Review Questions

1. Review Questions AP Economics Mr. Bordelon

2. Question 1 • Keynesland is facing an inflationary gap. Y1 is greater than YP. • Keynesland should use contractionary fiscal policy to return to LRE/YP. These policies would include decreasing government purchases of g/s, decreasing government transfers, and increasing taxes. • Graph should look something like this:

3. Question 2 • Miltonia is facing a recessionary gap. Y1 is less than YP. • Miltonia should use expansionary fiscal policy to return to LRE/YP. These policies include increasing government purchases of g/s, increasing government transfers, and decreasing taxes. • Graph should look something like this:

4. Question 3 • When the stock market is booming, value of stocks increases, which would cause an increase in consumer spending. This shifts AD to the right. Economy will have an inflationary gap. Economists should use contractionary fiscal policies to return the economy to LRE/YP. This would shift AD to the left. • Firms would decrease investment spending. AD shifts left and the economy has a recessionary gap. Economists should use expansionary fiscal policies to return the economy to LRE/YP. This would shift AD to the right. • If government increases purchases, AD shifts right. Economy has an inflationary gap. Economists should use contractionary fiscal policies to return to LRE/YP. Government could decrease spending and transfers, or increase taxes. AD shifts left. • Once interest rates increase, investment spending decreases, AD shifts left. Economy faces a recessionary gap. Economists should use expansionary fiscal policies to return to LRE/YP. AD shifts right.

5. Question 4 • Recessionary gap; real GDP is less than YP. Spending multiplier is 1/(1 – 0.75) = 4. Increase in government purchases of $15 billion will increase real GDP by $60 billion and close recessionary gap. For government transfers, taking into account taxes, 0.75/(1 – 0.75) = $3. Government should increase transfer by $20 billion to close recessionary gap. • Inflationary gap; real GDP is higher than YP. Spending multiplier is 1/(1 – 0.5) = 2. Decrease in government purchases would reduce real GDP by $50 billion and close inflationary gap. For government transfers, 0.5/(1 – 0.5) = 1. Government should decrease transfers by $50 billion to close the inflationary gap. • Inflationary gap; real GDP is higher than YP. Spending multiplier is 1/(1 – 0.8) = 5. Decrease in government purchases of $16 billion reduces real GDP by $80 billion and close inflationary gap. For government transfers, 0.8/(1 – 0.8) = 4. Government should decrease transfers by $20 billion to close the inflationary gap.

6. Question 5 • An increase in both LRAS and SRAS, coupled with an increase in AD can show how real GDP grew with little if any increase in APL. Increases in productivity due to increasing use of information technology could have shifted LRAS and SRAS. As stock value increased, consumer spending increased and thus so did AD to the right. • In short, the 90s were booming, jack.

7. Question 6 • Because of the oil shock, SRAS shifts left, decreasing real GDP to Y2. Unemployment increases and APL increases. This is known as stagflation—high unemployment and high inflation. • Government can use fiscal and monetary policies (focus on that one later) to increase real GDP or lower inflation, but not both.Somebody’s gonna get hurt.If government increasesspending, decreases taxes,or increases money supply,real GDP increases,but so does inflation.

8. Question 6 continued • If government decreases spending, increases taxes, or decreases money supply, APL decreases, but so does real GDP. This can make the inflationary gap worse, not to mention increasing unemployment. • Governments can’t usefiscal and monetary policyto fix stagflation problems—inflation and unemployment—at thesame time. It’s a Faustianbargain. Government has to choose which problem to fix first at the expense of the other.

9. Question 7 a. Increasing taxes will decrease consumer spending. AD shifts to the left. In the short run, all nominal wages are sticky, and the economy will end up in short run equilibrium (SRE). APL ends up lower than the original equilibrium, and aggregate output is lower than YP. Recessionary gap. Once contracts are renegotiated, however, nominal wagesdecline and SRAS shifts rightuntil back into LRE. Once atLRE, economy is back at YP,but at a lower APL.

