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1
AP MacroEconomics
Review
Production Possibility Curve
A
C
F
B
D
E
W
Capitalgoods
Consumer goods
B2
D
Capitalgoods
Consumer goods
D2
B
Market Equilibrium
Demand
Supply
Pe
Qe Quantity
Price
A change in Demand versus a change inthe Quantity Demanded
Change in Demand
√ Moves the curve
•Income
•Future Expectations
•# of Buyers
•Consumer Information
•Taste and Preference
•Substitues and Complements
Change in QuantityDemanded
√ Moves Along the SAMEcurve
• Caused only by Pricechange.
A change in Supply versus a change inthe Quantity Supplied
Change in Supply
√ Moves the curve
•Costs of Production
•Future Expectations
•# of Sellers
•Taxes and Subsidies
•Prices of goods using same resources
•Time period of production
Change in QuantitySupplied
√ Moves Along the SAMEcurve
• Caused only by Pricechange.
2
The Rule of 70 is a device that can find thenumber of years it will for some amount todouble.
# of yrs to double the real GDP = 70 annual rate of growth
Take the growth rate in 2004 of 4.070/4.0 = 17.5 years for Real GDP to double
Imagine that the rate of growth was 10%?Only 7 years to double!
Economic growth GROSS DOMESTIC PRODUCT
Market Value of the total
goods and services produced
within the boundaries of the
US whether by Americans or
foreigners in one year.
Defining…
+
+
+
++
++
GROSS DOMESTIC PRODUCT
Consumptionby Households
Investmentby Businesses
GovernmentPurchases
Expendituresby Foreigners
Expenditures Approach Income ApproachWages
Rents
Interest
Profits
StatisticalAdjustments
= =GDP
NOMINAL GDP vs. REAL GDP
Nominal GDP… reflects the current price level of goods and services andignores the effect of inflation on the growth of GDP.… this measure is called Current Dollar GDP.
Real GDP… measures the value of goods and services adjusted forchange in the price level. It will reflect the real change inoutput.… This measure is called the Constant Dollar GDP.… indicates what the GDP would be if the purchasing power ofthe dollar has not changed from what it was in a base year. Thegovernment currently uses 2000 as its base year for Real GDPmeasurement.
GDP Price Index
Price Indexin a given
year=
Price of market basketin specific year
Price of same marketbasket in base year
x 100
Real GDP =Nominal GDP
Price Index(in hundredths)
Price Index(in hundredths)
=Nominal GDP
Real GDP
An Alternative Method
Disposable IncomeBy subtracting from Personal Income,the dollars lost to taxes, we have theDisposable Income. This is the “bottom”line of national income accounting.
Disposable Income = C + S
3
√ by not counting non market transactions√ by not measuring Improved Product Quality√ by not considering Leisure Time
GDP understates the well-being…
GDP Overstates the well-being…√ by ignoring the Composition andDistribution of Output√ GDP and the EnvironmentPer Capita GDP measures the GDP interms of goods and services per person
Unemployment Rate =UnemployedLabor Force
Frictional – “temporary”, “transitional”,“short-term” (“between jobs” or “search”unemployment)Structural – “technological” or “long term”.basic changes in the “structure” of the laborforce which make certain “skills obsolete”.Cyclical – “economic downturns” in thebusiness cycle.
The Full employment rate ofunemployment or the Natural
Rate of Unemployment (NRU) ispresent when the economy is
producing its potential output.
The Natural Rate of Unemploymentexists when the cyclical unemployment
is zero.
GDP Gap and Okun’s Law√ The basic loss of unemployment is forgoneoutput. √ Potential GDP is the capacity of theeconomy assuming the Natural Rate ofUnemployment. The growth of the Potential GDPassumes the normal growth rate of the real GDP.
GDP GAP is the amount by which actual GDP fallsshort of potential GDPFor every 1% the unemployment rate exceedsthe natural rate…Approximately a 2% GDP Gapoccurs.
