Williamson Macroeconomics Consider the macroeconomic model of chapter 11. In add

Question

Williamson Macroeconomics

Consider the macroeconomic model of chapter 11. In addition to everything else consumers are subject to borrowing constraints that come from a problem of limited commitment. Consumers own housing (H) that is sold in the second period for a price p. They use housing as collateral of their loans so that the price of housing will affect aggregate demand.

(a) Pose the consumer’s problem with a borrowing constraint.

(b) Howdoestheborrowingconstraintchangethesensitivityofaggregatedemandtotheinterest rate?

(c) What happens to aggregate demand wen the price of housing decreases? Explain.

(d) What happens to aggregate supply wen the price of housing decreases? Explain.

(e) What happens to the equilibrium output, labor, interest rate and wage when the price of housing decreases? Explain.

Explanation / Answer

A. Consumer's problem with borrowing constraint is that it limits the level of current consumption and gives the affect of ceiling on consumption.

B. The higher interest rate raises the cost of borrowing as borrowing becomes expensive .this in turn reduces demand for investment, and eventually reduces output. Hence, interest rate is inversely related to both borrowing constraint and aggregate demand.

C. The aggregate demand increases when the price of housing decreases as according to the law of demand, demand and price levels are inversely proportional to each other.

D. The aggregate supply decreases and according to the law is supply, supply is directly proportional to the price levels.

E. The equilibrium output increases as the demand increases. The labour would increase due to increase in demand. The interest rates would go down as since the price of housing is low, people would invest more and wages will decrease due to more labour and less pricing of houses.

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