Short free-response question

Two policies at once

Units 3, 4 and 5
5 points
About 12 minutes

A shorter question on one or two models, often with data in a table. You might calculate something like an unemployment rate, real GDP or the spending change needed to close a gap, draw a labeled graph (described in words on this site), and explain an effect. On the exam: Questions 2 and 3 of 3 in Section II; each is worth a quarter of the section score, with about 12 minutes suggested for each. A four-function calculator is allowed.

The question

The economy of Tarn is in short-run equilibrium with a recessionary output gap. Tarn's banking system has limited reserves. At the same time, Tarn's government increases its spending and borrows to pay for it, and Tarn's central bank buys government bonds on the open market.

Suggested time: 12 minutes

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Part (a)

1 point

Based only on the government's borrowing, will the real interest rate in Tarn's loanable funds market increase, decrease, or remain the same?

Your answer to part (a)

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Part (b)

1 point

Based only on the central bank's bond purchase, will the nominal interest rate in Tarn's money market increase, decrease, or remain the same?

Your answer to part (b)

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Part (c)

1 point

With both policies in effect, can you determine the direction of the change in Tarn's real GDP in the short run? If so, state it. Explain.

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Part (d)

1 point

With both policies in effect, can you determine the direction of the change in Tarn's interest rates? Explain.

Your answer to part (d)

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Part (e)

1 point

Explain how the central bank's bond purchase could reduce the crowding out caused by the government's borrowing.

Your answer to part (e)

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