The circular flow model shows that households use income for: |
D) consumption, taxes, and saving |

In the circular flow diagram, firms receive revenue from the _____ market, which is used to purchase inputs in the _____ market. |
C) goods; factor |

In the circular flow model, households receive income from the _____ market and save through the _____ market. |
B) factor; financial |

In the long run, the level of national income in an economy is determined by its: |
A) factors of production and production function |

An economy’s factors of production and its production function determine the economy’s: |
D) output of goods and services |

In the long run, what determines the level of total production of goods and services in an economy? |
B) the quantity of capital, quantity of labor, and production technology |

The two most important factors of production are: |
C) capital and labor |

Unlike the real world, the classical model with fixed output assumes that: |
A) all factors of production are fully utilized |

A production function is a technological relationship between: |
C) factors of production and the quantity of output produced |

The production function feature called "constant returns to scale" means that if we: |
B) increase capital and labor by 10 percent each, we increase output by 10 percent |

If an increase of an equal percentage in all factors of production results in an increase in output of the same percentage, then a production function has the property called: |
C) constant returns to scale |

If bread is produced by using a constant returns to scale production function, then if the: |
C) amounts of equipment and workers are both doubled, twice as much bread will be produced |

At any particular point in time, the output of the economy: |
A) is fixed because the supplies of capital and labor and the technology are fixed |

The neoclassical theory of distribution: |
D) is a theory of how national income is divided among the factors of production |

The price received by each factor of production for its services is determined by: |
D) demand and supply of factors |

When factor supply is fixed and quantity of the factor is graphed on the horizontal axis while factor price is graphed on the vertical axis, the factor: |
B) supply curve is vertical |

A competitive firm: |
A) is small relative to the market in which it trades |

A firm’s economic profit is: |
B) revenue minus costs |

A competitive firm chooses the: |
C) quantity of labor and capital to employ |

The marginal product of labor is: |
B) additional output produced when one additional unit of labor is added |

The property of diminishing marginal product means that, after a point, when additional quantities of: |
D) a factor is added when another factor remains fixed, the marginal product of that factor diminishes |

A competitive, profit-maximizing firm hires labor until the: |
B) price of output multiplied by the marginal product of labor equals the wage |

The real wage is the return to labor measured in: |
B) units of output |

The marginal product of capital is: |
B) additional output produced when one additional unit of capital is added |

The real rental price of capital is the price per unit of capital measured in: |
B) units of output |

The real wage will increase if: |
B) the productivity of labor increases |

An increase in the supply of capital will: |
B) decrease the real rental price of capital |

In the classical model, what adjusts to eliminate any unemployment of labor in the economy? |
D) the real wage |

The neoclassical theory of distribution explains the allocation of: |
C) income among factors of production |

Economic profit is zero if: |
B) all factors are paid their marginal products and there are constant returns to scale |

According to Euler’s theorem, if competitive firms pay each factor its marginal product and the production function has constant returns to scale, the sum of all factor payments will equal: |
D) total output |

Accounting profit is: |
C) economic profit plus the return to capital |

According to the neoclassical theory of distribution, if firms are competitive and subject to constant returns to scale, total income in the economy is distributed: |
D) between the labor and capital used in production, according to their marginal productivities |

According to the neoclassical theory of distribution, total output is divided between payments to capital and payments to labor depending on their: |
D) marginal productivities |

What determines the distribution of national income between labor and capital in a competitive, profit-maximizing economy with constant returns to scale? |
D) the marginal productivity of labor relative to the marginal productivity of capital |

In fourteenth-century Europe, the bubonic plague: |
D) substantially increased real wages in Europe |

With a Cobb-Douglas production function, the share of output going to labor: |
D) is independent of the amount of labor |

If output is described by the production function Y = AK 0.2L0.8, then the production function has: |
A) constant returns to scale |

If Y = AK0.5L0.5 and A, K, and L are all 100, the marginal product of capital is: |
A) 50 |

Since 1960, the U.S. ratio of labor income to total income has: |
B) been about 0.7 |

If the production function describing an economy is Y = 100 K.25L.75, then the share of output going to labor: |
B) is 75 percent |

