AP® Macroeconomics · Free response

Limited reserves and an inflationary gap: an open market operation, the money market, bonds and unemployment

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

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The question

Name: ______________________   Date: ____________   Limited reserves and an inflationary gap: an open market operation, the money market, bonds and unemployment (10 points)

The invented country of Varne is producing above full-employment output, and its price level is rising. Varne's central bank operates with limited reserves.

  1. (A) Identify the open market operation the central bank should use to close the gap. [1 point]

  2. (B) Draw a correctly labeled graph of the money market and show the effect of the open market operation you identified in part A on the nominal interest rate. [3 points]

  3. (C) Explain what happens to the prices of existing bonds in Varne because of the open market operation. [1 point]

  4. (D) Explain how the change in the nominal interest rate you showed in part B affects aggregate demand in Varne. [2 points]

  5. (E) Based on your answer to part D, identify what happens to unemployment in Varne in the short run. [1 point]

  6. (F(i)) The required reserve ratio in Varne is 0.1. Calculate the money multiplier. Show your work. [1 point]

  7. (F(ii)) The central bank sells $50 million of bonds to commercial banks. Calculate the maximum change in the money supply. Show your work. [1 point]