Ap Sample Questions

AP Macroeconomics Sample Quesitons

Survey 1st Period

Phillips Curve

The Original Short Run Phillips Curve

Basic Assumptions:

·        There is an inverse relationship between inflation and unemployment.  When one increases, the other decreases.

·        If an economy has inflation, usually due to demand pull growth, then more workers are being hired to produce the greater number of goods being produced.

·        If an economy is in a recession, more resources are being left idle, therefore fewer workers are needed and less pressure is put on the resource base.  This results in less inflation.

·        Movement along the Phillips Curve represents year to year changes in the business cycle.

The original data collected in the 1940’s and 1950’s showed this general connection with the business cycle. This also held during the 1960’s in the US (see most texts).  

Why the Phillips Curve?  Notes Page

Original SR Phillips Curve
Inflation and Unemployment =
Inflation =
Recession =
Along the Curve =
Stagflation
Late 1970’s to 1981
Data?
A New Phillips Approach
New Range?
Cost Push Inflation
Supply Shocks
SRPC Curve moves
SRPC moves back
Long Run Phillips Curve
Inflation?
LRPC is?
Natural Rate of Unemployment
Phillips and AD/AS Curves
Change points on SRPC =
Move the SRPC =

The Problem of Stagflation

Phillips Curves under attack:

·        Starting in the mid-1970’s the economy started to suffer from increasing amounts of inflation and unemployment (see the Business Cycles Data chart).

·        The data points on the Phillips Curve no longer fit into any immediately recognizable pattern.

·        Did the model seem to present the relationship between inflation and unemployment too simplistically?

A New “Phillips” Approach

Stagflation, and its removal, explained:

·        If the fundamental efficiencies and demographics of an economy change, then the relationship between inflation and unemployment is still valid, just in a new range.

·        One key change is the type of inflation.  If inflation now becomes “cost push” inflation, the resource base has now changed.  The aggregate supply is reduced due to resources being used up or lost, disasters, boycotts, etc.  More costs and job losses occur.

·        The result of cost push inflation will be higher prices due to fewer and more expensive resources, plus more unemployment due to business production cuts.  This is also known as a supply shock.

·        The Short Run Phillips Curve still has a relationship between the two factors, but the curve moves outward.  Year to year business cycles still occur, just at higher levels than before.

·        When the economy is able to adjust with improved technologies, or the resource supply is re-established, the inflation pressures level off and businesses are able to lower costs and produce more.  The SRPC moves back inward (to the left). 

·        This approach appears to answer the late 1970’s changes.  As energy resources were cut and significant demographic changes like women moving into the workforce changed, the economy suffered from stagflation.  This was “cured” by the restoration of cheaper energy and new technologies in the 1980’s and 1990’s.

·        The logic of the Phillips Curve was intact, just in new ranges.

The Long Run Phillips Curve

Inflation has less importance in the Long Run.

·        Two new factors emerge in Long Run analysis.  The first is that the economy can adjust for inflation in the long run through wage and real-wage changes.  The second is based on Rational Expectations School theories that expected inflation rates are controllable and predictable by the market, therefore no longer a random factor. 

·        The Long Run Phillips Curve is therefore vertical at some natural rate of unemployment. This is now presumed to be around 4 to 5 % for the US and 6% for Canada.  This vertical LRPC is also known as the NAIRU line, or “non accelerating inflation rate of unemployment”. 

·        The analysis of the LRPC is now based on arguments of how a country can change the natural rate of unemployment.  Usually this is connected to long run productivity of the workforce and the willingness of a country to help those who are unemployed.   The theory is that financial assistance given to those who lose jobs will lengthen their “willingness” to wait, or settle, for new jobs.   This will increase the natural rate of unemployment (move it to greater levels of unemployment). 

The Phillips Curve and the AD/AS Model

Phillips Curves and AD/AS Graphs:  Mirror Images

·        When you move points along the SRPC you are showing changes in the year to year business cycle.  This is exactly what you are illustrating when you move the AD line on the AD/AS model.

·        When you move the entire SRPC outward to show supply shocks or cost push inflation problems, it is exactly the same at moving the SRAS curve inward. The AD/AS model will also show the simultaneous creation of greater inflation and more unemployment. This will also be true of movements in the opposite directions, like the SRPC moving back inward is the same as the SRAS curve moving outward to better levels of inflation and production.

Current Thinking About the Phillips Curve

Recent and growing critiques of the Phillips Curve use:

·        I quote a brief article from Dr. D. Hamermesh of the University of Texas at Austin, “By the mid-1980’s the Phillips Curve was no longer taught as offering a trade-off between inflation and unemployment and was hardly mentioned in economics courses anymore.”  “…Nobel Prize winners Milton Friedman and Edmund Phelps suggested that there was no good theoretical basis for the relationship…”  These words are typical of university critiques of the curve.

• Data from the 1990’s forward also seems to show that economies like the US can sustain long periods of growth, with falling inflation and low, steady levels of unemployment.

