Practice AP-style test for Sections 1-8 1. The unemployment rate of Ile is 25% and the labor force participation rate is 75%. There are 10,000 people living in Ile, 8,000 of them are working aged. How many people in Ile are unemployed? A. 4,000 B. 1,500 C. 2,000 D. 1,000 E. 750 Correct Answer: B Explanation: The unemployment rate = (# of people unemployed)/(labor force). Here the labor force is 75% of the working age population of 8000= 6000. If the unemployment rate is 25%, 0.25 *6,000= the unemployment rate. Use the following Table 1-1 to answer Questions 2 to 3.

2. Refer to Table 1-1. In the nation of Evad, a typical household consumes 50 plums, 1 lawnmower, and 200 pounds of pasta in a given year. Using 1992 as the base year, what is the CPI for 1991? A. 325 B. 90 C. 167 D. 65 E. 66 Correct Answer: B Explanation: To find the CPI in any given year, divide the cost of a basket of goods in that year by the cost of the same basket in the base year and multiply by 100. In this case CPI for 1991 is ($450/$500)*100 = 90.

Table 1-1

Prices for Evad 1990 1991 1992 Price of Plums $0.50 each $0.50 each $1.00 Price of Lawnmowers $100 $125 $150 Price perlb of Pasta $1 $1.50 $1.50

3. Refer to Table 1-1. In the nation of Evad, a typical household consumes 50 plums, 1 lawnmower, and 200 pounds of pasta in a given year. If 1992 is the base year, what is the rate of inflation from 1991 to 1992? A. 10% B. 11% C. 66% D. 65% E. 90% Correct answer: B Explanation: to find the rate of inflation, find the CPI in each year, then calculate (New-Old)/Old. In this case, the CPI for 1991 is 90, and the CPI for 1992 is 100. 100-90/90 = 11%. 4. If the real price level increased and unrelated to that change the Federal Reserve purchased bonds, what would be the effect on the quantity of money in circulation and the interest rate? Effect on interest rate Effect on Quantity of money in

circulation A. No change Increase B. Increase Increase C. Decrease Increase D. Ambiguous Increase E. Ambiguous Ambiguous Correct Answer: D Explanation. Recall that when both supply and demand shift either the price or quantity in a market will be ambiguous. If the Federal Reserve increases the amount of money in circulation, the money supply would increase. The increase in the price level will increase the demand for money. So, therefore, there will be an unambiguous increase in the quantity of money in circulation, since both supply and demand increased. But, the effect on the interest rate of the combined events will be ambiguous. 5. Suppose the marginal propensity to save is 0.25 and there is a $200 million dollar recession gap. If the government were to use fiscal policy to close the gap, by how much would they need to increase government spending? A. $200 million B. $150 million C. $50 million D. $125 million E. $175 million Correct answer: C Explanation: If the Marginal Propensity to Save is 0.25, then the Marginal Propensity to Consume is 0.75. The Multiplier is 1/1-MPC = 1/1-0.75 = 4. Therefore, output will increase by 4 times any amount the government spends, meaning that the government need only spend $50 million to close the output gap.

6. Which of the following would be necessary to represent economic growth in an aggregate supply and demand diagram: I. An increase in Aggregate Demand II. An increase in Short Run Aggregate Supply III. An increase in Long Run Aggregate Supply A. Only I is necessary. B. Only II is necessary C. Only III is necessary D. I and II are necessary. E. I, II, and III are all necessary. Correct Answer: C Explanation: Economic growth is an increase in potential output. Long run aggregate supply represents potential output. Even if AD and SRAS both increased, this increase would be unsustainable unless potential output also increased. Use the following Figure 2-1 to answer Question 7.

7. Refer to Figure 2-1. Which of the following describes who has comparative and absolute advantage? Absolute

Advantage in carrots

Absolute Advantage in

Sweaters

Comparative Advantage in Carrots

Comparative Advantage in Sweaters

A. Skylar Skylar Mackenzie Mackenzie B. Skylar Mackenzie Mackenzie Skylar C. Mackenzie Skylar Mackenzie Skylar D. Mackenzie Skylar Skylar Mackenzie E. Skylar Mackenzie Skylar Mackenzie Correct Answer: E Explanation: Absolute Advantage is the ability to make more of a good with the same resources. In this case, using the same resources, Mackenzie can make more sweaters and Skylar can make more Carrots. Comparative advantage is having a lower opportunity cost of production. In this case, Skylar’s opportunity cost for making sweaters is 2/5 of a carrot and Mackenzie’s opportunity cost is 1/5 of a carrot. Therefore Mackenzie has comparative advantage in making sweaters. Skylar’s opportunity cost

