1

AP MacroEconomics

Review

Production Possibility Curve

A

C

F

B

D

E

W

Capitalgoods

Consumer goods

B2

D

Capitalgoods

Consumer goods

D2

B

Market Equilibrium

Demand

Supply

Pe

Qe Quantity

Price

A change in Demand versus a change inthe Quantity Demanded

Change in Demand

√ Moves the curve

•Income

•Future Expectations

•# of Buyers

•Consumer Information

•Taste and Preference

•Substitues and Complements

Change in QuantityDemanded

√ Moves Along the SAMEcurve

• Caused only by Pricechange.

A change in Supply versus a change inthe Quantity Supplied

Change in Supply

√ Moves the curve

•Costs of Production

•Future Expectations

•# of Sellers

•Taxes and Subsidies

•Prices of goods using same resources

•Time period of production

Change in QuantitySupplied

√ Moves Along the SAMEcurve

• Caused only by Pricechange.

2

The Rule of 70 is a device that can find thenumber of years it will for some amount todouble.

# of yrs to double the real GDP = 70 annual rate of growth

Take the growth rate in 2004 of 4.070/4.0 = 17.5 years for Real GDP to double

Imagine that the rate of growth was 10%?Only 7 years to double!

Economic growth GROSS DOMESTIC PRODUCT

Market Value of the total

goods and services produced

within the boundaries of the

US whether by Americans or

foreigners in one year.

Defining…

+

+

+

++

++

GROSS DOMESTIC PRODUCT

Consumptionby Households

Investmentby Businesses

GovernmentPurchases

Expendituresby Foreigners

Expenditures Approach Income ApproachWages

Rents

Interest

Profits

StatisticalAdjustments

= =GDP

NOMINAL GDP vs. REAL GDP

Nominal GDP… reflects the current price level of goods and services andignores 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 forchange in the price level. It will reflect the real change inoutput.… This measure is called the Constant Dollar GDP.… indicates what the GDP would be if the purchasing power ofthe dollar has not changed from what it was in a base year. Thegovernment currently uses 2000 as its base year for Real GDPmeasurement.

GDP Price Index

Price Indexin a given

year=

Price of market basketin specific year

Price of same marketbasket in base year

x 100

Real GDP =Nominal GDP

Price Index(in hundredths)

Price Index(in hundredths)

=Nominal GDP

Real GDP

An Alternative Method

Disposable IncomeBy subtracting from Personal Income,the dollars lost to taxes, we have theDisposable Income. This is the “bottom”line of national income accounting.

Disposable Income = C + S

3

√ by not counting non market transactions√ by not measuring Improved Product Quality√ by not considering Leisure Time

GDP understates the well-being…

GDP Overstates the well-being…√ by ignoring the Composition andDistribution of Output√ GDP and the EnvironmentPer Capita GDP measures the GDP interms of goods and services per person

Unemployment Rate =UnemployedLabor Force

Frictional – “temporary”, “transitional”,“short-term” (“between jobs” or “search”unemployment)Structural – “technological” or “long term”.basic changes in the “structure” of the laborforce which make certain “skills obsolete”.Cyclical – “economic downturns” in thebusiness cycle.

The Full employment rate ofunemployment or the Natural

Rate of Unemployment (NRU) ispresent when the economy is

producing its potential output.

The Natural Rate of Unemploymentexists when the cyclical unemployment

is zero.

GDP Gap and Okun’s Law√ The basic loss of unemployment is forgoneoutput. √ Potential GDP is the capacity of theeconomy assuming the Natural Rate ofUnemployment. The growth of the Potential GDPassumes the normal growth rate of the real GDP.

GDP GAP is the amount by which actual GDP fallsshort of potential GDPFor every 1% the unemployment rate exceedsthe natural rate…Approximately a 2% GDP Gapoccurs.

Inflation A rising of the general level of prices

=Price of the same market

basket in 2000

x 100CPIPrice of the market basket

in the particular year

Producer Price Index (PPI) Prices at the wholesale orproduction level which are early indicators ofinflation.

