AP MACROECONOMICS FINAL

LAST WEEK ALMOST THERE!!!!

Components of GDP using the expenditures approach

Formula: (C + I + G + NX)

• C – Consumption: You buying stuff 🛍

• I – Investment: Businesses & new homes 🏭🏠

• G – Government: Schools, roads, army 🏫🛣🪖

• NX – Net Exports: Exports minus imports ✈📦

Components of GDP using the income approach

Formula: (W + R + i + P + T – S)

“Who’s earning?”

• W – Wages: Workers’ pay 💵

• R – Rent: Landowners’ income 🏞

• i – Interest: Money from lending 💰

• P – Profit: Businesses’ gains 📈

• T – Taxes – Subsidies: Government take minus handouts 🏛

Things that are included when calculating GDP

• Final goods & services – Only end products

• Produced domestically – Inside the country

• Within the time period – This year/quarter

• Market transactions – Bought & sold legally

• Government spending – Roads, schools, defense

• Investment – Factories, equipment, inventories, new homes

• Net exports – Exports minus imports

Things that are excluded when calculating GDP

• Used goods – Already counted

• Financial transactions – Stocks, bonds, gifts

• Transfer payments – Social Security, unemployment

• Non-market activities – Unpaid work, volunteering

• Illegal activities – Underground economy

• Intermediate goods – Already counted in final goods

Nominal

• Measured in current prices.

• Reflects changes in both quantity and price.

• Can be misleading if prices (inflation) rise.

• Example: GDP this year = price × quantity at this year’s prices.

Nominal = Now (current prices)

Real

• Measured in constant prices (adjusted for inflation).

• Reflects only changes in quantity/output, not price.

• Gives a true picture of economic growth.

• Example: GDP this year = price × quantity at base year prices.

Real = Reality (inflation-adjusted)

Types of Unemployment

• Frictional Unemployment 🏃‍♂

• Structural Unemployment ⚙

• Cyclical Unemployment 📉

Frictional Unemployment

• Short-term unemployment between jobs.

• People are looking for a better fit or transitioning careers.

• Example: A college grad looking for their first job.

Frictional = finding a job

Structural Unemployment

• Caused by mismatches between skills and jobs or technological changes.

• Long-term and harder to fix without retraining.

• Example: Factory workers replaced by automation.

Structural = skills mismatch

Cyclical Unemployment

• Caused by economic downturns / recessions.

• Goes up when demand falls and down when economy improves.

• Example: Workers laid off during a recession.

Cyclical = economy dips

Labor Force

• All people 16+ who are employed or actively seeking work.

• Excludes retirees, students not seeking work, and discouraged workers.

Labor force = all trying

Labor Force Participation Rate

• Percentage of working-age people in the labor force.

Formula: LABOR FORCE / WORKING-AGE POPULATION x 100

LFPR = % trying

Unemployment Rate

• Percentage of labor force that is actively seeking work but not employed.

Formula: UNEMPLOYED / LABOR FORCE x 100

Unemployment = % failing

Underemployed

• Workers employed part-time but want full-time, or in jobs below their skill level.

Underemployed = underused

Discouraged Worker

• Someone who wants a job but has stopped looking because they believe no jobs are available.

• Not counted in the labor force, so they don’t affect the official unemployment rate.

Discouraged = gave up

Demand Curve Shifts

Mnemonic: T I P E N S

Shifts RIGHT (increase) or LEFT (decrease) because of changes in:

• Tastes – popularity, preferences

• Income – normal vs. inferior goods

• Price of related goods

  • Substitutes ↑ and demand ↑

  • Complements ↑ and demand ↓

• Expectations – future prices/income

• Number of buyers

• Subsidies/Taxes on consumers

⚠ Price of the good itself does NOT shift demand (that causes movement along the curve).

Supply Curve Shifts

Mnemonic: R I T E S

Shifts RIGHT (increase) or LEFT (decrease) because of changes in:

• Resource prices – wages, raw materials

• Input productivity – technology

• Taxes/Subsidies on producers

• Expectations – future prices

• Sellers – number of firms

⚠ Price of the good itself does NOT shift supply.

Change in quantity supplied

• Caused ONLY by a change in the price of the good.

• Shown as a movement along the supply curve (up or down).

Price ↑ and Quantity Supplied ↑
Price ↓ and Quantity Supplied ↓

• “Price moves you ON the curve.”

