Download AP Macroeconomics Review

Macro Review
Topics and Percentages
 8-12% Basic Economic Concepts
 12-16% Measurement of Economic Performance
 10-15% National Income and Price Determination
 15-20% Financial Sector
 20-30% Inflation, Unemployment, and Stabilization
Policies
 5-10% Economic Growth and Productivity
 10-15% Open Economy: International Trade and
Finance
8-12% Basic Economic Concepts
A. Scarcity, choice, and opportunity costs
B. Production possibilities curve
C. Comparative advantage, absolute advantage,
specialization, and exchange
D. Demand, supply, and market equilibrium
E. Macroeconomic issues: business cycle, unemployment,
inflation, growth
Production Possibilities
 Assumptions:
 Full Employment
 Fixed Resources and Technology
 Movements
 Along curve shows opportunity cost
 Outward shift illustrates economic growth
 Inward shift indicates destruction of resources
 Producing Capital Goods will lead to greater economic growth
than producing consumer goods. (Butter will lead to more
growth than guns)
Production
Possibilities
Graph
Capital
Points A,B,C,
are efficient pts.
Goods
Point D is underutilization
Point E is economic growth
A
May Lead to most
Future economic growth
E
B
D
C
F.E.
F.E.1
Consumer Goods
Supply and Demand Factors
 Demand Changes when:
 Income changes
 Related Products, complements and substitutes, (price or quality
change)
 Expectations (future price change)
 Consumers (more or less added)
 Tastes, Fads, Preferences change
Demand Increase: As Demand Increases,
Price and Quantity Increase as well.
Price
S1
P2
P1
D2
D1
Q1
Q2
Quantity
Demand Decrease: As Demand Decreases,
Price and Quantity decrease as well
Price
S1
P1
P2
D1
D2
Q2
Q1
Quantity
Supply Factors
 Supply Changes When:





Input prices change (resources and wages)
Government (tariffs, quotas, and subsidies)
Number of sellers change
Expectations (about price and product profitability change)
Disasters (weather, strikes, etc..)
Supply Increase: As Supply Increases,
Quantity Increases, but Price Falls.
S1
Price
S2
P1
P2
D1
Q1
Q2
Quantity
Supply Decrease: As Supply Decreases,
Quantity Decreases, but Price Increases.
S2
Price
S1
P2
P1
D1
Quantity
Q2
Q1
Comparative Advantage
 A nation should specialize in producing goods in which it has
a comparative advantage: ability to produce the good at a
lower opportunity cost.
Example:
Cheese
Spain:
France
2 pounds
Wine
2 Cases
2 pounds
Spain should produce cheese (1C = 1W)
France should produce wine (1W = 1/3C)
:
6 Cases
Currency Terms
Appreciation: Currency is
increasing in demand (stronger
dollar)
U.S. Currency will appreciate when
more foreigners: travel to the U.S., buy
more U.S. goods or services, or buy the
U.S. dollar to invest in bonds
Currency Terms
Depreciation: Currency is
decreasing in demand (weaker
dollar) Being SUPPLIED in exchange
for other currency.
U.S. Currency will depreciate when
fewer foreigners: travel to the U.S., buy
fewer U.S. goods or services, or sell the
U.S. dollar to invest in their own bonds
Business Cycles
 The increases and decreases in Real GDP consisting of four phases:




Peak: highest point of Real GDP
Recession: Real GDP declining for 6 months
Trough: lowest point of Real GDP
Recovery: Real GDP increasing (trough to peak)
15
Business Cycle
16
Full Employment
Peak -- Greatest spending and lowest unemployment.
Inflation becomes a problem.
Contraction/Recession -- Reduction of spending levels and
increasing unemployment. Some cyclical unemployment
begins.
Trough -- Least spending and highest unemployment
Expansion -- Spending increases and unemployment
decreases
We want to avoid extreme inflation and extreme
unemployment. We want stability!
17
The two big problems…
The two big problems that plague the economy are:
INFLATION
UNEMPLOYMENT
People generally prefer steady, stable growth to large
“ups” and “downs.” Therefore, government policies,
both fiscal and monetary (see later sections), are
aimed at flattening the business cycle.
