Unit 3

National Income and Price Determination: the one-page sheet

3.1 Aggregate Demand (AD)

Aggregate demand is total planned spending on real output at each price level, C + I + G + (X - M). It slopes down because a lower price level raises real wealth, lowers interest rates and makes domestic goods cheaper than foreign ones. A change in the price level moves along AD; a change in spending for any other reason shifts it.

Aggregate demand (AD) is the total real output that households, firms, the government and foreigners plan to buy at each price level: $AD = C + I + G + (X - M)$ .
AD slopes down because of three effects of a lower price level: the real wealth effect (savings buy more), the interest rate effect (lower interest rates raise investment) and the exchange rate effect (domestic goods are cheaper than foreign goods).
A change in the price level moves the economy along AD. A change in C, I, G or X - M for any other reason shifts AD.
Shifters: wealth, consumer and business expectations, household debt, taxes, interest rates at a given price level, government purchases, foreign incomes.
The axes are always Price level (vertical) and Real GDP (horizontal), never "price" and "quantity".

savings buy more, interest rates fall and domestic goods get cheaper than foreign goods consumption, investment and net exports rise real GDP demanded rises: a movement down along AD the whole AD curve shifts

aggregate demand: The total amount of real output that households, firms, the government and foreigners plan to buy at each price level: C + I + G + (X - M). The AD curve slopes down.
wealth effect: The real wealth effect: a lower price level raises what savings can buy, so consumption rises. With the interest rate effect and the exchange rate effect, it explains why AD slopes down.
determinant of aggregate demand: Anything other than the price level that changes consumption, investment, government spending or net exports, such as wealth, expectations, taxes or foreign incomes. It shifts the whole AD curve.
price level: The average level of prices of all goods and services in the economy, measured by a price index such as the GDP deflator. It is the vertical axis of the aggregate demand graph.

3.2 Multipliers

Each new dollar of spending becomes someone's income, who spends the MPC share of it, so output rises by a multiple of the first change. The spending multiplier is 1 / MPS; the tax multiplier is -MPC / MPS, one smaller in size because part of a tax cut is saved. To close a gap, choose the direction first, then divide the gap by the multiplier.

MPC $= \frac{\Delta C}{\Delta \text{DI}}$ and MPS $= \frac{\Delta S}{\Delta \text{DI}}$ , where DI is disposable income (income after taxes). MPC + MPS = 1.
Spending multiplier $= \frac{1}{1 - \text{MPC}} = \frac{1}{\text{MPS}}$ . Tax multiplier $= -\frac{\text{MPC}}{\text{MPS}}$ : negative, and one smaller in size.
Effect of a change: $\Delta Y = \Delta G \times$ multiplier. Closing a gap: direction first, then divide the gap by the multiplier.
A tax cut must be larger than a spending increase to close the same gap, because households save part of a tax cut.
Raising spending and taxes by the same amount still raises output by that amount: the balanced-budget multiplier is 1.

incomes of workers and firms rise by 100 households spend 80 more, which is income for others total spending rises by 100 × 1 / 0.2 = 500 households spend only 80 at first, so output rises by 400

disposable income: Household income after taxes are paid and transfers received: what households can spend or save.
marginal propensity to consume: Marginal propensity to consume: the share of an extra dollar of disposable income that households spend, the change in consumption divided by the change in disposable income.
marginal propensity to save: Marginal propensity to save: the share of an extra dollar of disposable income that households save. MPS = 1 - MPC.
spending multiplier: How many dollars real GDP changes for each dollar of new spending, 1 / MPS, because each round of spending is partly re-spent (the multiplier effect).
tax multiplier: How many dollars real GDP changes for each dollar of tax change, -MPC / MPS. It is negative and one smaller in size than the spending multiplier.
balanced-budget multiplier: The effect on real GDP of raising government spending and taxes by the same amount. The spending and tax multipliers add to 1, so output rises by the amount of the spending.

3.3 Short-Run Aggregate Supply (SRAS)

SRAS shows the real output firms supply at each price level while wages and some prices are sticky, so it slopes up. A change in the price level moves along SRAS. Changes in input prices, productivity, taxes and rules on firms, or the wages workers bargain for, shift it: higher costs shift SRAS left, lower costs shift it right.

