Sunny’s AP Economics

Sunny’s
AP Economics
AP Macroeconomics
(Teaching note)
Part. 2

Masterprep

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Sunny’s AP Economics

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Contents

CH. 1 Fundamentals of Economic Analysis

CH. 2 How Markets Work
CH. 3 Measurements of Macroeconomic Performance
CH. 4 Aggregate Supply and Aggregate Demand
CH. 5 Consumption, Saving, and Investment
CH. 6 Fiscal Policy
CH. 7 Monetary Policy
CH. 8 Economic Growth
CH. 9 International Trade

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CH. 5 Consumption, Saving, and Investment

1. Consumption and saving

(1) MPC vs. MPS

The most important element affecting consumption and saving is disposable income.
Disposable income = Gross income – Net taxes(= taxes paid – transfers received)
Disposable income = Consumption + Savings

<Consumption and saving schedules>

Disposable income (DI) Consumption ( C) Saving(S)
0 40 -40
100 120 -20
200 200 0
300 280 20
400 360 40
500 440 60

Consumption function : C = 40 + 0.80(DI)

Consumption

Disposable income

Saving function : S = -40 + 0.20(DI)

Saving

Disposable income

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The marginal propensity to consume, or MPC (slope of consumption function), is the

increase in consumer spending when disposable income rises by $1.

The marginal propensity to save, or MPS( slope of saving function), is the increase in

household savings when disposable income rises by $1.

 MPC + MPS = 1

(2) Change in Consumption and Saving

• Wealth

• Expectations

• Household Debt

• Taxes and Transfers

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2. Investment
Although consumer spending is much greater than investment spending, booms and busts
in investment spending tend to drive the business cycle. In fact, most recessions originate
as a fall in investment spending.

• Net investment = Gross investment – depreciation

Firms invest if,

Expected real rate of return of a project > Real rate of interest (= borrowing cost)

A rise in real interest rate(=borrowing cost) makes any given investment project less

profitable. Conversely, a fall in the interest rate makes some investment projects that were

unprofitable before profitable at the now lower interest rate. So some projects that had

been unfunded before will be funded now. So planned investment spending—spending on

investment projects that firms voluntarily decide whether or not to undertake—is

negatively related to the interest rate. Other things equal, a higher interest rate leads to a

lower level of planned investment spending.  investment demand curve

Real
interest
rate (%)

Investment ($)

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3. Loanable Fund market

we assume that the economy has only one financial market, called the market for loanable
funds. All savers go to this market to deposit their savings, and all borrowers go to this
market to get their loans. Thus, the term loanable funds refers to all income that people have
chosen to save and lend out, rather than use for their own consumption. In the market for
loanable funds, there is one interest rate, which is both the return to saving and the cost of
borrowing.

< Loanable Fund Market >

Saving and foreign investment are the sources of the supply of loanable funds and
investment and government spending are the sources of the demand for loanable funds.

• Factors to shift demand/supply curve of loanable fund

- Increase in government borrowing 

- Tax credit on spending for machinery (investment) 

- Increase in saving 

- Increase in foreign investment 

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1. A high marginal propensity to consume implies which of the following?

A. A small change in consumption when income changes

B. A high savings rate
C. A high marginal tax rate
D. An equilibrium level of income near full employment
E. A low marginal propensity to save

2. Assume that autonomous consumption is $400, while the MPC is 0.8. If disposable
income increases by $1,200, consumption spending will increase by

A. $1,200
B. $1,600 D. $400
C. $1,360 E. $960

3. Jennifer’s marginal propensity to consume is 0.8. In 2004 Jennifer spent $36,000 from her
disposable income of $40,000. If her disposable income in 2005 increased to $50,000, her
consumption spending increased by

A. $10,000
B. $14,000
C. $4,000
D. $8,000
E. $9,000

4. The best description of loanable funds market is that it brings together

A. banks and savers

B. savers and borrowers
C. investors and borrowers
D. financial institutions and investors
E. savers and lenders

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CH. 6 Fiscal Policy

1. Introduction

Keynes concluded that the Great Depression was caused by a deficiency of spending, or
aggregate demand. So, they recommended that the federal government boost its level of
spending. But government was not willing to try Keynes’ radical new idea to remedy the
Great Depression and the economic bad time persisted. World War Ⅱ forced many governments
to spend more money than they had, and those increased government spending finally helped
The Great Depression end.

2. Fiscal Policy _ Demand-side policy _ Discretionary policy

Fiscal policy refers to the government’s choices regarding the overall level of government
purchases or taxes. Fiscal policy stresses the importance of a hands-on role of government in
manipulating AD to “ fix” the economy.

(1) Government Budget

• Government Budget = Tax Revenue – Government Spending

> 0 Budget surplus  Public Saving
= 0 Balanced budget
< 0 Budget deficit  National/public debt

Public/national debt is government debt held by individuals and institutions outside the
government. There are two ways that government can borrow money:
① Issue bonds (= treasury bonds = government securities)
② Borrow from central bank

• Primary bond market vs Secondary bond market

• Inverse relationship between the price of bond and interest rate

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(2) Expansionary Fiscal Policy _ Recessionary Gap

Remedy:

Budget:

Price
Level

Real GDP

(3) Contractionary Fiscal Policy _ Inflationary Gap

Remedy:

Budget:

Price
Level

Real GDP

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(4) The Multiplier Effect

When the government buys $20 billion of goods from Boeing. The immediate impact of the
higher demand from the government is to raise employment and profits at Boeing. Then, as the
workers see higher earnings and the firm owners see higher profits, they respond to this increase
in income by raising their own spending on consumer goods. As a result, the government
purchase from Boeing raises the demand for the products of many other firms in the economy.
Because each dollar spent by the government can raise the aggregate demand for goods and
services by more than a dollar, government purchases are said to have a multiplier effect on
aggregate demand.

