Suppose that firms suddenly become very pessimistic about the future profitability of investment projects, and as a result, reduce their investment spending (for any given interest rate). This is an example of a negative shock to the goods market. Use this information to answer parts a, b, c, d, e, f, g of this question.

a.How should this affect the equilibrium output in the Keynesian cross? Explain with the use of a diagram.

b.What will be the Keynesian cross multiplier of this change in business investment spending? That is, finddY/dIShow the derivation.

c.Now use the IS-LM framework to analyze the effect of the shock mentioned above on the equilibrium interest rate and the equilibrium output. Clearly label the graph, carefully marking the initial equilibrium and the short run equilibrium after the shock. Explain the intuition as to why and how the equilibrium interest rate changes.

d.How does the change in output under the IS-LM model compare to the change in output under the Keynesian cross (that is, is it larger or smaller) in response to this negative investment spending shock? Why? Explain intuitively.

short run negative effects of this shock. With the help of the IS-LM model, analyze policies (fiscal and monetary) that the treasury and the Fed can pursue in the short run to bring the economy's output back to its initial (pre-shock) level.

You can analyze each policy on a separate graph and assume that the policy is powerful enough to bring the economy's output to its initial equilibrium level on its own. Starting from the after-shock equilibrium point, show how each policy brings the economy's output back to its pre-shock level. Explain in words (that is, provide intuition of) how and why equilibrium output and interest rate change in response to each policy. Clearly label the graphs.

f.Suppose that the negative investment shock is so large that it pushes the economy into a liquidity trap. Using the modified IS-LM framework with Zero Lower Bound constraint on nominal interest rate, analyze the effects of the same shock on equilibrium output. How does the fall in output compare to the case in part e (that is, does output fall by more or less when ZLB becomes binding)? Explain the intuition.

g. What policies could the government use to get the economy out of the liquidity trap? Illustrate your answers using graphs and explain the intuition.