Unit 3: National Income and Price Determination

Unit 3 is the core model of AP Macroeconomics. It builds the aggregate demand and aggregate supply model, explains how the economy settles at a level of output and a price level, and shows how fiscal policy and the economy's own wage adjustment move it back toward full employment.

3.1 Aggregate Demand (AD)

Aggregate demand is the total quantity of all final goods and services that households, firms, the government, and foreign buyers want to purchase at each price level, holding everything else constant. It is the whole-economy version of demand, and like a single-market demand curve it slopes downward. Adding up its parts gives the familiar identity: AD = C + I + G + Xn.

The downward slope comes from three effects of a changing price level. The wealth effect: when the price level rises, the money people hold buys less, so real wealth falls and households cut consumption. The interest-rate effect: a higher price level raises the demand for money, which pushes interest rates up and makes investment and big-ticket consumption more expensive. The net export effect: a higher domestic price level makes exports relatively expensive abroad and imports relatively cheap at home, so net exports fall. Each effect says the same thing in different words. A higher price level means a smaller quantity of output demanded.

Shifts of AD come from anything that changes C, I, G, or Xn at a given price level. Consumer spending shifts with after-tax income, household wealth from assets like stocks and housing, expectations about the future, and household debt. Investment shifts with interest rates set in financial markets, business expectations, and new technology. Government spending shifts when the budget changes. Net exports shift with foreign income, exchange rates, and foreign tastes for domestic goods.

3.2 Multipliers

A multiplier measures how an initial change in spending ripples through the economy. When the government spends an extra $100 billion building roads, the construction firms receive $100 billion of new income. They spend part of it and save the rest. The part they spend becomes someone else's income, which is partly spent again, and so on. Each round is smaller than the last because some income leaks into saving.

The size of the ripple depends on the marginal propensity to consume (MPC), the fraction of each extra dollar of income that gets spent, and the marginal propensity to save (MPS), the fraction saved. Since every extra dollar is either spent or saved, MPC + MPS = 1. The spending multiplier equals 1 / MPS, which is the same as 1 / (1 - MPC). With an MPC of 0.8, the MPS is 0.2 and the multiplier is 1 / 0.2 = 5. A $100 billion increase in government spending then raises real GDP by $500 billion, holding the price level constant.

Tax changes get a different multiplier. The tax multiplier equals -MPC / MPS. It is negative because a tax increase reduces GDP, and it is smaller in absolute value than the spending multiplier because the first round of a tax cut is partly saved. Only the spent portion, MPC times the cut, enters the spending chain. With an MPC of 0.8, the tax multiplier is -0.8 / 0.2 = -4, so a $100 billion tax cut raises GDP by $400 billion. If government spending and taxes rise by the same amount, the balanced-budget multiplier is 1, and GDP rises by exactly the amount of the increase.

3.3 Short-Run Aggregate Supply (SRAS)

Short-run aggregate supply shows the quantity of output firms are willing to produce at each price level, holding input prices and expectations fixed. It slopes upward. When the overall price level rises but wages and other input costs have not caught up yet, production becomes more profitable and firms expand output.

Three reasons explain why input costs lag behind. Sticky wages: many workers are paid under contracts that fix nominal wages for a year or more, so a rising price level cuts real labor costs temporarily. Sticky prices, sometimes called menu costs: firms face costs and risks in changing their posted prices, so some prices adjust slowly. Misperceptions: when the price level rises, an individual producer may mistake the general increase for a rise in the relative price of her own product and expand output. All three fade as time passes, which is why this curve describes the short run only.

SRAS shifts when the cost of production changes at a given price level. Higher input prices, such as oil or wages, shift SRAS left. Higher productivity shifts it right, since each worker produces more. Taxes on producers shift SRAS left by raising costs, while subsidies shift it right. Supply shocks like droughts or wars shift it left, and changes in expected inflation shift it as firms and workers build expectations into wages and prices.

3.4 Long-Run Aggregate Supply (LRAS)

Long-run aggregate supply is vertical at full-employment output, also called potential GDP and labeled Yf. In the long run, wages and prices have fully adjusted, so the price level no longer affects how much the economy can produce. What the economy can produce depends only on its resources and how productively it uses them.

LRAS shifts only when the economy's productive capacity changes: the quantity or quality of labor, capital, and natural resources, improvements in technology, or changes in institutions such as property rights and the legal system. A larger or better-educated labor force, more capital equipment, or a genuine technological advance shifts LRAS right. Nothing about demand, the price level, or fiscal policy moves it.

3.5 Equilibrium in the Aggregate Demand-Aggregate Supply Model

Short-run equilibrium is where AD and SRAS intersect. That point gives the economy's actual real GDP and the actual price level. Long-run equilibrium is stricter: all three curves, AD, SRAS, and LRAS, intersect at a single point, which means the economy is producing exactly at full-employment output Yf.

