4QQMN136 Introduction to Microeconomics and 4QQMN146 Introduction toMacroeconomics – joint assessmentExamination Period: Period 2, May 2020Question 1:Explain why employers pay a lower efficiency wage when unemployment ishigh. How would the efficiency wage change in an economy if it became easierto monitor the work that employees did? Other than to incentivise workers toput in effort, can you think of any other reasons why wages might be higherwhen unemployment is low (i.e. an upward-sloping wage-setting curve)?Solutions to Question 1:The first part of the question requires a description of the best response curvein the labour discipline model. A diagram showing how the best response curveshifts to the left when unemployment rises and so the intersection with a newisoprofit curve occurs with a lower wage. The economic intuition must also beprovided. Higher unemployment increases the employment rent in the job andso employers can pay workers less to get the same level of effort as previously.The second part requires an understanding that imperfect monitoring is crucialfor the efficiency wage model to work. If monitoring of effort was perfect,workers would be paid their marginal product and wages would have no roleas an incentive tool.The final part of the question should distinguish standard answers from verygood answers. Some possibilities include: (a) labour supply may be upwardsloping i.e. you need to pay higher wages to get more people to be willing toparticipate. When U is low, we need to get workers out of inactivity and thiswill require higher wages, (b) union bargaining – when U is low, the outsideoptions for workers are stronger, so their bargaining power rises and they pushfor a higher share of the pie. The aim here is just for the answer to give someideas that understand that we are looking for explanations that explain whythe wage that is agreed between workers and firms may rise when U is low(other than for the usual efficiency wage argument).2Question 2:To support the economy against a recession triggered by the Coronavirus, thegovernment is considering increasing public spending. Suppose thegovernment decides to finance the additional spending with new taxes, and toincrease taxes by the same amount as public spending. A critic to thegovernment objects saying that if public spending and taxes increase by thesame amount, no increase in GDP should be expected: what the governmentgives to the economy is taken back via taxes.Use the model of aggregate demand and aggregate supply to study if theproposed economic policy could increase GDP by computing the fiscalmultipliers.a) Start from the model C + I + G + NX = Y with C the aggregate level ofconsumption, I the aggregate level of investment, G the level of fiscalspending, NX the net experts and Y the level of GDP. Assume NX = 0 andassume that C = c0 + c1(Y-T), with T the level of taxes. Interpret theeconomic intuition behind the function for consumption. What is c1? (5marks)b) Derive the equilibrium level of GDP associated with this model. Study byhow much Y increases when G increases under the assumption T=G.Does your model predict that Y will be affected by the governmentintervention? Why? (10 marks)c) Now assume that NX = X – mY, where X represents total exports and mrepresents the marginal propensity to import. How does your answer toquestion b) change? Why? (10 marks)Solutions to Question 2:a) (5 marks) The function C = c0 + c1(Y-T) postulates that aggregateconsumption is a linear function of disposable income Yd = Y-T. Whendisposable income increases by 1 unit, consumption increases by c1units. The parameter c1 captures the marginal propensity to consume,defined as the propensity to increase consumption following a marginal3increase in (disposable) income.b) (10 marks) Starting from the equality C + I + G + NX = Y, substitutingNX=0 and C = c0 + c1(Y-T) and then solving for Y givesY* = 1/(1-c1) * (c0 + I + G – c1T)One can then impose the restrictions T=G and obtainY* = G + 1/(1-c1) * (c0 + I)The model hence predicts that an increase in G by 1 unit and acorresponding increase in taxes by 1 unit will indeed have an effect onoutput Y. The effect will consist of an increase by 1 unit. Contrary to thesupposition stated at the beginning of Question 2, the effects comingfrom an increase in government spending and an equivalent increase intaxes do not cancel out. The fiscal multiplier dY*/dG equals 1.The economic intuition is the following: the increase in governmentspending triggers a multiplicative effect through an increase in output,which increases disposable income, which increases consumption, whichincreases income, which increases disposable income, .. and so on. Bycontrast, an increase in taxes by 1 unit decreases consumption by onlyc1 units, hence decreasing consumption by less than the increase intaxes. The two effects (via G and via T) perfectly offset each other in away that leads to a 1-to-1 increase in GDP.c) In the new scenario, the new derivations lead toY* = 1/(1-c1+m) * (c0 + I + G – c1T+X)One can then impose the restrictions T=G and obtainY* = (1-c1)/(1-c1+m)*G + 1/(1-c1+m) * (c0 + I + X)The fiscal multiplier dY*/dG now equals (1-c1)/(1-c1+m). Since 0

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