Preparing for the AP Macroeconomics Test Prepared by Dr. Seth Rhine, which doesnt really matter much Prepared by Dr. Seth Rhine, which doesnt really matter.

Preparing for the AP Preparing for the AP Macroeconomics TestMacroeconomics Test

Prepared by Dr. Seth Rhine, Prepared by Dr. Seth Rhine, which doesn’t really matter much which doesn’t really matter much

Table of ContentsTable of Contents

Structure of the testStructure of the testAP Macroeconomics Content StrandsAP Macroeconomics Content StrandsExamples of MC questionsExamples of MC questionsKey Graphs to the courseKey Graphs to the course14 Rules of Thumb for Macro Policy14 Rules of Thumb for Macro Policy

Structure of TestStructure of Test 2 sections: Multiple Choice and Free Response2 sections: Multiple Choice and Free Response Multiple Choice partMultiple Choice part

60 MC questions in 70 minutes60 MC questions in 70 minutes All worth the same valueAll worth the same value Accounts for 2/3 of overall AP score (more than most other Accounts for 2/3 of overall AP score (more than most other

Social Studies courses)Social Studies courses) Free response (60 minutes, 10 planning and 50 writing)Free response (60 minutes, 10 planning and 50 writing)

Mixture of graphing and short answerMixture of graphing and short answer 3 questions: 1 really big one and 2 minor ones3 questions: 1 really big one and 2 minor ones Big question = 50 % of free response score (or 16.67 % of Big question = 50 % of free response score (or 16.67 % of

overall AP score)overall AP score) Minor questions – equal weight, together add up to 16.67 of Minor questions – equal weight, together add up to 16.67 of

overall score (8.33 % each)overall score (8.33 % each)

Where does the content come Where does the content come from?from?

Fundamental Economic Concepts (8 – 12 %)Fundamental Economic Concepts (8 – 12 %) Measuring the Economy (12-16 %)Measuring the Economy (12-16 %) National Income and Price Distribution (10 – 15 %)National Income and Price Distribution (10 – 15 %) Financial Sector (15 – 20 %)Financial Sector (15 – 20 %) Inflation, unemployment and stabilization policies (25 – Inflation, unemployment and stabilization policies (25 –

30 %)30 %) Economic growth and productivity (5 – 10 %)Economic growth and productivity (5 – 10 %) Open Economy: Trade and Finance (10 – 15 %)Open Economy: Trade and Finance (10 – 15 %) Link to the PDF outline of the course (click on the course Link to the PDF outline of the course (click on the course

description, which is the first link)description, which is the first link)

Things about Multiple Choice Things about Multiple Choice PortionPortion

First 10 tend to be much easierFirst 10 tend to be much easier Last 10 to 20 are more difficult questionsLast 10 to 20 are more difficult questions

Combine that with time crunch and testing fatigue and it creates Combine that with time crunch and testing fatigue and it creates real challenges for studentsreal challenges for students

Key is to know the answer without looking at the 5 Key is to know the answer without looking at the 5 choices choices As you read the stem, formulate the answer you are looking for As you read the stem, formulate the answer you are looking for

in the choicesin the choices 2 types of MC questions2 types of MC questions

Vocab – incredibly obvious IF you know the vocabularyVocab – incredibly obvious IF you know the vocabulary Connection – multiple layers of information required and Connection – multiple layers of information required and

normally an application of this informationnormally an application of this information

Examples of 2 types of MC Examples of 2 types of MC (vocabulary based)(vocabulary based)

Suppose that the consumer price index rises Suppose that the consumer price index rises from 100 to 200. From this information we may from 100 to 200. From this information we may conclude thatconclude that A: each person’s real income is cut in halfA: each person’s real income is cut in half B: consumer incomes are doubledB: consumer incomes are doubled C: the prices in an average consumer’s market C: the prices in an average consumer’s market

basket are doubledbasket are doubled D: all consumer goods prices are doubledD: all consumer goods prices are doubled E: all prices in the economy are doubledE: all prices in the economy are doubled

If you know what the CPI is and the definition, If you know what the CPI is and the definition, you know to look for the market basket, Cyou know to look for the market basket, C

