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=c0 +c1(Y-T)
I=b0 +b1Y-b2i
M / P = d1Y - d2i
b. Solve for equilibrium output. Assume c1 + b1 < 1.
c. Solve for the equilibrium interest rate.
d. Solve for investment.
e. Under what conditions on the parameters of the model (i.e., c0, c1 and so on) will investment increase when G decreases? (Hint: If G decreases by one unit, by how much does I increase?)
f. describe the condition you derived in part (e).