3. recession 1.Assume the U.S. economy is operating at full-employment output and the government has a balanced budget. A drop in consumer confidence reduces consumption spending, causing the economy to enter into a recession. (a) Using a correctly labeled graph of the short-run Phillips curve, show the effect “A” of the decrease in consumption spending. Label the initial position “A” and the “B” new position “B”. recession (b) What is the impact of the recession on the federal budget? Explain. Inflation Unemployment 2%2%2%2% 7% 4%4%4%4% 5% SRPCSRPCSRPCSRPC A B Answer to 1. (b): The decrease in consumption would result in a decrease in AD and a decrease in GDP. The decrease in consumption would result in a decrease in AD and a decrease in GDP. This would result in an increase in unemployment and an increase in transfer payments. This would result in an increase in unemployment and an increase in transfer payments. Due to the job losses, there would be a decrease in tax revenues, resulting in an increase Due to the job losses, there would be a decrease in tax revenues, resulting in an increase in government red ink for the federal budget. So a federal budget deficit would increase in government red ink for the federal budget. So a federal budget deficit would increase or a federal budget surplus would decrease. or a federal budget surplus would decrease. A. W. Phillips 1914-1975

4. (c) Assume current real GDP falls short of full-employment output by $500 billion and the MPC is 0.8. (i) Calculate the minimum increase in government spending that could bring about full employment. Answer to 1. (c) (i): The expenditure multiplier [ M E ] would be 5 [1/.2 = M E of 5]. Because current output The expenditure multiplier [ M E ] would be 5 [1/.2 = M E of 5]. Because current output falls short by $500 billion, it would take a minimum increase in government spending falls short by $500 billion, it would take a minimum increase in government spending of $100 billion to get to full employment. [5 X $100 = $500] of $100 billion to get to full employment. [5 X $100 = $500] (ii) Assume that instead of increasing government spending, the government decides to reduce personal income taxes. Will the reduction in personal income taxes required to achieve full employment be larger than or smaller than the government spending change you calculated in part (c) (i)? Explain why. Answer to 1. (c) (ii): Because the tax multiplier [ M T ] is smaller, or [MPC/MPS =.8/.2 = 4], it will take a larger Because the tax multiplier [ M T ] is smaller, or [MPC/MPS =.8/.2 = 4], it will take a larger tax cut then the increase in government spending. Because current output is $500 bil. tax cut then the increase in government spending. Because current output is $500 bil. short of FE Y, and the M T is 4, it would take a tax cut of $125 billion. [4 X $125 = $500] short of FE Y, and the M T is 4, it would take a tax cut of $125 billion. [4 X $125 = $500]

5. Real Interest Rate, (percent) rir = 6 % D1D1D1D1 F1F1F1F1 S D2D2D2D2 rir = 8 % F2F2F2F2 E1E1E1E1 E2E2E2E2 Borrowers Lenders $ 2 T G T Balanced Budget [G&T=$2 Tr.] $2.1 Tril. after $100 B increase $2 T $2 T (d) Using a correctly labeled graph of the loanable funds market, show the impact of the increased government spending on the real interest rate in the economy. (e) How will the real interest rate change in part (d) affect the growth rate of the U.S. economy? Explain. Answer to 1. (d) Answer to 1. (d) As can be seen on the LF graph, the RIR would increase as the government has to borrow As can be seen on the LF graph, the RIR would increase as the government has to borrow more than previously, increasing demand in the LFM, which pushes up the RIR. more than previously, increasing demand in the LFM, which pushes up the RIR. Answer to 1. (e): The increase in RIR will decrease real Ig, decreasing capital stock. This will decrease AD and decrease GDP or growth rate in the U.S. economy.