In a Cobb-Douglas production function the marginal product of labor will increase if: |
B) the quantity of capital increases |

In a Cobb-Douglas production function the marginal product of capital will increase if: |
A) the quantity of labor increases |

According to Goldin and Katz, the increasing income inequality of recent decades is the result of: |
C) a steady pace of technological advance and a slowdown in educational advance |

Skill-biased technological change ______ the demand for high-skilled workers, while the slowdown in the pace of educational advancement reduces the supply of skilled workers, resulting in relatively _____ wages for skilled workers. |
A) increases; higher |

The public policy implication of Goldin and Katz’s analysis of growing income inequality is that reversing this trend will require that more of society’s resources be put into: |
C) education |

Estimates by Goldin and Katz indicate that the financial returns of a year of college _____ between 1980 and 2005. |
A) increased |

According to the neoclassical theory of distribution, in an economy described by a Cobb-Douglas production function, workers should experience high rates of real wage growth when: |
C) average labor productivity is growing rapidly |

According to the neoclassical theory of distribution, in an economy described by a Cobb-Douglas production function, when average labor productivity is growing rapidly: |
C) workers will experience high rates of real wage growth |

In a closed economy, the components of GDP are: |
C) consumption, investment, and government purchases |

The demand for output in a closed economy is the sum of: |
C) consumption, investment, and government spending |

Disposable personal income is defined as income after the payment of all: |
A) taxes |

A consumption function shows the relationship between consumption and: |
C) disposable income |

Consumption depends ______ on disposable income, and investment depends ______ on the real interest rate. |
B) positively; negatively |

The marginal propensity to consume is: |
A) normally expected to be between zero and one |

If the consumption function is given by C = 500 + 0.5(Y – T), and Y is 6,000 and T is given by T = 200 + 0.2Y, then C equals: |
B) 2,800 |

If the consumption function is given by the equation C = 500 + 0.5Y, the production function is Y = 50K0.5L0.5, where K = 100 and L = 100, then C equals: |
C) 3,000 |

If the consumption function is given by C = 150 + 0.85Y and Y increases by 1 unit, then C increases by: |
C) 0.85 units |

If the consumption function is given by C = 150 + 0.85Y and Y increases by 1 unit, then savings: |
C) increases by 0.15 units |

If the consumption function is given by C = 150 + 0.85(Y – T) and T increases by 1 unit, then savings: |
B) decreases by 0.15 units |

Assume that the consumption function is given by C = 150 + 0.85(Y – T) and the tax function is given by T = t0 + t1Y. If t0 increases by 1 unit, then consumption: |
A) decreases by 0.85 units |

Assume that the consumption function is given by C = 150 + 0.85(Y – T), the tax function is given by T = t0 + t1Y, and Y is 5,000. If t1 decreases from 0.3 to 0.2, then consumption increases by: |
B) 425 |

Assume that the consumption function is given by C = 200 + 0.7(Y – T), the tax function is given by T = 100 + t1Y, and Y = 50K0.5L0.5, where K = 100 and L = 100. If t1 increases from 0.2 to 0.25, then consumption decreases by: |
C) 175 |

Assume that the consumption function is given by C = 200 + 0.7(Y – T), the tax function is given by T = 100 + 0.2Y, and Y = 50K0.5L0.5, where K = 100. If L increases from 100 to 144, then consumption increases by: |
A) 560 |

Investment goods as measured in the GDP are purchased by: |
C) business firms and household |

Total investment in the United States averages about ______ percent of GDP. |
B) 15 |

Other things equal, an increase in the interest rate leads to: |
A) a decrease in the quantity of investment goods demanded |

When economists speak of "the" interest rate, they mean: |
D) no particular interest rate, since it is assumed that various interest rates tend to move up and down together |

Assume that a firm wants to build a factory that will cost $5 million. It believes that it can get a return of $600,000 in one year and then can sell the used factory for its original cost. The rate of return on this investment would be: |
B) 12 percent |

Assume that a firm is considering building a factory that will cost $5 million. It believes that it can get a profit from this factory of $600,000 per year for many years. The interest rate at which the firm can borrow money is 15 percent. After evaluating whether it should build the factory, the firm decides that it should: |
B) not build because the rate of return on the factory is only 6 percent |

