Solutions to practice problems for midterm #1

I. Labor Market

1. See first page of handout for factors that affect labor supply and labor demand.

   The labor supply curve slopes upward and to the right because of the assumed dominating effect of the substitution effect over the income effect of a rise in the real wage.

   The labor demand curve slopes downward due to the diminishing marginal returns to labor given a fixed capital stock.

2. 1. Competition in the labor market drives equilibrium. Whenever the real wage is higher than the equilibrium real wage there is an excess supply of labor and competition by those seeking employment drive down the real wage. Whenever the real wage is below the equilibrium real wage there is an excess demand for labor and and competition by those seeking workers drives up the real wage.

   2. Let ND denote labor demand, NS labor supply, w* the equilibrium real wage and N* equilibrium labor amount.
      1. As LF increases, NS shifts right lowering w* and increasing N*.
      2. As A increases, ND shifts right (up) raising w* and N*.
      3. As WL increases, NS shifts left (in) increasing w* and decreasing N*.
      4. As Fwe increases, NS shifts left increasing w* and decreasing N*.
      5. As K increases, ND shifts right (up) increasing w* and N*.

Saving and investment

1. See the handout for factors that affect desired saving and investment.

   The demand for saving curve slopes upward and to the right due the the domination of the substitution effect over the income effect of an increase in the real interest rate, r. The demand for investment curve slopes downward due to the decreasing marginal productivity of capital for a fixed amount of labor.

2. In the following, SD denotes desired national saving, ID denotes desired investment, CD denotes desired consumption, r* denotes the equilibrium real interest, S* denotes equilibrium saving and I* denotes equilibrium investment.
   1. Goods market equilibrium is determined by the condition that aggregate demand equals aggregate supply; CD + ID + G = Y. Subtracting CD + G from both sides gives the equivalent equilibrium condition ID = SD.

   2. Competition between savers and investors moves the real interest rate so that the goods market stays in equilibrium. Whenever r is above r* there is an excess supply of saving and competition among savers drives r down to r*. Whenever r is below r* there is an excess demand for saving and competition among firms desiring funds for investment projects drives r up to r*.

   3. 1. Increases in FMPKe shifts ID up (right) increasing r*, S* and I*.
      2. Increases in G shifts SD left (in) increasing r* and decreasing S* and I*.
      3. Increases in FYe shifts SD left (in) increasing r* and decreasing S* and I*.
      4. Increases in CTAX shifts ID down (left) decreasing r*, S* and I*.
      5. Increases in WL shifts SD left (in) increasing r* and decreasing S* and I*.
      6. Increases in Y shifts SD right (out) decreasing r* and increasing S* and I*.

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