Reference no: EM133122473

A closed economy can be described by the long-run classical model:

Y = 3KαL1-α

C = 18500 + 0.75(Y - T) - 500r

I(r) = 11700 - 500r

Note: r represents the real interest rate and is measured in percentage points (for example, if we find r = 10, then r is interpreted as being equal to 10%). Keep your answer to 4 decimal places if needed.

Assume that there are two factors of production, capital (K) and labour (L), and that they are both fully employed. For this economy the supply of capital and labour are 50625 and 20736 respectively. In addition, labour's share of output is equal to three quarters. Initially, the government collects 10% of the economy's output as (income) taxes, and the size of the budget deficit is 796.

a) Compute the long-run equilibrium levels of consumption, investment and real interest rate. Also, find the long-run equilibrium real wage for labour and real rental price of capital.

Suppose a law that requires the government to run a balanced budget is passed. In order to comply with the newly passed law, the government adjusts the level of government spending.

b) Find the new long-run equilibrium levels of real interest rate, real wage for labour and real rental price of capital.

c) Use THREE diagrams (the loanable funds market diagram, the labour market diagram, and the rental market for capital diagram) to show your findings in parts (a) and (b). Be sure to clearly identify the equilibrium to each part of the question in your diagrams. No written explanation is needed.

Now, return to the initial long-run equilibrium as shown in part (a). Suppose both households and firms change their behaviours such that households decide to save more while firms decide to spend more the accumulation of physical capital. As a result, both autonomous consumption and autonomous investment change by 10%.

d) Find the new long-run equilibrium levels of real interest rate, real wage for labour and real rental price of capital.

e) Use THREE diagrams (the loanable funds market diagram, the labour market diagram, and the rental market for capital diagram) to show your findings in parts (a) and (d). Be sure to clearly identify the equilibrium to each part of the question in your diagrams. No written explanation is needed.

f) Suppose the government wants to set the (real) interest rate at 10.74% via a change in government spending. Find the level of government spending that could achieve this goal. What is the new equilibrium level of investment? What happens to the government budget surplus/deficit? Explain.