Real Interest Rate, (percent) Quantity of Loanable Funds Loanable Funds Market [*Use this graph if there is a chg in savings by consumers or chg in

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Loanable Funds MarketLoanable Funds Market[*Use this graph if there is a chg in savings by consumers or chg in fiscal policy][*Use this graph if there is a chg in savings by consumers or chg in fiscal policy]

[*[*Use theUse the Money Market graphMoney Market graph when there is awhen there is a change in MSchange in MS]]

rr==66%%

DD11

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Starting from a balanced budgetbalanced budget, if theG incr spendingG incr spending or decr Tdecr T to get out ofa recessionrecession, they would now be runninga deficitdeficit and have to borrow, pushing pushing up demand in the LFMup demand in the LFM and increasing increasing the interest ratethe interest rate.

DD22

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EE22

Use the “real interest rate”“real interest rate” withLFMLFM, because it is long-termlong-term.Use “nominal interest rate”“nominal interest rate” withmoney marketmoney market, as it is short-termshort-term. BorrowersBorrowers LendersLenders

$$2 2 tril.tril.

GG TT

Balanced BudgetBalanced Budget [[GG&&TT=$2 Tr.]=$2 Tr.]

$2.2 $2.2 tril.tril.

$2 $2 tril.tril.

Real GDP

PLSRAS

AD2

YYRR YF

[[Incr GIncr G;; Decr TDecr T]]

PPL1L1

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PL2

G AD Y/Empl./PL; G LFM I.R.

T DI C AD Y/Emp./PL;; T LFM IR

Start from a Balanced BudgetG & T = $2 Trillion

$2 tril.

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Loanable Funds Market

r=6%

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Real In. Rate

F1 F2

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Real GDP

PLPL SRAS

AD2

YYIIYF

[Decr GDecr G; Incr TIncr T ]

PPL1L1

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PL2

GG ADAD Y/Empl./PL;Y/Empl./PL; GG LFMLFM I.I.R.R.

TT DDII CC ADAD Y/Emp/PL;Y/Emp/PL; TT LFMLFM IIRR

Start from a Balanced BudgetG & T = $2 Trillion

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G T

[like we have ““money trees”money trees”]

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Loanable Funds Market

Real In. Rate

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EE11

1.1. Government cuts defense spendingGovernment cuts defense spending by $75 billion. As a result the following occur: - UnemploymentUnemployment increases from 6% to 9%9% - GDPGDP drops 3%3% - InflationInflation drops from 3% to 1%1%Based on this info, draw AD1AD1 to AD2AD2 on the graph.……………………………………………………………… A. Now “G” decreases taxes“G” decreases taxes, which (incr/decr) DIDI,which (incr/decr) CC, which (incr/decr) ADAD. [starting a balanced budgetbalanced budget] The result is an (incr/decr) in GDPGDP,employment & PL. With the increase of government’s demand for loanable funds, because they now have less tax revenue, the interest rateinterest rate (increase/decrease).Draw the new AD1 AD1 to AD2AD2 curves on the graph. B. Due to the change in interest ratesinterest rates, the dollardollar(appreciates/depreciates) and our exportsexports (incr/decr).

AP Macro FRQ Practice 1AP Macro FRQ Practice 1

LRASLRASSRASSRAS

LRASLRAS SRASSRAS

EE22

EE11

EE22

YY** Real YReal Y

PLPL22

PLPL

PLPL

PLPL22

YY**

ADAD11ADAD22

YYRR

99%%

YYRR

99%%

ADAD11 ADAD22

PLPL11

PLPL11

2. Net exports increase by $50 billionNet exports increase by $50 billion due to a depreciated dollar, resulting in the following: - UnemploymentUnemployment stays at 3%3% - GDPGDP stays the samesame - InflationInflation increases from 8% to 10%8% to 10%Based on this info, draw AD1 to AD2AD1 to AD2 on the graph.……………………………………………………………… A. Now government decreases spendinggovernment decreases spending by $100 bilby $100 bil. which leads to an (increase/decrease) in ADAD. The result is an (incr/decr) in GDPGDP, employmentemployment, and PLPL. With the reduction of “G”’s demand for dollars in the LFM, because of the decrease in “G”, the interest rate (increases/decreases). Draw the new AD1AD1 to AD2AD2 curves on the graph. B. Due to the change in price levelchange in price level, the dollardollar (apprec/deprec) and our importsimports (increase/decrease).


