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QUESTION:
Fiscal policy, the money market, and aggregate demand
Suppose there is some hypothetical economy in which households spend $0.75 of each additional dollar they earn and save the $0.25 they have left over. The following graph plots the economy's initial aggregate demand curve (AD1).
Suppose now that the government increases its purchases by $3.75 billion.
Use the green line (triangle symbol) on the following graph to show the aggregate demand curve (AD2) after the multiplier effect takes place.
Hint: Be sure the new aggregate demand curve (AD2) is parallel to AD1. You can see the slope of AD1 by selecting it on the following graph.
The following graph plots equilibrium in the money market 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.
Suppose that for every increase in the interest rate of one percentage point, the level of investment spending declines by $0.5 billion. Based on the changes made to the money market in the previous scenario, the new interest rate causes the level of investment spending toby.
Taking the multiplier effect into account, the change in investment spending will cause the quantity of output demanded tobyat every price level. The impact of an increase in government purchases on the interest rate and the level of investment spending is known as theeffect.
Use the purple line (diamond symbol) on the graph at the beginning of this problem to show the aggregate demand curve (AD3) 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 (AD3) is parallel to AD1 and AD2. You can see the slopes of AD1 and AD2 by selecting them on
ANSWER:
If households spend $0.75 of each additional dollar they earn, the marginal propensity to consume is 3/4, or 0.75. Recall that the formula for the spending multiplier is 11−MPC. In this case, the economy's multiplier is 10.25=4. That is, each $1.00 increase in spending leads to a $4.00 increase in total demand. When government purchases increase by $3.75 billion, total demand increases by $3.75 billion×4=$15 billion. The aggregate demand curve shifts to the right (from AD1 to AD2) by $15 billion at each price level.
The following graph plots equilibrium in the money market 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.
Points:
1 / 1
Suppose that for every increase in the interest rate of one percentage point, the level of investment spending declines by $0.5 billion. Based on the changes made to the money market in the previous scenario, the new interest rate causes the level of investment spending tofallby$1.25 billion.
Points:
0.5 / 1
Taking the multiplier effect into account, the change in investment spending will cause the quantity of output demanded todecreaseby$5 billionat every price level. The impact of an increase in government purchases on the interest rate and the level of investment spending is known as thecrowding-outeffect.
Points:
0.67 / 1
Use the purple line (diamond symbol) on the graph at the beginning of this problem to show the aggregate demand curve (AD3) 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 (AD3) is parallel to AD1 and AD2. You can see the slopes of AD1 and AD2 by selecting them on the graph.
Close Explanation
Explanation:
The increase in government purchases causes incomes to rise. At a higher level of income, households will undertake a greater number of transactions. Their demand for money with which to complete those transactions will increase accordingly, shifting the money demand curve to the right. The rightward shift of the money demand curve causes the interest rate to increase by 2.5% percentage points, from 7.5% to 10%. The higher interest rate increases the cost of borrowing and reduces investment. In this case, each one-percentage-point increase in the interest rate reduces investment spending by $0.5 billion. Therefore, a 2.5-percentage-point increase in the interest rate will reduce investment spending by 2.5×$0.5 billion=$1.25 billion.
Just as an increase in government spending has a positive multiplier effect on total demand, the decrease in investment will have a negative multiplier effect on total demand. Recall that the multiplier for this economy is 4. Each $1.00 decrease in investment will therefore cause total demand to decline by $4.00. The $1.25 billion decrease in investment reduces total demand by $1.25 billion×4=$5 billion, shifting the aggregate demand curve to the left (from AD2 to AD3) by $5 billion. The tendency for an increase in government purchases to increase interest rates and reduce investment is known as the crowding-out effect.
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