Price
Level

AD

Real GDP

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① Spending Multiplier

• Marginal propensity to consume (MPC)—the fraction of extra income that a household

consumes rather than saves.
• Marginal propensity to save (MPS) —the fraction of extra income that a household saves
rather than consumes.

Process >

• Spending Multiplier = 1 / (1-MPC) = 1/MPS

② Tax multiplier

Process >

• Tax Multiplier = MPC * Spending Multiplier = - MPC / MPS

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Tax multiplier is smaller than spending multiplier because some of tax benefit transferred to

recipients are saved and the leftover is only spent. So, tax will smaller multiplier

than government spending. If tax rate increases, GDP will decrease, and vise versa. That is,

tax rate moves in the opposite way of GDP. So, tax multiplier is negative. But transfer

payments multiplier(the same as that of tax multiplier) is positive.

③ The Balanced-Budget Multiplier

If an increase in government spending is accompanied by an equivalent increase in taxes in

order to balance the budget, government spending multiplier and the tax multiplier are

combined.

Ex. The government wants to spend $100 on a federal program and pay for it by collecting
$ 100 additional taxes. The MPC = 0.9

- Spending Effect :

- Taxation Effect :

- Balanced budget Effect :

• Balanced budget multiplier = 1/MPS + (-MPC/MPS) = (1-MPC)/MPS = 1

The balanced-budget multiplier is always equal to one, regardless of the MPC. That means

that an increase in government spending (with collected taxes) results in an increase in real

GDP by the same amount. The effect on the real GDP after implementing balanced-budget

policy follow the direction of government spending, not that of taxes.

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3. Difficulties of Fiscal Policy

① Crowding-out Effect
While an increase in government purchases stimulates the aggregate demand for goods and

services, it also causes the interest rate to rise, and a higher interest rate reduces investment

spending and chokes off aggregate demand. That is, when the government borrows funds to

cover a budget deficit, the interest rate increases, and households and firms are “crowded out”

of the market for loanable funds. The resulting decrease in consumption and investment

(=private spending) dampens the effect of expansionary fiscal policy. This mechanism is called

crowding-out effect.

Process

< Loanable Funds Market >

Real Price
interest Level
rate

Loanable Funds
Real GDP

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② Time Lag _ Automatic Stabilizers _ Non-discretionary policy

All economists agree that the time lags in implementation render policy less useful as a tool for

short-run stabilization. The economy would be more stable, therefore, if policymakers could

find a way to avoid time lags. In fact, they have. Automatic stabilizers are changes

in fiscal policy that stimulate aggregate demand when the economy goes into a recession

without policymakers having to take any deliberate action. The most important automatic

stabilizer is the tax system. Automatic stabilizers cannot prevent recessions or inflations, but

they can prevent recessions from becoming depressions and inflations from becoming

hyperinflations

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MCQ

1. When the United States government performs deficit spending, that spending is
mainly financed by
A. appreciating the value of the dollar
B. depreciating the value of the dollar
C. increasing the required reserve ratio
D. borrowing from the World Bank
E. issuing new bonds

2. Which of the following combinations of changes in government spending and taxes is

necessarily expansionary?
Government
Spending Taxes
A. Decrease Decrease
B. Increase Increase
C. Increase Decrease
D. Decrease Not change
E. Decrease Increase

3. If fiscal policy is used to correct a recessionary gap, which of the following is most
likely to occur in the absence of crowding out in the short run?
Real Output Unemployment
A. Decrease Increase
B. Decrease No change
C. Increase Decrease
D. Increase Increase
E. Decrease Decrease

4. Which of the following changes can increase the value of the multiplier?
A. A decrease in government unemployment benefits
B. A decrease in the marginal propensity to consume
C. A decrease in the marginal propensity to save
D. An increase in government expenditure
E. An increase in exports

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5. Given that the marginal propensity to consume is 0.75, a $100 increase in investment
will result in a maximum increase in equilibrium real gross domestic product of
A. $400.00
B. $500.00
C. $40.00
D. $100.00
E. $133.33

6. Suppose that the marginal propensity to consume is equal to 0.90. Due to an increase in
the tax rates, the government collects an additional $20 million. Given this information,
what will be the effect on gross domestic product (GDP) ?

A. GDP will decrease by a maximum of $200 million.

B. GDP will decrease by a maximum of $180 million.
C. GDP will decrease by a maximum of $20 million.
D. GDP will increase by a maximum of $200 million.
E. GDP will increase by a maximum of $180 million.

7. The current equilibrium output is $2,500,000, while the potential output is $2,600,000,
and the marginal propensity to consume 0.75. Given this information, a Keynesian
economist would most probably recommend

A. increasing government spending by $25,000

B. increasing government spending by $33,333
C. increasing government spending by $100,000
D. decreasing taxes by $25,000
E. decreasing taxes by $100,000

8. A country is faced with a large federal budget deficit, and its government decides to
lower expenditures and tax revenues by the same amount. This action taken by the
government will affect output and interest rates in which of the following ways?

Output Interest Rates

A. No change Decrease
B. Decrease Increase
C. Decrease Decrease
D. Increase Increase
E. Increase Decrease

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9. Crowding out due to government borrowing occurs when

A. a smaller money supply increases private sector investment

B. a smaller money supply decreases private sector investment
C. lower interest rates increase private sector investment
D. lower interest rates decrease private sector investment
E. higher interest rates decrease private sector investment

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FRQ_2014_1

FRQ답지는 http://blog.naver.com/econmania에 들어가서 AP 경제 자료실에 있습니

다! 꼭!!!! 확인해 주세요!

Assume that the United States economy is currently operating below the full
employment level of real gross domestic product with a balanced budget.

