8 am – may 17 th, 2012 ap macroeconomics test review rmce/hwrhs

8 AM – May 17th, 2012AP Macroeconomics Test Review

RMCE/HWRHS


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Circular Flow Model


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Gross Domestic ProductValuation of economy

Value of production, not simply production

Final Goods

Second hand goods not included

Transfers not included


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GDPGDP = AD (Aggregate Demand)

GDP = C + I + G + (X-M)

C = Personal Consumption I = Capital InvestmentsG = Government Expenditures No transfer payments

X-M = Net Exports = eXports - iMports


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GDP vs GNPGross Domestic Product

What is produced within a country’s borders, regardless of who produces it.

Mercedes built in America count towards American GDP

Fords built in Germany count towards German GDP

Gross National Product

What is produced by the citizens of a country, regardless of where they produce it.

Mercedes built in America count towards German GNP

Fords built in Germany count towards American GNP


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Real vs Nominal GDPNominal

Value of current production in current prices

RealValue of current production in base year prices

GDPReal = (GDPNom)(Price Index)

%∆GDPReal = %∆GDPNom - %Δ Index


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CPIConsumer Price Index

Measure inflationBase yearMarket Basket

What is the difference between the CPI and the GDP deflator?Both are price indices but they have different

market baskets. The CPI includes consumer goods whereas the GDP deflator contains all items that are produced domestically.


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Causes of Inflation2 types

Demand-pull inflation Aggregate demand > productive capacity

Causes include increases in money supply or credit.

Cost-push Prices increased by producers to cover higher costs of

production. Supply shocks such as changes in oil prices, crop failures & natural

disasters.


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5 Major Effects of Inflation

Decreased purchasing powerDecreased value of real wagesIncreased interest ratesDecreased savings & investingIncreased production costs


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UnemploymentUnemployed – must be looking for work to be part of labor force.

Unemployment rate is % of labor force that is unemployed.

Types of unemployment include: Frictional Seasonal Structural Cyclical

Full employment is economy at full steam. Since there is always frictional & structural unemployment, the Natural unemployment rate is the unemployment rate for full employment.


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Consumption Function

DI

CF

Consumption FunctionC = a + b (DI)a = autonomous spendingspending when income = 0B = consumption rate

Savings

Dissavings

Consumption

Disposable Income


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Marginal Propensity to Consume & Save

MPC = ΔC/ΔDI

MPS = ΔS/ΔDI

MPC + MPS = 1

C=Consumption, S=Savings, DI=Disposable Income

MPC= Consumption rate in consumption function


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MultiplierMultiplier

= 1 / MPS = 1 / (1-MPC)

Examples MPC = .9, Multiplier = 1/.1 = 10 MPC = .8, Multipler = 1/.2 = 5 MPC = .5, Multiplier = 1/.5 = 2

NB Taxes have a smaller multiplier than direct government spending


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AD – AS ModelPriceLevel

GDPR

LRAS SRAS

AD

YO

P

Aggregate Demand (AD)= C+I+G+(X-M)

Short-run Aggregate Supply (SRAS)

Long-run AggregateSupply (LRAS)


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AD – AS Model - InflationPriceLevel

GDPR

LRAS SRAS

AD

YO

P

Y1

Economy producingBeyond L-R capacity

Inflationary Gap

Higher rates drivedown interest sensitiveexpenditures (AD )

AD2

P2

GDP beyond L-REquilibrium at Y1 & P

AD Shift causes Y to go to L-R YO, & P


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AD – AS Model - InflationPriceLevel

GDPR

LRASSRAS

AD

YO

P

Y1

Economy producingunder L-R capacity

Recessionary Gap

Lack of demand drivesdown nominal wages ( SRAS )

SRAS2

P2

GDP below L-R Equilibrium at P & Y1

SRAS2 shift resultsin P & Y


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Shifts in AD

Changes in expectations Expectations – AD

Changes in wealth Wealth , - AD

Amount of physical capital Existing Capital – AD

Fiscal policy Government spending – AD

Monetary policy Money supply – AD


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Shifts in SRAS

Commodity pricesExample is oilPrices - AS

Nominal wagesWages - AS

ProductivityProductivity - AS


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AD AS Model

Shifts of AD

Demand shock

Negative “Great Depression” ADN, EN, PN, YN

Positive WWII ADP, EP, PP, YP

AD

SRAS

ESRPE

YE

Real GDP

Ag. Pr.Level

EP

EN

PP

PN

YPYN

ADP

ADN


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AD AS Model

Positive Demand Shock AD shifts to AD2

E1 up to E2

P1 up to P2

YP up to Y2

Inflationary Gap

Inflation causes L-R increase in wages SRAS shifts to SRAS2

E2 shifts to E3

P2 up again to P3

Y2 down to YP

AD

SRAS

E1P1

YP Real GDP

Ag. Pr.Level

LRAS

AD2

E3

E2

SRAS2

Y2

P3

P2


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AD AS Model

Shifts of SRAS

Supply shock

Negative Oil Crisis SRASN, EN, PN, YN

Positive Internet SRASP, EP, PP, YP

AD

SRAS

ESRPE

YE

Real GDP

Ag. Pr.Level

EP

ENPN

PP

YPYN

SRASN

SRASP


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Continuum – Government Policies

Restrictive

Low GrowthLow Inflation

Expansionary

High GrowthHigh Inflation


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Fiscal PolicyExpansionary

Stimulates economy Decrease taxes and/or increase spending Increases disposable incomes/demand Inflationary & leads to debt

Restrictive Reduces Disposable income/demand. Lack of cash reduces investments. Reduction in government spending/programs

Restrictive Expansionary


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Monetary PolicyMonetary PolicyEasy Money

