This HW assignment is very relevant to the Great Recession experienced in the US from December 1997 - June 1999. In particular, we experience a significant and negative wealth shock and map out how this effects the consumption decisions of households. We let the Fed 'come to the rescue' and lower real rates of interest to extremely low (and negative) levels, much like they did during the Great Recession! It is here that we can really see how and why consumers react differently to a change in real interest rates based on whether they are a saver or a borrower. The intuition is hopefully clear: the saver, Dagwood in what follows, is worse off due to the fall in real rates and Homer, our borrower, is better off due to the lower real rates. This homework also addresses the net (aggregate) effect on consumption in an economy that consists of both savers and borrowers (like economies do), and also considers the outcome if the borrowers become credit constrained, like many are given that so many mortgages are under water, much in line from the excerpt below (Click Here for entire article). We conclude by considering the idea that the Fed may be making matters worse with their zero interest rate policy.
a) What is the net effect of this expansionary monetary policy (i.e., negative real rates of interest) on consumption, all else constant (this is after the shock to Dagwood's wealth (a) and Homer's expected income (ye))? To answer this question, assume we have an equal amount of "Dagwoods" and "Homers" so we can simply add the change in Dagwood's consumption to the change in Homer's consumption. Please give the actual change in aggregate consumption, given this expansionary policy.
b) Now consider the case where Homer is credit constrained and thus, cannot qualify for cheap loans since his balance sheet is a wreck. As such, the real rate of interest that Homer faces is 08% (r = 0.08), and not the ultra low negative real rate = -.04 that Dagwood (who has a solid balance sheet) faces. Please re-answer part a) above, assuming that Homer faces a real rate of 0.08 and Dagwood faces a real rate of (-.04). Use the actual numbers, that is, add the change in Dagwood's consumption (you already did this in 3a)) to the change in Homer's consumption, given that he faces a real rate of 0.08, all else constant. Are your results consistent with this pic (click Here)? Why or why not?