AP Macroeconomics Study Guide

Test Taking Tips for Essay 1. Read question carefully and answer all questions directly, following the Roman numerals and letters. 2. Draw a relevant graph for every answer if possible noting guidelines below: A. Use the clearest graph for illustrating the point

B. Label the graph carefully, including the x/y axis and all points of intersection C. D. Show movement with arrows and letters Relate the graph clearly to the text, noting how movement occurs

3. Use economic terms to describe situations (e.g. contradictionary fiscal policy, real wages, allocative efficiency) 4. Analyze the information carefully to determine what sort of situation they are describing. Be careful not to go beyond the scope of the question or over-answer. However, clearly demonstrate the logic of your response 5. Analyze the information you are given to figure out what sort of situation they are describing. The following is a guideline for AP Macroeconomics questions: Inflation (CPI Growth) Unemployment GDP Growth

Low 0-2% Acceptable Target 3-4% High 5-7%

0-2% 3-4% 5-10%

2-3% 4-6% 7-10%

Recessionary Economy 1% and lower

0-3%

7% and above

Inflationary Economy varies Stagflation above

7% and above 7% and above

4% and below 7% and

1% and lower

AP Summary Outline of Macroeconomics I. Basic Economic Concepts 5-10% (3-6 Questions) A. B. C. Scarcity: The Nature of Economic Systems Opportunity Costs and Production Possibilities Specialization and Comparative Advantage

D. The Functions of an Economic System (What, how, when and for whom to produce) E. Demand, Supply and Price Determination

II. Measurement of Economic Performance 8-12% (5-7 Questions) A. B. C. Gross National Product, Gross Domestic Product, and National Income Inflation and Price Indices Unemployment

III. National Income and Price Determination 70-75% (42-45 Questions) A. 1. 2. 3. B. 1. 2. 3. Aggregate Supply Classical Analysis Keynesian Analysis Rational Expectations Aggregate Demand Circular Flow Components of Aggregate Demand Multiplier

4. 5. C. 1. 2. D. 1. 2. 3. E. 1. 2. 3.

Fiscal Policy Monetary Policy Money and Banking Definition of Money and its Creation Tools of Central Bank Policy Fiscal-Monetary Mix Interaction of Fiscal and Monetary Policies Monetarist-Keynesian Controversy Deficits Trade Offs between Inflation and Unemployment Long Run vs. Short Run Supply Shocks Role of Expectations 8-12%

IV. International Economics and Growth (5-7 Questions) A. B. Balance of Payments, International Finance, and Exchange Rates Economic Growth

Basic Economic Systems Chapter 2 The Economic Problem 1. Full Employment is the use of all available resources 2. Full Production is the employment of resources so that they provide the maximum possible satisfaction of our material wants. Includes two types of efficiency: a) Productive Efficiency (P=AC) is the production of any particular mix of goods/services in the least costly way b) Allocative Efficiency (P(=MB)=MC) is the production of that particular mix of goods/services most wanted by society. 3. A Production Possibilities Curve/Frontier represents some maximum combination of two products, which can be produced if full employment and

full production are achieved. Key Graph Figure 1.2 pg 12 4. The Opportunity Cost of a specific good is the amount of other products that must be forgone or sacrificed. The law of increasing opportunity costs states that the more of a product produced, the greater its opportunity cost. 5. Economic Growth is the ability of an economy to produce a larger total output as a result of increases in the supply of resources, improvements in resource quality, and/or technological advance. Fig. 1.5 pg 15 6. A Circular Flow Model (Key Graph Figure 2.2 pg 40) portrays an exchange between businesses and households in two markets: a) Resource or Factor Market: Households supply factors of production or resources (labor, capital, land, entrepreneurship) in exchange for resource payments (wages, interest, rent and profit, or WIRP) b) Product Market: Businesses supply finished goods/ services in exchange for money from households.

Chapter 3: Understanding Individual Markets: Demand and Supply 1. Demand is a curve or schedule showing the various amounts of a product consumers are willing and able to purchase at a series of possible prices during a specific period. 2. The Law of Demand states that, as the price falls, the quantity demanded rises and as price rises, the quantity demanded falls. There are three explanations for the law of demand: a) The Law of Diminishing Marginal Utility states that each buyer of a product will derive less satisfaction (utility) from each successive units of a good consumed and thus will only buy additional units if the price is reduced. b) The Income Effect indicates that a lower price increases the purchasing power of a buyers money income, enabling the buyer to purchase more of the product. c) The Substitution Effect indicates that at a lower price, buyers have the incentive to substitute the now cheaper good for similar goods, which are now relatively more expensive. 3. Determinants of Demand are non-price factors that will increase demand (shift right) or decrease demand (shift left) at all prices. Note that a Change in Demand is a shift of the entire demand curve due to one of the following demand determinants whereas a Change in Quantity Demanded is a

movement along the curve due to price change. The following are key determinants of demand: a) Change in the Price of a Complement- A decrease in the price of a complement (jelly) will result in an increase in demand for the good in question (peanut butter). b) Change in the Price of a Substitute- An increase in the price of a substitute (bagel) will result in an increase in demand for the good in question (donut). c) Change in Income- As income increases, a consumers ability to afford a normal product peanut butter increases and the demand for the product increases. However, if the good is an inferior good, consumers will decrease their demand as their income increases. d) Change in Number of Buyers- an increase in population will result in more customers and increase demand. e) Change in Consumer Tastes- An item that is popular or desired will increase in demand f) Change in Consumer Expectations- consumer expectations of higher prices or higher income will increase the demand for the good in the present. 4. Supply is a schedule or curve showing the amounts of a product a producer is willing and able to produce and make available for sale at a series of possible prices during a specific period. 5. The Law of Supply states that as price rises, the corresponding quantity supplied rises and as price falls, the quantity supplied falls. To a supplier, higher prices represent higher revenue and thus an increased incentive to produce and sell.

