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CAP MACRO REVIEW
The Three Types of Capital
Physical capital
•Machinery
•Plant
•Equipment
Human capital
•Education, skill level, experience
Financial capital
•Money
Unemployment Rate
Unemployment Rate = Number UnemployedLabor Force
x 100
• If given the number of employed and unemployed, you can sum both to get the labor force (sometimes you will be given the total civilian population to use and will need to subtract those who are not a part of the labor force)• Remember to take out those not actively looking for a job and
discouraged workers
Labor Force Participation Rate
Labor forceTotal population age 16 and over x 100
Nominal GDP
Nominal GDP = Deflator x Real GDP100
• This is the prices we see and pay for good and services
Real GDP
•Real GDP = Nominal GDP
GDP Deflator or Price Index
OR
•Real GDP= Nominal GDP
GDP Deflator or Price Index in hundredths
6
x 100
GDP
Good Price Quantity Total
Shoes $50 10 $500
T-shirts $10 50 $500
Socks $6 100 $600
$1,600
Nominal GDP: Sum of all Prices x Quantities
GDPGood 2015
Quantity2015 Price(Base year)
2016Quantity
2016 Price
Shoes 10 $50 12 $60
T-shirts 10 $10 15 $15
Socks 5 $6 10 $8
Nominal GDP in 2015 = 10 (50)+ 10(10) + 5(6) = 500+100+30= $630
GDP
Real GDP in 2016 = 12 (50)+ 15(10) + 10(6)= 600+150+60= $810
Take the 2016 quantities times the 2015 prices since 2015 is the base year
Good 2015Quantity
2015 Price(Base year)
2016Quantity
2016 Price
Shoes 10 $50 12 $60
T-shirts 10 $10 15 $15
Socks 5 $6 10 $8
GDP Deflator
10
GDP Deflator = Nominal GDPReal GDP
x 100
•The GDP deflator measures the prices of all goods (not just the market basket) produced in a nation relative to a base year
Inflation• Inflation is calculated year to year unlike the CPI, which is calculated relative to a base year
• If given the value of inflation in two different years, you can calculate the change in inflation
CPI= Year 2 - Year 1Year 1 or base year
x 100
Price Index/CPI•A price index/CPI: a number that summarizes what happens to a weighted composite of prices of a selection of goods over time
•The price index (CPI) is always 100 in the base year unless otherwise stated
•CPI is the most commonly used measurement of inflation
•Looks at a market basket of about 400 goods and services
CPI• If given the value of market baskets in two different years, you can calculate the CPI
•**The CPI is a number, not a percentage
CPI= Value of market basket in current year Value of market basket in base year
x 100
Calculating the Market Basket, Inflation, and CPI
Year Basket Price Inflation Rate
CPI
2015 $16 --
2016 50
2017 $40
2018 25%
2019 $56
Complete the table
Calculating the Market Basket, Inflation, and CPI
• Start by finding the market basket values first
• Start with 2018. You see that prices increased 25% from 2017 (the base year)• What is 25% of $40 (the value of the basket in 2017)?
• $10• So…the value of the market basket in 2018 must be $50• Double check: [50-40/40] x 100 = 25%
Calculating the Market Basket, Inflation, and CPI
• Finding the market basket value for 2016• Based on the 2016 CPI value of 50, you know that prices are 50%
less than they were in 2017• So, that means the 2016 market basket is $20
Calculating the Market Basket, Inflation, and CPI
• Calculate the inflation rate for 2017:• [20-16/16] x 100= 25%
Calculating the Market Basket, Inflation, and CPI
• Calculate the CPI for 2018• [50/40] x 100=125
Calculating the Market Basket, Inflation, and CPI
Year Basket Price Inflation Rate
CPI
2015 $16 -- 40
2016 $20 25% 50
2017 $40 100% 100
2018 $50 25% 125
2019 $56 12% 140
Completed table
AS/AD
•Demand pull inflation: inflation that occurs when the economy is at or above potential output
•There is an excess demand for goods
• In the short run it will be represented by an increase in AD
• In the long run, the economy would adjust back to equilibrium as SRAS decreases (wages and prices decrease)
AS/AD
•Cost-push inflation: inflation that occurs when the economy is below potential output
•Usually due to an increase in input costs
•Will be represented on an AS/AD graph by a decrease (leftward) shift in SRAS
•Stagflation would led to a decrease (leftward) shift in SRAS
AS/AD
•What happens to AS/AD when there is no government action (no change in taxes or government spending?)