Inflation A rising of the general level of prices
=Price of the same market
basket in 2000
x 100CPIPrice of the market basket
in the particular year
Producer Price Index (PPI) Prices at the wholesale orproduction level which are early indicators ofinflation.
70 divided by rate of inflation (expressedas whole numbers) will yield the numberof years for the price level to double.
Theories of Inflation:Demand Pull√ Excess of total demand√ prices are bid upward by the excess demand√ economy is seeking a point beyond its PPCwhen full employment-full production isevident
Qf
Increases in total spendingQuantity
Range 2
Range 3Price
level
Range 1
4
Theories of Inflation:Cost Push√ prices rising when output and employment areboth declining√ aggregate demand not excessive√ Per unit production costs are rising due to rawmaterials, energy, labor, etc.√ High per unit costs cause decline in profit; hence,the price level is “pushed up” by these costs.
Abrupt increases in the costs of raw materials orenergy inputs drive up per-unit production costsand hence prices.
CreditorsDebtors
SaversSpenders
Fixed IncomeFlexible Income
Those who loseThose who benefitUnanticipated Inflation
COLA-helps to stay up withrising prices
Real and Nominal IncomeNominal income … is the number of dollars
earned as rent, wages, interest or profitReal income… measures the amount of
goods and services nominal income can buy.√ If nominal income rises faster than pricelevel, real income will rise.
√ If the price level increases faster thannominal income, then real income will fall. √ Your real income falls only when nominalincome fails to keep up with inflation. o
PL1
ASsrASlr
AD1
Qf
Pric
e Lev
el
Real domestic output
Long Run EquilibriumIn the extendedAD-AS model,
equilibriumoccurs at the
intersection ofAD and the ASlr
and the ASsr.Qf is the amountof Real GDP at
full employment.
DEMAND-PULL INFLATIONand Self-Correction
Long RunNominal Wagesrise and AS2
srmoves left.
RGDP returnsto previouslevel on Aslr
But…PL riseseven more to
PL3!o
PL1[2%]
ASsrASlr
AD1
a
Qf
Pric
e Lev
el
Real domestic output
bPL2[5%]
AD2
Y2
c
AS2sr
PL3[7%]
ShortRun—Increase inAD shows point b
COST-PUSH INFLATIONwith government action
If governmentstimulates AD todotted line, aninflationary spiralwill occur…PL3 atQf. We have FullEmployment but ata higher price level.
o
PL1[2%]
ASsrASlr
AD1
a
Qf
Pric
e Lev
el
Real domestic output
b
AS2sr
PL2[3%]
Y2
AD2
cPL3[5%]
5
COST-PUSH INFLATIONwith NO government action
o
PL1[2%]
ASsr
ASlr
AD1
a
Qf
Pric
e Lev
el
Real domestic output
AS2sr If government lets
the recession takeits course, nominalwages will fall inthe long run andreturn to pointa…PL1 at Qf.
cPL3[5%]
o
PL3[2%]
AS2sr
ASlr
AD2
a
Qf
Pric
e Lev
el
Real domestic output
bPL2[3%]
AD1
Y2
c
AS1sr
PL1[5%]
RecessionThis decline inthe price levelwill eventuallyshift the AS1
sr toAS2
sr. Price leveldeclines to PL3at Qf . Shown atpoint c.
Ann
ual r
ate o
f inf
latio
n
Unemployment rate (percent)
7
6
5
4
3
2
1
01 2 3 4 5 6 7
As inflation declines...
The Phillips Curve Concept
Unemploymentincreases
PC √ In the long run, there is not a stable relationshipbetween unemployment and inflation.√ The long-run Phillips curve is the vertical line at thenatural rate of unemployment.
The Phillips CurveSummary
The short run Phillips Curve is downward sloping.
Aggregate Demand changes move along the sameshort run Phillips curve.
Aggregate Supply changes create new short runPhillips curves.
