AP Macroeconomics Exam: Course Study Guide

[ UNIT I ]
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 Stalins 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
TWO BASIC MODELS of an economy are introduced in UNIT I:
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.
[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 Simple Circular-Flow Diagram:

Product,
Output,
Goods & Service
Market

Businesses
Firms
Producers
I

Input,
Resource,
Factor
Market

Land
Labor
Capital
Entrepreneurship

Households
Individuals
Consumers
C

Rent
Wages & Salaries
Interest
Profit

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.
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.

This PPC illustrates no relationship

between Good A and Good B

This PPC also illustrates no

relationship between Good A and
Good B but merely shifts the axes.

We define opportunity cost as the

next best thing, but text definitions
tend to involve what was forgone or
alternative use of the common inputs.

THREE TYPES OF PPC CURVES could be drawn:

Increasing Opportunity Cost Curve
bowed-out or concave to the origin

Constant Cost Curve

looks like: a right triangle

Decreasing Opportunity Cost Curve

looks like: a ski-jump

Most PPC curves will be of this type.

As more of one good is made, it entails
an increasing cost in terms of the other
good forgone.

This is a less common but possible

variety of PPC. The ratio of exchange
between good A and good B is a
constant.

These are NOT possible!!! NEVER

pick this as an example even Harry
Potter could not make this happen.

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

such as, PPC1 to PPC2.
+ factors of production
- costs of production
+ technology

Decreases are graphically expressed as a shift to the left,

such as PPC1 to PPC2.
- factors of production
+ costs of production
- technology

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

DEMAND

1.
2.
3.
4.
5.
6.

Increase Demand
(Shift D Right)

Decrease Demand
(Shift D Left)

D P (P1-P2) Q (Q1-Q2)

D P (P1-P2) Q (Q1-Q2)

Increase in the # of consumers

Increase in income
Increase in expectations of future price
Increase in taste (advertising)
Increase in the price of a substitute good
Decrease in the price of a complementary good

1.
2.
3.
4.
5.
6.

Decrease in the # of consumers

Decrease in income
Decrease in expectations of future price
Decrease in taste (advertising)
Decrease in the price of a substitute good
Increase in the price of a complementary good

SUPPLY

1.
2.
3.
4.
5.
6.

Increase Supply
(Shift S Right)

Decrease Supply
(Shift S Left)

S P (P1-P2) Q (Q1-Q2)

S P (P1-P2) Q (Q1-Q2)

Increase in the # of producers

Increase in the # of inputs
Increase in technology
Decrease in the cost of production
(Increase in quality of inputs)
Decrease in government regulation and/or taxes
Positive exogenous supply shock (acts of God/OPEC)

1.
2.
3.
4.

Decrease in the # of producers

Decrease in the # of inputs
Decrease in technology
Increase in the cost of production
(Decrease in quality of inputs)
5. Increase in government regulation and/or taxes
6. Negative exogenous supply shock (acts of God/OPEC)

* Supply is really only effected by change in # of inputs, cost of inputs, and technology.
* Change in price results in a change in quantity demanded or quantity supplied. Dont fall for it.

[ UNIT II ]
Hello, my name is Macroeconomics.
Macroeconomics: the study of a nations 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 PL)
3. Unemployment
4. Growth
5. Trade
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 PQ, 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
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.)
4 TYPES OF UNEMPLOYMENT:
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, Im 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 rGDP or UE in its own letter, the answer must be explained
through this relationship: More jobs leads to more output, etc

[ UNIT III ]
Fiscal Policy
[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

Decrease Income Taxes (Tincome)

(G)

Increase Income Taxes (Tincome)

Decrease Corporate Taxes (Tcorporate)

Increase Corporate Taxes

(Tcorporate)

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
production at the highest level of
technology inefficient

fully employing all factors of

production at the highest level of
technology efficient

desirable but not possible given current

levels of factors of production and
technology, alone

[problem of]:
high unemployment
low output
recession

[long-run equilibrium]:
full employment (FE)
potential output (Y*)
natural rate of UE (NAIRU)
0% cyclical UE

not sustainable given current levels of

factors of production and technology
overheating
INFLATION

PROBLEM Graph A
Y1 < FE

Graph B
Y* = FE

PROBLEM Graph C
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

FISCAL POLICY
AD/AS SOLUTION GRAPH C

FISCAL POLICY
AD/AS SOLUTION GRAPH A

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.]

