AP Macroeconomics Long-Run Consequences of Stabilization Policies — Worked Answer Explanations

Unit 5 · 12 questions explained

Below is a complete answer key for our AP Macroeconomics Long-Run Consequences of Stabilization Policies practice questions. For each question you'll find the correct choice, a full written explanation of how to get there, and — for every wrong answer — a short note on exactly why it's tempting and where it goes wrong. Reading these straight through is one of the fastest ways to find the gaps in a unit before exam day.

Prefer to test yourself first? Take the timed Long-Run Consequences of Stabilization Policies practice test and come back here to review, or head back to the Long-Run Consequences of Stabilization Policies unit overview.

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Question 1 · Easy
Economic growth in the long run is best represented graphically by:
- A
  A rightward shift of the AD curve.
  Why not A: Rightward AD shifts affect short-run output and the price level; they do not increase an economy's long-run productive capacity.
- B
  A rightward shift of the LRAS curve.Correct
- C
  A movement along the SRAS curve from left to right.
  Why not C: Moving along the SRAS curve reflects a price-level change, not long-run capacity growth.
- D
  A leftward shift of the LRAS curve.
  Why not D: Leftward LRAS shift represents a decline in potential GDP (e.g., destruction of capital or labor force shrinkage) — the opposite of growth.
Explanation
The LRAS curve is vertical at potential GDP. Long-run economic growth — driven by more resources (labor, capital), better technology, or improved institutions — permanently increases productive capacity, shifting the LRAS rightward. This is distinct from short-run demand-side fluctuations.

Key takeaway
Long-run growth = rightward LRAS shift. Drivers: ↑ labor/capital, technological progress, institutional improvement. Not to be confused with short-run AD fluctuations.
Question 2 · Easy
In the long run, an increase in aggregate demand with an economy already at full employment will result in which of the following, according to classical macroeconomic theory?
- A
  Higher real GDP and a higher price level.
  Why not A: In the long run, the economy returns to potential GDP regardless of demand; real output cannot permanently exceed the LRAS constraint.
- B
  Higher price level only; real GDP returns to potential.Correct
- C
  Lower price level and lower real GDP.
  Why not C: An increase in AD raises the price level; it does not lower either price level or real GDP.
- D
  Permanently higher real GDP with no change in the price level.
  Why not D: This contradicts the vertical LRAS: long-run real GDP is fixed at potential, and AD increases translate fully into inflation.
Explanation
The LRAS is vertical at potential GDP. When AD increases at full employment, the short-run equilibrium overshoots potential, creating an inflationary gap. Rising wages and input costs shift SRAS left until the economy returns to potential GDP at a permanently higher price level. Real output is unchanged in the long run.

Key takeaway
Long-run: LRAS is vertical. AD increases → higher price level only; real GDP returns to potential. LRAS determines long-run output, not AD.
Question 3 · Easy
The short-run Phillips curve shows a trade-off between inflation and unemployment. If the government pursues expansionary fiscal policy, where does the economy move along the short-run Phillips curve?
- A
  Toward higher inflation and lower unemployment.Correct
- B
  Toward lower inflation and higher unemployment.
  Why not B: Lower inflation and higher unemployment is the direction of contractionary policy along the short-run Phillips curve.
- C
  Along the long-run Phillips curve toward lower unemployment.
  Why not C: The long-run Phillips curve is vertical at the natural rate; policy moves the economy along the short-run curve, not permanently along the long-run curve.
- D
  Upward along the long-run Phillips curve.
  Why not D: Expansionary policy shifts the economy along — not along the long-run curve; the LRPC is vertical and policy moves along the SRPC.
Explanation
Expansionary fiscal policy increases AD, raising output above potential and lowering unemployment below the natural rate. Increased demand also raises the price level — inflation rises. On the short-run Phillips curve, this movement is toward the upper-left: higher inflation, lower unemployment.

