AP Macro Exam Review

For all countries there are three major economic goals: Promote Economic Growth Limit Unemployment Keep Prices Stable (Limit Inflation) In this unit we will analyze how each of these are measured.

How do we know how well the economy is doing? Economists collect statistics on production, income, investment, and savings. This is called national income accounting. The most important measure of growth is GDP. Gross Domestic Product (GDP) is the dollar value of all final goods and services produced within a country’s borders in one year. Dollar value- GDP is measured in dollars. Final Goods-GDP does not include the value of intermediate goods. One Year-GDP measures annual economic performance.

REAL GDP IS THE BEST MEASURE OF ECONOMIC GROWTH! Real vs. Nominal GDP Nominal GDP is GDP measured in current prices. It does not account for inflation from year to year. Real GDP is GDP expressed in constant, or unchanging, dollars. Real GDP adjusts for inflation. REAL GDP IS THE BEST MEASURE OF ECONOMIC GROWTH!

The national economy goes up and down like a roller coaster over time The Business Cycle The national economy goes up and down like a roller coaster over time Real GDP Inflation Unemployment Peak Real GDP Trough Full Employment Recession (Contraction) Recovery (Expansion) Time A recession is 6 month period of decline in Real GDP. (If really bad…then depression)

Why is a stay at home mom not unemployed? What is Unemployment? Unemployment- Workers that are actively looking for a job but aren’t working The Unemployment Rate- The percent of people in the labor force who want a job but are not working. Unemployment rate # unemployed # in labor force x 100 = Who is in the Labor Force? Above 16 years old Able and willing to work Not institutionalized (in jails or hospitals) Not in military, in school full time, or retired Why is a stay at home mom not unemployed? 6

Effects of Unanticipated Inflation Hurt by Inflation Helped by Inflation Lenders-People who lend money (at fixed interest rates) People with fixed incomes Savers Borrowers-People who borrow money A business where the price of the product increases faster than the price of resources Nominal Wage- Wage measured by dollars rather than purchasing power Real Wage- Wage adjusted for inflation If there is inflation, you must ask your boss for a raise

Consumer Price Index (CPI) The most commonly used measurement of inflation for consumers is the Consumer Price Index (CPI) Here is how it works: The base year is given an index of 100 To compare, each year is given an index # as well = Price of market basket in base year x 100 CPI Price of market basket 1997 Market Basket: Movie is $6 & Pizza is $14 Total = $20 (Index of Base Year = 100) 2009 Market Basket: Movie is $8 & Pizza is $17 Total = $25 (Index of ) 125 This means inflation increased 25% b/w ’97 & ‘09 Items that cost $100 in ’97 cost $125 in ‘09

CPI vs. GDP Deflator The GDP deflator measures the prices of all goods produced, whereas the CPI measures prices of only the goods and services bought by consumers. An increase in the price of goods bought by firms or the government will show up in the GDP deflator but not in the CPI. = Real GDP x 100 GDP Deflator Nominal GDP If the nominal GDP in ’09 was 25 and the real GDP (compared to a base year) was 20 how much is the GDP Deflator?

Quantity Theory of Money If the real GDP in a year is $400 billion but the amount of money in the economy is only $100 billion, how are we paying for things? The velocity of money is the average times a dollar is spent and re-spent in a year. How much is the velocity of money in the above example? Quantity Theory of Money Equation: M x V = P x Y M = money supply P = price level V = velocity Y = quantity of output Notice that P x Y is Nominal GDP

Interest Rates and Inflation What are interest rates? Why do lenders charge them? Who is willing to lend me $100 if I will pay a total interest rate of 100%? (I plan to pay you back in 2050) If the nominal interest rate is 10% and the inflation rate is 15%, how much is the REAL interest rate? Real Interest Rates- The percentage increase in purchasing power that a borrower pays. (adjusted for inflation) Real = nominal interest rate - expected inflation Nominal Interest Rates- the percentage increase in money that the borrower pays not adjusting for inflation. Nominal = Real interest rate + expected inflation

What is Aggregate Demand? Aggregate- “added all together.” When we use aggregates we combine all prices and all quantities. Aggregate Demand is all the goods and services (real GDP) that buyers are willing and able to purchase at different price levels. The Demand for everything by everyone in the US. There is an inverse relationship between price level and Real GDP. If the price level: Increases (Inflation), then real GDP demanded falls. Decreases (deflation), the real GDP demanded increases.

Stagnate Economy + Inflation Still considered recessionary gap Example: If there is a negative “supply shock” of oil. What happens to PL and Output? LRAS Price Level AS1 AS Stagflation Stagnate Economy + Inflation PL1 PLe Still considered recessionary gap AD Q1 QY GDPR 13

In the long-run, wages & costs eventually decrease If consumer spending decreases, what will happen in the short-run and in the long-run? In the long-run, wages & costs eventually decrease LRAS Real GDP Price Level AS AS2 PLe PL1 Real GDP PL2 AD2 AD Q1 QY GDPR Time 14

Debates Over Aggregate Supply Keynesian Theory A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. Increase in AD during a recession puts no pressure on prices AS Price level “Sticky Wages” prevents wages from falling. The government should deficit spend to close the gap AD AD1 Q1 Qf Real domestic output, GDP 15