The government wants not only to stimulate the
economy when it’s slow, but also to slow it down
when it’s growing too quickly.
12-16% Measurement of
Economic Performance
A. National income accounts
1. Circular flow
2. Gross domestic product
3. Components of gross domestic product
4. Real versus nominal gross domestic product
B. Inflation measurement and adjustment
1. Price indices
2. Nominal and real values
3. Costs of inflation
C. Unemployment
1. Definition and measurement
2. Types of unemployment
3. Natural rate of unemployment
18
Circular Flow of Economic Activity
Households supply resources (land, labor,
capital, entrepreneurial ability) to the resource
market. Households demand goods and
services from businesses.
Businesses demand household resources and
supply goods and services to the product
(factor) market.
20
Gross Domestic Product
GDP (Gross Domestic Product): The total dollar (market) value of all final
goods and services produced in a given year.
Expenditure Formula:
Consumption (C) +
Business Investment (I) +
 Government Spending (G) +
Net Exports (Xn)
GDP: What Counts:
Goods Produced but not Sold (I)
Goods produced by a foreign country
(Japan) in the U.S. (Honda, Toyota)
Government spending on the military
Increase in business inventories
GDP: What DOES NOT count:
 Intermediate Goods (Tires sold by Firestone to Ford)
 Used Goods
 Non-Market Activities (Illegal, Underground)
 Transfer Payments (Social Security)
 Stock Transactions
Shortcomings of GDP: Leading to GDP being
understated.
Nonmarket activities: (services of homemakers)
does not count.
Leisure: Does not include the value of leisure.
Does not include improvements in product quality.
Underground economy
GDP: Overstated
 Includes damage to the environment
 Includes more spending on healthcare-Americans being unhealthy.
 Includes money spent to fight crime-more police officers, more jails, etc…
Real GDP
 Real GDP= Nominal GDP adjusted for inflation.
 Calculation:
 Real GDP =
Nominal GDP
Price Index in Hundredths( deflator)
Example:
U.S. 2005 Real GDP=
$11.048 Trillion
$12,4558 (billions)
1.1274 (based on 2000)
Real GDP Per Capita
 Most commonly used to compare and measure each country’s
standard of living and overall economic growth.
 Real GDP/Nation’s Population
Inflation
28
 Rise in the general level of prices
 Reduces the purchasing power of money
 Measured with the Consumer Price Index (CPI)
 Reports the price of a market basket , more than 300 goods that are typically
purchased by an urban household
Calculating Inflation
CPI in Recent Year – CPI in Past Year
Divided by CPI in Past Year
(Number then Multiplied by 100)
Example:
2002 CPI = 179.9
2001 CPI = 177.1
Rate of Inflation: 179.9-177.1 = 1.58%
177.1
Types of Inflation
Demand Pull Inflation: ‘too much money chasing
too few goods.”
 AD Curve will shift to the right, resulting in a higher Price
Level and greater Output (until reaching Y*
Cost-Push Inflation: Major cause is a supply shockOPEC cutting back on oil production
 AS Curve will shift to the left resulting in a higher Price
Level and a decrease in Real GDP.
Real and Nominal Terms
 Real Income = Nominal Income
Price Index (Hundredths)
 Real Interest Rate = Nominal Interest Rate –
Inflation Rate
 Nominal Interest Rate = Real Interest Rate +
Inflation Premium
(anticipated inflation)
Inflation: Winners & Losers
 Winners:
 Debtors who borrow money that will be repaid with
“cheap” dollars.
 Those who have anticipated inflation
 Losers:
 Savers (especially savings accounts)
 Creditors (Banks will be repaid with those “cheap” dollars
 Fixed-Income Recipients (retirees receiving the same
monthly pension)
Unemployment
Calculation: Number of Unemployed
Labor Force
(Multiplied by 100 to put as a %)
The Labor Force is the total of employed and
unemployed workers.
U.S. unemployment should be about 5%
33
Employed
 You are considered to be employed if:
 You work for 1 hour as a paid employee (so part-time workers count)
 You are temporarily absent from work (illness, strike, vacation)
 You work 15 hours or more as an unpaid worker (family farms are common)
Unemployed
 Must be looking for work (at least 1 attempt in the past 4 weeks)
 Are reporting to a job within 30 days
 Are temporarily laid off from their job
Not In Labor Force
 A person who is not looking for work:
 Full-time students
 Stay at home parents
 Discouraged workers: those who have given up hope of finding
a job.
