Download AP Macroeconomics Unit 5 Portfolio Questions and Answers

AP Macroeconomics
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UNIT 5 PORTFOLIO QUESTIONS AND ANSWERS
QUESTIONS
REPRESENT A BUSINESS CYCLE. WHY DOES THE ECONOMY MOVE IN CYCLES?
DEFINE THE BASIC PARADIGM OF CLASSIC ECONOMINC THEORY. GRAPH THE AGGREGATE SUPLY
MODEL IN THE LONG RUN AND DESCRIBE (EXPLAIN) ITS SHAPE.
DEFINE THE KEYNESIAN THEORY.
Aggregate Supply and Aggregate Demand Model (Keynesian Theory) (review the unit 5 material )
4.
Define Aggregate Demand (AD) and list the factors (components) of the aggregate demand that
shift the AD curve.
5.
Describe the shape of the AD. Why does the aggregate demand curve have a downward slope?
6.
7.
Describe the foreign sector substitution effect, the interest rate effect, and the wealth effect.
Define aggregate supply (AS).
8.
What is the meaning of short run and long run in the economy?
9.
Explain both the macroeconomic short run model and the long run model of the AS. What is the
best way to describe the AS curve in the long run?
10.
List the basic factors that affect short-run AS. Explain the effect of each factor.
11.
List the basic factors that affect both short-run AS and long-run AS. Explain the effect of each
factor. List the factors that affect the level of full employment.
12.
16.
Draw an aggregate supply/aggregate demand diagram. Label the axes of your diagram. Make the
aggregate supply curve upward sloping. Show which curve shifts when foreigners suddenly
develop a distaste for our products. What will happen to equilibrium price level in the short run?
Would you expect the same thing to happen to equilibrium output and the equilibrium price
level in the long run? Redraw the aggregate supply/aggregate demand diagram using a vertical
aggregate supply curve. Now what happen when foreigners develop distaste for our products?
Explain why the long run aggregate supply curve is draw as a vertical line and the short run
aggregate supply curve is draw upward sloping? Explain why the long run effects of a change in
foreign tastes are different from the short run effects.
Using the model of AD and AS, what happens to real GDP; the price level, and unemployment
with more consumption spending?
Explain the trade-off between inflation and unemployment.
17.
What is the main contrast between the short-run and long-run Philips curve?
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14.
15.
ANSWERS
1. REPRESENT A BUSINESS CYCLE. WHY DOES THE ECONOMY MOVE IN CYCLES?

The Business Cycle means Economic Instability.
 The business cycle affects all sectors of the economy, though in varying ways and
degrees. The cycle has greater effects on output and employment in the capital goods
and durable consumer goods industries than in the services and non-durable goods
industries.
 Recurring increases and decreases in the level of economic activity over periods of
years. It consists of 4 phases:
 Peak: Business activity has reached a temporary maximum. The
economy is near or at FULL EMPLOYMENT and the level of real GDP
(output) is at or very close to the economy’s capacity. The price level is
likely to rise (inflation) during this phase.
 Recession is a period of decline in total output, income, and
unemployment. It’s marked by the contraction of business activity in
many sectors of the economy, GDP declines, unemployment increases.
 Trough (depression) : output and unemployment “bottom out” at their
lowest levels.
 Recovery or Expansion: Period in which the real GD, income, and
employment rise. At some point the economy again approaches full
employment. Inflation can occur if Spending expands more rapidly than
does production capacity
WHY DOES THE ECONOMY MOVE IN CYCLES?
 The average growth rate of the United States economy, as measured by the
percentage change in real GDP is just over 3 % per year for the postwar period. Only
in a very few years has the economy grown at its average rate. It typically grows
faster than average and then in some years real GDP falls or shows negative growth.
 All economy experience fluctuations in economic activity (contractions and
expansions) The ups and downs in economy activity are recurrent but do not
conform to a uniform schedule.
 It’s extremely difficult to predict its severity and length.
2. DEFINE THE BASIC PARADIGM OF CLASSIC ECONOMINC THEORY. GRAPH THE AGGREGATE
SUPLY MODEL IN THE LONG RUN AND DESCRIBE (EXPLAIN) ITS SHAPE.
