1 Problem Set 1 1.1 I 8, LM, AD, and equilibrium in the very short run (VSR) [= Blanchard's \"short run\"] due by March 29 (Tue) Consider four kinds of exogenous changes in the macroeconomy: (I) Consumer pessimism (or loss of consumer condence). (II) Investor pessimism (or loss of investor condence). [m: By \"investor,\" we mean those who invest in physical capital (e.g., machines and equipment) rather than in nancial securities (e.g., bonds). In other words, we are talking about \"real\" (rather than \"nancial\") investors here] (III) Expecting a downturn in the bond market, people decide to reduce their bond-holding. (IV) The central bank decides to print and supply 5% more money to the economy (say, via open market purchase of government bonds). Assume that the central bank uses money supply (rather than interest rate) as its policy instrument (i.e., M -policy), so that the LM curve is upward-sloping and the corre- sponding AD curve is downward-sloping. In each of the above cases, explain how I 5', LM, and AD may be aifected. In other words, 1. Explain whether and in which direction each of the building blocks of AD visa, supply of loanable funds (5 = S) , demand for loanable funds (Ed = I) , money supply (m5 = Ag) , money demand (1nd) , as well as I S and LM and the aggregate demand (AD) curve itself may shift in response to each of the exogenous changes above. 2. Then explain how the (very short run) equilibrium values of output (Y), real interest rate (r), nominal interest rate (R), consumption (0), saving (5'), investment (I), loanable funds () , and real balance (m) would change as a result. 3. For Cases (I), (II) , and (III) , how would you revise your answers to the 2 questions above if the central bank adopts interest rate as its policy instrument (i.e., R-policy), so that the LM curve is a horizontal line and the corresponding AD curve is a vertical line