AP® Economics

AP® Macroeconomics Free-Response Questions Past Paper 2025 Solution

3 weeks ago
17 mins
37 Views

AP® Macroeconomics 2025 FRQ Set 1: Detailed Solutions

A Note from Your AP Macro Educator: Welcome! This guide will walk you through the 2025 Set 1 Free-Response Questions for AP Macroeconomics. Excelling in this part of the exam requires you to do more than just recall definitions. You must be able to apply economic models, draw and interpret graphs correctly, and explain the chain of causation in economic events. For each question, we'll break down the prompt, devise a step-by-step strategy, and provide a model answer that demonstrates the skills necessary for a top score.

Question 1: Long Free-Response Question

Vortania: Phillips Curve, AD/AS, and Foreign Exchange

A. Draw a correctly labeled graph of the short-run and long-run Phillips curves for the economy of Vortania, and label the long-run equilibrium point as P.

Thinking Process:
  1. Axes: The y-axis is the Inflation Rate (π). The x-axis is the Unemployment Rate (u).
  2. Curves: The Short-Run Phillips Curve (SRPC) is downward-sloping, showing the trade-off between inflation and unemployment. The Long-Run Phillips Curve (LRPC) is a vertical line at the Natural Rate of Unemployment (NRU).
  3. Point P: Long-run equilibrium occurs where the SRPC intersects the LRPC. At this point, the actual unemployment rate is equal to the NRU, and the actual inflation rate is equal to the expected inflation rate.

The graph shows a downward-sloping Short-Run Phillips Curve (SRPC) and a vertical Long-Run Phillips Curve (LRPC) at the Natural Rate of Unemployment (NRU). Point P is located at the intersection of the SRPC and LRPC, indicating the economy is in long-run equilibrium.

A correctly labeled Phillips Curve graph showing the downward sloping SRPC and vertical LRPC, with point P at their intersection.

B. Assume that new residential construction projects are being implemented in Vortania.

(i) Will real output in Vortania increase, decrease, or remain the same in the short run? Explain.

Thinking Process: "Residential construction" is a form of investment spending (I), which is a component of Aggregate Demand (AD). An increase in construction projects means an increase in investment spending, which increases AD. An increase in AD leads to an increase in real output (real GDP) and the price level in the short run.

Real output in Vortania will increase in the short run.

Explanation: New residential construction is a component of investment spending (I), which is a component of aggregate demand (AD). The increase in construction projects will increase investment spending, causing the aggregate demand curve to shift to the right, leading to a higher equilibrium real output and a higher price level in the short run.

(ii) On your graph in part A, show the short-run effect... labeling the new short-run equilibrium point as S.

Thinking Process: The increase in AD from part (i) leads to higher output and a higher price level. On the Phillips curve model, this corresponds to a movement *along* the existing SRPC. Higher output means lower unemployment, and a higher price level means higher inflation. So, point S will be on the SRPC to the left of and above point P.

The increase in aggregate demand causes a movement along the SRPC to a point with a lower unemployment rate and a higher inflation rate. Point S is shown on the SRPC to the left of the LRPC.

The Phillips Curve graph from Part A, now with a point S marked on the SRPC curve to the left of and above point P.

C. Draw a correctly labeled graph of the foreign exchange market for the Vortanian crown... and show the effect of the tariffs...

Thinking Process:
  1. Axes: The y-axis is the Exchange Rate, expressed as Rhodaran Marks per Vortanian Crown (RHM/VTC). The x-axis is the Quantity of Vortanian Crowns (VTC).
  2. Curves: The demand for VTC is downward-sloping (Rhodarans want more crowns when they are cheaper). The supply of VTC is upward-sloping (Vortanians supply more crowns to buy imports when the crown is stronger).
  3. Effect of a Tariff: Vortania imposes a tariff on imports from Rhodara. This makes Rhodaran goods more expensive for Vortanians. Vortanians will therefore buy fewer imports from Rhodara. To buy Rhodaran goods, Vortanians must supply their crowns (VTC) to the foreign exchange market to buy Rhodaran marks (RHM). Since they are buying fewer imports, they will supply fewer crowns to the market at every exchange rate. This causes the supply curve for the Vortanian crown to shift to the left.
  4. Result: The leftward shift of the supply curve leads to a higher equilibrium exchange rate. The Vortanian crown appreciates.

The graph shows the foreign exchange market for the Vortanian crown (VTC). The imposition of a tariff on imports from Rhodara reduces Vortanians' demand for Rhodaran goods, which in turn reduces the supply of VTC to the foreign exchange market. The supply curve shifts to the left from SVTC to S'VTC, causing the international value of the Vortanian crown to appreciate (increase).

