Aim for FiveMacroeconomics

Long free-response question

Borrowing to build roads

  • Units 3, 4, 5 and 6
  • 10 points
  • About 25 minutes

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 Tessaly is in long-run equilibrium, and its government budget is balanced. The government then increases its spending on roads and bridges by $50 billion per year without changing taxes, and it borrows to pay for the extra spending. Tessaly has a flexible exchange rate, financial capital moves freely between Tessaly and its trading partners, and Tessaly's currency is the tess. Its main trading partner is Ombria, whose currency is the omb.

Suggested time: 25 minutes

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Part (a)

1 point

Based only on the increase in spending, identify the effect on Tessaly's budget balance and on its national debt.

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Part (b)

2 points

Describe a correctly labeled graph of the loanable funds market in Tessaly, and show the effect of the government's borrowing on the real interest rate.

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Part (c)

1 point

Based on the change in the real interest rate in part (b), will private investment spending in Tessaly increase, decrease, or remain the same?

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Part (d)

1 point

Based on the change in the real interest rate in part (b), will the flow of financial capital from Ombria into Tessaly increase, decrease, or remain the same? Explain.

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Part (e)

2 points

Describe a correctly labeled graph of the foreign exchange market for the tess, and show the effect of the change in capital flows in part (d) on the international value of the tess.

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Part (f)

1 point

Based on the change in the value of the tess in part (e), will Tessaly's net exports increase, decrease, or remain the same?

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Part (g)

1 point

Based only on the increase in government spending, will Tessaly's price level increase, decrease, or remain the same in the short run?

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Part (h)

1 point

Explain how the change in private investment identified in part (c), by itself, would affect Tessaly's long-run economic growth.

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