Unit IV Measurement of Economic Performance (8%-12% of AP Macroeconomics Exam) and National

Unit IV – Measurement of Economic Performance (8%-12% of AP Macroeconomics exam) and National Income, Price Determination and Economic Growth (15-20% of AP Macroeconomics exam)

Objectives:

• NCEE Content Standard 3 – Different methods can be used to allocate goods and services. People acting individually or collectively through government, must choose which methods to use to allocate different kinds of goods and services.
• NCEE Content Standard 7 – Markets exist when buyers and sellers interact. This interaction determines market prices and thereby allocates scarce goods and services.
• NCEE Content Standard 8 – Prices send signals and provide incentives to buyers and sellers. When supply or demand changes, market prices adjust, affecting incentives.
• NCEE Content Standard 18 – A nation’s overall levels of income, employment, and prices are determined by the interaction of spending and production decision made by all households, firms, government agencies, and others in the economy.
• NCEE Content Standard 19 – Unemployment imposes costs on individuals and nations. Unexpected inflation imposes costs on many people and benefits some others because it arbitrarily redistributes purchasing power. Inflation can reduce the rate of growth of national living standards because individuals and organizations use resources to protect themselves against the uncertainty of future prices.

Vocabulary: Big Topics in Bold

GDP categories and formulaGDP vs GNPReal vs Nominal GDP

Per capita GDPGDP DeflatorIncome Approach

Expenditure ApproachConsumer Price Index and Formula

Problems with CPIDollar figures from different timesIndexation

Producer Price IndexNominal versus Real Interest Rate

Types of Inflation and Formula Cost Push InflationDemand Pull Inflation Anticipated and Unanticipated Shoeleather Costs Menu Costs

Unit of Account CostsTypes of Unemployment and formula

Labor Force Labor Force Participation formulaFull Employment

Natural Rate of UnemploymentCyclical Unemployment Frictional Unemployment Structural Unemployment Underemployment Hidden Unemployment Discouraged Workers Aggregate Demand Aggregate Supply

Wealth Effect Interest Rate EffectNet Export Effect

Short Run/Long Run ASSticky Wage TheorySticky Price Theory

Misperceptions TheoryMarginal Propensity to Save

Marginal Propensity to ConsumeAverage Propensity to Save

Average Propensity to ConsumeSpending MultiplierTax Multiplier

Economic GrowthDeterminants of Economic GrowthHuman Capital

Catch Up EffectForeign Direct InvestmentForeign Portfolio Investment

Numbers:

GDP FormulaLabor Force and Participation Rate Formula

GDP DeflatorUnemployment Rate Formula

CPI FormulaSpending Multiplier

Inflation Rate FormulaTax Multiplier

Visuals:

Circular Flow Diagram including government and Production Possibilities Frontier

Aggregate Demand and Supply Model

AP Multiple Choice Answers: (Answers to Macroeconomics Unit 1, 2, 3 and 6 M/C Sample Questions)

1. D 6. A11. B16. A
2. C 7. E 12. D17. A
3. C 8. B 13. C18. A
4. D 9. A 14. A 19. A
5. B 10. C 15. B 20. A

Unit IV Calendar:

AP Macroeconomics Resource Manual (answers to Unit 4 Activities)

Activity 2-1

1. Expenditure Approach
2. Income
3. Payments for goods and services
4. Taxes
5. Government Spending
6. Saving
7. Investment
8. Imports
9. Exports
10. Revenue from selling goods and services
11. Payments for resources
12. Income Approach

Activity 2-2

1. Excluded: Transfer payments are not included. This is a transfer payment from the government to the student.
2. Included: This is a fixed investment for a business
3. Excluded: The truck was not produced in the current year.
4. Excluded: A bond is a financial asset and does not reflect production.
5. Excluded: This is a nonmarket activity
6. Excluded: This is a transfer payment from the government to the retired store clerk.
7. Excluded: Tires are an intermediate good
8. Included: The submarine is a final good
9. Included: Haircuts are a service
10. Excluded: Existing stock is a financial asset and does not represent production
11. C 12. I 13. NC 14. C 15. G 16. NC 17. NC 18. I 19. NC 20. I 21. C 22. I 23. NC 24. Xn 25. C

