Transcript AP Macroeconomics Review Session One

AP Macroeconomics Review
Session One
• Key Vocabulary Terms
and Key Graphs.
• This is a fairly comprehensive review
largely based on the 2000 and 2005
released Multiple Choice Exams and
the recent Free Response Questions.
Production Possibilities
• Assumptions:
– Full Employment
– Fixed Resources and Technology
• Movements
– Along curve shows opportunity cost
– Outward shift illustrates economic growth
– Inward shift indicates destruction of resources
• Producing Capital Goods will lead to greater
economic growth than producing consumer
goods. (Butter will lead to more growth than
guns)
Production Possibilities Graph
Capital
Goods
Points A,B,C, are efficient pts.
Point D is underutilization
Point E is economic growth
A
May Lead to most
Future economic growth
E
B
D
C
Consumer Goods
Economic Systems
• Capitalism=Free Market
– Most decisions made by Private businesses
• Communism=Command Economy
– Most decisions made by the government
• Mixed Economy=Features of both Capitalism
and Communism
– Decisions made by both the market and
governments
Supply and Demand Factors
• Demand Changes when:
– Income changes
– Related Products, complements and
substitutes, (price or quality change)
– Expectations (future price change)
– Consumers (more or less added)
– Tastes, Fads, Preferences change
Demand Increase: As Demand Increases,
Price and Quantity Increase as well.
Price
S1
P2
P1
D2
D1
Q1
Q2
Quantity
Demand Decrease: As Demand Decreaes, Price
and Quantity decrease as well
Price
S1
P1
P2
D1
D2
Q2
Q1
Quantity
Supply Factors
• Supply Changes When:
– Input prices change (resources and wages)
– Government (tariffs, quotas, and subsidies)
– Number of sellers change
– Expectations (about price and product
profitability change)
– Disasters (weather, strikes, etc..)
Supply Increase: As Supply Increases, Quantity
Increases, but Price Falls.
S1
Price
S2
P1
P2
D1
Q1
Q2
Quantity
Supply Decrease: As Supply Decreases, Quantity
Decreases, but Price Increases.
S2
Price
S1
P2
P1
D1
Quantity
Q2
Q1
Comparative Advantage
• A nation should specialize in producing goods in which
it has a comparative advantage: ability to produce the
good at a lower opportunity cost.
Example:
Cheese
Wine
Spain:
2 pounds
2 Cases
France
2 pounds
6 Cases
Spain should produce cheese (1C = 1W)
France should produce wine (1W = 1/3C)
:
Currency Terms
• Appreciation: Currency is increasing
in demand (stronger dollar)
– U.S. Currency will appreciate when
more foreigners: travel to the U.S., buy
more U.S. goods or services, or buy
the U.S. dollar to invest in bonds
Currency Terms
• Depreciation: Currency is
decreasing in demand (weaker
dollar) Being SUPPLIED in
exchange for other currency.
– U.S. Currency will depreciate when
fewer foreigners: travel to the U.S., buy
fewer U.S. goods or services, or sell
the U.S. dollar to invest in their own
bonds
Circular Flow of Economic
Activity
• Households supply resources (land, labor,
capital, entrepreneurial ability) to the resource
market. Households demand goods and
services from businesses.
• Businesses demand household resources and
supply goods and services to the product
(factor) market.
GDP (Gross Domestic Product):
The total
dollar (market) value of all final goods and services
produced in a given year.
Expenditure Formula:
• Consumption (C) + Business
Investment (I) + Government
Spending (G) + Net Exports (x)
GDP: What Counts:
• Goods Produced but not Sold (I)
• Goods produced by a foreign
country (Japan) in the U.S. (Honda,
Toyota)
• Government spending on the military
• Increase in business inventories
GDP: What DOES NOT count:
• Intermediate Goods (Tires sold by
Firestone to Ford)
• Used Goods
• Non-Market Activities (Illegal,
Underground)
• Transfer Payments (Social Security)
• Stock Transactions
Shortcomings
of GDP: Leading to GDP
being understated.
• Nonmarket activities: (services of
homemakers) does not count.
• Leisure: Does not include the value of leisure.
• Does not include improvements in product
quality.
• Underground economy
GDP: Overstated
• Includes damage to the environment
• Includes more spending on healthcareAmericans being unhealthy.
• Includes money spent to fight crime-more
police officers, more jails, etc…
Real GDP
• Real GDP= Nominal GDP adjusted for
inflation.
