AP_Macro_Review - AP Macroeconomics Exam Review Mr Zywicki(Modified by Mr Miller Production Possibility Curve Production B2 Capital Capital goods

AP_Macro_Review - AP Macroeconomics Exam Review Mr...

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Unformatted text preview: AP Macroeconomics Exam Review Mr. Zywicki (Modified by Mr. Miller) Production Possibility Curve Production B2 Capital Capital goods Capital Capital goods B D2 D A B C W Consumer goods F D E Consumer goods Market Equilibrium Market P r i c e Supply Pe Demand Qe Quantity A change in Demand versus a change in the Quantity Demanded the Change in Demand √ Moves the curve •Income •Future Expectations •# of Buyers Change in Quantity Change Demanded Demanded √ Moves Along the SAME Moves SAME curve curve • Caused only by Price change. change. •Consumer Information •Taste and Preference •Substitutes and Complements A change in Supply versus a change in the Quantity Supplied the Change in Supply Change in Quantity Change Supplied Supplied √ Moves the curve •Costs of Production •Future Expectations •# of Sellers √ Moves Along the SAME Moves SAME curve curve • Caused only by Price change. change. •Taxes and Subsidies •Prices of goods using same resources •Time period of production 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 = of _______70__________ _______70__________ annual % rate of growth annual Take the growth rate in 2004 of 4.0 Take 70/4.0 = 17.5 years for Real GDP to double 70/4.0 Imagine that the rate of growth was 10%? Imagine Only 7 years to double! Only GROSS DOMESTIC PRODUCT GROSS Defining… Market Value of the total goods and services produced goods within the boundaries of the US whether by Americans or US foreigners in one year. foreigners GROSS DOMESTIC PRODUCT Expenditures Approach Consumption by Households Income Approach Wages + Expenditures + Rents + Interest + Profits + Statistical by Foreigners Adjustments + Investment G by Businesses =D = + Government P Purchases NOMINAL GDP vs. REAL GDP NOMINAL 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. 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. GDP Price Index GDP Price Index in a given = year Price of market basket in specific year Price of same market basket in base year Real GDP = Nominal GDP Price Index (in hundredths) An Alternative Method Price Index = (in hundredths) Nominal GDP Real GDP x 100 Disposable Income Disposable By subtracting from Personal Income, By the dollars lost to taxes, we have the Disposable Income. This is the “bottom” line of national income accounting. line Disposable Income = C + S GDP understates the well-being… GDP √ by not counting non market transactions √ by not measuring Improved Product Quality √ by not considering Leisure Time by GDP Overstates the well-being… √ by ignoring the Composition and by Distribution of Output Distribution √ GDP and the Environment Per Capita GDP measures the GDP in terms of goods and services per person Unemployment Rate = Unemployed Unemployed Labor Force Frictional – “temporary”, “transitional”, Frictional “short-term” (“between jobs” or “search” unemployment) unemployment) Structural – “technological” or “long term”. Structural basic changes in the “structure” of the labor force which make certain “skills obsolete”. force Cyclical – “economic downturns” in the Cyclical business cycle. business The Full employment rate of unemployment or the Natural Rate of Unemployment (NRU) is Rate is present when the economy is producing its potential output. producing The Natural Rate of Unemployment The exists when the cyclical unemployment is zero. is GDP Gap and Okun’s Law GDP √ 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. growth • GDP GAP is the amount by which actual GDP falls GDP short of potential GDP short • For every 1% the unemployment rate exceeds the For natural rate…Approximately a 2% GDP Gap occurs. occurs. Inflation A rising of the general level of prices Price of the market basket CPI = in the particular year x 100 Price of the same market basket in 2000 Producer Price Index (PPI) Prices at the wholesale or Producer 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. Theories of Inflation:Demand Pull Theories √ Excess of total demand Excess √ prices are bid upward by the excess demand prices √ economy is seeking a point beyond its PPC when full employment-full production is evident evident Range 3 P r i c e l e v e l Range 2 Range 1 Increases in total spending Qf Quantity Theories of Inflation:Cost Push Theories √ prices rising when output and employment are both declining both √ aggregate demand not excessive aggregate √ Per unit production costs are rising due to raw materials, energy, labor, etc. materials, √ High