AP Macroeconomics study package

AP Macroeconomics introduces students to the principles that apply to an economic system as a whole. The course emphasizes the study of national income, price-level determination, economic performance measures, the financial sector, stabilization policies, and the open economy.

Exam Format

Section	Type	# of Questions	Time	Weight
I	Multiple Choice	60 questions	70 minutes	66.7%
II	Free Response	3 questions	60 minutes	33.3%

Multiple-Choice Section

• 60 questions in 70 minutes (~70 seconds per question)
• Tests conceptual understanding, graphical analysis, and quantitative application
• Includes both standalone questions and question sets with data/graphs

Free-Response Section (3 FRQs)

1. FRQ 1 (Long): 10 points – Often involves multiple economic models (e.g., AD/AS, money market, Phillips curve)
2. FRQ 2 (Short): 5 points – Typically focuses on a single model or concept
3. FRQ 3 (Short): 5 points – Typically focuses on a single model or concept

Units and Exam Weight Distribution

Unit	Topic	Exam Weight
1	Basic Economic Concepts	5–10%
2	Economic Indicators and the Business Cycle	12–17%
3	National Income and Price Determination	15–20%
4	Financial Sector	15–20%
5	Stabilization Policies (Fiscal + Monetary)	20–25%
6	Open Economy – International Trade and Finance	5–10%

Key Models and Graphs to Master

1. Production Possibilities Curve (PPC) – Unit 1
2. Business Cycle Graph – Unit 2
3. Aggregate Demand / Aggregate Supply (AD/AS) Model – Unit 3
4. Phillips Curve (Short-Run) – Unit 3
5. Money Market Graph – Unit 4
6. Loanable Funds Market Graph – Unit 4
7. Money Creation (Banking System) – Unit 4
8. Foreign Exchange Market Graph – Unit 6

Study Package Contents

• 00-overview.md – This file
• 01-unit1.md through 01-unit6.md – Detailed unit notes
• 02-practice-unit1.md through 02-practice-unit6.md – Practice problems
• 03-full-practice-exam.md – Full-length practice exam
• 03-full-practice-exam-answers.md – Answer key
• 04-summary-sheet.md – Quick reference summary
• 05-exam-strategy.md – Test-taking strategies
• 06-presentation-outline.md – Presentation outline
• 07-audio-script.md – Audio review script

How to Use This Package

1. Read each unit note file thoroughly
2. Draw every graph by hand until you can do it from memory
3. Complete self-check questions
4. Work through practice problems
5. Take the full practice exam under timed conditions
6. Review the summary sheet before the exam

Scoring

• 5 = Extremely well qualified (typically 70%+)
• 4 = Well qualified (typically 60-69%)
• 3 = Qualified (typically 50-59%)
• 2 = Possibly qualified
• 1 = No recommendation

Key Topics

• Scarcity, choice, and opportunity cost
• Comparative advantage and trade
• Demand, supply, and market equilibrium
• Market failures and government intervention
• Economic systems

Scarcity, Choice, and Opportunity Cost

Scarcity

Scarcity is the fundamental economic problem: human wants are infinite, but resources are limited. Because of scarcity, every society must make choices about how to allocate its limited resources among competing uses.

Opportunity Cost

Opportunity cost is the value of the next best alternative foregone when making a choice. It is NOT the sum of all alternatives—only the single best one you gave up.

Example: If you spend 3 hours studying for AP Macro instead of working a job that pays $15/hour, the opportunity cost of studying is $45 (the wages you could have earned).

The Production Possibilities Curve (PPC)

The PPC is a graph that shows the maximum possible output combinations of two goods or services an economy can achieve when all resources are fully and efficiently employed.

Key features:

• Axes: Two different goods or categories of goods
• Curve: Shows all efficient production combinations
• Points ON the curve: Efficient (all resources used)
• Points INSIDE the curve: Inefficient (resources unemployed or underutilized)
• Points OUTSIDE the curve: Unattainable with current resources

  Shape:

• Concave (bowed out): Increasing opportunity costs (resources are not perfectly adaptable to producing both goods). This is the standard PPC shape.
• Straight line: Constant opportunity costs (resources are equally productive in both uses)

  Shifts:

• Outward shift: Economic growth (more resources, better technology, increased education)
• Inward shift: Decrease in resources (natural disaster, war, pandemic)

  Case Study: A country produces only capital goods and consumer goods. If it chooses to produce more capital goods today, it is investing in future production capacity. Its PPC will shift outward more in the future than if it had produced only consumer goods. This illustrates the tradeoff between current consumption and future growth.

Comparative Advantage and Gains from Trade

Absolute Advantage: A country can produce more of a good with the same resources, or the same amount with fewer resources. Having an absolute advantage in both goods does NOT mean trade is not beneficial.

Comparative Advantage: A country has a comparative advantage in producing a good if it can produce it at a lower opportunity cost than another country. Trade is always beneficial when countries specialize according to comparative advantage.

How to find comparative advantage:

1. Calculate the opportunity cost of producing one unit of each good in each country
2. The country with the LOWER opportunity cost has the comparative advantage

   Worked Example: | | Cars (per worker/day) | Trucks (per worker/day) | |---|---|---| | Country A | 4 | 2 | | Country B | 1 | 1 |

   Country A has an absolute advantage in both goods. But:

3. Country A: opportunity cost of 1 car = 2/4 = 0.5 trucks; opportunity cost of 1 truck = 4/2 = 2 cars
4. Country B: opportunity cost of 1 car = 1/1 = 1 truck; opportunity cost of 1 truck = 1/1 = 1 car

   Country A has a comparative advantage in cars (0.5 < 1). Country B has a comparative advantage in trucks (1 < 2). Both benefit from specialization and trade.

   Terms of Trade: For trade to benefit both, the terms of trade must be between the two opportunity costs. In this example, the price of 1 car should be between 0.5 and 1 truck.

Demand, Supply, and Market Equilibrium

Demand

Law of Demand: As price increases, quantity demanded decreases (ceteris paribus). The demand curve slopes downward.

Shifts in Demand (change in demand):

• Income (normal goods: demand increases with income; inferior goods: demand decreases with income)
• Prices of related goods (substitutes: price of one goes up, demand for other increases; complements: price of one goes up, demand for other decreases)
• Tastes and preferences
• Number of buyers
• Expectations about future prices or income

  Movement along vs. shift: A change in the good's OWN price causes movement along the curve. A change in any other factor shifts the entire curve.

Supply

Law of Supply: As price increases, quantity supplied increases. The supply curve slopes upward.

Shifts in Supply:

• Input costs (higher costs → supply shifts left)
• Technology (improvement → supply shifts right)
• Number of sellers
• Expectations
• Government policies (taxes, subsidies, regulations)

Market Equilibrium

Equilibrium occurs where quantity demanded equals quantity supplied. At this price, there is no surplus or shortage.

• Surplus (above equilibrium): Quantity supplied > quantity demanded → price falls
• Shortage (below equilibrium): Quantity demanded > quantity supplied → price rises

Price Controls

• Price ceiling: A legal maximum price set BELOW equilibrium. Creates a shortage.
• Price floor: A legal minimum price set ABOVE equilibrium. Creates a surplus.

Taxes and Subsidies

• Per-unit tax on sellers: Shifts supply curve left (up) by the amount of the tax. Creates a deadweight loss.
• Subsidy to sellers: Shifts supply curve right (down). Increases quantity and creates a deadweight loss from overproduction.

  Tax incidence: The burden of a tax is shared between buyers and sellers regardless of who officially pays it. The more inelastic side bears more of the burden.

Elasticity

Price elasticity of demand measures the responsiveness of quantity demanded to a change in price.

• Elastic (|ED| > 1): Quantity changes more than price. Revenue and price move in opposite directions.
• Inelastic (|ED| < 1): Quantity changes less than price. Revenue and price move in the same direction.
• Unit elastic (|ED| = 1): Revenue unchanged when price changes.

  Determinants of elasticity:

• Availability of substitutes (more substitutes = more elastic)
• Proportion of income (larger share = more elastic)
• Time horizon (longer = more elastic)
• Necessity vs. luxury (necessity = inelastic)

Common Mistakes

1. Confusing opportunity cost with total cost. Opportunity cost is only the NEXT BEST alternative, not all alternatives combined.
2. Thinking absolute advantage determines trade. Comparative advantage (lower opportunity cost) determines trade, not absolute advantage.
3. Confusing a movement along a curve with a shift. Only a change in the good's own price causes movement; all other factors shift the curve.
4. Misidentifying the direction of demand/supply shifts. For substitutes: if the price of coffee rises, demand for tea INCREASES (shifts right). For complements: if the price of coffee rises, demand for cream DECREASES (shifts left).
5. Thinking price ceilings help when set above equilibrium. A binding price ceiling must be set BELOW equilibrium to have an effect.

Self-Check Questions

1. Country X can produce 10 cars or 5 trucks per day. Country Y can produce 6 cars or 6 trucks per day. Which country has a comparative advantage in each good? Show your work.
2. Draw a PPC for an economy that produces guns and butter. Show a point that represents inefficiency, a point that represents efficiency, and a point that is unattainable.
3. If the price of peanut butter increases, what happens to the demand for jelly? Explain why.
4. Explain the difference between a binding and non-binding price ceiling.
5. If a tax is placed on gasoline, who bears more of the burden—buyers or sellers? Explain using elasticity.
6. Explain why specialization according to comparative advantage leads to gains from trade.

Key Topics

• Measuring economic performance: GDP, unemployment, inflation
• Circular flow model
• The business cycle
• Types of unemployment
• GDP components and calculation
• Real vs. nominal GDP
• CPI and inflation measurement

Gross Domestic Product (GDP)

GDP is the total market value of all final goods and services produced within a country's borders in a given time period (usually one year).

Key components of the definition:

• Market value: Uses prices to measure output
• Final goods and services: Count only the end product, not intermediate goods (to avoid double counting)
• Produced: Only counts current production, not the sale of used goods
• Within a country's borders: Includes production by foreign-owned firms operating domestically
• In a given time period: Usually measured annually or quarterly

What GDP Does NOT Count

• Used goods (resale of a 2015 car in 2024)
• Financial transactions (buying stocks, bonds)
• Transfer payments (Social Security, welfare)
• Non-market activities (unpaid housework, volunteer work)
• Underground/black market activities
• Intermediate goods (steel used in car manufacturing)

Components of GDP (Expenditure Approach)

GDP = C + I + G + NX

• C = Consumption: Household spending on goods and services (largest component, ~68-70% of US GDP). Includes durable goods (cars, appliances), nondurable goods (food, clothing), and services (healthcare, haircuts).
• I = Investment: Business spending on capital goods (machinery, factories), residential construction (new housing), and changes in business inventories. Note: In economics, "investment" does NOT mean buying stocks or bonds.
• G = Government Spending: Federal, state, and local government spending on goods and services. Does NOT include transfer payments.
• NX = Net Exports: Exports minus imports. NX = X - M. If imports > exports, NX is negative.

  Worked Example: If C = $14 trillion, I = $3.5 trillion, G = $4 trillion, and net exports = -$0.5 trillion, then GDP = 14 + 3.5 + 4 + (-0.5) = $21 trillion.

