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Macroeconomics Unit 3: National income and price determination

The AD–AS model shows how output and the price level are determined and how fiscal policy can close recessionary and inflationary gaps.

Covers: Aggregate demand, multipliers, short-run and long-run aggregate supply, AD–AS equilibrium, shifts and gaps, self-adjustment, fiscal policy, automatic stabilizers

Study guide

Aggregate demand (AD) is total spending on an economy's goods and services at each price level. It slopes downward because of the wealth effect, the interest-rate effect and the exchange-rate effect. AD shifts when any component of spending (C, I, G or Xn) changes, from things like consumer confidence, interest rates, government spending, taxes and foreign income. A change in spending has a multiplied effect on GDP. The marginal propensity to consume (MPC) is the share of extra income spent, and the spending multiplier = 1 ÷ (1 − MPC) = 1 ÷ MPS. The tax multiplier is −MPC ÷ MPS, smaller than the spending multiplier, and the balanced-budget multiplier is 1.

Short-run aggregate supply (SRAS) slopes upward because wages and some prices are sticky. SRAS shifts with input prices, productivity, expectations of inflation, business taxes and supply shocks. Long-run aggregate supply (LRAS) is vertical at full-employment (potential) output, because in the long run wages and prices fully adjust. Short-run equilibrium is where AD and SRAS cross. If output is below potential, there's a recessionary (negative) output gap with high unemployment; if above, an inflationary (positive) gap. A decrease in AD causes recession, while a negative supply shock causes stagflation: higher prices and lower output.

In the long run, the economy self-adjusts: in a recession, wages eventually fall, SRAS shifts right and output returns to potential; in an inflationary gap, wages rise and SRAS shifts left. Because this can take a long time, governments may use fiscal policy: changes in government spending and taxes. Expansionary fiscal policy (more spending or lower taxes) increases AD to close a recessionary gap; contractionary policy closes an inflationary gap. Automatic stabilizers, like progressive taxes and unemployment benefits, adjust without new legislation. Fiscal policy faces time lags and political constraints.

When AD and SRAS shift together, one outcome is certain and the other depends on the size of the shifts. If AD rises while SRAS falls, the price level definitely rises, but the change in real GDP is uncertain. If both rise, real GDP definitely rises, but the price level change is uncertain. A tax cut first raises disposable income, and people save part of it, so only MPC × the tax change is spent in the first round. That's why the tax multiplier (MPC ÷ MPS, ignoring its negative sign) is smaller than the spending multiplier. An equal increase in government spending and taxes therefore raises GDP by exactly that amount (a multiplier of 1).

A negative supply shock, like a jump in oil prices, raises the price level and lowers real output. If nominal wages are sticky, real wages fall in the short run. If short-run equilibrium output is to the right of the vertical LRAS, there is an inflationary (positive) output gap. If it is to the left, the gap is recessionary (negative). Draw LRAS at full-employment output, labeled Yf.

Key ideas

• AD slopes down because of the wealth, interest-rate and exchange-rate effects.
• Changes in spending have multiplied effects on GDP.
• LRAS is vertical at full-employment output.
• Recessionary and inflationary gaps eventually close through wage adjustment.
• Fiscal policy shifts AD to close output gaps faster.

Formulas and rules

Common mistakes

• Thinking a change in the price level shifts AD; it moves along AD.
• Using the spending multiplier for a tax change; the tax multiplier is smaller.

Words to know

Aggregate demand (AD)

Total spending on goods and services at each price level.

Wealth effect

A higher price level lowers the real value of wealth, reducing spending.

Interest-rate effect

A higher price level raises interest rates, reducing investment.

Exchange-rate effect

A higher price level makes exports less competitive.

Marginal propensity to consume (MPC)

The share of additional income spent.

Marginal propensity to save (MPS)

The share of additional income saved.

Spending multiplier

1 ÷ (1 − MPC): the total GDP change per dollar of new spending.

Tax multiplier

−MPC ÷ MPS: the GDP change per dollar of tax change.

Short-run aggregate supply (SRAS)

Upward-sloping supply curve with sticky wages.

Long-run aggregate supply (LRAS)

Vertical at full-employment output.

Potential output

The output level at full employment.

Recessionary gap

Output below potential; high unemployment.

Inflationary gap

Output above potential; rising prices.

Stagflation

Rising prices plus falling output, often from a negative supply shock.

Supply shock

A sudden change in input costs or productivity.

Self-adjustment

Wages and prices eventually move the economy back to potential output.

Fiscal policy

Changes in government spending and taxes.

Expansionary fiscal policy

More spending or lower taxes to increase AD.

Contractionary fiscal policy

Less spending or higher taxes to decrease AD.

Automatic stabilizers

Taxes and transfers that change automatically with the economy.

Sample practice questions

15 more questions like these, from level 1 to 5, are in the practice set.