You are tasked with creating a comprehensive study guide based on a list of topics that will be on a test. Your goal is to produce a guide that is at least as thorough as the provided example, but can be more in-depth and may use a different format. Use the following inputs to create the study guide:

<test_topics>
This is a basic overview of exam topics for next week. Let me know if you have additional questions.
Why SRAS is upward-sloping, why LRAS is vertical
Explain and show on AD-AS graph how output, employment/unemployment, and price level change in the short run in response to demand or supply shocks.
Explain and show on graph how SRAS, output, employment/unemployment, and price level change in the "long run self-adjustment" story.
Define fiscal policy, and show effects in AD-AS model
Calculate fiscal policy effects using the spending multiplier or tax multiplier.
Explain why there are lags in discretionary fiscal policy.
Since I asked several questions about automatic stabilizers on the last exam, you don't need to worry about them for this exam.
Define the nominal and real interest rate.
Explain how the banking system expands the money supply.
Be able to use information from a balance sheet
Define the money market, money demand, and money supply
Be able to draw the money market.
Define and show on a graph the equilibrium in the money market
Explain and show on a graph how nominal interest rate (the "price" of money) adjusts to bring equilibrium in the money market
Explain factors that shift the money demand curve.
Explain how monetary policy can shift the money supply curve.
Explain and show on graph how shifts in money demand and supply affect the equilibrium nominal interest rate.
</test_topics>

<example_study_guide>
# GDP and Circular Flow Model

## I. Understanding GDP (Gross Domestic Product)

### A. Basic Definition

GDP measures the total market value of all final goods and services produced within a country's borders during a specific time period (usually one year)

### B. Key Characteristics of GDP

1. Market Value  
     
   - All goods/services valued at market prices  
   - Even non-market goods (like government services) assigned market value  
   - Excludes non-market activities (household work, volunteer work)

   

2. Final Goods and Services  
     
   - Only counts end products  
   - Excludes intermediate goods to avoid double counting  
   - Examples:  
     - Counted: Finished car sold to consumer  
     - Not counted: Tires sold to car manufacturer  
     - Counted: Bread sold in store  
     - Not counted: Flour sold to bakery

   

3. Current Production  
     
   - Only newly produced items count  
   - Must be produced during the time period measured  
   - Excludes:  
     - Used goods sales  
     - Financial transactions (stock trades)  
     - Transfer payments (Social Security)

### C. Detailed Components of GDP

1. Consumption (C)  
     
   - Largest component (usually \~70% of GDP)  
   - Categories:  
     * Durable goods (last 3+ years)  
       - Cars, furniture, appliances  
     * Non-durable goods (used quickly)  
       - Food, clothing, fuel  
     * Services  
       - Healthcare, education, entertainment  
   - What's included:  
     * All household spending on final goods  
     * Services purchased by households  
     * Imported goods (but subtracted later in net exports)  
   - What's excluded:  
     * Used goods purchases  
     * Illegal transactions  
     * Financial asset purchases

   

2. Investment (I)  
     
   - Business spending on capital goods  
   - Categories:  
     * Fixed investment  
       - Non-residential (factories, equipment)  
       - Residential (new housing)  
     * Change in inventories  
       - Increases count as positive investment  
       - Decreases count as negative investment  
   - Important distinctions:  
     * Gross investment (Ig) vs Net investment (In)  
       - Ig \= total investment spending  
       - In \= Ig \- depreciation  
     * Financial investment NOT counted  
       - Stocks, bonds are transfers, not production

   

3. Government Spending (G)  
     
   - All government purchases of goods and services  
   - Includes:  
     * Federal, state, and local spending  
     * Military equipment and supplies  
     * Government employee salaries  
     * Public works and infrastructure  
   - Excludes:  
     * Transfer payments (Social Security, welfare)  
     * Interest payments on debt  
     * Grants to states (counted when spent)

   

4. Net Exports (X-M)  
     
   - Exports (X): Goods/services sold to other countries  
   - Imports (M): Goods/services bought from other countries  
   - Why subtract imports:  
     * Already counted in C, I, or G  
     * Must subtract to only count domestic production  
   - Important notes:  
     * Can be positive (trade surplus) or negative (trade deficit)  
     * Only counts final goods/services

### D. Three Approaches to Measuring GDP

1. Expenditure Approach  
     
   - Formula: GDP \= C \+ I \+ G \+ (X-M)  
   - Measures total spending on final goods/services  
   - Most commonly used approach  
   - Example calculation:  
     * C \= $14 trillion  
     * I \= $3 trillion  
     * G \= $4 trillion  
     * X \= $2 trillion  
     * M \= $3 trillion  
     * GDP \= $14T \+ $3T \+ $4T \+ ($2T \- $3T) \= $20 trillion

   

2. Income Approach  
     
   - Sums all income earned in production  
   - Components:  
     * Wages (payment for labor)  
     * Rent (payment for land use)  
     * Interest (payment for capital)  
     * Profits (payment for entrepreneurship)  
   - Additional components:  
     * Indirect business taxes  
     * Depreciation  
     * Net foreign factor income  
   - Should equal expenditure approach  
   - Example:  
     * Wages \= $12 trillion  
     * Rent \= $1 trillion  
     * Interest \= $2 trillion  
     * Profits \= $3 trillion  
     * Other \= $2 trillion  
     * Total \= $20 trillion

   

3. Value-Added Approach  
     
   - Measures value added at each production stage  
   - Value added \= Value of output \- Value of inputs  
   - Prevents double counting  
   - Example:  
     * Wheat farmer: $3 value  
     * Miller adds: $2 value  
     * Baker adds: $2 value  
     * Total value added \= $7  
   - Sum of all value added equals GDP

### E. What's Not Included in GDP

1. Underground Economy  
     
   - Illegal activities  
   - Unreported income  
   - Barter transactions

   

2. Non-Market Activities  
     
   - Household work  
   - Volunteer work  
   - DIY projects

   

3. Environmental Factors  
     
   - Resource depletion  
   - Pollution costs  
   - Environmental damage

   

4. Quality of Life  
     
   - Leisure time  
   - Health status  
   - Education quality

   

5. Income Distribution  
     
   - Inequality  
   - Poverty levels  
   - Wealth concentration

   

6. Intermediate Goods  
     
   - Components used in final products  
   - Raw materials  
   - Semi-finished goods

### F. Circular Flow Model

1. Basic Two-Sector Model  
     
   - Households:  
     * Provide factors of production  
     * Receive income  
     * Purchase goods/services  
   - Firms:  
     * Use factors of production  
     * Pay for factors  
     * Sell goods/services  
   - Two markets:  
     * Factor market (resources)  
     * Product market (goods/services)

   

2. Three-Sector Model (adds government)  
     
   - Government:  
     * Collects taxes  
     * Provides services  
     * Makes purchases  
   - Additional flows:  
     * Tax payments  
     * Government spending  
     * Transfer payments

   

3. Four-Sector Model (adds financial sector)  
     
   - Financial sector:  
     * Accepts savings  
     * Provides loans  
     * Facilitates investment  
   - Additional flows:  
     * Savings  
     * Investment  
     * Interest payments

   

4. Five-Sector Model (adds foreign sector)  
     
   - Foreign sector:  
     * Exports  
     * Imports  
     * International financial flows  
   - Additional flows:  
     * Import spending  
     * Export revenue  
     * Foreign investment

### G. Practice Problems and Applications

1. GDP Calculations Problem 1: Given the following data (in billions):  
- Consumer spending: $800  
- Business investment: $200  
- Government purchases: $300  
- Exports: $150  
- Imports: $100 Calculate GDP.

Solution: GDP \= C \+ I \+ G \+ (X-M) GDP \= $800 \+ $200 \+ $300 \+ ($150 \- $100) GDP \= $1,350 billion

2. Value-Added Calculations Problem 2: Production stages for a $4 loaf of bread:  
- Farmer (wheat): $1  
- Miller (flour): Adds $1  
- Baker (bread): Adds $2 Calculate total value added.

Solution: Total value added \= $1 \+ $1 \+ $2 \= $4

3. GDP Components Analysis Problem 3: Classify each transaction: a) Government builds new highway b) Family buys used car c) Company builds new factory d) Student pays college tuition

Solutions: a) Government spending (G) b) Not in GDP (used good) c) Investment (I) d) Consumption (C)

# Labor Force and Unemployment

## I. Understanding Labor Force Categories

### A. Basic Definitions and Formulas

1. Labor Force  
     
   - Definition: All people employed \+ unemployed actively seeking work  
   - Formula: Labor Force \= Employed \+ Unemployed  
   - Age requirement: 16 years or older  
   - Must be non-institutionalized civilian population

   

2. Key Rates and Calculations  
     
   - Labor Force Participation Rate \= (Labor Force/Population over 16\) × 100  
   - Unemployment Rate \= (Unemployed/Labor Force) × 100  
   - Employment Rate \= (Employed/Labor Force) × 100 \[FOR THIS TEST ONLY\]  
   - Note: Unemployment Rate \+ Employment Rate should \= 100% \[FOR THIS TEST\]

### B. Detailed Category Breakdowns

1. Employed Persons Include:  
     
   - Full-time workers  
   - Part-time workers (even if want full-time)  
   - Self-employed  
   - Temporary workers  
   - Underemployed workers  
   - People with multiple jobs (counted once)  
   - People on vacation/sick leave/maternity leave

   

2. Unemployed Persons Include:  
     
   - No current job  
   - Available for work  
   - Actively seeking work within last 4 weeks  
   - Temporarily laid off, expecting recall  
   - Important: Must meet ALL criteria

   

3. Not in Labor Force:  
     
   - Under age 16  
   - Retired persons  
   - Full-time students (even if job searching)  
   - Discouraged workers  
   - Stay-at-home parents  
   - Disabled persons unable to work  
   - Those not seeking work for 4+ weeks

### C. Types of Unemployment

1. Frictional Unemployment  
     
   - Definition: Temporary unemployment during job transitions  
   - Characteristics:  
     * Always exists in economy  
     * Usually short-term  
     * Part of healthy economy  
   - Examples:  
     * New graduates seeking first job  
     * People moving between cities  
     * Voluntary job changes  
     * Seasonal workers between jobs

   

2. Structural Unemployment  
     
   - Definition: Mismatch between worker skills and job requirements  
   - Characteristics:  
     * Longer-term  
     * Requires retraining/relocation  
     * Often due to technological change  
   - Examples:  
     * Factory workers replaced by automation  
     * Coal miners in declining industry  
     * Typewriter repairers after computers  
     * Travel agents after internet booking

   

3. Cyclical Unemployment  
     
   - Definition: Job loss due to business cycle downturns  
   - Characteristics:  
     * Varies with economic conditions  
     * Zero at full employment  
     * Can be negative during booms  
   - Examples:  
     * Retail workers during recession  
     * Construction workers in housing bust  
     * Auto workers during economic downturn

### D. Important Unemployment Relationships

1. Natural Rate of Unemployment  
     
   - Formula: Natural Rate \= Frictional \+ Structural  
   - Represents "full employment" rate  
   - Changes over time  
   - Usually 4-5% in U.S.

   

2. Total/Actual Unemployment  
     
   - Formula: Actual Rate \= Natural Rate \+ Cyclical  
   - At full employment:  
     * Actual Rate \= Natural Rate  
     * Cyclical Unemployment \= 0  
   - During recession:  
     * Actual Rate \> Natural Rate  
     * Cyclical Unemployment \> 0  
   - During boom:  
     * Actual Rate \< Natural Rate  
     * Cyclical Unemployment \< 0

### E. Limitations of Unemployment Statistics

1. Undercounting Problems  
     
   - Discouraged workers not counted  
   - Part-time workers wanting full-time work  
   - Underemployed workers  
   - "Hidden unemployment"

   

2. Overcounting Problems  
     
   - Underground economy workers  
   - Multiple job holders counted as one  
   - Seasonal variations

## II. Price Indices and Inflation

### A. Consumer Price Index (CPI)

1. Basic Definition  
     
   - Measures average price change for fixed market basket  
   - Base year \= 100  
   - Shows purchasing power changes

   

2. Market Basket Components  
     
   - Food and beverages  
   - Housing  
   - Apparel  
   - Transportation  
   - Medical care  
   - Recreation  
   - Education  
   - Other goods/services

   

3. CPI Calculation  
     
   - Formula: CPI \= (Cost of Market Basket Current Year/Cost of Market Basket Base Year) × 100  
   - Example:  
     * Base year basket cost: $100  
     * Current year same basket: $110  
     * CPI \= ($110/$100) × 100 \= 110

### B. GDP Deflator vs CPI

1. Key Differences  
     
   - CPI:  
       
     * Fixed basket of consumer goods  
     * Only consumer items  
     * Base year weights  
     * Domestic consumption focus

     

   - GDP Deflator:  
       
     * All goods in GDP  
     * Includes investment goods  
     * Current year weights  
     * Domestic production focus

   

2. When to Use Each  
     
   - CPI: Better for consumer cost of living  
   - GDP Deflator: Better for whole economy

### C. Types of Price Level Changes

1. Inflation  
     
   - Definition: Sustained increase in general price level  
   - Calculation: ((CPI₂ \- CPI₁)/CPI₁) × 100  
   - Types:  
     * Demand-pull (too much spending)  
     * Cost-push (higher production costs)

   

2. Deflation  
     
   - Definition: Sustained decrease in general price level  
   - Usually indicates serious economic problems  
   - Causes:  
     * Severe recession  
     * Monetary contraction  
     * Technological advancement

   

3. Disinflation  
     
   - Definition: Decreasing rate of inflation  
   - Still positive but lower rate  
   - Example:  
     * Year 1: 5% inflation  
     * Year 2: 3% inflation  
     * Still inflation but at lower rate

### D. Effects of Unexpected Inflation

1. Winners  
     
   - Borrowers with fixed-rate loans  
     * Pay back with less valuable dollars  
     * Real debt burden decreases  
   - Debtors in general  
   - Asset holders (if asset prices rise faster than inflation)

   

2. Losers  
     
   - Lenders with fixed-rate loans  
     * Receive repayment in less valuable dollars  
   - People on fixed incomes  
     * Purchasing power decreases  
   - Savers  
     * Money loses value unless interest rate \> inflation  
   - Creditors in general

### E. Converting Nominal to Real Values

1. Basic Formulas  
     
   - Real Value \= (Nominal Value/Price Index) × 100  
   - Nominal Value \= (Real Value × Price Index)/100

   

2. Applications  
     
   - GDP conversion  
   - Wage conversion  
   - Interest rates  
   - Investment returns

### F. Practice Problems

1. Labor Force Calculations Problem: Population data:  
- Total population over 16: 200 million  
- Employed: 120 million  
- Unemployed: 10 million

Calculate: a) Labor force b) Labor force participation rate c) Unemployment rate d) Employment rate \[test version\]

Solutions: a) Labor force \= 120M \+ 10M \= 130M b) LFPR \= (130M/200M) × 100 \= 65% c) Unemployment rate \= (10M/130M) × 100 \= 7.7% d) Employment rate \= (120M/130M) × 100 \= 92.3%

2. Inflation Rate Calculation Problem: CPI data: 2022: 200 2023: 210

Calculate inflation rate for 2023\.

Solution: Inflation Rate \= ((210-200)/200) × 100 \= 5%

3. Real Value Calculation Problem: Nominal GDP: $20 trillion Price Index: 125

Calculate Real GDP.

Solution: Real GDP \= ($20T/125) × 100 \= $16 trillion

# Aggregate Demand-Aggregate Supply Model and Business Cycles

## I. Aggregate Demand (AD)

### A. Basic Definition and Components

- Total planned spending at every price level  
- Components match GDP: AD \= C \+ I \+ G \+ (X-M)  
- Downward sloping curve  
- Shows inverse relationship between price level and real GDP

### B. Why AD Slopes Downward

1. Wealth Effect  
     
   - Higher prices reduce real wealth  
   - Lower purchasing power  
   - Less spending at higher prices

   

2. Interest Rate Effect  
     
   - Higher prices lead to higher interest rates  
   - Reduces borrowing and spending  
   - Especially affects investment and durable goods

   

3. Exchange Rate Effect  
     
   - Higher prices affect international trade  
   - Makes exports more expensive  
   - Reduces net exports

### C. Shifts in AD Curve

1. Rightward Shifts (Increase in AD)  
     
   - Consumption increases  
       
     * Higher consumer confidence  
     * Lower interest rates  
     * Increased wealth  
     * Tax cuts

     

   - Investment increases  
       
     * Better business expectations  
     * Lower interest rates  
     * New technology  
     * Tax incentives

     

   - Government spending increases  
       
     * Military spending  
     * Infrastructure projects  
     * New programs

     

   - Net exports increase  
       
     * Foreign income rises  
     * Exchange rates favorable  
     * Trade agreements

   

2. Leftward Shifts (Decrease in AD)  
     
   - Consumption decreases  
       
     * Lower consumer confidence  
     * Higher interest rates  
     * Decreased wealth  
     * Tax increases

     

   - Investment decreases  
       
     * Poor business outlook  
     * Higher interest rates  
     * Political uncertainty

     

   - Government spending decreases  
       
     * Austerity measures  
     * Program cuts

     

   - Net exports decrease  
       
     * Foreign recession  
     * Unfavorable exchange rates

## II. Short-Run Aggregate Supply (SRAS)

### A. Basic Characteristics

- Upward sloping  
- Shows relationship between price level and real GDP  
- Based on sticky wages/prices  
- Short run: some input prices fixed

### B. Why SRAS Slopes Upward

1. Sticky Wages  
     
   - Wages don't adjust quickly  
   - Higher prices \= higher profits  
   - Incentive to increase production

   

2. Sticky Prices  
     
   - Some prices fixed by contracts  
   - Menu costs limit price changes  
   - Implicit contracts with customers

### C. Shifts in SRAS Curve

1. Rightward Shifts (Increase in SRAS)  
     
   - Lower input costs  
       
     * Lower oil prices  
     * Lower raw material costs  
     * Lower wage rates

     

   - Technology improvements  
       
     * Better production methods  
     * Higher productivity

     

   - Favorable supply shocks  
       
     * Good weather for crops  
     * New resource discoveries

   

2. Leftward Shifts (Decrease in SRAS)  
     
   - Higher input costs  
       
     * Higher oil prices  
     * Higher raw material costs  
     * Higher wages

     

   - Negative supply shocks  
       
     * Natural disasters  
     * Poor weather  
     * Trade disruptions

     

   - Government regulations  
       
     * New environmental rules  
     * Higher minimum wage  
     * Higher taxes

## III. Long-Run Aggregate Supply (LRAS)

### A. Basic Characteristics

- Vertical line at potential output  
- Independent of price level  
- Shows maximum sustainable output  
- Based on:  
  * Available resources  
  * Technology  
  * Institutional structure

### B. Why LRAS is Vertical

- All prices/wages fully flexible in long run  
- No money illusion  
- Output determined by:  
  * Labor  
  * Capital  
  * Natural resources  
  * Technology  
  * Not price level

### C. Shifts in LRAS

1. Rightward Shifts  
     
   - More resources  
   - Better technology  
   - Improved education/training  
   - Better institutions  
   - Higher productivity

   

2. Leftward Shifts  
     
   - Fewer resources  
   - Natural disasters  
   - Brain drain  
   - Institutional decay  
   - Lower productivity

## IV. Equilibrium Analysis

### A. Short-Run Equilibrium

- Where AD intersects SRAS  
- Determines:  
  * Equilibrium price level  
  * Equilibrium real GDP  
  * Employment level

### B. Long-Run Equilibrium

- Where AD, SRAS, and LRAS all intersect  
- Economy at potential output  
- Natural rate of unemployment  
- Price level stable

### C. Output Gaps

1. Recessionary Gap  
     
   - When: Actual GDP \< Potential GDP  
   - Characteristics:  
     * High unemployment  
     * Below full employment  
     * Cyclical unemployment positive  
   - Adjustment Process:  
     * Wages fall  
     * SRAS shifts right  
     * Economy moves to potential

   

2. Inflationary Gap  
     
   - When: Actual GDP \> Potential GDP  
   - Characteristics:  
     * Low unemployment  
     * Above full employment  
     * Cyclical unemployment negative  
   - Adjustment Process:  
     * Wages rise  
     * SRAS shifts left  
     * Economy moves to potential

## V. Business Cycles

### A. Definition and Phases

1. Expansion  
     
   - Rising real GDP  
   - Falling unemployment  
   - Increasing production  
   - Rising income/spending

   

2. Peak  
     
   - Highest point of economic activity  
   - Full employment or beyond  
   - Capacity constraints  
   - Price pressures

   

3. Contraction/Recession  
     
   - Falling real GDP  
   - Rising unemployment  
   - Decreasing production  
   - Falling income/spending

   

4. Trough  
     
   - Lowest point  
   - High unemployment  
   - Excess capacity  
   - Price stability/deflation

### B. Measuring Business Cycles

1. Real GDP Growth  
     
   - Primary indicator  
   - Quarterly measurements  
   - Year-over-year comparisons

   

2. Other Indicators  
     
   - Employment  
   - Industrial production  
   - Retail sales  
   - Income

### C. Relationship to AD-AS Model

1. Expansion Phase  
     
   - AD shifting right  
   - Employment rising  
   - Price level rising  
   - Moving toward/past potential

   

2. Contraction Phase  
     
   - AD shifting left  
   - Employment falling  
   - Price level stable/falling  
   - Moving below potential

## VI. Practice Problems

1. AD-AS Analysis Problem: Identify the effects on equilibrium price level and real GDP for: a) Oil prices rise significantly b) Consumer confidence increases c) New technology improves productivity d) Government increases spending

Solutions: a) Oil prices rise:

- SRAS shifts left  
- Higher price level  
- Lower real GDP

b) Consumer confidence:

- AD shifts right  
- Higher price level  
- Higher real GDP

c) New technology:

- SRAS and LRAS shift right  
- Lower price level  
- Higher real GDP

d) Government spending:

- AD shifts right  
- Higher price level  
- Higher real GDP  
2. Output Gap Analysis Problem: Given:  
- Potential GDP: $20 trillion  
- Actual GDP: $19 trillion  
- Current unemployment: 6%  
- Natural unemployment: 4%

Identify: a) Type of gap b) Size of gap c) Cyclical unemployment d) Expected adjustment process

Solutions: a) Recessionary gap b) $1 trillion gap c) 2% cyclical unemployment d) Wages fall → SRAS shifts right → GDP rises to potential

# Production Possibilities Curve (PPC) and Final Topics

## I. Production Possibilities Curve (PPC)

### A. Basic Definition and Characteristics

- Graph showing maximum output combinations of two goods  
- Shows tradeoffs with fixed resources and technology  
- Represents society's production choices  
- Also called Production Possibilities Frontier (PPF)

### B. Key Concepts

1. Scarcity  
     
   - Limited resources  
   - Unlimited wants  
   - Forces choices  
   - Shown by inability to produce beyond curve

   

2. Opportunity Cost  
     
   - What must be given up  
   - Measured by slope at any point  
   - Usually increasing  
   - Formula: Opp Cost \= Change in Good Y/Change in Good X

   

3. Efficiency  
     
   - Points on curve \= efficient production  
   - Using all resources  
   - Best possible output  
   - No waste

### C. Different Points on/off PPC

1. Points on the Curve  
     
   - Efficient production  
   - Full employment of resources  
   - Maximum output possible  
   - Example: Point A (50 cars, 100 computers)

   

2. Points Inside Curve  
     
   - Inefficient production  
   - Unemployment  
   - Unused resources  
   - Example: Point B (30 cars, 60 computers)

   

3. Points Outside Curve  
     
   - Unattainable with current resources  
   - Cannot be reached  
   - Unless:  
     * Economic growth  
     * More resources  
     * Better technology

### D. Shape of PPC

1. Concave (Bowed Out)  
     
   - Most common shape  
   - Shows increasing opportunity cost  
   - Why it occurs:  
     * Resources not equally efficient  
     * Some specialization  
     * Different resource requirements

   

2. Straight Line  
     
   - Constant opportunity cost  
   - Resources equally efficient  
   - Perfect substitutability  
   - Rare in reality

   

3. Right Angle  
     
   - Fixed proportions  
   - No substitutability  
   - Perfect complements  
   - Very rare

### E. Shifts in PPC

1. Outward Shifts (Growth)  
     
   - Causes:  
     * More resources  
     * Better technology  
     * Improved skills  
     * Better institutions  
   - Results:  
     * Higher potential output  
     * More production possibilities

   

2. Inward Shifts (Decline)  
     
   - Causes:  
     * Natural disasters  
     * War  
     * Brain drain  
     * Resource depletion  
   - Results:  
     * Lower potential output  
     * Fewer possibilities

   

3. Asymmetric Shifts  
     
   - When growth affects one good more  
   - Examples:  
     * Technology specific to one industry  
     * Resource discovery for one good  
     * Skill improvements in one area

### F. Economic Growth on PPC

1. Types of Growth  
     
   - Capital accumulation  
   - Technological progress  
   - Human capital improvement  
   - Resource discovery

   

2. Effects on PPC  
     
   - Outward shift  
   - Changes in shape possible  
   - New production possibilities  
   - Higher living standards

## II. Integrating Concepts

### A. PPC and AD-AS Relationship

1. Similarities  
     
   - Both show production capacity  
   - Both affected by resources  
   - Both show efficiency concepts

   

2. Differences  
     
   - PPC: real output tradeoffs  
   - AD-AS: price level and output  
   - PPC: two goods  
   - AD-AS: whole economy

### B. Business Cycles and PPC

1. Expansion  
     
   - Movement toward PPC  
   - Better resource use  
   - Higher employment  
   - More output

   

2. Recession  
     
   - Movement inside PPC  
   - Resource underuse  
   - Higher unemployment  
   - Less output

### C. Practice Problems

1. PPC Analysis Problem: Given PPC for cars and computers: Cars | Computers 100  |    0 80   |   20 60   |   35 40   |   45 20   |   50 0    |   52

Calculate: a) Opportunity cost of first 20 computers b) Opportunity cost of last 2 computers c) Is opportunity cost increasing/constant/decreasing?

Solutions: a) First 20 computers:

- Change in cars: 20  
- Opp cost: 1 car per computer

b) Last 2 computers:

- Change in cars: 20  
- Opp cost: 10 cars per computer

c) Opportunity cost is increasing

- Shows by increasing cars given up  
- Typical concave PPC shape  
2. Economic Growth Problem Problem: Show effects on PPC: a) New car manufacturing technology b) General technological improvement c) Loss of computer engineers d) More resources for both goods

Solutions: a) Asymmetric shift right on car axis b) Entire curve shifts right c) Asymmetric shift left on computer axis d) Entire curve shifts right

## III. Comprehensive Integration

### A. Connecting All Concepts

1. Real vs. Nominal Values  
     
   - Affect measurement of:  
     * GDP  
     * Wages  
     * Interest rates  
     * Investment returns  
   - Importance in:  
     * Business cycles  
     * AD-AS analysis  
     * Economic growth

   

2. Price Level Changes  
     
   - Impact on:  
     * AD curve  
     * SRAS curve  
     * Real wages  
     * International trade  
   - Relationship to:  
     * Business cycles  
     * Employment  
     * Output gaps

   

3. Labor Markets  
     
   - Connection to:  
     * Business cycles  
     * Aggregate supply  
     * Economic growth  
     * PPC efficiency

### B. Key Mathematical Tools

1. Calculating Rates  
     
   - Unemployment  
   - Inflation  
   - Growth  
   - Labor force participation

   

2. Converting Values  
     
   - Nominal to real  
   - Real to nominal  
   - Base year adjustments  
   - Price index calculations

### C. Final Practice Problems

1. Comprehensive Problem Given:  
- Nominal GDP 2023: $22T  
- Price Index: 110  
- Unemployment: 6%  
- Labor force: 160M  
- Population (16+): 250M  
- Natural unemployment: 4%

Calculate: a) Real GDP b) Labor force participation rate c) Number employed d) Cyclical unemployment e) Type of gap

Solutions: a) Real GDP \= ($22T/110) × 100 \= $20T b) LFPR \= (160M/250M) × 100 \= 64% c) Employed \= 160M × (1-0.06) \= 150.4M d) Cyclical unemployment \= 6% \- 4% \= 2% e) Recessionary gap (actual unemployment \> natural)

2. Policy Analysis Problem Scenario: Economy experiencing:  
- 8% unemployment  
- 3% inflation  
- GDP below potential  
- Falling investment

Analyze: a) Position on PPC b) AD-AS situation c) Type of gap d) Business cycle phase e) Labor market conditions

Solutions: a) Inside PPC (inefficient) b) AD likely shifted left c) Recessionary gap d) Contraction/recession e) Cyclical unemployment, declining wages

### D. Key Test Tips

1. Graph Analysis  
     
   - Label all axes  
   - Show all shifts  
   - Indicate equilibrium points  
   - Mark gaps clearly

   

2. Calculations  
     
   - Show all work  
   - Include units  
   - Round reasonably  
   - Check feasibility

   

3. Definitions  
     
   - Be precise  
   - Include key characteristics  
   - Give examples  
   - Show relationships

   

4. Common Mistakes to Avoid  
     
   - Confusing shifts vs. movements  
   - Mixing up nominal/real  
   - Forgetting units  
   - Miscalculating rates  
   - Not labeling graphs

