The Money Market and Productive Government Spending (25 pts) Thinking back to our question from problem set 5, let's now address how the impacts of government spending could impact the money market. Suppose we have a full model of the economy this means we have a labor market, a goods market and a money market. These markets are for the most part standard in that we have an upward sloping labor supply curve, an upward sloping savings demand curve, a downward sloping labor demand curve and a downward sloping investment demand curve. We also have a downward sloping real money demand curve and the Federal Reserve controls the quantity of the nominal money supply. We will make one change to this market and that is the notion that government spending sometimes takes on the form of infrastructure spending. For our market let us assume that TFP (A) instead has two factors and evolves over time by the following equation At+t = At + t + (Ft M ) Where t represents an exogenous technology factor and Ftrepresents new infrastructure spending this period and M is the required cost to maintain the current level of infrastructure. This means that absent any new technology or new government spending on infrastructure we would expect TFP to remain constant. Though an increase or decrease in government spending on infrastructure or an increase or decrease in the technology factor would permanently increase or decrease TFP respectively. Government spending is then give as Gt = Ot + Ft Where Ot represents government spending that is on other non-infrastructure spending. The government raises revenue with lump sum taxation, and for now suppose they are unable to borrow. As a reminder recall monetary policy is the policy of the Fed in controlling the money supply and scal policy is the government spending we are talking about. We will also suppose there is no stickiness in prices so that they are fully exible. (a) (6 pts) Suppose that government decides it needs to do budget cuts and it decreases it's spending on other purchases (Ot goes down). Show graphically what happens in the money market due to this decrease in government spending. Feel free to use the solutions from Problem Set 5 to help in letting you know what's happening in the goods and labor markets. Specically, what happens to the quantity of real money balances and the price level? 9 b) (6 pts) Now suppose that the government decides to increase their spending on infrastructure spending so Ft increases (Once again one time only). This time however, they can fund it through borrowing. Suppose Ricardian Equivalence holds. Show graphically how you would represent this in the money market. Once again feel free to use your solutions from problem set 5 to gure out the overall impact on the money market. Specically what happens to the quantity of real money balances and the price level.

(c) (7 pts) Now suppose that Ricardian equivalence does not hold and the infrastructure spending is still nanced through borrowing as in part (c). In fact consumers do not perceive the increase in government borrowing as impacting their lifetime income at all! Show graphically how you would represent this in the money market. Once again feel free to use your solutions from problem set 5 to gure out the overall impact on the money market. Specically what happens to the quantity of real money balances and the price level.

(d) (6 pts) Along with your answer to part(c) suppose the federal reserve simultaneously engages in contractionary monetary policy because they are concerned about the threat of ination. This means they decrease the nominal money supply. Now what happens to the price level, and the quantity of real money balances as the fed tightens? Does this have any impact on the real economy? Why or why not?