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AP Macroeconomics Review

AP Macroeconomics Review. Vocabulary Graphs. Three basic economic questions. What to produce How to produce For whom to produce Can apply to anything. Production Possibilities. Assumptions: Full Employment Fixed Resources and Technology Movements Along curve shows opportunity cost

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AP Macroeconomics Review

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  1. AP Macroeconomics Review • Vocabulary • Graphs

  2. Three basic economic questions • What to produce • How to produce • For whom to produce • Can apply to anything

  3. Production Possibilities • Assumptions: • Full Employment • Fixed Resources and Technology • Movements • Along curve shows opportunity cost • Outward shift illustrates economic growth • Inward shift indicates destruction of resources • Producing Capital Goods will lead to greater economic growth than producing consumer goods. (Butter will lead to more growth than guns)

  4. Production Possibilities Graph Capital Goods Points B,C, D are efficient pts. Point G is underutilization Point F is economic growth A B F May Lead to most Future economic growth May Lead to most Future growth C G D E Consumer Goods

  5. Economic Systems • Capitalism=Free Market • Most decisions made by Private businesses • Communism=Command Economy • Most decisions made by the government • Mixed Economy=Features of both Capitalism and Communism • Decisions made by both the market and governments

  6. Supply and DemandFact for anything Demand is Down Supply is UP

  7. Supply and Demand Factors • Demand Shift when: • Taste and preferences of consumers • Related Products, complements and substitutes, (price or quality change) • Income of buyers(more or less added) • Buyers (population more or less) • Expectations (future price change) • DEMAND SHIFT HAPPENS

  8. Demand Increase: As Demand Increases, Price and Quantity Increase as well. Price S1 P2 P1 D2 D1 Q1 Q2 Quantity

  9. Demand Decrease: As Demand Decreaes, Price and Quantity decrease as well Price S1 P1 P2 D1 D2 Q2 Q1 Quantity

  10. Supplyand demand Factors • Supply shifts when: • Resource cost (Input prices change: resources and wages) • Other goods’ prices (substitutes in production and joint products) • Taxes and subsidies (Government: tariffs, quotas, regulations) • Technology changes • Expectations(about price and product profitability change: weather, strikes) • Number of sellerschange • SUPPLY SHIFT HAPPENS

  11. Supply Increase:As Supply Increases, Quantity Increases, but Price Falls. S1 Price S2 P1 P2 D1 Quantity Q2 Q1

  12. Supply Decrease:As Supply Decreases, Quantity Decreases, but Price Increases. S2 Price S1 P2 P1 D1 Quantity Q2 Q1

  13. Comparative Advantage • A nation should specialize in producing goods in which it has a comparative advantage: ability to produce the good at a lower opportunity cost. (who gives up the least in that product) Example: CheeseWine Spain: 2 pounds 2 Cases France 2 pounds 6 Cases Spain should produce cheese (1C = 1W) France should produce wine (1W = 1/3C) :

  14. Advantage definitions • Trade does not rely on absolute advantages, but on comparative advantages. • If you have a comparative advantage in production of a good, specialize in production of that good and trade for the other. • Absolute Advantage is when a country has the ability to produce a good using fewer resources per unit of output than another country • Comparative Advantage is when a country can produce a good at a lower opportunity cost (smaller loss in terms of production of another good)

  15. Currency Terms • Appreciation: Currency is increasing in demand (stronger dollar) • U.S. Currency will appreciate when more foreigners: travel to the U.S., buy more U.S. goods or services, or buy the U.S. dollar to invest in bonds

  16. Currency Terms • Depreciation: Currency is decreasing in demand (weaker dollar) Being SUPPLIED in exchange for other currency. • U.S. Currency will depreciate when fewer foreigners: travel to the U.S., buy fewer U.S. goods or services, or sell the U.S. dollar to invest in their own bonds

  17. Circular Flow of Economic Activity • Households supply resources (land, labor, capital, entrepreneurial ability) to the resource market. Households demand goods and services from businesses. • Businesses demand household resources and supply goods and services to the product (factor) market.

