Macroeconomics: The Level of Overall Economic Activity (2.1) Test Study Guide
What to Study
 Remember, all lessons from previous units are fair game!
 ECONOMIC ACTIVITY
o The circular flow of income model
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Explain, using a diagram, the circular flow of income between households and firms in
a closed economy with no government.
Identify the four factors of production and their respective payments (Also…know
that these four constitute the income flow in the model):
 rent
 wages
 interest
 profit
Outline that:
 income flow = expenditure flow and the value of output flow
Explain, using a diagram, the circular flow of income in an open economy with
government and financial markets, referring to:
 leakages/withdrawals (savings, taxes and import expenditure)
 injections (investment, government expenditure and export revenue)
Explain how the size of the circular flow will change depending on the relative size of
(a) injections and (b) leakages.
o Measures of economic activity: gross domestic product (GDP), and gross
national product (GNP) or gross national income (GNI)
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Distinguish between _____________ as measures of economic activity.
Distinguish between the nominal and real values of ___________________.
Distinguish between total and per capita __________________.
 GDP and GNP/GNI
Examine these approaches when measuring national income:
 output approach
 income approach
 expenditure approach
Evaluate the use of national income statistics, including:
 their use for making comparisons over time
 their use for making comparisons between countries
 their use for making conclusions about standards of living.
Explain the meaning and significance of “green GDP”, a measure of GDP that accounts
for environmental destruction.
THE BUSINESS CYCLE
o Short term fluctuations and long-term trend
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Explain, using a business cycle diagram, that economies typically tend to go through a
cyclical pattern characterized by the phases of the business cycle.
 Expansion & recession
o Peaks & troughs
Explain the long-term growth trend in the business cycle diagram as the potential
output of the economy.
Distinguish between a decrease in GDP and a decrease in GDP growth.
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Macroeconomics: Aggregate Demand and Aggregate Supply (2.2) Test Study Guide
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AGGREGATE DEMAND (AD)
o The AD curve
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Distinguish between
 the microeconomic concept of demand for a product
 the macroeconomic concept of aggregate demand.
Construct an aggregate demand curve.
Construct an AD curve and explain why it has a negative slope.
o The components of AD
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Describe the components of AD: (C + I + G + Xn)
 (1) consumption, (2) investment, (3) government spending, (4) net exports
o The determinants of AD or causes of shifts in the AD curve
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Explain how the AD curve can be shifted by changes in consumption (C) due to:
 changes in consumer expectations/confidence
 interest rates
 consumer wealth (this is not income…it is the value of an asset)
 personal income taxes (which changes disposable income)
 level of household indebtedness.
Explain how the AD curve can be shifted by changes in investment (I) due to:
 interest rates
 expected returns
o business expectations/confidence
o technology
o degree of excess capacity
 excess capacity = unused capital. Below capacity = little
incentive to build new factories
o business taxes
o level of corporate indebtedness.
Explain how the AD curve can be shifted by changes in gov’t spending (G) due to:
 political priorities
 economic priorities.
Explain how the AD curve can be shifted by changes in net exports (Xn) due to
 National income abroad (income of trading partners)
 exchange rates
 changes in the level of protectionism.
AGGREGATE SUPPLY (AS)
o The meaning of aggregate supply
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Define the term aggregate supply.
Explain, using a diagram, why the short-run aggregate supply curve (SRAS curve) is
upward sloping.
Explain, using a diagram, how the AS curve in the short run (SRAS) can shift due to:
 changes in resource prices
o domestic resource (inputs) – wages/salaries, benefits, land or capital
assets
o prices of imports
o market power (ability of some to set prices above competitive
levels…e.g. OPEC in the 1970s)
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changes in business taxes and subsidies
supply shocks.
o Alternative views of aggregate supply
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Explain, using a diagram, that the monetarist/new classical model of the long run
aggregate supply curve (LRAS) is vertical at the level of potential output (full
employment output) because aggregate supply in the long run is independent of the
price level.
Explain, using a diagram, that the Keynesian model of the aggregate supply curve has
three sections because of “wage/price” downward inflexibility and different levels of
spare capacity in the economy.
o Shifting the aggregate supply curve over the long term
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Compare and contrast, using the two models above, the ways that factors leading to
changes in the quantity and/or quality of factors of production (including (a)
improvements in efficiency, (b) new technology, (c) reductions in unemployment, and
(d) institutional changes) can shift the aggregate supply curve over the long term.