(a) Draw a correctly labeled graph of aggregate demand, short-run aggregate supply, and
long-run aggregate supply, and show each of the following in the United States.
(i) Current output and price level, labeled as Y 1 and PL 1, respectively
(ii) Full-employment output, labeled as Y f

(b) The United States government increases spending on goods and services by $100
billion, which is financed by borrowing. How will the increase in government spending
affect each of the following?
(i) Cyclical unemployment
(ii) The natural rate of unemployment

(c) If the marginal propensity to consume is equal to 0.75, calculate the maximum possible
change in real gross domestic product that could result from the $100 billion increase
in government spending.

(d) Using a correctly labeled graph of the loanable funds market, show the effect of the
$100 billion increase in government spending on the real interest rate.

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(e) Based on the real interest rate change in part (d) what is the effect on the long-run
economic growth rate? Explain.

(f) Now assume that instead of financing the $100 billion increase in government spending
by borrowing, the United States government increases taxes by $100 billion. With this
equal increase in government spending and taxes, will the real gross domestic product
increase, decrease, or remain the same? Explain.

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FRQ

2015_ 1_ d, e
2014_1
2013_1_a,b,c
2013_2_d,e
2011_1_b,c
2011_2_a
2010_1
2008_1_b,c,d,e
2006_3_a
2005_2_a,b,c

Form B
2010_1_a,b,d
2008_1_a,b,c
2007_2
2006_1_c,d
2005_3_a,b

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CH. 7 Monetary Policy

1. Money and financial assets

(1) Definition of Money

Money is any assets in the economy that people regularly use to buy goods and services
from other people. Money without intrinsic value is called fiat money. A fiat is simply an order
or decree, and fiat money is established as money by government decree.

Commodity money is a good used as a medium of exchange that has intrinsic value in other
uses. Ex. Gold, silver

Barter system: high transaction cost

(2) Financial assets _ bond vs. stock

A bond is a certificate of indebtedness that specifies the obligations of the borrower to the
holder of the bond.

Stock represents ownership in a firm and is, therefore, a claim to the profits that the firm makes.

(3) Function of money

① Medium of exchange ( = Transaction demand for money)

Transfer of money from buyer to seller allows the transaction to take place. When you walk
into a store, you are confident that the store will accept your money for the items. Money is the
commonly accepted medium of exchange.

② Unit of account
Money is the yardstick people use to post prices and record debts. When you go shopping, you
might observe that a shirt costs $20 and a hamburger costs $2. When we want to measure and
record economic value, we use money as the unit of account.

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③ Store of value
People can use money to transfer purchasing power from the present to the future. When a
seller accepts money today in exchange for a good or service, that seller can hold the money
and become a buyer of another good or service at another time.

(4) Time value of money

Imagine that someone offered to give you $100 today or $100 in ten years. Which would you
choose? This is an easy question. Getting $100 today is clearly better, because you can always
deposit the money in a bank, still have it in ten years, and earn interest along the way. The
lesson: Money today is more valuable than the same amount of money in the future.

What is the amount you can earn in one year if you deposit $1 in a bank account, using 5
percent interest rate?

What amount would you be willing to accept today as a substitute for receiving $1 one year
from now?

 Inverse relationship between the price of bond and interest rate

Present value(PV) is the amount of money today that would be needed, using prevailing
interest rates, to produce a given future amount of money.

Future value(FV) is the amount of money in the future that an amount of money today will
yield, given prevailing interest rates.

PV = FV/(1+r)n
FV = PV*(1+r)n

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(5) Two measures of the money stock (= Money supply)

Liquidity is describe the ease with which an asset can be converted into the economy’s medium

of exchange. Because currency is the economy’s medium of exchange, it is the most liquid

asset available.

How to measure money supply  M1, M2 (The order of Liquidity)

• M1 = Currency(coin and paper money)

+ Checking Deposits(= Demand Deposit = Transaction Account)

+ Travelers’ Check

M1 is the most liquid of money definition (for medium of exchange)

• M2 = M1

+ Saving Deposits

+ Money market mutual funds

M2 is slightly less liquid because the holders of these assets would likely incur penalty

if they wish to immediately convert the asset to cash

Ex. If Sara withdraws $10,000 from her saving account and deposit the money into checking
account, what is the change of money supply of M1 and M2?

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2. Money Market

(1) Money Demand (= Holding cash)

Although many factors determine the quantity of money demanded, the one emphasized by

the theory of liquidity preference is the interest rate. The reason is that the interest rate is the

opportunity cost of holding money. That is, when you hold wealth as cash in your wallet,

instead of as an interest-bearing bond, you lose the interest you could have earned. An

increase in the interest rate raises the opportunity cost of holding money and, as a result,

reduces the quantity of money demanded. A decrease in the interest rate reduces the

opportunity cost of holding money and raises the quantity demanded. Thus, the money

demand curve slopes downward.

• Factors to shift money demand

- Increase in income level (= increase in AD) 

- Increase in price level 

- Changes in credit markets and banking technology

Credit cards allow people to hold less money to fund their purchases, decreasing the
demand for money.

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(2) Money Supply

Because the quantity of money supplied is fixed by Fed policy, it does not depend on other

economic variables. In particular, it does not depend on the interest rate. Once the Fed has

made its policy decision, the quantity of money supplied is the same, regardless of the

prevailing interest rate. We represent a fixed money supply with a vertical supply curve.

(3) Money Market Equilibrium

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3. The Federal Reserve Banking System

The Federal Reserve is the central bank of the United States, controlling the money supply

and supervising all the depository institutions. It is simply called the Fed.

The Fed has two related jobs. The first job is to regulate banks and ensure the health of the

banking system. In particular, the Fed monitors each bank’s financial condition and facilitates

bank transactions. It also acts as a bank’s bank. That is, the Fed makes loans to banks when

banks themselves want to borrow. The Fed’s second and more important job is to control the

quantity of money that is made available in the economy, called the money supply. Decisions by

policymakers concerning the money supply constitute monetary policy.

