m_quiz2_2012_ans

QUIZ 2: Macro – Winter 2012

Name: __ANSWERS_________ Section Registered: Morning Evening

Question 1 (2 points each – 16 points total)

For question 1, circle the answer that makes the question stem true. When answering the questions, you should only use the models developed in class. For each question stem, there is only one true answer.

Note: When answering questions, you should compare the initial position of the economy to the new equilibrium in the economy (inclusive of both income and substitution effects). That means, we will assume that the labor market will always clear. Lastly, unless I tell you otherwise, assume TFP, tax rates, welfare programs, the capital stock, and the working age population is held fixed.

Which of the following are true about an unexpected permanent decline in labor income taxes (tn)? When answering the question, assume that income effects on labor supply are large relative to substitution effects on labor supply.

As taxes fall, the labor supply curve will shift right due to a substitution effect (from NS0 to NSSUBS). As a result, after tax wages increase (the government takes less of your paycheck in taxes) and before tax wages will initially fall as a result of the substitution effect. Recall—our model places the labor supply and demand curves in the space of real before-tax wages and N:

W/P

NSINC NS0 NSSUBS

N

Because this is a permanent change, the increase in after-tax wages means workers are permanently richer. This means the labor supply curve will also shift to the left as a result of the income effect (as workers feel richer—they will choose to work less) to NS INC. On net, the shift of the labor supply curve to the left (from the income effect) will outweigh the right shift (from the substitution effect). This means that N will decrease (leisure will increase) and before tax wages (W/P) will increase.

a. Aggregate expenditure will:

i. Unambiguously fallii. Unambiguously increaseiii. Unambiguously stay the same

In macroeconomic equilibrium, aggregate expenditures = aggregate output (Y=Y - a key equation in our class). Given that Y = f(A,K,N), we know that Y falls as N falls. N falls (as above), given that labor supply will shift in. There is no effect on labor demand given A and K are constant (per the assumptions). The fall in Y means that aggregate expenditures will have to fall. We do not know why yet. Aggregate expenditures = C + I + G. One of those variables must be falling to make aggregate expenditures fall. We will learn that soon enough. The key is that Y = Y and aggregate output falls. (Foreshadowing: the key will be I will be falling in the long run in this example even though C is rising).

b. Before tax real wages will:


See above: Before tax wages initially fall as a result of the substitution effect and then increase as a result of the income effect shifting the labor supply curve in. As we said, the income outweighs the substitution effect, so on net before tax wages (W/P) increase.

c. After tax real wages will:


Labor income taxes permanently decrease which means workers are able to take home more of their wages. Before tax wages went up and the tax rate went down. It is easy to see that after tax wages must have risen.

d. Unemployment will:


Unemployment occurs when there is a friction in the labor market (like sticky wages) so that we are not at an equilibrium condition (labor demand not equaling labor supply). In this example, we move to a new equilibrium condition (not a disequilibrium) so there is no unemployment. So, despite N falling, unemployment will not rise. I told you I would ask this question on the quiz.

e. The long run aggregate supply curve will:

i. Unambiguously shift right (on net)ii. Unambiguously shift left (on net)iii. Unambiguously not shift (on net)iv.

The Long Run Aggregate Supply curve is defined as Y* = f(A,K, N*). If A, K, or N* change, Y* changes. N* is set in the labor market – so, basically, anything that affects the labor market affects N*. As discussed above, the labor supply curve has permanently shifted in (N* has fallen). As a result, the LRAS curve shifts in (given A and K are fixed by assumption).

f. The marginal product of labor will:


Profit maximization ensures that MPN = W/P. From above, we know that W/P (before-tax wages) increased. The intuition is that as individuals work less, N falls. The decreased N increases MPN. We can also prove this to ourselves with a little math: Recall MPN = .7A(K/N).3. As stated above, N* falls as a result of the income effect. Thus, as N falls (the denominator shrinks), MPN increases.

g. The labor demand curve will:

i. Unambiguously shift right (on net)ii. Unambiguously shift left (on net)iii. Unambiguously not shift (on net)

Nothing happens. Labor demand is affected by A and K. An increase in either A or K will shift the labor demand curve to the right. A is fixed (I told you that). K is fixed (I told you that).

h. Tax revenues will:

i. Unambiguously fallii. Unambiguously increaseiii. Unambiguously stay the sameiv. Could either increase or decrease depending on the size of the income effect

Tax revenues are defined as the tax rate times aggregate income (Y). The tax rate has fallen and Y has fallen. So, unambiguously, tax revenues have fallen. Some people think tax revenues are a function of wages. That is not how we defined tax revenues. It is on total income (wages * N) plus capital income. We know unambiguously that Y fell. So, unambiguously, tax revenues fell.

Question 2- 4 points

In the episode of “This American Life” (episode 435, Act 1), the program primarily focuses on whether a state’s governor (or the president of a country) can create jobs. The governor in the program promised that he would create 250,000 new jobs in his state during his first term. What state was the governor from who made the promise that he would create 250,000 new jobs in his state during his first term (that was the focus of Act 1 of the episode)? You answer should just be the name of a U.S. state.

Wisconsin (Governor Scott Walker)

I will give you 4 points if you got either the state or the Governor’s name. No points are given for any other answer.

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