Key Economic Concepts and Definitions
Basic Economic Principles
The world operates under a principle of scarcity. Resources are limited, while human wants are virtually endless. This fundamental concept forces us to make choices. Every decision carries an opportunity cost—the value of the next best alternative that we forgo when we make that choice. Recognizing opportunity cost is essential for economic analysis.
Consider the classic example of a person choosing between studying for an exam and going to a concert. The opportunity cost of studying is missing the concert, and the opportunity cost of going to the concert is sacrificing time devoted to studying. Understanding opportunity cost helps in making informed decisions.
The Production Possibilities Frontier (PPF) visually represents the maximum possible output combinations an economy can achieve given its available resources and technology. It typically curves outward, reflecting increasing opportunity costs. A point inside the curve indicates inefficiency, while a point outside is currently unattainable. An outward shift of the PPF, a sign of economic growth, means the economy can produce more of both goods.
Comparative advantage is the ability to produce a good or service at a lower opportunity cost than another producer. Specialization, where individuals or countries focus on producing goods or services in which they have a comparative advantage, leads to increased overall output and economic efficiency. Global trade relies heavily on comparative advantage.
Economic systems are the framework of how a society organizes the production and distribution of goods and services. The market system is driven by supply and demand, with minimal government intervention. The command system is centrally planned, with the government controlling most economic activity. A mixed economy combines elements of both market and command systems. Most economies today operate as mixed economies, to varying degrees.
Supply and Demand
Supply and demand are the core forces driving market economies.
The Law of Demand states that, all other things being equal, as the price of a good or service increases, the quantity demanded decreases, and vice versa. This inverse relationship is represented by a downward-sloping demand curve.
The Law of Supply states that, all other things being equal, as the price of a good or service increases, the quantity supplied increases, and vice versa. This direct relationship is represented by an upward-sloping supply curve.
Several factors can shift the demand curve. These demand shifters are:
* Changes in consumer income (normal vs. inferior goods)
* Changes in the prices of related goods (substitutes vs. complements)
* Changes in consumer preferences or tastes
* Changes in consumer expectations about future prices or availability
* Changes in the number of consumers in the market
Supply shifters are also critical in determining market outcomes. These supply shifters are:
* Changes in input costs (e.g., wages, raw materials)
* Changes in technology
* Changes in the number of sellers
* Changes in producer expectations about future prices
* Changes in government policies (taxes, subsidies, regulations)
Market equilibrium occurs at the point where the quantity demanded equals the quantity supplied. This is where the supply and demand curves intersect. At the equilibrium price, there is no surplus or shortage.
Price floors are government-imposed minimum prices, typically set above the equilibrium price. They can lead to surpluses. Price ceilings are government-imposed maximum prices, typically set below the equilibrium price. They can lead to shortages.
Measurement of Economic Performance
Understanding how economies are measured is critical.
Gross Domestic Product (GDP) is the total market value of all final goods and services produced within a country’s borders during a specific time period, usually a year. GDP is a key indicator of economic health. There are several approaches to calculating GDP. The expenditure approach sums up all spending in the economy: Consumption (C), Investment (I), Government spending (G), and Net Exports (NX). The income approach sums up all the income earned in the economy.
Nominal GDP is measured using current prices. Real GDP is adjusted for inflation, providing a more accurate picture of economic output. To calculate real GDP, you must use the GDP deflator formula.
The GDP deflator is a price index used to measure the average price level of all goods and services included in GDP. It is calculated using the formula: (Nominal GDP / Real GDP) * 100.
The Consumer Price Index (CPI) measures the average change over time in the prices paid by urban consumers for a basket of consumer goods and services. CPI is a common measure of inflation.
Inflation is a sustained increase in the general price level of goods and services in an economy. It reduces the purchasing power of money. There are two main types of inflation: demand-pull inflation, caused by an increase in aggregate demand, and cost-push inflation, caused by an increase in production costs.
