US balance of payments deficit hits another record – WSWS.org – 16 March 2006

As I was looking for news stories about the balance of payments, which we started studying in AP Economics today, I stumbled upon a story from over two years ago, published on the World Socialist Website, of all places. The reason I am blogging about it today, 25 months later, is that it contains some ominously prophetic messages about what the future (now the past) could hold for the US based on the economic data at the time. Read below to see what I mean:

The extent of the imbalances in the global economy and the fact that normal growth patterns will not correct them has been underlined by the latest US balance of payments deficit. The current account deficit reached $225 billion in the fourth quarter of 2005, up from $185.4 billion in the third. For the year 2005 the deficit was $805 billion, equivalent to 6.4 percent of gross domestic product.The latest figures show that rather than being closed, the payments gap is widening. This was the seventh year out of the last eight in which the deficit hit a new record.

“The bottom line is that a current account deficit of this unparalleled magnitude is unsustainable and there is no hope of it being painlessly resolved through higher exports alone,” Paul Ashworth, an analyst at Capital Economic told the Financial Times.

Total US exports would need to increase by 70 percent to eliminate the payments gap. “This is clearly not going to happen,” Ashworth continued. “Instead it will require a big dollar depreciation alongside much weaker domestic demand for imports.”

In other words,

 

the only way the deficit would start to fall is through a major recession in the US.“a big dollar depreciation” would almost certainly lead to a sharp interest rate rise, as international banks and financial institutions demanded bigger compensation for placing their funds in dollar assets. And a significant interest rate rise would bring a downturn in the economy.On the other hand, On the one hand,

 

“weaker domestic demand for imports” could be achieved only by a severe contraction of the US economy.This is because the very structure of the US economy, in which imports of goods and services are some 59 percent higher than exports, means that normal economic growth automatically increases the deficit.

 

So far almost everything the article has mentioned has actually happened, except for the increase in US interest rates. In fact, the Fed has lowered interest rates as the economy has approached recession, indicating that it considers a slowdown in growth a bigger threat than a weaker dollar and the accompanying inflation. In fact, expansionary monetary policy in the US (i.e. lower interest rates) has accelerated the dollar’s decline as foreign investors have pulled their money out of the US assets as interest rates in Europe and other markets have become more attractive.The article doesn’t hold out much hope for rising exports helping the US out of the predicted recession:

The only way the US could export its way out of the crisis would be if economic growth in the rest of the world proceeded at a significantly higher rate than the American economy. But here a vicious circle is in operation because economic growth in the rest of the world is itself highly dependent on an expanding US market. This is especially the case in Asia where economic growth is increasingly being fuelled by exports to China where goods are manufactured for the American market.

Today in class we introduced the determinants of exchange rates. One way Americans have been able to import so much more from China and other countries (remember, the US has trade deficits with 13 of its 15 largest trading partners!!) has been through foreign purchase of financial and real assets in the US, including government bonds:

In fact, the US is becoming increasingly dependent on foreign sources to support its current account and budget deficits. Foreign lenders have been financing 80 percent of the increase in the federal budget deficit, and foreign holdings of treasury securities increased by $108 billion in the last quarter of 2005.As Stephen Roach noted, with a foreign capital inflow of $3 billion every business day—up from $2 billion in 2003—the external dependency of the US “is simply without precedent in the annals of globalization and international finance”.

 

I found it interesting that most of what this article predicted would happen has already transpired, or is in the process of transpiring as we speak. The dollar has depreciated by 18% to the RMB, and even more to other major currencies, the US has entered a recession, raising questions as to the degree to which the economies of Europe and Asia have “de-coupled” from the US economy.Whether the US recession will lead to a significant slowdown in growth among its trading partners has yet to be seen. Uncertainty in global financial market has resulted in an international credit-crunch, meaning lenders have been less willing to extend loans to borrowers, leading to a decline investment and consumption everywhere; but with growth rates still predicted at 8-10% in China, and not too far behind elsewhere in the developing world, it seems plausible that a continued decline of the dollar combined with healthy growth and rising incomes abroad will shift America’s balance of payments away from worsening deficits in 2008.

