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Unformatted text preview: Economics 200 Macroeconomic Theory Solutions to Problem Set 7 1. As the reporter is concerned about a recession, a model of the short-run behavior of the economy is appropriate. Consider the effects of a rise in government spending in the IS-LM model illustrated below. The rise shifts the IS curve to the right by an amount equal to the rise times the autonomous spending multiplier (the length of the arrow). GDP does not, however, increase by this amount as that would imply that the economy was off the LM curve with the demand for real balances exceeding the supply. To keep the money market in equilibrium interest rates must rise as the reporter suggests and this will indeed reduce investment. The result is that GDP increases from to rather than to . Note that the amount of crowding ] ] ] ! " out ( ) equals the fall in investment times the multiplier. However, for the reporter's fear ] ] " of a recession to be well founded, the reduction in investment would have to exceed the rise in...
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