Download Answers to Sample Short Free-Response Questions

UNIT
3 Macroeconomics
SHORT FREE-RESPONSE
SAMPLE QUESTIONS
Answer
Key
Answers to Sample Short Free-Response Questions
1. In the 1960s many newspaper reporters were accustomed to reporting a decrease in the unemployment rate when the overall price level increased. However, in the 1970s, when increases in the overall
price level were accompanied by increases, not decreases, in the unemployment rate, some reporters
went so far as to declare macroeconomics “bankrupt” and unable to explain this “mystery.”
Using short-run aggregate demand and aggregate supply analysis, explain the “mystery” of why
the increases in the overall price level during the 1960s might have been accompanied by decreases
in the unemployment rate and the increases in the overall price level during the 1970s might have
been accompanied by increases in the unemployment rate.
Graph A: 1960s
Graph B: 1970s
SRAS1
SRAS
P1
PRICE LEVEL
PRICE LEVEL
SRAS
P
P1
P
AD1
AD
AD
Y
Y1
REAL GDP
Y1
Y
REAL GDP
Graph A represents the 1960s. Increases in aggregate demand led to increases in the price level
(inflation) (P to P1 ), while at the same time the unemployment rate decreased as real GDP
increased from Y to Y1 . Graph B represents the 1970s. Decreases in the short-run aggregate
supply led to increases in the price level (inflation) (P to P1) and decreases in real GDP
(increases in the unemployment rate) as the level of output decreased from Y to Y1 . This
situation is called stagflation.
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Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
UNIT
3 Macroeconomics
SHORT FREE-RESPONSE
SAMPLE QUESTIONS
Answer
Key
2. The U.S. stock market declined dramatically from 2000 to 2003.
(A) What did this decline mean? As the stock market declines, the value of the financial assets held
by households decreases and, hence, the wealth that could be held if all financial assets were
liquidated would decline.
(B) What were the possible effects of this decline on the U.S. economy’s output, prices and
employment? A decrease in wealth will lead to a decrease in consumption expenditures, and a
decrease in the stock market will lead to a decrease in investment by private firms, and thus a
decrease in output (real GDP). U.S. output will decrease, employment will decrease and prices
will decrease.
3. Some economists claim that investment spending is more important than consumption spending
in causing changes in the business cycle. However, investment spending is only one-fourth of consumption spending. Explain why investment spending can be so important if it is so much less
than consumption spending. Decisions regarding investment spending are a marginal costmarginal benefit analysis. The benefit is the expected rate of return from the planned investment in
capital and the cost is the rate of interest to borrow or lose from using saved funds. Investment
spending is the unstable component of aggregate demand. Investment does not closely follow GDP,
yet investment in capital goods provides the seeds of productivity gains, the implementation of
technological advances and future increases in output. New investment increases the long-run
aggregate supply curve and allows for more capacity.
4. In 1981, factories used 79 percent of their capacity. In 1982, factories used 71 percent of their
capacity. In which year do you think the economy was on a steeper portion of its short-run aggregate supply curve? Explain. The economy would be on the steeper part of the aggregate supply
curve in 1981 at a 79 percent capacity utilization rate. The economy would be approaching the
potential level of output. In 1982, with a 71 percent capacity utilization rate, the economy would be
further away from potential GDP. In addition, the price level was probably rising faster in 1981
than in 1982 because as the economy nears full employment (potential GDP), pressure on prices
increases.
Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.
513
UNIT
3 Macroeconomics
SHORT FREE-RESPONSE
SAMPLE QUESTIONS
Answer
Key
5. Recently, an economist was asked if the Great Depression could occur again. The reply was, “It is
possible, but we have many more automatic stabilizers today than we had in 1929.” Describe three
automatic stabilizers and explain how they might prevent a depression. Automatic stabilizers
cause changes in aggregate demand without changes in policy or laws. Four possible answers are:
(A) Social Security maintains the incomes of retired people during a recession. Total income does
not fall as much as it might otherwise.
(B) The progressive personal income tax system decreases the marginal tax rate as income
decreases. Thus, the amount of tax decreases more than proportionally as income declines.
(C) Unemployment compensation and other transfer payment programs maintain incomes as the
economy slows and unemployment rises.
(D) Corporate dividend policy serves as an automatic stabilizer. In general, firms establish a level
of dividends and continue to pay this level for several years unless there is a major drop in the
demand for their products.
6. A town’s largest industry invests $50 million to expand its plant capacity. Without using a formula, explain how this expenditure will affect the town’s economy through the multiplier effect.
Suppose that the plant expansion takes the form of adding a new building. Local construction firms
will supply the labor for the construction and hence their incomes increase as do the number of
laborers hired to build the new plant. In turn these people spend part of their new income in town
to buy food and other consumer products. The incomes of stores increase and store owners in turn
spend a proportion of their income and the process continues multiplying the initial $50 million
expenditure.
7. Throughout most of the decade of the 1990s, gains were made in productivity. What effect do
these yearly gains have on the short-run aggregate supply curve? Is there any change in long-run
aggregate supply? Gains in productivity shift the short-run aggregate supply curve to the right. In
turn, the long-run aggregate supply curve also shifts to the right.
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Advanced Placement Economics Teacher Resource Manual © National Council on Economic Education, New York, N.Y.