Unit 3: National Income and Price Determination

Aggregate Demand (AD)

The total demand for all final goods and services in an economy at a given time and at various price levels.

Components of Aggregate Demand

AD = C + I + G + (X - M), where C is Consumer Spending, I is Investment Spending, G is Government Spending, and (X - M) is Net Exports.

Real Wealth Effect

When the price level falls, the purchasing power of assets increases, leading consumers to buy more goods and services.

Interest Rate Effect

When the price level rises, consumers need more money for goods, increasing demand for money and hence interest rates, which discourages investment.

Exchange Rate Effect

If domestic price levels rise relative to foreign countries, domestic goods become expensive to foreigners, reducing exports.

Shift in Aggregate Demand Curve

A change in any component of AD (C, I, G, X) shifts the entire AD curve.

Right Shift in AD

Occurs due to high consumer confidence, lower taxes, increased government spending, or lower interest rates.

Left Shift in AD

Triggered by recessions in trading partners, decreased wealth, or cuts in government spending.

Multiplier Effect

The concept that one person's spending becomes another person's income, leading to further spending.

Marginal Propensity to Consume (MPC)

The fraction of an additional dollar of income that is spent.

Marginal Propensity to Save (MPS)

The fraction of an additional dollar of income that is saved.

Spending Multiplier Formula

Spending Multiplier = 1 / MPS or 1 / (1-MPC). Used for changes in G, I, or autonomous Consumption.

Tax Multiplier Formula

Tax Multiplier = -MPC / MPS; always negative, indicating higher taxes reduce GDP.

Balanced Budget Multiplier

Always 1; if the government taxes and spends the same amount, GDP rises by that amount.

Short-Run Aggregate Supply (SRAS)

Total production of goods and services at different price levels; upward-sloping due to sticky wages.

Sticky Wages

Wages are slow to adjust to inflation, leading firms to supply more output when prices rise.

Shifters of SRAS

Resource prices, actions of government (taxes, subsidies), and productivity (technology improvements).

Long-Run Aggregate Supply (LRAS)

Vertical curve representing the economy's potential GDP at Full Employment Output.

Shifters of LRAS

Anything changing the capacity of production: new technology, capital, labor, or natural resource discoveries.

Equilibrium in AD and SRAS

The point where AD and SRAS intersect, determining equilibrium Price Level and Real GDP.

Common Mistake: Interest Rate Effect

Do not confuse with Federal Reserve interest rate changes; it's about the AD curve slope due to price levels.

Spending vs. Tax Multiplier

Spending Multiplier has a greater impact on the economy immediately than the Tax Multiplier.

Wages in AS/AD Model

Wages primarily affect SRAS as input costs, not directly AD.

Short Run vs. Long Run

Monitor if a question pertains to immediate impacts (SRAS shifts) or long-run adjustments (wage adjustments).