1999 Macro Free Response Answers

1.   Grading Rubric (a) 3 points  (b)  1 point  (c)  3 points  (d)  2 points  =   9 points total

(a)  Given the inverse relationship between desired investment and the rate of interest, higher interest rates will reduce investment.  With higher interest rates, firms will not undertake certain investment projects.  Higher interest rates will attract capital from abroad into this country.  The flow of funds increases the demand for the country's currency and leads to an appreciation of the currency.  With the appreciated currency, the country's exports are more expensive to foreigners who purchase less; thus, exports fall.

• (1 point) investment falls
• (1 point) the currency appreciates due to increased demand for currency in foreign exchange markets, inflow of foreign funds or increased supply of foreign currency
• (1 point) decrease in exports due to appreciated currency, the price of exported goods has increased for foreign purchasers who are importing the goods (purchasing power argument)

(b)  With reduced investment (and exports) , aggregate demand falls (shifts in) leading to less real output and a lowered price level.

• (1 point) On a correctly labeled Graph: AD falls-----> price and output falling
  alternative:  a vertical AS curve, Q (or Y) unchanged and P down; or shifts AS to left, acceptable only if AD also shifts correctly

(c)  An appropriate expansionary fiscal policy would either be an increase in government expenditures or a reduction in taxes.  Such a policy would increase (shift out) aggregate demand, leading to higher real output and a higher price level.  Nominal interest rates would increase.  The expansionary fiscal policy would increase the demand for loanable funds, raising interest rates.  Also, with a higher real output, the demand for money increases, raising interest rates.  Bond prices will fall.  An increase in the supply of bonds to fund the expansionary fiscal policy would lower bond prices.  Higher interest rates would also bid down the price of existing bonds.

(d)  An appropriate monetary policy would be for the monetary authorities to buy government bonds, increasing the money supply, or for the monetary authorities to lower reserve requirements or reduce the discount rate.  In each of these cases, the money supply would increase (or shift out). Given a constant money demand (a simplifying assumption), interest rates would fall.

2.  

(a)  

(b)  

3.

(a)  

 

(b)  

(c)