Norman

SRAS LRAS LRPC PL SRPC PL e Y A E1E1E1E1 recession 1.Assume that the U.S. economy is currently in a recession in a short-run equilibrium. short run and long-run Phillips curves A recession (a) Draw a correctly labeled graph of the short run and long-run Phillips curves. Use the letter A to label a point that could represent the current state of the economy in recession. YEYEYEYE PL Inflation Unemployment Rate 3% 1% 5% 8% graph of AD/AS (b) Draw a correctly labeled graph of AD/AS in the recession and show each of the following. LRoutput Y (i) The LR equilibrium output, labeled Y current outputprice levels (II) The current equilibrium output and price levels, YeP L e labeled Ye and P L e, respectively. raise income taxes Y2PL2 (c) To balance the federal budget, suppose that the government decides to raise income taxes while maintaining the current level of government spending. On the graph drawn in part (b), show the effect of the increase in taxes. Label the new equilibrium output and price levels Y2 and PL2, respectively. AD 1 AD 2 PL 2 Y2Y2Y2Y2 E2E2E2E2 Real GDP

Answer to 1. (d)(i) and (ii) The Fed will buy bonds which will increase the MS [from MS 1 to MS 2 ] and decrease the nominal interest rate. Answer to 1. (d)(iii) The lower nominal interest rate would increase quantity of investment The lower nominal interest rate would increase quantity of investment demanded by businesses [would also increase consumption and Xn] which would increase AD. The increase in AD would increase price level. Money Market 0 DmDmDmDm MS 1 MS 2 Nominal Interest Rate nir1 [buy bonds] Feduses monetary policy to stimulate the economy 1.(d) Assume that the Fed uses monetary policy to stimulate the economy. open-market policy (i) What open-market policy should the Fed implement? (ii) Using a correctly labeled graph of the money market show how the policy in interest rates part (d)(i) affects nominal interest rates. price level (iii) what will be the impact of the policy on the price level? Explain. The Fed should buy bonds. nir2 Q1 Q2

1.(e) Now assume instead that the government and the Fed take no policy action in response to the recession. short-run AS (i) In the long run, will the short-run AS increase, decrease, or remain unchanged? Explain. natural rate of unemployment (ii) In the long run, what will happen to the natural rate of unemployment? Answer to 1. (e) (i) In the long run, prices would come down, and workers would accept lower wages, decreasing resource cost to businesses, and they would hire more workers as the SRAS curve would increase. Answer to 1. (e)( ii) With the SRAS curve shifting back to the right, this would bring the economy back to equilibrium at the natural rate of employment. Because we are back to the natural rate of unemployment, it did not change in the long run.

S1S1 D r1 F1F1F1F1 Real Interest Rate, (%) Quantity of Loanable Funds E1 r2r2r2r2 F2F2F2F2 E2E2E2E2 S2S2S2S2 Loanable Funds Market 2. Japan, the European Union, Canada, and Mexico have flexible exchange rates. Japan attracts an increased amount of investment from the EU (a) Suppose Japan attracts an increased amount of investment from the EU. loanable funds market in Japan real interest rate in Japan (i) Using a correctly labeled graph of the loanable funds market in Japan, show the effect of the increase in foreign investment on the real interest rate in Japan. employment level in Japan in the short run (ii) How will the real interest rate change in Japan that you identified in part (a)(i) affect the employment level in Japan in the short run? Explain. Answer to 2. (a) (i) & (ii) (i) As can be seen on the graph, the increased investment in Japan would result in more yen in Japan’s depository institutions, and increasing the supply of LF in Japan and decreasing the real interest rate. (ii) With the RIR decreasing in Japan, there will be more investment [ a component of AD]which would increase AD and GDP, therefore increasing employment in the short run.

Quantity of Canadian Dollars Peso Price of Canadian Dollar 0 P10 PP/CD QeQe S D1D1D1D1 D A D2D2D2D2 P12 E1E1E1E1 E2E2E2E2 Pesodepreciates real interest rate in Canada 2. (b) Suppose in a different part of the world, the real interest rate in Canada increases increases relative to that in Mexico. foreign exchange market for the Canadian dollarinternational value of the Canadian dollar (i) Using a correctly labeled graph of the foreign exchange market for the Canadian dollar, show the effect of the change in real interest rate in Canada on the international value of the Canadian dollar (expressed as Mexican pesos per Canadian dollar). (ii) How will the change in the international value of the Canadian dollar that you Canadian exports to Mexico identified in part (b)(i) affect Canadian exports to Mexico? Explain. Answer to 2. (b)(i) The higher RIR in Canada would result in more demand for the Canadian dollar by international investors who are looking for better returns. It increases demand for the C. Dollar and appreciates that currency. Answer to 2. (b)(ii) The stronger Canadian dollar would make Canadian exports more expensive to Mexico, therefore decreasing Canadian exports to Mexico.

3. Sewell Bank has the simplified balance sheet below. required reserve ratio (a) Based on Sewell Bank’s balance sheet, calculate the required reserve ratio. Answer to 3. (a) The Fed’s RR would be 20% as DD is $10,000 and RR is $2,000 and excess reserves are $0. (b) Suppose that the Fed purchases $5,000 worth of bonds from Sewell Bank. change in the dollar value of each What will be the change in the dollar value of each of the following immediately after the purchase? (i) Excess reserves (ii) Demand deposit ER would be $5,000 as any loan from the Fed is ER. DD would not immediately increase as any money from the Fed is all ER.

3. [continued] MS can change 3. (c) Calculate the maximum amount that the MS can change as a result of the $5,000 purchase of bonds by the Fed.. Answer to 3. (c) The Total Money Supply could potentially change to $25,000. All of the $5,000 is ER for Sewell Bank so with a RR of 20% and a M M of 5, $5,000 x 5 = TMS of $25,000.

3. [continued] price of bonds 3. (d) When the Fed purchases bonds, what will happen to the price of bonds in the open market? Explain. Answer to 3. (d) When the Fed purchases bonds, the MS increases and people buy non-money assets like bonds which pushes bond prices up and interest rates down. 3. (e) Suppose that instead of the purchase of bonds by the Fed, an individual deposits $5,000 in cash into her checking (DD) account. What is the effect of the cash deposit on the M1 measure immediate effect of the cash deposit on the M1 measure of the MS? Answer to 3. (e) No impact. It stays the same although it changes composition from $5,000 currency to $5,000 DD.

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