Topics and percentages

8-12% Basic Economic Concepts 12-16% Measurement of Economic Performance 10-15% National Income and Price Determination 15-20% Financial Sector 20-30% Inflation, Unemployment, and Stabilization Policies 5-10% Economic Growth and Productivity 10-15% Open Economy: International Trade and Finance

8-12% Basic Economic Concepts

A. Scarcity, choice, and opportunity costs B. Production possibilities curve C. Comparative advantage, absolute advantage, specialization, and exchange D. Demand, supply, and market equilibrium E. Macroeconomic issues: business cycle, unemployment, inflation, growth

Production Possibilities
Assumptions: Full Employment Fixed Resources and Technology Movements Along curve shows opportunity cost Outward shift illustrates economic growth Inward shift indicates destruction of resources

Producing Capital Goods will lead to greater economic growth than producing consumer goods. (Butter will lead to more growth than guns)

Production Possibilities Graph

Capital Goods A
May Lead to most Future economic growth

Points A,B,C, are efficient pts. Point D is underutilization Point E is economic growth E B D C

F.E.

F.E.1

Consumer Goods

Supply and Demand Factors

Demand Changes when:
Income changes Related Products, complements and substitutes, (price or quality change) Expectations (future price change) Consumers (more or less added) Tastes, Fads, Preferences change

Increases, Price and Quantity Increase as well.

Price S1

P2

P1 D2 D1 Q1 Q2

Quantity

Decreases, Price and Quantity decrease as well

Price S1

P1

P2 D1 D2 Q2 Q1 Quantity

Supply Factors
Supply Changes When:
Input prices change (resources and wages) Government (tariffs, quotas, and subsidies) Number of sellers change Expectations (about price and product profitability change) Disasters (weather, strikes, etc..)

Supply Increase: As Supply Increases, Quantity Increases, but Price Falls.

S1

Price

S2

P1 P2

D1

Q1

Q2

Quantity

Supply Decrease: As Supply Decreases, Quantity Decreases, but Price Increases.

S2

Price

S1

P2

P1

D1

Quantity Q2 Q1

Comparative Advantage
A nation should specialize in producing goods in which it has a comparative advantage: ability to produce the good at a lower opportunity cost.
Example: Cheese Wine

Spain:
France

2 pounds
2 pounds

2 Cases
6 Cases

Spain should produce cheese (1C = 1W)

France should produce wine (1W = 1/3C)
:

Currency Terms
Appreciation: Currency is increasing in demand (stronger dollar)
U.S. Currency will appreciate when more foreigners: travel to the U.S., buy more U.S. goods or services, or buy the U.S. dollar to invest in bonds

Currency Terms
Depreciation: Currency is decreasing in demand (weaker dollar) Being SUPPLIED in exchange for other currency.
U.S. Currency will depreciate when fewer foreigners: travel to the U.S., buy fewer U.S. goods or services, or sell the U.S. dollar to invest in their own bonds

Business Cycles
The increases and decreases in Real GDP consisting of four phases:
Peak: highest point of Real GDP Recession: Real GDP declining for 6 months Trough: lowest point of Real GDP Recovery: Real GDP increasing (trough to peak)

15

Business Cycle
Full Employment

Peak -- Greatest spending and lowest unemployment. Inflation becomes a problem. Contraction/Recession -- Reduction of spending levels and increasing unemployment. Some cyclical unemployment begins. Trough -- Least spending and highest unemployment Expansion -- Spending increases and unemployment decreases We want to avoid extreme inflation and extreme unemployment. We want stability!

16

The two big problems

The two big problems that plague the economy are: INFLATION UNEMPLOYMENT People generally prefer steady, stable growth to large ups and downs. Therefore, government policies, both fiscal and monetary (see later sections), are aimed at flattening the business cycle. The government wants not only to stimulate the economy when its slow, but also to slow it down when its growing too quickly.

