AP Macroeconomics Review Session One

1
Massive Macro Cram Kit!
2
Topics and percentages

• 8-12 Basic Economic Concepts
• 12-16 Measurement of Economic Performance
• 10-15 National Income and Price Determination
• 15-20 Financial Sector
• 20-30 Inflation, Unemployment, and Stabilization
  Policies
• 5-10 Economic Growth and Productivity
• 10-15 Open Economy International Trade and
  Finance

3
8-12 Basic Economic Concepts
A. Scarcity, choice, and opportunity costs B.
Production possibilities curve C. Comparative
advantage, absolute advantage,
specialization, and exchange D. Demand, supply,
and market equilibrium E. Macroeconomic issues
business cycle, unemployment, inflation,
growth
4
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)

5
Production Possibilities Graph
Capital Goods
Points A,B,C, are efficient pts. Point D is
underutilization Point E is economic growth
A
E
May Lead to most Future economic growth
May Lead to most Future growth
B
D
C
F.E.
F.E.1
Consumer Goods
6
Supply and Demand Factors

• Demand Changes when Timer
• Tastes, Fads, Preferences change
• Income changes
• Market Size ( of potential consumers)
• Expectations about future price, income
  availability.
• Related Products, complements and substitutes,
  (price or quality change)

7
Demand Increase As Demand Increases, Price
Quantity Increase as well.
Price
S1
P2
P1
D2
D1
Q1
Q2
Quantity
8
Demand Decrease As Demand Decreases, Price and
Quantity decrease as well
Price
S1
P1
P2
D1
D2
Q1
Q2
Quantity
9
Supply Factors

• Supply Changes When RATNEST
• Resource prices change (resources and wages)
• Alternative output price changes substitutes in
  production
• Technology
• Number of sellers change
• Expectations (about future price)
• Subsidies
• Taxes

10
Supply Increase As Supply Increases, Quantity
Increases, but Price Falls.
S1
Price
S2
P1
P2
D1
Quantity
Q2
Q1
11
Supply Decrease As Supply Decreases, Quantity
Decreases, but Price Increases.
S2
Price
S1
P2
P1
D1
Quantity
Q1
Q2
12
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.
• Example
• Cheese Wine
• Spain 2 pounds 2 Cases
• France 2 pounds 6 Cases
• Spain should produce cheese (1C 1W)
• France should produce wine (1W 1/3C)

13
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

14
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

15
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)

16
Business Cycle
Full Employment

• Peak -- Greatest spending and lowest
  unemployment. Inflation becomes a problem.
• Contraction/Recession -- Reduction of spending
  levels and increasing unemployment. Some
  cyclical unemployment begins.
• Trough -- Least spending and highest unemployment
  
• Expansion -- Spending increases and unemployment
  decreases
• We want to avoid extreme inflation and extreme
  unemployment. We want stability!

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The two big problems

• The two big problems that plague the economy are
• INFLATION
• UNEMPLOYMENT
• People generally prefer steady, stable growth to
  large ups and downs. Therefore, government
  policies, both fiscal and monetary (see later
  sections), are aimed at flattening the business
  cycle.
• The government wants not only to stimulate the
  economy when its slow, but also to slow it down
  when its growing too quickly.

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12-16 Measurement of Economic Performance
A. National income accounts 1. Circular flow 2.
Gross domestic product 3. Components of gross
domestic product 4. Real versus nominal gross
domestic product B. Inflation measurement and
adjustment 1. Price indices 2. Nominal and real
values 3. Costs of inflation C. Unemployment 1.
Definition and measurement 2. Types of
unemployment 3. Natural rate of unemployment
19
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.

