Tutorial 4
Chapter 5: Labour markets and unemployment
Multiple choice questions
Question 1
Assume an economy with homogeneous labour and that the labour market is in
equilibrium. The market clearing real wage equals 100 units of goods. The
government introduces a minimum wage of 80 units of goods. Which ONE of the
following will be the consequence of this government policy?
a. The equilibrium rate of unemployment will increase.
Feedback: Incorrect.
Page reference: 124
b. Involuntary unemployment will rise.
Feedback: Incorrect.
Page reference: 124
*c. Employment will remain unchanged.
Feedback: Correct.
Page reference: 124
d. The equilibrium real wage will rise.
Feedback: Incorrect.
Page reference: 124
Question 2
When does involuntary unemployment exist?
a. When unemployed workers could be hired for jobs that are different from the job
for which they have been specifically trained.
Feedback: Incorrect.
Page reference: 118
b. When unemployed workers would be willing to work, but only for a wage that is
above that being paid to employed workers.
Feedback: Incorrect.
Page reference: 118
*c. When unemployed workers would be willing to work at the wage being paid to
employed workers but cannot find employment.
Feedback: Correct. For instance, the institution of union-negotiated wages raises the
collective labour supply above that of individuals, resulting in a rationing of jobs at
the higher wage that unemployed workers would accept if offered.
Page reference: 118
d. When employers are faced with a shortage of workers that is completely
independent of the wages that the employers would be willing to pay them.
Feedback: Incorrect.
Page reference: 118
Question 3
Which ONE of the following is true of the minimum wage?
*a. It is a source of unemployment should it exceed the marginal productivity of
workers.
Feedback: Correct. The important point is that you can legislate the wage, but you
cannot force employers to hire people, and they will only hire as long as the marginal
productivity of a worker does not fall below the wage paid.
Page reference: 124
b. It is always a cause of unemployment.
Feedback: Incorrect. It may be under the market clearing level.
Page reference: 124
c. It provides protection for the least skilled workers.
Feedback: Incorrect. Only those who get hired will benefit.
Page reference: 124
d. It is set to maximize employment.
Feedback: Incorrect.
Page reference: 124
Question 4
If wages were perfectly flexible and labour were completely homogeneous, which
ONE of the following would be true of an increase in immigration?
a. It would lead to an increase in the real wage and a reduction in employment.
Feedback: Incorrect. See Figure 5.8.
Page reference: 115
*b. It would lead to a reduction in the real wage and an increase in employment.
Feedback: Correct. It would represent a move down the labour demand curve to the
right. See Figure 5.8.
Page reference: 115
c. It would lead to a reduction in both the real wage and employment.
Feedback: Incorrect. See Figure 5.8.
Page reference: 115
d. It would have no effect on either the real wage or employment.
Feedback: Incorrect. See Figure 5.8.
Page reference: 115
Question 5
Compared to individual labour supply, aggregate labour supply in an economy
without unions is which ONE of the following?
a. More elastic, because employers prefer to bargain with individual workers.
Feedback: Incorrect. See Figure 5.4,
Page reference: 112
b. Less elastic, because employers prefer to bargain with individual workers.
Feedback: Incorrect. See Figure 5.4.
Page reference: 112
*c. More elastic, because new workers choose to enter the labour force as wages rise.
Feedback: Correct. See Figure 5.4.
Page reference: 112
d. Less elastic, because new workers choose to enter the labour force as wages rise.
Feedback: Incorrect. See Figure 5.4.
Page reference: 112
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Question 6
The steady-state unemployment rate depends [(A)________] on the job separation
rate
and [(B)_________] on the job-finding rate.
a. (A) positively; (B) positively
Feedback: Incorrect. See the equation in section 5.4.
Page reference: 127
*b. (A) positively; (B) negatively
Feedback: Correct. See the equation in section 5.4.
Page reference: 127
c. (A) negatively; (B) positively
Feedback: Incorrect. See the equation in section 5.4.
Page reference: 127
d. (A) negatively; (B) negatively
Feedback: Incorrect. See the equation in section 5.4.
Page reference: 127
Open question: Exercise 1 from the book.