70 divided by rate of inflation (expressedas whole numbers) will yield the numberof years for the price level to double.

Theories of Inflation:Demand Pull√ Excess of total demand√ prices are bid upward by the excess demand√ economy is seeking a point beyond its PPCwhen full employment-full production isevident

Qf

Increases in total spendingQuantity

Range 2

Range 3Price

level

Range 1

4

Theories of Inflation:Cost Push√ prices rising when output and employment areboth declining√ aggregate demand not excessive√ Per unit production costs are rising due to rawmaterials, energy, labor, etc.√ High per unit costs cause decline in profit; hence,the price level is “pushed up” by these costs.

Abrupt increases in the costs of raw materials orenergy inputs drive up per-unit production costsand hence prices.

CreditorsDebtors

SaversSpenders

Fixed IncomeFlexible Income

Those who loseThose who benefitUnanticipated Inflation

COLA-helps to stay up withrising prices

Real and Nominal IncomeNominal income … is the number of dollars

earned as rent, wages, interest or profitReal income… measures the amount of

goods and services nominal income can buy.√ If nominal income rises faster than pricelevel, real income will rise.

√ If the price level increases faster thannominal income, then real income will fall. √ Your real income falls only when nominalincome fails to keep up with inflation. o

PL1

ASsrASlr

AD1

Qf

Pric

e Lev

el

Real domestic output

Long Run EquilibriumIn the extendedAD-AS model,

equilibriumoccurs at the

intersection ofAD and the ASlr

and the ASsr.Qf is the amountof Real GDP at

full employment.

DEMAND-PULL INFLATIONand Self-Correction

Long RunNominal Wagesrise and AS2

srmoves left.

RGDP returnsto previouslevel on Aslr

But…PL riseseven more to

PL3!o

PL1[2%]

ASsrASlr

AD1

a

Qf

Pric

e Lev

el

Real domestic output

bPL2[5%]

AD2

Y2

c

AS2sr

PL3[7%]

ShortRun—Increase inAD shows point b

COST-PUSH INFLATIONwith government action

If governmentstimulates AD todotted line, aninflationary spiralwill occur…PL3 atQf. We have FullEmployment but ata higher price level.

o

PL1[2%]

ASsrASlr

AD1

a

Qf

Pric

e Lev

el

Real domestic output

b

AS2sr

PL2[3%]

Y2

AD2

cPL3[5%]

5

COST-PUSH INFLATIONwith NO government action

o

PL1[2%]

ASsr

ASlr

AD1

a

Qf

Pric

e Lev

el

Real domestic output

AS2sr If government lets

the recession takeits course, nominalwages will fall inthe long run andreturn to pointa…PL1 at Qf.

cPL3[5%]

o

PL3[2%]

AS2sr

ASlr

AD2

a

Qf

Pric

e Lev

el

Real domestic output

bPL2[3%]

AD1

Y2

c

AS1sr

PL1[5%]

RecessionThis decline inthe price levelwill eventuallyshift the AS1

sr toAS2

sr. Price leveldeclines to PL3at Qf . Shown atpoint c.

Ann

ual r

ate o

f inf

latio

n

Unemployment rate (percent)

7

6

5

4

3

2

1

01 2 3 4 5 6 7

As inflation declines...

The Phillips Curve Concept

Unemploymentincreases

PC √ In the long run, there is not a stable relationshipbetween unemployment and inflation.√ The long-run Phillips curve is the vertical line at thenatural rate of unemployment.

The Phillips CurveSummary

The short run Phillips Curve is downward sloping.

Aggregate Demand changes move along the sameshort run Phillips curve.

Aggregate Supply changes create new short runPhillips curves.

Expansionary Fiscal Policy

√ Increase Government Spending√ Decrease Tax Rates

…Or Combination of the Two

Goal: To Reduce Unemployment and Effectsof Recession…

Contractionary Fiscal Policy

√ Decrease Government Spending√ Increase Tax Rates

…Or Combination of the Two

Goal: To Reduce Demand—Pull Inflation… Pri

ce le

vel

Real GDP (billions)

EXPANSIONARY FISCAL POLICY

$60 billionincrease in AggregateDemand

AD1 AD2

$20 billion decrease in tax rates; $15 billion innew consumption spending

the multiplier at work...

