Question

4. Fiscal policy, the money market, and aggregate demand 

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 (AD1).

 Suppose the government increases its purchases by $3.5 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. 

Answer 1

Answer 2

If the households spends $0.50 each additional dollar they earn, the marginal propensity to consume 1/2 or 0.5. Recall that the formula for the expenditure multiplier is 1/(1-MPC). In this case, the economy's multiplier is 1/0.5=2. That's each 1 dollar increase in spending leading to a 2 dollar increase in total demand. When government purchases increase by 3.5 dollar billions, total demand increases by $3.5billion X 2 = $7 billion. The aggregate demand curve shifts to the right (from AD1 to AD2) by $ 7 billion at each price level. When the investment spending DECLINES by 0.5 billion; causes the investment spending to fall by 1 billion. After the multiplier effect is accounted for causes the quantity of output demand to decrease by $2 billion at each price level. This is referred to as the crowding-out effect. The graph shifts to the right with increase from 6 to 8 on the interest rate.