AP Macro: Economic Models and Graphs Study Guide

Price Level

AP Macro: Economic Models and Graphs Study Guide

Economic Conditions

Recession LRAS SRAS

Price Level

Serious Inflation LRAS SRAS

PL1

PL1

AD

AD

Y1 YF

Real GDP

Full Employment with Mild Inflation

Price Level

LRAS SRAS

PL1

Price Level

PL2

PL1

YF Y1 Real GDP

Stagflation SRAS2 LRAS SRAS1

SRAS Cost-Push Inflation

AD

AD

YF

Real GDP

Y2 YF

Real GDP

Interest Rate

Sm1 Sm2

Effects of Expansionary Monetary Policy

Interest Rate

Price Level

LRAS SRAS

i1 i2

i1 i2

PL2 PL1

AD2

Dm

ID

AD1

Q1 Q2 Q of Money

Q1 Q2 Q of Investment $

Y1 YF

RGDP

MS i

i I (and C)

AD PL GDP

(Sm)

unemployment

Expansionary Monetary Policy actions by FED:

Short Run vs Long Run Effects

reserve requirement

Short Run: i I AD (shift right) PL and

discount rate

output and unemployment; net export effect: Xn

Buy U.S. government bonds/securities (Open

Long Run eco growth: I LRAS (shift right ?

Market Operation)

same as shift right of PPC curve)

Interest Rate

Sm2 Sm1

Effects of Contractionary Monetary Policy

Interest Rate

Price Level

LRAS SRAS

i2 i1

i2 i1

PL1 PL2

AD1

Dm

ID

AD2

Q2 Q1 Q of Money

Q2 Q1 Q of Investment $

YF Y1

R GDP

MS i

i I (and C)

AD PL GDP

unemployment

Contractionary (Restrictive) Monetary Policy

Short Run vs Long Run Effects

actions by FED:

Short Run: I AD (shift left) PL output

reserve requirement

unemployment; Net export effect: Xn

discount rate

Sell U.S. bonds/securities (Open Market Operation) Long Run Eco. growth: I LRAS (shift left ?

same as shift left of PPC curve)

Effects of Expansionary Fiscal Policy: G T (creates deficit; government must borrow $ to spend)

Interest Rate

Sm Interest

Rate

Price Level

LRAS SRAS

i2 i1

i2 i1

PL2 PL1

AD2

Dm2

AD3

Dm1

ID

AD1

Q1

Q of Money

Q2 Q1 Q of Investment $

Y1 YF

RGDP

Dm i

i I (and C) (Crowding out effect)

Crowding out weakens the impact of expansionary fiscal policy

Expansionary Fiscal Policy actions:

Short Run vs Long Run Effects of Expansionary

Fiscal Policy

Increase in G directly increases AD as G is a

Short Run: increases AD (shift right): PL and

component of AE. Decrease in T increases Yd (disposable income) and more spending (C) occurs. Overall impact is increase in AD (increase in output, employment and PL). Side Effect: Deficit spending increases the demand

output; unemployment. Deficit Dmi I due to crowding out effect and Xn due to net export effect (I D foreign demand for bonds appreciation of $ Xn)

for money and pushes up interest rates. Higher interest rates crowd out some business investment and interest rate sensitive spending by consumers. To the extent that crowding out occurs, the expansionary

Long Run Economic Growth: decrease I decreases LRAS (shift left ? same as shift left of PPC curve) (depends on the amount of crowding out that occurs)

impact of the fiscal policy will be weakened.

Effects of Contractionary Fiscal Policy: G T (moves budget toward surplus; less borrowing)

Interest Rate

Sm Interest

Rate

Price Level

LRAS SRAS

i1 i2

i1 i2

PL1 PL2

Dm1

Dm2

ID

AD1 2

Q1

Q of Money

Q1 Q2 Q of Investment $

YF Y1 RGDP

Dm i

i I (and C)

(lessening of Crowding out effect)

overall impact: AD

Impact of Monetary and Fiscal Policies on Interest Rates and Business Investment Spending

Policy

Money Market

Interest Rates Investment (I)

Expansionary Monetary Policy Expansionary Fiscal Policy

Contractionary Monetary Policy Contractionary Fiscal Policy

Increase supply of money Increase demand for money Decrease supply of money Decrease demand for money

decrease increase increase decrease

increase decrease decrease increase

Effect of an increase in G or decrease in T

Effect of a decrease in G or increase in T

Initially at Full Employment

Initially at Full Employment

Price Level

LRAS SRAS

Price Level

LRAS SRAS

PL2

PL1

PL1

PL2 AD2

AD1

AD1

AD2

YF Y2 Real GDP

Y2 YF

Real GDP

Effect of a supply-side shock:

Initially at Full Employment

Price Level

PL2

SRAS2 LRAS SRAS1

PL1

AD

Effect of an increase in G and T of same amount: *

Initially at Full Employment

Price Level

LRAS SRAS

PL2 PL1

AD2 AD1

Y2 YF Real GDP

YF Y2 Real GDP

Balanced budget increase in G and T is expansionary. * If G and T were decreased by the same amount, the effect would be contractionary ( AD

Short Run vs Long Run Adjustments

Short Run --- not enough time for wages to adjust to price level changes. Changes in PL, output and unemployment occur. Long Run --- enough time for wages to adjust; key effect is on PL.

PL

LRAS

SRAS1 SRAS2

AD PL and output

and unemployment in SR

PL1

a

PL2

b

AD1

PL3

c

AD2

Y2 YF Real GDP

Over time lower PL and surplus of labor put downward pressure on wages.

Wages lower business costs and SRAS. LR: Lower PL. (a c)

If PRICES AND WAGES ARE FLEXIBLE --- NOT STICKY!

Short Run vs Long Run Adjustments

If PRICES AND WAGES ARE FLEXIBLE --- NOT STICKY!

SRAS2

PL

LRAS SRAS1

AD PL and output

PL3

c

and unemployment in SR

PL2

b

Over time higher PL and

PL1

a

AD2

shortage of labor put

upward pressure on wages.

AD1

YF Y2 Real GDP

Wages raise business costs and SRAS. LR: Higher PL.

1

Nonprice Level Determinants of Aggregate Supply and Aggregate Demand

C + I + G + Xn = AE AD GDP (Direct relationship between any component of AE and AD and GDP)

Factors that Shift AD Curve

personal taxes ( Yd) corporate income taxes ( profit exp.) government spending (exp. Fiscal) G and T by same amount . G offsets the C. Effect = 1 x G. profit expectations of businesses wealth or consumer indebtedness exports / imports $ depreciates money supply interest rates

Net export effect deficit spending DLF and/or Dm interest rates (i)

in personal taxes ( Yd) corporate income taxes (profit exp.) government spending (contr. Fiscal ) G and T by same amount . G offsets the C. Effect = 1 x G. profit expectations of businesses wealth or consumer indebtedness exports / imports $ appreciates money supply interest rates

Net export effect deficit spending DLF and/or Dm interest rates (i)

Factors that Shift the SRAS

C AD resource availability I AD WAGES (or any other resource cost) G AD New technology

AD PRODUCTIVITY

I AD government regulation C AD government subsidies Xn AD business taxes (sales/excises) Xn AD costs of production I C AD Xn I AD

C AD Supply-side shock ( energy prices) I AD resource availability G AD WAGES (or any other resource cost) G AD technology

I C Xn Xn I C Xn I

AD AD AD AD

AD

AD

PRODUCTIVITY government regulation government subsidies business taxes (sales/excises) costs of production

inflationary expectations wages

SRAS SRAS SRAS SRAS

SRAS SRAS SRAS SRAS

SRAS SRAS SRAS SRAS

SRAS SRAS SRAS SRAS SRAS

SRAS

INCREASE = SHIFT RIGHT DECREASE = SHIFT LEFT (APPLIES TO BOTH CURVES)

Reasons for the inverse relationship between the price level and the quantity of real output purchased (negative slope of the AD curve):

? Interest rate effect: PL Dm i quantity of I and C (real output purchased) (opposite true if PL) ? Wealth/Real balances effect: PL purchasing power of wealth/real balances quantity of C ? Foreign Purchases effect: PL exports (seem more expensive) and imports (seem cheaper) Xn

Reason for the positively sloped AS curve (direct relationship between the PL and the quantity of real output produced): higher PL needed to encourage higher production. Demand-pull inflation: AD PL (too much money chasing too few goods) Cost-push inflation: SRAS PL (stagflation)

If AD no in PL but increases in output and employment, the economy is operating in the horizontal (Keynesian) portion of its AS curve. High unemployment allows businesses to hire more workers without putting pressure on wages or prices. If AD PL but no in output and employment, economy is operating in the vertical (classical) range of its AS curve. Increased demand puts pressure on prices only as economy is operating at its maximum of output and employment.

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