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M a c r o e c o n o m i c s F r e e R e s p o n s e. 2007. Macro Free Response 2007. [Question 1 had 12 total points; Question 2 had 6 points; and Question 3 had 8 pts] 1. [3 pts] Assume that declining stock market prices in the U.S. cause many

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M a c r o e c o n o m i c s f r e e r e s p o n s e

Macroeconomics Free Response

2007


M a c r o e c o n o m i c s f r e e r e s p o n s e

Macro Free Response 2007

[Question 1 had 12 total points; Question 2 had 6 points; and Question 3 had 8 pts]

1. [3 pts] Assume that declining stock market prices in the U.S. cause many

U.S. financial investors to sell their stocks and increase their money holdings.

(a) Draw a correctly labeled graph of the money market and show the

impact of the financial investors’ actions on each of the following.

(i) Demand for money

(ii) Nominal interest rate

MS

DM2

DM1

  • Answers for 1. (a) (i) [2 points]

  • (a) (i) In an effort to preserve wealth,

  • investors sell off stocks when market

  • prices begin to decline. These new

  • money holdings will increase the

  • asset [speculative] demand for money.

  • In the volatile market, investors will

  • hold more money while determining

  • future needs. [2 pts: 1 pt for correct

  • graph and 1 pt for Dm shifting right.]

r2

Nominal Interest Rate

r1

M

Quantity

of Money

  • Answers for 1. (a) (ii) [1 point for saying the interest rate increases]

  • (a) (ii) The nominal interest rate would increase because the demand

  • for money increases as the DM curve shifts up, as shown above.


M a c r o e c o n o m i c s f r e e r e s p o n s e

FRQ 2007

1. (b) [3 pts] Due to the decline in wealth caused by the change in stock prices, the general price level in the U.S. falls relative to the price level in Japan, a trading partner. Use a correctly labeled graph of the foreign exchange market for the U.S. dollar to show the impact of the change in relative price levels on each of the following. (i) Demand for the dollar(ii) Price of the dollar

D2$

S$

D1$

  • Answers to 1. (b) (i)

  • (b) (i)

  • This decrease in PL will cause the

  • Japanese to want to buy more U.S.

  • goods, increasing the demand for

  • the dollar. [2 pts: 1 pt for graph and

  • 1 pt for showing increase in demand

  • for the dollar]

Y150

E2

Yen Price of Dollar

Y100

E1

Quantity of Dollars

Answers to 1. (b) (ii) [1 pt for saying the yen price of the dollar increased]

1. (b) (ii) Lower prices in the U.S. would cause an increase in demand for

the dollar, resulting in the Japanese having to pay more for American

goods. Therefore the yen would depreciate as the price of the dollar

has increased, and the dollar has appreciated.


M a c r o e c o n o m i c s f r e e r e s p o n s e

1. (c) [2 pts] How will the change in the price of the dollar you indicated in part (b) (ii) affect net exports of the U.S. Explain.

Answer to 1. (c) The appreciated dollar would cause American goods to be more expensive for Japan and Japan’s goods to be less expensive for Americans; therefore, we would export less and import more, resulting in a decrease in net exports. [1 pt for Xn decreasing

and 1 point for saying U.S. goods are relatively more expensive]

(d) [3 pts]Using a correctly labeled

AD/AS graph, show how thechange

in Xn in part (c) will affect each of

the followingin theshort run.

(i) Aggregate Demand

(ii) Output and price level

LRAS

SRAS

PL

AD1

FRQ 2007

AD2

Answer to 1. (d) [3 pts]

As can be seen on the graph, the

decrease in Xn would decrease AD.

The decrease in AD would decrease

output to Y2 and PL to PL2.

[1 pt for AD/AS graph, 1 pt for decr

In AD & 1 pt for PL & Y decreasing]

PL1

E1

PL2

E2

RGDP

Y2

Y1

Answer to 1. (e) [1 pt for increase in

unemployment because Y decreased]

The decrease in Xn in part (d) will result

in a decrease in AD and output, which

would increase unemployment in the SR.

