2017 AP Macroeconomics FRQ #2

2017 AP Macroeconomics FRQ #2

Watch me answer it here

https://youtu.be/tFNOUMUVzcM

(A) Draw a CLG of the money market and show the effect of the reduced holdings of money on the equilibrium nominal interest rate in the short-run.

Money Market = Monetary Policy

Reduced holdings of money = Demand for Money decreases

From the Monetary Policy cheat sheet here

Demand for Money falls, the Nominal Interest Rate (NIR) falls
The opportunity cost of holding cash has fallen.

Answer

(B) Based on the changes in the interest rate in part (A), what will happen to each of the following in the short-run?

(i) Prices of previously issued Bonds. ((Bond Prices will Increase)

MR. Waugh - If interest rates are falling then we must assume that the interest rates of previous bonds must be higher.

Jung Sub - What does that mean, Mr. Waugh?

Mr. Waugh - Well Jung Sub, each bond has an amount of interest that it pays to the owner of the bond every year. It could pay 5% of the face value to the owner every year. Bond holders are rational people. If the banks are only paying 1% to borrow your money a bond holder would be making a profit by having a bond paying 5%.

So, if the nominal interest rate falls to 1%, then the price of a bond paying 5% will increase as it is now a better value than bonds created and sold today with a yield rate of 1%.

Is that clear Jung Sub?

Jung Sub -  Not really Mr. Waugh, but I think we should move on.

Jung Sub's face when I start talking about Bonds.

(ii) The price level and real income.

Cause and effect - If the nominal interest rate falls then consumption increases which drives up AD and therefore the PL and causes the RGDP to increase which implies that real income (Y) increases also.

Answer - PL and Y (incomes) increase

Answer

(C) With a constant money supply, based on your answer in part (B)(ii), will the velocity of money increase, decrease, remain unchanged or will it be indeterminate?

Velocity of money is the rate that money exchanges for goods and services. If incomes are increasing we would expect that the velocity of money would increase.

AD is increasing along with RGDP and (Y) incomes so people are spending money faster than before. Velocity has increased.

Answer

(D) If the FED (central bank) wishes to reverse the changes in the interest rate identified in part (A), what open market operation (OMO) would it use?

If interest rates are falling (part A), then the FED would sell bonds, reducing the money supply and increasing the Nominal Interest Rate.

Answer

2010 Macro FRQ #2

2010 Macro FRQ #2

watch me answer it here

https://youtu.be/36FeNAAp3_I

(A) Using a CLG of the money market, show how the nominal interest rate will be affected.

There is the idea that people need a certain amount of cash monthly, daily to pay for incidentals. Lunch, snacks, school play, whatever. If credit card fees fall, then it is cheaper to use credit cards and they don't need to keep as much money on hand as now it is more affordable to just use a credit card.

The problem even tells you that the demand for money falls. So the demand for money will fall.

(B) Given the interest rate change in part (A), what will happen to bond prices in the short-run?

This is more of a finance question than an AP economic one. You must understand that a Bond is a financial asset that is bought (usually for a $1,000) and then the company that sells you the bond promises to pay you a yearly rate of interest (like 5%) to borrow your $1,000. At the end of the time the $1,000 is paid back to you in full.

If interest rates fall to lets say 2%, and you have a bond that is paying 5%, your 5% bond is worth more than the Bonds that now only pay 2%.

If interest rates fall, the bonds with higher paying amounts (Yields) will have higher prices as your bond, having a higher yield will be worth more than the lower yield bond.

(C) Given the interest rate change in part (A), what will happen the price level in the Short-run? Explain?

If interest rates fall, then more consumption and investment will occur, as it is now cheaper to borrow money. Therefore the AD curve will shift rightward and the price level will increase. (I wouldn't have thought of exports)

(D) Identify an open market operation that the FED could use to keep the nominal interest rate constant at the level that existed before the drop in credit card fees. Explain.

If the demand for money is falling which reduces the interest rate then the FED can reduce the money supply which will increase the interest rate. So the FED should sell bonds.

2010 B Macro FRQ #2

2010  B Macro FRQ #2

Watch me answer it here

https://youtu.be/rgncLbqXjLk

Sells bonds = Contractionary = MS decreases

(A) Assume that banks in Sewell have no excess reserves. What is the effect of the central bank's action on the amount of customer loans that banks in Sewell can make?

Banks have no excess reserves, meaning they have no money to lend out. Then the FED sells bonds and bank customers take out even more cash to buy FED bonds. The bank is now having to borrow money from other banks to cover the checks written by its customers to buy those FED bonds. There is even less money in the system and no excess reserves to loan out. Loans decrease.

(B) Using a CLG of the money market, show they affects of the central banks actions on the nominal interest rate in Sewell.

(C) What is the effect of the Central bank's action on each of the following.

(i) PL

(ii) Real interest rate (RIR) Explain.

If the Central Bank uses a contractionary policy by  selling bonds then the nominal interest rate will increase as the money supply shrinks. As the money supply decreases and the nominal interest rate increases then there will be less consumption and investment which will decrease AD. As AD (aggregate demand) decreases the Price Level will fall. 

