1) A competitive profit maximizing firm hires labor until the:

w
a)
wage equals the rental price of capital
= MPL
b)
real wage equals the real rental price of capital
p
c)
marginal product of labor equals the wage
d)
price of output multiplied by the marginal product of labor equals wage
2) If 10 French francs trade for $1, the U.S. price level equals $1 per good, and the French price level equals 4
francs per good, then the real exchange rate between French goods and U.S. goods is ______ French goods per
U.S. good.
a. 0.5
1 US good
b. 2.5
= $1
c. 5
=10 francs
d. 10
=10/4 French goods
e. 25
3)
If purchasing-power parity held, if a Big Mac costs $2 in the United States, and if 5 French francs
trade for $1 dollar, then a Big Mac in Paris should cost:
a)
1 franc.
1 US Mac=$2=2*5 Franc
b)
5 francs.
PPP
1 US Mac=1French Mac
c)
7 francs.
1French Mac= 10 Franc
d)
10 francs.
e)
15 francs.

4)
There are a number of statistics computed to measure the price level, such as the GDP deflator and the
CPI. The choice of which of these measures to use depends in many cases the specific question in which you
are interested. For each of the following situations state whether the CPI or GDP deflator is a more appropriate
measure to use and explain why the statistic (is CPI vs GDP deflator) is preferred.
a)

You are interested at looking at the impact of higher prices of imported oil in the overall cost of
living.
CPI because interested in the change in cost of living of consumers. Also imported oil prices will not be
included in GDP deflator.

b)

The government is interested whether easing import restrictions on food grains benefits poor urban
workers.
CPI because imported food grains are included in consumption basket but not in domestic GDP, and also
because the objective is to evaluate consumer welfare.

c)

An economic consulting firm is investigating the impact on aggregate price level due to the use of
computers and new technology in the production.
GDP deflator because the firm is interested in seeing the change in cost and prices of production process
and is not interested in only consumer welfare which might include imported goods.

5) It rains so much in the country of Tropicana that capital equipment rusts out (depreciation) at a much faster
rate than in the country of Sahara. If the countries are otherwise identical, in which country will the steady
state capital per worker be higher? Include graphical illustration in your explanation.

y,i, k
y=f(k)
Slope = Tropicana
i=s f(k)

We can see
graphically that the per
capital steady state
capital will be higher
where the depreciation
is lower (Sahara).

Slope = Sahara

k*Tropicana

k*Sahara

6) In classical macroeconomic theory, the concept of money neutrality means that changes in the money
supply do not influence real variables. Explain why changes in money growth affect the nominal interest rate
but not the real interest rate. Try to incorporate diagram(s) / equations in explaining.
Hint: The Quantity Theory predicts a one-for-one relation between changes in the money growth rate
and changes in the inflation rate .
In the classical model real interest rate is determined by the interaction of investment (demand for loanable
funds) and savings (supply of loanable funds). Hence changes in money supply do not affect the real interest
rate.

r
The real interest rate is defined to be the
nominal interest rate adjusted for inflation.
r = i .
Hence nominal interest rate is given by
i = r + , also known as the Fisher equation.

S=Y-C(Y-T)-G

reqbm

Once the real interest rate is determined by the

interaction of saving and investment, change in
money supply affects inflation which in turn
changes nominal interest rate

I(r)

S,I

7) Compare the impact of an increase in the governments budget deficit on domestic investment spending
within a small open economy with an otherwise comparable closed economy. Assume that factors are fully
employed in both economies. Assume that there is perfect capital mobility for the small open economy.
r

S1=Y-C(Y-T)-G1

S1=Y-C(Y-T)-G1

So=Y-C(Y-T)-Go

So=Y-C(Y-T)-Go

r1
I(r)

ro

I1

Io

I(r)

rworld

S, I

I*

S, I

In a closed economy (Panel 1 diagram), domestic investment has to equal domestic saving. As G goes up,
domestic saving goes down and hence domestic investment also goes down from Io to I1. Domestic interest
rate also increases from r0 to r1.
However, for small open economy (Panel 2 diagram), the world interest rate does not change when
government expenditure changes. When domestic saving goes down, foreign capital flows in to make up for
the shortfall. If the initial domestic investment level was I*, at unchanged world interest rate rworld, the
domestic investment demand is unchanged at I* as shown in 2nd diagram.