Expansionary Fiscal Policy
√ Increase Government Spending√ Decrease Tax Rates
…Or Combination of the Two
Goal: To Reduce Unemployment and Effectsof Recession…
Contractionary Fiscal Policy
√ Decrease Government Spending√ Increase Tax Rates
…Or Combination of the Two
Goal: To Reduce Demand—Pull Inflation… Pri
ce le
vel
Real GDP (billions)
EXPANSIONARY FISCAL POLICY
$60 billionincrease in AggregateDemand
AD1 AD2
$20 billion decrease in tax rates; $15 billion innew consumption spending
the multiplier at work...
P1
$550
AS
$490
P2
MPS = .25
6
Pri
ce le
vel
Real GDP (billions)
CONTRACTIONARY FISCAL POLICY
$60 billiondecrease in AggregateDemand
AD4AD3
$20 billion increase in tax rates; $15 billion lostin consumption spending
the multiplier at work...
P1
$550
AS
$490
P2
MPS = .25
Built-in StabilitySome changes in relative levels of government
expenditures and taxes occur automatically.
This is not like discretionary changes in spending
and tax rates since these net tax revenues vary
directly with RGDP.
…tends to increase the government deficit (or
reduce the surplus) during recession or to increase
the surplus ( or reduce the deficit) during inflation
without requiring specific action by policy makers.
Crowding —Out Effect
Rea
l Int
eres
t R
ate,
(pe
rcen
t)
Quantity of Loanable Funds
i%
D
LF0
SIncreaseddemand forloanable fundsby governmentraises theinterest rate.
D2
i%
LF1
Expansionary fiscal policyProblem: Recession
More government spendingand/or lower taxes
Higher domestic interest rates(crowding-out effect)
Increased foreign demand fordollars (foreigners want to earn
higher interest)Dollar appreciates
Net Exports decline(AD decreases, partially
offsetting expansionary policy)
Fiscal policy weakened by NET EXPORT EFFECT
Contractionary fiscal policyProblem: Inflation
Lower government spending and/orhigher taxes
Lower domestic interest rates(government role in loanable funds
market is less)
Decreased foreign demand for dollars(foreigners find
higher rates elsewhere)Dollar depreciates
Net Exports increase(AD increases, partially offsetting
contractionary policy)
Supply-Side Economics aims to manipulate aggregate supply byenacting policies designed to stimulate incentives to work, tosave and invest (including measures to encourageentrepreneurship).These policies may include tax cuts which will increasedisposable incomes, thus increasing household saving andincrease the profitability of investments by businesses.•Tax cut stimulates more consumption, saving and investmentto increase AD.•The new investment moves the AS curve to the right. Workincentives push more workers into employment and they spendand save increasing AD further.•Low taxes act to push risk takers to move toward newproduction methods and new products.
Supply-Side Economics…shows the relationship between tax ratesand tax revenues√ Up to a point, higher tax rates will resultin larger tax revenues.√ But still higher tax rates will adverselyaffect incentives to work and produce,reducing the size of the tax base andreducing tax revenues.√ Lower tax rates will lessen tax evasionand avoidance, and reduce governmenttransfer payments.
Laffer Curve
7
MI• Checkable deposits• Travelers checks• Currency
• Money market accounts• Savings deposits• Small time deposits
• Large time deposits
M2
M3+
+
M
O
N
E
Y
M
E
A
S
U
R
E
S
i%
$$ demanded
Dm
i%1
Sm
The Money MarketSupply ofmoney is avertical linesince monetaryauthorities(FED) andfinancialinstitutionshave providedthe economywith a certainstock of money.
Money supply is increased when:
1. Banks issue loans to customers and receive ademand deposit.
2. Banks buy securities from the public and credit ademand deposit for the cost.
Money supply is decreased when:
1. Customers repay loans take money from theirdemand deposit.
2. Banks sell securities to the public and ademand deposit is reduced to pay for the bond.
Creation of Money in the Banking System
MaximumDemand-Depositcreation
= Excessreserves
x MoneyMultiplier
MoneyMultiplier Required reserve ratio
1=The Money Multiplier
√ One bank can loan only its excess reserves and islimited by those reserves in creating money.
√ The banking system creates a “multiplied”amount.
Currency drain and no creditable customers willdecrease the amount multiplied.
