Economics 227: Intermediate Macroeconomics

Problem Set #2
1. In the long-run model, suppose that an increase in consumer condence about the
future raises consumption today. Use graphs to explain the eect on investment and
the interest rate.

2. Consider the following model of a countrys economy:

Y = F (K; L) = 60K 1=5 L4=5
C (Y

T ) = 150 + :5 (Y
K = 243;

L = 32;

T);

I (r) = 900

G = 300;

2700r

T = 300

(a) Calculate the real wage and the real interest rate / real rental rate of capital.
(b) Verify that Eulers Theorem holds.
(c) Solve for the levels of consumption, investment and the equilibrium real interest
rate.
(d) Suppose the government increases its spending to G = 600 without changing
taxes. What happens to consumption, investment, and the real interest rate?
(e) Now suppose the government increases its spending to 600, but funds the additional spending by raising taxes. Repeat part (d).

3. Suppose we modify the long-run model so that consumption depends on the interest
rate: C (Y T; r) = c0 (r) + c1 (Y T )
(a) If the interest rate rises, will consumption increase or decrease? Why?
(b) Suppose government purchases increases. What happens to the interest rate?
What happens to investment? Do we observe a positive or a negative relationship
between the interest rate and investment?
(c) Suppose the animal spirits parameter rises. What happens to the interest rate?
What happens to investment? Do we observe positive or a negative relationship
between the interest rate and investment?
(d) Will the data show a clear positive or negative relationship between the interest
rate and investment?