AP Macroeconomics Unit 5 & 6 Review Session Stabilization Policies 1. Use the AD-AS model to answer this question. The economy of Macroland is initially in long-run equilibrium. Then the central bank of Macroland decides to reduce interest rates through an open-market operation. a. Draw a graph representing the initial situation in Macroland. In your graph, be sure to include the SRAS, LRAS, and AD. Mark the equilibrium aggregate price and aggregate output levels, as well as potential output. b. Draw a graph of the money market depicting Macroland s initial situation before the central bank engages in monetary policy, as well as the effect of the monetary policy actions. Be sure to indicate the equilibrium as well as the new equilibrium after the monetary policy. c. How does this monetary policy action affect the aggregate economy in the short run? Explain you answer verbally while also including a graph of the AD-AS model to illustrate your answer. When the Fed reduces interest rates through an open-market purchase of T-bills, AD increases and shifts to the right. In the short-run, output and price level increases. d. How did this monetary policy action affect the aggregate economy in the long run? The economy must return to producing its potential output. This will occur as SRAS shifts to the left and nominal wages rise. As SRAS shifts back, this will eliminate the inflationary gap, and restore economy back to potential output level, and lead to even higher price level.
2. Explain how the Fed s actions can affect the economy. Be sure to include an explanation about how the Fed can affect the economy when it is in recession or when it is producing at an aggregate output level that is greater than the potential output level. The Fed can affect the economy through its open-market operations. When the Fed expands the money supply by purchasing T-bills, the interest rate falls, holding everything else constant. As the interest rate declines, this acts as a a stimulus to investment and consumer spending and, therefore, as a stimulus to AD. Thus, open-market purchases typically are used to stimulate the economy; when the economy is producing below the potential output level (i.e. the economy is in a recession), the Fed has the potential to alter this output level via active monetary policy. Conversely, when the economy is producing at a level greater than the potential output level, the Fed can engage in open-market sales that will effectively lead to higher interest rates and lower investment and consumer spending, thereby causing the level of AD to fall, holding everything else constant. 3. Expansionary monetary policy typically reduces the nominal interest rate, and this in turn acts as a stimulus for aggregate demand. Why does this not work in the case of a liquidity trap? Explain and use a graph to illustrate your answer. In the case of a liquidity trap, the nom interest rate initially is zero and thus cannot fall any lower despite expansionary monetary policy. The following graph illustrates a liquidity trap, in which MS is the nominal money supply, MD is the nominal money demand. Inflation 4. Joe lends Mary $1,000 for the year. They agree that Mary will repay the full $1,000 at the end of the year and in addition, they agree that Mary will pay Joe $50 in interest payments. a. What is the nominal interest rate that Mary and Joe have agreed to in this contract? 5%, since the $50 interest payment represents 5% of the $1,000 loan. b. If Joe and Mary both anticipate that inflation will be 3% for the year, what real interest rate is each of them trying to achieve in their loan contract? Real interest rate = nom interest rate expected inflation. 5% -- 3% = 2% c. Suppose the actual inflation rate for the year is 2%. Who benefits more from this inflation rate? Explain your answer. Lender Joe is gaining more payment than expected; Mary is paying back more dollars in real terms. d. Suppose the actual inflation rate for the year is 4%. Who benefits more from this inflation rate? Explain your answer. Borrower Joe is earning less than expected; Mary is paying back fewer dollars in real terms. e. If the actual inflation rate equals the nominal interest rate, how does this affect the outcome of this loan contract?
