Alayna Auerbach AP MACROECONOMICS FINAL EXAM REVIEW

PRODUCTION POSSIBILITIES FRONTIERS

1. What is it?
Production Possibilities: the alternative combos of final goods and services that could be
produced in a given time period with all available resources and technology.
2. What does it illustrate? What can we determine from it?
PPcurve illustrates two principles: 1. Scarce resources (there is a limit to the amount we
can produce in a given time period with available resources and technology)
2. Output (we can obtain additional quantities of any desired good only by reducing the
potential prediction of another good)
PPcurve shows potential output, not necessarily actual output.

3. What happens as we move along it? What causes it to shift out?

Each point on the PPcurve depicts an alternative mix of output. Any increase in
resources or improvement in technology (such as: immigration increase, population
growth, stock of capital increase, quality of labor and capital increase) shift the PPcurve
outwards. Usually occurs after economic growth.
4. Why would a PPF be a straight line? What product combination would you have if it was
a straight line?
A PPF is a straight line when the two items are similar such as Brand A Juice and Brand
B Juice.
5. Why would a PPF be bowed out (curved)? What law (principle) is being illustrated when
it is bowed out (curved)? What other curve relates to the bowed out shape and that law
(principle)? Why?
A PPF is curved when the two items are different from each other.
Law of increasing opportunity cost: we must give up ever-increasing quantities of other
goods and services in order to get more of a particular product.
SUPPLY AND DEMAND
6. What causes movement along a demand curve (change in QD)? What causes a shift of
the demand curve (change in demand)?
Movement along demand curve: is a response to price changes for that good. if
determinants of demand stay constant, a movement along the curve to a new quantity
demanded occurs. Shift of the demand curve: occur when the determinants of demand
change. Determinants of demand are: Tastes (desire for this and other goods), Income
(of the consumer), Other goods (their ability and price), Expectations (for income, prices,
tastes), and # of buyers *For example: the entire demand curves shifts to the right when
income goes up or an increase in taste occurs
7. What causes movement along a supply curve (change in QS)? What causes a shift of
the supply curve (change in supply)?
Movement along supply curve: is a response to changes in quantity supplied. Shift of
supply curve: is a response to changes in supply. Determinants of market supply:
Technology, Factor Cost, Other goods, Taxes/subsidies, Expectations, # of sellers
8. How do we determine equilibrium in the market for a product?
Equilibrium price: the price at which the quantity of a good demanded in a given time
period equals the quantity supplied. Determined by supply/demand
9. When there is a shift in either of the curves, what happens to equilibrium price and
quantity?
Equilibrium price and quantity will change
10. How does the slope of the curves affect changes in price and quantity?
A steep slope= drastic change in price, little change in quantity.
A flat slope= little change in price, drastic change in quantity.

REAL GDP AND PRICE LEVELS

11. What is GDP? How do we measure it?
Gross Domestic Product: the total market value of all final goods and services produced
within a nation’s borders in a given time period.
GDP= C(consumption) + I(investment) + G(government) + X(exports) + M(imports)
*Real GDP = nominal GDP
price index
*The total value of market income must GDP
12. What is potential GDP?
The highest level of real GDP possible with current constraints
13. What is inflation? How do we measure it?
Inflation: an increase in the avg. level of prices of goods and services
Measured by Consumer Price Index (CPI): A measure of changes in the avg. price of
consumer goods and services. Create a market basket with all the items that consumers
buy in it. Item weight x percent change in price of item = percent change in CPI
14. When we have unanticipated inflation, who wins and who loses?
Winners: borrowers Losers: lenders, people with long term employment contracts,
people with saved wealth Neutral for: people with hourly wages
 15. What is the historical relationship between wages and price levels?
Economies with the lowest inflation tend to have the least unemployment.
16. What is the difference between the GDP deflator and the Consumer Price Index?
GDP Deflator: A price index that refers to ALL goods and services in GDP (isn’t based
on a fixed basket of goods and services). Reflects price changes and market responses
to those price changes so the GDP deflator usually registers a lower inflation rate than
the CPI (CPI measures a specific basket of goods).
17. What is crowding out? When is it more likely to occur?
Crowding out: a reduction in private-sector borrowing and spending (which means there
is less private-sector output) caused by increased government borrowing (Govt. borrows
too much money from the pool of loanable funds, so investors are hesitant to borrow
money). Occurs during budget deficits. The risk of crowding out is greater the closer the
economy is to full employment.
18. What is crowding in? When is it more likely to occur?
Crowding in: an increase in private-sector borrowing and spending caused by decreased
government borrowing. Occurs during budget surpluses.