(1) Money Creation with Fractional-reserve banking system

(Central bank  Commercial banks  Individuals)

Deposits that banks have received but have not loaned out are called reserves. Fractional-
reserve banking system is that banks hold only a fraction of deposits as reserves. The fraction
of total deposits that a bank holds as reserves is called the reserve ratio. This ratio

is determined by a combination of government regulation and bank policy. The Fed places a

minimum on the amount of reserves that banks must hold, called a reserve requirement(of the

funds deposited in transaction accounts/demand account, not saving account). In addition,

banks may hold reserves above the legal minimum, called excess reserves, so they can be more

confident that they will not run short of cash. When banks hold only a fraction of deposits in

reserve, banks create money.

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T-account (Balance Sheet)

Required reserve ratio ( = reserve requirement)= 10%

Commercial Assets Liabilities

Bank A

Commercial
Bank B Assets Liabilities

Commercial
Bank C Assets Liabilities

• Money multiplier = 1/ Reserve requirement ratio =

• Maximum change in money supply =
• Maximum change in deposit =

The higher the reserve ratio, the less of each deposit banks loan out, and the smaller the
money multiplier.

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Bank Balance Sheets (= T-account)

Assets Liabilities and Owners’ Equity

Reserves $200 Deposits $800
Loans 700 Debt 150
Securities 100 Capital 150
Buildings 100 (Owners’ equity)

A T-account is a tool for analyzing a business’s financial position by showing, in a single table,
the business’s assets (on the left) and liabilities (on the right).

Asset: Anything owned by the bank or owed to the bank is an asset of the bank. Cash on reserve
is an asset and so are loans made to citizens

Liability: Anything owned by depositors or lenders to the bank is a liability. Checking deposits
of citizens or loans made to the bank are liabilities to the bank.

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(2) The Fed’s Tools of Monetary Control (Money Supply)

The Fed’s control of the money supply is indirect because commercial banks create money in

a system of fractional-reserve banking. When the Fed decides to change the money supply, it

must consider how its actions will work through the banking system. The Fed has three tools

in its monetary toolbox: open-market operations, reserve requirements, and the discount rate.

① Open-Market Operations

The Fed conducts open market operations when it buys or sells government bonds from the

public.

To increase the money supply, the Fed instructs its bond traders to buy bonds in the nation’s

bond markets. The dollars the Fed pays for the bonds increase the number of dollars in

circulation. Some of these new dollars are held as currency, and some are deposited in banks.

Each new dollar held as currency increases the money supply by exactly $1. Each new dollar

deposited in a bank increases the money supply to an even greater extent because it increases

reserves and, thereby, the amount of money that the banking system can create.

To reduce the money supply, the Fed does just the opposite: It sells government bonds to the

public in the nation’s bond markets. The public pays for these bonds with its holdings of

currency and bank deposits, directly reducing the amount of money in circulation. In addition,

as people make withdrawals from banks, banks find themselves with a smaller quantity of

reserves. In response, banks reduce the amount of lending, and the process of money creation

reverses itself.

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A central bank buys/sells treasury bonds from commercial banks

Buy bonds
Commercial Asset Liability
Bank A

Sell bonds
Commercial Asset Liability
Bank A

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② Discount Rate

Central Bank Commercial Bank A Commercial Bank B

Discount rate is the interest rate on the loans that the Fed makes to banks. A bank borrows

from the Fed when it has too few reserves to meet reserve requirements. When the Fed makes

such a loan to a bank, the banking system has more reserves than it otherwise would, and

these additional reserves allow the banking system to create more money.

• Discount rate ↑  Discouraging to borrow  Excess reserves↓  Loan ↓

 Money Supply ↓
• Discount rate ↓  Encouraging to borrow  Excess reserves ↑  Loan ↑
 Money Supply ↑

T-account when a commercial bank borrows from a central bank

Commercial Asset Liability

Bank A

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Federal funds rate is a short-term interest rate that commercial banks charge one another for

loans. If one bank finds itself short of reserves while another bank has excess reserves, the

second bank can lend some reserves to the first(short-term loan = overnight loan).

How can the Fed make the federal funds rate hit the target it sets?

Although the actual federal funs rate is set by supply and demand in the market for loans

among banks, the Fed can use open-market operation to influence that market. For example,

when the Fed buys bonds in open-market operation, it injects reserves into the banking

system. With more reserves in the system, fewer banks find themselves in need of borrowing

reserves to meet reserve requirements. The fall in demand for reserves decreases

the price of such borrowing, which is the federal funds rate. Conversely, when the Fed sells

bonds and withdraws reserves from the banking system, more banks find themselves short of

reserves, and they bid up the price of borrowing reserves.

Thus, open-market purchases lower the federal funds rate, and open-market sales raise the

federal funds rates.

③ Reserve requirement

The Fed also influences the money supply with reserve requirements, which are regulations

on the minimum amount of reserves that banks must hold against deposits. Reserve

requirements influence how much money the banking system can create with each dollar of

reserves.

• Reserve ratio ↑  Excess reserves↓  Loan ↓  Money Supply ↓

• Reserve ratio ↓  Excess reserves ↑  Loan ↑  Money Supply ↑

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4. Monetary policy

Monetary policy is the use of money and credit controls to influence interest rates, inflation,
exchange rates, unemployment, and real GDP . The Board of Governors of the FED designs
and executes monetary policy and the Federal Open Market Committee (FOMC) helps.

(1) Expansionary monetary policy _ Recessionary Gap

Remedy:

Money market AD/AS

Price
Nominal
Level
Interest
Rate

Quantity Real GDP

of money

(2) Contractionary monetary policy _ Inflationary Gap

Remedy:

Money market AD/AS

Price
Nominal
Level
Interest
Rate

Quantity Real GDP

of money

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5. Quantity Theory of Money

• Equation of Exchange: M*V =P*Q

- M is the money supply

- V is the velocity of money, which means that the number of times the typical dollar is
used to make purchases during a year
- P is the price level
- Q is the quantity of output or real GDP

(1) Classical View : long-run perspectives

Classical economic analysis concludes that changes in the money supply have no effect on the
equilibrium quantity of output; only price and wages are affected. An increase in the money
supply would increase AD, but the increase in AD would result in higher price level.