• “Anything else moves the curve itself.”

Change in quantity demanded

• Caused ONLY by a change in the price of the good.

• Shown as a movement along the supply curve (up or down).

Price ↑ and Quantity Supplied ↑
Price ↓ and Quantity Supplied ↓

• “Price moves you ON the curve.”

• “Anything else moves the curve itself.”

Production Possibilities Curve (PPC)

Shows the maximum combinations of two goods an economy can produce using all resources efficiently.

Outward shifts of the PPC

Economic Growth

Happens when:

• More resources (labor, land, capital)

• Better technology

• Improved education / human capital

• Trade or specialization

➡ Economy can produce more of both goods.

Inward shifts of the PPC

Economic Decline

Happens when:

• Loss of resources (war, natural disaster)

• Decrease in labor force

• Destruction of capital

➡ Economy can produce less of both goods.

Points on the PPC

On the Curve

• Efficient production

• All resources fully used
  ✔ Maximum output

Point inside the Curve

• Inefficient production

• Unemployment or underused resources
  ❌ Not producing at full capacity

Point outside (beyond) the Curve

• Currently unattainable

• Not possible with current resources & technology
  ➡ Only reachable after economic growth

Absolute Advantage

• A country/person can produce more of a good using fewer resources than another.

• Compares total output.

👉 Who is best at producing the most?

Absolute = “Who makes more?”

Comparative Advantage

• A country/person can produce a good at a lower opportunity cost than another.

• Compares opportunity cost, not output.

👉 Who gives up less to produce it?

Comparative = “Who gives up less?”

Rule for Trade (VERY IMPORTANT for AP)

• Specialize in comparative advantage

• Trade for the rest

Even if one country has absolute advantage in everything, trade is still beneficial.

Trade = specialize + exchange = both win

Gains from Trade

Trade allows:

• Higher total output

• Lower opportunity costs

• More consumption for both parties

• More efficient resource use

Trade = specialize + exchange = both win

Aggregate Demand (AD) Shifts

AD = C + I + G + (X − M)

Shifts RIGHT (increase) or LEFT (decrease) when any of these change:

• Consumer spending (C)

• Investment (I)

• Government spending (G)

• Net exports (X − M)

• Fiscal policy (taxes, government spending)

• Monetary policy (money supply, interest rates)

• Expectations (inflation, income, profit)

⚠ Price level does NOT shift AD (that’s a movement along).

AD = spending changes

Short-Run Aggregate Supply (SRAS) Shifts

Shifts due to changes in production costs:

• Wages (labor costs)

• Resource/input prices (oil, materials)

• Productivity (technology)

• Government regulations & taxes

• Inflation expectations

➡ Lower costs → SRAS shifts RIGHT
➡ Higher costs → SRAS shifts LEFT

SRAS = cost changes

Long-Run Aggregate Supply (LRAS) Shifts

Shifts when potential output changes:

• Quantity of resources (labor, capital, land)

• Quality of resources (education, skills)

• Technology & innovation

• Institutional changes (laws, property rights)

➡ More productive economy → LRAS shifts RIGHT
➡ Less productive economy → LRAS shifts LEFT

⚠ LRAS is vertical (price level doesn’t affect long-run output).

LRAS = growth changes

Long-Run Self-Adjustment (LRS)

This is what happens when the economy returns to full employment on its own, without government intervention.

Key idea:
➡ Wages adjust → SRAS shifts → economy returns to LRAS

Recessionary Gap for Long-Run Self-Adjustment

(Output below full employment)

1. AD decreases → Real GDP falls below LRAS

2. Unemployment rises

3. Workers accept lower wages

4. Production costs fall

5. SRAS shifts RIGHT

6. Economy returns to LRAS (full employment)

✅ Lower price level
✅ Output back to potential

Inflationary Gap for Long-Run Self-Adjustment

(Output above full employment)

1. AD increases → Real GDP exceeds LRAS

2. Labor shortages

3. Wages rise

4. Production costs increase

5. SRAS shifts LEFT

6. Economy returns to LRAS (full employment)

❌ Higher price level
✅ Output back to potential

Recession → wages ↓ → SRAS → RIGHT

Recession → wages ↓ → SRAS → RIGHT

Inflation → wages ↑ → SRAS → LEFT

Inflation → wages ↑ → SRAS → LEFT

Fiscal Policy equals

Government Spending & Taxes

Recessionary Gap (High Unemployment)

