Question 3

3. Changes in the money supply The following graph represents the money market for some hypothetical economy. This economy is similar to the United States in the sense that it has a central bank called the Fed, but a major difference is that this economy is closed (and therefore does not have any interaction with other world economies). The money market is currently in equilibrium at an interest rate of 2.5% and a quantity of money equal to $0.4 trillion, designated on the graph by the grey star symbol. 4.5 4.0 New MS Curve Money Demand 3.5 3.0 New Equilibrium IN TEREST RATE (Percent) 2.5 2.0 1.5 10 Money Supply 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 MONEY (Trillions of dollars) Suppose the Fed announces that it is lowering its target interest rate by 75 basis points, or 0.75 percentage points. To do this, the Fed will use open- market operations to the_ money by the public. Use the green line (triangle symbol) on the previous graph to illustrate the effects of this policy by placing the new money supply curve (MS) in the correct location. Place the black point (plus symbol) at the new equilibrium interest rate and quantity of money. Suppose the following graph shows the aggregate demand curve for this economy. The Fed's policy of targeting a lower interest rate will the cost of borrowing, causing residential and business investment spending to and the quantity of output demanded to at each price level.Shift the curve on the graph to show the general impact of the Fed's new interest rate target on aggregate demand. O Aggregate Demand PRICE LEVEL Aggregate Demand OUTPUT Grade It Now Save & Continue4. The multiplier effect of a change in government purchases Suppose there is some hypothetical closed economy in which households spend $0.80 of each additional dollar they earn and save the remaining $0.20. The marginal propensity to consume (MPC) for this economy is _, and the spending multiplier for this economy is_ Suppose the government in this economy decides to decrease government purchases by $300 billion. The decrease in government spending will lead to a decrease in income, creating an initial change in consumption equal to . This decreases income yet again, leading to a second change in consumption equal to . The total change in demand resulting from the initial change in government spending is The following graph shows the aggregate demand curve (AD1) for this economy before the change in government spending. Use the green line (triangle symbol) to plot the new aggregate demand curve ( AD2) after the multiplier effect takes place. For simplicity, assume that there is no "crowding out." Hint: Be sure that the new aggregate demand curve (AD)2) is parallel to the initial aggregate demand curve (AD1). You can see the slope of AD, by selecting it on the graph. (?) 140 AD 135 AD 2 130 126 120 PRICE LEVEL 115 110 105 100 5 7 OUTPUT ( Trillions of dollars) Grade It Now Save & Continue