6. Determinants of Supply are non-price factors that will increase supply (shift right) or decrease supply (shift left) at all prices. Note that a change in supply is a shift in the entire supply curve due to one of the following demand determinants whereas a change in quantity supplied is a movement along the curve do to a price change. The following are key determinants of supply: a) Resource Prices- lower resource prices (labor, capital, land) decrease production costs, increase profits, and increase supply at each product price. b) Technology- improvements in technology decrease production costs, increase profits, and increase supply at each product price

c) Taxes and Subsidies -Whereas taxes will raise production costs, decrease profits and decrease supply ate each product price, subsidies will have the opposite effect. d) Number of Sellers- an increase in the number of suppliers will increase market supply. 7. The Market Clearing or Equilibrium Price occurs where the quantity demanded is equal to the quantity supplied. At any price above equilibrium, a surplus will occur as the quantity supplied is greater than the quantity demanded and at any price below equilibrium, a shortage will occur as the quantity demanded is greater than the quantity supplied. Figure 3.6 Page 55 8. Changes in supply and changes in demand will result in a new equilibrium price and output. See table below and Figure 3.7 Page 58. Change in Supply Change in Demand Effect on Eq. Price Effect on Eq. Quantity 1. Increase Decrease Decrease Indeterminate 2. Decrease Increase Increase Indeterminate 3. Increase Increase Indeterminate Increase 4. Decrease

Decrease Indeterminate Decrease

Measurement of Economic Performance

Chapter 7: Measuring Domestic Output, National Income, and the Price Level 1. Gross Domestic Product (GDP) is the total market value of all final goods/services produced within a country in one year. GDP does NOT count in intermediate goods/services, secondhand goods, financial transactions (e.g. stocks, bonds), transfer payments (e.g. social security, unemployment insurance), profits/income earned by US companies/individuals overseas. 2. GDP can be calculated in two ways: the amount spent to purchase this years output (expenditures approach) or the money income derived from producing this years total output (incomes approach). a) Expenditures Approach: Consumption (C)+Investment (I)+Government (G)+Net Exports (Xn) b) Incomes Approach: Wages (W)+Interest (I)+Rent (R)+Profit (P)

3. Price Indices are used to measure price changes in the economy; they are used to compare the prices of a given market basket of goods/services in one year with the prices of the same market basket in another year. A price index has a base year, and the price level in that year is given an index number of 100. The price level in all other years is expressed as a percentage of the price level in the base year. Current Year Prices x 100 Price Index Number= Base Year Prices 4. Nominal GDP is expressed in current dollars and is unadjusted for price changes whereas real GDP is deflated or inflated for price-level changes. As a formula: Nominal GDP Real GDP= Price Index (In Hundredths)

Chapter 8: Macroeconomic Instability: Unemployment and Inflation 1. Unemployment occurs when people who are willing and able to work cannot find jobs. The unemployment rate is the percentage of the labor force (including both those employed and those who are unemployed but actively seeking work.) Unemployment Rate= Unemployed x100 Labor Force

2.

There are four types of unemployment

a) Frictional Unemployment includes people who are temporarily between jobs. They may have quit one job to find another or they could be trying to find the best opportunity after graduating from High School or College. b) Cyclical Unemployment rises in a recession. For example, it may be caused by too little spending in an economy. c) Structural Unemployment involves mismatches between job seekers and job openings. Unemployed people who lack skills or have a poor education are structurally unemployed. d) Seasonal Unemployment affects workers who have worked during the past year but are unemployed during other parts of the year due to seasonal conditions (e.g. weather related jobs).

3. The Full-Employment unemployment rate is equal to the total frictional and structural unemployment and occurs when cyclical unemployment is zero. It is currently estimated to be around 4-6% 4. Potential GDP is the real output produced when the economy is fully employed. The GDP Gap is the amount by which actual GDP falls short of potential GDP. According to Okuns Law, for every 1-percentage point at which the actual unemployment rate exceeds the natural rate, a GDP gap of about 2% occurs. Figure 9.3 Page 174 5. Inflation is a general rising in the level of prices whereas deflation is a falling general level of prices.

6. The inflation rate is calculated by the Consumer Price Index (CPI) which measures the prices of a market basket of 300 goods/services purchased by a typical urban consumer. 7. Nominal Income includes wages, interest, rent, and profit received in current dollars whereas real income measures the amount of goods/services nominal income can buy. As an equation: %Change in Real Income= %Change in Nominal Income - %Change in Price Level 8. While inflation reduces the purchasing power of the dollar (i.e. the amounts of goods/services each dollar will buy), it does not necessarily decrease a persons real income if nominal income rises with the price level. Unanticipated inflation will hurt the following groups: those with fixed incomes, savers, and lenders. 9. The Nominal Interest Rate includes the Real Rate of Interest (the % increase in purchasing power which the borrower pays the lender for the privilege of borrowing) and the expected rate of inflation. As a formula: Nominal Interest Rate= Expected Rate of Inflation + Real Rate of Interest 10. Three types of inflation include creeping, galloping, and hyperinflation

National Income and Price Determination

Chapter 9: Building the Aggregate Expenditures Model 1. The amount of goods and services produced and therefore the level of employment depend directly on the level of total/aggregate expenditures. Aggregate expenditures include C+I+G+Xn, although this explores only C & I. 1. Disposable income is personal income taxes.