Unemployment refers to the percentage of the labor force that is actively seeking work but is unable to find it. The labor force consists of people who are employed or actively seeking employment. The unemployment rate is calculated as (Number of Unemployed / Labor Force) * 100. There are different types of unemployment: frictional (temporary), structural (mismatch of skills), and cyclical (tied to the business cycle).
Economic Growth
Economic growth is crucial for raising living standards.
Economic growth is the sustained increase in the real GDP of an economy over time. Several factors influence economic growth. These factors include increased resources, advancements in technology, increased capital stock, and improved productivity.
Sustainable growth considers the long-run impact of economic activity on the environment and resource depletion. This promotes responsible growth models that consider environmental preservation.
Higher productivity, the amount of output produced per unit of input, is a key driver of economic growth and improved living standards. Policies that promote productivity, such as education, infrastructure, and technological innovation, are essential for long-term prosperity.
The Circular Flow Model
This model illustrates how money, resources, and goods and services flow through the economy.
The simple circular flow model shows the interaction between households and firms. Households supply resources (labor, land, capital) to firms, and firms pay households income (wages, rent, interest, profit). Firms produce goods and services that are sold to households, and households pay firms for these goods and services. The government and the foreign sector are then added.
Leakages are factors that remove money from the circular flow (e.g., savings, taxes, imports). Injections are factors that add money to the circular flow (e.g., investment, government spending, exports). Equilibrium in the circular flow occurs when leakages equal injections.
Aggregate Supply and Demand (AS-AD)
This model helps to understand the overall performance of the economy.
Aggregate Demand (AD) is the total demand for goods and services in an economy at a given price level. The factors that shift AD are: consumer spending (C), investment spending (I), government spending (G), and net exports (NX).
Aggregate Supply (AS) represents the total supply of goods and services in an economy at a given price level. The short-run aggregate supply (SRAS) curve is upward sloping, reflecting the relationship between the price level and the quantity supplied. The long-run aggregate supply (LRAS) curve is vertical, representing the economy’s potential output. Factors that shift AS are: changes in input costs, changes in technology, and changes in the supply of labor and capital.
Macroeconomic equilibrium occurs at the intersection of the AD and AS curves. The equilibrium price level and the equilibrium real GDP are determined at this point.
Shifts in AS and AD affect output, employment, and the price level. An increase in AD typically leads to higher prices and increased output (in the short run). An increase in AS typically leads to lower prices and higher output. Economic growth and recessions can be easily visualized with this model.
The multiplier effect occurs when an initial change in spending leads to a larger change in overall output. The multiplier effect can be calculated, though the details are beyond this high-level AP Macro Cheat Sheet.
Money, Banking, and Monetary Policy
This section explores the financial aspects of the economy.
Money serves three main functions: as a medium of exchange, a unit of account, and a store of value.
The money supply includes the total amount of money available in an economy. M1 includes currency in circulation, checking accounts, and traveler’s checks. M2 includes M1 plus savings deposits, money market accounts, and small-denomination time deposits.
The Federal Reserve System (The Fed) is the central bank of the United States. It is responsible for conducting monetary policy, supervising and regulating banks, and providing financial services.
The Fed uses various tools to control the money supply. Reserve requirements are the percentage of deposits banks are required to hold in reserve. The discount rate is the interest rate at which commercial banks can borrow money directly from the Fed. Open market operations (OMO) involve the buying and selling of government securities in the open market to influence the money supply.
Monetary policy tools have specific effects. Expansionary monetary policy (lowering interest rates) increases the money supply, stimulates borrowing and spending, and promotes economic growth. Contractionary monetary policy (raising interest rates) decreases the money supply, reduces borrowing and spending, and combats inflation.
The money multiplier quantifies the potential increase in the money supply resulting from an initial deposit.
Quantitative easing (QE) involves a central bank injecting money into the economy by purchasing assets, typically government bonds, to lower interest rates and stimulate lending.
