AP Macroeconomics Review Session One

• Key Vocabulary Terms and Key Graphs.

• This is a fairly comprehensive review largely based on the 2000 and 2005 released Multiple Choice Exams and the recent Free Response Questions.

Production Possibilities• Assumptions:

– Full Employment– Fixed Resources and Technology

• Movements– Along curve shows opportunity cost– Outward shift illustrates economic growth– Inward shift indicates destruction of resources

• Producing Capital Goods will lead to greater economic growth than producing consumer goods. (Butter will lead to more growth than guns)

Production Possibilities Graph

Capital Goods

Consumer Goods

A

B

CD

E

Points A,B,C, are efficient pts.Point D is underutilizationPoint E is economic growth

May Lead to mostFuture growth

May Lead to mostFuture economic growth

Economic Systems• Capitalism=Free Market

– Most decisions made by Private businesses

• Communism=Command Economy– Most decisions made by the government

• Mixed Economy=Features of both Capitalism and Communism– Decisions made by both the market and

governments

Supply and Demand Factors

• Demand Changes when:– Income changes– Related Products, complements and

substitutes, (price or quality change)– Expectations (future price change)– Consumers (more or less added)– Tastes, Fads, Preferences change

Demand Increase: As Demand Increases, Price and Quantity Increase as well.

P1

P2

Q1 Q2

S1

D1

D2

Price

Quantity

Demand Decrease: As Demand Decreaes, Price and Quantity decrease as well

D1

D2

S1

P1

P2

Q1Q2

Price

Quantity

Supply Factors

• Supply Changes When:– Input prices change (resources and wages)– Government (tariffs, quotas, and subsidies)– Number of sellers change– Expectations (about price and product

profitability change)– Disasters (weather, strikes, etc..)

Supply Increase: As Supply Increases, Quantity Increases, but Price Falls.

Price

QuantityQ1 Q2

P1

P2

S1S2

D1

Supply Decrease: As Supply Decreases, Quantity Decreases, but Price Increases.

Price

Quantity

S1

S2

D1

P1

P2

Q1Q2

Comparative Advantage• A nation should specialize in producing goods in which it

has a comparative advantage: ability to produce the good at a lower opportunity cost.

Example:Cheese Wine

Spain: 2 pounds 2 Cases

France 2 pounds 6 Cases

Spain should produce cheese (1C = 1W)

France should produce wine (1W = 1/3C)

:

Currency Terms

• Appreciation: Currency is increasing in demand (stronger dollar)– U.S. Currency will appreciate when

more foreigners: travel to the U.S., buy more U.S. goods or services, or buy the U.S. dollar to invest in bonds

Currency Terms• Depreciation: Currency is

decreasing in demand (weaker dollar) Being SUPPLIED in exchange for other currency.– U.S. Currency will depreciate when

fewer foreigners: travel to the U.S., buy fewer U.S. goods or services, or sell the U.S. dollar to invest in their own bonds

Circular Flow of Economic Activity

• Households supply resources (land, labor, capital, entrepreneurial ability) to the resource market. Households demand goods and services from businesses.

• Businesses demand household resources and supply goods and services to the product (factor) market.

GDP (Gross Domestic Product): The total dollar (market) value of all final goods and services

produced in a given year.

Expenditure Formula:

• Consumption (C) + Business Investment (I) + Government Spending (G) + Net Exports (x)

GDP: What Counts:

• Goods Produced but not Sold (I)

• Goods produced by a foreign country (Japan) in the U.S. (Honda, Toyota)

• Government spending on the military

• Increase in business inventories

GDP: What DOES NOT count:

• Intermediate Goods (Tires sold by Firestone to Ford)

• Used Goods

• Non-Market Activities (Illegal, Underground)

• Transfer Payments (Social Security)

• Stock Transactions

Shortcomings of GDP: Leading to GDP being understated.

• Nonmarket activities: (services of homemakers) does not count.

• Leisure: Does not include the value of leisure.

• Does not include improvements in product quality.

• Underground economy

GDP: Overstated

• Includes damage to the environment

• Includes more spending on healthcare-Americans being unhealthy.

