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3. SRAS LRAS AD 1 PL E Answer: 1. (b) (i) As can be seen on the graph, the increase in G would increase AD to AD2, increasing PL and Y. 1. (b) (II) The increase in AD to AD2 would decrease unemployment in 1. (b) (II) The increase in AD to AD2 would decrease unemployment in the short run, as the increase in AD would lead to an increase in output & profits, resulting in more workers being hired and therefore the decrease in unemployment. AD 2 PL 2 YIYIYIYI E1E1E1E1 Real GDP E2E2E2E2 [10 total points] 1. [10 total points] Assume that the U.S. economy is currently in long-run equilibrium. (a) [2 pts] Draw a correctly labeled graph of aggregate demand and aggregate supply and show each of the following. (i) The long-run aggregate supply curve (ii) The current equilibrium output & PL, labeled as YE and PLE, respectively. (b) [2 pts] Assume that the government increases spending on national defense without raising taxes. (i) On your graph in part (a), show how the government action affects AD. (ii) How will this government action affect the unemployment rate in the short run? Explain. YE PL Answer 1(a)(i): 1 pt for correctly labeled graph with downward-sloping AD, upward-sloping SRAS, PL E and Y E. (ii) 1 pt for showing a vertical LRAS at Y E.

4. SRAS 1 LRAS AD YE PL 2 E1E1E1E1 Real GDP E2E2E2E2 1. (c) [2 pts] Assume that the economy adjusts to a new long-run equilibrium after the increase in government spending. (i) How will the short-run aggregate supply curve in the new long-run equilibrium compare with that in the initial long-run equilibrium in part (a) ? Explain. (ii) On your graph in part (a), label the new long-run equilibrium price level as PL2. PL E YIYIYIYI SRAS 2 PL Answer 1.(c)(i): 1 pt for stating that the SRAS will shift to the left because the Increase in AD would result in more inflation so workers will demand higher wages AND showing PL2 correctly in part (a)’s graph. 1.(c)(ii) 1 pt for explaining that the actual PL is higher than the expected PL, or wages and commodity prices adjust to higher PL[flexible wages], causing the SRAS curve to shift to the left.

5. S D1D1 r1 F1F1F1F1 Real Interest Rate, (%) Quantity of Loanable Funds E1 r2r2r2r2 F2F2F2F2 E2E2E2E2 D2D2D2D2 LFM Answer to 1. (e) (i) [1 pt] The higher RIR will result in less investment in tools and machinery. 1. (e) (ii) [1 pt] The decrease in tools and machinery will decrease overall 1. (e) (ii) [1 pt] The decrease in tools and machinery will decrease overall productivity and economic growth [capital stock]. productivity and economic growth [capital stock]. 1. (d) [2 pts] In order to finance the increase in government spending on national defense from part (b), the government borrows funds from the public. Using a correctly labeled graph of the loanable funds market, show the effect of the government’s borrowing on the real interest rate. (e) [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. Answer to 1. (d) 1 pt for correctly labeled graph of the LFM. 1 pt for showing a rightward shift of the demand curve resulting in a higher interest rate OR a leftward shift of the supply curve resulting in a higher RIR.

6. Answer to 2. (c) The lower IR will increase AD due to more investment and interest sensitive consumption [the lower IR would also depreciate the dollar and increase Xn]. All 3 cause an increase in AD & PL in the SR. 2. (d) Selling bonds would be the OMO as it would decr MS, incr NIR and decr AD & PL. [Money Market] Dm1Dm1Dm1Dm1 MS Nominal Interest Rate n2 [6 total points] 2. [6 total points] A drop in credit card fees causes people to use credit cards more often for transactions and demand less money. (a) [2 pts] Using a correctly labeled graph of the money market, show how the nominal interest rate will be affected. (b) [1 pt] Given the interest rate change in part (a), what will happen to bond prices in the short run? (c) [2 pt] Given the interest rate change in part (a), what will happen to the price level in the short run? Explain. (d) [1 pt] I dentify an open-market operation the Fed could use to keep the nominal interest rate constant at the level that existed before the drop in credit card fees. Explain. Answer to 2. (a) The decrease in Dt for money would decrease the D m curve resulting in a lower NIR and RIR. 2. (b) Bond prices are inverse to the interest rate so bond prices would increase n1 Dm2Dm2Dm2Dm2 Quantity of Money

7. [6 total points] 3. [6 total points] A U.S. firm sells $10 million worth of goods to a firm in Argentina, where the currency is the peso. (a) [1 pt] How will the transaction above affect Argentina’s aggregate demand? Explain. (b) [1 pt] Assume that the U.S. current account balance with Argentina is initially zero. How will the transaction above affect the United States current account balance? Explain. Answer to 3. (a) The selling of $10 M of U.S. goods to Argentina would decrease Argentina’s net exports which would decrease their AD. decrease Argentina’s net exports which would decrease their AD. AD = C+I+G+X-M, when M gets larger, GDP gets smaller. AD = C+I+G+X-M, when M gets larger, GDP gets smaller. 3. (b) The $10 million increase in net exports would cause a flow of $10 million worth of pesos into the U.S. [recorded as a +$10 million] million worth of pesos into the U.S. [recorded as a +$10 million] and would cause a current account balance of ZERO to become a and would cause a current account balance of ZERO to become a +$10 million surplus account balance. +$10 million surplus account balance.

8. 3. (c) [2pt] Using a correctly labeled graph of the foreign exchange market for the U.S. dollar, show how a decrease in the U.S. financial investment in Argentina affects each. (i) The supply of United States dollars (ii) The value of the United States dollar relative to the peso Quantity of Dollars Peso Price of Dollar P50 P50 Price $S1$$S1$ D1$D1$D1$D1$ D A P100 E1E1E1E1 E2E2E2E2 S 2$ Pesodepreciates P looking for $’s $’s looking for P Answer to 3. (c) (i): If the U.S. decrease financial investment in Argentina, the U.S. would decrease their supply of dollars to Argentina, resulting in a decrease in demand for the peso. (c) (ii) As shown on the graph, the dollar would appreciate. (d) [2 pt] Suppose that the inflation rate is 3% in the U.S. and 5% in Argentina. What will happen to the value of the peso relative to the United States dollar as a result of the difference in inflation rates? Explain. (d) T he cheaper prices in the U.S. will result in more demand for U.S. goods and therefore the dollar, appreciating the dollar and depreciating the peso.

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