3. Changes in the money supply The following graph represents the money market for some hypothetical economy. This economy is similar to the United States in the sense that it has a central bank called the Fed, but a major difference is that this economy is closed (and therefore does not have any interaction with other world economies). The money market is currently in equilibrium at an interest rate of 4% and a quantity of money equal to $0.4 trillion, designated on the graph by the grey star symbol. 6.0 A 5.5 New MS Curve Money Demand 5.0 4.5 New Equilibrium INTEREST RATE (Percent) 4.0 3.5 3.0 2.5 Money Supply 2.0 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 MONEY (Trillions of dollars)Suppose the Fed announces that it is lowering its target interest rate by 75 basis points, or 0.75 percentage points. To do this, the Fed will use open- market operations to V the V money by V the public. Use the green line (triangle symbol) on the previous graph to illustrate the effects of this policy by placing the new money supply curve (MS) in the correct location. Place the black point (plus symbol) at the new equilibrium interest rate and quantity of money. Suppose the following graph shows the aggregate demand curve for this economy. The Fed's policy of targeting a lower interest rate will V the cost of borrowing, causing residential and business investment spending to V and the quantity of output demanded to V at each price level. Shift the curve on the graph to show the general impact of the Fed's new interest rate target on aggregate demand. O Aggregate Demand PRICE LEVEL Aggregate Demand OUTPUT4. The multiplier effect of a change in government purchases Suppose there is some hypothetical closed economy in which households spend $0.80 of each additional dollar they earn and save the remaining $0.20. The marginal propensity to consume (MPC) for this economy is V , and the spending multiplier for this economy is Y . Suppose the government in this economy decides to increase government purchases by $400 billion. The increase in government spending will lead to an increase in income, creating an initial change in consumption equal to V . This increases income yet again, leading to a second change in consumption equal to V . The total change in demand resulting from the initial change in government spending is Y . The following graph shows the aggregate demand curve (AD1 ) for this economy before the change in government spending. Use the green line (triangle symbol) to plot the new aggregate demand curve (AD; } after the multiplier effect takes place. For simplicity, assume that there is no "crowding out. " Hint: Be sure that the new aggregate demand curve (AD;) is parallel to the initial aggregate demand curve (AD1 ). You can see the slope ofAD1 by selecting it on the graph. \f5. Fiscal policy, the money market, and aggregate demand Suppose there is some hypothetical economy in which households spend $0.50 of each additional dollar they earn and save the $0.50 they have left over. The following graph plots the economy's initial aggregate demand curve (AD1 ). Suppose now that the government increases its purchases by $3.5 billion. Use the green line (triangle symbol) on the following graph to show the aggregate demand curve (AD; ) after the multiplier effect takes place. Hint: Be sure the new aggregate demand curve (AD;) is parallel to AD1 . You can see the slope of AD1 by selecting it on the following graph. /'\\ 8,3 116 A 114 A02 112 ' AD1 + _' 110 LL, AD3 :> LIJ -J 108 LL! 2 CE [L 106 104 102 100 ++4 100 102 104 106 108 110 112 114 116 OUTPUT (Billions of dollars) The following graph plots equilibrium in the money market at an interest rate of 6% and a quantity of money equal to $60 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. 12 Money Supply O 10 Money Demand O 8 Money Supply 6 INTEREST RATE 4 Money Demand 2 0 20 40 60 80 100 120 MONEY (Billions of dollars)Suppose that for every increase in the interest rate of one percentage point, the level of investment spending declines by $0.5 billion. Based on the changes made to the money market in the previous scenario, the new interest rate causes the level of investment spending tobe V. Taking the multiplier effect into account, the change in investment spending will cause the quantity of output demanded to V by V at every price level. The impact of an increase in government purchases on the interest rate and the level of investment spending is known as the V 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 (ADg) is parallel to AD1 and AD;. You can see the slopes of AD1 and AD2 by selecting them on the graph