One of the many reasons that I find the study of economics so fascinating is that what so often appears to be a negative situation to the average citizen is actually a positive one. In other words: “down is often up” and “black is often white”. One of my favorite examples of this “180 degree moment”, and why I love to teach AP Macroeconomics, relates to the study of unemployment.

One week from today thousands of 11th and 12th grade students around the world will sit for four hours of AP Economics exams. The final push is on to review for this long day of micro and macroeconomics problem solving.

Many AP Econ teachers accessed and downloaded from the College Board’s website the free practice exams the board produced for teachers to use to help prepare their students for the real thing on May 15. While I cannot distribute these practice exams from my site, any AP teacher should be able to access these documents by clicking here.

On the Exam Prep page of this blog, I’ve uploaded unit by unit study guides as well as teacher notes for both the Micro and the Macro practice exams. Also included are links to the student created wiki pages for every unit in Micro and Macroeconomics.

With one week left to review, these resources should come in handy for both students and teachers looking for a good sources of material focused specifically on the AP Economics exams.

Last week AP students at Shanghai American School took their final test for the class on the last Macro unit, “International Economics”. The free response question on this test was from Form B of the 2007 exam, which is written for students who take the exam outside of the United States.

Upon grading my students’ tests, I was surprised to see how poorly students did on the FRQ. The most common mistake was confusing the money market with the market for foreign currency. Read below to see the original question, along with my comments on common mistakes and the correct answer.

2007 AP Macroeconomics FRQ #1 (form B)

Assume that Australia and New Zealand are trading partners. Australia’s economy is currently in recession.

(a) Now assume that Australia begins to recover from its recession. Using a correctly labled graph of aggregate demand and aggregate supply for New Zealand, show the impact of Australia’s rising income on each of the following in the short-run.

(i) Aggregate demand in New Zealand. Explain.

(ii) Output in New Zealand

Mr. Welker: Here is where the first common mistake was made. The question asks for an AD/AS showing New Zealand’s economy, NOT Australia’s. As incomes in Australia rise, Aussies will demand more imports from NZ, meaning NZ’s net exports will rise, shifting NZ’s AD curve outward, increasing NZ’s output.

(b) Using a correctly labeled graph of the money market for New Zealand, show the effect of the output change in part (a)(ii) on the following.

(i) Demand for money. Explain

(ii) The nominal interest rate

Mr. Welker: This is the question that almost everyone screwed up on. The most common mistake was confusing NZ’s money market with the foreign exchange market for NZ’s currency. The money market, which the question is asking for, refers to the the money in circulation in New Zealand, the supply of which is determined by NZ’s central bank, the demand for which is determined by the amount of output in NZ and the public’s desire to hold money as an asset. As output increases in NZ due to higher net exports, demand for money will shift out, and if you recall the Y-axis in a money market shows the nominal interest rate, so nominal interest rates will increase as money demand shifts out.

The mistake most people made was misinterpreting the question to be asking about the foreign exchange market for NZ dollars. This market would show the price of NZ dollars in terms of Australian dollars on the Y-axes, the demand for NZ$ by Australians, and the supply of dollars by New Zealanders. This is not what the question is asking for, however, many of you included this diagram, which does not show the nominal interest rate.

(c) Assume that the price level in New Zealand rises. Given your answer to part (b)(ii), explain what will happen to real interest rates.

Mr. Welker: Here’s another question that most people messed up on. The answer is that as nominal interest rates rise while the price level is rising, we don’t know what will happen to real interest rates! Remember, real interest rate = nominal interest rate - inflation rate. Whether real interest rates rise or fall depends on the degree to which nominal interest rates and inflation rise. Therefore, the real interest rate cannot be determined.

(d) Although recovering, Australia remains in recession and its government takes no action. Indicate whether each of the following curves will shift to the left, shift to the right, or remain unchanged in the long run in Australia.

(i) Aggregate supply

(ii) Aggregate demand

Mr. Welker: I was truly shocked to see how many people got this one totally wrong. In fact, I suspect about half of you just guessed on this one, which was a surprise to me because this was something we had emphasized heavily in our class discussions; in fact you had even seen a very similar question in an FRQ a couple of units ago.

The key to knowing what this question is getting at is the phrase “its government takes no action.” This must, therefore, be referring to a “self-correction” scenario, which is based on the neo-classical theory of a vertical long-run aggregate supply curve, made possible by the downward flexibility of wages and prices.

