AP Economics Exam Review



REVIEW BOOKLET

AP MACROECONOMICS

Stolen From Mr. Peterson

MacArthur High School

SPRING 2016

TABLE OF CONTENTS

Pages 1-2: Nature & Method of Economics; Scarcity/Efficiency/Resource

Utilization

Pages 2-10: Individual Market Demand, Supply, and Equilibrium

Pages 10-14: Absolute & Comparative Advantage

Pages 14-15: GDP

Pages 15-18: CPI, Business Cycles, Unemployment, and Inflation

Pages 18-23: Aggregate Expenditure Model; Fiscal Policy Multipliers; AD/AS/AE

Pages 23-28: Fiscal Policy

Pages 29-33: Monetary Policy

Pages 39-42: SR vs. LR; Phillips Curves;

Pages 42-46: Economics Theories & Disputes

Pages 46-51: Foreign Exchange; Net Export Effects

Pages 52-54: Balance of Payments; Trade Barriers

Pages 55-59: Policy Mix

Page 59: Self-Correcting Economy

AP Macroeconomics Exam Review Booklet Spring 2016/Mr. Peterson

I. Nature & Method of Economics:

A. Fundamental Economic concept is scarcity. Scarcity requires

choices. “There is no such thing as a free lunch.”

B Macroeconomics - The study of the economy as a whole and its

aggregates.

C. Microeconomics - The study of individual sectors of the economy.

II. The Economizing Problem:

A. Economic Resources:

1. Land (gifts of nature)

2. Labor (people & their abilities)

3. Capital (‘things that make other things”)

4. Entrepreneurship (risk takers in search of profits)

B. Scarce Resources involve choices - An opportunity cost, which

is the next best alternative choice or what you give up to get

something else.

C. Full-Employment:

1. People = 5% unemployment 2. P&E = 85% capacity utilization rate

D. Productive Efficiency = Producing products in the most efficient

manner or the “right way.”

E. Allocative Efficiency = Producing the products society wants most or

the “right products.”

F. Full-Production: To achieve full-production an economy must achieve

both allocative and productive efficiency.

G. Production Possibilities Curve: Is an economic model of choices.

[pic]

Points inside the curve are attainable with current resources, but represent inefficient use of resources. Points on the curve are attainable with current resources and represent full-production, allocative efficiency, and productive efficiency. However, movement along the curve represents a opportunity cost. Increased production of one product results in decreased output of the other good. Points outside the curve are unattainable with the current level of resources.

In order to operate outside the PPC and “push out the curve,” and “bake a bigger economic pie” an economy must either:

1. Utilize new and improved technology.

2. Increase the 4 Economic Resources.

3. Utilize International Trade to increase Resources.

B. Circular Flow:

The idea here is that money spent from one sector of the economy becomes income for another sector.

[pic]

III. Demand, Supply, & Equilibrium:

A. Demand:

1. Law of Demand: Quantity demanded rises when the price falls and

increases when the price declines.

2. Quantity Demanded - alters due to a price change and is represented by

movement along a stable demand curve

. [pic]

3. Change in Demand: Results in a shift in the entire curve and is caused

by a non-price factor known as a determinant, such as:

a. Tastes & Preferences

b. Related Good Prices (substitutes & compliments)

c. Income Changes

d. Population changes

e. Expectations of the future

[pic]

[pic]

B . Supply:

1. Law of Supply: Quantity supplied rises when the price rises and

decreases when the price declines.

2. Quantity Supplied- alters due to a price change and is represented by

movement along a stable supply curve.

[pic]

3. Change in Supply: Results in a shift in the entire curve and Is caused

by a non-price factor known as a determinant, such as:

a. Natural/Manmade Phenomenon

b. Input Costs

c. Competition

d. Expectations

e. Profitability of other goods in supply

f. Profitability of goods in joint supply

[pic]

[pic]

C. Equilibrium: Where the AD and AS curves intersect, called the

equilibrium price. Here there are no shortages or surpluses. This is also

called the “market clearing” price. When the market price is set above the

“market clearing” price, surpluses exist. When the market price is set

below the “market clearing” price, shortages exist. Markets tend to seek

equilibrium and eliminate shortages or surpluses.

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

IV. The Market System:

A. Three Economic Questions:

1. What to produce?

2. How to produce it?

3. For whom to produce?

B. The “Invisible Hand.” Adam Smith’s idea of the operation of self-interest within the economy. The idea here is that if everyone pursues their own economic self-interest, then society will be better of as a whole.

V. U.S. & Global Economy:

A. Absolute/Comparative Advantage:

Absolute advantage is when one nation/person produces a product in the most efficient/cost effective manner.

2. Comparative advantage involves specialization.

Countries/people should specialize and produce those products

with with they have the lowest opportunity cost in terms of the

other product involved.

3. Once countries specialize and trade on the basis of comparative

advantage, both countries will be able to enjoy more output of both

products involved.

B. Absolute/Comparative Advantage Example:

In order to determine absolute and comparative advantage, the following

must be determined.

1. Is this an output or input problem? Output involves things like

tons produced per hour, bushels produced per acre. It involved

how much one can produce given a certain input. Input involves

how much input it takes to produce a given output. For example,

the number of hours to produce 1 car or number of workers to

produce 1 TV.

2. For output, absolute advantage involves the country/person

producing the most. For input, absolute advantage involves the country/person uses the least time, inputs, resources to come up with a given output.

3. If you have one country in with the absolute advantage in one product and the other country with the absolute advantage in the other product, then you have already determined comparative advantage. There is no reason to go further and utilize the formula.

4. Comparative advantage determines who should produce which product and why? Comparative advantage involves a country specializing in the production of the product it has the lowest opportunity cost in terms of the other product it could produce.

4. Shown below are examples of comparative advantage problems

for both input and output.

Output Problem: Remember, output means “over.”

In one hour, the USA can produce either ten Roman Togas or five Barbie Dolls. In one hour, South Korea can produce either Fifteen Roman Togas or ten Barbie Dolls.

Which nation has the absolute advantage in Togas? In Barbies? Why?

Which nation has the comparative advantage in Togas? Why?

Which nation has the comparative advantage in Barbies? Why?

Which nation should produce which product and why?

To solve this problem, you can set up the following table:

| | | | | |

| |Togas |Barbie Dolls |Togas |Barbie Dolls |

| | | | | |

|USA |10 |5 | |10/5 = 2 |

| | | | | |

|South Korea |15 |10 |10/15 = 2/3 | |

In this problem, South Korea has the absolute advantage in both products because

it can produce more of each in one hour.

After the calculations for comparative advantage, the USA has the lowest

opportunity cost when producing Togas. This means that if it produced one

Toga it could have produced 1/2 Barbies in the same time. Therefore it has the

comparative advantage because South Korea would give up 2/3 Barbies.

