Loanable Funds Market
[*Use this graph if there is a chg in savings by consumers or chg in fiscal policy]
Real Interest Rate, (percent)
[*Use
the Money Market graph when there is a change in MS]
D
Borrowers
1
D
S
2
Lenders
r= 8 %
E2
r= 6 %
E1
F1
Use the “real interest rate” with
LFM, because it is long-term.
Use “nominal interest rate” with
money market, as it is short-term.
Starting from a balanced budget, if the
G incr spending or decr T to get out of
a recession, they would now be running
a deficit and have to borrow, pushing
up demand in the LFM and increasing
the interest rate.
F
Quantity of Loanable
Funds
2
$2.2 tril.
$2 tril.
$2 tril.
G
T
Balanced Budget [G&T=$2 Tr.]
Loanable Funds Market
[Incr G; Decr T]
Start from a
PL
Balanced Budget
G & T = $2 Trillion
$2.2 tril.
$2 tril.
G
$2 tril. PL2
T
AD2 LRAS
AD1
PL1
E1
D2
S
D1
r=8%
r=6%
F1 F2
“Now, this is better.”
“I can’t
get a job.”
E2
Real GDP
$2.2
$2.2
AD
Y/Empl./PL;
G
LFM
I.R.
$1.8
$1.8
T
In. Rate
SRAS
YR YF
G
Real
DI
C
AD
Y/Emp./PL; T
LFM
IR
Loanable Funds Market
D1
Real
D2
S
In. Rate
r=6%
[Decr G; Incr T ]
PL
SRAS
Start from a
Balanced Budget
G & T = $2 Trillion
$2.2 T tril.PL1
$2
tril.
$1.8 tril..
G
r=3%
LRAS
AD2
F2 F1
E1
$2 T tril.
PL2
T
E2
AD1
YF YI Real GDP
$1.8
$1.8
G
Y/Empl./PL;
AD
G
LFM
I.R.
$2.2
$2.2
T
[like we have
“money trees”]
DI
C
AD
Y/Emp/PL;
T
LFM
IR
AP Macro FRQ Practice 1
1. Government cuts defense spending by $75 billion.
As a result the following occur:
- Unemployment increases from 6% to 9%
LRAS SRAS
- GDP drops 3%
PL
- Inflation drops from 3% to 1%
AD2 AD1
E1
Based on this info, draw AD1 to AD2 on the graph.
PL1
……………………………………………………………… PL2
E2
A. Now “G” decreases taxes, which (incr/decr) DI,
which (incr/decr) C, which (incr/decr) AD. [starting
a balanced budget] The result is an (incr/decr) in GDP,
employment & PL. With the increase of government’s
demand for loanable funds, because they now have
less tax revenue, the interest rate (increase/decrease).
Draw the new AD1 to AD2 curves on the graph.
B. Due to the change in interest rates, the dollar
(appreciates/depreciates) and our exports (incr/decr).
YR Y*
Real Y
9%
PL
PL2
PL1
LRAS SRAS
AD1 AD2
E2
E1
YR Y*
9%
AP Macro FRQ Practice 2
2. Net exports increase by $50 billion due to a
depreciated dollar, resulting in the following:
- Unemployment stays at 3%
- GDP stays the same
- Inflation increases from 8% to 10%
Based on this info, draw AD1 to AD2 on the graph.
………………………………………………………………
PL
PL2
PL1
LRAS
AD2 SRAS
AD1
E2
E1
Y*YI
A. Now government decreases spending by $100 bil.
3%
LRAS
which leads to an (increase/decrease) in AD.
SRAS
PL AD2
AD1
The result is an (incr/decr) in GDP, employment,
E1
PL1
and PL. With the reduction of “G”’s demand for
dollars in the LFM, because of the decrease in
PL2
“G”, the interest rate (increases/decreases).
E2
Draw the new AD1 to AD2 curves on the graph.
Real GDP Y* YI
B. Due to the change in price level, the dollar
3%
(apprec/deprec) and our imports (increase/decrease).
