AP Macroeconomics Exam: Course Study Guide

[ UNIT Ia Ib ]
Basic Concepts

What is economics? the systematic study of choice

textbook definitions – refer to the allocation of scarce resources in order to satisfy societal wants

What is the basic problem of economics? scarcity

scarcity is the problem in the world that humans invented economics in order to address ▪ scarcity CANNOT
be solved, only addressed or accommodated ▪ scarcity is the state of affairs in the world where a finite amount
of stuff exists to satisfy a virtually infinite amount of human wants ▪ [scarcity = wants > resources ] ▪ to be
scarce, something must be both limited and desirable ▪ scarce ≠ scarcity

Sometimes, definitions of economics incorporate the three basic questions of economics:

1. What to make/produce?
2. How to make/produce it?
3. For whom do we make/produce it?

As a practical matter, before any of the 3 basic questions can be addressed we must first take stock of what our
resources include. In other words, what do we have to make stuff with? The categories (of what we have to
make stuff with) are often collectively referred to as our resources, inputs, or factors of production  4
categories exist:

1. Land [natural resources]: stuff that came with the Earth ▪ sometimes called the stuff God made or
gifts of nature
2. Labor: physical/mental human effort employed in the production process
3. Capital: stuff we make in order to make stuff
a. physical capital: tools, equipment, etc. that we make in order to better make stuff ▪ includes
factories, tools, roads, and other things specifically made to assist in production
b. human capital: special knowledge, education, training, skills, and attributes utilized in the
production process ▪ “traditional buzzwords” for [human capital questions] include education
and health
4. Entrepreneurship: combination of the other factors of production in a novel way in search of a profit

Societies have organized themselves in three ways to address the three basic economic questions:
1. Tradition: characterized by subsistence agriculture and tribal/village life
2. Command: ranges from Ancient Egypt to Stalin’s USSR ▪ contemporary manifestations often employ
central planning as a synonym
3. Market: exists as an ideal in accord with 19th century Laissez Faire ▪ emphasizes the presence of
private property rights and the profit incentive
4. Mixed: #1-3 exist as points on a continuum rather than as actual existing forms of life ▪ all societies in
existence tend to manifest attributes of #1-3 ▪ the term mixed tends to refer to some combination of
command (government regulation, planning, and/or control) and market structures

Production Possibilities Frontier/Curve

Production possibilities curves illustrate the limits of what is possible to produce for an economy if all resources
are fully employed. A PPC illustrates the possible combinations of output available to an economy and
addresses the basic economic question of what to make.

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Five types of PPC curves could be drawn, illustrating the trade-offs and types of opportunity costs involved in
production.

Important vocabulary that fits here:

opportunity cost & trade-off
These are related, but NOT
synonymous words.
Trade-offs are analogous to the
possibilities represented to the curve
before a decision is made and the
opportunity cost can be measured after
the decision has been made.

We define opportunity cost as “the

This PPC also illustrates no
This PPC illustrates no relationship next best thing”, but text definitions
relationship between Good A and
between Good A and Good B tend to involve what was forgone or
Good B but merely shifts the axes.
alternative use of the common inputs.

THREE TYPES OF PPC CURVES could be drawn:

Increasing Opportunity Cost Curve Constant Cost Curve Decreasing Opportunity Cost Curve
bowed-out or concave to the origin looks like: a right triangle looks like: a ski-jump

Most PPC curves will be of this type. This is a less common but possible
These are NOT possible!!! NEVER
As more of one good is made, it entails variety of PPC. The ratio of exchange
pick this as an example… even Harry
an increasing cost in terms of the other between good A and good B is a
Potter could not make this happen.
good forgone. constant.

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Production Possibilities Curves (cont.):

We distinguish THREE TYPES OF POINTS on a PPC:

A. Any point just inside the PPC is understood to be characteristic of an
economy “not fully employing all factors of production at the highest
level of technology.” More simply put, the economy is not using
everything it has as best it can – it is inefficient.
B. Any point on the PPC curve is understood to be characteristic of an
economy “fully employing all factors of production at the highest level
of technology.” – using everything it has as best it can, or efficiently.
Economists cannot distinguish any point on the curve as preferable to
another without more contextual information often in the form of
normative preferences. Positive economic analysis requires economists
to consider all points on the curve as equal in so far as they are all
efficient.
C. Any point outside of the curve is considered desirable (because more is
better), but not possible, given current levels of factors of production
and technology, alone. The “comma alone” is an important device to
remind students that through the specialization of production based on
lowest opportunity cost (comparative advantage) and exchange with
another economy (trade), a consumption possibility can be achieved
beyond what is possible alone (autarky).
K. This point represents a level of extreme inefficiency characteristic of a
severe recession, depression, and/or market failure. We use “K” to
indicate that this is a setting when Keynesian economics is most likely
to be appropriate.

