1. Assume the US is operating at full employment.
(a) Using a CLG of the long-run aggregate supply, short-run aggregate supply, and aggregate demand, show each of the following.
(i) Current price level, labeled PL1
(ii) Current output level, labeled Y1
This first part should be automatic,, no real thinking,,,, they just want to see if you have memorized the graphs. You should be able to draw (at the drop of a hat) AD/AS curves for Equilibrium, recession, LR-recession, Inflation, LR-inflation, Stagflation, Growth and LR-Growth...
Check out the cheat sheets and practice. AD/AS Cheat Sheet
(b) Assume that personal savings in the US increases. Using a CLG of the loanable funds market, show the impact of the increase in personal savings on the real interest rate.
Straight forward question,, people save more and they deposit their cash in the commercial banks,, therefore the supply of loanable funds increase. If the Supply of loanable funds increase then the Supply of loanable funds curve shifts down (to the right) and the real interest rate decreases.
Loanable Funds Cheat Sheet
(i) Will interest sensitive expenditures, increase, decrease, or remain unchanged?
The use of the phrase interest sensitive expenditures is code for loans,,, so if we use different language could this question make more sense??
When the RIR (Real Interest Rate) falls will the number of people taking out loans, increase, decrease, or remain unchanged?
Answer - Interest sensitive expenditures will increase
(ii) What will happen to the rate of growth? Explain.
An increase of savings leads to a lowering of interstate rates that will encourage investment,, more investment leads to higher levels of capital formation (business plants, roads, construction, equipment, etc, etc) which leads to an expanding rate of growth in the economy.
Answer - growth rate will increase with an increase in capital formation.
(d) Assuming the real interest rate of the Euro Zone increases relative to the real interest rate of the US. Draw a CLG of the foreign exchange market for the Euro and show the impact of the change in the real interest rate in the Euro Zone in each of the following.
(i) Demand for the Euro. Explain.
If real interest rates are higher in the Euro Zone,, then US citizens wish to take advantage of the higher rates so they wish buy Euro Zone bonds (as these Euro Zone bonds are paying more than the US bonds) ,, to buy Euro Zone bonds they must exchange their US dollars for Euros. All of the US investors wishing to invest in Euro Zone bonds lead to a higher demand for the Euro.
Answer - Demand for the Euro increases because the higher real interest rate leads to higher returns for investors, thus US investors funds flow to the Euro Zone.
(ii) Value of the Euro to the US dollar.
Look at the graph, the value of the Euro is increasing,,, which also means the value of the dollar is decreasing,,, it will take more US dollars to buy a Euro as the values diverge.
(e) Assume that the US account balance is zero. Based on the change in value of the Euro identified in part (d) (ii), will the US current account be in surplus, deficit, or remain at zero?
As the Euro is increasing in value,, then the US goods and services will be cheaper ,, relatively to Euro goods and services,, and since the current account is about goods and services,, we would assume the US will be exporting more goods and services to the Euro Zone.
Answer - the US current account balance will be in surplus.