[*plus extra practice] MACROECONOMICS 2011 FRQ [*plus extra practice] Norman

[Relating AD/AS to the Phillips Curve] Phillips Curve Primer [Relating AD/AS to the Phillips Curve] The new Phillips Curve will have a SRPC & a LRPC. The SRPC is ALMOST the mirror image of the SRAS curve. If the SRAS shifts left… The SRPC shifts right. If the SRAS shifts right ... The SRPC shifts left. PL LRAS SRAS AD2 SRAS2 SRPC PC SRAS3 LRPC AD1 6.8% 110 2% Inflation [Chg in PL over time] AD3 103 SRPC2 1% Inflat. Gap Recess. Gap 100 Recess. Gap Inflat. Gap SRPC3 3% 5% 10% Unemployment Y* 5% NAIRU YR 10% YI 3% Unempl. 5% is U*(F) with 2% anticipated PL.

2011 Macroeconomics FRQ A Y2 Ye Y LRPC SRPC Inflation 8% 5% AD1 PL AD2   2011 Macroeconomics FRQ Assume 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 2% A 1% 8% 5% Unemployment Rate 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 AD1 PL AD2 PL PLe E1 PL2 E2 Y2 Ye Real GDP Y

2011 FRQ Dm MS1 MS2 Answer to 1. (d)(i) and (ii) (d) Assume that the Fed uses 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. The Fed should buy bonds. Answer to 1. (d)(i) and (ii) The Fed will buy bonds which will increase the MS [from MS1 to MS2] & decrease the nominal interest rate. Dm MS2 MS1 nir1 Nominal Interest Rate AD2 LRAS SRAS1 PL2 nir2 PL1 [buy bonds] Q1 Q2 Money Market AD2 Answer to 1. (d)(iii) The lower NIR would increase QID by businesses [would also incr “C” & Xn] which would increase AD and increase price level.

2011 FRQ 1. (e) Now assume instead that the government and the Fed take no policy action in response to the recession. (i) In the LR, 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? LRAS PL Answer to 1. (e) (i) In the long run, prices would come down, & workers would accept lower wages, decreasing resource cost to businesses, and they would hire more workers as the SRAS curve would increase. SRAS1 SRAS2 PL1 PL2 Answer to 1. (e)( ii) 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. [See above – Yf]

Let’s review the LFM

D2 S D1 Loanable Funds Market Primer G T r=8% r=6% F1 F2 [*Use this graph if there is a chg in savings by consumers or chg in fiscal policy] [*Use the Money Market graph when there is a change in MS] Loanable Funds Market Primer D2 D1 S Use the “real interest rate” with LFM, because it is long-term. Use “nominal interest rate” with money market, as it is short-term. Borrowers Lenders Starting from a balanced budget, if the G incr spending or decr T to get out of a recession, they would now be running a deficit and have to borrow, pushing up demand in the LFM and increasing the interest rate. Real Interest Rate, (percent) r=8% E2 r=6% E1 Another acceptable answer is a decrease in supply, also pushing up the RIR. This answer implies that G borrowing means “less supply of money for the private sector”. The increase in D involves both “private & public” demand for LF. $2.2 T $2 T $2 T G T F1 F2 Quantity of Loanable Funds Balanced Budget [G&T=$2 Tr.]

D1 S1 S2 Loanable Funds Market Primer r=6% r=4% F1 F2 [*Use this graph if there is a chg in savings by consumers or chg in fiscal policy] [*Use the Money Market graph when there is a change in MS] Loanable Funds Market Primer D1 S1 S2 Borrowers Lenders The following would cause an increase in supply in the LFM and lower real interest rates: 1. HH save more 2. Business save more 3. Government runs a surplus 4. Foreigners save more here r=6% E1 Real Interest Rate, (percent) r=4% E2 F1 F2 Quantity of Loanable Funds

Japan’s Loanable Funds Market 2011 FRQ 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. Japan’s 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.

Foreign Exchange [FOREX] Primer Country A Country B Country B Country A 1. Want popular goods 2. Want higher I.R. 3. Want cheaper goods 4. Currency is stronger 5. Expanding Growth Rate 1. Has popular goods 2. Has higher I.R. 3. Has cheaper goods 4. Currency is weaker 5. Trade partner’s economy is expanding. 1. Has less popular goods 2. Has lower interest rates 3. Has more exp. goods 4. Currency appreciates 5. Trade partner’s economy goes into recession. 1. Want popular goods 2. Want higher interest rates 3. Want cheaper goods 4. Currency is depreciates 5. Declining Growth Rate A B B A Incr. Supply Incr. Demand Decr. Demand Decr. Supply Remember this: “Both the demand and the supply curves for the different currencies must shift in the same direction" Remember, the country who initiates the action: a. buying more foreign goods [because of taste, lower PL, or more income], b. invests more based on higher interest rates overseas, etc. is the country whose supply of currency moves. The 2nd country has the popular goods, or the cheaper products, or the greater return on CDs and bonds. They are the country whose demand for their currency moves.

