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AP 宏觀經濟學講義
AP Macroeconomics
Version 4.0
2013.04 update
王祎
Eva Wang
王祎 – AP Macroeconomics
Context
Chapter 1 Introduction of AP Macroeconomics ..................................................... 3
 Basic Information on AP Macroeconomics Exam .................................................................... 3
 Our Study Program ................................................................................................................... 5
 Percentage Goals of Exam (multiple-choice section) ............................................................... 5
Chapter 2 Basic Economic Concepts .......................................................................... 11
 Scarcity, Choice, and Opportunity Cost .................................................................................. 11
 Production Possibilities Curve ................................................................................................ 13
 Comparative/Absolute Advantage, Specialization and Trade ................................................. 14
 Demand, Supply, and Market Equilibrium.............................................................................. 16
 Macroeconomic Issues: Business Cycle, Unemployment, Inflation, Growth ......................... 25
Chapter 3 Measuring A Nation’s Income ................................................................ 30
 Two Approaches to Calculate GDP ......................................................................................... 30
 Circular Flow Diagram ........................................................................................................... 30
 Gross Domestic Product.......................................................................................................... 31
 Components of Gross Domestic Product ................................................................................ 32
 Other National Accounting Systems ....................................................................................... 33
 Real versus Nominal Gross Domestic Product ....................................................................... 33
 GDP and Economic Well-Being .............................................................................................. 34
Chapter 4 Measuring the Cost of Living ................................................................... 36
 Consumer Price Indices........................................................................................................... 36
 Contrasting the Two Measurements of Inflation ..................................................................... 37
 Nominal and Real Values ........................................................................................................ 37
 Costs of Inflation ..................................................................................................................... 38
Chapter 5 Unemployment.............................................................................................. 39
 Definition and Measurement ................................................................................................... 39
 Limitations of the u-rate .......................................................................................................... 39
 The Duration of Unemployment ............................................................................................. 40
 Types of Unemployment ......................................................................................................... 40
 Changing Rate of Unemployment ........................................................................................... 41
Chapter 6 Saving, Investment and the Financial System .............................. 44
 Financial System ..................................................................................................................... 44
 Some Definitions..................................................................................................................... 44
 Market for Loanable Funds ..................................................................................................... 45
Chapter 7 The Basic Tools of Finance ........................................................................ 48
 Introduction ............................................................................................................................. 48
 Time Value of Money .............................................................................................................. 48
 Managing Risk ........................................................................................................................ 48
 Asset Valuation........................................................................................................................ 49
Chapter 8 The Monetary System ................................................................................. 51
 Money ..................................................................................................................................... 51
 Central Bank and Money Supply ............................................................................................ 51
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王祎 – AP Macroeconomics
 Money Demand ....................................................................................................................... 53
 Money Market & Quantity Theory of Money ......................................................................... 54
 Money and Inflation ................................................................................................................ 55
 Monetary Policy ...................................................................................................................... 55
Chapter 9 Aggregate Demand and Aggregate Supply ....................................... 60
 Aggregate Demand ................................................................................................................. 60
 Aggregate Supply .................................................................................................................... 61
 Economic Equilibrium ............................................................................................................ 64
Chapter 10 Monetary and Fiscal Policy ................................................................... 71
 Monetary Policy ...................................................................................................................... 71
 Fiscal Policy ............................................................................................................................ 71
 Policy Mix ............................................................................................................................... 71
 Multiplier and Crowding-out Effects ...................................................................................... 72
 Fiscal Policy and Aggregate Supply........................................................................................ 73
 Stabilization Policy ................................................................................................................. 73
Chapter 11 Phillips Curve.................................................................................................. 74
 Types of Inflation .................................................................................................................... 74
 The Phillips Curve: Short-run versus Long-run ...................................................................... 75
Chapter 12 Production and Growth ............................................................................. 83
 Incomes and Growth Around the World.................................................................................. 83
 Production Function ................................................................................................................ 83
 Growth policy ......................................................................................................................... 83
Chapter 13 Open Economy: International Trade and Finance ................... 86
 Basic Concepts ........................................................................................................................ 86
 Balance of payments accounts ................................................................................................ 87
 Foreign Exchange Market ....................................................................................................... 88
 Concepts to Be Covered .......................................................................................................... 90
Appendix I: Macroeconomics Free-Response Questions (1999-2012)............ 97
Appendix II: IS-LM Model ................................................................................................ 212
Appendix III: Solow Model ............................................................................................... 215
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王祎 – AP Macroeconomics
Chapter 1
Introduction of AP Macroeconomics
 Basic Information on AP Macroeconomics Exam
What Is AP


Language Test: TOEFL, IELTS
Aptitude Test: SAT Reasoning
GRE, GMAT, LSAT…
Knowledge Test: SAT Subject, AP
GRE Subject

Why taking AP





1. To stand out in the admission process
2. To experience college-level academics
3. To earn AP Scholar Awards, to grant an academic distinction
4. To earn course credits after entering college
5. To save time and money once they get to college
Time




Ordinary Testing 2013 May 6 – 10, 13 – 17
Late Testing
2013 May 22 – 24 (not available in mainland China yet)
e.g. 2013 May 16 8: 00 – Macro, 12:00 – Micro
May 22 Macro & Micro
Register commonly in Feb – Mar, refer to www.collegeboard.com & www.apchina.net.cn
Fee
1000 Yuan
Location (take Beijing for example)
首都師範大學附屬中學;北京市二十一世紀實驗學校;北京師範大學附屬實驗中學;
北京師範大學第二附屬中學;北京市海澱外國語實驗學校;人大附中;人大附中西山學校;
北京四中國際部;北京十一學校;北京潞河中學;北京聖保羅美國學校
Subjects

Macroeconomics, Microeconomics, Calculus AB/BC, Statistics, …
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王祎 – AP Macroeconomics


Physics B/C, Chemistry, Biology, Computer Science, …
U.S./ European/ World History, Psychology, …
Format (identical in Macro& Micro)

Section
Number
Time Limit
I. Multiple Choice
60
70min
II. Free Response
3
Planning time: 10min
Writing time: 50 min
Scoring as
Section I: Multiple Choice 2/3; Only count #correct (from 2011)
Section II: Free Response 1/3
60 + 30 = 90
2000
2005
Reference



www.collegeboard.com
www.apcentral.collegeboard.com
www.apchina.net.cn
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王祎 – AP Macroeconomics
 Our Study Program
Teaching Program



考點在
答案在
考法在
中
中
中
Reference Books

Main Text Books
講義及課堂筆記
N. Gregory Mankiw, Principles of Economics (>=4th Edition)
歷年真題(官方網站可下載free-response)

Main Reference Books
Barron
Princeton
Pearson
5 steps to a 5 (textbook, multiple choice)
McGraw-Hill
于寧, AP宏觀經濟學, 群言出版社, 2011

Expand Reading:
Robert Frank, The Economic Naturalist: in Search of Explanations for Everyday Enigmas
Steven Levitt, Freakonomics
David Friedman, Hidden Order: the Economics of Everyday Life
 Percentage Goals of Exam (multiple-choice section)
Macroeconomics
The purpose of an AP course in macroeconomics is to give students a thorough understanding of the
principles of economics that apply to an economic system as a whole. Such a course places particular
emphasis on the study of national income and price-level determination and also develops students’
familiarity with economic performance measures, the financial sector, stabilization policies, economic growth
and international economics. There is no single approach that an AP Macroeconomics course is expected to
follow. Whatever the approach, however, AP teachers are advised to take into account certain topics
generally covered in college courses. The following is a brief discussion of these topics and some aspects of
them that a teacher may choose to explore.
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王祎 – AP Macroeconomics
I. Basic Economic Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (8–12%)
A macroeconomics course introduces students to fundamental economic concepts such as scarcity and
opportunity costs. Students understand the distinction between absolute and comparative advantage and
apply the principle of comparative advantage to determine the basis on which mutually advantageous trade
can take place between individuals and/or countries and to identify comparative advantage from
differences in opportunity costs. Other basic concepts that are explored include the functions performed by
an economic system and the way the tools of supply and demand are used to analyze the workings of a
free-market economy. The course should also introduce the concept of the business cycle to give students an
overview of economic fluctuations and to highlight the dynamics of unemployment, inflation and economic
growth. Coverage of these concepts provides students with the foundation for a thorough understanding of
macroeconomic concepts and issues.
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
II. Measurement of Economic Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (12–16%)
To provide an overview of how the economy works, the course should start with a model of the circular flow
of income and products that contain the four sectors: households, businesses, government and international.
It is important to identify and examine the key measures of economic performance: gross domestic product,
unemployment and inflation.
In studying the concept of gross domestic product, it is also important that students learn how gross
domestic product is measured, have a clear understanding of its components and be able to distinguish
between real and nominal gross domestic product.
The course should examine the nature and causes of unemployment, the costs of unemployment and how
the unemployment rate is measured, including the criticisms associated with the measurement of the
unemployment rate. It is also important to understand the concept of the natural rate of unemployment and
the factors that affect it. Students should also have an understanding of inflation and how it is measured. In
this section, the course should cover the costs of inflation and the main price indices, such as the consumer
price index (CPI) and the gross domestic product deflator. Students should learn how these indices are
constructed and used to convert nominal values into real values, as well as to convert dollar values in the
past to dollar values in the present. It is also important to highlight the differences between the two price
indices as a measure of inflation, as well as the problems associated with each measure.
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
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王祎 – AP Macroeconomics
2. Nominal and real values
3. Costs of inflation
C. Unemployment
1. Definition and measurement
2. Types of unemployment
3. Natural rate of unemployment
III. National Income and Price Determination. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (10–15%)
This section introduces the aggregate supply and aggregate demand model to explain the determination of
equilibrium national output and the general price level, as well as to analyze and evaluate the effects of
public policy. It is important to discuss the aggregate demand and aggregate supply concepts individually to
provide students with a firm understanding of the mechanics of the aggregate demand and aggregate
supply model.
The aggregate demand and aggregate supply analysis often begins with a general discussion of the nature
and shape of the aggregate demand and aggregate supply curves and the factors that affect them. A
detailed study of aggregate demand may begin by defining the four components of aggregate demand:
consumption, investment, government spending and net exports. It also examines why the aggregate
demand curve slopes downward and how changes in the determinants affect the aggregate demand curve.
The spending-multiplier concept and its impact on aggregate demand, and how crowding out lessens this
impact, should be demonstrated as well. The course can then present the definition and determinants of
aggregate supply and the different views about the shape of the aggregate supply curve in the short run and
in the long run and highlight the importance of the shape in determining the effect of changes in aggregate
demand on the economy. It is also important to understand the notion of sticky-price and sticky-wage
models and their implication for the aggregate supply curve in comparison to flexible prices and wages.
Students should be able to use the aggregate demand and aggregate supply model to determine equilibrium
income and price level and to analyze the impact of economic fluctuations on the economy’s output and
price level, both in the short run and in the long run.
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. Business cycle and economic fluctuations
IV. Financial Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (15–20%)
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王祎 – AP Macroeconomics
To understand how monetary policy works, students must understand the definitions of both the money
supply and money demand and the factors that affect each of them. Here the course introduces students to
the definition of money and other financial assets such as bonds and stocks, the time value of money,
measures of the money supply, fractional reserve banking and the Federal Reserve System. In presenting the
money supply, it is important to introduce the process of multiple-deposit expansion and money creation
using T-accounts and the use of the money multiplier. In learning about monetary policy, it is important to
define money demand and examine its determinants. Having completed the study of money supply and
money demand, the course should proceed to investigate how equilibrium in the money market determines
the equilibrium interest rate, how the investment demand curve provides the link between changes in the
interest rate and changes in aggregate demand, and how changes in aggregate demand affect real output
and price level. Students should have an understanding of financial markets and the working of the loanable
funds market in determining the real interest rate. It is also important that students develop a clear
understanding of the differences between the money market and the loanable funds market.
Having an understanding of the financial markets, students should identify and examine the tools of central
bank policy and their impact on the money supply and interest rate. Students should understand the
distinction between nominal and real interest rate. Students should also be introduced to the quantity
theory of money and examine and understand the effect of monetary policy on real output growth and
inflation.
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 and the equilibrium nominal interest rate
B.. Loanable funds market
1. Supply of and demand for loanable funds
2. Equilibrium real interest rate
3. Crowding out
C. 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
V. Stabilization Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (20–30%)
Public policy affects the economy’s output, price level and level of employment, both in the short run and in
the long run. Students should learn to analyze the impacts of fiscal policy and monetary policy on aggregate
demand and aggregate supply, as well as on the economy’s output and price level both in the short run and
in the long run. It is also important to understand how an economy responds to a short-run shock and
adjusts to long-run equilibrium in the absence of any public policy actions.
With both monetary and fiscal policies now incorporated in the analysis of aggregate demand and
aggregate supply, an understanding of the interactions between the two is essential. Students should also
examine the economic effects of government budget deficits, including crowding out; consider the issues
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王祎 – AP Macroeconomics
involved in determining the burden of the national debt; and explore the relationships between deficits,
interest rates and inflation. The course should distinguish between the short-run and long-run impacts of
monetary and fiscal policies and trace the short-run and long-run effects of supply shocks. Short-run and
long-run Phillips curves are introduced to help students gain an understanding of the
inflation–unemployment trade-off and how this trade-off may differ in the short and long run.
In this section, the course identifies the causes of inflation and illustrates them by using the aggregate
demand and aggregate supply model. A well-rounded course also includes an examination of the
significance of expectations, including inflationary expectations.
A. Fiscal and monetary policies
1. Demand-side effects
2. Supply-side effects
3. Policy mix
4. Government deficits and debt
B. The Phillips curve
1. Short-run and long-run Phillips curves
2. Demand-pull versus cost-push inflation
3. Role of expectations
VI. Economic Growth and Productivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5–10%)
The course should introduce the framework and examine how long-run economic growth occurs. Students
should understand the role of productivity in raising real output and the standard of living, as well as the
role of investment in human capital formation and physical capital accumulation, research and development,
and technical progress in raising productivity. Having learned the determinants of growth, students should
examine how public policies influence the long-run economic growth of an economy.
A. Definition of economic growth
B. Determinants of economic growth
1. Investment in human capital
2. Investment in physical capital
3. Research and development, and technological progress
C. Growth policy
VII. Open Economy: International Trade and Finance . . . . . . . . . . . . . . . . . . . . . . (10–15%)
An open economy interacts with the rest of the world both through the goods market and the financial
markets, and it is important to understand how a country’s trans-actions with the rest of the world are
recorded in the balance of payments accounts. Students should understand the meaning of trade balance,
the distinction between the current account balance and the capital account balance, and the implications
for the foreign exchange market.
The course should also focus on the foreign exchange market and examine how the equilibrium exchange
rate is determined. Students should understand how market forces and public policy affect currency demand
and currency supply in the foreign exchange markets and lead to currency appreciation or depreciation. How
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王祎 – AP Macroeconomics
capital flows affect exchange rates and how appreciation or depreciation of a currency affects a country’s
net exports should be an integral part of the presentation. Having learned the mechanics of the foreign
exchange markets, students should then understand how changes in net exports and capital flows affect
financial and goods markets.
It is important to examine the effects of trade restrictions, how the international payments system hinders
or facilitates trade, how domestic policy actions affect international finance and trade, and how
international exchange rates affect domestic policy goals.
A. Balance of payments accounts
1. Balance of trade
2. Current account
3. Capital account (formerly known as capital account)
B. Foreign exchange market
1. Demand for and supply of foreign exchange
2. Exchange rate determination
3. Currency appreciation and depreciation
C. Imports, exports, and capital flows
D. Relationships between international and domestic financial and goods markets
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王祎 – AP Macroeconomics
Chapter 2
Basic Economic Concepts
 Scarcity, Choice, and Opportunity Cost
Economy


…ECONOMY comes from a Greek word oikonomia,
which means ”
”…
Scarcity
Economics


…is a
which studies
.
Economic/ Scarce Resources
 Labor and Human Capital
 Land or Natural Resources
 Capital (Physical and Financial)
 Entrepreneurship/ Entrepreneurial Ability

Economics is the
,
and the
that studies the
that
, and
make as they cope with
that influence and reconcile those
.
Choice

Faced with
, we must make CHOICES
 We must choose among the available alternatives.
 The choices we make depend on the incentives we face.
Incentive

An INCENTIVE is a
 a “carrot” or a “stick”
 that
or a
or
an action.
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王祎 – AP Macroeconomics
Economic Systems

/
Economy
 ruled by

/
/
Economy
/
/
Economy
 ruled by

 ruled by

Economy
 ruled by
Opportunity Cost

Principle 1 People face tradeoffs.
 “There is no such thing as a free lunch!”
 Principle 2 The cost of something is what you give up to get it.
 The OPPORTUNITY COST of an item is
 WHATEVER must be given up to obtain some item
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王祎 – AP Macroeconomics
 Production Possibilities Curve
Definition

a graph showing the various combinations of
given
that the economy can possibly produce
and
Production Possibilities Curve/ Frontier (PPC/PPF)
What does it mean by point E& F?
Concepts in PPC/ PPF

Why PPC/ PPF exists?

