2 Macro Free Response 2007 MS Money Market Macro Free Response 2007Assume that declining stock market prices in the U.S. cause many U.S.financial investors to sell their stocks and increase their money holdings.(a) Draw a correctly labeled graph of the money market and show theimpact of the financial investors’ actions on each of the following.(i) Demand for money(ii) Nominal interest rateMSDM1Answers for 1. (a) (i)(a) (i) The decline in wealthdecreases many investorsdemand for major purchasesand decreases the demand formoney.DM2Nominal Interest Ratei.r.1i.r.2Money MarketAnswers for 1. (a) (ii)(a) (ii) The nominal interest rate would decrease because the demandfor money decreases as the DM curve shifts down, as shown above.
3 1. (b) Due to the decline in wealth caused by the change in stock prices, the general price level in the U.S. falls relative to the price level in Japan, a trading partner. Use a correctly labeled graph of the foreign exchange market for the U.S. dollar to show the impact of the change in relative price levels on each of the following. (i) Demand for the dollar (ii) Price of the dollarFRQ 2007D2$D1$S$Answers to 1. (b) (i)(b) (i) The decrease in wealth willcause less consumer spendingwhich causes the AD curve to shiftleft and a decrease in the price level.This decrease in PL will cause theJapanese to want to buy more U.S.goods, increasing the demand forthe dollar.Y150E2Yen Price of DollarY100E1Quantity of DollarsAnswers to 1. (b) (ii)1. (b) (ii) Lower prices in the U.S. would cause an increase in demand forthe dollar, resulting in the Japanese having to pay more for Americangoods. Therefore the yen would depreciate as the price of the dollarhas increased, and the dollar has appreciated.
4 FRQ 20071. (c) How will the change in the price of the dollar you indicated in part (b) (ii) affect net exports of the U.S. Explain.Answer to 1. (c) The appreciated dollar would cause American goods to be more expensive for Japan and Japan’s goods to be less expensive for Americans; therefore, we would export less and import more, resulting in a decrease in net exports.(d) Using a correctly labeled AD/ASgraph, show how the change inXn in part (c) will affect each ofthe following in the short run.(i) Aggregate Demand(ii) Output and price levelLRASSRASPLAD1AD2PL1E1Answer to 1. (d)As can be seen on the graph, thedecrease in Xn would decrease AD.The decrease in AD would decreaseoutput to Y2 and PL to PL2.PL2E2RGDPY2Y1Answer to 1. (e)The decrease in Xn in part (d) will resultin a decrease in AD and output, whichwould increase unemployment in the SR.(e) Given your answers to part (d),what will happen to unemploymentin the short run? Explain.
5 2. In recent years, the Federal Reserve has made targeting the federal funds rate a main focus of its monetary policy. (a) Define the federal funds rate.FRQ 2007Answer: The rate that banks charge one another for overnight loans(b) If the Federal Reserve wants to lower the federal funds rate, whatopen-market operation would be appropriate?Answer: The Fed would buy bonds from the banks or public. Buyingbonds means a bigger supply of money and lower fed funds rate.(c) Assume that the open-market operation that you indicated in part(b) is equal to $10 million. If the RR is 0.2, calculate the maximumchange in loans throughout the banking system.Answer: If the Fed buys bonds from banks, DD could increase by the $10 million initially& with a MM of 5, the total money supply could increase to $50 million. If the Fed buys bondsfrom the public, DD could increase by $10 M initially. With MM of 5, $2 M would be kept in RR& $8 million could be loaned out & increase to $40 million more in DD for a total of $50 million.(d) Indicate the effect of the open-market operation that you indicatedin part (b) on the nominal interest rate.Answer: Buying bonds would increase the MS and lower nominal Interest rates.(e) Assume that the Fed’s action results in some inflation. What would be theimpact of the open-market operation on the real rate of interest? Explain.Answer: The real interest rate would decrease. Real IR = Nominal – Inflation; if weget more inflation, then Real IR = Nominal – even more Inflation, so it decreases.
6 FRQ 2007 3. Indicate whether each of the following is counted in the U.S. GDP for the year Explain each of your answers.(a) The value of a used textbook sold through an online auction in 2006Answer: No, it was counted the year it was produced. Because it wasnot produced again, it would not be counted. That would be double counting.b. Rent paid in 2006 by residents in an apartment building built in 2000Answer: Yes, rents consist of the income received by the households andbusinesses that supply property resources. It is included in the income approachapproach to GDP.c. Commissions earned in 2006 by a stockbrokerAnswer: Yes, payment is being made for productive services of thebroker. So the purchase of stocks would not count but his work would.d. The value of autos produced in 2006 entirely in South Korea by afirm fully owned by U.S. citizensAnswer: No, GDP measures production inside the U.S. regardless ofownership. These autos were produced in South Korea.