A correctly labeled foreign exchange market graph for the VTC. The supply curve shifts to the left, resulting in a higher equilibrium exchange rate.

D. Based solely on the change in the international value of the Vortanian crown... will Vortania’s net exports increase, decrease, or remain the same in the short run?

Vortania's net exports will decrease. The Vortanian crown has appreciated, making Vortanian goods more expensive for foreigners (decreasing exports) and foreign goods cheaper for Vortanians (increasing imports). Since Net Exports = Exports - Imports, a decrease in exports and an increase in imports will cause net exports to decrease.

E. Based on the change in net exports... what will happen to... i. The capital and financial account (CFA) balance... Explain. ii. Employment in Vortania.

(i) The capital and financial account (CFA) balance will increase (move toward a surplus).
Explanation: The balance of payments must sum to zero. The current account (CA) and the capital and financial account (CFA) are the two main components. Since net exports, a major part of the current account, have decreased (moved toward a deficit), the CFA must increase (move toward a surplus) to balance it out. (CA + CFA = 0).

(ii) Employment in Vortania will decrease.
Explanation: The decrease in net exports represents a decrease in a component of aggregate demand (AD = C + I + G + NX). The leftward shift of the AD curve will lead to a decrease in real output and, consequently, a decrease in employment (an increase in cyclical unemployment) in the short run.

F. Assume the central bank of Vortania wants to return the Vortanian crown to its international value before the imposition of the tariffs. Would the central bank buy or sell Vortanian crowns... ? Explain.

Thinking Process: The tariff caused the crown to appreciate (its value went up). To bring the value back down to the original level, the central bank needs to counteract the leftward shift in supply. It can do this by increasing the supply of crowns itself. To increase the supply of its own currency in the foreign exchange market, a central bank must sell it.

The central bank would sell Vortanian crowns in the foreign exchange market.

Explanation: The tariff caused the supply of crowns to decrease, leading to appreciation. To reverse this appreciation and lower the crown's value, the central bank must increase the supply of crowns. By selling its own currency in the foreign exchange market (in exchange for foreign currency like the RHM), the central bank increases the supply of crowns, shifting the supply curve back to the right and lowering the equilibrium exchange rate.

Question 2: Short Free-Response Question

Monetary Policy: Limited vs. Ample Reserves

A. What open-market operation would Country L implement to move the economy toward full employment in the short run?

To move the economy toward full employment from a recessionary gap, Country L needs to implement expansionary monetary policy. In a limited reserves system, the central bank would conduct an open-market purchase of government securities (bonds).

B. What specific monetary policy action would Country A implement to move the economy toward full employment in the short run?

Country A is in a system with ample reserves. To implement expansionary monetary policy, the central bank would decrease the administered interest rates it controls, such as the interest on reserve balances (IORB) or the discount rate. Decreasing these rates would encourage commercial banks to lend more, lowering other interest rates in the economy.

C. Draw a correctly labeled graph of the reserve market in Country A, and show the effect of the monetary policy action... on the policy rate.

Thinking Process:
  1. Axes: The y-axis is the Policy Rate (e.g., Federal Funds Rate). The x-axis is the Quantity of Reserves.
  2. Curves (Ample Reserves): The demand for reserves is downward-sloping but becomes horizontal (perfectly elastic) at the Interest on Reserve Balances (IORB) rate. The supply of reserves is a vertical line located in the horizontal, "ample" portion of the demand curve. The policy rate is determined by the IORB.
  3. Effect of Policy: The action in Part B was to *decrease* the administered interest rates. This means the central bank lowers the IORB. On the graph, this is shown by shifting the horizontal part of the demand curve downward to a new, lower IORB rate. This directly lowers the equilibrium policy rate.

The graph shows the market for reserves in an ample reserves system. The supply of reserves (SR) is vertical in the flat portion of the demand curve (DR). The equilibrium policy rate is determined by the Interest on Reserve Balances (IORB). To enact expansionary policy, the central bank lowers the IORB, which shifts the horizontal portion of the demand curve down, causing the equilibrium policy rate to fall from PR1 to PR2.

A correctly labeled graph of the reserve market in an ample reserves system. A decrease in the administered rate (IORB) shifts the horizontal part of the demand curve down, leading to a lower policy rate.

D. ...Will short-run aggregate supply in Country A increase, decrease, or remain the same as the economy self-adjusts in the long run? Explain.