ADAD11ADAD22

AD1AD1AD2AD2

LRASLRAS

SRASSRAS

LRASLRAS

EE11EE22

EE11

EE22

PLPL

PLPL11

PLPL22

YYII3%3%

YY**Real GDPReal GDP

YYII3%3%

YY**

PLPL22

PLPL11

SRASSRAS

PLPL

3. Government spends $99 billionGovernment spends $99 billion on a waron a war with Cuba. As a result the following occur: - UnemploymentUnemployment decreases from 14% to 10%14% to 10% - GDPGDP increases 10%10% - InflationInflation is 0%0%Based on this info, draw AD1 to AD2AD1 to AD2 on the graph.……………………………………………………………… A. Now government decreases taxes by $150 billiongovernment decreases taxes by $150 billion which (incr/decr) DI, which (incr/decr) CC, which (incr/decr) ADAD. The result is an (incr/decr) in GDPGDP, employmentemployment, & PLPL. With the increase of government’s demand for LF, because they now have less tax revenue, the interest rateinterest rate (increases/decreases). B. Due to the increase in the growth rateincrease in the growth rate, the dollardollar (apprec/deprec) and our importsimports (increase/decrease).


AD1AD1 AD2AD2

AD1AD1AD2

LRASLRASSRASSRAS

LRASLRASSRASSRAS

Real GDPReal GDP

Real GDPReal GDP YYRR10%10%

YY**

PLPL

PLPL22

EE11EE22

YYRR14%14%

YY**EE11

PLPL11

PLPL

PLPL

YYRR10%10%

EE22

4. Government spends $100 billion on the infrastructure.Government spends $100 billion on the infrastructure. As a result the following occur: - UnemploymentUnemployment decreases from 6% to 3%3% - GDPGDP increases 5%5% - InflationInflation increases from 2% to2% to 6% 6%Based on this info, draw AD1 toAD1 to AD2 AD2 on the graph.……………………………………………………………… A. Now government increases taxes by $100 billion,government increases taxes by $100 billion, which (incr/decr) DI, which (incr/decr) CC, which (incr/decr) ADAD. The result is an (incr/decr) in GDPGDP employmentemployment, and PLPL. With the decrease of “G”’s demand for dollars in the LFM, because of the increase in “T”, the interest rate (incr/decr). Draw the new AD1AD1 to AD2AD2 curves on the graph. B. Due to the change in interest ratechange in interest rate, the dollardollar (apprec/deprec) and our exportsexports (increase/decrease).


ADAD11ADAD22

ADAD11ADAD22

LRASLRAS

SRASSRAS

LRASLRAS

EE11

EE22

EE11

EE22

PLPL

PLPL11

PLPL22

YYII33%%

YY**Real GDPReal GDP

YYII3%3%

YY**

PLPL22

PLPL11

SRASSRAS

The economy is guilty of breaking the “FE 4% Speed Limit.” We are going to have to raise interest rates. Wait a minute – this is monetary policy. We’ll attack this on the next test. Let’s look again at fiscal policy.

PLPL

5. Net exports decrease by $60 billionNet exports decrease by $60 billion due to an appreciated dollar, resulting in the following: - UnemploymentUnemployment stays at 3% - GDPGDP stays the same - InflationInflation drops from 10% to 6% Based on this info, draw AD1 to AD2AD1 to AD2……………………………………………………………. A. Now government decreases spending by $90government decreases spending by $90 billion billion which leads to an (incr/decr) in ADAD. The result is an (incr/decr) in GDPGDP, employmentemployment, & PLPL. With the reduction of “G”’s demand for LF, because of the decrease in “G”, the interest rateinterest rate (increases/decreases). Draw the new AD1 to AD2 curves on the graph. B. Due to the change in PLchange in PL, the dollardollar (apprec/deprec) and our importsimports (incr/decr).


AD2AD1

ADAD11AD2

SRASSRAS

SRASSRAS

PLPL11

PPLL22

YYII3%3%

YY**

YY** YYII3%3%

PLPL11

PLPL22EE11

EE11

EE22

EE22

LRASLRAS

LRASLRAS

PLPL

PLPL

6. Rising U.S. tariffs cause Xn to drop by $30 billionRising U.S. tariffs cause Xn to drop by $30 billion. As a result the following occur: - UnemploymentUnemployment increases from 10% to 12%10% to 12% - GDPGDP decreases 8%8% - InflationInflation is 0%0% Based on this info, draw AD1 to AD2 on the graph.………………………………………………………………. A. NNow ow government decreases taxesgovernment decreases taxes by by $125 b$125 billionillion which (incr/decr) DIDI, which (incr/decr) CC, which (incr/decr) ADAD. The result is an (incr/decr) in GDPGDP, employment, and PLPL. With the increase of government’s demand for LF, because they now have less tax revenue, the iinterestnterest r rateate (incr/decr). Draw the new AD1AD1 to AD2 on the graph. B. Due to the increase in the growth rateincrease in the growth rate, the dollardollar (apprec/deprec) and our exportsexports (increase/decrease).


