# TUTORIAL 2 (WEEK 6-10 AUGUST

)
SOLUTION GUIDE Measuring Macroeconomic Performance: Output, Prices and Saving

Measuring Macroeconomic Performance: Investment, Unemployment and the Labour Market Main Concepts Investment and capital formation Model of saving, investment and the real interest rate Demand for labour Supply of labour Model of labour demand, supply and the real wage Unemployment – frictional, structural and cyclical Full employment Review Questions Question 1

(i) Identify three factors that can affect a firm’s cost of capital.
(ii) At the aggregate level what factor is likely to be the most significant cause of variation in the cost of capital? Explain your reasoning. (i)The final formula for the nominal cost of capital (derived in my lecture notes) is given by: Cost of capital = 𝑷𝑲 (𝒓 + 𝜹)

where 𝑷𝑲 is the price of a capital good for the firm, 𝒓 = 𝒊 − 𝝅 is the real interest rate and 𝜹 is the physical depreciation rate. In practice one might expect the price of capital and the real interest rate to be more important (more variable!) than the depreciation rate. Note that a rise in a firm’s cost of capital will (other things equal) reduce its investment. (ii)At the aggregate level it the real interest rate is likely to be the most important influence on the cost of capital. To see this divide both sides of the above formula by the aggregate price index P to get the real cost of capital Real cost of capital = 𝑷𝑲
(𝒓 𝑷

If the price of capital goods tends to rise at the same rate as the general price level, 𝑷𝑲 will be roughly constant. Of course there are cases where this is not true. then 𝑷 Think about what has happened to the relative price of IT (information technology) capital over time. Question 2 Use the aggregate saving and investment diagram to predict the effects on the real interest rate, saving and investment of the following events. (i)Parliament passes a 10 percent investment tax credit. (For every dollar a firm spends on investment it receives an extra \$10 in tax refunds from the government).

+ 𝜹)

moving the budget from a deficit to a surplus.The investment tax credit effectively lowers the price of new capital goods to the firm by 10%. and national saving rise as Investment curve shifts to the right. I (ii)Concerns about the level of public debt lead the government to reduce expenditure and raise taxes. national saving and investment rise. S(r) real rate r1 r0 I(r) S0=I0 S1=I1 S. Firms’ willingness to invest increases. The supply of saving (S) curve shifts right. S(r) real rate I(r) S. Increased public saving raises national saving. The real interest rate falls. I . shifting the I(r) curve to the right. The real interest rate. investment.

Following the introduction of the new machines. from the formula Marginal product = (200 – Ns). Increased productivity makes large-scale investment in solar power more profitable. the marginal product of a skilled worker rises to (300 – 100). At \$3 per toy. Similarly. equals 200 − 𝑁 𝑠 . See case (i) for diagram. (ii)Assuming that the number of skilled workers remains equal to 100. where 𝑁 𝑢 is the number of unskilled workers employed. vertical labour supply curves). if there are 50 employed unskilled workers (Nu = 50). measured in terms of toys produced per day. (i)Assume there are 100 skilled and 50 unskilled workers and these numbers are fixed (i. The value of the marginal product of unskilled workers and hence their wage is unchanged at \$150 per day. and (at \$3 per toy) their value of marginal product equals \$300 per day. The marginal product of skilled workers. The value of the marginal product of skilled workers (assuming that Ns = 100 + S) will be \$3[300 – (100 + S)]. (iii)Initially there are 100 skilled workers and 50 unskilled workers. But it is a good exercise for students to work though this question (particularly parts (i) and (ii)). their marginal product is 50 toys and the value of their marginal product is \$150 per day. as does their wage. or 200 toys per day. what will be the equilibrium wage for each type of worker? (ii)New machines are introduced that increases the marginal product of skilled workers to 300 − 𝑁 𝑠 . raising the real interest rate. where 𝑁 𝑠 is the number of skilled workers employed. In dollars. skilled workers will earn \$300 per day and unskilled workers will earn \$150 per day.(iii)A new innovation dramatically reduces the cost of producing solar power on a large scale. investment. and national saving. Question 3 Either skilled or unskilled workers can be used to produce a small toy. then there will be 100 + S skilled workers and 50 – S unskilled workers. Toys sell for \$3 each. but does not affect the marginal product of the unskilled workers. how many unskilled workers will become skilled? Note that I did not cover this issue of skill-biased technical change in my lectures. If S unskilled workers acquire skills. the marginal product of a skilled worker equals 100 toys per day. Since in equilibrium the wage equals marginal product. and the value of the marginal product of unskilled . The marginal product of unskilled workers is 100 − 𝑁 𝑢 . The Investment (I) curve shifts to the right. the value of the marginal product rises to \$600 per day. What is the new equilibrium wage for the two groups? (iii)Suppose that unskilled workers find it worthwhile to acquire skills when the wage differential between skilled and unskilled workers is at least \$300 per day. (i)If all skilled workers are employed (Ns = 100).e.

