Common Mistakes On The AP Macro Exam

The difference between a change in demand and a

change in quantity demanded

P

Qo

$5

4

3

2

1

P QD

$54321

1020355580

D

Price of Corn

Quantity of Corn

CORN

10 20 30 40 50 60 70 80

What if

Demand

Increases?

GRAPHING DEMAND

P

Qo

$5

4

3

2

1

P QD

$54321

D

Price of Corn

Quantity of Corn

CORN

10 20 30 40 50 60 70 80

D’

Increase

in

Demand

Increase

in Quantity

Demanded1020355580

30406080 +

GRAPHING DEMAND

The difference between a change in supply and a

change in quantity demanded

SP

Qo

$5

4

3

2

1

10 20 30 40 50 60 70 80

$54321

60503520 5

P QS

Price of Corn

Quantity of Corn

CORN

What if

Supply

Increases?

GRAPHING SUPPLY

SP

Qo

$5

4

3

2

1

10 20 30 40 50 60 70 80

Price of Corn

Quantity of Corn

$54321

60503520 5

P QS

CORN

8070604530

S’Increase

in

Supply

Increase

in Quantity

Supplied

GRAPHING SUPPLY

Mislabeling or NOT labeling graphs correctly

Pric

e Le

vel

Real Domestic Output, GDP

Q

P AS

AD

Equilibrium in theIntermediate Range

Qe

EQUILIBRIUM: REAL OUTPUTAND THE PRICE LEVEL

Pe

GROWTH IN THE AD-AS MODEL

A

B

C

D

Ca

pit

al G

oo

ds

Consumer Goods

Pri

ce

Lev

el

Real GDP

ASLR1 ASLR2

Q1 Q2

ECONOMIC GROWTH IN THEEXTENDED AD – AS MODEL

Pri

ce L

evel

Real GDP

o

P1

AS2

ASLR1

AD2

Q1

ASLR2

Q2

AD1

AS1

P2

No

min

al I

nte

res

t R

ate

Amount of money demanded(billions of dollars)

0 50 100 150 200 250 300

10

7.5

5

2.5

0

Dm

ie

Sm Use this graph when the FED changes the money supply to change interest rates.

Sm1

THE MONEY MARKET

Net effects of Monetary Policy and/or Fiscal

Policy onInterest Rate

FISCAL POLICY, AGGREGATE SUPPLY AND INFLATION

Pric

e le

vel

Real GDP (billions)

AS

AD2

$495 $515

P1

AD1

Fiscal PolicyAnd Inflation

$505

Expansionary Fiscal Policy = Interest Rate INCREASE

• Exp. Fiscal Policy (Gov’t deficit) Increase Demand for Money Increase Interest Rate.

• Higher Price Level Increase Demand for Money Increase Interest Rate.

Expansionary Monetary Policy Interest Rate DECREASE

Real domestic output, GDP

Dm

InvestmentDemand

Nom

inal

inte

rest

rat

e

10

8

6

0Quantity of money Amount of investment, I

MONETARY POLICY AND EQUILIBRIUM GDPSm1

AS

AD1P1

10

8

6

0

Sm2

AD2

P2

Money Supply Increases

Interest Rate Decreases

Investment Increases

AD & GDP Increaseswith slight inflation

If the moneysupply increasesto stimulate the

economy...

Pri

ce le

vel

AD3

Pri

ce le

vel

Real domestic output, GDP

Dm

InvestmentDemand

Rea

l rat

e of

inte

rest

, i

10

8

6

0Quantity of money demanded and supplied Amount of investment, i

MONETARY POLICY AND EQUILIBRIUM GDPSm1

AS

AD1P1

10

8

6

0

Sm2

AD2

P2

More Money Supply

Lower Interest Rates

More Investment

Still higher AD & GDPwith significant inflation

Sm3

P3 If the moneysupply increases

again…

MULTIPLIER(S) CONFUSION

Change inGDP = Multiplier x initial change

in spending

Multiplier = or 1

MPS

1

1 - MPC

THE MULTIPLIER EFFECT

.9

.8

.75

.67

.5

10

5

4

3

2

MPC Multiplier

MPC and the Multiplier

MONEY MULTIPLIER

• 1 / Required Reserve Ratio

• Maximum Multiple $$$ Money Expansion

MULTIPLE DEPOSIT EXPANSION PROCESS

BankAcquired reserves

and depositsRequiredreserves

Excessreserves

Amount bankcan lend - Newmoney created

ABCDEFGHIJKLMNOther banks

$100.00 80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 21.97

$20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40

$80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.57

$80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.57

$400.00Total amount of money created by the banking system

Balanced Budget Multiplier= 1

(Net Result on GDP)

New reserves$800

ExcessReserves

$4000Bank System Lending

FEDERAL RESERVE PURCHASE OF BONDS FROM PUBLIC

Purchase of a$1000 bondfrom public...

$200Requiredreserves

$1000Initial

Deposit

Total Increase in Money Supply ($5000)

New reserves$800

ExcessReserves

$4000Bank System Lending

Someone deposits $1000 in newReserves at a bank.