2. Consumption is the largest component of aggregate expenditures. A Consumption Schedule shows the various amounts households would plan to consume at each of the various levels of disposable income. If people consumed all of their disposable income, C=DI and this would be represented graphically as a 45 degree line. Figure 10.1 Page 189 3. Savings equals disposable income less consumption, in symbols S=DI-C. Graphically, savings is represented as the difference between the 45-degree line and consumption. Figure 10.1 Page 189

a. At low levels of disposable income, dissavings (consuming in excess of disposable income) occurs as people draw upon accumulated wealth. b. Where C=DI the consumption schedule intersects the 45 line and savings is zero (break-even level). c. At higher levels of income, DI>C and S is positive

4. A savings schedule shows the various amounts households would plan to save at each of various levels of disposable income Key Graph 10.2 Page 191 5. Average propensity to consume is the percentage of any specific level of total income consumed.

APC= Consumption Income 6. Average Propensity to Save is the percentage of any specific level of total income saved. APS=Saving or APS=1-APC

7. The Marginal Propensity to Consume is the change in consumption due to a change in income. MPC= Change in Consumption Change in Income

8. The Marginal Propensity to Save is the change in savings due to a change in income. MPS= Change in Saving Change in Income OR MPS= 1-MPC

9. 10.

The sum of MPC and MPS must equal 1

11. There are Non-Income Determinants of consumption and saving that will increase (shift up) or decrease (shift down) consumption and savings at all levels of disposable income. The major non income determinants are: a) Wealth: an increase in wealth will increase consumption and decrease savings at all levels of DI b) Expectations: Consumer expectations of rising prices or shortages will increase consumption and decrease savings at all levels of DI. c) Household Debt: An increase in household debt will increase consumption and decrease savings at all levels of disposable income. d) Taxes: A decrease in taxes will increase both consumption and savings at all levels of DI

12. Investment is the second component of aggregate expenditures. Businesses investment in capital goods occurs only if the marginal benefit from the investment (i.e. the expected rate of return) exceeds or is equal to the marginal cost (i.e. the interest rate on the investment loan). Figure 10.6 Page 198

13. The Investment Schedule shows the amounts business firms collectively intend to invest at each possible level of GDP. We assume that investment is fixed, that is, independent of the level of current disposable income or real output. Thus adding Planned I to the consumption schedule (C=I) will shift the consumption schedule upward by the amount of the planned investment. Figure 11.1 Page 210

14. Although we assume investment is fixed, most likely at higher levels of GDP there is some induced investment as excess capacity disappears and firms have incentives to add to their capital stock.

15. The aggregate expenditures-domestic output model (AKA the incomesexpenditures model) Key Graph 11.2 page 212 is used to determine equilibrium GDP

16. Equilibrium Output is that output where the total quantity of goods

produced (GDP) equals the total quantity of goods purchased (C+I). On the model, the 45 line shows potential GDP equilibrium where C+I=GDP 17. The actual equilibrium level of GDP is the GDP that corresponds to the intersection of the aggregates expenditures schedule and the 45-degree line. Figure 11.2 Page 212 18. Equilibrium GDP can be determined using the leakages-injections approach Figure 11.3-11.6 19. Savings is a leakage or withdrawal of spending from the incomeexpenditures stream whereas investment is an injection. At equilibrium GDP where C+I=GDP, S=I (In a closed economy with no public sector) 20. Actual Investment = Planned Investment and Unplanned Investment (i.e. unplanned changes in inventory investment). Unplanned investment acts as a balancing item, which equates the actual amounts, saved and invested in any period. a) At all above-equilibrium points, where savings exceed planned investment, inventories (i.e. unplanned investment) will rise until savings equals actual investment. Businesses will cut back on production until equilibrium (S=planned I) occurs. b) At all below-equilibrium points, where savings is less than planned investment, inventories (i.e. unplanned investment) will fall and businesses will increase production until equilibrium (S=planned I) occurs. c) Only at equilibrium does S=Planned I and the unplanned investment is zero. Chapter 10: Aggregate Expenditures, the Multiplier, Net Exports, and Government 1. The Multiplier Effect is that a change in a component of aggregate expenditures leads to a larger change in equilibrium GDP. Multiplier= Change in Real GDP

Initial Change in Spending (C or I or G or Xn) Thus the change in real GDP= Multiplier x Initial Change in spending The Expenditure Multiplier= 1 MPS or 1 1-MPC

2. Net Exports (Xn)= Exports(X) Imports (M). Positive Net Exports (X>M) will increase aggregate expenditures whereas negative net exports (X<M) will

