individually explaining how and why we get to point B (i.e., provide intuitive economic reasoning starting with how a lower 1' effects K\" and why)!). b) (20 POINTS) Now we are going to focus on the idea that in the longer run, the inuence of the decrease in the effective tax rate on capital will have 'supply-side' effects. [1'1 particular, argue that this new investment, spurred on by the lower effective tax rate on capital, will result in a positive productivity shock resulting in a higher "A and K" which will result in a shift upward in the production function (via increasing the MPKf and MPN!) In the space below draw a production function with the labor market diagram below it and show what is going on in this longer run. That is, locate the corresponding point B (from above), and then show the longer run inuence as point C in these two (supply - side) diagrams. What happens to N" and w*=W/P? Explain in detail. Are these results in the labor market consistent with the business cycle facts? Now explain why output has changed, give two specic reasons. Note, in this part of the problem, do not worry about identifying point A in the labor market diagram and production function diagram since point A does not exist given the assumption that labor markets always clear at full employment (i.e., a weakness of the classical model). Be sure to label your graphs completely or points will be taken off. c) (20 POINTS) Now show how graphs 1) through 4) are inuenced by this longer-run development. Note again that we assume that before these longer run developments take hold, the FE line in graph 3) and the LRAS in graph 4) is set at YB. Now let these longer run developments take hold, i.e., these supply side effects, and label this final equilibrium as point C. Again, please make sure you refer to each diagram individually explaining how and why we get to point C (i.e., provide intuitive economic reasoningl). d) (20 POINTS) In the space below, discuss how the new classical economists (hint, island) addressed the business cycle fact that money and output are positively correlated. In this part, be extremely specific in the model that was developed (tell a story) and relate the assumptions in the model to the empirical fact above. Include a completely labeled AS - AD diagram in your answer and be sure to explain why output changes, given a change in the money stock. Be sure to explain exactly why the firm changes their output, using the terms: relative shock and aggregate shock. Feel free to use the bread making example that we used in class making sure you identify clearly, the asymmetry with regard to the real wage the firm pays and the real wage the worker receives. In the last part of your essay, discuss what determines the power of monetary policy (in terms of changing output) in this model, what determines how long the short run is, and whether or not you believe that this model is a solid basis for conducting counter-cyclical monetary policy. Finish the essay by commenting on the following: This model was developed back in the 19605 and 1970s and it is now 2010. Do you believe the model is more relevant or less relevant today relative to when it was written? Explain
