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Posted: August 12th, 2013
















Question 1 (15 points) – Chapter 2

Each year Canada Pension Plan (CPP) benefits are increased in proportion to the increase in the consumer price index (CPI); even most economists believe that the CPI overstates actual inflation. If the elderly consume the same market basket as other people, does the CPP provide the elderly with an improvement in their standard of living each year? Explain. (6 points)

An increase in the consumer price index is an illustration of an increase in the cost of living. Hence, an increase in the CPP is negated by the increase in the cost of consumer products in the market. Due to overstatement of inflation this cold result in an improvement in individual finances as a result of increased incomes given the low levels of inflation results in better lifestyles for the elderly. Increased incomes given the presence of slow inflation results in higher disposable incomes for the elderly.

Suppose elderly people consume more prescription drugs than younger people do, and drug prices have risen faster than overall inflation. Now, what would you do to determine whether elderly people are actually better off from year to year? Explain. (9 points)

Measuring the cost of the drug products in relation to the going market rates would provide an express indication as to the consumer ability. Calculating the consumer price index would also provide the changes in terms of consumer ability to make purchases of basic consumer products.

Price change over the years would provide an elaborate view of the effect of costs of products on consumer disposable incomes. Substantial price increases hurt the consumers severely because of reduced disposable incomes despite the presence of financial stability.

Question 2 (15 points) – Chapter 2

The following table provides the labor market data for an economy.

  Year 1 Year 2 Year 3
Number of employed 75000 90000 98000
Not in the labor force 20000 25000 35000
Adult population 100000 125000 150000

Calculate the unemployment rate and the labor force participate rate for all three years. (6 points)

Unemployment rate= no. of unemployed/no. of adult population

▪ Year 1=20,000/100,000=0.2 or 20%

▪ Year 2=25,000/125,000=0.2 or 20%

▪ Year 3=35,000/150,000=0.23 or 23%

Labor Participate level=labor force/population size

▪ Year 1=80,000/100,000=0.8 or 80%

▪ Year 2=100,000/125,000= 0.8 or 80%

▪ Year 3=115,000/150,000= 0.76 or 76%

From year 1 to year 2, the number of employed workers increases but the unemployment rate rises. Why is it possible for this to happen? Explain. (4 points)

This is possible coupled by substantial increase in population sizes resulting in higher but minimally significant numbers of individuals to affect the unemployment rate in the market. Increased employment numbers do not significantly translate to a reduced number of unemployment individuals. This translates to a high number of individuals employed relative to the overall numbers of individuals who are in the labor market.

Compare the size of the labor force and the labor force participation rate from year 2 to year 3, what do you observe and could you explain your observation? (5 points)

  Year 1 Year 2 Year 3
Number of employed 75000 90000 98000
Not in the labor force 20000 25000 35000
Adult population 100000 125000 150000


A reduction in the labor participate level is an indication that individuals searching for unemployment has reduced despite a high level of unemployment. Furthermore, between the two years, the decline in the participation level is because of the relative increases in unemployed individuals, employed individuals all of which is comparable to the population size of both periods.

Question 3 (30 points) – Chapter 3

A closed economy can be described by the long-run classical model:

▪ Y (long-run level of output = 2K1/4L3/4

▪ C (consumption) = 8200 + 0.8(Y – T) – 700r

▪ I(r) = 9550 – 500r

▪ MPK = K– 3/4L3/4

▪ MPL = K1/4L–1/4

In this economy, there are two productive factors, K and L and both factor inputs are fully employed. The stock of capital and the supply of labor are equal to 10,000 and 50,625 respectively. Initially, the government collects 10% of the output from households as taxes and runs a budget surplus of 800.

Note: r represents the real interest rate and is measured in percentage points (for example, if r = 10, then this is interpreted as r = 10%). Keep your answers to 3 decimal points if needed.

Compute the long-run equilibrium levels of consumption, investment and real interest rate. Also, find the real wage for labor and real rental price of capital. (5 points).

▪ Equilibrium of the long-run classical model is given by: S = Y – C – G = I

S = Y – C – G = I

S = Y (= 2K1/4L3/4 –C (= 8200 + 0.8(Y – T) – 700r) = 9550 – 500r

S = Y (= 2K1/4L3/4 –C (= 8200 + 0.8(Y – T) – 700r) = 9550 – 500r

S = 2K1/4L3/48200 + 0.8(Y – T) – 700r = 9550 – 500r

=2K1/4L3/4   – 8200 + 0.8(2K1/4L3/4 -10%) – 700(5.7%) = 9550 – 500(5.7%)

= 8.567%

▪ Long-Run Equilibrium Levels of Consumption= S = Y – C – G = I

▪ Q*=800 for the demand for LF,

▪ r*= 0.04-0.000025*800

=0.04-0.02=0.02 or 2%.

▪ I(r) = 9550 – 500r

800= 9550 – 500r

I= 9550 – 500*10

I=9550 – 5000


▪ I=5.7% or 5. 6875%

Thus due to the presence of a pessimistic attitude among the consumers, the autonomous consumption reduces by 15%.

What are the new long-run equilibrium levels of consumption, investment, and real interest rate? Compute the new long-run equilibrium real wage rate for labor and real rental price of capital. (4 points)

Long-Run Equilibrium Levels of Consumption= r*= 0.04-0.000025*800=0.04-0.02=0.02 or 2%.

Thus due to the presence of a pessimistic attitude among the consumers, the autonomous consumption reduces by 15%.

