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UNIT 3: NATIONAL INCOME AND PRICE DETERMINATION

• AP MACROECONOMICS

• AP EXAM WEIGHTING: 17-27%

• Instructor: Mr. N 2024-25

AD-AS Model Overview

Aggregate Market

• Definition: The economy-wide dynamics and forces of all buyers and sellers of final-use products.

Axes of the AD-AS Model

• Y-Axis:

  • Represents Price Level (PL), measured by CPI or GDP Deflator.

  • Higher price levels indicate more expensive goods/services; lower levels lead to cheaper prices.

• X-Axis:

  • Represents Real GDP (RGDP), the total quantity of goods/services produced.

  • Higher RGDP indicates more economic output (growth); lower RGDP indicates less output (recession).

Aggregate Demand (AD)

Definition and Relationship

• AD is the total quantity of goods and services demanded at different price levels.

• The downward slope of the AD curve indicates an inverse relationship between PL and RGDP demanded:

  • Higher PL → Lower RGDP Demanded

  • Lower PL → Higher RGDP Demanded

Reasons for Negative Slope (AD Curve)

1. Real Wealth Effect

   • Higher prices reduce purchasing power, leading to lower consumption.

   • Example: $1,000 buys less if prices increase by 10%.

2. Interest Rate Effect

   • Higher prices increase demand for money, driving up interest rates and reducing borrowing and investment.

   • Example: Increased inflation leads banks to raise interest rates, slowing down borrowing.

3. Exchange Rate Effect

   • Higher domestic prices lead to reduced exports and increased imports.

   • Example: U.S. inflation makes American cars more expensive for foreigners.

Shifters of the AD Curve

• Components of AD:

1. Consumer Spending: Changes due to consumer confidence, wealth, and interest rates.

2. Investment Spending: Influenced by business sentiment, interest rates, and technology advancements.

3. Government Spending: Direct impact from fiscal policy changes.

4. Net Exports (NX): Affected by foreign income and exchange rates.

Spending Multiplier

Key Concepts

• Multiplier Effect: $1 of spending leads to more than $1 in economic impact due to repeated spending.

• Marginal Propensity to Consume (MPC): The proportion of an additional dollar spent rather than saved.

Examples of Government Spending Impact

• Historical instances of government stimulus (e.g., New Deal, WWII funding, 2008 economic stimulus, Covid-19 relief) demonstrate how fiscal policy can boost aggregate demand.

Calculation of Multiplier

1. Spending Multiplier Formula:

   • Multiplier = 1 / Marginal Propensity to Save (MPS)

2. Total GDP Change:

   • Total Change = Multiplier x Spending Increase

Practice Problems

• Practical examples of calculating spending multiplier effects based on MPS and GDP increase.

Short-Run Aggregate Supply (SRAS)

Definition

• SRAS illustrates the relationship between PL and RGDP supply willingness in the short run.

• Key Idea: Higher PL leads to more production; lower PL leads to less.

Factors Affecting SRAS

1. Sticky Wages: Wages do not adjust immediately, benefiting firms by increasing output at unchanged wage levels.

2. Resource Costs: Variations in wages or raw material prices affecting production capacity.

3. Productivity and Technology Changes: Improved technology can shift SRAS right; negative events can shift it left.

4. Government Policies: Taxes and regulations can either increase or decrease SRAS.

5. Supply Shocks: Unexpected events can have significant impacts on production capabilities.

Long-Run Aggregate Supply (LRAS)

Characteristics

• LRAS is vertical, indicating that in the long run, output is determined by resources, technology, and productivity—not price levels.

Long-Run Adjustment

• When price levels fluctuate, the economy may experience adjustments returning to potential output via wage and input cost adjustments.

Shifters of LRAS

• Factors influencing shifts in LRAS include changes in resources, technology advancements, and government policies.

Equilibrium in the AD-AS Model

Long-Run Equilibrium

• Conditions:

  • Full employment, where current output equals long-run output, and unemployment is at its natural rate.

  • Inflation must be stable, ensuring sustainable economic output.

Changes in the AD-AS Model

Scenarios

1. Positive Demand Shock: Increase in AD lowers unemployment and raises inflation.

2. Negative Demand Shock: Decrease in AD results in higher unemployment and potential deflation.

3. Positive Supply Shock: Leads to lower prices and increased output.

4. Negative Supply Shock: Often results in stagflation, where inflation and unemployment rise simultaneously.

Historical Examples of Inflation and Unemployment Relationship

1. COVID-19 Stimulus Checks: Increased demand and spending led to rising inflation.

2. 1990s Tech Boom: Innovations led to GDP growth with low inflation.

3. 1970s Oil Crisis: Buoyant oil prices caused inflation and decreased output.

4. 2008 Great Recession: Economic crash lowered AD significantly, leading to a recessionary gap.

Long-Run Self-Adjustment

• In absence of intervention, the economy is expected to adjust back to equilibrium over time through shifts in wages and resource prices.

Fiscal Policy Influence

Keynesian Perspective

• Emphasizes the need for active government intervention in economic downturns due to delays in self-correction processes .