rate of return and encourage private saving.

Give three explanations of why the real wage may remain above the level that equilibrates labor supply and labor demand. (3)

Efficiency-wage theories suggest that higher wages make workers more productive. The influence of wages on worker efficiency may explain why firms often do not cut wages when there is an excess supply of labor. Although a wage cut would decrease a firm's wage bill, it could also lower worker productivity and firm profits.

Do Europeans work more or fewer hours than Americans? List three hypotheses that have been suggested to explain the difference.

Europeans work fewer hours than Americans. - One explanation is that higher tax rates in Europe reduce the incentive to work. Higher tax rates may also lead to a larger underground economy in Europe as a result of tax evasion, and it is more difficult to measure hours worked in the underground economy. - A second explanation is the greater importance of unions in Europe since they can employ collective bargaining to reduce work hours. - A third explanation is based on preferences and argues that Europeans value leisure more than Americans and therefore elect to work fewer hours.

Many demographers predict that the United States will have zero population growth in the coming decades, in contrast to the historical average population of about 1% per year. Use the Solow model to forecast the effect of this slowdown in population growth on the growth of total output and the growth of output per person. Consider the effects both in the steady state and in the transition between steady states.

First consider steady states. As Figure 8-7 shows, a decrease in the population growth rate shifts the break-even investment curve downward and leads to a higher level of steady-state capital per worker and output per worker. In a steady state, total output grows at rate n, whereas output per worker is constant. Hence, in the long run, slower population growth will lead to slower total output growth but will leave per-worker output growth unchanged. In the transition to the new steady state, output per worker will increase as it converges to its new steady-state level, so there will be positive growth in output per worker in the short run, but the growth rate of output per worker will fall back to zero in the long run. The growth rate of total output during the transition will be equal to the growth rate in output per worker plus the new population growth rate, so the growth rate will be relatively high in the short run and will eventually fall back to the rate of population growth.

"Devoting a larger share of national output to investment would help restore rapid productivity growth and rising living standards." Do you agree with this claim? Explain, using the Solow model.

Suppose the economy begins in a steady with capital per worker below the Golden Rule level. Then suppose the economy adopts the (higher) saving rate needed to achieve the Golden Rule steady state. Comparing the two steady states, output per worker and consumption per worker are both higher with the higher saving rate, so the standard of living increases in the long run. But in both steady states the growth rate of output per worker is zero, so the long-run rate of productivity growth is unaffected by the higher saving rate. We can also consider the transition from one steady state to the other. The higher saving rate leads to higher growth in output per worker in the short run, but it also lowers consumption per worker in the short run, so there is a short-term sacrifice involved in achieving a higher standard of living in the long run.

Use the Keynesian cross to explain why fiscal policy has a multiplied effect on national income.

The Keynesian-cross model tells us that fiscal policy has a multiplied effect on income. The reason is that, according to the consumption function, higher income causes higher consumption. For example, an increase in government purchases of ΔG raises expenditure and, therefore, income by ΔG. This increase in income causes consumption to rise by MPC ΔG, where MPC is the marginal propensity to consume. This increase in consumption raises expenditure and income even further. This feedback from consumption to income continues indefinitely. Therefore, in the Keynesian-cross model, increasing government spending by one dollar causes an increase in income that is greater than one dollar: it increases by 1/(1 - MPC) dollars.

Give three explanations of why the real wage may remain above the level that equilibrates labor supply and labor demand. (2)

The monopoly power of unions causes wage rigidity because the wages of unionized workers are determined not by market supply and demand but by collective bargaining between union leaders and firm management. The wage agreement often raises the wage above the equilibrium level, which causes firms to hire fewer workers than they would have at the market-clearing wage, so structural unemployment increases.

What determines the natural rate of unemployment?

The rates of job separation and job finding determine the natural rate of unemployment. The rate of job separation is the fraction of people who lose their job each month. The higher the rate of job separation, the higher the natural rate of unemployment. The rate of job finding is the fraction of unemployed people who find a job each month. The higher the rate of job finding, the lower the natural rate of unemployment.

Give three explanations of why the real wage may remain above the level that equilibrates labor supply and labor demand. (1)

The real wage may remain above the level that equilibrates labor supply and demand because of minimum-wage laws, the monopoly power of unions, and efficiency wages. Minimum-wage laws cause wage rigidity when they prevent wages from falling to equilibrium levels. Although most workers are paid a wage above the minimum, for some workers, especially those who are unskilled and inexperienced, the minimum wage raises their wage above the equilibrium level. It therefore reduces the quantity of their labor that firms demand. This creates an excess supply of workers, which increases unemployment.

In the discussion of German and Japanese postwar growth, the text describes what happens when part of the capital stock is destroyed in a war. By contrast, suppose that a war does not directly affect the capital stock but that casualties reduce the labor force. Assume that the economy was in a steady state before the war, the saving rate is unchanged, and the rate of population growth after the war is the same as it was before. a.) What is the immediate impact of the war on total output and on output per person? b.) What happens subsequently to output per worker in the postwar economy? Is the growth rate of output per worker after the war smaller or greater than it was before the war?

a.) The production function in the Solow growth model is Y = F(K, L), or, expressed in per-worker terms, y = f(k). If a war reduces the labor force through casualties, then L falls but k = K/L rises. Thus, total output falls because there are fewer workers, but output per worker rises because each worker has more capital. b.) The economy is initially in a steady state with capital per worker k*, as shown in Figure 8-2. After the war, the reduction in the labor force increases capital per worker to k1. With capital per worker of k1, investment is lower than its break-even level, so capital per worker, and therefore output per worker, will fall over time as the economy converges to the steady state. The economy will experience an economic contraction.