EQUILIBRIUM
o Short-run equilibrium
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Explain, using a diagram, the determination of short-run equilibrium, using the SRAS
curve.
Examine, using diagrams, the impacts of changes in short run equilibrium.
o Equilibrium in the monetarist/new-classical model
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Explain, using a diagram, the determination of long-run equilibrium, indicating that
long-run equilibrium occurs at the full employment level of output.
Examine why, in the monetarist/new classical approach, while there may be shortterm fluctuations in output, the economy will always return to the full employment
level of output in the long run.
Examine, using diagrams, the impacts of changes in the long-run equilibrium.
o Equilibrium in the Keynesian model
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Explain, using the Keynesian AD/AS diagram, that the economy may be in equilibrium
at any level of real output where AD intersects AS.
Explain, using a diagram, that if the economy is in equilibrium at a level of real output
below the full employment level of output, then there is a deflationary (recessionary)
gap.
Discuss why, in contrast to the monetarist/new classical model, the economy can
remain stuck in a deflationary (recessionary) gap in the Keynesian model.
Explain, using a diagram, that if AD increases in the vertical section of the AS curve,
then there is an inflationary gap.
Discuss why, in contrast to the monetarist/new classical model, increases in
aggregate demand in the Keynesian AD/AS model need not be inflationary, unless the
economy is operating close to, or at, the level of full employment.
Know the basics of the Keynesian multiplier
Macroeconomics: Macroeconomic Objectives (2.3) Test Study Guide
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LOW UNEMPLOYMENT
o The meaning of unemployment
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Define the term unemployment.
Explain how the unemployment rate is calculated.
Explain the difficulties in measuring unemployment, including:
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the existence of hidden unemployment
the existence of underemployment
the fact that it is an average and therefore ignores regional, ethnic, age and
gender disparities.
o Consequences of unemployment
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Discuss possible economic consequences of unemployment, including:
 a loss of GDP
 loss of tax revenue
 increased cost of unemployment benefits
 loss of income for individuals
 greater disparities in the distribution of income.
Discuss possible personal and social consequences of unemployment, including
 increased crime rates
 increased stress levels
 increased indebtedness
 homelessness
 family breakdown.
o Types and causes of unemployment
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Describe, using examples, the meaning and causes of ___________ unemployment.
 frictional
 structural
 seasonal
 cyclical (demand-deficient).
Explain, using a diagram, that cyclical unemployment is caused by a fall in AD.
Explain, using a diagram, that structural unemployment is caused by:
 changes in the demand for particular labour skills
 changes in the geographical location of industries
 labour market rigidities.
Evaluate government policies to deal with the different types of unemployment.
LOW AND STABLE RATE OF INFLATION
o The meaning of inflation, disinflation, and deflation
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Distinguish between (1) inflation, (2) disinflation, and (3) deflation.
Explain that inflation and deflation are typically measured by calculating a consumer
price index (CPI), which measures the change in prices of a basket of goods and
services consumed by the average household.
Explain that different income earners may experience a different rate of inflation
when their pattern of consumption is not accurately reflected by the CPI.
Explain that inflation figures may not accurately reflect changes in consumption
patterns and the quality of the products purchased.
Explain that economists measure a core/underlying rate of inflation to eliminate the
prices of food and oil, for example.
Explain that a producer price index measuring changes in the prices of factors of
production may be useful in predicting future inflation.
o Consequences of inflation
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Discuss the possible consequences of a high inflation rate, including
 greater uncertainty
 redistributive effects
 less saving
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the damage to export competitiveness.
o Consequences of deflation
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Discuss the possible consequences of deflation, including
 high levels of cyclical unemployment
 bankruptcies.
o Types and causes of inflation
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Explain, using a diagram, that demand-pull inflation is caused by changes in the
determinants of AD, resulting in an increase in AD.
Explain, using a diagram, that cost-push inflation is caused by an increase in the
costs of factors of production, resulting in a decrease in SRAS.
