Consider a closed economy where the goods and money markets are described by the following relationships:

= 200 + 0.9( )

= 400 15

/ = 200 + 100

= 150

= 100

= 2000

=2

Where C is planned consumption, I is planned investment spending, T is government tax revenues, G is government purchases, M is the money supply, P is the price level and r is the interest rate.

1) What are the economy's equilibrium level of output Y and interest rate following the cut in taxation? Compute the equilibrium level of consumption and investment spending. With the help of the IS/LM graph, carefully explain what happens to the economy following the cut in taxation.

2) If the government intends to pursue monetary policy instead of fiscal policy in order to achieve the same level of output that you computed in question 1, how much should money supply change by? Use graphs to show the change in the economy and explain very carefully the monetary transmission mechanism.