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Mr. Maurer AP Economics Name: __________________________ Review for Unit 2 Test – AD/AS and Fiscal Policy Chapter 11 – Aggregate Demand and Aggregate Supply 1. When the economy is in equilibrium at potential gross domestic product, how does the actual unemployment rate compare to the natural unemployment rate? What is the cyclical unemployment rate at this output level? The actual unemployment rate is equal to the natural unemployment rate. Cyclical unemployment is zero. 2. What effect will a decrease in the corporate tax rate have on the aggregate supply curve? Explain. It will shift the SRAS curve to the right because decreased corporate taxes will lower marginal costs for businesses. 3. What effect will a decrease in the corporate tax rate have on the aggregate demand curve? Explain. It will shift the AD curve to the right, because decreased corporate taxes will lead to higher profits, which means greater returns on investment spending, which will increase investment spending. 4. Identify the factors that can shift aggregate supply and explain how each operates. These are all listed in your textbook in Chapter 11. You can find them. 5. Identify the factors that can shift aggregate demand and explain how each operates. These are all listed in your textbook in Chapter 11. You can find them. 6. What effect will an increase in the price level have on: a. The demand for money The demand for money will increase because consumers and businesses will need more money to purchase the same amount of goods and services. b. Interest rates Interest rates will increase as the demand for money increases. c. Investment spending Investment spending will decrease as interest rates rise. 7. Assume that the MPC is 0.9. a. What will be the effect of a $10 billion decrease in government spending on real output? Up to a$100 billion decrease in output (spending multiplier is 1/0.1 = 10). b. What will be the effect of a $10 billion decrease in income tax levels? Up to a $90 billion increase in output (tax multiplier is -.9/.1 or -9). c. What would be the overall change in GDP caused by these two actions together? Output could still go down by $10 billion 8. Complete this table: MPC Change in Govt. Spending .9 +$10 billion Effect on GDP Change in Tax Levels Effect on GDP Combined Effect on GDP +100 billion +$10 billion -90 Billion +10 billion -$100 billion +900 billion -100 billion +$50 billion -200 billion +50 billion .9 -$100 billion .8 +$50 billion -1000 billion (1 trillion) +250 billion .8 -$20 billion -100 billion -$20 billion +80 billion +-20 billion .75 +$10 billion +40 billion +$10 billion -30 billion +10 billion .75 -$40 billion - 160 billion -$40 billion +120 billion -40 billion Generalizing from the table above, what can you say about the effect of simultaneous and equal changes in government spending and tax levels on real GDP? How does the MPC affect this? Regardless of the MPC, simultaneous equal changes in government spending and taxes will create a change in GDP equal to the initial change in government spending. The MPC has no effect on this, so, if asked on a test what will happen if government increases spending and taxes by the same amount, you can answer without knowing what the MPC, MPS, spending multiplier, or tax multiplier is. 9. Assume the short-run aggregate supply curve is horizontal (remember, the long-run aggregate supply curve is always vertical) and government spending increases. Draw a properly labeled AD/AS graph that shows the effect of the change in government spending on real output and the price level. Draw the graph with a horizontal SRAS. If you do this, you will see that, if AD increases (through govt. spending in this example), real output will increase with no increase in the price level. 10. Draw a properly labeled AD/AS diagram. Assume an upward sloping SRAS curve. Demonstrate the effect of an increase in businesses spending on computers on your diagram. You should show an increase (rightward shift) in AD, caused by the increased investment spending. You should also have a rightward shift in your vertical LRAS curve, because computers are capital equipment. 11. A reduction in aggregate supply followed by an increase in aggregate demand will have what effect on price level and output? Price level will go up, change in output in undetermined (it depends on whether the decrease in AS is greater than the increase in AD or vice versa). 12. An increase in aggregate supply followed by a decrease in aggregate demand will have what effect on price level and output? Price level will go down. Change in output is undetermined. 13. A simultaneous increase in both aggregate supply and aggregate demand will have what effect on price level and output? Output level will increase, change in price level is undetermined. 14. A simultaneous decrease in both aggregate supply and aggregate demand will have what effect on price level and output? Output will decrease, price level is undetermined. 15. How will an increase in government expenditures most likely affect each of these in the short-run? A. The unemployment rate: Will go down. B. The inflation rate: Will go up. C. Real GDP: Will go up. 16. How will an increase in business investment affect the amount of capital per worker in the economy? How will that change affect productivity? Explain. Capital per worker will go up as more capital is purchased, but number of workers stays the same. This should increase productivity as each worker has more capital at his disposal (up to the point where the marginal return on increased capital is negative). 