AP Macroeconomics Review Notes

Economics Basics

• Economics: Study of how societies use scarce resources to satisfy unlimited wants; systematic study of choice.

• Scarcity: Limited resources but unlimited needs.

• Macroeconomics: Focuses on the economy as a whole (e.g., national imports/exports).

• Microeconomics: Focuses on individual economic agents.

• Factors of Production:

  • Labor: Human effort and talent.

  • Land: Natural resources.

  • Physical Capital: Human-made equipment.

  • Entrepreneurial Ability: Combining resources productively.

Economic Systems

• Tradition: Based on subsistence and tribal life.

• Command: Central planning of the economy.

• Market: Transactions between buyers and sellers.

• Mixed: Combination of command and market systems.

Opportunity Cost & Trade-offs

• Opportunity Cost: Value of the next best alternative given up.

• Trade-Offs: Choices due to scarce resources.

• Opportunity cost for guns $= (give up)/(gain)$

• Opportunity cost for butter $= (give up)/(gain)$

Production Possibilities Curve (PPC)

• Model showing allocation of scarce resources between two goods/services.

• Concave shape due to varying resource compatibility.

• PPC Curve:

  • The slope measures the opportunity cost of the good on the x-axis.

  • The inverse of the slope measures the opportunity cost of the good on the y-axis.

• Productive efficiency: Producing maximum output with given resources/technology.

• Allocative efficiency: Producing the optimal mix of goods/services.

• Market failure: Market fails to produce allocative efficient quantity.

• Economic growth: Ability to produce larger total output over time.

  • More resources.

  • Better quality of resources.

  • Technological advancements.

• Economic contraction: Economy shrinks.

Comparative Advantage and Trade

• Absolute Advantage: Producing more efficiently using fewer inputs.

• Comparative Advantage: Producing at a lower opportunity cost.

• Output Problems: Focus on which country can produce more.

  • Opportunity cost $= (give up)/(gain)$

• Input Problems: Focus on which country uses fewer resources.

  • Opportunity cost $= (gain)/(give up)$

• Terms of Trade: Relative price of a nation’s exports to its imports.

Demand

• Law of Demand: Price increases, quantity demanded decreases (ceteris paribus).

• Change in Quantity Demanded: Movement along the curve due to price changes.

• Change in Demand: Shift of the entire curve.

• Determinants of Demand (INSECT):

  • I = Income

  • N = Number of Buyers

  • S = Substitutes

  • E = Expectations of Future Price

  • C = Complements

  • T = Tastes and Preferences

Supply

• Law of Supply: Price increases, quantity supplied increases.

• Quantity Supplied: Amount produced at a specific price.

• Determinants of Supply (ROTTEN):

  • R = Resources

  • O = Other good prices

  • T = Taxes

  • T = Technology

  • E = Expectations of the supplier

  • N = Number of competitors

Market Equilibrium

• Equilibrium: Price where quantity demanded equals quantity supplied also known as market-clearing price.

• Disequilibrium: Shortage (excess demand) or surplus (excess supply).

• Market shortage: quantity demanded exceeds the quantity supplied.

• Market surplus: quantity supplied exceeds the quantity demanded.

• Changes in Equilibrium:

  • Demand Increase: Price and quantity increase.

  • Demand Decrease: Price and quantity decrease.

  • Supply Increase: Price decreases, quantity increases.

  • Supply Decrease: Price increases, quantity decreases.

Circular Flow and GDP

• Circular Flow Model: Shows flow of resources, goods, and income between households and firms.

• Closed economy: No foreign sector (imports/exports).

• GDP: Market value of final goods/services produced within a nation in a given period.

  • $GDP = C + I + G + (X – M)$

  • C: Consumer Spending

  • I: Investment Spending

  • G: Government spending

  • (X – M): Exports – Imports (Net Exports)

• Aggregate Income (AI): Sum of all income earned by suppliers of resources in the economy.

