Attachment 3083

Macroeconomics Exam Problems: Demand for Money
(The attached PDF file has better formatting.)

Take heed: Several homework assignments analyze the demand for money. The practice
problems here are simple; they are basic relations you should know. Some final exam
problems are patterned after the homework assignments.
! Know how each macroeconomic variable (real interest rate, inflation rate, consumption,
transaction costs) affects the real demand for money.
! Know how the demand for money and the money supply determine the price level.
! Know the effects of business cycles and seasonality on the real demand for money and
the price level.
! Given a scenario and a change, trace the effects on each macroeconomic variable.
Review the homework assignments for complete exam preparation.
! The four scenarios in the homework assignment for Module 24 are not tested on the
final exam, since they are not explicitly discussed in the textbook.
! The other homework assignments use scenarios explicitly discussed in the textbook.
If you do not understand the macroeconomic relations after reviewing the textbook
chapter, post a question on the discussion forum for any item that is unclear to you.
*Question 1.1: Nominal Demand for Money

People demand money to buy goods, but currency and checking deposits earn no interest.
Which of the following increases the nominal demand for money?
A.
B.
C.
D.
E.
A one time only decrease in the price level.

A one time only decrease in the money supply.
A decrease in the nominal interest rate.
A decrease in the amount of consumption expenditures.
A decrease in the transaction costs of exchanging bonds for money.
Answer 1.1: C
Statements A and B: A one time only decrease in the price level or the money supply has
no effect on inflation or nominal interest rates. The change in the price level decreases the
nominal demand for money.
Statement C: A decrease in the nominal interest rate makes consumers less concerned
about investing their cash and more concerned about avoiding transaction costs. They
exchange bonds for money less frequently and hold larger average money balances.
Statement D: A decrease in consumption causes a decrease in the demand for money.
Statement E: A decrease in transaction costs causes consumers to exchange bonds for
money more frequently, leading to a decrease in average money balances.
*Question 1.2: Demand for Money

Suppose the government bans on-line banking and ATM machines to reduce identify theft.
Consumers must do their banking at bank branch offices with live tellers, raising the
transaction costs of bank visits. If money is neutral, the government action causes
A.
B.
C.
D.
E.
The real interest rate to decline.

The real interest rate to rise.
The price level to decline.
The price level to rise.
Neither the real interest rate nor the nominal interest rate to change.
Answer 1.2: C
The demand for money increases, since consumers want to avoid bank visits. For the
money market to remain in equilibrium, the real money supply must increase, so the price
level must decline. Money is neutral so it has no effect on real interest rates.
Macroeconomics Final Exam Practice Problems: Indifference Curves

Indifference curves are used in both the microeconomics and macroeconomics courses.
! The microeconomics course uses indifference curves for two commodities (bread and
wine) to illustrate free market pricing.
! The macroeconomics course uses indifference curves for leisure and wage income to
explain the labor market.
The concepts are the same. Material from one course is valid for the other course as well.
Indifference curves are downward sloping and convex (decreasing marginal utility). The
practice problems focus on these two properties. Given a set of points on one indifference
curve, determine if another point might be on the same curve.
If you have not taken the microeconomics on-line course, see the discussion forum for that
course for additional practice problems.
*Question 1.1: Indifference Curves

Leisure (time not working) is on the horizontal axis and consumption is on the vertical axis.
An indifference curve is the locus of points among which the consumer is indifferent.
Three combinations of leisure and consumption on one indifference curve are
1. 20 hours of leisure per day + $80,000 of consumption per year
Which of the following combinations might be on the same indifference curve? (Four of
these points can not be on the same indifference curve; one might be on the same curve.)
A.
B.
C.
D.
E.
22 hours of leisure per day + $75,000 of consumption per year

Answer 1.1: E
Leisure and consumption are economic goods with positive utility. If one point has more
leisure and more consumption than a second point, that point has greater utility.
Indifference curves show decreasing marginal utility along each axis. If the two axes are
Goods Y and Z, as we reduce Good Y, we need increasing amounts of Good Z to retain
the same utility.
! As we reduce Good Y, its marginal utility increases.
! As we increase Good Z, its marginal utility decreases.
Illustration: Three points lie on the same indifference curve: (L1, C1), (L2, C2), and (L3, C3),
with L1 < L2 < L3. (L is leisure; C is consumption.)
Both goods are valuable, so C1 > C2 > C3. As leisure increases along an indifference
curve, consumption decreases (and vice versa).
By decreasing marginal utility, (C2 C3) / (L3 L2) > (C1 C2) / (L2 L1). As leisure
increases, its marginal value decreases, so we need more consumption per unit of leisure
to have the same total utility.
Consider Points 1, 2, and 3.
! Point #1 has the highest leisure and the lowest consumption.
! Point #3 has the lowest leisure and the highest consumption.
We compare the ratios (C2 C3) / (L3 L2) and (C1 C2) / (L2 L1) in $000 per hour:
! (C2 C3) / (L3 L2): ($84,000 $92,000) / (16 hours 18 hours) = 4.000
! (C1 C2) / (L2 L1). ($80,000 $84,000) / (18 hours 20 hours) = 2.000
Decreasing marginal utility means that indifference curves are convex (concave upwards).
These three points on the same indifference curve imply that a consumer who has
~ 16 hours of leisure a day would pay $6,000 a year for two more hours of leisure a day.
~ 18 hours of leisure a day would pay $4,000 a year for two more hours of leisure a day.
We infer the following items about this indifference curve:
! The curve is convex between 18 and 20 hours of leisure a day. A consumer who has
19 hours of leisure must receive less than (or equal to) ($80,000 + $84,000) =
$82,000 to be on the same indifference curve.
17 hours of leisure must receive less than (or equal to) ($84,000 + $92,000) =
$88,000 to be on the same indifference curve.
14 hours of leisure must receive more than (or equal to) $92,000 + ($92,000 $84,000)
= $100,000 to be on the same indifference curve.
22 hours of leisure must receive more than (or equal to) $80,000 ($84,000 $80,000)
= $76,000 to be on the same indifference curve.
The principle of economic goods eliminates Choices C and D.
! Point C has more leisure and more consumption than point #2, so it has higher utility.
! Point D has more leisure and more consumption than point #1, so it has higher utility.
The principle of decreasing marginal utility eliminates Choices A and B.
! Statement A: Points #1 and #2 imply that leisure is worth $2,000 an hour. As leisure
increases, it is worth less per hour. But Points A and #1 imply that leisure is worth
$2,500 an hour at a higher amount of leisure.
! Statement B: Points #2 and #3 imply that leisure is worth $4,000 an hour. As leisure
decreases, it is worth more per hour. But Points B and #3 imply that leisure is worth
$3,500 an hour at a lower amount of leisure.
Only point E can be on the same indifference curve as Points 1, 2, and 3.
This solution reviews more the concepts of indifference curves. Economics is a science of
choices: why consumers choose one situation over another. Much of this course deals with
preferences: do people work, consume, save, and invest more in one scenario or another?
*Question 1.2: Indifference Curves

An indifference curve for leisure and consumption is the locus of points (combinations of
leisure and consumption) among which the consumer is indifferent. Each consumer has
an infinite number of indifference curves that cover the plane.
Joseph has two job offers.
! Job k requires 7 hours of work a day and pays $49,000 a year
! Job j requires 6 hours of work a day and pays $44,000 a year
For the indifference curve analysis, we express this as
! Job k is 17 hours of leisure a day and $49,000 of consumption a year
! Job j is 18 hours of leisure a day and $44,000 of consumption a year
On July 1, Joseph is just graduated from college and has no savings. On July 2, Joseph
wins a $2 million lottery.
A.
B.
C.
D.
E.
If Joseph is indifferent between jobs j and k on July 1, he prefers job k on July 3.

If Joseph is indifferent between jobs j and k on July 3, he prefers job j on July 1.
If Joseph prefers job k on July 1, he prefers job k on July 3.
If Joseph prefers job j on July 1, he prefers job k on July 3.
If Joseph prefers job k on July 3, he prefers job k on July 1.
Answer 1.2: E
Work is less important and leisure is more valuable to Joseph on July 3 than on July 1,
since he is richer on July 3.
~ If Joseph prefers leisure to work in some scenario on July 1, he surely prefers leisure
to work in that scenario on July 3.
~ If Joseph prefers work to leisure in some scenario on July 3, he surely prefers work to
leisure in that scenario on July 1.
Statement A says that Joseph is indifferent between an extra hour of work and an extra
$5,000 a year on July 1. We infer that Joseph might prefer the extra hour of leisure on July
3, which is Job j, not Job k.
Statement B is the inverse of Statement A; Joseph might prefer Job k, not Job j, on July 1.
Statement C: Joseph might prefer Job k on July 1 because he needs income. On July 3,
when he has less need f or income, he might prefer Job j.
Statement D: If Joseph prefers Job j on July 1, he surely prefers Job j on July 3.
Statement E is correct. Even when Joseph is wealthy (on July 3) he prefers the extra
$5,000 of income to the extra hour of leisure. When he is poor (on July 1), he surely
prefers the extra income to the extra leisure.
Jacob: Can we say that Joseph prefers Job k on July 1 and Job j on July 3?
Rachel: No. We dont know Josephs preference for leisure vs income.
! Perhaps Joseph has no use for leisure, and prefers Job k on both July 1 and July 3.
! Perhaps Joseph has great use for leisure, and prefers Job j on both July 1 and July 3.
If Josephs tastes are the same on July 1 and July 3 except for the effects of greater wealth
on July 3, we infer Statement E.
Macroeconomic final exam practice problems: comparative advantage

*Question 1.1: Corn and Mushrooms
Corn and mushrooms are grown in the U.S. and Mexico.
! Mushrooms grow in the wild and are harvested by hand (with no machines).
! Corn is grown on large farms using tractors and harvesters.
The capital per worker is higher in the U.S. than in Mexico. In all other respects, the two
countries are the same: the quality of the work force and investment risks do not differ.
! U.S. farms have all the tractors and harvesters they can use.
! Mexican farms have no tractors or harvesters and must rely on hand labor.
All but which of the following is true?
A.
B.
C.
D.
E.
The U.S. has a comparative advantage in growing corn.