South Korea has the comparative advantage for Barbie Dolls because it has the

lowest opportunity cost when producing Barbies. That is, when it produces one

Barbie, it could have produced 3/2th of a Toga in the same time. The USA would

have to give up 2 Togas in the same time, therefore South Korea has the

comparative advantage.

4. Because they have the lowest opportunity cost in terms of the other product

(comparative advantage), the USA should produce Togas and South Korea should produce Barbies. If they specialize in the production of these products and then

trade, both will enjoy more output than if specialization had not occurred.

Additional Issues with this type of problem:

You may be called upon to draw a PPC from the information above. I’ve drawn

one below: PPC

Togas 15

10 USA S. Korea

5 10 Barbies

The PPC above shows the domestic terms of trade for each country. If the USA produces one Toga it could trade for 2 Barbies domestically. If South Korea produces one Toga, it could trade domestically for 3 Barbies.

The Question IS:

If the two nations offered each other 1 Toga for 2.5 Barbies, would these terms of trade be mutually beneficial.

USA – Makes Togas & Domestic Terms of Trade are 1 Toga for ½ of a Barbie.

Yes, they gain 2 Barbies by trading internationally.

South Korea – Makes Barbies & Domestic Terms of Trade are 1 Barbie for 3/2 Togas.

No, they have to give up 1.5 more Barbies for ½ less Togas by trading internationally.

Input Problem:

To produce one tank, it takes Canada 12 hours. To produce one dove, it takes Canada 3 hours. To produce one tank, it takes Austria 10 hours. To produce one dove, it takes Austria 2 hours

| | | | | |

| |Tanks |Doves |Tanks |Doves |

| | | | | |

|Canada |12 |3 | |3/12 = 1/4 |

| | | | | |

|Austria |10 |2 |10/2 = 5 | |

| | | | | |

From the table above, it is evident that Austria has the absolute advantage in both tanks and doves because it produces on unit of each product faster than Canada. However, Canada has the comparative advantage in tanks, because in the time it takes Canada to produce one tank it could have made 4 doves. 4 is less than 5, so it has the lowest opportunity cost in terms of doves when producing a tank. Austria has the comparative advantage in doves because it only gives up 1/5th of a tank when producing 1 dove.

Additional Issues with this type of problem:

1. You may be called upon to draw a PPC from the information above.

[pic]

The PPC above shows the domestic terms of trade for each country.

The Question IS:

If the two nations offered each other 6 Tanks for 1 Dove, would these terms of trade be mutually beneficial?

Answer:

Canada: – Makes Tanks & Domestic Terms of Trade are 1 Tank for 4 Doves.

No. They would have to give up 5 more Tanks to get just one Dove.

Austria: – Makes Doves & Domestic Terms of Trade are 1 Dove for 1/5th a Tank.

Yes, they get 5 and 4/5ths more Tanks by trading internationally.

VI. Measuring Domestic Output, National Income, & Price Level:

A. GDP:

1. Stands for Gross Domestic Product or the final value of all goods and services produced and sold in the U.S. at their final market prices during one year. It differs from GNP or Gross National Product in that GDP involves U.S. or foreign production w/I the U.S. borders, while GNP involves the production of U.S.

citizens/corp’s worldwide.

2. GDP is a macroeconomic indicator of and economy’s health.

3. The two methods for calculating GDP include the following:

a. Expenditures Approach = C + I + G + Xn This is the spending for this year’s output.

b. Flow of Income Approach. This is the income received for

this year’s output. Usually only general questions are

asked on the AP Exam for this method. However, if you

did get a technical question, the most you would need to

know is shown below:

GDP

- Depreciation

= Net Domestic Product

- Net Foreign Factor Income

- Indirect Business Taxes

= National Income

You could calculate this by either the build-up or tear-down

methods.

B. Nominal & Real GDP:

1. Is Real GDP + inflation for that year.

2. Real GDP measures what was actually produced for that year.

C. Important GDP Formulas:

Real GDP = Nominal GDP – inflation since the base year.

Real GDP Calculation: = Nominal GDP Current Yr x 100

GDP Deflator or Price Index Current Year

Note: The base year deflator is always 100 and the current year deflator

will be provided.

Percentage Change in Real GDP:

= Real GDP Current Year - Real GDP Base Year x 100

Real GDP Base Year

Per-Capita Nominal GDP:

= Nominal GDP divided by population

Per-Capita Real GDP:

= Real GDP divided by population

D. Shortcomings of GDP:

1. Does not include financial transactions

2. Does not include non-market transactions

3. Does not measure improved product quality

4. Does not include underground economy

5. Does not address the composition/distribution of output

6. Does not address per-capita output

7. Does not address non-economic sources of well-being

E. CPI = Consumer Price Index:

1. It is a measure of inflation based on consumer purchases. It is a

market basket of 300 commonly purchased items by households

which are weighted.

2. The base year CPI is always 100. To calculate the change in

inflation since the base year, you simply take the current year CPI

and subtract 100.

3. To compare calculate the change in inflation from one year to the next, use the following formula for percentage change:

CPI Current Year – CPI Other Year x 100

CPI Other Year

This is the old New – Old/Old percentage change formula.

VII. Economic Growth & Instability:

A. Business Cycle – The ups and downs of the economy.

1. 4 Phases shown below:

[pic]

2. Cyclical Impact of Business Cycle:

Durable goods industries are more severely affected than

nondurable goods industries. People will cut back on big ticket

items and non-necessities when there is recession. Industries

involving necessities such as food, clothing, insurance, and other

non-durables and services are somewhat protected from recessions.

B. Unemployment:

1. Unemployment Rate = Unemployed/Labor Force x 100

2. Labor Force = Unemployed (those w/o jobs, but looking for jobs)

+ the employed.

3. Types of Unemployment:

a. Frictional – People between jobs

b. Structural – Unemployed who need retraining or

relocation to find jobs.

c. Cyclical – Unemployment caused by the Business Cycle.

d. Seasonal – Unemployment based on the time of the

year.

4. Natural Rate of Unemployment = 5% unemployment. It is the

combination of frictional and structural unemployment.

C. Inflation:

1. Types:

a. Demand-Pull: Caused by excessive AD. “Too many

dollars chasing too few goods.” This inflation will

continue as long as AD increases. Here the AD curve shifts right.

[pic]

b. Cost-Push Inflation (“Stagflation): Caused by supply

shocks (oil embargoes of the 1970’s), wage-price spiral, monopoly

monopoly power of industries, union power. This inflation results

from an increase in per-unit costs, causing the SRAS to

shift left. Left alone, this inflation will eventually die out by

itself due to the increase in costs resulting in higher

unemployment and reduced AD/GDPr.

