From 2002 through 2005, residential investment boomed in the United states, as financial innovations seemingly made it possible to better match borrowers and lenders. (It subsequently became apparent that many of the loans made towards the end of this period were based on unduly optimistic assumptions about the productivity of the underlying investments.)

a. Consider a market-clearing economy in which output (Y₁)depends only on the capital stock (k₁) and an exogenous productivity variable (_θ1) according to the production function y1 = θ₂f(k₂). Use a two quadrant diagram with the capital stock, k_o on the horizontal axes and consumption, C_o on one vertical axis and the real interest rate r_o on the other -to depict the steady state equilibrium of the economy. Label the various curves plotted in your diagram.

b. Suddenly, current and expected future values pof _I are believed to have interested. How does the Steady state to u depicted in 2(a) shift? How does the economy get from the original steady state to the new steady state? (That is, how do consumption, output and the capital stock. And the real interest rate move, over time, in response to the new information?) What happens to the total value of the stock market as the economy moves from the original steady state to the new steady state?