CLEP Principles of Macroeconomics Quick Review

Because resources are scarce, every choice has a cost, and the production possibilities curve (PPC) maps the maximum output combinations an economy can produce with fixed resources and technology.

Opportunity cost = what is given up $$ what is gained; a bowed-outward PPC reflects increasing opportunity cost; points on the curve are efficient, points inside are attainable but inefficient (unemployed/underused resources), points outside are unattainable given current resources and technology.

Opportunity cost (the next-best alternative forgone, relevant to current decisions) vs.\ sunk cost (already spent, irrelevant to future decisions).

Misreading which axis good's opportunity cost is being asked for, or treating a straight-line PPC segment slope as inverted.

Scarce resources $arrow$ trade-offs $arrow$ bowed PPC $arrow$ increasing opportunity cost.

Two parties gain from trade when each specializes in the good for which it has the lowest opportunity cost (comparative advantage), even if one party is better at producing everything (absolute advantage).

Absolute advantage: produces more output with the same inputs; comparative advantage: lower opportunity cost of production; mutually beneficial terms of trade must lie between the two producers' opportunity-cost ratios.

Absolute advantage (who produces more/faster) vs.\ comparative advantage (who gives up less to produce it) --- trade should follow comparative, not absolute, advantage.

Computing opportunity cost by dividing output ratios the wrong way around, which flips who actually has the comparative advantage.

Lower opportunity cost $arrow$ comparative advantage $arrow$ specialize $arrow$ trade.

The law of demand states an inverse relationship between price and quantity demanded, holding all other influences constant.

Determinants that shift demand: income (normal vs.\ inferior goods), prices of related goods (substitutes vs.\ complements), tastes/preferences, expectations, and number of buyers.

A change in demand (the whole curve shifts, caused by a non-price determinant) vs.\ a change in quantity demanded (movement along a fixed curve, caused only by a price change).

Shifting the demand curve when the scenario only describes a price change for the good itself.

Non-price factor changes $arrow$ shift; price of the good changes $arrow$ movement along.

The law of supply states a direct relationship between price and quantity supplied, holding all other influences constant.

Determinants that shift supply: resource/input prices, technology, taxes and subsidies, producer expectations, and number of sellers.

A change in supply (shift, from a non-price determinant) vs.\ a change in quantity supplied (movement along the curve, from a price change).

Confusing a subsidy (shifts supply right) with a price floor (does not shift supply --- it sets a legal minimum price).

Input cost or tech change $arrow$ supply shifts; price of the good changes $arrow$ movement along.

Equilibrium is where quantity demanded equals quantity supplied; a binding price ceiling creates a shortage and a binding price floor creates a surplus.

Shortage: $Q_d > Q_s$, caused by a ceiling set below equilibrium price; Surplus: $Q_s > Q_d$, caused by a floor set above equilibrium price; a control set on the "wrong side" of equilibrium is non-binding and has no effect.

Price ceiling (legal maximum, binds below equilibrium) vs.\ price floor (legal minimum, binds above equilibrium).

Assuming any price control changes the market outcome, even when it is set above (ceiling) or below (floor) the equilibrium price and is therefore non-binding.

Ceiling below equilibrium $arrow$ shortage; floor above equilibrium $arrow$ surplus.

GDP is the market value of all final goods and services produced within a country's borders in a given period, measured by summing the four expenditure components.

$GDP = C + I + G + (X - M)$, where $C$ = consumption, $I$ = gross private investment, $G$ = government spending, $X-M$ = net exports; GDP excludes intermediate goods, used-good resales, purely financial transactions, and transfer payments.

GDP (output produced within a country's borders, regardless of who owns the resources) vs.\ GNP (output produced by a country's citizens/firms, regardless of location).

Double-counting intermediate goods, or mistakenly including transfer payments (Social Security, unemployment benefits) inside $G$.

$GDP = C + I + G + NX$ --- final goods only, no double counting, no transfers.

Nominal GDP is valued at current-year prices; Real GDP is adjusted to a base year's prices so output --- not inflation --- drives the comparison over time.

$GDP deflator = /Nominal GDPReal GDP × 100$; equivalently $Real GDP = /Nominal GDPGDP deflator × 100$.

GDP deflator (covers all domestically produced goods, basket changes with current output) vs.\ CPI (fixed consumer basket, includes imported goods).

Forgetting to multiply by 100, or inverting the numerator and denominator when solving for real GDP.

Deflator $= /NominalReal×100$ $arrow$ strips out price-level changes.

Real GDP does not grow smoothly --- it moves through expansion, peak, contraction, and trough around the economy's long-run growth trend.