If actual inflation rate equals nominal interest rate, then the real interest rate equals zero. The lender earns no real return on the money he or she has lent out, while the borrower is paying no real cost for the use of the money. The borrower wins, while the lender is hurt under this scenario. f. Why are lenders more likely to supply loanable funds when the inflation rate is stable? No, if you knew that the actual inflation rate was going to be and it equaled the nominal interest rate for the loan, you would refuse to be a lender since the real return you would earn on the loan would be zero. If you made the loan, you would be giving up use of your funds for the period of the loan without receiving any real compensation for the use of those funds. 5. Suppose that both borrowers and lenders anticipate correctly that the inflation rate will increase 5 percentage points over the next year. a. What do you know will happen to the real interest rate? The real interest rate will be unaffected by the anticipated inflation rate because both consumers and suppliers in the loanable funds market will take this anticipated inflation into account. b. What do you know will happen to the nominal interest rate? The nominal interest rate will increase by 5% points due to the increase in the anticipated rate of inflation of 5% points. c. Describe the effects of this anticipated inflation in the loanable funds market. Both the demand and supply curves in the loanable funds market will shift upward (demand will shift to the right and supply will shift to the left) by the amount of the anticipated inflation rate, leaving the equilibrium quantity of loanable funds unchanged in the market while increasing the nominal interest rate by the amount of the anticipated inflation. This is the Fisher Effect! The Phillips Curve 6. Draw a short-run Phillips curve for an expected rate of inflation of 0, a short-run Phillips curve with an expected rate of inflation of 2%, and the long-run Phillips curve. What does the negative portion of the vertical axis on this graph represent? The graph will show a SRPC with a y-intercept of zero. The graph will show another SRPC with a y-intercept of 2. The negative portion of the vertical axis is measuring negative rates of inflation (deflation). 7. Assume the economy is in long-run equilibrium with an expected inflation rate of 3% and an unemployment rate of 8%. a. Draw the short-run and long-run Phillips curves, and show the long-run equilibrium. The LRPC will be vertical at 8% on the horizontal axis. Make a SRPC with the curve intercepting with the LRPC at 3% inflation. b. Suppose expected inflation rises to 4%. Show on your graph, and explain what will happen to the short-run Phillips curve and the long-run equilibrium. Expected inflation will turn into actual inflation and the SRPC will shift up to 4% inflation. 8. Suppose you are given the following information about the economy of Funland. Unemployment Rate Inflation Rate Expected Inflation Rate 1% 6% 2% 2 5 2 3 4 2 4 3 2 a. Draw a graph with the unemployment rate on the horizontal axis and the inflation rate on the vertical axis. On this graph, represent the above short-run Phillips curve (SRPC) based on expected inflation of 2%. Label this SRPC 1. Assume this curve is linear.
b. Given the SRPC 1, at what rate of unemployment will inflation equal 0% for this economy? If expected inflation is 2%, then how will this economy adjust over time to this expected inflation rate? Illustrate this short-run adjustment on a graph and then explain your answer. Given SRPC₁, inflation is )% when the unemployment rate is 7%. Over time, people will come to expect inflation of 2%, causing the SRPC to shift up by this amount of people s expectations of inflation to rise to 4%. The new SRPC will be SRPC₂, as illustrated in the following graph. Of course, over time this will cause SRPC₂ to shift up reflecting higher inflationary expectations. c. If policy makers could effectively change inflationary expectations such that people expected inflation to be 0%, then what would be this country s NAIRU? Illustrate this on a correctly labeled graph and then explain your answer. This country s NAIRU would be 5%. Effectively, we are looking for the SRPC that has inflationary expectations of 0%, which we can illustrate as a downward shift of SRPC₁ where at any given unemployment rate, the inflation rate is reduced by 2%. We can illustrate this in the following figure as SRPC₀. Remember, that the expected inflation rate for SRPC₂, is 4%, the expected inflation rate for SRPC₁ is 2% and the expected inflation rate for SRPC₀ is 0%. d. For the economy of Funland, what will the long-run Phillips curve (LRPC) look like and where will it be located? Use a graph to explain and illustrate your answer. For Funland the LRPC will be a vertical line at 5% unemployment rate, as illustrated in the following figure.
