Unit 3: National Income and Price Determination

a. Define (using graphs as appropriate) the aggregate demand (AD) curve. b. Explain (using graphs as appropriate) the slope of the AD curve and its determinants.

• The aggregate demand (AD) curve describes the relationship between the price level and the quantity of goods and services demanded by households (consumption), firms (investment), government (government spending), and the rest of the world (net exports).
• The negative slope of the AD curve is explained by the real wealth effect, the interest rate effect, and the exchange rate effect. [See EK MKT-3.A.1]
• Any change in the components of aggregate demand (consumption, investment, government spending, or net exports) that is not due to changes in the price level leads to a shift of the AD curve.
• Enduring understanding MOD-2: Economists use the aggregate demand–aggregate supply model to represent the relationship between the price level and aggregate output in an economy and to illustrate how output, employment, and the price level respond to macroeconomic shocks.

a. Define the expenditure multiplier, the tax multiplier, the marginal propensity to consume, and the marginal propensity to save. b. Explain how changes in spending and taxes lead to changes in real GDP. c. Calculate how changes in spending and taxes lead to changes in real GDP.

• A $1 change to autonomous expenditures leads to further changes in total expenditures and total output.
• The expenditure multiplier quantifies the size of the change in aggregate demand as a result of a change in any of the components of aggregate demand.
• The tax multiplier quantifies the size of the change in aggregate demand as a result of a change in taxes.
• The expenditure multiplier and tax multiplier depend on the marginal propensity to consume.
• The marginal propensity to consume is the change in consumer spending divided by the change in disposable income. The sum of the marginal propensity to consume and marginal propensity to save is equal to one.
• Enduring understanding MOD-2: Economists use the aggregate demand–aggregate supply model to represent the relationship between the price level and aggregate output in an economy and to illustrate how output, employment, and the price level respond to macroeconomic shocks.

a. Define (using graphs as appropriate) the short-run aggregate supply (SRAS) curve. b. Explain (using graphs as appropriate) the slope of the SRAS curve and its determinants.

• The short-run aggregate supply (SRAS) curve describes the relationship between the price level and the quantity of goods and services supplied in an economy.
• The SRAS curve is upward-sloping because of sticky wages and prices. [See EK MOD-2.E.1]
• Any factor that causes production costs to change, such as a change in inflationary expectations, will cause the SRAS curve to shift.
• Enduring understanding MOD-2: Economists use the aggregate demand–aggregate supply model to represent the relationship between the price level and aggregate output in an economy and to illustrate how output, employment, and the price level respond to macroeconomic shocks.

Explain (using graphs as appropriate) how movement along the SRAS curve implies a relationship between the price level (and inflation) and unemployment.

• Moving along the SRAS curve, an increase in the price level is associated with an increase in output, which means employment must correspondingly rise. With the labor force held constant, unemployment will fall. So, there is a short-run trade-off between inflation and unemployment. [See EK MOD-3.A.1]
• Enduring understanding MOD-2: Economists use the aggregate demand–aggregate supply model to represent the relationship between the price level and aggregate output in an economy and to illustrate how output, employment, and the price level respond to macroeconomic shocks.

Define (using graphs as appropriate) the short run and the long run.

• In the long run all prices and wages are fully flexible, while in the short run some input prices are fixed. A consequence of flexible long-run prices and wages is the lack of a long-run trade-off between inflation and unemployment.
• Enduring understanding MOD-2: Economists use the aggregate demand–aggregate supply model to represent the relationship between the price level and aggregate output in an economy and to illustrate how output, employment, and the price level respond to macroeconomic shocks.

Define (using graphs as appropriate) the long-run aggregate supply (LRAS) curve.

• The LRAS curve corresponds to the production possibilities curve (PPC) because they both represent maximum sustainable capacity. Maximum sustainable capacity is the total output an economic system will produce over a set period of time if all resources are fully employed.
• The LRAS curve is vertical at the full-employment level of output because in the long run wages and prices fully adjust. [See LO MOD-2.I]
• Enduring understanding MOD-2: Economists use the aggregate demand–aggregate supply model to represent the relationship between the price level and aggregate output in an economy and to illustrate how output, employment, and the price level respond to macroeconomic shocks.

