Question 3 (25 points) - Topic 2

In this question, we assume Australia is a closed economy and is in its long-run equilibrium. Recently,

the country is being ravaged by the worst wildfires seen in decades. The fires have not only killed

millions of animals, but also has caused significant losses to farmers as the productivity of some

farmland has been adversely affected (as some land are no longer suitable for farming) and much farm

equipment has been destroyed.

Note: In here, labour force does not change unless otherwise stated.

a) According to the long-run classical model, what happens to the equilibrium levels of output, real

interest rate, and investment in Australia? What happens to the real rental price of capital? Explain

your answer with the aid of TWO diagrams - one for the loanable funds market and one for the

rental market for capital. (15 points)

b) Suppose after the fires, the government of Australia decides to take more actions against climate

change. To speed up the adoption of greener technology, the government decides to provide

subsidies to businesses that adopt green technology and green equipment.

Explain in words, what happens to autonomous investment? (3 points)

With the aid of the loanable fund market diagram drawn in part (a), explain the effect of the

change in autonomous investment on the real interest rate and support your answer by a new

diagram for the market for loanable funds. (3 points)

As time passes (i.e., in the very long run which will be 10-15 years from now), what happens to

the stocks of productive inputs in Australia? What happens to the level of employment in

Australia? Explain in words only. (4 points)