Consider the following IS-LM model for a closed economy:
YD = Y-T
C = c0 + c1YD
I = b0 + b1Y-b2i
M/P = d1Y -d2i
where G and T are constant; c1+b1<1
a) Write down the equations for the IS curve and the LM curve. Solve for equilibrium output. What is the multiplier?
b) Using the LM relation from part a), express a new equation for investment (I) as a function of Y (note: interest rates should be eliminated in this new equation). For simplicity, students need not expand Y as derived from part a).
c) Under what conditions on the parameters of the model (ie. c0, c1, etc) will investment increase when G decreases? If G decreases by one unit, by how much does I increase?