ECONS3213 Summer 2021

Intermediate Macroeconomics
Problem Set 2
Individual Draft Due: Friday May 21st at 11:59 pm
Final Group Submission Due: Tuesday May 25th at 10:00 am

Instructions: Please attempt to answer the following 6 questions on your own by 11:59 PM on
Friday and submit a single document containing your work to Gradescope under the `DRAFT
Problem Set 2’ Assignment. This draft will be graded pass/fail, so you will simply need to
demonstrate that you’ve attempted each question. Typed answers are preferred, but handwritten
answers will be accepted as long as they are extremely clear. Please meet with your group to
discuss your drafts and generate a single group submission. The group submission will be
assigned a grade out of 6 points and everyone in the group will receive the same grade. One
member from each group must upload the submission to the `FINAL Problem Set 2’ Assignment
by Tuesday morning before class. Please ensure that when you upload you tag the corresponding
question on Gradescope. If you have any questions about how to submit to Gradescope, please
email one of the TAs.

1.(This problem requires the use of calculus.) Consider a Cobb–Douglas production function
with
three inputs. K is capital (the number of machines), L is labor (the number of workers), and
H is

human capital (the number of college degrees among the workers). The production
function is
Y =K 1/ 3 L1 /3 H 1 /3 .

a) Derive an expression for the marginal product of labor. How does an increase in the
amount of human capital affect the marginal product of labor?
Solution:

M P L =Y 'L
1 K 1 /3 H 1/3
M P L=
3 L2 /3

The increase in the amount of Human capital increases marginal product of labor since
there is a positive relationship between them.
b) Derive an expression for the marginal product of human capital. How does an increase in
the amount of human capital affect the marginal product of human capital?

Solution:

M P H =Y 'H
1 K 1/3 L1/ 3
M PH=
3 H 2/ 3

The increase in the amount of Human capital(H) decreases marginal product of H since
each additional unit of human capital increases production by less than the previous one.

c) What is the income share paid to labor? What is the income share paid to human capital?
In the national income accounts of this economy, what share of total income do you think
workers would appear to receive? (Hint: Consider where the return to human capital
shows up.)

Solution:
Labor’s income share is equal to the exponent above Labor in the production function,
therefore
1
Labor Share=
3
Same with human capital share,
1
Human Capital Share=
3
In general, benefits of high human capital go to the workers that own skills and
knowledge which constitute H. Therefore, workers would appear to receive 2/3 out of the
total income.

d) An unskilled worker earns the marginal product of labor, whereas a skilled worker earns
the marginal product of labor plus the marginal product of human capital. Using your
answers to parts (a) and (b), find the ratio of the skilled wage to the unskilled wage. How
does an increase in the amount of human capital affect this ratio? Explain.

Solution:
The ratios is the following
 1 1
1 K 3 L3
2
M P L+ M P H 3H 3 L
=1+ =1+
M PL 1/ 3
1K H
1 /3
H
3 L2/ 3

The increase in Human capital decreases the ratio as more skilled labor becomes
accessible thus driving the return to human capital down.

e) Some people advocate government funding of college scholarships to create a more

egalitarian society. Others argue that scholarships help only those who can go to college.
Do your answers to the preceding questions shed light on this debate?
Solution:

Egalitarian society in this context is the society where wages for unskilled and skilled
workers are not drastically different. Using the inference done in “d” we can see that
higher level of human capital decreases this disparity thus making the society more
egalitarian. If we assume that government funding for scholarships increases human
capital, we can conclude that this policy does indeed benefit more than scholarship
recipients and drives wage differences down.