Investors prefer to invest in the U.S. rather than in Mexico.
Farmers trade U.S. corn for Mexican mushrooms.
The U.S. runs a current-account surplus.
Mexico runs a current-account deficit.
Answer 1.1: B
Growing corn requires much capital to buy tractors and harvesters. Capital does not help
growing mushrooms, since all work is done by hand.
The U.S. has more capital per worker, so it has a comparative advantage in growing corn.
U.S. farmers grow corn and exchange it for Mexican mushrooms.
Mexico has less capital per worker, so it has a comparative advantage in growing
mushrooms. Mexican farmers grow mushrooms and exchange them for U.S. corn.
U.S. farms already have all the capital they can use and more investment wont help. But
some Mexican farms may want to grow crops that require much capital. They are willing
to pay higher interest rates for the capital, so investors prefer to invest in Mexican farms.
The current-account deficit reflects national savings minus domestic investment.
! U.S. citizens save money and invest in Mexico.
" U.S. national savings exceeds domestic investment, so the U.S. runs a currentaccount surplus.
! Mexican farmers borrow money from U.S. investors.

" Mexican national savings is less than domestic investment, so Mexico runs a
current-account deficit.
Jacob: This seems counter-intuitive. If Mexico is the better place to invest, why does the
U.S. have so much more capital? People invest in developed countries with much capital,
not in developing countries with little capital.
Rachel: This exercise stipulates that all else is equal in the two countries. People invest in
developed countries because the labor force is better educated, the economies are more
open, the governments are more stable, and business contracts are subject to law, not to
the personal interests of bureaucrats.
Macroeconomics Final Exam Practice Problems: Government

*Question 1.1: Permanent Increase in Government Expenditures
Government spending may affect private consumption, investment, and interest rates.
Suppose government spending is now $500 billion. If the government permanently raises
spending to $600 billion to finance national health insurance, which of the following is true?
Private Consumption
Private Investment
Interest Rates
rise
rise
fall
B
C
D
E
fall
no change
fall
rise
fall
fall
no change
rise
rise
rise
no change
no change
Answer 1.1: D
Increased government spending makes it harder for private firms to borrow and causes
people to consume and invest less.
If the government finances its spending with debt, interest rates rise, and private firms
invest less. Consumers expect to pay higher taxes in later years, so they spend less.
If the government finances its spending with higher taxes, consumers spend less and save
less. Interest rates rise, and private firms invest less.
*Question 1.2: Permanent Increase in Government Expenditures

Suppose government spending is now $500 billion. If the government permanently raises
spending to $600 billion to finance national health insurance, which of the following is true?
A
B
C
D
E
Real GDP
Private Consumption
Private Investment
Interest Rates
fall
rise
fall
no change
rise
rise
fall
no change
fall
rise
rise
fall
fall
no change
rise
fall
rise
rise
no change
no change
Answer 1.2: D
*Question 1.3: Cyclicality

The correlation of consumption, investment, and government expenditures with real GDP
affects our interpretation of business cycles.
! Pro-cyclical a correlation significantly greater than zero.
! Counter-cyclical a correlation significantly less than zero.
! Independent a correlation not significantly different from zero.
What is the correlation of private consumption, gross domestic investment, and permanent
(non-wartime) government expenditures with real GDP?
A
B
C
D
E
Answer 1.3: E
Private Consumption
Gross Domestic
Investment
Permanent Government
Expenditures
pro-cyclical
counter-cyclical
independent
counter-cyclical
pro-cyclical
pro-cyclical
counter-cyclical
counter-cyclical
independent
pro-cyclical
counter-cyclical
pro-cyclical
pro-cyclical
independent
independent
*Question 1.4: Temporary Increase in Government Expenditures

Suppose government spending is now $500 billion. If the government temporarily raises
its consumption to $600 billion to finance a short-term war, which of the following is true?
A
B
C
D
E
Private Consumption
Private Investment
Interest Rates
rise slightly
fall slightly
rise slightly
fall slightly
rise slightly
rise
fall
fall
rise
rise
fall
rise
rise
fall
no change
Answer 1.4: B
Macroeconomics Final Exam Practice Problems: Labor

This set of practice problems on labor supply has topics from several modules. Changes
in several variables change the labor supply curve, the quantity of labor supplied, the real
wage rate, or the marginal product of labor. Focus on the following items:
A change in the tax law that changes the marginal tax rate changes (by the substitution
effect) the supply curve for labor as a function of the pre-tax real wage rate. Similar effects
come from technology, capital per worker ratios, and human capital (education, health).
A change in workers wealth (from taxes, government services, or supply shocks) changes
the labor supply curve by the income effect.
Changes in one industry (such as higher wages in factory work) change the labor supply
curve for other industries (such as farm work).
The macroeconomics course covers the supply and demand curves for labor. Given any
scenario, know how the supply and demand curves move. When one or both of the curves
move, the equilibrium quantity of labor and real wage rate change.
The equilibrium real wage rate and quantity of labor change, affecting both the employment
rate and the hours worked. The hours of leisure change, so the marginal value of leisure
changes. The marginal product of labor changes, both pre-tax and after-tax. The change
in the labor supply changes the capital per worker and the marginal product of capital.
The final exam problems test the mathematics of the natural unemployment rate. From the
job finding and separation rates, calculate the natural unemployment rate. The homework
assignment reviews the relations, and two exhibits in the textbook show the computations.
These quantitative problems may be asked various ways, such as
! From the natural unemployment rate and job finding rate, compute the job separation
rate.
! From specified changes in job finding and separation rates, compute the percentage
change in the natural unemployment rate.
Some exam problems test the qualitative influences on the natural unemployment rate. A
qualitative influence may have two or more stages. For example, a higher minimum wage
may raise unemployment among unskilled workers and lower unemployment among skilled
workers. We show practice problems with several stages.
Some exam problems test relations among the real wage rate, marginal product of labor,
nominal wage rate, price level, real demand for money, and nominal money supply. These
questions combined several course modules. Focus on
! the equilibrium relations, such as real demand for money equals the real money supply,
or the real wage rate equals the marginal product of labor
! the conversion of real values (real wage rate, real interest rate, real GDP) to nominal
values (nominal wage rate, nominal interest rate, nominal GDP)
*Question 1.1: Technology level

Workers in Bangladesh sew clothes for sale as exports to Western Europe. Bangladesh
is a small country, and its exports are a tiny portion of the world clothes market.
The workers are paid an hourly wage, which reflects the marginal product of labor. A new
sewing machine enables workers to sew clothes twice as efficiently.
What are the effects on the supply and demand curves for workers who sew clothes?
A
B
Demand curve
moves right (increases)
Supply curve
no change
C
D
E

no change
no change
moves left (decreases)

moves left (decreases)
Answer 1.1: B
Suppose a worker could sew five shirts in an hour without the new sewing machine, and
firms would hire 1,000 workers at the going rate of $2 an hour. With the new sewing
machine, workers sew 10 shirts an hour, and firms want to hire more workers at the rate
of $2 an hour, so the demand curve shifts to the right.
The supply curve is the same workers as before. At a rate of $2 an hour, the same number
of people want to work. If the real wage rate increases, more of these people take jobs
sewing shirts. That is a shift in the quantity supplied, not a shift in the supply curve.
*Question 1.2: Technology level

Workers in Bangladesh sew clothes for sale as exports to Western Europe. Bangladesh
is a small country, and its exports are a tiny portion of the world clothes market.
The workers are paid an hourly wage, which reflects the marginal product of labor. A new
sewing machine enables workers to sew clothes twice as efficiently.
What are the effects on the real wage rate and the number of textile workers?
Real W age Rate
Numb er of W ork ers
A
B
increases
increases
increases
no change
C
D
E
increases
no change
no change
decreases
decreases
increases
Answer 1.2: A
The previous question says the demand curve moves to the right (increases) and the
supply curve does not change.
! The intersection of the supply and demand curves occurs further to the right.
! The supply curve is upward sloping, so a point further to the right is higher.
Farther to the right mean a higher quantity of workers. A higher point means a higher real
wage rate.
*Question 1.3: Labor Force

Unskilled men in parts of the Congo work as farm laborers, tilling crops by hand, or search
for diamonds by hand. Neither task requires much skill, and all workers can do either task.
! People do not search for diamonds on their own. They are hired by diamond search
firms, which pay an hourly wage.
! The Congo is a small portion of the diamond market. The price of diamonds is not
affected by the number of diamond workers in the Congo.
! The Congo has a limited amount of land on which to search for diamonds. If more
workers search for diamonds, each worker expects to find fewer diamonds.
In 20X8, a drought ruins the harvest, and the demand for farm laborers falls. What are the
effects on the labor market for diamond workers? For this problem, assume that
Supply of
Diamond W ork ers
Demand for
Diamond W ork ers
Numb er of
Diamond W ork ers
Real W age Rate of

