AP Macroeconomics review. By: Maria Villasmil. Economis: The study of how people, firms, and government make decisions when faced with scarcity.

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1 AP Macroeconomics review By: Maria Villasmil Economis: The study of how people, firms, and government make decisions when faced with scarcity. Factors of Production: 1)Land: natural resources 2) Labor: work by people 3)Capital: manmade, used as aids of production 4) Entrepreneurial Ability: combines the others Due to scarcity all decisions are tradeoffs - Every choice means a loss Opportunity Cost: the highest valued alternative you must give up to obtain a good or service. Incentive= motivation Rational= trying to fulfill utility (be happy ) Assumption in economics= we act rationally Marginal Analysis Marginal: 1 additional unit so. Marginal Analysis is the analysis of what will occur when you add one additional unit. Marginal Benefit is always Marginal Cost is always diminishing increasing Law of increasing cost: as you produce more of a product your cost to society rises Law of diminishing returns: the more you produce the lower your returns will be

2 Production Possibilities Curve (ppc) Scarcity is shown by the PPF (Production Possibility Frontier / the line) Tradeoff- the options Changes to the Production Possibility Frontier A change in technology, innovation, education or the factors of productions shift the PPF 3 Basic Economic Questions WHAT? What to produce? HOW? How to produce it? WHO? For whom to produce? The answers to these questions provide our economic system Central Command economy: the government decides what,how, who Free Market economy: People decide what,how, who Mixed economy: People and government decide what,how, who

3 The Circular Flow Model Factor Market Households Factor Payments Factors of Production Firms Products $$$$ Specialization and Trade Product Market Absolute Advantage: The product or resource that a person, group, or society can produce more of (absolutely) Comparative Advantage: The product or resource that a person, group, or society can produce at the least possible cost (Lower opportunity cost). Supply and Demand The Law of Demand: as price increases the quantity demanded decreases. Demand= what you are willing and able to pay Determinants of Deman= Substitutes, expectations, population, taste, income, complements Law of Supply: as price increases quantity supplied increases Determinants of Supply= taste, taxes, input cost, expectations, sellers

4 Market Graph: Surplus Supply Demand Shortage GDP (Gross Domestic Product): the total value of goods and services produced in a country during a year. Calculating GDP: Expenditure approach: GDP= Consumption+ Investment+ Government+ Net Exports GDP= C+I+G+ (Exports- Imports) Income approach: GDP= wages+ Interest+ profit+ rent+ statistical adjustment GNP(Gross National Product): the total value of goods produced and services provided by a country during one year (adds income from foreign investment)

5 What is counted on GNP and GDP: Final goods and services What is NOT counted on GNP and GDP: Intermediary goods Transfer payments (money exchanged without any production) Used goods House work/ services that are not being paid Nominal GDP: calculated using current year prices Real GDP: calculated using base year prices Note: instead of GDP deflator it can be the CPI (Consumer Price Index): considers basket of goods Types of Goods: Inferior: as income rises demand decreases Normal: as income rises demand increases Types of Unemployment: -Seasonal: unemployed because the season is over. -Cyclical: occurs when GDP is decreasing (tied to the business cycle) -Structural: the structure of the economy has changed and those jobs are not needed anymore

6 -Frictional: people being in the process of moving from one job to another. Discouraged Worker: someone who gave up looking for a job (are not counted as unemployed) Natural Rate of unemployment: number of frictional, structural and seasonal unemployed (not cyclical) Natural Rate of unemployment formula: Labor Force: sum of employed and unemployed Marginal Propensity to Consume(MPC): The proportion of an aggregate raise in pay that a consumer spends on the consumption of goods and services Marginal Propensity to Save(MPS): The proportion of an aggregate raise in pay that a consumer saves. MPC+MPS=1 Multiplier effect: the amount of times the money spent is put back into the economy Spending Multiplier: Tax multiplier: Aggregate Demand(AD)/ Aggregate Supply (AS) AD=GDP=C+I+G+Net Exports AS= Total Supply 3 types-immediate, short run, long run

7 Note: The immediate aggregate supply is a horizontal line AD/AS graph shows: -price level -output= Real GDP -income -unemployment (has an inverse relationship with RGDP) What changes? For Aggregate Demand: Consumption- changes in income, the wealth effect (increase in stock prices) Investment- interest rates, business expectations, business taxes Government Spending- the need to spend Net Exports- Foreign exchange rates For Aggregate Supply Immediate-nothing it is fixed LRAS- (acts like PPC) Changes in Factors of production, technology, innovation, education SRAR-Resource Prices, Environment of Business, Productivity Economic Problems: Inflationary Gap What Happens? AD increases, RGDP increases (unemployment decreases), Price increases (inflation) Recessionary Gap