Thinking Process: The economy is in a recessionary gap (output below full employment). In the long run, without policy action, the economy self-corrects. A recessionary gap means high unemployment. High unemployment puts downward pressure on nominal wages and other input prices. A decrease in input prices makes production cheaper for firms, causing the Short-Run Aggregate Supply (SRAS) curve to shift to the right.

Short-run aggregate supply in Country A will increase.

Explanation: The economy is in a recessionary gap, which means there is high unemployment. High unemployment leads to a surplus of labor, which puts downward pressure on nominal wages. As wages and other resource prices fall, the cost of production for firms decreases. This decrease in production costs causes the short-run aggregate supply (SRAS) curve to shift to the right, moving the economy back to long-run equilibrium at the full employment level of output.

Question 3: Short Free-Response Question

GDP and Aggregate Expenditures

A. Was the real GDP in 2021... greater than, less than, or equal to the nominal GDP in 2021? Explain.

Real GDP in 2021 was equal to the nominal GDP in 2021.

Explanation: The base year is 2021. Real GDP is calculated using base-year prices. In the base year, current prices are the same as base-year prices, so real GDP will always be equal to nominal GDP for the base year.

B. Calculate the real GDP in Middleland in 2022. Show your work.

Thinking Process: Real GDP for 2022 must be calculated using 2022 quantities and 2021 (base-year) prices.
Real GDP = (Qshirts,22 × Pshirts,21) + (Qbread,22 × Pbread,21) + (Qpants,22 × Ppants,21)
Real GDP2022 = (Quantity of Shirts2022 × Price of Shirts2021) + (Quantity of Bread2022 × Price of Bread2021) + (Quantity of Pants2022 × Price of Pants2021)
Real GDP2022 = (50 × $11) + (70 × $4) + (30 × $12)
Real GDP2022 = $550 + $280 + $360
Real GDP2022 = $1,190

C. Draw a correctly labeled graph of the aggregate demand, short-run aggregate supply, and long-run aggregate supply curves for Middleland in 2022...

Thinking Process: The economy is in short-run equilibrium in 2022. From Part B, we found the equilibrium real output (Y1) is $1,190. The prompt states that potential (full-employment) real GDP (YF) is $1,150. Since Y1 > YF, the economy is in an inflationary gap. My graph must show this.

The graph shows the AD/AS model. The long-run aggregate supply curve (LRAS) is vertical at the full-employment output YF = $1,150. The short-run equilibrium occurs where the AD and SRAS curves intersect to the right of the LRAS curve, at an equilibrium output Y1 = $1,190 and a corresponding price level PL1. This depicts an inflationary gap.

A correctly labeled AD/AS graph showing an inflationary gap. LRAS is vertical at YF. The intersection of AD and SRAS is at Y1, which is to the right of YF.

D. Assume the marginal propensity to consume... is 0.8. Calculate the minimum change and state the direction of change in government spending required to close the output gap...

Thinking Process:
  1. Identify the Gap: The output gap is the difference between current output and potential output. Gap = $1,190 - $1,150 = $40. This is an inflationary gap, so we need to decrease AD. This requires contractionary fiscal policy, so government spending must decrease.
  2. Calculate the Spending Multiplier: Multiplier = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5.
  3. Calculate the Required Change in Spending: The formula is ΔGDP = Multiplier × ΔG. We want to change GDP by -$40.
    -$40 = 5 × ΔG
    ΔG = -$40 / 5 = -$8.
  4. State the Answer: The government must decrease spending by $8.
1. Calculate the Spending Multiplier (M):
M = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5

2. Calculate the desired change in Real GDP (ΔY):
The economy has an inflationary gap. Current output Y1 = $1,190. Full-employment output YF = $1,150.
ΔY = YF - Y1 = $1,150 - $1,190 = -$40

3. Calculate the required change in Government Spending (ΔG):
ΔY = M × ΔG
-$40 = 5 × ΔG
ΔG = -$40 / 5 = -$8

The government must decrease spending by a minimum of $8.

AP® Macroeconomics 2025 FRQ Set 2: Detailed Solutions

A Note from Your AP Macro Educator: Welcome, economists! This guide provides a detailed walkthrough of the 2025 Set 2 Free-Response Questions. To excel on this section, you need to master economic models, accurately draw and interpret graphs, and clearly explain the cause-and-effect relationships within the economy. For each question, we'll break down the prompt, devise a step-by-step strategy, and present a model answer demonstrating the skills required for a high score.

