2009 B Microeconomics FRQ #2

2009 B Microeconomics FRQ #2

Watch me answer it here

https://youtu.be/Bv5i6-9NvRg

(A) Assume the last unit of peanuts consumed increased Sasha's total utility from 40 utils to 48 utils and that the last unit of bananas consumed increase her total utility from 52 to 56 utils.

(i) If the price of a unit of peanuts is $1 and Sasha is maximizing utility, calculate the price of a unit of bananas.

Anytime, you see a utility question use the formula:

(ii) If the price of a unit of peanuts increases and the price of a unit of bananas remains unchanged from the price you determined in (a)(i), how will Sasha's purchase of peanuts change?

Understand that if the price of peanuts increases, then the value of MU (marginal utility) to price will decrease. If the price of peanuts increase then for every dollar spent on peanuts I will be able to buy fewer and fewer peanuts.

(B) Assume that the cross price elasticity (XED) of demand between peanuts and bananas is positive. A widespread disease has destroyed the banana crop. What will happen to the equilibrium price and quantity of peanuts in the short-run? Explain.

Understand what a positive XED means, from the elasticity cheat sheet here.

Since peanuts and bananas are substitutes, when the crop of bananas are destroyed (banana's supply curve shifts leftward) the price of bananas will rise and consumers will demand more peanuts as they are a substitute for bananas they (peanuts) are relatively cheaper. You must understand that if the price of bananas rises and the price of peanuts stays the same, then, per dollar spent, peanuts have now become cheaper. 

(C) Assume the price of bananas increase.

(i) Will the substitution effect increase, decrease, or have no effect on the quantity of bananas demanded?

The substitution effect will decrease the quantity of bananas demanded. Price goes up the quantity demanded goes down. The substitution effect is one of the very reasons that the demand curve slopes down....

(ii) What happens to Sasha's real income?

 If prices rise/Inflation increases then real incomes/wages fall.

From an earlier post on nominal and real wages here.

2009 Macroeconomics FRQ #2

2009 Macroeconomics FRQ #2

(A) How will this decision by investors affect the international value of the Tara's currency on the foreign exchange market? Explain.

So, If I have my money in Tara, and all hell breaks loose. I will want to get my money out of the country super quick. I have to exchange my Tara currency for some other more stable currency to preserve the value of my money. So the FOREX will have many people trying to do this and therefore the supply of Taras' will increase in the FOREX, meaning that the value of the Tara will fall.

(B) Using a CLG of the loanable funds market in Tara, show the impact of the decision by investors on the real interest rate in Tara.

Understand that the loanable funds market is the graph of the amount of money in the commercial banks in Tara. If investors pull their money out of Tara then the supply of cash in Tara's banks must decrease. 

The real rate will increase as the supply of loanable funds decrease.

(C) Given your answer in part (b), what will happen to Tara's rate of economic growth.

A rising interest rate will deter people from borrowing money. This will deter investment and consumption and therefore Tara's economic growth will suffer. 

2009 Macroeconomics FRQ #3

2009 Macroeconomics FRQ #3

Watch me answer it here

https://youtu.be/wgV3xOqAjZA

(A) Assume that Kim deposits $100 of cash from her pocket into her checking account. Calculate each of the following.

Refer to the Reserve Requirement Cheat Sheet here.

(i) The maximum dollar amount the commercial bank can initially lend.

So, Kim deposits her $100 into the bank. The bank has to hold in reserves 20% of the $100. So, $20 is kept in reserve (it cannot be loaned out), which leaves $80 that can be loaned by this commercial bank.

(ii) The maximum total change in demand deposits in the banking system.

This one confused me today,,, That tends to happen if you don't go over these questions regularly.

So, the change in demand deposits in the banking system. Demand deposit is the amount deposited into a bank and payable back to the customer upon demand. The whole $100 is owed to Kim. 

Excess reserves x money multiplier = max. change in loans

                  $80 x 5 - $400

                  Max. change in loans + original deposit = max. change in demand deposits

                  $400 + $100 = $500                 

So, $100 is deposited which makes demand deposits increase by $100 and then money creation happens within the banking system.

How does that look????