of making carrots is 2 ½ sweaters, and Mackenzie’s opportunity cost of making carrots is 5 sweaters. Therefore Skylar has comparative advantage in making carrots. 8. Which of the following would result in an leftward shift of the money supply? I. The Federal Reserve Lowers the reserve ratio II. The Federal Reserve sells bonds III. The Federal Reserve buys bonds A. I only B. II only C. III only D. I and II E. I and III Correct Answer: B Explanation: When the Fed lowers the reserve ratio, banks are able to loan more money and the money supply increases. When the Fed buys bonds, it pulls bonds out of circulation and puts money in circulation. However, when the Fed sells bonds it puts bonds in circulation and pulls money out of circulation. 9. Which of the following would lead to an unambiguous increase in the price level? A. An increase in consumer optimism and an increase in wages. B. An increase in consumer optimism and a decrease in wages. C. A decrease in resource prices and a decrease in consumer optimism. D. An increase in resource prices and an increase in imports. E. An increase in resource prices and a decrease in exports. Correct answer: A Explanation: An increase in consumer optimism would increase aggregate demand and an increase in wages would decrease short run aggregate supply. Therefore, while the effect on output would be ambiguous, there would definitely be an increase in the price level. 10. If the Fed sells bonds, this will , which will , leading to A. Increase the money supply, increase the interest rate, an increase in Aggregate Demand.

.

B. Increase the money supply, increase the interest rate, a decrease in Aggregate Demand. C. Decrease the money supply, decrease the interest rate, a decrease Aggregate demand. D. Decrease the money supply, decrease the interest rate, an increase Aggregate Demand. E. Decrease the money supply, increase the interest rate, decrease Aggregate demand. Correct Answer: E When the Fed sells bonds, they put bonds in circulation and pull money out of circulation. This results in a higher interest rate. The higher interest rate will decrease investment spending, which will decrease aggregate demand.

11. Which of the following terms describes the situation when a government spends more than it collects revenue in a given year? A. Budget Deficit B. Budget Surplus C. Capital inflow D. National Debt E. National Savings Correct Answer: A Explanation: The budget deficit is the difference between tax revenue and government spending when government spending exceeds tax revenue. A budget surplus is when revenue exceeds spending. National debt is the accumulation of deficit over more than one year. National savings is the sum of private savings and the budget balance (whether that is a surplus or deficit). Capital inflow refers to the net inflow of funds into a country. 12. Which of the following describes a situation where money fails in its role as being a store of value? A. Money is no longer a commonly accepted measure that individuals use to set prices. B. Hyperinflation lowers the purchasing power of the currency. C. Employees are no longer willing to accept a currency as payment. D. Money is no longer used to make calculations of economic variables such as GDP or Profit. E. Non-smokers and smokers both start to trade goods and services for cigarettes. Correct answer: B Explanation: A and D both describe failures of money as unit of account. C and E describe failures of the “medium of exchange” role of money. 13. If the interest rate is 20%, what is the present value of $150 received next year? A. $130 B. $125 C. $100 D. $180 E. $150 Correct answer: B Explanation: If the interest rate is 20%, you would be willing to accept $125 for every $150 to be paid 1 year from now. This is because if you accepted $125 and put it in an account bearing 20% interest, you would have $150 in one year. To calculate this, find $X = 150/(1+0.2) = 150/1.20=125.

14. If the interest rate increases from 20% to 25%, does the present value of $180 paid next year increase or decrease, and by how much? Present value of money

increases or decreases? By How Much?