Remember there are two graphs for FOREX [Curves move in same direction] D D2 S D S 1. Show how an “ increase in taste” for Japanese cars would affect the market for the Yen and the Dollar. S2 $1.50 e2 $ Price of Yen Yen Price of $ Appreciate $1 e1 ¥100 e1 Depreciate ¥50 e2 *If there had been an “ increase in taste” for American cars, then there would have been an increase in S of Y & increase in D for the $. # of Yen # of Dollars D D2 S D S S2 2. How would an increase in Mexico’s real interest rate affect the value of the Peso and the value of the Euro? €150 e2 Euro Price of Peso Appreciate Peso Price of Euro €100 e1 P16 e1 e2 Depreciate P12 # of Pesos # of Euros S2 D S S D 3. How would high inflation in South Korea affect the market for the Won and the Dollar? D2 e2 $ Price of Won Won Price of $ W1,070 Depreciate $1 e1 W1,030 e1 Appreciate $.50 e2 # of Won # of Dollars D D D2 S S S2 4. How would a U.S. economic expansion affect the value of the Dollar and the value of the Yen? Appreciate Yen Price of $ $1.50 e2 ¥100 e1 Depreciate $ Price of Yen $1.00 e1 ¥50 e2 # of Dollars # of Yen

D A D1 S D2 P P12 P10 Qe Answer to 2. (b)(i) E2 E1 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 Answer to 2. (b)(i) The higher RIR in Canada would result in more demand for the Canadian dollar by international investors who are looking for better returns. It increases demand for the C. Dollar and appreciates that currency. P P/CD D2 P12 E2 D Peso depreciates P10 Peso Price of Canadian Dollar E1 Answer to 2. (b)(ii) The stronger Canadian dollar would make Canadian exports more expensive to Mexico, therefore decreasing Canadian exports to Mexico. Qe A Quantity of Canadian Dollars *If asked to graph the FOREX market for Mexico, it would show Mexico increasing their supply of pesos for Canadian dollars, depreciating the peso and appreciating the Canadian dollar.

3. Sewell Bank has the simplified balance sheet below. 2011 FRQ (a) Based on Sewell Bank’s balance sheet, calculate the required reserve ratio. Answer to 3. (a) 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.

3. [continued] 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. Answer to 3. (c) 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.

3. [continued] 2011 FRQ 3. (d) When the Fed purchases bonds, what will happen to the price of bonds in the open market? Explain. Answer to 3. (d) When the Fed enters the bond market, this results in an increase in the demand for bonds, driving the price of bonds upward and interest rates down as the banks now have more money. 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? Answer to 3. (e) No impact. It stays the same although it changes composition from $5,000 currency to $5,000 DD.

But what if the questions were these?

But what if the questions were these!   But what if the questions were these! 1. The U.S. economy has an inflationary gap & is producing above potential RGDP. (a) Draw a correctly labeled graph of the short run and long-run Phillips curves. Use the letter I to label a point that could represent the current state of the economy with an inflationary gap. LRPC (b) Draw a correctly labeled graph of AD/AS with the inflation gap & 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 I 6% Inflation 3% 4% 5% Unemployment Rate LRAS SRAS AD2 (c) To get rid of a government surplus, suppose that the government decides to decrease income taxes and increase government spending. On the graph drawn in part (b), show the effect of the decrease in T & increase in G. Label the new equilibrium output and price levels Y2 and PL2. PL AD1 PL2 E2 PLe E1 PL Ye Y2 Y RGDP

But what if the questions were these! 2011 FRQ 1. (d) Assume that the Fed uses monetary policy to slow down 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. The Fed should sell bonds. Dm MS1 MS2 Answer to 1. (d)(i) and (ii) The Fed would sell bonds which would decrease the MS [from MS1 to MS2] and increase the nominal interest rate. nir2 Nominal Interest Rate nir1 [sell bonds] Q2 Q1 Money Market Answer to 1. (d)(iii) The higher nominal interest rate would decrease quantity of investment demanded by businesses [would also decrease consumption and Xn] which would decrease AD. The decrease in AD would decrease price level.

