Macroeconomics Final Exam Review – Step-by-Step Study Guidance

Q1. In 2009, the Federal Reserve began a policy known as quantitative easing. The basic idea was to purchase assets from banks to increase asset prices and lower the interest rate on these assets, thereby improving banks' financial standing.

Part a: Display graphically and verbally how this policy impacts the money market. What happens to the short-term interest rate?

Background

Topic: Monetary Policy – Money Market

This question tests your understanding of how expansionary monetary policy (quantitative easing) affects the money market, specifically the supply of money and short-term interest rates.

Key Terms and Formulas:

• Money Supply ($M_s$): The total amount of money available in the economy.

• Money Demand ($M_d$): The desire to hold cash balances for transactions and precautionary purposes.

• Interest Rate ($r$): The cost of borrowing money, determined in the money market.

Step-by-Step Guidance

1. Recognize that when the Federal Reserve purchases assets, it increases the reserves of banks, which increases the overall money supply ($M_s$) in the economy.

2. Graphically, this is shown as a rightward shift of the money supply curve in the money market diagram (vertical $M_s$ line shifts right).

3. With the money demand ($M_d$) curve unchanged, the intersection point with the new $M_s$ curve determines a new, lower equilibrium interest rate ($r$).

4. Verbally, explain that an increase in the money supply leads to a surplus of money at the original interest rate, causing the interest rate to fall until a new equilibrium is reached.

Try solving on your own before revealing the answer!

Final Answer (Part a):

The policy increases the money supply, shifting $M_s$ to the right, which lowers the short-term interest rate in the money market.

This is shown graphically as a rightward shift of the vertical $M_s$ curve, resulting in a lower equilibrium interest rate where $M_s$ and $M_d$ intersect.

Part b: Display graphically and verbally how this policy impacts the bond market. What happens to the price of bonds?

Background

Topic: Monetary Policy – Bond Market

This part examines how expansionary monetary policy affects the bond market, specifically the relationship between bond prices and interest rates.

Key Terms and Formulas:

• Bonds: Debt securities issued by governments or corporations to raise funds.

• Bond Price and Interest Rate Relationship: Bond prices and interest rates move inversely.

• Bond Demand ($B_d$) and Bond Supply ($B_s$): The market for bonds is determined by the interaction of these curves.

Step-by-Step Guidance

1. When the Fed buys assets (including bonds), it increases demand for bonds ($B_d$), shifting the demand curve to the right.

2. Graphically, this is shown as a rightward shift of the bond demand curve, leading to a higher equilibrium bond price ($P_b$).

3. As bond prices rise, the yield (interest rate) on bonds falls, due to their inverse relationship.

4. Verbally, explain that increased demand for bonds (from the Fed's purchases) raises bond prices and lowers interest rates.

Try solving on your own before revealing the answer!

Final Answer (Part b):

The policy increases the demand for bonds, shifting $B_d$ to the right, which raises the price of bonds and lowers their yield (interest rate).

This is shown graphically as a rightward shift in the bond demand curve, resulting in a higher equilibrium bond price.

Part c: Display graphically and verbally how this policy and the previous two graphs impact the economy overall. What happens to the price level and output level in the economy as a result of this policy?

Background

Topic: Aggregate Demand and Aggregate Supply (AD-AS) Model

This part tests your understanding of how monetary policy affects the overall economy, specifically the price level and real GDP, using the AD-AS framework.

Key Terms and Formulas:

• Aggregate Demand (AD): The total demand for goods and services in the economy at different price levels.

• Aggregate Supply (AS): The total supply of goods and services at different price levels.

• Expansionary Monetary Policy: Policy that increases the money supply, lowers interest rates, and stimulates investment and consumption.

Step-by-Step Guidance

1. Lower interest rates (from Parts a and b) make borrowing cheaper, encouraging investment and consumption, which are components of aggregate demand ($AD$).

2. Graphically, this is shown as a rightward shift of the $AD$ curve in the AD-AS model.

3. The new intersection of $AD$ and short-run aggregate supply ($SRAS$) determines the new equilibrium price level ($PL$) and output ($Y$).

4. Verbally, explain that expansionary monetary policy increases output and the price level in the short run.

Try solving on your own before revealing the answer!