A. Increases $5 B. Increases $6 C. Decreases $6 D. Decreases $5 E. Does not change Does not change Correct Answer: C Explanation: When the interest rate is 20% the present value of $180 paid in one year is $150. When the interest rate is 25% the present value of $180 is $144 15. Assume that banks do not keep excess reserves. Suppose the required reserve ratio is raised from 20% to 25%. If $1000 is deposited into banks, then what is true about the final change in the money supply? A. The resulting change in the money supply is $500 more than it would have been had the reserve ratio remained 20% B. The resulting change in the money supply is $1000 more than it would have been had the reserve ratio remained 20%. C. The resulting change in the money supply is $1000 less than it would have been had the reserve ratio remained 20%. D. The resulting change in the money supply is $500 less than it wouldhave been had the reserve ratio remained 20% E. The money supply is unaffected by the required reserve ratio. Correct Answer: C Explanation: When the required reserve ratio is 20%, then a $1000 deposit will increase the money supply by $5000. When the required reserve ratio is 25%, then a $1000 deposit will increase the money supply by $4000. 16. The Federal Reserve System I. Was created in part as a response to the 1907 banking panic II. Was created in part as a response to the Great Depression III. Eliminated the potential for bank runs. A. I only. B. II only. C. III only. D. I and III. E. I and II. Correct answer: A Explanation: The Federal Reserve System was created in 1913 due in part to the unprecedented severity of the 1907 bank crisis and the role that J.P. Morgan played in saving the financial system from collapse. However, because fractional reserves mean that the value of individual and firms’ deposits are greater than the banks reserves, banking runs are still possible

17. The discount rate refers to A. The rate of return that the Federal Reserve receives from the Treasury Bills that it holds. B. The rate of return that the Federal Reserve received from the Treasury Bills that it sells C. The rate of interest that banks pay if they borrow money from other banks D. The rate of interest that the Federal Reserve charges to banks that borrow money from the Federal Reserve. E. The amount that the Federal Reserve discounts money loaned directly to the federal government. Correct Answer: D Explanation: The discount rate is the interest rate that the Fed charges at the discount window: a means by which banks in need of reserves can borrow directly from the Fed if the Fed purchases new bonds created by the federal government, at an initial offering, some may interpret this as the Fed lending directly to the government) Use the following Figure 2-2 to answer Questions 18 to 19.

18. Refer to Figure 2-2. Which of the following terms would best describe the movement from r1 to r2? A. An increase in the opportunity cost of holding money. B. A decrease in the opportunity cost of holding money. C. An increase in the aggregate price level. D. A decrease in real GDP. E. A change in technology in bank operations. Correct answer: A Explanation: The demand for money is downward sloping because of the opportunity cost of holding money, which is reflected by the real interest rate. As the opportunity cost of money increases, people are less willing to hold money because the opportunity cost of holding money has increased. C, D, and E would explain shifts in the money demand curve, rather than movement along the money demand curve.

19. Refer to Figure 2-2. If the money demand curve shifts from MD1 to MD2, which of the following describes the situation if the interest rate is r1? A. The quantity of money demanded is less than is what is available, and people will reduce their holdings of money in response to this. B. The quantity of money demanded is less than what is available, and people will increase their holdings of interest bearing assets in response to this. C. The quantity of money demanded is more than what is available, and people will increase their holdings of interest bearing assets in response to this. D. The quantity of money demanded is less than what is available, and people will decrease their holdings of interest bearing assets in response to this. E. The quantity of money demanded is more than what is available, and people will sell bonds in response. Correct answer: E Explanation: If the money demand increases, people want to hold more money regardless of what the interest rate is. However, the actual quantity of money available is fixed and cannot respond. As people attempt to increase their holdings of money, they will decrease their holdings of interest bearing assets, driving the interest rate for these up. 20. In the market for loanable funds, what will happen if businesses believe the rate of return on projects will increase? A. The demand for loanable funds will decrease, and supply will increase B. The demand for loanable funds will increase, and supply will stay the same C. The supply of loanable funds will decrease, and demand will decrease D. The supply of loanable funds will increase, and demand will stay the same E. The demand for loanable funds will increase,and the supply will decrease. Correct Answer: B Explanation: The demand for loanable funds depends on the perceived opportunities for projects. If the perceived rate of return of businesses increases, then for any given interest rate the quantity of loanable funds demanded will be higher. Use Figure 2-3 to answer Question 21.