The home that would have the highest mortgage payment on a 30-year fixed-rate mortgage would be a home with a mortgage of: |
D) $200,000 at 12 percent |

The nominal interest rate is the: |
A) rate of interest that investors pay to borrow money |

The real interest rate is the: |
D) nominal intersect rate minus the rate of inflation |

Assume that the investment function is given by I = 1,000 – 30r, where r is the real rate of interest (in percent). Assume further that the nominal rate of interest is 10 percent and the inflation rate is 2 percent. According to the investment function, investment will be: |
C) 760 |

The investment function slopes ______ because there are ______ investment projects that are profitable as the interest rate decreases. |
D) downward; more |

Consumption depends positively on ______ and investment depends negatively on ______. |
A) disposable income; the real intersect rate |

The government spending component of GDP includes all of the following except: |
C) federal spending on transfer payments |

If government purchases exceed taxes minus transfer payments, then the government budget is: |
B) in deficit |

All of the following actions increase government purchases of goods and services except the: |
A) federal government’s sending a Social Security check to Betty Jones |

Government transfer payments: |
B) can be viewed as negative tax payments, T |

In examining the impact of fiscal policy, it is assumed that: |
A) consumption, investment, and the interest rate are endogenous variables |

In a classical model with fixed factors of production and flexible prices, the amount of consumption spending depends on _____ , the amount of investment spending depends on _____, and the amount of government spending is determined _____. |
D) disposable income; the interest rate; exogenously |

In the classical model with fixed output, the supply and demand for goods and services are balanced by: |
D) the interest rate |

equation |
… |

The demand for the economy’s output: |
C) is equal to consumption, investment, and government purchases |

In the classical model with fixed income, if the demand for goods and services is less than the supply, the interest rate will: |
B) decrease |

In the classical model with fixed income, if the demand for goods and services is greater than the supply, the interest rate will: |
A) increase |

In the classical model with fixed income, if the interest rate is too low, then investment is too ______ and the demand for output ______ the supply. |
A) high; exceeds |

In the classical model with fixed income, if the interest rate is too high, then investment is too ______ and the demand for output ______ the supply. |
D) low; falls short of |

National saving refers to: |
C) income minus consumption minus government spending |

Public saving is: |
D) either positive, negative, or zero |

In a closed economy, Y – C – G equals: |
A) national saving |

In a closed economy, private saving equals: |
B) Y – T – C |

The factor that makes national saving equal investment, in equilibrium, is: |
A) the interest rate |

Private saving is: |
B) disposable income minus consumption |

Public saving is: |
D) government revenue minus government spending |

National saving is: |
C) private saving plus public saving |

If disposable income is 4,000, consumption is 3,500, government spending is 1,000, and taxes minus transfers are 800, national saving is equal to: |
A) 300 |

If income is 4,800, consumption is 3,500, government spending is 1,000, and taxes minus transfers are 800, private saving is: |
B) 500 |

If income is 4,800, consumption is 3,500, government spending is 1,000, and taxes minus transfers are 800, public saving is: |
A) -200 |

In equilibrium, total investment equals: |
C) national saving |

The demand for loanable funds is equivalent to: |
D) investment |

The supply of loanable funds is equivalent to: |
A) national saving |

The supply and demand for loanable funds determines the: |
C) real interest rate |

If saving exceeds investment demand, and consumption is not a function of the interest rate: |
B) the interest rate will fall |

In the classical model with fixed income, if households want to save more than firms want to invest, then: |
B) the interest rate falls |

When the demand for loanable funds exceeds the supply of loanable funds, households want to save ______ than firms want to invest and the interest rate ______. |
C) less; rises |

Assume that equilibrium GDP (Y) is 5,000. Consumption (C). is given by the equation C = 500 + 0.6Y. No government exists. In this case, equilibrium investment is: |
A) 1,500 |

Assume that equilibrium GDP (Y) is 5,000. Consumption (C) is given by the equation C = 500 + 0.6(Y – T). Taxes (T) are equal to 1,000. Government spending is 600. In this case, equilibrium investment is: |
C) 1,500 |

