AP Macro Review

You need:◦ Pencils◦ Pen (blue or black only)◦ Personal ID

You can not have:◦ Phones◦ Calculators

Actual Test Day:

Part 1: The ContentWhat is in the AP Curriculum?

A. Scarcity, choice, and opportunity costsB. Production possibilities curveC. Comparative advantage, specialization,

and exchangeD. Demand, supply, and market equilibriumE. Macroeconomic issues: business cycle,

unemployment, inflation, growth

Basic Economic Concepts . (8–12%)

Scarcity◦ All resources that are both desirable and in limited supply are

considered scarce◦ Resources can be placed into four categories

1. Land2. Labor3. Capital (Physical AND Human)4. Entrepreneurship

Choice◦ Because of scarcity, we have to make choices◦ When ever a choice is made, alternatives are forgone

Opportunity cost◦ Most desirable alternative forgone when a choice is made

A. Scarcity, choice, and opportunity costs

Shows various ways an economy can allocate scarce resources between the production of two things

Each axis represents a good or service that could be produced

The line/curve itself represents different combinations that utilize all available resources.◦ Called the “Frontier”

Economic growth is shown by an outward shift of the frontier. Can be caused by:◦ More resources◦ Better technology

B. Production possibilities curve

Comparative Advantage◦ Focusing on the good or service that can be made at the lowest

opportunity cost◦ When calculating remember:

Input problem? IOU (Input = Other goes Under) Output problem? OOO (Output = Other goes Over)

Specialization◦ Basis for global trade◦ Countries focus on producing whatever good they can make the

most efficiently and trade with other nations

Exchange◦ As long as both parties benefit, there is a net gain from trade.◦ Trade between countries allows them to consume outside their

production possibilities curves.

C. Comparative advantage, specialization, and exchange

D. Demand, supply, and market equilibrium Demand

◦ Represents consumers◦ Negative Slope◦ Determinants (things

that shift it) Consumer Tastes Price of related goods Population Consumer Income Future Prices

Supply◦ Represents producers◦ Positive slope◦ Determinants

Technology Input costs # of suppliers Future prices

Business Cycle◦ Four Phases:

1. Expansion/recovery – growing GDP2. Peak3. Recession/contraction – shrinking GDP4. Trough

Unemployment◦ Measured by the Unemployment Rate

(# of unemployed)/(total labor force) = Unemployment rate

◦ Three types:1. Cyclical – caused by recession/economic downturn2. Structural – skills do not match available jobs3. Frictional – chose to leave job to find another/looking for first job

Inflation◦ Measured by the Consumer Price Index (CPI)

[(Price in current year)/($ in base year)] x 100 = CPI Values > 100 indicate inflation since base year

E. Macroeconomic issues: business cycle, unemployment, inflation, growth

A. National income accounts1.Circular flow2.Gross domestic product3.Components of gross domestic product4.Real versus nominal gross domestic product

B. Inflation measurement and adjustment1.Price indices2.Nominal and real values3.Costs of inflation

C. Unemployment1.Definition and measurement2.Types of unemployment3.Natural rate of unemployment

Measurement of Economic Performance (12–16%)

Simple Circular Flow◦ Shows interaction between producers (firms) and

consumers (households)

National Income Accounts: Circular Flow – Part 1

Expanded Circular Flow◦ More realistic picture of money moving through

an economy◦ REMEMBER: Money going into each square MUST

EQUAL money going out

National Income Accounts: Circular Flow – Part 2

GDP is the total dollar value of all final goods in services produced in a country in a given year◦ Final goods – goods in the final form they are sold◦ Produced within a country – only domestically produced

goods count toward GDP Not counted

◦ Intermediate goods – used to make final goods◦ Used goods – already have been counted◦ Transfers – money changing hands (stock, bonds, social

security, etc…)◦ Foreign Produced – count toward other nations GDP◦ Underground Economy – illegal goods and “under the

table” payments

National Income Accounts: Gross Domestic Product

Expenditure Approach – measures total spending◦ C+I+G+NX = GDP

C = consumer spending. Largest component. I = investment (business spending, inventories) G = government spending NX = net exports (imports – exports)

Income Approach – measures total income◦ Sum of all income sources

Wages for labor Rents from land Interest from capital Profits from entrepreneurship