21. Refer to Figure 2-3. Which of the following could have caused the shifts indicated? A. An increase in government budget deficits and an increase in private savings B. An increase in government budget deficits and an increase in foreign lending. C An decrease in government budget deficits and a decrease in foreign lending D. A decrease in government budget deficits and an increase in private savings. E. An increase in government budget deficits and a decrease in foreign lending. Correct answer: E Explanation: The amount of foreign capital inflows will shift the supply of loanable funds. When there are less foreign funds available to lend, the supply of loanable funds decreases. The demand for loanable funds is affected by government budget deficits: higher government budget deficits increase the demand for loanable funds. 22. Which of the following would definitely lead to a decrease in interest rates in the market for loanable funds? A. The government runs a budget deficit and consumers decrease their personal savings. B. Businesses expect lower returns to investment and consumers increase their personal savings. C. The government runs a budget surplus and consumers decrease their personal savings. D. Businesses expect greater returns to investment and consumers decrease their personal savings. E. The government runs a budget surplus and consumers decrease their amount of personal savings. Correct Answer: B Explanation: If the government runs a budget deficit the demand for loanable funds will increase. If the government runs a budget surplus the demand for loanable funds will decrease. If consumers decrease their personal savings the supply of loanable funds will decrease. If consumers increase their personal savings the supply of loanable funds will increase. If businesses expect greater returns to investment, the demand for loanable funds will increase, but if they expect lower returns to investment the demand for loanable funds will deacrease. If supply and demand both increase, the effect on the interest rate is indeterminant. If supply decreases and demand increases, the interest rate will definitely INCREASE. If supply and demand both decrease, the effect on interest rates is again indeterminate. If Supply Increases, and Demand Decreases, the interest rate will definitely fall. 23. Which of the following is true of the relationship between the liquidity preference model of the interest rate and the loanable funds model of the interest rate? A. The loanable funds model of the interest rate determines the equilibrium interest rate in the long run, and the money market follows the lead of the loanable finds market. B. The money market determines the equilibrium interest rate in the short run and the loanable funds market follows the lead of the money market. C. The interest rate is set by the Federal reserve for both markets. D. Each model is interchangeable in determining the interest rate in the long run or the short run. E. The money market determines the equilibrium interest rate in the short run or the long run, but the loanable funds market only applies to the long run. Correct answer: B Explanation: The supply and demand for money determine the interest rate, but only in the short run. For example, consider a change in the supply or demand for money that leads to a decrease in the interest rate. This decrease will make the rate of return of investment increase, which will lead to businesses demanding more loanable funds and lead to an increase GDP. However, the potential real output has not changed. This will cause an increase in the aggregate price level. Ultimately, this will increase the demand for money, which will raise the demand for money and return interest rates to their long run equilibrium.

24. The Budget Balance is I. Savings by the government. II. A government budget that is balanced. III. The difference between what the government receives in tax revenue and what it spends on government spending and government transfers. A. I and II. B. II and III. C. I and III. D. II only. E. III only. Correct answer: C Explanation: The budget balance is given by Sgovernment = T-G-TR. S is the amount of government savings, G is the amount of government spending, and TR is the amount of transfer payments. If the budget is “balanced” then T=G+TR and the amount of the budget balance is zero, however the budget balance can also be positive (which happens when there is a budget surplus) or negative (which happens when there is a budget deficit). 25. Which of the following results in the amount of the actual future debt liabilities of the US government being higher than that reflected by the debt-GDP ratio? A. The GDP already captures the government debt. B. Debts owed to foreign entities are not counted in the Debt-GDP ratio. C. The debt-GDP ratio will always increase as government incur more debt. D. The debt-GDP ratio only counts explicit debt owed and omits implicit debt. E. The actual amount of future debt liabilities is smaller than the debt-GDP, rather than higher. Correct answer: D Explanation: The debt only counts explicit liabilities to all entities. Even though the debt-GDP ratio itself might fall if the amount of debt service increases at a slower rate than the growth of GDP, the actual amount of future lilabilties includes implicit liabilities such as future promised payments to Social Security recipients. 26. Contractionary monetary policy is conducted by ______________ and leads to ____________. A. Expanding the money supply, a decrease in aggregate demand. B. Decreasing the money supply, a decrease in aggregate demand. C. Increasing government spending, an increase the money supply. E. Decreasing government spending, an increase in the money supply. F. Decreasing the money supply, a contraction of government spending. Correct answer: B Explanation: Contractionary money supply is aimed at reducing aggregate demand. If the money supply is lowered, this will lead to an increase in interest rates, which will lower investment and therefore lower aggregate demand.

Use Figure 2-4 to answer Question 27.

27. Refer to Figure 2-4. According to the Taylor rule, what should the federal funds rate be if the inflation rate? is 3%? A. 1.5% B. 3% C. 3.5% D. 10% E. 10.5% Answer: E Explanation: According to the Taylor Rule, the Federal Funds rate should be set = 1+(1.5*inflation rate)+0.5(output gap). Here, =1+1.5*3+0.5*10 = 10.5% 28. Which of the following is believed to be a goal of the Federal Reserve through its use of monetary policy? A. Low inflation. B. Zero inflation. C. Low unemployment. D. Zero unemployment. E. Maintaining balanced budgets. Correct: A Explanation: The two goals of the Federal Reserve when it conducts monetary policy is low (but not zero) inflation and stability of the banking system. It is not the express target to keep maintain employment levelsat any particular rate directly, or control government budgets.