AD = C + I + G + Nx

AD = C + I + G + Nx

therefore, an increase in one of these components will

increase AD. An increase in AD is graphically expressed as
a shift to the right with a corresponding increase in price
level (P1 P2), increase in rGDP (Y1 Y* ), and decrease in
UE (Y1 FE ).
letter chains for
Expansionary Discretionary Fiscal Policy Solution
(implemented to address low output/high unemployment)

therefore, a decrease in one of these components will

decrease AD. A decrease in AD is graphically expressed as
a shift to the left with a corresponding decrease in price level
(P1 P2), decrease in rGDP (Y1 Y* ), and increase in UE
(Y1 FE ).
letter chains for
Contractionary Discretionary Fiscal Policy Solution
(implemented to address inflation)

PL (P1-P2)
G AD rGDP (Y1-Y*)
UE (Y1-FE)
PL (P1-P2)
Tincome DI C AD rGDP (Y1-Y*)
UE (Y1-FE)
PL (P1-P2)
Tcorporate I AD rGDP (Y1-Y*)
UE (Y1-FE)

PL (P1-P2)
G AD rGDP (Y1-Y*)
UE (Y1-FE)
PL (P1-P2)
Tincome DI C AD rGDP (Y1-Y*)
UE (Y1-FE)
PL (P1-P2)
Tcorporate I AD rGDP (Y1-Y*)
UE (Y1-FE)

[multipliers related to taxing and spending]:

basic concept spending (consumption) becomes somebody elses 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)

[ 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:
1
transactions demand, 2precautionary demand, and 3speculative demand. These three demands are related to the THREE
FUNCTIONS of MONEY: 1medium of exchange, 2unit 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) + travelers checks. The ratios are roughly 50% checks, 49% cash, and 1 % travelers checks.

Monetary Policy FRQs come in TWO VARIETIES:

Three Ls and Win & Behroz Makes a Deposit

MONETARY POLICY
SOLUTION GRAPH A

Three Ls and Win:

OMO buy MS r

discount rate MS r

r I

(the decrease in r leads to an

increase in the quantity of interest
sensitive investment demanded)

B
RR MS r

r I

(the decrease in r leads to an

increase in the quantity of interest
sensitive investment demanded)

r I

(the decrease in r leads to an

increase in the quantity of interest
sensitive investment demanded)

10

I AD PL (P1-P2)
rGDP (Y1-Y*)
UE (Y1-FE)
E (Y1-FE)
I AD PL (P1-P2)
rGDP (Y1-Y*)
UE (Y1-FE)
E (Y1-FE)
I AD PL (P1-P2)
rGDP (Y1-Y*)
UE (Y1-FE)
E (Y1-FE)

MONETARY POLICY
SOLUTION GRAPH C

OMO sale MS r

r I

(the increase in r leads to a

decrease in the quantity of interest
sensitive investment demanded)

A
discount rate MS r

r I

(the increase in r leads to a

decrease in the quantity of interest
sensitive investment demanded)

B
RR MS r

r I

(the increase in r leads to a

decrease in the quantity of interest
sensitive investment demanded)

I AD PL (P1-P2)
rGDP (Y1-Y*)
UE (Y1-FE)
E (Y1-FE)
I AD PL (P1-P2)
rGDP (Y1-Y*)
UE (Y1-FE)
E (Y1-FE)
I AD PL (P1-P2)
rGDP (Y1-Y*)
UE (Y1-FE)
E (Y1-FE)

We label the money markets 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 Ls.
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.

11

Behroz deposits $1,000 in cash into Happy Bank. The reserve requirement is 20%. Happy Bank has no
excess reserves.
a.
b.
c.
d.
a.

What is the immediate effect on the MS?

What is the maximum increase on MS that can be made by Happy Bank?
What is the maximum effect on the MS by the entire banking system?
Why wont the MS be increased by its theoretical maximum amount?

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
-$1,000

Demand Deposits
+$1,000

Travelers Checks

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.

[ UNIT V ]
Monetary and Fiscal Policy Interactions
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

12

Expansionary Fiscal/
Budget Deficit
Scenario

[The Arguments for Crowding Out]:

(A)

MD

1
(B)

MD

Crowding out is an unintended consequence of expansionary fiscal policy.

