AP Macroeconomics - Unit 3: National Income and Price Determination

Aggregate

• “added all together”

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

Aggregate Demand

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

What is the relationship between price level and real GDP?

• 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

What are the three reasons why AD is downward sloping?

1. The Wealth Effect

2. Interest Rate Effect

3. Foreign Trade Effect

The Wealth 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

The Interest Rate Effect

• 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

The Foreign Trade Effect

• 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

Shifters of Aggregate Demand

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

Multiplier Effect

Shows how spending is magnified in the economy

Marginal Propensity to Consume (MPC)

• MPC = Change in consumption / Change in disposable income

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

Marginal Propensity to Save (MPS)

• MPS = Change in savings / Change in disposable income

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

Spending multiplier formula

1 / MPS or 1 / 1 - MPC

Total change in GDP formula

• Multiplier × Initial change in spending

• Tax Multiplier × Initial change in taxes

Tax multiplier formula

MPC / MPS or Spending Multiplier - 1

Why is the tax multiplier weaker than the spending multiplier?

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

Aggregate Supply

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

Short-run Aggregate Supply

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

Long-run Aggregate Supply

• 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

Shifters of Short-run Aggregate Supply

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

Shifters of Long-run Aggregate Supply

• 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

Stagflation

• 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

Long-Run Self-Adjustment

• 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)

Autonomous consumption

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

Disposable income

Income after taxes

Consumer Spending formula

Autonomous consumption + Disposable income

Fiscal Policy

Actions by congress to stabilize the economy (laws)

Monetary Policy

Actions by the Federal Reserve Bank to stabilize the economy

Discretionary Fiscal Policy

• 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

Non-Discretionary Fiscal Policy (Automatic Stabilizers)

• 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

Contractionary Fiscal Policy

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

  • Decrease government spending

  • Increase taxes (decreasing disposable income)

Expansionary Fiscal Policy

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

  • Increase government spending

  • Decrease taxes (increasing disposable income)

The three lags of Fiscal Policies:

1. Recognition Lag

2. Administrative Lag

3. Operational Lag

Recognition Lag

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

Administrative Lag

Congress takes time to pass legislation

Operational Lag

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

Progressive Income Tax System

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

Unemployment benefits and social service programs (automatic stabilizer)

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