17

12-16% Measurement of Economic Performance

A. National income accounts 1. Circular flow 2. Gross domestic product 3. Components of gross domestic product 4. Real versus nominal gross domestic product B. Inflation measurement and adjustment 1. Price indices 2. Nominal and real values 3. Costs of inflation C. Unemployment 1. Definition and measurement 2. Types of unemployment 3. Natural rate of unemployment

18

Circular Flow of Economic Activity

Households supply resources (land, labor, capital, entrepreneurial ability) to the resource market. Households demand goods and services from businesses.

Businesses demand household resources and supply goods and services to the product (factor) market.

20

Gross Domestic Product

GDP (Gross Domestic Product): The total dollar (market)
value of all final goods and services produced in a given year. Expenditure Formula:

Consumption (C) + Business Investment (I) + Government Spending (G) + Net Exports (Xn)

GDP: What Counts:

Goods Produced but not Sold (I) Goods produced by a foreign country (Japan) in the U.S. (Honda, Toyota) Government spending on the military Increase in business inventories

GDP: What DOES NOT count:

Intermediate Goods (Tires sold by Firestone to Ford) Used Goods Non-Market Activities (Illegal, Underground) Transfer Payments (Social Security) Stock Transactions

Shortcomings of GDP: Leading to GDP being

understated.

Nonmarket activities: (services of homemakers) does not count.

Leisure: Does not include the value of leisure.

Does not include improvements in product quality. Underground economy

GDP: Overstated
Includes damage to the environment Includes more spending on healthcareAmericans being unhealthy. Includes money spent to fight crime-more police officers, more jails, etc

Real GDP
Real GDP= Nominal GDP adjusted for inflation. Calculation:
Real GDP = Nominal GDP Price Index in Hundredths( deflator)

Example: U.S. 2005 Real GDP=

$12,4558 (billions) 1.1274 (based on 2000)

$11.048 Trillion

Real GDP Per Capita

Most commonly used to compare and measure each countrys standard of living and overall economic growth.

Real GDP/Nations Population

Inflation
Rise in the general level of prices Reduces the purchasing power of money Measured with the Consumer Price Index (CPI)
Reports the price of a market basket , more than 300 goods that are typically purchased by an urban household

28

Calculating Inflation
CPI in Recent Year CPI in Past Year Divided by CPI in Past Year (Number then Multiplied by 100)
Example: 2002 CPI = 179.9 2001 CPI = 177.1

Rate of Inflation: 179.9-177.1 = 1.58% 177.1

Types of Inflation
Demand Pull Inflation: too much money chasing too few goods.
AD Curve will shift to the right, resulting in a higher Price Level and greater Output (until reaching Y*

Cost-Push Inflation: Major cause is a supply shockOPEC cutting back on oil production
AS Curve will shift to the left resulting in a higher Price Level and a decrease in Real GDP.

Real and Nominal Terms

Real Income = Nominal Income Price Index (Hundredths) Real Interest Rate = Nominal Interest Rate Inflation Rate Nominal Interest Rate = Real Interest Rate + Inflation Premium (anticipated inflation)

Inflation: Winners & Losers

Winners:
Debtors who borrow money that will be repaid with cheap dollars. Those who have anticipated inflation

Losers:
Savers (especially savings accounts) Creditors (Banks will be repaid with those cheap dollars Fixed-Income Recipients (retirees receiving the same monthly pension)

Unemployment
Calculation: Number of Unemployed Labor Force (Multiplied by 100 to put as a %) The Labor Force is the total of employed and unemployed workers.

