Consider an economy in the long run with real GDP equal to the level of potential output, \(Y^{*}\).

a. Draw the diagram of the market for financial capital. Explain the slopes of the investment demand curve and the national saving curve.

b. Suppose the government pursued a fiscal contraction by reducing the level of government purchases. Explain what would happen to the equilibrium interest rate, the amount of investment in the economy, and the long-run growth rate.

c. Now suppose the fiscal contraction occurs by increasing taxes. Explain what effect this would have on the interest rate, investment, and long-run growth rate. (An increase in taxes is likely to reduce disposable income and thus reduce aggregate consumption.)