Long free-response question

An investment tax credit

Units 1, 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 and its sources

The economy of Kestrel is in long-run equilibrium. Its government then adopts a permanent investment tax credit, which lowers the taxes firms pay when they buy new machinery, equipment, and factories. The table shows data for Kestrel in the year the tax credit began (Year 1) and four years later (Year 5).

Table 1. Real GDP and workers in Kestrel

Year	Real GDP (billions of dollars)	Number of workers (millions)
Year 1	900	30
Year 5	1,080	32

Source: Hypothetical data

Suggested time: 25 minutes

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Part (a)

2 points

Describe a correctly labeled graph of the loanable funds market in Kestrel, and show the effect of the investment tax credit on the real interest rate.

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Part (b)

2 points

Describe a correctly labeled graph of aggregate demand, short-run aggregate supply, and long-run aggregate supply for Kestrel. Show the initial long-run equilibrium at PL1 and YF, and show the short-run effect of the increase in investment spending caused by the tax credit, labeling the new price level PL2 and real output Y2.

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Part (c)

1 point

Explain how the investment tax credit will affect Kestrel's long-run aggregate supply curve.

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Part (d)

2 points

Kestrel can produce two types of goods: capital goods and consumer goods. Its production possibilities curve (PPC) is bowed outward from the origin. (i) As Kestrel's firms produce more capital goods, identify the opportunity cost. (ii) Explain how choosing to produce more capital goods today will affect Kestrel's PPC in the future.

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Part (e)

1 point

Using the data in Table 1, calculate the percentage change in output per worker in Kestrel from Year 1 to Year 5. Show your work.

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Part (f)

1 point

Identify one public policy other than an investment tax credit that could increase productivity in Kestrel, and explain how it would do so.

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Part (g)

1 point

Based on the change in the real interest rate shown in part (a), will the quantity of loanable funds supplied by savers in Kestrel increase, decrease, or remain the same?

Your answer to part (g)

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