Suppose in an economy, the amount of consumption and investment depend on interest rate and income as follow:

= 800 5000 + 0.8

= 1200 5000

where Y and r are output and the real interest rate, respectively. Government purchases, G, are 1000. For simplicity, we disregard the taxation in the problem, i.e. the government has a large amount of surplus from past years thus it does not have to raise tax.

The real money demand function is

/ = 1000 20000

And in this economy, nominal money supply = 14000, price level = 2.

(a) Find the IS curve function.

(b) Find the LM curve function.

(c) Find the values of equilibrium interest rate and equilibrium output that clear both the output market and money market.

(d) Suppose the full-employment level of output is 12,000.

(i) Is the current level of output above or below the full-employment level?

(ii) Suppose the price level is fixed at = 2, and if the government attempts to increase the government to raise output level to full-employment level, how much is the necessary increase in government spending? What will be the corresponding interest rate?

(iii) Show the changes in part (d)(ii) on an IS-LM diagram.