• Includes money spent to fight crime-more police officers, more jails, etc…

Real GDP• Real GDP= Nominal GDP adjusted for

inflation.• Calculation:

– Real GDP = Nominal GDP

Price Index in Hundredths( deflator)

Example:

U.S. 2005 Real GDP= $12,4558 (billions)

1.1274 (based on 2000)

$11.048 Trillion

Real GDP Per Capita

• Most commonly used to compare and measure each country’s standard of living and overall economic growth.

• Real GDP/Nation’s Population

Business Cycles

• The increases and decreases in Real GDP consisting of four phases:– Peak: highest point of Real GDP– Recession: Real GDP declining for 6 months– Trough: lowest point of Real GDP– Recovery: Real GDP increasing (trough to

peak)

Unemployment

• Calculation: Number of Unemployed Labor Force

(Multiplied by 100 to put as a %)

The Labor Force is the total of employed and unemployed workers.

U.S. unemployment should be about 5%

Employed

• You are considered to be employed if:– You work for 1 hour as a paid employee (so

part-time workers count)– You are temporarily absent from work

(illness, strike, vacation)– You work 15 hours or more as an unpaid

worker (family farms are common)

Unemployed

• Must be looking for work (at least 1 attempt in the past 4 weeks)

• Are reporting to a job within 30 days

• They are temporarily laid off from their job

Types of Unemployment• Frictional: Have skills that are in demand; just need

time to find a job (College Graduate)

• Structural: Current skills do not match job openings (Factor jobs being outsourced; Flight attendant after 9/11/2001).

– Frictional + Structural = Natural Rate of Unemployment (Full –Employment rate)

• Cyclical: Due to a recession (Requires Government action).

Not In Labor Force

• A person who is not looking for work:– Full-time students– Stay at home parents– Discouraged workers: those who have given

up hope of finding a job.– Retirees

Inflation• Rise in the general level of prices

• Reduces the purchasing power of money

• Measured with the Consumer Price Index (CPI)– Reports the price of a market basket , more

than 300 goods that are typically purchased by an urban household

Consumer Price Index (CPI)• CPI = Recent Price of Market Basket

Price of same basket in base year

(This number is then multiplied by 100)

Example: Assuming only 2 Goods

Recent Year Base Year

P Q P Q Jeans $25 5 $20 5

Pizza $20 10 $15 10

$325 = 1.3 * 100=130 $250

Calculating Inflation

• CPI in Recent Year – CPI in Past Year

Divided by CPI in Past Year

(Number then Multiplied by 100)

Example: 2002 CPI = 179.9

2001 CPI = 177.1

Rate of Inflation: 179.9-177.1 = 1.58%

177.1

Types of Inflation

• Demand Pull Inflation: ‘too much money chasing too few goods.”

– AD Curve will shift to the right, resulting in a higher Price Level and greater Output (up til FE)

• Cost-Push Inflation: Major cause is a supply shock-OPEC cutting back on oil production

– AS Curve will shift to the left resulting in a higher Price Level and a decrease in Real GDP.

Real and Nominal Terms

• Real Income = Nominal Income

Price Index (Hundredths)

• Real Interest Rate = Nominal Interest Rate – Inflation Rate

• Nominal Interest Rate = Real Interest Rate + Inflation Premium

(anticipated inflation)

Inflation: Winners & Losers• Winners:

– Debtors who borrow money that will be repaid with “cheap” dollars.

– Those who have anticipate inflation

• Losers:– Savers (especially savings accounts)– Creditors (Banks will be repaid with those “cheap” dollars– Fixed-Income Recipients (retirees receiving the same monthly

pension)

Consumption and Saving

• As income increases, both consumption and savings will increase.

• The determinants of overall consumption and savings are: (More money or a positive outlook will increase consumption and reduce savings. Less money or a negative outlook will increase savings and reduce consumption.– Wealth (financial assets)– Expectations about future prices and income– Real Interest Rates– Household Debt– Taxes

Marginal Propensities

• Marginal Propensity to Consume (MPC) and the Marginal Propensity to save (MPS) must equal 1.

• The MPS is used to derive the spending multiplier, which equals: 1

MPS

If the MPS is .2, the spending multiplier is 5.

Any increase in spending must be multiplied by 5 to determine the overall increase in Real GDP.

