Norman

1. [11 total points] Assume that the U.S. economy is currently in long-run equilibrium.
(a) [3 pts] Draw a correctly labeled graph of aggregate demand and aggregate supply
and show each of the following.
(i) The long-run aggregate supply curve
(ii) The current equilibrium output & PL, labeled as YE and PLE, respectively.

LRAS SRAS
AD1
PL2 E2
PLE E1 AD2

YE YI Real GDP
(b) [2 pts] Assume that the government increases spending on national defense without
raising taxes.
(i) On your graph in part (a), show how the government action affects AD.
(ii) How will this government action affect the unemployment rate in the short run?
Explain.
Answer: 1. (b) (i) As can be seen on the graph, the increase in G would increase
AD to AD2, increasing PL and Y.
1. (b) (II) The increase in AD to AD2 would decrease unemployment in
the short run, as the increase in AD would lead to an increase in output & profits,
resulting in more workers being hired and therefore the decrease in unemployment.
 

1. (c) [2 pts] Assume that the economy adjusts to a new long-run equilibrium after the
increase in government spending.
(i) How will the short-run aggregate supply curve in the new long-run equilibrium
compare with that in the initial long-run equilibrium in part (a) ? Explain.
(ii) On your graph in part (a), label the new long-run equilibrium price level as PL2.
LRAS
SRAS2 SRAS1

PL2 E2

PLE E1
AD
YE YI Real GDP

Answer: 1. (c) (i) The increase in AD will result in more inflation and workers
demanding higher wages. This increase in resource cost at contract time in
the long run would move the SRAS to the left.
(c) (ii) PL2, as shown on the above graph, is a higher PL than PLE.
1. (d) [2 pts] In order to finance the increase in government spending on national defense
from part (b), the government borrows funds from the public. Using a correctly
labeled graph of the loanable funds market, show the effect of the government’s
borrowing on the real interest rate.
(e) [2 pts] Given the change in the real interest rate in part (d), what is the impact
on each of the following?
(i) Investment
(ii) Economic growth rate. Explain. Mankiw users: Increasing
government borrowing reduces
D2 LFM the supply of private loanable
funds. Interest Rates would also
D1 S
Real Interest Rate, (%)

go up, and investment would

decrease.

r2 E2

r1 E1

F1 F2
Quantity of Loanable Funds
Answer to 1. (d) As can be shown in the graph, the government borrowing would
increase demand for money in the LFM and push the RIR up.
1.(e) (i) The higher RIR will result in less investment in tools and machinery.
(e) (ii) The decrease in tools and machinery will decrease overall productivity
and economic growth [capital stock].
2. [7 total points] A drop in credit card fees causes people to use
credit cards more often for transactions and demand less money.
(a) [2 pts] Using a correctly labeled graph of the money market, show how the nominal
interest rate will be affected.
(b) [1 pt] Given the interest rate change in part (a), what will happen to bond prices in
the short run?
Answer to 2. (a) The decrease in Dt for money
would decrease the Dm curve resulting in a
lower NIR and RIR.
Nominal Interest Rate

Dm 1
MS 2. (b) Bond prices are inverse to the interest
rate so bond prices would increase
n1 Answer to 2. (c) The lower IR will increase
AD due to more investment and interest
n2
sensitive consumption [the lower IR would
Dm 2
also depreciate the dollar and increase Xn].
All 3 cause an increase in AD & PL in the SR.
Money Market 2. (d) Selling bonds would be the OMO as
it would increase NIR and decrease AD & PL.
(c) [2 pts] Given the interest rate change in part (a), what will happen to the price level
in the short run? Explain.
(d) [2 pts] Identify an open-market operation the Fed could use to keep the nominal interest
rate constant at the level that existed before the drop in credit card fees. Explain.
3. [9 total points] A U.S. firm sells $10 million worth of goods to a firm in
Argentina, where the currency is the peso.
(a) [2 pts] How will the transaction above affect Argentina’s aggregate
demand? Explain.
(b) [2 pts] Assume that the U.S. current account balance with Argentina is
initially zero. How will the transaction above affect the United States
current
account balance? Explain.

Answer to 3. (a) The selling of $10 M of U.S. goods to Argentina would

decrease Argentina’s net exports which would decrease their AD.
AD = C+I+G+X-M, when M gets larger, GDP gets smaller.

3. (b) The $10 million increase in net exports would cause a flow of $10
million worth of pesos into the U.S. [recorded as a +$10 million]
and would cause a current account balance of ZERO to become a
+$10 million surplus account balance.
 S2$
Price D1$ S1$ Answer to 3. (c) (i): If the U.S.
decrease financial investment
P looking for $’s in Argentina, the U.S. would
$’s looking for P
Peso Price of Dollar
decrease their supply of
P100 E2 dollars to Argentina, resulting

D
in a decrease in demand for
Peso the peso.
depreciates
P50 E1 (c) (ii) As shown on the graph,
the dollar would appreciate.

(d) The cheaper prices in the

U.S. will result in more
demand for U.S. goods and
therefore the dollar,
appreciating the dollar and
Quantity of Dollars
A depreciating the peso.

3. (c) [3 pts] Using a correctly labeled graph of the foreign exchange market for the U.S.
dollar, show how a decrease in the U.S. financial investment in Argentina affects each.
(i) The supply of United States dollars
(ii) The value of the United States dollar relative to the peso
(d) [2 pts] Suppose that the inflation rate is 3% in the U.S. and 5% in Argentina.
What will happen to the value of the peso relative to the United States dollar as
a result of the difference in inflation rates?
Explain.
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