Economic Growth 9. Show economic growth using the PPC and AD-AS graphs. The PPC curve with shift out and the LRAS curve will shift to the right. 10. Complete the following chart to show the effects of the following changes on the PPC and the LRAS (shift left, shift right, or no change). Scenario PPC LRAS The economy s physical capital stock decreases due to depreciation. Government education programs lead to increases in human capital. Research and development spending lead to technological progress. A war reduces a country s political instability. 11. Suppose real GDP per capita in Funland is $10,000 in 2009. Economists there predict steady increases in real GDP of 7% per year for the foreseeable future. a. According to the Rule of 70, how many years will it take for Funland s real GDP per capita to double? Ten years because the Rule of 70 syas the number of years it takes for a variable to double is approximately equal to 70 divided by the annual growth rate of the variable. b. Complete a table like the one below in which you compute the values for real GDP to verify your answer in part (a) above. Real GDP per capita 2009 $10,000 2010 10,700 2011 11,449 2012, etc. 12,250 c. Is your value for real GDP per capita in the final year equal to $20,000? If not, does this surprise you? Explain your answer. The value of real GDP per capita for 2019 is $19,672, which is less than the estimated $20,000. This is not
surprising because the Rule of 70 is an estimation of the number of years it takes a variable to double rather than a numerically precise calculation. 12. How does the classical model of the price level differ from the Keynesian model? Rise in money supply does not equal a rise in Real GDP in the long run, since price level rises as well by the same percentage Classical Model of Price Level Since money supply and price level rise together, the Real Quantity of Money (M/P) stays at the original level (Wages and prices are more responsive to money supply changes in periods of high inflation). With the Keynesian model, we don t live in the long-run, we live in the short-run. 13. You are given the following information about the country of Macronesia. Nominal GDP CPI Real GDP Population 2009 $10 billion 100 $10 billion 1.0 million 2010 10.5 billion 105 10 billion 1.05 million 2011 11.0 billion 108 10.19 billion 1.08 million a. What is the base year for the economy represented in the previous table? 2009 How did you identify the base year? The base year is that year with the CPI value of 100. b. Calculate the missing values in the table, and then round to the nearest billion: e.g., 14,829,000,000 would be rounded to 14.8 billion. c. Use the completed table from part (b) to calculate the missing values in the following table. You will find it helpful to define real GDP in millions (for example, 14.8 billion to 14,800 million) because population is expressed in millions. Real GDP per capita 2009 $10,000 2010 9,524 2011 9,435 d. Let s compare the percentage changes in some of the variables we are working with in this problem. Use the following table to organize your calculations. Percentage change in nominal GDP Percentage change in real GDP Percentage change in population Percentage change in real GDP per capita 2009 --- --- --- --- 2010 5% 0% 5% -4.8% 2011 4.80% 1.90% 2.90% -0.93% e. In order for real GDP per capita to increase over time, what must be true about the relationship between the percentage change in real GDP and the percentage change in population? The percentage change in real GDP must be greater than the percentage change in population for real GDP per capita to increase over time. f. Why do we measure long run growth using real GDP per capita? Real GDP per capita allows us to track the increase in the quantity of goods and services available in our economy rather than just the effects of a rising price level. 14. Why are increases in productivity important? Sustained growth in real GDP per capita occurs only when the amount of output produced by the average worker increases steadily. The term labor productivity, or productivity for short, is used to refer to output per worker. In general, overall real GDP can grow because of population growth, but any large increase in real GDP per capita must be the result of increased output per worker. Therefore, it must be due to higher productivity. 15. What are the three major determinants of productivity? Physical capital Increases in manufactured goods used to produce other goods & services Human capital Improvement in education, knowledge & health Technology Progress in technical means for production 16. What is meant by diminishing returns on physical capital? Increases in amount of physical capital leads to smaller increases in productivity
