Consider a hypothetical economy in which households spend $0.50 of each addition

Question

Consider a hypothetical economy in which households spend $0.50 of each additional dollar they earn and save the remaining $0.50. The following graph shows the economy's initial aggregate demand curve (aD_1). Suppose the government increases its purchases by $5 billion. Use the green line (triangle symbol) on the following graph to show the aggregate demand curve (ad_2) after the multiplier effect takes place. Be sure the new aggregate demand curve (ad_2) is parallel to ad_1. You can see the slope of AD_1 by selecting it on the following graph. The following graph shows the money market in equilibrium at an interest rate of 7.5% and a quantity of money equal to $45 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 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 the level of investment spending to by. After the multiplier effect is accounted for, the change in investment spending will cause the quantity of output demanded to by 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 effect. Use the purple line (diamond symbol) on the graph at the beginning of this problem to show the aggregate demand curve (ad_3) after accounting for the impact of the increase in government purchases on the interest rate and the level of investment spending. Be sure your final aggregate demand curve (AD_3) is parallel to ad_1 and ad_2. You can see the slopes of ad- and ad_2 by selecting them on the graph.

Explanation / Answer

AD2 after the multiplier effect will be on the right hand side , such that it cuts Y axis or price level at 116 and X-axis or Output at 140

Increase in Output = Government multiplier*Increase in Government Spending

Government multiplier = 1/1-MPC = 1/1-0.5 = 2

Increase in Output = 2*5 = $10 billion

2. Money Demand curve will shift to the right such that it cuts Y-axis at 17.5 and 105 on X-axis and Money supply at interest rate = 10.

3. Decrease by 2.5*0.5 = 1.25 billion

4 Decrease by 1.25 bilion

5 Crowding out effect

6. AD3 will between AD1 and AD2 , Cutting Y-axis at 115 , X-axis at 138.5.

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