MC: Connect and apply typeMC: Connect and apply type Suppose that a national government increased deficit spending on goods Suppose that a national government increased deficit spending on goods

and services, increasing its demand for loanable funds. In the long run, this and services, increasing its demand for loanable funds. In the long run, this policy would most likely result in which of the following changes in this policy would most likely result in which of the following changes in this country?country? Interest RatesInterest Rates InvestmentInvestment A:A: decreasedecrease decreasedecrease B:B: decreasedecrease increaseincrease C:C: increaseincrease decreasedecrease D:D: increaseincrease no changeno change E:E: no changeno change increaseincrease

You would first need to know why deficit spending mattered, then You would first need to know why deficit spending mattered, then know how an increase in demand would affect the loanable funds. know how an increase in demand would affect the loanable funds. Next, you would then need to know how interest rates would be Next, you would then need to know how interest rates would be affected and how investment would change based on that affected and how investment would change based on that information. information.

Correct answer is CCorrect answer is C

What I am providing to each What I am providing to each student that is interestedstudent that is interested

Key vocabulary Sheet Key vocabulary Sheet 22 page course review created by another great 22 page course review created by another great

Economic teacherEconomic teacher John Jameson from Berkmar HSJohn Jameson from Berkmar HS

2 to 3 page handouts on the following major 2 to 3 page handouts on the following major topics:topics: Supply and demand, AD / AS, LF market, MM market, Supply and demand, AD / AS, LF market, MM market,

FEM market, and KeynesianFEM market, and Keynesian Access to old Free Response and MC test Access to old Free Response and MC test

questions (if interested)questions (if interested)

Where I would go if you need Where I would go if you need specific topical helpspecific topical help

I would try one of these two spots for helpI would try one of these two spots for helpwww.reffonomics.comwww.reffonomics.comhttp://www.sparknotes.com/economics/http://www.sparknotes.com/economics/

Both of these do a great job of Both of these do a great job of condescending the materialcondescending the material

What economic theories should I What economic theories should I be familiar with?be familiar with?

Dominant TwoDominant Two Classical v. KeynesClassical v. Keynes Classical – free market approach with flexible wages and pricesClassical – free market approach with flexible wages and prices Keynesian – short term approach on fiscal policy solutions to Keynesian – short term approach on fiscal policy solutions to

recessionary issues (taxes and government spendingrecessionary issues (taxes and government spending Other ones that pop – upOther ones that pop – up

Monetarists = MV = PY (relationship between money supply, Monetarists = MV = PY (relationship between money supply, velocity of money, price level, and GDP)velocity of money, price level, and GDP)

Supply-side (the goal of pushing out SRAS and LRAS combined Supply-side (the goal of pushing out SRAS and LRAS combined with investment back into the economy)with investment back into the economy)

Rational expectations: behaviors of society tend to be proactive, Rational expectations: behaviors of society tend to be proactive, resulting in no change in real output variablesresulting in no change in real output variables

What are the key graphs?What are the key graphs?

I always tell my kids these 10 graphs are hugeI always tell my kids these 10 graphs are huge Must knowMust know: AD / AS, Phillips Curve, Money : AD / AS, Phillips Curve, Money

Market, Foreign Exchange Market, Loanable Market, Foreign Exchange Market, Loanable Funds Market, PPCFunds Market, PPC

Usable dependent on student preferencesUsable dependent on student preferences Investment Demand Curve, Bond Market, Keynesian Investment Demand Curve, Bond Market, Keynesian

(not drawn, but must be able to interpret)(not drawn, but must be able to interpret) Supply and Demand graph is the 10Supply and Demand graph is the 10 thth, but that , but that

graph is the heart of so many, so if you don’t graph is the heart of so many, so if you don’t know that one, I wouldn’t take the examknow that one, I wouldn’t take the exam

Production Possibilities CurveProduction Possibilities Curve Shows the relationship for an Shows the relationship for an

entity as they make 2 productsentity as they make 2 products Also shows a maximum level Also shows a maximum level

of production with current of production with current resourcesresources

Curve shifting out = economic Curve shifting out = economic growthgrowth

Point outside = unattainable Point outside = unattainable and non-sustainableand non-sustainable