If Australia remains in a recession, high levels of unemployment and low levels of overall spending will put downward pressure on wages and prices. As price levels fall and large number of workers are unemployed, people will begin accepting lower wages, which means input costs for firms will decrease, inducing firms to hire more workers, shifting short-run aggregate supply and output back towards the full-employment level. Since the question makes no mention of any new spending (implied by the “government takes no action” statement, meaning no fiscal or monetary stimulus is employed), there is no impact on aggregate demand.

The question simply says “indicate”, therefore the correct answers are:

(i) Aggregate supply will shift right

(ii) Aggregate demand will remain unchanged

The mistakes made on this FRQ are fairly common and simple mistakes. But this final macro test should serve as a wakeup call to some of you who may have coasted through the last few units. Macroeconomics is the harder of the two AP subjects. Last year’s classes averages .42 points lower on the macro AP exam than the micro, despite having completed Macro more recently.

Over the next 12 days, AP Econ students all over the world need to focus on their review and studies for the AP exams. To help you, I’ve put all of our review materials onto one page here on the blog. Click on the tab at the top of this page that says “Exam Prep”, and there you will find downloadable .pdf study guides for every unit in the course, as well as links to each unit’s wiki over at Welker’s Wikinomics Page. New on the wiki is a “graph bank” containing all of the graphs we’ve learned this year. As part of your exam review, please add titles and descriptions to these graphs by May 8.

Forbes.com to Launch Business and Finance Blog Network - Forbes.com

A few weeks ago I received an invitation to join the Forbes.com Business and Finance Blog Network. The network is set to launch this month:

Today Forbes.com, home page for the world’s business leaders, announced the creation of a Business and Finance Blog Network, comprised of a community of pre-screened, influential business and financial blogs.

The Blog Network’s content will focus on senior business decision makers and high-net-worth investors. Topics will be relevant to the banking, trading, hedge fund management, affluent investing, and senior business decision-making communities. Participation in the network is by invitation only, and all blogs are vetted by Forbes.com editors for appropriate content, and to ensure that they are in keeping with the Forbes editorial brand.

I guess the folks at Forbes.com figured that even billionaire investors needed to be educated in the basic Economic concepts! So now Welker’s Wikinomics will cater to the following audiences:

• 17-18 year old IB and AP Economics students
• Teachers of IB and AP Economics
• University students in Principles of Economics courses
• Hedge fund managers
• Billionaire investors
• Warren Buffet

I’m honored to be a part of this network; and don’t worry, the blog will continue to focus on communicating Economics news in a way accessible and educationally appropriate for students in a principles of Economics course. After all, that is my comparative advantage!

Carmen submitted the following through the “Econ Help Desk“

Please help me with a student question. If the FED pursues expansionary monetary policy, lowering the nominal interest rate in hopes of spurring investment and increasing aggregate demand, how does this connect to the loanable funds market? If nominal interest rates are down, won’t real ones go down too, causing people to save less? In this case, where will the supply of loanable funds to meet investment demand come from?

Below is my reply to Carmen:

Good question… here’s my understanding, so take it as you will…

To expand the money supply the Fed will buy bonds on the open market. This increases demand for bonds, raises their prices, lowering the effective interest rate on bonds, making these securities less attractive to investors, who will sell them back to the Fed in exchange for liquid money that is now part of the money supply.

Investors will put some of their new money into banks, where interest rates are now relatively more attractive than the declining rates on government bonds. Some of the new money created by the Fed’s purchase of bonds therefore ends up in the loanable funds market, shifting the supply of loanable funds out, lowering real interest rates, increasing the quantity demanded of funds for investment and consumption, hence the expansionary impact on Aggregate Demand.

If any readers has another take on the transition from expansionary monetary policy to a decline in the real interest rate in the LF market, please leave your ideas in a comment below.

~Jason Welker

Throughout the year I’ve been developing SMARTBoard lessons for every topic in the AP Economics class. These lessons have now all been turned into .pdf files available for download in the “AP/IB Exam Prep” page of this blog. Check it out for links study guides for the nine units we’ve covered this year, as well as links to the wiki pages where the students have created their own, collaborative resource for AP exam preparation.

If you download and use the .pdf files, all I ask is that you leave a comment on the page telling me where you are, what school you go to or work for, and how you plan to use the study guides as part of your review!

Thanks, and good luck in preparing for the upcoming exams!

