Download 4 ∆ C ÷ ∆ DI = 4 Government multiplier 2.5 X $ 200 = $ 500

LIGHTHOUSE CPA SOCIAL SCIENCES DEPARTMENT
AP ECONOMICS
EXAM PREP WORKSHOP # 3 > AGGREGATE DEMAND AND
SUPPLY
NAME
:
DATE :
________________________________________________________________________________
1.
Figure out the following multiplier questions :
A. What is the value of the tax increase multiplier if the MPC is .80 ?
-4
B. Consumption changes by 400 and disposable income by 100 . What is the MPC ?
∆ C ÷ ∆ DI = 4
C. What is the value of the government spending multiplier if the MPC is .50
.20
D. If there is a country that has an MPC of .60 in which the government increased
spending by $ 200 and increased taxes by $ 100 , what would be the change in GDP ?
Government multiplier 2.5 X $ 200 = $ 500
Tax multiplier - 1.25 X $ 100 = $ - 125
$ 500 - $ 125 = $ 375
2.
Why is the aggregate demand curve downward sloping ?
A. According to the aggregate demand curve , what is the relationship between the price
level and real GDP ?
There is an inverse relationship : the lower the price level , the higher
the real GDP or real national output
B. Explain how each of the following effects helps explain why the AD curve is
downward sloping .
1. Interest rate effect :
A lower price level decreases the demand for money , which decreases
the equilibrium interest rate and increases investment and interest
sensitive components of consumption and , therefore , the real output .
2. Net export effect :
A lower United States price level means prices for goods produced in
the United States are lower relative to the prices in foreign countries .
Thus , people will buy more United States produced goods and fewer
foreign produced goods . This increases net exports , a component of
GDP .
3. In what ways do the reasons that explain the downward slope of the AD curve
differ from the reasons that explain the downward slope of the demand curve for a
single product ?
The demand curve for a single product is downward sloping because of
diminishing marginal utility and income and substitution effects for
the individual at a specific level of income . For macro aggregate
demand , the reasons are the interest rate effect and the net export
effect .
3.
What shifts the aggregate demand curve ? Using the chart below , determine whether
each situation will cause an increase ( I ) , decrease ( D ) , or no change ( NC ) in AD .
Always start at curve “ B ” . For each situation that causes a change in AD , write the
letter of the new demand curve in the “ New AD Curve ” column .
A
B
C
Change In AD
New AD Curve
A. Congress cuts taxes
I
C
B. Business investment spending decreases
D
A
C. Government spending to increase next
fiscal year ; president promises not to
increase taxes
I
C
D. Survey shows consumer confidence jumps
I
C
E. Stock market collapses ; investors lose billions
D
A
4.
F. Productivity rises for fourth straight year
NC
G. President cuts defense spending by 20 % ; no
increase in domestic spending
D
A
Why can the aggregate supply curve have three different shapes ?
PL
PL
SRAS
PL
SRAS
SRAS
REAL GDP
REAL GDP
REAL GDP
A. Under what conditions would an economy have a horizontal SRAS curve ?
When there are a lot of unemployed resources or a constant price level as
in a depression
B. Under what conditions would an economy have a vertical SRAS curve ?
An AS curve is vertical when real GDP is at a level with unemployment at
the full employment level and where any increase in demand will result
only in an increase in prices . The economy is unable to produce any
more goods and services for a sustainable period of time .
C. Under what conditions would an economy have a positively sloped SRAS curve ?
In this range , resources are getting closer to full employment levels ,
which creates upward pressure on prices . The upward pressure on prices
is caused by rising costs of doing business . Wages and prices may be slow
to adjust , we call this “ sticky ” , because firms and workers might lack
information .
D. Assume AD increased . What would be the effect on real GDP and the price level if the
economy had a horizontal SRAS curve ? A positively sloped SRAS curve ? A vertical
SRAS curve ?
With a horizontal SRAS curve , an increase in AD results in an increase
in real GDP and no change in the price level .
With a positively sloped SRAS curve , an increase in AD results in
increases in real GDP and the price level .
With a vertical SRAS curve , an increase in AD results in no change in
real GDP and an increase in the price level .
E. What range of the SRAS curve do you think the economy is in today ? Explain your
answer .
5.
What shifts the SRAS curve ? Using the chart below , determine whether each situation
will cause an increase ( I ) , decrease ( D ) , or no change ( NC ) in AD . Always start at
curve “ B ” . For each situation that causes a change in SRAS , write the letter of the new
demand curve in the “ New SRAS Curve ” column .
