1995 AP Macroeconomics Exam Answers 1. E  Developing a more efficient steelmaking process means productivity has increased. The only way for a production possibilities curve to shift outward is if there is a discovery of new resources or an increase in the productivity of resources. Productivity may increase as a result of a technological advancement, and improvement in the quality of labor, or an increase in the allocation of resources. 2. B  Real GDP = Nominal GDP – Inflation. Thus, 4% = 11% - Inflation. So, Inflation = 11% - 4% = 7%. 3. C  Structural unemployment is unemployment resulting from a mismatch of skills. Someone who leaves her job to move to Florida is frictionally unemployed (she is between jobs voluntarily). Someone who loses his job during a recession is cyclically unemployed (he is unemployed due to changes in the business cycle). A construction worker who is always unemployed during the winter months is seasonally unemployed. A worker who is engaged in unproductive work is employed (just not efficient). So, an autoworker who is replaced by a robot is structurally unemployed since he lost his job because his skills were no longer needed. 4. B  A large increase in labor productivity would shift the aggregate supply curve to the right (AS increases since costs of production are now less). This shift of the AS curve will result in an increase in real GDP and a decline in the price level. 5. D  The spending multiplier (m) = [1 / (1 – MPC)] where MPC is the marginal propensity to consume (∆ consumption / ∆ income). Thus, if the MPC ↑, the denominator becomes smaller and, thus, the spending multiplier increases. 6. A  Aggregate demand (AD) = C + I + G + Xn. An increase in any of these components would result in an increase in aggregate demand. Therefore, if autonomous investment (the amount of investment independent of income) increases, aggregate demand would also increase. 7. B  First of all, the slope of the consumption function is (1,500 – 300) / (1,500 – 0) = 1,200 / 1,500 = 4/5. Since the MPC = 4/5, the spending multiplier (m) = 1 / (1 – 4/5) = 1 / (1/5) = 5. In addition, because the change in real GDP after government spending is 500, 500 = 5 x ∆ Government Spending. So, ∆ Government Spending = 500 / 5 = 100. 8. E  Money is created through the loaning of excess reserves by banks! 9. D  Since the reserve requirement is 20%, the money multiplier = 1 / .20 = 5. And, since excess reserves are $100, the banking system has the ability to expand the money supply by 5 x $100 = $500. 10. D  The lowering of the reserve requirement is one way for the Fed to expand (increase) the money supply. As the money supply increases, interest rate decrease, and investment spending increases. Therefore, businesses will be purchasing more factories and equipment since the cost of borrowing money (interest rate) is low. 11. E  If people decide to hold more money in the form of currency, they won’t be depositing as much in banks. This causes the banks’ excess reserves to decrease. And, thus, the banks’ wouldn’t be able to expand credit by as much simply because they expand credit through loaning out their excess reserves (which are now less).

12. C  Decreasing taxes and increasing government spending represents an expansionary fiscal policy. This would result in more consumption and, therefore, a decrease in unemployment since aggregate demand would be increasing (shifting to the right). 13. B  To cure a severe recession, the government is going to want to implement expansionary fiscal and monetary policies. Expansionary fiscal policies include decreasing taxes and/or increasing government spending. Expansionary (“easy”) monetary policies include buying securities, lowering the discount rate, or lowering the reserve requirement. 14. A  Increasing taxes and decreasing government expenditures is a contractionary fiscal policy. The result of this policy would be a decrease in consumer and government spending. This causes the aggregate demand curve to decrease (shift to the left) and unemployment to increase. 15. B  A tariff on an imported commodity, Y, will result in a reduced supply on that import and an increased demand for the domestic production of Y. Thus, the only answer that is correct is an increase in the domestic production of Y. 16. D  Specialization results in greater efficiency. So, both countries would become better off due to trade. If both were not made better off, trade would not exist! 17. C  Remember, gross domestic product for the U.S. includes all final goods and services produced within the U.S. during one year. Thus, by closing the bases overseas and relocating those operations in the U.S., we’ll actually create a positive impact on our GDP. 18. E  This is a simple AD/AS shift question. Physically do the shifts! A leftward shift of AD or AS would result in a decrease in output. 19. E  An increase in government spending or a decrease in taxes would increase aggregate demand. Therefore, the combination of a $100 increase in government spending with a $100 reduction in taxes would lead to the greatest increase in aggregate demand. 20. A  Expansionary fiscal policy consists of increasing government spending or decreasing taxes. Since changes in government spending have a direct effect, an increase in government spending would be the most effective in stimulating production. 21. D  The MPC (marginal propensity to consume) is the slope of the consumption function. If the MPC increases, the slope of the consumption line becomes steeper. In addition, the spending multiplier (m) increases since m = 1 / (1 – MPC). So, if the MPC increases, the equilibrium level of income and consumption will both increase. 22. B  If private investment of $100 is added to the economy, the consumption function simply shifts upward by $100. This results in an increase in both the equilibrium level of income and consumption. 23. C  A dollar would have no value if it could not buy anything. Thus, the real value of the dollar is determined by the amount of goods and services it can buy. 24. A  As national income increases, consumer spending also increases. In order to buy goods and services, we must have dollars. Thus, if we are spending more, we also must be demanding more dollars. 25. E

