1. The discovery of a new technology increases the expected future marginal product of capital.

a. Use of the classical IS-LM model to determine the effect of the increase in the expected future MPK on current output, the real interest rate, employment, real wages, consumption, investment, and the price level. Assume that expected future real wages and future incomes are unaffected by the new technology. Assume also that current productivity is unaffected.

2. Use the IS-LM model to analyze the general equilibrium effects of a permanent increase in the price of oil (a permanent adverse supply shock) on current output, employment, the real wage, national saving, consumption, investment, the real interest rate, and the price level. Assume that, besides reducing the current productivity of capital and labor, the permanent supply shock lowers both the expected future MPK and households expected future incomes. (Assume that the rightward shift in labor supply is smaller than the leftward shift in labor demand.) Show that, if the real interest rate rises at all, it will rise less than in the case of a temporary supply shock that has an equal effect on current output.

3. Consider a business cycle theory that combines the classical IS-LM model with the assumption that temporary changes in government purchases are the main source of cyclical fluctuations. How well would this theory explain the observed cyclical behavior  of each of the following variables? Give Reasons for your answers.

     a. Employment

     b. The Real Wage

     c. Average labor productivity

     d. Investment

     e. The price level

4. What does the Keynesian model predict about monetary neutrality (both in the short run and in the long run)? Compare the Keynesian predictions about neutrality with the basic classical model and the extended classical model with misperceptions (Island Economy).

5.       According to the Keynesian IS-LM  model, what is the effect of each of the following on output, the real interest rate, employment, and the price level? Distinguish between the short run and the long run.

a.       Increased tax incentives for investment (the tax breaks for investment are offset by lump-sum tax increases that keep total current tax collections unchanged).

b.      Increased tax incentives for saving (as in part (a), lump-sum tax increases offset the effect on total current tax collections).

c.       A wave of Investor pessimism about the future profitability of capital investments.

d.      An increase in consumer confidence, as consumers expect that their incomes will be higher in the future.

6. To fight an ongoing 10% inflation, the government makes rising wages or prices illegal. However, the government continues to increase the money supply (and hence aggregate demand) by 10% per year. The economy starts at full-employment output, which remains constant.

A.      Using the IS-LM framework, show the effects of the government’s policies on the economy. Assume that firms meet the demand at the fixed price level.

B.      After several years in which the controls have kept prices from rising, the government declares victory over inflation and removes the controls. What happens?

7. Describe three alternative responses available to policymakers when the economy is in recession. What are the advantages and disadvantages of each strategy? Be sure to discuss the effects on employment, the price level, and the composition of output. What are some of the practical difficulties in using macroeconomic stabilization policies to fight recessions?