• Value-added approach: Considers all stages of production of a final good.

• What is not included in GDP?

  • Illegal Activities

  • Unpaid work

  • Transfer payments

  • Intermediate goods

  • Depreciation

GDP Limitations

• Uses of GDP

  • Measuring Economic Growth

  • Comparing Living Standards

  • Assessing Business Cycles

  • Formulating Economic Policies

  • Attracting Foreign Investment

• Limitations of GDP (PIES):

  • P = Population

  • I = Inequality

  • E = Environment

  • S = Shadow economy

Unemployment

• Employed: Worked for pay at least one hour per week.

• Unemployed: Not working but actively seeking work.

• Labor force: $LF = E + U$ (Employed + Unemployed).

• Out of the labor force: Not seeking employment.

• Labor force participation rate: $LFPR = (LF/Pop) * 100$

• Unemployment rate: $UR = 100 × (U/LF)$

• Discouraged workers: Not included in unemployment rate.

• Types of Unemployment:

  • Frictional: Switching jobs or new entrants.

  • Seasonal: Predictable, periodic.

  • Structural: Due to economic shifts.

  • Cyclical: Rises and falls with the business cycle.

• Full employment: No cyclical unemployment.

• The natural rate of unemployment: 4-6%.

Price Indices and Inflation

• Consumer Price Index (CPI): Measures average price level of a market basket.

• Deflation: Decrease in prices.

• Inflation: Increase in prices.

• Disinflation: Decrease in the rate of inflation.

• Market basket: A collection of goods and services used to represent what is consumed in the economy.

• Inflation rate: Percentage change in CPI.

• GDP deflator: Includes all domestic products.

• Consumer Inflation rate $= 100 \cdot (CPI<em>{new} - CPI</em>{old})/(CPI_{old})$

• Nominal income: Income in today's dollars.

• Real income: Income adjusted for inflation.

• Real income $= (Nominal income)/(CPI in hundredths)$

• Difficulties with CPI:

  • Consumer can substitute, goods evolve, quality differences.

Costs of Inflation

• Expected Inflation: Can be planned for.

• Nominal interest rate $= Real interest rate + Expected inflation$

• Real rate of interest: Percentage increase in purchasing power.

• Unexpected inflation: Redistributes wealth.

• Costs of Inflation:

  • Menu costs.

  • Shoe-leather costs.

  • Loss of purchasing power.

  • Wealth distribution costs.

Real vs. Nominal GDP

• Nominal GDP: Current production at current prices also know as money GDP.

• Real GDP: Current production at base year prices also known as constant-dollar or real GDP.

• Real GDP $= 100 \cdot (NominalGDP)/(Price index)$

• % Δ real GDP = % Δ nominal GDP - % Δ price index

• GDP price deflator: Price index measuring average price level of goods/services in GDP.

Business Cycles

• Business cycle: Periodic rise and fall in economic activity.

• Phases: Expansion, Peak, Contraction, Trough.

• Recession: Two consecutive quarters of falling real GDP.

• Depression: Prolonged, deep contraction.

Aggregate Demand (AD)

• Inverse relationship between spending on domestic output and aggregate price level.

  • $AD = C + I + G + (X – M)$

• Foreign sector substitution effect: Higher U.S. output prices leads to increased preference for imports.

• Interest rate effect: Higher price levels increase borrowing costs, decreasing investment and consumption.

• Wealth effect: Higher price levels decrease purchasing power of wealth.

• Changes in AD: Shifts due to changes in C, I, G, (X – M).

Spending and Tax Multipliers

• Multiplier effect: Initial spending change magnified in the economy.

• Marginal propensity to consume (MPC): Portion of new income spent.

• Marginal propensity to save (MPS): Portion of new income saved.

• $MPC + MPS = 1$

• Spending Multiplier: $1/MPS$

• Tax Multiplier: $-MPC/MPS$

Tax Multiplier< Spending Multiplier

Short-Run Aggregate Supply (SRAS)

• Positive relationship between domestic output and aggregate price level.