Fiscal Policy
Governments also play a role in the economy.
Fiscal policy involves the government’s use of spending and taxation to influence the economy.
Expansionary fiscal policy involves increasing government spending and/or decreasing taxes to stimulate economic activity. Contractionary fiscal policy involves decreasing government spending and/or increasing taxes to cool down an overheated economy.
Fiscal policy tools have distinct effects. Increased government spending directly increases aggregate demand. Tax cuts increase disposable income, leading to increased consumption and potentially increased investment.
Budget deficits occur when government spending exceeds tax revenue. Budget surpluses occur when tax revenue exceeds government spending. The national debt is the accumulated total of all past budget deficits, less any surpluses.
The crowding-out effect occurs when increased government borrowing to finance a budget deficit leads to higher interest rates, which reduces private investment spending.
International Trade and Finance
Understanding the global economy is critical.
The balance of payments summarizes all economic transactions between a country and the rest of the world. It includes the current account (trade in goods and services, net investment income, and net transfers) and the capital account (investment flows).
Exchange rates are the prices at which currencies are traded. They are determined by the supply and demand for currencies. Several factors influence exchange rates including interest rates, inflation rates, economic growth, and government intervention.
Appreciation is an increase in the value of a currency relative to other currencies. Depreciation is a decrease in the value of a currency relative to other currencies.
Trade deficits occur when a country imports more goods and services than it exports. Trade surpluses occur when a country exports more goods and services than it imports.
Tariffs are taxes on imported goods. Quotas are limits on the quantity of imported goods.
Economic Growth and Development
The factors that propel and hamper economic growth are important considerations.
Several factors drive economic growth. These include technological advancements, increases in the quantity and quality of labor and capital, and institutional improvements.
Supply-side economics focuses on policies that increase aggregate supply, such as tax cuts, deregulation, and investments in education and infrastructure.
Labor market dynamics are crucial to understanding unemployment and inflation. The supply and demand for labor impact wages, employment levels, and overall economic activity.
Exam Tips and Strategies
Effective test-taking is as important as subject matter knowledge.
Time management is essential. Learn to allocate your time efficiently between multiple-choice and free-response questions. Practice pacing yourself under timed conditions.
Multiple-choice questions often involve identifying the correct definition, applying a concept, or interpreting a graph. Read each question and answer choices carefully. Eliminate obviously wrong answers. Don’t spend too much time on any single question.
Free-response questions (FRQs) test your ability to apply macroeconomic concepts and analyze economic scenarios. Understand the different types of FRQs and how to approach each type. Practice writing clear, concise, and well-organized answers.
There are many good practice resources available, including the AP Classroom, practice tests, and review books. Practice is key to success.
Formulas Cheat Sheet
Real GDP = (Nominal GDP / GDP Deflator) * 100
Inflation Rate = ((CPI Year 2 – CPI Year 1) / CPI Year 1) * 100
CPI = (Cost of Market Basket in Current Year / Cost of Market Basket in Base Year) * 100
Unemployment Rate = (Number of Unemployed / Labor Force) * 100
Money Multiplier = 1 / Reserve Requirement Ratio
Graphs Cheat Sheet
Production Possibilities Frontier (PPF)
Supply and Demand
Aggregate Supply and Aggregate Demand (AS/AD)
Money Market
Loanable Funds Market
Phillips Curve
Conclusion
This AP Macro Cheat Sheet provides a streamlined overview of the essential concepts, formulas, and graphs needed for success on the AP Macroeconomics exam. Remember that memorization alone isn’t enough. Actively use this information. Regularly review these concepts, and practice applying them to different scenarios. Practice, practice, practice! Consistently review your notes, complete practice problems, and take full-length practice exams. By using this AP Macro Cheat Sheet along with diligent study, you can greatly enhance your understanding and boost your performance on the exam. Your hard work and dedication will pay off. Good luck!
