A closed economy can be described by the long-run classical model:

Y = 5000

C = 950 + 0.5(Y - T) - 70r

I(r) = 3000 - 30r

Note: r is measured in percentage points (i.e., if r = 5, then r = 5%).

Initially, the government collects 14% of output as income taxes and it runs a budget surplus of 100.

Part (a) Find the equilibrium levels of real interest rate and investment.

Part (b) Suppose the business confidence index changes from 113 to 115. As a result, autonomous investment changes by 6%. Find the new equilibrium levels of real interest rate, and investment.

Note: you will need to decide whether autonomous investment increases or decreases.

Part (c) (continued from part b) Suppose the government wants to raise its budget surplus by 60 via a change in government spending. Find the level of government spending that could achieve this goal and the new level of investment.

Answers:

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Part (a)

Government spending = (keep your answer to 1 decimal place if needed)

Real interest rate = (keep your answer to 1 decimal place if needed)

Investment = (keep your answer to 1 decimal place if needed)

Part (b)

New investment function: I = - 30r (keep your answer to 1 decimal place if needed)

Real interest rate = (keep your answer to 1 decimal place if needed)

Investment = (keep your answer to 1 decimal place if needed)

Part (c)

Government spending = (keep your answer to 1 decimal place if needed)

Investment = (keep your answer to 1 decimal place if needed)