• Short Run: Input prices not fully adjusted to output price changes.

• Changes in AS: Fluctuations without affecting full employment.

• Short-Run Shifts: Input prices, tax policy, deregulation, political/environmental factors.

Long-Run Aggregate Supply (LRAS)

• Goods/services economy can produce with full employment of resources.

• Long Run: Input prices fully adjust to market forces.

• Long-Run Shifts: Availability of resources, technology/productivity, policy incentives.

Equilibrium in AD-AS Model

• Macroeconomic equilibrium: Quantity of real output demanded equals quantity supplied.

• Recessionary gap: Full-employment GDP exceeds equilibrium GDP.
  Inflationary gap: Equilibrium GDP exceeds full employment GDP.

Changes in the AD-AS Model in the Short Run

• Supply shocks: Impacts costs of firms and SRAS.
  Positive: Higher productivity or lower energy prices.
  Negative: Increase in economy-wide input prices.

Long-Run Self-Adjustment

• Recessionary Gap: SRAS shifts right as resource prices fall.

• Inflationary Gap: SRAS shifts left as resource prices rise.

Fiscal Policy

• Deliberate changes in government spending and net tax collection.

• Expansionary Fiscal Policy: Increases government spending or lowers net taxes to increase AD.

• Contractionary Fiscal Policy: Decreases government spending or increases net taxes to decrease AD.

Classical school economists believe that the long-run economy adjusts naturally to full employment sees the AS curve as vertical.
Keynesians believe the price level does not usually fall with contractionary policy.

Automatic Stabilizers

• Offsets economic activity fluctuations.

• Examples: Income taxes and anti-poverty programs.
  Expansionary Automatic Stabilizers.
  Contractionary Automatic Stabilizers.
  Doesn't prevent anything.

Financial Assets

• Financial investments yield a rate of return.

• Liquidity: Ease of converting asset to cash.

• Rate of return: Net gain/loss of investment over a period.

• Risk: Chance of actual gains differing from expected outcome.

• Stocks: Represent ownership in a firm.

  • Equity financing.

• Bonds: Certificate of indebtedness.

  • Debt financing.

• Loans: Borrowing money with interest.

• Bank Deposits.

• Bonds and Interest Rates: Inverse relationship.

Nominal vs. Real Interest Rates

• Nominal interest rate = real interest rate + inflation

• Real interest rate = nominal interest rate - inflation

Definition, Measurement, and Functions of Money

• Fiat Money: No intrinsic value.

• Commodity Money: Alternative, non-monetary use.

• Functions: Medium of exchange, unit of account, store of value.

• Money supply: Quantity in circulation.

• M1: Cash, coins, checking deposits, traveler's checks.

• M2: M1 + savings deposits, small time deposits, money market deposits.

• Monetary Base (MO/MB): currency in circulation + bank reserves.

Banking and the Expansion of the Money Supply

• Fractional reserve banking: Only a fraction of deposits held in reserve.

• Reserve ratio (rr) = Cash reserves/Total deposits.

• Money multiplier: M = 1/rr.
  The money multiplier is smaller if:

• At any stage the banks keep more than the required dollars in reserve

• At any stage borrowers do not redeposit funds into the bank and keep some as cash

• Customers are not willing to borrow.

The Money Market

• Transaction demand: Money held for transactions.

• Asset demand: Money demanded as an asset.

• Increase or decrease based on change in price level. Changes in Real GDP, Change in Transaction costs.

• Money market equilibrium: Money demanded equals money supplied. *Central Banks three tools *Engaging in open market operations

  • Changing the discount rate

• Changing the required reserve ratio

  • Investment demand has a inverse reaction to nominal interest rate.

Monetary Policy

• Expansionary monetary policy: Increase money supply, lower interest rates.

