Please answer with a thorough explaination. Thank you
This question studies the effects of the 2020- coronavirus pandemic on the market-clearing real interest rate using the two-period model of consumption and dynamic macroeconomic model from the Michaelmas term lectures. Our starting point is to treat the pandemic as a temporary supply shock, with a temporary decline in total factor productivity representing the greater difficulty of producing goods and services. [21 marks] (a) Using the dynamic macroeconomic model, carefully explain the effects of temporarily lower TFP on the demand and supply curves in the goods and labour markets. Explain what happens to the market-clearing real interest rate. [4 marks] (b) A feature of the early stages of the pandemic was uncertainty about which firms would be win- ners or losers from the disruption. Considering the model of asymmetric information in credit markets, suppose there is a increase in the proportion of borrowers who will default on loans, but where the identities of these borrowers are not known to lenders at the time loans are made. Explain the effect on the spread between the interest rate on loans and the safe interest rate on government bonds. Supposing some firms have insufficient retained earnings to finance investment and cannot issue new equity, what effects on GDP and the market-clearing (safe) real interest rate are predicted by the dynamic macroeconomic model following the change in the interest-rate spread? (assume all households are savers) [3 marks] (c) Underlying consumption demand in the dynamic macroeconomic model is the two-period model of consumption covered in the lectures. A household receives after-tax incomes y - t and y' -t' in the current and future time periods and can borrow or save at real interest rate r. Illustrate the lifetime budget constraint and indifference curves in a diagram and show the effect of a decline in y with no change in the expected value of y'. Explain why the optimal response of the household features 'consumption smoothing'. [2 marks] (d) Governments in many countries imposed lockdowns during the pandemic. One effect of lock- downs is to limit opportunities to spend on some goods and services ordinarily purchased. In what follows, treat all households as identical in preferences and income prior to the pandemic. Suppose households planned current consumption Co prior to the pandemic. Representing the lockdown restrictions as a additional constraint c 0 measures the extent of the lockdown, show for a household whose income y is unchanged the effect on the set of feasible consumption plans (c, c') and the constrained optimal plan. Explain why the lockdown constraint can be understood as 'forced saving'. [2 marks](e) In addition to the constraint from part (d), the lockdown also leads to lower current income y across households. Some households suffer large drops in income, others' incomes are much less affected. Assume the average drop in income across households is equal to L. Combining your analysis in parts (c) and (d), will current consumption averaged across households drop by more or less than income? [4 marks] (f) Using the framework of the dynamic macroeconomic model, what are the implications of your answer to (e) for the market-clearing real interest rate during the pandemic? [2 marks] (g) How would your answers to (e) and (f) change if households cannot borrow? [2 marks] (h) Suppose the government makes a transfer payment to all households financed by issuing bonds. Would none, some, or all of households spend the transfer payment? (as in part (g), assume households cannot borrow) [2 marks]