Nominal vs. Real GDP

Nominal GDP: Measured using current prices. Can increase because output increased OR because prices increased.

Real GDP: Measured using constant (base year) prices. Reflects changes in output only.

GDP Deflator = (Nominal GDP / Real GDP) × 100

Inflation rate using GDP deflator = [(GDP Deflator Year 2 - GDP Deflator Year 1) / GDP Deflator Year 1] × 100

Real GDP = (Nominal GDP / GDP Deflator) × 100

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Unemployment

Measuring Unemployment

The unemployment rate is calculated by the Bureau of Labor Statistics (BLS):

Unemployment Rate = (Number of Unemployed / Labor Force) × 100

Labor Force = Employed + Unemployed

Labor Force Participation Rate = (Labor Force / Working-Age Population) × 100

NOT in the labor force: People under 16, full-time students, retirees, homemakers, discouraged workers, institutionalized persons

Types of Unemployment

1. Frictional Unemployment: Workers are between jobs, searching for new ones. This is always present and is actually healthy (indicates a dynamic labor market). Example: A college graduate looking for their first job.
2. Structural Unemployment: Workers' skills don't match the available jobs. Caused by technological change, globalization, or changes in consumer preferences. Example: A factory worker replaced by automation.
3. Cyclical Unemployment: Caused by economic downturns (recessions). Workers lose jobs because overall demand has decreased. This rises during recessions and falls during expansions.

   Natural Rate of Unemployment (NRU): = Frictional + Structural unemployment. This is the rate of unemployment when the economy is at full employment. Typically around 4-5% in the US.

   Full Employment: Does NOT mean zero unemployment. It means cyclical unemployment = 0, so actual unemployment = natural rate.

Problems with Unemployment Statistics

• Discouraged workers have stopped looking for jobs and are NOT counted as unemployed (they're not in the labor force). This makes the unemployment rate understate true unemployment.
• Underemployment: Part-time workers who want full-time work are counted as employed.

Inflation

Inflation is a sustained increase in the general price level.

Consumer Price Index (CPI)

The CPI measures the average change in prices paid by urban consumers for a market basket of goods and services.

CPI = (Cost of market basket in current year / Cost of market basket in base year) × 100

Inflation rate = [(CPI Year 2 - CPI Year 1) / CPI Year 1] × 100

CPI vs. GDP Deflator

Feature	CPI	GDP Deflator
Basket	Fixed basket of consumer goods	All goods and services produced
Imports	Includes imported consumer goods	Excludes imports
Substitution	Does not account for substitution	Accounts for all current production

The CPI tends to overstate inflation because:

1. It uses a fixed basket (doesn't account for substitution toward cheaper goods)
2. It doesn't account for quality improvements
3. It doesn't account for new products

Types of Inflation

1. Demand-pull inflation: "Too much money chasing too few goods." Aggregate demand increases faster than aggregate supply. The AD curve shifts right.
2. Cost-push inflation: Increases in production costs (wages, oil prices) shift SRAS left, raising prices and reducing output (stagflation).

Effects of Inflation

• Redistributes income: Borrowers benefit (repay loans with cheaper dollars); lenders lose. Fixed-income earners are hurt.
• Menu costs: Costs of changing prices
• Shoe-leather costs: Costs of trying to avoid holding money that's losing value
• Tax distortions: Bracket creep pushes people into higher tax brackets
• Uncertainty: Makes long-term planning more difficult

Real vs. Nominal Values

• Real Interest Rate ≈ Nominal Interest Rate - Inflation Rate (Fisher equation)
• Real Wage = (Nominal Wage / CPI) × 100

  Case Study: If you receive a 3% raise but inflation is 5%, your nominal wage increased but your real wage DECREASED by approximately 2%. Your purchasing power went down.

The Business Cycle

The business cycle describes fluctuations in economic activity around the long-term growth trend.

Phases:

1. Peak: Maximum output before the downturn. Unemployment is low, inflation may be rising.
2. Recession (Contraction): Declining real GDP, rising unemployment, falling incomes. A recession is technically defined as two consecutive quarters of declining real GDP.
3. Trough: The lowest point before recovery begins.
4. Expansion (Recovery): Rising real GDP, falling unemployment, increasing incomes.

   Leading Indicators (predict the future): Stock market, building permits, new orders for capital goods, consumer expectations

   Lagging Indicators (confirm trends): Unemployment rate, CPI, prime interest rate

   Coincident Indicators (move with the economy): Industrial production, retail sales, personal income

The Circular Flow Model

The circular flow model shows the flow of money, goods, services, and resources between households and firms.

In a closed economy (no international trade):

• Households supply factors of production (land, labor, capital, entrepreneurship) to firms through factor markets
• Firms supply goods and services to households through product markets
• Households pay firms for goods and services (C)
• Firms pay households for factors of production (income/wages)

  With government added:

• Government collects taxes from households and firms
• Government provides goods and services (G) and transfer payments

  Leakages and Injections:

• Leakages (withdrawals): Saving (S), Taxes (T), Imports (M) – money leaving the circular flow
• Injections: Investment (I), Government spending (G), Exports (X) – money entering the circular flow
• When leakages = injections, the economy is in equilibrium

Common Mistakes

1. Counting intermediate goods in GDP. Only count the VALUE ADDED at each stage, or count only the final good.
2. Confusing the unemployment rate with the labor force participation rate. The unemployment rate = unemployed / labor force. The participation rate = labor force / working-age population.
3. Thinking full employment means zero unemployment. Full employment = natural rate (frictional + structural), not zero.
4. Confusing nominal and real values. Always distinguish between values measured in current prices (nominal) and constant prices (real).
5. Forgetting that GDP does NOT include transfer payments. Social Security, welfare, and unemployment benefits are NOT part of GDP.

Self-Check Questions

1. Calculate GDP using the expenditure approach given: C = $12T, I = $3T, G = $3.5T, Exports = $2T, Imports = $2.5T.
2. If the CPI in Year 1 is 150 and in Year 2 is 165, what is the inflation rate?
3. Explain the difference between frictional, structural, and cyclical unemployment. Which type does the government try to reduce?
4. If the nominal interest rate is 8% and inflation is 3%, what is the real interest rate? Who benefits from unexpected inflation?
5. Why does the CPI tend to overstate the true inflation rate?
6. Draw and label the phases of the business cycle. Identify one leading and one lagging economic indicator.

Key Topics

• Aggregate Demand and Aggregate Supply (AD/AS) model
• Short-run and long-run equilibrium
• Shifts in AD and AS
• Recessionary and inflationary gaps
• The Phillips curve

The Aggregate Demand / Aggregate Supply Model

The AD/AS model is the core macroeconomic model. It shows the relationship between the overall price level (PL) and real GDP (output).

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Aggregate Demand (AD)

Aggregate Demand is the total demand for all goods and services in the economy at each price level.

AD = C + I + G + NX

The AD curve slopes DOWNWARD (from left to right). This is different from a microeconomic demand curve and has different reasons:

Why AD Slopes Downward (3 effects)

1. Wealth Effect (Pigou Effect): As the price level falls, the purchasing power of money balances increases. People feel wealthier and spend more, increasing C.
2. Interest Rate Effect (Keynes Effect): As the price level falls, households need to hold less money for transactions. They save more, driving down interest rates, which increases investment (I) and consumption of durable goods (C).
3. Exchange Rate Effect (Mundell-Fleming Effect): As the price level falls (and interest rates fall), US interest rates fall relative to foreign rates. US investors seek higher returns abroad, increasing the supply of dollars in foreign exchange markets. The dollar depreciates, making US exports cheaper and imports more expensive. Net exports (NX) increase.

Shifts in Aggregate Demand

Any change in C, I, G, or NX (other than a change in the price level) shifts the AD curve.

Factor	AD Shifts	Reason
Consumer confidence increases	Right	C increases
Interest rates decrease	Right	I and C increase
Government spending increases	Right	G increases
Taxes decrease	Right	C increases (more disposable income)
Income increases	Right	C increases
Foreign income increases	Right	X increases (NX increases)
Dollar appreciates	Left	NX decreases (exports more expensive)

Case Study: The 2008 Financial Crisis The collapse of the housing market destroyed household wealth, reducing consumer confidence and spending (C decreased). Financial institutions stopped lending, reducing investment (I decreased). AD shifted sharply to the left, creating a severe recessionary gap with falling output and rising unemployment.

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Aggregate Supply (AS)

Short-Run Aggregate Supply (SRAS)

The SRAS curve slopes UPWARD because input prices (especially wages) are "sticky" or slow to adjust in the short run. When the price level rises, firms' revenues increase faster than their costs (because wages are fixed by contracts), so they increase production.

Shifts in SRAS:

Factor	SRAS Shifts	Reason
Input prices (wages, oil) increase	Left	Production costs rise
Technology improves	Right	Productivity increases
Supply shock (natural disaster)	Left	Resources destroyed
Government regulations increase	Left	Costs rise
Subsidies to firms	Right	Costs decrease
Expectation of higher future prices	Left	Workers demand higher wages

Long-Run Aggregate Supply (LRAS)

The LRAS curve is VERTICAL at the full employment level of output (potential GDP / Y*). In the long run, all input prices are flexible, and the economy always returns to full employment.

Shifts in LRAS: Only changes in the quantity or quality of resources or technology shift LRAS (economic growth):

• Increase in labor force → LRAS shifts right
• Increase in capital stock → LRAS shifts right
• Technological improvement → LRAS shifts right
• Improvement in education/training → LRAS shifts right
• Natural disaster → LRAS shifts left

Equilibrium in the AD/AS Model

Short-Run Equilibrium

Where AD and SRAS intersect. This determines the equilibrium price level and real GDP.

Long-Run Equilibrium

Where AD, SRAS, and LRAS all intersect. The economy is at full employment (Y*), and there is no cyclical unemployment.

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Gaps and Adjustments

Recessionary Gap (Negative Output Gap)

• Real GDP < Potential GDP (Y < Y*)
• AD and SRAS intersect to the LEFT of LRAS
• High unemployment (cyclical unemployment > 0)
• Self-correction: In the long run, high unemployment puts downward pressure on wages. As wages fall, SRAS shifts RIGHT until the economy returns to Y* at a LOWER price level.

Inflationary Gap (Positive Output Gap)

• Real GDP > Potential GDP (Y > Y*)
• AD and SRAS intersect to the RIGHT of LRAS
• Unemployment below the natural rate, upward pressure on wages and prices
• Self-correction: Low unemployment puts upward pressure on wages. As wages rise, SRAS shifts LEFT until the economy returns to Y* at a HIGHER price level.

The Phillips Curve

The Phillips Curve shows the short-run tradeoff between inflation and unemployment.

Short-Run Phillips Curve (SRPC)

• Slopes DOWNWARD: lower unemployment ↔ higher inflation (and vice versa)
• This reflects the AD/AS model: when AD shifts right, output and employment increase (lower unemployment) but the price level rises (higher inflation)
• Shifts in SRPC: Changes in expected inflation shift the SRPC. If people expect higher inflation, the SRPC shifts UP (worse tradeoff). Supply shocks also shift the SRPC.

