Macroeconomic Models

Why This Matters

Macroeconomic models are the analytical tools you'll use to explain virtually everything on the AP Macroeconomics exam—from why recessions happen to how the Fed fights inflation. These aren't just abstract diagrams; they're frameworks for understanding how aggregate demand, aggregate supply, interest rates, and unemployment interact to determine economic outcomes. The AP exam will test your ability to use these models to predict what happens when policies change or shocks hit the economy, so you need to know which model applies to which situation and how to shift curves correctly.

Think of these models as different lenses for viewing the same economy. The AD-AS model shows you price levels and output, the Phillips Curve reveals inflation-unemployment trade-offs, and the money market model explains how interest rates are determined. You're being tested on your ability to connect these models—understanding that a shift in one often triggers changes in another. Don't just memorize the shapes of curves; know what forces cause them to shift and what economic outcomes result.

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Models for Output and Price Level Determination

These models explain how an economy reaches equilibrium levels of real GDP and the price level. They're your go-to frameworks for analyzing recessions, inflation, and the effects of fiscal and monetary policy.

Aggregate Demand-Aggregate Supply (AD-AS) Model

• The AD curve slopes downward due to three effects: the real wealth effect (higher prices reduce purchasing power), the interest rate effect (higher prices increase money demand and interest rates), and the exchange rate effect (higher prices make exports less competitive)
• SRAS slopes upward because of sticky wages and prices—firms can increase output when prices rise but wages are fixed by contracts, boosting profit margins temporarily
• LRAS is vertical at potential GDP ($Y^*$), representing the economy's maximum sustainable output when all resources are fully employed

Short-Run Aggregate Supply (SRAS)

• Sticky wages and menu costs explain why SRAS slopes upward—nominal rigidities prevent immediate price adjustments, so firms respond to higher price levels by producing more
• Supply shocks shift SRAS—an increase in input costs (like oil prices) shifts SRAS left, causing cost-push inflation and reduced output simultaneously
• The gap between current output and potential GDP determines whether the economy faces a recessionary gap (output below $Y^*$) or an inflationary gap (output above $Y^*$)

Long-Run Aggregate Supply (LRAS)

• LRAS is vertical at full-employment output because in the long run, wages and prices are fully flexible, so changes in the price level don't affect real output
• Shifts in LRAS represent changes in productive capacity—technological progress, capital accumulation, labor force growth, and human capital improvements all shift LRAS rightward
• LRAS connects directly to the PPC—both represent the economy's maximum sustainable production given available resources and technology

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Models for Policy Analysis

These frameworks help you trace the effects of government spending, taxation, and monetary policy through the economy. Master these for any policy-related FRQ.

Keynesian Cross Model

• The 45-degree line shows where aggregate expenditure equals output—equilibrium occurs where planned spending ($AE = C + I + G + NX$) intersects this line
• The spending multiplier amplifies fiscal policy effects—the formula $\frac{1}{1-MPC}$ shows how an initial change in spending creates larger changes in equilibrium GDP
• Recessionary gaps close through increased government spending—Keynes argued that when private demand falls short, government intervention can restore full employment

Fiscal Policy in the AD-AS Framework

• Government spending shifts AD directly while tax changes work indirectly through consumption—this is why the spending multiplier exceeds the tax multiplier
• The crowding-out effect limits fiscal policy effectiveness—government borrowing raises interest rates, reducing private investment and partially offsetting the stimulus
• Policy lags create timing challenges—recognition lag, legislative lag, and implementation lag mean fiscal policy may take effect after the problem has passed

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Models for Inflation-Unemployment Trade-offs

The Phillips Curve framework is essential for understanding why policymakers face difficult choices and how expectations shape economic outcomes.

Short-Run Phillips Curve (SRPC)

• The SRPC shows an inverse relationship between inflation and unemployment—expansionary policy can reduce unemployment but at the cost of higher inflation
• Demand shocks cause movement along the SRPC—an increase in AD raises inflation and lowers unemployment, moving the economy up and left along the curve
• Supply shocks shift the entire SRPC—adverse supply shocks (like oil price spikes) shift the curve outward, causing stagflation with both higher inflation and higher unemployment

Long-Run Phillips Curve (LRPC)

• The LRPC is vertical at the natural rate of unemployment—in the long run, there's no trade-off because inflation expectations fully adjust to actual inflation
• The natural rate reflects structural unemployment—factors like labor market frictions, demographics, and unemployment benefits determine where the LRPC sits
• Expectations determine SRPC position—when expected inflation rises, the SRPC shifts upward; credible central bank policy can anchor expectations and stabilize the curve

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Foundational and Conceptual Models

These models provide the building blocks for understanding economic flows and long-term growth—concepts that underpin more complex analysis.

Circular Flow Model

• Households supply factors of production to firms and receive income (wages, rent, interest, profits) in return through the factor market
• Leakages and injections determine equilibrium—savings, taxes, and imports leak out while investment, government spending, and exports inject back in
• GDP can be measured three ways—as total expenditure, total income, or total output, all of which are equivalent in the circular flow

Classical Model

• Say's Law argues supply creates its own demand—in the long run, markets self-correct because flexible prices and wages ensure all output gets purchased
• Full employment is the normal state because wage flexibility clears the labor market—unemployment above the natural rate is temporary
• Government intervention is unnecessary for stabilization since markets naturally return to equilibrium; classical economists favor policies promoting long-term growth

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Advanced Models (Beyond Core AP Curriculum)

These models appear in advanced economics but connect to AP concepts. Understanding their basic premises can deepen your grasp of core material.

IS-LM Model

• The IS curve shows goods market equilibrium—combinations of interest rates and output where planned investment equals saving; it slopes downward because lower rates boost investment
• The LM curve shows money market equilibrium—combinations where money demand equals money supply; it slopes upward because higher output increases money demand
• Fiscal policy shifts IS while monetary policy shifts LM—this framework explains how both policies affect interest rates and output simultaneously

Monetarist Model

• The quantity theory of money ($MV = PY$) argues that changes in money supply directly affect nominal GDP—velocity is assumed stable in the long run
• Inflation is always a monetary phenomenon—monetarists like Friedman argued that sustained inflation results only from excessive money supply growth
• Rules-based policy beats discretion—monetarists advocate steady money supply growth rather than active intervention, which they see as destabilizing

Real Business Cycle Model

• Real shocks drive economic fluctuations—technology changes and productivity shifts, not monetary factors, explain most business cycle movements
• Markets are always in equilibrium—prices adjust instantly, so observed fluctuations represent optimal responses to changing conditions
• Policy intervention is ineffective—since fluctuations reflect rational responses to real shocks, government stabilization efforts are unnecessary or counterproductive

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Quick Reference Table

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Self-Check Questions

1. How does the AD-AS model show the difference between a demand shock and a supply shock? Which curves shift in each case, and what happens to the price level and output?

2. Compare the SRPC and LRPC: Why does the short-run trade-off between inflation and unemployment disappear in the long run?

3. If the government increases spending during a recession, trace the effects through both the Keynesian Cross model and the AD-AS model. What role does the multiplier play?

4. Why is LRAS vertical while SRAS slopes upward? What assumption about wages and prices differs between the short run and long run?

5. An FRQ asks you to explain stagflation using the Phillips Curve framework. Which curve shifts, in which direction, and what combination of inflation and unemployment results?