We use the following terminology in this part: aggregate income Y and disposable income Y_d

(= (1t)Y ), consumption function C(Y_d), planned investment function I(r), government spending G, and taxation T = tY where t is the marginal tax rate; r% denotes the real interest rate in the economy. (Note, r is in percentage points, e.g. r = 2 means the interest rate is 2%. When doing calculations, the interest rate should not simply be inserted in decimal form.

For example, if r = 5 then I(5) = 52 0.2 5 = 51.)

Consider a hypothetical economy where:

C(Y_d) = 58 + 0.6 Y_d

I(r) = 52 0.2 r

G = 180

t = 0.4 (represents 40%)

1. Using the information above, write out the planned Aggregate Expenditure equation. (Hint: Remember that this takes the form of AE = ....)
2. Write down an expression for the Investment-Savings (IS) Curve. (Hint: First use the AE equation to find an expression for equilibrium Y . Next, remember that the IS equation takes the form of r = ....)

1. Assume that inflation is zero, so that i = r. This economy's central bank follows a given Monetary Policy Rule: r = i = 0.02 Y + 0.05 P , where P is the price level. Given this and the expression for the IS Curve, write down an expression for the Aggregate Demand Curve. (Hint: Remember that the AD Curve takes the form P = ....)
2. Suppose that the price level (P) is 20. What is the equilibrium value of aggregate income, Y ? (Hint: use the AD equation.)
3. What are the equilibrium values of the interest rate, r, and investment, I? (Hint: use the MPR or IS, and I(r) equations.)
4. Suppose that the level of Government expenditure increases to G = 200. What is the equilibrium value of aggregate income, Y ? (Note: you will no longer get a round number for

Y .)

1. What are the new equilibrium values of the interest rate, r, and investment, I?
2. Discuss why how the increase in G impacts Y , r and I in the context of the ideas of fiscal stimulus, spending multipliers, and crowding-out.