Activity 2-3

1. H, The money the bank receives for the loan payment will be less in real terms (purchasing power) than the loan amount.
2. G, The farmer makes payments that are less in real terms than the loan amount.
3. U, It depends on what happens to the future interest rate relative to the inflation rate. If the real interest rate rises, the family will be hurt.
4. H, The return from savings will be worth less because of inflation and the fixed rate of return.
5. H, The purchasing power of the income will be less as inflation continues to deflate the value of the dollar.
6. U, It depends on whether the pension has a cost of living adjustment. If it does not, then the purchasing power of the pension payment will be less as inflation continues.
7. U, It depends on whether the Social Security payments are fully indexed for inflation. If Social Security payments do not increase at the same rate as inflation, then the retired man is hurt by inflation because he cannot purchase the same amount of goods and services.
8. U, It depends on the growth of the stock dividends relative to the inflation rate. In general, stock dividends increase with inflation while bond interest rates are fixed; however, the increase does not have to match the inflation rate.
9. G, The government will repay the debt with money that has less purchasing power.
10. H, Revenue from the contract will be worth less.
11. U, It depends on how much tax revenue increases relative to inflation.
12. H, Revenue will have a smaller purchasing power.
13. G, Rent payments will be lower in real terms.
14. H, Loan repayments will have less value or purchasing power
15. U, Individuals who receive fixed incomes are hurt by inflation – for example, lenders and savers. People who make fixed payments gain – for example, borrowers.

Activity 2-4

1. (530/480)/100 = 110
2. 10%
3. 11%
4. Year 1 = 100, Year 2 = 125, Year 3 = 175
5. A = 75%, B = 40%
6. $4,000
7. $4,400
8. $364
9. $367
10. 10%
11. 0.82%

Activity 2-5

1. Shoe Leather Costs = B, C; Menu Costs = A, E; Unit of Account = D, F

Activity 2-6

1. Chart
2. C 3. F 4. F 5. S 6. C 7. F 8. S 9. C 10. S 11. N 12. N

Activity 3-1

1. A lower price level decreases the demand for money, which decreases the equilibrium interest rate and increases investment and interest sensitive components of consumption and, therefore, the real output.
2. As the price level falls, cash balances will buy more so people will spend more, thus increasing the real output.
3. A lower US price level means prices for goods produced in the United States are lower relative to prices in foreign countries. Thus, people buy more US produced goods and fewer foreign produced goods. This increase net exports, a component of real GDP.
4. C, decrease, AD2
5. I, decrease, AD2
6. G, increase, AD1
7. C, increase, AD1
8. I and C, decrease, AD2
9. N/A, NC (affects AS), AD
10. Xn, decrease, AD2

1. A change in anything that affects the MC or MB of investment spending; for example, a change in the expected profitability of investments.

Activity 3-2

1. Chart
2. Chart
3. The only choice people have is to consume or to save. Thus, an additional dollar in income must result in a change in consumption and/or a change in savings. The sum of the change must be 1.
4. Smaller
5. There would not be any change in output from consumption
6. There would be an infinite change in output in consumption
7. -4
8. 3
9. -3

Activity 3-3

1. Input Prices, decrease, AS1
2. Input Prices, decrease, AS1
3. Productivity, Increase, AS2
4. Input Prices, Increase, AS2
5. Productivity, Increase, AS2
6. N/A, NC (Affects AD), AS
7. N/A, NC, AS
8. Input Prices, NC (until the future), AS
9. Productivity, Increase, AS2

5. It tells you that real GDP and the price level are not related. This could happen when there are a lot of unemployed resources or a constant price level as in a recession or depression.

6. It tells you that changes in real GDP are not possible, only changes in the price level. This happens at the full employment level when any increase in AD will only result in an increase in prices.

