Intermediate Macroeconomics Heman Das Lohano

Q:
Suppose the production function in Pakistan economy is as follows:

𝑌 = 𝐴𝐾 𝛼 𝐿1−𝛼

𝑌 = 40𝐾 0.5 𝐿0.5

where
Y is real GDP
K is the amount of capital input
L is the amount of labor input
A denotes overall productivity or total factor productivity (TFP)

(a) Find the marginal product of labor as a function.

(b) Assume that the country possesses 100 units of capital: K = 100. Draw the curve of marginal
product of labor.

(c) For the above production function, solve the profit maximization problem of the representative
firm and find the labor demand function for given level of capital stock: K = 100.

(d) Draw the labor demand curve with real wages (W/P). Suppose the supply of labor is fixed: 100
units. On the same graph, draw the labor supply curve with real wages.

(e) Suppose, output price (inflation index) is P = 1. Draw the labor demand curve with nominal
wages. Suppose the supply of labor is fixed: 100 units. On the same graph, draw the labor supply
curve.

(f) Find the equilibrium in the labor market: real wages (W/P), nominal wages at P = 1, and quantity
of labor in the market. Also, compute real GDP and nominal GDP.

(g) Suppose, output price (inflation index) increases to P = 2. Draw the labor demand curve with
nominal wages. On the same graph, draw the labor supply curve.

(h) Find the equilibrium in the labor market: real wages (W/P), nominal wages at P = 2, and quantity
of labor in the market. Also, find real GDP and nominal GDP.

(i) Draw the aggregate supply curve of real GDP.

Key:
(a)
Marginal production of labor as a function:

𝜕𝑌 20𝐾 0.5
𝑀𝑃𝐿 = = 0.5
𝜕𝐿 𝐿

(b)
Marginal production of labor at K = 100:

200
𝑀𝑃𝐿 =
𝐿0.5

Page 1 of 14
 Marginal Product of Labor
120

100

80
MPL

60

40

20

0
0 50 100 150 200 250 300 350 400 450
L

(c)
Define profit as total revenue minus total costs:

𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡

𝜋 = 𝑃𝑌 − 𝑅𝐾 − 𝑊𝐿

𝜋 = 𝑃𝐹(𝐾, 𝐿) − 𝑅𝐾 − 𝑊𝐿

For given K:

̅ , 𝐿) − 𝑅𝐾
𝜋 = 𝑃𝐹(𝐾 ̅ − 𝑊𝐿

Representative firm’s problem:

̅ , 𝐿) − 𝑅𝐾
max 𝜋 = 𝑃𝐹(𝐾 ̅ − 𝑊𝐿
𝐿

First order necessary condition for profit maximization:

𝜕𝜋
= 𝑃𝑀𝑃𝐿 − 𝑊 = 0
𝜕𝐿
𝑊
𝑀𝑃𝐿 = (1)
𝑃

where MPL denotes marginal product of labor. Given production function is:

𝑌 = 40𝐾 0.5 𝐿0.5

When K=100, the production function is:

𝑌 = 400𝐿0.5
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Marginal production of labor at K = 100:

200
𝑀𝑃𝐿 =
𝐿0.5

Putting MPL function in equation (1) yields

200 𝑊
=
𝐿0.5 𝑃

Solving for L yields the labor demand function:

200𝑃 2
𝐿𝐷 = ( )
𝑊

200 2
𝐿𝐷 = ( )
𝑊/𝑃
(d)
For drawing the labor demand curve with real wages (W/P), we write the inverse demand function
as:

𝑊 200
= 0.5
𝑃 𝐿𝐷

The right hand side of this function is MP L function. Thus, the labor demand curve with real wages
is the same as MPL curve.

Labor Demand Curve and Labor Supply Curve

120

100
W/P (Real Wages)

80

60

40

20

0
0 50 100 150 200 250 300 350 400 450
L

The supply of labor is fixed: 100 units. The labor supply curve with real wages has also been drawn
in the above graph.