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

PL (P1-P2)
rGDP (Y1-Y*)
E (Y1-FE)
UE (Y1-FE)

(A)

DLF
OUR
WAY

G deficit DLF r
Financing

I AD PL (P2-P3)
rGDP (Y1-Y*)
E (Y* - Y3)
(the increase in r leads to
UE (Y* - Y3)
a decrease in the quantity
of interest sensitive
investment demanded)
The final position of AD is between AD1 and AD2.
,

13

r I

[Crowding Out]: (cont.)

(B)

SLF
THE
TRUTH

G deficit SLF r , r I , I AD
Financing
(the increase in r leads to
a decrease in the quantity
of interest sensitive
investment demanded)
The final position of AD is between AD1 and AD2.

PL (P1-P2)
rGDP (Y1-Y*)
E (Y1-FE)
UE (Y1-FE)

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]

Contractionary Fiscal/
Budget Surplus
Scenario

Crowding in is an unintended consequence of contractionary fiscal policy.

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

(A)

DLF
OUR
WAY

G deficit DLF r
Financing

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

14

r I

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 simplicitys 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.

EXPANSIONARY
CONTRACTIONARY

EXPANSIONARY
CONTRACTIONARY

MONETARY POLICY

FISCAL POLICY

The BIG Picture of Fiscal/Monetary Policy

AD

PL

rGDP

UE

Tincome

Tcorporate

Tincome

Tcorporate

OMO buy

discount

reserve
requirement

OMO sale

rate

discount
rate

reserve
requirement

15

potential
crowding
out

potential
accommodating
monetary
policy

[ UNIT VI ]
International Economics

r in county X
r in the U.S., relative to
country X
capital outflow from
country X
OR
capital inflow to the U.S.

r in county X
r in the U.S., relative to
country X
capital inflow to country
X
OR
capital outflow from the
U.S.

demand for dollar

denominated financial
assets

demand for dollar

denominated financial
assets

16

D$

D$

appreciation of
the US$ relative
to the X$ from
(e1 e2)

depreciation of
the US$ relative
to the X$ from
(e1 e2)

[Typical International Goods (Current Account) Question]:

[HINT] If forced to use S$, it should respond to rGDP. [TRUTH] Goods questions are S$.
Appreciation of the $ relative
to the from e1 e2
Depreciation of the $ relative
to the from e1 e2
PL in U.S. ($)

PL in U.S. ($)

$ denominated goods become relatively more expensive D$

[truth
( denominated goods become relatively less expensive)
$ denominated goods become relatively less expensive D$
[truth
( denominated goods become relatively more expensive)
$ denominated goods become relatively more expensive D$
[truth
( denominated goods become relatively less expensive)
$ denominated goods become relatively less expensive D$
[truth
( denominated goods become relatively more expensive)

X
S$]

M
X

S$]
M
X
S$]
M
X
S$]

[Flow of Goods and Services]:

CAUSE

EXPLANATION

EFFECT

PL: The increase in price level makes

PL in the U.S country you are

looking at
Appreciation of $ value of the
currency you are looking at
PL in the other country
Depreciation of value of the
other countrys currency

PL in the U.S country you are

looking at
Depreciation of $ value of the
currency you are looking at
PL in the other country
Appreciation of value of the
other countrys currency.

dollar denominated goods relatively more

expensive.
Appreciation here: The appreciated $
makes dollar denominated goods relatively
more expensive.
PL in other country: The decrease in
price level makes denominated goods
relatively less expensive.
Depreciation of : The depreciated
makes denominated goods relatively less
expensive.
PL: The decrease in price level makes
dollar denominated goods relatively less
expensive.
Depreciation here: The depreciated $
makes dollar denominated goods relatively
less expensive.
PL in other country: The increase in
price level makes denominated goods
relatively more expensive.
Appreciation of : The appreciated
makes denominated goods relatively
more expensive.

17

Decrease in
U.S. exports
(X)
Increase in U.S.
imports (M)

Increase in U.S.
exports (X)

Decrease in

U.S. imports
(M)

EXPANSIONARY
CONTRACTIONARY
EXPANSIONARY

Tincome

Tcorporate

Tincome

Tcorporate

OMO buy

discount
rate

reserve
requirement

CONTRACTIONARY

MONETARY POLICY

FISCAL POLICY

A Look-Ahead to Other International Consequences:

[NOTICE] Your answer is different depending on whether it is a goods or financial assets question.