Increases are graphically expressed as a shift to the right Decreases are graphically expressed as a shift to the left,
such as, PPC1 to PPC2. such as PPC1 to PPC2.
+ factors of production - factors of production
- costs of production + costs of production
+ technology - technology

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 Basic SUPPLY and DEMAND GRAPHS are a vital component of UNIT I:
DEMAND

Increase Demand Decrease Demand

(Shift D Right) (Shift D Left)

D  P (P1-P2) Q (Q1-Q2) D  P (P1-P2) Q (Q1-Q2)

1. Increase in the # of consumers 1. Decrease in the # of consumers

2. Increase in income 2. Decrease in income
3. Increase in expectations of future price 3. Decrease in expectations of future price
4. Increase in taste (advertising) 4. Decrease in taste (advertising)
5. Increase in the price of a substitute good 5. Decrease in the price of a substitute good
6. Decrease in the price of a complementary good 6. Increase in the price of a complementary good

SUPPLY
Increase Supply Decrease Supply
(Shift S Right) (Shift S Left)

S  P (P1-P2) Q (Q1-Q2) S  P (P1-P2) Q (Q1-Q2)

1. Increase in the # of producers 1. Decrease in the # of producers

2. Increase in the # of inputs 2. Decrease in the # of inputs
3. Increase in technology 3. Decrease in technology
4. Decrease in the cost of production 4. Increase in the cost of production
(Increase in quality of inputs) (Decrease in quality of inputs)
5. Decrease in government regulation and/or taxes 5. Increase in government regulation and/or taxes
6. Positive exogenous supply shock (acts of God/OPEC) 6. Negative exogenous supply shock (acts of God/OPEC)
Supply is really only effected by change in # of inputs, cost of inputs, and technology.

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* Change in price results in a change in quantity demanded or quantity supplied. Don’t fall for it.

[ UNIT II ]
Measuring Economic Performance

Macroeconomics: the study of a nation’s economy as a whole

(UNIT II introduces all of the basic Macro lingo and measures.)

AP Macroeconomics has a total of 5 IDEAS:

1. Output
2. Inflation (often substituted in practice by ΔPL)
3. Unemployment
4. Growth
5. Trade

TWO BASIC MODELS of an economy are introduced in UNIT II:

Simple Circular-Flow Diagram & Production Possibility Frontier/Curve [PPF/PPC]

Simple Circular-Flow Diagram

The simple circular-flow illustrates how the basic agents (1producers / 2consumers) in an economy interact with
each other through two distinct markets (1input/resource/factor market AND 2output/goods&services/product
market). producers – often referred to as businesses/firms ▪ illustrated by a factory-shaped icon
consumers – often referred to as households/individuals ▪ illustrated by a house-shaped icon

The circular-flow diagram illustrates two distinct flows in the economy: 1the flow of money and 2the flow of
stuff.

Both money and stuff get specialized names contingent on the contextual circumstances.

[IMPORTANT] money = stuff | output = input | output = income

Input/Resource/Factor Market:
Households/individuals/consumers are the owners of the factors of production and exchange them for money.
The money households/individuals/consumers receive is collectively called income.
From the perspective of the firms/businesses, this money is collectively called factor payments.
Each factor of production has a specific name for its payment:
payments for… are called…
land = rent
labor = wages & salaries
capital = interest
entrepreneurship = profit

Output/Goods&Service/Product Market:
Households/individuals/consumers take their income earned through their participation in the factor market and
exchange it for goods and services in the product market. What they purchase is called goods & services and
the money they spend is called household/consumer expenditures. The money from the perspective of firms is
called revenue. From the perspective of the firms, the inputs are combined through the production process
adding value along the way and converting it into goods & services.

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[Historical Note] The big-picture idea illustrated through the simple circular-flow is that production exists in
order to generate income. The relationship was understood as income exists to generate production in the 19th
century. The difference in perspective represents our cultural belief in consumer sovereignty.

The Circular Flow Model

Product,
$ Output,
Goods & Service $
Market

Businesses Firms
Households
Producers
Individuals
“I”
G Land
Consumers
“C”
Labor
Input, Capital
Entrepreneurship
Resource,
Rent
Factor Wages & Salaries
$ Market Interest$
Profit

OUTPUT:
Basic measure of output = real Gross Domestic Product (rGDP)
GDP: the total market value of all final goods and services produced in an economy in a given year
nominal GDP: the total market value of all final goods and services produced in an economy in a given year ▪
this is the simple measure of P•Q, or [the number of goods times their price]
*** rGDP: the total market value of all final goods and services produced in an economy in a given year,
adjusted for change in price
rGDP per capita: the total market value of all final goods and services produced in an economy in a given
year, adjusted for change in price and divided by the (#) population ▪ this is the best measure to
evaluate standard of living in an economy, across economies, or in an economy over time ▪
Functionally, it is still just a mathematical average and does not speak to the actual distribution of
wealth/income in a society.

rGDP is the measure we employ most often in class to refer to real output, but we have many synonyms and
identities:
rGDP = C + I + G + Nx = rent + wages&salaries + interest + profit = RNI, and sorta = AE = AD

We have TWO WAYS to COUNT rGDP:

1. [The Income Approach] The income approach simply adds rent + wages&salaries + interest + profit.
▪ Keynesian economics is most interested in the manipulation of income and demand, and this is their
method of choice. ▪ In fact, the preferred Keynesian term for output is Real National Income (RNI)
and, their primary emphasis for policy is to manipulate Aggregate Expenditure (AE).
2. [The Expenditure Approach] THIS IS OUR METHOD!!! ▪ Consumption expenditures +
planned/autonomous/private Investment expenditures + Government expenditures on production + Net

