Norman

SRASLRASLRASAD1

PLPLEE

 

Answer: 1. (b) (i) As can be seen on the graph, the increase in G would increase Answer: 1. (b) (i) As can be seen on the graph, the increase in G would increase AD to AD2, increasing PL and Y.AD to AD2, increasing PL and Y. 1. (b) (II) The increase in AD to AD2 would decrease unemployment in1. (b) (II) The increase in AD to AD2 would decrease unemployment inthe short run, as the increase in AD would lead to an increase in output & profits, the short run, as the increase in AD would lead to an increase in output & profits, resulting in more workers being hired and therefore the decrease in unemploymentresulting in more workers being hired and therefore the decrease in unemployment..

ADAD22

PLPL22

YYII

EE11

Real GDPReal GDP

EE22

1. [10 total points] [10 total points] Assume that the U.S. economy is currently in long-run equilibrium. (a) [2 pts] Draw a correctly labeled graph of aggregate demand and aggregate supply and show each of the following. (i) The long-run aggregate supply curve (ii) The current equilibrium output & PL, labeled as YE and PLE, respectively.

(b) [2 pts] Assume that the government increases spending on national defense without raising taxes. (i) On your graph in part (a), show how the government action affects AD. (ii) How will this government action affect the unemployment rate in the short run? Explain.

YEYE

PLPL Answer 1(a)(i): 1 pt for correctly labeled graph Answer 1(a)(i): 1 pt for correctly labeled graph with downward-sloping AD, upward-sloping with downward-sloping AD, upward-sloping SRAS, PLSRAS, PLEE and Y and YE.E.

(ii) 1 pt for showing a vertical LRAS at Y(ii) 1 pt for showing a vertical LRAS at YE.E.

SRAS1LRASLRAS

AD

YEYE

 

PLPL22

EE11

Real GDPReal GDP

EE22

1. (c) [2 pts] Assume that the economy adjusts to a new long-run equilibrium after the increase in government spending. (i) How will the short-run aggregate supply curve in the new long-run equilibrium compare with that in the initial long-run equilibrium in part (a) ? Explain. (ii) On your graph in part (a), label the new long-run equilibrium price level as PL2.

PLPLEE

YYII

SRAS2PLPL

Answer 1.(c)(i): 1 pt for stating that the SRAS will shift to the left because the Answer 1.(c)(i): 1 pt for stating that the SRAS will shift to the left because the Increase in AD would result in more inflation so workers will demand higherIncrease in AD would result in more inflation so workers will demand higherwages AND showing PL2 correctly in part (a)’s graph.wages AND showing PL2 correctly in part (a)’s graph.1.(c)(ii) 1 pt for explaining that the actual PL is higher than the expected PL, or1.(c)(ii) 1 pt for explaining that the actual PL is higher than the expected PL, orwages and commodity prices adjust to higher PL[flexible wages], causing the wages and commodity prices adjust to higher PL[flexible wages], causing the SRAS curve to shift to the left.SRAS curve to shift to the left.

SD1

r1r1

FF11

Rea

l In

tere

st R

ate,

(%

)

Quantity of Loanable Funds

E1E1

rr22

FF22

EE22

DD22 LFM

Answer to 1. (e) (i) [1 pt] The higher RIR will result in less investment in tools and machinery.Answer to 1. (e) (i) [1 pt] The higher RIR will result in less investment in tools and machinery. 1. (e) (ii) [1 pt] The decrease in tools and machinery will decrease overall 1. (e) (ii) [1 pt] The decrease in tools and machinery will decrease overall productivity and economic growth [capital stock]. productivity and economic growth [capital stock].

1. (d) [2 pts] In order to finance the increase in government spending on national defense from part (b), the government borrows funds from the public. Using a correctly labeled graph of the loanable funds market, show the effect of the government’s borrowing on the real interest rate. (e) [2 pts] Given the change in the real interest rate in part (d), what is the impact on each of the following? (i) Investment (ii) Economic growth rate. Explain.

Answer to 1. (d) 1 pt for correctly labeled graphAnswer to 1. (d) 1 pt for correctly labeled graphof the LFM.of the LFM.1 pt for showing a rightward shift of the demand1 pt for showing a rightward shift of the demandcurve resulting in a higher interest rate curve resulting in a higher interest rate OROR a aleftward shift of the supply curve resulting in a leftward shift of the supply curve resulting in a higher RIR.higher RIR.

