MATT ROMANO: Hi, and welcome to AP Daily Practice.
My name is Matt Romano.
I'm coming to you from Mary's School in Atlanta, Georgia.
And today, we're going to work on some free response
questions focused on unit 4.
But it's a cumulative course.
You're going to see some unit 3, you're
going to see some unit 5.
But the emphasis is going to be on unit 4.
As always, the case of the AP Daily,
you've got a PDF you can access to see
these questions on your own if you'd
like to answer them first.
And then follow along.
Feel free to do so, or simply pause as I go.
All right.
Let's get into this.
FRQ number one.
Let's read and define first because we
have to define the problem before we can do anything else.
Assume that an economy is in long run equilibrium.
You're going to need to know that.
Assume the consumers wish to hold less money because they
use credit cards more frequently to purchase goods and services
than cash.
That long run equilibrium is going to be important.
Highlight that.
Mark this up.
Make sure you know what the situation is
as you get into the question.
That tells us that output is equal to full employment.
It also tells us that unemployment
is equal to the natural rate.
Part A. Draw a correctly labeled graph of the money market,
and show the effect of the reduced holdings of money
on the equilibrium nominal interest rate in the short run.
Now, something I'm going to do throughout these questions.
I'm going to make sure that we highlight
any verbs within the question.
Because that's what we have to do.
In an FRQ, you have to do something.
You have to provide new information.
You have to provide data.
You have to provide graphs.
So highlight that as you go.
In this question, they're asking you first to draw.
They're drawing the money market.
Then they're asking you to show something.
Show the effect of the reduced holdings of money.
Now, that was up in the prompt.
That was where they said hold less money.
Make those connections between the prompt
and then the question the statement here
that's telling you what to do.
So we've got a draw graph, and we got to show something.
We've got to show what happened to nominal interest rates
as it reduced-- as a result of the reduced holdings of money
and how that's going to affect equilibrium.
All right.
So let's do this.
What's that going to look like?
It's going to look like a decrease in demand for money.
All right.
That's what this is getting at.
We're talking money market, money supply, and money demand.
The correct answer-- and on these slides,
you're going to see, I'm going to put
the correct responses in blue.
The correct response should have a correctly
labeled graph of the money market
with a leftward shift in the money demand curve,
resulting in a lower nominal interest rate.
Now, any time you draw a graph, remember the acronym ACE.
ACE stands for Axes, Curves, Equilibrium.
You probably-- some of you all out there probably
have teachers that use this.
It's a popular thing.
I didn't make it up.
Always check to make sure that you have properly labeled
your axes, your curves, and your equilibrium in every graph
that you do.
All right.
Moving on.
Part B. Based on the change in interest rate in part A,
recall what that was, what will happen
to each of the following in the short run?
First, the price of previously issued bonds.
Second, the price level and real income explain.
All right.
So for Bi-- note, it doesn't say explain,
you don't have to explain.
You're just identifying what's going to happen.
Is the price of previous issue bonds
is going to go up, going to go down,
it's going to stay the same, do we not know?
Well, it was based on the change in interest rates
in part A. In part A, interest rates decreased.
If interest rates decrease, what's
going to happen to the price of bonds?
Well, we know from our learning over the course of the year,
there's an inverse relationship between interest rates
and the price of previously issued bonds.
Therefore, the price of previously issue bonds
will increase.
That takes care of Bi.
Now, be Bii, B2, what's going to happen
to price level and real income?
Explain.
I've got to give a little explanation here.
The question becomes, what do I have
to help me answer this question?
What connection, what concept, what graph or number
or whatever do I have to connect interest rates to price
level and real income?
Well, there's really one thing that's
going to show you changes in price level and income.
And that's the AD-AS model.
So use the AD-AS model to connect interest rates
to a change in price level and real income.
And now, you've got your answer.
So your correct answer is both price level and real income
will increase.
Because the lower interest rate will increase consumption,
investment, or net exports.
Those are your interest sensitive spending.
And that's going to increase aggregate demand.
Visualize that.
You don't have to draw it for the answer here.
But visualize that.
Draw it off on the side for some sketches
and just allow yourself to see how
that's going to cause the increase in price
level and real income.
On to part C. Again, focus on that original prompt.
There's going to be something in there we need.
With a constant money supply, based on your answer
to part B2, will the velocity of money
increase, decrease, or remain the same
or is the change in determinant?
Once again, we have a constant money supply.
What do I have that's going to help me answer this question?
The reference to velocity of money is important.
What tool do I have that actually addresses
the velocity of money?
Equation of exchange.
MV equals PY.
Or you may have learned MV equals PQ.
