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Essential Graphs in Macroeconomics (for Mock Preparation) Graphs are required of students when requested on the AP Economics Exams. Here is a short list of required graphs for macro that can assist students in understanding theoretical material. Students must be able to analyze these graphs as well as construct them. I. The Production Possibility Curve (PPC) or the Production Possibility Frontier (PPF) (a) INVESTMENT GOODS A C PPC B Possibilities Curve CONSUMPTION GOODS Point A. Efficiency = full employment of existing economic resources Point B. Inefficiency = underemployment of existing economic resources Point C. Unattainable with the existing quantity and quality of economic resources and the level of technology (b) Movement from the Recession to the Full-employment = movement from the point inside the PPC to the point on the PPC INVESTMENT GOODS A PPC B Possibil ities Curve CONSUMPTION GOODS (c) The long-run Economic Growth = increase in the Production Possibilities due to the increase in the Quantity and/or Quality of Economic Resources and/or in the Level of Technology = rightward shift of the PPC = movement from point A to point C INVESTMENT GOODS INVESTMENT GOODS INVESTMENT GOODS C A PPC1 PPC2 Possibilities Curve Possibilities Curve CONSUMPTION GOODS (C) CONSUMPTION GOODS CONSUMPTION GOODS II. The Circular Flow Model (a) The Simple (two-sector) Model: household and business, resource and product markets (Circular Flows in a Simple Private Closed Economy) Revenues Spending on goods & services Goods & Services Goods Market Goods & Services Households Firms Economic Resources Incomes Economic Resources Resource Market Factor Payments (b) The Simple (two-sector) Model with the Financial Market (Circular Flows in a Simple Private Closed Economy with Financial Market) Revenues Consumption Spending (C) Goods & Services Goods Market Goods & Services Investment Spending (I) Households Saving (S) Financial Market Loanable Funds (F) Economic Resources Incomes Firms Economic Resources Resource Market Factor Payments (c) The Model with the Government Sector (three-sector model or closed-economy macro model) (Circular Flows in a Mixed Closed Economy) Revenues Goods Market Consumption Spending (C) Government Purchases (G) Taxes (Tx) расходы (С) Investment Spending (I) Taxes (Tx) Government Subsidies (Sb) Loan to the Government Transfers (Tr) Households Saving (S) Loanable Funds (F) Financial Market Incomes Firms Resource Market Factor Payments (d) The Open-Economy (four-sector) Macro Model (Circular Flows in an Open Economy) Exports (Ex) Foreign Sector Imports (Im) Consumption Spending (C) Taxes (С) (Tx) расходы Revenues Goods Market Government Purchases (G) Investment Spending (I) Taxes (Tx) Government Households Transfers (Tr) Saving (S) Subsidies (Sb) Loan to the Government Financial Market