AP® Macroeconomics · Free response

Higher real interest rates in Arland: loanable funds, capital flows, the currency and net exports

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: ____________   Higher real interest rates in Arland: loanable funds, capital flows, the currency and net exports (10 points)

Arland and Belvia are invented countries that trade with each other, and savers in each can buy assets in the other. Arland's currency is the arl and Belvia's is the bel. Both economies begin in long-run equilibrium. Arland's government increases its spending and pays for it by borrowing, which raises its budget deficit.

  1. (A) Draw a correctly labeled graph of the loanable funds market in Arland and show the effect of the increase in government borrowing on the real interest rate in Arland. [3 points]

  2. (B(i)) Based on your answer to part (A), and assuming Belvia's real interest rate does not change, will financial capital flow into Arland or out of Arland? [1 point]

  3. (B(ii)) Explain your answer to part (B)(i). [1 point]

  4. (C) Draw a correctly labeled graph of the foreign exchange market for the arl and show the effect of the change you identified in part (B)(i) on the international value of the arl. [3 points]

  5. (D) Given the change in the value of the arl in part (C), will Arland's net exports increase, decrease or stay the same? Explain. [1 point]

  6. (E) What happens to the balance of Arland's capital and financial account as a result of the financial capital flow in part (B)(i)? [1 point]