Suppose the initial conditions of the economy are characterized by the following equations.

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 = 400 4) X-M = X-M 4') X-M = -200 Where: a0 = 200, a1 = .80, a2 = .05, a3 = .10, a4 = .8, a5 = -500, b0 = 300, 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?

4. Derive an expression for the aggregate expenditure curve and graph it on your exam sheet labeling this initial equilibrium output as point A.

Also, add this point A to your consumption function. Show all work. Draw an aggregate demand and an aggregate supply curve in the right hand graph on your exam sheet identifying this initial point as point A. NOTE: We are holding the price level fixed at 100 in this problem. Also, note that you that you cannot derive an expression for the aggregate demand curve, just draw it with a negative slope going through point.

5. We now let G rise to 500 as the Federal Government (fiscal policy) authorities are not happy with the level of GDP. Solve for the new equilibrium output and label as point B on all three of your diagrams. Please be sure to label your diagrams completely and show all work.

6. What is the government spending multiplier in this problem and what does this government spending multiplier depend on?

7. Suppose, that instead of holding prices fixed as we did in this problem, that prices were perfectly flexible, as in a classical world. Discuss, do not show, how your graphs would be different. Also, comment on what would happen to the government multiplier under the assumption of perfectly flexible prices.