AP Macroeconomics Test Review
8 AM – May 17th, 2012
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
Circular Flow Model
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
Gross Domestic Product
Valuation of economy
 Value of production, not simply production
 Final Goods
 Second hand goods not included
 Transfers not included
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
GDP
GDP = AD (Aggregate Demand)
GDP = C + I + G + (X-M)
 C = Personal Consumption
 I = Capital Investments
 G = Government Expenditures
 No transfer payments
 X-M = Net Exports = eXports - iMports
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
GDP vs GNP
Gross Domestic Product
 What is produced within a
country’s borders, regardless of
who produces it.
 Mercedes built in America count
towards American GDP
 Fords built in Germany count
towards German GDP
Gross National Product
 What is produced by the citizens
of a country, regardless of where
they produce it.
 Mercedes built in America count
towards German GNP
 Fords built in Germany count
towards American GNP
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
Real vs Nominal GDP
Nominal
 Value of current production in current prices
Real
 Value of current production in base year prices
GDPReal = (GDPNom)(Price Index)
%∆GDPReal = %∆GDPNom - %Δ Index
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
CPI
Consumer Price Index
 Measure inflation
 Base year
 Market Basket
What is the difference between the
CPI and the GDP deflator?
 Both are price indices but they have different
market baskets. The CPI includes consumer
goods whereas the GDP deflator contains all
items that are produced domestically.
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
Causes of Inflation
2 types
 Demand-pull inflation
 Aggregate demand > productive capacity
 Causes include increases in money supply or credit.
 Cost-push
 Prices increased by producers to cover higher costs of
production.
 Supply shocks such as changes in oil prices, crop failures & natural
disasters.
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
5 Major Effects of Inflation
Decreased purchasing power
Decreased value of real wages
Increased interest rates
Decreased savings & investing
Increased production costs
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
Unemployment
Unemployed – must be looking for work to be part
of labor force.
Unemployment rate is % of labor force that is
unemployed.
Types of unemployment include:
 Frictional
 Seasonal
 Structural
 Cyclical
Full employment is economy at full steam. Since
there is always frictional & structural
unemployment, the Natural unemployment rate is
the unemployment rate for full employment.
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
Consumption Function
Consumption Function
C = a + b (DI)
a = autonomous spending
spending when income = 0
B = consumption rate
Consumption
DI
CF
Savings
Dissavings
Disposable Income
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
Marginal Propensity to Consume & Save
MPC = ΔC/ΔDI
MPC= Consumption rate in
consumption function
MPS = ΔS/ΔDI
MPC + MPS = 1
 C=Consumption, S=Savings, DI=Disposable Income
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
Multiplier
Multiplier
 = 1 / MPS
 = 1 / (1-MPC)
Examples
 MPC = .9, Multiplier = 1/.1 = 10
 MPC = .8, Multipler = 1/.2 = 5
 MPC = .5, Multiplier = 1/.5 = 2
NB Taxes have a smaller multiplier than
direct government spending
RMCE/HWRHS
8 AM – May 17th, 2012
AP Macroeconomics Test Review
AD – AS Model
Price
Level
LRAS
Long-run Aggregate
Supply (LRAS)
SRAS
Short-run Aggregate
Supply (SRAS)
P
Aggregate Demand (AD)
= C+I+G+(X-M)
AD
YO
GDPR
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
AD – AS Model - Inflation
Price
Level
LRAS
SRAS
GDP beyond L-R
Equilibrium at Y1 & P
Inflationary Gap
Higher rates drive
down interest sensitive
expenditures (AD )
P
P2
AD Shift causes Y to go
 to L-R YO, & P 
AD2
YO
Y1
AD
GDPR
Economy producing
Beyond L-R capacity
RMCE/HWRHS
8 AM – May 17th, 2012
AP Macroeconomics Test Review
AD – AS Model - Inflation
Price
Level
SRAS
LRAS
GDP below L-R
Equilibrium at P & Y1
SRAS2
Recessionary Gap
Lack of demand drives
down nominal wages
( SRAS  )
P
P2
SRAS2 shift results
in P  & Y 
AD
Y1
YO
GDPR
Economy producing
under L-R capacity
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
Shifts in AD
Changes in expectations
 Expectations  – AD 
Changes in wealth
 Wealth  , - AD 
Amount of physical capital
 Existing Capital  – AD 
Fiscal policy
 Government spending  – AD 
Monetary policy
 Money supply  – AD 
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
Shifts in SRAS
Commodity prices
 Example is oil
 Prices  - AS 
Nominal wages
 Wages  - AS 
Productivity
 Productivity  - AS 
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
AD AS Model
Shifts of AD
Demand shock
Negative
 “Great Depression”
 ADN, EN, PN, YN
Ag. Pr.
