Econ 223 Midterm Student Number: ______

Econ 223 Midterm Student Number: ______

1. Give an equation for labour productivity. Describe four things a government could do that are likely to improve labour productivity. Refer to the equation. (5 out of 40 marks)

Y/L = A (K/L)1/3

To increase labour productivity, one could:

• improve A by conducting research
• improve A by lessening regulations
• improve A by promoting competition
• improve K/L by subsidizing investment investment
• This model ignores natural resource capital. If natural resource capital were included in "K", improve K by exploration
• This model ignores labour quality. If labour quality were included in "K", improve K by funding education.

A decrease in the interest rate would improve investment and, consequently, K/L. However, economists are usually reluctant to recommend changing the interest rate for growth purposes. The interest rate is really the only thing that monetary policy can use. Plus, it is wise to let the interest rate signal the supply and demand for money.

An increase in the wage might motivate harder work. However, we don't usually recommend that the government change the wage. It is wise to let the wage signal the supply and demand for employees. The things that improve Y/L also improve demand for labour and, consequently, the wage.

2. If output is growing at 1%, and person-hours worked is growing at 2%, how quickly is labour productivity growing/shrinking? Show your math. How quickly should the wage be growing/shrinking? (3 marks)

the rate of growth of labour productivity will be = the rate of growth in output minus the rate of growth in person-hours i.e. 0.5%.

Since the wage is proportional to labour productivity, it grows at the same rate.

3. What evidence has emerged to suggest that employers have monopsony power? (3 marks)

Batra has noted that the wage has not been growing as quickly as it should, i.e. not as quickly as labour productivity. This suggests that employers have market power. Further evidence is the amount employers have spent on assets rather than on business expansion. The working class does not seem able to afford purchases without the use of credit.

Card and Krueger found that raising the minimum wage in New Jersey did not reduce employment in the fast food sector. This too suggests that employees were not paid the value of their marginal product. Their wage was artificially low, so raising it did not make the employees unaffordable.

4. Describe the features of an ideal market. (4 marks)

An ideal market has a large number of buyers and sellers none of whom can influence the price. They are well informed and free to buy or sell the amount they wish. There are low transactions costs. Sellers bear all the costs of production, including external costs. Buyers reap all the benefits of consumption, including external benefits.

5. (6 marks)

a) Draw a macroeconomic equilibrium in Price-GDP space.

b) A temporary boon of good weather is likely to do what to the Aggregate Supply curve? Draw the new situation.

c) What happens to unemployment?

d) In the absence of government intervention, how might unemployment return to its original level?

e) What fiscal policy will return output to its original level? Is there any rationale for pursuing this course, other than that of restoring equilibrium?

I will not draw the diagram. A boon of good weather means more can be produced at any given price. Thus the AS curve shifts away from the origin. Output and employment increase. Prices fall. Unemployment falls.

In the absence of government intervention, or a change in the weather, unemployment may return to its original level when wages rise, reflecting the stronger demand for labour. Higher wages cause the AS curve to shift back towards the origin.

Instead of waiting for this to occur, a government might raise taxes or reduce spending. This would shift AD towards the origin, returning unemployment to its original level. The government might do this in order to save for bad times.

Some students said that the government might tax suppliers, moving AS back toward the origin. This is another possibility. Usually fiscal policy targets the AD curve using income taxes or consumption taxes.

6. (7 marks)

a) Complete the table.

b) What was inflation between 2007 and 2008? = (103-100)/100 = 3%

c) Did the nominal wage keep up with inflation between 2007 and 2008? The real wage fell, indicating that the nominal wage did not keep up with inflation.

d) Express 2007's wage in 2009 dollars. If we are using 2009 dollars, the price index number for 2009 should be 100. The price index number for 2007 should be 100 x 100/104 = 96.15.

Hence the 2007 wage, expressed in 2009 dollars, is 25.50/96.15 x 100 = 26.52

Alternatively, simply multiply 25.50 by 4% inflation = 25.50 x 1.04 = 26.52

7. Situation: A U.S. state is heavily indebted. Thestate government is paying a high interest rate on debt, which is in its own currency. Its citizens, however, are able to secure low interest rates for their private business. Most of the state's exports and imports are to/from Canada. The state economy is currently in recession due to falling investor confidence. (8 marks)

a) Why will fiscal stimulus accomplish in this situation?

Fiscal stimulus will stimulate aggregate demand, reducing unemployment and causing prices to rise. However, since the state is indebted, the stimulus will be paid for with extra borrowing. The indebtedness of the state will rise. This could worry creditors to lose confidence in the state, and charge even higher rates of interest, if they continue to lend at all. It could also worry investors, so that investment demand and AD do not move much. This will be discussed more in part (c).

b) Is any kind of crowding out or crowding it likely to be a problem?

Normally, government spending causes interest rates to rise and crowd out investment. This might occur, but is unlikely to be serious, because investors currently enjoy low interest rates.

To the extent that interest rates do rise, investors will reduce investment, and the currency will appreciate. Any currency appreciation will reduce net exports.

c) What effect will fiscal stimulus have on the underlying problem of investor confidence?

Investor confidence could rise if it believes that the government's fiscal policy will be good for the economy, saving it from a slump. Investor confidence could also fall if it believes that taxes will go up in future to pay for current borrowing. This is called Ricardian Equivalence. Investor confidence could also fall if it believes that the government's increasing credit un-worthiness will cause interest rates to rise for everyone.

d) If the government is determined to go ahead with fiscal stimulus, propose a particular stimulus and explain why you think it would be a good choice of program.

Since investor confidence is the problem, a fiscal stimulus that makes things easier for investors would be a good idea. Several students suggested reducing corporate tax rates. Theoretically, spending has more of a multiplier effect than taxation does, though recent empirical work says that it's actually the other way around. Good spending programs are those that build capital for the future or increase efficiency. A good spending program that improves efficiency would be subsidization of communications infrastructure.

8. Use the government budget equation to show how, in the absence of seignourage, a government could spend more than its tax revenue. (3 marks)

G + new savings + interest on debt = T + new borrowing + interest on savings

(I have left seignourage out of the equation.)

G, or indeed the whole left hand side of the equation, could exceed T if there was new borrowing or if money was earned on savings.

Additional ways that G could exceed T is if the government depleted its savings or if the interest charges on debt were renegotiated to lower levels.

9. A government seeks to raise money by selling government bonds. It asks the Central Bank to buy $1,000,000 worth of these bonds. The Central Bank agrees. Under what circumstances would this be uncomfortably similar to seignourage? (1 mark)

This would be seignourage if the Central Bank were coerced to buy these bonds with newly printed money. Similar to coercion is the case when the Central Bank buys the bonds with new money even though it does not believe it can sell these bonds to the public at the same price. This occurs when the public believes that the government is unlikely to honour the bonds. Perhaps also the bonds have no set maturity date, or they pay an uncompetitively low rate of interest.