Department of Economics Spring 2008

University of California, Berkeley Professor Christina Romer

ECONOMICS 2

SUGGESTED ANSWERS TO SAMPLE SECOND MIDTERM

1. False. The nominal interest rate is determined in the market for (high-powered) money (M). When the
nominal interest rate is low, the opportunity cost of holding money is low. People demand more money
when the opportunity cost is low than when it is high because they give up relatively little for the
convenience of having lots of cash with which to make transactions. Thus, the demand curve for money
(MD) as a function of the nominal interest rate slopes downward. Because the available stock of high-
powered money is just some number and does not depend on the interest rate, the money supply curve (MS)
is vertical. The nominal interest rate adjusts to equilibrate money supply and money demand.

If the quantity of money demanded at a given MS1 MS2

i
interest rate increases, this implies that the money demand
curve has shifted out (from MD1 to MD2). If the Federal
Reserve did nothing, the nominal interest rate would rise
to i2. To prevent the interest rate from rising, the Federal i2
Reserve needs to increase the money supply. The money
supply curve needs to shift out to MS2, so that it intersects i1
MD2 at i1. To increase the money supply, the Federal
Reserve does not sell bonds, it buys bonds. By doing so, it
MD2
takes some currency that was not in circulation and puts it
MD1
into the hands of the public.
M1 M2 M

2. True. A decrease in government purchases will

indeed reduce output in the short run by more than the PAE
initial decrease in government expenditures. This is true Y=PAE
because of the multiplier effect. The amount that
consumers want to spend depends on output. The PAE1
reduction in government spending reduces output, which PAE2
reduces consumer spending, which reduces output
further, and so on. We can see this multiplier effect in
the Keynesian Cross diagram. In the short run, the
economy produces where the expenditure line (PAE)
intersects the 45-degree line (Y=PAE). The slope of the
expenditure line is the marginal propensity to consume.
A decrease in government purchases will shift the Y2 Y1 Y
expenditure line down by the amount of the decline in
government spending (from PAE1 to PAE2). Output
falls from Y1 to Y2, which is greater than the initial fall
in government spending.

3. False. Increasing the normal employment-to-population ratio of female workers will increase
potential output per person, not lower it. To see this, consider the aggregate production function:
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Y* K * N *
= f , T ,
POP N * POP

where Y* is potential output, POP is population, K* is normal capital input, T is technology, and N* is
normal labor input. The aggregate production function says that potential output per person depends on
the normal employment-to-population ratio and average labor productivity, and average labor
productivity is a function of normal capital per worker and technology.

Whenever we think of changing one element in the production function, we hold other elements
the same. In particular, we never assume that some other variable will automatically move in a
compensating direction. In this case, we hold fixed population, normal capital, technology, and the
normal male employment-to-population ratio. An increase in the employment-to-population ratio of
female workers will increase the overall employment-to-population ratio (N*/POP). Since N*/POP enters
the aggregate production function positively, this change will tend to increase potential output per person.
At the same time, the increase in N* caused by this change in female behavior will reduce average labor
productivity. This is true because the increase in normal employment, holding capital fixed, will reduce
normal capital per worker. That is, there are diminishing returns to labor. However, it is clear that the
negative effect of the increase in normal employment on average labor productivity cannot fully offset the
positive effect of the higher employment-to-population ratio. Even if the new workers have no capital to
work with, they will add something to Y*. Since population has not changed, Y*/POP will have to rise at
least somewhat in response to the rise in female labor force participation.

4. False. Because the question asks about normal unemployment among low-skilled workers, it is
appropriate to use the long-run labor market diagram for low-skilled workers. This diagram shows the
relationship between both the quantity of labor supplied and the quantity of labor demanded and the real
wage in normal times. In a country such as France, the prevailing real wage (wN) is substantially above
the equilibrium level. As a result, there is unemployment among low-skilled workers in normal times.

The marginal revenue product of labor curve

(MRPL) shows the value to firms of another worker at w* U*2
each level of employment. The demand curve for labor S1
shows the amount firms would be willing to pay to U*1
workers in the form of a wage at each level of wN
employment. When the only cost associated with an
additional worker is the wage, the MRPL curve and the
demand curve for labor are the same thing. However, Firing Costs
when there are additional costs associated with
employment, such as a payroll tax, mandated benefits, or
MRPL, D2
firing costs, the demand curve for labor lies below the
D1
MRPL curve by the amount of these additional costs. In
the diagram, the initial labor demand curve in France (D1) N*D1 N*D2 N*S1 N*
is below the MRPL curve by the amount of the expected
firing costs. When combined with a high minimum or
negotiated wage, this low labor demand curve results in significant initial normal unemployment among
low-skilled workers (U*1). A reduction in firing costs will raise the French labor demand curve to D2. If
firing costs were the only additional cost associated with employment and they were removed completely,
labor demand would shift up all the way to the MRPL curve. The result of this change would be a reduction,
not an increase, in normal unemployment (from U*1 to U*2)
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5.a. Total output in the short run is determined by the