U.S. unemployment should be about 5%

33

Employed
You are considered to be employed if:
You work for 1 hour as a paid employee (so parttime workers count) You are temporarily absent from work (illness, strike, vacation) You work 15 hours or more as an unpaid worker (family farms are common)

Unemployed
Must be looking for work (at least 1 attempt in the past 4 weeks) Are reporting to a job within 30 days Are temporarily laid off from their job

Not In Labor Force

A person who is not looking for work:
Full-time students Stay at home parents Discouraged workers: those who have given up hope of finding a job. Retirees

Unemployment
100% of the people will never be employed, so the government considers 4-6% unemployment to be full employment. Types of Unemployment Frictional - temporary and unavoidable Structural - results from changes in technology or a business restructure (ex. Merger) Seasonal- occurs when industries slow or shut down for a season Cyclical - results from a decline in the business cycle.

We can never be at Full Employment if there is any percentage cyclically unemployed.

37

10-15% National Income and Price Determination

A. Aggregate demand 1. Determinants of aggregate demand 2. Multiplier and crowding-out effects B. Aggregate supply 1. Short-run and long-run analyses 2. Sticky versus flexible wages and prices 3. Determinants of aggregate supply C. Macroeconomic equilibrium 1. Real output and price level 2. Short and long run 3. Actual versus full-employment output 4. Economic fluctuations

38

Consumption and Saving

As income increases, both consumption and savings will increase.
The determinants of overall consumption and savings are: (More money or a positive outlook will increase consumption and reduce savings. Less money or a negative outlook will increase savings and reduce consumption.

Wealth (financial assets) Expectations about future prices and income Real Interest Rates Household Debt Taxes

Marginal Propensities
Marginal Propensity to Consume (MPC) and the Marginal Propensity to save (MPS) must equal 1. The MPS is used to derive the spending multiplier, which equals: 1_ MPS If the MPS is .2, the spending multiplier is 5. Any increase in spending must be multiplied by 5 to determine the overall increase in Real GDP.

Aggregate Demand
Price Level

Downward sloping: 1. Real-Balances Effect: change in purchasing power 2. Interest-Rate Effect: Higher interest rates curtail spending 3. Foreign Purchase Effect: Substitute foreign products for U.S. products AD (C + I + G + X) Real GDP

Aggregate Demand
Determinants of AD:
C + I + G + Xn (Yes, its GDP) An increase in any of these, due to lower interest rates or optimism will increase AD and shift the curve to the right. A decrease in any of these: more debt, less spending, tax increase, will cause a decrease in AD and shift the curve to the left

Aggregate Demand Determinants

Consumption
Wealth Expectations Debt Taxes

Government
Change in Gov. spending

Net Exports
National Income Abroad Exchange Rates

Investment
Interest Rates Expected Returns
Technology Inventories Taxes

Aggregate Supply Factors:

R: resource prices (The CELL/ wages and materials, as well as OIL) E: environment [legal-institutional] (Taxes, Subsidies, more regulation) P: productivity (better technology)

Aggregate Supply
Short Run:
Assumes that nominal wages are sticky and do not respond to price level changes. Is Upward sloping as businesses will increase output to maximize profits Generally considered to be a year or less.

Long Run:
Curve is vertical because the economy is at its fullemployment output. As prices go up, wages have adjusted so there is no incentive to increase production. Generally considered to be longer than a year.

Aggregate Supply Graph

Price Level Short Run

AS
Inflation

Long Run

Recession

Growth Extended vertical line Illustrates the LRAS and Y* (Full-Employment)

Y*

Real GDP

Another look as AS
LRAS PL Changes that lead to a new equilibrium on the left of LRAS = Recession

SRAS
Changes that lead to a new equilibrium on the right of LRAS = Inflation (AKA an overheated economy) RGDP

PL

AD Y*

NOTE!!
For the AP exam, assume that there are only two determinants that simultaneously affect BOTH short term aggregate supply and aggregate demand
business tax changes and foreign currency changes.

A change in business taxes shifts AD and AS in the same direction A change in FX sends both curves in the opposite directions.

