Section II: Long-Answer Questions Economic environment common to both. questions Consider a. twoperiod production economy consisting of consumers, rms, and a government. In the current period the consumer allocates total time it between leisure {f3} and work (Ni). Working earns the consumer a real wage to. In addition the consumer consumes goods C, pays lumpsum taxes T to the government, and receives dividend income from the rm II. The same is true in the future period {denote all future variables with a prime}. The market real interest rate is r. The objective of the consumer is to maximise utility from consumption and leisure over the two periods. The rm produces output in the clirrent period (Y) according to the constant returns to scale production function Y = sF{K,N}, where z and K are current TFP and capital stock respectively, which are exogenous. The same production function with primes holds in the future period. The representative rm chooses labour in each period (N, N'} as well as investment (I), which determines future capital (capital depreciates at rate {5 c: 1]. To undertake one unit of investment the rm has to give up one unit of the current consumption good. The representative rm makes these choices so as to maximize the present value of prots. Finally the government purchases G units of the current consumption good and G" of the future consumption good, but can borrow by issuing bonds. 1. (3:? marks) Suppose the intertemporal eeonomy described above is initially in a competi tive equilibrium in which the current labour and goods markets clear. Suppose then that there is a negative permanent productivity shock that reduces both current TFF' z and anticipated future TFP 3' by the same amount [2 = z' c: [l]. {a} (It? marks] Using diagrams and equations show the equilibrium eects of the above simultaneous shock on consumption, investment, the real interest rate, aggcgate output, employment, and the real wage. {b} [5 merits} How would your answer to part {a} change if current consumption demand was only a flmction of cln'rcnt income? {c} (5 marks] In the money market, what kind of monetary policy should the central bank follow to maintain a constant price level, in light of the permanent shock in {a}? {d} (5 manta] Suppose that in response to the negative shock the govermnent will run a decit in the current period and an equivalent {in present value terms) surplus in the future period. Explain when such a policy will be eeetive in boosting employment and output