AP Macroeconomics Practice Exam 1

Answers and Explanations

1. A—The gains from free trade are based upon the principles of comparative advantage and specialization. Free trade allows nations to consume at points beyond their own PPF. In this way, free trade improves the economic well being of trading nations.
2. D—Points within the PPF imply unemployed resources and this is indicative of a recession.
3. D—Balanced budget fiscal policy to eliminate a recession could increase spending and pay for that spending with higher taxes. Coordination of monetary policy requires some expansion of the money supply.
4. D—Combining a leftward supply shift with a rightward demand shift unambiguously raises the price.
5. B—Computing the change in the CPI is the most common way to measure price inflation.
6. D—A centrally planned economy decides which goods are needed and how best to provide them to the population. Resources are allocated and goods are distributed by the government, not the price system.
7. A—Lower taxes increase disposable income. Consumers spend most of this disposable income, which increases real GDP and lowers the unemployment rate.
8. C—Savers receive interest payments in "cheap" dollars and fixed income recipients lose purchasing power of their pensions due to rapid inflation.
9. B—Choice I is incorrect because the equation of exchange defines the velocity of money as nominal GDP divided by money supply. The supply of loanable funds includes savers, not investors.
10. E—The %D in real income is equal to the %D in nominal income less the rate of inflation.
11. E—The GDP deflator is a price index for all goods and services that go into national product. It is more inclusive than the CPI (consumer goods) and the PPI (producer inputs).
12. D—Expansionary fiscal policy can be weakened if government borrowing drives up interest rates and diminishes private investment.
13. D—If the unemployment rate and inflation rate are both falling, they are likely the result of an increase in AS.
14. C—Scarce resources require that difficult decisions be made. Something may be gained, but at the cost of something that was given up and this scenario illustrates the opportunity cost of increased funding for higher education.
15. B—If AD is falling and prices are not also falling, the AS curve must be horizontal. Keynesians believe that prices are sticky in the downward direction, but Classical economists believe prices are flexible. It is no surprise that the classical AS curve is vertical.
16. C—Supply-side fiscal policy tries to boost investment and productivity to increase AS and foster economic growth over time.
17. B—Falling bond prices correspond to rising interest rates so look for the choice that increases interest rates. Lower money demand, one financial asset, creates rising demand for bonds, an alternative financial asset. Choice E therefore increases bond prices and lowers interest rates.
18. A—If prices and wages are flexible, the long-run economy readjusts to full employment. Falling AD lowers the price level and real GDP in the short run, but eventually lower wages shift the short-run AS curve to the right, further lowering the price level and moving long-run production back to full employment.
19. C—The short-run AS curve is upward sloping, the long-run AS is vertical at full employment.
20. A—The BLS only counts a worker as "unemployed" if he is actively seeking work. A discouraged worker is, by definition, not seeking work and so his omission from the unemployment rate understates this measure of economic health, making the economy look better than it is.
21. E—In the full circular flow model, the role of government is to collect taxes from firms and households in exchange for goods and services. Choice C is tempting, but households supply resources in exchange for wages, which they then use to purchase goods and services.
22. D—All production done in the United States is counted in U.S. GDP, regardless of the nationality of the entrepreneur.
23. E—Increased AS lowers the price level, but increased AD increases the price level. The change in the price level is uncertain, but real GDP rises.
24. B—The transaction demand for money rises with higher levels of nominal GDP. With a fixed supply of money, increased demand for money increases the interest rate as consumers sell financial assets (e.g., bonds), lowering the bond price and increasing the interest rate.
25. A—The spending multiplier M = 1/(1–MPC) = 1/MPS so an increase in the marginal propensity to consume increases the multiplier.
26. B—Asset demand for money is negatively related to the interest rate. Lower interest rates decrease the opportunity cost of holding money.
27. E—This is the only choice that combines contractionary fiscal and expansionary monetary policy.
28. E—Increased consumer wealth shifts the saving function downward. Less saving decreases the supply of loanable funds, raising the interest rate.
29. C—Increased optimism shifts investment demand to the right.
30. E—At the peak of the business cycle, the economy is very strong. Real GDP and incomes are high, unemployment is low, and the threat is a rapid increase in the price level.
31. E—An increase in demand for bonds as a financial asset decreases the demand for money and lowers the interest rate. A lower interest rate in the U.S. money market makes the United States a less attractive place for foreign investors to place their money. This decreased demand for dollars depreciates the value of the dollar relative to foreign currencies.
32. C—Greater optimism shifts the consumption function upward. The MPC is unchanged.
33. E—If the value of the dollar is high, it makes American goods more expensive to foreign consumers. This decreases net exports and lowers U.S. real GDP. All other choices likely increase real GDP.
34. A—With the economy operating beyond full employment, look for a combination of expansionary policies. All of the other choices include a contractionary policy with an expansionary policy, thus making A the most likely culprit.
35. D—Contractionary monetary policy increases interest rates. Higher interest rates decrease new home demand, investment spending, and AD, and increase the unemployment rate.
36. A—Expanding the money supply decreases the interest rate, increases investment, and stimulates AD.
37. B—Because the spending multiplier is larger than the tax multiplier, AD shifts further to the right when spending is increased with no change in taxes. This greatly exacerbates an already inflationary situation.
38. C—Because M1 is the most liquid measure of money, it begins with cash and coins.
39. D—For a given MPC, the spending multiplier exceeds the tax multiplier, which exceeds the balanced budget multiplier, which is always 1.
40. B—Money creation slows if banks do not loan all excess reserves.
41. B—More exports means an increased demand for the dollar. Stronger demand for the dollar increases the value of the dollar.
42. B—The money multiplier is 1/rr = 10. So a $500 deposit creates $450 of new excess reserves, which can multiply to $4500 of newly created money.
43. A—Lower levels of investment are the result of higher interest rates so look for the choice that describes a decrease in the money supply.
44. B—If $700 of a $1000 deposit is in excess reserves, $300 or 30 percent must have been reserved.
45. C—Reducing debt lowers interest rates, which increases private investment and risks inflation. Lower interest rates decrease foreign investment in the United States. Weaker demand for dollars depreciates the value of the dollar.
46. D—The short-run AS curve is upward sloping because when AD increases, the prices of goods and services rise faster than wages. This results in a profit opportunity for producers to increase output. In the long run, wages have time to fully respond to changes in the price level.
47. C—High levels of government borrowing increase the interest rate and squeeze private investors out of the investment market.
48. E—Quotas do not raise money for the domestic government, but they do increase prices and protect inefficient domestic producers, drawing resources away from efficient foreign producers.
49. A—To avoid crowding out, the Fed should increase the money supply and a lower discount rate does that.
50. D—Long-term investment in human capital and new technologies increases economic growth rates. Protection of a nation's natural resources and health of the citizens increases labor productivity.
51. B—Extensive borrowing increases the interest rate on U.S. securities. Foreign investors seek to buy dollars so that they can invest in these securities, but when the dollar appreciates, American exports become more expensive to foreign consumers and so net exports fall.
52. E—When a nation's productive capacity increases, the PPF and long-run AS curves both shift rightward.
53. A—This choice describes exactly what automatic stabilizers do. By providing automatic fiscal stimulus during a recession, they also lessen the impact of a recession by shortening the business cycle.
54. C—Buying securities from commercial banks puts excess reserves in the banks, which begins the money creation process.
55. A—Subsidized public education is an investment in human capital and greatly increases labor productivity over time. This is one of the determinants of economic growth.
56. C—This choice describes the negative sloping Phillips curve with the inflation rate on the y axis and the unemployment rate on the x axis.
57. E—If AS shifts to the left, both inflation and unemployment rise, and results in a Phillips curve that is further to the right than before the supply shock.
58. A—At the natural rate of unemployment, there is frictional and structural unemployment, but no cyclical job loss.
59. D—If more children are immunized against disease, the size of the adult workforce increases and higher levels of human capital and productivity are seen over time.
60. C—Lower interest rates decrease the demand for the dollar, which makes U.S.-made goods more affordable to foreign consumers so exports from the United States increase.