Assume that equilibrium GDP (Y) is 5,000. Consumption (C) is given by the equation C = 500 + 0.6Y. Investment (I) is given by the equation I = 2,000 – 100r, where r is the real interest rate in percent. No government exists. In this case, the equilibrium real interest rate is: |
B) 5 percent |

Assume that equilibrium GDP (Y) is 5,000. Consumption (C) is given by the equation C = 500 + 0.6(Y – T). Taxes (T) are equal to 600. Government spending is equal to 1,000. Investment is given by the equation I = 2,160 – 100r, where r is the real interest rate in percent. In this case, the equilibrium real interest rate is: |
D) 13 percent |

According to the model developed in Chapter 3, when government spending increases without a change in taxes: |
D) investment decreases |

According to the model developed in Chapter 3, when taxes decrease without a change in government spending: |
C) consumption increases and investment decreases |

According to the model developed in Chapter 3, when government spending increases and taxes increase by an equal amount: |
B) consumption and investment both decrease |

According to the model developed in Chapter 3, when government spending increases but taxes are not raised, interest rates: |
A) increase |

According to the model developed in Chapter 3, when taxes are increased but government spending is unchanged, interest rates: |
C) decrease |

In a closed economy with fixed output, when government spending increases: |
C) public saving decreases |

In the neoclassical model with fixed income, if there is a decrease in government spending with no change in taxes, then public saving ______ and private saving ______. |
B) increases; does not change |

Crowding out occurs when an increase in government spending ______ the interest rate and investment ______. |
B) increases; decreases |

The reduction in investment brought about by the increase in the interest rate caused by increased government spending is called: |
D) crowding out |

In the United Kingdom between 1730 and 1920, during wartime, government spending tended to increase: |
B) and the interest rate also increased |

In the classical model with fixed income, an increase in the real interest rate could be the result of a(n): |
A) increase in government spending |

In the classical model with fixed income a decrease in the real interest rate could be the result of a(n): |
C) increase in taxes |

In the classical model with fixed income, a reduction in the government budget deficit will lead to a: |
B) lower real interest rate |

When government spending increases and taxes are increased by an equal amount, interest rates: |
A) increase |

In the neoclassical model with fixed income, if there is a decrease in taxes with no change in government spending, then public saving ______ and private saving ______. |
C) decreases; increases |

… |
… |

Use the model developed in Chapter 3 and assume that consumption does not depend on the interest rate. In this case, when there is a technological advance that leads to an increase in investment demand: |
B) investment is unchanged and the interest rate rises |

Use the model developed in Chapter 3 and assume that consumption does not depend on the interest rate. In this case, when the government lowers taxes on business investment, thus increasing desired investment, but does not change government spending or change any taxes that affect disposable income, then the quantity of investment: |
D) decreases and the interest rate rises |

Use the model developed in Chapter 3, but assume that consumption decreases, other things being equal, when the interest rate rises. If there is a technological advance that leads to an increase in investment demand: |
A) investment increases and the interest rate rises |

When there is a fixed supply of loanable funds, an increase in investment demand results in a(n): |
A) higher interest rate |

When saving (the supply of loanable funds) increases as the interest rate increases, an increase in investment demand results in a ______ interest rate and ______ in the quantity of investment. |
B) higher; an increase |

Suppose that GDP (Y) is 5,000. Consumption (C) is given by the equation C = 500 + 0.5(Y – T). Investment (I) is given by the equation I = 2,000 – 100r, where r is the real interest rate in percent. Government spending (G) is 1,000 and taxes (T) is also 1,000. When a technological innovation changes the investment function to I = 3,000 – 100r: |
C) I is unchanged and r rises by 10 percentage points |

If increased immigration raises the labor force, the neoclassical theory of distribution predicts: |
D) the real wage will fall and the real rental price of capital will rise |

If an earthquake destroys some of the capital stock, the neoclassical theory of distribution predicts: |
D) the real wage will fall and the real rental price of capital will rise |

If a neutral technological advance improves the production function, the neoclassical theory of distribution predicts: |
C) both the real wage and the real rental price of capital will rise |