Classical economists assume that V and Q are constant. It means that if M increases 10%,
price level must also increase 10%(Proportional effect)  Monetary neutrality
The change of money supply does not affect real GDP, the rate of unemployment, and other
real variables. The only things that can affect the quantity of output are resources availability
and technology (=factors that shift LRAS =Economic growth)

(2) Monetarist View

Monetarists see the money supply as the primary tool to bring economic stability. For stability,
they suggest following a strict “monetary rule”, such as increasing the money supply at a rate
equal to the average growth in real output. Monetarists believe that investment is relatively
elastic to interest rate changes.

Monetarist assumed that V and Q are stable, not constant in the short run. So if money
supply increases, both price level and output level will be affected

Money Supply ↑  Interest rate↓  Investment↑  AD↑

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(3) Keynesian View

Keynesians view the economy as inherently unstable. So, they assume that V and Q are
variable. They recommend active government policy to respond to inflationary and
recessionary gaps and believe that change in money supply has a relatively small and indirect
effect on output. Keynesians believe that the investment demand curve is relative inelastic to
interest rate.

<Perspectives on the Money Supply _ Summary>

Classical economists Keynesian

Monetarist
(long-run perspectives) economist

V and Q are Constant Stable Variable

MV=PQ MV=PQ MV=PQ
MV=PQ

MS ↑ MS ↑
 Price level↑,  Price level↑,
A change in the Price level and
money supply affect 𝐑𝐞𝐚𝐥 𝐆𝐃𝐏, Real GDP ↑, output
Nominal GDP ↑ Nominal GDP ↑

Strong but limited to

The effect is Strong Weak
prices and wages

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* Rational Expectations

LRAS
Price
Level SRAS

AD

Yf Real GDP
Potential GDP

This hypothesis is based on the idea that households and businesses will use all the

information available when making economic decisions. Rational expectations imply that

demand-side policy will be ineffective at changing the quantity of output. The reason is that

this theory assumes that people and firms will know that an expansionary fiscal policy will

result in higher prices. Because prices are expect to be higher in the future( decrease in real

wage), people work less and firms supply less right now. They would prefer to work and supply

more later when wages and prices are higher. The reduction is supply offsets the expansionary

fiscal and monetary policy.

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6. Phillips Curve

(1) Short-run Phillips Curve

< Expansionary policy > < Contractionary policy >

Price Price
Level Level

Real GDP Real GDP

• Fiscal/Monetary policy(demand-side policies) cannot remedy both unemployment and

inflation at the same time
• Curing recession through expansionary policy causes inflation
• Curing inflation through contractionary policy causes unemployment

The Phillips curve simply shows the combinations of inflation and unemployment that arise in
the short-run as shifts in the aggregate-demand curve move the economy along the short-run
aggregate-supply curve. The Phillips curve illustrates a negative association(= trade-off) between
the inflation rate and the unemployment rate.

< Short-run Phillips Curve>

Inflation
rate(%)

Unemployment rate(%)

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 Sunny’s AP Economics

Movement and Shift of Short-run Philips Curve

• Movement on Short –run Phillips Curve _ Due to AD curve shifts

Phillips Curve Movement Phillips Curve Movement

after Expansionary Policy after Contractionary Policy

Inflation rate(%) Inflation rate(%)

Unemployment Unemployment
rate(%) rate(%)

• Shift of Short-run Phillips Curve _ Due to Positive/Negative supply shocks(AS Shift)

Negative Supply Shock Positive Supply Shock

Inflation rate(%) Inflation rate(%)

Unemployment Unemployment
rate(%) rate(%)

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 Sunny’s AP Economics

(2) Long-run Phillips Curve

< AD / AS > < Long-run Phillips Curve >

Price Inflation
Level LRAS rate(%)

AD

Yf Real GDP Unemployment rate(%)

There is no trade-off between inflation and unemployment in the long run. Growth in the
money supply determines the inflation rate. Regardless of the inflation rate, the employment
rate gravitates toward its natural rate. As a result, the long-run Phillips curve is vertical.
The vertical long-run Phillips curve is, in essence, one expression of the classical idea of
monetary neutrality. Unemployment rate at the long-run Phillips curve is called natural rate
of unemployment.

• Shift of Long-run Philips Curve

< Shift of Long-run Philips Curve> < LRPC + SRPC>

Inflation Inflation
rate(%) rate(%)

Unemployment rate(%) Unemployment rate(%)

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 Sunny’s AP Economics

MCQ

1. According to the narrowest definition of money, M1, savings accounts are excluded
because they are

A. interest-paying accounts
B. not a medium of exchange
C. not insured by federal deposit insurance
D. available from financial institutions other than banks
E. a store of purchasing power

2. Which of the following is not a component of the money supply in the United States?

A. coins
B. demand deposits
C. paper money
D. gold bullion
E. checkable deposits

3. The money demand curve slopes downwards because

A. with higher incomes, people are willing to hold smaller percentages of their money
B. the transaction demand for money decreases as interest rates fall
C. people hold less money as the opportunity cost of holding money rises
D. money is less liquid as interest rates rise, so people are able to hold less of it
E. banks are more willing to create money when interest rates fall

4. An increase in which factor will lead to an increase in the demand for money?

A. The price level

B. The interest rate
C. The supply of money
D. The trade deficit
E. The velocity of money

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 Sunny’s AP Economics

5. The main reason for demanding commercial banks to keep reserve balances
with the Federal Reserve is that these balances

A. ensure that banks do not make excessive profits

B. assist the Treasury in refinancing government debt
C. enable the government to borrow cheaply from the Federal Reserve's discount
window
D. provide the maximum amount of reserves a bank would ever need
E. give the Federal Reserve more control over the money-creating operations of banks

6. Lindsay deposits in her checking account $1,000 cash she had been keeping at home as
emergency money. Assuming that the required reserve ratio is 0.20, what is the maximum
change in the money supply from her deposit?
A. $2,000
B. $4,000
C. $5,000
D. $1,000
E. $1,250

7. A commercial bank has no excess reserves, while the reserve requirement is 10 percent.
What is the value of new loans this one bank alone can issue if a new customer deposits
$10,000 ?
A. $10,000
B. $9,000
C. $1,000
D. $100,000
E. $90,333

8. Suppose that the reserve requirement for demand deposits is 20 percent, that no excess
reserves are held by banks, and that no currency is held by the public. If the central bank
sells $10,000 worth of government securities to commercial banks, what happens to the
total money supply?

