1. 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

2. 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

3. (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

4. 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

5. 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

6. 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 ↑)

7. 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.