20
(No Transcript)
21
GDP (Gross Domestic Product) The total dollar
(market) value of all final goods and services
produced in a given year.Expenditure Formula
Gross Domestic Product

• Consumption (C)
• Business Investment (I)
• Government Spending (G)
• Net Exports (Xn)

22
GDP What Counts

• Goods Produced but not Sold (I)
• Goods produced by a foreign country (Japan) in
  the U.S. (Honda, Toyota)
• Government spending on the military
• Increase in business inventories

23
GDP What DOES NOT count

• Intermediate Goods (Tires sold by Firestone to
  Ford)
• Used Goods
• Non-Market Activities (Illegal, Underground)
• Transfer Payments (Social Security)
• Stock Transactions

24
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

25
GDP Overstated

• Includes damage to the environment
• Includes more spending on healthcare-Americans
  being unhealthy.
• Includes money spent to fight crime-more police
  officers, more jails, etc

26
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

27
Real GDP Per Capita

• Most commonly used to compare and measure each
  countrys standard of living and overall economic
  growth.
• Real GDP/Nations Population

28
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

29
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

30
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 (until
  reaching Y
• 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.

31
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)

32
Inflation Winners Losers

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

33
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

34
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)

35
Unemployed

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

36
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

37
Unemployment

• 100 of the people will never be employed, so the
  government considers 4-6 unemployment to be
  full employment.
• Types of Unemployment
• Frictional - temporary and unavoidable
• Structural - results from changes in technology
  or a business restructure (ex. Merger)
• Seasonal- occurs when industries slow or shut
  down for a season
• Cyclical - results from a decline in the business
  cycle.
• We can never be at Full Employment if there is
  any percentage cyclically unemployed.

38
10-15 National Income and Price Determination
A. Aggregate demand 1. Determinants of aggregate
demand 2. Multiplier and crowding-out effects B.
Aggregate supply 1. Short-run and long-run
analyses 2. Sticky versus flexible wages and
prices 3. Determinants of aggregate supply C.
Macroeconomic equilibrium 1. Real output and
price level 2. Short and long run 3. Actual
versus full-employment output 4. Economic
fluctuations
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
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
42
Aggregate Demand

• Determinants of AD
• C I G Xn (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

43
Aggregate Demand Determinants

• Consumption
• Wealth
• Expectations
• Debt
• Taxes
• Investment
• Interest Rates
• Expected Returns
• Technology
• Inventories
• Taxes

• Government
• Change in Gov. spending
• Net Exports
• National Income Abroad
• Exchange Rates

44
Aggregate Supply Factors

• R resource prices (The CELL/ wages and
  materials, as well as OIL)
• E environment legal-institutional (Taxes,
  Subsidies, more regulation)
• P productivity (better technology)

45
Aggregate Supply

• 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
• Generally considered to be a year or less.

• 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.
• Generally considered to be longer than a year.

46
Aggregate Supply Graph
Price Level
AS
Inflation
Short Run
Long Run
Growth
Recession
Extended vertical line Illustrates the LRAS
and Y (Full-Employment)
Y
Real GDP
47
Another look as AS
LRAS
SRAS
PL
Changes that lead to a new equilibrium on the
left of LRAS Recession
Changes that lead to a new equilibrium on the
right of LRAS Inflation (AKA an overheated
economy)
PL
AD
RGDP
Y
48
NOTE!!

• For the AP exam, assume that there are only two
  determinants that simultaneously affect BOTH
  short term aggregate supply and aggregate demand
• business tax changes and
• foreign currency changes.
• A change in business taxes shifts AD and AS in
  the same direction
• A change in FX sends both curves in the opposite
  directions.

49
Demand-Pull Inflation
AS
Price Level
P2
P1
AD2
AD1 (C I G X)
Y
Real GDP
50
Cost-Push Inflation
AS2
Price Level
AS1
P2
P1
AD1 ( C I G X)
Y
Y
Real GDP
51
Demand-Pull Inflationvs.Cost-Push Inflation
52
DEMAND-PULL INFLATION
ASLR
AS2
AS1
c
P3
Price Level
b
P2
a
P1
AD2
AD1
o
Q1
Real domestic output
53
COST-PUSH INFLATION
Occurs when short-run AS shifts left
ASLR
AS2
AS1
Price Level
b
P2
a
P1
AD1
o
Q2
Q1
Real domestic output
54
COST-PUSH INFLATION
Government response with increased AD
ASLR
AS2
AS1
Even higher price levels
c
P3
Price Level
b
P2
a
P1
AD2
AD1
o
Q2
Q1
Real domestic output
55
COST-PUSH INFLATION
If government allows a recession to occur
ASLR
AS2
AS1
Price Level
b
P2
a
P1
AD1
o
Q2
Q1
Real domestic output
56
COST-PUSH INFLATION
If government allows a recession to occur
ASLR
AS2
AS1
Nominal wages fall AS returns to its
original location
Price Level
b
P2
a
P1
AD1
o
Q2
Q1
Real domestic output
57
15-20 Financial Sector(Money and Banking)
A. Money, banking, and financial markets 1.
Definition of financial assets money, stocks,
bonds 2. Time value of money (present and future
value) 3. Measures of money supply 4. Banks and
creation of money 5. Money demand 6. Money
market 7. Loanable funds market B. Central bank
and control of the money supply 1. Tools of
central bank policy 2. Quantity theory of
money 3. Real versus nominal interest rates
58
Money Supply Terms

