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AP Macro Economics Review. Production Possibility Curve. A. Capital goods. B. C. W. F. D. E. Consumer goods. B 2. Capital goods. B. D 2. D. Consumer goods. Market Equilibrium. P r i c e. Supply. P e. Demand. Q e. Quantity.

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Ap macro economics review

Production Possibility Curve

A

Capital goods

B

C

W

F

D

E

Consumer goods

B2

Capital goods

B

D2

D

Consumer goods


Market equilibrium
Market Equilibrium

P

r

i

c

e

Supply

Pe

  • Demand

Qe

  • Quantity


Ap macro economics review

A change in Demand versus a change in the Quantity Demanded

  • Change in Demand

  • √ Moves the curve

  • Income

  • Future Expectations

  • # of Buyers

  • Consumer Information

  • Taste and Preference

  • Substitues and Complements

Change in Quantity Demanded

√ Moves Along the SAME curve

• Caused only by Price change.


Ap macro economics review

A change in Supply versus a change in the Quantity Supplied

  • Change in Supply

  • √ Moves the curve

  • Costs of Production

  • Future Expectations

  • # of Sellers

  • Taxes and Subsidies

  • Prices of goods using same resources

  • Time period of production

Change in Quantity Supplied

√ Moves Along the SAME curve

• Caused only by Price change.


Ap macro economics review

Economic growth

  • The Rule of 70 is a device that can find the number of years it will for some amount to double.

    • # of yrs to double the real GDP = 70

      • annual rate of growth

  • Take the growth rate in 2004 of 4.0

    • 70/4.0 = 17.5 years for Real GDP to double

  • Imagine that the rate of growth was 10%? Only 7 years to double!


  • Ap macro economics review

    GROSS DOMESTIC PRODUCT

    Defining…

    Market Value of the total goods and services produced within the boundaries of the US whether by Americans or foreigners in one year.


    Ap macro economics review

    GROSS DOMESTIC PRODUCT

    Expenditures Approach

    Income Approach

    Consumption

    by Households

    Wages

    +

    +

    Rents

    +

    G

    D

    P

    Investment

    by Businesses

    =

    =

    +

    Interest

    +

    Government

    Purchases

    Profits

    +

    +

    Expenditures

    by Foreigners

    Statistical

    Adjustments


    Ap macro economics review

    NOMINAL GDP vs. REAL GDP

    Nominal GDP

    … reflects the current price level of goods and services and ignores the effect of inflation on the growth of GDP.

    … this measure is called Current Dollar GDP.

    Real GDP

    … measures the value of goods and services adjusted for change in the price level. It will reflect the real change in output.

    … This measure is called the Constant Dollar GDP.

    … indicates what the GDP would be if the purchasing power of the dollar has not changed from what it was in a base year. The government currently uses 2000 as its base year for Real GDP measurement.


    Ap macro economics review

    Price of market basket

    in specific year

    Price Index

    in a given

    year

    x 100

    =

    Price of same market

    basket in base year

    Nominal GDP

    =

    Real GDP

    Price Index

    (in hundredths)

    Nominal GDP

    Price Index

    (in hundredths)

    =

    Real GDP

    GDP Price Index

    An Alternative Method


    Ap macro economics review

    Disposable Income

    By subtracting from Personal Income, the dollars lost to taxes, we have the Disposable Income. This is the “bottom” line of national income accounting.

    Disposable Income = C + S


    Ap macro economics review

    GDP understates the well-being…

    √ by not counting non market transactions

    √ by not measuring Improved Product Quality

    √ by not considering Leisure Time

    GDP Overstates the well-being…

    √ by ignoring the Composition and Distribution of Output

    √ GDP and the Environment

    Per Capita GDP measures the GDP in terms of goods and services per person


    Unemployment rate unemployed labor force
    Unemployment Rate = UnemployedLabor Force

    Frictional – “temporary”, “transitional”, “short-term” (“between jobs” or “search” unemployment)

    Structural – “technological” or “long term”. basic changes in the “structure” of the labor force which make certain “skills obsolete”.

    Cyclical – “economic downturns” in the business cycle.