Firms Loanable Funds (F) Capital Inflow (when Im > Ex) Resource Market Incomes Factor Payments III. The Business Cycle Points A and C – peak, point B – trough, time period of movement from A to B – recession or contraction, time period of movement from B to C – recovery or expansion. REAL GDP C TREND A BUSINESS CYCLE B TIME (years) IV. The Keynesian Cross Model (a) The Consumption Line, where С – autonomous consumption spending and mpc – marginal propensity to consume. CONSUMPTION SPENDING (C) С C С mpcYD mpc DISPOSABLE INCOME (YD) (b) The Shifts and the Slope of the Consumption Line CONSUMPTION SPENDING (C) Increase in autonomous consumption spending CONSUMPTION SPENDING (C) С 2 mpcYD Increase in marginal propensity to consume С mpc 2 YD С mpc1YD С1 mpcYD С2 С1 mpc С DISPOSABLE INCOME (YD) mpc2 mpc1 DISPOSABLE INCOME (YD) (c) The Saving Line, where С is autonomous saving, and mps – marginal propensity to save. SAVING (S) S С mpsYD DISPOSABLE INCOME (YD) mps С (d) The Shifts and the Slope of the Saving Line SAVING (S) SAVING (S) Increase in autonomous saving Increase in marginal propensity to save S2 С mps2YD S2 С2 mpsYD S1 С1 mpsYD С2 С1 DISPOSABLE INCOME (YD) mps S1 С mps1YD С DISPOSABLE INCOME (YD) mps1 (e) The Investment Line INVESTMENT SPENDING (I) REAL INTEREST RATE (r) In the (I – Y) space In the (r – I) space I(Y) I(r) INVESTMENT SPENDING (I) REAL OUTPUT (Y) (f) The Equilibrium in the Two-sector Model, where YE – equilibrium level of income/output, AEP – planned aggregate expenditures, and IP – planned investment spending AGGREGATE EXPENDITURES (AE) AE = Y SAVING (S), INVESTMENT (I) AEP = C + IP E S С mpsYD E YE YE REAL OUTPUT (Y) IP REAL OUTPUT (Y) (g) The Multiplier Effect of the increase in autonomous planned investment spending, where A is autonomous spending. AGGREGATE EXPENDITURES (AE) AE = Y AEP(I2) B AEP(I1) A2 С I 2 A A1 С I1 Y1 REAL OUTPUT (Y) Y2 (h) The “Paradox of Thrift” SAVING (S), INVESTMENT (I) SAVING (S), INVESTMENT (I) Increase in autonomous saving Increase in the marginal propensity to save S2 B Y2 S1 A IP B A Y2 Y1 Y1 REAL OUTPUT (Y) S2 S1 IP REAL OUTPUT (Y) (i) The Equilibrium in the Three-sector Model (closed economy) and in the Four-sector Model (open economy) AGGREGATE EXPENDITURES (AE) AGGREGATE EXPENDITURES (AE) Closed Economy Open Economy AE = Y AE = Y AEP = C+ IP+G AEP = C+ IP+G+NX E E mpc-mpm mpc YE REAL OUTPUT (Y) YE REAL OUTPUT (Y) (g) Output gaps and expenditure gaps, where YE – equilibrium (short-run) output, and YF – fullemployment (long-run) or potential output. AGGREGATE EXPENDITURES (AE) AGGREGATE EXPENDITURES (AE) Recessionary Gap Inflationary Gap AE = Y AE = Y AEP AEP E E YE < Y F REAL OUTPUT (Y) REAL OUTPUT (Y) YF > Y E (h) Aggregate Demand Curve PRICE LEVEL (P) P2 B A P1 AD Y2 Y1 REAL OUTPUT (Y) (i) Shifting Aggregate Demand PRICE LEVEL (P) Increase in AD PRICE LEVEL (P) Aggregate Demand Decrease