If no scarcity, then?

How do we call the points like A,C,E,F?

How about B?

How about D?
Scarcity
Tradeoff
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王祎 – AP Macroeconomics

Is PPC/ PPF upward sloping or downward sloping, (possitive or negative slope)?

Why?

What is the opportunity cost from A to C?

How about C to A?

Is PPC/ PPF concave or convex (bowed outward or inward)? Why?

If the technology of producing
change? Show it in the initial graph.

How about increasing the amounts of production factors?
Efficiency
Opportunity
cost
improved, how does PPF/ PPC
Economic
Growth
 Comparative/Absolute Advantage, Specialization and Trade
Definitions

Principle 5 Trade can make EVERYONE better off.
 Variety of goods & services
 Specialization, outward shift of PPC/ PPF
 Producer surplus, Consumer surplus and total surplus

Absolute Advantage
 Describes the productivity of one person, firm, or nation compared to that of another.
 is the ability to produce a good or service more efficiently—a lower cost of resources—than another
producer.
 the comparison among producers of a good according to their

Comparative Advantage
 is the ability to produce a good or service at a lower opportunity cost than another producer.
 Resources are scarce, so that one can only produce more of one product by taking the resources away
from another.
 the comparison among producers of a good according to their
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王祎 – AP Macroeconomics



Questions
Can a nation has absolute advantage in both products?
What about comparative advantage?
Why?

Specialization
 occurs when workers or nations concentrate on what they do best.
 It usually means improved quality and/or increases in output.
Example

Two countries are considering trading two products, which they both produce.
Tea (Tons)
Tea (Tons)
30
20
10
3
0
16
24
Corn (Tons)






7 10
Corn (Tons)
Nation B
Nation A

0
1. These production possibility curves show the combinations of tea and corn that can be produced by
each of these nations without trade assuming constant opportunity costs.
2. With this data, one can see that Nation A can produce any combination of tea and corn along its
production possibility curve and Nation B can produce any combination of tea and corn along its own
production possibility curve.
3. Nation A has comparative advantage in corn since it has an opportunity cost of 1 ton of tea for 1 ton of
corn and an opportunity cost of 1 ton of corn for 1 ton of tea.
4. Nation B has a comparative advantage in tea since it has an opportunity cost of 2 tons of tea for 1 ton
of corn and an opportunity cost of 1/2 ton of corn for 1 ton of tea.
5. Assume that the outputs before specialization are:
 Nation A produces 16 tons of corn and 10 tons of tea
 Nation B produces 7 tons of corn and 3 tons of tea
6. If both nations specialize in the good in which they hold the Comparative Advantage . . . Nation A will
produce 30 tons of corn and Nation B will produce 20 tons of tea.
7. Terms of trade analysis asks the question: At what rate of exchange will trade take place? For this
example terms of trade must lie between 1 ton of corn = 1 ton of tea and 1 ton of corn = 2 tons of tea.
Each nation needs to gain from the exchange, so Nation A needs to buy more than one ton of tea for one
ton of corn and Nation B needs to buy one ton of corn for less than two tons of tea. The actual ratio
depends on the world supply and demand for these goods.
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王祎 – AP Macroeconomics

8. Let’s assume that the terms of trade are 1 ton of corn = 1.5 tons of tea. The following chart shows the
gains from trade using this assumption.

Conclusion: By using their comparative advantage and agreeing to the stated terms of trade, both Nation
A and Nation B will gain more corn AND more tea. Note that each nation has expanded its consumption
possibilities frontier with trade. This is the equivalent of having more and better resources or discovering
new production methods.
 Demand, Supply, and Market Equilibrium
Market


A market is a group of
Market Type

and
of a particular
We can divide market types maily by
1.
2.
3.
4.
 Perfectly Competition
 Monopoly
 Monopolistic Competition
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王祎 – AP Macroeconomics
 Oligopoly
Demand



The quantity demanded of any good is the amount of the good that buyers are
to purchase.
Law of demand
How to Express Them?
 Demand Schedule
Price
Quantity Demanded
 Demand Curve
 Demand Function
Simple demand functions
More complex demand functions
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王祎 – AP Macroeconomics

Determinants of the Demand
 Price
The Law of Demand
Price rises
Price falls
 Numbers of Consumers
Individual Demand → Market Demand
 Income
Normal Good
Demand for a normal good is
Inferior Good
Demand for a inferior good is
related to income.
related to income.
Income increases (normal good)
Income increases (inferior good)
 Price of related goods
Substitutes
Two goods are substitutes if an increase in the price of one causes an
demand for the other.
Example:
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王祎 – AP Macroeconomics
Complements
Two goods are complements if an increase in the price of one causes an
demand for the other.
Example:
Income increases (normal good)
in
Income increases (inferior good)
 Taste/ Preference/ Inclination
Anything that causes a shift in tastes toward a good will
shift its D curve to the
.
Prefer more
demand for that good and
Prefer less
 Expectation
If people expect their incomes to rise, their demand for
may decrease now.
If the economy sours and people worry about their future job security, demand for new autos may
now.
Expect more income (normal good)

Shifts and Changes in Quantity Demanded or Demand
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Expect a expasion in economy
王祎 – AP Macroeconomics
Variable

A change in Qd or D?
Exercise
Supply



The quantity supplied of any good is the amount of the good that sellers are
to sell.
Law of supply
How to Express Them?
 Supply Schedule
Price
Quantity Supplied
 Supply Curve
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王祎 – AP Macroeconomics
 Supply Function
Simple demand functions
More complex demand functions

Determinants of the Supply
 Price
The Law of Supply
Price rises
Price falls
 Numbers of Consumers
Individual Supply → Market Supply
 Input Prices
Examples of input prices:
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王祎 – AP Macroeconomics
Input price rises
Input price falls
 Technology
Technology determines how much inputs are required to produce a unit of output.
A cost-saving technological improvement has the same effect as a
shifts S curve to the
.
Technology better off
in input prices,
Technology worse off
 Expectations
Example
Events in the Middle East lead to expectations of higher oil prices.
In response, owners of Texas oilfields
supply now, S curve shifts
Lower price expectation
Worse economy expectation
22
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王祎 – AP Macroeconomics

Shifts and Changes in Quantity Supplied or Supply
Variable

A change in Qs or S?
Exercise
Supply and Demand

Equilibrium
 Equilibrium Price
the price that equates
 Equilibrium Quantity
the
with
and
at the equilibrium price
=

Excess Supply/ Surplus
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＞
＞

Excess Demand/ Shortage
＞
＞

The Law of Supply and Demand
 Three Steps to Analyzing Changes in Equilibrium
1. Decide whether the event shifts the supply or demand curve (or both).
2. Decide whether the curve(s) shift(s) to the left or to the right.
3. Examine how the shift affects equilibrium price and quantity.
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王祎 – AP Macroeconomics

Relationship between Price & Quantity when Supply or Demand Shifts
No change in supply
An increase in supply
A decrease in supply
No change in demand
P
Q
P
Q
P
Q
An increase in demand
P
Q
P
Q
P
Q
A decrease in demand
P
Q
P
Q
P
Q
Show them in the following graphs
m
 Macroeconomic Issues: Business Cycle, Unemployment, Inflation, Growth
3 Classifications

Microeconomics VS Macroeconomics
 Microeconomics
focuses on the
of the economy.
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王祎 – AP Macroeconomics
the study of how
markets.
 Macroeconomics
looks at the economy
the study of
and


and
make decisions and how they interact in
.
, including
,
.
Scientists VS Policy Advisers
 When they are trying to
 When they are trying to
the world, they are scientists.
the world, they are policymakers.
Positive Analysis VS Normative Analysis
 Positive Analysis
are statements that
called descriptive analysis
 Normative Analysis
are statements about how the world
called prescriptive analysis
.
.
Business Cycle
Phases of the Business Cycle

Expansion/ Recovery
 This phase of the business cycle denotes
in the economy.
 In this phase, businesses, employment, and price level is
.
 Peak
 The peak is the
of the expansion phase.
 This phase is usually not known until after it is over.
 Unemployment reaches its
point in the cycle and businesses reach their
.
 Contraction/ Recession
26
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王祎 – AP Macroeconomics
 This is the
of the expansion phase.
 In this phase, unemployment begins to
while businesses are downsizing and making
cuts. Two consecutive quarters of this phase denotes a
.
 Trough
 The trough is the “
” of the contraction phase.
 Again, this phase is usually not known until after it has passed.
 Employment and firm contraction reach their
points in the cycle in this phase.
Growth

Principle 8 A country’s standard of living depends on its ability to produce goods and services.
 Almost all variation in living standards is attributable to differences in countries’ productivity.
 Productivity is the amount of goods and services produced from each hour of a worker’s time.
 Higher productivity → Higher standard of living
Inflation

Principle 9 Prices rise when the government prints too much money.
 Inflation is an
in the
 One cause of inflation is the
in the quantity of money.
 When the government creates large quantities of money, the value of the money
in the economy.
.
Unemployment

Principle 10 Society faces a short-run tradeoff between inflation and unemployment.
 The Phillips Curve illustrates the tradeoff between
and
 Inflation & Unemployment, it’s a
-run tradeoff!!!
 Some prices are slow to adjust, prices are said to be
in the short run.
Chapter Review Questions
1. Assume that Countries X and Y have equal amounts of resources and identical technology. Country X can
produce 100 bushels of corn or 100 yards of cloth or any combination as shown in line AB. Country Y can
produce 100 bushels of corn or 200 yards of cloth or any combination as shown in line CD.
27
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a. Which country has the absolute advantage in the production of corn and which has the absolute advantage
in the production of cloth? How do you know?
b. Which country has the comparative advantage in the production of corn and which has the comparative
advantage in the production of cloth? Explain.
c. With specialization and trade, which country will import corn?
d. Assume that the countries trade and that one bushel of wheat is exchanged for two yards of cloth, what
will the country that imports corn gain from trade?
Answer Key
a. Neither country has the absolute advantage in the production of corn since they make identical amounts of
corn. Country Y has the absolute advantage in the production of cloth since it can make more.
b. Country X gives up 1 yard of cloth for 1 bushel of corn, while Country Y gives up 2 yards of cloth for 1 bushel
of corn. It is relatively more expensive for Country Y to produce corn so Country X has the comparative
advantage in the production of corn and Country Y has a comparative advantage to produce cloth.
c. Country Y will import corn.
d. Country Y using trade will gain more of each good. Specialization and trade increases Country Y’s
consumption possibilities making it possible to consume more of both.
Homework & Problems
1. Which one of the following is a factor of production?
A. Money
B. Government
C. Land
D. Checkable deposits
E. None of the above
Answer: C. Land is a factor of production. Money is a medium of exchange, not a resource. To produce a good
or service, the government has to use one of the factors of production.
2. A student decides that, having already spent three hours studying for an exam, she should spend one more
hour studying for the same exam. Which of the following is most likely true?
A. The marginal benefit of the fourth hour is certainly less than the marginal cost of the fourth hour.
B. The marginal benefit of the fourth hour is at least as great as the marginal cost of the fourth hour.
C. Without knowing the student’s opportunity cost of studying, we have no way of knowing whether or not
her marginal benefits outweigh her marginal costs.
D. The marginal cost of the third hour was likely greater than the marginal cost of the fourth hour.
E. The marginal benefit of the third hour was less than the marginal cost of the third hour.
Answer: B. If we observe her studying for the fourth hour, then it must be the case that the MB ≥ MC of
studying for that next hour. If we observe her putting her books away and doing something else, the opposite
must be true.
3. When a nation is specializing in the production of a product for which it has least opportunity cost in relation
to another nation, it is
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A. achieving full employment of its resources
B. specializing in its comparative advantage
C. specializing in its absolute advantage
D. maximizing exchange between businesses and households
E. achieving economic growth in its own economy
Answer: B
4. Specialization in production is important primarily because it:
A. results in a greater output for society
B. allows society to avoid the unequal distribution problem
C. allows society to inefficiently use its scarce resources
D. allows society to trade by barter
E. allows society to have fewer capital goods
Answer: A
5. According to the table, which of the following is true?
A. Altunia has an absolute advantage in producing both goods and a comparative advantage in producing
computers.
B. Batavia has an absolute advantage in producing both goods and a comparative advantage in producing
books.
C. Neither country has an absolute advantage in production.
D. Altunia has an absolute advantage in producing both goods and a comparative advantage in producing
books.
E. There can be no gains from trade between these two countries.
Answer: A
6. What is Batavia’s opportunity cost per book?
A. 50 computers
B. 150 books
C. 0.4 computers
D. 2.5 computers
E. 1,000 computers
Answer: C
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Chapter 3
Measuring A Nation’s Income
 Two Approaches to Calculate GDP

Income Method
Economic Resources Supplied




Income Received in GDP









Expenditure Method
Income equals Expenditure for the economy as a whole, since:
 1. Every dollar a buyer spends is a dollar of income for the seller.
 2. Using Circular Flow Diagram
 Circular Flow Diagram

Simple Model
 a simple depiction of the macroeconomy & microeconomy
 illustrates GDP as spending, revenue, factor payments, and income
 Preliminaries
Factors of production are inputs like labor, land, capital, and natural resources…
Factor payments are payments to the factors of production (e.g., wages, rent…).
The Circular-Flow Diagram
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 What This Diagram Omits?
The government
-collects taxes, buys g&s
The foreign sector
-trades g&s, financial assets, and currencies with the country’s residents
The financial system
-matches savers’ supply of funds with borrowers’ demand for loans

Complete Model
 Income (Y) equals the sum of flow in expenditure method.
 that is: Y = C + I + G + X – M
 Gross Domestic Product
Definition
GDP is the market value of the final goods and services produced within a nation in a
given period of time.

