Unit 3 National Income and Price Determination Summary

Aggregate Demand

• Demand for everything

• Price Level

• Quantity: Real GDP

Downward Sloping:

• Real Wealth Effect

  • Higher price levels shrink the purchasing power of money. Decreases the quantity of expenditures.

    • Purchasing power is currency in terms of goods or services one unit of it can buy.

• The Interest Rate Effect

  • When the price level increases, lenders charge higher interest rates to get a return on their loans

  • Higher interest rates discourage consumer spending and business investment.

• The Foreign Trade Effect

  • When the US price level rises, foreign buyers purchase fewer US goods, and Americans buy more foreign goods.

  • Exports fall and imports rise, causing real GDP demand to fall. (Xn Decreases)

• Negative relationship between price level and the Real GDP

• Shifters = C+I+G+Xn

  • Consumer spending

  • Investment Business spending

  • Governance spending

  • Net exports

• Multiplier Effect: Initial change in spending causes a bigger change in spending in the economy.

  • One person’s spending becomes somebody else’s income, and that person saves a portion and spends the rest.

• Marginal Prospensity to Save (MPS)

  • How much people save rather than consume when there is a change in disposable income

  • It is also always expressed as a fraction (Decimal).

  • MPS = Change in Savings/Change in Disposable Income

• Marginal Propensity to Consume (MPC)

  • How much people consume rather than save when there is a change in disposable income

  • It is always expressed as a fraction (decimal).

  • MPC = Change in consumption/Change in Disposable income

• Equation for spending multiplier: 1/MPS or 1/1-MPC

• Simple tax multiplier: MPC x 1/MPS OR MPC/MPS

• Short-run aggregate supply

  • When price level goes up produces have an incentive to produce more

  • When the price level goes down, producers are going to produce less in the short run

• In the short run, wages and resource prices DONT CHANGE 

• In the long run, wages and resource prices are going to adjust

• Methods that can change the curve:

  • Change in the price of resources

  • Change in taxes, subsidies, and/or regulations

  • Change in productivity

  • Expectations

• No relationship between price level and real gdp in long run

• Negative output gap

• Full employment

• Positive output gap

• Negative supply shock loss of key resource

• Positive supply shock increase in key resource

• Cost push - supply shift to the left, producing less stuff

• Demand pull - demand is increasing

• Real gdp is opposite of unemployment

• Long-run adjustment shortened supply because wages and resource prices adjust

• Fiscal policy

• Expansionary and contractionary

• Expnasionary fiscal policy

  • Laws that reduce unemployment and increase gdp

    • Increase government spending

    • Decrease taxes

    • Combinations of the two

• Contractionary fiscal policy

  • Laws that reduce inflation, decrease gdp

    • Decrease government spending

    • Increase taxes (decreasing disposable income)

    • Combinations of the two

• Discrentionary Fiscal Policy

  • Congress creates a new bill that is designed 2 change

  • AD thru gov spending or taxation

  • One problem lag time due 2 bureaucracy

  • It takes time for congress 2 act

  • Ex: in a recession, congress increases spending.

• Non-discretionary fiscal policy

  • Automatic stabilizers

  • Permanent spending or taxation laws 2 work counter cylically to stablize economu

  • When gdp goes down, gov spending automatically increases & taxes automatically fall

  • Ex: welfare, unemployment, income tax