AP Macro Unit 5

The Phillips Curve

The Phillips Curve

shows the tradeoff between inflation and unemployment

→ in general, there is an inverse relationship unemployment and inflation

Short Run Phillips Curve

when the economy is overheating, there is low unemployment but high inflation

→ higher expected inflation shifts SRPC to the right

What happens when AS falls causing stagflation?

increase in unemployment and inflation

Short Run v. Long Run

in the long run, there is no trade off between inflation and unemployment

→ the LRPC is vertical at the Natural Rate of Unemployment

When AD increases/decreases

point on SRPC moves along the curve

When SRAS increases/decreases

whole SRPC curve shifts

Quantity Theory of Money

money supply and price level in an economy are in direct proportion to one another

M * V = P * Y

M = money supply

V = velocity

P = price level

Y = quantity of output (Real GDP)

→ assume the velocity is relatively constant because people’s spending habits are not quick to change, and that output (Y) is not affected by the quantity of money because it is based on production, not the value of the stuff produced

What happens in the long-run when the central bank increases the money supply?

→ short-run spending eventually leads to higher resource prices and inflation

→ if inflation is bad enough, banks don’t lend and the economy tanks

→ MS↑, nominal interest rates↓, investment spending↑, AD↑, SRAS↓, PL↑, demand for money↑

Budget Deficit

when annual government spending and transfer payments are greater than tax revenue

Budget Surplus

when annual government spending and transfer payments are less than tax revenue

The National Debt

the accumulation of all the budget deficits over time

→ if the government increases spending without increasing taxes they will increase the annual deficit and the national debt

Neutrality of Money

money has no real effect on equilibrium

Expansionary Monetary Policy in the short-run

real output↑, price level↑, interest rates↓

Expansionary Monetary Policy in the long-run

real output no change, price level↑, interest rates indeterminate

Contractionary Monetary Policy in the short-run

real output↓, price level↓, interest rates↑

Contractionary Monetary Policy in the long-run

real output no change, price level↓, interest rates indeterminate

Automatic stabilizers in a recessionary gap

AD↑, real GDP↑, PL↑, budget towards deficit, national debt↑

Automatic stabilizers in an inflationary gap

AD↓, real GDP↓, PL↓, budget towards surplus, national debt↓

Tax cuts and government spending increases

AD↑, real GDP↑, PL↑, towards deficit, national debt↑

Government spending cuts and tax increases

AD↓, real GDP↓, PL↓, towards surplus, national debt↓

What is the long-run impact of higher real interest rates?

less economic growth because investment falls, less capital stock

Assume the government increases government spending -- what will happen to the demand for loanable funds, the real ir, and private domestic investment?

→ demand increases

→ real interest rate increases

→ private investment decreases

Crowding Out

the adverse effect of government borrowing on interest-sensitive private sector spending

Which monetary policy would help accommodate or reinforce a contractionary fiscal policy?

sell bonds, increase reserve ratio, or increase discount rate

→ ir↑, bond prices↓

→ MS↓, bank reserves↓

→ quantity of loanable funds demanded by private sector↓

→ AD↓

Which monetary policy would help accommodate or reinforce an expansionary fiscal policy?

buy bonds, decrease reserve ratio, or decrease discount rate

→ ir↓, bond prices↑

→ MS↑, bank reserves↑

→ quantity of loanable funds demanded by private sector↑

→ AD↑

Real GDP Per Capita

the real GDP divided by the population

Growth Rate

the change in real GDP per capita over time

Why do some countries have more economic growth?

( 1 ) Economic System

( 2 ) Rule of Law

( 3 ) Capital Stock

( 4 ) Human Capital

( 5 ) Natural Resources

Productivity

output per unit of input

Capital Stock

machinery and tools purchased by businesses that increase their output

What government policies most likely result in long-run economic growth?

( 1 ) Education/training spending

→ increases human capital

( 2 ) Infrastructure spending

→ increases physical capital

( 3 ) Production/investment incentive programs

→ increases physical capital

Supply-side Fiscal Policies

government policies designed to increase production by reducing business taxes and/or regulations

Why are Supply-side Fiscal Policies controversial?

( 1 ) Providing tax breaks to businesses might disproportionately benefit the wealthy

( 2 ) It assumes that corporations will spend tax cuts on investment rather than pay out shareholders

Aggregate Production Function

What Shifts the Long-Run Phillips Curve?

anything that changes the natural rate of unemployment (LRAS)

Velocity of Money

the average number of times a dollar is spent and respent

When the economy is at full employment, why will an increase in the money supply have no effect on real output in the long-run?

an increase in money supply doesn’t change the amount of physical capital in the economy or the real output that can be produced

Difference Between the Budget Deficit and the National Debt

a budget deficit is the amount that the government overspends in a year, while the national debt is the total accumulated debt over the years from deficit spending

How does the existence of a large national debt affect government spending in the future?

future spending falls because the government must pay interest on the debt and will not have funds for alternative uses

What influences productivity?

( 1 ) Technology

( 2 ) Amount/quality of physical capital

( 3 ) Amount/quality of human capital

What happens in the long-run when lower interest rates lead to more investment?

AD, SRAS, and LRAS shift to the right