Unit 3: National Income and Price Determination (Princeton Review AP Macroeconomics 2023 [21st Edition])

Aggregate Demand

the total demand for good and services in an economy

The AD curve illustrates…

inflation, unemployment, relative value of national currency

The AD curve is the relationship between…

Price level and real GDP

The AD curve reflects changes in the demand for…

all goods and services

Price and GDP relationship type

indirect

For AD, when price decreases, GDP…

increases

For AD, when price increases, GDP…

decreases

The indirect relationship between price level and GDP are determined by which three primary effects?

the foreign trade effect, the interest rate effect, and the real wealth (real balances) effect

The Foreign Trade Effect

when the price level in one country increases, the prices of imports from other countries become relatively less expensive

How does the foreign trade effect impact imports and exports in a country when price level increases?

The country buys more imported goods, and sells fewer exports.

The Interest Rate Effect

when price level increases, purchasing power decreases, leading to higher interest rates and reduced investment

An increase in price level…

increases interest rates and decreases real GDP

Why does an increase in price level increase interest rates and decrease real GDP?

An increase in price level leads to a decrease in the purchasing power of money, causing lenders to demand higher interest rates to compensate for inflation. This results in reduced borrowing and investment, ultimately decreasing real GDP.

A decrease in price level…

dcereases interest rates and increases real GDP

The Real Wealth (Real Balances) Effect

when the price level imcreases, the value of assets such as cash and checking account balances falls

Aggregate Demand Equation

AD = C + I + G + X_n

What does C represent in the aggregate demand equation?

consumption

What does I represent in the aggregate demand equation?

investment (business spending)

What does G represent in the aggregate demand equation?

government purchases

What does X_n represent in the aggregate demand equation?

net exports

Net Export Equation

(X - M) exports minus imports

Indirect Relationship between Price Level and Real GDP acronym

Friends (Foreign Trade Effect) Inspire (Interest Rate Effect) Relationships (Real Wealth Effect)

The AD curve shifts to the right due to…

consumption increases, investment increases, government carries out expansionary policy, or net exports increase

The AD curve shifts to the left due to…

consumption decreases, investment decreases, government carries out contractionary policy, or net exports decrease

Consumption increases due to…

expectations of inflation or shrtages in the future, increased income or wealth, optimism about jobs and income

Investment increases due to…

interest rates dropping, investors gaining optimism

Government carries out expansionary policy means…

increased spending, increased money supply, and/or decreasing taxes

Government carries out contractionary policy means…

decreased spending, decreased money supply, and/or increasing taxes

Net exports increase due to…

the exchange rate decreases (imports decrease), foeign income increases (exports increase)

SRAS curve horizontal represents

depression or Keynesian stage

SRAS curve upward sloping represents

intermediate stage

SRAS curve vertical represents

classical stage

During a depression, firms have _______ inventories

large

Why is the depression or Keynesian stage on the SRAS curve horizontal?

large inventories mean firms will be glad to sell more at an existing price level and workers being plentiful means there is less upward pressure on prices or wages

If a firm sees the price of its product going up and does not realize that all prices are increasing at the same time, the firm might think the relative value of its good has _________ and may be fooled into producing ____

increased; more

If a firm sees the price of its product going down and does not realize that all prices are decreasing at the same time, the firm might think the relative value of its good has _________ and may be fooled into producing ____

decreased; less

The SRAS curve shifts in response to…

changes in input prices and availability, technology, public policy, and other macro disturbances

The SRAS curve shifts to the right due to…

inputs becoming cheaper, more productive, or more plentiful, government policies reducing production costs, or macro disturbances being absent

The SRAS curve shifts to the left due to…

inputs becoming expensive, less productive, or less plentiful, government policies increasing production costs, or macro disturbances like wars and natural disasters

Inputs becoming cheaper, more productive, or more plentiful is due to…

new discoveries of raw materials, increases in labor supply, decreases in wages or other input prices, improvements in education or training, decrease inflationary expectations, increased investment (more capital), technological advances, or predictable and beneficial weather conditions

Government policies reducing production costs is due to…

tax cuts, deregulation, reform in welfare or unemployment insurance programs

The LRAS curve is vertical because…

when price level increases, there is no incentive to produce more

Y_f indicates

full employment on the LRAS curve

Y_f and LRAS shift right due to…

increased skill levels, increased capital levels, improved technology, or increased resource availability

An inital negative demand shock decreases aggregate demand to the left, resulting in…

higher unemployment in the short run and shifting equilibrium to a lower output level and price level.

