Answers to Sample Long Free-Response Questions

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1 s to Sample Long Free-Response Questions 1. Assume you are a member of Congress. A member of your staff has just given you the following economic statistics: Year Ago Last Estimate for Quarter Quarter Quarter Now Ending Real gross domestic product (in billions of 1997 dollars) $2,789 $2,689 $2,598 Consumer price index Unemployment rate 5% 8% 10.2% Gross private investment (in billions of 1997 dollars) $312 $300 $287 (A) What economic problem is this nation facing? There is a recession. Real GD is declining and unemployment is rising. Inflation is moderate, rising 3 percent in the last year. (B) Identify the fiscal policy actions you would recommend. olicy recommendations are to decrease personal income taxes, decrease corporate income taxes and/or increase government spending. (C) What are the goals of your fiscal policy actions? The goal would be to enact expansionary fiscal policy actions to raise employment and increase the level of real GD, but to do so without causing more inflation. (D) Explain how each policy action you identified in Question 1(B) will fit the goals you stated in Question 1(C). Decreasing personal income taxes will provide more disposable income available for consumption and saving. Higher consumption will increase aggregate demand and raise the level of real GD and employment and possibly the price level. Because unemployment is high, the effect on the price level may be small. Some of the savings might find its way to financial markets and become investment. Decreasing corporate income taxes will give businesses more money for investment, raising aggregate demand, real GD and employment. If businesses undertake purchases of new capital, this could increase the aggregate supply and the price level might fall. Increasing government spending is an option. Government spending is a direct injection and none is lost to savings. Additional disposable income as it passes through the income stream will also add to real GD and employment. Advanced lacement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y. 515

2 (E) Use a correctly labeled aggregate demand and aggregate supply graph to show the effects of your fiscal policy on the economy. Show the changes that will occur in the price level and the level of real GD. The rightward movement of aggregate demand results in increases in the price level and real GD. 1 1 Y Y 1 2. Assume you are a member of Congress. A staff member has just given you the following economic statistics: Year Ago Last Estimate for Quarter Quarter Quarter Now Ending Real gross domestic product (in billions of 1997 dollars) $2,356 $2,589 $2,752 Consumer price index Unemployment rate 10% 6.5% 5.1% Gross private investment (in billions of 1997 dollars) $312 $340 $352 (A) What economic problem is this nation facing? The main problem is inflation. Inflation rose almost 20 percent in the last year. (B) Identify the fiscal policy actions you would recommend. olicy recommendations are to increase personal income taxes, increase corporate income taxes and/or decrease government spending. (C) What are the goals of your fiscal policy actions? The goal would be to enact contractionary fiscal policy to lower inflation to a level that is acceptable. The fine line between lowering inflation and not causing lower employment and lower levels of real GD is the difference between success and recession. 516 Advanced lacement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y.

3 (D) Explain how each policy action you identified in Question 2(B) will fit the goals you stated in Question 2(C). Increasing personal income taxes will decrease disposable income available for consumption and saving. Lower levels of consumption will decrease aggregate demand to lower the level of real GD and employment. If the economy is in the vertical range or upwardsloping range of AS, price levels will fall. Increasing corporate income taxes will give businesses less money for investment, reducing aggregate demand, real GD and employment. rice levels will fall. Decreasing government spending is an option. Raising taxes and cutting the budget may create a budget surplus. The loss of disposable income, as it passes through the income stream, will also lower real GD and employment, but price levels will fall. (E) Use a correctly labeled aggregate demand and aggregate supply graph to show the effects of your fiscal policy on the economy. Show the changes that will occur in the price level and the level of real GD. The leftward movement of aggregate demand results in a decline in the price level and real GD. 1 1 Y 1 Y 3. Assume that the economy has been operating at the full-employment levels of output and employment but has recently experienced a decrease in consumption spending because of a sharp decline in stock market indexes that has reduced the wealth of the nation by about 18 percent. Consumption expenditures have decreased at all levels of income. (A) Use correctly labeled aggregate demand and aggregate supply graphs to illustrate the shortrun effect of the decrease in consumption expenditures on each of the following: (i)ii Output (ii)i Employment (iii) The price level Advanced lacement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y. 517

4 The decline in consumption expenditures at each and every level of income will create an output gap at the full-employment level of output. As a result of this autonomous change in aggregate demand, the following will occur: LRAS (i)ii Output will decline. 1 (ii)i Employment will decline, and the unemployment rate will rise. (iii) The price level will decline. 1 Y 1 Y* (B) Identify two fiscal policy actions that could be used to counter the effects of the initial decrease in consumption spending. Explain, using correctly labeled aggregate demand and aggregate supply graphs, the short-run effects of each of your policies on each of the following: (i)ii Output (ii)i Employment (iii) The price level Fiscal-policy measures can include a cut in both personal and business taxes and/or increase in government spending. Another idea would be to raise taxes and increase government spending by equal amounts. This would result in an increase in real GD. 2 1 LRAS 1 2 Y 1 Y 2 Y* (i)ii Output will increase. (ii)i Employment will increase and the unemployment rate will fall. (iii) The price level will increase. The decline in consumption moved the aggregate demand curve from to 1 ; the fiscal policy shifted the aggregate demand curve back to Advanced lacement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y.

5 4. Assume that political problems restrict the supply of oil in international markets. Consequently, increased production costs result in the following economic conditions in the United States: The unemployment rate is 8 percent and rising. The CI is rising 9 percent annually and accelerating. The annual rate of growth of real GD is 1.5 percent. (A) Identify and describe the major macroeconomic problems in the economy. Using correctly labeled aggregate demand and aggregate supply graphs, show the condition of the economy. High rates of unemployment and negative growth rates combined with a high rate of inflation show that the economy is suffering from stagflation. The graph shows price levels increasing and unemployment rising. 1 Y 1 Y 1 (B) With a federal budget deficit of nearly $350 billion, fiscal authorities are considering the following policy actions to address the existing economic problems: olicy 1: Increase government expenditures. olicy 2: Increase personal income taxes. olicy 3: Decrease business taxes and regulations. Describe the effect of each of the policies on the economy, and demonstrate each on an individual aggregate demand and aggregate supply graph. Be sure to include each of the following in your description: (i)ii Output (ii)i Employment (iii) The price level Advanced lacement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y. 519

6 olicy 1: Increased government spending would move the curve to the right. (i)ii Output would increase. 1 (ii)i Employment would increase. (iii) The price level would increase. olicy 2: Increased personal taxes would move the curve to the left. (i)ii Output would decline. 1 (ii)i Employment would decrease. (iii) The price level would decrease. olicy 3: Decreased business taxes and decreased regulation would move the curve to the right. 1 (i)ii Output would increase if business expectations are positive. (ii)i Employment would rise if business expectations are positive. (iii) The price level will fall as increases. 520 Advanced lacement Economics Teacher Resource Manual National Council on Economic Education, New York, N.Y.