• If in a recessionary gap: SRAS shifts to the right (increases) as wages and input prices decrease
• If in an inflationary gap: SRAS shifts to the left (decreases) as wages and input prices increase
Investment Spending
•Private domestic investment spending (I)
•Domestic spending by firms on capital stock
•Capital stock: the amount of capital goods available for use in the production of goods and services
•Capital goods: goods used to produce other goods and services
Supply Shocks
•A negative supply shock is a decrease in supply and raises prices
•A positive supply shock is an increase in supply and lowers the price of goods
Impact of Fiscal and Monetary Policies on AS/AD
What fiscal and monetary policies will lead to an increase in AD?
• Expansionary fiscal policies
• Increase in government spending
• Decrease in taxes
• Expansionary monetary policies
• Increase in MS
• Buying bonds (open-market purchase)
• Decrease in reserve requirement
• Decrease in discount rate
How do expansionary policies affect each of the following?
• Relative income
• When SRAS is horizontal or upward sloping, AD increases and real GDP increases
• Relative inflation rates
• When SRAS is horizontal there is no change in PL
• When SRAS is upward sloping or vertical, AD increases and PL increases
• Relative interest rates
• It depends
Simple (Fiscal) Spending Multiplier
•Multiplier=1/MPS
•Multiplier= 1/(1– MPC)
• If given the amount of the gap, divide it by the multiplier to determine how much must be spent in order to get to long run equilibrium
•Total change in GDP equals the spending multiplier x initial change in spending
Tax Multiplier• It is always one less than the simple spending multiplier (transfer payments work the same way)
•Tax multiplier = MPC/MPS
•Or: MPC x Spending Multiplier
•Use the one that makes the math easier
Interest Rates
• Simply put, if inflation increases, so do nominal interest rates
• Example: Increase in AD leads to a higher price level
•Result: Increase in demand for money and a higher NIR
• Then, the supply of loanable funds decreases (due a higher NIR the RIR is also higher)
Interest Rates and Investment Spending
• Short-term borrowing by firms is a function of nominal interest rates
• Long-term borrowing by firms is a function of real interest rates
•All else equal:
•When the real interest rate increases, investment spending decreases
•When the real interest rate decreases, investment spending increases
Interest Rates
•Nominal interest rate: the stated or published rate (the rate you “see”)
•Nominal interest rate = Real interest rates + expected rate of inflation
• In the short-run (before inflationary expectations have changed) nominal and real interest rates move together
Interest Rates
•Real interest rate: the actual cost of borrowed money
•Real interest rate = Nominal - expected rate of inflation
• In the long-run (once inflationary expectations have been factored in to decision-making) nominal interest rates adjust to achieve a desired real interest rate
Nominal and Real Interest Rates(Money Market and Loanable Funds Graphs)
•Money Market graph and expansionary monetary policy
• In the short run:
• Increase money supply
•Decreases interest rates
• Increases investment (consumer spending & GDP)
• In the long run:
• This will increase the price level and increase the demand for money
• Consistent with Quantity Theory of Money MV=PY
•A increase in the money supply increases inflation but real GDP stays the same
Nominal and Real Interest Rates(Money Market and Loanable Funds Graphs)
• Loanable Funds is a long run graph
• Real interest rate= Nominal interest rate – inflation
• If more inflation that is expected, it decreases the supply of loanable funds and increases the (nominal) interest rate
• Borrowers would also demand more loans because inflation would make those loans easier to pay back in the future
• So, nominal interest rate increases due to inflation, but the real rate stayed the same
• The Fisher effect: an increase in expected inflation causes nominal interest rates to increase
•See Mr. Clifford Video Money Market and Loanable Funds
Bond Prices and Interest Rates
•**Bond prices and interest rates are always inversely related**
Expansionary Monetary Policy and Expansionary Fiscal Policy
Expansionary Fiscal Policy
Expansionary Monetary Policy
Determinate or Indeterminate
AD Increase Increase Determinate
Real GDP Increase Increase Determinate
Employment Increase Increase Determinate
Price level Increase Increase Determinate
Interest rates Increase Decrease Indeterminate
Investment spending Decrease Increase Indeterminate
Expansionary monetary policy mitigates the increase in real interest rates caused by expansionary fiscal policy
How do monetary policies affect the economy in the long-run?
• If there is an increase in the money supply:
•Nominal interest rate decreases
•AD increases
• Real GDP increases
• Price level increases
How do monetary policies affect the economy in the long-run?