An example of decreasing returns to scale is when capital and labor inputs: |
A) both increase 10 percent and output increases by 5 percent |

An example of increasing returns to scale is when capital and labor inputs: |
C) both increase 5 percent and output increases 10 percent |

If the productivity of farmers has risen substantially over time because of technological progress, and workers can move freely between being farmers and barbers, the neoclassical theory of distribution predicts that the real wage(s) of: |
B) both barbers and farmers should have rise over time |

The government raises lump-sum taxes on income by $100 billion, and the neoclassical economy adjusts so that output does not change. If the marginal propensity to consume is 0.6, private saving: |
D) falls by $40 billion |

The government raises lump-sum taxes on income by $100 billion, and the neoclassical economy adjusts so that output does not change. If the marginal propensity to consume is 0.6, public saving: |
A) rises by $100 billion |

The government raises lump-sum taxes on income by $100 billion, and the neoclassical economy adjusts so that output does not change. If the marginal propensity to consume is 0.6, national saving: |
B) rises by $60 billion |

The government raises lump-sum taxes on income by $100 billion, and the neoclassical economy adjusts so that output does not change. If the marginal propensity to consume is 0.6, investment: |
B) rises by $60 billion |

Assume that an increase in consumer confidence raises consumers’ expectations of future income and thus the amount they want to consume today for any given income. This shift, in a neoclassical economy, will: |
A) lower investment and raise the interest rate |

In a neoclassical economy, assume that the government lowers both government spending and taxes by the same amount. By doing so: |
B) investment rises and the interest rate falls |

In a neoclassical economy, assume that the government lowers both government spending and taxes by $100 billion. If the marginal propensity to consume is 0.6, investment will: |
C) rise $40 billion |

In a neoclassical economy, if consumption increases as the interest rate decreases, then a $10 billion rise in government spending would: |
B) crowd out between zero and $10 billion of investment |

Assume that the production function is Cobb-Douglas with parameter α = 0.3. If factors are paid their marginal products, capital and labor, respectively, receive the shares of income: |
C) 0.3 and 0.7 |

Assume that the production function is Cobb-Douglas with parameter α = 0.3. In the neoclassical model, if the labor force increases by 10 percent, then output: |
B) increases by about 7 percent |

In an economy with flexible prices, competitive factor markets and fixed supplies of the factors of production, graphically illustrate the impact of a change in immigration policy in a country that permits a huge influx of foreign workers into the labor market, ceteris paribus. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curve’s shift; and v. the terminal equilibrium values. Explain in words how the equilibrium values of labor, the real wage, saving, investment, and the real interest rate change |
the supply of labor force increases, which forces the real wage lower and increases the quantity of labor employed, since there is no unemployment in this model. Output (Y) increases as labor increases, national saving (Y – C – G) increases, which makes the equilibrium of rate of interest fall to bring national saving and investment into equilibrium |

In an economy with flexible prices, competitive factor markets, and fixed supplies of the factors of production, graphically illustrate the impact of an advance in technology that greatly improves the productivity of capital, ceteris paribus. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the terminal equilibrium values. Explain in words how the equilibrium values change. |
the demand for capital increases, which increases the real rental price of capital, but the quantity of capital employed is unchanged at the level of the fixed supply |

In an economy with flexible prices, competitive factor markets, and fixed supplies of the factors of production, graphically illustrate the impact of a deadly virus that kills a large part of the labor force, but leaves the other factors of production untouched, ceteris paribus. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the terminal equilibrium values. Explain in words how the equilibrium values change. |
the supply of labor decreases, which increases the real wage. All of the reduced labor force is employed |

Assume that the production function is given by Y = AK0.5L0.5, where Y is GDP, K is capital stock, and L is labor. The parameter A is equal to 10. Assume also that capital is 100, labor is 400, and both capital and labor are paid for their marginal products. |
a. 2,000 b. 2.5 c. 10 |

Assume that GDP (Y) is 6,000. Consumption (C). is given by the equation C = 600 + 0.6(Y – T). Investment (I) is given by the equation I = 2,000 – 100r, where r is the real rate of interest in percent. Taxes (T) are 500 and government spending (G) is also 500. |
a. 3,900; 1,600; 4 percent b. 1,600; 0; 1,600 c. 3,900; 1,100; 9 percent d. 1,600; -500; 1,100 |

