AP Macro Economics Review Production Possibility Curve

AP Macro Economics Review

Production Possibility Curve B 2 Capital goods B D 2 D A B C F W Consumer goods D E Consumer goods

Market Equilibrium P r i c e Supply Pe Demand Qe Quantity

A change in Demand versus a change in the Quantity Demanded Change in Demand Change in Quantity Demanded √ Moves the curve • Income • Future Expectations • # of Buyers √ Moves Along the SAME curve • Caused only by Price change. • Consumer Information • Taste and Preference • Substitues and Complements

A change in Supply versus a change in the Quantity Supplied Change in Supply Change in Quantity Supplied √ Moves the curve • Costs of Production • Future Expectations • # of Sellers √ Moves Along the SAME curve • Caused only by Price 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 = 70 annual rate of growth Take the growth rate in 2004 of 4. 0 70/4. 0 = 17. 5 years for Real GDP to double Imagine that the rate of growth was 10%? Only 7 years to double!

GROSS DOMESTIC PRODUCT Defining… Market Value of the total goods and services produced within the boundaries of the US whether by Americans or foreigners in one year.

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 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. … 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. The government currently uses 2000 as its base year for Real GDP measurement.

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 By subtracting from Personal Income, the dollars lost to taxes, we have the Disposable Income. This is the “bottom” line of national income accounting. Disposable Income = C + S

GDP understates the well-being… √ by not counting non market transactions √ by not measuring Improved Product Quality √ by not considering Leisure Time GDP Overstates the well-being… √ by ignoring the Composition and Distribution of Output √ GDP and the Environment Per Capita GDP measures the GDP in terms of goods and services person

Unemployment Rate = Unemployed/Labor Force Frictional – “temporary”, “transitional”, “short-term” (“between jobs” or “search” unemployment) Structural – “technological” or “long term”. basic changes in the “structure” of the labor force which make certain “skills obsolete”. Seasonal- “based on the seasons” agriculture. Cyclical – “economic downturns” in the business cycle.

The Full employment rate of unemployment or the Natural Rate of Unemployment (NRU) is present when the economy is producing its potential output. The Natural Rate of Unemployment exists when the cyclical unemployment is zero.

GDP Gap and Okun’s Law √ 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 GAP is the amount by which actual GDP falls short of potential GDP For every 1% the unemployment rate exceeds the natural rate…Approximately a 2% GDP Gap 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 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 √ Excess of total demand √ prices are bid upward by the excess demand √ economy is seeking a point beyond its PPC when full employment-full production is 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 √ prices rising when output and employment are both declining √ aggregate demand not excessive √ Per unit production costs are rising due to raw materials, 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 or energy inputs drive up per-unit production costs and hence prices.

Unanticipated Inflation Those who benefit Those who lose Flexible Income Fixed Income Spenders Savers Debtors Creditors COLA (Cost-of-Living-Allowance) helps to stay up with rising prices

Real and Nominal Income Nominal income … is the number of dollars earned as rent, wages, interest or profit Real income… measures the amount of goods and services nominal income can buy. √ 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. √ Your real income falls only when nominal income fails to keep up with inflation.

Long Run Equilibrium Price Level ASlr PL 1 o In the extended ASsr AD-AS model, equilibrium occurs at the intersection of AD and the ASlr and the ASsr. Qf is the amount of Real GDP at full employment. AD 1 Qf Real domestic output

Price Level DEMAND-PULL INFLATION and Self-Correction PL 3[7%] PL 2[5%] PL 1[2%] o ASlr AS 2 sr ASsr Short Run— Increase in AD shows point b Long Run Nominal Wages rise and AS 2 sr c moves left. b RGDP returns to previous a level on Aslr AD 2 But…PL rises even more to AD 1 PL 3! Qf Y 2 Real domestic output

Price Level PL 3[5%] PL 2[3%] COST-PUSH INFLATION with government action ASlr AS 2 sr ASsr c b a PL 1[2%] o Y 2 Qf AD 1 If government stimulates AD to dotted line, an inflationary spiral will occur…PL 3 at Qf. We have Full Employment but at a higher price level. AD 2 Real domestic output

Price Level COST-PUSH INFLATION with NO government action ASlr AS 2 sr c PL 3[5%] a PL 1[2%] o If government lets ASsr the recession take its course, nominal wages will fall in the long run and return to point a…PL 1 at Qf. AD 1 Qf Real domestic output

Price Level Recession ASlr AS 1 sr AS 2 sr a PL 1[5%] PL 2[3%] b This decline in the price level will eventually shift the AS 1 sr to AS 2 sr. Price level declines to PL 3 at Qf. Shown at point c. c PL 3[2%] AD 1 o AD 2 Y 2 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 Summary The short run Phillips Curve is downward sloping. Aggregate Demand changes move along the same short run Phillips curve. Aggregate Supply changes create new short run Phillips curves. √ In the long run, there is not a stable relationship between unemployment and inflation. √ The long-run Phillips curve is the vertical line at the natural rate of unemployment.

