MACROECONOMICS Economics 2008 [Form B FRQ]

FRQ 2008 [Form B] Country Z PL AD1 PL2(6%) PL1(3%) Yi Y* AD2 Assume that the economy of Country Z is operating on the upward-sloping portion of its short-run AS curve. Assume that the government increases spending. (a) How will the increase in government expenditures affect each of the following in the short run? (i) AD (ii) Short-run AS (b) Using a correctly labeled graph of AD/AS, show the effect of the increase in government expenditures on real output and the price level. Answer to 1. (a) (i) AD would increase as government expenditures is a determinant of AD. Country Z LRAS SRAS PL Answer to 1. (a) (ii) SRAS curve would not be affected as government expenditures is not a determinant of the SRAS curve. There is a movement up the SRAS curve. AD1 PL2(6%) PL1(3%) AD2 Real GDP Y* Yi Answer to 1. (b) As can be seen on the graph, the increase in government expenditures would increase AD which would increase real output. The increase in AD would move the AD curve up along the SRAS curve and increase PL.

D1 D2 S FRQ 2008 [Form B] Quantity of Loanable Funds G T rir=8% rir=6% (c) Assume that the government funded this increase in expenditure by borrowing from the public. Using a correctly labeled graph of the loanable-funds market, show the effect of the increase in government borrowing on the real interest rate. FRQ 2008 [Form B] Answer to 1. (c) The increase in government borrowing in the LFM would push up demand for money and increase the RIR. D1 D2 S Borrowers Lenders rir=8% E2 rir=6% Real Interest Rate, (percent) E1 $2.1 Tril. after “G” increase $2 T $2 T G T F1 F2 Quantity of Loanable Funds Balanced Budget [G&T=$2 Tr.]

FRQ 2008 [Form B] (d) Given the change in the real interest rate in part (c), what will be the effect on each of the following on the foreign exchange market? (i) Supply of Country Z’s currency. Explain. (ii) The value of Country Z’s currency. Answer to 1. (d) (i): The supply of Country Z’s currency would decrease as there is a lack of demand for other country’s currency by sellers of Country Z’s currency. The decrease in supply is causing the currency to appreciate [as well as the increase in demand for Country Z’s currency by other nations]. Answer to 1. (d) (ii): Because of the higher return on financial investments [bonds & CDs], there would would be an increase in demand for Country Z’s currency, which would appreciate their currency. (e) Given your answer in part (d) (ii), what will be the effect of the change in the value of Country Z’s currency on Country Z’s exports? Explain. Answer to 1. (e): The appreciated currency in Country Z would make their exports more expensive and therefore decrease their exports.

FRQ 2008 [Form B] 2. Suppose that Mexico decreases its tariff rates on all of its imports of automobiles from abroad. (a) Will each of the following groups benefit from the decrease in the tariff rate? (i) Mexican consumers (ii) Mexican automobile manufacturers. Explain. Answer to 2. (a) (i): Mexican consumers will benefit by paying lower prices for autos. The decrease in auto tariffs will make Mexican producers compete with the lower prices. Answer to 2. (a) (ii): Mexican auto manufacturers will not benefit as they will have to lower their prices to compete with the cheaper imported autos and therefore receive lower profits. (b) How would the decrease in the tariff rates affect each of the following in Mexico? (i) Current account balance. Explain. (ii) Capital account balance. Answer to 2. (b) (i): Lower tariffs mean lower prices and an increase in imports. This would cause a deficit in the current account which includes exports and imports. Answer to 2. (b) (ii): The capital account balance would move toward surplus because the current account moved toward deficit. (c) Given the change in Mexico’s current account in part (b) (i), what will happen to the aggregate demand in Mexico? Answer to 2. (c): The increase in imports would result in a decrease in net exports, which is a determinant of AD, therefore it would decrease AD.

Outputs and Prices in GALA LAND 3. Gala Land produces three final goods: bread, water, and fruit. The table [right] shows this year’s output and price for each good. (a) Calculate this year’s nominal GDP. (b) Assume that in Gala Land the GDP deflator [GDP price index) is 100 in the base year and 150 this year. Calculate the following. (i) The inflation rate, expressed as a percentage, between the base year & this year. (ii) This year’s real GDP (c) Since the base year, workers have received a 20% increase in their nominal wages. If workers face the same inflation that you calculated in part (b)(i), what has happened to their real wages? Explain. (d) If the GDP deflator in Gala Land increases unexpectedly, would a borrower with a fixed-interest-rate loan be better off or worse off? Explain. FRQ 2008 [Form B] Outputs and Prices in GALA LAND This Year’s Output This Year’s Price 400 loaves of bread $6 per loaf 1,000 gallons of water $2 per gallon 800 pieces of fruit $2 per piece Answer to 3. (a): 400x$6=$2,400; 1,000x$2=$2,000; and 800x$2 = $1,600 for a Nominal GDP of $6,000. Answer to 3. (b) (i): Change/Original x 100; therefore 50/100 x 100 = 50% inflation rate. Answer to 3. (b) (ii): Nominal GDP/GDP deflator x 100 = Real GDP; $6,000/150 X 100 = Real GDP of $4,000. Answer to 3. (c): Inflation between these years has increased 50%; wages have increased only 20%; therefore workers real wages or real purchasing power has decreased. Answer to 3. (d): The borrower has borrowed “dear” money but is paying back “cheaper” money. He is better off because he is paying back money that isn’t worth what it was when he took out the loan.

Finished Animationeconomics.com