[pic]

c. Quantity Theory of Inflation:

Here inflation is caused by the government printing too

much money. It is based on the Equation of Exchange:

MV = PQ

Here M = Money Supply, V = velocity of money (how

many times a dollar is spent in a year), P = today’s prices

or inflation, and Q = real GDP or output. P x Q = Nominal

GDP.

* Note that M directly affects P & V directly affects Q

2. Who is helped/hurt by inflation:

Helped Hurt

1. Flexible Income People 1. Fixed-Income people

2. Debtors 2. Savers

3. Owners of real property 3. Creditors

like real estate.

D. Nominal v. Real Interest Rates:

1. Nominal Interest rates are real interest rates + inflation. They

include this year’s estimate of inflation by lenders. They will place an inflation premium on to a loan.

2. Real interest rates are a result of competition for bank

savings/deposits between depositors and financial institutions. If

the pool of savings shrinks, interest rates increase. If the pool of

savings increases, interest rates decrease. Real interest rates are

determined in the Loanable Funds Market.

VIII. Building the Aggregate Expenditures Model:

A. Consumption Function.

1. Defined – As DI goes up C goes up, but not as fast as DI.

2. Determinants of Consumption:

a. Most important – DI.

b. Expectations

c. Keeping up with the Jones

d. Amount of Durable Goods on hand

e. Amount of Credit Available

f. Amount of Financial Assets on hand

B. Savings Function:

1. Defined – As DI goes up, S goes up, but not as fast as DI>

2. Determinants of Savings – Only personal habit.

C. APC, APS, MPC, and MPS:

1. APC: Average Propensity to Consume = Consumption/DI.

2. APS: Average Propensity to Save = Savings/DI

3. MPC: Marginal Propensity to Consume. This relates to a

person’s propensity to spend if additional income is

received. The formula is: MPC = change in

consumption/change in DI.

4. MPS: Marginal Propensity to Save. It relates to a person’s

propensity to save if additional income is received. The

formula is: MPS = change in savings/change in DI

D. Investment:

1. Defined: New P&E, New Construction (business &

residential), and net inventory investment.

2. The key factor in the quantity of investment demand (movement

along a stable ID curve is the real rate of interest. If the real rate of interest is less than the expected profit rate, then firms will invest.

If r% is greater than the expected profit rate, then firms won’t

invest.

2. Determinants of Investment (cause the ID curve to shift):

a. Cost of Production

b. Business Taxes

c. Technological change

d. Stock of Capital

e. Expectations.

[pic]

[pic]

X. Aggregate Expenditures:

A. The Spending Multiplier:

The formula for the spending multiplier is 1/1-MPC or 1/MPS.

This is an economic tool for economists to determine how much of a

multiplied effect fiscal policy has on the economy. When government

spending or investment spending occurs, its effect on GDP is multiplied

by the circular flow model.

Application of the Spending Multiplier:

If the government increased spending by $20 Billion and the MPC is .90, how

much will real GDP increase?

Answer: Multiplier = 1/1-MPC = 10.

The Multiplied Effect = 10 x $20 Billion = $200 Billion.

B. The Tax Multiplier:

The government can also have an effect on real GDP by changing taxes or transfer payments. Tax increases or decreases also have a multiplied effect on

real GDP through circular flow.

The formula for a tax increase is: -MPC/1-MPC.

Application of the Tax Multiplier for a tax increase:

If the MPC is .90 and the government increases taxes by $20 Billion, what is the

multiplied effect on real GDP?

Tax Multiplier = -MPC/1-MPC = -.9/1-.9 = -9

The Multiplied Effect = -9 x $20 Billion = Negative $180 Billion

The formula for a tax decrease is: MPC/1-MPC.

Application of the Tax Multiplier for a tax decrease:

Tax Multiplier = MPC/1-MPC = .9/1-.9 = 9

The Multiplied Effect = 9 x $20 Billion = Positve $180 Billion

C. Balanced Budget Multiplier:

The government both collects taxes and spends revenue. In a simple model, the

dollars spent equal the dollars collected and the budget is balanced. We have

already looked at how the tax and spending multipliers are different. The example below exhibits the balanced budget multiplier by using data from the

spending and tax multipliers above.

Balanced Budget Multiplier = 1

Why?

A $20 Billion increase in government spending results in an increase in real GDP or $200 Billion, while a $20 Billion increase in taxes results in a decrease in real GDP of $180 Billion. The net result is an increase in real GDP of $20B or 1 x the increase in G. From a non-mathematical standpoint this is true because G is a direct injection into circular flow while T is a leakage from circular flow. G has a quicker impact on GDRr, while taxes have a delayed impact.

C. Equilibrium GDP vs. Full-Employment GDP:

Equilibrium GDP is simply the current level of spending in the economy. Where the AD/SRAS curves intersect. Full-Employment GDP is the

level of spending to achieve full-employment within the economy. Here

the AD,SRAS, and LRAS all intersect.

[pic]

E. Recessionary or Deflationary Gap:

1. Defined – when Equilibrium GDP is less than Full-Employment

GDP. There is too little spending in the economy to achieve full-

employment. The AD curve intersects the SRAS curve to the left

of the LRAS curve

[pic]

How to close the gap: Raise G, decrease T, or both. However, one must consider the degree of recession before recommending both

raising G and decreasing T. A mild recession might only require a tax cut. A severe recession may require both measures.

F. Inflationary Gap:

1. When Equilibrium GDP is greater than Full-Employment GDP.

There is too much spending. The AD curve intersects the SRAS

curve to the right of the LRAS curve.

[pic]

2. How to close the gap: Decrease G, Raise T, or both. However,

one must consider the degree of recession before recommending

both decreasing G and increasing T. Mild inflation might only require a tax increase. Severe inflation may require both measures.

XI. AD/AS/AE:

A. AD = Aggregate Demandor all spending in the economy. It is

equivalent to AE or Aggregate Expenditures or GDP.

1. Movement along a stable AD curve is caused by a change in the price level. The factors involved are the interest rate effect, real

balances effect, and foreign purchases effect.

2. Factors that shift the AD Curve:

a. Change in consumer spending due to wealth,

expectations

b. Change in investment

d. Changes in G.

e. Changes in Net Exports (Exports – Imports)

B. AS = Aggregate Supply or all output within an economy.

1. Movement along a stable AS curve is also caused by a change

in the PL.

2. Factors that shift the AS curve:

a. Changes in input prices.

b. Changes in productivity.

c. Legal Institution Environment Changes.

