## Macroeconomics Study Guides

Keep the following two comprehensive study guides handy throughout your macroeconomics course study. They provide brief oulines for many of the major macroeconomics topics studied in this course and can help prepare you for your final economics exams.

### AP Macroeconomics Study Guide

#### V. Alternative Theories/Approaches

 Stagflation Stagflation is increasing inflation and rising unemployment in an economy at the same time. It is usually caused by a decrease in supply (supply-shock inflation). Stagflation in the 1970s proved that the Phillips Curve didn't represent a stable inflation-unemployment relationship. Phillips Curve The main concept of this is a stable, inverse relationship between inflation and unemployment. The short-run Phillips curve has a negative slope; the long-run Phillips curve is vertical. The Adaptive Expectations Theory predicts that there is a short-run tradeoff between inflation and unemployment but there is no long-run tradeoff. In the short run, the inverse relationship works, but in the long run, it seems that the graph will always shift back to a vertical line. Supply-side economics They believe that changes in aggregate supply are active forces in determining the levels of both inflation and unemployment. Economic disturbances can be generated on both the supply side and the demand side of the economy. They also contend that certain government policies have reduced the growth of aggregate supply over time, and if these policies were reversed, the economy could achieve low levels of unemployment without producing rapid inflation. Supply-siders also say that the US tax-transfer system has "eroded" productivity and decreased incentives to work, invest, innovate, and assume entrepreneurial risks. If taxes were decreased, people would have more money after taxes and they would have more of an incentive to work. Supply-siders also believe that reductions in marginal tax rates increase aggregate supply. They believe in the Laffer Curve, which says that up to a certain point in tax rate, tax revenue increases, and at that point, tax revenue is a maximum. However, when taxes go past that point, tax revenue starts to decrease again. Criticisms of the Laffer Curve include 1) evidence that tax cuts don't necessarily increase incentive to work, 2) inflation might still occur because AD might overwhelm AS, and 3) no one knows where we are on the curve. "Old" Classical theory They believe that the AS curve is vertical and it is the only factor in determining real output. The AD curve is still downsloping, and classical economists view it as stable when the money supply is constant. Also, domestic output doesn't change when price level decreases; it's only the AD curve moving down. They believe in Say's law, which says that supply creates its own demand. "New" Classical theory Their theory is that when the economy occasionally diverges from its full-employment output, internal mechanisms within the economy automatically move it back to that output. In their opinion, if a change in AD moves the equilibrium outside of $AS_{LR}$, there will be a change in AS that will bring it back. Rational Expectations Theory It states that businesses, consumers, and workers understand how government policies will affect the economy and anticipate the impacts in their own decision making. In other words, everyone knows what's going to happen and they plan for it. For example, when the government begins some expansionary polices, workers will anticipate that a result will be higher inflation which would cause a decrease in their real wages. So, the workers quickly ask for more money for their nominal wage. If things work out well, there will be no temporary increases in profit, output, or unemployment. They also say that policies designed to push unemployment below its natural rate will quickly increase the rate of inflation, having no effect on unemployment. Monetarism Monetarists believe that the economy is stable in the long run at the natural rate of unemployment, and the observed instability of the economy is caused by inappropriate monetary policy. Keynesians, on the other hand, believe that the economy is potentially unstable and observed instabilities are caused by fluctuations in AD and AS. They believe that changes in the money supply directly changes AD, which directly changes GDP. They do not think investment is an important issue. Monetarists also believe that without government interference, the economy would be very stable. The government caused the economy to become what it is today: downward wage inflexibility, business cycles, etc. Monetarist Equation of Exchange $MV \,= \, PQ$, where $M$ is the supply of money, $V$ is the velocity of money (the number of times per year the average dollar is spent on final goods and services), $P$ is the price level (average price at which each unit of physical output is sold), and $Q$ is the physical volume of goods and services produced. The left side is the total amount spent; the right side is total amount received. Monetarists believe that $V$ is stable, or that the factors altering velocity change gradually and predictably.