  18. Circular flow

  19. GDP (Gross Domestic Product):The total dollar (market) value of all final goods and services produced in a given year. • Expenditure Formula: • Consumption (C) + Business Investment (I) + Government Spending (G) + Net Exports (X-M)

  20. What are the components of GDP? Exports Imports Inventories Fixed Investment Residential Nonresidential GDP Personal Consumption Expenditures (C) Investment (I) Government (G) Net Exports (NX) GDP =C+ I +G+NX

  21. GDP: What Counts: • Goods Produced but not Sold (I) • Goods produced by a foreign country (Japan) in the U.S. (Honda, Toyota) • Government spending (F,SL) • Increase in business inventories

  22. GDP: What DOES NOT count: • Intermediate Goods (Tires sold by Firestone to Ford for a car off the production line) • Used Goods • Non-Market Activities (Illegal, Underground) • Transfer Payments (Social Security) • Stock Transactions

  23. Shortcomings of GDP: Leading to GDP being understated. • Nonmarket activities: (services of homemakers) does not count. • Leisure: Does not include the value of leisure. • Does not include improvements in product quality. • Underground economy

  24. Real GDP • Real GDP= Nominal GDP adjusted for inflation. • Calculation: • Real GDP = Nominal GDP Price Index in Hundredths( deflator) Example: U.S. 2005 Real GDP= $12,4558 (billions) 1.1274 (based on 2000) $11.048 Trillion

  25. Real GDP Per Capita • Most commonly used to compare and measure each country’s standard of living and overall economic growth. • Real GDP/Nation’s Population

  26. GDP Extra • Value added price: how much value the product has through the stages of production • GNP: GDP + the rest of the world • NI: income adjusted for depreciation and indirect business taxes • PI: households only • DPI: income after taxes (spent + save)

  27. Business Cycles • The increases and decreases in Real GDP consisting of four phases: • Peak: highest point of Real GDP • Recession: Real GDP declining for 6 months • Trough: lowest point of Real GDP • Recovery: Real GDP increasing (trough to peak)

  28. Unemployment • Calculation: Number of Unemployed Labor Force (Multiplied by 100 to put as a %) The Labor Force is the total of employed and unemployed workers. U.S. unemployment should be about 5%

  29. Employed • You are considered to be employed if: • You work for 1 hour as a paid employee (so part-time workers count) • You are temporarily absent from work (illness, strike, vacation) • You work 15 hours or more as an unpaid worker (family farms are common)

  30. Unemployed • Must be looking for work (at least 1 attempt in the past 4 weeks) • Are reporting to a job within 30 days • They are temporarily laid off from their job

  31. Types of Unemployment • Frictional: Have skills that are in demand; just need time to find a job (College Graduate) • Structural: Current skills do not match job openings (Factor jobs being outsourced; Flight attendant after 9/11/2001). • Frictional + Structural = Natural Rate of Unemployment (Full –Employment rate) • Cyclical: Due to a recession (Requires Government action).

  32. Not In Labor Force • A person who is not looking for work: • Full-time students • Stay at home parents • Discouraged workers: those who have given up hope of finding a job. • Retirees

  33. Inflation • Rise in the general level of prices • Reduces the purchasing power of money • Measured with the Consumer Price Index (CPI) • Reports the price of a market basket , more than 300 goods that are typically purchased by an urban household

  34. Consumer Price Index (CPI) • CPI = Recent Price of Market Basket Price of same basket in base year (This number is then multiplied by 100) Example: Assuming only 2 Goods Recent YearBase Year PQPQ Jeans $25 5 $20 5 Pizza $20 10 $15 10 $325 = 1.3 * 100=130 $250

  35. Calculating Inflation • CPI in Recent Year – CPI in Past Year Divided by CPI in Past Year (Number then Multiplied by 100) Example: 2002 CPI = 179.9 2001 CPI = 177.1 Rate of Inflation: 179.9-177.1 = 1.58% 177.1

  36. Types of Inflation • Demand Pull Inflation: ‘too much money chasing too few goods.” • AD Curve will shift to the right, resulting in a higher Price Level and greater Output (up til FE) • Cost-Push Inflation: Major cause is a supply shock-OPEC cutting back on oil production • AS Curve will shift to the left resulting in a higher Price Level and a decrease in Real GDP.

