AP Macroeconomics Test Booklet Unit 3 Progress Check: FRQ Name 1. Include correctly labeled diagrams, if useful or required, in explaining your answers. A correctly labeled diagram must have all axes and curves clearly labeled and must show directional changes. If the question prompts you to “Calculate,” you must show how you arrived at your final answer. The economy of Country X is at full employment. (a) Draw a correctly labeled graph of the long-run aggregate supply, short-run aggregate supply, and aggregate demand curves, and show each of the following. (i) Current price level, labeled (ii) Current real output, labeled (b) Assume that household income increases as a result of recent economic prosperity in Country X. On your graph in part (a), show the effect of the increase in household income on real output and price level. (c) What will be the effect of the change identified in part (b) on unemployment in Country X? (d) Will the change in real output shown in part (b) be smaller or larger in the presence of automatic stabilizers? Explain. Please respond on separate paper, following directions from your teacher.
The correct answer and explanation is:
Answer
(a) Long-Run Aggregate Supply, Short-Run Aggregate Supply, and Aggregate Demand Graph
- Draw a correctly labeled graph with:
- X-axis: Real Output (GDP)
- Y-axis: Price Level
- A vertical curve labeled LRAS (Long-Run Aggregate Supply) at full-employment output.
- A downward-sloping curve labeled AD (Aggregate Demand).
- An upward-sloping curve labeled SRAS (Short-Run Aggregate Supply).
- Mark the intersection of AD, SRAS, and LRAS with the current price level (P₁) and real output (Y₁), representing full employment.
(b) Effect of Increased Household Income
- On the graph:
- Shift the AD curve to the right (AD → AD₁) to reflect higher aggregate demand due to increased household income.
- Identify and label the new price level (P₂) and real output (Y₂) at the intersection of AD₁ and SRAS.
- The new equilibrium shows higher real output and price level compared to the initial point.
(c) Effect on Unemployment
- With an increase in real output (Y₂ > Y₁), unemployment in Country X decreases. As businesses produce more to meet higher demand, they hire more workers, reducing cyclical unemployment.
(d) Automatic Stabilizers and Real Output Change
- Smaller Change: Automatic stabilizers, such as progressive taxes and unemployment benefits, moderate changes in aggregate demand. When household incomes rise, higher taxes reduce disposable income, dampening the increase in consumption. This limits the extent of the AD shift, making the increase in real output smaller compared to an economy without such stabilizers.
Explanation
Country X starts at full employment, meaning its economy operates at the long-run aggregate supply (LRAS). Any equilibrium change reflects short-run adjustments since the long-run output remains unchanged.
When household income rises, consumption—a key component of aggregate demand—increases. On the graph, this is illustrated by a rightward shift of the AD curve (AD → AD₁). The immediate effect is an increase in the price level (P₁ → P₂) and real output (Y₁ → Y₂). This short-run expansion indicates higher demand-driven growth.
As firms respond to higher demand, they increase production by hiring more workers, reducing unemployment. This is especially relevant for cyclical unemployment, as greater demand stimulates job creation.
However, the magnitude of real output change depends on automatic stabilizers. Progressive tax systems reduce disposable income as incomes rise, dampening the increase in consumption. Similarly, unemployment benefits decline as fewer workers are unemployed, stabilizing overall spending. These mechanisms smooth economic fluctuations, ensuring that the AD curve’s rightward shift is less pronounced. This results in a smaller increase in real output compared to an economy without automatic stabilizers.
Thus, while increased household income initially drives economic growth and lowers unemployment, automatic stabilizers moderate these changes, promoting economic stability.