2023 AP AP Macroeconomics Practice Paper with Answers

(a) AD-AS Graph:
- The vertical axis is labeled "Price Level" (or PL) and the horizontal axis is labeled "Real GDP" (or Y).
- The downward-sloping aggregate demand curve (\(AD_1\)) and upward-sloping short-run aggregate supply curve (\(SRAS_1\)) intersect at price level \(PL_1\) and real output \(Y_1\).
- The vertical long-run aggregate supply curve (LRAS) is drawn to the left of \(Y_1\) at full-employment output \(Y_F\) ($400 billion vs. $440 billion), showing an inflationary (positive) output gap.

(b) Multiplier Calculations:
(i) The spending multiplier is:
\[ \text{Spending Multiplier} = \frac{1}{\text{MPS}} = \frac{1}{0.2} = 5 \]
The output gap is \(\Delta Y = -\$40\text{ billion}\) (since output must decrease by \(\$440 - \$400 = \$40\text{ billion}\)).
\[ \Delta G = \frac{\Delta Y}{\text{Spending Multiplier}} = \frac{-\$40\text{ billion}}{5} = -\$8\text{ billion} \]
Thus, government spending must **decrease by $8 billion**.

(ii) The tax multiplier is:
\[ \text{Tax Multiplier} = -\frac{\text{MPC}}{\text{MPS}} = -\frac{1 - 0.2}{0.2} = -\frac{0.8}{0.2} = -4 \]
To achieve \(\Delta Y = -\$40\text{ billion}\):
\[ \Delta T = \frac{\Delta Y}{\text{Tax Multiplier}} = \frac{-\$40\text{ billion}}{-4} = +\$10\text{ billion} \]
Thus, lump-sum taxes must increase by $10 billion.

(c) AD Shift on Graph:
- The decrease in government spending shifts the \(AD\) curve to the left (labeled \(AD_2\)), establishing a new short-run equilibrium at the intersection of \(AD_2\) and \(SRAS_1\) at \(Y_F\) and a lower price level labeled \(PL_2\).

(d) Monetary Policy with Ample Reserves:
(i) The central bank would increase its administered interest rates (such as increasing the interest on reserve balances / interest on reserves rate, or increasing the discount rate/administered policy rate).
(ii) An increase in administered interest rates (interest on reserves) raises the return that commercial banks earn on risk-free reserve deposits at the central bank, which increases the opportunity cost of lending to other banks and the public, thereby driving up the policy rate and other market nominal interest rates.

(e) Long-Run Self-Adjustment and Phillips Curve:
(i) Because the economy is producing beyond full employment (unemployment rate of 3% is below the natural rate of 5%), workers and firms face a tight labor market and higher expected inflation. Over time, nominal wages and other resource prices will rise, shifting the SRAS curve to the left until output returns to full-employment output \(Y_F\).
(ii) Phillips Curve Graph:
- The vertical axis is labeled "Inflation Rate" and the horizontal axis is labeled "Unemployment Rate".
- The LRPC is vertical at the natural rate of unemployment (5%).
- The initial downward-sloping \(SRPC_1\) has point A plotted to the left of LRPC at an unemployment rate of 3%.
- As inflationary expectations and nominal wages increase during the long-run adjustment, the short-run Phillips curve shifts to the right (upward) to \(SRPC_2\), moving the economy to a long-run equilibrium on the LRPC at 5% unemployment.

Total: 10 points

- Part (a): 2 points
- 1 point: For drawing a correctly labeled AD-AS graph showing \(PL_1\) and \(Y_1\) at the intersection of \(AD\) and \(SRAS\).
- 1 point: For drawing a vertical \(LRAS\) curve to the left of \(Y_1\) and labeling the full-employment output as \(Y_F\).

- Part (b): 2 points
- 1 point (b)(i): For calculating the minimum change in government spending as a **decrease of $8 billion** (or \(-\$8\text{ billion}\)) and showing correct work using the spending multiplier of 5.
- 1 point (b)(ii): For calculating the minimum change in taxes as an **increase of $10 billion** (or \(+\$10\text{ billion}\)) and showing correct work using the tax multiplier of \(-4\).

- Part (c): 1 point
- 1 point: For showing a leftward shift of the \(AD\) curve resulting in full-employment output \(Y_F\) and a lower price level labeled \(PL_2\).

- Part (d): 2 points
- 1 point (d)(i): For identifying that the central bank should increase its administered interest rates (e.g., increase interest on reserve balances / interest on reserves / policy rate).
- 1 point (d)(ii): For explaining that increasing interest on reserves raises the opportunity cost of lending, causing market nominal interest rates to increase (or setting a higher floor for short-term interest rates).

- Part (e): 3 points
- 1 point (e)(i): For explaining that nominal wages (or input costs / inflationary expectations) will increase due to labor shortages / low unemployment, shifting \(SRAS\) to the left until real GDP returns to full employment.
- 1 point (e)(ii): For drawing a correctly labeled Phillips curve graph with a vertical \(LRPC\) at 5% and the initial short-run equilibrium point A on the \(SRPC\) to the left of the \(LRPC\) at 3% unemployment.
- 1 point (e)(ii): For showing that the short-run Phillips curve shifts to the right (upward) as a result of the long-run adjustment.