Long-Run Phillips Curve (LRPC)

• VERTICAL at the natural rate of unemployment (NRU)
• In the long run, there is NO tradeoff between inflation and unemployment
• The economy always returns to the NRU regardless of the inflation rate

  Case Study: Stagflation Stagflation occurs when there is simultaneously high inflation AND high unemployment. This is caused by a leftward shift in SRAS (a negative supply shock, such as an oil price increase). On the Phillips Curve diagram, stagflation appears as a point above and to the right of the current SRPC (higher inflation AND higher unemployment). This is particularly problematic because the usual policy response (stimulating AD) reduces unemployment but worsens inflation.

Common Mistakes

1. Confusing reasons for AD slope with micro demand slope. AD slopes down due to the wealth, interest rate, and exchange rate effects — NOT the substitution and income effects that explain micro demand.
2. Confusing a movement along AD with a shift. Only a change in the price level causes movement along AD. Changes in any component (C, I, G, NX) shift the curve.
3. Shifting LRAS for the wrong reasons. LRAS only shifts due to changes in resources/technology. A change in AD does NOT shift LRAS.
4. Misidentifying the self-correction mechanism. The economy self-corrects through wage adjustments shifting SRAS, not through AD shifts.
5. Confusing SRAS and AD shifts with Phillips Curve shifts. AD shifts cause MOVEMENTS ALONG the SRPC. SRAS shifts and changes in expectations shift the SRPC itself.

Self-Check Questions

1. Draw an AD/AS model showing a recessionary gap. Label the equilibrium price level, equilibrium output, and potential output. Show the self-correction process.
2. Explain the three reasons the AD curve slopes downward.
3. What happens to the SRAS curve if oil prices suddenly double? Show this on an AD/AS graph and explain the effect on output and the price level.
4. Draw a short-run Phillips curve. Explain how an increase in expected inflation would shift this curve.
5. If the economy is in an inflationary gap, describe the self-correction process without any government intervention.
6. Explain the difference between a movement along the SRPC and a shift of the SRPC. What causes each?

Key Topics

• Financial assets: money, bonds, stocks
• The money market
• The banking system and money creation
• The loanable funds market
• The Federal Reserve System

Money and Its Functions

What is Money?

Money is anything that is widely accepted as a medium of exchange. It does NOT need to have intrinsic value (fiat money has value because the government says so).

Three Functions of Money

1. Medium of exchange: Used to facilitate transactions (eliminates the need for barter)
2. Unit of account: Provides a standard measure of value (prices are stated in dollars)
3. Store of value: Can be saved and used for future purchases (money is not the best store of value due to inflation, but it is the most liquid)

Liquidity

Liquidity is the ease with which an asset can be converted into money. Money is the most liquid asset. Real estate is very illiquid.

Measures of Money Supply

• M1: The narrowest measure. Currency (coins and bills) + demand deposits (checking accounts) + traveler's checks. Most liquid.
• M2: M1 + savings deposits + small time deposits (CDs) + money market funds. Less liquid than M1.

  AP Exam Focus: The AP exam typically refers to money supply changes as changes in M1.

The Banking System and Money Creation

Fractional Reserve Banking

Banks are required to hold only a fraction of their deposits as reserves. The rest can be lent out, creating new money through the money multiplier process.

Key Terms

• Reserves: Deposits that banks keep (not lent out)
• Required reserves: The minimum reserves banks must hold (set by the Fed)
• Required reserve ratio (RRR): The fraction of deposits banks must hold as reserves
• Excess reserves: Reserves above the required amount that banks can lend out
• Balance sheet: Assets = Liabilities + Net Worth. For a bank: Assets include reserves, loans, and bonds. Liabilities include deposits.

The Money Multiplier

Money Multiplier = 1 / RRR

Maximum change in the money supply = Money Multiplier × Change in Reserves

Or step by step: Maximum change in money supply = (1/RRR) × New Deposit

Worked Example:

• RRR = 0.2 (20%)
• A customer deposits $1,000 in Bank A
• Bank A must hold $200 (20%) and can lend out $800
• The borrower spends the $800, which is deposited in Bank B
• Bank B must hold $160 and can lend out $640
• Bank C: holds $128, lends $512
• ... and so on
• Maximum new money created = $1,000 × (1/0.2) = $5,000
• Total money supply change = $5,000 (includes the original $1,000 deposit)

Why the Maximum is Rarely Reached

• Banks may hold excess reserves (not lend out everything they can)
• People may hold cash (not deposit all their money in banks)

The Money Market

The money market shows the relationship between the nominal interest rate and the quantity of money.

Money Demand (MD)

• Transaction demand: Money needed for everyday purchases. Increases with income (Y).
• Asset demand: Money held as a store of value. Decreases as the interest rate rises (opportunity cost of holding money increases).
• MD slopes DOWNWARD (negative relationship between interest rate and quantity of money demanded)
• MD shifts RIGHT if income increases or if people expect to need more transactions

Money Supply (MS)

• The Fed controls the money supply. It is INDEPENDENT of the interest rate.
• MS is a VERTICAL line at the quantity of money the Fed has chosen.

Money Market Equilibrium

The equilibrium interest rate is where MD = MS.

If the Fed increases MS (shifts MS right):

• Surplus of money at the current interest rate
• People buy bonds (with their excess money)
• Bond prices rise
• Interest rates fall (bond prices and interest rates are inversely related)

  If the Fed decreases MS (shifts MS left):

• Shortage of money at the current interest rate
• People sell bonds (to get money)
• Bond prices fall
• Interest rates rise

Bond Prices and Interest Rates

This is a crucial relationship: Bond prices and interest rates move in OPPOSITE directions.

Why? If you buy a bond that pays $100/year and the bond costs $1,000, the interest rate (yield) is 10%. If bond prices rise to $2,000, the same $100 payment represents only a 5% yield. So when bond prices go up, interest rates go down.

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The Loanable Funds Market

The loanable funds market shows the relationship between the real interest rate and the quantity of loanable funds (money available for borrowing).

Demand for Loanable Funds

• Comes from borrowers (firms wanting to invest, government borrowing, consumers)
• Slopes DOWNWARD: as the real interest rate falls, borrowing becomes cheaper, so quantity demanded increases
• Shifts RIGHT if: business optimism increases, government runs a deficit (increased borrowing), consumer confidence increases
• Shifts LEFT if: business pessimism, government runs a surplus (reduced borrowing)

Supply of Loanable Funds

• Comes from savers (households, foreign investors, government surplus)
• Slopes UPWARD: as the real interest rate rises, saving becomes more attractive, so quantity supplied increases
• Shifts RIGHT if: private saving increases, government runs a surplus (by reducing taxes or spending), capital inflows from abroad
• Shifts LEFT if: private saving decreases, government runs a deficit

Loanable Funds Equilibrium

The equilibrium real interest rate and quantity of loanable funds are determined where demand = supply.

Government Budget Deficit Effect: When the government runs a deficit, it borrows from the loanable funds market, increasing demand for loanable funds. The demand curve shifts right, increasing the real interest rate and crowding out some private investment. This is called crowding out.

Case Study: If the government increases spending without raising taxes, it runs a larger deficit. This shifts the demand for loanable funds to the right, raising real interest rates. Higher interest rates discourage some private investment. The increase in government spending is partially offset by the decrease in private investment.

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The Federal Reserve System

Structure of the Fed

• Board of Governors: 7 members appointed by the president, confirmed by the Senate, 14-year terms
• 12 Regional Federal Reserve Banks
• Federal Open Market Committee (FOMC): The main policymaking body. Consists of the 7 Board members + 5 of the 12 regional bank presidents (NY Fed president always included). Meets 8 times per year.

The Fed's Three Tools of Monetary Policy

1. Open Market Operations (OMO) – Primary Tool

• Buying government securities (bonds): The Fed buys bonds from banks → banks' reserves increase → money supply increases → interest rates fall
• Selling government securities: The Fed sells bonds to banks → banks' reserves decrease → money supply decreases → interest rates rise

  2. Discount Rate

• The interest rate the Fed charges banks for borrowing from the Fed (discount window)
• Lowering the discount rate: Encourages banks to borrow, increasing reserves and the money supply
• Raising the discount rate: Discourages borrowing, decreasing reserves and the money supply
• This is less frequently used than OMO

  3. Reserve Requirement Ratio (RRR)

• Lowering the RRR: Banks can lend out more of their deposits → money supply increases
• Raising the RRR: Banks must hold more reserves → money supply decreases
• This is a blunt tool and rarely changed

Expansionary vs. Contractionary Monetary Policy

Policy	Goal	Fed Action	Effect
Expansionary	Reduce unemployment/recession	Buy bonds, lower discount rate, lower RRR	MS↑, interest rate↓, AD shifts right
Contractionary	Reduce inflation	Sell bonds, raise discount rate, raise RRR	MS↓, interest rate↑, AD shifts left

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Common Mistakes

1. Confusing the money market with the loanable funds market. The money market is about the NOMINAL interest rate and the money supply (controlled by the Fed). The loanable funds market is about the REAL interest rate and savings/borrowing.
2. Forgetting the bond price/interest rate inverse relationship. When bond prices go up, interest rates go down, and vice versa.
3. Confusing required reserves with excess reserves. Required reserves are what the bank MUST hold. Excess reserves can be lent out.
4. Double-counting in the money multiplier. The formula (1/RRR) × new deposit gives the TOTAL change, not the additional money created beyond the deposit.
5. Confusing nominal and real interest rates in the wrong market. Money market = nominal. Loanable funds = real.

Self-Check Questions

1. If the required reserve ratio is 10% and a bank receives a new deposit of $500, what is the maximum amount the banking system can create in new money?
2. Draw the money market. Show the effect of the Fed selling government bonds. What happens to the interest rate?
3. Explain the inverse relationship between bond prices and interest rates.
4. Draw the loanable funds market. Show the effect of an increase in government borrowing (a budget deficit). What happens to the real interest rate and private investment?
5. List the Fed's three tools of monetary policy. For each, explain how the Fed would use it in an expansionary policy.
6. Why might the actual money multiplier be smaller than 1/RRR?

Key Topics

• Fiscal policy: government spending and taxation
• Monetary policy: Federal Reserve actions
• Policy effectiveness and lags
• Crowding out
• Combining fiscal and monetary policy

Fiscal Policy

Fiscal policy is the use of government spending and taxation to influence the economy. It is enacted by Congress and the president (the legislative and executive branches).

Expansionary Fiscal Policy

Used during recessions to increase output and reduce unemployment.

• Increase government spending (G) → AD shifts right
• Decrease taxes (T) → Disposable income increases → Consumption (C) increases → AD shifts right
• Combination: Increase G and decrease T

Contractionary Fiscal Policy

Used during inflationary periods to reduce the price level.

• Decrease government spending (G) → AD shifts left
• Increase taxes (T) → Disposable income decreases → Consumption (C) decreases → AD shifts left

The Spending Multiplier

When the government changes spending, the total effect on output is larger than the initial change because of the multiplier effect.

