Question

5. Fiscal policy, the money market, and aggregate demand Consider a hypothetical economy in which households spend $0.50 of each additional dollar they earn and save the remaining $0.50. The following graph shows the economy's initial aggregate demand curve ( AD1 ). Suppose the government increases its purchases by $2.5 billion. Use the green line (triangle symbol) on the following graph to show the aggregate demand curve ( AD2 ) after the multiplier effect takes place. Hint: Be sure the new aggregate demand curve ( AD2 ) is parallel to AD1 . You can see the slope of AD1 by selecting it on the following graph. AD 2 AD 3 100 102 104 106 108 110 112 114 116 116 114 112 110 108 106 104 102 100 PRICE LEVEL OUTPUT (Billions of dollars) AD 1 The following graph shows the money market in equilibrium at an interest rate of 3% and a quantity of money equal to $15 billion. Show the impact of the increase in government purchases on the interest rate by shifting one or both of the curves on the following graph. Money Demand Money Supply 0 5 10 15 20 25 30 6 5 4 3 2 1 0 INTEREST RATE MONEY (Billions of dollars) Money Demand Money Supply Suppose that for each one-percentage-point increase in the interest rate, the level of investment spending declines by $0.5 billion. The change in the interest rate (according to the change you made to the money market in the previous scenario) therefore causes the level of investment spending to by . After the multiplier effect is accounted for, the change in investment spending will cause the quantity of output demanded to by at each price level. The impact of an increase in government purchases on the interest rate and the level of investment spending is known as the effect. Use the purple line (diamond symbol) on the graph at the beginning of this problem to show the aggregate demand curve ( AD3 ) after accounting for the impact of the increase in government purchases on the interest rate and the level of investment spending. Hint: Be sure your final aggregate demand curve ( AD3 ) is parallel to AD1 and AD2 . You can see the slopes of AD1 and AD2 by selecting them on the graph.

Answer 1

Consider the given problem here “MPC=0.5”, => the government spending multiplier is given by, => m=1/1-MPC = 1/(1-0.5) = 1/0.5 = 2, => m=2. So, if the “G” increases by “2.5 billion”, => the equilibrium output will increase by “m*dG = 2*2.5 = 5 billion”. So, here the AD will shift to the right side by “5 units”. Consider the following fig shows the AD2 curve.

Consider the money market where the equilibrium interest rate and quantity of money are given by, “R=3%” and “M=15 billion”. Now, let’s assume that if “R” increases by 1% implied the investment will fall by “0.5 billion”. So, here as the income increases by “5 billion”, => the money demand also increase by “5 billion” for each “R”, => the new equilibrium interest rate is “4%”.

The change in the “R” causes the level of investment spending to “fall” by “0.5 billion”. After the multiplier accounting for, the change in “I” cause the quantity of “Y” to “decrease” by “0.5” for each “P”. the impact of increase of “G” on “R” and “I” is known as the “crowding out” effect.

So, as the “I” decrease by “0.5 billion”, => the AD to shift to the left by “0.5 billion”, => the new AD is given the above fig as AD3.