  37. Real and Nominal Terms • Real Income = Nominal Income Price Index (Hundredths) • Real Interest Rate = Nominal Interest Rate – Inflation Rate • Nominal Interest Rate = Real Interest Rate + Inflation Premium (anticipated inflation)

  38. Inflation: Winners & Losers • Winners: • Debtors who borrow money that will be repaid with “cheap” dollars. • Those who have anticipate inflation • Losers: • Savers (especially savings accounts) • Creditors (Banks will be repaid with those “cheap” dollars • Fixed-Income Recipients (retirees receiving the same monthly pension)

  39. Consumption and Saving • As income increases, both consumption and savings will increase. • The determinants of overall consumption and savings are: (More money or a positive outlook will increase consumption and reduce savings. Less money or a negative outlook will increase savings and reduce consumption. • Wealth (financial assets) • Expectations about future prices and income • Real Interest Rates • Household Debt • Taxes

  40. Marginal Propensities • Marginal Propensity to Consume (MPC) and the Marginal Propensity to save (MPS) must equal 1. • The MPS is used to derive the spending multiplier, which equals: 1 MPS If the MPS is .2, the spending multiplier is 5. Any increase in spending must be multiplied by 5 to determine the overall increase in Real GDP.

  41. Interest Rate-Investment • Expected Rate of Return: Amount of Profit (expressed as a percentage) a business expects to gain on a project/investment. • This rate must be greater than the interest in order to be profitable. • The Real Rate of Return is most important. An expected profit of 10%, that costs 5% in interest = The real rate of return: 5%.

  42. Investment Demand Curve: Real Rate of Return At lower real interest rates businesses will Increase investment , leading to an increase In AD (aggregate demand). At higher rates of Interest, less money will be invested r1 r2 ID Q2 Quantity of Investment Q1

  43. Shifts of the Investment Demand Curve A shift from ID1 to ID2 Represents an increase in Investment demand. A shift From ID1 to ID3 represents a decrease in investment Demand. PL ID2 ID1 ID3 Real GDP

  44. Aggregate Demand • Downward sloping: • Real-Balances Effect: change • in purchasing power • 2. Interest-Rate Effect: Higher • interest rates curtail spending • Foreign Purchase Effect: • Substitute foreign products for • U.S. products Price Level AD (C + I + G + X) Real GDP

  45. Aggregate Demand • Determinants of AD: • C + I + G + X (Yes, its GDP) • An increase in any of these, due to lower interest rates or optimism will increase AD and shift the curve to the right. • A decrease in any of these: more debt, less spending, tax increase, will cause a decrease in AD and shift the curve to the left

  46. Aggregate Demand Determinants • Government • Change in Gov. spending • Net Exports • National Income Abroad • Exchange Rates • Consumption • Wealth • Expectations • Debt • Taxes • Investment • Interest Rates • Expected Returns • Technology • Inventories • Taxes

  47. Aggregate Supply Factors: • R: resource prices (wages and materials, as well as OIL) • A: actions by government (Taxes, Subsidies, more regulation) • P: productivity (better technology)

  48. Aggregate Supply • Long Run: • Curve is vertical because the economy is at its full-employment output. • As prices go up, wages have adjusted so there is no incentive to increase production. • Short Run: • Assumes that nominal wages are “sticky” and do not respond to price level changes. • Is Upward sloping as businesses will increase output to maximize profits

  49. Aggregate Supply Graph Price Level AS Short Run Inflation Long Run Growth Recession Extended vertical line Illustrates the LRAS and QF (Full-Employment) QF Real GDP

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