AP MACRO MID-TERM REVIEW MODULES 1-23 Mr. Lipman UNIT 1: THE BASICS Economics- The study of scarcity and choice. Macroeconomics- A focus on the overall ups and downs in the economy The Four Factors of Production •Producing goods and services requires the use of resources. •ALL resources can be classified as one of the following four factors of production: Land Labor Capital Entrepreneurship 3 ALL decisions involve trade-offs. Trade-offs are all the alternatives that we give up whenever we choose one course of action over others. (Examples: going to the movies or going to a game) The most desirable alternative given up as a result of a decision is known as opportunity cost. Key Economic Assumptions 1. Wants are unlimited, resources are limited (scarcity). 2. Due to scarcity, choices must be made. Every choice has a cost (a trade-off). 3. Everyone acts rationally by comparing the marginal costs and marginal benefits of every choice 4. Ceteris paribus: “other things being equal” In economics the term marginal = additional “Thinking on the margin”, or MARGINAL ANALYSIS involves making decisions based on the difference of additional benefit vs. the additional cost. Everyone will continue to do the same thing until the marginal cost outweighs the marginal benefit being gained and then they will stop doing it. The Various Business Cycles Depression • Recession • Expansion or growth (which leads to inflation) • Graph demonstrates changes happening over time as cycles change When using a PPC always remember that if a point is inside or on the curve it is feasible but if it lies outside the curve then it is not feasible. Being on the curve is most efficient (aka no missed opportunities) • An individual has a comparative advantage in producing a good or service if the opportunity cost of producing the good is lower for that individual than for other people. • An individual has an absolute advantage in an activity if he or she can do it better than other people. Having an absolute advantage is not the same thing as having a comparative advantage. 9 of 16 5 KEY ELEMENTS TO SUPPLY & DEMAND • THE DEMAND CURVE • THE SUPPLY CURVE • FACTORS THAT CAUSE CURVES TO SHIFT • MARKET EQUILIBRIUM • HOW MARKET EQUILIBRIUM CHANGES WHEN SUPPLY OR DEMAND CURVE “SHIFTS” Demand is the different quantities of goods that consumers are willing and able to buy at different prices. The law of demand states there is an INVERSE relationship between price and quantity demanded : AS PRICE GOES UP THE QUANTITY DEMANDED WILL DROP & AS PRICE DROPS DEMAND RISES 11 The law of demand has 3 parts 1.The Substitution effect as price of good goes up consumers will purchase a substitute good 2. The Income effect as price drops the purchasing power increases 3. Law of Diminishing Marginal Utility the more you buy of ANY GOOD the less satisfaction you get from each new unit of that good. 12 Keys to Graphing Supply & Demand • 1. The slope of the curve is always down and to the right • 2. A change in demand at the same price requires a SHIFT but a change in demand due to a change in price is show as MOVEMENT along the curve Demand Will Shift because of: • 1. Market Size • 2. Expectations • 3. Related Prices (compliments/substitutes) • 4. Income (normal & inferior) • 5. Tastes Key Terms • Substitute good is one whose demand goes up when the price of another good goes up (coffee and tea are examples of this) • Compliment goods are ones usually used together and thus if demand for one falls then demand for the other will also fall (cars and gasoline are examples of this) • Most goods are “normal” (demand increases as income rises) but some are “inferior” (demand drops as income rises…for example buses…as income rises people tend to then take taxis) Unit 3 Measuring Economic Performance • GROSS DOMESTIC PRODUCTION (GDP) • UNEMPLOYMENT • INFLATION The most important measure of growth is GDP. Gross Domestic Product (GDP) is the dollar value of all final goods and services produced within a country’s borders in one year. • Dollar value- GDP is measured in dollars. • Final Goods-GDP does not include the value of intermediate goods. Intermediate goods are goods used in the production of final goods and services. • One Year-GDP measures annual economic performance. 17 What is NOT included in GDP? 1. Intermediate Goods • No Multiple Counting, Only Final Goods • EX: Price of finished car, not the radio, tire, etc. 2. Nonproduction Transactions •Financial Transactions (nothing produced) •Ex: Stocks, bonds, Real estate •Used Goods •Ex: Old cars, used clothes 3. Non-Market (Illegal) Activities •Ex: Illegal drugs, unpaid work 18 Circular Flow Diagram: Inflow of money into each market or sector must equal the outflow of money coming from that market or sector How can you measure growth from year to year? % Change in GDP = Year 2 - Year 1 Year 1 X 100 20 1. Expenditures Approach-Add up all the spending on final goods and services produced in a given year. GDP = C + I + G + Xn (exportsimports) C IS CONSUMER SPENDING I IS INVESTMENT SPENDING G IS GOVERNMENT PURCHASES OF GOODS AND SERVICES 21 For each situation, identify if it is included in GDP the identify the category C, I, G, or Xn AND WHAT