MS i% In C AD PL RGDP
EASY MONEY Goal: Cheap, available credit;increase the money supply
Actions • FED willbuygovernmentbonds frombanks andthe public
• FED will lower thelegal reserve ratio
• FED will lowerthe discount ratecharged to memberbanks
Results √ Increasethe bankexcessreserves, andbanks canmake moreloans.
An increase in themoney supply willlower the interest rate,causing Investment toincrease andequilibrium GDP torise.
The amount of thechange will bedependent on thesize of the IncomeMultiplier (1/MPS)
Easy money is reinforced by the Net Export EffectReal domestic output, GDP
Dm
InvestmentDemand
Rea
l rat
e of
inte
rest
, i 10
8
6
0Quantity of money demanded and supplied Amount of investment, i
Sm1
AS
AD1(I=$15)
PL1
10
8
6
0
Sm2
AD3(I=$25)PL2
If the Money SupplyIncreases to Stimulatethe Economy…
Interest Rate DecreasesInvestment IncreasesAD & GDP Increases with slight inflation
Pri
ce le
vel
AD2(I=$20)
PL3
Sm3
Increasing money supply continues the growth – but, watch Price Level.
Easy Monetary Policy And Equilibrium GDP
8
MS i% In C AD PL RGDP
Tight Money Goal: Restrict credit; decrease themoney supply
Actions • FED willsellgovernmentbonds tobanks andthe public
• FED will raise thelegal reserve ratio
• FED will raisethe discount ratecharged tomember banks
Results √ Decreasethe bankexcessreserves, andbanks willissue fewerloans
An decrease in themoney supply will raisethe interest rate,causing Investment toincrease andequilibrium GDP tofall.
The amount of thechange will bedependent on thesize of the IncomeMultiplier (1/MPS)
Tight money is reinforced by the Net Export EffectReal domestic output, GDP
Dm
InvestmentDemand
Rea
l rat
e of
inte
rest
, i 10
8
6
0Quantity of money demanded and supplied Amount of investment, i
Sm3
AS
AD3(I=$15)
PL3
10
8
6
0
Sm2
AD1(I=$25)PL2
If the Money SupplyDecreases to “cool”the Economy…
Interest Rate IncreasesInvestment DecreasesAD & GDP Decreases with lower PL
Pri
ce le
vel
AD2(I=$20)
PL1
Sm1
Decreasing money supply continues the “cooling” – as Price Level falls.
Tight Monetary Policy And Equilibrium GDP
Nominal Rate =Real Interest rate + expected rateof inflation
Real Interest Rate =Nominal rate—expected rate ofinflation
Smi%
Q of $$demanded
Dm
The supply of money isvertical no matter whatthe interest rate is onthe vertical axis. TheFED controls thesupply of money.
The demand formoney iscomposed of thetransactiondemand andasset demand.
Money MarketGraph—NominalInterest Rate
Qe
i%e
r
re
Q of LFQe
SLF
DLF
Loanable Funds Market—RealInterest Rate
Changes in the real interest rate caused bymovements of demand (from borrowers) and supply(from savers).
Demand is:
• Business for investment
• Consumer for spending
• Government for Deficitspending
Supply is mostly fromprivate savings
GROWTH IN THE AD-AS MODEL
A
B
C
D
Cap
ital
Goo
ds
Consumer Goods
Pri
ce L
evel
Real GDP
ASLR1 ASLR2
Q1 Q2
9
Classical View:
√ AS is vertical anddetermines the output atQf √ AD is stable anddetermines the pricelevel as long as moneysupply is stable. √ If AD is unstable,prices and wages adjust.
P1
Qf
AS
AD1Pr
ice L
evel
Real Domestic OutputA shift to AD2 showsthat the price leveldeclines.
AD2
P2
Keynesian View:
√ Product prices andwages are downwardinflexible√ AS is horizontal up toQf then becomes vertical √ If AD is unstable,changes in AD have noeffect on PL but affectRGDP. Movement from AD1 to AD2
reduces the Real GDP butthe PL remains constant.