Diamond W ork ers
Decreases
Increases
Increases
No change
Increases
Decreases
Increases
No change
No change
Decreases
No change
Increases
Increases
Decreases
Decreases
Decreases
No change
Decreases
Increases
No change
A
B
C
D
E
Answer 1.3: C
The supply of diamond workers is the number of workers who want to search for diamonds
at a given real wage rate. At a wage rate of $2 an hour for diamond workers
! When the harvest is bountiful, landowners pay more than $2 an hour for farm laborers.
Most workers find jobs on farms, and only 10,000 want to hunt for diamonds.
! When the harvest is poor, landowners pay less than $2 an hour for farm laborers. Few
workers find jobs on farms, and 50,000 workers want to hunt for diamonds.
Take heed: The demand for farm workers has changed, which affects the reservation wage
for diamond workers and the supply of diamond workers.
The demand for diamond workers has not changed. The owners of diamond search firms
pay a real wage rate based on the marginal product of labor. The market for diamonds has
not changed and the quality of diamond workers has not changed, so the demand curve
does not change.
The greater supply of diamond workers means the supply curve shifts to the right (shifts
down). The intersection of the supply and demand curves is at a higher quantity of labor
and a lower price for labor (real wage rate).
*Question 1.4: Real Wage Rate

Chicago raises the minimum wage from $5.50 to $8.50 an hour so that all employees earn
a living wage. Chicago has many pizza shops and restaurants that hire teen-age workers
and small shops that hire part-time sales clerks at the minimum wage. The change in the
minimum wage does all but which of the following?
A.
B.
C.
D.
E.
Lowers the quantity demanded of unskilled labor

Raises the quantity supplied of unskilled labor
Encourages firms to substitute capital for unskilled labor
Lowers unemployment of teen-age workers
Hurts workers whose marginal product of labor is less than the new real wage rate
Answer 1.4: D
Statement A: Unskilled labor costs more after the increase in the minimum wage, so less
is demanded. A pizza shop may pay a teen-ager $6.00 an hour because the hours work
is worth $6.00. If the pizza shop must pay $8.50 an hour, it prefers to hire an older worker
with a higher marginal product of labor.
Statement C: Unskilled labor costs more, so firms look for substitutes. Instead of hiring
check-out clerks, supermarkets may install self-checkout lanes with machines (capital) for
reading the prices of goods.
Illustration: Many factories in France are highly automated: machines do the work, with few
human workers. The French say they are more intelligent that other nations, so they more
easily automate their factories. Economists say that restrictions on labor in France, such
as the 35 hour work week, the difficulty of firing unneeded workers, and the high benefits,
reduce the relative value of labor. Firms substitute capital for the high-priced labor.
Statement D: Many teenagers work at the minimum wage, since their marginal product of
labor is low.
! If demand for teen-age labor falls, the unemployment rate increases.
! If the minimum wage rises, more teen-agers leave school and seek jobs, further raising
the unemployment rate. Teen-agers who leave school suffer later on.
Statement E: The equilibrium real wage rate is the marginal product of labor. In a free
labor market, workers with a marginal product of labor of $7.00 an hour receive $7.00 an
hour in wages. If the minimum wage is $10.00 an hour, firms do not hire these workers.
The effects of minimum wage laws are grasped by a comparison with consumer products.
Suppose beef costs $5.00 a pound on free markets, and 40 farms produce 10,000 pounds
of beef apiece. Legislators fear that beef producers are not earning a living wage, so they
mandate that beef be sold for not less than $10.00 a pound.
Consumers substitute cheaper foods for beef. They eat more fowl and fish and less beef.
The quantity of beef demanded declines from 400,000 pounds to 100,000 pounds.
At the higher price, farmers are more willing to sell their cattle for beef. At $5.00 a pound,
farmers supply 400,000 pounds of beef. At $10.00 a pound, farmers are willing to supply
1,000,000 pounds of beef.
Of the 1,000,000 pounds that farmers supply, only 100,000 are bought. The other 900,000
pounds that farmers supply but can not sell are like unemployed labor: people who want
to work but no firm wants to hire them.
The real world is worse. Farm price supports in the U.S. and Western Europe give farmers
extra income through the tax system and transfer payments. Consumers pay more for
food and farmers produce too much, which is sold to third world countries. Farmers in third
world countries can not compete with government subsidized crops. Everyone loses
except the farmers in the U.S. and Western Europe.
Take heed: The terms differ among economists. The natural unemployment rate reflects
the time needed to search for jobs and workers. Some economists say the higher minimum
wage raises the unemployment rate above its natural level. Other economists (like Barro)
do not distinguish among causes of unemployment. The higher minimum wage reduces
the job finding rate and raises the natural unemployment rate.
*Question 1.5: Minimum Wage

A city has pizza shops and restaurants that employ waiters, busboys, and cooks.
! Pizza shops cater to blue collar consumers and hire teen-age staff earning $6 an hour.
! Restaurants cater to white collar consumers and hire skilled staff earning $12 an hour.
The city has 50 pizza shops and 50 restaurants, with each store serving 1,000 consumers
a week.
The mayor believes that income inequality causes unhappiness. To reduce income
inequality, the city raises the minimum wage from $6 an hour to $12 an hour.
If the wage of pizza shop workers rises to $12 an hour, with no change in the type of
workers of the work requirements, what are the effects on the quantity of labor supplied
and the quantity of labor demanded?
A.
B.
C.
D.
E.
The quantity supplied increases and the quantity demanded decreases.

The quantity supplied decreases and the quantity demanded increases.
The quantity supplied and demanded decrease.
The quantity supplied and demanded increase.
The quantity supplied decreases and the quantity demanded does not change.
Answer 1.5: A

After the change to a $12 minimum wage, the pizza shops move to other cities. Some
consumers who previously ate pizza now eat at the restaurants.
! In the long-run, more restaurants are opened.
! In the short run, the current restaurants serve more consumers, and prices adjust.
Teen-age waiters, busboys, and cooks do not have the skills for high-income restaurants.
The current restaurant staff will work more hours, if needed. Their indifference curve
relating income and leisure is convex; that is, they have an upward sloping supply curve.
In the short run, what are the effects on supply of and demand for experienced labor by
restaurants? Assume that no teen-age staff have the experience to work in restaurants,
and no experienced workers switch to restaurants from other industries. (The question
asks about the effects on the supply and demand curves, not the quantity supplied and the
quantity demanded.)
A.
B.
C.
D.
E.
Supply increases and demand decreases.

Supply decreases and demand increases.
Supply and demand increase.
Supply and demand decrease.
Supply does not change and demand increases.
Answer 1.6: E
! The demand curve increases because more customers want to eat in restaurants.
! The supply curve does not change because no workers switch from other industries.

After the change to a $12 minimum wage, the pizza shops close and their owners move
to other states. Some consumers who previously ate pizza now eat at the restaurants.
In the short run, what are the effects on the cost of restaurant meals and the real wage rate
for restaurant workers?
A.
B.
C.
D.
E.
Restaurant meals cost more, and the real wage rate rises.
Restaurant meals cost more, and the real wage rate stays the same.
Restaurant meals cost the same, and the real wage rate rises.
Restaurant meals cost the same, and the real wage rate stays the same.
Restaurant meals cost more, and the real wage rate declines.
Answer 1.7: A
The supply curve is upward sloping. To induce employees to work more, owners must pay
them a higher real wage rate. The variable costs of restaurant meals increases, so the
price of the meals increases.
*Question 1.8: Gains and Losses

After the change to a $12 minimum wage, the pizza shops close and their owners move
to other states. Some consumers who previously ate pizza now eat at the restaurants.
Who gains from the minimum wage law?
A.
B.
C.
D.
E.
Teen-age waiters gain from the higher real wage rate.

Restaurant staff gain from the higher demand for their labor.
Consumers gain from the reduced competition between restaurants and pizza shops.
Pizza shop owners gain from the higher quality of labor.
Society gains by the reduced income inequality.
Answer 1.8: B
Statement A: Teen-age workers are now unemployed; they lose.
Statement B: Restaurant workers are paid more and work more. If they want, they could
work the same hours and be paid more, so they surely gain.
Statement C: Reduced competition hurts consumers.
Statement D: Pizza shop owners have to close and move to other cities; they lose.
Statement E: Income inequality has increased, since teen-age workers are unemployed
and restaurant workers earn more.
*Question 1.9: Job Separation

In 20X7, the job separation rate for disabled persons is 0.5% a month, meaning that 0.5%
of disabled persons leave their jobs each month, and the job finding rate is 4.5% a month,
meaning that 4.5% of unemployed disabled persons find new jobs each month.
To prevent disabled persons from being laid off, Congress adjusts the Americans with
Disabilities Act in 20X8, making it harder to fire disabled persons.
! The job separation rate declines to 0.25% a month.
! Employers now are more reluctant to hire disabled workers, so the job finding rate
declines to 1.75% a month.
What is the natural unemployment rate for disabled persons, at which workers finding new
jobs equals workers leaving their jobs in 20X7 and 20X8?
A
B
C
D
E
20X7
0.50%
4.50%
5.00%
9.00%
10.00%
20X8
0.25%
1.75%
2.00%
10.00%
12.50%
Answer 1.9: E
Use the following reasoning: Let
Z be the natural unemployment rate
F be the monthly job finding rate
S be the monthly job separation rate
! Workers finding jobs each month are F Z.
! Workers leaving jobs each month are S (1 Z).
In equilibrium, workers finding jobs just offset workers leaving jobs.
We solve for the natural unemployment rate before and after the new legislation:
! Before: 4.5 Z = 0.5 (1 Z) A 5Z = 0.5 A Z = 10%
! After: 1.75 Z = 0.25 (1 Z) A 2Z = 0.25 A Z = 12.5%
People sometimes speak of a lawof unintended consequences. Free markets are efficient,
in that they often maximize social welfare. Legislation that interferes with free markets to
help one party generally reduces total social welfare. All parties respond to the legislation
to maximize their own self-interests. Since the total pie is smaller, all parties may be worse
off, including the party that the legislation was designed to help.
*Question 1.10: Marginal Product of Labor