AS/AD DIAGRAMS
19. What happens to GDP and Price Levels when AD and/or AS shift?
They change according to the graph:

20. What factors cause a change in AD and AS (shift the curves)?

AD: Population, Income, Related products (substitutes and complements), Preferences
AS: # of Suppliers, Productivity of workers, Technology and Capital, Change in related
products, Cost of inputs (things used in product), Acts of nature
21. What is the impact of having a very steep AS curve? A very flat AS curve?
Steep AS: Price level changes drastically Flat AS: GDP changes drastically
GDP does not Price levels do not
 22. How does the level of resource utilization affect changes in Price Levels and RGDP
when there are changes in AD?
A shift in AD curve during full employment leads to highest inflation because the AS
curve eventually becomes vertical because output cannot increase anymore after a
certain point past full employment.
23. How is Price Level related to the slope and shape of the AS and AD curves?

24. Does the intersection of AS and AD necessarily occur at Full Employment?

No.
25. What occurs if there is an adverse shift of the AS curve?
PL GDP

MPS/MPC, THE CONSUMPTION FUNCTION, CONSUMPTION SCHEDULES, THE

EXPENDITURE SCHEDULE AND THE MULTIPLIER
1. What is the definition of the MPC? MPS? What does the MPC tell us? The MPS?
Marginal Propensity to Consume (MPC): the fraction of each additional (marginal) dollar
of disposable income spent on consumption; how much of every extra dollar we turn into
spending; Change in consumption
Change in disposable income
Marginal Propensity to Save (MPS): the fraction of each additional (marginal) dollar of
disposable income not spent on consumption; 1-MPC
2. What is the consumption function and what does it illustrate?
Consumption function: a mathematical relationship indicating the rate of desired
consumer spending at various income levels;
C= MPC x Disposable Income – Autonomous spending
*Tells us: how much consumption will be included in AD at the prevailing price level, how
the consumption component of AD will shift when incomes change
3. What causes movements along the consumption function?
Movement: income changes Shift: wealth changes
4. How are the slope of the consumption function and the MPC related?
The slope of the consumption function is the MPC…
5. When are the slope of the consumption function, the consumption schedule and the
expenditure schedule all equal?
Mr. Olson says they always are in our class so it doesn’t matter…alright!
6. What is the formula for the oversimplified multiplier?
1
1 - MPC
7. How does the slope of the consumption function, the consumption schedule and the
expenditure schedule affect the value of the multiplier?
If they shift up, multiplier increases
*A downward shift of consumption function implies a leftward shift of the AD curve
*An upward shift of consumption function implies a rightward shift of AD curve
 8. What causes shifts of the expenditure schedule?
AD curve shifts if consumer incomes change or autonomous consumption changes
Shift factors that can alter autonomous consumption: changes in expectations, wealth,
credit conditions, tax policy
9. What will happen to the expenditure schedule when there is an interest rate change?
How much will the shift be?
AD Interest rates
10. What happens to the slope and position of the consumption schedule when the variable
tax rate changes?
Shifts up because consumption (raised taxes means a flatter slope)
11. What happens to the value of the multiplier when the variable tax rate changes?
Decreases
12. What is the paradox of thrift and why does it occur?
Occurs in bad times when all individuals decide to save more and spend less. This shifts
AD leftward and deepens any recession aka they were worse off than before.

