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Flashcards · AP® Macroeconomics · Unit 3

Unit 3: National Income and Price Determination flashcards

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3.1 Aggregate Demand (AD)

What is aggregate demand?
The relationship between the price level and the quantity of real GDP that households (C), firms (I), the government (G) and the rest of the world (NX) want to buy. Axes: price level (vertical) and real GDP (horizontal).
Why does the AD curve slope downward?
Real wealth effect: PL up, real value of money and savings down, C down. Interest rate effect: PL up, money demand up, interest rates up, I down. Exchange rate effect: interest rates up, currency appreciates, NX down. Not substitution between goods.
What shifts AD?
Any change in spending not caused by the price level: consumer wealth or confidence, income taxes and transfers (C); business expectations, policy interest rates, business taxes (I); government purchases (G); foreign incomes, a depreciation (NX).
Does a higher price level decrease AD?
No. It decreases the quantity of real GDP demanded: a movement up along AD. A policy rise in interest rates, by contrast, shifts AD left.
Graph: consumer confidence rises. Describe the AD graph.
Price level on the vertical axis, real GDP on the horizontal. AD shifts right from AD₁ to AD₂: the quantity of real GDP demanded is higher at every price level.
At one price level, C = 700, I = 150, G = 250 and NX = −30 (VD billion). What is real GDP demanded?
700 + 150 + 250 − 30 = VD 1,070 billion.
Does a tax cut raise G?
No. It raises disposable income and so consumption, C. G is government purchases of goods and services.

3.2 Multipliers

What are the MPC and MPS?
MPC = ΔC ÷ ΔDI: the share of an extra unit of disposable income that is spent. MPS = ΔS ÷ ΔDI = 1 − MPC. Use changes, not totals.
What is the spending multiplier, and why does it exist?
1 ÷ MPS = 1 ÷ (1 − MPC), not 1 ÷ MPC. A change in autonomous spending becomes someone's income, part of which is spent again, so AD changes by more than the first change.
What is the tax multiplier, and why is it smaller?
−MPC ÷ MPS. A tax change works through disposable income and part of it is saved first, so the first round of spending is smaller. A change in transfers uses +MPC ÷ MPS.
The MPS is 0.2 and government spending falls by VD 10 billion. What is the change in AD?
Spending multiplier = 1 ÷ 0.2 = 5, so AD falls by VD 50 billion. The tax multiplier here would be −4.
The MPC is 0.6 and taxes rise by VD 20 billion. What is the change in AD?
Tax multiplier = −0.6 ÷ 0.4 = −1.5, so AD falls by VD 30 billion.
What happens with a balanced-budget rise in spending and taxes?
AD rises by the amount of the spending change, not by zero, because the tax multiplier is smaller in size than the spending multiplier.
How does the MPC affect the multipliers?
A higher MPC (lower MPS) makes both bigger. MPC 0.75 gives 4 and −3; 0.8 gives 5 and −4; 0.9 gives 10 and −9.

3.3 Short-Run Aggregate Supply (SRAS)

What does the SRAS curve show, and why does it slope upward?
The real output firms supply at each price level in the short run. Nominal wages and some input prices are sticky, so when the price level rises, costs lag, profit per unit rises and firms produce more.
What shifts SRAS?
Left: higher nominal wages or input prices, higher expected inflation, bad harvests or disasters. Right: higher productivity, producer subsidies, lower business taxes. A change in the price level is a movement along it.
Graph: the price of a key input rises across the economy. Describe the graph.
Price level on the vertical axis, real GDP on the horizontal. SRAS shifts left (up) from SRAS₁ to SRAS₂: at the same price level, firms supply less real output. Compare the same price level on the two curves to show the shift.
What happens to unemployment as the economy moves up along SRAS?
Output and employment rise, so the unemployment rate falls (labour force fixed). This is the short-run trade-off between inflation and unemployment.
The price level rises from 100 to 108 while a contract fixes the nominal wage at VD 24 an hour. What is the real wage?
24 ÷ 1.08 = VD 22.22 in base-period valdas. The real wage falls, which is why firms produce more.
Why does higher expected inflation shift SRAS left?
Workers demand higher nominal wages, which raises firms' costs at every price level.
Does a change in consumer confidence or household taxes shift SRAS?
No. Household spending shifts AD, not SRAS.

