1. Assume that the U.S. economy is in a severe recession with no inflation. (a) Using a correctly labeled aggregate demand and aggregate supply graph, show each of the following for the economy. (i) Full-employment (ii) Current output level (iii) Current price level 2003 Long Free Response Solved

As government spending decreases this causes AD to shift (b) The federal government announces a major decrease in spending. Using your graph in part (a), show how the decrease in spending will affect each of the following. (i) Level of output (ii) Price level As government spending decreases this causes AD to shift to the left, causing Q and PL to go down. AD2

(c) Explain the mechanism by which the decrease in government spending will affect unemployment rate. As government spending decreases this causes less consumption and investment in the economy shifting AD to the left, causing unemployment to rise AD2

MS MS2 i i2 MD As interest rates fall, this increases C and I, (d) The Federal Reserve purchases bonds through its open-market operations. (i) Using a correctly labeled graph, show the effect of this purchase on the interest rate. As interest rates fall, this increases C and I, causing AD to shift to the right. Qty and PL increase. MS MS2 Nominal Interest Rate i i2 MD QTY Money

S S2 D Q P P2 As U.S. interest rates go down relative (e) Explain how the change in the interest rate you identified in part (d) will affect each of the following. (i) International value of the dollar relative to other currencies As U.S. interest rates go down relative to other countries’ interest rates, U.S. citizens would “save money” in other countries, thus increasing the supply of dollars in the foreign exchange market causing the dollar to depreciate. Market for Dollars S ?/$ S2 P P2 D Q Qty of Dollars

As the dollar depreciates relative to other (e) Explain how the change in the interest rate you identified in part (d) will affect each of the following. (ii) United States exports As the dollar depreciates relative to other countries’ currencies, our exports goods and services become cheaper relative to other countries’. Exports increase. (NX ↑)

As the dollar depreciates relative to other (e) Explain how the change in the interest rate you identified in part (d) will affect each of the following. (iii) United States imports As the dollar depreciates relative to other countries’ currencies, their goods and services become more expensive relative to the U.S.’. U.S. imports decrease.