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Norman
1. Assume that the U.S. economy is currently in a recession in a
short-run equilibrium.
(a) Draw a correctly labeled graph of the short run and long-run Phillips curves. Use
the letter A to label a point that could represent the current state of the economy in
recession.
LRPC
Inflation
SRPC
3%
1%
A
5% 8%
(b) Draw a correctly labeled graph of AD/AS
in the recession and show each of the following.
(i) The LR equilibrium output, labeled Y
(II) The current equilibrium output and price levels,
labeled Ye and PLe, respectively.
Unemployment Rate
(c) To balance the federal budget, suppose that the
AD1
government decides to raise income taxes while
PL
maintaining the current level of government spending.
AD2
On the graph drawn in part (b), show the effect of the PL
increase in taxes. Label the new equilibrium output PLe
PL2
and price levels Y2 and PL2, respectively.
SRAS
LRAS
E1
E2
Y2 YE Y
Real GDP
Nominal Interest Rate
1. (d) Assume that the Fed uses monetary policy to stimulate the economy.
(i) What open-market policy should the Fed implement? The Fed should buy bonds.
(ii) Using a correctly labeled graph of the money market show how the policy in
part (d)(i) affects nominal interest rates.
(iii) what will be the impact of the policy on the price level? Explain.
DmMS1 MS2
nir1
nir2
0
[buy bonds]
Q1
Answer to 1. (d)(i) and (ii)
The Fed will buy bonds which will increase
the MS [from MS1 to MS2] and decrease the
nominal interest rate.
Q2
Money Market
Answer to 1. (d)(iii)
The lower nominal interest rate would increase quantity of investment
demanded by businesses [would also increase consumption and Xn] which
would increase AD. The increase in AD would increase price level.
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 increase, decrease, or remain unchanged?
Explain.
Answer to 1. (e) (i)
In the long run, prices would come down, and workers would accept lower
wages, decreasing resource cost to businesses, and they would hire
more workers as the SRAS curve would increase.
(ii) In the long run, what will happen to the natural rate of unemployment?
Answer to 1. (e)( ii)
With the SRAS curve shifting back to the right, this would bring the
economy back to equilibrium at the natural rate of employment. Because
we are back to the natural rate of unemployment, it did not change in the
long run.
2. Japan, the European Union, Canada, and Mexico have flexible exchange rates.
(a) Suppose Japan attracts an increased amount of investment from the EU.
(i) Using a correctly labeled graph of the loanable funds market in Japan, show the
effect of the increase in foreign investment on the real 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 run? Explain.
Real Interest Rate, (%)
Loanable Funds Market
D
r1
r2
S1 S2
E1
E2
F1 F2 Japan’s Quantity of Loanable Funds
Answer to 2. (a) (i) & (ii)
(i) As can be seen on the graph, the increased investment in Japan would result in more yen
in Japan’s depository institutions, and increasing the supply of LF in Japan and decreasing
the real interest rate.
(ii) With the RIR decreasing in Japan, there will be more investment [a component of AD]which
would increase AD and GDP, therefore increasing employment in the short run.
2. Japan, the European Union, Canada, and Mexico have flexible exchange rates.
(a) Suppose Japan attracts an increased amount of investment from the EU.
(i) Using a correctly labeled graph of the loanable funds market in Japan, show the
effect of the increase in foreign investment on the real 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 run? Explain.
Real Interest Rate, (%)
Loanable Funds Market
D
r1
r2
S1 S2
E1
E2
F1 F2 Quantity of Loanable Funds
Answer to 2. (a) (i) & (ii)
(i) As can be seen on the graph, the increased investment in Japan would result in more yen
in Japan’s depository institutions, and increasing the supply of LF in Japan and decreasing
the real interest rate.
(ii) With the RIR decreasing in Japan, there will be more investment [a component of AD]which
would increase AD and GDP, therefore increasing employment in the short run.
3. Sewell Bank has the simplified balance sheet below.
(a) Based on Sewell Bank’s balance sheet, calculate the required reserve ratio.
Answer to 3. (a)
The Fed’s RR would be 20% as DD is $10,000 and RR is $2,000
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 of the following
immediately after the purchase?
(i) Excess reserves ER would be $5,000 as any loan from the Fed is ER.
(ii) Demand deposit DD would not immediately increase as any money
from the Fed is all ER.
3. [continued]
3. (c) Calculate the maximum amount that the MS can change as a result of the
$5,000 purchase of bonds by the Fed. .
Answer to 3. (c)
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
MM 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
in the open market? Explain.
Answer to 3. (d)
When the Fed purchases bonds, the MS increases and people buy
non-money assets like bonds which pushes bond prices up and
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 of the MS?
Answer to 3. (e)
No impact. It stays the same although it changes composition from
$5,000 currency to $5,000 DD.
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