Evaluate government policies to deal with the different types of inflation.
o Possible relationships between unemployment and inflation
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Know that a Phillips curve diagram shows the view that:
 there is a possible trade-off between the unemployment rate and the inflation
rate in the short run, but
 in the long run, there is no trade off between unemployment and inflation.
ECONOMIC GROWTH
o The meaning of economic growth
 Define economic growth as an increase in real GDP.
o Causes of economic growth
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Explain, using a production possibilities curve (PPC) diagram, economic growth as an
increase in actual output resulting from factors such as (1) the utilization of
unemployed resources and (2) increases in productive efficiency, leading to a
movement of a point inside the PPC to a point closer to the PPC.
Explain, using a PPC diagram, economic growth as an increase in production
possibilities caused by factors including increases in the quantity and quality of
resources, leading to outward PPC shifts.
Explain, using an LRAS diagram, economic growth as an increase in potential output
caused by factors including increases in the quantity and quality of resources, leading
to a rightward shift of the LRAS curve.
Evaluate the view that increased investment is essential to achieve economic growth.
Evaluate the view that improved productivity is essential to achieve economic
growth.
o Consequences of economic growth
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Discuss the possible consequences of economic growth, including
 the possible impacts on living standards
 unemployment
 inflation
 the distribution of income
 the current account of the balance of payments
 sustainability.
EQUITY IN THE DISTRIBUTION OF INCOME
o The meaning of equity in the distribution of income
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Explain the difference between
 equity in the distribution of income and
 equality in the distribution of income.
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Explain that due to unequal ownership of factors of production, the market system
may not result in an equitable distribution of income.
o Indicators of income equality/inequality
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Analyse data on relative income shares of given percentages of the population,
including deciles and quintiles.
Draw a Lorenz curve and explain its significance.
Explain how the Gini coefficient is derived and interpreted.
o Poverty
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Distinguish between absolute poverty and relative poverty. Explain possible causes of
poverty, including low incomes, unemployment and lack of human capital.
Explain possible consequences of poverty, including low living standards, and lack of
access to health care and education.
o The role of taxation in promoting equity
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Distinguish between direct and indirect taxes, providing examples of each, and
explain that direct taxes may be used as a mechanism to redistribute income.
Distinguish between (1) progressive, (2) regressive and (3) proportional taxation,
providing examples of each.
o Other measures to promote equity
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Explain that governments undertake expenditures to provide directly, or to subsidize,
a variety of socially desirable goods and services (including health care services,
education, and infrastructure that includes sanitation and clean water supplies),
thereby making them available to those on low incomes.
Explain the term transfer payments, and provide examples, including
 (1) old age pensions
 (2) unemployment benefits
 (3) child allowances.
o The relationship between equity and efficiency
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Evaluate government policies to promote equity such as (1) taxation, (2) government
expenditure, and (3) transfer payments in terms of their potential positive or
negative effects on efficiency in the allocation of resources.
Macroeconomics: Fiscal Policy (2.4) Test Study Guide
What to Study
 Know the 3 Macroeconomic Objectives
o (1) full employment (low unemployment) (2) low & stable rate of inflation (3)
economic growth
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IB Econ adds a 4th—equity in the distribution of income (will be discussed later in the course)
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Know the information from the “A Few Econ Ideas” PPT
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Be able to diagram an economy at equilibrium at full employment. From that diagram, be
able to show (a) demand-pull inflation and (b) cost-push inflation and explain why each shift
would have occurred.
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Fiscal Policy
o What is fiscal policy?
o How does the Keynesian multiplier 1/(1-MPC) relate to fiscal policy?
 Note: You do not need to graph/do math for this.
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o The government budget
 Main ways gov’t earns revenue:
 (1) Taxes (direct & indirect)—Taxes are #1 way
o Direct—collected by gov’t (e.g. - income, capital gains)
o Indirect—collected by intermediaries (e.g. - sales, VAT)
 (2) the sale of goods and services
 (3) the sale of state-owned (government-owned) enterprises
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Classifications of government spending:
 (1) current expenditures & (2) capital expenditures
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(3) transfer payments
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http://www.bized.co.uk/virtual/economy/policy/tools/government/gexpth3.htm
http://www.bized.co.uk/virtual/economy/policy/tools/government/gexpth1.htm
***Be able to provide examples of each.
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What is the difference between a budget deficit, a budget surplus, & a balanced
budget?
