1. This long macro question was aimed at testing the student's understanding of aggregate analysis and, in particular, macroeconomic policy tools and their relative effectiveness. The student needed to understand the concept of full employment, as well as recession. Moreover, the student needed to understand the relative effectiveness of increasing government spending compared to reducing taxes. Also, the student needed to assess the impacts on imports and exports from an expansionary fiscal policy. Finally, the question tested the student's understanding of both the short-run and long-run impacts of an increase in net investment.
(a) The AS-AD graph should show an equilibrium price level and real output (real GDP). Given that the economy is in a deep recession, the equilibrium level of output clearly should be below the full-employment level of output.
(b) An increase in government expenditures will have an greater impact on real income or GDP than will a decrease in personal taxes of an equivalent magnitude. The government expenditure multiplier is more powerful than the tax multiplier since a portion of the tax decrease is saved rather than directly spent.
(c) A decrease in personal income taxes will lead to an increase in disposable income and an increase in consumption. With an increase in consumption, aggregate demand will increase or shift out, increasing the price level and the value of read GDP or output. With a higher domestic price level and and unchanged "foreign" price level, imports will become relatively less expensive and increase, while exports will become relatively more expensive to foreigners and decrease. [Also, with higher real income or GDP demand for all goods, including imports will increase. Finally, it is also true that the expansionary fiscal policy should increase the demand for loanable funds, raising interest rates, and appreciating the dollar. An appreciated dollar will lead to increased imports and reduced exports.]
(d) Since investment is a component of aggregate demand,
an increase in net investment will shift out the aggregate demand
function. Since positive net investment will increase the stock of
capital, the aggregate supply curve will shift out to the right.
2. This question was aimed at testing the student's understanding of the working of a foreign exchange market. In particular, the student needed to assess the impact on the value of the dollar from a change in tastes towards more French goods; then the student was asked to assess the market impact from an increase in real interest rates in the United States.
(a) With an increased demand for French goods, there will be an increase in the supply of dollars to purchase French francs. With the increase in the supply of dollars the French franc price of the dollar will fall or the dollar will depreciate.
(b) With an increase in real interest rates in the Untied States, there will be an increased demand (by those holding French francs) for the dollar to purchase dollar-denominated assets. [Also, there will be a reduced supply of dollars to convert to French francs.] In this case, the French franc price of the dollar will increase or the dollar will appreciate. With the increase in demand for dollars, the quantity of dollars supplied will increase along an upward sloping supply curve for dollars.
(a) A decrease in the money supply will increase equilibrium interest rates in the money market.
(b) An increase in interest rates will lead to a reduction in those consumption expenditures that are interest-sensitive, such as automobiles or furniture purchased on credit. Given the inverse relationship between desired investment and the interest rate, investment will fall; some investment projects will not be profitable with the higher interest rates. There should be no automatic change in government expenditures as a result of the higher interest rate; one exception would be higher interest outlays on new short-term debt.
(c) In the short run, aggregate demand will shift in to the left, leading to a decrease in output or GDP and a decrease in the price level. The aggregate supply curve should not change in the short-run.