    Ap macro economics review

    The Full employment rate of unemployment or the Natural Rate of Unemployment (NRU) is present when the economy is producing its potential output.

    The Natural Rate of Unemployment exists when the cyclical unemployment is zero.


    Ap macro economics review

    GDP Gap and Okun’s Law

    √ The basic loss of unemployment is forgone output. √ Potential GDP is the capacity of the economy assuming the Natural Rate of Unemployment. The growth of the Potential GDP assumes the normal growth rate of the real GDP.

    GDP GAP is the amount by which actual GDP falls short of potential GDP

    For every 1% the unemployment rate exceeds the natural rate…Approximately a 2% GDP Gap occurs.


    Ap macro economics review

    Price of the market basket in the particular year

    CPI

    =

    x 100

    Price of the same market

    basket in 2000

    Inflation A rising of the general level of prices

    Producer Price Index (PPI)Prices at the wholesale or production level which are early indicators of inflation.

    70 divided by rate of inflation (expressed as whole numbers) will yield the number of years for the price level to double.


    Ap macro economics review

    Range 3

    P

    r

    i

    c

    e

    l

    e

    v

    e

    l

    Range 2

    Range 1

    Increases in total spending

    Quantity

    Qf

    Theories of Inflation:Demand Pull

    √ Excess of total demand

    √ prices are bid upward by the excess demand

    √ economy is seeking a point beyond its PPC when full employment-full production is evident


    Ap macro economics review

    Theories of Inflation:Cost Push

    √ prices rising when output and employment are both declining

    √ aggregate demand not excessive

    √ Per unit production costs are rising due to raw materials, energy, labor, etc.

    √ High per unit costs cause decline in profit; hence, the price level is “pushed up” by these costs.

    Abrupt increases in the costs of raw materials or energy inputs drive up per-unit production costs and hence prices.


    Ap macro economics review

    Unanticipated Inflation

    COLA-helps to stay up with rising prices


    Ap macro economics review

    • Real and Nominal Income

      • Nominal income … is the number of dollars earned as rent, wages, interest or profit

      • Real income… measures the amount of goods and services nominal income can buy.

    • √ If nominal income rises faster than price level, real income will rise.

  • √ If the price level increases faster than nominal income, then real income will fall.

  • √ Your real income falls only when nominal income fails to keep up with inflation.


  • Ap macro economics review

    ASlr

    ASsr

    Price Level

    PL1

    AD1

    o

    Qf

    Real domestic output

    Long Run Equilibrium

    In the extended AD-AS model, equilibrium occurs at the intersection of AD and the ASlr and the ASsr.

    Qf is the amount of Real GDP at full employment.


    Ap macro economics review

    DEMAND-PULL INFLATION

    and Self-Correction

    Short Run—Increase in AD shows point b

    Price Level

    ASlr

    AS2sr

    ASsr

    Long Run

    Nominal Wages rise and AS2sr moves left. RGDP returns to previous level on Aslr

    But…PL rises even more to PL3!

    c

    PL3[7%]

    b

    PL2[5%]

    a

    PL1[2%]

    AD2

    AD1

    o

    Qf

    Y2

    Real domestic output


    Ap macro economics review

    COST-PUSH INFLATION

    with government action

    If government stimulates AD to dotted line, an inflationary spiral will occur…PL3 at Qf. We have Full Employment but at a higher price level.

    Price Level

    ASlr

    AS2sr

    ASsr

    c

    PL3[5%]

    b

    PL2[3%]

    a

    PL1[2%]

    AD2

    AD1

    o

    Qf

    Y2

    Real domestic output


    Ap macro economics review

    COST-PUSH INFLATION

    with NO government action

    ASlr

    AS2sr

    If government lets the recession take its course, nominal wages will fall in the long run and return to point a…PL1 at Qf.

    Price Level

    ASsr

    c

    PL3[5%]

    a

    PL1[2%]

    AD1

    o

    Qf

    Real domestic output


    Ap macro economics review

    Recession

    This decline in the price level will eventually shift the AS1sr to AS2sr. Price level declines to PL3 at Qf . Shown at point c.