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 export expenditures [exports (x) – imports (m)] ▪ Use the memorized definition of rGDP above as a
filter to determine what is counted as rGDP and how it is counted.

a. consumption: includes final purchases of all new goods and services produced in an economy in
a given year
b. government: excludes transfer payments since they are simply a transfer of money from one
person to another without any actual production occurring
c. investment: This is part of our most important idea in the class. ▪ We refer to all “I” as
purchasing capital “K” which is a seed for future growth ▪ (victory > truth) ▪ (new houses and
increases in inventories count as I)
d. net exports: just (x – m)

[Things that do not count, but are often in questions include]: non-market production, such as household
production and black market production, intermediate goods included in the final price, and pure financial
transactions, such as transactions including stocks/bonds, etc.

INFLATION: the rate of the increase in the overall average price level

Price indexes are used to calculate changes in price level (inflation).

Consumer Price Index (CPI): uses a constant quantity of goods, often referred to as a market basket of goods
and compares their prices over time ▪ base year CPI value is always 100

[Basic CPI Formula]:

[Basic formula for determining % change between two CPI values or other numbers]:

GDP deflator is a similar tool used to determine real changes in GDP. Rather than constant quantities (baskets
of goods) and changing prices over time, it employs constant (base year prices) and multiplies them times the
changes in output. GDP deflator is employed to provide changes in rGDP.

[Unemployment]:

(Other rates called for could be labor force participation rate, employment rate, etc.)

TWO CRITERIA must be met to be considered unemployed:

1. NOT have a job
2. Be looking for a job – (Other technical stuff about over 16, not institutionalized/military, etc. also exists
in the definition but not in our practical definition.)

FOUR TYPES OF UNEMPLOYMENT:

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 1. Seasonal: not likely the answer ▪ [If you cannot figure out what this is, you should (insert sarcastic joke
here).]
2. Frictional: this type of unemployment relates to physical or metaphorical movement ▪ people that
physically move from one place to another ▪ recent graduates ▪ marriage/divorce ▪ all big life changes
and moves could relate to this assuming no job and looking
3. Structural: the mismatch between jobs and skills within a society ▪ robot took my job
4. Cyclical: unemployment that is related directly to changes in the business cycle ▪ this is the ONLY
type of unemployment that is EVER influenced by policy (fiscal and/or monetary)

 Discouraged workers: people without jobs that have given up looking for work
 [Methods of counting UE]: asking people through surveys/phone calls ▪ door-to-door census procedures;
people tend to report, “Yeah, I’m looking.”
 Output and unemployment are inversely related to each other. As output goes up, more workers are
required and vice versa. If an FRQ asks for ΔrGDP or ΔUE in its own letter, the answer must be explained
through this relationship: More jobs leads to more output, etc…

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 [ UNIT III ]
National Income and Price Determination

Aggregate Demand / Aggregate Supply (AD/AS) Analysis

AD/AS graphs can illustrate three conditions in an economy that correspond roughly with a, b, c on PPC:

not fully employing all factors of fully employing all factors of desirable but not possible given current
production at the highest level of production at the highest level of levels of factors of production and

A
technology – inefficient

[problem of]:
B
technology – efficient
[long-run equilibrium]:
full employment (FE)
C
technology, alone

not sustainable given current levels of

high unemployment factors of production and technology
potential output (Y*)
low output overheating
natural rate of UE (NAIRU)
recession INFLATION
0% cyclical UE

PROBLEM Graph A Graph B PROBLEM Graph C

Y1 < FE Y* = FE Y1 > FE

Long-Run Aggregate Supply (LRAS) and PPC

LRAS and PPC are the same thing and are both moved by the same things:
1. Changes in # of factors of production
2. Changes in $ of factors of production
3. Changes in technology

growth: graphically expressed by shifting LRAS or PPC to the right

EVERYTHING IN THIS CLASS IS SUBORDINATE IN IMPORTANCE TO GROWTH!!!
“Story of I” is the Story of Growth:
I buys K; increase I » increase K » increase AS » increase stock of K » LRAS (positive economic growth)
[Negative growth is the same sequence of events with decrease instead of increase.]

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 AD/AS SOLUTION GRAPH AFISCAL POLICY

AD/AS SOLUTION GRAPH CFISCAL POLICY

AD = C + I + G + Nx AD = C + I + G + Nx
… therefore, an increase in one of these components will … therefore, a decrease in one of these components will
increase AD. An increase in AD is graphically expressed as decrease AD. A decrease in AD is graphically expressed as
a shift to the right with a corresponding increase in price a shift to the left with a corresponding decrease in price level
level (P1 – P2), increase in rGDP (Y1 – Y* ), and decrease in (P1 – P2), decrease in rGDP (Y1 – Y* ), and increase in UE
UE (Y1 –FE ). (Y1 –FE ).
letter chains for letter chains for
Expansionary Discretionary Fiscal Policy Solution Contractionary Discretionary Fiscal Policy Solution
(implemented to address low output/high unemployment) (implemented to address inflation)
PL (P1-P2) PL (P1-P2)
G  AD rGDP (Y1-Y*) G  AD rGDP (Y1-Y*)
UE (Y1-FE) UE (Y1-FE)
PL (P1-P2) PL (P1-P2)
Tincome  DI  C  AD rGDP (Y1-Y*) Tincome  DI  C  AD rGDP (Y1-Y*)
UE (Y1-FE) UE (Y1-FE)
PL (P1-P2) PL (P1-P2)
Tcorporate  I  AD rGDP (Y1-Y*) Tcorporate  I  AD rGDP (Y1-Y*)
UE (Y1-FE) UE (Y1-FE)

