AP® Macroeconomics · Free response

Ample reserves in a recession: the reserve market, investment, output and loanable funds

write it first, then score yourself point by point

Long free-response question · four-function calculator · 10 points · about 25 minutes

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The question

Name: ______________________   Date: ____________   Ample reserves in a recession: the reserve market, investment, output and loanable funds (10 points)

The invented country of Ostra is in a recession: real GDP is below full-employment output. Ostra's central bank operates with ample reserves.

  1. (A) Identify the change the central bank should make to its administered interest rates to close the gap. [1 point]

  2. (B) Draw a correctly labeled graph of the market for reserves and show the effect of the action you identified in part A on the policy rate. [3 points]

  3. (C) Explain how the change in the policy rate you showed in part B affects investment spending in Ostra. [1 point]

  4. (D) Based on your answer to part C, identify the short-run effect on each of the following in Ostra: (i) real output; (ii) the price level. [2 points]

  5. (E(i)) Suppose instead that Ostra's government uses expansionary fiscal policy: it raises government spending and borrows to pay for it. Draw a correctly labeled graph of the loanable funds market and show the effect of the government borrowing on the real interest rate. [2 points]

  6. (E(ii)) Based on your answer to part E(i), explain how the change in the real interest rate affects private investment in Ostra. [1 point]