Remember: Aggregate spending = Aggregate income

National Income Accounts: Components of GDP

Nominal GDP – Value of current production using current prices

Real GDP – Value of current production, but using prices from a fixed point in time◦ Also called “constant dollar GDP”◦ Accounts for inflation◦ More accurate

“Deflating” Nominal GDP◦ Real GDP = 100 x (nominal GDP)/(Price Index)

National Income Accounts: Real and Nominal GDP

Main measure of inflation is the CPI◦ Calculated by the Bureau of Labor Statistics◦ Establishes the rate of inflation by comparing

prices of a “market basket” of goods to a base year

Calculating a price index◦ Price Index = 100 x [Current year $/Base year $]

Inflation measurement and adjustment: Price Indexes

“Nominal” = Not adjusted for inflation “Real” = Adjusted for inflation

Inflation measurement and adjustment: Nominal and Real Values

18

Nominal V Real GDP

Nominal GDP: GDP measured in terms of current Price Level at the time of measurement. (Unadjusted for inflation)

Real GDP: GDP adjusted for inflation; GDP in a year divided by a GDP deflator (Price Index) for that year

19

Nominal V Real INCOME

NOMINAL INCOME: number of dollars received by an individual or group for its resources during some period of time

REAL INCOME: amount of goods and services which can be purchased with nominal income during some period of time; nominal income adjusted for inflation

20

Nominal V Real INTEREST RATE

NOMINAL I%: interest rate expressed in terms of annual amounts currently charged for interest; not adjusted for inflation

REAL I%: interest rate expressed in dollars of constant value (adjusted for Inflation) and equal to the NOMINAL I% minus the EXPECTED RATE OF INFLATION

21

NominalInterestRate

RealInterestRate

InflationPremium

=11%

5%

6%+

ANTICIPATED INFLATION

22

Nominal V Real WAGES

NOMINAL WAGES: amount of money received by a worker per unit of time (hour, day, etc.);

Money Wage

REAL WAGES: amount of goods and services a worker can purchase with their NOMINAL WAGE; purchasing power of the nominal wage.◦ (Real = Nominal –

Inflation rate)

23

NOMINAL/REAL TIPs

If nominal rates INCREASE and Price Level INCREASE, the CHANGE in Real is “indeterminable.”

If nominal Wage rates do NOT change and Price Level fall. REAL WAGES increase.

NOMINAL RATES “PIGGY-BACK” REAL RATES & NOT VICE VERSA.

Unexpected Inflation Hurts:◦ Businesses that have to change prices

menu costs◦ People of Fixed incomes

pension receivers & minimum wage earners◦ People saving money at fixed interest◦ People loaning money at fixed interest

Unexpected Inflation Helps◦ People borrowing money at fixed interest

Inflation measurement and adjustment: Costs of Inflation

Measurements:◦ Labor Force – Sum of all individuals over 16 that

are employed or unemployed Remember: Unemployed MUST BE searching for work

Not searching for work = “discouraged worker”

◦ Unemployment Rate – Unemployed/Labor Force

Unemployment: Definition and Measurement

1. Frictional – Someone new enters labor market OR chooses to switch jobs

2. Seasonal – periodic/predictable job loss

3. Structural – Jobs lost because skills are no longer in demand

4. Cyclical – Jobs lost as a result of an economic downturn

Unemployment: Types of Unemployment

Full Employment: ◦ NO CYCLICAL UNEMPLOYEMENT◦ Traditionally 5-6%◦ Natural Rate of Unemployment

Unemployment rate associated with full employment

Unemployment: Natural Rate of Unemployment

A. Aggregate demand1.Determinants of aggregate demand2.Multiplier and crowding-out effects

B. Aggregate supply1.Short-run and long-run analyses2.Sticky versus flexible wages and prices3.Determinants of aggregate supply

C. Macroeconomic equilibrium1.Real output and price level2.Short and long run3.Actual versus full-employment output4. Business cycle and economic fluctuations

National Income and Price Determination (10–15%)

AD Always slopes down◦ Wealth effect – As prices rise

purchasing power of wealth falls AD Shifts when…

◦ There is a change in consumer spending

◦ There is a change in government spending

◦ There is a change in investment spending This includes changes in taxes and

transfers◦ There is a change in net exports

Aggregate demand: Determinants

Consumption and Savings◦ MPC = △Consumption/ △Disposable Income◦ MPS = △Savings/ △Disposable Income◦ MPC + MPS = 1

Spending Multiplier◦ 1/MPS or 1/(1-MPC)

Tax Multiplier◦ MPC/MPS◦ ALWAYS smaller then spending multiplier

Taxes have a smaller impact than government spending!