Banks Money Creation Money Multipliers

Banks and the Creation of Money

Bank Balance Sheets

How do banks “create” money?

Where do the loans come from?

How are the amounts of potential loans calculated?

Bank Liabilities (the right side of the T Account Sheet):

#1 =

#2 =

Key concept for AP concerning Liabilities:

Bank Assets (the left side of the T Account Sheet):

#1=

#2 =

#3 =

#4 =

#5 =

Money Creation (Using Excess Reserves)

The Monetary Multiplier (also known as):

The formula is simple:  1divided by the reserve requirement (ratio)

Excess Reserves are multiplied by the Multiplier

Summary of Items to Know

Bank Balance Sheet =

Liabilities =

Assets =

Assets must Equal Liabilities

DD =

Money is Created through the Monetary Multiplier

ER x 1/RR (Multiplier)=

The Money Supply is affected

Cash from a citizen

ER x Multiplier become

The Fed Buying bonds

IF the Fed buys the bonds IF the Fed buys bonds

Supplemental Note about Bonds

Countercyclical Policies

Connections:  Countercyclical Fiscal Policies

International Markets

Reminder: 

Interest Rates are a domestic COST of borrowing and therefore high interest rates are BAD for Ig.

Interest Rates are an international DRAW for investors and therefore high interest rates are GOOD for currency inflows.

Fighting a Recession: Interest Rates Up due to Crowding Out	Fighting Inflation: Interest Rates Down (due to Crowding In—If it occurs)
D for the US Dollar will =	D for the US Dollar will =
The US Dollar will =	The US Dollar will =
US Exports will =	US Exports will =
Xn will therefore =	Xn will therefore =
The US Current Account Balance will decrease (more on this later).	The US Current Account Balance will increase (more on this later).

Connections: Countercyclical Monetary Policies

International Markets

Fighting a Recession: Interest Rates Down due to Fed Policies	Fighting Inflation: Interest Rates Up due to Fed Policies
D for the US Dollar will =	D for the US Dollar will =
The US Dollar will =	The US Dollar will =
US Exports will =	US Exports will =
Xn will therefore =	Xn will therefore =
The US Current Account Balance will increase (more on this later).	The US Current Account Balance will decrease (more on this later).

Domestic Countercyclical Policies

(Don’t say “Government”, say either Congress or the Fed)

Fighting a Recession:  Congressional Fiscal Policy

	What is the Change?
Congress can change Taxes:
or Congress can change Spending Programs:
The “C” component of AD should:
The “G” component of AD should:
Overall AD should:
(This should be graphed on the Aggregate Model)	----------
However, the Tax and Spending change will create a budget_____
In order to fund this, Congress must have bonds ____ to the public
On the Money Market Graph, Congressional actions will change this line on the graph:
The line will move:
This will cause nominal interest rates to:
This will affect Private Gross Investment:
The effect of Congress’s actions will also cause a change on the Loanable Funds Market.  First, the Supply line will move:
Also, Congress’s actions will cause the Demand line to move:	Outward (some texts)
Both of these events will affect the Real Interest Rate:
(This should be shown on the Investment Demand Graph)	----------

Fighting Inflation:  Congressional Fiscal Policy

Congress can change Taxes:
or Congress can change Spending Programs:
The “C” and “G” components of AD should:
Overall AD should:
(This should be graphed on the AD/AS Model)	----------
On the Money Market Graph, Congressional actions will change this line on the graph:
The line will move:
This will cause nominal interest rates to:
This will affect Private Gross Investment:
On the Loanable Funds Graph, the Supply line will move:
The Demand Line will also move:
Both of these events will affect the Real Interest Rate:

Fighting Recession:  The Federal Reserve Monetary Policy

	What is the Change?
The Fed will do this with the Bond Market:
On the Money Market Graph, this line will move:
It will move in this direction:
Therefore, Nominal Interest Rates will:
(This change can be shown on the Investment Demand Graph)	----------
This component of GDP will therefore change:
Therefore, AD will:
(This change can be shown on the Aggregate Demand Graph)	----------
The Fed can also do the following:	----------
Change the target rate for the Fed Fund Rate between banks:
Change the Discount Rate for banks borrowing from the Fed:
Change the Reserve Requirement within banks:
All of these will change loan availability to the public:

Fighting Inflation:  The Federal Reserve Monetary Policy

	What is the Change?
The Fed will do this with the Bond Market:
On the Money Market Graph, this line will move:
It will move in this direction:
Therefore, Nominal Interest Rates will:
(This change can be shown on the Investment Demand Graph)	----------
This component of GDP will therefore change:
Therefore, AD will:
(This change can be shown on the Aggregate Demand Graph)	----------
The Fed can also do the following:	----------
Change the target rate for the Fed Fund Rate between banks:
Change the Discount Rate for banks borrowing from the Fed:
Change the Reserve Requirement within banks:
All of these will change loan availability to the public: