National Income and Price Determination: The AD-AS Model

Aggregate Demand (AD)

Total quantity of all goods and services demanded by the economy at different price levels.

AD Formula

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.

Consumer Spending (C)

Spending by households on goods and services.

Investment Spending (I)

Spending by businesses on physical capital, inventory, and new housing.

Government Spending (G)

Spending by the government on goods and services, excluding transfer payments.

Net Exports (X - M)

Exports minus Imports.

Real Wealth Effect

When the aggregate Price Level rises, the purchasing power of assets falls, leading to a decrease in quantity demanded.

Interest Rate Effect

When Price Level rises, interest rates increase, which decreases investment and consumption, leading to a lower quantity demanded.

Foreign Trade Effect

When U.S. Price Level rises, U.S. goods become expensive to foreigners and foreign goods become cheap to Americans, resulting in a decrease in net exports.

Determinants of AD

Factors that can shift the AD curve, including changes in C, I, G, or X.

Shift Right in AD Curve

Increase in spending leads to an increase in Real GDP and a decrease in unemployment.

Shift Left in AD Curve

Decrease in spending leads to a decrease in Real GDP and an increase in unemployment.

Marginal Propensity to Consume (MPC)

Fraction of any change in disposable income that is spent.

Marginal Propensity to Save (MPS)

Fraction of any change in disposable income that is saved.

The Rule of 1

MPC + MPS = 1.

Spending Multiplier

Multiplier_S = 1 / MPS or 1 / (1 - MPC). Used when there is a change in government spending or investment.

Tax Multiplier

Multiplier_T = -MPC / MPS. Always negative and less impactful than the spending multiplier.

Balanced Budget Multiplier

Equal to 1. A simultaneous increase in spending and taxes leads to a GDP increase equal to the amount spent.

Short-Run Aggregate Supply (SRAS)

Shows the relationship between the price level and the amount of real GDP supplied in the short run.

SRAS Upward Sloping

Producers are willing to supply more as price levels rise due to sticky input costs.

Shifters of SRAS

Resource prices, actions of government, and productivity changes that affect the SRAS curve.

Resource Prices Effect on SRAS

Changes in input costs like wages and commodity prices can shift the SRAS curve.

Actions of Government Effect on SRAS

Changes in taxes, subsidies, and regulations can shift the SRAS curve.

Productivity Effect on SRAS

Advancements in technology or human capital can shift the SRAS curve right.

Long-Run Aggregate Supply (LRAS)

Represents the economy's potential output when all resources are fully employed.

Vertical Slope of LRAS

In the long run, wages and input prices are flexible and do not affect the quantity of Real GDP produced.

Shifters of LRAS

Changes in quantity/quality of resources and technological advancements that shift the LRAS curve.

Macroeconomic Equilibrium

Occurs where AD intersects SRAS, determining the current price level and real GDP.

Recessionary Gap

Equilibrium GDP is to the left of LRAS, indicating higher unemployment and actual GDP below potential GDP.

Inflationary Gap

Equilibrium GDP is to the right of LRAS, indicating lower unemployment and actual GDP above potential GDP.

Positive Demand Shock

AD shifts right, causing higher price level, GDP increase, and unemployment decrease.

Negative Demand Shock

AD shifts left, causing lower price level, GDP decrease, and unemployment increase.

Negative Supply Shock

SRAS shifts left due to rising input prices, causing inflation and stagnation (stagflation).

Long-Run Self-Adjustment

The economy self-corrects over time through flexible wages and prices.

Adjusting from Recessionary Gap

High unemployment leads to lower nominal wages, causing SRAS to shift right and restoring full employment.

Adjusting from Inflationary Gap

Low unemployment leads to higher nominal wages, causing SRAS to shift left and restoring full employment.

Fiscal Policy

Use of government spending and taxation to influence the economy.

Expansionary Fiscal Policy

Involves increasing government spending or decreasing taxes to combat a recession.

Contractionary Fiscal Policy

Involves decreasing government spending or increasing taxes to control inflation.

Automatic Stabilizers

Built-in mechanisms that mitigate fluctuations in economic activity without new legislation.

Progressive Income Tax System

Adjusts tax rates based on income levels, impacting consumption based on economic conditions.

Transfer Payments

Government payments, such as unemployment insurance, that automatically adjust based on economic conditions.

Discretionary Fiscal Policy

Requires new laws to implement changes in spending or taxation.

Common Mistake: Financial Assets vs. Capital

Investment in macroeconomics refers to buying physical capital, not financial assets.

Common Mistake: Changes in Price Level

Changes in price level cause movements along AD and SRAS curves, not shifts.

Common Mistake: Self-Correction

In the long run, prices and wages are flexible, but self-adjustment does not involve shifts in AD.

Common Mistake: Fiscal vs. Monetary Policy

Fiscal policy deals with taxes and spending, while monetary policy involves interest rates and money supply.