decrease aggregate expenditures Fig. 11.4 Pg 216 3. Increases in public or government spending (G) will increase aggregate expenditures whereas decreases in G will decrease aggregate expenditures Figure 11.5 Page 219 4. Changes in taxes will have a smaller multiplied effect on equilibrium than the expenditure multiplier above because taxes initially change disposable income before affecting consumption. For example, if the government reduces taxes by a lump sum of $20 billion at all levels of disposable income and the MPC is .75, people will only spend $15 billion and save $5 billion. Thus, the multiplied effect would increase GDP by $60 billion ($15 billion x 4). Thus the tax multiplier is only 3. Contrast this to an increase in government spending by $20 billion, which would increase GDP by $80 billion ($20 billion x 4). The Tax Multiplier= -MPC 1-MPC 5. Equal increases in government spending and taxation increases the equilibrium GDP by the amount of the increase. If the government increased both taxes and spending by $40 billion, equilibrium GDP would increase by $40 billion. If the MPC were .8, the government spending would increase equilibrium GDP by $200 billion ($40 billion x 5) whereas the increased lump sum tax of $40 billion would first lower disposable income by $32 billion ($40 billion x .8) and then reduce equilibrium GDP by $160 billion ($32 billion x 5). $200 billion- $160 billion = $40 billion. Government spending affects aggregate expenditures more powerfully than a tax change of the same size. The Balanced Budget Multiplier=1 6. A Recessionary Gap is the amount by which aggregate expenditures at the full-employment level of GDP fall short of those required to achieve the full-employment GDP. If full employment GDP was $500 billion and actual equilibrium GDP was $400 billion and the MPC .8, aggregate expenditures would have to increase by $20 billion ($100 billion/5) to solve the recessionary gap. Figure 11.7 Page 223 7. An Inflationary Gap is the amount by which an economys aggregate expenditures at the full-employment GDP exceed those necessary to achieve the full-employment GDP. If the full-employment GDP were $500 billion and the actual equilibrium GDP $750 billion and the MPC .9, aggregate expenditures would have to be reduced by $25 billion ($250 billion/10) to solve the inflationary gap. Figure 11.7 Page 223 Chapter 11: Aggregate Demand and Aggregate Supply

1. Aggregate Demand is a schedule or curve showing the various amounts of goods/services (i.e. real output) that domestic consumers, businesses, government, and foreign buyers collectively desire to purchase at each possible price level. There are three reasons for the downward slope of AD where higher price level will decrease the quantity of real GDP demanded and a lower price level will increase the quantity of real GDP demanded. Figure 12.1 Page 231 a) Wealth Effect: A higher price level reduces the real value or purchasing power of the publics accumulated financial assets. b) Interest Rate Effect: A higher price level increases the demand for money and (assuming a fixed supply of money) raises the interest rate, which reduces consumption and investment. c) Foreign Purchases Effect: A higher price level makes U.S. exports relatively expensive and foreign imports relatively cheap, reducing net exports (X M), a component of aggregate demand. 2. Determinants of Aggregate Demand will increase (shift right) or decrease (shift left) AD at all price levels. Factors that will increase AD include: a) Consumption Spending (increase in consumer wealth, expectations of future price increases, household debt and taxes) b) Investment Spending (decrease in interest rate, higher expected returns on investment, lower business taxes, new technology, excess capacity.) c) Government Spending

d) Net Export Spending (rising foreign national income, depreciation of US dollar) Figure 12.2 Page 233 3. Aggregate Supply is a schedule or curve showing the level of real domestic output which will be produced at each price level. There are three regions of the AS curve: a) horizontal or Keynesian b) upward sloping and c) vertical or classical. Figures 12.3-12.5 Pages 236 and 237 4. Determinants of Aggregate Supply will increase (shift right) or decrease (shift left) AS at all price levels. When per-unit costs decrease, aggregate supply will increase and when per-unit costs increase, AS will decrease. Figure 12.6 Page 239. Some aggregate supply determinants include: a) Lower input prices (for land, labor, and capital) will increase AS

b) An appreciation of the dollar will lower the price of imported resources and increase AS c) Increased productivity= total output/total inputs will lower costs and increase AS d) Supply-side economic policies that lower business taxes will reduce costs and increase AS 5. The equilibrium price level and equilibrium real GDP occur where AD=AS Figure 12.7 Page 242 6. The effect of changes in AD on equilibrium price level and output depend upon which of the three ranges the shift of AD occurs. Figures 12.8 +12.9 Page 243 If AD increased, the following table summarizes the effects:

Range Multiplied Effect Horizontal Full Effect Intermediate Reduced Effect Vertical None

Price Level No Change Moderate Increase Large Increase

Real GDP Large Increase Moderate Increase No Increase

Chapter 12: Fiscal Policy 1. Discretionary Fiscal Policy is the deliberate manipulation of taxes and government spending to alter GDP and employment, control inflation and stimulate growth. 2. Stabilization policies in the short run involve the following two option:

a) Expansionary Fiscal Policy is used to eliminate a recessionary gap and stimulate AD in order to return the economy to full employment. b) Contractionary Fiscal Policy is used to counteract and inflationary gap and reduce AD in order to return the economy to full employment. 3. Fiscal Policy Options Govt Spending Effect on Prices* Effect on Budget Taxes Effect on GDP

a. Expansionary increase

increase toward deficit

lower raise

increase decrease

b. Contractionary decrease decrease toward surplus

*Effect on prices assumes in an intermediate or vertical region of AS (In a horizontal region, no change) 4. The crowding out effect is an argument that an expansionary fiscal policy (deficit spending) will increase the interest rate and reduce private investment, reducing the stimulus of the fiscal policy Figure 13.8 Page 269.Specifically, here are the linkages a) Government spending and/or tax reduction increases the budget deficit

b) The budget deficit is financed through government borrowing of funds in the money market c) d) The increase in the demand for money raises the interest rate The higher interest rate discourages or crowds out private investment

e) Economic growth in the long run (LRAS) will be reduced due to smaller private capital stock 5. The Net Export Effect further reduces the impact of expansionary fiscal policy as higher domestic interest rates.. a) b) Increase foreign demand for dollars The increased demand for dollars results in an appreciated dollar

c) The appreciated dollar makes exports more expensive and imports cheaper d) Net exports decline partially offsetting the expansionary fiscal policy