Increases growth (good) Increases inflation (bad)

Tight MoneyDecreases growth (bad)Decreases inflation (good)

Easy MoneyTight Money


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How the Fed Can Change MSHow the Fed Can Change MS

Fed Tools

1. Open Market Operations

2. Fed Funds Rate & Discount Rate

3. Reserve Requirements for Banks

4. Moral suasion


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Expansionary PolicyExpansionary PolicyGDPR

up

Imports down

Price Level

up

Exports up Unemploy

-ment down

GDPN up

Exchange rates down

Invest-ments

up

AD up

InterestRatesdown

MoneySupply

up

Inflation up


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Phillips CurveInflation

Unemployment

LRPC

SRPC

NRU/NAIRU

%

S-R trade-off betweenInflation & unemployment

Trade-off does not Occur in the L-R

SRPC2

Shifts in SRPC the result of Δ expected inflation

%2


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Money SupplyInterestRate, i

GDPR

MS

MD

M

i

i = nominalinterest rates

Δ in MS controlledby the Fed Reserve

M * V = P * Q

MS*Velocity or multiplier= Price Level * Output


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Money Supply & Interest RatesMoney Supply & Interest RatesInterest rate

r1

r2

Mde1

Money supply

MD1

Quantityof money

MS2

AD1

GDPRY1 Y2

P1

Mde2

AD2

SRAS

P2

Increased MS leads to r

Lower r leads to C& I meaning AD

AD shifts right, leading to Price Level & GDPR P

rice

Leve

l


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Loanable FundsInterestRate, r

GDPR

SM

DM

YO

r

r = real interest rates

NB - With interest ratesi includes inflationwhile r is for real


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TermsCrowding out

Government competes with or eliminates private enterprise. Providing a service otherwise supplied by a company Competing in the marketplace for loans to finance debt.

Rational Expectations TheoryBusinesses & consumers react to expected changes in

monetary & fiscal policy, thereby negating their impact.

Automatic Stabilizersadjust automatically, without government deliberation,

to offset economic conditions


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Crowding Out Effect – Change in Demand

Quantity ofLoanable Funds

Interest Rate, r S1

D1

D2

∆ in Demand:government debtcreates additional demand for funds.

r1

r2

Rightward shift of demand curve resultsin r & Q .

Q1 Q2


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Crowding Out Effect – Change in Supply

Quantity ofLoanable Funds

Interest Rate, r S1

D1

S2

∆ in Supply:Government is Most credit worthyBorrower, so FedDebt removes supply

r1

r2

Leftward shift of Supply curves resultsIn r & Q

Q2 Q1


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Automatic Stabilizers$

GDPR

Deficit – Economy in recession, causestaxes to drop below govt. expenditures

Taxes

Govt

Surplus – Economy booms, causes taxes to increase above govt spending

Automatic adjustments to economic conditions by increasing deficit during recessions & increasing surplus in boom periods (income taxes)


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Macroeconomic TheoriesClassical

Changes in MS only affect nominal rates, not realAutomatic stabilizers will correct market fluctuationsNo government action

KeynesianFiscal policy as a tool to correct cyclical fluctuationsGovt spending up to offset recessions

MonetaristsGovt often wrong or late, only make matters worseMS to grow at rate of GDP growth (no fiscal remedies)


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Foreign TradeRevisit Comparative & Absolute advantages from

Micro PP

Balance of PaymentsCurrent Account – Transactions w/o liabilitiesCapital Account – Transactions w/ liabilities

Exchange Rate ChangesConsumer tastesRelative incomesRelative inflationSpeculationMoney supply/ relative interest rates


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Exchange Rates$/€

Q

S

D

Qe

$

Demand for $ increases asother currencies trade for $

Demand Curve shifts to D2

causing $ & Q

D2

$2

Q2

Looking at exchange rate fromother side – euros/dollarHigh demand for $ means people want to trade euros in& this leads to excess supply

Supply curve shifts to S2, causing € & Q

S2

€2

€

€/$


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International Trade & TaxesDollars/Euro

Q

SDom

D

10

$100

$80

8 12

Imports

Example: US Oil Market Equilibrium at $100 & 10MBarrels.

World price is $80. Effect onUS market is Demand at $80 Is 12M while Supply is 8M.Difference of 4M is imports.

Protective tariff of $10/Barrel added

$90

9 11

Deadweight Loss (DWL)

Effects of tariff include P $10, Q 1M barrels, & Imports 2M barrels


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Graph RelationshipsGraph RelationshipsI

Money Market

M

MD

MS

Investment Demandi

I

I

GDPR

i i

I

I

Y

MS

M M

i i

Y

I

I

Contraction of MS leads to higher i, which reduces I, causing GDP to fall

Graph reversed so GDP is falling


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Graph Review – MS Money Supply Loanable Funds Investment Demand

ADAS ModelExchange RatesPhillips Curve

i

Q Q Q

Q

I/RI/R I/R

M

r r

Iq

P/L

P

Real GDPY

A/B

ER

qUnemployment

Infl

atio

n

%

M

i

q

rr

I

Y

P

ER

q

%

NRUU/R

MD

MS MS SS

DI/D

AD

AD

ASLRPC

SRPC

SS

D

Fed increases MS i MS leads to

shift right in S inloanable fundsr & q

r leads to I

I = AD AD = P & Y

P/L = X & M Supply of $ ER & q

AD = Inflation &Unemployment

8 am – may 17 th, 2012 ap macroeconomics test review rmce/hwrhs

Documents

ad aggregate demand

p y slide

sensitive expenditures

index slide

p2p2 gdp

gdp deflator

consumption function

y1 p ad shift