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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 1 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 1 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, … 3 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 4 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. 5 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 6 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%) 7 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 8 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 9 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 10 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. 11 , 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 12 . 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 13 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 14 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. 15 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 16 . 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 17 and 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: 18 in 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 19 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 20 and 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: 21 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 .why? 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 23 王祎 – AP Macroeconomics > > 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. 24 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. 25 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 , 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 . 王祎 – AP Macroeconomics 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 28 王祎 – AP Macroeconomics 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 29 王祎 – AP Macroeconomics 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 30 王祎 – AP Macroeconomics 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 31 王祎 – AP Macroeconomics 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? 32 王祎 – AP Macroeconomics 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: 33 王祎 – AP Macroeconomics 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 . 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. 35 王祎 – AP Macroeconomics 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 36 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 37 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 . 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 39 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 40 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 41 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 42 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. 43 王祎 – AP Macroeconomics 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 . 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 45 王祎 – AP Macroeconomics Supply The demand of loanable funds comes from Equilibrium Demand Policies influencing Loanable Funds 1. Saving Incentives 2. Investment Incentives 46 王祎 – AP Macroeconomics 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. 47 王祎 – AP Macroeconomics 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 48 years 王祎 – AP Macroeconomics 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 = 49 王祎 – AP Macroeconomics 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. 50 王祎 – AP Macroeconomics 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 51 王祎 – AP Macroeconomics 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 52 王祎 – AP Macroeconomics 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 53 王祎 – AP Macroeconomics 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 54 王祎 – AP Macroeconomics 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 55 王祎 – AP Macroeconomics 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 56 王祎 – AP Macroeconomics 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 57 王祎 – AP Macroeconomics 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? 58 王祎 – AP Macroeconomics (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. 59 王祎 – AP Macroeconomics 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 ) 60 王祎 – AP Macroeconomics 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. 61 王祎 – AP Macroeconomics 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 62 王祎 – AP Macroeconomics 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 63 王祎 – AP Macroeconomics Economic Equilibrium Recessionary Gap Inflationary Gap 64 王祎 – AP Macroeconomics 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 65 王祎 – AP Macroeconomics 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 66 王祎 – AP Macroeconomics 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. 67 王祎 – AP Macroeconomics Equilibrium 68 王祎 – AP Macroeconomics 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. 69 王祎 – AP Macroeconomics 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. 70 王祎 – AP Macroeconomics 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 71 by 王祎 – AP Macroeconomics 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 72 王祎 – AP Macroeconomics 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 73 王祎 – AP Macroeconomics 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 74 王祎 – AP Macroeconomics 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 75 王祎 – AP Macroeconomics 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 76 王祎 – AP Macroeconomics 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 77 王祎 – AP Macroeconomics 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? 78 王祎 – AP Macroeconomics 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. 79 王祎 – AP Macroeconomics 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. 