1. Concepts and Key M odels in Concepts and Key Models in AP Macroeconomics Concepts and Key M odels in Concepts and Key Models in AP Macroeconomics Sally Meek Sally Meek sally@carlylesisters.com

2. Test Specifications AP Economics Tests Microeconomics and Macroeconomics Test Date - Macro, Thursday, May 14, 2015 (afternoon) Micro, Friday May 15, 2015 (morning) Two components to test – Multiple choice questions and free response questions 2

3. Test Specifications Multiple Choice 60 questions to be answered in 70 minutes (5 answer choices per question) One point is given for each correct answer. The grade on this part of the test makes up 2/3 of the AP score. Suggestions:  Skip questions that are completely unfamiliar  Answer easy questions first  Intent of question will probably be included in stem, therefore, try to formulate an answer before you read the distractors 3

4. Test Specifications Free Response (Not Essay!) 3 Questions; 1 long question and two short questions. 10 minute reading period and 50 minutes to complete answers in answer booklet. The free response portion of the test makes up 1/3 of the AP score. Question 1 comprises half of the free response score and questions two and three comprise the other half. Suggestions:  Reading period is important – use it wisely, formulating analysis and practicing graphs  Testing conceptual knowledge, and step by step analysis, therefore, the linkages and consistency in your answer are crucial  The models generally are the proof for your answers.  Never simply make assertions! 4

5. Test Specifications Resources –  5 Steps to a 5: AP Macroeconomics/ Microeconomics by Eric Dodge, published by McGraw Hill  The Princeton Review Cracking the AP Economics Macro and Micro AP Exam by David Anderson, published by Random House Website Resources  www.apcentral.collegeboard.com – this website includes the past free response questions and answers from 1999 through 2014 www.apcentral.collegeboard.com 5

6. Models in AP Macroeconomics

7. Macroeconomics Key Graphs  Production Possibilities Frontier (opportunity cost, economic growth, trade) (opportunity cost, economic growth, trade)  Circular Flow Model National Income Accounting) (National Income Accounting)  Market Supply and Demand foreign exchange markets, money market, (foreign exchange markets, money market, loanable funds market) loanable funds market)

8. Macroeconomics Key Graphs Aggregate Supply and Demand,Aggregate Supply and Demand, Including LRAS Including LRAS (monetary policy, fiscal policy, market self regulation) Investment demandInvestment demand Money MarketMoney Market (monetary policy)

9. Macroeconomics Key Graphs  Loanable funds market (fiscal policy)  Phillips Curve – short run and long run

10. Production Possibility Frontier Good X Good Y Good X Good Y Increasing opportunity costs resources are NOT perfectly substitutable Constant opportunity costs perfectly substitutable resources

11. Potential Output at Full Employment Capital goods Consumer goods Real GDP Price Level LRAS Yf

12. Using PPFs and comparative advantage Radios Wheat 3 12 2 4 Country C Country M

13. Determining Comparative Advantage Input Output Time to produce 1 Amount produced in 1 hour Radios Wheat Radios Wheat M 20 min 5 min 3 12 C 30 mi 15 min 2 4 Input Output Time to produce 1 Amount produced in 1 hour Radios Wheat Radios Wheat M 20 min 5 min 3 12 C 30 mi 15 min 2 4 13

14. Determining Comparative Advantage Input Output Time to produce 1 Amount produced in 1 hour Radios Wheat Radios Wheat 12 3 M 20 min 5 min 3 12 5 20 4 2 C 30 min 15 min 2 4 15 30 input = under output = over Input Output Time to produce 1 Amount produced in 1 hour Radios Wheat Radios Wheat 12 3 M 20 min 5 min 3 12 5 20 4 2 C 30 min 15 min 2 4 15 30 input = under output = over 14

15. Determining Comparative Advantage Input Output Time to produce 1 Amount produced in 1 hour Radios Wheat Radios Wheat M 4 w 1/4 r 4w 1/4 r C 2 w 1/2 r 2 w 1/2 r Input Output Time to produce 1 Amount produced in 1 hour Radios Wheat Radios Wheat M 4 w 1/4 r 4w 1/4 r C 2 w 1/2 r 2 w 1/2 r 15 Opportunity Costs for the production of each product

16. Using PPFs and CPFs Assume they trade 1 r for 3 w 1 r for 3 w Radio s Wheat 3 12 2 46 4 Country M Country C

17. Circular Flow Model Households Firms Resource Market Product Market Land, labor, capital. entrepreneurial ability Rent, wages, interest, profits Goods and services Consumption expenditures Government Net taxes Public goods and services

18. National Income Accounting  GDP: total value of all new and final goods and services produced within a country’s borders in a given period 18 Expenditure Approach Personal Consumption Expenditures by households + Gross Private Domestic investment by firms + Government Purchases + Net exports (exports minus imports Income Approach Rent + Wages + Interest + Profits National Income + Statistical adjustments: depreciation, indirect business taxes and GNP to GDP adjustment