Spending Multiplier = 1 / (1 - MPC) = 1 / MPS

MPC (Marginal Propensity to Consume): The fraction of each additional dollar of income that is spent on consumption. MPS (Marginal Propensity to Save): The fraction of each additional dollar of income that is saved. MPC + MPS = 1

Total change in real GDP = Spending Multiplier × Change in Government Spending

Worked Example:

• MPC = 0.8
• Government increases spending by $100 billion
• Multiplier = 1 / (1 - 0.8) = 1 / 0.2 = 5
• Total change in GDP = 5 × $100 billion = $500 billion

  Why it works: The government spends $100B → recipients spend 80% ($80B) → those recipients spend 80% ($64B) → and so on.

The Tax Multiplier

A change in taxes has a SMALLER effect than an equal change in government spending because some of the tax cut is saved rather than spent.

Tax Multiplier = -MPC / (1 - MPC) = -MPC / MPS

The tax multiplier is negative (increase in taxes decreases GDP) and is always smaller in absolute value than the spending multiplier.

Total change in GDP = Tax Multiplier × Change in Taxes

Worked Example:

• MPC = 0.8
• Taxes are decreased by $100 billion
• Tax multiplier = -0.8 / 0.2 = -4
• Change in GDP = -4 × (-$100B) = +$400B

  Compare: A $100B increase in G produces $500B in GDP. A $100B tax cut produces only $400B in GDP. Government spending is more powerful per dollar.

Balanced Budget Multiplier

If the government increases spending AND taxes by the SAME amount:

Balanced Budget Multiplier = 1

A $100B increase in G and a $100B increase in T results in exactly a $100B increase in GDP. This is because the spending multiplier (1/MPS) is always 1 larger than the tax multiplier (MPC/MPS), and their difference is 1.

Fiscal Policy and Crowding Out

Crowding out occurs when increased government spending raises interest rates, which reduces private investment.

Mechanism: G increases → AD increases → income increases → money demand increases → interest rates rise → I decreases (partially offsetting the increase in AD)

In the loanable funds market, government deficit spending increases demand for loanable funds → real interest rate rises → private investment decreases.

Partial crowding out: Some private investment is reduced, but AD still increases (just not by the full multiplier amount).

Complete crowding out: Private investment decreases by the exact amount government spending increased. AD does not change at all. This is theoretically possible but unlikely.

Problems with Fiscal Policy

1. Recognition lag: It takes time to recognize that a recession or inflation has begun.
2. Implementation lag: It takes time for Congress to pass legislation.
3. Impact lag: It takes time for the policy to actually affect the economy.
4. Political constraints: Politicians may prefer tax cuts over spending increases (or vice versa) for ideological reasons, regardless of what's economically optimal.
5. Crowding out: Government borrowing can raise interest rates and reduce private investment.
6. Timing: By the time fiscal policy takes effect, the economy may have already self-corrected.

Monetary Policy

Monetary policy is conducted by the Federal Reserve through changes in the money supply and interest rates.

Expansionary Monetary Policy

Used during recessions.

• Fed buys bonds → bank reserves increase → money supply increases → interest rates fall
• Lower interest rates → Investment (I) and Consumption (C) increase → AD shifts right
• Result: Higher output, lower unemployment, higher price level

Contractionary Monetary Policy

Used to fight inflation.

• Fed sells bonds → bank reserves decrease → money supply decreases → interest rates rise
• Higher interest rates → I and C decrease → AD shifts left
• Result: Lower output, higher unemployment, lower price level

The Monetary Policy Transmission Mechanism

The chain of causation from Fed action to real economic effects:

Step 1: Fed conducts OMO (buy/sell bonds) Step 2: Bank reserves change Step 3: Money supply changes Step 4: Nominal interest rate changes (in the money market) Step 5: Real interest rate changes (if expected inflation is unchanged) Step 6: Investment (I) and interest-sensitive consumption change Step 7: AD shifts Step 8: Real GDP and the price level change

Case Study: The Fed's Response to the 2008 Financial Crisis

As the financial crisis unfolded, the Fed engaged in aggressive expansionary policy. It lowered the federal funds rate to near zero (zero lower bound) and began quantitative easing (QE) — large-scale purchases of long-term government bonds and mortgage-backed securities. The goal was to inject liquidity into the financial system and lower long-term interest rates to stimulate investment and consumption. This was an extraordinary use of monetary policy, going beyond traditional OMO.

The Federal Funds Rate

The federal funds rate is the interest rate banks charge each other for overnight loans of reserves. It is the primary target of Fed monetary policy. The Fed does not set this rate directly but uses OMO to influence it.

Limitations of Monetary Policy

1. Liquidity trap: When interest rates are already near zero, further increases in the money supply may have little effect (the horizontal portion of the money demand curve).
2. Banks may not lend: Even if the Fed injects reserves, banks may hold excess reserves rather than lending them out.
3. Time lags: Monetary policy operates with lags, though typically shorter than fiscal policy lags.
4. Expectations: If people expect the policy to fail or expect higher inflation, they may adjust their behavior in ways that offset the policy.

Comparing Fiscal and Monetary Policy

Feature	Fiscal Policy	Monetary Policy
Who controls it?	Congress + President	Federal Reserve
Main tools	G and T	OMO, discount rate, RRR
Speed of implementation	Slow (Congress)	Fast (FOMC)
Subject to political pressure?	Yes	No (independent)
Can be reversed quickly?	No	Yes
Direct effect on AD?	Yes	Indirect (through interest rates)

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Common Mistakes

1. Confusing the spending multiplier and tax multiplier. The spending multiplier = 1/MPS. The tax multiplier = -MPC/MPS. The spending multiplier is always larger.
2. Forgetting that crowding out reduces the effectiveness of fiscal policy. Always consider the interest rate effect when analyzing fiscal policy.
3. Confusing expansionary and contractionary policy actions. Expansionary = increase AD. For fiscal: increase G or decrease T. For monetary: increase MS (buy bonds).
4. Mixing up the money market and loanable funds market. Fiscal policy's crowding out effect is shown in the loanable funds market. Monetary policy is shown in the money market.
5. Thinking the Fed controls the real interest rate directly. The Fed controls the money supply, which influences the nominal interest rate in the money market. The real interest rate = nominal rate - expected inflation.

Self-Check Questions

1. If MPC = 0.75 and the government increases spending by $200 billion, what is the total change in GDP?
2. If the economy is in a recessionary gap, describe the appropriate fiscal policy and monetary policy, including the specific actions for each.
3. Explain the crowding out effect using the loanable funds market. Draw the graph.
4. Why is the spending multiplier larger than the tax multiplier in absolute value?
5. Describe the full transmission mechanism for expansionary monetary policy, from the Fed's action to the effect on real GDP.
6. What is the balanced budget multiplier and what is its value? Explain why it equals 1.

Key Topics

• Absolute and comparative advantage in international trade
• Balance of payments
• Exchange rates
• Foreign exchange market
• Effects of trade on markets
• Capital flows

The Balance of Payments

The balance of payments tracks all economic transactions between a country and the rest of the world. It has two main accounts:

Current Account

Tracks trade in goods and services, investment income, and transfers.

1. Balance of Trade (Goods and Services): Exports of goods and services minus imports of goods and services. A trade deficit occurs when imports > exports. A trade surplus occurs when exports > imports.
2. Net Investment Income: Income earned by domestic factors of production abroad minus income earned by foreign factors domestically (e.g., dividends from foreign investments)
3. Net Transfers: Unilateral transfers such as foreign aid, remittances, and gifts

Capital and Financial Account

Tracks flows of financial capital and assets.

1. Capital Account: Relatively minor; includes debt forgiveness and non-financial assets
2. Financial Account: Records purchases and sales of financial assets (stocks, bonds, real estate, direct investment)
   • Capital inflow: Foreigners purchase domestic assets (a credit)
   • Capital outflow: Domestic residents purchase foreign assets (a debit)

Key Relationship

The balance of payments must always sum to zero (ignoring statistical discrepancies):

Current Account + Capital/Financial Account = 0

If a country runs a current account deficit (imports > exports), it must run a capital/financial account surplus (foreigners are buying more domestic assets, financing the deficit).

Case Study: The US Trade Deficit The US has run a persistent current account deficit for decades. This means Americans buy more foreign goods and services than foreigners buy American goods and services. This deficit is financed by capital inflows—foreign investors buying US Treasury bonds, stocks, and real estate. The US dollar remains strong because of high demand for US financial assets.

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Exchange Rates

An exchange rate is the price of one currency in terms of another.

Types of Exchange Rate Systems

1. Fixed (Pegged) Exchange Rate: The government or central bank sets the exchange rate and maintains it by buying/selling currency. Requires large foreign exchange reserves.
2. Floating (Flexible) Exchange Rate: The exchange rate is determined by supply and demand in the foreign exchange market. The central bank does not intervene.
3. Managed Float: Mostly floating but with occasional central bank intervention.

Appreciation and Depreciation

• Appreciation: The currency becomes more valuable relative to other currencies (it takes fewer dollars to buy a euro). Good for imports (cheaper), bad for exports (more expensive).
• Depreciation: The currency becomes less valuable (it takes more dollars to buy a euro). Good for exports (cheaper for foreigners), bad for imports (more expensive).

The Foreign Exchange Market

The foreign exchange (forex) market shows the supply and demand for a currency and determines the exchange rate.

For the US Dollar Market:

Demand for dollars: Comes from foreigners who need dollars to buy US goods, services, and assets.

• Foreigners buy US exports → they need dollars → demand for dollars increases
• Foreigners invest in the US → they need dollars to buy US assets → demand increases
• Higher US interest rates attract foreign capital → demand for dollars increases

  Supply of dollars: Comes from Americans who are selling dollars to obtain foreign currency.

• Americans buy imports → they supply dollars to get foreign currency → supply of dollars increases
• Americans invest abroad → they supply dollars → supply increases

Determinants of Exchange Rates

Change	Effect on Dollar	Reason
US interest rates increase	Appreciates	Foreign capital flows in, increasing demand for $
Foreign interest rates increase	Depreciates	US capital flows out, increasing supply of $
US income increases	Depreciates	Americans buy more imports, supplying more $
Foreign income increases	Appreciates	Foreigners buy more US exports, demanding more $
US inflation rises relative to other countries	Depreciates	US goods become less competitive
Speculators expect dollar to appreciate	Appreciates	They buy dollars now, increasing demand

How Exchange Rates Affect the Economy

Dollar Depreciation:

• US exports become cheaper for foreigners → exports increase
• US imports become more expensive for Americans → imports decrease
• Net exports (NX) increase → AD shifts right
• Import prices rise → SRAS may shift left (cost-push inflation)

  Dollar Appreciation:

• US exports become more expensive → exports decrease
• US imports become cheaper → imports increase
• Net exports (NX) decrease → AD shifts left
• Import prices fall → SRAS may shift right

The J-Curve Effect

When a currency depreciates, the trade balance may initially WORSEN before it improves. This is because:

1. Import prices rise immediately (more expensive imports), but quantities demanded adjust slowly
2. Export quantities take time to increase as foreign buyers adjust
3. In the short run, the value effect (higher import prices) dominates
4. In the long run, the quantity effect (more exports, fewer imports) dominates and the trade balance improves

Capital Flows and Interest Rates

Capital is highly mobile internationally. Investors seek the highest risk-adjusted returns.