1. See the figure below. The budget line AB shifts upward by AD which is the amount
of the (leisure-invariant) inheritance. The reaction of the household will depend on
preferences, which are described by the indifference curves. If leisure and
consumption are both normal goods, an increase in wealth will be used to enjoy both
more consumption and more leisure relative to point R. The proportion is determined
by the new point of tangency. The lesson: ceteris paribus, richer households work
less. It is important to stress the notion of ceteris paribus -- all other things equal. In
reality, richer households tend also to face higher wages and indeed seem to work
harder (implying the substitution effect is at work), which confounds the pure wealth
effect. For that reason, economists like to examine the effect of windfalls such as
lottery winnings or inheritances – they allow us to separate the two effects, to the
extent the windfall was unanticipated.
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Extra questions: Exercises 2, 6, 9, and 10 from the book.
2. (a) From eight to sixteen hours of leisure, Crusoe’s budget constraint is as in Figure
5.2; from zero to eight, however, it has a slope equal to minus the (higher) overtime
wage. The budget line is kinked upwards. The two segments intersect at eight hours of
leisure. The budget line is no longer a simple straight line, but piecewise and convex
(bowed in towards the origin). See the diagram below. We assume that Crusoe was
working exactly 8 hours before overtime pay was introduced.
(b) Overtime makes him better off in the following weak sense: he can always choose
to ignore the offer of higher overtime pay and continue to work the same number of
hours. He can potentially use overtime to increase his level of utility – note that the
crucial element is not his consumption or income, but how happy he is. That is given
by the position of the difference curve which is attained.
(c) Crusoe will choose to work overtime if he can reach a higher indifference curve.
Optimal behaviour implies that his marginal rate of substitution of consumption for
leisure equals the real wage, given the extra hours worked. Since the overtime wage is
paid only for the additional hours, there will generally be two points of tangency and
thus the crucial criterion is which point has the higher level of utility. Yet if point R
was already optimal at the previous flat wage, a small increment in pay for additional
hours worked is sufficient to induce additional labour supply (how much more is a
different question). It is for this reason that employers like to use overtime pay, not
only for periods of high labour demand, but also during normal times. Overtime pay
shuts down the income effect of a wage increase – since the higher wage only applies
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to marginal and not inframarginal hours. In some labour markets employers combine
higher overtime pay with lower base pay – if workers accept it. The outcome is seen
in the figure below: Crusoe increases labour supply, moving from R to R´.
Would Crusoe ever refuse to work overtime? If he is already at his optimum and there
aren’t any other changes (i.e. the previous base wage is unchanged) he will never
refuse to work a little more. Yet we could imagine a situation in which additional
work involved fixed costs (i.e. missing a ride home or missing dinner with the family)
which might wipe out the utility gain of additional labour supply. (See Problem 3 for
more on this).
6. Early retirement was seen in Europe in the 1980s as a means of reducing labour
supply in the face of rising unemployment, especially when it results from a drop in
labour demand. Politicians argued that it was better to allocate a limited supply of
jobs to young people to keep them attached to the labour market. In the figure below,
the leftward shift in demand is countered by a leftward policy-induced shift in supply,
taking individuals out of the market. In market clearing contexts, this could be seen as
a way of maintaining high wages (compare equilibrium at point C and point B).
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Judging from economic history, however, the “lump-of-labour fallacy” is incorrect.
Recently, the Netherlands proved the point; early retirement and sickness leave were
adopted – with varying degrees of success in reducing the unemployment rate. Yet as
the economy boomed in the early 2000s, serious labour shortages emerged. The lack
of labour available for work resulted in tangible losses of potential output. In the end,
early retirement is a largely cosmetic measure, because those who are removed from
the working population must receive compensation for leaving the labour force – a
retirement pension or disability benefits – and these measures must be paid for. That
money comes from those working, in the form of higher taxes. Higher taxes, which
increase the costs of labour to employers, are likely to reduce the demand for labour.
9. Migration can be seen as an increase in labour supply is shown in the figure below,
patterned after the second panel of Figure 5.8 or Figure 5.12 in the text. In the case of
flexible wages, the result of migration is an increase in equilibrium employment
(more hours are worked) and a fall in the equilibrium real wage. Some native workers
may even leave the labour force, raising voluntary unemployment and making room
for more migrant workers. If the real wage is rigid and above the equilibrium wage as
in Figure 5.12, there is simply more involuntary unemployment. Do migrants cause
unemployment, then? Yes and no. mechanically yes, but the true cause of
unemployment is wage rigidity, not the entry of new workers into the labour force.