 From 1800 – 1930. The basic classic idea is the Say’s Law “Supply creates its
own demand” (Supply = Demand . Whenever anything is produced, it
generated an amount of income equal to its value. Then, that it would be
impossible to produce too much because of this fact. When something is
produced (supplied), it gendered enough income to purchase (demand) the
item.
 However, there is no rule that says the income generated in the production process
must be used to buy the item produced. Workers and employees may decide to save
a portion of their earnings.
 The unpurchased Items would collect in INVENTORIES
Inventories (extra supply) induce producer to lower prices, people buy more and
finally prices would adjust to ensure there was no excess production (Say’s answer
/Classical approach answer).
 THE BASIC PARADIGM OF CLASSIC ECONOMINC THEORY: Demand for product was
never a concern for Classical thinkers. There was enough demand, then the most
important factor determining output (GDP) was SUPPLY, and the most important
factors determining the supply were the AMOUNT of Resources (Factor of
Production) in economy and the state of technology.
 The classical analysis has a very simple answer to the questions “What does decide
the amount of output in the economy? RESOURCES and TECHNOLOGY
 In 1930, the Great Depression years, the classical analysis cannot explain the
macroeconomics situation: There was no decrease in lands, labor, and capital, the
same technical level, but the output (GDP) fells during the Great Depression.
 A classical aggregate supply curve
Price Level
AS
Real GDP (Output)
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
It’s a perfect vertical line indicating the classical approach: output depends on the
amount of resources and the state of technology, NOT PRICES. Classical reasoning says
“the price level would be high or low; it doesn’t matter, because the amount of supply
(real GDP or output) is NOT a function of prices”.
There are many situations where the price level in the economy really affects the amount
supplied by all producers.
In 1936 J. M. Keynes (elaborated another approach to explain the macroeconomic behavior
during the Great Depression (Keynesian Theory)
3. DEFINE THE KEYNESIAN THEORY.
 The classical postulate that the price adjustments guarantee that supply would be
always equal demand did not work under certain conditions. Keynes pointed out
that Say’s Law, the basis of the classical analysis did not hold true in all cases (all
time).
 Keynes presented the AD/AS Model to explain how the economy worked during
the Great Depression.
 The AD/AS model indicates that the Great Depression was caused by a lack of
demand for goods and services. Based on this evaluation of the situation, Keynes
developed a remedy (cure) for the Great Depression. Keynes’ approach was
considered too radical and it was not applied until World War II.
Aggregate Supply and Aggregate Demand Model (Keynesian Theory) (review the unit 5 material )
4. Define Aggregate Demand (AD) and list the factors (components) of the aggregate
demand that shift the AD curve.
Aggregate demand is a schedule or curve that shows the amounts of real output (real
GDP) that buyers collectively desire to purchase at each possible price level. The
relationship between the price level (as measured by the GDP price index) and the
amount of real GDP demanded is inverse or negative: When the price level rises, the
quantity of real GDP demanded decreases; when the price level falls, the quantity of real
GDP demanded increases.
AD= C + I + G + Xn
X n = Export -Import
Determinants of aggregate demand / factors that shift the aggregate demand curve
1. Change in consumer spending
a. Consumer wealth
b. Consumer expectations
c. Household borrowing
d. Personal taxes
2. Change in investment spending
a. Interest rates
b. Expected returns
• Expected future business conditions
• Technology
• Degree of excess capacity
• Business taxes
3. Change in government spending
4. Change in net export spending
a. National income abroad
b. Exchange rates
5. Describe the shape of the AD. Why does the aggregate demand curve have a
downward slope?
An aggregate demand curve (AD) shows the relationship between the total
quantity of output demanded (measured as real GDP) and the price level
(measured as the implicit price deflator). At each price level, the total quantity of
goods and services demanded is the sum of the components of real GDP, as
shown in the table. There is a negative relationship between the price level and
the total quantity of goods and services demanded all other things unchanged.