29. According to the idea of money neutrality, A. monetary policy neutralizes the effects of recessions, but not expansions. B. monetary policy neutralizes the effects of expansions, but not recessions. C. monetary policy is neutral: it affects neither real nor nominal variables. D. monetary policy is neutral in the long run: it will impact only nominal variables. E. monetary policy is neutral in that it is equally preferred to fiscal policy as a means to manage the economy. Correct answer: D Explanation: According to the idea of money neutrality, monetary policy has no effect on real variables and only on nominal variables. Therefore, only price level will change as a result of monetary policy in the long run. Use Figure 2-5 to answer Questions 30 to 31.

30. Refer to Figure 2-5. What would cause a shift of the short run Phillips curve from SRPC1 to SRPC2? A. People adjust their expectations of unemployment to always be at 5% B. People adjust their expectations of unemployment to always be at 7% C. People adjust their expectations of inflation to always be zero. D. People adjust their expectations of inflation to always be 2% E. People adjust their expectations of the natural rate of unemployment. Correct answer: D Explanation: Shifts of the Short Run Phillips Curve are the result of changes in expectations of inflation. Initially, unemployment is at 7% and the inflation rate is zero. However, if policies are implemented to keep unemployment at 5%, this will cause 2% inflation. Eventually, people will come to expect inflation of 5% and SRPC will shift to include this assumption.

31. Refer to Figure 2-5. If the economy is currently at E2, which of the following rates of unemployment would lead to decelerating inflation? A. 5% B. 6% C. 7% D. 8% E. Inflation can never decelerate. Correct Answer: D Explanation: Any rate of unemployment higher than the NAIRU will result in deceleating decelerating inflation. 32. Suppose the nominal interest rate is 4%, and the expected rate of inflation is 0%. Suppose the expected rate of inflation changes to -7%. What is the name of the policy problem that this presents for central banks? A. Hyperinflation. B. Liquidity Trap. C. The Fisher Effect. D. The nonaccelerating inflation rate of unemployment. E. Seignorage. Correct Answer: B Explanation: If the expected rate of inflation is -7% and the nominal interest rate is 4%, the real interest rate is negative. However, central banks cannot adjust the interest rate to below 0%. This presents a situation in which conventional monetary policy cannot be used because nominal interest rates face a zero bound, a problem called the liquidity trap. 33. The real GDP of Maxistan is $200 million and the rate of growth of real GDP in Maxistan is 5%. How long will it take the real GDP of Maxistan to equal $400 million? A. 5 years. B. 40 years. C. 20 years D. 24 years E. 14 years Correct answer: E Explanation: The rule of 70 is used to calculate the doubling time of an economy: 70/rate of growth = # of years to double. In this case, 70/5=14 34. In order for there to be economic growth in an economy: A. Real GDP must increase without an increase in inflation. B. Real GDP must increase with an increase in inflation. C. the Long Run Aggregate supply curve must shift out. D. aggregate demand must shift out. E. short run aggregate supply must shift out. Correct Answer: C Explanation: Economic growth is an increase in potential output, which is reflected by the Long Run Aggregate Supply curve. This may occur with or without inflation. While an increase in aggregate demand or short run aggregate supply may temporarily increase real GDP, this is not growth. Growth must be a sustained increase in real GDP.

