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.
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”.
“B”
SRPC 2 pts – 1 pt for correctly labeled
Inflation SRPC graph.
1 pt for initial & new pt on
SRPC graph.
A
4%
2%
B
A. W. Phillips
1914-1975 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.
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,2which
pts – pushes
1 pt – correctly
up the RIR. labeled

D D S LFM graph;
Real Interest Rate, (percent)

1 2 1 pt – rightward shift
of D curve
Borrowers Lenders or leftward supply
shift.
(e) How will the real interest rate
change in part (d) affect the growth
rate of the U.S. economy? Explain.
rir=8% E2
Answer to 1. (e): The increase in RIR will
decrease real Ig, decreasing capital stock.
rir=6% E1 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 formation.
$2.1 Tril. after $100 B increase
$2 T $2 T
G T
F1 F2
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
would
1 pt –also go on the current account.
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.
 Price D1$ S1$
R looking for $’s $’s looking for R

Rupee Price of Dollar

R100

S2$
R50 E1
Rupee

A
appreciates

R25 E2

D 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
depreciating the–dollar.
correctly labeled foreign exchange
graph for the dollar.
1 pt – rightward shift in supply and
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
DCC: Rayland DCC:
will import bicycles? Explain. Artland
Answer to 3. (b): 1B=4H 1B=2H
Rayland will import bicycles. Domestically, they have to give ¼ B= 1 H ½ B= 1 H
up 4 hats to get a bicycle but with trade they have to give up
2 pts for “Rayland will import
only 3 hats. Terms of Trade
bicycles” 1B=3H
(c) If the terms of trade are 5 hats for 1 bicycle, would trade
1 pt for “Yes, 5 H is better 1/3 B = 1 H
be advantageous for each of the following?
than 2 H”
(i) Artland Answer to 3. (c) (i): Yes, 5 hats is better than 2 hats they are getting domestically.
(ii) Rayland Answer to 3. (c) (ii): No, Rayland is going to export hats so opportunity
1 pt for
cost
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”
Finished