Department of Applied Economics Johns Hopkins UniversityEconomics 602 Macroeconomic Theory and Policy Midterm Exam – Suggested Solutions Professor Sanjay Chugh Fall 2010 NAME: The Exam has a total of four (4) problems and pages numbered one (1) through six (6). 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 notuse a calculator. Problem 1 / 20 Problem 2 / 30 Problem 3 / 25 Problem 4 / 25 TOTAL / 100

1Problem 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 /WPof 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) 168nl+=. 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)/t WP−, and you are given that /WPis 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.) consumptionleisureOptimal choice of European168European’s budget constraintAmerican’s budget constraintOptimal choice of American

2Problem 1 continued.