• If US interest rates rise relative to foreign rates, capital flows INTO the US, increasing demand for dollars and causing the dollar to appreciate.
• If US interest rates fall, capital flows OUT of the US, increasing supply of dollars and causing the dollar to depreciate.

  This creates a connection between monetary policy and exchange rates:

• Expansionary monetary policy (lower interest rates) → capital outflow → dollar depreciates → net exports increase → reinforces the AD shift right
• Contractionary monetary policy (higher interest rates) → capital inflow → dollar appreciates → net exports decrease → reinforces the AD shift left

Common Mistakes

1. Confusing appreciation and depreciation. If the dollar appreciates, it takes FEWER dollars to buy foreign currency. Think: "appreciate" = get stronger = fewer needed.
2. Confusing who is on which side of the forex market. FOREIGNERS demand dollars (to buy US stuff). AMERICANS supply dollars (to buy foreign stuff).
3. Thinking a trade deficit is always bad. A trade deficit means the country is consuming more than it produces, which is financed by capital inflows. This can be sustainable.
4. Forgetting the J-curve effect. Currency depreciation doesn't immediately improve the trade balance.
5. Confusing the current account with the capital/financial account. The current account tracks trade in goods, services, income, and transfers. The capital/financial account tracks financial asset flows.

Self-Check Questions

1. If the US runs a current account deficit of $500 billion, what must be true about its capital and financial account?
2. Draw the foreign exchange market for the US dollar. Show the effect of an increase in US interest rates relative to foreign interest rates.
3. Explain how a depreciation of the Japanese yen would affect the Japanese economy using the AD/AS model.
4. Why does expansionary monetary policy tend to cause the domestic currency to depreciate? Trace the full chain of causation.
5. Explain the J-curve effect. Why might a currency depreciation initially worsen the trade balance?
6. If Americans' income increases, what happens to the value of the dollar? Explain using the foreign exchange market.

1. Country A can produce 10 bushels of wheat or 5 bushels of corn with one unit of resources. Country B can produce 6 bushels of wheat or 6 bushels of corn with one unit of resources. Which country has a comparative advantage in wheat?

(A) Country A
(B) Country B
(C) Both countries
(D) Neither country

Answer: A. Country A's opportunity cost of wheat = 5/10 = 0.5 corn. Country B's opportunity cost of wheat = 6/6 = 1 corn. Country A has the lower opportunity cost (0.5 < 1). Answer: C. A straight-line PPC means resources are equally productive in both uses, giving constant opportunity costs. Answer: B. Coffee and tea are substitutes. When coffee becomes more expensive, consumers switch to tea, increasing demand. Answer: C. A price ceiling set above equilibrium is non-binding because the market is already below the ceiling. Answer: B. With inelastic demand, the percentage change in quantity is smaller than the percentage change in price. Lower price × less proportionally higher quantity = lower revenue.

(A) Increasing opportunity costs
(B) Decreasing opportunity costs
(C) Constant opportunity costs
(D) That the economy is in a recession

Answer: C. A straight-line PPC means resources are equally productive in both uses, giving constant opportunity costs. Answer: B. Coffee and tea are substitutes. When coffee becomes more expensive, consumers switch to tea, increasing demand. Answer: C. A price ceiling set above equilibrium is non-binding because the market is already below the ceiling. Answer: B. With inelastic demand, the percentage change in quantity is smaller than the percentage change in price. Lower price × less proportionally higher quantity = lower revenue.

3. If the price of coffee increases, what is the most likely effect on the market for tea (a substitute)?

(A) Demand for tea decreases
(B) Demand for tea increases
(C) Supply of tea decreases
(D) Supply of tea increases

Answer: B. Coffee and tea are substitutes. When coffee becomes more expensive, consumers switch to tea, increasing demand. Answer: C. A price ceiling set above equilibrium is non-binding because the market is already below the ceiling. Answer: B. With inelastic demand, the percentage change in quantity is smaller than the percentage change in price. Lower price × less proportionally higher quantity = lower revenue.

4. A price ceiling set above the equilibrium price will:

(A) Create a shortage
(B) Create a surplus
(C) Have no effect
(D) Increase quantity supplied

Answer: C. A price ceiling set above equilibrium is non-binding because the market is already below the ceiling. Answer: B. With inelastic demand, the percentage change in quantity is smaller than the percentage change in price. Lower price × less proportionally higher quantity = lower revenue.

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5. If a good has an inelastic demand, a decrease in price will cause:

(A) An increase in total revenue
(B) A decrease in total revenue
(C) No change in total revenue
(D) An increase in quantity demanded that is proportionally larger than the price decrease

Answer: B. With inelastic demand, the percentage change in quantity is smaller than the percentage change in price. Lower price × less proportionally higher quantity = lower revenue.

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Free-Response Question

Country Alpha can produce either 100 units of food or 50 units of clothing per day. Country Beta can produce either 60 units of food or 120 units of clothing per day.

a. Calculate the opportunity cost of producing one unit of food in each country.

b. Which country has a comparative advantage in food? Which has a comparative advantage in clothing? Explain.

c. If the terms of trade are 1 unit of food for 1.5 units of clothing, will both countries benefit from trade? Explain.

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Scoring Guidelines

Part (a):

• Alpha: 50/100 = 0.5 units of clothing per unit of food
• Beta: 120/60 = 2 units of clothing per unit of food

  Part (b):

• Alpha has a comparative advantage in food (0.5 < 2)
• Beta has a comparative advantage in clothing (0.5 food < 2 food per unit of clothing, or equivalently Beta's OC of clothing = 60/120 = 0.5 food, vs Alpha's OC of clothing = 100/50 = 2 food)

  Part (c):

• Yes. The terms of trade (1 food for 1.5 clothing) falls between Alpha's cost of food (0.5 clothing) and Beta's cost of food (2 clothing). Both benefit: Alpha gets 1.5 clothing for each unit of food (better than 0.5 through domestic production). Beta gets 1 food for 1.5 clothing (better than giving up 2 clothing domestically).

1. Which of the following is included in GDP?

(A) The sale of a used car
(B) A father babysitting his own child
(C) The purchase of a new tractor by a farmer
(D) Social Security payments to a retiree

Answer: C. New capital goods purchased by a farmer count as investment (I). Used goods, non-market activities, and transfer payments are excluded. Answer: A. Inflation rate = (220 - 200) / 200 × 100 = 10%. Answer: B. Structural unemployment occurs when workers' skills no longer match available jobs due to technological change or shifting consumer preferences. Answer: D. The NRU = frictional + structural. Full employment means zero cyclical unemployment, not zero unemployment. Answer: A. Real GDP Year 1 = (500/125)×100 = $400B. Real GDP Year 2 = (550/130)×100 = $423B. Real GDP increased.

(A) 10%
(B) 20%
(C) 9.1%
(D) 11%

Answer: A. Inflation rate = (220 - 200) / 200 × 100 = 10%. Answer: B. Structural unemployment occurs when workers' skills no longer match available jobs due to technological change or shifting consumer preferences. Answer: D. The NRU = frictional + structural. Full employment means zero cyclical unemployment, not zero unemployment. Answer: A. Real GDP Year 1 = (500/125)×100 = $400B. Real GDP Year 2 = (550/130)×100 = $423B. Real GDP increased.

3. A worker who loses her job at a video rental store because streaming services have made the business obsolete is experiencing:

(A) Frictional unemployment
(B) Structural unemployment
(C) Cyclical unemployment
(D) Seasonal unemployment

Answer: B. Structural unemployment occurs when workers' skills no longer match available jobs due to technological change or shifting consumer preferences. Answer: D. The NRU = frictional + structural. Full employment means zero cyclical unemployment, not zero unemployment. Answer: A. Real GDP Year 1 = (500/125)×100 = $400B. Real GDP Year 2 = (550/130)×100 = $423B. Real GDP increased.

4. The natural rate of unemployment equals:

(A) Zero
(B) Frictional unemployment only
(C) Structural unemployment only
(D) Frictional plus structural unemployment

Answer: D. The NRU = frictional + structural. Full employment means zero cyclical unemployment, not zero unemployment. Answer: A. Real GDP Year 1 = (500/125)×100 = $400B. Real GDP Year 2 = (550/130)×100 = $423B. Real GDP increased.

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5. If nominal GDP increases from $500 billion to $550 billion while the GDP deflator increases from 125 to 130, what happens to real GDP?

(A) Real GDP increases
(B) Real GDP decreases
(C) Real GDP stays the same
(D) Cannot be determined

Answer: A. Real GDP Year 1 = (500/125)×100 = $400B. Real GDP Year 2 = (550/130)×100 = $423B. Real GDP increased.

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Free-Response Question

The following data are available for an economy:

• Population: 300 million
• Employed: 150 million
• Unemployed: 10 million
• Not in labor force: 140 million

  a. Calculate the unemployment rate.

  b. Calculate the labor force participation rate.

  c. If 3 million discouraged workers were to start actively seeking work, how would the unemployment rate change? Explain.

Scoring Guidelines

Part (a):

• Labor force = 150 + 10 = 160 million
• Unemployment rate = (10/160) × 100 = 6.25%

  Part (b):

• LFPR = (160/300) × 100 = 53.3%

  Part (c):

• Discouraged workers are not currently in the labor force. When they start seeking work, both the labor force AND the number of unemployed increase by 3 million.
• New unemployment rate = (10 + 3)/(160 + 3) × 100 = 13/163 × 100 = 7.98%
• The unemployment rate INCREASES because the new unemployed are added to both the numerator and denominator, but the ratio of unemployed to labor force increases.

1. Which of the following would shift the AD curve to the right?

(A) An increase in taxes
(B) A decrease in consumer confidence
(C) An increase in government spending
(D) An appreciation of the domestic currency

Answer: C. Increase in G increases AD. Taxes reduce C (AD shifts left). Lower confidence reduces C. Appreciation reduces NX. Answer: B. A negative supply shock increases production costs, shifting SRAS left (stagflation: higher prices, lower output). Answer: C. The LRPC is vertical at the NRU because in the long run, the economy returns to full employment regardless of inflation. Answer: C. An inflationary gap means the economy is overheating. Low unemployment puts upward pressure on wages, which shifts SRAS left, increasing the price level. Answer: B. Stagflation = stagnation (high unemployment, low growth) + inflation (high prices). Caused by a leftward SRAS shift.

(A) SRAS to shift right, decreasing the price level and increasing output
(B) SRAS to shift left, increasing the price level and decreasing output
(C) AD to shift left, decreasing both the price level and output
(D) AD to shift right, increasing both the price level and output

Answer: B. A negative supply shock increases production costs, shifting SRAS left (stagflation: higher prices, lower output). Answer: C. The LRPC is vertical at the NRU because in the long run, the economy returns to full employment regardless of inflation. Answer: C. An inflationary gap means the economy is overheating. Low unemployment puts upward pressure on wages, which shifts SRAS left, increasing the price level. Answer: B. Stagflation = stagnation (high unemployment, low growth) + inflation (high prices). Caused by a leftward SRAS shift.