 Retirees
Unemployment
 100% of the people will never be employed, so the
government considers 4-6% unemployment to be
“full employment.”
 Types of Unemployment
 Frictional - temporary and unavoidable
 Structural - results from changes in technology or
a business restructure (ex. Merger)
 Seasonal- occurs when industries slow or shut
down for a season
 Cyclical - results from a decline in the business
cycle.
We can never be at Full Employment if there is
any percentage cyclically unemployed.
37
10-15% National Income and
Price Determination
A. Aggregate demand
1. Determinants of aggregate demand
2. Multiplier and crowding-out effects
B. Aggregate supply
1. Short-run and long-run analyses
2. Sticky versus flexible wages and prices
3. Determinants of aggregate supply
C. Macroeconomic equilibrium
1. Real output and price level
2. Short and long run
3. Actual versus full-employment output
4. Economic fluctuations
38
Consumption and Saving
 As income increases, both consumption and savings will
increase.
 The determinants of overall consumption and savings are: (More money
or a positive outlook will increase consumption and reduce savings.
Less money or a negative outlook will increase savings and reduce
consumption.
 Wealth (financial assets)
 Expectations about future prices and income
 Real Interest Rates
 Household Debt
 Taxes
Marginal Propensities
Marginal Propensity to Consume (MPC) and the
Marginal Propensity to save (MPS) must equal 1.
The MPS is used to derive the spending multiplier,
which equals:
1_
MPS
If the MPS is .2, the spending multiplier is 5.
Any increase in spending must be multiplied by 5 to
determine the overall increase in Real GDP.
Aggregate Demand
Price
Level
Downward sloping:
1. Real-Balances Effect: change
in purchasing power
2. Interest-Rate Effect: Higher
interest rates curtail spending
3. Foreign Purchase Effect:
Substitute foreign products for
U.S. products
AD (C + I + G + X)
Real GDP
Aggregate Demand
Determinants of AD:
 C + I + G + Xn (Yes, its GDP)
 An increase in any of these, due to lower interest rates or
optimism will increase AD and shift the curve to the
right.
 A decrease in any of these: more debt, less spending, tax
increase, will cause a decrease in AD and shift the curve
to the left
 Consumption
 Wealth
 Expectations
 Debt
 Taxes
 Investment
 Interest Rates
 Expected Returns
 Government
 Change in Gov. spending
 Net Exports
 National Income Abroad
 Exchange Rates
Aggregate Demand Determinants
 Technology
 Inventories
 Taxes
Aggregate Supply Factors:
R: resource prices (The CELL/ wages
and materials, as well as OIL)
E: environment [legal-institutional]
(Taxes, Subsidies, more regulation)
P: productivity (better technology)
 Short Run:
 Assumes that nominal wages
are “sticky” and do not
respond to price level changes.
 Is Upward sloping as
businesses will increase output
to maximize profits
 Generally considered to be a
year or less.
 Long Run:
 Curve is vertical because the
economy is at its fullemployment output.
 As prices go up, wages have
adjusted so there is no
incentive to increase
production.
 Generally considered to be
longer than a year.
Aggregate Supply
Price Level
AS
Aggregate Supply Graph
Inflation
Short Run
Recession
Long Run
Growth
Extended vertical line
Illustrates the LRAS and
Y* (Full-Employment)
Y*
Real GDP
LRAS
Another look as AS
PL
Changes that
lead to a new
equilibrium
on the left of
LRAS =
Recession
SRAS
Changes that
lead to a new
equilibrium
on the right
of LRAS =
Inflation
(AKA “an
overheated
economy”)
PL
AD
Y*
RGDP
For the AP exam, assume that there are only two
determinants that simultaneously affect BOTH short
term aggregate supply and aggregate demand
NOTE!!
 business tax changes and
 foreign currency changes.
A change in business taxes shifts AD and AS in the
same direction
A change in FX sends both curves in the opposite
directions.
