AP Macroeconomics Unit 3 Review: National Income and Price Determination

The AD curve shows the inverse relationship between the price level and the total quantity of real GDP demanded by households (C), firms (I), government (G), and the rest of the world (NX). Its downward slope comes from three effects, not from the law of demand for a single good.

• Real wealth effect: A higher price level reduces the purchasing power of money balances, so households feel poorer and spend less.
• Interest rate effect: A higher price level increases money demand, pushing up interest rates, which reduces interest-sensitive investment and consumption.
• Exchange rate effect: Higher domestic prices make exports more expensive and imports cheaper, reducing net exports and total AD.
• AD shifters: Any change in C, I, G, or NX that is not caused by a price-level change shifts the entire AD curve left or right.

A change in autonomous spending triggers rounds of additional spending throughout the economy. The expenditure multiplier (1/(1-MPC)) is larger in absolute value than the tax multiplier (-MPC/(1-MPC)) because a tax cut first passes through household saving before becoming spending.

• MPC: Marginal propensity to consume: the fraction of each additional dollar of disposable income that households spend. MPC + MPS = 1.
• Expenditure multiplier: Equals 1/(1-MPC) or 1/MPS. Multiply this by the change in autonomous spending to find the total change in real GDP.
• Tax multiplier: Equals -MPC/(1-MPC). Smaller in absolute value than the expenditure multiplier because the first round of a tax cut is partly saved.
• Balanced-budget multiplier: When government spending and taxes rise by the same amount, real GDP rises by that same amount (multiplier equals 1).

The SRAS curve shows a positive relationship between the price level and real GDP supplied. It slopes upward because wages and some prices are sticky in the short run: firms can sell more at higher prices before input costs fully adjust. Moving along SRAS, higher output means lower unemployment, creating the short-run inflation-unemployment trade-off.

• Sticky wages: Nominal wage contracts and efficiency wages prevent wages from falling quickly, so firms respond to higher prices by producing more rather than raising wages immediately.
• SRAS shifters: Changes in input costs (wages, oil prices), inflationary expectations, business taxes, or productivity shift SRAS left or right.
• Cost-push inflation: A negative supply shock shifts SRAS left, raising the price level and reducing output simultaneously.
• Short-run inflation-unemployment trade-off: Along SRAS, higher output requires more employment, so rising output is associated with falling unemployment and rising inflation.

The LRAS curve is vertical at the full-employment level of output (Y*) because in the long run all wages and prices are fully flexible. A higher price level does not increase sustainable real GDP. LRAS corresponds to the PPC: both represent maximum sustainable capacity. LRAS shifts right only when the economy's productive capacity grows through more resources, better technology, or higher productivity.

• Full-employment output (Y*): The real GDP produced when all resources are fully employed at the natural rate of unemployment; the position of the LRAS curve.
• Long-run price and wage flexibility: In the long run, wages and prices adjust fully, eliminating any trade-off between inflation and unemployment.
• LRAS shifters: Increases in labor, capital, technology, or productivity shift LRAS right, raising potential output and economic growth.
• PPC and LRAS equivalence: Both the PPC and LRAS represent the economy's maximum sustainable output; a rightward LRAS shift is equivalent to an outward PPC shift.

Short-run equilibrium is where AD intersects SRAS, giving the short-run price level and real GDP. Long-run equilibrium requires AD and SRAS to intersect on the LRAS at full-employment output. When short-run equilibrium is to the left of LRAS, there is a recessionary gap; when it is to the right, there is an inflationary gap.

• Short-run equilibrium: The price level and real GDP at the intersection of AD and SRAS; may be above, below, or at full-employment output.
• Long-run equilibrium: AD, SRAS, and LRAS all intersect at full-employment output; no output gap exists.
• Recessionary gap: Short-run output is below Y*; unemployment exceeds the natural rate.
• Inflationary gap: Short-run output is above Y*; unemployment is below the natural rate and upward price pressure builds.

When AD or SRAS shifts, the short-run equilibrium changes. A positive AD shock raises output, employment, and the price level (demand-pull inflation). A negative SRAS shock raises the price level while reducing output and employment, producing stagflation. The direction of price-level and output changes together identifies whether the shock is on the demand or supply side.

• Positive AD shock: AD shifts right: real GDP rises, employment rises, price level rises. Example: a large increase in government spending.
• Negative AD shock: AD shifts left: real GDP falls, employment falls, price level falls. Example: a collapse in consumer confidence.
• Positive SRAS shock: SRAS shifts right: real GDP rises, employment rises, price level falls. Example: a drop in oil prices.
• Negative SRAS shock (stagflation): SRAS shifts left: real GDP falls, employment falls, price level rises. Example: a sharp rise in oil prices or wages.

Without government intervention, the economy self-corrects over time. In a recessionary gap, unemployment puts downward pressure on wages, lowering production costs and shifting SRAS right until output returns to Y*. In an inflationary gap, tight labor markets push wages up, shifting SRAS left until output falls back to Y*. Shifts in LRAS itself represent changes in the economy's long-run productive capacity.

• Self-correcting mechanism: Flexible wages and prices shift SRAS in the direction needed to close an output gap and restore full-employment output without policy action.
• Recessionary gap self-correction: Unemployment causes wages to fall, reducing production costs, shifting SRAS right, raising output back to Y* and lowering the price level.
• Inflationary gap self-correction: Labor shortages push wages up, raising production costs, shifting SRAS left, reducing output back to Y* and raising the price level.
• LRAS shifts and growth: A rightward LRAS shift means the economy's full-employment output has grown, reflecting long-run economic growth from capital, labor, or technology gains.

Fiscal policy uses government spending and taxes or transfers to shift AD toward full-employment output. Expansionary fiscal policy (increase G or cut taxes) shifts AD right to close a recessionary gap. Contractionary fiscal policy (cut G or raise taxes) shifts AD left to close an inflationary gap. Government spending shifts AD directly; tax changes work indirectly through household disposable income. The spending multiplier is always larger in absolute value than the tax multiplier, so a given dollar of spending has a bigger AD impact than the same dollar of tax change.

• Expansionary fiscal policy: Increase government spending, cut taxes, or raise transfers to shift AD right and close a recessionary gap.
• Contractionary fiscal policy: Cut government spending, raise taxes, or reduce transfers to shift AD left and close an inflationary gap.
• Spending vs. tax multiplier: Government spending multiplier (1/MPS) exceeds the tax multiplier (-MPC/MPS) in absolute value because a tax change is first filtered through household saving.
• Fiscal policy lags: Discretionary fiscal policy faces recognition lag (identifying the problem), legislative lag (passing a law), and implementation lag (spending reaching the economy).

Automatic stabilizers are tax and transfer systems that moderate business cycles without new legislation. During recessions, tax revenues fall automatically as incomes drop, and transfer payments such as unemployment insurance rise, both of which cushion the fall in disposable income and consumption. During expansions, rising incomes generate higher tax revenues that slow spending growth. Because no legislative action is needed, automatic stabilizers have no implementation lag.

• Automatic stabilizers: Tax and transfer mechanisms that automatically reduce fiscal drag during recessions and reduce overheating during expansions without new policy decisions.
• Progressive income taxes: Tax revenues fall automatically when incomes fall in a recession, preserving disposable income and limiting the drop in consumption.
• Unemployment insurance: Transfer payments that rise automatically during recessions, replacing some lost income and supporting consumer spending.
• No implementation lag: Unlike discretionary fiscal policy, automatic stabilizers respond immediately to economic conditions because they are built into existing law.