Consider a simple financial market for a closed economy with government, such as might be crudely representative of the world as a whole.

a) Construct a diagram to represent this market and note and explain your choice of the variables on the vertical and horizontal axes.

b) Draw the saving supply curve and the investment demand curve, indicating and explaining which variables shift them to the right and left and why.

c) Imagine that this market faces simultaneous pessimism shocks. There are declines in what level of future income is expected by households and in the net rate of return on new physical capital that is expected by investors. Illustrate and explain how these shocks change the diagram and how you would expect the yield on long maturity assets to change.

d) Then use your diagram to further explain how this result might be affected in the short run by a rise in government spending, and hence a decline in government saving or an increase in sovereign debt.