When short-run equilibrium output differs from Yf, the economy has an output gap. An inflationary gap means equilibrium output is above Yf. The economy is overproducing, unemployment is below its natural rate, and upward pressure on wages and prices is building. A recessionary gap means equilibrium output is below Yf. Resources sit idle, unemployment is above its natural rate, and downward pressure on wages and prices is building. The gap is named by where output sits relative to Yf, not by what happens to prices.

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

Every shock in this model works through one of the curves, and the table below summarizes what follows. A rightward shift of AD raises output and the price level while lowering unemployment. If it persists, the rising price level is demand-pull inflation: too much spending chasing the economy's capacity.

A leftward shift of SRAS does the opposite on output and prices at once: output falls while the price level rises, and unemployment climbs. Rising prices with falling output is cost-push inflation, and the combination of stagnation plus inflation is stagflation. This is the painful shock, because the usual policy response to inflation makes the output problem worse and vice versa.

3.7 Long-Run Self-Adjustment

The model has a built-in return mechanism because wages eventually adjust. Start with a recessionary gap: output is below Yf and unemployment is above its natural rate. With many workers competing for few jobs, nominal wages fall. Lower wages cut firms' production costs, which shifts SRAS to the right. Output rises back toward Yf, and the price level falls along the way. The economy reaches a new long-run equilibrium at full employment with a lower price level, and no government action was required.

An inflationary gap self-corrects in the mirror image. Output above Yf means unemployment below its natural rate, so firms bid wages up to attract scarce workers. Higher wages raise production costs and shift SRAS left. Output falls back to Yf while the price level rises. The classical economists trusted this mechanism completely and saw little need for government intervention.

The Keynesian objection is about speed and symmetry. Wages may be sticky downward: workers resist pay cuts, contracts lock wages in, and minimum wage laws set a floor. If wages do not fall during a recession, the SRAS shift is slow or never arrives, and the economy can sit below full employment for a long time. That possibility is the intellectual case for active fiscal policy in the next topic.

3.8 Fiscal Policy

Fiscal policy is deliberate change in government spending or taxes to influence the economy, and it works by shifting AD. Expansionary fiscal policy fights a recessionary gap: the government increases spending, cuts taxes, or raises transfer payments, which shifts AD right and moves output toward Yf. Contractionary fiscal policy fights an inflationary gap: the government cuts spending or raises taxes, which shifts AD left and cools the economy back toward Yf.

The policy must be multiplied to size it. Closing a $200 billion recessionary gap with an MPC of 0.8 means the AD curve must shift right by $200 billion, so the required spending increase is $200 billion divided by the spending multiplier of 5, or $40 billion. A tax cut would need to be larger, $50 billion, because the tax multiplier is only 4 in absolute value. This is where topic 3.2 stops being arithmetic practice and starts being policy.

Fiscal policy moves the budget too. Expansionary policy during a recession typically increases a budget deficit or shrinks a surplus, since spending rises or tax revenue falls. Contractionary policy does the reverse. Policy also faces lags: time to recognize the problem, time to pass legislation, and time for the spending to take effect. By the time the stimulus arrives, the economy may have already started recovering on its own.

3.9 Automatic Stabilizers

Automatic stabilizers are features of the tax and transfer system that cushion the economy without any new legislation. The three to know are progressive income taxes, unemployment insurance, and welfare and transfer programs. They are always on, and they push back against whichever direction the economy is moving.

In a recession, incomes fall, so households automatically owe less under a progressive tax system, which leaves them with more after-tax income than a flat tax would. Layoffs automatically trigger unemployment insurance payments, and more families automatically qualify for welfare programs. All of this supports consumer spending and softens the fall in AD. In an expansion, the reverse happens automatically: rising incomes push households into higher tax brackets, transfer payments shrink, and the extra drag cools demand. Stabilizers reduce the size of fluctuations, but they do not close gaps on their own.

Confusions That Cost Points

Practice Questions

Original questions written for this guide in the style of the AP exam. Answers and explanations are on the next page, so complete the questions before checking them.

Answer Key

1. A. A change in the price level moves the economy along the existing AD curve because the curve already plots quantity demanded against the price level. B shifts AD left through G. C shifts AD right through net exports, since richer foreigners buy more domestic goods. D shifts AD right through C, since households keep more after-tax income.

2. C. The spending multiplier is 1 / MPS = 1 / (1 - 0.75) = 1 / 0.25 = 4. Multiply the $200 billion of new spending by 4 to get $800 billion. A multiplies by the MPC instead of the multiplier, which gives only the second round of spending. B ignores the multiplier entirely. D divides by the MPC, which is the wrong formula; the multiplier uses the MPS in the denominator.

