Suppose there is a RISE in the real price of capital (p_k). Notice that capital has become relatively more costly.

A. Use a diagram to Illustrate the the impact of a RISE in the real price of capital on optimal Kf* (i.e. optimal future capital stock). Label all curves, all axes, and shows the initial levels vs. final levels (i.e label everything in your diagram).

B. Continue with a. Is the shock causing MPKf>user costs or MPKfJust state. Will the firm increase profits by increasing Kf* or decreasing Kf*? Just state.

C. Given your results so far, what impact does the shock have on the S-I model (i.e. on the diagram)? Specifically, illustrate the impact on the S-I diagram. Label everything in your diagram. [no discussion yet]

D. Continue with c. Now discuss the impact on equilibrium r, S, and I (as done in lecture). In your discussion, elaborate on which curve shifts and why, and what leads to the change in r, S, and I. Make sure to provide COMPLETE economic reasoning/intuition of the mechanism that transmits the shock [it is essential that you discuss the adjustment following the change in r].

E. Now state the final impact on C and Y once the Output Market adjusts and the new equilibrium is reached. Just state (increase or decrease). No discussion.

F. [1 point] Continue with e. and briefly explain why C changes (what is the economic reasoning for the change in C). Discuss briefly.