Presentation on theme: "AP Macroeconomics Review Session One"— Presentation transcript:
1 AP Macroeconomics Review Session One Key Vocabulary Terms and Key Graphs.This is a fairly comprehensive review largely based on the 2000 and 2005 released Multiple Choice Exams and the recent Free Response Questions.
2 Production Possibilities Assumptions:Full EmploymentFixed Resources and TechnologyMovementsAlong curve shows opportunity costOutward shift illustrates economic growthInward shift indicates destruction of resourcesProducing Capital Goods will lead to greater economic growth than producing consumer goods. (Butter will lead to more growth than guns)
3 Production Possibilities Graph Capital GoodsPoints A,B,C, are efficient pts.Point D is underutilizationPoint E is economic growthAEMay Lead to mostFuture growthMay Lead to mostFuture economic growthBDCConsumer Goods
4 Economic Systems Capitalism=Free Market Most decisions made by Private businessesCommunism=Command EconomyMost decisions made by the governmentMixed Economy=Features of both Capitalism and CommunismDecisions made by both the market and governments
5 Supply and Demand Factors Demand Changes when:Income changesRelated Products, complements and substitutes, (price or quality change)Expectations (future price change)Consumers (more or less added)Tastes, Fads, Preferences change
6 Demand Increase: As Demand Increases, Price and Quantity Increase as well.
7 Demand Decrease: As Demand Decreaes, Price and Quantity decrease as well
8 Supply Factors Supply Changes When: Input prices change (resources and wages)Government (tariffs, quotas, and subsidies)Number of sellers changeExpectations (about price and product profitability change)Disasters (weather, strikes, etc..)
9 Supply Increase: As Supply Increases, Quantity Increases, but Price Falls. D1QuantityQ1Q2
10 Supply Decrease: As Supply Decreases, Quantity Decreases, but Price Increases.
11 Comparative Advantage A nation should specialize in producing goods in which it has a comparative advantage: ability to produce the good at a lower opportunity cost.Example:Cheese WineSpain: 2 pounds 2 CasesFrance 2 pounds 6 CasesSpain should produce cheese (1C = 1W)France should produce wine (1W = 1/3C):
12 Currency TermsAppreciation: Currency is increasing in demand (stronger dollar)U.S. Currency will appreciate when more foreigners: travel to the U.S., buy more U.S. goods or services, or buy the U.S. dollar to invest in bonds
13 Currency TermsDepreciation: Currency is decreasing in demand (weaker dollar) Being SUPPLIED in exchange for other currency.U.S. Currency will depreciate when fewer foreigners: travel to the U.S., buy fewer U.S. goods or services, or sell the U.S. dollar to invest in their own bonds
14 Circular Flow of Economic Activity Households supply resources (land, labor, capital, entrepreneurial ability) to the resource market. Households demand goods and services from businesses.Businesses demand household resources and supply goods and services to the product (factor) market.
