Topics and percentages • 8-12% Basic Economic Concepts • 12-16% Measurement of Economic Performance • 10-15% National Income and Price Determination • 15-20% Financial Sector • 20-30% Inflation, Unemployment, and Stabilization Policies • 5-10% Economic Growth and Productivity • 10-15% Open Economy: International Trade and Finance
8-12% Basic Economic Concepts A. Scarcity, choice, and opportunity costs B. Production possibilities curve C. Comparative advantage, absolute advantage, specialization, and exchange D. Demand, supply, and market equilibrium E. Macroeconomic issues: business cycle, unemployment, inflation, growth
Production Possibilities • Assumptions: • Full Employment • Fixed Resources and Technology • Movements • Along curve shows opportunity cost • Outward shift illustrates economic growth • Inward shift indicates destruction of resources • Producing Capital Goods will lead to greater economic growth than producing consumer goods. (Butter will lead to more growth than guns)
Production Possibilities Graph Capital Goods Points A,B,C, are efficient pts. Point D is underutilization Point E is economic growth A E May Lead to most Future economic growth May Lead to most Future growth B D C F.E. F.E.1 Consumer Goods
Supply and Demand Factors • Demand Changes when: [Timer] Tastes, Fads, Preferences change Income changes Market Size (# of potential consumers) Expectations about future price, income & availability. Related Products, complements and substitutes, (price or quality change)
Demand Increase: As Demand Increases, Price & Quantity Increase as well. Price S1 P2 P1 D2 D1 Q1 Q2 Quantity
Demand Decrease: As Demand Decreases, Price and Quantity decrease as well Price S1 P1 P2 D1 D2 Q2 Q1 Quantity
Supply Factors • Supply Changes When: [RATNEST] • Resource prices change (resources and wages) • Alternative output price changes [substitutes in production] • Technology • Number of sellers change • Expectations (about future price) • Subsidies • Taxes
Supply Increase: As Supply Increases, Quantity Increases, but Price Falls. S1 Price S2 P1 P2 D1 Quantity Q2 Q1
Supply Decrease: As Supply Decreases, Quantity Decreases, but Price Increases. S2 Price S1 P2 P1 D1 Quantity Q2 Q1
Comparative Advantage • A nation should specialize in producing goods in which it has a comparative advantage: ability to produce the good at a lower opportunity cost. Example: CheeseWine Spain: 2 pounds 2 Cases France 2 pounds 6 Cases Spain should produce cheese (1C = 1W) France should produce wine (1W = 1/3C) :
Currency Terms • Appreciation: Currency is increasing in demand (stronger dollar) • U.S. Currency will appreciate when more foreigners: travel to the U.S., buy more U.S. goods or services, or buy the U.S. dollar to invest in bonds
Currency Terms • Depreciation: Currency is decreasing in demand (weaker dollar) Being SUPPLIED in exchange for other currency. • U.S. Currency will depreciate when fewer foreigners: travel to the U.S., buy fewer U.S. goods or services, or sell the U.S. dollar to invest in their own bonds
Business Cycles • The increases and decreases in Real GDP consisting of four phases: • Peak: highest point of Real GDP • Recession: Real GDP declining for 6 months • Trough: lowest point of Real GDP • Recovery: Real GDP increasing (trough to peak)
Business Cycle Full Employment Peak -- Greatest spending and lowest unemployment. Inflation becomes a problem. Contraction/Recession -- Reduction of spending levels and increasing unemployment. Some cyclical unemployment begins. Trough -- Least spending and highest unemployment Expansion -- Spending increases and unemployment decreases We want to avoid extreme inflation and extreme unemployment. We want stability!
The two big problems… The two big problems that plague the economy are: INFLATION UNEMPLOYMENT • People generally prefer steady, stable growth to large “ups” and “downs.” Therefore, government policies, both fiscal and monetary (see later sections), are aimed at flattening the business cycle. • The government wants not only to stimulate the economy when it’s slow, but also to slow it down when it’s growing too quickly.