2. The government raises taxes by $100 billion. If the marginal propensity to consume is 0.6,
what happens to the following? Do they rise or fall? By what amounts?

a) Public saving
Solution:
The tax increase has a 1-for-1 direct impact on public saving. Therefore, increase in T
equal to $100 billion results in public saving increasing by $100 billion
b) Private saving
Solution:
Since MPC is 0.6, the decrease in disposable income caused by tax increase results in
dT∗MPC=100∗0.6=$ 60 bil decrease in consumption. Therefore,
Δ Private saving=−100+ 60=−$ 40 bil
c) National saving
Solution:
National saving is the sum of private and public saving, so the $100 billion tax increase
leads to a $60 billion increase in national saving.
d) Investment
Solution:
 GDP is given by
Y = C(Y-T) + I(r) + G + NX. Following this expenditures approach, investment should
equal savings at any particular point. We know that National saving (Y – C(Y-T) – G –
NX) increased by $60 billion, the investment also increased by the same amount $60
billion

3. “Transfer payments are not included in GDP”. Discuss the validity of this statement in
light of the effects, if any, of transfer payments on the various components of GDP in a closed
economy. Do transfer payments affect savings, and, if so, how? Does your answer depend on the
marginal propensity to consume and, if so, how? Does it make a difference if the government’s
budget is running a surplus or deficit?
Transfer payments are not included in the GDP because it is a form of money
reallocation when no goods or services are created. Transfer payments do indeed have
effect on consumption, and saving in the economy, although these effects cancel out.
Transfers affect savings because they increase disposable income. Since not all
additional income is consumed as there is marginal propensity to consume, the part that
does not end up spend is saved. Therefore, the influence of transfers depends on the MPC
in the economy. Since deficits can be covered by borrowing, there is no apparent
connection between transfer increases and tax increases that can cancel out changes to
disposable income. Thus, it does not matter whether there is a deficit or surplus as
transfers do not create additional value in the economy in both cases.
4. We have stated that consumption is a function of disposable income. Using FRED data
on US disposable income and Total Consumption per capita,
a) Create a scatterplot that has disposable income on the X axis and Total Consumption
per capita on the Y axis.
(See the graph below)
I. What is the relationship between the two variables?
Solution:
There is a clear positive relationship between two variables. When the
smoothing line is added, it becomes apparent that it closely resembles a
positive linear relationship.
II. Visually, on average by how much would an increase in disposable income
per capita of $10,000 affect consumption?
Solution:
Visually, this increase would result in around $8,000 growth in consumption.
 III. Using your answer, compute the marginal propensity to consume for the
period?
Solution:
8,000
In this case, marginal propensity to consume would be MPC= =0.8
10,000
as only $8,000 out of $10,000 increase in income is consumed.

b) Using Excel, or other statistical program, run a linear regression on the two
variables.
(See regression summary below)
I. What is the implied slope
 The implied slope for this model is the estimated parameter for income,
which is equal 0.886
II. What does the implied slope mean?
It means that for every additional dollar in income, the model estimate that
the consumption would grow by $0.886. Therefore, this is an estimate for
MPC
III. Is it statistically significant?
Yes, the result is statistically significant at 1% confidence level.

5.. Suppose MPC = 0.8 and MPL = 20. For each of the following, compute the change in
savings, ΔS:
Δ S=Δ Y −ΔC−Δ G=Δ Y −MPC ( ΔY −Δ T )−Δ G

a. ΔG = 100
Δ S=−Δ G=−100
b. ΔT = 100
Δ S=MPC∗Δ T =0.8∗100=80
c. ΔY = 100
Δ S=Δ Y −MPC∗ΔY =100−0.8∗100=20
d. ΔL = 10
ΔY =MPL∗Δ L=20∗10=20 0
Δ S=Δ Y −MPC∗ΔY =200−0.8∗200=40
6. Determine whether each of these production functions has constant, decreasing, or
increasing returns to scale:
for λ ≥1 ,
F ( λK , λ L ) > λF ( K , L ) is increasing
F ( λK , λL )=λF ( K , L ) isconstant
F ( λK , λL ) < λF ( K , L ) is decreasing
K2
a. F ( K , L )=
L
F ( λK , λL ) ? λF ( K , L )
λ2 K 2 K2
?λ
λL L
2
λK K2
=λ
L L
Therefore, there are constant returns to scale.
b. F ( K , L )=K + L
F ( λK , λL ) ? λF ( K , L )
λ K + λ L=λ ( K + L )

Therefore, there are constant returns to scale.