[multipliers related to taxing and spending]:

basic concept – spending (consumption) becomes somebody else’s income, which is in turn split between
further consumption and saving
Disposable Income (DI) is split between consumption and spending. The fraction of the next bit of income that
is spent is called MPC, whereas the fraction of the next bit of income that is saved is called MPS.

G bigger ▪ G is a direct component of AD T smaller because it affects DI and loses some

of its initial effect to savings (leakage to savings)

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 [ UNIT IV ]
Monetary Policy

The FED is the name of the central bank in the U.S. ▪ It is NOT part of the government or a government agency
and does not receive 1 single dollar from the government for its operations. ▪ The government has some
oversight regarding its operation through the Chairman of the FED, but the FED is NOT the GOV!!!

The focus of monetary policy is captured by the ambiguous phrase: price stability. ▪ The FED attempts to
promote price stability by keeping inflation in check and provide sufficient MS in order to facilitate a
sustainable rate of growth. ▪ The FED and monetary policy can only ever affect the Money Supply (MS). ▪ MS
then interacts with MD, resulting in an interest rate change. ▪ Money demand is independent of all FED
activity. ▪ THREE distinct TYPES of MD exist: 1transactions demand, 2precautionary demand, and 3speculative
demand. ▪ These three demands are related to the THREE FUNCTIONS of MONEY: 1medium of exchange,
2
unit of account, and 3store of value.

Money has a number of PROPERTIES, as well, including durability, divisibility, acceptability, and many others
in the Mort worksheet on money.

Although the Treasury department prints money, money is actually created through the Deposit Expansion
Multiplier Process. ▪ The FED is in charge of regulating the rate of the growth of the supply of money.

Money Supply refers to M1, the stock of money— high power money. ▪ Money that is not as liquid is assigned
higher numbers than 1, such as M2. ▪ These distinctions are more or less irrelevant for our class. ▪ M1 is the
variety of money acceptable at Publix and includes demand deposits (checking accounts) + other demand
deposits (other checking accounts) + currency & coin (cash) + traveler’s checks. ▪ The ratios are roughly 50%
checks, 49% cash, and 1 % traveler’s checks.

Monetary Policy FRQs come in TWO VARIETIES:

Three L’s and Win & “Behroz Makes a Deposit”

Three L’s and Win:

SOLUTION GRAPH AMONETARY POLICY

1 A OMO buy  MS  r , r  I , I  AD

PL (P1-P2)
(the decrease in r leads to an
rGDP (Y1-Y*)
increase in the quantity of interest
UE (Y1-FE)
sensitive investment demanded)
E (Y1-FE)

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 discount rate  MS  r , r  I , I  AD
PL (P1-P2)
B (the decrease in r leads to an
rGDP (Y1-Y*)
increase in the quantity of interest
UE (Y1-FE)
sensitive investment demanded)
E (Y1-FE)
RR  MS  r , r  I , I  AD
PL (P1-P2)
C (the decrease in r leads to an rGDP (Y1-Y*)
increase in the quantity of interest UE (Y1-FE)
sensitive investment demanded) E (Y1-FE)
SOLUTION GRAPH CMONETARY POLICY

OMO sale  MS  r , r  I , I  AD

PL (P1-P2)
A (the increase in r leads to a rGDP (Y1-Y*)
decrease in the quantity of interest UE (Y1-FE)
sensitive investment demanded) E (Y1-FE)
discount rate  MS  r , r  I , I  AD
PL (P1-P2)
2 B (the increase in r leads to a rGDP (Y1-Y*)
decrease in the quantity of interest UE (Y1-FE)
sensitive investment demanded) E (Y1-FE)
RR  MS  r , r  I , I  AD
PL (P1-P2)
C (the increase in r leads to a rGDP (Y1-Y*)
decrease in the quantity of interest UE (Y1-FE)
sensitive investment demanded) E (Y1-FE)

We label the money market’s vertical axis as interest rate and “r” rather than nominal interest rate and “i” as
a tactic – unless some compelling reason in the question exists to do otherwise. This facilitates the linkage
between the first and second L’s.
“Behroz Makes a Deposit”:

Step #1: Is the deposit a shift within the composition of MS or is it an infusion of new money in the
system?
Step #2: Find out the required reserve ratio (RR) and determine the amount of required reserves.
Step #3: Does the question indicate anything about preexisting reserves or excess reserves?
Step #4: Make a chart that is an identity of all of the basic terms explicit and implicit in the question.
Step #5: Calculate the effect of the deposit from this one bank and the maximum effect on the entire MS.
Step #6: Be prepared to list the three limitations that could have kept the MS from reaching its maximum if
they were not already incorporated in the question.

