Chapter 5: Closed one-period model

Part A

1. Textbook review question 1.

2. What kind of actors exist in the closed one-period model? What is the role of each of
these?

3. Write down the government budget constraint. What does each of the letters represent?

4. Textbook review question 3.

5. Textbook review question 4.

6. Textbook review question 5.

7. What is required for a market to clear?

8. What markets exist in our model?

9. Textbook review question 6.

10. Why is there no investment, exports or imports in the model?

11. What does the production possibilities frontier show?

12. Textbook review question 7.

13. Show that Y = C + G must hold in the competitive equilibrium of the model.

14. Draw output Y as a function of the labor input N given our usual assumptions about
the production function (marginal product of labor is positive, but diminishing).
(a) What is the slope of the production function?
(b) Choose three points A, B and D on your production function such that N = 0
at point A, N = h at point D, and point B is between A and E in terms of the
quantity of labor input used.
(c) How does the marginal product of labor M PN compare across the three points
A, B and D.
(d) Use points A, B and D to plot output Y as a function of leisure l, exploiting that
l = h N , so that these points show up in your new figure.
(e) What is the slope of this new function. Explain. How does the slope of your
function compare at points A, B and D?
(f) Given that C = Y G, plot consumption C as a function on leisure l. Note
where points A, B and D are on this new figure. How does the slope of this new
function compare at points A, B and D?

1
 15. Draw a production possibilities frontier (PPF) as that in Figure 5.2c in the textbook.
(a) It is the firms that choose how much is produced in an economy. Picking an
arbitrary real wage w, illustrate in your figure what point the firm in our model
would choose, assuming it maximizes profits and exploiting that the slope of the
production possibilities frontier equals M PN . Denote this point A and briefly
explain why no other point can be optimal for the firm. (Hint: remember that
profit maximizing firms choose employment N so that the M PN = w, and that by
definition l = h N ).
(b) It is the consumers that choose how much is consumed in an economy. Draw a
budget constraint and an arbitrary indifference curve (both satisfying the usual
assumptions) to show what point a utility-maximizing consumer would choose.
Denote this point B and briefly explain why no other point can be optimal.
(c) How do we know that the firm and consumer will choose the same point, so that
points A and B are the same? What does this imply about the relationship
between the demand and supply for consumption goods? About the demand and
supply for labor?
(d) Combine the PPF, the budget constraint and the indifference curves in the same
diagram. Explain why M RSl,c = M PN in the competitive equilibrium?

Part B

1. What is required for an equilibrium to be Pareto optimal?

2. Textbook review question 8.

3. Textbook review question 10.

4. What is the difference between an endogenous and an exogenous variable?

5. Textbook review question 11.

6. Why does government spending crowd out private spending?

7. Draw a production possibilities frontier (PPF) as that in Figure 5.2c in the textbook.
(a) Draw arbitrary indifference curves in your figure to show what point on the PPF
maximizes the consumers utility, hence being the Pareto optimal choice. Denote
this point D and briefly explain why no other point can be optimal.
(b) Explain why M RSl,C = M PN in the Pareto optimal solution, just as we showed
for the competitive equilibrium without externalities (see problem B15d). What
does this imply about the relationship between the competitive equilibrium and
the Pareto optimal solution?

2
 8. Imagine that there is a distorting tax on wage income, so that the consumers budget
constraint is
C = w (1 t) l + w (1 t) h +
where t is the tax rate.
(a) Draw the budget constraint and an arbitrary indifference curve, showing the con-
sumers optimal choice. Denote this point A and explain what the consumers
M RSl,C will equal at point A.
(b) Draw the PPF and illustrate the firms profit-maximizing choice picking an arbi-
trary real wage w. Denote this point B and explain what the M PN will equal at
point B.
(c) Are the household and firm choosing the same point? Explain.
(d) Assuming that both the firm and the household are choosing points that are fea-
sible (on or inside the PPF), combine your results from part a and b to show
graphically that the competitive equilibrium is not Pareto optimal with the dis-
torting tax.

9. Use the closed one-period model to show that increased government spending crowds
out private consumption. What is the effect on aggregate output? Employment? The
real wage? Why are changes in government spending not likely to be a major source
of business cycle fluctuations?

10. Textbook problem 1.

11. Textbook problem 4.

Part C

1. Give three examples of what could cause total factor productivity to increase.

2. Textbook review question 13.

3. Textbook review question 14.

4. Explain how the long-run evolution of the U.S. economy is consistent with total factor
productivity having grown since WWII.

5. How do the short-run effects of changes in total factor productivity compare with the
business cycle facts studied in chapter 3?

6. According to the closed economy one-period model, why might it not be a good idea
to raise government spending to limit the drop in output that results from a decline in
total factor productivity?

3
 7. Using the closed one-period model to analyze the effects of an increase in total factor
productivity (TFP).
(a) Show graphically how an increase in TFP affects the PPF.
(b) Draw arbitrary indifference curves in your diagram and illustrate the effects on
consumption and leisure.
(c) Graphically split the impact into an income and substitution effect to see whether
your results above are just due to the way you happened to draw things. What
do we tell for sure about the effects on consumption and leisure (independently
of how we draw things)?
(d) What is the impact on employment or hours worked?
(e) What is the impact on aggregate output
(f) What is the impact on the real wage?

8. Using the closed one-period model to analyze the effects of a fall in total factor pro-
ductivity (TFP).
(a) Show graphically how a fall in TFP affects the PPF.
(b) Draw arbitrary indifference curves in your diagram and illustrate the effects on
consumption and leisure.
(c) Graphically split the impact into an income and substitution effect to see whether
your results above are just due to the way you happened to draw things. What
do we tell for sure about the effects on consumption and leisure (independently
of how we draw things)?
(d) What is the impact on employment or hours worked?
(e) What is the impact on aggregate output
(f) What is the impact on the real wage?

9. Textbook problem 2.

10. Textbook problem 6.

11. Textbook problem 3.

12. Textbook problem 5.

If you are interested, the mathematical appendix to chapter 4 shows how the closed
economy one-period model works using calculus (including practice problems).