• M1 Checkable Deposits and Currency
• M2 M1 Savings deposits, money market accounts,
  small time deposits (less than 100,000)
• Velocity of Money Equation
• MV PQ ( GDP) (M Money Supply and V Velocity
  (number of times per year the average dollar is
  spent on goods and services.

59
Banks and Balance Sheets

• Assets Liabilities
• Reserves 15,000 Checkable Deposits 100,000
• Securities 15,000
• Loans 70,000
• If the current reserve requirement is 10
• 1. What is the amount of new loans this bank
  can generate?
• Answer 100,000 Checkable deposits X a 10
  reserve requirement 10,000 required reserves.
  If the bank has 15,000 in reserves, 5,000 of
  those are excess reserves and can be loaned out .
• 2. How much in new loans can be generated by
  the entire banking
• system?
• Answer Money Multiplier 1/Required Reserve
  Ratio1/.10
• 10 X 5,000 50,000

60
FED and the Money Market
Nominal Interest Rate
MS2
MS1
Vertical curve-Supply controlled By the FED. An
increase in MS leads to a rightward shift
and lower nominal interest rates.
nir1
nir2
MD
Q2
Q1
Quantity of Money
61
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.

62
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
Quantity of Investment
Q1
Q2
63
Shifts of the Investment Demand Curve
Expected Rate of Return ( Real Interest Rate.)
A shift from ID1 to ID2 Represents an increase
in Investment demand. A shift From ID1 to ID3
represents a decrease in investment Demand.
ID2
ID1
ID3
Quantity of Investment
64
Loanable Funds Market and Expansionary Fiscal
Policy

• Used for FISCAL POLICY (Government
  spending-Deficit Spending)

An increase in Gov. spending increases the demand
for loanable funds and raises real interest rates
Real Interest Rate
SLF
R2
R1
DLF2
DLF1
Quantity of Funds
Q1
Q2
65
Loanable Funds Market and Contractionary Fiscal
Policy

• Used for FISCAL POLICY (Government
  spending-Deficit Spending)

A decrease in Gov. spending decreases the demand
for loanable funds and lowers real interest rates
SLF
Real Interest Rate
R1
R2
DLF1
DLF2
Quantity of Funds
Q2
Q1
66
Nominalwith InflationRealwithout Inflation
67
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

68
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

69
INTEREST RATE (I)

• 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

70
ANTICIPATED INFLATION


Inflation Premium
Nominal Interest Rate
Real Interest Rate
71
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 sevices a worker
  can purchase with their NOMINAL WAGE purchasing
  power of the nominal wage.
• (Real Nominal Inflation rate)

72
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.

73
20-30 Inflation, Unemployment, and Stabilization
Policies
A. Fiscal and monetary policies 1. Demand-side
effects 2. Supply-side effects 3. Policy mix 4.
Government deficits and debt B. Inflation and
unemployment 1. Types of inflation a. Demand-pull
inflation b. Cost-push inflation 2. The Phillips
curve short run versus long run 3. Role of
expectations
74
Fiscal Policy

• Using Taxes and Government spending to stabilize
  the economy.
• Controlled by the President and Congress
• Discretionary Fiscal Policy Congress must take
  action (change the tax rates) in order for the
  action to be implemented.
• Automatic Stabilizers Unemployment benefits,
  Progressive Tax System, these changes are
  implemented automatically to help the economy.