Demand-Pull Inflation
AS

Price Level
P2

P1

AD2 AD1 (C + I + G + X) Y* Real GDP

Cost-Push Inflation
Price Level
P2 P1

AS2
AS1

AD1 ( C + I + G + X) Y Y* Real GDP

Demand-Pull Inflation

vs. Cost-Push Inflation

51

DEMAND-PULL INFLATION
ASLR
AS2 AS1

Price Level

P3 P2 P1

c
b a AD2 AD1

Real domestic output

Q1

52

COST-PUSH INFLATION
Occurs when short-run AS shifts left
ASLR
AS2 AS1

Price Level

P2 P1

b
a

AD1

Real domestic output

Q2 Q 1

53

COST-PUSH INFLATION
Government response with increased AD
ASLR
AS2 AS1

P3 P2 P1

c b
a

Even higher price levels

AD2 AD1

Price Level

Real domestic output

Q2 Q 1

54

COST-PUSH INFLATION
If government allows a recession to occur

ASLR

AS2 AS1

Price Level

P2 P1

b
a

AD1

Real domestic output

Q2 Q 1

55

COST-PUSH INFLATION
If government allows a recession to occur

ASLR

AS2 AS1

Price Level

P2 P1

b
a

Nominal wages fall & AS returns to its original location

AD1

Real domestic output

Q2 Q 1

56

15-20% Financial Sector (Money and Banking)

A. Money, banking, and financial markets 1. Definition of financial assets: money, stocks, bonds 2. Time value of money (present and future value) 3. Measures of money supply 4. Banks and creation of money 5. Money demand 6. Money market 7. Loanable funds market B. Central bank and control of the money supply 1. Tools of central bank policy 2. Quantity theory of money 57 3. Real versus nominal interest rates

Money Supply Terms

M1= Checkable Deposits and Currency M2= M1 + Savings deposits, money market accounts, small time deposits (less than $100,000) Velocity of Money Equation:
MV = PQ ( GDP) (M= Money Supply and V = Velocity (number of times per year the average dollar is spent on goods and services.

58

Banks and Balance Sheets

Assets Reserves $15,000 Checkable Deposits Securities $15,000 Loans $70,000 If the current reserve requirement is 10%:
1. What is the amount of new loans this bank can generate? Answer: $100,000 Checkable deposits X a 10% reserve requirement = $10,000 required reserves. If the bank has $15,000 in reserves, $5,000 of those are excess reserves and can be loaned out . 2. How much in new loans can be generated by the entire banking system? Answer: Money Multiplier = 1/Required Reserve Ratio=1/.10 10 X $5,000 = $50,000

Liabilities $100,000

59

FED and the Money Market

Nominal Interest Rate

MS1

MS2

nir1

Vertical curve-Supply controlled By the FED. An increase in MS leads to a rightward shift and lower nominal interest rates.

nir2

MD
Q1

Q2

Quantity of Money

60

Interest Rate-Investment
Expected Rate of Return: Amount of Profit (expressed as a percentage) a business expects to gain on a project/investment.
This rate must be greater than the interest in order to be profitable. The Real Rate of Return is most important. An expected profit of 10%, that costs 5% in interest = The real rate of return: 5%.

61

Investment Demand Curve:

Real Rate of Return

r1

At lower real interest rates businesses will Increase investment , leading to an increase In AD (aggregate demand). At higher rates of Interest, less money will be invested

r2

ID
Q1 Q2 Quantity of Investment

62

Shifts of the Investment Demand Curve

Expected Rate of Return ( Real Interest Rate.)