AD1AD1ADAD22

AD1AD1AD2

LRASLRASSRASSRAS

LRASLRASSRASSRAS

YY**YYRR1212%%

YYRR1212%%

YYRR1010%%

YY**

PLPL11

PLPL

PLPL22 EE22

PLPL

PLPL

EE11

Fiscal Policy FRQ Practice Question 1Fiscal Policy FRQ Practice Question 11. Suppose the following conditions describe the current state of the economy. -The unemployment rate is 3.5% -Real GDP is growing at the rate of 5% -The inflation rate is 9%inflation rate is 9% (a) Identify the main problem this economy faces [inflation] (b) Now Congress votes to increase personal income taxesincrease personal income taxes. Using AD/AS analysis [graph this], explain what effect this policy will have on each of the following. (i) AD, & thus output & employment (ii) The price level (iii) The interest rate

Answers:Answers: (i) The increase in personal taxes will decrease DI, which will decrease C, which will decrease AD, which will decrease output and employmentdecrease output and employment.(ii) The decrease in AD will result in a lower equilibrium [AD1 to AD2 & E1 to E2] and a lower price levellower price level.(iii) The increase in personal taxes results in more tax revenue v. government spending, which decreases the demand for money in the LFM & a decrease in interest ratesdecrease in interest rates.

Fiscal Policy FRQ Practice Question 2Fiscal Policy FRQ Practice Question 2

2. Assume that in the U.S., nominal wage rates rise faster than labornominal wage rates rise faster than labor productivityproductivity. Using AD/AS analysis [graph this]AD/AS analysis [graph this], analyze the short- run effects of this situation on each of the following. [Base your (b) answer on what the price level does][Base your (b) answer on what the price level does] (a) The general price level (b) The international value of the dollar [based on PL]

(c) The level of exports

Answers:Answers: (a) As shown (graph), nominal wage rates rising faster than labor productivity would decrease the AS curve from AS1 to AS2. The decrease in AS would change equilibrium from E1 to E2, which would result in a higher general price level.higher general price level.

(b) The higher price level would make our exports more expensive relative to foreign goods, thus decreasing demand for the U.S. dollar and depreciating the dollar.depreciating the dollar.

(c) The depreciated dollar would make our goods cheaper than the previous period and increase our exportsincrease our exports.

YYRR

DDMM

InvestmentDemand

no

min

al

Inte

res

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4

0Money Market QID1QID1

MSMS11

ASASADAD11

PLPL11

8%8%

6%6%

4%4%

00

MSMS22

ADAD22

PL2

Pri

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If there is aIf there is a RECESSIONRECESSIONMS will beMS will beincreased.increased.

QID2QID2

DDII

Y*Y*

Buy Buy BBondsonds MSMS I.R.I.R. QIDQID ADAD YY//EEmp/mp/PLPL

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Real GDPReal GDP

BuyBuy

FEDERAL RESERVE BANK OF THE U.S.FEDERAL RESERVE BANK OF THE U.S.

EE11E2E2

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InvestmentDemand

Nom

inal In

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8%8%

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10

88

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MSMS11

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MSMS22

If there isIf there isINFLATIONINFLATION,,MS will beMS will bedecreased.decreased.

SellSell

QIDQID11

YY**

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SellSellBondsBonds MSMS I.R.I.R. QIDQID ADAD Y/EY/Empl.mpl./PL/PL

FEDERAL RESERVE BANK OF THE U.S.FEDERAL RESERVE BANK OF THE U.S.

like““money trees”money trees”

EE11

EE22

SRASLRASLRASAD1

PLPL11

Y*Y*

(b) [3 pts] Japan is a major importer of U.S. products. Assume that the JapaneseJapanese economy goes into aeconomy goes into a recessionrecession. (i) Explain the impact of the Japanese recession on the U.S. impact of the Japanese recession on the U.S. equilibrium output and price levelsequilibrium output and price levels. (ii) Show these effectsShow these effects on your graphon your graph in part (a).

Answer (b)(i) & (ii): Answer (b)(i) & (ii): The Japanese recession would cause job losses in Japan, lowering prices and incomes there, which would reduce U.S. exports to Japan. This would decrease aggregate demand in the U.S, which would decrease PLdecrease PL, outputoutput, and employmentand employment.

