A closed economy

Question 2 (25 points) – Chapter 3

A closed economy can be described by the long-run classical

model:

Y = 4Kla‘3L2f‘3

C = 6440 + 0.8(Y – T) – 80or

I = 3000 – 20or

MPK = K* 2”L”3 MPL = K“3L”“3

In this economy, there are two productive factors, K and L and

both factor inputs are fully employed. The stock of capital and

the supply of labour are equal to 8000 and 3375 respectively.
Initially, the government collects one-tenth of the long-run level
of output from households as taxes and it runs a budget surplus

of 200.

Note: r represents the real interest rate and is measured in

percentage points (for example, if r = 10, then this is interpreted

as r = 10%). Keep your answers to 4 decimal points if needed.

a) Compute the long-run equilibrium levels of consumption,
national savings and real interest rate. Also, find the long-run
equilibrium real wage for labour and real rental price of
capital. (5 points).

a) According to the long-run classical model, what happens to the
equilibrium levels of output, real interest rate, and investment
happens to the real wage in Canada? Explain your answer
with the aid of TWQ diagrams one for the loanablc funds
market and one for the labour market. (10 points)

b) (Continued from part a) As time passes (i.e., in the very long
run which will be 10-15 years from now), what happens to the
stocks of productive inputs in Canada? How would this
change in the stocks of productive inputs affect the
equilibrium levels of output and real interest rate in Canada?

What happens to the real wage in Canada? Explain, and
support your answer by a new set of loanable funds market
and one for the labour market diagrams (15 points)

Question 4 (25 points) – Chapters 7 & ‘7

Consider an economy that is characterized by the Solow Model.

The (aggregate) production function is given by:

Y = I4K””‘L3M

Note: Keep your answer to mm if needed. Be sure

to show your work.

In this economy, workers consume 85% of income and save the

rest. The labour force is growing at 3.5% per year while the

annual rate of capital depreciation is 7%.

Initially, the economy is endowed with 2250 units of capital and

200 workers.

a) Is the economy in its steady state? Yes/no, explain why or
why not. If the economy is not in its steady state, explain
what happens to the capital-labour ratio and output per worker
in the economy during very long-run transition. (10 points) 