SRAS LRPC LRAS Price Level Inflation PLe AD2 AD SRPC AD3 QY GDPR UY Unemployment

AS1 SRAS LRPC LRAS Price Level Inflation AS2 PLe SRPC1 AD SRPC2 SRPC QY GDPR UY Unemployment

Calculating the Spending Multiplier If the MPC is .5 how much is the multiplier? Spending Multiplier OR If the multiplier is 4, how much will an initial increase of $5 in Government spending increase the GDP? How much will a decrease of $3 in spending decrease GDP? MPC = .5 the multiplier is 2 = Multiplier x Total change in GDP Initial Change in Spending 18

How is Spending “Multiplied”? Assume the MPC is .5 for everyone Assume the Super Bowl comes to town and there is an increase of $100 in Ashley’s restaurant. Ashley now has $100 more income. She saves $50 and spends $50 at Karl’s Salon Karl now has $50 more income He saves $25 and spends $25 at Dan’s fruit stand Dan now has $25 more income. This continues until every penny is spent or saved = Multiplier x Total change in GDP Initial Change in Spending

Calculating the Tax Multiplier If the MPC is .75 how much is the tax multiplier? MPC MPS Simple Tax Multiplier MPC x OR If the spending multiplier is 4, then the tax multiplier is only 3 But remember that an increase in taxes decreases GDP so the tax multiplier is negative. MPC = .5 the multiplier is 2 = Tax Multiplier x Total change in GDP Initial Change in Taxes

Increasing the Money Supply Interest Rate (ir) MS MS1 If the FED increases the money supply, a temporary surplus of money will occur at 5% interest. The surplus will cause the interest rate to fall to 2% 10% 5% 2% How does this affect AD? MD 200 250 Quantity of Money (billions of dollars) Increase money supply Decreases interest rate Increases investment Increases AD

Decreasing the Money Supply Interest Rate (ir) MS1 MS If the FED decreases the money supply, a temporary shortage of money will occur at 5% interest. The shortage will cause the interest rate to rise to 10% 10% 5% 2% How does this affect AD? MD 150 200 Quantity of Money (billions of dollars) Decrease money supply Increase interest rate Decrease investment Decrease AD 22

Using The Reserve Requirement 1. If there is a recession, what should the FED do to the reserve requirement? (Explain the steps.) Decrease the Reserve Ratio Banks hold less money and have more excess reserves Banks create more money by loaning out excess Money supply increases, interest rates fall, AD up 2. If there is inflation, what should the FED do to the reserve requirement? (Explain the steps.) Increase the Reserve Ratio Banks hold more money and have less excess reserves Banks create less money Money supply decreases, interest rates up, AD down

#2. The Discount Rate The Discount Rate is the interest rate that the FED charges commercial banks. Example: If Banks of America needs $10 million, they borrow it from the U.S. Treasury (which the FED controls) but they must pay it back with 3% interest. To increase the Money supply, the FED should _________ the Discount Rate (Easy Money Policy). To decrease the Money supply, the FED should _________ the Discount Rate (Tight Money Policy). DECREASE INCREASE

#3. Open Market Operations How are you going to remember? Open Market Operations is when the FED buys or sells government bonds (securities). This is the most important and widely used monetary policy To increase the Money supply, the FED should _________ government securities. To decrease the Money supply, the FED should _________ government securities. BUY SELL How are you going to remember? Buy-BIG- Buying bonds increases money supply Sell-SMALL- Selling bonds decreases money supply

Loanable Funds Market Example: The Gov’t increases deficit spending? Government borrows from private sector Increasing the demand for loans Real Interest Rate SLenders Real interest rates increase causing crowding out!! r1 re D1 DBorrowers QLoans Q1 Quantity of Loans 26

What happens if Europeans prefer vacationing in the United States? € Dollars $ Euros $ € S er1 S S1 ere ere D1 er1 D D Quantity of Dollars Quantity of Euros The Dollar APPRECIATES The Euro DEPRECIATES

2. Changes in Relative Incomes (Resulting in more imports)- 1. Changes in Tastes- Ex: British tourists flock to the U.S… Demand for U.S. dollars increases (shifts right) Supply of British pounds increases (shifts right) Pound-depreciates Dollar-appreciates 2. Changes in Relative Incomes (Resulting in more imports)- Ex: US growth increase US incomes…. U.S. buys more imports… U.S. Demand for pounds increases Supply of U.S. dollars increases Pound- appreciates Dollar- depreciates

3. Changes in Relative Price Level (Resulting in more imports)- Ex: US prices increase relative to Britain…. U.S. demand for cheaper imports increases… U.S. demand for pounds increases Supply of U.S. dollars increases Pound- appreciates Dollar- depreciates 4. Changes in relative Interest Rates- Ex: US has a higher interest rate than Britain. British people want to put money in US banks Capital Flow increase towards the US British demand for U.S. dollars increases… British supply more pounds Pound-depreciates Dollar- appreciates

If the Dollar appreciates, what happens to U.S. Net Exports???? U.S. Net Exports Decrease and AD Decreases If the Dollar depreciates, what happens to U.S. Net Exports???? U.S. Net Exports Increase and AD Increases