AP Macro Unit 3 Notes: National Income and Price

Unit Three: National Income and Price Concepts

Key Concepts

1. Multipliers

  • Definition: Economic concept that measures the effect of initial spending on overall GDP as it ripples through the economy.

  • Key components:

    • Disposable Income: Personal income minus taxes.

    • Consumers have two choices for disposable income: spend or save.

Marginal Propensity to Consume (MPC)

  • Definition: Percentage of new income that a consumer is likely to spend.

  • Can be expressed as a decimal. Example:

    • If disposable income increases by $1,000:

    • Spending increases by $800 → MPC = 0.8 (or 80%)

    • Savings increases by $200 → MPS = 0.2 (or 20%)

Marginal Propensity to Save (MPS)

  • Definition: Percentage of new disposable income that a consumer saves rather than spends.

  • Connection: MPC + MPS = 1

Example of Spending Ripple Effect

  • Initial spending: $800 on a fishing boat.

  • Boat store owner now has:

    • New disposable income: $800

    • Spend 80% ($640) → Buys a new bicycle

    • Bicycle store owner then spends 80% of $640… and so on.

  • Example expenditure sequence:

    • Boat → Bicycle → Television → Trip → Gym Membership

  • Continuous spending leads to a larger impact on GDP.

2. Spending Multiplier

  • Formula: extSpendingMultiplier=rac1MPS=rac11−MPCext{Spending Multiplier} = rac{1}{MPS} = rac{1}{1 - MPC}

    • Example Calculation:

    • Given MPS = 0.2 →

    • extSpendingMultiplier=rac10.2=5ext{Spending Multiplier} = rac{1}{0.2} = 5

  • Economic impact of increased consumption:

    • Initial spending of $800 can result in a $4,000 increase in GDP.

3. Tax Multiplier

  • Definition: Evaluates the impact of tax changes on overall disposable income and therefore GDP.

  • Formula: extTaxMultiplier=rac−MPCMPSext{Tax Multiplier} = rac{-MPC}{MPS}

    • Absolute value of tax multiplier is one less than spending multiplier.

  • Example Calculation:

    • Given MPC = 0.8 and MPS = 0.2:

    • extTaxMultiplier=rac−0.80.2=−4ext{Tax Multiplier} = rac{-0.8}{0.2} = -4

  • Implication of tax reduction:

    • A decrease of $10 million in taxes could lead to a maximum of $40 million increase in GDP.

ASAD Model of the Economy

1. Aggregate Demand Curve

  • Definition: Represents the total demand for all goods and services in the economy.

  • Graphical Representation: Price level y-axis, Real GDP x-axis.

  • Shape: Downward sloping, indicating an inverse relationship between price level and output.

Reasons for Downward Sloping Aggregate Demand Curve

  1. Wealth Effect: As prices fall, real wealth increases, leading to increased purchasing.

  2. Interest Rate Effect: Lower price levels lead to lower interest rates and higher investment.

  3. Net Export Effect: At lower prices, exports become cheaper, increasing demand from foreign countries.

2. Shifters of Aggregate Demand

  • Four main components affecting aggregate demand (represented as C + IG + G + XN):

    1. Consumer Spending (C)

    2. Gross Investment (IG)

    3. Government Purchases (G)

    4. Net Exports (XN)

  • Impact on Curve: An increase in any of the components shifts the aggregate demand curve to the right; a decrease shifts it to the left.

3. Short-Run Aggregate Supply Curve (SRAS)

  • Represents total supply of goods and services within the economy in the short run.

  • Relationship: Direct—higher prices lead to higher output due to sticky wages and resource prices.

  • Direction of curve shifts:

    • Factors creating shifts in SRAS:

    1. Resource Prices: Higher resource prices → left shift; Lower → right shift.

    2. Productivity: Increase → right shift.

    3. Inflation Expectations: Higher expectations → left shift; Lower expectations → right shift.

    4. Business Taxes: Decrease in business taxes → right shift; Increase → left shift.

    5. Business Regulations: Increase → left shift; Decrease → right shift.

4. Long-Run Aggregate Supply Curve (LRAS)

  • Characteristics: Vertical at the full employment level of output (denoted as YF).

  • Implication: Long run output is not affected by price levels as wages are flexible.

  • Represents long-standing potential output which can be influenced by various economic factors (resources, productivity, technology changes).

  • Shifts in LRAS:

    • Inward shift indicates reduced potential (e.g., natural disasters).

    • Outward shift indicates increased potential (e.g., technological advancements).

5. Equilibrium in ASAD Model

  • Short-run Equilibrium: Occurs at the intersection of AD and SRAS.

  • Inflationary Gap: When current output exceeds long-run potential (Y1 > YF), typically characterized by low unemployment.

  • Recessionary Gap: When current output is below long-run potential (Y1 < YF), indicating high unemployment and low national income.

  • Long-Run Equilibrium: The point where AD intersects LRAS; current output equals full employment output. Unemployment is at natural rate.

Shocks to the Economy

  • Demand Shocks: Increase in net exports leading to inflationary gap caused by increases in AD. Conversely, a decrease in consumer confidence leads to lower price levels—negative demand shock.

  • Supply Shocks: Changes in SRAS from external factors (e.g., oil prices affect production).

    • Positive shocks (e.g., drop in oil prices) can shift SRAS right, causing price levels to fall and output to increase—indicating an inflationary gap.

    • Negative shocks (e.g., external costs) can shift SRAS left, causing price levels to rise and output to decrease, associated with cost-push inflation (stagflation).

Long-term Adjustments to Equilibrium

  • Self-Correction without Intervention: In recessionary gap, lower wages lead SRAS back to equilibrium; in inflationary gap, rising wages shift SRAS left.

Fiscal Policy Adjustments

  • Expansionary Fiscal Policy: Used to combat unemployment by increasing government spending or reducing taxes, shifting AD to the right, restoring employment.

  • Contractionary Fiscal Policy: Used to address inflation by decreasing government spending or raising taxes, shifting AD left to return to equilibrium.

  • Automatic Stabilizers: Mechanisms that adjust based on business cycle changes, affecting budget deficits without active intervention (e.g., taxes and transfer payments) to mitigate economic fluctuations.Conclusion

  • Strong grasp of multipliers, ASAD model, various shifts, and their impact on GDP is essential.

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