Consider an economy characterized by the following equations for consumption (C), investment (I), government spending (G), taxes (T), aggregate demand (Z), and output (Y).

C = 54 + 0.3·(Y – T) T = 30

I = 16 + 0.1·Y – 300·i Z = C + I + G

G = 35

a) Find the equation for the IS relation. [Hint: Solve for Y in terms of i]

Suppose the central bank has set the interest rate equal to 2% (this is, ī = 0.02).

b) Draw the IS curve and the LM curve on a graph with Y on the horizontal axis and i on the vertical axis.

Consider a drop in consumer and business confidence that changes the consumption and investment equations to:

C = 44 + 0.3·(Y – T)

I = 8 + 0.1·Y – 300·i

T= 30

Z = C + I + G

G = 35

a) Find the equation for the new IS relation. What is the new equilibrium level of output (Y**)?

b) Can the government reverse the effects of this decline in consumer and business confidence and restore the original output level Y* using fiscal policy alone (i.e., with no change in monetary policy)? If so, how much of a change in G (call it ΔG) would it take? Explain. As an alternative to raising G by ΔG, could the government accomplish its goal (restoring Y*) by lowering taxes T by this same amount (ΔG) instead? Why or why not? Explain.

c) Can the central bank reverse the effects of this drop in consumer and business confidence and restore the original output level Y* using monetary policy alone (i.e., with no change in fiscal policy)? If so, how much of a change in the interest rate ī would be necessary? Explain.

d) Propose a fiscal-monetary policy mix (i.e.: a simultaneous change in G and/or T and in ī) that accomplishes the goal of returning the economy to its original output level Y*.