7. 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 (AD1AD1).

Suppose now that the government increases its purchases by $3 billion.

Use the green line (triangle symbol) on the following graph to show the aggregate demand curve (AD2AD2) after the multiplier effect takes place.

Hint: Be sure the new aggregate demand curve (AD2AD2) is parallel to AD1AD1. You can see the slope of AD1AD1by selecting it on the following graph.

AD2AD3100102104106108110112114116116114112110108106104102100PRICE LEVELOUTPUT (Billions of dollars)AD1

The following graph plots equilibrium in the money market at an interest rate of 1.5% 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.

Money DemandMoney Supply01020304050603.02.52.01.51.00.50INTEREST RATEMONEY (Billions of dollars)Money DemandMoney Supply

Suppose that for every increase in the interest rate of one percentage point, the level of investment spending declinesby $1 billion. Based on the changes made to the money market in the previous scenario, the new interest rate causes the level of investment spending to by .

Taking the multiplier effect into account, the change in investment spending will cause the quantity of output demanded to by 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 effect.

Use the purple line (diamond symbol) on the graph at the beginning of this problem to show the aggregate demand curve (AD3AD3) 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 (AD3AD3) is parallel to AD1AD1and AD2AD2. You can see the slopes of AD1AD1and AD2AD2by selecting them on the graph.