A shift from ID1 to ID2 Represents an increase in Investment demand. A shift From ID1 to ID3 represents a decrease in investment Demand. ID2 ID3
ID1
Quantity of Investment

63

Loanable Funds Market and Expansionary Fiscal Policy

Used for FISCAL POLICY (Government spendingDeficit Spending)
Real Interest Rate R2 SLF
An increase in Gov. spending increases the demand for loanable funds and raises real interest rates

R1 DLF2

DLF1

Q1

Q2

Quantity of Funds

Loanable Funds Market and Contractionary Fiscal Policy

Used for FISCAL POLICY (Government spending-Deficit Spending) A decrease in Gov.
Real Interest Rate R1 SLF
spending decreases the demand for loanable funds and lowers real interest rates

R2 DLF1

DLF2

Q2

Q1

Quantity of Funds

Nominal: with Inflation

Real: without Inflation

66

GDP
Nominal GDP: GDP measured in terms of current Price Level at the time of measurement. (Unadjusted for inflation) Real GDP: GDP adjusted for inflation; GDP in a year divided by a GDP deflator (Price Index) for that year

67

INCOME
NOMINAL INCOME: number of dollars received by an individual or group for its resources during some period of time REAL INCOME: amount of goods and services which can be purchased with nominal income during some period of time; nominal income adjusted for inflation

68

INTEREST RATE (I%)

NOMINAL I%: interest rate expressed in terms of annual amounts currently charged for interest; not adjusted for inflation REAL I%: interest rate expressed in dollars of constant value (adjusted for Inflation) and equal to the NOMINAL I% minus the EXPECTED RATE OF INFLATION

69

ANTICIPATED INFLATION

11%

=
5%
Real Interest Rate

6%
Inflation Premium

Nominal Interest Rate

70

WAGES
NOMINAL WAGES: amount of money received by a worker per unit of time (hour, day, etc.); Money Wage REAL WAGES: amount of goods and sevices a worker can purchase with their NOMINAL WAGE; purchasing power of the nominal wage. (Real = Nominal Inflation rate)

71

NOMINAL/REAL TIPs
If nominal rates INCREASE and Price Level INCREASE, the CHANGE in Real is indeterminable. If nominal Wage rates do NOT change and Price Level fall. REAL WAGES increase. NOMINAL RATES PIGGY-BACK REAL RATES & NOT VICE VERSA.

72

20-30% Inflation, Unemployment, and Stabilization Policies

A. Fiscal and monetary policies 1. Demand-side effects 2. Supply-side effects 3. Policy mix 4. Government deficits and debt B. Inflation and unemployment 1. Types of inflation a. Demand-pull inflation b. Cost-push inflation 2. The Phillips curve: short run versus long run 3. Role of expectations
73

Fiscal Policy
Using Taxes and Government spending to stabilize the economy. Controlled by the President and Congress Discretionary Fiscal Policy: Congress must take action (change the tax rates) in order for the action to be implemented. Automatic Stabilizers: Unemployment benefits, Progressive Tax System, these changes are implemented automatically to help the economy.

FISCAL POLICY CHANGES AD . EXCEPT when the question specifically states there is a change in business taxes.

Types of Fiscal Policy

Expansionary
Used to Fight a Recession LOWER TAXES INCREASE GOVERNMENT SPENDING

Contractionary
Used to fight Inflation RAISE TAXES DECREASE GOVERNMENT SPENDING

Expansionary Fiscal Policy

Price Level

AS1

P2 P1

AD2 AD1 ( C + I + G + X ) Real GDP Y*

Y1

Contractionary Fiscal Policy

Raising taxes or reducing government spending to fight inflation and stabilize the economy.
Price Level P1 AS

P2

AD1 AD2

Y*

Real GDP

Tax Multiplier [-MPC/MPS]

Remember, if the government decreases taxes, the result is not as great as a spending increase, since households will save a portion (MPS) of the tax cut. The Tax Multiplier = -MPC /MPS
Example: If the MPC is .8 and the MPS is .2 Spending Multiplier = 1/.2 or 5 Tax Multiplier = -.8 /.2 or -4

Crowding-Out Effect
An Expansionary Fiscal Policy as previously diagrammed will lead to higher interest rates. At higher interest rates, businesses will take out fewer loans and there will be a decrease in INVESTMENT (I) At the same time there will be a decrease in CONSUMER SPENDING (C) as they will take out fewer loans as well. This CROWDING OUT EFFECT will reduce the gain made by the expansionary fiscal policy.