6. Non Discretionary Fiscal Policy or Built-In Stabilizers are counter cyclical government programs (e.g. progressive income tax and transfer payments such as unemployment conversation) that automatically counteract both recessions and high inflation. a) For example, as GDP rises during prosperity, tax revenues under a progressive income tax system automatically increase and transfer

payments, such as unemployment insurance, automatically decrease, both reducing consumer spending and restraining economic expansion. The budget will automatically move towards a surplus b) Conversely, as GDP falls during a recession, tax revenues automatically decline and transfer payments automatically increase, stimulating consumer spending and preventing a prolonged recession. The budget will automatically move toward a deficit. Chapter 13: Money and Banking 1. Money serves three functions: Medium of Exchange, Unit of Account, and Store of Value 2. M1 is the most liquid category of money and includes currency and checkable deposits 3. M2 includes M1 and near monies (e.g. savings, time deposits, money market mutual funds) 4. The purchasing power of money is the amount of goods/services money will buy. Higher prices lower the value of the dollar because more dollars will be needed to buy a particular amount of goods/services. 5. The public demands money for two reasons: to make purchases with (transaction demand) and to hold as an asset. Figure 16.1 Page 309 The total demand curve for money includes two components: a) The assets demand for money varies inversely with the rate of interest. When the interest rate (i.e. the opportunity cost of holding money) is low, the public will choose to hold a large amount of money as assets whereas when the interest rate is high, people will hold less money as assets. Thus, the demand curve for money is downward sloping. b) The transactions demand for money varies directly with nominal GDP. If higher prices increase nominal GDP, the transaction demand for money will shift the total money demand curve to the right at all levels of interest. 6. Money Market Equilibrium occurs where the vertical supply curve of money intersects the downward sloping demand curve. Change in $ Supply Equilibrium Interest Increase Decrease Change in $ Demand No Change No Change Change in Decrease Increase

No Change No Change

Increase Decrease

Increase Decrease

Chapter 14: How Banks Create Money 1. A balance sheet is a statement of what the bank owns (assets) and what the bank owes (liabilities). Bank assets include cash reserves, bonds, and loans. Bank liabilities include demand deposits (checking) and savings accounts. 2. The Federal Reserve requires that banks keep a specific percentage of its own demand deposit liabilities on reserve. The Reserve Ratio= Commercial Banks Required Reserves Commercial Banks Demand-Deposit Liabilities 3. Excess Reserves= Actual Reserves- Required reserves

4. The money multiplier indicates the maximum amount of new demanddeposit money that can be created in the banking system by a single dollar of excess reserves. As a formula, m= ratio 1 R Maximum Demand-Deposit Creation = Excess Reserves x m If, for example, the required reserve ratio was .2, $100 billion of excess reserves would multiply to $500 billion Higher Reserve Ratios mean lower money multipliers and therefore less creation of a new deposit money via loans whereas smaller reserve ratios mean higher money multipliers and thus more creation of new deposit money via loan Two limitations that reduce the full effect of the money multiplier include: a) Money received by a borrower may not be deposited into the banking system b) Bankers may hold excess reserves above the required reserve ratio. Where m= money multiplier and R= required reserve

Chapter 15 Monetary Policy 1. Monetary Policy consists of altering the economys money supply to

stabilize aggregate output, employment, and the price level. The three major tools of monetary policy and the effect on real GDP and the price level include: a) Open Market Operations involves the buying and selling of government bonds (securities) by the Federal Reserve Banks in the open market. Buying securities from banks and/or the public will increase bank reserves and thus the money supply. When the Fed buys government bonds the supply decreases, raising bond prices and lowering interest rates. Selling securities to banks and/or the public will decrease bank reserves and thus the money supply. When the Fed sells government bonds, the supply increases, lowering bond prices and raising the interest rates. b) The Reserve Ratio: Lowering the reserve ratio decreases the amount of required reserves banks must maintain increasing excess reserves and the money supply via new loans. Raising the reserve ratio increases the amount of required reserves banks must maintain decreasing excess reserves and the money supply. c) The Discount Rate: The Fed charges commercial banks for loans. When the discount rate is decreased, commercial banks are encouraged to obtain additional reserves by borrowing from Federal Reserve Banks. 2. A tight or contractionary monetary policy is an attempt by the Fed to lower the supply of money in order to encourage spending, increase aggregate demand, and increase employment. Figure 13.2 Page 256

Easy Money Policy

Tight Money Policy Problem: Inflation

Problem: Unemployment and Recession

Federal Reserve buys bonds, lowers reserve increases reserve ratio ratio, or lowers the discount rate rate

Federal Reserve sells bonds, or increases the discount

Excess Reserves Increase

Excess Reserves Decrease

Money Supply Rises

Money Supply Falls

Interest Rate Falls

Interest Rate Rises

Investment Spending Increases

Investment Spending Decreases

Aggregate Demand Increases

Aggregate Demand Decreases

Real GDP rises by a multiple of the Income investment

Inflation Declines

2. The effectiveness of monetary policy depends upon the elasticity of the demand for money and the investment. The steeper (more inelastic) the demand curve for money, the larger the effect of any change in the money supply on the equilibrium rate of interest. Furthermore, any change in the interest rate will have a larger impact on investment --and hence aggregate demand and the GDPthe flatter (more elastic) the demand curve.

r0 r1

MS

MS

MD I

Q$

I0

I1

3. The net export effect of monetary policy, unlike fiscal policy, will increase net exports if expansionary and decrease net exports if contractionary.