FISCAL POLICY CHANGES AD . EXCEPT when the
question specifically states there is a change in
business taxes.
75
Types of Fiscal Policy

• Expansionary
• Used to Fight a Recession
• LOWER TAXES
• INCREASE GOVERNMENT SPENDING

• Contractionary
• Used to fight Inflation
• RAISE TAXES
• DECREASE GOVERNMENT SPENDING

76
Expansionary Fiscal Policy
AS1
Price Level
P2
P1
AD2
AD1 ( C I G X )
Real GDP
Y
Y1
77
Contractionary Fiscal Policy

• Raising taxes or reducing government spending to
  fight inflation and stabilize the economy.

Price Level
AS
P1
P2
AD1
AD2
Real GDP
Y
78
Tax Multiplier -MPC/MPS

• Remember, if the government decreases taxes, the
  result is not as great as a spending increase,
  since households will save a portion (MPS) of the
  tax cut.
• The Tax Multiplier -MPC /MPS
• Example If the MPC is .8 and the MPS is .2
• Spending Multiplier 1/.2 or 5
• Tax Multiplier -.8 /.2 or -4

79
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.

80
Net Export Effect Expansionary Fiscal Policy

• Government spending has led to an increase in
  interest rates.
• At higher interest rates, foreigners demand more
  U.S. dollars to invest in bonds.
• This leads to an appreciation of the U.S. dollar.
• This leads to a decrease in Net Exports, as
  foreigners now have to exchange more of their
  currency for the U.S. dollar to buy exports.
• This decrease in Net Exports will reduce AD and
  counter to some extent the expansionary fiscal
  policy.

81
Net Export Effect Contractionary Fiscal Policy

• A decrease in government spending has led to a
  decrease in real interest rates.
• At lower interest rates, foreigners demand less
  U.S. dollars to invest in bonds.
• This leads to a depreciation of the U.S. dollar.
• This leads to an increase in Net Exports, as
  foreigners now have to exchange less of their
  currency for the U.S. dollar to buy exports.
• This increase in Net Exports will increase AD and
  further strengthen the contractionary fiscal
  policy.

82
Criticisms of Fiscal Policy

• Timing Problems
• Recognition Lag identifying recession or
  inflation
• Administrative Lag getting Congress/President
  to agree to take action
• Operational Lag Time needed to see the results
  of the fiscal policy
• Political Business Cycles Politicians may take
  inappropriate action to get reelected (lower
  taxes during an inflationary period). Plus it is
  difficult to raise taxes

83
The Federal Reserve System (FED)

• Control Monetary Policy
• Headquartered in Washington D.C.
• 12 Federal Reserve Districts
• Board of Governors (7 members) is the central
  authority
• Members are appointed by the President and
  confirmed by the Senate

84
Federal Open Market Committee (FOMC)

• Made up of 12 people Board of Governors New
  York FED President 4 other regional presidents
  (who rotate)
• Meets regularly to direct OPEN MARKET OPERATIONS
  (buying or selling of bonds) to maintain or
  change interest rates

85
FED and the Money Market
Nominal Interest Rate
MS2
MS1
Vertical curve-Supply controlled By the FED. An
increase in MS leads to a rightward shift
and lower interest rates.
nir1
nir2
MD
Q2
Q1
Quantity of Money
86
Easy Money Policy on AD/AS

• Buying Government Bonds, lowering the discount
  rate, or lowering reserve requirements, to fight
  a recession, by decreasing interest rates,
  increasing investment spending and/or consumption
  and increasing AD.

AS
Price Level
P2
AD2
P1
AD1 (C I G X)
Q1
QF
Real GDP
87
Effects of an Easy Money Policy

• LOWER INTEREST rates which will lead to an
  INCREASE in INVESTMENT and CONSUMPTION.
• The U.S. dollar will DEPRECIATE, leading to an
  increase in NET EXPORTS as well.
• These effects STRENGTHEN the overall monetary
  policy (opposite of fiscal policys crowding-out
  and net export effect

88
FED and a TIGHT Money Policy
Nominal Interest Rate
MS1
MS2
Vertical curve-Supply controlled By the FED. A
decrease in the Money supply, shifts the MS
curve to the left and raises interest rates.
nir2
nir1
MD
12
Q2
Quantity of Money
89
Tight Money Policy and AD/AS

• Selling bonds, raising the discount rate, or
  raising reserve requirements to fight inflation
  which will raise interest rates, decrease
  investment and/or consumption and decrease
  Aggregate Demand (AD).

