💶AP Macroeconomics Unit 3 – National Income and Price Determination

Key Concepts and Definitions

• Gross Domestic Product (GDP) measures the total value of all final goods and services produced within a country's borders in a given period (usually a year)
• Nominal GDP is the value of goods and services measured at current prices, while Real GDP adjusts for inflation to measure the actual quantity of goods and services produced
• Aggregate Demand (AD) represents the total demand for goods and services in an economy at different price levels
  • Consists of consumption (C), investment (I), government spending (G), and net exports (X-M)
• Aggregate Supply (AS) represents the total supply of goods and services in an economy at different price levels
  • Includes the total output that firms are willing and able to produce at various price levels
• Short-run Aggregate Supply (SRAS) assumes that some input prices (wages) are fixed, while Long-run Aggregate Supply (LRAS) assumes that all input prices are flexible
• Equilibrium occurs when AD and AS intersect, determining the equilibrium price level and real GDP
• Economic growth is an increase in the production of goods and services over time, typically measured by the percentage change in real GDP
• Business cycles are the fluctuations in economic activity that an economy experiences over time, consisting of expansions and contractions

Aggregate Demand (AD)

• AD curve shows the relationship between the price level and the quantity of goods and services demanded in an economy
• The AD curve is downward sloping because a higher price level leads to lower quantity demanded due to the wealth effect, interest rate effect, and exchange rate effect
• Wealth effect states that as prices rise, the purchasing power of assets decreases, leading to lower consumption
• Interest rate effect occurs when higher prices lead to higher interest rates, which reduces borrowing and investment spending
• Exchange rate effect happens when higher prices make domestic goods more expensive relative to foreign goods, reducing net exports
• The AD curve can shift due to changes in consumption (C), investment (I), government spending (G), or net exports (X-M)
  • Factors such as consumer confidence, tax rates, interest rates, and exchange rates can cause these components to change

Aggregate Supply (AS)

• AS curve shows the relationship between the price level and the quantity of goods and services supplied in an economy
• The AS curve is divided into three ranges: Keynesian (horizontal), Intermediate (upward sloping), and Classical (vertical)
  • Keynesian range occurs when there is high unemployment and excess capacity, so firms can increase output without raising prices
  • Intermediate range happens when firms start to face resource constraints and must raise prices to produce more
  • Classical range occurs when the economy is at full employment, and any increase in AD only leads to higher prices
• Short-run Aggregate Supply (SRAS) assumes that some input prices (wages) are fixed, so firms can increase output by hiring more labor
• Long-run Aggregate Supply (LRAS) assumes that all input prices are flexible, and the economy will always return to its potential output (full employment) in the long run
• Shifts in the SRAS curve can occur due to changes in input prices (oil prices), productivity, or government regulations
• Shifts in the LRAS curve can occur due to changes in the quantity or quality of factors of production (labor, capital, technology)

Equilibrium and Price Level

• Macroeconomic equilibrium occurs when AD and AS intersect, determining the equilibrium price level and real GDP
• If AD is greater than AS, there will be an inflationary gap, leading to higher prices and possibly higher output in the short run
• If AS is greater than AD, there will be a recessionary gap, leading to lower prices and lower output
• In the long run, the economy will always move towards the full employment level of output (potential GDP), as prices and wages adjust
• Changes in AD or AS will lead to a new equilibrium price level and real GDP, either through a movement along the curves or a shift in the curves
  • For example, an increase in government spending (G) will shift the AD curve to the right, leading to a higher price level and higher real GDP in the short run

Shifts in AD and AS

• Shifts in AD can be caused by changes in consumption (C), investment (I), government spending (G), or net exports (X-M)
  • Factors such as consumer confidence, tax rates, interest rates, and exchange rates can cause these components to change
• An increase in AD will shift the curve to the right, leading to a higher price level and higher real GDP in the short run
• A decrease in AD will shift the curve to the left, leading to a lower price level and lower real GDP in the short run
• Shifts in SRAS can be caused by changes in input prices (oil prices), productivity, or government regulations
  • An increase in SRAS will shift the curve to the right, leading to a lower price level and higher real GDP
  • A decrease in SRAS will shift the curve to the left, leading to a higher price level and lower real GDP
• Shifts in LRAS can be caused by changes in the quantity or quality of factors of production (labor, capital, technology)
  • An increase in LRAS will shift the curve to the right, leading to a higher potential GDP and lower price level in the long run
  • A decrease in LRAS will shift the curve to the left, leading to a lower potential GDP and higher price level in the long run

