Assume the commodity market and the money market for an economy are described by the following IS and LM curve.

IS: Y = 11,000 - 250r; LM: Y = 8,000 + 250r.

a. Compute the equilibrium interest rate (r) and equilibrium real output (Y).

b. Suppose that fiscal policymakers raise taxes and cut government spending. As a result, the IS curve shifts left to Y = 10,000 - 250r. Compute the new equilibrium interest rate (r) and new equilibrium real output (Y).

c. Suppose that there is no change in fiscal policy, so that ther IS curve is Y = 11,000 - 250r. Instead monetary policymakers take action to reduce the money supply so that the LM curve shifts to Y = 7,000 + 250r. Compute equilibrium interest rate (r) and new equilibrium real output (Y).

Solution Preview

a. Compute the equilibrium interest rate (r) and equilibrium real output (Y).
For equilibrium, 11,000 - 250r = 8,000 + 250r
Or 500r = 3000, which gives r = 3000/500 = 6.
At r = 6, Y = 11,000 - 250*6 = 9,500.

b. Suppose that fiscal ...

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