15 GDP (Gross Domestic Product): The total dollar (market) value of all final goods and services produced in a given year. Expenditure Formula:Consumption (C) + Business Investment (I) + Government Spending (G) + Net Exports (x)
16 GDP: What Counts: Goods Produced but not Sold (I) Goods produced by a foreign country (Japan) in the U.S. (Honda, Toyota)Government spending on the militaryIncrease in business inventories
17 GDP: What DOES NOT count: Intermediate Goods (Tires sold by Firestone to Ford)Used GoodsNon-Market Activities (Illegal, Underground)Transfer Payments (Social Security)Stock Transactions
18 Shortcomings of GDP: Leading to GDP being understated. Nonmarket activities: (services of homemakers) does not count.Leisure: Does not include the value of leisure.Does not include improvements in product quality.Underground economy
19 GDP: Overstated Includes damage to the environment Includes more spending on healthcare-Americans being unhealthy.Includes money spent to fight crime-more police officers, more jails, etc…
20 Real GDP Real GDP= Nominal GDP adjusted for inflation. Calculation: Price Index in Hundredths( deflator)Example:U.S Real GDP= $12,4558 (billions)(based on 2000)$ Trillion
21 Real GDP Per CapitaMost commonly used to compare and measure each country’s standard of living and overall economic growth.Real GDP/Nation’s Population
22 Business CyclesThe increases and decreases in Real GDP consisting of four phases:Peak: highest point of Real GDPRecession: Real GDP declining for 6 monthsTrough: lowest point of Real GDPRecovery: Real GDP increasing (trough to peak)
23 Unemployment Calculation: Number of Unemployed Labor Force (Multiplied by 100 to put as a %)The Labor Force is the total of employed and unemployed workers.U.S. unemployment should be about 5%
24 Employed You are considered to be employed if: You work for 1 hour as a paid employee (so part-time workers count)You are temporarily absent from work (illness, strike, vacation)You work 15 hours or more as an unpaid worker (family farms are common)
25 UnemployedMust be looking for work (at least 1 attempt in the past 4 weeks)Are reporting to a job within 30 daysThey are temporarily laid off from their job
26 Types of UnemploymentFrictional: Have skills that are in demand; just need time to find a job (College Graduate)Structural: Current skills do not match job openings (Factor jobs being outsourced; Flight attendant after 9/11/2001).Frictional + Structural = Natural Rate of Unemployment (Full –Employment rate)Cyclical: Due to a recession (Requires Government action).
27 Not In Labor Force A person who is not looking for work: Full-time studentsStay at home parentsDiscouraged workers: those who have given up hope of finding a job.Retirees
28 Inflation Rise in the general level of prices Reduces the purchasing power of moneyMeasured with the Consumer Price Index (CPI)Reports the price of a market basket , more than 300 goods that are typically purchased by an urban household
29 Consumer Price Index (CPI) CPI = Recent Price of Market BasketPrice of same basket in base year(This number is then multiplied by 100)Example: Assuming only 2 GoodsRecent Year Base YearP Q P QJeans $ $Pizza $ $$325 = 1.3 * 100=130$250
30 Calculating Inflation CPI in Recent Year – CPI in Past YearDivided by CPI in Past Year(Number then Multiplied by 100)Example: CPI = 179.92001 CPI = 177.1Rate of Inflation: = 1.58%177.1
31 Types of InflationDemand Pull Inflation: ‘too much money chasing too few goods.”AD Curve will shift to the right, resulting in a higher Price Level and greater Output (up til FE)Cost-Push Inflation: Major cause is a supply shock-OPEC cutting back on oil productionAS Curve will shift to the left resulting in a higher Price Level and a decrease in Real GDP.
32 Real and Nominal Terms Real Income = Nominal Income Price Index (Hundredths)Real Interest Rate = Nominal Interest Rate – Inflation RateNominal Interest Rate = Real Interest Rate Inflation Premium(anticipated inflation)
33 Inflation: Winners & Losers Debtors who borrow money that will be repaid with “cheap” dollars.Those who have anticipate inflationLosers:Savers (especially savings accounts)Creditors (Banks will be repaid with those “cheap” dollarsFixed-Income Recipients (retirees receiving the same monthly pension)
34 Consumption and Saving As income increases, both consumption and savings will increase.The determinants of overall consumption and savings are: (More money or a positive outlook will increase consumption and reduce savings. Less money or a negative outlook will increase savings and reduce consumption.Wealth (financial assets)Expectations about future prices and incomeReal Interest RatesHousehold DebtTaxes
35 Marginal Propensities Marginal Propensity to Consume (MPC) and the Marginal Propensity to save (MPS) must equal 1.The MPS is used to derive the spending multiplier, which equals:MPSIf the MPS is .2, the spending multiplier is 5.Any increase in spending must be multiplied by 5 to determine the overall increase in Real GDP.
36 Interest Rate-Investment Expected Rate of Return: Amount of Profit (expressed as a percentage) a business expects to gain on a project/investment.This rate must be greater than the interest in order to be profitable.The Real Rate of Return is most important. An expected profit of 10%, that costs 5% in interest = The real rate of return: 5%.
