Question

Suppose that individuals become more optimistic about their future incomes, and increase consumption at their current levels of disposable income. Use the Romer model to explain the short-run (immediate) and long-run effects of this law on inflation, output, the real interest rate, consumption, and investment.

Answer 1

Individuals become more optimistic about future incomes,aqnd increase consumption at their levels of disposable income.we discuss about what is disposable income disposable income means is total income minus personal current taxes.in national accounts definitions,personal income minus personal current taxes equals disposable personal income.disposable personal income is the amount of money that you receive in your paycheck.this amount is net of any income taxes,payroll taxes,health care deductions,retirement savings saving deductions,and other items taken out of your paycheck like cafeteria plans.consumption increases as current income increases and the larger the marginal propensity to consume,the more sensitive current spending is to current disposable income.the smaller the marginal propensity to consume the stronger is the consumption smoothing effect.consumption function is a relationship between current disposable income and current consumption.it is intended as a simple description of household behavior that captures the idea of consumption smoothing.it is upword sloping but slope is less than one.disposable income increasing consumption is also increasing.consumption=autonomous consumption+marginal propensity to consume multiply by disposable income.a consumption function of this form implies tgat individuals divided additional income between consumption and saving.we assume autonomous consumption is positive households consume something even if their income is zero.if a household has accumulated a lot of wealth in the past or if a household expects its future income to be larger autonomous consumpyion also larger.MPC and is positive and less than one.the permanent income hypothesis is nested with in amor genral model in which a fraction of income acures to individuals who consume their current income raher than their permanent income.Romer model (1986) and romer (1987) had an AK model.real ouput was equal to A times K,where A is positive constant and K is the amount of physical capital.this model has been an effective workhours for 30 years and remains.in particular the adoption of intrest rates.the IS-MP MODEL monetary policy and the mp curve is curve shows realtion between the real intrest rate and equibrium output in goods market.an increase in intrest rate reduce investment.reduce palnned expenditure at a given level of output.thus the planned expenditure line in the keynesians cross digram shifts down ,and so the level of output at which planned expenditure output falls.this negetive relation is known the IScurve in romer model.using the IS-MP model to understand short run fluctuations in terms of the given intrest rate equilibrium income is higher than before.that is IS curve shifts to the right.increse in govt. purchase raise both intrest rate and output both in short run.govt. purchase crowed out investment in short run and di in the long run.the money market and central bank control of the real intrest rate equilibrium in the money market occures when the supply of real money balances equals to demand.this model is often quit simple three equation a.phillips curve,an aggregate demand function and an intrest rate. the TR model consists of simple form three equation.the final step inflation and output change it rises if output above its netural rate and falls it is below,inflation and output along the ad curve.inflation rising output falling.increse inflation are causing central bank rising the real intrest rate.output fall .and vice versa.after inflation remains steady.long run equlibrium the ia curve comes to rest at the point where it intersect the ad curve y=y.as one would expect the level of the intrest rate in the long run equilibrium output its netural rate.inflation rises and thus it is hifg in the long run if the cental bank follows a fairly tight policy rule,on the other hand inflation is low in the long run.short run and long run effect of inflation ,output real intrest rate consumption and investment use the romer model.romer model endogenious technical progress.