Market Value
Goods are valued at their market prices, so:
 All goods measured in the same units (e.g., dollars in the U.S.)
 Things that don’t have a market value are excluded,
e.g.
,
,

Final
 Final goods: intended for the end user
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 Intermediate goods: used as components or ingredients in the production of other goods
 GDP only includes final goods – they already embody the value of the intermediate goods used in their
production, avoids double counting.

Goods and Services
 GDP includes
 and
goods (like DVDs, mountain bikes, beer)
services (like dry cleaning, concerts, cell phone service)

Produced
GDP includes currently produced goods, NOT goods produced in the past.
 How about inventories?
 Secondhand goods?
 Stock?

Within a Nation
 A geographic concept, whether done by its own citizens or by foreigners located there.
 GNP?

A Given Period of Time
 Usually
or
 Components of Gross Domestic Product
GDP expenditures = C + I + G + (X − M)
 Consumption (C)
 total spending on
 Note on housing costs:
For renters,
For homeowners,


Investment Spending (I)
 total spending on
 There are 3 general types of investment that are included in GDP:
-New capital machinery purchased by firms (e.g.
-New construction for firms or consumers (e.g.
-Market value of the change in unsold inventories (e.g.
)
)
)
Government Spending (G)
 The government, at all levels (the federal, state, and local levels), purchases final goods and services
and invests in infrastructure.
 Note:
(e.g. Social Security, unemployment insurance benefits) do
NOT count toward GDP. Why?
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
Net Exports (NX= X- M)

produced goods purchased by
(exports = X) subtract the
spending by
on purchases of goods made
(imports = M).
 Exports represent foreign spending on the economy’s g&s.
 Imports are the portions of C, I, and G that are spent on g&s produced abroad.
 Other National Accounting Systems


NDP (Net Domestic Product)
NNP (Net National Product)
NI (National Income)

PI (Personal income)

DPI (Disposable Personal Income)

 Real versus Nominal Gross Domestic Product

Nominal GDP
 The value of current production at the current prices. It is not corrected for inflation.
 It is also known as current-dollar GDP or “money GDP”.

Real GDP
 The value of current production, but using prices from a fixed point in time (base year). Real GDP is
corrected for inflation.
 It is also known as constant-dollar GDP or real GDP.

e.g.
Pizza
Latte
year
P
Q
P
Q
2009
$10.00
400
$2.00
1000
2010
$11.00
500
$2.50
1100
2011
$12.00
600
$3.00
1200
 Compute nominal GDP in each year:
2009:
2010:
2011:
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 Compute real GDP in each year, using 2009 as the base year:
2009:
2010:
2011:
 In sum, for each year,
Nominal GDP is measured using the (then) current prices. The change in nominal GDP reflects
both prices and quantities.
Real GDP is measured using constant prices from the base year (2009 in this example). The change
in real GDP is the amount that GDP would change if prices were constant (i.e., if zero inflation).

GDP Deflator
 is a measure of the
 GDP deflator =
.

GDP
GDP
 e.g. Compute GDP deflator in each year, using 2009 as the base year:
2009:
2010:
2011:
 GDP and Economic Well-Being


Real GDP per capita is the main indicator of the
But GDP is NOT a perfect measure of well-being.
“GDP does not allow for the health of our children, the quality of their education, or the joy
of their play. It does not include the beauty of our poetry or the strength of our marriages,
the intelligence of our public debate or the integrity of our public officials. It measures
neither our courage, nor our wisdom, nor our devotion to our country. It measures
everything, in short, except that which makes life worthwhile, and it can tell us everything
about America except why we are proud that we are Americans.”
- Senator Robert Kennedy, 1968

GDP Does Not Value
 the quality of the environment
 leisure time
 non-market activity, such as the child care a parent provides his or her child at home
 an equitable distribution of income
 income distribution
 …
34
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王祎 – AP Macroeconomics
1. Which of the following transactions would be counted in GDP?
(A) The wage you receive from babysitting your neighbor’s kids.
(B) The sale of illegal drugs.
(C) The sale of cucumbers to a pickle manufacturer.
(D) The sale of a pound of tomatoes at a supermarket.
(E) The resale of a sweater you received from your great aunt at Christmas that you never wore on eBay.
Answer: d. The supermarket tomatoes are the only final good sale and are counted. Babysitting is a nonmarket,
cash “under the table”, service. The sale of illegal drugs is a part of an underground economy. The sale of the
cucumbers is an intermediate good. The resale of the sweater, even though it was never worn, is a
second-hand sale. When your great aunt originally purchased it at the mall, it was counted in GDP.
2. GDP is $10 million, consumer spending is $6 million, government spending is $3 million, exports are $2
million, and imports are $3 million. How much is spent for investments?
(A) $0 million
(B) $1 million
(C) $2 million
(D) $3 million
(E) $4 million
Answer: c. GDP = C + I + G + (X − M). This would mean that 10 = 6 + I + 3 + (2 − 3) therefore I = $2 million.
3. If Real GDP= $200 billion and the price index= 200, Nominal GDP is
(A) $4 billion.
(B) $400 billion.
(C) $200 billion.
(D) $2 billion.
(E) impossible to determine since the base year is not given.
Answer: b. Nominal GDP/price index (in hundredths) = real GDP. Use this relationship to solve for Nominal GDP.
$200 = (Nominal GDP)/2. Nominal GDP = $400 billion.
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Chapter 4
Measuring the Cost of Living
 Consumer Price Indices

Definition
 measures the typical consumer’s cost of living

How CPI is Calculated
 1. Fix the “basket”
The Bureau of Labor Statistics (BLS) surveys consumers to determine what’s in the typical consumer’s
“shopping basket.”
 2. Find the prices
The BLS collects data on the prices of all the goods in the basket.
 3. Compute the basket’s cost
Use the prices to compute the total cost of the basket.
 4. Choose a base year and compute the index
The CPI in any year equals

cost of basket in
cost of basket in
 5. Compute the inflation rate
The percentage change in the CPI from the preceding period
Inflation rate =

CPI
- CPI
100%
CPI
e.g.
year
Price of
Price of
Cost of basket
Compute the CPI in each year
20 :
20 :
20 :

Problems with CPI
 Substitution Bias
Over time, some prices rise faster than others.
Consumers substitute toward goods that become relatively cheaper.
The CPI misses this substitution because it uses a fixed basket of goods.
Thus, the CPI
increases in the cost of living.
 Introduction of New Goods
The introduction of new goods increases variety, allows consumers to find products that more closely
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王祎 – AP Macroeconomics
meet their needs.
In effect, dollars become more valuable.
The CPI misses this effect because it uses a fixed basket of goods.
Thus, the CPI
increases in the cost of living.
 Unmeasured Quality Change
Improvements in the quality of goods in the basket increase the value of each dollar.
The BLS tries to account for quality changes
but probably misses some, as quality is hard to measure.
Thus, the CPI
increases in the cost of living.
 Summary
Each of these problems causes the CPI to
cost of living increases.
The BLS has made technical adjustments, but the CPI probably still overstates inflation by about 0.5
percent per year.
This is important because Social Security payments and many contracts have COLAs tied to the CPI.
 Contrasting the Two Measurements of Inflation


CPI
GDP Deflator
 Nominal and Real Values

Comparing Dollar Figures from Different Times
 Amount in today's dollars = Amount in year T dollars 

Indexation
 A dollar amount is indexed for inflation if it is automatically corrected for inflation by law or in a
contract.

Real v.s. Nominal Interest Rate
 The nominal interest rate
-the interest rate not corrected for inflation
-the rate of growth in the dollar value of a deposit or debt
 The real interest rate
-corrected for inflation
-the rate of growth in the purchasing power of a deposit or debt
 Fisher Effect
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王祎 – AP Macroeconomics

Real v.s. Nomial Income
 Real income this year = Nominal income this year 
 Costs of Inflation
Does inflation really induce our real income?

Shoeleather Costs
 Initial Meaning
 Innotation

Menu Costs
 Initial Meaning
 Innotation

Misallocation of Resources from Relative-price Variability

Confusion & Inconvenience

Tax Distortions
e.g.
Economy 1
Economy 2
Real Interest Rate
Inflation Rate
Nominal Interest Rate
Tax Rate
After-tax Nominal Interest Rate
After-tax Real Interest Rate

Argitrary Redistribution of Wealth
 Higher-than-expected inflation transfers purchasing power from
get to repay their debt with dollars that aren’t worth as much.
 Lower-than-expected inflation transfers purchasing power from
 High inflation is more variable and less predictable than low inflation.
 So, these arbitrary redistributions are frequent when inflation is high.
38
to
:
to
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王祎 – AP Macroeconomics
Chapter 5
Unemployment
 Definition and Measurement


Produced by Bureau of Labor Statistics (BLS), in the U.S. Dept. of Labor
BLS divides adult population into 3 groups:
 Employed
paid employees, self-employed, and unpaid workers in a family business
 Unemployed
people not working who have looked for work during previous 4 weeks
 Labor force
the total # of workers, including the employed and unemployed
 Not in the labor force
everyone else

Labor Force Statistics
 Unemployment Rate (u-rate)
u-rate =

 Labor Force Participation Rate
labor force participation rate =

 Limitations of the u-rate

Discouraged Workers

Full-time v.s. Part-time Jobs

Dishonest People
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王祎 – AP Macroeconomics
 The Duration of Unemployment

Most spells of unemployment are short.
 Yet, most observed unemployment is long term.
 Types of Unemployment

Natural rate of unemployment
 the normal rate of unemployment around which the actual unemployment rate fluctuates

Cyclical unemployment
 the deviation of unemployment from its natural rate
 associated with business cycles

Demand-lacking unemployment
 the number of job vacancies based on current wage rate is smaller than that of unemployed person
 Growth lacking unemployment: increasing rate of the demand for unemployed persons is
smaller than that of the labor-force and labor productivity.
 Growth lacking unemployment and cyclical unemployment both belong to Demand
Lacking Unemployment
Even when the economy is doing well, there is always some unemployment, including:
 Seasonal unemployment
 happens with the changes of
 e.g.

Voluntary unemployment
 People are not willing to be employed because of dissatisfaction of current wage rate and working
condition.

Frictional unemployment
 occurs when

for most workers
 Job search
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王祎 – AP Macroeconomics
 Sectoral shifts

Structural unemployment
 occurs when
 usually
 Changing Rate of Unemployment

Public Policies
 Government employment agencies
provide information about job vacancies to speed up the matching of workers with jobs
(increase/ decrease)
unemployment
 Public training programs
aim to equip workers displaced from declining industries with the skills needed in growing industries
(increase/ decrease)
unemployment
 Unemployment insurance (UI)
A govt program that partially protects workers’ incomes when they become unemployed.
(increase/ decrease)
unemployment
Then why govt sets UI?
1.
2.

Wage >Equilibrium Wage
 Minimum Wage Laws
 Unions
a worker association that bargains with employers over wages, benefits, and working conditions
A union is a type of
attempting to exert its market power.
The process by which unions and firms agree on the terms of employment is
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王祎 – AP Macroeconomics
called
strike
Are unions good or bad? Economists disagree.
Critics:
.
Advocates:
 Efficiency wages
The Theory of efficiency wages
1. Worker health
2. Worker turnover
3. Worker quality
4. Worker effort
Homework & Problems
For questions 1 to 2 use the information below for a small town.
Total Population: 2000
Total Employed Adults: 950
Total Unemployed Adults: 50
1. What is the size of the labor force?
(A) 2000
(B) 950
(C) 900
(D) 1000
(E) 1950
Answer: d. Labor force is the employed + the unemployed. LF = 950 + 50 = 1000. The remaining citizens are out
of the labor force.
2. What is the unemployment rate?
(A) 5 percent
(B) 2.5 percent
(C) 5.5 percent
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王祎 – AP Macroeconomics
(D) 7 percent
(E) Unknown, as we do not know the number of discouraged workers.
Answer: a. The unemployment rate is the ratio of unemployed to the total labor force. UR = U/LF = 50/1000 =
5%.
3. You are working at a supermarket bagging groceries but you are unhappy about your wage so you quit and
begin looking for a new job at a competing grocery store. What type of unemployment is this?
(A) Cyclical
(B) Structural
(C) Seasonal
(D) Frictional
(E) Discouraged
Answer: d. Frictional unemployment occurs when a person is in between jobs. This person has not been laid off
due to a structural change in the demand for skills, or because of a cyclical economic downturn, or because of
a new season. A low wage might be discouraging; a discouraged worker is a worker who has been unemployed
for so long that he or she has ceased the search for work.
4. What will be the result of an increase in the labor force participation rate?
A. Increased investment
B. Increased savings and decreased investment
C. No effect on unemployment
D. Decreased revenue for firms
E. Decreased purchasing power for consumers
Answer: a. When more people have jobs, consumption increases because purchasing power increases.
5. What would be the effect of a large increase in labor productivity on the real GDP and the price level?
Real GDP
Price Level
A. Increase Increase
B. Increase Decrease
C. No effect Increase
D. Decrease Increase
E. Decrease Decrease
Answer: a. An increase in the price level and an increase in the real GDP would be the result of an increase in
labor productivity. When more people have jobs, the economy is more productive and the price level rises.
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Chapter 6
Saving, Investment and the Financial System
 Financial System
the group of institutions that helps match the
another
 Financial Markets
institutions through which savers can
 Bond
a certificate of
that specifies
of the bond
Characteristics:
of one person with the
of
provide funds to borrowers
of the
to the
 Stock
a claim to
in a firm, and is therefore, a claim to the profits that the firm makes
equity financing
Compared to bonds, stocks offer
risk and potentially
returns
Most newspaper stock tables provide the following information:

Financial Intermediaries
institutions through which savers can
 Banks
Banks take deposits from people
Banks pay depositors
on their loans.
provide funds to borrowers
and use the deposits to
.
on their deposits and charge borrowers
 Mutual funds
institutions that
They allow people
to
 Some Definitions

Saving
44
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王祎 – AP Macroeconomics
 Private saving
 Public saving
 National saving

Saving and Investment
Saving = Investment in a closed economy
 Budget Deficits and Surpluses
 Budget surplus
=
=
=
 Budget deficit
=
=
=
 Budget balance
 Market for Loanable Funds





Loanable funds refer to all income that people have chosen to
, rather than use
for
.
A supply-demand model of the financial system
Helps us understand
 how the financial system coordinates saving & investment
 how govt policies and other factors affect saving, investment, the interest rate
Assume: only one financial market
 All savers deposit their saving in this market.
 All borrowers take out loans from this market.
 There is one interest rate, which is both the return to saving and the cost of borrowing.
The supply of loanable funds comes from
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王祎 – AP Macroeconomics

Supply
The demand of loanable funds comes from

Equilibrium
Demand
 Policies influencing Loanable Funds
 1. Saving Incentives
2. Investment Incentives
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 3. Budget Deficits
Budget Deficits, Crowding Out, and Long-Run Growth
Increase in budget deficit causes fall in investment.
The govt borrows to finance its deficit, leaving less funds available for investment.
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Chapter 7
The Basic Tools of Finance
 Introduction

Financial System

Finance
 Time Value of Money

Present Value
 the amount that would be needed today to yield that future sum at prevailing interest rates
 Future Value
 the amount the sum will be worth at a given future date, when allowed to earn interest at the prevailing
rate
 Present value formula:

Compounding
 the accumulation of a sum of money where the interest earned on the sum earns additional interest

Rule of 70
 If a variable grows at a rate of x percent per year, that variable will double in about
 Managing Risk


Risk Aversion
Managing Risk
Standard deviation
 Insurance
Two problems in Insurance Markets
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1. Adverse selection
A high-risk person benefits more from insurance, so is more likely to purchase it
2. Moral hazard
People with insurance have less incentive to avoid risky behavior
 Diversification
reduces risk by replacing a single risk with a large number of smaller, unrelated risks
firm-specific risk
market risk
 Tradeoff between Risk & Return
Riskier assets pay a
return, on average, to compensate for the extra risk of holding them.
 Asset Valuation
 Overvalued
 Undervalued
 Fairly valued
 Value of a share =
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
Efficient Markets Hypothesis (EMH)
the theory that each asset price reflects all publicly available information about the value of the asset
 Implications of EMH
1. Stock market is informationally efficient
2. Stock prices follow a random walk
3.
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Chapter 8
The Monetary System
 Money

Definition of Money
the set of assets that people regularly use to buy g&s from other people
 2 Types of Money
 Commodity money
takes the form of a commodity with
value
Example
 Fiat money
money
value, used as money because of govt decree
Example

3 Functions of Money
 Medium of Exchange
an item buyers give to sellers when they want to purchase g&s
 Unit of Account
the yardstick people use to post prices and record debts
 Store of Value
an item people can use to transfer purchasing power from the present to the future
 Central Bank and Money Supply

Money Supply (or Money Stock)
the quantity of money available in the economy
 Components of Money Supply
 Currency
the paper bills and coins in the hands of the (non-bank) public
 Demand deposits
balances in bank accounts that depositors can access on demand by writing a check
 Measures of U.S. Money Supply
M1
M2
M3
 M1
= cash + coins + traveler’s checks + other checkable deposits
M1 is the most liquid of money definitions.
 M2
= M1 + savings deposits + small (i.e., under $100,000 certificates of deposit) time deposits + money
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market deposits + money market mutual funds
M2 is slightly less liquid because the holders of these assets would likely incur a penalty if they wished
to immediately convert the asset to cash.
 M3
= M2 + large (over $100,000) time deposits, M3 is even less liquid than M2 because the asset holder
would have to wait longer to liquidate a CD or pay a large penalty.

