1. Assume that the economy of Country Z is operating on the upward-sloping portion
of its short-run AS curve. Assume that the government increases spending.
(a) How will the increase in government expenditures affect each of the following in
the short run?
(i) AD
(ii) Short-run AS
Answer to 1. (a) (i) AD would increase as government
expenditures is a determinant of AD.
LRAS
PL
Answer to 1. (a) (ii) SRAS curve would not be affected
as government expenditures is not a
determinant of the SRAS curve. There is
a movement up the SRAS curve.
PL2(6%)
PL1(3%)
SRAS
AD1
AD2
Real GDP Y*
(b) Using a correctly labeled graph of AD/AS, show the effect of the
increase in government expenditures on real output and the price level.
Answer to 1. (b)
As can be seen on the graph, the increase in government expenditures would
increase AD which would increase real output. The increase in AD would move
the AD curve up along the SRAS curve and increase PL.
Yi
(c) Assume that the government funded this increase in expenditure by
borrowing from the public. Using a correctly labeled graph of the loanable-funds market,
show the effect of the increase in government borrowing on the real interest rate.
Answer to 1. (c)
The increase in government borrowing in the LFM would push up demand for money
and increase the RIR.
Real Interest Rate, (percent)
D1
D2
S
Lenders
Borrowers
rir=8%
E2
rir=6%
E1
$2.1 Tril. after “G” increase
$2
F1
F2
T
$2 T
G
T
Balanced Budget [G&T=$2 Tr.]
(d) Given the change in the real interest rate in part (c), what will be the
effect on each of the following on the foreign exchange market?
(i) Supply of Country Z’s currency. Explain.
Answer to 1. (d) (i):
The supply of Country Z’s currency would decrease as there is a lack of demand
for other country’s currency by sellers of Country Z’s currency. The decrease in supply
is causing the currency to appreciate [as well as the increase in demand for Country Z’s
currency by other nations].
(ii) The value of Country Z’s currency.
Answer to 1. (d) (ii):
Because of the higher return on financial investments [bonds & CDs], there would
would be an increase in demand for Country Z’s currency, which would appreciate their
currency.
(e) Given your answer in part (d) (ii), what will be the effect of the change
in the value of Country Z’s currency on Country Z’s exports? Explain.
Answer to 1. (e):
The appreciated currency in Country Z would make their exports more expensive
and therefore decrease their exports.
2. Suppose that Mexico decreases its tariff rates on all of its imports of automobiles from abroad.
(a) Will each of the following groups benefit from the decrease in the tariff rate?
(i) Mexican consumers
Answer to 2. (a) (i):
Mexican consumers will benefit by paying lower prices for autos. The
decrease in auto tariffs will make Mexican producers compete with the lower prices.
(ii) Mexican automobile manufacturers. Explain.
Answer to 2. (a) (ii):
Mexican auto manufacturers will not benefit as they will have to lower their
prices to compete with the cheaper imported autos and therefore receive lower profits.
(b) How would the decrease in the tariff rates affect each of the following in Mexico?
(i) Current account balance. Explain.
Answer to 2. (b) (i):
Lower tariffs mean lower prices and an increase in imports. This would cause a
deficit in the current account which includes exports and imports.
(ii) Capital account balance.
Answer to 2. (b) (ii):
The capital account balance would move toward surplus because the current
account moved toward deficit.
(c) Given the change in Mexico’s current account in part (b) (i), what will happen to the aggregate
demand in Mexico?
Answer to 2. (c):
The increase in imports would result in a decrease in net exports, which is a
determinant of AD, therefore it would decrease AD.
3. Gala Land produces three final goods: bread,
water, and fruit. The table [right] shows this
year’s output and price for each good.
(a) Calculate this year’s nominal GDP.
This Year’s Output
400 loaves of bread
Answer to 3. (a): 400x$6=$2,400; 1,000x$2=$2,000; 1,000 gallons of water
and 800x$2 = $1,600 for a Nominal GDP of $6,000. 800 pieces of fruit
This Year’s Price
$6 per loaf
$2 per gallon
$2 per piece
(b) Assume that in Gala Land the GDP deflator [GDP price index) is 100 in the base
year and 150 this year. Calculate the following.
(i) The inflation rate, expressed as a percentage, between the base year & this year.
Answer to 3. (b) (i):
Change/Original x 100; therefore 50/100 x 100 = 50% inflation rate.
(ii) This year’s real GDP
Answer to 3. (b) (ii):
Nominal GDP/GDP deflator x 100 = Real GDP; $6,000/150 X 100 = Real GDP of $4,000.
(c) Since the base year, workers have received a 20% increase in their nominal wages.
If workers face the same inflation that you calculated in part (b)(i), what has
happened to their real wages? Explain.
Answer to 3. (c): Inflation between these years has increased 50%; wages have increased
only 20%; therefore workers real wages or real purchasing power has decreased.
(d) If the GDP deflator in Gala Land increases unexpectedly, would a borrower with a
fixed-interest-rate loan be better off or worse off? Explain.
Answer to 3. (d): The borrower has borrowed “dear” money but is paying back “cheaper”
money. He is better off because he is paying back money that isn’t worth what it was when
he took out the loan.
Finished