AP Macroeconomics – Unit 3: National Income & Price Determination
AP Macroeconomics β€’ Unit 3

National Income & Price Determination

Aggregate Demand, Aggregate Supply, Equilibrium & Fiscal Policy

2. Short-Run Aggregate Supply (SRAS)

Aggregate Demand tells us how much everyone wants to buy. Short-Run Aggregate Supply tells us how much producers are willing and able to supply at each price level β€” when some input costs (especially wages) are sticky (slow to adjust).

SRAS: The total quantity of final goods and services that all producers in the economy are willing to supply at each price level in the short run β€” a period when at least some input prices (especially wages) are fixed.

Why Does SRAS Slope Upward?

Real GDP (Y) Price Level (PL) SRAS SRAS' Shift β†’

In the short run, if the price level rises but input costs (wages, rent, contracts) remain fixed, firms earn higher profit per unit and are willing to produce more. Hence, SRAS slopes upward.

🧠 The "Sticky Wage" Story: Imagine you run a bakery. Your workers have a contract for $20/hour. If bread prices rise from $3 to $4, your revenue per loaf goes up but your labor cost stays $20/hr. More profit β†’ you hire more workers and bake more bread. That's why SRAS slopes up.

What Shifts SRAS?

SRAS shifts when the cost of production changes for the entire economy (at every price level).

Shifter SRAS Shifts Right (↑ Supply) SRAS Shifts Left (↓ Supply)
Input Prices ↓ Oil prices, ↓ wages, ↓ raw materials ↑ Oil prices, ↑ wages, ↑ raw materials
Productivity ↑ Technology, better training ↓ Productivity (unlikely but possible)
Supply Shocks Favorable weather, discoveries of resources Natural disasters, wars, pandemics, supply chain disruptions
Government Policy ↓ Business taxes, ↓ regulations, subsidies ↑ Business taxes, ↑ regulations
Inflationary Expectations ↓ Expected inflation β†’ workers accept lower wages ↑ Expected inflation β†’ workers demand higher wages
Exam Tip: A negative supply shock (like an oil crisis) shifts SRAS left β†’ prices rise AND output falls. This deadly combination is called stagflation. You'll see this scenario on the FRQ.

3. Long-Run Aggregate Supply (LRAS)

In the long run, all prices β€” including wages β€” are fully flexible. Workers renegotiate contracts. Input costs adjust completely. This changes the supply picture dramatically.

LRAS: The total output the economy can produce when all resources are fully employed β€” i.e., when the economy is at the Natural Rate of Unemployment (NRU). This output level is called potential GDP (Yf).

Why Is LRAS Vertical?

Real GDP (Y) Price Level (PL) LRAS Yf LRAS' Growth

In the long run, the price level has no effect on total output. Here's the logic:

  • If the price level rises, workers eventually demand higher wages to match.
  • Firms' profit margins return to normal β†’ no incentive to produce more or less.
  • Output returns to the level determined by the economy's real resources (labor, capital, technology, natural resources).

That's why LRAS is vertical at potential GDP (Yf). It doesn't care about the price level β€” only about the economy's productive capacity.

What Shifts LRAS?

LRAS shifts when the economy's productive capacity permanently changes. Think of it as shifting the PPC outward:

Shifter Direction
↑ Quantity or Quality of Labor LRAS shifts right (immigration, population growth, education)
↑ Capital Stock LRAS shifts right (more factories, infrastructure, equipment)
↑ Technology LRAS shifts right (innovation = more output from same inputs)
↑ Natural Resources LRAS shifts right (discovery of new resources)
Destruction of Resources LRAS shifts left (war, natural disaster, emigration)

🎯 AP Connection: An LRAS shift = a PPC shift = a change in potential GDP. These are all the same thing shown on different graphs. The AP exam will test whether you understand this equivalence.

4. The AD-AS Model & Equilibrium

This is the most important graph in AP Macroeconomics. The AD-AS model combines everything into one framework to show how the price level and Real GDP are determined.

Long-Run Equilibrium

The economy is in long-run equilibrium when AD, SRAS, and LRAS all intersect at the same point. At this point: output = potential GDP, unemployment = NRU, and there's no pressure for prices to change.

Real GDP (Y) Price Level (PL) LRAS SRAS AD E PL* Yf

Short-Run Disequilibrium: The Two Gaps

When AD shifts, the economy temporarily moves away from potential GDP, creating a gap:

Recessionary Gap (Negative Output Gap)

Actual GDP < Potential GDP

  • Caused by a decrease in AD (or leftward shift in SRAS)
  • High unemployment (above NRU)
  • Price level falls (or rises less)
  • Economy is inside the PPC
LRAS SRAS AD₁ E₁ Gap

Inflationary Gap (Positive Output Gap)

Actual GDP > Potential GDP

  • Caused by an increase in AD
  • Low unemployment (below NRU)
  • Price level rises (inflation)
  • Economy is temporarily beyond Yf
LRAS SRAS ADβ‚‚ Eβ‚‚ Gap

Long-Run Self-Correction

The AP exam expects you to explain how the economy returns to Yf on its own β€” without any government intervention:

Starting Point Self-Correction Mechanism
Recessionary Gap High unemployment β†’ workers accept lower wages over time β†’ firms' costs fall β†’ SRAS shifts right β†’ economy returns to Yf at a lower price level.
Exam Note: This process is slow. That's why governments often intervene with fiscal or monetary policy instead of waiting.
Inflationary Gap Low unemployment β†’ workers demand higher wages β†’ firms' costs rise β†’ SRAS shifts left β†’ economy returns to Yf at a higher price level.