intersection of the expenditure line and the 45-degree line PAE Y=PAE
in the Keynesian Cross diagram. The expenditure line
(PAE) shows how planned spending rises with output, PAE2
working through the response of consumption to output.
PAE1
The 45-degree line shows all the points where output is
equal to planned spending (Y=PAE). The intersection of
these two curves shows the only point where planned
spending at some level of output is equal to that same
level of output. That is, it shows the only point where the
macroeconomy is in balance in the short run. The
problem says to assume that output is initially at potential
Y1 Y2 Y
output (Y1 = Y*). (Y*)

Planned expenditure (PAE) is the sum of consumption (C), planned investment (IP), government
purchases (G), and net exports (NX). That is:

PAE = C + IP + G + NX.

The increase in optimism among consumers implies that consumer confidence is higher. This will increase
planned consumption at every level of output. The increase in optimism among firms means that firms will
want to purchase more capital. This is true because a typical firm wants to purchase capital up to the point
where:
PV(Stream of Expected Future MRPK) = Purchase Price.

The improved expectations of the future MRPK means that firms need to invest more at a given interest rate
to return the optimization condition to balance.
The increase in C and IP means that the permanent increase in optimism will shift the PAE curve up
(from PAE1 to PAE2). Output will rise in the short run (from Y* to Y2). Output will go above potential for
a while.

b. To analyze what the permanent rise in optimism among consumers and firms will do to the real interest
rate and investment in the long run, we use the saving and investment diagram. National saving in normal
times depends positively on the real interest rate; investment depends negatively on the real interest rate.
When total output is at potential, the real interest rate adjusts to equilibrate the amount of output not being
used for current consumption and government purchases with the desired use of this leftover output for
investment.

The rise in optimism among consumers and firms

r* S2
is described as permanent. Therefore, it will affect S1
consumption and investment behavior in the long run as
well as in the short run. A permanent rise in consumer
confidence implies that consumers will spend more at a r*2
given real interest rate than before. Normal national
saving (S*) is the amount of potential output (Y*) that is r*1
left over when we subtract off normal consumption (C*)
and normal government purchases (G*). That is:
I2
I1
S* = Y* C* G*.
I*2 I*1 S*, I*
A permanent rise in C* will reduce S* at a given real
interest rate. This implies that the saving function will
 4

shift back (from S1 to S2). The permanent rise in firms expectations of the future marginal revenue
products of capital means that firms will want to invest more at a given real interest rate in the long run.
This corresponds to a shift out in the long-run investment curve (from I1 to I2). The new equilibrium real
interest rate and normal level of investment is determined by the intersection of S2 and I2. The real
interest rate unambiguously rises as a result of the permanent rise in optimism (from r*1 to r*2).
However, the effect on normal investment is ambiguous. It depends on which curve shifts more. As I
have drawn it, normal investment falls slightly (from I*1 to I*2)

This problem illustrates the crucial fact that developments have different effects in the short run
and the long run. In the short run, both consumption and investment can rise because output rises above
normal. In the long run, output returns to Y*. The normal real interest rate will rise to choke off
consumption and investment enough that planned spending once again equals Y*.

6.a. Subsidizing an import good will decrease American imports, but it will not increase the total surplus of
Americans. To see this, consider the supply and demand diagram with international trade for sugar. The
supply curve (SUS1) is the marginal cost curve of American producers; the demand curve (DUS1) is the
marginal benefit curve of American consumers. For this to be a good that we import, it must be the case
that the world price of sugar (PW) is below the price that would prevail without trade. Before the subsidy,
American sugar production is QUSS1 and American consumers demand QUSD1. Therefore, we import the
difference (Imports1).

P SUS1
SUS2

a subsidy

c
b d
PW
e g
f
DUS

QUSS1 QUSS2 QUSD1 Q

Imports1

Imports2

The subsidy will shift down the supply curve for American producers by the amount of the subsidy
(from SUS1 to SUS2). The marginal cost of producing any quantity is lower because the government is paying
a subsidy. The subsidy will increase American production to QUSS2. As a result, imports will indeed fall (to
Imports2). To see what happens to welfare, one needs to calculate consumer surplus, producer surplus, and
government expenditure before and after the subsidy.

at QUSS1, QUSD1 at QUSS2, QUSD1

Consumer Surplus a+b+c+d a+b+c+d

Producer Surplus e e+f+g
Government Expenditure -(f+g+b)
Total Surplus a+b+c+d+e a+c+d+e
Deadweight Loss b
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The subsidy reduces the total surplus by area b. Therefore, there is a welfare loss associated with a subsidy.
The source of this welfare loss is the fact that the subsidy pushes production to a point where the true
domestic marginal cost is greater than the prevailing world price.

b. The subsidy will increase the employment of workers in the American sugar industry. We can see this
intuitively by recalling that the American production of sugar rises as a result of the subsidy (from QUSS1 to
QUSS2). More production implies that the industry needs more workers.

