a. Derive the IS relation.

b. Derive the LM relation.

c. Solve for equilibrium real output.

d. Solve for the equilibrium real money supply.

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

f. Now suppose that the interest rate, i0 was cut to 3% (i.e. 0.03). Solve for Y, M/P, C, and I, and describe in words the effects of an expansionary monetary policy.

g. Set the interest rate back to 5%. Now suppose that government spending increases to G =400. If the central bank keeps the interest rate unchanged, find the effects of this fiscal expansion on Y and C. If the central bank responds by raising the interest rate by enough so that M/P is the same value as you found in part (d), what would be the effect on Y, i, and C. Summarize the effects of an expansionary fiscal policy on Y, i, and C.

2. Assume that consumption is described by a linear function C = c0 +c1YD. Using IS-LM framework, analyze the effects of an increase in consumer confidence on the economy (that is equilibrium output, interest rate, money supply, consumption and investment) under the 2 scenarios:

a) The central bank controls money supply (that is keeps money supply constant).

b) The central bank controls the interest rate.

If the central bank is concerned about the possible overheating of the economy what would be an appropriate monetary policy response? Explain using a diagram.

3. Assume that the central bank controls the interest rate. Using an IS-LM diagram analyze what would happen to the economy if both consumer and business confidence decrease dramatically. Which policy mix would you advocate? Explain using a diagram.