This question is asking you how much money creation can happen throughout the banking system due to the deposit of $100 by Kim, in the banking system. The 1st bank takes in Kim's $100, keeps $20 (20%) of it in required reserves, and loans out the remaining $80. That money is then used and deposited into bank #2. Bank #2 takes the $80 and keeps $16 (20%) of it in required reserves and loans out the other $64 dollars. That $64 loan is spent and ends up in Bank #3 of which $12.8 (20%) is required to be kept in reserve and the remaining $51.2 is loaned out. Rinse, Repeat.

(iii) The maximum change in the money supply.

We can understand that the multiplier is 5. 

How do we know this?

Check out the MPC/MPS Cheat Sheet here.

You can also use the formula 1/RRR and 1/.2 is 5. (the .2 is the 20%, required to be held in reserve)

So, Kim, deposits $100 and 20% is held in reserve which means that $80 can be loaned out and so on.

$80 x 5 = $400 ,,,,,,, 

Understand that Kim's $100 is not counted because it was already considered part of the money supply. So we just look at change in the money supply or just the new money created by the banks loaning out money.

(B) Assume that the Federal Reserve buys 5 million in government bonds on the open market. As a result of the open market purchase, calculate the maximum increase in the money supply in the banking system.

First, the FED has created $5m and injected it into the money supply increasing the supply of money by $5m immediately. Then the banks create money by loaning out the excess reserves.  The banks have $5m deposited and their required reserves are $5m x 20% or $1m. Now banks have $4m in excess reserves able to be loaned out by the banks. If they loan it all out, the $4m is multiplied by 5 (just like above) which will give us $20m.... oops!, don't forget to add to the $20m the original $5m that the FED invested into the money supply to get a total money supply increase of $25m

(C) Given the increase in the money supply in part (b), what happens to real wages in the short-run. Explain.

If the money supply increases real wages fall as the value of every individual dollar someone holds will decline. We could also say that the prices of all goods will rise as more money chases the same amount of goods, pushing prices higher. If there are no wage increases to keep up with rising prices (inflation) then real wages have fallen.

AD/AS Recession FRQ Review

AD/AS Recession FRQ Review

Developing a workbook for AP - Thoughts are appreciated (wcwaugh@aol.com)

Over the last 22 AP Macro Exams the Recession Graph of the economy has been requested 12 times. It is expected that you not only be able to graph an economy in recession but you must be able to recognise an economy in recession by the AP's language (phraseology)

2003B - Assume that the country's economy is operating below full-employment.

2003 - Assume the economy is in a severe recession with no inflation.

2004 - Assume the economy is operating at less than full-employment 

2006B - Assume the economy is operating at less than full-employment

2006 - Assume the economy is currently at equilibrium below full-employment

2007 - The economy is currently in recession but recovering

2009B - The unemployment rate is greater than the natural rate of unemployment

2010B - Assume the country's economy is in short-run equilibrium with an output level less than the full employment output level.

2011 - Assume the economy is currently in recession in a short-run equilibrium.

2012 - Assume the country is in recession

2014 - Assume the economy is operating below the full-employment level of real gross domestic product with a balanced budget

2015 - Suppose the economy is operating below full employment

2016 - Assume the economy is currently in a short-run equilibrium with the actual rate above the natural rate of unemployment.

So, if we deconstruct this a bit, we see a few phrases that keep repeating.

1. Recession (easy)
2. less than full employment or below full employment (full employment is the NRU)
3. unemployment rate is greater than (above) the natural rate of unemployment (NRU)

So, if you see any of these phrases, its a tip that a recession curve will be asked to be drawn.

So, how would this look.

1. Assume the economy is in recession.

(a) Draw a CLG (clearly labelled graph) of the AD/AS curve of the economy below full employment.

List all of these, every time to check your own thinking. (ROUPY)

RGDP - Decreasing 

Output - Decreasing

Unemployment - Increasing (above the natural rate of unemployment) (Understand this!!!!)

Price Level - Decreasing at PL2

Y = Income - Decreasing at Y2

2. Assume the economy is operating below the full-employment level.

(a) Draw a CLG (clearly labelled graph) of the AD/AS curve of the economy below the full employment level and (ROUPY).

(b)The government decides to lower individual income tax rates to achieve full employment.

(c) Explain (WHY) how the government's decision to lower income tax rates will affect the AD & SRAS curve.

(d) List using (ROUPY) what happens in the economy when the government lowers the tax rates.