Key takeaway
Short-run Phillips curve: expansionary policy → move up-left (↑ inflation, ↓ unemployment). Contractionary policy → move down-right (↓ inflation, ↑ unemployment).
Question 4 · Easy
The long-run Phillips curve (LRPC) is vertical at the natural rate of unemployment (NRU). This vertical shape implies that:
- A
  Higher inflation permanently reduces unemployment below the NRU.
  Why not A: The vertical LRPC says there is no long-run trade-off; persistent inflation cannot permanently lower unemployment below the NRU.
- B
  In the long run, there is no trade-off between inflation and unemployment.Correct
- C
  The short-run Phillips curve is also vertical.
  Why not C: The short-run Phillips curve is downward sloping; only the long-run version is vertical.
- D
  Any level of inflation is consistent with the natural rate of unemployment.
  Why not D: While the LRPC is vertical (consistent with any long-run inflation rate), this answer overstates the implication — it does not mean inflation doesn't matter, only that unemployment returns to NRU.
Explanation
The LRPC is vertical because workers eventually adjust their inflation expectations. If the government tries to keep unemployment below the NRU by accepting higher inflation, workers demand higher wages to compensate. SRAS shifts left, returning the economy to the NRU at a permanently higher inflation rate. The long-run trade-off disappears.

Key takeaway
Vertical LRPC: no long-run trade-off between inflation and unemployment. Inflation expectations adjust, returning unemployment to the NRU regardless of inflation.
Question 5 · Easy
Crowding out occurs when expansionary fiscal policy leads to:
- A
  Lower private investment because government borrowing raises interest rates.Correct
- B
  Higher private investment because government spending raises incomes.
  Why not B: Higher incomes from government spending could increase saving, but the crowding-out effect specifically refers to the interest-rate channel reducing private investment.
- C
  Lower price levels because increased supply of goods reduces inflation.
  Why not C: Expansionary fiscal policy increases demand, typically raising price levels; lower prices are not the mechanism of crowding out.
- D
  Lower government spending in future periods to balance the budget.
  Why not D: Future budget adjustments are a fiscal sustainability concern, not the definition of crowding out, which is a real-time interest-rate effect.
Explanation
Deficit-financed government spending increases the demand for loanable funds. This raises the real interest rate, making borrowing more expensive for private firms and households. Private investment (I) falls, partially offsetting the stimulus effect of government spending (G). The multiplier effect is smaller than in the absence of crowding out.

Key takeaway
Crowding out: ↑G (deficit) → ↑ demand for loanable funds → ↑ real interest rate → ↓ private investment (I). Partially offsets the fiscal multiplier.
Question 6 · Easy
According to the quantity theory of money ( $M V = P Q$ ), if the velocity of money (V) and real output (Q) are constant, a 5% increase in the money supply (M) will cause:
- A
  A 5% increase in real output (Q).
  Why not A: If V and P adjust while Q is held constant, changes in M affect nominal values (P), not real output (Q).
- B
  A 5% increase in the price level (P).Correct
- C
  A 5% increase in velocity (V).
  Why not C: V is assumed constant in the quantity theory; it does not absorb the change in M.
- D
  No change in any variable, as the equation must always balance.
  Why not D: MV = PQ must balance, but it does so by P adjusting when M increases and V, Q are held constant — not by nothing changing.
Explanation
With $V$ and $Q$ constant: $M ↑ 5% \Rightarrow P ↑ 5%$ , since $M V = P Q \Rightarrow P = \frac{M V}{Q}$ . This is the monetarist implication: money supply growth translates one-for-one into inflation when velocity and real output are stable. It supports the argument that inflation is 'always and everywhere a monetary phenomenon.'