8 What Happens? AD decreases, RGDP decreases (unemployment increases), Price decreases (deflation) Stagflation (NOT GOOD ) What Happens? SRAS decreases, RGDP decreases (unemployment increases), Price increase (inflation) Invisible Hand Theory (self correcting economy):since a change in price affects ALL prices including resource prices SRS will adjust to return to full employment equilibrium however does not work for stagflation) Fiscal Policy: How the government can intervene in the economy 3 options: change taxes, change spending, BOTH 2 Types -Contractionary- decrease spending, increase taxes (or both) -Expansionary- increase spending, decrease taxes (or both) Keynesian Economics: government intervention in the economy using fiscal policy Classical Economics: the economy can fix itself Market of Loanable Funds: Real interest Rates Q* Quantity of Loanable funds

9 What are Loanable Funds? Money that can be lent out Who needs Loanable Funds? Anyone who needs to borrow money What changes the Demand of Loanable Funds? The need to borrow What changes the Supply of Loanable Funds? People saving Crowding Out: government pushing out private investors because it took a large amount of loanable funds. Discretionary policy is fiscal policy that is done on purpose Nondiscretionary policy is fiscal policy that requires no action such as progressive tax system: as people s income rises the amount of tax also rises. Uses of Money: Medium of exchange, store value, unit of account. M1 money: cash and checking accounts which are liquid money M2 money: M1 money and near money (savings deposit and other time deposits)

10 SM I* DM Q* -The supply of money is a straight line because it is controlled by the Federal Reserve -Demand of Money-money you want in your pocket (M1 and M2) 3 reasons it changes: inflation, precautionary spending, income The Federal Reserve has 3 tools: 1. Open Market Operations: Buying or Selling Bonds 2. Changing the Reserve Ratio 3. Changing the discount Rate When interest rates rise bond prices lower, and vice versa When the Fed sells Bonds the money supply decreases, this increases interest rates which causes investment to decrease ( vice versa)

11 Money Creation- Banks can create money using financial transactions Money multiplier = 1/reserve requirement Excess reserves*money multiplier=money created Open Monetary Policy (increase the money supply) Buy Bonds Lower Reserve Ratio Lower Discount Rate Closed monetary Policy (decrease money supply) Sell Bonds Higher Reserve Ratio Higher Discount Rate Discount Rate: interest rate the FED charges banks for loans Federal Funds Rate: interest rates banks charge each other for loans Phillips Curve LRPC IR SRPC UR -When AD changes a point on the SRPC changes (increases left, decreases right) - When SRAS changes the SRPC shifts (increases left, decreases right) -When factors of production change (LRAS changes), LRPC shifts (increases left, decreases right)

12 Foreign Exchange Market Determinants of exchange Rates: Taste Relative Price Level Relative income Relative interest rates for financial investments Speculation Example

13 Dollars/ Yuann Labeling S Who is Looking at this? The USA e* D Quantity of Yuan Q* S Who is Looking at this? China D When one line shifts the other line shifts in the other graph in the same direction (For example if the demand of Yuan decreases in America the supply of dollars decrease in China) -When Financial investments increase in your country.. foreign money comes in So Supply of Loanable Funds increase. Interest rates decrease capital investments increase Agrgate Demand increases Real GDP and Price Level increases (in the long run there will be economic growth since investment investments in capital increase so LRAS increases) -if money leaves your country it is a leakage so the opposite occurs meaning economic decline in the long run. Balance of Payment= Current Account+ Financial Accounts

14 Current Account= money we get from physical goods and services that are exported and imported Financial Account=money we get from financial investment, capital flow. Other Terms/ Formulas Recession: two consecutive periods of GDP decreasing Depression: a prolonged and deep recession Okun s Law when unemployment falls by 1%, GNP rises by 3%. Inflation Rate Formula: Types of inflation: Demand-Pull : caused by an increase in AD Cost Push: supply decreases. Rule of 70: used to estimate the time it takes for an economy to double in size equals to 70 divided by the growth rate. Dissaving: spending more than your income. Velocity of Money GDP=VM (Note GDP=P*Q) Where V=Velocity of money M= money Supply P=Price Level PQ=MV Notice the equal sign, so if the money supply increases, P or Q or both must increase. Think about it! MS increasing means interest rates decrease Investment increases AD increases and so does Price level and GDP. You can also be asked to analyze the equation with the assumption that some variable may be constant. Make sure you understand this.

15 Time Value of Money formula. FV = PV(1+i)^n (note that n is an exponent) Where FV = Future Value, PV = Present Value, n = number of years, and i = Real Interest Rate. Make sure to remember key words... Economic growth= LRAS or PPC Short run (The initial effect) vs Long run (What happens after the initial effect) Self-correction (Classical, Capitalism, Self-adjusting) is when AS moves to return to a better equilibrium. Make the link of interest rates- investment in CAPITAL- and LRAS Make the link between unemployment and GDP Review your formulas and careful with the two part questions.