12-16% Measurement of Economic Performance • A. National income accounts • 1. Circular flow • 2. Gross domestic product • 3. Components of gross domestic product • 4. Real versus nominal gross domestic product • B. Inflation measurement and adjustment • 1. Price indices • 2. Nominal and real values • 3. Costs of inflation • C. Unemployment • 1. Definition and measurement • 2. Types of unemployment • 3. Natural rate of unemployment
Circular Flow of Economic Activity • Households supply resources (land, labor, capital, entrepreneurial ability) to the resource market. Households demand goods and services from businesses. • Businesses demand household resources and supply goods and services to the product (factor) market.
Gross Domestic Product GDP (Gross Domestic Product):The total dollar (market) value of all final goods and services produced in a given year.Expenditure Formula: • Consumption (C) + • Business Investment (I) + • Government Spending (G) + • Net Exports (Xn)
GDP: What Counts: • Goods Produced but not Sold (I) • Goods produced by a foreign country (Japan) in the U.S. (Honda, Toyota) • Government spending on the military • Increase in business inventories
GDP: What DOES NOT count: • Intermediate Goods (Tires sold by Firestone to Ford) • Used Goods • Non-Market Activities (Illegal, Underground) • Transfer Payments (Social Security) • Stock Transactions
Shortcomings of GDP: Leading to GDP being understated. • Nonmarket activities: (services of homemakers) does not count. • Leisure: Does not include the value of leisure. • Does not include improvements in product quality. • Underground economy
GDP: Overstated • Includes damage to the environment • Includes more spending on healthcare-Americans being unhealthy. • Includes money spent to fight crime-more police officers, more jails, etc…
Real GDP • Real GDP= Nominal GDP adjusted for inflation. • Calculation: • Real GDP = Nominal GDP Price Index in Hundredths( deflator) Example: U.S. 2005 Real GDP= $12,4558 (billions) 1.1274 (based on 2000) $11.048 Trillion
Real GDP Per Capita • Most commonly used to compare and measure each country’s standard of living and overall economic growth. • Real GDP/Nation’s Population
Inflation • Rise in the general level of prices • Reduces the purchasing power of money • Measured with the Consumer Price Index (CPI) • Reports the price of a market basket , more than 300 goods that are typically purchased by an urban household
Calculating Inflation • CPI in Recent Year – CPI in Past Year Divided by CPI in Past Year (Number then Multiplied by 100) Example: 2002 CPI = 179.9 2001 CPI = 177.1 Rate of Inflation: 179.9-177.1 = 1.58% 177.1
Types of Inflation • Demand Pull Inflation: ‘too much money chasing too few goods.” • AD Curve will shift to the right, resulting in a higher Price Level and greater Output (until reaching Y* • Cost-Push Inflation: Major cause is a supply shock-OPEC cutting back on oil production • AS Curve will shift to the left resulting in a higher Price Level and a decrease in Real GDP.
Real and Nominal Terms • Real Income = Nominal Income Price Index (Hundredths) • Real Interest Rate = Nominal Interest Rate – Inflation Rate • Nominal Interest Rate = Real Interest Rate + Inflation Premium (anticipated inflation)
Inflation:Winners&Losers • Winners: • Debtors who borrow money that will be repaid with “cheap” dollars. • Those who have anticipated inflation • Losers: • Savers (especially savings accounts) • Creditors (Banks will be repaid with those “cheap” dollars • Fixed-Income Recipients (retirees receiving the same monthly pension)
Unemployment • Calculation: Number of Unemployed Labor Force (Multiplied by 100 to put as a %) The Labor Force is the total of employed and unemployed workers. U.S. unemployment should be about 5%
Employed • You are considered to be employed if: • You work for 1 hour as a paid employee (so part-time workers count) • You are temporarily absent from work (illness, strike, vacation) • You work 15 hours or more as an unpaid worker (family farms are common)
Unemployed • Must be looking for work (at least 1 attempt in the past 4 weeks) • Are reporting to a job within 30 days • Are temporarily laid off from their job
Not In Labor Force • A person who is not looking for work: • Full-time students • Stay at home parents • Discouraged workers: those who have given up hope of finding a job. • Retirees
Unemployment • 100% of the people will never be employed, so the government considers 4-6% unemployment to be “full employment.” • Types of Unemployment • Frictional - temporary and unavoidable • Structural - results from changes in technology or a business restructure (ex. Merger) • Seasonal- occurs when industries slow or shut down for a season • Cyclical - results from a decline in the business cycle. We can never be at Full Employment if there is any percentage cyclically unemployed.
