National Income and Price Determination

Why does this unit's model look the way it does?

• Classical economists (pre-1930s) believed the economy was self-correcting: a slump in output would be met by falling prices (raising real spending), falling wages (raising employment), and falling interest rates (expanding investment) — restoring full employment automatically. This rests on Say's Law: "supply creates its own demand," since the very act of producing generates income equal to the value of that output. Under this view, the economy is always at (or quickly returning to) full employment, so the aggregate supply curve is effectively vertical.
• The Great Depression (GDP fell ~40%, unemployment near 25% in the US) challenged this. John Maynard Keynes argued that not all income gets spent — some is saved, and that saving "leaks" out of the spending stream unless businesses reinvest it. He also argued wages and prices are not flexible downward ("sticky") — so producers facing unsold inventory are more likely to cut output than cut prices, and a slump can persist rather than self-correct quickly.
• The modern synthesis used in this course blends both views across time horizons: in the short run, sticky wages give the aggregate supply curve an upward slope (Topic 3.3); in the long run, wages and prices become flexible, and the economy tends back toward full employment, giving a vertical long-run aggregate supply curve (Topic 3.4) — closer to the classical view, but specifically as a long-run outcome rather than an always-true description of the economy.

Before Aggregate Demand, two building blocks are worth understanding directly.

Consumption and saving

• Disposable income (DI) is split between consumption (C) and saving (S): DI = C + S.
• APC (average propensity to consume) = C ÷ DI. APS (average propensity to save) = S ÷ DI. APC + APS = 1.
• MPC (marginal propensity to consume) = change in C ÷ change in DI — the fraction of any additional income that gets spent.
• MPS (marginal propensity to save) = change in S ÷ change in DI — the fraction of any additional income that gets saved.
• MPC + MPS = 1, always, since every extra dollar of income is either spent or saved.
• Non-income determinants that can shift consumption/saving even when income doesn't change: wealth, expectations, consumer debt, and interest rates.

Investment decisions

• Investment (here meaning real capital — machinery, equipment, buildings — not financial investments like stocks) is driven by comparing the expected rate of return on a project to the prevailing (real) interest rate. A business only invests if the expected return exceeds what it could earn by putting the same money elsewhere at the going interest rate.
• This is why the investment demand curve slopes downward: as the interest rate falls, more projects clear that bar, so the quantity of investment demanded rises.
• Investment is far less stable/predictable than consumption, since it depends on hard-to-forecast expected profits. Determinants that shift investment demand: the cost of acquiring/maintaining capital goods, business taxes, technology, the existing stock of capital goods on hand, and changes in profit expectations.

Aggregate Demand (AD) is the total quantity of all final goods and services (real GDP) demanded in the economy at each possible price level: AD = C + I + G + Xn (the same components as GDP's expenditure approach, viewed from the demand side).

Why AD slopes downward

The AD curve slopes downward — but for different reasons than an individual product's demand curve:

• Wealth effect (real balances effect): a lower price level makes existing money and savings worth more in real terms, so people spend more.
• Interest rate effect: a lower price level means people need to hold less money for everyday transactions, freeing up funds to lend; this pushes interest rates down, encouraging more borrowing and investment spending.
• Foreign purchases effect (exchange rate effect): a lower domestic price level makes domestic goods relatively cheaper than foreign goods, increasing exports and reducing imports.

Movements vs. shifts

A movement along the AD curve happens only from a change in the price level. A shift of the entire AD curve happens when C, I, G, or Xn changes for any other reason:

• C shifts with changes in consumer wealth, expectations, interest rates, or debt.
• I shifts with changes in interest rates, profit expectations, business taxes, technology, or the degree of excess capacity.
• G shifts with new government programs or spending cuts.
• Xn shifts with changes in trading partners' income, exchange rates, or trade barriers.

Any initial change in spending has a multiplied effect on GDP, because one person's spending becomes another person's income, part of which gets spent again, and so on.

