2.Consider now the full intertemporal model in which in addition to the goods and labour markets, the money market also clears. The supply of money is determined exogenously by the central bank. The demand for real money balances of consumers and firms is given byMd=L(Y,R), which depends positively on real incomeY(transac- tion motive) and negatively on the nominal interest rateR(opportunity cost of holding money). For this question assume that firms and consumers receive the safe interest raterwhen lending, but have to repay the risky raterl=r+xwhen borrowing. Note thatxis the default premium, that captures perceived credit market uncertainty. The economy is initially in long-run equilibrium. Suppose that a pessimism shock hits the economy, whereby credit market uncertaintyxincreases today,andTFP in the futurezis expected to fall.

12 marks) How will the simultaneous increase inxand decrease inzaffect the current equilibrium values of the price level, consumption, investment, the real interest rates (safe and risky), aggregate output, employment, and the real wage?

(b)(7 marks) Suppose that in response to the negative shock in (a) the government increases the money supply (known to agents) by an amount Min order to boost employment and output. Using diagrams analyze the equilibrium effects of this policy (in combination with the negative joint shock in (a)) on the price level, consumption, investment, the real interest rates (safe and risky), aggregate output, employment, and the real wage. Is the policy effective in increasing employment and output?

(c)(7 marks) How would your answer to part (b) change if agentsdid not observe(know) that the increase inMhas taken place? Analyze the effects of the unantic- ipated increase inMin the context of the Lucas-Friedman imperfect information model.