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York University
ECON 2400

Instructors Manual for Macroeconomics Fourth Canadian EditionTEXTBOOK QUESTION SOLUTIONSProblems1 Although we often think about the negative externalities of congestion and pollution in cities there may also be some positive externalities A concentrated population is better able to support the arts professional sports etc cities typically have a greater variety of good restaurants and so forth Perhaps a more basic issue is that there may be some increasing returns to scale at low output levels that make industrial production more costly in small towns There may also be externalities in production in being located close to other producersOne example would be the financial industry in financial centres like New York London and Tokyo Another example would be large city medical centres that enhance coordination between primary physicians and specialistsOne market test of whether productivity is higher in cities would be to look at the wages in cities versus the wages in smaller towns and rural areas Wages are often higher in cities for individuals of comparable skills Market efficiency suggests that the higher wages are reflective of a higher marginal product of labour and that the higher wages compensate those choosing to live in cities for the negative externalities they face2 In a one period model taxes must be exactly equal to government spending A reduction in taxes is therefore equivalent to a reduction in government spending This result is exactly the opposite of the case of an increase in government spending presented in the textbook A reduction in government spending induces a pure income effect that induces the consumer to consume more and work less At lower employment the equilibrium real wage is higher because the marginal product of labour rises when employment falls Output falls consumption rises employment falls and the real wage rises3 A reduction in the capital stockaThis works exactly the same as for the increase in total factor productivity in Figures 59 and 510 except in reverse that is the PPF shifts down Output falls employment may rise or fall because of offsetting income and substitution effects leisure may rise or fall likewise consumption falls and the real wage fallsbShocks to the capital stock qualitatively could replicate key business cycle facts provided that the substitution effect on labour supply dominates However for Canada over the last 50 years for example the kinds of natural disasters or other capitalstockdestroying events that have occurred have typically had very small effects on the aggregate capital stock This is not to say that such large disasters are impossible or could not happen in the future Copyright2013 Pearson Canada Inc 52
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