Central bank
an institution that oversees the banking system and regulates the money supply
 Monetary policy
the setting of the money supply by policymakers in the central bank
 Federal Reserve (Fed)
 the central bank of the U.S.
 Background
The Fed was created in 1914 after a series of bank failures convinced Congress that the U.S. needed a
central bank to ensure the health of the nation’s banking system.
 The Federal Reserve System consists of
Board of Governors (7 members)
located in Washington, DC
7 members
appointed by the President
confirmed by the Senate
Serve staggered 14-year terms so that one comes vacant every 2 years
President appoints a member serve a 4-year term
12 regional Fed banks
located around the U.S.
12 District banks
9 directors: 3 appointed by the Board of Governors; 6 elected by the commercial banks in the district
the directors appoint the district president which is approved by the Board of Governors
the New York Fed implements some of the Fed’s most important policy decisions
Federal Open Market Committee (FOMC)
includes the Bd of Govs and presidents of some of the regional Fed banks
the FOMC decides monetary policy
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 Three Primary Functions of the Fed
1. Regulates banks to ensure they follow federal laws intended to promote safe and sound banking
practices.
2. Acts as a banker’s bank, making loans to banks and as a lender of last resort.
3. Conducts monetary policy by controlling the money supply.
 Money Demand

3 Motivations & 2 Demands of Money
Motivation
Demand
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 Money Market & Quantity Theory of Money


Money Market①
Quantity Theory of Money
 Developed by 18th century philosopher David Hume and the classical economists
 Advocated more recently by Nobel Prize Laureate Milton Friedman
 Asserts that the quantity of money determines the value of money
 We study this theory using two approaches:
-A supply-demand diagram (refer to ①)
-An equation (refer to ②)
 Real v.s. Nominal Variables
-Nominal variables are measured in monetary units.
-Real variables are measured in physical units.
 Classical Dichotomy
the theoretical separation of nominal and real variables
Hume and the classical economists suggested that monetary developments affect nominal variables but
not real variables.
 Monetary Neutrality
the proposition that changes in the money supply do not affect real variables
 Velocity Formula (Fisher Equation/ Quantity Equation) ②
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 Money and Inflation

Types of Inflation

Inflation Tax

Fisher Effect
 Monetary Policy

Bank Reserves
 In a fractional reserve banking system, banks keep a fraction of deposits as reserves and use the rest
to make loans.
 Reserves
Reserves
Reserves
 Reseve Ratio
= fraction of deposits that banks hold as reserves
= total reserves as a percentage of total deposits
= reserves/ total deposits
 Bank T-account
a simplified accounting statement that shows a bank’s assets & liabilities
Banks’ liabilities include deposits, assets include loans & reserves
e.g.

Money Creation (3 different cases)
 1. No banking system
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 2. 100% reserve banking system: banks hold 100% of deposits as reserves, make no loans
 3. Fractional reserve banking system
A fractional reserve banking system creates money, but NOT wealth.
Money multiplier
the amount of money the banking system generates with each dollar of reserves

Basic Monetary Policies
 1. Open-Market Operations (OMO)
the purchase and sale of U.S. government bonds by the Fed
OMOs are easy to conduct, and are the Fed’s monetary policy tool of choice.
“B”
Expansionary Monetary Policy
“B”
→ “B”
“S”
To increase money supply, Fed buys govt bonds,
paying with new dollars.
…which are deposited in banks, increasing
reserves
…which banks use to make loans, causing the
money supply to expand
Contractionary Monetary Policy
“S”
→ “S”
To reduce money supply, Fed sells govt bonds,
taking dollars out of circulation, and the
process works in reverse.
 2. Reserve Requirements (RR)
Expansionary Monetary Policy
Contractionary Monetary Policy
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To increase money supply, Fed reduces RR.
Banks make more loans from each dollar of
reserves, which increases money multiplier and
money supply.
To reduce money supply, Fed raises RR, and
the process works in reverse.
Fed rarely uses reserve requirements to control money supply: fequent changes would disrupt banking.
 3. Discount Rate
the interest rate on loans the Fed makes to banks
When banks are running low on reserves, they may borrow reserves from the Fed.
Expansionary Monetary Policy
Contractionary Monetary Policy
To increase money supply, Fed can lower discount
rate, which encourages banks to borrow more
reserves from Fed.
Banks can then make more loans, which increases
the money supply.
To reduce money supply, Fed can raise
discount rate.
 ++ Federal Funds Rate
the short-run interest rate on the loans that banks with insufficient reserves borrow from other banks
with excess reserves
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
Problems Cotrolling the Money Supply
Homework & Problems
1. Which function of money best defines $1.25 as the price of a 20 oz. bottle of pop?
(A) Medium of exchange.
(B) Unit of account.
(C) Store of value.
(D)Transfer of ownership.
(E) Fiat money.
Answer: b. The price in this case measures the relative price (value) of the pop.
2. If a bank has $500 in checking deposits and the bank is required to reserve $50, what is the reserve ratio?
How much does the bank have in excess reserves?
(A) 10 percent, $450 in excess reserves.
(B) 90 percent, $50 in excess reserves.
(C) 90 percent, $450 in excess reserves.
(D) 10 percent, $50 in excess reserves.
(E) 10 percent, $500 in excess reserves.
Answer: a. The reserve ratio = Required reserves/checking deposits = .1 = 10%. Excess reserves = (checking
deposits – required reserves) = ($500 – $50) = $450.
3. Which is NOT a way that the Fed can affect the money supply?
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(A) A change in discount rate.
(B) An open market operation.
(C) A change in reserve ratio.
(D) A change in tax rates.
(E) Buying Treasury securities from commercial banks.
Answer: d. The Fed has no control of tax rates, which are an example of fiscal policy. All of the other choices are
tools of monetary policy.
4. If the money supply increases, what happens in the money market? (Assuming money demand is downward
sloping)
(A) The nominal interest rates rises.
(B) The nominal interest rates falls.
(C) The nominal interest rate does not change.
(D)Transaction demand for money falls.
(E) Transaction demand for money rises.
Answer: b. If the demand for money is downward sloping, the nominal interest rate falls because the money
supply curve has shifted rightward.
5. To move the economy closer to full employment, the central bank decides that the federal funds rate must
be increased. The appropriate open market operation is to ______, which ______ the money supply, ______
aggregate demand, and fight ______.
OMO
MONEY SUPPLY
AD
TO FIGHT
(A) Buy bonds
Increases
Increase
Unemployment
(B) Buy bonds
Increases
Increase
Inflation
(C) Sell bonds
Decreases
Decrease
Unemployment
(D) Sell bonds
Decreases
Increase
Inflation
(E) Sell bonds
Decreases
Decrease
Inflation
Answer: e. If the central bank has decided that moving to full employment requires an increase in the federal
funds rate, it must sell bonds to decrease the money supply. The resulting increase in interest rates decreases
AD and puts downward pressure on the price level.
6. Which of the following is a predictable advantage of expansionary monetary policy in a recession?
(A) Decreases aggregate demand so that the price level falls.
(B) Increases aggregate demand, which increases real GDP and increases employment.
(C) Increases unemployment, but low prices negate this effect.
(D) It keeps interest rates high, which attracts foreign investment.
(E) It boosts the value of the dollar in foreign currency markets.
Answer: b. Expansionary monetary policies decrease the interest rate causing AD to increase, which increases
GDP at equilibrium and increases employment.
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Chapter 9
Aggregate Demand and Aggregate Supply
 Aggregate Demand

Facts About Economic Fluctuations
 Over the long run, real GDP grows about 3% per year on average.
 In the short run, GDP fluctuates around its trend.
 Recessions: periods of falling real incomes and rising unemployment
 Depressions: severe recessions (very rare)
 FACT 1
 FACT 2
 FACT 3

The Aggregate-Demand (AD) Curve

Why the AD Curve Slopes Downward
Y = C + I + G + NX
Assume G fixed by government policy
 The Wealth Effect (P and C )
 The Interest-Rate Effect (P and I )
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 The Exchange-Rate Effect (P and NX )

Changes in AD
 Changes in C
--Stock market boom/crash
--Preferences re: consumption/saving tradeoff
--Tax hikes/cuts
 Changes in I
--Firms buy new computers, equipment, factories
--Expectations, optimism/pessimism
--Interest rates, monetary policy
--Investment Tax Credit or other tax incentives
 Changes in G
--Federal spending, e.g., defense
--State & local spending, e.g., roads, schools
 Changes in NX
--Booms/recessions in countries that buy our exports.
--Appreciation/depreciation resulting from international speculation in foreign exchange market
 Aggregate Supply

Long-run AS
 The natural rate of output (YN) is the amount of
also called potential output or full-employment output.
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 Changes of LRAS
 Changes in L or natural rate of unemployment
 Immigration
 Baby-boomers retire
 Govt policies reduce natural u-rate
 Changes in K or H
 Investment in factories, equipment
 More people get college degrees
 Factories destroyed by a hurricane
 Changes in natural resources
 Discovery of new mineral deposits
 Reduction in supply of imported oil
 Changing weather patterns that affect agricultural production
 Changes in technology
 Productivity improvements from technological progress

Short-run AS
Three Theories of SRAS
In each,
 some type of market imperfection
 result:
Output deviates from its natural rate when the actual price level deviates from the
price level people expected.
 1. The Sticky-Wage Theory
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 2. The Sticky-Price Theory
 3. The Misperceptions Theory
In all 3 theories, Y deviates from YN when P deviates from PE.
Y = YN + a (P – PE)

SRAS
and LRAS
The imperfections in these theories are temporary. Over time,
 sticky wages and prices become flexible
 misperceptions are corrected
In the LR,
 PE = P
 AS curve is vertical
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 Economic Equilibrium

Recessionary Gap

Inflationary Gap
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Chapter Review Questions
 A Comparison of Graphs from Micro- and Macro-economics
 The Axes
“Price” or “P” represents the amount of money that buyers are willing to pay and/or producers are willing
to accept per unit for a given quantity of a particular good or service.
“Quantity” or “Q” represents the quantity of a particular good that is demanded and/or supplied.
“Price level” or “PL” represents the overall price level for goods and services in an economy at a given
point in time. The consumer price index and the GDP deflator are examples of measures of the price level.
“Real GDP” or “rGDP” represents the quantity of final goods and services; in essence, it is the output of
an economy, adjusted for inflation.
 Demand
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Why is this curve downward-sloping?
The quantity demanded of any good
or service is determined by its price.
Consumers react to prices depending
upon:
(1) The income effect: As the price
falls, buyers feel as though they can
afford more, and thus quantity
demanded rises (and vice versa).
(2) The substitution effect: As the
price of good X rises, buyers substitute
good Y for X, and thus the quantity
demanded of X falls (and vice versa).
(3) Diminishing marginal utility: As
buyers increase their consumption of
a good, the satisfaction received from
consuming each additional unit falls;
buyers will only buy additional units if
the price falls accordingly.
Why is this curve downward-sloping?
(1) The interest rate effect: As the PL
rises, buyers need more dollars to
purchase goods and services. The
resulting increase in the demand for
dollars means higher interest rates.
Thus, since dollars cost more to borrow,
investment decreases, and so the total
amount of goods and services
demanded falls (and vice versa).
(2) The wealth effect (or the real
balances effect): As the PL rises, buyers
feel their purchasing power has fallen;
they are “less wealthy.” Thus, spending
falls as PL rises, and vice versa.
(3) The foreign purchases effect: When
the PL in the United States rises relative
to the PL in other countries, foreign
demand for United States goods falls, as
they become more expensive relative to
goods from elsewhere. Thus, United
States net exports fall (and vice versa).
 Supply
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The supply curve indicates the quantity
of a particular good or service, such as
chocolate bars, that firms are willing to
supply at each price.
The supply curve is upward-sloping
because sellers are willing to provide
greater quantities of a good or service to
the market as price rises (and vice versa).
As a firm’s marginal costs increase with
the production of each additional unit, it
is only rational for that firm to want to
receive more revenue for those additional
units.
The short-run aggregate supply curve
indicates the quantity of final goods and
services that producers are willing to
supply at each price level in the short
run.
In the short run, increases in prices are
not met by proportional increases in
wages because, among other reasons,
wage contracts are negotiated only
periodically. Thus, the cost of labor does
not increase at the rate of price
increases. As prices rise, the real
(inflation adjusted) value of fixed
nominal wages falls, profits per unit
increase, and firms are willing to supply
a larger quantity. This results in an
upward-sloping short-run aggregate
supply curve.
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 Equilibrium
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When the price equals Peq in product
market, buyers are willing to purchase
the same quantity of output that sellers
are willing to provide—Qeq. Thus, the
market is in “equilibrium.”
At price level PLeq, the macroeconomy depicted
above is in long-run equilibrium. A short-run
equilibrium exists whenever SRAS equals AD. At
long-run equilibrium, actual output Yeq also
equals potential output Yp
In the graph to the right, actual (short-run
equilibrium) output is greater than potential
output. The result is an “inflationary gap.”
Unemployment is low and nominal wages
tend to rise.
The bottom graph shows a “recessionary
gap.” Actual output is less than potential
output. The result is usually high
unemployment and falling nominal wages.
Aggregate Demand (AD): the inverse relationship between all spending on domestic output and the average
price level of that output. AD measures the sum of consumption spending by households, investment spending
by firms, government purchases of goods and services, and the net exports bought by foreign consumers.
Determinants of AD: AD is a function of the four components of domestic spending (C, I, G (X – M)). If any of
these components increases (decreases), holding the others constant, AD increases (decreases), or shifts to the
right (left).
Aggregate Supply (AS): the positive relationship between the level of domestic output produced and the
average price level of that output.
Macroeconomic short run: a period of time during which the prices of goods and services are changing in their
respective markets, but the input prices have not yet adjusted to those changes in the product markets. During
the short run, the AS curve has three stages––horizontal, upward sloping, and vertical.
Macroeconomic long run: a period of time long enough for input prices to have fully adjusted to market forces.
In this period, all product and input markets are in a state of equilibrium and the economy is operating at full
employment (GDPf ). Once all markets in the economy have adjusted and there exists this long-run equilibrium,
the AS curve is vertical at GDPf.
Determinants of AS: AS is a function of many factors that impact the production capacity of the nation. If these
factors make it easier, or less costly, for a nation to produce, AS shifts to the right. If these factors make it more
difficult, or more costly, for a nation to produce, AS shifts to the left.
Macroeconomic equilibrium: occurs when the quantity of real output demanded is equal to the quantity of
real output supplied. Graphically this is at the intersection of AD and AS. Equilibrium can exist at, above, or
below full employment.
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Homework & Problems
1. Using the model of AD and AS, what happens to real GDP, the price level, and unemployment with more
consumption spending (C)?
REAL GDP
PRICE LEVEL
UNEMPLOYMENT
(A) Increases
Decreases
Decreases
(B) Decreases
Increases
Increases
(C) Increases
Increases
Decreases
(D) Decreases
Decreases
Decreases
(E) Decreases
Decreases
Increases
Answer: c. An increase in consumption spending increases, or shifts rightward, the AD curve, increasing the
level of real GDP, the price level, and lowers the unemployment rate.
2. Which is the best way to describe the AS curve in the long run?
(A) Always vertical in the long run.
(B) Always upward sloping because it follows the Law of Supply.
(C) Always horizontal.
(D) Always downward sloping.
(E) Without more information we cannot predict how it looks in the long run.
Answer: a. All resources are employed at full employment in the long run so firms cannot respond to an
increase in the price level by increasing production. Thus any increase in prices cannot increase production in
the long run, and so AS is assumed to be vertical. Any short-run discrepancy in GDP, above or below, full
employment adjusts back to GDPf in the long run.
3. Stagflation most likely results from
(A) increasing AD with constant AS.
(B) decreasing AS with constant AD.
(C) decreasing AD with constant AS.
(D) a decrease in both AD and AS.
(E) an increase in both AD and AS.
Answer: b. Stagflation is an increase in the price level and an increase in unemployment. This is most often the
result of falling AS and a constant AD. Choice D is incorrect because a simultaneous decrease in AD puts
downward pressure on the price level, which offsets the upward pressure from falling AS.
4. Equilibrium real GDP is far below full employment and the government lowers household taxes. Which is the
likely result?
(A) Unemployment falls with little inflation.
(B) Unemployment rises with little inflation.
(C) Unemployment falls with rampant inflation.
(D) Unemployment rises with rampant inflation.
(E) No change occurs in unemployment or inflation.
Answer: a. A deep recession describes macroeconomic equilibrium in the horizontal section of AS. Here, rising
AD increases real GDP, lowers unemployment rates, with little inflation.
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Chapter 10 Monetary and Fiscal Policy
 Monetary Policy
 Fiscal Policy