XII: Fiscal Policy:

A. Defined: Manipulation of the federal budget to achieve economic

stabilization (ie. Steady economic growth, price stability, and low unemployment)

B. Expansionary Fiscal Policy:

Options:

1. Increase G 2. Decrease T 3. Both

The idea here is to stimulate the economy and increase AD, employment, and GDP.

[pic]

C. Contractionary Fiscal Policy:

Options:

1. Decrease G. 2. Increase T 3. Both

The idea here is to slow down the economy and reduce AD without

severely affecting employment and GDP (although that can happen)

[pic]

D. Discretionary Fiscal Policy:

1. Defined: Fiscal policy at the discretion of Congress/President. It

requires that a law or governmental regulation be passed.

2. Examples:

a. Making the Automatic Stabilizers more effective

b. Public Works:

c. Transfer Payments:

d. Changes in Tax Rates:

e. Changes in government spending

E. Automatic or Non-Discretionary Fiscal Policy:

1. This is fiscal policy which automatically kicks in w/o governmental action.

2. Examples

a. Personal Income & Social Security Taxes.

b. Personal Savings.

c. Credit Availability:

d. Unemployment Benefits:

e. The Corporate Profits Tax:

f. Other Transfer Payments

- The more progressive a country’s tax system, the greater an economy’s built-in

stability.

F. Why are large budget deficits so bad?

1. Sops up savings & raises interest rates – “the Crowding Out” Effect.

[pic]

The “Crowding Out Effect” involves the federal government using deficit

spending to increase government spending and get the economy out of a

recession. To do this, the government demands more loanable funds (it sells government securities to the public), causing the real interest rate to increase. When the real interest rate increases, investment demand goes down because it is now more expensive for businesses to borrow money to invest in plant and equipment.

2. Increasing dependence on foreign investors to finance the debt, a

National Sovereignty Issue.

3. If the deficits are not paid off, the interest adds to the National Debt.

G. How to Pay off the Debt:

1. Raise Taxes. 2. Decrease G. 3. Maintain high economic growth.

H. What about a balanced budget amendment?

- Problem is it eliminates deficit spending as a stabilization tool.

I. Problems with Fiscal Policy:

1 Recognition Lag – Time between the beginning of a recession or

inflation and the awareness that it is actually happening.

2. Administrative Lag – Time between when the need for fiscal

policy action is recognized and when the action is taken. By the time Congress/Pres. take action, the problem may have already resolved itself.

3. Operational Lag – Time between when fiscal policy action is taken

and the time it affects output, employment, or prices. Tax rate changes can be put into place quickly, but public works, such as new construction for dams, highways, etc., take long planning periods

4. Political Cycle – Fiscal Policy may be corrupted for political

purposes.

5. Offsets State/Local Finance.

6. Crowding-Out Effect – However, some economists, like John

Maynard Keynes, say that during severe recessions or depressions, deficit spending does not crowd-out. This is because interest rates won’t go up as deficit spending would only sop up idle funds as companies would not invest during severe economic slack times. In fact, the stimulative effect on AD during this time would “Crowd-In” investment spending.

J. Example of Net Export Effect of Expansionary Fiscal Policy:

Problem: Recession

Expansionary Fiscal Policy

Sell bonds to finance deficit spending

Higher Domestic Interest Rates

Due to “Crowding Out”

Increased Foreign Demand for Dollars

Due to higher bond interest rates

Dollar Appreciates

Net Exports Decline

AD Declines, Partially offsetting Expansionary Fiscal Policy

K. Example of Net Export Effect of Contractionary Fiscal Policy:

Problem: Inflation

Contractionary Fiscal Policy

Buy bonds to finance budget surplus

Lower Domestic Interest Rates

More supply of $’s for savings & bond interest rates go down

Decreased Foreign Demand for Dollars

Due to lower bond interest rates

Dollar Depreciates

Net Exports Increase

AD Increases (& GDP), Partially offsetting the Contractionary Policy

XII: Money & Banking::

A. Three Jobs of Money:

1. Medium of Exchange

2. Unit of Account (Standard of Value)

3. Store of Value

B. Our Money Supply:

1. .M1: Currency, demand deposits, traveler’s

checks, & other checkable deposits (NOW

and Share Draft Accounts).

2.. M2: M1 + savings accounts, small time deposits

(CD’s) under $100,000, money market funds

and overnight Eurodollar deposits.

3. M3: M2 + large time deposits – over $100,000,

and Eurodollar deposits with maturities longer than one day

C. What Backs the Money Supply?

- The U.S. governments ability to keep the value of money relatively stable.

D. Money as Debt: Paper money and checkable deposits are promises to pay.

E. Value of Money is Determined by:

1. Acceptability – our confidence.

2. Legal Tender – Government designates it as legal tender.

3. Relative Scarcity – As managed by the govt .

F. Stabilization of Money’s Value – Depends on the appropriate fiscal policy

and intelligent management of the economy by the Federal Reserve.

G. The Demand for Money:

1. Transactions Demand:

1st Reason for holding money. Focuses on holding money as a

medium of exchange.

2 The main determinant of transactions demand is the level of Nominal

Nominal GDP. The larger GDP is, the higher the transactions demand

A direct relationship

3. The demand for money here is independent of the interest rate. That is why the Transactions Demand Curve is vertical.

[pic]

H. Asset Demand for Money:

1. The second reason for holding money is derived from people holding money as a store of value.

2. People can hold their money as an asset or invest it in financial assets

such as stocks, bonds, etc.

3. The key here is an inverse relationship between money held as an asset and interest rates. The lower the interest rate, the more money people will hold as an asset or cash (that is, on their person, in their vault, or in a non-interest bearing checking account). When the interest rate goes up, people will invest their money in savings accounts, CD’s, bonds, etc. in order to take advantage of the higher interest rates. If they don’t invest, they will have an opportunity cost in terms of the interest they could have earned from those investments.

[pic]

I. The Money Market:

1 Lower bond prices offered by the government are associated with higher interest rates.

2. Higher bond prices offered by the government are associated with lower interest rates. An inverse relationship.

XIII: Monetary Policy:

A. Tools of Monetary Policy:

1 Reserve Requirement – The % of checkable deposits (basically demand

deposits that banks may not lend out. These are required reserves. The

remaining reserves are excess reserves and may be loaned out. An

expansionary monetary policy would involve decreasing the reserve requirement and an contractionary monetary policy would involve increasing it.

2. Deposit Expansion or Money Multiplier = 1/Reserve Requirement. This tells us how much a bank or the banking system can expand the money supply. Ex: If a bank receives a $1000 deposit and the reserve requirement is 10%, how much can this bank expand the money supply by making loans. How much is the money supply expanded by this deposit and new loans from this bank? How much can the banking system expand the money supply overall from this $1000 deposit. How much can the banking system expand the money supply via making loans.