Easy Money Policy Tight Money Policy Contractionary Fiscal Policy Problem: Recession, Problem: inflation slow growth Problem: Inflation

Expansionary Fiscal Policy Problem: Recession, slow growth

Easy money policy Tight money policy Contractionary Fiscal policy (lower interest rate) (higher interest rate)

Expansionary Fiscal Policy

Decreased demand for Increased demand for interest rate Lower domestic interest rate foreign dollars foreign dollars

Higher domestic

Dollar depreciates Dollar appreciates Decreased foreign demand for dollars

Increased foreign demand for dollars

Xn increases (Aggregate Dollar Depreciates Demand Increases strengthening the easy Net Exports increase

Xn decreases (Aggregate demand decreases strengthening the tight

Dollar Appreciates

Net Exports decline

money policy)

money policy)

Chapter 16 Extending the Analysis of Aggregate Supply and Aggregate Demand Chapter 17 Disputes in the Macro Theory and Policy

1. The short run is a period in which nominal wages (and other input prices) are fixed as the price level changes. The short run aggregate supply curve (SRAS) is upward sloping because if the prices rise while the nominal wages are fixed, profits rise and output will increase. If prices fall while nominal wages are fixed, profits fall and output will decrease. 2. The long run is a period in which nominal wages are fully responsive to changes in the price level. As a result, the long run aggregate supply curve (LRAS) is perfectly vertical (inelastic) as higher prices result in higher wages and no change in output. Note that the LRAS is the production possibilities curve (PPF) in an economy. 3. Although aggregate demand and SRAS may intersect beyond the LRAS in the short run, economic growth only occurs when the LRAS shifts to the right due to increased productivity, lower input costs for business, new technology, etc. 4. Classical Model Assumptions

i) The economy operates at full-employment (Qf) where long run aggregate supply curve is vertical (LRAS) ii) Wages, prices, and interest rates are fully flexible (long run assumption)

iii) Aggregate demand is relatively stable iv) If there is an inflationary or recessionary gap, the economy will selfcorrect without government intervention (laissez-faire) A. Theory of Self-Correction Scenario A: Inflationary Gap (Model A on Left) i. ii. AD increases from AD1 to AD2 In short run (SR) prices increase revenue increases profit

increases (as nominal wages and other input costs are fixed in the short run) real output increases (Point b at Q2 PL2) iii. In long run (LR), economy self corrects as nominal wages and other input costs increase iv. SRAS curve shifts left (AS2) and prices increase to PL3 (point c) real output falls and returns to Q1

B. Theory of Self-Correction Scenario B: Recessionary Gap (Model B on Right) a) AD decreases from AD1 to AD3

b) In short run (SR), prices fall revenue falls profit falls (as nominal wages and other input costs are fixed in the short run) real output falls (point d at Q3, PL4) c) In long run (LR), an economy self-corrects as nominal wages and other input costs fall d) SRAS curve shifts right (AS3) and prices fall to PL5 (point e) Price Level real output increases and returns to Qf

Price Level

ASLR

AS2

P1

P3

P2 e

P4

P1

P5

AD2 AD1

Q1 Q2 Q4 Q3 Q1 Real Domestic Output (a) Effects of an Increase in AD in AD Real Domestic Output (b) Effects of a Decrease

5.

Keynesian Model Assumptions

i. Economy may operate below Qf in equilibrium for extended periods of time where AS is horizontal ii. iii. Prices, Wages, and Interest are often sticky Aggregate demand (especially investment) is volatile

iv. Government intervention (fiscal/ monetary policy) manipulating aggregate demand is often necessary to help the economy reach and remain at full employment (stabilization policies)

A. Critique of Theory of Self-Correction Scenario B: Recessionary Gap (Model B on above Right) i. AD falls from AD1 to AD3

ii. Prices downwardly inflexible and new temporary equilibrium where PL1 intersects AD3 (point f) iii. Surpluses result as AS>AD and prices fall to point d (AS1 and AD3) on graph iv. However the SRAS will not shift right to Qf (contrast classical view) because wages are also sticky v. The economy will be stuck at point d with high unemployment, low RDGP with a recession vi. Expansionary fiscal and monetary policies will enable shift AD right and the economy will return to full employment.

Macroeconomic Policy Dilemmas

Option Disadvantages Monetary Policy 1. Inflation may worsen 2. Exchange rates may fall Expansionary

Advantages 1. IR may fall 2. Economy may grow 3. Decreases UE

3. Capital Outflow 4. Trade deficit may increase

Contractionary 2. Increases UE

1. Exchange rate

1. Risks recession may rise 2. Helps fight inflation

3. Slows growth 3. Trade deficit may 4. May cause short run decrease political problems 4. Capital outflow 5. IR may rise

Fiscal Policy Expansionary continue 1. Budget deficit worsens (Borrow and Spend) 2. Hurts countrys ability

1. Growth may 2. May help solve SR political problems

to borrow in the future 3. Decreases UE 3. Trade deficit may increase 4. Upward pressure on interest rates

inflation 2. Increases UE

Contractionary 1. Risks recession

1. May help fight 2. May allow a better monetary/fiscal mix

3. Slows growth 3. Trade deficit may 4. May help cause SR decrease political problems 4. Interest rates may fall

Comparison of Classical and Keynesian Policies

Problem

Keynesian Policy

Classical Policy

Cause: Inflation is a monetary problem

Avoid inflation by relying on strict monetary rule-use contractionary monetary policy

Be careful about expanding output too high and causing inflation

Push inflation to zero by strict monetary rule

Cause: Inflation is a combination institutional and monetary problem

Use contractionary monetary and fiscal policy

Supplement above policy with policies to change wage and price-setting institutions- possibly consider a temporary income policy

Some small amount of inflation may be good for economy, and it is not worth trying to push inflation to zero if it involves significant unemployment.