Explain (using graphs as appropriate) the short-run and long-run equilibrium price level and output level.

• Short-run equilibrium occurs when the aggregate quantity of output demanded and the aggregate quantity of output supplied are equal—i.e., at the intersection of the AD and SRAS curves.
• Long-run equilibrium occurs when the AD and SRAS curves intersect on the LRAS—i.e., at the full-employment level of real output.
• The short-run equilibrium output can be at the full-employment level of output, above it, or below it, creating positive (i.e., inflationary) or negative (i.e., recessionary) output gaps.
• Enduring understanding MOD-2: Economists use the aggregate demand–aggregate supply model to represent the relationship between the price level and aggregate output in an economy and to illustrate how output, employment, and the price level respond to macroeconomic shocks.

Explain (using graphs as appropriate) the response of output, employment, and the price level to an aggregate demand or aggregate supply shock in the short run.

• A positive (negative) shock in AD causes output, employment, and the price level to rise (fall) in the short run.
• A positive (negative) shock in SRAS causes output and employment to rise (fall) and the price level to fall (rise) in the short run.
• Inflation can be caused by changes in aggregate demand (demand-pull) or aggregate supply (cost-push).
• Enduring understanding MOD-2: Economists use the aggregate demand–aggregate supply model to represent the relationship between the price level and aggregate output in an economy and to illustrate how output, employment, and the price level respond to macroeconomic shocks.

Explain (using graphs as appropriate) the response of output, employment, and the price level to an aggregate demand or aggregate supply shock in the long run.

• In the long run, in the absence of government policy actions, flexible wages and prices will adjust to restore full employment and unemployment will revert to its natural rate after a shock to aggregate demand or short-run aggregate supply. [See EK MEA-1.E.2]
• Shifts in the long-run aggregate supply curve indicate changes in the full-employment level of output and economic growth.
• Enduring understanding MOD-2: Economists use the aggregate demand–aggregate supply model to represent the relationship between the price level and aggregate output in an economy and to illustrate how output, employment, and the price level respond to macroeconomic shocks.

a. Define fiscal policy and related terms. b. Explain (using graphs as appropriate) the short-run effects of a fiscal policy action. c. Calculate the short-run effects of a fiscal policy action.

• Governments implement fiscal policies to achieve macroeconomic goals, such as full employment.
• The tools of fiscal policy are government spending and taxes/transfers.
• Changes in government spending affect aggregate demand directly, and changes in taxes/transfers affect aggregate demand indirectly.
• The government spending multiplier is greater than the tax multiplier.
• Expansionary or contractionary fiscal policies are used to restore full employment when the economy is in a negative (i.e., recessionary) or positive (i.e., inflationary) output gap.
• Fiscal policy can influence aggregate demand, real output, and the price level. [See also EK MKT-5.E.2 for the effect on exchange rates.]
• The AD–AS model is used to demonstrate the short-run effects of fiscal policy.
• Enduring understanding POL-1: Fiscal and monetary policy have short-run effects on macroeconomic outcomes.

Define why there are lags to discretionary fiscal policy.

• In reality, there are lags to discretionary fiscal policy because of factors such as the time it takes to decide on and implement a policy action.
• Enduring understanding POL-1: Fiscal and monetary policy have short-run effects on macroeconomic outcomes.

a. Define automatic stabilizers. b. Explain how automatic stabilizers moderate business cycles.

• Automatic stabilizers support the economy during recessions and help prevent the economy from being overheated during expansionary periods.
• Tax revenues decrease automatically as GDP falls, preventing consumption and the economy from falling further.
• Tax revenues increase automatically as GDP rises, slowing consumption and preventing the economy from overheating.
• Government policies, institutions, or agencies may also have social service programs whose transfer payments act as automatic stabilizers.
• Enduring understanding POL-1: Fiscal and monetary policy have short-run effects on macroeconomic outcomes.