AP Macroeconomics Page 1 of 5

Test: Basic Economic Concepts

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Directions
• Neatly write your responses in the spaces provided. Use a blue or black pen. Don’t
write in the margins.
• Remember to complete the submission information on every page you turn in.

1. The circular flow model presents a simplified picture of how money flows through a
market economy.

A. There are three important equations that come out of the circular flow model.
They come from looking at flows into and out of households, firms, and if you
choose to think of it this way, financial markets.

i. What equation is related to flows into and out of households? Explain

which components are flows in and which are flows out. (2 points)

1.i The equation related to flows into and out of households is Y = C + S + T, where Y is
household income. The inflow is income received from firms in exchange for labor and
other resources. The outflows are consumption spending (C), which is the money
households spend on goods and services, savings (S), which households place in
financial markets, and taxes (T), which are paid to the government.

ii. What equation is related to flows into and out of firms? Explain which
components are flows in and which are flows out. (2 points)

1.ii The equation representing flows into and out of firms is GDP = C + I + G + (X - M). The
inflows are the revenues firms earn from selling goods and services: consumption spending
(C), investment (I), government spending (G), and net exports (exports minus imports, X -
M). These revenues represent money coming into firms. Outflows include payments to
households in the form of wages, rent, interest, and profit for their inputs of production.

iii. What equation is related to flows into and out of financial

intermediaries? Explain which components are flows in and which are
flows out. (2 points)

The equation that corresponds to flows into and out of financial intermediaries is I = S + (T -
G) + (M - X). The inflows here are household savings (S), government surplus or deficit (T -
G), and net inflow of funds from foreign trade (M - X). These inflows provide the funds
available for investment (I), which is the outflow from the financial sector to firms.

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 AP Macroeconomics Page 2 of 5
Test: Basic Economic Concepts

User Name:_______________ Instructor: _______________ Date:_________

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B. Consider an economy in which Y = 1800, I = 400, G = 400, T = 300, and

with M = X. Solve for consumption spending and household saving. (2
points)

1.B Given that Y = 1800, I = 400, G = 400, T = 300, and M = X, we can use the income
equation Y = C + S + T. Plugging in the known values: 1800 = C + S + 300. Also, we know
from the GDP equation: Y = C + I + G + (X - M), and since M = X, net exports are 0. So,
1800 = C + 400 + 400 C = 1000. Now plug into the income equation: 1800 = 1000 + S +
300 S = 500. Therefore, consumption spending is 1000 and household saving is 500.

C. Consider an economy in which I = 800, S = 700, T = 500, G = 600, and with M

= X.

i. Using the third equation you found in part A, show that the financial
market is not in equilibrium. (2 points)

1.C.i The third equation is I = S + (T - G) + (M - X). Substituting the values: I = 800, S = 700, T
= 500, G = 600, and M = X (so net exports = 0). Right side: 700 + (500 - 600) + 0 = 700 - 100
= 600. Since 800 600, the financial market is not in equilibrium. The inflow of funds (600) is
less than the outflow (800), indicating a shortage of available funds for investment.

ii. What should happen to the interest rate to bring the financial market
into equilibrium? Explain your answer. (3 points)

1.C.ii To bring the financial market into equilibrium, the interest rate should rise. A
higher interest rate encourages more saving and discourages some investment, which
would help close the gap between available savings and desired investment. As saving
increases and investment demand decreases, the financial market moves toward
balance.

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 AP Macroeconomics Page 3 of 5
Test: Basic Economic Concepts

User Name:_______________ Instructor: _______________ Date:_________

(print clearly)

2. The reason governments calculate things such as GDP and unemployment rates is to
get a picture of what’s happening with their large, complicated economies, and to
judge whether the well-being of their population is improving or deteriorating.