Interest Rate-Investment

• Expected Rate of Return: Amount of Profit (expressed as a percentage) a business expects to gain on a project/investment.– This rate must be greater than the interest in

order to be profitable.– The Real Rate of Return is most important.

An expected profit of 10%, that costs 5% in interest = The real rate of return: 5%.

Investment Demand Curve:

Quantity of Investment

Real Rate ofReturn

ID

r1

r2

Q1 Q2

At lower real interest rates businesses will Increase investment , leading to an increaseIn AD (aggregate demand). At higher rates ofInterest, less money will be invested

Shifts of the Investment Demand Curve

PL

Real GDP

ID1ID2

ID3

A shift from ID1 to ID2 Represents an increase inInvestment demand. A shiftFrom ID1 to ID3 represents adecrease in investment Demand.

Aggregate Demand

AD (C + I + G + X)

PriceLevel

Real GDP

Downward sloping:1. Real-Balances Effect: change in purchasing power

2. Interest-Rate Effect: Higherinterest rates curtail spending

3. Foreign Purchase Effect: Substitute foreign products for U.S. products

Aggregate Demand

• Determinants of AD:– C + I + G + X (Yes, its GDP)– An increase in any of these, due to lower

interest rates or optimism will increase AD and shift the curve to the right.

– A decrease in any of these: more debt, less spending, tax increase, will cause a decrease in AD and shift the curve to the left

Aggregate Demand Determinants

• Consumption– Wealth– Expectations– Debt– Taxes

• Investment– Interest Rates– Expected Returns

• Technology

• Inventories

• Taxes

• Government– Change in Gov.

spending

• Net Exports– National Income Abroad– Exchange Rates

Aggregate Supply Factors:

• R: resource prices (wages and materials, as well as OIL)

• A: actions by government (Taxes, Subsidies, more regulation)

• P: productivity (better technology)

Aggregate Supply

• Short Run:– Assumes that nominal

wages are “sticky” and do not respond to price level changes.

– Is Upward sloping as businesses will increase output to maximize profits

• Long Run:– Curve is vertical because

the economy is at its full-employment output.

– As prices go up, wages have adjusted so there is no incentive to increase production.

Aggregate Supply Graph

Price Level AS

Recession Growth

InflationShort Run

Long Run

QF

Extended vertical lineIllustrates the LRAS andQF (Full-Employment)

Real GDP

Demand-Pull Inflation

AD1 (C + I + G + X)

AD2

AS

Price Level

Real GDPQF

P1

P2

Cost-Push Inflation

QFQ2

P1

P2

Price Level

Real GDP

AD1 ( C + I + G + X)

AS1

AS2

Fiscal Policy• Using Taxes and Government spending to stabilize the

economy.

• Controlled by the President and Congress

• Discretionary Fiscal Policy: Congress must take action (change the tax rates) in order for the action to be implemented.

• Automatic Stabilizers: Unemployment benefits, Progressive Tax System, these changes are implemented automatically to help the economy.

Types of Fiscal Policy

• Expansionary– Used to Fight a

Recesssion– LOWER TAXES– INCREASE

GOVERNMENT SPENDING

• Contractionary– Used to fight Inflation– RAISE TAXES– DECREASE

GOVERNMENT SPENDING

Expansionary Fiscal Policy• Increasing Government Spending and or cutting taxes

will shift AD to the right and increase output and the price level.

Price Level

Real GDPAD1 ( C + I + G + X )

AD2

As1

P1

QFEQ1

P2

Tax Multiplier

• Remember, if the government decreases taxes, the result is not as great as a spending increase, since households will save a portion (MPS) of the tax cut.

• The Tax Multiplier = MPC X Spending Multiplier.– Example: If the MPC is .8 and the MPS is .2– Spending Multiplier = 1/.2 or 5– Tax Multiplier = .8 X 5 or 4

Loanable Funds Market & Expansionary Fiscal Policy

• Used for FISCAL POLICY (Government spending-Deficit Spending)

Quantity of Funds

Real Interest Rate

D1

D2

An increase in Gov. spending increases the demand for loanable funds and raises real interest rates

R1

R2

Q1 Q2

Crowding-Out Effect

• An Expansionary Fiscal Policy as previously diagrammed will lead to higher interest rates.

