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psoln3 - Professor S McCafferty Practice Problems III...

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Professor S. McCafferty Practice Problems III: Solutions 1. For the purposes of this question, assume that a typical business cycle contraction includes all of the following phenomena: 1.) Reduced Real Output 2.) Reduced Consumption 3.) Reduced Investment 4.) Reduced Real Interest Rate 5.) Reduced Employment of Labor Services 6.) Reduced Real Wage Rate 7.) Reduced Average Labor Productivity Assume a standard classical macroeconomic model in which there is complete information. Can a temporary reduction in government spending explain all of these phenomena? YES If you answered no, please circle those changes that are INCONSISTENT with the proposed explanation. 1.) Real GDP falls The reduction in government spending has a wealth effect that makes people more well- off, due to lower lifetime taxes. Therefore they can increase consumption in the present, increase consumption in the future, and reduce labor supply. The positive wealth effect plus the added stimulation of consumption spending due to a lower real interest rate both work in the direction of increased current consumption. 4.) Real Interest Rate falls 5.) Employment falls NO 6.) Real Wage Rate falls 2.) Consumption falls 3.) Investment falls
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Next, carefully explain how it is that this disturbance is inconsistent with the circled phenomena. In answering this question it may be useful to use the diagrams below. N Y r S, I r 0 Y AF N K = ( , ) 2 7.) Labor Productivity falls NS ND 1 N w 1 w N d S d I r 1 r 1 1 I S = I S ,
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2. For the purposes of this question, assume that a typical business cycle contraction includes all of the following phenomena: 1.) Reduced Real Output 2.) Reduced Consumption 3.) Reduced Investment 4.) Reduced Real Interest Rate 5.) Reduced Employment of Labor Services 6.) Reduced Real Wage Rate 7.) Reduced Average Labor Productivity Assume a Keynesian macroeconomic model in which there may be excess supply of output and temporarily fixed prices. Also assume that the nominal money supply and government fiscal policies are both fixed. Can a negative shock to the expected future marginal product of capital explain all of these phenomena?
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