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Assume the money sector (LM-curve) can be described by the following two equations:
md = (1/4)Y - 10i and ms = 400
In the expenditure sector only investment spending (I) is affected by the interest rate (i), and the equation of the IS-curve is: Y = 2,000 - 40i.
a. Assume the size of the expenditure multiplier is ?G = 2. What is the effect of an increase in government purchases by ?G = 200 on income and the interest rate?
b. By how much will private investment be crowded out as a result of this increase in government purchases?
c. If the money demand equation were changed to md = (1/4)Y (note the interest rate does not enter the demand function for money) how would your answers in questions “a” and “b” change?
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