19. Definitions of Domestic Private Investment  Actual Investment = spending by firms on capital, all construction (includes residential) and changes in inventories  Planned investment or Gross Private Domestic Investment (Ig) = Net Private Domestic Investment + Depreciation (also called consumption of fixed capital or capital consumption allowance)  Actual Investment = spending by firms on capital, all construction (includes residential) and changes in inventories  Planned investment or Gross Private Domestic Investment (Ig) = Net Private Domestic Investment + Depreciation (also called consumption of fixed capital or capital consumption allowance) 19

20. Ig = In = depreciation  If Ig = depreciation, a static economy (no change in the ability to produce goods and services)  If Ig is greater than depreciation, In is positive, therefore economics growth  If Ig is less than depreciation, a declining economy  If Ig = depreciation, a static economy (no change in the ability to produce goods and services)  If Ig is greater than depreciation, In is positive, therefore economics growth  If Ig is less than depreciation, a declining economy 20

21. Perfectly Competitive Market P Q S D P1 Q1

22. Changes in quantity supplied and demanded  Caused by a changes in the product price, graphed by moving along existing curve  Demand: P increases and QD decreases and vice versa  Supply: P increases and QS increases and vice versa  Caused by a changes in the product price, graphed by moving along existing curve  Demand: P increases and QD decreases and vice versa  Supply: P increases and QS increases and vice versa 22

23. Non-price determinants for Perfectly Competitive Product Markets Demand Demand Changes in : Taste and preferenceTaste and preference IncomeIncome Marketsize (# of buyers)Marketsize (# of buyers) Consumer expectationsConsumer expectations Price of related goodsPrice of related goods complements or substitutes complements or substitutes Supply Changes in : Resource pricesResource prices TechnologyTechnology Number of sellersNumber of sellers Producer expectationsProducer expectations Taxes and subsidiesTaxes and subsidies Price of alternative goodsPrice of alternative goods Changes in Demand or Changes in Supply: Graphed by shifting the curve (creating a new curve) Changes in Demand or Changes in Supply: Graphed by shifting the curve (creating a new curve)

24. Perfectly Competitive Markets in Macro  Money Market  Loanable Funds Market  Currency Market 24

25. $/Yen Yen/$ USD Yen D$ S$ DYen SYen D$1 SYen1 Currency Markets Supply and Demand The supplier of one currency is the consumer of the other currency. The sellers of Dollars IS the buyer of Yen and the seller of Yen IS the buyer of Dollars

26. Determinants of Exchange Rates  Changes in any of the following:  Relative real interest rates  Relative price levels  Relative national income  Taste for imports  Speculation

27. Aggregate Supply and Demand PL RGDP LRAS Yf SRAS AD=C+Ig+G+Xn PL1

28. Long-run Aggregate Supply PL RGDP LRAS Yf  Determinants: changes in technology, productivity, and the quantity or quality of land, labor, capital

29. Using LRAS to illustrate Using LRAS to illustrate Economic Growth (a LONG RUN concept) PL RGDP LRAS 1 Yf 1 LRAS 2 Yf 2 Economic Growth Economic Growth

30. Using PPF to illustrate Economic Growth an increase in potential output at Yf 30

31. Short-run Aggregate Supply 31 Determinants (all long run determinants + plus determinants + plus short-run only determinants short-run only determinants changes in input costs changes in input costs and inflation expectations and inflation expectations PL RGDP SRAS

32. Short-run Aggregate Supply 32 Assumption: “sticky input prices” PL RGDP SRAS

33. Aggregate Demand 33 PL AD = C+Ig+G +Xn RGDP

34. Investment Demand RIR (As compared to the expected rate of return) Q ID As RIR changes the quantity ofAs RIR changes the quantity of Investment demanded changes Other determinants shift the ID curve:Other determinants shift the ID curve: costs of capital costs of capital business taxesbusiness taxes TechnologyTechnology expectationsexpectations

35. Determinants  LRAS –changes in technology, productivity, and the quantity or quality of land, labor, capital  SRAS – changes in technology, productivity, and the quantity or quality of land, labor, capital AND changes in input costs and inflation expectations inflation expectations  AD – changes in personal consumption spending, gross private domestic investment, government purchases and net exports

36. Spending and Tax Multipliers  Disposable Income = Consumption + Savings Income creates consumption which creates more income: this is the basis for the multiplier effect Change in output/change in spending = multiplier spending or income multiplier = 1/1-MPC or1/MPS tax multiplier = - MPC/MPS (smaller because of a leakage to savings) balanced budget multiplier = 1 ba 36

