AP Macro Review

Aggregate Demand• Consumption, investment, govt. purchases and net exports

(exports – imports)• More income, more wealth = more spending• Investment – purchases of new capital by businesses; interest

rate rises – less investment; interest rate falls – more investment

• $ appreciates – U.S. goods more expensive; exports fall• $ depreciates – U.S. goods less expensive; exports rise• AD increases – shifts to right; P rises, GDP rises,

unemployment falls• AD decreases – shifts left; P falls, GDP falls, unemployment

rises

MPC and MPS• MPC = ∆ consumption resulting from a ∆ in income• MPS = ∆ savings resulting from a ∆ in income• MPC = 1 – MPS• If MPC = .80 then a $100 increase in income will cause us

to spend $80• Multiplier = 1/MPS• ∆ in GDP = multiplier x ∆ in spending• If multiplier is 5, consumption rises by $100, GDP rises by

$500.• If MPC = .8, multiplier is 5; income rises by $100,

consumption rises by $80, GDP rises by $400• Multiplier works for any increase in spending, whether to

consumption, investment, govt. purchases or net exports

Money Market

Sm1 Sm2Sm3 Dm

i1

i2

i3

i

Q

Vertical S curve –S set by FED; Includes S and D for all $ in the economy

i

Q

D

S

i1

Q1

Loanable Funds Market

Government deficit affects demand; Savings affects supply

Loanable funds market

• Increase in budget deficit increases D for loanable funds; interest rate increases

• Decrease in budget deficit decreases D for loanable funds; interest rate falls

• Increase in savings increases S for loanable funds; interest rate falls

• Decrease in savings decreases S for loanable funds; interest rate rises

AS

AD1

P

GDPGDP1

P1 AD2

P2

ExpansionaryFiscal Policy or Easy Money Policy

Qf

ASlr

Fiscal vs. Monetary policy

Expansionary Fiscal

• Implemented by govt.• Cut taxes• Increase govt. purchases• Increases budget deficit• Increases D for loanable

funds• Increases interest rate• $ appreciates

Easy money policy

• Implemented by FED• Buy bonds• Decrease required

reserve ratio• Decrease discount rate• Increases S of $ in

money mkt.• Interest rate falls• $ depreciates

AS

AD2

P

GDPQf GDP1

P1

P2ContractionaryFiscal Policy or Tight Money Policy

AD1

ASlr

Fiscal vs. Monetary policy

Contractionary Fiscal

• Implemented by govt.• Increase taxes• Decrease govt.

purchases• Decreases budget deficit• Decreases D for loanable

funds• Decreases interest rate• $ depreciates

Tight money policy

• Implemented by FED• sell bonds• increase required reserve

ratio• increase discount rate• decreases S of $ in

money mkt.• Interest rate rises• $ appreciates

Demand-Pull InflationP

GDP

ASSR1

AD1

ASLR

P1

Qf

AD2

Q2

ASSR2

P3

P2

Demand pull inflation if govt does not respond to the inflation• In the long run, prices and wages are flexible.• Increase in price level causes wages to rise.• Increase in wages shifts AS in short run to left –

more expensive to produce• As economy approaches long run equilibrium,

GDP returns to full employment GDP and unemployment returns to the natural rate of unemployment

RecessionP

GDP

ASSR1

AD1

ASLR

P1

Qf

AD2

Q2

ASSR2

P3

P2

Recession if govt does not respond w/ fiscal or monetary

policy• In the long run, prices and wages are flexible.• Wages fall when unemployment increases.• decrease in wages shifts AS in short run to right

– cheaper to produce• As economy approaches long run equilibrium,

GDP returns to full employment GDP and unemployment returns to the natural rate of unemployment

Inflationrate

Unemployment rate

SRPC1

SRPC2

AD

AS1

AS2P

GDP

P2

P1

GDP2 GDP1

P goes upUnemployment rises

Phillips Curve

Phillips Curve

• Short run – tradeoff between unemployment and inflation; as 1 goes up the other falls

• If AS shifts, short run PC shifts in opposite direction

• If AD shifts, movement along the PC.• Long run – no tradeoff between

unemployment and inflation• LRPC is a vertical line

Effect on ASCapitalgoods

Consumergoods

P

GDP

PPF1

PPF2

ASLR1 ASLR2

Qf1 Qf2

Economic Growth

• Rightward shift of PPF curve = rightward shift of long run AS

• Caused by increase in technology, # or quality of natural or human resources, increase in capital stock

• Economic growth influenced by interest rates – if interest rates rise, I (investment) falls, capital stock declines, less economic growth

Effect on ASP

GDP

Inflation

Unem.

ASLR1 ASLR2

Qf1 Qf2 NRU1NRU2

LRPC1LRPC2

Mkt. for Dollars Mkt. for Pounds

U.S. Exports – English buying American wheatP in pounds

Q

P in dollars

D1

D2S

D

S1

S2

P2

P1

Q1 Q2Q1 Q2

P1

P2

Exchange rates• If 1 currency appreciates, the one it’s being

compared to depreciates.• Interest rates and value of the currency move in

same direction.• If D for $ increases (b/c people want U.S. wheat

or higher interest rates in U.S.), $ appreciates.• The English must supply more pounds to get the

dollars they demand so the pound depreciates.

Mkt. for Dollars Mkt. for Pounds

U.S. Imports – Americans buying English teaP in pounds

Q

P in dollars

D1

D2

S

D

S1

S2

P2

P1

Q1 Q2Q1 Q2

P1

P2