Suppose that a financial crisis causes autonomous consumption to fall by 400 and autonomous investment to fall by 300, so that the new functions are C= 2600 + 0.8(Y – T) Ac€?o 12,000r and I = 700 Ac€?o 25,000r. Now, what is the equation for planned aggregate expenditure as a function of output and the real interest rate? Calculate the new level of short-run equilibrium output at each inflation rate; show your work and complete column D in the table above. Sketch a new diagram showing the relative positions of the old and new aggregate demand curves. In the short run, what is the new level of equilibrium output? What is the output gap?
Rate of inflation (?)
Real interest rate (r)
Short-run equilibrium output Column C
Short-run equilibrium output Column D
a. Suppose that the government declares that it will increase government purchases in order to raise GDP. Calculate the multiplier. Using the multiplier, determine by how much government purchases would need to be changed in order to raise GDP back to potential. Show your work.
b. Suppose that the government wants to reduce taxes in order to spur spending and raise GDP. By how much would taxes need to be reduced in order to raise GDP back to potential? Show your work. Is this change in taxes realistic?