Final Answer (Part c):

The policy shifts the $AD$ curve to the right, resulting in a higher equilibrium price level and higher output (real GDP) in the short run.

This is shown graphically as a rightward shift of $AD$, leading to new, higher equilibrium values for $PL$ and $Y$.

Q2. In 1937, President Roosevelt increased taxes to balance the federal budget. This policy has been criticized for prolonging the Great Depression.

Part a: What are the direct impacts of this policy on U.S. GDP levels? Which component of GDP is directly impacted as a result of these tax increases?

Background

Topic: Fiscal Policy – GDP Components

This question tests your understanding of how changes in taxes affect GDP and its components, especially consumption.

Key Terms and Formulas:

• GDP Formula: $GDP = C + I + G + (X - M)$

• Consumption ($C$): Spending by households on goods and services.

• Fiscal Policy: Government decisions on taxation and spending.

Step-by-Step Guidance

1. Recognize that increasing taxes reduces disposable income for households.

2. Lower disposable income leads to a decrease in consumption ($C$), which is a direct component of GDP.

3. As consumption falls, aggregate demand decreases, leading to a lower equilibrium GDP.

Try solving on your own before revealing the answer!

Final Answer (Part a):

The direct impact is a decrease in GDP, primarily through a reduction in the consumption component ($C$) of GDP.

Higher taxes reduce disposable income, which lowers consumption and thus GDP.

Part b: What does this act do to the government budget? (i.e., is the budget in a surplus or a deficit?)

Background

Topic: Fiscal Policy – Government Budget

This part tests your understanding of how changes in taxes affect the government budget balance.

Key Terms and Formulas:

• Government Budget = Taxes – Expenditures

• Budget Surplus: Taxes > Expenditures

• Budget Deficit: Taxes < Expenditures

Step-by-Step Guidance

1. Increasing taxes raises government revenue.

2. If expenditures remain constant, higher taxes reduce the deficit or increase the surplus.

3. Determine whether the budget moves toward surplus or a smaller deficit as a result.

Try solving on your own before revealing the answer!

Final Answer (Part b):

The act either decreases the budget deficit or increases the budget surplus, depending on the initial balance.

Higher taxes mean more government revenue relative to expenditures.

Part c: What happens to the exchange rate as a result of this act?

Background

Topic: Fiscal Policy – Exchange Rates

This part examines the effect of fiscal policy on the exchange rate, considering capital flows and interest rates.

Key Terms and Formulas:

• Exchange Rate: The value of one currency for the purpose of conversion to another.

• Interest Rate Effect: Lower interest rates can lead to currency depreciation.

Step-by-Step Guidance

1. Higher taxes reduce aggregate demand, which can lower interest rates if the government borrows less.

2. Lower interest rates make U.S. assets less attractive to foreign investors, reducing demand for the U.S. dollar.

3. This leads to a depreciation of the U.S. exchange rate, making exports cheaper and imports more expensive.

Try solving on your own before revealing the answer!

Final Answer (Part c):

The exchange rate depreciates as a result of lower interest rates, making U.S. assets less attractive to foreign investors.

This should increase exports and decrease imports.

Part d: What is the impact upon GDP in the economy of these tax increases? Explain and display graphically using the Aggregate Demand / Aggregate Supply framework.

Background

Topic: Fiscal Policy – AD-AS Model

This part tests your ability to use the AD-AS model to show the effects of contractionary fiscal policy (tax increases) on output and the price level.

Key Terms and Formulas:

• Aggregate Demand (AD): $AD = C + I + G + (X - M)$

• Aggregate Supply (AS): Total output at various price levels.

• Contractionary Fiscal Policy: Policy that reduces aggregate demand.

Step-by-Step Guidance

1. Tax increases reduce disposable income, lowering consumption and shifting the $AD$ curve to the left.

2. Graphically, this is shown as a leftward shift of the $AD$ curve in the AD-AS model.

3. The new equilibrium shows a lower price level and lower output (real GDP).

4. Verbally, explain that this can lead to recessionary pressures and higher unemployment.

Try solving on your own before revealing the answer!

Final Answer (Part d):

The $AD$ curve shifts left, resulting in lower equilibrium output and price level, which can increase unemployment and deepen a recession.