10. Question 7 continued b. Increasing the money supply encourages saving and lending. Interest rates drop and this increases investment and consumer spending. For APL, aggregate output demanded increases. AD shifts right. In the short run, nominal wages are sticky, and economy goes to SRE. APL is higher than the original equilibrium, and aggregateoutput is higher than YP.Inflationary gap. Oncecontracts are renegotiated,nominal wages will increaseand SRAS shifts to the left toLRE. Once at LRE, economy isback at YP, but at a higher APL.

11. Question 7 continued • Increasing government spending will increase AD. For APL, quantity of aggregate output will be higher. AD will shift right. In the short run, nominal wages are sticky, and the economy will be in SRE. APL is higher than original equilibrium, and aggregate output is higher than YP.Inflationary gap. Oncecontracts are renegotiated,nominal wages willincrease and SRAS will shiftleft until LRE is met. OnceLRE is met, economy isback at YP but at ahigher APL.

12. Question 8 a. The decline in household wealth reduces consumer spending. AD will shift left. In the short run, nominal wages are sticky, and economy will end up at SRE. APL will be lower than original equilibrium, aggregate output will be lower than YP. Recessionary gap. Once contracts are renegotiated,nominal wages decreaseand SRAS shifts to the rightuntil back at LRE. Once atLRE, economy is back at YP,but lower APL.

13. Question 8 continued b. Increasing disposable income increases consumer spending. AD shifts right. In the short run, nominal wages are sticky, and economy is in SRE. APL is higher than at original equilibrium, and aggregate output is higher than YP. Inflationary gap. Once contracts are renegotiated, nominal wages increase and SRAS shifts left until LRE. At LRE, economyis back at YP, but at ahigher APL.

14. Question 9 • When labor productivity increases, production costs decrease and profit per unit increases. Producers will increase aggregate output. SRAS shifts right. APL decreases and real GDP increases in short run.

15. Question 10 • This should be the graph you draw:

16. Question 10 continued b. An increase in the price of oil causes a supply shock in some form. SRAS shifts left. Economy ends up at a SRE with a higher APL and lower real GDP (stagflation).

17. Question 10 continued • Decrease in home prices causes a demand shock due to the wealth effect. AD shifts left. APL is either above, below or equal to original price level (we don’t know which shift is bigger between AD and SRAS). Real GDP is below original equilibrium. • APL is indeterminate.In this diagram, P1 andP2 are at the same levelbecause the negativesupply and demandshocks have the sameoffsetting price effect.Prices could either riseor fall when both anegative supply anddemand shock happen.Decrease in real GDP canbe known because the twoshocks reinforce their negativeeffects on GDP.

18. FRQ Coaching • Answer the question asked. And only the question asked. Remember the question I asked Tyler, “Do you know what time it is?” The answer to that question is not “It’s 3:30.” It is either “Yes” or “No”. • Answer in complete sentences. Do not speak to either me or your reader like you’re barking at them. “Recessionary gap.” Wrong. “This is a recessionary gap.” Right. • Be authoritative. Even when unsure, be confident. THIS is the right answer. Dare your reader to find you wrong. • Label your graphs. Acronyms are fine and are expected. Missing even one label on a graph is unacceptable. • Get the graphs right. If you get the graphs right, more often than not, your remaining answers will be based on reading the graphs. No outside knowledge necessary. • Show your work. If there’s a question asking for math, you better show it. It’s not enough to say that the MPC is 0.75 and therefore the spending multiplier is 4. Write out the equation. Input the math step-by-step. • Relax. You have 20 minutes for this first one. It’s more than enough time. You will find that you even finish earlier than 20 minutes, maybe well within the 12 minutes we will practice for. That’s not necessarily a bad thing. • Do not worry for mistaken answers. The AP Economics exams reward for consistency. If you make a mistake in your first part, and it carries through to the rest, you can and will earn points if the rest of your answers are consistently correct with the initial wrong point. • Explaining answers. AP Economics questions are about objectivity. You can justify your answers with specific objective answers. DO NOT go off into typical social studies subjectivity wonderland. It is an indication to your reader that you don’t know what’s going on. This is not a guessing game. • Do not simply raise your hands in the air and give up. If you’ve studied, there’s at least one point you can answer on these questions.