• At higher interest rates, businesses will take out fewer loans and there will be a decrease in INVESTMENT (I)

• At the same time there will be a decrease in CONSUMER SPENDING (C) as they will take out fewer loans as well.

• This CROWDING OUT EFFECT will reduce the gain made by the expansionary fiscal policy.

Net Export Effect & Expansionary Fiscal Policy

• Government spending has led to an increase in interest rates.

• At higher interest rates, foreigners demand more U.S. dollars to invest in bonds.

• This leads to an appreciation of the U.S. dollar.• This leads to a decrease in Net Exports, as foreigners

now have to exchange more of their currency for the U.S. dollar to buy exports.

• This decrease in Net Exports will reduce AD and counter to some extent the expansionary fiscal policy.

Contractionary Fiscal Policy• Raising taxes or reducing government

spending to fight inflation and stabilize the economy.

Price Level

Real GDP

AD1

P1

P2

AD2

QF

AS

Loanable Funds Market & Contractionary Fiscal Policy

• Used for FISCAL POLICY (Government spending-Deficit Spending)

Quantity of Funds

Real Interest Rate

D2

D1

A decrease in Gov. spending decreases the demand for loanable funds and lowers real interest rates

R2

R1

Q2 Q1

Net Export Effect & Contractionary Fiscal Policy

• A decrease in government spending has led to a decrease in real interest rates.

• At lower interest rates, foreigners demand less U.S. dollars to invest in bonds.

• This leads to a depreciation of the U.S. dollar.• This leads to an increase in Net Exports, as foreigners

now have to exchange less of their currency for the U.S. dollar to buy exports.

• This increase in Net Exports will increase AD and further strengthen the contractionary fiscal policy.

Criticisms of Fiscal Policy

• Timing Problems– Recognition Lag: identifying recession or inflation– Administrative Lag: getting Congress/President to

agree to take action– Operational Lag: Time needed to see the results

of the fiscal policy– Political Business Cycles: Politicians may take

inappropriate action to get reelected (lower taxes during an inflationary period). Plus it is difficult to raise taxes

Money Supply Terms

• M1= Checkable Deposits and Currency• M2= M1 + Savings deposits, money

market accounts, small time deposits (less than $100,000)

• Velocity of Money Equation:– MV = PQ ( GDP) (M= Money Supply and V =

Velocity (number of times per year the average dollar is spent on goods and services.

The Federal Reserve System (FED)

• Control Monetary Policy

• Headquartered in Washington D.C.

• 12 Federal Reserve Districts

• Board of Governors (7 members) is the central authority

• Members are appointed by the President and confirmed by the Senate

Federal Open Market Committee (FOMC)

• Made up of 12 people: Board of Governors + New York FED President + 4 other regional presidents (who rotate)

• Meets regularly to direct OPEN MARKET OPERATIONS (buying or selling of bonds) to maintain or change interest rates

Banks and Balance SheetsAssets Liabilities

Reserves $15,000 Checkable Deposits $100,000Securities $15,000Loans $70,000

If the current reserve requirement is 10%:

1. What is the amount of new loans this bank can generate?Answer: $100,000 Checkable deposits X a 10% reserve requirement

= $10,000 required reserves. If the bank has $15,000 in reservers, $5,000 of those are excess reserves and can be loaned out .

2. How much in new loans can be generated by the entire banking system?

Answer: Money Multiplier = 1/Required Reserve Ratio=1/.1010 X $5,000 = $50,000

FED and the Money Market

MS1 MS2

MD

Nominal InterestRate

Quantity of Money

I1

I2

Q1 Q2

Vertical curve-Supply controlledBy the FED. An increase in MSleads to a rightward shift and

lower interest rates.

Easy Money Policy• Buying Government Bonds, lowering the discount rate, or lowering

reserve requirements, to fight a recession, by decreasing interest rates, increasing investment spending and/or consumption and increasing AD.

Price Level

Real GDPQ1

P1

P2

QF

AS

AD2

AD1 (C + I + G + X)

Effects of an Easy Money Policy

• LOWER INTEREST rates which will lead to an INCREASE in INVESTMENT and CONSUMPTION.

• The U.S. dollar will DEPRECIATE, leading to an increase in NET EXPORTS as well.

