Long free-response question

A stock market slump

Units 2, 3, 4 and 5
10 points
About 25 minutes

You can use a calculator on this question, just like on exam day.

A multi-part question that follows one economy through a situation and ties several models together, such as AD–AS, the Phillips curve, the money or reserve market, loanable funds and the foreign exchange market. You draw and label graphs (described in words on this site), name the right policy, do a calculation or two, and explain the chain of effects step by step. On the exam: Question 1 of 3 in Section II (60 minutes for all three, including a 10-minute reading period; 33.35% of the exam score). Worth half the section score; about 25 minutes suggested. A four-function calculator is allowed.

The question

The economy of Dunmore is in long-run equilibrium. A sharp fall in stock prices then reduces household wealth, and consumer spending in Dunmore falls. Dunmore's banking system has limited reserves, and the required reserve ratio is 20 percent.

Suggested time: 25 minutes

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Part (a)

2 points

Describe a correctly labeled graph of aggregate demand, short-run aggregate supply, and long-run aggregate supply for Dunmore. Show the initial long-run equilibrium, labeling the price level PL1 and output YF. Then show the short-run effect of the fall in consumer spending, labeling the new price level PL2 and real output Y2.

Your answer to part (a)

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Part (b)

1 point

Identify the type of unemployment that increases as a result of the change shown in part (a).

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Part (c)

1 point

Without any new laws being passed, what will happen to Dunmore's income tax revenue and to its spending on unemployment benefits? Explain how these changes affect the decrease in aggregate demand.

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Part (d)

2 points

Based on the changes in the price level and real output shown in part (a), describe a correctly labeled graph of the money market in Dunmore, and show the effect on the nominal interest rate.

Your answer to part (d)

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Part (e)

1 point

Dunmore's central bank lowers the required reserve ratio from 20 percent to 10 percent. Before the change, a commercial bank in Dunmore had $500,000 in demand deposits and held exactly its required reserves, with no excess reserves. Calculate the bank's excess reserves immediately after the change. Show your work.

Your answer to part (e)

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Part (f)

1 point

Calculate the maximum change in Dunmore's money supply that can result from the bank lending out the excess reserves you found in part (e). Show your work.

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Part (g)

1 point

Explain how the lower reserve requirement will affect real output in Dunmore in the short run.

Your answer to part (g)

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Part (h)

1 point

Based only on the fall in consumer spending shown in part (a), and before the central bank acts, describe how Dunmore's position on its short-run Phillips curve changes.

Your answer to part (h)

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