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ECON 104
HOMEWORK #10 (100 points total)
1.(35 points total) We discussed the idea of crowding out and why it occurs. In this problem we are considering two scenarios: Scenario 1: G rises and the Fed does not accommodate the shock to money demand. Scenario 2: G rises and the Fed accommodates the shock to money demand, as they would if they were committed to the zero bound. a.(10 points for each correct and completely labeled diagram). Draw three diagrams side by side. On the left, draw a consumption function, in the middle, draw a money market diagram, and on the right, draw an investment demand function. Locate the initial equilibrium as point A, labeling the relevant values using subscript A as in the level of consumption at point A as CA, the level of interest rates as iA, etc.Scenario 1:G rises, no accommodation by the Fed, locate the new equilibrium as point B on all three diagrams, being sure to label your diagrams completely. Show and explain the crowding out that Barro discusses in the "Government Spending is no Free Lunch" article. In particular, we are assuming total crowding so that Y does not change, along with the assumption of a closed economy. Be sure to explicitly identify the crowding out on the consumption function and investment demand functions that you drew above.Scenario 2:G rises, the fed completely accommodates the shock to money demand so that interest rates remain unchanged (identical to the Romer assumption). Show this development as point C on all three diagrams.