1. Assume that the United States economy is operating below full employment.

(a) Draw a correctly labeled graph of long-run aggregate supply, short-run aggregate supply,
and aggregate demand, and show each of the following.

(i) Current equilibrium output and price level, labeled as Y 1 and P 1

(ii) Full-employment output, labeled as Y f

(b) Assume that the Federal Reserve targets a new federal funds rate to reach full
employment. Should the Federal Reserve target a higher or lower federal funds rate?

Lower

(c) Given the Federal Reserve action you identified in part (b), draw a correctly labeled
graph of the money market and show the effect on the nominal interest rate.

(d) The policy makers pursue a fiscal policy rather than the monetary policy in part (b). Assume
that the marginal propensity to consume is 0.8 and the value of the recessionary gap is $300
billion.
(i) If the government changes its spending without changing taxes to eliminate the
recessionary gap, calculate the minimum required change in government spending.

Spending Multiplier = 1/1-MPC; = 1/1-.8 = 1/.2 = 5

Therefore $300 Billion/5 = $60 Billion change in government spending is required.
 (ii) If the government changes taxes without changing government spending to eliminate
the recessionary gap, will the minimum required change in taxes be greater than,
smaller than, or equal to the minimum required change in government spending in
part (d)(i) ? Explain.

It would have to be greater than the change in government spending. This is because
government spending has a faster effect on the economy than taxes and because some
of a tax cut would be saved.

(e) Assume the government lowers income tax rates to eliminate the recessionary gap. Will each
of the following increase, decrease, or stay the same?

(i) Aggregate demand. Explain.

AD will increase. Lower income taxes will cause increased consumption

spending by households. Because consumption spending is a direct component of
AD, it will cause AD to go up.

(ii) Long-run aggregate supply. Explain.

No effect. Changes in income tax rates have a short-run effect and on AD. LRAS
is affected by utilizing improved technology over the long-run, more economic
resources, and international trade for to obtain the necessary technology and
resources.
2. Country X and Country Y are trading partners, and both produce furnaces and solar panels. The
countries can produce the following amounts using equal amounts of resources.

Country X: 6 furnaces or 8 solar panels

Country Y: 6 furnaces or 12 solar panels

(a) Which country has an absolute advantage in producing solar panels?

The absolute advantage in solar panels belongs to Country Y.

(b) Calculate the opportunity cost of a furnace in Country Y.

Nation Furnaces Solar Panels Furnaces Solar Panels

X 6 8 8/6 = 4/3 6/8 = 3/4

Y 6 12 12/6 = 2 6/12 = 1/2

The opportunity cost of a furnace in Country Y is 2 solar panels.

 (c) Which country has the comparative advantage in producing furnaces? Explain.

Country X has the comparative advantage in producing furnaces because it has the lowest
opportunity cost of making furnaces.

(d) If the terms of trade were that 2 furnaces are exchanged for 1 solar panel, should Country X
produce solar panels domestically or import solar panels from Country Y?

Domestic Terms of Trade:

Country X Makes furnaces, its domestic terms of trade are:
3 furnaces for 4 solar panels
Country Y Makes Solar Panels, its domestic terms of trade are:
2 solar panels for 1 furnace
Based on the domestic terms of trade above, Country X would be better off
producing solar panels domestically. It’s domestic terms of trade of 3 furnaces
for 4 solar panels are better than the proposed 2 furnaces for 1 solar panel.

3. Exchange rates and interest rates are important for macroeconomic decision making.
(a) How does an increase in Japan’s government budget deficit affect each of the following?

(i) The real interest rate in the short run in Japan. Explain.

If Japan is running a budget deficit, it will demand more loanable funds in order
to finance its deficit spending. This would cause the real interest rate to increase
in the short-run.

(ii) Private domestic investment in plant and equipment in Japan.

Private domestic investment in plant and equipment in Japan would decrease

because it would become more expensive to borrow money for investment due to
the aforementioned increase in the real interest rate.

(b) Draw a correctly labeled graph of the foreign exchange market for the euro, and show the
effect of the change in the real interest rate in Japan from part (a)(i) on each of the
following.

(i) Supply of euros. Explain.

 The supply of Euros will increase in the world market as Europeans are attracted to the
higher real interest rates on Japanese financial assets. European investors will supply
more euros and in order to exchange them for the Yen required to invest in Japanese
financial assets.

(ii) Yen price of the euro

The Yen price of the euro will increase or appreciate.

(d) To reverse the change in the yen price of the euro identified in part (b)(ii), should the
European Central Bank buy or sell euros in the foreign exchange market?

The European Central bank should buy euros from the foreign exchange market.
This would decrease supply of euros causing appreciation, and if the euros are
bought with yen, it would increase supply of yen causing depreciation.