per unit costs cause decline in profit; hence, the price level is “pushed up” by these costs. the Abrupt increases in the costs of raw materials or Abrupt energy inputs drive up per-unit production costs and hence prices. Unanticipated Inflation Those who benefit Those who lose Those Flexible Income Fixed Income Spenders Savers Debtors Creditors COLA-helps to stay up with COLA-helps rising prices rising Real and Nominal Income Real Nominal income … is the number of dollars earned as rent, wages, interest or profit earned Real income… measures the amount of measures goods and services nominal income can buy. goods √ 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. nominal √ Your real income falls only when nominal Your income fails to keep up with inflation. income Long Run Equilibrium Price Level ASlr PL1 o In the extended In ASsr AD-AS model, equilibrium occurs at the intersection of AD and the ASlr AD and the ASsr. and Qf is the amount of Real GDP at full AD1 full employment. Qf Real domestic output Price Level DEMAND-PULL INFLATION and Self-Correction and PL3[7%] PL2[5%] PL1[2%] o ASlr AS2sr ASsr Short Run— Increase in AD Increase shows point b point Long Run Long Nominal Wages rise and AS2sr c rise moves left. b RGDP returns to previous a level on Aslr level AD2 But…PL rises But…PL even more to AD1 PL3! PL Qf Y2 Real domestic output Price Level PL3[5%] COST-PUSH INFLATION with government action ASlr AS2sr ASsr c b PL2[3%] a PL1[2%] o AD1 Y2 Q f If government stimulates AD to dotted line, an inflationary spiral will occur…PL3 at will Qf. We have Full Employment but at a higher price level. higher AD2 Real domestic output Price Level COST-PUSH INFLATION with NO government action ASlr AS2sr c PL3[5%] a PL1[2%] If government lets If ASsr the recession take its course, nominal wages will fall in the long run and return to point a… return PL1 at Qf. AD1 o Qf Real domestic output Price Level Recession Recession ASlr AS1sr AS2sr a PL1[5%] PL2[3%] b c PL3[2%] This decline in the price level will eventually shift the AS1sr to shift AS2sr. Price level AS sr. declines to PL3 declines at Qf . Shown at at point c. point AD1 AD2 o Y2 Qf Real domestic output The Phillips Curve Concept Annual rate of inflation 7 As inflation declines... 6 5 4 Unemployment increases 3 2 1 0 PC 1 2 3 4 5 6 7 Unemployment rate (percent) The Phillips Curve The Summary The short run Phillips Curve is downward sloping. Aggregate Demand changes move along the same Aggregate short run Phillips curve. short Aggregate Supply changes create new short run Aggregate Phillips curves. Phillips √ In the long run, there is not a stable relationship In between unemployment and inflation. between √ The long-run Phillips curve is the vertical line at the The natural rate of unemployment. natural Expansionary Fiscal Policy Expansionary 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 Income – Consumption and Income – Saving Relationships •Personal Saving (S) •Consumption (C) •Disposable Income (DI) •S = DI - C •45-Degree Line •The Consumption Schedule •The Saving Schedule •Break-even Income CONSUMPTION AND SAVING APC Consumption / Income APS Saving / Income MPC Change in Consumption Change in Income MPS Change in Saving Change in Income CONSUMPTION AND SAVING Consumption SAVING Saving DISSAVING DISSAVING C Consumption schedule C o 45 MPC = Slope of C o MPC + MPS = 1 Disposable Income Saving schedule MPS = Slope of S S o S Disposable Income SAVING EXPANSIONARY FISCAL POLICY the multiplier at work... $20 billion decrease in tax rates; $15 billion in $20 new consumption spending new Price level AS $60 billion increase in increase Aggregate Aggregate Demand P2 P1 AD1 $490 $550 $550 MPS = .25 AD2 Real GDP (billions) CONTRACTIONARY FISCAL POLICY the multiplier at work... $20 billion increase in tax rates; $15 billion lost $20 in consumption spending in Price level AS $60 billion decrease in decrease Aggregate Aggregate Demand P2 P1 AD4 $490 $550 MPS = .25 AD3 Real GDP (billions) THE MULTIPLIER EFFECT Multiplier Change in GDP Change in Real GDP = Initial Change in Spending = Multiplier x initial change in spending For Example… THE MULTIPLIER EFFECT (2) (3) Change in Change in (1) Saving Change in Consumption (MPC = .75) (MPS = .25) Income Increase in Investment of $5 $ 5.00 $ 3.75 $ 1.25 Second Round 3.75 2.81 .94 Third Round 2.81 2.11 .70 Fourth Round 2.11 1.58 .53 Fifth Round 1.58 1.19 .39 All Other Rounds 4.75 3.56 1.19 $20.00 $15.00 $ 5.00 Total THE MULTIPLIER EFFECT Multiplier Effect and the Marginal Propensities Inverse relationship between: Multiplier & MPS Multiplier Change in GDP = 1 MPS or = Multiplier x 1 1 - MPC initial change in spending FULL-EMPLOYMENT GDP Aggregate Expenditures (billions