Consider a hypothetical economy in which households spend $0.75 of each additional dollar they earn and save the remaining $0.25. The following graph shows the economy’s initial aggregate-demand curve (AD1AD1).

Consider a hypothetical economy in which households spend $0.75 of each additional dollar they earn and save the remaining $0.25. The following graph shows the economy’s initial aggregate-demand curve (AD1AD1).

Suppose the government increases its purchases by $3.75 billion.

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Consider a hypothetical economy in which households spend $0.75 of each additional dollar they earn and save the remaining $0.25. The following graph shows the economy’s initial aggregate-demand curve (AD1AD1).
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Use the green line (triangle symbol) on the following graph to show the aggregate-demand curve (AD2AD2) after the multiplier effect takes place.

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Hint: Be sure the new aggregate-demand curve (AD2AD2) is parallel to AD1AD1. You can see the slope of AD1AD1 by selecting it on the following graph.

 

 

AD2AD3100105110115120125130135140116114112110108106104102100PRICE LEVELOUTPUT (Billions of dollars)AD1

The following graph shows the money market in equilibrium at an interest rate of 7.5% and a quantity of money equal to $60 billion.

Show the impact of the increase in government purchases on the interest rate by shifting one or both of the curves on the following graph.

 

 

Money DemandMoney Supply02040608010012015.012.510.07.55.02.50INTEREST RATEMONEY (Billions of dollars)Money Demand   Money Supply   

Suppose that for each one-percentage-point increase in the interest rate, the level of investment spending declines by $0.5 billion. The change in the interest rate (according to the change you made to the money market in the previous scenario) therefore causes the level of investment spending to   (fall/rise) by    .(2.5 billions/ 1.25 bil/ 0.62 bil)

After the multiplier effect is accounted for, the change in investment spending will cause the quantity of output demanded to   (decrease/increase) by   (5 bil/1.2 bil/2bil)at each price level. The impact of an increase in government purchases on the interest rate and the level of investment spending is known as the   ( multiplier/liquidty preference/ automatic stabilizer/ crowding out) effect.

Use the purple line (diamond symbol) on the graph at the beginning of this problem to show the aggregate-demand curve (AD3AD3) after accounting for the impact of the increase in government purchases on the interest rate and the level of investment spending.

Hint: Be sure your final aggregate-demand curve (AD3AD3) is parallel to AD1AD1 and AD2AD2. You can see the slopes of AD1AD1 and AD2AD2 by selecting them on the graph.

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