Price Level
AS
P1
P2
AD1
AD2
Real GDP
QF
90
Effects of a Tight Money Policy

• At the higher interest rates, INVESTMENT
  SPENDING, and CONSUMPTION will decrease.
• At higher interest rates, the U.S. dollar will
  APPRECIATE (foreigners demand more U.S.
  securities). This will lead to a DECREASE in NET
  EXPORTS.
• Again, the Monetary Policy is STRENGTHENED as a
  result, unlike the effects of a contractionary
  fiscal policy.

91
Extended AD-AS Model

• This is the other way to graph the AD-AS Model

Price Level
LRAS
SRAS
P1
AD
Y
Real GDP
The intersection of the 3 curves Is the
Full-Employment Equilibrium
92
Extended AD-AS Model and Demand-Pull Inflation

• In Demand-Pull Inflation, the AD curve has
  shifted to the right of the LRAS and SRAS
  intersection.

LRAS
Price Level
SRAS
P2
PF
AD2
AD1
Y
Y2
Real GDP
The Price Level and Real GDP has increased.
93
Extended AD-AS and Demand-Pull Inflation

• Mainstream economists will fight inflation as
  previously discussed with either a tight
  monetary policy or a contractionary fiscal
  policy. The goal would be to move the aggregate
  demand curve to the left.
• Classical economists would argue to DO NOTHING.
  As nominal wages rise, the SHORT-RUN AS curve
  will shift to the left (resources and wages are
  becoming more expensive), restoring the economy
  to its full-employment output level, but with a
  higher Price Level.

94
Extended AD-AS Model and Cost-Push Inflation
Cost-Push inflation occurs when the SRAS has
shifted to the left Of the LRAS and AD
intersection.
SRAS2
LRAS
Price Level
SRAS1
Here the Price level has Increased and REAL
GDP has decreased.
P1
PF
AD1
Y
Y1
Real GDP
95
Extended AD-AS and Cost-Push Inflation

• Mainstream economists must decide whether to
  target the Price Level or Unemployment, before
  taking any action.
• Classical economists would argue to DO NOTHING.
  Eventually, wages and resource prices must
  decrease and when they do the SRAS curve will
  shift back to the right, restoring the economy to
  its full-employment output level and the original
  Price Level.

96
Extended AD-AS Model and Recession

• In a recession due to a decrease in AD, the AD
  curve is to the left of the LRAS and SRAS
  intersection showing a decrease in both
• the Price Level and Real GDP.

LRAS
Price Level
SRAS
PF
P1
AD
Y
Y1
Real GDP
97
Extended AD-AS and Recession

• Mainstream economists will fight a recession as
  previously discussed with either an easy money
  policy or an expansionary fiscal policy. The
  goal would be to move the aggregate demand curve
  to the right.
• Classical economists would argue to DO NOTHING.
  The decrease in wages and resource prices will
  shift the SRAS curve to the right, restoring the
  economy to its full-employment output level, but
  with a LOWER price. (SELF-CORRECTION)

98
Short-Run Phillips Curve

• Suggests an inverse relationship between the
  inflation rate and the unemployment rate.

Inflation Rate (percent)
When the unemployment rate is Low (2), the
inflation rate will Most likely be high (8).
8
When the Unemployment rate Is high, inflation
will likely be low.
2
SRPC1
2
8
Unemployment Rate (percent)
99
Short-Run Phillips Curve

• When the Government fights unemployment,
  typically higher inflation will result. When the
  Government fights inflation, typically, more
  unemployment will result. Thereby, we move along
  the Short-Run Phillips Curve. (Changes in AD
  movements on the SRPC.