Demand-Pull Inflation
AS
Price Level
P2
P1
AD2
AD1 (C + I + G
+ X)
Y*
Real GDP
AS2
Cost-Push Inflation
AS1
Price
Level
P2
P1
AD1 ( C + I + G + X)
Y
Y*
Real GDP
51
Demand-Pull Inflation
vs.
Cost-Push Inflation
DEMAND-PULL INFLATION
ASLR
AS2
Price Level
AS1
c
P3
b
P2
a
P1
AD2
AD1
o
Q1
Real domestic output
52
COST-PUSH INFLATION
Occurs when short-run AS shifts left
ASLR
AS2
Price Level
AS1
b
P2
a
P1
AD1
o
Q2 Q 1
Real domestic output
53
COST-PUSH INFLATION
54
Government response with increased AD
ASLR
AS2
Price Level
AS1
c
P3
b
P2
a
P1
Even
higher
price
levels
AD2
AD1
o
Q2 Q 1
Real domestic output
COST-PUSH INFLATION
55
If government allows a recession to occur
ASLR
AS2
Price Level
AS1
b
P2
a
P1
AD1
o
Q2 Q 1
Real domestic output
COST-PUSH INFLATION
56
If government allows a recession to occur
ASLR
AS2
Price Level
AS1
b
P2
a
P1
Nominal
wages fall &
AS returns
to its original
location
AD1
o
Q2 Q 1
Real domestic output
15-20% Financial Sector
(Money and Banking)
A. Money, banking, and financial markets
1. Definition of financial assets: money, stocks, bonds
2. Time value of money (present and future value)
3. Measures of money supply
4. Banks and creation of money
5. Money demand
6. Money market
7. Loanable funds market
B. Central bank and control of the money supply
1. Tools of central bank policy
2. Quantity theory of money
57
3. Real versus nominal interest rates
Money Supply Terms
58
 M1= Checkable Deposits and Currency
 M2= M1 + Savings deposits, money market accounts, small time
deposits (less than $100,000)
 Velocity of Money Equation:
 MV = PQ ( GDP) (M= Money Supply and V = Velocity (number of times
per year the average dollar is spent on goods and services.
Banks and Balance Sheets
Assets
Liabilities
Reserves $15,000 Checkable Deposits
Securities
$15,000
Loans
$70,000
$100,000
59
If the current reserve requirement is 10%:
1. What is the amount of new loans this bank can generate?
Answer: $100,000 Checkable deposits X a 10% reserve requirement =
$10,000 required reserves. If the bank has $15,000 in reserves, $5,000 of those
are excess reserves and can be loaned out .
2. How much in new loans can be generated by the entire banking
system?
Answer: Money Multiplier = 1/Required Reserve Ratio=1/.10
10 X $5,000 = $50,000
60
Nominal Interest
Rate
MS1
MS2
FED and the Money Vertical
Market
curve-Supply controlled
nir1
By the FED. An increase in MS
leads to a rightward shift and
lower nominal interest rates.
nir2
MD
Q1
Q2
Quantity of Money
Interest Rate-Investment
61
 Expected Rate of Return: Amount of Profit (expressed as a percentage) a
business expects to gain on a project/investment.
 This rate must be greater than the interest in order to be profitable.
 The Real Rate of Return is most important. An expected profit of 10%, that
costs 5% in interest = The real rate of return: 5%.
Investment Demand Curve:
Real Rate of
Return
62
At lower real interest rates businesses will
Increase investment , leading to an increase
In AD (aggregate demand). At higher rates of
Interest, less money will be invested
r1
r2
ID
Q1
Q2
Quantity of Investment
63
Expected Rate of
Return
( Real Interest Rate.)
A shift fromCurve
ID1 to ID2
Shifts of the Investment Demand
Represents an increase in
Investment demand. A shift
From ID1 to ID3 represents a
decrease in investment
Demand.
ID2
ID3
ID1
Quantity of Investment
Loanable Funds Market and Expansionary
Fiscal Policy
Used for FISCAL POLICY (Government spendingDeficit Spending)
Real Interest Rate
SLF
R2
An increase in Gov.
spending increases the
demand for loanable
funds and raises real
interest rates
R1
DLF2
DLF1
Q1
Q2
Quantity of Funds
Used
for FISCALFunds
POLICY Market
(Government
Loanable
andspending-Deficit
Spending)
A decrease in Gov.