A. not change
B. increase by $10,000
C. increase by $50,000
D. decrease by $10,000
E. decrease by $50,000

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 Sunny’s AP Economics

9. Although the reserve requirement is 20 percent, banks choose to keep some

excess reserves voluntarily. Then, a $1 million increase in new reserves will result in
which of the following?

A. a decrease in the money supply of $1 million

B. a decrease in the money supply of $5 million
C. a decrease in the money supply of more than $5 million
D. an increase in the money supply of $5 million
E. an increase in the money supply of less than $5 million

10. A restrictive monetary policy is most appropriate under which of the following
conditions?

A. Low interest rates

B. A budget deficit
C. High inflation
D. High unemployment
E. Full employment with stable prices

11. Which set of events will follow when a central bank sells securities in the open market?

A. A decrease in the money supply, an increase in interest rates, and a decrease In

aggregate demand
B. A decrease in the money supply, a decrease in interest rates, and a decrease in
aggregate demand
C. An increase in the money supply, a decrease in interest rates, and an increase in
aggregate demand
D. An increase in the money supply, an increase in interest rates, and a decrease in
aggregate demand
E. An increase in interest rates, an increase in the government budget deficit, and a
movement toward trade surplus

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12. If an expansionary monetary policy follows a contractionary fiscal policy, then in the
short run, nominal interest rate and employment would most likely be affected in which of
the following ways?

Nominal Interest Rate Employment

A. Decrease Decrease
B. Decrease Indeterminate
C. Indeterminate Decrease
D. Increase Increase
E. Increase Decrease

13. Which policy is most appropriate if during a mild recession, policymakers wish to
lower unemployment by increasing investment?

A. Purchase of government securities by the Federal Reserve

B. Equal increases in government expenditure and taxes
C. An increase in government expenditure only
D. An increase in transfer payments
E. An increase in the reserve requirement

14. In the long run, an increase in aggregate demand due to a rise in the money
supply will cause the increase of

A. real output but not the price level

B. price level and real output
C. nominal output and real output
D. nominal output but not the price level
E. nominal output and the price level

15. The theory of rational expectations claims that a fully anticipated expansionary
monetary policy will do which of the following?

A. have no impact on real output

B. promote the production of consumer goods over capital goods
C. result in deflation
D. increase potential output
E. increase unemployment
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16. The most likely cause to a rightward shift of the short-run Phillips curve is

A. an increase in aggregate supply

B. an increase in aggregate demand
C. a decrease in aggregate demand
D. a decrease in the expected rate of inflation
E. an increase in the expected rate of inflation

17. An increase in AD will cause

A. The short-run Phillips curve to shift to the left

B. The long-run Phillips curve to shift to the right
C. The long-run Phillips curve to shift to the left
D. A movement along a given short-run Phillips curve
E. The long-run Phillips curve to become horizontal

18. Which of the following is true according to the long-run Phillip’s curve?

A. The natural rate of unemployment is independent of monetary and fiscal policy

changes that affect aggregate demand.
B. Unemployment increases with an increase in inflation.
C. Unemployment decreases with an increase in inflation.
D. Increased automation will lead to lower levels of structural unemployment in the
long run.
E. Changes in the composition of the overall demand for labor tend to be deflationary
in the long run.

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 Sunny’s AP Economics

FRQ

2016_1_a~d
2016_2
2015_1_ a, b, c,
2014_2
2013_3_a,b,c
2012_1_b
2012_2
2011_1_a, d
2011_3
2010_2
2009_1, 3
2009_1_a
2007_1_a
2007_2
2006_2_a,b
2006_3_c
2005_1_c,d,e
2005_3_a,b,c,d
2004_3

Form B
2011_1_c
2010_1_c
2010_3_a,b,c
2009_1_b,c
2009_2
2007_1_b.c
2006_2
2005_1
2003_3

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 Sunny’s AP Economics

CH. 8 Economic Growth

Economic growth is defined by the growth of output usually as measured by real GDP or real
GDP per capita ( standard of living). Economic growth varies substantially around the world.
That means the standard of living also varies a lot in the world. Explaining the large variation
in living standards around the world is productivity. Productivity means the amount of goods
and services produced from each unit of labor input. That is, the growth in productivity is the
key determinant of growth in living standards.

1. How productivity is determined

• Physical capital per worker

Workers are more productive if they have tools with which to work. The stock of equipment
and structures used to produce goods and services is called physical capital, or just capital. An
important feature of capital is that it is a produced factor of production. That is, capital is an
input into the production process that in the past was an output from the production process.

• Human capital per worker

Human capital is the economist’s term for the knowledge and skills that workers acquire
through education, training, and experience. Students can be viewed as “workers” who have the
important job of producing the human capital that will be used in future production.

• Natural resources per worker

Natural resources are inputs into production that are provided by nature, such as land, rivers,
and mineral deposits.

• Technological Knowledge
Technological knowledge is the understanding of the best ways to produce goods and services.
It is worthwhile to distinguish between technological knowledge and human capital. Although
they are closely related, there is an important difference. Technological knowledge refers to
society’s understanding about how the world works. Human capital refers to the resources
expended transmitting this understanding to the labor force.

