Economics 302 Spring 2005 Homework 2 Due February 16 2005 1 Your liberal activist roommate is plotting to bring down capitalist society He she claims that workers are being cheated out of compensation that is rightly theirs He she points to sizable profit announcements by large corporations as evidence that workers should be paid more You decide unwisely to debate the issue from the standpoint of an academic economist a What common misconception about profit should you point out in your opening statement Your roommate is likely thinking of accounting profits which are revenue minus operating costs in our model this is labor cost Accounting profits have not taken into account the fact that the owners of capital should be paid a return b Explain how economists believe that wages are determined Economist believe that real wages are equal to the marginal product of labor MPL w p This is the result of profit maximization c Show how if the aggregate production function is homogeneous of degree one which is a reasonable long run assumption that economic profit is zero rendering your roommate s argument based upon profit weak Be thorough in your explanation since your roommate is not easily convinced If the production function is homogeneous of degree one it can be written as Y MPK K MPL L Knowing that the marginal products are equal to the real wage or real rental rate we can rewrite the above as Y r w K L p p Multiplying through by the price of output we have pY r K w L The left hand side is the firm s revenue and the right hand side is the firm s costs Since these two are equal economic profits are zero 2 Suppose that the economy s output is fixed by the amount of labor and capital present the government balances its budget the m p c is 0 9 and NX 0 Suppose the government increases its spending by 20 taxes must increase to keep the budget balanced a Write the change in investment as a function of the initial level of government spending I 0 1 0 2 G1 b What must happen to the interest rate As investment decreased the interest rate must have risen It is a good idea to check the loanable funds market to be sure that what occurs there is consistent with a decrease in the interest rate With our assumptions the savings equation becomes Savings 0 1Y 0 1G So as G increases savings decreases When savings decreases the intersection of the savings curve and I r curve is at a higher interest rate and lower level of investment c In general find an expression for the change in investment as a function of the change in government spending I 0 1 G d Suppose now that when the government increases or decreases spending it leaves taxes unchanged Find an expression for the change in investment as a function of the change in government spending I G e Regardless of how the government finances increased spending what is the effect on savings and the interest rate Briefly explain In the Classical model there is complete crowding out That is an increase in government spending reduced investment dollar for dollar When the government is running a balanced budget the decrease in investment is smaller are the MPC is less than one Consumption also decreases which means that investment does not need to change by the full amount 3 For the years 1999 through 2004 collect data to calculate an estimate for the velocity of money Nominal GDP can be used as an estimate of Pr ice Output Data on the money stock can be found on the St Louis Federal Reserve s website located at http research stlouisfed org fred2 categories 24 Calculate the velocity using M1 M2 and M3 for each year You will need to average the quarterly reports to get a yearly average of the money supply a Over the 5 years examined what is the trend in velocity Year 1999 2000 2001 2002 2003 2004 GDP 9 268 40 9 817 00 10 128 00 10 487 00 11 004 00 11 728 00 M1 1101 47 1103 461 1136 99 1192 028 1264 02 1332 24 M2 4525 873 4801 405 5219 493 5614 811 5998 417 6266 947 M3 6270 044 6861 391 7643 641 8257 342 8778 864 9232 705 V M1 8 414571 8 896557 8 90773 8 797615 8 705558 8 803216 8 754208 V M1 M 0 33964 0 142349 0 153522 0 043407 0 04865 0 049009 0 165838 V M2 2 04787 2 04461 1 940418 1 867739 1 834484 1 871406 1 934421 V M2 M 0 113449 0 110189 0 005997 0 06668 0 09994 0 06302 0 043453 V M3 1 478203 1 430759 1 325023 1 270021 1 253465 1 270267 1 337957 The velocity moves about depending on definition It tends to be decreasing in the early years with an upswing at the end b Which money aggregate is most consistent with a constant velocity The final number in the columns labeled V M M is the variance of the series This is smallest for M2 but very close to M3 s variance If you graphed the series they would look about the same c Having examined the data is the assumption of a constant velocity justified For M2 and M3 the movement around the mean is pretty small I would say that constant velocity is an okay assumption at least in the short run V M3 M 0 140247 0 092803 0 01293 0 06794 0 08449 0 06769 0 044785 4 Again record the price of the basket of goods you selected in the previous homework Calculate a CPI like figure for the first period and this second period with the first measurement period being the base period Recall that the CPI is a number around 100 and that it is based upon the price of the entire basket not individual goods