Goal: Increase AD

Expansionary Fiscal Policy

• Increase government spending (G ↑)

• Cut taxes (T ↓) → consumers spend more

➡ AD shifts RIGHT
➡ Output & employment increase

Recession → Spend more, tax less

Inflationary Gap (High Inflation)

Goal: Decrease AD

Contractionary Fiscal Policy

• Decrease government spending (G ↓)

• Raise taxes (T ↑) → consumers spend less

➡ AD shifts LEFT
➡ Price level falls

Inflation → Spend less, tax more

Automatic Stabilizers (Happen Automatically)

• Progressive income taxes

• Unemployment benefits

➡ Reduce the severity of recessions and inflation without new laws

Substitute Goods

• Goods that can be used in place of each other.

• Positive relationship between price of one and demand for the other.

If price of A ↑ → demand for B ↑

Examples:

• Coke & Pepsi

• Butter & margarine

• Uber & Lyft

Complementary Goods

• Goods that are used together.

• Negative relationship between price of one and demand for the other.

If price of A ↑ → demand for B ↓

Examples:

• Cars & gas

• Phones & phone cases

• Printers & ink

Change in price of one good shift what and doesn’t shift what

• Change in price of one good → shifts demand for the related good

• Does NOT affect supply

CPI (Consumer Price Index)

What it is:

• Measures the average change in prices paid by urban consumers for a fixed basket of goods and services

• Used to measure inflation

How CPI is Calculated (Simple)

Cost of market basket this year / Cost of market basket base year X 100

What’s in the CPI basket? 🧺

• Food 🍎

• Housing 🏠

• Transportation 🚗

• Medical care 🏥

• Education 📚

• Clothing 👕

• Recreation 🎮

What CPI is Used For

• Tracking inflation / deflation

• Adjusting COLAs (Cost-of-Living Adjustments)

• Converting nominal → real values

CPI Problems / Biases (AP loves these) ⚠

• Substitution bias – people switch to cheaper goods

• New goods bias – new products not included right away

• Quality change bias – better products cost more

• Outlet bias – ignores discount stores at first

MPC (Marginal Propensity to Consume)

The fraction of extra income that is spent on consumption.

Formula: change in Consumption / change in Income

MPS (Marginal Propensity to Save)

The fraction of extra income that is saved instead of spent.

Formula: change in Saving / change in Income

Spending / Government Spending Multiplier

Formula: 1 / 1 - MPC = 1 / MPS

• Shows how much total GDP changes for a change in spending.

• Example: MPC = 0.8 → Multiplier = 1 / (1 - 0.8) = 5

Tax Multiplier

Formula: -MPC / MPS

• Shows how much GDP changes for a change in taxes.

• Always smaller than the spending multiplier (because not all tax change is spent)

Stagflation

A period where the economy experiences both high inflation and high unemployment at the same time.

Stagflation = SRAS left shift → ↑prices, ↓output

• Fighting inflation (raise taxes, cut spending) → unemployment ↑

• Fighting unemployment (spend more, cut taxes) → inflation ↑

Supply Shock

A sudden unexpected event that changes production costs and shifts the short-run aggregate supply (SRAS).

Always affects SRAS, not AD

Negative Supply Shock

• Increases production costs → SRAS shifts LEFT

• Effects: higher prices (inflation), lower output → can cause stagflation

• Example: oil price spike, natural disaster

Negative = bad → LEFT

Positive Supply Shock

• Decreases production costs → SRAS shifts RIGHT

• Effects: lower prices, higher output

• Example: technological improvement, drop in raw material costs

Positive = good → RIGHT

Demand Shock

• A sudden unexpected event that changes aggregate demand (AD) in the economy.

Always affects AD, not SRAS

Positive Demand Shock

• Increases AD → AD shifts RIGHT

• Effects: higher output, higher price level (can cause demand-pull inflation)

• Example: sudden surge in consumer confidence, government stimulus

Positive → AD RIGHT → ↑output, ↑price

Negative Demand Shock

• Decreases AD → AD shifts LEFT

• Effects: lower output, lower price level → can cause recessionary gap

• Example: stock market crash, pandemic reducing spending

Negative → AD LEFT → ↓output, ↓price