! In 20X8, real GDP = $400, price level = 100, and the nominal wage rate = $20 / hour
The real interest rate, inflation rate, and bank transaction costs do not change.
Which of the following is true?
A.
B.
C.
D.
E.
The money supply increased 50%, and the marginal product of labor increased 25%
The money supply decreased 50%, and the marginal product of labor decreased 25%
The money supply increased 50%, and the marginal product of labor decreased 25%
Answer 1.10: A
Real GDP increases 25%, so the real demand for money increases 25% and the real
money supply increases 25%. The price level increases 20%, so the nominal money
supply increases 1.25 1.20 1 = 50.00%.
The nominal wage rate increases 50% and the price level increases 20%, so the real wage
rate increases 1.500 / 1.200 1 = 25.00%
The change in the price level reflects real GDP growth and money growth.
! 1% rise in money supply with no change in real GDP 1% rise in the price level
! 1% rise in real GDP with no change in money supply 1% rise in the price level
From the changes in real GDP and the price level, determine the change in the money
supply. The changes are large, so use a multiplicative model, not an additive model.
The real wage rate is the nominal wage rate divided by the price level. From the changes
in the nominal wage rate and the price level, determine the change in the real wage rate.
If the labor market is in equilibrium, the real wage rate equals the marginal product of labor.
Alternative problems:
give change in money supply; determine the change in the price level and then the change
in the real wage rate and the marginal product of labor.
308 *Question 1.11: Marginal Product of Labor

A.
B.
C.
D.
E.
The money supply increased 50%, and the marginal product of labor decreased 25%
Answer 1.11: A
Real GDP increases 25%, so the real demand for money increases 25% and the real
money supply increases 25%. The price level increases 20%, so the nominal money
supply increases 1.25 1.20 1 = 50.00%.
rate increases 1.500 / 1.200 1 = 25.00%
The change in the price level reflects real GDP growth and money growth.
! 1% rise in money supply with no change in real GDP 1% rise in the price level
! 1% rise in real GDP with no change in money supply 1% rise in the price level
From the changes in real GDP and the price level, determine the change in the money
supply. The changes are large, so use a multiplicative model, not an additive model.
The real wage rate is the nominal wage rate divided by the price level. From the changes
in the nominal wage rate and the price level, determine the change in the real wage rate.
If the labor market is in equilibrium, the real wage rate equals the marginal product of labor.
Alternative problems:
give change in money supply; determine the change in the price level and then the change
in the real wage rate and the marginal product of labor.
*Question 1.12: Real Wage Rate

! 20X8: nominal money supply = $400, price level = 100, nominal wage rate = $20 / hour
! 20X9: nominal money supply = $500, price level = 120, nominal wage rate = $30 / hour
A.
B.
C.
D.
E.
Real GDP decreases 25%, and the marginal product of labor increases 25%
Real GDP decreases 20%, and the marginal product of labor increases 20%
Real GDP decreases 5%, and the marginal product of labor decreases 25%
Real GDP does not change, and the marginal product of labor increases 5%
Real GDP increases 4%, and the marginal product of labor increases 25%
Answer 1.12: E
The real demand for money equals the real money supply. The nominal money supply
increases 25% and the price level increases 20%, so the real money supply increases
1.250 / 1.200 1 = 4.17%.
The real money supply equals the real demand for money, so the real demand for money
increases 4.17%.
The real demand for money is proportional to real GDP, so real GDP increases 4.17%.
rate increases 1.500 / 1.200 1 = 25.00%
*Question 1.13: Capital Deepening

In 2001, a developing country has many laborers and few machines. All laborers are
identical and all machines are identical. The real interest rate is 5% per annum, the
marginal product of labor is $10 per hour, and the marginal product of a machine (capital)
is $20 per hour.
From 2002 to 2048, the country invests in new capital. A strong birth control program plus
greater education for women reduces the fertility rate and the population.
In 2049, the country has many machines and few workers. The technology level has not
changed.
Which of the following is the most likely for 2049? (Dollar figures are in real terms.)
A
B
C
D
E
Real Interest Rate
Marginal Product of
a W ork er
Marginal Product of
a Machine
7%
3%
7%
3%
5%
$14
$14
$8
$8
$8
$16
$16
$22
$22
$22
Answer 1.13: B
The country has more machines (more capital) in 2049. Think of labor as farm workers and
machines as tractors.
If the country has only a few tractors, each one is used on productive land, so its marginal
product is high.
If the country has many tractors, all farms have tractors. The marginal product is the value
added by an additional tractor. Adding another tractor doesnt do as much as the first
tractors, so the marginal product of a machine declines.
The real interest rate is the marginal value of capital. If farms dont need more tractors, no
one buys more machines, so no one has incentive to produce more machines. Firms dont
borrow money to produce machines, so the interest rate falls.
*Question 1.14: Labor and Capital

In 20X1-20X3, an insurrection in Country W destroys all factories and equipment. People
live on farms, food is planted and harvested by hand, and capital per worker decreases.
In 20X4, a coup restores democracy. In 20X4 through 20X9, Country W adopts industrial
and agricultural technology from other countries, and capital per worker increases.
For the period 20X4 through 20X9, which of the following is true?
(This exam problem deals with 20X4 20X9, when capital per worker increases, not 20X1
20X3, when capital per worker decreases.)
A
B
C
D
E
Marginal
Product of
Capital
Real Rental
Price
Marginal
Product of
Lab or
Real W age
Rate
Key:
! = the variable increases
! = the variable decreases
Use the following reasoning:
! What is the relation of the capital per worker ratio to the marginal product of capital and
the marginal product of labor?
! What is the relation of the real rental price to the marginal product of capital? The real
rental price equals the real interest rate.
! What is the relation of the real wage rate to the marginal product of labor?
Answer 1.14: B
The capital per worker increases, so the marginal product of labor and the real wage rate
increase and the marginal product of capital and the real rental price decrease/
Macroeconomics Final Exam Practice Problems: Convergence

Background: Convergence is a malleable concept. In the nineteenth century, the Western
European nations were more successful than Asian or African countries. Most Europeans
presumed they were innately superior to Asians or Africans.
In later decades, as third world countries developed, fewer people believed in the innate
superiority of Europeans. Instead, they presumed that natural advantages of Europe made
these nations successful: accessible coasts for shipping, fertile agricultural land, or even
religious (Protestant) systems that fit well with capitalism.
By the second half of the twentieth century, European civilization had produced two world
wars. Numerous countries in Asia, Europe, the Americas, and the Middle East seemed
economically capable. Differences were ascribed to historical happen-stance. Low income
countries would grow quickly by imitating the economies of advanced countries.
Some economists adopted a theory of absolute convergence. Countries were inherently
similar, and eventually all would achieve the same economic level. The emergence of
African nations after WW2 and the rapid rise of Asian economies in the 1960s and 1970s
seemed to support this theory. Japans ability to duplicate or exceed the characteristics of
Western economies seemed proof of the theory.
In recent years, some parts of the world (such as Asia) have moved closer or caught up
to developed countries and some parts (such as Africa and the Middle East) are falling
further behind. Barro presumes that each country has a steady state level, but countries
may differ. He suggests that political, legal, and cultural attributes affect the steady state
income of the economy. For example, a culture that does not allow women to work may
never reach the per capital income of Western economies.
Exam problems test absolute convergence, conditional convergence, and their attributes
with scenarios. Focus on the following items:
! When absolute convergence occurs and when only conditional convergence occurs.
! How convergence relates to income inequality.
! What attributes cause faster or slower growth rates.
*Question 1.1: Conditional Convergence

Conditional convergence presumes a countrys long-term expected economic growth rate
(g) is a function of its steady state economic level (y*) and its current economic level (y).
Which of the following correctly expresses the signs of the correlation of g with y and y*?
! D(g, y) = correlation of g with y, holding y* fixed; same sign as Mg/My
! D(g, y*) = correlation of g with y*, holding y fixed; same sign as Mg/My
A
B
C
D(g, y)
>0
<0
>0
D(g, y*)
>0
<0
0
D
E
>0
<0
<0
>0
You may think of the question as: If y increases with no change in y* (or vice versa) does
g increase or decrease?
Answer 1.1: E
Take heed: The text uses plus and minus signs to show the sign of the partial derivative.
Exam problems may use partial derivatives, correlations, or plus/minus signs.
*Question 1.2: Conditional Convergence