35. Which of the following describes the effects of economic growth? PPF shifts LRAS Non Accelerating

Inflation Rate of Unemployment

A. In Increases Increases B. In Decreases Increases C. Out Increases Increases D. Out Decreases Decreases E. Out Increases Decreases Correct answer: E Explanation. When there is economic growth, an economy is able to make more of all goods and services, shifting the PPF out. This makes the country’s productive capacity greater, which increases the LRAS curve. The LRAS curve is vertical at a countries natural rate of unemployment. If the LRAS curve shifts out, the natural rate of unemployment goes down. The NAIRU is the same a country’s natural rate of unemployment, so the NAIRU decreases as well. 36. The balance of payments on the current account plus the balance of payments on the financial account will always A. be greater than zero B. be less than zero. C. be equal to zero. D. sum to 1. E. sum to the rate of inflation. Correct answer: C. Explanation: The current account + the financial account =0. 37. The currency of the nation of Maxistan is the ruble and the currency of the nation of Ile is the dollar. Suppose capital flows between Ile and Maxistan increases because Ile investors prefer to invest more in Maxistan. If investors always prefer to invest abroad, then, the _______ of Maxistan rubles would and the exchange rate of Ile dollars to rubles would ? A. Demand Increase Increase B. Demand Increase Decrease C. Demand Decrease Decrease D. Supply Decrease Increase E. Supply Increase Increase Correct answer: A Explanation: If the capital flows increase from Ile to Maxistan because the investors of Ile want to invest more, then they will need to purchase more Maxistan rubles. The demand for rubles will increase, which will drive up the exchange rate of rubles per Ile dollar.

38. The exchange rate of Ile is currently 100 Ile dollars per 5 Maxistan Rubles. If there is inflation in Maxistan then what happens to the real exchange rates of Ile and Maxistan? ` Exchange rate for Ile dollars Exchange rate for Maxistan

Rubles A. Unchanged Increase B. Increase Increase C. Decrease Increase D. Increase Decrease E. Increase Unchanged Correct Answer: D Explanation: Consider the example of the Japanese Yen and the US Dollar: e = ¥/$ RER (for U.S. Goods) = e*P(u.s.)/P(japan). Note: (¥/$)*($/US Good) / (¥/Japan good) = # of Japan goods per 1 US Good. Therefore, if the price level of Maxistan goes up, the real exchange rate of Maxistan goes down and the real exchange rate of Ile goes up. 39. The market basket for the nation of Pamalonia consists of 2 gym bags, 10 salads, and 5 books. If 2002 is the base year, what is the CPI in 2000?

A. 191 B. 52 C. 55 D. 80 E. 105 Correct answer: B Explanation: to find the CPI in any year, calculate the price of a basket of goods in the year you are interested in and divide that by the price of the same basket in the base year. IN this case, the price of the basket of goods in the base year is 105. The price of the basket in 2000 was 55. 55/105 = about 52.

Price of Gym Bags Price of Salads Price of Books 2000 $10 $1 $5 2001 $15 $2 $6 2002 $20 $3 $7

40. In one day, Dave can make 20 tee shirts or 30 necklaces, and Brian can make 30 tee shirts or 40 necklaces. Which of the following describes the breakdown of absolute and comparative advantage in tee shirts and necklaces? Absolute

advantage in producing tee shirts

Absolute advantage in producing necklaces

Comparative Advantage in producing tees

Comparative advantage in producing necklaces

A. Dave Brian Brian Dave B. Brian Brian Brian Dave C. Brian Dave Brian Brian D. Brian Dave Dave Dave E. Dave Dave Brian Brian Correct Answer: B Explanation: Absolute advantage is the ability to produce more goods given the same resources, in this case 1 days work. It takes less of a fraction of a day for Brian to produce either good. Comparative advantage is whoever has the lowest opportunity cost. In this case, Dave has a lower opportunity cost of producing necklaces, and Brian the lower opportunity cost of producing tees.

Free Response Questions for Sections 5-8

1. Assume the economy of Cire is currently operating below the full employment level of GDP. a. Draw a correctly labeled graph of aggregate supply and aggregate demand and show each

of the following: i. Long Run Aggregate Supply

ii. The current level of output and price level, labeled GDP1 and PL1, respectively iii. The potential output level of the economy, labeled Yp iv. What kind of gap is this economy experiencing?

b. Assume the shortfall between potential output is $200 million. i. If the government were to use fiscal policy to bring output to the full employment

level, what are two tools it could use? ii. If the marginal propensity to consume is 0.75, how much would the tool you

describe in part (i) have to change in order to bring about full employment GDP? c. Explain how the change you describe in part B would affect aggregate supply and

aggregate demand. i. Show the effect of this on the graph from part (a).

ii. Explain what happens to the price level. d. The nation of Cire has a trading partner, Lem.

i. What will happen to the exchange rate of Lem pesos per Cire dollars as a result of the change you describe in (c)?

ii. What will happen for the demand for exports from Cire to Lem as result of this change in the real exchange rate?

