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Aggregate Expenditures, Aggregate Supply and Aggregate Demand Questions

1. 20 points. Use an aggregate demand (AD) and aggregate supply (AS) model (short run model) to analyze this problem. Do not use a different model. Use AD & AS.
NOTE: this may be fastest with a hand-drawn graph. One option is to draw and scan, while another option is to draw, take a photo and insert the photo to your document. Feel free to use other approaches too.

A. Represent an initial equilibrium price and output level with the economy operating at or near full capacity (Hint: think about the shape of the AS curve and what this means for where AD crosses along the AS curve).
Label the following: each axis, the AD curve, the AS curve, the equilibrium output level and the equilibrium price level.

B. Suppose there is a tax cut, holding constant government purchases and all other factors affecting the AD curve. Illustrate the short run effects on output and the price level and LABEL them.

C. Give a 2 -4 sentence explanation and include why the initial state of the economy matters in your explanation.

2. 15 points. Suppose, ceteris paribus, government purchases decreased by $4 billion, investment spending increased by $40 billion.

A. EXPLAIN (no calculation yet). Would total output increase or decrease? What is the multiplier effect and how does it influence the answer to the question.
B. SOLVE. If 70% of a change in income is spent on new goods and services, what is the anticipated change in total output? Use the formula for the multiplier effect to calculate the change in total output.

3. 10 points. Evaluate the following as true or false and explain:
A five percent sales tax on food is an example of a flat tax.

4. 10 points. How does the article "Meltdown Averted, Bernanke Struggled to Stoke Growth- Fed Chairman Fails to Engineer Robust Recovery, Even with Extraordinary Measures"" illustrate the Federal Reserve's dual mandate, monetary policy, and monetary policy tools? Use your notes and book to describe the purpose of the Fed and the article for examples.


Solution Preview

Please see attached files


Note that the above AD and AS lines were drawn as straight lines rather than the curved lines that AD and AS lines should be. This is because it is difficult to draw curved lines in PowerPoint. You can replace the straight lines by curves lines anytime - I attached the PowerPoint where I drew the graph.

Whenever taxes on consumer income is reduced, in the short run, it is expected that the aggregate demand shifts to the right - consumers tend to spend most of what they saved on the tax cuts. However, the aggregate supply curve doesn't move because the tax cuts doesn't affect the producers. Nevertheless, since the demand cruve shifted to the right, then it is expected that the equilibrium price will also ...

Solution Summary

The solution does the following:

Draw and discuss the impact of tax cuts on aggregate demand and aggregate supply.
How does the multiplier effect impact total output?
Compare and contrast flat tax and sales tax.
Discuss the rule of the Federal Reserve.