Fiscal Policy Problems and Solutions

Fiscal Policy Problems and Solutions - Candidate Answers...

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Candidate Answers Homework #8 ECON 402 – Spring 2014 1. Briefly describe the wealth effect, interest rate effect, and exchange rate effect, as they relate to the shape/slope of the aggregate demand curve. Price Level and Consumption (The Wealth Effect): A decrease in the price level makes consumers wealthier, which in turn encourages them to spend more. The increase in consumer spending means a larger quantity of goods and services demanded. Price Level and Investment (The Interest-Rate Effect): A lower price level reduces the transactions demand for balances, and households take some of the ‘extra’ money and lend it out. This reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded. Price Level and Net Exports (The Exchange-Rate Effect): When a fall in the price level causes interest rates to fall, the real exchange rate depreciates, and this depreciation stimulates net exports and thereby increases the quantity of goods and services demanded. 2. (Q1, p. 352) According to the IS-LM model, what happens in the short run to the interest rate, income, consumption, and investment under the following circumstances? Be sure your answer includes an appropriate graph. a. The central bank increases the money supply. b. The government increases government purchases. c. The government cuts taxes. d. The government increases government purchases and taxes by equal amounts. Very briefly… a. Money supply increases: this causes the interest rate to decrease at all levels of income; this shifts the LM curve down. In equilibrium, income increases, and thus consumption increases. Investment increases with the decreased interest rate. b. Government purchases increase: this directly shifts the IS curve to the right, increasing equilibrium income and consumption. As the interest rate increases, investment decreases – crowding out.
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