Keynesian model with efficiency wage and sticky prices
a. Draw IS-LM-FE, AS-AD, and labor market graphs. Label initial equilibrium points assuming the economy is initially at full employment.
b. Taxes are lump sum and some agents are liquidity-constrained. Assume that there is a reduction in current taxes and an increase in future taxes such that the present value of taxes is unchanged. Use the graphs you drew in part (a) to illustrate the short-run effects on output, interest, prices, employment, and the wage. Label short-run equilibrium points with subscripts SR. Describe below why curves shift.
c. Now, allow prices to adjust and use the same graph to illustrate the long-run effects of the shock. Assume the long-run has enough time pass for prices to adjust, but not enough for future taxes to rise. Describe below any shifts in curves.
d. Write the expression for the government’s present value budget constraint. If agents were not liquidity constrained, explain how your answer would change if at all.