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 (AD

1

AD1).

Suppose 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

2

AD2) after the multiplier effect takes place.

Hint: Be sure the new aggregate demand curve (AD

2

AD2) is parallel toAD

1

AD1. You can see the slope ofAD

1

AD1by 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)

The following graph shows the money market in equilibrium at an interest rate of 6% and a quantity of money equal to $30 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.

Suppose that for each one-percentage-point increase in the interest rate, the level of investment spendingdeclinesby $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 (AD

3

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 (AD

3

AD3) is parallel toAD

1

AD1andAD

2

AD2. You can see the slopes ofAD

1

AD1andAD

2

AD2by selecting them on the graph.

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