3. The long-run Phillips curve is vertical at:

(A) Zero percent unemployment
(B) The actual unemployment rate
(C) The natural rate of unemployment
(D) The cyclical unemployment rate

Answer: C. The LRPC is vertical at the NRU because in the long run, the economy returns to full employment regardless of inflation. Answer: C. An inflationary gap means the economy is overheating. Low unemployment puts upward pressure on wages, which shifts SRAS left, increasing the price level. Answer: B. Stagflation = stagnation (high unemployment, low growth) + inflation (high prices). Caused by a leftward SRAS shift.

4. In the short run, if the economy is operating at a level of output greater than potential GDP, there will be upward pressure on:

(A) Only the price level
(B) Only wages
(C) Both wages and the price level
(D) Neither wages nor the price level

Answer: C. An inflationary gap means the economy is overheating. Low unemployment puts upward pressure on wages, which shifts SRAS left, increasing the price level. Answer: B. Stagflation = stagnation (high unemployment, low growth) + inflation (high prices). Caused by a leftward SRAS shift.

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5. Stagflation is best described as:

(A) High unemployment and low inflation
(B) High unemployment and high inflation
(C) Low unemployment and high inflation
(D) Low unemployment and low inflation

Answer: B. Stagflation = stagnation (high unemployment, low growth) + inflation (high prices). Caused by a leftward SRAS shift.

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Free-Response Question

Assume the economy of Econland is currently in long-run equilibrium. A significant increase in consumer confidence occurs.

a. Draw a correctly labeled AD/AS graph showing the initial equilibrium and the short-run effect of the increase in consumer confidence. Label the initial price level PL1, initial output Y1, the new short-run price level PL2, and the new short-run output Y2.

b. Based on your graph, what happened to the unemployment rate in the short run? Explain.

c. Draw a correctly labeled short-run Phillips curve. Show the short-run effect of the increase in consumer confidence as a movement from point A to point B.

d. Assuming no government or Fed intervention, describe the long-run self-correction process that will return the economy to long-run equilibrium.

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Scoring Guidelines

Part (a):

• Correct axes (PL on vertical, real GDP on horizontal)
• AD, SRAS, LRAS all drawn and labeled
• Initial equilibrium at intersection of AD, SRAS, LRAS
• AD shifts right to AD2
• New short-run equilibrium at AD2 ∩ SRAS with higher PL2 and higher Y2

  Part (b):

• The unemployment rate decreases because output increased (firms hired more workers to produce more). The economy moved past potential GDP, reducing cyclical unemployment below zero.

  Part (c):

• Correct axes (inflation rate on vertical, unemployment rate on horizontal)
• Downward-sloping SRPC drawn
• Movement from a point with higher unemployment and lower inflation (point A) to a point with lower unemployment and higher inflation (point B)

  Part (d):

• The inflationary gap (Y2 > Y*) causes wages to rise as employers compete for scarce labor
• Rising wages shift SRAS to the left
• SRAS continues shifting left until it intersects AD2 at the LRAS (returning to Y* at a higher price level PL3)
• The economy self-corrects through wage and price adjustments

1. If the required reserve ratio is 20% and a bank has $100 million in demand deposits and $30 million in total reserves, what are the bank's excess reserves?

(A) $10 million
(B) $20 million
(C) $30 million
(D) $70 million

Answer: A. Required reserves = 20% × $100M = $20M. Excess reserves = $30M - $20M = $10M. Answer: B. The Fed pays for the bonds by crediting bank reserves. Bank reserves increase, enabling more lending, which increases the money supply. Answer: B. Bond prices and interest rates move in opposite directions. When bond prices rise, the yield (interest rate) falls. Answer: B. Government deficit spending increases demand for loanable funds, shifting the demand curve right, raising the real interest rate, and crowding out private investment. Answer: B. Selling bonds reduces bank reserves by $10M. Maximum decrease in money supply = $10M × 5 = $50M decrease.

(A) A decrease in bank reserves and the money supply
(B) An increase in bank reserves and the money supply
(C) An increase in the discount rate
(D) A decrease in the required reserve ratio

Answer: B. The Fed pays for the bonds by crediting bank reserves. Bank reserves increase, enabling more lending, which increases the money supply. Answer: B. Bond prices and interest rates move in opposite directions. When bond prices rise, the yield (interest rate) falls. Answer: B. Government deficit spending increases demand for loanable funds, shifting the demand curve right, raising the real interest rate, and crowding out private investment. Answer: B. Selling bonds reduces bank reserves by $10M. Maximum decrease in money supply = $10M × 5 = $50M decrease.

3. Bond prices and interest rates have which type of relationship?

(A) Direct (positive)
(B) Inverse (negative)
(C) No relationship
(D) Direct in the short run, inverse in the long run

Answer: B. Bond prices and interest rates move in opposite directions. When bond prices rise, the yield (interest rate) falls. Answer: B. Government deficit spending increases demand for loanable funds, shifting the demand curve right, raising the real interest rate, and crowding out private investment. Answer: B. Selling bonds reduces bank reserves by $10M. Maximum decrease in money supply = $10M × 5 = $50M decrease.

4. An increase in government borrowing to finance a deficit will:

(A) Decrease the demand for loanable funds
(B) Increase the demand for loanable funds, raising the real interest rate
(C) Increase the supply of loanable funds, lowering the real interest rate
(D) Have no effect on the loanable funds market

Answer: B. Government deficit spending increases demand for loanable funds, shifting the demand curve right, raising the real interest rate, and crowding out private investment. Answer: B. Selling bonds reduces bank reserves by $10M. Maximum decrease in money supply = $10M × 5 = $50M decrease.

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5. If the money multiplier is 5 and the Fed sells $10 million in government bonds, what is the maximum change in the money supply?

(A) An increase of $50 million
(B) A decrease of $50 million
(C) An increase of $10 million
(D) A decrease of $10 million

Answer: B. Selling bonds reduces bank reserves by $10M. Maximum decrease in money supply = $10M × 5 = $50M decrease.

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Free-Response Question

Assume the required reserve ratio is 10%. The Federal Reserve purchases $1,000 in government bonds from Bank A.

a. Calculate the maximum change in the money supply from the Fed's open market purchase.

b. What is the maximum amount of new loans Bank A can make after the purchase?

c. Draw a correctly labeled money market graph showing the effect of the Fed's action on the equilibrium nominal interest rate.

d. Explain how the change in the interest rate you identified in part (c) would affect investment spending and aggregate demand.

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Scoring Guidelines

Part (a):

• Money multiplier = 1/0.10 = 10
• Maximum change in money supply = $1,000 × 10 = $10,000 increase

  Part (b):

• Bank A receives $1,000 in new reserves
• Required reserves on this new deposit = 10% × $1,000 = $100
• Maximum new loans = $1,000 - $100 = $900

  Part (c):

• Correct axes (nominal interest rate on vertical, quantity of money on horizontal)
• Downward-sloping money demand (MD) and vertical money supply (MS)
• MS shifts right to MS2
• New equilibrium at a lower interest rate

  Part (d):

• The lower interest rate makes borrowing cheaper, so firms increase investment spending (I increases)
• The increase in investment spending increases aggregate demand (AD shifts right)
• This would increase real output and the price level

1. If the MPC is 0.8, the government spending multiplier is:

(A) 0.8
(B) 1.25
(C) 4
(D) 5

Answer: D. Spending multiplier = 1/(1-MPC) = 1/(1-0.8) = 1/0.2 = 5. Answer: C. Open market operations (buying and selling government bonds) are the Fed's primary tool. Answer: B. To fight inflation, use contractionary fiscal policy: decrease G and/or increase T to shift AD left. Answer: B. Government deficit spending increases demand for loanable funds, raising the real interest rate and crowding out (reducing) private investment. Answer: D. Multiplier = 1/(1-0.75) = 4. Change in GDP = 4 × $50B = $200B.

(A) Changing the discount rate
(B) Changing the required reserve ratio
(C) Open market operations
(D) Changing the federal funds rate directly

Answer: C. Open market operations (buying and selling government bonds) are the Fed's primary tool. Answer: B. To fight inflation, use contractionary fiscal policy: decrease G and/or increase T to shift AD left. Answer: B. Government deficit spending increases demand for loanable funds, raising the real interest rate and crowding out (reducing) private investment. Answer: D. Multiplier = 1/(1-0.75) = 4. Change in GDP = 4 × $50B = $200B.

3. An appropriate fiscal policy to combat inflation would be to:

(A) Increase government spending and decrease taxes
(B) Decrease government spending and increase taxes
(C) Increase government spending and increase taxes by the same amount
(D) Decrease the money supply

Answer: B. To fight inflation, use contractionary fiscal policy: decrease G and/or increase T to shift AD left. Answer: B. Government deficit spending increases demand for loanable funds, raising the real interest rate and crowding out (reducing) private investment. Answer: D. Multiplier = 1/(1-0.75) = 4. Change in GDP = 4 × $50B = $200B.

4. Crowding out occurs when government borrowing:

(A) Decreases the demand for loanable funds
(B) Increases the real interest rate, reducing private investment
(C) Increases the money supply
(D) Decreases tax revenue

Answer: B. Government deficit spending increases demand for loanable funds, raising the real interest rate and crowding out (reducing) private investment. Answer: D. Multiplier = 1/(1-0.75) = 4. Change in GDP = 4 × $50B = $200B.

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5. If the government increases spending by $50 billion and the MPC is 0.75, the maximum increase in GDP is:

(A) $50 billion
(B) $66.7 billion
(C) $150 billion
(D) $200 billion

Answer: D. Multiplier = 1/(1-0.75) = 4. Change in GDP = 4 × $50B = $200B.

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Free-Response Question

The economy of Zeta is experiencing a recessionary gap. The marginal propensity to consume is 0.75.

a. If the government of Zeta increases spending by $100 billion, calculate the maximum change in real GDP.

b. Instead of increasing spending, the government decides to decrease taxes by $100 billion. Calculate the maximum change in real GDP from this tax cut.

c. Explain why the spending multiplier is larger than the tax multiplier.

d. Draw a correctly labeled loanable funds market graph showing the crowding out effect that could result from the increase in government spending.

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Scoring Guidelines

Part (a):

• Spending multiplier = 1/(1-0.75) = 4
• Maximum change in GDP = 4 × $100 billion = $400 billion

  Part (b):

• Tax multiplier = -MPC/(1-MPC) = -0.75/0.25 = -3
• Change in GDP = -3 × (-$100 billion) = +$300 billion

  Part (c):

• When government spending increases, the full amount is injected into the economy as new spending.
• When taxes are cut, only the portion that is consumed (MPC × tax cut) enters the spending stream, because households save a portion (MPS × tax cut).
• Therefore, government spending has a larger initial impact per dollar than a tax cut.

