Economics402:BusinessCyclesProf.

YaminAhmad

SampleMidtermSolutions

Instructions: Please answer both questions. You should show your working and calculations for each
applicable problem. Correct answers without working will get you relatively few points. Make sure to
putyournameandidnumberonthetopofeverysinglepieceofpaperthatyouturnin.Also,please
write in a page number at the bottom of every piece of paper that you turn in and assemble them
sequentiallybeforesubmitting.

Question1:MathandOptimization(50%)
Consider the Primal problem faced by a producer. Namely, a producer (or firm) can be thought to
maximize profits, subject to producing their goods based on a particular kind of technology, or
productionfunction.
Supposethatproductionofgoodyrequirestwoinputs:K(capital)andL(Labor),whichhaveinputprices
r and w respectively. Furthermore, assume that the firms price is normalized to 1, and that the
productionfunctionisgivenbyaconstantelasticityofsubstitution(CES)productionfunction:
1

y F K , L K L

[Quickaside:
Justasanaside,andasapointofinterest(sincesomeofthe paperswemayreadmight usetheCES
function),herearesomeofthepropertiesofthefunctionabove.Asitsnamesuggests,theelasticityof
substitution (whichinthiscasewouldmeasurethecurvatureoftheproductionisoquant)isconstant
for the CES production function. More specifically, the elasticity of substitution measures the
percentage change in the factor ratio divided by the percentage change in the technical rate of
substitution,whilstholdingoutputfixed.Thatis:

K / L
d ln K / L d ln K / L
K/L

dK / dL d ln dK / dL
d ln TRS
dK / dL

Economics402:BusinessCyclesProf.YaminAhmad

The usefulness of the CES production function in replicating different types of production functions
becomesapparentaswevarytheparameter .Forexample:
CaseI:Linearproductionfunction:
Whenweset 1 ,theproductionfunctionabovebecomes: y K L ,wherethetwoinputs,capital
andlaborareperfectsubstitutes.
Case2:CobbDouglasproductionfunction:
When tends to 0, i.e. lim 0 y , the isoquants of the CES production function look very much like
those of the CobbDouglas production function. This can be shown a variety of different ways
mathematically,buttheeasiestistocomputethetechnicalrateofsubstitution.Assuch,thetwoinputs
inthiscaseareimperfectsubstitutes,wheretheproductionisoquantsaredownwardsloping.
Case3:LeontieffProductionfunction:
When tends to , i.e. lim y , the production isoquants become Lshaped, which we
associatewiththeperfectcomplementscaseforinputs.
EndAside]
a. [5pts]CalculatethepartialderivativesofywithrespecttoKandwithrespecttoL.
Answer:
1

y K L
F 1 1
z K 1 z
K
1

F 1 1 1
z L z
L
1

K 1 , where z K L

L 1

b. [5pts]Considerthatthetotalderivativeoftheproductionfunctionabovewouldbecalculated
as:

dy

F
F
dk
dL .Thetechnicalrateofsubstitutionmeasureshowoneoftheinputsmust
K
L

adjustinordertokeepoutputconstant(i.e.when dy 0 )whentheotherchanges,andcanbe

Economics402:BusinessCyclesProf.YaminAhmad

calculated from the total derivative above as: TRS

dK
F / L
. Using your answer to

F / K
dL

part(a),calculatethetechnicalrateofsubstitutionfortheCESproductionfunctionabove.
Answer:
1

dK
z L 1
L
1

TRS
dL
K
z K 1

K

L

c. [4 pts] Using your answer from part (b), rewrite the equation so that you have (K/L) as a
functionoftheTRS.[Hint:taketheabsolutevaluesoftheTRSandthenrearrangefor(K/L)]].
Answer:
1

K
TRS
L

1
K
TRS 1
L
d. [4pts]Takelogsofbothsidesanddifferentiateto showthattheelasticityofsubstitution isa
constant
Answer:

1
ln TRS
1
1
d ln TRS
d ln K / L
1
ln K / L

d ln K / L
1

d ln TRS
1

Analternativewaytothinkabouttheproducersproblemistoviewitasafirmschoicetoproducea
certainamountofoutput, y ,andthentheywishtominimizetheamountofcostsneededtoproduce
thatamountofoutput.ThisistypicallytheDualproblemtothefirmsdecisions.
e. [6 pts] Given input prices r and w for K and L respectively, write out the Lagrangean for the
firmscostminimizationproblemforproducinganamountofoutput y .
1

Answer:Thefirmsproblemisto min rK wL subjectto: K L y .Itisactuallyeasier

K ,L

totransformtheconstraintabit,sothattheproductionfunctionisnow: K L y .