The Golden Rule of AD-AS

In the long run, the economy always returns to Yf.

AD shifts change the price level. Only changes in productive capacity (LRAS shifts) change long-run output.

5. Fiscal Policy & the Multiplier Effect

Instead of waiting for the economy to self-correct (which can take years), the government can use Fiscal Policy to deliberately shift AD and close output gaps faster.

Fiscal Policy: The use of government spending (G) and taxation (T) to influence the economy. It is controlled by Congress and the President (not the Fed).

Two Types of Fiscal Policy

Expansionary Fiscal Policy

Goal: Close a recessionary gap.

  • ↑ Government Spending (G)
  • ↓ Taxes (T) β†’ more disposable income β†’ ↑ C
  • Or both

Effect: AD shifts right β†’ ↑ Real GDP, ↓ Unemployment, ↑ Price Level.

Side effect: creates a budget deficit (G > T).

Contractionary Fiscal Policy

Goal: Close an inflationary gap.

  • ↓ Government Spending (G)
  • ↑ Taxes (T) β†’ less disposable income β†’ ↓ C
  • Or both

Effect: AD shifts left β†’ ↓ Real GDP, ↑ Unemployment, ↓ Price Level.

Side effect: creates a budget surplus (T > G).

The Multiplier Effect

Here's the magic of fiscal policy: when the government spends $1, the total impact on GDP is more than $1. Each dollar gets re-spent over and over. This chain reaction is called the multiplier effect.

How it works: Government builds a $100M bridge β†’ construction workers earn $100M β†’ they spend, say, 80% ($80M) at local businesses β†’ those businesses earn $80M and spend 80% ($64M) β†’ and so on. The initial $100M creates far more than $100M of total economic activity.

The key variable is the Marginal Propensity to Consume (MPC) β€” the fraction of each additional dollar of income that is spent. Its counterpart is the Marginal Propensity to Save (MPS) β€” the fraction that is saved.

MPC + MPS = 1

The Spending Multiplier

Used when the government changes its spending (G) directly:

Spending Multiplier =
1
1 βˆ’ MPC
=
1
MPS

Example: MPC = 0.8 β†’ Multiplier = 1 / (1 βˆ’ 0.8) = 1 / 0.2 = 5. A $10B increase in G β†’ $50B increase in GDP.

The Tax Multiplier

Used when the government changes taxes (T). It's smaller than the spending multiplier because households save some of the tax cut.

Tax Multiplier =
βˆ’MPC
1 βˆ’ MPC
=
βˆ’MPC
MPS

Example: MPC = 0.8 β†’ Tax Multiplier = βˆ’0.8 / 0.2 = βˆ’4. A $10B tax cut (βˆ’$10B change) β†’ +$40B increase in GDP. Notice: smaller impact than $10B in direct spending!

Exam Tip: The tax multiplier is NEGATIVE because: ↑ Taxes = ↓ GDP, and ↓ Taxes = ↑ GDP. The spending multiplier is always one unit larger in absolute value.

Calculating the Change in GDP

Ξ”Y = Multiplier Γ— Ξ”Spending
Ξ”Y = Tax Multiplier Γ— Ξ”Taxes

The Balanced Budget Multiplier

What if the government increases spending and taxes by the same amount?

Balanced Budget Multiplier = 1

If G increases by $10B and T increases by $10B, GDP increases by exactly $10B. The spending multiplier effect (+$50B at MPC=0.8) and the tax multiplier effect (βˆ’$40B) partially cancel, leaving a net impact equal to the initial change.

Automatic vs. Discretionary Stabilizers

Type What It Is Examples
Automatic Stabilizers Programs that automatically increase G or decrease T during a recession β€” no new legislation needed. Progressive income tax (tax revenue falls automatically in recession), Unemployment insurance, Welfare/SNAP benefits
Discretionary Policy Deliberate changes in G or T that require new legislation by Congress. Stimulus packages, infrastructure bills, tax reform acts

Limitations of Fiscal Policy

Problem Explanation
Time Lags Recognition lag (takes time to identify the problem) + Legislative lag (Congress is slow) + Implementation lag (takes time to spend). By the time policy kicks in, the economy may have already changed.
Crowding Out ↑ G financed by borrowing β†’ government competes with private borrowers β†’ interest rates rise β†’ private Investment falls. The increased G partially "crowds out" private I, weakening the overall stimulus.
Exam Favorite: Crowding out is the #1 criticism of expansionary fiscal policy on the AP exam.
Political Constraints Contractionary policy (cutting spending, raising taxes) is politically unpopular. Politicians prefer expansionary policy even when the economy doesn't need it.
National Debt Persistent deficits from expansionary fiscal policy add to the national debt, which carries long-run interest costs.

Unit 3 Formula Cheat Sheet

Spending Multiplier = 1 / MPS = 1 / (1 βˆ’ MPC)

Tax Multiplier = βˆ’MPC / MPS

Balanced Budget Multiplier = 1 (always)

Ξ”Y = Multiplier Γ— Ξ”G   or   Ξ”Y = Tax Mult. Γ— Ξ”T

MPC + MPS = 1

Unit 3 is the highest-weighted unit on the AP exam. Master these multipliers and the AD-AS model.

End of Unit 3 Study Guide.

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