(a) Financial capital will flow from Belgravia to Artavia. When the real interest rate increases in Artavia relative to Belgravia, lenders and financial investors earn a higher rate of return on Artavian assets (such as bonds), attracting financial capital inflows into Artavia from Belgravia.

(b) In the foreign exchange market for the crown:
- Vertical Axis: Price of Crown in terms of Pesos (Exchange rate, Pesos/Crown)
- Horizontal Axis: Quantity of Crowns
- Downward-sloping Demand curve for crowns (\(D_{\text{crown}}\)) and upward-sloping Supply curve for crowns (\(S_{\text{crown}}\)).
- As Belgravian investors seek to buy Artavian financial assets, they supply more crowns in the foreign exchange market to buy pesos. Thus, the supply curve of crowns shifts to the right (\(S_1\rightarrow S_2\)), resulting in a lower equilibrium exchange rate (depreciation of the crown relative to the peso). Alternatively, a leftward shift in the demand curve for crowns (\(D_1\rightarrow D_2\)) also correctly illustrates depreciation.

(c) The current account balance of Belgravia will move into surplus (or increase). As the crown depreciates, Belgravian goods and services become relatively cheaper to buyers in Artavia, increasing Belgravian exports. Concurrently, Artavian goods become relatively more expensive to Belgravian buyers, decreasing Belgravian imports. Consequently, Belgravia's net exports increase, improving its current account balance.

(d) Real output in Belgravia will increase in the short run because the increase in net exports increases aggregate demand (\(AD = C + I + G + NX\)), shifting the aggregate demand curve to the right and increasing equilibrium real GDP.

Part (a): 1 point
- 1 point is earned for stating that financial capital will flow from Belgravia to Artavia AND explaining that investors will seek higher returns/real interest rates on financial assets in Artavia.

Part (b): 2 points
- 1 point is earned for drawing a correctly labeled graph of the foreign exchange market for the crown (vertical axis labeled Pesos/Crown or Price of Crown; horizontal axis labeled Quantity of Crowns; downward-sloping Demand curve; upward-sloping Supply curve; initial equilibrium labeled).
- 1 point is earned for showing a rightward shift of the supply curve for crowns (and/or a leftward shift of the demand curve for crowns) resulting in a decrease in the equilibrium exchange rate (depreciation of the crown).

Part (c): 1 point
- 1 point is earned for stating that Belgravia's current account balance will move toward surplus (or increase) AND explaining that the depreciation of the crown makes Belgravia's goods relatively cheaper to foreign buyers (or foreign goods more expensive), leading to an increase in Belgravia's net exports.

Part (d): 1 point
- 1 point is earned for stating that real output in Belgravia will increase in the short run.

### Solution

(a)
Draw a graph of the reserve market:
- Vertical axis: Policy Rate (or Interest Rate)
- Horizontal axis: Quantity of Reserves
- **Reserve Supply Curve (\(S_R\)):** Vertical line located in the flat region of the demand curve.
- **Reserve Demand Curve (\(D_R\)):** Downward-sloping at low reserve levels and flat (horizontal) at the administered rate (Interest on Reserves, IORB) reflecting ample reserves.
- Equilibrium: Intersection in the flat portion of \(D_R\), labeled with equilibrium policy rate \(PR_1\) on the vertical axis and reserve quantity \(Q_1\) on the horizontal axis.

(b)
To close a recessionary gap, expansionary monetary policy is required. In an ample-reserves framework, the central bank achieves this by lowering its administered interest rate (specifically, decreasing the interest on reserves / interest on reserve balances, IORB).

(c)
Lowering the administered rate lowers the horizontal floor/administered section of the reserve demand curve (\(D_R\)), shifting it downward and resulting in a lower equilibrium policy rate labeled \(PR_2\).

(d)
- (i) The nominal interest rate in interbank lending markets will decrease as it tracks the lower administered policy rate.
- (ii) Aggregate demand will increase. A decrease in the policy rate lowers broader market interest rates, decreasing the cost of borrowing for households and businesses, which stimulates interest-sensitive consumption (\(C\)) and business investment spending (\(I\)).

Question Total: 5 points

- Part (a): 1 point
- 1 point is earned for drawing a correctly labeled graph of the reserve market showing the policy rate (or interest rate) on the vertical axis, the quantity of reserves on the horizontal axis, a reserve demand curve that is horizontal at the administered rate, a vertical supply curve intersecting the flat region of the demand curve, and the initial equilibrium labeled \(PR_1\) and \(Q_1\).

- Part (b): 1 point
- 1 point is earned for stating that the central bank would decrease an administered interest rate (or decrease interest on reserves / interest on reserve balances / IORB).
- Note: Do not accept traditional limited-reserves tools (e.g., buying bonds via open market operations or lowering required reserves) as the primary tool in an ample-reserves framework.

- Part (c): 1 point
- 1 point is earned for showing on the graph from part (a) a downward shift in the administered rate / horizontal segment of the reserve demand curve, leading to a lower policy rate labeled \(PR_2\).

- Part (d)(i): 1 point
- 1 point is earned for stating that the nominal interest rate will decrease.

- Part (d)(ii): 1 point
- 1 point is earned for stating that aggregate demand will increase AND explaining that lower interest rates reduce the cost of borrowing, which increases interest-sensitive consumption (\(C\)) and/or gross private investment (\(I\)).