AP macroeconomics study guide

market economy

An economic system where economic decisions and the pricing of goods and services are determined by supply and demand, with minimal government intervention.

command economy

An economic system where the government or central authority makes all major decisions regarding the production and distribution of goods and services.

opportunity cost formula

]the value of the next best alternative forgone when making a choice. It can be expressed as: Opportunity Cost = Return on Best Foregone Option - Return on Chosen Option.

ceteris paribus

A Latin phrase meaning "all other things being equal," used to analyze the relationship between two variables while keeping other relevant factors constant.

recession

A significant decline in economic activity spread across the economy, lasting more than a few months, characterized by a decrease in real GDP, real income, employment, industrial production, and wholesale-retail sales.

frictional unemployment

The type of unemployment that occurs when individuals are temporarily unemployed while transitioning between jobs or entering the workforce. It is often considered a natural form of unemployment in healthy economies.

structural unemployment

occurs when there is a mismatch between workers’ skills (or locations) and the jobs available in the economy.

demand pull inflation

inflation caused by aggregate demand increasing faster than an economy’s productive capacity.

cyclical unemployment

Unemployment that occurs due to a decline in economic activity during periods of recession or slowdown.

natural rate of unemployment

The level of unemployment that exists when the economy is operating at full capacity, made up of frictional and structural unemployment.

cost push inflation

Inflation caused by rising production costs, such as higher wages or raw material prices, which push up prices.

what does GDP consist of

includes the value of final goods and services produced within a country, such as C (consumer spending), I (business investment), G (government spending on goods and services), and X−M (net exports). It excludes intermediate goods, transfer payments, financial transactions, second-hand goods, unpaid household work, illegal activities, and imports.

unemployment rate

Unemployment Rate (%)= (# unemployed / labor force)​×100

GDP gap

actual gdp − potential gdp∗​≈ −2⋅ (actual unemployment - NRU)

inflation helps:

debtors, owners of real assets, and workers whose wages rise faster than prices, because the value of money they owe or hold decreases relative to rising prices.

inflation hurts:

creditors, savers, people on fixed incomes, and businesses with fixed contracts, since the purchasing power of money they receive or hold falls behind rising costs.

MPC

The marginal propensity to consume (MPC) is the fraction of additional income that a household spends on consumption rather than saving. MPC= change comsumption/change income

MPS

The marginal propensity to save (MPS) is the fraction of additional income that a household saves rather than spends on consumption. MPS = change savings/change income

fiscal policy

the use of government spending and taxation to influence a country’s economic activity, such as controlling inflation, stimulating growth, or reducing unemployment.

discretionary fiscal policy

deliberate government action to change spending or taxes to influence economic activity, such as increasing infrastructure spending during a recession.

non discretionary fiscal policy

also called automatic stabilizers, this refers to government spending or tax changes that happen automatically in response to economic conditions without new legislation, such as unemployment benefits rising during a recession or taxes increasing as incomes rise.

change GDP formula

(1/1-MPC) x change government spending

determinates of consumption

disposable income, wealth, interest rates, taxes, consumer confidence, inflation expectations, and access to credit. Higher income, wealth, or optimism generally increase spending, while higher taxes, interest rates, or pessimism tend to reduce it.

determinates of saving

disposable income, interest rates, wealth, consumer confidence, and future expectations. Higher income, higher interest rates, or a desire for future security usually increase saving, while optimism or easy access to credit may reduce it.

determinates of investment

interest rates, expected profits, business confidence, technology, government policies, and the cost of capital goods. Lower interest rates, higher expected returns, technological advances, and supportive policies encourage investment, while high costs or economic uncertainty can reduce it.

determinates of aggregate supply

input prices, technology, labor availability, and government policies. In a graph, shifts in aggregate supply (AS) affect the overall price level and output: an increase in AS shifts the curve right, raising output and lowering prices, while a decrease shifts it left, reducing output and raising prices, interacting with aggregate demand (AD) to determine equilibrium.

determinates of aggregate demand

consumption, investment, government spending, and net exports, which are influenced by factors like income, interest rates, taxes, and consumer confidence. On a graph, shifts in AD change the overall price level and output: an increase in AD shifts the curve right, raising output and prices, while a decrease shifts it left, lowering output and prices, interacting with aggregate supply to set equilibrium.

cost push inflation on AD/AS graph

shifts the short-run aggregate supply (SRAS) left, raising prices and reducing output; AD stays the same, so the equilibrium moves up along the AD curve.

demand pull inflation on AD/AS graph

shifts aggregate demand (AD) right, raising both the price level and output, while aggregate supply (AS) remains unchanged.

crowding out effect

when increased government spending raises interest rates, reducing private investment.

tools of fiscal policy

government spending, taxation, and transfer payments.

why use expansionary fiscal policy

needed during a recession or economic slowdown to increase aggregate demand, boost output, and reduce unemployment.

