AP Economics Final ExamAP Economics Final Exam

ReviewReview

The Basics The Basics

Marginal AnalysisMarginal Analysis – Marginal Cost vs. – Marginal Cost vs. Marginal BenefitMarginal Benefit

Opportunity CostOpportunity Cost – What is lost when we – What is lost when we make certain economic decisions.make certain economic decisions.

Theoretical EconomicsTheoretical Economics – systematically – systematically arranging facts, interpret them, and then arranging facts, interpret them, and then generalize from themgeneralize from them

Rational BehaviorRational Behavior – We assume that – We assume that humans will act rationally when it comes humans will act rationally when it comes to making economic decisionsto making economic decisions

Economic GoalsEconomic Goals

Economic GrowthEconomic Growth Full EmploymentFull Employment Economic EfficiencyEconomic Efficiency Price-Level StabilityPrice-Level Stability Economic FreedomEconomic Freedom Equitable Distribution of IncomeEquitable Distribution of Income Economic SecurityEconomic Security Balance of TradeBalance of Trade

Basics ContinuedBasics Continued

Positive Economics – Fact based Positive Economics – Fact based statementsstatements

Normative Economics – Opinion Normative Economics – Opinion based statementsbased statements

Post Hoc Fallacy – We cannot assume Post Hoc Fallacy – We cannot assume that certain effects are the result of that certain effects are the result of specific behavior in some casesspecific behavior in some cases

The Economizing Problem The Economizing Problem

Scarcity of ResourcesScarcity of Resources – We must – We must develop a system that allocates effectively develop a system that allocates effectively the limited amount of resources available the limited amount of resources available for consumptionfor consumption

4 Factors of Production4 Factors of Production - Land, Labor, - Land, Labor, Capital, Entrepreneurship Capital, Entrepreneurship

Full EmploymentFull Employment – Understand what is – Understand what is meant, desired goal is 4-6% meant, desired goal is 4-6% unemploymentunemployment

Production Possibilities Production Possibilities

Understand what a table, a graph, Understand what a table, a graph, and a curve could all look like and and a curve could all look like and how they depict opportunity cost as how they depict opportunity cost as it relates to the production of two it relates to the production of two different goodsdifferent goods

Supply & Demand Supply & Demand

Law of DemandLaw of Demand – The lower the – The lower the price, the higher the quantity price, the higher the quantity demanded (Downward sloping in demanded (Downward sloping in Expenditure Model)Expenditure Model)

Law of SupplyLaw of Supply – Firms will produce – Firms will produce more of a product the higher the more of a product the higher the price for that product (Upward price for that product (Upward sloping in Expenditure Model)sloping in Expenditure Model)

Supply & Demand Cont’dSupply & Demand Cont’d

Law of Diminishing Marginal UtilityLaw of Diminishing Marginal Utility – As – As a product is consumed in greater a product is consumed in greater quantities, the satisfaction level for that quantities, the satisfaction level for that product will decreaseproduct will decrease

Demand DeterminantsDemand Determinants – Consumer – Consumer tastes, number of consumers, income tastes, number of consumers, income levels, price level, expectationslevels, price level, expectations

Supply DeterminantsSupply Determinants – Resource prices, – Resource prices, technology, taxes & subsidies, competition, technology, taxes & subsidies, competition,

Substitute Goods vs. Complementary Goods Substitute Goods vs. Complementary Goods

The Market SystemThe Market System

Command Economies vs. Market Command Economies vs. Market EconomiesEconomies

Importance of private property rightsImportance of private property rights Specialization as it relates to the Specialization as it relates to the

division of labordivision of labor The “Invisible Hand” The “Invisible Hand” The How, What, & Who question The How, What, & Who question

General View of U.S General View of U.S Economy Economy

Sole ProprietorshipSole Proprietorship – Single ownership – Single ownership PartnershipPartnership – Two or more owners – Two or more owners CorporationsCorporations – Legally formed – Legally formed

organization, funds raised through sale of organization, funds raised through sale of stock, double taxationstock, double taxation

LLCLLC – Limited Liability Company – Limited Liability Company Government intervenes in the form of Government intervenes in the form of

transfer payments, restricting monopolies, transfer payments, restricting monopolies, & promoting stability& promoting stability