3.4 Long-Run Aggregate Supply (LRAS)

What is the LRAS curve, and why is it vertical?
It is vertical at full-employment (potential) output, Yf. In the long run all input prices rise or fall with the price level, so real profit per unit does not change; output depends only on resources and technology.
What is the difference between the short run and the long run here?
Short run: some input prices, especially nominal wages, are fixed. Long run: all wages and prices have adjusted fully. Neither is a fixed number of years.
Is there a long-run trade-off between inflation and unemployment?
No. At any price level the economy ends at Yf and the natural rate of unemployment in the long run.
Can real output be above Yf?
Yes, for a time, by over-using resources, but not sustainably. Right of LRAS, unemployment is below the natural rate.
How does LRAS relate to the PPC?
Both show maximum sustainable capacity. Full employment: on the PPC and on LRAS. Unemployed resources: inside the PPC and left of LRAS. More resources or better technology: the PPC shifts out and LRAS shifts right.
Does a temporary rise in input prices shift LRAS?
No. It shifts SRAS only. LRAS moves only when capacity, meaning resources or technology, changes.
Labour force 25.0 million, natural rate 5.0% and unemployment 6.0%. How many are cyclically unemployed?
(6.0% − 5.0%) × 25.0 million = 0.25 million people.

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

What is short-run equilibrium in the AD–AS model?
Where AD crosses SRAS: aggregate quantity demanded equals aggregate quantity supplied, giving the equilibrium price level and real output. It can be below, at or above Yf.
What is long-run equilibrium in the AD–AS model?
AD and SRAS cross on LRAS, so real GDP = Yf and unemployment equals the natural rate. All three curves cross at one point.
Graph: describe a recessionary gap in the AD–AS model.
Price level on the vertical axis, real GDP on the horizontal. AD and SRAS cross to the left of the vertical LRAS at Yf. Output is below Yf, the output gap is negative and unemployment is above the natural rate.
What happens when the price level is above its short-run equilibrium?
There is a surplus: inventories rise unexpectedly, so the price level and output fall. Below equilibrium, inventories fall and both rise. The economy moves along AD and SRAS; no curve shifts.
Equilibrium real GDP is VD 470 billion and Yf is VD 500 billion. What is the gap?
−VD 30 billion, or −30 ÷ 500 = −6% of Yf: a negative, recessionary gap.
Unemployment is 3.8% and the natural rate is 4.5%. Where is short-run equilibrium?
Right of LRAS: a positive, inflationary gap, with negative cyclical unemployment.

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

What shifts AD and what shifts SRAS?
Spending changes (C, I, G, NX) shift AD. Cost changes (wages, input prices, expected inflation, productivity, supply shocks) shift SRAS. In the short run LRAS does not move.
How do the effects of AD shocks and SRAS shocks differ?
AD shock: the price level, real output and employment move in the same direction. SRAS shock: output and employment move one way and the price level the other.
What are demand-pull inflation, cost-push inflation and stagflation?
Demand-pull: AD shifts right. Cost-push: SRAS shifts left. Stagflation: a higher price level with lower output and higher unemployment, after a negative SRAS shock.
Graph: energy prices rise sharply. Describe the AD–AS graph.
Price level on the vertical axis, real GDP on the horizontal. SRAS shifts left; AD and LRAS do not move. The new short-run equilibrium has a higher price level and lower real GDP, with unemployment rising: stagflation.
Government spending rises by VD 10 billion and the MPC is 0.8. How far does AD shift?
10 × 1 ÷ (1 − 0.8) = VD 50 billion. Real output rises by less than this, because the price level also rises.
After a shock the price level rises from 104 to 108 and real GDP falls. Which shock caused it?
A decrease in SRAS: cost-push inflation of (108 − 104) ÷ 104 × 100 = 3.85%.