3. Discount Rate: The interest rate the fed charges banks when they borrow money from the Fed. The Fed directly sets this rate. An expansionary monetary policy involves decreasing this rate and a contractionary policy involves increasing this rate.

4. Open Market Operations: The buying or selling of government securities to expand or contract the money supply. The Fed also uses open market operations to influence the Federal Funds Rate, which is the interest rate charged to banks when they borrow from another bank. The Fed does not directly set this rate, but it influences it in order to influence economic stability and give signals of changes in monetary policy. Expansionary monetary policy involves buying bonds from the public and a contractionary policy involves selling bonds to the public.

B. Monetary Policy for Recession/Inflation:

Problem: Unemployment/Recession Problem: Inflation

Use Expansionary Policy Use Contractionary Policy

Fed buys bonds, lowers RR, Fed sells bonds, incr.

or lowers DR RR, or incr. DR

Excess Reserves Increase Excess Reserves Decrease

Money Supply Rises Money Supply Decreases

Interest Rate Falls (more $’s Interest Rate Rises (fewer

avail. for savings) dollars avail. for savings)

AD Increases AD Decreases

Real GDP increases by a Inflation Declines

Multiple increase in I

Graphical Example of Expansionary Monetary Policy:

[pic]

Graphical Example of Contractionary Monetary Policy:

[pic]

C. Effectiveness of Monetary Policy:

1. Strengths:

a. Speed & Flexibility: Quick compared to fiscal policy. Fed can

make changes in RR, DR, FFR, and sell/buy bonds from day to

day.

b. Political Isolation: Governors of Fed. can be concerned about

long-term health of the economy.

2. Weaknesses:

a. The ease of flow of electronic funds, the global financial capital

flows, and movement of money to mutual funds or stocks may

undermine Fed action.

b. Changes in Velocity (Velocity is the number of times money is

spent during a year) In some instances velocity may change to

counter monetary policy. During inflation, Fed contracts M (the

Money Supply) and V (Velocity - may increase. During

recession, Fed increases M and velocity may fall.

Velocity may behave this way due to the Asset Demand for

money. An easy money policy lower interest rates and people hold more cash (as an asset) when interest rates are lower. Thus V declines. The reverse is true when the Fed contracts M. Interest rates increase, people hold less cash (as an asset), and velocity increases.

c. Cyclical Assymetry: The Fed is much better at controlling

inflation than recession. “pulling on a string v. pulling on a

string.” The Fed can cut off the water effectively to the banking

system and choke off inflation. However, easy money policies can

be thwarted by:

1. Banks, seeking liquidity, may not want to make loans.

2. Businesses may not want to borrow money during recessions

regardless of the interest rate.

3. Business confidence may be severely hurt during a heavy

recession that the Investment Demand Curve shifts to the

left. This happened to Japan in the 1990’s (their central

bank lowered interest rates) and ours in 2002-03.

4. Impact Lag – The time until monetary policy has substantial

effect. Economists estimate this may be between 9 months to

3 years.

D. Net Export Effect and Monetary Policy:

Problem: Unemployment/Recession Problem: Inflation

Easy Money Policy lowers i% Tight Money Policy increases i%

Decreased foreign demand Increased foreign demand

For dollars (as bond interest rates for dollars (as bond interest

go down) rates increase)

Dollar Depreciates Dollar Appreciates

Net Exports Increase & Net Exports Decrease &

AD Increases, thus strengthens AD Decreases, thus tight

easy money policy. money policy is strengthened

XV: Chapter 16 – Short-Run v. Long-Run AS/AD Analysis

A. Short-Run: Period where wages and other input costs stay fixed.

Why: 1. Workers not aware of inflation & don’t adjust wage demand

2. Labor contracts set wages for 2-3 year periods.

3. Managers receive yearly salaries..

B. Long-Run: Period where nominal wages fully respond to inflation. In the Long- Run

Workers realize that their real income or buying power has

declined. As such, they demand and receive nominal wage increases,

causing production costs to increase. This results in the SRAS curve shifting

leftward to restore the economy to the full-employment level of GDPr.

[pic]

C. Cost-Push Inflation & Extended AS-AD Model:

1. Supply Shocks (such as increased oil prices), raises overall per-unit costs of production.

a. This shifts the AS Curve inward. Prices rise, output declines,

and unemployment goes above its natural rate.

2. Policy-Dilemas:

a. The AS Curve shift is the cause of inflation, not a response to it. If policy makers use expansionary fiscal policy or monetary

policy to counter the recession, they may aggravate inflation.

a. If the govt realizes this dilemma & does not use expansionary

policy to increase AD, the recession will run its course. Employment

will go down due to layoffs and businesses fail. Ultimately, however,

per-unit price decreases and the inward shift of the AS curve will reverse itself, prices go down, output rises and employment will

rise back to its natural level.

G. The Phillips Curve:

• In a 1958 paper, New Zealand born economist, A.W. Phillips

published the results of his research on the historical relationship between the unemployment rate (u%) and the rate of inflation (π%) in Great Britain. His research indicated a stable inverse relationship between the u% and the π%. As u%↓, π%↑ ; and as u%↑, π%↓. The implication of this relationship was that policy makers could exploit the trade-off and reduce u% at the cost of increased π%. The Phillips curve was used as a rationale for the Keynesian aggregate demand policies of the mid-20th century.

[pic]

Trouble for the Phillips Curve

• In the 1970’s the United States experienced concurrent high u% & π%, a condition known as stagflation. 1976 American Nobel Prize economist Milton Friedman saw stagflation as disproof of the stable Phillips Curve. Instead of a trade-off between u% & π%, Friedman and 2006 Nobel Prize recipient Edmund Phelps believed that the natural u% was independent of the π%. This independent relationship is now referred to as the Long-Run Phillips Curve. I believe it’s relevant that by this time the Bretton-Woods system had collapsed.

[pic]

The Long-Run Phillips Curve (LRPC)

• Because the Long-Run Phillips Curve exists at the natural rate of unemployment (un), structural changes in the economy that affect un will also cause the LRPC to shift.

• Increases in un will shift LRPC (

• Decreases in un will shift LRPC (

The Short-Run Phillips Curve (SRPC)

• Today many economists reject the concept of a stable Phillips curve, but accept that there may be a short-term trade-off between u% & π% given stable inflation expectations. Most believe that in the long-run u% & π% are independent at the natural rate of unemployment. Modern analysis shows that the SRPC may shift left or right. The key to understanding shifts in the Phillips curve is inflationary expectations!

Relating Phillips Curve to AS/AD

• Changes in the AS/AD model can also be seen in the Phillips Curves

• An easy way to understand how changes in the AS/AD model affect the Phillips Curve is to think of the two sets of graphs as mirror images.

