Always draw a graph when in doubt!!! Answer the questions you know first and

then spend more time on the calculations or more time-consuming ones graph/charts)

Identify- short word or phrase (1 sentence) to receive points (don’t write paragraphs)

Illustrate- draw or re-draw graphs (be sure to label all axes & all points (Q & P) OR (Y & PL)

Define- definition of concept (1-2 sentences) Indicate- state what is expected to happen

Use the 10 minute reading period to write notes (pre-write)- draw graphs & start outlining your ideas

Work in order a, b, c & d (each part will ask you to build on the prior one)

Be prepared for other graphs- Money market, money supply, etc to bring back the AD/AS graph

Law of Demand (inverse relationship)As price increases, quantity demanded will

decrease.As price decreases, quantity demanded will

increase. Law of Supply (direct relationship)As price increase, the quantity supplied will

increase.As price decrease, the quantity supplied

decreases.

Opportunity Cost Trade-offs Inefficiency (inside curve) vs. efficiency (any

point on the curve) Growth (rightward shift in curve)

2.The opportunity cost of moving from b to d is…

4.The opportunity cost of moving from f to c is…

3.The opportunity cost of moving from d to b is…

5.What can you say about point F?

6. What can you say about point G?

1. The opportunity cost of moving from a to b is…

Example:

Opportunity Cost

7

2 Bikes

2.The opportunity cost of moving from b to d is…

4.The opportunity cost of moving from f to c is…

3.The opportunity cost of moving from d to b is…

7 Bikes

4 Computer

0 Computers

5.What can you say about point F?

Inefficient

6. What can you say about point G?

Unattainable

1. The opportunity cost of moving from a to b is…

Example:

Opportunity Cost

8

Absolute advantage- producing a higher quantity given the same amount of resources

Comparative advantage- producing at a lower opportunity cost (must do calculation)

Food ClothingGreat Britain 5 3U.S. 15 12

1. Which of the following statements must be true?

A.The U.S. has both the absolute and comparative advantage in producing food.B.Japan has both the absolute and comparative advantage in producing food.C.The U.S. has both the absolute and comparative advantage in producing clothing.D.Japan has both the absolute and comparative advantage in producing clothing.E.Japan has the absolute advantage in producing soybeans and the comparative advantage in producing clothing.

2. In the Japan, the opportunity cost of the first unit of

A.Food is 1/3 units of clothing.B.Food is ¼ units of clothing.C.Clothing is 3 units of food.D.Clothing is 4 units of food.E.Clothing is 5 units of food.

GDP = C + I + G + Nx (net exports = exports (goods going out of

U.S.)- imports (goods coming into U.S.)

1. Promote Economic Growth2. Limit Unemployment3. Keep Prices Stable (Limit Inflation)

In this unit we will analyze how each of these are measured.

For all countries there are three major economic goals:

13

Economists collect statistics on production, income, investment, and savings.

This is called national income accounting.

The most important measure of growth is GDP.

Gross Domestic Product (GDP) is the dollar value of all final goods and services produced within a country’s borders in one year.

• Dollar value- GDP is measured in dollars.• Final Goods-GDP does not include the value of

intermediate goods. Intermediate goods are goods used in the production of final goods and services.

• One Year-GDP measures annual economic performance.

14

2. Nonproduction Transactions•Financial Transactions (nothing produced)

•Ex: Stocks, bonds, Real estate•Used Goods

•Ex: Old cars, used clothes

What is NOT included in GDP?1. Intermediate Goods

• No Multiple Counting, Only Final Goods• EX: Price of finished car, not the

radio, tire, etc.

3. Non-Market (Illegal) Activities •Ex: Illegal drugs, unpaid work

15

Calculating GDP

Two Ways of calculating GDP:

1. Expenditures Approach-Add up all the spending on final goods and services produced in a given year.

2. Income Approach-Add up all the income that resulted from selling all final goods and services produced in a given year.

Both ways generate the same amount since every dollar spent is a dollar of income.