Activity 3-4

1. Menu pricing, wage contracts, lags in identifying unanticipated inflation
2. As the price level increases, firms’ input prices remain fixed in the short run while their output prices are increasing
3. No, their profits would not change if input prices adjusted immediately, and so the firms would have no incentive to change output based on a change in the price level.
4. Perfectly Inelastic LRAS

Activity 3-5

1. Real GDP Increase, Price Level Increase, Unemployment Decrease
2. Real GDP Increase, Price Level Decrease, Unemployment Decrease
3. Real GDP decrease, Price Level Decrease, Unemployment Increase
4. Real GDP decrease, Price level Increase, Unemployment Increase

Activity 3-6

1. Price Level Decrease, Real GDP Increase
2. Price Level Increase, Real GDP Increase
3. Price Level Decrease, Real GDP Increase
4. Price Level Increase, Real GDP Increase
5. Price Level Increase, Real GDP Decrease
6. Price Level Decrease, Real GDP Increase
7. Price Level Increase, Real GDP Increase
8. Price Level Decrease, Real GDP Decrease
9. Increase in AD
10. Increase in AD
11. Increase SRAS
12. Increase AD
13. Decrease AD
14. Increase AD
15. Decrease AD
16. Decrease AD

Activity 3-7

1. Demand Pull Inflation, The increased military spending will increase AD
2. Cost Push Inflation, The increased energy costs will decrease SRAS
3. Demand Pull Inflation, The spending increases will increase AD
4. Cost Push Inflation, The increased labor costs will decrease SRAS

Activity 3-8

1. Output initially increases to Y1 and the price level increases to PL1 in response to the increase in AD. As the price level rises, real wages fall but nominal wages stay the same in the short run.
2. Overtime, labor realizes that the real wage has fallen and workers bargain for a higher nominal wage. The increase in the nominal wage causes the SRAS curve to decrease and output returns to Y*, but with a higher price level.
3. Chart
4. Chart
5. Output will decrease to Y1 and the price level will increase to PL1 because of the decrease in SRAS. Real wages initially decrease with the higher price level while nominal wages stay the same in the short run.
6. Output will return to Y*. As the level of unemployment increases with the reduction in real GDP, nominal wages fall.
7. The SRAS shifts back to where it intersects AD at LRAS
8. AD increases due to the increase in G. When PL increases, real wages decrease. Eventually workers bargain for higher nominal wages and SRAS shifts to the left.
9. The increase in energy prices decreases SRAS. The increase in unemployment at Y1 drives down the nominal wage so that the SRAS shifts back to the right.
10. The increase in government spending increases AD. When PL increases, real wages decrease. Eventually workers bargain for higher nominal wages and SRAS shifts to the left.
11. If the government wants to move the economy to Y1, a level of output above the natural level of output, then it must increase aggregate demand to AD1. There will be a tendency for the SRAS to shift to the left as labor demands higher nominal wages. The SRAS will shift to the SRAS1. The expansionary policy has resulted in increases in the price level. If the government wants to maintain the level ofY1, then it must continue to implement additional expansionary policy as shown in AD2. There will continue to be a tendency for the SRAS to shift left, the government must continue to implement expansionary policy to keep the economy at Y1.

Activity 3-9

1. Aggregate Model where Y* > Y1
2. Aggregate Model where Y* < Y1
3. It will increase. Unemployment is inversely related to output and employment.
4. Recessionary gap

Activity 6-1

1. It shows the alternative combinations of goods an economy can produce when resources are fully employed and technology is constant.
2. More resources, improvement in technology
3. B, All resources are fully employed; C, There is unemployment in the economy; A, The economy is operating beyond the full employment level of output (this level of output cannot be sustained in the long run without a change in LRAS (i.e. shift of the PPC)
4. Improved technology, more resources
5. For example, people can work overtime. Eventually nominal wages and the price level will increase and the economy will move back to Y*.