AP Macro FRQ Practice 3
3. Government spends $99 billion on a war with Cuba.
As a result the following occur:
- Unemployment decreases from 14% to 10%
- GDP increases 10%
- Inflation is 0%
Based on this info, draw AD1 to AD2 on the graph.
PL
AD1 AD2
SRAS
LRAS
………………………………………………………………
A. Now government decreases taxes by $150 billion
which (incr/decr) DI, which (incr/decr) C, which
(incr/decr) AD. The result is an (incr/decr) in GDP,
employment, & PL. With the increase of government’s
demand for LF, because they now have less tax
revenue, the interest rate (increases/decreases).
B. Due to the increase in the growth rate, the dollar
(apprec/deprec) and our imports (increase/decrease).
PL
E2
E1
Real GDP YR YR Y*
14% 10%
LRAS
PL
AD1
SRAS
AD2
PL2
E1
PL1
Real GDP
E2
YR Y*
10%
AP Macro FRQ Practice 4
4. Government spends $100 billion on the infrastructure.
As a result the following occur:
PL
- Unemployment decreases from 6% to 3%
- GDP increases 5%
- Inflation increases from 2% to 6%
PL2
Based on this info, draw AD1 to AD2 on the graph.
PL1
………………………………………………………………
LRAS
AD1
AD2 SRAS
E2
E1
Y* YI
A. Now government increases taxes by $100 billion,
LRAS3%
which (incr/decr) DI, which (incr/decr) C, which
PL
AD2 AD1 SRAS
(incr/decr) AD. The result is an (incr/decr) in GDP
employment, and PL. With the decrease of “G”’s
PL1
E1
demand for dollars in the LFM, because of the
PL2
increase in “T”, the interest rate (incr/decr).
E2
Draw the new AD1 to AD2 curves on the graph.
Real GDP
B. Due to the change in interest rate, the dollar
Y* YI
3%
(apprec/deprec) and our exports (increase/decrease).
The economy is guilty of breaking the
“FE 4% Speed Limit.” We are going to
have to raise interest rates. Wait a
minute – this is monetary policy. We’ll
attack this on the next test. Let’s look
again at fiscal policy.
AP Macro FRQ Practice 5
5. Net exports decrease by $60 billion due to an
appreciated dollar, resulting in the following:
- Unemployment stays at 3%
- GDP stays the same
- Inflation drops from 10% to 6%
Based on this info, draw AD1 to AD2
…………………………………………………………….
A. Now government decreases spending by $90
billion which leads to an (incr/decr) in AD.
The result is an (incr/decr) in GDP, employment,
& PL. With the reduction of “G”’s demand for LF,
because of the decrease in “G”, the interest rate
(increases/decreases).
Draw the new AD1 to AD2 curves on the graph.
B. Due to the change in PL, the dollar
(apprec/deprec) and our imports (incr/decr).
PL
PL1
PL2
LRAS
AD1 SRAS
AD2
E1
E2
Y* YI
3%
PL
PL1
PL2
LRAS
SRAS
AD1
AD2
E1
E2
Y* YI
3%
AP Macro FRQ Practice 6
6. Rising U.S. tariffs cause Xn to drop by $30 billion.
As a result the following occur:
- Unemployment increases from 10% to 12%
- GDP decreases 8%
- Inflation is 0%
Based on this info, draw AD1 to AD2 on the graph.
LRAS
SRAS
PL
AD2 AD1
……………………………………………………………….
A. Now government decreases taxes by $125 billion which PL
(incr/decr) DI, which (incr/decr) C, which (incr/decr) AD.
The result is an (incr/decr) in GDP, employment, and PL.
With the increase of government’s demand for LF,
because they now have less tax revenue, the interest rate
PL
(incr/decr). Draw the new AD1 to AD2 on the graph.
B. Due to the increase in the growth rate, the dollar
(apprec/deprec) and our exports (increase/decrease).
