AP Macroeconomics Course Study Guide

1 AP Macroeconomics Course Study Guide UNIT 1 1 UNIT 2 3 UNIT 3 Error! Bookmark not defined. UNIT 4 7 UNIT 5 10 UNIT 6 18 ● ● ● ● ● ● ● ● ● UNIT 1 Marginal benefits: what you gain from obtaining one more unit of good/service Marginal costs: what you pay for obtaining one more unit of good/service Ceteris paribus: holding all other variables constant, examining the effect of changing one variable Scarcity: when goods are limited in quantity, but there is unlimited want Opportunity cost: the loss of potential gain from other alternatives when one alternative is chosen Types of resources: land, labor, capital (raw goods, machines, capital stock, tech, money), entrepreneurship Free market (capitalist economy): ○ People make their own choices ○ Prices determine value/trade Command economy: ○ Government decides who gets what PPC shows the opportunity cost of using scarce resources for one product vs another (note: Production Possibility Curve and Frontier are the same thing!) 2 ● PPC that’s linear has a CONSTANT opportunity cost per unit for the goods ● PPC that’s concave to the origin (one pictured above) has an INCREASING opportunity cost per unit for the goods - explained by “law of increasing opportunity cost” ○ If one side of the goods is continuously increased, it will get harder to convert goods to produce the other thing, so it will have a greater cost ● Zero opportunity cost per unit of the good -> vertical line (does not take any more of good A to produce more of good B) ● A point on PPC is an economy in full employment ● ECONOMIC GROWTH: ○ Happens due to IMPROVED TECH, EDUCATION IMPROVEMENTS, and NEW RESOURCES ○ Point below the curve is achieved when people in BOTH industries are inefficient or unable to work (sick) - indicates a recession ○ Sometimes only one side (consumer or capital) affected, so curve only moves out to new point on that side ● DEMAND GRAPH: price on y-axis, quantity on x-axis, SLOPED DOWNWARDS ○ SHIFT OUTWARD: more demand, meaning more output AND higher price ○ SHIFT INWARD: less demand, meaning less input AND lower price ● For Y amount of money, able to get X amount of stuff = QUANTITY DEMANDED (along demand curve, whole curve doesn’t shift) ● If people have LESS INCOME meaning LESS DEMAND, WHOLE DEMAND SHIFTS (more income, meaning more demand) ● What shifts demand? ○ Consumer tastes ○ Income levels ○ Prices of COMPLEMENTARY GOODS (more complementary goods, more demand for the original goods) ○ Prices in SUBSTITUTE GOODS (more substitute goods, less demand for the original goods) ○ Consumer expectations ○ Number of consumers ● SUPPLY GRAPH: price on y-axis, quantity on x-axis, SLOPED UPWARDS ○ SHIFT OUTWARD: more supply, meaning more output AND lower price ○ SHIFT INWARD: less supply, meaning less output AND higher price ● Anything beyond just price is shift in supply curve, shifted by: ○ Change in input prices (cost of production) ○ Changes in taxes ○ Price of other goods 3 ● Absolute advantage: simply outputting more of a good in a certain amount of time than another ● Comparative advantage: outputting more of a good in a way that makes for the least opportunity cost ● Business cycle: ○ Full employment exists when most individuals who are willing to work and able to are employed ○ Price stability is the average level of prices not changing ○ Economic growth exists when there is increasing output of goods and services UNIT 2 ● What is NOT counted in GDP (total market value of final goods and services produced in a country): ○ Secondary sales (Craigslist, garage sales) ○ Transfer payments (welfare, gifts, social security) 4 ○ Illegal goods ○ Intermediate goods (oranges to make orange juice) ○ Financial transactions (sale of existing stocks, moving money to new accounts, sale of existing home, only initial public offering counts) ● GDP (expenditure approach) = C + I + G + X ○ Consumption: stuff bought by households (biggest) (includes rent because that is a service) ○ Investment: stuff bought by businesses (construction + homes) ○ Government: stuff bought by the government ○ Net exports: exports - imports (rent counts in GDP) ● GDP (income approach) ○ Wages + rent + interest + profit + statistical adjustments = national income ● Inflation: rise in OVERALL price levels, DECREASE in value of money ● Deflation: decrease in OVERALL price levels, INCREASE in value of money ● Anticipated vs unanticipated inflation: ○ Anticipated = inflation that is expected, used to make decisions (worker will demand higher wages to keep purchasing power the same if prices are expected to rise in the market) ■ People aren’t hurt or helped because money can still buy same amount of stuff ○ Unanticipated = inflation was not expected, INCREASE IN INFLATION makes for debtors to WIN and creditors to LOSE ■ Debtors win because they have to pay less because same amount of money on paper, but money is worthless ■ Creditors lose because they get the same amount of money on paper, but the money is worthless ● Price index: used to measure price changes in the economy ○ CPI = (cost of market basket in current-year prices)/(cost of market basket in base-year prices) * 100 ○ Percent change for CPI = change in CPI / beginning CPI * 100 ● How to calculate unemployment: ○ Unemployed / labor force * 100 (to find %) ○ If labor force up, unemployment can go up, more ppl looking for work ○ Labor force participation rate (LFPR) is labor force/population * 100 ● Labor force = 16 years, able to work, wants work ○ Employed ○ Underemployed - part time but want full time, not working to full potential ○ Unemployed - actively looking ● Types of unemployment: 5 ● ● ● ● ● ● ● ○ Frictional: hate job, get fired ○ Structural: system-wide change (VHS repairman) ○ Cyclical: due to recession/depression Nominal values: values that increase or decrease with the price level ○ Prices are as stated, useless for comparison of prices Real values: adjusted for price changes ○ Prices that take inflation into account, set in some chosen “base year” Real GDP is a better measure of economic performance - takes out the effects of price changes and isolates changes in output Price index is used to measure price changes in the economy (same as finding CPI) ○ Current-year cost / base-year cost * 100 Real GDP = nominal GDP / (price index / 100) Percent change for GDP = change in GDP / beginning GDP * 100 Costs of inflation: ○ Shoe leather costs: inflation causing more trips to the bank or store ○ Menu costs: raising prices so must print new advertisements, or new price labels ○ Unit of account costs: you remember when something used to cost less to buy the same thing (spend more to get the same amount of groceries) UNIT 3 ● Aggregate demand is the relationship between real GDP and price level ● Has negative slope ○ As price level increases, real GDP decreases ○ As price level decreases, real GDP increases ● When price level changes, consumers affected - wealth effect ○ Movement along the curve ■ When price level is higher, then GDP is lower ■ When price level is lower, then GDP is higher ● When interest rates paid by consumers change - interest rate effect ● When the prices of domestic goods vs imported goods change - net export effect ● INCREASE in AD means (shift right) ○ Real GDP increase, price level increase ● DECREASE in AD means (shift left) ○ Real GDP decrease, price level decrease ● Things that can shift AD: ○ Increase in optimism and wealth ○ Low stock (pay less) ○ Tax cuts or increase in gov spending ○ Bank has more money ● Investment demand: 6 ● ● ● ● ● ● ● ● ● ○ Any increase in investment spending will increase GDP and AD Short-run aggregate supply (SRAS) is relationship between real GDP and price level Positive relationship: producers seek to maximize profits and production costs are inflexible When price levels rise, production cost stay the same, firms make more profit, will increase quantity produced When price levels decrease, production cost stay the same, firms make less profit, will decrease quantity produced INCREASE in AS means (shift right) ○ Real GDP increase, price level decrease DECREASE in AS means (shift left) ○ Real GDP decrease, price level increase If firms produce more, SRAS shift right; if firms produce less, SRAS shift left Flat Slope for SRAS - for increase in real GDP, price levels don’t go up much Steep Slope for SRAS - for increase in real GDP, price levels up a LOT STICKY vs FLEXIBLE WAGES + PRICES ● Short-run - one factor is fixed ○ EX: price of inputs remains fixed, or sticky, while the price of output increases when price level increases, decreases when price decreases ● Factors remain fixed bc of contracts, menu pricing, delays in recognizing inflation ● Lag between input and output prices lead to: ○ Short run profits when