(iii)Structural. Alice’s unemployment is temporary and associated with a recession. so it is likely that there is also a structural element to Tim’s unemployment. The delay in taking a new job arises because Karen is trying to find the best opportunity. Thus S will be determined by the condition that Skilled wage – Unskilled wage = \$300 \$3[300 – (100 + S)] – \$3[100 – (50 – S)] = \$300 Solving this equation for S yields S = 25. When there is no fruit to pick he is unemployed. Lance lacks the skills to land a long-term. She interviewed for a position with five firms. However one consequence of the recent recession in the US has been a large decline in the housing and real estate sectors. Tim initially lost his job due to a recession so his unemployment might be classified as cyclical. He has worked in the steel plant since leaving high-school and owns a house in Newcastle. (i)Structural. (ii)Alice was laid-off from her job in the car industry because the recession reduced the demand for cars. Note that there is a \$300 differential. (iv)Karen. (ii)Cyclical. (iv)Frictional. before eventually accepting a new job in a firm in the same industry. a software engineer. (i)Ted lost his job when the steel plant in Newcastle closed. If 125 workers are skilled. 25 unskilled workers will become skilled. note also that labour mobility has reduced the gap in wages somewhat. the value of their marginal product and hence their wage will be \$3(300 – 125) = \$525. structural or cyclical. Remember that the wage will equal the value of marginal product in equilibrium. as required. stable job. that is. lost her job when the start-up company she was working in went bankrupt. He has been unemployed since that time but is still searching for employment as a real estate agent. (v)Tim worked in real estate in the US but lost his job when the Global Financial Crisis hit in 2008.workers will be \$3[100 – (50 – S)]. not because work is unavailable. (iii)Lance is an unskilled worker who does seasonal work picking fruit in Victoria. The 25 remaining unskilled workers will earn \$3(100 – 25) = \$225. (v)Cyclical/Structural. Discussion Questions Question 5 Go to statistics on the RBA Website at . Ted’s skills are mismatched with existing employment opportunities. This is particularly so if he does not have the necessary skills to find employment in other industries. Question 4 In each of the following cases explain whether unemployment is frictional.

F & G) (i)Unemployment Rate 12.0 60.0 8. Relatively small increase due to GFC around 2008-09.0 64.0 4. summarise (with graphs) the main tends in Australia over the last 20 years for: (i) unemployment rate (column I) (ii) participation rate (column D) (iii) The relative proportions of part-time and full-time workers in total employment (columns E. There is no obvious trend until about 2003.0 61.0 0.rba. when it rises sharply and then seems to have stabilised at higher level of participation.0 62.http://www.0 Unemployment rate (%) 10.au/statistics/tables/index.0 2.gov.0 63. (ii)Participation Rate 67.html#output_labour Using Table G7.0 65.0 Jan-1990 Mar-1992 May-1994 Jun-1995 Oct-1999 Jan-2003 Mar-2005 Apr-1993 Feb-1991 May-2007 Aug-1997 Nov-2000 Sep-1998 Feb-2004 Apr-2006 Jun-2008 Jul-1996 Aug-2010 Dec-2001 Jul-2009 Sep-2011 Participation rate is the Labour Force as a percent of the Working-age Population (15+).0 Mar-1991 Mar-1998 Mar-2005 Jan-1990 Jan-2004 May-1992 May-1999 May-2006 Mar-2012 Jan-1997 Nov-1995 Nov-2002 Sep-2001 Nov-2009 Sep-1994 Sep-2008 Jan-2011 Jul-1993 Jul-2000 Jul-2007 Main feature is the downward trend in the rate of unemployment from early 1990s to about 2007.0 66. .0 6.

