AP Macro Unit 3

Aggregate demand

all the goods/services (real GDP) buyers are willing/able to purchase at different price levels

What happens as price level increase

inflation, then real GDP demand falls

what happens as GDP demand falls

decreases (deflation) then the real GDP demand increases

Why is AD Downward sloping (3 terms)

1. Wealth Effect

2. Interest Rate Effect

3. Foreign Trade Effect

Why is AD downward sloping: 1. Wealth Effect

higher price level reduces the purchasing power of money. This decreases the quantity of expenditures.

Why is AD downward sloping: Interest Rate Effect

when price levels increase lenders need to change, higher interest rates to get a real return on their loans. Higher interest rates discourage consumer spending.

Why is AD downward sloping: Foreign Trade Effect

when US price level rises foreign buyers purchase fewer US goods and Americans buy more foreign goods (exports fall Xn decreases)

Aggregate Supply

amount of goods/services (real GDP) that firms will produce in an economy at different price levels

what is the difference between short run and long run aggregate supply

Short run: wages and prices will not increase as price levels increase

long run: wages and resource prices will increase as price levels increase

What happens in a negative supply shock

inflationary expectation, AS shifts to the left (more money is needed), nominal wages increase, need to increase u/e wages are too high for economy to afford.

In a negative supply shock, what happens if producers expect higher prices and workers demand higher wages

cost will increase which increases aggregate supply

What are fixed resources

resources that don’t change with quantity produced

what are variable resources

resources that do change with quantity demanded

Total cost equation

fixed costs + variable costs

How are costs and production related

inversely

Total physical output (TP)

total output or quantity produced

marginal output (MP)

the additional output generated by additional inputs (workers)

Average Product (ap)

the output per unit of input

AP equation

ap = total product / units of labor

law of diminishing marginal returns

as variable resources (workers) are added to fixed resources (ovens, tools, ect) the additional output produced from each additional worker will eventually fall

three stages of returns: stage 1

increasing marginal returns. MP rising, TP rising at increasing rate due to specialization

three stages of returns: step 2

decreasing marginal returns (MP still positive) but falling. TP increase at decreasing rate because of fixed resources

3 stages of returns: stage 3

negative marginal returns. MP is negative TP is decreasing because one or more doesn’t have something to do, workers get in each other’s way too many people.

What happens at a supply shock

PL increases, quantity decreases. Still considered a gap

Capital Stock

machinery and tools purchased by businesses that increase output

Classical Theory

1. A change in AD will not change output even in Short Run because prices of resources (wages) are flexible

2. AS is vertical so AD can’t increase without causing inflation

Does the government fix itself in the Classical theory

no, economy will fix itself

Keynsian Theory

1. a decrease in AD will lead to a persistent recession because prices of resources (wages) are not flexible DOWNWARDS

2. increase in AD during resource puts no pressure on prices

Sticky Wages

prevents ages from falling. The government should deficit to close the gap (recessionary gap)

What does this Phillips curve show

trade off between inflation and unemployment

What is the inverse relationship in the Phillips curve

inverse relationship between unemployment and inflation

What happens what AS falls and causes stagflation

increase in unemployment and inflation due to limited resources. nominal wages will adjust, supply shift. Produce less stuff at higher prices

what does a supply shock equal in terms of short run pc

less standard of living (stagflation)

What types of unemployment makeup LR Phillips curve

frictional and structural

Fiscal policy

actions by congress to stabilize economy

Monetary policy

actions by fed reserve bank to stabilize economy

Discretionary policy

congress new bill designed to change AD through gov spending or taxation

Non-discretionary

automation stabilizers, permanent spending or taxation/laws to encounter economy

Contractionary Fiscal Policy and what are two types of policies

laws that reduce inflation, decrease GDP (close inflationary gap)

• decrease government spending

• increase taxes

Expansionary policy and two types of policies

increase gov spending and decrease taxes. Laws that reduce unemployment and increase GDP (close recessionary gap).

What is MCP

marginal propencity to consume, how much people save rather than consume

MPC equation

Change in consumption / change in income

What is MPS

marginal propensity to save, how much people save rather than consume when change in income

what does MPS = (in terms of MPS and MPC)

MCP = 1 - MPS

Spending multiplier equation (in terms of GDP)

total change in GDP = multiplier x initial change in spending

Spending multiplier equation (in terms of MPC and MPS)

SM = 1/MPS or 1/1-MPC

taxing multiplier equation

simple tax multiplier = MPC x 1/MPS or MPC/MPS

total change in GDP formula in terms of tax multiplier

total change in gdp = tax multiplier x initial change in tax

Budget position

G - T

what does it mean when G is increasing at a higher rate than T is increasing

then budget position worsens

what does it mean when T is increasing at a higher rate than G

budget position improves

When G increasing at same rate as T

Budget position unchanged

If G increases at same amount tax increases...

then AD increases by the change in government spending

5 Problems with fiscal policy

1. Deficit Spending

2. Problems with timing

3. Politically motivated

4. Crowding out Effect

5. Net Export Effect

1. Deficit spending

If the Government increases spending without increasing taxes they will increase the annual deficit and the budget deficit

• Budget Deficit is when the government’s expenditures

  exceeds its revenue.

• National Debt is the accumulation of all the budget

  deficits over time

2. Problems with timing

recognition log - congress must react to economic indicators before too late

administrative log - congress take time pass legislation

operational log - spend/planning taxes takes time to organize execute (changing taxing is quicker)

3. Politically motivated policies

politicians may use economically inappropriate policies to get reelected

4. crowding out effect

government spending might cause unintended effected and weaken impact of policiy

5. Net exports effects

international trade reduces effectiveness of fiscal policy