The money and commodity markets are as described in problems 1 and 2 and the real money supply equals $2,750, so that the economy’s equilibrium is initially the same as in part d of problem 2.
(a) In an effort to reduce oil consumption, fiscal policy makers decide to increase government spending on research and development of alternative energy sources by $48 billion. Derive the new equations for the autonomous planned spending, Ap, and the IS curve, Y = kAp, given the increase in energy spending. Graph that new IS curve when the interest rate equals 4.7, 5.0, 5.3, 5.6, and 5.9.
(b) Using your answer to part a, explain at what interest rate and at which level of real income the commodity and money markets are both in equilibrium, given the increase in energy spending.
(c) Using your graph of the new IS curve and your answer to part b, compute how much real income is crowded out by the increase in energy spending. Using your equation for autonomous planned spending, compute how much autonomous private sector spending is crowded out by the increase in energy spending.
(d) Suppose that the Fed wants to prevent any crowding out from the increase in energy spending. Using your answer to either part d or e of problem 1, explain how the Fed should change the real money supply in order to avoid the crowding out effect. For the Fed to be willing to do this without risking a rise in the inflation rate, explain what the smallest level of natural real GDP could be.
(e) Suppose that natural real GDP equals $12,000 and that the Fed does not want the increase in energy spending to cause a rise in the inflation rate. Using your answer to either part d or e of problem 1, explain how the Fed should change the real money supply in order to avoid a rise in the inflation rate.