Increase resource availability Increased Productivity

• Discovery of new natural resources • More capital per unit of labor
• Growth of the labor force • Technological progress
• Growth of the capital stock • Better educated and trained work force

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2. Graphs that express economic growth

(1) Production Possibilities Frontier

Capital
goods

Consumer goods

(2) Long-run Aggregate Supply curve (3) Long-run Philips Curve

Inflation
Price rate(%)
Level

Real GDP Unemployment rate(%)

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MCQ

1. Which of the following regarding economic growth is correct?

A. Long-run economic growth is only possible with demand management policies.

B. If the population is growing faster than potential output, real gross domestic product
per capita will definitely increase.
C. With long-run economic growth, there is an increase in aggregate supply.
D. The gap between rich and poor must widen with long-run economic growth.
E. Increasing potential output necessarily increases the economic welfare of the average
citizen.

2. Which of the following is LEAST likely to promote economic growth?

A. Investment in tools and machines

B. Investment in training of labor
C. Increase in consumption of nondurable goods
D. Tax credit for technology improvement
E. Increase in the labor force participation rate

3. Potential gross domestic product will decrease if

A. The monetary authorities adopt an easy monetary policy

B. The growth rate of the population increases more rapidly than the growth rate of
gross domestic product.
C. Nominal gross domestic product increases more than real gross domestic product.
D. The natural rate of unemployment decreases.
E. The country’s annual depreciation is greater than its annual gross investment.

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 Sunny’s AP Economics

CH. 9 International Trade

Closed economy is an economy that does not interact with other economies. Yet some new
macroeconomic issues arise in an open economy—an economy that interacts freely with other
economies around the world.

1. International Flow of Goods/Services and Financial flow

An open economy interacts with other economies in two ways:

① It buys and sells goods and services in world markets
② It buys and sells capital assets (=financial investment) in world financial markets.

(1) The Flow of Goods/Services : Exports, Import, and Net Exports

• Net Exports = Trade Balance = Exports – Imports

> 0 Trade Surplus
< 0 Trade Deficit

(2) The Flow of Financial Resources: capital flows

If McDonald’s opens up a fast food outlet in Russia, that is an example of foreign direct
investment. Alternatively, if an American buys stock in a Russian corporation, that is an
example of foreign portfolio investment.

When a U.S. resident buys stock in Telmex, the Mexican phone company,
 US financial outflow(= capital outflow) and Mexico financial inflow(=capital inflow)

When a Japanese resident buys a bond issued by the U.S. government,

 Japan financial outflow(= capital outflow) and US financial inflow(=capital inflow)

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 Sunny’s AP Economics

(3) Balance of Payment

The Bureau of Economics Analysis tracks the flow of goods and currency in the balance of
payment statement. This statement summarizes the payment received by the United States from
foreign countries and the payments sent by the United States to foreign countries.

Balance of Payment
Current Account
Export 1,437
Trade Balance Import - 2,202
-765
Income Inflow 622
Net Investment Income
Income Outflow -629
(Dividend, Interest)
-7
Transfer Inflow 5
Net Transfer
Transfer Outflow -56
(Grants, Gifts and aids)
-51
Current Account Balance -823
Financial Account (=capital account)
Financial inflow 1,765
Financial Account
Financial outflow -1,046
Financial Account Balance 719
Statistically Discrepancy 104
Net Balance 0

If there is a deficit in the current account, there must be a corresponding surplus in the financial
accounts. If current balance is negative, that indicates a trade deficit in goods and services or
investment payments or gifts and aid.

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2. Foreign Exchange Rate

The rate of exchange between two currencies is determined in the foreign exchange market.
In a free floating foreign exchange market, exchange rate is determined by demand and supply
(market force) without government intervention. Some nations fix their exchange rates while
other are allowed to “float” with the forces of demand and supply. The exchange rate between
two currencies tells us how much of one currency you must give up to get one unit of the
second currency.

Quantity of USD
Current Exchange Rate:

Appreciation(Stronger)  Import ↑

Depreciation(Weaker)  Export ↑

Exchange rate is the relative price of domestic and foreign goods and, therefore, is a key
determinant of net exports. When the U.S. real exchange rate appreciates, U.S. goods become
more expensive relative to foreign goods, making U.S. goods less attractive to consumers both
at home and abroad. As a result, exports from the United States fall, and imports into the
United States rise. For both reasons, net exports fall.

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 Sunny’s AP Economics

3. Determinants of Exchange rates

(1) Change in Exchange rates

Exchange rate is the value of one country’s currency in terms of another’s and determined by
supply and demand,

Export/Import : When a Japanese airline wants to buy a plane made by Boeing, it needs to
change its yen into dollars, so it demands dollars in the market for foreign-currency
exchange(Buy Dollar and Sell Yen).

Financial flow: When a U.S. mutual fund wants to buy a Japanese government bond, it needs to
change dollars into yen. So it supplies dollars in the market for foreign-currency exchange (Buy
Yen And Sell Dollar).

In the perspective of the United States (relative to Japan)

• Export 
• Import 
• Capital Inflow 
• Capital Outflow 

Quantity of USD

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 Sunny’s AP Economics

Cause and effects

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 Sunny’s AP Economics

(2) Specific Examples ( USA ↔ India, in the perspective of India )

① Consumer Tastes
When domestic consumers build a stronger preference for foreign produced goods and
services, the demand for foreign currencies increases and the domestic currency depreciated.
• Americans tastes for Indian product ↑ 

② Relative Incomes
When one nations’ macroeconomy is strong and incomes are rising, all else equal, they
increases their demand for all goods, including those produced abroad.
• If America is better off than India in terms of income 

③ Relative Inflation
If one nation’s price level is rising faster than another nation, consumers seek the goods that
are relatively less expensive.
• If price levels rise in India while they hold steady in America 

④ Relative Interest Rates

• Interest rates in India rise relative to interest rate of America 

⑤ Speculation
Because foreign currencies can be traded as assets, there are investors who seek to profit from
buying at a low rate and selling it at a higher rate.
• If the depreciation of Rupees is expected 

⑥ Political Stability
• India’s political Stability ↓ 

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 Sunny’s AP Economics

4. Trade Barriers

(1) Arguments for Trade Restrictions

- To protect jobs from foreign competition/Promote domestic employment

- To protect infant industry

- Diversity of production

(2) Instituting Trade Restrictions (Discourage or prevent imports)

① Import quota: Limit on the amount of a imported product

② Tariff: Tax on imported goods

(3) Effects of imposition of tariff and quota

• Decrease in import

• Increase in domestic prices

• Decrease in domestic consumption

• Increase in domestic production

• Increase in government tariff revenues (not for quota)

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 Sunny’s AP Economics

5. Monetary and Fiscal Policy in an Open Economy

Exchange rates are affected when a country pursues monetary and fiscal policy.