• Calculation:
– Real GDP =
Nominal GDP
Price Index in Hundredths( deflator)
Example:
U.S. 2005 Real GDP=
$11.048 Trillion
$12,4558 (billions)
1.1274 (based on 2000)
Real GDP Per Capita
• Most commonly used to compare and
measure each country’s standard of living
and overall economic growth.
• Real GDP/Nation’s Population
Business Cycles
• The increases and decreases in Real
GDP consisting of four phases:
– Peak: highest point of Real GDP
– Recession: Real GDP declining for 6 months
– Trough: lowest point of Real GDP
– Recovery: Real GDP increasing (trough to
peak)
Unemployment
• Calculation: Number of Unemployed
Labor Force
(Multiplied by 100 to put as a %)
The Labor Force is the total of employed and
unemployed workers.
U.S. unemployment should be about 5%
Employed
• You are considered to be employed if:
– You work for 1 hour as a paid employee (so
part-time workers count)
– You are temporarily absent from work
(illness, strike, vacation)
– You work 15 hours or more as an unpaid
worker (family farms are common)
Unemployed
• Must be looking for work (at least 1
attempt in the past 4 weeks)
• Are reporting to a job within 30 days
• They are temporarily laid off from their job
Types of Unemployment
• Frictional: Have skills that are in demand; just need
time to find a job (College Graduate)
• Structural: Current skills do not match job openings
(Factor jobs being outsourced; Flight attendant after
9/11/2001).
– Frictional + Structural = Natural Rate of
Unemployment (Full –Employment rate)
• Cyclical: Due to a recession (Requires Government
action).
Not In Labor Force
• A person who is not looking for work:
– Full-time students
– Stay at home parents
– Discouraged workers: those who have given
up hope of finding a job.
– Retirees
Inflation
• Rise in the general level of prices
• Reduces the purchasing power of money
• Measured with the Consumer Price
Index (CPI)
– Reports the price of a market basket , more
than 300 goods that are typically purchased
by an urban household
Consumer Price Index (CPI)
• CPI = Recent Price of Market Basket
Price of same basket in base year
(This number is then multiplied by 100)
Example: Assuming only 2 Goods
Recent Year
Base Year
Jeans
P
$25
Q
5
P
$20
Q
5
Pizza
$20
10
$15
10
$325 = 1.3 * 100=130
$250
Calculating Inflation
• CPI in Recent Year – CPI in Past Year
Divided by CPI in Past Year
(Number then Multiplied by 100)
Example:
2002 CPI = 179.9
2001 CPI = 177.1
Rate of Inflation: 179.9-177.1 = 1.58%
177.1
Types of Inflation
• Demand Pull Inflation: ‘too much money
chasing too few goods.”
– AD Curve will shift to the right, resulting in a higher
Price Level and greater Output (up til FE)
• Cost-Push Inflation: Major cause is a supply
shock-OPEC cutting back on oil production
– AS Curve will shift to the left resulting in a higher
Price Level and a decrease in Real GDP.
Real and Nominal Terms
• Real Income = Nominal Income
Price Index (Hundredths)
• Real Interest Rate = Nominal Interest Rate –
Inflation Rate
• Nominal Interest Rate = Real Interest Rate +
Inflation Premium
(anticipated inflation)
Inflation: Winners & Losers
• Winners:
– Debtors who borrow money that will be repaid with “cheap”
dollars.
– Those who have anticipate inflation
• Losers:
– Savers (especially savings accounts)
– Creditors (Banks will be repaid with those “cheap” dollars
– Fixed-Income Recipients (retirees receiving the same monthly
pension)
Consumption and Saving
• As income increases, both consumption and savings
will increase.
• The determinants of overall consumption and savings are: (More
money or a positive outlook will increase consumption and
reduce savings. Less money or a negative outlook will
increase savings and reduce consumption.
–
–
–
–
–
Wealth (financial assets)
Expectations about future prices and income
Real Interest Rates
Household Debt
Taxes
Marginal Propensities
• Marginal Propensity to Consume (MPC) and
the Marginal Propensity to save (MPS) must
equal 1.
• The MPS is used to derive the spending
multiplier, which equals:
1
MPS
If the MPS is .2, the spending multiplier is 5.
Any increase in spending must be multiplied by
5 to determine the overall increase in Real
GDP.
Interest Rate-Investment
• Expected Rate of Return: Amount of
Profit (expressed as a percentage) a
business expects to gain on a
project/investment.