Point Y = underutilization of Point Y = underutilization of resourcesresources

PPC = LRAS (both represent PPC = LRAS (both represent most that can be produced most that can be produced with current factors of with current factors of production)production)

Supply and Demand GraphSupply and Demand Graph Price of the item on the y – Price of the item on the y –

axis (differs, but always the axis (differs, but always the price of the item)price of the item)

Quantity of item on x (this is Quantity of item on x (this is where you can tell what you where you can tell what you are looking at)are looking at)

Make sure you can Make sure you can differentiate between a change differentiate between a change in D / S and change in in D / S and change in Quantity demanded / quantity Quantity demanded / quantity suppliedsupplied

Increase in D / S shift to the Increase in D / S shift to the rightright

Decrease in D / S shift to the Decrease in D / S shift to the leftleft

Keynesian GraphKeynesian Graph Simplistic spending modelSimplistic spending model

Helps show spending Helps show spending multiplier (no changes in price multiplier (no changes in price level on this model)level on this model)

Can be used to find Tax Can be used to find Tax multiplier, MPC, MPSmultiplier, MPC, MPS

Shows GDP gaps and Shows GDP gaps and recessionary (or inflationary recessionary (or inflationary gaps)gaps)

From this graph you know:From this graph you know: I = 25, C = 50, SEM = 4, TM = I = 25, C = 50, SEM = 4, TM =

3, MPS = .25, MPC = .75, 3, MPS = .25, MPC = .75, Government spending needed Government spending needed

to solve = $50to solve = $50 Must be able to interpret if on a Must be able to interpret if on a

MC test question MC test question

AD / AS graphAD / AS graph Most used graph in the courseMost used graph in the course AD = potential consumption on AD = potential consumption on

new goods and services by new goods and services by households, businesses, households, businesses, government and foreign government and foreign entitiesentities

SRAS = capabilities of SRAS = capabilities of production at a variety of price production at a variety of price levels (takes into account cost levels (takes into account cost of labor)of labor)

LRAS = capabilities of LRAS = capabilities of production in economy (only production in economy (only looks at capital equipment, looks at capital equipment, ideas, labor quality and ideas, labor quality and quantity, and resources)quantity, and resources)

Yfe = output at full employmentYfe = output at full employment

Possible Economic SituationsPossible Economic Situations

Equilibrium At full employment

Inflation = Over-production

Stagflation:SRAS hasDecreasedAnd causedPL to increaseAnd RGDPTo decrease

RecessionOutput is Less thanFullemployment

Phillips CurvePhillips Curve Has gained increased Has gained increased

attention by the College attention by the College BoardBoard

An indirect way of An indirect way of assessing students assessing students knowledge about the AD / knowledge about the AD / AS modelAS model

Is basically the mirror Is basically the mirror image of the AS curves image of the AS curves

NAIRU = non-NAIRU = non-accelerating inflation rate accelerating inflation rate of unemployment of unemployment (basically the natural rate (basically the natural rate of unemployment)of unemployment)

Phillips Curve continuedPhillips Curve continued How is the AD / AS model connected to the Phillips How is the AD / AS model connected to the Phillips

Curve?Curve? AD changes cause changes to PL and unemployment (one gets AD changes cause changes to PL and unemployment (one gets

better while the other gets worse)better while the other gets worse) This leads to movement along the Short run phillips curve This leads to movement along the Short run phillips curve AS changes affect PL and unemployment in the same direction AS changes affect PL and unemployment in the same direction

(either they both get better or both get worse)(either they both get better or both get worse) This causes a complete shift of the Phillips CurveThis causes a complete shift of the Phillips Curve If you put the AD / AS model and Phillips Curve side-by-side with If you put the AD / AS model and Phillips Curve side-by-side with

a “mirror” between them, shifts of the AD / AS will be “mirrored” a “mirror” between them, shifts of the AD / AS will be “mirrored” by the shifts in the Phillips Curveby the shifts in the Phillips Curve

An increase in SRAS (shift towards the mirror to the right), will An increase in SRAS (shift towards the mirror to the right), will cause the SR Phillips curve to move towards the mirror (to the left)cause the SR Phillips curve to move towards the mirror (to the left)

