Economics 312/702 -Macroeconomics: Problem Set 5

Q1. Suppose that there is a persistent increase in productivity.

(a) In a closed economy, what are the effects of this change on output, interest rates, employment, consumption, and investment?

(b) In a small open economy, what are the effects of this change on output, the current account surplus, employment, consumption, and investment?

Q2. Suppose that everyone knows that government spending is to be increased for one period, but because of delays in Congress it may take effect either in the current year or the next. Find the effects of this increase on the current values of output, interest rates, employment, and real wages in the following two scenarios.

(a) The increase is announced in the current period but takes effect next year. This year spending remains at its original level. Consider a closed economy model with flexible prices.

(b) The increase is announced in the current period and takes effect immediately. Next year spending returns to its original level. Consider a small open economy model with flexible prices.

(c) The increase is announced in the current period and takes effect immediately. Next year spending returns to its original level. Consider a closed economy Keynesian model with sticky prices and efficiency wages.

Q3. Consider a small open economy model where the government can borrow and lend at the interest rate r which is determined on world markets. However the representative consumer lends at the interest rate r but borrows at an interest rate r^∗ > r which is also determined on world markets.

(a) Suppose that r^∗ increases but r is unchanged. Determine the effects of this change on consumption in the current and future periods and the current account balance.

(b) Suppose that initially the current account balance is zero, and then the government cuts current taxes and increases future taxes, keeping government spending fixed in both periods. What will be the effects of this policy change on consumption in the current and future periods and the current account balance?

(c) Suppose as well that the economy has flexible exchange rates, and that there is an increase in both r and r^∗. What will be the effects of these changes on the exchange rate? Assume that money demand is more responsive to changes in income than the interest rate.

Q4. Suppose that the labor market is divided into two sectors. There is a primary sector which has a high marginal product of labor and firms pay an efficiency wage. There is also a secondary sector which has a low marginal product of labor and the market is competitive (labor supply equals labor demand). Workers are alike and prefer to work in the primary sector, but those who can't find jobs in the primary sector work in the secondary sector. What are the effects of the following on the real wage and employment in both sectors?

(a) Immigration increases the labor force.

(b) There is a temporary productivity improvement in the primary sector.