(a) 

RGDP - Decreasing 

Output - Decreasing

Unemployment - Increasing

Price Level - Decreasing to PL2

Y = Income - Decreasing to Y2

(b) The government lowers individual tax rates (this is a determinate of AD) 

Be careful not to get this confused with a lowering of business tax rates as that would be a determinate of AS)

(c) The lowering of individual income tax rates (expansionary policy) will increase the levels of disposable incomes in the economy and lead to more (C) consumption and (I) investment and therefore AD will increase. The SRAS curve will not be affected.

(d) 

RGDP - Increases as (C) & (I) increases

Output - Increases as more disposable income in the economy stimulate AD.

Unemployment - Decreases as more people are put back to work as output increases.

Price Level - Increases (Businesses raise prices as demand increases)

Y = Increasing Incomes due to demand for labor because of rising demand for goods

Understand the flow of these questions.

The economy is at a point (equilibrium, recession, inflation)

You can be asked to graph (AD/AS) the above.

Then the government, or the FED does something, or something happens in the economy (oil prices fall, Consumer confidence rises, government spending increases, the FED buys bonds)

You are asked to graph (AD/AS) the affects of the above and or explain.

The last section pertaining to the AD/AS curve is if the government does nothing. 

The AP exam has asked this 5 times over the last 22 FRQ exams.

2004 - No policy action is taken

2006B - no policy action is taken and wages and prices are flexible

2009B - Government decides to take no policy action

2011B - In the absence of any fiscal (government) or monetary (FED) policy

2011 - Now assume the government and the Federal reserve take no policy action

Equilibrium

Equilibrium to Recession

Recession in the Long-Run (No Policy (Gov't/FED) Actions)

AD/AS Equilibrium FRQ Review

AD/AS Equilibrium Review

Ok, so I'm working on a review booklet for the AP Macro Course.

Equilibrium: Understanding and Practice

Over the last 22 AP Macro Exams the Equilibrium Graph of the economy has been requested 8 times. It is expected that you not only be able to graph an economy in equilibrium but you must be able to recognise an economy in equilibrium by the AP language (phraseology)

2004B - Assume the economy is in Equilibrium.

2005B - Assume the country's economy is in Equilibrium

2005 - Assume the economy is in equilibrium at the full-employment level of real gross domestic product.

2007 - Assume the economy is in equilibrium.

2008 - Assume the economy is at full employment and has a balanced budget.

2009 - Assume the economy is in long-run equilibrium.

2010 - Assume the government is currently in long-run equilibrium.

2011B - Assume the economy is in long-run equilibrium with a balanced government budget.

2013 - Assume the economy is operating at full employment.

The words that tip you off for equilibrium are: Equilibrium (Obviously), Full-employment, and Long-Run Equilibrium - These all mean an Equilibrium graph

Be able to draw a country's economy in equilibrium using a LRAS, SRAS, and AD curve. Know that the axis are labelled PL (price level) and RGDP (real gross domestic product). Understand that the Y stands for Income.

I always start every problem from Equilibrium. From the AD/AS cheat Sheet Here. 

There are literally only 5 (five) main graphs that you need to be able to draw to answer the AD/AS sections of the course.

These are: Equilibrium, Recession, Inflation, Stagflation and Growth.

If you can draw the above with their long-run companions then you are well on your way to be able to master this section of the course. At least for the FRQ portion of the exam. 

I also find it helpful to answer all questions using the acronym (ROUPY)

Show when you answer a section of the question what is happening.

R - RGDP

O - Output

U - Unemployment

P - Price Level (PL)

Y - Income 

Understand that RGDP/Output/Incomes all travel in the same directions

You might be tempted to say that the PL will increase also when the three above increase but during deep recessions the Keynesians would argue the point. They believe that during deep recessions the AS curve is flat/horizontal in the beginning range and therefore if AD increases price levels don't necessarily rise..... Be aware of this, it isn't quizzed very often but it should be in the back of your mind.

So, how would this look on an AP exam.

1. Assume the economy is in equilibrium with full employment.

(a) Draw a CLG (clearly labelled graph) of the AD/AS curve of the economy at full employment.

(ROUPY)

RGDP - Stable (stable means not decreasing or increasing)

Output - Stable

Unemployment - NRU (at the natural rate of unemployment) (Understand this!!!!)

