a) Assume that the US economy begins in a situation in which actual GDP (Y) is below the potential level of GDP (YP). Illustrate this situation in the AD/AS diagram, labeling the initial equilibrium point A. [Hint: recall that actual output is always on the AD and the AS curves]. b) Consider now the IS diagram. Suppose that the government increases government expenditures (G) on purchases of goods and services, does not undertake new investment expenditures, and keeps taxes unchanged. Assume (for now) that the interest rate remains constant. i. Keeping the interest rate constant, what is the effect on the aggregate demand for goods and services? ii. Keeping the interest rate constant, what is the effect on the demand for investment and consumption goods? iii. How does the IS curve shift in the IS diagram? (Draw the shift) c) Turning back to your AD/AS diagram derived in part a): i. Draw the shift (if any) of the AD curve, due to the increase in government expenditures. ii. Does the increase in G have any effect on the MP curve or the AS and LRAS curves? iii. Determine the short-run equilibrium following the increase in government expenditures, labeling this new equilibrium point B. At this point, what do you expect should happen to inflation compared to point A? Is the real interest rate at point B higher or lower than in point A? [Hint: Consider the Taylor principle in your answer]. iv. In the short-run equilibrium B, is consumption and investment higher or lower compared to point A? v. As we approach the medium run, which curve do you expect should move in the AD/AS diagram? Draw the shift and label the medium run equilibrium point C.

CRAS 2 ) a) Price As A AD yo yo GDP 6 ) IS curve shifts to the right Saving B GDP A Investment Interest Rate i ) Aggregate demand increases bcause government spending increases Demand for investment increases as consumers have higher disposable income and this higher consumption