National Advanced Placement Economics Conference Washington D.C James Chasey Homewood-Flossmoor High School College of DuPage 1985-present

Common Errors on the 2006 AP Economics Exam Arthur Raymond Muhlenberg College Chief Reader, Economics

Common Errors on the 2006 Exam Macro 1, Part (c) (c) Given your answer in part (b), explain what will happen to unemployment in the United States in the short run. In part (b), the level of production fell, so in the AD/AS model, employment falls in the short run leading to an increase in unemployment Common Error: Inability to link increasing unemployment with falling output.

Common Errors on the 2006 Exam Macro 1, Part (d) (d) Assume the United States trades with Japan. Draw a correctly labeled graph of the foreign exchange market for the United States dollar. Based on your indicated change in real output in part (b), show and explain how the supply of the United States dollar will be affected in the foreign exchange market. The properly labeled graph should contain yen per dollar on the vertical axis, the quantity of $ on the horizontal axis with the demand and supply curves properly labeled. The effect of reduced output in part (b) means less income in the US, so imports will fall, leading to a reduced supply of dollars on the foreign exchange market.

Common Errors on the 2006 Exam Macro 1, Part (d) – Cont’d. Common Errors: Mislabeled graph, inability to link reduced output with reduced imports and supply of dollars.

Common Errors on the 2006 Exam Macro 2, Part (a) a) Using a correctly labeled graph of the money market, show how an increase in the income level will affect the nominal interest rate in the short run. The correctly labeled graph will have the interest rate on the vertical axis, the quantity of money on the horizontal axis, with the supply and demand schedules properly labeled. An increase in income will increase the demand for money for transactions purposes, shifting Md to the right and increasing the nominal interest rate.

Common Errors on the 2006 Exam Macro 2, Part (a)-Continued Common Errors: Mislabeled Graph, shift of Ms to right.

Common Errors on the 2006 Exam Macro 2, Part (b) b) Using a correctly labeled graph of the loanable funds market, show how a decision by households to increase saving for retirement will affect the real market interest rate in the short run. An increase in savings will increase the supply of loanable funds, which will lower the real interest rate.

Common Errors on the 2006 Exam Macro 2, Part (b) – Cont’d. Common Errors: General unfamiliarity with the loanable funds framework. Many used the money supply and money demand framework.

Common Errors on the 2006 Exam Macro 2, Part (c) (c) Suppose that the nominal interest rate has been 6 percent with no expected inflation. If inflation is now expected to be 2 percent, determine each of the following. (i) The new nominal interest rate. (ii) The new real interest rate. With an increase in expected inflation of 2 percent, the nominal interest rate will increase by 2 percent to 8%. The new real interest rate will be 6%, the same as before the change in expected inflation. Common Errors: General unfamiliarity with the effect of expected inflation on nominal and real interest rates.

Common Errors on the 2006 Exam Macro 3, Part (c) Macro 3 (c) Assume the government reduces the level of unemployment compensation. (i) Explain how this affects the natural rate of unemployment. (ii) Using a correctly labeled graph, show how this affects the long-run Phillips Curve. The correctly labeled graph has inflation on the vertical axis, unemployment on the horizontal, and a vertical long-run Phillips Curve. A reduction in unemployment compensation reduces the benefit of unemployment, leading more active job searches and a reduction in the natural rate of unemployment and so a shift to the left of the long-run Phillips Curve.

Common Errors on the 2006 Exam Macro 3, Part (c) - Cont’d Common Error: Use of a downward sloping Phillips curve.

 Arthur Raymond Chief Reader Muhlenberg College  Meet the Test Development Committee APAC, Las Vegas, 2007

Top Ten Errors on the 2007 Economics AP Exam

Macro 2 (c) (3)  Assume that the open-market operation that you indicated in part (b) (purchase) is equal to $10 million. If the required reserve ratio is 0.2, calculate the maximum change in loans throughout the banking system.  $40 million

Macro 2 (e) (5 and 10)  Assume that the Federal Reserve’s action results in some inflation. What would be the impact of the open market operation (purchase) on the real rate of interest?  Real rate falls because nominal rate decreases and inflation increases.

Macro 2 (a) (7)  Define the Federal Funds Rate  It is the interest rate banks charge to other banks for borrowed reserves.

Macro 1 (b) (9)  Using a correctly labeled graph of the foreign exchange market for the US dollar to show the impact of the change in relative price levels (P US falls relative to Japan) on each of the following.  (i) Demand for the dollar  (ii)  D shifts up

Top 10 AP Econ Mistakes 2008

Overview 11. Compare MSC, MSB 10. Tax → ↑MC → ↓Q 9. Foreign Exchange Market with Shift 8. Automatic Stabilizers 7. Optimal Consumption Rule 6. Number of Firms Can’t Increase in SR 5. Currency Appreciation from Real Interest Rate ↑ 4. Current Account Changes Resulting from Real Income Changes 3. Link between Growth and Capital 2. Elements of the Current and Capital Account 1. Effects of a Lump Sum Subsidy