Micro and Macro Graphs - Welker’s Wikinomics Page

Throughout the year, I’ve been saving the graphs we’ve learned in class on the Smartboard. Just yesterday Wetpaint, our wiki provider, added a new feature allowing users to create albums of uploaded images. I have created two albums (Micro and Macro), found through the link above, containing all of the graphs we learned this year.

Here’s the catch: the graphs contain no titles or detailed descriptions. That’s where YOU come in. Follow the link above, enter an album, and add any information you know about the graphs or images there. Of course, you as an individual don’t have to do more than one or two, but YOU as a group of AP Econ students need to complete all 60 or so descriptions before May 8.

Use your notes, the wiki pages, and text book to recall the important information for each of the graphs. By May 8, one week before your AP Exams, we should have one place to go to review all of the graphs you learned this year, full color images, titles and descriptions included!

I just noticed this on my blog dashboard:

Blog Stats: There are currently 241 posts and 2,000 comments, contained within 133 categories and 0 tags.

Wow, awesome! 2,000 comments, quite the milestone! This blog has grown into quite the resource for econ students here at SAS and in other places too! Keep up the great discussions guys! Hopefully all your fantastic contributions will pay off on the exam here in just one month!

“Dan” submits the following questions to the AP/IB Economics Help Desk:

Hello Jason, I’m a first year Macro AP Econ Teacher, but a long time social studies and JA Economics Teacher. My Questions:

1. I’m confused about Crowding Out. I thought it meant that when the government ran a budget deficit. It causes the government to compete for loanable money so that they can finance the deficit. Thus competing for loanable funds in the “money market”? Causing interest rates to rise because of increased demand. Moving private investment money to government bonds etc, because of the higher interest? Am I way off?

My reply: There are actually two markets for money. In the one the AP refers to as the “money market”, supply of money is perfectly inelastic, in other words it does not change with the interest rate, rather the interest rate is determined by the supply curve’s movements in or out. Supply in the “money market” is determined by the central bank which manipulates the amount of money in circulation through open market operations, changing the discount rate and the reserve ratio. Demand in the money market is the sum of the public’s demand for money as an asset and for transactions. Primarily, as national income grows, money demand grows. We say that the “money market” shows the nominal interest rate, since it’s determined by the Fed’s monetary policies.

The other market for money is the “loanable funds market”. This market refers to the money that banks and other lending institutions make available to households, firms and the government to borrow. When the government deficit spends, it does so by issuing new debt securities. Increasing the supply of government bonds lowers their price making them attractive to investors, who take their money out of banks to buy bonds. Both the money supply and the supply of loanable funds shift leftward, driving up nominal and real interest rates (of course, that depends on the rate of inflation). Another way to think of this is the demand for loanable funds shifts out as the government deficit spends; either way (leftward shift of supply or rightward shift of demand), the real interest rate will increase.

Crowding-out occurs because of the inverse relationship between real interest rate and the demand for investment funds. Private investors face higher real interest rates when the government finances its spending by selling bonds to the public (in other words, borrowing from the public).
To see the graphs for the money market and the loanable funds market, read my recent blog post, “Loanable Funds vs. the Money Market: what’s the difference?”

Dan: Other questions, when does “saving” become “investment”

Example: If I buy McDonalds stock in the primary market is that “saving” in the sense that McDonalds uses my money to then “invest” in expanding their market share with New Restaurants in market’s around the world. Or is my purchase of the stock investment? Am I right that individuals contribute to the Saving Supply by putting deposits in banks which then becomes loanable money?

My reply: The purchase of stocks is not considered an investment, because it does not get included in the nation’s GDP. Stock purchases are purely financial transactions; you’re making capital available to the firm for investment. I’m not exactly sure what the buying of stocks would be called from an accounting standpoint, but it is a “non-production transaction”, so does not contribute to national income.

You’re correct that when you increase your savings in financial institutions, you are contributing to the supply of loanable funds. In fact, anything that increases national savings rates will shift the supply of loanable funds outward, lowering the real interest rate and encouraging new investment. So in that regard, savings leads to investment, yes.

Dan: One more about money creation. If I put 1,000 dollars in the bank and reserve ratio is 25%. Is with no drainage, can you say that 4,000 dollars are “created” and does the 4,000 include the original 1,000? Thus really only 3,000 is created?

My reply: I teach my students that the initial deposit of $1,000 does not count as “new money” since it was already part of the money supply. Therefore, a bank that prefers to loan out all its excess reserves would keep $250 of your $1,000 on reserve, loan out $750, and by determining the money multiplier (1/RR, or 4 in this case), we can determine how much new money is created from your initial deposit. Multiply the new excess reserves by the multiplier, and you’ll see that $750 x 4 = $3000 of new money created after an initial change in checkable deposits of $1000.