inflation ○ Losses when deflation ● Long run is time when input prices adjust to changes in the overall price level (inflation) ● FIXED input prices and HIGHER output prices → profit, increase production ○ Demonstrated in upward slope of SRAS ● CGIX shifts the AD curve ○ Increase in anything in CGIX increases AD curve ● AS curve only shifted when there are changes in the price of inputs or changes in productivity ○ Increase price of inputs, lower supply ■ Ex. Higher nominal wages, SRAS shifts left ○ Decrease price of input, higher supply ○ More productivity, higher supply ○ Less productivity, lower supply ● Inflation ○ Higher demand means higher inflation 7 ○ Lower supply means higher inflation ● Long run is when input price has time to catch up to output price ○ Wages and prices fully flexible ○ No overall effect ○ Output prices GO UP BECAUSE OF INFLATION, eventually, input prices and wages catch up to the output prices to make LONG RUN vertical ● LRAS vertical at full employment output ○ If not full employment, above would lead to greater productivity therefore greater supply so greater LRAS ○ Below would lead to lesser supply, lower LRAS ○ LRAS curve represents point on PPC graph - outward shift in PPC means outward shift in LRAS ● Productive capacity based on quantity and quality of resources - human resources, natural resources, capital goods, technology ● Short run phillips curve is unemployment (x) vs inflation (y) ○ Higher unemployment, lower inflation ○ Lower unemployment, higher inflation ○ Always negative slope ● Long run phillips curve ○ If natural rate of unemployment decreases, LRAS shifts to the right, more supply because more people are working ○ If the natural rate of unemployment increases, LRAS shifts to the left, less supply because less people working ○ In long run, no trade off between inflation and unemployment 8 UNIT 4 ● Initial change in components of AD will lead to changes in the economy, larger final change in GDP ● Final impact of an initial change in spending can be calculated with the spending multiplier ● The marginal propensity to consume - the amount of additional spending that results when households receive additional income, fraction spent of any change in disposable income (ΔC / ΔDI) ● The marginal propensity to save - fraction saved of any change in disposable income (ΔS / ΔDI) ● MPC + MPS always add up to 1 ● APC is the average propensity to consume, total income households spend / disposable income (C / DI) ● APS is the average propensity to save, total income households save / disposable income (S / DI) ● SPENDING MULTIPLIER: ○ 1 / (1 - MPC) ○ Change in AD component * spending multiplier = change in GDP ○ Used when there is a change in a component of AD ● TAX MULTIPLIER: ○ - MPC / MPS ○ Change in taxes * tax multiplier = change in GDP ○ Used when there is a change in lump-sum taxes ● Lower taxes ⇒ increased spending Higher taxes ⇒ decreased spending Effect of taxes on spending is negative, so tax multiplier has a negative sign Taxes are not a component of AD AD shifts to the right if the government spends or taxes are cut - move towards full employment ● AD shifts to the left if the government decreases spending or increases taxes - move toward a lower employment ○ Expansionary fiscal policy increases employment, increases output, can raise price levels, increase budget deficits ■ Used when demand is too low to bring about full employment of resources ○ Contractionary fiscal policy decreases employment, decreases output, can decrease price levels, increase budget surpluses ■ Used when AD too high, inflationary pressures ● When AD down, EXPANSIONARY FISCAL POLICY, the objective is to get it up, lower taxes, raise spending, the effect is more deficit for federal budget and more national debt ● ● ● ● 9 ● When AD up, CONTRACTIONARY FISCAL POLICY, the objective is to get it down, raise taxes, decrease spending, effect is more surplus for federal budget, and less national debt ● GOAL: stabilize the economy - promoting full employment and stable prices ● AD must be near full-employment level ● If too low, unemployment. If too high, inflation. ● When government has to pass law, take action to change taxes or spending, then the action is at the government's discretion - DISCRETIONARY POLICY ● If effect of stabilization happens automatically as economic situation changes AUTOMATIC STABILIZER ○ EX: unemployment compensation when people laid off in recession - payment creates income and spending to keep aggregate demand from falling as much ● Policy effects on aggregate supply ○ EX: SRAS affected by changes in economy-wide input prices (wages, the price of oil) and productivity ○ EX: LRAS affected by technological advancements, more available resources, higher quality resources ● Lowering business taxes shifts AS right ● Raising government regulation shifts AS left ● The deficit and the debt: ○ Two primary tools of discretionary fiscal policy are gov. spending and taxes ● Budget deficit when gov. spends more than it collects in taxes - borrows to cover it ○ Issues bonds ● SUM of past deficits = DEBT, which is subject to annual interest charges ● Budget surplus is when the government taxes more than it spends ○ Can be used to reduce debt ● Government budget deficit results in an increase in the demand for loanable funds ● Government budget surplus results in a decrease in the demand for loanable funds, increases the supply of loanable funds if gov. pays off debt ● EXPANSIONARY - raise gov spending, lower taxes, higher deficit, lower surplus, higher debt, higher interest rate ○ Can close a recessionary gap ● CONTRACTIONARY - decrease gov spending, raise taxes, lower deficits, higher surplus, lower debt, lower interest rate ● Crowding out: ○ Government borrows to pursue expansionary fiscal policy, replaces private borrowing and spending ○ Part of the increase in AD from increased gov spending is offset by decrease in AD from decreased consumption and investment ● SHIFTS IN THE DEMAND FOR LOANABLE FUNDS 10 ○ Changes in perceived business opportunities ■ Increases in investment by small businesses shift the demand for loanable funds to the right ■ Decrease in optimism shifts demand to the left ○ Investment tax credit can increase the rate of return on investments, shifts demand to the right ○ Changes in the government’s borrowing ■ Budget deficits can cause shifts ■ Increases in gov’t borrowing shifts demand to right and decreases shifts it to left ● SHIFTS IN SUPPLY FOR LOANABLE FUNDS ○ Changes in private saving behavior ■ Rising home prices made home owners feel richer, they spent more ■ Shifts supply to the left ○ Changes in capital inflows ○ Increase in the supply of loanable funds ■ Decreases interest rate ● KEYNESIAN EQUILIBRIUM ○ Keynesian Economics refers to using active government policy to manage aggregate demand in order to address or prevent economics ■ Active fiscal and monetary policy ○ Equilibrium for the Keynesian model refers to when opposing forces of aggregate expenditures equal to aggregate production and achieve a balance with no inherent tendency for change 11 UNIT 5 Money & Financial Assets ● Money: generally accepted in payment for goods and services ○ serves three IMPORTANT functions ■ Medium of exchange ■ Standard of value ■ Store of value ● Good medium of exchange requirements ○ Accepted by people when they buy and sell ○ Portable ○ Divisible ○ Uniform ■ All quarters need to be worth the same ● Good standard of value (unit of account) ○ Useful for denominating values ■ Familiar ■ Divisible ■ Accepted ● Good store of value ○ Durable ○ Stable purchasing power ● History of money (looking at the progression) ○ Gold ○ Tobacco ○ Beer ○ Cattle ○ Metal coins ○ Paper bills ○ Checks ● Fed: uses monetary aggregates (M1 and M2) to measure money supply ○ M2 includes M1 + less liquid assets ○ Liquidity: ease which asset can be turned into cash ■ Cash is most liquid ○ M1: paper currency, coins, demand deposits, checks ○ M2: M1, savings and any time deposits, money market shares, mutual funds ● Financial system: made up of financial markets ○ Facilitate flow of funds from lenders to borrowers ○ Households invest savings in financial assets ■ Provides funds for investment spending ● Leads to long-run economic growth 12 ○ Addresses 3 problems: ■ Transactions costs, risk, and liquidity ○ Reduces transaction costs by ■ Making it easier and less costly to match borrowers and lenders ● Allows for diversification (investing in several different assets) ○ Used as a way to provide liquidity (access to cash) ○ Financial intermediaries (banks and mutual funds) ■ Institutions transform funds that are gathered into financial assets ● Financial asset: paper claim that entitles its buyer to future income from the seller ○ Four types: ■ Loans ■ Stocks ■ Bonds ■ Bank deposits ○ Loan: agreements to repay with interest ○ Bond: IOU issued by borrower, a promise to pay FIXED interest payments at regular intervals ○ Stock: share in ownership of a company ○ Mutual fund: financial intermediary that creates a portfolio (collection of financial assets) Time Value of Money ● PV = FV/(1+r)^n ○ PV: present value ○ FV: future value ○ r: rate of interest per period ○ n: the number of compounding periods/yr ● Present value is inversely related to the interest rate ○ Less business investment spending is better @ higher interest rates Banks and the Creation of Money ● Bank = financial intermediary ○ Uses bank deposits to finance investment ○ Deposits = come from households/savers ○ Loans = out deposits to investors/firms ● Banks earn profit from loans ● Fraction of deposits kept on hand = bank reserves ○ In vault or federal reserve ● Required reserves = the fraction of deposits they must keep as reserves ○ Reserves that are left over are called excess reserves ● Fractional reserve: banks keep a fraction of deposits and loan out the rest 13 ○ Banks can create money to expand money supply ● T-accounts: shows offsetting of assets and liabilities ○ Bank assets: ■ Loans ■ Deposits w/ fed. reserve ■ Treasury securities ○ Liabilities: ■ Deposits ● To determine the amount of money can be created: deposit expansion multiplier ○ Bank loans out all of the excess reserves ○ Determines how much money can be created from deposit ■ Deposit expansion multiplier: 1/rr ● Rr: reserve requirement ■ Expansion of money supply: ● Excess reserves x multiplier ○ Multiplier = 1/rr Money Market ● M1 = determined by Federal Reserve ● Price of money = interest rate ● There is money demand and money supply ○ Money supply = determined by fed ■ Independent of interest rate ■ Is a vertical line ○ Money demand = determine by consumers to hold wealth ■ Savings accounts ■ Inverse relationship with interest rate ■ Money ■ Three types: ● Transactions demand: purchase of goods and services ● Precautionary demand: protection against unexpected need ● Speculative demand: store of wealth ● Demand for money = function of income ● Interest rate: opportunity cost of having money ● Inverse relationship with interest rate ○ Interest rate goes up ■ Ppl hold less money ○ Interest rate falls ■ Ppl hold more money ● Loanable funds market: borrowers and lenders 14 ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ Demand funds = borrowers Supply funds = lenders Determines real interest rate (price of loans) FOUR groups supply and demand loans ■ Consumers ■ Government ■ Foreigners ■ Businesses More loans get demanded at LOWER interest rates ■ Vice versa Profits rise when interest rates fall Gov’t borrowing is not sensitive to interest rates Opportunity cost of saving is spending ■ More saved, less spent ■ Opportunity cost rises as more income = saved ● High interest rates are needed for the increasing opp. Cost of living Equilibrium = total amount savers are willing to lend is equal to total amount borrowers are willing to borrow DETERMINANTS FOR DEMAND ■ Business confidence/expectations ■ Consumer confidence/expectations ■ Gov’t budget plans ■ Income levels SUPPLY ■ Gov’t reduces income tax rate on interest income ● Consumers want to save more → more supply 15 ■ Consumers saving will always shift supply to right Federal Reserve and Central Banking ● Is the central bank for the US ● An institution that oversees / regulates banking system, controls money supply ● Known as “The Fed” ● Made of 12 privately owned District Federal Reserve Banks + federal government agency overseeing system: Board of Governors ● Fed’s four functions: ○ Financial services for commercial banks ■ Holding reserves ■ Providing cash ■ Clearing checks ○ Supervise and regulate banking institutions ■ Ensure safety + soundness ○ Maintain stability of financial system by providing liquidity ○ Conduct monetary policy ■ Prevents or addresses extreme economy fluctuations ● Goal is to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates ● Primary goal is to stabilize prices ● Monetary policies have: ○ Strong long-term influence over prices ○ Short term influence on real output ○ Short term influence on interest rates ● Monetary policy raises and lowers interest rates in money market ○ Lower rates → increased spending → increased employment (EXPANSIONARY) - buy