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AP Macroeconomics · Unit 5 of 6

Long-Run Consequences of Policy

20–30% of the exam8 lessons · 110 min50 terms
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What this unit covers

The topics below follow the published Macro course framework for Unit 5. This unit is worth 20–30% of the exam, so budget your time against that rather than against how long the unit takes to teach.

Phillips curveDeficitsCrowding outEconomic growth

Lessons in this unit

Formulas in Unit 5

Phillips curve ↔ AD–AS correspondence
AD ↑ ⇒ move up-left along SRPC (inflation ↑, unemployment ↓) · negative supply shock ⇒ SRPC shifts right
Demand changes are movements along the SRPC; supply shocks shift it. The LRPC sits vertically at the natural rate of unemployment.
Deficit, debt, and crowding out
Debt(this year) = Debt(last year) + Deficit(this year) · Gov’t borrowing ↑ ⇒ real interest rate ↑ ⇒ private investment ↓
The deficit is a yearly flow that adds to the debt stock. In loanable funds, government borrowing raises demand for funds, lifting the real rate and crowding out investment.
Growth in real GDP
Growth rate of real GDP = [(Real GDP_new − Real GDP_old) / Real GDP_old] × 100
Sustained positive growth in *real* GDP (and in real GDP per capita, which divides by population) reflects a rising standard of living.
The two curves, mapped to AD–AS
SRPC ↔ SRAS (both rest on sticky wages) · LRPC ↔ LRAS (both vertical, both at the natural level)
They are the same model in different coordinates. A rightward AD shift is a movement up-left along the SRPC.
The quantity theory, in growth rates
MV = PY → %ΔM + %ΔV ≈ %ΔP + %ΔY → with V stable: inflation ≈ money growth − real growth
The growth-rate form is what the exam uses. Money growing 8% with real output growing 3% implies roughly 5% inflation.
The chain
deficit ↑ → demand for loanable funds right → real interest rate ↑ → private investment ↓ → capital stock grows more slowly → LRAS shifts right more slowly
The last two links are what make crowding out a long-run problem rather than merely an offsetting short-run effect.
The relationship, and the ratio
debt_this year = debt_last year + deficit_this year · debt-to-GDP = debt / nominal GDP
The ratio falls whenever nominal GDP grows faster than the debt — which can happen while deficits continue.
What shifts LRAS right
more labor · more physical capital · more human capital · better technology · stronger institutions and property rights · more efficient resource allocation
Every genuine growth policy operates through one of these. If a proposal does not, it is a demand policy.

Every term in Unit 5

All 50 terms we publish for Long-Run Consequences of Policy, with definitions. Reading them through is the fastest way to find the ones you cannot define — then drill those in cram mode until you can produce them without the prompt.