in AD Aggregate Demand AD1 AD2 AD2 AD1 REAL OUTPUT (Y) REAL OUTPUT (Y) V. The Fiscal Policy (a) Changes in Government Purchases: increase in G = expansionary fiscal policy, decrease in G = contractionary fiscal policy AGGREGATE EXPENDITURES (AE) AGGREGATE EXPENDITURES (AE) Increase in G AE = Y Decrease in G AE = Y AEP( G2 ) A AEP( G1 ) B A AEP( G1 ) AEP( G2 ) B G G Y1 Y2 Y2 REAL OUTPUT (Y) REAL OUTPUT (Y) Y1 (b) Changes in the Lump-sum Taxes: decrease in T x = expansionary fiscal policy, increase in T x = contractionary fiscal policy AGGREGATE EXPENDITURES (AE) Decrease in T x AE = Y AGGREGATE EXPENDITURES (AE) AEP( T x2 ) Increase in T x AE = Y A AEP( T x1 ) B A AEP( T x1 ) AEP( T x2 ) B ΔC = mpc×Δ T x ΔC = mpc×Δ T x Y1 Y2 Y2 REAL OUTPUT (Y) (c) The Balanced Budget Policy: G T x AGGREGATE EXPENDITURES (AE) AE = Y B AEP( G1 , T x1 ) С ΔC = mpc×Δ T x AEP( G2 , T x 1 ) AEP ( G2 , T x2 ) A G Y1 Y2 Y1' ΔY = G T x REAL OUTPUT (Y) Y1 REAL OUTPUT (Y) (d) Changes in the Proportional Tax Rate: decrease in t = expansionary fiscal policy, increase in t = contractionary fiscal policy. AGGREGATE EXPENDITURES (AE) AGGREGATE EXPENDITURES (AE) Decrease in t AE = Y Increase in t AE = Y AEP(t1) A AEP(t2) AEP(t2) AEP(t1) B B A Y1 Y2 Y1 REAL OUTPUT (Y) Y2 REAL OUTPUT (Y) (e) Changes in Transfer Payments: increase in T r = expansionary fiscal policy, decrease in T r = contractionary fiscal policy AGGREGATE EXPENDITURES (AE) AGGREGATE EXPENDITURES (AE) Increase in T r AE = Y A Decrease in T r AE = Y AEP( T r1 ) A AEP( T r2 ) AEP( T r2 ) AEP( T r1 ) B B ΔC = mpc×Δ T r ΔC = mpc×Δ T r Y1 Y2 Y2 REAL OUTPUT (Y) Y1 (f) The Impact of Automatic Stabilizers on the Business Cycle REAL GDP BUSINESS CYCLE (with the presence of built-in stabilizers) TREND BUSINESS CYCLE (with the absence of built-in stabilizers) TIME (years) REAL OUTPUT (Y) (g) The Laffer Curve TAX REVENUES (Tx) B Txmax A Tx topt t TAX RATE (t) VI. The Loanable Funds Market (a) Equilibrium in the loanable funds market (where rE - real rate of interest, FE – equilibrium quantity of loanable funds, FD – demand for loanable funds, and FS – supply of loanable funds) REAL INTEREST RATE (r) FS E rE FD FE QUANTITY OF LOANABLE FUNDS (F) (b) Shifts in the demand for loanable funds REAL INTEREST RATE (r) Increase in G, Tr or in I FS REAL INTEREST RATE (r) Decrease in G, Tr or in I S F S2 F B r2 A r1 r1 A FD2 FD1 QUANTITY OF LOANABLE FUNDS (F) r2 B FD2 FD1 QUANTITY OF LOANABLE FUNDS (F) (c) Shifts in the supply of loanable funds in the closed economy Decrease in Tx or in SPRIVATE Increase in Tx or in SPRIVATE REAL INTEREST RATE (r) REAL INTEREST RATE (r) FS1 S F FS2 S F FS21 2 B r2 A r1 r1 r2 A B FD FD QUANTITY OF LOANABLE FUNDS (F) QUANTITY OF LOANABLE FUNDS (F) (g) Crowding-out effect of the expansionary fiscal policy (the case of increase in government purchases) REAL INTEREST RATE (r) AGGREGATE EXPENDITURES (AE) REAL