Advanced Macroeconomics II

Chap 1
1) Why is Unemployment fluctuating more between business cycles than within
business cycles?

Ans:

The GDP of the economy changes during a change in a business cycle. For
example, during peak business cycle, the GDP is very high as compared to
the business cycle at Trough. During recession the GDP falls down while
during recovery the GDP increases as shown on below fig. whereas, within a
business cycle the GDP is more or less the same. The more the GDP the
more the employment and the less the unemployment. With less GDP, the
more the unemployment. The unemployment rate is inversely related to
expansion in the business cycle.That is why unemployment fluctuates more
between business cycles.

2) Explain the relationship of real GDP, unemployment rate and inflation rate.
When does inflation max and when does it will be min?

3) When does high unemployment and high inflation exist at the same time?

Ans:

During stagflation. Stagflation is a condition in which slow economic growth

(stagnation), rising prices (inflation), and rising unemployment all happen at the
same time. Although it is rare for slow economic growth and high inflation to
coexist, it has happened in the past, and many believe it could happen again.
4) Explain why is there high persistence of unemployment in time series?

Ans:

a. The apparent persistence of higher unemployment could be a result

of structural changes that have produced adverse responses on the
supply and or demand sides of the market.

b. The unemployment rate is inversely related to the rate of growth of

GDP. So, high unemployment indicates that the GDP is low and that
means firms output is less. During this time, firms are obliged to
reduce their employee wages to compete in the market and they have
also a large pool of labor market to compete for. But during the
recovery of the economy, firms willnot adjust the reduced wages to
the previous level instantaneously, it takes time and it is a gradual
process. Hence this will affect the unemployment rate negatively.

c. Unemployment in the long run may erode the skills and attitudes of
the unemployed to work. There may be a loss of training
opportunities and in the long run this makes the individual less and
less employable.

d. The costs of changing the level of employment and employee

protection legislations make the labor demand to react sluggishly to
the improving economic conditions. For example, if the costs of hiring
and firing are significant, firms may not hire more even during
economic recovery.

5) How do the unemployment rates related between two periods?

6) Derive the long run (time series) unemployment rate from the above (5)
relation?

7) Suppose that the unemployment rate is currently U0 and the long-run

unemployment rate is 𝑼
̅ . How many periods does it take, for example,
before half of the difference [U0 - 𝑼
̅ ] is eliminated?

Ans:
 From the relation:

then

8) Explain briefly the five stylized facts about unemployment.

9) Show that the marginal productivity of the skilled and unskilled labor is
equal to the real wage rate.

10) How is demand for labor and the real wage rate related? (note)

11) Derive the skilled and unskilled labor demand in matrix format.
(note)

12) What does Fsu < 0 implies? (note)

13) Suppose the government imposes a min real wage rate, 𝒘

̅ , which is
below the market clearing real wage for skilled labor but above the market
clearing real wage for unskilled labor. Explain, using graphs, how this

a. Affects the unemployment level of the unskilled labor and by what

amount?

b. Why is the demand for the skilled labor shifts to the right?

c. How is the previous unemployment effect for the unskilled labor

offsets?

d. Determine the new equilibrium points after the effect of the min real
wage rate in both the skilled and unskilled labor.

e. Why is the min real wage rate law increase the level of
unemployment?
14) List the solutions to cure unemployment with their side effects.

15) Derive the relation given by:

= -εd
𝒅𝑵 𝒅𝒘
𝑵 𝒘

Where ε d = FN/(NFNN) and w = W/P.

16) Show that the MRS (= U1-N/Uc) indicates that the substitution between

consumption and leisure is affected by the marginal tax rate tM on labor

income [not by the average tax rate] and also the tax on consumption.

17) Explain the effect of:

a. A progressive tax rate on HH keeping the other taxes constant.

b. increasing the average tax rate on wages with the other taxes
contestant.

