(b) [2 pts][2 pts] Now assume a significant increase in the world price of oilsignificant increase in the world price of oil, a major production inputproduction input for the U.S. Show on your graph in part (a) how the increase in the oil priceincrease in the oil price affectsaffects each of the following in the SR. (i) Short-run ASShort-run AS (ii) Real outputReal output && PLPL

SRAS1

LRASLRAS

Y*Y*

 

(c) [2 points][2 points] Given your answer in part (b), explain what will happen to what will happen to unemployment in the U.S. in the short rununemployment in the U.S. in the short run.

ADAD11

PLPL11

YYRR

EE22

Real GDPReal GDP

1. [11 pts total][11 pts total] Assume the U.S. economy is currently operating at anoperating at an equilibrium below full employmentequilibrium below full employment. (a) [3 pts][3 pts] Draw a correctly labeled graphcorrectly labeled graph of of AD/ASAD/AS, & show each of the following. (i) Long-run ASLong-run AS (ii) Current equilibrium output & price levelCurrent equilibrium output & price level

EE11

SRASSRAS22

PLPL22

YY22

AnswerAnswer (c)(c) As indicated by Y2 in the graph, unemployment will increase As indicated by Y2 in the graph, unemployment will increase due to the decrease in output caused by the decrease in AS.due to the decrease in output caused by the decrease in AS. [2 points] [2 points]

Decreases as shown above Decreases as shown above [1 pt for showing decr in SRAS][1 pt for showing decr in SRAS]Real output decreasesReal output decreases & & PL increasesPL increases as shown as shown [1 point][1 point]

[The 3 pts would be for drawing[The 3 pts would be for drawingthe AD/AS graph, drawing thethe AD/AS graph, drawing theLRAS, LRAS, and and showing equilibriumshowing equilibriumbelow full employment.] below full employment.]

(d) (d) [3 pts][3 pts] Assume Assume that thethat the U.S. trades with Japan. Draw U.S. trades with Japan. Draw a a correctly labeled correctly labeled graph of the foreign exchange market for the U.S. dollargraph of the foreign exchange market for the U.S. dollar. Based on . Based on your indicated change in real output in part (b), your indicated change in real output in part (b), show and explain how the show and explain how the supply of the U.S. dollar will be affected in the foreign exchange marketsupply of the U.S. dollar will be affected in the foreign exchange market ..

(e) [1 point][1 point] Given your answer in part (d), indicate what will happen what will happen to theto the value of the U.S. dollar relative to the Japanese yenvalue of the U.S. dollar relative to the Japanese yen.

SS11$$

DD$$

Quantity of DollarsQuantity of Dollars

EE11

Yen

Pri

ce o

f D

ollar

Y100Y100

SS22$$

EE22Y110Y110 Answer (d): The decrease in Answer (d): The decrease in

real U.S. output will cause real U.S. output will cause job losses in the U.S. and job losses in the U.S. and decrease decrease the the dollars supplied dollars supplied for Japanese goods, that is,for Japanese goods, that is,decrease import demand.decrease import demand.

Answer (e): Due to the decrease in supply of U.S. dollars Answer (e): Due to the decrease in supply of U.S. dollars [as shown above],[as shown above], it will take more yen it will take more yen to to purchasepurchase a a dollar, dollar, depreciating the yen depreciating the yen and and therefore appreciating the dollar.therefore appreciating the dollar.

[3 pts for correct graph showing[3 pts for correct graph showingdecrease in supply, decrease in supply, which resultswhich results

in a decrease in import demand.]in a decrease in import demand.]

[1 pt for depreciation][1 pt for depreciation]

2. [8 total points] [8 total points] Interest rates are important in explaining economic activity. (a) [3 pts] [3 pts] Using a correctly labeled graph of the money market, show how an increase in the income level will affect the nominal interest rateincrease in the income level will affect the nominal interest rate in the short run.

MSMS

No

min

al

Inte

rest

Rat

e

IRIR11

Money Market

DDM1M1

DDM2M2

IRIR22

Answer 2 (a): An increase in income will cause more consumption in the Answer 2 (a): An increase in income will cause more consumption in the economy which will push up demand [to economy which will push up demand [to DDM2M2 above] for money above] for money which will increase the nominal interest rate [to which will increase the nominal interest rate [to IRIR22]. ].

[3 points for drawing correctly labeled [3 points for drawing correctly labeled graph, showing an increase in graph, showing an increase in DDm andm andthe nominal interest rate rising.]the nominal interest rate rising.]

2 (b) [3pts][3pts] Using a correctly labeled graph of the loanable funds marketcorrectly labeled graph of the loanable funds market, show how a decision by households to increase savingdecision by households to increase saving for for retirementretirement will affect the real market interest rateaffect the real market interest rate in the short run.