  Part (d):

• Correct axes: real interest rate (vertical), quantity of loanable funds (horizontal)
• Downward-sloping demand for loanable funds, upward-sloping supply
• Government deficit spending shifts demand to the right (DLF to DLF2)
• New equilibrium at higher real interest rate and higher quantity
• Indicate the reduction in private investment (crowding out)

1. If the United States is running a current account deficit, it must be running a:

(A) Current account surplus
(B) Capital and financial account deficit
(C) Capital and financial account surplus
(D) Balanced budget

Answer: C. The balance of payments must sum to zero. A current account deficit must be offset by a capital/financial account surplus. Answer: B. Higher US interest rates attract foreign capital, increasing demand for dollars and causing appreciation. Answer: C. Peso depreciation makes Mexican goods cheaper for foreigners (exports increase) and US goods more expensive for Mexicans (imports decrease), increasing Mexican net exports. Answer: B. Lower US income means Americans buy fewer imports, so they supply fewer dollars to the foreign exchange market. The supply curve shifts left, causing the dollar to appreciate. Answer: B. The J-curve shows an initial worsening of the trade balance (due to higher import prices) before improvement (as export and import quantities adjust).

(A) Depreciate because demand for dollars decreases
(B) Appreciate because demand for dollars increases
(C) Depreciate because supply of dollars increases
(D) Not change because exchange rates are fixed

Answer: B. Higher US interest rates attract foreign capital, increasing demand for dollars and causing appreciation. Answer: C. Peso depreciation makes Mexican goods cheaper for foreigners (exports increase) and US goods more expensive for Mexicans (imports decrease), increasing Mexican net exports. Answer: B. Lower US income means Americans buy fewer imports, so they supply fewer dollars to the foreign exchange market. The supply curve shifts left, causing the dollar to appreciate. Answer: B. The J-curve shows an initial worsening of the trade balance (due to higher import prices) before improvement (as export and import quantities adjust).

3. A depreciation of the Mexican peso relative to the US dollar will most likely cause:

(A) Mexican exports to become more expensive for Americans
(B) Mexican imports from the US to become cheaper
(C) Mexican exports to become cheaper for Americans, increasing Mexican net exports
(D) No change in trade flows

Answer: C. Peso depreciation makes Mexican goods cheaper for foreigners (exports increase) and US goods more expensive for Mexicans (imports decrease), increasing Mexican net exports. Answer: B. Lower US income means Americans buy fewer imports, so they supply fewer dollars to the foreign exchange market. The supply curve shifts left, causing the dollar to appreciate. Answer: B. The J-curve shows an initial worsening of the trade balance (due to higher import prices) before improvement (as export and import quantities adjust).

4. In the foreign exchange market for US dollars, a decrease in US income would cause:

(A) The demand for dollars to decrease
(B) The supply of dollars to decrease
(C) The dollar to depreciate
(D) The dollar to appreciate

Answer: B. Lower US income means Americans buy fewer imports, so they supply fewer dollars to the foreign exchange market. The supply curve shifts left, causing the dollar to appreciate. Answer: B. The J-curve shows an initial worsening of the trade balance (due to higher import prices) before improvement (as export and import quantities adjust).

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5. The J-curve effect suggests that after a currency depreciation:

(A) The trade balance immediately improves
(B) The trade balance worsens before improving
(C) The trade balance worsens permanently
(D) There is no change in the trade balance

Answer: B. The J-curve shows an initial worsening of the trade balance (due to higher import prices) before improvement (as export and import quantities adjust).

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Free-Response Question

The United States and Country X trade with each other. The Federal Reserve conducts expansionary monetary policy, lowering US interest rates.

a. Draw a correctly labeled graph of the foreign exchange market for the US dollar. Show the effect of the lower US interest rates on the value of the dollar.

b. Based on your answer to part (a), explain how US net exports will change.

c. Draw a correctly labeled AD/AS graph showing the additional effect on US aggregate demand from the change in net exports.

d. If Country X's central bank responds by also lowering its interest rates, what will happen to the value of the dollar relative to Country X's currency? Explain.

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Scoring Guidelines

Part (a):

• Correct axes (exchange rate on vertical, quantity of dollars on horizontal)
• Downward-sloping demand for dollars, upward-sloping supply of dollars
• Lower US interest rates cause US investors to seek higher returns abroad, increasing the supply of dollars (supply shifts right)
• The exchange rate (value of the dollar) depreciates (falls)

  Part (b):

• The dollar depreciation makes US exports cheaper for foreigners and US imports more expensive for Americans.
• Exports increase and imports decrease, so net exports (NX) increase.

  Part (c):

• Correct AD/AS graph with AD, SRAS, LRAS
• AD shifts right due to the increase in NX
• Real GDP increases and the price level increases

  Part (d):

• If Country X also lowers its interest rates, the interest rate differential between the US and Country X may not change much.
• The effect on the dollar is ambiguous and depends on the relative magnitude of the rate changes.
• If both countries lower rates by the same amount, the exchange rate may not change significantly because capital has no additional incentive to flow between the two countries.

• Scarcity → choice → opportunity cost (next best alternative)
• PPC: Concave = increasing OC; Straight = constant OC; Points inside = inefficient
• Comparative advantage = lower opportunity cost → basis for trade
• Terms of trade must be between the two OCs
• Demand: P↑ QD↓ (law of demand). Shifts: income, substitutes, complements, tastes, expectations, # buyers
• Supply: P↑ QS↑ (law of supply). Shifts: input costs, technology, # sellers, expectations, gov policy
• Elasticity: |Ed|>1 elastic, |Ed|<1 inelastic, |Ed|=1 unit elastic
• Price ceiling below equilibrium = shortage; Price floor above = surplus
• Tax incidence: More inelastic side bears more burden

Unit 2: Economic Indicators

• GDP = C + I + G + NX (expenditure approach)
• GDP excludes: used goods, financial transactions, transfer payments, non-market activities
• Nominal GDP uses current prices; Real GDP uses base year prices
• GDP Deflator = (Nominal/Real) × 100
• CPI = (current basket cost / base basket cost) × 100
• Inflation rate = (new - old) / old × 100
• Unemployment rate = Unemployed / Labor Force × 100
• Labor Force Participation Rate = Labor Force / Working-Age Pop × 100
• Frictional = between jobs; Structural = skills mismatch; Cyclical = recession
• NRU = frictional + structural; Full employment = zero cyclical unemployment
• Real interest rate ≈ nominal rate - inflation rate

Unit 3: AD/AS Model

• AD = C + I + G + NX; slopes DOWN (wealth, interest rate, exchange rate effects)
• AD shifts: change in C, I, G, NX (NOT price level)
• SRAS slopes UP (sticky wages); shifts: input prices, technology, supply shocks, regulations
• LRAS is VERTICAL at Y* (potential output); shifts: resources, technology
• Recessionary gap: Y < Y*; self-corrects via SRAS shifting right (wages fall)
• Inflationary gap: Y > Y*; self-corrects via SRAS shifting left (wages rise)
• SRPC: downward sloping (unemployment-inflation tradeoff)
• LRPC: vertical at NRU (no long-run tradeoff)
• Stagflation: high unemployment + high inflation (SRAS shift left)

Unit 4: Financial Sector

• Money functions: medium of exchange, unit of account, store of value
• M1 = currency + demand deposits; M2 = M1 + savings + small time deposits
• Money multiplier = 1 / RRR
• Maximum Δ Money Supply = Change in reserves × (1/RRR)
• Money market: MD slopes down (interest rate vs. quantity of money); MS vertical
• MS↑ → interest rate↓; MS↓ → interest rate↑
• Bond prices and interest rates are INVERSELY related
• Loanable funds market: Demand (borrowers) slopes down; Supply (savers) slopes up
• Crowding out: Government deficit → DLF shifts right → real interest rate↑ → private I↓
• Fed tools: OMO (primary), discount rate, RRR
• Expansionary: buy bonds, lower discount rate, lower RRR
• Contractionary: sell bonds, raise discount rate, raise RRR

Unit 5: Stabilization Policies

• Spending multiplier = 1 / MPS = 1 / (1 - MPC)
• Tax multiplier = -MPC / MPS (always smaller than spending multiplier)
• Balanced budget multiplier = 1
• Expansionary fiscal: ↑G, ↓T → AD shifts right
• Contractionary fiscal: ↓G, ↑T → AD shifts left
• Crowding out reduces fiscal policy effectiveness (shown in loanable funds market)
• Fiscal policy lags: recognition, implementation, impact
• Monetary policy transmission: Fed OMO → bank reserves → MS → interest rate → I and C → AD → Y and PL
• Expansionary monetary: buy bonds → MS↑ → i↓ → AD right
• Contractionary monetary: sell bonds → MS↓ → i↑ → AD left

Unit 6: Open Economy

• Current account: trade balance + net investment income + net transfers
• Capital/financial account: financial asset flows (stocks, bonds, FDI)
• Current account + Capital/financial account = 0
• Forex market: Demand for $ (foreigners buying US goods/assets), Supply of $ (Americans buying foreign goods/assets)
• US interest rates↑ → demand for $↑ → dollar appreciates
• Dollar depreciates → exports↑, imports↓ → NX↑ → AD right
• Dollar appreciates → exports↓, imports↑ → NX↓ → AD left
• J-curve: Depreciation initially worsens trade balance, then improves it

Key Graphs Checklist

□ PPC □ AD/AS □ SRPC/LRPC □ Money market □ Loanable funds □ Forex market

Key Formulas

• GDP = C + I + G + NX
• GDP Deflator = (Nominal/Real) × 100
• Inflation rate = (CPI₂ - CPI₁)/CPI₁ × 100
• Real interest rate ≈ Nominal - Inflation
• Money multiplier = 1/RRR
• Spending multiplier = 1/MPS
• Tax multiplier = -MPC/MPS
• Unemployment rate = Unemployed/Labor Force × 100

• MCQ: 70 minutes / 60 questions = ~70 sec each. No penalty for guessing.
• FRQ: 60 minutes / 3 questions. Long FRQ (~25 min), two short FRQs (~17 min each).
• Always show your work on FRQ calculations.

MCQ Strategies

1. Read the entire question before looking at answers
2. For calculation questions, work out the answer independently first
3. For graph questions, mentally sketch the graph and identify key features
4. Eliminate obviously wrong answers (2+ eliminations before guessing)
5. Watch for EXCEPT/NOT questions
6. Pay attention to the difference between "shift" and "movement along"

Graph Drawing Tips (Critical for FRQs)

• ALWAYS label both axes (even if the question doesn't explicitly say so)
• Label ALL curves (AD, SRAS, LRAS, MD, MS, etc.)
• Show shifts with arrows
• Mark initial and new equilibrium points
• Common graph errors that cost points:
  • Forgetting axis labels
  • Wrong direction of shift
  • Confusing the money market with the loanable funds market
  • Drawing AD/AS with the wrong axis (price level goes on VERTICAL)

FRQ-Specific Strategies

For ALL FRQs:

• Read the entire question before starting
• Answer each part in order
• Use economic terminology precisely
• If the question says "explain," provide a cause-and-effect chain
• If the question says "calculate," show your work

Common FRQ Pitfalls:

1. Money market vs. Loanable funds: Money market = nominal interest rate, MS vertical, MD downward. Loanable funds = real interest rate, supply upward, demand downward. DO NOT mix them up.
2. AD/AS direction of shifts: Always think about the chain. "Interest rates rise" → I decreases → AD shifts LEFT (not right).
3. Bond prices: When the Fed buys bonds, bond PRICES rise and interest RATES fall. Don't confuse the two.
4. Multiplier calculations: Spending multiplier = 1/(1-MPC). Tax multiplier = -MPC/(1-MPC). Don't mix them up.
5. SRAS vs. AD shifts on Phillips Curve: An AD shift causes a MOVEMENT along the SRPC. An SRAS shift or change in expectations SHIFTS the SRPC.