Discussion Questions:

1. Define “US balance of payments deficit“. What accounts make up a country’s balance of payments?
2. In what ways would “a big dollar depreciation alongside much weaker domestic demand for imports” help achieve more balanced trade between the US and its trading partners?
3. Explain the statement: “weaker domestic demand for imports could be achieved only by a severe contraction of the US economy“
4. Which of the determinants of exchange rates that we learned in class (remember “SIPIT”) is referred to in the following claim: “The only way the US could export its way
   out of the crisis would be if economic growth in the rest of the world
   proceeded at a significantly higher rate than the American economy“.

This past weekend, the Obama administration officially put an end to US combat in Iraq. Seven years after the invasion, both politicians and economists are looking back and asking themselves, was the invasion into Iraq and the ensuing occupation of coalition forces actually worth it. Or in economic terms, was the benefit of the war greater than the costs of fighting it.

What have been the benefits of the US being in Iraq? Have their indeed been any and if so how can we measure them? There are some clear explicit benefits that can be measured such as companies that have profited from the war as well as evidence of increased investment in the middle east due to the presence of the coalition forces. But there are also benefits that are hard to measure such as the creation of democracy, freedom or the removal of a ruthless dictator. On the cost side there are explicit costs for the war in Iraq such as the total amount currently spent by the US Government which is around 748 billion USD. Like the benefits there are also costs that are hard to place a number on such as  the human cost with an estimate of over 100,000 total deaths, close to 4400 of which were Americans. For a more detailed look at these costs you can view the American Progress web site.

But as you know, economists do not only look at the explicit or obvious costs. In order to get a better understanding of the true costs of a decision, economists must look at the “could have beens” or the opportunity costs. In their recent article “The true cost of the Iraq war: $3 trillion and beyond” Nobel Economics recipient Joseph Stiglitz and Harvard Professor Linda Bilmes do just this. They calculate the costs of the war not only based on the explicit costs, but on the hidden ones. Several years ago, the authors estimated that the costs of the war in Iraq would eventually reach 3 trillion USD. This week, they claim that they may have underestimated the amount. The article states ,

Moreover, two years on, it has become clear to us that our estimate did not capture what may have been the conflict’s most sobering expenses: those in the category of “might have beens,” or what economists call opportunity costs. For instance, many have wondered aloud whether, absent the Iraq invasion, we would still be stuck in Afghanistan. And this is not the only “what if” worth contemplating. We might also ask: If not for the war in Iraq, would oil prices have risen so rapidly? Would the federal debt be so high? Would the economic crisis have been so severe? The answer to all four of these questions is probably no. The central lesson of economics is that resources — including both money and attention — are scarce. What was devoted to one theater, Iraq, was not available elsewhere.

Economists believe that if we can get a sense of what the “true costs” of a decision are, then we can make a more rational choice when faced with a decision.  Read the following two articles, the one quoted above by Joseph Stiglitz and the other entitled Iraq: Weighing the Costs and Benefits by Tim Kane and answer the following questions:

Questions

1. Why is it important to look at the hidden costs when making a decision?
2. In your opinion, what would be some of the opportunity costs associated with not invading Iraq? What are some that are associated with invading Iraq?
3. In your opinion, is it possible to properly do a cost benefit analysis of a war? Are there some things that we cannot put a price on? Is it possible to use opportunity costs as “true costs” when they are essentially “could have beens”?

As the Singapore economy rebounded spectacularly this week ,the government moved to limit inflationary pressures. This was after year-on-year economic growth reached 13.1% in the first quarter of 2010.  This strong performance was related to the increased demand for electronic components and growth in the pharmaceutical industry.

The Singapore government operates a managed exchange rate regime. The Singapore dollar is pegged to a trade-weighted index of five currencies. The exact make-up of the index is kept secret, but the rate is allowed to fluctuate within a four percent target range. This ambiguity leads to less speculation by currency traders, and what is known as a basket, band and crawl method of currency management. Overtime, this has allowed the government to steadily appreciate the currency as demand for exports surged. Since 1980’s the value of the Singapore dollar versus the US Dollar has appreciated by nearly 80%.