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What is the relationship between (a) fiscal policy and either increasing or
decreasing budget deficits/surpluses & (b) fiscal policy w/the public debt?
o The role of fiscal policy
 How do gov’t spending & taxes affect AD?
 How does the Laffer Curve try to explain the relationship between taxation
and government revenue?
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How does expansionary fiscal policy close a deflationary (recessionary) gap?
 Be able to diagram the potential effects of expansionary fiscal policy,
outlining the importance of the shape of the AS curve. (See the
“Graphing Deflationary & Inflationary Gaps” handout for help.)
 ***Note: Keynesians believe the AS curve can be relatively elastic
(flat)…monetarists believe the AS curve is relatively inelastic (steep).
o Keynesians—If there is spare capacity (economy is below full
employment), then increasing AD will increase real GDP/output
but have little impact on the price level.
o Monetarists—Economies often are operating at or near full
capacity. Increasing AD will have little impact on GDP but will
increase only the price level in the long run.
o (We’ll talk more about these two sides later, but in a nutshell—
Keynesians support expansionary fiscal policy via gov’t spending
while monetarists are critical of it, saying it will cause inflation
and/or crowding out. Monetarists emphasize controlling the
money supply to keep inflation low.
o Here are some diagrams that can help w/ visualizing the
different ideas:
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How does contractionary fiscal policy close an inflationary gap?
 Be able to diagram the potential effects of contractionary fiscal policy,
outlining the importance of the shape of the AS curve.
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What are 2 automatic stabilizers and how do they stabilize short-term
fluctuations in both directions…expansionary and recessionary?
 Be able to distinguish between automatic and discretionary fiscal policy
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How can fiscal policy promote long-term growth (increases in potential
output) both indirectly and directly?
 Indirectly – Creating an environment favorable to private investment
 Directly – Government spending on physical capital goods and human
capital formation; providing incentives for firms to invest
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How effective is fiscal policy? Be able to evaluate. Consider…
 Strengths
o The ability to target certain sectors of the economy
o Direct impact on aggregate demand
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o Effectiveness of promoting economic activity in a recession
(avoids deflationary spiral; market forces may not be able to
correct)
Weaknesses
o Time lags
o Political constraints
o Crowding out
o Inability to deal with supply-side causes of instability
Monetary Policy (Most monetary policy material will be covered on the next summative)
o A few basic things about money
 Money market
 Liquidity
 Fractional reserve banking system
Macroeconomics: Monetary Policy (2.5) Test Study Guide
What to Study
 Fiscal Policy
o Review all things learned for the previous test
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Monetary Policy
o What is monetary policy?
o A few money basics -- money market, liquidity, fractional reserve banking system
o Overnight rate (bank to bank), discount rate (Fed to bank), prime rate (bank to
quality lenders)
 Note: In the US, the overnight rate is known as the ‘federal funds rate’
 http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html;
 http://www.fedprimerate.com/charts/federal-funds-target-rate_vs_prime-rate_vs_1-monthlibor_vs_3-month-libor.gif
o Central banks & interest rates
 Know that almost every single country in the world has a central bank
 How do central banks serve as regulators of (a) commercial banks and (b)
bankers to governments?
 How do central banks use interest rates to control inflation (their #1
macroeconomic objective)?
 Be able to diagram both the demand for money and the supply of
money on the same curve. Be able to show how lowering or increasing
the supply of money affects the interest rate.
o Be able to distinguish between the idea of investing in bonds/etc
vs. business investment. (The 1st involves transfer payments
NOT counted toward the GDP and the 2nd involves spending on
goods/services that IS counted toward the GDP.
o Be able to show 3 tools central banks use to affect interest rates
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Know that interest rates & inflation rates are inversely rated (and why!)
o The role of monetary policy
 How do changes in interest rates influence the level of AD in an economy?
