Suppose the initial conditions of the economy are characterized by the following equations in black font.

We then shock the economy as shown in the red font.

1) C = a0 + a1 (Y-T) + a2 (WSM) + a3 (WRE) + a4 (CC) + a5 (r)

1) C = a0 + a1 (Y-200) + a2 (10,000) + a3 (15,000) + a4 (120) + a5 (4)

1′) C = a0 + a1 (Y-200) + a2 (12,000) + a3 (15,000) + a4 (160) + a5 (4)

2) I = b0 + b1AS + b2CF + b3 (r)

2) I = b0 + b1 (140) + b2 (1500) + b3 (4)

2) I = b0 + b1 (180) + b2 (2000) + b3 (4)

3) G = G

3) G = 200

4) X-M = X-M

4) X-M = -200

4) X-M = -400

5) AE = C + I + G + X-M

Where: a0 = 50, a1 = .60, a2 = .05, a3 = .10, a4 = .5, a5 = -400, b0 = 100, b1 = .5, b2 = .2, b3 = -50

a) (20 points total 5 points for expression and 15 points for correct and completely labeled

diagram). Given the initial conditions, find expression for consumption function and provide a

completely labeled diagram. Please show all work.

b) (20 points total 5 points for expression and 15 points for correct and completely labeled

diagram). Given the initial conditions, find an expression for the aggregate expenditure curve (AE

in terms of Y), solve for equilibrium output and provide a graph of this aggregate expenditure

curve labeling this initial equilibrium as point A. Please add point A to your consumption

function diagram, being sure to label this point completely. Please show all work.

c) (10 points) We now incur shocks as provided in red font. Solve for a new expression of the

consumption function and aggregate expenditure curve, solve for the new equilibrium output and

add this new equilibrium point to both of your diagrams (label as point B). Please show all work.

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d) (10 points) Are your results consistent with the new economy? Why or why not? Explain in

detail.

Part 2: True / False Questions (2 points each – 40 points total) Answer T for True and F for False

1) Consumption is positively related to stock market wealth but negatively related to taxes and tax

rates.

2) If aggregate expenditures rise unexpectedly, then inventories will also rise unexpectedly.

3) Services are the most interest rate sensitive component of consumption.

4) Investment is the most cyclical component of aggregate expenditures.

5) The ‘job-loss’ recovery occurred following the 2001 recession.

6) Negative real interest rates imply that if you save today, you can purchase a smaller basket of

goods and services in the future, relative to the basket you could have consumed today.

7) The higher the marginal propensity to consume the more powerful tax policy is to influencing

consumption.

8) According to the results of the estimated consumption function, consumption is more sensitive to

changes in stock market wealth relative to changes in real estate wealth.

9) The sensitivity parameter in the consumption function that measures how sensitive consumption

is to changes in consumer confidence is referred to as the marginal propensity to consume.

10) In a consumption function with income (Y) on the horizontal axis and consumption (C) on the

vertical axis, a fall in the real rate of interest (all else constant) will cause a shift upward of the

consumption function.

11) In a consumption function with income (Y) on the horizontal axis and consumption (C) on the

vertical axis, a rise in the price level (all else constant) will cause a shift upward of the

consumption function.

12) A fall in tao, the effective tax rate on capital will result in the investment demand function

shifting to the right.

13) The slope of the investment demand function indicates how sensitive investment is to changes in

real interest rates. The ‘flatter’ the investment demand function, the less sensitive investment is to

changes in the real rate of interest, all else constant.

14) A rise in imports, all else constant, will increase net exports.

15) If the US is growing faster than the rest of the world, then all else constant, the trade deficit will

widen (get more negative assuming we were running a trade deficit to begin with).

16) If the inflation rate rises in China so that it exceeds that of the US, then net exports for the US

should increase, all else constant.

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17) If the exchange rate between the US dollar and Japanese yen changes from $1 = 100 yen to $1 =

80 yen, then US exports to Japan will become more expensive to Japanese importers.

18) We argued that cash flow (CF) increased during the Great Recession and thus, had a positive

effect on investment.

19) In a consumption function with income (Y) on the horizontal axis and consumption (C) on the

vertical axis, a rise in stock market wealth, all else constant, will result in a movement along the

consumption function.

20) The stronger the US dollar is relative to the rest of the world, all else constant, the larger the net

exports in the US.