1. 2. An economy is described by the following equations:

Desiredconsumption Desiredinvestment Cd = 130+0.5(Y −T)−500r.

Id = 100−500r.

Governmentpurchases G = 100.

Taxes T = 100.

Realmoneydemand Moneysupply L = 0.5Y −1000r.

M = 1320.

Full-employmentoutput ¯¯¯

Y = 500.

Note that the expected rate of inflation is assumed to equal zero so that money demand depends directly on the real interest rate, which equals the nominal interest rate.

a. Write the equations for the IS and LM curves. (These equations express the relationship between and when r

the goods and asset markets, respectively, are in equilibrium.)

Y

b. Calculate the full-employment values of output, the real interest rate, the price level, consumption, and investment.

c. Suppose that, because of investor optimism about the future marginal product of capital, the investment function becomes Id

= 200−500r.

Assuming that the economy was initially at full employment, what are the new values of output, the real interest rate, the price level, consumption, and investment in the short run? In the long run? Show your results graphically.