Same thing.
Connect that to what we just did in part B2.
In part B2, we learned that both price level and real income
are going up.
Which means the entire right hand
side of this equation just increased.
Nominal GDP increased.
If money supply doesn't change, what's
going to happen to the velocity of money?
Well, there's only one option.
The velocity of money has to go up.
So my correct answer, the velocity of money
will increase.
Use the tools that you have.
This equation, it's a tool for you
to use to understand what's happening in these questions.
OK.
On the part D. Assume the country's banking system
has limited reserves.
I'm going to need that information.
If the central bank wishes to reverse the change in interest
rate identified in part A, what open market operation
would it use?
All right.
So they're talking about using open market operations
to change interest rates.
Is that even possible?
Yes.
It is.
Because we have limited reserves,
we automatically know that open market operations is effective.
It works.
You want-- what I would recommend,
what I recommend in my students is
any time you see limited reserves in a prompt, just
jot down a note, OMO woeks.
It is effective here.
It will have an effect on interest rates.
So you want to use open market operations to do what?
Reverse the change in interest rates.
So what was that change in interest rates?
Well, interest rates fell because money demand decreased.
Now, we want to reverse that.
What type of an open market operation
would they have to use?
The central bank would have to sell bonds.
And that's your answer, selling bonds.
Selling securities.
All right.
On to FRQ 2.
Coolway is an open economy that's currently
in a recessionary output gap.
Coolway's banking system has ample reserves.
OK.
We're going to need to know that.
Recessionary output gap.
Output is below full employment.
Ample reserves.
What does that tell us?
It tells us that we're way out there
on the reserve market graph.
It also tells us that open market operations
are no longer effective.
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.
Draw.
There's your verb.
Show.
There's another verb.
The current equilibrium real output and price level, Y1,
PL1 respectively.
Full employment, YF.
This is a pretty standard question, pretty
standard setup.
Goes back to unit 3.
And it's just making sure that how to draw the graph,
and you know how to represent a recessionary output gap.
You've got to have a correctly labeled graph of AD-AS.
Remember, ACE your graphs.
Correct axes, curves, equilibrium.
Those are easy points.
Your axes, price level, and GDP.
Your curves correctly labeled.
Your equilibrium correct.
In this case, that equilibrium is
showing that we have a recessionary gap.
Y1 is going to be over to the left of YF.
All right.
So that gets us started.
Move on to part B. We still have that recessionary output gap.
The central bank and government do not take any policy action
to close the output gap.
Do not take any policy action.
That means we can't reference any kind of policy
in any of the upcoming responses.
We don't know what they're going to ask yet,
but we have a pretty good idea it's
going to be related to the long run self-adjustment.
Explain how the economy will adjust to full employment
in the long run.
In other words, they're at a recessionary gap.
They're below full employment.
How do you get back to full employment without policy?
And then on your graph in part A,
show how the economy adjusts to full employment
in the long run.
Looking for verbs?
Explain.
That's a verb.
You've got to write something out.
You've got to verbalize what's going to happen.
And then show.
You've got to go back to your graph in part
and show the adjustment that you're explaining in part Bi.
So we tell the same story for long run self-adjustment
every time.
A change in resource prices leads to a change in SRAS.
So in this case, you're going to have
a decrease in either nominal wages, input prices, expected
inflation.
Any of those will do, causing shares to shift to the right.
We need to show that on our graph in part A.
And that's what it should look like.
SRAS shifts to the right, resulting in output back
at full employment levels.
On to part C. Suppose now Coolway's government
is unwilling to wait for the long run adjustment process.
The marginal propensity to consume is 0.8.
Equilibrium real output is $500 billion,
and full employment is $540 billion.
They're telling us right here that we have an MPC of 0.8.
Automatically, my mind is going to the multiplier.
They don't have to ask a multiplier question.
But this is, again, one of those little hints
that they're giving you.
I bet the multiplier is going to be involved.
So just remind yourself, what are we dealing with here?
How do we use the multiplier?
What is the multiplier?
Part Ci, calculate, there's your verb, calculate,
the minimum change and indicate the direction
of change and government spending
require to shift AD by the amount of the output gap.
Show your work.
It's important to show your work on this.
So what do I need?
I need to know the multiplier.
And I need to know the desired change in aggregate demand.
By how much are they attempting to change aggregate demand?
Your multiplier, spending multiplier in this case,
is one over MPS.
So it's one over 0.2.
That's the same as 10 divided by 2.
You're spending multiplier is 5.
By how much do they want to increase AD?
They want to increase it enough to close the output gap.
It's a negative output gap of $40 billion.
