Econ 101 midterm 1

private savings

(Y-T)-C

Equilibrium in the market for real money balances

M/P=L(i,Y)

quantity equation

MV=PY and MV=T

Which of these would decrease the real exchange rate in a small open economy?

a reduction in government spending

An example of decreasing returns to scale is when capital and labor inputs

both increase 10 percent and output increases 5 percent.

Unlike the real world, the classical model with fixed output assumes that:

capital and labor are fully utilized.

If output is described by the production function Y = AK0.2L0.8, then the production function has:

constant returns to scale.

Epsilon=

e.P/P*

NX is a function of

epsilon

Ex-ante vs ex-post interest rate

ex ante: the real interest rate that is calculated before the actual rate of inflation. (expected) ex post: the interest rate after inflation

When saving (the supply of loanable funds) increases as the interest rate increases, an increase in investment demand results in a _____ real interest rate and _____ in the quantity of investment.

higher; an increase

The production function feature called "constant returns to scale" means that if we:

increase capital and labor by 10 percent each, we increase output by 10 percent.

n the classical model with fixed income, a decrease in the real interest rate could be the result of a(n)

increase in taxes

public saving + private saving (S private + S public)

national saving (S)

I is a function of

r*

fisher equation

t=r+pi (nominal interest rate = real interest rate + inflation)

What determines the ratio of the wage to rental rate of capital in a competitive, profit-maximizing economy with constant returns to scale?

the marginal productivity of labor relative to the marginal productivity of capital

The real rental price of capital is the price per unit of capital measured in:

units of output.

If the demand for money depends positively on real income and depends inversely on the nominal interest rate, what will happen to the price level today if the central bank announces (and people believe) that it will decrease the money growth rate in the future, but it does not change the money supply today?

People will expect lower inflation in the future. The nominal interest rate will fall. Money demand will increase. Since the central bank does not immediately decrease the money supply, prices must fall to keep the newly increased money demand equal to the constant money supply. Thus, current prices fall as a result of expected future decreases in money growth rates.

Open Economy identity:

S-I=NX

Closed economy identity:

S=I

public savings

T-G

National Savings formula

Y-C-G

Cobb-Douglas production function

Y=AK^aL^1-a

Assume that a competitive economy can be described by a constant returns to scale (Cobb-Douglas) production function and all factors of production are fully employed. Holding other factors constant, including the quantity of capital and technology, carefully explain how a one-time, 10 percent increase in the quantity of labor (perhaps as a result of a special immigration policy) will change each of the following: a. the level of output produced b. the real wage of labor c. the real rental price of capital d. labor's share of total income

a. Output increases by less than 10 percent because of diminishing returns to labor. b. The real wage decreases because the average productivity of labor decreases (Y/L decreases, as Y increases less in proportion than the increase in L), so the MPL, which equals (1 - a)Y/L, decreases. c. The real rental price of capital increases because the average productivity of capital increases (Y/K increases as Y increases, and K is constant), so the MPK, aY/K, increases. d. Labor's share of income is unchanged since it depends only on the parameter (1 - a) from the production function, which does not change.

Price flexibility plays a key role in the classical model by ensuring that the markets reach equilibrium. a. Explain which price adjusts to bring equilibrium in the labor market. Describe how the price adjusts when demand exceeds supply in this market. b. Explain which price adjusts to bring equilibrium in the loanable funds market. Describe how the price adjusts when supply exceeds demand in this market.

a. The real wage adjusts to make labor demand equal to labor supply. If labor demand is greater than labor supply, the real wage rises, decreasing the quantity of labor demanded until the quantity demanded equals the fixed supply of labor. b. The real interest rate adjusts to make the supply of loanable funds equal to the demand for loanable funds. If the supply of loanable funds is greater than the demand for loanable funds, the interest rate will decrease, increasing the desired quantity of investment spending, which is the demand for loanable funds, until the demand and supply are equal.

If the production function describing an economy is Y = 100 K0.25L0.75, then the share of output going to labor:

is 75 percent