PL2
PL1
YR YR
12%10%
Y*
LRAS
SRAS
AD1
AD2
E2
E1
YR
12%
Y*
Fiscal Policy FRQ Practice Question 1
1. Suppose the following conditions describe the current state of the economy.
-The unemployment rate is 3.5%
-Real GDP is growing at the rate of 5%
-The inflation rate is 9%
(a) Identify the main problem this economy faces [inflation]
(b) Now Congress votes to increase personal income taxes.
Using AD/AS analysis [graph this], explain what effect this
policy will have on each of the following.
(i) AD, & thus output & employment
(ii) The price level
(iii) The interest rate
Answers:
(i) The increase in personal taxes will decrease DI,
which will decrease C, which will decrease AD,
which will decrease output and employment.
(ii) The decrease in AD will result in a lower
equilibrium [AD1 to AD2 & E1 to E2] and a lower price level.
(iii) The increase in personal taxes results in more tax revenue v.
government spending, which decreases the demand for money
in the LFM & a decrease in interest rates.
Fiscal Policy FRQ Practice Question 2
2. Assume that in the U.S., nominal wage rates rise faster than labor
productivity. Using AD/AS analysis [graph this], analyze the shortrun effects of this situation on each of the following.
[Base your (b) answer on what the price level does]
(a) The general price level
(b) The international value of the dollar [based on PL]
(c) The level of exports
Answers:
(a) As shown (graph), nominal wage rates rising faster
than labor productivity would decrease the AS curve
from AS1 to AS2. The decrease in AS would change
equilibrium from E1 to E2, which would result in a
higher general price level.
(b) The higher price level would make our exports more expensive
relative to foreign goods, thus decreasing demand for the U.S.
dollar and depreciating the dollar.
(c) The depreciated dollar would make our goods cheaper than the
previous period and increase our exports.
nominal Interest Rate
Price level
If there is a
RECESSION
MS will be
increased.
DI
MS MS2
1
8%
8
6%
6%
4%
4
0
DM
Buy
Money Market
AD
AD
1
2
0
Investment
Demand
QID1 QID2
AS
I want a job
as a Rockette
PL2
PL1
E2
E1
FEDERAL RESERVE BANK OF THE U.S.
Real GDP
Buy
Bonds
MS
YR
I.R.
Y*
QID
AD
Y/Emp/PL
Price level
If there is
INFLATION,
MS will be
decreased.
Nominal Interest Rate
“It’s cheaper
to burn money
than wood.”
10
Dm
Bonds
8%
6
6%
Sell
Money Market
AS
AD2 AD1
0
like
“money trees”
QID2 QID1
E1
PL1
PL2
MS
Investment
Demand
10%
E2
Y* YI
FEDERAL RESERVE BANK OF THE U.S.
Sell
MS2MS1
8
0
DI
I.R.
QID
AD
Y/Empl./PL
Free Response 2005
1. [13 total pts] Assume that the U.S. economy is currently in equilibrium at the
full-employment level of real GDP.
(a) [3 pts] Draw a correctly labeled graph of AD/AS showing each of the following
in the U.S.
(i) Output level
(ii) Price level
LRAS SRAS
AD1
AD2
PL1
PL2
E1
E2
YR Y* Real GDP
(b) [3 pts] Japan is a major importer of U.S. products. Assume that the Japanese
economy goes into a recession.
(i) Explain the impact of the Japanese recession on the U.S.
equilibrium output and price levels.
(ii) Show these effects on your graph in part (a).
Answer (b)(i) & (ii): The Japanese recession would cause job losses in
Japan, lowering prices and incomes there, which would reduce U.S.
exports to Japan. This would decrease aggregate demand in the U.S,
which would decrease PL, output, and employment.
(c) [5 pts] Assume that the Fed takes action to curb the effects
of the Japanese recession on the U.S. economy.
(i) What open-market operation would the Fed undertake?
FR 2005
Answer (c) (i): The Fed would buy bonds which would increase the MS and
decrease interest rates.