Activity 6-2

1. Charts
2. From Year 1 to Year 2
3. From Year 1 to Year 2
4. Both increased the most from year 1 to year 2. However, per capita real GDP increased by less than real GDP because of population
5. From Year 2 to Year 3
6. From year 2 to year 3
7. The per capita growth rate is smaller than the GDP growth rate because the population has increased. Real GDP per capita is larger in Jefferson County than in Hamilton County.
8. Real GDP per capita is larger in Jefferson County than in Hamilton County.
9. LRAS and SRAS Shift to the right, PPC shift outward

Activity 6-3

1. Yes. One of the keys to economic growth is steady technological progress. Better production technology allows a nation to produce more output with the given level of inputs (or economic resources). The research involved in better technology is inherently risky because some projects will not succeed. Providing subsidies and tax incentives to invest in research lowers the financial risk to firms, thus boosting their efforts to increase our collective productivity.
2. Yes. The quality of the nation’s workforce is an important driver of economic growth. A workforce that has more educational attainment and literacy is able to produce more output for a given quantity of capital and technology. A more educated workforce is also better able to adapt to changing technologies and competition from other nations. Economists have also found that nations with more education also tend to have better health outcomes and lower levels of social ills like criminal activity.
3. No. An increase in the money supply should lower interest rates and boost spending to help recover more quickly from a recession. But expansionary monetary policy will not fundamentally increase the nation’s ability to produce goods and services once the nation has recovered from a recession.
4. No. To recover from a recession it is often very important to put more income in the hands of household so that they spend that income on goods and services. Expansionary fiscal policy that lowers taxes and increases military spending should boost the economy back into recovery but doesn’t provide a long-run increase in the nation’s productive capacity.
5. Decrease, because firms have fewer resources to invest in production.
6. Increase, because of the improvement in infrastructure
7. Increase, because firms can produce more with the same (or fewer) resources.
8. Increase, because labor can produce more with the same inputs
9. Increase, if sustained lower interest rates encourage investment
10. Decrease, because investment will fall with political instability
11. Increase, because sustainability of natural resources assures future supplies of inputs for production
12. Increase in SRAS
13. Increase in LRAS

What you should know at the end of this unit?

• Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy.
• GDP measures an economy’s total expenditure on newly produced goods and services and the total income earned from the production of these goods and services. GDP = C+I+G+NX
• Nominal GDP uses current prices and Real GDP uses constant base-year prices to value the economy’s production of goods and services. The GDP Deflator measures the level of prices in the economy.
• CPI shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. The percentage change in the consumer price index measures the inflation rate.
• The consumer price index is an imperfect measure of the cost of living for three reasons: Substitution Bias, Introduction of new goods and Unmeasured Quality change.
• Various laws and private contracts use price indexes to correct for the effects of inflation. The tax laws, however, are only partially indexed for inflation.
• The real interest rate equals the nominal interest rate minus the rate of inflation.
• The unemployment rate is the percentage of those who would like to work but do not have jobs. Some people who call themselves unemployed may actually not want to work, and some people who would like to work have left labor force after an unsuccessful search and therefore are not counted as employed.
• One reason for unemployment is the time it takes for workers to search for jobs that best suit their tastes and skills. This frictional unemployment is increased as a result of unemployment insurance, a government policy designed to protect workers’ incomes.
• All societies experience short-run economic fluctuations around long-run trends. These fluctuations are irregular and largely unpredictable. When recessions do occur, real GDP and other measures of income, spending, and production fall, and unemployment rises.
• Economists analyze short-run economic fluctuations using the model of aggregate demand and aggregate supply. According to this model, the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply.
• The aggregate-demand curve slopes downward for three reasons: Wealth Effect, Interest rate Effect and Exchange Rate Effect.
• Any event or policy that increases or decreases the components of gross domestic product will increase or decrease aggregate demand.
• The long run aggregate supply curve is vertical. In the long run, the quantity of goods and services supplied depends on the economy’s labor, capital, natural resources, and technology, but not on the overall level of prices.
• The three theories explaining why the short run aggregate supply curve is upward sloping: Sticky Wage Theory, Sticky Price Theory, and Misperceptions Theory.
• Events that alter the economy’s ability to produce output, such as changes in labor, capital, natural resources, or technology, shift the short run aggregate supply curve (and may shift the long run aggregate supply curve as well.)
• When the aggregate demand curve shifts to the left, output and prices fall in the short run.