• NOTE: The 2 models are not equivalent. The AS/AD model is static, but the Phillips Curve includes change over time. Whereas AS/AD shows one time changes in the price-level as inflation or deflation, The Phillips curve illustrates continuous change in the price-level as either increased inflation or disinflation.

[pic]

[pic]

[pic]

[pic]

Summary

• In the long-run, no trade-off exists between u% & π%. This is referred to as the long-run Phillips Curve (LRPC)

• The LRPC exists at the natural rate of unemployment (un).

– un ↑ .: LRPC (

– un ↓ .: LRPC (

• ΔC, ΔIG, ΔG, and/or ΔXN = Δ AD = Δ along SRPC

– AD ( .: GDPR↑ & PL↑ .: u%↓ & π%↑ .: up/left along SRPC

– AD ( .: GDPR↓ & PL↓ .: u%↑ & π%↓ .: down/right along SRPC

• Inflationary Expectations, Δ Input Prices, Δ Productivity, Δ Business Taxes and/or Δ Regulation = Δ SRAS = Δ SRPC

– SRAS ( .: GDPR↑ & PL↓ .: u%↓ & π%↓ .: SRPC (

– SRAS ( .: GDPR↓ & PL ↑ .: u%↑ & π%↑.: SRPC (

H. Supply-Side Economics:

1. Supply-Side emphasizes increases in AS to achieve satisfactory levels

of output, employment, and inflation.

2. Tax Cuts Provide Incentives:

a. To work more and produce more

b. To save and invest

3. Laffer Curve – Lower Marginal tax rates will actually increase

tax revenue

[pic]

4. Criticism of Laffer Curve: It did not prove valid during the

1980’s under Reagan.

a. Incentives of tax cuts caused limited impact. Some people

work more, some less

b. Inflation. Tax cuts near full-employment levels of output

produce demand-pull inflation. Increases in AD overwhelm increases

in AS.

c. The optimal position on the curve is unknown.

I. Has the Impact of Oil Price Increases Diminished?

1. Reduction in OPEC strength

2. Reduced energy consumption

3. Fed has not let oil prices significantly affect inflation

XVI: Economic Growth and Productivity:

Economic Growth Defined

• Sustained increase in Real GDP over time.

• Sustained increase in Real GDP per Capita over time.

Why Grow?

• Growth leads to greater prosperity for society.

• Lessens the burden of scarcity.

• Increases the general level of well-being.

Conditions for Growth

• Rule of Law

• Sound Legal and Economic Institutions

• Economic Freedom

• Respect for Private Property

• Political & Economic Stability

– Low Inflationary Expectations

• Willingness to sacrifice current consumption in order to grow

• Saving

• Trade

Physical Capital

• Tools, machinery, factories, infrastructure

• Physical Capital is the product of Investment.

• Investment is sensitive to interest rates and expected rates of return.

• It takes capital to make capital.

• Capital must be maintained.

Technology & Productivity

• Research and development, innovation and invention yield increases in available technology.

• More technology in the hands of workers increases productivity.

• Productivity is output per worker.

• More Productivity = Economic Growth.

Human Capital

• People are a country’s most important resource. Therefore human capital must be developed.

• Education

• Economic Freedom

• The right to acquire private property

• Incentives

• Clean Water

• Stable Food Supply

• Access to technology

[pic]

[pic]

Hindrances to Growth

• Economic and Political Instability

– High inflationary expectations

• Absence of the rule of law

• Diminished Private Property Rights

• Negative Incentives

– The welfare state

• Lack of Savings

• Excess current consumption

• Failure to maintain existing capital

• Crowding Out of Investment

– Government deficits & debt increasing long term interest rates!

• Increased income inequality ( Populist policies

• Restrictions on Free International Trade

XVI: Disputes over Macro Theory and Policy

A. Classical Theory:

Classical economic theory dominated economic thinking from Adam Smith in the 1770’s until the 1930’s with the onset of the Great Depression and the Keynesian influenced deficit spending of Franklin Roosevelt’s New Deal programs.

AS Curve is Vertical:

In the Classical analysis the AS curve is vertical at the full-employment level of GDP. The downsloping AD curve is stable and is the sole determinant of the

price level. According to the classicals, the economy will operate at its full-

employment level output. Recessions and inflations are temporary situations and

the economy will automatically self-adjust in the long-run to its full-employment level of output. This adjustment is based on the following:

(1) Say’s Law, which states that “supply creates its own demand,” which means that the act of producing output will create the income needed by people to

purchase all of that output. If AD declines, no problem, the economy must only

produce output to maintain employment; the act of producing output generates

exactly the amount of income needed to purchase the output.

(2) Flexible wages, prices, and interest rates: If the economy strayed from

full-employment, this would only be a temporary situation as wages, prices, and

interest rates would be upwardly and downwardly flexible in order to return the

economy to a full-employment output position. If people save their income rather

than spend it, output and employment will not decline. This is because the

mechanism of interest rates maintains an equilibrium between savings and

investment. If consumers save more, interest rates will fall and businesses will

invest more. If savings declines, interest rates will rise and business investment

will decline. And if AD falls, wages will fall. If wages fall, price falls. Lower

prices will be an incentive for consumers to buy more, which will increase AD.

Therefore, there is no need for government intervention in the economy because

of the economy’s self-regulating mechanisms. Government intervention, in fact,

may interfere with the economy’s self-regulating mechanisms and thereby cause instability.

The Classical AS Curve:

[pic]

Classicals and Money Velocity:

Classicals believe that the velocity of money is stable. This is because people have a stable desire to hold money relative to holding other financial and real

assets. Factors determining the amount of money people hold at any one time

depend upon how often they get paid, their inflationary expectations, and the real

level of interest rates.

B. Keynesian Theory:

In the 1930’s during the Great Depression, John Maynard Keynes asserted that laissez-faire capitalism is subject to recurring recessions that bring widespread

unemployment. In Keynes’ view, active government involvement is required to

stabilize the economy and prevent valuable resources from standing idle. In

response to the Classical assumption that the economy will self-adjust to full-

employment in the long-run is that “in the long-run we are all dead.”

AD Critical:

The main determinant of the level of output and employment in the economy according Keynesian analysis is the level of AD or AE. If income increases, consumers will buy more, and producers will produce more. If income declines, however, consumers will fail to purchase the output produced, and producers will

cut back.

Wages, Prices, Interest Rate Not Flexible:

Wages and prices are not downwardly flexible. Wages are downwardly inflexible

because of collective bargaining contracts between unions and management

which set wages for a number up to three years and salaries which are set for a

year or so. Firms with monopoly or oligopoly power generally do not decrease

prices during times of recession, they would rather reduce output and lay off

people. Interest rates are not equate the leakage of savings with investment because people save for different reasons and companies invest for different

reasons. In addition, during times of sever recession or depression, companies

may not invest even if interest rates are low. This is because there would be little

opportunity to sell their increased output.