10-15% National Income and Price Determination • A. Aggregate demand • 1. Determinants of aggregate demand • 2. Multiplier and crowding-out effects • B. Aggregate supply • 1. Short-run and long-run analyses • 2. Sticky versus flexible wages and prices • 3. Determinants of aggregate supply • C. Macroeconomic equilibrium • 1. Real output and price level • 2. Short and long run • 3. Actual versus full-employment output • 4. Economic fluctuations
Consumption and Saving • As income increases, both consumption and savings will increase. • The determinants of overall consumption and savings are: (More money or a positive outlook will increase consumption and reduce savings. Less money or a negative outlook will increase savings and reduce consumption. • Wealth (financial assets) • Expectations about future prices and income • Real Interest Rates • Household Debt • Taxes
Marginal Propensities • Marginal Propensity to Consume (MPC) and the Marginal Propensity to save (MPS) must equal 1. • The MPS is used to derive the spending multiplier, which equals: 1_ MPS If the MPS is .2, the spending multiplier is 5. Any increase in spending must be multiplied by 5 to determine the overall increase in Real GDP.
Aggregate Demand • Downward sloping: • Real-Balances Effect: change • in purchasing power • 2. Interest-Rate Effect: Higher • interest rates curtail spending • Foreign Purchase Effect: • Substitute foreign products for • U.S. products Price Level AD (C + I + G + X) Real GDP
Aggregate Demand • Determinants of AD: • C + I + G + Xn (Yes, its GDP) • An increase in any of these, due to lower interest rates or optimism will increase AD and shift the curve to the right. • A decrease in any of these: more debt, less spending, tax increase, will cause a decrease in AD and shift the curve to the left
Aggregate Demand Determinants • Consumption • Wealth • Expectations • Debt • Taxes • Investment • Interest Rates • Expected Returns • Technology • Inventories • Taxes • Government • Change in Gov. spending • Net Exports • National Income Abroad • Exchange Rates
Aggregate Supply Factors: • R: resource prices (The CELL/ wages and materials, as well as OIL) • E: environment [legal-institutional] (Taxes, Subsidies, more regulation) • P: productivity (better technology)
Aggregate Supply • Short Run: • Assumes that nominal wages are “sticky” and do not respond to price level changes. • Is Upward sloping as businesses will increase output to maximize profits • Generally considered to be a year or less. • Long Run: • Curve is vertical because the economy is at its full-employment output. • As prices go up, wages have adjusted so there is no incentive to increase production. • Generally considered to be longer than a year.
Aggregate Supply Graph Price Level AS Inflation Short Run Long Run Growth Recession Extended vertical line Illustrates the LRAS and Y* (Full-Employment) Y* Real GDP
Another look as AS LRAS SRAS PL Changes that lead to a new equilibrium on the left of LRAS = Recession Changes that lead to a new equilibrium on the right of LRAS = Inflation (AKA “an overheated economy”) PL AD Y* RGDP
NOTE!! • For the AP exam, assume that there are only two determinants that simultaneously affect BOTH short term aggregate supply and aggregate demand • business tax changes and • foreign currency changes. • A change in business taxes shifts AD and AS in the same direction • A change in FX sends both curves in the opposite directions.
Demand-Pull Inflation AS Price Level P2 P1 AD2 AD1 (C + I + G + X) Y* Real GDP
Cost-Push Inflation AS2 Price Level AS1 P2 P1 AD1 ( C + I + G + X) Y Y* Real GDP