Long free-response question

A trading partner's recession

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

Marisco and Velland are trading partners with a flexible exchange rate. Marisco's currency is the mar (MAR), and Velland's currency is the vell (VEL). Marisco is initially in long-run equilibrium. Then Velland, Marisco's largest export market, enters a severe recession, and incomes in Velland fall sharply.

Suggested time: 25 minutes

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Part (a)

2 points

Describe a correctly labeled graph of the foreign exchange market for the mar, and show the effect of the recession in Velland on the international value of the mar.

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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 Marisco. Show the initial long-run equilibrium at PL1 and YF, and show the short-run effect of the fall in Marisco's exports to Velland, labeling the new price level PL2 and real output Y2.

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Part (c)

1 point

Based only on the fall in Marisco's exports, will Marisco's current account balance increase, decrease, or remain the same?

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Part (d)

1 point

Marisco's recessionary gap is 300 million mars, and its marginal propensity to consume is 0.8. The government decides to cut taxes to close the gap. Calculate the minimum tax cut needed. Show your work.

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Part (e)

1 point

Would the minimum increase in government purchases needed to close the same gap be larger than, smaller than, or the same as the tax cut in part (d)? Explain.

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Part (f)

1 point

The government borrows to pay for the tax cut. Based on this borrowing, will the real interest rate in Marisco increase, decrease, or remain the same? Explain.

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Part (g)

1 point

Based on the change in the real interest rate in part (f), will the international value of the mar increase, decrease, or remain the same? Explain.

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Part (h)

1 point

Based only on the tax cut, will Marisco's unemployment rate increase, decrease, or remain the same in the short run?

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