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Your Question
Suppose an economy in which the aggregate demand at time t is given by ttttfpmy+−=tp, where is the aggregate output at time t, is the stock of money supply, is the aggregate price level and is the level of confidence of the consumers. An increase in the confidence of the consumers increases their willingness to spend and so it increases aggregate demand. All the variables are in logs. The Lucas aggregate supply in the economy is:tyy+tmtfep− xpe)(ttyhere yis the exogenous natural level of output, 0>αis a parameter and tepis the ected price level.
(a) [5 marks] Assume that expectations are always correct. Find the equilibrium aggregate price level and the equilibrium aggregate output in the economy at time t.
(b) [5 marks] Show how a fall in consumer confidence will affect the equilibrium you obtained in part (a). Show your results in a diagram. Provide an economic intuition for your results.
(c) [6 marks] Now assume that expectations are static in the short-run (). Find the new equilibrium in the AD-AS model for the economy at time t. How your results differ from part (a)? Provide an economic intuition for your results. 1−=ttepp
(d) [5 marks] Assume that expectations are static in the short-run as in part (c), explain the short-run and the long-run effects of a fall in consumer confidence. Use a diagram to illustrate your answer. Provide an economic intuition for your results.
(e) [4 marks] Assume that compared to case (d), the parameter α is now larger. How would your answer to part (d) be different? Explain.
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