Consider an economy characterized by the following equations: C = 300 + 0.75(Y − T) I = 500 − 40r G = 200 T = 0.25Y L(r, Y ) = Y − 100r M P = 500 where C,Y ,I,G,T,r,L and M P , denote consumption, output, investment, government spending, taxes, the interest rate, liquidity preferences and the real money supply, respectively.
(a) Derive expressions for the IS and the LM and plot the two curves and find the equilibrium interest rate and the equilibrium level of income.
(b) The Government decide to double the public spending. Calculate the new equilibrium and explain the transmission mechanism behind the result.
(c) Compute the crowding-out effect and calculate the amount of money supply needed to eliminate it.