(e) [1pt] Given your answers to part

(d), what will happen to unemploy-

ment in the short run? Explain.


M a c r o e c o n o m i c s f r e e r e s p o n s e

FRQ 2007

2.[6 total pts]In recent years, the Federal Reserve has made targeting the federal funds rate a main focus of its monetary policy. (a) Define the federal funds rate.

Answer: The rate that banks charge one another for overnight loans.

[1 point for saying this is the interest rate on loans between banks]

(b) If the Federal Reserve wants to lower the federal funds rate, what

open-market operation would be appropriate?

Answer: The Fed would buy bonds from the banks or public. Buying

bonds means a bigger supply of money and lower fed funds rate.

[1 point for saying the Fed would “buy bonds”.]

(c) Assume that the open-market operation that you indicated in part

(b) is equal to $10 million. If the RR is 0.2, calculate the maximum

change in loans throughout the banking system.

Answer: $40 million if the Fed buys the bonds from the public. The

public’s $10 million in DD could result in an increase in loans of

$40 million. ER of 8 M x Mm of 5 = $40 million in loans. If the Fed buys

bonds from banks, ER could increase by the $10 million initially and with a

Mm of 5, the increase in loans could be as much as $50 million.

[1 point for $40 million if the bonds were purchased from the public as the

$8 million ER x 5 would become $40 million or $50 million if the bonds were

purchased from banks. The $10 million x 5 would become $50 million.]


M a c r o e c o n o m i c s f r e e r e s p o n s e

FRQ 2007

(d) Indicate the effect of the open-market operation that you indicated

in part (b) on the nominal interest rate.

Answer: Buying bonds would increase the MS and lower nominal Interest rates.

[1 point for saying the nominal interest rate decreases. A contingency point

would be “nominal interest rate increase” if he said “sell bonds” in part b]

(e) Assume that the Fed’s action results in some inflation. What would be the

impact of the open-market operation on the real rate of interest? Explain.

Answer: The RIR would fall as the assumption is the increase in inflation was not

anticipated. If the actual rate of inflation is greater than the anticipated rate, then

the RIR would fall. RIR=NIR-anticipated inflation. If we get more inflation than

anticipated, then RIR = NIR – more inflation than anticipated, so RIR decreases.

RIR falls because the NIR has decreased and inflation has increased.

[2 points: 1 pt for saying the real interest rate falls as inflation was more than

anticipated. RIR = NIR – anticipated inflation. 1 pt for saying the RIR falls

because the NIR has decreased and inflation increased. ]


M a c r o e c o n o m i c s f r e e r e s p o n s e

FRQ 2007

Answer: No, it was counted the year it was produced. Because it was

not produced again, it would not be counted. That would be double counting.

[2 pts: 1 pt for saying not included and 1 pt for saying not produced in 2006]

3. [8 pts]Indicate whether each of the following is counted in

the U.S. GDP for the year 2006. Explaineach ofyour answers.

(a) The value of used textbook sold through online auction in 2006.

b. Rent paid in 2006 by residents in an apartment building built in 2000

Answer: Yes, rents consist of the income received by the households and

businesses that supply property resources. The properties have to be maintained

or “serviced” each year. It is included in the income approach to GDP.

[2 pts: 1 point for “yes” and 1 pt for saying this is the payment for services]

c. Commissions earned in 2006 by a stockbroker

Answer: Yes, payment is being made for productive services of the

broker. So the purchase of stocks would not count but his work would.

[2 pts: 1 pt for “yes” and 1 pt for saying this is the payment for services]

d. The value of autos produced in 2006 entirely in South Korea by a

firm fully owned by U.S. citizens

Answer: No, GDP measures production inside the U.S. regardless of

ownership. These autos were not produced in the U.S.

[2 pts: 1 pt for “not included” and 1 pt for saying not produced in U.S.]


M a c r o e c o n o m i c s f r e e r e s p o n s e

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