Level
SRAS
EP
PP
PE
ESR
PN
ADP
EN
ADN
Positive
 WWII
 ADP, EP, PP, YP
YN
YE
YP
AD
Real GDP
RMCE/HWRHS
AP Macroeconomics Test Review
AD AS Model
Positive Demand Shock
 AD shifts to AD2
 E1 up to E2
 P1 up to P2
 YP up to Y2
 Inflationary Gap
Ag. Pr.
Level
P3
8 AM – May 17th, 2012
SRAS2
SRAS
LRAS
E3
P2
P1
E2
E1
AD2
Inflation causes L-R
increase in wages
AD
 SRAS shifts to SRAS2
 E2 shifts to E3
 P2 up again to P3
 Y2 down to YP
YP
Y2
Real GDP
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
AD AS Model
Shifts of SRAS
Supply shock
Negative
 Oil Crisis
 SRASN, EN, PN, YN
SRASN
Ag. Pr.
Level
SRAS
SRASP
PN
EN
PE
ESR
PP
EP
AD
Positive
 Internet
 SRASP, EP, PP, YP
YN
YE
YP
Real GDP
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
Continuum – Government Policies
Restrictive
Low Growth
Low Inflation
Expansionary
High Growth
High Inflation
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
Fiscal Policy
Expansionary
 Stimulates economy
 Decrease taxes and/or increase spending
 Increases disposable incomes/demand
 Inflationary & leads to debt
Restrictive
Expansionary
Restrictive
 Reduces Disposable income/demand.
 Lack of cash reduces investments.
 Reduction in government spending/programs
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
Monetary Policy
Easy Money
 Increases growth (good)
 Increases inflation (bad)
Tight Money
Easy Money
Tight Money
 Decreases growth (bad)
 Decreases inflation (good)
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
How the Fed Can Change MS

Fed Tools
1.
2.
3.
4.
Open Market Operations
Fed Funds Rate & Discount Rate
Reserve Requirements for Banks
Moral suasion
RMCE/HWRHS
AP Macroeconomics Test Review
Money
Supply
up
Interest
Rates
down
Exchange
rates
down
8 AM – May 17th, 2012
Expansionary Policy
Investments
up
AD
up
GDPR
up
GDPN
up
Exports
up
Imports
down
Price
Level
up
Inflation
up
Unemploy
-ment
down
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
Phillips Curve
Inflation
LRPC
S-R trade-off between
Inflation & unemployment
Trade-off does not
Occur in the L-R
Shifts in SRPC the result
of Δ expected inflation
%2
SRPC2
%
SRPC
NRU/
NAIRU
Unemployment
RMCE/HWRHS
8 AM – May 17th, 2012
AP Macroeconomics Test Review
Money Supply
Interest
Rate, i
i = nominal
interest rates
MS
Δ in MS controlled
by the Fed Reserve
i
M*V=P*Q
MS*Velocity or multiplier
= Price Level * Output
MD
M
GDPR
RMCE/HWRHS
AP Macroeconomics Test Review
Interest
rate
Money Supply & Interest Rates
Money supply
MS2
Price Level
Increased MS
leads to r 
8 AM – May 17th, 2012
Lower r leads to C
& I  meaning AD 
AD shifts right,
leading to Price
Level  & GDPR 
SRAS
P2
P1
r1
AD2
r2
MD1
Mde1 Mde2 Quantity
of money
AD1
Y1 Y2 GDPR
RMCE/HWRHS
8 AM – May 17th, 2012
AP Macroeconomics Test Review
r = real
interest rates
Loanable Funds
Interest
Rate, r
SM
NB - With interest rates
i includes inflation
while r is for real
r
DM
YO
GDPR
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
Terms
Crowding out
 Government competes with or eliminates private
enterprise.
 Providing a service otherwise supplied by a company
 Competing in the marketplace for loans to finance debt.
Rational Expectations Theory
 Businesses & consumers react to expected changes
in monetary & fiscal policy, thereby negating their
impact.