Contractionary Fiscal Policy
SLF
Real Interest Rate
spending decreases the
demand for loanable
funds and lowers real
interest rates
R1
R2
DLF1
DLF2
Q2
Q1
Quantity of Funds
66
Nominal:
with Inflation
Real:
without Inflation
GDP
 Nominal GDP: GDP measured in
terms of current Price Level at the
time of measurement.
(Unadjusted for inflation)
67
 Real GDP: GDP adjusted for
inflation; GDP in a year divided by
a GDP deflator (Price Index) for
that year
INCOME
 NOMINAL INCOME: number of
dollars received by an individual or
group for its resources during
some period of time
68
 REAL INCOME: amount of goods
and services which can be
purchased with nominal income
during some period of time;
nominal income adjusted for
inflation
INTEREST RATE (I%)
 NOMINAL I%: interest rate
expressed in terms of annual
amounts currently charged for
interest; not adjusted for inflation
69
 REAL I%: interest rate expressed
in dollars of constant value
(adjusted for Inflation) and equal
to the NOMINAL I% minus the
EXPECTED RATE OF INFLATION
ANTICIPATED INFLATION
70
11%
=
+
5%
Nominal
Interest
Rate
Real
Interest
Rate
6%
Inflation
Premium
WAGES
 NOMINAL WAGES: amount of
money received by a worker per
unit of time (hour, day, etc.);
 Money Wage
71
 REAL WAGES: amount of goods
and sevices a worker can purchase
with their NOMINAL WAGE;
purchasing power of the nominal
wage.
 (Real = Nominal – Inflation rate)
NOMINAL/REAL TIPs
72
 If nominal rates INCREASE and Price Level INCREASE, the CHANGE
in Real is “indeterminable.”
 If nominal Wage rates do NOT change and Price Level fall. REAL
WAGES increase.
 NOMINAL RATES “PIGGY-BACK” REAL RATES & NOT VICE VERSA.
20-30% Inflation, Unemployment, and
Stabilization Policies
A. Fiscal and monetary policies
1. Demand-side effects
2. Supply-side effects
3. Policy mix
4. Government deficits and debt
B. Inflation and unemployment
1. Types of inflation
a. Demand-pull inflation
b. Cost-push inflation
2. The Phillips curve: short run versus long run
3. Role of expectations
73
Fiscal Policy
 Using Taxes and Government spending to stabilize the
economy.
 Controlled by the President and Congress
 Discretionary Fiscal Policy: Congress must take action
(change the tax rates) in order for the action to be
implemented.
 Automatic Stabilizers: Unemployment benefits, Progressive
Tax System, these changes are implemented automatically to
help the economy.
FISCAL POLICY CHANGES AD ….
EXCEPT when the question specifically states
there is a change in business taxes.
Expansionary
Types of Fiscal
 Used to Fight a Recession
 LOWER TAXES
 INCREASE GOVERNMENT
SPENDING
Contractionary
Policy
 Used to fight Inflation
 RAISE TAXES
 DECREASE GOVERNMENT
SPENDING
Expansionary Fiscal Policy
AS1
Price Level
P2
P1
AD2
Y1
AD1 ( C + I + G + X )
Real GDP
Y*
Contractionary Fiscal Policy
Raising taxes or reducing government spending to
fight inflation and stabilize the economy.
Price Level
AS
P1
P2
AD1
AD2
Y*
Real GDP
 Remember, if the government decreases taxes, the result is not as great
as a spending increase, since households will save a portion (MPS) of the
tax cut.
 The Tax Multiplier = -MPC /MPS
Tax Multiplier [-MPC/MPS]
 Example: If the MPC is .8 and the MPS is .2
 Spending Multiplier = 1/.2 or 5
 Tax Multiplier =
-.8 /.2 or -4
Crowding-Out Effect
An Expansionary Fiscal Policy as previously
diagrammed will lead to higher interest rates.
At higher interest rates, businesses will take out
fewer loans and there will be a decrease in
INVESTMENT (I)
At the same time there will be a decrease in
CONSUMER SPENDING (C) as they will take out
fewer loans as well.
