Government spending, taxes, and aggregate demand effects

Macroeconomics Question Set

a.) The increase in expenditures necessarily causes government spending levels to rise, and this means that the aggregate demand curve moves to the right. When the presence of a multiplier effect or an investment accelerator is accounted for, aggregate demand shifts are more pronounced. Conversely, when crowding-out occurs, aggregate demand moves less.

) In this scenario, the multiplier is 1/(1 -- MPC) = 1/(1 -- .8) = 1/.2 = 5. When government expenditures are increased by $150 billion results in a shift of $750 billion in aggregate demand, because ($150 billion x 5) = $750 billion. By increasing taxes by $150 billion income levels decrease the same amount, and this initially decreases consumption by $120 billion, because ($150 billion x MPC) = ($150 billion x .8) = $120 billion. The subsequent change in consumption creates a multiplier effect of $600 billion, because ($120 billion x 5) = $600 billion. In effect, the net change is $150 billion, because ($750 billion -- $600 billion) = $150 billion, however, the changes do not cancel each other out as a tax increase reduces consumption levels by less than a tax increase.

25.)

a.) When supply decreases and demand is constant: Price increases and quantity decreases.

b.) When demand decreases and supply is constant: Price decreases and quantity decreases.

c.) When supply increases and demand is constant: Price decreases and quantity increases.

d.) When demand increases and supply increases: Price is indeterminate and quantity increases.

e.) When demand increases and supply is constant: Price increases and quantity increases.

f.) When supply increases and demand decreases: Price decreases and quantity is indeterminate.

g.) When demand increases and supply decreases: Price increases and quantity is indeterminate.

h.) When demand decreases and supply decreases: Price is indeterminate and quantity decreases.

27.)

a.) When the Federal Reserve buys bonds, the effect is typically an increase in overall money supply. This example of open market operations results in either the public or commercial banks holding more of their assets in cash reserves, and less in securities, and this increases the money supply. When the Fed buys bonds from commercial banks, these lending institutions see their checkable deposits and reserves increase, and this makes them far more willing to lend.

b.) When the Federal Reserve raises the discount rate, which is the specialized interest rate made available to commercial banks on loans procured from the Fed, this action results in the money supply decreasing. This phenomenon occurs because when the discount rate is higher, it becomes more expensive for commercial banks to borrow money, which reduces their willingness to increase the money supply through utilization of excess reserves.