Economics402:BusinessCyclesProf.YaminAhmad

Assuch,thelagrangeanfortheproblemis:

rK wL y K L
f.

[6pts]Derivethefirstorderconditions(FOC)fortheproblemabove.
Answer:

r K 1 0
K

w L 1 0
L

K L y

(I)
(II)
(III)

g. [10pts]Solvefortheoptimalvaluesof K * and L* .
Answer: Using equations (I) and (II) above, we can eliminate to get the expression that the
absolutevalueofthemarginalrateoftechnicalsubstitutionequalsthe(input)priceratio:

K

L

r
r 1
K * L*
w
w

(IV)

WenowhaveanexpressionforKintermsofL.Finally,byplugging(IV)into(III)(whichwehave
notuseduptothispoint),wecansolveforL*firstandthenK*asfollows:

r 1

L L y
w
L

1
r
1 y
w

1 1

1
w
w r y

L* w

K* r

1
1

1
w
r

1
1

1
w r

h. [10pts]CalculatetheValuefunctionforthecostfunction,whichisobtainedbyplugginginthe
optimalvaluesofK*andL*thatyouobtainedinpart(g)aboveintothecostfunctionitself.

Economics402:BusinessCyclesProf.YaminAhmad

Answer: By plugging in the optimal values for K* and L* into the cost function, we can obtain
totalcostsasafunctionoftheinputpricesandthelevelofoutputthefirmwishestoachieve.
Thatis:

C r , w, y rK * wL*
r

1
1

y r

1
w r

1
y r w

yw

1
1

1
w r

y r w

[Notice that the form of the cost function is the same as the original CES production function
exceptwith replacedwith instead,andtheinputsreplacedbytheirfactorprices.]
Question2:ISLMquestion(50%)
ConsiderthefollowingISLMmodel:

1
C 200 (Y T )
4
1
I 150 Y 1000r
4
G 250

T 200
L r , Y 2Y 8000r
M
1600
P

a. [8pts]DerivetheISequation
Answer:TogettheISequation,justaddupC+I+Gasfollows:

1
1
Y 200 150 Y 1000r 250
4
4
1

Y 550 Y 1000r
2
Y 1100 2000r
(1)
IS : Y 200

Economics402:BusinessCyclesProf.YaminAhmad

b. [8pts]DerivetheequationfortheLMcurve.[Hint,youwanttowriteitasinterestratesasa
functionofeverythingelse].
Answer:TogettheLMequation,justsetdemandequaltosupplyforrealmoneybalances:

M
L r, Y
P
1600 2Y 8000r

8000r 1600 2Y
r 0.2 0.00025Y

(2)

c. [8pts]Solvefortheequilibriumoutput.[Hint:substitutetheLMequationintotheISequation
andthensolveforoutput]
Answer:

Y 1100 2000(0.2 0.00025Y )

1500 0.5Y

Y * 1000
d. [8pts]Solvefortheequilibriuminterestrate.[Hint:substitutethevalueyouobtainedforoutput
in part (c) into either the IS or LM equations, and solve for interest rates. You should get the
samenumberfrombothifyoudidthemathcorrectly]
Answer:PluggingintotheLMequation,weget:

r 0.2 0.00025 1000

r * 0.2 0.25 0.05

Thusinterestratesare5%inequilibrium.
e. [8pts]Calculatethevaluesofconsumptionandinvestmentinequilibrium.Verifythatthesumof
C,IandGadduptooutput.
Answer:

C * 200 0.25 (1000 200) 400

I * 150 0.25 1000 1000 0.05 350

G 250
C * I * G 400 350 250 100
f.

[10 pts] Suppose that the money supply increases to M/P = 1840. Solve for Y, r, C and I and
describeinwordstheimpactofamonetaryexpansion.
Answer:Intuitively,amonetaryexpansionshouldimpacttheLMcurve.Itshouldcreateasurplus
ofmoneyinthemoneymarketandcauseinterestratestogodown,shiftingtheLMcurveout.

Economics402:BusinessCyclesProf.YaminAhmad

Thedecreaseininterestratesshouldspurinvestmentandoutputandwewouldmovealongthe
IScurveintheshortrun.Sinceoutputgoesup,consumptionshouldtoo.

1840 2Y 8000r
r 0.23 0.00025Y

ThisisthenewLMcurve.PluggingintotheIScurveyields:

Y * 1100 2000(0.23 0.00025Y * )

1.5Y * 1560
Y * 1040
r * 0.23 0.00025 1040 0.03
C * 200 0.25 1040 200 410
I * 150 0.25 1040 1000 0.03 380
Thusourobservationsareverified.