Net Export Effect & Expansionary Fiscal Policy

Government spending has led to an increase in interest rates. At higher interest rates, foreigners demand more U.S. dollars to invest in bonds. This leads to an appreciation of the U.S. dollar. This leads to a decrease in Net Exports, as foreigners now have to exchange more of their currency for the U.S. dollar to buy exports. This decrease in Net Exports will reduce AD and counter to some extent the expansionary fiscal policy.

Net Export Effect & Contractionary Fiscal Policy

A decrease in government spending has led to a decrease in real interest rates. At lower interest rates, foreigners demand less U.S. dollars to invest in bonds. This leads to a depreciation of the U.S. dollar. This leads to an increase in Net Exports, as foreigners now have to exchange less of their currency for the U.S. dollar to buy exports. This increase in Net Exports will increase AD and further strengthen the contractionary fiscal policy.

Criticisms of Fiscal Policy

Timing Problems Recognition Lag: identifying recession or inflation Administrative Lag: getting Congress/President to agree to take action Operational Lag: Time needed to see the results of the fiscal policy Political Business Cycles: Politicians may take inappropriate action to get reelected (lower taxes during an inflationary period). Plus it is difficult to raise taxes

The Federal Reserve System (FED)

Control Monetary Policy Headquartered in Washington D.C. 12 Federal Reserve Districts Board of Governors (7 members) is the central authority Members are appointed by the President and confirmed by the Senate

Federal Open Market Committee (FOMC)

Made up of 12 people: Board of Governors + New York FED President + 4 other regional presidents (who rotate) Meets regularly to direct OPEN MARKET OPERATIONS (buying or selling of bonds) to maintain or change interest rates

FED and the Money Market

Nominal Interest Rate

MS1

MS2
Vertical curve-Supply controlled By the FED. An increase in MS leads to a rightward shift and

nir1

lower interest rates.

nir2

MD
Q1

Q2

Quantity of Money

Easy Money Policy on AD/AS

Buying Government Bonds, lowering the discount rate, or lowering reserve requirements, to fight a recession, by decreasing interest rates, increasing investment spending and/or consumption and increasing AD.
AS

Price Level

P2 AD2 P1 AD1 (C + I + G + X) Q1 QF

Real GDP

Effects of an Easy Money Policy

LOWER INTEREST rates which will lead to an INCREASE in INVESTMENT and CONSUMPTION. The U.S. dollar will DEPRECIATE, leading to an increase in NET EXPORTS as well. These effects STRENGTHEN the overall monetary policy (opposite of fiscal policys crowding-out and net export effect

FED and a TIGHT Money Policy

Nominal Interest Rate

MS2

MS1
Vertical curve-Supply controlled By the FED. A decrease in the Money supply, shifts the MS curve to the left and raises interest rates.

nir2

nir1

MD
Q2

12

Quantity of Money

Tight Money Policy and AD/AS

Selling bonds, raising the discount rate, or raising reserve requirements to fight inflation which will raise interest rates, decrease investment and/or consumption and decrease Aggregate Demand (AD).

Price Level P1

AS

P2

AD1 AD2

QF

Real GDP

Effects of a Tight Money Policy

At the higher interest rates, INVESTMENT SPENDING, and CONSUMPTION will decrease. At higher interest rates, the U.S. dollar will APPRECIATE (foreigners demand more U.S. securities). This will lead to a DECREASE in NET EXPORTS. Again, the Monetary Policy is STRENGTHENED as a result, unlike the effects of a contractionary fiscal policy.

Extended AD-AS Model

This is the other way to graph the AD-AS Model
Price Level
LRAS

SRAS

P1 AD

Y* The intersection of the 3 curves Is the Full-Employment Equilibrium

Real GDP

Extended AD-AS Model and Demand-Pull Inflation

In Demand-Pull Inflation, the AD curve has shifted to the right of the LRAS and SRAS intersection.
LRAS

Price Level

SRAS P2 PF AD2 AD1 Y* Y2 Real GDP

The Price Level and Real GDP has increased.