</example_study_guide>

<textbook_chapters>
<chapter_3>
Unit 3 97
UNIT 3
National Income and
Price Determination
When you think of income, you probably think of the total amount of
money someone earns from various sources during a year. National income is
calculated differently. It is the total market value of production in a country’s
economy during a year, which is usually expressed as the gross domestic product
(GDP). As you learned in Unit 2, economic activity fluctuates over time in
what is known as the business cycle. These fluctuations affect an economy’s
output and price level, both in the short run and in the long run.
Economists use the aggregate demand–aggregate supply model to analyze
these fluctuations, as well as the impact of spending and production decisions,
and the effects of economic policy actions on macroeconomic outcomes. (The
term aggregate is used to indicate that all of the goods and services produced
by the economy are being taken into account.) In the long run, flexible wages
and prices will adjust and unemployment will return to its natural state.
Governments also use fiscal policy to achieve macroeconomic goals. By
cutting taxes or increasing government spending, they can stimulate economic
growth, while by raising taxes or decreasing government spending they can
slow an overactive economy. In this unit, you will learn how economists use the
aggregate demand–aggregate supply model to make economic policy decisions.
98 MACROECONOMICS: AP®
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Topic Titles and Essential Knowledge
Topic 3.1 Aggregate Demand (AD)
• The aggregate demand (AD) curve describes the relationship between the
price level and the quantity of goods and services demanded by households
(consumption), firms (investment), government (government spending), and the
rest of the world (net exports).
• The negative slope of the AD curve is explained by the real wealth effect, the
interest rate effect, and the exchange rate effect.
• Any change in the components of aggregate demand (consumption, investment,
government spending, or net exports) that is not due to changes in the price level
leads to a shift of the AD curve.
Topic 3.2 Multipliers
• A $1 change to autonomous expenditures leads to further changes in total
expenditures and total output.
• The expenditure multiplier quantifies the size of the change in aggregate demand
as a result of a change in any of the components of aggregate demand.
• The tax multiplier quantifies the size of the change in aggregate demand as a result
of a change in taxes.
• The expenditure multiplier and tax multiplier depend on the marginal propensity to
consume.
• The marginal propensity to consume is the change in consumer spending divided
by the change in disposable income. The sum of the marginal propensity to
consume and marginal propensity to save is equal to one.
Topic 3.3 Short-Run Aggregate Supply (SRAS)
• The short-run aggregate supply (SRAS) curve describes the relationship between
the price level and the quantity of goods and services supplied in an economy.
• The SRAS curve is upward-sloping because of sticky wages and prices.
• Any factor that causes production costs to change, such as a change in inflationary
expectations, will cause the SRAS curve to shift.
• Moving along the SRAS curve, an increase in the price level is associated with an
increase in output, which means employment must correspondingly rise. With the
labor force held constant, unemployment will fall. So, there is a short-run trade-off
between inflation and unemployment.
Topic 3.4 Long-Run Aggregate Supply (LRAS)
• In the long run all prices and wages are fully flexible, while in the short run some
input prices are fixed. A consequence of flexible long-run prices and wages is the
lack of a long-run trade-off between inflation and unemployment.
• The LRAS curve corresponds to the production possibilities curve (PPC) because
they both represent maximum sustainable capacity. Maximum sustainable capacity
is the total output an economic system will produce over a set period of time if all
resources are fully employed.
• The LRAS curve is vertical at the full-employment level of output because in the
long run wages and prices fully adjust.
Unit 3 99
Topic 3.5 Equilibrium in the Aggregate Demand–Aggregate Supply (AD–AS) Model
• Short-run equilibrium occurs when the aggregate quantity of output demanded and the
aggregate quantity of output supplied are equal—i.e., at the intersection of the AD and
SRAS curves.
• Long-run equilibrium occurs when the AD and SRAS curves intersect on the LRAS—i.e.,
at the full-employment level of real output.
• The short-run equilibrium output can be at the full-employment level of output, above it,
or below it, creating positive (i.e., inflationary) or negative (i.e., recessionary) output gaps.
Topic 3.6 Changes in the AD–AS Model in the Short Run
• A positive (negative) shock in AD causes output, employment, and the price level to rise
(fall) in the short run.
• A positive (negative) shock in SRAS causes output and employment to rise (fall) and the
price level to fall (rise) in the short run.
• Inflation can be caused by changes in aggregate demand (demand-pull) or aggregate
supply (cost-push).
Topic 3.7 Long-Run Self-Adjustment
• In the long run, in the absence of government policy actions, flexible wages and prices
will adjust to restore full employment and unemployment will revert to its natural rate
after a shock to aggregate demand or short-run aggregate supply.
• Shifts in the long-run aggregate supply curve indicate changes in the full-employment
level of output and economic growth.
Topic 3.8 Fiscal Policy
• Governments implement fiscal policies to achieve macroeconomic goals, such as full
employment.
• The tools of fiscal policy are government spending and taxes/transfers.
• Changes in government spending affect aggregate demand directly, and changes in
taxes/transfers affect aggregate demand indirectly.
• The government spending multiplier is greater than the tax multiplier.
• Expansionary or contractionary fiscal policies are used to restore full employment when
the economy is in a negative (i.e., recessionary) or positive (i.e., inflationary) output gap.
• Fiscal policy can influence aggregate demand, real output, and the price level.
• The AD–AS model is used to demonstrate the short-run effects of fiscal policy.
• In reality, there are lags to discretionary fiscal policy because of factors such as the time
it takes to decide on and implement a policy action.
Topic 3.9 Automatic Stabilizers
• Automatic stabilizers support the economy during recessions and help prevent the
economy from being overheated during expansionary periods.
• Tax revenues decrease automatically as GDP falls, preventing consumption and the
economy from falling further.
• Tax revenues increase automatically as GDP rises, slowing consumption and preventing
the economy from overheating.
• Government policies, institutions, or agencies may also have social service programs
whose transfer payments act as automatic stabilizers.
Source: AP® Macroeconomics Course and Exam Description. Effective Fall 2019 (College Board).
100 MACROECONOMICS: AP®
 EDITION
Topic 3.1
Aggregate Demand (AD)
“Consumption is the sole end and purpose of all production; and the
interest of the producer ought to be attended to, only so far as it may be
necessary for promoting that of the consumer.”
Scottish political economist Adam Smith, The Wealth of Nations (1776)
Essential Question: What is aggregate demand and how is it determined?
The owner of a local shoe store closely monitors which products are selling—
and which are not selling—in order to respond to customer demand and
current trends. She also needs to minimize the quantity of shoes she has in
stock that are not moving off the shelves. This is simple, straightforward supply
and demand. If managed well, it can help a shoe store can turn a profit every
week, month, and year.
So how are supply and demand measured and managed on a national
scale? And not only for shoes—but the total demand for every good or service
the economy produces? Aggregate demand is the total amount of demand for
all goods and services in an economy. Cars, t-shirts, dry cleaning, fighter jets,
pizza delivery—they are all part of the calculation. Economists use this broad
calculation to understand how economies work. Businesses, individuals, and
governments use it to respond to national and international events that effect
the economic future.
What Is Aggregate Demand?
Aggregate demand (AD) is the demand for all finished goods and services
at various price levels in a given period of time. This is different from GDP,
which measures the total market or monetary value of all the finished goods
and services produced in a country in a given period. AD is more interested in
how desirable all those GDP goods are in an economy and how much money is
spent buying those goods. The way aggregate demand is calculated, however, is
the same way GDP is calculated: AD = C + I + G + X – M.
• C = consumer spending on goods
• I = investment spending on goods like factories and equipment
• G = government spending on goods and services
• X = exported goods to other countries
• M = imported goods from other countries
 Topic 3.1 Aggregate demand (ad) 101
AD and GDP are calculated in the same way because they are connected.
If demand for certain goods rises, more of those goods will be produced, thus
raising the GDP. The reverse is true as well: Less demand means less reason to
produce as much of the good or service.
The Aggregate Demand Curve
Aggregate demand is visually represented by the aggregate demand curve,
which shows the relationship between the desire for aggregate goods and
services by consumers, businesses, government, and the rest of the world
and the aggregate price level for all goods and services. The vertical Y-axis
represents the price level for all the AD goods and services. The horizontal
X-axis represents the real GDP, or the total output of goods. The AD curve
slopes downward from left to right because aggregate demand increases or
decreases as prices increase or decrease. As the price level decreases, more
goods will be purchased.
The Aggregate Demand (AD) Curve
Increased price level and
reduced aggregate output
Decreased price level and
higher aggregate output
R2 R1 R3
PL2
PL1
PL3
Aggregate Price Level
Real GDP
The Difference Between Demand and Aggregate Demand It may seem
perfectly reasonable to equate the law of demand, which affects an individual
good or service, with aggregate demand. After all, both curves are downward
sloping. But they are not the same. The demand curve for an individual product,
like a designer handbag, reflects how the demand for the handbag changes based
on its price (provided the prices of other goods remain constant). A primary
reason the quantity demanded for a designer handbag falls when the price goes
up is that consumers decide to spend their money on other goods or services.
The aggregate demand curve, however, is not focused on an individual
product. It is concerned with the simultaneous change in pricing for all goods
and services. For example, if the sales of a designer handbag drop but consumers
purchase more smartphones, it does not necessarily change the total demand
for goods and services in the economy. But there are economic elements that
will have an impact on the relationship between aggregate price levels and all
final goods and services (GDP) created.
102 MACROECONOMICS: AP®
 EDITION
The Wealth Effect One reason demand for GDP goods will drop is because
the aggregate price of goods rises. When aggregate prices go up, consumers do
not have as much buying power as they do with lower prices. For example,
imagine that a couple budgets $4,000 in January to spend on furniture for their
new house that they will purchase when the house is completed in September. If
the aggregate price level goes up by 10 percent between January and September,
the couple is able to buy the equivalent of 10 percent less furniture—what they
could have bought for $3,600 in January. They might decide to buy less total
furniture because their money is not able to buy as much as they wanted, or
they might decide to purchase less expensive furniture.
Since the change is to aggregate demand, it means that all other consumers
would feel the same effect of the 10-percent aggregate price increase, leading
millions and millions of people to reduce their spending on goods and services.
The opposite is true as well: Lower aggregate prices result in increased consumer
buying power and more demand for goods. The wealth effect is what happens
to consumer spending when the aggregate price level changes. When the
aggregate price level goes up, the aggregate demand curve slopes downward.
The Interest Rate Effect Consumers and businesses—the C and I in the
aggregate demand and GDP calculations—make purchasing decisions based
not only on price but on the funds they have available. The actual money
they have in their accounts or funds that are available to them via loans are
primary spending resources for consumers and businesses. The interest rate
effect refers to the impact that changes in borrowing power has on aggregate
demand and aggregate prices. If interest rates go up, consumers and businesses
become more hesitant to borrow money for larger purchases (refrigerators,
cars, homes, and so on) because their purchasing power is lower, and the total
cost will be higher. Conversely, lower interest rates might make businesses and
consumers more likely to make investments or bigger purchases because they
will get more for their money.
A person shopping for real estate will consider the interest rates
available to them before pursuing a purchase. The lower the interest
rate for large purchases like homes, the more likely buyers will be able
to buy.
 Topic 3.1 Aggregate demand (ad) 103
The Exchange Rate Effect Aggregate demand can also be affected by
the currency exchange rate with other countries. In order for countries with
different currencies to do business, they must be able to exchange currencies
through a foreign exchange market. If a currency like the U.S. dollar increases
in value compared to other currencies, the dollar has appreciated in value and
gives people who have U.S. dollars stronger buying power to purchase foreign
goods. If the U.S. dollar decreases in value compared to other currencies, it has
depreciated in value and the buying power for foreign goods is lessened. (See
Topic 6.2 for more on exchange rates.)
The currency exchange rates have an impact on the demand and price
of goods and services in their respective countries. For example, if a new
smartphone in the U.S. costs $1,000, while the same phone in Spain costs €1,000,
and the exchange rate between dollars and euros is $1 = €1, the phone has the
same price. But if the exchange rate is €1.20 = $1, the Spanish smartphone
is 20 percent cheaper than the U.S. phone. Similarly, if the exchange rate is
€0.80 = $1, the Spanish phone is about 20 percent more expensive than the U.S.
phone. The exchange rate’s influence on aggregate demand for goods between
countries causes decreases and increases depending on how weak or strong the
countries’ currencies are relative to each other.
What Shifts the Aggregate Demand Curve?
As you have already seen, movement along the aggregate demand curve is
driven by changes in price level. As prices rise, the aggregate quantity of goods
demanded falls. As prices fall, the aggregate quantity of goods demanded rises.
But just as with demand in Topic 1.4, certain economic factors can shift the
aggregate demand curve left or right, signaling a decrease or increase in the
quantity of goods and services demanded at any price level.
Changes in Consumer Spending The level at which consumers spend
is dependent, to a significant degree, on their confidence about the future
direction of the economy. When consumers expect the economy to remain
strong or improve, meaning that their personal finances will likely do the
same, they increase spending. This increases the quantity of goods and
services demanded at any price level, shifting the AD curve to the right.
When consumers foresee a weakening economy, they limit their spending.
Aggregate demand decreases and the AD curve shifts to the left.
Changes in wealth, too, change consumer spending. Economy-wide
phenomena such as a stock market or real estate boom can increase wealth
to the extent that aggregate demand increases. An unexpected event such as
the oil embargo of the 1970s that caused oil prices to suddenly increase, or the
impact of COVID-19 in 2020 that caused a sharp decline in the stock market,
have the opposite effect, decreasing spending and aggregate demand.
Changes in Investment (Business Spending) Confidence about
the future of the economy also directly affects investment (spending) by
businesses. If businesses expect the economy to remain strong or improve, 
104 MACROECONOMICS: AP®
 EDITION
they generally have high expectations about future revenues from the
goods or services they provide. They, in turn, line up investment plans on
this basis. Investment takes the shape of building new facilities, upgrading
technology, investing in new equipment, and the like. Business investment
on this scale increases aggregate demand and shifts the AD curve to the
right. Negative expectations about the economic future can have the
opposite effect, decreasing aggregate demand and shifting the AD curve
to the left.
Changes in Governmental Policies Increases in government spending
can shift the aggregate demand curve as well. Many of the better-known
“alphabet agencies” of the New Deal during the Great Depression, such as
the Civilian Conservation Corps (CCC), the Works Progress Administration
(WPA), and the Federal Emergency Relief Administration (FERA), were
designed specifically to employ people, putting money in their pockets.
Increases in income lead to increases in spending, which lead to increases in
aggregate demand. Massive government spending on weapons and supplies
for World War II was another example of the government’s ability to shift the
AD curve.
Governments also influence aggregate demand through tax policy
and transfers. Tax cuts are often employed as a tool to put more money in
the hands of consumers and businesses, in an effort to boost spending.
Government transfers, too, help boost spending. For example, in response to
the unemployment and economic stagnation caused by the COVID-19 crisis
of 2020, the U.S. government approved direct payments of $1,200 per adult
person (and $500 per dependent) for most U.S. citizens. Again, the goal was
to encourage spending and thereby increase aggregate demand—or even just
keep it from decreasing too drastically.
Shifts in Aggregate Demand
Price Level
Real GDP
AD Left: Decrease
in aggregate demand
AD Right: Increase
in aggregate demand
 Topic 3.1 Aggregate demand (ad) 105
KEY TERMS
aggregate demand (AD)
aggregate demand curve
wealth effect
interest rate effect
appreciate
depreciate
MULTIPLE-CHOICE QUESTIONS
Questions 1 to 3 refer to the chart below.
Aggregate Demand during the Great Depression
Real GDP
Y1 Y
PL1
PL
Aggregate Price Level
AD1929
AS
AD1933
1. Which of the following best describes why aggregate demand shifted
left between 1929 and 1933?
(A) Interest rates for loans dropped quickly.
(B) Exchange rates for the U.S. dollar depreciated.
(C) Consumer income dropped severely.
(D) Inflationary pressures reduced government spending.
(E) Businesses undertook major investments.
ANSWER THE TOPIC ESSENTIAL QUESTION
1. In one to three paragraphs, explain what aggregate demand is and how
it is determined.
106 MACROECONOMICS: AP®
 EDITION
2. How does the leftward shift on the curve reflect the shock to
employment during the Depression?
(A) GDP fell because of fear of inflationary price levels.
(B) Rising price levels made it difficult for workers to afford goods.
(C) More people were able to contribute to production of goods.
(D) Rapid growth in unemployment reduced consumer buying power.
(E) Uncertainty about the economy did not affect business hiring.
3. Which would be the most effective way for government action to reduce
falling aggregate demand between 1929 and 1933?
(A) Offer businesses low interest loans for investment.
(B) Promote certain goods and services to the buying public.
(C) Create federal jobs to provide work and income for the unemployed.
(D) Stop all imports and purchase only domestic goods and services.
(E) Pass legislation to raise taxes on businesses and the extremely wealthy.
FREE-RESPONSE QUESTIONS
1. Use the graph below to answer all parts of the questions that follow. Price Level
Real GDP
AD
Yp
(a) Describe the relationship between price level and real GDP reflected
in the graph.
(b) If the U.S. experiences a recessionary period, how will the AD
curve shift? Explain your answer.
(c) Suppose that a war between the U.S. and China ensues. The government
increases its purchases of military equipment. How will this war impact
the aggregate demand in the United States? Explain.
(d) Businesses confidence is on the rise due to a leap in the stock market.
How is the aggregate demand curve altered in this situation?
(e) A new tariff is placed on all imported goods. How will the aggregate
demand curve be affected? Explain. 
 Topic 3.1 Aggregate demand (ad) 107
THINK AS AN ECONOMIST: DRAW AN ACCURATELY LABELED VISUAL TO
REPRESENT AN ECONOMIC MODEL
Economists use graphs to display economic behavior, creating models that
attempt to show how producers and consumers will behave. One way of
showing an economic model is with a demand curve, such as the “The Aggregate
Demand (AD) Curve” in this topic.
Economists can also use other kinds of visuals to model economic
behavior. For example, a market demand schedule shows the market demand
for a product at given prices.
Apply the Skill
Use a two-column chart to show the impact on aggregate demand of each of these
economic circumstances. List each change on its own row in the first column. Use an
up or down arrow in the second column to indicate whether the particular change will
have the effect of increasing or decreasing aggregate demand.
Chart these changes in a nation’s economy:
• Banks cut interest rates for consumer loans.
• Unemployment jumps as businesses lay off workers.
• Congress passes a law raising income tax rates across the board.
• International sales of American-made cars increase.
• The inflation rate rises from 1.3 percent to 4.0 percent.
108 MACROECONOMICS: AP®
 EDITION
Topic 3.2
Multipliers
“Don’t save what is left after spending; spend what is left after saving.”
Billionaire investor Warren Buffett (b. 1930)
Essential Question: How do changes in income and taxes effect
spending, savings, and the GDP?
Melina was surprised by the $4,000 end-of-year bonus she received from her
employer. It was much more than she expected. Melina can spend the money,
save it, or do a combination of the two. Now she can afford to replace her old
TV with a bigger, more advanced model that she has been eyeing. And she can
replace the noisy muffler on her car. Even with these expenditures, she will still
have a chunk of her bonus money to add to her savings account. The end of the
year turned out much better than Melina expected.
Melina’s reward for excellent work does not only affect her. What she does
with her bonus money has ripple effects throughout the economy. Buying an
expensive new TV means more TVs need to be produced, which means more
workers get paid and more electronics supply companies have to sell parts to
make that TV. And more shipping companies make money shipping additional
products. The workers who make the TV and the parts for the TV continue to
receive income—maybe even annual bonuses. Then they can make purchases,
which will create demand for the products they buy. The money Melina puts
into savings contributes to the bank’s ability to lend more money to other
borrowers. Melina’s benefit has a multiplying effect on the economy, aggregate
demand, and the real GDP.
What Is the Multiplier Effect?
A multiplier is an economic factor that changes and causes subsequent changes
in other associated areas. The multiplier effect refers to how an increase (or
decrease) in one economic activity causes increases (or decreases) across a range
of other related economic activities. The multiplier effect can cause increases
in gross domestic product (GDP) that are much larger than the initial change
in the economy that started the ripple effect. In the example above, where
Melina received unexpected income and spent a portion of it, her purchase of
a TV resulted in subsequent economic activity that was worth more than the
price of her purchase. When consumers gain new income, as Melina did, they
make decisions about how much of the new income they should spend or save. 
 Topic 3.2 Multipliers 109
How they decide to use that new money is what determines the impact of the
multiplier effect on the economy.
Marginal Propensity to Consume and Save
The marginal propensity to consume (MPC) refers to the percentage of
new income a consumer spends on goods and services compared to what
they save. Suppose you get a raise that amounts to an extra $200 a month
in take-home pay. That is new disposable income. If you spend $160 of
that $200—or 80  percent—every month, and save the remaining $40, your
marginal propensity to consume is expressed as 0.8 ($160 divided by $200).
People commonly use the symbol ∆ (delta) to represent a change in a quantity.
If ∆C means “change in consumption” and ∆DI means “change in disposable
income,” the calculation to represent your MPC is:
∆C / ∆DI = MPC
So, in this example with a $200 increase in income, the MPC is 0.8
(0.8/1 = 0.8). As discussed above, spending that $160 in new income is what sets
off the multiplier effect. Let us say the $160 is spent on a new dress. The store
will spend a percentage of that $160 (saving some of it) to pay employees and
bills and order new merchandise. The store workers will spend some of their
additional income (and save some) on other goods, as will the manufacturer,
and so on and so on.
The MPC is also determined by income level. A household with a higher
income will spend a smaller percentage of its new income because many of its
wants are already met. Lower income households will have a higher MPC
because a higher percentage of their income will be used for immediate
concerns.
The MPC graph slopes upward because as disposable income increases, so does consumption.
Consumption/Income Graph
Consumption
Income
Marginal propensity to consume
110 MACROECONOMICS: AP®
 EDITION
What about that unspent new income? It is assumed that the money is
saved: Whether it actually is or not—it is simply not spent. That is called the
marginal propensity to save (MPS) and refers to the percentage of aggregate
new income not used for consumption. The MPS and MPC work hand in hand
because every amount of new income is considered a whole dollar (whether it
is $1 or $100,000). In a calculation where ∆S means “change in savings” and
∆DI means “change in disposable income,” your MPS is:
∆S / ∆DI = MPS
So, in the example of an additional $200 in income, if $160 is spent, $40 is
saved. This means the MPS is 0.2 (40/200 = 0.2). Combining the MPC and MPS
should always equal 1.
As with the MPC, the MPS is largely determined by household income.
Lower income households are usually less able to save a large percentage of new
income, whereas higher income households are able to save a larger percentage
of new income. Economists use both the MPC and the MPS to help calculate
the impact of the multiplier effect on an economy. The higher the MPC is, the
higher the multiplier and the greater the increase in total consumption. The
higher the MPS is, the more money is saved for future use.
Autonomous Spending and Disposable Income Consumers, businesses,
and governments all have autonomous expenditures, which are necessary
costs built into operating a home, business, or government. For consumers,
rent, utility bills, and food are all items they must expend money on simply to
maintain their daily lives. Often, these autonomous expenses do not change
drastically over a short period of time, so consumers can budget for these costs.
What is left over after these autonomous expenditures are taken care of
is considered disposable income. Consumers can either save this income or
spend it (MPC or MPS). Regardless of a consumer’s total disposable income, the
multiplier effect works the same way. Whether someone buys a new microwave
or a yacht, the expenditure will ripple through the economy and generate more
total GDP than the price of the original product.
The Expenditure Multiplier
An annual bonus or a raise in salary are good examples of how the expenditure
multiplier (also called the spending multiplier) works for an individual.
Melina’s $4,000 annual bonus and subsequent MPC makes a small but
important contribution to GDP. The multiplier effect can be much bigger and
make a greater impact on GDP when a government or business makes a large
expenditure.
If the Iowa state government decides to spend $200 million on a new
facility for a state university, the initial expenditure will cause a chain reaction
through the economy because of all the additional consumption that goes into
building the new facility. Everything from buying materials and equipment
to paying worker salaries and workers buying lunches at businesses near the 
 Topic 3.2 Multipliers 111
construction site involves consumption. All those levels of spending (MPC)
create a change in real GDP that is shown by this formula:
Initial expenditure = $200 million
Second level of consumer spending = MPC × $200 million
Third level of consumer spending = MPC2 × $200 million
Fourth level of consumer spending = MPC3 × $200 million
(The levels of spending can continue on indefinitely.)
Total increase in real GDP = (1 + MPC + MPC2
 + MPC3
 . . . .) × $200 million
Each level of MPC is based on what percentage of new income will be
spent (rather than saved) by the consumer. If we assume the MPC is 0.8 of each
new dollar in disposable income, this table shows how a $200 million state
expenditure plays out:
GDP Increase from Initial
Expenditure (in millions)
Total Increase in Real GDP
(in millions)
Initial Expenditure 100.00 100.00
2nd level 80.00 180.00
3rd level 64.00 244.00
4th level 51.20 295.20
5th level 40.96 336.16
 . . . . . . . . .
Based on five levels of consumer MPC, that initial $200 million expenditure
by the state of Iowa has already generated $338 million in real GDP—and it will
be even more when additional levels of spending are added in. The formula to
calculate the expenditure multiplier can be written in two ways. Each formula
ends with the same product:
Expenditure multiplier = 1 / (1 – MPC)
Expenditure multiplier = 1 / MPS
The increases in levels of spending and GDP that result are clear indicators
of increased aggregate demand.
The Tax Multiplier
Government tax policy can impact aggregate demand and GDP as well, though
in a much smaller way than expenditures. The tax multiplier (TM) refers
to how an increase (or decrease) in taxes impacts spending and GDP. A tax
cut increases disposable income; a tax increase decreases disposable income.
Households react to a tax decrease differently, just as they do to other increases
in income. Overall, lower income households will spend a larger percentage
of additional income from taxes whereas higher income households will save
more of it. 
112 MACROECONOMICS: AP®
 EDITION
Say the federal government enacts an across-the-board tax cut of 8 percent
that results in a $400 billion increase in disposable income for taxpayers. (This
also means the federal government will receive less in revenue to pay its bills.)
If we assume the MPC is 0.75 (of every $1), people will spend $300 billion
of that tax cut (the other 0.25, or $100 billion, is MPS). The second level of
consumer spending would be 0.75 × $300 = $225 billion. The third level will be
$169 (225 × 0.75), and so on. The formula for the tax multiplier is:
TM = MPC / MPS = MPC / 1-MPC
TM = Simple tax multiplier
MPC = Marginal propensity to consume
MPS = Marginal propensity to save
One important difference between the tax multiplier and the expenditure
multiplier is that people will not spend the full $400 billion of the initial tax
decrease. They will save more of it. With the expenditure multiplier, the full
initial total is spent by the government or investing business. This is one of the
key reasons that expenditures have a larger impact on aggregate demand and
GDP than tax decreases.
ANSWER THE TOPIC ESSENTIAL QUESTION
1. In one to three paragraphs, explain how changes in income and taxes
affect spending, savings, and the GDP.
KEY TERMS
multiplier
multiplier effect
marginal propensity to consume (MPC)
marginal propensity to save (MPS)
disposable income
expenditure multiplier
tax multiplier (TM)
MULTIPLE-CHOICE QUESTIONS
1. If a city of 100,000 people invests $1 billion in a major electrical grid upgrade,
what direct outcome will businesses in the city during the upgrade?
(A) Inflation will rise due to increased aggregate demand.
(B) People will likely save more money as a result of increased local
business.
(C) Increased income will spur consumption by the city’s population.
(D) Disruption to business districts during the upgrade will reduce
overall consumption.
(E) Autonomous expenses will rise for local businesses and households.
 Topic 3.2 Multipliers 113
2. Assume that Jacob spent $20,000 of his disposable income of $30,000
in 2019. If his disposable income increased to $40,000 and his marginal
propensity to consume equals 0.8, what did his consumption increase
by?
(A) $4,000
(B) $8,000
(C) $9,000
(D) $10,000
(E) $12,000
3. If the marginal propensity to consume is 0.75, the government decreases
personal income taxes by $100, real gross domestic product will
(A) increase by $300
(B) decrease by $400
(C) increase by $250
(D) decrease by $160
(E) increase by $1,000
FREE-RESPONSE QUESTIONS
1. Use the graph below to answer all parts of the questions that follow.
(G = government expenditure)
Multiplier Effect
Price Level
Real GDP
Change
in G Multiplier Effect
AD1
AD2
AD3
114 MACROECONOMICS: AP®
 EDITION
(a) Describe what causes the shift in aggregate demand between AD1
and AD2
.
(b) How is the multiplier between AD2
 and AD3
 determined?
(c) Aggregate demand (AD) shifts to the right in this graph. Explain
how the change in government expenditure (G) impacts real gross
domestic product (GDP).
(d) Both government expenditure and tax cuts affect aggregate demand
and GDP. Explain the primary difference in GDP impact between
the two expansionary policies.
(e) What effect would an increase in personal income taxes have on
AD3
? Explain.
THINK AS AN ECONOMIST: DETERMINE THE EFFECTS OF AN ECONOMIC
CHANGE USING CALCULATIONS
Economists use quantitative data and calculations to determine the effects of
a change in an economic situation. Government economists are no different.
They use data and calculations to try to estimate the effects of government
policy decisions. Doing so requires them to answer two questions:
• What variable in the situation changed?
• What effect will that change have on economic outcomes?
Of course, when government policy decisions involve the multiplier effect,
they have to take into account that the effect of a change extends beyond the
initial impact.
Apply the Skill
Suppose you are an economist in the governor’s office charged with the task of
determining the multiplier effect of a tax cut in the state income tax. Assume that
current output in the state due to the tax cut is $11 billion and potential output is $20
billion. Assume that the MPC in the state is 0.75. Calculate the minimum amount of a
tax cut that is necessary to close the gap.
Topic 3.3 Short-Run Aggregate Supply (SRAS) 115
Topic 3.3
Short-Run Aggregate Supply
(SRAS)
“In boom times companies have high profits. They increase production to
 satisfy demand for goods. This leads to excess supply. Companies cut
prices to compete for customers, leading to lower profits, lay-offs,
and economic depression. Eventually lower prices lead to an increase
in demand and profits go back up. The economy is a yo-yo.”
Niall Kishtainy, A Little History of Economics (2017)
Essential Question: How do employment and production costs affect
price and supply in the short run?
Jones Smart Supply Company makes hands-free smartphone holders for car
dashboards. Jones employs 400 workers and has been growing at a surprising
rate for the past four years—especially as more and more states have adopted
punitive laws against using smartphones while driving. But this year, with the
holiday season approaching, Jones has to pay more than double the amount for
a key component of its phone holder due to tariffs on China implemented by
the U.S. government. The socket component that makes Jones’s holders unique
will now cost the company $3 per unit (instead of $1). This higher per-unit cost
will markedly cut into Jones’s anticipated profit. The company is facing a shortrun supply issue. What can Jones do? Lay off workers and save on wages? Raise
their prices? Produce fewer hands-free holders? Which option is best?
Short-Run vs. Long-Run
Economists examine how the economy and its producers react to changes
differently depending on how much time the producers have to respond.
The term short-run does not necessarily mean “a short amount of time.” It
refers to the fact that producers have fixed and variable costs—like wages and
contracts—that limit their ability and flexibility to respond to market changes
to maintain their profits.
A spike in the price of oil, for example, makes producing almost everything
more expensive. Oil is used not only as a raw material to make products such as
plastics and many chemicals, but it provides most of the fuel for transporting
goods by truck, train, or plane. So, when oil prices increase, producers need
to make immediate adjustments if they want to maintain their same level of 
116 MACROECONOMICS: AP®
 EDITION
profitability. Reducing costs for raw materials or wages quickly can be very
hard (see explanation of “sticky wages” below). Hiking prices could make
products lose their attraction to consumers. Usually, the option that makes the
most sense in the short run is to decrease supply, creating what is known as a
short-run supply problem.
The term long-run, on the other hand, refers to a period of time when all
production and costs can be changed. Businesses looking at the long-run have
much more flexibility and ability to respond to expected or predicted changes.
(Short-run changes do not allow for such broad capabilities in reaction time.)
Concerns such as adding more employees or increasing warehousing space can
be planned for and inform long-run thinking about where the business will be
located. Improvements in production technology that can increase output and
lower costs are also long-run considerations.
The Short-Run Aggregate Supply Curve
Short-run aggregate supply (SRAS) refers to the total output (aggregate)
of goods and services (GDP) that exist in a period of time when production
costs can be considered fixed (and thus not easily and quickly changed).
The short-run aggregate supply curve shows the positive relationship
between an economy’s aggregate price level and the total quantity of final
goods and services (real GDP) supplied by producers—in the short run.
The SRAS curve slopes upward because higher aggregate prices lead to
higher profit for every unit produced. If the price for a certain product
rises, the producers will produce more products and might need to employ
more workers to do so. And as one might expect, a fall in the aggregate
price level will result in a decrease in the total quantity of aggregate output
(GDP).
The SRAS curve slopes upward
because higher demand for
products leads to higher profits
per product produced.
Short-Run Aggregate Supply Curve
Aggregate Price Level
Real GDP
SRAS
Nominal and Sticky Wages Businesses determine the profitability of
their products based on a simple formula:
Price per unit sold – Production costs per unit = Profit per unit
 Topic 3.3 Short-run aggregate supply (sras) 117
Some production costs are fixed, meaning they cannot be changed for
an extended period of time. For many businesses, the largest fixed cost is the
amount they pay their employees (wages, salaries, and benefits combined).
Nominal wages are the dollar amounts paid to employees, and they are not
easily changed. Some are set by contracts between workers and management
that have to be honored for a specified period of time.
Further, companies know that reducing wages risks losing valuable
employees and raising wages risks reducing profits that could go to owners.
Companies are also hesitant to change nominal wages because of their effect
on employee attitudes.
• If the economy is poor and sales are down, companies do not want to
create resentment from employees by cutting wages.
• If the economy is good and demand for labor is high, companies do not
want to create high expectations in employees by raising wages
Overall, when nominal wages are slow to rise or fall in response to changes
in the economy, they are referred to as sticky wages.
Note that sticky wages are not sticky forever. Even contracts and agreements
eventually have to be renegotiated and usually the new ones are based on
economic conditions. In 2019, the United Auto Workers Union (UAW) and
the big three automakers (Ford, GM, and Fiat Chrysler) negotiated a new
contract, which changed the wages for employees. From 2014 to 2019, the big
three automakers realized increased profits, but workers’ wages were stuck at
the agreed levels from the previous contract. The UAW was able to negotiate
higher wages and higher profit sharing for their union members, though it took
a 40-day work stoppage, or strike, against GM to settle the contract dispute with
the company. This new contract covered the next four years, which meant that
the automakers and UAW agreed what the nominal wages would be regardless
of whether the market for automobiles rose or dipped.
Changes in Pricing Pricing, or deciding how much a product costs, is
determined in part by the cost of elements that go into producing, marketing,
and delivering the product. Nominal price rigidity, or price stickiness, refers
to prices for goods and services that are fixed or not very flexible. For example,
a consumer’s phone service plan with a set monthly price for two years can be
considered fixed (or rigid). But after two years, that price can change. Luxury
brand goods are often priced more rigidly. Instead of dropping their prices to
meet reduced demand, these companies will opt to reduce total output and
maintain the sticky price. Changes in pricing are usually based on multiple
market considerations.
To think through the pricing process, consider a perfectly competitive
market, which exists only in theory. It would have certain elements:
• an unlimited number of buyers and sellers
• products that are identical (or can be easily substituted)
• companies that have no power to set prices
118 MACROECONOMICS: AP®
 EDITION
For example, if the aggregate price level falls, the price for an individual
good (like a hat) falls. But the company’s hat production output does not fall