17. Suppose there are two countries, Macroland and Pacifica, that currently have real GDP per capita of $10,000 and $15,000, respectively. Furthermore, suppose Macroland s economy has an average annual growth rate of 2%, while Pacifica s has an average annual growth rate of 1.4% a. Compute real GDP per capita for both Macroland and Pacifica 50 years from now. = ($10,000)(1 + 0.02)⁵⁰ or $26,916. b. Compute real GDP per capita for both Macroland and Pacifica 100 years from now. = ($15,000)(1 + 0.014)⁵⁰ or $30,060. c. Initially, Macroland s real GDP per capita is 67% of Pacifica s real GDP per capita. = ($10,000)(1 + 0.02)ⁱ⁰⁰ or $72,446. After 50 years, what is the relationship of Macroland s real GDP per capita to Pacifica s real GDP per capita in percentage terms? = ($15,000)(1 + 0.014) ⁱ⁰⁰ or $60,240. What is the relationship after 100 years? In 50 years, the ratio of Macroland s real GDP per capita to Pacifica s real GDP per capita in percentage terms will be 89.5%, while in 100 years, it will be 120.3%. 18. Many people fear that the world may run out of important resources, such as oil, and that this depletion of a vital resource will bring an end to economic growth. Why do many economists disagree with this particular perspective? Economists argue that vital resources, as they grow scarce, will command increasingly higher prices. These higher prices will cause people to conserve resources, and their scarcity will spur the development of alternatives to replace the scarce, but vital, resources. 19. Economists argue that the problems presented by widespread environmental degradation can be resolved only through governmental intervention, as well as intergovernmental cooperation. Why do they hold this view? Climate destruction arises from widespread economic growth, and this destruction is an example of a negative externality. Negative externalities arise when a market fails to include all the costs of producing a good in the calculation of the good s price. Many goods produced today also produce significant pollution, and the market does not internalize these costs of pollution. Without government intervention, firms and individuals do not have any incentive to reduce negative externalities. Reducing pollution and the climate destruction that accompanies it will require the cooperation of governments in the imposition of some form of market-based incentives: for example, both a carbon tax and a cap and trade system would reduce the amount of carbon emitted into the air. Debt-GDP Ratio 20. Uplandia is concerned about its debt-gdp ratio and the projections about this ratio over the next five years. The following table gives data about Uplandia s real GDP for this year (year 1) and its projected real GDP for the next five years. Real GDP is projected to grow 3% per year over the next five years as is the government deficit. a. Fill in the missing cells in the table. Real GDP (millions of Debt (millions of (millions of Debt (percentage of real GDP) (percentage of real GDP) 1 $800 $200 $20 25% 2.5% 2 824 220.6 20.6 26.77 2.5 3 848.72 241.82 21.22 28.49 2.5 4 874.18 263.68 21.86 30.16 2.5 5 900.41 266.2 22.52 31.79 2.5 6 927.42 309.4 23.2 33.36 2.5 b. Describe in words what is happening to the government s debt-gdp ratio and deficit-gdp ratio when real GDP and the government deficit grow at the same rate. When the real GDP and the government deficit grow at the same rate, the deficit-gdp ratio stays constant at 2.5%, while the debt-gdp ratio increases from 25% to 33.36% in five years. Suppose Uplandia decides to reduce government spending over the next five years. This results in government deficit growing 1% per year over the next five years while real GDP continues to grow 3% per year. c. Fill in the table below based on these projections. Real GDP (millions of Debt (millions of (millions of Debt (percentage of real GDP) (percentage of
real GDP) 1 $800 $200 $20 25% 2.5% 2 824 220.2 20.2 26.72 2.45 3 848.72 240.6 20.4 28.35 2.40 4 874.18 261.2 20.6 29.88 2.36 5 900.41 282.0 20.8 31.32 2.31 6 927.42 303.0 21 32.67 2.26 d. Describe in words what is happening to the government s debt-gdp ratio and deficit-gdp ratio when real GDP grows at a faster rate than the deficit. When the real GDP grows at 3% per year and the government deficit grows at 1% per year, the deficit-gdp ratio falls from 2.5% to 2.26% in five years, while the debt-gdp ratio increases from 25% to 32.67% in five years. Suppose Uplandia passes legislation reducing its taxes while simultaneously deciding to go to war. Its economists project real GDP will continue to grow at 3% per year bur now, due to these policy decisions, the government deficit is projected to grow at 10% per year. The results of these changes are shown in the following table. Real GDP (millions of Debt (millions of (millions of Debt (percentage of real GDP) (percentage of real GDP) 1 $800 $200 $20 25% 2.5% 2 824 222 22 26.94 2.67 3 848.72 246.2 24.2 29.01 2.85 4 874.18 272.82 26.62 31.21 3.05 5 900.41 302.10 29.38 33.55 3.25 6 927.42 334.30 32.2 36.05 3.47 e. Describe in words what is happening to the government s debt-gdp ratio and deficit-gdp ratio when real GDP grows at a slower rate than the deficit. When real GDP grows at 3% per year and the deficit grows at 10% per year, the deficit-gdp ratio increases from 2.5% to 3.47% over five years while the debt-gdp ratio increases from 25% to 36.05% over five years. Adapted from Strive for a 5: Preparing for the Macroeconomics AP Examination (Margaret Ray and David Mayer)