Explain what it means for production to exhibit constant returns to scale. Assum

Question

Explain what it means for production to exhibit constant returns to scale. Assume the economy is hit by an adverse aggregate demand shock. To stabilize output and employment the Central Bank should: Lower real interest rates Increase real interest rates Central Bank cannot do anything in this case, government should increase its spending All of the above e. None of the above Most available evidence suggest foreign aid has been ineffective in raising rates of economic growth in poor countries. Because of this rich countries should stop aiding poor ones. Discuss. The economy has the following production function: Y = A K^1/4L^2/3 where K is capital, L is labor and A is technology. This production function exhibits Constant returns to scale Increasing returns to scale Decreasing returns to scale Variable returns to scale None of the above

Explanation / Answer

1)

A production function is said to exhibit constant returns to scale if the output is increased in the same proportion in which the inputs are increased. Assume a production function F = K^1/2L^1/2 that uses two different inputs (factors): capital (K) and labor (L). Assume that each input is increased by a constant fraction a:

F = (aK)^1/2(aL)^1/2

F = a^1/2K^1/2a^1/2L^1/2

F = aK^1/2L^1/2

F = aF

Since the output Y also increases by the same constant fraction a, it can be concluded that the given production function displays constant returns to scale. Another method is to add the output elasticities. If they add upto 1, then the production function displays constant returns to scale.

2) In case of demand shock, AD shifts to the left, real income, output and employment all fall. A central bank should adopt monetary expansion. When the central bank increases the money supply, money market becomes out of equilibrium. Interest rate falls to restore the equilibrium, to a new level of money demand. This shifts the LM curve to the right. A fall in the interest rate stimulates investment spending and thus Aggregate Demand.

Hence, the correct option is A.

3) There are reasons ranging from corruption, poor management, creeping inequalities to inefficiency and lack of technical skills that make us believe that poor nations squander all the financial help they receive. But its is unreasonable to conclude that rich nations should not help them out.

There was a time when rich nations were also suffering from these problems.They should view this situation in terms of their own historical backdrop and continue to help their poor counterparts

4) As mentioned, the sum of output elasticites is 1/4 + 2/3 = 11/12 which is less than 1. This implies that the production function displays diminishing returns to scale.

Hence the correct option is C

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