The goal of this question is to analyze the macroeconomic implications of the burst of a house price bubble. Consider the two-period real intertemporal model. However, assume that individuals start the economy with an initial wealth of pH, which is tied to housing wealth. Now, suppose that unexpectedly individuals realize that the price of housing p decreases. More importantly, suppose that due to the credit market imperfections lenders face a limited commitment problem, and they require the housing value as collateral for borrowing. So, upon a decrease in the housing price, the value of the collateral decreases, and this will decrease the borrowing capacity of the borrowers.

(a) Analyze the eect of a decrease in the house price on the equilibrium prices (current period interest rate and wages) and quantities (output, consumption, employment, investment). Notice that there are two eects of a decrease in the house price. First it decreases the initial wealth, and it also decreases the borrowing capacity of the borrowers. Analyze the eect of each of these channels.

(b) Consider the eect of a decrease in the current period lump-sum taxes within this environment. That is, suppose the government decreases the current period taxes but increases the future period taxes to leave the total amount of revenue constant. Analyze the eect of such a tax policy on equilibrium prices and quantities. Does Ricardian equivalence hold in this environment? Explain.

(c) How would your answer change of the taxes were proportional instead of lumpsum. Explain.