AP Macro Unit 3-AD/AS Model, Self-Correction, Fiscal Policy

Marginal propensity to consume (MPC)

the increase in consumer spending when disposable income rises by $1 (equation to find: change in consumer spending/change in disposable income)

Marginal propensity to save (MPS)

The increase in household savings when disposable income rises by $1

Spending Multiplier Equation

1/1-MPC or 1/MPS

Inventories

stocks of goods held to satisfy future sales

wealth effect

the change in the quantity of aggregate demand that results from household wealth buying more or less goods based on the Price Level- the lower the PL, the greater the quantity of Aggregate Demand

Interest rate effect of a change in the aggregate price level

the change in investment and consumer spending caused by altered interest rates that result from changes in the demand for money, the lower the PL and interest rate, the greater the level of Investment and consumer spending

Fiscal policy

the use of taxes, government transfers, or government purchases of goods and services to stabilize the economy

Nominal wages

the dollar amount of the wage paid unadjusted for inflation, changes to nominal wages can shift SRAS

Sticky wages

nominal wages that are slow to fall or rise compared to changes in the PL because of labor contracts

Short-run aggregate supply curve

shows the relationship between the aggregate price level and the quantity of aggregate output supplied that exists in the short run

Long-run aggregate supply curve

shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible

Potential output

the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible

Demand shock

a dramatic event that shifts the aggregate demand curve - sudden increase or decrease of spending in the economy

Supply shock

an dramatic event that shifts the short-run aggregate supply curve, most often tied to changing costs of production

Stagflation

the combination of inflation and stagnating (falling) aggregate output from a leftward shift of SRAS- very hard for Fiscal Policy to fix because inflation or unemployment will become worse

Recessionary gap

when aggregate output is to the left of potential output

Inflationary gap

when aggregate output is to the right of potential output

Output gap

the percentage difference between actual aggregate output and potential output

Self-correcting economy

Step 1 - a change in AD creates a recessionary or inflationary gap (PL, unemployment, and GDP change)

Step 2- this change to unemployment will create higher wages in an inflationary gap or lower wages in a recessionary gap

Step 3- This change to wages will change costs of production shifting SRAS back to long-run equilibrium

Expansionary fiscal policy

increases aggregate demand (raise govt spending, cut taxes, raise govt transfers)

Contractionary fiscal policy

reduces aggregate demand (lower govt spending, raise taxes, lower govt transfers)

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

Tax/Transfer Multiplier

MPC / (1-MPC) or MPC/MPS

--can be positive or negative depending on whether it is an expansionary or contractionary action

--always 1 less than the government spending multiplier

discretionary fiscal policy

fiscal policy that is the result of deliberate actions by policy makers rather than pre-existing tax or transfer policies