▪ Investment rate= I(r) = 9550 – 500r

=9550 – 500*2


▪ Investment rate= I(r) =85.55%

▪ Real interest rate= r*= 0.04-0.000025*800=0.04-0.02=0.02 or 2%.

Use words and three diagrams (the loanable funds market, the labor market, and the rental market for capital) to explain your answer in parts (a) & (b). (15 points)

The loanable funds market:

(Evans 1999)


The labor market:


The rental market for capital:


Suppose the government finds the change in the long-run equilibrium level of investment in part (b) undesirable and wants to increase it to 8500. Find the level of government spending that could achieve this goal. What happens to the government budget? Explain. Show your answers in parts (a), (b) & (d) in NEW loanable funds market diagram (No further explanation of this diagram is needed just show impact/shift(s) that shock causes). (6 points)

Regulation of monetary policy is termed as constriction of price; hence, it results in volatility the market thus a high rate of inflation. Increased spending results in higher interest rates as the government sources for funds from the public resulting in higher demand values of funds in the market.



Question 4 (25 points) – Chapter 3

 “According to the long-run classical model, if government spending and taxes decrease by the same amount simultaneously, there will be no change in the long-run levels of output, investment and real interest rate.” True/False, explain in words and support your answer with ONE loanable funds diagram. (10 points)

False. The reduced revenue collections would warrant reduced employment opportunities because of the inability of the government to sustain initial levels of output in the long-term attributable to the employment. Long-term goals are usually affected by the short term goals in the market. Reduced taxes and spending is because of reduced government activity in terms of its collection of capital inflows and possible investments by the government. The tax rates and spending by the government are not provided for over the long term; they are provided for under the short term due to market dynamics. The level of employment and level of output is the point of intersection in a labor diagram. In the loanable funds diagram the shift is actualized by the movement in terms of level of output and the rates provided. The loanable funds value is usually equal to the level of deficit of the government budget. A decrease in the government tax collectibles decreases the quantity of funds available in a given market.


The government is contemplating changes to the country’s labor policy; the proposed changes include the raising of the minimum legal working age and, at the same time, the elimination of mandatory retirement. The government asks you to evaluate the effect of these changes on the country’s long-run equilibrium real wage and real rental price of capital. Support your analysis by ONE labor market diagram and ONE rental market for capital diagram. (10 points)

Changes in labor policies identified would reduce the number of new labor into the market. This would result in a possible increase in the number of unemployed individuals. Increased output is usually marked by an increase in labor responsible for high production levels. However a minimal legal working age would result in an increase in comparison for positions within the labor market. Essentially, it translates in an increase in competition in labor. This would reduce the real wage over the long run and an increase in the rental price due to an increase in the number of employed individuals competing for identical household commodities and services in the economy. Rental cost of capital is related to the costs of labor and access to services and basic commodities. This is in relation to the output level in the market, excess supplies result in the surpluses necessitating the need for new policies to reduce labor because supplies are not purchased in the provided conditions. This is a need to stimulate demand for consumption of goods and reduction of the excess production of goods in the market.

Labor market diagram

(Macroblog, 2013). Retrieved from www.http// )

Rental Market for Capital Diagram

(Living Economics (2013). Retrieved from www.http// )


Rental Market for Capital Diagram


“If the labor share of income is two-thirds and the growth rate of total factor productivity is 1%, to achieve an output growth of 3%, then the growth rate of labor must be equal to 2%.” True/False/Uncertain, explain. (5 points) 

True. Nominal wages during the long run are highly flexible. Hence, prices have little impact on the quantity of aggregate output provided. The level of employment and level of output is the point of intersection in a labor diagram. Output and spending by government are equal to each other. Output level is determined by labor which is a primary factor of production.

Question 5 (15 points) – Chapters 3 & 4

Suppose the labor force and (physical) capital stock are growing at a rate of 2.5% and 3% respectively, and the labor share of income is 60%. In addition, the total factor productivity is increasing at 0.8%. If the velocity of money is rising at 2% and the central bank wants to obtain a target of inflation at 2%, then it should set a monetary growth rate of 5.5%. (5 points)

Note:  All the growth rates are annual rates. 

The loanable funds market:

The capital funds and inflows are related to a country’s exports and imports. The growth of the labor markets and the capital stock are reflective of the increasing rate of inflation. Hence, the combination of both would provide an appropriate cap in terms of the monetary policy towards curbing inflation in the market. This would have an effect on the labor market in that nominal wages during the long run are highly flexible. Hence, prices have little impact on the quantity of aggregate output provided.

The government just releases its budget for the coming fiscal year. The government projects that it will run a budget deficit as tax revenues are expected to fall even there is no change in government spending. According to the long-run classical model, what happens to the long-run equilibrium real interest rate when the government runs a budget deficit? What happens to the long-run price level? Explain and support your answer by ONE loanable funds market diagram. (10 points)

Total spending according to the classical model total government spending is equal to total output. A budget deficit is an illustration of a negative contribution to the budget. The government borrows funds to cover for the deficit in terms of projected expenses and future projects to be undertaken. The long-run equilibrium real interest rate reduces because the government is unable to provide for such a rate over the long run. The government needs short terms borrowings for its investment projects. Investment spending is relative to the national savings and capital inflows anticipated by the government. A budget deficit is an indication in decline of output. Hence this means a reduction in terms of taxes collected thus affecting future spending by government if borrowing is not provided. This results in an increase in interest rates to accrue funds to make payments for the borrowings. Hence, there is a shift in the supply curve for credit to the left to mark an increase in supply of credit and move by the demand for credit curve  to the right to mark an increase in the demand for the same.










ebruary 2013.

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