Question 1: Long Free-Response Question

The Economy of Barrikos

A. What is the numerical value of the actual unemployment rate in Barrikos?

Thinking Process: The actual unemployment rate is the sum of all types of unemployment present in the economy. This includes frictional, structural, and cyclical unemployment. The Natural Rate of Unemployment (NRU) is the sum of frictional and structural unemployment.
Actual Unemployment Rate = Natural Rate + Cyclical Rate.
Alternatively, Actual = Frictional + Structural + Cyclical.
The table gives Cyclical = 6% and Natural = 4%.
Actual Unemployment Rate = Natural Unemployment Rate + Cyclical Unemployment Rate
Actual Unemployment Rate = 4% + 6% = 10%

B. Using the relevant numerical values, draw a correctly labeled graph of the short-run and long-run Phillips curves for Barrikos. Indicate the current short-run equilibrium with a point labeled X. Plot the relevant numerical values on the graph.

Thinking Process:
  1. Axes: Y-axis is Inflation Rate (π). X-axis is Unemployment Rate (u).
  2. LRPC: The Long-Run Phillips Curve is vertical at the Natural Rate of Unemployment (NRU). From the table, NRU = 4%. So, draw a vertical line at u=4%.
  3. SRPC: The Short-Run Phillips Curve is downward sloping. It must pass through the point representing the current equilibrium (Point X).
  4. Point X: The current short-run equilibrium has an actual unemployment rate of 10% (from part A) and an actual inflation rate of 3% (from the table). So, point X is at (10%, 3%).
  5. Expected Inflation: The SRPC is defined by the expected inflation rate. The SRPC intersects the LRPC at the expected inflation rate. The table gives expected inflation as 5%. So, the SRPC must pass through the point (4%, 5%). My downward-sloping SRPC must go through both (4%, 5%) and (10%, 3%).

The graph shows a vertical LRPC at the natural rate of unemployment, 4%. The downward-sloping SRPC intersects the LRPC at the expected inflation rate of 5%. The current short-run equilibrium, point X, is located on the SRPC at an actual unemployment rate of 10% and an actual inflation rate of 3%.

A Phillips curve graph showing a vertical LRPC at 4% and a downward sloping SRPC passing through (4%, 5%). Point X is marked on the SRPC at (10%, 3%).

C. Based on your graph in part B, identify one specific fiscal policy action that the government of Barrikos would take to move the economy toward long-run equilibrium.

Thinking Process: The economy is in a recessionary gap because the actual unemployment rate (10%) is greater than the natural rate (4%). To close a recessionary gap, the government must use expansionary fiscal policy. The two tools of fiscal policy are government spending and taxes. Expansionary policy means increasing government spending or decreasing taxes. I need to name one specific action.

The government of Barrikos could increase government spending or decrease personal income taxes.

D. Assume that the fiscal policy action identified in part C is implemented.

(i) Will the government budget in Barrikos move into surplus, move into deficit, or remain balanced? Explain.

Thinking Process: The budget was initially balanced (T=G). The expansionary fiscal policy involves either increasing government spending (G ↑) or decreasing taxes (T ↓). In either case, government outlays will now be greater than tax revenues (G > T). This is the definition of a budget deficit.

The government budget will move into a deficit.

Explanation: The government started with a balanced budget (Tax Revenues = Government Spending). Expansionary fiscal policy requires either increasing government spending or decreasing taxes. Either action will cause government spending to exceed tax revenues, resulting in a budget deficit.

(ii) On your graph in part B, show a possible new short-run equilibrium point, labeled Z, that would result from the fiscal policy action identified in part C.

Thinking Process: Expansionary fiscal policy increases aggregate demand. This leads to lower unemployment and higher inflation. On the Phillips curve graph, this is represented by a movement up and to the left along the existing SRPC. Point Z will be on the SRPC somewhere between point X and the LRPC. It doesn't have to be exactly on the LRPC, just in that direction.

Point Z is shown on the SRPC curve to the left of point X, indicating a lower unemployment rate and a higher inflation rate as a result of the expansionary fiscal policy.

The Phillips curve graph from Part B, now with point Z marked on the SRPC between point X and the LRPC.

(iii) Draw a correctly labeled graph of the loanable funds market, and show the effect of the fiscal policy action identified in part C on the real interest rate.

