GOOD NEWS/BAD NEWS: ISSUES IDENTIFIED ON THE 2011 AP MACRO TEST Chris Cannon Sandy Creek High School

Background  Info taken from an Arthur Raymond (Chief AP Macro Reader) Presentation  Original Presentation here:  rses/ html rses/ html  This version can be found at: 

Content Areas Foreign Exchange Market Fiscal Policy Effect on AD Good News More Than ~50% of Students Answered Correctly

Success 1  Macro 2 (b) (ii)  b) Suppose in a different part of the world, the real interest rate in Canada increases relative to that in Mexico.  (i) Using a correctly labeled graph of the foreign exchange market for the Canadian dollar, show the effect of the change in real interest rate in Canada on the international value of the Canadian dollar (expressed as Mexican pesos per Canadian dollar).  (ii) How will the change in the international value of the Canadian dollar that you identified in part (b)(i) affect Canadian exports to Mexico? Explain.

Success 1 Pesos per CAD Canadian Dollar Supply Demand Demand2 e e2

Success 1 Pesos per CAD Canadian Dollar Supply Demand Supply2 e e2

Success 1 - Continued  Canadian exports to Mexico will decrease because appreciation of the Canadian dollar increases the prices of Canadian goods relative to Mexican goods.

Success 2  Macro 1 (b)  (b) Draw a correctly labeled graph of aggregate demand and aggregate supply in the recession and show each of the following.  (i) The long-run equilibrium output, labeled Yf (Success 2)  (ii) The current equilibrium output and price levels, labeled Ye and PLe, respectively. (Labels, AS, AD, and Ye, PLe) (Success 3)

Success 2 and 3 Yf AS AD PL Y PLe Ye

Success 4  Macro 1 (c)  To balance the federal budget, suppose that the government decides to raise income taxes while maintaining the current level of government spending. On the graph drawn in part (b), show the effect of the increase in taxes. Label the new equilibrium output and price levels Y2 and PL2, respectively.  On AS-AD diagram of part (b),AD shifts to the left, decreasing Y to Y2 and PL to PL2.

Success 4- Continued Y* SRAS AD1 PL Y PL2 Y2 AD LRAS PL1 Y1

Success 5  Macro 1 (d) (i)  (d) Assume that the Federal Reserve uses monetary policy to stimulate the economy.  (i) What open-market policy should the Federal Reserve implement?  Buy Bonds

Content Areas The Mechanics of Money Creation Categories of Unemployment Classical Adjustment to Recession Bad News Less than ~25% of Students Correctly Answered

2011 Test FR #3  3 of the top 5 errors come from this question  Problem areas: 3 (b) (ii) 3 (c) 3 (e)  Other issues: Students using irrelevant data from the question

Economic Concepts at Work  Reserve requirements  Money Multiplier  Bond Market  Money Supply

Activities 37 and 38  If you’re not doing this activity, you should be…

Mr. Cannon…  …How do I know when to multiply by the TOTAL amount of the deposit and how do I know when to multiply by the new loan?

Depends on the source…  If the money is already IN the money supply, then it can only expand by the amount of the initial loan  HOWEVER  If the money is NEW to the money supply (a la a FED bond purchase), then the money supply increases by the initial injection

Give question 3 a try!

Errors 5 and 4  Macro 3  (a) Based on Sewell Bank’s balance sheet, calculate the required reserve ratio. Req. Res. Ratio=0.20 (Required Reserves compared to Demand Deposits)  (b) Suppose that the Federal Reserve purchases $5,000 worth of bonds from Sewell Bank. What will be the change in the dollar value of each of the following immediately after the purchase?  (i) Excess reserves. $5,000  (ii) Demand deposit No change in demand deposits. (The purchase increases Sewell Bank’s reserves and decreases its bond holdings.)  (c) Calculate the maximum amount that the money supply can change as a result of the $5,000 purchase of bonds by the Federal Reserve. (Error 4)  Max. Change in Money Supply = 5,000 x 5 = $25,000

Error 2  Macro 3 (e)  (e) Suppose that instead of the purchase of bonds by the Federal Reserve, an individual deposits $5,000 in cash into her checking (demand deposit) account. What is the immediate effect of the cash deposit on the M1 measure of the money supply?  No effect. There is no change in the M1 measure of the money supply. (Demand deposits increase by the same amount that cash holdings fall.)

Classical Theory

Errors 1 and 3  3 rd most common error was on 1 (e) (ii)  Student’s misinterpreting natural unemployment  MOST common error last year was 1 (e) (i)  Deals with the long run shift of the SHORT RUN aggregate supply curve

Error 3  Macro 1 (e) (ii)  (e) Now assume instead that the government and the Federal Reserve take no policy action in response to the recession.  (ii) In the long run, what will happen to the natural rate of unemployment?  The natural rate of unemployment will not change.  Natural = Frictional + Structural  Based on productive resources at that time

Classical Theory Assumptions  Says Law = If a country can generate X GDP, they can generate enough income to buy X GDP  Therefore, the economy should have no inherent trouble reaching full employment  Nay”sayers” point out that not all income is spent

Classical Theory Assumptions  Prices, wages, and interest rates are all flexible in either direction  Don’t believe me?

Classical Theory Assumptions  In 2010 TOTAL wages paid to workers was just over $6 trillion.  Adjusted for inflation, that was the SAME amount paid to workers in 2005 when the population was 4.2% smaller  WAGES ARE FLEXIBLE!!!!!

Classical Explanation  If a recession, then  1. Unemployment (and unemployed resources) increases  2. Workers begin to accept wage cuts  3. Decrease in resource prices increase SRAS!!!!!

Y* SRAS PL Y PL2 AD LRAS PL1 Y1 SRAS2

Silly Example that works

Classical Explanation  If a inflationary gap, then  1. Prices increase  2. REAL WAGES decrease  3. Workers demand higher nominal wages (other input prices increase as well)  4. SRAS shifts left

Y* SRAS2 PL Y PL2 AD LRAS PL1 Y1 SRAS

Activity 28  If you’re not doing this activity, you should be! What are you doing??!

Error 1  Macro, Question 1 (e) (i)  (e) Now assume instead that the government and the Federal Reserve take no policy action in response to the recession.  (i) In the long run, will the short-run aggregate supply increase, decrease, or remain unchanged? Explain.  In response to the recession and no policy action, the short-run aggregate supply curve will increase (shift to the right) because the recession will eventually lead to lower wages and or other factor costs.

Why doesn’t this happen?  Government and FED are tampering with AD  Incomplete knowledge (never know where you are until you know where you were!)  Takes indeterminant amount of time (people impatient)  How flexible are wages/prices?