Aggregate demand: Multipliers

Commonly Used Multipliers…

If MPC is The Spending Multiplier is..

.90 10

.80 5

.75 4

.50 2

Short Run AS◦ Input costs and wages are

“sticky” in the short run and do not change quickly

◦ This lag between changes in output price and input prices create a positive slope

Long Run AS◦ All inputs prices are flexible

in the long run regardless of price level

Aggregate supply: Short-run v Long-run

Short run shifts◦ △ input prices◦ △ taxes on producers◦ △ regulations

Long Run Shifts◦ △ Quantity and Quality of

resources◦ △ Technology◦ △ Human capital (education and

training of labor force)◦ Policy initiatives

Government programs designed to encourage investment

Aggregate supply: Determinants of AS

Macroeconomic equilibrium occurs when real output demanded is equal to real output supplied

Macroeconomic equilibrium: Real output and price level

Macroeconomic equilibrium: short and long run

Short Run Equilibrium Long Run Equilibrium OR“economy at full employment”

Macroeconomic equilibrium: Actual vs Full Employment Output

Macroeconomic equilibrium: Business Cycle and Fluctuations

A. Money, banking, and financial markets1. Definition of financial assets: money, stocks, bonds2. Time value of money (present and future value)3. Measures of money supply4. Banks and creation of money5. Money demand6. Money market and the equilibrium nominal interest rate

B. Loanable funds market1. Supply of and demand for loanable funds2. Equilibrium real interest rate3. Crowding out

C. Central bank and control of the money supply1. Tools of central bank policy2. Quantity theory of money3. Real versus nominal interest rates

IV. Financial Sector (15–20%)

Money, banking, and financial markets

Money, banking, and financial markets

Money, banking, and financial markets

Money, banking, and financial markets

1. Supply of and demand for loanable funds

Loanable funds market

2. Equilibrium real interest rate Found at the intersection of Slf and Dlf

Loanable funds market

3. Crowding out◦ Government deficits increase the demand for

loanable funds because the government bust borrow money to continue operations This drives up interest rates, and lowers business

and personal investment in the economy.

Loanable funds market

1. Tools of central bank policyOpen Market Operations

Buying and selling bonds to influence the amount of money in circulation. Buy Bonds = Bigger Bucks - MS and AD increase, IR decreases Sell Bonds = Smaller Bucks - MS and AD decrease, IR increases

Discount Rate Interest rate a central bank charges member banks for loans

Higher discount rate = Lower MS, AD decreases, IR increases Lower discount rate = Higher MS, AD increases, IR decreases

Reserve RequirementThe amount of money banks are required to hold in reserves.

Influenced the money multiplier Lower RR = higher MS, AD increases, IR decreases Higher RR = Lower MS, AD decreases, IR increases

Central bank and control of the money supply

2. Quantity theory of money Velocity of money is defined simply as the rate at which

money changes hands. ◦ If velocity is high, money is changing hands quickly, and a relatively

small money supply can fund a relatively large amount of purchases. ◦ if velocity is low, then money is changing hands slowly, and it takes

a much larger money supply to fund the same number of purchases. The relationship between velocity, the money supply, the

price level, and output is represented by the equation M * V = P * Y ◦ M is the money supply◦ V is the velocity◦ P is the price level◦ Y is the quantity of output.

Central bank and control of the money supply

A. Fiscal and monetary policies1.Demand-side effects2.Supply-side effects3.Policy mix4.Government deficits and debt

B. The Phillips curve1.Short-run and long-run Phillips curves2. Demand-pull versus cost-push inflation3.Role of expectations

Stabilization Policies . (20–30%)

Crowding-Out Effect An Expansionary Fiscal Policy as

previously diagrammed will lead to higher interest rates.◦ At higher interest rates, businesses will take

out fewer loans and there will be a decrease in INVESTMENT (I)

◦ At the same time there will be a decrease in CONSUMER SPENDING (C) as they will take out fewer loans as well.