Thinking Process:
  1. Axes: Y-axis is the Real Interest Rate (r). X-axis is the Quantity of Loanable Funds (QLF).
  2. Curves: The supply of loanable funds (SLF) is upward-sloping (people save more at higher interest rates). The demand for loanable funds (DLF) is downward-sloping (firms borrow more to invest at lower interest rates).
  3. Effect of Policy: The government is now running a budget deficit (from part D(i)). To finance a deficit, the government must borrow money. This means the government enters the loanable funds market and increases the demand for funds. Alternatively, one can think of government borrowing as decreasing the supply of savings available for private investment. Both interpretations are common. The College Board typically models this as an increase in demand OR a decrease in supply. Let's use the demand-side shift. The demand for loanable funds increases, shifting the DLF curve to the right.
  4. Result: The rightward shift of the demand curve leads to a higher equilibrium real interest rate.

The graph shows the loanable funds market. The government's expansionary fiscal policy leads to a budget deficit, which it must finance by borrowing. This increases the demand for loanable funds, shifting the demand curve to the right from DLF to D'LF. As a result, the equilibrium real interest rate increases from r1 to r2.

A correctly labeled loanable funds market graph. The demand curve shifts to the right, causing the equilibrium real interest rate to increase.

E. ...will Barrikos’ capital and financial account (CFA) balance move into surplus, move into deficit, or remain the same? Explain.

Thinking Process: The real interest rate in Barrikos has increased (from D(iii)). Higher real interest rates attract foreign financial investment. Foreign investors want to buy Barrikos' assets (like bonds) to earn the higher return. To do this, they must bring foreign currency into Barrikos. This inflow of financial capital is recorded as a credit on the CFA. An increase in capital inflows means the CFA moves toward a surplus.

Barrikos' capital and financial account (CFA) will move into a surplus.

Explanation: The increase in the real interest rate in Barrikos will make its financial assets (like bonds) more attractive to foreign investors compared to assets in other countries. This will lead to an inflow of financial capital as foreign investors seek the higher returns, which increases the surplus (or decreases the deficit) in the capital and financial account.

F. Based on the change in Barrikos’ capital and financial account (CFA) balance identified in part E, what will happen to the international value of Barrikos’ currency? Explain.

Thinking Process: The CFA moved into surplus due to capital inflows. To buy Barrikos' assets, foreign investors must first buy Barrikos' currency. This increased demand for Barrikos' currency in the foreign exchange market. An increase in demand for a currency causes its international value to appreciate (increase).

The international value of Barrikos' currency will appreciate (increase).

Explanation: The capital inflow described in part E means that foreign investors need to purchase Barrikos' currency in order to buy its assets. This action increases the demand for Barrikos' currency in the foreign exchange market. An increase in the demand for a currency causes its equilibrium price, or international value, to rise.

Question 2: Short Free-Response Question

Monetary Policy and the Economy of Jenland

A. ...Identify a specific monetary policy action that the central bank of Jenland would implement to return the economy to full employment in the short run.

The economy is in an inflationary gap (output above full employment). To return to full employment, the central bank must implement contractionary monetary policy. In a system with ample reserves, the central bank would increase its administered interest rates, such as the interest on reserve balances (IORB) or the discount rate.

B. Draw a correctly labeled graph of the reserve market for Jenland, and show the effect of the central bank’s action identified in part A on the policy rate.

The graph shows the market for reserves in an ample reserves system. The initial equilibrium policy rate (PR1) is determined by the initial Interest on Reserve Balances (IORB1). To enact contractionary policy, the central bank raises the IORB to IORB2. This shifts the horizontal portion of the demand curve up, causing the equilibrium policy rate to rise to PR2.

A correctly labeled graph of the reserve market in an ample reserves system. An increase in the administered rate (IORB) shifts the horizontal part of the demand curve up, leading to a higher policy rate.

C. Based on the change in the interest rate shown on your graph in part B, will each of the following increase, decrease, or remain the same in Jenland in the short run?

(i) The price of previously issued bonds

(ii) The price level. Explain.

Thinking Process:
  • (i) Bond Prices: The interest rate has increased. There is an inverse relationship between interest rates and the price of previously issued bonds. When new bonds are issued at a higher interest rate, the older bonds with lower fixed interest payments become less attractive, so their market price must fall to offer a competitive yield.
  • (ii) Price Level: The higher interest rate is the goal of the contractionary monetary policy. Higher interest rates will discourage interest-sensitive consumption and investment spending (C and I). This decrease in C and I will cause aggregate demand (AD) to decrease (shift left). A leftward shift in the AD curve leads to a decrease in the overall price level.

(i) The price of previously issued bonds will decrease.