 If the AS curve is horizontal, we are in the Keynesian range and resources are underemployed. Therefore, we have the capability to increase production without having price levels rise. 26. A  Monetary policy that reinforces fiscal policy will be “easy” when expansionary fiscal policy is used and “tight” when contractionary fiscal policy is used. Therefore, the Fed should increase in money supply when government spending is increased since both of those policies are used to expand the economy. 27. B  The short-run Phillips curve shows the tradeoff between inflation and unemployment. In the shortrun, these two goals are not compatible and, therefore, there is an inverse relationship between them. So, a decrease in the inflation rate corresponds to an increase in the unemployment rate. 28. D  A simultaneous increase in inflation and unemployment is known as stagflation. Stagflation occurs when aggregate supply decreases (shifts to the left). If producers expect resource prices to rise, they will reduce production and the AS curve will decrease. 29. D  If we are importing more goods, we must be demanding foreign currencies. And, to buy foreign currencies, there has to be an increased supply of dollars. So, as the international supply of dollars increases (due to our increased level of imports), the value of the dollar will depreciate since the supply curve for dollars is shifting to the right. 30. E  Standard of living will improve if our production possibilities curve expands (since we will have more goods in general). An increase in the size of the population or labor force does not mean there are more people employed. To know that, we would have to look at the employment rate. Remember, the labor force consists of those employed and unemployed. An increase in the productivity of labor could cause the production possibilities curve to expand and, thus, improve our standard of living over time. 31. B  If productivity increases, costs per-unit of production have decreased and, therefore, firms will be willing to produce more. This results in a rightward shift (increase) of the aggregate supply curve. 32. A  The consumer price index measures the weighted prices in a market basket of 300-400 goods of the average consumer from one period to the next. 33. C  Remember, when the economy is at the full-employment level of output, there is still typically 4-6% unemployment. What is true at the full-employment level of output is that cyclical unemployment is zero. There are still other types of unemployment like frictional unemployment. 34. B  Classical economics is all about self-correcting mechanisms of the economy. Due to the selfcorrecting nature of the economy, Classical economists believe that full employment will always be maintained. And, one of the main reasons the economy can self-correct revolves around the fact that Classical economists feel prices and wages are flexible. 35. E  Government spending is one of the components of aggregate demand. Thus, if government spending decreases, aggregate demand must also decrease. 36. C  There is currently a recessionary gap of $2,600,000 - $2,500,000 = $100,000. If the MPC = 0.75, the spending multiplier (m) = 1 / (1 - .75) = 1 / .25 = 4. Therefore, to close this gap we must solve the following equation to determine by how much spending must change: $100,000 = 4 x ∆ Initial Spending. So, the ∆ Initial Spending = $100,000 / 4 = $25,000. A Keynesian would therefore recommend increasing government spending by $25,000. If the Keynesian were to decrease taxes, it

would have to be by an amount more than $25,000 since not all of the increased income would be spent (some of it would be saved). In other words, the tax reduction would have to be multiplied by the MPC to determine the actual change in consumer spending. So, we would have to solve the following equation: $100,000 = 4 x (∆ Taxes)(MPC) or $100,000 = 4 x (∆ Taxes)(0.75). Thus, ∆ Taxes = $100,000 / 3 = $33,333.33. 37. C  An inflationary gap exists when we are spending too much. Thus, we would want to implement a contractionary policy. Contractionary fiscal policies include increasing taxes and/or decreasing government spending. Contractionary monetary policies include decreasing the money supply through raising the discount rate, raising the reserve requirement, or by selling securities on the open market. 38. D  Households buy products from the income they receive for providing services to firms (labor, etc.) Firms sell products to households and buy factor services from them (labor, etc.). 39. B  Since the reserve ratio is 20%, this bank must keep 20% x $100 = $20 as required reserves. This leaves the bank with $100 - $20 = $80 as excess reserves (which it can loan out). 40. A  If the public decides to increase its holdings of currency, the excess reserves of banks decrease (and, thus, their ability to create money and the money supply decreases). If the money supply decreases (shifts to the left), interest rates will increase. 41. E  To increase investment, policymakers will want to increase the money supply since a rightward shift of the money supply results in lower interest rates and more investment. The tools the Fed has to increase the money supply include lowering the discount rate, lowering the reserve requirement, or buying (purchasing) government securities on the open market. 42. E  A decrease in aggregate demand will result from contractionary policies. Contractionary fiscal policies include decreasing government spending and/or raising taxes. Contractionary monetary policies reduce the money supply by raising the discount rate, raising the reserve requirement, or selling bonds on the open market. 43. A  Supply shocks will change both relative prices and the general price level in the economy since the aggregate supply curve shifts to the left. These supply shocks affect relative prices simply because they affect resource costs. 44. D  If unemployment and inflation are both decreasing, the aggregate supply curve must be increasing (shifting to the right). 45. B  If the demand for the dollar increases (shifts to the right), the value of the dollar will increase. As the value of the dollar increases, it costs foreigners more of their currency to buy a dollar’s worth of goods. This, in turn, causes our exports to decrease. 46. C  First, simplify to make things easy of yourself. It takes Country X 2 times as long to produce one unit of food than it does Country Y, and it takes Country X 2.5 times as long to produce one unite of clothing than it does County Y. Country Y has an absolute advantage in the production of both goods, however it only has a comparative advantage in the production of clothing. Country X will produce food simply because it takes them less time (domestic opportunity cost is lowest) as compared to its comparison of clothing production with Country Y. 47. B