• These effects STRENGTHEN the overall monetary policy (opposite of fiscal policy’s crowding-out and net export effect

FED and a TIGHT Money Policy

MS2 MS1

MD

Nominal InterestRate

Quantity of Money

I2

I1

Q2 12

Vertical curve-Supply controlledBy the FED. A decrease in the Money supply, shifts the MS curve to the left and raises interest rates.

Tight Money Policy• Selling bonds, raising the discount rate, or raising reserve

requirements to fight inflation which will raise interest rates, decrease investment and/or consumption and decrease Aggregate Demand (AD).

Price Level

Real GDP

AD1

P1

P2

AD2

QF

AS

Effects of a Tight Money Policy

• At the higher interest rates, INVESTMENT SPENDING, and CONSUMPTION will decrease.

• At higher interest rates, the U.S. dollar will APPRECIATE (foreigners demand more U.S. securities). This will lead to a DECREASE in NET EXPORTS.

• Again, the Monetary Policy is STRENGTHENED as a result, unlike the effects of a contractionary fiscal policy.

Extended AD-AS Model

• This is the other way to graph the AD-AS Model

AD

Price Level

Real GDPQF

P1

SRAS

LRAS

The intersection of the 3 curvesIs the Full-Employment Equilibrium

Extended AD-AS Model and Demand-Pull Inflation

• In Demand-Pull Inflation, the AD curve has shifted to the right of the LRAS and SRAS intersection.

AD2

Price Level

Real GDPQF

P2

SRAS

LRAS

Q2

The Price Level and Real GDP has increased.

AD1

PF

Extended AD-AS and Demand-Pull Inflation

• Mainstream economists will fight inflation as previously discussed: with either a tight monetary policy or a contractionary fiscal policy. The goal would be to move the aggregate demand curve to the left.

• Classical economists would argue to DO NOTHING. As nominal wages rise, the SHORT-RUN AS curve will shift to the left (resources and wages are becoming more expensive), restoring the economy to its full-employment output level, but with a higher Price Level.

Extended AD-AS Model and Cost-Push Inflation

AD1

Price Level

Real GDPQF

SRAS2

LRAS

Cost-Push inflation occurs when the SRAS has shifted to the left Of the LRAS and AD intersection.

P1

Q1

Here the Price level has Increased and REAL GDP

has decreased.

SRAS1

PF

Extended AD-AS and Cost-Push Inflation

• Mainstream economists must decide whether to target the Price Level or Unemployment, before taking any action.

• Classical economists would argue to DO NOTHING. Eventually, wages and resource prices must decrease and when they do the SRAS curve will shift back to the right, restoring the economy to its full-employment output level and the original Price Level.

Extended AD-AS Model and Recession

• In a recession due to a decrease in AD, the AD curve is to the left of the LRAS and SRAS intersection; showing a decrease in both

the Price Level and Real GDP.

AD

Price Level

Real GDPQF

SRAS

LRAS

P1

Q1

PF

Extended AD-AS and Recession

• Mainstream economists will fight a recession as previously discussed: with either an easy money policy or an expansionary fiscal policy. The goal would be to move the aggregate demand curve to the right.

• Classical economists would argue to DO NOTHING. The decrease in wages and resource prices will shift the SRAS curve to the right, restoring the economy to its full-employment output level, but with a LOWER price. (SELF-CORRECTION)

Short-Run Phillips Curve

• Suggests an inverse relationship between the inflation rate and the unemployment rate.InflationRate(percent)

Unemployment Rate (percent)

2

8

2 8

When the unemployment rate isLow (2%), the inflation rate willMost likely be high (8%).

When theUnemployment rateIs high, inflation willlikely be low.

SRPC1

Short-Run Phillips Curve

• When the Government fights unemployment, typically higher inflation will result. When the Government fights inflation, typically, more unemployment will result. Thereby, we move along the Short-Run Phillips Curve.

InflationRate(percent)

Unemployment Rate (percent)

A

B7

2

3 6

SRPC1

Shifting the Short-Run Phillips Curve• The Short-Run Phillips curve can also shift, this would mean that

both the unemployment rate and inflation rate are changing at the same time.

SRPC1

SRPC2

4

5

6 7

Stagflation, unemployment andInflation occurring together (OPEC decreasing Oil supply,causes this type of shift)

Inflation Rate%

Unemployment Rate %

Shifting the Short-Run Phillips Curve• The Short-Run Phillips curve can also shift, this would mean that

both the unemployment rate and inflation rate are changing at the same time.

