AP Macroeconomics Test: The AD/AS

User Name: (print clearly) ___Clara Bui___ Instructor: _Young Kim_

Date:_Dec 5 , 2023__
th

Directions
• Neatly write your responses in the spaces provided. Use a blue or black pen. Don’t
write in the margins.
• Remember to complete the submission information on every page you turn in.

1. First, let’s consider the basics of the AD/AS model.

A. List and explain the three reasons why the AD curve is downward
sloping. (3 points)

1. Income effect: at higher price levels, the real value of money decreases, you cannot afford to
buy as much, leading to decreasing in consumer spending.

2. Interest rate effect: at higher price levels, the interest rate increases, which causes firms and
individuals to borrow and spend less.

3. Net exports effect: at higher prices in this country, people in other countries buy less of our
goods and services, while at the same time, we buy their goods and services.

B. Explain an important assumption behind the upward slope of the AS

curve. (3 points)

The upward slope of the Aggregate Supply (AS) curve is based on the assumption of
nominal wage rigidity. In the short run, wages and input prices do not adjust immediately to
changes in the price level. As the price level rises, firms experience higher revenue, leading to
increased output because their production costs, particularly wages, remain relatively constant.

C. Explain the process through which an economy returns to long-run

equilibrium in the AD/AS model when output is above full employment. You may
use a graph to help you answer, but your answer should be in words — the graph
will not be graded. (4 points)

When output is above full employment, there is inflationary pressure. In the short run,
increased demand raises prices and output. In the long run, nominal wages and prices adjust,
causing a decrease in short-run aggregate supply (SRAS), leading to a reduction in output back
to the full employment level.

D. Explain the process through which an economy returns to long-run

equilibrium in the AD/AS model when output is below full employment. You may
use a graph to help you answer, but your answer should be in words — the graph
will not be graded. (4 points)
When output is below full employment, there is unemployment. In the short run, lower demand
reduces prices and output. In the long run, nominal wages and prices adjust, causing an increase
in SRAS, leading to an expansion of output back to the full employment level.

2. Now, let’s apply your knowledge of the AD/AS model to predict the effect on
economic variables (i.e., P, RGDP, interest rates, wages, savings and spending) of
some events on the U.S. economy. Diagram the effect of the following events. Be sure
to explain the effects in the short run and effects in the long run for each question, in
words. To keep things clear, assume that in each case the economy starts out at long-
run equilibrium.

A. Labor unions become better organized, and this allows them to drive up
wages in the short run in the U.S. (3 points)

Short Run: Increased aggregate demand and aggregate supply

Long Run: Nominal wages and prices adjust, the economy returns to full employment.

B. Tensions in South America dramatically increase the price of coffee. For

the sake of argument, suppose coffee is an important input in many industries,
including computer programming, transportation, and financial services. (3
points)
The rise in production costs is responsible for the leftward shift in the short-run AS curve.
Because the price is higher and the output is lower, the SRAS curve will shift to the right to
return to its starting position in the long run, indicating that there will be no change in the
situation.
C. The government increases both taxes and spending by $500 billion. The
money is spent domestically. Hint: Be sure to provide a strict interpretation of the
AD/AS model as part of your answer. (3 points)

Short Run:
Both AD and SRAS shift right.
New equilibrium with higher output and moderate price increase.
Long Run:
Nominal wages adjust, SRAS shifts left.
Economy returns to full employment at a higher price level.

D. Suddenly, foreign countries sell great quantities of important inputs

such as steel and computer chips at very low prices in this country. Hint: The
long-run effect will depend on whether the price decrease is permanent or not. (3
points)
 A temporary drop in input prices (SRAS1 to SRAS2) initially boosts output and lowers
prices in the short run. Nominal wages gradually adjust, bringing the economy back to its
original state (SRAS1) in the long run. Although the AD curve temporarily shifts due to
increased expenditure and savings, it returns to its original position in the long run since nothing
fundamental has changed.

E. Households significantly reduce their spending and start saving a larger

portion of their income, leading to a decrease in interest rates. Hint: Think about
another sector of the economy and how it might respond to lower interest rates and
what effect this will have on the model. (3 points)

Short Run:
Reduced spending decreases AD.
New equilibrium with lower output and decreased prices.
Long Run:
Nominal wages adjust, SRAS shifts right.
Economy returns to full employment with lower interest rates.
3. Everyone loves a tax cut. How will the short-run effects of a tax cut on the price
level and on unemployment differ if the economy is in a recession from the
effects if the economy is at full employment? (Hint: Examine the slope of the AS
curve.) (5 points)

When an economy is experiencing a recession, the rate of unemployment tends to be quite high.
The tax cuts would lead to an increase in demand, which would have a minimal effect on the
overall price level due to the fact that the AS curve is not particularly steep. This would be a
positive for the economy. A change in demand has a significant impact on the price level when
there is full employment because the AS curve is steep. People who are working full-time and
earning a good amount of money will see a reduction in the quantity of money they have
available to spend if taxes are decreased. As a consequence of this, there will be a reduction in
both the aggregate demand and the supply of the good since the price will fall, and as a
consequence of this, some people will lose their jobs and find themselves in a position where
they are unemployed.

4. The economy is at full employment and an election is coming up. To make sure
they’re all re-elected, various officials decide to increase government spending by $100
billion. Senator Graham says the money should be spent on improving education and
transport systems. Senator Dole proposes building several very large Coast Guard
training facilities in states that currently have none, including Kentucky, Nebraska,
Nevada, and Arkansas.

A. What is the major difference between the spending plans of Senator

Graham and Senator Dole? (3 points)

Senator Graham focuses on improving education and transport systems, contributing to long-
term productivity and potential growth.

Senator Dole proposes building Coast Guard training facilities, which may have a more
immediate impact on employment and may not contribute as directly to long-term productivity.

B. What effect would Senator Graham’s proposal have on the AD/AS

model? Describe all shifts as well as the effects on short-run and long-run
equilibrium change in output and the price level. (4 points)

Short Run: Increased government spending raises AD, leading to higher output and a moderate
increase in prices.

Long Run: If spending enhances productivity, it may lead to a rightward shift in LRAS,
contributing to sustained economic growth with higher prices.

C. What effect would Senator Dole’s proposal have on the AD/AS model?
Describe all shifts as well as the effects on short-run and long-run equilibrium
change in output and the price level. (4 points)
Short Run: Increased government spending raises AD, leading to higher output and a moderate
increase in prices.

Long Run: Impact on long-term productivity may be less compared to Senator Graham's
proposal, potentially resulting in a less substantial rightward shift in LRAS and higher prices
without as much sustained growth.