Norman

SRASLRASLRAS

LRPC

PLPL

 

SRPC

PLPLee

YY

AA

EE11

1. Assume that the U.S. economy is currently in a recessionrecession in a short-run equilibrium. (a) Draw a correctly labeled graph of the short run and long-run Phillips curvesshort run and long-run Phillips curves. Use

the letter AA to label a point that could represent the current state of the economy in recessionrecession.

YYEE

PLPL

Infl

ati

on

Unemployment RateUnemployment Rate

3%1%

5%5% 8%8%

(b) Draw a correctly labeled graph of AD/AS graph of AD/AS in the recession and show each of the following. (i) The LRLR equilibrium outputoutput, labeled YY (II) The current current equilibrium outputoutput and price levelsprice levels, labeled YeYe and PPLLee, respectively.

(c) To balance the federal budget, suppose that the government decides to raise income taxes 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 Y2Y2 and PL2PL2, respectively.

AD1

ADAD22

PLPL22

YY22

EE22

Real GDPReal GDP

Answer to 1. (d)(i) and (ii) Answer to 1. (d)(i) and (ii) The Fed will The Fed will buy bonds buy bonds which will increase which will increase the MS [from MSthe MS [from MS11 to MS to MS22] and ] and decrease thedecrease thenominal interest ratenominal interest rate..

Answer to 1. (d)(iii)Answer to 1. (d)(iii) The lower nominal interest rate would increase quantity of investmentThe lower nominal interest rate would increase quantity of investmentdemanded by businesses demanded by businesses [would also increase consumption and Xn] [would also increase consumption and Xn] whichwhichwould increase AD. The increase in AD would would increase AD. The increase in AD would increase price levelincrease price level. .

Money MarketMoney Market

0

DDmmMSMS11 MS2

Nom

inal In

tere

st

Rate

nir1

[buy bonds] [buy bonds]

1. (d) Assume that the FedFed uses monetary policy to stimulate the economyuses monetary policy to stimulate the economy. (i) What open-market policy open-market policy should the Fed implement? (ii) Using a correctly labeled graph of the money market show how the policy in part (d)(i) affects nominal interest ratesinterest rates. (iii) what will be the impact of the policy on the price levelprice level? Explain.

The Fed should buy bonds. 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.

(i) In the long run, will the short-run AS short-run AS increase, decrease, or remain unchanged? Explain.

(ii) In the long run, what will happen to the natural rate of unemploymentnatural rate of unemployment?

Answer to 1. (e) (i) Answer to 1. (e) (i) In the long run, prices would come down, and workers would accept lower In the long run, prices would come down, and workers would accept lower wages, decreasing resource cost to businesses, and they would hirewages, decreasing resource cost to businesses, and they would hiremore workers as the more workers as the SRAS curve would increaseSRAS curve would increase..

Answer to 1. (e)( ii) Answer to 1. (e)( ii) With the SRAS curve shifting back to the right, this would bring the With the SRAS curve shifting back to the right, this would bring the economy back to equilibrium at the natural rate of employment. Becauseeconomy back to equilibrium at the natural rate of employment. Becausewe are back to the natural rate of unemployment, it did we are back to the natural rate of unemployment, it did not change in the not change in the long runlong run. .

S1D

r1r1

FF11

Rea

l In

tere

st R

ate,

(%

)

Quantity of Loanable Funds

E1E1

rr22

FF22

EE22

SS22

Loanable Funds Market

2. Japan, the European Union, Canada, and Mexico have flexible exchange rates. (a) Suppose Japan attracts an increased amount of investment from the EUJapan attracts an increased amount of investment from the EU. (i) Using a correctly labeled graph of the loanable funds market in Japanloanable funds market in Japan, show the

effect of the increase in foreign investment on the real interest rate in Japanreal interest rate in Japan. (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 runemployment level in Japan in the short run? Explain.

