English
This practice question is in the style of the long AP free-response question. Try each part before reading the answer.
The economy of Lumeria is in short-run equilibrium with real GDP of $900 billion. Full-employment output is $1,000 billion. The marginal propensity to consume is 0.8.
(a) Draw a correctly labeled AD-AS graph showing Lumeria's current situation.
Draw AD, SRAS and a vertical LRAS. Label the axes price level and real GDP. Mark equilibrium output $Y_1$ to the left of $Y_f$ on LRAS, and the price level $PL_1$. (This is the left panel of the output-gaps figure above.)
(b) Is the unemployment rate above, below or equal to the natural rate? Explain.
Above the natural rate. Output is below full employment, so there is cyclical unemployment.
(c) Calculate the maximum change in real GDP that a $20 billion increase in government spending could cause.
Spending multiplier $=\dfrac{1}{1-0.8}=5$, so the maximum change $=5\times\$20\text{ billion}=\$100$ billion. That is exactly the size of the gap. Write "maximum" because crowding out or price-level rises can make the actual change smaller.
(d) Instead of spending, the government cuts taxes. What is the smallest tax cut that could close the gap?
Tax multiplier $=-\dfrac{0.8}{0.2}=-4$. The gap is $100 billion, so the tax cut is $\dfrac{\$100\text{ billion}}{4}=\$25$ billion. A tax cut must be larger than a spending rise ($25 billion against $20 billion), because households save part of it.
(e) If the government does nothing, what happens to nominal wages and to SRAS in the long run? What happens to the price level?
High unemployment pushes nominal wages down, so SRAS shifts right. Real GDP returns to $1,000 billion and the price level falls.
Common ways to lose the mark: writing "price" on the vertical axis; showing $Y_1$ on the wrong side of LRAS; raising taxes when the gap calls for a tax cut (the tax multiplier is negative, so a cut raises GDP); saying AD shifts in self-adjustment (only SRAS shifts).