1. Consider an extended ISLM model given by Y = C+ I + G C = c0 + 1/2 ( Y − T ) T = 110 I = b0 −1000(i−π^e +x) G = 125 i

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1. Consider an extended ISLM model given by
Y = C+ I + G
C = c0 + 1/2 ( Y − T )
T = 110
I = b0 −1000(i−π^e +x)
G = 125 i = .03 x = .05 πe = .01
A) Suppose c0 = 50, b0 = 150. Find equilibrium output,
consumption, and investment.
B) After a natural disaster, potential output, consumer
confidence, and firms’ animal spirits all decline. Mathematically,
c0 = 40 and b0 = 140.
I) Calculate the new equilibrium value of Y and describe the
economic intuition of this result.
ii) Now suppose that the government gives certain victims
of the natural disaster economic assistance and tax breaks. As a
result, T falls to 90 and G rises to 135. What are output,
consumption, and investment now?
iii) Suppose that the potential output is Yn = 390. Would
you suggest fur- their policies by the government to restore output
to its potential? What if Yn = 370? Explain. What are the
implications of these policies for consumption and investment?
iv Arguably, a natural disaster would change the risk
premium x too. Would you expect x to go up or down after a natural
disaster? Why? How would a changing risk premium change equilibrium
output?