Macroeconomics 5th Edition by Olivier Blanchard

Exercise 3

The response of investment to fiscal policy
a. Using the IS-LM diagram, show the effects on output and the interest rate of a decrease in government spending. Can you tell what happens to investment Why
Now consider the following IS-LM model:
C = c 0 + c 1 (Y - 2 )
I= b 0 + b 1 Y - b 2 i
M/P = d 1 Y - d 2 i
b. Solve for equilibrium output. Assume c 1 + b 1 6 1. (Hint: You may want to re-work through Problem 2 if you are having trouble with this step.)
c. Solve for the equilibrium interest rate. (Hint: Use the LM relation.)
d. Solve for investment.
e. Under what conditions on the parameters of the model (i.e., c 0 , c 1 , and so on) will investment increase when G decreases (Hint: If G decreases by one unit, by how much does I increase Be careful; you want the change in I to be positive when the change in G is negative.)
f. Explain the condition you derived in part (e).