3. The response of tnvestment to fiscal policy
a) Using the IS-La diagram, show the elects on output and
the interest rate or a decrease in government spending.
Can you tell what happens to investment. why:
Now consider the following IS-LM modes
C= $c_{0}+c_{1}(Y-T)$
I= $b_{0}+b_{1}Y-b_{2}i$
MiP = $d_{i}Y-d_{2}i$

Question

b. Solve for equilibrium output Assume $c_{1}$ + $b_{1}$ , < I. (Hint
You may want to re-work through Problem 2 If you are
having trouble with this step.)
c. Solve for the equilibrium interest rate. (Flint: Use the LM
relation.?
d. Solve tor investment.
e. Under what conditions on the parameters of the model
(LE-, Co, C,, and so on) will Investment Increase when G de-
creases? (Hint: If G decreases by one unit, by how much
does I increase? Be careful; you want the change in / to De
positive when the change in G is negative.)
f.. Explain the condition you derived in part (e).

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