6. 2. Balance of payments accounts record all of a country’s international transactions during a year. (a)Two major subaccounts in the balance of payments accounts are the current account and the capital account. In which of these subaccounts will each of the following transactions be recorded? (i) A United States resident buys chocolate from Belgium. (b) How would an increase in the real income in the United States affect the United States current account balance? Explain. (ii) A United States manufacturer buys computer equipment from Japan. Answer to 2. (a) (i): Answer to 2. (a) (i): Chocolate from Belgium would go in the current account as it includes the import of goods. Chocolate from Belgium would go in the current account as it includes the import of goods. Answer to 2. (a) (ii): Answer to 2. (a) (ii): Computer equipment by a U.S. manufacturer would also be classified as an import so it Computer equipment by a U.S. manufacturer would also be classified as an import so it would also go on the current account. would also go on the current account. Answer to 2. (b): Answer to 2. (b): An increase in real income would make U.S. citizens richer. We would buy more imports, An increase in real income would make U.S. citizens richer. We would buy more imports, decreasing net exports, and increasing the deficit on the current account. decreasing net exports, and increasing the deficit on the current account.

7. R25 Quantity of Dollars Rupee Price of Dollar R50 R50 P rice $S1$$S1$ D1$D1$D1$D1$ A D R100 E1E1E1E1 E2E2E2E2 S2$S2$S2$S2$ Rupeeappreciates R looking for $’s $’s looking for R (c) Using a correctly labeled graph of the foreign exchange market for the U.S. dollar, show how an increase in U.S. firms’ direct investment in India will affect the value of the U.S. dollar relative to the Indian currency (the rupee). Answer to 2. (c): Answer to 2. (c): The increase in investment in India will increase demand for the rupee & appreciate that The increase in investment in India will increase demand for the rupee & appreciate that currency. This would result in an increase in supply of the U.S. dollar for more rupees, currency. This would result in an increase in supply of the U.S. dollar for more rupees, depreciating the dollar. depreciating the dollar.

8. 3. The diagram shows the PPCs for two countries: Artland and Rayland. Using equal amounts of resources, Artland can produce 600 hats or 300 bicycles, whereas Rayland can produce 1,200 hats or 300 bicycles. (a)Calculate the opportunity cost of a bicycle in Artland. (b) If the two countries specialize and trade, which country will import bicycles? Explain. (c) If the terms of trade are 5 hats for 1 bicycle, would trade be advantageous for each of the following? (i) Artland (ii) R ayland (d) If productivity in Artland triples, which country has the comparative advantage in the production of hats? Answer to 3. (a): Answer to 3. (a): The Domestic Comparative (opportunity cost) of a bicycle The Domestic Comparative (opportunity cost) of a bicycle in Artland is 2 units of hats. [1 bicycle = 2 hats or 600/300=2] in Artland is 2 units of hats. [1 bicycle = 2 hats or 600/300=2] Answer to 3. (b): Answer to 3. (b): Rayland will import bicycles. Domestically, they have to give Rayland will import bicycles. Domestically, they have to give up 4 hats to get a bicycle but with trade they have to give up up 4 hats to get a bicycle but with trade they have to give up only 3 hats. only 3 hats. DCC: Rayland DCC: Artland 1 B = 4 H 1 B = 2 H ¼ B= 1 H ½ B= 1 H Terms of Trade Terms of Trade 1 B = 3 H 1 B = 3 H 1/3 B = 1 H 1/3 B = 1 H Answer to 2. (c) (i): Yes, 5 hats is better than 2 hats they are getting domestically. Answer to 2. (d): 300 bicycles would become 900 and 600 hats would become 1,800, so the Answer to 2. (d): 300 bicycles would become 900 and 600 hats would become 1,800, so the DCC would still be 1 bicycle = 2 hats, same as before. Rayland still has a C.A. in hats. DCC would still be 1 bicycle = 2 hats, same as before. Rayland still has a C.A. in hats. Answer to 2. (c) (ii): No, Rayland is going to export hats so opportunity cost is ¼ bicycle. So 1/5 of a bicycle would not benefit them.

9. Finished