ADAD22

PLPL22

YYRR

EE11

Real GDPReal GDP

Free Response 2005Free Response 20051. [13 total pts] Assume that the U.S. economy is currently in equilibrium at the U.S. economy is currently in equilibrium at the full-employment level of real GDPfull-employment level of real GDP. (a) [3 pts] Draw a correctly labeled graph of AD/AScorrectly labeled graph of AD/AS showing each of the following in the U.S. (i) Output levelOutput level (ii) Price levelPrice level

EE22

(c) [5 pts] Assume that the Fed takes action to curb the effects Fed takes action to curb the effects of the Japanese recessionof the Japanese recession on the U.S. economy. (i) What open-market operationopen-market operation would the Fed undertake?

Answer (c) (i):Answer (c) (i): The Fed would buy bondsbuy bonds which would increase the MS and decrease interest rates.

(ii) Use a correctly labeled graph of the money marketcorrectly labeled graph of the money market to show how the Fed policy action will affect the nominal interest rateaffect the nominal interest rate.

Answer (c) (ii):Answer (c) (ii): The Fed buying bondsbuying bonds would mean a bigger MSbigger MS, which would lead to lower nominal interest rateslower nominal interest rates.

(iii) Explain how the change in the nominal interest ratechange in the nominal interest rate in part (c) (ii) will affect ADaffect AD, price levelprice level, and real outputreal output in the U.S.

Answer (c) (iii):Answer (c) (iii): As seen in the graphs above, the decrease in the nominal interest rate would increase investment, which would increase AD. The increase in ADincrease in AD would increase price levelincrease price level and real outputreal output in the U.S.

FR 2005FR 2005

(d) [1 pt] Define the real interest ratereal interest rate.FR 2005FR 2005

Answer 1 (d):Answer 1 (d): The real interest rate is the nominal interest rate less the nominal interest rate less the expected rate of inflationexpected rate of inflation.

(e) [1 pt] Indicate the effect of the open-market operationopen-market operation you identified in part (c) on the real interest rate in the U.S.on the real interest rate in the U.S.

Answer (e):Answer (e): The buying of bonds by the Fed would increase the MS, whichwould decrease the interest rate, which would increase Ig and increase AD increase AD and price leveland price level. The increase in PL would be subtracted from the nominalinterest rate, which would decrease the real interest ratedecrease the real interest rate.

Rea

l In

tere

st R

ate

Quantity of Funds

rr=8%=8%

D1D1

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rr=10%=10%

FF22

EE11

EE22

Demand for FundsDemand for Funds

upply of Fundsupply of Funds

FR 2005FR 2005Loanable Funds MarketLoanable Funds Market

2. [8 total pts] The graph above shows the loanable funds marketloanable funds market for a country. (a) [2 pts] Assume that now the country’s government increases deficit spendinggovernment increases deficit spending. Explain how the increaseincrease in in deficit spending will affectdeficit spending will affect the the real interest ratereal interest rate.

Answer 2. (a):Answer 2. (a): The increase in deficit spending means the government has to borrow morein the LFM. The increase in demand in the LFM increases the real interest rateincrease in demand in the LFM increases the real interest rate.

(b) [1 pt] Indicate how the real interest rate changereal interest rate change you identified in part (a) will affect the investmentwill affect the investment in plant and equipmentin plant and equipment.

Answer 2. (b):Answer 2. (b): The increase in the real interest rate will make plant & equipmentprojects less profitable and will decrease investment in those projectsdecrease investment in those projects. Thatis, there is “crowding-out”“crowding-out” of investment, due to the higher interest rate.

FR 2005FR 2005

(c) [2 pts] Explain how the real interest rate changehow the real interest rate change you identified in part (a) will affect long-term economic growthwill affect long-term economic growth.

Answer 2. (c):Answer 2. (c): Because the real interest rate increased in part (a), there will be lower investment in plant & equipment lower investment in plant & equipment that make up that country’s national factory, therefore making its citizens less productivemaking its citizens less productive. This will result in slower long-term economic growthslower long-term economic growth and shift the LRAS curve leftLRAS curve left. However, unless there is negative net investment, there could still be economic growth.

(d) [3 pts] Explain how the real interest rate changereal interest rate change you identified in part (a) will affect each of the followingwill affect each of the following in the foreign exchange market. (i) The demand for the country’s currencydemand for the country’s currency (ii) The value of the country’s currencyvalue of the country’s currency

Answer 2. (d), (i) & (ii):Answer 2. (d), (i) & (ii): With real interest rates increasing in part (a), the demand for financial capital (CDs, bonds, etc.) in that country will increase because of the greater relative return on them. (i)(i) This will result in more demand for its currency.more demand for its currency. (ii)(ii) The increase in demand, caused by better return on its financial capital,will increase the value of that nation’s currency, appreciating it.

