The response of the economy to fiscal policy

a. Use an IS-LM diagram, show the effects on output of a decrease in government spending. Can you tell what happens to investment? Why? Now consider the following IS-LM model:

\[
\begin{aligned}
C & =c_{0}+c_{1}(Y-T) \\
I & =b_{0}+b_{1} Y-b_{2} i \\
Z & =C+I+G \\
i & =\bar{i}
\end{aligned}
\]

b. Solve for equilibrium output when the interest rate is \(\bar{i}\). Assume \(c_{1}+b_{1}<1\). ( You may want to rework through Problem 2 if you are having trouble with this step.)

c. Solve for equilibrium level of investment.

d. Let's go behind the scene in the money market. Use the equilibrium in the money market \(M / P=d_{1} Y-d_{2} i\) to solve for the equilibrium level of the real money supply when \(i=\bar{i}\). How does the real money supply vary with government spending?