2010 Macro FRQ #1
(A) Draw a CLG of AD/AS and show each of the following.
(i) The Long Run Supply Curve.
(ii) The current equilibrium output/price levels, labeled a sYE & PLE.
(B) Assume the government increases spending on national defence without raising taxes.
(i) On your graph in part (a), show the effect on AD.
Government spending on national defence is government spending that increases the G in the GDP formula. So, C + I + G + XN = GDP,,, If, G increases (defence spending) then AD increases, increasing GDP.
(ii) How will this action affect the unemployment rate in the short-run? Explain.
If the government is spending then the G is increasing, people are supplying goods to the government, so GDP is increasing and output is increasing which means businesses are hiring to keep up with the increased demand from government spending and increased output.
(C) Assume that the economy adjusts to a new long-run equilibrium after the increase in government spending.
(i) How will the new short-run aggregate supply curve compare to the initial SRAS curve in part (a)? Explain.
The college board is simply asking you what happens in the long-run, after inflation happens in the economy. Notice that when an economy is in equilibrium and then the government spends, that we are in an inflationary gap. If the government does nothing in the long run the SRAS curve will shift leftward as prices and wages adjust. In essence during an inflationary gap, there isn't enough labor to handle the increased demand for goods and services, so wages rise to entice more people into the workforce and prices also rise.
(D) In order to finance the increase in government spending national defence in part (B), the government borrows from the public. Using a CLG of the loanable funds market, show the effect of the government's borrowing on the real interest rate.
If the government is borrowing from the public then the demand for loanable funds is increasing driving up the interest rate.
(E) Given the change in the Real Interest Rate in part (d), what is the impact of the following.
Crowding out will occur as the real interest rate rises it deters people from taking out loans to invest. As the government drives up the interest rates by borrowing there is less and less private investment.
(ii) Economic growth rate. Explain.
If there is less private investment there will be less long-term growth as there will be less capital formation, less capital goods produced so in the long-run society will suffer.