AP Macroeconomics

AP Classroom

The Core Econ Textbook

0. Microeconomics Curriculum

1. Basic Economics
2. Supply / Demand
3. Production / Cost
4. Imperfect Competition / Games
5. Factor Markets
6. Government

1. Basic Economic Concepts

1.1 Scarcity

1.2 Opportunity Cost and the PPC

1.3 Comparative Advantage and Trade

1.4 Demand

• T - Tastes and preferences
• R - Related goods and services
• I - Income of consumers
• B - Buyers
• E - Expectations of the future

1.5 Supply

• I - Input prices
• N - Number of suppliers
• E - Expectations of future
• R - Related products
• T - Technology

1.6 Market Equilibrium

Elasticity

• S - Substitutes
• P - Proportion of income
• L - Luxury or necessity
• A - Addictive
• T - Time

2. Economic Indicators and the Business Cycle

Circular Flow

GDP

$$GDP=Y=C+I+G+(X-M)=\sum income$$

Income = Expenditures = Value Added

• GDP = Aggregate Demand
• Y = Income
• C = Consumption Expenditure = household spending on goods/services
• I = Investment Expenditure = firms buying stuff (capital - machines, factories), or increasing stock (making computers)
• G = Government Spending = government spending on goods/services (eg. infrastructure, paying employees, NOT welfare → that’s transfer payments)
• X = Exports
• M = Imports

Restrictions of GDP

• Volunteer work (charity, stay at home)
• Inequality
• Negative things (repairs, weapons)

Output Gap = Actual - Potential GDP

Unemployment

Employed = number of people currently employed (part + full time) Unemployed = number of people looking for work but not employed Underemployed = number of part time people that would rather work full time, or people with jobs that don’t make full use of their qualifications

$$UnemploymentRate=\frac{Unemployed}{Unemployed+Employed}\ast 100$$

• Low = 5%, High = 8%

Labor force = Employed + Unemployed Labor force participation rate: People not seeking work

$$ParticipationRate=\frac{LaborForce}{Age\ge 16}\ast 100$$

• Excludes children
• retirees
• adult students
• those who can’t work (illness or disability)
• those who don’t want to work
• those who have given up looking for work (discouraged)

Employment rate excludes:

• Discouraged workers
• Marginally attached workers (eg. taking time off)

Types of unemployment:

1. Structural Unemployment: Economic restructuring making skills obsolete, Oversaturated labour market, Change in geographic location of industries
2. Frictional Unemployment: Unemployment caused by new entrants into the job market and people quitting a job to find another
3. Seasonal Unemployment: Unemployment caused by seasonal work
4. Cyclical (demand deficient) unemployment: Unemployment caused by the business cycle

Natural Rate of Unemployment

• Natural rate: Normal rate
  • Above natural rate during growth
  • Below natural rate during recession
• Cyclical Unemployment: Deviation from the natural rate
  • Change in labour force characteristics
  • Changes in labour market institutions
  • Changes in government policy

The Business Trade Cycle: Economic Fluctuations

Economic Fluctuations = tied to success of agriculture and stuff

Inflation

$$GDPDeflator=\frac{NominalGDP}{RealGDP}\ast 1000$$

CPI = Consumer Price Index = Price of a basket of goods

$$CP{I}_t=\frac{C_t}{C_0}\ast 100$$

• Inflation: CPI up
• Deflation: CPI down
• Disinflation: Inflation concave down
• Hyperinflation: Inflation concave up
• Stagflation: Recession + Inflation Phases of the Business Cycle
• Expansion = when there is positive growth in real GDP
  • Employment rises, prices rise
• Peak = the cycle’s max level of real GDP marks the end of an expansion
  • Unemployment falls, prices rise
• Contraction = After peak, there’s falling real GDP (negative growth)
  • Recession = 2 quarters of contraction
  • Depression = long recession
• Trough = After contraction, expansion again

3. National Income and Price Determination

Fiscal Policy

Fiscal Policy = when legislature does stuff Monetary Policy = when central banks do stuff

• To encourage or discourage growth

Policy Rate = Central Bank Rates Prime Rate = Rate for Bank’s best customers Bank Lending Rate = Rate between banks

Shocks and smoothing

Shocks = unexpected event that change GDP

1. Good/bad fortune that strike households
   1. Self-insurance = save and borrow
   2. Co-insurance = support from social network / governments
   3. This means that households prefer to smooth their consumption (save/borrow) and that they are altruistic
2. Good/bad fortune that strike economies
   1. Co-insurance becomes less effective, but is still necessary
   2. People used to practice trust, reciprocity, and altruism