– This rate must be greater than the interest in
order to be profitable.
– The Real Rate of Return is most important.
An expected profit of 10%, that costs 5% in
interest = The real rate of return: 5%.
Investment Demand Curve:
Real Rate of
Return
At lower real interest rates businesses will
Increase investment , leading to an increase
In AD (aggregate demand). At higher rates of
Interest, less money will be invested
r1
r2
ID
Q1
Q2
Quantity of Investment
Shifts of the Investment Demand Curve
A shift from ID1 to ID2
Represents an increase in
Investment demand. A shift
From ID1 to ID3 represents a
decrease in investment
Demand.
PL
ID2
ID1
ID3
Real GDP
Aggregate Demand
Price
Level
Downward sloping:
1. Real-Balances Effect: change
in purchasing power
2. Interest-Rate Effect: Higher
interest rates curtail spending
1. Foreign Purchase Effect:
Substitute foreign products for
U.S. products
AD (C + I + G + X)
Real GDP
Aggregate Demand
• Determinants of AD:
– C + I + G + X (Yes, its GDP)
– An increase in any of these, due to lower
interest rates or optimism will increase AD and
shift the curve to the right.
– A decrease in any of these: more debt, less
spending, tax increase, will cause a decrease in
AD and shift the curve to the left
Aggregate Demand Determinants
• Consumption
–
–
–
–
Wealth
Expectations
Debt
Taxes
• Investment
– Interest Rates
– Expected Returns
• Technology
• Inventories
• Taxes
• Government
– Change in Gov.
spending
• Net Exports
– National Income Abroad
– Exchange Rates
Aggregate Supply Factors:
• R: resource prices (wages and
materials, as well as OIL)
• A: actions by government (Taxes,
Subsidies, more regulation)
• P: productivity (better technology)
Aggregate Supply
• Short Run:
– Assumes that nominal
wages are “sticky” and
do not respond to price
level changes.
– Is Upward sloping as
businesses will increase
output to maximize
profits
• Long Run:
– Curve is vertical because
the economy is at its fullemployment output.
– As prices go up, wages
have adjusted so there is
no incentive to increase
production.
Aggregate Supply Graph
Price Level
AS
Short Run
Inflation
Long Run
Recession
Growth
Extended vertical line
Illustrates the LRAS and
QF (Full-Employment)
QF
Real GDP
Demand-Pull Inflation
AS
Price Level
P2
P1
AD2
AD1 (C + I + G
+ X)
QF
Real GDP
Cost-Push Inflation
Price
Level
AS2
AS1
P2
P1
AD1 ( C + I + G + X)
Q2
QF
Real GDP
Fiscal Policy
• Using Taxes and Government spending to stabilize the
economy.
• Controlled by the President and Congress
• Discretionary Fiscal Policy: Congress must take action
(change the tax rates) in order for the action to be
implemented.
• Automatic Stabilizers: Unemployment benefits,
Progressive Tax System, these changes are
implemented automatically to help the economy.
Types of Fiscal Policy
• Expansionary
– Used to Fight a
Recesssion
– LOWER TAXES
– INCREASE
GOVERNMENT
SPENDING
• Contractionary
– Used to fight Inflation
– RAISE TAXES
– DECREASE
GOVERNMENT
SPENDING
Expansionary Fiscal Policy
• Increasing Government Spending and or cutting taxes
will shift AD to the right and increase output and the
price level.
As1
Price Level
P2
P1
AD2
Q1
AD1 ( C + I + G + X )
Real GDP
QFE
Tax Multiplier
• Remember, if the government decreases
taxes, the result is not as great as a
spending increase, since households will
save a portion (MPS) of the tax cut.
• The Tax Multiplier = MPC X Spending
Multiplier.
– Example: If the MPC is .8 and the MPS is .2
– Spending Multiplier = 1/.2 or 5
– Tax Multiplier = .8 X 5 or 4
Loanable Funds Market &
Expansionary Fiscal Policy
• Used for FISCAL POLICY (Government
spending-Deficit Spending)
An increase in Gov.
spending increases the
demand for loanable
funds and raises real
interest rates
Real Interest Rate
R2
R1
D2
D1
Q1
Q2
Quantity of Funds
Crowding-Out Effect
• An Expansionary Fiscal Policy as previously
diagrammed will lead to higher interest rates.
