AP Economics:
Economic Growth FRQs
March 31, 2015
Economic Growth FRQs
1. Assume the United States economy is operating at full-employment output and the
government has a balanced budget. A drop in consumer confidence reduces consumption
spending, causing the economy to enter into a recession.
a) Using a correctly labeled graph of the short-run Phillips curve, show the effect
of the decrease in consumption spending. Label the initial position “A” and the
new position “B”.
Correct labels; downward sloping SRPC; “B” below “A” on curve
b) What is the impact of the recession on the federal budget? Explain. Increases,
due to a decrease in tax revenue and an increase in transfer payments such as
unemployment benefits
c) Assume that current real gross domestic product falls short of full-employment
output by $500 billion and the marginal propensity to consume is 0.8.
i) Calculate the minimum increase in government spending that could bring
about full employment. $100b; MPC = .8 so multiplier = 5
ii) Assume that instead of increasing government spending, the government
decides to reduce personal income taxes. Will the reduction in personal
income taxes required to achieve full employment be larger than or smaller
than the government spending change you calculated in part (c)(i) ? Explain
why. Larger. The tax multiplier is less than the spending multiplier.
d) Using a correctly labeled graph of the loanable funds market, show the impact
of the increased government spending on the real interest rate in the economy.
Correct labels; increase in G causes increase in D, shown by shift to the right;
causing increase in real interest rates
e) How will the real interest rate change in part (d) affect the growth rate of the
United States economy? Explain. Growth rate declines because rise in real
interest rates causes decrease in Investment.
2. Over the past two years, the unemployment rate in Country X has risen from 5 percent to 9
percent. As the leader of Country X, you have been presented with two policy options to
address the unemployment problem.
Policy 1: Use tariffs and quotas to restrict imports and thus protect jobs in
Country X
Policy 2: Use monetary and fiscal policies to solve the unemployment problem
without resorting to trade restrictions
a) Explain two disadvantages of selecting Policy 1. Creates deadweight loss
which reduces efficiency; other countries may retaliate and cause job losses
in exporting sector; consumers have lower quality products and fewer choices
b) Describe in detail one specific monetary policy action and one specific fiscal
policy action you would take to reduce unemployment. Explain how each of
these actions would affect each of the following in the short run: Monetary
policy: 1) Increase MS by buying securities in Open Market Operations, 2)
Reduce Reserve Requirements or 3) Reduce Discount Rate. Fiscal Policy: 4)
Increase spending or (5) decrease taxes.
i) aggregate demand Monetary policies 1-3: reduces interest rates which
causes increase in Investment which causes increase in AD; Fiscal policy 4:
increase in G increases AD; Fiscal policy 5: decrease in taxes causes
increase in disposable income, which causes increase in C which causes
increase in AD
ii) output and the price level All actions above increase AD, which increases
both output and price level
iii) real interest rates Monetary policies 1-3: interest rates decrease; Fiscal
policies 4-5: the higher output and price level increase demand for money
which causes an increase in interest rates
c) If the interest rate effects you identified in part b) continues in the long run,
explain the impact of these effects on economic growth. Monetary policies 13: reduced interest rates lead to an increase in I, which causes an increase in
productivity and results in long run growth; Fiscal policies 4-5: higher interest
rates lead to a decrease in I, causing a decrease in long run growth
3. Suppose that the following statements describe the current state of the United States
economy:
• the economy is at full employment
• the consumer price index is rising at 2 percent annually
• the federal government budget deficit is equal to $200 billion (5 percent
of gross national product)
a) Legislation is just been passed which holds government spending constant and
raises personal income taxes enough to balance the budget. Explain briefly
how and why this policy will affect output and employment in the short run.
Increase in taxes will reduce disposable income, reducing AD, reducing output
and employment in the short run
b) Following the income tax increase, the Federal Reserve announces a goal of
significantly increased growth rates in the money supply. If the Federal
Reserve achieves its goal, explain in detail the short run effects of the Federal
Reserve’s actions on each of the following:
i) interest rates Buying bonds causes shift to right in MS, intersecting
downward sloping MD curve at lower interest rate
ii) output and employment decrease in interest rate leads to increase in
Investment, causing increase in AD, causing increase in output and
employment
iii) prices Increase in AD causes increase in price level
c) Summarize the combined effects of the federal government’s actions and the
Federal Reserve’s actions on long-run growth. It is indeterminant if the tax
decrease will reduce AD more or less than the increase in AD resulting from
the increase in MS. However, both policies reduce interest rates, causing an
increase in I, which leads to productivity gains and therefore long-term
growth
4. Assume the economy of Andersonland is in a long-run equilibrium with full employment. In
the short run, nominal wages are fixed.
a) Draw a correctly labeled graph of short-run aggregate supply, long-run
aggregate supply, and aggregate demand. Show each of the following.
i) Equilibrium output, labeled Y1
ii) Equilibrium price level, labeled PL1
Correct lables; Y1 and PL1 at intersection of SRAS, AD and LRAS
b) Assume that there is an increase in exports from Andersonland. On your graph
in part (a), show the effect of higher exports on the equilibrium in the short
run, labeling the new equilibrium output and price level Y2 and PL2,
respectively. Show rightward shift in AD and new Y2 and PL2 levels at
intersection of AD’ and SRAS
c) Based on your answer in part (b), what is the impact of higher exports on real
wages in the short run? Explain. Increase in XN leads to rightward shift in AD,
which causes PL to rise. Nominal wages are sticky in the short run, so rise in
PL means real wages fall.
d) As a result of the increase in exports, export-oriented industries in
Andersonland increase expenditures on new container ships and equipment.
i) What component of aggregate demand will change? I
ii) What is the impact on the long-run aggregate supply? Explain. The LRAS
will shift to the right due to the increase in I.