Therefore, active government management of AD is needed in order to maintain a

full-employment level of output.

The Keynesian AS Curve:

[pic]

Keynesian View on Velocity of Money:

The Keynesian view here is that the velocity of money is unstable. This is because money is not only demanded for transactions, but also to hold onto as a

asset. Transactions money is “active” and asset money is “idle.” The greater the

importance of “active” transactions, the larger velocity is. The greater the relative

importance of of “idle” transactions, the smaller velocity will be. Keynsians

believe the following about the velocity of money and interest rates:

a. Velocity varies directly with the rate of interest.

b. Velocity varies inversely with the supply of money.

If M goes up, then interest rates go down. This makes it less expensive to hold

onto M as an asset, thus velocity goes down. Bond prices rise and people sell

some bonds. They hold more cash and velocity decreases. If M decreases, then

interest rates go up. This makes it more expensive to hold M as an asset (more of

an opportunity cost in terms of interest lost on an investment). People buy some

bonds, hold less cash as an asset, and velocity increases.

C. Monetarism:

Monetarists are part of the Neoclassical or New Classical school of economics.

One of the leading proponents of Monetarism was Milton Friedman from the

University of Chicago. The believed in the following tenants:

1. Markets are highly competitive, this gives the economy a high degree of

stability.

2. Wages and prices would be flexible except for government interference via

minimum wage, pro-union laws, price supports, pro-business monopoly laws,

and discretionary monetary an fiscal policy.

3. Monetarism focuses on the Equation of Exchange: MV = PQ

4. They argue that Velocity is stable in the short-run for the same basic reasons as

the Classicals. This is because people have a stable desire to hold money

relative to holding other financial and real assets. Factors determining the

amount of money people hold at any one time depend upon how often they get

paid, their inflationary expectations, and the real level of interest rates.

5. Monetarists believe that fiscal policy is weak and ineffective due to the

“crowding out” effect, this deficit spending’s affect on AD is unpredictable at

best. They also criticize monetary policy due to the time lags between when

monetary policy is implemented and when it actually affects the economy.

6. Monetarists also believe in a vertical AS curve at full-employment, like the

Classicals.

Monetarist Solution:

The monetarist solution is to propose a “monetary rule.” That is to increase the

annual rate of growth of the money supply by 3 to 5% and match the expected

annual level of Real GDP growth. The stability provided by the competitive

market will allow for economic stability and long-term growth.

D. Rational Expectations Theory:

Like the Monetarists, the Rational Expectations Theorists are a Neo-Classical

School of Economics. They also believe that markets are highly competitive and

wages and prices are flexible. They concur with the Classicals and Monetarists

that the AS curve is vertical at full-employment.

Rational Expectations Theorists’ Solution:

The Rational Expectations Theorists also propose a Monetary Rule like the

Monetarists. However, their reasoning is different. They propose a Monetary

Rule not because of the incompetence of government officials, but because of the

public’s reactions to the government’s attempts to stabilize the economy. They

believe that the public will react rationally and adjust their investment options to

counter fiscal policy changes by Congress/President and monetary policy changes

by the Fed. This would render those attempts to stabilize the economy

ineffective. Therefore a monetary rule tying the annual rate of growth of the

money supply with the expected annual rate of growth of Real GDP will work

best.

XVII: Foreign Exchange (FOREX):

• The buying and selling of currency

– Ex. In order to purchase souvenirs in France, it is first necessary for Americans to sell their Dollars and buy Euros.

• Any transaction that occurs in the Balance of Payments necessitates foreign exchange

• The exchange rate (e) is determined in the foreign currency markets.

– Ex. The current exchange rate is approximately 8 Yuan to 1 dollar

• Simply put. The exchange rate is the price of a currency.

Changes in Exchange Rates

• Exchange rates (e) are a function of the supply and demand for currency.

– An increase in the supply of a currency will decrease the exchange rate of a currency

– A decrease in supply of a currency will increase the exchange rate of a currency

– An increase in demand for a currency will increase the exchange rate of a currency

– A decrease in demand for a currency will decrease the exchange rate of a currency

Appreciation and Depreciation

• Appreciation of a currency occurs when the exchange rate of that currency increases (e↑)

• Depreciation of a currency occurs when the exchange rate of that currency decreases (e↓)

– Ex. If American tourists flock to France to go shopping, then the supply of dollars will increase and the demand for Euros will increase. This will cause the Euro to appreciate and the dollar to depreciate.

[pic]

Exchange Rate Determinants

• Consumer Tastes

– Ex. a preference for Japanese goods creates a decrease in the supply of Yen in the currency exchange market which leads to depreciation of the Euro and an appreciation of Yen.

[pic]

• Relative Income

– Ex. If the U.S. economy is strong, then Americans will buy more British goods, increasing the demand for the British Pound, causing the Pound to appreciate and the dollar to depreciate

[pic]

• Relative Price Level

– Ex. If the price level is higher in Japan than in the United States, then American goods are relatively cheaper than Japanese goods, thus Japanese will import more American goods causing the U.S. Dollar to appreciate and the Japanese Yen to depreciate. This can be shown by a decrease in the demand for the Yen below:

[pic]

• Speculation

– Ex. If U.S. investors expect that German real interest rates will climb in the future, then Americans will demand more Euros in order to earn the higher rates of return in Germany. This will cause the Dollar to depreciate and the Euro to appreciate.

[pic]

Exports and Imports

• The exchange rate is a determinant of both exports and imports

• Appreciation of the dollar causes American goods to be relatively more expensive and foreign goods to be relatively cheaper thus reducing exports and increasing imports

• Depreciation of the dollar causes American goods to be relatively cheaper and foreign goods to be relatively more expensive thus increasing exports and reducing imports

[pic]

[pic]

[pic]

[pic]

XVIII: Balance of Payments:

• Measure of money inflows and outflows between the United States and the Rest of the World (ROW)

– Inflows are referred to as CREDITS

– Outflows are referred to as DEBITS

• The Balance of Payments is divided into 3 accounts

– Current Account

– Capital/Financial Account

– Official Reserves Account

Current Account

• Balance of Trade or Net Exports

– Exports of Goods/Services – Import of Goods/Services

– Exports create a credit to the balance of payments

– Imports create a debit to the balance of payments

• Net Foreign Income

– Income earned by U.S. owned foreign assets – Income paid to foreign held U.S. assets

– Ex. Interest payments on U.S. owned Brazilian bonds – Interest payments on German owned U.S. Treasury bonds

• Net Transfers (tend to be unilateral)

– Foreign Aid ( a debit to the current account

– Ex. Mexican migrant workers send money to family in Mexico

Capital/Financial Account

• The balance of capital ownership

• Includes the purchase of both real and financial assets

• Direct investment in the United States is a credit to the capital account

– Ex. The Toyota Factory in San Antonio

• Direct investment by U.S. firms/individuals in a foreign country are debits to the capital account

– Ex. The Intel Factory in San Jose, Costa Rica

• Purchase of foreign financial assets represents a debit to the capital account.