• At higher interest rates, businesses will take out fewer
loans and there will be a decrease in INVESTMENT (I)
• At the same time there will be a decrease in
CONSUMER SPENDING (C) as they will take out
fewer loans as well.
• This CROWDING OUT EFFECT will reduce the gain
made by the expansionary fiscal policy.
Net Export Effect & Expansionary
Fiscal Policy
• Government spending has led to an increase in interest
rates.
• At higher interest rates, foreigners demand more U.S.
dollars to invest in bonds.
• This leads to an appreciation of the U.S. dollar.
• This leads to a decrease in Net Exports, as foreigners
now have to exchange more of their currency for the
U.S. dollar to buy exports.
• This decrease in Net Exports will reduce AD and counter
to some extent the expansionary fiscal policy.
Contractionary Fiscal Policy
• Raising taxes or reducing government
spending to fight inflation and stabilize the
economy.
Price Level
AS
P1
P2
AD1
AD2
QF
Real GDP
Loanable Funds Market &
Contractionary Fiscal Policy
• Used for FISCAL POLICY (Government
spending-Deficit Spending)
A decrease in Gov.
spending decreases the
demand for loanable
funds and lowers real
interest rates
Real Interest Rate
R1
R2
D1
D2
Q2
Q1
Quantity of Funds
Net Export Effect & Contractionary
Fiscal Policy
• A decrease in government spending has led to a
decrease in real interest rates.
• At lower interest rates, foreigners demand less U.S.
dollars to invest in bonds.
• This leads to a depreciation of the U.S. dollar.
• This leads to an increase in Net Exports, as foreigners
now have to exchange less of their currency for the U.S.
dollar to buy exports.
• This increase in Net Exports will increase AD and further
strengthen the contractionary fiscal policy.
Criticisms of Fiscal Policy
• Timing Problems
– Recognition Lag: identifying recession or inflation
– Administrative Lag: getting Congress/President to
agree to take action
– Operational Lag: Time needed to see the results of
the fiscal policy
– Political Business Cycles: Politicians may take
inappropriate action to get reelected (lower taxes
during an inflationary period). Plus it is difficult to
raise taxes
Money Supply Terms
• M1= Checkable Deposits and Currency
• M2= M1 + Savings deposits, money
market accounts, small time deposits (less
than $100,000)
• Velocity of Money Equation:
– MV = PQ ( GDP) (M= Money Supply and V =
Velocity (number of times per year the
average dollar is spent on goods and
services.
The Federal Reserve System (FED)
•
•
•
•
Control Monetary Policy
Headquartered in Washington D.C.
12 Federal Reserve Districts
Board of Governors (7 members) is the
central authority
• Members are appointed by the President
and confirmed by the Senate
Federal Open Market Committee
(FOMC)
• Made up of 12 people: Board of Governors
+ New York FED President + 4 other
regional presidents (who rotate)
• Meets regularly to direct OPEN MARKET
OPERATIONS (buying or selling of bonds)
to maintain or change interest rates
Banks and Balance Sheets
Assets
Reserves
Securities
Loans
Liabilities
$15,000 Checkable Deposits
$15,000
$70,000
$100,000
If the current reserve requirement is 10%:
1. What is the amount of new loans this bank can generate?
Answer: $100,000 Checkable deposits X a 10% reserve requirement =
$10,000 required reserves. If the bank has $15,000 in reservers,
$5,000 of those are excess reserves and can be loaned out .
2. How much in new loans can be generated by the entire banking
system?
Answer: Money Multiplier = 1/Required Reserve Ratio=1/.10
10 X $5,000 = $50,000
FED and the Money Market
Nominal Interest
Rate
MS1
MS2
Vertical curve-Supply controlled
By the FED. An increase in MS
leads to a rightward shift and
I1
lower interest rates.
I2
MD
Q1
Q2
Quantity of Money
Easy Money Policy
• Buying Government Bonds, lowering the discount rate, or lowering
reserve requirements, to fight a recession, by decreasing interest
rates, increasing investment spending and/or consumption and
increasing AD.
AS
Price Level
P2
AD2
P1
AD1 (C + I + G + X)
Q1
QF
Real GDP
Effects of an Easy Money Policy
• LOWER INTEREST rates which will lead to an
INCREASE in INVESTMENT and
CONSUMPTION.
• The U.S. dollar will DEPRECIATE, leading to an
increase in NET EXPORTS as well.