Free-Response Questions

Planning time—10 minutes
Writing time—50 minutes

1. It is January 1, 2010, and the U.S. economy is operating at the level of real GDP that corresponds to full employment. The U.S. government is operating with a balanced budget and net exports are equal to zero.
   1. Using a correctly labeled aggregate demand and aggregate supply graph, identify each of the following:
      1. The current level of real GDP.
      2. The current price level.
   2. Suppose that by the end of 2010 Americans are importing more goods and services from other nations than they are exporting to other nations (a trade deficit) and there exists a deficit balance in the current account.
      1. How will this affect the balance of the capital/financial account? Explain.
      2. In the AD/AS graph above, show how the trade deficit will affect the U.S. economy, the level of real GDP, and the equilibrium price level.
   3. Consider again the deficit balance in the current account.
      1. How will the deficit balance in the current account affect the demand for the dollar in the market for dollars?
      2. Will the dollar appreciate or depreciate against other major foreign currencies?
   4. Given your response to (B)(ii), how could the U.S. government engage in discretionary fiscal policy to return the economy to full employment GDP? Explain.
2. Suppose that political upheaval in Argentina has sparked rampant inflation.
   1. Explain how this unexpected inflation would impact the following groups:
      1. Retirees living on fixed monthly pensions.
      2. Banks with many outstanding loans that are being repaid at fixed interest rates.
   2. Assume that the central bank of Argentina has the same tools of monetary policy as the Fed in the United States. Explain one monetary policy that the central bank could use to lessen the inflation.
   3. Explain one fiscal policy that the government could use to lessen the inflation.
   4. Suppose that the inflation in Argentina is still a problem in the long run. Using a correctly labeled graph, show how the inflation would affect the value of the Argentine peso in the foreign exchange markets.
3. Assume that the United States economy is currently operating at the full employment level of real gross domestic product.
   1. Based on this scenario, draw a correctly labeled AD/AS graph.
   2. Suppose that full employment occurs at an unemployment rate of 4 percent, and an annual inflation rate of 3 percent.
      1. Based upon this new information, draw correctly labeled short-run and long-run Phillips curves in a new graph.
   3. Assume that rising global demand for oil, coal, and other nonrenewable sources of energy creates a permanent increase in the price of energy.
      1. Show this impact on your graph in part (A). Identify changes to the equilibrium price level and real GDP.
   4. Now assume the United States economy is back at full employment, with an unemployment rate of 4 percent and an annual inflation rate of 3 percent. The government decides to increase personal income taxes.
      1. Identify how this will impact the United States economy, the equilibrium price level and real GDP.
      2. Show the impact of this increase in personal income taxes on your graph in part B.

Note: Based on my experience, these point allocations roughly approximate the weighting on similar questions on the AP examinations. Be aware that every year the point allocations differ and partial credit is awarded differently.