This exchange rate mechanism is also how the government controls the rate of inflation in the small city-state. Because Singapore’s net exports make up over 100% of GDP, a subtle appreciation of the exchange rate leads to less imported inflation and less demand for exports. The effect of a 1.3% appreciation of the currency band this week, is expected to reduce inflationary pressure over the next 12 months.

The approach is something that the Chinese government is maybe looking towards. The Yuan is pegged directly to the US Dollar and has been since mid-2007. China has been able to maintain this peg by selling vast amounts of yuan to purchase US Treasury Bonds, and to thereby create large foreign currency reserves. As widely reported, the Chinese government has been under pressure to appreciate the yuan by anything up to 60% compared to the US dollar. How the government achieves this shift is complicated but may lead to a significant loss of export competitiveness and imported inflation.

However as Wei Gu from Reuters reports,

“This (Singapore) approach is not open to China, whose inflationary pressures are home-grown, and whose exchange rate looks more undervalued. Nevertheless, Beijing can learn from Singapore’s model, which offers a better balance between stability and flexibility”

Of course, there are huge differences between a city-state and the world’s third-largest economy. Singapore, whose foreign trade is three times its GDP, has to allow enough freedom in its exchange rate to achieve domestic price stability. China, where foreign trade accounts for 50 percent of GDP, that incentive is much smaller.

Moreover, China could not adopt Singapore’s approach without a one-time appreciation in its currency. Otherwise it would be hard to create a two-way trade: China currently restricts the yuan’s movement against the dollar to just 0.5 percent every day. Nevertheless, as China considers making its exchange rate more flexible without abandoning stability, the Singaporean model is worth studying.”

Discussion Questions:

1. What are the advantages and disadvantages of a floating exchange rate?
2. What are the advantages and disadvantages of a fixed exchange rate?
3. What is the common tool used by many governments to control inflation. Why can’t all countries use the Singapore approach?
4. Can a country use both Monetary Policy and a managed exchange rate to control inflation? Do trade-offs exist?
5. Evaluate the effects on the Chinese economy of an appreciation of the yuan.

Welker’s Wikinomics Blog was created three years ago as a way to communicate economic ideas and theories in a clear and intelligible way for the high school economics student. Over those three years over 500 posts have been published, nearly 10 Economics teacher have contributed as authors and over 250,000 readers have visited (now up to over 600 per day).  But where did the name Welker’s Wikinomics come from, anyway?

When my adventure in Web 2.0 teaching began over three years ago, there was no blog. At first Welker’s Wikinomics was, not surprisingly, a wiki for my AP and IB Economics students in Shanghai to use as a study tool. But then came the blog, and for lack of a better name, it took on the same name as the wiki. Today the Welker’s Wikinomics name is actually shared by not only the wiki and this blog, but also by the Economics Universe, where econ students and teachers can find RSS feeds from hundreds of resources for learning economics, as well as the free lecture notes I publish here and which have been downloaded thousands of times by Econ students around the world.

Last year I began thinking about changing the name of this blog, as I was never quite satisfied having my blog called “Wikinomics”, since so many visitors to my site have always been confused about the difference between the wiki and the blog. So today I am happy to announce a new name for this blog, Economics in Plain English.

I thought of the new name while writing a blog post recently for which I spent a frustrating hour reading an article from the Economist. While struggling through the difficult article I guessed that most people without at least two years of college economics would have had a hard time understanding what the author was trying to say with all his economics jargon. Why, I thought, aren’t more journalists and academics writing about economics in a way that anyone interested in the subject, whether he be a high school student or a retired grandfather, can understand. Why don’t more people write about economics in plain english!?

Well, that’s precisely what I’ve been trying to do here for three years. So I decided it was the right name for this blog.

From now on this blog can be accessed by going to the URL: http://www.economicsinplainenglish.com. The original domain will remain intact, however, since over 500 articles on this blog are still used by myself and other Econ teachers and their hyperlinks must remain active. Welker’s Wikinomics is not disappearing, as my homepage will still be located at http://www.welkerswikinomics.com. Only the blog is getting a new name. The wiki, the universe, and the lecture notes will continue to be part of the Welker’s Wikinomics suite of resources available for econ teachers and students.