A commonly cited rule of thumb for recession is two consecutive quarters of declining real GDP; the long-run trend line represents potential (full-employment) GDP, around which actual real GDP fluctuates.

Recession (a decline in real GDP) vs.\ depression (an unusually severe, prolonged recession) --- and actual real GDP vs.\ potential GDP (the trend line).

Treating any single quarter of slower growth (not an actual decline) as a recession.

Expansion $arrow$ peak $arrow$ contraction $arrow$ trough, around the potential-GDP trend.

The unemployment rate only measures people in the labor force who are actively seeking work; the natural rate is the unemployment that remains even at full employment.

$Unemployment rate = /UnemployedLabor force × 100$; Labor force = employed + unemployed (excludes discouraged workers and those not seeking work); types: frictional, structural, cyclical, seasonal; natural rate = frictional + structural (cyclical $=0$).

Frictional unemployment (temporary, between jobs) vs.\ structural unemployment (skills/location mismatch) vs.\ cyclical unemployment (caused by a recessionary gap).

Dividing the unemployed by total population instead of the labor force, which understates the true rate.

Unemployed $$ labor force $×100$; natural rate = frictional + structural.

The Consumer Price Index tracks the cost of a fixed market basket of goods over time to measure the cost of living and the inflation rate.

$Inflation rate = /CPI_new - CPI_oldCPI_old × 100$; real income $= /Nominal incomeCPI × 100$.

CPI-based inflation (fixed consumer basket) vs.\ GDP-deflator-based inflation (basket reflects current total output, including capital and government goods).

Using this year's CPI in the denominator instead of last year's when computing the percentage change.

$% CPI = /new-oldold×100$ = the inflation rate.

AD shows total real spending on domestic output at every price level, and it slopes downward because of the wealth, interest-rate, and exchange-rate effects.

$AD = C + I + G + NX$; AD shifts right/left from a change in $C$, $I$, $G$, or $NX$ at every price level --- not from a change in the price level itself.

A movement along AD (caused by a price-level change) vs.\ a shift of AD (caused by a change in one of its components).

Shifting the AD curve when the scenario describes only a change in the price level.

$AD=C+I+G+NX$; price level moves along it, everything else shifts it.

SRAS slopes upward because input prices are sticky in the short run, while LRAS is vertical at potential GDP because it reflects the economy's fixed productive capacity.

LRAS position depends on the quantity/quality of resources, capital, and technology --- not the price level; SRAS shifts with resource/input price changes; LRAS shifts only with changes in factors of production or technology.

A shift of SRAS (resource-price shock) vs.\ a shift of LRAS (change in the economy's underlying productive capacity).

Treating a price-level change as something that shifts LRAS, when LRAS is vertical and unaffected by the price level.

SRAS shifts with input costs; LRAS shifts only with real capacity changes.

Short-run macroeconomic equilibrium is where AD intersects SRAS; comparing that equilibrium GDP to potential (LRAS) GDP reveals a recessionary or inflationary gap.

Recessionary gap: equilibrium real GDP $<$ potential GDP (AD--SRAS intersection left of LRAS); Inflationary gap: equilibrium real GDP $>$ potential GDP (intersection right of LRAS); without intervention, the gap self-corrects as SRAS shifts back toward LRAS.

Recessionary gap (below potential, high unemployment) vs.\ inflationary gap (above potential, overheating).

Identifying the gap direction backward, or assuming self-correction shifts AD rather than SRAS.

Equilibrium left of LRAS $arrow$ recessionary; right of LRAS $arrow$ inflationary.

An initial change in spending ripples through the economy because one person's spending becomes another person's income, which is partly re-spent, producing a larger total change in real GDP.

$Spending multiplier = /1MPS = /11-MPC$; $ GDP = multiplier × initial change in spending$; $MPC + MPS = 1$.

The spending multiplier ($1/MPS$) vs.\ the tax multiplier ($-MPC/MPS$) --- the tax multiplier is smaller in magnitude because part of any tax change is saved, not spent.

Plugging MPC into the denominator instead of MPS, or forgetting the tax multiplier's extra $MPC$ factor and negative sign.

Multiplier $=/1MPS$; bigger MPC $arrow$ smaller MPS $arrow$ bigger multiplier.

Households split each additional dollar of disposable income between consumption and saving, and the marginal propensities describe that split.

$MPC = / C Y_d$; $MPS = / S Y_d$; $MPC+MPS=1$; consumption function $C = a + (MPC)(Y_d)$, where $a$ is autonomous consumption.

MPC (marginal --- the fraction of an extra dollar consumed) vs.\ APC (average --- total consumption divided by total disposable income, $C/Y_d$).