What would you learn about an economy if you determined that its GNP was
growing more quickly than its GDP? Discuss this in a sentence or two. Hint:
Be sure to include a definition of GNP and GDP in your answer. (6 points)

2 GDP (Gross Domestic Product) measures the total value of all goods and services
produced within a country’s borders, while GNP (Gross National Product) measures the
total income earned by a country's residents, regardless of where they are located. If GNP
is growing faster than GDP, it suggests that income earned by citizens from abroad is
increasing faster than income from domestic production. This could indicate strong
performance of a country’s businesses or individuals in global markets.

3. The two least-discussed sectors of the economy are the government (also called the
public sector) and the rest of the world (also called the foreign sector). An economy
that includes foreign trade, or trade with the rest of the world, is called an open
economy, and its opposite is a closed economy.

A. Consider the savings equals investment equation,

I = S + (T - G) + (M - X). How is investment affected when an economy
moves from being closed to being open? Explain your answer. (4 points)

3.A When an economy moves from being closed to being open, investment (I) can be
supported by foreign capital inflows. This is reflected in the term (M - X) in the investment
equation I = S + (T - G) + (M - X). If imports exceed exports, the country is borrowing from
the rest of the world, effectively increasing the pool of funds available for domestic
investment.

B. Consider the leakages equals injections equation, I + G + X = S + T + M.

What is the effect of a public sector balanced budget (where G=T) on the
economy, according to this equation? What if the government runs a
budget deficit? (4 points)

3.B The equation I + G + X = S + T + M equates injections with leakages. If the

government has a balanced budget (G = T), then its role in the equation cancels out,
neither stimulating nor draining the economy. If the government runs a deficit (G > T), it
increases injections relative to leakages, which can stimulate economic activity in the short
run, though it may have long-term consequences such as increased public debt.

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 AP Macroeconomics Page 4 of 5
Test: Basic Economic Concepts

User Name:_______________ Instructor: _______________ Date:_________

(print clearly)

4. Economic growth is a very important topic. To the extent that GDP measures the
well-being of people in an economy, increases in GDP should translate into increases
in standard of living.

A. What measure of GDP is most closely related to the economic well-being

of the people in an economy? (4 points)

4.A The measure of GDP most closely related to economic well-being is real GDP per
capita, because it accounts for both inflation (by adjusting to constant prices) and
population size. This gives a clearer picture of the average income or output per person,
making it more meaningful for assessing changes in living standards.

B. If Y = C + I + G + (X - M), is it necessarily true that decreased

consumption and increased saving by households will result in lower
GDP in the short run? (4 points)

4.B In the short run, a decrease in consumption could reduce GDP, because consumption is
a major component of aggregate demand. However, increased household saving could lead
to greater investment if those funds are channeled into productive activities, which may
offset the decline in consumption. But the immediate effect is typically a drop in GDP due to
reduced consumption.

C. The production possibilities frontier shows output combinations at which

an economy can produce given its current resources. On a PPF graph,
show the long-term effect of increased household saving, and explain
the effect in words. (5 points)

4.C On a PPF graph, increased household saving leads to increased investment, especially in capital
goods. Over time, this investment expands the economy’s productive capacity, shifting the PPF outward.
In words, the long-term effect of increased saving is greater economic growth potential and a higher
standard of living, assuming the saved funds are efficiently invested.

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 AP Macroeconomics Page 5 of 5
Test: Basic Economic Concepts

User Name:_______________ Instructor: _______________ Date:_________

(print clearly)

D. On a production possibilities frontier, the two goods may be classified as

"consumption" and "investment" goods. How will the shift in the PPF
from this year to, say, five years from now differ if we choose a point
with high consumption as opposed to choosing a point with high
investment? Or a point with high investment goods? Explain in words
and with graphs. (6 points)

produciton
goods

consumption good

4.D If an economy chooses a point on the PPF with high consumption, it enjoys immediate
benefits but sacrifices investment, which limits future growth. Conversely, choosing a point with
high investment increases capital formation, which expands future production possibilities and
shifts the PPF outward more rapidly. Over time, this results in faster economic growth, although it
may involve short-term sacrifice in consumption.

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