INTEREST RATE (r) AE = Y FS AEP( G2 , I1 ) AEP ( G2 , I 2 ) AEP( G1 , I1 ) r2 A' B B r2 B I r1 A A r1 A I(r) FD2 G FD1 Y1 Y2 Y1' REAL OUTPUT (Y) QUANTITY OF LOANABLE FUNDS (F) VII. The Money Market a) Equilibrium in the money market (where iE – equilibrium nominal rate of interest, ME – equilibrium quantity of money, MD – demand for money, MS – supply of money) NOMINAL INTEREST RATE (i) iE MS E MD ME QUANTITY OF MONEY (M) I2 I1 INVESTMENT SPENDING (I) (b) Shifts of the demand for money Increase in the demand for money MS NOMINAL NOMINAL INTEREST INTEREST RATE RATE(i) (i) i2 B iE1 A Decrease in the demand for money NOMINAL NOMINAL INTEREST INTEREST RATE(i)(i) RATE MDD12 M MSS M iE1 AA i2 B MD1 MD1 MEe MD2 QUANTITY OF MONEY (M) MEe QUANTITY OF MONEY (M) (c) Crowding-out effect of the expansionary fiscal policy (the case of increase in government purchases): alternative explanation AGGREGATE EXPENDITURES (AE) INTEREST RATE (i) AE = Y MS AEP(G2,I1) AEP (G2,I2) A' AEP(G1,I1) B B r2 B i2 A r1 i1 ΔI INTEREST RATE (i) A A I(r) MD2 ΔG MD1 Y1 Y2 REAL OUTPUT (Y) Y’1 QUANTITY OF MONEY (M) I2 INVESTMENT I1 SPENDING (I) (d) Shifts of the supply of money NOMINAL INTEREST RATE (i) NOMINAL INTEREST RATE (i) MS1 MS2 i2 i1 A MS2 MS1 B i1 A B i2 MD M1 M2 QUANTITY OF MONEY (M) MD M2 M1 QUANTITY OF MONEY (M) VIII. Monetary Policy (a) Money transmission mechanism under monetary expansion NOMINAL INTEREST RATE (i) INTEREST RATE (i) MS1 i1 LRAS MS2 SRAS A i1 A B i2 PRICE LEVEL (P) P2 B i2 B A P1 MD M1 M2 AD1 I I1 QUANTITY OF MONEY (M) I2 AD2 Y1 INVESTMENT (I) YF REAL OUTPUT (Y) (b) Money transmission mechanism under monetary contraction NOMINAL INTEREST RATE (i) INTEREST RATE (i) MS2 i2 SRAS B i2 A P1 A i1 P2 MD M2 LRAS MS1 B i1 PRICE LEVEL (P) M1 A B AD1 I I2 QUANTITY OF MONEY (M) I1 INVESTMENT (I) AD2 Y2 YF (c) The Shape of the Money Demand Curve NOMINAL INTEREST RATE (i) In the Keynesian Model NOMINAL INTEREST RATE (i) MD QUANTITY OF MONEY (M) In the Monetarist Model MD QUANTITY OF MONEY (M) REAL OUTPUT (Y) (d) The Shape of the Investment Demand Curve In the Keynesian Model INTEREST RATE (r) INTEREST RATE (r) In the Monetarist Model I I INVESTMENT SPENDING (I) INVESTMENT SPENDING (I) IX. The Labour Market (a) Equilibrium in the labour market (where (W/P)E - real wage, LE – equilibrium quantity of labour, LD – demand for labour, and LS – supply of labour) REAL WAGE (W/P) LS E (W/P)E LD LE QUANTITY OF LOANABLE FUNDS (F) (b) Changes in the demand for labour (the main cause are the changes in the labour productivity MPL) Decrease in LD Increase in LD REAL WAGE (W/P) LS REAL WAGE (W/P) S LF S2 B (W/P)2 A (W/P)2 (W/P)1 A LD(MPL2) LD(MPL1) L1 L2 QUANTITY OF LABOUR (L) (W/P)1 B L2 LD(MPL1) LD(MPL2) L1 QUANTITY OF LABOUR (L) (c) Changes in the supply of labour Increase in LS Decrease in LS REAL WAGE (W/P) (W/P)1 LS1 LS2 LS2 REAL WAGE (W/P) LFSS21 (W/P)2 A B (W/P)1 (W/P)2 