AP macroeconomics Unit 4: Long Run Economic growth and loanable funds

Topic 1: Review of AD/AS graph

What is the AD/AS graph used to illustrate??? 1. changes in price level

2. changes in quantity of real GDP/output

3. changes in employment

4. FISCAL POLICY action

1. Draw an AD/AS graph at full employment equilibrium

2. Draw an AD/AS graph showing a recession

3. Draw an AD/AS graph showing inflation

Reasons AD curve will shift:

• 1. Change in C (*wealth, income taxes, confidence)

*Wealth = the value of all things a person owns. ASSETS

How much $ a person earns (wage/income) is

NOT the same thing as wealth

Reasons AD curve will shift:

• 2. Change in I (includes business taxes)• 3. Change in G • 4. Change in Xn

*FISCAL POLICY impacts this curve

Reasons SRAS curve will shift???

1. Change in resources quality and quantity

2. Change in price of resources (wages)3. Change in business taxes 4. Change in legalities 5. Change in technology6. Change in productivity

*This curve can SELF ADJUST in the long run due to flexible wages

Reasons LRAS will shift???

1. change in resources quality and quantity

2. Change in technology

Topic 2: Review of Phillips curve graph

• What is the Phillips curve used to illustrate??

The relationship between inflation and

unemployment

1. Draw a Phillip’s curve graph at FE

2. Draw a Phillip’s curve with a recessionary gap

3. Draw a Phillips curve with an inflationary gap

Reasons Phillips curve will shift:

Inflation and unemployment both move in thesame direction

Topic 3: Review of money market graph

What is the money market graph used toillustrate???

1. changes in NOMINAL interest rate

2. MONETARY policy action

Draw a correctly labeled money market graph

Reasons Md will shift

• 1. Change in price level

• 2. change in real GDP

Reasons Ms will shift

• Fed action (monetary policy) changing the reserve ratio changing the discount rate open market operations

Review of multipliers Spending multiplier Tax multiplier Money multiplier

When to use when there is a change in spending in the economy

When there is a change in income taxes in the economy

When there is a deposit placed in the bank or the Fed uses open market operations

Formula for 1/MPS or - 1/MPS

MPC/MPS or - MPC/MPS

1/RR or -1/RR

See practice WS

• QUIZ

Topic 4:Long Run Economic growth

Long Run Economic growth

1. The increase in real GDP which occurs over a period of time

2. The increase in real GDP per capita which occurs over a period of time

Calculation of Rate of Growth

Example: Real GDP this year is $11 million. Last year, real GDP was $10 million. What is the Growth rate???

Ingredients of economic growth

Supply Factors: 1. Increases in the quantity and quality of

natural resources 2. Increases in the quantity and quality of

human resources/human capital (ex education)

3. Increases in the supply of capital stock 4. Improvements in technology

Ingredients of Economic Growth

• 5. Demand Factor To achieve higher production created by

the supply factors, households, businesses and G must purchase the expanding output

Ingredients of Economic growth

6. Efficiency productive efficiency: Use of resources in least costly way

allocative efficiency: produce what society

desires

Graphing economic growth

• 1. Can be shown as an outward shift in a nation’s production possibilities curve

• 2. Can be shown as a rightward shift of a nation’s LRAS curve

Economic growth and PPC

Economic growth and AD/AS graph

Topic 5: The Financial System

• Consists of institutions that help match one person’s savings with another person’s investment

• The Financial System is made up of financial institutions (2 types) 1. financial markets 2. financial Intermediaries

Financial Markets

• Institutions through which savers can directly provide funds to borrowers

• Examples: stock market and the bond market

Financial Intermediaries

• Financial institutions through which savers can indirectly provide funds to borrowers

Example: Banks

Topic 6: loanable funds theory of interest

• Looks at the impact of an action on REAL interest rates

Nominal Interest Rate (i) The actual interest rate Measures the annual percentage increase in the

nominal (current dollar) valueNIR = RIR + inflation rate

Real Interest Rate (r)Interest rate taking inflation into account

RIR = NIR – inflation rate

Nominal vs. Real Interest Rates

Example:You lend out $100 with 20% interest. Inflation is 15%.

