AP Macroeconomics Review Session One

1. 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.

2. 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)

3. Production Possibilities Graph Capital Goods Points A,B,C, are efficient pts. Point D is underutilization Point E is economic growth A E May Lead to most Future economic growth May Lead to most Future growth B D C Consumer Goods

4. 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

5. 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

6. Demand Increase: As Demand Increases, Price and Quantity Increase as well. Price S1 P2 P1 D2 D1 Q1 Q2 Quantity

7. Demand Decrease: As Demand Decreaes, Price and Quantity decrease as well Price S1 P1 P2 D1 D2 Q2 Q1 Quantity

8. 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..)

9. Supply Increase:As Supply Increases, Quantity Increases, but Price Falls. S1 Price S2 P1 P2 D1 Quantity Q2 Q1

10. Supply Decrease:As Supply Decreases, Quantity Decreases, but Price Increases. S2 Price S1 P2 P1 D1 Quantity Q2 Q1

11. 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: CheeseWine Spain: 2 pounds 2 Cases France 2 pounds 6 Cases Spain should produce cheese (1C = 1W) France should produce wine (1W = 1/3C) :

12. 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

13. 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

14. 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.

15. 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)

16. 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

17. 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

18. 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

19. 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…

20. 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

21. 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

22. 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)

23. 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%

24. 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)

25. 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

26. 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).

27. 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

28. 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

29. 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 YearBase Year PQPQ Jeans $25 5 $20 5 Pizza $20 10 $15 10 $325 = 1.3 * 100=130 $250

30. 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

31. 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.

32. 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)

33. 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)

34. 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

35. 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.

36. 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%.

37. Investment Demand Curve: Real Rate of Return 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 r1 r2 ID Q2 Quantity of Investment Q1

38. Shifts of the Investment Demand Curve A shift from ID1 to ID2 Represents an increase in Investment demand. A shift From ID1 to ID3 represents a decrease in investment Demand. PL ID2 ID1 ID3 Real GDP

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

40. 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

41. 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 Demand Determinants

42. 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)

43. 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

44. Aggregate Supply Graph Price Level AS Short Run Inflation Long Run Growth Recession Extended vertical line Illustrates the LRAS and QF (Full-Employment) QF Real GDP

45. Demand-Pull Inflation AS Price Level P2 P1 AD2 AD1 (C + I + G + X) QF Real GDP

46. Cost-Push Inflation AS2 Price Level AS1 P2 P1 AD1 ( C + I + G + X) Q2 QF Real GDP

47. 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.

48. Expansionary Used to Fight a Recesssion LOWER TAXES INCREASE GOVERNMENT SPENDING Contractionary Used to fight Inflation RAISE TAXES DECREASE GOVERNMENT SPENDING Types of Fiscal Policy

49. 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

50. 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