AP Macroeconomics Unit 3 ReviewNational Income and Price Determination

AP Macro Unit 3 is where the course's central tool, the aggregate demand-aggregate supply (AD-AS) model, comes together. The big idea is that one graph can show how output, employment, and the price level all respond when something hits the economy, whether that's a drop in consumer confidence, an oil price spike, or a government stimulus package. You'll also learn the multiplier math that turns a $100 billion spending change into a bigger change in real GDP, and how fiscal policy uses these mechanics on purpose. Unit 3 is 17-27% of the AP exam, tied for the largest weight of any unit, and nearly everything in Units 4 through 6 builds on it.

What this unit covers

Aggregate demand and why it slopes down

• The AD curve shows the relationship between the price level and the total quantity of goods and services demanded by households (consumption), firms (investment), the government (government spending), and the rest of the world (net exports). Same components as GDP, which is no accident.
• AD slopes downward for three reasons. The real wealth effect (higher prices shrink the purchasing power of your savings, so you buy less), the interest rate effect (higher prices push interest rates up, which discourages borrowing and investment), and the exchange rate effect (higher domestic prices make exports pricier abroad, so net exports fall).
• Any change in C, I, G, or net exports that is NOT caused by the price level shifts the whole AD curve. Think consumer confidence, business expectations, tax changes, or foreign income changes.

The multiplier effect

• A $1 change in autonomous spending doesn't just change GDP by $1. The first dollar becomes someone's income, they spend part of it, that becomes someone else's income, and so on. The total effect is a multiple of the initial change.
• How much of each new dollar gets spent is the marginal propensity to consume (MPC). What gets saved is the marginal propensity to save (MPS), and MPC + MPS = 1.
• The expenditure multiplier is 1/MPS, or 1/(1-MPC). If MPC = 0.8, the multiplier is 5, so $20 billion of new government spending can raise GDP by up to $100 billion.
• The tax multiplier is smaller (its absolute value is MPC/MPS) because a tax cut only enters the spending stream after households save part of it. A $1 spending increase moves AD more than a $1 tax cut.

Aggregate supply, short run vs. long run

• The SRAS curve slopes upward because wages and some prices are "sticky" in the short run. When the price level rises but wages haven't caught up, producing more becomes profitable, so firms expand output and hire more workers. That's the short-run trade-off between inflation and unemployment.
• SRAS shifts when production costs change, including input prices, productivity, and inflationary expectations.
• In the long run, all wages and prices are fully flexible, so the LRAS curve is vertical at the full-employment level of output. There is no long-run trade-off between inflation and unemployment.
• LRAS is the production possibilities curve from Unit 1 drawn a different way. Both represent the economy's maximum sustainable capacity, and both shift only when resources or technology change.

Equilibrium, gaps, and shocks

• Short-run equilibrium is where AD and SRAS cross. Long-run equilibrium is where AD and SRAS cross on the LRAS curve, at full employment.
• If short-run equilibrium output sits below full employment, the economy has a negative (recessionary) gap. If it sits above, there's a positive (inflationary) gap.
• A positive AD shock raises output, employment, and the price level together. A negative AD shock lowers all three. Inflation driven by AD shifts is demand-pull inflation.
• A negative SRAS shock (like a sudden jump in oil prices) is nastier. Output and employment fall while the price level rises, which is stagflation. Inflation from this side is cost-push inflation.
• Left alone, the economy self-corrects. In a recessionary gap, high unemployment eventually pushes nominal wages down, SRAS shifts right, and output returns to full employment at a lower price level. In an inflationary gap, the process runs in reverse. Unemployment reverts to its natural rate either way.

Fiscal policy and automatic stabilizers

• Fiscal policy means the government deliberately changes spending or taxes/transfers to close output gaps. Expansionary policy (more spending, lower taxes) fights recessions. Contractionary policy (less spending, higher taxes) cools an inflationary gap.
• Government spending hits AD directly. Taxes and transfers hit AD indirectly through consumption, which is why the spending multiplier is bigger than the tax multiplier.
• Discretionary fiscal policy has lags. It takes time to recognize a problem, pass a law, and roll the money out, so policy can arrive late.
• Automatic stabilizers work without any new legislation. Tax revenues fall automatically as GDP falls (cushioning the drop in consumption) and rise as GDP rises (slowing an overheating economy). Transfer programs like unemployment insurance do the same thing from the spending side.

Unit 3, National Income and Price Determination at a glance

Why Unit 3, National Income and Price Determination matters in AP Macro

Unit 3 hands you the model the rest of the course runs on. Units 1 and 2 gave you concepts and measurements; this unit gives you the machine that explains why those measurements move. Almost every policy question in AP Macro ultimately asks you to shift a curve in the AD-AS model and read off what happens to output, employment, and the price level.

• The AD-AS graph is the single most drawn graph on the AP Macro free-response section, and this is the unit where you learn to build and label it correctly.
• Demand-pull vs. cost-push inflation explains why the same symptom (rising prices) can have two very different causes and very different policy responses.
• Long-run self-adjustment sets up the core policy debate of the course, whether to intervene with fiscal or monetary policy or let flexible wages fix things on their own.
• Multiplier math is one of the few places in AP Macro where you calculate exact dollar effects, and it reappears whenever fiscal policy comes up.

