Unit 3 AP Macroeconomics: National Income and Price Determination

AGGREGATE DEMAND CURVE

• Definition: The Aggregate Demand (AD) curve shows the relationship between the aggregate price level and the quantity of aggregate demand by households, firms, the government, and the rest of the world.
• Components of Aggregate Demand: Aggregate demand is composed of the following four elements:     - Consumption     - Investment     - Government spending     - Net exports
• Downward Slope of the AD Curve: The AD curve is downward sloping (or has a "downwarding slope") due to three specific effects:     - Real-balance effect: An increase in the price level decreases the purchasing power of money, leading to a decrease in the quantity of goods and services demanded.     - Interest rate effect: An increase in the interest rate leads to a decrease in borrowing and spending by consumers and firms.     - Open economy effect: Higher internal price levels make domestic goods more expensive relative to foreign goods, which decreases net exports.
• Shifters of Aggregate Demand: Changes in the following factors will cause the AD curve to shift:     - Changes in expectations: Optimistic beliefs about the future state of the economy increase aggregate demand.     - Changes in wealth: A rise in the value of assets (wealth) increases aggregate demand.     - Size of existing physical capital: A small existing stock of physical capital increases the demand for more investment, shifting AD to the right.     - Fiscal Policy: Aggregate demand increases if there is an increase in government spending or if there are tax cuts.     - Monetary Policy: An increase in the quantity of money available in the economy increases aggregate demand.

SHORT-RUN AGGREGATE SUPPLY (SRAS)

• Definition: Short-run Aggregate Supply occurs during the period when firms have not yet made price changes in response to an economic shock, a phenomenon known as "sticky prices."
• Upward Slope of the SRAS Curve: The SRAS curve is upward sloping due to the following theories:     - The misperception theory: Producers may mistake a general price level increase for an increase in their own relative prices, leading them to believe they are making a greater profit and thus increasing production.     - Sticky Price Theory: Producers may temporarily reduce their quantity of output because of menu costs, which are the costs associated with changing listed prices.     - Sticky Wage Theory: Production costs can remain high because of fixed nominal wages, such as those set by long-term union contracts, which do not adjust immediately to economic changes.
• Shifters of Short-run Aggregate Supply: The SRAS curve will shift based on changes in these factors:     - Changes in commodity prices: A decrease in commodity prices (inputs) lowers production costs and increases SRAS.     - Changes in nominal wages: Lower nominal wages reduce the cost of labor, thereby increasing SRAS.     - Changes in productivity: An increase in worker productivity allows for more output per unit of input, increasing SRAS.

LONG-RUN AGGREGATE SUPPLY (LRAS)

• Definition: The LRAS represents the economy's output after producers have had time to adjust their prices according to economic shocks.
• Characteristics:     - All production costs are considered fully flexible in the long run.     - The LRAS curve represents an economy’s potential output.     - It represents the "full-employment output" level.
• Shifters that Increase LRAS:     - Increases in the quantity of resources: This includes increases in land or labor.     - Increases in the quality of resources: Examples include improvements in education or specialized training.     - Technological progress: Advancements in technology can lead to an increase in LRAS.
• Economic Significance: Shifts in the LRAS indicate changes in the full-employment level of output and the rate of economic growth. A decrease in LRAS is caused by the opposite of the factors listed above.

AD-AS MODEL DYNAMICS

• Equilibrium Adjustments:     - If the aggregate price level ($PL$) is above equilibrium, Aggregate Supply ($AS$) will exceed Aggregate Demand ($AD$), causing the price level to fall back to the equilibrium point.     - If the aggregate price level ($PL$) is below equilibrium, Aggregate Demand ($AD$) will exceed Aggregate Supply ($AS$), causing the price level to rise back toward the equilibrium point.
• Economic Shocks:     - Positive demand shock: Increases both the aggregate price level and aggregate output (often called demand-pull inflation).     - Negative demand shock: Decreases both the aggregate price level and aggregate output.     - Positive supply shock: Decreases the aggregate price level and increases aggregate output.     - Negative supply shock: Increases the aggregate price level and decreases aggregate output (often called supply-push inflation).
• Economic Gaps:     - Recessionary gap: This exists when the Short-run Aggregate Supply equilibrium is less than the Long-run Aggregate Supply equilibrium ($SRAS_{eq} < LRAS_{eq}$). To correct this, wages would eventually fall, shifting the SRAS to the right and returning the economy to the LRAS equilibrium.     - Inflationary gap: This exists when the Short-run Aggregate Supply equilibrium is greater than the Long-run Aggregate Supply equilibrium ($SRAS_{eq} > LRAS_{eq}$). To correct this, wages would rise and SRAS would shift to the right, bringing the economy back to LRAS equilibrium.
• Self-Correction: The economy is understood to self-correct in the long-run.

EQUILIBRIUM DEFINITIONS

• Short-run equilibrium: This occurs at the point where Aggregate Demand ($AD$) and Short-run Aggregate Supply ($SRAS$) are equal.
• Long-run equilibrium: This occurs when Aggregate Demand ($AD$) and Short-run Aggregate Supply ($SRAS$) are equal, and that intersection point lies on the Long-run Aggregate Supply ($LRAS$) curve.

FISCAL POLICIES

• Expansionary Fiscal Policies: These policies are designed to increase aggregate demand and are typically used during recessions. They include:     - Increase in government purchases: This has the greatest effect on the economy.     - Cut in taxes.     - Increase in government transfers.
• Contractionary Fiscal Policies: These policies are designed to decrease aggregate demand and are typically used during economic expansions (to prevent overheating). They include:     - Decrease in government purchases.     - Increase in taxes.     - Decrease in government transfers.
• Fiscal Policy Formulas and Multipliers:     - MPC (Marginal Propensity to Consume): $MPC = \frac{\Delta \text{Consumer Spending}}{\Delta \text{Disposable Income}}$     - Relationship between MPC and MPS: $\text{MPC} + \text{MPS} = 1$     - Tax Multiplier: $\text{Multiplier} = \frac{\text{MPC}}{\text{MPS}}$     - MPS (Marginal Propensity to Save): $\text{MPS} = 1 - \text{MPC}$

AUTOMATIC STABILIZERS

• Definition: Rules regarding government spending and taxation that cause fiscal policy to be automatically expansionary during recessions and contractionary during expansions without requiring deliberate action by policymakers.
• Examples:     - Recessionary Automatic Stabilization: Tax revenues automatically decrease as Gross Domestic Product ($GDP$) falls. This increases consumption and prevents the economy from falling into a deeper recession.     - Expansionary Automatic Stabilization: Tax revenues automatically increase as Gross Domestic Product ($GDP$) rises. This decreases consumption and prevents the economy from overheating.

KEY TERMS AND ABBREVIATIONS

• UMP: Unemployment
• PL: Price level
• MB: Market basket
• G&S: Goods and services
• PV: Present value
• FV: Future value
• RGP: Real gross domestic product
• AD: Aggregate demand
• SRAS: Short-run aggregate supply
• LRAS: Long-run aggregate supply
• SRPC: Short-run Phillip’s curve
• LRPC: Long-run Phillip’s curve
• PPC: Production possibilities curve