Using APC instead of MPC when computing the spending multiplier.

MPC + MPS = 1; multiplier uses MPC/MPS, not APC/APS.

Fiscal policy --- government spending and taxation decisions made by Congress and the President --- shifts AD to close output gaps.

Expansionary fiscal policy (used for a recessionary gap): increase $G$ and/or decrease $T$, shifting AD right; Contractionary fiscal policy (used for an inflationary gap): decrease $G$ and/or increase $T$, shifting AD left; the balanced-budget multiplier (equal increase in $G$ and $T$) equals 1.

Fiscal policy (Congress/President, controls $G$ and $T$) vs.\ monetary policy (the central bank, controls the money supply and interest rates).

Pairing the wrong policy direction with the wrong gap, e.g., raising taxes during a recessionary gap.

Recessionary gap $arrow$ $G$/$T$; inflationary gap $arrow$ $G$/$T$.

Money functions as a medium of exchange, a unit of account, and a store of value, and economists track it using increasingly broad monetary aggregates.

$M1$ = currency + checkable deposits + traveler's checks; $M2 = M1$ + savings deposits + small time deposits + money market mutual funds; $M2$ is less liquid than $M1$.

Money (a stock, measured at a point in time) vs.\ income (a flow, measured over a period of time).

Classifying a savings account as part of $M1$ instead of the broader $M2$.

$M1$ = spendable now; $M2 = M1$ + near-money savings.

Fractional-reserve banking allows commercial banks to create money by lending out the portion of deposits they are not required to hold in reserve.

Required reserves = required reserve ratio $×$ deposits; Excess reserves = actual reserves $-$ required reserves; a single bank can safely lend out only its excess reserves.

Required reserves (must be held, set by the Fed) vs.\ excess reserves (available to be loaned out).

Computing a bank's maximum new loan from total reserves instead of excess reserves only.

Excess reserves = actual $-$ required $arrow$ the amount a bank can lend.

A single injection of excess reserves expands the banking system's total money supply by a multiple set by the required reserve ratio.

$Money multiplier = /1rr$ (rr = required reserve ratio); maximum change in the money supply $= Excess Reserves × /1rr$.

The money multiplier ($1/rr$, banking-system money creation) vs.\ the spending multiplier ($1/MPS$, fiscal-policy income effects) --- different formulas testing different mechanisms.

Applying the full initial deposit (instead of just the excess reserves) to the money multiplier, double-counting the required-reserve portion.

Money multiplier $= /1rr$; apply it to excess reserves, not total deposits.

The Fed conducts monetary policy by controlling the money supply and short-term interest rates using three main tools.

Open market operations (buy bonds $arrow$ MS up; sell bonds $arrow$ MS down); the discount rate (rate the Fed charges banks); the required reserve ratio (raise $rr$ $arrow$ smaller money multiplier $arrow$ MS down).

Buying bonds (expansionary, injects reserves, MS increases) vs.\ selling bonds (contractionary, removes reserves, MS decreases).

Reversing the reserve-ratio effect --- raising $rr$ shrinks the multiplier and the money supply; it does not expand it.

Buy bonds/lower $rr$/lower discount rate $arrow$ expansionary; reverse $arrow$ contractionary.

The short-run nominal interest rate is set where a vertical, Fed-controlled money supply curve meets a downward-sloping money demand curve.

Money demand shifts with the price level and real GDP/income; it slopes down because the interest rate is the opportunity cost of holding money instead of an interest-bearing asset; expansionary monetary policy shifts MS right, lowering the interest rate.

The money market (sets the short-run nominal interest rate via MS and MD) vs.\ the loanable funds market (sets the real interest rate via saving and investment).

Shifting the money demand curve when only the interest rate has changed --- that is a movement along a fixed MD curve.

Vertical MS + downward MD $arrow$ nominal interest rate.

The loanable funds market determines the real interest rate through the interaction of national saving (supply) and investment/borrowing (demand).

Supply of loanable funds rises with higher private and public saving; demand for loanable funds is investment demand and slopes downward; a government budget deficit reduces the supply of loanable funds, raising the real interest rate and crowding out private investment.

Crowding out (deficit-driven higher interest rates reducing private investment) vs.\ the multiplier effect (expansionary fiscal policy raising GDP through respending).

Shifting the loanable funds demand curve for a budget deficit scenario, when it is the supply curve that shifts left.

Government deficit $arrow$ loanable funds supply shifts left $arrow$ real rate up $arrow$ crowding out.

Inflation can be triggered by excess aggregate demand pulling prices up, or by rising production costs pushing prices up, and the two look different on an AD--AS graph.