Price Level - Stable at PL1

Y = Income - Stable at Y1

You must draw this graph at least 100 times,, as all questions should (in my opinion) start from this point.

2009 B Macroeconomics FRQ #2

2009 B Macroeconomics FRQ #2

These questions must be evaluated from their starting places.  The FED's actions must be thought of as outside the system.

(A) Calculate each of the following:

(i) The total change in reserves in the banking system.

This is a contractionary policy as the money supply is being decreased.

If the FED sells government securities (bonds) on the open market. Then the supply of money will be reduced by $50 million in reserves. Individuals will exchange $50m for FED bonds.

Understand that Required reserves and excess reserves will be reduced.

(ii) The maximum possible change in the money supply.

So this withdrawal of $50 million out of the system would reduce the money supply by $500m.

Why?

The multiplier works in reverse for this question: Its a contractionary policy...

But first let us think about the expansionary policy, if the FED had bought bonds instead of sold them.

So if the FED had bought bonds there would normally be an increase in the money supply of $450m 

$50 million bonds bought by the FED and 10% must be held in reserves, 50 x 10% = 5 mil

So we are down to $50 - 5 = $45 million able to be loaned out and multiplied.

With a 10% RRR the $45 million would be multiplied by a factor of 10m which would increase the money supply by $450m but don't forget the original 50m which would need to be added into the multiplied amount. So, 450m + original 50m = 500m expansion of the money supply.

The FED withdrawals the whole $50m out of the money supply reducing the amount of money that the banks have in reserves or could have loaned out, thus decreasing the money supply by the entire $500m.

(B) Using a CLG of the money market, show the impact of the Central Bank's bond sale on the nominal interest rate.

If the money supply is reduced then the nominal interest rate will rise. 

(C) What is the impact of the Central Bank's bond sale on the equilibrium price level in the short-run?

If a contractionary policy is enacted (selling of bonds) then the nominal interest rate will rise. A rising interest rate will cause investment and consumption to fall. If consumption (C) and investment (I) fall then AD will fall and therefore the PL will fall.

Graph - 

(D) As a result of the price level change in (C), are people with fixed incomes better off, worse off, or unaffected. Explain.

Recognise that even if you don't have a clue that by guessing you have a 331/3% chance of getting a point. 

If the price level falls, then people with a fixed income will be better off. They can buy more stuff as prices have fallen. Their purchasing power has increased.

Crowding-Out

Crowding-Out

Reffonomics on Crowding Out Video

Definition: A situation when increased interest rates lead to a reduction in private investment spending such that it dampens the initial increase of total investment spending is called crowding out effect.

Simply put, The Federal Government spends more money than they have as revenue and to keep spending must borrow from the banks. How do they borrow? They sell Government Bonds. In selling these bonds cash is sucked out of the banks. Interest rates rise as there is less cash in the banks coupled with a larger demand for this cash. Rising interest rates slow the amount of investment in the economy.

The government has an expansionary policy and with its spending is trying to push AD aggregate demand higher, taking advantage of the multiplier. Spending raises interest rates that slows or even decreases (I) investment spending thus decreasing the effects of the multiplier.

Fiscal Policy Cheat Sheet here.

Lets look at examples of multiple choice questions:

2008 AP Multiple Choice

Answer - (decrease in private investment due to increased borrowing by the government)

2000 AP Multiple Choice

Answer - (C) higher interest rates decrease private sector investment

2005 AP Multiple Choice

Answer - (B) The decrease in consumption or private investment spending caused by an increase in government spending.

2010 AP Multiple Choice

Answer - (B) government borrowing to finance its spending decrease private sector investment.

1995 AP Multiple Choice

Answer - (A)

Tricky!

A tax cut is an expansionary fiscal policy. If the government decreases tax rates then it has less revenue. Less revenue means it must borrow to keep spending. The borrowing raises interest rates. Raising of interest rates will slow the amount of (I) investment which will keep GDP from increasing as much as expected, but it will increase. Just less than the government would have liked.

(Practice Question)

Answer - (B) Increasing the real interest rate

(Practise Question)

Answer - (C) Budget deficit increases

2010 FRQ#1

2010B FRQ#1

2008 FRQ#1

Blog post for 2008 FRQ#1 here.