Long-run Consequences & Open Economy — AP Macroeconomics
1. Long-run Growth and Productivity ★★☆☆☆ ⏱ 5 min
The single largest driver of long-run growth is labor productivity, calculated as:
text{Labor Productivity} = \frac{\text{Real GDP}}{\text{Total Hours Worked}}
- Physical capital stock (machinery, infrastructure, tools)
- Human capital (worker education, training, and health)
- Technological progress
- Natural resources (secondary driver for most advanced economies)
Growth accounting breaks down GDP growth into component inputs, with Total Factor Productivity (TFP, the Solow residual) capturing unmeasured gains like technological innovation:
\% \Delta \text{Real GDP} \approx \% \Delta \text{Labor} + \% \Delta \text{Capital} + \% \Delta \text{Total Factor Productivity (TFP)}
Exam tip: Examiners frequently test which policies drive long-run growth: R&D tax credits, public education funding, and infrastructure investment shift LRAS right, while short-term consumption stimulus does not.
2. Short-Run and Long-Run Phillips Curves ★★★☆☆ ⏱ 4 min
The Short-Run Phillips Curve (SRPC) is downward-sloping, reflecting a temporary tradeoff between inflation and unemployment when expected inflation and input prices are fixed. Its formula is:
\pi = \pi^e - \alpha(u - u_n)
Where $\pi$ = actual inflation, $\pi^e$ = expected inflation, $\alpha$ = sensitivity of inflation to the unemployment gap, $u$ = actual unemployment, and $u_n$ = natural rate of unemployment (NAIRU). The Long-Run Phillips Curve (LRPC) is vertical at $u_n$, meaning no permanent tradeoff exists between inflation and unemployment as expectations adjust over time.
SRPC shifters: changes in expected inflation, supply shocks. LRPC shifters: changes in structural or frictional unemployment.
Exam tip: Always explicitly label which curve you reference in FRQs to earn full credit.
3. The Crowding Out Effect ★★★☆☆ ⏱ 3 min
The mechanism: expansionary fiscal policy increases budget deficits, raising government demand for loanable funds and pushing up real interest rates. Higher rates increase firm borrowing costs, reducing private investment. The magnitude of crowding out depends on the economy's position:
- In a recession (output below potential): crowding out is minimal, as idle resources mean limited competition for funds
- At long-run full employment: crowding out is nearly 100%, with no net change in real output
Exam tip: Full crowding out only applies at long-run full employment equilibrium in AP exam questions.
4. Fiscal Policy and Government Debt ★★☆☆☆ ⏱ 3 min
Government budget balances are annual flow measures, while national debt is a cumulative stock measure:
\text{Budget Balance} = \text{Tax Revenue (T)} - \text{Government Spending (G)} - \text{Transfer Payments (TR)}
A positive balance is a surplus, negative is a deficit, zero is balanced. National debt is the total accumulated amount owed to bondholders from all past deficits minus surpluses.
\text{Debt-to-GDP Ratio} = \frac{\text{Total National Debt}}{\text{Nominal GDP}}
If nominal GDP growth exceeds the annual deficit as a share of GDP, the debt-to-GDP ratio will fall over time, even with consistent annual deficits.
5. Exchange Rates and Net Exports ★★★★☆ ⏱ 4 min
The nominal exchange rate ($e$) is the price of one currency in terms of another. The real exchange rate ($\varepsilon$), which determines trade flows, adjusts for price level differences between countries:
\varepsilon = \frac{e \times P_{domestic}}{P_{foreign}}
A real appreciation (rise in $\varepsilon$) makes domestic goods more expensive for foreigners and foreign goods cheaper for domestic residents, reducing net exports ($NX = Exports - Imports$). A real depreciation increases net exports. Key shifters of exchange rates:
- Higher domestic real interest rates attract foreign capital, causing domestic currency appreciation
- Higher domestic inflation makes domestic goods less competitive, causing domestic currency depreciation
- Higher domestic income increases import demand, causing domestic currency depreciation
Exam tip: Always explicitly state which currency is appreciating or depreciating to earn full credit in FRQs.
Common Pitfalls
Why: Students only memorize the downward-sloping SRPC and forget the LRPC property
Why: Students learn the crowding out mechanism without context of the business cycle position
Why: Students mix up the flow vs stock nature of the two measures
Why: Students associate a 'strong' currency with a strong economy regardless of context
Why: Students confuse demand shocks (which move along the curve) with expectation/supply shocks (which shift the curve)