Demand-pull: AD shifts right along an upward-sloping SRAS $arrow$ price level and real GDP both rise; Cost-push: SRAS shifts left $arrow$ price level rises but real GDP falls (stagflation).

Demand-pull inflation (AD shift, output rises) vs.\ cost-push inflation (SRAS shift, output falls).

Assuming inflation is always accompanied by rising output --- true only for demand-pull, false for cost-push.

AD shifts right = demand-pull; SRAS shifts left = cost-push (stagflation).

The Fed changes the money supply and interest rates to shift AD and fight recessions or inflation.

Expansionary (recessionary gap): buy bonds / lower $rr$ / lower discount rate $arrow$ MS up $arrow$ interest rate down $arrow$ investment up $arrow$ AD right; Contractionary (inflationary gap): sell bonds / raise $rr$ / raise discount rate $arrow$ MS down $arrow$ interest rate up $arrow$ investment down $arrow$ AD left.

Expansionary monetary policy (lowers interest rates via MS) vs.\ expansionary fiscal policy (raises $G$ or cuts $T$) --- both shift AD right, through different mechanisms.

Mixing up which open-market operation --- buying or selling bonds --- is expansionary.

Buy bonds $arrow$ rates down $arrow$ I up $arrow$ AD right (expansionary).

The short-run Phillips curve shows an inverse, trade-off relationship between the inflation rate and the unemployment rate.

Expansionary policy moves the economy up the SR Phillips curve (lower unemployment, higher inflation); contractionary policy moves down it (higher unemployment, lower inflation); an adverse supply shock shifts the entire SR Phillips curve rightward (stagflation --- both rise).

A movement along the SR Phillips curve (demand-side policy trade-off) vs.\ a shift of the curve (a supply shock changing the trade-off itself).

Treating a stagflation scenario (a curve shift) as if it were simply a movement along a fixed curve.

Down the SRPC = expansionary trade-off; the whole SRPC shifting = supply shock.

In the long run there is no trade-off between inflation and unemployment --- the economy returns to the natural rate regardless of the inflation rate.

The LR Phillips curve is vertical at the natural rate of unemployment (NRU); this mirrors LRAS being vertical at potential GDP; expected inflation adjusts until unemployment returns to the NRU.

The SR Phillips curve (downward-sloping, real trade-off exists temporarily) vs.\ the LR Phillips curve (vertical, no permanent trade-off).

Assuming policymakers can permanently keep unemployment below the natural rate by tolerating higher inflation.

LR Phillips curve is vertical at the natural rate --- no long-run trade-off.

Automatic stabilizers smooth the business cycle without new legislation, while discretionary fiscal policy requires deliberate government action.

Automatic stabilizers: progressive income taxes, unemployment insurance, and welfare/transfer payments --- they rise automatically in a recession and fall automatically in an expansion; discretionary policy: explicit changes to $G$ or $T$ that require new legislation and are subject to recognition, implementation, and impact lags.

Automatic stabilizers (built into the system, act instantly) vs.\ discretionary fiscal policy (requires a new law, acts with a lag).

Describing unemployment insurance benefits as discretionary policy rather than an automatic stabilizer.

No new law needed = automatic stabilizer; new law needed = discretionary.

In the long run, the quantity theory of money holds that changes in the money supply translate into roughly proportional changes in the price level.

Equation of exchange: $MV = PQ$ ($M$ = money supply, $V$ = velocity of money, $P$ = price level, $Q$ = real output); if $V$ and $Q$ are roughly stable, $% M ≈ % P$ (the long-run inflation rate).

Nominal GDP ($P × Q$) vs.\ velocity of money ($V$ = how many times the average dollar is spent per period, so $MV$ = nominal GDP).

Rearranging $MV=PQ$ incorrectly when solving for an unknown variable, or applying it as a short-run prediction rather than a long-run relationship.

$MV=PQ$ $arrow$ in the long run, money growth $≈$ inflation.

Supply-side policies try to shift aggregate supply rightward by boosting the economy's productive capacity and incentives to work, save, and invest.

The Laffer curve plots tax revenue against the tax rate: revenue is \$0 at both a 0% and a 100% tax rate and is maximized at some intermediate rate; supply-side tax cuts or deregulation aim to shift AS right rather than shift AD.

Supply-side policy (shifts AS, targets production costs/incentives) vs.\ demand-side fiscal/monetary policy (shifts AD).

Assuming a tax cut always raises tax revenue --- true only if the current rate sits on the descending (high-rate) side of the Laffer curve.

Laffer curve: revenue = 0 at 0% and 100% tax rates, peaks in between.

