1.- In this question, you will put into practice your knowledge of the effects of the fiscal policy. Consider the US economy in the context of the two-period model with investment and government. We will model the effects of the COVID-19 pandemic on the US economy and evaluate the effect of government intervention. Answer the following question that will guide you along the way.

Suppose that the COVID-19 pandemic negatively affected the TFP of the US economy. How does this affect labor demand and why? Draw a diagram to help yourself to understand your answer. Hint: Remember that the labor demand is determined by the marginal product of labor,MPL=?N?zF(K,N)?

A) With the reduction of the TFP, workers are less productive, so firms reduce the current demand for labor, which lowers the market real wage. This is represented graphically as the labor demand shifts to the left.

B) With the reduction of the TFP, workers are less productive, so firms need to hire more workers to maintain the same level of production, which increases the market real wage. This is represented graphically as the labor demand shifts to the right.

C) With the reduction of the TFP, workers are less productive, so firms need to hire more workers to maintain the same level of production, which decreases the market real wage. This is represented graphically as the labor demand shifts to the right.

D) With the reduction of the TFP, workers are less productive, so firms reduce the current demand for labor, which increases the market real wage. This is represented graphically as the labor demand shifts to the left.

2.- Consider the same context as in the previous question.

Will the labor market clear to this change in labor demand? In other words, will labor supply respond accordingly, and why?

A) Yes, the market will clear because the reduction of labor demand will lower real wages. In response, workers will offer less labor because they will be willing to work less at lower wages. Instead, they will prefer to consume leisure. Remember that we are assuming that the substitution effect more than compensates the income effect.

B) Yes, the market will clear because the reduction of labor demand will increase real wages. In response, workers will offer more labor because they will be willing to work more at higher wages. Instead, they will prefer to consume less leisure. Remember that we are assuming that the substitution effect more than compensates the income effect.

C)No, the market will not clear, which implies that there will be unemployment.

D) No, the market will not clear, which implies that there will be an excess demand for workers.

3.- Continue considering the context from the previous questions.

How does the decrease in TFP affect output and interest rate? Draw a diagram to help yourself understand your answer. Hint: There are no shifts of the output demand curve, the only curve that shifts is the output supply, but an equilibrium is met, why?

A) The negative shock to the TFP shifts the output supply to the left. This shift is consistent with a higher interest rate. To this higher interest rate, the output demand responds accordingly with less investment and less consumption, having a new equilibrium.

B) The negative shock to the TFP shifts the output supply to the right. This shift is consistent with a lower interest rate. To this lower interest rate, the output demand responds accordingly with more investment and more consumption, having a new equilibrium.

C) The negative shock to the TFP shifts the output supply to the right. This shift is consistent with a lower interest rate. To this lower interest rate, the output demand responds accordingly with less investment and less consumption, having a new equilibrium.

D) The negative shock to the TFP shifts the output supply to the left. This shift is consistent with a higher interest rate. To this higher interest rate, the output demand responds accordingly with more investment and more consumption, having a new equilibrium.

4.- If you found an effect on the interest rate, in the previous question, how does this affect labor supply and why?

A) With a higher interest rate, consumers increase their labor supply because they substitute current for future leisure.

B)With a higher interest rate, consumers decrease their labor supply because they substitute current for future leisure.

C) With a lower interest rate, consumers increase their labor supply because they substitute current for future leisure.

D) With a lower interest rate, consumers lower their labor supply because they substitute current for future leisure.

5.- Now suppose that after reaching this new equilibrium, the government responds by increasing government spending, G. How does this policy affect the output demand curve and the labor supply, and why? Draw a diagram to help yourself understand your answer.

A) As government spending is a component of output demand, more spending means more output, shifting the output demand curve to the right. However, this translates into a higher interest rate. Consumers respond by working more today, shifting the labor supply curve to the right, which also lowers wages to clear the market.

B) As government spending is a component of output demand, more spending means more output, shifting the output demand curve to the right. However, this translates into a higher interest rate. Consumers respond by working less today, shifting the labor supply curve to the left, which also increases wages to clear the market.

C) As government spending is a component of output demand, more spending means more output, shifting the output demand curve to the right. However, this translates into a lower interest rate. Consumers respond by working more today, shifting the labor supply curve to the right, which also lowers wages to clear the market.

D) As government spending is a component of output demand, more spending means more output, shifting the output demand curve to the right. However, this translates into a lower interest rate. Consumers respond by working less today, shifting the labor supply curve to the left, which also increases wages to clear the market.

6.- Consider the previous context.

How do changes in labor supply affect the output supply curve and the interest rate? Draw a diagram to help yourself understand your answer.

A) The increase in labor supply shifts the output supply curve to the right, lowering the interest rate

B) The increase in labor supply shifts the output supply curve to the right, increasing the interest rate

C) The reduction in labor supply shifts the output supply curve to the left, increasing the interest rate

D) The reduction in labor supply shifts the output supply curve to the left, lowering the interest rate

7.- After the change in output supply, is the interest rate still higher than the equilibrium after the COVID-19 shock? Why? Does the final effect on the interest rate translate into additional changes in labor supply? Explain

A) It is still higher, this is because the temporary increase in government spending should lead to only a small decrease in lifetime wealth for the consumer, which will produce a small effect on labor supply and, ultimately, a small shift of the output supply curve. Hence, this higher interest rate increases even more the labor supply, which is represented by an additional shift to the right of the labor supply curve.

B) It is still higher, this is because the temporary increase in government spending should lead to only a small decrease in lifetime wealth for the consumer, which will produce a small effect on labor supply and, ultimately, a small shift of the output supply curve. Hence, this higher interest rate reduces even more the labor supply, which is represented by an additional shift to the left of the labor supply curve.

C) It is lower, this is because the temporary increase in government spending should lead to only a small decrease in lifetime wealth for the consumer, which will produce a small effect on labor supply and, ultimately, a small shift of the output supply curve. Hence, this higher interest rate reduces even more the labor supply, which is represented by an additional shift to the left of the labor supply curve.

D) It is lower, this is because the temporary increase in government spending should lead to only a small decrease in lifetime wealth for the consumer, which will produce a small effect on labor supply and, ultimately, a small shift of the output supply curve. Hence, this higher interest rate increases even more the labor supply, which is represented by an additional shift to the right of the labor supply curve.

Let's break it down: 1. Initial Assertion: "The temporary increase in government spending should lead to only a small decrease in lifetime wealth for the consumer." 2. Consequence Claim: "This [temporary increase in government spending] higher interest rate increases even more the labor supply, which is represented by an additional shift to the right of the labor supply curve." However, in economic theory, an increase in interest rates typically leads to a decrease in labor supply, as higher interest rates make saving more attractive than spending and discourage borrowing for consumption or investment. Therefore, the claim that higher interest rates would lead to an increase in labor supply seems counterintuitive