Page 3 of 14
(e)
With P = 1, the inverse labor demand function with nominal wages is:

200
𝑊=
𝐿𝐷 0.5

The labor demand curve and supply curve with nominal wages are drawn below.

Labor Demand Curve and Labor Supply Curve

120

100
W (Nominal Wages)

80

60

40

20

0
0 50 100 150 200 250 300 350 400 450
L

(f)
Market clearing condition is:
𝐿𝐷 = 𝐿𝑆

200 2
( ) = 100
𝑊/𝑃

Solving for W/P gives real wages:

𝑊
= 20
𝑃
Nominal wages at P=1:
𝑊 = 20

At these wages, the labor demand and supply are equal at:

𝐿∗ = 100

Real GDP: 𝑌 = 400𝐿∗ 0.5 = 4000

Nominal GDP: PY = 1*4000 = 4000

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(g)
With P = 2, the inverse labor demand function with nominal wages is:

𝑊 200
= 0.5
2 𝐿𝐷

400
𝑊=
𝐿𝐷 0.5

The labor demand curve and supply curve with nominal wages are drawn below.

Labor Demand Curve and Labor Supply Curve

240

200
W (Nominal Wages)

160

120

80

40

0
0 50 100 150 200 250 300 350 400 450
L

(h)
Market clearing condition is:
𝐿𝐷 = 𝐿𝑆

200 2
( ) = 100
𝑊/𝑃
Solving for W/P gives real wages:
𝑊
= 20
𝑃
Nominal wages at P=2:
𝑊 = 40

At these wages, the labor demand and supply are equal at:

𝐿∗ = 100

Real GDP: 𝑌 = 400𝐿∗ 0.5 = 4000

Nominal GDP: PY = 2*4000 = 8000

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(i)
Aggregate supply curve of real GDP:

4000 Y

Q:
Solve the above question assuming that the labor supply function is:

𝑊
𝐿𝑆 = 5
𝑃

Key:
Parts (a – c) are the same as above.
(d)
For drawing the labor demand curve with real wages (W/P), we write the inverse demand function
as:
𝑊 200
= 0.5
𝑃 𝐿𝐷

The right hand side of this function is MP L function. Thus, the labor demand curve with real wages
is the same as MPL curve. The labor supply function is:

𝑊
𝐿𝑆 = 5
𝑃
The inverse supply function is:
𝑊
= 0.2𝐿𝑆
𝑃

The labor demand and supply curves with real wages have been drawn in the following graph.

Page 6 of 14
 Labor Demand Curve and Labor Supply Curve
120

100
W/P (Real Wages)

80

60

40

20

0
0 50 100 150 200 250 300 350 400 450
L

(e)
With P = 1, the inverse labor demand function with nominal wages is:

200
𝑊=
𝐿𝐷 0.5
With P = 1, the inverse supply function is:
𝑊 = 0.2𝐿𝑆

The labor demand and supply curves with nominal wages have been drawn in the following graph.

Labor Demand Curve and Labor Supply Curve

120

100
W (Nominal Wages)

80

60

40

20

0
0 50 100 150 200 250 300 350 400 450
L

Page 7 of 14
(f)
Market clearing condition is:
𝐿𝐷 = 𝐿𝑆

200 2 𝑊
( ) =5
𝑊/𝑃 𝑃
Solving for W/P gives real wages:
𝑊
= 20
𝑃
Nominal wages at P=1:
𝑊 = 20

At these wages, the labor demand and supply are equal at:

𝐿∗ = 100

Real GDP: 𝑌 = 400𝐿∗ 0.5 = 4000

Nominal GDP: PY = 1*4000 = 4000

(g)
With P = 2, the inverse labor demand function with nominal wages is:

400
𝑊=
𝐿𝐷 0.5
With P = 2, the inverse supply function is:
𝑊 = 0.4𝐿𝑆

The labor demand and supply curves with nominal wages have been drawn in the following graph.