• The long-run neutrality of money
• Potential output is a function of economic resources
•Money is NOT an economic resource
• Changes in the money supply have NO affect on potential output
• The long-run effects of expansionary monetary policy:
•Real GDP: no change
• Employment: no change
• Price level: increase
The Federal Funds Rate
•Federal funds are loans of excess reserves that banks make to one another
•The federal funds rate is the interest rate that banks charge one another for one-day loans of reserves
•By selling bonds, the Fed decreases reserves•This causes the federal funds rate to increase (banks have less
reserves to loan out)•By buying bonds, the Federal increases reserves•This causes the federal funds rate to decrease (banks have more
reserves to loan out)
The Federal Funds Rate as an Operating Target
• If the federal funds rate is above the Fed’s target range, it buys bonds to increase reserves and lower the federal funds rate
• If the federal funds rate is below the Fed’s target range, it sellsbonds to decrease reserves and raise the federal funds rate
Money Market• MS shifters are the three tools used by the Fed:
• Open-market operations (buying/selling of bonds)
• Reserve requirement
• Discount rate
• MD shifters
• Changes in income (or real GDP)
• Changes in the price level
• Changes in expectations (of prices)
• Changes in preferences
• MD Examples (how you might see it in the FRQs):
• A drop in credit card fees causes consumers to use credit cards more often (increases MD)
• Consumers hold less cash and use credit cards more often (decreases MD)
• Consumers’ income increases (increases MD)
Loanable Funds• The market for borrowers and savers
• Loanable funds are demanded by borrowers, businesses, and the government
• Demand shifters (Borrowers and investors):
• Government borrowing (increase D or Decrease S)
• Government deficit spending (leads to crowding out)
• Demand for loanable funds examples (how you might see it in the FRQs):
• A country’s government increases deficit spending
• An increase in government borrowing from the public
• Increase in a country’s budget deficit
• Businesses are granted a tax credit for spending on machinery
Loanable Funds• Supply shifters (Lenders and savers):
• Increase in savings (public savings)
•Higher real interest rate on assets (increases supply)
• Supply for loanable funds examples (how you might see it in the FRQs):
• Increase in a country’s national savings
•Government reduces tax rate on household interest earnings
• The tax rate on household interest earning is lowered
• The government issues a special tax incentive to get individuals to increase savings for retirement
Loanable Funds• Supply for loanable funds is also the same as demand for bonds as
savers want to generate income on savings
•Demand for loanable funds is also the same supply of bonds as firms and governments issue bonds to raise financial capital
• (This is not something we covered in class; I don’t expect you will see it on the AP exam)
Loanable Funds and Crowding Out
•Assume that the economy is in a recessionary gap and that the government is operating a balanced budget
• The government implements an expansionary fiscal policy to close the recessionary gap
• So, there is an increase in government spending and/or decrease in taxes
•AD shifts to the right
• But, this expansionary fiscal policy caused the balanced budget to move into a deficit
•As a result, there is an increase in the demand for loanable funds, which increases the real interest rate, and crowds out domestic private investment spending
Creation of Money • Required reserve ratio is 10%. Adam Smith deposits $100 in the bank.
•What is the maximum dollar amount the bank can loan out?
• $90 ($100-$10)
•What is the maximum change in demand deposits?
• $1,000 (100 x 10)
•What is the maximum change over time in loans?
• $900 (90 x 10)
•What is the maximum change over time in the money supply?
• $900 (90 x 10)
•Watch Mr. Clifford Bank Balance Sheets Video
Creation of Money • Required reserve ratio is 10%. The Fed buys $1,000 in bonds.
•What is the maximum dollar amount the bank can loan out?
• $1,000
•What is the maximum change in the money supply?
• $10,000 (1,000 x 10)
•What is the maximum change in checkable bank deposits?
•No change (buying bonds does not impact customer accounts)
•What is the maximum change in required reserves?
• $1,000 (bonds become reserves until loaned out)
•Watch out for a question that asks about the public buying bonds…you would then have to hold 10%
Bank Balance Sheet
•Maximum change in anything= initial change x the money multiplier
•Maximum change in the money supply= (initial change in excess reserves x multiplier) + initial change in money supply
Bank Balance Sheet
Assets Liabilities
Required reserves $10,000Loans $70,000Treasury bonds $20,000
Demand deposits $100,000
What is the reserve ratio?
Bank Balance Sheet
Assets Liabilities
Required reserves $10,000Loans $70,000Treasury bonds $20,000
Demand deposits $100,000
What is the reserve ratio?10%
Bank Balance Sheet
Assets Liabilities
Required reserves $10,000Loans $70,000Treasury bonds $20,000
Demand deposits $100,000
How are reserves impacted if a customer withdraws $5,000?
