2. Use the classical IS–LM model to analyze the effects of a permanent increase in government purchases of 100 per year (in real terms). The increase in purchases is financed by a permanent increase in lump-sum taxes of 100 per year.

a. Begin by finding the effects of the fiscal change on the labor market. How does the effect of the permanent increase in government purchases of 100 compare with the effect of a temporary increase in purchases of 100?

b. Because the tax increase is permanent, assume that at any constant levels of output and the real interest rate, consumers respond by reducing their consumption each period by the full amount of the tax increase. Under this assumption, how does the permanent increase in government purchases affect desired national saving and the IS curve?

c. Use the classical IS–LM model to find the effects of the permanent increase in government purchases and taxes on output, the real interest rate, and the price level in the current period. What happens if consumers reduce their current consumption by less than 100 at every level of output and the real interest rate? 3. Consider a business cycle theory that combines the classical IS–LM model with the assumption that temporary changes in government purchases are the main source of cyclical fluctuations. How well would this theory explain the observed cyclical behavior of each of the following variables? Give reasons for your answers.

a. Employment

b. The real wage

c. Average labor productivity

d. Investment

e. The price level