Smoothing Consumption = making consumption plans based on expectations of the future

1. Readjust long-run consumption if permanent shock
2. Don’t if temporary

Consumption smoothing on a macro scale

• Stabilization
• Limits: Credit constraints, weakness of will, limited co-insurance
  • Credit constraints = limit on ability to borrow
  • Weakness of will = no passion
  • Limited co-insurance = less altruism

Government size vs GDP

• As governments get bigger, GDP stabilizes and is less susceptible to shocks

Sticky = nominal price is resistant to change → moving up / down curve Automatic Stabilizer = Counteracts the business cycle without any government policy (unemployment, welfare)

AD-AS Model

Consumption Function

Aggregate Consumption has:

1. Autonomous Consumption (how much you will spend anyway)
2. Consumption dependent on income

1. Aggregate Demand (AD) = consumption function + investment
   1. Investment is independent of consumption
   2. Slope <45 deg
2. 45 deg line is when Y = AD

Slope of consumption function = marginal propensity to consume

• Poor households with credit constraints have large MPC
• Wealthy households have small MPC
• Expectations of the future are reflected in autonomous consumption

Shifts in AC (Aggregate Consumption) function

• Changes in expected future
• Disposable income
• Changes in aggregate wealth (eg. stock market UP, recession DOWN)

Assumptions about the spending multiplier

1. Producers are willing to supply additional outputs at a fixed price
   1. $1kinvestment=$1k more goods
2. Given interest rate
3. Just looking at C and I

Spending increases by $100b

• Aggregate output increases but $100b
• Multiplier Effect: Some of the $100b goes to people, which goes to firms, which goes to people (multiple rounds of spending)

MPC and MPS

• Higher for richer people

$$MPC=\frac{\Delta ConsumerSpending}{\Delta ConsumerIncome}$$ $$MPS=1-MPC$$

Total increase in real GDP =

(1+MPC+MPC^2+MPC^3+\ldots)*$100b $$total=\frac{1}{1-MPC}\ast principal=\frac{1}{MPS}$$

The Multiplier and the Great Depression

• most economists thought 1929-33 was a collapse in investment spending
• but as economy shrank, it also fell, multiplying the effect on real GDP
• our taxes and spending > 1929
• taxes and spending are stabilizers

John Maynard Keynes (Keynesian economics)

• Untangled the Depression and the multiplier effect
• Tax more + spend less when times are good, tax less + spend more when times are bad

Household Wealth

• broad wealth = broad assets - debt
• target wealth = aim
• precautionary saving = more saving
• fall in expected earnings ⇒ precautionary savings

Changes in house prices

1. change household wealth (home equity)
2. change in credit constraints (harder to borrow)
   1. You pay capital gains tax on a house that isn’t your primary residence (house flipping)

Investment: Aggregate investment function (like aggregate consumption)

4. Financial Sector

Financial Assets

• Stocks = investment into company
• Bonds = investment into government
• Equity = Value - Debts
• Liquidity: House < Bonds < Savings account < Cash

What is money?

• Financial asset to purchase gods / services
• Currency in Circulation: held by the public
• Checkable in bank accounts: demand deposits
• Money Supply: total of financial assets
  • M1 = Public currency and coins, checkable deposits, checks
  • M2 = M1 + Savings deposits, small time deposits, shares in mutual funds

Purpose of money (requires trust)

• A medium of exchange
• A store of value
• A unit of account
• Allows purchasing power to be transferred
• Gershan’s Law: “bad money drives out good” - metallic vs paper money, fiat money

Income (money) vs Wealth (capital)

• Net income = gross income - depreciation
• Earnings = income from labour
• Saving = income not consumed
• Investment = expenditure on capital goods

Banking

Mutual Gain

• People spend time by browsing / investing / lending / saving
• Conflict of interest between borrowers and lenders over interest rate
• Principle-agent relationship - lender (principle) cannot guarantee borrower (agent) pays back
  • Lenders often require borrowers to contribute their own funds *collateral)
  • This means that poor people can’t get money (credit constrained / excluded)
  • Bank account needs address → can’t get paid → Money Mart / microfinancing
  • Gini Coefficient is a measure of inequality

