Problem #5

Consider an economy where

MP L = 309 - 2 L
LS = 22 + 12 w + 2 T
L - 22 - 2 T
wS =
12
Since the tax is lump-sum, there will be an income effect but no substitution effect (because all prices remain equal and the
real wage remains unchanged); the reduction in wealth incentivizes the individuals incentive to earn more money.
Imagine you were making $600 and you needed $400 to live. Imagine a lmp-sum tax of $300 was levied upon you, you
need $400 to live but you only have $300. Would you work less or more?
Now suppose that T = 35. The equilibrium levels of wage and labour are given by
w = MP L
L - 22 - 2 T
= 309 - 2 L
12
L - 22 - 2 T + 12 (2 L) = 12 (309)
12 (309) + 22 + 2 T
L* =
25
3730 + 2 T
=
25
3730 + 2 (35)
=
25
= 152
L* - 22 - 2 T
*
w =
12
152 - 22 - 2 (35)
=
12
=5
The government then enacts a minimum wage of
w*m = 7
which is binding so,
w*m = MP L
7 = 309 - 2 L
L* = 151

Sodiq.nb

Labour market
w
50

40

30

20

10

50

100

150

200

Problem #6
Suppose that the production function is
Y = 9 K 1/2 L1/2 .
With this production function, the marginal product of labour is
MP L =

9
2

K 1/2 L-1/2 ,

the capital stock is

K = 25,
and so the production function and marginal product of labour are given by
Y = 45 L1/2
45 -1/2
MP L =
L
2
and the labour supplied at real wage w and tax t is given by
LS = 100 ((1 - t) w)2
L
wS =

100 (1 - t)2

>0

L1/2
=

10 (1 - t)

Define the after-tax real wage as W = (1 - t) w.

If t = 0, find the equilibrium levels of the real wage and employment, the level of full-employment output, and the
total after-tax wage income of workers.
Firms will hire labour until the wage rate is equal to the marginal product of labour because intuitively, if
w > MP L , the cost of hiring additional workers exceeds the benefits of hiring them, so they should hire fewer workers.
So the condition is
L

wS
1/2

10

= MP L
=

45
2

L-1/2

Sodiq.nb

L* = 225
1/2

L*

w =
=
=

10
2251/2
10
3
2

Equilibrium output is given by

1/2

Y * = 45 L*

= 45 225
= 675
and the after-tax real wage is given by
W * = (1 - t) w*
3
= (1 - 0)
2
3
=
2
thus the total after-tax income of the workers is
= W * L*
3
= 225
2
675
=
2
= 337.5
Labour market
w
3.5
3.0
2.5
2.0
1.5
1.0
0.5

100

200

300

If t = 3 / 5, the optimal condition becomes

wS = MP L
L

1/2

10 (1 - 3 / 5)

45
2

L-1/2

400

Sodiq.nb

45

L* = 10 (1 - 3 / 5)

= 90
1/2

L*

w =

10 (1 - 3 / 5)
901/2

10 (1 - 3 / 5)
90

4
2.37171

Equilibrium output is given by

1/2

Y * = 45 L*
= 45

90

= 135 10
426.907
and the after-tax real wage is given by
W * = (1 - 3 / 5) w
2
= w*
5
=

90

5 4
= 0.948683

thus the total after-tax income of the workers is

= W * L*
=

90

5 4
= 405

135

10

Labour market
w

100

200

300

400

Sodiq.nb

If t = 0 but there is a minimum wage of w = 2; from before, optimality requires that

w* =

3
2

but the minimum wage prevents this equilibrium level. Thus the wage will be pushed upwards to 2 and
w*m = 2
Graphically,
Labour market
w

3.0
2.5
2.0
1.5
1.0
0.5

100

200

300

400

This effectively makes the true supply curve a piece-wise function: it is the green line until the green line intersects the
blue line (which is the labour supply). When the labour supply exceeds the minimum wage (the green line), the labour
supply curve takes over. Basically, you restrict the labour curve to never be below the minimum wage. As such, the new
intersection is at a place where the green line intersects the labour demand to the left of the unrestricted equilibrium.
The firm will thus hire
w*m =
2=
1/2

L*

L* =

45
2
45
2
45

1/2

L*

1/2

L*

4
2025

16
126.563

and the total after-tax income of the workers is noting that W * = w*m for this case,
= W * L*
2025
=2
16
2025
=
8
= 253.125
Relative to the t = 0 case in absence of a minimum wage, the workers take in significantly less income as a group.

Sodiq.nb

Problem #8
Dude buys a bond for $500 and gets $545 a year later. The nominal return is
r=
=

545 - 500
500
9
100

The CPI is 200 then, while it goes to 214. The inflation rate can be estimated as the rate of change of the CPI,
=
=

214 - 200
200
7
100

Dude expected it to be 210 instead, so

exp =
=

210 - 200
200
5
100

Real interest rate is

i = r-
2
=
100
Expected real interest rate is
iexp = r - exp
=

4
100

Problem #9
GDP deflator is
GDPdeflator = 100

Nominal
Real

In 2005 it is 200, then its 242 in 2007 and 266.2 in 2008. Between P1 and P2 the overall inflation rate is
=
=

GDP2007 - GDP2005
GDP2005
242 - 200

200
= 0.21
However that isnt the annual rate. That would be given by
200 (1 + x)2 = 242
1+x =

242
200

Sodiq.nb

=
x=

11
10
1
10

Thus an inflation rate of 10% describes the price movement. The annual rate over the three periods is given by
200 (1 + x)3 = 266.2
1+x =

=
x=

2662
3

200 10

11
10
1
10

which implies the same annual rate.

Problem #8 (Another one)
Use the figure to calculate how many people become unemployed in a month.
1% of the employed go unemployed and 2% of those not in the labour force enter and become unemployed. So thats
0.02 (77.4) + 0.01 (144.0) = 2.988
But 13% of the unemployed leave the labour force completely while 22% become employed,
0.13 (7.0) + 0.22 (7.0) = 2.45
with a net effect of
2.988 - 2.45 = 0.538
Repeat the procedure for the others.
Problem #9 (Another one)
Okuns law defines potential GDP as
Y -Y

= 2 (u - u)
Y
Y = 2 (u - u) Y + Y
(1 - 2 (u - u)) Y = Y
Y
Y =
1 - 2 (u - u)
Assuming u = 0.06, you just plug in values for each year.