# AP Macro Review.

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AP Macro Review

Actual Test Day: You need: You can not have: Pencils
Pen (blue or black only) Personal ID You can not have: Phones Calculators

Part 1: The Content What is in the AP Curriculum?

Basic Economic Concepts . (8–12%)
A. Scarcity, choice, and opportunity costs B. Production possibilities curve C. Comparative advantage, specialization, and exchange D. Demand, supply, and market equilibrium E. Macroeconomic issues: business cycle, unemployment, inflation, growth

A. Scarcity, choice, and opportunity costs
All resources that are both desirable and in limited supply are considered scarce Resources can be placed into four categories Land Labor Capital (Physical AND Human) Entrepreneurship Choice Because of scarcity, we have to make choices When ever a choice is made, alternatives are forgone Opportunity cost Most desirable alternative forgone when a choice is made

B. Production possibilities curve
Shows various ways an economy can allocate scarce resources between the production of two things Each axis represents a good or service that could be produced The line/curve itself represents different combinations that utilize all available resources. Called the “Frontier” Economic growth is shown by an outward shift of the frontier. Can be caused by: More resources Better technology

C. Comparative advantage, specialization, and exchange
Focusing on the good or service that can be made at the lowest opportunity cost When calculating remember: Input problem? IOU (Input = Other goes Under) Output problem? OOO (Output = Other goes Over) Specialization Basis for global trade Countries focus on producing whatever good they can make the most efficiently and trade with other nations Exchange As long as both parties benefit, there is a net gain from trade. Trade between countries allows them to consume outside their production possibilities curves.

D. Demand, supply, and market equilibrium
Represents consumers Negative Slope Determinants (things that shift it) Consumer Tastes Price of related goods Population Consumer Income Future Prices Supply Represents producers Positive slope Determinants Technology Input costs # of suppliers Future prices

E. Macroeconomic issues: business cycle, unemployment, inflation, growth
Four Phases: Expansion/recovery – growing GDP Peak Recession/contraction – shrinking GDP Trough Unemployment Measured by the Unemployment Rate (# of unemployed)/(total labor force) = Unemployment rate Three types: Cyclical – caused by recession/economic downturn Structural – skills do not match available jobs Frictional – chose to leave job to find another/looking for first job Inflation Measured by the Consumer Price Index (CPI) [(Price in current year)/(\$ in base year)] x 100 = CPI Values > 100 indicate inflation since base year

Measurement of Economic Performance (12–16%)
A. National income accounts 1.Circular flow 2.Gross domestic product 3.Components of gross domestic product 4.Real versus nominal gross domestic product B. Inflation measurement and adjustment 1.Price indices 2.Nominal and real values 3.Costs of inflation C. Unemployment 1.Definition and measurement 2.Types of unemployment 3.Natural rate of unemployment

National Income Accounts: Circular Flow – Part 1
Simple Circular Flow Shows interaction between producers (firms) and consumers (households)

National Income Accounts: Circular Flow – Part 2
Expanded Circular Flow More realistic picture of money moving through an economy REMEMBER: Money going into each square MUST EQUAL money going out

National Income Accounts: Gross Domestic Product
GDP is the total dollar value of all final goods in services produced in a country in a given year Final goods – goods in the final form they are sold Produced within a country – only domestically produced goods count toward GDP Not counted Intermediate goods – used to make final goods Used goods – already have been counted Transfers – money changing hands (stock, bonds, social security, etc…) Foreign Produced – count toward other nations GDP Underground Economy – illegal goods and “under the table” payments

National Income Accounts: Components of GDP
Expenditure Approach – measures total spending C+I+G+NX = GDP C = consumer spending. Largest component. I = investment (business spending, inventories) G = government spending NX = net exports (imports – exports) Income Approach – measures total income Sum of all income sources Wages for labor Rents from land Interest from capital Profits from entrepreneurship Remember: Aggregate spending = Aggregate income

National Income Accounts: Real and Nominal GDP
Nominal GDP – Value of current production using current prices Real GDP – Value of current production, but using prices from a fixed point in time Also called “constant dollar GDP” Accounts for inflation More accurate “Deflating” Nominal GDP Real GDP = 100 x (nominal GDP)/(Price Index)

Inflation measurement and adjustment: Price Indexes
Main measure of inflation is the CPI Calculated by the Bureau of Labor Statistics Establishes the rate of inflation by comparing prices of a “market basket” of goods to a base year Calculating a price index Price Index = 100 x [Current year \$/Base year \$]

Inflation measurement and adjustment: Nominal and Real Values

Nominal V Real GDP Nominal GDP: GDP measured in terms of current Price Level at the time of measurement. (Unadjusted for inflation) Real GDP: GDP adjusted for inflation; GDP in a year divided by a GDP deflator (Price Index) for that year