37. Money Market NIR Q1 Q MD MS i1i1i1i1 MS – affected by actions of theMS – affected by actions of the Federal Reserve Federal Reserve MD –MD – Transaction demandTransaction demand determined by GDP determined by GDP Asset demandAsset demand determined by NIR determined by NIR

38. Money Creation 38 Asset Liabilities & Net Worth required reserves excess reserves loans government securities demand deposits owner’s equity Max possible change in MS = change in er X 1/rr

39. $900 X 10 = $9000 39 Asset Liabilities & Net Worth required reserves excess reserves loans government securities demand deposits owner’s equity Assume a 10% rr and a cash deposit of $1000 $100 $900 $1000 $0

40. $900 X 10 = $9000 created in the banking system + $1000 created by Fed = $10,000 40 Asset Liabilities & Net Worth required reserves excess reserves loans government securities demand deposits owner’s equity Assume a 10% rr and the Fed buys $1000 in bonds from the public Assume a 10% rr and the Fed buys $1000 in bonds from the public $100 $900 $1000 $0

41. $1,000 X 10 = $10,000 41 Asset Liabilities & Net Worth required reserves excess reserves loans government securities demand deposits owner’s equity Assume a 10% rr and the Fed buys a $1000 bond from a bank Assume a 10% rr and the Fed buys a $1000 bond from a bank $1,000 -$1000

42. Loanable Funds Market RIR Q D LF S LF r1 Q1 Supply of Loanable Funds:Supply of Loanable Funds: personal savings and personal savings and financial capital from financial capital from abroad abroad Demand for Loanable Funds:Demand for Loanable Funds: firms demand for funds for firms demand for funds for capital and interest capital and interest sensitive consumption sensitive consumption

43. Phillips Curve – LR and SR Inflation rate LRPC Unemployment rate SRPC (assumes 4 % expected inflation at each UR) Natural rate of unemployment 2% 4% SRPC (assumes 2% expected inflation at each UR)

44.  Short-run instability associated with the business cycle  Demand Pull Inflation - during expansion  Cyclical Unemployment - during recession 44 Contraction or recession Expansion or recovery Short-run instability and the business cycle

45.  Inflation - a sustained increase in the general level of prices  Demand pull - all sectors spending outstrips production (AD increases)  Cost push - input costs increase and push up prices (SRAS decreases)  Measured with CPI, PPI and GDP deflator 45 Inflation

46. Index number price of market basket in a selected period price of market basket in base 46 X 100 Nominal and Real Numbers Nominal numbers include current prices Real numbers adjust for price level changes

47.  Nominal GDP = current prices X current output  Real GDP = base year prices X current output  or GDP/price index (in hundredths) = Real GDP  Nominal interest rates = real interest rates + expected inflation 47

48. Natural rate of unemployment  the rate of unemployment consistent with full employment level of output  the rate of unemployment with zero cyclical unemployment or with frictional and structural unemployment only Natural rate of unemployment  the rate of unemployment consistent with full employment level of output  the rate of unemployment with zero cyclical unemployment or with frictional and structural unemployment only 48 Natural rate of Unemployment

49.  Official unemployment rate (U3 unemployment rate) unemployed labor force (employed + unemployed) 49 Calculating Unemployment

50. Comparing Fiscal and Monetary Policies 50

51. 51 Assume recession PL RGDP LRAS Yf SRAS AD=C+Ig+G+Xn Y1 PL1 FiscalMonetary Decrease taxes to increase disposable income and consumption spending, And/or increase government spending Creates a deficit budget OMO -Buy bonds decreasing fed funds rate, decrease rr, decrease discount rate This increases money supply in Money market

52. FiscalMonetary Q RGDP LRAS Yf SRAS AD=C+Ig+G+Xn Y1 PL1 AD2 NIR MS MD MS1 ID RIR Q Money market Investment demand PL

53. FiscalMonetary PL RGDPYf SRAS AD=C+Ig+G+Xn Y1 PL1 AD1 SLF DLF RIR Loanable Funds Market Q DLF1

54. FiscalMonetary Xn Effects $/YenYen/$ $/Yen Yen/$ USD Yen Yen USD D$ S$ DYen SYen D$ S$ DYen SYen D$1 SYen1 SYen1 D$1 RIR increases, demand for $ increases, $ appreciates, exports decrease and imports increase, Xn decreases (or S$ decreases, with DYen decrease) NIR and RIR decreases, demand for $ decreases, $ depreciates, exports increase, imports decrease, Xn increases (or S$ increases with DYen increase) DYen increase)

55. PL RGDP LRAS Yf SRAS AD=C+Ig+G+Xn Y1 PL1 FiscalMonetary Increase taxes to decrease disposable income and consumption spending, And/or decrease government spending Creates a surplus budget OMO -Sell bonds increases fed funds rate, increase rr, increase discount rate This decreases money supply in Money market Assume demand pull inflation

