AP Macroeconomics National Income and Price Determination — Worked Answer Explanations

Unit 3 · 12 questions explained

Below is a complete answer key for our AP Macroeconomics National Income and Price Determination 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 National Income and Price Determination practice test and come back here to review, or head back to the National Income and Price Determination unit overview.

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Question 1 · Easy
Which of the following events would shift the Aggregate Demand (AD) curve to the right?
- A
  A significant increase in personal income taxes.
  Why not A: Higher income taxes reduce disposable income and consumer spending (C), shifting AD left.
- B
  A decrease in consumer confidence about the future.
  Why not B: Lower consumer confidence reduces household spending, shifting AD left.
- C
  A decrease in interest rates that stimulates business investment.Correct
- D
  An appreciation of the domestic currency that makes exports more expensive abroad.
  Why not D: A stronger currency raises export prices, reducing foreign demand and net exports (NX), shifting AD left.
Explanation
AD = C + I + G + NX. Lower interest rates reduce the cost of borrowing, encouraging businesses to invest in capital ( $I$ rises) and households to borrow for big purchases ( $C$ rises). The resulting increase in total spending shifts AD rightward.

Key takeaway
AD shifts right when C, I, G, or NX increase. Lower interest rates → higher investment and consumption → rightward AD shift.
Question 2 · Easy
The marginal propensity to consume (MPC) is 0.75. The government increases spending by $100 billion. By how much does equilibrium GDP increase, assuming no crowding out?
- A
  $75 billion
  Why not A: 75 billion multiplies the spending change by the MPC rather than the multiplier; the multiplier equals $\frac{1}{1 - M P C}$ .
- B
  $400 billionCorrect
- C
  $100 billion
  Why not C: 100 billion assumes the multiplier is 1, ignoring the additional rounds of induced spending the initial injection creates.
- D
  $133 billion
  Why not D: 133 = 100/0.75, which uses MPC as the divisor rather than (1 − MPC) = 0.25.
Explanation
The spending multiplier $= \frac{1}{1 - M P C} = \frac{1}{1 - 0.75} = \frac{1}{0.25} = 4$ . $\Delta GDP = \text{multiplier} \times \Delta G = 4 \times \$ 100\text{B} = $400$ billion. Each dollar of government spending triggers additional rounds of consumer spending based on the MPC.

Key takeaway
Spending multiplier $= \frac{1}{1 - MPC} = \frac{1}{MPS}$. $\Delta GDP = \text{multiplier} \times \Delta \text{autonomous spending}$.
Question 3 · Easy
In the AD/AS model, a decrease in aggregate demand (AD) with a downward-sticky price level will most likely result in:
- A
  Lower price level and unchanged real GDP.
  Why not A: If prices are downward sticky, they do not fall when AD decreases, so the adjustment falls on output instead.
- B
  Lower real GDP with the price level unchanged in the short run.Correct
- C
  Higher price level and lower real GDP simultaneously.
  Why not C: A higher price level from a leftward AD shift contradicts basic AD/AS logic; leftward AD shift lowers both output and prices (though prices are sticky downward).
- D
  Unchanged real GDP and unchanged price level.
  Why not D: A decrease in AD that is met with no adjustment in either price or output is inconsistent with any AD/AS equilibrium mechanism.
Explanation
In the short run, wages and prices are sticky downward — firms are reluctant to cut prices or wages. When AD decreases, rather than reducing prices, firms respond by cutting output and employment. The result is a recessionary gap: real GDP falls below potential while the price level remains relatively stable.

Key takeaway
Short-run downward price stickiness means a fall in AD primarily reduces real GDP (recessionary gap), not the price level.
Question 4 · Easy
An economy is operating below potential GDP (recessionary gap). Using the Keynesian model, which fiscal policy would best restore full employment?
- A
  Increase taxes and reduce government spending to balance the budget.
  Why not A: Contractionary fiscal policy (higher taxes + lower spending) shifts AD further left, deepening the recession.
- B
  Increase government spending and/or cut taxes to shift AD right.Correct
- C
  Reduce the money supply to raise interest rates and reduce inflation.
  Why not C: Contractionary monetary policy would further depress investment and AD; in a recessionary gap, the problem is insufficient demand, not excessive inflation.
- D
  Allow wages and prices to fall until the economy self-corrects.
  Why not D: This describes the classical (long-run) self-correction mechanism, not Keynesian fiscal policy; Keynesians argue such adjustment is too slow and advocates active policy.
Explanation
A recessionary gap exists when actual GDP < potential GDP. Expansionary fiscal policy — increasing government spending (G) or cutting taxes (raising disposable income and C) — shifts AD rightward, closing the gap and restoring full employment. The multiplier amplifies the initial stimulus.