Nominal V Real INCOME NOMINAL INCOME: number of dollars received by an individual or group for its resources during some period of time REAL INCOME: amount of goods and services which can be purchased with nominal income during some period of time; nominal income adjusted for inflation

Nominal V Real INTEREST RATE
NOMINAL I%: interest rate expressed in terms of annual amounts currently charged for interest; not adjusted for inflation REAL I%: interest rate expressed in dollars of constant value (adjusted for Inflation) and equal to the NOMINAL I% minus the EXPECTED RATE OF INFLATION

ANTICIPATED INFLATION
11% 6% = + 5% Inflation Premium Nominal Interest Rate Real Interest Rate

Nominal V Real WAGES NOMINAL WAGES: amount of money received by a worker per unit of time (hour, day, etc.); Money Wage REAL WAGES: amount of goods and services a worker can purchase with their NOMINAL WAGE; purchasing power of the nominal wage. (Real = Nominal – Inflation rate)

NOMINAL/REAL TIPs If nominal rates INCREASE and Price Level INCREASE, the CHANGE in Real is “indeterminable.” If nominal Wage rates do NOT change and Price Level fall. REAL WAGES increase. NOMINAL RATES “PIGGY-BACK” REAL RATES & NOT VICE VERSA.

Inflation measurement and adjustment: Costs of Inflation
Unexpected Inflation Hurts: Businesses that have to change prices menu costs People of Fixed incomes pension receivers & minimum wage earners People saving money at fixed interest People loaning money at fixed interest Unexpected Inflation Helps People borrowing money at fixed interest

Unemployment: Definition and Measurement
Measurements: Labor Force – Sum of all individuals over 16 that are employed or unemployed Remember: Unemployed MUST BE searching for work Not searching for work = “discouraged worker” Unemployment Rate – Unemployed/Labor Force

Unemployment: Types of Unemployment
Frictional – Someone new enters labor market OR chooses to switch jobs Seasonal – periodic/predictable job loss Structural – Jobs lost because skills are no longer in demand Cyclical – Jobs lost as a result of an economic downturn

Unemployment: Natural Rate of Unemployment
Full Employment: NO CYCLICAL UNEMPLOYEMENT Traditionally 5-6% Natural Rate of Unemployment Unemployment rate associated with full employment

National Income and Price Determination (10–15%)
A. Aggregate demand 1.Determinants of aggregate demand 2.Multiplier and crowding-out effects B. Aggregate supply 1.Short-run and long-run analyses 2.Sticky versus flexible wages and prices 3.Determinants of aggregate supply C. Macroeconomic equilibrium 1.Real output and price level 2.Short and long run 3.Actual versus full-employment output 4. Business cycle and economic fluctuations

Aggregate demand: Determinants
AD Always slopes down Wealth effect – As prices rise purchasing power of wealth falls AD Shifts when… There is a change in consumer spending There is a change in government spending There is a change in investment spending This includes changes in taxes and transfers There is a change in net exports

Aggregate demand: Multipliers
Consumption and Savings MPC = △Consumption/ △Disposable Income MPS = △Savings/ △Disposable Income MPC + MPS = 1 Spending Multiplier 1/MPS or 1/(1-MPC) Tax Multiplier MPC/MPS ALWAYS smaller then spending multiplier Taxes have a smaller impact than government spending! Commonly Used Multipliers… If MPC is The Spending Multiplier is.. .90 10 .80 5 .75 4 .50 2

Aggregate supply: Short-run v Long-run
Short Run AS Input costs and wages are “sticky” in the short run and do not change quickly This lag between changes in output price and input prices create a positive slope Long Run AS All inputs prices are flexible in the long run regardless of price level

Aggregate supply: Determinants of AS
Short run shifts △ input prices △ taxes on producers △ regulations Long Run Shifts △ Quantity and Quality of resources △ Technology △ Human capital (education and training of labor force) Policy initiatives Government programs designed to encourage investment

Macroeconomic equilibrium: Real output and price level
Macroeconomic equilibrium occurs when real output demanded is equal to real output supplied

Macroeconomic equilibrium: short and long run
Short Run Equilibrium Long Run Equilibrium OR “economy at full employment”

Macroeconomic equilibrium: Actual vs Full Employment Output

Macroeconomic equilibrium: Business Cycle and Fluctuations

IV. Financial Sector (15–20%)
A. Money, banking, and financial markets 1. Definition of financial assets: money, stocks, bonds 2. Time value of money (present and future value) 3. Measures of money supply 4. Banks and creation of money 5. Money demand 6. Money market and the equilibrium nominal interest rate B. Loanable funds market 1. Supply of and demand for loanable funds 2. Equilibrium real interest rate 3. Crowding out C. Central bank and control of the money supply 1. Tools of central bank policy 2. Quantity theory of money 3. Real versus nominal interest rates

Money, banking, and financial markets

Money, banking, and financial markets

Money, banking, and financial markets

Money, banking, and financial markets

Loanable funds market 1. Supply of and demand for loanable funds

Loanable funds market 2. Equilibrium real interest rate
Found at the intersection of Slf and Dlf

Loanable funds market 3. Crowding out
Government deficits increase the demand for loanable funds because the government bust borrow money to continue operations This drives up interest rates, and lowers business and personal investment in the economy.

