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Housing Wealth. In 2008 the housing market crashed, which lead to a large fall in household wealth as home prices fell but mortgage debt remained...

3.1.

Housing Wealth.

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

interest rate?

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