37 Investment Demand Curve: Real Rate ofReturnAt lower real interest rates businesses willIncrease investment , leading to an increaseIn AD (aggregate demand). At higher rates ofInterest, less money will be investedr1r2IDQ1Q2Quantity of Investment
38 Shifts of the Investment Demand Curve A shift from ID1 to ID2Represents an increase inInvestment demand. A shiftFrom ID1 to ID3 represents adecrease in investmentDemand.PLID2ID1ID3Real GDP
39 Aggregate Demand Downward sloping: Real-Balances Effect: change in purchasing power2. Interest-Rate Effect: Higherinterest rates curtail spendingForeign Purchase Effect:Substitute foreign products forU.S. productsPriceLevelAD (C + I + G + X)Real GDP
40 Aggregate Demand Determinants of AD: C + I + G + X (Yes, its GDP) An increase in any of these, due to lower interest rates or optimism will increase AD and shift the curve to the right.A decrease in any of these: more debt, less spending, tax increase, will cause a decrease in AD and shift the curve to the left
41 Aggregate Demand Determinants ConsumptionWealthExpectationsDebtTaxesInvestmentInterest RatesExpected ReturnsTechnologyInventoriesGovernmentChange in Gov. spendingNet ExportsNational Income AbroadExchange Rates
42 Aggregate Supply Factors: R: resource prices (wages and materials, as well as OIL)A: actions by government (Taxes, Subsidies, more regulation)P: productivity (better technology)
43 Aggregate Supply Short Run: Long Run: Assumes that nominal wages are “sticky” and do not respond to price level changes.Is Upward sloping as businesses will increase output to maximize profitsLong Run:Curve is vertical because the economy is at its full-employment output.As prices go up, wages have adjusted so there is no incentive to increase production.
44 Aggregate Supply Graph Price LevelASShort RunInflationLong RunRecessionGrowthExtended vertical lineIllustrates the LRAS andQF (Full-Employment)QFReal GDP
45 Demand-Pull Inflation ASPrice LevelP2P1AD2AD1 (C + I + G + X)QFReal GDP
46 Cost-Push Inflation AS2 Price Level AS1 P2 P1 AD1 ( C + I + G + X) Q2 QFReal GDP
47 Fiscal PolicyUsing Taxes and Government spending to stabilize the economy.Controlled by the President and CongressDiscretionary Fiscal Policy: Congress must take action (change the tax rates) in order for the action to be implemented.Automatic Stabilizers: Unemployment benefits, Progressive Tax System, these changes are implemented automatically to help the economy.
48 Types of Fiscal Policy Expansionary Contractionary Used to Fight a RecesssionLOWER TAXESINCREASE GOVERNMENT SPENDINGContractionaryUsed to fight InflationRAISE TAXESDECREASE GOVERNMENT SPENDING
49 Expansionary Fiscal Policy Increasing Government Spending and or cutting taxes will shift AD to the right and increase output and the price level.As1Price LevelP2P1AD2AD1 ( C + I + G + X )Real GDPQ1QFE
50 Tax MultiplierRemember, if the government decreases taxes, the result is not as great as a spending increase, since households will save a portion (MPS) of the tax cut.The Tax Multiplier = MPC X Spending Multiplier.Example: If the MPC is .8 and the MPS is .2Spending Multiplier = 1/.2 or 5Tax Multiplier = .8 X 5 or 4
51 Loanable Funds Market & Expansionary Fiscal Policy Used for FISCAL POLICY (Government spending-Deficit Spending)Real Interest RateAn increase in Gov. spending increases the demand for loanable funds and raises real interest ratesR2R1D2D1Q1Q2Quantity of Funds
52 Crowding-Out EffectAn Expansionary Fiscal Policy as previously diagrammed will lead to higher interest rates.At higher interest rates, businesses will take out fewer loans and there will be a decrease in INVESTMENT (I)At the same time there will be a decrease in CONSUMER SPENDING (C) as they will take out fewer loans as well.This CROWDING OUT EFFECT will reduce the gain made by the expansionary fiscal policy.