(ii) Use a correctly labeled graph of the money market to show how the
Fed policy action will affect the nominal interest rate.
Answer (c) (ii): The Fed buying bonds would mean a bigger MS, which
would lead to lower nominal interest rates.
(iii) Explain how the change in the nominal interest rate in part (c) (ii)
will affect AD, price level, and real output in the U.S.
Answer (c) (iii): As seen in the graphs above, the decrease in the nominal
interest rate would increase investment, which would increase AD. The
increase in AD would increase price level and real output in the U.S.
FR 2005
(d) [1 pt] Define the real interest rate.
Answer 1 (d): The real interest rate is the nominal interest rate less the
expected rate of inflation.
(e) [1 pt] Indicate the effect of the open-market operation you identified
in part (c) on the real interest rate in the U.S.
Answer (e): The buying of bonds by the Fed would increase the MS, which
would decrease the interest rate, which would increase Ig and increase AD
and price level. The increase in PL would be subtracted from the nominal
interest rate, which would decrease the real interest rate.
Real Interest Rate
Loanable Funds Market
S upply of Funds
D1 D2
r=10%
FR 2005
E2
E1
r=8%
Demand for Funds
F1
F2
Quantity of Funds
2. [8 total pts] The graph above shows the loanable funds market for a country.
(a) [2 pts] Assume that now the country’s government increases deficit spending.
Explain how the increase in deficit spending will affect the real interest rate.
Answer 2. (a): The increase in deficit spending means the government has to borrow more
in the LFM. The increase in demand in the LFM increases the real interest rate.
(b) [1 pt] Indicate how the real interest rate change you identified in part (a)
will affect the investment in plant and equipment.
Answer 2. (b): The increase in the real interest rate will make plant & equipment
projects less profitable and will decrease investment in those projects. That
is, there is “crowding-out” of investment, due to the higher interest rate.
FR 2005
(c) [2 pts] Explain how the real interest rate change you identified in part (a)
will affect long-term economic growth.
Answer 2. (c): Because the real interest rate increased in part (a), there will be
lower investment in plant & equipment that make up that country’s national
factory, therefore making its citizens less productive. This will result in
slower long-term economic growth and shift the LRAS curve left.
However, unless there is negative net investment, there could still be economic growth.
(d) [3 pts] Explain how the real interest rate change you identified in part (a)
will affect each of the following in the foreign exchange market.
(i) The demand for the country’s currency
(ii) The value of the country’s currency
Answer 2. (d), (i) & (ii): With real interest rates increasing in part (a), the demand
for financial capital (CDs, bonds, etc.) in that country will increase because of
the greater relative return on them.
(i) This will result in more demand for its currency.
(ii) The increase in demand, caused by better return on its financial capital,
will increase the value of that nation’s currency, appreciating it.
FR 2005
3. [4 total pts] Assume that the table below shows the unemployment
and inflation data in Country X as a result of a shift in AD.
Period
Unemployment Rate
Inflation Rate
Last Year
2%
8%
This Year
5%
4%
(a)[2 pts] Draw a correctly labeled graph of a short-run Phillips curve for
Country X, showing the actual unemployment and inflation rates for both years.
Label the Phillips curve as SRPC.
(b) [2 pts] Now assume that the SRAS
curve has shifted to the left.
(i) Identify one factor that could
cause the AS curve to shift to the left.
cost could shift the AS curve left.
[Other OK answers would be increase in
bus. regs., increase in business taxes,
decrease in subsidies, or an increase
in expected inflation.]
(ii) On the graph, show how this shift
would affect the short-run Phillips curve.
SRPC*
8%
Inflation
Answer 3 (b) (i): An increase in input
SRPC
4%
2%
5%
Unemployment
FR 2005
(c) [1 pt] Assume that the natural rate of unemployment in Country X is 5%. Draw
a correctly labeled graph of the long-run Phillips curve and label it as LRPC.
