May 03 2008

## A common error – confusing the money market and market for foreign exchange

Last week AP students at Shanghai American School took their final test for the class on the last Macro unit, “International Economics”. The free response question on this test was from Form B of the 2007 exam, which is written for students who take the exam outside of the United States.

Upon grading my students’ tests, I was surprised to see how poorly students did on the FRQ. The most common mistake was confusing the money market with the market for foreign currency. Read below to see the original question, along with my comments on common mistakes and the correct answer.

2007 AP Macroeconomics FRQ #1 (form B)

Assume that Australia and New Zealand are trading partners. Australia’s economy is currently in recession.

(a) Now assume that Australia begins to recover from its recession. Using a correctly labled graph of aggregate demand and aggregate supply for New Zealand, show the impact of Australia’s rising income on each of the following in the short-run.

(i) Aggregate demand in New Zealand. Explain.

(ii) Output in New Zealand

Mr. Welker: Here is where the first common mistake was made. The question asks for an AD/AS showing New Zealand’s economy, NOT Australia’s. As incomes in Australia rise, Aussies will demand more imports from NZ, meaning NZ’s net exports will rise, shifting NZ’s AD curve outward, increasing NZ’s output.

(b) Using a correctly labeled graph of the money market for New Zealand, show the effect of the output change in part (a)(ii) on the following.

(i) Demand for money. Explain

(ii) The nominal interest rate

Mr. Welker: This is the question that almost everyone screwed up on. The most common mistake was confusing NZ’s money market with the foreign exchange market for NZ’s currency. The money market, which the question is asking for, refers to the the money in circulation in New Zealand, the supply of which is determined by NZ’s central bank, the demand for which is determined by the amount of output in NZ and the public’s desire to hold money as an asset. As output increases in NZ due to higher net exports, demand for money will shift out, and if you recall the Y-axis in a money market shows the nominal interest rate, so nominal interest rates will increase as money demand shifts out.

The mistake most people made was misinterpreting the question to be asking about the foreign exchange market for NZ dollars. This market would show the price of NZ dollars in terms of Australian dollars on the Y-axes, the demand for NZ\$ by Australians, and the supply of dollars by New Zealanders. This is not what the question is asking for, however, many of you included this diagram, which does not show the nominal interest rate.

(c) Assume that the price level in New Zealand rises. Given your answer to part (b)(ii), explain what will happen to real interest rates.

Mr. Welker: Here’s another question that most people messed up on. The answer is that as nominal interest rates rise while the price level is rising, we don’t know what will happen to real interest rates! Remember, real interest rate = nominal interest rate – inflation rate. Whether real interest rates rise or fall depends on the degree to which nominal interest rates and inflation rise. Therefore, the real interest rate cannot be determined.

(d) Although recovering, Australia remains in recession and its government takes no action. Indicate whether each of the following curves will shift to the left, shift to the right, or remain unchanged in the long run in Australia.

(i) Aggregate supply

(ii) Aggregate demand

Mr. Welker: I was truly shocked to see how many people got this one totally wrong. In fact, I suspect about half of you just guessed on this one, which was a surprise to me because this was something we had emphasized heavily in our class discussions; in fact you had even seen a very similar question in an FRQ a couple of units ago.

The key to knowing what this question is getting at is the phrase “its government takes no action.” This must, therefore, be referring to a “self-correction” scenario, which is based on the neo-classical theory of a vertical long-run aggregate supply curve, made possible by the downward flexibility of wages and prices.

If Australia remains in a recession, high levels of unemployment and low levels of overall spending will put downward pressure on wages and prices. As price levels fall and large number of workers are unemployed, people will begin accepting lower wages, which means input costs for firms will decrease, inducing firms to hire more workers, shifting short-run aggregate supply and output back towards the full-employment level. Since the question makes no mention of any new spending (implied by the “government takes no action” statement, meaning no fiscal or monetary stimulus is employed), there is no impact on aggregate demand.

The question simply says “indicate”, therefore the correct answers are:

(i) Aggregate supply will shift right

(ii) Aggregate demand will remain unchanged

The mistakes made on this FRQ are fairly common and simple mistakes. But this final macro test should serve as a wakeup call to some of you who may have coasted through the last few units. Macroeconomics is the harder of the two AP subjects. Last year’s classes averages .42 points lower on the macro AP exam than the micro, despite having completed Macro more recently.

Over the next 12 days, AP Econ students all over the world need to focus on their review and studies for the AP exams. To help you, I’ve put all of our review materials onto one page here on the blog. Click on the tab at the top of this page that says “Exam Prep”, and there you will find downloadable .pdf study guides for every unit in the course, as well as links to each unit’s wiki over at Welker’s Wikinomics Page. New on the wiki is a “graph bank” containing all of the graphs we’ve learned this year. As part of your exam review, please add titles and descriptions to these graphs by May 8.

• ## Order Welker’s books

for IB Economics

for AP Macro