Short-run aggregate supply (SRAS) is the total real output firms supply at each price level in the short run, while nominal wages and some prices are fixed.
SRAS slopes up because of sticky wages and prices: when the price level rises, many costs do not, so more output is profitable.
A change in the price level moves along SRAS. A change in costs at a given price level shifts it.
SRAS shifts left when input prices rise (nominal wages, energy, raw materials), productivity falls, business taxes or costly rules rise, or expected inflation rises (workers come to expect faster price growth and raise wage demands). The reverse shifts it right.
A sudden, economy-wide change in input costs is a supply shock.

profit on each extra unit rises firms produce more real output: a movement up along SRAS costs per unit rise firms supply less at every price level: SRAS shifts left

short-run aggregate supply: Short-run aggregate supply: the total real output firms supply at each price level while nominal wages and some prices are fixed. The SRAS curve slopes up.
sticky wages: Nominal wages (and some prices) that do not adjust right away when the price level changes, often because of contracts. They make SRAS slope up.
determinant of short-run aggregate supply: A change in production costs at a given price level, such as input prices, productivity, taxes or subsidies on firms. A sudden economy-wide one is a supply shock.
long run: The short run is the period in which nominal wages and some prices are fixed; the long run is long enough for all wages and prices to adjust.
expected inflation: The inflation rate households and firms expect, which they build into wages and prices. A rise in expected inflation raises nominal wage demands and production costs, so SRAS shifts left.

3.4 Long-Run Aggregate Supply (LRAS)

In the long run, nominal wages and input prices catch up with the price level, so real output depends only on resources and technology. LRAS is vertical at full-employment output, and it shifts right when the economy gains labor, capital or better technology, just as the PPC shifts out. Spending and the price level do not move it.

In the long run all wages and prices adjust, so real output is set by resources and technology, not by the price level.
Long-run aggregate supply (LRAS) is vertical at full-employment output (potential output, YF).
LRAS shifts right with more or better labor, more capital, more land and resources, or better technology; it shifts left when productive capacity is lost.
LRAS and the PPC tell the same story: when LRAS shifts right, the PPC shifts out.
Changes in spending (AD) or in the price level do not move LRAS.

production is no more profitable than before real output returns to full-employment output LRAS is vertical at YF YF rises: LRAS shifts right and the PPC shifts out

long-run aggregate supply: Long-run aggregate supply: the real output an economy produces when wages and prices have fully adjusted, which is full-employment output. The LRAS curve is vertical at that output.

3.5 Equilibrium in the Aggregate Demand-Aggregate Supply (AD-AS) Model

The AD-AS model shows the price level and real GDP where AD meets SRAS (short-run equilibrium). Comparing that output with LRAS shows the gap: left of LRAS is a recessionary gap with unemployment above the natural rate, right of LRAS an inflationary gap with unemployment below it. Long-run equilibrium is where all three curves meet.

The AD-AS model puts AD, SRAS and LRAS on one graph: Price level (PL) up the side, Real GDP (Y) along the bottom.
Short-run equilibrium is where AD crosses SRAS; label it PL1 and Y1 with dashed lines to both axes.
Long-run equilibrium is where AD and SRAS cross on LRAS: output at full employment (YF), unemployment at the natural rate.
Y1 < YF: a recessionary gap, unemployment above the natural rate. Y1 > YF: an inflationary gap, unemployment below it.

the short-run price level (PL1) and real GDP (Y1) are set a recessionary gap: unemployment above the natural rate an inflationary gap: unemployment below the natural rate long-run equilibrium at full employment

AD-AS model: The graph of aggregate demand, short-run aggregate supply and long-run aggregate supply against the price level and real GDP. Short-run equilibrium is where AD meets SRAS; long-run equilibrium is where both meet on LRAS.

3.6 Changes in the AD-AS Model in the Short Run

In the short run, a shift of AD moves the price level and real GDP in the same direction (demand-pull inflation when AD rises), while a shift of SRAS moves them in opposite directions (cost-push inflation and stagflation when SRAS falls). Unemployment moves opposite to output. When both curves shift, one of the two outcomes is indeterminate.

A demand shock shifts AD: positive (right) raises the price level and real GDP; negative (left) lowers both.
A supply shock shifts SRAS: negative (left) raises the price level and lowers real GDP; positive (right) does the reverse.
Demand-pull inflation: AD right. Cost-push inflation: SRAS left, with higher unemployment too (stagflation).
In the short run, unemployment moves opposite to real GDP.
When AD and SRAS both shift, one outcome is indeterminate: say which, and why.