3.7 Long-Run Self-Adjustment

How does the economy self-adjust from a recessionary gap?
With no policy, unemployment above the natural rate lowers nominal wages and other input prices as contracts are renewed. SRAS shifts right, the price level falls and output rises back to Yf.
How does the economy self-adjust from an inflationary gap?
A labour shortage raises nominal wages, so SRAS shifts left, the price level rises and output falls back to Yf, with unemployment back at the natural rate.
Graph: AD rises from long-run equilibrium. Describe the adjustment with no policy.
Price level on the vertical axis, real GDP on the horizontal. AD shifts right, so output rises above Yf. Nominal wages then rise and SRAS shifts left until it meets the new AD on LRAS. The economy ends at Yf at a higher price level than before.
After an AD shock, does the price level return to its old value?
No. Real GDP returns to Yf, but the price level ends lower if AD fell and higher if AD rose. After a temporary SRAS shock, the economy returns to its original price level and Yf.
What does a rightward shift of LRAS mean?
Full-employment output has risen: economic growth. Only changes in resources and technology move LRAS; self-adjustment shifts SRAS.
Real GDP is VD 820 billion and Yf is VD 840 billion. What happens without policy?
There is a recessionary gap of VD 20 billion. Nominal wages fall and SRAS shifts right until output reaches Yf. The SRAS shift needed is usually larger than the gap.

3.8 Fiscal Policy

What is fiscal policy?
Government changes to spending and to taxes and transfers to reach goals such as full employment and stable prices. G changes AD directly; taxes and transfers change it indirectly through disposable income and consumption.
Which fiscal policy closes each type of gap?
Recessionary gap: expansionary policy (G up, taxes down, transfers up). Inflationary gap: contractionary policy (G down, taxes up, transfers down).
The MPC is 0.8 and there is a recessionary gap of VD 20 billion. What rise in G, or cut in taxes, closes it?
Change in G = gap ÷ spending multiplier = 20 ÷ 5 = VD 4 billion. Tax cut = gap ÷ size of tax multiplier = 20 ÷ 4 = VD 5 billion. Divide, never multiply.
Graph: expansionary fiscal policy in a recession. Describe the AD–AS graph.
Price level on the vertical axis, real GDP on the horizontal. AD shifts right towards the vertical LRAS at Yf. Real output and the price level rise and unemployment falls. Expansionary policy raises the price level in the short run; it never lowers it.
Why may fiscal policy fail to stabilise the economy in time?
Lags: it takes time to recognise a gap, decide on a policy, implement it, and for the policy to take effect.
Why are calculated policy sizes a minimum?
The calculations hold the price level constant. With an upward-sloping SRAS, real GDP rises by a little less than the AD shift.

3.9 Automatic Stabilizers

What are automatic stabilizers?
Parts of the tax and transfer system that change by themselves when real GDP changes, with no new law or announcement. Tax revenue moves with real GDP; transfers move the opposite way.
How do automatic stabilizers work in a recession?
Incomes fall, so tax revenue falls; more people qualify for benefits, so transfers rise. Disposable income and consumption fall by less, so AD still shifts left, but by less, and the recession is milder.
How do automatic stabilizers work in an expansion?
Tax revenue rises and transfers fall, so disposable income and consumption rise by less, and the economy is less likely to overheat.
How do automatic stabilizers differ from discretionary fiscal policy?
Discretionary policy needs a new decision and faces decision and implementation lags; stabilizers avoid these lags. But stabilizers only moderate the cycle: they do not close output gaps or restore full employment on their own.
Income falls by VD 20 billion, the tax takes 30% of income, and transfers rise by VD 2 billion. How much does disposable income fall?
Tax revenue falls by 0.3 × 20 = VD 6 billion, so disposable income falls by 20 − 6 − 2 = VD 12 billion. With an MPC of 0.75, first-round consumption falls by VD 9 billion.
Is a vote to extend unemployment benefits for six months an automatic stabilizer?
No. It is a new decision, so it is discretionary fiscal policy.

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