16

NRU- natural rate of unemployment (4-6%) Frictional and cyclical unemp. is normal Labor force = # ppl employed/# actively

seeking work within last 6 weeks Unemp rate = # ppl unemployed/# actively

seeking work within last 6 weeks

Nominal prices- are actual prices for that calendar year

Real prices- prices adjusted for inflation

real interest rate = inflation + nominal

=Price of market

basket in base year

x 100CPI Price of market basket

Consumer Price Index (CPI)The most commonly used measurement inflation for

consumers is the Consumer Price IndexHere is how it works:• The base year is given an index of 100• To compare, each year is given an index # as well

1997 Market Basket: Movie is $6 & Pizza is $14 Total = $20 (Index of Base Year = 100)

2009 Market Basket: Movie is $8 & Pizza is $17Total = $25 (Index of )125

•This means inflation increased 25% b/w ’97 & ‘09•Items that cost $100 in ’97 cost $125 in ‘09

Problems with the CPI1. Substitution Bias- As prices increase for the fixed

market basket, consumers buy less of these products and more substitutes that may not be part of the market basket. (Result: CPI may be higher than what consumers are really paying)

2. New Products- The CPI market basket may not include the newest consumer products. (Result: CPI measures prices but not the increase in choices)

3. Product Quality- The CPI ignores both improvements and decline in product quality. (Result: CPI may suggest that prices stay the same though the economic well being has improved significantly)

Aggregate- the sum of the entire economy’s demand or supply

Aggregate Demand & Supply

Shifters of Aggregate Demand

Change in Consumer Spending

Change in Investment Spending

Change in Government Spending

Net EXport Spending

AD = C + I + G + X

Shifters of Aggregate SupplyAS = P + A + I + R

Change in Resource Prices

Change in Actions of the GovernmentChange in Productivity (Investment)

22

Change in Inflationary Expectations

Shifters of Aggregate Demand1. Change in Consumer Spending

Consumer Wealth (Boom in the stock market…)Consumer Expectations (People fear a recession…)Household Indebtedness (More consumer debt…)Taxes (Decrease in income taxes…)

2. Change in Investment SpendingReal Interest Rates (Price of borrowing $)

(If interest rates increase…)

(If interest rates decrease…)

Future Business Expectations (High expectations…)Productivity and Technology (New robots…) Business Taxes (Higher corporate taxes means…)

23

Shifters of Aggregate Demand3. Change in Government Spending

(War…)(Nationalized Heath Care…)(Decrease in defense spending…)

24

4. Change in Net Exports (X-M) Exchange Rates(If the us dollar depreciates relative to the euro…) National Income Compared to Abroad(If a major importer has a recession…)(If the US has a recession…)

“If the US get a cold, Canada gets Pneumonia” AD = GDP = C + I + G + Xn

Why is AD downward sloping?1. Real-Balance Effect-• Higher price levels reduce the purchasing

power of money• This decreases the quantity of expenditures• Lower price levels increase purchasing power

and increase expendituresExample: • If the balance in your bank was $50,000, but inflation

erodes your purchasing power, you will likely reduce your spending.

• So…Price Level goes up, GDP demanded goes down.

25

2. Interest-Rate Effect• When the price level increases, lenders

need to charge higher interest rates to get a REAL return on their loans.

• Higher interest rates discourage consumer spending and business investment. WHY?

• Example: An increase in prices leads to an increase in the interest rate from 5% to 25%. You are less likely to take out loans to improve your business.

• Result…Price Level goes up, GDP demanded goes down (and Vice Versa).

26

Why is AD downward sloping?

3. Foreign Trade Effect• When U.S. price level rises, foreign buyers

purchase fewer U.S. goods and Americans buy more foreign goods

• Exports fall and imports rise causing real GDP demanded to fall. (XN Decreases)

• Example: If prices triple in the US, Canada will no longer buy US goods causing quantity demanded of US products to fall.

• Again, Price Level goes up, GDP demanded goes down (and Vice Versa).

27

Why is AD downward sloping?

A major increase in productivity.

Answer and identify shifter: C.I.G.X or P. A.I. R.

28

BA

D

A

D

B

A

A

C A major increase in productivity.A

Answer and identify shifter: C.I.G.X or P. A.I. R.

29

Price Level

30

AS

Inflationary Gap

GDPR

LRAS

QY

AD1

PL1

Q1

Output is high and unemployment is less than NRU

Actual GDP above

potential GDP

Price Level

31

AD

GDPRQY

PL1

Q1

LRAS AS1

Recessionary Gap

Output low and unemployment is more than NRU

Actual GDP below

potential GDP

Inflation

32

SRPC

Short Run Phillips Curve

Unemployment2% 9%

1%

5%

What happens when AS falls causing stagflation?Increase in unemployment and inflation

SRPC1

Inflation

33

SRPC

Short Run vs. Long Run

Unemployment2% 9%

1%

5%

What happens when AD falls?

SRPC1

3%

5%

Long Run Phillips Curve

In the long run wages fall and there is no tradeoff between

inflation and unemployment

What happens in the long run?