Nominal interest rate = 20% Real interest rate = 5%

Example:You borrow $100 with 10% interest. Prices increase13%.

Nominal interest rate = 10% Real interest rate = -3%

Topic 7: The Supply of Loanable Funds

The supply of loanable funds comes from SAVINGS – INVESTMENT for SAVINGS

Examples of Savings:

• Purchase a certificate of deposit at a bank • Put money into savings account at a bank• Purchase corporate stock or bonds • Buy shares of a mutual fund

Supply of Loanable funds

• A high real interest rate is an incentive tosave.

• The real interest rate is the OPPORTUNITY COST of spending

example: You decide to spend your money rather than save it – the interest rate you could have earned on your money is what

you give up

Reasons the Supply of loanable funds will shift:

1. A change in disposable incomemore disposable income = more savingsless disposable income = less savings

2. A change in taxes on interest income increase in taxes = less savings decrease in taxes = more savings

3. Anything that can impact savings (INVESTING FOR THE FUTURE)

4. FOREIGN INVESTMENT (SAVINGS)

Supply in money market vs supply in loanable funds

• Money market graph = source of supply from the Fed

• Loanable Funds graph = source of supply from savers

Topic 8: The demand for Loanable Funds

• In order for firms to increase their capital stock, they must purchase machinery, tools and education for their workers.

• Firms must often borrow $ to do this

Demand for Loanable funds

The sources of demand are the economy’s businesses who want to borrow $ to acquire more factories, inventory and equipment

The demand for loanable funds = BORROWING FOR INVESTMENT (BORROWING TO IMPROVE BUSINESS)

Investment = purchase of capital goods, construction and inventory IT IS NOT the buying of STOCK

Examples of INVESTMENT

-GM spends $250 million to build a new factory-you buy $5,000 worth of computer equipment for your business - your parents spend $200,000 to have a new house built

Demand for loanable funds

If firms must borrow funds, they regard theREAL rate of interest as a cost for anInvestment

Example: firms expect profits to increase by 5% due to a new investment of which they can borrow at a 3% rate of interest. Should this firm borrow the money???

Reasons the Demand for loanable funds will shift:

1. A change in investment tax credits (tax break) more tax credits = more investment less tax credits = less investment

2. A change in business/corporate tax lawsmore taxes = less investment less taxes = more investment

3. Change in the expected rate of profitmore expected profit = more investment less expected profit = less investment

4. A change in the government’s budget deficitincrease in budget deficit = increase in D decrease in budget deficit = decrease in D

Topic 9: Relationship between supply and demand of Loanable funds

• The long run amount of savings directly affects the amount of money available for investment

• Savings rate in a country is the single most important determinant of investment

more investment = more capital stock more capital stock = Long run growth

The market for Loanable Funds

• The market in which those who want to save supply funds and those who want to borrow to invest demand funds

Assume: only one financial market - all savers deposit their savings in this market

- all borrowers take out loans from this market

Real Interest Rate

50

D(Investment)

S (savings)

Loanable Funds Market

Quantity of LoansQLoans

re

At the equilibrium real interest rate, the amount borrowers want to borrow equals the amount lenders want to lend. SAVINGS = INVESTMENT

Practice:

• Tax incentives for savings increase. Draw a loanable funds graph to illustrate this.

Practice

• An investment tax credit increases the demand for loanable funds. Illustrate this on a loanable funds graph.

Practice

• The government borrows money to finance their budget deficit. Illustrate this action on a loanable funds graph.

Crowding Out

• Crowding out = An increase in budget deficit increase real interest rates which decreases investment

• Remember: investment is important for long run economic growth – budget deficits reduce the economy’s growth rate and future standard of living