– Ex. Warren Buffet buys stock in Petrochina.

• Purchase of domestic financial assets by foreigners represents a credit to the capital account.

– The United Arab Emirates sovereign wealth fund purchases a large stake in the NASDAQ.

[pic]

Relationship between Current and Capital Account

• Remember double entry bookkeeping?

• The Current Account and the Capital Account should zero each other out.

• That is… If the Current Account has a negative balance (deficit), then the Capital Account should then have a positive balance (surplus).

• Ex. The constant net inflow of foreign financial capital to the United States (capital account surplus) is what enables us to import more than we export (current account deficit)

Official Reserves

• The foreign currency holdings of the United States Federal Reserve System

• When there is a balance of payments surplus the Fed accumulates foreign currency and debits the balance of payments.

• When there is a balance of payments deficit the Fed depletes its reserves of foreign currency and credits the balance of payments

• The Official Reserves zero out the balance of payments

Active v. Passive Official Reserves

• The United States is passive in its use of official reserves. It does not seek to manipulate the dollar exchange rate.

• The People’s Republic of China is active in its use of official reserves. It actively buys and sells dollars in order to maintain a steady exchange rate with the United States.

Trade Barriers: Winners and Losers

1. Define tariff - A tax on imported goods.

2. Define quota - A limit on imports.

3. Define embargo - Cutting off trade with another nation

DIRECTIONS: for each of the following examples identify the winners and the losers from trade barriers.

4. The U.S. government imposes a tariff on foreign cars.

a. General Motors ( or ( or ? ---why?

Happy. They can sell more cars and make higher profits.

b. BMW ( or ( or ? ---why?

Sad. They sell fewer cars.

c. Car buyers ( or ( or ? ---why?

Sad. They get higher prices, less selection, and lower quality.

d. The government ( or ( or ? ---why?

Happy. They get tax revenue and political support from the auto industry and its suppliers.

5. The U.S. government imposes a quota on foreign cars.

a. General Motors ( or ( or ? ---why?

Happy. Same reasons as #4.

b. BMW ( or ( or ? ---why?

Sad. Same reasons as #4

c. Car buyers ( or ( or ? ---why?

Sad. Same reasons as #4

d. The government ( or ( or ? ---why?

? They lose tax revenue, but retain political support from the auto industry and its suppliers.

6. Why might the United States impose a trade embargo on a foreign nation?

a. Punish a nation for bad behavior (Saddam Hussein in Iraq, Iran today)

b. Punish a nation for unfair trade practices.

c. To protect infant domestic industries.

XIX: Policy Mix:

Fiscal and Monetary Policy do not exist in a vacuum and operate independent of each other.

Ideally, they should work together to solve common problems in the economy. An

expansionary fiscal policy combined with an expansionary monetary policy will increase

AD and real GDP, increase the PL, and reduce unemployment. A contractionary fiscal

policy combined with a contractionary monetary policy will decrease AD/GDPr, decrease the PL, and increase unemployment.

However, because fiscal and monetary policy actions have opposite effects on interest

rates. As such, it is impossible to predict the effect on investment.

The chart below summarizes the effect of fiscal and monetary policies on interest rates:

| | | |

| |Expansionary |Contractionary |

| | | |

|Fiscal Policy |Increases the real interest rate |Decreases the real interest rate |

| | | |

|Monetary Policy |Decreases the nominal and real interest |Increases the real and nominal interest |

| |rates |rates. |

Shown below is a graphical representation of how fiscal and monetary policy interact and affect AD, real GDP, the unemployment rate, interest rates, and investment:

Policy Mix and Interest Rates:

Policy mix involves using fiscal and monetary policy at the same time. However, each policy has a different effect on interest rates, but the same effect on AD, GDPr, and U%. This results in the

following effect for policy mix situations:

Combination of expansionary fiscal policy and monetary policy:

- Effect on AD, GDPr, and U% = AD & GDPr should go up and U% go down.

- Effect on interest rates = Indeterminate. Fiscal policy increases r%, while monetary policy reduces i% (and r% goes up too, typically).

[pic]

[pic]

[pic]

Combination of contractionary fiscal policy and monetary policy:

- Effect on AD, GDPr, and U% = AD & GDPr should go down and U% go up. Effect on interest rates = Indeterminate. Fiscal policy decreases r%, while monetary policy increases i% (and r% goes up too, typically).

[pic]

[pic]

[pic]

Combination of expansionary fiscal policy and contractionary monetary policy:

- Effect on AD, GDPr, and U% = Indeterminate. The expansionary fiscal policy should increase AD, GDPr, and reduce u% while the contractionary monetary policy should decrease AD, GDPr, and increase u%. Effect on interest rates = Increase. Expansionary Fiscal policy increases r% and contractionary monetary policy increases i%.

Combination of contractionary fiscal policy and expansionary monetary policy:

- Effect on AD, GDPr, and U% = Indeterminate. The contractionary fiscal policy should reduce AD, GDPr, and increase u% while the expansionary monetary policy should increase AD, GDPr, and reduce u%. Effect on interest rates = Decrease. Contractionary fiscal decreases r%, while expansionary monetary policy decreases i%.

XX: SELF-CORRECTING ECONOMY:

A. What does a self-correcting economy involve?

A situation where an economy self-corrects to the full-employment level of GDPr without government intervention (ex: fiscal or monetary policy action)

B. If the economy is in recession, what happens to wages and other input costs in t he

LR?

They go down. People will take jobs at lower pay due to the recession.

C. With lower wages/input costs during a recession, what will happen to production costs

and the SRAS?

Production cost go down and the SRAS shifts rightward to restore the economy to the

full-employment level of GDPr.

D. If there is an inflationary gap, what will happen to wages/input costs and

overall production costs?

Workers will demand and get higher nominal wage increases, thus increasing

production costs.

E. With the increased production costs during an inflationary gap, what

which curve will shift and in which direction to restore the economy to the

full-employment level of GDPr?

The SRAS will shift leftward to restore the economy to the full-employment

level of GDPr.

-----------------------

5/10= 1/2

15/10 = 3/2

12/3 = 4

2/10 = 1/5

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download