This CROWDING OUT EFFECT will reduce the gain
made by the expansionary fiscal policy.
Net Export Effect & Expansionary Fiscal Policy
 Government spending has led to an increase in interest
rates.
 At higher interest rates, foreigners demand more U.S. dollars
to invest in bonds.
 This leads to an appreciation of the U.S. dollar.
 This leads to a decrease in Net Exports, as foreigners now
have to exchange more of their currency for the U.S. dollar
to buy exports.
 This decrease in Net Exports will reduce AD and counter to
some extent the expansionary fiscal policy.
Net Export Effect & Contractionary Fiscal Policy
 A decrease in government spending has led to a decrease in
real interest rates.
 At lower interest rates, foreigners demand less U.S. dollars
to invest in bonds.
 This leads to a depreciation of the U.S. dollar.
 This leads to an increase in Net Exports, as foreigners now
have to exchange less of their currency for the U.S. dollar to
buy exports.
 This increase in Net Exports will increase AD and further
strengthen the contractionary fiscal policy.
 Timing Problems
 Recognition Lag: identifying recession or inflation
 Administrative Lag: getting Congress/President to agree
to take action
 Operational Lag: Time needed to see the results of the
fiscal policy
 Political Business Cycles: Politicians may take
inappropriate action to get reelected (lower taxes during
an inflationary period). Plus it is difficult to raise taxes
Criticisms of Fiscal Policy
The Federal Reserve System (FED)
 Control Monetary Policy
 Headquartered in Washington D.C.
 12 Federal Reserve Districts
 Board of Governors (7 members) is the central authority
 Members are appointed by the President and confirmed by the Senate
Federal Open Market Committee
(FOMC)
 Made up of 12 people: Board of Governors + New York FED
President + 4 other regional presidents (who rotate)
 Meets regularly to direct OPEN MARKET OPERATIONS (buying or
selling of bonds) to maintain or change interest rates
Nominal Interest
Rate
MS1
MS2
FED and the Money Market
Vertical curve-Supply controlled
By the FED. An increase in MS
leads to a rightward shift and
nir1
lower interest rates.
nir2
MD
Q1
Q2
Quantity of Money
Easy Money Policy on AD/AS
 Buying Government Bonds, lowering the discount rate, or lowering
reserve requirements, to fight a recession, by decreasing interest rates,
increasing investment spending and/or consumption and increasing AD.
AS
Price Level
P2
AD2
P1
AD1 (C + I + G + X)
Q1
QF
Real GDP
Effects of an Easy Money Policy
LOWER INTEREST rates which will lead to an
INCREASE in INVESTMENT and CONSUMPTION.
The U.S. dollar will DEPRECIATE, leading to an
increase in NET EXPORTS as well.
These effects STRENGTHEN the overall
monetary policy (opposite of fiscal policy’s
crowding-out and net export effect
FED and a TIGHT Money Policy
Nominal Interest
Rate
MS2
MS1
Vertical curve-Supply controlled
By the FED. A decrease in the
Money supply, shifts the MS
curve to the left and raises
interest rates.
nir2
nir1
MD
Q2
12
Quantity of Money
Tight Money Policy and AD/AS
 Selling bonds, raising the discount rate, or raising reserve requirements
to fight inflation which will raise interest rates, decrease investment
and/or consumption and decrease Aggregate Demand (AD).
Price Level
AS
P1
P2
AD1
AD2
QF
Real GDP
Effects of a Tight Money Policy
 At the higher interest rates, INVESTMENT SPENDING, and
CONSUMPTION will decrease.
 At higher interest rates, the U.S. dollar will APPRECIATE
(foreigners demand more U.S. securities). This will lead to a
DECREASE in NET EXPORTS.
 Again, the Monetary Policy is STRENGTHENED as a result,
unlike the effects of a contractionary fiscal policy.
Extended AD-AS Model
 This is the other way to graph the AD-AS Model
Price Level
LRAS
SRAS
P1
AD
Y*
The intersection of the 3 curves
Is the Full-Employment Equilibrium
Real GDP
Extended AD-AS Model and Demand-Pull
Inflation
 In Demand-Pull Inflation, the AD curve has shifted to the right of the
LRAS and SRAS intersection.