• These effects STRENGTHEN the overall
monetary policy (opposite of fiscal policy’s
crowding-out and net export effect
FED and a TIGHT Money Policy
Nominal Interest
Rate
MS2
MS1
Vertical curve-Supply controlled
By the FED. A decrease in the
Money supply, shifts the MS
curve to the left and raises
interest rates.
I2
I1
MD
Q2
12
Quantity of Money
Tight Money Policy
• Selling bonds, raising the discount rate, or raising reserve
requirements to fight inflation which will raise interest rates,
decrease investment and/or consumption and decrease Aggregate
Demand (AD).
Price Level
AS
P1
P2
AD1
AD2
QF
Real GDP
Effects of a Tight Money Policy
• At the higher interest rates, INVESTMENT SPENDING,
and CONSUMPTION will decrease.
• At higher interest rates, the U.S. dollar will
APPRECIATE (foreigners demand more U.S.
securities). This will lead to a DECREASE in NET
EXPORTS.
• Again, the Monetary Policy is STRENGTHENED as
a result, unlike the effects of a contractionary fiscal
policy.
Extended AD-AS Model
• This is the other way to graph the AD-AS Model
Price Level
LRAS
SRAS
P1
AD
QF
The intersection of the 3 curves
Is the Full-Employment Equilibrium
Real GDP
Extended AD-AS Model and Demand-Pull Inflation
• In Demand-Pull Inflation, the AD curve has shifted to the right of
the LRAS and SRAS intersection.
LRAS
Price Level
SRAS
P2
PF
AD2
AD1
QF
Q2
Real GDP
The Price Level and Real GDP has increased.
Extended AD-AS and Demand-Pull Inflation
• Mainstream economists will fight inflation as previously
discussed: with either a tight monetary policy or a
contractionary fiscal policy. The goal would be to move
the aggregate demand curve to the left.
• Classical economists would argue to DO NOTHING.
As nominal wages rise, the SHORT-RUN AS curve will
shift to the left (resources and wages are becoming
more expensive), restoring the economy to its fullemployment output level, but with a higher Price
Level.
Extended AD-AS Model and Cost-Push Inflation
Cost-Push inflation occurs when the SRAS has shifted to the left
Of the LRAS and AD intersection.
LRAS
Price Level
P1
SRAS1
Here the Price level has
Increased and REAL GDP
has decreased.
SRAS2
PF
AD1
Q1
QF
Real GDP
Extended AD-AS and Cost-Push Inflation
• Mainstream economists must decide whether to target
the Price Level or Unemployment, before taking any
action.
• Classical economists would argue to DO NOTHING.
Eventually, wages and resource prices must decrease
and when they do the SRAS curve will shift back to the
right, restoring the economy to its full-employment
output level and the original Price Level.
Extended AD-AS Model and Recession
• In a recession due to a decrease in AD, the AD curve is to the left
of the LRAS and SRAS intersection; showing a decrease in both
the Price Level and Real GDP.
LRAS
Price Level
SRAS
PF
P1
AD
Q1
QF
Real GDP
Extended AD-AS and Recession
• Mainstream economists will fight a recession as
previously discussed: with either an easy money policy
or an expansionary fiscal policy. The goal would be to
move the aggregate demand curve to the right.
• Classical economists would argue to DO NOTHING.
The decrease in wages and resource prices will shift
the SRAS curve to the right, restoring the economy to
its full-employment output level, but with a LOWER
price. (SELF-CORRECTION)
Short-Run Phillips Curve
• Suggests an inverse relationship between the inflation
rate and the unemployment rate.
Inflation
Rate
(percent)
When the unemployment rate is
Low (2%), the inflation rate will
Most likely be high (8%).
8
When the
Unemployment rate
Is high, inflation will
likely be low.
2
SRPC1
2
8
Unemployment Rate (percent)
Short-Run Phillips Curve
• When the Government fights unemployment, typically higher
inflation will result. When the Government fights inflation, typically,
more unemployment will result. Thereby, we move along the
Short-Run Phillips Curve.
Inflation
Rate
(percent)
7
B
2
A
SRPC1
3
6
Unemployment Rate (percent)
Shifting the Short-Run Phillips Curve
• The Short-Run Phillips curve can also shift, this would mean that
both the unemployment rate and inflation rate are changing at the
same time.
Stagflation, unemployment and
Inflation occurring together
(OPEC decreasing Oil supply,
causes this type of shift)
Inflation Rate
% 5
4
SRPC2
SRPC1
6
7
Unemployment Rate %
Shifting the Short-Run Phillips Curve
• The Short-Run Phillips curve can also shift, this would mean that
both the unemployment rate and inflation rate are changing at the
same time.