the setting of the level of
Expansionary fiscal policy
 an
in G and/or
 shifts AD
Contractionary fiscal policy
 a
in G and/or
 shifts AD
and
in T
in T
 Policy Mix
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 Multiplier and Crowding-out Effects

The Multiplier Effect
the additional shifts in AD that result when fiscal policy increases income and thereby increases
consumer spending

Government Spending Multiplier

Taxation Multiplier
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
The Crowding-Out Effect
The reduction in demand that results when a fiscal expansion raises the interest rate is called the
crowding-out effect. It tends to dampen the effects of fiscal policy on aggregate demand.
 Fiscal Policy and Aggregate Supply
 Stabilization Policy
Automatic Stabilizers
changes in fiscal policy that stimulate agg demand when economy goes into recession, without
policymakers having to take any deliberate action
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Chapter 11 Phillips Curve
 Types of Inflation

Demand-pull Inflation
To remedy demand-pull inflation, the Fed calls for a policy that discourages aggregate demand.
Policymakers can implement contractionary, or tight, monetary policy. The Fed can decrease the money
supply and cause interest rates to rise, which in turn discourages investment and reduces aggregate demand.
Once aggregate demand is reduced, GDP/output will stabilize, and so will the price level.
The economy’s reaction to a tight monetary policy
On the other hand, if policymakers decide to stimulate aggregate demand, they elect to increase the
money supply, which in turn decreases interest rates. This then provides incentives for consumers to
spend money.
An economy after the Fed has implemented expansionary, or loose, monetary policy
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
Cost-push Inflation
 The Phillips Curve: Short-run versus Long-run

A Short-run Phillips Curve
1. Under normal conditions, there is a short-run trade-off between unemployment and inflation, and the
Phillips curve shows this trade-off.
2. The Phillips curve demonstrates an inverse relationship between inflation and unemployment. In the
short run, changes in aggregate demand are movements along the short-run aggregate supply curve:
3. Expansionary fiscal policies will increase aggregate demand, causing unemployment to fall and price
levels to rise. Contractionary fiscal policies will cause aggregate demand to decrease, causing price levels
to fall and unemployment to rise.
a. As AD increases, both the price level and the real GDP increase.
b. The real GDP and the unemployment rate are inversely related, so the opportunity cost of reducing
unemployment is higher inflation, and the opportunity cost of reducing inflation is higher unemployment.
c. In the short run, changes in AD are movements along the short-run aggregate supply curve.
d. If aggregate demand moves upward, the price level rises and the real GDP rises. This is reflected as a
new point on the short-run Phillips curve showing a higher rate of inflation and higher unemployment.
There will be a movement up the Phillips curve.
e. If AD moves down, the price level falls and the real GDP falls. This is reflected as a new point on the
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short-run Phillips curve showing a lower rate of inflation and lower unemployment. Movement will be
down the Phillips curve.
4. Given AS, high rates of inflation should be accompanied by low rates of unemployment. This is the
work of A. W. Phillips, who looked at data for the 1960s, which reinforced his Phillips curve idea.
5. In the last 25 years, there has been a changing interpretation of the short-run Phillips curve.
a. Most economists today accept the idea of a short-run trade-off, perhaps lasting a few years.
b. Many economists believe that adverse supply shocks can cause periods of rising unemployment and
rising inflation. Rapid and significant increases in resource prices push AS to the left.
c. The OPEC-induced price increases for oil in the 1970s are an example. Agricultural problems, a
depreciated dollar, and a rise in wages following the wage-price control of mid-1970s, combined with
declining productivity, also contributed to the situation.
6. Stagflation was the term defined in the 1970s and early 1980s, which suggested that the Phillips curve
shifted to a less desirable position, negating the trade-off between inflation and unemployment. High
inflation was matched with high levels of unemployment. The short-run relationship was dispelled.
a. In the later 1980s and through the 1990s, the effect of high unemployment and hence smaller increases
in wages was coupled with foreign competition that held down prices and wages. This seemed to be the
demise of stagflation. Deregulation and the decline of OPEC’s power pushed the rates back closer to the
earlier tradeoff picture. The ASSR shifted back to its old position, and the ASLR adjusted.
b. During the decade of the 1990s, unemployment reached a 30-year low of 3.7 percent, a figure well
below what most judge as the “natural rate”. Some economists suggest that the surplus budgets of the
later 1990s, coupled with gains in productivity, helped the economy to grow at low rates of inflation and
higher rates of employment.

A Long-Run Phillips Curve
Natural-rate hypothesis
the claim that unemployment eventually returns to its normal or “natural” rate, regardless of the inflation
rate
1. In the long run, the Phillips curve is vertical at full employment because the actual inflation rate is equal
to the expected inflation rate.
2. In the long run, the actual price level equals the expected price level, and output is at potential output
with unemployment at its natural rate.
3. To compensate for a higher-than-expected price level (expansionary gap), labor shortages and
dissatisfaction with lower real wages will lead to higher wages in the next round of negotiation.
a. The ASSR curve will shift to the left (due to higher costs), returning the economy to its potential output.
b. The higher AD will have no lasting effects since the price level increase is not matched by a decline in
employment.
4. To compensate for a lower-than-expected price level (recessionary gap), labor surpluses and firms
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gaining advantage in labor negotiations will force lower wage rates.
a. The ASSR curve will shift to the right (due to lower costs), returning the economy to its potential
output.
b. Both the price level and unemployment will fall.
5. Following the graph shown below, increases in AD beyond full employment (5 percent) temporarily
boost profits, output, and employment (a1 to b1).
6. Nominal wages eventually catch up to sustain real wages.
a. AS decreases and the price level rises while real GDP falls.
b. Profits fall, canceling the short-run effect, with employment returning to its full employment level (b1
to a2) but at higher inflation.
7. The cycle starts again as AD grows, profits grow, and employment rises (a2 to b2).
a. Again, in time, nominal wages catch up, and employment returns to its natural rate.
b. The reward is a higher inflation rate.
8. There is not a stable relationship between unemployment and inflation as shown.
9. The long-run Phillips curve is the vertical line through a1, a2, and a3. Any rate of inflation is consistent
with the 5 percent rate of unemployment.
10. When there are changes in the natural rate of unemployment, both the short-run and long-run Phillips
curves shift.

Role of Expectations

Supply Shock
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
Disinflation
Sacrifice ratio
Chapter Review Questions
1. Draw a correctly labeled graph showing the short-run Phillips curve for Country Z. Label the graph PCSR.
2. Amend the graph to show the effect of an expansionary fiscal policy. Use a label to identify the change.
Explain your amendment to the graph.
3. Amend the graph to show the effect of a contractionary fiscal policy. Use a label to identify the change.
Explain your amendment to the graph.
4. Draw a new correctly labeled graph showing the short-run Phillips curve for Country Z. Label the graph PCSR2.
5. Amend the graph to show the effect of an aggregate supply shock. Use a label to identify the change. Explain
your amendment to the graph.
6. Amend the graph to show the effect of a lower price for oil worldwide. Use a label to identify the change.
Explain your amendment to the graph.
7. Why is the long-run Phillips curve vertical?
8. What causes a long-run Phillips curve to shift?
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Answer Key
1. Note on the Phillips curve shown on the left, A is the original position before any amendment.
2. An expansionary fiscal policy will increase the AD, increasing both the price level and the real GDP. The
inflation rate increases while the unemployment rate decreases. This is movement up the Phillips curve, noted
by B.
3. A contractionary fiscal policy will decrease the AD, decreasing both the price level and the real GDP. The
inflation rate decreases while the unemployment rate increases. This is movement down the Phillips curve,
noted by C.
4. Note on the Phillips curve shown on the right, D is the original position before any amendment.
5. An aggregate supply shock will decrease the AS. This causes the price level to rise and the real GDP to fall.
The trade-off between unemployment and inflation is still true, but the curve must shift upward to reflect
higher rates of unemployment and inflation.
6. Lower prices for oil will increase the AS. This causes the price level to decrease and the real GDP to increase.
The trade-off between unemployment and inflation is still true, but the curve must shift downward to reflect
lower rates of unemployment and inflation.
7. In the long run, the Phillips curve is vertical at full employment because the actual inflation rate is equal to
the expected inflation rate. In the long run, the actual price level equals the expected price level, and output is
at potential output with unemployment at its natural rate.
8. The long-run Phillips curve will shift when there are changes in the natural rate of unemployment.
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Homework & Problems
1. The traditional Phillips curve shows the:
a. Direct relationship between the rate of inflation and the unemployment rate
b. Inverse relationship between the rate of inflation and the unemployment rate
c. Direct relationship between the short-run and the long-run aggregate supply
d. Inverse relationship between the short-run and the long-run aggregate supply
e. No relationship between the rate of inflation and the unemployment rate
Answer: b
2. Negative supply shocks will:
a. Move the economy along the Phillips curve toward less unemployment
b. Move the economy along the Phillips curve toward less inflation
c. Shift the Phillips curve to the left
d. Shift the Phillips curve to the right
e. Not move the Phillips curve at all
Answer: d
3. A vertical long-run Phillips curve would most likely be associated with:
a. A rate of inflation that is zero
b. A rate of unemployment that is low
c. The natural rate of unemployment
d. An aggregate demand increase
e. An aggregate demand decrease
Answer: c
4. Given a fixed Phillips curve with stable inflation and unemployment trade-offs, it
appears that:
a. An expansionary fiscal policy can shift the curve to the right.
b. A contractionary fiscal policy can shift the curve to the right.
c. Manipulating aggregate demand through fiscal policy has the effect of causing
movement along the curve.
d. Manipulating aggregate demand through fiscal policy has the effect of shifting
the curve.
e. Fiscal policy has no effect on the Phillips curve.
Answer: c
5. What is the main contrast between the short-run and long-run Phillips curve?
(A) In the short run there is a positive relationship between inflation and unemployment, and in the long run
the relationship is negative.
(B) In the short run there is a positive relationship between inflation and unemployment, and in the long run
the relationship is constant.
(C) In the short run there is a negative relationship between inflation and unemployment, and in the long run
the relationship is positive.
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(D) In the short run there is a negative relationship between inflation and unemployment, and in the long run
the relationship is constant.
(E) In the short run there is a constant relationship between inflation and unemployment, and in the long run
the relationship is negative.
Answer: d. The short-run Phillips curve is downward sloping but vertical in the long run.
Questions 1 and 2 refer to this table:
1. a. Based on the above data, draw a correctly labeled short-run Phillips curve for Country X. Label the curve
PCSR.
b. Identify how each of the following affects inflation, unemployment, and the short-run Phillips curve:
i. Increase in taxes
ii. Increase in costs of production
c. Assume that the natural rate of unemployment in Country X is 5 percent. Draw the long-run Phillips curve
on the graph drawn in part (a) and label it PCLR.
d. What is the relationship between the rate of inflation and the unemployment rate in the long run?
2. a. Draw a correctly labeled graph showing the short-run and long-run Phillips curves for Country X.
b. Identify how each of the following affects inflation, unemployment, and the short-run Phillips curve:
i. Expansionary fiscal policy
ii. Drop in the cost of a resource used across the economy
Scoring Rubric
1. 8 points maximum
a. 2 points
An accurate Phillips curve, inflation labeled on the vertical axis and unemployment labeled on the horizontal
axis, and a downward sloping short-run Phillips curve.
b. 4 points
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i. An increase in taxes will shift the aggregate demand curve to the left, which causes the inflation rate to
decrease and unemployment to increase. This causes movement down a short-run Phillips curve. Award 1
point for each of the following:
• Correctly identifying inflation decreases and unemployment rate increases
• Correctly identifying movement down the short-run Phillips curve
ii. An increase in costs of production will cause a leftward shift of the aggregate supply curve, which causes
inflation and unemployment to rise. This will cause an outward shift to the right of the short-run Phillips
curve. Award 1 point for each of the following:
• Correctly identifying that inflation increases and unemployment increases
• Correctly identifying that the Phillips curve shifts to the right
2. 7 points maximum
a. 3 points
An accurate short-run Phillips curve, inflation labeled on the vertical axis and unemployment labeled on the
horizontal axis; a downward-sloping short-run Phillips curve; and a vertical long-run Phillips curve with Q at
full employment labeled.
b. 4 points
i. An expansionary fiscal policy will shift the aggregate demand curve to the right, which causes the inflation
rate to increase and unemployment to decrease. This causes movement up a short-run Phillips curve.
Award 1 point for each of the following:
• Correctly identifying inflation increases and unemployment decreases
• Correctly identifying movement up the short-run Phillips curve
ii. A decrease in costs of production will cause a rightward shift of the aggregate supply curve, which causes
inflation and unemployment to fall. This will cause an inward shift to the left of the short-run Phillips curve.
Award 1 point foreach of the following:
• Correctly identifying that inflation decreases and unemployment decreases
• Correctly identifying that the Phillips curve shifts to the left
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Chapter 12 Production and Growth
 Incomes and Growth Around the World
 Production Function
 Growth policy
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Chapter Review Questions
Productivity: the quantity of output that can be produced per worker in a given amount of time.
Human capital: the amount of knowledge and skills that labor can apply to the work that they do and the
general level of health that the labor force enjoys.
Non-renewable resources: natural resources that cannot replenish themselves. Coal is a good example.
Renewable resources: natural resources that can replenish themselves if they are not overharvested. Lobster is
a good example.
Technology: a nation’s knowledge of how to produce goods in the best possible way.
Investment tax credit: a reduction in taxes for firms that invest in new capital like a factory or piece of
equipment.
Supply-side fiscal policy: fiscal policy centered on tax reductions targeted to AS so that real GDP increases with
very little inflation. The main justification is that lower taxes on individuals and firms increase incentives to
work, save, invest, and take risks.
Fiscal policy: deliberate changes in government spending and net tax collection to affect economic output,
unemployment, and the price level. Fiscal policy is typically designed to manipulate AD to “fix” the economy.
Expansionary fiscal policy: increases in government spending or lower net taxes meant to shift the aggregate
expenditure function upward and shift AD to the right.
Contractionary fiscal policy: decreases in government spending or higher net taxes meant to shift the
aggregate expenditure function downward and shift AD to the left.
Sticky prices: if price levels do not change, especially downward, with changes in AD, then prices are thought
of as sticky or inflexible. Keynesians believe the price level does not usually fall with contractionary policy.
Budget deficit: exists when government spending exceeds the revenue collected from taxes.
Budget surplus: exists when the revenue collected from taxes exceeds government spending.
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Homework & Problems
1. In a long period of economic expansion the tax revenue collected ____ and the amount spent on welfare
programs ____ , creating a budget ____ .
(A) increases, decreases, surplus
(B) increases, decreases, deficit
(C) decreases, decreases, surplus
(D) decreases, increases, deficit
(E) increases, increases, surplus
Answer: a. In an expansion, households should earn more income, which increases the taxes paid to the
government. At the same time, people who needed welfare, or other government assistance, do not need it
now because the unemployment level is low and wages are high. In this time of prosperity, the government
should run a budget surplus.
2. Which of the following would likely slow a nation’s economic growth?
(A) Guaranteed low-interest loans for college students.
(B) Removal of a tax on income earned on saving.
(C) Removal of the investment tax credit.
(D)More research grants given to medical schools.
(E) Conservation policies to manage the renewable harvest of timber.
Answer: c. An investment tax credit rewards firms that invest in physical assets. Removal of this tax credit slows
investment, productivity and growth. All other policies would increase the productivity of resources or increase
technological innovation.
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Chapter 13 Open Economy: International Trade and Finance
 Basic Concepts