Bank Balance SheetAssets Liabilities
Required reserves $10,000Loans $70,000Treasury bonds $20,000
Demand deposits $100,000
How are reserves impacted if a customer withdraws $5,000?The bank will need to increase reserves by $4,500 (needs to hold 10% of $9,500 but only has $5,000 in reserves)
Assets Liabilities
Required reserves $5,000Loans $70,000Treasury bonds $20,000
Demand deposits $95,000
Impact of Fiscal Policy on the Budget
When the budget balance is negative, the government is running a deficit
When the budget balance is zero, the government is running a balanced budget
When the budget balance is positive, the government is running a surplus
Expansionary fiscal policy causes receipts to decrease and outlays to increase
Expansionary fiscal policy causes receipts to decrease and outlays to increase
Expansionary fiscal policy causes receipts to decrease and outlays to increase
The government will have to borrow money to pay for the increase in the deficit
The government will have to borrow money because it goes into a deficit
The government will have to run down its surplus to pay for the expansionary policy
Demand for loanable funds increases; real interest rate increases
Demand for loanable funds increases; real interest rate increases
Supply of loanable funds decreases; real interest rate increases
Balanced Budget and Fiscal Policy• Changes in government spending have a greater effect on AD than changes in taxes or
transfer payments
• Spending multiplier: 1/1-MPC or 1/MPS
• Tax multiplier (and transfer payment multiplier): MPC/MPS
• If MPC is 0.75:
• The spending multiplier is 4
• The tax multiplier is 3
• If the government increases spending by $10 billion:
• AD increase by $40 billion (10 x 4)
• If the government raises taxes by $10 billion, AD decreases by $30 billion (10 x 3)
• The net effect on the budget balance=no change
• The net effect on AD= Increase of $10 billion
Economic Growth
An increase in the amount of resources
•An increase in natural resources
•An increase in the amount of labor
•An increase in the labor participation rate
An increase in the productivity of existing resources
• Technological advancement
•An increase in physical capital per worker
•An increase in human capital per worker
What causes economic growth?
Economic Growth
•Why is economic growth a good thing?
• In general, the higher a nation’s real GDP per capita, the higher the standard of living for people in that nation
•What are the limits of using an increase in real GDP as a measure of economic prosperity?
• Real GDP per capita = Real GDP/Population
• If population increases faster than real GDP increases, real GDP per capita falls
•Neither real GDP nor real GDP per capita measure income distribution
Economic Growth
• Economic growth is the real GDP per capita over time illustrated by shifts in the PPC and LRAS
What causes economic growth?
• Productivity gains (increase in output per worker)
How does productivity increase?
• Capital formation: development of capital stock (physical and human
• Development of application of new production technologies
What leads to capital formation?
• Investment spending
Economic Growth• Private domestic investment spending drives economic growth
• Investment spending is spending on capital stock
• The more capital stock, the greater the productive capacity of an economy
• Productive capacity is a function of resources: land, labor, and capital
• Investment spending is a function of real interest rates
•When real interest rates rise, investment spending falls
•A decrease in investment spending causes the economic growth rate to slow, because fewer capital goods are being adding to the economy’s productive capacity
Economic Growth
•How does crowding out factor in to economic growth?
•An increase in government borrowing for deficit spending (due to an expansionary fiscal policy) causes a decrease in private domestic spending due to an increase in real interest rates
Public Policy and Economic Growth• Technological advancements
• Subsidies or tax credits for firms that engage in research and development
• Government spending on programs that lead to technological innovation
• Increase in physical capital per worker
• Subsidies or tax credits for firms that engage in investment spending on physical capital
• Government spending on infrastructure
• Human capital per worker
• Subsidies or tax credits for firms that provide education or job training
• Government spending on education and job training
Rational Expectations Theory
• Looks at past trends but also the best information available to make a best guess of what inflation might be
• If inflation was 2% last year and is 4% this year, but the economists model predicts 2% inflation for the next year, individuals will expect 2% inflation
Short-Run Phillips Curve
• Shifts:
• Changes in productivity
• Changes in input prices
• Changes in inflationary expectations
•SRPC shifts opposite of SRAS
Short-Run Phillips Curve
•A change in AD will move along the SRPC
• If AD increases, inflation increase and unemployment decreases
• If AD decreases, inflation decreases and unemployment increases
Price Level
AD1
SRAS
Real GDPY1
P1
LRASInflation
SRPC
UnemploymentUY
LRPC
AD2
P2
Y2
Result: Higher inflation and lower unemployment
6%
5%
U1
Short-Run Phillips CurveIncrease in AD
Short-Run Phillips CurveIncrease in Inflationary Expectations
Inflation
SRPC1
UnemploymentUY
LRPC
SRPC2
U1
Inflation and unemployment increase
6%
5%
What Shifts LRPC?
•Since LRPC is tied to the natural rate of unemployment (NRU), only a change in frictional or structural unemployment would cause it to shift