Now, if the new money had come not from YOU or ME, but from the FED (from the purchase of bonds from the bank), then the $1000 WOULD be counted as new money, since it was not in the money supply while held by the Fed. In that case, new money creation would be $1000 x 4 = $4000. But money already in circulation is deposited, only the new excess reserves count towards new money creation.

Great questions, Dan. I hope my answers are helpful… by no means do I claim that they’re necessarily right, they’re just my interpretation and what I’m teaching my students here at SAS!

Judging by today’s headlines, things aren’t looking too hot for the US economy:

• Job losses, unemployment both worse than forecast - Apr. 4, 2008
• Dollar slips against euro, yen on jobs - Apr. 4, 2008
• BBC NEWS | Business | Oil price edges up on Opec stance
• FT.com / Asia-Pacific / China - US economy is ‘down sharply’, Paulson says
• Bernanke Nods at Possibility of a Recession - New York Times

From the last article:

In his bleakest economic assessment to date, the Federal Reserve chairman, Ben S. Bernanke, said Wednesday that the American economy could contract in the first half of 2008, meeting the technical definition of a recession, and he encouraged Congress to help homeowners caught up in the mortgage crisis.

For the first time during his three years in the job, Bernanke has admitted we could be in a recession, defined as two consecutive quarters of negative GDP growth. By June, we could very well have experienced just such a decline in output; every central banker’s nightmare!

The source of America’s economic woes? Weak housing market. In fact, house prices have fallen around 10% nationwide over the last 12 months. To understand why, we need to recall the basic microeconomic principles of supply and demand. Quite simply, too many homes were built over the last decade, as low interest rates and optimism about the continued strenght of the housing market (rooted, of course, in the irrational exuberance about the economy as a whole) led builders to expand the suburban sprawl like never before, anticipating growing demand forever into the future. Problem was, demand couldn’t keep up with supply, and now the price is starting to reflect this basic economic principle.

To make things more complicated, many home buyers over the last seven years should never have been given loans based on their credit histories and household incomes. Many of these buyers were thus given “sup-prime” loans, many with adjustable interest rates, which means that today people who were too poor to get a normal loan four years ago are seeing their monthly payments increase just as the economy is slowing down. Rising unemployment puts downward pressure on wages, and inflation (caused by rising energy and commodity prices) forces poor homeowners to allocate more of their wages towards food and electricity, making it doubly hard to make their monthly mortgage payments.

The outcome is predictable: foreclosures. Banks that made loans to uncreditworthy buyers are now taking the houses back and putting them on the market for really low prices, putting even more downward pressure on all home prices. Since their homes make up the majority of Americans’ wealth, and since wealth and disposable income are the main determinants of consumption, inflation and falling home prices both lead to huge decreases in consumption.

The cycle continues: declines in household consupmtion signals to firms that it’s a bad time to invest, so investment spending declines. As consumption and investment fall, aggregate demand shifts in, causing output and employment to fall, hence our current recession.

“It now appears likely that real gross domestic product, or G.D.P., will not grow much, if at all, over the first half of 2008 and could even contract slightly,” he said. “We expect economic activity to strengthen in the second half of the year, in part as the result of stimulative monetary and fiscal policies.”

For now, however, judging by today’s headlines, conditions will continue to worsen for the American worker, homeowner, consumer and firm.

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FT.com / Asia-Pacific / China - Weak dollar troubles Beijing

Inflation, with its erosive effects on wealth and income, has plagued China at increasing rates since mid-2007. In February it reached an annualized rate of 8.7%, threatening to undermine China’s GDP growth rate, which has been predicted in the 8% range for this year.

As we have discussed in our our AP Econ class here in Shanghai, China’s inflation is caused by a combination of demand and supply-side factors. On the demand-side, a growing middle class has driven consumer spending to record levels recently, surpassing investment as the largest component of China’s GDP in 2007. Of course, as always, high inflation (thus low real interest rates), optimism about rising consumption in the future, and a comparative advantage in labor-intensive manufacturing (albeit a diminishing one as wages continue to rise) all combine to keep investment extremely high. Furthermore, cheap exports have helped keep demand for China’s output from abroad strong. The combination of increasing consumption, strong investment, and its trade surplus have resulted in demand-pull inflation.

