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4. (25%) Suppose that policy makers want to raise investment but keep out- put and consumption unchanged. (a) Analyze whether

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Answer #1

a) To increase investment, rate of interest should be lower. This can be done by reducing the money supply. This however, raises the GDP as well so government should reduce its spending. This will increase budget surplus and reduce the rate of interest further. However, real GDP and consumption do not change. Government can also raise taxes, if not reducing the government spending, which will serve the same purpose. Hence we have a monetary expansion and a fiscal contraction.

b) In this case IS shifts left and LM shifts right. Output will remain unchanged but interest rate will decline further.

Real interest rate, r M1 LM2 - - - 4-L-XB WC IS Y, Y, Income, Output, Y

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