• Spending multiplier = 1 ÷ (1 − MPC) = 1 ÷ MPS. Applies to changes in C, I, G, or Xn: change in GDP = change in spending × spending multiplier.
• Tax multiplier = −MPC ÷ (1 − MPC) = −MPC ÷ MPS. Applies to changes in taxes: change in GDP = change in taxes × tax multiplier. It's negative (a tax hike lowers GDP, a tax cut raises it) and always smaller in absolute value than the spending multiplier, since a tax change only affects spending indirectly, through the fraction MPC.
• Balanced-budget multiplier = 1. If government spending and taxes rise (or fall) by the same amount, GDP changes by that same amount — not zero — because the spending increase hits GDP directly and fully, while the tax increase only dampens consumption by the MPC fraction.

The SRAS curve slopes upward. In the short run, wages and resource prices are largely fixed by contracts ("sticky"). So when the price level rises, firms' revenue rises while their costs mostly don't — boosting profit margins and giving firms an incentive to supply more.

Determinants that shift SRAS

All of them work through per-unit production cost = total input cost ÷ units of output:

• Input/resource prices (land, labor, capital, imported resources) — higher costs shift SRAS left; lower costs shift it right.
• Productivity — getting more output from the same inputs lowers per-unit costs, shifting SRAS right.
• Legal/institutional environment — business taxes and regulation raise costs (SRAS left); subsidies lower costs (SRAS right).

The LRAS curve is vertical, positioned at the economy's full-employment (potential) level of real GDP. In the long run, all resource prices — including wages — become flexible and fully adjust, so the price level has no lasting effect on how much the economy actually produces.

LRAS represents the same "potential GDP" and "natural rate of unemployment" concepts from Unit 2 — they're the same full-employment benchmark, viewed through the AD-AS model.

• Short-run equilibrium is where AD intersects SRAS — this determines the current price level and real GDP.
• Long-run equilibrium is where AD, SRAS, and LRAS all intersect at once — the economy is producing exactly at its full-employment potential.
• A recessionary gap exists when short-run equilibrium sits to the left of LRAS: actual output is below potential, and actual unemployment exceeds the natural rate.
• An inflationary gap exists when short-run equilibrium sits to the right of LRAS: actual output exceeds potential (unsustainable long-term), and actual unemployment is below the natural rate.

• Demand shocks (a shift in AD) move the short-run equilibrium along SRAS: the price level and real GDP move in the same direction. AD increases → both P and Y rise. AD decreases → both P and Y fall.
• Supply shocks (a shift in SRAS) move the short-run equilibrium along AD: the price level and real GDP move in opposite directions. SRAS increases → P falls, Y rises. SRAS decreases → P rises and Y falls simultaneously — a combination known as stagflation.

• If a recessionary gap persists with no policy action: high unemployment creates downward pressure on wages and resource prices as workers accept lower pay to find jobs. Costs fall, SRAS shifts right, and the economy self-corrects back to full-employment output on LRAS — with a lower price level than at the short-run recessionary equilibrium.
• If an inflationary gap persists with no policy action: tight labor markets let workers demand higher wages. Costs rise, SRAS shifts left, and the economy self-corrects back to full-employment output on LRAS — with a higher price level than at the short-run inflationary equilibrium.
• This self-correction can take a long time in practice, since wages and contracts adjust slowly — which is exactly the classical-vs-Keynesian debate about whether the government should intervene rather than wait.

• Fiscal policy is the government's use of spending (G) and taxation (T) to influence Aggregate Demand, aiming for growth, low unemployment, and stable prices.
• Expansionary fiscal policy (increase G and/or decrease T) increases AD — used to close a recessionary gap.
• Contractionary fiscal policy (decrease G and/or increase T) decreases AD — used to close an inflationary gap.
• Discretionary fiscal policy requires deliberate, new legislation — for example, a stimulus package, an infrastructure bill, or a one-time tax rebate passed in response to current conditions.

• Automatic stabilizers are already-existing policies that adjust on their own as economic conditions change, with no new legislation required.
• Progressive income taxes: as incomes fall in a downturn, tax revenue automatically falls too, cushioning the drop in after-tax spending; as incomes rise in a boom, tax revenue automatically rises, helping cool things off — all without Congress passing anything new.
• Unemployment benefits and other transfer programs: more people automatically qualify (and receive more support) during a downturn, and fewer do during an expansion — smoothing the business cycle automatically.