FF11

rr11

Quantity of Loanable Funds

DD SS11

EE11

Re

al I

nte

res

t R

ate

, (p

erc

en

t)

SS22

rr22 EE22

Answer 2 (b): If householders save more the banks have more money toAnswer 2 (b): If householders save more the banks have more money to loan out [loan out [S2S2] which would decrease the real interest rate [to ] which would decrease the real interest rate [to r2r2].].

FF22

[3 points showing correctly[3 points showing correctlylabeled graph,labeled graph, showing showing increaseincreasein supply in supply & & real I.R. dropping.]real I.R. dropping.]

NominalNominalInterestInterest

RateRate

RealRealInterestInterest

RateRate

InflationInflationPremiumPremium

= 8%8%

22%%

6%6%

[[Real I.R.Real I.R. ++ anticipated inflation anticipated inflation == nominal I.R.nominal I.R.]]

+

NominalNominalInterestInterest

RateRate

RealRealInterestInterest

RateRate

InflationInflationPremiumPremium

-88%%

66%%

22%%

[[Nominal I.R.Nominal I.R. – – inflation rateinflation rate == Real I.R.Real I.R.]]

==

2 (c) [2 pts] [2 pts] Suppose that the nominal interest rate nominal interest rate has beenhas been 6% 6% with no no expected inflationexpected inflation. If inflation is now expected to be 2%inflation is now expected to be 2%,, determine the value of eachvalue of each of the following. (i) The new nominal interest ratenew nominal interest rate (ii) The new real interest ratenew real interest rateAnswer Answer 2(c)(i): The nominal interest rate is 8%.2(c)(i): The nominal interest rate is 8%. [6% real + [6% real + 2% expected inflation premium2% expected inflation premium]]

Answer 2(c)(ii): The new real interest rate would be 6%.Answer 2(c)(ii): The new real interest rate would be 6%. [8% new nominal interest rate – [8% new nominal interest rate – 2% anticipated inflation2% anticipated inflation = 6% real I.R.] = 6% real I.R.] [*A point was also given here if the student says the real interest rate [*A point was also given here if the student says the real interest rate is 2% less than whatever they said the nominal was]is 2% less than whatever they said the nominal was]

RealRealII.Rates.Rates

66%%

3. [7pts] [7pts] The unemployment rate unemployment rate is an important indicator of the health of the U.S. economy. (a) [1 pt] [1 pt] Assume that with the economy at full employmenteconomy at full employment, the government implements an expansionary fiscal policyexpansionary fiscal policy. How does the actual unemployment rate actual unemployment rate at the newat the new short-run equilibrium compare with the natural rate of unemploymentshort-run equilibrium compare with the natural rate of unemployment?

(b) [2 pts] [2 pts] Assume that a significant number of workers are involuntarily workers are involuntarily changed from full-time to part-time employmentchanged from full-time to part-time employment. Explain how this will affect the number of people who are officially classified as unemployed.

Answer 3. (b): The official unemployment rate would not change because Answer 3. (b): The official unemployment rate would not change because part-time workers are also counted as fully employed. part-time workers are also counted as fully employed.

SRASSRASADAD11

LRASLRAS

Y*Y*55%%

PLPL11

PLPL22

ADAD22

YYii44%%

Answer 3. (a): Actual output [Answer 3. (a): Actual output [YiYi] would exceed] would exceedthe natural output rate [the natural output rate [Y*Y*] at the new shor-run] at the new shor-runequilibrium [equilibrium [E2E2]. Therefore, the actual unemploy-]. Therefore, the actual unemploy-ment rate [ment rate [4%4%] would be lower than the natural ] would be lower than the natural rate of unemployment [rate of unemployment [5%5%].].

EE11

EE22

3 (c) [4 pts] [4 pts] Assume that the government reduces the level of government reduces the level of unemployment compensationunemployment compensation.

LRPCLRPC11

Unemployment Unemployment

PLPL

Answer 3(c): (i): The natural rate of unemployment would decrease to Answer 3(c): (i): The natural rate of unemployment would decrease to YY22 because of “more labor” in the work force. because of “more labor” in the work force. (ii): Lower payment for unemployment compensation will mean that workers (ii): Lower payment for unemployment compensation will mean that workers have more incentive to work and go out and search for jobs more quickly. They have more incentive to work and go out and search for jobs more quickly. They remain unemployed for shorter periods of time and hence the natural rate of remain unemployed for shorter periods of time and hence the natural rate of unemployment tends to be lower. The LRPC would shift to the left to unemployment tends to be lower. The LRPC would shift to the left to YY22. .

YY11YY22

(i) Explain how this affects the natural rate of unemploymentaffects the natural rate of unemployment. (ii) Using a correctly labeled graphcorrectly labeled graph, show how this affects the affects the long-run long-run PPhillips curvehillips curve.

LRPCLRPC22

[4 points given for saying the a.) natural[4 points given for saying the a.) naturalrate will fall, b.) People have more rate will fall, b.) People have more incentive to look for work, c.) graph of incentive to look for work, c.) graph of LRPC, and d.) leftward shift of the LRPC]LRPC, and d.) leftward shift of the LRPC]

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