Key takeaway
Quantity theory ($MV = PQ$): with V and Q constant, % change in M = % change in P. Money growth → proportional inflation.
Question 7 · Easy
When an economy has an inflationary gap, the long-run self-correction mechanism works through:
- A
  Workers demanding higher wages as the labor market tightens, causing SRAS to shift left.Correct
- B
  The government automatically cutting spending to reduce AD.
  Why not B: Automatic government spending cuts describe discretionary fiscal policy or a balanced-budget rule, not the classical self-correction mechanism.
- C
  The Fed automatically raising the money supply to lower interest rates.
  Why not C: Expanding the money supply would worsen an inflationary gap, not correct it; self-correction does not involve Fed expansion.
- D
  Firms reducing output due to falling demand as consumers cut back on spending.
  Why not D: This describes a demand-side contraction, not the supply-side wage-adjustment mechanism of classical self-correction.
Explanation
In an inflationary gap, actual GDP > potential GDP, so the labor market is tight and unemployment is below the NRU. Workers (with more bargaining power) negotiate higher wages. Rising labor costs shift SRAS left, reducing output and raising the price level until real GDP returns to potential. This is the classical self-correction mechanism.

Key takeaway
Inflationary gap self-correction: tight labor market → ↑ wages → ↑ production costs → SRAS shifts left → output returns to potential at a higher price level.
Question 8 · Easy
Stagflation is most directly caused by which of the following?
- A
  A rapid increase in aggregate demand that outpaces productive capacity.
  Why not A: Rapid AD growth causes inflation and potentially overheating, but also raises real GDP — not the falling output that defines stagflation.
- B
  A negative supply shock that shifts SRAS to the left.Correct
- C
  A large increase in government spending that crowds out private investment.
  Why not C: Crowding out reduces private investment but does not simultaneously raise the price level and reduce real output the way a supply shock does.
- D
  A decrease in the money supply that reduces both output and prices.
  Why not D: Contractionary monetary policy lowers both output and prices (disinflation + recession), not a simultaneous rise in prices and fall in output.
Explanation
Stagflation (simultaneous high inflation and high unemployment) is caused by a negative supply shock — a leftward shift of SRAS. Input costs (e.g., oil prices) rise, shifting SRAS left. The economy moves up and left along AD: higher price level and lower real GDP (higher unemployment). Policy trade-offs become painful because any cure for inflation worsens unemployment and vice versa.

Key takeaway
Stagflation = ↑ price level + ↓ real GDP (↑ unemployment). Caused by negative supply shock (leftward SRAS). Not caused by demand changes.
Question 9 · Medium
A positive supply shock (e.g., a dramatic fall in energy prices) shifts SRAS to the right. What are the short-run and long-run effects on the price level and real GDP?
- A
  Short run: lower price level and higher real GDP. Long run: price level and real GDP return to original levels.
  Why not A: The long-run correction is not a full reversal — SRAS shifts back only partially, as the new energy price may persist; the LRAS itself may shift right if the shock is permanent.
- B
  Short run: lower price level and higher real GDP. Long run: wages fall, SRAS shifts further right, permanently raising potential GDP.
  Why not B: Wages falling is a long-run correction mechanism for demand shocks; a supply shock improves the economy and does not require wages to fall.
- C
  Short run: lower price level and higher real GDP above potential. Long run: wages and input costs adjust upward, returning output to potential at a lower price level than before the shock.Correct
- D
  Short run: higher price level and higher real GDP. Long run: price level falls back to original.
  Why not D: A positive supply shock lowers the price level (favorable cost conditions); higher price level and output simultaneously is a demand-shock outcome.
Explanation
A positive supply shock shifts SRAS right: the economy moves to lower prices and higher real GDP above potential (inflationary gap). In the long run, the tight labor market raises wages, shifting SRAS left until the economy returns to potential GDP — but at a lower price level than before the shock (since the original shock lowered input costs permanently until reversed).