But what if the questions were these! 2011 FRQ 1. (e) Now assume instead that the government and the Fed take no policy action in response to the inflation. (i) In the LR, 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? PL LRAS SRAS2 Answer to 1. (e) (i) In the long run, prices would go up, and workers would demand higher wages, increasing resource cost to businesses, and they would hire fewer workers as the SRAS curve would decrease. SRAS1 PL2 PL1 Answer to 1. (e)( ii) With the SRAS curve shifting back to the left, 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. [See above – Yf]

But what if the LFM questions were these?

But what if the LFM questions were these! 2. A. [2 pts] In order to finance an increase in government spending on national defense, the government borrows funds from the public. Using a correctly labeled graph of the U.S. loanable funds market, show the effect of the government’s borrowing on the real interest rate. B. [2 pts] Given the change in the real interest rate in part (d), what is the impact on each of the following? (i) Investment (ii) Economic growth rate. Explain. D2 LFM D1 S Answer to 2. A. 1 pt for correctly labeled graph of the LFM. 1 pt for showing a rightward shift of the demand curve resulting in a higher RIR OR a leftward shift of the supply curve resulting in a higher RIR. [LFM for the private economy-this would imply less funds for private businesses to borrow as the government has entered the LFM]. r2 E2 Real Interest Rate, (%) r1 E1 F1 F2 Quantity of Loanable Funds Answer to 2. B. (i) [1 pt] The higher RIR will result in less investment in tools and machinery. 2. B. (ii) [1 pt] The decrease in real capital [tools and machinery] will decrease overall productivity and economic growth [less capital stock].

What if the FOREX questions were these?

But what if the FOREX questions were these! 2. (c) Suppose the real interest rate in the U.S. increases relative to that in Mexico. (i) Using a correctly labeled graph of the foreign exchange market for the Mexican peso, show the effect of the change in real interest rate in the U.S. on the international value of the Mexican Peso (expressed as U.S. dollars per Mexican peso). (ii) How will the change in the international value of the U.S. dollar that you identified in part (b)(i) affect Mexico’s imports to the U.S.? Explain. D S Answer to 2. (c)(i) The higher RIR in the U.S. would result in more demand for the U.S. dollar by Mexico. They would increase their supply of pesos to the U.S., which would depreciate the peso and appreciate the dollar. $/P S2 $1 A E1 Dollar Price of Mexican Peso Dollar appreciates .50 E2 Answer to 2. (c)(ii) The stronger U.S. dollar would make Mexico’s imports cheaper, therefore increasing Mexico’s imports to the U.S.. Qe D Quantity of Mexican Pesos *If asked to graph the FOREX market for the U.S., it would show an increase in D for the dollar, appreciating the dollar (& depreciating the peso), which would also increase Mexican imports.

What if the Money Creation questions were these?

3. Republic Bank has the simplified balance sheet below. 2011 FRQ $$10,000 $$40,000 (a) Based on Republic Bank’s balance sheet, calculate the required reserve ratio. Answer to 3. (a) The Fed’s RR would be 25% as DD is $40,000 and RR is $10,000 and excess reserves are $0. (b) Suppose that the Fed purchases $75,000 worth of bonds from Republic 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 $75,000 as any loan from the Fed is ER. DD would not immediately increase as any money from the Fed is all ER.

2011 FRQ and a MM of 4, $75,000 x 4 = TMS of $300,000. 3. [continued] 2011 FRQ $$10,000 $$40,000 3. (c) Calculate the maximum amount that the MS can change as a result of the $75,000 purchase of bonds by the Fed. Answer to 3. (c) The Total Money Supply could potentially change to $300,000. All of the $75,000 is ER for Republic Bank so with a RR of 20% and a MM of 4, $75,000 x 4 = TMS of $300,000.

3. [continued] 2011 FRQ $$10,000 $$40,000 3. (d) When the Fed sells bonds, what will happen to the price of bonds in the open market? Explain. Answer to 3. (d) When the Fed sells bonds in the bond market, this results in a decrease in the demand for bonds, driving the price of bonds down and interest rates up as the banks now have less money. 3. (e) Suppose that instead of the sell of bonds by the Fed, Susie RahRah deposits $30,000 in cash into her checking (DD) account. What is the immediate effect of the cash deposit on the M1 measure of the MS? Answer to 3. (e) No impact. It stays the same although it changes composition from $30,000 currency to $30,000 DD.

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