Inflation
SRPCLRPC
8%
4%
2% 5%
Unemployment
(d) [1 pt] What is the relationship between the unemployment rate and the
inflation rate in the long run?
Answer 2. (d): There is no relationship between the unemployment rate
and inflation in the long run. As can be seen in the graph above. If there is
unanticipated inflation or disinflation, although PL increases or decreases,
unemployment ends up at the natural rate.
2004 Macro Free Response
1. Assume our economy is operating at less than full employment.
(a) Using a correctly labeled AD & AS graph, show the following.
(i) Full-employment output
LRAS SRAS
(ii) Current output
(iii) Current price level
My InfoTech job was
outsourced to India.
Need
Job
AD1
PL1
E1
YR YYFF Real GDP
(b) Identify an
open-market operation that could
restore full employment in the short run.
Answer: An open-market operation to increase AD would
be the Fed buying bonds.
Nominal
Interest
Rates
Dm MS1
Di
MS2
IR1
IR2
Money Market
Demand
Money
2004
LRAS SRAS
IR1
IR2
PL2
PL1
QID1 QID2
Quantity of Investment
AD1
This job
is more
like it.
AD2
E2
E1
YR
RY
YFF
Y
(c) Using a correctly labeled graph of the money market, show how the
open market operation you identified in part (b) affects the I.R. in the SR.
Answer: See the above graph. The increase in MS decreases the I.R. in the SR.
(d) Explain how the change in the interest rate you identified in part (c) will affect AD.
Answer: The decrease in the interest rate will increase QID
and consumption which will increase AD. (It will also increase Xn
because it depreciates the dollar, making our products cheaper.)
(e) Show on the graph in part (a) how the change in the IR you identified in
part (c) will affect output and price level.
Answer: The lower IR will increase QID, which will increase AD which will
increase output and price level as shown by the movement from AD1 to AD2.
(f) Instead of the open-market in part (b), suppose that no policy actions are
taken to address the unemployment problem. With flexible prices & wages,
explain how each of the following will eventually change.
(i) Short-run AS
(ii) Output and price level
PL AD1 LRAS SRAS1
SRAS2
AD
-20%
$10
Surplus
$8
YR Y*
RGDP
Answer: As price level drops, workers will accept lower wages. With cheaper
resource cost, firms will hire more workers shifting the SRAS curve to the
right, decreasing price level and increasing output.
2. (a) Assume that national saving in the U.S. increases. Explain
the effect of this increase on the real interest rate in the U.S.
Answer: If national savings increase, then banks have more loanable
funds. More LF would lead to a decrease in the real interest rate.
or Money
Market?
(b) Suppose that realLFM
interest
rates in
the rest of the world
Use theremain
“Money Market”
model, with the vertical MS, when the Fed changes the MS.
unchanged.
(i) Explain the effect of the real interest rate change in the U.S.
Use the “LFM” model, with the upward sloping supply curve, if there is a
that you identified in part (a) on the demand for the U.S. dollar
“change
savings”
or “change in demand for loanable funds”, such as
in theinforeign
exchange
market.
expansionary or contractionary fiscal policy.
Answer: Because the U.S. real interest rate is going down and they are
unchanged in the rest of the world, foreign investors would decrease
their demand for U.S. financial assets because of less return on the lower real I.Rates.
(ii) As a result of the effect you identified in (i), what will happen
to the international value of the U.S. dollar?
Answer: The decrease in foreign demand for U.S. financial assets
because of the decreasing interest rate would depreciate the dollar.
(c) Given your answer in part (b), indicate how each of the following
will change.
(i) U.S. imports
(ii) U.S. exports
Answer: U.S. imports would decrease because the depreciated dollar
would make imports more expensive. U.S. exports would increase
because the depreciated dollar would make U.S. exports cheaper.
3. The Fed buys $5,000 in bonds from Clark Consulting Services, which
then deposits the money in a checking account at First Generation Bank.
(a) As a result of the Fed’s action, what is the change in MS if RR is 100%?
