1.(30 marks) Consider the following open economy:

Goods Market

Money Market

C = 100 + 0.9(Y - T)

Ms = 4000

I = 50 - 7.5r

P = 10

NX = -50; G = 200; T = 100

L(Y,r) = Y - 350r

a.Derive the IS equation of this economy. Also derive the LM for the case where money supply (Ms) is the policy instrument of the central bank (set at the current level of Ms). [Note r is expressed in percentage terms and not in decimal places.]

b.Find the equilibrium r and Y and draw the diagram for the IS-LM equations.

c.What is the tax multiplier of this economy? If the government wish to reduce output by 450 at the current interest rate level, how should they change the tax amount? What will be the resulting equilibrium r and Y?

d.Going back to the original situation as in a. except that interest rate (r) is the policy instrument of the central bank (set at a target rate of 3%) instead. What is the LM equation and what are the equilibrium values of r and Y? How would Ms change to achieve this?