Question

(15 points) (Inspired by Williamson, Question 11.10) Let’s compare the U.S. economy in 1994 to the current U.S. economy. Ignoring population growth, the two major changes between 1994 and 2014 are: (1) total factor productivity has permanently increased (z and z' both increase); and (2) the capital stock, K, has increased. (a) Using the real intertemporal model we developed in class, show graphically how these changes have affected output, employment, real wages and the real interest rate. What happens to consumption? Based on your answer to question 5(e), what happens to investment?

Answer 1

Total hoduct - Labor Wage Rate wyt- di z Laber Real Interest 2 Rate sy saming & Irnestment

An increase in Total Factor Productivity and increase in the level of capital stock in the economy has led to upward shift of the Total product Curve to TP' because the level of output produced by each unit of labor has increased with the increase in the level of productivity in the production process. Thus total output produced by the economy increases. This increase in production levels will shift the labor demand curve in the labor market rightwards to Ld' and in the equilibrium in the labor market, both the real wages and employment has increased in the economy. In the Loanable fund market in panel iii, increase in capital stock has led to increase in the demand for loanable funds in the economy and thus the curve has shifted rightwards to I' where at the new equilibrium point, the level of real interest rate has increased in the economy. Thus, increase in the overall production levels has increased income in the economy which also increases consumption level. Increase in capital employed has led to increase in the demand for investment in the economy.