AP Macroeconomics - Unit 3: National Income and Price Determination

• “added all together”

• When we use it, we combine all the prices and all quantities

All the goods and services (real GDP) that buyers are willing and able to purchase at different price levels

• There is an inverse relationship

• If the price level:

  • Increases (inflation), then real GDP demand falls as people buy less

  • Decreases (deflation), then real GDP demand increases as people spend more

1. The Wealth Effect

2. Interest Rate Effect

3. Foreign Trade Effect

• Higher price levels reduce the purchasing power of money, which decreases the quantity of expenditures

• Lower price levels increase purchasing powers and increase expenditures

• AKA Real Balance Effect

• Price level goes up and GDP demanded goes down

• When the price level increases, lenders need to charge a higher interest rate to get a REAL return on their loans

• High interest rates discourage consumer spending and business investment

• Price level goes up and GDP demanded goes down

• When U.S. price level rises, foreign buyers purchase fewer U.S. goods and Americans buy more foreign goods

• Exports fall and imports rise causing real GDP demanded to fall (Xn decreases)

• Price level goes up and GDP demanded goes down

1. Consumer Spending

   1. Increase in disposable income

   2. Consumer expectations

   3. Household indebtedness

   4. Income taxes

2. Investment Spending

   1. Real interest rates

   2. Future business expectations

   3. Productivity and technology

   4. Business taxes

3. Government Spending

   1. Government expenditures

      1. Transfer payments NOT included

4. Net Exports

   1. Exchange rates

   2. National income compared to abroad

Shows how spending is magnified in the economy

• MPC = Change in consumption / Change in disposable income

• How much people consume rather than save when there is a change in disposable income

• MPS = Change in savings / Change in disposable income

• How much people save rather than consume when there is a change in disposable income

1 / MPS or 1 / 1 - MPC

• Multiplier × Initial change in spending

• Tax Multiplier × Initial change in taxes

MPC / MPS or Spending Multiplier - 1

It is weaker because some people won’t spend all the money they get from an increase in their disposable income (unless transfer payments)

The amount of goods and services (real GDP) that firms will produce in an economy at different price levels. The supply for everything by all firms

Wages and resource prices are sticky and WILL NOT change as price levels change

• Wages and resource prices are flexible and WILL change as price levels change

• Price level increases but GDP doesn’t (vertical curve)

• Considered to be the production of the economy at full employment (maximum sustainable capacity)

• Current output = potential output

• When Yc < Yf, the economy is in a recessionary/negative gap

• When Yc > Yf, the economy is in an inflationary/positive gap

1. Change in Resource Prices

   1. Prices of domestic and imported resources

   2. Supply shocks

   3. Inflationary expectations

      1. Workers will demand higher wages if consumers and producers expect higher prices in the future

2. Change in Actions of the Government

   1. Taxes on producers

   2. Subsidies for domestic producers

   3. Government regulations

3. Change in Productivity

   1. Technology

• A permanent in the production possibilities of the economy can shift LRAS

• Only investment causes growth since firms increase their capital stock

• Same as the shifters of the PPC

1. Change in resource quantity or quality

2. Change in technology

• A mix of high inflation and a stagnant economy

• Still considered a recessionary gap

• Hard to correct, since inflation and recession are dealt with differently

• In the long-run, the economy will always self-adjust, even if there is no policies implement by the government (it just adjusts more slowly)

• Positive and negative output gaps will slowly adjust back to the full employment level over time

• Picture shows long-run self adjustment on a positive output gap (SRAS decreases due to an increase in PL)

Consumers will spend a certain amount no matter what, regardless of their income (usually paying for their necessities)

Income after taxes

Autonomous consumption + Disposable income

Actions by congress to stabilize the economy (laws)

Actions by the Federal Reserve Bank to stabilize the economy

• Congress creates a new one time bill/law that is designed to change AD through government spending or taxation

• One problem is lag times due to

  bureaucracy

• It takes time for Congress to act

• Permanent spending/taxation laws enacted to work counter cyclically to stabilize the economy

• When GDP Goes down, government spending automatically increases and taxes automatically fall

• Laws that reduce inflation, decrease GDP (close an inflationary gap)

  • Decrease government spending

  • Increase taxes (decreasing disposable income)

• Laws that reduce unemployment and increase GDP (close a recessionary gap)

  • Increase government spending

  • Decrease taxes (increasing disposable income)

1. Recognition Lag

2. Administrative Lag

3. Operational Lag

Congress must react to economic indicators before it’s too late

Congress takes time to pass legislation

Spending/planning takes time to organize and execute (changing taxing is quicker)

When GDP is down, the tax burden on consumers is low, which promotes consumption and increases AD and vice versa

When GDP is down, unemployment is higher and more benefits are payed out, which increases AD and vice versa