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 Behroz deposits $1,000 in cash into Happy Bank. The reserve requirement is 20%. Happy Bank has no excess
reserves.
a. What is the immediate effect on the MS?
b. What is the maximum increase on MS that can be made by Happy Bank?
c. What is the maximum effect on the MS by the entire banking system?
d. Why won’t the MS be increased by its theoretical maximum amount?

a. No immediate change in the quantity of the money supply, but its composition will shift to relatively less cash and
relatively more demand deposits.
MS = Cash + Demand Deposits + Traveler’s Checks
-$1,000 +$1,000
… therefore, no change in MS.

b. RR = 20% | $1,000 • 0.20 = $200 | $1,000 [deposit] – $200 = $800 [excess reserves available to loan]

c.

[Method 1] (initial deposit • multiplier) – initial deposit  [ $1,000 • 5 = $5,000 – $1,000 = $4,000 ]
[Method 2] initial loan • multiplier  [ $800 • 5 = $4,000 ]
Method 1is preferred because it requires the student to double-check if the initial deposit was a shift within MS or a
new infusion of high-power money.
d. if banks keep excess reserves, every dollar held in excess reserve represents [1 • multiplier dollars], not expanded
if people hold money in the form of cash rather than redeposit funds
the banks offer loans but customers are unwilling to take out loans at prevailing market rates.

[Other Monetary Stuff]:

 OMOs are undertaken every business day and considered to have a precise/fine tuning capability by
monetary policy advocates.
 The discount window represents the portal through which the FED acts as a lender of last resort for
banks in trouble. ▪ Negative social stigma is attached to using the discount window.
 Changes in the required reserve ratio/reserve requirement (RR) are considered to be as precise as
surgery with a chainsaw and predictable as the geometry of a snowflake.
 Federal funds rate is the rate at which banks lend money to other banks for short term loans. ▪ another
example: tricky language associated with monetary policy
 MV = PQ
M = M1 = MS = stock of money
V= income velocity of money
P = average overall price level= GDP deflator
Q= rGDP
PQ = nominal GDP
 Winners and Losers from unanticipated inflation: People that pay with inflated money (TP) win
those that get inflated money lose. Fixed income(contractors), Savers and Lenders are big losers;
Borrowers, debtors, and mostly U.S. Gov “win”.

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 [ UNIT V ]
Monetary and Fiscal Policy Interactions

[involves the taxing and spending policies of Congress]

Automatic Fiscal Policy: (often called automatic fiscal policy stabilizers)

These are policies/laws that are on the books and are activated automatically by circumstances in the economy
in a counter-cyclical way to stabilize the economy. These function to “tame the business cycle.”
[examples include]: the progressive income tax system ▪ most all transfer payments – but specifically social
security and unemployment insurance

Discretionary Fiscal Policy: requires new legislation on the part of Congress in response to specific economic
conditions ▪ characterized by an insufferable long internal lag but a virtually nonexistent external lag ▪ can
ONLY ever effect AD directly

EXPANSIONARY CONTRACTIONARY

Increase Government Expenditures (G) Decrease Government Expenditures (G)

Decrease Income Taxes (Tincome) Increase Income Taxes (Tincome)

Decrease Corporate Taxes (Tcorporate) Increase Corporate Taxes (Tcorporate)

fiscal policy has long internal lag and short external lag

monetary policy has short internal lag and long/indeterminate external lag

the BIG IDEA is that fiscal and monetary policy have opposite effects on interest rates that leads to crowding
out/crowding in

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[The Arguments for Crowding Out]:
ScenarioBudget DeficitExpansionary Fiscal/

Crowding out is an unintended consequence of expansionary fiscal policy.

For simplicity’s sake, assume that each of the following scenarios follows:

PL (P1-P2)
G  AD rGDP (Y1-Y*)
E (Y1-FE)
UE (Y1-FE)

In order to purchase the new greater quantity (Y*) at the new higher prices (P2),
there is an increase in the transactions demand for money.
(A) MD  r , r  I , I  AD PL (P1-P2)
(the increase in r leads to a rGDP (Y1-Y*)
MD decrease in the quantity of E (Y1-FE)
interest sensitive investment UE (Y1-FE)
demanded)
1 The final position of AD is between AD1 and AD2.

[ rGDP = RNI ]
rGDP  RNI  MD  r , r  I , I  AD PL (P1-P2)
(B) (the increase in r leads to a rGDP (Y1-Y*)
decrease in the quantity of E (Y1-FE)
MD interest sensitive investment UE (Y1-FE)
demanded)
The final position of AD is between AD1 and AD2.

(A)

2 DLF
OUR
WAY
G   deficit  DLF  r , r  I , I  AD PL (P2-P3)
Financing rGDP (Y1-Y*)
E (Y* - Y3)
(the increase in r leads to a
UE (Y* - Y3)
decrease in the quantity of
interest sensitive investment
demanded)
The final position of AD is between AD1 and AD2.

15
[Crowding Out]: (cont.)

