1. Consider the following model of an economy. The following equation represents the goods market equilibrium:

bG = iY ,

where b > 0 is a parameter, G is government expenditure, i is interest rate and Y is output. The equilibrium in the money market is given by: Ms/P = aY/i ; where MS is money supply, P is the general price level and a > 0 is a parameter.

(a) Derive the equation of the LM curve.

(b) What is the slope of the LM curve?

(c) Derive the equation of the IS curve.

(d) What is the slope of the IS curve?

(e) Find equilibrium output (Y ) and interest rate (i).

(f) Draw the IS and LM curves in a diagram and show the effects of a decrease in parameter a on equilibrium output and interest rate.