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 Points A,B,C, are efficient pts.

Goods Point D is underutilization
Point E is economic growth
A E

May Lead to most

Future economic growth 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

Quantity
Q1 Q2
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: 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:

Real Rate of At lower real interest rates businesses will

Return Increase investment , leading to an increase
r1 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

A shift from ID1 to ID2

PL 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:
Price 1. Real-Balances Effect: change
Level
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
 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 • Government
– Wealth – Change in Gov.
– Expectations spending
– Debt • Net Exports
– Taxes – National Income Abroad
• Investment – Exchange Rates
– 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: • Long Run:

– Assumes that nominal – Curve is vertical because
wages are “sticky” and the economy is at its full-
do not respond to price employment output.
level changes. – As prices go up, wages
– Is Upward sloping as have adjusted so there is
businesses will increase no incentive to increase
output to maximize production.
profits
 Aggregate Supply Graph

Price Level
AS
Short Run
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

AS2
Price
Level
AS1

P2

P1

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 • Contractionary
– Used to Fight a – Used to fight Inflation
Recesssion – RAISE TAXES
– LOWER TAXES – DECREASE
– INCREASE GOVERNMENT
GOVERNMENT SPENDING
SPENDING
 Expansionary Fiscal Policy
• Increasing Government Spending and or cutting taxes
will shift AD to the right and increase output and the
price level.

As1
Price Level

P2

P1 AD2
AD1 ( C + I + G + X )
Real GDP
Q1 QFE
 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 An increase in Gov.
spending increases the
demand for loanable
R2 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 AS

P1

P2 AD1

AD2

QF Real GDP
 Loanable Funds Market &
Contractionary Fiscal Policy
• Used for FISCAL POLICY (Government
spending-Deficit Spending)
Real Interest Rate A decrease in Gov.
spending decreases the
demand for loanable
R1 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 Liabilities

Reserves $15,000 Checkable Deposits $100,000

Securities $15,000
Loans $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/.10
10 X $5,000 = $50,000
 FED and the Money Market
Nominal Interest
MS1 MS2
Rate

Vertical curve-Supply controlled

I1 By the FED. An increase in MS
leads to a rightward shift and
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 policy’s
crowding-out and net export effect
 FED and a TIGHT Money Policy
Nominal Interest
MS2 MS1
Rate

Vertical curve-Supply controlled

I2 By the FED. A decrease in the
Money supply, shifts the MS
curve to the left and raises
interest rates.

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 AS

P1

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
Real GDP
The intersection of the 3 curves
Is 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.
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 full-
employment 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.
LRAS
Price Level
SRAS1
Here the Price level has
P1 SRAS2
Increased and REAL GDP
has decreased.
PF

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

When the
Unemployment rate
Is high, inflation will
likely be low. 2
SRPC1

2 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)
B
7

2 A
SRPC1

3 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 Stagflation, unemployment and

% 5 Inflation occurring together
(OPEC decreasing Oil supply,
4 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.
When Supply increases
Inflation Rate % (productivity surge in 90s)
more than demand, prices will
5 fall, while GDP and employment
Increase; shifting the curve to the left.

3
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.
Inflation Rate% LRPC

3
SRPC

5 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

0 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.
LRAS2
LRAS1 SRAS1 SRAS2
Price Level

P2

P1
AD2
AD1

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
• 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.

Yen Price of Dollar

dollar Price S1
S1 of Yen
P2
S2
P1 P1
D2
P2
D1 D1

Q1 Q2
Q1 Q2

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.