(ii) The price level will decrease.
Explanation: The increase in the policy rate shown in the graph will lead to higher interest rates throughout the economy. Higher interest rates will decrease interest-sensitive spending, specifically consumption and investment, which are components of aggregate demand. This decrease in aggregate demand will cause the AD curve to shift to the left, leading to a lower equilibrium price level in the short run.

Question 3: Short Free-Response Question

AD/AS Model and Fiscal Policy for Nepal

A. Draw a correctly labeled graph of the aggregate demand, short-run aggregate supply, and long-run aggregate supply curves for Nepal...

The graph shows the AD/AS model in long-run equilibrium. The vertical LRAS curve, the upward-sloping SRAS curve, and the downward-sloping AD curve all intersect at a single point. This establishes the full-employment output (YF) and the equilibrium output and price level (Y1 and PL1), where Y1 = YF.

A correctly labeled AD/AS graph showing the economy in long-run equilibrium. AD, SRAS, and LRAS all intersect at one point.

B. On your graph in part A, show the short-run effect of the increase in real income in Thailand on real output and the price level in Nepal...

Thinking Process: Thailand's real income increases. Since Thailand is a trading partner, Thais will buy more goods and services, including those imported from Nepal. This means Nepal's exports will increase. Exports are a component of Nepal's aggregate demand. An increase in exports will shift Nepal's AD curve to the right, leading to a higher output (Y2) and higher price level (PL2), creating an inflationary gap.

The increase in real income in Thailand increases its demand for Nepal's exports. This increase in net exports shifts Nepal's aggregate demand curve to the right, from AD1 to AD2. The new short-run equilibrium occurs at a higher real output, Y2, and a higher price level, PL2.

The AD/AS graph from Part A, now showing the AD curve shifted to the right to AD2, resulting in a new equilibrium at Y2 and PL2, creating an inflationary gap.

C. ...Calculate the minimum change and state the direction of change in government spending required to completely close the output gap...

Thinking Process:
  1. Identify the Gap: The prompt states there is a 400 million rupee output gap. Since the economy is in an inflationary gap (from part B), this means Y2 is 400 million rupees greater than YF. So, we need to decrease AD. The required change in GDP (ΔY) is -400 million rupees. This requires contractionary fiscal policy, so government spending must decrease.
  2. Calculate the Spending Multiplier: MPC = 0.75. Multiplier = 1 / (1 - MPC) = 1 / (1 - 0.75) = 1 / 0.25 = 4.
  3. Calculate the Required Change in Spending: ΔY = Multiplier × ΔG.
    -400 million = 4 × ΔG
    ΔG = -400 million / 4 = -100 million.
  4. State the Answer: The government must decrease spending by 100 million rupees.
1. Calculate the Spending Multiplier (M):
M = 1 / (1 - MPC) = 1 / (1 - 0.75) = 1 / 0.25 = 4

2. Identify the desired change in Real GDP (ΔY):
To close the inflationary gap of 400 million rupees, real GDP must decrease by that amount.
ΔY = -400 million rupees

3. Calculate the required change in Government Spending (ΔG):
ΔY = M × ΔG
-400 million = 4 × ΔG
ΔG = -400 million / 4 = -100 million

The government must decrease spending by a minimum of 100 million rupees.

D. Assume instead that no discretionary policy actions are taken. Explain how automatic stabilizers in the short run would reduce the effect of the change in real output shown on your graph in part B.

Thinking Process: The economy is in an inflationary gap (higher incomes, higher output). What are automatic stabilizers? They are features of the tax and transfer system that work automatically to dampen business cycles. In an inflationary period, what happens automatically? As people's incomes rise, they are pushed into higher tax brackets, so tax revenues automatically increase. Also, government transfer payments (like unemployment benefits) automatically decrease as more people are employed. Both of these effects reduce disposable income, which dampens the initial increase in consumption and aggregate demand, thus making the inflationary gap smaller than it otherwise would have been.

Automatic stabilizers would reduce the effect of the increase in real output. As real income and output rise during the inflationary period, the progressive income tax system will automatically cause government tax revenues to increase as people move into higher tax brackets. Simultaneously, government transfer payments, such as unemployment benefits, will automatically decrease as unemployment falls. Both the increase in taxes and the decrease in transfer payments will reduce households' disposable income, which will dampen the growth in consumption spending and thus partially offset the initial rightward shift of the aggregate demand curve, making the final increase in real output smaller than it would have been otherwise.

Shares:

Related Posts

Nothing Found! Ready to publish your first post? Get started here.