ap macro review - ms. lopiccolo's website · 2020-05-09 · unemployment rate = number...

CAP MACRO REVIEW

The Three Types of Capital

Physical capital

•Machinery

•Plant

•Equipment

Human capital

•Education, skill level, experience

Financial capital

•Money

Unemployment Rate

Unemployment Rate = Number UnemployedLabor Force

x 100

• If given the number of employed and unemployed, you can sum both to get the labor force (sometimes you will be given the total civilian population to use and will need to subtract those who are not a part of the labor force)• Remember to take out those not actively looking for a job and

discouraged workers

Labor Force Participation Rate

Labor forceTotal population age 16 and over x 100

Nominal GDP

Nominal GDP = Deflator x Real GDP100

• This is the prices we see and pay for good and services

Real GDP

•Real GDP = Nominal GDP

GDP Deflator or Price Index

OR

•Real GDP= Nominal GDP

GDP Deflator or Price Index in hundredths

6

x 100

GDP

Good Price Quantity Total

Shoes $50 10 $500

T-shirts $10 50 $500

Socks $6 100 $600

$1,600

Nominal GDP: Sum of all Prices x Quantities

GDPGood 2015

Quantity2015 Price(Base year)

2016Quantity

2016 Price

Shoes 10 $50 12 $60

T-shirts 10 $10 15 $15

Socks 5 $6 10 $8

Nominal GDP in 2015 = 10 (50)+ 10(10) + 5(6) = 500+100+30= $630

GDP

Real GDP in 2016 = 12 (50)+ 15(10) + 10(6)= 600+150+60= $810

Take the 2016 quantities times the 2015 prices since 2015 is the base year

Good 2015Quantity

2015 Price(Base year)

2016Quantity

2016 Price

Shoes 10 $50 12 $60

T-shirts 10 $10 15 $15

Socks 5 $6 10 $8

GDP Deflator

10

GDP Deflator = Nominal GDPReal GDP

x 100

•The GDP deflator measures the prices of all goods (not just the market basket) produced in a nation relative to a base year

Inflation• Inflation is calculated year to year unlike the CPI, which is calculated relative to a base year

• If given the value of inflation in two different years, you can calculate the change in inflation

CPI= Year 2 - Year 1Year 1 or base year

x 100

Price Index/CPI•A price index/CPI: a number that summarizes what happens to a weighted composite of prices of a selection of goods over time

•The price index (CPI) is always 100 in the base year unless otherwise stated

•CPI is the most commonly used measurement of inflation

•Looks at a market basket of about 400 goods and services

CPI• If given the value of market baskets in two different years, you can calculate the CPI

•**The CPI is a number, not a percentage

CPI= Value of market basket in current year Value of market basket in base year

x 100

Calculating the Market Basket, Inflation, and CPI

Year Basket Price Inflation Rate

CPI

2015 $16 --

2016 50

2017 $40

2018 25%

2019 $56

Complete the table


• Start by finding the market basket values first

• Start with 2018. You see that prices increased 25% from 2017 (the base year)• What is 25% of $40 (the value of the basket in 2017)?

• $10• So…the value of the market basket in 2018 must be $50• Double check: [50-40/40] x 100 = 25%


• Finding the market basket value for 2016• Based on the 2016 CPI value of 50, you know that prices are 50%

less than they were in 2017• So, that means the 2016 market basket is $20


• Calculate the inflation rate for 2017:• [20-16/16] x 100= 25%


• Calculate the CPI for 2018• [50/40] x 100=125


Year Basket Price Inflation Rate

CPI

2015 $16 -- 40

2016 $20 25% 50

2017 $40 100% 100

2018 $50 25% 125

2019 $56 12% 140

Completed table

AS/AD

•Demand pull inflation: inflation that occurs when the economy is at or above potential output

•There is an excess demand for goods

• In the short run it will be represented by an increase in AD

• In the long run, the economy would adjust back to equilibrium as SRAS decreases (wages and prices decrease)

AS/AD

•Cost-push inflation: inflation that occurs when the economy is below potential output

•Usually due to an increase in input costs

•Will be represented on an AS/AD graph by a decrease (leftward) shift in SRAS

•Stagflation would led to a decrease (leftward) shift in SRAS

AS/AD

•What happens to AS/AD when there is no government action (no change in taxes or government spending?)