Expansionary Fiscal Policy 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

EXPANSIONARY FISCAL POLICY the multiplier at work. . . $20 billion decrease in tax rates; $15 billion in new consumption spending Price level AS $60 billion increase in Aggregate Demand P 2 P 1 AD 2 AD 1 $490 $550 Real GDP (billions) MPS =. 25, 1/MPS= 1/. 25; multiplier=4

CONTRACTIONARY FISCAL POLICY the multiplier at work. . . $20 billion increase in tax rates; $15 billion lost in consumption spending Price level AS $60 billion decrease in Aggregate Demand P 2 P 1 AD 4 $490 $550 MPS =. 25 AD 3 Real GDP (billions)

Built-in Stability Some 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.

Real Interest Rate, (percent) Crowding —Out Effect S i% i% D 2 Increased demand for loanable funds by government raises the interest rate. D LF 0 LF 1 Quantity of Loanable Funds

Fiscal policy weakened by NET EXPORT EFFECT Expansionary fiscal policy Problem: Recession More government spending and/or lower taxes Contractionary fiscal policy Problem: Inflation Lower government spending and/or higher taxes Higher domestic interest rates (crowding-out effect) Lower domestic interest rates (government role in loanable funds market is less) Increased foreign demand for dollars (foreigners want to earn higher interest) Dollar appreciates Net Exports decline (AD decreases, partially offsetting expansionary policy) 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 by enacting policies designed to stimulate incentives to work, to save and invest (including measures to encourage entrepreneurship). These policies may include tax cuts which will increase disposable incomes, thus increasing household saving and increase the profitability of investments by businesses. • Tax cut stimulates more consumption, saving and investment to increase AD. • The new investment moves the AS curve to the right. Work incentives push more workers into employment and they spend and save increasing AD further. • Low taxes act to push risk takers to move toward new production methods and new products.

Laffer Curve …shows the relationship between tax rates and tax revenues √ Up to a point, higher tax rates will result in larger tax revenues. √ But still higher tax rates will adversely affect incentives to work and produce, reducing the size of the tax base and reducing tax revenues. √ Lower tax rates will lessen tax evasion and avoidance, and reduce government transfer payments.

M M O N E Y E A S U R E S • Large time deposits M 3 • Money market accounts • Savings deposits • Small time deposits M 2 + + • Checkable deposits • Travelers checks • Currency MI

The Money Market i% i%1 Sm Supply of 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: 1. Banks issue loans to customers and receive a demand deposit. 2. Banks buy securities from the public and credit a demand deposit for the cost. Money supply is decreased when: 1. Customers repay loans take money from their demand deposit. 2. Banks sell securities to the public and a demand deposit is reduced to pay for the bond.

√ One bank can loan only its excess reserves and is limited by those reserves in creating money. √ The banking system creates a “multiplied” amount. The Money Multiplier 1 = Money Multiplier Required reserve ratio Maximum Demand. Excess x Money = Deposit reserves Multiplier creation Currency drain and no creditable customers will decrease the amount multiplied.

EASY MONEY Goal: Cheap, available credit; increase the money supply MS i% In C AD PL RGDP Easy money is reinforced by the Net Export Effect

Easy Monetary Policy And Equilibrium GDP Real rate of interest, i Sm 1 Sm 2 Sm 3 10 10 8 8 6 6 0 Dm Quantity of money demanded and supplied AS Price level Investment Demand PL 3 PL 2 PL 1 0 Amount of investment, i If the Money Supply Increases to Stimulate the Economy… §Interest Rate Decreases §Investment Increases §AD & GDP Increases AD 3(I=$25) with slight inflation AD 2(I=$20) §Increasing money supply AD 1(I=$15) continues the growth – Real domestic output, GDP but, watch Price Level.