LRAS
Price Level
SRAS
P2
PF
AD2
AD1
Y*
Y2
Real GDP
The Price Level and Real GDP has increased.
Extended AD-AS and Demand-Pull Inflation
Mainstream economists will fight inflation as
previously discussed: with either a tight monetary
policy or a contractionary fiscal policy. The goal
would be to move the aggregate demand curve to
the left.
Classical economists would argue to DO NOTHING.
As nominal wages rise, the SHORT-RUN AS curve will
shift to the left (resources and wages are becoming
more expensive), restoring the economy to its fullemployment output level, but with a higher Price
Level.
Extended AD-AS Model and Cost-Push Inflation
Cost-Push inflation occurs when the SRAS has shifted to the left
Of the LRAS and AD intersection.
Price Level
SRAS2 LRAS
SRAS1
Here the Price level has
Increased and REAL GDP
has decreased.
P1
PF
AD1
Y1
Y*
Real GDP
Extended AD-AS and Cost-Push Inflation
 Mainstream economists must decide whether to target the
Price Level or Unemployment, before taking any action.
 Classical economists would argue to DO NOTHING.
Eventually, wages and resource prices must decrease and
when they do the SRAS curve will shift back to the right,
restoring the economy to its full-employment output level
and the original Price Level.
Extended AD-AS Model and Recession
 In a recession due to a decrease in AD, the AD curve is to the left of the
LRAS and SRAS intersection; showing a decrease in both
the Price Level and Real GDP.
LRAS
Price Level
SRAS
PF
P1
AD
Y1
Y*
Real GDP
Extended AD-AS and Recession
Mainstream economists will fight a recession as
previously discussed: with either an easy money
policy or an expansionary fiscal policy. The goal
would be to move the aggregate demand curve to
the right.
Classical economists would argue to DO NOTHING.
The decrease in wages and resource prices will shift
the SRAS curve to the right, restoring the economy
to its full-employment output level, but with a
LOWER price. (SELF-CORRECTION)
Short-Run Phillips Curve
 Suggests an inverse relationship between the inflation rate
and the unemployment rate.
Inflation
Rate
(percent)
When the unemployment rate is
Low (2%), the inflation rate will
Most likely be high (8%).
8
When the
Unemployment rate
Is high, inflation will
likely be low.
2
SRPC1
2
8
Unemployment Rate (percent)
Short-Run Phillips Curve
 When the Government fights unemployment, typically higher inflation
will result. When the Government fights inflation, typically, more
unemployment will result. Thereby, we move along the Short-Run Phillips
Curve. (Changes in AD = movements on the SRPC.
Inflation
Rate
(percent)
7
B
2
A
SRPC1
3
6
Unemployment Rate (percent)
Shifting the Short-Run Phillips Curve
 The Short-Run Phillips curve can also shift, this would mean that both the
unemployment rate and inflation rate are changing at the same time. (A
change in AS)
Stagflation, unemployment and
Inflation occurring together
(OPEC decreasing Oil supply,
causes this type of shift)
Inflation Rate
% 5
4
SRPC2
SRPC1
6
7
Unemployment Rate %
Shifting the Short-Run Phillips Curve
 The Short-Run Phillips curve can also shift, this would mean that both the
unemployment rate and inflation rate are changing at the same time.
When Supply increases
(productivity surge in 90s)
more than demand, prices will
fall, while GDP and employment
Increase; shifting the curve to the left.
Inflation Rate %
5
3
The SRPC is
a mirror
image of AS
– If AS
moves right,
SRPC
moves left.
SRPC1
SRP2
5
7
Unemployment Rate %
Long-Run Phillips Curve
 The Long-Run Phillips Curve is vertical, like the Long Run Aggregate
Supply Curve. So, in the long run there is no tradeoff between inflation
and unemployment. Only the Price Level will change.
LRPC
Inflation Rate%
3
SRPC
5
Unemployment Rate %
Laffer Curve
 What is the optimal tax rate? A tax of 0% will provide no tax revenue. A
tax rate of 100% will also lead to no tax revenue (no incentive to work).