Economic Growth and Fluctuations

• Economic growth is an increase in the production of goods and services over time, typically measured by the percentage change in real GDP
• Long-term economic growth is driven by increases in the quantity and quality of factors of production (labor, capital, technology)
• Short-term economic fluctuations, known as business cycles, are the periodic expansions and contractions in economic activity
  • Expansions are characterized by increasing real GDP, low unemployment, and mild inflation
  • Contractions (recessions) are characterized by decreasing real GDP, high unemployment, and possible deflation
• Factors that can contribute to economic fluctuations include changes in AD (consumption, investment, government spending, net exports) and AS (input prices, productivity, regulations)
• Policymakers use fiscal and monetary policies to try to smooth out economic fluctuations and promote stable growth
  • Fiscal policy involves changes in government spending and taxation to influence AD
  • Monetary policy involves changes in the money supply and interest rates to influence AD and AS

Fiscal and Monetary Policy Impacts

• Fiscal policy refers to the use of government spending and taxation to influence the level of AD in the economy
  • Expansionary fiscal policy involves increasing government spending (G) or reducing taxes to stimulate AD and economic growth
  • Contractionary fiscal policy involves decreasing government spending (G) or increasing taxes to reduce AD and control inflation
• Monetary policy refers to the actions taken by the central bank to influence the money supply and interest rates in the economy
  • Expansionary monetary policy involves increasing the money supply or lowering interest rates to stimulate AD and economic growth
  • Contractionary monetary policy involves decreasing the money supply or raising interest rates to reduce AD and control inflation
• The effectiveness of fiscal and monetary policies depends on various factors, such as the size of the multiplier effect, the responsiveness of investment to interest rate changes, and the time lags involved in implementing policies
• In the short run, expansionary policies can help to close recessionary gaps and stimulate economic growth, while contractionary policies can help to close inflationary gaps and control inflation
• In the long run, the economy will always move towards its potential output (full employment), and policies should focus on promoting sustainable growth through improvements in productivity and resource allocation

Real-World Applications

• The Great Recession of 2008-2009 was caused by a significant decrease in AD, primarily due to a decline in consumption (C) and investment (I) following the housing market crash and financial crisis
  • Policymakers responded with expansionary fiscal policy (stimulus spending, tax cuts) and monetary policy (lower interest rates, quantitative easing) to stimulate AD and promote recovery
• The COVID-19 pandemic in 2020 led to a sharp contraction in economic activity, as lockdowns and social distancing measures reduced consumption (C) and disrupted supply chains
  • Governments and central banks implemented large-scale fiscal and monetary stimulus measures to support households and businesses, such as direct payments, unemployment benefits, and low-interest loans
• Stagflation, a situation of high inflation and high unemployment, can occur when there is a decrease in AS (e.g., due to an oil price shock) combined with policies that stimulate AD
  • This situation presents a challenge for policymakers, as expansionary policies to reduce unemployment may worsen inflation, while contractionary policies to control inflation may increase unemployment
• Developing countries often face challenges in achieving sustainable economic growth due to factors such as low productivity, inadequate infrastructure, and weak institutions
  • Policies that promote investment in human capital (education, health), infrastructure development, and institutional reforms can help to shift the LRAS curve to the right and promote long-term growth
• Globalization and international trade can impact AD and AS in an economy through changes in net exports (X-M) and the flow of factors of production (labor, capital) across borders
  • Trade agreements, tariffs, and exchange rate fluctuations can all influence the level of AD and AS in an economy, as well as the distribution of income and resources between countries