Rubric: 1. 12 Points (5+2+3+2)

a. 5 points

1 point for a correctly labeled AD/AS graph 1 point for a vertical LRAS curve 1 point for showing currently price level and output at a level below full employment 1 point for GDP* on the output axis where LRAS intersects. 1 point for recessionary gap

b. i. 1 point for stating Lower taxes, increase Government spending

ii. 1 point for $50 million c. 1 point for stating that this would increase aggregate demand

i. 1 point for showing a rightward shift of aggregate demand

ii. 1 point for stating that this would drive the price level up. d.

i. 1 point for stating that the exchange rate would depreciate ii. 1 point for stating that the demand for Cire’s exports would increase.

2. Suppose the economy of Xam is in long run equilibrium.

a. Draw a correctly labeled graph of aggregate supply and aggregate demand and show each of the following:

i. Long Run Aggregate Supply ii. The current level of output and price level, labeled GDP1 and PL1, respectively.

iii. The potential output level of the economy, labeled Yp. b. Assume the natural rate of unemployment in 7% and expected inflation rate of 0%. Draw

a graph showing the short run and long run Phillips curves. c. Suppose the Federal Reserve decides to lower interest rates.

i. Describe the OPEN MARKET action that they would take in order to lower interest rate.

ii. Draw a correctly labeled graph of the money market showing the effect of this action.

d. Show what the effect of the action you describe in c will be on the aggregate demand and aggregate supply curve. Label any changes in price level or output as PL2 and GDP2, respectively.

i. Explain the change you showed in your graph in d. ii. What will happen to the price level and output?

e. What effect will what you describe in part d have on the graph you describe in part b in the long run?

Rubric:

2. 11 points (3+2+3+2+1) a.

i. 1 point for a correctly labeled graph of an aggregate demand and aggregate supply curve.

ii. 1 point for a vertical LRAS curve iii. 1 point for labeling GDP1=Yp

b.

1 point for a correctly labeled Phillips curve graph. 1 point for a vertical LRPC that is vertical at 7%

c.

i. 1 point for a correctly labeled graph of the money market ii. 1 point for showing an increase in the money supply

1 point for buy bonds d.

i. 1 point for showing an increase in aggregate demand ii. 1 point for saying PL increased and output increased

e. 1 point for describing that the SRPC curve will shift upwards as people adjust their expectations to a higher expected level of inflation

3. Suppose there is currently an inflationary output gap of $6 billion and an inflation rate of 2%, the reserve requirement is 5%, and banks do not keep excess reserves.

a. If the federal reserve follows the Taylor rule, what should it set the federal funds rate at? b. Suppose the current Federal Funds rate is 5%.

i. What OPEN MARKET action would the Federal Reserve take in order to achieve this rate?

ii. If the quantity of money would need to change by $200 million to achieve the Fed Funds target, what dollar amount would this change need to be?

c. Draw a correctly labeled graph of the money market showing the change described in b. d. How would the change you describe in part b affect aggregate demand?.

Rubric:

3. Points (1+2+2+1) a. 1 point for 7% b. 1 point for selling bonds

1 point for $10 million c. 1 point for a correctly labeled graph of the money market

1 point for showing a decrease in the money supply

d. 1 point for An increase in the Federal Funds rate would decrease Investment and Consumption and thus Decrease Aggregate Demand

4. The Bureau of Labor Statistics collected the following data based on a telephone survey of households:

Population Employment Status (collected for potential workforce

only) Age group # of people Description # of 0-10 100 Not working 11-15 75 Looking for

work 500

16-30 2000 Not looking for work

1000

31-45 4000 Working 0-10 hours per week

500

46-65 2000 Working 11-20 hours per week

500

66+ 2000 Working 21-30 hours per week

2000

Working 31-40 hours per week

3000

Working 40+ hours per week

2000

a. What is the size of the potential labor force in this country? b. What is the labor force participation rate? c. What is the unemployment rate? d. Why might this unemployment rate overstate the true rate unemployment in this country? e. Why might this unemployment rate understate the true rate of unemployment in this country?

Rubric:

4. 5 Points (1+1+1+1+1) a. 1 point for 10,000 – ok. Ages 16 and older b. 1 point for 85% - lbr force part rate = (#un + #em) / Labor Force = (500 + 8000)/10,000

= 85% c. 1 point for 5% - Unemploy rate = #unemployed / lbr force = 500/10,000 = 5% d. 1 point for stating that people may not be truthful about whether or not they are looking

for work e. 1 point for stating either:

• people may be underemployed • People may have become discouraged workers.