Price Level

34

AD

AS

AD/AS and the Phillips Curve

GDPRQY

PLe

LRAS Inflation

SRPC

UnemploymentUY

LRPC

Show what happens on both graphs if AD increase

AD1

Price Level

35

AD

AS

AD/AS and the Phillips Curve

GDPRQY

PLe

LRAS Inflation

SRPC

UnemploymentUY

LRPC

Correctly draw the LRPC and SRPC with the recessionary gap. What happens when AD falls?

AD1

Price Level

36

AD

AS

AD/AS and the Phillips Curve

GDPRQY

PLe

LRAS Inflation

SRPC

UnemploymentUY

LRPC

Correctly draw the LRPC and SRPC at full employment. What happens when AS falls?

AS1

SRPC1

Price Level

37

AD

AS

AD/AS and the Phillips Curve

GDPRQY

PLe

LRAS Inflation

SRPC

UnemploymentUY

LRPC

Correctly draw the LRPC and SRPC with an recessionary gap. What happens when AS goes up?

AS1

SRPC1

How does the Government Stabilizes the Economy?

The Government has two different tool boxes it can use:

1. Fiscal Policy-Actions by Congress to

stabilize the economy.OR

2. Monetary Policy-Actions by the

Federal Reserve Bank to stabilize the

economy. 38

Two Types of Fiscal PolicyDiscretionary Fiscal Policy-

• Congress creates a new bill that is designed to change AD through government spending or taxation.•Problem is time lags due to bureaucracy. •Takes time for Congress to act. •Ex: In a recession, Congress increase spending.

Non-Discretionary Fiscal Policy•AKA: Automatic Stabilizers•Permanent spending or taxation laws enacted to work counter cyclically to stabilize the economy •Ex: Welfare, Unemployment, Min. Wage, etc.•When there is high unemployment, unemployment benefits to citizens increase consumer spending.

39

Laws that reduce inflation, decrease GDP (Close a Inflationary Gap)

• Decrease Government Spending• Tax Increases• Combinations of the Two

Contractionary Fiscal Policy (The BRAKE)

Laws that reduce unemployment and increase GDP (Close a Recessionary Gap)

• Increase Government Spending• Decrease Taxes on consumers• Combinations of the Two

Expansionary Fiscal Policy (The GAS)

How much should the Government Spend? 40

Money multiplier= 1/MPS

1/.2= 1/1/5= 5

If the FED increases the money supply, a

temporary surplus of money will occur at 5%

interest.The surplus will cause the interest rate to fall to 2%

Increasing the Money Supply

Increase money supply

Decreases interest rate

Increases investment

Increases AD

43

200

DM

SM

10%

5%

2%

Quantity of Money(billions of dollars)

Interest Rate (ir)

How does this affect AD?

250

SM1

If the FED decreases the money supply, a temporary

shortage of money will occur at 5% interest.

The shortage will cause the interest rate to rise to 10%

Decreasing the Money Supply

Decrease money supply

Increase interest rate

Decrease investment

Decrease AD 44

200

DM

SM

10%

5%

2%

Quantity of Money(billions of dollars)

Interest Rate (ir)

How does this affect AD?

150

SM1

Showing the Effects of Monetary Policy

Graphically

45

Three Related Graphs: • Money Market• Investment Demand• AD/AS

Investment DemandS&D of Money

The FED increases the money supply to stimulate the economy…

46

200

DM

SM

10%

5%

2%

QuantityM

Interest Rate (i)

250

SM1

DI

Quantity of Investment

10%

5%

2%

Interest Rate (i)

AD/AS

Qe

AD

AS

GDPR

PL

AD1

Q1

PLe

PL1

1. Interest Rates Decreases2. Investment Increases 3. AD, GDP and PL Increases

Investment DemandS&D of Money

The FED decreases the money supply to slow down the economy…

47

200

DM

SM

10%

5%

2%

QuantityM

Interest Rate (i)

175

SM1

DI

Quantity of Investment

10%

5%

2%

Interest Rate (i)

AD/AS

Qe

AD

AS

GDPR

PL

AD1

Q1

PLe

PL11. Interest Rates increase2. Investment decreases3. AD, GDP and PL decrease

Real Interest Rate

48

DBorrowers

SLenders

Loanable Funds Market

Quantity of LoansQLoans

re

At the equilibrium real interest rate the amount borrowers want to borrow equals the amount lenders

want to lend.

Real Interest Rate

49

DBorrowers

SLenders

Loanable Funds Market

Quantity of LoansQLoans

D1

re

r1

Q1

Example: The Gov’t increases deficit spending?Government borrows from private sector

Increasing the demand for loans

Real interest rates increase

causingcrowding out!!