 Inflation hurts savers since their money has less purchasing power once prices increase. Lenders are also hurt since they will be paid back with “cheap” dollars. Borrowers are the only group that benefits simply because they will be able to pay off their loans with “cheap” dollars. 48. E  An increase in the labor force participation rate means a greater percentage of the labor force is employed. As more and more people are employed, it becomes difficult to reduce unemployment further. 49. D  Keynesians believe that macro equilibrium can occur at less than full employment. They believe this mainly because of what happened during the Great Depression when there was a sustained period of unemployment. In addition, since they feel prices/wages are “sticky” downwards, active government intervention is often needed to correct the economy. 50. A  If an increase in total spending has no effect on real GDP, me must be along the classical range (vertical part) of the aggregate supply curve. Therefore, an increase in spending would simply result in higher prices. 51. C  Keynesians were too convinced that lower interest rates would necessarily stimulate investment. They related this idea to the fact that you can always lead a horse to water, but you can make the horse drink the water. However, Keynesians did believe that there was a direct relationship between savings/consumption and income. 52. B  An increase in the money supply would be most effective in increasing real GDP if the economy was starting to recover from a recession. Thus, if interest rates were high and we were producing at less than full employment, an increase in the money supply would result in lower interest rates. If interest rates drop and businesses are optimistic about the future, investment should increase. This, in turn, would increase real GDP since we were below the full-employment level of output. 53. E  If the government decides to decrease expenditures and tax revenues by the same amount, the end result will be a decrease in AD since the decrease in expenditures has a direct effect while the decrease in taxes has an indirect effect. Therefore, output and interest rates will decrease. 54. A  Interest rates will increase due to crowding out. But, since the crowding out only partially offsets the effects of the tax cut, consumer spending will increase by more than then decrease in investment (due to higher interest rates) and AD will increase (shift to the right). Thus, GDP will also increase. 55. B  Paper money and coins are considered currency. Checkable deposits are also known as demand deposits. Both currency and checkable deposits make up the United States money supply. Gold bullion is not a component of the money supply in the United States. 56. B  The equilibrium price level in the short run is determined where SRAS intersects AD. This occurs at a price of 0B. In the long run, nominal wages will decrease due to the lower prices. As nominal wages decrease, the costs of production for a firm also decrease thereby causing the SRAS curve to shift to the right. The end result of this shift is a long run equilibrium price of 0A (where SRAS2, AD, and LRAS intersect). 57. C  When the Fed reduces the discount rate (the interest rate the Fed charges commercial banks for loans), the excess reserves of banks increase since they will be more willing to borrow from the Fed. As excess reserves increase, the supply of money increases (shifts to the right) and market interest rates fall. 58. C

 Long run growth is increased when the production possibilities curve expands. One method of expanding the curve revolves around increases in productivity. If the educational attainment of the population increases, the quality of labor itself has increased. This, in turn, results in greater productivity and an increase in the long-run growth rate of an economy’s real per capita income. 59. D  If the quantity of money demanded is not very sensitive to interest rates, the money demand curve is inelastic (more vertical). If you compare an inelastic money demand curve with an elastic demand curve, you will see that an increase in the money supply will result in a greater drop in interest rates when the money demand curve is inelastic. And, if interest rates drop by a lot, investment will increase by more as will real GDP. 60. D  If our interest rates decrease, foreigners aren’t going to want to invest in our financial markets. Thus, there will be capital outflows from the U.S. Or, capital inflows to the United States will be decreasing in the short run.