So they would like a positive $40 billion
change in aggregate demand.
So $8 billion is equal to $40 billion divided by 5.
The answer is $8 billion.
You would take the $40 billion output gap, divide it
by your multiplier of 5.
They would need to change government spending
by $8 billion.
On the C2.
We're still dealing with MPC.
We're still dealing with multiplier questions.
But in this case, now they want to change taxes
to shift AD to close the gap.
We need the same information because we
have to calculate once again.
In this case, it's a tax question.
We did tax multiplier.
That's going to be negative MPC over MPS.
So a negative 0.8 over 0.2.
And that's going to be negative 4.
Our output gap's the same, a negative $40 billion
output gap.
So again, attempting to increase output by $40 billion
to close the gap.
That means that they would have to cut taxes by $10 billion.
On to Part D. Assume instead Coolway Central Bank
takes action to restore the economy to full employment
by influencing investment spending.
Draw a correctly label graph of the reserve market.
Show the effect of the actions taken by the central bank
on the policy rate.
We're still at a recessionary gap in this case.
It said assume instead.
So forget what you just did with the multiplier.
Now, we have a separate situation.
Forget about all the other things.
Now, we're looking at the central bank.
They're going to take action.
They want to influence investment spending
by manipulating interest rates.
We have to make sense of this.
We know they have ample reserves, which
means open market operations doesn't work.
The abbreviation we've used in our class,
my students suggested this one, is NOMO.
No OMO.
Open market operations doesn't work in this case.
It's not an effective policy.
So NOMO.
We can't use it.
Where do we go?
Now, we go administered interest rates.
So we're going to draw, there's your verb,
a correct label graph of the reserve market.
And then we're going to show, another verb,
the effect of those actions on the policy rate.
The correct answer.
You're going to have a correctly labeled graph of the reserve
market, and you're showing a decrease
in administered interest rates as represented
by a decrease in the upper and lower bounds of that demand
curve.
Remember, ACE your graph every time.
Axes, curves, equilibrium every time.
OK, on to FRQ number three.
Interest rates are important at explaining economic activity.
Using a correctly labeled graph of the money market shown
an increase in income level will affect the nominal interest
rate in the short run.
So we're in the money market again.
Show, there's your verb, how an increase in income level
affects nominal interest rates.
So we're drawing the money market graph,
and we've got to interpret how this increase in income
is going to affect things.
So that's a direct connection.
As income increases, the demand for money increases.
We have more money, we're going to spend more money.
So demand for money increases.
We want to show that on our money market graph
with a rightward shift of the money demand curve.
And that's going to result in an increase in interest rates.
ACE your graph.
Don't ever forget.
I almost forgot there.
Don't forget to ACE your graphs.
Part B. Using a correctly labeled graph
for the loanable funds market, show
how a decision by households to increase saving for retirement
will increase the real market interest rate in the short run.
So now, switch gears.
You're in a loanable funds market.
You've got to show how household increase savings by households
is going to affect real interest rates.
Savings are on the supply curve.
A good way to remember that, S for Supply, S for Savings.
When we're in the loanable funds market,
that's where loanable funds come from, savings.
That's going to increase the supply of loanable funds.
We want to show that.
Always ACE your graphs.
Didn't forget that time.
That increase in the supply is going
to cause real interest rates to fall,
leading to lower interest rates.
And we'll talk about what happens
next and other questions.
On to part C. Suppose the nominal interest rate
has been 6% with no expected inflation.
If inflation is now expected to be 2%,
determine the value of each of the following.
New nominal interest rate, new real interest rate.
You know where they're going as soon as they
start the question with inflation and nominal interest
rates.
This is a Fisher equation question.
You're going to need the ex ante, the before the fact,
and the ex poste version of that.
In order to answer the first part of it
with no expected inflation, our nominal rate is 6%.
With no expected inflation, it's still 6%.
With 2% inflation, it's now up to 8%.
So the new nominal interest rate with your 2% and expected
inflation is going to be 8%.
The new real interest rate, there
doesn't appear to be anything that
would cause a change in the real interest rate.
The correct answer is 6%.
This is a case where you just have to trust yourself
in the work you do.
Use your Fisher equation, understand the Fisher effect,
and know nothing has happened here
to cause a change in the real interest rate.
We go back to 6%.
I want to thank you for viewing this video today.
Thank you for the work that you're putting into AP Macro.
We're going to ask you to keep doing it.
Keep coming back for more.
We have more videos coming.
It takes time.
It takes practice.
But you're doing the right thing.
So keep watching AP Daily Practice.
And as always, remember, a problem well defined
is half solved.
Have a great day.