As always, if you’re an economics teacher who enjoys what you read here and think you may have something to add, please drop me an email at welkerswikinomics@yahoo.com to receive an author account on this blog. Become a regular contributor and I’ll add your face and bio to the “About the Authors” sidebar! How can you pass that up?

A big thanks to everyone who has visited this blog, read our posts and left a comment over the last few years!

Op-Ed Contributor – Buy American. I Am. – NYTimes.com

So Wall Street has recently experienced its worst shocks since the great depression. Every day the Dow Jones is like a roller coaster, DOWN 800 points, then  UP 500 points, then DOWN 200 followed by another rally of 600! In just three weeks the Dow has gone from 11,500 to below 900 points. Surely, the wise thing to do is get OUT of the stock market, right? WRONG! At least, so says the richest man in the world, Warren Buffet, someone who should know a thing or two about smart investing.

Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.”

I don’t like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: “Put your mouth where your money was.” Today my money and my mouth both say equities.

Discussion Questions:

1. Why does holding cash seem like the smart thing to do during periods of volatile stock prices like the last month or so? Why does Mr. Buffet think that holding cash is NOT so smart?
2. Mr. Buffet’s advice is counter-intuitive to some. Buying more of something that is falling in value (American stocks) may appear unwise… but what is Buffet’s rationale for why buying now may in fact be the smartest thing for an investor to do?
3. Does the behavior of investors on the stock market reflect the behavior of consumers in a typical product market? In other words, do the laws of supply and demand apply to the stock market? Discuss…

Economists see financial bailout as necessary – Yahoo! News

Economists in the US are calling this week’s bailout of numerous US companies a necessary step in ensuring that no permanent harm is caused to the financial system and that we do not head into a deep recession.

The Treasury Department under the leadership of Henry Paulson is currently asking congress to move quickly on a bill that would provide $700 billion to the Department to buy up much of the bad debt that many financial institutions have incurred over the past years. Where’s this money going to come from? Since it doesnt look like the Bush Administration will be pushing for increased taxes anythime soon, Congress will have to borrow the money. 

Though most economists are agreeing that this is a necessary step in ensuring the integrity of the economy, I believe that it is important to look at how this additional debt may effect our government and economy in the future. So lets start with some numbers. The following statisitics are taken from the above article.

The deficit for this budget year, which ends on Sept. 30, is expected to rise to $407 billion, a figure that is more than double the $161.5 billion imbalance for 2007, reflecting what the economic slowdown and this year’s $168 billion economic stimulus program are already doing to the government’s books.

The Bush administration is estimating that the deficit for the budget year that begins Oct. 1, which will cover the new president’s first year in office, will hit $482 billion, a record in dollar terms.

And that forecast doesn’t include the $200 billion the administration committed to spending two weeks ago when it took over the nation’s two biggest mortgage companies, Fannie Mae and Freddie Mac.

And it doesn’t have any of the $700 billion the administration is seeking to soak up the bad mortgage-backed securities that have been at the heart of the severe credit crisis the country has been struggling with since August 2007.

The legislation the administration is now seeking to authorize the financial system bailout, according to a draft obtained by The Associated Press, would boost that debt limit to $11.3 trillion, up another $700 billion.

It is the rapidly rising debt that is cause for concern. The government is already spending more than $400 billion a year just to pay interest on the national debt. The higher that debt goes, the higher the government’s borrowing costs and the less it has to spend on other programs.

Discussion Questions:

1. What impact does the knoweldge that the government will bailout struggling financial firms have on investors willingness to take risks?
2. Should the government intervene in these finacial markets or leave the “invisble hand” to its own devices?
3. What are the opportunity costs associated with this decision?
4. What are some short term and long term implications of this bailout?

Now is that time of year when thousands of students across the world, from Zurich to Zimbabwe, will be taking their first economics course. Perhaps it will be a basic, high school introductory course or perhaps an even more challenging AP or IB course. Perhaps you are taking an introductory college course.

It seems like all economic text book authors seem make the point, usually in their chapter 1, that a primary benefit of studying economics is that it transforms us into more effective citizens by enabling us to better understand and conclude on the economic positions and promises of those running for public office.

