In the December 7, 2010 edition of The New York Times, David Leonhardt discussed the tax and spending deal President Obama reached with Congressional Republicans:
Mr. Obama effectively traded tax cuts for the affluent, which Republicans were demanding, for a second stimulus bill that seemed improbable a few weeks ago. Mr. Obama yielded to Republicans on extending the high-end Bush tax cuts and on cutting the estate tax below its scheduled level. In exchange, Republicans agreed to extend unemployment benefits, cut payroll taxes and business taxes, and extend a grab bag of tax credits for college tuition and other items. ... [W]ith the recovery faltering and Republicans retaking the House, the administration is turning back to short-term job creation. Use the (Keynesian interpretation of the) AD-AS model to answer the following questions. You can assume the decline in wealth reflects speculative forces.

a. Many observers attribute the recession/faltering recovery to a decrease in consumer and business spending, in turn driven by decreases in wealth and optimism. Using graphs, show how, in the absence of any stabilization policies, these spending decreases would affect prices and output in the short and long run. In addition, show how real interest rates change in the long run. Assume that immediately before the spending decreases occur, the economy is at full-employment output.

b. Using graphs, show how the deal reached by President Obama would offset the effects of the spending decrease described in your answer to part (a). If these policies are implemented, what would happen to real interest rates?