To see how this rise in employment comes about,

consider the labor market diagram for the American sugar w
industry. The demand curve for labor in any industry (D1) S1
is the marginal revenue product of labor (MRPL1). Before
the subsidy, the labor demand curve (D1) intersects the
labor supply curve for this industry (S1) at employment
w2
level L1. Recall that the MRPL is equal to the marginal MPL Subsidy
w1
product of labor (MPL) times marginal revenue (MR).
For a competitive industry, marginal revenue is just equal
to the price of the output. The subsidy increases the price MRPL2, D2
sellers receive for any quantity of sugar from PW to MRPL1, D1
PW+subsidy. Therefore, the MRPL curve will shift up by
MPL subsidy (from MRPL1 to MRPL2). Hence, the labor L1 L2 L
demand curve will shift up (from D1 to D2). (Because
MPL is declining, the gap between D1 and D2 is declining
rather than constant.) Employment and wages will both
increase as a result of the subsidy (from L1 to L2 and from
w1 to w2, respectively).
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PART III: MULTIPLE CHOICE [20 POINTS TOTAL]

Circle the best answer to each question. Each question is worth 2 points.

7. The paper by David Card in the supplemental reader presents evidence that:
a. immigration appears to significantly reduce the wages of low-skilled U.S.-born workers but not
high-skilled U.S.-born workers.
b. immigration appears to have no significant effect on the wages of U.S.-born workers.
c. immigration appears to actually increase the wages of U.S.-born workers.
d. because immigrants tend to go to cities where wages are high, it is not possible to determine how
immigration affects the wages of U.S.-born workers.

8. Suppose a typical worker in China can produce 30 radios or 5 computers in a day, while the typical
worker in the United States can produce 20 radios or 10 computers in a day. For both countries to want
to trade, the world relative price of computers will have to be between:
a. 20 and 30 radios per 1 computer.
b. 2 and 5 radios per 1 computer.
c. 2 and 3 radios per 1 computer.
d. 1/2 and 1/6 radio per 1 computer.
e. 1/2 and 3/2 radios per 1 computer.
f. none of the above.

9. A permanent tax cut will:

a. reduce output in the short run.
b. raise the real interest rate in the long run.
c. increase investment in the long run.
d. increase national saving in the long run.
e. none of the above.

10. If a country imposes a tariff on some good that it was previously importing that makes the world price
plus the tariff (PW+t) greater than the equilibrium price without trade:
a. the country will stop either importing or exporting the good.
b. the country will start to export the good.
c. consumer surplus in the market for the good will fall to zero.
d. the government will obtain a large amount of revenue from the tariff.
e. (b) and (c)
f. (a) and (d).

11. Normal average labor productivity is:

a. Y*/POP.
b. Y*/N*.
c. N*/POP.
d. N*/K*.
e. none of the above.

12. The main reason that investment is lower when the interest rate is higher is that an increase in the
interest rate:
a. increases the purchase price of capital.
b. reduces planned aggregate expenditure, and so reduces the amount that firms can sell.
c. decreases the present value of the future marginal revenue products of capital.
d. makes banks more willing to lend to firms, and so causes firms to borrow rather than invest.
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13. If the interest rate is 4%, the present value of $200 to be received 2 years from now is:
a. 200/(1+0.04)2.
b. 200/(1+0.4)2.
c. 200/(1+0.04) + 200/(1+0.04)2.
d. 200/(1+0.04).
e. none of the above.

14. All of the following will shift the expenditure line (PAE ) up except:
a. a reduction in the real interest rate
b. an improvement in consumer confidence.
c. an increase in government spending.
d. an increase in total output.

15. If the nominal interest rate is 5% and the (expected) rate of inflation is 2%, the real interest rate is:
a. 7%.
b. 3%.
c. -3%
d. none of the above.

16. Suppose that a country produces two goods, a and b. The point of tangency between the production
possibilities curve (PPC) and the consumption possibilities curve (CPC) shows:
a. the quantity of the two goods the country will consume.
b. the amount of each good that the country will export.
c. the point where the domestic opportunity cost is the same for both goods.
d. the combination of the two goods the country can produce that has the highest value on world
markets.