by the same amount because the production costs are fixed. So, a drop in hat
prices means the profit per hat drops. The best the hat company can do is
reduce the quantity of hats they produce in the short run to try to respond
to the price drop. However, if the aggregate price level rises, the price for hats
rises. Remember, the company’s hat production costs remain fixed, so there is
no change in output costs for each hat even though the price per unit is rising.
In this case, the company would probably increase hat output in the short run.
An imperfectly competitive market is not just a theoretical idea; it is the
market producers and consumers encounter every day. It has more realistic
elements:
• competition for market share
• a wide variety of products
• prices that can be set by supply and demand or by the producers.
The term imperfect refers to the fact that these markets do not react and
respond like the ideal, or perfect, market. This means there can be benefits
for the consumers and producers, like price competition and improvements
in products. There can also be detrimental effects to the market: monopolies
(one seller) and oligopolies (few sellers) can develop in imperfect markets and
undermine the very idea of competition. Imperfect markets show how the
pricing process works differently from a perfectly competitive market.
For example, the hat company can choose to set its own price for their
hats based on production costs and their desired profit. If the hats are a hit
with consumers and fly off the shelves, the company can increase the price
and increase its output, which will increase the profit per unit. Economists
refer to this as pricing power. But if the aggregate price level falls and the hats
stop selling, the company can cut prices and slow production to offset the lost
demand and profits. In both situations, the company’s production costs remain
fixed.
Shifts in the SRAS Curve
As economists know so well, and as you have just read, stickiness occurs
because economies do not adjust instantaneously. The SRAS curve shows how
businesses respond to such stickiness. The SRAS curve is a graphic example
of the relationship between real production and price level. As the price level
increases, so does production. When price levels fall, production falls, too.
Movement along the SRAS curve occurs as a result of changes in the
relationship between aggregate price level and aggregate supply. However,
movement of the SRAS curve also occurs. This happens when the actions of
producers in an economy either increase (rightward shift) or decrease (leftward shift) aggregate supply at any price level. Several determinants can cause
these shifts. 
 Topic 3.3 Short-run aggregate supply (sras) 119
Changes in Input Cost Input costs are the prices of the resources needed
to produce a particular product. These costs include such things as materials,
labor, and energy.
An increase in input cost causes the SRAS curve to shift to the left
because it makes goods more expensive to produce. This can reduce profits.
When an input like the price of energy increases suddenly, for example, it
causes a decrease in aggregate supply and has a negative economic impact.
Unemployment may rise, inflation can increase, and the economy can contract
as production wanes.
On the other hand, the aggregate supply curve shifts rightward when
inputs fall and productivity increases. This creates the possibility of lower
unemployment, higher output, and lower inflation. When energy prices are
low, for example, the economy can expand, and unemployment and inflation
can decrease.
Energy prices are not the only key inputs that can shift the SRAS curve. A
change in the cost of raw materials used to produce other products, for example,
steel, lumber, plastic, or sugar, can also change the quantity of aggregate supply
at any price level, thereby shifting the SRAS curve.
Changes in Workplace Productivity Workplace productivity is also an
important factor affecting the SRAS curve. In economics, the term productivity
is a measure of how much a manufacturer can produce, also known as output,
with a given quantity of inputs. Workplace inputs include such things as labor
and technology.
When a positive change in inputs, such as the introduction of efficient
digital order-processing systems, increases workplace productivity, output
increases and the curve shifts to the right. That means at every price level, the
aggregate output supply increases. When a change in inputs results in decreased
workplace productivity, the curve shifts to the left.
Many things influence productivity, including better management
practices, new technology, and sustained labor actions, such as strikes.
Changes in Government Action Governments often intervene in
market economies. What they do or do not do can impact the SRAS curve.
Governments impact economies through a variety of laws, regulations, taxes,
and subsidies. New laws, revised regulations, higher taxes, and lower subsidies,
even if they prove worthwhile in the long run, can cause the SRAS curve to
shift to the left. The opposite occurs when governments change laws, decrease
regulations, lower taxes, and increase subsidies.
Inflationary Expectations Movement along the SRAS curve is also
dependent on inflationary expectations. When producers expect inflation to
rise, they foresee being able to sell their goods at a higher price. In response,
producers will increase supply, causing a shift of the SRAS curve to the right.
When deflation is expected, the opposite occurs.
120 MACROECONOMICS: AP®
 EDITION
KEY TERMS
short run
long run
short-run aggregate supply
(SRAS)
short-run aggregate supply
curve
profitability
nominal wages
sticky wages
nominal price rigidity
pricing power
MULTIPLE-CHOICE QUESTIONS
1. If a major disruption of worldwide oil supplies occurred, resulting
in 25- to 40-percent higher oil prices, how would it impact the SRAS
curve?
(A) The oil crisis would be offset by decreased wages and the SRAS
curve would remain stable.
(B) Prices on the SRAS curve would drop due to lack of consumer
demand.
(C) The SRAS curve would reflect the cost change by shifting to the left.
(D) Real GDP on the SRAS curve would be unaffected because goods
would still be needed.
(E) The SRAS curve would shift to the right due to increased aggregate
prices.
The SRAS curve shifts to the left (SRAS1) when there is a decrease in short-run aggregate
supply. The SRAS curve shifts to the right (SRAS2) when there is an increase in short-run
aggregate supply.
SRAS Curve Shifts
Price Level
Real GDP
SRAS
SRAS2
SRAS1
ANSWER THE TOPIC ESSENTIAL QUESTION
1. In one to three paragraphs, explain how employment and production
costs affect price and supply in the short run.
 Topic 3.3 Short-run aggregate supply (sras) 121
2. Which of the following would shift the short-run aggregate supply
curve to the right?
(A) An increase in business taxes
(B) A requirement for car manufacturers to retrofit their plants to be
able to include air-bags in new cars
(C) New legislation that requires all food and medicines to have
nutrition and warning labels
(D) New technology that replaces assembly-line workers with robots
(E) An increase in the price of lumber and steel
3. Which of the following would NOT shift aggregate supply to the right?
(A) A decrease in the price of oil
(B) Government reducing regulations on manufacturing
(C) Government easing requirements for citizenship
(D) Government increasing tax on manufacturers
(E) Farmers receiving a subsidy to raise cattle
FREE-RESPONSE QUESTIONS
1. Use the graph below, which depicts the SRAS during the Depression, to
answer all parts of the questions that follow.
Short-Run Aggregate Supply Curve
The Depression (1929-1933)
Y1 Y
PL1
PL
Aggregate Price Level
Real GDP (in billions of 2000 dollars)
1929
SRAS
1933
(a) Describe what happened to the aggregate price level between 1929
and 1933 and how it impacted consumers.
122 MACROECONOMICS: AP®
 EDITION
(b) How did real GDP respond to the change in aggregate price level
and why?
(c) Describe how this graph reflects the way deflation impacts an
imperfectly competitive market.
(d) What effect did the change in real GDP have on employment
numbers?
(e) What might producers have done between 1929 and 1933 to
respond to the fall in SRAS?
THINK AS AN ECONOMIST: DRAW AN ACCURATELY LABELED GRAPH TO
REPRESENT AN ECONOMIC MARKET
The aggregate supply curve generally slopes upward and to the right, as does an
individual firm’s or the market’s supply curve. The rationale is fundamental to
the law of supply: Firms are willing to produce more as price increases.
As with a market supply curve, the aggregate supply curve can shift to the
left or to the right when economic conditions change, and firms are willing
to produce more or less at any given price. In the short run, producers are
sensitive to certain changing market conditions. Changes in those conditions
can prompt short-run production decisions that affect the aggregate supply
curve.
Apply the Skill
One of the factors that affects the aggregate supply curve is cost of materials, which
can be affected by trade barriers if the materials are imported. You read earlier in the
topic about Jones Smart Supply Company, manufacturer of hands-free smartphone
holders for car dashboards. Jones saw the cost of a key component of its product triple
due to a tariff imposed by the United States on goods imported from China. Jones
Smart Supply was not the only company to see such an increase. Countless other
manufacturers saw the prices of their materials go up as well. The tariffs on Chinese
goods, then, had an effect on aggregate supply. Draw a graph that shows the general
shape of the short-run aggregate supply curve for the United States both before the
tariffs (labeled SRAS1) and after the tariff (SRAS2). You do not need to show specific
dollar values for the price of GDP figures for output. Just show the basic shape of the
two curves and indicate the direction of change.
Topic 3.4 Long-Run Aggregate Supply (LRAS) 123
Topic 3.4
Long-Run Aggregate Supply (LRAS)
“Of course, it is not the employer who pays wages. He only handles the
money. It is the product that pays wages and it is the management that
arranges the production so that the product may pay the wages.”
Henry Ford (1863–1947), founder of Ford Motors and
developer of assembly line production
Essential Question: How does the flexibility of the long run affect
pricing and production costs for businesses?
Two companies share the same office complex: Banner Plastics and Feldman
Textiles. Banner makes customized industrial fittings for use in large municipal
projects like replacing old city water and sewage pipes. Feldman is a textile
company that makes customized fabrics for airlines, airports, trains, and buses.
When the world price of oil skyrockets due to unrest in the Middle East, Banner
Plastics experiences severe impacts. It needs to make quick decisions about
reducing output to offset the increase in production costs. Feldman Textiles,
on the other hand, is relatively unaffected by the increase in world oil prices.
In fact, Feldman is about to invest half a million dollars in a new color-mixing
technology that will ultimately save it both labor and dye material costs.
This is the difference between the short run and long run: Banner Plastics
is limited because most of their production costs are rigid, or fixed, in the short
run, whereas Feldman Textiles is not limited by the short run and has more
flexibility to plan for technology changes that will reduce their production
costs in the long run.
The Long-Run Aggregate Supply Curve
Recall that in the short run, producers have fixed costs, such as wages and
contracts, that limit their ability and flexibility to respond to market changes
to maintain their profits. Long-run aggregate supply (LRAS), on the other
hand, refers to the timeframe when price levels, wages, and contracts can adjust
to the changes in the economy. Nominal wages and aggregate price levels are
not sticky in the long run. In fact, in the long run, aggregate price levels have
no effect on aggregate output (or real GDP). Feldman Textiles, in the example
above, can plan and implement technology upgrades to their production system
based on long-run expectations of output and wage costs that will ultimately
increase profits and reduce costs. The company is not restricted by short-run
fixed costs, and neither is their output.
124 MACROECONOMICS: AP®
 EDITION
Despite the fact that they both illustrate the connection between price
level and real GDP, the LRAS curve differs from the SRAS curve. The long run aggregate supply curve shows the relationship between aggregate
price level and the quantity of aggregate output that would exist if all costs,
including nominal wages, were completely flexible. The LRAS curve does not
actually curve—it is a vertical line. One reason the LRAS curve is vertical is
because changes in aggregate price levels have no effect on aggregate output
in the long run.
Imagine that the aggregate price level for goods in an economy falls by
20 percent, and all production costs, including wages, also fall by 20 percent.
What would happen to GDP in the long run? Nothing. Profits would drop by
20 percent but so would all of the output costs. So, businesses would maintain
their profit margins even with a large reduction in the aggregate price level.
The LRAS curve is a vertical
line because it represents
an economy’s output at
full employment (Yf
), so it
remains static in a graph.
Price Level
Long-Run Aggregate Supply Curve
LRAS
Yf
Aggregate Output or Real GDP
0
P3
P2
P1
Full-Employment, or Potential, Output Another reason the LRAS
curve is a vertical line is because it represents an economy’s full-employment
output (Yf
). This is also sometimes called maximum sustainable capacity or the
potential output—level of real GDP if all prices and wages were fully flexible
and used efficiently. Think of potential output as the ideal if an economy is
working on all cylinders. Of course, potential output is an ideal and can only
be estimated, like a prediction of how well the economy could perform. The
U.S government’s Congressional Budget Office (CBO) estimates the annual
potential output for federal budgetary analysis purposes. Because this potential
output is an estimate, real GDP will usually fall either below or above the
potential output line depending on how well the economy performs.
The difference between the full-employment output and real GDP is called
the output gap. Between 2000 and 2007, for example, the output gap was fairly
consistent, landing just above and just below the full-employment output
line. In 2008, when the financial crisis hit the U.S. and world economies, that
changed. In the graph on the following page, you can see the large dip in real
GDP and the wide output gap that remained through 2013.
 Topic 3.4 Long-run aggregate supply (lras) 125
Congressional Budget Office Annual Potential Output Estimates
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
15
14.5
14
13.5
13
12.5
12
11.5
11
10.5
Billions of Dollars
Potential Output vs. GDP
Full-Employment Output
Real GDP
Output
Gap
Full-employment output and real GDP are often closely aligned. The output gap widens greatly in 2008 as a
result of the financial crisis.
The vertical line of the LRAS, which represents the economy’s potential
output, tends to shift to the right—meaning it increases—over time because of
long-run factors:
• increases in physical capital
• increases in human capital
• technological progress
Unlike the SRAS curve, the LRAS curve has the benefit of time. It remains
a static vertical line because, in the long run, wages and prices fully adjust.
Short-Run to Long-Run Curve Shifts
An economy can be on both the SRAS and LRAS curves simultaneously. This
occurs when real GDP and potential output coincide (see the graph above for
years 2001, 2005, and 2007 for examples). The economy can be on the SRAS
curve during periods when the aggregate output does not match potential
output. But the SRAS will shift over time until the economy reaches a point
where both curves cross and aggregate output matches potential output. Wages
and other production costs have a large effect on these shifts. If the economy’s
SRAS real GDP is strong and exceeds the LRAS potential output, it means lots
of people are working and creating great numbers of goods. (This is akin to
maximum sustainable capacity.) This usually means unemployment is low and
competition for workers will cause a rise in nominal wages—which shifts the
SRAS to the left because now output costs have risen for producers.
The opposite process will cause the SRAS to shift rightward: When the
SRAS real GDP is weak and falls short of the LRAS potential output, fewer 
126 MACROECONOMICS: AP®
 EDITION
people are working, and fewer goods are being created. This usually results in
a lower need for workers, so unemployment rises, nominal wages fall, and the
SRAS curve shifts to the right. Note that when both the leftward and rightward
shifts occur, the aggregate price level does not change because it has no effect
on aggregate output.
SRAS Shifts and the LRAS Curve
A rise in
nominal wages
shifts SRAS
leftward.
Aggregate Price Level
Real GDP
SRAS2
SRAS1
LRAS
YP
A fall in
nominal wages
shifts SRAS
Aggregate Price Level
rightward.
Real GDP
SRAS1
SRAS2
LRAS
YP
The long-run aggregate supply curve (LRAS)—based on potential output
(YP
)—is unaffected by changes in aggregate price level. The short-run
aggregate supply (SRAS) curve shifts in response to real GDP and its relation
to potential output.
LRAS and the Production Possibilities Curve The long-run aggregate
supply curve and the production possibilities curve (PPC), which you learned
about in Topic 1.2, are related because they are two different ways of looking
at maximum sustainable capacity in an economy. The LRAS and PPC look at
total economic output if all resources are fully employed—but from different
perspectives.
COMPARING LRAS CURVES AND PPCS
Characteristic Long-Run Aggregate Supply
Curve Production Possibilities Curve
Assumptions Used
to Create
• Assumes all costs,
including nominal wages,
are completely flexible and
efficiently used
• Assumes goods and services
production is as efficient as
possible
Relationship
Portrayed
• Shows relationship
between aggregate price
level and the aggregate
output (real GDP) based on
potential output (YP)
• Shows the relationship between
two possible products based on
scarcity and opportunity
Value as a Baseline • Establishes a baseline for
measuring an economy’s
output (falling below,
matching, or exceeding the
baseline)
• Establishes a baseline for
measuring inefficient, efficient,
and unachievable production
 Topic 3.4 Long-run aggregate supply (lras) 127
The PPC can provide capacity information about two specific products,
whereas the LRAS provides capacity information about the total economy.
Supply and demand, opportunity, and scarcity are important measures that
economists use to understand the complex relationship among prices, wages,
and real GDP.
ANSWER THE TOPIC ESSENTIAL QUESTION
1. In one to three paragraphs, explain how the flexibility of the long run
affects pricing and production costs for businesses.
KEY TERMS
long-run aggregate supply (LRAS)
long-run aggregate supply curve
full-employment output
potential output
output gap
MULTIPLE-CHOICE QUESTIONS
1. Which best describes a primary reason the LRAS curve is a vertical line
in a graph?
(A) Because it represents where aggregate prices and real GDP intersect
(B) Because LRAS is tied to production costs, which remain static over
time
(C) Because variations in aggregate price levels have no effect on
aggregate output
(D) Because LRAS is the opposite of SRAS, which curves or slopes
based on economic conditions
(E) Because it represents full unemployment, which is estimated by the
CBO
2. Which of the following is a reason the LRAS will shift to the right over
time?
(A) rising commodity costs
(B) potential output is revised downward
(C) nominal wage increases
(D) advances in production technology
(E) actual GDP matches potential output
128 MACROECONOMICS: AP®
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3. In what ways are the production possibilities curve and long-run
aggregate supply related?
(A) Both show two different products.
(B) Both show the different time periods in an economy.
(C) Both show demand of one product over another.
(D) Both show supply of one product over another.
(E) Both show an economy that is using its resources to its fullest
capacity.
FREE-RESPONSE QUESTIONS
1. Use the graph below to answer all parts of the questions that follow. Price Level
AD
B
A
RGDP
LRAS SRAS
Ye Yf
PL
(a) Explain what the long-run aggregate supply curve represents in an
economy.
(b) Identify one factor that would create growth, shifting the LRAS
curve and explain how that would occur.
(c) Explain the difference between point A and point B.
(d) Explain what point A on the graph would above represent on a
production possibilities curve.
(e) Explain what point B on the graph above would represent on a
production possibilities curve.
 Topic 3.4 Long-run aggregate supply (lras) 129
THINK AS AN ECONOMIST: DESCRIBE ECONOMIC CONCEPTS
Economics has specialized concepts that economists use to explain economic
behavior. To do so, they take these steps:
• Define the concept.
• Explain how the concept relates to other concepts.
• Explain why the concept is important in the field of economics.
For example, economists define the multiplier effect as the way an increase
(or decrease) in one economic activity causes increases (or decreases) across
a range of other related economic activities. The multiplier effect is related to
gross domestic product (GDP) because increased consumer purchasing causes
increases in GDP. This is important because it helps explain the benefits of
income growth to an economy.
Apply the Skill
Economists use the long-run aggregate supply curve to explain the long-term effects
of producers’ decision-making about how much to produce. Define the concept and
explain both how it relates to potential output and why it is an important concept.
130 MACROECONOMICS: AP®
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Topic 3.5
Equilibrium in the AD-AS Model
“The equilibrium between supply and demand is achieved only through
a reaction against the upsetting of the equilibrium.”
British economist David Harvey, The Limits to Capital (1982)
Essential Question: How does the AD-AS model reflect the economic
fluctuations and production decisions that affect prices and GDP?
Running a small retail business is complicated. Managing employees and
carrying out the necessary day-to-day tasks are only part of the process.
Understanding clients’ needs, predicting trends, managing inventory, keeping
on top of the supply chain, reacting to changes in nominal costs and competitive
prices, ensuring product orders are shipped on time and material orders arrive
in time—it can be an exhausting balancing act to keep a business afloat. And
the goal is always to have your supply match your demand at a good price to
have a successful business.
Now imagine trying to get a handle on a national economy with very
similar variables and influences—but multiplied by millions of businesses.
Even understanding such a complex system is a prodigious challenge. As you
have learned, economists use a variety of tools and measurements to try to
understand the actions and reactions of an economy. The aggregate demand aggregate supply model is one of the essential tools used to understand the
complicated fluctuations in an economy.
Equilibrium and the AD-AS Model
In previous topics in this unit, you have encountered aggregate demand
(total demand for goods and services in an economy) and aggregate supply
(total output of goods and services in an economy). The aggregate demand aggregate supply model (AD-AS) combines aggregate demand data with
aggregate supply data. This allows economists and analysts to get an overview
of an economy by bringing together the key elements that affect it. Demand,
long- and short-run supply, prices, unemployment, and real GDP all coincide
in the AD-AS model. One can learn a lot about what has happened and what
may happen by analyzing this fundamental economic tool.
The word equilibrium refers to when two or more things are in balance.
In economics, equilibrium has a more specific definition: It is when market
supply and demand are balanced and prices are stable. This is not an easy or 
 Topic 3.5 Equilibrium in the ad-as model 131
usual state for an economy to attain, and even when economic equilibrium
does occur, it is fleeting. In simple supply and demand terms, there are actions
consumers and producers push the economy toward equilibrium. If
there is a shortage of goods, prices will rise; if there is a surplus of goods, prices
will drop. From the macroeconomic point of view, however, the AD-AS model
tells a more complicated story of the economy, with both long-run and short run implications.
Short-Run Macroeconomic Equilibrium
When an economy is at a point of short-run macroeconomic equilibrium,
it means the amount of aggregate output supplied by producers equals the
aggregate demand by consumers, businesses, and governments. (This is
marked on a graph with ESR). This would indicate that an economy’s price
levels are stable, with no major cost shifts to require short-run adjustments
for producers. This is called short-run equilibrium aggregate price level and
is represented on a graph by PE. This also indicates that employment is stable,
and unemployment is low because demand must be met consistently. This is
called short-run equilibrium aggregate output and appears on a graph as YE.
Where the aggregate demand (AD) and
short-run aggregate supply (SRAS) curves
intersect is considered the equilibrium point
(usually noted with ESR). The total aggregate
output (GDP) demanded by consumers and
businesses is equal to the output supplied.
The PE
 line marks the short-run aggregate
price level and the YE
 marks the short-run
equilibrium level of aggregate output.
The AD-AS Model
AD
SRAS
YE
PE
ESR
Aggregate Price Level
Real GDP
The AD-AS model will reflect market fluctuations just like the supply
and demand model you learned about earlier. (See Topics 1.4 and 1.5.) If
the aggregate price level is above the equilibrium point, the aggregate output
supplied by producers exceeds demand for goods—which leads to a drop in the
aggregate price level in an attempt to maintain equilibrium. The opposite holds
if the aggregate price level is below the equilibrium point: there is not enough
aggregate supply to meet demand and prices will rise.
Take the release of a new tech product such as a smartphone, for example.
The XeTek company releases a new style of smartphone with innovative
features and a very affordable price. It is a huge hit and consumers buy the new
phone in droves. Because the demand for the product exceeds XeTek’s supply,
the price will rise. That is just one company experiencing supply and demand
disequilibrium. The AD-AS model looks at the aggregate numbers for an entire
economy.
132 MACROECONOMICS: AP®
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Note that both aggregate output and aggregate prices trend upward. Very
few years in the past century experienced a fall in aggregate price level.
When aggregate demand
rises, the AD curve shifts to
the right and increases the
aggregate price level, creating
a new equilibrium point.
AD-AS Disequilibrium
AD1
AD2
AS
Y1 Y2
P1
P2
AD
Rises E1
E2
Aggregate Price Level
Real GDP
Long-run macroeconomic equilibrium occurs when the short-run
aggregate macroeconomic equilibrium intersects with the long-run aggregate
supply curve—essentially equaling potential output and full employment.
Long-run macroeconomic equilibrium assumes the passage of time so that the
economy is on both the LRAS and SRAS curves.
Short-Run Output Gaps
Recall that an economy can be on the short-run and/or long-run at varying
times. Short-run aggregate output fluctuates more frequently based on
economic activity. It can be at, above, or below the full-employment level of
output. When aggregate demand and pricing shift in the short-run, there can
be output gaps—differences between actual and potential output—that are
reflected in relation to the LRAS, or an economy’s potential output.
Inflationary Gap When aggregate demand for goods and services is
greater than aggregate supply, the economy has an inflationary gap. This can
develop when economic production levels are high due to low unemployment
and more consumer disposable income, robust trade with other countries, or
government purchases. Aggregate demand (AD) increases and the AD curve
shifts to the right, resulting in higher aggregate price levels and aggregate
output (GDP). Employment and nominal wages rise. This new aggregate
output level exceeds the LRAS curve, creating the inflationary gap. In the long run, aggregate supply, demand, output, and price levels will self-correct and
move toward long-run macroeconomic equilibrium.
Recessionary Gap When an economy is operating below full employment
equilibrium it has a recessionary gap. Because demand is down, unemployment
will rise and prices will drop. Producers responding to this recessionary gap 
 Topic 3.5 Equilibrium in the ad-as model 133
will make changes in production costs, wait until they can adjust the sticky
nominal wages, and ultimately increase output. Over time, the SRAS curve
will begin to shift back to the right until it again reaches the equilibrium point
where the SRAS and LRAS curves intersect with a new AD point.
This graph depicts what happens
to aggregate supply, demand,
output, and price levels in the
short- and long-run when there
is a recessionary gap. Note that an
inflationary gap (indicated as Y3
on the horizontal axis) would be
represented by the same source
lines (LRAS, SRAS, AD) but all
moving in the opposite direction
(rightward instead of leftward).
Output Gaps
AD2
AD1
E3
E1
E2
SRAS Inflationary
Recessionary
LRAS
Y1
Recessionary Gap
Y2 Y3
P1
P2
PS
Inflationary Gap
Negative
Demand
Shock
Potential Output
Aggregate Price Level
Real GDP
ANSWER THE TOPIC ESSENTIAL QUESTION
1. In one to three paragraphs, explain how the AD-AS model is used as
a tool to reflect economic fluctuations and production decisions that
affect prices and GDP.
MULTIPLE-CHOICE QUESTIONS
1. Which must be at the same levels to attain short-run macroeconomic
equilibrium?
(A) real GDP and potential output
(B) the SRAS curve and the LRAS curve
(C) aggregate output and demand for goods and services
(D) price levels and aggregate output
(E) aggregate supply and potential price levels
KEY TERMS
aggregate demand
aggregate supply
aggregate demand-aggregate supply
model (AD-AS)
equilibrium
short-run macroeconomic equilibrium
short-run equilibrium aggregate price level
short-run equilibrium aggregate output
long-run macroeconomic equilibrium
output gap
134 MACROECONOMICS: AP®
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2. If price level is above long-run equilibrium, what must happen to help
price levels return to long-run equilibrium?
(A) Real GDP must decrease in the short run.
(B) Long-run supply estimates must reduce.
(C) Production costs must be adjusted upward.
(D) Tax rates must be increased to reduce AD.
(E) Tax rates must be decreased to increase AD.
3. Assuming an economy is in a recession, if the aggregate supply curve
increases (shifts to the right), which of the following would occur?
Price Level Real Output
(A) Increase Decrease
(B) Increase Remain the same
(C) Decrease Remain the same
(D) Decrease Increase
(E) Decrease Decrease
FREE-RESPONSE QUESTIONS
1. Assume the federal government institutes a large stimulus program
for infrastructure repair. Use the graph below to answer all parts of the
questions that follow. Inflation
Demand Shock and AD-AS Model
AD1 AD
Real GDP
SRAS
Y1 Y
P1
P
 Topic 3.5 Equilibrium in the ad-as model 135
(a) In what direction would this stimulus shift aggregate demand?
Explain.
(b) What would the effect of the above shift have on real output and
price level?
(c) How would employment be affected by this stimulus program?
(d) What might be a potential long-run pitfall of this stimulus
program?
(e) Assume a devastating crash of the stock market occurred. How
would the economy respond to such a massive negative demand
shock? Draw a graph (or use the one above) that shows the shifts in
aggregate demand, real GDP, aggregate pricing, and the short-run
aggregate supply curve. Remember to use arrows to indicate these
changes.
THINK AS AN ECONOMIST: DRAW AN ACCURATELY LABELED GRAPH TO
REPRESENT AN ECONOMIC MARKET
The aggregate supply curve generally slopes upward and to the right, as does an
individual firm’s or the market’s supply curve. The rationale is fundamental to
the law of supply—firms are willing to produce more as price increases.
As you know, the aggregate demand and aggregate supply curves can shift
in response to economic conditions. These shifts happen in the short run. In
the long run, both AD and AS tend toward a new equilibrium point.
Apply the Skill
Study the graph below. Write a brief explanation of what dynamic is taking place and
what the three arrows on the graph represent. Price Level
Real GDP per year
AD2 AD1
SRAS2 SRAS1
LRAS
Yp Y2
P3
P2
P1
136 MACROECONOMICS: AP®
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Topic 3.6
Changes in the AD-AS Model
in the Short Run
“Supply and demand always uses prices and profits to signal to producers
what society required. Thus producers, in search of profit, produce what
society requires—in the correct quantity and at a competitive price.”
Scottish economist Adam Smith, The Wealth of Nations (1776)
Essential Question: How do shocks to supply and demand impact
employment, prices, and output in the short run?
Whenever a major world event takes place, economies around the globe
experience effects and respond to such large events. Devastating earthquakes,
terrorist attacks, technological innovations, a crisis in the oil market, even
major government spending plans can all cause shocks to economies. How
a shock impacts an economy depends on the state of the economy when the
shock occurs. There can be demand shocks and supply shocks, and both of
these can be either negative or positive. Whichever way they break, shocks to
an economic system result in short-run consequences.
Aggregate Demand Shocks
An aggregate demand shock is an unforeseen event or occurrence that causes
an increase or decrease in demand for goods and services. It can be either
positive or negative.
Positive Demand Shock An increase in aggregate demand, represented by
a shift of the aggregate demand curve to the right, is a positive demand shock.
In the late 1990s, a technology revolution spurred a positive demand shock.
The rise of the Internet and portable computing caused a spike in demand for
related goods and services. The effect of this rippled through the economy,
resulting in rising prices, increased output, and lower unemployment.
Some positive demand shocks are intentional by the government as a
response to an economic downturn. Examples include large government tax
cuts and sudden decreases in interest rates on loans.
Producers respond by supplying more, which often requires increased
hiring and paying higher wages. This can create general economic growth,
although it can also lead to inflation.
 Topic 3.6 Changes in the ad-as model in the short run 137
Negative Demand Shock A decrease in aggregate demand, represented
by a shift of the aggregate demand curve to the left, is a negative demand
shock. Examples include events that cause enough fear or uncertainty among
consumers that they decide to purchase less and save more and events that
reduce employment. For example, a high-profile terrorist attack can cause
a decline in aggregate demand. In 2020, to slow the spread of the COVID19 outbreak, people stayed at home, dramatically reducing their overall
consumption. Some acted out of uncertainty, but many had to cut back on
expenditures because they had lost their income.
Producers have to make choices about how to respond to the decrease in
demand. Because nominal wages are sticky, production costs are primarily
reduced by decreasing output, which can lead to a decrease in prices, too.
The negative demand shock
shifts the aggregate demand
(AD) curve to the left. This leads
to a decrease in both aggregate
prices and aggregate output.
P1
P2
Aggregate Price Level
Real GDP
AD1 AD2
SRAS
Y2 Y1
Negative
Demand Shock
E1
E2
Changes in the AD-AS Model in the Short-Run
Short-Run Aggregate Supply Shock
A supply shock is when something unforeseen quickly and dramatically
changes product supply levels. Like demand shocks, supply shocks can be
positive or negative. A positive supply shock creates increased aggregate
supply; a negative supply shock results in lower aggregate supply. But unlike
demand shocks, supply shocks cause aggregate output (GDP) and aggregate
price levels to move in opposite directions—no matter whether the shock is
positive or negative.
Positive Supply Shock A positive supply shock, like the tech boom in
the United States in the late 1990s, is distinguished by a number of economic
shifts:
• Production costs decrease.
• Output quantities increase.
• Aggregate price levels adjust downward.
This kind of supply shock shifts the SRAS curve to the right. Employment
rises as well because producers generally need more workers to increase supply.
138 MACROECONOMICS: AP®
 EDITION
Negative Supply Shock A negative supply shock, such as a hurricane or
earthquake or the economic crisis in 2008, affects the short run in the opposite
direction:
• Production costs increase.
• Output quantities decrease.
• Aggregate price levels adjust upward.
This supply shock shifts the SRAS curve to the left. Unemployment can
also rise because supply decreases (though sticky nominal wages and contracts
mitigate severe drops in unemployment). Historically, shocks to the AS model
tend to be negative.
Stagflation One form of negative supply shock has a special name:
stagflation. This occurs when inflation meets decreasing aggregate output
(stagnation + inflation). Unemployment also rises. This is a particularly
difficult negative shock for an economy or government to respond to. The most
recent experience of stagflation hit the U.S. economy hard in 1973. Middle East
oil-producing countries put an embargo, or ban, in place for many Western
nations like the United States. This sudden supply shock—oil prices increased
about 400 percent in a few months—exploded the global price of oil, which
increased the costs to produce and transport goods and services. Aggregate
output began to decrease, but aggregate prices began to rise. Add an increase
in unemployment from producer layoffs, and you can see how stagflation
becomes a very difficult downward spiral (or curve shift) to turn around.
Stagflation means aggregate
output falls and aggregate
price levels increase.
Unemployment also rises
when this occurs.
P2
P1
Aggregate Price Level
Real GDP
AD
SRAS2
Y2 Y1
Negative
Demand
Shock
Lower GDP
and higher
aggregate
prices
E1
E2
SRAS1
Changes in the AD-AS Model in the Short-Run/Stagflation
Types of Inflation
Inflation measures the rate at which the aggregate price levels in an economy
increase over time. Economists gauge inflation because it’s an indication
of consumer purchasing power. Some inflation is believed to be needed to
contribute to economic growth. There are, however, different forms of inflation. 
 Topic 3.6 Changes in the ad-as model in the short run 139
Demand-Pull Inflation This occurs when aggregate prices rise in
response to a supply shortage. This is the most common and well-known cause
of inflation. It is common on a microeconomic level: a hot new product comes
out, consumers go crazy for it, it becomes hard to get, and the price goes up.
At the macroeconomic level, several widespread developments in an
economy can cause demand-pull inflation:
• Economic growth Confident consumers spend more money and use
more debt.
• Export surge If the value of exports increases relative to the value of
imports, more money will be entering the domestic economy.
• Government spending More federal spending on big projects means
more goods and services demand.
• Inflation expectations If inflation is expected to rise, companies may
hike up prices and consumers may make major purchases before prices
rise.
• More money in the system If governments increase the money supply
but output cannot keep up with demand, prices will increase.
An example of demand-pull inflation would be if the U.S. government
instituted a special tax-credit incentive to get people to buy electric cars and
the program was a massive success. If automakers could not keep up with the
extreme demand, the price of the most popular models would spike, resulting
in higher aggregate prices for the cars.
One of the most famous and extreme examples of demand-pull inflation
occurred in Germany after World War I ended in 1918. Production collapsed
in the postwar economy, and the government, saddled with enormous debts,
responded by printing more and more money. This combination—so much
cash and so few available goods—produced not just regular inflation, but
hyperinflation. For a while, the price of common items doubled every 3.7 days.
Bundles of the worthless currency were used as building blocks by children
and as kindling for making fires.
Cost-Push Inflation This is a supply issue that results in higher prices for
consumers. Unlike demand-pull inflation, cost-push inflation occurs when the
cost of materials and wages increases. The higher costs for production reduce
aggregate supply even though demand for goods remains constant, so the
higher production costs get passed on to consumers. There are a variety of
supply changes that can cause cost-push inflation:
• The cost of raw materials increases.
• Wages and associated labor costs increase.
• Natural hazards affect production facilities.
• Changes in government regulations occur.
140 MACROECONOMICS: AP®
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All of these cause production cost increases to which producers respond
with price increases in order to maintain profitability. An example of a material
cost increase is when coffee prices spiked between 2001 and 2006. The aggregate
price per pound rose from 50 cents to $1.60, so coffee retailers passed along
the cost increase to their customers. In 2009, Japan was hit by a magnitude
9 earthquake and tsunami that devastated cities where large semiconductor
production plants were located. Japan accounted for 20 percent of the world’s
semiconductor supply. Because so many facilities were damaged—and
semiconductor supply dropped—the price for electronics such as smartphones,
TVs, medical equipment, and even washing machines increased.
Source: Library of Congress
Gas line in the 1970s caused by the shortage of oil and rising gas prices as a result of the OPEC
embargo.
A dramatic example of cost-push inflation occurred in the 1970s when the
Organization of Petroleum Exporting Countries (OPEC), an oil-producing
cartel of member nations, imposed an oil embargo on the United States and
other Western countries. Despite the fact that there was no increase in demand,
the supply restrictions caused oil prices to quadruple. Gas prices skyrocketed,
jumping by 37 percent in 1973 alone, and consumers waited in long lines to fill