Crowding out
Deficit-financed government spending raises loanable funds demand, pushing up the real interest rate and reducing private investment. It weakens the multiplier in the short run and slows capital accumulation and growth in the long run. Nominal money supply is unchanged — this is fiscal, not monetary, in origin.
Short-run Phillips curve (SRPC)
A downward-sloping inverse relationship between the inflation rate and the unemployment rate, holding inflation expectations fixed. It is the AD–SRAS model with different axes.
Long-run Phillips curve (LRPC)
Vertical at the natural rate of unemployment. No permanent trade-off exists: any inflation rate is compatible with the natural rate once expectations adjust.
Movement along vs shift of the SRPC
An AD shift moves you along the SRPC. A change in expected inflation or a supply shock shifts the whole curve — which is how stagflation appears here.
What shifts the SRPC
Changes in expected inflation and supply shocks. Higher expected inflation shifts it up and right, worsening the trade-off at every unemployment rate.
What shifts the LRPC
Only changes in the natural rate of unemployment — the same structural and frictional factors, not demand policy. It moves when LRAS does.
Mapping AD–AS onto the Phillips curve
A rightward AD shift is a movement down the SRPC (lower unemployment, higher inflation). A leftward SRAS shift moves the SRPC up and right (both worse at once).
Adaptive expectations
People form expectations of inflation from recent experience. Explains why a demand expansion buys lower unemployment temporarily and then only higher inflation.
Rational expectations
People use all available information, including announced policy. Implies anticipated policy has no real effect even in the short run — the strong critique of activist policy.
Disinflation and its cost
Reducing inflation requires a period of unemployment above the natural rate while expectations adjust downward. The sacrifice ratio measures how much output is lost per point of inflation removed.
Showing crowding out on graphs
Deficit → loanable funds demand rises (or supply falls) → real interest rate rises → investment falls → AD shifts left, partly offsetting the original stimulus.
Crowding out in a recession
Weaker, because idle resources and slack credit demand mean the interest-rate rise is small. This is why the objection carries less force at the bottom of a cycle.
Budget deficit
Government spending exceeds revenue in a year, financed by borrowing. Cyclical deficits arise from a downturn; structural deficits persist even at full employment.
National debt
The accumulated stock of past borrowing. The exam-relevant burden measure is debt as a share of GDP, because growth can shrink the ratio without repaying anything.
Costs of a growing national debt
Higher interest payments crowd out other spending, crowding out reduces private investment, and reliance on foreign lenders sends future interest payments abroad.
Economic growth
A sustained increase in real GDP per capita, shown as an outward shift of the PPC and a rightward shift of LRAS. Not the same as a recovery from a recessionary gap.
Sources of long-run growth
More physical capital, more human capital, better technology, more natural resources, and institutions that protect property rights and enforce contracts.
Investment in human capital
Education, training and health that raise labor productivity. It shifts LRAS right and is the growth lever most under policy control.
Productivity
Output per worker or per hour. The proximate source of rising living standards — real wages track productivity over long periods.
Why saving matters for growth
National saving funds investment. Higher saving shifts loanable funds supply right, lowers the real interest rate, and raises the capital stock over time.
Supply-side policies
Measures aimed at LRAS rather than AD: investment tax credits, deregulation, research subsidies, education spending. Their effects arrive slowly and are hard to measure.
Real interest rate and investment
Investment demand slopes downward against the real interest rate: cheaper borrowing makes more projects clear their hurdle rate. The link that carries monetary policy into AD.
Nominal interest rate targeting and inflation
If the Fed holds the nominal rate fixed while expected inflation rises, the real rate falls and policy becomes accidentally expansionary. The reason policy is discussed in real terms.
Policy lag comparison
Monetary policy has a short decision lag but a long impact lag. Fiscal policy has a long decision lag but can act quickly once passed. Neither is fast enough to fine-tune a cycle.
Rules vs discretion
Rules bind policymakers to a formula and anchor expectations; discretion allows response to unforeseen shocks but risks inflation bias. The core credibility argument for central-bank independence.
Central bank independence
Insulating monetary policy from electoral pressure. Justified by the time-inconsistency problem: a government that can inflate before an election will be expected to, which raises expected inflation.
Time inconsistency
A policy that is optimal to announce becomes suboptimal to follow through on. Once people expect low inflation, a policymaker gains from surprising them — so nobody believes the announcement.
Fiscal and monetary policy in combination
Expansionary fiscal with accommodative monetary policy avoids crowding out but risks inflation. Expansionary fiscal with contractionary monetary policy raises rates sharply and shifts the composition of output away from investment.
Natural rate hypothesis
Unemployment returns to its natural rate regardless of the inflation rate. The reason the LRPC is vertical and demand policy cannot buy permanent employment gains.
Deficit spending in a recession vs at full employment
In a recessionary gap it raises real output with little crowding out. At full employment it mostly raises the price level and the real interest rate — same policy, opposite verdict.
Real GDP growth vs an AD-driven expansion
Growth shifts LRAS right and raises potential output permanently. An AD expansion raises actual output toward potential and cannot push it past potential for long.
Why the short-run Phillips curve slopes down
Wages are set on EXPECTED inflation, so when actual exceeds expected, real wages fall, hiring rises and unemployment drops. Close the expectations gap and the trade-off vanishes.
Why the long-run Phillips curve is vertical
Expectations adjust, real wages recover, and unemployment returns to the natural rate — now with higher inflation permanently embedded. No lasting trade-off.
SRPC ↔ SRAS, LRPC ↔ LRAS
The same model in different coordinates. A rightward AD shift is a movement up-left along the SRPC.
What shifts the short-run Phillips curve
Expected inflation and supply shocks. Higher expectations shift it up and right — the 1970s stagflation in one sentence.
What moves the long-run Phillips curve
Only a change in the natural rate itself: job-matching technology, retraining, demographics, institutions. Demand policy cannot move it at all.
MV = PY is an identity
True by construction, since PY is nominal GDP and V is defined as PY/M. It becomes a THEORY when you assume V is stable and Y is set by real factors.
Quantity theory in growth rates
%ΔM + %ΔV ≈ %ΔP + %ΔY, so with stable velocity, inflation ≈ money growth − real growth. Use this form, not the levels form.
Price level versus inflation rate
A one-off shock raises the price level once — a step. Sustained inflation needs sustained money growth above real growth — a slope.
Why hyperinflations accelerate
Deficits financed by money creation raise prices, and people then spend faster to avoid holding a depreciating currency, raising velocity and compounding it.
Crowding out, on which graph
Loanable funds: government borrowing shifts demand right, the real rate rises, private investment falls. This is the version rubrics expect.
Why crowding out blunts the multiplier
The higher rate reduces investment, itself a component of AD, canceling part of the intended increase. The multiplier gives a ceiling, not a forecast.
When crowding out is small
Deep recession with idle saving and near-zero rates; investment insensitive to rates; or foreign capital inflows expanding the supply of funds.
Deficit versus debt
Deficit is a FLOW, one year's shortfall. Debt is a STOCK, the accumulation of all past deficits. A shrinking deficit still ADDS to the debt.
Debt-to-GDP can fall during deficits
It is a ratio: if nominal GDP grows faster than the debt, the ratio declines. Growth and moderate inflation, not surpluses, retired most post-war debt.
The real costs of large debt
Interest payments displacing other spending, crowding out of investment, income transferred abroad on foreign-held debt, and reduced fiscal space for the next recession.
Growth is an LRAS question
Demand policy moves output TOWARD potential; growth policy moves potential itself. Expansionary policy offered as a growth strategy answers the wrong question.
What actually shifts LRAS right
More labor, more physical capital, more human capital, better technology, stronger institutions, more efficient allocation. Every real growth policy runs through one of these.
Why productivity is the only unlimited source
More workers or longer hours raise output but hit limits and do not raise output PER PERSON indefinitely. Productivity growth does.
The shape of every growth policy
Current sacrifice for future output — saving instead of consuming, training instead of working. Which is exactly why they are politically harder than stimulus.

