National Income and Price Determination: The AD-AS Model

3.1 Aggregate Demand (AD)

Definition

Aggregate Demand represents the total quantity of all goods and services demanded by the economy at different price levels. It represents the sum of all spending in the economy.

The AD Formula

To calculate Aggregate Demand, we sum the four components of GDP:

AD = C + I + G + (X - M)

• C (Consumer Spending): Spending by households on goods/services.
• I (Investment Spending): Spending by businesses on physical capital (factories, tools), inventory, and new housing.
• G (Government Spending): Spending by the government on goods/services (does not include transfer payments like Social Security).
• X - M (Net Exports): Exports minus Imports.

Why is AD Downward Sloping?

The negative slope is NOT due to the law of diminishing marginal utility (that is for microeconomics). It is due to three specific effects:

1. The Real Wealth Effect (Real Balance Effect):
   • When the aggregate Price Level (PL) rises, the purchasing power of accumulated assets (cash, savings) falls.
   • People feel poorer and buy less.
   • Result: PL $\uparrow$ $\rightarrow$ Quantity Demanded $\downarrow$.
2. The Interest Rate Effect:
   • When PL rises, lenders need to charge higher interest rates to get a real return, and people demand more money to conduct transactions.
   • Higher interest rates increase the cost of borrowing for investment and large consumption (like houses/cars).
   • Result: PL $\uparrow$ $\rightarrow$ Interest Rates $\uparrow$ $\rightarrow$ Investment (I) and Consumption (C) $\downarrow$ $\rightarrow$ Quantity Demanded $\downarrow$.
3. The Foreign Trade (Exchange Rate) Effect:
   • When U.S. PL rises compared to other countries, U.S. goods look expensive to foreigners (Exports $\downarrow$) and foreign goods look cheap to Americans (Imports $\uparrow$).
   • Result: PL $\uparrow$ $\rightarrow$ Net Exports $\downarrow$ $\rightarrow$ Quantity Demanded $\downarrow$.

Determinants of AD (Shifts)

A change in Price Level causes a movement along the curve. A change in C, I, G, or Xn causes a shift of the curve.

• Shift Right: Increase in Spending $\rightarrow$ Increase in Real GDP $\rightarrow$ Decrease in Unemployment.
• Shift Left: Decrease in Spending $\rightarrow$ Decrease in Real GDP $\rightarrow$ Increase in Unemployment.

3.2 Multipliers

Key Concepts

When spending changes in the economy, it creates a ripple effect. One person's spending becomes another person's income, leading to further spending.

• Marginal Propensity to Consume (MPC): The fraction of any change in disposable income that is spent.
  • MPC = \frac{\Delta Consumption}{\Delta Disposable Income}
• Marginal Propensity to Save (MPS): The fraction of any change in disposable income that is saved.
  • MPS = \frac{\Delta Savings}{\Delta Disposable Income}
• The Rule of 1: Since you can only spend or save new income:
  • MPC + MPS = 1

The Formulas

1. The Spending Multiplier
Used when there is a change in government spending (G) or investment (I).
Multiplier_S = \frac{1}{MPS} \quad \text{or} \quad \frac{1}{1 - MPC}

2. The Tax Multiplier
Used when the government changes lump-sum taxes. Note: It is always negative (taxes $\uparrow$ = GDP $\downarrow$) and its magnitude is always 1 less than the spending multiplier.
Multiplier_T = \frac{-MPC}{MPS} \quad \text{or} \quad \frac{-MPC}{1 - MPC}

3. The Balanced Budget Multiplier
If the government increases Spending ($G$) and Taxes ($T$) by the same amount, the result is not zero.
Balanced \ Budget \ Multiplier = 1
Example: If G increases by $10B and Taxes increase by $10B, GDP increases by exactly $10B.

Worked Example

Scenario: The government wants to bridge a $20 billion recessionary gap. The MPC is 0.8.

1. Calculate Multipliers:
   • MPS = $1 - 0.8 = 0.2$
   • Spending Multiplier = $1 / 0.2 = 5$
   • Tax Multiplier = $-0.8 / 0.2 = -4$
2. Option A (Change Spending):
   • Target $\Delta GDP = +20B$
   • Formula: $\Delta G \times Multiplier = \Delta GDP$
   • $x \times 5 = 20 \rightarrow x = 4$
   • Solution: Increase Govt Spending by $4 billion.
3. Option B (Change Taxes):
   • Formula: $\Delta T \times Multiplier = \Delta GDP$
   • $x \times -4 = 20 \rightarrow x = -5$
   • Solution: Decrease Taxes by $5 billion.

Common Mistakes

• Confusion: Thinking the Tax Multiplier has the same impact as the Spending Multiplier. Spending is direct injection; Taxes must pass through the MPC (some is saved) before entering the economy, making the tax multiplier weaker.

3.3 Short-Run Aggregate Supply (SRAS)

Definition

SRAS shows the relationship between the price level and the quantity of declared real GDP supplied in the short run.

• Upward Sloping: As price levels rise, producers are willing to produce more because input costs (wages, raw materials) are sticky (slow to change) in the short run. Since sale prices rise while costs stay the same, profit margins increase.

Shifters of SRAS

Acronym: R.A.P.

1. R - Resource Prices (Input Costs):
   • Wages (labor costs).
   • Commodity prices (oil, energy, steel).
   • Example: A negative supply shock (oil prices spike) shifts SRAS to the left.
2. A - Actions of Government:
   • Taxes on producers (shift left).
   • Subsidies for producers (shift right).
   • Regulations (more regulation generally shifts left due to compliance costs).
3. P - Productivity:
   • Technology advancements (shift right).
   • Human capital improvements (education) shift right.

3.4 Long-Run Aggregate Supply (LRAS)

Definition

LRAS represents the economy's potential output when all resources are fully employed (Full Employment Output, $Y_f$).

• Vertical Slope: In the long run, wages and input prices are flexible. They adjust fully to price level changes. Therefore, a change in Price Level has no effect on the quantity of Real GDP produced in the long run.

Shifters of LRAS

The LRAS curve shifts for the same reasons perfectly competitive Production Possibilities Curves (PPC) shift:

1. Change in quantity/quality of resources (Land, Labor, Capital, Entrepreneurship).
2. Change in Technology.

• Note: If LRAS shifts right, it represents Economic Growth.

3.5 Equilibrium in the AD-AS Model

Macroeconomic Equilibrium

Occurs where AD intersects SRAS. This determines the current Price Level ($PLe$) and current Real GDP ($Ye$).

Determining the State of the Economy

We compare current Equilibrium GDP ($Ye$) to Full Employment GDP ($Yf$ or LRAS).

1. Recessionary Gap (Negative Output Gap)

• Equilibrium ($Ye$) is to the left of LRAS ($Yf$).
• Actual GDP < Potential GDP.
• Unemployment is higher than the Natural Rate of Unemployment (NRU).

2. Inflationary Gap (Positive Output Gap)

• Equilibrium ($Ye$) is to the right of LRAS ($Yf$).
• Actual GDP > Potential GDP.
• Unemployment is lower than the NRU (economy is overheating).

3.6 Changes in the Short Run (Shocks)

Demand Shocks

• Positive Demand Shock: AD shifts right. PL $\uparrow$, GDP $\uparrow$, Unemployment $\downarrow$. (Inflationary Gap created).
• Negative Demand Shock: AD shifts left. PL $\downarrow$, GDP $\downarrow$, Unemployment $\uparrow$. (Recessionary Gap created).

Supply Shocks (Stagflation)

• Negative Supply Shock: SRAS shifts left (usually caused by a spike in input prices like oil).
  • Result: Price Level $\uparrow$ (Inflation) AND Real GDP $\downarrow$ (Stagnation/Unemployment).
  • This is called Stagflation. It is the worst-case scenario because traditional fiscal policy struggles to fix both inflation and unemployment simultaneously.

3.7 Long-Run Self-Adjustment

What happens if the government does nothing? The economy will self-correct in the long run due to flexible wages and prices.

adjusting from a Recessionary Gap

1. Situation: Economy is operating below potential (High unemployment).
2. Reaction: With high unemployment, there is a surplus of labor. Workers will eventually accept lower nominal wages to get jobs.
3. Result: As nominal wages (an input cost) fall, production becomes cheaper.
4. Shift: SRAS shifts RIGHT.
5. Outcome: Price Level falls, Output returns to Full Employment.

Adjusting from an Inflationary Gap

1. Situation: Economy is operating above potential (Extremely low unemployment).
2. Reaction: Labor is scarce. Workers demand higher wages due to high inflation expectations.
3. Result: As nominal wages rise, production costs increase.
4. Shift: SRAS shifts LEFT.
5. Outcome: Price Level rises, Output returns to Full Employment.

Common Mistakes

• The Trap: Students often try to shift AD to self-adjust. AD does NOT shift during self-adjustment. Only SRAS shifts as wages adjust to the gap.

3.8 Fiscal Policy

Fiscal Policy is the use of government spending and taxation to influence the economy. It is conducted by the Congress/President (not the Federal Reserve).

1. Expansionary Fiscal Policy

• Goal: Fix a Recession.
• Tools:
  • $\uparrow$ Government Spending (Direct impact).
  • $\downarrow$ Taxes (Indirect impact via disposable income).
• Result: AD shifts Right. PL $\uparrow$, GDP $\uparrow$.
• Side Effect: Increases the Budget Deficit (or reduces surplus).

2. Contractionary Fiscal Policy

• Goal: Fix Inflation (cool down an overheating economy).
• Tools:
  • $\downarrow$ Government Spending.
  • $\uparrow$ Taxes.
• Result: AD shifts Left. PL $\downarrow$, GDP $\downarrow$.
• Side Effect: Decreases the Budget Deficit (or increases surplus).

3.9 Automatic Stabilizers

Discretionary Fiscal Policy requires a new law (long time lag). Automatic Stabilizers are mechanisms already built into the law that dampen the business cycle without new legislation.

Examples

1. Progressive Income Tax System:
   • In an Economic Boom: Incomes rise $\rightarrow$ People move into higher tax brackets $\rightarrow$ Average tax rate increases $\rightarrow$ Slows down consumption (acts as contractionary policy).
   • In a Recession: Incomes fall $\rightarrow$ People drop to lower tax brackets $\rightarrow$ Disposable income stays relatively stable.
2. Transfer Payments (Unemployment Insurance):
   • In a Recession: More people apply for unemployment benefits $\rightarrow$ Government spending (transfer payments) increases automatically $\rightarrow$ Sustains consumption.

Comparison Table

Summary: Common Unit 3 Mistakes to Avoid

1. Financial Assets vs. Capital: "Investment" (I) in Macro means buying machinery/factories, not buying stocks or bonds. Buying stocks is saving, not investment.
2. Changes in Price Level: A change in PL causes a movement along the AD or SRAS curve. It does not shift the curve. (Only exogenous factors shift the curves).
3. Self-Correction: Remember that in the long run, prices/wages are flexible. In the short run, prices/wages are sticky.
4. Fiscal vs. Monetary: Unit 3 is about Fiscal policy (Taxes/Spending). Do not mention interest rates or money supply as policy tools here (that is Unit 4/Monetary Policy).