RECESSIONARY AND INFLATIONARY GAPS AND THE SELF-CORRECTING MECHANISM

13. How can you define a recessionary gap? An inflationary gap?
Recessionary gap: the amount AS at full employment falls short of full employment
output *Producers may respond to the spending shortfall by cutting back on production
and laying off workers
Inflationary gap: the amount by which AS at full employment exceeds full employment
output *Market participants want to spend more income than can be produced at full
employment
14. Describe the self-correcting mechanism for a recessionary gap. On what does it
depend?
Lower wages close gap. Depends on stickiness of wages
15. Describe the self-correcting mechanism for an inflationary gap. On what does it
depend?
Higher wages close gap. Depends on stickiness of wages
16. Which one is more likely to occur and why?
Recessionary gap
17. What is the effect on RGDP and Price Levels as the self-correcting mechanism occurs
for either of the gaps?
Aggregate supply shifts either left or right
18. What is the “cost” of closing a recessionary gap with expansionary monetary or fiscal
policies rather than waiting on the self-correcting mechanism?
Inflation
KEYNEIAN/FISCAL POLICY

19. What did Keynes believe about the economy’s ability to automatically gravitate toward
full employment?
“In the long run, we die”… Classical economist’s approach of letting economy gravitate
toward full employment is possible, but it takes too long and the consequences of the
current problems may only worsen by the time it “fixes” itself.
20. What is the traditional Keynesian (Fiscal) Policy to cure a recessionary gap?
Fiscal policy: Increase Government spending, Decrease taxes
21. What is the traditional Keynesian (Fiscal) Policy to cure an inflationary gap?
Fiscal policy: Decrease Government spending, Increase taxes
22. When G increases, does it have any different effect on EGDP as an increase in any
other component of AD? Why?
No. All spending has the same multiplier so when spending increases, GDP is affected
the same.
23. What will be the effect of equal tax cuts and government spending cuts on AD and
RGDP?
Government spending cuts are more effective because tax cuts must be multiplied by
MPC.
24. What typically happens to the government’s budget during a recession? Why?
Increases, needs to borrow money to restore growth in economy.
25. What would we expect to happen to the national debt during a recession? Why?
Increases because government borrows money which increases debt.

SUPPLY-SIDE ECONOMICS
26. A cornerstone of supply-side thinking is that some types of tax cuts can be expected to
do what?
Increase Aggregate supply (rightward shift of AS can reduce unemployment and inflation
at the same time)
27. What are the main policies included in supply-side economics?
 Tax incentives for saving/investment/work, Human capital investment, (de)regulation,
Trade liberalization, Infrastructure development *All of these policies have the potential
to change supply independently of any changes in AD
28. What were the short run and long run impacts of the supply–side policies of the 1980s?
Tax rates decreased in short run
*Problem with supply-side: if leftward shift, all is bad (unemployment increases and so
does inflation)

MONEY & BANKING/THE FED & MONETARY POLICY/MONETARISM

29. Know the oversimplified deposit creation formula – Backwards and forward
1
Reserve Requirement
30. What is the Federal Reserve System?
Private/public bank that steers the economy by manipulating money supply/interest rates
31. What is the major advantage of the Fed’s institutional independence?
Not political
32. What are the Fed tools of monetary policy and how do they affect the money supply
and interest rates?
1. Reserve requirements (% of deposit banks must hold)
2. Discount rate (rate the Fed charges banks on loans)
3. Open market operation (buy or sell bonds)
33. What affect do the tools of monetary policy have on the Keynesian model
C+I+G+(X-IM) and therefore RGDP and Price Levels?
Decrease RR/Decrease DR/Buy bonds= GDP and PL increase, Interest Rate decrease
Increase RR/Increase DR/Sell bonds= GDP and PL decrease, Interest Rate increase
34. When would expansionary policies be the most inflationary? The least inflationary?
Most inflationary at full employment. Least inflationary at unemployment
35. If the Fed decides to stabilize the growth of the money supply, what does it lose control
over?
 Interest rates
36. What is monetizing the debt and how does it occur?
Fed buys bonds and increases the money supply to drive down interest rates and spur
more borrowing and growth.
37. Who are the monetarists and what are their beliefs?
Monetarists argue velocity of money can be easily predicted so we can manage the
economy by managing quantity of money