How banks create money

• Lend money to other people who deposit to other banks
  • Reserve Ratio: how much you have to keep
  • Excess Reserves: 90% of total reserves
• Money Multiplier = $\frac{1}{rr}$

$$1000+1000(1-rr)+1000(1-rr{)}^2+\dots$$

• Broad money = base money + bank money

Risk

• Banks provide maturity transformation (after period of time)
• They also provide liquidity transformation because loans are frozen (illiquid)
  • Default Risk
  • Liquidity risk
• Bank run:
  • Everyone asks for money
  • Bank makes bad investments

Banking Business

• Cost = Operational, Interest
• Revenue = Interest, repayment (they want you to invest)
• Expected return = return on loans * default risk (99%, 80%, …)
  • Mortgages > normal loans because no default risk
• Balance Sheets = Equity = Net Worth = Assets - Liabilities
  • If Net Worth < 0 , the bank is insolvent / bankrupt
  • Most common debt is consumer debt (credit card debt)

$$leverage=\frac{assets}{worth}$$

Money Market

• Banks borrow from each other / central banks at a short term interest rate
• Policy Interest rate: Set by Fed
• Bank lending rate: average interest rate charged by banks to households
• Prime Rate: Rates for best customers
  • Fixed vs Variable (prime, prime+1)

Monetary Policy

• To Increase $M_s$, the Bank of Canada buy bonds from the market
• To decrease $M_s$, they sell bonds
• Higher interest = Reduced AD = Lower inflation = higher unemployment

Loanable Funds Market

What’s being bought and sold is money that has been saved

• Borrowers demand loanable funds
• Savers supply loanable funds
• When governments borrow, supply decreases

5. Stabilization Policy

The Phillips Curve

Inflation and Unemployment are inversely proportional

Money Growth and Inflation

Velocity of Money

$$V_T=\frac{PT}{M}$$

• P = price level
• T = aggregate real value of transactions
• M = total amount of money in circulation

Fiscal Policy

How Governments React to Economic Fluctuation

1. Government size (spending on health/education, higher tax rates which reduce the multiplier → smaller growth = smaller crash)
2. Unemployment benefits (also pension plans)
3. Intervention (fiscal policy)

Long-run

• ”we’re all dead”- Keynes
• The economy is self correcting (growth w/o government intervention)
  • People will acclimatize to having less and doing more (eg. Black Plague)
• Stabilization policy to reduce the severity of recessions

Macro Policy

• Demand Shocks
  • If policy could perfectly anticipate shifts of the AD curve
  • Price stability is good (Inflation in 70s-80s was high, 2010s was good, 2020s bad)
• Supply Shocks
  • Much harder
  • If people are willing to work for lower wages → Input prices go down → Supply shifts right → Aggregate Supply shifts right
• Unemployment vs Inflation
  • Lower unemployment = higher inflation

Taxes and Government Spending

• Funds → Government through taxes and government borrowing
• Funds ← Government through purchases of goods/services, transfers
• When spending increases and taxes are cut, economy expands
  • Trickle Down Economics
• Fiscal policy shifts the Demand curve

Expansionary and Contractionary Fiscal Policy

• This can eliminate an inflationary gap Expansionary (increasing AD)

1. Increases in gov’t purchases of goods and services
2. cut in taxes
3. increases in gov’t transfers

Contractionary (decreasing AD)

1. reduction spending
2. more taxes
3. reduction transfers

Problem: Lags in Fiscal Policy Time Sinks:

1. Realizing the recession / inflationary gap + analyzing data
2. Government developing a spending plan
3. Implementing the plan

Multiplier Effect

• Changes in taxes, transfers, government spending
• Multiplier effect: Increase in real GDP > initial reduction in aggregate spending
• Spending Multiplier

$$\frac{1}{1-MPC}\to G(1+MPC+MP{C}^2+\dots )$$

• Tax Multiplier

$$\frac{MPC}{1-MPC}\to G(MPC+MP{C}^2+MP{C}^3+\dots )$$

• There is no **first round of spending ** / the initial injection isn’t all spent
• Changes in government purchases > changes in taxes / transfers

Balanced Budget Multiplier

• Government increases taxes to cover spending

$$(\frac{1}{1-MPC}-\frac{MPC}{1-MPC})=1$$

• Automatic Stabilizers: Progressive taxation, Healthcare, food stamps
• Discretionary fiscal policy: deliberate actions

Stabilizing

1. Government spending (large and exogenous)
2. Higher tax rate lowers the multiplier
3. Unemployment insurance
4. Deliberate intervention via fiscal policy

