AP Macro Unit 3: National Income and Price Determination

Aggregate Demand (AD)

The total quantity of all goods and services demanded by households, firms, government, and the rest of the world at each aggregate price level.

Aggregate Supply (AS)

The total quantity of all goods and services supplied by all firms in an economy at each aggregate price level.

Short-Run Aggregate Supply (SRAS)

A curve that shows the relationship between the aggregate price level and the quantity of aggregate output supplied, assuming nominal wages and input costs are fixed or sticky.

Long-Run Aggregate Supply (LRAS)

A vertical line at the economy's potential output; shows the maximum sustainable level of output when all prices are fully flexible.

Full-Employment Output (YF)

The level of real GDP an economy achieves when it is producing at the natural rate of unemployment. Also called Potential Output.

Recessionary Gap

When aggregate output (short-run equilibrium) is less than potential output (Ye < YF), resulting in high unemployment.

Inflationary Gap

When aggregate output (short-run equilibrium) is greater than potential output (Ye > YF), leading to low unemployment and upward pressure on prices.

Spending Multiplier

The ratio of the total change in real GDP caused by an autonomous change in aggregate spending. Formula: 1 / MPS or 1 / (1 - MPC).

Marginal Propensity to Consume (MPC)

The fraction of an increase in disposable income that is spent on consumption. Formula: Change in Consumption / Change in Disposable Income.

Marginal Propensity to Save (MPS)

The fraction of an increase in disposable income that is saved. Formula: Change in Saving / Change in Disposable Income.

Tax Multiplier

The ratio of the total change in real GDP caused by a change in taxes. Formula: -MPC / MPS.

Wealth Effect

The change in consumer spending due to the change in the purchasing power of assets when the aggregate price level changes.

Interest Rate Effect

The change in investment and consumption spending caused by a change in interest rates resulting from a change in the aggregate price level.

Fiscal Policy

The use of government spending (G) and taxation (T) to stabilize the economy by shifting the Aggregate Demand curve.

Expansionary Fiscal Policy

Policy to close a recessionary gap; involves increasing government spending, decreasing taxes, or increasing transfers. Shifts AD right.

Contractionary Fiscal Policy

Policy to close an inflationary gap; involves decreasing government spending, increasing taxes, or decreasing transfers. Shifts AD left.

Automatic Stabilizers

Government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the economy expands.

Long-Run Self-Adjustment

The process by which a recessionary or inflationary gap is closed by the shift of the SRAS curve as nominal wages and input prices eventually become flexible.

Nominal Wages

The dollar amount of wages paid. They are sticky in the short run but flexible in the long run, causing the SRAS curve to shift during self-adjustment.

Stagflation

A period of economic stagnation (falling output/GDP) combined with high inflation (rising price level). Caused by a negative supply shock (SRAS shifts left).

Natural Rate of Unemployment

The unemployment rate at which the economy is producing at its potential output (YF); includes frictional and structural unemployment but no cyclical unemployment.

Supply Shock

An unexpected event that shifts the Short-Run Aggregate Supply (SRAS) curve, such as a sharp change in commodity prices or productivity.

Demand Shock

An unexpected event that shifts the Aggregate Demand (AD) curve, such as a sudden change in consumer or business optimism.

Disposable Income (YD)

Total household income minus taxes plus government transfers. It is the amount available to households for consumption and saving.

Autonomous Change in Aggregate Spending

An initial change in the desired level of spending by firms, households, or government at any given level of real GDP.

Government Transfers

Payments by the government to households for which no good or service is provided in return (e.g., unemployment benefits, social security).

Discretionary Fiscal Policy

Deliberate changes in taxes or spending by the government to shift the aggregate demand curve (e.g., passing a new spending bill).

Sticky Wages

Nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor shortages. This explains the upward slope of SRAS.

Potential Output

The economy's maximum sustainable output level, determined by resources and technology, represented by the LRAS curve.

Real GDP

The value of all final goods and services produced in the economy during a given year, calculated using the prices of a selected base year. (Used on the X-axis of the AD-AS model).

Nominal GDP

The value of all final goods and services produced in the economy during a given year, calculated using the current year's prices.

Net Export Effect

A factor explaining the downward slope of AD: A higher price level makes domestic goods relatively more expensive than foreign goods, causing imports to rise and exports to fall, thus decreasing Net Exports.

Planned Investment Spending

The investment spending that firms intend to undertake during a given period. It depends negatively on the real interest rate.

Unplanned Inventory Investment

Occurs when actual sales differ from expected sales, leading to unexpected changes in inventories. A positive value signals a recession is likely.

Consumption Function

An equation showing how an individual household's consumer spending varies with the household's disposable income.

Financial Wealth

The value of a household's accumulated assets minus its accumulated liabilities. This value is a factor in the Wealth Effect.

Negative Demand Shock

An event that shifts the AD curve to the left, decreasing both real GDP and the price level in the short run and often causing a recessionary gap.

Positive Demand Shock

An event that shifts the AD curve to the right, increasing both real GDP and the price level in the short run and often causing an inflationary gap.

Real Interest Rate

The nominal interest rate minus the rate of inflation. It is the true cost of borrowing and is the main determinant of investment spending.

Inventories

Stocks of goods held by firms to satisfy future sales. Changes in inventories are included in investment spending.

Government Spending

The total expenditures on final goods and services by federal, state, and local governments (a key component of AD).