3. [4 total pts] Assume that the table below shows the unemploymentunemployment and inflation inflation data in Country XCountry X as a result of a shift in AD.

FR 2005FR 2005

PeriodPeriod Unemployment RateUnemployment Rate Inflation RateInflation RateLast Year 2%2% 88%%This Year 55%% 44%%

(a)[2 pts] Draw a correctly labeled graph of a short-run Phillips curve correctly labeled graph of a short-run Phillips curve for Country XCountry X, showing theshowing the actual actual unemploymentunemployment and inflation ratesinflation rates for both years. Label the Phillips curve as SSRRPPCC.

Infl

atio

nIn

flat

ion

UnemploymentUnemployment

8%8%

2%2%

4%4%

5%5%

SSRRPPCC

(b) [2 pts] Now assume that the SSRRAASS curve has shifted tocurve has shifted to the left the left. (i) Identify one factor that could cause the AS curve to shift to the leftcause the AS curve to shift to the left.

Answer 3 (b) (i):Answer 3 (b) (i): An increase in inputincrease in input costcost could shift the AS curve left. [Other OK answers would be increase inbus. regs., increase in business taxes,decrease in subsidies, or an increase in expected inflation.]

(ii) On the graph, show how this shift show how this shift would affect the short-run Phillips curvewould affect the short-run Phillips curve..

SSRRPPCC**

FR 2005FR 2005

Infl

atio

nIn

flat

ion


88%%

2%2%

44%%

5%5%

SSRRPPCC

(c) [1 pt] Assume that the natural rate of unemployment in Country X is 5%natural rate of unemployment in Country X is 5%. Draw Draw aa correctly labeled graph of the long-run Phillips curve and label it ascorrectly labeled graph of the long-run Phillips curve and label it as LRPCLRPC.

LRPCLRPC

(d) [1 pt] What is the relationship between the unemployment rate and the relationship between the unemployment rate and the inflation rate in the long runinflation rate in the long run?

Answer 2. (d):Answer 2. (d): There is no relationshipno relationship between the unemployment rate between the unemployment rate and inflation in the long runand inflation in the long run. As can be seen in the graph above. If there is unanticipated inflationinflation or disinflationdisinflation, although PL increasesincreases or decreasesdecreases,unemployment ends up at the natural rateunemployment ends up at the natural rate.

2004 Macro Free Response2004 Macro Free Response1. Assume our economy is operating at less than full employmentless than full employment. (a) Using a correctly labeled AD & AS graphcorrectly labeled AD & AS graph, show the following. (i) Full-employment outputFull-employment output (ii) Current outputCurrent output (iii) Current price levelCurrent price level

LRAS SRAS

AD1

YR YF

PL1 E1

(b) Identify an open-market operationopen-market operation that could restore full employment in the short run.

Answer: An open-market operation to increase AD would be the Fed buying bondsbuying bonds.

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YYRR YYF Real GDPF Real GDP

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LRAS SRAS

AD1

YR YF

PL1

IR1

MS1 Dm Di

QI D1

E1

IR1

Money Demand

(c) Using a correctly labeled graph of the money marketgraph of the money market, show how the open market operation you identified in part (b) affects the I.R. in the SRI.R. in the SR.

MSMS22

IRIR22 IRIR22

QQIIDD22

ADAD22

PLPL22

Quantity of InvestmentQuantity of Investment

EE22

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(d) Explain how the change in the interest ratechange in the interest rate you identified in part (c) will affect ADaffect AD. Answer:Answer: The decrease in the interest rate will increase QID and consumption which will increase ADincrease AD. (It will also increase Xn because it depreciates the dollar, making our products cheaper.) (e) Show on the graph in part (a) how the change in the IR you identified in part (c) will affect output and price levelaffect output and price level. Answer:Answer: The lower IR will increase QID, which will increase AD which will increase AD which will increase output increase output andand price level price level as shown by the movement from AD1 to AD2.

YYFFMoney MarketMoney Market

YYRR

Answer:Answer: See the above graph. The increase in MS decreases the decreases the II.R. in the SR.R. in the SR.

20042004

Nominal Nominal Interest Interest

RatesRates

(f) Instead of the open-market in part (b), suppose that no policy actions areno policy actions are takentaken to address the unemployment problem. With flexible prices & wagesflexible prices & wages, explain how each of the following will eventually change. (i) Short-run ASShort-run AS (ii) Output and price levelOutput and price level

-20%-20%

$10$10

$8$8

Y*Y*

SRASSRAS11

SRASSRAS22

ADAD11

ADAD

LRASLRASPLPL

YYRR RGDPRGDP

Answer:Answer: As price level drops, workers will accept lower wages. With cheaperresource cost, firms will hire more workers shifting the SRAS curve to theshifting the SRAS curve to theright, decreasing price level and increasing outputright, decreasing price level and increasing output.