The "Explain" Requirement

When asked to explain, always provide a chain of reasoning:

• "Interest rates decrease, making borrowing cheaper for firms, which increases investment spending, shifting AD to the right."
• NOT just: "AD increases because of lower interest rates."

Exam Day Checklist

• [ ] Practice drawing all 6 key graphs from memory
• [ ] Memorize all formulas
• [ ] Know the difference between the money market and loanable funds
• [ ] Understand the full monetary policy transmission mechanism
• [ ] Know when to use the spending vs. tax multiplier
• [ ] Bring a calculator (approved type)
• [ ] Bring extra pencils for graphing
• [ ] Answer every MCQ question (no penalty for guessing)
• [ ] Budget your FRQ time carefully

• AP Macroeconomics Complete Review
• 6 Units, 8 Key Graphs, Essential Formulas

Slide 2: Exam Overview

• MCQ: 60 questions, 70 min, 66.7%
• FRQ: 3 questions (1 long + 2 short), 60 min, 33.3%
• Graph drawing is essential

Slide 3: Unit 1 – Basic Concepts (5-10%)

• Scarcity → Opportunity Cost
• PPC: concave (increasing OC), shifts = growth/decline
• Comparative Advantage: lower OC → trade benefits
• Demand/Supply: shift vs. movement along
• Elasticity: |Ed| > 1 elastic, < 1 inelastic
• Price controls: ceiling (shortage), floor (surplus)

Slide 4: Unit 2 – Indicators (12-17%)

• GDP = C + I + G + NX (no used goods, transfers, stocks)
• Nominal vs. Real GDP; GDP Deflator = Nominal/Real × 100
• CPI: fixed basket; inflation rate = (new-old)/old × 100
• Unemployment: frictional + structural + cyclical
• NRU = frictional + structural (full employment ≠ zero)
• Real interest rate ≈ nominal rate - inflation
• Business Cycle: peak → recession → trough → expansion

Slide 5: Unit 3 – AD/AS (15-20%)

• AD slopes down (wealth, interest rate, exchange rate effects)
• AD shifts: C, I, G, NX changes
• SRAS slopes up (sticky wages); shifts: input prices, tech, shocks
• LRAS vertical at Y*; shifts: resources, technology only
• Recessionary gap: Y < Y* → wages fall → SRAS right
• Inflationary gap: Y > Y* → wages rise → SRAS left
• SRPC downward (inflation-unemployment tradeoff)
• LRPC vertical at NRU (no long-run tradeoff)
• Stagflation = SRAS left → high inflation + high unemployment

Slide 6: Unit 4 – Financial Sector (15-20%)

• Money: medium of exchange, unit of account, store of value
• M1 = currency + demand deposits; M2 = M1 + savings + small CDs
• Money multiplier = 1/RRR
• Money Market: MD down, MS vertical → Fed shifts MS
• Bond prices ↑ ↔ Interest rates ↓ (INVERSE)
• Loanable Funds: D down, S up → crowding out when gov borrows
• Fed tools: OMO (buy/sell bonds), discount rate, RRR
• Expansionary: buy bonds, lower rates, lower RRR

Slide 7: Unit 5 – Stabilization (20-25%)

• Spending multiplier = 1/MPS; Tax multiplier = -MPC/MPS
• Balanced budget multiplier = 1
• Expansionary fiscal: ↑G, ↓T → AD right
• Contractionary fiscal: ↓G, ↑T → AD left
• Crowding out: deficit → DLF↑ → real i↑ → private I↓
• Monetary transmission: OMO → reserves → MS → i → I,C → AD
• Fiscal: slow, political, crowding out
• Monetary: fast, independent, indirect (through interest rates)

Slide 8: Unit 6 – Open Economy (5-10%)

• Current account + Capital/financial account = 0
• Forex market: demand for $ (foreigners), supply of $ (Americans)
• US rates↑ → dollar appreciates → NX decreases
• Depreciation → exports↑ imports↓ → NX↑ → AD right
• J-curve: depreciation worsens trade balance initially

Slide 9: 8 Must-Know Graphs

1. PPC 2. AD/AS 3. SRPC/LRPC 4. Money Market
2. Loanable Funds 6. Forex Market 7. Circular Flow 8. Business Cycle

Slide 10: Key Formulas

• GDP = C + I + G + NX
• GDP Deflator = (Nom/Real) × 100
• Inflation = (CPI₂-CPI₁)/CPI₁ × 100
• Real i ≈ Nominal i - Inflation
• Money mult = 1/RRR
• Spending mult = 1/MPS; Tax mult = -MPC/MPS
• Unemployment = Unemployed/Labor Force × 100

Slide 11: Final Tips

• Draw, label, and shift graphs carefully
• Money market (nominal) ≠ Loanable funds (real)
• AD shift → movement along SRPC; SRAS shift → SRPC shifts
• Show work on all FRQ calculations
• Answer every MCQ

Welcome to the AP Macroeconomics audio review. The exam has 60 multiple-choice questions in 70 minutes worth about 67 percent of your score, and 3 free-response questions in 60 minutes worth about 33 percent. You need to master 8 key graphs and several critical formulas. Let's review each unit.

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Unit 1: Basic Economic Concepts (3 minutes)

Everything in economics starts with scarcity: unlimited wants but limited resources. Because of scarcity, every choice has an opportunity cost, the value of the next best alternative.

The production possibilities curve shows the maximum output of two goods. It's typically concave, reflecting increasing opportunity costs. Points inside are inefficient, points on the curve are efficient, and points outside are unattainable.

For comparative advantage, find the opportunity cost for each good in each country. The country with the lower opportunity cost has the comparative advantage. Trade benefits both countries as long as the terms of trade fall between the two opportunity costs.

Remember the demand and supply basics. Price changes cause movement along the curve. Everything else shifts the curve. Elasticity measures responsiveness. If demand is elastic, price and total revenue move in opposite directions.

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Unit 2: Economic Indicators (4 minutes)

GDP measures the total market value of all final goods and services produced within a country in a year. Use the expenditure approach: GDP equals C plus I plus G plus NX. It excludes used goods, financial transactions, transfer payments, and non-market activities.

Distinguish nominal GDP, which uses current prices, from real GDP, which uses constant prices. The GDP deflator equals nominal GDP divided by real GDP times 100.

The CPI measures changes in the price of a fixed basket of consumer goods. The inflation rate is the percentage change in the CPI from one period to the next. The real interest rate approximately equals the nominal interest rate minus the inflation rate.

There are three types of unemployment. Frictional unemployment is between jobs and is healthy. Structural is a skills mismatch. Cyclical is due to recessions. The natural rate of unemployment equals frictional plus structural. Full employment means zero cyclical unemployment, not zero total unemployment.

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Unit 3: AD/AS Model (6 minutes)

The AD/AS model is the heart of macroeconomics. Aggregate demand slopes downward due to the wealth effect, the interest rate effect, and the exchange rate effect. AD shifts when C, I, G, or NX changes.

Short-run aggregate supply slopes upward because wages are sticky. SRAS shifts with changes in input prices, technology, supply shocks, and regulations.

Long-run aggregate supply is vertical at potential output, Y star. Only changes in resources or technology shift LRAS.

A recessionary gap occurs when output is below potential. The self-correction mechanism is that unemployment puts downward pressure on wages, shifting SRAS right until output returns to Y star at a lower price level. An inflationary gap works in reverse.

The short-run Phillips curve shows the tradeoff between inflation and unemployment: lower unemployment comes with higher inflation. AD shifts cause movements along the SRPC. SRAS shifts or changes in expectations shift the SRPC itself. The long-run Phillips curve is vertical at the natural rate of unemployment.

Stagflation, high inflation plus high unemployment, results from a leftward SRAS shift, such as an oil price shock.

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Unit 4: Financial Sector (6 minutes)

Money has three functions: medium of exchange, unit of account, and store of value. M1 includes currency and demand deposits. M2 adds savings accounts and small time deposits.

Under fractional reserve banking, banks hold a fraction of deposits as reserves. The money multiplier equals 1 divided by the required reserve ratio. If the RRR is 10 percent, the money multiplier is 10.

In the money market, money demand slopes downward and money supply is vertical, controlled by the Fed. When the Fed buys bonds, money supply increases and the interest rate falls. When it sells bonds, money supply decreases and the interest rate rises. Remember: bond prices and interest rates always move in opposite directions.

The loanable funds market shows savings and borrowing at the real interest rate. Demand slopes down, supply slopes up. Government deficit spending increases demand for loanable funds, raising the real interest rate and crowding out private investment.

The Fed has three tools: open market operations, which is the primary tool, the discount rate, and the reserve requirement ratio.

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Unit 5: Stabilization Policies (5 minutes)

Fiscal policy uses government spending and taxes. The spending multiplier equals 1 divided by MPS. The tax multiplier equals negative MPC divided by MPS. The tax multiplier is always smaller because people save part of a tax cut. The balanced budget multiplier equals 1.

Expansionary fiscal policy increases government spending or cuts taxes to shift AD right during recessions. Contractionary policy does the opposite to fight inflation. But fiscal policy faces crowding out: government borrowing raises interest rates, reducing private investment.

Monetary policy works through the transmission mechanism: the Fed conducts open market operations, which changes bank reserves, which changes the money supply, which changes the interest rate, which changes investment and consumption, which shifts aggregate demand.

Fiscal policy is slow and political. Monetary policy is faster and the Fed is independent. But monetary policy is indirect, working through interest rates.

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Unit 6: Open Economy (3 minutes)

The balance of payments has two accounts. The current account tracks trade in goods and services, investment income, and transfers. The capital and financial account tracks financial asset flows. They must sum to zero.

In the foreign exchange market, demand for dollars comes from foreigners buying US goods and assets. Supply comes from Americans buying foreign goods and assets.

Higher US interest rates attract foreign capital, increasing demand for dollars and causing appreciation. Dollar appreciation makes exports more expensive and imports cheaper, reducing net exports. Depreciation does the opposite.

The J-curve effect shows that a depreciation initially worsens the trade balance because import prices rise immediately, but the quantity effects take time.

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Final Tips (2 minutes)

Memorize all eight key graphs. On the FRQ, label every axis and every curve. Never confuse the money market with the loanable funds market: the money market uses the nominal interest rate and has a vertical supply; the loanable funds market uses the real interest rate with an upward-sloping supply. Show all work on calculations. Answer every MCQ because there's no guessing penalty. Good luck on the exam!