SRP2

SRPC1

5

7

When Supply increases (productivity surge in 90s)more than demand, prices willfall, while GDP and employmentIncrease; shifting the curve to the left.

Inflation Rate %

Unemployment Rate %

3

5

Long-Run Phillips Curve

• The Long-Run Phillips Curve is vertical, like the Long Run Aggregate Supply Curve. So, in the long run there is no tradeoff between inflation and unemployment. Only the Price Level will change.

Inflation Rate%

Unemployment Rate %5

3

SRPC

LRPC

Laffer Curve

• What is the optimal tax rate? A tax of 0% will provide no tax revenue. A tax rate of 100% will also lead to no tax revenue (no incentive to work). Answer must be somewhere in between.

Tax Rate

Tax Revenue0

100

Economic Growth

• Five Factors connected to long run economic growth.

• Supply Factors:– Increase in natural resources (quantity and quality)– Increase in human resources (quantity and quality)– Increase in capital goods– Improvements in technology

• Demand Factors:– Increase in consumption by households, businesses, and

government

Illustrating Economic Growth

• Production Possibilities Curve

Capital Goods

Consumer Goods

AB

PPC1

PPC2

Illustrating Long Run Growth

• Can also be illustrated with the extended AD-AS Model.

Real GDP

Price Level

AD1AD2

SRAS1 SRAS2LRAS1LRAS2

Q1 Q2

P1

P2

Budget Philosophies

Annually Balanced Budget: Government will spend what

it makes.• Problem: Does not have money during a recession, it

will not be able to increase spending to help the economy.

• If there is inflation, it will also be forced to spend the extra money

• In both cases the economy will be worse off

Cyclically Balanced Budget: Government will finance a deficit during a recession and pay it off with tax revenue received during expansion.

Problem: A long recession may run up a large deficit that a short expansion period can not pay off

National Debt ($8.7 Trillion and growing)

Functional Finance: A deficit is necessary to balance

the economy. The national debt should not be worried

about too much.

Causes of the Debt:

1. Wars

2. Recessions

3. Lack of Fiscal Discipline

Concerns:

1. Interest Payments

2. Income Gap (Debt and interest payments held by the wealthy)

2. Crowding Out

Economic Philosophies• Classical: Believes that the government

SHOULD NOT interfere in the economy. And believes in self-correction of economic problems.

• Keynesian: Believes that GOVERNMENT SHOULD interfere in the economy (taxes, government spending)

International Trade

• Comparative Advantage and Specialization allows for economic growth and efficiency. (More of each good can be obtained by trading-Trading line illustrates this)

• Trade barriers create more economic loss than benefits.

• Today there is a trend towards free trade and a reduction in trade barriers.

• Strongest arguments for protection are the infant industry and military self-sufficiency arguments.

• WTO oversees trade agreements and disputes, but has become a target of protesters lately.

Foreign Exchange Market• Let’s say a U.S. citizen travels to Japan. This transaction will

provide a supply of the U.S. dollar and result in a demand for yen. It will become cheaper for the Japanese to buy the dollar and more expensive for Americans to buy the Yen. The Yen is Appreciating and the dollar is Depreciating.

Quantity of U.S. Dollars Quantity of Yen

Yen Price of dollar

Dollar Price

of Yen

P1

Q1

D1

S1

S2

P2

Q2

P1

Q1

D1

S1

D2

Q2

P2

Balance of Payments: The sum of all transactions between U.S. residents and residents of all foreign

nations

• Current Account: Shows U.S. exports and U.S. imports of goods and services.

• Capital Account: Shows the U.S. investment (financial as well as capital-plants and factories) abroad and Foreign investment in the U.S.

• Credits: A credit are those transactions for which the U.S. receives income (exports, foreign purchase of assets)

• Debits: Those transactions that the U.S. must pay for: imports and purchasing of assets abroad.

Balance of Payments continued

• The Current Account and Capital Account must be equal.

• Official Reserves Account: The Central Banks of all nations hold foreign currency to make up any deficit in the combined capital and current accounts.

• If the U.S. has more credits than debits it finances this difference by dipping into its reserve account.