The Global Economy The Global Economy

Comparative Advantage & SpecializationComparative Advantage & Specialization Foreign Exchange Market – Currencies are Foreign Exchange Market – Currencies are

traded or exchanged so that each country traded or exchanged so that each country may receive its desired monetary unit may receive its desired monetary unit when purchasing goods and serviceswhen purchasing goods and services

Exchange Rate - Rate at which one Exchange Rate - Rate at which one currency is exchanged for anothercurrency is exchanged for another

Tariffs and their effect on the global Tariffs and their effect on the global economyeconomy

Measuring Domestic Output Measuring Domestic Output

GDP – Measure of the total amount of GDP – Measure of the total amount of goods & services produced in a given goods & services produced in a given year within the borders of the U.S.A.year within the borders of the U.S.A.

Only final goods are counted as Only final goods are counted as multiple counting must be avoided to multiple counting must be avoided to maintain accuracymaintain accuracy

Transfer Payments and stock Transfer Payments and stock purchases are NOT counted as a way purchases are NOT counted as a way to figure GDPto figure GDP

Measuring Domestic OutputMeasuring Domestic Output

Expenditures Approach - Expenditures Approach - C+Ig+Xn+G=GDPC+Ig+Xn+G=GDP

Income Approach – Rents + Interest Income Approach – Rents + Interest + Proprietor Income + Corporate + Proprietor Income + Corporate Profits + Wages - This = National Profits + Wages - This = National Income - You also must add Indirect Income - You also must add Indirect Business Taxes + Depreciation + Net Business Taxes + Depreciation + Net Foreign Factor IncomeForeign Factor Income

Measuring Domestic OutputMeasuring Domestic Output

Nominal (w/ out inflation )GDP vs. Nominal (w/ out inflation )GDP vs. Real (w/ inflationary adjustments) Real (w/ inflationary adjustments) GDPGDP

Price Index = Nominal / Real OR Price Index = Nominal / Real OR

Real = Nominal / Price Index (in Real = Nominal / Price Index (in hundredths)hundredths)

Unemployment & Inflation Unemployment & Inflation

Structural Unemployment – Structure Structural Unemployment – Structure of the market changes due to of the market changes due to changes in demandchanges in demand

Frictional Unemployment – The Frictional Unemployment – The “Natural” unemployment, job “Natural” unemployment, job seekers continue seeking workseekers continue seeking work

Cyclical Unemployment – Determined Cyclical Unemployment – Determined by fluctuations in the business cycleby fluctuations in the business cycle

Unemployment & InflationUnemployment & Inflation

Okun’s Law – For every 1 % that the Okun’s Law – For every 1 % that the unemployment rate exceeds that natural rate, unemployment rate exceeds that natural rate, GDP will decrease by 2% from the previous GDP will decrease by 2% from the previous yearyear

Demand-Pull Inflation – Higher streams of Demand-Pull Inflation – Higher streams of income cause demand to increase which results income cause demand to increase which results in an increase in the prices of goods and in an increase in the prices of goods and servicesservices

Cost-Push Inflation – usually during Cost-Push Inflation – usually during recessionary periods, the per unit cost of goods recessionary periods, the per unit cost of goods increases and results in firms having to raise increases and results in firms having to raise prices in order to maintain previous profit levels prices in order to maintain previous profit levels

Aggregate Expenditures Aggregate Expenditures

The Multiplier (Real GDP / Change in The Multiplier (Real GDP / Change in Spending) – In short, a change in Spending) – In short, a change in investment spending will have an investment spending will have an exponential effect on GDPexponential effect on GDP

Injection – Injecting $ into the Injection – Injecting $ into the economyeconomy

Leakage - $ that falls out of the Leakage - $ that falls out of the spending streamspending stream

AD/ AS Models AD/ AS Models

Be able to express this model graphically Be able to express this model graphically Downward sloping AD due to Real Downward sloping AD due to Real

Balances Effect (Higher price Level Balances Effect (Higher price Level reduces purchasing power or demand), reduces purchasing power or demand), Interest Rate Effect (Higher price means Interest Rate Effect (Higher price means higher interest rates which reduces higher interest rates which reduces demand), and Foreign Purchases Effect demand), and Foreign Purchases Effect (High price level increases imports which (High price level increases imports which reduces output)reduces output)

AD/ AS ModelsAD/ AS Models

Three phases of AS curve:Three phases of AS curve: Horizontal – RecessionaryHorizontal – Recessionary Intermediate – Price Level and Intermediate – Price Level and

Output both increasing, full Output both increasing, full employment not reachedemployment not reached

Vertical – Full employment and full Vertical – Full employment and full production have been achievedproduction have been achieved

Fiscal Policy Fiscal Policy

Expansionary Policy – Expanding the role Expansionary Policy – Expanding the role of the government, the money supply, etc.of the government, the money supply, etc.