53 Net Export Effect & Expansionary Fiscal Policy Government spending has led to an increase in interest rates.At higher interest rates, foreigners demand more U.S. dollars to invest in bonds.This leads to an appreciation of the U.S. dollar.This leads to a decrease in Net Exports, as foreigners now have to exchange more of their currency for the U.S. dollar to buy exports.This decrease in Net Exports will reduce AD and counter to some extent the expansionary fiscal policy.
54 Contractionary Fiscal Policy Raising taxes or reducing government spending to fight inflation and stabilize the economy.Price LevelASP1P2AD1AD2QFReal GDP
55 Loanable Funds Market & Contractionary Fiscal Policy Used for FISCAL POLICY (Government spending-Deficit Spending)Real Interest RateA decrease in Gov. spending decreases the demand for loanable funds and lowers real interest ratesR1R2D1D2Q2Q1Quantity of Funds
56 Net Export Effect & Contractionary Fiscal Policy A decrease in government spending has led to a decrease in real interest rates.At lower interest rates, foreigners demand less U.S. dollars to invest in bonds.This leads to a depreciation of the U.S. dollar.This leads to an increase in Net Exports, as foreigners now have to exchange less of their currency for the U.S. dollar to buy exports.This increase in Net Exports will increase AD and further strengthen the contractionary fiscal policy.
57 Criticisms of Fiscal Policy Timing ProblemsRecognition Lag: identifying recession or inflationAdministrative Lag: getting Congress/President to agree to take actionOperational Lag: Time needed to see the results of the fiscal policyPolitical Business Cycles: Politicians may take inappropriate action to get reelected (lower taxes during an inflationary period). Plus it is difficult to raise taxes
58 M1= Checkable Deposits and Currency Money Supply TermsM1= Checkable Deposits and CurrencyM2= M1 + Savings deposits, money market accounts, small time deposits (less than $100,000)Velocity of Money Equation:MV = PQ ( GDP) (M= Money Supply and V = Velocity (number of times per year the average dollar is spent on goods and services.
59 The Federal Reserve System (FED) Control Monetary PolicyHeadquartered in Washington D.C.12 Federal Reserve DistrictsBoard of Governors (7 members) is the central authorityMembers are appointed by the President and confirmed by the Senate
60 Federal Open Market Committee (FOMC) Made up of 12 people: Board of Governors + New York FED President + 4 other regional presidents (who rotate)Meets regularly to direct OPEN MARKET OPERATIONS (buying or selling of bonds) to maintain or change interest rates
61 Banks and Balance Sheets Assets LiabilitiesReserves $15,000 Checkable Deposits $100,000Securities $15,000Loans $70,000If the current reserve requirement is 10%:1. What is the amount of new loans this bank can generate?Answer: $100,000 Checkable deposits X a 10% reserve requirement = $10,000 required reserves. If the bank has $15,000 in reservers, $5,000 of those are excess reserves and can be loaned out .2. How much in new loans can be generated by the entire bankingsystem?Answer: Money Multiplier = 1/Required Reserve Ratio=1/.1010 X $5,000 = $50,000
62 FED and the Money Market Nominal InterestRateMS1MS2Vertical curve-Supply controlledBy the FED. An increase in MSleads to a rightward shift andlower interest rates.I1I2MDQ1Q2Quantity of Money
63 Easy Money PolicyBuying Government Bonds, lowering the discount rate, or lowering reserve requirements, to fight a recession, by decreasing interest rates, increasing investment spending and/or consumption and increasing AD.ASPrice LevelP2AD2P1AD1 (C + I + G + X)Q1QFReal GDP
64 Effects of an Easy Money Policy LOWER INTEREST rates which will lead to an INCREASE in INVESTMENT and CONSUMPTION.The U.S. dollar will DEPRECIATE, leading to an increase in NET EXPORTS as well.These effects STRENGTHEN the overall monetary policy (opposite of fiscal policy’s crowding-out and net export effect
65 FED and a TIGHT Money Policy Nominal InterestRateMS2MS1Vertical curve-Supply controlledBy the FED. A decrease in theMoney supply, shifts the MScurve to the left and raisesinterest rates.I2I1MDQ212Quantity of Money
66 Tight Money PolicySelling bonds, raising the discount rate, or raising reserve requirements to fight inflation which will raise interest rates, decrease investment and/or consumption and decrease Aggregate Demand (AD).Price LevelASP1P2AD1AD2QFReal GDP
67 Effects of a Tight Money Policy At the higher interest rates, INVESTMENT SPENDING, and CONSUMPTION will decrease.At higher interest rates, the U.S. dollar will APPRECIATE (foreigners demand more U.S. securities). This will lead to a DECREASE in NET EXPORTS.Again, the Monetary Policy is STRENGTHENED as a result, unlike the effects of a contractionary fiscal policy.