Suppose the rate of conditional convergence is 10% per annum for all countries.
Illustration: If steady state output is $20,000 per capita and current output is $16,000 per
capita, the expected growth rate is 10% ($20,000 $16,000) / $16,000 = 2.50%.
Countries W, Y, and Z have the following current and steady state output at 1/1/20X6.
Country
Current Output
Steady State Output
W
Y
Z
20,000
30,000
30,500
28,000
40,000
31,000
Which country has the highest growth rate in 20X6 and which has the greatest output level
at 12/31/20X6?
A
B
C
D
E
Highest Growth Rate

in 20X6
Highest Economic Output

at 12/31/20X6
W
Y
Y
W
W
W
Y
Z
Y
Z
Answer 1.2: D
We compute the growth rates in 20X6 and the output level at 12/31/20X6.
Country
Current Output
Steady State
Output
Growth rate
12/31/20X6
Output Level
W
Y
Z
20,000
30,000
30,500
28,000
40,000
31,000
4.00%
3.33%
0.16%
20,800
31,000
30,550
*Question 1.3: Convergence and Fertility Rates

An economist examining convergence among a group of developing countries finds that
economic growth stimulates greater education of women and lower birth rates: a 10%
increase in GDP per capital leads to a 10% decline in the fertility rate.
! Developing countries start with fertility rates of 5 to 6 live births per woman.
! As countries develop, fertility rates decline to between 2 and 3 live births per woman.
All countries benefit from modern medicine. Infant mortality, infectious diseases, and
mortality rates rapidly decline in all the countries, whether or not the fertility rate declines.
What type of convergence do we expect over the next generation?
A. Fertility rates do not affect long-term economic growth. The economist examines only
developing countries, so we expect absolute convergence.
B. Fertility rates do not affect long-term economic growth. Developing countries may differ,
so we expect conditional convergence, not absolute convergence.
C. High fertility rates promote economic growth. Countries with low fertility rates have low
future growth. We expect absolute convergence with especially rapid mean reversion.
D. High fertility rates are important for economic growth. Countries with lower fertility rates
have lower future growth, but other conditions may preclude absolute convergence. We
expect conditional convergence with especially rapid mean reversion.
E. High fertility with low mortality prevents consumers from saving money. New capital
must support new workers, and the capital per worker ratio may decline. If development
leads to lower fertility rates, convergence may not be evident, since countries that grow
rapidly and have lower birth rates may grow even more rapidly in later years.
Answer 1.3: E
Barro explains why convergence has not been evident in Africa and the Middle East over
the past forty years. One explanation relies on endogenous population growth.
Economic development often leads to better education and equal opportunity for women
and lower fertility rates, which leads to faster development.
Take heed: Neither Barro nor NEAS advocate lower fertility or take any position regarding
birth control, family planning, or abortion. The textbook summarizes a common perspective
on economic growth. Economists argue about the effects of low fertility on the social and
economic future of Western Europe, Russia, Japan, China, and other low growth countries.
*Question 1.4: Convergence

An economist examines convergence in two places:
! Among the states of the U.S.
! Among the countries of Africa.
The economist finds convergence in the U.S. but not among the countries of Africa.
The likely reasons for this difference include all but which of the following?
A.
B.
C.
D.
E.
Labor moves easily across U.S. states but not between African countries.
U.S. states have similar legal and court systems; African countries do not.
U.S. states have the same currency and federal taxes; African countries do not.
U.S. states have similar public education systems; African countries do not.
U.S. states have never had large economic differences; African wars caused large
differences that convergence could not overcome.
Answer 1.4: E
The civil war in the U.S. was as severe (for its time) as most African wars. Europe has also
had absolute convergence, though its world wars were more severe than African wars.
*Question 1.5: International Trade and Convergence

Since the mid-1980s, the removal of trade barriers, reduction in transportation costs, and
better education enable skilled workers in developing countries, such as China and India,
to perform jobs formerly done in North America and Western Europe. Western countries
now out-source both skilled and unskilled jobs to China, India, and other Asian nations.
Countries focus on industries and professions where they have comparative advantages.
China and India were among the worlds most advanced nations in the fifteenth through
seventeenth centuries. They have highly intelligent populations, strong support for civil law,
economic freedoms, and widespread education. Their steady state income per worker is
the same as that of the U.S. and Europe.
Which of the following is most likely to be true?
A.
B.
C.
D.
E.
GDP falls in Europe and the U.S. and it rises in China and India.
Employment falls in Europe and the U.S. and it rises in China and India.
GDP rises everywhere, but more in Europe and the U.S. than in China and India.
GDP rises everywhere, but less in Europe and the U.S. than in China and India.
Employment rises everywhere, but more in Europe and the U.S. than China and India.
Answer 1.5: D
The steady state income per worker of China and India is the same as that of the U.S. and
Europe, so they show absolute convergence. They have lower current income per worker,
so their income per worker rises faster than that of the U.S. and Europe.
International trade helps all parties, as countries make the goods and services for which
they have comparative advantages.
Macroeconomics Final Exam Practice Problems: Income Taxes

The final exam problems compare various tax systems. Each tax has two effects:
! The income effect causes people to work more.
! The substitution effect causes people to work less.
The income effect is difficult to measure. Taxes pay for government programs, which pay
for peoples needs.
Illustration: A person earns $50,000 of pre-tax income. The government imposes a $5,000
head tax (lump-sum tax), which has no substitution effect. The person receives $45,000
after-tax, and has an incentive to work more.
Suppose the tax funds a national health insurance system. For the same private insurance,
the person might pay $10,000. After adjusting for the value of health insurance, the
persons wealth increases after the tax, and the person works less.
Some exam problems compare two tax systems with the same total tax revenue. The
government services are the same under both programs, but the income and substitution
effects differ for each worker.
Take heed: If the exam problem does not mention the value of the government programs
to the taxpayer, assume the tax is used for foreign aid (such as helping residents of Sudan)
or foreign wars that have no effect on the taxpayers work effort.
Taxes on labor income are of several forms:
! Flat tax on all income. The marginal tax rate is the statutory tax rate.
! Progressive tax on all income. The tax rate is generally linear from Y% to Z%. Know
how to compute the marginal tax rate from the statutory tax rate. The mathematics is
straight-forward: differentiate the tax liability with respect to pre-tax income. If the tax
rate increases with income, the marginal tax rate exceeds the statutory tax rate.
! A tax credit for low income workers makes the tax more progressive.
! A two-tiered flat tax (Y% on one range and Z% on another range) has different marginal
tax rates in each range.
Take heed: Taxes are a critical part of the macroeconomic model. The textbook does not
show the mathematics, since many college students can not handle differentiation and
integration. The final exam problems give simple tax systems and ask for the income and
substitution effects.
*Question 1.1: Marginal Tax Rates

Workers pre-tax wages in Country W are a uniform distribution from $0 to $100,000.
The labor force has 10,000 persons with an average of 2,000 work-hours a year.
In 20X7, Country W has a flat tax rate of 20%.
To reduce income inequality, the government changes the tax code for 20X8 so that
! Workers earning $0 receive a $10,000 tax refund (a negative tax liability).
! The tax refund declines linearly to zero as the workers earnings increase to $100,000.
! Income is taxed at a flat rate of 40%.
Illustration: Esther earns $25,000 pre-tax.
! 20X7: Esther pays $25,000 20% = $5,000 and keeps $20,000 after-tax.
! 20X8: Esther keeps (1 $25,000 / $100,000) = 75% of the $10,000 tax refund and
pays tax of $25,000 40% = $10,000. Her net tax is $10,000 75% $10,000 =
$2,500. Her after-tax income is $25,000 $2,500 = $22,500.
What are the marginal tax rates in 20X7 and 20X8?
A
B
C
D
E
20X7
20%
40%
20%
40%
20%
20X8
40%
50%
50%
40%
60%
Answer 1.1: C
20X7: For a flat tax of 20%, the marginal tax rate is the tax rate of 20%.
20X8: For a flat tax of 40%, the marginal tax rate is the tax rate of 40%. Workers also
return the tax refund of $10,000 linearly as 10% of their income. The combination is a 50%
flat tax rate.
The marginal tax rate is the slope of the graph, where the horizontal axis is pre-tax income
and the vertical axis is the tax liability. In 20X8, the tax liability is
$10,000 Y / $100,000 + Y 40% = 50% Y
Intuition: A person earning $0 gets a tax credit of $10,000, and a person earning $100,000
get no tax credit. The tax credit has a 10% tax for all taxpayers.
! Pre-tax income is a uniform distribution from $10,000 to $110,000.
! The tax rate is 50%, not 40%.
*Question 1.2: Marginal Tax Rate

People earn $100 million in 20X7 and pay a flat tax rate of 20%. Each person earns
between $20,000 and $60,000 a year (pre-tax), with an average of $40,000 per person.
To make the income tax more progressive in 20X8, the government makes the tax rate 0%
for the first $20,000 of income and 40% for the next $40,000 of income.
! Joseph earns $35,000 a year (pre-tax) before the change in the tax rate.
! Benjamin earns $40,000 a year (pre-tax) before the change in the tax rate.
! Ephraim earns $45,000 a year (pre-tax) before the change in the tax rate.
The marginal tax rate affects peoples incentives to work. The amount they work affects
the total tax they pay.
For this question, ignore wealth effects on labor supply. Assume only the substitution effect
(the relative benefit of work vs leisure) affects hours worked.
Who works more hours, who works fewer hours, and who works the same hours?
A
B
C
D
E
Joseph
Benjamin
Ephraim
more
more
more
fewer
fewer
more
same
fewer
same
fewer
more
fewer
fewer
more
fewer
Answer 1.2: E
For all three workers, the marginal tax rate increases, so each one works fewer hours.
*Question 1.3: Marginal Tax Rate