A closed economy does not interact with other economies in the world.
An open economy interacts freely with other economies around the world.
Exports: domestically-produced g&s sold abroad
Imports: foreign-produced g&s sold domestically
Net exports (NX), aka the trade balance = value of exports – value of imports
Trade deficit: an excess of imports over exports
Trade surplus: an excess of exports over imports
Balanced trade: when exports = imports

Variables that Influence Net Exports
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 Balance of payments accounts

Current Account
shows current import and export payments of both goods and services. It also reflects investment income
sent to foreign investors and investment income received by U.S. citizens who invest abroad.

Capital and Financial Account
When a nation buys a foreign firm, or real estate or financial assets of another nation, it appears in the
capital account.
The Federal Reserve holds quantities of foreign currency called official reserves. When adding the current
account and the capital account, if the United States has sent more dollars out than foreign currency has
come in, as in the hypothetical example above, there exists a balance of payments deficit.
With the balance of payments surplus, the Fed transfers the surplus currency back into official reserves.
• U.S. imports require a demand for foreign currency and a supply of U.S. dollars.
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• U.S. exports require a supply of foreign currency and a demand for U.S. dollars.
• If current account balance + capital account balance < 0, there is a balance of payments deficit.
• If current account balance + capital account balance > 0, there is a balance of payments surplus.
 Foreign Exchange Market

Net capital outflow (NCO)

The flow of capital abroad takes two forms:


Foreign direct investment:
Domestic residents actively manage the foreign investment, e.g., McDonalds opens a
fast-food outlet in Moscow.
Foreign portfolio investment:
Domestic residents purchase foreign stocks or bonds, supplying “loanable funds” to a
foreign firm.

Variables that Influence NCO

The Equality of NX and NCO

The Nominal Exchange Rate


Appreciation (or “strengthening”):
an increase in the value of a currency as measured by the amount of foreign currency
it can buy
Depreciation (or “weakening”):
a decrease in the value of a currency as measured by the amount of foreign currency
it can buy
 Demand and Supply of Foreign Exchange
A. Assuming only two currencies, the dollar and the euro, the following supply and demand graphs
indicate both a market for dollars and a market for euros to show the relationship between the two.
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B. In these graphs, the exchange rate is considered to be one euro = one dollar.
C. Using both graphs, you can see what will happen to the value of a currency. For example, if there is an
increased demand for goods from the United States, then there will be an increase in the demand for the
dollar. At the same time, in the euro market there will be an increase in the supply of euros. Demanders of
dollars are supplying their euros. In the dollar market, the dollar appreciates. It takes more euros to buy a
dollar. In the euro market, the euro depreciates because the dollar price of a euro has decreased.