    ASlr

    AS1sr

    Price Level

    AS2sr

    a

    PL1[5%]

    PL2[3%]

    b

    c

    PL3[2%]

    AD1

    AD2

    o

    Qf

    Y2

    Real domestic output


    Ap macro economics review

    The Phillips Curve Concept

    7

    6

    5

    4

    3

    2

    1

    0

    As inflation declines...

    Unemployment

    increases

    Annual rate of inflation

    PC

    1 2 3 4 5 6 7

    Unemployment rate (percent)


    The phillips curve
    The Phillips Curve

    Summary

    The short run Phillips Curve is downward sloping.

    Aggregate Demand changes move along the same short run Phillips curve.

    Aggregate Supply changes create new short run Phillips curves.

    √ In the long run, there is not a stable relationship between unemployment and inflation.

    √ The long-run Phillips curve is the vertical line at the natural rate of unemployment.


    Ap macro economics review

    Expansionary Fiscal Policy

    Goal: To Reduce Unemployment and Effects of Recession…

    √ Increase Government Spending

    √ Decrease Tax Rates

    …Or Combination of the Two

    Contractionary Fiscal Policy

    Goal: To Reduce Demand—Pull Inflation…

    √ Decrease Government Spending

    √ Increase Tax Rates

    …Or Combination of the Two


    Ap macro economics review

    EXPANSIONARY FISCAL POLICY

    the multiplier at work...

    $20 billion decrease in tax rates; $15 billion in new consumption spending

    AS

    $60 billion

    increase in

    Aggregate

    Demand

    Price level

    P2

    P1

    AD2

    AD1

    $490

    $550

    Real GDP (billions)

    MPS = .25


    Ap macro economics review

    CONTRACTIONARY FISCAL POLICY

    the multiplier at work...

    $20 billion increase in tax rates; $15 billion lost in consumption spending

    AS

    $60 billion

    decrease in

    Aggregate

    Demand

    Price level

    P2

    P1

    AD3

    AD4

    $490

    $550

    Real GDP (billions)

    MPS = .25


    Ap macro economics review

    Built-in Stability

    Some changes in relative levels of government expenditures and taxes occur automatically.

    This is not like discretionary changes in spending and tax rates since these net tax revenues vary directly with RGDP.

    …tends to increase the government deficit (or reduce the surplus) during recession or to increase the surplus ( or reduce the deficit) during inflation without requiring specific action by policy makers.


    Ap macro economics review

    Increased demand for loanable funds by government raises the interest rate.

    S

    i%

    Real Interest Rate, (percent)

    i%

    D2

    D

    LF0

    LF1

    Quantity of Loanable Funds


    Ap macro economics review

    Fiscal policy weakened by NET EXPORT EFFECT

    Expansionary fiscal policy

    Problem: Recession

    More government spending and/or lower taxes

    Higher domestic interest rates

    (crowding-out effect)

    Increased foreign demand for dollars (foreigners want to earn higher interest)

    Dollar appreciates

    Net Exports decline

    (AD decreases, partially offsetting expansionary policy)

    Contractionary fiscal policy

    Problem: Inflation

    Lower government spending and/or higher taxes

    Lower domestic interest rates

    (government role in loanable funds market is less)

    Decreased foreign demand for dollars (foreigners find

    higher rates elsewhere)

    Dollar depreciates

    Net Exports increase

    (AD increases, partially offsetting contractionary policy)


    Ap macro economics review

    Supply-Side Economics

    • Supply-Side Economics aims to manipulate aggregate supply by enacting policies designed to stimulate incentives to work, to save and invest (including measures to encourage entrepreneurship).

    • These policies may include tax cuts which will increase disposable incomes, thus increasing household saving and increase the profitability of investments by businesses.

    • Tax cut stimulates more consumption, saving and investment to increase AD.

    • The new investment moves the AS curve to the right. Work incentives push more workers into employment and they spend and save increasing AD further.

    • Low taxes act to push risk takers to move toward new production methods and new products.


    Ap macro economics review

    Laffer Curve

    • …shows the relationship between tax rates and tax revenues

      • √ Up to a point, higher tax rates will result in larger tax revenues.

      • √ But still higher tax rates will adversely affect incentives to work and produce, reducing the size of the tax base and reducing tax revenues.