Ans:

a. Due to the higher marginal tax rate, HH tend to supply less labor and
with the same gross real wage rate. The labor supply curve shifts to
the left and the equilibrium shifts from E0 to E1. This results in the
decline in employment and increase in wages.

b. Due to the increase in the average tax, HH feel poorer and start to
supply more labor to buy the goods and service they use to buy. This
makes the supply curve to shirt to the right and change the
equilibrium from E0 to E2. The employment rises and wages decrease.
18) Explain the seven reasons as to why it may not be always optimal for
firms to lower wages despite excess supply of labor.

19) Derive the Solow Condition for employment. Identify the elasticity of
effort and the efficiency wage.

Ans:
20) With respect to the elasticity of effort when should the firm shouldnot
hire & fire, should hire and should stop hiring? (note book)

21) Given the reservation wage and the effort function as below:

a. Show that the firm pays a wage rate that exceeds the reservation
wage

b. A firm pays a constant markup times the reservation wage.

c. The equilibrium unemployment rate given that all firms are treated
symmetrically, they pay the same wage Wi = 𝑾
̅̅̅.

22) Suppose effort is given by:

where 0 < β < 1 and b > 0. X is a measure of labor-market conditions.

Compute the efficiency wage.

(Romer, page 464)

Chap 2
23) Derive the Harrod-Domar GDP growth rate and interpret the result.

Ans:
Note: decreasing θ means increasing capital efficiency since θ = K/Y.
24) Derive the Harrod-Domar rate of growth per capita income and
interpret the result.

Ans:
25) Show that output per unit of effective labor depends only on the
quantity of capital per unit of effective labor.

Ans:

Y = F(K, AL)

Dividing both sides of the equation by AL

Y/AL = F(K/AL, 1)

With Y/AL = y which is output per effective labor and

K/AL = k, capital effective labor. Then,

y = F(k,1)

with F(k,1) = f(k)

hence, y = f(k)

which shows output per unit of effective labor depends only on the quantity
of capital per unit of effective labor.

26) Prove the Inada conditions

For a CD PF given by

Ans:

f(k) = F(K/L, 1) = (K/L)α(1)α-1= (K/L)α = kα (note the last k is small k.)

f’(k) =αkα-1 = αkα/k. hence,

lim αkα/k as k→0 = ꝏ.

And lim αkα/k as k→ ꝏ = 0

Note that 0<α<1.

27) What is the steady state?

Ans:

steady state is a situation in which the economy's output per effective

labor, and capital stock per effective labor are constant that is, in the
steady state, yt, and kt don't change over time.

28) Derive the steady state net investment and gross investment if the
total capital grows at the rate of n.

Ans:

Net investment = Kt+1 - Kt

If total capital grows at the rate of n, then Kt+1 = Kt + nKt = (1+n)Kt. hence,

Net investment = (1+n)Kt - Kt = Kt + nKt - Kt = nKt.

The gross investment = Net investment + Depreciated capital

= nKt + δKt = (n+δ)Kt

From I(t) = Y(t)-C(t)

(n+δ)Kt = Y(t)-C(t)

nKt = Y(t)-C(t)- δKt

But Y(t)-C(t) = saving = S(t)

And S(t) = sY(t)

Hence, nKt = sY(t) - δKt

29) Derive the fundamental differential equation for the Solow-Swan

model. Interpret the result.

Ans:
30) Derive the Solow-Swan fundamental differentail equation given

k = K(t)/A(t)L(t). Identify the breakeven investment amount. Depict the

results on graph.

Ans:
When actual investment per unit of effective labor (sf(k)) exceeds the
investment needed to break even, k is rising. When actual investment falls
short of break-even investment, k is falling. And when the two are equal, k is
constant.

The Inada conditions imply that at k = 0, f’(k) is large, and thus that the sf(k)

line is steeper (have larget slope) than the (n + g+δ)k line. Thus, for small

values of k, actual investment (sf(k)) is larger than breakeven investment

(n+g+δ)k. The Inada conditions also imply that f’(k) falls toward zero as k
becomes large. This is shown on the phase diagram of the Solow model:
31) Notice that in the Solow-Swan production function A and L enter
multiplicatively. AL is referred to as effective labor, and technological progress
that enters in this fashion is known as labor-augmenting or Harrod-neutral.

