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Consider a closed economy, where wages are sticky in the short run. The consumption function is C = (:0 + (:1 (Y T), where the marginal propensity to consume c1 is equal to 0.9. Initially the economy is in equilibrium at Y = Y* and P = P8, where P'3 is the price level that was expected when agents agreed their xed nominal wage contracts. The short-run aggregate supply curve (SEAS) is horizontal. Suddenly the government increases government spending G by $400. For the following questions, if you think a variable goes up by (say) $50, just enter 50 as your answer. If you think a variable goes down by $50, enter -50 as your answer. If you think a variable doesn't change at all, enter 0 as your answer. 10. 11. 12. 13. 14. 15. By how much will output Y change in the short run? By how much will consumption 0 change in the short run? By how much will investment I change in the short run? By how much will output Y change in the long run, after wage contracts are renegotiated? By how much will consumption 0 change in the long run, after wage contracts are renegotiated'? By how much will investment I change in the long run, after wage contracts are renegotiated? Suppose the household chooses C, and C2 to solve the following maximization program given B ro, r1, Q1 and Q2 argmaxcc,|In(C1) + 3In(C2) subject to the intertemporal budget constraint (IBC) C2 Q2 C1+ = (1 + ro) By + Q1+ = Y 1+ r1 1 + r1A B Equity 10m 8m 8% debt 4m 12m You are going to show how arbitrage can make the value of the companies equal. Mr Jones has $400,000 to invest. Investing in these two companies and borrowing and lending in the risk-free market are the only choices available. (i) What will Mr Jones earn if he puts all his savings into Company B? (ii) What will Mr Jones earn if he puts all his savings into Company A? (iii) Company A is ungeared and Company B is geared. The gearing of a portfolio is a measure of its risk, so a portfolio of Company A's shares is less risky than a portfolio of Company B's shares. Mr Jones can increase the riskiness of a portfolio that includes Company A's shares by borrowing EX in the risk-free market (which is assumed to be available to both companies and individuals at the same rate) and using all the available funds ( $400,000+ EX ) to invest in Company A's shares. Find the value of X that makes the two investment portfolios equally risky. (iv) For this value of X compare the expected returns from each of the two investment portfolios. (v) What will happen to the market prices of the shares in Company A and in Company B? (vi) Assuming that Company B's shares take all the adjustment, how far will the market price of Company B's shares fall? Explain