3. B. Tax changes use the tax multiplier, -MPC / MPS = -0.8 / 0.2 = -4. A tax cut is a negative change in taxes, so the change in GDP is -4 times -$100 billion, which is +$400 billion. A applies the spending multiplier of 5 to a tax change, the classic error; part of the cut is saved, so the tax multiplier is smaller. C counts only the first round of new spending, $100 billion times 0.8, and stops before the multiplier chain finishes. D gets the magnitude right but the sign wrong; a tax cut raises GDP, it does not reduce it.

4. B. An oil price increase raises firms' input costs, which shifts SRAS left. It does not change the economy's long-run productive capacity, so LRAS stays put. A shifts both curves right: better technology raises productivity (SRAS) and expands long-run capacity (LRAS). C expands the economy's resources, which shifts LRAS right. D raises net exports, which shifts AD right, not either supply curve.

5. B. Output of $18 trillion is below full-employment output of $19 trillion, which is the definition of a recessionary gap, and the gap is $1 trillion. A reverses the names; output above Yf would be the inflationary gap. C confuses the gap with its price pressure: a recessionary gap puts downward pressure on wages and prices, and nothing here says prices must be rising. D invents a curve shift; the gap is measured against a fixed LRAS, and no information suggests LRAS moved.

6. A. In the classical self-adjustment story, high unemployment in a recessionary gap pushes nominal wages down, lower wages cut production costs, and SRAS shifts right until the economy is back at Yf with a lower price level. B shifts the wrong curve; self-adjustment works through supply, not a spontaneous demand recovery. C describes discretionary fiscal policy, which is government action, the opposite of what the question asks for. D shifts the wrong curve and misunderstands LRAS; unemployed workers finding jobs moves the economy back toward Yf along existing curves, it does not shift long-run capacity.

7. B. An inflationary gap calls for contractionary fiscal policy: lower government spending, higher taxes, or both, which shifts AD left and cools the economy back toward Yf. A is expansionary policy, which would widen the inflationary gap. C pushes in both directions at once and is not a coherent stabilization policy. D misstates how stabilizers work; automatic stabilizers take effect without any new legislation, which is exactly what makes them automatic.

8. B. Unemployment insurance payments rise automatically when layoffs increase under existing law, with no new vote required. That is the definition of an automatic stabilizer. A is discretionary fiscal policy because Congress had to pass it. C is monetary policy, not fiscal policy at all. D is a regulatory change, not a stabilizer; it does not automatically expand and contract with the business cycle.

One-Page Recall Check

Say each answer out loud before you look back, and mark the ones you cannot finish. Anything you cannot say out loud yet belongs in your flashcard deck. In Rycal, add those items to the National Income and Price Determination deck and let spaced review bring them back over the next few days.

• Define aggregate demand and write the identity that adds up its components.
• Explain the wealth effect, the interest-rate effect, and the net export effect behind the downward slope of AD.
• List three things that shift AD and explain which component each one works through.
• Explain why a change in the price level is a movement along AD, not a shift.
• Write the spending multiplier formula and compute it for an MPC of 0.9.
• Write the tax multiplier formula and explain why it is smaller in absolute value than the spending multiplier.
• Give the three reasons the SRAS curve slopes upward.
• List the shifters of SRAS and the shifters of LRAS, and name one shifter that moves SRAS but not LRAS.
• Define short-run equilibrium and long-run equilibrium in the AD-AS model.
• Define the inflationary gap and the recessionary gap using output relative to Yf.
• Use the shock table to describe what happens to output, the price level, and unemployment when SRAS shifts left.
• Walk through the long-run self-adjustment process for a recessionary gap, naming the curve that shifts and the final price level result.
• State which fiscal policy fits each gap and which direction AD shifts in each case.
• Name the three automatic stabilizers and explain how each one responds in a recession without new legislation.

Key terms for this unit

Aggregate demand (AD), Wealth effect, Interest-rate effect, Net export effect, Marginal propensity to consume (MPC), Marginal propensity to save (MPS), Spending multiplier, Tax multiplier, Balanced-budget multiplier, Short-run aggregate supply (SRAS), Sticky wages, Sticky prices (menu costs), Misperceptions, Productivity, Supply shock, Long-run aggregate supply (LRAS), Full-employment output (potential GDP, Yf), Short-run equilibrium, Long-run equilibrium, Inflationary gap, Recessionary gap (output gap), Demand-pull inflation, Cost-push inflation, Stagflation, Long-run self-adjustment, Sticky downward wages, Fiscal policy, Expansionary fiscal policy, Contractionary fiscal policy, Discretionary fiscal policy, Budget deficit, Automatic stabilizers, Progressive income taxes, Unemployment insurance.

About this guide. Written for Rycal and aligned to the College Board AP Macroeconomics course framework, Unit 3. All questions and explanations are original Rycal writing. Rycal is independent and is not affiliated with or endorsed by the College Board.