G   deficit  SLF  r , r  I , I  AD PL (P1-P2)

(B) Financing rGDP (Y1-Y*)
(the increase in r leads E (Y1-FE)
SLF to a decrease in the UE (Y1-FE)
2
quantity of interest
THE sensitive investment
“TRUTH” demanded)
The final position of AD is between AD1 and AD2.

The monetary authority/central bank/FED is monitoring the economy and will sometimes act to prevent
the unintended consequences of fiscal policy through what is called accommodating or reinforcing monetary
policy. Essentially, this means enacting a monetary policy to minimize the interest rate effect of the fiscal
policy in question.

[Crowding In: Our Way]

ScenarioBudget SurplusContractionary Fiscal/

Crowding in is an unintended consequence of contractionary fiscal policy.

PL (P1-P2)
G  AD rGDP (Y1-Y*)
E (Y1-FE)
UE (Y1-FE)

(A)

2 DLF
OUR
WAY
G   deficit  DLF  r , r  I , I  AD PL (P1-P2)
Financing rGDP (Y1-Y*)
E (Y1-FE)
(the decrease in r leads to a
UE (Y1-FE)
increase in the quantity of
interest sensitive
investment demanded)
The final position of AD is between AD1 and AD2.
16
 The “Crowding In” scenario is listed as a matter of symmetry for our Crowding Out discussion. Any
government activity that induces (mal)investment from the private sector could result in a Crowding In
scenario. We prefer the symmetrical scenario detailed above for simplicity’s sake where victory > truth.

Mankiw discusses the effects when the government intervenes in the market in such a way that result in
an increase in private-sector investment, mainly on fixed inputs (capital, such as a factory). This occurs because
government spending increases the demand for goods and services (G  AD), which results in higher
business optimism (when business see that more people are buying their products, they are more optimistic
about producing more of that product), and the demand for new output sources by businesses (capital is a source
of output; it makes stuff; stuff is output) increases. New output sources are demanded because people are
buying more stuff (due to government spending), and to meet this new demand, businesses need to invest (buy)
the stuff that makes the goods and services that people are willing to pay for. Businesses are buying capital
(stuff that makes stuff), which is an increase in investment (I). This idea is different from crowding out, which
states that expansionary fiscal policy (G) results in a decrease in investment. Crowding in states that
expansionary fiscal policy (G) results in an increase in investment.

The BIG Picture of Fiscal/Monetary Policy

AD PL rGDP UE E r

G      
EXPANSIONARY

potential
 Tincome       crowding
out
FISCAL POLICY

 Tcorporate      

G      
CONTRACTIONARY

 Tincome      

 Tcorporate      

OMO buy      
EXPANSIONARY

potential
 discount       accommodating
MONETARY POLICY

rate monetary
policy
 reserve      
requirement
CONTRACTIONARY

OMO sale      

 discount      
rate

 reserve      
requirement

17
 Phillips Curve

“Something that…”Four Scenarios

 PL   inflation  a  b, along the

1 AD
UE  unemployment curve
 PL   inflation  a  c, along the
2 AD
UE  unemployment curve
 PL   inflation 
3 AS SRPC1  SRPC2
UE  unemployment

 PL   inflation 
4 AS SRPC1  SRPC3
UE  unemployment
Scenarios

natural rate of UE right shift in LRPC explanation required

 
Two

1 such as an from LRPC1  LRPC2 (i.e. technology, stock of

UE compensation (This is left shift LRAS) labor, capital, or land)
2  natural rate of UE  left shift in LRPC from  explanation required
18
 such as a LRPC1  LRPC3 (i.e. technology, stock of

“Something
UE compensation labor, capital, or land)

that can…”
(This is right shift LRAS)

[ UNIT VII ]
International Economics

 r in county X
 r in the U.S., relative to appreciation of
 demand for dollar
country X    the US$ relative to
denominated financial  D$
 capital outflow from country the X$ from (e1 –
assets
X OR e2)
 capital inflow to the U.S.

 r in county X
 r in the U.S., relative to
depreciation of
country X  demand for dollar
   the US$ relative to
 capital inflow to country X denominated financial  D$
the X$ from (e1 –
OR assets
e2)
 capital outflow from the
U.S.

19
[Typical International Goods (Current Account) Question]:
[HINT] If forced to use S$, it should respond to ΔrGDP. [TRUTH] Goods questions are S$.

$ denominated goods become relatively more expensive » D$ X

Appreciation of the $ relative to
[truth » S$]
the  from e1 –e2
( denominated goods become relatively less expensive) M
$ denominated goods become relatively less expensive » D$ X
Depreciation of the $ relative to
[truth » S$]
the  from e1 –e2
( denominated goods become relatively more expensive) M
$ denominated goods become relatively more expensive » D$ X
PL in U.S. ($) [truth » S$]
( denominated goods become relatively less expensive) M
$ denominated goods become relatively less expensive » D$ X
PL in U.S. ($) [truth » S$]
( denominated goods become relatively more expensive) M

[Flow of Goods and Services]:

CAUSE EXPLANATION EFFECT

 PL: The increase in price level makes dollar
denominated goods relatively more expensive.
 PL in the U.S – country you are
 Appreciation here: The appreciated $ makes
looking at
dollar denominated goods relatively more  Decrease in U.S.
 Appreciation of $ –  value of the
expensive. exports (X)
currency you are looking at
 PL in other country: The decrease in price  Increase in U.S.
 PL in  – the other country
level makes  denominated goods relatively imports (M)
 Depreciation of  –  value of the
less expensive.
other country’s currency
 Depreciation of : The depreciated  makes
 denominated goods relatively less expensive.
 PL: The decrease in price level makes dollar
denominated goods relatively less expensive.
 PL in the U.S – country you are  Depreciation here: The depreciated $ makes
looking at dollar denominated goods relatively less
 Increase in U.S.
 Depreciation of $ – value of the expensive.
exports (X)
currency you are looking at  PL in other country: The increase in price
 Decrease in U.S.
 PL in  – the other country level makes  denominated goods relatively
imports (M)
 Appreciation of  – value of the more expensive.
other country’s currency.  Appreciation of : The appreciated  makes
 denominated goods relatively more
expensive.

20
 A Look-Ahead to Other International Consequences:
[NOTICE] Your answer is different depending on whether it is a goods or financial assets question.

Financial
Goods/Current Value of the Value of the
PL r Assets/Capital
Account $ $
Account
$ denominated goods Depreciation  demand for $ appreciation
become relatively of the $ denominated financial of the $
G  
more expensive  relative to assets in order to relative to
EXPANSIONARY

D$ the  from yield a higher return the  from

(truth  Sgoods
$ denominated $) e1 – e2
Depreciation  D$for $
 demand e1 - e2
appreciation
become relatively of the $ denominated financial of the $
Tincome  
more expensive  relative to assets in order to relative to
D$ the  from yield a higher return the  from
(truth  Sgoods
$ denominated $) e1 – e2
Depreciation  D$for $
 demand e1 - e2
appreciation
FISCAL POLICY

become relatively of the $ denominated financial of the $

Tcorporate  
more expensive  relative to assets in order to relative to
D$ the  from yield a higher return the  from
(truth  Sgoods
$ denominated $) e1 – e2
Appreciation  D$for $
 demand e1 - e2
depreciation
become relatively less of the $ denominated financial of the $
G  
expensive  D$ relative to assets in order to relative to
CONTRACTIONARY

(truth  S$) the  from yield a higher return the  from

$ denominated goods e1 – e2
Appreciation  D$for $
 demand e1 - e2
depreciation
become relatively less of the $ denominated financial of the $
Tincome  
expensive  D$ relative to assets in order to relative to
(truth  S$) the  from yield a higher return the  from
$ denominated goods e1 – e2
Appreciation  D$for $
 demand e1 - e2
depreciation
become relatively less of the $ denominated financial of the $
Tcorporate  
expensive  D$ relative to assets in order to relative to
(truth  S$) the  from yield a higher return the  from
$ denominated goods e1 – e2
Depreciation  D$for $
 demand e1 - e2
depreciation
become relatively of the $ denominated financial of the $
OMO buy  
more expensive  relative to assets in order to relative to
EXPANSIONARY

D$ the  from yield a higher return the  from

(truth  Sgoods
$ denominated $) e1 – e2
Depreciation  D$for $
 demand e1 - e2
depreciation
 discount become relatively of the $ denominated financial of the $
 
rate more expensive  relative to assets in order to relative to
D$ the  from yield a higher return the  from
(truth  Sgoods
$) e1 – e2  D$for $ e1 - e2
MONETARY POLICY

$ denominated Depreciation  demand depreciation

 reserve become relatively of the $ denominated financial of the $
 
requirement more expensive  relative to assets in order to relative to
D$ the  from yield a higher return the  from
(truth  Sgoods
$ denominated $) e1 – e2
Appreciation  D$for $
 demand e1 - e2
appreciation
become relatively less of the $ denominated financial of the $
OMO sale  
expensive  D$ relative to assets in order to relative to
CONTRACTIONARY

(truth  S$) the  from yield a higher return the  from

$ denominated goods e1 – e2
Appreciation  D$for $
 demand e1 - e2
appreciation
 discount become relatively less of the $ denominated financial of the $
 
rate expensive  D$ relative to assets in order to relative to
(truth  S$) the  from yield a higher return the  from
$ denominated goods e1 – e2
Appreciation  D$for $
 demand e1 - e2
appreciation
 reserve become relatively less of the $ denominated financial of the $
 
requirement expensive  D$ relative to assets in order to relative to
(truth  S$) the  from yield a higher return the  from
e1 – e2  D$ e1 - e2

21
 AP Macroeconomics BIG IDEA:
TRADE IS GOOD!

1. Trade is a non-zero sum game through which participants specialize based on their comparative
advantage [lowest opportunity cost] and exchange goods and services.
The results include:
a. a consumption possibility through trade greater than what could be achieved through autarky
[production alone without trade/self-sufficiency]
b. a higher standard of living in both countries – [same as a.]
c. more efficient allocation of productive resources in both countries ▪ greater efficiency in both
countries
2. Consequences of trade barriers:
a. a consumption possibility less than what could be achieved through trade
b. a lower standard of living in both countries – [same as a.]
c. less efficient allocation of productive resources in both countries ▪ less efficiency in both
countries
3. A few words on PROTECTIONISM
a. ALL protectionist policies have serious consequences as listed above in #2  “Consequences of
trade barriers”
b. Trade barriers are only justifiable on political/value-based grounds. Two circumstances tend to
exist for trade barriers despite the myriad of different seeming circumstances.
i. A mode of production vital to national interests and/or the common good of a people
require protection and/or significant government regulation inhibiting free trade.
ii. A powerful lobby utilizes the mechanisms of government to protect them against
competition. This is functionally a conspiracy against the national interests/common
goods through the complicity of government.

