National Income and Price Determination (AD-AS and Fiscal Policy)

Aggregate Demand (AD)

The total amount of real (inflation-adjusted) domestic output that households, firms, government, and foreign buyers plan to purchase at each price level.

National Income Accounting Identity

Equation linking real GDP to spending: Y = C + I + G + Xn.

Real GDP (Y)

Inflation-adjusted value of final goods and services produced domestically; also equals total income in the economy.

Consumption (C)

Household spending on goods and services; a major component of aggregate demand.

Investment (I)

Firms’ spending on capital goods and new construction (and related investment spending); a component of aggregate demand.

Government Purchases (G)

Government spending on goods and services that directly enters GDP and AD (not transfer payments).

Net Exports (Xn)

Exports minus imports; the foreign sector component of AD.

Imports (M)

Spending on foreign-produced goods and services; reduces net exports and does not count toward domestic GDP.

AD vs GDP (key distinction)

GDP is an actual measured outcome for a period; AD is a relationship between the price level and planned total spending on domestic output.

AD Curve (downward sloping)

Graph showing an inverse relationship between the aggregate price level and quantity of real GDP demanded.

Wealth Effect (Real Balances Effect)

When the price level rises, purchasing power of wealth/money balances falls, reducing consumption; when price level falls, consumption tends to rise.

Interest Rate Effect

Higher price level raises money demand and interest rates, discouraging investment and some consumption; lower price level tends to lower rates and increase spending.

International Trade Effect (Foreign Sector Substitution Effect)

When domestic prices rise relative to foreign prices, exports fall and imports rise, reducing net exports and real GDP demanded.

AD Shifters (Determinants of AD)

Non-price-level factors that change planned spending (C, I, G, or Xn), shifting the entire AD curve left or right.

Movement Along AD

A change in the price level causing a change in real GDP demanded (a point change on the AD curve).

Shift of AD

A change in a non-price determinant (like taxes, expectations, foreign income, exchange rates) changing planned spending at every price level.

Consumer Expectations (Confidence)

Beliefs about future income/economy that influence consumption; higher confidence tends to increase C and shift AD right.

Business Expectations (Profit Outlook)

Firms’ expectations about profitability; improved outlook tends to raise investment and shift AD right.

Exchange Rate Appreciation (Stronger Currency)

Makes domestic goods relatively more expensive to foreigners; exports fall and imports rise, reducing net exports and shifting AD left.

Exchange Rate Depreciation (Weaker Currency)

Makes domestic goods relatively cheaper to foreigners; exports rise and imports fall, increasing net exports and shifting AD right.

Multiplier Effect

An initial change in spending triggers repeated rounds of spending and income, magnifying the total change in equilibrium GDP.

Marginal Propensity to Consume (MPC)

Fraction of an additional dollar of disposable income that households spend (ΔC/ΔYd).

Marginal Propensity to Save (MPS)

Fraction of an additional dollar of disposable income that households save (ΔS/ΔYd).

MPC + MPS = 1

In the simplified model, each additional dollar of income is either consumed or saved, so the fractions sum to 1.

Spending Multiplier

How much equilibrium GDP changes for a $1 change in autonomous spending; multiplier = 1/(1 − MPC) = 1/MPS.

Autonomous Spending (A)

Initial spending not caused by current income (e.g., new investment or government purchases) that can start the multiplier process.

Multiplier Equation for GDP Change

ΔY = (multiplier) × (ΔA) in the simple spending model.

Tax Multiplier

Effect of a tax change on equilibrium GDP in the simplified model: (−MPC)/(1 − MPC) = (−MPC)/MPS.

Why the Tax Multiplier Is Smaller (in magnitude)

Tax changes affect GDP indirectly through consumption, so not all of a tax cut becomes spending.

Leakages (Multiplier Weakening Factors)

Forces that reduce the multiplier (e.g., spending on imports, higher taxes as income rises, and higher interest rates).

Crowding Out

Higher government spending (often deficit-financed) can raise interest rates and reduce private investment, offsetting some AD increase.

Short-Run Aggregate Supply (SRAS)

Relationship between the price level and quantity of real GDP supplied in the short run when input prices (especially wages) are sticky.

Sticky Wages (Sticky Input Prices)

Contracts/norms that keep wages and other input costs from adjusting quickly, helping SRAS slope upward in the short run.

Misperceptions (Imperfect Information)

Firms may confuse economy-wide price changes with relative price increases for their product and temporarily raise output.

SRAS Shifters

Factors that change firms’ costs/ability to produce at each price level (input prices, inflation expectations, productivity, supply-side taxes/regulation, disruptions).

Negative Supply Shock

An event (e.g., oil price spike) that raises economy-wide production costs, shifting SRAS left.

Positive Supply Shock

An event (e.g., productivity gain or lower energy prices) that lowers costs and shifts SRAS right.

Long-Run Aggregate Supply (LRAS)

Vertical line at potential output (GDPf) showing the economy’s long-run production capacity at full employment.

Potential Output (Full-Employment Output, GDPf)

Real GDP produced when resources are used at sustainable, normal levels; corresponds to the natural rate of unemployment, not zero unemployment.

Why LRAS Is Vertical

In the long run, wages and input prices are flexible, so price-level changes do not permanently change real GDP; output is determined by real factors.

Economic Growth (Rightward Shift of LRAS)

An increase in productive capacity (resources, human capital, technology/productivity, incentives) that shifts LRAS to the right.

Short-Run Macroeconomic Equilibrium

Point where AD intersects SRAS; determines equilibrium price level (vertical axis) and equilibrium real GDP (horizontal axis).

Full-Employment Equilibrium

When AD, SRAS, and LRAS intersect at GDPf; the economy is producing at potential output.

Recessionary Gap

When equilibrium real GDP is below potential output (left of LRAS); associated with underused resources and high cyclical unemployment.

Inflationary Gap

When equilibrium real GDP is above potential output (right of LRAS); economy is overheating with rising inflation pressure.

Self-Correction (Self-Adjustment)

Long-run process where wages/input prices adjust and SRAS shifts to return real GDP to potential output (GDPf).

Demand-Pull Inflation

Rising price level caused by a rightward shift of AD (often with higher short-run real GDP).

Cost-Push Inflation

Rising price level caused by a leftward shift of SRAS (with lower short-run real GDP).

Stagflation

Combination of falling/stagnant real GDP and a rising price level; often linked to SRAS shifting left.

Fiscal Policy

Use of government taxing and spending decisions to influence aggregate demand and stabilize the economy (primarily shifts AD in this framework).

Automatic Stabilizers

Fiscal features that change taxes or spending automatically with the business cycle (e.g., progressive income taxes, unemployment insurance, TANF), dampening fluctuations without new laws.

Time Lags (Fiscal Policy)

Delays that can reduce policy effectiveness: recognition lag (identify problem), decision lag (pass legislation), and implementation lag (roll out programs).