AP Macro Unit 3

Aggregate Demand

represents the total quantity of all final goods and services demanded by all sectors of the economy; C + I + G + NX

AD Downward Slope Causes

wealth effect, interest rate effect, and exchange rate effect

Wealth Effect

when price level falls, real purchasing power increases; consumers fell wealthier and increase consumption

Interest Rate Effect

when price level rises, demand for money to borrow increases, driving up interest rates; high interest rates discourage business investment and consumer borrowing

Exchange Effect

if domestic price levels drop, domestic goods become relatively cheaper compared to foreign goods resulting in higher exports and fewer imports

Shifters of AD

any change in C, I, G, NX unrelated to a change in price level

Short-Run Aggregate Supply

upward-sloping due to sticky wages and input prices, menu cost

Sticky Wages

nominal wages are slow to adjust because they are often locked into contracts; when price level rises and wages stay the same, production is more profitable

Menu Cost

some firms have sticky prices because it is costly constantly update catalogs, restaurant menus, price tags, etc

Shifters of SRAS

resource prices, government action, productivity

Long-Run Aggregate Supply

perfectly vertical at the full-employment output because in the long run, all wages and resource prices are fully flexible (real profit remains unchanged)

Shifters of LRAS

change in productive capacity

Recessionary Gap

occurs when short-run equilibrium output is less than full-employment output; there is cyclical unemployment

Inflationary Gap

occurs when short-run equilibrium output is greater than full-employment output

Self-Correction in a Recessionary Gap

if output is low and UE is higher, the surplus of idle workers lose bargaining leverage and nominal wages/resource prices fall; lower wages reduce production costs for firms and SRAS shifts right until it intersects with AD on the LRAS line; lower permanent price level

Self-Correction in an Inflationary Gap

if output is higher and UE is lower, scarce workers have bargaining leverage and nominal wages/resource prices rise; higher wages increase production costs for firms and SRAS shifts left until it intersects with AD on the LRAS line; higher permanent price level

Fiscal Policy

discretionary updates to government spending or taxes enacted by Congress

Marginal Propensity to Consume (MPC)

the fraction of disposable income that is spent on consumption

Marginal Propensity to Save (MPS)

the fraction of disposable income that is saved

Spending Multiplier

1/MPS

Tax Multiplier

-MPC/MPS; less powerful than the spending multiplier

Balanced Budget Multiplier

always equal to 1

Stagflation

marked by high unemployment and high inflation