Extended AD-AS and Demand-Pull Inflation

Mainstream economists will fight inflation as previously discussed: with either a tight monetary policy or a contractionary fiscal policy. The goal would be to move the aggregate demand curve to the left. Classical economists would argue to DO NOTHING. As nominal wages rise, the SHORT-RUN AS curve will shift to the left (resources and wages are becoming more expensive), restoring the economy to its full-employment output level, but with a higher Price Level.

Extended AD-AS Model and Cost-Push Inflation

Cost-Push inflation occurs when the SRAS has shifted to the left Of the LRAS and AD intersection. Price Level P1 PF

SRAS2 LRAS SRAS1

Here the Price level has Increased and REAL GDP has decreased. AD1

Y1

Y*

Real GDP

Extended AD-AS and Cost-Push Inflation

Mainstream economists must decide whether to target the Price Level or Unemployment, before taking any action. Classical economists would argue to DO NOTHING. Eventually, wages and resource prices must decrease and when they do the SRAS curve will shift back to the right, restoring the economy to its full-employment output level and the original Price Level.

Extended AD-AS Model and Recession

In a recession due to a decrease in AD, the AD curve is to the left of the LRAS and SRAS intersection; showing a decrease in both the Price Level and Real GDP.
LRAS

Price Level

SRAS

PF P1

AD

Y1

Y*

Real GDP

Extended AD-AS and Recession

Mainstream economists will fight a recession as previously discussed: with either an easy money policy or an expansionary fiscal policy. The goal would be to move the aggregate demand curve to the right. Classical economists would argue to DO NOTHING. The decrease in wages and resource prices will shift the SRAS curve to the right, restoring the economy to its full-employment output level, but with a LOWER price. (SELF-CORRECTION)

Short-Run Phillips Curve

Suggests an inverse relationship between the inflation rate and the unemployment rate.
Inflation Rate
(percent)

When the unemployment rate is Low (2%), the inflation rate will Most likely be high (8%).

When the Unemployment rate Is high, inflation will likely be low. 2

SRPC1

8 Unemployment Rate (percent)

Short-Run Phillips Curve

When the Government fights unemployment, typically higher inflation will result. When the Government fights inflation, typically, more unemployment will result. Thereby, we move along the Short-Run Phillips Curve. (Changes in AD = movements on the SRPC. Inflation Rate
(percent)

A
SRPC1

6
Unemployment Rate (percent)

Shifting the Short-Run Phillips Curve

The Short-Run Phillips curve can also shift, this would mean that both the unemployment rate and inflation rate are changing at the same time. (A change in AS)
Inflation Rate % 5

Stagflation, unemployment and Inflation occurring together (OPEC decreasing Oil supply, causes this type of shift) SRPC2 SRPC1 6 7
Unemployment Rate %

Shifting the Short-Run Phillips Curve

The Short-Run Phillips curve can also shift, this would mean that both the unemployment rate and inflation rate are changing at the same time.
Inflation Rate % When Supply increases (productivity surge in 90s) more than demand, prices will fall, while GDP and employment Increase; shifting the curve to the left.

3
The SRPC is a mirror image of AS If AS moves right, SRPC moves left.

SRPC1 SRP2 5 7
Unemployment Rate %

Long-Run Phillips Curve

The Long-Run Phillips Curve is vertical, like the Long Run Aggregate Supply Curve. So, in the long run there is no tradeoff between inflation and unemployment. Only the Price Level will change. Inflation Rate% LRPC

3 SRPC

Unemployment Rate %

Laffer Curve
What is the optimal tax rate? A tax of 0% will provide no tax revenue. A tax rate of 100% will also lead to no tax revenue (no incentive to work). Answer must be somewhere in between. Tax Rate 100

Tax Revenue

Economic Philosophies
Classical: Believes that the government SHOULD NOT interfere in the economy. And believes in selfcorrection of economic problems. Keynesian: Believes that GOVERNMENT SHOULD
interfere in the economy (taxes, government spending). Most mainstream economists are Keynesians

Rational Expectations: Believes that monetary and

fiscal policy have certain effects on the economy and take action to make these policies ineffective.

