BU1003 Study Guide - Final Guide: Real Interest Rate, Loanable Funds, Disinflation
Eco 202 Name_______________________________
Final Exam Key 10 May 2004
150 points. Please write answers in ink. Allocate your time efficiently. Good luck.
1. Suppose that Congress passes an investment tax credit, which subsidizes domestic
investment. How does this policy affect national saving, domestic investment, net capital
outflow, the interest rate, the exchange rate, and the trade balance. Please explain and illustrate
your answer with a graph.
If Congress passes an investment tax credit, it subsidizes domestic investment. The desire to
increase domestic investment leads firms to borrow more, increasing the demand for loanable
funds, as shown in figure below. This raises the real interest rate, thus reducing net capital
outflow. The decline in net capital outflow reduces the supply of dollars in the market for
foreign exchange, raising the real exchange rate. The trade balance also declines, since net
capital outflow, hence net exports, are lower. The higher real interest rate also increases the
quantity of national saving. In summary, saving increases, domestic investment increases, net
capital outflow declines, the real interest rate increases, the real exchange rate increases, and the
trade balance decreases.
2. Illustrate the classical analysis of growth and inflation with aggregate demand and long-run
aggregate supply curves. What factors cause the long-run economic growth? What factors give
rise to the inflation? How would your graph differ if we experienced economic growth but with
falling prices over the long run?
Over time, technological advances cause the long-run aggregate supply curve to shift right. Increases in
the money supply cause the aggregate demand curve to shift right. Output growth puts downward
pressure on the price level, but money supply growth contributes to rising prices.
Economic growth with falling prices implies that the LRAS schedule shifts rightward relative to AD.
This would occur if money supply growth was slower than economic growth, as occurred in the late 19th
century in the United States.
3. In the 1970s people had become accustomed to high inflation. In 1979, the Fed decided to
fight inflation and decreased the money supply growth rates. Many people thought that the Fed’s
action would cause a recession. Is this thinking consistent with the aggregate demand and supply
model? Explain. According to the monetary misperceptions theory what should have happened
to output if the inflation fell more than people expected? Explain.
The decrease in the money supply would shift aggregate demand to the left causing prices to fall, but also
causing output to fall. So, the aggregate demand and aggregate supply model does suggest the Fed's
actions could have created a recession.
According to the price misperceptions theory, if prices fall more (or rise less) than people expect, they
will think the price of what they sell has fallen relative to the price of other goods and decrease
production. This provides one explanation for the upward sloping aggregate supply curve.
To the extent that people expected inflation to fall, the aggregate supply curve should have shifted right.
This would have offset some of the recessionary impact of the money supply decrease.
4. Recently, some members of Congress have proposed a law that would make price stability
the sole goal of monetary policy. Suppose such a law were passed.
a. How would the Fed respond to an event that contracted aggregate demand, such as the
attack on 11 September 2001?
b. How would the Fed respond to an event that caused an adverse (negative) shock to short-
run aggregate supply?
a. If there were a contraction in aggregate demand, the Fed would need to increase the money
supply to increase aggregate demand and stabilize the price level, as shown in the figure below.
Document Summary
Good luck: suppose that congress passes an investment tax credit, which subsidizes domestic investment. How does this policy affect national saving, domestic investment, net capital outflow, the interest rate, the exchange rate, and the trade balance. Please explain and illustrate your answer with a graph. If congress passes an investment tax credit, it subsidizes domestic investment. The desire to increase domestic investment leads firms to borrow more, increasing the demand for loanable funds, as shown in figure below. This raises the real interest rate, thus reducing net capital outflow. The decline in net capital outflow reduces the supply of dollars in the market for foreign exchange, raising the real exchange rate. The trade balance also declines, since net capital outflow, hence net exports, are lower. The higher real interest rate also increases the quantity of national saving. Over time, technological advances cause the long-run aggregate supply curve to shift right.