The Graph (not required for part b) $/unit S = MSC Quantity of Vaccinations D MSB Q market

The Graph (not required for part c) $/unit ATC Quantity MC $/unit S Quantity D SMB QsQs Q1Q1

9. Macro 2 (c) Question: Using a correctly labeled graph of the foreign exchange market for the U.S. dollar, show how an increase in U.S. firms’ direct investment in India will affect the value of the dollar relative to the rupee. Answer: In the dollar market, the supply of dollars will increase as dollars are exchanged for rupees, shifting the dollar supply curve to the right and decreasing the value of the dollar. 33% drew the graph correctly 29% shifted S correctly

The Graph rupees/ dollar Supply Quantity of Dollars Demand New Supply Q e e’ Q’

8. Macro 1 (b) Question: [Starting with a balanced budget] What is the impact of the recession on the federal budget? Answer: There will be a deficit because government spending / transfer payments increase and/or taxes fall due to automatic stabilizers (for example, unemployment insurance). Discretionary fiscal or monetary policy not accepted, for such answers violate the ceteris paribus assumption. 81% correctly indicated a deficit 27% indicated awareness of automatic stabilizers

5. Overseas Macro 1 (d) ii Question: Given the [increase] in the real interest rate in part (c), what will be the effect on the value of Z’s currency? Answer: Z’s currency will increase in value (because the higher real interest rate attracts more financial investment in Z, thus increasing the demand for Z’s currency and decreasing the supply). 23% answered correctly

4. Macro 2 (b) Question: How would an increase in the real income of the United States affect the U.S. current account balance? Explain. Answer: The current account balance will decrease or move toward a deficit (15 percent answered correctly) because the increase in real income causes imports to increase relative to exports. (33 percent answered correctly)

3. Macro 1 (e) Question: How will the real interest rate [increase] in part (d) affect the growth rate of the U.S. economy? Answer: The growth rate will fall (49 percent answered correctly) because a higher real interest rate discourages investment and as a result, capital formation will decrease. (12 percent answered correctly)

2. Macro 2 (a) ii Question: Two major subaccounts in the balance of payments accounts are the current account and the capital account. In which of these subaccounts will the following be recorded? (ii) A U.S. manufacturer buys computer equipment from Japan. Answer: Current Account 10 percent answered correctly

Top 10 Most Common Errors AP Economics 2009

Overview of Trouble Spots 10. Monopolistic Competition and Economies of Scale 9. A Tax Reduces Allocative Efficiency 8. Capital Flight Decreases S LF and Increases r. 7. A Lump-Sum Tax Doesn’t Effect Q* because it Doesn’t Effect MC 6. Elasticity Calculation and Interpretation 5. Money/Deposit Multiplier 4. An Increase in the Money Supply Results (via #3) in a Decrease in Real Wages 3. Real Wages Fall due to an Increase in the Price Level 2. Link between Growth and Capital Formation 1. SRPC Shifts due to Changes in Inflationary Expectations

Monopolistic Competition $/unit Marginal Revenue Demand Marginal Cost P Q Quantity Long-Run Average Cost

Monopolistic Competition $/unit Marginal Revenue Demand Marginal Cost P Q Quantity Long-Run Average Cost Economies of Scale

8. Macro 2 (b) Question: Using a correctly labeled graph of the loanable funds market in Tara, show the impact of this decision by investors [to move their funds out of the country of Tara] on the real interest rate in Tara.

The Graph Real interest rate Loanable funds D LF S LF r Q 40% Correct

The Shift and Change Real interest rate S LF ’ Loanable funds D LF S LF Q’ r' r Q 22% Correct

5. Macro 3 (a) ii Question: Assume that the reserve requirement is 20 percent and banks hold no excess reserves. Assume that Kim deposits $100 of cash from her pocket into her checking account. Calculate the maximum change in demand deposits in the banking system. Answer: (The money multiplier of) 5 x $100 = $500. (14% answered correctly.)

3. and 4. Macro 3 (c) Question: Given the increase in the money supply in part (b), what happens to real wages in the short run? Answer: Real wages fall (20% answered correctly) because the increase in the money supply raises the price level (or inflation). (15% answered correctly)

2. Macro 2 (c) Question: Given your answer in part (b) [that interest rates increase], what will happen to Tara’s rate of economic growth? Explain. Answer: The growth rate will fall (61% correct) because investment spending decreases, and as a result, capital formation will decrease. 9% answered correctly

1. Macro 1 (f) i Question: Assume the Federal Reserve action [to reduce inflation] is successful. What will happen to each of the following as the economy approaches a new long- run equilibrium? (i) The short-run Phillips curve. Explain. (ii) The natural rate of unemployment.

The Phillips Curve Inflation Long-Run Phillips Curve Natural Rate SRPC w/High Expected Inflation Unemployment SRPC w/Low Expected Inflation

Answer: The SRPC will shift to the left (28% answered correctly) because the Fed policy will lower inflationary expectations. (2% answered correctly) The natural rate of unemployment will not change. (24% answered correctly)