2 2010 FRQ1. [11 total points] Assume that the U.S. economy is currently in long-run equilibrium.(a) [3 pts] Draw a correctly labeled graph of aggregate demand and aggregate supplyand show each of the following.(i) The long-run aggregate supply curve(ii) The current equilibrium output & PL, labeled as YE and PLE, respectively.LRASSRASPLAD1PL2E2PLEE1AD2YEYIReal GDP(b) [2 pts] Assume that the government increases spending on national defense withoutraising 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.Answer: 1. (b) (i) As can be seen on the graph, the increase in G would increaseAD to AD2, increasing PL and Y.1. (b) (II) The increase in AD to AD2 would decrease unemployment inthe 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.
3 2010 FRQ1. (c) [2 pts] Assume that the economy adjusts to a new long-run equilibrium after theincrease in government spending.(i) How will the short-run aggregate supply curve in the new long-run equilibriumcompare 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.LRASSRAS2SRAS1PLPL2E2PLEE1ADYEYIReal GDPAnswer: 1. (c) (i) The increase in AD will result in more inflation and workersdemanding higher wages. This increase in resource cost at contract time inthe long run would move the SRAS to the left.(c) (ii) PL2, as shown on the above graph, is a higher PL than PLE.
4 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 correctlylabeled graph of the loanable funds market, show the effect of the government’sborrowing on the real interest rate.(e) [2 pts] Given the change in the real interest rate in part (d), what is the impacton each of the following?(i) Investment(ii) Economic growth rate. Explain.Mankiw users: Increasing government borrowing reduces the supply of private loanable funds. Interest Rates would also go up, and investment would decrease.D2LFMD1Sr2E22010 FRQReal Interest Rate, (%)r1E1F1F2Quantity of Loanable FundsAnswer to 1. (d) As can be shown in the graph, the government borrowing wouldincrease demand for money in the LFM and push the RIR up.(e) (i) The higher RIR will result in less investment in tools and machinery.(e) (ii) The decrease in tools and machinery will decrease overall productivityand economic growth [capital stock].
5 2010 FRQ Dm1 Dm2 MS Answer to 2. (a) The decrease in Dt for money 2. [5 total points] A drop in credit card fees causes people to usecredit cards more often for transactions and demand less money.(a) [2 pts] Using a correctly labeled graph of the money market, show how the nominalinterest rate will be affected.(b) [1 pt] Given the interest rate change in part (a), what will happen to bond prices inthe short run?2010 FRQAnswer to 2. (a) The decrease in Dt for moneywould decrease the Dm curve resulting in alower NIR and RIR.2. (b) Bond prices are inverse to the interestrate so bond prices would increaseDm1MSn1Answer to 2. (c) The lower IR will increaseAD due to more investment and interestsensitive consumption [the lower IR wouldalso 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 asit would decr MS, incr NIR and decr AD & PL.Nominal Interest Raten2Dm2Money Market(c) [1 pt] Given the interest rate change in part (a), what will happen to the price levelin the short run? Explain.(d) [1 pt] Identify an open-market operation the Fed could use to keep the nominal interestrate constant at the level that existed before the drop in credit card fees. Explain.
6 3. [5 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 aggregatedemand? Explain.(b) [1 pt] Assume that the U.S. current account balance with Argentina isinitially zero. How will the transaction above affect the United States currentaccount balance? Explain.2010 FRQAnswer to 3. (a) The selling of $10 M of U.S. goods to Argentina woulddecrease Argentina’s net exports which would decrease their AD.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 $10million worth of pesos into the U.S. [recorded as a +$10 million]and would cause a current account balance of ZERO to become a+$10 million surplus account balance.
7 D A S1$ 2010 FRQ D1$ S2$ P looking for $’s $’s looking for P E2 E1 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.PriceP looking for $’s$’s looking for PP100E2DPesodepreciatesPeso Price of DollarP50E1(d) The 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.Quantity of DollarsA3. (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(d) [1 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 asa result of the difference in inflation rates?Explain.
8 2010 FRQ The End Animationeconomics.com Econ FRQs How To Score Well On FRQsFRQs for Dummies2010 FRQThe EndAnimationeconomics.com