LRAS and LR Phillips Curve behave the same way as the Short LRAS and LR Phillips Curve behave the same way as the Short run AS and Phillips Curverun AS and Phillips Curve

Money Market GraphMoney Market Graph Almost always attached to the FED Almost always attached to the FED

and Monetary policy questionsand Monetary policy questions Demand for moneyDemand for money

Transaction, precautionary and Transaction, precautionary and speculative reasons to hold moneyspeculative reasons to hold money

Supply of moneySupply of money Influenced by tools of the FED: Influenced by tools of the FED:

OMO, discount rate, and reserve OMO, discount rate, and reserve requirementrequirement

Nominal interest rate is the “price” of Nominal interest rate is the “price” of money in circulationmoney in circulation

Follows same basic rules for Follows same basic rules for changes as the supply and demand changes as the supply and demand graphgraph

Can be “connected” to Investment Can be “connected” to Investment Demand CurveDemand Curve

Loanable Funds Market GraphLoanable Funds Market Graph Widely used graph can be connected Widely used graph can be connected

to fiscal policy, monetary policy, and to fiscal policy, monetary policy, and capital flowcapital flow

Y-axis is real interest rateY-axis is real interest rate X-axis is the quantity of loanable X-axis is the quantity of loanable

funds (money that is capable of funds (money that is capable of being borrowed)being borrowed)

D = any entity that wishes to borrow D = any entity that wishes to borrow money (households, businesses, money (households, businesses, and government when it runs a and government when it runs a deficit)deficit)

S = the volume of savings by a S = the volume of savings by a variety of entities (can be thought of variety of entities (can be thought of as the money in banks that they can as the money in banks that they can loan out)loan out)

Can be connected to Investment Can be connected to Investment Demand CurveDemand Curve

Foreign Exchange MarketForeign Exchange Market Basic demand and supply Basic demand and supply

graph looking and the demand graph looking and the demand for $ and the supply of $ in the for $ and the supply of $ in the foreign currency (or exchange) foreign currency (or exchange) marketmarket

Increased demand for a Increased demand for a currency will lead to currency will lead to appreciation of currency (can appreciation of currency (can draw a supply decrease too)draw a supply decrease too)

Increased supply occurs when Increased supply occurs when people “dump” a currency to people “dump” a currency to attain another currency attain another currency This causes a decrease in the This causes a decrease in the

value of the currencyvalue of the currency

Bond MarketBond Market Rarely required as a drawn graphRarely required as a drawn graph Rule: Bond prices are inversely related Rule: Bond prices are inversely related

to interest ratesto interest rates Adds depth to the reasons that interest Adds depth to the reasons that interest

rates changerates change Expansionary fiscal policy (G up, AD up) Expansionary fiscal policy (G up, AD up)

leads to deficit spending, which causes leads to deficit spending, which causes the government to sell bonds the government to sell bonds (increasing the supply in this graph), (increasing the supply in this graph), causing the price of bonds to drop and causing the price of bonds to drop and the interest rates in the market to rise, the interest rates in the market to rise, then Consumption and investment then Consumption and investment spending decrease (AD slightly down)- spending decrease (AD slightly down)- this is crowding outthis is crowding out

Can also be used with FED and Can also be used with FED and monetary policy monetary policy Open market operations changes the Open market operations changes the

supply of bonds in the marketsupply of bonds in the market

Investment Demand CurveInvestment Demand Curve Shows the relationship Shows the relationship

between the interest rates between the interest rates (real or nominal) and the (real or nominal) and the quantity of Investment quantity of Investment spending in the economyspending in the economy

Can be “connected” or Can be “connected” or linked with the MM and linked with the MM and LF graphsLF graphs

Shifts of this curve can be Shifts of this curve can be caused by:caused by: Changes in business Changes in business

conditionsconditions Profitability expectationsProfitability expectations

Rule # 1Rule # 1

Too much money chasing too few goods creates Too much money chasing too few goods creates inflation; too little money chasing too many inflation; too little money chasing too many goods creates deflation.goods creates deflation. Monetary Equation of ExchangeMonetary Equation of Exchange MV = PYMV = PY

