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.

2. Consider the following IS-LM mode:

C=200 + .25YD

I=150+.25Y-1,000i

G=250

T=200

(M/P)^d =2Y-8000i

M/P=1,600

2a. Derive the IS relation

2b. Derive the LM relation.

2c. Solve for equilibrium real output

2d. Solve for the equilibrium interest rate.

2e. Solve for the equilibrium values of C and I, and verify the value you obtained for Y by adding C, I, and G.

2f. Now suppose that the money supply increases to M/P=1840. Solve for Y,i,C, and I.

2g. Set M/P equal to its initial value of 1,600. Now suppose that government spending increases to G=400. Summarize the effects of an expansionary fiscal policy on Y, i, and C.

3. Investment and Interest Rate

If a firm is considering using its own funds (rather than borrowing) to finance investment projects, will higher interest rates discourage the firm from undertaking these projects? Explain.