The paradox of thrift

• If a family is worried about falling wealth, they spend left
• With an entire economy, spending = income
  • The aggregate attempt to increase savings leads to a fall in aggregate
• Fallacy of composition = what’s true for one part of the economy is not true of the whole
• Problem with the EU: if Greece has problems, the Euro is reliant on the ECB
  • Fiscal policy becomes important

Fiscal Stimulus

• Budget Balance = T-G
• Budget Surplus is when Revenue > spending, Deficit is opposite

Government debt

• Debt to GDP ration is a good indicator of government success
• They can just roll back debt by selling new bonds

Reserves Market

6. International Trade and Finance

6.1 Balance of Payment Accounts

CA + CFA = 0

CA = Current Accounts (always balanced)

• Net exports (purchases or sale of goods)
• Money transfers (receiving money)
• Investment Income (overseas assets)
• Net unilateral income Net Exports = Trade Balance = Exports (credit) - imports (debit)
• Surplus / Deficit

CFA = Capital and Financial Account (not always balanced)

• Balance of payments for assets (purchases / sale of bonds)
• Financial capital transfers (physical assets, FDI) Financial capital going into an economy is a surplus (financial capital inflow)

Credit vs Debit

• Money in = Credit
• Money out = Debit
• Sum of Credit = Sum of Debit

6.2 Exchange Rates

Exchange Rate = The price of one currency in the terms of another

• Appreciation = more valuable
• Depreciation = less valuable
• When you buy something from another country, you use their currency

6.3 The Foreign Exchange Market

Foreign Exchange Market = Exchanging currency

• Demand for currency comes from demand for goods, services, financial assets
• Exchange rate is inversely proportional with quantity demanded
• Equilibrium = exchange rate and quantity demanded are equal

6.4 Effects of Policies and Conditions

Who participates in the market?

1. Those looking to purchase international goods
2. Those who want to earn income from another country

Determinants of currency demand:

1. International Demand for goods and services
2. International Demand for assets
3. Fiscal / Monetary Policy

Determinants of Currency Supply

1. Domestic demand for other country’s goods and services
2. Domestic demand for other country’s goods assets
3. Protectionist policies (tariffs, quotas)

6.5 Changes in the Foreign Exchange Market

Shifting AD → Net Exports = Export - Import

• Fluctuating currency values → changes relative price of goods
• Changes in the relative price of goods → changes next exports
• ex: US goods become more expensive to Canadians → US exports fall

6.6 Real Interest Rates and International Capital Flows

• Capital inflow: Supply shifts right
• Capital flight / outflow: Supply shifts left

Changes in interest rates:

• Monetary policy:
  • Expansionary: decrease rates
  • Contractionary: increase rates
• Demand for money:
  • Increase: increase
  • Decrease: decrease
• Budget Balance
  • Deficit: increase
  • Surplus: decrease
• Households saving
  • Increase: decrease
  • Decrease: increase

Financial Capital chases high interest rates

• Investors will gravitate towards higher returns (higher interest rates)

Practice Exam

1. Economic growth = per capital real gross domestic product
2. Reducing price level = decrease spending, increase interest rates
3. Spending increase + Interest increase = interest increase + unchanged private investment
4. Unanticipated increase in gov spending shifts LR Phillips Curve left (less unemployment)
5. Crowding Out = private investment spending decreases b/c interest rates increase b/c government borrowing increases
6. Anticipated expansion of MS increases nominal GDP and price
7. Only selling to other countries increases current account surplus
8. Decreasing taxes means higher nominal GDP
9. To reduce unemployment, buy bonds to decrease interest rate and increase AD
10. Central bank selling bonds to commercial banks decreases MS
11. Current account deficit is financed by a surplus in financial (capital) amount
12. Firm’s optimism about future income shifts AD right, increasing real output and price
13. Balance = Deposits - Withdrawals
14. tight monetary policy = higher interest and less private investment
15. multiplier = 1/rr
16. Recession caused by a decrease in AD
17. More discouraged workers makes unemployment and labor force participation rate decrease
18. Gov spending down and private saving up causes real interest down and interest-sensitive spending up
19. Increased budget deficit = gov spending > tax revenue, and central bank increases MS
20. CPI doesn’t fully measure inflation because improvement in quality of goods/services
21. Demand-pull inflation increases real output, Cost-push inflation decreases it
22. Buying bonds increases MS
23. higher interest = lower inflation = higher employment