Answer to 2. (c) The lower IR will increaseAnswer to 2. (c) The lower IR will increaseAD due to more investment and interest AD due to more investment and interest sensitive consumption [the lower IR would sensitive consumption [the lower IR would also depreciate the dollar and increase Xn].also depreciate the dollar and increase Xn].All 3 cause an increase in AD & PL in the SR.All 3 cause an increase in AD & PL in the SR.2. (d) Selling bonds would be the OMO as2. (d) Selling bonds would be the OMO asit would decr MS, incr NIR and decr AD & PL. it would decr MS, incr NIR and decr AD & PL.

[Money Market][Money Market]

DDmm11MS

Nom

inal In

tere

st

Rate

n2

2. [6 total points] [6 total points] A drop in credit card fees causes people to use credit cards more often for transactions and demand less money. (a) [2 pts] Using a correctly labeled graph of the money market, show how the nominal interest rate will be affected. (b) [1 pt] Given the interest rate change in part (a), what will happen to bond prices in the short run?

(c) [2 pt] Given the interest rate change in part (a), what will happen to the price level in the short run? Explain. (d) [1 pt] Identify an open-market operation the Fed could use to keep the nominal interest rate constant at the level that existed before the drop in credit card fees. Explain.

Answer to 2. (a) The decrease in Dt for money Answer to 2. (a) The decrease in Dt for money would decrease the Dwould decrease the Dmm curve resulting in a curve resulting in a lower NIR and RIR.lower NIR and RIR.2. (b) Bond prices are inverse to the interest2. (b) Bond prices are inverse to the interestrate so bond prices would increase rate so bond prices would increase

n1

DDmm22

Quantity of MoneyQuantity of Money

3. [6 total points] [6 total points] A U.S. firm sells $10 million worth of goods to a firm in Argentina, where the currency is the peso. (a) [1 pt] How will the transaction above affect Argentina’s aggregate demand? Explain. (b) [1 pt] Assume that the U.S. current account balance with Argentina is initially zero. How will the transaction above affect the United States current account balance? Explain.

Answer to 3. (a) The selling of $10 M of U.S. goods to Argentina wouldAnswer to 3. (a) The selling of $10 M of U.S. goods to Argentina would decrease Argentina’s net exports which would decrease their AD. decrease Argentina’s net exports which would decrease their AD. AD = C+I+G+X-M, when M gets larger, GDP gets smaller.AD = C+I+G+X-M, when M gets larger, GDP gets smaller.

3. (b) The $10 million increase in net exports would cause a flow of $103. (b) The $10 million increase in net exports would cause a flow of $10 million worth of pesos into the U.S. [recorded as a +$10 million]million worth of pesos into the U.S. [recorded as a +$10 million] and would cause a current account balance of ZERO to become a and would cause a current account balance of ZERO to become a +$10 million surplus account balance. +$10 million surplus account balance.

3. (c) [2pt] Using a correctly labeled graph of the foreign exchange market for the U.S. dollar, show how a decrease in the U.S. financial investment in Argentina affects each. (i) The supply of United States dollars (ii) The value of the United States dollar relative to the peso

Quantity of DollarsQuantity of Dollars

Pe

so P

rice

of

Do

llar

P50P50

Price S1$$DD11$$

DD

AA

P100P100

EE11

EE22

SS2$2$

PesoPesodepreciatesdepreciates

P looking for $’s$’s looking for P

Answer to Answer to 3. (c) (i): 3. (c) (i): If the If the U.S.U.S.decrease financial investment decrease financial investment in Argentina, the U.S. would in Argentina, the U.S. would decrease their supply of decrease their supply of dollars to Argentina, resulting dollars to Argentina, resulting in a decrease in demand for in a decrease in demand for the peso.the peso.(c) (ii) (c) (ii) As shown on the graph, As shown on the graph, the dollar would appreciate.the dollar would appreciate.

(d) [2 pt] Suppose that the inflation rate is 3% in the U.S. and 5% in Argentina. What will happen to the value of the peso relative to the United States dollar as a result of the difference in inflation rates? Explain.

(d) T(d) The he cheaper prices cheaper prices in the in the U.S. will result in more U.S. will result in more demand for U.S. goods and demand for U.S. goods and therefore the dollar, therefore the dollar, appreciating the dollar and appreciating the dollar and depreciating the peso. depreciating the peso.

2010 FRQ

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