Transcript Slide 1

Norman
1. [11 pts] Assume that the U.S economy is in long-run equilibrium with an expected
inflation rate of 6% & an unemployment rate of 5%. The nominal interest rate is 8%.
(a) [2 pts] Using a correctly labeled graph with both the short-run and long-run Phillips
curves and the relevant numbers from above, show the current long-run equilibrium
as point A.
Inflation
SRPC LRPC
6%
A
5%
1. (a) 1 point for graph of SRPC and
1 point for showing point A at 5%
unemployment and 6% inflation.
Unemployment
(b) [1 pt] Calculate the real interest rate in the long-run equilibrium.
Answer to 1. (b)
The real interest rate = the nominal interest rate – anticipated (expected)
inflation.
NIR [8%] - expected inflation [6%] = RIR [2%]
(c) [1 pt] Assume that the Federal Reserve decides to target an inflation rate of 3%.
What open-market operation should the Federal Reserve undertake?
Answer to 1. (c)
The open market operation to decrease inflation from 6% to 3%
would be for the Fed to sell bonds on the open market.
Nominal Interest Rate
(d) [2 pts] Using a correctly labeled graph of the money market, show how the
Fed’s action you identified in part c will affect the nominal interest rate.
DmMS2 MS1
ir2
ir1
0
[Sell bonds]
Money Market
Answer to 1. (d)
The Fed’s selling of bonds would decrease MS from MS1 to MS2
and increase nominal interest rates. [One point for correct
graph and one point for leftward shift of the MS and higher interest rate.]
Dm
DI
MS2 MS1
AD1
AD2
NIR
ir2
ir2
PL3
ir1
ir1
PL2
0
0
QID2 QID1 QID
AS
RGDP Y* YI
Money Market
Investment Demand
(e) [2 pts] How will the interest rate change you identified in part d affect
aggregate demand in the short run?
Answer to 1. (e)
The Fed’s selling of bonds would decrease MS from MS1 to MS2 and
increase nominal interest rates, decreasing interest rate sensitive
consumption, also decreasing quantity of investment demanded,
which decreases AD in the short run. [One point for decrease in
AD & one point for any one of these: C, Ig, Xn decrease OR imports
or savings increase]
(f) [3 pts] Assume that the Federal Reserve action is successful. What will happen to
each of the following as the economy approaches a new long-run equilibrium.
(i) [1 pt] The short-run Phillips Curve. Explain
LRPC 1. (f) (i) & (ii) On pt for SRPC shifting left;
SRPC1
Inflation
SRPC2
6%
3%
one point for decrease in inflationary
expectations; and one point for
A saying the natural rate remains
unchanged.
B
5% Unemployment
Answer to 1. (f) (i)
As can be seen on the graph, the decrease in AD would result in a
movement down and to the right on the SRPC, but as the economy
approaches LR equilibrium, the decrease in inflationary expectations
would result in the SRPC shifting left.
(ii) [1 pt] The natural rate of unemployment
Answer to 1. (f) (ii) The natural rate of unemployment would not increase
in the long run, but stay the same.
Real Interest Rate, (%)
2. [6 pts] Assume that as a result of increased political instability, investors move their
funds out of the country of Tara.
(a) [2 pts] How will this decision by investors affect the international value of Tara’s
currency on the foreign exchange market? Explain.
Answer to 2. (a) As foreign investors pull their money out of Tara, there would be
a decrease in demand for their currency, which would depreciate their currency.
[ 2 pts for saying the exchange rate depreciates & supply incr OR demand decr]
(b) [2 pts] Using a correctly labeled graph of the loanable funds market in Tara, show
the impact of this decision by investors on the real interest rates in Tara.
S2
D
r2
r1
LFM
E2
E1
F2 F1
S1
Answer to 2. (b)
As can be seen on the graph, as
investors pull their money out of Tara,
there is a decrease in supply in their LF
market[1 pt], increasing the RIR[1 point].
Quantity of Loanable Funds
(c) [2 pts] Given your answer in part b, what will happen to Tara’s rate of economic
growth? Explain.
Answer to 2. (c) As the RIR increases, it becomes less profitable for firms to invest in capital
equipment, which decreases economic growth. [1 point for decr ease in growth rate and
1 point for decrease in capital formation {can’t just say “investment”}, but capital formation or equipment.]
3. [6 pts] Assume that the reserve requirement is 20% & banks hold no excess reserves.
(a) [3 pts] Assume that Kim deposits $100 of cash from her pocket into her checking
account. Calculate each of the following.
(i) The maximum dollar amount the commercial bank can initially lend
(ii) The maximum total change in demand deposits in the banking system
(iii) The maximum change in the money supply.
Answer to 3. (a) [1 pt each for (i) $80, (ii) $500, and (iii) $400]
(i) The $100 in DD will result in $80 new ER that the banks can initially lend.
(ii) Maximum total DD could be as high as $500. This includes $100 DD in the
first bank and a PMC of $400. MM [5] x ER [$80] = PMC of $400. Total DD of $500.
(iii) The MS was already $100 as the $100 in cash was part of MS, so this results
in an increase in money supply of $400.
(b) [1 pts] Assume that the Federal Reserve buys $5 million in government bonds on
the open market. As a result of the open market purchase, calculate the maximum
increase in the money supply in the banking system.
Answer to 3. (b)
Once this $5 million is deposited by the public, $1 million has to be kept in RR
and $4 million becomes ER. MM [5] x ER [$4 M] = $20 million increase in the MS
in the banking system. The Total MS is now $25 million [DD of $5 & PMC of $20]
(c) [2 pts] Given the increase in the money supply in part b, what happens to real
wages in the short run? Explain.
Answer to 3. (c)
The increase in MS results in a decrease in the NIR, resulting in a increase in
QID, and an increase in AD, which pushes prices up [1 pt], therefore a decrease
in real wages [1 pt].
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