In 2008 the housing market crashed, which lead to a large fall in
household wealth as home prices fell but mortgage debt remained constant. In our models,
this would be like reducing the wealth parameter of households (ais the variable we have
used). This question has you think through the effects of such a decline in wealth.
(1) Consider the labor market effects of this change in wealth in the labor market in
the short run when prices are fixed (i.e. the Keynesian short-run model). Assume
that, due to efficiency wages, the labor market does not clear fully. What happens
to GDP in the short-run? What about unemployment (i.e. the amount of labor
supply in excess of demand)?
(2) We also learned how a change in wealth affects the household's consumption and
savings decision. For the next part, show how this decrease in wealth affects the
equilibrium of the investment and savings market and the IS curve. First assume
that the price can adjust immediately as in the classical model, show how to shift
the LM curve using the money market diagram. What happens to GDP? Prices?
(3) Reconsider part (2) above but in the Keynesian short-run when prices cannot ad-
just. Again, fully explain how you move along the LM curve using the money
market diagram. What happens to GDP?
(4) Now combine the two effects in the short-run. What happens to GDP and the real
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