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AP Macro Review Aggregate Demand • Consumption, investment, govt. purchases and net exports (exports – imports) • More income, more wealth = more spending • Investment – purchases of new capital by businesses; interest rate rises – less investment; interest rate falls – more investment • $ appreciates – U.S. goods more expensive; exports fall • $ depreciates – U.S. goods less expensive; exports rise • AD increases – shifts to right; P rises, GDP rises, unemployment falls • AD decreases – shifts left; P falls, GDP falls, unemployment rises MPC and MPS • • • • • • • • • MPC = ∆ consumption resulting from a ∆ in income MPS = ∆ savings resulting from a ∆ in income MPC = 1 – MPS If MPC = .80 then a $100 increase in income will cause us to spend $80 Multiplier = 1/MPS ∆ in GDP = multiplier x ∆ in spending If multiplier is 5, consumption rises by $100, GDP rises by $500. If MPC = .8, multiplier is 5; income rises by $100, consumption rises by $80, GDP rises by $400 Multiplier works for any increase in spending, whether to consumption, investment, govt. purchases or net exports i Money Market Vertical S curve – S set by FED; Includes S and D for all $ in the economy i3 i1 i2 Sm3 Sm1 Sm2 Dm Q Loanable Funds Market i S Government deficit affects demand; Savings affects supply i1 D Q1 Q Loanable funds market • Increase in budget deficit increases D for loanable funds; interest rate increases • Decrease in budget deficit decreases D for loanable funds; interest rate falls • Increase in savings increases S for loanable funds; interest rate falls • Decrease in savings decreases S for loanable funds; interest rate rises ASlr P AS Expansionary Fiscal Policy or Easy Money Policy P2 P1 AD2 AD1 GDP1 Qf GDP Fiscal vs. Monetary policy Expansionary Fiscal • Implemented by govt. • Cut taxes • Increase govt. purchases • Increases budget deficit • Increases D for loanable funds • Increases interest rate • $ appreciates Easy money policy • Implemented by FED • Buy bonds • Decrease required reserve ratio • Decrease discount rate • Increases S of $ in money mkt. • Interest rate falls • $ depreciates ASlr P AS P1 AD1 P2 Contractionary Fiscal Policy or Tight Money Policy AD2 Qf GDP1 GDP Fiscal vs. Monetary policy Contractionary Fiscal • Implemented by govt. • Increase taxes • Decrease govt. purchases • Decreases budget deficit • Decreases D for loanable funds • Decreases interest rate • $ depreciates Tight money policy • Implemented by FED • sell bonds • increase required reserve ratio • increase discount rate • decreases S of $ in money mkt. • Interest rate rises • $ appreciates Demand-Pull Inflation P ASLR ASSR2 ASSR1 P3 P2 AD2 P1 AD1 Qf Q2 GDP Demand pull inflation if govt does not respond to the inflation • In the long run, prices and wages are flexible. • Increase in price level causes wages to rise. • Increase in wages shifts AS in short run to left – more expensive to produce • As economy approaches long run equilibrium, GDP returns to full employment GDP and unemployment returns to the natural rate of unemployment Recession ASLR AS AS SR1 SR2 P P1 P2 AD1 P3 AD2 Q2 Qf GDP Recession if govt does not respond w/ fiscal or monetary policy • In the long run, prices and wages are flexible. • Wages fall when unemployment increases. • decrease in wages shifts AS in short run to right – cheaper to produce • As economy approaches long run equilibrium, GDP returns to full employment GDP and unemployment returns to the natural rate of unemployment P Inflation rate AS2 Phillips Curve AS1 P2 P1 SRPC2 AD GDP2 GDP1 P goes up Unemployment rises GDP SRPC1 Unemployment rate Phillips Curve • Short run – tradeoff between unemployment and inflation; as 1 goes up the other falls • If AS shifts, short run PC shifts in opposite direction • If AD shifts, movement along the PC. • Long run – no tradeoff between unemployment and inflation • LRPC is a vertical line Capital goods Effect on AS P ASLR1 ASLR2 PPF1 PPF2 Consumer goods Qf1 Qf2 GDP Economic Growth • Rightward shift of PPF curve = rightward shift of long run AS • Caused by increase in technology, # or quality of natural or human resources, increase in capital stock • Economic growth influenced by interest rates – if interest rates rise, I (investment) falls, capital stock declines, less economic growth P Effect on AS ASLR1 ASLR2 Qf1 Qf2 Inflation GDP LRPC2 LRPC1 NRU2 NRU1 Unem U.S. Exports – English buying American wheat P in pounds P in dollars D2 S1 S S2 P2 P1 P1 P2 D D1 Q1 Q2 Mkt. for Dollars Q Q1 Q2 Mkt. for Pounds Exchange rates • If 1 currency appreciates, the one it’s being compared to depreciates. • Interest rates and value of the currency move in same direction. • If D for $ increases (b/c people want U.S. wheat or higher interest rates in U.S.), $ appreciates. • The English must supply more pounds to get the dollars they demand so the pound depreciates. U.S. Imports – Americans buying English tea P in pounds P in dollars S1 S S2 P2 P1 D2 P1 P2 D1 D Q1 Q2 Mkt. for Dollars Q Q1 Q2 Mkt. for Pounds