P1
Qf
AS
AD1
Pric
e Lev
el
Real Domestic Output
AD2
Q2
NEW CLASSICAL VIEW OF SELF-CORRECTION
P2
Q1
Pri
ce L
evel
Real Domestic Output
AD2
AD1
ASLR
P1
AS1
AS2
P3
Self-Correction
a
bc
AD increasesmoves economyfrom a to b.Price level rises(P2) and thenself-correctionto c by shiftingleft to AS2 asNominal Wagesrise.
Monetary rule : supported by Monetaristsand other Neo-Classical Economists likeRational Expectationists. …directs theFed to expand the money supply eachyear at the same annual rate as thetypical growth of the economy’sproductive capacity.
Discretionary Fiscal and MonetaryPolicy (especially monetary): supportedby Mainstream Economists.
Summary of Alternative ViewsNew Classical Economics
Issue MainstreamMacroeconomicsKeynesian Based
Monetarism Rationalexpectations
View of theprivate
economy
Potentiallyunstable
Stable in long runat natural rate ofunemployment
Stable in long runat natural rate ofunemployment
Cause ofobserved
stability ofprivate
economy
Investment doesnot equal saving
causing changes inAD; AS shocks
Inappropriatemonetary policy
Unanticipated ADand AS shocks in
the short run
Appropriatemacro policy
Active fiscal andmonetary
Monetary rule Monetary rule
How changesin money
supply affectthe economy
By changinginterest rates,
changinginvestment and
real GDP
By directlychanging AD
which changesGDP
No effect on outputbecause price-level
changes areanticipated
View ofvelocity of
money
Unstable Stable No consensus
How fiscalpolicy affectsthe economy
Changes AD andGDP via themultiplier
No effect unlessmoney supply
changes
No effect on outputbecause price-level
changes areanticipated
View of Costpush inflation
Possible (wage-push, AS shock)
Impossible in longrun in absence ofexcessive moneysupply growth
Impossible in longrun in absence ofexcessive moneysupply growth
The National or Public Debt is theaccumulated deficits and surpluses of thegovernment over time.
Deficits, Surpluses and DebtA budget deficit is the amount by which thegovernment expenditure exceeds thegovernment revenue in a particular year.A budget surplus is the amount by whichthe government revenue exceeds thegovernment expenditure in a particularyear.
10
Types of Budgets
Annually Balanced—procyclical
Cyclically Balanced—to hard to
predict cycles
Functional Finance-work for goals
√ Comparative Advantage …is the ability toproduce an item at a lower opportunity cost. Resourcesare scarce, so that one can only produce more of oneproduct by taking the resources away from another. Itmeans that total world output will be greatest when eachgood is produced by the nation which has the lowestdomestic opportunity cost.
√ As a result of trade, countries that trade products basedon their own specialization will have more of BOTHproducts (produced and traded for).√ Terms of Trade…the exchange ratio between goodstraded. This ratio explains how the gains frominternational specialization and trade are dividedamong the trading nations; it depends on the worldsupply and demand for the two products.
S
D
$ Price ofForeign
Currency
Quantity of Foreign Currency
The intersectionwill be the
exchange rate.
Flexible exchange rates
Qfc
$fc
A nation’s Balance of Paymentsrecords all the transactions that takeplace between its residents and the
residents of a foreign nation.Current Account
Mdse. Trade
Services Trade
Net InvestmentIncome
Net Transfers
Capital Account
Real Investment
Financial Investments
Official Reserves Account
+ to balance a deficit
—to balance a surplus=
The Market For Currency
$P/fc
Q
D
S
Dol
lar p
rice
of f
orei
gn cu
rren
cy
Quantity of foreign currency
FCDepreciates; $ Appreciates
FCAppreciates; $ Depreciates
FCP/$
Q
D
S
FC p
rice
of d
olla
rs
Quantity of $
DollarDepreciates; FC Appreciates
DollarAppreciates; FC Depreciates
Changes in tastes
Changes in relative incomes
Changes in relative prices
Changes in relative interest rates
Speculation in currencies
Determinants of exchange rates: