1. AP Macro Economics Review

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

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

5. 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.

6. 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.

7. Economic growth
The Rule of 70 is a device that can find the number of years it will for some amount to double.
# of yrs to double the real GDP = 70
annual rate of growth
Take the growth rate in 2004 of 4.0
70/4.0 = 17.5 years for Real GDP to double
Imagine that the rate of growth was 10%? Only 7 years to double!

8. 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.

9. + + + + + + + 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

10. 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.

11. GDP Price Index An Alternative Method x 100 = = = Nominal GDP Real GDP
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)
An Alternative Method
Price Index
(in hundredths) =
Nominal GDP
Real GDP

12. 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

13. GDP understates the well-being…
√ by not counting non market transactions
√ by not measuring Improved Product Quality
√ by not considering Leisure Time
GDP Overstates the well-being…
√ by ignoring the Composition and Distribution of Output
√ GDP and the Environment
Per Capita GDP measures the GDP in terms of goods and services per person

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

15. 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.

16. GDP Gap and Okun’s Law
√ The basic loss of unemployment is forgone output. √ Potential GDP is the capacity of the economy assuming the Natural Rate of Unemployment. The growth of the Potential GDP assumes the normal growth rate of the real GDP.
GDP GAP is the amount by which actual GDP falls short of potential GDP
For every 1% the unemployment rate exceeds the natural rate…Approximately a 2% GDP Gap occurs.

17. 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.
70 divided by rate of inflation (expressed as whole numbers) will yield the number of years for the price level to double.

18. Theories of Inflation:Demand Pull
√ Excess of total demand
√ prices are bid upward by the excess demand
√ economy is seeking a point beyond its PPC when full employment-full production is evident Qf
Increases in total spending
Quantity
Range 2
Range 3 P r i c e l v
Range 1

19. Theories of Inflation:Cost Push
√ prices rising when output and employment are both declining
√ aggregate demand not excessive
√ Per unit production costs are rising due to raw materials, energy, labor, etc.
√ High per unit costs cause decline in profit; hence, the price level is “pushed up” by these costs.
Abrupt increases in the costs of raw materials or energy inputs drive up per-unit production costs and hence prices.

20. COLA-helps to stay up with rising prices
Unanticipated Inflation
Those who benefit
Those who lose
Flexible Income
Fixed Income
Spenders
Savers
Debtors
Creditors
COLA-helps to stay up with rising prices

21. 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.

22. 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

23. 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

24. 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

25. 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

26. 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

27. The Phillips Curve Concept7 6 5 4 3 2 1
As inflation declines...
Unemployment
increases
Annual rate of inflation PC
Unemployment rate (percent)

28. 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.

29. 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

30. 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
$490
$550
Real GDP (billions)
MPS = .25

31. 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
AD4
$490
$550
Real GDP (billions)
MPS = .25

32. Built-in Stability
Some changes in relative levels of government expenditures and taxes occur automatically.
This is not like discretionary changes in spending and tax rates since these net tax revenues vary directly with RGDP.
…tends to increase the government deficit (or reduce the surplus) during recession or to increase the surplus ( or reduce the deficit) during inflation without requiring specific action by policy makers.

33. 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

34. Fiscal policy weakened by NET EXPORT EFFECT
Expansionary fiscal policy
Problem: Recession
More government spending and/or lower taxes
Higher domestic interest rates
(crowding-out effect)
Increased foreign demand for dollars (foreigners want to earn higher interest)
Dollar appreciates
Net Exports decline
(AD decreases, partially offsetting expansionary policy)
Contractionary fiscal policy
Problem: Inflation
Lower government spending and/or higher taxes
Lower domestic interest rates
(government role in loanable funds market is less)
Decreased foreign demand for dollars (foreigners find
higher rates elsewhere)
Dollar depreciates
Net Exports increase
(AD increases, partially offsetting contractionary policy)

35. Supply-Side Economics
Supply-Side Economics aims to manipulate aggregate supply by enacting policies designed to stimulate incentives to work, to save and invest (including measures to encourage entrepreneurship).
These policies may include tax cuts which will increase disposable incomes, thus increasing household saving and increase the profitability of investments by businesses.
Tax cut stimulates more consumption, saving and investment to increase AD.
The new investment moves the AS curve to the right. Work incentives push more workers into employment and they spend and save increasing AD further.
Low taxes act to push risk takers to move toward new production methods and new products.

36. Laffer Curve
…shows the relationship between tax rates and tax revenues
√ Up to a point, higher tax rates will result in larger tax revenues.
√ But still higher tax rates will adversely affect incentives to work and produce, reducing the size of the tax base and reducing tax revenues.
√ Lower tax rates will lessen tax evasion and avoidance, and reduce government transfer payments.

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

38. 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

39. Creation of Money in the Banking System
Money supply is increased when:
1. Banks issue loans to customers and receive a demand deposit.
2. Banks buy securities from the public and credit a demand deposit for the cost.
Money supply is decreased when:
1. Customers repay loans take money from their demand deposit.
2. Banks sell securities to the public and a demand deposit is reduced to pay for the bond.

40. √ 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.

41. 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

42. 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

43. 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

44. 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

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

46. 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

47. 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).

48. GROWTH IN THE AD-AS MODEL
ASLR1
ASLR2 C A
Price Level
Capital Goods Q1 Q2 B D
Real GDP
Consumer Goods

49. 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.

50. 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.

51. 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

52. Monetary rule : supported by Monetarists and other Neo-Classical Economists like Rational Expectationists. …directs the Fed to expand the money supply each year at the same annual rate as the typical growth of the economy’s productive capacity.
Discretionary Fiscal and Monetary Policy (especially monetary): supported by Mainstream Economists.

54. 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.

55. Types of Budgets Annually Balanced—procyclical
Cyclically Balanced—to hard to predict cycles
Functional Finance-work for goals

56. √ 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.

57. 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

58. 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 =

59. The Market For Currency
FCP/$ Q D S
FC price of dollars
Quantity of $
Dollar
Depreciates;
FC Appreciates
Appreciates;
FC Depreciates
$P/fc Q D S
Dollar price of foreign currency
Quantity of foreign currency FC
Depreciates;
$ Appreciates
Appreciates;
$ Depreciates

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