A
B
C
Change In SRAS
New SRAS Curve
A. Unions grow more aggressive ; wage
rates increase
D
A
B. OPEC successfully increases oil prices
D
A
C. Labor productivity increases dramatically
I
C
D. Giant natural gas discovery decreases
energy prices
I
C
E. Computer technology brings new efficiency
to industries
I
C
F. Government spending increases
NC
Change In SRAS
G. Cuts in tax rates increase incentives to save
NC
H. Low birth rate will decrease the labor force
in the future
NC
I. Research shows that improved schools have
increased the skills of American workers
and managers
I
New SRAS Curve
C
** NOTE : F and G do not affect the aggregate supply curve . They do shift the
AD curve . Also , H will not affect AS for 16 years or more .
6.
Equilibrium price and output levels based on the chart below :
PL
SRAS
P2
P
P1
AD
Y Y1
Y2
REAL GDP
A. What are the equilibrium price level and output ?
P and Y
B. What would eventually happen to the price level and output if the initial price level
were P2 rather than P ? Why would this happen ?
There is excess supply of goods and services . Inventories are building up.
To reduce the inventory levels , firms will cut prices and output . The
price level will fall , and real output will decrease . This would happen
because higher inventories will cause sellers to reduce prices ; lower
prices will provide fewer incentives to increase production . However ,
consumers will purchase more output at lower prices .
C. What would eventually happen to the price level and output if the initial price level
were P1 rather than P ? Why would this happen ?
There is excess demand . Inventories are below intended levels . Firms
will seek to increase inventory levels , prices will rise and output will
increase . This would happen because competition among buyers will
increase the price level ; increased prices will encourage producers to
increase their output and consumers will buy less .
7.
For each situation below , illustrate the change on the aggregate supply and demand
graph and describe the effect on the equilibrium price level and real GDP by writing in an
( I ) for an increase , ( D ) for a decrease , or ( NC ) for unchanged .
A. Congress passes a tax cut for the middle class , and the president signs it .
PL
SRAS
Price Level :
I
Real GDP :
I
P1
P
AD 1
AD
Y
REAL GDP
Y1
B. During a recession , the government increases spending on schools , highways ,
and other public works .
PL
SRAS
P1
P
Price Level :
I
Real GDP :
I
AD 1
AD
Y
REAL GDP
Y1
C. New natural gas discoveries cause large decrease in energy prices .
PL
SRAS
P
Price Level :
D
Real GDP :
I
SRAS 1
P1
AD
REAL GDP
Y
Y1
D. Illustrate the effects of an increase in aggregate demand .
SRAS
PL
P1
Price Level :
I
Real GDP :
I
AD 1
P
AD
REAL GDP
Y
Y1
E. Illustrate the effects of increases in production costs .
PL
SRAS 1
SRAS
Price Level :
I
Real GDP :
D
P1
P
AD
REAL GDP
Y1
Y
F. New technology and better education increase productivity .
PL
SRAS
SRAS 1
P
P1
Price Level :
D
Real GDP :
I
AD
REAL GDP
Y
Y1
G. With the unemployment rate at 5 % , the federal government reduces personal
taxes and increases spending .
LRAS
PL
P1
SRAS
P
Price Level :
I
Real GDP :
I
AD 1
AD
Y
Y1
REAL GDP
8.
Illustrate the indicated change on both the modern AD and AS model , and the Keynesian
model .
A. The economy is at less than full employment . Then an increase in consumer
confidence moves the economy to full employment .
LRAS
SRAS
PL
AE 1
AE
AE
AD 1
AD
Y
9.
REAL GDP
REAL GDP
FE
An “ exogenous shock ” is a change in a variable outside the primary economic model
that affects aggregate demand or supply . For each of the situations below , draw a new
curve that will represent the impact of the exogenous demand shock highlighted and
briefly explain the reason for the change in the graph .
A. As part of its countercyclical policy , the government both reduces taxes and
increases transfer payments .
SRAS
PL
P1
With increased discretionary
incomes , taxpayers will increase
consumption . AD will increase .
AD 1
P
AD
Y
REAL GDP
Y1
B. While the United States was in the midst of the Great Depression , a foreign power
attacked . Congress declared war and more than one million soldiers were drafted
in the first year , while defense spending was increased several times over .
SRAS
PL
P1
AD 1
P
AD
Consumers who had been unemployed
are hired to fill production demand
and will spend their income . The
government has also increased
spending and its demand for goods
and services . AD will increase .
REAL GDP
Y
Y1
C. Good weather results in the highest corn and wheat yields in 40 years .
PL
SRAS
SRAS 1
P
AD
P1
Y
The weather produces an increase in
the supply of corn and wheat , and if
demand remains constant , the price
will decrease . This in turn will
decrease the price of goods for many
food related industries . The SRAS
curve will shift to the right .