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Questions about this unit

How much of the AP Macroeconomics exam is Unit 5?

Unit 5, Long-Run Consequences of Policy, is worth 20–30% of the Macro multiple-choice section according to the published course framework. Across all 6 units that makes it one of the heaviest units on the exam, and worth front-loading.

What topics are covered in Macro Unit 5?

Long-Run Consequences of Policy covers Phillips curve, Deficits, Crowding out and Economic growth. We publish 50 terms with definitions for this unit, all of them on this page.

How should I study Macro Unit 5?

Read the 8 lessons below first — about 110 minutes — then drill the 50 terms in cram mode until you can produce each definition from memory rather than just recognize it. Recognition is what makes a unit feel finished when it is not. Finish with practice questions and read the explanation for every one you get right by elimination as well as the ones you miss.

All 6 units of AP Macroeconomics

  1. Unit 1 · Basic Economic Concepts
  2. Unit 2 · Economic Indicators & Business Cycle
  3. Unit 3 · National Income & Price Determination
  4. Unit 4 · Financial Sector
  5. Unit 5 · Long-Run Consequences of Policy
  6. Unit 6 · Open Economy

Unit names, topics and exam weights follow the published College Board course framework for AP Macroeconomics. AP® is a trademark registered by the College Board, which does not endorse this site.