• If in a recessionary gap: SRAS shifts to the right (increases) as wages and input prices decrease

• If in an inflationary gap: SRAS shifts to the left (decreases) as wages and input prices increase

Investment Spending

•Private domestic investment spending (I)

•Domestic spending by firms on capital stock

•Capital stock: the amount of capital goods available for use in the production of goods and services

•Capital goods: goods used to produce other goods and services

Supply Shocks

•A negative supply shock is a decrease in supply and raises prices

•A positive supply shock is an increase in supply and lowers the price of goods

Impact of Fiscal and Monetary Policies on AS/AD

What fiscal and monetary policies will lead to an increase in AD?

• Expansionary fiscal policies

• Increase in government spending

• Decrease in taxes

• Expansionary monetary policies

• Increase in MS

• Buying bonds (open-market purchase)

• Decrease in reserve requirement

• Decrease in discount rate

How do expansionary policies affect each of the following?

• Relative income

• When SRAS is horizontal or upward sloping, AD increases and real GDP increases

• Relative inflation rates

• When SRAS is horizontal there is no change in PL

• When SRAS is upward sloping or vertical, AD increases and PL increases

• Relative interest rates

• It depends

Simple (Fiscal) Spending Multiplier

•Multiplier=1/MPS

•Multiplier= 1/(1– MPC)

• If given the amount of the gap, divide it by the multiplier to determine how much must be spent in order to get to long run equilibrium

•Total change in GDP equals the spending multiplier x initial change in spending

Tax Multiplier• It is always one less than the simple spending multiplier (transfer payments work the same way)

•Tax multiplier = MPC/MPS

•Or: MPC x Spending Multiplier

•Use the one that makes the math easier

Interest Rates

• Simply put, if inflation increases, so do nominal interest rates

• Example: Increase in AD leads to a higher price level

•Result: Increase in demand for money and a higher NIR

• Then, the supply of loanable funds decreases (due a higher NIR the RIR is also higher)

Interest Rates and Investment Spending

• Short-term borrowing by firms is a function of nominal interest rates

• Long-term borrowing by firms is a function of real interest rates

•All else equal:

•When the real interest rate increases, investment spending decreases

•When the real interest rate decreases, investment spending increases

Interest Rates

•Nominal interest rate: the stated or published rate (the rate you “see”)

•Nominal interest rate = Real interest rates + expected rate of inflation

• In the short-run (before inflationary expectations have changed) nominal and real interest rates move together

Interest Rates

•Real interest rate: the actual cost of borrowed money

•Real interest rate = Nominal - expected rate of inflation

• In the long-run (once inflationary expectations have been factored in to decision-making) nominal interest rates adjust to achieve a desired real interest rate

Nominal and Real Interest Rates(Money Market and Loanable Funds Graphs)

•Money Market graph and expansionary monetary policy

• In the short run:

• Increase money supply

•Decreases interest rates

• Increases investment (consumer spending & GDP)

• In the long run:

• This will increase the price level and increase the demand for money

• Consistent with Quantity Theory of Money MV=PY

•A increase in the money supply increases inflation but real GDP stays the same

Nominal and Real Interest Rates(Money Market and Loanable Funds Graphs)

• Loanable Funds is a long run graph

• Real interest rate= Nominal interest rate – inflation

• If more inflation that is expected, it decreases the supply of loanable funds and increases the (nominal) interest rate

• Borrowers would also demand more loans because inflation would make those loans easier to pay back in the future

• So, nominal interest rate increases due to inflation, but the real rate stayed the same

• The Fisher effect: an increase in expected inflation causes nominal interest rates to increase

•See Mr. Clifford Video Money Market and Loanable Funds

Bond Prices and Interest Rates

•**Bond prices and interest rates are always inversely related**

Expansionary Monetary Policy and Expansionary Fiscal Policy

Expansionary Fiscal Policy

Expansionary Monetary Policy

Determinate or Indeterminate

AD Increase Increase Determinate

Real GDP Increase Increase Determinate

Employment Increase Increase Determinate

Price level Increase Increase Determinate

Interest rates Increase Decrease Indeterminate

Investment spending Decrease Increase Indeterminate

Expansionary monetary policy mitigates the increase in real interest rates caused by expansionary fiscal policy

How do monetary policies affect the economy in the long-run?

• If there is an increase in the money supply:

•Nominal interest rate decreases

•AD increases

• Real GDP increases

• Price level increases

How do monetary policies affect the economy in the long-run?

