1. Business cycles with a systematic response of monetary policy to changes in real GDP: [30 marks] Suppose there is bad news about the prospects for future income growth. Households react to this by increasing their desired level of saving. This is done by cutting consumption demand, and also by increasing labour supply to try to earn more now. Firms react to the news by reducing investment demand. Using the New Keynesian model with completely sticky prices, and assuming the central bank passively sets a constant interest rate, what effect does the bad news have on current output and employment? Suppose the central bank were to raise or lower interest rates automatically in the same direction as any changes in real GDP. How would this affect the shape of the MM line in the goods-market diagram of the New Keynesian model? How do the effects of the bad news change compare to your earlier answers? 2. Stabilization policy following a financial shock: [70 marks] Consider the New Keynesian model with completely sticky goods prices. Wages are flexible and adjust so demand equals supply in the labour market, which implies the real wage is equal to households' marginal rate of substitution between leisure and consumption, that is, w = MRS .. Assume all households are alike and have a demand for consumption that depends negatively on real interest rate r and which satisfies the equation MRS; . = 1 + r. In equilibrium, households are savers. Firms must borrow to finance investment at interest rate 77, so investment is determined by MP, d = 1;, where M Py d is the future marginal product of capital net of depreciation. There is a spread x = r; r between the interest rate 7; paid by borrowers and the interest rate r received by savers. Suppose a financial crisis leads to a higher interest-rate spread x (for example, because lenders expect more defaults in the future). (a) [20 marks] What is the effect of a higher interest-rate spread x on the output demand curve Y%? Assuming the stance of monetary policy remains unchanged (a horizontal MM line with a constant nominal and real interest rate 1), what happens to real GDP Y and employment N? Suppose the central bank adjusts monetary policy to close the gap between actual GDP and the 'natural level of output' (GDP if prices were fully flexible) after the shock to x. (b) [20 marks] Show in a diagram what adjustment of the real interest rate r is required for this. After the increase in x and the monetary policy response, what are the overall effects on Y, 17, consumption C, and investment I? (c) [15 marks] Explain why the monetary policy response in part (b) benefits households by getting closer to a level of employment where MPy = MRS, .. The condition MPy = MRS, describes the optimal level of employment and production in the economy. An optimal allocation of resources between consumption and investment requires MPyr d = MRS . 1, which says that the net return on capital investment is equal to the extra future consumption households require so as not to be worse off by delaying consumption. (d) [15 marks] Explain why the financial crisis leads to a more inefficient allocation of resources between consumption and investment. Does the monetary policy response you found in part (b) help to fix this