Example free response question from AP macroeconomics | AP Macroeconomics | Khan Academy

Video, I want to tackle an entire AP Macroeconomics free response exercise with you. Assume that the economy of Country X has an actual unemployment rate of seven percent, a natural rate of unemployment of five percent, and an inflation rate of three percent. Using the numerical values given above, draw a correctly labeled graph of the short-run and long-run Phillips curves. Label the current short-run equilibrium as point B. Plot the numerical values above on the graph.

So pause this video if you are inspired to do so, but I will now work through it. So remember, Phillips curves show the relationship, or the theoretical relationship, between the unemployment rate and the inflation rate. So I'm going to put the inflation rate in the vertical axis, which is typical, and then on the horizontal axis, I am going to do my unemployment rate. So this is going to be my unemployment rate, which is going to be a percentage.

Now, we want to graph the short-run and long-run Phillips curves. Let's do the long run first, because we've seen before the long run just sets our unemployment rate at the natural rate of unemployment, and it isn't related to our inflation rate. It'll just be a vertical line, and so it'll be a vertical line at our natural rate of unemployment, which is 5. So maybe it looks just like this. So I could call that our long-run Phillips curve, and it's going to be right there at five percent.

And I'm going to now have to do the short-run Phillips curve, and that will show a relationship between inflation rate and unemployment. And just think about what's going on: if you have a low rate of unemployment, especially if it's below your natural rate of unemployment, well then there's a lot of demand for people. And so people say, "Hey, if you want me to work, you gotta pay me a little bit more." And so that could just lead to a higher inflation rate. And then, if a lot of people are unemployed, they might be willing to work for less, or they might have less money in their pocket with which to drive up prices. And so you will have this inverse relationship right over here.

So this is the short-run Phillips curve, which is downward sloping, and then they say label the short-run equilibrium as point B. So let's say this is point B right over here. And they say the short-run equilibrium, we have an unemployment rate of seven percent and an inflation rate of three percent. So our unemployment rate right over here is seven percent, and our inflation rate right over here is three percent.

All right, let's do the next section. Assume that the government of Country X takes no policy action to reduce unemployment in the long run. Which of the following: shift to the right, shift to the left, or remain the same? So here they're saying short-run aggregate supply curve, explain. So here it's kind of tricky because you might be thinking they're asking about what you just drew, but here they're talking about aggregate supply.

So let me draw a graph to even help visualize this. So if we're talking about aggregate demand and aggregate supply, our vertical axis is going to be our price level. I'll just call that PL, and our horizontal axis, that is going to be our real GDP. So this is real GDP right over here, GDP. Now you're just going to have a long-run supply curve which is vertical; that's just the full employment output for our country. So that's the long-run aggregate supply.

But what about the short-run aggregate supply curve? Well, that's going to be upward sloping. If price levels are low, people might not be willing to output a lot, and if price levels are high, people will output more. So our short-run aggregate supply would look like that. I'll call that SRAS1 since we're going to think about how it shifts, and then aggregate demand would look something like this. Let me draw it like that, and notice our equilibrium point right over here. Let me call that aggregate demand right over here; let's call that Y1, and we are at price level PL1.

I drew it to the left of the long-run aggregate supply curve; I drew it to the left of the full employment output, because we are dealing with a recession here. Our unemployment rate is higher than the natural level of unemployment. So if our actual unemployment rate is higher than the natural rate of unemployment, what will happen to the short-run aggregate supply?

So one way to think about it is, at a given price level, because there's people out there looking for a job, you might be able to get more output, or at a given amount of output, it might cost less because there's just people out there competing for that work. And so you would have your short-run aggregate supply curve shift to the right, SRAS2, and then your equilibrium price level would go down, PL2 would go down.

So we could say, because of high unemployment, that could apply wage pressure. We could say wages come down, which would shift the short-run aggregate supply curve to the right. And there are a couple of ways to think about that: you would have more output at a given price level. You could also think that at a given output level, you would have a lower price level at a given price level.

Part two: Long-run Phillips curve. So that's this vertical line right over here. And the thing to appreciate is these long-run Phillips curve or the long-run aggregate supply curve, these don't change unless something structurally changes in the economy. Unless the economy changes in some very fundamental way, maybe a change in education levels, change in population, or a change in technology. And so here we would say it just remains the same, remains the same.

All right, we have more parts here. Now let's go to part C: Identify a fiscal policy action that could be used to reduce the unemployment rate in the short run. So you have to be very careful here. They're saying a fiscal policy action, not a monetary policy. If you said, "Hey, we would change the federal funds rate, or we would increase the money supply, or decrease the money supply," those would be monetary actions. We care about a fiscal policy action, and this would be in relation to lowering taxes or raising taxes or increasing or decreasing government spending.

Well, if we want to reduce the unemployment rate, one way to do that would be to shift aggregate demand to the right. And one way to do that would be to put more money in people's pockets. And one way to do that is to have a tax cut, a tax cut.

All right, draw a correctly labeled graph of aggregate demand and short-run aggregate supply, and show the impact on the equilibrium price level and real GDP of the fiscal policy action identified in part C. All right, let me draw that. So this is going to be... so that we have our price level axis up here, and we just drew something very similar to this: real GDP. And now let's draw our short-run aggregate supply, which we have seen before. That would be upward sloping. As the price level increases, people would—or the economy might be willing to output more—so that short-run aggregate supply.

And then let's draw an aggregate demand curve. So let's call that AD1, and then you have the equilibrium output. Let's call that Y1, and you have your equilibrium price level PL1. And now if you have a tax cut, that would shift aggregate demand to the right. At any given price level, people are going to want more; they're going to demand more because now they have more money in their pockets. And so it's going to shift to the right.

So I'll do AD2, and now we have a different equilibrium real GDP. So that is going to be Y2, and it happens. And then we have PL2. So you see our price level goes up, and our aggregate output—our GDP, our real GDP—goes up as well.

Based on the change in real GDP identified in part D, will the supply of Country X's currency in the foreign exchange market increase, decrease, or remain the same? Explain. The way I think about it is, if you have real GDP increasing, you're in a situation where you just have more economic activity; the national income has gone up. And if national income has gone up, people are going to do a lot more of everything, including buying imports. And to buy imports, they would have to increase the supply of their currency in exchange markets because they want to convert it into foreign currencies to buy those imports. And so this will increase, increase.

And we could say, because national income has gone up, people will buy more imports. So the supply of Country X's currency for exchange will go up; Country X's currency for exchange will go up. All right, part F: Based on your answer to part E and assuming a flexible exchange rate system, will Country X's currency appreciate, depreciate, or remain the same in the foreign exchange market?

Well, if you hold all else equal but you increase the supply of something, well, then the price of it is going to go down if the demand for it stays constant. But if you increase the supply—and that's what we just talked about in part E—well then the price is going to go down. And when we're talking about the price of a currency, and we're saying it's going down, we would say that that currency is depreciating. So it would depreciate, and we're done.