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PP4 - Practice Problems on the Capital Market 1 Define...

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Practice Problems on the Capital Market 1- Define marginal product of capital (i.e., MPK) . How can the MPK be shown graphically? The marginal product of capital ( MPK ) is the output produced per unit of additional capital. The MPK can be shown graphically using the production function. For a fixed level of labor, plot the output provided by different levels of capital; this is the production function. The MKP is just the slope of the production function. 2- What effect does a temporary increase in government purchases- for example, to fight a war- have on desired consumption and desired national saving, for a constant level of output? When government purchases increase temporarily, consumers see that higher taxes will be required in the future to pay off the deficit. They reduce both current consumption and future consumption, but current consumption declines by less than the amount of the government purchases. Since national saving is output minus desired consumption minus government purchases, and government purchases have increased more than current desired consumption has decreased, national saving declines at a given real interest rate. 3- What is the desired capital stock? How does it depend on the expected future marginal product of capital? The desired capital stock is the amount of capital that allows the firm to earn the largest possible profit. The higher the expected future marginal product of capital, the higher the desired capital stock, since any given amount of capital will be more productive in the future. The higher the user cost of capital, the lower the desired capital stock, since a higher user cost yields lower profits on each unit of capital. The higher the effective tax rate, the lower the desired capital stock, again because the firm gets lower profits on each unit of capital. 4- What is the difference between gross investment and net investment? Can gross investment be positive when net investment is negative? Gross investment represents the total purchase or construction of new capital goods that takes place during a period. Net investment is gross investment minus the depreciation on existing capital. Thus net investment is the overall increase in the capital stock. Yes, it is possible for gross investment to be positive when net investment is negative. This occurs whenever gross investment is less than the amount of depreciation (and, in fact, happened in the United States during World War II).
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