Consider the following Traditional Classical Model.

Aggregate Capital Stock:K = 900 ,

Aggregate Labor Supply: L = 400 ,

Production Function: Y = K .5 L .5 ,

Consumption Function: C = 120 + .6 Y d ,

Investment Function: I = 86 − 100 r ,

Government Spending: G = 100 ,

Tax Collections: T = 100.

With this production function

M P L ( K , L ) = .5 K .5 L − .5 and M P K ( K , L ) = .5 K − .5 L .5.

 

a. Define the term competitive equilibrium.

b.  What is Walras Law.

c. Find the competitive equilibrium by leaving out the goods market in initial calculations. Then verify Walras Law by showing that the goods market clears. Draw diagrams which show the supply and demand curves for each of the markets and show the competitive equilibrium prices and allocations.

d. Suppose that government spending decreases to G = 97 but taxes are left at T = 100. Find the equilibrium level of output, consumption, investment and interest rates.

e. Suppose that government wishes to reach a target interest rate of 7% (i.e. r=0.07). What level of government spending will achieve this target? (Leave the tax rate T = 100.)