When Supply increases
(productivity surge in 90s)
more than demand, prices will
fall, while GDP and employment
Increase; shifting the curve to the left.
Inflation Rate %
5
3
SRPC1
SRP2
5
7
Unemployment Rate %
Long-Run Phillips Curve
• The Long-Run Phillips Curve is vertical, like the Long Run
Aggregate Supply Curve. So, in the long run there is no tradeoff
between inflation and unemployment. Only the Price Level will
change.
LRPC
Inflation Rate%
3
SRPC
5
Unemployment Rate %
Laffer Curve
• What is the optimal tax rate? A tax of 0% will provide no tax
revenue. A tax rate of 100% will also lead to no tax revenue (no
incentive to work). Answer must be somewhere in between.
Tax Rate
100
0
Tax Revenue
Economic Growth
• Five Factors connected to long run economic growth.
• Supply Factors:
–
–
–
–
Increase in natural resources (quantity and quality)
Increase in human resources (quantity and quality)
Increase in capital goods
Improvements in technology
• Demand Factors:
– Increase in consumption by households, businesses, and
government
Illustrating Economic Growth
• Production Possibilities Curve
Capital Goods
B
A
PPC2
PPC1
Consumer Goods
Illustrating Long Run Growth
• Can also be illustrated with the extended AD-AS
Model.
LRAS1 SRAS1
Price Level
LRAS2
SRAS2
P2
P1
AD2
AD1
Q1
Q2
Real GDP
Budget Philosophies
Annually Balanced Budget: Government will spend what
it makes.
• Problem: Does not have money during a recession, it
will not be able to increase spending to help the
economy.
• If there is inflation, it will also be forced to spend the
extra money
• In both cases the economy will be worse off
Cyclically Balanced Budget:
Government will finance a
deficit during a recession and pay it off with tax revenue received
during expansion.
Problem: A long recession may run up a large deficit that a
short expansion period can not pay off
National Debt ($8.7 Trillion and growing)
Functional Finance: A deficit is necessary to balance
the economy. The national debt should not be worried
about too much.
Causes of the Debt:
1. Wars
2. Recessions
3. Lack of Fiscal Discipline
Concerns:
1. Interest Payments
2. Income Gap (Debt and interest payments held by the wealthy)
2. Crowding Out
Economic Philosophies
• Classical: Believes that the government
SHOULD NOT interfere in the economy. And
believes in self-correction of economic
problems.
• Keynesian: Believes that GOVERNMENT SHOULD
interfere in the economy (taxes, government spending)
International Trade
• Comparative Advantage and Specialization allows for
economic growth and efficiency. (More of each good
can be obtained by trading-Trading line illustrates this)
• Trade barriers create more economic loss than
benefits.
• Today there is a trend towards free trade and a
reduction in trade barriers.
• Strongest arguments for protection are the infant
industry and military self-sufficiency arguments.
• WTO oversees trade agreements and disputes, but has
become a target of protesters lately.
Foreign Exchange Market
• Let’s say a U.S. citizen travels to Japan. This transaction will
provide a supply of the U.S. dollar and result in a demand for
yen. It will become cheaper for the Japanese to buy the dollar and
more expensive for Americans to buy the Yen. The Yen is
Appreciating and the dollar is Depreciating.
Yen Price of
dollar
Dollar Price
of Yen
S1
P2
S2
P1
S1
P1
D2
P2
D1
D1
Q1
Q2
Quantity of U.S. Dollars
Q1
Q2
Quantity of Yen
Balance of Payments: The sum of all transactions
between U.S. residents and residents of all foreign
nations
• Current Account: Shows U.S. exports and U.S. imports of
goods and services.
• Capital Account: Shows the U.S. investment (financial as well
as capital-plants and factories) abroad and Foreign investment
in the U.S.
• Credits: A credit are those transactions for which the U.S.
receives income (exports, foreign purchase of assets)
• Debits: Those transactions that the U.S. must pay for: imports
and purchasing of assets abroad.
Balance of Payments continued
• The Current Account and Capital Account must be
equal.
• Official Reserves Account: The Central Banks of all
nations hold foreign currency to make up any deficit in
the combined capital and current accounts.
• If the U.S. has more credits than debits it finances this
difference by dipping into its reserve account.