Answer: The change in MS would be the $5,000 DD.
(b) If the RR is reduced to 10%, calculate the following.
(i) The maximum amount this bank could lend from this deposit.
Answer: With 10% or $500 in RR, the bank could loan out $4,500.
(ii) The maximum increase in the total MS from the Fed’s bond purchase.
Answer: Potential money creation in the banking system could be as
much as $45,000 [10x$4,500=$45,000]. Clark Consulting has a DD
of $5,000. Adding these two together gives a TMS of $50,000.
(c) If banks keep some of the deposit as ER, how will this influence
the change in the MS that was determined in part (b)(II)? Explain.
Answer: If the bank doesn’t loan out all of the $4,500 ER, then the
1st loan would not be as much as $4,500, therefore reducing PMC.
(d) If the public decides to hold some money in the form of currency
rather than in demand deposits, how will this influence the change in
the money supply that was determined in part (b)(ii)? Explain.
Answer: If the public gets the loan and holds part of it as currency, then
this is a leakage in the PMC of the banking system. If the person who takes
the $4,500 loan from First Generation Bank takes $500 in cash, then only
$4,000 gets deposited in the next bank, thus reducing the PMC of the system.
Inflation
1. Assume the U.S. economy is operating at full-employment output and the
government has a balanced budget. A drop in consumer confidence reduces
consumption spending, causing the economy to enter into a recession.
(a) Using a correctly labeled graph of the short-run Phillips curve, show the effect
of the decrease in consumption spending. Label the initial position “A” and the
new position “B”.
SRPC
2 pts – 1 pt for correctly labeled SRPC
graph.
1 pt for initial & new pt on SRPC
graph.
4%
2%
A. W. Phillips
1914-1975
A
B
5% 7%
Unemployment
(b) What is the impact of the recession on the federal budget? Explain.
Answer to 1. (b):
The decrease in consumption would result in a decrease in AD and a decrease in GDP.
This would result in an increase in unemployment and an increase in transfer payments.
Due to the job losses, there would be a decrease in tax revenues, resulting in an increase
in government red ink for the federal budget. So a federal budget deficit would increase
or a federal budget surplus would decrease.
2 pts - 1 pt for budget deficit and 1 pt for explanation.
(c) Assume current real GDP falls short of full-employment output by
$500 billion and the MPC is 0.8.
(i) Calculate the minimum increase in government spending that could
bring about full employment.
Answer to 1. (c) (i):
The expenditure multiplier [ME] would be 5 [1/.2 = ME of 5]. Because current output
falls short by $500 billion, it would take a minimum increase in government spending
of $100 billion to get to full employment. [5 X $100 = $500]
(ii) Assume that instead of increasing government spending, the government
decides to reduce personal income taxes. Will the reduction in personal
income taxes required to achieve full employment be larger than or
smaller than the government spending change you calculated in part
(c) (i)? Explain why.
Answer to 1. (c) (ii):
Because the tax multiplier [MT] is smaller, or [MPC/MPS = .8/.2 = 4], it will take a larger
tax cut then the increase in government spending. Because current output is $500 bil.
short of FE Y, and the MT is 4, it would take a tax cut of $125 billion. [4 X $125 = $500]
3 pts – 1 pt – $100;
1 pt – larger Tax reduction;
1 pt – smaller MT or not all increased
Y spent.
(d) Using a correctly labeled graph of the loanable funds market, show the impact
of the increased government spending on the real interest rate in the economy.
Real Interest Rate, (percent)
Answer to 1. (d)
As can be seen on the LF graph, the RIR would increase as the government has to borrow
more than previously, increasing demand in the LFM, which pushes up the RIR.
2 pts – 1 pt – correctly labeled LFM
graph;
2
1
1 pt – rightward shift of D
Lenderscurve
Borrowers
or leftward supply shift.
D
D
S
rir=8%
E2
rir=6%
(e) How will the real interest rate
change in part (d) affect the growth
rate of the U.S. economy? Explain.