A B LD LD L1 L2 L2 L1 QUANTITY OF LABOUR (L) QUANTITY OF LABOUR (L) X. Aggregate Demand and Aggregate Supply Model (a) Aggregate Demand Curve PRICE LEVEL (P) B P2 A P1 AD Y2 Y1 REAL OUTPUT (Y) PRICE LEVEL (P) Decrease in AD (b) Shifting Aggregate Demand PRICE LEVEL (P) Increase in AD Aggregate Demand AD2 AD1 Aggregate Demand AD1 AD2 REAL OUTPUT (Y) REAL OUTPUT (Y) (c) Aggregate Supply Curve AS PRICE LEVEL (P) Classical Range Intermediate Range Depression or Keynesian Range Full Physical Employment Output (YF) Limit (d) Shifting Aggregate Supply Increase in AS PRICE LEVEL (P) REAL OUTPUT (Y) Decrease in AS AS1 Aggregate Demand AS PRICE LEVEL (P) 2 2 Aggregate AS Demand AS1 REAL OUTPUT (Y) REAL OUTPUT (Y) (e) Equilibrium in the AD-AS Model Point A - Long-run Equilibrium (where YF - equilibrium full-employment level of real output and PE – equilibrium price level, AD – aggregate demand curve, SRAS – short-run aggregate supply curve, and LRAS – long-run aggregate supply curve) PRICE LEVEL (P) LRAS SRAS PE E AD YF REAL OUTPUT (Y) (f) Output gaps in the AD-AS model PRICE LEVEL (P) Recessionary Gap PRICE LEVEL (P) Inflationary Gap LRAS LRAS SRAS SRAS A P A P AD AD REAL OUTPUT (Y) Y < YF (g) Shocks of Aggregate Demand Positive (= increase in AD) PRICE LEVEL (P) Negative (= decrease in AD) PRICE LEVEL (P) LRAS REAL OUTPUT (Y) YF < Y LRAS SRAS SRAS B P2 P1 P1 P2 A AD2 A B AD1 AD2 AD1 REAL OUTPUT (Y) YF Y2 REAL OUTPUT (Y) Y2 YF E (h) PRICE LEVEL (P) P1 P2 Shocks of Aggregate Supply Favorable (= increase in SRAS) LRAS SRAS1 SRAS2 PRICE LEVEL (P) A P2 P1 Adverse (= decrease in SRAS) LRAS SRAS2 SRAS1 B A B AD AD YF Y2 REAL OUTPUT (Y) Y2 YF REAL OUTPUT (Y) (i) Shifts in LRAS curve Increase in production possibilities PRICE LEVEL (P) LRAS1 LRAS2 PRICE LEVEL (P) SRAS1 SRAS2 LRAS2 LRAS1 SRAS2 SRAS1 B P2 P1 A P1 P2 Decrease in production possibilities A B AD AD REAL OUTPUT (Y) Y F Y F’ (j) REAL OUTPUT (Y) Y F’ Y F Self-correction of the economy after a negative aggregate demand shock (classical view) PRICE LEVEL (P) LRAS SRAS1 SRAS2 A P1 P2 B C AD1 AD2 REAL OUTPUT (Y) Y2 YF (f) Effects of fiscal and monetary policy actions Expansionary Policy (= increase in AD) PRICE LEVEL (P) Contractionary Policy (= decrease in AD) PRICE LEVEL (P) LRAS LRAS SRAS A P2 P1 P1 P2 B A B AD2 AD1 Y1 YF SRAS AD2 AD1 REAL OUTPUT (Y) YF Y1 REAL OUTPUT (Y) (g) Fiscal policy – the ‘supply-siders’ approach PRICE LEVEL (P) LRAS SRAS1 SRAS2 A P1 P2 B AD REAL OUTPUT (Y) Y1 YF XII. Economic Growth (a) The change in real GDP over time REAL GDP TREND 1970 1980 1990 2000 TIME (years) 2010 (b) The increase in production possibilities of the economy INVESTMENT GOODS B PPC2 A PPCPossibilities 1 Curve Possibilities Curve CONSUMPTION GOODS (c) Increase in the long-run aggregate supply and in the potential level of output PRICE LEVEL (P) LRAS1 LRAS 2 P1 P2 SRAS1 SRAS2 A B AD Y F Y F’ REAL OUTPUT (Y)