SurplusSurplus

2. (a) Assume that national saving in the U.S. increasesnational saving in the U.S. increases. Explain the effect of this increase on the real interest rate in the U.Sreal interest rate in the U.S.

Answer:Answer: If national savings increase, then banks have more loanablefunds. More LF would lead to a decrease decrease in thein the real interest rate real interest rate.

(b) Suppose that real interest rates in the rest of the world real interest rates in the rest of the world remain unchangedremain unchanged. (i) Explain the effect of the real interest rate change in the U.S. that you identified in part (a) on the demand for the U.S. dollardemand for the U.S. dollar in the foreign exchange market.Answer:Answer: Because the U.S. real interest rate is going down and they areunchanged in the rest of the world, foreign investors would decreasedecrease their demandtheir demand for for U.S. financial U.S. financial assetsassets because of less return on the lower real I.Rates. (ii) As a result of the effect you identified in (i), what will happento the international value of the U.S.international value of the U.S. dollardollar?

Answer:Answer: The decrease in foreign demand for U.S. financial assets because of the decreasing interest rate would depreciate the dollardepreciate the dollar. (c) Given your answer in part (b), indicate how each of the following will change. (i) U.S. importsU.S. imports (ii) U.S. exportsU.S. exportsAnswer:Answer: U.S. U.S. importsimports wouldwould decreasedecrease because the depreciated dollar would make imports more expensive. U.S. U.S. exports would increaseexports would increasebecause the depreciated dollar would make U.S. exports cheaper.

LFMLFM oror Money Market Money Market?? Use the “Money Market”“Money Market” modelmodel, with the vertical MSvertical MS, when the Fed changesFed changes tthe he MSMS.

Use the “LFM” model“LFM” model, with the upward sloping supply curveupward sloping supply curve, if there is a““change in savings”change in savings” or “change in demand for loanable funds”“change in demand for loanable funds”, such as expansionary or contractionary fiscal policyexpansionary or contractionary fiscal policy.

3. The Fed buys $5,000 in bondsFed buys $5,000 in bonds from Clark Consulting Servicesfrom Clark Consulting Services, which then deposits the money in a checking account at First Generation Bank. (a) As a result of the Fed’s action, what is the changechange in MS in MS if if RRRR is is 100100%%?Answer:Answer: The change in MS would be the $5,000$5,000 DDDD.

(b) If the RR is reduced to 10%RR is reduced to 10%, calculate the following. (i) The maximum amount this bank could lendthis bank could lend from this deposit.Answer:Answer: With 10% or $500 in RR, the bank could loan out $4,500loan out $4,500. (ii) The maximum increasemaximum increase in in the total MSthe total MS from the Fed’s bond purchase.Answer:Answer: Potential money creation in the banking system could be asmuch as $45,000 [10x$4,500=$45,000]. Clark Consulting has a DDof $5,000. Adding these two together gives a TMS of $50,000TMS of $50,000. (c) If banks keep some of the deposit as ERbanks keep some of the deposit as ER, how will this influence the change in the MSchange in the MS that was determined in part (b)(II)? Explain.Answer:Answer: If the bank doesn’t loan out all of the $4,500 ER, then the1st loan would not be as much as $4,500not be as much as $4,500, therefore reducing PMC. (d) If the public decidespublic decides to to hold some money in the form of currencyhold some money in the form of currencyrather than in demand deposits, how will this influence the change inchange inthe money supplythe money supply that was determined in part (b)(ii)? Explain.

Answer:Answer: If the public gets the loan and holds part of it as currency, thenthis is a leakage in the PMC of the banking system. If the person who takesthe $4,500 loan from First Generation Bank takes $500 in cash, then only$4,000 gets deposited in the next bank, thus reducing the PMCreducing the PMC of the system.

1. Assume the U.S. economy is operating at full-employment output and the government has a balanced budget. A drop in consumer confidence reduces consumption spending, causing the economy to enter into a recessionrecession.

(a) Using a correctly labeled graph of the short-run Phillips curve, show the effect of the decrease in consumption spending. Label the initial position “A”“A” and the new position “B”“B”.

(b) What is the impact of the recessionrecession on the federal budget? Explain.