$200Requiredreserves

$1000Initial

Deposit

Total Increase in Money Supply ($4000)

New reservesNew reserves

$1,000$1,000Excess

Reserves

$5,000$5,000PMCPMC thru Bank Lending

FedFed Buys A Buys A $1,000 Bond$1,000 Bond From From Joe’s BankJoe’s Bank

TMSTMS isis $$50005000

20% RR20% RR

$20$20Requiredreserves

$100$100New reserves

$100Initial

Deposit

$400Bank system lending

Money Created

$80Excess

reserves

OUTCOME OF MONEY EXPANSIONOUTCOME OF MONEY EXPANSION

Leakages exist...

(Savings) Currency Drains Excess Reserves

$20$20Requiredreserves

$100$100New reserves

$100Initial

Deposit

$400Bank system lending

Money Created

$80Excess

reserves

Injections: Additional Spending into

Income – Expenditures stream: Investment,

G, or Xn

UNEMPLOYMENTTypes of Unemployment

Frictional UnemploymentStructural UnemploymentCyclical Unemployment

Natural rate of Unemployment = Structural + Frictional (Around 4-5%)

Confusing Comparative Advanatge

Calculations

real

in

tere

st r

ate

Quantity of Loanable Funds

LOANABLE FUNDS MARKET

r

D

Q

S

This graph shows how the supply and demand for loanable funds affects long-term interest rates!

Loanable Funds Market Graph(Long-Term Interest Rates)

What changes Supply:

1. Increase in Household savings

2. Increase in Gov’t savings

3. Increase in Business savings

4. Increase in Business savings

5. Increase in Foreigners’ savings

What changes Demand: 1. Increase in Household

borrowing2. Increase in business

Investment3. Increase in Foreign

borrowing4. Increase in Government

borrowing (When the gov’t has a budget deficit!) = (the crowding -out effect)

Price Index

Price Index Price of market basket in specific yearin a given = --------------------------------------------- X 100 Year Price of same market basket in base year

Nominal GDPReal GDP = -------------------------------

Price Index (in hundredths)

Remembering the difference between

Real and

Nominal

Nominal:with Inflation

Real:Adjusted for Inflation

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

INCOME

• NOMINAL INCOME: number of dollars received by an individual or group for its resources during some period of time

• (Not adjusted for Inflation)

• REAL INCOME: amount of goods and services which can be purchased with nominal income during some period of time

• (nominal income adjusted for inflation)

INTEREST RATES

• NOMINAL: interest rate expressed in terms of annual amounts currently charged for interest.

• REAL: interest rate expressed in dollars of constant value (adjusted for Inflation) and equal to the NOMINAL i % minus the EXPECTED RATE OF INFLATION

NominalInterest

Rate

RealInterest

Rate

InflationPremium

=11%

5%

6%+

Nominal vs. Real

NominalInterest

Rate

RealRealInterestInterest

RateRate

InflationInflationPremiumPremium

-16%16%

1010%%6%6%

Real Interest RateReal Interest Rate[[Nominal I.R. – inflation rate Nominal I.R. – inflation rate == Real I.R.Real I.R.]]

=

Demand-Pull Inflation

vs.

Cost-Push Inflation

DEMAND-PULL INFLATION

o

P1

AS1

ASLR

AD1

a

Q1

Pri

ce L

evel

Real domestic output

bP2

P3

AD2

AS2

c

Q2

COST-PUSH INFLATION

o

P1

AS1

ASLR

AD1

a

Q1

Pri

ce L

evel

Real domestic output

bP2

AS2

Occurs when short-run AS shifts left

Q2

COST-PUSH INFLATION

o

P1

AS1

ASLR

AD1

a

Q1

Pri

ce L

evel

Real domestic output

bP2

P3

AD2

AS2

Government response with increased AD

c

Evenhigherpricelevels

COST-PUSH INFLATION

o

P1

AS1

ASLR

AD1

a

Q1

Pri

ce L

evel

Real domestic output

bP2

AS2

Q2

Q2

COST-PUSH INFLATION

o

P1

AS1

ASLR

AD1

a

Q1

Pri

ce L

evel

Real domestic output

bP2

AS2

If government allows a recession to occur

Nominal wages fall (which

increases AS &AS returns

to its originallocation

People must believe Fed is serious about stopping inflation.

Phillips Curve

An

nu

al r

ate

of in

flat

ion

(per

cen

t)

Unemployment rate (percent)

7

6

5

4

3

2

1

01 2 3 4 5 6 7

As inflation declines...

THE PHILLIPS CURVE CONCEPT

Unemploymentincreases

An

nu

al r

ate

of in

flat

ion

(per

cen

t)

Unemployment rate (percent)

7

6

5

4

3

2

1

01 2 3 4 5 6 7

THE PHILLIPS CURVE CONCEPT

LRPC = Natural Rate of Unemployment

GENERAL EXAM ADVICE

Free Response:

• Do not restate question

• Use correct terminology

• Even if a graph is not required, draw one anyway and explain.

• Use same outline as question

• Use Good Handwriting

GENERAL EXAM ADVICE

• Draw graphs large enough for the reader to tell what’s going on.

• Explain your reasoning: “the price increased”, why?

• No Calculators

• If you can eliminate one answer, answer the question.