AP Macro Review

Aggregate Demand Consumption, investment, govt. purchases and net exports (exports – imports) More income, more wealth = more spending Investment – purchases of new capital by businesses; interest rate rises – less investment; interest rate falls – more investment $ appreciates – U.S. goods more expensive; exports fall $ depreciates – U.S. goods less expensive; exports rise AD increases – shifts to right; P rises, GDP rises, unemployment falls AD decreases – shifts left; P falls, GDP falls, unemployment rises

MPC and MPS MPC = ∆ consumption resulting from a ∆ in income MPS = ∆ savings resulting from a ∆ in income MPC = 1 – MPS If MPC =.80 then a $100 increase in income will cause us to spend $80 Multiplier = 1/MPS ∆ in GDP = multiplier x ∆ in spending If multiplier is 5, consumption rises by $100, GDP rises by $500. If MPC =.8, multiplier is 5; income rises by $100, consumption rises by $80, GDP rises by $400 Multiplier works for any increase in spending, whether to consumption, investment, govt. purchases or net exports

Money Market Sm1Sm2 Sm3Dm i1 i2 i3 i Q Vertical S curve – S set by FED; Includes S and D for all $ in the economy

i Q D S i1 Q1 Loanable Funds Market Government deficit affects demand; Savings affects supply

Loanable funds market Increase in budget deficit increases D for loanable funds; interest rate increases Decrease in budget deficit decreases D for loanable funds; interest rate falls Increase in savings increases S for loanable funds; interest rate falls Decrease in savings decreases S for loanable funds; interest rate rises

AS AD1 P GDP GDP1 P1 AD2 P2 Expansionary Fiscal Policy or Easy Money Policy Qf ASlr

Fiscal vs. Monetary policy Expansionary Fiscal Implemented by govt. Cut taxes Increase govt. purchases Increases budget deficit Increases D for loanable funds Increases interest rate $ appreciates Easy money policy Implemented by FED Buy bonds Decrease required reserve ratio Decrease discount rate Increases S of $ in money mkt. Interest rate falls $ depreciates

AS AD2 P GDP Qf GDP1 P1 P2 Contractionary Fiscal Policy or Tight Money Policy AD1 ASlr

Fiscal vs. Monetary policy Contractionary Fiscal Implemented by govt. Increase taxes Decrease govt. purchases Decreases budget deficit Decreases D for loanable funds Decreases interest rate $ depreciates Tight money policy Implemented by FED sell bonds increase required reserve ratio increase discount rate decreases S of $ in money mkt. Interest rate rises $ appreciates

Demand-Pull Inflation P GDP AS SR1 AD1 AS LR P1 Qf AD2 Q2 AS SR2 P3 P2

Demand pull inflation if govt does not respond to the inflation In the long run, prices and wages are flexible. Increase in price level causes wages to rise. Increase in wages shifts AS in short run to left – more expensive to produce As economy approaches long run equilibrium, GDP returns to full employment GDP and unemployment returns to the natural rate of unemployment

Recession P GDP AS SR1 AD1 AS LR P1 Qf AD2 Q2 AS SR2 P3 P2

Recession if govt does not respond w/ fiscal or monetary policy In the long run, prices and wages are flexible. Wages fall when unemployment increases. decrease in wages shifts AS in short run to right – cheaper to produce As economy approaches long run equilibrium, GDP returns to full employment GDP and unemployment returns to the natural rate of unemployment

Inflation rate Unemployment rate SRPC1 SRPC2 AD AS1 AS2 P GDP P2 P1 GDP2GDP1 P goes up Unemployment rises Phillips Curve

Short run – tradeoff between unemployment and inflation; as 1 goes up the other falls If AS shifts, short run PC shifts in opposite direction If AD shifts, movement along the PC. Long run – no tradeoff between unemployment and inflation LRPC is a vertical line

Effect on AS Capital goods Consumer goods P GDP PPF1 PPF2 AS LR1 AS LR2 Qf1Qf2

Economic Growth Rightward shift of PPF curve = rightward shift of long run AS Caused by increase in technology, # or quality of natural or human resources, increase in capital stock Economic growth influenced by interest rates – if interest rates rise, I (investment) falls, capital stock declines, less economic growth

Effect on AS P GDP Inflation Unem. AS LR1 AS LR2 Qf1Qf2NRU1 NRU2 LRPC1 LRPC2

Mkt. for DollarsMkt. for Pounds U.S. Exports – English buying American wheat P in pounds Q P in dollars D1 D2 S D S1 S2 P2 P1 Q1 Q2 Q1Q2 P1 P2

Exchange rates If 1 currency appreciates, the one it’s being compared to depreciates. Interest rates and value of the currency move in same direction. If D for $ increases (b/c people want U.S. wheat or higher interest rates in U.S.), $ appreciates. The English must supply more pounds to get the dollars they demand so the pound depreciates.

Mkt. for DollarsMkt. for Pounds U.S. Imports – Americans buying English tea P in pounds Q P in dollars D1 D2 S D S1 S2 P2 P1 Q1 Q2 Q1Q2 P1 P2