FINAL REVIEW

AP MACROECONOMICS

Unit One: Intro to Economics

A. What is Economics?Study of decisions.Why do we make decisions?

ScarcityEach decision comes with an…

Opportunity Cost-next best optionChoices are also called TRADEOFFSTwo types:

Micro-individual and business decisionsMacro-government and economy-wide

decisions

PPC or PPF: A picture of choices

Economic Growth

Absolute AdvantageA country has an absolute advantage in

the production of a good when it can produce it using few resources than another country or individual

TIP: Always plug data given into a Production Possibilities Table!

Absolute Advantage, Cont.A country has an absolute advantage in the

production of a good when it can produce it using few resources than another country or individual

TIP: Always plug data given into a Production Possibilities Table!

In this example, the US has the Absolute Advantage in both cell phones and apples

Country/Good Cell Phones (millions) Produced by 1,000 Workers

Apples (millions) Grown by 1,000

Workers

United States 13 39

Korea 12 24

Comparative AdvantageA country has a comparative advantage in

production of a certain product when it can produce that product at a lower relative opportunity cost than another country

Country/Good Cell Phones (millions) Produced by 1,000 Workers

Apples (millions) Grown by 1,000

Workers

United States 13 39

Korea 12 24

Comparative Advantage, Cont.To grow 39 million apples, the US must give up

13 million cell phones. Therefore each apple costs the US 13/39 = .33 cell phones

To grow 24 million apples in Korea, 12 million cell phones must be given up. Each apple costs Korea 12/24= .5 cell phones

The US has a comparative advantage in apples because it costs the US fewer cell phones to make an apple than it costs KoreaCountry/Good Cell Phones

(millions) Produced by 1,000 Workers

Apples (millions) Grown by 1,000

Workers

United States 13 39

Korea 12 24

B. How does an economy function?Three types:

CommandTraditionalMarket-capitalism, free-enterprise, etc.

For this class we use a market. Market-where resources follow prices

(profits), which are determined by supply and demand.

Adam Smith, incentives, equilibrium, Wealth of Nations, invisible hand, self-interest.

Simple Supply and Demand: All individual products

D: Taste Buyers Income Related Goods

S: Cost of Inputs

(Production costs) Number of sellers Related Goods

Shortages If prices are BELOW

equilibrium: There will be a

shortage as more quantity is demanded than is supplied.

Prices will RISE until they reach equilibrium.

If the price is SET below equilibrium it is a PRICE CEILING.

SurplusesIf prices are ABOVE

equilibrium: There will be a

surplus as more quantity is supplied than is demanded.

Prices will FALL until they reach equilibrium.

If the price is SET above equilibrium it is a PRICE FLOOR.

Applied Supply and Demand: The Foreign Exchange Market

Determinants (the five I’s): Interest Rates Inflation Inflows Income Interest (Taste)

FX MARKET

TO PURCHASE FOREIGN GOODS YOU NEED THAT COUNTRIES CURRENCY.

To buy goods from Europe, we need EUROS. To import, we go to the FX Market (increasing demand for Euros) and trade in dollars (increasing the supply of dollars) and get Euros (decreasing the supply of Euros).

InflationHigher price levels encourage more

imports due to their relatively lower price (Demand for other currency goes up).

Lower price levels encourage more exports due to their relatively lower price on the foreign market (Demand for our currency goes up).

Interest RatesHigher interest rates encourage more

inflows of funds as foreign investors try to save their money in America (Demand for our currency increases).

Lower interest rates encourage more outflows of funds as foreign investors try to save their money in other countries (Demand for other currency increases).

Interest (Taste)Increased taste for American products

encourages greater exports (Demand for dollar increases).

Increased taste for European products encourages greater imports (Demand for other currency increases).

InflowsInvestor worries about America would

cause them to move their money to other countries, increasing outflows. (Demand for other currency would go up).

Investor worries in other countries would cause them to move their money to America, increasing inflows (Demand for dollars increases).

IncomeRecession in America causes American

incomes to decrease, causing imports to decrease (Demand for other currencies decreases).

Expansion in America causes incomes to rise, thus Americans import more (Demand for other currency increases).

