MACREC1 Review Questions

Practice answering and, if possible, explaining to your study group the following:

1. We assume that a country uses two factors of production: capital and labor.
a. Understand what is meant by marginal product of capital and by marginal product of labor.
b. Understand the concept of diminishing marginal product of capital and diminishing product of labor.
c. Practice stating both diminishing marginal product of capital and diminishing marginal product of labor
mathematically, where Y = F (K, L) is a C 2 function. Understand what these concepts mean.
d. Practice drawing the production function with respect to capital, holding labor constant. Then, practice
drawing the production function with respect to labor, holding capital constant.
e. Practice drawing (1) the marginal product of capital as a function of capital and (2) the marginal product of
labor as a function of labor.
f. Practice explaining: What is the condition for how many units of capital a typical firm will hire? What does
this mean/imply? And, what is the condition for how many units of labor a typical firm will hire? What
does this mean/imply?
√ √
2. Suppose our production function is given by Y = K L, practice showing that this function exhibits constant
returns to scale.
3. Suppose national production is defined by this production function Y = K α Lβ where Y is output, K is capital,
and L is labor.
a. Practice solving for the condition (involving α and β) under which the production function displays constant
returns to scale.
b. Practice the same for increasing returns to scale.
c. Practice the same for decreasing returns to scale.
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4. Suppose the aggregate production function is given by Y = [K ρ + Lρ ] ρ where 0 6= ρ < 1.

a. Practice checking if this function displays constant, increasing or decreasing returns to scale.
b. Practice solving for the marginal product of capital.
c. Practice solving for the marginal product of labor.
5. Using the Classical Model of National Income, where an economy is described by the equations discussed in
class, practice showing the effects of each occurrence below using the saving-investment graph.

Y = C +I +G
Y = F (K̄, L̄)
C = C(Y − T )
I = I(r)
G = Ḡ
T = T̄

a. First, practice deriving the equation that shows saving is equal to investment. Show all the steps clearly.
b. When there is a decrease in taxes (understand the change graphically).
c. When there is an increase in investment demand (understand the change graphically).
d. When government spending and taxes are increased by the same amount (again, understand the change
graphically).

6. Practice explaining the three functions of money. Explain each carefully in no more than one sentence.

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 7. Suppose the original deposit into a bank is 1000, and that the reserve deposit ratio is rr, this implies that Bank
A can lend (1 − rr)1000. If this is deposited into Bank B, then Bank B can lend (1 − rr)(1 − rr)1000, and so
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on. What then would be the total money supply in the economy? (Hint: 1 + x + x2 + x3 + ... = 1−x ) Now, if
rr = 0.20, how much would total money supply be?

8. Show the step-by-step derivation of money supply, where M is money supply, B is the monetary base, cr is the
currency-deposit ratio, and rr is the reserve-deposit ratio. Show that when cr increases, M decreases.
9. Using the Classical AD − SRAS − LRAS model, with aggregate demand being described by M P = kY where
k = V1 , practice showing what will happen in the short run and in the long run when the following events occur:

a. Money supply decreases (understand the change graphically).

b. The velocity of money increases (understand the change graphically)
c. There is an adverse supply shock and the central bank accommodates the adverse supply shock. Understand
if this accommodation is an increase or a decrease in money supply.
10. Understand and practice explaining the exercises done in class:

a. The derivation of the IS curve graphically (do this as carefully and as clearly as you can).
b. The derivation of the LM curve graphically (do this as carefully and as clearly as you can).
11. Using the IS − LM model, show what will happen when the following events occur. Practice drawing the goods
market graph and draw the IS-LM graph to assess the following events.

PE = C +I +G
AE = Y
C = C(Y − T )
I = I(r)
M
MS =
P
MD = L(r, Y )

a. When consumer confidence decreases (understand the change graphically, note the proper shift in the IS
curve).
b. When taxes decrease (understand the change graphically, note the proper shift in the IS curve).

12. Given Y = C(Y − T ) + I(r) + G,

a. Practice solving for the government spending multiplier.
b. Practice solving for the tax multiplier.
c. Which is larger, your answer in a. or b.? Understand why and practice showing why.

13. Practice showing the possible effects when a combination of monetary policy and fiscal policy is implemented.
Try different combinations of policies. Note the differences dependent on the slopes and magnitude of shifts.
14. Practice deriving the IS-LM graph in each given case below and practice assessing the effects of the stated policy
on r, Y ,C, I, and M D (by using arrows).

a. If investment I does not depend on the interest rate r and an expansionary monetary policy is implemented.
b. If money demand L does not depend on income r and an expansionary fiscal policy is implemented.
c. If investment I does not depend on the interest rate r and money demand function L does not depend on
income and an expansionary monetary policy and an expansionary fiscal policy are implemented.

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15. Suppose that taxes are dependent on the level of income and the model of the goods market in this economy is:

C = c0 + c1 (Y − T )
T = t0 + t1 Y
I = i0 − i1 r
G = Ḡ

a. What is the set of values that the parameter t1 can take? Make sure to understand why.
b. Practice solving for equilibrium output Y .
c. Based on b., what is the multiplier? Practice understanding why this is a “multiplier.”
d. Practice solving how the multiplier changes when the parameter t1 changes?

16. Suppose we are given the following equations that describe our economy.

C = a + b(Y − T ), a > 0, b ∈ (0, 1)

I = c − dr, c > 0, d>0
G = Ḡ
T = T̄
M
MS = P
M D = eY − f r, e > 0, f >0

(a) For the goods market, practice solving for equilibrium Y as a function of r, G, T , a, b, c, d.
(b) How does the slope of the IS curve depend on the parameter d? Understand and practice explaining.
(c) Which will cause a bigger horizontal shift in the IS curve, a P100 tax cut or a P100 increase in government
spending? Understand and practice explaining.
(d) For the money market, practice solving for equilibrium r as a function of Y , M , P , e and f .
(e) How does the slope of the LM curve depend on the parameter f ? Understand and practice explaining.
(f) Suppose there is a P100 increase in money supply, how does the size of the shift in the LM curve depend
on:
i) the value of the parameter e? Understand and practice explaining.
ii) the value of the parameter f ? Understand and practice explaining.

17. Practice deriving the Aggregate Demand curve from the IS-LM model.
18. Understanding what occurrences/policies can cause the AD curve to shift to the right, and to the left.

19. Practice explaining the sticky price model for Aggregate Supply. Complete all steps until you derive Y =
Y + α(P − EP ). Why is Aggregate Supply upward sloping?
20. Using both the IS-LM model and the Keynesian LRAS-SRAS-AD model (derived from the previous three
questions), practice assessing what will happen in the economy when there is
a. an increase in government spending
b. a decrease in money supply.