Transcript Answer to 2.

1. Assume the U.S. economy is operating at full-employment output and the
government has a balanced budget. A drop in consumer confidence reduces
consumption spending, causing the economy to enter into a recession.
(a) Using a correctly labeled graph of the short-run Phillips curve, show the effect
of the decrease in consumption spending. Label the initial position “A” and the
new position “B”.
Inflation
SRPC
4%
2%
A. W. Phillips
1914-1975
A
B
5% 7%
Unemployment
(b) What is the impact of the recession on the federal budget? Explain.
Answer to 1. (b):
The decrease in consumption would result in a decrease in AD and a decrease in GDP.
This would result in an increase in unemployment and an increase in transfer payments.
Due to the job losses, there would be a decrease in tax revenues, resulting in an increase
in government red ink for the federal budget. So a federal budget deficit would increase
or a federal budget surplus would decrease.
(c) Assume current real GDP falls short of full-employment output by
$500 billion and the MPC is 0.8.
(i) Calculate the minimum increase in government spending that could
bring about full employment.
Answer to 1. (c) (i):
The expenditure multiplier [ME] would be 5 [1/.2 = ME of 5]. Because current output
falls short by $500 billion, it would take a minimum increase in government spending
of $100 billion to get to full employment. [5 X $100 = $500]
(ii) Assume that instead of increasing government spending, the government
decides to reduce personal income taxes. Will the reduction in personal
income taxes required to achieve full employment be larger than or
smaller than the government spending change you calculated in part
(c) (i)? Explain why.
Answer to 1. (c) (ii):
Because the tax multiplier [MT] is smaller, or [MPC/MPS = .8/.2 = 4], it will take a larger
tax cut then the increase in government spending. Because current output is $500 bil.
short of FE Y, and the MT is 4, it would take a tax cut of $125 billion. [4 X $125 = $500]
(d) Using a correctly labeled graph of the loanable funds market, show the impact
of the increased government spending on the real interest rate in the economy.
Real Interest Rate, (percent)
Answer to 1. (d)
As can be seen on the LF graph, the RIR would increase as the government has to borrow
more than previously, increasing demand in the LFM, which pushes up the RIR.
D1
D2
S
Lenders
Borrowers
rir=8%
E2
rir=6%
E1
(e) How will the real interest rate
change in part (d) affect the growth
rate of the U.S. economy? Explain.
Answer to 1. (e): The increase in RIR will
decrease real Ig, decreasing capital stock.
This will decrease AD and decrease GDP
or growth rate in the U.S. economy.
$2.1 Tril. after $100 B increase
$2
F1
F2
T
$2 T
G
T
Balanced Budget [G&T=$2 Tr.]
2. Balance of payments accounts record all of a country’s international transactions during a year.
(a) Two major subaccounts in the balance of payments accounts are the current account and the
capital account.
In which of these subaccounts will each of the following transactions be recorded?
(i) A United States resident buys chocolate from Belgium.
Answer to 2. (a) (i):
Chocolate from Belgium would go in the current account as it includes the import of goods.
(ii) A United States manufacturer buys computer equipment from Japan.
Answer to 2. (a) (ii):
Computer equipment by a U.S. manufacturer would also be classified as an import so it
would also go on the current account.
(b) How would an increase in the real income in the United States affect the United States current
account balance? Explain.
Answer to 2. (b):
An increase in real income would make U.S. citizens richer. We would buy more imports,
decreasing net exports, and increasing the deficit on the current account.
Rupee Price of Dollar
Price
D1$
R looking for $’s
S1$
$’s looking for R
R100
R50
Rupee
A
S2$
E1
appreciates
R25
D
E2
Quantity of Dollars
(c) Using a correctly labeled graph of the foreign exchange market for the U.S.
dollar, show how an increase in U.S. firms’ direct investment in India will affect
the value of the U.S. dollar relative to the Indian currency (the rupee).
Answer to 2. (c):
The increase in investment in India will increase demand for the rupee & appreciate that
currency. This would result in an increase in supply of the U.S. dollar for more rupees,
depreciating the dollar.
3. The diagram shows the PPCs for two countries:
Artland and Rayland. Using equal amounts of resources,
Artland can produce 600 hats or 300 bicycles, whereas
Rayland can produce
1,200 hats or 300 bicycles.
(a) Calculate the opportunity cost of a bicycle in Artland.
Answer to 3. (a):
The Domestic Comparative (opportunity cost) of a bicycle
in Artland is 2 units of hats. [1 bicycle = 2 hats or 600/300=2]
(b) If the two countries specialize and trade, which country
will import bicycles? Explain.
Answer to 3. (b):
Rayland will import bicycles. Domestically, they have to give
up 4 hats to get a bicycle but with trade they have to give up
only 3 hats.
DCC: Rayland
1B=4H
¼ B= 1 H
DCC: Artland
1B=2H
½ B= 1 H
Terms of Trade
1B=3H
1/3 B = 1 H
(c) If the terms of trade are 5 hats for 1 bicycle, would trade
be advantageous for each of the following?
(i) Artland Answer to 2. (c) (i): Yes, 5 hats is better than 2 hats they are getting domestically.
(ii) Rayland Answer to 2. (c) (ii): No, Rayland is going to export hats so opportunity cost
is ¼ bicycle. So 1/5 of a bicycle would not benefit them.
(d) If productivity in Artland triples, which country has the comparative advantage in the
production of hats?
Answer to 2. (d): 300 bicycles would become 900 and 600 hats would become 1,800, so the
DCC would still be 1 bicycle = 2 hats, same as before. Rayland still has a C.A. in hats.
Finished