80 王祎 – AP Macroeconomics (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 81 王祎 – AP Macroeconomics 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 82 王祎 – AP Macroeconomics Chapter 12 Production and Growth Incomes and Growth Around the World Production Function Growth policy 83 王祎 – AP Macroeconomics 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. 84 王祎 – AP Macroeconomics 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. 85 王祎 – AP Macroeconomics 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 86 王祎 – AP Macroeconomics 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. 87 王祎 – AP Macroeconomics • 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. 88 王祎 – AP Macroeconomics 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”. 89 王祎 – AP Macroeconomics 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 90 王祎 – AP Macroeconomics 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. 91 王祎 – AP Macroeconomics 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. 92 王祎 – AP Macroeconomics 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 93 王祎 – AP Macroeconomics 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. 94 王祎 – AP Macroeconomics 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? 95 王祎 – AP Macroeconomics 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. 96 王祎 – AP Macroeconomics Appendix I: Macroeconomics Free-Response Questions (1999-2012) 1999 97 王祎 – AP Macroeconomics 98 王祎 – AP Macroeconomics 99 王祎 – AP Macroeconomics 100 王祎 – AP Macroeconomics 101 王祎 – AP Macroeconomics 102 王祎 – AP Macroeconomics 103 王祎 – AP Macroeconomics 104 王祎 – AP Macroeconomics 2000 105 王祎 – AP Macroeconomics 106 王祎 – AP Macroeconomics 107 王祎 – AP Macroeconomics 108 王祎 – AP Macroeconomics 109 王祎 – AP Macroeconomics 2001 110 王祎 – AP Macroeconomics 111 王祎 – AP Macroeconomics 112 王祎 – AP Macroeconomics 113 王祎 – AP Macroeconomics 114 王祎 – AP Macroeconomics 2002a 115 王祎 – AP Macroeconomics 116 王祎 – AP Macroeconomics 117 王祎 – AP Macroeconomics 118 王祎 – AP Macroeconomics 119 王祎 – AP Macroeconomics 120 王祎 – AP Macroeconomics 2002b 121 王祎 – AP Macroeconomics 122 王祎 – AP Macroeconomics 123 王祎 – AP Macroeconomics 124 王祎 – AP Macroeconomics 125 王祎 – AP Macroeconomics 2003 126 王祎 – AP Macroeconomics 127 王祎 – AP Macroeconomics 128 王祎 – AP Macroeconomics 129 王祎 – AP Macroeconomics 130 王祎 – AP Macroeconomics 2003b 131 王祎 – AP Macroeconomics 132 王祎 – AP Macroeconomics 133 王祎 – AP Macroeconomics 134 王祎 – AP Macroeconomics 135 王祎 – AP Macroeconomics 2004 136 王祎 – AP Macroeconomics 137 王祎 – AP Macroeconomics 138 王祎 – AP Macroeconomics 139 王祎 – AP Macroeconomics 2004b 140 王祎 – AP Macroeconomics 141 王祎 – AP Macroeconomics 142 王祎 – AP Macroeconomics 2005 143 王祎 – AP Macroeconomics 144 王祎 – AP Macroeconomics 145 王祎 – AP Macroeconomics 2005b 146 王祎 – AP Macroeconomics 147 王祎 – AP Macroeconomics 148 王祎 – AP Macroeconomics 149 王祎 – AP Macroeconomics 2006 150 王祎 – AP Macroeconomics 151 王祎 – AP Macroeconomics 152 王祎 – AP Macroeconomics 153 王祎 – AP Macroeconomics 2006b 154 王祎 – AP Macroeconomics 155 王祎 – AP Macroeconomics 156 王祎 – AP Macroeconomics 2007 157 王祎 – AP Macroeconomics 158 王祎 – AP Macroeconomics 159 王祎 – AP Macroeconomics 160 王祎 – AP Macroeconomics 2007b 161 王祎 – AP Macroeconomics 162 王祎 – AP Macroeconomics 163 王祎 – AP Macroeconomics 164 王祎 – AP Macroeconomics 2008 165 王祎 – AP Macroeconomics 166 王祎 – AP Macroeconomics 167 王祎 – AP Macroeconomics 168 王祎 – AP Macroeconomics 2008b 169 王祎 – AP Macroeconomics 170 王祎 – AP Macroeconomics 171 王祎 – AP Macroeconomics 2009 172 王祎 – AP Macroeconomics 173 王祎 – AP Macroeconomics 174 王祎 – AP Macroeconomics 2009b 175 王祎 – AP Macroeconomics 176 王祎 – AP Macroeconomics 177 王祎 – AP Macroeconomics 2010 178 王祎 – AP Macroeconomics 179 王祎 – AP Macroeconomics 180 王祎 – AP Macroeconomics 2010b 181 王祎 – AP Macroeconomics 182 王祎 – AP Macroeconomics 183 王祎 – AP Macroeconomics 2011 184 王祎 – AP Macroeconomics 185 王祎 – AP Macroeconomics 186 王祎 – AP Macroeconomics 187 王祎 – AP Macroeconomics 2011b 188 王祎 – AP Macroeconomics 189 王祎 – AP Macroeconomics 190 王祎 – AP Macroeconomics 2012 191 王祎 – AP Macroeconomics 192 王祎 – AP Macroeconomics 193 王祎 – AP Macroeconomics 194 王祎 – AP Macroeconomics Appendix II: Macroeconomics Practice Test Section I ■ 60 multiple choice questions 70 minutes Section II ■ 1 long free-response question and ■ 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 195 王祎 – AP Macroeconomics 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. 196 王祎 – AP Macroeconomics 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. 197 王祎 – AP Macroeconomics 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 198 王祎 – AP Macroeconomics 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 199 王祎 – AP Macroeconomics 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 200 王祎 – AP Macroeconomics 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. 201 王祎 – AP Macroeconomics 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. 202 王祎 – AP Macroeconomics 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? 203 王祎 – AP Macroeconomics 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. 204 王祎 – AP Macroeconomics 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 205 王祎 – AP Macroeconomics 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 206 王祎 – AP Macroeconomics 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 207 王祎 – AP Macroeconomics 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 208 王祎 – AP Macroeconomics 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: 209 王祎 – AP Macroeconomics 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 210 王祎 – AP Macroeconomics 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. 211 王祎 – AP Macroeconomics Appendix II: IS-LM Model WE KNOW LM IS 212 王祎 – AP Macroeconomics IS-LM Model 213 王祎 – AP Macroeconomics 214 王祎 – AP Macroeconomics Appendix III: Solow Model WE KNOW 215 王祎 – AP Macroeconomics 216 王祎 – AP Macroeconomics 217 王祎 – AP Macroeconomics 218 王祎 – AP Macroeconomics 219 王祎 – AP Macroeconomics 220 王祎 – AP Macroeconomics 221 王祎 – AP Macroeconomics 222 王祎 – AP Macroeconomics 223