Inflation Rate (percent)
B
7
A
2
SRPC1
3
6
Unemployment Rate (percent)
100
Shifting the Short-Run Phillips Curve

• The Short-Run Phillips curve can also shift, this
  would mean that both the unemployment rate and
  inflation rate are changing at the same time. (A
  change in AS)

Stagflation, unemployment and Inflation occurring
together (OPEC decreasing Oil supply, causes
this type of shift)
Inflation Rate
5
4
SRPC2
SRPC1
6
7
Unemployment Rate
101
Shifting the Short-Run Phillips Curve

• The Short-Run Phillips curve can also shift, this
  would mean that both the unemployment rate and
  inflation rate are changing at the same time.

When Supply increases (productivity surge in
90s) more than demand, prices willfall, while
GDP and employment Increase shifting the curve
to the left.
Inflation Rate
5
3
SRPC1
The SRPC is a mirror image of AS If AS moves
right, SRPC moves left.
SRP2
7
5
Unemployment Rate
102
Long-Run Phillips Curve

• The Long-Run Phillips Curve is vertical, like the
  Long Run Aggregate Supply Curve. So, in the long
  run there is no tradeoff between inflation and
  unemployment. Only the Price Level will change.

LRPC
Inflation Rate
3
SRPC
5
Unemployment Rate
103
Laffer Curve

• What is the optimal tax rate? A tax of 0 will
  provide no tax revenue. A tax rate of 100 will
  also lead to no tax revenue (no incentive to
  work). Answer must be somewhere in between.

Tax Rate
100
Tax Revenue
0
104
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.

105
5-10 Economic Growth and Productivity
A. Investment in Human Capital B. Investment in
Physical Capital C. Research and development, and
technological progress D. Growth Policy
106
Economic Growth

• Five Factors connected to long run economic
  growth.
• Supply Factors
• Increase in natural resources (quantity and
  quality)
• Increase in human resources (quantity and
  quality)
• Increase in capital goods
• Improvements in technology
• Demand Factors
• Increase in consumption by households,
  businesses, and government

107
Illustrating Economic Growth

• Production Possibilities Curve

Capital Goods
B
A
PPC2
PPC1
Consumer Goods
108
Illustrating Long Run Growth

• Can also be illustrated with the extended AD-AS
  Model.

LRAS2
SRAS2
LRAS1
SRAS1
Price Level
P2
P1
AD2
AD1
Y1
Y2
Real GDP
109
10-15 Open Economy International Trade and
Finance
A. Balance of payments accounts 1. Balance of
trade 2. Current account 3. Capital account B.
Foreign exchange market 1. Demand for and supply
of foreign exchange 2. Exchange rate
determination 3. Currency appreciation and
depreciation C. Net exports and capital flows D.
Links to financial and goods markets
110
International Trade

• Comparative Advantage and Specialization allows
  for economic growth and efficiency. (More of each
  good can be obtained by trading-Trading line
  illustrates this)
• Trade barriers create more economic loss than
  benefits.
• Today there is a trend towards free trade and a
  reduction in trade barriers.
• Strongest arguments for protection are the infant
  industry and military self-sufficiency arguments.
• WTO oversees trade agreements and disputes, but
  has become a target of protesters lately.

111
Exchange Rates and International Markets
The value of a foreign nations currency in
relation to your own currency is called the
exchange rate.

• 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.

112
Types of Exchange Rate Systems

• 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.

• Flexible Exchange-Rate Systems
• Flexible exchange-rate systems allow the exchange
  rate to be determined by supply and demand.

113
Foreign Exchange Market

• Lets 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.

Yen Price of dollar (Y/)
Dollar Price of Yen (/Y)
SY1
S1
P2
S2
P1
P1
DY2
P2
DY1
D1
Q1
Q2
Q1
Q2
Quantity of Yen
Quantity of U.S. Dollars
114
Balance of Payments The sum of all transactions
between U.S. residents and residents of all
foreign nations

• Current Account Shows U.S. exports and U.S.
  imports of goods and services.
• Capital Account Shows the U.S. investment
  (financial as well as capital-plants and
  factories) abroad and Foreign investment in the
  U.S.
• Credits A credit are those transactions for
  which the U.S. receives income (exports, foreign
  purchase of assets)
• Debits Those transactions that the U.S. must
  pay for imports and purchasing of assets abroad.

115
Balance of Payments continued

• The Current Account and 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.

116
So, Thats it!

• Easy, huh?