their cars’ tanks. In an attempt to shorten lines and head off panic buying, some
U.S. states enacted odd-even rationing. Vehicles with license plates ending in
an odd number could only buy gas on odd-numbered days. 
 Topic 3.6 Changes in the ad-as model in the short run 141
MULTIPLE-CHOICE QUESTIONS
1. If there is a positive demand shock, which best describes how aggregate
price levels react?
(A) Aggregate price levels will remain generally static.
(B) Aggregate price levels are not affected by demand shocks.
(C) Aggregate price levels will likely rise due to scarcity.
(D) Aggregate price levels respond based only on supply levels.
(E) Aggregate price levels will drop due to much higher demand.
2. Which does NOT contribute to demand-pull inflation?
(A) Growth in GDP
(B) Increased exports
(C) Expectation of rising prices
(D) Increase in workers’ wages
(E) Federal spending programs
3. A supply shock, such as a severe drought, would lead to
(A) a decrease in price level and an increase in employment
(B) a decrease in price level and an increase in unemployment
(C) an increase in price level and an increase in employment
(D) an increase in price level and an increase in unemployment
(E) an increase in price level and an increase in real wages
KEY TERMS
aggregate demand shock
positive demand shock
negative demand shock
negative supply shock
positive supply shock
stagflation
ANSWER THE TOPIC ESSENTIAL QUESTION
1. In one to three paragraphs, explain how positive and negative shocks to
both supply and demand impact employment, prices, and output in the
short run.
142 MACROECONOMICS: AP®
 EDITION
FREE-RESPONSE QUESTIONS
1. Use the graph below to answer all parts of the questions that follow. For
these questions, one does not build upon the others. Aggregate Price Level PE
LRAS
AD
SRAS
Yf
Real GDP
LRAS and the AD-AS Model
(a) What would be the short-run effect of a negative shock like the
government passing a large increase in the minimum wage?
(b) If a solar panel company can no longer import necessary materials
from China because of a trade war, what kind of inflation would
likely occur? How will that affect the aggregate price levels?
(c) Draw a graph that represents the effect the trade war would have on
this economy.
(d) How would the graph change if the federal government implements
measures such as a large tax increase and a severe cut in nonmilitary spending?
(e) Assume farmers across the world experience remarkably moderate
temperatures and ideal precipitation. The yield on the four primary
crops—corn, rice, wheat, and potatoes—is nearly 50 percent higher
than customary and anticipated. What will be the short-run effect
on aggregate price levels and aggregate output? 
 Topic 3.6 Changes in the ad-as model in the short run 143
THINK AS AN ECONOMIST: DEMONSTRATE THE EFFECT OF A CHANGE
IN AN ECONOMIC SITUATION ON AN ACCURATELY LABELED GRAPH
Economists can demonstrate the effects of a change by using accurately labeled
graphs. Two common types of graphs used to display data are bar graphs and
line graphs. Each type is better suited to displaying particular kinds of data.
• Bar graphs are best suited to comparing data points at specific points
in time or in different locations.
• Line graphs are useful for showing trends over time.
Each type of graph plots data against the horizontal x-axis and the vertical
y-axis. With a bar graph, the y-axis is typically the quantity being measured.
The x-axis is used to plot the different points in time or places being compared.
With a line graph, the y-axis is the quantity measured, and the x-axis is the
period of time covered by the graph. A simple bar graph might look like this:
For an example of a line graph, see the graph showing changes in the
components of the Consumer Price Index (CPI) from 2000 to 2017 in Topic 2.5.
Apply the Skill
The chart below shows the inflation rate each year in the 1970s. Use the data to
construct a graph that emphasizes the change over time.
0
5%
10%
15%
20%
25%
Unemployment Rate in Major U.S. Contractions
Percent Unemployed
Real GDP
Great Depression
(1933)
Postwar Bust
(1946)
Stagflation
(1975)
Oil Crisis
(1980)
Great Recession
(2009)
1970 1971 1972 1973 1974 1975 1976 1977 1978 1979
5.6% 3.3% 3.4% 8.7% 12.3% 6.9% 5.8% 6.7% 9.0% 13.3%
144 MACROECONOMICS: AP®
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Topic 3.7
Long-Run Self-Adjustment
“This long run is a misleading guide to current affairs. In the long run
we are all dead. Economists set themselves too easy, too useless
a task if in tempestuous seasons they can only tell us that when
the storm is past the ocean is flat again.”
British economist John Maynard Keynes, A Tract on Monetary Reform (1923)
Essential Question: In the long run, how does the economy adjust to
supply and demand shocks in order to return to full employment and
economic growth?
Problems that were urgent and seemed devastating often look much less
daunting after time has passed. Consumers, businesses, and governments keep
an eye on the long run, but it’s the more immediate, short-run problems and
obstacles that generally demand the greatest attention and effort. The same
applies to how people behave in economic situations: they focus on the short
run. As Keynes famously noted, the long-run view is not always useful in helping
people in their dynamic interaction with the immediacy of the economy.
Long-Run Equilibrium
Recall that the long run assumes a passage of time. Some economists suggest a
decade or more needs to pass for long-run corrections to take place. Long-run
equilibrium occurs when the point of short-run equilibrium intersects with
the long-run aggregate supply curve. This means short-run aggregate output
is equal to potential output (the LRAS line on graphs). In the long run, the
economy is self-correcting, and shifts in the long-run aggregate supply curve
indicate changes in the full-employment level of output and economic growth
over time.
When short-run demand shocks occur, the long run reflects the outcomes
of those shocks based on how consumers, businesses, and governments
responded. Wages, prices, and employment levels will adjust to their natural
rates after a short-run aggregate demand or supply shock passes.
LRAS and Aggregate Demand Shocks Unlike the short-run perspective,
in the long run, all elements of production and its costs (materials, labor) are
variable. Aggregate demand and GDP are essentially the same. The vertical
long-run aggregate supply (LRAS) curve on a graph is a straight line because 
 Topic 3.7 Long-run self-adjustment 145
changes in aggregate price levels have no effect on aggregate output in the long
run. And the LRAS curve represents the economy’s potential output—the GDP
level if all prices and wages were fully flexible, resources were used efficiently,
and the economy was at full employment output.
So, what happens to the LRAS curve when there is a positive aggregate
demand shock—for example, an unexpected decrease in interest rates by the
Federal Reserve? The aggregate demand (AD) will shift to the right because
of increased demand, and the SRAS curve will shift to the left because supply
cannot keep pace with demand in the short run. Aggregate demand (AD)
will shift to the right in response to increased demand from the increased
government expenditures. Price levels will rise, and GDP will exceed potential
output—the LRAS curve—and create an inflationary gap.
The inflationary gap results in higher real GDP and higher price levels
and would decrease unemployment below the natural rate of unemployment.
The higher price levels reduce the real wages of workers who begin to demand
higher nominal wages to offset the higher prices. This increases the costs of
production, shifting the SRAS to the left, reducing the real GDP back to the
LRAS and increasing unemployment back to the natural rate of unemployment.
At this point long-run equilibrium is restored.
LRAS and Positive Demand Shock
AD2
AD1
E1
SRAS2
SRAS1
LRAS
Y1
Potential Output Inflationary Gap
Y2
P3
P2
P1
Positive
Demand
Shock
E2
E3
Aggregate Price Level
Real GDP
A positive aggregate demand shock shifts SRAS and AD in opposite directions
and exceeds potential output (GDP). This inflationary gap will eventually
self-correct, and potential output, AD, and SRAS will meet LRAS for a new
equilibrium point.
If a negative demand shock occurs, something like a pandemic or a terror
attack, the opposite of what’s depicted in the graph will happen. Aggregate
output and prices will fall in the short-run. Unemployment will rise as well.
This is called a recessionary gap, and GDP falls short of the LRAS, or potential 
146 MACROECONOMICS: AP®
 EDITION
output. But this will self-correct over time. Real GDP, employment, and price
levels will adjust back to a new LRAS point to attain equilibrium.
LRAS and Aggregate Supply Shocks More time and study is given to
aggregate demand shocks than aggregate supply shocks because supply shocks
that affect the entire economy are comparatively rare. But when supply shocks
hit, they tend to be harsh, especially regarding employment numbers.
• In 1973, the Arab-Israeli War resulted in an oil embargo initiated by
OPEC (the Organization of Petroleum Exporting Countries) against
countries OPEC believed supported Israel. This, in turn, led to an
increase in oil prices and an unemployment rate near 10 percent.
• In 1979, the Iranian revolution and hostage crisis resulted in another
decrease in oil supply. This and the fear of further supply interruptions
spiked oil prices again; unemployment neared 12 percent.
Shaded areas indicate U.S recessions
1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014
12
11
10
9
8
7
6
5
4
3
2
Percent
U.S. Unemployment 1970-2014
The grey shaded areas indicate recessionary periods. In each recessionary period,
unemployment tends to rise slightly. Note the spike in unemployment that
immediately followed a supply shock to the economy in 1973 and 1979.
The 2008 financial and housing crises were a combination of both supply
and demand shocks, but you can see that the recessionary effect of an aggregate
supply shock has a more devastating effect on unemployment than short-run
aggregate demand shocks. There are a few damaging things happening at once
with a supply shock: aggregate output is falling, unemployment is rising, and
prices are going up.
Policy makers can use fiscal and monetary policies to try to get aggregate
demand back on track (see Topics 3.8, 4.6, and 5.1). But there are fewer
policy options to shift the short-run aggregate supply curve to its original
position. Increasing government stimulus to increase aggregate demand and
slow down rising unemployment will reduce aggregate output at the risk of
causing inflation. Decreasing stimulus to reduce aggregate demand may rein
in inflation, but it risks causing higher unemployment. Like all economic
decisions, either option offers a tradeoff. 
 Topic 3.7 Long-run self-adjustment 147
MULTIPLE-CHOICE QUESTIONS
1. Assuming a negative supply shock, in which of the following ways could
the economy self-adjust and be restored to full employment?
(A) The government could decrease spending.
(B) The federal reserve could lower interest rates.
(C) The government could institute new regulations for manufacturers.
(D) Citizens could accept lower wages.
(E) Citizens could ask for higher wages.
2. How do supply shocks differ from demand shocks regarding GDP and
price levels?
(A) Demand shocks cause prices and GDP to decrease sharply.
(B) Demand shocks affect prices and GDP in opposite directions.
(C) Supply shocks only impact prices and not GDP.
(D) Supply shocks move prices and GDP in opposite directions.
(E) Supply shocks cause prices and GDP to drop severely.
3. What do shifts in the long-run aggregate supply curve indicate?
(A) Economic growth
(B) Falling price levels
(C) Rising producer costs
(D) Stable nominal wages
(E) GDP fluctuations over time
KEY TERMS
long-run equilibrium long-run aggregate supply
ANSWER THE TOPIC ESSENTIAL QUESTION
1. In one to three paragraphs, explain how the long run adjusts to
supply and demand shocks in order to return to full employment and
economic growth.
148 MACROECONOMICS: AP®
 EDITION
FREE-RESPONSE QUESTIONS
1. Assume there has been a negative demand shock to the economy. Use
the graph below to answer all parts of the questions that follow.
Negative Demand Shock and the LRAS
AD2
AD1
E2
E1
SRAS2
SRAS1 LRAS
E3
Y2 Y1
P1
P2
PS
Potential Output
Aggregate Price Level
Real GDP
(a) What does the shift from AD1
 to AD2
 signify?
(b) What happens to employment numbers when aggregate demand
shifts due to a negative demand shock?
(c) What is the short-run impact of lower aggregate demand on price
levels? Explain.
(d) Describe what must happen once a recessionary gap occurs for the
SRAS curve to shift rightward to establish a new equilibrium point
(E3
 in the graph).
(e) Assume there is a positive demand shock to the economy. Re-label
this graph to show how AD and SRAS shift and how prices are
affected. (Be sure to denote which way curves shift and mark the
equilibrium points.)
 Topic 3.7 Long-run self-adjustment 149
THINK AS AN ECONOMIST: DETERMINE THE OUTCOME OF AN ECONOMIC
SITUATION USING ECONOMIC MODELS
Economists use models to analyze markets and explain the outcomes of
economic situations. For example, economists note that market forces push
a market toward equilibrium. When disequilibrium occurs, producers and
consumers change their behavior until supply and demand meet at the market
price again. This is true both on the microeconomic level, regarding individual
firms and industries, and on the macroeconomic level, in terms of aggregate
supply and demand.
Apply the Skill
Economists identify two reasons that disequilibrium occurs in the aggregate demandaggregate supply (AD-AS) model. They are demand shocks and supply shocks. In
2020, the U.S. economy was jolted by the economic ramifications of the COVID-19,
or coronavirus, pandemic. Mayors and state governors ordered the forced closing of
most places of business except those providing essential services. Employers had to
send most or all of their employees to work at home—when such work was possible.
Economic life for many Americans and U.S. firms came to a virtual standstill.
What kind of shock to the economy was the COVID-19 pandemic? Was it a positive or
negative demand shock or a positive or negative supply shock? Identify the type and
explain your reasoning based on the AD-AS model.
150 MACROECONOMICS: AP®
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Topic 3.8
Fiscal Policy
“The great thing about fiscal policy is that it has a direct impact and does
not require you to bind the hands of future policy makers.”
American economist and Nobel Laureate Paul Krugman (May 2012)
Essential Question: How do government fiscal policies involving
spending and taxation affect demand, GDP, and employment?
The biggest players in a nation’s economy are the consumers and businesses
that purchase and produce goods and services. The next biggest player is the
federal government, which can impact the economy positively or negatively
through laws, regulations, taxes, spending, and adjustments to the money
supply. Sharp disagreements over government economic policies fuel political
debates. Since the beginning of modern industrialization in the mid-18th
century, governments have played an important role in economies, and the role
has generally expanded. It is through fiscal policies that governments respond
to developments in the national economy.
Government Fiscal Policies
Fiscal policy refers to the changes in spending and taxes governments make to
affect overall spending. Modern fiscal policy was greatly influenced by British
economist John Maynard Keynes, whose ideas about government evolved in
the early 1900s and then sharpened in reaction to the Great Depression of the
1930s. Before Keynes, most economists believed that economies were selfcorrecting. The Great Depression proved to many that a hands-off approach
was not sufficient. Or, even if in theory the economy would correct in the long
run, the short-term suffering in unemployment and reduced consumption was
not a good tradeoff.
Keynes believed governments could help stabilize an economy by
implementing fiscal policies based primarily on spending and taxation that
reduced dramatic ups and downs. The usefulness of his ideas was demonstrated
by the New Deal legislation passed under President Franklin Delano Roosevelt
in the United States and by similar efforts in other countries. They became
more influential in Europe and the United States after World War II, when
these regions experienced almost three decades of economic growth.
Some fiscal policies are ways the government handles complicated needs and
services for the public—national defense and social insurance, for example—that 
 Topic 3.8 Fiscal policy 151
do not necessarily involve a return of goods and services. Other fiscal policies
are meant to be a stimulus to the economy. In 2009, after the 2008 financial crisis
known as the “Great Recession,” the economy was reeling and unemployment
was approaching 10 percent. The Obama administration’s American Recovery
Act of 2009 was an $800 billion stimulus package that spent money to create jobs
and provided tax relief for citizens and businesses. By the end of 2009, GDP was
on the uptick. In 2010, unemployment stopped rising and began to slowly drop.
Taxation and Expenditures Governments collect taxes to pay for the
goods and services that citizens want. About half of all government revenue
goes directly to state and local governments. These taxes vary from place to
place but often include income taxes, sales taxes, and property taxes. Many
people pay more in these taxes than they pay to the federal government.
The other half of government revenue goes to the federal government,
mostly in one of three forms:
• personal income taxes
• corporate profit taxes
• social insurance fees for programs such as Social Security, Medicare,
and Medicaid
In some statistics, payments for social insurance programs are not figured
as part of taxes. These fees are dedicated to particular programs, so they are not
available for general expenditures. Most people pay more for these programs
than they pay in federal income taxes.
Federal spending falls into two broad categories:
• Mandatory spending/transfers These are programs that must be paid
for with no goods or services in return. This is the biggest chunk of
the total federal spending (62 percent in 2018). These include social
insurance programs such as Social Security, Medicare, and Medicaid.
These are also called entitlements, though the name is misleading as
taxpayers pay into these programs via social insurance fees throughout
their working life.
• Discretionary spending This spending results from legislation or
policies that are not mandatory. Discretionary spending makes up
31 percent of 2018 federal spending. Every year, Congress must
approve and decide discretionary spending limits on national defense,
education, highway funds, aid to foreign countries, and so on.
Fiscal Policy as Stimulus
Economies run in cycles. They grow and expand with low unemployment, high
wages, and a lot of buying power for consumers and businesses. Economies also
contract, when unemployment rises, GDP dips, and wages and prices stagnate
or fall. Fiscal policy is intended to moderate downturns in the economy (like
recessions) and aid in continuing expansion. 
152 MACROECONOMICS: AP®
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Changes in government spending have a direct effect on aggregate demand
and purchasing. If the federal government spends billions on a national
highway improvement program, GDP will rise and unemployment will begin
to fall because of the increased short-run demand. If the government makes a
change in tax policy—like an across-the-board cut in federal income tax—it
will also impact aggregate demand, but not as directly and as successfully as
spending does.
There is always a lag associated with discretionary stimulus spending by
governments because once Congress approves a program, it takes some time to
implement the policies and allow the effects of the stimulus to take effect. But
as you can see in the AD-AS model graph, an influx of federal money increases
demand for goods, which increases the quantity supplied of goods needed and
causes a rise in price levels. As you might expect, unemployment will drop
because more workers are needed.
Though there may be a lag between
when a federal stimulus plan is
enacted by Congress and when its
effects are realized in the economy,
fiscal stimulus spending generates
an increase in aggregate demand.
Price Level
Federal Stimulus and the AD-AS Model
AD1 AD2
AS
Real Output
Aggregate Demand Increases
Q1
0 Q2
P1 P2
Multiplier Effect and Fiscal Stimulus Policy One reason fiscal spending
and transfer policies are so effective is because of the multiplier effect (covered
in Topic 3.2). Recall that when governments spend money on goods and
services, a chain reaction throughout the economy is created. Depending on
peoples’ marginal propensity to consume (MPC) and marginal propensity to
save (MPS), every dollar of stimulus will lead to a certain amount of additional
spending. For example, if the multiplier is 2, it means for every $1 of federal
spending, an additional $2 dollars will be spent—which increases demand and
GDP.
Imagine a $50 billion federal program to replace lead water pipes running
to homes and businesses. People want to replace these pipes because they
can cause lead poisoning, which particularly harms young children. With a
multiplier of 2, that initial federal outlay will end up increasing real GDP by
$100 billion because of the multiplier effect. As the table below shows, the
first round of initial federal spending is $50 billion—that reflects the direct 
 Topic 3.8 Fiscal policy 153
purchases of goods and services by the government. That money allows workers
to buy more goods and services—everything from lunch to equipment to new
clothes to entertainment. Each subsequent round of spending by consumers
and businesses adds more to the total effect on GDP. Because consumers will
save some portion of their increased income (MPS), the effect of the stimulus
is lower with each round of spending. But in this case, it ultimately results in
double the initial amount spent by the federal government—which fuels GDP
and economic growth.
Spending Effect on Real GDP $50 Billion in Federal Purchases
for Lead Pipe Replacement Program
1st round $50.0 billion
2nd round $25.0 billion
3rd round $12.5 billion
. . . . . . . .
. . . . . . . .
Eventual effect $100.0 billion
Multiplier Effect and Taxes and Transfers Everyone knows what taxes
are. A transfer payment is money transferred to citizens with no good or service
in return. Social Security, Medicare, and Medicaid are examples of transfer
payments. When governments make changes in taxes or transfer payments,
the multiplier effect still applies. However, the tax/transfer multiplier’s impact
on GDP and the aggregate demand curve is much less than the spending
multiplier’s. Tax stimulus is cutting tax rates or offering tax rebates or incentives
for certain kinds of purchases and investments.
In the previous example of the $50 billion federal program to replace lead
water pipes, imagine that the government uses that money to make transfer
payments to households instead of actually paying to replace the old lead pipes.
People will save (MPS) more of that transferred money and use it to pay bills or
debts. The chain reaction that stimulus spending causes, fueling demand and
the GDP, is much smaller with transfers and tax incentives. So, each subsequent
round, as the graph shows, makes a much smaller impact on demand. That
initial $50 billion maxes out at the initial amount.
Transfer Effect on Real GDP $50 Billion Increase in Federal Transfer Payments
1st round $25.00 billion
2nd round $12.50 billion
3rd round $6.25 billion
. . . . . . . .
. . . . . . . .
Eventual effect $50.00 billion
154 MACROECONOMICS: AP®
 EDITION
Expansionary and Contractionary Fiscal Policy
Two of the main purposes behind government fiscal policies are to combat
recessions and inflation. If there is a recessionary gap (aggregate output falling
below potential output) or an inflationary gap (aggregate output exceeding
potential output), fiscal policy can shift the aggregate demand curve to get back
to potential output equilibrium.
During a recession, expansionary fiscal policy is employed when potential
output is not being met. The goal is to increase aggregate demand to close the
gap between actual GDP and potential GDP. Expansionary policies include
these three approaches:
• increase government purchasing of goods and services (often called
stimulus spending)
• increase government transfers to households
• decrease taxes
The idea is that if people have more disposable income to spend, they will
buy more goods and thus increase aggregate demand, which increases aggregate
output and gets the economy closer to potential output (or full employment
output). This was the Obama administration’s fiscal policy approach to the
2008 financial crisis. Increased government spending is the most direct and
effective of the three approaches. Aggregate Price Level
Expansionary Fiscal Policy
AD1
AD2
Real GDP
LRAS
YP Y1
P1
P2
SRAS
E2
E1
2. . . . reduces the
aggregate price level and
aggregate output and leads
to higher unemployment in
the short run. . .
1. An initial
negative
demand shock. . .
3. . . . until an eventual
fall in nominal wages in
the long run increases
short-run aggregate
supply and moves the
economy back to
potential output.
Recessionary Gap
YP = Potential Output
Expansionary
Spending
Expansionary fiscal policy attempts to shift aggregate demand rightward to close the
recessionary gap between real GDP and potential output.
 Topic 3.8 Fiscal policy 155
To address inflationary gaps, policy makers employ contractionary fiscal
policy. The goal of this fiscal policy is to decrease aggregate demand to close the
gap between actual GDP and potential GDP. Contractionary policies include
these three approaches:
• decrease government spending on goods and services
• decrease government transfers to households
• increase taxes
The idea with contractionary fiscal policy is that if the government and
consumers and businesses spend less, there will be less aggregate demand,
which will eventually decrease aggregate output and gets the economy closer
to potential output. Reducing government spending is the most direct and
effective of the three approaches. During the Vietnam War in the 1960s,
President Lyndon Johnson passed a temporary 10 percent tax increase to try
to deal with rising inflation. Contractionary responses such as raising taxes are
rarely used in the United States as there are other policies, such as actions by
the Federal Reserve, that can be used to greater effect. Tax increases are also
deeply unpopular with voters, making them equally as unpopular as they are
with legislators. Aggregate Price Level
Contractionary Fiscal Policy
AD1
AD2
Real GDP
LRAS
YP Y1
P1
P2
SRAS
E2
E1
2. . . . reduces the
aggregate price level and
aggregate output and leads
to higher unemployment in
the short run. . .
1. An initial
negative
demand shock. . .
3. . . . until an eventual
fall in nominal wages in
the long run increases
short-run aggregate
supply and moves the
economy back to
potential output.
Inflationary Gap
YP = Potential Output
Contractionary
 Fiscal
 Spending
Contractionary fiscal policy attempts to shift aggregate demand leftward to close the inflationary
gap between real GDP and potential output.
156 MACROECONOMICS: AP®
 EDITION
ANSWER THE TOPIC ESSENTIAL QUESTION
1. In one to three paragraphs, explain how government fiscal policies
involving spending and taxation affect demand, GDP, and employment.
KEY TERMS
fiscal policy
discretionary policies
mandatory spending
transfers
social insurance (entitlements)
multiplier effect
expansionary fiscal policy
contractionary fiscal policy
MULTIPLE-CHOICE QUESTIONS
1. When governments increase spending on goods and services, which
indicator is the spending intended to directly affect?
(A) Nominal wages
(B) Short-run aggregate supply
(C) Aggregate demand
(D) Output potential
(E) Aggregate price levels
2. Which type of fiscal policy might the government institute to respond
to an inflationary gap in the economy?
(A) Hike import taxes on all foreign goods
(B) Raise the national minimum wage
(C) Increase federal spending on goods and services
(D) Increase personal and corporate taxes
(E) Freeze all mandatory and discretionary spending
3. To eliminate a recessionary gap, the government is most likely to do
which of the following?
(A) Increase interest rates
(B) Decrease government spending
(C) Decrease taxes
(D) Increase taxes
(E) Decrease transfer payments
 Topic 3.8 Fiscal policy 157
FREE-RESPONSE QUESTIONS
1. Assume the graph below shows the economy of Freedonia. Answer all
parts of the questions that follow.
SRAS and Fiscal Policy
RGDP
Price Level
AD
SRAS
Recessionary
Gap
LRAS
Ye Yf
PL e
(a) Which kind of GDP gap is Freedonia experiencing? Explain.
(b) Which kind of fiscal policy—expansionary or contractionary—
would shift the economy to potential output (Yf
)? What are some
policies they could employ to close this gap?
(c) Assume the marginal propensity to consume is 0.8, the equilibrium
level of GDP is $200 billion and potential GDP is $260 billion.
Calculate the change in government spending necessary to bring about
full employment.
(d) Explain what should happen to employment numbers when the gap
is closed and why.
(e) Draw a graph that represents the shifts in aggregate demand (AD),
short-run aggregate supply (SRAS), and price levels when the
government’s fiscal policy to close the gap is implemented. Label the
AD and SRAS curves appropriately and indicate the direction of the
shifts with arrows.
158 MACROECONOMICS: AP®
 EDITION
THINK AS AN ECONOMIST: USE ECONOMIC MODELS TO EXPLAIN WHAT
ACTION SHOULD BE TAKEN
Government economists use economic models to analyze situations and
explain what actions policy makers should take. To do so, they take these steps:
• Identify the specific economic conditions and describe the likely
short-term future conditions.
• Use an economic model to recommend policy actions and explain the
impacts these policies will have on economic conditions.
For example, in an inflationary period, government economists will
identify whether demand-pull or cost-push inflation is taking place. They will
predict whether the inflation rate will continue to rise absent any changes in
the economy and how long that rise will take place. Suppose they identify the
cause as increased energy costs. They may recommend that the government
release some of the strategic oil reserve to increase the supply of oil and put a
price cap on oil. These actions would be intended to bring energy prices down.
Apply the Skill
The graph below shows the impact on the Aggregate Demand-Aggregate Supply
model resulting from a drop in aggregate demand.
You are a government economist. Recommend the correct fiscal policy for the
government to use, choosing among these three options:
• Increase or reduce government purchasing of goods and services.
• Increase or decrease government transfers to households.
• Cut or increase taxes.
Explain what policy—or policies—you recommend and what effect you think they will
have on the economy.
AD-AS Disequilibrium
AD1
AD2
AS
Y1 Y2
P1
P2
AD
Rises E1
E2
Aggregate Price Level
Real GDP
 Topic 3.8 Fiscal policy 159
MACROECONOMICS PERSPECTIVES: HOW DID COUNTRIES RESPOND
TO THE GREAT RECESSION?
The Great Recession began in December 2007 and ended, officially, in June
2009. This recession was responsible for an estimated $4 trillion contraction in
U.S. GDP. Though the recession is largely thought to have started in the United
States, many other countries around the world felt its effects, and some entered
their own recessionary periods.
Keynesian Response to the Great Recession Keynesian economics
dictates that governments, during a recession, should use fiscal policy actions
such as tax breaks and increased government spending to increase aggregate
demand and encourage economic growth.
This was the strategy employed by the Bush and Obama administrations.
According to Miguel Faria-e-Castro, an economist at the Federal Reserve,
Congress authorized increases to discretionary spending from 2007 to 2009
of $1.2 trillion per year. Faria-e-Castro stated, “New programs ranged from
financial assistance for large banks and car manufacturers to tax rebates for
low-income households and also included funding for public projects, such
as highway construction.” The purpose of these fiscal policies was to increase
confidence in markets again and get people and businesses spending again.
Expansionary Austerity and the Great Recession On the other hand,
some governments, particularly in Europe, decided to implement another type
of fiscal policy known as expansionary austerity. Proponents of this policy
believe that by cutting government spending and reducing deficits, governments
provide the means for economies in recession to return to economic growth.
Economists such as Harvard’s Alberto Alesina believe that spending
cuts, for example, were often “associated with economic expansions rather
than recessions.” The reasoning is that spending cuts created confidence
among consumers and businesses alike and that the positive effect on
private consumption and investment outweigh the negative effect of reduced
government spending.
Which Approach Is Better or More Effective? According to economist
Paul Krugman, the “doctrine of expansionary austerity . . . brutally failed the
reality test; instead, the evidence pointed overwhelmingly to the continued
existence of something very like the old-fashioned Keynesian multiplier.”
However, Tim Worstall, a fellow at the Adam Smith Institute in London,
points to parallels in the historical evidence of Britain’s use of expansionary
austerity during the Great Depression and the Great Recession. Worstall,
referring to the Great Depression, stated, “Britain’s experience in the 1930s was
very, very different from the American one. Yes, there was the same sort of
financial crash, then the collapse in world trade, then the European banking
systems fell over and so on. So, much the same as conditions in 2008 and 2009
then. But Britain’s recovery was entirely unlike that of the U.S. Britain came
off the gold standard in 1931 and two years later output (GDP) was above precrisis levels. And the government had been cutting spending the whole while.”
160 MACROECONOMICS: AP®
 EDITION
Topic 3.9
Automatic Stabilizers
“Power has only one duty—to secure the social welfare of the People.”
Benjamin Disraeli, British prime minister and author (1804–1881)
Essential Question: How do automatic stabilizers moderate business
cycles and impact aggregate demand and GDP?
Economists disagree on how actively the government should respond to
economic changes in general or to a specific economic change. However,
creating mechanisms that respond without special government action can
help even out the ups and downs in an economy. Since these variations occur
consistently, individuals and businesses can plan for them.
What Are Automatic Stabilizers?
Automatic stabilizers are fiscal policies that help moderate fluctuations
in an economy and occur without special government action. They are set
up by legislation and can be adjusted the same way, but once in place, they
happen on their own. When the economy starts to decline, they help stimulate
the economy by putting more money in the hands of consumers. When the
economy starts to overheat, they can help slow it down. The U.S. government
uses several automatic stabilizers, including these:
• a progressive income tax structure
• unemployment insurance
• the Supplemental Nutrition Assistance Program
• Medicaid
Progressive Income Tax Structure Adjusting income tax rates is one of
the primary automatic stabilizers used to moderate swings in the economy. The
multiplier effect (see Topic 3.2) is not as productive with tax cuts as it is with
federal stimulus spending. But tax cuts do help, which is why they are used as
stabilizers. A progressive taxation system is one in which as income increases
so does the percentage of tax paid. For example, people might pay no tax on
the first $20,000 they earn, 10 percent tax on the next $80,000 they earn, and 20
percent on any money they earn beyond that. In the United States, the federal
income tax is progressive. In contrast, some states have a flat-rate income tax in
which everyone pays the same rate regardless of total income. Some taxes are 
 Topic 3.9 Automatic stabilizers 161
regressive, ones in which people with lower incomes pay a higher percentage
of their income in taxes than do people with higher incomes. Sales taxes are
generally regressive because lower income people spend a higher percentage of
their income than do wealthier individuals.
Automatic Stabilizers Response During Overheating Economy
Social benefits and taxes can act as automatic stabilizers
Unemployment
falls
Social
payments
decline
Government
spending
declines
AD falls
Higher
income:
higher taxes
Less
disposable
income
Reduction in
consumption AD falls
The kind of automatic stabilizer that kicks in depends on the shift that is occurring in the economy. You
can see how both types of fiscal policies ultimately impact aggregate demand (AD).
During a recession—a negative demand shock—taxation as a stabilizer
automatically reduces the percentage of taxes from personal income as the
personal income falls. By leaving more money in people’s pockets as disposable
income, people will be able to buy more goods and thus support a healthy
aggregate demand and real GDP. (This also applies to business and corporate
taxes.)
Recessions are the most common economic condition for which taxation
automatic stabilizers are important. They promote recovery. However,
during very severe downturns, the government often reinforces the changes
promoted by the stabilizers with additional actions. For example, when the
Great Recession began during the winter of 2007–2008, automatic stabilizers
began to counter it immediately. Then, the Federal Reserve quickly began to
increase the supply of money in the economy. In February 2009, Congress
passed and the president signed the American Recovery Act, which further
countered the recession by boosting aggregate demand. The combination of
automatic stabilizers and actions by the government reversed the economic
decline by the end of 2009, starting a period of sustained growth that
continued until 2020.
Unemployment Insurance Unemployment is one of the key indicators of
an economy’s health, so it stands to reason that a program like unemployment
insurance is used as an automatic stabilizer. Unemployment insurance gives
newly unemployed workers some money—about half their salary—to get by
until they can find a new job. The Federal Unemployment Tax Act (FUTA)
was passed in 1939 while the country was still trying to recover from the Great 
162 MACROECONOMICS: AP®
 EDITION
Depression. FUTA is a federal program that works with the states to provide
people monetary benefits when they lose their jobs through no fault of their
own. All states have to meet the FUTA federal guidelines for this program, so
there are some differences depending on where one lives, but the purpose of
the program is the same everywhere.
Employers pay a certain amount quarterly to their state’s unemployment
insurance fund. The amount paid into the unemployment insurance fund is
based on a percentage of employee salaries, but the maximum an employer
must pay is $420 per employee per year. Employees who are laid off or lose
their jobs must file an application with their state’s unemployment bureau.
Unemployed workers are then paid weekly for up to 26 weeks. Unemployment
insurance can be extended for additional weeks under certain circumstances
and situations. For example, in 2009, part of the American Recovery Act
extended unemployment insurance benefits for some recipients up to 99 weeks.
In a recessionary period when unemployment rises and workers have less
(or no) disposable income, an automatic stabilizer like unemployment insurance
reduces the impact of rising unemployment on a troubled economy. Unemployed
workers making half of their usual salary still need to pay their bills and can still
make purchases, which helps buoy aggregate demand and real GDP.
Supplemental Nutrition Assistance Program Commonly known as the
“food stamp” program, the Supplemental Nutrition Assistance Program
(SNAP) gives vouchers (transfers) to low-income households below the FPL
to buy food. These transfers are usually made electronically to a state or federal
welfare benefits card monthly or weekly (depending on the state).
The calculation to determine how much SNAP money a person or
family receives each month is rather complicated. According to recent U.S.
Department of Agriculture data, an individual can receive approximately
$150–$190 per month from SNAP (that’s $5–$6.33 a day); a family of four can
receive $465–$650 monthly (that’s $15.50–$21.66 daily for four people). As of
2019, approximately one in every eight Americans used the SNAP program.
The majority of SNAP benefits go to elderly people, disabled individuals, and
families with children.
There are limits on the kinds of food recipients can spend SNAP money
on. Healthy foods (fruits, vegetables, meat and fish, dairy, breads and cereals)
are allowed, as are some limited types of snack foods and soda. SNAP accounts
cannot be used to buy alcohol, tobacco, prescription drugs, fast food, and a
variety of household items.
Medicaid The public health insurance program Medicaid funds health
care for individuals or families with low or no income. Signed into law in 1965
by President Lyndon Johnson, it is a jointly funded program between states
and the federal government. Because it is administered by the states, Medicaid
coverage can differ quite a bit depending on which state you live in. In 2017,
just under one in every four Americans received coverage through Medicaid,
and the program cost $593 billion. 
 Topic 3.9 Automatic stabilizers 163
For some citizens, if they did not have Medicaid, they would have no
medical insurance at all. Along with the popular Medicare program (which
is different, primarily providing health care for those aged 65 and older), it is
another jointly administered program.
Two in every five recipients of Medicaid are children—the largest subgroup
of American beneficiaries of this program. Medicaid also covers people with
disabilities. Eligibility for Medicaid is determined using the Federal Poverty
Line. The Affordable Care Act, sometimes referred to as Obamacare, was passed
in 2010, and it expanded the coverage and eligibility for Medicaid for states
that chose to adopt the new provision. Thirty-six states adopted the new ACA
Medicaid program, which by 2017 had reduced the percentage of uninsured in
the United States from 16 percent to 9 percent. Billions of Dollars
Projected and Actual Medicaid Spending
CBO Estimate
2017 Actual Cost 2018 Actual Cost
$600
$500
$400
$300
$200
$100
2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
The Congressional Budget Office (CBO) annually makes 10-year projections on Medicaid spending in
