Part (a)
1 point
1 Point
for Inflation
Part (b): 3 Points
The FED would follow a
contractionary policy and decrease the money supply by OMO of a Treasury
security sale. The result will be a decrease in the money supply leading
to an increase in the interest rate which decreases investment and aggregate
demand. The leftward shift of AD results in a decrease in GDP,
employment and Price level.
Points:
- 1/2 correct OMO
of a sale of securities
- 1/2 OMO sale
leads to money supply decrease and an increase in interest rates
- 1 explanation of linkage of interest rate increase--->
investment decrease--> aggregate demand decrease
- 1 decrease in
aggregate demand => decrease in output, decrease in employment and
decrease in price level
Part (c):
1 Point
Possible limitations on the effectiveness of the monetary policy are:
(1 point awarded for any of the following limitations)
- Money demand is interest
elastic
- investment
is interest inelastic
- velocity increases
- Bank excess reserves
and/or public's holding of currency
- Uncertain effectiveness
lag of monetary policy
- Inflow of international capital
from the increase in interest rates
Part (d): 3 Points
An increase in personal
income taxes decreases the disposable income and hence reduces consumption
which, in turn, decreases aggregate demand. The decrease in aggregate
demand decreases output, employment and prices. Assuming that government
spending is constant, with the reduction of the government's demand for
loanable funds, because they now have the tax revenue, the interest rate
falls. Note: Aggregate supply shifts are not acceptable.
An alternative explanation
for the interest rate effect is: the resulting decrease in income decreases
the demand for money reducing the interest rates. This answer is
acceptable. However, this answer is not as good as the loanable funds
argument because it is a secondary argument and it also occurs as a secondary
response in the implementation of monetary policy.
Points:
1- Linkage between
increased taxes [decrease in disposable income] and decrease in consumption
and AD decreases
1- Decrease
in AD decreases output, employment, and price level.
1- Explanation of
effect on interest rate.
Part (e):
1 Point
Possible limitations on
this policy are
- Lags in adjustment to
increase taxes--if Ricardian equivalence holds then people will merely
take increased taxes out of savings and spending (AD) will continue
unchanged
- If people view the tax
change as temporary, then consumption will not decrease and AD will not
decrease as much. Idea behind this limitation is the Friedman
consumption function or life-cycle consumption function.
- Crowding-in:
business demand and hence interest rates may not fall and AD may not fall
as much because of the increase in I offsetting the decrease in C.
The
point is awarded for any of the above examples.
ALTERNATIVE ANSWERS
ACCEPTED:
The monetarists would use
the monetary policy tools to maintain a constant money supply growth to ensure
a stable financial environment to permit the economy to self-adjust toward
full employment GDP. The monetarist transmission mechanism of monetary
policy is an increase in money supply directly increasing aggregate demand
without the interest rate effect.
Supply-siders would
suggest that a decrease in taxes would provide incentives for increasing
productivity and thus the AS curve would shift rightward. An
accompanying AD shift is required for full credit.
If the student uses the
Keynesian Cross model, they should receive credit. however, they must
give a correct explanation for the decrease in price.
A rational expectations
approach which states that anticipated monetary and fiscal policy are
ineffective and that only an unanticipated stabilization policy would have
short run effects is a viable answer.
2. Grading Rubric for #2: 5 Points
Part (a) 1 point
U.S. tourism will increase [because the dollar is stronger against the
franc and the mark]
Part (b) 2 points
The increase in the value of the dollar results in more imports and fewer
exports, therefore the Aggregate Demand curve shifts to the left resulting in
a decrease in output and price in the U.S.
- 1 point - Correct AD-AS graph and results with respect to price
level and output. [Aggregate Supply shift only is not sufficient;
see note below.]
- 1 point - Relating change in value of the dollar to the decline
in exports and increase in imports, and the relationship of net exports to
aggregate demand.
Part (c) 2 points
The increase in the value of the dollar makes foreign goods less expensive
for U.S. consumers and U.S. goods more expensive for foreign consumers;
therefore imports will increase and exports will decrease. The increase
in imports and decrease in exports increases the trade deficit.
- 1 point - Relative price change causes the increase in imports
and decrease in exports.
- 1 point - Increase in trade deficit or a decrease in the trade surplus
or the trade balance worsens.
Note: The argument that the dollar appreciation makes foreign
input factors less expensive and thus the aggregate supply curve would shift
rightward is acceptable in conjunction with the decrease in aggregate
demand. The aggregate demand curve will decrease always whereas the shift in
the aggregate supply curve is highly dependent on other factors.
3. Grading Rubric for #3: 5 Points
Part (a) 3 points
The local banks reserve increase by $1,000: $100 in required reserves and
$900 in excess reserves. The maximum possible increase in the bank's
loan portfolio is $900. The maximum possible increase in the value of
the money supply is $10,000. The source of the $10,000 is $9,000 from
money creation from the original $900 of excess reserves plus the additional
$1,000 of the "new money."
Points:
- 1 Point - $1,000 for reserves. [This may be states as
"The reserves consist of $900 in excess reserves and $100 of required
reserves." In this case, the student needs to indicate that
they know that reserves consist of excess and required reserves.]
- 1 Point - $900 for local bank's new loans with
explanation/relationship
- 1 Point - $10,000 for increase in money supply with
explanation/suggestion of an understanding how the number is derived.
Part (b) 2 points
1 point per reason up to two correct reasons:
Real world factors which can change the maximum possible impact of the new
$1,000 are:
- people may decide to hold currency and not redeposit in the banking
system;
- the banks may decide to hold excess reserves and not make loans;
- demand for loans may be less than the excess reserves that banks are
willing to loan out.