1. AP Macro Exam Review

2. 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.

3. 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.

4. 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!

5. 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)

6. 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

7. 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

8. 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
Market Basket: Movie is $6 & Pizza is $14
Total = $20 (Index of Base Year = 100)
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

9. 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?

10. 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

11. 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

12. 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.

13. 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

14. 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

15. 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

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

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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. #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

25. #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

26. 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

27. 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

28. 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

29. 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

30. 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