• The long-run neutrality of money

• Potential output is a function of economic resources

•Money is NOT an economic resource

• Changes in the money supply have NO affect on potential output

• The long-run effects of expansionary monetary policy:

•Real GDP: no change

• Employment: no change

• Price level: increase

The Federal Funds Rate

•Federal funds are loans of excess reserves that banks make to one another

•The federal funds rate is the interest rate that banks charge one another for one-day loans of reserves

•By selling bonds, the Fed decreases reserves•This causes the federal funds rate to increase (banks have less

reserves to loan out)•By buying bonds, the Federal increases reserves•This causes the federal funds rate to decrease (banks have more

reserves to loan out)

The Federal Funds Rate as an Operating Target

• If the federal funds rate is above the Fed’s target range, it buys bonds to increase reserves and lower the federal funds rate

• If the federal funds rate is below the Fed’s target range, it sellsbonds to decrease reserves and raise the federal funds rate

Money Market• MS shifters are the three tools used by the Fed:

• Open-market operations (buying/selling of bonds)

• Reserve requirement

• Discount rate

• MD shifters

• Changes in income (or real GDP)

• Changes in the price level

• Changes in expectations (of prices)

• Changes in preferences

• MD Examples (how you might see it in the FRQs):

• A drop in credit card fees causes consumers to use credit cards more often (increases MD)

• Consumers hold less cash and use credit cards more often (decreases MD)

• Consumers’ income increases (increases MD)

Loanable Funds• The market for borrowers and savers

• Loanable funds are demanded by borrowers, businesses, and the government

• Demand shifters (Borrowers and investors):

• Government borrowing (increase D or Decrease S)

• Government deficit spending (leads to crowding out)

• Demand for loanable funds examples (how you might see it in the FRQs):

• A country’s government increases deficit spending

• An increase in government borrowing from the public

• Increase in a country’s budget deficit

• Businesses are granted a tax credit for spending on machinery

Loanable Funds• Supply shifters (Lenders and savers):

• Increase in savings (public savings)

•Higher real interest rate on assets (increases supply)

• Supply for loanable funds examples (how you might see it in the FRQs):

• Increase in a country’s national savings

•Government reduces tax rate on household interest earnings

• The tax rate on household interest earning is lowered

• The government issues a special tax incentive to get individuals to increase savings for retirement

Loanable Funds• Supply for loanable funds is also the same as demand for bonds as

savers want to generate income on savings

•Demand for loanable funds is also the same supply of bonds as firms and governments issue bonds to raise financial capital

• (This is not something we covered in class; I don’t expect you will see it on the AP exam)

Loanable Funds and Crowding Out

•Assume that the economy is in a recessionary gap and that the government is operating a balanced budget

• The government implements an expansionary fiscal policy to close the recessionary gap

• So, there is an increase in government spending and/or decrease in taxes

•AD shifts to the right

• But, this expansionary fiscal policy caused the balanced budget to move into a deficit

•As a result, there is an increase in the demand for loanable funds, which increases the real interest rate, and crowds out domestic private investment spending

Creation of Money • Required reserve ratio is 10%. Adam Smith deposits $100 in the bank.

•What is the maximum dollar amount the bank can loan out?

• $90 ($100-$10)

•What is the maximum change in demand deposits?

• $1,000 (100 x 10)

•What is the maximum change over time in loans?

• $900 (90 x 10)

•What is the maximum change over time in the money supply?

• $900 (90 x 10)

•Watch Mr. Clifford Bank Balance Sheets Video

Creation of Money • Required reserve ratio is 10%. The Fed buys $1,000 in bonds.

•What is the maximum dollar amount the bank can loan out?

• $1,000

•What is the maximum change in the money supply?

• $10,000 (1,000 x 10)

•What is the maximum change in checkable bank deposits?

•No change (buying bonds does not impact customer accounts)

•What is the maximum change in required reserves?

• $1,000 (bonds become reserves until loaned out)

•Watch out for a question that asks about the public buying bonds…you would then have to hold 10%

Bank Balance Sheet

•Maximum change in anything= initial change x the money multiplier

•Maximum change in the money supply= (initial change in excess reserves x multiplier) + initial change in money supply

Bank Balance Sheet

Assets Liabilities

Required reserves $10,000Loans $70,000Treasury bonds $20,000

Demand deposits $100,000

What is the reserve ratio?

Bank Balance Sheet

Assets Liabilities



What is the reserve ratio?10%

Bank Balance Sheet

Assets Liabilities



How are reserves impacted if a customer withdraws $5,000?