P1

$550

AS

$490

P2

MPS = .25

6

Pri

ce le

vel

Real GDP (billions)

CONTRACTIONARY FISCAL POLICY

$60 billiondecrease in AggregateDemand

AD4AD3

$20 billion increase in tax rates; $15 billion lostin consumption spending

the multiplier at work...

P1

$550

AS

$490

P2

MPS = .25

Built-in StabilitySome changes in relative levels of government

expenditures and taxes occur automatically.

This is not like discretionary changes in spending

and tax rates since these net tax revenues vary

directly with RGDP.

…tends to increase the government deficit (or

reduce the surplus) during recession or to increase

the surplus ( or reduce the deficit) during inflation

without requiring specific action by policy makers.

Crowding —Out Effect

Rea

l Int

eres

t R

ate,

(pe

rcen

t)

Quantity of Loanable Funds

i%

D

LF0

SIncreaseddemand forloanable fundsby governmentraises theinterest rate.

D2

i%

LF1

Expansionary fiscal policyProblem: Recession

More government spendingand/or lower taxes

Higher domestic interest rates(crowding-out effect)

Increased foreign demand fordollars (foreigners want to earn

higher interest)Dollar appreciates

Net Exports decline(AD decreases, partially

offsetting expansionary policy)

Fiscal policy weakened by NET EXPORT EFFECT

Contractionary fiscal policyProblem: Inflation

Lower government spending and/orhigher taxes

Lower domestic interest rates(government role in loanable funds

market is less)

Decreased foreign demand for dollars(foreigners find

higher rates elsewhere)Dollar depreciates

Net Exports increase(AD increases, partially offsetting

contractionary policy)

Supply-Side Economics aims to manipulate aggregate supply byenacting policies designed to stimulate incentives to work, tosave and invest (including measures to encourageentrepreneurship).These policies may include tax cuts which will increasedisposable incomes, thus increasing household saving andincrease the profitability of investments by businesses.•Tax cut stimulates more consumption, saving and investmentto increase AD.•The new investment moves the AS curve to the right. Workincentives push more workers into employment and they spendand save increasing AD further.•Low taxes act to push risk takers to move toward newproduction methods and new products.

Supply-Side Economics…shows the relationship between tax ratesand tax revenues√ Up to a point, higher tax rates will resultin larger tax revenues.√ But still higher tax rates will adverselyaffect incentives to work and produce,reducing the size of the tax base andreducing tax revenues.√ Lower tax rates will lessen tax evasionand avoidance, and reduce governmenttransfer payments.

Laffer Curve

7

MI• Checkable deposits• Travelers checks• Currency

• Money market accounts• Savings deposits• Small time deposits

• Large time deposits

M2

M3+

+

M

O

N

E

Y

M

E

A

S

U

R

E

S

i%

$$ demanded

Dm

i%1

Sm

The Money MarketSupply ofmoney is avertical linesince monetaryauthorities(FED) andfinancialinstitutionshave providedthe economywith a certainstock of money.

Money supply is increased when:

1. Banks issue loans to customers and receive ademand deposit.

2. Banks buy securities from the public and credit ademand deposit for the cost.

Money supply is decreased when:

1. Customers repay loans take money from theirdemand deposit.

2. Banks sell securities to the public and ademand deposit is reduced to pay for the bond.

Creation of Money in the Banking System

MaximumDemand-Depositcreation

= Excessreserves

x MoneyMultiplier

MoneyMultiplier Required reserve ratio

1=The Money Multiplier

√ One bank can loan only its excess reserves and islimited by those reserves in creating money.

√ The banking system creates a “multiplied”amount.

Currency drain and no creditable customers willdecrease the amount multiplied.