bonds, decrease discount rate, decrease rr ○ Higher rates → prevent inflation → promote price stability (CONTRACTIONARY) - sell bonds, increase discount rate, increase rr ● Three main tools used by the Fed to control equilibrium interest rates ○ Reserve requirement: ■ Sets the percentage of deposits that must be held as reserves ■ Greater excess reserves → expand credit for banks → greater money supply ■ Lower excess reserves → decrease credit for banks → lower money supply ■ Changes in reserve requirement can have a powerful impact, seldom used ○ Discount rate: ■ Discount rate - rate that commercial banks must pay to borrow from Fed 16 ■ When cheaper, banks borrow more ■ When more expensive, banks borrow less ■ Lower rate -> More reserves → expand credit → expand money supply ■ Higher rate -> Fewer reserves → reduce credit → decrease money supply ■ Equilibrium federal funds rate established in the money market is the focus of monetary policy ○ Open-market operations: ■ Fed buying and selling US Treasury bills ● When bought, bank reserves increase (more money in bank), supply increases ● When sold, bank reserves decrease (less money in bank), supply decreases ■ Most frequently used monetary policy tool ○ Fed actions and effects: ■ Sold treasury securities on the open market ● Lower bank reserves ● Lower money supply ● Higher Fed funds rate ■ Bought treasury securities on the open market ● Higher bank reserves ● Higher money supply ● Lower Fed funds rate ■ Raised discount rate ● More interest paid on loaned money to commercial banks ● Lower bank reserves ● Lower money supply ● Higher Fed funds rate ■ Lowered discount rate ● Less interest paid on loaned money to commercial banks ● Higher bank reserves ● Higher money supply ● Lower Fed funds rate ■ Raised reserve requirement ● Lower bank reserves ● Lower money supply ● Higher Fed funds rate ■ Lowered reserve requirement ● Higher bank reserves ● Higher money supply 17 ● Lower Fed funds rate ○ Discount rate is the interest rate on the money lent to commercial banks from the Fed ○ Fed funds rate is the interest rate that the banks use when loaning money to other banks ● Monetary policy ○ Prevent or address extreme economic fluctuations ○ Fed lowers interest rates through expansionary monetary policy, prevent or address recessions ○ Fed raises interest rates through contractionary monetary policy, prevent or address inflation ○ Monetary policy transmitted through changes in AD ■ Short run and long run effects ○ For cases of equilibrium less than LRAS, what monetary policy? ■ To get to full-employment: expansionary monetary policy (move more toward full-employment output ■ To use open market operations: BUY treasury securities ■ Effect on Treasury bond prices?: INCREASE when bought ■ In the short run, nominal interest rates FALL ● The Quantity Theory of Money ○ MV = PQ ■ M = money supply ■ V = velocity of money (# of times an average dollar bill spent) ■ P = average price level ■ Q = real value of all final goods and services (GDP) ○ Equation shows balance between money (left) and goods (right) ○ For given V, if M increases more than Q, then must have increase in P (inflation) to keep both sides equal ○ INCREASE IN MONEY must be offset by INCREASE IN REAL OUTPUT or else INFLATION ○ How much people are paid help determine velocity ● Real vs Nominal Interest Rates ○ You buy a bond for $1000, bond paid interest rate of 10%, but can you buy 10% more stuff? ■ You will have 10% more money, but if the price level rises, cannot buy as much as 10% more ○ Nominal interest rate - rate the bank pays you on your savings, rate that appears on bond/load ○ Real interest rate - change in your purchasing power 18 ○ Expected real interest rate - amount you need to receive in real terms to forgo consumption now for consumption in the future ○ FISHER EQUATION: ■ r = i - pi ● r = real interest rate ● i = nominal interest rate ● pi = inflation rate ○ EXPECTED REAL INTEREST RATE: ■ r * e = i - pi * e ● pi * e is expected interest rate ○ If Fed increases the money supply, price level increase, inflation will increase nominal interest rate, decrease real interest rate, some combo ○ This is FISHER EFFECT ○ SHORT RUN - increases in money supply will decrease nominal interest and real interest rates ○ LONG RUN - increases in money supply will increase the price level and nominal interest rate UNIT 6 Activity 7-1: Balance