REAL GDP
Y1
D. An enemy power sets up a blockade of the sea lanes leading to a country , and
most ships refuse to deliver cargo through the blockade .
SRAS 1
PL
SRAS
P1
A significant decrease in available
goods will increase the cost of
production for businesses . The SRAS
curve will shift to the left .
P
AD
REAL GDP
Y1
Y
E. To balance the budget , the federal government cuts Social Security payments by
10 % and federal aid to education by 20 % .
SRAS
F.
PL
P
AD
P1
AD 1
Y1
Y
Recipients of Social Security will have
less income to spend . Local school
districts will cut back by laying off
teachers or will raise taxes . Either
action will reduce discretionary
income , and , thus consumption
decreases . AD will decrease .
REAL GDP
F. During a long , slow recovery from a recession , consumers postponed major
purchases . Suddenly they begin to buy cars , refrigerators , and televisions to replace
their failing models .
SRAS
PL
P1
AD will increase as a result of
increased autonomous spending .
AD 1
P
AD
Y
REAL GDP
Y1
G. With no other dramatic changes , the government raises taxes and reduces transfer
payments in the hope of balancing the federal budget .
SRAS
PL
P
Higher taxes and a reduction in
transfer payments reduce disposable
income , which reduces consumption
spending . AD will decrease .
AD
P1
AD 1
REAL GDP
Y1
Y
H. Brazil solves its foreign debt and inflation problems . It then orders ten billion worth
of capital equipment from the United States . Illustrate and explain how this affects
the United States economy .
SRAS
PL
P1
P
AD will increase as a result of
increased demand for exports .
AD 1
AD
REAL GDP
10.
Y
Y1
In the following graph , suppose the aggregate demand shifts from AD to AD1 . Guided by
items A through E below , show how will the economy react over time ? Assume that no
monetary or fiscal policy is undertaken .
PL
LRAS
SRAS 1
SRAS
P1
AD 1
P
AD
Y
Y1
REAL GDP
A.
What will happen to output in the short run ?
Output initially increases to Y1 in response to the increase in
aggregate demand .
B.
What will happen to output as the economy moves to the long run equilibrium ?
Explain .
Over time , labor realizes that the real wage has decrease and
demands a higher nominal wage . The increase in the nominal
wage causes the short run aggregate supply curve to decrease , and
output returns to Y .
C.
What will happen to the price level ?
The price level increases initially because firms are paying overtime
and are using less productive resources to produce beyond full
employment output . The price level will continue to rise to cover
increased costs .
D.
What will happen to wages ?
With the increase in AD , the price level rises and the real wage
decreases . Once labor realizes that the real wage has decreased , it
demands higher nominal wages , forcing the real wage to return to
the original level . In response to the increase in nominal wages ,
firms increase price and the SRAS shifts to the left .
E.
In the graph , draw the shifts in AD and SRAS that you think will occur . Indicate
the final aggregate demand and short run aggregate supply curves by labeling
them as AD1 and SRAS1
The economy will return to full employment .
11.
Draw a new SRAS or AD curve that represents the change based on the situation
described below . Also , explain the reasons for the change in the graph , and then explain
what happens in the long run if no stabilization policy is implemented .
The government increases spending on education , health care , housing and basic
services for low income people . No increase in taxes accompanies the program .
LRAS
SRAS 1
Higher government spending
PL
increases the AD in the short run.
SRAS
AD 1
AD
Over the long run , nominal wages
increase to maintain real wages , and
the SRAS decreases . The final result
is on the LRAS at SRAS1 and AD1 .
REAL GDP
12.
Test your understanding of fiscal policy by completing the table below . Your choices for
each situation must be consistent , that is , you should choose either an expansionary or
contractionary fiscal policy . Be aware that fiscal policy can not provide a solution to one
of the situations . Fill in the spaces as follows :
For columns A , B , and C indicate whether you want to increase the item using an I , or
decrease it using a D .
For column D use the I or D to indicate whether the national debt would be increased or
decreased .
Situation
(A)–
Objective for
aggregate
demand
(B)–
Action on
taxes
(C)–
Action on
government
spending
(D)–
Effect on
the
national
debt
NA
NA
NA
NA
National unemployment rate rises to
12 %
Surveys show that consumers are
losing confidence in the economy ,
retail sales are weak , and business
inventories are increasing rapidly
Business sales and investment are
expanding rapidly and economists
think strong inflation lies ahead
Inflation persists while unemployment
stays high
13.
