Question 3 (20 points) - Topic 2 & 3

Our closed economy has a production function Y = AF(K,LxE), where Y, K, L, E & A all have their usual meanings as per our lectures & course textbook. Also, this production function exhibits all the usual mathematical/economic properties we usually assume: positive marginal products, diminishing marginal products, complementarity between K & (LxE), and constant returns to scale. The aggregate consumption function depends negatively on the real interest rate, the government budget is balanced initially & the economy is in both a long-run equilibrium and steady state initially. The population growth rate is 2% per year, capital depreciates at a rate of 3% per year, the saving rate is 25% and technology is constant.

Suppose the level of labour effectiveness (E) suddenly permanently rises by 10%.

a) Use the long-run classical model to determine the qualitative impact of this shock on the long-run equilibrium levels of real output, consumption, investment, real interest rate, real wage & real rental price of capital. Support your answer with three diagrams one for the market for loanable funds, one for the labour market & one for the rental market for capital. (10 points)

NOTE: Fill in the following table to submit along with your answer to this part. Do not

forget to provide an economic explanation as to why this change did or did not occur.

Variable (part a) Change (if any) Explanation

Output Consumption Investment

Real interest rate Real wage

Real rental price of K