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Econ 302 Fall 2012 Practice Questions and Solutions – the IS-LM model (1) (A modified version of Analytical Question #2, p. 439) Use the classical IS-LM model to analyze the effects of a permanent increase in government expenditure. The permanent increase is financed by a permanent increase in lump-sum taxes. (a) From the perspective of the labor market alone, how does the effect of the permanent increase in government purchases compare with the effect of a temporary increase in government purchases? (b) Because the tax increase is permanent, assume that at any level of output and real interest rate consumers respond by reducing their consumption each period by the full amount of the tax increase. Under this assumption, how does the permanent increase in government purchases affect the IS curve? (c) Use the classical IS-LM model to find the effects of the permanent increase in government purchases and taxes on output, the real interest rate, and the price level in the current period. (d) What happens if consumers reduce their current consumption by less than the full amount of the increase in government purchases? (e) What happens if instead of lump sum taxes, the increase in G is financed by a higher labor income tax?