Inflation:

Cause: Growth rates reflect peoples desires; probable cause of slow growth is too much regulation, too high tax rates, and too few incentives for growth

Remove government impediments to growth; go back to laissez-faire policy

Cause: An institutional and AD problem

Use expansionary monetary and fiscal policy

Supplement above policy with policies to establish incentive for growth

Slow Growth:

Recessionary Cause: Earlier government policies were too expansionary, causing inflation

If UE were very high, use expansionary monetary and fiscal policy. Generally, however, government policies should focus on LR

Cause: Institutional and AD problem

Use expansionary monetary and fiscal policy.

Unemployment:

Fiscal Policy Advocates of fiscal policy solutions believe that the governments decisions about spending and taxing can influence the equilibrium of the nations GDP. More specifically, a fundamental function of the governmentsspending and taxing policy is to stabilize the economy. This stabilization is achieved in part through the manipulation of the public budget-government spending and tax collections- for the expressed purpose of increasing output and employment or reducing the rate of inflation.

In addition to its role in stabilizing the economy, the Federal government is also concerned with the provision of public goods and services and the redistribution of income. In this regard, the specific types of spending and taxing policies are important. For example, the government could engage in an expansionary policy by increasing the dollars going toward education, by serving as employer of last resort for low-skilled, unemployed workers, or by reducing income taxes for the wealthy. While all of these scenarios might have the same expansionary impact on the economy as a whole, they have very different distributional impacts. One policy helps the middle class (the primary recipients of education), one helps the poor (low-skilled and unemployed), and one helps the wealthy (tax breaks)

Fiscal policy can be targeted toward either the supply or the demand side of the economy. Supply-side policies include all policies targeted toward production in the business sector (e.g. changing incentives for investment). Demand-side policies include all policies targeted toward spending by consumers (e.g. altering employment opportunities or taxes on consumption).

Expansionary Fiscal Policy Increased government spending or decreased taxes are used when the growth of the economy is too slow. That is, the economy is faced with a recession, high levels of unemployment, and a slow growth in GDP. Expansionary fiscal policy includes: Increased government spending Lower taxes A combination of the two

If the budget is balanced, an expansionary fiscal policy will increase the deficit as government spending is increased. Critics of fiscal policy measures argue that this expansion of the government crowds out expansion by private firms by competing for investment funds used to finance spending.

Assuming that the crowding out effects are minimal, expansionary fiscal policy is effective when the economy needs stimulation. It stimulates

spending (of consumers or firms), which, in turn, stimulates production and reduces unemployment. If it is undertaken when demand-pull inflationary pressures are present or when the economy is at full employment, it will overheat the economy and create increased rates of inflation. If prices are rising because of non-labor cost-push factors and the economy is sluggish, expansionary fiscal policies can expand the economy with little impact on price levels.

Contrary Fiscal Policy Decreasing government spending or increasing taxes is used when growth in the economy is overheated. That is, contractionary fiscal policies are most effective when the economy faces excess demand for workers by firms or for goods by consumers. These pressures underlie inflationary pressures and GDP growth that is too rapid. Contractionary fiscal policy includes: Decreased government spending Increased taxes A combination of the two

If the budget is balanced at the outset, a contractionary fiscal policy would move the government toward a budget surplus. This surplus slows economic growth and production. Contractionary fiscal policy is effective when the economy contains (demand-side) inflationary pressures. By decreasing spending (of consumers or firms), production is slowed and the demand for workers decreases. If it is undertaken when the economy is in a recession, it will further reduce economic growth and exacerbate unemployment. If prices are rising because of non-labor cost push factors and the economy is sluggish, contractionary fiscal policies will increase the sluggishness of the economy and will have little impact on price levels. Provided by Kristen Lubenow, Lowell H.S. Work from Buck Trust Seminar, 1997. Agreement about Macroeconomic Policy

Both Keynesians and Classicals generally agree that:

1.

Expansionary monetary and fiscal policies have short-run simulative

effects on income. 2. Expansionary monetary and fiscal policies have potential long-run inflation effects 3. Monetary policy is politically easier to implement than fiscal policy.

4. Expansionary monetary and fiscal policies tend to increase the trade deficit. 5. Expansionary monetary policy places downward pressure on the exchange rate. 6. Expansionary fiscal policy has an ambiguous effect on the exchange rate. 7. Supply Side Economics in a Few Words

Policy regime: The general set of rules, whether explicit or implicit, governing the monetary and fiscal policies a country follows.

The big difference in policy regimes bore and after WWII was the introduction of Keynesian economics and its use of discretionary fiscal policy. Before WWII, Classical economics dictated that government budget deficits were bad and that, except in wartime, they should be avoided, which was the policy of the US government. That was changed to Keynesian economics, which prescribed deficits to stimulate the economy and achieve higher levels of output. According to Keynesian economics, deficits were NOT necessarily bad. You had to look at the state of the economy to decide whether a deficit was good or bad.

Keynesians were blamed for the deficit, but when the government changed hands in the 1980s, and Classical supply-side economic policy came in, the deficit did not disappear, but grew.

Traditional macro policies offer trade-offs. To expand the economy, one must run deficits and increase the money supply. Doing so increases inflation. Supply-side policies offer hope of expanding potential output and hence having it allgrowth, prosperity, and low unemploymentwithout deficits.

SUPPLY-SIDE policies expand potential output by creating supply-side incentives by lowering tax rates or by modifying the composition of government spending and taxes to stimulate the economy. Because they expand potential output, they allow the economy to grow; that growth decreases the budget deficit and creates jobs.

