QUIZ 3: Macro – Winter 2007

Name: ______________________

Section Registered (circle one): WF 8:30 – 10:00 WF 10:00-11:30 W 6:00-9:00

Instructions: For questions 1-3, circle ALL of the true answers to the question stem. Each answer is worth 2 points. For each question below, assume that TFP, tax rates, welfare programs, and the working age population are constant unless I tell you otherwise. Answer all questions using the model of the labor market developed in class. Lastly, unless I tell you otherwise, make no assumptions about whether the income effect dominates the substitution effect on labor supply (when relevant).

Question 1: In the early 1970s, the “baby boom” generation started to enter the labor force at a faster rate than previous generations causing a rapid increase in the working age population. Given our labor market analysis, which of the following are necessarily true from such an event? (6 points total)

The analysis: Increase in working age population will shift out the labor supply curve causing wages to fall and N to increase.

W/P

z 1

N

The movement from 0 to z (on the new labor supply curve holding real wages fixed) is due to the increase in the working age population – all else equal, more people working results in a greater labor supply at every wage. (Note – the labor supply curve did NOT shift out because of a substitution effect – it shifted out because more workers were working). There is a substitution effect on this graph. That is illustrated by the movement from z to 1 along the new labor supply curve. z is not an equilibrium point. When more people work, labor becomes abundant to firms and as a result, labor is less valuable to firms (the MPN falls).

If the increase in the working age population was temporary (i.e., had no effect on the PVLR), this would be the end of the story. Labor supply shifts right, W/P falls, N increases, Y increases (given Y = A K.3N.7), MPN falls (as N increases), Y/N falls (W/P = 0.7 Y/N and W/P falls).

If the increase is permanent, the results are exactly the same qualitatively (although the magnitudes will change). The reason is that as real wages fall permanently, PVLR will

0

fall – in other words, those in the work force would be poorer as a result of the large influx of workers. The income effect says that we will work more when we are poorer (we can afford less leisure). So, the income effect will result in another shift right of the labor supply curve. On net, the labor supply curve will definitely shift right regardless of whether the income effect is strong or not.

Recap – from the labor supply stand point there are 3 effects: increase in N (shift in labor supply) due to the entry of workers into the economy; decline in N due to falling real wages (movement along labor supply curve); increase in N due to falling PVLR (income effect – shift in labor supply).

N definitely increases, Y definitely increases, W/P definitely falls, and Y/N definitely falls.

a. The labor demand curve will shift out as the marginal product of labor falls.

False – movement along the labor demand curve.

b. If the income effect is large enough, total production in the economy would actually fall.

False – income effect shifts labor supply to the right and increases N (and Y). See above.

c. If the substitution effect is large enough, the change in output per worker would be ambiguous as both Y and N increase.

False – Y/N falls (Y/N is proportional to real wages and real wages fall).

Question 2: Which of the following temporary changes will induce a substitution effect that will cause the labor supply curve to shift to the right? (6 points total)

a. An increase in TFP.

False – see supplemental notes. The substitution effect is a movement along the labor supply curve.

b. A decline in the marginal tax rate on labor (tn)

True – decreasing labor income taxes increases the price of leisure. Holding before tax wages constant, this is represented as a rightward shift in the labor supply curve. The substitution effect causes the labor supply curve to shift.

c. An increase in the amount of immigrants into the country.

False – the labor supply curve shifts because of more workers in the economy. See the answer to question 1 for an analogous discussion (increasing the baby boom population in the work force is analogous to increasing the amount of immigrants into the country).

Question 3: Which of the following are true about a permanent decline in labor income taxes (tn)? Assume the income effect and the substitution effects on labor supply exactly offset. (6 points total)

a. The potential level of output (Y*) will increase as consumers spend more because of the tax cut.

False – demand side factors do not determine Y* only supply side factors.

Y* = A K.3 N*.7

In this example, if the income and substitution effects cancel each other out, N* will not change. Given that A and K are fixed (unless I tell you otherwise), Y* will not change in this situation. So, Y* will remain constant if the income and substitution effects cancel each other out.

b. The marginal product of labor will remain constant.

Given that N is exactly the same, the MPN will not change. MPN = W/P = .7 A (K/N).3

If A and K do not change and N does not change (given the income and substitution effects offset), then the MPN does not change. This also implies that before tax wages do not change (W/P = MPN).

c. After tax wages will fall.

After tax wages will increase. If W/P is constant (see above) and tax rates fall, then after tax wages will rise.

Question 4: In the article from the Economist entitled “A Strange Recovery” (8/9/2003), the author pointed out that there was something strange about the U.S. recovery out of the 2001 recession. Usually, as economies recover from a recession, this variable increases rapidly in the subsequent 2 years. However, in the 2 years after the 2001 recession ended, this variable actually declined. What was this variable that “behaved” strangely? Your answer should be no more than 1- 2 words. (2 points total).

Total employment. Total employment actually continued falling after the last recession ended. We will talk about the reason for this later in class.