2021 (Set 1) AP Macro FRQ#2
Watch me answer it here
2. Assume the country is operating below full employment.
Below full employment = Recession
a) Identify a fiscal policy that could restore the economy back to full employment.
Fiscal Policy is either (Government spending or Taxes)
Recession = (More Government Spending or Reduce Taxes)
b) Draw a CLG of the loanable funds market and show the effects of the fiscal policy chosen on the equilibrium real interest rate.
Government spending = an increase in the RIR (Real Interest Rate)
If the government wants to spend more money they must either tax citizens more or borrow the funds. Borrowing of the funds means selling bonds to citizens.
The citizens must take the money out of the banks to pay for the bonds.
(Demand shift) = People walking into banks needing to take out money to buy bonds
increases (rightward shift) of the demand for loanable funds
(Supply Shift) = As people take the money out of the bank it
reduces (shifts leftward) the supply of loanable funds in the banks.
Both shifts are technically correct (Use the one that seems correct to you)
Easiest for me to recognize that anytime the govenment is spending they are borrowing from the Banks reducing the supply of lonable funds which increases the RIR.
c) Based solely (only) on the real interest rate change what will happen to the following?
i) Net Exports. Explain.
If the RIR increases then the demand for the currency will increase causing the currency to appreciate which will decrease the amount of exports for the country.
As the RIR increases citizens of other countries will want to put their money in our banks to get the higher interest rate (they want higher profits)
To put their money in our banks they must exchange it in the FOREX, causing the demand for our currency to increase which drives up the value of our currency.
Since our currency is increasing in value our goods are becoming more expensive.
More expensive goods means less people will want to buy our goods therefore
our exports will decline.
ii) Stock of physical capital (capital goods) . Explain.
As the RIR increases (Loans are now more expensive)
Domestic Investment (taking out of loans) will decrease which implies that less capital goods will be produced in our country. Less physical stock (capital formation/goods) means that the country's long-run growth will be damaged.
RIR increase = Less physical stock (capital goods/formation)
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