2014 AP Macro FRQ#1
I can't wait!!
1. Assume that the US is currently operating below the full-emplyment level (think of this as code language for (Recession) ,, of R-GDP with a balanced budget.
(a) Draw a correctly labeled graph (CLG) of aggregate demand (AD), short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS),,.. and show each of the following in the US.
(i) Current output and price level, labeled as Y1 & PL1.
(ii) Full- employment output, labeled as Yf.
So operating below full employment is code for Recession,,, and then you have to add all the pieces to create a CLG correctly labeled graph,, with AD, SRAS, & LRAS,, and then label as they demand.
I always start all of my AD/AS curves from Equilibrium and then show a shift to recession. You might have been taught different,, and that is OK,, just make sure that you have all the pieces and you show what is happening.
How do we show? We use arrows or we write it out. The people grading your test shouldn't have to hunt for the answers. Make it easy on them...
Do we have all the pieces? CLG,,, axis labeled, LRAS, SRAS, AD (shifting), Y1, PL1, arrows,,,,,Check, check, check, check, check.
OK, move to
(b) The US increase spending on goods and services by 100 billion, which is financed by borrowing, how will the increase in government spending affect each of the following.
(i) Cyclical Employment.
So, first you must know what cyclical employment is. From my cheat sheet...
So, if cyclical employment varies with business conditions and the economy is in a recession,, then we have to assume that the Gov't spending 100 billion will cause consumption (C) to increase and Investment (I) to increase , and therefor AD will increase causing businesses to increase employment.
Answer (i) Increased employment causes by Gov't spending causes Cyclical Employment to decrease.
(ii) The Natural Rate of Employment
So, first you must know what the Natural Rate of Employment is,,, from my cheat sheet.
Gov't spending will affect cyclical employment but will not change, Frictional as government spending doesn't effect people searching for work,, and there is no technological change so no structural change either.
Answer (ii) the natural rate of employment will not change.
(c) If the Marginal propensity to consume is equal to .75, calculate the maximum, possible change in real gross domestic product that could result from the $100 billion increase in government spending.
Translation - if the MPC is .75 using the multiplier what happens to the $100b to R-GDP.
If the MPC is .75 then the MPS must be .25 ,, together they must equal 1.
A dollar earned can only have to things done with it,, spend it (consumed) or save it. If .75 was consumed then .25 must be saved.. From the Cheat sheet..
The formula for the multiplier is 1/1-MPC = 1/1-.75 or 1/.25 = 4 (look at the cheat sheet above)
with a multiplier of 4 and $100b being spent by the gov't the maximum possible change on the Real-GDP is $400 billion,,, 4(multiplier) X $100b (gov't spending) = $400 billion.
Answer (C) $400 billion
Ok, question? Why did they underline maximum. Because they know that you have been studying your head off trying to prepare for the exams and you have crammed all this knowledge into that wee brain and they just want you to do the math and not try and figure in crowding-out affects,, etc,, etc... They (college board) do try and help sometimes...
(D) Using a CLG of the loanable funds market show the effects of the $100 billion increase in government spending on the real interest rate RIR.
First,, you must know how to draw a loanable funds graph,,, if you can't see it in your mind how to draw a CLG (correctly labeled graph) of the loanable market then you have some studying to do. Then you should look at the cheat sheet.
As we can see,, government borrowing will raise the RIR.
You should be able to talk (causal chain of thinking) your way through what happens.
It is tricky,, so do it a number of times,, until it is stuck in your head... and draw the graph 50 times.
As the demand for loanable fund increases and the real interest rate rises,, more people are enticed to place their funds in the banks to get the higher interest rate (foreigners included) and therefore the quantity of loanable funds increases.
Answer - CLG of the LF market,, RIR on vertical axis,, quantity of funds on horizontal axis,, simple supply and demand shifts,, but showing both will guarantee points as both happen together,, arrows showing an increase on both graphs of the RIR,, always good to write out what happens also.
(e) Based on the Real Interest Rate changes in part (d), what is the effect on the long-run economic growth rate.
Fiscal Policy cheat sheet
The Long-Run Growth rate is negatively effected because the RIR is pushed higher,, a high RIR means that their will be less investment (capital formation) in the long-run,,, remember that Keynesian government spending during a recession was a short term fix,,,,, because in the Long-Run we are all dead.
Answer - Long-Run growth will be sacrificed with short-run government spending, due to higher real interest rates that will decrease domestic investment and therefore capital formation.
(f) Now assume that instead of financing the $100b increase in government spending by borrowing, the US government increases taxes by $100 billion. With this equal increase in government spending and taxes, will the real gross domestic product increase, decrease, or remain the same? Explain.
I haven't put this in a cheat sheet but I have blogged about it (http://econowaugh.blogspot.hk/2016/03/spending-multiplier-vs-taxing-multiplier.html) that with an increase in government spending and an equal increase in taxes. The government spending (expansionary) will flow directly into the economy,, all 100 billion and then will be multiplied, The tax multiplier works in reverse with an increase in taxes, (Contractionary) with this question,, and we know that the tax multiplier is less than the spending multiplier so the net effect will still be an increase in the RGDP.
Answer - the real GDP will increase as the expansionary policy of government spending increases by a multiple larger than the contractionary policy of an equal increase in taxes.
This is fun