5-10% Economic Growth and Productivity

A. Investment in Human Capital B. Investment in Physical Capital C. Research and development, and technological progress D. Growth Policy

105

Economic Growth
Five Factors connected to long run economic growth. Supply Factors:
Increase in natural resources (quantity and quality) Increase in human resources (quantity and quality) Increase in capital goods Improvements in technology

Demand Factors:
Increase in consumption by households, businesses, and government

Illustrating Economic Growth

Production Possibilities Curve
Capital Goods B A PPC2 PPC1 Consumer Goods

Illustrating Long Run Growth

Can also be illustrated with the extended AD-AS Model.
LRAS1 SRAS1 LRAS2 SRAS2

Price Level P2 P1

AD2 AD1

Y1

Y2 Real GDP

10-15% Open Economy: International Trade and Finance

A. Balance of payments accounts 1. Balance of trade 2. Current account 3. Capital account B. Foreign exchange market 1. Demand for and supply of foreign exchange 2. Exchange rate determination 3. Currency appreciation and depreciation C. Net exports and capital flows D. Links to financial and goods markets

109

International Trade
Comparative Advantage and Specialization allows for economic growth and efficiency. (More of each good can be obtained by trading-Trading line illustrates this) Trade barriers create more economic loss than benefits. Today there is a trend towards free trade and a reduction in trade barriers. Strongest arguments for protection are the infant industry and military self-sufficiency arguments. WTO oversees trade agreements and disputes, but has become a target of protesters lately.

Exchange Rates and International Markets

The value of a foreign nations currency in relation to your own currency is called the exchange rate.

An increase in the value of a currency is called appreciation. A decrease in the value of a currency is called depreciation. Multinational firms convert currencies on the foreign exchange market, a network of about 2,000 banks and other financial institutions.
111

Types of Exchange Rate Systems

Fixed Exchange-Rate Systems A currency system in which governments try to keep the values of their currencies constant against one another is called a fixed exchange-rate system. Flexible Exchange-Rate Systems Flexible exchange-rate systems allow the exchange rate to be determined by supply and demand.

112

Foreign Exchange Market

Lets say a U.S. citizen travels to Japan. This transaction will provide a supply of the U.S. dollar and result in a demand for yen. It will become cheaper for the Japanese to buy the dollar and more expensive for Americans to buy the Yen. The Yen is Appreciating and the dollar is Depreciating.
Yen Price of dollar (Y/$) P1 P2 D$1 Q1 Q2 Q1 Q2 DY1 Dollar Price of Yen ($/Y) P2 S$2 P1 SY1

S$1

DY2

Quantity of U.S. Dollars

Quantity of Yen

Balance of Payments: The sum of all transactions between U.S.

residents and residents of all foreign nations

Current Account: Shows U.S. exports and U.S. imports of goods and services. Capital Account: Shows the U.S. investment (financial as well as capitalplants and factories) abroad and Foreign investment in the U.S. Credits: A credit are those transactions for which the U.S. receives income (exports, foreign purchase of assets) Debits: Those transactions that the U.S. must pay for: imports and purchasing of assets abroad.

Balance of Payments [continued]

The Current Account and Capital Account must be equal.

Official Reserves Account: The Central Banks of all nations hold foreign currency to make up any deficit in the combined capital and current accounts.
If the U.S. has more credits than debits it finances this difference by dipping into its reserve account.

So, Thats it!

Easy, huh?
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