outlying years based on current budget planning. This is the CBO’s projection for Medicaid spending from
2013 through 2023. You can see that the projections for 2017 and 2018 were off by about $200 billion each
year. Some of this difference can be attributed to the aging U.S. population. Since approximately 2005, the
Baby Boomer generation has been moving beyond 60 years old, when medical needs and the cost of health
care increase for most people.
Like unemployment insurance and the SNAP program, Medicaid is an
automatic stabilizer. These transfer payment programs tend to go up in use
and cost when the economy is contracting (such as during a recession), and
the use and cost fall when the economy is expanding. Combined, they help to
moderate fluctuations in an economy—especially negative fluctuations—and
attempt to maintain aggregate demand and real GDP.
Government Transfers Automatic stabilizers such as food stamps and
Medicaid serve the same purpose as tax cuts and unemployment insurance—
to cushion the impact of a negative (or positive) shock to the economy. Recall
that government transfers are payments to individuals with no goods or
services provided in return. Most social service programs—sometimes called
welfare programs—are joint efforts by states and the federal government. They 
164 MACROECONOMICS: AP®
 EDITION
are paid for by taxes at the state and federal levels. Anyone receiving welfare
benefits must have income below the Federal Poverty Line. The FPL differs for
individuals and families. In 2019, the FPL was
• $12,490 for an individual
• $16,910 for a two-person household
• $25,750 for a family of four
For perspective on the federal poverty level, consider this: an individual
with a full-time job working 40 hours a week at $10 per hour—about $3 more
per hour than the federal minimum wage in 2020—would make $20,000 for
an entire year. A family of four with one full-time employed worker who made
$15 per hour—that’s double the federal minimum wage—would make $30,000
a year. Neither of these examples would have been eligible for welfare benefits
according to the Federal Poverty Line. As of 2018, 50 percent of American
workers made less than $30,000 a year.
But in a recessionary period, both the examples above would likely be at
risk of falling below the FPL, at which point they would be eligible to receive
social service program benefits.
ANSWER THE TOPIC ESSENTIAL QUESTION
1. In one to three paragraphs, explain how automatic stabilizers moderate
business cycles and impact aggregate demand and GDP.
KEY TERMS
automatic stabilizers
income tax
progressive taxation
unemployment insurance
Supplemental Nutrition Assistance
Program (SNAP)
Medicaid
government transfers
federal poverty line
 Topic 3.9 Automatic stabilizers 165
MULTIPLE-CHOICE QUESTIONS
1. What is the primary purpose of automatic stabilizers as fiscal policy?
(A) To replace direct cash payments with vouchers
(B) To moderate fluctuations in the economy
(C) To increase the unemployment rate
(D) To raise income taxes on those with the most income
(E) To keep aggregate prices stable
2. Why are government transfers more effective than tax cuts as automatic
stabilizers?
(A) Tax cuts only happen when annual taxes are filed.
(B) Transfers have a greater multiplier effect.
(C) Tax cuts are not tied to the federal poverty level.
(D) Transfers cost less than tax cuts.
(E) Transfers do not adhere to the federal poverty level.
3. Who most directly funds the unemployment insurance system?
(A) All employees
(B) The federal government
(C) All employers
(D) Individual states
(E) Employers who wrongfully fire workers
FREE-RESPONSE QUESTIONS
1. Answer all parts of the questions that follow.
SRAS and Fiscal Policy
Price Level
AD
RGDP
LRAS SRAS
Ye Yf
PL
166 MACROECONOMICS: AP®
 EDITION
(a) The graph depicts the beginning of a recession. Explain what will
happen to the aggregate supply curve as the recession worsens.
(b) Identify one automatic stabilizer that would work to correct the
recession and explain how it would ease the recession.
(c) What effect would the automatic stabilizer you identified in part (b)
have on the above graph?
(d) Draw a graph that represents an inflationary economy and describe
how automatic stabilizers should mitigate the changes in aggregate
demand (AD) and price levels. Label the AD curve appropriately
and indicate whether the price level increases, decreases, or remains
the same.
(e) Identify one automatic stabilizer that would work to correct the
inflationary economy you drew on the graph in part (d).
THINK AS AN ECONOMIST: DESCRIBE ECONOMIC PRINCIPLES
Certain economic principles underlie economic policy. Being able to accurately
explain these principles is an essential part of understanding economic thought.
To describe an economic principle, answer these questions about it:
• What does the principle mean?
• When and how is it applied to economic behavior?
For example, economists apply the principle that economic decision
makers—whether individuals or firms—make decisions on the margin. That
is, economic actors decide whether to continue to consume or produce one
additional unit based on whether the additional benefit gained from doing
so is more than the additional cost of that increase. For example, a consumer
stops purchasing slices of pizza when the discomfort from eating another slice
outweighs the cost of purchasing it.
Apply the Skill
Another economic principle is the creation of automatic stabilizers to impact aggregate
demand. Explain how automatic stabilizers work and why they have a beneficial
impact on aggregate demand.
UNIT 3 LONG FREE-RESPONSE QUESTION 167
UNIT 3
Long Free-Response Question
1. Assume that Curuguay, a country that makes capital goods and
consumer goods, is operating at below full employment.
(a) Using a correctly labeled graph of aggregate demand, aggregate
supply, and long-run aggregate supply, show each of the following:
(i) Long run aggregate supply labeled Yf.
(ii) The current output and price level labeled as Y1
 and PL1
respectively.
(b) Assume the recessionary gap in Curuguay is $120 billion and the
marginal propensity to consume is 0.75.
(i) Calculate the minimum increase in government spending
necessary to bring about full employment.
(ii) If the government decided to decrease personal taxes instead,
would the change required to bring about full employment
be greater than or smaller than the increase in spending you
calculated in question (b) (i)?
(iii) Explain your answer to question (b) (ii).
(c) If it is assumed that the government takes no discretionary policy
action to correct the gap,
(i) Will short-run aggregate supply increase, decrease, or stay the
same?
(ii) Explain your answer to question (c) (i).
(iii) Illustrate the change you identified here in question (c) on the
graph you created in question (a). Label the new equilibrium
price PL2
.
(d) Draw a correctly labeled production possibilities curve based on
the change you identified in question (c). Label the Y axis capital
goods and the X axis consumer goods. Label the original point of the
economy point A and the point that represents the change in fiscal
policy point B.
(e) The government of Curuguay creates a law that enables immigrants
to receive their citizenship much more easily. Will the long-run
aggregate supply curve increase, decrease, or remain the same?
</chapter_3>
<chapter_4>
168 MACROECONOMICS: AP® EDITION UNIT 4 Financial Sector The financial sector is made up of thousands of institutions that move the economy’s scarce resources from savers to borrowers. The sector is made up of entities such as banks, credit unions, investment companies, credit card companies, consumer-finance companies, and insurance companies. Financial assets include not only money but also bank deposits, stocks, bonds, and mutual funds that can be easily converted to cash. People, businesses, and institutions save and borrow money for many reasons. The money that savers deposit in banks expands as those institutions lend it to borrowers, who in turn, deposit it. Banks then lend those deposits, which borrowers also deposit. This process goes on many times, essentially expanding the amount of money in the nation’s monetary system. Central banks like the U.S. Federal Reserve use monetary policy to achieve macroeconomic goals, such as controlling inflation. They have several tools to accomplish these ends, including increasing or decreasing the money supply and setting interest rates that will affect the rates banks pay savers and the rates they charge borrowers. In this unit, you will learn about financial assets, interest rates, how the financial sector works, and how monetary policy affects the economy. Topic Titles and Essential Knowledge Topic 4.1 Financial Assets • The most liquid forms of money are cash and demand deposits. • Other financial assets people can hold in place of the most liquid forms of money include bonds (interest-bearing assets) and stocks (equity). Unit 4 169 • The price of previously issued bonds and interest rates on bonds are inversely related. • The opportunity cost of holding money is the interest that could have been earned from holding other financial assets such as bonds. Topic 4.2 Nominal vs. Real Interest Rates • A nominal interest rate is the rate of interest paid for a loan, unadjusted for inflation. • Lenders and borrowers establish nominal interest rates as the sum of their expected real interest rate and expected inflation. • A real interest rate can be calculated in hindsight by subtracting the actual inflation rate from the nominal interest rate. Topic 4.3 Definition, Measurement, and Functions of Money • Money is any asset that is accepted as a means of payment. • Money serves as a medium of exchange, unit of account, and store of value. • The money supply is measured using monetary aggregates designated as M1 and M2. • The monetary base (often labeled as M0 or MB) includes currency in circulation and bank reserves. Topic 4.4 Banking and the Expansion of the Money Supply • Depository institutions (such as commercial banks) organize their assets and liabilities on balance sheets. • Depository institutions operate using fractional reserve banking. • Banks’ reserves are divided into required reserves and excess reserves. • Excess reserves are the basis of expansion of the money supply by the banking system. • The money multiplier is the ratio of the money supply to the monetary base. • The size of expansion of the money supply depends on the money multiplier. • The maximum value of the money multiplier can be calculated as the reciprocal of the required reserve ratio. • The amount predicted by the simple money multiplier may be overstated because it does not take into account a bank’s desire to hold excess reserves or the public holding more currency. Topic 4.5 The Money Market • The demand for money shows the inverse relationship between the nominal interest rate and the quantity of money people want to hold. • Given a monetary base determined by a country’s central bank, money supply is independent of the nominal interest rate. • In the money market, equilibrium is achieved when the nominal interest rate is such that the quantities demanded and supplied of money are equal. • Disequilibrium nominal interest rates create surpluses and shortages in the money market. Market forces drive nominal interest rates toward equilibrium. • Factors that shift the demand for money, such as changes in the price level, and supply of money, such as monetary policy, change the equilibrium nominal interest rate. 170 MACROECONOMICS: AP® EDITION Topic 4.6 Monetary Policy • Central banks implement monetary policies to achieve macroeconomic goals, such as price stability. • The tools of monetary policy include open-market operations, the required reserve ratio, and the discount rate. The most frequently used monetary policy tool is openmarket operations. • When the central bank conducts an open-market purchase (sale), reserves increase (decrease), thereby increasing (decreasing) the monetary base. • The effect of an open-market purchase (sale) on the money supply is greater than the effect on the monetary base because of the money multiplier. • Many central banks carry out policy to hit a target range for an overnight interbank lending rate. (In the United States, this is the federal funds rate.) • Central banks can influence the nominal interest rate in the short run by changing the money supply, which in turn will affect investment and consumption. • Expansionary or contractionary monetary policies are used to restore full employment when the economy is in a negative (i.e., recessionary) or positive (i.e., inflationary) output gap. • Monetary policy can influence aggregate demand, real output, the price level, and interest rates. • A money market model and/or the AD–AS model are used to demonstrate the short-run effects of monetary policy. • In reality, there are lags to monetary policy caused by the time it takes to recognize a problem in the economy and the time it takes the economy to adjust to the policy action. Topic 4.7 The Loanable Funds Market • The loanable funds market describes the behavior of savers and borrowers. • The demand for loanable funds shows the inverse relationship between real interest rates and the quantity demanded of loanable funds. • The supply of loanable funds shows the positive relationship between real interest rates and the quantity supplied of loanable funds. • In the absence of international borrowing and lending, national savings is the sum of public savings and private savings. • For an open economy, investment equals national savings plus net capital inflow. • In the loanable funds market, equilibrium is achieved when the real interest rate is such that the quantities demanded and supplied of loanable funds are equal. • Disequilibrium real interest rates create surpluses and shortages in the loanable funds market. Market forces drive real interest rates toward equilibrium. • The loanable funds market can be used to show the effects of government spending, taxes, and borrowing on interest rates. • Factors that shift the demand (such as an investment tax credit) and supply (such as changes in saving behavior) of loanable funds change the equilibrium interest rate and the equilibrium quantity of funds. Source: AP® Macroeconomics Course and Exam Description. Effective Fall 2019 (College Board). Topic 4.1 Financial Assets 171 Topic 4.1 Financial Assets The one thing I will tell you is the worst investment you can have is cash. . . . Cash is going to become worthless over time. But good businesses are going to become worth more over time. Warren Buffett, speaking at Columbia University, November 12, 2009 Essential Question: What are financial assets, and what is meant by “the opportunity cost of money”? As billionaire investor Warren Buffett points out, under normal circumstances, cash is worth less over time. The value of a dollar has dropped significantly since 1913, when the Consumer Price Index began measuring inflation by comparing the prices of a basket of goods and services every month. By 1920, the value of a dollar was only about half what it was in 1913, largely as a result of inflation during World War I. Today’s dollar buys less than 4 percent of what a 1913 dollar bought, meaning it takes $25 to buy what $1 bought in 1913. And a dollar today buys only half of what a dollar could buy in 1990. But there are ways of investing money to keep up with inflation or even build wealth. What Are Financial Assets? An asset is any resource of value that can be converted into cash. There are several ways of classifying assets—real, intangible, and financial; tangible and intangible; liquid and nonliquid. • Real assets are physical things like real estate, land, fine art and antiques, precious metals, and commodities such as soybeans or oil. • Intangible assets are property that is not physical, like intellectual property, which includes patents for inventions, trademarks for company logos, and copyrights for songs. • Financial assets consist of things like currency and investments in stocks and bonds. Financial assets get their value from a contractual claim or ownership claim. For example, currency is just paper with a value printed on it, but that value is backed by the federal government. The most common financial assets are cash and bank deposits such as checking and savings accounts. These are sometimes referred to as demand deposits because they can be withdrawn as 172 MACROECONOMICS: AP® EDITION desired. Most savings accounts and many checking accounts pay interest, in this case, money paid by a financial institution to depositors. Interest is usually expressed in terms of an annual percentage rate. Banks also offer money market accounts, which pay market interest rates but limit the number of transactions that may be made during a period of time, as well as term deposits such as certificates of deposit (CDs). Term deposits usually pay a higher rate of interest than savings accounts, but an investor’s money is tied up for a length of time that may range from three months to five years. Financial assets also include certain types of investment accounts, such as stocks, bonds, and mutual funds. Stocks are equity, meaning investors who buy stocks become part owners of a company and share in its profits and losses. Investors may hold stocks indefinitely or sell them to other investors. Governments and companies issue interest-bearing assets called bonds to raise money. The holder of the bond is a lender, and the bond indicates how much has been lent, what the interest rate is, and when it will be redeemed, or bought back. Mutual funds are organizations that sell shares to the public and use the proceeds to purchase a portfolio of stocks or bonds, or both. Liquid and NonLiquid Assets The word liquidity refers to the ease with which assets can be converted to cash, which can then be used for paying bills, purchasing goods or services, or any of the other things that cash is used for. The most liquid accounts are those that can be most easily converted, such as checking and savings accounts. The more liquid the asset, the lower the return on investment (ROI). Money held as cash has no ROI. Checking and savings accounts are quite liquid, so they provide their holders with a low interest rate. Therefore, they have a low ROI. Term deposits are less liquid, so they usually have higher interest rates and ROIs. Because they are readily traded, securities are considered liquid. Securities are investments traded on the secondary market, also known as the stock market. They include equities, bonds, and derivatives. Equity securities are ownership shares in a corporation. They include stocks and mutual funds. Bonds, as previously discussed, are long-term loans to a corporation or government entity. Derivatives are financial contracts that derive their value from underlying assets. They are often used for commodities such as gold, oil, or gasoline. Although they have value, real assets and most intangible assets are considered nonliquid because they cannot be quickly converted into cash. Risk Financial risk is the danger of losing money. It can apply to individuals, businesses, government entities, and the financial market. Individuals face risk when they make decisions that affect their ability to earn money or pay their debts. Businesses face risks that their cash flow will not be adequate to meet their obligations. Governments face risk when they are unable to control inflation. Financial markets face risks due to changes in the market interest rate, defaults by sectors or large corporations, or other macroeconomic forces. Topic 4.1 Financial assets 173 As you might expect, there are many forms of financial risk. • Credit risk This is the danger associated with lending money. If the borrower defaults or is unable to repay the loan, investors experience decreased income from loan repayments as well as lost principal and interest. • Liquidity risk This may involve securities or assets that cannot be sold or bought fast enough to cut losses. Investing in real estate involves more liquidity risk than investing in a mutual fund. • Speculative risk Most financial investments, such as the purchase of stock, involve speculative risk, since share values may go down, resulting in a loss. • Foreign investment risk Investments made by people in one country of assets in another country take many kinds of risks. Among these are variations in market operations, higher investment costs, and political volatility, including nationalization of industries. One of the most common risks in this category comes from changes in currency exchange rates. For example, as the value of U.S. dollars as measured in Mexican pesos changes, the value of an investment made by someone in the United States of an asset in Mexico also changes constantly. Bank accounts are essentially risk-free. Most bank accounts—including checking, savings, money market, NOW, and CDs—are insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC). Bonds and Interest Rates A bond is a promise by a corporation or government to repay a specified sum of money (the face value, or principal, of the loan) at the end of a specific number of years, along with fixed annual interest. A bond’s maturity date is the date at which the issuer of the bond promises to redeem it at its face value. For example, an investor who pays $500 in 2020 for a 10-year bond with a face value of $1,000 can expect to receive $1,000 in 2030. TYPES OF BONDS Type Description Level of Risk Treasury bonds (“Treasuries”) The U.S. government issues Treasury bonds such as savings bonds to fund government activities or to pay off debt. Lowest: Because they are backed by the “full faith and credit” of the U.S. government, they carry almost no risk at all. The only risk is if Congress decides to not repay the money the government has borrowed. Agency bonds U.S. government agencies such as Fannie Mae and Freddie Mac issue bonds to provide assistance to home buyers and others. Low: Though issued by the federal government, these bonds do not have the government’s “full faith and credit” guarantee. 174 MACROECONOMICS: AP® EDITION TYPES OF BONDS Type Description Level of Risk Municipal bonds (“Munis”) State and municipal governments issue bonds to finance special projects or other governmental necessities. Cities may issue municipal bonds to fund new buildings to house schools or libraries, for example. Low: State and municipal governments can tax people to repay loans, but laws often limit how much they can borrow. Corporate bonds Corporations issue bonds to finance expansions or other activities. These bonds are fully taxable but pay a higher rate of interest than government bonds. Highest: Corporations sometimes lose so much money they can’t repay investors fully. Interest Rates Interest is the cost of borrowing money as well as the profit depositors receive from a bank for the use of their money. Banks make their money by lending the money that depositors entrust to them. The rate of interest they charge on loans, the money they lend, is significantly higher than the interest they pay depositors. The difference between what a bank pays to depositors and what it charges borrowers covers its costs of operation and provides it a profit. For example, during a time of low interest rates, a bank might pay 1 percent on savings accounts. It might charge 4 percent for a home mortgage loan and 20 percent on credit card purchases. A bond is essentially a loan. The interest a bond’s issuer pays over the term of a security is referred to as its coupon rate. The issuer makes these interest payments according to a predetermined schedule, which may be semi-annual, annual, or when the bond matures. A bond’s interest rate is based on the prevailing market interest rate at the time the bond is issued. Once the bond has been issued, if the prevailing interest rate rises, the value of the bond decreases, and if it falls, the value of the bond increases. In other words, a bond’s value varies inversely with interest rates. Rate of Return The percentage rate of return, or yield, varies from one type of savings or investment to another. The rate of interest in a savings account depends on the bank, the type of account, and when it is opened. Securities offer the possibility of earning more money than savings accounts, but the rate of return may rise or fall along with the fortunes of the company that issued the stocks or bonds. Investors who buy bonds at face value and hold them to maturity earn the interest rate that was set when the bond was issued. However, if they purchase previously issued bonds on the secondary market, the return they earn from interest may be higher or lower than the bond’s coupon rate. This effective rate of return is called yield to maturity. If market interest rates go up, the bond’s price will fall if the investor decides to sell it. When interest rates fall, investors prefer to hold in their portfolios previously issued bonds with higher interest rates rather than purchase newly Topic 4.1 Financial assets 175 issued bonds with lower rates. As a result of increased demand, the price of previously issued bonds rises. The Cost of Money Interest rates reflect the cost of money. When you deposit money into a savings account, the interest you receive is the payment from the bank to use your money. When you borrow money, the interest rate you pay is what you are spending to get the use of someone else’s money. Money has a time value, a consideration of how the value of money changes over time because of factors such as inflation and interest earned. In general, a dollar today is worth more than a dollar in the future. The opportunity cost of holding money depends on the rate of interest that could be earned by investing it in other financial assets such as bonds. Between 2009 and 2019, the U.S. inflation rate hovered around 2 percent. The average interest rate for savings accounts was very low by historic standards, often less than 1 percent. So, money placed in a savings account lost value, but not as much as money kept under a mattress. The best CD rates paid around 2 percent interest, meaning that money placed in a CD would more or less hold its value against inflation. U.S. Treasury bonds paid an average interest rate of 2.5 percent, while interest rates on riskier corporate bonds averaged 3.1 percent. The average stock market return was almost 9.5 percent before inflation. When inflation is considered, the actual increase in value was around 7.5 percent. However, investing in stocks was risky. By one measure, stocks decreased in value by one-third in the single year 2008. ANSWER THE TOPIC ESSENTIAL QUESTION 1. In one to three paragraphs, discuss financial assets and the opportunity cost of money. KEY TERMS asset demand deposit liquidity securities risk loans rate of return time value MULTIPLE-CHOICE QUESTIONS 1. Which of the following assets would be most liquid? (A) Fine art (B) Antiques (C) Real estate (D) Commodities such as oil (E) Stock in a corporation 176 MACROECONOMICS: AP® EDITION 2. One example of financial assets that can be withdrawn at will are (A) nonliquid assets (B) interest rates (C) municipal bonds (D) demand deposits (E) corporate bonds 3. When the prevailing market interest rate drops, one effect on previously issued bonds is that (A) their interest rate also drops (B) their interest rate rises (C) their value also drops (D) their value rises (E) their value is unaffected FREE-RESPONSE QUESTIONS 1. For each of the following assets, briefly describe the relation between risk and rate of return. (a) Savings account (b) Certificate of deposit (c) Corporate bond (d) Treasury bond (e) Stock in a corporation Topic 4.1 Financial assets 177 THINK AS AN ECONOMIST: DESCRIBE SIMILARITIES AND DIFFERENCES OF AN ECONOMIC CONCEPT To describe the similarities and differences betweeen economic concepts, economists address these questions: • What characteristics do the concepts share? • What characteristics differentiate the concepts? • Why do the concepts have these differences? An asset is any resource of value that can be converted into cash. The majority of assets for financial institutions are financial assets—typically the loans they issue to individuals and businesses. These are assets to financial institutions because they represent promises by the borrowers to repay the loan over time. Liabilities are financial debts or obligations that are settled over time. To financial institutions, demand deposits are liabilities because the institutions have an obligation to return to depositors their money when requested. Apply the Skill Individuals and businesses have assets and liabilities as well. Identify the similarities and differences between the assets and liabilities of a business and those of a financial institution. Explain why these two entities differ in how they view demand deposits and loans. 178 MACROECONOMICS: AP® EDITION Topic 4.2 Nominal vs. Real Interest Rates Money costs too much. Ralph Waldo Emerson, The Conduct of Life, 1855 Essential Question: How do interest rates provide a measure of the price of money that is borrowed or saved? It’s strange to think that money has a cost. But those who provide capital to others do so in order to make a profit. Interest rates are the cost of money, and they are the avenue through which banks and other lending institutions attempt to make a profit on their transactions. The cost of money—interest rates—can be measured in different ways. Interest and Inflation As you learned in the previous topic, banks pay depositors interest on most accounts. They then use the money deposited to make loans, charging more interest on the loans than they pay for the use of depositors’ money. The difference between the amount a bank collects and the amount it pays out enables it to generate a profit. A loan is money lent by one party to another with the understanding that it will be repaid at a future date, along with a fee for its use. The amount of the original loan is the principal, and the additional fees added to that are the interest. Interest is typically expressed as an annual percentage rate (APR). Interest Financial institutions such as banks and credit unions, corporations, and governments all issue loans so that they can earn interest on them. If lenders believe that a period of inflation is approaching, they can protect themselves against the loss of purchasing power of their loan by charging a higher rate of interest than they would have if there were no inflation. Conversely, if deflation occurs—that is, if the Consumer Price Index drops—interest rates go down. Deflation occurs in times of economic crisis, such as recession or depression, and is indicated by a negative inflation rate. People start to keep hold of their money, putting off major purchases because they expect prices to continue to drop. At times, interest can become negative. In effect, the lender is paying the borrower to take a loan. In 2014, the European Central Bank, a bank supported by the governments of most countries in Europe, introduced negative interest rates as a way to stimulate borrowing and spending. Topic 4.2 Nominal vs. Real interest rates 179 Interest rates affect the economic decisions of individuals, businesses, and governments. Most people take into account the cost of borrowing when they make major purchasing decisions, such as whether to buy a car. Similarly, business firms thinking of replacing equipment or expanding their operations compare the cost of financing those moves with the return on the same funds if they were placed in interest-bearing investments. Such decisions affect the nation’s economic well-being. Inflation The U.S. inflation rate is based on the Consumer Price Index (CPI), which measures the average change in prices of a “basket” of goods and services over a period of time. The CPI helps determine cost-of-living increases in salaries and Social Security benefits, among other things. It also helps the Federal Reserve determine whether it needs to modify economic policies, including interest rates. As you learned in the previous topic, the trend is for prices to rise over time, which means that the buying power of a dollar drops. For example, a cup of coffee that cost $0.25 in 1970 would have cost $1.00 in 2000 and $1.59 in 2019. The following graph shows the average U.S. inflation rates from 1960 to 2018. The period between 1965 and 1982 is known as the Great Inflation. It led economists to rethink the policies of central banks such as the Federal Reserve. Since the mid-1990s, the rate of inflation has been fairly low. Average U.S. Inflation Rates from 1960 to 2016 12-Month Percent Change Year 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 14 12 10 8 6 4 2 0 Source: U.S. Bureau of Labor Statistics How Interest Rates Are Set Lenders and borrowers use their expected real interest rate and the expected rate of inflation to establish nominal interest rates. Three forces determine those rates in the United States: 180 MACROECONOMICS: AP® EDITION • The Federal Reserve System (Fed). The Fed sets the Fed funds rate and the prime rate. The Fed funds rate is the interest rate banks charge each other to lend Federal Reserve funds overnight. The prime rate is what banks charge their best customers. It is usually above the Fed funds rate but slightly below the average variable interest rate, which fluctuates over time as market interest rates change. • The U.S. Treasury. The U.S. Treasury borrows money for the U.S. government by selling fixed-income investments for various term lengths. Treasury bills mature in 4 weeks to a year. Treasury notes mature in 2 years to 10 years. Treasury bonds mature in 30 years. The Treasury also issues Treasury Inflation-Protected Securities (TIPS) for terms of 5, 10, and 30 years. These are similar to Treasury bonds, but the Treasury increases their value if inflation increases. • The financial industry. Banks are usually free to set the interest rates for deposits and loans. However, banks have to take into account their competition, as well as Federal Reserve rates and other factors, such as stock market performance and expected levels of inflation. The Federal Reserve System, known as “the Fed,” was established in 1913. It acts as the central bank for the United States. The Fed is headquartered in Washington, D.C., which is where its seven-member board of governors meets. The Federal Reserve also operates 12 regional banks based in major cities across the country. The Fed has a number of important functions, including setting and implementing the country’s monetary policy, regulating banks, and maintaining the stability of the U.S. financial system. It is a powerful institution, and its ability to influence interest rates as described above is an outgrowth of this power. (For more on the Fed, see Topic 4.6.) Nominal vs. Real Interest Rates The percentage return that is advertised for bank deposits, loans, or bonds is usually referred to as the annual percentage rate, or APR. The APR is a nominal interest rate, one that does not take into account inflation, compounding, and other factors. Banks use the nominal interest rate when they describe their loans, as do financial advisers when they describe investments. The Fed funds rate (also called the Federal funds rate) mentioned above is also a nominal interest rate. In the United States, the Federal Reserve System sets short-term nominal interest rates. Banks and other financial institutions base the interest they charge on those rates. The Fed may decide to keep nominal rates low to spur economic activity, since low interest rates encourage consumers and businesses to take on more debt and spend more. This was the case following the recession of 2008, when the Fed dropped its Fed funds rate to between 0 percent and 0.25 percent until December 2015. As you have already learned, interest rates must exceed the rate of inflation, or the returns on investments will lose buying power. The real interest rate can be calculated in hindsight by adjusting the nominal interest rate for inflation. It gives borrowers a better idea of the actual cost of borrowing and lenders a Topic 4.2 Nominal vs. Real interest rates 181 better idea of the actual yield on the loans they make. In other words, it shows the true interest rate of loans and bonds. To determine the real interest rate, subtract the rate of inflation from the nominal interest rate: Real interest rate = Nominal interest rate – Rate of inflation Thus, if the nominal interest rate on a loan is 5 percent and the rate of inflation is 2 percent, the real interest rate is 3 percent. Normally, because of inflation, the nominal interest rate will be higher than the real interest rate. However, if the inflation rate is 0, the nominal interest rate is also the real interest rate. In the case of deflation, the real interest rate is actually higher than the nominal rate. For example, the U.S. economy entered a period of deflation between March and October 2009, reaching a low of –2.1 percent in July, and the Fed funds interest rate was 0.16 percent, which would result in a real interest rate of 2.26 percent: 2.26% = 0.16% – (–2.1%) = 0.16% + 2.1% Real interest rates are considered predictive when the actual inflation rate is unknown, which is the case when a loan is actually being taken out or a bond is being purchased. In other words, interest rates are based on the best estimate of what the rate of inflation will be during the period of the loan or bond. Lenders and investors can estimate their real rate of return by comparing the yields of Treasury bonds and TIPS that have the same maturity, subtracting the rate of return of the bond from that of the TIPS, which estimates the rate of inflation. Because they are interested in making money, lenders and investors tend to be more interested in real interest rates than nominal interest rates. The World Bank has a web page that publishes the real interest rates for most countries. Real Interest Rates for the United States, 1960–2020 Percentage Year 10 8 6 4 2 0 -2 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 Source: World Bank 182 MACROECONOMICS: AP® EDITION ANSWER THE TOPIC ESSENTIAL QUESTION 1. In one to three paragraphs, explain how interest rates provide a measure of the price of money that is borrowed or saved. KEY TERMS nominal interest rate real interest rate MULTIPLE-CHOICE QUESTIONS 1. How do banks make most of their money? (A) By charging depositors interest on their savings accounts (B) By selling stocks and bonds (C) By investing in U.S. Treasury notes (D) By charging interest on loans they issue (E) By lending money to other banks overnight 2. Who sets short-term nominal interest rates in the United States? (A) The president (B) The World Bank (C) The Federal Reserve (D) The banking industry (E) The Consumer Price Index 3. If the nominal interest rate is 7 percent and the rate of inflation is 4 percent, what is the real interest rate? (A) −28 percent (B) −11 percent (C) –3 percent (D) 3 percent (E) 11 percent Topic 4.2 Nominal vs. Real interest rates 183 FREE-RESPONSE QUESTIONS 1. Use the following scenario to answer all parts of the free-response questions below. Bank A is offering fixed-rate loans at a 5 percent nominal interest rate. The actual inflation rate is 4 percent. (a) Calculate the real interest rate. (b) Assuming there is no inflation, explain the relationship between the nominal and real interest rates. (c) Assume that Jacob takes out a loan from Bank A. Who gains from this transaction: the bank, Jacob, or neither? Explain. (d) What is the difference between the Fed funds rate and the prime rate? (e) Assume the inflation rate increased to 5 percent. Who gains from this increase? Explain. THINK AS AN ECONOMIST: DESCRIBE ECONOMIC PRINCIPLES Economists use economic principles to explain economic decision-making or to analyze economic performance. Being able to accurately explain these principles demonstrates an understanding of economics. To describe an economic principle, answer these questions about it: • What does the principle mean? • Why is it a useful economic idea? One principle is the utility of using baseline standards to analyze economic measures in order to better understand economic conditions. For example, while GDP measures the total value in money of all the goods produced in a year by a country, that measure has limitations when comparing one country’s output to another’s because it does not control for the size of the countries. Per capita GDP allows such comparison, as it divides GDP by population. It effectively states output per person, which controls for size and thus more effectively measures each country’s productivity. Apply the Skill This lesson discussed the difference between nominal and real interest rates. What economic principle is demonstrated by this difference between these two concepts? Why is this principle useful? Give an example of how financial institutions would apply this principle. 