Tight Money Goal: Restrict credit; decrease the money supply MS i% In C AD PL RGDP Tight money is reinforced by the Net Export Effect

Tight Monetary Policy And Equilibrium GDP Real rate of interest, i Sm 3 Sm 2 Sm 1 10 10 8 8 6 6 0 Dm Quantity of money demanded and supplied PL 1 PL 2 PL 3 0 Amount of investment, i If the Money Supply Decreases to “cool” the Economy… §Interest Rate Increases §Investment Decreases §AD & GDP Decreases AD 1(I=$25) with lower PL AD 2(I=$20) §Decreasing money supply AD 3(I=$15) continues the “cooling” – Real domestic output, GDP as Price Level falls. AS Price level Investment Demand

Nominal Rate = Real Interest rate + expected rate of inflation Real Interest Rate = Nominal rate—expected rate of inflation

Money Market Graph—Nominal Interest Rate i% Sm The supply of money is vertical no matter what the interest rate is on the vertical axis. The FED controls the supply of money. i%e Qe Q of $$ demanded The demand for money is composed of the Dmtransaction demand asset demand.

Loanable Funds Market—Real Demand is: Interest Rate r SLF • Business for investment • Consumer for spending re • Government for Deficit spending DLF Qe Q of LF Supply is mostly from private savings Changes in the real interest rate caused by movements of demand (from borrowers) and supply (from savers).

GROWTH IN THE AD-AS MODEL ASLR 1 ASLR 2 C Price Level Capital Goods A B D Consumer Goods Q 1 Q 2 Real GDP

Classical View: determines the output at Qf √ AD is stable and determines the price level as long as money supply is stable. √ If AD is unstable, prices and wages adjust. Price Level √ AS is vertical and AS P 1 P 2 AD 1 AD 2 Qf Real Domestic Output A shift to AD 2 shows that the price level declines.

Keynesian View: AS Price Level √ Product prices and wages are downward inflexible √ AS is horizontal up to P 1 Qf then becomes AD 1 vertical AD 2 √ If AD is unstable, Q 2 Qf changes in AD have no Real Domestic Output effect on PL but affect Movement from AD 1 to AD 2 RGDP. reduces the Real GDP but the PL remains constant.

NEW CLASSICAL VIEW OF SELF-CORRECTION Price Level Self-Correction P 3 P 2 P 1 AD increases ASLR AS 1 moves economy from a to b. Price level rises (P 2) and then c self-correction b to c by shifting a AD 2 left to AS 2 as Nominal Wages AD 1 rise. Q 1 AS 2 Real Domestic Output

Monetary rule : supported by Monetarists and other Neo-Classical Economists like Rational Expectationists. …directs the 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 by Mainstream Economists.

Deficits, Surpluses and Debt A budget deficit is the amount by which the government expenditure exceeds the government revenue in a particular year. A budget surplus is the amount by which the government revenue exceeds the government expenditure in a particular year. The National or Public Debt is the accumulated deficits and surpluses of the government over time.

Types of Budgets Annually Balanced—procyclical Cyclically Balanced—too hard to predict cycles Functional Finance-work for goals

√ Comparative Advantage …is the ability to produce an item at a lower opportunity cost. Resources are scarce, so that one can only produce more of one product by taking the resources away from another. It means that total world output will be greatest when each good is produced by the nation which has the lowest domestic opportunity cost. (input & output methods) √ As a result of trade, countries that trade products based on their own specialization will have more of BOTH products (produced and traded for). √ Terms of Trade…the exchange ratio between goods traded. Terms of Trade Index (To. T) = 100 x Average export price index / Average import price index If a country can buy more imports with a given quantity of exports, its terms of trade have improved.

Flexible exchange rates S $ Price of Foreign Currency The intersection will be the exchange rate. $fc D Qfc Quantity of Foreign Currency

A nation’s Balance of Payments records all the transactions that take place between its residents and the residents of a foreign nation. Current Account Capital Account Net exports: Goods/Services Real Investment Net Investment Income Net Transfers Financial Investments Official Reserves Account is the foreign currency and securities held by the government, usually by its central bank, and is used to balance the payments from year to year

The Market For Currency S FC Appreciates; $ Depreciates FC price of dollars Dollar price of foreign currency S Dollar Appreciates; FC Depreciates FCP/$ Dollar Depreciates; FC Appreciates $P/fc D FC Depreciates; $ Appreciates Q D Q Quantity of foreign currency Quantity of $

Determinants of exchange rates: p Changes in tastes p Changes in relative incomes p Changes in relative prices p Changes in relative interest rates p Speculation in currencies