AP® Macroeconomics · Free response

A recessionary gap in Calder: fiscal policy, the money market and self-adjustment

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Long free-response question · four-function calculator · 10 points · about 25 minutes

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The question

Name: ______________________   Date: ____________   A recessionary gap in Calder: fiscal policy, the money market and self-adjustment (10 points)

Calder is an invented country in a recessionary gap: its real GDP is 80 billion dollars below full-employment output. Its marginal propensity to consume (MPC) is 0.75. The government decides to raise its purchases of goods and services.

  1. (A) Draw a correctly labeled AD-AS graph showing Calder's recessionary gap, with LRAS, and show the short-run effect of the rise in government purchases on the price level and real GDP. [3 points]

  2. (B(i)) Calculate Calder's spending multiplier. Show your work. [1 point]

  3. (B(ii)) Calculate the minimum increase in government purchases that closes the gap, assuming the price level does not change. Show your work. [1 point]

  4. (C) Suppose the government cut taxes instead. Explain why the tax cut needed to close the same gap is larger than your answer in part B(ii). [1 point]

  5. (D) Assume Calder's central bank works in a limited-reserves framework and holds the money supply constant. Draw a money market graph and show the effect of the rise in real GDP from part A on the nominal interest rate. [2 points]

  6. (E(i)) Suppose instead that Calder's government had taken no action. Explain how the economy would return to full-employment output in the long run. [1 point]

  7. (E(ii)) Compared with the long-run equilibrium reached through the rise in government purchases, identify whether the price level at the long-run equilibrium in part E(i) is higher, lower or the same. [1 point]