AD shifts right the price level and real GDP rise; unemployment falls (demand-pull inflation) SRAS shifts left the price level rises, real GDP falls and unemployment rises (cost-push inflation)

demand-pull inflation: Inflation caused by aggregate demand shifting right: more spending pulls up the price level while real GDP rises in the short run.
cost-push inflation: Inflation caused by short-run aggregate supply shifting left, as when input costs rise: the price level rises while real GDP falls. Rising prices with falling output is stagflation.
demand shock: A sudden change in spending at every price level that shifts AD. A positive demand shock shifts it right; a negative one shifts it left.

3.7 Long-Run Self-Adjustment

Left alone, an economy closes its own output gap through nominal wages and input prices. In a recessionary gap, high unemployment pushes wages down, SRAS shifts right, and output returns to full employment at a lower price level; in an inflationary gap, wages rise and SRAS shifts left, raising the price level. AD is not the mechanism, and in the long run AD changes only the price level.

Long-run self-adjustment: with no policy, the economy returns to full employment because nominal wages and input prices adjust and SRAS shifts.
Recessionary gap: unemployment above the natural rate, nominal wages fall, SRAS shifts right; the price level falls and output rises to YF.
Inflationary gap: unemployment below the natural rate, nominal wages rise, SRAS shifts left; the price level rises and output falls to YF.
The mechanism is never a shift in AD. In the long run, a change in AD changes only the price level.
It can be slow, especially downward, because nominal wages resist cuts.

unemployment is above the natural rate nominal wages and input prices fall as contracts are renewed SRAS shifts right real GDP rises to full-employment output and the price level falls

long-run self-adjustment: The economy's return to full employment with no policy: in a recessionary gap nominal wages and input prices fall and SRAS shifts right; in an inflationary gap they rise and SRAS shifts left.

3.8 Fiscal Policy

Fiscal policy uses government purchases, taxes and transfers to shift aggregate demand. In a recessionary gap, expansionary policy (more G, lower taxes, more transfers) shifts AD right, raising output and the price level; in an inflationary gap, contractionary policy shifts AD left. Size it with the gap: direction first, then divide the gap by the spending or tax multiplier.

Fiscal policy is the government's use of purchases (G), taxes and transfer payments to change aggregate demand. Discretionary means a deliberate decision.
Expansionary (recessionary gap): raise G, cut taxes or raise transfers, so AD shifts right. Contractionary (inflationary gap): the reverse.
A change in G has a bigger effect than the same change in taxes or transfers: spending multiplier 1 / MPS against MPC / MPS.
Size the policy with the gap: direction first, then divide the gap by the right multiplier.
Lags in recognizing, deciding and carrying out policy can make it arrive at the wrong time.

spending rises (directly, or through disposable income and consumption) AD shifts right by a multiple of the change real GDP and the price level rise; unemployment falls AD shifts left: the price level and real GDP fall toward full employment

fiscal policy: Changes in government purchases, taxes and transfer payments meant to shift aggregate demand. Expansionary fiscal policy raises AD; contractionary fiscal policy lowers it. Discretionary policy is a deliberate decision.

3.9 Automatic Stabilizers

Automatic stabilizers are tax and transfer rules that respond to the business cycle by themselves. In a recession, progressive income taxes fall faster than income and unemployment compensation rises, so disposable income, consumption and AD fall by less; in a boom they slow AD's rise. They soften fluctuations quickly, but they do not close a gap and are not the self-adjustment mechanism.

Automatic stabilizers are taxes and transfers that change with the business cycle with no new law: the progressive tax on income and unemployment compensation are the main ones.
In a recession they keep disposable income, consumption and AD from falling as much; in a boom they slow the rise.
They act at once, with no wait for a decision, unlike discretionary fiscal policy.
They soften the cycle; they do not close a gap, and they are not the long-run self-adjustment mechanism (that is wages and SRAS).

progressive tax bills fall faster than income and unemployment compensation rises disposable income falls by less than income consumption and AD fall by less the recession is milder, though a gap can remain

automatic stabilizer: A tax or transfer, such as a progressive income tax or unemployment compensation, that rises or falls with the business cycle without any new law, softening swings in disposable income and aggregate demand.