Question

1. The Response of investment to fiscal policy

1a. Using the IS-LM diagram, show the effects on output and the interest rate of a decrease in government spending. Can you tell whay happens to investment? Why?

Now consider the following IS-LM model:

C=c0+c1(Y-T)

I=b0+b1Y-b2i

M/P=d1Y-d2i

1b. Solve for equilibrium output. Assume c1+b1<1

1c. Solve for the equilibrium interest rate.

1d. Solve for investment.

1e. Under waht conditions on the parameters of the model will investment increase when G decreases?

1f. Explain the condition you derived in part e.