Contractionary Policy – Limiting the role of Contractionary Policy – Limiting the role of the government, the money supply, etc.the government, the money supply, etc.

Built-in Stabilizers – Economic features Built-in Stabilizers – Economic features that maintain economic stability that maintain economic stability throughout the business cycle without throughout the business cycle without requiring specific action from policy requiring specific action from policy makers makers

Fiscal Policy ContinuedFiscal Policy Continued

Recognition LagRecognition Lag – Time involved in – Time involved in actually recognizing the problem in an actually recognizing the problem in an economyeconomy

Administrative lagAdministrative lag – Time involved in – Time involved in between the recognition and then when between the recognition and then when the corrective action takes placethe corrective action takes place

Operational LagOperational Lag – Time involved in – Time involved in between in the corrective action and then between in the corrective action and then when actual results can be seenwhen actual results can be seen

Money & Banking Money & Banking

Money has 3 basic functions – medium Money has 3 basic functions – medium of exchange, unit of account, store of of exchange, unit of account, store of valuevalue

M1 = Currency in circulationM1 = Currency in circulation M2 = Savings deposits, including M2 = Savings deposits, including

money markets, and money markets money markets, and money markets Understand that the demand for Understand that the demand for

money has an indirect relationship money has an indirect relationship with interest rateswith interest rates

How Banks & Thrifts Create How Banks & Thrifts Create Money Money

Fractional Reserve Banking – Fractional Reserve Banking – Principle that allows banks to lend Principle that allows banks to lend out more money than what they out more money than what they actually have as reservesactually have as reserves

Reserve Ratio = Excess Reserves / Reserve Ratio = Excess Reserves / Required ReservesRequired Reserves

Banks are unable to loan out Banks are unable to loan out required reservesrequired reserves

How Banks Create MoneyHow Banks Create Money Federal Funds RateFederal Funds Rate – Rate at – Rate at

which banks may make overnight which banks may make overnight loans to each otherloans to each other

Monetary multiplierMonetary multiplier – Similar to – Similar to the investment spending multiplier, the investment spending multiplier, equals 1 / Reserve Ratio. The new equals 1 / Reserve Ratio. The new multiplier then allows to determine multiplier then allows to determine how much money is available for how much money is available for loan in a multi-bank system loan in a multi-bank system

Monetary Policy Monetary Policy 3 Tools used by the Fed to 3 Tools used by the Fed to

manipulate money supply:manipulate money supply: Open Market Operations – Selling Open Market Operations – Selling

BondsBonds Changing the Reserve Ration (rarely Changing the Reserve Ration (rarely

done)done) The Discount Rate (Interest Rate)The Discount Rate (Interest Rate)

Monetary Policy ContinuedMonetary Policy Continued

Easy Money Policy – Actions which Easy Money Policy – Actions which usually increase the money supplyusually increase the money supply

Tight Money Policy – Actions which Tight Money Policy – Actions which usually decrease the money supplyusually decrease the money supply

Extending Aggregate Supply Extending Aggregate Supply

Long run aggregate supply is shown with a Long run aggregate supply is shown with a vertical line that intersect the AD/AS Model vertical line that intersect the AD/AS Model at the equilibrium point.at the equilibrium point.

Phillips Curve – Depicts relationship between Phillips Curve – Depicts relationship between unemployment and inflation (indirect)unemployment and inflation (indirect)

Laffer Curve – Depicts relationship between Laffer Curve – Depicts relationship between tax rates and tax revenues. Direct until tax rates and tax revenues. Direct until optimal point is reached. Curve then retracts optimal point is reached. Curve then retracts and is an indirect relationshipand is an indirect relationship

Long Run vs Short RunLong Run vs Short Run