Consider a consumer who consumes only 
and 
. The price of 
falls.
a. On a graph
with 
on the horizontal and 
on the vertical axis, illustrate the change in this consumer's budget constraint assuming exogenous income I.
b. Illustrate income and substitution effects for 
assuming that both goods are normal.
c. Can you tell whether the cross-price demand curve for 
is upward or downward sloping?
d. Suppose 
is leisure hours and 
is a composite consumption good. Consider an increase in the wage assuming a fixed endowment of leisure (and no exogenous source of income). How is your graph similar and how is it different from what you graphed in (a) through (c)?
e. Is the leisure-demand curve a cross-price demand curve? Why or why not?
What will be an ideal response?
b. The substitution effect is indicated in each of the top panels --- the income effect points in the opposite direction. On the vertical axis, the income effect implies C must lie above B.
c. No -- it depends on how large the substitution effect is relative to the income effect (as shown in the graphs).
d. The top graphs would be identical. But the bottom graphs are not -- because the wage appears on the vertical axis, and the wage is not the same as the price of consumption.
e. Not quite. The wage is not the price of consumption -- the good on the vertical axis in the top panels. Rather, the wage is the price of leisure. The models differ in that there is an exogenous income in the first case and an endogenous budget (derived from the leisure endowment) in the second case. But, when viewed as if the leisure demand curve arose from a model with exogenous income, an increase in the wage looks like a decrease in the price of consumption.
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When the LM curve is horizontal,
A) fiscal policy has no impact on equilibrium income. B) fiscal policy has no impact on the equilibrium interest rate. C) the economy is at full employment. D) monetary policy has no impact on equilibrium income.
The economy pictured in the figure has a(n) ________ gap with a short-run equilibrium combination of inflation and output indicated by point ________. 
A. recessionary; A B. recessionary; C C. recessionary; B D. expansionary; A