FRQ Review Questions & Answers

#1 1. Suppose the United States economy is experiencing a period of rapid economic growth. a. Using a correctly labeled AD/AS graph, show the equilibrium price level and real GDP. PL rGDP LRAS SRAS AD ePL Qn Qe IG

#1… b. Should Congress choose to “cool down” the economy, what fiscal policy options are available? How would each impact GDP? Use a graph to support your explanation. Congress could reduce transfers or government spending or increase personal income taxes. Each of these would decrease aggregate demand and eGDP through the spending multiplier. The overall effect of a government spending cut would be GREATER, however, because consumers will draw on savings to pay some of their taxes where as government will reduce spending by the full amount stated. This mirrors the greater power of a government spending increase to later aggregate demand relative to a tax cut (consumers will save some of their tax rebate, rather than spending the full amount as the government would). PL rGDP LRAS SRAS AD1 ePL Qn Qe IG AD2

#1… c. What would be the impact of the decisions above on the government’s national deficit? Contractionary fiscal policies could serve to reduce the government’s deficit by increasing revenues even as spending is reduced. d. If the Federal Reserve chose to take action instead, what policy options are available to them? How would these policies impact the Money Market, Investment Demand, and the AD/AS model? Use graphs to support your explanation. The Fed can sell bonds, raise DR or RR IRn Q$ Q investment Md Ms1 Ms2 B A SRAS AD1 AD2 LRAS PL rGDP Each of these policies serves to reduce banks’ excess reserves (loanable funds), make money more scarce, raise interest rates and, in turn, reduce investment and overall spending due to higher borrowing costs.

#1… e. If the government chose to take no action, how would the economy ultimately return to LR equilibrium? Use a graph to support your explanation. The inflationary gap would ultimately self correct and close through stagflation. As producers compete for workers at higher wages, they will be force to let employees go even as the price level rises. This process will take time (prices and wages are sticky), but will self adjust to close more efficiently than a recessionary gap. PL rGDP LRAS SRAS AD ePL Qn Qe IG SRAS2

#1… f. Compare how the actions taken in B and E would be reflected on the Phillips curve While contractionary fiscal policy seen in B (shifting the AD Left) would be reflected with movement to the right along the Phillips Curve (higher unemployment traded off for lower price levels), the stagflation evident in e (shifting AS Left) would be shown as a rightward shift of the Phillips curve (the inflation unemployment trade off still exists, but is worse overall). B. E. Infl. Unemp. SRPC LRPC Qn Infl. Unemp. SRPC LRPC Qn A B SRPC2

#2… Imagine the Obama Administration successfully champions a bill to build 10,000 new schools across the country. Rather than increasing taxes to pay for this investment in infrastructure, the government chooses to fund their efforts through increased debt. What effect will this policy have on: a. The AS/AD model? AD1 LRAS AD2 SRAS

#2 b. The loanable funds market and interest rates?

#2 c. If the Federal Reserve chooses to adopt a supportive monetary policy stance in response to the Obama Administrations efforts, what will they do? How will it impact the loanable fund market and interest rates? Monetize the debt—buy bonds to increase Ms, bring IR back down Slf3

#3 Assume that Broudatopia and Wusslerville are the only 2 countries on the planet Macro. Broudatopia uses Bs as their form of currency. Wusslerville uses Ws as their form of currency. a. Assume that real incomes rise in Wusslerville at a faster pace than those in Broudatopia. Use a graph to explain how will this change affect: – the supply of Ws – the international value of the W Pw’s Qw’s W’s S of w’s 1 Sw’s 2 B’s D for w’s The supply of W’s increases as Wusslervillians bring more currency to the ForEx Mkt to purchase goods from Broudatopia. This increase in supply causes the W to depreciate in value.

#3 Assume that Broudatopia and Wusslerville are the only 2 countries on the planet Macro. Broudatopia uses Bs as their form of currency. Wusslerville uses Ws as their form of currency. b. If the Federal Reserve Bank of Wusslerville engages in the open market sale of bonds, use graphs to explain how the following will be altered: the supply of Bs in international currency markets the international value of the B Pb’s Qb’s B’s S of b’s 1 Sb’s 2 W’s D for b’s The supply of B’s increases as Broudatopians bring more currency to the ForEx Mkt to move their money to Wusslerville, where interest rates are higher. This increase in supply causes the B to depreciate in value.