## Saturday, April 11, 2015

### 2012 Macroeconomics Exam FRQ #1

2012 Macroeconomics Exam FRQ #1

(a) Assume that Rankinland produces only food and clothing. Draw a correctly labeled PPC for Rankinland. Show a point that could represent the current output combination and label it A.

Remember, Rankinland is in Recession,, so all resources are not being utilized. Again,, recession usually means higher unemployment,, so the point A on the PPC represents, (or can represent) unemployment.

(b) Assume that the Central Bank of Rankinland pursues an expansionary policy.

(i) Identify the OMO, Open Market Operation that the central bank would use.

Expansionary fiscal policy,,, the OMO the central bank would use is the buying of bonds. When bonds are bought,, cash flows into the economy. The money supply is increased and nominal interest rates fall,, as interest rates fall, consumption (C) and investment (I) increase and therefore aggregate demand (AD) increases.

(ii) Draw a CLG of the money market graph and show the short-run effects of the expansionary monetary policy on the nominal interest rate.
CLG - Correctly Labeled Graph,, nominal interest rate on the vertical axis,, and quantity of money on the horizontal.. MS for money supply shifting right (with arrows) and a decreasing of the nominal interest rate (with arrows) and a downward sloping demand for money curve.

(iii) Assume no change in the price level, what happens to the real interest rate, as a result of the expansionary policy,, Explain...

NO Change in the Price Level

Ok,, so first,, if you have learned the graphs like I have,, then when AD increases then the PL Price Level increases also. But that is because I was taught the classical/monetarist graph that has an upward sloping aggregate supply curve.
 As AD increases the PL rises.
This no price level change can (theoretically) happen if the recession is bad and we use the Keynesian aggregate supply curve.
 The Keynesian AS curve is viewed as horizontal during a recession and therefore that AD can increase with no Price Level changes
So,, we have expansionary monetary policy with no PL change and we need to know what happens to the real interest rate.

Let us look at the cheat sheet.Monetary Policy Cheat Sheet

If we understand that when the Fed buys bonds the Nominal Interest rate will fall and that with no price level change the nominal interest rate is the real interest rate then the Real interest rate must fall also.

Answer - One point is earned for explaining that with the price level remaining constant, when the nominal interest rate falls, the real interest rate also falls

(iv) Given your answer to part (b)(iii) regarding the real interest rate, what happens to the real gross domestic product (GDP) in the short-run? Explain.

As we can see,, the AD curve in the short run will increase and the R-GDP will also increase because an increase in the money supply will cause nominal interest rates to fall,, the lower rates will entice people to consume (C) and invest (I) which increases the AD therefore increasing (in the short-run) the R-GDP.

Why in the short-run???,,, because in the long-run we can be sure that prices will rise and rising prices will cause the demand for money to rise,, this will cause the Nominal interest rates to rise and that will decrease consumption (C) and Investment (I) and a decreasing of AD..

Answer - One point is earned for stating that the real GDP will increase in the short run and explaining that investment or consumption increases, causing aggregate demand to increase.

(c) Suppose Rankinland has a current account deficit. Rankinland's currency is called the Bera.

(i) What will initially happen to the current account deficit in Rankinland solely due to the change in real GDP from part (b) (iv). Explain.

First, you must know that a current account deficit is a situation where imports > exports. If there is more money being pumped into the economy by the central bank,, we can assume that more imports will be consumed. So the deficit will increase.

Answer - One point is earned for explaining that the increase in real GDP increases income, which causes imports to increase and net exports to decrease.

(ii) What will happen to the international value of the Bera solely due to the change in the R-GDP from part (b) (iv). Explain.

If there is an increase in the money supply and more citizens spend money on imports,, then goods will come into the country and Bera's will go out. An increasing supply of Bera's in the international market will decrease their value.

FOREX Cheat Sheet

an increasing level of imports will increase the supply of Bera in the FOREX market which will lower the value of the Bera.

Answer - One point is earned for explaining that the decline in the international value of the bera is due to an increase in the supply of the bera

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