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, ). 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:) after the multiplier effect takes place. Hint: Be sure the new aggregate demand curve (AD: ) is parallel to AD . You can see the slope of AD, by selecting it on the following graph. Your Anewer Correct Answer 116 A 11 AD. 112 X 110 AD: 03 PRICE LEVEL 108 102 100 100 102 104 106 110 112 114 116 OUTPUT (Billions of dollars) Points: 0.5/ 1 Close Explanation Explanation: If households spend $0.50 of each additional dollar they earn, the marginal propensity to consume is 1/2, or 0.5. Recall that the formula for the spending multiplier is Tape . In this case, the economy's multiplier is = 2. That is, each $1.00 increase in spending leads to a $2.00 increase in total demand. When government purchases increase by $3.5 billion, total demand increases by $3.5 billion * 2 = $7 billion . The aggregate demand curve shifts to the right (from AD, to AD ) by $7 billion at each price level