Suppose that desired consumption and desired investment are given as: C = c1 + cY (Y T) crr I = i1 irr G = G0 T = 1 + Y

(a) Derive the equation for IS curve and draw its graph assuming c1 = 200 cY = 0.8 cr = 500 i1 = 200 ir = 500 G = 196 1 = 20 = 0.25

(b) What would happen to the IS curve when lump-sum taxes, 1, increases?

(c) What would happen to the IS curve when income tax, , increases?

(d) The parliament passes a new law requiring balanced budget, that is G = T. How would this new law affect the IS curve?

In some macroeconomic models, desired investment depends on both the current level of output and the real interest rate. One possible reason that desired investment may depend on output is that, when current production and sales are high, firms may expect continued strong demand for their products in the future, which leads them to want to expand capacity. Algebraically, we can allow for a link between desired investment and current output by replacing the desired investment equation in the previous question with I = i1 irr + iY Y, where iY is a positive number. Use this alternative equation for desired investment to derive the algebraic expressions for the IS curve.