People earn $100 million in 20X7 and pay a flat tax rate of 20%. Each person earns
between $20,000 and $60,000 a year (pre-tax), with an average of $40,000 per person.
To make the income tax more progressive in 20X8, the government makes the tax rate 0%
for the first $20,000 of income and 40% for the next $40,000 of income.
! Jacob earns $35,000 a year (pre-tax) before the change in the tax rate.
! Rachel earns $45,000 a year (pre-tax) before the change in the tax rate.
The marginal tax rate affects peoples incentives to work by the substitution effect. Their
net after-tax income affects their need for cash (the income effects). The amount they work
affects the total tax they pay.
A.
B.
C.
D.
E.
Jacob pays less tax in 20X7; Rachel may pay more or less
Rachel pays more tax in 20X7; Jacob may pay more or less
Both Jacob and Rachel pay less tax in 20X7
Jacob pays less tax in 20X7; Rachel pays more tax
Both Jacob and Rachel may pay more or less tax in 20X7
Answer 1.3: A
Jacob pays less tax in 20X7; Rachel may pay more or less
To solve this problem, we determine
! The total tax each person would pay if he/she worked the same amount.
! Whether each person works more or less in 20X8 than in 20X7.
We reason through each scenario.
! If the same work leads to less tax and the person works less in 20X8, he/she surely
pays less tax.
! If the same work leads to more tax and the person works less in 20X8, he/she may pay
more or less tax.
! If the same work leads to more tax and the person works more in 20X8, he/she surely
pays more tax.
! If the same work leads to less tax and the person works more in 20X8, he/she may pay
more or less tax.
A higher marginal tax rates induces a person to work less, though we dont know how
much less. Raising the marginal tax rate from 20% to 40% may induce a person to work
one hour less or not to work at all at the 40% marginal tax rate. For example,
! Raising the tax rate from 1% to 2% has a small effect on the hours worked.
! Raising the tax rate from 50% to 100% causes the person to stop working.
The marginal tax rate increases for both Jacob and Rachel, so both work less in 20X7.
The decrease in work lowers pre-tax income. One is tempted to reason that:
! If the marginal value of leisure is small, the decrease in work is small, and the pre-tax
income declines little.
! If the marginal value of leisure is large, the decrease in work effort is large, and the pretax income declines much.
This reasoning is a good way to start, but it is not well worded. At equilibrium, the marginal
value of leisure equals the marginal variance of the work income. Raising the marginal tax
rate reduces the marginal variance of work income. To determine how much less the
person works, we examine the slopes of the value of leisure and work income.
! If the value of leisure and of work are relatively flat (the marginal value varies little by
amount of work or leisure), a decrease in the after-tax wage causes a large decrease
in work effort.
! If the value of leisure and of work are relatively steep (the marginal value varies greatly
by amount of work or leisure), a decrease in the after-tax wage causes a small
decrease in work effort.
Take heed: For the final exam, focus on the intuition. The exam problems do not compute
the exact amount by which work effort increases or declines.
We also consider the income effect.
If Jacobs work hours do not change, his after-tax income is
! 20X7: $35,000 (1 20%) = $28,000
! 20X8: $35,000 40% ($35,000 $20,000) = $29,000
Jacob has more income in 20X8, so the income effect induces him to work less.
If Rachels work hours do not change, her after-tax income is
! 20X7: $45,000 (1 20%) = $36,000
! 20X8: $45,000 40% ($45,000 $20,000) = $35,000
Rachel has less income in 20X8, so the income effect induces her to work more.
The substitution effect causes Rachel to work less. We dont know which effect is stronger,
so we dont know if she works more or less.
Take heed: Some exam problems separate the income effect from the substitution effect,
giving easier problems. For your exam preparation, first examine each effect separately.
The exam problems are not intricate, and they do not test mathematical ability. If you
understand the concepts and review the practice problems, you can solve exam problems.
*Question 1.4: Marginal Tax Rates

A country has a flat income tax, so the total tax revenue is the pre-tax income times the tax
rate. The government wants to maximize the total tax revenue. An increase in the tax rate
A.
B.
C.
D.
E.
Raises total tax revenue.

Lowers total tax revenue.
Lowers total tax revenue at low tax rates and raises total tax revenue at high tax rates.
Raises total tax revenue at low tax rates and lowers total tax revenue at high tax rates.
Has little or no effect on total tax revenue.
For this exam problem, interpret low tax rates as a tax rate that approaches zero and high
tax rates as a tax rate that approaches one. The actual demarcation point depends on
other characteristics of the economy and the workers. Barro believes the dividing point is
somewhere between 50% and 75%
Answer 1.4: D
We use the following reasoning:
! At a zero tax rate, the total tax revenue is zero, so an increase in the tax rate increases
the total tax revenue.
! At a 100% tax rate, people dont work, since they keep none of their earnings, and total
tax revenue is zero. A decrease in the tax rate induces some people to work, so total
tax revenue increases.
Illustration: Suppose workers earn $10 an hour. If the tax rate is zero, people work 2,000
hours a year. If the tax rate is Z%, people work (1 Z%) 2,000 hours a year.
~ If the tax rate is 10%, people work 90% 2,000 = 1,800 hours a year. Total tax
revenue is 10% $10 1,800 = $1,800.00 per worker.
~ If the tax rate is 11%, people work 89% 2,000 = 1,780 hours a year. Total tax
revenue is 11% $10 1,780 = $1,958.00 per worker.
At low tax rates, total tax revenue increases as the tax rate increases.
~ If the tax rate is 90%, people work 10% 2,000 = 200 hours a year. Total tax revenue
is 90% $10 200 = $180.00 per worker.
~ If the tax rate is 91%, people work 9% 2,000 = 180 hours a year. Total tax revenue
is 91% $10 180 = $162.00 per worker.
At low tax rates, total tax revenue decreases as the tax rate increases.
Intuition: At a 0% tax rate, total tax revenue is zero. At a 100% tax rate, people do no
work, since they keep nothing of what they earn, and total tax revenue is again zero. At
rates between 0% and 100%, people do some work, so total tax revenue is positive. We
infer that at low tax rates, total tax revenue increases from zero to a positive amount, and
at high tax rates, total tax revenue decreases from a positive amount to zero.
Algebra: In the example here, people work 2,000 (1 Z) hours, where Z is the tax rate.
The total tax revenue is 2,000 (1 Z) Z. The partial derivative with respect to Z is
2,000 (1 2Z).
~ If Z < 50%, the partial derivative is positive and total tax revenue increases.
~ If Z = 50%, the partial derivative is zero and total tax revenue stays the same.
~ If Z < 50%, the partial derivative is negative and total tax revenue decreases.
The incentive effects are stronger when the tax rate is progressive. This illustration uses
flat tax rates, with weaker but still evident effects.
In countries with high marginal tax rates, such as Switzerland, total tax revenue decreases,
because people have less incentive to work. If the tax rate were lower, the government
would have more tax revenue and the workers would have more after-tax income.
Jacob: If reducing the tax rate causes people to work more and raises total tax revenue,
the government has more money for social programs. Why would anyone oppose a tax
reduction?
! Conservatives want to reduce the tax rate.
! Progressives want more total tax revenue for social programs.
Rachel: Progressive tax rates reduce income inequality. Many people dont like inequality.
They would like everyone to be wealthy. But if not everyone can be wealthy, they prefer
everyone to be poorer if it reduces economic differences.
*Question 1.5: Income and Substitution Effects

In 20X7, Country W has a flat tax rate of 20%.
To reduce income inequality, the government changes the tax code for 20X8 so that
! Workers earning $0 receive a $10,000 tax refund (a negative tax liability).
! The tax refund declines linearly to zero as the workers earnings increase to $100,000.
! Income is taxed at a flat rate of 40%.
Abigail earns pre-tax income of $33,333 in 20X7. What are the income and substitution
effects on her labor hours if each is considered separately.
Illustration: Choice A says:
! If the substitution effect is zero, the income effect causes her work hours to decrease.
! If the income effect is zero, the substitution effect causes her work hours to increase.
Income Effect
Substitution Effect
Fewer Hours
More Hours
More Hours
Fewer Hours
Fewer Hours
Fewer Hours
More Hours
More Hours
No Change
Fewer Hours
Answer 1.5: E
Abigail has pre-tax income of $33,333 in 20X7.
! 20X7: The tax liability is 20% $33,333 = $6,667
! 20X8: The net tax liability is 50% $33,333 $10,000 = $6,667
As worked out above, a tax refund that decline from $10,000 to $0 is like a tax refund of
$10,000 and an extra 10% tax rate.
If Abigail works the same hours in 20X8, her net tax liability is the same as in 20X7, so the
income effect is zero.
If the substitution effect is zero, the income effect by worker is
! A worker who earns less than $33,333 pays less tax and works fewer hours.
! A worker who earns more than $33,333 pays more tax and works more hours.
The marginal tax rate is higher in 20X8 than in 20X7 for all workers. The substitution effect
causes all workers to work fewer hours.
*Question 1.6: Income and Substitution Effects

Abigail earns pre-tax income of $33,333 in 20X8. What are the income and substitution
effects on her labor hours if each is considered after the other has its effect.
Illustration: Choice A says:
! After the substitution effect, the income effect causes her work hours to decrease.
! After the income effect, the substitution effect causes her work hours to increase.
Income Effect
Substitution Effect
Fewer Hours
More Hours
More Hours
Fewer Hours
Fewer Hours
Fewer Hours
More Hours
More Hours
No Change
Fewer Hours
Answer 1.6: B
Abigail has pre-tax income of $33,333 in 20X7.
! 20X7: The tax liability is 20% $33,333 = $6,667
! 20X8: The net tax liability is 50% $33,333 $10,000 = $6,667
The marginal tax rate is higher in 20X8 than in 20X7 for all workers. The substitution effect
causes all workers to work fewer hours.
Because of the substitution effect, Abigail works fewer hours in 20X8. Her net tax liability
is smaller than in 20X7, so her after-tax income is lower and the income effect makes her
work more hours.
*Question 1.7: Income Effect

