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Solution_to_Simulated_Prelim2 - Solution To Simulated...

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Solution To Simulated Prelim 2 (1) (b) Explanation: (a)The willingness of the banks to lend will not shift the IS curve (b) The willingness of the banks to lend is reduced because of the uncertainty in the financial market. That will shrink the real balance supply. So the LM curve will shift upward. (c) The reduced willingness to spend of the households will shift the IS curve to the left. (d) and (e) are incorrect because of the above explanation.
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(2) (a) Explanation(This is given by Professor Wan): Problem 2 relates to Lucas’ paper, in particular Section VIII. Statement (a) is correct. It says only if business cycles are recurrent, individuals can form rational expectations from past observations, about what does a rise in the unit money price of one’s own product mean. By this process of signal extraction, the individual guesses the likelihood that there is a temporary rise of that price relative to the general price level, and increase output accordingly. Only then, if the true cause is actually a rise
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