of Payment Accounts ● Balance of payments accounts: a record of all of the country's transactions with other countries ○ These accounts are either current and financial ■ Current Accounts = exports of goods + services, net investment income and net transfers ● Net investment income = US earnings on investment abroad foreign earnings on investment in US ■ Financial Accounts = country’s sale of assets to foreigners - purchase of assets from foreigners ● EX: US invest in hotel in Tokyo, while foreigners invest in factory in US ● Foreign assets bought on foreign exchange markets ● Financial flows are part of loanable funds market since foreign investors provide money that can be used as loanable funds ● Changes in loanable funds affect real interest rate in the loanable funds market, affecting investment, AD, GDP, employment, prices ○ Balance essential for knowing the nation's position in the global economy ● TWO SIDES (current and financial) ADD TO ZERO ○ If CURRENT ACCOUNT SURPLUS, FINANCIAL ACCOUNT DEFICIT 19 ○ If CURRENT ACCOUNT DEFICIT, FINANCIAL ACCOUNT SURPLUS Activity 7-2: Barriers to Trade ● Total output = greater when countries specialize according to their comparative advantage ● Policies promoting free trade attempt to achieve efficiency benefits from free trade ○ EX: groups of countries create free trade areas to promote international trade ■ NAFTA: creation of trilateral trade bloc in NA ■ WTO: world trade organization ■ EU: european union ■ APEC: Asia-Pacific Economic Cooperation ● Countries sometimes impose trade barriers to protect domestic industries ○ Tariffs ■ Tax on imports ○ Quotas ■ Limit on quantity of goods that can be imported within a given period ● Domestic Demand Curve ○ represents demand by the domestic economy for a commodity that is produced domestically and imported ● Domestic Supply Curve ○ What domestic suppliers are willing and able to produce at alternative prices ● Total Supply ○ Domestic supply + supply of imports ● No international trade/complete ban on imports —> domestic demand and supply would determine the equilibrium price and quantity ● Yes international trade —> total supply curve would represent production by domestic and foreign producers ○ Domestic consumers would consume more of the commodity at a lower price ● DOMESTIC FIRMS PRODUCE LESS UNDER FREE TRADE Activity 7-3: Foreign Exchange Market 20 ● ● ● ● In an economy, prices are in domestic currency In the US, prices in DOLLARS; in Europe, prices in EUROS Domestic currency are used to buy domestic goods When goods bought from DIFFERENT country, it has to be bought in that country’s currency ● International trade requires currencies to also be traded ● Currencies are traded in foreign exchange markets ● Equilibrium price at which currencies traded called the exchange rate ○ Exchange rate is the rate at which currency of one country is exchanged for the currency of another ● When buying foreign goods, US dollars supplied to foreign exchange market and foreign currency demanded ● When foreigners buy things, US dollars demanded in foreign exchange market and foreign currency supplied by foreigners ● Appreciation: an increase in the exchange rate for a currency ○ Can be caused by INCREASE IN DEMAND or DECREASE IN SUPPLY ○ Takes more of foreign currency to purchase a dollar ■ So the dollar is worth more in this case ● Depreciation: a decrease in the exchange rate for a currency ○ Can be caused by DECREASE IN DEMAND or INCREASE IN SUPPLY ○ Takes less foreign currency to purchase a dollar ■ So the dollar is worth less in this case ● Appreciation or depreciation changes price of imports and exports ● When goods APPRECIATE - more expensive for foreigners to buy exports, cheaper for countries to buy imports ● When goods DEPRECIATE - cheaper for foreigners to buy exports, more expensive for countries to buy imports ● Affects NET EXPORTS ● EXAMPLE: ○ US goods INCREASE in price. US citizens prefer to buy GERMAN goods since those are LESS expensive. To buy GERMAN goods, you need EUROS, so demand for euros goes UP. People exchange US dollars for EUROS, so supply of US dollars goes UP. ○ US goods DECREASE in price. GERMAN citizens prefer to buy US goods since those are LESS expensive. To buy US goods, you need DOLLARS, so demand for dollars goes UP. People exchange Euros for US dollars, so supply of euros goes UP. ■ Whichever currency is being