Exchange Rate Determinations

Currency Appreciation and Depreciation
 Currency appreciation: When the price of a currency is rising, it is said to be appreciating or
“stronger”.
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
Currency depreciation: When the price of a currency is falling, it is said to be depreciating or
“weaker”.
 Concepts to Be Covered
 I. What is the foreign exchange market?
A. The market in which the currencies of foreign countries are traded with one another
B. The market that determines the exchange rate through the use of supply of and demand for one
currency in terms of another currency
C. Not a single market but rather the interactions of thousands of people and institutions such as
exporters and importers, banks, and foreign exchange brokers throughout the world
 II. What is the purpose of the foreign exchange market?
A. To facilitate trade
1. People using one country’s currency (e.g., dollars) want to buy goods and services from another
country, but they do not have the currency used in that country (e.g., euros).
2. People using one country’s currency (e.g., dollars) want to purchase assets such as stocks, bonds, or
real estate from another country, but they do not have the currency used in that country (e.g., euros).
B. To allow for the trade of one currency for another
 III. How are foreign exchange rates determined?
A. Supply and demand
1. Supply
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a. Supply represents anyone holding a currency who is willing and able to offer it in exchange for
another currency.
b. Since the quantity supplied of a currency will increase as the exchange rate increases, the supply
curve is upward sloping.
2. Demand
a. Demand represents anyone who is willing and able to buy one currency in exchange for another.
b. Since the quantity demanded of a currency decreases as the exchange rate increases, the demand
curve is downward sloping.
c. For currencies, demand is considered a derived demand, since it represents demand for goods,
services, or assets.
d. Demand for currency is also related to speculation.
3. Equilibrium
a. Equilibrium is the rate at which the quantity supplied of one currency equals the quantity demanded
of the same currency.
b. The definition assumes a floating exchange rate, with rates changing with fluctuations in the supply
of or demand for the currency.
 IV. What causes changes to the exchange rate?
A. An increased/decreased preference for one country’s goods
B. An increase/decrease in real GDP in one country, which will increase/decrease incomes—affecting
demand for imports/exports
C. An increase/decrease in real interest rates in one country relative to another
D. Speculation on the expected future exchange rate
E. An increase in the price level of one country relative to another
 V. How do changes in the foreign exchange rate affect exports and imports, ceteris
paribus?
A. When a currency appreciates, the relative price of a foreign good decreases, so imports increase and
exports decrease.
B. When a currency depreciates, the relative price of a foreign good increases, so imports decrease and
exports increase.
 VI. How do changes in a country’s monetary policy affect the foreign exchange rate?
A. Changes will affect relative real interest rates.
B. Higher/lower relative real interest rates will increase/decrease demand for a currency in the foreign
exchange market.
C. Higher/lower relative real interest rates will increase supply/demand of the other currency in the
foreign exchange market.
 VII. How do changes in the exchange rate affect aggregate demand and equilibrium GDP
in the short run? Assuming an upward-sloping aggregate supply curve, since exchange
rate changes affect the demand for exports and imports:
A. With a depreciated currency, exports will increase and imports will decrease, causing an increase in
aggregate demand and equilibrium GDP.
B. With an appreciated currency, exports will decrease and imports will increase, causing a decrease in
aggregate demand and equilibrium GDP.
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Chapter Review Questions
1. Draw foreign currency markets for the US dollar and the European zone euro. Show on each model the
impact of US exports of grain to the European zone. Determine the impact on the international value of the US
dollar and of the euro.
2. Draw foreign currency markets for the US dollar and the Singapore dollar. Show on each model the impact of
US imports of silk from Singapore. Determine the impact on the international value of the US dollar and of the
Singapore dollar.
3. Draw foreign currency markets for the US dollar and the Mexican peso. Show on each model the impact of
US firms importing architectural services from a Mexican architectural firm. Determine the impact on the
international value of the US dollar and of the peso.
4. Draw foreign currency markets for the US dollar and the Japanese yen. Show on each model the impact of a
Japanese firm importing US healthcare services. Determine the impact on the international value of the US
dollar and of the yen.
5. Draw a model for the US loanable funds market. Show the impact on the real interest rate of increasing
purchases of US government securities by China. How would this impact the international value of the US
dollar? Explain.
6. Draw a loanable funds market for Zambia. Show the impact on the real interest rate of worried foreign
investors moving their funds out of the country. How would this impact the international value of Zambia’s
currency? Explain.
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Answer Key
1. US dollar appreciates and the euro depreciates
2. The US dollar depreciates and the Singapore dollar appreciates.
3. The US dollar depreciates and the peso appreciates.
4. The US dollar depreciates and the yen appreciates
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5. Capital flows into the US, increasing the supply of loanable funds and decreasing the real interest rate. The
dollar would appreciate as dollars are purchased in order buy US government bonds.
6. Capital flows out of Zambia, decreasing the supply of loanable funds and increasing the real interest rate.
Zambia’s currency would depreciate as the currency is used to purchase other currencies.
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Homework & Problems
1. Flexible exchange rates are determined by:
a. Central banks of the nations
b. Governments of the nations
c. International agreements
d. Forces of supply and demand
e. Businesses of the nations
Answer: d
2. If U.S. citizens decide to increase their purchases of Japanese cars, this will lead to:
a. Increase in the value of the dollar
b. Decrease in the value of the dollar
c. Decrease in the value of the yen
d. Stronger dollar
e. Weaker yen
Answer: b
3. The appreciation of a currency will lead to:
a. Increase in exports
b. Increase in imports
c. Decrease in imports
d. Increase in the balance of trade
e. Any of the above is likely.
Answer: b
4. Assume that originally 1 U.S. dollar = 1 euro. Which of the following may explain a change to 1 U.S. dollar =
1.3 euros?
a. U.S. buyers prefer European products.
b. U.S. GDP increases, increasing U.S. incomes.
c. European banks increase their interest rates relative to the U.S. rates.
d. U.S. banks increase their interest rates relative to the European rates.
e. The price level in the countries of the European Union increases.
Answer: d
1. Assume that the U.S. and Japan operate under a flexible exchange rate system and that the interest rate in
both nations is the same.
a. Using a correctly labeled graph of the foreign exchange market for yen, indicate the equilibrium exchange
rate of the yen in terms of the dollar.
b. If the Federal Reserve sells bonds on the open market:
i. Explain how this will affect interest rates.
ii. Indicate on the graph how the change in the interest rates will affect the value of the yen.
iii. How will imports of U.S. products by the Japanese be affected?
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Scoring Rubric
7 points maximum, as follows:
Graph for parts (a) and (b)(ii): 2 points
Part (b)(i): 4 points—If the Federal Reserve sells bonds, the excess reserves in banks will decrease, decreasing
the supply of money and increasing interest rates. Japanese investors will want to increase their holdings of U.S.
securities. This will lead to an increase in the supply of yen in the foreign exchange market, shifting the supply
curve to the right. This will lower the value of the Japanese yen and increase the value of the U.S. dollar.
Part (b)(iii): 1 point—Japanese imports of U.S. products will decrease due to the depreciation of the yen.
2. Interest rates in the countries of the European Union have not risen, but interest rates in the U.S. have risen
and are now higher than the rates in the EU.
a. Explain the change in the international value of the dollar.
b. Explain the change in the international value of the euro.
c. Explain the effect on the U.S. exports to the member countries of the European Union.
d. Explain the effect on the European Union exports to the U.S.
Scoring Rubric
8 points maximum: Answers to parts (a) through (d) are worth 2 points each
a. The value of the dollar will appreciate since capital will flow into the U.S. to earn the higher interest rate
returns. Those people in the European Union wanting to invest in the U.S. will demand dollars and supply euros
to the foreign exchange market.
b. The value of the euro will depreciate since funds will flow from the member countries in search of better
returns on their investment. Those people in the European Union wanting to invest in the U.S. will demand
dollars and supply euros to the foreign exchange market.
c. Exports from the U.S. will now be more expensive since citizens in the member countries will need to give up
more euros to get a dollar for an export good. Exports from the U.S. will decline.
d. Exports from the European Union are really U.S. imports. We must give up fewer dollars to obtain euros to
buy their goods. Exports coming from the European Union will increase; U.S. imports will rise.
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Appendix I: Macroeconomics Free-Response Questions
(1999-2012)
1999
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98
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99
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100
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101
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102
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103
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104
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2000
105
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106
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107
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108
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109
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2001
110
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111
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112
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113
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114
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2002a
115
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116
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117
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118
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119
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120
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2002b
121
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122
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123
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124
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125
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2003
126
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127
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128
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129
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130
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2003b
131
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132
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133
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134
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135
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2004
136
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137
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138
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139
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2004b
140
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141
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142
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2005
143
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144
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145
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2005b
146
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147
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148
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149
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2006
150
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151
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152
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153
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2006b
154
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155
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156
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2007
157
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158
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159
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160
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2007b
161
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162
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163
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164
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2008
165
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166
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167
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168
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2008b
169
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170
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171
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2009
172
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173
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174
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2009b
175
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176
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177
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2010
178
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179
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180
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2010b
181
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182
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2011
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Appendix II: Macroeconomics Practice Test
Section I
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60 multiple choice questions 70 minutes
Section II
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1 long free-response question and
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2 short free-response questions 10 minutes for planning, 50 minutes for writing
Total Time: 2 Hours and 10 Minutes
Macroeconomics Section I: Multiple-Choice Questions
Directions: You have 70 minutes to complete the 60 multiple-choice questions in this section of the exam.
1. Which of the following would cause the production possibilities curve to shift outward (to the right)?
A. Reopening an oil factory that had been closed
B. Rehiring oil workers
C. Using machinery for steel production instead of oil production
D. Becoming more efficient at making oil
E. Using machinery for oil production instead of steel production
2. If in 1976, nominal GDP grew by 11 percent and real GDP grew by 5 percent, what would be the inflation rate for this year?
A. 2 percent
B. –6 percent
C. 6 percent
D. 3 percent
E. 16 percent
3. Of the following types of unemployment, which one is structural unemployment?
A. A software engineer who leaves his job to move to Spain
B. A worker who loses his job during a recession
C. An assembly line worker who is replaced by a machine
D. A teacher who is unemployed during the summer months
E. A worker who is unproductive
4. If there were a large labor productivity increase, what would be the effect on GDP and the price level?
A. An increase in GDP, an increase in the price level
B. An increase in GDP, a decrease in the price level
C. No effect on GDP, an increase in the price level
D. A decrease in GDP, an increase in the price level
E. A decrease in GDP, a decrease in the price level
5. Which of the following could be attributed to an increase in the spending multiplier?
A. An increase in the supply of money
B. An increase in GDP
C. An increase in personal income taxes
D. An increase in the marginal propensity to consume
E. An increase in the required reserve ratio
6. According to Keynesians, which of the following could be attributed to an increase in aggregate demand?
A. An increase in investment
B. An increase in interest rates
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C. A decrease in transfer payments
D. A decrease in government expenditures
E. A decrease in consumer spending
7. Question 7 refers to the following graph
In the graph above, equilibrium A is indicated for an economy without government spending. With the addition of government
spending resulting at equilibrium B, which of the following must be true?
A. Government spending is $500 and the spending multiplier is 5.
B. Government spending is $100 and the multiplier is 5.
C. Government spending is $100 and consumption increases by $500.
D. Government spending has no effect on GDP.
E. Consumption increases government spending by $300.
8. How can commercial banks increase the money supply?
A. By transferring funds to the Federal Reserve
B. By buying bonds from the Federal Reserve
C. By transferring money to other banks
D. By keeping all deposits in reserves
E. By lending out excess reserves
9. If the reserve requirement is 20 percent, the existence of $100 in excess reserves can create how much money in the money
supply?
A. $20
B. $100
C. $300
D. $500
E. $750
10. If the Federal Reserve lowers the reserve requirement for banks, which of the following is true?
A. There will be an increase in the money supply.
B. Interest rates will rise.
C. There will be a decrease in the money supply.
D. Banks will be forced to keep more money in their vaults.
E. Businesses will purchase less capital equipment.
11. If the transaction demand for money increases, what is the impact on the banking system?
A. The Fed can decrease unemployment.
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B. The Fed can decrease aggregate supply.
C. The Fed can decrease taxes.
D. Banks will have a difficult time loaning excess reserves.
E. Banks will have an easy time loaning excess reserves.
12. According to Keynesians, what will an increase in spending and a decrease in taxes do to consumption and unemployment?
A. A decrease in consumption, an increase in unemployment
B. A decrease in consumption, no change in unemployment
C. An increase in consumption, a decrease in unemployment
D. An increase in consumption, an increase in unemployment
E. No change in consumption, a decrease in unemployment
13. Which of the following is the best solution for a recession?
A. Increased taxes, increased spending
B. Decreased taxes, increased spending
C. Decreased taxes, decreased spending
D. Increased taxes, decreased spending
E. None of the above
14. If the economy is functioning at full employment, and an increase in income tax with a reduction of government spending is
implemented to reduce government debt, which of the following is most likely to occur?
A. An increase in employment
B. An increase in the inflation rate
C. A decrease in employment
D. An increase in government debt
E. A decrease in the price level
15. To protect domestic producers, a country poses a tariff on an imported good (X); which of the following is likely to occur?
A. An increase in the production of X
B. A decrease in the price for X
C. An increase in the price for X
D. A decrease in the quantity of X
E. Both C and D
16. When two countries decide to specialize and trade, which of the following will occur?
A. The goods the countries are trading become more expensive.
B. The goods the countries are trading become scarcer.
C. Unemployment will increase in both countries.
D. There will be more efficient production of the traded goods.
E. Both countries will be producing at less efficient rates.
17. Which of the following situations would have a positive impact on GDP for the United States?
A. An increase in the production of Canadian chairs
B. An increase in domestic consumption spending
C. A decrease in foreign trade
D. An decrease in quotas
E. A decrease in tariffs
18. Question 18 refers to the following graph.
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According to the graph above, which of the following will result in a decrease in output?
A. A shift to the left of the aggregate supply curve and a shift to the left of the aggregate demand curve
B. A shift to the right of the aggregate supply curve and a shift to the left of the aggregate demand curve
C. An increase in government spending and a decrease in taxes
D. A decrease in taxes only
E. None of the above
19. Which of the following will cause the biggest increase in aggregate demand?
A. A $200 million decrease in taxes
B. A $100 million increase in taxes
C. A $500 million increase in government spending
D. A $500 million increase in government spending and a $100 million decrease in taxes
E. A $500 million increase in government spending and a $100 million increase in taxes
20. Which one of the following fiscal policies would be most effective for an economy in a severe recession?
A. An increase in government spending
B. A decrease in government spending
C. An increase in personal income taxes
D. The Fed’s decision to sell open-market securities
E. The Fed’s decision to buy open-market securities
21. If an increase in the income tax rate is implemented in an economy experiencing a recession, which of the following will occur?
A. An increase in unemployment
B. A decrease in unemployment
C. A decrease in the price level
D. An increase in consumer spending
E. Both A and C
22. Which of the following is a tool of the Federal Reserve?
A. Taxes
B. Selling of bonds
C. Spending
D. A reduction of interest rates
E. An increase in employment
23. What determines the value of the dollar in the United States?
A. Governmental regulations
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B. The amount of gold the United States possesses
C. The goods and services the United States will buy
D. The multiplier
E. The marginal propensity to save
24. As national income increases, the demand for money increases due to:
A. An increase in consumption of goods and services
B. An increase in interest rates
C. An increase in the money supply
D. A change in consumer confidence
E. An increase in demand for foreign currency.
25. Which of the following best describes why the aggregate supply curve is horizontal over a certain range?
A. Higher price levels lead to higher interest rates.
B. Changes in the aggregate price level do not induce substitution.
C. Output cannot increase unless the price level and interest rates increase.
D. Rigid prices prevent employment from fluctuating.
E. Resources are underemployed in the economy; an increase in spending can occur without any price level pressure.
26. Which of the following would be an appropriate combination of fiscal and monetary policy?
A. An increase in the reserve requirement and a decrease in taxes
B. A decrease in government spending and a decrease in the reserve requirement
C. The purchase of open-market securities and an increase in government spending
D. The purchase of open-market securities and a decrease in government spending
E. A decrease in spending and an increase in taxes
27. What does a Phillips Curve illustrate?
A. Unemployment and inflation
B. Unemployment and government spending
C. Inflation and government spending
D. Price level and aggregate demand
E. Aggregate demand and aggregate supply
28. Which of the following could cause a simultaneous increase in inflation and unemployment?
A. A decrease in government spending
B. A decrease in the money supply
C. A decrease in the velocity of money
D. An increase in inflationary expectations
E. An increase in the overall level of productivity
29. What will an increase in U.S. imports do?
A. Cause the dollar to appreciate
B. Cause the dollar to depreciate
C. Cause no change in the value of the dollar
D. Cause the price level to rise
E. Cause the price level to fall
30. Which of the following would increase the standard of living in an economy?
A. An increase in taxes
B. An increase in the number of banks
C. An increase in federal regulations
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D. An increase in labor productivity
E. An increase in the labor force
31. Which of the following could shift the long-run aggregate supply curve to the right?
A. An increase in the price of product resources
B. An increase in productivity
C. An increase in the federal budget deficit
D. A decrease in the money supply
E. A decrease in the labor force
32. What does the CPI measure?
A. Unemployment
B. Price level
C. A change in the price of heavy machinery
D. Taxation
E. Government spending
33. If the economy is currently experiencing full employment, which of the following must be true?
A. There is zero unemployment.
B. There is only cyclical unemployment.
C. There is equilibrium with imports and exports.
D. There is frictional unemployment.
E. There is a high level of inflation.
34. A classical economist would support which of the following?
A. Saving should be greater than investment.
B. The economy can be in equilibrium even though it is not experiencing full employment.
C. Inflation is not a serious economic problem.
D. Prices of products are inflexible.
E. The economy self-corrects itself when disequilibrium is reached.
35. If the government decides to decrease spending, which of the following is most likely to occur?
A. An increase in aggregate demand
B. An increase in output
C. A decrease in aggregate consumption
D. A decrease in aggregate supply
E. An increase in taxes
36. If current unemployment is at 10 percent and the price level is stable, what would a Keynesian recommend?
A. An increase in interest rates
B. A decrease in interest rates
C. A decrease in taxes
D. An increase in government spending and taxes
E. An increase in government spending and a decrease in taxes
37. The government can reduce an inflationary gap by:
A. Increasing spending
B. Increasing the supply of money
C. Decreasing the money supply
D. Increasing personal income taxes
E. Decreasing the reserve requirement
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38. What does the circular flow include?
A. Businesses buying from households in a factor market
B. Households buying from businesses in a factor market
C. Households buying from the government in a factor market
D. Government regulation over what is sold and bought
E. Only a monetary flow of goods and services
39. If the required reserve ratio is 20 percent and Marty’s bank has no excess reserves, what impact will a $100 deposit have on the
bank’s excess reserves?
A. $50 in excess reserves
B. $100 in excess reserves
C. $500 in excess reserves
D. $80 in excess reserves
E. $120 in excess reserves
40. If more people decide to hold currency as opposed to keeping it in the bank, which of the following is
likely to occur?
