Problem Set I

1. (20 points) Explain why macroeconomists like to build models and why do they build
models based on microeconomic principles? Discuss.
Answer:

2. (10 points) Macroeconomists are interested in two types of phenomena: economic growth
and business cycles. Explain how macroeconomists utilize economic data in order to
study these two problems.
Answer:

3. (20 points) Suppose that the government imposes a proportional income tax on the
representative consumer’s wage income. That is, the consumer’s wage income is
w(1−t)(h − l) where t is the tax rate. What effect does the income tax have on
consumption and labor supply? Explain your results in terms of income and substitution
effects.
Answer:

4. (25 points) Suppose that a consumer cannot vary hours of work as he or she chooses. In
particular, he or she must choose between working q hours and not working at all, where
q > 0. Suppose that dividend income is zero, and that the consumer pays a tax T if he or
she works, and receives a benefit b when not working, interpreted as an unemployment
insurance payment.
a. If the wage rate increases, how does this affect the consumer’s hours of work?
What does this have to say about what we would observe about the behavior of
actual consumers when wages change?
Answer:
b. Suppose that the unemployment insurance benefit increases. How will this affect
hours of work? Explain the implications of this for unemployment insurance
programs.
Answer:

5. (25 points) To control pollution, assume that your government tightens regulations on one
hand and provides a lump-sum subsidy (S) to firms that use clean technology on the
other. Now, a representative firm decides to use clean technology throughout the
production process, thereby improving its total factor productivity. How will this
government policy affect the profit-maximizing firm’s choice of labor input and labor
demand curve?
Answer: