INTRODUCTORY TO MACROECONOMICS

FINAL-TERM REVIEW

Problem 1: Open-Economy Macroeconomics: Basic Concepts

A can of soda costs $1.25 in the United States and 25 pesos in Mexico. What is the peso–dollar
exchange rate (measured in pesos per dollar) if purchasing-power parity holds? If a monetary
expansion caused all prices in Mexico to double, so that soda rose to 50 pesos, what would happen
to the peso–dollar exchange rates?

If purchasing-power parity holds, then 25 pesos per soda divided by $1.25 per soda equals the
exchange rate of 20 pesos per dollar. If prices in Mexico doubled, the exchange rate will double to 40
pesos per dollar.

Problem 2: A Macroeconomic Theory of the Open Economy

Suppose that real interest rates increase in the United States. Explain how this development will
affect Indonesia net capital outflow. Then explain how it will affect Indonesia net exports by using a
formula from the chapter and by drawing a diagram. What will happen to the Indonesia real interest
rate and real exchange rate?

Higher real interest rates in U.S. lead to increased Indonesia net capital outflow. Higher net capital
outflow leads to higher net exports, because in equilibrium net exports equal net capital outflow (NX
= NCO). Figure 8 shows that the increase in net capital outflow leads to a lower real exchange rate,
higher real interest rate, and increased net exports.

Figure 1

Quantity of Rupiah

Problem 3: Aggregate Demand and Aggregate Supply

Suppose firms become very optimistic about future business conditions and invest heavily in new
capital equipment.
a. Draw an aggregate-demand/ aggregate-supply diagram to show the short-run effect of this
optimism on the economy. Label the new levels of prices and real output. Explain in words
why the aggregate quantity of output supplied changes.
b. Now use the diagram from part (a) to show the new long-run equilibrium of the economy.
(For now, assume there is no change in the long-run aggregate-supply curve.) Explain in
words why the aggregate quantity of output demanded changes between the short run and
the long run.
c. How might the investment boom affect the long-run aggregate-supply curve? Explain.

a. If firms become optimistic about future business conditions and increase investment, the
result is shown in Figure 2. The economy begins at point A with aggregate-demand curve
AD1 and short-run aggregate-supply curve AS1. The equilibrium has price level P1 and output
level Y1. Increased optimism leads to greater investment, so the aggregate-demand curve
shifts to AD2. Now the economy is at point B, with price level P2 and output level Y2. The
aggregate quantity of output supplied rises because the price level has risen and people
have misperceptions about the price level, wages are sticky, or prices are sticky, all of which
cause output supplied to increase.

Figure 2

b. Over time, as the misperceptions of the price level disappear, wages adjust, or prices adjust,
the short-run aggregate-supply curve shifts to the left to AS2 and the economy gets to
equilibrium at point C, with price level P3 and output level Y1. The quantity of output
demanded declines as the price level rises.
c. The investment boom might increase the long-run aggregate-supply curve because higher
investment today means a larger capital stock in the future, thus higher productivity and
output.

Problem 4: The Influence of Monetary and Fiscal Policy on Aggregate Demand

Suppose that survey measures of consumer confidence indicate a wave of pessimism is sweeping the
country. If policymakers do nothing, what will happen to aggregate demand? What should Bank
Indonesia do if it wants to stabilize aggregate demand? If Bank Indonesia does nothing, what might
Fiscal Policy Agency do to stabilize aggregate demand?
If pessimism sweeps the country, households reduce consumption spending and firms reduce
investment, so aggregate demand falls. If Bank Indonesia wants to stabilize aggregate demand, it
must increase the money supply, reducing the interest rate, which will induce households to save
less and spend more and will encourage firms to invest more, both of which will increase aggregate
demand. If Bank Indonesia does not increase the money supply, Fiscal Policy Agency could increase
government purchases or reduce taxes to increase aggregate demand.

Problem 5: The Short-Run Trade-off between Inflation and Unemployment

Suppose that a fall in consumer spending causes a recession.
a. Illustrate the immediate change in the economy using both an aggregate-supply/ aggregate-
demand diagram and a Phillips-curve diagram. On both graphs, label the initial long-run
equilibrium as point A and the resulting short-run equilibrium as point B. What happens to
inflation and unemployment in the short run?
b. Now suppose that over time expected inflation changes in the same direction that actual
inflation changes. What happens to the position of the short-run Phillips curve? After the
recession is over, does the economy face a better or worse set of inflation–unemployment
combinations? Explain.

Figure 3

a. Figure 3 shows how a reduction in consumer spending causes a recession in both an

aggregate-supply/aggregate-demand diagram and a Phillips-curve diagram. In both
diagrams, the economy begins at full employment at point A. The decline in consumer
spending reduces aggregate demand, shifting the aggregate-demand curve to the left from
AD1 to AD2. The economy initially remains on the short-run aggregate-supply curve AS1, so
the new equilibrium occurs at point B. The movement of the aggregate-demand curve along
the short-run aggregate-supply curve leads to a movement along short-run Phillips curve
SRPC1, from point A to point B. The lower price level in the aggregate-supply/ aggregate-
demand diagram corresponds to the lower inflation rate in the Phillips-curve diagram. The
lower level of output in the aggregate-supply/ aggregate-demand diagram corresponds to
the higher unemployment rate in the Phillips-curve diagram.
b. As expected inflation falls over time, the short-run aggregate-supply curve shifts to the right
from AS1 to AS2, and the short-run Phillips curve shifts to the left from SRPC1 to SRPC2. In
both diagrams, the economy eventually gets to point C, which is back on the long-run
aggregate-supply curve and long-run Phillips curve. After the recession is over, the economy
faces a better set of inflation-unemployment combinations.