32) Explain the Inada condition for capital.

Ans:

The Inada condition for capital is:

and

These conditions state that the marginal product of capital is very large
when the capital stock is sufficiently small and that it becomes very small
as the capital stock becomes large; their role is to ensure that the path of
the economy does not diverge.

33) Prove the below relation for labor and knowledge.

Ans;
34) Explain the fact that the Solow model implies that, regardless of its
starting point, the economy converges to a balanced growth path—a
situation where each variable of the model is growing at a constant rate.

Ans:

By assumption, labor and knowledge are growing at rates n and g,

respectively. Then:

a. The capital stock, K, which equals ALk; grown at n+g due to AL since k
is constant at k*

b. From f(k) = Y/AL, Y = ALf(k). Since k is constant at k*, Y will grow by

n+g that is due to AL.
 c. K/L & Y/L grow at g.

35) On the balanced growth path, actual investment equals break-even

investment, (n+g+δ)k*.

36) Discuss the impact of increasing the saving rate on capital using the
balanced growth path of Solow’s model.

Ans:

Increasing the saving rate, s, shifts the actual investment line upwards as
shown below. The new actual investment is above the break-even

investment from the origin to the new value of k*new ,dk/dt is positive. At
k*new it will be constant. Because the increase in s, we have a new higher k*.

Let’s say t0 is the time of increase in the saving rate, s, and it remains
constant thereafter. Since the jump in s causes actual investment to exceed
break-even investment by a strictly positive amount, 𝒌̇ jumps from zero to a
strictly positive amount. k rises gradually from the old value of k* to the new
value, and 𝒌̇ falls gradually back to zero.
37) Explain a permanent increase in the saving rate produces a
temporary increase in the growth rate of output per worker but it does not
affect the growth rate of output per worker on the balanced growth path of
Solow’s model.

Ans:

Using f(k) = Y/AL, then Y/L = Af(k). When k is constant, Y/L grows at the
growth rate of A which is g. But when k is increasing, Y/L grows both at g
and because of k, which is more than the previous growth. When k reaches
the new value of k*, however, the growth rate of Y/L returns to g again as
shown below. Hence, a permanent increase in the saving rate produces a
temporary increase in the growth rate of output per worker.

In sum, a change in the saving rate has a level effect but not a growth effect.
38) Explain the impact of increasing the saving rate, s, on consumption.

Ans:

Consumption per unit of effective labor equals output per unit of effective
labor, f(k), times the fraction of that output that is consumed, 1−s. That is:

c = C/AL = f(k)(1 – s) = f(k) – sf(k)

When k is constant and s is increasing, c will decrease because of f(k)(1 – s).

Consumption then rises gradually as k rises and s remains at its higher
level. This is shown below:

39) Show that consumption on the balanced growth path equals output
less breakeven investment.

Ans:

c = f(k) – sf(k)

but on the balanced growth path, the actual investment equals the break-
even investment, hence,

c* = f(k*) – (n+g+δ)k*

40) Discuss the change in consumption per effective labor with respect to
the change in saving rate, s using graphs.

Ans:

Taking the first derivate of c* = f(k*) – (n+g+δ)k* with respect to s we get:

Note that k* is determined by s and the other parameters of the model, n, g,
and δ.

Thus whether the increase raises or lowers consumption in the long run
depends on whether f’(k*)—the marginal product of capital—is more or less

than n+g+δ.

Let’s take three different cases:

Case1: s is high.

When s is high, k* is also high since it shifts the sf(k) upward. At k*

however, as shown on the graph, the slope of f(k) is less than the slope of
the break-even investment. This means f’(k) is less than (n+g+δ). This makes
consumption (dc/ds) decreasing for increasing s.

