Answer Happy

13. The response of investment to fiscal policy a. Using the IS-LM diagram, show the effects on output and the interest rate of a decrease in government spending. Can you tell what happens to investment? Why? Now consider the following IS-LM model: C = Co + C₁ (Y-T) 1 = bo + b Y – bi M/P=d₂Y-d₂l b. Solve for equilibrium output. Assume c₁ + b₂ < 1. (Hint: You may want to re-work through Problem 2 if you are having trouble with this step.) c. Solve for the equilibrium interest rate. (Hint: Use the LM relation.) d. Solve for investment. e. Under what conditions on the parameters of the model (i.e., co, C₁, and so on) will investment increase when G decreases? (Hint: If G decreases by one unit, by how much does I increase? Be careful; you want the change in I to be positive when the change in G is negative.) f. Explain the condition you derived in part (e).