56. FiscalMonetary Q RGDPYf SRAS AD=C+Ig+G+Xn Y1 PL1 AD2 NIR MS1 MD MS ID RIR Q Money market Investment demand PL

57. FiscalMonetary PL RGDP Yf SRAS Y1 PL1 AD1 SLF DLF1 RIR Loanable Funds Market Q DLF AD=+Ig++Xn AD=C+Ig+G+Xn

58. FiscalMonetary $/Yen $/Yen Yen/$ USD Yen Yen USD D$ S$ DYen SYen1 D$ S$ SYen1 D$1 SYen SYen D$1 RIR decreases, demand for $ decreases, $ depreciates, exports increase and imports decrease, Xn increases NIR and RIR increases, demand for $ increases, $ appreciates, for $ increases, $ appreciates, exports decrease, imports increase, Xn decreases Yen/$ Xn Effects

59. Balance of Payments 59 Two Major Accounts Current Account Exports + Imports - Net Income Net Transfers Balance on Current Account Financial Account Foreign owned US assets + (portfolio and real assets) Us owned assets abroad - (portfolio and real assets) Balance on Financial Account Two Major Accounts Current Account Exports + Imports - Net Income Net Transfers Balance on Current Account Financial Account Foreign owned US assets + (portfolio and real assets) Us owned assets abroad - (portfolio and real assets) Balance on Financial Account

60. Balance of payments 60 Current Account + Financial Account MUST equal zero If Current Account is in deficit then Financial Account will be an offsetting surplus If Current Account is in surplus then Financial Account will be an offsetting deficit

61. Comparing Fiscal and Monetary Policies 61

62. Fiscal Monetary Fiscal Monetary 62 Congress and The PresidentThe Federal Reserve Board of Governors and FOMC Key Tool – The Federal Budget (Expenditures and Taxes) Key Tool – The Money Supply (open market operations, reserve requirement, discount and fed funds rate) To fight inflation – Raise taxes to decrease consumption spending, And decrease government Spending Creates a surplus budget Sell bonds, increase rr Increase fed funds/discount rate Decreasing money supply in Money market

63. Fiscal Monetary Fiscal Monetary 63 Decreases AD, PL and RDO decrease Surplus budget– decreases demand for loanable funds, decreasing i Decreasing MS increases i i decreases Ig increasesi increases, Ig decreases, AD decreases, PL and RDO decreases i decreases, demand for $ decreases, $ depreciates, exports increase and imports decrease, Xn increases i increases, demand for $ increases, $ appreciates, exports decrease and imports increase, Xn decreases

64. Fiscal Monetary Fiscal Monetary 64 To fight unemployment Recession – To fight unemployment & Recession – Decrease taxes to increase Consumption spending, And increase government Spending Creates a deficit budget Buy bonds, decrease rr, Decrease discount rate/ fed funds rate Increasing money supply in Money market

65. Fiscal Monetary Fiscal Monetary 65 Increases AD, PL and RDO increase Increasing MS decreases i Deficit budget – increases demand for loanable funds increasing i i decreases, Ig increases, i increases Ig decreases (Crowding out effect) AD increases, PL and RDO Increase i increases, demand for $ increases, $ appreciates, exports decrease and imports increase, Xn decreases i decreases, demand for $ decreases, $ depreciates, exports increase, imports decrease, Xn increases

66. Classical Understanding of the Macroeconomy 66

67. PL RGDP LRAS Yf SRAS AD=C+Ig+G+Xn PL1 Classical Flexible wages, other input prices and flexible inflation expectations produce an output level at full-emploment

68. PL RGDP LRAS Yf SRAS1 AD=C+Ig+G+Xn Y1 PL1 Classical If a short-run equilibrium occurs as AD increases, as input prices and inflation expectations become flexible in the long run, wages increase and SRAS decreases If a short-run equilibrium occurs as AD increases, as input prices and inflation expectations become flexible in the long run, wages increase and SRAS decreases SRAS2

69. 69 PL RGDP LRAS Yf SRAS1 AD=C+Ig+G+Xn Y1 PL1 Classical If a short-run equilibrium occurs as AD declines, as input prices and inflation expectations become flexible in the long run, wages decrease. This increases SRAS. If a short-run equilibrium occurs as AD declines, as input prices and inflation expectations become flexible in the long run, wages decrease. This increases SRAS. SRAS2

70. 70 Classical PL RGDP LRAS Yf SRAS1 AD=C+Ig+G+Xn Y1 PL1 If a short-run equilibrium occurs when SRAS decreases, as input prices and inflation expectations become flexible in the long run, wages decrease and SRAS increases. If a short-run equilibrium occurs when SRAS decreases, as input prices and inflation expectations become flexible in the long run, wages decrease and SRAS increases. SRAS2