This CROWDING OUT EFFECT will reduce the gain made by the expansionary fiscal policy.

Economic Philosophies Classical: Believes that the government

SHOULD NOT interfere in the economy. And believes in self-correction of economic problems.

Keynesian: Believes that GOVERNMENT SHOULD interfere in the economy (taxes, government spending). Most “mainstream” economists are Keynesians

Rational Expectations: Believes that monetary and fiscal policy have certain effects on the economy and take action to make these policies ineffective.

A. Definition of economic growthB. Determinants of economic growth

1.Investment in human capital2.Investment in physical capital3.Research and development, and technological

progressC. Growth policy

Economic Growth . (5–10%)

Defined as an increase in “Real GDP per capita”◦ Per capita is used in order to isolate the effect of

changes in population◦ Sustained growth in real GDP per capita occurs

ONLY WHEN the amount produced by the average worker increases steadily Productivity = output per worker

Definition of economic growth

1. Investment in Human Capital◦ Education and knowledge improve a nations work-

force, making it more productive

2. Investment in Physical Capital◦ Equipment used to produce a good or service

3. Technology◦ Technical means for the production of a good or

service

Determinants of economic growth

Policies that promote economic growth◦ Promote investments in technology, education,

and capital investment

Growth Policy

A. Balance of payments accounts1.Balance of trade2.Current account3.Financial account (formerly known as capital

account) B. Foreign exchange market

1.Demand for and supply of foreign exchange2.Exchange rate determination3.Currency appreciation and depreciation

C. Imports, exports, and financial capital flows D. Relationships between international and

domestic financial and goods markets

Open Economy: International Trade and Finance . (10–15%)

Balance of Payments:

The sum of all transactions between U.S. residents and residents of all foreign nations◦ Current Account: a country’s exports and imports of goods and

services.◦ Capital/Financial Account: Shows the country’s investment

(financial as well as capital-plants and factories) abroad and Foreign investment in the country

Credits: A credit are those transactions for which the country receives income (exports, foreign purchase of assets)

Debits: Those transactions that the country must pay for: imports and purchasing of assets abroad.

Balance of Payments [continued]

The Current Account and Financial/Capital Account must be equal.

Official Reserves Account: The Central Banks of all nations hold foreign currency to make up any deficit in the combined capital and current accounts.

If the U.S. has more credits than debits it finances this difference by dipping into its reserve account.

57

The value of a foreign nation’s currency in relation to your own currency is called the exchange rate.

Foreign exchange market

An increase in the value of a currency is called appreciation.

A decrease in the value of a currency is called depreciation.

Multinational firms convert currencies on the foreign exchange market, a network of about 2,000 banks and other financial institutions.

Fixed Exchange-Rate Systems◦ A currency system in

which governments try to keep the values of their currencies constant against one another is called a fixed exchange-rate system.

58

Types of Exchange Rate Systems

Flexible Exchange-Rate Systems◦ Flexible exchange-rate

systems allow the exchange rate to be determined by supply and demand.

Demand for and supply of foreign exchange Let’s say a U.S. citizen travels to Japan. This transaction

will provide a supply of the U.S. dollar and result in a demand for yen. It will become cheaper for the Japanese to buy the dollar and more expensive for Americans to buy the Yen. The Yen is Appreciating and the dollar is Depreciating.

Quantity of U.S. Dollars Quantity of Yen

Yen Price of dollar(Y/$)

Dollar Priceof Yen($/Y)

P1

Q1

D$1

S$1

S$2

P2

Q2

P1

Q1

DY1

SY1

DY2

Q2

P2

Part 2: The GraphsYou must be able to draw/label/manipulate these graphs

Production Possibilities Curve

AD/AS

AD/AS: Recessionary Gap OR “Below full employment”

AD/AS: Inflationary Gap OR “beyond/above full employment”

Money Market

Loanable Funds Market

Phillips Curve: Part I

Phillips Curve: Part II

Economic Growth

Causes of Economic Growth1. Increased investment in

physical capital Equipment and

machinery2. Increased investment in

human capital Education and

training3. New Technology4. Increase in

quality/quantity of resources