Key takeaway
Recessionary gap → expansionary fiscal policy: ↑G or ↓taxes → AD shifts right → GDP rises toward potential.
Question 5 · Easy
If the short-run aggregate supply (SRAS) curve shifts left due to a sharp rise in oil prices, the most likely immediate outcome is:
- A
  Higher price level and higher real GDP.
  Why not A: A leftward SRAS shift raises the price level but reduces real GDP; output and prices cannot both rise from a supply contraction.
- B
  Lower price level and lower real GDP.
  Why not B: A leftward SRAS shift raises the price level, not lowers it; lower GDP is correct, but lower prices is not.
- C
  Higher price level and lower real GDP (stagflation).Correct
- D
  Higher price level and unchanged real GDP.
  Why not D: Unchanged GDP would occur only on the vertical LRAS; in the short run, the SRAS shift moves the economy along the AD curve, reducing both output and the price rising.
Explanation
A leftward SRAS shift (negative supply shock) moves the short-run equilibrium to a higher price level and lower real GDP — the combination known as stagflation (stagnation + inflation). This occurred dramatically during the 1970s oil crises. The AD curve is unchanged; the economy moves up and left along it.

Key takeaway
Negative supply shock: SRAS shifts left → stagflation (↑ price level, ↓ real GDP). Opposite of demand shocks, which move price level and GDP in the same direction.
Question 6 · Easy
The consumption function is $C = 200 + 0.75 Y_{d}$ . If disposable income $(Y_{d})$ increases by $400 billion, by how much does consumption change?
- A
  $200 billion
  Why not A: 200 is the autonomous consumption constant, not the change in consumption; the change depends on MPC × ΔY.
- B
  $300 billionCorrect
- C
  $400 billion
  Why not C: 400 billion would imply MPC = 1 (all additional income is consumed); MPC = 0.75 means 25% is saved.
- D
  $100 billion
  Why not D: 100 = 0.25 × 400, which applies the MPS (not the MPC) to the income change.
Explanation
$\Delta C = MPC \times \Delta Y_d = 0.75 \times \$ 400\text{B} = $300$ billion. The MPC (0.75) tells us what fraction of each additional dollar of disposable income goes to consumption. The autonomous consumption (200) is unchanged — it shifts only with non-income factors like wealth or confidence.

Key takeaway
$\Delta C = MPC \times \Delta Y_d$. The autonomous term is fixed; only income changes drive movements along the consumption function.
Question 7 · Easy
In the AD/AS model, an economy is initially at long-run equilibrium. Which combination of events creates an inflationary gap?
- A
  AD shifts left while SRAS shifts right.
  Why not A: Leftward AD + rightward SRAS both reduce the price level; real GDP could rise, fall, or stay constant, but the combination does not necessarily create an inflationary gap above potential.
- B
  AD shifts right, moving actual GDP above potential GDP.Correct
- C
  LRAS shifts right, increasing potential GDP above actual GDP.
  Why not C: If LRAS shifts right (potential rises) while actual GDP stays put, an economy falls below the new potential — a recessionary gap, not inflationary.
- D
  SRAS shifts left, reducing real GDP below potential.
  Why not D: A leftward SRAS creates a recessionary gap (actual < potential), not an inflationary gap.
Explanation
An inflationary gap exists when actual real GDP exceeds potential GDP. This happens when AD shifts rightward beyond the LRAS. The economy is 'overheating': unemployment is below the natural rate, resources are overutilized, and upward pressure on wages and prices builds until the SRAS shifts left to restore long-run equilibrium.

Key takeaway
Inflationary gap: actual GDP > potential GDP. Caused by rightward AD shift beyond LRAS. Self-corrects via rising wages (SRAS shifts left).
Question 8 · Medium
If the MPC is 0.8 and the government simultaneously increases spending by $50 billion AND raises taxes by \$ 50 billion, what is the net change in equilibrium GDP (balanced budget multiplier)?
- A
  $0 (no net change)
  Why not A: Zero net change would only occur if both multipliers were equal; the tax multiplier is smaller than the spending multiplier, so GDP rises.
- B
  $50 billion increaseCorrect
- C
  $200 billion increase
  Why not C: 200 billion uses only the spending multiplier (5 × 50) without subtracting the tax multiplier effect.
- D
  $40 billion decrease
  Why not D: A decrease would result only if the tax effect dominated, but the tax multiplier (−MPC/(1−MPC)) is always smaller in absolute value than the spending multiplier.
Explanation
Spending multiplier = $\frac{1}{1 - 0.8} = 5$ . Tax multiplier = $\frac{- M P C}{1 - M P C} = \frac{- 0.8}{0.2} = - 4$ . Net $\Delta GDP = (5 \times \$ 50\text{B}) + (-4 \times $50\text{B}) = \$ 250\text{B} - $200\text{B} = \$ 50$ billion. The balanced budget multiplier always equals 1, so GDP rises by the amount of the spending increase.