68 Extended AD-AS Model This is the other way to graph the AD-AS Model Price LevelLRASSRASP1ADQFReal GDPThe intersection of the 3 curvesIs the Full-Employment Equilibrium
69 Extended AD-AS Model and Demand-Pull Inflation In Demand-Pull Inflation, the AD curve has shifted to the right of the LRAS and SRAS intersection.LRASPrice LevelSRASP2PFAD2AD1QFQ2Real GDPThe Price Level and Real GDP has increased.
70 Extended AD-AS and Demand-Pull Inflation Mainstream economists will fight inflation as previously discussed: with either a tight monetary policy or a contractionary fiscal policy. The goal would be to move the aggregate demand curve to the left.Classical economists would argue to DO NOTHING. As nominal wages rise, the SHORT-RUN AS curve will shift to the left (resources and wages are becoming more expensive), restoring the economy to its full-employment output level, but with a higher Price Level.
71 Extended AD-AS Model and Cost-Push Inflation Cost-Push inflation occurs when the SRAS has shifted to the leftOf the LRAS and AD intersection.LRASPrice LevelSRAS1Here the Price level hasIncreased and REAL GDPhas decreased.P1SRAS2PFAD1Q1QFReal GDP
72 Extended AD-AS and Cost-Push Inflation Mainstream economists must decide whether to target the Price Level or Unemployment, before taking any action.Classical economists would argue to DO NOTHING. Eventually, wages and resource prices must decrease and when they do the SRAS curve will shift back to the right, restoring the economy to its full-employment output level and the original Price Level.
73 Extended AD-AS Model and Recession In a recession due to a decrease in AD, the AD curve is to the left of the LRAS and SRAS intersection; showing a decrease in boththe Price Level and Real GDP.LRASPrice LevelSRASPFP1ADQ1QFReal GDP
74 Extended AD-AS and Recession Mainstream economists will fight a recession as previously discussed: with either an easy money policy or an expansionary fiscal policy. The goal would be to move the aggregate demand curve to the right.Classical economists would argue to DO NOTHING. The decrease in wages and resource prices will shift the SRAS curve to the right, restoring the economy to its full-employment output level, but with a LOWER price. (SELF-CORRECTION)
75 Short-Run Phillips Curve Suggests an inverse relationship between the inflation rate and the unemployment rate.InflationRate(percent)When the unemployment rate isLow (2%), the inflation rate willMost likely be high (8%).8When theUnemployment rateIs high, inflation willlikely be low.2SRPC128Unemployment Rate (percent)
76 Short-Run Phillips Curve When the Government fights unemployment, typically higher inflation will result. When the Government fights inflation, typically, more unemployment will result. Thereby, we move along the Short-Run Phillips Curve.InflationRate(percent)B72ASRPC136Unemployment Rate (percent)
77 Shifting the Short-Run Phillips Curve The Short-Run Phillips curve can also shift, this would mean that both the unemployment rate and inflation rate are changing at the same time.Inflation Rate%Stagflation, unemployment andInflation occurring together(OPEC decreasing Oil supply,causes this type of shift)54SRPC2SRPC167Unemployment Rate %
78 Shifting the Short-Run Phillips Curve The Short-Run Phillips curve can also shift, this would mean that both the unemployment rate and inflation rate are changing at the same time.When Supply increases(productivity surge in 90s)more than demand, prices will fall, while GDP and employmentIncrease; shifting the curve to the left.Inflation Rate %53SRPC1SRP257Unemployment Rate %
79 Long-Run Phillips Curve The Long-Run Phillips Curve is vertical, like the Long Run Aggregate Supply Curve. So, in the long run there is no tradeoff between inflation and unemployment. Only the Price Level will change.LRPCInflation Rate%3SRPC5Unemployment Rate %
