1) Suppose the initial conditions of the economy are characterized by the following equations. In this problem, we assume that prices are fixed at 1 (the price index is 100 and when we deflate, we use 1.00) so that nominal wealth equals real wealth.
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 (100) + a5 (3)
2) I = b0 + b1AS + b2CF + b3 (r)
2′) I = b0 + b1 (160) + b2 (1800) + b3 (3)
3) G = G
3′) G = 300
4) X-M = X-M
4′) X-M = -100
Where: a0 = 100, a1 = .75, a2 = .05, a3 = .10, a4 = .8, a5 = -500, b0 = 200, b1 = .5, b2 = .5, b3 = -200
Derive an expression for the consumption function and graph it on your exam sheet. Show all work.
2) Interpret a2 and a3 (i.e., what do they measure) and why are they so important in terms of measuring the impact of the Great Recession on consumption.
3) Why is a3 larger than a2?