Bank Balance SheetAssets Liabilities



How are reserves impacted if a customer withdraws $5,000?The bank will need to increase reserves by $4,500 (needs to hold 10% of $9,500 but only has $5,000 in reserves)

Assets Liabilities



Impact of Fiscal Policy on the Budget

When the budget balance is negative, the government is running a deficit

When the budget balance is zero, the government is running a balanced budget

When the budget balance is positive, the government is running a surplus

Expansionary fiscal policy causes receipts to decrease and outlays to increase



The government will have to borrow money to pay for the increase in the deficit

The government will have to borrow money because it goes into a deficit

The government will have to run down its surplus to pay for the expansionary policy

Demand for loanable funds increases; real interest rate increases

Demand for loanable funds increases; real interest rate increases

Supply of loanable funds decreases; real interest rate increases

Balanced Budget and Fiscal Policy• Changes in government spending have a greater effect on AD than changes in taxes or

transfer payments

• Spending multiplier: 1/1-MPC or 1/MPS

• Tax multiplier (and transfer payment multiplier): MPC/MPS

• If MPC is 0.75:

• The spending multiplier is 4

• The tax multiplier is 3

• If the government increases spending by $10 billion:

• AD increase by $40 billion (10 x 4)

• If the government raises taxes by $10 billion, AD decreases by $30 billion (10 x 3)

• The net effect on the budget balance=no change

• The net effect on AD= Increase of $10 billion

Economic Growth

An increase in the amount of resources

•An increase in natural resources

•An increase in the amount of labor

•An increase in the labor participation rate

An increase in the productivity of existing resources

• Technological advancement

•An increase in physical capital per worker

•An increase in human capital per worker

What causes economic growth?

Economic Growth

•Why is economic growth a good thing?

• In general, the higher a nation’s real GDP per capita, the higher the standard of living for people in that nation

•What are the limits of using an increase in real GDP as a measure of economic prosperity?

• Real GDP per capita = Real GDP/Population

• If population increases faster than real GDP increases, real GDP per capita falls

•Neither real GDP nor real GDP per capita measure income distribution

Economic Growth

• Economic growth is the real GDP per capita over time illustrated by shifts in the PPC and LRAS

What causes economic growth?

• Productivity gains (increase in output per worker)

How does productivity increase?

• Capital formation: development of capital stock (physical and human

• Development of application of new production technologies

What leads to capital formation?

• Investment spending

Economic Growth• Private domestic investment spending drives economic growth

• Investment spending is spending on capital stock

• The more capital stock, the greater the productive capacity of an economy

• Productive capacity is a function of resources: land, labor, and capital

• Investment spending is a function of real interest rates

•When real interest rates rise, investment spending falls

•A decrease in investment spending causes the economic growth rate to slow, because fewer capital goods are being adding to the economy’s productive capacity

Economic Growth

•How does crowding out factor in to economic growth?

•An increase in government borrowing for deficit spending (due to an expansionary fiscal policy) causes a decrease in private domestic spending due to an increase in real interest rates

Public Policy and Economic Growth• Technological advancements

• Subsidies or tax credits for firms that engage in research and development

• Government spending on programs that lead to technological innovation

• Increase in physical capital per worker

• Subsidies or tax credits for firms that engage in investment spending on physical capital

• Government spending on infrastructure

• Human capital per worker

• Subsidies or tax credits for firms that provide education or job training

• Government spending on education and job training

Rational Expectations Theory

• Looks at past trends but also the best information available to make a best guess of what inflation might be

• If inflation was 2% last year and is 4% this year, but the economists model predicts 2% inflation for the next year, individuals will expect 2% inflation

Short-Run Phillips Curve

• Shifts:

• Changes in productivity

• Changes in input prices

• Changes in inflationary expectations

•SRPC shifts opposite of SRAS

Short-Run Phillips Curve

•A change in AD will move along the SRPC

• If AD increases, inflation increase and unemployment decreases

• If AD decreases, inflation decreases and unemployment increases

Price Level

AD1

SRAS

Real GDPY1

P1

LRASInflation

SRPC

UnemploymentUY

LRPC

AD2

P2

Y2

Result: Higher inflation and lower unemployment

6%

5%

U1

Short-Run Phillips CurveIncrease in AD

Short-Run Phillips CurveIncrease in Inflationary Expectations

Inflation

SRPC1

UnemploymentUY

LRPC

SRPC2

U1

Inflation and unemployment increase

6%

5%

What Shifts LRPC?

•Since LRPC is tied to the natural rate of unemployment (NRU), only a change in frictional or structural unemployment would cause it to shift

ap macro review - ms. lopiccolo's website · 2020-05-09 · unemployment rate = number...

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