325_Fall2010_MidtermExamSolutions

325_Fall2010_MidtermExamSolutions - Department of Economics...

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Department of Economics University of Maryland Economics 325 Intermediate Macroeconomic Analysis Midterm Exam – Suggested Solutions Professor Sanjay Chugh Fall 2010 NAME: Each problem’s total number of points is shown below. Your solutions should consist of some appropriate combination of mathematical analysis, graphical analysis, logical analysis, and economic intuition, but in no case do solutions need to be exceptionally long. Your solutions should get straight to the point – solutions with irrelevant discussions and derivations will be penalized. You are to answer all questions in the spaces provided. You may use one page (double-sided) of notes. You may not use a calculator. TOTAL PART 1 / 50 TOTAL PART 2 / 50 TOTAL / 100

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1 Problem 1: European and U.S. Consumption-Leisure Choices (20 points). Europeans work fewer hours than Americans. There are likely very many possible reasons for this, and indeed in reality this fact arises from a combination of many reasons. In this question, you will consider two reasons using the simple (one-period) consumption-leisure model. a. (10 points) Suppose that both the utility functions and pre-tax real wages / WP of American and European individuals are identical. However, the labor income tax rate in Europe is higher than in America. In a single carefully-labeled indifference-curve/budget constraint diagram (with consumption on the vertical axis and leisure on the horizontal axis), show how it can be the case that Europeans work fewer hours than Americans. Provide any explanation of your diagram that is needed. Solution: If Europeans work fewer hours than Americans, then Europeans have more leisure time than Americans, simply because (in our weekly framework) 168 nl ± . Europeans and Americans have identical utility functions, which means that their indifference maps are identical. This means that the difference in hours worked must arise completely from differences in their budget constraints. With a higher labor income tax in Europe, the budget constraint of the European consumer is less steep than the budget constraint of the American, as the diagram below shows (because the slope of the budget constraint is (1 ) / tW P ² , and you are given that / is the same in the two countries). The diagram shows that the European optimally chooses more leisure (hence less labor) and less consumption than the American. Here, the difference between Europeans and Americans is solely in the relative prices (embodied by the slope of the budget constraint) they face. (For full credit here, you had to somehow make clear that the indifference maps of the representative European and the representative American are identical.) consumption leisure Optimal choice of European 168 European’s budget constraint American’s budget constraint Optimal choice of American
2 Problem 1 continued.

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This document was uploaded on 11/01/2011 for the course ECON 325 at Maryland.

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325_Fall2010_MidtermExamSolutions - Department of Economics...

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