Answer Key Chapter 11 - Principles of Macroeconomics for AP® Courses

An increase in home values will increase consumption spending (due to increased wealth). AD will shift to the right and may cause inflation if it goes beyond potential GDP.
Rapid growth by a major trading partner will increase demand for exports. AD will shift to the right and may cause inflation if it goes beyond potential GDP.
Increased profit opportunities will increase business investment. AD will shift to the right and may cause inflation if it goes beyond potential GDP.
Higher interest rates reduce investment spending. AD will shift to the left and may cause recession if it falls below potential GDP.
Demand for cheaper imports increases, reducing demand for domestic products. AD will shift to the left and may be recessionary.

A tax increase on consumer income will cause consumption to fall, pushing the AD curve left, and is a possible solution to inflation.
A surge in military spending is an increase in government spending. This will cause the AD curve to shift to the right. If real GDP is less than potential GDP, then this spending would pull the economy out of a recession. If real GDP is to the right of potential GDP, then the AD curve will shift farther to the right and military spending will be inflationary.
A tax cut focused on business investment will shift AD to the right. If the original macroeconomic equilibrium is below potential GDP, then this policy can help move an economy out of a recession.
Government spending on healthcare will cause the AD curve to shift to the right. If real GDP is less than potential GDP, then this spending would pull the economy out of a recession. If real GDP is to th right of potential GDP, then the AD curve will shift farther to the right and healthcare spending will be inflationary.

An inflationary gap is the result of an increase in aggregate demand when the economy is at potential output. Since the AS curve is vertical at potential GDP, any increase in AD will lead to a higher price level (i.e. inflation) but no higher real GDP. This is easy to see if you draw AD₁ to the right of AD₀.

A decrease in government spending will shift AD to the left.

The following figure shows the aggregate expenditure-output diagram with the recessionary gap.

The following figure shows the aggregate expenditure-output diagram with an inflationary gap.

First, set up the calculation.

\begin{array}{rcl} AE & = & 400 + 0.85(Y – T) + 300 + 200 + 500 – 0.1(Y – T) \\ AE & = & Y \end{array}

Then insert Y for AE and 0.25Y for T.

\begin{array}{rcl} Y & = & 400 + 0.85(Y – 0.25Y) + 300 + 200 + 500 – 0.1(Y – 0.25Y) \\ Y & = & 1400 + 0.6375Y – 0.075Y \\ 0.4375Y & = & 1400 \\ Y & = & 3200 \end{array}

If full employment is 3,500, then one approach is to plug in 3,500 for Y throughout the equation, but to leave G as a separate variable.

\begin{array}{rcl} Y & = & 400 + 0.85(Y – 0.25Y) + 300 + G + 500 + 0.1(Y – 0.25Y) \\ 3500 & = & 400 + 0.85(3500 – 0.25(3500)) + 300 + G + 500 – 0.1(3500 – 0.25(3500)) \\ G & = & 3500 – 400 – 2231.25 – 1300 – 500 + 262.5 \\ G & = & 331.25 \end{array}

A G value of 331.25 is an increase of 131.25 from its original level of 200.

Alternatively, the multiplier is that, out of every dollar spent, 0.25 goes to taxes, leaving 0.75, and out of after-tax income, 0.15 goes to savings and 0.1 to imports. Because (0.75)(0.15) = 0.1125 and (0.75)(0.1) = 0.075, this means that out of every dollar spent: 1 –0.25 –0.1125 –0.075 = 0.5625.

Thus, using the formula, the multiplier is:

\begin{array}{rcl} \frac{1}{1 – 0.5625} & = & 2.2837 \end{array}

To increase equilibrium GDP by 300, it will take a boost of 300/2.2837, which again works out to 131.25.

The following table illustrates the completed table. The equilibrium is level is italicized.

National Income	After-Tax Income	Consumption	I + G + X	Minus Imports	Aggregate Expenditures
$8,000	$4,800	$4,340	$5,000	$240	$9,100
$9,000	$5,400	$4,820	$5,000	$270	$9,550
$10,000	$6,000	$5,300	$5,000	$300	$10,000
$11,000	$6,600	$5,780	$5,000	$330	$10,450
$12,000	$7,200	$6,260	$5,000	$360	$10,900
$13,000	$7,800	$46,740	$5,000	$4,390	$11,350

The alternative way of determining equilibrium is to solve for Y, where Y = national income, using: Y = AE = C + I + G + X – M

Y = $500 + 0.8(Y – T) + $2,000 + $1,000 + $2,000 – 0.05(Y – T)

Solving for Y, we see that the equilibrium level of output is Y = $10,000.

The multiplier refers to how many times a dollar will turnover in the economy. It is based on the Marginal Propensity to Consume (MPC) which tells how much of every dollar received will be spent. If the MPC is 80% then this means that out of every one dollar received by a consumer, $0.80 will be spent. This $0.80 is received by another person. In turn, 80% of the $0.80 received, or $0.64, will be spent, and so on. The impact of the multiplier is diluted when the effect of taxes and expenditure on imports is considered. To derive the multiplier, take the 1/1 – F; where F is equal to percent of savings, taxes, and expenditures on imports.

10.

A decrease in energy prices, a positive supply shock, would cause the AS curve to shift out to the right, yielding more real GDP at a lower price level. This would shift the Phillips curve down toward the origin, meaning the economy would experience lower unemployment and a lower rate of inflation.

11.

Keynesian economics does not require microeconomic price controls of any sort. It is true that many Keynesian economic prescriptions were for the government to influence the total amount of aggregate demand in the economy, often through government spending and tax cuts.

12.

The three problems center on government’s ability to estimate potential GDP, decide whether to influence aggregate demand through tax changes or changes in government spending, and the lag time that occurs as Congress and the President attempt to pass legislation.