exchanged, MONEY SUPPLY of THAT CURRENCY WILL GO UP Activity 7-4: Policies and Economic Conditions Affect Exchange Rates 21 ● Changes in the nation's monetary and fiscal policies affect its exchange rates and its balance of trade through: ○ Real interest rate ○ Income ○ Price level ● CHANGES in the VALUE of a country’s CURRENCY ○ AFFECTS the balance of trade which AFFECTS aggregate demand ● CHANGES IN AGGREGATE DEMAND ○ AFFECTS: ■ Real interest output ■ Price level ● Domestic policies and currency values are directly related Activity 7-5: Net Exports and Capital Flows: Linking Financial and Goods Markets ● Capital flow: ○ Movement of financial capital (money) b/w economies ● Capital inflow: ○ Consists of foreign funds moving into an economy from another country ○ EX: ■ Perspective: US ● Japan builds a new plant within the US ● Capital outflow: ○ Like inflow but it’s out of the economy to another country ○ EX: ■ Perspective: US ● US builds a planet outside of the US ● Loanable funds market = used to analyse capital flows in an economy ● FINANCIAL CAPITAL AFFECTS AMOUNT OF MONEY AVAILABLE TO BORROWERS ○ Changes in capital flows shifts the supply curve for loanable funds ■ Capital inflows increase supply of loanable funds ● Results in: decrease in domestic real interest rate Activity 6-3: Policies to Promote Economic Growth ● Economic growth in the country if it has increased long-run ability to produce goods and services, it doesn’t matter what the short run is ● Short run fluctuations caused by AD or SRAS changes, leading to changes in GDP ● These changes are movement along long-run stability of full-employment GDP ● Economic growth is considering level of real GDP when nation is at full employment ● Using production possibilities model, economic growth is outward move of PPC ○ More goods and services produced ● EXAMPLES: what leads to economic growth? (tech, education, more resources) 22 ○ Gov’t incentivizes technology research - GROWTH ○ More education and literacy - GROWTH ○ Money supply expanded - NOPE ○ Lower taxes and increase military spending - NOPE Government Policies to Promote Long-Run Economic Growth ● Key to economic growth: productivity of the nation ○ Productivity is measured as the quantity of goods and services produced from each unit of labor ● Factors that contribute to a nation’s productivity ○ Capital per worker ■ Workforce = more productive if there are more tools ■ Tools = physical capital ● Paired with labor to produce goods & services ● Must be replaced at a rate that outpaces depreciation ■ If country invests in capital production —> workforce = more productive ■ Gov’t can promote economic growth through policies that encourage investment in physical capital ■ Country has public capital —> infrastructure ● Gov’t invest directly through road, bridges, powerlines, and networks ○ Human capital per worker ■ Acquired from schooling, training, experience ■ Depreciates over time ■ Gov’t promotes economic growth by investing in education system ○ Natural resources per worker ■ Minerals, sources of energy, rivers, forests, and fisheries ■ To ensure long run economic growth ● Resources should be protected and sustainably extracted ○ Technology ■ Country’s state of knowledge = understanding of how to best produce goods and services ■ Better technology: harvest more output ■ Gov’t promote economic growth by ● Facilitating technological progress through research and development PPC Curve Out (to the right) Improved technology, more education, and new resources 23 In (to the left, or point within the curve) Point below the curve is achieved when people in BOTH industries are inefficient or unable to work (sick) - indicates recession NOTE: Sometimes only one side (consumer or capital) affected, so curve only moves out to new point on that side Demand (Supply and Demand) Out (to the right) Consumer tastes, income levels increase, prices of complementary goods decrease, prices of substitute goods increase, consumer expectations, number of consumers increase In (to the left) Consumer tastes, income levels decrease, prices of complementary goods increase, prices of substitute goods decrease, consumer expectations, number of consumers decrease Supply (Supply and Demand) Out (to the right) Input prices decrease, sales tax decrease, price of other goods In (to the left) Input prices increase, sales tax increase, price of other goods