Case 2: s is low
 When s is low, k is also low. That is k will be at kL*. At kL*, the slope of f(k) is
higher than the break-even investment. Hence f’(k) is greater than (n+g+δ).
This implies that an increase in s raises consumption in the long run.

Case 3: s is at the level that cause the slope of f(k) and (n+g+δ)k equals.

When f’(k) and (n+g+δ) are equal, a marginal change in s has no effect on
consumption in the long run, and consumption is at its maximum possible
level among balanced growth paths. This value of k, kM*, is called the
golden-rule level of the capital stock.

Note that consumption is the vertical distance between f(k) and (n+g+δ)k at
the k*.

41) Derive the elasticity of the balanced growth path level of output with
respect to the saving, where output is the output per unit of effective labor
on the balanced growth path. That is

y* = f(k*). (Romer, page 23-4)

Ans:
 Where αk is the elasticity of output with respect to capital at k=k*. Hence the
final equation is the relationship of two elasticities, that is the elasticity of
output with respect to saving is equal to the elasticity of output with respect
to capital at k=k*.

42) Derive the rate at which k converges to its balanced growth path
value.

Ans:
43) At the golden rule level of capital, consumption is at its maximum
level

44) Derive the below relation which shows the decomposition of the
growth of output per worker into the contribution of capital per worker and
the Solow residual.

Ans:
45) Explain the reason for poor countries tend to grow faster than rich
countries.

Ans

a. The Solow model predicts that countries converge to their balanced

growth paths. Thus, one would expect poor countries to catch up to
rich ones.

b. The Solow model implies that the rate of return on capital is lower in
countries with more capital per worker. Thus for the rich countries to
increase their return on capital, they have to sell or donate excess
capital to poor countries to decrease their capital per worker and
thereby increase their rate of return. This will enable the poor
countries to converge.

c. As poorer countries gain access to state-of-the-art methods and di,

the income differences with the rich tend to decrease and converge.
46) On the balanced growth path, dk/dt = 0.

47) At k=k*, f’(k) = (n+g+δ)

48) Roamer end of chapter 1 Questions to focus:

a. Q1.3 (a to d)

b. Q1.4 (a)

c. Q1.5(a to c)

d. Q1.6

e. Q1.7

f. Q1.10

49) What is the objective function and constraint on the Ramsey-Cass-

Koopmans model?

50) What are the assumptions of the three growth models? And their
respective model equations.

51) Derive the HH/consumer problem in the Ramsey-Cass-Koopmans

model.

Ans:
52) For Ramsey–Cass–Koopmans economy that is on its balanced growth
path, how is

a. Consumption is expressed.

b. The consumption growth rate expressed.

c. The fraction of output that is saved and invested expressed.

Ans:

a. The capital stock per unit if effective labor is given by:

𝒌̇(t) = f(k(t)) – c(t) – (n+g)k(t)

On the balanced growth path, 𝒌̇(t)=0, hence,

c(t) = f(k(t)) – (n+g)k(t)

b.

c. [f(k*) – c*] / f(k*)

53) The two equations of motion are:

𝒌̇(t) = f(k(t)) – c(t) – (n+g)k(t)

And

54) The Euler equation

55) The capital accumulation equation

Chapter 4
1) Derive the optimal labor for work and leisure.

Ans:

2) Show that Leisure is independent of the wage level.

Ans
3) Express l in terms of w, r and ρ. (lecture , page 22)

Chapter 5
4) What are the three distinct roles of Government in market economies?

5) How is the allocation role of government is executed?

6) How is the redistributive role of government executed?

7) How is the stabilization role of government executed in the case of

unemployment and inflation?

8) What are the two reasons why government intervention may produce
negative effects?

9) Explain the direct and indirect effects of public intervention on individuals

and markets with example.

10) Explain how limited information on public bureaucracy and

limitations imposed by the political process causes government intervention
failure.
11) Explain the Ricardian Equivalence Theorem (RET).

12) Explain why government debt is delayed taxation.