(1) Fiscal Policy in an Open Market

In a closed economy, budget deficits crowd out domestic investment. In an open economy,

however, the increase in demand of loanable funds has additional effects which is the increase

in the interest rate. Thus, when budget deficits raise interest rates, the increased interest rate

induces capital inflow. So, the demand of USD increases, appreciating USD. That is, the dollar

becomes more valuable compared to foreign currencies. This appreciation, in turn, makes U.S.

goods more expensive compared to foreign goods. U.S. net exports fall. Hence, in an open

economy, government budget deficits raise real interest rates, crowd out domestic

investment, cause the dollar to appreciate, and push the trade balance toward deficit,

which shifts the AD to the left.

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 Sunny’s AP Economics

(2) Monetary Policy in an Open Market

When the Fed increases the money supply, the interest rates on American financial assts begin

to fall. If the interest rate is relatively lower in the United States, people around the world see

U.S. financial asset as less attractive places to put their money. Demand of the dollar falls, and

the dollar depreciates relative to other foreign currencies. A depreciating dollar makes goods

in the United States less expensive to foreign consumers, so American net exports increase,

which shifts the AD to the right.

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 Sunny’s AP Economics

MCQ
1. The purchase of Mexican government bonds by Chinese investors will be
included in China’s

A. financial account (formerly called capital account)

B. Imports
C. trade deficit
D. current account
E. foreign direct investment

2. When supposing that a country has a current account deficit, which of the following is
necessarily true?

A. It must increase the domestic interest rates on its bonds.

B. It must limit the flow of foreign capital investment.
C. It must also show a deficit in its capital account.
D. It must show a surplus in its capital account.
E. It must increase the purchases of foreign goods and services.

3. Which of the following is considered a current account transaction?

A. A United States firm builds a new factory in Kenya.

B. A United States firm sells $500 million of its products to a Chinese company.
C. The United States buys $8 billion worth of euro.
D. India buys $10 billion of new United States Treasury bonds.
E. A United States firm buys 5 percent of the stock of another United States firm.

4. Assume that the Yen cost of the US dollar decreases. Then, Japan imports from and
exports to the United States will change in which of the following ways?

Imports Exports
A. Increase No change
B. Decrease Decrease
C. Decrease Increase
D. Increase Decrease
E. Increase Increase

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 Sunny’s AP Economics

5. If exchange rates are allowed to fluctuate freely and the British demand for the US
dollar increases, which of the following will most likely occur?

A. The pound price of US dollars will fall.

B. The pound price of American goods will fall.
C. British will have to pay more for goods made in the US.
D. Americans will find that British goods are getting more expensive.
E. The United Kingdom balance-of-payments deficit will increase.

6. What is the most likely change in the international value of Country W’s currency and
Country W’s exports and imports if Country W’s central bank takes monetary policy
actions that lead to a decline in interest rates?

Value of
the Currency Exports Imports

A. Increase Increase Increase

B. Increase Increase Decrease
C. Increase Decrease Decrease
D. Decrease Increase Decrease
E. Decrease Increase Increase

7. If UK’s real interest rates increase, relative to real interest rates in the rest of
the world, what will be the result for UK?

A. Depreciation of the pound

B. A decrease in imports
C. An increase in exports
D. A reduced government budget deficit
E. Financial capital inflow

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 Sunny’s AP Economics

8. Assume that Country X”s inflation is higher than that of Country Y. Country Y is
seeing steady growth with a stable price level. In this case, what would happen in
the foreign exchange market?

A. A depreciation of Country X”s currency

B. An increase in the demand for Country X’s currency
C. An increase in the supply of Country Y’s currency
D. A decrease in the supply of Country X’s currency
E. A decrease in the demand for Country Y’s currency

9. Which of the following will result in depreciation of a country’s currency?

A. Decreased supply of the nation’ s currency

B. Lower inflation in the nation than in the rest of the world
C. Higher required reserve ratio in the nation than in the rest of the world
D. Decreased real interest rates in the nation compared with the rest of the world
E. Increased demand for the nation’ s currency

10. After a decrease in the real interest rate, there follows an increase in financial capital
outflows from Country R. This increase in capital outflows will most likely impact
Country R’s net exports and aggregate demand in which of the following ways?

Net Exports Aggregate Demand

A. Increase Increase
B. Increase Decrease
C. Increase No change
D. Decrease Decrease
E. Decrease No change

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 Sunny’s AP Economics

11. Tariffs differ from assigned import quotas because tariffs will

A. hurt domestic producers of goods facing import competition

B. generate additional revenue for the domestic government
C. restrict imports
D. increase the price of imported goods
E. benefit domestic consumers of imported goods

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 Sunny’s AP Economics

FRQ

2016_1_f,g
2015_3
2014_3
2013_1_d,e
2012_1_c
2011_2_b
2010_3
2009_2
2008_2
2007_1_b,c,d,e
2006_1_d,e
2005_2_d

Form B
2011_2
2010_2_d
2009_3
2008_1_d,e
2008_2
2007_3
2006_3
2005_3_c,d

64