AP Macroeconomics Unit 3 Notes: The AD-AS Model for Output and the Price Level

Aggregate Demand (AD)

The total quantity of real GDP (real output) that all buyers in an economy want to purchase at each possible price level, holding other factors constant.

Aggregate Demand Curve (AD curve)

A downward-sloping curve showing the relationship between the price level and the quantity of real GDP demanded.

AD Spending Components

A spending-based breakdown often used to organize AD shifters: AD = C + I + G + (X − M), where C is consumption, I is investment, G is government purchases (not transfers), and (X−M) is net exports.

Net Exports (X − M)

Exports minus imports; an increase in net exports raises aggregate demand, while higher imports (holding exports constant) lowers net exports and AD.

Wealth Effect (Real Balances Effect)

When the price level falls, the real purchasing power of money holdings rises, making consumers feel wealthier and increasing consumption, raising real GDP demanded.

Interest Rate Effect (AD slope)

A lower price level reduces money needed for transactions, tending to lower interest rates and encourage borrowing and spending (especially investment), increasing real GDP demanded.

International Trade Effect (Exchange Rate Effect)

If the domestic price level falls relative to foreign prices, domestic goods become relatively cheaper, exports rise and imports fall, increasing net exports and real GDP demanded.

AD Shifters

Factors (other than the price level) that change total real GDP demanded at every price level, such as consumer confidence, expected future income, interest rates, taxes, government spending, exchange rates, and foreign income.

Movement Along AD vs. Shift of AD

A movement along AD is caused by a change in the price level (changing real GDP demanded via the three AD-slope effects); a shift of AD is caused by changes in C, I, G, or (X−M) at the same price level.

Multiplier Effect

The process by which an initial change in spending leads to a larger final change in real GDP because one person’s spending becomes another person’s income, generating additional rounds of spending.

Marginal Propensity to Consume (MPC)

The fraction of an additional dollar of income that households spend on consumption.

Marginal Propensity to Save (MPS)

The fraction of an additional dollar of income that households save rather than spend.

MPC + MPS = 1

An identity stating that each additional dollar of income is either consumed or saved, so the marginal propensities must add to one.

Spending Multiplier (k)

In the simple Keynesian model, the multiplier for autonomous spending changes: k = 1/(1−MPC) = 1/MPS.

Change in GDP from Multiplier (ΔY = kΔA)

A formula linking an initial change in autonomous spending (ΔA, such as ΔG or ΔI) to the total change in equilibrium real GDP (ΔY) via the multiplier k.

Tax Multiplier (k_T)

In the simple model, k_T = −MPC/(1−MPC); it is negative because higher taxes reduce output, and tax changes typically have a smaller effect than equal-sized spending changes.

Short-Run Aggregate Supply (SRAS)

The relationship between the price level and the quantity of real GDP firms produce in the short run, when some input prices (especially wages) are sticky; SRAS is typically upward sloping.

Why SRAS Slopes Upward

Because in the short run nominal wages and some input prices adjust slowly and misperceptions can occur; a higher price level can temporarily raise profit margins, leading firms to produce more.

SRAS Shifters

Cost or productivity changes that shift SRAS at every price level; SRAS shifts right when per-unit costs fall or productivity rises, and shifts left when costs rise (e.g., higher wages, higher oil prices, supply chain disruptions, higher expected inflation).

Negative Supply Shock

An event that increases economy-wide production costs (such as an oil price spike), shifting SRAS left and causing higher price levels and lower real GDP in the short run.

Stagflation

A combination of rising price level (inflation) and falling real GDP (and typically higher unemployment), commonly associated with a leftward SRAS shift from a negative supply shock.

Long-Run Aggregate Supply (LRAS) and Potential Output

LRAS is a vertical line at potential (full-employment) real GDP, showing that in the long run output is determined by resources and technology, not by the price level.

Recessionary Gap

A situation where short-run equilibrium real GDP is below potential output (left of LRAS), typically associated with higher unemployment.

Inflationary Gap

A situation where short-run equilibrium real GDP is above potential output (right of LRAS), often described as an “overheating” economy with rising inflation pressure.

Self-Correction (Long-Run Adjustment)

The process by which wages and expectations adjust over time, shifting SRAS (not LRAS) so the economy returns to potential output: SRAS shifts right in a recessionary gap and left in an inflationary gap.