OMO sale

discount
rate

reserve
requirement

PL

Goods/Current
Account

Value of
the $

$ denominated goods
become relatively more
expensive D$
(truth S$)

Depreciation
of the $
relative to the
from e1 e2

$ denominated goods
become relatively more
expensive D$
(truth S$)

Depreciation
of the $
relative to the
from e1 e2

$ denominated goods
become relatively more
expensive D$
(truth S$)

Depreciation
of the $
relative to the
from e1 e2

$ denominated goods
become relatively less
expensive D$
(truth S$)

Appreciation
of the $
relative to the
from e1 e2

$ denominated goods
become relatively less
expensive D$
(truth S$)

Appreciation
of the $
relative to the
from e1 e2

$ denominated goods
become relatively less
expensive D$
(truth S$)

Appreciation
of the $
relative to the
from e1 e2

$ denominated goods
become relatively more
expensive D$
(truth S$)

Depreciation
of the $
relative to the
from e1 e2

$ denominated goods
become relatively more
expensive D$
(truth S$)

Depreciation
of the $
relative to the
from e1 e2

$ denominated goods
become relatively more
expensive D$
(truth S$)

Depreciation
of the $
relative to the
from e1 e2

$ denominated goods
become relatively less
expensive D$
(truth S$)

Appreciation
of the $
relative to the
from e1 e2

$ denominated goods
become relatively less
expensive D$
(truth S$)

Appreciation
of the $
relative to the
from e1 e2

$ denominated goods
become relatively less
expensive D$
(truth S$)

Appreciation
of the $
relative to the
from e1 e2

18

Financial
Assets/Capital
Account

Value of
the $

demand for $
denominated financial
assets in order to yield a
higher return D$

appreciation of
the $ relative
to the from
e1 - e2

demand for $
denominated financial
assets in order to yield a
higher return D$

appreciation of
the $ relative
to the from
e1 - e2

demand for $
denominated financial
assets in order to yield a
higher return D$

appreciation of
the $ relative
to the from
e1 - e2

demand for $
denominated financial
assets in order to yield a
higher return D$

depreciation of
the $ relative
to the from
e1 - e2

demand for $
denominated financial
assets in order to yield a
higher return D$

depreciation of
the $ relative
to the from
e1 - e2

demand for $
denominated financial
assets in order to yield a
higher return D$

depreciation of
the $ relative
to the from
e1 - e2

demand for $
denominated financial
assets in order to yield a
higher return D$

depreciation of
the $ relative
to the from
e1 - e2

demand for $
denominated financial
assets in order to yield a
higher return D$

depreciation of
the $ relative
to the from
e1 - e2

demand for $
denominated financial
assets in order to yield a
higher return D$

depreciation of
the $ relative
to the from
e1 - e2

demand for $
denominated financial
assets in order to yield a
higher return D$

appreciation of
the $ relative
to the from
e1 - e2

demand for $
denominated financial
assets in order to yield a
higher return D$

appreciation of
the $ relative
to the from
e1 - e2

demand for $
denominated financial
assets in order to yield a
higher return D$

appreciation of
the $ relative
to the from
e1 - e2

Two Scenarios
Something that
can

Four Scenarios
Something that

[Unit VII]
Phillips Curve

1
2
3
4

PL
UE
PL
AD
UE
PL
AS
UE
PL
AS
UE

AD

natural rate of UE
such as an
UE compensation
natural rate of UE
such as a
UE compensation

inflation
unemployment

inflation
unemployment

inflation
unemployment

inflation
unemployment

right shift in LRPC

from LRPC1 LRPC2

a b, along the curve

a c, along the curve

SRPC1 SRPC2

SRPC1 SRPC3

labor, capital, or land)

(This is left shift LRAS)

left shift in LRPC from

LRPC1 LRPC3
(This is right shift LRAS)

19

explanation required
(i.e. technology, stock of

explanation required
(i.e. technology, stock of

labor, capital, or land)

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.

20

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

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

Alpha: 10 hours per gun or 20 hours per butter

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

21