(ii)Use the labour supply and demand model to show the effect of the payroll tax on employment and wages.4000 0.9000 0. from about 20% of employment to about 30%. S(W/P) real wage D(W/P) Employment .6000 0. Question 6 (i) Draw the demand and supply model of the aggregate labour market.1 Labour Demand Curve Negative slope is due to diminishing marginal product of labour Position of curve is determined by the productivity of workers Labour Supply Curve Positive slope reflects fact that higher real wages are required to induce an increased supply of labour. Position of curve is primarily affected by size of working age population and participation rate. (iii) Suppose that the payroll tax is re-interpreted as a compulsory superannuation levy.8000 0.0000 Jan-1990 Jan-1993 Jan-1996 Jan-1999 Jan-2002 Jan-2005 Jan-2008 Jan-2011 Jul-1991 Jul-1994 Jul-1997 Jul-2000 Jul-2003 Jul-2006 Jul-2009 Part-Time Full-Time We see a upward trend in the share of PT worker over the past 20 years.2000 0. Explain what factors determine the slope and position of each curve? Suppose the government introduces a tax on labour.3000 0. Consider a payroll tax that is levied on the employer. the employer or the employee? (i) • • • • See BOF Section 3.(iii) Shares of PT and FT Workers 0. Use the model to analyse who pays the levy.5000 0.7000 0.1000 0.

Note that if labour supply were more inelastic there would be less of a fall in employment. equilibrium employment falls to E1. in addition to paying a wage the firm now has to pay a tax of \$X. The wage received by the employee falls relative to the pre-tax wage and the wage paid by the employer rises relative to the pre-tax wage. Question 7* (All students must submit a written answer to this question at the beginning of this tutorial) Consider the following model for a closed economy (there is no overseas borrowing and lending) where the real interest r is measured in percent. (iii)Now assume the above diagram represents a superannuation levy of \$X that has to be paid by employers for each worker.5r I = 20 − 0. (iii) Suppose there is a fall in the demand for investment so that. (ii) Draw a diagram to illustrate your answer. In order to employ a worker the firm.5r (i) Calculate the equilibrium real interest rate and levels of saving and investment. Who pays for the levy? It depends on the elasticity of the labour supply and demand curves. S = 10 + 1. but the worker pays the full levy in terms of a lower real wage. then the levy has no effect on employment. The difference represents the payroll tax.5r calculate the new equilibrium real interest rate and levels of saving and investment. After the tax.(ii)To make life simple just assume the payroll tax is just \$X for each person who is employed and is levied on employers. If labour supply is perfectly inelastic. I ′ = 15 − 0. but a greater share of the tax would be paid by workers. real wage S employee cost to firms \$X tax employee wage D E1 E0 Employment The initial equilibrium is at E0. This will act to reduce each firm’s demand for labour and shift the aggregate demand for labour curve to the left. . In this case the incidence of the tax falls partly on employers and partly on workers. When the tax is introduced the labour demand curve shifts downwards by the amount \$X.

What are the implications of this change for the economy? .(iv) Now suppose this country opens up its capital market so that residents can borrow and lend at the world real interest rate of 1 percent.

5r = 20 − 0.5r I = 20 − 0.5r 2r = 10 r* = 5 (ii) In equilibrium S r 5 I 17. I 10 + 1.5r = 15 − 0.TUTORIAL 2 (WEEK 6-10 AUG) SOLUTION GUIDE HAND-IN QUESTION Question 7* (All students must submit a written answer to this question at the beginning of this tutorial) Consider the following model for a closed economy (there is no overseas borrowing and lending) where the real interest r is measured in percent.5r calculate the new equilibrium real interest rate and levels of saving and investment. (iv) Now suppose this country opens up its capital market so that residents can borrow and lend at the world real interest rate of 1 percent.5r (i) Calculate the equilibrium real interest rate and levels of saving and investment. (iii) Suppose there is a fall in the demand for investment so that. What are the implications of this change for the economy? (i) In equilibrium S=I so 10 + 1.5 S * = I * = 13. (ii) Draw a diagram to illustrate your answer.75 . S = 10 + 1.5r 2r = 5 r * = 2. I ′ = 15 − 0.5 (iii) New equilibrium S.

5 19.S r 5 2.5 17.5 S. 2 . I The gap between national saving and investment is 11 and this equals the deficit on the current account (or trade balance) for the economy.5 I S. I (iv) The situation where savers and investors face an exogenous world interest rate of 1 percent. The key point to note is that investment in this country is no longer constrained to equal national saving as is the case for a closed economy. r w = 1 is illustrated in the following diagram (for the original I curve) I S r 5 rw = 1 8.