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Macroeconomic s Free Response

[Question 1 had 12 total points; Question 2 had 6 points; and Question 3 had 8 pts] 1. [3 pts] Assume that declining stock market prices in the U.S. cause many U.S. financial investors to sell their stocks and increase their money holdings.

investors sell off stocks when market prices begin to decline. These new money holdings will increase the asset [speculative] demand for money. In the volatile market, investors will hold more money while determining future needs. [2 pts: 1 pt for correct graph and 1 pt for Dm shifting right.]

Nominal Interest Rate

(a) Draw a correctly labeled graph of the money market and show the impact of the financial investors’ actions on each of the following. (i) Demand for money DM2 MS (ii) Nominal interest rate DM1 Answers for 1. (a) (i) [2 points] r2 • (a) (i) In an effort to preserve wealth,

r1 M Quantity

of Money

Answers for 1. (a) (ii) [1 point for saying the interest rate increases] 2. (a) (ii) The nominal interest rate would increase because the demand for money increases as the DM curve shifts up, as shown above.

Yen Price of Dollar

1. (b) [3 pts] Due to the decline in wealth caused by the change in stock prices, the general price level in the U.S. falls relative to the price level in Japan, a trading partner. Use a correctly labeled graph of the foreign exchange market for the U.S. dollar to show the impact of the change in relative price levels on each of the following. (i) Demand for the dollar D2$ S$ D1$ (ii) Price of the dollar Answers to 1. (b) (i)
2. (b) (i) This decrease in PL will cause the Japanese to want to buy more U.S. goods, increasing the demand for the dollar. [2 pts: 1 pt for graph and 1 pt for showing increase in demand for the dollar]

Y 150 Y 100

E2 E1

Quantity of Dollars

Answers to 1. (b) (ii) [1 pt for saying the yen price of the dollar increased] 1. (b) (ii) Lower prices in the U.S. would cause an increase in demand for the dollar, resulting in the Japanese having to pay more for American goods. Therefore the yen would depreciate as the price of the dollar has increased, and the dollar has appreciated.

Answer to 1. (c) The appreciated dollar would cause American goods to be more expensive for Japan and Japan’s goods to be less expensive for Americans; therefore, we would export less and import more, resulting in a decrease in net exports. [1 pt for Xn decreasing and 1 point for saying U.S. goods are relatively more expensive] (d) [3 pts] Using a correctly labeled
AD/AS graph, show how the change in Xn in part (c) will affect each of the following in the short run.
LRAS SRAS

1. (c) [2 pts] How will the change in the price of the dollar you indicated in part (b) (ii) affect net exports of the U.S. Explain.

(i) Aggregate Demand (ii) Output and price level Answer to 1. (d) [3 pts] As can be seen on the graph, the decrease in Xn would decrease AD. The decrease in AD would decrease output to Y2 and PL to PL2. [1 pt for AD/AS graph, 1 pt for decr In AD & 1 pt for PL & Y decreasing] (e) [1 pt] Given your answers to part (d), what will happen to unemployment in the short run? Explain.

PL

AD2
PL1 PL2

AD1
E1
E2

Y2 Y1

RGDP

Answer to 1. (e) [1 pt for increase in unemployment because Y decreased] The decrease in Xn in part (d) will result in a decrease in AD and output, which would increase unemployment in the SR.

2. [6 total pts] In recent years, the Federal Reserve has made targeting the federal funds rate a main focus of its monetary policy. (a) Define the federal funds rate. rate Answer: The rate that banks charge one another for overnight loans. [1 point for saying this is the interest rate on loans between banks] (b) If the Federal Reserve wants to lower the federal funds rate, what rate open-market operation would be appropriate? Answer: The Fed would buy bonds from the banks or public. Buying bonds means a bigger supply of money and lower fed funds rate. [1 point for saying the Fed would “buy bonds”.] (c) Assume that the open-market operation that you indicated in part (b) is equal to $10 million. If the RR is 0.2, calculate the maximum million 0.2 change in loans throughout the banking system. system

Answer: $40 million if the Fed buys the bonds from the public. The public’s $10 million in DD could result in an increase in loans of $40 million. ER of 8 M x Mm of 5 = $40 million in loans. If the Fed buys
bonds from banks, ER could increase by the $10 million initially and with a Mm of 5, the increase in loans could be as much as $50 million. [1 point for $40 million if the bonds were purchased from the public as the $8 million ER x 5 would become $40 million or $50 million if the bonds were purchased from banks. The $10 million x 5 would become $50 million.]

(d) Indicate the effect of the open-market operation that you indicated in part (b) on the nominal interest rate. rate
Answer: Buying bonds would increase the MS and lower nominal Interest rates. [1 point for saying the nominal interest rate decreases. A contingency point would be “nominal interest rate increase” if he said “sell bonds” in part b] (e) Assume that the Fed’s action results in some inflation. What would be the inflation impact of the open-market operation on the real rate of interest? Explain. interest Answer: The RIR would fall as the assumption is the increase in inflation was not anticipated. If the actual rate of inflation is greater than the anticipated rate, then the RIR would fall. RIR=NIR-anticipated inflation. If we get more inflation than anticipated, then RIR = NIR – more inflation than anticipated, so RIR decreases. RIR falls because the NIR has decreased and inflation has increased. [2 points: 1 pt for saying the real interest rate falls as inflation was more than anticipated. RIR = NIR – anticipated inflation. 1 pt for saying the RIR falls because the NIR has decreased and inflation increased. ]

3. [8 pts] Indicate whether each of the following is counted in the U.S. GDP for the year 2006. Explain each of your answers. (a) The value of used textbook sold through online auction in 2006. Answer: No, it was counted the year it was produced. Because it was not produced again, it would not be counted. That would be double counting.
[2 pts: 1 pt for saying not included and 1 pt for saying not produced in 2006]

b. Rent paid in 2006 by residents in an apartment building built in 2000
Answer: Yes, rents consist of the income received by the households and businesses that supply property resources. The properties have to be maintained or “serviced” each year. It is included in the income approach to GDP. [2 pts: 1 point for “yes” and 1 pt for saying this is the payment for services]

c. Commissions earned in 2006 by a stockbroker Answer: Yes, payment is being made for productive services of the broker. So the purchase of stocks would not count but his work would. [2 pts: 1 pt for “yes” and 1 pt for saying this is the payment for services] d. The value of autos produced in 2006 entirely in South Korea by a firm fully owned by U.S. citizens Answer: No, GDP measures production inside the U.S. regardless of ownership. These autos were not produced in the U.S. [2 pts: 1 pt for “not included” and 1 pt for saying not produced in U.S.]