Labor Demand Curve and Labor Supply Curve

240

200
W (Nominal Wages)

160

120

80

40

0
0 50 100 150 200 250 300 350 400 450
L

Page 8 of 14
(h)
Market clearing condition is:
𝐿𝐷 = 𝐿𝑆

400 2 𝑊
( ) =5
𝑊/𝑃 𝑃
Solving for W/P gives real wages:
𝑊
= 20
𝑃
Nominal wages at P=2:
𝑊 = 40

At these wages, the labor demand and supply are equal at:

𝐿∗ = 100

Real GDP: 𝑌 = 400𝐿∗ 0.5 = 4000

Nominal GDP: PY = 2*4000 = 8000

(i)
Aggregate supply curve of real GDP:

4000 Y

Page 9 of 14
Q:
Suppose the production function in Pakistan economy is as follows: 𝑌 = 40𝐾 0.5 𝐿0.5 ,
where Y is real GDP, K is the amount of capital, and L is the amount of labor. Assume that the
country has 81 units of capital and 81 units of labor, which are fully employed. Assume neoclassical
theory of distribution. (a) How much would be the real wage rate? (b) If both capital and labor
increase to 100 units, respectively, what would be the real wage rate? (c) If capital increases to 121
and labor increases to 100 units, what would be the real wage?

Key:
(a)
We find labor demand function from firm’s profit maximization:

𝑊
= 𝑀𝑃𝐿
𝑃

𝜕𝑌 20𝐾 0.5
𝑀𝑃𝐿 = = 0.5
𝜕𝐿 𝐿
Inverse demand function for labor is:
𝑊 20𝐾 0.5
=
𝑃 𝐿𝐷 0.5

Labor supply is LS = 81. At K = 81, the labor market equilibrium (LD = LS) will result in the real
wage as:
𝑊 20(81)0.5
= = 20
𝑃 (81)0.5
(b)
Labor supply is LS = 100. At K = 100, the labor market equilibrium (LD = LS) will result in the real
wage as:
𝑊 20(100)0.5
= = 20
𝑃 (100)0.5
(c)
Labor supply is LS = 100. At K = 121, the labor market equilibrium (LD = LS) will result in the real
wage as:
𝑊 20(121)0.5
= = 22
𝑃 (100)0.5

Q:
GDP: Y = 6000
Consumption: C = 600 + 0.6 (Y – T)
Investment: I = 2000 – 100 r
Taxes: T = 500
Government spending: G = 700
where r is real interest rate in percent.

(a) Find the equilibrium values of C, I and r. Also, find private saving (SP), public saving (SG), and
national saving (SN).
(b) If government spending increases to 900, find all the values solved in part (a).
(c) Compare the results in (a) and (b). Discuss the implications.

Page 10 of 14
Key:
(a)
Consumption: C = 600 + 0.6 (Y – T) = 600 + 0.6 (6000 – 500) = 3900
National saving: SN = Y – C – G = 6000 – 3900 – 700 = 1400
Private saving: SP = Y – C – T = 6000 – 3900 – 500 = 1600
Public saving: SG = T – G = 500 – 700 = – 200

Market for loanable funds in private market:

Aggregate demand: Expenditure: E = C + I + G

Households income used on: Y = C + SP + T

Equilibrium:

E=Y

C + I + G = C + SP + T

I = SP + (T – G)
I = SP + S G
I = SN

Demand side: Investment function: I = 2000 – 100 r

Supply side: National saving: SN = 1400

Market clearing condition:

I(r) = SN
2000 – 100 r = 1400
r=6%

Putting r in investment function yields: I = 1400

Note: For investment function I = 2000 – 100 r, investment curve is a graph of inverse
investment function: r = 20 – 0.01 I.

r S0: SN

20

D0: I(r)

1400 2000 I

Page 11 of 14
(b)
Consumption: C = 600 + 0.6 (Y – T) = 600 + 0.6 (6000 – 500) = 3900
National saving: SN = Y – C – G = 6000 – 3900 – 900 = 1200
Private saving: SP = Y – C – T = 6000 – 3900 – 500 = 1600
Public saving: SG = T – G = 500 – 900 = – 400

Market for loanable funds in private market:

Demand side: Investment function: I = 2000 – 100 r
Supply side: National saving: SN = 1200

Market clearing condition:

I(r) = SN
2000 – 100 r = 1200
r=8%
Putting r in investment function yields: I = 1200

S1: SN S0: SN
r

20

D0: I(r)
8
6

1200 1400 2000 I

Q:
Consider a classical model for an economy where GDP = 1400. The components of GDP from
expenditure side are also given below.

