Correct Answer and Standards for 1998 Macro Free Response

1.    I.    Correct Answer

The increase in government spending leads to an outward shift in aggregate demand. Given that the economy is at full employment, the price level increases. The effect on real output is determined by the assumption made concerning the aggregate supply curve. Using a long-run or a classical aggregate supply function that is vertical at the full employment output level real output is unchanged. However, it would not be wrong to argue that the economy can operate, in the short run, above full employment. With this approach, a contrast between full-employment output and potential output must be shown. Alternatively, a contrast between long-run and short-run aggregate supply can be used. In these cases, real output could increase, at least in the short run.

The increased government spending will lead to an increase in the nominal interest rate. With a higher nominal GDP, the transactions demand for money will increase. Also, increased government borrowing raises the demand for loanable funds and increases the interest rate.  With an increased supply of government bonds to fund the debt, the price of bonds falls and the rate of interest rises. Higher inflationary expectations will pressure upward the nominal interest rate.

The real interest rate is equal to the difference between the nominal interest rate and the rate of inflation. With both the nominal interest rate increasing and the expected price level increasing the change in the real interest rate is indeterminate.   

The government deficit is the difference between inflows (taxes and other government revenues) minus outflows (expenditures and transfer payments) for some period of time (typically a year).   The national (or federal, for the U.S.) debt is the sum of accumulated government deficits (minus repayments) at some point in time.

An increase in the economy's potential to produce output is captured by an outward shift in the long-run aggregate supply function. A tax policy that:

a)      increases the return or profitability from supplying inputs and stimulates a greater use of inputs (at each aggregate price level) or

b)      increases the productivity of inputs will lead to an outward shift in the aggregate supply curve.  

Examples of such tax policies are investment tax credits, reduced corporate profits taxes, and educational tax credits. For each tax policy, a specific linkage to economic growth must be developed. For instance, an investment tax credit will lead to increased net investment and an increase in the capital stock, with more capital the aggregate supply function shifts outward.  Economic growth leads to an outward shift in the economy's production possibilities frontier or boundary.

 II. Grading Rubric for Macroeconomics Question 1: 9 Points

 Part (a) 2 points

1 Point for:

•  an acceptable AS-AD graph with full employment shown either as: vertical portion of AS or a clear notion of capacity constraint, such as a SRAS and a LRAS.

½ point for

•  an increase in the price level (must show AD shift)

½ point for 

• either no increase in real output if full employment is on the vertical portion of AS

• or an increase above the full-employment output level if the SRAS is upward sloping

Part (b): 2 Points

1 point for nominal interest rises with any of the following reasons:

• nominal rate = real rate + expected inflation rate; price level goes up thus inflationary expectations increase
• increased transactions demand for money
• increased demand for loanable funds (supply of government bonds), and thus lower price of bonds and  higher interest rates
• higher inflationary expectations (or higher inflation).

1 point for

• real interest rate change being uncertain because the nominal interest rate increases while the price level rises.  [If the student declares that one change is larger than the other (nominal interest rate change vs. inflation rate) a specific conclusion is acceptable.]

 Part (c): 2 Points

• 1 Point   Deficit = difference between inflows (taxes) and outflows (spending) within a given time period
• 1 Point   Debt = sum of accumulated deficits/,surpluses (at some point in time)

 Part (d): 3 Points

1 Point for a correct tax policy (must link to aggregate production or aggregate supply),

• such as increased investment tax credit,
• increased R&D tax credit,
• reduced capital gains tax, 
• and reduced corporate profits tax. 

[Do not accept demand-oriented answers, such as lowering personal income taxes to increase consumption.]

1 Point for a correct linkage from tax policy to higher investment leading to a greater capital stock and greater capacity. 

[It is acceptable to argue that a demand-side tax policy would increase business profits, leading to increased business investment. Then the capital stock would increase, leading to an increase in capacity and an outward shift in AS.] 

1 Point for an outward shift in the production possibilities frontier (PPF, PPB, PPC).

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2.    I.    Correct Answer

The Federal Reserve sells bonds to the public; purchasers pay for these bonds with demand deposits.  When these checks clear, the banking system loses cash reserves.  As banks call in loans to increase their cash reserves, interest rates increase.  Alternatively, a reduced amount of bank reserves  will support a lower money supply, and interest rates will increase.  Or, an increased supply of bonds lowers the price of bonds and raises the interest rate.

A proper money graph would show the supply of money shifting in and the equilibrium interest rate rising.

A higher interest rate will reduce investment (and reduce all interest-sensitive expenditures).  As a result, the aggregate demand function will shift in.  With an unchanged aggregate supply curve, the decrease in aggregate demand will result in a decrease in the price level and real output.

II.    Grading Rubric for #2:  5 Points

Part (a) 2 points

1 point for bank reserves will fall because demand deposits are used by the public to buy securities (leading to an outflow of reserves).

1 point for any of the following:

• Banks cut back on lending or call in loans, putting upward pressure on the interest rate
• Sale of bonds decreases the money supply and raises the interest rate
• Sale of bonds represents an increase in the supply of bonds, lowering the price of bonds, and increasing interest rates

Part (b) 1 point

• A complete, correct, and well-labeled graph of the money market must show that the supply of money decreases (shifts leftward), and thus the equilibrium interest rate rises

Part (c) 2 points  (each item worth 1/2 point)

• Explain that investment falls as a result of higher interest rates.
• Explain that aggregate demand falls because investment is a component of AD.  [Accept a decrease in interest-sensitive consumption spending causing a decrease in AD].
• Explain that output falls because of decrease in AD.
• Explain that the price level falls because of decrease in AD.

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3.    I.    Correct Answer

With the increase in productivity, coupled with a constant nominal wage, country X's price level will fall.  The decrease in the price level can be shown by an outward shift in the aggregate supply (AS) curve or by reasoning that unit production costs will fall.  With an unchanged nominal wage (w) and a lower price level (P), the real wage (w/P) will increase.

Since country X's productivity is growing less rapidly than that of other countries, country X's exports will become relatively more expensive than those of other countries.  Country X's exports will fall as the country experiences reduced international demand for its relatively higher-priced products.  With reduced exports, the demand for country X's currency will fall and the currency will depreciate.  In the short run, with country X experiencing reduced exports, aggregate demand should shift in and real output will be lower.  Employment (particularly in export industries) will fall.  [Depending upon the behavior of the nominal wage, the AS function for country X may also be changing, most likely increasing.  However, no information concerning the nominal wage was provided for this part of the question; so, an unchanged AS function is acceptable.]

II.    Grading Rubric for #3:  5 Points

Part (a) 2 points

1 point for price level falls

• due to an outward shift in AS
• or because the productivity increase will lower unit costs and reduce prices
• or because production becomes more difficult

1 point for a real wage increase

• because the nominal wage is constant and the price level falls
• or because a given wage will have greater purchasing power

Part (b) 3 points

1 point for

• exports will fall, as the relative rice of Country X's exports rise. [Note that this is a relative price change. AS may still be increasing, and thus domestic prices are not necessarily rising.  There must be a sense of relative price to receive credit.]

1 point for

• demand for Country X's currency will decrease due to reduced demand for its exports and thus the currency will depreciate.  [It is unacceptable to assert that exports fall and thus the currency depreciates.]

1 point for

• falling exports leads to a decrease in AD, which leads to decreased employment.  [It is unacceptable to assert simply that exports fall so employment falls.]