ECON 206: Problem Set 8 1) The two questions in Tutorial Problems 7 looked at how changes in different macroeconomic variables affected the interest rate and and aggregate income. This week we'll extend the changes to how they affect the aggregate demand curve.

For b) - c) remember that this means that r does not affect C and I and so the IS curve exists but is not downward sloping. So now you need to know what this means for the slope of the AD curve. When r does affect C and I we get a downward sloping IS curve and a downward sloping AD curve. When r does not affect C and I we do not get a downward sloping IS curve. This means we also do not get a downward sloping AD curve. Once you have worked out what the AD curve looks like and why it looks like this, then you can answer b)-c).

a) Show on a diagram how the fiscal stimulus in Q1) of tutorial problems 7 affects the aggregate demand curve.

b) What would the aggregate demand curve look like when people and businesses are completely unresponsive to changes in the real interest rate over say 3-5 years? [Note: this is from Q2) of tutorial problems 7.]

c) What happens to the aggregate demand curve if the government spends more on goods and services when people and businesses are completely unresponsive to changes in the real interest rate over say 3-5 years? [Note: this is from Q2) of tutorial problems 7.]

d) What happens to the aggregate demand curve if the central bank increases the money supply when people and businesses are completely unresponsive to changes in the real interest rate over say 3-5 years? [Note: this is from Q2) of tutorial problems 7.]

Q1 :Say you are working for the government and they desperately want to boost incomes because the country is in a recession and the government has an election coming up. You are charged with working out the likely effects of a boost in government spending of $2.9 billion. This figure is what the ruling party thinks they can afford without upsetting the financial ratings companies and incurring a debt rating downgrade.1 Just under forty-five percent of this amount is to be used for transfer payments (unemployment benefit, domestic purposes benefit etc). You also know from your statistician that aggregate consumption was $54,521 billion in a past year and is currently $75,840 billion, and aggregate income was $92,679 billion in the same past year and is currently $123,985 billion (all figures in constant dollars).

Q2: Reserve Banks in some countries are currently finding that no matter how much they decrease interest rates they do not seem to increase economic activity. So what we will do is investigate changes in government spending and the money supply and see when this situation is likely to occur and also compare how effective monetary and fiscal policies are at causing changes in output and income.

For this question assume that changes in r do not affect C and I. This change means that you need to work out what the IS curve looks like before answering any of the other questions. The IS curve still exists but it is not downward sloping as shown in class because I and C are not affected by r for this question. The IS curve is only downward sloping if I and C are affected by r. The size of any shifts of the IS curve will also be different when r does not affect C and I. The LM curve does not change what it looks like or how much it shifts because it does not depend on C and I.