• Contractionary monetary policy: Decrease money supply, raise interest rates.

• Open market operations (OMOs) - A traditional tool of monetary policy, it involves the Fedʼs buying (or selling) of securities from (to) commercial banks and the general public.
  *Federal funds rate - The interest rate paid on short-term loans made from one bank to another.
  Discount rate - The interest rate commercial banks pay on short-term loans from the Fed. Lowering the discount rate (or federal funds rate) increases excess reserves in banks and expands the money supply. Raising the discount rate (or federal funds rate) decreases excess reserves in commercial banks and contracts the money supply.
  Required Reserve Ratio - Lowering the reserve ratio increases excess reserves in commercial banks and expands the money supply. Increasing the reserve ratio decreases excess reserves in commercial banks and contracts the money supply.
  MS, which also increases net exports, which creates inflation.
  Unemployment is too high →MS, ↓i%, ↑I, ↑AD, ↑real GDP, ↓unemployment
  Inflation is too high →MS, ↑↓i%, ↓I, ↓AD, ↓real GDP, ↓price level
  If the FOMC wants to lower interest rates, it buys bonds. If the FOMC wants to rise interest rates, it sells bonds.

The Loanable Funds Market

Demand of Loanable Funds

• It is the quantity of credit wanted and needed at every real interest rate by borrowers in an economy.
  Shift: (FADE)

• F = Foreign Demand for domestic currency

• A = All Borrowing, Lending, and Credit

• D = Deficit Spending

• E = Expectations for the Future
  A higher real interest rate makes the currency of that country more attractive to foreign investors, leading to that currency appreciating

Supply of Loanable Funds

• It is the quantity of credit provided at every real interest rates by banks and other lenders in an economy.
  Shift (SELF)

• S = Savings rate

• E = Expectations for the Future

• L = Lending at the Discount Window

• F = Foreign Purchases of Domestic Assets
  A lower real interest rate makes the currency of that country less attractive to foreign investors, leading to that currency depreciate.

Real interest rate will increase due to increased demand.
Real interest rate will decrease due to decreased demand.
Real interest rate will decrease due to increased supply.
Real interest rate will increase due to decreased supply.

Coordination of Fiscal and Monetary Policy

Goal to coordinate monetary policy with expansionary or contractionary fiscal policy in order to move to full employment, whether there may be inflation or rising interest rates in the near future.
1n a mild recession gap, contractionary monetary could be used to offset expansionary fiscal policy to gradually move to full employment.

Phillips Curve

A graphical device that shows the relationship between infaltion and the unemployment rate.

Shifts in AD.
supply-side boom increase the SRAS curve the price level falls real GDP increases and the unemployment rate falls.
The AS model assumes that the long-run AS curve is vertical and at full employment.
This causes the philips curve to be vertical at the natural rate of unemployment.
Inflation
It is the result of increasing the money supply.
A change in the money supply does not affect the economy.

Deficits and the National Debt

Use of expansionary fiscal policy.
Fiscal restraint- Use of contractionary policy.
Budget surplus- The condition that exists when government revenues exceed government expenditures.
Budget deficits- The condition that exists when government expenditures exceed government revenues.
Accumulation of deficits over multiple years is National Debt.
Deficits and surpluses
When the US is operating in a recessionary gap- leading a deficit
When the US is operating in a expansionary gap- leading to a surplus

Crowding Out

Is the economic theory that public sector spending can lessen or eliminate private sector spending.
Not always an issue, sometimes there will be enough loanable funds for everyone.
Long-Run Impact - prolonged economic growth reduction resulting in economic doom.

Economic Growth

GDP per capita= real GDP/ population
If GDP per capita increases economy grew.
Shows long-run economic growth.
Determinants of Productivity - Stock of physical capital, Human capital, Natural resources, and Technology.

Public Policy and Economic Growth

Public Policy- Increase innovation, employment, increase education, and increase infrastructure spending