An inital positive demand shock increases aggregate demand to the right, resulting in…

less unemployment in the short run and shifting equilibrium to a higher output level and price level.

When the price level is above equilibrium, surpluses lead to price level…

decreasing

When the price level is below equilibrium, shortages lead to price level…

increasing

Inflation is a result of…

AS decreasing or AD increasing

When prices rise due to an increase in the costs of the factors of production, this is called…

cost-push inflation or supply-side inflation

Cost-push inflation pushes SRAS to the…

left

Stagflation

inflation is concurrent with relatively high unemployment and a reduction of GDP

Demand-pull inflation

AD shifts to the right relative to the AS curve

Demand-pull inflation pulls AD to the…

right

Creeping Inflation

inflation the remains steady for a long period of time at a low rate

Galloping Inflation

unsteady inflation that exceeds 10% per year and grows month after month

Hyperinflation

very rapid price increases in excess of 50% per year

Recessionary gaps are indicated by…

high unemployment and LRAS being right of equilibrium

Inflationary gaps are indicated by…

low unemployment and LRAS being left of equilibrium

Recessionary Gap Inequality

Y_e < Y_f

Full Employment Equation

Y_e = Y_f

Inflationary Gap Inequality

Y_e > Y_f

According to classical theory, the recessionary gap results in…

the surplus of workers will causes wages to fall, shifting AS to the right, lowering price level and increasing real GDP until equilibrium is at Y_f

According to classical theory, the inflationary gap results in…

the shortage of workers will causes wages to rise, shifting AS to the left, increasing price level and decreasing real GDP until equilibrium is at Y_f

Keynesian theory counters classical theory by stating…

wages are not flexible enough to respond quickly to inflation and recession, needing government to step in

Spending (Expenditure) Multiplier

the number by which the inital amount of new spending should be multiplied to find the total resulting increase in real GDP

How is the spending multiplier visualized?

an additional dollar of spending adds more than one dollar to real GDP because the initial dollar ends up in someone’s pocket as income, and that person will turn around and spend some of it, creating more income and spending (and the cycle goes on…)

MPC (Marginal Propensity to Consume)

the amount by which consumption increases for every additional dollar of real income

MPC Formula

MPS Formula

MPS (Marginal Propensity to Save)

the fraction of each additional dollar of income that is saved

MPC + MPS = 1

MPS = 1 - MPC

Spending (Expenditure) Multiplier Formula

Automatic Stabilizers

ongoing governmental policies such as unemployment insurance, welfare, social security, personal income tax, payroll tax, and corporate income tax

How do automatic stablilizers work?

they protect individuals and businesses from routine fluctuations in the economy by automatically adjusting government spending and taxes based on economic conditions

Fiscal Policy is exercised by the…

government

Expansionary Fiscal Policy

increasing government spending, increasing transfers, decreasing taxes

Contractionary Fiscal Policy

decreasing government spending, decreasing transfers, increasing taxes

Expansionary fiscal policy shifts AD

to the right and boosts real GDP

Contractionary fiscal policy shifts AD

to the left and diminished real GDP

The government spending multiplier is the same as the…

autonomous spending multiplier

Tax Multiplier Formula

Tax Multiplier

indicates the total change in real GDP resulting from each $1 change in taxes

Balanced Budget Multiplier

when government spending change is accompanied by a tax change

Balanced Budget Multiplier Formula

When real GDP increases, the demand for money

increases

When real GDP decreases, the demand for money

decreases

Supply-side economists believe

changes in tax rates change aggregate supply and aggregate demand