13) Why is government debt in the hands of the public should not be
counted as net wealth according to the RET?

Ans:

Because the government debt in the hand of the public is exactly matched
by the equal sized liability in the form of future taxation.

14) Using the HH and Government budget constraints,

a. Derive the consolidated (or life time) HH budget constraint.

b. Derive the consolidated Gov. budget constraint (GBC).

c. prove that the Ricardian Equivalence Theorem (RET).

Note: assume only income is taxed.

Ans:
15) With the instantaneous utility of a representative HH given by;

U(Ct) = lnCt ; Note: assume only income is taxed.

a. Derive the consumption Euler equation.

b. Expressions for C1 and C2 .

c. Show that the HH saving depends on the tax.

d. Show that if the government cut the tax rate in the first period, the
tax rate in the second period must increase. How should the HH
compensate this tax increase in the second period?
Ans:
16) Derive the present value of the net liabilities of the government or
the government consolidated budget constraint when government
expenditure is divided into consumption and investment.

17) Show that public investments that attain the market rate of return (rG
= r, the golden rule of government finance) donot give rise to a net liability
of the government and donot lead to the present or future taxation.
Ans (for both 16 & 17):
18) Derive:

a. the Euler equation for government’s optimal taxation problem.

b. The tax rates in the two periods in the case of tax-tilting (r ≠ ρ ) and
G

with the absence of tax-tilting effect (r = ρ ).

G

Ans:
19) What are the 7 rules of thumbs for government finances?

20) Express real money balances or money supply interms of:

 a. Real interest rate, expected inflation and income.

b. Constant real interest rate, actual inflation and constant income.

Ans:

21) What is Seignorage?

Ans:

Seignorage—the revenue the government gets from printing money.

22) Express Seignorage interms of:

a. The growth rate of money stock and Qty of real money supply.
 b. Tax rate on real balances and the amount being taxed.

23) Sketch the graph of gm vs Seignorage (S)

a. At what value of gm does S=Smax

b. When does hyperinflation arises with regard to S?

24) Show the impact of a change in money growth on seignorage using

the Cagan money demand function.

Ans:

25) Express the total tax collected by the government with respect to the
change in the tax rate and interpret it.

Ans:
26) Explain the potential sources of inflation empirically.

Ans:

The demand for real money balance is given by:

It is decreasing in the nominal interest rate (Li<0) and increasing in real

income (Ly>0). Where i is the nominal interest rate, Y is real income, M is the
money stock and P is the price.

It can be rearranged as:

The above equation suggests that there are many potential sources of
inflation. The price level can rise as the result of increases in the money
supply, increases in interest rates, decreases in output, and decreases in
money demand for a given i and Y [L(I,Y)].

Note that the reason increases in interest rates increases the price level while
interest rate is at the denominator is because money supply is decreasing in
the nominal interest rate.

27) What is the main cause of long-term inflation?

Ans:

When it comes to understanding inflation over the longer term, economists

typically emphasize just one factor: growth of the money supply.

Money growth plays a special role in determining inflation not because

money affects prices more directly than other factors do, but because
empirically money growth varies more than other determinants of inflation.

28) With Smax = 10% of GDP and b=1/3, show that C must be 9% of GDP.

Ans:
29) Explain monetization of deficits.

Ans:

A government deficit is said to be monetized when the central bank

purchases the bonds the government issues to cover its deficit.

30) Explain how monetization of deficits leads to inflation.

Ans:

A monetization of deficits means when the central bank purchases the

bonds the government issues to cover its deficit. If the Central Bank buys
the debt of the government (treasury bonds), then government gets paper
money and buys goods and services and this will affect the purchasing
power of the public and thus leads to inflation.

31) Show empirically how the government sources its debt.

Ans:
From eqns (a) and (e), we get:

If the public is not willing or unable to lend loans to the government, then it
has to either deplete its foreign reserves or print paper money to finance its
budgets.

32) What are the negative and positive effects of deficit?