Long free-response question

Cooling an overheating economy

Units 3, 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

The economy of Brisa is in short-run equilibrium with an inflationary output gap of $90 billion. The marginal propensity to consume (MPC) in Brisa is 0.75, and the government's budget is initially balanced. Brisa has a flexible exchange rate, financial capital moves freely across its borders, and its currency is the brin.

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 Brisa. Show each of the following: (i) the current equilibrium price level and real output, labeled PL1 and Y1; (ii) the full-employment output, labeled YF.

Your answer to part (a)

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Part (b)

1 point

Brisa's government decides to change taxes to close the gap. Calculate the minimum change in taxes needed, and identify whether it is an increase or a decrease. Show your work.

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Part (c)

1 point

Based only on the tax change in part (b), will Brisa's government budget be in deficit, in surplus, or balanced?

Your answer to part (c)

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Part (d)

2 points

Describe a correctly labeled graph of the loanable funds market in Brisa, and show the effect of the budget change in part (c) on the real interest rate.

Your answer to part (d)

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Part (e)

1 point

Based on the change in the real interest rate in part (d), will the inflow of financial capital into Brisa increase, decrease, or remain the same? Explain.

Your answer to part (e)

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Part (f)

1 point

Based on the change in capital flows in part (e), will the international value of the brin increase, decrease, or remain the same?

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Part (g)

1 point

Based on the change in the real interest rate in part (d), explain the effect on Brisa's long-run economic growth.

Your answer to part (g)

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Part (h)

1 point

Based only on the tax change in part (b), will Brisa's unemployment rate increase, decrease, or remain the same in the short run?

Your answer to part (h)

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