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10. A technological innovation which raises the marginal product of labour (MPL)
will shift the labour demand curve out at every wage. With an upward-sloping labor
supply curve, wages rise (left panel). If wages are rigid, employment rises more (right
panel).
In the case of labour saving technical progress, the same level of labour implies a
lower MPL, and labour demand curve shifts back at any wage. A labour market with
flexible wages results in a sharper drop in equilibrium wages but a more modest drop
in employment, whereas a rigid wage labour market implies a sharper drop in
employment. We could infer from this that while labour-saving technical progress is
always bad from the perspective of the union, different unions will react differently to
it – a “wages-first” union will be willing to accept large drops in employment,
whereby employment-sensitive unions would rather accept larger wage reductions to
preserve employment.
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Chapter 6: Money, prices, and exchange rates in the long run
Multiple choice questions
Question 1
Assume that real GDP is growing at a constant A per cent per year and that the
nominal money supply is growing at a constant rate of B per cent per year: in the long
run, we would expect the inflation rate to be equal to C per cent. Which ONE of the
following combinations would you expect to hold?
Feedback: See the discussion preceding Table 6.1.
Page reference: 144, 145
The correct answer is b.
Question 2
Suppose that the nominal exchange rate has depreciated at a rate of 10 per cent per
year and the domestic inflation rate has been 9 per cent per year, while the foreign
inflation rate has been equal to 12 per cent per year. From this information, which
ONE of the following would be true of the real exchange rate?
Feedback: The appreciation rate of the real exchange rate is equal to the sum of the
appreciation of the nominal exchange rate plus our country’s inflation rate differential
with respect to foreign.
Page reference: 147
The correct answer is a.
Question 3
The diagram above illustrates two money market equilibria for the long run according
to the Cambridge equation for money demand. Which of the following interpretations
of the figure is consistent with the theory?
a. Income has increased from period 1 to period 2, resulting in a corresponding
increase in the price level.
Feedback: Incorrect. Note that line D has not rotated! This answer confuses income,
a flow, and the supply of money, a stock. See Figure 6.4.
Page reference: 143
*b. The stock of money has increased from period 1 to period 2, resulting in an
increase in the price level.
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Feedback: Correct. See Figure 6.4.
Page reference: 143
c. The price level has increased from period 1 to period 2, resulting in an increase in
the money stock.
Feedback: Incorrect. See Figure 6.4.
Page reference: 143
d. Both the price level and the stock of money have increased from period 1 to period
2 in response to economic growth (i.e. Y has increased from period 1 to period 2).
Feedback: Incorrect. Were this true, then the D would have rotated counter
clockwise. See Figure 6.4.
Page reference: 143
Question 4
First express the prices of the different cars in European euros by dividing the price in
local currency by the amount of foreign currency per European euro. The last column
of the table below gives the prices of the different cars in European euros. It can be
seen that the Hyundai is the cheapest car.
Prices in local
Local currency per Prices in European
currency
euro
euro
Chevrolet
23000
1.25
18400
Volkswagen
15900
1.00
15900
Honda
2200000
132.50
16604
Hyundai
22000000
1401.13
15702
If the Korean won appreciates, the Hyundai car becomes relatively more expensive. If
for example the Korean won appreciates to 1350 won per euro (i.e., less won has to be
paid to buy one euro), the Hyundai (22 million/1350=16296) becomes more
expensive than the Volkswagen (15900 euro).
The correct answer is D.
Extra questions: Exercises 2 and 5 from the book.
2. For a given nominal exchange rate and foreign prices, a doubling of the domestic
price level results in the doubling (appreciation) of the real exchange rate (as P
increases to 2P, σ = SP/P* increases to 2SP/P* = 2σ). Similarly, all other things
given, an increase of S to 2S also means a doubling of the real exchange rate. A
doubling in foreign prices on the other hand implies a 50% depreciation (σ = SP/P*
falls to SP/2P* = σ/2).
5. From equation (6.5), holding k constant, we have π =
annual inflation rate of 2.5%. Then (6.8) says
ΔM Δ Y
. This implies an
M
Y
Δσ Δ S
=
+ π - π* = 0 or
σ
S
ΔS Δσ
=
+ π * - π = 0 . Noting that π* = 3.5%, when σ is constant, the exchange rate
S
σ
appreciates by 1% per year.
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