Free Response 2015

Scoring Guidelines 2015

Question 1 (d)

  • Spending Multiplier

    • Minimum required change in government spending = Value of recessionary gap / Spending Multiplier

    A Formula for the Spending Multiplier The formula for the multiplier
is: Multiplier = 1/(1 - MPC) An important number in this formula is
the marginal propensity to consume (MPC). — It is the fraction of
extra income that a household consumes rather than saves. If the MPC
is 3/4, then the multiplier will be: Multiplier = 1/(1 - 3/4) = 4 In
this case, a $20 billion increase in government spending generates $80
billion of increased demand for goods and services.

  • The minimum required change in taxes will be greater than the minimum required change in government spending.

  • The tax multiplier (mpc/mps = 0.8/0.2 = 4) is smaller than the government spending multiplier (1/mps = 1/0.2 = 5) because part of the initial increase in disposable income caused by the decrease in income tax will be saved rather than spent.

Question 1 (e)

  • Lower income tax rate --> More disposable income --> More consumption and investment --> Increase in Aggregate Demand

Question 3 (a)

  • Foreign exchange market for the euro


  • The supply of Euro in the foreign exchange market will increase because when real interest rates in Japan increased, people with euros will want to invest in Japan's financial assets because they will see a high return.

  • To purchase Japan's financial assets, they will demand yen from the foreign exchange market, leaving behind euro.

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