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UNIT 3: NATIONAL INCOME AND PRICE DETERMINATION

AP MACROECONOMICS

AP EXAM WEIGHTING: 17-27%Instructor: Mr. N 2024-25

Introduction to the AD-AS Model

The Aggregate Demand-Aggregate Supply (AD-AS) model is a macroeconomic framework used to analyze changes in the economy's total production and pricing levels. It captures the interactions between aggregate demand from consumers, businesses, and the government, and aggregate supply from producers in the economy. The AD-AS model is essential for understanding key economic relationships and the effects of policy changes.

Overview of the AD-AS Model

• Axes of the Model

  • Y-Axis: Price Level

    • Measured by indices such as the Consumer Price Index (CPI) or GDP Deflator.

    • Represents the overall price level in the economy, where an increase indicates rising costs of goods and services and a decrease signals falling costs.

  • X-Axis: Real GDP (RGDP)

    • Indicates the total quantity of goods and services produced in the economy, adjusted for inflation.

    • A higher RGDP signifies economic growth and increased production, while a lower RGDP indicates a recession or economic slowdown.

Learning Objectives for the Unit

1. Understanding Aggregate Demand (AD): Examine its components and importance in the economy.

2. Understanding Aggregate Supply (AS): Explore short-run and long-run supply dynamics.

3. Downward Slope of the AD Curve: Explain the reasons for its negative slope and implications.

4. Functions of AS Curves: Analyze the behavior of short-run and long-run aggregate supply.

5. Vertical Supply Curves: Understand the characteristics of the Long-Run Aggregate Supply curve (LRAS).

6. Economic Changes: Examine how factors such as fiscal policy can shift the AD-AS model.

UNIT 3.1: AGGREGATE DEMAND (AD)

• Definition of Aggregate Demand

  • Aggregate Demand (AD) represents the total quantity of goods and services demanded in the economy across various price levels. It illustrates the inverse relationship between price levels and RGDP demanded, contributing to overall economic activity.

• Characteristics of the AD Curve

  • Negative Slope: The AD curve slopes downward, indicating that as price levels increase, RGDP demanded decreases, and vice versa. This characteristic reflects fundamental consumer behavior in response to changing price levels.

Reasons for Downward Slope

1. Real Wealth Effect: Rising prices decrease the real purchasing power of money and assets, making consumers feel poorer and leading to reduced spending.

   • Example: A savings account worth $1,000 will purchase fewer goods if inflation causes prices to rise by 10%.

2. Interest Rate Effect: Increased price levels raise the demand for money, causing higher interest rates which discourage borrowing and investment, thereby decreasing RGDP.

   • Example: Higher inflation can lead banks to raise interest rates, resulting in fewer loans available for major purchases like homes or cars.

3. Exchange Rate Effect: Higher domestic prices can render exports more expensive, resulting in reduced foreign demand for U.S. goods.

   • Example: If U.S. inflation rises, Japanese consumers may buy fewer American goods due to increased costs.

Shifters in the AD Curve

1. Decrease in AD: Leftward shift, indicating reduced demand in the economy.

2. Increase in AD: Rightward shift, indicating heightened demand in the economy.

• Factors influencing AD:

  • Consumer Spending: Influenced by consumer confidence, wealth levels, and interest rates.

  • Investment Spending: Affected by business confidence, interest rates, and technological advancements.

  • Government Spending: Changes in fiscal policy, such as increased government expenditure or taxation, significantly impact AD.

  • Net Exports: Fluctuates based on changes in foreign income and exchange rates.

UNIT 3.2: SPENDING MULTIPLIER

Key Historical Contexts

• FDR & The New Deal: Implemented extensive public work projects to stimulate employment and aggregate demand during the Great Depression.

• WWII & Government Spending: Government initiatives for war production served as a powerful stimulus, revitalizing the economy.

• 2008 Recession & Stimulus Package: Aimed to rejuvenate the economy through significant government spending following the financial crisis.

• 2020 Covid-19 Relief: Legislative relief measures provided direct payments and support to businesses and individuals to foster economic activity during the pandemic.

Multiplier Effect

• The concept of the multiplier illustrates how an initial change in spending (government or consumer) leads to larger overall changes in economic output due to successive rounds of spending.

• Marginal Propensity to Consume (MPC): Refers to the proportion of additional income that consumers choose to spend rather than save, dictating the extent of the multiplier effect.

Practical Example

• If the government invests $1 billion in infrastructure, the overall GDP may experience a rise of up to $4 billion, showcasing the magnified effects of such fiscal policies due to the multiplier.

Calculations

• Multiplier Calculation: The multiplier is calculated using the formula 1 / MPS (Marginal Propensity to Save). Higher values of MPC correspond to a larger multiplier impact on GDP.

• GDP Change Calculation: The overall change in GDP can be determined by multiplying the spending increase by the multiplier value.

UNIT 3.3: SHORT-RUN AGGREGATE SUPPLY (SRAS)

Overview of SRAS

The Short-Run Aggregate Supply curve demonstrates how price levels influence the total output that producers are willing to supply. Generally, as the price level increases, suppliers have the incentive to produce more due to heightened profit margins, while a decrease in price levels can lead to reduced production levels.

Factors Affecting SRAS

1. Sticky Wages: Wages and some production costs often do not adjust immediately, causing temporary increases in profits and leading firms to augment production in the short run.

   • Wage adjustments are impacted by pre-existing contracts and social norms that inhibit immediate changes to wages.

2. Trade-offs: As production scales increase, unemployment may fall; however, this can lead to inflationary pressures as wage levels rise.

Shifters of the SRAS Curve

1. Resource Costs: An increase in resource costs (e.g., raw materials) will shift the SRAS curve left, while a decrease will shift it right.

2. Productivity & Technology: Technological advancements enhance productivity, resulting in a rightward shift of the SRAS curve, while adverse events can reverse this trend.

3. Government Policies: Taxes and regulations can shift the SRAS curve left, while subsidies and tax reductions may result in a rightward shift.

4. Supply Shocks: Unforeseen positive occurrences can shift the SRAS curve to the right, whereas negative shocks would conversely shift it left.