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Answer to 1. (b): Answer to 1. (b): The decrease in consumption would result in a decrease in AD and a decrease in GDP.The decrease in consumption would result in a decrease in AD and a decrease in GDP. This would result in an increase in unemployment and an increase in transfer payments.This would result in an increase in unemployment and an increase in transfer payments. Due to the job losses, there would be a decrease in tax revenues, resulting in an increaseDue to the job losses, there would be a decrease in tax revenues, resulting in an increase in government red ink for the federal budget. So in government red ink for the federal budget. So a a federal budget deficit would increase federal budget deficit would increase or a federal budget surplus would decrease. or a federal budget surplus would decrease.

A. W. PhillipsA. W. Phillips1914-19751914-1975

2 pts – 1 pt for correctly labeled SRPC graph.2 pts – 1 pt for correctly labeled SRPC graph. 1 pt for initial & new pt on SRPC graph.1 pt for initial & new pt on SRPC graph.

2 pts - 1 pt for budget deficit and 1 pt for explanation.2 pts - 1 pt for budget deficit and 1 pt for explanation.

(c) Assume current real GDP falls short of full-employment output by $500 billion and the MPC is 0.8. (i) Calculate the minimum increase in government spending that could bring about full employment. Answer to 1. (c) (i):Answer to 1. (c) (i):

The expenditure multiplier [The expenditure multiplier [MMEE] would be 5 [1/.2 = ] would be 5 [1/.2 = MMEE of 5]. Because current output of 5]. Because current output falls short by $500 billion, it would take a minimum increase in government spendingfalls short by $500 billion, it would take a minimum increase in government spending of $100 billion to get to full employment. [5 X $100 = $500]of $100 billion to get to full employment. [5 X $100 = $500]

(ii) Assume that instead of increasing government spending, the government decides to reduce personal income taxes. Will the reduction in personal income taxes required to achieve full employment be larger than or smaller than the government spending change you calculated in part (c) (i)? Explain why. Answer to 1. (c) (ii): Answer to 1. (c) (ii):

Because the tax multiplier [Because the tax multiplier [MMTT] is smaller, or [MPC/MPS = .8/.2 = 4], it will take a larger] is smaller, or [MPC/MPS = .8/.2 = 4], it will take a larger tax cut then the increase in government spending. Because current output is $500 bil.tax cut then the increase in government spending. Because current output is $500 bil.

short of FE Y, and the short of FE Y, and the MMTT is 4, it would take a tax cut of $125 billion. [4 X $125 = $500] is 4, it would take a tax cut of $125 billion. [4 X $125 = $500]

3 pts – 1 pt – $100; 3 pts – 1 pt – $100; 1 pt – larger Tax reduction; 1 pt – larger Tax reduction; 1 pt – smaller M1 pt – smaller MTT or not all increased Y spent. or not all increased Y spent.

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(d) Using a correctly labeled graph of the loanable funds market, show the impact of the increased government spending on the real interest rate in the economy.

(e) How will the real interest rate change in part (d) affect the growth rate of the U.S. economy? Explain.

Answer to 1. (d)Answer to 1. (d) As can be seen on the LF graph, the RIR would increase as the government has to borrow As can be seen on the LF graph, the RIR would increase as the government has to borrow more than previously, increasing demand in the LFM, which pushes up the RIR.more than previously, increasing demand in the LFM, which pushes up the RIR.

Answer to 1. (e): The increase in RIR will Answer to 1. (e): The increase in RIR will decrease real Ig, decreasing capital stock. decrease real Ig, decreasing capital stock.

This will decrease AD and decrease GDP This will decrease AD and decrease GDP or growth rate in the U.S. economy.or growth rate in the U.S. economy.

2 pts – 1 pt – correctly labeled LFM graph;2 pts – 1 pt – correctly labeled LFM graph; 1 pt – rightward shift of D curve1 pt – rightward shift of D curve or leftward supply shift. or leftward supply shift.

2 pts – 1 pt – growth rate falls;2 pts – 1 pt – growth rate falls; 1 pt – Ig 1 pt – Ig decreases, slowing capital formation. decreases, slowing capital formation.

2. Balance of payments accounts record all of a country’s international transactions during a year.(a)Two major subaccounts in the balance of payments accounts are the current account and the capital account. In which of these subaccounts will each of the following transactions be recorded? (i) A United States resident buys chocolate from Belgium.

(b) How would an increase in the real income in the United States affect the United States current account balance? Explain.

(ii) A United States manufacturer buys computer equipment from Japan.

Answer to 2. (a) (i):Answer to 2. (a) (i): Chocolate from Belgium would go in the current account Chocolate from Belgium would go in the current account as it as it includes the import of goods. includes the import of goods.

Answer to 2. (a) (ii):Answer to 2. (a) (ii): Computer equipment by a U.S. manufacturer would also be classified as an import so itComputer equipment by a U.S. manufacturer would also be classified as an import so it would also go on the current account. would also go on the current account.

