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effects on the equilibrium levels of aggregate output

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1. For each of the following, predict the effects on the equilibrium levels of aggregate output (Y) and the interest rate ( r ):

A) During 2005, the Federal Reserve was tightening monetary policy in an attempt to slow the economy. The Congress passed a substantial cut in the individual income tax at the same time.

B) During the summer of 2003, the Congress passed and President Bush signed the third tax cut in 3 years. Many of the tax cuts took effect in 2005. Assume the FED holds Ms fixed.

C) In 1993, the Congress and the president raised taxes. At the same time, the FED was pursuing an expansionary monetary policy.

D) In 2005, conditions in Iraq led to a sharp drop in consumer confidence and a drop in consumption. Assume the FED holds the money supply constant.

2) State whether you disagree or agree with the following and why.

A) Inflation, a rise in the price level, causes the demand for money to decline. Because inflation causes money to be worth less, households desire to hold less of it.

B) If the FED buys bonds in the open market and at the same time we experience a recession, interest rates will no doubt rise.

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Solution Preview

1. A. This problem presents a policy mix, in which we have contractionary monetary policy coupled with expansionary fiscal policy. We can use the IS-LM diagram to analyze the effects of such a policy mix. See the attached file. The IS curve shifts outward from IS0 to IS1 in response to the fiscal policy, while the LM curve shifts inward from LM0 to LM1 as a ...

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the effect on the marginal propensity to spend

Question 1
Consider the following information about the demand for goods and services. All variables are in billions of dollars.

Consumption Function: C = 1000 + 0.9 YD
Investment Demand: I = 1400
Government Purchases: G = 1500
Taxes: Ta = 1000 + 0.15 Y
Transfer Payments: Tr = 1100
Exports: X = 800
Imports: Imp = 1200

a. Suppose that the potential level of output is $12,000 billion. Use the above information to calculate the size of the output gap?the actual level of output minus the potential level?if the economy is at equilibrium, that is, the actual level of output is the equilibrium level. Show your work and illustrate the size of the output gap graphically with a Keynesian cross diagram.

b. Calculate the size of the trade deficit or trade surplus at equilibrium. Be clear whether there is a deficit or a surplus.

c. Suppose that next year the economy reaches potential output, that is,
the equilibrium level of output next year is $12,000 billion. Calculate the magnitude of the exogenous change in aggregate demand that is necessary to achieve this result. Show your work.

d. Now assume that Imports also vary positively with income such that
Imp = 1200 + 0.1Y.
First, explain what will be the effect on the marginal propensity to spend, that is, on the slope of the AD curve and illustrate graphically.
Second, explain what will be the effect on the multiplier. Be clear about the form of the multiplier and why it changes.

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