184 MACROECONOMICS: AP® EDITION Topic 4.3 Definition, Measurement, and Functions of Money Our entire monetary system is based on trust. . . . Rather like the fairy Tinkerbell in Peter Pan, who is kept alive because the audience claps to affirm its belief in her existence, it is our faith that keeps the system going. Philip Coggan, “Trust (not Money) Makes the World Go Round,” OECD Forum, 2014 Essential Question: What are the functions and measures of money? When people think of money, they usually think of cash, whether they actually handle it or not. Everything people buy has a price expressed in dollars and cents, the legal tender in the United States. However, employers often pay by direct deposit into employees’ banks or credit unions, and many businesses no longer accept checks. Some don’t even accept cash, and there are those who think that it’s time to do away with cash altogether. Today’s consumers seem to prefer the ease of paying with credit or debit cards or their smartphones. The possibility of a future cashless economy seems much more plausible than it ever did. What Is Money? Money is anything that most people are willing to accept in payment for goods and services. The word salary comes from sal, the Latin word for salt, because Roman soldiers were often paid their wages in salt rather than money. In Mexico, the Aztecs used cacao beans as money. In colonial North America, ferry operators accepted fur pelts as payment for taking people and goods across rivers. A Brief History of Money Because it was durable and easy to carry, metallic money became popular thousands of years ago. The Egyptians began to use one of the earliest forms of metallic money, in the form of rings, around 2500 bce. About 400 years later, the Chinese began using gold cubes as money. The Lydians, a people who lived in what is now Turkey, minted the first metal coins around 600 bce. From there coins spread to Greece, Rome, the Byzantine Empire, and the rest of Europe. The Chinese invented paper money in the 7th century ce. The Italian traveler Marco Polo reported use of it in the late 1200s. During the late Middle Topic 4.3 Definition, measurement, and functions of money 185 Ages, European merchants and travelers exchanged their gold coins for goldsmiths’ receipts to protect themselves from highway robbers. The receipts could be exchanged for coins by goldsmiths in other cities. In time, such receipts came to be used as money without being changed to coins. The first European banknotes were issued in 1661, and by the 1690s, the Massachusetts Bay Company began printing paper money in what is now the United States. The Functions of Money Money serves a number of purposes. It provides a medium of exchange, a unit of account, and a store of value. • A medium of exchange is something that buyers give to sellers when they purchase goods and services. When you buy a pair of jeans, for example, you give the store money, and the store gives you the jeans. • A unit of account provides a convenient standard for expressing the values of different items. For example, $60 might buy one video game or 10 sub sandwiches, but no one would say the price of a video game is 10 subs, or the price of a sub is one-tenth of a video game. • Because people can save it for future use, money is considered a store of value. The restaurant owner who accepts money today for a sub sandwich can hold the money and buy another good or service at a future time. The Kinds of Money The most obvious kind of money is cash, or currency. Currency is the money used in a particular country as a medium of exchange for goods and services, especially paper money but also including coins. In the United States, currency is issued by the federal government. All U.S. currency is legal tender, meaning that it must be accepted in payment for debts. The unit of currency used in the United States is the dollar, while most European nations use the euro, and Japan uses the yen. A monetary unit is the basic form of currency in a country and may be issued in various denominations that are multiples (such as $1, $5, $10, $20, etc.) or fractions (1¢, 5¢, 10¢, 25¢, etc.) of the basic unit. Whatever commodity or definitions a society uses for its money is its monetary standard. Money that gets its value from the substance it is made of is called commodity money. As you read earlier, salt and cacao beans were historical forms of commodity money. Coins were minted from metals that were worth the value displayed on the coin. In contrast, representative money has little or no value in itself. Rather, its value comes from the commodity it represents, such as a precious metal. By the mid-1800s, in order to facilitate international trade, many countries used paper currency. Most countries adopted the gold standard, which guaranteed that governments would redeem paper money for gold. At times, the United States allowed people to trade in their paper money for either gold or silver. However, the gold standard had many problems. One of these was a lack of flexibility, which led to economic instability. As a country’s population and economy grew, it needed more currency in circulation. Expanding the quantity 186 MACROECONOMICS: AP® EDITION of currency was difficult when money was tied to gold. During World War I, countries began moving off the gold standard so they could print more money to help pay military expenses. Today, no country uses the gold standard. Source: Public domain, U.S. Treasury The U.S. Treasury issued gold certificates like this one that could be exchanged for gold coins. Today, most of the currency in circulation is neither commodity nor representative money. It is fiat money, which means that its value is based on the confidence people have in the government that issues it. In the United States, paper money is issued by the Federal Reserve System and backed by the U.S. government. However, paper currency and coins represent only about one-tenth of the total money in circulation. Most transactions are paid for using financial instruments like credit and debit cards or checks. In recent years, people have developed money that exists only in digital form. These cryptocurrencies, like any other forms of money, have value only to the extent they are accepted by people. One challenge for cryptocurrencies to gain acceptance is to develop trust. Like any online transactions, cryptocurrencies are subject to hacking and theft. Measuring the Money Supply The money supply is the total amount of money—cash, coins, and balances in bank accounts—in circulation. Economists closely monitor the money supply and its rate of flow—that is, the number of times it changes hands. However, determining the rate of flow is difficult. It is more challenging because economists use several definitions when discussing the money supply. The money supply includes assets that households and businesses can use to make payments or to hold as short-term investments. Because some forms of money can be used immediately to make purchases while others might take a few days to convert to cash, there are several ways of measuring the money supply, based on the size of accounts and the liquidity each type of money has Topic 4.3 Definition, measurement, and functions of money 187 in the economy. Three of the many ways to measure the money supply are particularly important: • M0: More commonly known as the monetary base (and sometimes referred to as MB), this is a measure of all the currency in circulation and deposits kept by banks and other depository institutions in their accounts at the Federal Reserve. (Depository institutions are institutions that get their funds through deposits by the public. They include savings banks, credit unions, and savings and loan associations as well as commercial banks.) • M1: This is a measure of currency held by the public or in fully liquid demand deposits, such as checking accounts, at depository institutions. It does not include currency at the U.S. Treasury, Federal Reserve Banks, and in vaults of depository institutions. When economists and others discuss the money supply, they are usually referring to M1. • M2: This measure includes M1 plus savings accounts (which are not normally used to make purchases or pay bills), money market deposit accounts, certificates of deposit (CDs) in amounts of less than $100,000, and certain other bank reserves that are less easily converted to cash than those included in M1. M0 and M1 are sometimes referred to as “narrow money,” meaning physical money—coins and paper currency—that is readily available for commercial transactions. Funds in the monetary base are held in both M1 and M2, which are the two monetary aggregates most commonly used to measure the money supply. Estimates of the money supply provide important information that helps the government set economic policies. In recent decades, however, economists have reconsidered long-held views about the relationships among money supply, inflation, and gross domestic product growth. For example, economists believed that a rapid expansion of the money supply would cause inflation. Then, to help end the Great Recession of 2008, the Federal Reserve doubled the money supply and yet inflation remained very low. Events such as this led economists to reevaluate their ideas about how the economy operates. Topic 4.6 will examine monetary policy in more detail. ANSWER THE TOPIC ESSENTIAL QUESTION 1. In one to three paragraphs, explain the functions of money and how economists measure it. 188 MACROECONOMICS: AP® EDITION MULTIPLE-CHOICE QUESTIONS 1. Which of the following is an example of money as a unit of account? (A) A monthly credit card statement (B) A money market account (C) A checking account (D) Pricing of items in a grocery store (E) Direct deposit 2. Which of the following best describes fiat money? (A) Money that is backed by a commodity such as gold (B) Money that is backed by the government that issued it (C) U.S. dollars held in foreign financial institutions (D) Money that is held in demand deposits (E) Money that is not included in the M1 or M2 money supplies 3. Money held by the public that includes demand deposits and currency is measured as (A) M1 (B) M2 (C) M0 (D) Fiat money (E) Commodity money KEY TERMS medium of exchange unit of account store of value currency monetary unit commodity money representative money gold standard fiat money money supply monetary base Topic 4.3 Definition, measurement, and functions of money 189 FREE-RESPONSE QUESTIONS 1. Use the following scenario to answer all parts of the following questions: Diego opens a new checking account in Bank A with $5,000. (a) If Diego uses the debit card that accompanies this account, what function of money does his transaction serve? (b) Diego decides to deposit as much as he can into this account after his initial deposit to purchase a car. What function is his money serving? Explain. (c) Diego sees an advertisement for the car he wants for $8,000. In this scenario, money is serving which purpose? Explain. (d) Diego writes a check against his account for the car. Which measurement of money will he be using for this purchase? (e) After the purchase of his car, Diego has $2,000 left over, $1,000 of which he decides to put into a certificate of deposit. What measurement of money is his $1,000 CD a part of? THINK AS AN ECONOMIST: IDENTIFY AN ECONOMIC CONCEPT ILLUSTRATED BY AN EXAMPLE Economists analyze the behaviors of economic actors. They must have the ability to identify the economic concepts or principles illustrated by particular actions. By doing so, they have a conceptual framework for understanding the action. For example, economists observe financial institutions raising interest rates in the face of rising inflation. They recognize this as lenders attempting to maximize their real interest rates. The action demonstrates the firms’ acting on their incentive to make profits. Apply the Skill Read the description of a series of transactions below. Identify the component of the money supply that is illustrated by each transaction. First State Bank grants a loan to Acme Enterprises to fund a new construction project. The bank electronically transfers $100,000 to Acme. Acme’s treasurer writes a check to All-Pro Construction to cover the first month of construction work on the project. After two weeks of construction work, All-Pro issues payroll checks to its five workers. Harry, who is one of those workers, has 10 percent of his wages automatically deposited in a money market account. Acme makes its first monthly payment on its loan to First State Bank. The bank places 10 percent of that money in its reserve account with the regional Federal Reserve Bank. 190 MACROECONOMICS: AP® EDITION ECONOMICS PERSPECTIVES: ARE CRYPTOCURRENCIES MONEY? Modern Money It is estimated that $1.5 trillion of U.S. physical currency is in circulation worldwide. In 2018, the U.S. economy alone was measured at almost $21 trillion. Clearly, physical currency alone cannot account for the volume of the U.S. economy. Therefore, a virtual currency is widely used and accepted as money. This virtual currency is not only commonly used but is also accepted as an official medium of exchange by the U.S. government. Cryptocurrency However, virtual dollars were not the only electronic money exchanged. The desire for financial anonymity was the driving reason for American cryptographer David Chaum to devise a form of electronic money he called “ecash.” The concept evolved, and early forms of “cryptocurrency” were born. These early forms of cryptocurrency provided a means for parties to exchange bank notes through a set of encrypted keys. This allowed the cryptocurrency to be untraceable by banks or governments. Bitcoin, created in 2009, was the first and best-known cryptocurrency. Eventually other forms of cryptocurrency were created. The Case for Cryptocurrency as Money According to Clem Chambers, author of the book Trading Cryptocurrencies: A Beginner’s Guide, cryptocurrencies are, in fact, money. He says that cryptocurrencies are “an excellent means of exchange.” He also says cryptocurrencies are as much a store of wealth as any other currency, despite the fact that they have been very volatile. This just makes them similar to currencies of countries that experience high rates of inflation. Lastly, Chambers argues that cryptocurrencies are widely used as a unit of account. Chambers wrote in Forbes magazine, “Again it is self-evident that you can use bitcoin as a unit of account. Every one of the 500-plus crypto exchanges use crypto as a unit of account. The blockchain that is the underlying technology is by definition a ‘ledger.’ Crypto is by definition a token and by design encapsulated on a ledger.” Cryptocurrencies Are Not Money The argument against cryptocurrencies as money largely lies in the notion that they lack one of money’s important traits: reliability. The fact that cryptocurrencies are not backed by a government or a national bank means that widespread use of cryptocurrencies has been hampered by a lack of trust. The perception of cryptocurrencies as being volatile and unreliable stems from what economic historian Barry Eichengreen calls “high information costs.” This means that fiat money has an advantage over cryptocurrency because there is a single issuer (the government) who is credible and creditworthy. Therefore, Eichengreen says that “the only reliable way of creating a stable-value digital currency is for the central bank to issue it.” Of course, this would defeat the original purpose of cryptocurrency, to provide anonymity to sender and recipient. But Eichengreen and other economists believe that a cryptocurrency is not money until a government says it is. Topic 4.4 BANKING AND THE EXPANSION OF THE MONEY SUPPLY 191 Topic 4.4 Banking and the Expansion of the Money Supply Mobile has become the primary way in which millions of our customers interact with us daily. Customers have higher expectations of their interactions with us. They expect it to be easy for them to cross channels. Brett Pitts, former executive vice president and group head of digital at Wells Fargo, quoted in “Digital Strategy: Does Your Bank Have One?” (2016) Essential Question: What role does the banking system play in the expansion of the money supply? According to the Federal Reserve, on January 8, 2020, there was $1.75 trillion in U.S. currency in circulation, but the total M2 money supply was more than $15.5 trillion. How can the total money supply be nearly nine times as large as the total amount of currency in existence? The answer to that question lies in the ability of banks to expand the supply of money. But that is only a small part of what banks do. Today’s banks offer so many services that they have been likened to “financial supermarkets.” And, like brick-and-mortar supermarkets, they have had to go digital to compete. Types of Depository Institutions Banks are financial institutions licensed by either the federal or a state government to receive deposits and make loans. Broadly speaking, the term bank encompasses a variety of depository institutions that hold funds or securities for depositors. Banks that directly serve the public fall into three categories: commercial banks, thrift institutions (or “thrifts”), and credit unions. Commercial Banks With more than $17 trillion in assets as of January 2020, commercial banks are the nation’s most important financial institutions. Like other businesses, banks may be privately owned and operated or owned by stockholders and managed by boards of directors. Commercial banks work directly with the public, offering a variety of services. One reason that commercial banks dominate the banking sector is that, unlike thrifts, they offer a full range of services to businesses. Another reason for their dominance is the high profits they make from business loans. 192 MACROECONOMICS: AP® EDITION Thrift Institutions The original purpose of thrift institutions was to help people buy homes. They could accept customer deposits and make mortgages. Today, they are generally small community-based institutions. Often thrifts are mutual companies, meaning they are owned by their account holders. As a result, they generally pay higher interest than banks on their customers’ savings. They are restricted by law in their services to businesses. They must invest 65 percent of their assets in residential mortgages and consumer loans and can lend only up to 20 percent of their assets for commercial loans. There are two major types of thrift institutions. The first, mutual savings banks, were established in 1816 to serve low-income families, generating profits for their members. Most of them were located in the Mid-Atlantic and northeast regions of the United States. The federal government first chartered savings and loan associations (S&Ls) during the Great Depression to provide affordable mortgages for middle-class home buyers. By 1965, there were more than 6,000 S&Ls in the United States, but in the 1970s they were struggling. In an effort to address the challenges of a stagnant economy, Congress deregulated S&Ls, leading to widespread fraud and mismanagement. Between 1986 and 1995, nearly a third of the remaining 3,234 S&Ls in the United States failed. By the end of 2018, there were only 691 federally insured S&Ls left. Credit Unions Originally, membership in credit unions was limited to people who shared a common bond—that is, they worked for the same company or in the same industry or lived in the same community. Today, credit unions allow the general public to join. Credit unions are often grouped with thrifts, but since they are nonprofit organizations, they have two distinct advantages: 1. They are exempt from corporate income tax. 2. They need to generate only enough earnings to fund day-to-day operations, allowing them to pay higher interest on deposits and charge less for loans and ATM fees. The Business of Banking The primary function of banks is to accept deposits and lend funds. Deposits are sums of money placed in a bank account. People making deposits receive interest on their money. Banks offer several types of accounts, although the most common are checking and savings accounts. Most deposits in checking and savings accounts (demand deposits) and in certificates of deposit (CDs) are insured up to $250,000 by the federal government, either through the Federal Deposit Insurance Corporation (FDIC) for banks and thrifts or through the NCUA (National Credit Union Administration) for credit unions. Before deposit insurance was created in the 1930s, putting money in a bank was risky. If the bank went broke, as they often did, depositors could lose all of their savings. Depository Accounts As you have seen, checking accounts are considered cash because they are completely liquid. The name came from the fact that customers wrote and signed paper checks directing their bank to pay a Topic 4.4 Banking and the expansion of the money supply 193 specified amount of money from their checking account to a particular person or entity. Today, electronic payments often take the place of physical checks. Customers can use debit cards like credit cards or checks to pay for purchases in person or online or to withdraw cash from an ATM, or automatic teller machine. Instead of cash, checks, or debit cards, many people pay for purchases using smartphone apps. Another option for making payments electronically is electronic funds transfer (EFT). EFT allows bills to be paid by moving funds from one account to another account at the same bank or a different one. Employers use EFT for direct deposit of paychecks into their employees’ accounts, and many people authorize automatic payments for utilities, credit cards, and other recurring bills. Banks offer several types of savings accounts, most of which pay interest on deposits. Money market accounts and certificates of deposit (CDs) usually pay more interest than basic savings accounts. Depending on the type of account and the amount of money involved, however, cash withdrawals may not be available on demand. Withdrawals are sums of money withdrawn, or taken out of an account, either at a bank or an ATM. Loans and Other Services Banks make most of their money by using depositors’ money to make loans and charging a higher rate of interest than they pay on depositors’ accounts. Many loans are secured, meaning that borrowers pledge assets as collateral in case they default, or fail to repay. Unsecured personal loans usually have a higher rate of interest than loans that are secured by collateral. With a secured loan, the bank holds a car title as collateral until an automobile loan is paid off, or the title to a house until a mortgage is paid off. Small business loans may be secured by the business owner’s personal property. Larger commercial loans also usually require that the business post collateral. ln addition to accepting deposits and making loans, banks offer a variety of financial services. These include issuing credit cards, selling money orders and bank drafts, exchanging foreign currency, and renting safe-deposit boxes for the storage of important documents and other valuables. Many banks offer investment services or maintain trust departments to help their customers manage their wealth. Reading a Balance Sheet As discussed in Topic 4.1, everything of value that a business owns is an asset, and everything it owes is a liability. In addition to its real estate and equipment, a bank owns the loans and investments it makes; these are its assets. Bank deposits, on the other hand, belong to the customers who deposited them, and therefore are liabilities. A financial statement that summarizes assets, liabilities, and net worth is known as a balance sheet. The table on the following page shows the balance sheet of Capital City National Bank at the end of January 2020. 194 MACROECONOMICS: AP® EDITION Capital City National Bank Balance Sheet, January 31, 2020 Assets Liabilities and Net Worth Cash in vault $ 1,500,000 Total deposits $34,500,000 Reserve account 2,500,000 Net worth 5,000,000 Loans 25,750,000 Total $39,500,000 Securities 8,500,000 Other assets 1,250,000 Total $39,500,000 Assets The assets of Capital City National Bank totaled $39,500,000: • Cash in vault. Banks’ vaults hold the bulk of their cash (although during business hours some of that cash is in the tellers’ drawers), securities, and other valuables. Cash in vault refers to the amount of paper currency and coins the bank has on hand and fluctuates from day to day. • Reserve account. The Federal Reserve System requires banks with more than $16.3 million in deposits to reserve a percentage of their total deposits. Banks keep most of their reserves in accounts at a district Federal Reserve Bank, where they earn interest. Capital City has $2.5 million in its reserve account. Taken with the $1.5 million cash in its vaults, the bank held a total of $4 million in reserves. • Loans. Loans are considered assets because they are owned by the bank and represent debts payable to the bank. Banks earn most of their profits from the interest on consumer and business loans. Capital City had $25.75 million in loans on January 31. • Securities. Rather than allow funds for which they have no borrowers to lie idle, banks invest those sums in relatively safe interest-bearing securities, such as government bonds. Capital City’s investments totaled $8.5 million. • Other assets. Capital City’s other assets include its building, fixtures, and equipment, including ATMs. Liabilities and Net Worth In a balance sheet, the sum of the liabilities and net worth equals the sum of the assets; in other words, assets and liabilities should balance each other. • Deposits. A bank’s principal obligations are its deposits. They are considered a liability because they represent funds owed to the bank’s depositors. City Capital’s deposits totaled $34.5 million. • Net worth. The difference between a bank’s assets and its liabilities is its net worth. Capital City’s net worth was $5 million. Topic 4.4 Banking and the expansion of the money supply 195 The Federal Reserve System and the Money Supply A nation’s central bank is responsible for regulating member banks. The Federal Reserve System, or “the Fed,” is the central bank of the United States. Congress founded it in 1913 to promote a safe and stable monetary and financial system. In addition to a governing board in Washington, D.C., there are 12 regional Federal Reserve Banks, each of which is responsible for a geographic area of the United States. (For a complete treatment of the tools that the Federal Reserve uses to conduct monetary policy, see Topic 4.6.) Reserve Requirements The Fed regulates and supervises the nation’s banking institutions. One of the chief ways the Fed does this is by setting the reserve requirement, the percentage of its deposits a bank must hold in reserve, either as cash or in deposits with Federal Reserve Banks. The higher the reserve requirement, the less money a bank has to lend on which to make a profit. For this reason, small banks—those with demand deposits totaling less than $16.9 million—are exempted from this requirement. The Fed updates the reserve requirement regularly, raising the deposit level that is subject to different ratios. As of January 2020, banks with demand deposits between $16.9 million and $127.5 million were required to reserve 3 percent of those deposits. Banks with more than $127.5 million in demand deposits must reserve 10 percent of those deposits. This percentage is the reserve ratio. Since even a small change in the reserve ratio causes a significant change in the monetary system, the Fed very rarely changes this number. Any amount over a bank’s required reserves, is considered excess reserves. How Banks Create Money Banks expand the money supply by making loans. The Fed requires that they operate on a fractional reserve banking system, which means they hold a portion of their depositors’ money in reserve. Anything above the required reserves is available to make loans. If a bank’s reserve requirement is 10 percent, the bank can lend 90 percent of its total deposits. If Customer A deposits $10,000, the bank needs to keep $1,000 in reserve but can lend $9,000 to Customer B. When Customer B deposits the $9,000 in her checking account, the bank must keep $900 in reserve but can lend $8,100. Each time money is deposited and a new loan is made, money is created. The progress of the original $10,000 through the banking system is shown in the table on the following page. 196 MACROECONOMICS: AP® EDITION Progress of $10,000 through the Banking System Bank Deposits Required Reserves Loan First $10,000.00 $1,000.00 $9,000.00 Second 9,000.00 $900.00 8,100.00 Third 8,100.00 810.00 7,290.00 Fourth 7,290.00 729.00 6,561.00 Fifth 6,561.00 656.10 5,904.90 Sixth 5,904.90 590.49 5,314.41 Seventh 5,314.41 531.44 4,782.97 Eighth 4,782.97 478.30 4,304.67 Ninth 4,304.67 430.47 3,874.20 Tenth 3,874.20 387.42 3,486.78 Subtotal $65,132.15 $6,513.22 $58,618.93 Sum of remaining banks 34,867.85 3,486.78 31,381.07 Total $100,000.00 $10,000.00 $90,000.00 While it may seem that the creation of money could go on forever, that is not the case. If you were to laboriously add all the possible deposits and loans, eventually you would find that the original $10,000 deposit grows to $100,000 in deposits, thus expanding the money supply tenfold. The amount of money banks generate with each dollar is called the money multiplier. The money multiplier is the reciprocal of the reserve ratio: 1/Reserve ratio For banks with the highest reserve requirement of 10 percent, the money multiplier would be 1/0.10 = 10. For smaller banks with a 3-percent reserve requirement, banks can lend 97 percent of their deposits, and the money multiplier is 33.33 (1/0.03  =  33.33). The actual amount of money created is actually less than the money multiplier predicts, since banks may wish to keep excess reserves and borrowers may not deposit all the money they receive. ANSWER THE TOPIC ESSENTIAL QUESTION 1. In one to three paragraphs, explain the role of the banking system in the expansion of the money supply. Topic 4.4 Banking and the expansion of the money supply 197 MULTIPLE-CHOICE QUESTIONS 1. The money multiplier is (A) the amount of money generated on the balance sheet (B) the amount of loans that can be called in on a balance sheet (C) the way in which one finds the dollar amount eventually generated by loans given (D) the way in which money is measured (E) the percentage banks must hold in reserve 2. Which of the following represents a bank’s largest liability? (A) Loans (B) Reserve requirement (C) Excess reserves (D) Demand deposits (E) Securities 3. Which of the following is true of the Fed’s reserve requirements? (A) Larger banks have a smaller reserve requirement than do smaller banks. (B) A bank’s required reserves are based on the total value of its deposits. (C) A bank’s required reserves are based on the value of its demand deposits. (D) Banks must deposit all of their reserve funds in their regional Federal Reserve Bank. (E) There is no reserve requirement for banks with less than $50 million in demand deposits. KEY TERMS depository institutions commercial banks savings and loan associations credit unions deposits checks ATM electronic funds transfer withdrawals balance sheet Federal Reserve System reserve requirement reserve ratio excess reserves fractional reserve banking money multiplier 198 MACROECONOMICS: AP® EDITION FREE-RESPONSE QUESTIONS 1. Use the following balance sheet to answer all parts of the questions that follow: Seaside Bank Assets Liabilities Required Reserves $ 10,000 Demand deposits $100,000 Excess Reserves $90,000 Owners' equity $80,000 Loans $50,000 Other assets $30,000 Total $180,000 Total $180,000 (a) Based on the above balance sheet, calculate the required reserve ratio. (b) Suppose the Federal Reserve purchases $2,000 worth of bonds from the above bank. Explain what will change in each of the following? (i) Excess reserves (ii) Demand deposits (c) If Pat deposits $2,000 into her checking account, what is the immediate effect on the M1 measure of the money supply? (d) Calculate the new required and excess reserves due to Pat’s deposit after the Federal Reserve bond purchase. THINK AS AN ECONOMIST: DETERMINE THE EFFECTS OF AN ECONOMIC CHANGE USING CALCULATIONS Economists use quantitative data and calculations to determine the effects of a change in an economic situation. Government economists do the same to try to estimate the effects of government policy decisions. Doing so requires them to answer two questions: • What variable in the situation changed? • What effect will that change have on economic outcomes? When considering the reserve ratio, the effect of a change extends beyond one point. Apply the Skill Suppose you are an economist at the Federal Reserve asked to calculate the impact of a possible reduction in the reserve ratio from 4 percent to 3 percent. Assume that $3.5 trillion worth of deposits will be affected by this change. What is the money multiplier at the current 4 percent reserve ratio? What would the money multiplier be under the 3 percent ratio? What is the maximum amount that the money supply will change as a result of this ratio adjustment? Topic 4.5 The Money Market 199 Topic 4.5 The Money Market Up to a point it is worthwhile to sacrifice a certain amount of interest for the convenience of liquidity. But, given that the rate of interest is never negative, why should anyone prefer to hold his wealth in a form which yields little or no interest to holding it in a form which yields interest? John Maynard Keynes, The General Theory of Employment, Interest, and Money (1936) Essential Question: How do the demand for and supply of money determine the equilibrium nominal interest rate and influence the value of other financial assets? As discussed in the previous topics, liquidity refers to the ease with which financial assets can be converted to money to spend. The English economist John Maynard Keynes developed a theory on liquidity preference—how people choose to divide their resources between highly liquid forms, particularly cash, and less liquid forms such as bonds. This was part of his larger attempt to understand how the demand for and supply of money influence nominal interest rates. The Demand for Money As you have learned, money is a major financial asset. Two functions of money help explain the demand for money: 1. It functions as a medium of exchange, allowing people to purchase goods or services. 2. It functions as a store of value, allowing it to be saved for future use. The phrase “the demand for money” refers to how much of their assets people choose to hold in some form of easily obtainable money rather than in less liquid assets. He also described three reasons or motives for holding money: • “The transactions motive” (also known as “the transactions demand for money”) refers to the money people hold as cash or in liquid demand deposits such as checking accounts to pay for goods and services they need on a regular basis. This motive is directly related to the level of income. 200 MACROECONOMICS: AP® EDITION • “The precautionary motive” (also known as “the precautionary demand for money”) refers to money people may hold in less liquid form, such as a savings account, where it will be ready for future contingencies, such as health care expenses or automobile maintenance, that they want to be prepared for. • “The speculative motive” (also known as the speculative demand for money or “asset demand”) refers to money people hold in stocks, bonds, and other securities that will earn them interest. These are considered speculative because their value may rise or fall. In order to focus on the issue of how people make choices, assume that people have only two ways to hold financial assets: in checking accounts or as bonds. Assets in a checking account are highly liquid, while bonds are less liquid. While there is generally an expectation that money invested in bonds will be tied up until they mature, bonds can be converted to cash, although the seller might need to pay a penalty for doing so before maturity. Other Determinants of the Demand for Money Liquidity is important, but it does not tell the whole story of how people decide how to allocate their resources. Several other factors also help determine the demand for money. Level of Income and Real GDP As the total of all incomes in an economy increase, people demand more money, and as total incomes fall, people demand less money. As real gross domestic product (GDP) increases, so do incomes, resulting in a greater demand for money throughout the economy. (Real GDP is the GDP adjusted for inflation.) Price Level The price level refers to the buying power of money. In the United States, the most common measure of price level is the Consumer Price Index (CPI), which is calculated by measuring changes in the prices of a basket of consumer goods and services. An increase in the price level is referred to as inflation; a decrease is known as deflation. When there is an increase in the price level, there is a corresponding increase in the demand for money. When there is a decrease in the price level, the demand for money also decreases. Expectations The speculative demand for money is based on bond prices. When people expect bond prices to fall, they sell, thus increasing the demand for money. When people expect bond prices to rise, they buy, which reduces the demand for money. The expectation that bond prices are going to rise or fall actually causes them to do so. Transfer Costs If the cost of transferring funds between money and nonmoney deposits becomes more expensive, customers tend to make fewer transfers, which increases the quantity of money they demand. If transfer costs decline, the demand for money tends to fall. New technology has made it easier and less expensive for people to convert their wealth into money, so today, people tend to invest more of their money than the did in the past. Topic 4.5 The money market 201 Preferences As with other kinds of demand, preferences play a part in the demand for money. Some people like to keep a large amount of money available, while others prefer to invest as much as possible. People’s attitudes about the trade-off between risk and yield also affect the demand for money. Some people prefer safe options for storing their money, such as insured deposit accounts but with lower interest, while others prefer to invest their money in bonds with higher yields but with more risk that the bond’s issuer may default. Interest Rates and the Demand for Money The quantity of money that people hold varies inversely with the nominal interest rates they can earn from other financial assets, such as bonds. • If people think interest rates are low, they have less incentive to invest in bonds than to hold money, so the demand for money increases. • If people view interest rates as high, bonds become more attractive, and the demand for money decreases. The demand curve for money shows the quantity of money demanded at each interest rate. It slopes downward from the left to the right, reflecting the inverse relationship between the quantity of money demanded and the interest rate. Interest Rate Money Demand Quantity of Money The Demand Curve for Money The law of demand applies to the relationship between interest rates and the quantity of money demanded. If holding bonds is the alternative to holding money, then nominal interest rates are the price of holding money. As with other goods and services, an increase in this price results in a decrease in the quantity demanded. When there is an increase in the demand for money, the demand curve shifts to the right, reflecting an increase in the quantity of money demanded at any interest rate r, as shown in the paired graphs “Changes in the Demand for or Supply of Money” on page 205. Conversely, a drop in the demand for money would shift the demand curve to the left. 202 MACROECONOMICS: AP® EDITION The Money Supply Central banks are financial institutions that control a country’s monetary supply. They do this through the production and distribution of money. In the United States, the central bank is the Federal Reserve Bank (Fed), which controls the money supply chiefly through its Federal Open Market Committee (FOMC). The Fed has three basic tools for influencing the supply of money: • It can buy and sell U.S. Treasury notes, bills, and bonds as a way to directly affect how much money people have for other purchases. • It can raise or lower the reserve requirements on deposits, which influences how much money banks have available for loans. • It can raise or lower the discount rate, which is the interest rate the Fed charges for loans of 24 hours or less that its regional banks make to financial institutions to prevent funding shortfalls. Raising the discount rate makes loans to banks more expensive, which signals a reduced money supply and higher overall interest rates. Conversely, lowering the discount rate signals an expanded money supply and lower overall interest rates. Equilibrium and Disequilibrium in the Money Market The money market is the interaction between the demand for money and the money supply. It is in equilibrium when the nominal interest rate is such that the quantity of money demanded equals the quantity of money supplied. This is referred to as the equilibrium nominal interest rate. In Figure 2, the money demand curve is labeled D, the money supply is the vertical line S, and the equilibrium nominal interest rate is r. Money Market Equilibrium r D Interest Rate M Quantity of Money S Disequilibrium occurs when there is either a change in demand for money or in the money supply. When that occurs, nominal interest rates create a surplus or shortage in the money market. Market forces cause nominal interest rates to adjust until the quantity of money people want to hold is equal to the amount Topic 4.5 The money market 203 of money that exists. When the nominal interest rate is above equilibrium, people reduce the amount of money they hold, and when the nominal interest rate is below equilibrium, they increase the amount of money they hold. Changes in the Demand for Money According to Keynes’s theory of liquidity preference, the nominal interest rate adjusts to balance the supply of and demand for money. People may choose to hold more or less money at each nominal interest rate due to changes in any of the five determinants listed above, such as a change in real GDP, the price level, or expectations. If the demand for money decreases, there will be an increase in the demand for bonds, causing the money demand curve to shift to the left and a corresponding drop in the nominal interest rate. An increase in the demand for money will have the opposite effect: The money demand curve will shift to the right, and the resulting higher nominal interest rate will lead to a lower quantity invested. Changes in the Money Supply If the market for money is in equilibrium and the Fed changes the money supply when there are no changes in any of the determinants of money demand, a corresponding change in the demand for money and in nominal interest rates will occur. The Fed increases the money supply by buying government bonds. When this happens, the money it pays for the bonds is typically deposited in banks, adding to bank reserves. Then the nominal interest rate must fall to restore equilibrium. Lower interest rates stimulate investment. Bond prices rise, causing nominal interest rates to fall and an increase in the quantity of money people demand. When the Fed sells government bonds, the money it receives for them is withdrawn from the banking system, and bank reserves fall. Bond prices fall, causing nominal interest rates to rise and a decrease in the demand for money. The changes in bank reserves that result from the buying or selling of bonds change the quantity of money in the economy. (a) Increase in the Demand for Money (b) Increase in the Money Supply Changes in the Demand for or Supply of Money S r 1 r 2 D1 D2 Interest Rate M Quantity of Money r 2 r 1 D S1 S2 Interest Rate M Quantity of Money 204 MACROECONOMICS: AP® EDITION In graph (a), an increase in the demand for money, from D1 to D2 , results in a rise in the equilibrium nominal interest rate, from r1 to r2 . In graph (b), an increase in the money supply, from S1 to S2 , results in a fall in the equilibrium nominal interest rate, from r1 to r2 . ANSWER THE TOPIC ESSENTIAL QUESTION 1. In one to three paragraphs, explain how the demand for and supply of money determine the equilibrium nominal interest rate and influence the value of other financial assets. KEY TERMS liquidity speculative demand for money monetary supply money market MULTIPLE-CHOICE QUESTIONS 1. According to Keynes, the three motives for holding money are (A) the transactions motive, the precautionary motive, and the speculative motive (B) the transactions motive, the precautionary motive, and the profit motive (C) the transactions motive, the profit motive, and the speculative motive (D) the preference motive, the profit motive, and the speculative motive (E) the preference motive, the precautionary motive, and the speculative motive 2. As a country comes out of a recession and the price level and income levels increase, (A) the demand for money increases, which increases nominal interest rates (B) the demand for money decreases, which increases nominal interest rates (C) the supply of money increases, which decreases nominal interest rates (D) the supply of money decreases, which increases nominal interest rates (E) there is a simultaneous increase in the money supply and decrease in money demand Topic 4.5 The money market 205 3. What happens when the Federal Reserve buys bonds? (A) The transaction demand for money increases, and the supply of money decreases. (B) The transaction demand for money decreases, and the supply of money decreases. (C) The supply of money decreases, and nominal interest rates decrease. (D) The money supply decreases, and nominal interest rates increase. (E) The money supply decreases, and nominal interest rates decrease. FREE-RESPONSE QUESTIONS (a) Briefly explain the speculative demand for money. (b) How does the real gross domestic product (GDP) affect the demand for money? (c) What is price level, and how does it affect the demand for money? (d) What part do expectations play in the demand for money? (e) Describe two changes that can lead to disequilibrium in the money market. THINK AS AN ECONOMIST: DRAW AN ACCURATELY LABELED GRAPH TO REPRESENT AN ECONOMIC MARKET The supply of and demand for money react to market forces in similar ways to the supply of and demand for goods or services. The demand for money responds inversely to changes in the interest rate—the price of money. The supply of money responds to monetary policy set by the Federal Reserve. Economists use supply-demand curves to display the interaction of these two forces to find the equilibrium price of money. They can also use these curves to show changes in supply and demand that occur. Apply the Skill Consider the following situation. Supply (S) of and demand (D) for money establish the equilibrium nominal interest rate (r) for the quantity of money (M). Suddenly the economy enters a downturn, with employers laying off workers and unemployment rising from 4.3 to 6.7 percent. In the face of these economic troubles, consumer spending falls and the demand for money drops lower (D1). Create a supply and demand curve for money showing the original situation described and new market conditions resulting from the change in demand. Label the new demand curve D1 and the new nominal interest rate r1. Assume no change in the money supply. Label the curves, relevant points, and axes correctly. Include arrows showing the direction of change. 