Licenciaturas em
Economia, Gestão e Negócios Internacionais
Macroeconomia I Ficha de Trabalho III.1
Questions for Review
1. What determines the amount of output an economy produces?
2. Explain how a competitive, profit-maximizing firm decides how much of each factor of produc-
tion to demand.
3. What is the role of constant returns to scale in the distribution of income?
4. Write down a Cobb-Douglas production function for which capital earns one-fourth of total
income.
5. What determines consumption and investment?
6. Explain the difference between government purchases and transfer payments. Give two exam-
ples of each.
7. What makes the demand for the economy’s output of goods and services equal the supply?
8. Explain what happens to consumption, investment, and the interest rate when the government
increases taxes.
Problems and Applications
1. Use the neoclassical theory of distribution to predict the impact on the real wage and the real
rental price of capital of each of the following events:
(a) A wave of immigration increases the labor force.
(b) An earthquake destroys some of the capital stock.
(c) A technological advance improves the production function.
2. If a 10-percent increase in both capital and labor causes output to increase by less than 10
percent, the production function is said to exhibit decreasing returns to scale. If it causes
output to increase by more than 10 percent, the production function is said to exhibit increasing
returns to scale. Why might a production function exhibit decreasing or increasing returns to
scale?
3. Suppose that an economy’s production function is Cobb-Douglas with parameter α = 0.3.
(a) What fractions of income do capital and labor receive?
(b) Suppose that immigration increases the labor force by 10 percent. What happens to total
output (in percent)? The rental price of capital? The real wage?
(c) Suppose that a gift of capital from abroad raises the capital stock by 10 percent. What
happens to total output (in percent)? The rental price of capital? The real wage?
(d) Suppose that a technological advance raises the value of the parameter A by 10 percent.
What happens to total output (in percent)? The rental price of capital? The real wage?
4. Consider a Cobb-Douglas production function with three inputs. K is capital (the number of
machines), L is labor (the number of workers), and H is human capital (the number of college
degrees among the workers). The production function is
Y = K1/3 L1/3 H1/3 (1)
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Macroeconomia I Ficha de Trabalho III.1
(a) Derive an expression for the marginal product of labor. How does an increase in the
amount of human capital affect the marginal product of labor?
(b) Derive an expression for the marginal product of human capital. How does an increase in
the amount of human capital affect the marginal product of human capital?
(c) What is the income share paid to labor? What is the income share paid to human cap-
ital? In the national income accounts of this economy, what share of total income do
you think workers would appear to receive? (Hint: Consider where the return to human
capital shows up.)
(d) An unskilled worker earns the marginal product of labor, whereas a skilled worker earns
the marginal product of labor plus the marginal product of human capital. Using your
answers to parts (a) and (b), find the ratio of the skilled wage to the unskilled wage. How
does an increase in the amount of human capital affect this ratio? Explain.
(e) Some people advocate government funding of college scholarships as a way of creating a
more egalitarian society. Others argue that scholarships help only those who are able to
go to college. Do your answers to the preceding questions shed light on this debate?
5. The government raises taxes by $100 billion. If the marginal propensity to consume is 0.6,
what happens to the following? Do they rise or fall? By what amounts?
(a) Public saving.
(b) Private saving.
(c) National saving.
(d) Investment.
6. Suppose that an increase in consumer confidence raises consumers’ expectations about their
future income and thus increases the amount they want to consume today. This might be inter-
preted as an upward shift in the consumption function. How does this shift affect investment
and the interest rate?
7. Consider an economy described by the following equations:
Y =C +I +G (2)
Y = 5000 (3)
G = 1000 (4)
T = 1000 (5)
C = 250 + 0, 75(Y − T ) (6)
I = 1000 − 50r (7)
(a) In this economy, compute private saving, public saving, and national saving.
(b) Find the equilibrium interest rate.
(c) Now suppose that G rises to 1 250. Compute private saving, public saving, and national
saving.
(d) Find the new equilibrium interest rate.
8. Suppose that the government increases taxes and government purchases by equal amounts.
What happens to the interest rate and investment in response to this balanced-budget change?
Does your answer depend on the marginal propensity to consume?
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Macroeconomia I Ficha de Trabalho III.1
9. When the government subsidizes investment, such as with an investment tax credit, the subsidy
often applies to only some types of investment. This question asks you to consider the effect of
such a change. Suppose there are two types of investment in the economy: business investment
and residential investment. And suppose that the government institutes an investment tax
credit only for business investment.
(a) How does this policy affect the demand curve for business investment? The demand curve
for residential investment?
(b) Draw the economy’s supply and demand for loanable funds. How does this policy affect
the supply and demand for loanable funds? What happens to the equilibrium interest
rate?
(c) Compare the old and the new equilibria. How does this policy affect the total quantity of
investment? The quantity of business investment? The quantity of residential investment?
10. If consumption depended on the interest rate, how would that affect the conclusions reached
in this chapter about the effects of fiscal policy?
11. Consider the following Cobb-Douglas production function:
H = 60K1/3 L2/3 (8)
(a) Prove that this Cobb-Douglas production function has constant returns to scale.
(b) Derive the algebraic expression for the marginal product of labor (MPL).
(c) Evaluate the expression you just derive - that is, find the numerical value of MPL - when
K = 64 and L = 8. If firms in the economy had decided to employ 8 workers, what would
the equilibrium real wage have to be?
(d) Derive the algebraic expression for the marginal product of capital (MPK ).
(e) Evaluate the expression you just derive - that is, find the numerical value of MPK, when
K = 64 and L = 8. If firms in the economy had decided to employ 64 units of capital,
what would the equilibrium real rental price of capital have to be?
(f) Illustrate how Cobb-Douglas production functions results in constant factor shares that
are equal to the exponents on the respective factors of production.
(g) Use the algebraic expressions you derived for the MPL and MPK to prove your answer
to part (f) algebraically.
(h) Show that this production function satisfies Euler’s theorem.
12. Consider that there are two factors of production, K and L, and that they are fully employed
at K = K̄ and L = L̄. Furthermore, assume that the economy is described by the following set
of equations:
Y = Ȳ = F (K̄, L̄) = 1200 (9)
Y =C +I +G (10)
C = 125 + 0, 75(Y − T ) (11)
I = I(r) = 200 − 10r (12)
G = Ḡ = 150 (13)
T = T̄ = 100 (14)
(a) Solve for the value of Consumption.
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Macroeconomia I Ficha de Trabalho III.1
(b) Solve for the initial equilibrium values of both S (national saving) and I and for the real
interest rate.
(c) Use the I, S diagram to draw a curve representing the investment equation and a curve
representing national saving (note: indicate the slope of the investment curve, the initial
equilibrium interest rate and initial levels of saving and investment).
(d) Calculate the initial levels of public and private saving and verify that they sum to the
level of national saving.
(e) Suppose Taxes are reduced by 20 to 80. What happens to the levels of Consumption,
private saving and public saving? Use the I,S diagram and illustrate the effects of this
policy on national saving, investment and real interest rate.
(f) Now suppose that we start again with T = T̄ = 100 and a technology breakthrough
increases investment demand such that investment rises by 100 at each interest rate. Use
the I,S diagram and illustrate the effects of this policy on national saving, investment and
real interest rate. Would your answer be different if saving were positively related to the
interest rate?
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