AP Macro Economics Review Peggy Pride, Presenter

Production Possibility Curve Capital goods B D2 D A C F B D E W Capital goods Consumer goods Consumer goods

Market Equilibrium P r i c e Supply Pe Demand Qe Quantity

A change in Demand versus a change in the Quantity Demanded √ 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.

Price Change P QD $5 4 3 2 1 10 20 35 55 80 P D o Q Price of Corn $5 10 20 30 40 50 60 70 80 Q Quantity of Corn

GRAPHING DEMAND Increase in Quantity Demanded P QD $5 4 3 2 1 10 20 35 Price of Corn P Increase in Quantity Demanded $5 4 3 2 1 CORN P QD $5 4 3 2 1 10 20 35 55 80 30 40 60 80 + Increase in Demand D’ D o 10 20 30 40 50 60 70 80 Q Quantity of Corn

A change in Supply versus a change in the Quantity Supplied √ 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.

Price Change P QD $5 4 3 2 1 10 20 35 55 80 P S o Q Price of Corn $5 10 20 30 40 50 60 70 80 Q Quantity of Corn

GRAPHING SUPPLY Increase in Supply P QS $5 4 3 2 1 60 50 35 20 5 80 70 Price of Corn P Increase in Supply S’ S $5 4 3 2 1 CORN P QS $5 4 3 2 1 60 50 35 20 5 80 70 60 45 30 Increase in Quantity Supplied o 10 20 30 40 50 60 70 80 Q Quantity of Corn

Verbal Clues Use a correctly labeled graph and show… Analyze the effect… Explain the mechanism… Identify the area of… Show the impact… Calculate (number and process)… Show price and output… Compare before and after… Two separate graphs correctly labeled graph Side-by-side What is the relationship…

Distinguish between: Price and price level AS and S AD and D ASlr ASsr o PL1 ASsr ASlr AD1 Qf Price Level Real domestic output

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.

+ + + + + + + G D = P = GROSS DOMESTIC PRODUCT Consumption Wages Expenditures Approach Income Approach Consumption by Households Wages + + Rents G D P + Investment by Businesses = + = Interest + Government Purchases Profits + + Expenditures by Foreigners Statistical Adjustments

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.

GDP Price Index x 100 = = Nominal GDP Real GDP Price Index in a given year = Price of market basket in specific year Price of same market basket in base year x 100 Real GDP = Nominal GDP Price Index (in hundredths)

Disposable Income = C + S 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

Unemployment Rate = Unemployed Labor Force Frictional – “temporary”, “transitional”, “short-term” (“between jobs” or “search” unemployment) (seasonal work) 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.

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.

CPI = x 100 Inflation A rising of the general level of prices Price of the same market basket in 2000 x 100 CPI Price of the market basket in the particular year Producer Price Index (PPI) Prices at the wholesale or production level which are early indicators of inflation.

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.

Qf is the amount of Real GDP at full employment. 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. o PL1 ASsr ASlr AD1 Qf Price Level Real domestic output

DEMAND-PULL INFLATION But…PL rises even more to PL3! 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

with government action 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 Y2 Qf Real domestic output

with NO government action 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

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 PL3[2%] c AD1 AD2 o Qf Y2 Real domestic output

The Phillips Curve Concept 7 6 5 4 3 2 1 As inflation declines... Unemployment increases Annual rate of inflation PC 1 2 3 4 5 6 7 Unemployment rate (percent)

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.

Expansionary Fiscal Policy Contractionary 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

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 AD1 AD2 MPS = .25 $490 $550 Real GDP (billions)

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 MPS = .25 AD4 $490 $550 Real GDP (billions)

Quantity of Loanable Funds Crowding —Out Effect 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

+ + M3 M2 MI Large time deposits Money market accounts Savings deposits Small time deposits M2 + Checkable deposits Travelers checks Currency MI

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. i% $$ demanded Dm i%1 Sm

√ The banking system creates a “multiplied” amount. √ 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 Money Multiplier Required reserve ratio 1 = Maximum Demand- Deposit creation = Excess reserves x Money Multiplier Currency drain and no creditable customers will decrease the amount multiplied.

EASY MONEY Goal: Cheap, available credit; increase the money supply MS i% In C AD PL RGDP Easy money is reinforced by the Net Export Effect

Quantity of money demanded and supplied Easy Monetary Policy And Equilibrium GDP Sm1 Sm2 Sm3 Investment Demand 10 8 6 10 8 6 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 PL1 AD3(I=$25) AD2(I=$20) Increasing money supply continues the growth – but, watch Price Level. AD1(I=$15) Real domestic output, GDP

Tight Money Goal: Restrict credit; decrease the money supply MS i% In C AD PL RGDP Tight money is reinforced by the Net Export Effect

Quantity of money demanded and supplied Tight Monetary Policy And Equilibrium GDP Sm3 Sm2 Sm1 Investment Demand 10 8 6 10 8 6 Real rate of interest, i Dm Quantity of money demanded and supplied Amount of investment, i AS If the Money Supply Decreases to “cool” the Economy… Interest Rate Increases PL1 Price level Investment Decreases PL2 AD & GDP Decreases with lower PL PL3 AD1(I=$25) AD2(I=$20) Decreasing money supply continues the “cooling” – as Price Level falls. AD3(I=$15) Real domestic output, GDP

Nominal Rate = Real Interest rate + expected rate of inflation Real Interest Rate = Nominal rate—expected rate of inflation

ANTICIPATED INFLATION 11% 6% = + 5% Inflation Premium Nominal Interest Rate Real Interest Rate

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. Sm i% Q of $$ demanded Dm The demand for money is composed of the transaction demand and asset demand. i%e Qe

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).

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.

Keynesian View: AS √ AS is horizontal up to Qf then becomes vertical √ 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 Price Level Real Domestic Output P1 AD1 AD2 Q2 Qf Movement from AD1 to AD2 reduces the Real GDP but the PL remains constant.

Self-Correction AS2 ASLR AS1 P3 P2 P1 AD2 AD1 Q1 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 P2 b P1 a AD2 AD1 Q1 Real Domestic Output

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.

√ 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.

The intersection will be the exchange rate. Flexible exchange rates S $ Price of Foreign Currency The intersection will be the exchange rate. $fc D Qfc Quantity of Foreign Currency

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 =

Determinants of exchange rates: Changes in tastes Changes in relative incomes Changes in relative prices Changes in relative interest rates Speculation in currencies