38. What is the expression M x V = P x Y?

Quantity of $ x Velocity of $ = Price Level x Output = Nominal GDP
*Equation of Exchange
39. When looking at the Quantity Theory of Money (Equation of Exchange) what would
occur due to a large increase in the money supply when the economy is near full
employment?
Price Level

PHILIPS CURVE

40. What explains the slope of the short run Philips curve?
Most changes are in Aggregate Demand which determines the slope.
41. What can be said about the points on the short run Philips curve?
As unemployment decreases, inflation increases. As unemployment increases, inflation
decreases.
42. What explains the slope of the long run Philips curve?
In the long run if there is no policy, natural correcting mechanism will return
unemployment to full employment rate.
 43. What can be said about the points on the long run Philips curve?
It is vertical at full employment, which can be altered if structural/frictional unemployment
changes.
44. What causes a change in the position of the short run Philips curve?
Demand changes
*The Philips curve assumes that the biggest changes in the economy always have to do
with AD

INTERNATIONAL TRADE

1. What is the benefit of trade between nations?

Countries can increase consumption choices
2. Why do many US economists support free international trade?
Because it allows for specialization, competition, etc.
3. What is absolute advantage? How is it determined?
Absolute advantage: the ability to make something more efficiently than competitors
(whoever makes the most)
4. What is comparative advantage? How is it determined?
Comparative advantage: the ability to produce something at a lower opportunity cost
than a competitor
5. Which matters most when discussing international trade? Why?
Comparative advantage matters most because countries should produce at lowest
opportunity cost.
6. What would happen in the economy of a large trading partner if the US falls into a
recession? Why?
Large trading partner would be hurt and most likely fall into a recession as well because
U.S. won’t buy its products
7. What happens in economies of trading partners when there is a change in price levels in
one country that are larger than the change in price levels in another country?
People will want to buy from the cheaper country so exports decrease and imports
increase.
8. The equilibrium price in the world market for a product will be determined where?
Demand/supply curve intersection
9. What will happen when a tariff or a quota is used to inhibit trade?
No equilibrium price
10. What is the difference between the use of a tariff and the use of a quota?
Tariff: tax products, government makes money
Quota: Limit # of something, cost governments money
11. How many exchange rates are there?
Between two countries, there is one exchange rate.
12. What are the main determinants of exchange rates in the short run, medium run and
long run?
Short Run: Interest rates
Medium Run: Income and economic activity
Long Run: Relative prices *Purchasing power parity (exchange rates even out in long
run)
13. Be able to determine what is happening with exchange rates based on given situations.
14. If we buy more financial instruments, goods, services and capital from a foreign nation;
a. What happens to the demand for the foreign country’s currency?
Increases.
b. To which country is more capital flowing?
Foreign country.
c. What will happen to the value of the foreign country’s currency?
Appreciate.
d. What will happen to the price of exports in the foreign country due to the
exchange rate changes?
Increase.
15. When there is a deficit in a country’s current account? What must be true of their capital
account?
There is a deficit in a country’s current account when they import a lot. Their capital
account must be a capital account surplus.
16. What type of transactions would lead to
A deficit in a country’s balance of payments? Quantity supplied > Quantity demanded
A surplus in the balance of payments? Quantity supplied < Quantity demanded