Long free-response question

Recession with ample reserves

Units 3, 4 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 Corvania is in short-run equilibrium. Corvania's banking system has ample reserves. Corvania trades with other countries under a flexible exchange rate, and financial capital moves freely across its borders. Corvania's currency is the corva.

Table 1. Data for Corvania

Measure	Value
Current real GDP	$1,600 billion
Full-employment real GDP	$1,800 billion
Marginal propensity to consume (MPC)	0.8

Source: Hypothetical data

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

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Part (b)

1 point

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

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Part (c)

1 point

Explain why the total increase in real GDP is larger than the initial increase in government spending.

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Part (d)

1 point

Suppose instead that Corvania's central bank acts to close the output gap. Identify a specific action the central bank would take with its administered interest rates.

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Part (e)

2 points

Describe a correctly labeled graph of the market for reserves in Corvania, and show the effect of the action you identified in part (d) on the policy rate.

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Part (f)

1 point

Based on the change in the policy rate shown in part (e), will the international value of the corva increase, decrease, or remain the same? Explain.

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Part (g)

1 point

Based on the change in the value of the corva in part (f), will Corvania's net exports increase, decrease, or remain the same? Explain.

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Part (h)

1 point

Based on the change in the policy rate shown in part (e), will consumer spending on interest-sensitive goods in Corvania, such as cars and appliances bought on credit, increase, decrease, or remain the same?

Your answer to part (h)

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