M=money supply, V=velocity of money, P= price level M=money supply, V=velocity of money, P= price level (inflation), Y = real GDP(inflation), Y = real GDP

In the long run, monetary policy doesn’t change the In the long run, monetary policy doesn’t change the resources a nation has, so therefore there is no resources a nation has, so therefore there is no bearing on long run output levels bearing on long run output levels

Rule # 2Rule # 2

A higher-valued dollar on international A higher-valued dollar on international currency markets discourages US exports; currency markets discourages US exports; a lower-valued dollar encourages exports.a lower-valued dollar encourages exports.Huge conceptHuge conceptWhen the $ appreciates, our dollar will stretch When the $ appreciates, our dollar will stretch

further in foreign markets (imports increase), further in foreign markets (imports increase), but foreign consumers can buy less US goods but foreign consumers can buy less US goods (exports decrease)(exports decrease)

This causes AD to decreaseThis causes AD to decrease

Rule # 3Rule # 3

Increases in the demand for money and cash by Increases in the demand for money and cash by the public raises interest rates.the public raises interest rates. Increasing importance in both the money market Increasing importance in both the money market

graph and loanable funds graphgraph and loanable funds graph 3 types of demand for money: Transaction (related to 3 types of demand for money: Transaction (related to

price levels), Speculation (related to money as an price levels), Speculation (related to money as an asset), Precautionary (related to fear about the asset), Precautionary (related to fear about the economy)economy)

When you demand the money, you are essentially When you demand the money, you are essentially demanding cash instead of other forms of M1 and M2 demanding cash instead of other forms of M1 and M2 moneymoney

Rule # 4Rule # 4

Higher interest rates Higher interest rates discourage borrowing for discourage borrowing for investment and investment and consumption; lower consumption; lower interest rates encourage interest rates encourage borrowing.borrowing. Understand the cost of the Understand the cost of the

item doesn’t change, but item doesn’t change, but the amount of interest goes the amount of interest goes up (which increases the up (which increases the overall or “true” price of the overall or “true” price of the item) item)

Rule # 5Rule # 5 The Federal Reserve can manipulate interest The Federal Reserve can manipulate interest

rates to try to stabilize the economy – this is rates to try to stabilize the economy – this is called “monetary policy”.called “monetary policy”. Notice the word manipulate, they do not set the Notice the word manipulate, they do not set the

market interest rates (banks and customers do this)market interest rates (banks and customers do this) 3 tools of MP3 tools of MP

Open market operations (influences the federal funds rate)Open market operations (influences the federal funds rate) Discount rate (overnight borrowing from banks and FED)Discount rate (overnight borrowing from banks and FED) Reserve Requirement (% banks must keep in required Reserve Requirement (% banks must keep in required

reserves), this helps determine the money multiplierreserves), this helps determine the money multiplier Leakages in the money expansion – banks not Leakages in the money expansion – banks not

loaning out all excess reserves, businesses not loaning out all excess reserves, businesses not redepositing into banks, customers holding cashredepositing into banks, customers holding cash

Rule # 6Rule # 6

Pessimism about sales and profits reduce Pessimism about sales and profits reduce business investment.business investment. True of household consumption alsoTrue of household consumption also Decreases the investment demand curve (an actual Decreases the investment demand curve (an actual

shift would occur)shift would occur) I down = AD down = PL / Output downI down = AD down = PL / Output down I down = LRAS down = PPC down (notice that the I down = LRAS down = PPC down (notice that the

SRAS doesn’t change because the current capital SRAS doesn’t change because the current capital equipment is not removed), but if no new capital equipment is not removed), but if no new capital equipment is purchased, when the current equipment equipment is purchased, when the current equipment breaks-down, nothing is there to replace itbreaks-down, nothing is there to replace it

Rule # 7Rule # 7

Decreases in spending Decreases in spending for consumption, for consumption, investment, government investment, government purchases or exports can purchases or exports can cause recessions, cause recessions, meaning reduction in meaning reduction in output and increases in output and increases in unemployment.unemployment. This is the AD formulaThis is the AD formula Graph is of the short run Graph is of the short run