IMPORTANT DIFFERENCE: It looks as though the Supply-Side argument for cutting taxes is much like the Keynesian argument for fiscal policy in which cutting taxes stimulates the economy via the multiplier effect. However, there is an important difference. The supply-side explanation of how the tax cut would stimulate the economy is by microeconomic incentives. It focuses on TAX RATES, not tax revenues.

The supply-side argument goes as follows: If the government cuts tax rates, people will have greater incentive to work, to save, and to invest. As they do all these things, output will increase, not because of expectations of increased demand, but because of the incentive effects of lower tax rates on supply. (The aggregate supply curve and hence potential income will shift out). Since supply creates its own demand, AD will also increase. The economy will expand because of greater incentives to work. ****CLAIM: A decrease in taxes directly shifts the AD curve.

Monetarism:

3 Tenets 1. Changes in the supply of money DO NOT affect the economy via their effect on Interest Rates and Investment. Rather, changes in the money supplyin the banks ability to make loansresult directly in changes in expenditure.

2.

There is a natural rate of unemployment that controls the rate of growth.

The natural rate of UE refers to the willingness of individuals to work, given the prevailing wage. Changes in expenditure (MV) may result in bursts of activity, but will not budge that fundamental controlling force. Hence, attempts to accelerate growth through spending will only crowd out private activity. The system will return to its natural path. Therefore, too, booms and busts will be transientindeed, they are more often caused than cured by government intervention.

3. Changes in M affect P. Where money matters most is in its effect on the price level. An increase in M leads to an increase in MV; but because the level of output is fixed by the natural rate of UE, its effects will be felt in changes in P. These natural changes are the only source of rising or falling prices. Strategies:

1. A steady increase in M, geared to the economys natural rate of UE, is best for the economy. This rate would not vary (2-4%). If circumstances tended to push the economy ahead faster than the fixed rate of growth of M, the steady rate would hold it back. If the economy lagged for any reason, the steady increase in M would stimulate growth to its natural rate.

Rational Expectations link M and MV

1) This theory asserts that all individuals are guided by common sense predictions about the future. When they read that the authorities are increasing M, they expect P to rise. Therefore, they spend their incomes more quickly to beat the coming price rise. As intuitive monetarists, they make monetarist theory come true.

Anti-Monetarists contest all these tenets:

1. They deny that the Fed controls the money supply as the monetarists state. Rather, they suggest that the demand for money (for transactions needs) forces the Fed to change the money base.

2. They deny a natural rate of UE or the uselessness of intervention, and assert that costs, not M, determine P. The bases for inflation are such changes in supply shocks and changes in wages.

3. Tend to favor a discretionary monetary policy that will try to fit the supply of money to changing needs.

Rational Expectations and the New Classical Model You already know that economists assume that economic participants act as though they were rational and calculating. We think of firms that rationally maximize profits when they choose todays output and consumers who rationally maximize utility when they choose how much of what goods to consume. One of the pivotal features of current macro theory research of the assumption that rationality also applies to the way that economic participants think about the future as well as the present. In particular, there is widespread agreement among the many leading macro researchers that the rational expectations hypothesis extends our understanding of the behavior of the macro economy. There are two key elements to the hypothesis:

1. Individuals base their forecasts or expectations about the future values of economic variables on all the available information past and present.

2. These expectations incorporate individuals understanding about how the economy operates, including the operation of monetary and fiscal policy.

In essence, the rational expectation hypothesis assumes that Lincoln was correct when he stated, It is true that you may fool all the people some of the time; you can even fool some of the people all the time; but you cant fool all the people all the time.

The theory of rational expectations suggests that after policy makers pursue either expansionary or contractionary policies a few times, people learn how to predict both changes in policies and the policies themselves. Consumers and investors will then behave in ways that prevent predictable policies from having any real effect.

Therefore, policy goals cannot be achieved, even in the short-run, unless the effects of demand-management policies come as complete surprises to the public.

Realistic?

Assumes that people are able to accurately forecast government policymaking when it often seems the government is unable to do so itself. Information about government policies is unavoidably expensive and imprecise. As a result, many people remain rationally ignorant. Assumes people understand economics and react according to changes in policy. Assumes wages and prices are totally flexible and adjust instantly to changes in the market. Union contracts, certain laws and regulations, longterm business contracts and numerous other obstacles all keep wages and prices for adjusting immediately to changes in AD and AS. It takes time for private investment and households to:

a)

Recognize that policies and situations have changed

b)

Implement plans to reflect new circumstances

c)

Have their new plans take effect

Government policies face parallel recognition, administrative, and impact lags. All of these reasons cause critics of this version of the new classical theory.

The Classical Explanation: A reduction in taxes for businesses moves AS out and since supply creates its own demand, also shifts the AD curve out. In the supply side view, AS is the best estimate of potential income, which means the tax rate cut increases potential income too.

The Keynesian Explanation: Cuts in taxes increase income and expected AD. IF the level of potential income is greater than the actual level of income, producers will increase output because of that increased expected demand, which further increases AD. If, however the economy is initially at potential income, the tax cut shifts the AD but not AS because AS cannot increase beyond potential income. The result will be either shortages or inflation.

The Keynesian (Demand-Side) explanation if a tax cuts effect is the multiplier process: In it, demand leads supply and potential income is unaffected. In the supply-side explanation, supply leads demand and potential income is increased. The differences are important because the supply-side explanation has specific policy implications. The supply-side explanation states that a deficit financed by a tax cut will not be inflationary. (For SupplySide: Society can have a free lunch).