Unit 3
National Income and Price Determination
Learn about aggregate demand, aggregate supply, equilibrium, and fiscal policy
3.1: Aggregate Demand
Aggregate
A word that simply means "total" or "combined." In this unit, it means we are looking at the demand for all goods and services in an entire economy, not just one product.
Price Level
The overall or average level of prices in an economy. It is represented on the vertical axis of the AD-AS graph.
Aggregate Demand (AD)
The total demand for all goods and services in an economy. The AD curve shows the amount of goods and services that households, businesses, the government, and foreign customers are willing to buy at different price levels.
Inverse Relationship between Price Level and AD
The AD curve is downward sloping because as the price level goes down, the quantity of real GDP demanded goes up, and vice versa.
Key Points
- The Real Wealth Effect: When the price level falls, the money you have is more valuable, making you feel wealthier and causing you to spend more.
- The Interest Rate Effect: When the price level falls, people save more, which drives down interest rates and makes it cheaper for businesses to borrow and invest.
- The Net Export Effect: When a country’s price level falls, its goods become cheaper compared to foreign goods, which causes its net exports to go up.
Shifters of Aggregate Demand
The entire AD curve will shift when there is a change in one of the components of GDP that is not caused by a change in the price level.
Key Points
- Changes in Consumption (C): Caused by factors like consumer confidence. If fears of a recession cause consumers to lose confidence, they spend less, shifting AD to the left.
- Changes in Investment (I): Caused by factors like business confidence. If businesses lose confidence, they invest less, shifting AD to the left.
- Changes in Government Spending (G): Caused by direct government action. If the government passes a new spending bill, G increases, shifting AD to the right.
- Changes in Net Exports (NX): Caused by factors like the economic health of trading partners. If a key trading partner falls into a recession, they will buy fewer of our goods, causing our net exports to fall and shifting AD to the left.
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3.2: Multipliers
Multiplier Effect
The ripple effect in which an initial change in spending leads to a larger total change in GDP.
Marginal Propensity to Consume (MPC)
The fraction of any extra income that a household spends.
Key Points
- Example: If you get a $100 bonus and spend $80, your MPC is 0.8.
Marginal Propensity to Save (MPS)
The fraction of any extra income that a household saves.
Key Points
- Example: If you spend $80 of a $100 bonus, you save $20, so your MPS is 0.2.
Spending Multiplier
A value that tells us the total change in GDP that will result from an initial change in spending.
Key Points
- Formula: 1 / MPS
Tax Multiplier
The multiplier that applies to a change in taxes; it is always one less than the spending multiplier because the initial change in spending is smaller.
Key Points
- Formula: -MPC / MPS
Calculating Maximum GDP Change
Using a multiplier to find the total potential change in GDP.
Key Points
- For spending: Initial Change in Spending × Spending Multiplier
- For taxes: Initial Change in Taxes × Tax Multiplier
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3.3: Short-Run Aggregate Supply
Short-Run Aggregate Supply (SRAS)
Shows the direct relationship between the overall price level and the quantity of output that firms produce in the short run. It is upward-sloping.
Sticky Wages
The main reason the SRAS curve slopes upward. In the short run, wages don’t change quickly, often due to contracts.
Key Points
- If the price of goods rises while wages remain "stuck," company profits go up, creating an incentive to produce more.
Shifters of SRAS
Non-price factors that cause the entire SRAS curve to shift, typically related to widespread changes in the costs of production.
Key Points
- Changes in resource prices (e.g., a nationwide increase in wages or oil prices)
- Changes in government policy (e.g., business taxes or subsidies)
- Widespread changes in technology and productivity
- Changes in producers’ expectations about future prices
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3.4: Long-Run Aggregate Supply
Long-Run Aggregate Supply (LRAS)
Shows the total amount of production possible for an economy when it’s using all of its resources efficiently. It is a vertical line at the economy’s full-employment output level (Yf).
Full-Employment Output (Yf)
The level of output an economy can produce when it is using all of its resources efficiently; also known as potential output.