IS TOTAL GDP 1. $10.00 for movie tickets 2. $5M Increase in defense expenditures 3. $45 for used economics textbook 4. Ford makes new $2M factory 5. $20K Toyota made in Mexico 6. $10K Profit from selling stocks 7. $15K car made in US, sold in Canada 8. $10K Tuition to attend college 9. $120 Social Security payment to Bob 10.Farmer purchases new $100K tractor 22 Included or not Included in GDP? GDP=$7,125,010 1. $10.00 for movie tickets 2. $5M Increase in defense expenditures X $45 for used economics textbook 4. Ford makes new $2M factory X $20K Toyota made in Mexico X $10K Profit from selling stocks 7. $15K car made in US, sold in Canada 8. $10K Tuition to attend college X $120 Social Security payment to Bob 10.Farmer purchases new $100K tractor 23 Real vs. Nominal GDP Nominal GDP is GDP measured in current prices. It does not account for inflation from year to year. Real GDP is GDP expressed in constant, or unchanging, dollars. Real GDP adjusts for inflation. REAL GDP IS THE BEST MEASURE OF ECONOMIC GROWTH! 24 3 Types of Unemployment #1. Frictional Unemployment •“Temporarily unemployed” or being between jobs. •Individuals with transferable skills •Seasonal Unemployment •Examples: College Grads, Santa Claus Workers 25 #2. Structural Unemployment •Workers DO NOT have transferable skills and these jobs will never come back. •Technological Unemployment •Workers must learn new skills to get a job. Examples: •VCR repairmen •Carriage makers •Automobile Workers replaced by robots 26 #3 Cyclical Unemployment •Unemployment that results from economic downturns (recessions). •As demand for goods and services falls, demand for labor falls and workers are fired. Examples: •Steel workers laid off during recessions. •Restaurant owners fire waiters after months of poor sales due to recession. 27 The Natural Rate of Unemployment 2 of 3 types of unemployment are unavoidable: •Frictional unemployment •Structural unemployment •They are natural rate of unemployment (NRU). We are at full employment if we have only the natural rate of unemployment. •This is the normal amount of unemployment that we SHOULD have. •The number of jobs seekers equals the number of jobs vacancies. 28 Three Causes of Inflation 1. Printing too much Money 2.Demand-Pull Inflation 3. Cost-Push Inflation Measuring Inflation • Inflation Rate Percentage =‘s Price Yr 2 - Price Yr 1 x 100 Price Yr 1 The process of bringing the inflation rate down is known as Disinflation and it is difficult to do because you must temporarily slow growth or even depress the economy. Key Inflation Terms • Shoe-leather costs – Increased transaction costs of shopping around • Menu Costs – $ it costs to change prices • Unit of Accounts Costs – inflation makes $ less reliable as a unit of measurement Hurt by Inflation Helped by Inflation • Lenders-People who lend money (at fixed interest rates) • People with fixed incomes • Savers • Borrowers-People who borrow money • A business where the price of the product increases faster than the price of resources Cost-of-Living-Adjustment (COLA) Some works have salaries that mirror inflation. They negotiated wages that rise with inflation The most commonly used method to determine inflation for consumers is the Consumer Price Index Here is how it works: • The base year is given an index of 100 • To compare, each year is given an index # as well CPI = Price of market basket Price of market basket in base year x 100 Problems with using CPI as a Measurement 1. Substitution Bias- As prices increase for the fixed market basket, consumers buy less of these products and more substitutes that may not be part of the market basket. (Result: CPI may be higher than what consumers are really paying) 2. New Products- The CPI market basket may not include the newest consumer products. (Result: CPI measures prices but not the increase in choices) 3. Product Quality- The CPI ignores both improvements and decline in product quality. (Result: CPI may suggest that prices stay the same though economic well being has improved significantly) CPI vs. GDP Deflator The GDP deflator measures the price of all goods produced, whereas the CPI measures prices of only the goods and services bought by consumers. An increase in the price of goods bought by firms or the government will show up in the GDP deflator but not in the CPI. The GDP deflator includes only those goods and services produced domestically. GDP Deflator = Nominal GDP Real GDP x 100 Calculating GDP Deflator GDP Deflator Nominal GDP = = Nominal GDP Real GDP x 100 (Deflator) x (Real GDP) 100 UNIT 4: How is Spending “Multiplied”? Assume the MPC is .5 for everyone •Assume that when the Super Bowl comes to town there is an increase of $100 in Ashley’s restaurant. •Ashley now has $100 more income. •She saves $50 and spends $50 at Carl’s Salon •Carl now has $50 more income •He saves $25 and spends $25 at Dan’s fruit stand •Dan now has $25 more income. This continues until every penny is spent or saved Change in GDP = Multiplier x Initial Change in Spending 37 Marginal Propensity to Consume (MPC) •How much people consume rather than save when there is an change in income. •It is always expressed as a fraction (decimal). MPC= Change