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# solhmk5 - Econ 73-200 Fall 2008 Prof Daniele Coen-Pirani...

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Econ 73-200 Fall 2008 Prof. Daniele Coen-Pirani Suggested Solution Problem Set #5 As indicated on Blackboard, this problem set is due on Friday, November 21, at the end of your recitation session. Please consult the syllabus on the policy for homework assignments handed in late. There are three questions on the homework worth a total of 100 points. The points assigned to each part of each question are indicated in brackets. Please staple the sheets of your homework together (I decline responsibility for missing homework sheets, if not stapled). You may work together to solve the exercises, but must write your own answers (in your own words) to each problem. Exercise #1 [34 pts.]. Use the standard graphs for the labor market equilibrium, the production function, and the desired saving-desired investment curves (closed economy) to evaluate the e/ect of a drop in consumer con°dence on output, employment, consumption, and investment. By ±consumer con°dence²I mean a drop in consumers³demand for con- sumption goods for each level of income and the interest rate. In answering these questions consider the two di/erent models you are familiar with: (a) [8 pts.] The classical model according to which all prices are perfectly ´exible, so that desired markups are always equal to actual markups. See Figure 1: the economy moves from A to B in the graph of desired saving and invest- ment. In the classical model (or, equivalently, in the long-run), the desired saving curve will move to the right (from S 0 to S 1 for given Y 0 ), driving down the real interest rate from r 0 to r 1 . Consumption will drop but investment will increase. Output and employment do not change. (b) [10 pts.] The Keynesian model according to which output prices are ±sticky²so that desired markups are not always equal to actual ones. When evaluating the e/ect of the drop in consumer con°dence on the economy³s equilibrium assume that the Fed keeps the real interest rate constant at the level corresponding to the intersection of the original desired investment and saving curves.

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