Key takeaway
Positive supply shock: SRAS right → ↓ price, ↑ real GDP (short run). Long-run self-correction via rising wages returns output to potential at a permanently lower price level.
Question 10 · Medium
An economist argues that expansionary fiscal policy in the long run primarily increases the price level rather than real GDP. This position is most consistent with which framework?
- A
  The Keynesian model, which emphasizes the multiplier effect.
  Why not A: Keynesians argue expansionary policy raises real GDP (especially when the economy has slack); the described position that policy only raises prices is more classical.
- B
  The classical/monetarist model, which holds that LRAS is vertical and real GDP returns to potential.Correct
- C
  The short-run AD/AS model without crowding out.
  Why not C: The short-run model (with slack) predicts real GDP rises from expansionary policy; the vertical LRAS constraint only binds in the long run.
- D
  The Phillips curve, which predicts that lower unemployment always reduces inflation.
  Why not D: The Phillips curve predicts lower unemployment raises inflation (not lowers it), and it is a short-run relationship; the described long-run neutrality is a separate argument.
Explanation
Classical and monetarist economists argue that in the long run, real GDP is determined by supply-side factors (LRAS), not by demand. Expansionary fiscal policy shifts AD right; in the short run, real GDP rises. But wages and prices adjust, SRAS shifts left, and the economy returns to potential GDP at a higher price level. Long-run real GDP is unchanged — policy is 'neutral' in the long run.

Key takeaway
Classical/monetarist long-run view: AD changes are neutral — they change only the price level, not real GDP. Keynesians allow for long-run demand effects, especially with persistent slack.
Question 11 · Medium
If expected inflation increases while the nominal interest rate is unchanged, which of the following is most likely to occur in the loanable funds market?
- A
  Borrowers demand more loanable funds, and lenders supply more, raising the nominal rate.
  Why not A: Higher expected inflation raises borrower demand (lower real cost) but lowers lender supply (lower real return); the net effect raises the nominal rate, not lowers supply by lenders — the direction of supply change is wrong here.
- B
  Lenders demand a higher nominal rate to preserve the real return; the equilibrium nominal rate rises.Correct
- C
  Real interest rates rise because expected inflation raises the cost of borrowing.
  Why not C: If nominal rates adjust fully to inflation (Fisher effect), the real rate is unchanged. The rise is in the nominal rate, not the real rate.
- D
  Both supply and demand for loanable funds shift right by equal amounts, leaving the rate unchanged.
  Why not D: Demand shifts right (borrowers benefit from lower real costs) and supply shifts left (lenders demand compensation) — the shifts are in opposite directions, reinforcing rate increases.
Explanation
The Fisher effect: $i = r + π^{e}$ . When expected inflation $π^{e}$ rises, lenders require a higher nominal rate $i$ to preserve their real return $r$ . Simultaneously, borrowers are willing to pay more (real cost of borrowing falls). Both forces push the equilibrium nominal interest rate up by approximately the increase in expected inflation, leaving the real rate approximately unchanged.

Key takeaway
Fisher effect: $i = r + \pi^e$. ↑ expected inflation → ↑ nominal rate by the same amount; real rate approximately unchanged. Lenders demand, borrowers accept higher nominal rates.
Question 12 · Medium
The short-run Phillips curve shifts upward (worsens the trade-off) primarily because of:
- A
  An increase in the labor force participation rate.
  Why not A: Changes in labor force participation affect the NRU but do not by themselves shift the short-run Phillips curve vertically.
- B
  Rising inflation expectations or an adverse supply shock.Correct
- C
  A decrease in aggregate demand that reduces inflation.
  Why not C: Decreased AD moves the economy along the short-run Phillips curve (down-right), but does not shift the curve itself upward.
- D
  A decrease in the money supply engineered by the Fed.
  Why not D: Tighter monetary policy moves the economy along the SRPC toward lower inflation and higher unemployment; it shifts along the curve, not the curve itself.
Explanation
The short-run Phillips curve shifts upward when: (1) inflation expectations rise — workers and firms build higher expected inflation into wage bargains and price-setting, so any given unemployment rate is now associated with higher actual inflation; or (2) an adverse supply shock (e.g., oil price spike) raises costs independently of demand, producing stagflation (both higher inflation and higher unemployment — the SRPC shifts up-right).

Key takeaway
SRPC shifts upward from: ↑ inflation expectations (adaptive expectations mechanism) or adverse supply shocks. This worsens the inflation-unemployment trade-off for policymakers.