why use contractionary fiscal policy

needed during high inflation or an overheating economy to reduce aggregate demand and control rising prices.

net exports effect

When domestic prices rise, exports become more expensive for other countries and imports become cheaper, reducing net exports and aggregate demand

surplus in fiscal policy

A contractionary fiscal policy—increasing taxes or reducing government spending—can lead to a budget surplus by raising government revenue or lowering expenditures.

deficit in fiscal policy

An expansionary fiscal policy—increasing government spending or cutting taxes—can lead to a budget deficit by increasing expenditures or reducing revenue.

examples of discretionary fiscal policy

deliberate, new government actions

examples of non discretionary fiscal policy

government programs that adjust automatically with economic conditions

monetary policy

Monetary policy is the use of a central bank’s tools, such as interest rates and the money supply, to influence economic activity, control inflation, and stabilize the currency.

discount rate

the interest rate a central bank charges commercial banks for short-term loans, influencing borrowing, money supply, and overall economic activity.

open market operations

the buying and selling of government securities by a central bank to control the money supply and influence interest rates.

tight money policy

a monetary policy aimed at reducing the money supply and raising interest rates to control inflation.

ample reserves market

a banking system condition where commercial banks hold more reserves than required, reducing the central bank’s need to actively manage short-term interest rates through open market operations.

federal funds rate (policy rate)

the interest rate at which banks lend reserves to each other overnight, and it serves as a key benchmark for U.S. monetary policy.

easy money policy

monetary policy aimed at increasing the money supply and lowering interest rates to stimulate economic growth.

limited reserve market

a banking system condition where commercial banks hold just enough or slightly above the required reserves, making the central bank’s actions, such as open market operations, more effective in influencing short-term interest rates.

change money supply

= (1/reserve ratio) x reserves injected/withdrawn

asset demand

the demand for money as a store of value rather than for transactions, reflecting people’s desire to hold liquid assets to safeguard wealth.

transaction demand

the demand for money to make everyday purchases and payments, depending mainly on the level of income and spending.

MP tool: OMO

buying securities: SM up, IR down, U down

selling securities: SM down, IR down, inf down

MP tool: discount rate

lower DR: borrowing up, SM up, U down

raise DR: borrowing down, SM down, infl down

MP tool: reserve requirements

lower res. req.: bands lend more, SM up, U down

raise res. req: banks lend less, SM down, inf down

MP tool: interest on reserves

IOR up: banks hold more, SM down, Inf down

IOR down: bands lend more, SM up, U down

effects of expansionary MP

SM up ( buy securities, lower DR), IR down, borrowing cheaper, I up, C up, AD up, GDP up

effects of contractionary MP

SM down (sell securities, raise DR), IR up, borrowing more expensive, I down, C down, AD down, GDP down

IR up

Bond prices down

strengths of MP

fast, flexible, politically independent, controls inflation effectively, and influences investment and consumption through interest rates.

weaknesses of MP

slow, less effective in deep recessions, doesn’t fix structural unemployment, may increase inequality, and risks causing inflation or over-tightening.

LFM supply shift

slow, less effective in deep recessions, doesn’t fix structural unemployment, may increase inequality, and risks causing inflation or over-tightening.

LFM demand shift

a rightward shift in demand (more borrowing) raises the interest rate, while a leftward shift (less borrowing) lowers the interest rate, assuming supply is constant.

effects of MP tools in ample reserves

OMO: less effect on short term IR

DR: less sensitive to changes in bank borrowing if they already hold excess reserves

RR: no impact on lending

IOR: has more impact in controlling short term rates

classical economics

free markets, self-regulating economies, and minimal government intervention

Keyensian economics

active government intervention to manage demand, arguing that aggregate demand drives output and employment

MP and FP

Monetary and fiscal policy work side by side by jointly influencing aggregate demand: monetary policy adjusts interest rates and the money supply to affect borrowing and investment, while fiscal policy changes government spending and taxes to directly stimulate or slow the economy, reinforcing each other to reduce unemployment or control inflation.

LRAS shifters

productive capacity changes—labor and skills, capital stock, technology, institutions, or resources—right if they improve, left if they worsen.

current account balance

a country’s net inflow of income from abroad: trade in goods and services plus net primary income (interest, dividends, wages) plus net secondary income (transfers like remittances).

balance of payments

a country’s full record of transactions with the world—current, capital, and financial accounts—where total inflows equal outflows.

financial account balance

net change in a country’s ownership of foreign assets and foreigners’ ownership of domestic assets (FDI, portfolio, other investment, reserves).

quota

government-imposed limit on the quantity or value of a good that can be imported (or exported) over a given period, typically an import quota.

subsidy

a government payment or tax break to producers or consumers to lower costs or prices and encourage production or consumption of a good.

demand determinates of foreign currency

ises with stronger demand for that country’s goods and assets, higher relative interest rates or expected appreciation, lower relative prices, higher domestic income, and favorable risk or policy conditions.