Question 2 The closed economy of Temptation Island is characterized by the following equations: Consumption: C = 6000 + 0.85(Y - T) Investment: I = 1500 - 300r Government spending: G = 5000 Taxes: T = 4500 Real money demand: L = 0.65Y - 500i Expected inflation: e = 0 Production function: Y = K1/2 L1/2 The nominal money supply = 35000

Note: Interest rates, both i and r, are expressed in percentage points, i.e., if r = 5.5, then the real interest rate is interpreted as being equal to 5.5%.

Suppose the IS-LM model can be to describe Temptation Island and answer the following questions. Keep your answer to at least THREE decimal points if necessary.

a) Derive the IS and LM equations for this economy. (4 points) b) Suppose we are in the base period, so the price level is fixed at 1.00. Calculate the resulting short-run equilibrium values of real output, real interest rate, investment, consumption, the government budget balance, and price level. (3 points)