Tackle the Test: Free-Response Questions

1. Question

   
   

   1. How would a decrease in real income in the United States affect the U.S. current account balance? Explain.

      
      
   
   

   2. Suppose China financed a huge program of infrastructure spending by borrowing. How would this borrowing affect the U.S. balance of payments? Explain.

      
      
   
   

   Rubric for FRQ 1 (4 points)

   1 point: The current account balance would increase (or move toward a surplus).

   1 point: The decrease in income would cause imports to decrease.

   1 point: The increase in infrastructure spending in China would reduce the surplus in the U.S. financial account and reduce the deficit in the U.S. current account.

   1 point: Because China is financing the program by borrowing, the demand for loanable funds in China would increase, causing an increase in the interest rate. It is likely that other countries would increase their lending to China, decreasing their lending to the United States. These capital outflows from the United States would reduce the U.S. surplus in the financial account and reduce the deficit in the current account.

2. Question

   Use two correctly labeled side-by-side graphs of the loanable funds market in the United States and China to show how a higher interest rate in the United States will lead to capital flows between the two countries. On your graphs, be sure to label the equilibrium interest rate in each country in the absence of international capital flows, the international equilibrium interest rate, and the size of the capital inflows and outflows. (6 points)

   Rubric for FRQ 2 (6 points)

   1 point: Two graphs with “Interest rate” on the vertical axes and “Quantity of loanable funds” on the horizontal axes

   1 point: An upward-sloping supply curve and a downward-sloping demand curve on each graph

   1 point: Starting equilibrium interest rates labeled on each graph, with the rate in the United States higher than that in China

   1 point: The same ending or “International equilibrium” interest rate labeled on both graphs

   1 point: Indication of the correct capital inflow to the United States, as shown on the graph

   1 point: Indication of the correct capital outflow from China, as shown on the graph