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In the space below, discuss how the new classical economists (hint, island) addressed the business fact that money and output are positively correlated.  In this part, be extremely specific in the model that was developed (tell a story) and relate the assumptions in the model to the empirical fact above.   Be sure to explain exactly why the firm changes their output, using the terms: relative shock and aggregate shock. Use the bread making example that we used in class making sure you identify clearly, the asymmetry with regard to the real wage the firm pays and the real wage the worker receives.  Include 2 graphs as we did in class and explain the intuition as to why the workers change their behavior and why the boss (firm) changes their behavior. Now draw an aggregate demand and aggregate supply diagram explaining how your individual island analysis (as given above) maps to the macro economy (include points A, B, and C as we did in class). Write out the expression for the Lucas aggregate supply curve explaining the intuition underlying the Lucas Aggregate supply curve.  In the last part of your essay, discuss what determines the power of monetary policy (in terms of changing output) in this model, what determines how long the short run is, and whether or not you believe that this model is a solid basis for conducting countercyclical monetary policy.  Finish the essay by commenting on the following:  This model was developed back in the 1960s and 1970s and it is now 2014.  Do you believe the model is more relevant or less relevant today relative to when it was written?  Explain. 

We drew a non-linear aggregate supply in class with its shape depending on the state of the economy. Draw that aggregate supply curve identifying the Keynesian portion and the Classical portion and provide the intuition as to why the shape of the aggregate supply curve does depend on the state of the economy. We now consider the Great Recession where the unemployment rate went up to 10% and the corresponding GDP gap went from zero to -7%.  Write a brief essay explaining why the unemployment rate went up to 10% and the GDP gap fell to -7% (think about and mention what happened to all of the relevant shift variables for aggregate demand). Locate this point as point A on your diagram with an aggregate demand curve going through point A that corresponds to the conditions during the Great Recession. Now explain how macroeconomic policy makers responded to these conditions and explain why we would or wouldn’t expect these policies to work in terms of lowering unemployment and eliminating the GDP gap. Locate as point B that corresponds to the conditions as of the present, where the unemployment rate is 5.5% and the GDP gap is -3% (still some slack but much less than before). Which of the policies would Keynes favor and why?  Are your results consistent with the following pic of the misery index? Why or why not?

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