(no LRAS is needed (no LRAS is needed sometimes)sometimes)

Rule # 8Rule # 8 The Federal Government (Washington DC) can The Federal Government (Washington DC) can

alter its taxes and spending to try and stabilize alter its taxes and spending to try and stabilize the economy – this is called “the economy – this is called “fiscal policy”.fiscal policy”. Some fiscal policy takes place automatically Some fiscal policy takes place automatically (called automatic stabilizers) and some requires (called automatic stabilizers) and some requires acts by Congress and the President acts by Congress and the President (discretionary).(discretionary). Automatic include: welfare payments, unemployment Automatic include: welfare payments, unemployment

compensation, progressive tax structurecompensation, progressive tax structure Regulations can also influence the economic Regulations can also influence the economic

situation, but regulations are not normally changed to situation, but regulations are not normally changed to change the economic situationchange the economic situation

Rule # 9Rule # 9

# 9: There is short-# 9: There is short-run tradeoff between run tradeoff between inflation and inflation and unemployment. unemployment. Higher unemployment Higher unemployment reduces inflation and reduces inflation and lower unemployment lower unemployment increases inflation.increases inflation. See short run Phillips See short run Phillips

Curve Curve

Rule # 10Rule # 10 If inflation remains high for some If inflation remains high for some

time, people will begin to expect it. A time, people will begin to expect it. A wage-price spiral can develop that wage-price spiral can develop that can keep inflation going despite can keep inflation going despite changes in policy or the economy.changes in policy or the economy. When AD is in the classical (inflationary When AD is in the classical (inflationary

area), workers will notice the higher area), workers will notice the higher prices in their livesprices in their lives

This causes workers to ask for raisesThis causes workers to ask for raises Because there are very few available Because there are very few available

workers, businesses grant the raisesworkers, businesses grant the raises The raises cause the cost of production to The raises cause the cost of production to

go upgo up Causing SRAS to shift to the left and Causing SRAS to shift to the left and

causing higher prices and output to causing higher prices and output to gravitate back to the Yfe pointgravitate back to the Yfe point

Rule # 11Rule # 11

Sudden increases in resource prices or Sudden increases in resource prices or decrease in availability of resources can decrease in availability of resources can cause simultaneous recession and cause simultaneous recession and inflation (called stagflation). inflation (called stagflation). Stagflation is a decrease in SRAS (also call Stagflation is a decrease in SRAS (also call

cost-push inflation)cost-push inflation)More resources tend to increase growth More resources tend to increase growth

and reduce inflation.and reduce inflation.SRAS increases, causing output and SRAS increases, causing output and

employment to increase and PL’s to decreaseemployment to increase and PL’s to decrease

Rule # 12Rule # 12 Federal budget deficits can crowd Federal budget deficits can crowd

out business investmentout business investment As the government spends money it As the government spends money it

doesn’t have (creates deficit spending)doesn’t have (creates deficit spending) The government has to borrow money The government has to borrow money

by issuing bondsby issuing bonds This increased demand for loanable This increased demand for loanable

funds leads to an increase in real funds leads to an increase in real interest ratesinterest rates

r going up causes less borrowing by r going up causes less borrowing by businesses and less investment businesses and less investment spendingspending

The end result is a slight cancelling out The end result is a slight cancelling out of the AD increase that came with of the AD increase that came with expansionary fiscal policyexpansionary fiscal policy

Rule # 13Rule # 13

Higher interest rates can Higher interest rates can increase the value of the increase the value of the dollar in international dollar in international currency markets.currency markets. Higher interest rates Higher interest rates

causes capital inflow causes capital inflow Foreign savers put their Foreign savers put their

money in our marketmoney in our market This causes the demand This causes the demand

for the $ to increasefor the $ to increase Value of dollar appreciatesValue of dollar appreciates

Rule # 14Rule # 14

Increases in Increases in productivity can lead productivity can lead to expansion with to expansion with lower inflation. lower inflation. Productivity is a nice Productivity is a nice

thing, we can make thing, we can make more with the same more with the same amount of inputsamount of inputs

SRAS increases SRAS increases