Key takeaway
Balanced budget multiplier = 1. Equal increases in G and T raise GDP by the same amount as the spending increase, regardless of the MPC.
Question 9 · Medium
Automatic stabilizers help smooth the business cycle without new legislative action. Which of the following is the best example of an automatic stabilizer?
- A
  A government stimulus package passed during a recession.
  Why not A: A legislated stimulus package requires new Congressional action; it is discretionary fiscal policy, not an automatic stabilizer.
- B
  A central bank cutting interest rates during a downturn.
  Why not B: Central bank rate decisions are monetary policy, not automatic fiscal stabilizers; they require an active Fed decision.
- C
  Progressive income taxes and unemployment insurance benefits.Correct
- D
  A balanced-budget requirement that forces spending cuts during recessions.
  Why not D: A balanced-budget rule is actually destabilizing — it requires cutting spending or raising taxes during downturns, amplifying the recession rather than stabilizing it.
Explanation
Automatic stabilizers change automatically with the business cycle without requiring new legislation. During recessions, income falls, so progressive income tax revenues fall (reducing the tax burden automatically) and unemployment insurance payments rise (supporting income). Both prop up AD without policy action, dampening the downturn.

Key takeaway
Automatic stabilizers = built-in mechanisms that stabilize AD: progressive taxes ↓ during recessions; transfer payments ↑ during recessions. No legislative action required.
Question 10 · Medium
In a closed economy with no government, the equilibrium condition is $Y = C + I$ . If $C = 100 + 0.8 Y$ and $I = 200$ , what is the equilibrium level of income $Y$ ?
- A
  $1,000
  Why not A: 1,000 would result from a different parameter set; solving 0.2Y = 300 yields Y = 1,500.
- B
  $1,500Correct
- C
  $3,000
  Why not C: 3,000 might come from applying the multiplier (5) to total spending (100 + 200 = 300) without solving the equilibrium equation correctly.
- D
  $300
  Why not D: 300 is the autonomous spending (100 + 200), not the equilibrium income; the multiplier process amplifies this to 1,500.
Explanation
At equilibrium: $Y = C + I = (100 + 0.8 Y) + 200$ . Solving: $Y - 0.8Y = 300 \Rightarrow 0.2Y = 300 \Rightarrow Y = \$ 1{,}500 $. A l t er na t i v e l y, m u l t i pl i er =$ \frac{1}{1-0.8} = 5 $; a u t o n o m o u ss p e n d in g =$ 100 + 200 = 300 $;$ Y = 5 \times 300 = 1{,}500$.

Key takeaway
Equilibrium income: $Y = \frac{\text{autonomous spending}}{1 - MPC} = \text{multiplier} \times \text{autonomous spending}$.
Question 11 · Medium
Which of the following best explains why fiscal policy may be less effective when an economy is at or near full employment?
- A
  The MPC falls to zero at full employment, eliminating the multiplier effect.
  Why not A: The MPC does not become zero at full employment; consumers still spend a fraction of additional income.
- B
  Expansionary fiscal policy primarily raises the price level rather than real output when the economy is at potential.Correct
- C
  The government cannot increase spending when unemployment is low.
  Why not C: There is no mechanical constraint preventing government spending; the issue is the economic effect, not a legal barrier.
- D
  Fiscal policy only works during recessions and has no effect at any other time.
  Why not D: Fiscal policy has effects at all points in the cycle; the key distinction is whether slack capacity exists to absorb the stimulus.
Explanation
At full employment (LRAS), real GDP cannot increase beyond potential in the long run. When expansionary fiscal policy shifts AD rightward at this point, firms cannot produce more output; instead, rising demand bids up wages and prices. The rightward AD shift causes inflation rather than real GDP growth — a key limitation of expansionary policy at capacity.

Key takeaway
Near LRAS, additional AD primarily raises the price level (inflationary), not real output. Fiscal stimulus is most effective when the economy has spare capacity.
Question 12 · Medium
The multiplier effect on GDP from a change in taxes is different from the multiplier effect from a change in government spending. Given $M P C = 0.75$ , what are the spending multiplier and the tax multiplier, respectively?
- A
  Spending multiplier = 3; Tax multiplier = −3
  Why not A: With MPC = 0.75, MPS = 0.25, spending multiplier = 1/0.25 = 4. The tax multiplier = −MPC/MPS = −0.75/0.25 = −3 is correct, but the spending multiplier is wrong here.
- B
  Spending multiplier = 4; Tax multiplier = −3Correct
- C
  Spending multiplier = 4; Tax multiplier = −4
  Why not C: Equal multipliers would only apply if taxes had the same first-round effect as spending; a tax cut first goes partly to saving (MPS fraction), so the tax multiplier is smaller in absolute value.
- D
  Spending multiplier = 5; Tax multiplier = −4
  Why not D: A spending multiplier of 5 would require MPS = 0.2 (MPC = 0.8), not MPC = 0.75.
Explanation
Spending multiplier $= \frac{1}{1 - M P C} = \frac{1}{0.25} = 4$ . Tax multiplier $= \frac{- M P C}{1 - M P C} = \frac{- 0.75}{0.25} = - 3$ . The tax multiplier is smaller in absolute value because the first dollar of a tax cut is partly saved (MPS = 0.25), whereas the first dollar of government spending directly enters the income stream.

Key takeaway
Spending multiplier $= \frac{1}{MPS}$; Tax multiplier $= \frac{-MPC}{MPS}$. |Tax multiplier| < |Spending multiplier| by exactly 1.