How this unit connects across the course

• The business cycle, unemployment, and inflation you measured in Economic Indicators and the Business Cycle (Unit 2) become positions on the AD-AS graph here. A recession is a negative output gap; demand-pull inflation is AD pushing past LRAS.
• The interest rate effect behind AD's slope previews the Financial Sector (Unit 4), where you'll see exactly how interest rates are determined in the money market and how monetary policy shifts AD the same way fiscal policy does here.
• Long-run self-adjustment and the inflation-unemployment trade-off feed directly into the Phillips curve and the policy debates of Long-Run Consequences of Stabilization Policies (Unit 5). LRAS shifts are also how that unit models economic growth.
• Net exports as a component of AD sets up Open Economy-International Trade and Finance (Unit 6), where exchange rates and trade flows become AD shifters you analyze in detail. LRAS itself echoes the production possibilities curve from Basic Economic Concepts (Unit 1).

Key models and graphs to know

• AD-AS model (AD, SRAS, LRAS on one graph): the workhorse for showing how shocks and policies change real output and the price level; label axes as price level (PL) and real GDP, mark full-employment output where LRAS sits.
• Recessionary gap graph: AD and SRAS intersect at output below LRAS; used whenever a question describes a recession or rising unemployment.
• Inflationary gap graph: AD and SRAS intersect at output above LRAS; used for overheating economies and demand-pull inflation prompts.
• Long-run self-adjustment: show SRAS shifting (right after a recessionary gap, left after an inflationary gap) as wages adjust and output returns to full employment.
• Spending multiplier: multiplier = 1/MPS = 1/(1-MPC); multiply by the initial spending change to get the maximum change in real GDP.
• Tax multiplier: -MPC/MPS; smaller in absolute value than the spending multiplier because part of any tax change leaks into saving first.
• MPC and MPS: MPC = change in consumption / change in income, MPS = change in saving / change in income, and MPC + MPS = 1.

Unit 3, National Income and Price Determination on the AP exam

Unit 3 carries 17-27% of the exam weight, the heaviest band in AP Macro (shared with Unit 4). Multiple-choice questions test the mechanics directly. You'll identify which curve shifts and in which direction given a scenario, predict what happens to output, employment, and the price level, and calculate multiplier effects from a given MPC or MPS. On the free-response section, this unit is the backbone of the classic policy question. A typical prompt describes an economy in a recessionary or inflationary gap, asks you to draw a correctly labeled AD-AS graph showing the gap, then asks you to identify an appropriate fiscal policy, show its effect on the graph, and sometimes calculate the minimum spending or tax change needed to close the gap using the multiplier. Precise labeling matters. The axes, all three curves, equilibrium points, and full-employment output each need to be marked, and points are earned line by line. Practice drawing the gap graphs from memory until the labels are automatic.

Essential questions

• Why does an economy's total output and price level settle where they do, and what makes them change?
• How can a relatively small change in spending or taxes produce a much larger change in real GDP?
• Why does inflation sometimes come with falling unemployment and sometimes with rising unemployment?
• If the economy fixes itself in the long run, why would the government ever intervene with fiscal policy?

Key terms to know

• Aggregate demand (AD): the relationship between the price level and total output demanded by households, firms, government, and the rest of the world.
• Real wealth effect: when a higher price level reduces the purchasing power of assets, lowering consumption (one reason AD slopes down).
• Marginal propensity to consume (MPC): the fraction of each additional dollar of income that households spend.
• Expenditure multiplier: 1/MPS, the factor by which a change in autonomous spending changes total output.
• Tax multiplier: -MPC/MPS, the (smaller) factor by which a tax change moves total output.
• Short-run aggregate supply (SRAS): the upward-sloping relationship between the price level and output supplied when wages and some prices are sticky.
• Long-run aggregate supply (LRAS): the vertical curve at full-employment output, where all wages and prices have fully adjusted.
• Recessionary (negative output) gap: short-run equilibrium output below the full-employment level.
• Inflationary (positive output) gap: short-run equilibrium output above the full-employment level.
• Demand-pull inflation: a rising price level caused by an increase in aggregate demand.
• Cost-push inflation: a rising price level caused by a decrease in short-run aggregate supply, often from higher input costs.
• Stagflation: falling output and rising prices at the same time, the signature of a negative SRAS shock.
• Fiscal policy: deliberate changes in government spending or taxes/transfers to influence aggregate demand.
• Automatic stabilizers: taxes and transfer programs that adjust with GDP on their own, softening booms and recessions without new legislation.

Common mix-ups

• A change in the price level moves you ALONG the AD or SRAS curve. Only non-price factors (confidence, costs, policy) SHIFT the curves. If a question says "the price level rises," don't shift AD.
• The wealth, interest rate, and exchange rate effects explain AD's slope, not AD shifts. Shifts come from changes in C, I, G, or net exports.
• The tax multiplier is smaller than the spending multiplier because households save part of any tax cut before spending it. Equal-sized spending and tax changes do not have equal effects.
• Self-adjustment works through SRAS, not AD. To close a recessionary gap without policy, falling wages shift SRAS right; AD stays put.
• Demand-pull and cost-push inflation both raise the price level, but output rises with demand-pull and falls with cost-push. Check what happens to GDP to tell them apart.