Factors of Production (Macro)
The resources that determine a country’s potential output and the position of the LRAS curve.
Key Points
- Includes resources like land, labor, and capital, as well as the level of technology.
Shifters of LRAS
Factors that change a country’s productive capacity, which shifts the entire LRAS curve.
Key Points
- An increase in the capital stock or human capital causes a rightward shift
- Discovery of new natural resources causes a rightward shift
- A decrease in the workforce or destruction of infrastructure causes a leftward shift
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3.5: Equilibrium in the AD-AS Model
Short-Run Equilibrium
Occurs where the AD curve and the SRAS curve intersect. An economy will always be in a state of short-run equilibrium.
Long-Run Equilibrium
A special case where the AD, SRAS, and LRAS curves all intersect at the same point, meaning current output is equal to the country’s potential output.
Recessionary Gap
Occurs when the short-run equilibrium is to the left of the LRAS curve.
Key Points
- Actual output is less than potential output
- Unemployment rate is greater than the natural rate
Inflationary Gap
Occurs when the short-run equilibrium is to the right of the LRAS curve.
Key Points
- Actual output is greater than potential output
- Unemployment rate is less than the natural rate
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3.6: Changes in the AD-AS Model
Negative Supply Shock
A sudden event that makes production more difficult or expensive across the economy, such as a sharp rise in the price of oil. It shifts the SRAS curve to the left.
Positive Supply Shock
A sudden event that makes production easier or cheaper, such as a major technological breakthrough. It shifts the SRAS curve to the right.
Stagflation
A situation, often caused by a negative supply shock, where the economy experiences both higher unemployment and a higher price level.
Demand-Pull Inflation
A rise in the price level caused by an increase in aggregate demand.
Key Points
- Can be thought of as "too much money chasing too few goods."
Cost-Push Inflation
A rise in the price level caused by a decrease in short-run aggregate supply, often due to higher input costs.
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3.7: Long-Run Self-Adjustment
Long-Run Self-Adjustment
The process through which an economy gets out of an output gap and back to long-run equilibrium on its own, without government action.
Key Points
- Driven by changes in resource prices, like wages, which shift the SRAS curve.
Self-Adjustment from a Recessionary Gap
The process by which an economy naturally returns to long-run equilibrium from a recessionary gap.
Key Points
- High unemployment causes nominal wages to fall
- Lower wages shift the SRAS curve to the right
- Economy returns to full-employment output at a lower price level
Self-Adjustment from an Inflationary Gap
The process by which an economy naturally returns to long-run equilibrium from an inflationary gap.
Key Points
- Low unemployment causes wages to rise
- Higher wages shift the SRAS curve to the left
- Economy returns to full-employment output at a higher price level
Long-Run Impact of Self-Adjustment
The final outcome for an economy after it moves into an output gap and then self-adjusts.
Key Points
- In the long run, output returns to full-employment level
- Price level changes to bring the economy back to equilibrium
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3.8: Fiscal Policy
Fiscal Policy
The government’s use of spending and taxation to influence the economy.
Key Points
- Action taken by the federal government
- Directly affects aggregate demand
Expansionary Fiscal Policy
Policy used to stimulate the economy during a recessionary gap by increasing spending or decreasing taxes.
Key Points
- Shifts aggregate demand to the right
- Increases the price level
- Increases real GDP
- Decreases unemployment
Contractionary Fiscal Policy
Policy used to slow the economy during an inflationary gap by decreasing spending or increasing taxes.
Key Points
- Shifts aggregate demand to the left
- Decreases the price level
- Decreases real GDP
- Increases unemployment
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3.9: Automatic Stabilizers
Discretionary Fiscal Policy
When lawmakers make explicit, deliberate changes to spending and taxes.
Automatic Stabilizers
Features of the tax and spending system that work to stabilize the economy automatically, without any new action from lawmakers.
Key Points
- Common examples include unemployment benefits and the income tax system
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Comprehension Check
Test your understanding with practice questions