Long free-response question

Faster money growth

Units 2, 4, 5 and 6
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 Oranto is in long-run equilibrium with an unemployment rate of 5 percent, which is its natural rate, and an inflation rate of 2 percent that people have come to expect. The table shows data for Oranto. Oranto's central bank then begins increasing the money supply much faster than before.

Table 1. Data for Oranto

Measure	Value
Money supply	$400 billion
Velocity of money	5
Real GDP (base-year dollars)	$2,000 billion

Source: Hypothetical data

Suggested time: 25 minutes

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Part (a)

1 point

Using the equation of exchange, calculate Oranto's nominal GDP. Show your work.

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Part (b)

1 point

Over the next year, Oranto's money supply increases by 10 percent. Velocity does not change, and real GDP stays at $2,000 billion. Calculate the percentage change in Oranto's price level. Show your work.

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Part (c)

2 points

Describe a correctly labeled graph of the short-run and long-run Phillips curves for Oranto. Plot the initial long-run equilibrium as point A using the numbers given. Then show the short-run effect of the faster, unexpected money growth, labeling the new point B.

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Part (d)

1 point

Explain what will happen to Oranto's short-run Phillips curve in the long run if the faster money growth continues.

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Part (e)

1 point

Before the money growth began, a saver put money in a one-year deposit at a fixed nominal interest rate of 4 percent. The actual inflation rate over that year turns out to be 10 percent. Calculate the real interest rate the saver earned. Show your work.

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Part (f)

1 point

Identify the function of money that high inflation weakens most directly, and explain why.

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Part (g)

1 point

Assume the price levels of Oranto's trading partners do not change. Based on the higher price level in Oranto, will the international value of Oranto's currency increase, decrease, or remain the same? Explain.

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Part (h)

1 point

Lenders in Oranto now expect inflation of 10 percent per year and want to earn a real interest rate of 3 percent. Calculate the nominal interest rate they will charge on new loans.

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Part (i)

1 point

Suppose the faster money growth continues for many years. In the long run, will Oranto's real GDP be higher than, lower than, or the same as it would have been without the faster money growth? Explain.

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