Assume that GDP (Y) is 5,000. Consumption (C). is given by the equation C = 1,000 + 0.3(Y – T). Investment (I) is given by the equation I = 1,500 – 50r, where r is the real interest rate in percent. Taxes (T) are 1,000 and government spending (G) is 1,500. |
a. 2,200; 1,300; 4 percent b. 1,800; -500; 1,300 c. 2,200; 1,300; 14 percent d. 1,800; -500; 1,300 |

Assume that GDP (Y) is 5,000. Consumption (C). is given by the equation C = 1,200 + 0.3(Y – T) – 50r, where r is the real interest rate. Investment (I) is given by the equation I = 1,500 – 50r. Taxes (T) are 1,000 and government spending (G) is 1,500. |
a. 2,200; 1,300; 4 percent b. 1,800; -500; 1,300 c. 1,950; 1,550; 9 percent d. 2,050; -500; 1,550 |

a. Suppose a government moves to reduce a budget deficit. Using the long-run model of the economy developed in Chapter 3, graphically illustrate the impact of reducing a government’s budget deficit by reducing government purchases. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction curves shift; and v. the terminal equilibrium values. |
b. i. real interest rate decreases ii. national saving increases iii. investment increases iv. consumption is unchanged v. output is unchanged, fixed because it is determined by the factors of production |

a. Suppose a government moves to reduce a budget deficit. Using the long-run model of the economy developed in Chapter 3, graphically illustrate the impact of reducing a government’s budget deficit by increasing (lump-sum) taxes on household income. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction curves shift; and v. the terminal equilibrium values. |
b. i. real interest rate decreases ii. national saving increases iii. investment increases iv. consumption decreases v. output is unchanged, fixed because it is determined by the factors of production |

a. Suppose a government education program succeeds in getting households to save more (you may interpret this as a downward shift in the consumption function). Using the long-run model of the economy developed in Chapter 3, graphically illustrate the impact of the higher saving rate by households. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction curves shift; and v. the terminal equilibrium values. |
b. i. real interest rate decreases ii. national saving increases iii. investment increases iv. consumption decreases v. output is unchanged, fixed because it is determined by the factors of production |

a. Suppose there is a technological breakthrough that increases the productivity of all capital and, consequently, increases the demand for investment. Using the long-run model of the economy developed in Chapter 3, graphically illustrate the impact of the increased investment demand. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction curves shift; and v. the terminal equilibrium values. |
b. i. real interest rate increases ii. national saving is unchanged iii. amount of investment is unchanged iv. consumption is unchanged v. output is unchanged, fixed because it is determined by the factors of production |

a. Suppose a government decides to reduce spending and (lump-sum) income taxes by the same amount. Using the long-run model of the economy developed in Chapter 3, graphically illustrate the impact of the equal reductions in spending and taxes. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction curves shift; and v. the terminal equilibrium values. |
b. i. real interest rate decreases ii. national saving increases iii. investment increases iv. consumption increases v. output is unchanged, fixed because it is determined by the factors of production |

Consider two competitive economies that have the same quantities of labor (L = 400) and capital (K = 400), and the same technology (A = 100). The economies of the countries are described by the following Cobb-Douglas production functions: |
a. output is the same in both economies, given the symmetry of the parameters of the productions function and the equal quantities of labor and capital b. The MPL is larger in the South Economy. The MPL depends on the value of (1 – α) and the average productivity of labor (Y/L). Since the average productivity of labor is the same in both countries, differences in the MPL depend on the value of (1 – α), which is larger in South Economy (.7) than in North Economy (.3). c. Since factors are paid according to the values of their marginal products, the real wage is larger in South Economy, because the MPL is larger in South Economy than in North Economy (from part b). d. Labor’s share of income equals (1 – α), which is larger in South Economy (.7) than in North Economy (.3). |

