U3: National Income and Price Determination

Unit 3 - National Income and Price Determination

Aggregate Demand Curve

Shows relationship between aggregate price level & quantity of aggregate demand by  households, firms, government, and the rest of the world.

Downwarding Slope

● Real-balance effect (increase in price level decreases the purchasing power of money)

● Interest rate effect (increase in interest rate decreases borrowing and spending)

● Open economy effect (higher price levels decreases net exports)

○ Made up of consumption, investment, government spending, and net exports

● Shifters

● Changes in expectations (optimistic beliefs increase demand)

● Changes in wealth (rise in asset value increase demand)

● Size of existing physical capital (small existing stock of physical capital increases demand)

Fiscal Policy: Government spending increase or tax cuts increase demand.

Monetary Policy: Quantity of money increases demand.

Short-run Aggregate Supply (SRAS)

When firms haven’t made price changes in response to an economic shock (sticky prices).

Upward Slope

● The misperception theory (producers mistaken price increase as greater profit)

● Sticky Price Theory (producers temporarily reduce quantity b/c of menu costs)

● Sticky Wage Theory (production costs can be higher from union contracts)

● Shifters

● Changes in commodity prices (lower commodity price increases SRAS)

● Changes in nominal wages (lower nominal wages increases SRAS)

● Changes in productivity (more productive workers increases SRAS)

Long-run aggregate supply (LRAS)

● After producers have adjusted their prices according to economic shocks

● All production costs are fully flexible

● It is an economy’s potential output (represent the full-employment output)

● Shifters that cause and increase

● Increases in the quantity of resources (e.g., land, labor)

● Increases in the quality of resources (e.g., education)

● Technological progress can increase LRAS

LRAS shifts indicate changes in full-employment level of output & economic growth.

AD-AS Model

● If aggregate price level is above equilibrium, AS will exceed AD and cause the aggregate PL to fall, pushing it back to the equilibrium. If aggregate price level is below equilibrium, AD will exceed AS and cause the aggregate price level to rise, pushing it back to the equilibrium.

● Positive demand shock increases aggregate price and aggregate output (demand-pull). Negative demand shock decreases aggregate price and aggregate output.

● Positive supply shock decreases aggregate price and increases aggregate output. Negative supply shock increases aggregate price and decreases aggregate output (supply-push).

Recessionary Gap

Exists when SRAS equilibrium is less than LRAS equilibrium.

If so, wages would fall and SRAS would shift to the right, bringing the economy back to LRAS equilibrium.

Inflationary Gap

Exists when SRAS equilibrium is greater than LRAS equilibrium. 

If so, wages would rise and SRAS would shift to the right, bringing the economy back to LRAS equilibrium.

● Economy self-corrects in the long-run

Equilibrium

● Short-run equilibrium is when AD & SRAS are equal

● Long-run equilibrium is when AD & SRAS are equal and interest on LRAS

Fiscal Policies (Affect AD)

Expansionary Fiscal policies that increase aggregate demand:

● Increase in government purchases (has greatest effect)

Multiplier = 1/(1 - MPC) * ΔAAS

MPC = (Change in consumer spending) / change in disposable income

MPC + MPS = 1

● Cut in taxes

Multiplier = (MPC)/MPS

MPS = 1 - MPC

● Increase in government transfers

Fiscal Policy and Demand

Contractionary Fiscal Policies that decrease aggregate demand:

● Decrease in government purchases

● Increase in taxes

● Decrease in government transfers

Expansionary policies are used in recessions and contractionary fiscal policies are used in expansions.

Government spending and taxation rules that cause fiscal policy to be automatically expansionary during recessions and contractionary during expansions are automatic stabilizers:

● Ex. Tax revenues automatically decrease as GDP falls, increasing consumption and preventing the economy falling into a greater recession.

● Ex. Tax revenues automatically increase as GDP rises, decreasing consumption and the economy from overheating.