A quick way to know about the RIR is to know that nominal and real interest rates for the AP exam move in the same direction. So if the Nominal IR is increasing then the Real IR must also be increasing.

The central bank is contracting the money supply. The real interest rate is affected by the supply of money in the loanable funds market (commercial banks). If the FED is contracting the money supply then the supply of loanable funds is being extracted from the commercial banks. This lowers the supply of loanable funds and therefore the RIR will increase.

(D) Given your answer in part (C)(ii), how is the international value of the Sewell's currency, the Ono, affected. Explain.

Understand that when the AP College Board starts speaking about currency and RIR's together then we have to take the affects on the FOREX market.

So, if the RIR increases, foreigners will see the higher interest rates in the country of Ono, and want to invest in the country to get the higher interest rates. Profits attract investors. So if the RIR in Ono, increases and foreigners demand more currency from Ono in the FOREX. Then we will see the value of Ono's currency increasing. As demand for the Ono increases in the FOREX the value of the Ono will increase.

2009 Macroeconomics FRQ #1

2009 Macroeconomics FRQ #1

(A) Using a CLG with both short-run and long-run Phillips curves and the relevant numbers from above, show the current long-run equilibrium as point A.

Understand that the expected inflation rate in long-run equilibrium is the NRU (Natural Rate of Unemployment) --- A is the NRU.

(B) Calculate the real interest rate in the long run equilibrium.

Understand that: Real = Nominal (with no inflation)

                            Real = Nominal - Inflation

                            Nominal = Real + Inflation

Real (6%) = Nominal Rate (8%)  - Inflation (Expected Rate 2%)

(C) Assume now that the Fed targets an inflation (price level) rate of 3%. What open market operation should the FED undertake.

If the FED sells bonds (Contractionary policy) it will reduce the Money Supply raising the nominal interest rates. Think about it: if the inflation rate (PL) is 6% and the FED wants a lower price level (inflation rate) then it needs to decrease the (C) and (I), consumption and investment. It needs to lower the PL by decreasing the AD (aggregate demand). AD decreases and the PL / Inflation rate falls  from 6% to 3%.

Crazy tricky college board:

Looking at you college board.

 (D) Using a CLG of the money market, show how the actions of the FED in part (C), will affect the nominal interest rate.

You must have recognised that selling bonds was contractionary.

(E) How will the interest rate change you identified in part (D), affects aggregate demand in the short-run.

If the FED sells bonds (Contractionary policy) it will reduce the Money Supply raising the nominal interest rates. Think about it: if the inflation rate (PL) is 6% and the FED wants a lower price level (inflation rate) then it needs to decrease the (C) and (I), consumption and investment. It needs to lower the PL by decreasing the AD (aggregate demand). AD decreases and the PL / Inflation rate falls  from 6% to 3%.

(F) Assume that the FED's actions are successful. What will happen to the following  as the economy approaches a new long-run equilibrium.

(i) Short-run phillips curve 

(ii) The NRU (natural rate of unemployment)

The NRU (natural rate of unemployment) remains unchanged at 5%

2009 B Macroeconomics FRQ #2

2009 B Macroeconomics FRQ #2

These questions must be evaluated from their starting places.  The FED's actions must be thought of as outside the system.

(A) Calculate each of the following:

(i) The total change in reserves in the banking system.

This is a contractionary policy as the money supply is being decreased.

If the FED sells government securities (bonds) on the open market. Then the supply of money will be reduced by $50 million in reserves. Individuals will exchange $50m for FED bonds.

Understand that Required reserves and excess reserves will be reduced.

(ii) The maximum possible change in the money supply.

So this withdrawal of $50 million out of the system would reduce the money supply by $500m.

Why?

The multiplier works in reverse for this question: Its a contractionary policy...

But first let us think about the expansionary policy, if the FED had bought bonds instead of sold them.

So if the FED had bought bonds there would normally be an increase in the money supply of $450m 

$50 million bonds bought by the FED and 10% must be held in reserves, 50 x 10% = 5 mil

So we are down to $50 - 5 = $45 million able to be loaned out and multiplied.

With a 10% RRR the $45 million would be multiplied by a factor of 10m which would increase the money supply by $450m but don't forget the original 50m which would need to be added into the multiplied amount. So, 450m + original 50m = 500m expansion of the money supply.

The FED withdrawals the whole $50m out of the money supply reducing the amount of money that the banks have in reserves or could have loaned out, thus decreasing the money supply by the entire $500m.

(B) Using a CLG of the money market, show the impact of the Central Bank's bond sale on the nominal interest rate.

If the money supply is reduced then the nominal interest rate will rise. 

(C) What is the impact of the Central Bank's bond sale on the equilibrium price level in the short-run?

If a contractionary policy is enacted (selling of bonds) then the nominal interest rate will rise. A rising interest rate will cause investment and consumption to fall. If consumption (C) and investment (I) fall then AD will fall and therefore the PL will fall.

Graph - 

(D) As a result of the price level change in (C), are people with fixed incomes better off, worse off, or unaffected. Explain.

Recognise that even if you don't have a clue that by guessing you have a 331/3% chance of getting a point. 

If the price level falls, then people with a fixed income will be better off. They can buy more stuff as prices have fallen. Their purchasing power has increased.