1. During the real estate bubble of the early 2000s, real estate prices were soaring, so most Americans felt relatively well-off. As a result, they had great confidence in the economy and in their personal futures. The economy was growing rapidly and people were spending heavily.

1. On the graph above, draw what you think was happening as consumer confidence surged. What problem(s) might the government be worried about in the economy as this is happening?

2. Identify one monetary policy and one fiscal policy the government might use to stabilize this situation.

3. Explain in your own words how the two policies in (b) will have the desired effect. Can you show or describe the effect on the graph too?

4. Assume the governments economists estimate that the gap between the natural rate of output and the current rate of output is $3 trillion. The MPC= 0.5. Based on the multiplier, what should be the amount of money involved in the policies you suggested in part b?

5. Do you think the monetary or fiscal policy in (b) is a better idea? Why? (There is no right answer here. Its a matter of opinion. I just want you to have one and be able to justify it.)

2. Suppose the government reduces taxes by $20 billion, that there is no crowding out, and that the MPC is 1/4 or 0.25.

1. What is the initial (immediate) effect of the tax reduction on aggregate demand?

2. What additional effects follow this initial effect? What is the total effect of the tax cut on AD?

3. How does the total effect of this $20 billion tax cut compare to the total effect of a $20 billion increase in government purchases? Why?

4. Based on your answer to part c, can you think of a way in which the government can increase aggregate demand without changing its budget deficit?

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