This is shown graphically as a leftward shift of $AD$ in the AD-AS model.

Q3. Refer to Table 1 to answer the following questions about market equilibrium.

Part a: What is the equilibrium price and quantity for this marketplace?

Background

Topic: Market Equilibrium – Supply and Demand

This question tests your ability to find the equilibrium price and quantity using supply and demand schedules.

Key Terms and Formulas:

• Equilibrium: The price and quantity where quantity demanded equals quantity supplied.

• From the table, match price levels to quantities demanded and supplied.

Step-by-Step Guidance

1. List the price levels and corresponding quantities demanded and supplied from the table.

2. Find the price at which quantity demanded equals quantity supplied.

3. The matching quantity at this price is the equilibrium quantity.

Try solving on your own before revealing the answer!

Final Answer (Part a):

The equilibrium price is $300 and the equilibrium quantity is 50 units.

Part b: Using the demand and supply schedules from Table 1, what is the demand and supply equation?

Background

Topic: Supply and Demand Equations

This part tests your ability to derive linear equations for demand and supply from tabular data.

Key Terms and Formulas:

• Linear Demand Equation: $P = a - bQ$

• Linear Supply Equation: $P = c + dQ$

• Use two points from the table to solve for the coefficients.

Step-by-Step Guidance

1. Choose two data points from the demand schedule and set up two equations to solve for $a$ and $b$.

2. Repeat for the supply schedule to solve for $c$ and $d$.

3. Write the final equations for demand and supply.

Try solving on your own before revealing the answer!

Final Answer (Part b):

Demand: $P = 80 - 10Q$

Supply: $P = 10Q - 200$

Part c: Demonstrate graphically the equilibrium price and quantity in the marketplace.

Background

Topic: Market Equilibrium Graph

This part tests your ability to graph supply and demand curves and identify equilibrium.

Key Terms and Formulas:

• Plot the demand and supply equations on a graph with price on the vertical axis and quantity on the horizontal axis.

• The intersection point is the equilibrium.

Step-by-Step Guidance

1. Draw the demand curve using the demand equation.

2. Draw the supply curve using the supply equation.

3. Mark the intersection point as the equilibrium price and quantity.

Try solving on your own before revealing the answer!

Final Answer (Part c):

The equilibrium is shown at the intersection of the demand and supply curves at $P = 300$, $Q = 50$.

Part d: What would you observe if the market price was $400 rather than the equilibrium price?

Background

Topic: Surplus and Shortage

This part tests your understanding of what happens when the market price is above equilibrium.

Key Terms and Formulas:

• Surplus: Quantity supplied > Quantity demanded at a given price.

Step-by-Step Guidance

1. At $P = 400$, find the quantity demanded and quantity supplied from the table.

2. Calculate the difference to determine the surplus.

Try solving on your own before revealing the answer!

Final Answer (Part d):

There would be a surplus of 20 units: quantity supplied is 60, quantity demanded is 40.

Part e: What would you observe if the market price was $200 rather than the equilibrium price?

Background

Topic: Surplus and Shortage

This part tests your understanding of what happens when the market price is below equilibrium.

Key Terms and Formulas:

• Shortage: Quantity demanded > Quantity supplied at a given price.

Step-by-Step Guidance

1. At $P = 200$, find the quantity demanded and quantity supplied from the table.

2. Calculate the difference to determine the shortage.

Try solving on your own before revealing the answer!

Final Answer (Part e):

There would be a shortage of 20 units: quantity demanded is 60, quantity supplied is 40.

Multiple Choice Questions (Selected Guidance)

Q1. The three broad types of factors of production are:

Background

Topic: Factors of Production

This question tests your knowledge of the basic inputs used to produce goods and services in an economy.

Key Terms:

• Capital: Tools, machinery, and buildings used to produce goods and services.

• Labor: Human effort used in production.

• Natural Resources: Raw materials supplied by nature.

Step-by-Step Guidance

1. Recall the standard classification of productive resources in economics.

2. Eliminate options that include financial assets or outcomes (e.g., money, profit, stocks).

3. Identify the option that lists only productive resources.

Try solving on your own before revealing the answer!

Final Answer (Q1):

a. capital, labor, and natural resources