206 MACROECONOMICS: AP® EDITION Topic 4.6 Monetary Policy He who controls the money supply of a nation controls the nation. Attributed to U.S. President James Garfield, 1881 Essential Question: What are the short-run effects of monetary policy on macroeconomic outcomes? When President George W. Bush nominated him to chair the Federal Reserve Board, Ben Bernanke had no idea that within a year of taking over, the country would be blindsided by a major financial crisis. The Great Recession lasted from December 2007 to June 2009. The Fed implemented aggressive and unprecedented monetary policies to prevent greater damage to the economy. In spite of this, unemployment rose from 5 percent at the end of 2007 to a high of 10 percent in October 2009, and it did not fall back to 5 percent until 2015. However, the Fed’s policies likely helped keep the Great Recession from becoming something as damaging as the Great Depression of the 1930s. What Is Monetary Policy? A nation’s monetary policy consists of the actions and communications its central bank takes to manage the nation’s money supply and interest rates. There are three major monetary policy objectives: • To promote maximum employment • To promote stable prices by controlling inflation • To promote moderate long-term interest rates What Is a Central Bank? A central bank is the financial institution authorized to produce and distribute money and credit for a nation and to conduct its monetary policy. It does this by managing the level of short term interest rates and influencing the overall availability and cost of credit in the economy. Monetary policy indirectly affects longer-term interest rates, currency exchange rates, and the prices of stocks, bonds, and other assets. As a result, monetary policy influences a nation’s household spending, business investment, production, employment, and prices. The Federal Reserve System, or Fed, is the central bank of the United States. Other central banks include the European Central Bank, the Bank of England, the Bank of Japan, and the Bank of Canada. Topic 4.6 Monetary policy 207 Atlanta The Twelve Federal Reserve Districts ALASKA HAWAII Boston New York Philadelphia Richmond Atlanta Cleveland St. Louis Chicago Kansas City Dallas Minneapolis San Francisco 1-12 Federal Districts Federal Reserve Bank Cities 12 12 12 1 2 3 4 7 8 6 5 9 10 11 Source: Federal Reserve Bank of San Francisco The Tools of Monetary Policy When interest rates are low, people can more easily afford to buy homes, and businesses are more likely to expand. When interest rates are high, individuals and companies are less likely to borrow and spend. Central banks try to limit the harmful effects of inflation and recession. In times of economic downturn or recession, a central bank will want to adopt an expansionary policy to increase the money supply and lower interest rates, thus spurring economic growth. Conversely, in times of inflation it will put into effect a contractionary policy, decreasing the money supply and causing interest rates to rise, with the intention of slowing economic growth. Central banks do this by using their monetary tools to increase or decrease interest rates. The tools of monetary policy used by the Federal Reserve include open-market operations, the required reserve ratio, and the discount rate. The monetary policy tool most frequently used is open-market operations. Open-Market Operations A central bank can influence the nominal interest rate in the short run by changing the money supply, which in turn will affect investment and consumption. In open-market operations, a central bank sells or buys government bonds in the open market to change the money supply. In the United States, the branch of the Federal Reserve that determines the nation’s monetary policy is the Federal Open Market Committee (FOMC). The FOMC normally meets eight times a year to discuss whether to maintain or change the current policy. It changes the money supply by either buying or selling government securities such as U.S. Treasury bills to control the supply of money in the economy. 208 MACROECONOMICS: AP® EDITION During a recession, the Fed tries to spur growth by increasing the money supply. Conversely, it tries to curb inflation by shrinking the money supply. As you learned in Topic 4.5, the Fed can increase the money supply by buying back securities from the nation’s largest security dealers and banks, or it can decrease the money supply by selling securities. When it does so, the equilibrium nominal interest rate either falls or rises. When an open-market purchase takes place, the Fed is buying, and the public—in this case, a bank or a security dealer—is selling. The Fed gives the seller of the securities a check, which the seller then deposits in the bank, resulting in an automatic increase in the bank’s reserve balance with the Fed. The bank can use these new reserves to make additional loans, thus increasing the money supply. When the bank makes additional loans, the people receiving those loans get the money deposited in their accounts, further expanding the money supply. As you learned in Topic 4.4, this process is referred to as the money multiplier effect. As you will recall, the money multiplier is determined by dividing 1 by a bank’s reserve ratio. If it is a large bank with a reserve ratio of 10 percent, the money multiplier is 10, meaning that for every $1,000 deposited, the money supply can expand by $10,000. Another policy many central banks carry out is to set a target range for the overnight interbank lending rate. In the United States, the FOMC accomplishes this by setting the target federal funds rate every six weeks at its regular meetings. Federal funds are the balances that banks maintain in their accounts at their Federal Reserve Bank, and the federal funds rate, or fed funds rate, is the interest that banks charge one another for overnight loans of federal funds. Banks, credit unions, and other lenders base the interest rates they charge their customers on the federal funds rate. An increase in the fed funds rate results in an increase in interest rates on consumer loans, mortgages, and other credit vehicles. Conversely, a decrease in the fed funds rate results in a decrease in those interest rates. Required Reserve Ratio The central bank also sets requirements for the nation’s banking industry, such as the amount of cash a bank must keep on reserve. A major part of a bank’s income comes from the interest it earns on the loans it makes using its depositors’ money. However, it must also keep enough cash on hand to take care of day-to-day transactions such as withdrawals. Small private banks are sometimes exempted from reserve requirements since they hold only a small percentage of the total assets of a banking system. Most banks cannot lend all of the money in depositors’ accounts but must keep a percentage of those deposits on reserve. In the United States, the Federal Reserve Board of Governors sets this percentage, or reserve ratio. When the Fed increases the reserve ratio, banks’ lending ability is reduced. When reserve ratios are reduced, the opposite happens. In Topic 4.4, you learned that with a reserve ratio of 10 percent, a deposit of $10,000 could lead to an expansion of deposits totaling $100,000 as the deposit traveled through the banking system. This is because of the money multiplier Topic 4.6 Monetary policy 209 effect. With a reserve ratio of 20 percent, the same $10,000 deposit could be expanded to only $50,000 in deposits, whereas with a reserve ratio of 5 percent it could be expanded to $200,000. As you can see, the effect of a change in reserve requirements on the banking system as a whole can be quite dramatic. During periods of expansion, when resources are fully employed and prices are moving into inflationary levels, the central bank can move against these trends by increasing the reserve ratio. During recessions the central bank can reduce the reserve ratio, enabling banks to make more loans. By making more loans, the banks can, in turn, add to the money supply and aggregate demand. Discount Rate Another monetary policy tool of central banks is known as the discount rate or rediscount rate. The discount rate is the interest rate charged by a central bank for loans of reserve funds to commercial banks and other financial institutions. When their reserves get low, member banks can replenish them with loans from the central bank. In the United States, this is the Federal Reserve Bank that services their district. Since banks are in business to earn a profit, they must charge their loan customers something more than this rate. The amount of money that the public borrows is affected by prevailing interest rates. As the cost of loans increases, borrowing decreases. The Fed can use its power of increasing or decreasing the discount rate to affect the volume of loans and the quantity of money in circulation and credit available. The discount rate is usually a percentage point above the federal funds rate, and it is normally changed whenever the FOMC changes the fed funds rate. The Fed may increase the discount rate to tighten up on credit and slow the growth of the money supply, as it did during the mild inflation of the early 1990s. A slower growth of the money supply, in turn, puts downward pressure on prices and inflation. During recessions like the one that hit the United States between 2007 and 2009, the Fed can choose to reduce the discount rate. As banks follow suit by reducing their interest charges, business and consumer loans increase. This in turn leads to increased business activity, consumer spending, and employment. The graph on the following page illustrates the relationship between different interest rates, specifically the effect of changes in the federal funds rate and the discount rate on the prime rate and credit card interest rates. The prime rate is the interest rate that commercial banks charge corporations whose credit rating is so high that there is virtually no risk of loss. It also affects all other interest rates. The credit card rate represents the average interest charged on unpaid credit card balances. Notice that the fed funds rate hovered near 0 percent during the economic recovery that followed the Great Recession. 210 MACROECONOMICS: AP® EDITION Interest Rate Year Commercial Bank Interest Rates on Credit Card Plans Effective Federal Funds Rate Discount Rate for United States Bank Prime Loan Rate Interest Rates, 2003-2019 17.5 15 12.5 10 7.5 5 2.5 0 2004 2006 2008 2010 2012 2014 2016 2018 Source: Federal Reserve Bank of St. Louis The Effects of Monetary Policy In the short run, monetary policy influences aggregate demand, real output, the price level, employment, and interest rates—either directly by adjusting interest rates or indirectly by adjusting the money supply. The following graphs show some of the short-run economic effects of an increase to the money supply. Interest Rate Short-Run Effects of Changes to the Money Supply M Quantity of Money Price Level Quantity of Output S1 S2 D 0 r 2 r 1 AD2 AD1 Y2 Y1 0 P (a) Change in the Money Supply (b) Shifts in the Aggregate-Demand Curve In graph (a), an increase in the money supply, from S1 to S2 , results in a drop in the equilibrium nominal interest rate, from r1 to r2 . Graph (b) shows the resultant shift of the short-run aggregate demand curve to the right, from AD1 to AD2 , as the quantity of goods and services demanded at a given price level Topic 4.6 Monetary policy 211 increases from PL1 to PL2 and the output from Ye back to Yf .A decrease in the money supply would have the opposite effect, shifting the short-run aggregate demand curve to the left and leading to a decreased demand for goods and services at a given price. During economic downturns or periods of inflation, central banks like the Federal Reserve use expansionary or contractionary monetary policies to stabilize the economy and promote full employment. Expansionary Monetary Policy Central banks use expansionary monetary policy to lower unemployment and avoid recession while stimulating economic growth. Because it is difficult to catch the contractionary phase of the business cycle in time, expansionary policy usually is not set until after a recession has begun. The Fed has several options available to stimulate the economy: • Buy securities. The Fed buys Treasury notes and other securities, giving banks more money to lend and expanding the money supply. Interest rates drop, making loans less expensive. This boosts spending. • Lower the discount rate. The FOMC may also lower the fed funds rate, which also results in a lower discount rate. This also causes interest rates to drop and boosts spending. • Lower reserve requirements. The Fed rarely lowers the reserve requirement, even though this immediately increases the money supply. When the Federal Reserve engages in expansionary monetary policy, the money supply increases, which decreases the interest rate. When the interest rate decreases, interest-sensitive spending in the form of business investment and consumption increase, thereby increasing aggregate demand. When aggregate demand increases, price level and real GDP increase as well. Contractionary Monetary Policy In an inflationary economy, with prices increasing at an unacceptable rate, central banks adopt a contractionary monetary policy. This policy slows the rate of increase in the money supply to something less than the increase in the GDP and reduces aggregate demand. The Fed has several options available to bring inflation under control: • Sell securities. By selling Treasury bills, bonds, and notes to the public, the Federal Reserve System receives the payments from the sales of these securities. The sales reduce bank reserves, the lending ability of the banking system, and the money supply. • Raise the discount rate. By raising the discount rate, the Fed charges local banks more to borrow from the Federal Reserve System. The banks then raise the interest rates they charge their customers. Higher interest rates discourage borrowing, slow the growth of the money supply, and reduce aggregate demand and prices. 212 MACROECONOMICS: AP® EDITION • Increase reserve requirements. By requiring that local banks hold a larger portion of their deposits on reserve, the Fed reduces banks’ lending ability, along with the money supply. When the Federal Reserve engages in contractionary monetary policy, the money supply decreases, which increases the interest rate. When the interest rate decreases, interest-sensitive spending in the form of business investment and consumption decrease, thereby decreasing aggregate demand. When aggregate demand decreases, price level and real GDP decrease. Monetary Policy Limitations The Fed has monetary tools to regulate the economy. How well the Fed can achieve its goals depends on a number of factors. Forecasting and Timing Difficulties The success of monetary policy depends on how quickly and accurately the Fed recognizes and responds to economic trends. Although economists can describe in general terms how well or how poorly the economy is doing, it is impossible to predict possible problems in the economy with certainty. This makes it difficult for the Fed to know exactly how much to raise or lower interest rates or increase or decrease the money supply. There are numerous time lags, initially between recognizing a problem and adjusting monetary policies, then between making those adjustments and seeing the impact they have on the business community. In retrospect, it may turn out that changes were too early or too late, too extreme or not extreme enough, or perhaps not even necessary. The Business Cycle Monetary policy is least effective at either end of the business cycle. During the recessionary phase, the Fed will lower interest rates. However, this may not be enough to allay fears created by job layoffs and business failures, and spending may remain at low levels in spite of the reduced cost of loans. Similarly, as the business cycle climbs toward the upper reaches of expansion, the effectiveness of monetary policy wanes. Then the Fed may increase interest rates to discourage loans, slow the growth of the money supply, and lower prices. But as long as business prospects are good, firms will continue to borrow and expand, believing that increased sales will more than offset the higher cost of money. As a result, prices will continue to rise in spite of the Fed’s efforts to reverse the trend. New Banking Laws In the mid-20th century, most people placed the bulk of their savings in regular savings accounts, and the interest offered by savings institutions was limited by law. In the 1980s, however, Congress removed those limits and repealed the prohibition against the payment of interest on demand deposits. As a result of deregulation, banks became more competitive, but they also became less responsive to shifts in Fed policies. For example, in the days before deregulation, the Fed could tell banks to reduce the interest rates they paid on deposits as a way of discouraging savings and encouraging Topic 4.6 Monetary policy 213 KEY TERMS monetary policy central bank expansionary policy contractionary policy open-market operations federal funds rate discount rate MULTIPLE-CHOICE QUESTIONS 1. Which of the following best describes the discount rate? (A) It is the interest rate set by the Fed for overnight interbank lending. (B) It is the interest rate charged by a central bank for loans of reserve funds. (C) It is the interest rate commercial banks charge their best corporate customers. (D) It is the percentage of a bank’s deposits that must be held in reserve. (E) It is the amount by which the money supply expands as a result of the money multiplier. 2. If the reserve ratio is 5 percent, how much could an initial deposit of $10,000 grow to as a result of the money multiplier? (A) $20,000 (B) $40,000 (C) $100,000 (D) $200,000 (E) $400,000 consumption. Today, however, bankers can ignore such suggestions if they think it would be more profitable to do otherwise. The Global Economy One result of globalization is that individuals and governments in foreign countries hold many more U.S. dollars than they once did. Even though those holdings are abroad, they still have an effect on prices in the United States, and those prices directly affect the level of economic activity. While the Fed has a great deal of control over the money supply in the United States, it is limited in its ability to regulate dollars in foreign hands, which lessens its ability to regulate the value of the dollar, price levels, and the business cycle. ANSWER THE TOPIC ESSENTIAL QUESTION 1. In one to three paragraphs, describe the short-run effects of monetary policy on macroeconomic outcomes. 214 MACROECONOMICS: AP® EDITION 3. Which of the following is a short-run effect of an increase in the money supply? (A) Interest rates increase. (B) Demand for money increases. (C) Price level increases. (D) Aggregate demand for goods and services increases. (E) Aggregate demand for goods and services decreases. FREE-RESPONSE QUESTIONS (a) How does the federal funds rate differ from the discount rate? (b) Identify and briefly explain the three tools that the Federal Reserve has it its disposal. (c) Assume the United States is experiencing a recession. What open market operation could the Federal Reserve engage in to ease the burden of the recession? (d) Create a graph that shows the effect of the above monetary policy action on the money market. (e) Briefly explain the effect of expansionary monetary policy on employment. Topic 4.6 Monetary policy 215 THINK AS AN ECONOMIST: USE ECONOMIC PRINCIPLES TO EXPLAIN HOW TO ACHIEVE A SPECIFIC OUTCOME Economists use economic principles to explain what decisions economic actors should make. To do this, they do the following: • Identify what specific economic behaviors are taking place in a particular situation. • Use an economic principle to explain how to achieve a specific outcome. For example, economists note that individuals and businesses are willing to borrow money in a period of inflation, as long as interest rates are not too high. The main driver of this fact is the desire to minimize costs. Since prices are going up, the value of money is going down. Thus, borrowers will be repaying their loans with cheaper dollars, making it less costly to borrow. Apply the Skill As you have read, the Federal Reserve has several tools, some of which have a contractionary effect on the economy and some of which have an expansionary effect. Suppose that a natural gas pipeline disaster depletes the flow of gas substantially. Electric utilities that rely on natural gas see huge increases in the cost of this fuel, causing electricity rates to sharply rise as well. Utilities that rely on other fuel sources raise their rates, too. As a result, businesses across the economy raise their prices. Within a few months, the inflation rate reaches double digits. What Fed tool would be most effective in responding to this situation? What economic principle explains why it would be the most effective? 216 MACROECONOMICS: AP® EDITION Topic 4.7 The Loanable Funds Market One-fifth of Americans are adding nothing to their savings, according to a Bankrate survey. Why not?  Taylor Tepper, Bankrate.com, March 14, 2018 Essential Question: How do the interactions of borrowers and savers determine the equilibrium interest rate of loanable funds? The loanable funds market, like so many other parts of the economy, is one of supply and demand. In this case, the supply is money, in the form of savings. U.S. families save a smaller portion of their incomes than their counterparts in many other countries, from Luxembourg and Switzerland to South Korea and Australia. Instead of encouraging people to save money, the consumer-driven U.S. economy entices them to spend. On average an adult in the United States spends $18,000 a year on nonessentials, but 60 percent of these same people do not have enough in savings to cover a $1,000 emergency. As you will see in this topic, the lack of savings has a direct impact on the supply of loanable funds, interest rates, investments, and economic growth. How the Loanable Funds Market Works The market for loanable funds, like other markets in an economy, is governed by the laws of supply and demand. The loanable funds market is a model of the way money from savers makes its way into the hands of borrowers. Supply and Demand The supply of loanable funds comes from national saving, which consists of all of a nation’s private saving and public saving. It includes the money people deposit in bank accounts to save for future use, business profits, and government budget surpluses. Interest is the reward paid to savers. Lenders—usually financial institutions—then supply funds to the loanable funds market. High interest rates on deposits provide an incentive to save, and thus a larger supply of loanable funds. There is less incentive to save when interest rates are low, with the result that there might be a shortage of loanable funds. The demand for loanable funds usually comes from the desire to make a financed purchase of some sort. A family might want to purchase a new car or a new house, while a business may want to build a new office or purchase new equipment. Businesses and individuals are more likely to borrow when interest rates are low, because that keeps their costs down. As interest rates rise, the cost of borrowing goes up, people and businesses are less likely to borrow, and there is a drop in investment spending. Topic 4.7 The loanable funds market 217 Interest Rates The interest rate is the price of a loan. It is also the amount that people receive for the use of the money they save or that they pay to borrow money. As you learned in Topic 4.2, there are two types of interest rates. The rate that is usually cited when banks advertise interest rates is the nominal interest rate. The real interest rate is the nominal interest rate minus the rate of inflation. For example, if the nominal interest rate is 7 percent and the rate of inflation is 2 percent, the real interest rate is 5 percent. Throughout this topic, the term interest rate will refer to the real interest rate. Graphing the Market for Loanable Funds The graph for loanable funds is similar to the other supply and demand graphs you have studied. The supply curve is directly proportional to the interest rate, so it slopes upward from left to right. There is an inverse relationship between real interest rates and the quantity demanded, so the demand curve slopes downward from left to right. The point at which the two curves intersect is the equilibrium level, where the supply of and demand for loanable funds are equal. The interest rate at this point is the equilibrium interest rate. Whenever there is a change in either the supply or demand of loanable funds, the interest rate adjusts to the equilibrium level for the usual reasons. In reality, interest rates vary greatly depending on their amount, duration, and purpose. The interest rate on short-term credit card debt is often six times the rate on long-term home loans. For clarity, the loanable funds model simplifies this by assuming only one average interest rate. If the interest rate fell lower than the equilibrium level, the supply of loanable funds would be lower than the demand for them, and lenders would raise their interest rates. This would encourage saving, which would increase the supply of loanable funds. But at the same time, higher interest rates would discourage borrowing, and thus decrease the demand for loanable funds. If, on the other hand, the interest rate was higher than the equilibrium, the supply of loanable funds would exceed the demand for them. In order to attract borrowers, lenders would lower their interest rates, and thus restore equilibrium. Determinants of Supply and Demand in the Loanable Funds Market The national savings rate measures the part of the gross domestic product (GDP) that is saved in a nation. It includes savings from personal income, business earnings, and tax revenues. In the United States, the Commerce Department’s Bureau of Economic Analysis (BEA) tracks this data as an economic indicator of the nation’s financial health, since investments are funded through savings. Retirement plans such as 401(k)s and IRAs make up a large part of national savings. A general rise in incomes does not ensure a higher rate of savings, since it may be accompanied by a rise in consumption. The U.S. national savings rate has declined significantly since the mid-1960s. As of 2017, the United States 218 MACROECONOMICS: AP® EDITION ranked 113th out of 181 nations, with personal, business, and government savings accounting for only 17.5 percent of the GDP. Economists often use a closed economy—that is, one that does not interact with other economies—in order to keep their models simple. In such a model, national saving is equal to investment. In fact, no such economy exists in the world today. In an open economy—one that interacts freely with other economies—investment equals national savings plus the net inflow of capital from abroad. Other factors can enter the picture as well and alter the outcomes. For example, government policies can affect the supply of or demand for loanable funds. Incentives to Save and to Invest Americans save a much smaller portion of their income than people in many other countries. U.S. tax laws are at least partly responsible for this: Since interest income is taxable, it reduces the future payoff and thus reduces the incentive to save. If a country has high interest rates that discourage investments, it could change the tax laws to encourage people to save more. This could increase the supply of loanable funds, lowering the interest rate and stimulating investment. In periods of low interest rates, a sign that businesses can borrow money easily and at a low cost, changes to encourage savings would have little effect. From time to time Congress passes investment tax credits to make investing more attractive. This gives a tax advantage to businesses that invest in capital improvements, such as buying new equipment or building new factories. Such an incentive would increase the demand for loanable funds at all interest levels, but it would not directly affect the supply of loanable funds. However, the increased demand would raise interest rates, which would encourage more saving, thus increasing the supply of loanable funds. Interest Rate The Effects of Incentives to Save and to Invest Loanable Funds (a) Saving Incentives (b) Investment Incentives Loanable Funds Interest Rate S1 S2 D 0 r 2 r 1 r 2 r 1 D2 D1 0 S LF1 LF2 LF2 LF1 Topic 4.7 The loanable funds market 219 Graph (a) shows how saving incentives increase the supply of loanable funds, shifting it to the right, from S1 to S2 . The equilibrium interest rate drops from r1 to r2 , and the equilibrium quantity of loanable funds saved and invested rises. In graph (b), an investment tax credit raises the demand for loanable funds, shifting it to the right, from D1 to D2 . The equilibrium interest rate rises from r1 to r2 , and the equilibrium quantity of loanable funds saved and invested rises. Government Budget Deficits or Surpluses A federal budget deficit exists when government spending exceeds tax revenue. In order to finance these deficits, the government borrows in the bond market. This reduces the supply of loanable funds that is available to finance investment by individuals and companies. Hence, it has the potential to push up interest rates, thereby discouraging both individuals and businesses from borrowing. If government borrowing causes a decrease in private borrowing, it is called “crowding out.” Depending on what the government is borrowing to finance, it can reduce the economy’s growth rate. (Crowding out is discussed in greater detail in Topic 5.5.) A budget surplus (or a decrease in the deficit) can have the opposite effect. When the government spends less than it collects in taxes, the budget surplus increases the supply of loanable funds. This has the potential to reduce the interest rate and stimulate investment and economic growth. However, decreasing the federal deficit or running a surplus might also reduce aggregate demand, which could reduce economic growth. Interest Rate The Effects of Government Budget Deficits and Surpluses Loanable Funds (a) Budget Deficit (b) Budget Surplus Loanable Funds Interest Rate S1 S2 D 0 r 2 r 1 r 2 r 1 D 0 S1 S2 LF1 LF2 LF2 LF1 220 MACROECONOMICS: AP® EDITION In graph (a), a budget deficit lowers national saving, so the supply of loanable funds decreases, and the supply curve shifts to the left, from S1 to S2 . The equilibrium interest rate rises from r1 to r2 , and the equilibrium quantity of loanable funds saved and invested falls. Graph (b) illustrates a budget surplus. The supply of loanable funds increases, and the supply curve shifts to the right, from S1 to S2 . The equilibrium interest rate drops from r1 to r2 , and the equilibrium quantity of loanable funds saved and invested increases. ANSWER THE TOPIC ESSENTIAL QUESTION 1. In one to three paragraphs, explain how the interactions of borrowers and savers determine the equilibrium interest rate of loanable funds. KEY TERMS loanable funds market national saving investment spending equilibrium interest rate MULTIPLE-CHOICE QUESTIONS 1. Which of the following will result in an increase in the real interest rate? (A) An increase in household saving (B) An increase in national saving (C) An increase in the supply of loanable funds (D) An increase in the government budget surplus (E) An increase in the demand for loanable funds 2. Why is the supply of loanable funds upward sloping? (A) As the real interest rate decreases, people are willing to save more. (B) As the real interest rate increases, people are willing to save more. (C) As the real interest rate decreases, people demand more loanable funds. (D) As the real interest rate decreases so does demand. (E) As the real interest rate increases, so does the government’s demand for loanable funds. Topic 4.7 The loanable funds market 221 3. What happens when a government spends more than it collects in tax revenues? (A) There is a budget surplus amounting to an increase in the demand of loanable funds. (B) There is a budget surplus amounting to a decrease in the supply of loanable funds. (C) There is a budget deficit amounting to a decrease in the supply of loanable funds. (D) There is a budget deficit amounting to an increase in the supply of loanable funds. (E) There is a balanced budget amounting to an increase in the demand for loanable funds. FREE-RESPONSE QUESTIONS (a) Explain what happens to the demand for loanable funds if the government were to offer a tax credit on interest earned. (b) Briefly explain what might cause the shift in the graph below. Interest Rate LoaInterest Rate Loanable Funds 0 r 2 r 1 D1 D2 S 0 r 2 r 1 LF1 LF2 222 MACROECONOMICS: AP® EDITION (c) Briefly explain what might cause the shift in the graph below. Interest Rate LoanabInterest Rate Loanable Funds 0 r 2 r 1 LFS1 S2 D 0 r 2 r 1 LF1 LF2 (d) Briefly explain what might cause the shift in the graph below. LoanInterest Rate Loanable Funds Interest Rate r 2 r 1 0 r 2 r 1 D 0 S2 LF2 LF1 S1 (e) What effect would a government budget surplus have on the supply of and demand for loanable funds? Topic 4.7 The loanable funds market 223 THINK AS AN ECONOMIST: DEMONSTRATE THE EFFECT OF A CHANGE IN AN ECONOMIC SITUATION ON AN ACCURATELY LABELED GRAPH Economists can demonstrate the effects of a change by using accurately labeled visuals. For example, look back at the graphs under “The Effects of Incentives to Save and to Invest” in the topic text. The two supply-demand curves show what happens in the loanable funds market if incentives are in place to encourage either savings or investments. Apply the Skill Suppose the economy is in the midst of a deflationary period. Falling prices encourage consumers to refrain from purchasing big-ticket goods and services. They reason that price reductions will continue and that, as a result, their money will be worth more and have more purchasing power in the future than it does now. Draw and accurately label a supply-demand curve that shows the original supply (S1) and demand (D1) in the loanable funds market and the interest rate (r1) in that market. Also show the effect of consumers’ increased savings on supply and demand (S2 and D2, as appropriate) and the new equilibrium interest rate (r2). Graph and label the original and new quantity of loanable funds (use LF) on the horizontal axis. Use arrows to show any changes in supply, demand, and interest rates. Label all axes and curves correctly. 224 MACROECONOMICS: AP® EDITION UNIT 4 Long Free-Response Question 1. Country X is currently in a recession, and the Central Bank decides to take action to bring the country back to full employment. (a) Identify an open-market operation that the central bank should engage in. (b) Draw a correctly labeled graph of the money market to show the change you indicated in part (a) and to show the effect on the nominal interest rate. (c) Using an aggregate demand and aggregate supply graph, show the original status of Country X, labeling full employment Yf and equilibrium output and price level as Y1 and PL1 , respectively. Then show the effect of the monetary policy action you indicated in (a) on the graph, and label the new equilibrium price level PL2. (d) What is the effect of the open-market operation you indicated in part (a) on the price of bonds? Use the following table showing assets and liabilities for Investime Bank in Country X to answer questions (e) through (h). Assets Liabilities Required Reserves $8,000 Demand Deposits $80,000 Excess Reserves $80,000 Owner’s Equity $20,000 Loans $12,000 TOTAL $100,000 TOTAL $100,000 (e) What is the reserve requirement? (f) Suppose Amanda deposited $2,000 in to her checking account at this bank. Calculate each of the following: (i) The immediate change in the M1 measure of money (ii) The change in required reserves (g) What effect does the above transaction have on each of the following? (i) The supply of loanable funds (ii) The real interest rate (h) If the nominal interest rate is 5 percent and the real interest rate is 3 percent, calculate the inflation rate.
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<credit_market_constraints>