50

Loanable Funds Market

1. Changes in private savings behavior

2. Changes in public savings

3. Changes in foreign investment

4. Changes in expected profitability

1. Changes in perceived business opportunities

2. Changes in government borrowing

• Budget Deficit• Budget Surplus

Demand Shifters Supply Shifters

MoneyMultiplier Reserve Requirement (ratio)

1=

The Money Multiplier

Example:• If the reserve ratio is .20 and the money supply increases

2 Billion dollars. How much the money supply increase?51

Example: Assume the reserve ratio in the US is 10%You deposit $1000 in the bank The bank must hold $100 (required reserves)The bank lends $900 out to Bob (excess reserves) Bob deposits the $900 in his bankBob’s bank must hold $90. It loans out $810 to JillJill deposits $810 in her bankSO FAR, the initial deposit of $1000 caused the CREATION of another $1710 (Bob’s $900 + Jill’s $810)

Using Reserve Requirement1. If there is a recession, what should the FED do to

the reserve requirement? (Explain the steps.)

52

2. If there is inflation, what should the FED do to the reserve requirement? (Explain the steps.)

Decrease the Reserve Ratio1. Banks hold less money and have more excess reserves2. Banks create more money by loaning out excess3. Money supply increases, interest rates fall, AD goes up

Increase the Reserve Ratio1. Banks hold more money and have less excess reserves2. Banks create less money3. Money supply decreases, interest rates up, AD down

PracticeDon’t forget the Monetary Multiplier!!!!

1. If the reserve requirement is .5 and the FED sells $10 million of bonds, what will happen to the money supply?

2. If the reserve requirement is .1 and the FED buys $10 million bonds, what will happen to the money supply?

3. If the FED decreases the reserve requirement from .50 to .20 what will happen to the money multiplier?

53

FOREIGN EXCHANGE

FOREX Supply and Demand Simplified

Imagine a huge table with all the different currencies from every country

This is the Foreign Exchange Market!Just like at a product market, you can’t take

things without paying.If you demand one currency, you must supply

your currency.Ex: If Canadians what Russian Rubles. The demand for Rubles in the FOREX market will increase and the supply of Canadian Dollars will increase.

$

D1

S1

Euros

Quantity of Euros

er1

S

ere

D

€$Dollars

Quantity of Dollars

er1

S

ere

D

€

What happens if Europeans prefer vacationing in the United States?

The Dollar APPRECIATES The Euro DEPRECIATES

1. Changes in Tastes-Ex: British tourists flock to the U.S…

Demand for U.S. dollars increases (shifts right)Supply of British pounds increases (shifts right)

Pound-depreciates Dollar-appreciates

2. Changes in Relative Incomes (Resulting in more imports)-

Ex: US growth increase US incomes….U.S. buys more imports…U.S. Demand for pounds increasesSupply of U.S. dollars increases

Pound- appreciatesDollar- depreciates

3. Changes in Relative Price Level (Resulting in more imports)-

Ex: US prices increase relative to Britain….U.S. demand for cheaper imports increases… U.S. demand for pounds increasesSupply of U.S. dollars increases

Pound- appreciatesDollar- depreciates

4. Changes in relative Interest Rates-Ex: US has a higher interest rate than Britain.

British people want to put money in US banksCapital Flow increase towards the USBritish demand for U.S. dollars increases… British supply more pounds

Pound-depreciatesDollar- appreciates

Pesos

What will happen to the international value of the Mexican peso if there is high inflation in Mexico?

The demand for pesos will decrease since Mexico's trading partners will not want to purchase higher priced Mexican products.The supply will increase as Mexicans look to buy lower priced imports. The peso DEPRECIATES

PracticeFor each of the following examples, identify what will

happen to the value of US Dollars and Japanese Yen. 1. American tourists increase visits to Japan.

2. The US government significantly decreases personal income tax.

3. Inflation in the Japan rises significantly faster than in the US.

4. Japan has a large budget deficit that increases Japanese interest rates.

5. Japan places high tariffs on all US imports.6. The US suffers a larger recession.7. The US Federal Reserve sells bonds at high

interest rates. How do these scenarios affect exports and imports?

PracticeFor each of the following examples, identify what will

happen to the value of US Dollars and Japanese Yen. 1. USD depreciates and Yen appreciates

2. USD depreciates and Yen appreciates 3. USD appreciates and Yen depreciates4. USD depreciates and Yen appreciates5. USD depreciates (Demand Falls) and Yen

appreciates (Supply Falls)6. USD appreciates (Supply Falls) and Yen

depreciates (Demand Falls)7. USD appreciates and Yen depreciatesScenarios 1, 2, and 4 will increase US exports because

US products are now relatively “cheaper”