A. An increase in interest rates
B. An increase in the reserve requirement
C. An increase in employment
D. An increase in disposable income
E. An increase in the price level
41. Which of the following would be most effective in stimulating aggregate demand?
A. Increased taxes
B. Decreased taxes
C. Increased government spending
D. Decreased government spending
E. Decreased money supply
42. What happens to the price level when there is an increase in taxes?
A. It decreases.
B. It stabilizes.
C. It increases.
D. There is no impact on the price level.
E. None of the above.
43. Which of the following best describes a supply shock?
A. It changes the price level in the economy.
B. It affects only the general price level.
C. It can always be anticipated.
D. It can change the short-run aggregate supply curve into the long run aggregate supply curve.
E. It does not harm the economy.
44. If from 2003–2004 the unemployment level decreased from 6.5 percent to 5.9 percent and the inflation rate fell from 2.9 percent
to 1.3 percent, which of the following could explain these changes?
A. The aggregate demand curve shifted to the left.
B. The aggregate demand curve shifted to the right.
C. The aggregate supply curve shifted to the right.
D. The aggregate supply curve shifted to the left.
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E. The production possibilities curve shifted to the left.
45. What occurs to autonomous investment when there is an increase in interest rates?
A. It increases because investors want to earn more for their money.
B. It increases because less people want to spend.
C. It decreases because businesses have less incentive to borrow money.
D. It decreases because the government increases spending.
E. Interest rates do not influence autonomous investment.
46. Which of the following best describes comparative advantage?
A. When one country can produce a good or service at a cheaper price than another
B. When one country is less capable than another at producing a good or service
C. When both countries decide to specialize in the production of one good
D. When one country can produce a good or service at a lower opportunity cost than another country
E. When neither country can specialize because of trade barriers
47. When inflation is unanticipated, which of the following groups would benefit from it: savers, borrowers, or lenders?
A. Savers only
B. Borrowers only
C. Lenders only
D. Savers and borrowers only
E. Savers and lenders only
48. What is the result if there is an increase in the labor force?
A. Investment increases and savings decrease.
B. Investment decreases and savings increase.
C. There is no impact on investment or savings.
D. It will be easier to reduce the unemployment rate.
E. It will become more difficult to reduce the unemployment rate.
49. Which of the following do the Keynesians believe?
A. Savings depends on interest rates.
B. Government spending depends on interest rates.
C. The economy returns itself to full employment.
D. Macroeconomic equilibrium can occur at less than full employment.
E. Wages are more flexible than prices.
50. If the government increases its total spending by $10 billion yet it has no impact on GDP, what could be the reason for this?
A. The price level is rising.
B. There is high unemployment already present in the economy.
C. The spending multiplier has increased.
D. The economy is in equilibrium.
E. There has been an increase in aggregate supply.
51. What is the most important factor in saving and consumption according to Keynesians?
A. The interest rate
B. The inflation rate
C. The income of individuals
D. The level of employment
E. The price level and wages
52 through 54. Questions 52 through 54 refer to the following graph.
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52. What does each plot point on the graph above represent on the production possibilities curve?
A. Quantity demanded
B. Quantity supplied
C. Supply and demand
D. Opportunity costs
E. All of the above
53. What does point F represent?
A. An unattainable point
B. Underutilization
C. Trade-offs
D. Opportunity cost
E. Where firms can produce most efficiently
54. What does a production possibilities curve illustrate?
A. The relationship between price and quantity demanded
B. The relationship between price and quantity supplied
C. The various combinations of how resources can be applied efficiently
D. The various combinations of how supply and demand can be applied efficiently
E. The various combinations of unemployment and inflation
55. through 57. Questions 55 through 57 refer to the following graph.
55. In what range is full employment located on the graph above?
A. Range 1
B. Range 2
C. Range 3
D. Ranges 1 and 2
E. Ranges 2 and 3
56. According to aggregate demand on the graph, what is the economy experiencing?
A. Low unemployment
B. High inflation
C. High unemployment
D. High levels of government spending
E. High levels of growth
57. According to Keynesians, what fiscal policy would help aggregate demand shift into full employment?
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A. Increased taxes and decreased spending
B. Decreased interest rates
C. Increased interest rates and decreased spending
D. Increased spending and decreased taxes
E. Decreased reserve requirement
58. An increase of which of the following is likely to help the long-run growth rate in the economy?
A. Population
B. GDP
C. Education for the public
D. The supply of goods and services
E. Interest rates
59. What effect will an increase in the money supply have on the economy?
A. It will cause interest rates to rise.
B. It will increase the amount of money banks hold in primary reserves.
C. It will decrease interest rates.
D. It will decrease unemployment.
E. It will increase unemployment.
60. If the economy were experiencing high levels of inflation, which of the following would be proper monetary policy?
A. Lowering interest rates
B. Increasing interest rates
C. Decreasing the reserve requirement
D. Selling open-market securities
E. Raising taxes
Macroeconomics Section II: Free-Response Questions
Directions: You have one hour to answer all three free-response questions: one long and two short questions. Spend the first 10
minutes for planning, and in the remaining 50 minutes construct your responses. Explain your answers thoroughly with examples and
illustrations if appropriate.
1. The U.S. economy is currently experiencing the following conditions:
■ Inflation is at 7 percent.
■ Unemployment is at 4.2 percent.
■ Real GDP is growing at 4 percent.
A. Examining the data, what is the main problem in this scenario? Explain.
B. Describe the appropriate actions the Federal Reserve should take to provide a solution to this scenario. Use an aggregate supply
and demand curve to illustrate the impact of the Fed’s policy on the following:
■ Interest rates
■ Price level
C. Describe the appropriate actions Congress would take to remedy the scenario. Illustrate the effects of your answer on an
aggregate demand and aggregate supply model.
D. Why is it important for Congress and the Federal Reserve to work together?
2. Assume a closed economy with business, households, and the government:
A. Draw and correctly label a circular flow diagram for the headline above.
B. Identify two methods of calculating GDP and explain how each works.
C. Identify the determinants of aggregate demand and the determinants of aggregate supply.
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3. Assume the economy is experiencing a recession:
A. Identify possible remedies the Federal Reserve would implement.
B. Identify possible remedies Congress would vote on implementing.
Multiple-Choice Answers and Explanations
1. D. D is the only answer that describes efficiency. All other possible choices are interchangeable and too ambiguous. The production
possibilities curve shifts outward when there is an increase in productive resources or a more efficient means of using productive
resources.
2. C. The inflation rate in 1976 would be 6 percent because that is the difference between nominal and real GDP. Remember that
nominal GDP is the unadjusted version of output, whereas real GDP is adjusted for inflation. The difference between the two will give
us the inflation rate.
3. C. A worker who is replaced by a machine is an example of someone who is structurally unemployed. The worker’s skills have
become obsolete for the required job.
4. B. As labor productivity rises, so does GDP; however, the price level decreases because there is an increase in supply. When there is
an increase in aggregate supply, the price level decreases. This essentially happens in order to decrease supply.
5. D. An increase in the marginal propensity to consume increases the value of the spending multiplier. When people consume more
of their additional income, the spending multiplier is increased because more transactions are taking place in the economy. The
higher the marginal propensity to consume, the stronger the impact of the multiplier becomes.
6. A. Keynesians hold that an increase in investment will increase aggregate demand. Remember that investment to an economist is
not holding money in an account; rather, investment is when firms purchase capital to expand. When firms purchase capital, they
typically borrow money from banks. When more money is borrowed, the economy benefits from an increase in consumption and
aggregate demand thus increases.
7. A. Government spending is $500 and the multiplier is 5. With the addition of government spending, the expenditures curve
increases in value because we now have investment, consumption, and government expenditures.
8. E. Commercial banks can increase the money supply by lending out excess reserves. When banks have large amounts of excess
reserves, the interest rate on their loans drops to entice investors. Once the interest rate falls, the public can borrow money for
consumption.
9. D. $500 can be created as a result of $100 in excess reserves in a bank that has a 20 percent reserve requirement. The $100
eventually turns into $500 because of the money multiplier (1/reserve requirement).
10. A. When the Federal Reserve lowers the reserve requirement for banks, it is attempting to increase the money supply. The money
supply can increase because banks are allowed to loan excess funds to borrowers. Borrowers will borrow money at a low interest rate
and use it for consumption. The reserve requirement tells banks how much they have to keep in reserves and how much they may
have in excess reserves (loanable funds).
11. E. If the transaction demand for money increases, banks have an easier time lending out excess reserves. When the public wants
more money for transactions (buying goods and services), the demand for loans increases and banks have an easier time lending
their excess reserves.
12. C. An increase in spending coupled with a decrease in taxes stimulates growth in the economy. Unemployment decreases because
firms employ more resources (including labor), and consumption increases because disposable income is increased as a result of a tax
cut.
13. B. A recession can be remedied by decreasing taxes and increasing spending. This is an example of fiscal policy. Remember that a
recession is at least two consecutive quarters of declining GDP.
14. C. A decrease in the employment level is likely to occur if the government reduces spending and increases taxes. The
contractionary decision by the government may slow or even halt growth. These particular policies are typically used when the
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economy is growing too quickly, risking high inflation.
15. E. Both C and D are correct answers. Depending on producers’ reaction to a tariff, the good will increase in price, and may
decrease in quantity because it becomes more expensive for producers to create the good.
16. D. More efficient production of the traded goods will result because of specialization. Countries that specialize will concentrate
resources on the production of a specific good. This concentration will allow producers to increase efficiency and minimize costs.
17. B. An increase in consumption spending will have a positive impact on GDP because consumption is one of the components of the
GDP expenditure approach. Consumption increases aggregate demand, which helps the economy grow.
18. A. When aggregate supply and aggregate demand decrease, we have a decrease in output. Quantity or output decreases because
there is a decline in aggregate supply. To better understand this, draw an aggregate supply and aggregate demand curve on your own
and draw decreasing shifts. Notice what occurs with quantity or output. Output declines to a decrease in aggregate supply.
19. D. A $500 million increase in spending along with a $100 million decrease in taxes will affect the economy the greatest. When the
government spends money, the impact due to the multiplier will be greater than the tax break. However, coupled with a tax break,
government spending becomes that much more effective.
20. A. An increase in government spending is the appropriate fiscal policy for a recession. Recessions occur because money is not
being spent and the economy is not growing. For growth, the government injects money into the economy, producing opportunities
for firms and households. The other two answer choices are examples of monetary policy.
21. A. If there were an increase in taxes during a recessionary period, the effects of this decision could have a major negative impact
on the economy. Unemployment would soar because firms would have to pay higher taxes. Higher taxes means less money for wages
and resources.
22. B. The selling of bonds is a tool that the Federal Reserve uses often because of its subtle effects on the economy. The Fed does not
directly control all interest rates; however, it can manipulate interest rates by adjusting the discount rate or electing to alter the
money supply. An alteration of the money supply forces interest rates to rise or fall according to the level of money banks have in
reserve.
23. C. The value of the dollar is determined by the goods and services it will buy. Long ago, the amount of gold in reserve determined
the value of money, but the United States no longer uses that policy.
24. A. An increase in the consumption of goods and services occurs when national income increases. This is called the income effect.
When income increases, so does the marginal propensity to consume.
25. E. Over the horizontal range, any increase in demand can be facilitated by the economy without any pressure on the price level.
The price level is not influenced because the economy’s resources are underemployed. Any rise in demand increases employment but
will be in no danger of increasing the price level significantly.
26. C. The purchase of open-market securities and increased government spending are the appropriate combinations of monetary
and fiscal policy for an economy that is experiencing a recession.
27. A. The Phillips Curve illustrates the relationship between unemployment and inflation. Normal inflation (1 percent–3 percent)
helps the economy grow and increases unemployment. However, high levels of inflation decrease unemployment and growth.
28. D. An increase in inflationary expectations leads to a simultaneous increase in inflation and unemployment. The price level rises
because consumers are bracing for a higher price level, and the unemployment level rises because producers are bracing for a higher
price level.
29. B. An increase in U.S. imports will tend to cause the U.S. dollar to depreciate because of an increased supply of dollars
internationally. When U.S. consumers purchase international goods, the international supply of the dollar increases, causing the
decline of the value of the dollar.
30. D. An increase in the productivity of labor increases the standard of living in an economy. When workers are more productive,
costs per unit fall and more goods and services are available for consumers.
31. B. An increase in productivity shifts the long-run aggregate supply curve to the right. An increase in productivity increases the
economy’s capacity for production. When the capacity improves, more goods and services can be provided without pressure on the
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price level.
32. B. The CPI is used to measure the price level. It examines a particular amount of goods, called a market basket, to reveal any
changes in the average price for those goods. If the average price rises, the price level rises (inflation).
33. D. If the economy is experiencing full employment, it does not mean that the unemployment level is zero. It simply means that
the economy is performing at its productive capacity, where most of its resources are employed. In this condition, structural
unemployment still exists because people graduate from school and search for jobs and people are still unhappy with their jobs and
search for new ones. No matter how healthy the economy is, there are always some instances of unemployment simply due to
matriculation and normal market activity.
34. E. Classical economists believe that the economy is self-correcting when disequilibrium occurs. The basic principle that is outlined
by classical economists is that the economy needs no government intervention because it is capable of returning to equilibrium on its
own.
35. C. If the government were to decrease spending, initially aggregate expenditures would decline because there would be fewer
jobs available due to a lack of spending. This lack of spending would diminish the purchasing power of individuals and in turn
decrease aggregate consumption.
36. E. If the unemployment level reached a high point while the price level remained stable, Keynesians would recommend an
increase in government spending and a decrease in taxes. This would stimulate growth as well as increase purchasing power for the
public. Firms could then employ more resources because taxes would be lower. Individuals would spend more money because
disposable income would be increased.
37. D. Inflationary gaps are the result of too much disposable income. When individuals have extra money, they tend to spend it,
causing the price level to rise. When the price level rises, the value of the dollar falls and an inflationary gap is created. An increase in
the income tax rate can curb disposable income, forcing consumption to decrease and the price level to stabilize.
38. A. A circular flow chart includes businesses paying for factors of production from households in a factor market. Some examples of
factor markets include labor (wages) and payments to households for land.
39. D. A deposit of $100 in a banking system that has a 20 percent reserve ratio will have an $80 impact in excess reserves because 20
percent is kept in reserves while excess reserves are exposed to the remaining 80 percent—in this case, $80.
40. A. If the public’s desire to hold money in the form of currency increases, demand for loanable funds rises. This demand causes
interest rates to climb.
41. C. Government spending is the most effective option for stimulating aggregate demand because of the multiplier effect.
Consumers spend only a portion of a tax cut; a greater portion is dispersed into the economy with government spending.
42. B. When an increase in taxes occurs, the price level is stabilized because disposable income declines. When people have less
money to spend, the price level is stabilized because of decreased consumption.
43. A. Supply shocks change the price level in the economy because they have a ripple effect on goods and services. When one
industry is influenced by a supply shock, interdependent industries are affected as well. When enough industries are affected by a
supply shock, the price level rises because of a lack of available goods and services in the economy.
44. D. If the unemployment level and the price level fall, it can be attributed to an increase in the aggregate supply curve. The
aggregate supply curve is an indicator of the economy’s productive capacity. When the aggregate supply curve increases, so does the
economy’s productive capacity. Avoiding an increase in the price level and increasing employment is the result of an increased
aggregate supply curve.
45. C. When interest rates increase, incentives for autonomous investment decrease because of the increased cost to borrow money.
Firms borrow less money, buy less capital, and employ fewer workers. An increase in interest rates has a contractionary impact on the
economy.
46. D. Comparative advantage describes one nation’s ability to produce a good or service at a lower opportunity cost than another
nation producing that same good or service. Comparative advantage outlines opportunity costs, not necessarily monetary costs.
47. B. When inflation is unanticipated, borrowers benefit because the value of what they owe is actually decreasing as a result of
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inflation. Inflation decreases purchasing power and lowers the value of currency. If a borrower is lent money and the inflation rate
increases, the payback amount for the borrower remains the same; however, the ability to obtain the amount becomes easier.
48. E. If there is an increase in the labor force, it becomes more difficult to reduce the unemployment rate because more jobs have to
be created to satisfy the increased labor force. As the number of labor force participants grows, the number of jobs has to increase
with it or we will experience an increase in unemployment.
49. D. According to Keynesians, macroeconomic equilibrium can occur at less than full employment. Where shortrun aggregate
supply meets aggregate demand, we have macroeconomic equilibrium.
50. A. When government spending has no impact on GDP, one reason could be that the price level is rising. This means that the
economy has reached its productive capacity and that GDP can no longer increase. All that’s left for producers to do is to increase the
price level.
51. C. According to Keynesians, the most important factor of savings and consumption is the level of income for individuals. The more
people receive in income, the more they spend and save. The marginal propensity to consume and save rises as income climbs.
Consumption and savings are dependent on the level of income.
52. D. Each plot point on the production possibilities graph represents an opportunity cost. As you move from one plot point to
another, you have to give up one good for another. The production possibilities graph is designed to illustrate available resources and
describe their allocative possibilities.
53. B. Point F on the graph represents underutilization. Underutilization occurs when a country is producing inside the production
possibilities curve. Any point inside the curve illustrates a country that is not being efficient with its available resources. The
production possibilities curve represents allocative efficiency; any point on the curve represents efficient use of resources.
54. C. A production possibilities curve illustrates the various combinations of resources that can be applied or allocated. The
combination of the vertical and horizontal axis is the sum of resources in the scenario. The production possibilities curve illustrates
the allocative efficiency of the goods on the horizontal and vertical axes.
55. B. Full employment is located in range 2. Range 2 has a slight increase in price level (growth) and is the optimum level of
performance for applied resources in the economy. In range 2, the economy is at or near productive capacity, meaning that resources
are being used efficiently for production.
56. C. The graph illustrates the economy’s aggregate demand in range 1. In range 1, there are high levels of unemployment and any
increase in spending can satisfy aggregate demand without any pressure on the price level. Range 1 illustrates an economy that is
lacking spending and disposable income.
57. D. Increased spending and decreased taxes are the fiscal policy options a Keynesian would recommend for an economy that is
lacking growth. Spending helps increase employment whereas lower taxes increase disposable income and allow firms to produce at
lower costs.
58. C. Education is considered human capital. Human capital helps the economy in the long run because the labor force becomes
more productive with increased education. When workers are educated, skills become more advanced and firms can produce more
goods and services and increase quality.
59. C. An increase in the money supply results in a decline in interest rates. Lenders will have more money to lend, and to make it
more enticing for consumers to borrow, they will lower interest rates. The relationship between money supply and interest rates is an
inverse one.
60. D. If the economy experiences high levels of inflation, the appropriate monetary policy is to sell open-market securities in order to
decrease the money supply. When the money supply decreases, the price level becomes stabilized.
Free-Response Answers and Explanations
1. A. The main problem in this scenario is inflation. At a 7-percent rise in the price level, the economy has reached
and started to surpass its productive capacity. A 4.2-percent unemployment rate indicates that the economy has
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fully employed its labor resources, further indicating a problem with inflation as aggregate demand continues to
grow. The growth in real GDP is not a problem; however, it is expected due to the low rate of unemployed people
in the labor force and a growing price level.
B. To combat inflation, the Federal Reserve should implement a “tight” monetary policy—the Fed decreases the
money supply with the intension of increasing the value of the available dollars in the economy. To accomplish
this, the Fed could use any one of its monetary policy tools: increasing the reserve ratio, increasing the discount
rate, or, most likely, selling open market securities. Refer to the following illustration:
C. Congress would partake in a contractionary fiscal policy with the objective of halting the price level by
decreasing disposable income. To do this, the government could increase taxes and/or reduce spending.
Refer to the following illustration:
D. It is important for Congress and the Fed to work together because they are the two most influential entities on
the economy. If the Fed and Congress do not work together, the effectiveness of policies enacted by either of the
two would be diminished significantly.
2. A. Refer to the following illustration:
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B. Two ways of calculating GDP are the expenditure approach and the income approach. The expenditure approach examines the
amount spent on all final goods and services produced in a specific year on a nation’s soil.
The income approach examines the amount received from the purchases of all final goods and services produced
in a specific year on a nation’s soil. One examines the amount spent (expenditures), while the other examines the
amount received (income).
C. The determinants of aggregate demand are:
■ Income
■ Taste and preferences
■ Price of complementary product
■ Price of substitute product
■ Future expectation of price
■ Number of consumers
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Determinants of Aggregate Supply:
■ Resource prices
■ Technology
■ Government (subsidies and taxes)
■ Number of suppliers
3. A. If the economy were experiencing a recession, the Federal Reserve would increase the money supply, which
would make more money available at a lower cost for consumption.
B. Congress would vote on decreasing taxes and/or increasing spending. This would increase disposable income,
which would increase aggregate demand to stimulate a sleeping economy.
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Appendix II: IS-LM Model
WE KNOW
 LM
 IS
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
IS-LM Model
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Appendix III: Solow Model
WE KNOW
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