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 the result of a special immigration policy) will change each of the following: |
a. output increases by less than 10 percent because 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 – α)Y/L, decreases c. the real rental price of capital increases because the average productivity of capital increases (Y/K increases, as Y decreases proportionally less than K decreases), so the MPK, αY/K increases d. labor’s share of income is unchanged, since it depends only on the parameter (1 – α) from the production function, which does not change. |

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 labor and technology, carefully explain how a one-time, 50-percent decrease in the quantity of capital (perhaps the result of war damage) will change each of the following: |
a. Output decreases by less than 50 percent because of diminishing returns to capital. b. The real wage decreases because the average productivity of labor decreases (Y/L decreases, as Y decreases and L is constant), so the MPL, which equals (1 – α)Y/L, decreases. c. The real rental price of capital increases because the average productivity of capital increases (Y/K increases, as Y decreases proportionally less than K decreases), so the MPK, αY/K increases. d. capital’s share of income is unchanged since it depends only on the parameter (α) 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. 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 of labor demanded equals the fixed supply of labor |

After studying the circular flow of dollars in the economy, explain with an example how saving done by households goes back into the circular flow. In reality, does all saving go back as an investment? |
according to the circular flow of dollars diagram, households save their money in financial markets and then financial markets lend this money to markets, some of the money is kept by people to themselves as cash, which does not get converted to investment |

The economy of Miniland has an income of $400, consumption is $200, government expenditure is $200, and the tax earnings of government is $150. |
Y = $400 C = $200 T = $150 G = $200 a. Private saving= Y – C – T = 400-200-150=$50 b. Public saving = T-G= 150 – 200 = -$50 c. National saving = private saving + public saving= 50 + -50 = $0 |

Suppose people in an economy reduce their saving. What will be the effect on real interest rate and investment? |
if households develop a tendency of saving less, there will be less money to lend, so the support of loanable funds will be less. This will increase the real interest rates r, and due to the increase in r investors will find it more costly to take a loan, so investment will decrease |

What effect does advancement in technology have upon the equilibrium between real rental price and capital (assuming supply of capital is fixed)? |
provided that the supply of capital is fixed, advancement in technology will increase the demand for capital. but as the supply is fixed, the real rental price will increase. So the new equilibrium will be in the same supply amount of capital with increased real rental price |

The government of an economy has increased its spending and taxes by the same amount. What is the effect on investment? |
with increased taxes, people will have less money to consume and save, so there will be reduction in private saving. With increased government spending, public saving will also be reduced. Reduction in both private saving and public saving will lead to a reduction in national saving, and as national saving is equal to investment, this implies a decrease in investment |

The closed economy of Moneyland has total income of $5000, consumption function is C = 2000 – 30r, investment function I = 1500 – 20r, government spending is $2000, r is nominal interest rate. Inflation is 6 percent. Find the real rate of interest. |
Y = C+I+G; 5000=2000-30r+1500-2r+2000; r=10 percent real interest rate = r-inflation=10-6=4 percent |

The production of an economy is explained by a function: Y = 20 (L.5K.5) where L is labor and K is capital with L = 400 and K = 400. Does this economy support constant returns to scale? |
when increase in percentage of output equals the increased percentage of all factors of production it is called constant returns to scale. Here output is 8000 units, so if we double the factors of production, L=800 and K=800, we see that the output becomes 16,000 units, double of 8000 units supporting the constant returns to scale |

The total output of the closed economy Moneyland is 10,000. Consumption is explained by the function C = 3,800 + 0.7T – 150r, where r is the real interest rate. Investment (I) is given by the equation, I = 1,500 + 50r. Taxes (T) are 1,000 and government spending (G) is 3,500. What are the values of consumption, investment, and real interest rate? |
Y = 10,000 C = 3,800 + .7T – 150r I = 1,500 + 50r T = 1,000 G = 4,500 Y = C + I + G by plugging in values of Y, C, I, T and G we get r = 5 percent by plugging in the value of r in C and G we get: C = 3,750 and I= 1,750 |

What is the effect of an increase in interest rate on keeping government spending constant on consumption and investment? |
with increase in interest rates, firms find taking loans for investments to be more costly, so this will decrease investments. and households start looking to saving as a better option than consuming, so consumption will decrease |

# Macroeconomics Ch 3

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