Economics Micro & Macro (CliffsAP)

Free-Response Answers and Explanations

1. A.The main problem in this scenario is inflation. At a 7-percent rise in the price level, the economy has reached
   and started to surpass its productive capacity. A 4.2-percent unemployment rate indicates that the economy has
   fully employed its labor resources, further indicating a problem with inflation as aggregate demand continues to
   grow. The growth in real GDP is not a problem; however, it is expected due to the low rate of unemployed people
   in the labor force and a growing price level.
   B.To combat inflation, the Federal Reserve should implement a “tight” monetary policy—the Fed decreases the
   money supply with the intension of increasing the value of the available dollars in the economy. To accomplish
   this, the Fed could use any one of its monetary policy tools: increasing the reserve ratio, increasing the discount
   rate, or, most likely, selling open market securities. Refer to the following illustration:

C.Congress would partake in a contractionary fiscal policy with the objective of halting the price level by

decreasing disposable income. To do this, the government could increase taxes and/or reduce spending.

Refer to the following illustration:

D. It is important for Congress and the Fed to work together because they are the two most influential entities on

the economy. If the Fed and Congress do not work together, the effectiveness of policies enacted by either of the

two would be diminished significantly.

Real GDP

Price

Level

AD^2

AD^1

Real GDP

Price

Level

AD^2

AD^1

Money Supply

Interest

Rates

MS^2 MS^1

Part IV: AP Macroeconomics & Microeconomics Tests