Automatic Stabilizers
 adjust automatically, without government deliberation,
to offset economic conditions
RMCE/HWRHS
8 AM – May 17th, 2012
AP Macroeconomics Test Review
Crowding Out Effect – Change in Demand
Interest Rate, r
∆ in Demand:
government debt
creates additional
demand for funds.
S1
r2
r1
Rightward shift of
demand curve results
in r  & Q .
D2
D1
Q1 Q2
Quantity of
Loanable Funds
RMCE/HWRHS
8 AM – May 17th, 2012
AP Macroeconomics Test Review
Crowding Out Effect – Change in Supply
S2
Interest Rate, r
∆ in Supply:
Government is
Most credit worthy
Borrower, so Fed
Debt removes supply
S1
r2
r1
Leftward shift of
Supply curves results
In r  & Q 
D1
Q2
Q1
Quantity of
Loanable Funds
RMCE/HWRHS
8 AM – May 17th, 2012
AP Macroeconomics Test Review
Automatic Stabilizers
$
Deficit – Economy in recession, causes
taxes to drop below govt. expenditures
Taxes
Surplus – Economy booms,
causes taxes to increase
above govt spending
Govt
Automatic adjustments to
economic conditions by
increasing deficit during
recessions & increasing surplus
in boom periods (income taxes)
GDPR
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
Macroeconomic Theories
Classical
 Changes in MS only affect nominal rates, not real
 Automatic stabilizers will correct market fluctuations
 No government action
Keynesian
 Fiscal policy as a tool to correct cyclical fluctuations
 Govt spending up to offset recessions
Monetarists
 Govt often wrong or late, only make matters worse
 MS to grow at rate of GDP growth (no fiscal remedies)
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
Foreign Trade
 Revisit Comparative & Absolute advantages from
Micro PP
Balance of Payments
 Current Account – Transactions w/o liabilities
 Capital Account – Transactions w/ liabilities
Exchange Rate Changes
 Consumer tastes
 Relative incomes
 Relative inflation
 Speculation
 Money supply/ relative interest rates
RMCE/HWRHS
8 AM – May 17th, 2012
AP Macroeconomics Test Review
Exchange Rates
Demand for $ increases as
other currencies trade for $
$/€
€/$
S
S2
Demand Curve shifts to D2
causing $  & Q 
Looking at exchange rate from
other side – euros/dollar
High demand for $ means
people want to trade euros in
& this leads to excess supply
$2
€
$
€2
D
Qe
Q2
D2 Supply curve shifts to S2,
causing €  & Q 
Q
RMCE/HWRHS
8 AM – May 17th, 2012
AP Macroeconomics Test Review
International Trade & Taxes
Dollars/
Euro
SDom
Example: US Oil Market
Equilibrium at $100 & 10M
Barrels.
Effects of tariff include
P $10, Q  1M barrels,
& Imports  2M barrels
$100
$90
$80
World price is $80. Effect on
US market is Demand at $80
Is 12M while Supply is 8M.
Difference of 4M is imports.
Imports
D
Q
Protective tariff of
$10/Barrel added
8 9 10 11 12
Deadweight Loss (DWL)
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
Graph Relationships
I
Money Market
MS
i
Investment Demand
MS
i
i
i
i
MD
M
M
Contraction of MS
leads to higher i,
which reduces I,
causing GDP to fall
Graph reversed so
GDP is falling
M
I
I
I
I
I
I
Y
Y
GDPR
RMCE/HWRHS
AP Macroeconomics Test Review
8 AM – May 17th, 2012
Graph Review – MS 
I/R
Money Supply
MS
I/R
Loanable Funds
Fed increases
MS i 
MS
i
S
S
r
r
i
MD
M
M
D
Q
I/R
q q
Investment Demand
 r leads
to  I
 MS leads to
shift right in S in
r
loanable funds
r
r&q
Q
I/D
I
I
Q
Inflation
 I =  AD
P/L = X  & M 
AD =
 AD =  P & Y
Supply of $ 
Phillips CurveInflation  & Exchange Rates
ER  & q P/L ADAS Model
A/B
LRPC Unemployment 
S
AS
S
ER
ER
%
P
P
AD
SRPC
%
D
U/R NRU
Unemployment
q q
Q
AD
YY
Real GDP
RMCE/HWRHS