MS i% In C AD PL RGDP

EASY MONEY Goal: Cheap, available credit;increase the money supply

Actions • FED willbuygovernmentbonds frombanks andthe public

• FED will lower thelegal reserve ratio

• FED will lowerthe discount ratecharged to memberbanks

Results √ Increasethe bankexcessreserves, andbanks canmake moreloans.

An increase in themoney supply willlower the interest rate,causing Investment toincrease andequilibrium GDP torise.

The amount of thechange will bedependent on thesize of the IncomeMultiplier (1/MPS)

Easy money is reinforced by the Net Export EffectReal domestic output, GDP

Dm

InvestmentDemand

Rea

l rat

e of

inte

rest

, i 10

8

6

0Quantity of money demanded and supplied Amount of investment, i

Sm1

AS

AD1(I=$15)

PL1

10

8

6

0

Sm2

AD3(I=$25)PL2

If the Money SupplyIncreases to Stimulatethe Economy…

Interest Rate DecreasesInvestment IncreasesAD & GDP Increases with slight inflation

Pri

ce le

vel

AD2(I=$20)

PL3

Sm3

Increasing money supply continues the growth – but, watch Price Level.

Easy Monetary Policy And Equilibrium GDP

8

MS i% In C AD PL RGDP

Tight Money Goal: Restrict credit; decrease themoney supply

Actions • FED willsellgovernmentbonds tobanks andthe public

• FED will raise thelegal reserve ratio

• FED will raisethe discount ratecharged tomember banks

Results √ Decreasethe bankexcessreserves, andbanks willissue fewerloans

An decrease in themoney supply will raisethe interest rate,causing Investment toincrease andequilibrium GDP tofall.

The amount of thechange will bedependent on thesize of the IncomeMultiplier (1/MPS)

Tight money is reinforced by the Net Export EffectReal domestic output, GDP

Dm

InvestmentDemand

Rea

l rat

e of

inte

rest

, i 10

8

6

0Quantity of money demanded and supplied Amount of investment, i

Sm3

AS

AD3(I=$15)

PL3

10

8

6

0

Sm2

AD1(I=$25)PL2

If the Money SupplyDecreases to “cool”the Economy…

Interest Rate IncreasesInvestment DecreasesAD & GDP Decreases with lower PL

Pri

ce le

vel

AD2(I=$20)

PL1

Sm1

Decreasing money supply continues the “cooling” – as Price Level falls.

Tight Monetary Policy And Equilibrium GDP

Nominal Rate =Real Interest rate + expected rateof inflation

Real Interest Rate =Nominal rate—expected rate ofinflation

Smi%

Q of $$demanded

Dm

The supply of money isvertical no matter whatthe interest rate is onthe vertical axis. TheFED controls thesupply of money.

The demand formoney iscomposed of thetransactiondemand andasset demand.

Money MarketGraph—NominalInterest Rate

Qe

i%e

r

re

Q of LFQe

SLF

DLF

Loanable Funds Market—RealInterest Rate

Changes in the real interest rate caused bymovements of demand (from borrowers) and supply(from savers).

Demand is:

• Business for investment

• Consumer for spending

• Government for Deficitspending

Supply is mostly fromprivate savings

GROWTH IN THE AD-AS MODEL

A

B

C

D

Cap

ital

Goo

ds

Consumer Goods

Pri

ce L

evel

Real GDP

ASLR1 ASLR2

Q1 Q2

9

Classical View:

√ AS is vertical anddetermines the output atQf √ AD is stable anddetermines the pricelevel as long as moneysupply is stable. √ If AD is unstable,prices and wages adjust.

P1

Qf

AS

AD1Pr

ice L

evel

Real Domestic OutputA shift to AD2 showsthat the price leveldeclines.

AD2

P2

Keynesian View:

√ Product prices andwages are downwardinflexible√ AS is horizontal up toQf then becomes vertical √ If AD is unstable,changes in AD have noeffect on PL but affectRGDP. Movement from AD1 to AD2

reduces the Real GDP butthe PL remains constant.

