2 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 inthe short run?(i) AD(ii) Short-run AS(b) Using a correctly labeled graph of AD/AS, show the effect of theincrease in government expenditures on real output and the price level.Answer to 1. (a) (i) AD would increase as governmentexpenditures is a determinant of AD.Country ZLRASSRASPLAnswer to 1. (a) (ii) SRAS curve would not be affectedas government expenditures is not adeterminant of the SRAS curve. There isa movement up the SRAS curve.AD1PL2(6%)PL1(3%)AD2Real GDPY*YiAnswer to 1. (b)As can be seen on the graph, the increase in government expenditures wouldincrease AD which would increase real output. The increase in AD would movethe AD curve up along the SRAS curve and increase PL.
3 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 byborrowing 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 [Form B]Answer to 1. (c)The increase in government borrowing in the LFM would push up demand for moneyand increase the RIR.D1D2SBorrowersLendersrir=8%E2rir=6%Real Interest Rate, (percent)E1$2.1 Tril. after “G” increase$2 T$2 TGTF1F2Quantity of Loanable FundsBalanced Budget [G&T=$2 Tr.]
4 FRQ [Form B](d) Given the change in the real interest rate in part (c), what will be theeffect 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 demandfor other country’s currency by sellers of Country Z’s currency. The decrease in supplyis causing the currency to appreciate [as well as the increase in demand for Country Z’scurrency by other nations].Answer to 1. (d) (ii):Because of the higher return on financial investments [bonds & CDs], there wouldwould be an increase in demand for Country Z’s currency, which would appreciate theircurrency.(e) Given your answer in part (d) (ii), what will be the effect of the changein 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 expensiveand therefore decrease their exports.
5 FRQ [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. Thedecrease 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 theirprices 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 adeficit in the current account which includes exports and imports.Answer to 2. (b) (ii):The capital account balance would move toward surplus because the currentaccount moved toward deficit.(c) Given the change in Mexico’s current account in part (b) (i), what will happen to the aggregatedemand in Mexico?Answer to 2. (c):The increase in imports would result in a decrease in net exports, which is adeterminant of AD, therefore it would decrease AD.
6 Outputs and Prices in GALA LAND 3. Gala Land produces three final goods: bread,water, and fruit. The table [right] shows thisyear’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 baseyear 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 hashappened to their real wages? Explain.(d) If the GDP deflator in Gala Land increases unexpectedly, would a borrower with afixed-interest-rate loan be better off or worse off? Explain.FRQ [Form B]Outputs and Prices in GALA LANDThis Year’s Output This Year’s Price400 loaves of bread $6 per loaf1,000 gallons of water $2 per gallon800 pieces of fruit $2 per pieceAnswer 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 increasedonly 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.