Central bank and control of the money supply
1. Tools of central bank policy Open Market Operations Buying and selling bonds to influence the amount of money in circulation. Buy Bonds = Bigger Bucks - MS and AD increase, IR decreases Sell Bonds = Smaller Bucks - MS and AD decrease, IR increases Discount Rate Interest rate a central bank charges member banks for loans Higher discount rate = Lower MS, AD decreases, IR increases Lower discount rate = Higher MS, AD increases, IR decreases Reserve Requirement The amount of money banks are required to hold in reserves. Influenced the money multiplier Lower RR = higher MS, AD increases, IR decreases Higher RR = Lower MS, AD decreases, IR increases

Central bank and control of the money supply
2. Quantity theory of money Velocity of money is defined simply as the rate at which money changes hands. If velocity is high, money is changing hands quickly, and a relatively small money supply can fund a relatively large amount of purchases. if velocity is low, then money is changing hands slowly, and it takes a much larger money supply to fund the same number of purchases. The relationship between velocity, the money supply, the price level, and output is represented by the equation M * V = P * Y M is the money supply V is the velocity P is the price level Y is the quantity of output.

Stabilization Policies . (20–30%)
A. Fiscal and monetary policies 1.Demand-side effects 2.Supply-side effects 3.Policy mix 4.Government deficits and debt B. The Phillips curve 1.Short-run and long-run Phillips curves 2. Demand-pull versus cost-push inflation 3.Role of expectations

Crowding-Out Effect An 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.

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). Most “mainstream” economists are Keynesians Rational Expectations: Believes that monetary and fiscal policy have certain effects on the economy and take action to make these policies ineffective.

Economic Growth . (5–10%) A. Definition of economic growth
B. Determinants of economic growth 1.Investment in human capital 2.Investment in physical capital 3.Research and development, and technological progress C. Growth policy

Definition of economic growth
Defined as an increase in “Real GDP per capita” Per capita is used in order to isolate the effect of changes in population Sustained growth in real GDP per capita occurs ONLY WHEN the amount produced by the average worker increases steadily Productivity = output per worker

Determinants of economic growth
Investment in Human Capital Education and knowledge improve a nations work- force, making it more productive Investment in Physical Capital Equipment used to produce a good or service Technology Technical means for the production of a good or service

Growth Policy Policies that promote economic growth
Promote investments in technology, education, and capital investment

Open Economy: International Trade and Finance . (10–15%)
A. Balance of payments accounts 1.Balance of trade 2.Current account 3.Financial account (formerly known as capital account) B. Foreign exchange market 1.Demand for and supply of foreign exchange 2.Exchange rate determination 3.Currency appreciation and depreciation C. Imports, exports, and financial capital flows D. Relationships between international and domestic financial and goods markets

Balance of Payments: The sum of all transactions between U.S. residents and residents of all foreign nations Current Account: a country’s exports and imports of goods and services. Capital/Financial Account: Shows the country’s investment (financial as well as capital-plants and factories) abroad and Foreign investment in the country Credits: A credit are those transactions for which the country receives income (exports, foreign purchase of assets) Debits: Those transactions that the country must pay for: imports and purchasing of assets abroad.

Balance of Payments [continued]
The Current Account and Financial/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.

Foreign exchange market
The value of a foreign nation’s currency in relation to your own currency is called the exchange rate. An increase in the value of a currency is called appreciation. A decrease in the value of a currency is called depreciation. Multinational firms convert currencies on the foreign exchange market, a network of about 2,000 banks and other financial institutions.

Types of Exchange Rate Systems
Fixed Exchange-Rate Systems A currency system in which governments try to keep the values of their currencies constant against one another is called a fixed exchange-rate system. Flexible Exchange- Rate Systems Flexible exchange-rate systems allow the exchange rate to be determined by supply and demand.

Demand for and supply of foreign exchange
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 of dollar (Y/\$) Dollar Price of Yen (\$/Y) SY1 S\$1 P2 S\$2 P1 P1 DY2 P2 DY1 D\$1 Q1 Q2 Q1 Q2 Quantity of Yen Quantity of U.S. Dollars

Part 2: The Graphs You must be able to draw/label/manipulate these graphs

Production Possibilities Curve

AD/AS: Recessionary Gap OR “Below full employment”

AD/AS: Inflationary Gap OR “beyond/above full employment”

Money Market

Loanable Funds Market

Phillips Curve: Part I

Phillips Curve: Part II

Economic Growth Causes of Economic Growth
Increased investment in physical capital Equipment and machinery Increased investment in human capital Education and training New Technology Increase in quality/quantity of resources