THIS IS THE QUESTION:

1) The two questions in Tutorial Problems 7 locked at how changes in different macroe conomic 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 1" does not affect C and I and so the I 3 curve exists but is not downward sloping. So now you need to know what this means for the slope of the AD curve. When 1" does affect C and I we get a downward sloping I 3 curve and a downward sloping AD curve. 'When 1" does not affect C and I we do not get a downward sloping I 3 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 this1 then you can answer b}c}. Remember to ask for help if you get stuck. a) Show on a diagram how the scal stimulus in Q1} of tutorial problems T affects the aggregate demand curve. b} 1What would the aggregate demand curve look like when people and businesses are completely unresponsive to changes in the real interest rate over say 35 years'l.P [Note: this is from Q2) of tutorial problems 7.] c} 1Nhat 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 35 years? [Note: this is from Q2} of tutorial problems 7.] d} 1What 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 sayr 35 years?I [Note: this is from Q2} of tutorial problems 7.] Solutions 1) a) The first thing you have to explain to the ruling party is that their fiscal stimulus only increases planned expenditures for goods by $1.595 billion. You explain to them that this is because forty-five percent of the proposed spending is on transfers which doesn't increase planned expenditure in the goods market, just who does it. Of the spending only fifty-five percent of the $2.9 billion, or $1.595 billion, is on purchasing goods and services. The other one quarters worth is just a redistribution of income from one group of people in the economy to another group of people in the economy. From your economies education you know that to work out the impact of government expenditure on goods and services on income in the goods market that you need to know the marginal propensity to consume (MPC), since the government expenditure multiplier is equal to AY = = 1 - MPC x AG where the coefficient on the AG term is the government expenditure multiplier. Thankfully you have two values of aggregate consumption and income at different points in time so you can make a quick rough calculation of the MPC. Using the information on consumption and income you get, MPC = C20us - C1956 Y2005 - Y1996 75, 840 - 54, 521 123, 985 - 92, 679 = 0.681 Substituting this into the formula for the government expenditure multiplier you work out that the increase in government spending leads to an increase of income of AY = 1 - MPC 1.595 1 - 0.681 1.595 = $5 billion 206 Solutions for Problem Set 7 3 Due: Friday, 4 October when considering just the goods market.b) You appear before cabinet and explain to them about the transfers meaning a smaller stimulus than they realise. You also then explain to them that even allowing for this that aggregate income will increase but not even by as much as would be expected by the $1.595 billion spending on goods and services. Someone asks what about the multiplier process. You say there is a multiplier process but it is moderated by the fact that the increased income will increase interest rates in the money market. That the increased interest rates will moderate the multiplier increase in consumption by consumers transferring some consumption to the future (saving more) and business cancelling their marginally profitable investment projects. Increase in Government Spending on Aggregate Income LM . Real Interest Rate I' how G IS High G IS how G 124.0 129.0 Income ($b) Someone asks why does the interest rate increase? You answer that the increase in income caused by the increase in government spending will cause an increase in the quantity demand of money since it is used as a medium of exchange. Since the supply of money is fixed by the central bank, then the interest rate must increase to ensure that demand for money as an asset falls to get money market equilibrium. You present your diagram of the effects of the changes which impresses the cabinet because it looks impressive. You comment that the moderation of the effects of the fiscal stimulus is the result of a partial "crowded out" of some private spending. They thank you and then consider what to do!Increase in Government Spending IS law G IS high G LM . Real Interest Rate HOW G YG Yhigh G Income Increase in the Money Supply IS a LM Low M LM high M Real Interest Rate Fhigh M Yo IncomeECON 206: Problem Set 7 1) 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.' 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). a) You have to use the given information to calculate the increase in aggregate income in the goods market implied by the increase in government spending. You have to explain that the makeup of the increase in government spending won't have as big an impact as they think in the goods market. b) The government thinks that the fiscal stimulus in the goods market is also the change in aggregate income. You need to explain to them that this isn't correct because they haven't included the money market in their thinking. You can't work out the numbers but you can work out how big the change in aggregate income is relative to just looking at the goods market. Since the politicians aren't trained in economics you have to explain it to them using a diagram with a simple concise explanation.2) 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 These are costly because they then result in lenders wanting higher interest payments because of a perceived increase in the riskiness of the country's government. It also tells you that the government is funding the increase in spending by borrowing and not by raising taxes. 206 Solutions for Problem Set 7 1 Due: Friday, 4 October 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. a) If you work for the central bank and are trying to figure out the impacts of monetary policy on aggregate economic behaviour how would you model the goods market, money market, and aggregate income diagramatically? What explanation would you give for how you model the aggregate economy?"b) Central banks worry about the inationary effects of increases in government spending on goods and services. Given a ltuation where consumption and investment are unresponsive to the real interest rate, how would an increase in spending on goods and services proposed by the government affect the interest rate and aggregate income? How would you show this diagrammatically and what explanation would you give your manager? c} Central banks are in control of monetary policy. They also need to know how monetary policy affects aggregate economic behaviour to work out what monetary policy they should take to reach a certain price level. Given a situation where consumption and investment is unresponsive to the real interest rate how would an increase in the money supply by the central bank affect the interest rate and aggregate income? How would you show this diagrammatically and what explanation would you give your manager? 2) 206 Solutions for Problem Set 7 4 Due: Friday, 4 October a) The LM curve is unchanged because nothing has changed in the money market. The IS changes a lot. The only reason that the IS curve is downward sloping in the "standard" model is because consumption and investment are affected by the interest rate. If investment and consumption are unaffected by the interest rate then the IS curve is vertical. Diagrammatically the situation looks like: Investment and Consumption Unaffected by the Real Interest Rate IS. LM . Real Interest Rate Yo Income b) If government spending on goods and services increases then we know that the IS curve shifts to the right by the government expenditure multiplier or: 1 - MPC x AG With consumption and investment unresponsive to the interest rate the associated level of equilibrium income also increases by this amount. Even though the interest rate increases (to offset the increase in the demand for money for its use as a medium of exchange due to the increase in income), it has no affect on income because it does not affect consumption or investment. Diagrammatically this situation looks like: c) If the supply of money increases, then we know that the LM curve shifts to the right. The interest rate falls to induce people to hold more money as an asset. But nothing else happens! This is a big concern for the central bank as it means they cannot affect aggregate income (and hence aggregate demand and the price level as we'll see next week). Monetary policy doesn't over 1-5 years if consumption and investment are unresponsive to the real interest rate! Diagrammatically this situation looks like