      • √ Lower tax rates will lessen tax evasion and avoidance, and reduce government transfer payments.


    Ap macro economics review

    M

    E

    A

    S

    U

    R

    E

    S

    • Large time deposits

    M3

    +

    M

    O

    N

    E

    Y

    • Money market accounts

    • Savings deposits

    • Small time deposits

    M2

    +

    • Checkable deposits

    • Travelers checks

    • Currency

    MI


    Ap macro economics review

    i%

    i%1

    Dm

    $$ demanded

    The Money Market

    Supply of money is a vertical line since monetary authorities (FED) and financial institutions have provided the economy with a certain stock of money.

    Sm


    Ap macro economics review

    Creation of Money in the Banking System

    Money supply is increased when:

    1. Banks issue loans to customers and receive a demand deposit.

    2. Banks buy securities from the public and credit a demand deposit for the cost.

    Money supply is decreased when:

    1. Customers repay loans take money from their demand deposit.

    2. Banks sell securities to the public and a demand deposit is reduced to pay for the bond.


    Ap macro economics review

    1

    =

    Money

    Multiplier

    Required reserve ratio

    Maximum

    Demand-

    Deposit

    creation

    Excess

    reserves

    Money

    Multiplier

    x

    =

    √ One bank can loan only its excess reserves and is limited by those reserves in creating money.

    √ The banking system creates a “multiplied” amount.

    The Money Multiplier

    Currency drain and no creditable customers will decrease the amount multiplied.


    Ap macro economics review

    MS i% In C AD PL RGDP

    EASY MONEY Goal: Cheap, available credit; increase the money supply

    Easy money is reinforced by the Net Export Effect


    Ap macro economics review

    Easy Monetary Policy And Equilibrium GDP

    Sm1

    Sm2

    Sm3

    Investment

    Demand

    10

    8

    6

    0

    10

    8

    6

    0

    Real rate of interest, i

    Dm

    Quantity of money demanded and supplied

    Amount of investment, i

    AS

    If the Money Supply

    Increases to Stimulate

    the Economy…

    • Interest Rate Decreases

    PL3

    Price level

    • Investment Increases

    PL2

    • AD & GDP Increases

    • with slight inflation

    AD3(I=$25)

    PL1

    AD2(I=$20)

    • Increasing money supply

    • continues the growth –

    • but, watch Price Level.

    AD1(I=$15)

    Real domestic output, GDP


    Ap macro economics review

    MS i% In C AD PL RGDP

    Tight Money Goal: Restrict credit; decrease the money supply

    Tight money is reinforced by the Net Export Effect


    Ap macro economics review

    Tight Monetary Policy And Equilibrium GDP

    Sm3

    Sm2

    Sm1

    Investment

    Demand

    10

    8

    6

    0

    10

    8

    6

    0

    Real rate of interest, i

    Dm

    Quantity of money demanded and supplied

    Amount of investment, i

    If the Money Supply

    Decreases to “cool”

    the Economy…

    AS

    • Interest Rate Increases

    PL1

    • Investment Decreases

    Price level

    PL2

    • AD & GDP Decreases

    • with lower PL

    AD1(I=$25)

    PL3

    AD2(I=$20)

    • Decreasing money supply

    • continues the “cooling” –

    • as Price Level falls.

    AD3(I=$15)

    Real domestic output, GDP


    Ap macro economics review

    Nominal Rate =

    Real Interest rate + expected rate of inflation

    Real Interest Rate =

    Nominal rate—expected rate of inflation


    Ap macro economics review

    Sm

    i%

    Dm

    Q of $$ demanded

    Money Market Graph—Nominal Interest Rate

    The supply of money is vertical no matter what the interest rate is on the vertical axis. The FED controls the supply of money.

    The demand for money is composed of the transaction demand and asset demand.

    i%e

    Qe


    Ap macro economics review

    Loanable Funds Market—Real Interest Rate

    Demand is:

    • Business for investment

    • Consumer for spending

    • Government for Deficit spending

    r

    SLF

    re

    DLF

    Supply is mostly from private savings

    Qe

    Q of LF

    Changes in the real interest rate caused by movements of demand (from borrowers) and supply (from savers).