80 Laffer CurveWhat is the optimal tax rate? A tax of 0% will provide no tax revenue. A tax rate of 100% will also lead to no tax revenue (no incentive to work). Answer must be somewhere in between.Tax Rate100Tax Revenue
81 Economic Growth Five Factors connected to long run economic growth. Supply Factors:Increase in natural resources (quantity and quality)Increase in human resources (quantity and quality)Increase in capital goodsImprovements in technologyDemand Factors:Increase in consumption by households, businesses, and government
82 Illustrating Economic Growth Production Possibilities CurveCapital GoodsBAPPC2PPC1Consumer Goods
83 Illustrating Long Run Growth Can also be illustrated with the extended AD-AS Model.LRAS2LRAS1SRAS2SRAS1Price LevelP2P1AD2AD1Q1Q2Real GDP
84 Budget PhilosophiesAnnually Balanced Budget: Government will spend whatit makes.Problem: Does not have money during a recession, it will not be able to increase spending to help the economy.If there is inflation, it will also be forced to spend the extra moneyIn both cases the economy will be worse offCyclically Balanced Budget: Government will finance a deficit during a recession and pay it off with tax revenue received during expansion.Problem: A long recession may run up a large deficit that a short expansion period can not pay off
85 National Debt ($8.7 Trillion and growing) Functional Finance: A deficit is necessary to balancethe economy. The national debt should not be worriedabout too much.Causes of the Debt:1. Wars2. Recessions3. Lack of Fiscal DisciplineConcerns:1. Interest Payments2. Income Gap (Debt and interest payments held by the wealthy)2. Crowding Out
86 Economic Philosophies Classical: Believes that the government SHOULD NOT interfere in the economy. And believes in self-correction of economic problems.Keynesian: Believes that GOVERNMENT SHOULD interfere in the economy (taxes, government spending)
87 International TradeComparative Advantage and Specialization allows for economic growth and efficiency. (More of each good can be obtained by trading-Trading line illustrates this)Trade barriers create more economic loss than benefits.Today there is a trend towards free trade and a reduction in trade barriers.Strongest arguments for protection are the infant industry and military self-sufficiency arguments.WTO oversees trade agreements and disputes, but has become a target of protesters lately.
88 Foreign Exchange Market Let’s say a U.S. citizen travels to Japan. This transaction will provide a supply of the U.S. dollar and result in a demand for yen. It will become cheaper for the Japanese to buy the dollar and more expensive for Americans to buy the Yen. The Yen is Appreciating and the dollar is Depreciating.Yen Price ofdollarDollar Priceof YenS1S1P2S2P1P1D2P2D1D1Q1Q2Q1Q2Quantity of YenQuantity of U.S. Dollars
89 Balance of Payments: The sum of all transactions between U. S Balance of Payments: The sum of all transactions between U.S. residents and residents of all foreign nationsCurrent Account: Shows U.S. exports and U.S. imports of goods and services.Capital Account: Shows the U.S. investment (financial as well as capital-plants and factories) abroad and Foreign investment in the U.S.Credits: A credit are those transactions for which the U.S. receives income (exports, foreign purchase of assets)Debits: Those transactions that the U.S. must pay for: imports and purchasing of assets abroad.
90 Balance of Payments continued The Current Account and Capital Account must be equal.Official Reserves Account: The Central Banks of all nations hold foreign currency to make up any deficit in the combined capital and current accounts.If the U.S. has more credits than debits it finances this difference by dipping into its reserve account.