[Typical Absolute/Comparative Advantage Questions]:

1. Absolute advantage is simply who can make more with the same # of resources, time, or other common
denominator.
 Atlantis has absolute advantage because X > Y, with the same resources.
2. Absolute advantage can be held by one player in both goods, both players in one good, and one player
in zero goods.
3. Comparative advantage means lowest opportunity cost – whoever gives up the least Y per unit X
produced has absolute advantage in X.
4. Comparative advantage cannot be held in both goods or zero goods. It must be split between the
players (law of MATH). A possible exception is if both countries have exactly the same production
possibility curves for both goods  a very unlikely question prompt.
5. [Input/Output Method] This is a FALSE dichotomy. There is only an output method – absolute and
comparative advantages are always referring to products. Some questions present the data in the form
of some factor/input, such as units of farmland, time, etc. Do not fall for the trick. If you do not
recognize whether or not the original data of the question is input or output, you run the risk of having
the opposite answer. The supposed input method is simply taking the data provided and turning it into
how much stuff each player can make.

22
 Output (Product Market) Input (Factor Market)
(assume with same amount of resources) (assume hours per 1 unit of goods)

Atlantis: 10 guns or 20 butter Alpha: 10 hours per gun or 20 hours per butter
Xanadu: 2 guns or 10 butter Beta: 2 hours per gun or 10 hours per butter
Atlantis has absolute advantage in guns because Beta has absolute advantage in guns because
10 > 2 with the same amount of resources. 1 > 1/5 in the same amount of time.
Atlantis has absolute advantage in butter because Beta has absolute advantage in butter because
20 > 10 with the same amount of resources. 2 > 1 in the same amount of time.
Atlantis can make 1 gun or 2 butter. Alpha can make 1 gun or ½ butter.
Atlantis per/unit opportunity cost of 1G is 2B. Alpha per/unit opportunity cost of 1G is ½B.
Atlantis can make 1 butter or ½ gun. Alpha can make 1 butter or 2 gun.
Atlantis per/unit opportunity cost of 1B is ½G. Alpha per/unit opportunity cost of 1B is 2G.
Xanadu can make 1 gun or 5 butter. Beta can make 1 gun or 1/5 butter.
Xanadu per/unit opportunity cost of 1G is 5B. Beta per/unit opportunity cost of 1G is 1/5B.
Xanadu can make 1 butter or 1/5 gun. Beta can make 1 butter or 5 gun.
Xanadu per/unit opportunity cost of 1B is 1/5G. Beta per/unit opportunity cost of 1B is 5G.
Atlantis has comparative advantage in guns because their Alpha has comparative advantage in butter because their
opportunity cost per 1G is 2B and Xanadu’s opportunity opportunity cost per 1B is 2G and Beta’s opportunity cost
cost per 1G is 5B. [2B < 5B] per 1B is 5G. [2G < 5G]
Xanadu has comparative advantage in butter because their Beta has comparative advantage in guns because their
opportunity cost per 1B is 1/5G and Atlantis’s opportunity opportunity cost per 1G is 1/5B and Alpha’s opportunity
cost per 1B is ½G. [1/5G < ½G] cost per 1G is 1/2B. [1/5B < ½ B]
Atlantis should specialize in guns. Alpha should specialize in butter.
Xanadu should specialize in butter. Beta should specialize in guns.
Atlantis: exports guns, imports butter. Alpha: exports butter, imports guns.
Xanadu: exports butter, imports guns Beta: exports guns, imports butter.
Acceptable terms of trade must be better than autarky. Acceptable terms of trade must be better than autarky.
Atlantis must get >2B per 1G. Alpha must get >2G per 1B.
Xanadu must get >1/5G per 1B. Beta must get >1/5B per 1G.
… therefore, acceptable per unit terms of trade: … therefore, acceptable per unit terms of trade:
Atlantis: exports 1G for imports >2B to <5B Alpha: exports 1B for imports >2G to <5G
Xanadu: imports 1G for exports >2B to <5B Beta: imports 1B for exports >2G to <5G
Atlantis: imports 1B for exports <½G to >1/5G Alpha: imports 1G for exports <½B to >1/5B
Xanadu: export 1B for import <½G to >1/5G Beta: exports 1G for imports <½B to >1/5B
If terms were 1G : 3B, what are benefits? If terms were 1B : 3G, what are benefits?
Atlantis: gain 1 more B per unit G, alone Alpha: gain 1 more G per unit B, alone.
Xanadu: cost 2 fewer B per unit G, alone Beta: cost 2 fewer G per unit B, alone

23