    Ap macro economics review

    GROWTH IN THE AD-AS MODEL

    ASLR1

    ASLR2

    C

    A

    Price Level

    Capital Goods

    Q2

    Q1

    B

    D

    Real GDP

    Consumer Goods


    Ap macro economics review

    Classical View:

    √ AS is vertical and determines the output at Qf

    √ AD is stable and determines the price level as long as money supply is stable.

    √ If AD is unstable, prices and wages adjust.

    AS

    Price Level

    P1

    P2

    AD1

    AD2

    Qf

    Real Domestic Output

    A shift to AD2 shows that the price level declines.


    Ap macro economics review

    Price Level

    Real Domestic Output

    Keynesian View:

    √ Product prices and wages are downward inflexible

    √ AS is horizontal up to Qf then becomes

    vertical

    √ If AD is unstable, changes in AD have no effect on PL but affect RGDP.

    AS

    P1

    AD1

    AD2

    Q2

    Qf

    Movement from AD1 to AD2 reduces the Real GDP but the PL remains constant.


    Ap macro economics review

    NEW CLASSICAL VIEW OF SELF-CORRECTION

    Self-Correction

    AD increases moves economy from a to b.

    Price level rises (P2) and then self-correction to c by shifting left to AS2 as Nominal Wages rise.

    AS2

    ASLR

    AS1

    Price Level

    P3

    c

    b

    P2

    P1

    AD2

    a

    AD1

    Q1

    Real Domestic Output


    Ap macro economics review

    Monetary rule: supported by Monetarists and other Neo-Classical Economists like Rational Expectationists. …directs the Fed to expand the money supply each year at the same annual rate as the typical growth of the economy’s productive capacity.

    Discretionary Fiscal and Monetary Policy (especially monetary): supported by Mainstream Economists.


    Ap macro economics review

    Deficits, Surpluses and Debt

    A budget deficit is the amount by which the government expenditure exceeds the government revenue in a particular year.

    A budget surplus is the amount by which the government revenue exceeds the government expenditure in a particular year.

    The National or Public Debt is the accumulated deficits and surpluses of the government over time.


    Ap macro economics review

    Types of Budgets

    Annually Balanced—procyclical

    Cyclically Balanced—to hard to predict cycles

    Functional Finance-work for goals


    Ap macro economics review

    Comparative Advantage …is the ability to produce an item at a lower opportunity cost. Resources are scarce, so that one can only produce more of one product by taking the resources away from another. It means that total world output will be greatest when each good is produced by the nation which has the lowest domestic opportunity cost.

    √ As a result of trade, countries that trade products based on their own specialization will have more of BOTH products (produced and traded for).

    √ Terms of Trade…the exchange ratio between goods traded. This ratio explains how the gains from international specialization and trade are divided among the trading nations; it depends on the world supply and demand for the two products.


    Ap macro economics review

    Flexible exchange rates

    S

    $ Price of

    Foreign Currency

    The intersection will be the exchange rate.

    $fc

    D

    Qfc

    Quantity of Foreign Currency


    Ap macro economics review

    A nation’s Balance of Payments records all the transactions that take place between its residents and the residents of a foreign nation.

    Current Account

    Mdse. Trade

    Services Trade

    Net Investment Income

    Net Transfers

    Capital Account

    Real Investment

    Financial Investments

    Official Reserves Account

    + to balance a deficit

    —to balance a surplus

    =


    Ap macro economics review

    S

    Dollar

    Depreciates;

    FC Appreciates

    FC price of dollars

    FCP/$

    Dollar

    Appreciates;

    FC Depreciates

    S

    FC

    Depreciates;

    $ Appreciates

    D

    Dollar price of foreign currency

    Q

    Quantity of $

    $P/fc

    FC

    Appreciates;

    $ Depreciates

    D

    Q

    Quantity of foreign currency

    The Market For Currency


    Ap macro economics review

    Determinants of exchange rates:

    • Changes in tastes

    • Changes in relative incomes

    • Changes in relative prices

    • Changes in relative interest rates

    • Speculation in currencies