Sustained growth in potential GDP comes from increases in the quantity and quality of resources and technology --- not from changes in AD.

Key drivers: growth in the labor force and human capital, physical capital investment, natural resources, and technological progress; represented graphically by an outward shift of the PPC or a rightward shift of LRAS.

Economic growth (an outward PPC/LRAS shift, a long-run phenomenon) vs.\ a short-run recovery to an existing potential GDP (a movement toward an unchanged PPC/LRAS).

Labeling a recovery from a recessionary gap back to potential GDP as "economic growth" when the PPC/LRAS itself has not shifted.

More/better resources + technology $arrow$ PPC and LRAS shift right = growth.

An economy that devotes more current resources to capital goods (investment) sacrifices present consumption for a faster future expansion of its production possibilities.

Producing closer to the capital-goods end of the PPC today $arrow$ a larger outward PPC shift in the future; producing closer to the consumer-goods end today $arrow$ slower future growth.

Investment in capital goods (expands future productive capacity) vs.\ consumption spending (satisfies present wants but does not expand future capacity).

Assuming any point on today's PPC implies the same future growth rate, regardless of the capital-goods/consumer-goods mix chosen.

More capital goods today $arrow$ bigger PPC tomorrow.

Labor productivity --- output per worker or per hour worked --- is the primary long-run driver of rising real wages and living standards.

$Labor productivity = /Real outputLabor hours (or workers)$; rises with more capital per worker, better technology, and stronger human capital/education.

Productivity growth (more output per worker, raises average living standards) vs.\ employment growth alone (more workers producing at the same rate, raises total output but not output per person).

Crediting a rise in total output to "growth" without checking whether it came from more workers (no productivity gain) or from higher output per worker.

Output $$ labor $arrow$ productivity $arrow$ real wages and living standards.

The balance of payments records all of a country's transactions with the rest of the world, split into a current account and a financial (capital) account that offset each other.

Current account: net exports of goods/services, net investment income, net transfers; Financial account: net capital flows (foreign purchases of domestic assets minus domestic purchases of foreign assets); Current account balance $+$ Financial account balance $≈ 0$.

The current account (trade in goods, services, and income) vs.\ the financial account (trade in assets and capital flows).

Treating a current account deficit as automatically harmful without recognizing it is offset by a financial account surplus (a capital inflow).

Current account + financial account $≈ 0$ --- a trade deficit means a capital inflow.

Under a floating exchange rate system, a currency's value is set by the supply and demand for that currency in the foreign exchange market.

Appreciation: a currency's value rises relative to another currency; Depreciation: it falls; higher relative domestic interest rates tend to attract foreign capital, increasing demand for the domestic currency and causing appreciation.

Currency appreciation (buys more foreign currency, but makes exports pricier abroad) vs.\ depreciation (buys less foreign currency, but makes exports cheaper abroad).

Assuming currency appreciation helps net exports --- it actually raises the foreign price of exports and lowers the domestic price of imports, reducing NX.

Appreciation $arrow$ exports more expensive $arrow$ NX falls; depreciation $arrow$ NX rises.

Domestic monetary and fiscal policy change interest rates, which change exchange rates and net exports, linking domestic stabilization policy to the open economy.

Expansionary monetary policy $arrow$ lower domestic interest rates $arrow$ currency depreciates $arrow$ net exports rise (reinforces the AD increase); Expansionary fiscal policy (deficit spending) $arrow$ higher domestic interest rates $arrow$ currency appreciates $arrow$ net exports fall (partially offsets the AD increase).

The interest-rate/exchange-rate effect of monetary policy (currency depreciates) vs.\ the interest-rate/exchange-rate effect of deficit-financed fiscal policy (currency appreciates).

Forgetting that expansionary fiscal policy's higher interest rates can appreciate the currency and shrink net exports, partly offsetting the intended AD increase.

Expansionary MP $arrow$ currency down $arrow$ NX up; expansionary fiscal (deficit) $arrow$ currency up $arrow$ NX down.

Ten formulas, ten questions --- know every symbol cold.

When two terms sound alike on this exam, assume the question is testing the difference.

Fiscal = elected branches; Monetary = the Fed; data = BEA (GDP) and BLS (prices/jobs).

If you can sketch and correctly label all seven, you can answer most graph items.

Shock $arrow$ which curve moves $arrow$ new equilibrium $arrow$ gap $arrow$ correct policy.

$$80 questions, 90 minutes, all MCQ, no calculator --- know the formulas cold.

Wages/prices are sticky short run, flexible long run $arrow$ SRAS drifts back to LRAS.

Axis variable changes $arrow$ move along; everything else $arrow$ shift the curve.