Label the following scenarios with the type of fiscal policy they are related to . Use an
( E ) for expansionary and a ( C ) for contractionary .
A.
B.
C.
D.
14.
The government cuts personal income taxes
The government increases the capital gains tax
The government launches a major new space program
The government gives all its employees a pay raise
E
C
E
E
Assume a persistent gap between current income , Y1 , and full employment income , Y ,
as shown in the figure below .
LRAS
PL
SRAS
SRAS2
p2
SRAS1
p
AD2
p1
AD1
AD
Y1
Y
A.
If the government decided not to implement any fiscal policy , the unemployment
of resources would eventually lead to a decrease in factor prices . Show on the
graph that this could eliminate the gap .
See in red .
B.
A second possibility would be to depend on a smaller shift of aggregate supply and
have a modest shift in aggregate demand by a discretionary fiscal stimulus so that
the price level was maintained at “ p ” . Show these two changes .
See in blue .
C.
A third possibility is that government would seek changes in taxes and / or
expenditures that would rapidly bring the economy to full employment . Show this
on the graph .
See in green .
15.
True , false , or uncertain , and explain why ? “ In the long run , when nominal wages
increase , everyone has more money to spend ; therefore , the economy as a whole
benefits . ”
False . If prices rise and the real wage is maintained , then there will be no
change in the standard of living
16.
True , false , or uncertain , and explain why ? “ Our economy is able to adjust to a long
run equilibrium after a decrease in aggregate demand because prices and wages are
sticky . ”
False . Sticky wages and prices make it more difficult to respond .
17.
True , false , or uncertain and explain why ? “ If we are in a recession , as long as we
continue to increase aggregate demand , we can achieve full employment without driving
up the inflation rate . ”
False . As aggregate demand increases and the economy starts to approach
full employment , there will be a tendency for the price level to rise .
18.
True , false , or uncertain and explain why ? “ When the economy experiences an
increase in aggregate demand , it will discover that its production possibilities curve has
shifted outward . ”
False . The nation’s PPC shifts outward when it finds more resources or
develops new technology . These are the same elements that will cause the
LRAS to shift outward .
19.
Use short run AD and AS analysis to illustrate the results of the following events . Also
provide a very brief explanation of the changes .
A.
There is a 25 % decrease in the price of crude oil
SRAS
PL
Lower energy costs
allows more to be
produced
SRAS1
AD
REAL GDP
B.
Price levels in Germany , Japan , and Great Britain rise considerably ,
while price levels in the United States remain unchanged .
PL
SRAS
AD1
AD
More goods will be
exported because they
are less expensive when
compared to foreign
goods
REAL GDP
20.
For each situation below , make additions to the graphs to illustrate the change . Then
indicate the response in terms of shifts in or movements along the aggregate demand or
aggregate supply curve and the short run effect on real GDP and the price level .
Indicate shifts in the curve by an “ S ” and movements along the curve by an “ A ” .
Indicate the changes in price level , unemployment , and real GDP by writing in an ( I )
for an increase , ( D ) for a decrease , or ( NC ) for unchanged .
A.
Increase in labor productivity due to technological change .
PL
SRAS
SRAS 1
AD
REAL GDP
AD Curve :
AS Curve :
Real GDP :
Price Level :
Unemployment :
A
S
I
D
NC / D
B.
Increase in the cost of goods used by many firms .
PL
SRAS 1
AD Curve :
AS Curve :
Real GDP :
Price Level :
Unemployment :
SRAS
A
S
D
I
I
AD
REAL GDP
C.
A major reduction in investment and consumer spending .
SRAS
PL
AD Curve :
AS Curve :
Real GDP :
Price Level :
Unemployment :
AD
S
A
D
D
I
AD 1
REAL GDP
21.
Illustrate the indicated change on both the modern AD and AS model , and the Keynesian
model .
The economy is at full employment but businesses begin to believe that a recession is
head .
LRAS
PL
SRAS
AE
AE
AE 1
AD
AD 1
REAL GDP
REAL GDP
FE
22.
For each of the situations below , draw a new curve that will represent the impact of the
exogenous demand shock highlighted and briefly explain the reason for the change in the
graph .
A.
Economic booms in both Japan and Europe result in massive increases in orders
for exported goods from the United States .
SRAS
PL
AD 1
Increased orders for exports will
cause more people to be hired and
their increased income will result in
increased consumer spending . AD
will increase .
AD
REAL GDP
B.
New environmental standards raise the average cost of autos and truck 5 % .
SRAS 1
SRAS
PL
The new standards result in
increases in the costs of producing
automobiles and trucks. This
decreases AS .