Unit Two: The Macroeconomy

I. Players in the Macro EconomyA. Buyers-ADB. Sellers-short-term=SRAS; long-term=LRASC. Cost of goods-Price levelD. Goods and Services produced-Real GDPE. Employed

Workers-Unemployment/EmploymentF. How workers spend income-MPC/MPSG. Consumption=CH. Business Purchases=IgI. Government Purchases=GJ. Net Exports=Exports-Imports

A. AD-Aggregate DemandAggregate Demand-all buyers in an

economy who are willing and able to purchase a good or service

AD=C+Ig+G+NX (all four represent the four potential buyers=consumers, businesses, government and foreigners)

AD is downward sloping because…1. Wealth Effect- as price level goes down

people feel richer and buy more.2. Interest Rate Effect-Lower price levels

(inflation) means there is a lower interest rate, so output would go up.

3. International Effect-A decrease in the price level causes our stuff to feel cheaper, which causes exports and output to rise.

B. SRAS/LRASAS-willingness of producers to sell goods and

services at specific price levels.SRAS represents short-term changes to the cost

of production. Input price changes-ex, oil costs rising Productivity gains ASSUME A QUESTION IS SHORT RUN

LRAS represents LONG-TERM changes. Four Factors of production/PPC changes:

Land Labor Capital Entrepreneurship Technology

C. Price LevelPrice level-average of all prices in a countries

economy.CPI (Consumer Price Index)-best measure of PL,

picks several items to be a representative market basket of goods.

Another way to find inflation: solve for it given nominal interest rates-real interest rates=inflation.

Demand-pull Inflation-Demand for goods causes prices to rise.

Cost-push-Decreases in Supply causes prices to rise.

Increase in price level=InflationDecrease in price level (but still

positive)=DisinflationNegative Inflation = Deflation

Two ways to solve:Market basket CPI way=EASY and

COMMON SENSE(New-old)/old=rate of inflation

Inflation 2Calculate rate of

inflation:

Quantities in Market Basket

Price in Base Year

Price in Current Year

Shoes 3 $15 $20

Foot-Long Subs

5 $5 $6

Guns 1 $30 $40

Basket AnswersInflation Rate=30% from base year to

currentGDP Deflator=100 in base and 130 in

current

Inflation: Who is hurt and helped?Helped:

People with fixed rate loansHurt:

People on a fixed incomeLenders of fixed-rate loansSavers in fixed-rate accounts

D. GDP 1Nominal GDP has not been adjusted for

inflationReal GDP is output that HAS been

adjusted for inflation (this is what you use on AD/AS graph)

GDP-Gross (Total) Domestic (In America) Product (Stuff Produced). GDP is the total amount of stuff produced in America in a given year.

GDP2Things that count in GDP:

Additions to business inventories Rent and other services like a financial consultant. Final output at final prices

Things that don’t count in GDP: Household work Intermediate Goods Illegal activity Stuff from last year’s inventories Secondhand goods Stocks and Bonds

E. Unemployment 1Four Types

Frictional-I’m between jobsStructural-My skills don’t match the existing

jobsCyclical-Caused by a recession, this is all

unemployment below full-employment. Expansionary policy targets this.

Seasonal-Freebie.

Unemployment 2Labor force-people over 16, not in the

army, who are able and willing to work.Part time workers count as EMPLOYED.

NRU-Natural Rate of Unemployment=LRPCStructuralFrictional-Can be changed via changes in unemployment compensation.

F. MPC/MPSNational Income=MPC+MPSYou can spend or you can save.I give you $500 and you spend $400, your

MPC is .80.MPS=.2Marginal Propensity to Consume or Save

G. ConsumptionHow much consumers are spendingTAX CUTS TARGET THISThe amount consumers spend is

dependent on the MPC/MPS.Consumers save some portion of all

increases in income.

H. Gross InvestmentIg is HIGHLY sensitive to Interest Rates.As IR goes up, Ig goes DOWN

Inverse Relationship AS IR goes down, Ig goes UPBest way to target this is by altering

interest rates.

I. Government SpendingNO PORTION OF G IS LOST THROUGH

SAVING.100% of an increase in GS goes into the

economy.