principal–agent relationship This relationship exists when one party (the principal) would like another party (the agent) to act in some way, or have some attribute that is in the interest of the principal, and that cannot be enforced or guaranteed in a binding contract. See also: incomplete contract. Also known as: principal–agent problem. collateral An asset that a borrower pledges to a lender as a security for a loan. If the borrower is not able to make the loan payments as promised, the lender becomes the owner of the asset. • 10.12 CREDIT MARKET CONSTRAINTS: A PRINCIPAL–AGENT PROBLEM Lending is risky. A loan is made now and has to be repaid in the future. Between now and then, unanticipated events beyond the control of the borrower can occur. If the crops in Chambar, Pakistan were destroyed by bad weather or disease, the moneylenders would not be repaid even though the farmers were hard-working. The obsolescence of the skill you have invested in using your student loan is an unavoidable risk, and will mean the loan may not be repaid. The interest rate set by a bank or a moneylender would be greater if the default risk due to unavoidable events was greater. But lenders face two further problems. When loans are taken out for investment projects, the lender cannot be sure that a borrower will exert enough effort to make the project succeed. Moreover, often the borrower has more information than the lender about the quality of the project and its likelihood of success. Both of these problems arise from the difference between the information the borrower and the lender have about the borrower’s project and actions. This creates a conflict of interest. If the project doesn’t succeed because the borrower made too little effort, or because it just wasn’t a good project, the lender loses money. If the borrower were using only her own money, it is likely that she would have been more conscientious or maybe not engaged in the project at all. The relationship between the lender and the borrower is a principal–agent problem. The lender is the ‘principal’ and the borrower is the ‘agent’. The principal–agent problem between borrower and lender is similar to the ‘somebody else’s money’ problem discussed in Unit 6. In that case, the manager of a firm (the agent) is making decisions about the use of the funds supplied by the firm’s investors (the principals), but they are not in a position to require him to act in a way that maximizes their wealth, rather than pursuing his own objectives. In the case of borrowing and lending, it is often not possible for the lender (the principal) to write a contract that ensures a loan will be repaid by the borrower (the agent). The reason is that it is impossible for the lender to ensure by contract that the borrower will use the funds in a prudent way that will allow repayment according to the terms of the loan. The table in Figure 10.19 compares two principal–agent problems. One response of the lender to this conflict of interest is to require the borrower to put some of her wealth into the project (this is called equity). The more of the borrower’s own wealth is invested in the project, the more closely Actors Conflict of interest over Enforceable contract covers Left out of contract (or unenforceable) Result Labour market (Units 6 and 9) Employer Employee Wages, work (quality and amount) Wages, time, conditions Work (quality and amount), duration of employment Effort underprovided; unemployment Credit market (Units 10 and 12) Lender Borrower Interest rate, conduct of project (effort, prudence) Interest rate Effort, prudence, repayment Too much risk, credit constraints Figure 10.19 Principal–agent problems: The credit market and the labour market. UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET 448 Those seeking loans to purchase a car are often required to allow a device to be installed in the vehicle that is controlled by the bank, which will disable the ignition of the car if the loan payments are not made as required, as this New York Times video shows. The practice has not made lenders very popular. https://tinyco.re/7861205 credit rationing The process by which those with less wealth borrow on unfavourable terms, compared to those with more wealth. credit-excluded A description of individuals who are unable to borrow on any terms. See also: credit-constrained. credit-constrained A description of individuals who are able to borrow only on unfavourable terms. See also: credit-excluded. aligned her interests are with those of the lender. Another common response, whether the borrowers are home buyers in New Zealand or car buyers in New Orleans, is to require the borrower to set aside property that will be transferred to the lender if the loan is not repaid (this is called collateral). Equity or collateral reduces the conflict of interest between the borrower and the lender. The reason is that when the borrower has some of her money (either equity or collateral) at stake: • She has a greater interest in working hard: She will try harder to make prudent business decisions to ensure the project’s success. • It is a signal to the lender: It signals that the borrower thinks that the project is of sufficient quality to succeed. But there is a hitch. If the borrower had been wealthy, she could either use her wealth as collateral and as equity in the project, or she could have been on the other side of the market, lending money. Typically the reason why the borrower needs a loan is that she is not wealthy. As a result, she may be unable to provide enough equity or collateral to sufficiently reduce the conflict of interest and hence the risk faced by the lender, and the lender refuses to offer a loan. This is called credit rationing: those with less wealth borrow on unfavourable terms compared with those with more wealth, or are refused loans entirely. Borrowers whose limited wealth makes it impossible to get a loan at any interest rate are termed credit-excluded. Those who borrow, but only on unfavourable terms, are termed credit-constrained. Both are sometimes said to be wealth-constrained, meaning that their wealth limits their credit market opportunities. Adam Smith had credit rationing in mind when he wrote: The relationship between wealth and credit is summarized in Figure 10.20. The exclusion of those without wealth from credit markets or their borrowing on unfavourable terms is evident in these facts: • In a survey, one in eight US families had their request for credit rejected by a financial institution: The assets of these credit-constrained families were 63% lower than the unconstrained families. ‘Discouraged borrowers’ (those who did not apply for a loan because they expected to be rejected) had even lower wealth than the rejected applicants. • Credit card borrowing limits are often increased automatically: If borrowing increases in response to an automatic change in the borrowing limit, we can conclude that the individual was credit-constrained. The authors of this study suggested that approximately two-thirds of US families may be credit-constrained or excluded. • Inheritance leads the self-employed to considerably increase the scale of their operations: An inheritance of £5,000 in 1981 (around $24,000 today) doubled a typical British youth’s likelihood of setting up a business. Adam Smith, ‘Of the Profits of Stock’ (https://tinyco.re/6397441). In An Inquiry into the Nature and Causes of the Wealth of Nations, 1776. Money, says the proverb, makes money. When you have got a little it is often easy to get more. The great difficulty is to get that little. (An Inquiry into the Nature and Causes of the Wealth of Nations, 1776) David Gross and Nicholas Souleles. 2002. ‘Do Liquidity Constraints and Interest Rates Matter for Consumer Behavior? Evidence from Credit Card Data’. The Quarterly Journal of Economics 117 (1) (February): pp. 149–185. 10.12 CREDIT MARKET CONSTRAINTS: A PRINCIPAL–AGENT PROBLEM 449 • Owning a house can be used as collateral: A 10% rise in value of housing assets that could be used as collateral to secure loans in the UK increases the number of startup businesses by 5%. • Asset-poor people in the US frequently take out short-term ‘payday loans’: In the state of Illinois, the typical short-term borrower is a low-income woman in her mid-thirties ($24,104 annual income), living in rental housing, borrowing between $100 and $200, and paying an average annual rate of interest of 486%. • Poor and middle-income Indian farmers could substantially raise their incomes if they did not face credit constraints: Not only do they generally underinvest in productive assets, but the assets they hold are biased towards those they can sell in times of need (bullocks) and against highly profitable equipment (irrigation pumps), which have little resale value. QUESTION 10.11 CHOOSE THE CORRECT ANSWER(S) Which of the following statements are correct regarding the principal–agent problem? A principal–agent problem exists in loans due to a positive possibility of the principal not being repaid. The principal–agent problem can be resolved by writing a binding contract for the borrower to exert full effort. One solution for the principal–agent problem in loans is for the borrower to provide equity. The principal–agent problem leads to credit rationing in the loans market. Samuel Bowles. 2006. Microeconomics: Behavior, Institutions, and Evolution (the Roundtable Series in Behavioral Economics). Princeton, NJ: Princeton University Press. Lender assesses the characteristics of the borrower and project Wealth of borrower Quality of project (known better to borrower than to lender) Borrower’s equity stake in project or collateral Borrower’s incentive to work hard Borrower’s incentive to select a high quality project Lender’s loan decision Lender finds out what the borrower is willing to contribute Lender uses this information to assess the borrower’s incentives Lender’s decision 1 2 3 4 Figure 10.20 Wealth, project quality, and credit. 
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<income_and_wealth>
UNIT 9 9.2 Income and wealth Understanding borrowing, lending, and investment requires some terms—like wealth and income—that are in common use but are used in a precise way in economics. Wealth LINK Wealth is the value of things that you own that contribute to your well-being in some way, called assets. Householdsinvest in assets, including houses, works of art, and financial assets like shares, to ‘save’ or ‘accumulate’ wealth. The assets can either provide an income, for example the rents, profits, interest, or dividends from physical and financial assets you own, or provide other valued services, for example the transport and accommodation made possible by your vehicle and home. If you own intellectual property (such as patents, trademarks, and copyrights) these are also part of your wealth. A work of art is an asset that may appreciate in value, and at the same time, provide pleasure on the wall of your sitting room. Debt Require you to make payments to others, and therefore count as negative wealth. The term wealth is also sometimes used in a broader sense to include your health,skills, and ability to earn an income (your human capital). But we will use the narrower definition of material wealth in this unit,since we focus on forms of wealth that can potentially be turned into spending on goods and services. Income LINK Your income is the maximum amount that you could spend over a given period of time without reducing your wealth, for example by selling some of what you own or by borrowing (remember taking on a debt by borrowing reduces your wealth). Thisincludes what you receive as: earnings (wages or salaries from labor) profits, interest, dividends, and rents from assets that you own any increase or decrease in the value of those assets(called capital gains and losses) transfersfrom the government minus taxes paid. Since it is measured over a period of time (such as weekly or yearly), income is a flow. Wealth is a stock, meaning that it has no time dimension. At any moment of time it is just there. 11/8/24, 2:45 PM 9.2 Income and wealth – Microeconomics https://www.core-econ.org/the-economy/microeconomics/09-lenders-borrowers-02-income-and-wealth.html 1/9 To highlight the difference between wealth and income, think of filling a bathtub, asin Figure 9.1. Wealth is the amount (stock) of water in the tub, while income is the flow of water into the tub. The inflow is measured by liters(or gallons) per minute; the stock of water is measured by liters(or gallons) at a particular moment in time. Figure 9.1 Wealth, income, depreciation, and consumption: the bathtub analogy. Income either adds to wealth (in which case it is termed saving) or is used for consumption spending. Some wealth takes physical forms,such as a car or office equipment. The value of physical wealth tends to decline, either due to use or simply the passage of time. Thisreduction in the value of a stock of wealth over time is called depreciation. Using the bathtub analogy, depreciation is the amount of evaporation of the water. In economics, an example of depreciation is the fall in the value of a car with mileage and with age. Like income, depreciation is a flow (for example, you could measure it in dollars per year for a car or computer), but a negative one. In this unit, we simplify by not considering taxes as a deduction from one’s income, or transfers from the government as an addition. Wealth Depreciation Gross income Consumption FULLSCREEN 11/8/24, 2:45 PM 9.2 Income and wealth – Microeconomics https://www.core-econ.org/the-economy/microeconomics/09-lenders-borrowers-02-income-and-wealth.html 2/9 In order to take account of depreciation, economists distinguish between income (which is net of depreciation) and gross income. The flow of income into the bathtub is gross income. A person’s wealth will affect the opportunities they have for borrowing and investing. This Is The reason why we focus on wealth (and wealth inequalities) in this unit rather than income and income inequalities. Consumption and saving LINK Water also flows out of the tub. The flow through the drain is called consumption, and it reduces wealth just as income increases it. Consumption refers to household spending on goods and services. An individual (or household)saves when consumption is less than net income,so wealth increases. Wealth is the accumulation of past and current savings. Saving can take a number of forms, for example, putting money into bank deposits, or buying financial assets,such as shares (also known as stocks) in a company, or bonds issued by a government or a company in the financial markets. The choice about where and how to save depends on the relative returns that you can earn and on how easy it is to turn the savings back into money for consumption. Purchases of shares or bonds are often done on behalf of the individual by another organization, most often the company that runs their personal pension fund who will have more expertise on what to buy and when. The decisions about how much money to save in each saving option will depend on what the expected return is, which will depend on the riskiness of the asset. Returns in asset markets are generally higher for assets that are considered higher-risk. Contributions To a personal pension fund are an example of the use of savings to buy financial assets. When a government's spending is greater than its tax revenue, it borrows by issuing bonds. A government bond is generally considered to be a safe asset because it is a promise from the government to pay some x  amount to the holder of the bond on a given schedule over a fixed period of time, and because it is assumed that the government will not default on the payments. When companies plan to spend more than their revenue (for example, on the purchase of machinery and equipment), they have a number of choices. They can borrow from banks(bank loans), borrow from the public by selling company bonds, or sell part of the company (shares). A company is more likely to default on its payments to bondholders than is the government. This higher risk of default means that it is generally more expensive for firms to borrow than it is for the government. The return that a bondholder searches for will be higher to compensate for the higher risk relative to government bonds—in other words, company bonds are riskier than government bonds. 11/8/24, 2:45 PM 9.2 Income and wealth – Microeconomics https://www.core-econ.org/the-economy/microeconomics/09-lenders-borrowers-02-income-and-wealth.html 3/9 Shares are literally a share in the ownership of a company. The holder owns some fraction of the company’s buildings, equipment, intellectual property, and other assets. As a part owner of the firm, the shareholder also owns a share of the profits of the firm. The value of a share fluctuates depending on how profitable the firm is and is expected to be in the future. Shares Therefore differ from bonds in two important respects: there is no promised payment to the holder (it depends on how profitable the firm is), and there is no fixed maturity period for the ownership of a share (it may be held for a lifetime). For these reasons, shares are a riskier type of savings or class of asset than are company bonds, which in turn are riskier than government bonds due to the higher risk of default. QUESTION 9.1 Choose the correct answer(s) LINK Read the following statements and choose the correct option(s). 1. Your material wealth is the largest amount that you can consume without borrowing; it includes the value of your house, car, financial savings, and human capital. 2. Income minus depreciation is the maximum amount that you can consume while still leaving your wealth unchanged. 3. Bonds are a way for companies and governments to borrow from the public. 4. Depreciation is the loss in your financial savings due to unfavorable movements in the market. Check my answers Read Extension 9.2 for more details on the characteristics of bonds and shares. 11/8/24, 2:45 PM 9.2 Income and wealth – Microeconomics https://www.core-econ.org/the-economy/microeconomics/09-lenders-borrowers-02-income-and-wealth.html 4/9 QUESTION 9.2 Choose the correct answer(s) LINK Freny Mistry has wealth of £800,000. To make this example more realistic, we introduce an income tax. There is no wealth tax in this economy. She has a market income of £60,000 per year, on which she is taxed 25%. Her wealth includes some equipment, which depreciates by £4,000 every year. Based on this information, read the following statements and choose the correct option(s). 1. Her after-tax income is £60,000. 2. Her net income (income after tax and depreciation) is £45,000. 3. The maximum amount of consumption expenditure possible for Freny Mistry is £41,000. 4. If she decides to spend 70% of her net income on consumption and the rest on investment, then her investment is £12,300. Check my answers Differences in types of debt and assets (wealth) of poor and rich households LINK This unit explains how a person's situation—especially how much wealth they have—affected the borrowing and lending opportunities open to them. Their choice will depend on what is feasible and on their preferences. Before providing a model to shed light on this choice, we present information on the debts and assets of poor and rich households. Figure 9.2 shows the types of debt (what is owed to others) and assets(what is owned by the household) for the four quarters(quartiles) of US households ordered by their net wealth. In the figure, ‘Equity in businesses’ refers to ownership stakes in particular businesses whereas ‘Directly held stocks’ refers to the ownership of shares traded on the stock exchange. The most striking feature of the figure is that the wealthiest quarter of US households own 97.7% of the shares that are directly held and of equity in businesses. The poorest quarter have virtually none of these assets and even the third wealthiest quarter of the population own very little equity or stocks. Stocks and equity are held almost exclusively by the richest quarter of Americans. On the debit side, the poorest quarter, which includes a lot of young people, hold more than their proportional share in education loans(56.5%). Otherwise their participation both in borrowing (as reflected in debt shares) and in saving (as reflected in asset shares) is much lower than their share in the population. Note that they hold 4.7% of residential (or mortgage) debt and only 1.7% 11/8/24, 2:45 PM 9.2 Income and wealth – Microeconomics https://www.core-econ.org/the-economy/microeconomics/09-lenders-borrowers-02-income-and-wealth.html 5/9 of residential home equity. It is only the richest quarter whose share of residential home equity is greater than their share of debt. Figure 9.2 Who owns what? Who owes what? To explore more data on wealth inequality in the US and other countries, try this interactive visualization. Percentage share of total per quartile of net worth (%) Percentage share of total per quartile of net worth (%) Debt Assets 0 25 50 75 100 0 25 50 75 100 Directly held pooled investment funds Life insurance and retirement accounts Equity in businesses Directly held stocks Owned vehicles Residential home equity All assets Car loans Credit card balances Education installment loans Residential debt All debt Poorest quartile 2nd quartile 3rd quartile Richest quartile Mortgages & home equity loans secured by primary residence Debt secured by other residential property Education loans Vehicle loans Credit card balances after last payment Home equity lines of credit secured by primary residence Other installment loans Other debt Other lines of credit Share of total debt in the economy Primary residence Business equity Life insurance and retirement accounts Directly held pooled investment funds Stocks and bonds Residential property excluding primary residence Other assets Transaction (bank) accounts Net equity in non-residential real estate Vehicles Share of total assets in the economy FULLSCREEN Top: Proportion of total debts and assets in the economy held by each quartile of the population in 2019. The poorest quartile holds 25% of total net worth (assets – debts) in the economy. Bottom: Distribution of total debt and assets in the US economy. Source: Federal Reserve System. 2021. Survey of Consumer Finances. 11/8/24, 2:45 PM 9.2 Income and wealth – Microeconomics https://www.core-econ.org/the-economy/microeconomics/09-lenders-borrowers-02-income-and-wealth.html 6/9 – QUESTION 9.3 Choose the correct answer(s) LINK Based on the two bar charts and two pie charts in Figure 9.2, read the following statements and choose the correct option(s). 1. The richest quartile has half of all residential debt, and mortgages make up more than half of total debt, so the richest quarter must have a disproportionately large share of total debt. 2. The least wealthy quartile has the largest share of education loan debt, but has a disproportionately small share of total debt. 3. The category of assets for which the poorest quartile has the highest share (relative to other categories) is the category that makes up the smallest share of total assets in the pie chart. 4. The third quartile holds a substantial share of equity in business and directly held stocks, but they do not own a substantial share of life insurance and retirement accounts. Check my answers EXTENSION 9.2 Financial assets: Bonds and shares LINK We have explained in the main part of this section that bonds and shares are financial assets that can be bought by households, as different forms in which to hold their savings. Here we describe in more detail the characteristics of these assets, and what determines their value. Bonds Governments and firms raise finance by issuing bonds which are then bought and sold in the bond markets. The government and firms are the borrowers and the households(or organizations like pension funds) are the lenders. The loan is provided for a fixed period, called the maturity of the bond. There are two forms of payment that make up the return that a bondholder receives for lending the government or a firm money: Face value, which is an amount paid when the bond matures Coupons, which are fixed payments made at known periods until maturity (for example, every year or every three months). The name ‘coupons’ is used because, in the past, bonds were physical pieces of paper, and when one of the fixed payments was redeemed, a coupon was clipped from the bond. 11/8/24, 2:45 PM 9.2 Income and wealth – Microeconomics https://www.core-econ.org/the-economy/microeconomics/09-lenders-borrowers-02-income-and-wealth.html 7/9 These are guaranteed returns, in contrast to shares where the shareholder does not know in advance what they will earn, as it depends on the firm’s profitability. A bond is a financial asset: Issuing or selling a bond is equivalent to borrowing. A bond buyer is a lender or saver. Governments and firms borrow by issuing bonds. Households buy bonds as a form of saving. Stocks Firms also borrow from households by selling them shares(stock) in their company. The shares are bought and sold on the stock market. The proportion of company shares that an individual (or household) owns will determine the share of returns on the stock that they earn. The value of the stock can go up or down, depending on how profitable the firm is expected to be in the future. Firms expected to generate greater net earnings will have higher valuations, and if expectations change,so will the value of the shares. Like bonds, their value will also depend on interest rates elsewhere in the economy, and on how risky the earnings are thought to be. If the value is expected to go up, then lenders will pay a higher price for the shares; and if the value goes down, lenders will only be willing to pay a low price. The households that buy the shares are not guaranteed a specific return, in contrast to bonds. Shares are therefore more risky than bonds. There are several examples of different determinants of changes in the price of shares in Question E9.1. 11/8/24, 2:45 PM 9.2 Income and wealth 
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opportunity cost When taking an action implies forgoing the next best alternative action, this is the net benefit of the foregone alternative. QUESTION 10.2 CHOOSE THE CORRECT ANSWER(S) Mr Bond has wealth of £500,000. He has a market income of £40,000 per year, on which he is taxed 30%. Mr Bond’s wealth includes some equipment, which depreciates by £5,000 every year. Based on this information, which of the following statements is correct? Mr Bond’s disposable income is £40,000. Mr Bond’s net income is £28,000. The maximum amount of consumption expenditure possible for Mr Bond is £23,000. If Mr Bond decides to spend 60% of his net income on consumption and the rest on investment, then his investment is £9,200. 10.2 BORROWING: BRINGING CONSUMPTION FORWARD IN TIME To understand borrowing and lending we will use feasible sets and indifference curves. In Units 3 and 5 you studied how Alexei and Angela make choices between conflicting objectives such as free time and grades or bushels of grain. They made choices from the feasible set, based on preferences described by indifference curves that represented how much they valued one objective relative to the other. Here you will see that the same feasible set and indifference curve analysis applies to choosing between having something now, and having something later. In earlier units we saw that giving up free time is a way of getting more goods, or grades, or grain. Now we see that giving up some goods to be enjoyed now will sometimes allow us to have more goods later. The opportunity cost of having more goods now is having fewer goods later. Borrowing and lending allow us to rearrange our capacity to buy goods and services across time. Borrowing allows us to buy more now, but constrains us to buy less later. To see how this works, think about Julia, who needs to consume now but has no money today. She knows that in the next period (later) she will have $100 from her paycheck or harvest. Julia’s situation is shown in Figure 10.2. Each point in the figure shows a combination of Julia’s capacity to consume things, now and later. We assume that she spends everything that she has, so each point in the figure gives her consumption now (measured on the horizontal axis) and later (measured on the vertical axis). Initially Julia is at the point labeled ‘Julia’s endowment’ in Figure 10.2. To consume now, Julia is considering taking out a payday loan (or she could be a farmer borrowing to finance her consumption before she can harvest and sell her crop). Julia could, for example, borrow $91 now and promise to pay the lender the whole $100 that she will have later. Her total repayment of $100 would include the principal (how much she borrowed) plus the interest charge at the rate r, or: 10.2 BORROWING: BRINGING CONSUMPTION FORWARD IN TIME 415 interest rate The price of bringing some buying power forward in time. See also: nominal interest rate, real interest rate. And if ‘later’ means in one year from now, then the annual interest rate, r, is: 0 23 0 67 100 30 56 70 91 Feasible frontier (10% interest rate) Julia’s endowment Feasible frontier (78% interest rate) Consumption later ($) Consumption now ($) Figure 10.2 Borrowing, the interest rate, and the feasible set. 1. Julia has nothing. Julia has no money now, but she knows that in the next period she will have $100. 2. Bringing future income to the present Julia could, for example, borrow $91 now and promise to pay the lender the $100 that she will have later. The interest rate would be 10%. 3. Borrowing less At the same interest rate (10%), she could also borrow $70 to spend now, and repay $77 at the end of the year. In that case she would have $23 to spend next year. 4. Borrowing even less At the same interest rate (10%), she could also borrow $30 to spend now, and repay $33 at the end of the year. In that case she would have $67 to spend next year. 5. Julia’s feasible set The boundary of Julia’s feasible set is her feasible frontier, shown for the interest rate of 10%. 6. Julia’s feasible frontier Juila can borrow now and choose any combination on her feasible frontier. 7. A higher interest rate If, instead of 10%, the interest rate is 78%, Julia can only borrow a maximum of $56 now. 8. The feasible set The feasible set with the interest rate of 78% is the dark shaded area, while the feasible set with an interest rate of 10% is the dark shaded area plus the light shaded area. UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET 416 You can think of the interest rate as the price of bringing some buying power forward in time. At the same interest rate (10%), she could also borrow $70 to spend now, and repay $77 at the end of the year, that is: In that case she would have $23 to spend next year. Another possible combination is to borrow and spend just $30 now, which would leave Julia with $67 to spend next year, after repaying her loan. All of her possible combinations of consumption now and consumption later (($91, $0), ($70, $23) ($30, $67), and so on) generate the feasible frontier shown in Figure 10.2, which is the boundary of the feasible set when the interest rate is 10%. The fact that Julia can borrow means that she does not have to consume only in the later period. She can borrow now and choose any combination on her feasible frontier. But the more she consumes now, the less she can consume later. With an interest rate of r = 10%, the opportunity cost of spending one dollar now is that Julia will have to spend 1.10 = 1 + r dollars less later. One plus the interest rate (1 + r) is the marginal rate of transformation of goods from the future to the present, because to have one unit of the good now you have to give up 1 + r goods in the future. This is the same concept as the marginal rate of transformation of goods, grain, or grades into free time that you encountered in Units 3 and 5. But suppose that, instead of 10%, the interest rate is now 78%, the average rate paid by the farmers in Chambar. At this interest rate Julia can now only borrow a maximum of $56, because at 78% the interest on a loan of $56 is $44, using up all $100 of her future income. Her feasible frontier therefore pivots inward and the feasible set becomes smaller. Because the price of bringing buying power forward in time has increased, the capacity to consume in the present has fallen, just as your capacity to consume grain would fall if the price of grain went up (assuming you are not a producer of grain). Of course the lender will benefit from a higher interest rate, as long as the loan is repaid, so there is a conflict of interest between the borrower and the lender. 10.3 IMPATIENCE AND THE DIMINISHING MARGINAL RETURNS TO CONSUMPTION Given the opportunities for bringing forward consumption shown by the feasible set, what will Julia choose to do? How much consumption she will bring forward depends on how impatient she is. She could be impatient for two reasons: • She prefers to smooth out her consumption instead of consuming everything later and nothing now. • She may be an impatient type of person.
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UNIT 5 5.12 Current costs and future benefits: Understanding investment and asset prices In our model of the business cycle, firms’ investment decisions depend on interest rates and expected future profits. We argued in Unit 3 that if the interest rate rises, firms will reduce their investmentspending. In the model, thisis how monetary policy affects aggregate demand. Secondly, if firms become more optimistic about future profits, investmentspending and hence aggregate demand will increase. In thissection, we will analyse investment in more detail. We use the concept of present value, which enables us to evaluate decisions where the costs and benefits arise at different times. Present value is useful for calculating the value of many different types of assets; we will explain how asset prices also depend on interest rates, providing a second channel through which monetary policy affects the economy. Investment and present value LINK Imagine that your employer has asked you to assess whether the company should engage in a major investment project which is expected to earn profits for the company in the future. In practice, these profits might be many years away, and almost invariably could not be guaranteed. But to illustrate the logic of the decision, we will start with an example. Suppose that the project will last just a single year. Assume that the initial investment will cost $I, and there is no uncertainty: if it invests, the company will receive a return of $X in a year’s time (measured in real terms). Furthermore,suppose that your firm has sufficient funds available from accumulated profits to make the investment if it so chooses. The question you need to consider is whether the return X is sufficiently high that it is worth spending I now, and then waiting for a whole year to obtain it. Are there other ways of using the company's funds during the year that would leave it in a better position? In other words, what is the opportunity cost of the project? Assuming that this is the best project available to the firm, you should consider the alternative of investing the funds in the financial markets. Suppose that risk-free financial assets pay a guaranteed real interest rate, r. In both cases, the firm would pay $I now. Then in a year's time it would have: $X if it invested in the project $I(1 + r) if it invested in the risk-free asset. So you should recommend that the firm undertake the project if and only if: This criterion compares the future return from the project, X, with its future costs’: the opportunity cost is the amount the company would be giving up in a year's time to obtain the amount, $X. Remember we assumed that the firm had sufficient funds to finance the investment itself. However, the same criterion would apply if the firm had to borrow the initial cost I—assuming that it could borrow to finance a risk-free project at the risk-free interest rate. In that case is the amount it would have to pay back at the end of year;so again it should invest provided the repayment is below the return, X. The criterion above is expressed in ‘future values’. Another way of writing it is: We can interpret this as telling us that, if we consider the project from the perspective of the present, its cost is $I, but its benefit is effectively smaller than $X—because it takes a year to arrive. The present value of the return from the project is . Then we say that the net present value of the project is and the project should be undertaken if and only if its net present value is positive. We can use present values to make comparisons between benefits and costs received at different times. In general, we calculate the present value of a future payment by discounting it: in the example above, where the firm is interested only in maximizing its profit and the project's risk free, the discount rate isr, the market interest rate on risk-free assets. But capitalist enterprises are not, typically, engaged in activities that generate risk-free returns. If the project was risky, your discount rate, which we will call d, would be higher. For a risky project with expected (or average) return , the investment decision rule is: 𝑋 > 𝐼(1 + 𝑟) 𝐼(1 + 𝑟) 𝐼(1 + 𝑟) − 𝐼 > 0 𝑋 1 + 𝑟 𝑋/(1 + 𝑟) NPV = − 𝐼 𝑋 1 + 𝑟 $𝑋 𝐸 As before, your discount rate is equal to the interest paid on market assets that have a similar level of risk to your project. But this is higher than the risk-free rate, r: it is where RP is the risk premium (which is strictly greater than 0). Risky assets have to offer a higher level of interest—otherwise buyers would always choose the risk-free alternatives. How big RP is will depend on both the degree of uncertainty and the nature of the uncertainty of what you expect to get back from the investment. But one key prediction of finance theory is that the size of the risk premium will not reflect individual preferences, but simply reflects the ‘market price of risk’. From the point of view of the firm, the discount rate, d, is therefore exogenous, since it is just set by a combination of financial markets and the central bank. The investment function LINK Using the present value criterion for investment, we can now understand why (as we previously assumed) aggregate investment depends on the interest rate, and expected future profits. First, if expected future profits increase for all potential investment projects that firms are considering, more of these projects will satisfy the investment criterion. So aggregate investment will rise. Now suppose the expected profits, , remain as before, but the market interest rate, r, rises. Then firms’ discount rates are higher, reducing the present value of expected profits, and hence the net present value of all projects. Fewer projects will satisfy the investment criterion,so aggregate investment will fall. This Is one of the transmission channels of monetary policy. In the extension to this section, we model these two effects in more detail. Present value and asset prices LINK We can use present value to analyze other problems. Suppose that you are considering buying a share in a company. As a shareholder, you can expect to receive dividend payments from the company in future. If real interest rates fall, then, other things being equal, the present value of any future dividend will increase. Intuitively, if the present value of what the share offers you goes up, it is likely to lead you, and many other investors, to be more willing to buy it. If large Invest if and only if NPV > 0, where NPV = − 𝐼 𝑋𝐸 1 + RP + 𝑟 𝑑 = 𝑟 + RP 𝑋𝐸 𝑋𝐸 + numbers of investors are suddenly more willing to buy a given share, its price is highly likely to increase. Demand has risen relative to the fixed supply of shares. And it is not just the price of shares that will be affected. Similar considerations apply to almost any asset that will generate an income in the future, from financial assets like shares and bonds to real assets like houses or land. As we discussed in the next section, the impact on asset prices is a key element of the transmission of monetary policy. EXTENSION 5.12 More about investment and present value LINK This extension explains the decision to invest in fixed capital in more detail, including the effect on investment of changes in the interest rate and in the expected rate of profit. </current_costs_and _future_ benefits>
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UNIT 3 3.11 Why is investment volatile? Householdstend to smooth their consumption spending when they can, but there is no similar motivation for a firm to smooth investment spending. Firms Increase their stock of machinery and equipment and build new premises whenever they identify an opportunity to make profits. But, unlike eating and most other consumption expenditures, investment can be postponed. There are several reasons why this likely to produce clusters of investment projects at some times and few at other times. New technology LINK When an innovation like the spinning jenny in the Industrial Revolution or spreadsheet programmes in the information and communications technology (ICT) revolution is introduced, firms using the new technology can produce output at lower cost or produce higher-quality output. They expand their share of the market. Firms That fail to follow may be forced out of business because they are unable to make a profit using the old technology. But new technology means that firms must install new machines. As firms do this, there is an investment boom. This will be amplified if the firms producing the machinery and equipment need to expand their own production facilities to meet the extra demand expected. In this case, investment by one firm pushes other firms to invest: if they don’t, they may lose market share or even be unable to cover their costs and eventually have to leave the industry. But investment by one firm can also pull other firms to invest by helping to increase their market and potential profits. The high-tech investment boom in the US can be identified in the aggregate data. From the mid1990s, new ICT was introduced into the US economy on a large scale. Figure 3.20 shows the sustained growth of investment in new technologies—around 10% or higher—through the second half of the 1990s. Nothing similar is visible in the data since then. 3.10 Shocks to households and the limits to smoothing consumption 3.12 Investment spending in the multiplier model Figure 3.20 Investment in new technologies and the dot-com bubble (1991–2022). Figure 3.20 also shows the behavior of the NASDAQ index. The NASDAQ is the US stock exchange where shares(orstocks) in high-tech companies are bought and sold. The index is an average of the prices at which these shares are traded. The index rose strongly from the mid-1990 sto an all-time peak in 1999 stock market investors’ confidence in the profitability of new tech firms grew. Investment in IT equipment (the red line) grew rapidly as a result of this confidence, but dropped sharply following the collapse in confidence that caused the fall of the stock market index. Thissuggeststhat overinvestment in machinery and equipment had occurred: investment did not begin growing again until 2003. Robert Shiller, the economist, argued that the NASDAQ index was driven high by what he called ‘irrational exuberance’. Beliefsin the future of high-tech led not only to share prices rising to levels that were unsustainable, but also to excessive investment in machinery and equipment in the high-tech sector. Units 5 and 6 will show why, on the basis of ‘present value’ we might expect investment and stock prices to rise and fall together. 1 9 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9 2 0 0 0 2 0 0 1 2 0 0 2 2 0 0 3 2 0 0 4 2 0 0 5 2 0 0 6 2 0 0 7 2 0 0 8 2 0 0 9 2 0 1 0 2 0 1 1 2 0 1 2 2 0 1 3 2 0 1 4 2 0 1 5 2 0 1 6 2 0 1 7 2 0 1 8 2 0 1 9 2 0 2 0 2 0 2 1 2 0 2 2 −50 −40 −30 −20 −10 0 10 20 30 40 50 60 Growth of investment in new technologies (%) Growth of nominal GDP (%) Growth of NASDAQ index (%) Years of recession (from NBER) Year Per cent age growth FULLSCREEN US Bureau of Economic Analysis. 2023. Fixed Assets Accounts Tables. FRED. 2023. NASDAQ Composite Index. Note: the series are in current US dollars. NASDAQ value is the yearly average of the close price value of the NASDAQ. Investment in new technologies is the investment in information processing equipment, computers and peripheral equipment, communication equipment, communication structure, and investments for software, semiconductors, and other electronic components and computers. Creditconstraints LINK In Section 3.10, we highlighted the role of credit constraints for consumption behavior. Credit constraints also affect firms, and are another reason for the clustering of investment projects and the volatility of aggregate investment. In a buoyant economy, profits are high and firms can use these profits to finance investment projects. They will also typically find it easier to borrow and to issue new shares. Access To finance from sources outside the firm is also easier: in the US high-tech boom, for example, the expansion of the NASDAQ exchange reflected the appetite of investors to provide finance by buying shares in firm in the emerging ICT industries. In Unit 6, we examine this mechanism in more detail. A coordination problem: Vicious and virtuous circles LINK To understand how one firm's investment can induce another firm to invest, think of a local economy consisting of just two firms. Firm A’s machinery and equipment are not fully used,so although the firm can produce more if it hires more employees, there is not enough demand to sell the products it would produce. This Is a situation of low capacity utilization. For the owners of Firm A to undertake new investment, they need to anticipate growing demand for their output. Firm B has the same problem. Because of low capacity utilization, profits are low for both. Incomes In the local economy remain low, and so does demand. Therefore, when we think about both firms together, we have a vicious circle (Figure 3.21). Robert Shiller explains in a VoxEU podcast how ‘animal spirits’ contribute to the volatility of investment and to both overinvestment and a stock market bubble. Figure 3.21 Low expected demand for the firm’s products creates a vicious circle. If the owners of both A and B decide to invest in new capacity and hire at the same time, they would employ more workers, who would spend more, increasing the demand for the products of both firms. The profits of both would rise, and we have a virtuous circle (Figure 3.22): Low expected demand for the firm’s products Low capacity utilization and low profits No incentive to invest or hire Little spending by firms or workers FULLSCREEN Figure 3.22 High expected demand for the firm’s products creates a virtuous circle. These two circles highlight the role of expectations of future demand. The incentive to invest depends on expected demand, which in turn depends on the behavior of other actors in the economy. The firm in the vicious circle have a coordination problem. If both invested together, everyone would be better off. High expected demand for the firm’s products High capacity utilization and high profits Firms invest and hire Higher spending by firms and workers FULLSCREEN
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</supplemental_readings>

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9. Use a clear and concise writing style, suitable for students reviewing for a test.

10. If there are any key terms or concepts that require definition, consider including a glossary section at the end of the guide.

Present your completed study guide within <study_guide> tags. Use appropriate formatting (such as headers, bullet points, or numbered lists) to organize the information clearly and make it easy to read and study from.