Answer to 2. (b):Answer to 2. (b): An increase in real income would make U.S. citizens richer. We would buy more imports,An increase in real income would make U.S. citizens richer. We would buy more imports, decreasing net exports, and increasing the deficit on the current account. decreasing net exports, and increasing the deficit on the current account.

1 pt – current account1 pt – current account

1 pt – current account1 pt – current account

2 pts - 1 pt – imports increase or Xn decrease.2 pts - 1 pt – imports increase or Xn decrease. 1 pt – current account balance decreases or current account balance goes into deficit.1 pt – current account balance decreases or current account balance goes into deficit.

2 pts - 1 pt – correctly labeled foreign exchange graph for the dollar.2 pts - 1 pt – correctly labeled foreign exchange graph for the dollar. 1 pt – rightward shift in supply and depreciation of the 1 pt – rightward shift in supply and depreciation of the dollar.dollar.

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(c) Using a correctly labeled graph of the foreign exchange market for the U.S. dollar, show how an increase in U.S. firms’ direct investment in India will affect the value of the U.S. dollar relative to the Indian currency (the rupee). Answer to 2. (c):Answer to 2. (c): The increase in investment in India will increase demand for the rupee & appreciate thatThe increase in investment in India will increase demand for the rupee & appreciate that currency. This would result in an increase in supply of the U.S. dollar for more rupees,currency. This would result in an increase in supply of the U.S. dollar for more rupees, depreciating the dollar.depreciating the dollar.

3. The PPCs for Artland & Rayland are shown. Using equal amounts of resources, Artland can produce 600 hats or 300 bicycles, & Rayland can produce1,200 hats or 300 bicycles.(a)Calculate the opportunity cost of a bicycle in Artland.

(b) If the two countries specialize and trade, which country will import bicycles? Explain.

(c) If the terms of trade are 5 hats for 1 bicycle, would trade be advantageous for each of the following? (i) Artland (ii) Rayland

(d) If productivity in Artland triples, which country has the comparative advantage in the production of hats?

Answer to 3. (a):Answer to 3. (a): The Domestic Comparative (opportunity cost) of The Domestic Comparative (opportunity cost) of a bicycle a bicycle in Artland is 2 units of hats. [1 bicycle = 2 hats or 600/300=2] in Artland is 2 units of hats. [1 bicycle = 2 hats or 600/300=2]

Answer to 3. (b):Answer to 3. (b): Rayland will import bicycles. Domestically, they have to giveRayland will import bicycles. Domestically, they have to give up 4 hats to get a bicycle but with trade they have to give upup 4 hats to get a bicycle but with trade they have to give up only 3 hats. only 3 hats.

DCC: Rayland DCC: ArtlandDCC: Rayland DCC: Artland1 B = 4 H1 B = 4 H 1 B = 2 H 1 B = 2 H¼ B= 1 H¼ B= 1 H ½ B= 1 H ½ B= 1 H

Terms of TradeTerms of Trade 1 B = 3 H1 B = 3 H 1/3 B = 1 H 1/3 B = 1 H

Answer to 3. (c) (i): Answer to 3. (c) (i): Yes, 5 hats Yes, 5 hats is is better better than than 2 hats they are getting domestically. 2 hats they are getting domestically.

Answer to 3. (d): 300 bicycles would become 900 and 600 hats would become 1,800, so theAnswer to 3. (d): 300 bicycles would become 900 and 600 hats would become 1,800, so the DCC would still be 1 bicycle = 2 hats, same as before. Rayland still has a C.A. in hats. DCC would still be 1 bicycle = 2 hats, same as before. Rayland still has a C.A. in hats.

Answer to 3. (c) (ii): Answer to 3. (c) (ii): No, Rayland is going to export hats so opportunity costNo, Rayland is going to export hats so opportunity costis ¼ bicycle. So 1/5 of a bicycle would not benefit them. is ¼ bicycle. So 1/5 of a bicycle would not benefit them.

1 pt for “1 B = 2 H”1 pt for “1 B = 2 H”

2 pts for “Rayland will import bicycles” 2 pts for “Rayland will import bicycles”

1 pt for “Yes, 5 H is better than 2 H”1 pt for “Yes, 5 H is better than 2 H”

1 pt for “No” 1 pt for “No”

1 pt for “No change, so Rayland still has a comparative advantage in hats”1 pt for “No change, so Rayland still has a comparative advantage in hats”

Documents

Real Interest Rate, (percent) Quantity of Loanable Funds Loanable Funds Market [*Use this graph if there is a chg in savings by consumers or chg in