Macroeconomics · Hard · 20 marks
EO past paper: 2026 International Final, Macroeconomics paper
Econoland's Green Growth Dilemma (20 points)
Econoland is a small open economy with a floating exchange rate experiencing a mild recession and stable prices. To combat climate change and stimulate economic growth during an election year, the government simultaneously imposes a per-unit carbon tax on high-emission producers, increasing firms' production costs, and increases government spending on environmentally friendly infrastructure. Assume that the increase in government spending exceeds the revenue generated by the carbon tax, causing the government's budget deficit and public debt to increase.
(a) Part A: Using a single, correctly labeled AD-AS diagram that includes the short-run aggregate supply (SRAS), long-run aggregate supply (LRAS), and aggregate demand (AD) curves, analyze the combined short-run effects of the two policies on the price level and real output.
Identify the new short-run equilibrium and explain how the two policies interact. (Type your answer: describe the diagram in words, naming the axes, curves, shifts and areas.) [5] marks (b) Part B: Assume for this part only, place Econoland at its long-run equilibrium before the two policies are implemented and that the carbon tax affects only short-run production costs. The policies do not affect the economy's long-run productive capacity.
If the contractionary effect of the carbon tax is greater than the expansionary effect of the increase in government spending, illustrate and describe the long-run adjustment process using a correctly labeled AD-AS diagram.
Show the final long-run equilibrium and explain the effects on the price level and real output. (Type your answer: describe the diagram in words, naming the axes, curves, shifts and areas.) [4] marks (c) Part C: Assume that the increase in government spending exceeds the revenue collected from the carbon tax, causing the government budget deficit to increase. Assuming private saving remains unchanged, (i) describe what happens to national saving. Then, using the loanable funds and foreign exchange market framework for a small open economy, explain the resulting effects on the (ii) domestic real interest rate, (iii) net capital outflow, (iv) the foreign exchange market, (v) the exchange rate, and (vi) net exports.
Answer (i): describe what happens to national saving. [2] marks (d) Continue Part C. Answer (ii): explain the effect on the domestic real interest rate. [2] marks (e) Continue Part C. Answer (iii): explain the effect on net capital outflow. [2] marks (f) Continue Part C. Answer (iv): explain the effect on the foreign exchange market. [2] marks (g) Continue Part C. Answer (v): explain the effect on the exchange rate. [1] mark (h) Continue Part C. Answer (vi): explain the effect on net exports. [2] marks
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