in Consumer Spending Change in Income 38 Marginal Propensity to Save (MPS) •How much people save rather than consume when there is an change in income. •It is always expressed as a fraction (decimal) MPS= Change in Saving Change in Income 39 MPS = 1 - MPC Why is this true? Because people can either save or consume 40 Two factors can change Aggregate Consumption Function • 1. Changes in expected future disposable income – (higher expected future income tends to lead to lower savings today…this is known as the permanent income hypothesis) • 2. Changes in aggregate wealth – (wealth has an effect on consumer spending and consumers generally plan their spending over their lifetime and not just based on current disposable income…the life-cycle hypothesis). Aggregate Demand Curve Price Level AD is the demand by consumers, businesses, government, and foreign countries Changes in price level cause a move along the curve not a shift of the curve AD = C + I + G + Xn Real domestic output (GDPR) 42 Shifters of Aggregate Demand ------------------------------------------An increase in Aggregate Demand means a shift of the curve to the right and may include the following factors: 1. Changes in expectations 2. Changes in wealth 3. Size of firm capacity 4. Government Policies GDP = C + I + G + Xn 43 Aggregate Supply The amount of goods and services (real GDP) that firms produce in an economy at different price levels. Aggregate Supply differentiates between short run and long-run and has two different curves. Short-run Aggregate Supply •Wages and Resource Prices will not increase as price levels increase. Long-run Aggregate Supply •Wages and Resource Prices will increase as price levels increase. 44 Shifters of Aggregate Demand AD = C + I + G + X Change in Consumer Spending Change in Government Spending Change in Investment Spending Net EXport Spending Shifters of Aggregate Supply AS = I + R + A + P Change in Inflationary Expectations Change in Change in Change in Resource Prices Actions of the Government Productivity (Investment) 45 Assume the government increases spending. What happens to PL and Output? Price Level LRAS AS PL and Q will Increase PL1 PLe AD QY Q1 GDPR AD1 46 How the Government Stabilizes the Economy The Government has two different tool boxes it can use: 1. Fiscal PolicyActions by Congress & the President OR 2. Monetary PolicyActions by the Federal Reserve Bank (aka Central Bank actions) 47 Two Types of Fiscal Policy Discretionary Fiscal Policy• Congress creates a law designed to change AD through government spending or taxation. •Problem is time lags due to bureaucracy. •Takes time for Congress to act. •Ex: In a recession, Congress increases spending. Non-Discretionary Fiscal Policy •AKA: Automatic Stabilizers •Permanent spending or tax laws enacted to counter cyclical problem to stabilize the economy •Ex: Welfare, Unemployment, Min. Wage, etc. •When there is high unemployment, unemployment benefits to citizens increase consumer spending. 48 Contractionary Fiscal Policy (The BRAKE) Laws that reduce inflation, decrease GDP Either Decrease Government Spending or Enact Tax Increases • Combinations of the Two Expansionary Fiscal Policy (The GAS) Laws that reduce unemployment and increase GDP • Increase Government Spending or Decrease Taxes on consumers • Combinations of the Two How much should the Government Spend? 49 KEY TERMS TO KNOW: unit 5 •Budget Surplus •Budget Deficit and Budget Debt •Budget Balance •National Savings v. Private Savings •Capital inflow Money is anything that is generally accepted in payment for goods and services Commodity Money- Something that performs the function of money and has alternative uses. – Examples: Gold, silver, cigarettes, etc. Fiat Money- Something that serves as money but has no other important uses. – Examples: Paper Money, Coins 51 3 Functions of Money 1. A Medium of Exchange • Money can easily be used to buy goods and services with no complications of barter system. 2. A Unit of Account • Money measures the value of all goods and services. Money acts as a measurement of value. • 1 goat = $50 = 5 chickens OR 1 chicken = $10 3. A Store of Value • Money allows you to store purchasing power for the future. • Money doesn’t die or spoil. 52 Types of Money Liquidity- ease with which an asset can be accessed and converted into cash (liquidized) M1 (High Liquidity) - Cash, Traveler’s Checks and Checkable Deposits. In general, this is known as the MONEY SUPPLY M2 (Medium Liquidity) - M1 plus other “near money” such as savings accounts (CD’s) and mutual funds M3 (Low Liquidity) – No longer used 53 To Protect Against Bank Runs the Following Regulations are in effect • FDIC : Insured to $250K • Capital Requirements: Owners must hold more assets then the value of the deposits (usually at least 7% more) • Reserve Requirements: Reserve ratio is presently 10% of all checkable deposits • Discount Window: Ability to borrow from the Fed to avoid having to sell assets at below market prices • The Federal Reserve uses three primary tools in the pursuit of monetary policy: – Reserve Requirements – The Discount Rate – Open Market Operations These tools are used to increase or decrease the money supply.