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METU Department of Economics 2025 Fall Econ 204
Problem Set IV
Question 1
Consider the real intertemporal model with investment. Suppose that the economy of Economica is currently in equilibrium with output Y 1 , employment N 1 , real interest rate r 1 , real wage w 1 as follows:
Assume that the government of Economica satisfies its present value budget constraint, G + (^) 1+G′r = T + (^) 1+T^ ′r. Suppose that this year the firms in Economica are incentivized to engage in more research and development (R&D) for new technology and innovation, as well as transfer of new technology from abroad, and they are known to continue with this high R&D activities and transfer of new technology into the next few years, as well. Within the context of the real intertemporal model with investment (where all agents have full information), discuss the impact of the current increase in innovation and transfer of new technology and the continuation of these activities in the future on the current economy of Economica, and carefully show on appropriate diagrams and explain in words, the impact on
i. Current labor market equilibrium (real wage and employment); ii. Current output supply and current output demand; iii. Real interest rate; iv. Current real output; v. Current consumption and investment. (Note: Whenever appropriate, make all necessary assumptions.)
i
Hint: In your answer, you can decide on the relative magnitudes of the shifts in the output supply and output demand curves. There are 3 possibilities, choose only one of the following:
- The magnitude of the shift in output supply curve is the same as the magnitude of the shift in output demand curve;
- The magnitude of the shift in output supply curve is larger than the magnitude of the shift in output demand curve;
- The magnitude of the shift in output supply curve is smaller than the magnitude of the shift in output demand curve.
Question 2
Determine and explain how the following events affect the slope of the output demand curve. Use diagrams where necessary: a. The demand for investment goods becomes more sensitive to the changes in real interest rate
b. The intertemporal substitution effect of the changes in real interest rate on current consumption decreases
Determine and explain how the following events affect the slope of the output supply curve. Use diagrams where necessary: c. The intertemporal substitution effect of the changes in the real interest rate on current leisure increases
d. Labor demand becomes more sensitive to changes in the real wage (Hint: Slope of the labor demand curve decreases, curve becomes flatter)
Consider the model presented in Chapter 11 for the following questions. Solve each question independently.
Question 3
What is the effect of an increase in δ, the depreciation rate, on the representative firm’s investment decision, and on its optimal investment schedule? Explain your results carefully
ii
Question 8
A war breaks out that is widely expected to last only one year. Show how the effect of this shock on aggregate output depends on the size of the intertemporal substitution effect of the real interest rate on current leisure, and carefully explain your results.
Question 9
A macroeconomist suggests that, since aggregate output and employment have decreased, the government should increase expenditures on goods and services to increase both output and employment. Suppose that output and employment fell because of a sectoral shock. a. Determine, using diagrams, what the net effects on output, employment, consumption, investment, the real interest rate, and the real wage, would be of such a policy, combined with the sectoral shock.
b. Do you think such a policy is appropriate? Why or why not?
iv
