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Assume that an economy is described by the IS curve Y = 4,800 + 3G - 2T - 300r and the LM curve Y = 2 M / P + 200r. The investment function for this economy is 1,200 - 100r. The consumption function is C = 400 + (2 / 3)(Y - T). Long-run equilibrium output for this economy is 5,000. The price level is 1.0.
a) Assume that government spending is fixed at 1,500. The government wants to achieve a level of investment equal to 900 and also achieve Y = 5,000. What level of r is needed for I = 900? What levels of T and M must be set to achieve the two goals? What will be the levels of private saving, public saving, and national saving? (Hint: Check C + I + G = Y.)
b) Now assume that the government wants to cut taxes to 1,100. With G set at 1,500, what will the interest rate be at Y = 5,000? What must be the value of M? What will I be? What will be the levels of private, public, and national saving? (Hint: Check C + I + G = Y.)
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