ECON 2123 Problem Set 2

Instructor: Prof. Wenwen Zhang

TA: Mr. Ding Dong

Due at 15:00 on Monday, April 9th, 2018

Question 1: The natural rate of unemployment

Suppose that the markup of goods prices over marginal cost is 5%, and that the
wage-setting equation is
W = P (1 − u)
where u is the unemployment rate.
a. What is the real wage, as determined by the price-setting equation?
b. What is the natural rate of unemployment?
c. Suppose that the markup of prices over costs increases to 10%. What happens
to the natural rate of unemployment? Explain the logic behind your answer.
Solution:
a. Price setting equation: P = (1 + m)W, m = 0.05.
W/P = 1/1.05 = 0.952
b. From wage setting: un = 1 − W/P = 1 − 0.952 = 4.8%.
c. W/P=1/1.1=.91; u=1-.91=9%. The increase in the markup lowers the real wage.
Algebraically, from the wage-setting equation, the unemployment rate must rise for
the real wage to fall. So the natural rate increases. Intuitively, an increase in the
markup implies more market power for firms, and therefore less production, since
firms will use their market power to increase the price of goods by reducing supply.
Less production implies less demand for labor, so the natural rate rises.

Question 2: Demand shocks and demand management

Assume that the economy starts at the natural level of output. Now suppose there
is a decline in business confidence, so that investment demand falls for any interest
rate.
a. In an AS-AD diagram, show what happens to output and the price level in the
short run and the medium run.

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b. What happens to the unemployment rate in the short run? in the medium run?
Suppose that the Federal Reserve decides to respond immediately to the decline in
business confidence in the short run. In particular, suppose that the Fed wants to
prevent the unemployment rate from changing in the short run after the decline in
business confidence.
c. What should the Fed do? Show how the Feds action, combined with the decline
in business confidence, affects the AS-AD diagram in the short run and the medium
run.
d. How do short-run output and the short-run price level compare to your answers
from part (a)?
e. How do the short-run and medium-run unemployment rates compare to your
answers from part (b)?
Solution:
a. The AD curve shifts left in the short run. Output and the price level fall in the
short run.
In the medium run, the expected price level falls, and AS shifts right, returning the
economy to the original natural level of output, but at a lower price level.
b. The unemployment rate rises in the short run, but returns to its original level
(the natural rate, which is unchanged) in the medium run.
c. The Fed should increase the money supply, which shifts the AD curve right. A
monetary expansion of the proper size exactly offsets the effect of the decline in
business confidence on the AD curve. The net effect is that the AD curve does not
move in the short run or medium run, and neither does the AS curve.
d.Under the policy option in part (c), output and the price level are higher in the
short run. In the medium run, output is the same in parts (a) and (c), but the price
level is higher in part (c).
e. The unemployment rate is lower in the short run in part (c). In the medium run,
the unemployment rate is the same in parts (b) and (c).

Question 3.
Suppose that the interest rate has no effect on investment.

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a. Can you think of a situation in which this may happen?
b. What does this imply for the slope of the IS curve?
c. What does this imply for the slope of the LM curve?
d. What does this imply for the slope of the AD curve?
Continue to assume that the interest rate has no effect on investment. Assume that
the economy starts at the natural level of output. Suppose there is a shock to the
variable z, so that the AS curve shifts up.
e. What is the short-run effect on output and the price level? Explain in words.
f. What happens to output and the price level over time? Explain in words.
Solution:
a. (The solution is not unique) Firms may be pessimistic about sales and the econ-
omy, therefore they do not want to borrow at any interest rate.
b. IS curve is vertical. Interest rate is not affected by the interest rate.
c. The LM curve is normal upward sloping.
d. The AD curve is vertical. Price level does not affect equilibrium output.
e. The natural level of output changes due to the change in variable z. The equilib-
rium output doesnt change. Therefore, current output is greater than the natural
level of output. Price level will increase.
f. Output remains unchanged, natural level of output remains below current output.
AS curve will shift up forever, thus price level will continue to increase forever.

Question 4.
Consider the production function
Y = K + 2N
a. Suppose that K = 10 and N = 20. What is the value of Y?
b. Suppose that K and N triple. What happens to Y?
c. How would you qualify the returns to scale for this function?
d. Write this function as a relation between output per worker and capital per
worker.
e. Suppose K/N = 2. What is the value of Y/N? What happens to Y/N if K/N is
doubled?

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f. Does the relation between output per worker and capital per worker exhibit the
same returns to scale as the above production function?
g. What is the difference between the two functions?
h. Plot the relation between output per worker and capital per worker. How does
the shape of the relationship between the two compare with Figure 10.4?
Solution:
a. Y=50.
b. Y triples.
c. Constant returns to scale.
d. Y/N = K/N + 2.
e. K/N=2 implies Y/N=4. K/N=4 implies Y/N=6. Output less than doubles.
f. No.
g. In part (e), we are essentially looking at what happens to output when we in-
crease capital only, not capital and labor in equal proportion. There are decreasing
returns to capital.
h. The curves are not the same. One is linear and this other is not.

Question 5: The Cobb-Douglas production function and the steady state

This problem is based on the material in the chapter appendix. Suppose that the
economy’s production function is given by:
Y = K α N 1−α
and assume that α = 1/3.
a. Is this production function characterized by constant returns to scale? Explain.
b. Are there decreasing returns to capital?
c. Are there decreasing returns to labor?
d. Transform the production function into a relation between output per worker
and capital per worker.
e. For a given saving rate, s, and deprecation rate, δ, give an expression for capital
per worker in the steady state.
f. Give an expression for output per worker in the steady state.
g. Solve for the steady-state level of output per worker when s = 0.32 and δ = 0.08.

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h. Suppose that the depreciation rate remains constant at δ = 0.08, while the sav-
ing rate is reduced by half, to s = 0.16. What is the new steady-state output per
worker?
Solution:
a. Yes. Doubling inputs K and N will double output Y.
b. Yes. Keep labor constant and only increasing capital, output doesnt increase
with constant returns to scale.
c. Yes. Keep capital constant and only increasing labor, output doesnt increase
with constant returns to scale.
Y α 1−α
d. N = K NN = (K
N
)α .
Y
e. s N = δK N
s( N ) = δ K
K α
N
K s 1.5
N
= ( δ
)
Y
f. N = ( δs )0.5
g. KN
= (4)1.5 = 8
Y
N
= (4)0.5 = 2
h. KN
= (2)1.5
Y
N
= (2)0.5

THIS IS THE END OF PROBLEM SET 2.