Real GDP: Y = 1400

Consumption: C = 150 – 10 r + (2/3) (Y – T)
Investment: I = 250 – 10 r
Government spending: G = 400
Taxes: T = (1/4)Y

where r is the real interest rate in percent.

(a) Find the equilibrium values of C, r, and I. Also, compute tax revenues (T), private saving (SP),
public saving (SG), national saving (SN), and budget deficit/surplus.

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(b) Suppose the government spending rises by 100. Compute all the values solved in part (a). What
are the effects of this increase in government spending? How much of private domestic
investment (I) is crowded out?

Key:

Real GDP: Y = 1400

Consumption: C = 150 – 10 r + (2/3) (Y – T)
Investment: I = 250 – 10 r
Government spending: G = 400
Taxes: T = (1/4)Y

(a)
Consumption: C =150 – 10 r + (2/3) (Y – T) = 150 – 10 r + (2/3) (Y – (1/4)Y)
C = 150 – 10 r + (1/2)Y = 150 – 10 r + (1/2)1400 = 850 – 10 r

National saving: SN = Y – C – G = 1400 – 850 + 10 r – 400 = 150 + 10 r

Market for loanable funds in private market:

Demand side: Investment function: I = 250 – 10 r

Supply side: National saving: SN = 150 + 10 r

Market clearing condition:

I = SN Or use: I = Y – C – G or Y = C + I + G
250 – 10 r = 150 + 10 r
r=5%

Putting r = 5 in investment (or national saving) function yields: I = 200

Putting r = 5 in consumption function yields: C = 850 – 10 r = 800

Tax revenue: T = (1/4)Y = (1/4)1400 = 350

Private saving: SP = Y – C – T = 1400 – 800 – 350 = 250
Public saving: SG = T – G = 350 – 400 = – 50
Budget deficit: BD = G – T = 400 – 350 = 50

(b) G = 500

Consumption: C =150 – 10 r + (2/3) (Y – T) = 150 – 10 r + (2/3) (Y – (1/4)Y)

C = 150 – 10 r + (1/2)Y = 150 – 10 r + (1/2)1400 = 850 – 10 r

National saving: SN = Y – C – G = 1400 – 850 + 10 r – 500 = 50 + 10 r

Market for loanable funds in private market:

Demand side: Investment function: I = 250 – 10 r

Supply side: National saving: SN = 50 + 10 r

Page 13 of 14
Market clearing condition:

I = SN
250 – 10 r = 50 + 10 r
r = 10 %

Putting r = 10 in investment (or national saving) function yields: I = 150

Putting r = 10 in consumption function yields: C = 850 – 10 r = 750

Tax revenue: T = (1/4)Y = (1/4)1400 = 350

Private saving: SP = Y – C – T = 1400 – 750 – 350 = 300
Public saving: SG = T – G = 350 – 400 = – 150
Budget deficit: BD = G – T = 400 – 350 = 150

When G = 400 When G = 500 Change

I 200 150 –50 (crowd out)

C 800 750 –50
r 5% 10% 5%
Private saving 250 300 50
Public saving –50 –150 –100
National saving 200 150 –50
Budget deficit 50 150 100

Y = C + I + G. As Y is fixed, additional government spending of 100 results in decrease in I by 50

and decreases in C by 50 (or increase in private saving by 50). Due to additional government
spending, budget deficit increases by 100. Although private saving increased by 50, decrease in
public saving by 100 results in decrease in national saving by 50, which in turn leads to increase in
the interest rate by 5% points and decrease in private invest (crowd out by 50).

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