J. Net Exports=Exports-ImportsAppreciation=Net Exports go towards

DEFICIT as we import more.Depreciation=Net exports move towards

SURPLUS as we export more (our goods are cheaper).

NE Increase=AD IncreaseNE Decrease=AD Decrease

II. Big PictureCause effects to know:

AD INCREASE -> Real GDP INCREASE -> Income INCREASE -> Unemployment DECREASE

THE GRAPHS:AD/ASPhillips Curve

AD/AS Graph

Phillips Curve (The MISERY Index)

Unit Three: Congress We Have a Problem (The TWIN terrors and Fiscal Policy)

Economies face TWO problems: Recession and InflationRecession-decreases in Output

Caused by decreases in AD or ASIts like the economy doesn’t have enough

coffee (energy)Real problems: Unemployment, decreased

income, vicious cycle.All policies to fight recessions are

EXPANSIONARY (by increasing AD)

InflationInflation

Economy is experiencing increases in the price level.

Its like the economy has had too MUCH caffeine.

Short-run equilibrium is above full-employment.

Increasing AD ONLY increases PL (vertical portion/classical range)

Causes uncertainty in the market and various problems.

All policies to fight inflation: contractionary.

Other Problems: Supply ShocksPositive Supply Shocks (this is good)

Increase ASNegative Supply Shocks

ContractionaryDecreases ASCauses Stagflation

Ask me what we should do if we have stagflation?

THIS IS THE GOAL OF ALL ECONOMIC POLICIES

Where do these come from?Classical Economists and KeynesianClassical

Given flexible prices and wage, a classical economist would deal with a recession by doing nothing.

They believe a recession would cause wages to drop ( as employers cut costs) and thus increasing AS back to full-employment.

THIS IS A NO ACTION QUESTION, YOU HAVE TO BE ABLE TO DO THIS.

Keynesian EconomistsArgue that wages and prices aren’t

flexible, and that decreased wages would cause AD to decrease even more.

He argues that the government must take action and increase AD through government spending and tax cuts (fiscal policy).

What can the federal government do to solve this? First off, you’re voting for these people so

you BETTER care about the decisions that they make and the effectiveness of those decisions.

Federal government can do TWO things: Monetary and/or Fiscal Policy.

Fiscal Policy=CongressMonetary Policy=Fed or Central Bank

What is fiscal policy?The taxing and spending of Congress.That’s it.Four Options

Tax CutsTax IncreasesGS IncreasesGS Decreases

Taxes: TypesRegressive-poor pay moreProportional-everyone pays the sameProgressive-rich pay more

Taxes: When to change them?Inflation-raise taxes

Raise taxes->decreases C (the component of AD)->lowers AD->lowers PL/real GDP

Recession-cut taxesLower Taxes->increases C (the component of

AD)->increases AD->increases real GDP/PL

Problems with taxationPeople hate taxesBut they love tax CUTS, which increases

the DEFICIT.NOT ALL OF TAX CUTS ARE PUT BACK

INTO THE ECONOMY. MPC/MPS concept means that some of a tax cut is SAVED (the MPS percentage).100% of Government Spending increases go

straight into the economy.For example, an equal cut in taxes and cut in

government spending will DECREASE AD.

REMEMBER: Taxes target CONSUMPTION (C).

Government SpendingIncreases in GS->increase G-> increase

AD-> increase real GDP/PLIncreases the deficit.Puts 100% of money into the economy.

Decreases in GS->decrease G-> decrease AD->decrease real GDP/PLPushes budget towards surplus or balance.

GS: ProblemsCrowding Out-Loanable Funds Diagram

As the government spends more to finance its deficit spending (deficit spending means someone is LOANING them money) it increases the Demand for Loanable Funds. This increases the Real IR, encouraging private businesses to save instead of invest.

Increase in GS->increase in D for LF-> Increase in Real IR->decrease in Ig->decrease in AD->decrease in real GDP/PL

Crowding out means that expansionary government spending will be OFFSET by decreases in private Ig

Increases the deficit

The dreaded LF

Criticisms of FISCAL PolicyCrowding OutPolicy Lag Time

Policy takes FOREVER. We might have inflation by the time Congress actually got around to doing something about a recession, meaning they could MAKE IT WORSE.