Answer must be somewhere in between.
Tax Rate
100
0
Tax Revenue
Economic Philosophies
Classical: Believes that the government SHOULD NOT
interfere in the economy. And believes in selfcorrection of economic problems.
Keynesian: Believes that GOVERNMENT SHOULD interfere
in the economy (taxes, government spending). Most
“mainstream” economists are Keynesians
Rational Expectations: Believes that monetary and fiscal
policy have certain effects on the economy and take action to
make these policies ineffective.
5-10% Economic Growth and
Productivity
A. Investment in Human Capital
B. Investment in Physical Capital
C. Research and development, and technological progress
D. Growth Policy
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Economic Growth
Five Factors connected to long run economic
growth.
Supply Factors:
 Increase in natural resources (quantity and quality)
 Increase in human resources (quantity and quality)
 Increase in capital goods
 Improvements in technology
Demand Factors:
 Increase in consumption by households, businesses, and
government
Illustrating Economic Growth
 Production Possibilities Curve
Capital Goods
B
A
PPC2
PPC1
Consumer Goods
Illustrating Long Run Growth
 Can also be illustrated with the extended AD-AS Model.
LRAS1 SRAS1
Price Level
LRAS2
SRAS2
P2
P1
AD2
AD1
Y1
Y2
Real GDP
10-15% Open Economy:
International Trade and Finance
A. Balance of payments accounts
1. Balance of trade
2. Current account
3. Capital account
B. Foreign exchange market
1. Demand for and supply of foreign exchange
2. Exchange rate determination
3. Currency appreciation and depreciation
C. Net exports and capital flows
D. Links to financial and goods markets
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International Trade
 Comparative Advantage and Specialization allows for
economic growth and efficiency. (More of each good can be
obtained by trading-Trading line illustrates this)
 Trade barriers create more economic loss than benefits.
 Today there is a trend towards free trade and a reduction in
trade barriers.
 Strongest arguments for protection are the infant industry
and military self-sufficiency arguments.
 WTO oversees trade agreements and disputes, but has
become a target of protesters lately.
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Exchange Rates and International Markets
The value of a foreign nation’s currency in relation to
your own currency is called the exchange rate.
 An increase in the value of a currency is called appreciation.
 A decrease in the value of a currency is called depreciation.
 Multinational firms convert currencies on the foreign exchange
market, a network of about 2,000 banks and other financial
institutions.
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Fixed Exchange-Rate Systems
 A currency system in which
governments try to keep the
values of their currencies
constant against one another is
called a fixed exchange-rate
system.
Flexible Exchange-Rate
Systems
 Flexible exchange-rate systems
allow the exchange rate to be
determined by supply and
demand.
Types of Exchange Rate Systems
Foreign Exchange Market
 Let’s say a U.S. citizen travels to Japan. This transaction will provide a
supply of the U.S. dollar and result in a demand for yen. It will become
cheaper for the Japanese to buy the dollar and more expensive for
Americans to buy the Yen. The Yen is Appreciating and the dollar is
Depreciating.
Yen Price of
dollar
(Y/$)
Dollar Price
of Yen
($/Y)
P2
S$1
S$2
P1
SY1
P1
DY2
P2
DY1
D$1
Q1
Q2
Quantity of U.S. Dollars
Q1
Q2
Quantity of Yen
Balance of Payments: The sum of all transactions
between U.S. residents and residents of all foreign nations
 Current Account: Shows U.S. exports and U.S. imports of
goods and services.
 Capital Account: Shows the U.S. investment (financial as
well as capital-plants and factories) abroad and Foreign
investment in the U.S.
 Credits: A credit are those transactions for which the U.S.
receives income (exports, foreign purchase of assets)
 Debits: Those transactions that the U.S. must pay for:
imports and purchasing of assets abroad.
Balance of Payments [continued]
 The Current Account and Capital Account must be equal.
 Official Reserves Account: The Central Banks of all nations
hold foreign currency to make up any deficit in the combined
capital and current accounts.
 If the U.S. has more credits than debits it finances this
difference by dipping into its reserve account.
Let’s Do This !!!
Eat a good breakfast
Pump yourself up tunes
Positive self talk
Comfy clothes
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