There are two reasons for a negative relationship between price and quantity
demanded in individual markets. First, a lower price induces people to substitute
more of the good whose price has fallen for other goods, increasing the quantity
demanded. Second, the lower price creates a higher real income. This normally
increases quantity demanded further.
6. Describe the foreign sector substitution effect, the interest rate effect, and the wealth
effect.
An increase in wealth will induce people to increase their consumption. The
consumption component of aggregate demand will thus be greater at lower price
levels than at higher price levels. The tendency for a change in the price level to
affect real wealth and thus alter consumption is called the wealth effect; it suggests
a negative relationship between the price level and the real value of consumption
spending. A lower price level thus reduces interest rates. Lower interest rates make
borrowing by firms to build factories or buy equipment and other capital more
attractive. A lower interest rate means lower mortgage payments, which tends to
increase investment in residential houses. Investment thus rises when the price
level falls. The tendency for a change in the price level to affect the interest rate
and thus to affect the quantity of investment demanded is called the interest rate
effect. A lower price level makes that economy’s goods more attractive to foreign
buyers, increasing exports. It will also make foreign-produced goods and services
less attractive to the economy’s buyers, reducing imports. The result is an increase
in net exports. The international trade effect is the tendency for a change in the
price level to affect net exports.
7. Define aggregate supply (AS).
Aggregate supply is a schedule or curve showing the relationship between the price levels
of output and the amount of real domestic output that firms in the economy produce.
This relationship varies depending on the time horizon and how quickly output prices
and input prices can change. We will define three time horizons.
• In the immediate short run, both input prices and output prices are fixed.
• In the short run, input prices are fixed but output prices can vary.
• In the long run, input prices as well as output prices can vary.
8. What is the meaning of short run and long run in the economy?
 Short run: a time period at which the prices of goods and services are changing in
their respective markets, but INPUT PRICE S has NOT yet adjusted to those
product market changes.

Long-run: a time period long enough for input prices to be adjusted to market
forces. Now all product and input markets are in equilibrium and the economy is
at full employment.
9. Explain both the macroeconomic short run model and the long run model of the AS.
What is the best way to describe the AS curve in the long run?
Short Run Aggregate Supply Curve
Price Level
Real GDP
10. List the basic factors that affect short-run AS. Explain the effect of each factor.
11. List the basic factors that affect both short-run AS and long-run AS. Explain the effect
of each factor. List the factors that affect the level of full employment.
See unit 5 material
12. Draw an aggregate supply/aggregate demand diagram. Label the axes of your
diagram. Make the aggregate supply curve upward sloping. Show which curve shifts
when foreigners suddenly develop a distaste for our products. What will happen to
equilibrium price level in the short run?
13. Would you expect the same thing to happen to equilibrium output and the
equilibrium price level in the long run? Redraw the aggregate supply/aggregate
demand diagram using a vertical aggregate supply curve. Now what happen when
foreigners develop distaste for our products?
14. Explain why the long run aggregate supply curve is draw as a vertical line and the
short run aggregate supply curve is draw upward sloping? Explain why the long run
effects of a change in foreign tastes are different from the short run effects.
15. Using the model of AD and AS, what happens to real GDP; the price level, and
unemployment with more consumption spending?
16. Explain the trade-off between inflation and unemployment.
Phillips Curve Showing Tradeoff between unemployment and inflation
If an economy experienced inflation, then the Central Bank could raise interest rates. Higher interest rates will
reduce consumer spending and investment leading to lower aggregate demand. This fall in aggregate demand
will lead to lower inflation. However, if there is a decline in Real GDP, firms will employ fewer workers leading
to a rise in unemployment.
17. What is the main contrast between the short-run and long-run Philips curve?
It is also possible to have a rise in both inflation and unemployment. If there was a rise in cost-push
inflation, the aggregate supply curve would shift to the left, there would be a fall in economic activity
and higher prices. For example, during an oil price shock, it is possible to have a rise in inflation (costpush) and rise in unemployment due to lower growth. However, there is still a tradeoff. If the Central
Bank sought to reduce the cost-push inflation through higher interest rates, they could. However, it
would lead to an even bigger rise in unemployment.