Discuss the effects of the policy on equilibrium output and interest rate in the economy using the ISLM-ADAS model in the short run.

a. What would be the effect of such a policy on equilibrium interest rate in the money market? Explain why the equilibrium interest rate changes the way it does. Provide a graphical illustration using the appropriate diagram(s). (10 points)

b. Discuss the effects of the policy on equilibrium output and interest rate in the economy using the ISLM-ADAS model in the short run. Explain which market (or markets) is (or are) affected and which curves shift. Illustrate your answer with the appropriate diagrams. (10 points). 

c. Now discuss the effects in the medium run. You do not need to draw new diagrams; but you should refer to the diagrams in part b above and state which curves shift and in which direction they shift, and what happens to output and the interest rate in the medium-run equilibrium. A branch of the economics profession has argued that money is “neutral”. Does your analysis support this claim? Explain. (10 points) 

Question II.3 (30 points) 2 

a. Describe the factors that influence wage setting. Write down the equation that represents wage setting, describe the effect of each factor in the equation/function, and draw the corresponding diagram. Clearly state the assumptions behind your analysis. (10 points) 

b. Briefly describe the “efficiency wage” theory. Explain why a firm would want to pay a wage that is higher than the market wage rate. What theories can motivate such a practice? (10 points) 

c. The conventional (classical) labor market theory suggests that i) the wage rate adjusts smoothly so that labor supply equals labor demand; ii) wages are set competitively across markets; iii) there is no ‘involuntary’ unemployment (anyone who wishes to work can work). Does this reflect the reality in real economies? If not, explain why. (10 points)