Answer to 2. (a) (i) & (ii)Answer to 2. (a) (i) & (ii)(i) As can be seen on the graph, the increased investment in Japan would result in more yen(i) As can be seen on the graph, the increased investment in Japan would result in more yenin Japan’s depository institutions, and increasing the supply of LF in Japan and in Japan’s depository institutions, and increasing the supply of LF in Japan and decreasingdecreasingthe real interest ratethe real interest rate..(ii) With the RIR decreasing in Japan, there will be more investment [(ii) With the RIR decreasing in Japan, there will be more investment [a component of AD]whicha component of AD]whichwould would increase AD and GDP, therefore increasing employment in the short runincrease AD and GDP, therefore increasing employment in the short run..

Quantity of Canadian Dollars

Peso P

rice o

f C

an

ad

ian

Dollar

0

P10P10

PPP/CDP/CD

Qe

SSDD11

DD

AA

DD22

P12P12

EE11

EE22

PesoPesodepreciatesdepreciates

2. (b) Suppose in a different part of the world, the real interest rate in Canada real interest rate in Canada increases increases relative to that in Mexico. (i) Using a correctly labeled graph of the foreign exchange market for the Canadian foreign exchange market for the Canadian dollardollar, show the effect of the change in real interest rate in Canada on the international international value of the Canadian dollarvalue 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 identified in part (b)(i) affect Canadian exports to MexicoCanadian exports to Mexico? Explain. Answer to 2. (b)(i) Answer to 2. (b)(i) The higher RIR in Canada wouldThe higher RIR in Canada wouldresult in more demand for the result in more demand for the Canadian dollar by internationalCanadian dollar by internationalinvestors who are looking forinvestors who are looking forbetter returns. It increases better returns. It increases demand for the C. Dollar anddemand for the C. Dollar andappreciates that currencyappreciates that currency.. Answer to 2. (b)(ii) Answer to 2. (b)(ii) The stronger Canadian dollarThe stronger Canadian dollarwould make Canadian exports would make Canadian exports more expensive to Mexico, more expensive to Mexico, therefore therefore decreasing Canadiandecreasing Canadianexports to Mexicoexports to Mexico..

3. Sewell Bank has the simplified balance sheet below.

(a) Based on Sewell Bank’s balance sheet, calculate the required reserve ratiorequired reserve ratio. Answer to 3. (a) Answer to 3. (a) The Fed’s The Fed’s RR would be 20% RR would be 20% as DD is $10,000 and RR is $2,000 as DD is $10,000 and RR is $2,000 and excess reserves are $0.and excess reserves are $0. (b) Suppose that the Fed purchases $5,000 worth of bonds from Sewell Bank.

What will be the change in the dollar value of each 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 ER would be $5,000 as any loan from the Fed is ER.as any loan from the Fed is ER. DD DD would not immediately increase would not immediately increase as any money as any money from the Fed is all ER.from the Fed is all ER.

3. [continued]

3. (c) Calculate the maximum amount that the MS can change MS can change as a result of the $5,000 purchase of bonds by the Fed. .

Answer to 3. (c) Answer to 3. (c) The Total Money Supply could potentially change to $25,000.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 All of the $5,000 is ER for Sewell Bank so with a RR of 20% and a

MMMM of 5, $5,000 x 5 = TMS of $25,000. of 5, $5,000 x 5 = TMS of $25,000.

3. [continued]

3. (d) When the Fed purchases bonds, what will happen to the price of bonds price of bonds in the open market? Explain.

Answer to 3. (d) Answer to 3. (d) When the Fed purchases bonds, the MS increases and people buy When the Fed purchases bonds, the MS increases and people buy non-money assets like bonds which pushes non-money assets like bonds which pushes bond prices up bond prices up and and interest rates down. 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 immediate effect of the cash deposit on the M1 measure effect of the cash deposit on the M1 measure of the MS?

Answer to 3. (e) Answer to 3. (e) No impact. It stays the same although it changes composition fromNo impact. It stays the same although it changes composition from$5,000 currency to $5,000 DD.$5,000 currency to $5,000 DD.

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