In 20X7, Sarah, Rebecca, and Leah earn pre-tax income of $30,000, $40,000, and
$50,000, respectively.
From the income effect alone (not the substitution effect), will they work more or fewer
hours in 20X8?
Sarah
Rebecca
Leah
Fewer
Fewer
Fewer
More
More
Fewer
Fewer
More
More
Fewer
No Change
More
More
No Change
Fewer
Answer 1.7: C
Consider Rebecca, who earns $40,000 in 20X7.
! In 20X7, she pays tax of 20% $40,000 = $8,000.
! In 20X8, she keeps 1 40% = 60% of the tax refund. She pays tax of 40% $40,000
= $16,000. Her net tax liability is $16,000 $6,000 = $10,000.
! She has less after-tax income in 20X8. By the income effect, she works more hours.
Similar analysis for Sarah and Leah give Choice C for the answer.
*Question 1.8: Substitution effect

In 20X6, Sarah, Rebecca, and Leah earn pre-tax income of $30,000, $40,000, and
$50,000, respectively.
From the substitution effect alone (not the income effect), will they work more or fewer
hours?
Sarah
Rebecca
Leah
Fewer
Fewer
Fewer
More
More
Fewer
Fewer
More
More
Fewer
No Change
More
More
No Change
Fewer
Answer 1.8: A
The marginal tax rate increases from 20% to 50% for all workers, so all workers work fewer
hours by the substitution effect.
*Question 1.9: Marginal tax rates

Country W and Country Z have identical labor forces, with workers earning pre-tax incomes
in a uniform distribution from $0 to $100,000. Neither country yet has an income tax.
To finance the costs of reversing global warming, both countries levy an income tax.
! Country W imposes a flat 20% income tax for all workers.
! Country Z imposes a progressive income tax that rises linearly from 0% at $0 of pre-tax
income to 30% at $100,000 of pre-tax income.
For a person earning $50,000, what are the marginal tax rates in Countries W and Z?
A
B
C
D
E
Country W
Country Z
20%
20%
20%
40%
40%
15%
30%
60%
30%
60%
Answer 1.9: B
Let Y be the pre-tax income.
In Country W:
! The tax is 20% Y.
! The marginal tax rate is M(20% Y)/MY = 20%.
The marginal tax rate equals the tax rate for all workers.
In Country Z:
! The tax rate is 30% Y / $100,000.
! The tax is Y 30% Y / $100,000 = 30% Y2 / $100,000.
! The marginal tax rate is M(30% Y2 / $100,000)/MY = 60% Y / $100,000.
For a person earning $50,000, the marginal tax rate is 60% $50,000 / $100,000 = 30%.
*Question 1.10: Average tax rates

If people do not change their work hours because of the tax, what are the average tax rates
in Country W and Country Z?
Take heed: You must weight the tax rates by the pre-tax income. For persons with incomes
of $10,000 and $20,000 and tax rates of 3% and 6%, the average tax rate is ($10,000
3% + $20,000 6%) / $30,000 = 5.00%.
A
B
C
D
E
Country W
Country Z
20%
20%
20%
10%
10%
10%
20%
30%
10%
20%
Answer 1.10: B
Country W: The tax rate is 20% for all workers.
Country Z: To simplify the mathematics, we use units of $100,000. The pre-tax income is
Y, which ranges from 0 ($0) to 1 ($100,000).
! The tax rate is 30% Y.
! The tax is Y 30% Y = 30% Y2.
We integrate the tax over the uniform distribution from 0 to 1 to get total tax revenue:
I 30% Y2 MY = 30% a Y3 from 0 to 1 = 10%.
The average pre-tax income is $50,000, or 0.5 in units of $100,000.
The average tax rate is 10% / 0.5 = 20%.
*Question 1.11: Average tax rates

A tax affects work effort two ways:
! Substitution effect: The tax reduces the value of each hour of labor compared to an
hour of leisure, so people prefer less work and more leisure.
! Income effect: The tax reduces total income, so people have more need for income and
work more.
The income effect and substitution effect depend on the wealth of the worker.
! The income effect is strong as low wage levels. A poor person earning subsistence
wages may work an extra hour if the tax rate rises.
! The substitution effect is strong at high wage levels. A rich person may decide to work
less if the tax reduces the net income.
If people change their work hours because of the tax, which country raises the greater total
tax revenue and which country has the greater after-tax net income?
A
B
C
D
E
Greater Total Tax

Revenue
Greater After-tax Net

Income
Country W
Country W
Country Z
Country Z
Country W
Country W
Country Z
Country W
Country Z
Equal
Answer 1.11: A
If people do not change their work hours because of the tax, the two countries have the
same pre-tax income, the same average tax rate, the same total tax revenue, and the
same after-tax income.
We group workers by pre-tax income:
! Low income workers earn less than $33,333.

! Medium income workers earn from $33,333 to $66,667.
! High income workers earn more than $66,667.
We compare the tax rates and marginal tax rates in the two countries.
The tax rate and the tax liability in Country Z are lower for people earning < $66,667 and
higher for people earning > $66,666. From the income effect,
! Low income and medium income workers pay less tax in Country Z, so they have more
after-tax income and they work fewer hours.
! High income workers pay more tax in Country Z, so they have less after-tax income and
they work more hours.
The marginal tax rate in Country Z is lower for people earning < $33,333 and higher for
people earning > $33,333. From the substitution effect:
! Low income workers have a lower marginal tax rate in Country Z, so they have a
greater preference for work over leisure and they work more hours.
! Medium income and high income workers have a higher marginal tax rate in Country
Z, so they have a weaker preference for work over leisure and they work fewer hours.
We combine the two effects by income level.
! The income effect is strong at low incomes, so low income workers work fewer hours.
! At medium incomes, both the income effect and the substitution effect causes people
to work fewer hours.
! The substitution effect is strong at high incomes, so high income workers work fewer
hours.
Empirical data supports these relations.
Tax rates in the U.S. rose from zero at the beginning of the 20th century to about 30% now.
Average personal wealth for low income workers doubled or tripled (in real terms). The
precise change depends on how we measure wealth.
Average work hours per week for low income workers declined from about 55 to about 40.
! In 1900, a poor person worked 55 hours a week to pay for food, clothing, and rent.
! In 2000, a person earns enough in 40 hours a week for food, clothing, and rent.
The substitution effect is seen from tax rate changes.
! When tax rates for high income workers rise, they work less and often pay less tax.
! When tax rates for high income workers fall, they work more and often pay more tax.
For the average tax per capita, assume one taxpayer. We use units of $100,000
The total tax revenue is number of workers times 10,000 in Country W and Country Z.
The marginal tax rates are 20% in Country W and 60% y in Country Z,
MACROECONOMICS FINAL EXAM PRACTICE PROBLEMS ON ECONOMIC GROWTH

The final exam has three types of problems on economic growth
! Qualitative problems on convergence
! Qualitative/quantitative problems using the Solow growth model
! Quantitative problems using the Cobb-Douglas production function
Take heed: The homework assignments that cover economic growth issues are also tested
on the final exam. One homework assignment discusses convergence (mean reversion)
and stochasticity. Questions on this topic appear on the final exam.
Know the attributes of the Cobb-Douglas production function. The final exam may test the
steady state income level and capital per worker, the elasticity of income with respect to
capital or labor, the range of ", the profits or capital or labor, and similar items.
Take heed: For the transition path of the Cobb-Douglas production function, the final exam
asks qualitative (not quantitative) questions. Know how the growth rate along the transition
path relates to steady state capital per worker, current capital per worker, savings, growth
rate of technology, and population growth rate.
Practice problems on convergence are in a separate file.
*Question 1.1: Cobb-Douglas Production Function

An economy has a Cobb-Douglas production function: Y = AK L(1 ).
A is the technology level, K is capital; L is labor; and Y is income.
A.
B.
C.
D.
E.
" is the elasticity of income with respect to capital.