Answer to 1. (e): The increase in RIR will
decrease real Ig, decreasing capital stock.
This will decrease AD and decrease GDP
or growth rate in the U.S. economy.
2 pts – 1 pt – growth rate falls;
1 pt – Ig decreases, slowing capital
E1
formation.
$2.1 Tril. after $100 B increase
$2
F1
F2
T
$2 T
G
T
Balanced Budget [G&T=$2 Tr.]
2. Balance of payments accounts record all of a country’s international transactions during a year.
(a) Two major subaccounts in the balance of payments accounts are the current account and the
capital account.
In which of these subaccounts will each of the following transactions be recorded?
(i) A United States resident buys chocolate from Belgium.
Answer to 2. (a) (i):
Chocolate from Belgium would go in the current account as it includes the import of goods.
1 pt – current
account
(ii) A United States manufacturer buys computer equipment from Japan.
Answer to 2. (a) (ii):
Computer equipment by a U.S. manufacturer would also be classified as an import so it
also go on the current account.
1would
pt – current
account
(b) How would an increase in the real income in the United States affect the United States current
account balance? Explain.
Answer to 2. (b):
An increase in real income would make U.S. citizens richer. We would buy more imports,
decreasing net exports, and increasing the deficit on the current account.
2 pts - 1 pt – imports increase or Xn decrease.
1 pt – current account balance decreases or current account balance
goes into deficit.
Rupee Price of Dollar
Price
D1$
R looking for $’s
S1$
$’s looking for R
R100
R50
Rupee
A
S2$
E1
appreciates
R25
D
E2
Quantity of Dollars
(c) Using a correctly labeled graph of the foreign exchange market for the U.S.
dollar, show how an increase in U.S. firms’ direct investment in India will affect
the value of the U.S. dollar relative to the Indian currency (the rupee).
Answer to 2. (c):
The increase in investment in India will increase demand for the rupee & appreciate that
currency. This would result in an increase in supply of the U.S. dollar for more rupees,
2 pts - 1 pt –the
correctly
depreciating
dollar. labeled foreign exchange graph for
the dollar.
1 pt – rightward shift in supply and depreciation of
3. The PPCs for Artland & Rayland are shown. Using equal
amounts of resources, Artland can produce 600 hats or 300
bicycles, & Rayland can produce1,200 hats or 300 bicycles.
(a) Calculate the opportunity cost of a bicycle in Artland.
Answer to 3. (a):
The Domestic Comparative (opportunity cost) of a bicycle
in Artland is 2 units of hats. [1 bicycle = 2 hats or 600/300=2]
1 pt for “1 B = 2 H”
(b) If the two countries specialize and trade, which country
will import bicycles? Explain.
Answer to 3. (b):
Rayland will import bicycles. Domestically, they have to give
up 4 hats to get a bicycle but with trade they have to give up
only 3 hats. 2 pts for “Rayland will import bicycles”
DCC: Rayland
1B=4H
¼ B= 1 H
DCC: Artland
1B=2H
½ B= 1 H
Terms of Trade
1B=3H
1/3 B = 1 H
(c) If the terms of trade are 5 hats for 1 bicycle, would trade
be advantageous for each of the following? 1 pt for “Yes, 5 H is better than 2 H”
(i) Artland Answer to 3. (c) (i): Yes, 5 hats is better than 2 hats they are getting domestically.
cost
(ii) Rayland Answer to 3. (c) (ii): No, Rayland is going to export hats so opportunity
1 pt for
is ¼ bicycle. So 1/5 of a bicycle would not benefit them.
“No”
(d) If productivity in Artland triples, which country has the comparative advantage in the
production of hats?
Answer to 3. (d): 300 bicycles would become 900 and 600 hats would become 1,800, so the
DCC would still be 1 bicycle = 2 hats, same as before. Rayland still has a C.A. in hats.
1 pt for “No change, so Rayland still has a comparative
advantage in hats”