On the supply-side, China has encountered additional inflationary pressures of late. Rising energy prices (mostly due to coal and oil shortages) combined with record rises in food prices (24% increase in the last year), have driven costs to firms up, shifting the aggregate supply curve leftward, further fueling inflation.

Knowing the damaging effects inflation has on income and wealth, it might be assumed that Beijing would place the utmost emphasis on taming the country’s rising prices. This, however,is not at the top of the government’s macroeconomic goals, according to premier Wen Jiabao:

On the issue of whether he would sacrifice economic output to bring down inflation, at the risk of increasing unemployment, Mr Wen indicated that growth re­mained the overarching priority. “We must ensure that our economy will grow…in order to ensure employment,” he said. “China is a developing country with 1.3bn people. We have to maintain a certain degree of fast economic growth to provide enough jobs.

”He said China needed to add about 10m jobs a year for the next five years, a lower figure than in the past when the aim was growth of 15m-20m jobs a year.

The tradeoff between inflation and unemployment to which Mr. Wen refers is a text book example of the challenges faced by macroeconomic policymakers everywhere. This trade-off is illustrated in the Phillips Curve model, which shows that in the short-run, there exists an inverse relationship between the price level and the unemployment rate.

In his words above, Mr. Wen demonstrates Beijing’s preference in the trade-off between inflation and unemployment: He’ll take inflation… Here’s why.

In case you haven’t heard, China is not a democracy. Nor is it a, ehem, “free” country. According to Alan Greenspan in his book “The Age of Turbulence”, democracy and freedom of speech act as “safety valves” in Western countries; in other words, in times of economic or political unrest, the right to gather in the streets, the right to vent frustrations through a free press and the opportunity to advocate political and economic change through the various media, all combine to prevent violent and revolutionary uprisings when times get tough economically.

Take the US for example. Times are certainly tough right now. Inflation’s approaching 4-5%, while nominal growth has nearly stagnated. Unemployment, while it has technically fallen recently, in reality has risen as hundreds of thousands of workers have given up searching for work. The bursting of the housing bubble represents one of the most massive losses of wealth in recent history. A weak dollar has meant that even cheap imports don’t seem so cheap anymore. Throw in the desperate war in Iraq, the nuclear threat from Iran, rising food prices, $110 oil and an incredibly unpopular national leader, and by some measures the country would appear ripe for revolution. However, a revolution is about the least likely thing to occur in America, because it enjoys the “safety valve” of democracy. Rather than overthrowing their government, Americans have the right to go to the pole and vote for a new one, which in all likelihood will occur this November when it seems either Barrack or Hillary stand the greatest chance and winning the White House.

Now let’s look at China. The picture’s not quite so gloomy for the Chinese right now. Yes, inflation is high, as in the US. But unlike America, China is still growing at a very healthy pace, unemployment is probably still below its natural level, the real estate markets in China’s cities are still booming, meaning the middle class residents there are experiencing leaps and bounds in terms of personal wealth. Demand for its exports remains strong, and ever more poor Chinese are finding jobs in high paying factories across the country. Investments in capital, infrastructure and education point towards a bright future of continued growth for the foreseeable future.

But wait, 8.4% is something to worry about, especially when we take into account the 24% increase in food prices. Shouldn’t Wen and Beijing be taking drastic steps to reign in this high rate of inflation? In short, NO, they shouldn’t. Because as can be seen in the Phillips Curve, to reduce inflation could result in another, far more serious problem for Beijing; rising unemployment.

It appears that Beijing’s greatest fear is a population out of work. Its goal of creating 10 million new jobs is ambitious, but in the eye’s of the government, necessary. The Chinese people do not enjoy the “safety valve” of democracy through which economic frustrations and hardships can be channeled were the country to experience a slowdown in growth and an increase in unemployment. The last time the economy faced high inflation AND high unemployment, students, workers, soldiers and tanks all gathered for an afternoon of urban warfare under Mao’s somber gaze in Beijing. To avoid such massive revolutionary movements in the future, Beijing must do all it can to insure job creation continues and growth remains strong, even if the trade-off is record high inflation.

This one passage spoken by Wen Jiabao, China’s premier, tells a vivid story about the reality of Communist dictatorship in China. Sound economic policy may go on the back burner in times of political uncertainty. Price controls, such as those on petrol in Shanghai (speaking of, the long lines at gas stations are back!), were a microeconomic example of bad economics; Beijings hesitance to seriously tackle inflation is a macroeconomic example. Holding on to power seems to be more important than stabilizing prices, at least for now.

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