Not reliableThere is no assurance that Congress will

actually follow these guidelines. For example, by cutting government spending in a recession (such as my job).

Politics sucks

MOST IMPORTANT SLIDE EVERFiscal Policy Taxes Government

Spending

Expansionary Cut Taxes Increase Government Spending

Contractionary Raise Taxes Cut Government Spending

MPC and Balanced BudgetMPC is Marginal Propensity to ConsumeMPS is Marginal Propensity to SaveMPC + MPS = 1Government Spending or Expenditure

Multiplier is 1/MPS.Tax Multiplier is 1/MPS x MPC.Balanced Budget Concept-Government

Spending has a greater effect on AD than tax cuts.

StabilizersThe federal government is set up with

automatic stabilizers that use expansionary policy in a recession, and contractionary in inflationary phases.

In a recession:Tax receipts go down so taxes are in effect,

CUT.More people are unemployed so

unemployment compensation would go UPThis process avoids a lot of the difficulties

in using fiscal policy as it is automatic.

Unit Four: Fiscal Policy

Unit Five: Monetary Policy

FundamentalsInvestment-purchase of real assets (factories,

machines).INVESTMENT IS THE BEST. Increase I

increases AD in the short run and increases LRAS!

Monetary policy influences AD/AS by effecting interest rates.

Higher interest rates decrease AD.Lower interest rates increase AD.Theory of rational expectations-Increasing the

MS on its own doesn’t increase AD because if the inflation is expected, then buying habits won’t change.

SECOND MOST IMPORTANT SLIDE EVERMonetary Policy Expansionary Contractionary

Open Market Operations

Buy Bonds Sell Bonds

Discount Rate Lower Raise

Reserve Requirement

Lower Raise

TermsFederal Reserve-central bank, conducts Monetary

PolicyDiscount Rate-Short-term interest rate on loans

from the Federal Reserve to Banks.Federal Funds Rate-Short-term interest rate on

loans from one bank to another.Prime Rate-Prime lending rate a bank will give to

people with the best credit.Fractional Reserve Banking-When you deposit

money, banks only keep a fraction and lend out the rest, allowing the money supply to be expanded.

MoneyFiat Money-money only backed by

government say so.3 Functions of Money

Store of Value-Can last for extended periods of time.

Unit of Account-can vary in prices.Medium of Exchange-can be traded for real

goods.

The Money Supply

M1-Checkable Deposits (Checking Accounts) Cash and Coins IN CIRCULATION

M2M1Savings AccountsShort Term CD’s (Money Market Accounts)

Quantity Theory of InflationMV=PQ

M is Money SupplyV is velocity of moneyP=Price LevelQ=Quantity of Real Goods SoldPQ=Nominal GDP

Assume V is constant, thus MS changes will change Nominal GDP.

Q is also unrelated to changes in MS, so price level is most directly effected by changes in MS.

Unit Six: International TradeGraphs: Foreign Exchange Market

Big Concepts: Balance of Payments, Comparative and Absolute Advantage

TermsBalance of Trade: Exports-ImportsBalance of Payments: Current Account –

Capital/Financial AccountCurrent: All real goods and services

traded between countries.Capital/Financial: All loans

(inflows/outflows) that will have to be paid back at some point.

Complex DetailsInflationary Expections-If a questions says

this phrase, its referring to producers changing supply based on inflation.Lower than expected inflation-cut input costs

thus increasing AS

Unit Six: International TradeTerms:

Shift 1: Millions of people leave AmericaWhat happens to the PPC?

Shift 2: AD/AS, Negative Supply Shock causes an Increase in the Worldwide price of oilShow the change in price level and output.

Shift 3: Phillips CurveAggregate demand increases.Point A is your before, point B your after.

Shift 4: Money MarketFederal Reserve buys bonds.Show the change to IR and QM.

Shift 5: Loanable FundsFederal government starts deficit

spending.Show the change to IR and QLF.What effect does this graph show?

Shift 6: Mexico has relatively higher interest rates than Japan.Show the change to price and quantity of

each. Mark appreciate and depreciate below each graph.