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MACROECONOMICS. 2011 FRQ. Norman. 2011 Macroeconomics FRQ. Assume that the U.S. economy is currently in a recession in a short-run equilibrium.

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2011 FRQ

Norman

• Assume that the U.S. economy is currently in a recession in a

• short-run equilibrium.

• (a) Draw a correctly labeled graph of the short run and long-run Phillips curves. Use the letter A to label a point that could represent the current state of the economy in recession.

LRPC

(b) Draw a correctly labeled graph of AD/AS

in the recession and show each of the following.

(i) The LR equilibrium output, labeled Y

(II) The current equilibrium output and price levels,

labeled Ye and PLe, respectively.

SRPC

Inflation

A

3%

1%

8%

Unemployment Rate

5%

SRAS

(c) To balance the federal budget, suppose that the government decides to raise income taxes while maintaining the current level of government spending. On the graph drawn in part (b), show the effect of the increase in taxes. Label the new equilibrium output and price levels Y2 and PL2, respectively.

LRAS

PL

PL

PLe

E1

PL2

E2

Y2

Real GDP

YE

Y

• (d) Assume that the Feduses monetary policy to stimulate the economy.

• (i) What open-market policy should the Fed implement?

• (ii) Using a correctly labeled graph of the money market show how the policy in

• part (d)(i) affects nominal interest rates.

• (iii) what will be the impact of the policy on the price level? Explain.

Dm

0

MS2

MS1

nir1

Answer to 1. (d)(i) and (ii)

The Fed will buy bonds which will increase

the MS [from MS1 to MS2] and decrease the

nominal interest rate.

Nominal Interest Rate

nir2

Q1

Q2

Money Market

The lower nominal interest rate would increase quantity of investment

demanded by businesses [would also increase consumption and Xn] which

• (e) Now assume instead that the government and the Fed take no policy action in response to the recession.

• (i) In the long run, will the short-run AS increase, decrease, or remain unchanged?

• Explain.

• (ii) In the long run, what will happen to the natural rate of unemployment?

In the long run, prices would come down, and workers would accept lower

wages, decreasing resource cost to businesses, and they would hire

more workers as the SRAS curve would increase.

With the SRAS curve shifting back to the right, this would bring the

economy back to equilibrium at the natural rate of employment. Because

we are back to the natural rate of unemployment, it did not change in the

long run.

2. Japan, the European Union, Canada, and Mexico have flexible exchange rates.

(a) Suppose Japan attracts an increased amount of investment from the EU.

(i) Using a correctly labeled graph of the loanable funds market in Japan, show the effect of the increase in foreign investment on the real interest rate in Japan.

(ii) How will the real interest rate change in Japan that you identified in part (a)(i) affect the employment level in Japan in the short run? Explain.

Loanable Funds Market

D

S1

S2

Real Interest Rate, (%)

r1

E1

r2

E2

F1

F2

Quantity of Loanable Funds

Answer to 2. (a) (i) & (ii)

(i) As can be seen on the graph, the increased investment in Japan would result in more yen

in Japan’s depository institutions, and increasing the supply of LF in Japan and decreasing

the real interest rate.

(ii) With the RIR decreasing in Japan, there will be more investment [a component of AD]which

would increase AD and GDP, therefore increasing employment in the short run.

2. (b) Suppose in a different part of the world, the real interest rate in Canada

increases relative to that in Mexico.

(i) Using a correctly labeled graph of the foreign exchange market for the Canadian dollar, show the effect of the change in real interest rate in Canada on the international value of the Canadian dollar (expressed as Mexican pesos per Canadian dollar).

(ii) How will the change in the international value of the Canadian dollar that you

identified in part (b)(i) affect Canadian exports to Mexico? Explain.

D1

S

D2

P

P/CD

The higher RIR in Canada would

result in more demand for the

investors who are looking for

better returns. It increases

demand for the C. Dollar and

appreciates that currency.

P12

E2

D

Peso

depreciates

P10

E1

more expensive to Mexico,

exports to Mexico.

0

Qe

A

2011 FRQ

(a) Based on Sewell Bank’s balance sheet, calculate the required reserve ratio.

The Fed’s RR would be 20% as DD is \$10,000 and RR is \$2,000

and excess reserves are \$0.

(b) Suppose that the Fed purchases \$5,000 worth of bonds from Sewell Bank.

What will be the change in the dollar value of each of the following

immediately after the purchase?

(i) Excess reserves

(ii) Demand deposit

ER would be \$5,000 as any loan from the Fed is ER.

DD would not immediately increase as any money

from the Fed is all ER.

2011 FRQ

3. (c) Calculate the maximum amount that the MS can change as a result of the

\$5,000 purchase of bonds by the Fed. .

The Total Money Supply could potentially change to \$25,000.

All of the \$5,000 is ER for Sewell Bank so with a RR of 20% and a

MM of 5, \$5,000 x 5 = TMS of \$25,000.

2011 FRQ

3. (d) When the Fed purchases bonds, what will happen to the price of bonds

in the open market? Explain.

When the Fed purchases bonds, the MS increases and people buy

non-money assets like bonds which pushes bond prices up and

interest rates down.

3. (e) Suppose that instead of the purchase of bonds by the Fed, an individual

deposits \$5,000 in cash into her checking (DD) account. What is the

immediate effect of the cash deposit on the M1 measure of the MS?

No impact. It stays the same although it changes composition from

\$5,000 currency to \$5,000 DD.

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