of dollars) Recessionary Gap AE0 530 AE1 510 Recessionary Gap = $5 Billion 490 Full Employment o 45 o 490 510 530 Real domestic product, GDP (billions of dollars) FULL-EMPLOYMENT GDP Aggregate Expenditures (billions of dollars) Inflationary Gap 530 AE2 AE0 Inflationary Gap = $5 Billion 510 490 Full Employment o 45 o 490 510 530 Real domestic product, GDP (billions of dollars) Built-in Stability Built-in Some changes in relative levels of government expenditures and taxes occur automatically. automatically. This is not like discretionary changes in spending and tax rates since these net tax revenues vary directly with RGDP. directly …tends to increase the government deficit (or tends reduce the surplus) during recession or to increase the surplus ( or reduce the deficit) during inflation without requiring specific action by policy makers. without Real Interest Rate, (percent) Crowding —Out Effect Crowding S i% i% D2 Increased Increased demand for loanable funds by government raises the interest rate. interest D LF0 LF1 Quantity of Loanable Funds Fiscal policy weakened by NET EXPORT EFFECT Expansionary fiscal policy Expansionary Problem: Recession More government spending More and/or lower taxes and/or Contractionary fiscal policy Problem: Inflation Lower government spending and/or higher taxes higher Higher domestic interest rates (crowding-out effect) Lower domestic interest rates (government role in loanable funds (government market is less) market Increased foreign demand for Increased dollars (foreigners want to earn higher interest) higher Dollar appreciates Net Exports decline Net (AD decreases, partially offsetting expansionary policy) offsetting Decreased foreign demand for dollars Decreased (foreigners find higher rates elsewhere) higher Dollar depreciates Net Exports increase Net (AD increases, partially offsetting contractionary policy) contractionary 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 save entrepreneurship). These policies may include tax cuts which will increase tax disposable incomes, thus increasing household saving and increasing increase the profitability of investments by businesses. increase •Tax cut stimulates more consumption, saving and investment Tax to increase AD. to •The new investment moves the AS curve to the right. Work The incentives push more workers into employment and they spend and save increasing AD further. and •Low taxes act to push risk takers to move toward new Low production methods and new products. Laffer Curve …shows the relationship between tax rates shows and tax revenues and √ Up to a point, higher tax rates will result higher in larger tax revenues. in √ But still higher tax rates will adversely affect incentives to work and produce, reducing the size of the tax base and reducing tax revenues. reducing √ Lower tax rates will lessen tax evasion and avoidance, and reduce government transfer payments. transfer THE LAFFER CURVE Tax rate (percent) 100 l 0 Tax revenue (dollars) THE LAFFER CURVE Tax rate (percent) 100 m l 0 Tax revenue (dollars) THE LAFFER CURVE 100 Tax rate (percent) n m l 0 Tax revenue (dollars) THE LAFFER CURVE Tax rate (percent) 100 n m m Maximum Tax Revenue l 0 Tax revenue (dollars) M M O N E Y E A S U R E S • Large time deposits Large M3 • Money market accounts Money • Savings deposits Savings • Small time deposits Small M2 + + • Checkable deposits Checkable • Travelers checks Travelers • Currency Currency MI MI The Money Market i% i%1 Sm Supply of Supply money is a vertical line since monetary authorities (FED) and financial institutions have provided Dm the economy with a certain stock of money. $$ demanded Creation of Money in the Banking System Money supply is increased when: increased 1. Banks issue loans to customers and receive a issue demand deposit. demand 2. Banks buy securities from the public and credit a 2. buy demand deposit for the cost. demand Money supply is decreased when: Money decreased 1. Customers repay loans take money from their repay demand deposit. demand 2. Banks sell securities to the public and a demand 2. sell deposit is reduced to pay for the bond. deposit √ One bank can loan only its excess reserves and is One limited by those reserves in creating money. limited √ The banking system creates a “multiplied” The amount. amount. The Money Multiplier 1 = Money Multiplier Required reserve ratio Maximum Maximum DemandExcess x Money = Deposit reserves Multiplier creation Currency drain and no creditable customers will Currency decrease the amount multiplied. decrease EASY MONEY Goal: Cheap, available credit; increase the money supply increase MS i% In C AD PL RGDP MS Actions • FED will buy government bonds from banks and the public • FED will lower