I couldn’t agree any stronger!

In my classroom, I like to informally call the study of economics “the 180 degree science” because as the student studies this science for the very first time they often develop opinions and conclusions that are precisely the opposite of what they had originally believed before taking the course.

For example, here are 3 of my favorite “180 degree moments”, which are applicable to the United States’ economy but are generally applicable to all global economies, that you will probably learn in your first year economics’ course:

Ø Pre-Econ Course Citizen Quote: “We don’t make anything anymore in America. America’s manufacturing prowess is in a state of constant decline.”

Ø AP Student’s Response: “I disagree. The dollar value of manufactured goods in the United States, restated for price level changes so the comparison is accurate, is up over 50% in the last 12 years! Yes, it is true that the U.S. has lost several million jobs in manufacturing over that same time period, but that is primarily due to rising productivity (think machines & technology), where the U.S. can now produce more valuable manufactured products than ever before with many less people freeing those workers to be employed in more lucrative service-related businesses. Moreover, the US has maintained its share of global manufacturing product over that same aforementioned time period, whereas other manufacturing countries, such as Japan and Germany, have actually decreased their percentage share of global manufactured product. But, I think I understand where you may have gotten that mistaken notion that manufacturing in the U.S. is in decline; from the U.S.’s shrinking automobile industry, the lower employment in manufacturing due to higher productivity, and from the negativity inherent in the media and press which focuses mostly on the lost jobs.

Ø Pre-Econ Course Citizen Quote: “The U.S. government’s national debt of $9.6T is out of control. Imagine our country having to borrow $9.6T to pay its debts because it has no fiscal control!”

Ø AP Student’s Response: “The United States’ current level of national debt is both affordable and consistent with most nations. National accounting statistics show that the U.S.’s 67% national debt/national income percentage is average compared with other modern economies. Moreover, the level of U.S. national debt as a percentage of national income (67%) is at the same ratio as it was back in 1997 and 1992, and is much less than it was in 1950! The ‘”trick” is that debt must be benchmarked to income. It interesting that if someone knows that Bill Gates owes someone $10M they quickly can figure out that he’s probably fine, but if the guy at Starbucks finds out that the U.S. owes $9.6T they think the country is fiscally out of control!”

Ø Pre-Econ Course Citizen Quote: “International trade is hurting our economy as we have lost millions of jobs to lower wage countries. NAFTA (North American Free Trade Agreement between U.S., Mexico, and Canada) has really hurt us by having million of American jobs being lost to Mexico.”

Ø AP Student’s Response: “I challenge you to find me a reputable economist who will tell you that NAFTA, or any other free trade agreement for that matter, has not been beneficial for the United States, Mexico, and Canada. Over the past 15 years, independent and numerous studies show that free trade agreements increase employment, incomes, and standards of living in ALL countries and NAFTA is no exception to this rule. Sure, free trade does cause certain industries to lose out to better competitors but, overall, international trade increases competition with the nation’s citizens benefitting through increased product quality, lower product prices, and increased incomes and standards of living.

I really hope you work hard in your economic course so that, you too, will see your nation’s economy, and our global economy, in a whole new light. As an AP Economics’ teacher in the U.S., I see it as an especially “sweet year” for a first time economics’ student due to a presidential election.

Let the YouTube video-analysis clips of Barack Obama and John McCain begin! Our “economic analysis” hats are on… and we are ready to apply what we have learned and conclude on their economic positions.

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.

• Republicans: War on Economics
  Here’s an accurate and entertaining critique of the McCain/Clinton gas tax holiday
  (tags: ta)
• Capital Flow Chart « AP Economics
  A nice table from Econ teacher David Prudente illustrating the impact of changing interest rates on capital flows and exchange rates.
  (tags: interest rates, exchange economics,)

Recession may be bad for your income, employment and level of consumption, but it might be just what you need to get yourself into better shape! Turns out when times are tough economically, Americans are at their healthiest. Listen to this short conversation:

From APM's "Marketplace" [ 3:25 ] Play Now | Play in Popup | Download (1)

What do you think? Is this ridiculous or is there really something to it?