Consider the following structure of an economy:
Consumption: C = 25 + 0.75(Y-T)
Investment: I = 5 + 0.25i
Government Spending: G = 10
Taxes: T = 20
Money Supply: MS = 80
Money Demand: MD = (Y-i)P
Where i is interest rate in percentages, C is consumption, Y is nominal GDP, I is investment, G is government expenditures, T is taxes, MS is money supply and MD is money demand.
a) Assuming that the price level is P = 1, find the equilibrium real output, interest rate, consumption, and investment. Organize your results in the following table. (Hint: You should solve both the goods market and the money market equilibrium.)
b) Now assume that the government increases spending so that G = 15. Answer part a). for the new condition and illustrate the effects of the fiscal expansion with the diagrams of the goods market and the money market.
c) What would be the change in the equilibrium output in part b). in the simple Keynesian model without the money market? (Hint: Think about the simple multiplier) Compare this with the change in output in part b). and explain why there is a difference.