the legal reserve ratio • FED will lower the discount rate charged to member banks Results ¦ Increase the bank excess reserves, and banks can make more loans. An increase in the money supply will lower the interest rate, causing Investment to increase and equilibrium GDP to rise. The amount of the change will be dependent on the size of the Income Multiplier (1/MPS) Easy money is reinforced by the Net Export Effect Easy reinforced Easy Monetary Policy And Equilibrium GDP Real rate of interest, i Sm1 Sm2 Sm3 10 10 8 8 6 6 0 Dm Quantity of money demanded and supplied PL3 PL2 PL1 0 Amount of investment, i If the Money Supply Increases to Stimulate the Economy… Interest Rate Decreases Investment Increases AD & GDP Increases AD3(I=$25) with slight inflation with AD2(I=$20) Increasing money supply AD1(I=$15) continues the growth – continues Real domestic output, GDP but, watch Price Level. but, AS Price level Investment Demand Tight Money Goal: Restrict credit; decrease the money supply money MS MS i% Actions Results In • FED will sell government bonds to banks and the public ¦ Decrease the bank excess reserves, and banks will issue fewer loans C AD PL RGDP • FED will raise the legal reserve ratio • FED will raise the discount rate charged to member banks An decrease in the money supply will raise the interest rate, causing Investment to increase and equilibrium GDP to fall. The amount of the change will be dependent on the size of the Income Multiplier (1/MPS) Tight money is reinforced by the Net Export Effect Tight reinforced Tight Monetary Policy And Equilibrium GDP Real rate of interest, i Sm3 Sm2 Sm1 10 10 8 8 6 6 0 Dm Quantity of money demanded and supplied PL1 PL2 PL3 0 Amount of investment, i If the Money Supply Decreases to “cool” the Economy… Interest Rate Increases Investment Decreases AD & GDP Decreases with lower PL AD1(I=$25) with AD2(I=$20) Decreasing money supply AD3(I=$15) continues the “cooling” – continues Real domestic output, GDP as Price Level falls. as AS Price level Investment Demand Real vs. Nominal Interest Rate • Nominal Rate = Nominal – Real Interest rate + expected rate of inflation • Real Interest Rate = – Nominal rate—expected rate of inflation Money Market Money Graph—Nominal Graph—Nominal Interest Rate Interest i % Sm The supply of money is The vertical no matter what the interest rate is on the vertical axis. The FED controls the supply of money. supply i%e Qe Q of $$ demanded The demand for The money is composed of the Dm transaction demand and asset demand. asset Loanable Funds Market—Real Loanable Demand is: Interest Rate Interest r SLF • Business for investment Business • Consumer for spending Consumer re • Government for Deficit spending spending DLF Qe Q of LF of Supply is mostly from Supply private savings private Changes in the real interest rate caused by Changes movements of demand (from borrowers) and supply (from savers). (from GROWTH IN THE AD-AS MODEL GROWTH ASLR1 ASLR2 C Price Level Capital Goods A B D Consumer Goods Q1 Q2 Real GDP AS √ AS is vertical and AS determines the output at Qf √ AD is stable and AD determines the price level as long as money supply is stable. √ If AD is unstable, If prices and wages adjust. Price Level Classical View: Classical P1 P2 AD1 AD2 AD Qf Real Domestic Output A shift to AD2 shows that the price level declines. Keynesian View: Keynesian AS Price Level √ Product prices and wages are downward inflexible √ AS is horizontal up to AS P1 Qf then becomes Qf AD1 vertical vertical AD2 √ If AD is unstable, If Q2 Qf changes in AD have no Real Domestic Output effect on PL but affect Movement from AD1 to AD2 RGDP. RGDP. reduces the Real GDP but the PL remains constant. the NEW CLASSICAL VIEW OF SELF-CORRECTION NEW Price Level Self-Correction P3 P2 P1 AD increases ASLR AS1 moves economy from a to b. Price level rises Price (P2) and then (P and c self-correction b to c by shifting a AD2 left to AS2 as left Nominal Wages AD1 rise. rise. Q1 AS2 Real Domestic Output Monetary rule : supported by Monetarists Monetary and other Neo-Classical Economists like Rational Expectationists. …directs the directs 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 Policy by Mainstream Economists. Deficits, Surpluses and Debt Deficits, A budget deficit is the amount by which the budget government expenditure exceeds the government revenue in a particular year. A budget surplus is the amount by which budget the government revenue exceeds the government expenditure in a particular year. The National or Public Debt is the National accumulated deficits and surpluses of the government over time. government Types of Budgets Types Annually Balanced—procycl...
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