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 A
May Lead to most Future economic growth

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

Consumer Goods

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.

Price

S1

P2

P1 D2 D1 Q1 Q2

Quantity

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

Price

S1

P1

P2 D1 D2 Q2 Q1 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.

S1

Price

S2

P1 P2

D1

Q1

Q2

Quantity

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

S2

Price

S1

P2

P1

D1

Quantity Q2 Q1

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:
France

2 pounds
2 pounds

2 Cases
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.

The total dollar (market) value of all final goods and services produced in a given year.
Expenditure Formula:

GDP (Gross Domestic Product):

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 healthcareAmericans 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 countrys standard of living and overall economic growth. Real GDP/Nations 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
P $25 $20 Q 5 10

Base Year
P $20 $15 Q 5 10

Jeans Pizza

$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:

Real Rate of Return

r1

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

r2

ID
Q1 Q2 Quantity of Investment

Shifts of the Investment Demand Curve

PL

A shift from ID1 to ID2 Represents an increase in Investment demand. A shift From ID1 to ID3 represents a decrease in investment Demand. ID2
ID1

ID3

Real GDP

Aggregate Demand
Downward sloping: 1. Real-Balances Effect: change in purchasing power 2. Interest-Rate Effect: Higher interest rates curtail spending 3. Foreign Purchase Effect: Substitute foreign products for U.S. products AD (C + I + G + X) Real GDP

Price Level

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

Government
Change in Gov. spending

Net Exports
National Income Abroad Exchange Rates

Investment
Interest Rates Expected Returns
Technology Inventories Taxes

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

Aggregate Supply Graph

Price Level Short Run

AS
Inflation

Long Run

Recession

Growth Extended vertical line Illustrates the LRAS and QF (Full-Employment)

QF

Real GDP

Demand-Pull Inflation
AS

Price Level
P2

P1

AD2 AD1 (C + I + G + X) QF Real GDP

Cost-Push Inflation
Price Level
P2 P1

AS2
AS1

AD1 ( C + I + G + X) Q2 QF Real GDP

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 As1

P2 P1

AD2 AD1 ( C + I + G + X ) Real GDP QFE

Q1

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)
Real Interest Rate R2
An increase in Gov. spending increases the demand for loanable funds and raises real interest rates

R1 D2

D1

Q1

Q2

Quantity of Funds

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 P1 AS

P2

AD1 AD2

QF

Real GDP

Loanable Funds Market & Contractionary Fiscal Policy

Used for FISCAL POLICY (Government spending-Deficit Spending)
Real Interest Rate R1
A decrease in Gov. spending decreases the demand for loanable funds and lowers real interest rates

R2 D1

D2

Q2

Q1

Quantity of Funds

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 Sheets

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

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/.10 10 X $5,000 = $50,000

FED and the Money Market

Nominal Interest Rate

MS1

MS2
Vertical curve-Supply controlled By the FED. An increase in MS leads to a rightward shift and

I1

lower interest rates.

I2

MD
Q1

Q2

Quantity of Money

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 AS

P2 AD2 P1 AD1 (C + I + G + X) Q1 QF

Real GDP

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 policys crowding-out and net export effect

FED and a TIGHT Money Policy

Nominal Interest Rate

MS2

MS1
Vertical curve-Supply controlled By the FED. A decrease in the Money supply, shifts the MS curve to the left and raises interest rates.

I2

I1

MD
Q2

12

Quantity of Money

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 P1 AS

P2

AD1 AD2

QF

Real GDP

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
Price Level
LRAS

SRAS

P1 AD

QF The intersection of the 3 curves Is the Full-Employment Equilibrium

Real GDP

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.
LRAS

Price Level

SRAS P2 PF AD2 AD1 QF Q2 Real GDP

The Price Level and Real GDP has increased.

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 fullemployment output level, but with a higher Price Level.

Extended AD-AS Model and Cost-Push Inflation

Cost-Push inflation occurs when the SRAS has shifted to the left Of the LRAS and AD intersection. Price Level P1 PF SRAS2
LRAS

SRAS1 Here the Price level has Increased and REAL GDP has decreased. AD1

Q1

QF

Real GDP

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.
LRAS

Price Level

SRAS

PF P1

AD

Q1

QF

Real GDP

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.
Inflation Rate
(percent)

When the unemployment rate is Low (2%), the inflation rate will Most likely be high (8%).

When the Unemployment rate Is high, inflation will likely be low. 2

SRPC1

8 Unemployment Rate (percent)

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. Inflation Rate
(percent)

A
SRPC1

6
Unemployment Rate (percent)

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.
Inflation Rate % 5

Stagflation, unemployment and Inflation occurring together (OPEC decreasing Oil supply, causes this type of shift) SRPC2 SRPC1 6 7
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.
Inflation Rate % When Supply increases (productivity surge in 90s) more than demand, prices will fall, while GDP and employment Increase; shifting the curve to the left.

SRPC1 SRP2 5 7
Unemployment Rate %

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. LRPC Inflation Rate%

3 SRPC

Unemployment Rate %

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 100

Tax Revenue

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 B A PPC2 PPC1 Consumer Goods

Illustrating Long Run Growth

Can also be illustrated with the extended AD-AS Model.
Price Level P2 P1
AD2 AD1
LRAS1 SRAS1 LRAS2 SRAS2

Q1

Q2 Real GDP

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

Lets 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.
Yen Price of dollar S1 P1 P2 D1 Q1 Q2 Q1 Q2 D1 S2 Dollar Price of Yen P2 P1 S1

D2

Quantity of U.S. Dollars

Quantity of Yen

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.