17. Draw a correctly labeled AD/AS graph. Assume now that wages increase faster than productivity. Demonstrate the effects of this change on your graph. Graph should show a leftward shift in AS, caused by higher wages that have grown faster than productivity (if productivity increased equally with wages, then marginal costs would come down and offset the increase in wages.) 18. If firms are able to reduce their production costs, how will each of the following be affected? A. Aggregate supply curve Shift to the right. B. Price level Decrease C. Real output Increase 19. What type of inflation would be caused by a decrease in interest rates when the economy is operating at full employment? Demand Pull (decreased interest rates will spur investment spending, increasing AD). 20. Draw a correctly labeled AD/AS graph of the economy at less than full employment. On your graph, show the effects of a decrease in business taxes. Explain the changes you indicated. Graph needs to have equilibrium at some point to the left of the long run vertical aggregate supply curve. Decrease in business taxes will shift both the SRAS and the AD curve to the right due to increased investment spending and decreased marginal costs. 21. Explain the reasons the aggregate demand curve is downward-sloping. See page 194 in your text for this. 22. Assume the MPC is .75. What effect (and how large of an effect) would each of the following have on GDP? A. an increase in exports of $100 _____$400 increase___________________________________ B. an increase in government spending of $100 ____$400 increase_________________________ C. a decrease in taxes of $100 _____$300 increase______________________________________ D. A decrease in imports of $100 ____$400 increase____________________________________ E. A decrease in savings of $100. ____$400 increase____________________________________ Wages will rise because unemployment is lower than the natural rate. This will shift the SRAS curve to the left until it intersects the LRAS at AD and a higher price level than before. 23. How will the economy depicted in the graph above return to long-run equilibrium? Draw the change on the graph and explain it in the space to the right of the graph. Wages will decrease because unemployment is high. The SRAS will shift right until it intersects AD at the LRAS curve and a lower price level. 24. How will the economy depicted in the graph above return to long-run equilibrium? Draw the change on the graph and explain it in the space to the right of the graph. Chapter 12 – Fiscal Policy 1. Explain how the crowding out effect can affect both investment and consumption spending. How does this partially counteract the effects of discretionary expansionary fiscal policy? If the government increase spending and finances the spending through borrowing, this can drive up interest rates as the government increases the demand for money. With higher interest rates, businesses may borrow less for investment, reducing some of the impact of the increase in government spending. 2. Explain the alternatives the U.S. government has to finance a budget deficit. What are the effects of each? See page 217 - 218 3. How does an increase in government spending, with no change in taxes, affect output and price level? Increases output and price level. 4. Identify and explain the government fiscal policy options for addressing inflationary pressure and explain how those options will help to reduce that pressure. See “Contractionary Fiscal Policy on pages 216 – 217. 5. Identify and explain the government’s fiscal policy options for addressing unemployment or a recession and explain how those options will increase economic output and reduce unemployment. See “Expansionary Fiscal Policy” on pages 215-216. 6. Explain how the spending multiplier and the tax multiplier affect fiscal policy and provide numerical examples of each in operation. You can do this. Just show specific examples of the two multipliers in effect. 7. If the economy was in a severe recession, what would be the most expansionary action the government could take with both government spending and tax levels? Increased spending, decreased tax levels. 8. What combination of government actions on spending and tax levels is definitely contractionary? Decreased spending, increased tax levels. 9. What two combinations of government actions on spending and tax levels are indeterminate, that is, they are neither definitely expansionary nor definitely contractionary? Decreased spending and decreased taxes. Increased spending and increased taxes 11. If the government simultaneously increases government spending $100 billion and increases tax revenues $100 billion, what will be the net effect on aggregate demand? Show your calculations. Change will be +$100 billion. Plug in any MPC, MPS, spending multiplier and tax multiplier you want. It will always work out. 12. Crowding out is most likely to occur when the federal budget deficit is moving in which direction (increasing or decreasing). Why? Increasing, because the government will have to borrow more money to finance an increasing deficit.