AD
REAL GDP
C.
To avoid having to pay tariffs , firms begin to build new factories in the United
States . In doing so , they invest in advanced United States technology that will
help them produce goods in the United States at prices that are competitive .
SRAS
PL
SRAS 1
AD 1
AD
REAL GDP
The increase in foreign investment to
produce goods reduces
unemployment , increases disposable
income , and increases AD .
Increased investment in technology
will result in increased productivity
and this increases AS .
23.
Draw a new SRAS or AD curve that represents the change based on the situation
described below . Also , explain the reasons for the change in the graph , and then explain
what happens in the long run if no stabilization policy is implemented .
OPEC cuts oil production by 30 % , and the world price for oil rises by 40 % .
LRAS 1 LRAS
SRAS 1
PL
SRAS
AD 1
Higher production costs decrease
SRAS to SRAS1 . If the increase is
permanent , with no othe alternative
fuel found , the LRAS will shift left
( decrease ) to LRAS1 .
AD
REAL GDP
24.
Answer the following questions regarding the aggregate supply and production
possibilities curves ( PPC ) .
A.
What information does a PPC provide for us about a nation’s economy ?
The maximum possible combinations of two types of goods an
economy can produce when the economy is employing all its resources
in a given time period and with a given technology .
B.
What would cause a nation’s PPC to shift ?
Changes in the amount of resources or changes in technology .
C.
What do you know about a nation’s economy that is operating on the LRAS
curve ?
The economy is fully employing its resources in the most efficient way
given the current state of technology . It can’t produce more of one
good without producing less of another .
D.
If the price level rises , will LRAS curve shift ? Will the LRAS curve shift if AD
changes ?
NO
NO
Base your answers to E through J on the charts below
LRAS
PL
SRAS
Y1
Y
Y2
C
A
P
I
T
A
L
G
O
O
D
S
B
A
C
CONSUMER GOODS
REAL GDP
E.
If an economy finds that it faces a short run equilibrium where real GDP is Y1 ,
how would you describe the condition of the economy ? Given this equilibrium
level of output , at what point would the economy line on the PPC ? Explain your
answer .
Resources are employed . The economy is inside the PPC at a point
like C . The economy can produce more consumer goods and more
capital goods if all resources are fully employed .
F.
If an economy finds that it faces a short run equilibrium where real GDP is Y ,
how would you describe the condition of the economy ? Given this equilibrium
level of output , at what point would the economy line on the PPC ? Explain your
answer .
The economy would be operating on the PPC at point B . All resources
are fully employed .
G.
If an economy finds that it faces a short run equilibrium where real GDP is Y2 ,
how would you describe the condition of the economy ? Given this equilibrium
level of output , at what point would the economy line on the PPC ? Explain your
answer .
The economy is overheated and at point A outside the PPC . The
economy is working beyond the full employment level of production
and will not be able to sustain this level unless the LRAS increases , or
shifts to the right .
H.
If the economy were producing at Y2 , what would happen in the long run ? Why ?
The price level and nominal wages will increase = inflation .
I.
What would cause a nation’s LRAS curve to shift ?
Loss of resources will shift it to the left .
Development of new resources will shift it to the right .
J.
How would a rightward shift in LRAS be shown on a PPC ?
The PPC would shift outward , to the right .
25.
Assume that a hypothetical economy is currently at an equilibrium national income level
of $ 1 trillion , but the full employment national income is $ 1.2 trillion . Assume the
government’s budget is currently in balance at $ 200 billion and the marginal propensity
to consume is 0.75 . Use this data to answer the questions below .
A.
What is the gap between the equilibrium income and full employment ?
$ 200 BILLION
4
B.
The value of the multiplier is :
C.
Aggregate expenditures would have to be ( increased or decreased ? ) , and by how
much , to eliminate the gap ?
Increased by $ 50 billion
D.
The government could attempt to eliminate the gap by holding taxes constant and (
increasing or decreasing ? ) , expenditures by how much ?
Increase by $ 50 billion
E.
Alternatively , the government could attempt to eliminate the gap by holding
expenditures constant and ( increasing or decreasing ? ) its tax receipts by how
much ?
Decreasing by $ 66.7 billion
26.
True , false , or uncertain , and explain why ? “ Regardless of our current economic
situation , an increase in aggregate demand will always create new jobs . ”
False , at a level higher than full employment output , workers will
push for higher wages , which will shift the SRAS curve left ; output
and employment will decrease , and the price level will rise . Thus , as
aggregate demand increases , an increase in output cannot be
sustained and only prices rise .