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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. 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.

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Macro Free Response 2007

  • 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



  • Answers for 1. (a) (i)
  • (a) (i) The decline in wealth
  • decreases many investors
  • demand for major purchases
  • and decreases the demand for
  • money.



Nominal Interest Rate


Money Market

  • Answers for 1. (a) (ii)
  • (a) (ii) The nominal interest rate would decrease because the demand
  • for money decreases as the DM curve shifts down, as shown above.

FRQ 2007

1. (b) 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




  • Answers to 1. (b) (i)
  • (b) (i) The decrease in wealth will
  • cause less consumer spending
  • which causes the AD curve to shift
  • left and a decrease in the price level.
  • This decrease in PL will cause the
  • Japanese to want to buy more U.S.
  • goods, increasing the demand for
  • the dollar.



Yen Price of Dollar



Quantity of Dollars

Answers to 1. (b) (ii)

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.


FRQ 2007

1. (c) 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.

(d) Using a correctly labeled AD/AS

graph, show how the change in

Xn in part (c) will affect each of

the following in the short run.

(i) Aggregate Demand

(ii) Output and price level








Answer to 1. (d)

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.






Answer to 1. (e)

The decrease in Xn in part (d) will result

in a decrease in AD and output, which

would increase unemployment in the SR.

(e) Given your answers to part (d),

what will happen to unemployment

in the short run? Explain.


FRQ 2007

2. 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

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

open-market operation would be appropriate?

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

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

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

(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: If the Fed buys bonds from banks,DD could increase by the $10 million initially

& with a MM of 5, the total money supply could increase to $50 million. If the Fed buys bonds

from the public, DD could increase by $10 M initially. With MM of 5, $2 M would be kept in RR

& $8 million could be loaned out & increase to $40 million more in DD for a total of $50 million.

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

in part (b) on the nominal interest rate.

(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 real interest rate would decrease. Real IR = Nominal – Inflation; if we

get more inflation, then Real IR = Nominal – even more Inflation, so it decreases.


FRQ 2007

3. Indicate whether each of the following is counted in the

U.S. GDP for the year 2006. Explain each of your answers.

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

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.

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. It is included in the income approach

approach to GDP.

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.

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 produced in South Korea.