" is the elasticity of income with respect to labor.
" is the derivative of income with respect to capital.
" is the derivative of income with respect to labor
" is the elasticity of income with respect to the marginal product of capital.
Answer 1.1: A
For the Cobb-Douglas production function, the marginal product of capital equals
MPK = MY / MK
= " AK -1 L 1-
= " AK K -1 L 1-
= " AK L 1- (1/K)
= " (Y/ K)
The elasticity of income with respect to capital is MY / MK (K / Y) = (MPK K) / Y
= " (Y/ K) K / Y = " (see equation 3.20 on page 67)
MPK is the effect on Y from a change in K, holding A and L fixed:
Take heed: The elasticity of income with respect to capital is the percentage change in
income from a percentage change in capital. If " = 40%, a 5% increase in capital raises
income 5% 40% = 2%.
The microeconomics and regression analysis courses have full modules on elasticity. If you
have difficulty with elasticities, review the practice problems from microeconomics.
! The derivative of income with respect to capital is MY / MK.
! The elasticity of income with respect to capital is (MY/Y) / (MK/K) = MY / MK (K/Y).
*Question 1.2: Solow Growth Model

In the Solow growth model, an economys growth rate depends on five variables:
!
!
!
!
!
current capital per worker, k

the depreciation rate of its capital, *
the population growth rate, n
the savings rate, s
the technology level, A
As each of these parameters increases (holding other parameters constant), does the
growth rate of capital per worker increase, decrease, or remain the same?
k
A
B
C
D
E
_
`
`
`
_
*
`
`
`
`
_
_
`
`
`
`
_
_
`
_
_
_
_
_
`
_
! _ = the growth rate of capital increases

! ` = the growth rate of capital decreases
Answer 1.2: B
Current capital per worker: Economies converge (revert) to their steady state capital per
worker and steady state income per worker, by absolute convergence or conditional
convergence. Mean reversion (convergence) implies that as a random variable increases
toward the mean, its rate of increase slows, and as the variable decreases toward the
mean, its rate of decrease slows. A lower current capital per worker implies a faster growth
of capital per worker during the transition phase.
Depreciation * is a reduction in capital. Higher depreciation means that more capital wears
out and disappears from national income accounts.
Savings provides for three items: replacement of capital that wears out (depreciation);
capital for new workers (population growth); and higher capital per worker. A higher savings
rate means that more remains after providing for depreciation and population growth, so
capital per worker continues to grow. Conversely, a higher population growth rate means
that more savings are needed to provide capital for new workers and less is available for
growth in capital per worker.
Take heed: The savings rate s offsets the population growth rate n and the depreciation
rate *, and it supplies funds for further growth in capital per worker. As the capital per
worker grows, the savings needed to support depreciation and population growth is larger.
When capital is large enough that savings just offsets depreciation and population growth
the economy is in its steady state.
Savings and population growth differ by country. They are (in part) culturally determined.
Some cultures place more stress on large families than others do, or they are more
opposed to birth control, family planning, and abortion. Contrast the large families in the
Middle East and Latin America with small families in Western Europe, Canada, and China.
We do not know if economic growth in the Middle East and Latin America will reduce the
population growth rate to European levels or if Islamic and Catholic cultures will continue
with large families.
Some cultures have higher savings rates than others. Japan and other Asian countries
have higher savings rates than North America and Western Europe.
! An economy with a high population growth rate and a low savings rate may be near its
steady state capital per worker even at a low capital level (Nigeria, Congo).
! An economy with a low population growth rate and a high savings rate may be below
its steady state capital per worker even at a high capital level (Japan).
The countries above in parentheses are illustrations to help you understand the concepts.
Take heed: Distinguish between capital and the technology level. A higher technology level
raises the marginal product of capital and leads to more capital per worker. To remember
this, think of two workers:
! Jacob lives in a shepherd culture, with no knowledge of industrial society (A is low). The
only capital is knives, jars, and tents.
! Jacques lives in Paris and works in an information-age society (A is high). He uses cellphones and laptop computers (high capital).
Take heed: Some exam problems specify the Solow growth model. Unless specified
otherwise, the exam problems use the Solow growth model.
The Solow growth model has several forms: fixed values for A, s, and n; exogenous and
endogenous changes in the parameters. The type of model should be clear from the
context of the exam problem.
Macroeconomics Final Exam Practice Problems Implicit Price Deflator

In prosperous years with positive inflation, both nominal and real GDP grow over time. The
exam problems may combine negative inflation with real GDP growth or positive inflation
with real GDP decline. Review the practice problem here and the examples in the textbook.
! Know how to construct the implicit price deflator using the chain-linked method.
! The exam problems derive the implicit price deflator and real GDP in each year.
*Exercise 1.1: Real GDP and the Implicit Price Deflator
A country makes bread and wine in 20X7 and 20X8, at the quantities and prices shown in
the table below. The implicit price deflator in 20X7 is 100.
20X7
Quantity
Price
20X8
Bread
W ine
Bread
W ine
26000
4
5000
10
32000
5
4000
20
Use the average prices in 20X7 and 20X8 as base prices (the chain-link method).
A.
B.
C.
D.
E.
F.
G.
What is nominal GDP in 20X7 and 20X8?

What are the base prices of bread and wine for comparing 20X7 and 20X8?
What is GDP in 20X7 and 20X8 at the base prices?
What is the ratio of real GDP in 20X8 to real GDP in 20X7?
What is real GDP in 20X7 and 20X8?
What is the implicit price deflator in 20X8?
Explain the error in the following statement: The price of bread rose 25% from 20X7
to 20X8, yet consumers bought more bread. The demand curve for bread must have
changed from 20X7 to 20X8.
H. Explain the error in the following statement: Real GDP depends on the quantities of
goods, not their prices. To determine if real GDP increased or decreased, we need the
quantities of each good in the two years, not the prices of the goods in the two years.
Part A: Nominal GDP uses the prices in each year.

! 20X7: 26,000 $4 + 5,000 $10 = $154,000
! 20X8: 32,000 $5 + 4,000 $20 = $240,000
Part B: The base prices are the average prices:
! Bread: ($4.00 + $5.00) = $4.50
! Wine: ($10.00 + $20.00) = $15.00
Part C: We use the same base prices for both years.
! 20X7: 26,000 $4.50 + 5,000 $15 = $192,000
! 20X8: 32,000 $4.50 + 4,000 $16 = $204,000
Part D: The ratio of real GDP in 20X8 to real GDP in 20X7 is $204,000 / $192,000 = 1.063
Part E: In 20X7, the implicit price deflator is one, so real GDP = nominal GDP = $154,000.
In 20X8, real GDP = $154,000 1.063 = $163,625
Take heed: Nominal GDP has units of current dollars. It does not depend on the way we
measure inflation or the implicit price deflator. Real GDP has no natural units. Real GDP
for 20X8 could be in 20X1 dollars, 20X5 dollars, or 20X9 dollars. It also depends on the
way we measure inflation. The textbook uses the chain-link method, which causes fewer
distortions than other common methods, but it is not perfect.
Part F: The implicit price deflator is 100 nominal GDP / real GDP
= 100 $240,000 / $163,625 = 146.68
Part G: The nominal price of bread rose 25%. Inflation is 46.68%, so the real price of bread
rose by a factor of 1.25 / 1.4668 = 0.852. The real price declined 14.8%, and the quantity
of bread bought rose 32,000 / 26,000 1 = 23%.
Take heed: An exam problem may ask for the change in the price of a good after adjusting
for inflation. Derive the implicit price deflator from all the goods in the economy, and then
derive the change in the real price of the good.
Part H: The change in the real GDP is the weighted average change in the quantities of
goods produced. The prices of goods give the weights.
Illustration: A country produces the following quantities of bread and wine.
! 20X7: 200 loaves of bread and 300 flasks of wine.
! 20X8: 300 loaves of bread and 200 flasks of wine.

From the quantities alone, we dont know if real GDP increased or decreased.
! If bread is expensive and wine is cheap, real GDP increased.
! If bread is cheap and wine is expensive, real GDP decreased.

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Macroeconomics Exam Problems: Demand for Money

(The attached PDF file has better formatting.)

*Question 1.1: Nominal Demand for Money

A one time only decrease in the price level.

*Question 1.2: Demand for Money

The real interest rate to decline.

Macroeconomics Final Exam Practice Problems: Indifference Curves

*Question 1.1: Indifference Curves

22 hours of leisure per day + $75,000 of consumption per year

*Question 1.2: Indifference Curves

If Joseph is indifferent between jobs j and k on July 1, he prefers job k on July 3.

Macroeconomic final exam practice problems: comparative advantage

The U.S. has a comparative advantage in growing corn.

! Mexican farmers borrow money from U.S. investors.

Macroeconomics Final Exam Practice Problems: Government

*Question 1.2: Permanent Increase in Government Expenditures

*Question 1.3: Cyclicality

*Question 1.4: Temporary Increase in Government Expenditures

Macroeconomics Final Exam Practice Problems: Labor

*Question 1.1: Technology level

moves right (increases)

moves left (decreases)

*Question 1.2: Technology level

Numb er of W ork ers

*Question 1.3: Labor Force

Real W age Rate of

*Question 1.4: Real Wage Rate

Lowers the quantity demanded of unskilled labor

*Question 1.5: Minimum Wage

The quantity supplied increases and the quantity demanded decreases.

*Question 1.6: Minimum Wage

Supply increases and demand decreases.

*Question 1.7: Minimum Wage

*Question 1.8: Gains and Losses

Teen-age waiters gain from the higher real wage rate.

*Question 1.9: Job Separation

*Question 1.10: Marginal Product of Labor

308 *Question 1.11: Marginal Product of Labor

*Question 1.12: Real Wage Rate

*Question 1.13: Capital Deepening

Real Interest Rate

*Question 1.14: Labor and Capital

Macroeconomics Final Exam Practice Problems: Convergence

*Question 1.1: Conditional Convergence

*Question 1.2: Conditional Convergence

Steady State Output

Highest Growth Rate

Highest Economic Output

*Question 1.3: Convergence and Fertility Rates

*Question 1.4: Convergence

*Question 1.5: International Trade and Convergence

Macroeconomics Final Exam Practice Problems: Income Taxes

*Question 1.1: Marginal Tax Rates

*Question 1.2: Marginal Tax Rate

*Question 1.3: Marginal Tax Rate

*Question 1.4: Marginal Tax Rates

Raises total tax revenue.

*Question 1.5: Income and Substitution Effects

*Question 1.6: Income and Substitution Effects

*Question 1.7: Income Effect

*Question 1.8: Substitution effect

*Question 1.9: Marginal tax rates

*Question 1.10: Average tax rates

*Question 1.11: Average tax rates