 How does easy (expansionary) monetary policy help close a
deflationary (recessionary) gap? How does tight (contractionary)
monetary policy help close an inflationary gap?
o Be able to recreate what is shown in the table on p. 279
o Be able (a) to graph the investment curve (based on interest
rate) and (b) to graph how expanding/contracting the money
supply affects AD (on an AD/AS curve)
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Graphing Resources – p. 276-277 in textbook +
http://www.youtube.com/watch?v=4bxrGKRChf0 &
http://www.youtube.com/watch?v=OueKt-mYlpY
o Be sure to outline the importance of the shape of the AS curve.
o Monetary policy and inflation targeting
 Be aware that many central banks believe (either implicitly or explicitly) that
around a 2% inflation rate target is desirable and use monetary policy to help
achieve that goal. (Many announce their target which gives investors
important information for planning purposes.)
o Comparing the net export effects of an expansionary fiscal policy to an easy money
policy
 Expansionary fiscal policy  decrease in net exports (Why?)
 Easy money policy  increase in net exports (Why?)
o Evaluating monetary policy
 How effective is monetary policy? Consider…
 the independence of the central bank (pro)
 the ability to adjust interest rates incrementally (pro)
 the ability to implement changes in interest rates relatively quickly (pro)
 certain time lags (con)
 limited effectiveness in increasing AD if the economy is in deep
recession (con)
o ***it is much easier for a central bank to slow inflation (w/ a tight
money policy) than it is to encourage spending (w/easy money)***
 conflict among government economic objectives (con) –
o Consider Phillips Curve***did not do last year, not required for SL
 changes in velocity of money (con)
o The Keynesian multiplier v. the money multiplier
 Keynesian  1/(1-MPC) -- related to fiscal policy
 Money multiplier  1/reserve ratio – related to monetary policy
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Note: SL does not need to graph/do math for either, but you should be
familiar with the main ideas behind each one
Reminder…anything from previous units are fair game on current tests.
Macroeconomics: Supply-Side Policies (2.6) & Macro Controversies Test Study Guide
What to Study
 Remember…anything from previous units is fair game!
 Supply-Side Policies
o What is a supply-side policy?
 How do supply-side policies differ from fiscal and monetary policy?
 In what direction do supply-side policies try to shift the LRAS curve?
 What is the difference between interventionist & market-based supply-side
policy?
 Be able to diagram an increase in LRAS (including AD/SRAS/LRAS on the
diagram) and explain what that does to GDP & price level.
o Interventionist supply-side policies
 How do investment in human capital (education and training), technology
(including R & D), and infrastructure (including roads/airports/etc) increase
LRAS?
 How does targeting specific industries through tax cuts, tax allowances, and
subsidies increase LRAS?
 ***How do each of the interventionist policies impact AD in the short-term
while increasing LRAS?***
o Market-based supply-side policies
 What are some supply-side policies that encourage competition?
 Deregulation, privatization, trade liberalization, and anti-monopoly
regulation
 What are some supply-side labour market reforms?
 Reducing unemployment benefits, abolishing minimum wages
 What are some supply-side policies that increase the incentive to invest?
 Personal income tax cuts, cuts in business and capital gains taxes
o Evaluating supply-side policies
 How effective are supply side policies? Consider the following:
 Time lags
 Ability to create employment
 Ability to reduce inflationary pressure
 The impact on economic growth (short-term & long-term)
 The impact on the government budget
 The impact on equity
 The effect on the environment
 Graphing Keynesian & monetarist/neo-classical:
o Monetarist/Neo-Classical
 AS is vertical. This means (a) economy is always at or close to full
employment and (b) any increase in AD is inflationary
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Economy will not remain stuck in a deflationary (recessionary) gap; it will
return to full level of employment in long run
 LRAS is vertical @ the level of potential output (full employment) because AS
in the long run is independent of the price level.
o Keynesian AD/AS:
 Economy may be in equilibrium @ any price level or real output where AD
intersects AS
 Economy can remain stuck in a deflationary (recessionary) gap in the
Keynesian model
 Increase in AD is not always inflationary (unless economy is at or near full
employment)
 Keynesian model of AS curve has 3 sections because of (a) “wage/price”
downward inflexibility and (b) different levels of spare capacity in the
economy
• Comparing Keynesian, and monetarist/classical, & supply-side views of the economy
o Consider the lessons from:
 The guided reading activity
 The “Macroeconomic Theories” handout
 The debates—interpreting data & suggesting policy.
o ***The most important part of this section will be interpreting data and
suggesting policy from the perspectives of 1, 2, or all 3 of the theories we studied
in class.***
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