P1

Qf

AS

AD1

Pric

e Lev

el

Real Domestic Output

AD2

Q2

NEW CLASSICAL VIEW OF SELF-CORRECTION

P2

Q1

Pri

ce L

evel

Real Domestic Output

AD2

AD1

ASLR

P1

AS1

AS2

P3

Self-Correction

a

bc

AD increasesmoves economyfrom a to b.Price level rises(P2) and thenself-correctionto c by shiftingleft to AS2 asNominal Wagesrise.

Monetary rule : supported by Monetaristsand other Neo-Classical Economists likeRational Expectationists. …directs theFed to expand the money supply eachyear at the same annual rate as thetypical growth of the economy’sproductive capacity.

Discretionary Fiscal and MonetaryPolicy (especially monetary): supportedby Mainstream Economists.

Summary of Alternative ViewsNew Classical Economics

Issue MainstreamMacroeconomicsKeynesian Based

Monetarism Rationalexpectations

View of theprivate

economy

Potentiallyunstable

Stable in long runat natural rate ofunemployment

Stable in long runat natural rate ofunemployment

Cause ofobserved

stability ofprivate

economy

Investment doesnot equal saving

causing changes inAD; AS shocks

Inappropriatemonetary policy

Unanticipated ADand AS shocks in

the short run

Appropriatemacro policy

Active fiscal andmonetary

Monetary rule Monetary rule

How changesin money

supply affectthe economy

By changinginterest rates,

changinginvestment and

real GDP

By directlychanging AD

which changesGDP

No effect on outputbecause price-level

changes areanticipated

View ofvelocity of

money

Unstable Stable No consensus

How fiscalpolicy affectsthe economy

Changes AD andGDP via themultiplier

No effect unlessmoney supply

changes

No effect on outputbecause price-level

changes areanticipated

View of Costpush inflation

Possible (wage-push, AS shock)

Impossible in longrun in absence ofexcessive moneysupply growth

Impossible in longrun in absence ofexcessive moneysupply growth

The National or Public Debt is theaccumulated deficits and surpluses of thegovernment over time.

Deficits, Surpluses and DebtA budget deficit is the amount by which thegovernment expenditure exceeds thegovernment revenue in a particular year.A budget surplus is the amount by whichthe government revenue exceeds thegovernment expenditure in a particularyear.

10

Types of Budgets

Annually Balanced—procyclical

Cyclically Balanced—to hard to

predict cycles

Functional Finance-work for goals

√ Comparative Advantage …is the ability toproduce an item at a lower opportunity cost. Resourcesare scarce, so that one can only produce more of oneproduct by taking the resources away from another. Itmeans that total world output will be greatest when eachgood is produced by the nation which has the lowestdomestic opportunity cost.

√ As a result of trade, countries that trade products basedon their own specialization will have more of BOTHproducts (produced and traded for).√ Terms of Trade…the exchange ratio between goodstraded. This ratio explains how the gains frominternational specialization and trade are dividedamong the trading nations; it depends on the worldsupply and demand for the two products.

S

D

$ Price ofForeign

Currency

Quantity of Foreign Currency

The intersectionwill be the

exchange rate.

Flexible exchange rates

Qfc

$fc

A nation’s Balance of Paymentsrecords all the transactions that takeplace between its residents and the

residents of a foreign nation.Current Account

Mdse. Trade

Services Trade

Net InvestmentIncome

Net Transfers

Capital Account

Real Investment

Financial Investments

Official Reserves Account

+ to balance a deficit

—to balance a surplus=

The Market For Currency

$P/fc

Q

D

S

Dol

lar p

rice

of f

orei

gn cu

rren

cy

Quantity of foreign currency

FCDepreciates; $ Appreciates

FCAppreciates; $ Depreciates

FCP/$

Q

D

S

FC p

rice

of d

olla

rs

Quantity of $

DollarDepreciates; FC Appreciates

DollarAppreciates; FC Depreciates

Changes in tastes

Changes in relative incomes

Changes in relative prices

Changes in relative interest rates

Speculation in currencies

Determinants of exchange rates: