Unit 3: National Income and Price Determination

Students will explore how changes in aggregate spending and production, economic fluctuations, and policy actions affect national income, unemployment, and inflation.

Aggregate Demand (AD)

Definition and Components

Aggregate demand is the schedule of total planned expenditure on domestically produced final goods and services at each aggregate price level. It is summarized by \(AD \equiv Y = C + I + G + X_n\) with \(X_n = X - M\). The vertical axis is the aggregate price level \(P\) and the horizontal axis is real output \(Y\).
Consumption \(C\) is household spending on goods and services in the current period. Investment \(I\) is business fixed investment, new residential construction, and change in inventories. Government purchases \(G\) are government expenditures on currently produced goods and services.
Net exports \(X_n\) equals exports of domestically produced goods and services minus imports of foreign produced goods and services. A positive \(X_n\) adds to aggregate demand and a negative \(X_n\) subtracts from aggregate demand. The sign on imports is negative because imported spending is not production of domestic output.
AD uses final goods and services only to avoid double counting of intermediate inputs. Used goods and purely financial transactions are excluded because they do not represent current production. These exclusions align the AD identity with the GDP expenditure approach.
AD is macroeconomic and is not a market demand for a single product. It relates the overall price level to the total quantity of real output demanded holding non price determinants constant. Treat AD as an entire curve rather than as a single number.

Why AD Slopes Downward

The real balances effect states that when \(P\) rises the purchasing power of money balances falls. Lower real wealth reduces planned consumption and the quantity of real output demanded falls. When \(P\) falls real wealth rises and the quantity of real output demanded increases.
The interest rate effect states that a higher \(P\) increases transactions demand for money for a given nominal money supply. Higher money demand raises interest rates which reduces interest sensitive consumption and investment. A lower \(P\) lowers interest rates and raises the quantity of real output demanded.
The foreign purchases effect states that a higher domestic \(P\) raises domestic prices relative to foreign prices holding the exchange rate constant. Exports decrease and imports increase so \(X_n\) falls and the quantity of real output demanded falls. A lower \(P\) has the opposite effect on \(X_n\) and increases the quantity of real output demanded.
These three effects are aggregate level mechanisms and not substitution across individual goods. They operate simultaneously to produce a downward sloping relationship between \(P\) and \(Y\). The slope is established holding all non price determinants of \(C\), \(I\), \(G\), and \(X_n\) fixed.
A change in \(P\) moves the economy along a given AD curve by changing the quantity of real output demanded. The direction of movement follows the inverse relationship between \(P\) and \(Y\). This movement is distinct from a shift of the entire AD curve.

Movements Along AD versus Shifts of AD

A movement along AD occurs only when the aggregate price level changes. Non price determinants of spending are held constant for this movement. The change is a new quantity of real output demanded on the same AD curve.
A shift of AD occurs when autonomous changes in \(C\), \(I\), \(G\), or \(X_n\) change total planned expenditure at every price level. The entire curve moves right for an increase and left for a decrease. The price level is held constant when evaluating the shift cause.
The algebraic summary of a shift is \(\Delta AD = \Delta C + \Delta I + \Delta G + \Delta X_n\). If the net change is positive AD shifts right and if the net change is negative AD shifts left. This statement is independent of a contemporaneous change in \(P\).
Policy actions can shift AD by altering components at a given \(P\). For example a tax cut raises disposable income and increases \(C\) which shifts AD right. For example a cut in real interest rates raises interest sensitive \(C\) and \(I\) which shifts AD right.
Supply side cost changes do not shift AD because they affect production conditions rather than autonomous spending. Such cost changes shift SRAS and cause movements along AD at the new price level. Correct classification of curve movements is required for accurate diagrams and narratives.

Determinants of AD by Component

Consumption \(C\) depends on disposable income \(Y_d\), expected future income, household wealth, and the real interest rate. An increase in \(Y_d\) or expected income or wealth raises \(C\) at a given \(P\) and shifts AD right. A higher real interest rate reduces durable consumption and shifts AD left.
Investment \(I\) depends on the real interest rate, expected profitability, business taxes, and expected sales. A lower real interest rate or higher expected profitability raises planned investment and shifts AD right. Higher business taxes or higher uncertainty lowers planned investment and shifts AD left.
Government purchases \(G\) are determined by fiscal policy decisions and enter AD directly. An increase in purchases shifts AD right and a decrease shifts AD left. Transfer payments affect AD indirectly by changing \(C\) through disposable income.
Net exports \(X_n\) depend on foreign income, the exchange rate, and relative price levels. Higher foreign income raises exports and shifts AD right and an appreciation of the domestic currency reduces \(X_n\) and shifts AD left. A depreciation of the domestic currency raises \(X_n\) and shifts AD right.
Inventory adjustment enters through the investment component because change in inventories is part of \(I\). An autonomous rise in desired inventories increases \(I\) and shifts AD right at a given \(P\). An autonomous decline in desired inventories decreases \(I\) and shifts AD left.

Interpreting and Diagramming AD

Label the vertical axis as the aggregate price level \(P\) and the horizontal axis as real GDP \(Y\). Draw AD as downward sloping to reflect the inverse relation between \(P\) and the quantity of real output demanded. Mark specific points to show movements along the curve when \(P\) changes.
Show shifts by drawing a second AD curve to the right for increases and to the left for decreases. Annotate the component responsible such as \(C\), \(I\), \(G\), or \(X_n\). Keep the price level label unchanged when identifying the cause of the shift.
When a problem lists several component changes compute the net autonomous change. Sum \(\Delta C\), \(\Delta I\), \(\Delta G\), and \(\Delta X_n\) to determine the direction of the AD shift. State the sign and identify the curve motion in one sentence.
Use clear language to distinguish quantity changes from curve shifts. Say “the quantity of real output demanded rises” for movement along AD and “AD increases” for a shift of the curve. This distinction prevents mixed reasoning in written explanations.
Connect the AD diagram to later AD SRAS analysis by noting that shifts of AD change short run equilibrium \(Y\) and \(P\). The output gap sign is determined by the position of equilibrium \(Y\) relative to \(Y^*\) on the LRAS diagram. Detailed multiplier sizing belongs to the multiplier section that follows.

Spending and Tax Multipliers

Marginal Propensities: MPC and MPS

The marginal propensity to consume is \( \text{MPC} \equiv \frac{\Delta C}{\Delta Y_d} \) and the marginal propensity to save is \( \text{MPS} \equiv \frac{\Delta S}{\Delta Y_d} \). They satisfy the identity \( \text{MPC} + \text{MPS} = 1 \) because additional disposable income must be either consumed or saved. The parameters are treated as constants within the short-run model used in this unit.
Both MPC and MPS are bounded between 0 and 1 in the theory of this course. A higher MPC implies a lower MPS by the identity and vice versa. These parameters determine the size of induced spending across successive rounds of income changes.
The analysis distinguishes marginal from average propensities, but multiplier arithmetic uses the marginal measures. Average propensities refer to ratios \( C/Y_d \) and \( S/Y_d \) for the whole level of income. Marginal measures refer to changes and govern the geometric series below.
Stability of MPC and MPS is an assumption for the standard multiplier derivations. If MPC varied across rounds, the common closed-form expressions would not apply. This unit maintains constant parameters to keep the series tractable.
All subsequent multiplier formulas in this section are functions of MPC and MPS. Comparative statements about magnitudes therefore follow directly from these parameters. This keeps results consistent across different autonomous components.

Simple Spending Multiplier

The simple spending multiplier under a fixed price level is \( k = \frac{1}{1-\text{MPC}} = \frac{1}{\text{MPS}} \). It converts any autonomous change in spending into the total change in equilibrium real output. The result holds for autonomous changes in \(C\), \(I\), \(G\), or \(X_n\).
The expression arises from the geometric series \( 1 + \text{MPC} + \text{MPC}^2 + \dots = \frac{1}{1-\text{MPC}} \) with \( 0 \le \text{MPC} < 1 \). Convergence follows from the bound on MPC in this model. Each successive round of induced consumption is smaller than the previous round.
Total output change is written \( \Delta Y = k \cdot \Delta A \) where \( \Delta A \) is the autonomous spending change. The sign of \( \Delta Y \) matches the sign of \( \Delta A \). Linearity means proportional scaling with the size of the autonomous shift.
Inventory change is included in \(I\) by national income accounting conventions. Therefore autonomous desired inventory adjustments are treated as autonomous spending changes in the multiplier framework. This preserves consistency with the expenditure approach to GDP.
The multiplier is monotonically increasing in MPC and monotonically decreasing in MPS. If \( \text{MPC} = 0 \), then \( k = 1 \), and if \( \text{MPC} \to 1^{-} \), then \( k \to \infty \) within the model. These limit statements are properties of the formula rather than empirical claims.

Tax and Transfer Multipliers (Lump-Sum)

With lump-sum taxes, the tax multiplier is \( k_T = -\frac{\text{MPC}}{1-\text{MPC}} = -\frac{\text{MPC}}{\text{MPS}} \). The negative sign indicates that a tax increase reduces equilibrium real output in the model. The absolute value is smaller than the spending multiplier because taxes change output indirectly through consumption.
The transfer multiplier under lump-sum treatment is \( k_{TR} = \frac{\text{MPC}}{1-\text{MPC}} \). It is the positive counterpart to the tax multiplier because transfers raise disposable income. The relationship \( k_{TR} = -k_T \) holds by construction.
Taxes and transfers operate through disposable income \( Y_d \). A change in \(T\) or \(TR\) alters \(C\) by \( \text{MPC} \) times the change in \(Y_d\). The induced rounds then proceed with the same common ratio \( \text{MPC} \).
Autonomous changes in \(I\), \(G\), and \(X_n\) use the spending multiplier \(k\) directly. Autonomous changes in lump-sum \(T\) and \(TR\) use \(k_T\) and \(k_{TR}\) respectively. The linear model allows superposition across components at a given price level.
All formulas in this subsection presuppose a fixed price level and a closed income determination framework. Interest rates, output capacity, and exchange rates are not part of this derivation. Those considerations enter in other parts of the curriculum.

Balanced-Budget Multiplier

A balanced-budget change sets \( \Delta G = \Delta T \) with both changes in the same direction. In the simple model with lump-sum taxes and fixed prices, the total effect is \( \Delta Y = \Delta G \). This property is called the balanced-budget multiplier and equals one.
The algebra is \( \Delta Y = k\Delta G + k_T\Delta T = \left(\frac{1}{1-\text{MPC}} - \frac{\text{MPC}}{1-\text{MPC}}\right)\Delta G \). Simplifying yields \( \Delta Y = 1 \cdot \Delta G \). The result follows from the identity \( \text{MPC} + \text{MPS} = 1 \).
This statement applies specifically to changes in purchases and lump-sum taxes. Replacing taxes with transfers yields \( \Delta Y = (k + k_{TR})\Delta G \), which exceeds one in the simple model. Therefore “balanced-budget” refers to purchases and taxes in standard presentations.
The unity result is a theoretical property under the stated assumptions. It is independent of the numerical value of MPC within the unit interval. The key requirement is the equivalence \( \Delta G = \Delta T \).
If leakages beyond saving are introduced, the balanced-budget multiplier is less than one. The exact value then depends on the additional leakage parameters specified below. This subsection restricts attention to the baseline case.

Leakage-Adjusted Multipliers

Introduce a marginal propensity to import \( m \) as an additional leakage. With imports but without proportional income taxes, the spending multiplier becomes \( k = \frac{1}{\text{MPS} + m} \). The corresponding lump-sum tax multiplier becomes \( k_T = -\frac{\text{MPC}}{\text{MPS} + m} \).
Introduce a proportional income tax rate \( t \) so that \( Y_d = (1-t)Y \). With proportional taxes but no imports, the spending multiplier becomes \( k = \frac{1}{\text{MPS} + \text{MPC}\cdot t} \). The tax and transfer multipliers are not defined in this formulation unless a separate lump-sum component is specified.
With both imports and proportional taxes present, the spending multiplier is \( k = \frac{1}{\text{MPS} + m + \text{MPC}\cdot t} \). The denominator collects all marginal leakages out of the circular flow. Each additional leakage increases the denominator and reduces \(k\).
Monotonicity properties remain: larger \( \text{MPS} \), larger \( m \), or larger \( t \) each imply a smaller multiplier. The signs of all multipliers remain as in the baseline derivations. The comparative statics therefore carry over to this expanded setting.
Under these leakages, the balanced-budget multiplier falls below one. The precise expression depends on which tax instrument is varied and how transfers are treated. In this unit, it is sufficient to state that additional leakages reduce the total response.

Price-Level Considerations in Multiplier Analysis

The simple formulas above assume a fixed aggregate price level. When the price level is allowed to vary with an upward-sloping SRAS, some of the nominal spending change appears as a change in \(P\). The implied change in real output is therefore smaller than in the fixed-price framework.
The AD–SRAS model is used to represent this interaction in later sections. A shift of AD then yields simultaneous changes in \(Y\) and \(P\). The relative magnitudes depend on the slope of SRAS at the initial equilibrium.
Multiplier arithmetic in a variable-price setting does not have a single closed form in this unit. The direction statements about components and signs remain the same. Quantitative results are evaluated with diagrams rather than a fixed scalar \(k\).
All statements here are internal to the model and involve no external behavioral changes. The framework maintains constant parameter values during the comparative exercise. This preserves the clarity of the short-run analysis in Unit 3.
Subsequent sections connect these results to equilibrium determination without adding new parameters. The purpose is to align component changes with diagram shifts consistently. This keeps notation and definitions uniform across the unit.

Short-Run Aggregate Supply (SRAS)

Definition and Short-Run Assumptions

Short-run aggregate supply is the relationship between the aggregate price level \(P\) and real output \(Y\) when some input prices are fixed. In this unit, nominal wages and several input contracts are assumed sticky. Capital stock and technology are treated as given in the short run.
Because nominal wages are predetermined, a change in \(P\) alters real wages in the short run. When \(P\) rises and nominal wages are fixed, real wages fall and firms find it profitable to produce more. When \(P\) falls, real wages rise and firms reduce output.
The SRAS curve summarizes output supplied by firms for different \(P\) holding input costs and expectations constant. It is not the supply curve for a single market but an aggregate schedule. Its position depends on expected price level \(P^{e}\) and per-unit production costs.
At \(P = P^{e}\) and with no temporary disturbances, output equals potential output \(Y^{*}\). Deviations of \(P\) from \(P^{e}\) create temporary gaps between \(Y\) and \(Y^{*}\). These gaps reflect short-run misalignment between prices received and input costs.
SRAS is distinct from LRAS, which is vertical at \(Y^{*}\). LRAS does not depend on \(P\) because input prices and wages fully adjust in the long run. SRAS depends on sticky elements that prevent immediate full adjustment.

Shape and Three Ranges of SRAS

In the Keynesian range at low output, SRAS is relatively flat. Excess capacity allows output to increase with little pressure on \(P\). Small changes in demand translate mostly into changes in \(Y\).
In the intermediate range, SRAS slopes upward more noticeably. Bottlenecks and rising marginal costs cause both \(P\) and \(Y\) to increase together. The degree of slope reflects the intensity of cost pressures.
In the classical range near capacity, SRAS becomes very steep. Additional output requires sharply higher costs, so changes in \(P\) dominate changes in \(Y\). Output is close to \(Y^{*}\) and quantity responses are limited.
These ranges are stylized segments of a single SRAS curve. The economy can operate at different segments depending on slack and utilization. The local slope determines the mix of price-level and output changes for a given disturbance.
A steeper SRAS implies larger changes in \(P\) for the same horizontal disturbance. A flatter SRAS implies larger changes in \(Y\) for the same disturbance. This property is used when interpreting AD shifts in the model.

Determinants (Shifters) of SRAS

Changes in nominal wages shift SRAS by altering per-unit costs. Higher nominal wages shift SRAS left because unit costs rise, and lower nominal wages shift SRAS right. These changes are distinct from movements along SRAS caused by \(P\).
Changes in input prices such as energy, commodities, or imported materials shift SRAS. A rise in widely used input prices shifts SRAS left, and a fall shifts SRAS right. Exchange rate movements that alter imported input costs are included here.
Changes in productivity or technology alter unit costs at each \(Y\). Higher productivity shifts SRAS right by lowering the cost per unit, and lower productivity shifts SRAS left. Organizational efficiency changes are treated in the same manner.
Government actions affecting production costs shift SRAS. Per-unit taxes and regulatory burdens shift SRAS left, while per-unit subsidies or cost-reducing policies shift SRAS right. Lump-sum taxes are not per-unit and do not directly shift SRAS in this model.
Changes in the expected price level \(P^{e}\) shift SRAS. An increase in \(P^{e}\) raises wage and price setting, shifting SRAS left, while a decrease in \(P^{e}\) shifts SRAS right. Expectations are held constant for movements along SRAS but may change across equilibria.

Expected Price Level and Output Deviations

When actual \(P\) exceeds expected \(P^{e}\), real wages are lower than planned at given nominal wages. Firms expand output above \(Y^{*}\) because revenues rise faster than short-run costs. This corresponds to an inflationary gap in the AD–AS framework.
When actual \(P\) is below \(P^{e}\), real wages are higher than planned at given nominal wages. Firms contract output below \(Y^{*}\) because costs exceed expected revenues. This corresponds to a recessionary gap in the AD–AS framework.
Adjustments of \(P^{e}\) realign SRAS with long-run conditions. If \(P>P^{e}\), future wage setting tends to lift \(P^{e}\) and shift SRAS left. If \(P
These expectation adjustments move the economy toward \(P = P^{e}\). At that point, short-run misalignments between prices and input costs are removed. Output returns to \(Y^{*}\) in the long-run configuration.
Expectation shifts are treated as SRAS shifts rather than LRAS shifts. LRAS moves only with changes in resources, technology, or institutional capacity. This separation preserves the roles of short-run and long-run analysis.

Supply Shocks and Cost-Push Inflation

A negative supply shock raises per-unit costs at existing output. SRAS shifts left, producing higher \(P\) and lower \(Y\) at the new short-run equilibrium. This joint movement is labeled cost-push inflation with reduced output.
A positive supply shock lowers per-unit costs at existing output. SRAS shifts right, producing lower \(P\) and higher \(Y\) at the new short-run equilibrium. This configuration improves both price level and output simultaneously.
Stagflation is the coexistence of rising inflation and rising unemployment. In the AD–AS model, stagflation follows a leftward shift of SRAS. Output falls below \(Y^{*}\) while the price level rises.
Cost-push episodes are analytically distinct from demand-pull episodes. Demand-pull involves a rightward shift of AD and tends to raise both \(P\) and \(Y\) initially. Supply shocks alter costs and shift SRAS rather than AD.
Temporary shocks may unwind without altering long-run capacity. Persistent shocks that change productivity or resource availability can affect LRAS as well. In this section, the emphasis is the SRAS displacement and its short-run consequences.

Movements Along SRAS vs. SRAS Shifts

A movement along SRAS results from a change in \(P\) with input costs and expectations held fixed. Such movements are typically induced by shifts in AD. The economy slides to a new quantity \(Y\) on the same SRAS curve.
A shift of SRAS changes the position of the entire curve at every \(P\). Shifts arise from changes in nominal wages, input prices, productivity, \(P^{e}\), or per-unit taxes and subsidies. The economy attains new \(P\)–\(Y\) combinations even if AD is unchanged.
Short-run equilibrium occurs at the intersection of AD and SRAS. Comparing this \(Y\) to \(Y^{*}\) given by LRAS identifies the output gap. The sign of the gap determines whether unemployment is above or below \(u^{*}\).
For a given horizontal AD shift, the output response depends on SRAS slope. A flatter SRAS produces a larger change in \(Y\) and a smaller change in \(P\). A steeper SRAS produces a smaller change in \(Y\) and a larger change in \(P\).
Diagram conventions place \(P\) on the vertical axis and \(Y\) on the horizontal axis. Curves are labeled AD, SRAS, and LRAS, with LRAS vertical at \(Y^{*}\). Shifts are indicated by parallel relocations of the relevant curve.

Long-Run Aggregate Supply (LRAS)

Definition and Long-Run Assumptions

Long-run aggregate supply is the level of real output that an economy can produce when all prices, including wages, are fully flexible. It is drawn as a vertical line at potential output \(Y^{*}\) because changes in the aggregate price level \(P\) do not change long-run real output. The vertical nature reflects that real capacity is determined by resources and technology, not by \(P\).
In the long run, nominal wages and input prices adjust to the price level, eliminating any incentive to produce above or below capacity. Firms’ real costs return to their planned levels after contracts and expectations have adjusted. Consequently, deviations of output from \(Y^{*}\) are temporary in the model.
LRAS is independent of aggregate demand because demand affects the price level in the long run rather than real output. Shifts of AD change \(P\) permanently but leave \(Y\) at \(Y^{*}\) after full adjustment. This statement is the long-run neutrality of money in the model.
Potential output \(Y^{*}\) represents full employment of labor and capital consistent with the natural rate of unemployment \(u^{*}\). Full employment does not mean zero unemployment because frictional and structural components persist. Cyclical unemployment is zero at \(Y^{*}\).
LRAS is a macro relationship and is not a micro supply curve for a single good. It summarizes the productive capacity of the entire economy under flexible prices and wages. Its position depends on real factors summarized in the production function.

Potential Output and the Natural Rate

Potential output \(Y^{*}\) is the maximum sustainable real GDP given available resources, technology, and institutional constraints. It is the level consistent with normal utilization of capital and labor without inflationary or deflationary pressure. Diagrammatically, \(Y^{*}\) is the horizontal coordinate where LRAS is placed.
The natural rate of unemployment \(u^{*}\) equals frictional plus structural unemployment. At \(u^{*}\), labor markets clear in the long-run sense with no cyclical unemployment. This anchors LRAS at full-employment output.
The output gap measures deviation from potential: \( \%\text{gap} = \frac{Y - Y^{*}}{Y^{*}} \times 100\% \). A positive value indicates an inflationary gap and a negative value indicates a recessionary gap. Long-run adjustments eliminate this gap by moving \(Y\) back to \(Y^{*}\).
At \(Y^{*}\), the short-run Phillips relationship is consistent with stable inflation expectations. Attempts to maintain \(Y>Y^{*}\) raise inflation expectations without permanently lowering unemployment. This is consistent with a vertical long-run Phillips curve at \(u^{*}\).
Potential output changes only with real determinants, not with aggregate demand. Therefore, policy statements about long-run growth refer to shifting LRAS rather than moving along it. This maintains the separation of real and nominal influences in the framework.

Determinants and Shifters of LRAS

Capital accumulation shifts LRAS by changing the physical capital stock \(K\). An increase in \(K\) raises productive capacity and shifts LRAS right. A sustained decline in \(K\) shifts LRAS left.
Labor quantity and quality shift LRAS through population, participation, and human capital \(H\). Growth in the labor force or improvements in education and skills raise \(Y^{*}\). Reductions in labor supply or human capital lower \(Y^{*}\).
Technology and total factor productivity \(A\) shift LRAS by altering efficiency in the production function. Higher \(A\) raises output for given inputs and shifts LRAS right. Lower \(A\) reduces efficiency and shifts LRAS left.
Natural resources and infrastructure affect attainable output at full employment. Improved resource availability or better infrastructure raises capacity and shifts LRAS right. Resource depletion or infrastructure deterioration shifts LRAS left.
Institutional environment influences incentives for work, saving, and investment. Stable property rights and efficient rules support higher potential output, shifting LRAS right. Persistent distortions or rigidities can depress potential, shifting LRAS left.

LRAS, Production Function, and Growth Representation

The production function representation is \( Y = A \cdot F(K, L, H, N) \). Increases in \(A\), \(K\), \(L\), \(H\), or \(N\) raise \(Y^{*}\) and shift LRAS right in the model. Decreases in these inputs shift LRAS left.
Economic growth is depicted as a rightward shift of LRAS and a corresponding outward shift of the PPC. Both diagrams express higher feasible real output at full employment. The AD curve is not needed to depict long-run growth.
Chain-weighted real GDP is the measure used to track \(Y\) through time for growth comparisons. Changes in base year do not alter growth rates in the real series. LRAS shifts are interpreted relative to these real output measures.
Growth accounting attributes changes in \(Y^{*}\) to component changes in inputs and productivity. This decomposition is consistent with the role of \(A\) and the factor stocks in the function. The model treats these as real drivers, separate from nominal effects.
Diagram placement uses a vertical LRAS at \(Y^{*}_1\) and a second vertical LRAS at \(Y^{*}_2>Y^{*}_1\). The horizontal displacement measures the increase in potential output. The price level coordinate is not required to identify the shift.

Distinguishing LRAS from SRAS and AD Changes

LRAS shifts reflect changes in resources, productivity, or institutions and are permanent in the model. SRAS shifts reflect temporary cost or expectation changes at given resources and productivity. AD shifts reflect changes in planned spending at a given price level.
A change in the expected price level \(P^{e}\) shifts SRAS but does not shift LRAS. Adjustments in nominal wages realign SRAS with LRAS at \(Y^{*}\). The economy then returns to long-run equilibrium at the new \(P\).
Demand shocks do not shift LRAS because they do not alter productive capacity. Long-run outcomes of demand shocks are changes in the price level with \(Y\) unchanged at \(Y^{*}\). This maintains the neutrality result for real output.
Simultaneous shifts can occur if a real factor changes while a cost shock occurs. The LRAS position identifies the new potential \(Y^{*}\), and SRAS determines the short-run price-output combination. AD determines the intersection point at each stage of analysis.
When analyzing diagrams, locate LRAS first to anchor \(Y^{*}\). Then place SRAS and AD to determine short-run and long-run equilibria. This ordering preserves the distinction between capacity and demand conditions.

AD–AS Equilibrium and Output Gaps

Short-Run AD–AS Equilibrium

Short-run macroeconomic equilibrium occurs at the intersection of AD and SRAS, which determines the aggregate price level \(P\) and real output \(Y\). At this point, planned aggregate spending equals the value of output firms are willing to supply at the given input costs. Expectations and input contracts are treated as fixed for the comparison.
A movement along a given SRAS curve is caused by a change in \(P\) that results from a shift of AD. A movement along a given AD curve is caused by a change in \(P\) that results from a shift of SRAS. The identity of the shifting curve determines the sign pattern for \(P\) and \(Y\).
Holding SRAS fixed, a rightward shift of AD raises both \(P\) and \(Y\) at the new equilibrium. Holding SRAS fixed, a leftward shift of AD lowers both \(P\) and \(Y\). These directional results are standard properties of the model.
Holding AD fixed, a rightward shift of SRAS raises \(Y\) and lowers \(P\). Holding AD fixed, a leftward shift of SRAS lowers \(Y\) and raises \(P\). The combination of lower output and higher price level is identified as cost-push pressure.
The location of equilibrium \(Y\) is interpreted relative to potential output \(Y^{*}\) indicated by LRAS. If \(Y \neq Y^{*}\), the model describes a short-run deviation from full-employment output. This deviation is labeled and analyzed as an output gap.

Long-Run Equilibrium and Self-Adjustment

Long-run equilibrium occurs where AD, SRAS, and LRAS intersect at \(Y^{*}\). At this point, the aggregate price level equals the expected price level \(P^{e}\), and nominal wages are consistent with firms’ cost plans. No systematic forces remain to change \(Y\) given resources and technology.
If \(Y>Y^{*}\) initially, nominal wages and other input prices tend to adjust upward over time. Higher input costs shift SRAS left until the economy returns to \(Y^{*}\) at a higher \(P\). This process eliminates the short-run inflationary gap.
If \(Y
Under pure demand disturbances, the long-run outcome is a change in \(P\) with \(Y\) restored to \(Y^{*}\). The real quantity supplied in the long run is independent of the aggregate price level in this framework. This statement is the long-run neutrality of demand shifts for real output.
Expected price level \(P^{e}\) aligns with actual \(P\) in long-run equilibrium. When \(P \neq P^{e}\), subsequent wage and price setting change \(P^{e}\) and shift SRAS. Adjustment ceases when \(P = P^{e}\) at \(Y^{*}\).

Output Gaps: Recessionary vs. Inflationary

A recessionary gap exists when equilibrium output is below potential output, \(Y
An inflationary gap exists when equilibrium output is above potential output, \(Y>Y^{*}\). This configuration corresponds to unemployment below the natural rate \(u^{*}\). Upward pressure on nominal wages is implied in the short-run analysis.
The percent output gap is \( \%\text{gap} = \frac{Y - Y^{*}}{Y^{*}} \times 100\% \). A negative value indicates a recessionary gap and a positive value indicates an inflationary gap. The sign convention is standard for model-based comparisons.
In a recessionary gap, disinflationary forces are present because excess capacity reduces cost pressure. In an inflationary gap, inflationary forces are present because capacity constraints raise cost pressure. These statements describe short-run tendencies under fixed expectations.
Graphically, LRAS is vertical at \(Y^{*}\), and the horizontal distance between \(Y\) and \(Y^{*}\) measures the gap. The label “recessionary” is used when the equilibrium lies to the left of LRAS. The label “inflationary” is used when the equilibrium lies to the right of LRAS.

Demand Shocks vs. Supply Shocks

A positive demand shock shifts AD right and raises both \(P\) and \(Y\) in the short run. The new equilibrium typically lies to the right of LRAS, forming an inflationary gap. Subsequent wage adjustments shift SRAS left toward long-run equilibrium at \(Y^{*}\).
A negative demand shock shifts AD left and lowers both \(P\) and \(Y\) in the short run. The new equilibrium typically lies to the left of LRAS, forming a recessionary gap. Subsequent wage adjustments shift SRAS right toward long-run equilibrium at \(Y^{*}\).
A negative supply shock shifts SRAS left, which raises \(P\) and lowers \(Y\). The joint movement is identified as cost-push pressure with potential stagflation. The equilibrium lies left of \(Y^{*}\) with higher \(P\) simultaneously.
A positive supply shock shifts SRAS right, which lowers \(P\) and raises \(Y\). The joint movement improves the price-output combination in the short run. The equilibrium lies right of \(Y^{*}\) with lower \(P\) simultaneously if AD is unchanged.
Shock identification is completed by naming the shifting curve and direction and then stating the implied movements in \(P\) and \(Y\). Demand shocks yield same-direction changes in \(P\) and \(Y\). Supply shocks yield opposite-direction changes in \(P\) and \(Y\).

Measuring and Interpreting the Output Gap

Real GDP \(Y\) is compared to potential GDP \(Y^{*}\) to measure the output gap. The absolute gap is \(Y - Y^{*}\) and the proportional gap is \( \frac{Y - Y^{*}}{Y^{*}} \). Potential GDP is represented by LRAS in the diagram.
A commonly used approximate relationship links the output gap to the unemployment gap. The expression \( \%\text{gap} \approx -2\,(u - u^{*}) \) summarizes the direction and typical magnitude. A positive unemployment gap corresponds to a negative output gap in this approximation.
The aggregate price level in AD–AS is typically proxied by a broad index. The GDP deflator is used as a comprehensive measure of the price level for domestic output. CPI is a consumer cost-of-living index and is distinct from the model’s price-level variable.
When LRAS shifts right due to higher potential output, an unchanged AD–SRAS intersection can become a recessionary gap. When LRAS shifts left due to lower potential output, an unchanged AD–SRAS intersection can become an inflationary gap. Dynamic comparisons therefore require locating LRAS before classifying gaps.
In multi-period diagrams, trace the sequence of equilibria to separate price-level changes from real output changes. A return to \(Y^{*}\) with a different \(P\) indicates long-run adjustment after a demand disturbance. A new \(Y^{*}\) indicates a structural change represented by an LRAS shift.

Fiscal Policy

Definition, Instruments, and Targets

Fiscal policy is the use of government purchases, taxes, and transfers to influence aggregate demand in the short run. It operates within the identity \(AD \equiv C + I + G + X_n\), where \(G\) enters directly and taxes and transfers affect \(C\) through disposable income. The objectives are to stabilize real output around \(Y^{*}\) and the aggregate price level around a chosen benchmark.
Government purchases \(G\) are expenditures on currently produced goods and services and count fully in the expenditure approach to GDP. Transfers are monetary payments without a current good or service received and enter indirectly via consumption. Distinguishing purchases from transfers prevents misclassification in AD analysis.
Taxes are modeled as lump-sum or proportional to income depending on the exercise. Disposable income satisfies \(Y_d = Y - T + TR\) and determines the consumption component through parameters like \( \text{MPC} \). The sign convention implies that higher \(T\) reduces \(Y_d\) and higher \(TR\) raises \(Y_d\).
The budget balance is \( \text{BB} \equiv T - G - TR \), with \(\text{BB} > 0\) indicating a surplus and \(\text{BB} < 0\) indicating a deficit. This accounting identity tracks the fiscal stance without implying causation for \(Y\) by itself. Changes in \(G\), \(T\), or \(TR\) are the channels that shift AD.
Short-run effects are represented in the AD–SRAS framework while long-run capacity is summarized by LRAS at \(Y^{*}\). Demand management shifts AD with input costs and expectations held fixed. In the long run, wage and price adjustments neutralize purely demand-driven changes in real output.

Expansionary vs. Contractionary Fiscal Policy

Expansionary fiscal policy consists of increasing \(G\), decreasing \(T\), or increasing \(TR\) to shift AD right at a given \(P\). In the short run with upward-sloping SRAS, this configuration raises \(Y\) and the aggregate price level. The equilibrium moves closer to \(Y^{*}\) if a recessionary gap is present.
Contractionary fiscal policy consists of decreasing \(G\), increasing \(T\), or decreasing \(TR\) to shift AD left at a given \(P\). In the short run with upward-sloping SRAS, this configuration lowers \(Y\) and the aggregate price level. The equilibrium moves closer to \(Y^{*}\) if an inflationary gap is present.
Government purchases have a direct first-round impact on AD by the amount of the change. Taxes and transfers operate through \(Y_d\) and thus affect AD through the consumption function. This distinction implies different magnitudes for equal-sized changes in instruments.
Under the fixed-price assumption, the spending multiplier is \( k = \frac{1}{1-\text{MPC}} \) and the tax multiplier is \( k_T = -\frac{\text{MPC}}{1-\text{MPC}} \). Transfers use \( k_{TR} = \frac{\text{MPC}}{1-\text{MPC}} \) with the same parameters. The sign structure aligns with the direction of AD shifts caused by each instrument.
The balanced-budget multiplier describes the combined change when \( \Delta G = \Delta T \) in the same direction. In the baseline with lump-sum taxes and fixed prices, the net effect on output equals \( \Delta G \). This property is summarized as a balanced-budget multiplier of one.

Automatic Stabilizers

Automatic stabilizers are fiscal features that change net taxes or transfers with income without new legislation. They are built into the structure of progressive taxes and income-contingent transfers. Their purpose is to dampen fluctuations in AD over the business cycle.
In the income tax system, tax liabilities rise more than proportionally when income rises and fall when income falls. This creates an endogenous countercyclical movement in \(Y_d\) and thus in \(C\). The effect reduces the sensitivity of output to shocks in autonomous spending.
Transfers such as unemployment insurance and means-tested programs move inversely with income. When income falls, transfers rise and partially support consumption; when income rises, transfers fall. This mechanism reduces the amplitude of short-run output deviations from \(Y^{*}\).
The cyclically adjusted (full-employment) budget isolates the budget balance that would occur at \(Y^{*}\). This construct separates discretionary policy from automatic responses to the cycle. It is used to assess whether fiscal policy is expansionary or contractionary after controlling for the gap.
With a proportional tax rate \(t\), the leakage-adjusted spending multiplier becomes \( k = \frac{1}{\text{MPS} + \text{MPC}\cdot t} \). A higher \(t\) increases the denominator and reduces \(k\). Automatic stabilizers therefore reduce multiplier magnitudes in the model.

Policy Lags and Model Constraints

Recognition lag refers to the time needed to identify a deviation of \(Y\) from \(Y^{*}\). Decision lag refers to the time required to authorize fiscal changes. Implementation lag refers to the time between authorization and actual changes in \(G\), \(T\), or \(TR\).
Combined lags can cause fiscal actions to affect the economy after conditions have changed. This timing risk can produce effects that are larger or smaller than intended in the short run. The curriculum treats these as limitations on stabilization effectiveness.
Model comparisons require clarity on assumptions about the aggregate price level. In fixed-price multiplier analysis, output adjusts fully to the AD shift, while in AD–SRAS analysis, both \(Y\) and \(P\) adjust. The slope of SRAS determines the division between price-level and real-output changes.
Fiscal instruments operate on AD rather than on LRAS in this unit. Persistent changes in \(G\) composition or incentives are not modeled as LRAS shifts here. Real capacity shifts are reserved for changes in resources, technology, or institutions.
When proportional taxes or other leakages are present, all multiplier-based predictions shrink in magnitude. The denominator of the multiplier collects the marginal leakages that remove income from the spending stream. This condition is summarized by adding terms to the denominator as specified.

Crowding Out and the Net Export Effect

Crowding out is a theoretical reduction in private investment \(I\) associated with expansionary fiscal policy that raises interest rates. The mechanism reduces the total rightward shift of AD relative to the initial change in \(G\) or \(TR\). The curriculum treats this as a potential offset to stabilization.
In the loanable funds framework, increased public borrowing raises the demand for loanable funds. Higher equilibrium real interest rates lower interest-sensitive components of spending. The net effect is a smaller increase in equilibrium \(Y\) than implied by the simple multiplier.
The net export effect links interest-rate movements to currency valuation in an open-economy setting. Higher domestic interest rates can appreciate the currency and reduce \(X_n\). This offset reduces the AD shift produced by expansionary fiscal policy.
These offsets are not included in the closed-economy fixed-price multiplier arithmetic. When they are included, the realized change in \(Y\) is smaller than the baseline prediction. The sign of the AD shift remains the same under the stated instruments.
Crowding out and the net export effect are context-specific adjustments to the AD impact of fiscal changes. They are presented as theoretical channels rather than unconditional outcomes in this unit. Their inclusion depends on whether the model incorporates interest-rate and exchange-rate linkages.

Budget Balance, Deficits, and Public Debt

The budget balance \( \text{BB} \equiv T - G - TR \) measures the difference between revenues and outlays for a period. A deficit occurs when \( \text{BB} < 0 \) and a surplus occurs when \( \text{BB} > 0 \). The primary balance excludes interest payments on existing debt when specified.
Public debt is the cumulative stock of past deficits minus surpluses. Interest payments on the debt are outlays that enter the budget but are not purchases of current output. The distinction between flow (deficit) and stock (debt) prevents interpretive errors.
The structural (cyclically adjusted) deficit measures the deficit that would prevail at \(Y^{*}\). The cyclical component reflects automatic stabilizers responding to \(Y - Y^{*}\). Decomposing the deficit by these parts clarifies the discretionary stance.
The debt-to-GDP ratio is a scale-free measure of indebtedness relative to the economy’s size. Changes in this ratio depend on deficits, growth in \(Y\), and the aggregate price level. The curriculum uses the ratio for comparative statements rather than for causal inference here.
In the AD–AS framework, changes in \(G\), \(T\), and \(TR\) shift AD regardless of the contemporaneous balance. The existence of a deficit or surplus does not itself move AD without a change in instruments. Analysis therefore focuses on the directional effects of instrument changes on the model’s curves.

Inflation and Expectations

Inflation, Disinflation, and Deflation

Inflation is a sustained increase in the aggregate price level \(P\). The inflation rate is \( \pi_t = \frac{P_t - P_{t-1}}{P_{t-1}} \times 100\% \). A positive \(\pi\) indicates that the average level of prices has risen between periods.
Disinflation is a decrease in the inflation rate while the price level continues to rise. It means \( \pi \) remains positive but gets smaller over time. Disinflation is distinct from falling prices.
Deflation is a sustained decrease in the aggregate price level. It corresponds to a negative inflation rate \( \pi < 0 \). The model treats deflation as the opposite of inflation in level terms.
The price level \(P\) is a level index, whereas inflation \(\pi\) is a rate of change. A constant \(P\) implies \(\pi=0\). A rising \(P\) with a falling \(\pi\) is disinflation by definition.
Inflation can be computed from any consistent broad price index. The GDP deflator measures prices of domestically produced final goods and services, while CPI tracks a consumer basket. The curriculum permits either index for \(\pi\) if used consistently.

Demand-Pull vs. Cost-Push Inflation

Demand-pull inflation results from a rightward shift of AD at a given SRAS. The short-run equilibrium shows \(Y\uparrow\) and \(P\uparrow\). The economy moves to the right of \(Y^{*}\) if the shift is large enough.
Cost-push inflation results from a leftward shift of SRAS at a given AD. The short-run equilibrium shows \(Y\downarrow\) and \(P\uparrow\). The simultaneous fall in output and rise in prices defines the cost-push configuration.
Stagflation is the combination of higher inflation with lower real output. In AD–AS terms, it corresponds to an SRAS leftward shift. The equilibrium lies to the left of LRAS with a higher \(P\).
Positive supply shocks shift SRAS right and reduce inflation pressure. The short-run equilibrium shows \(Y\uparrow\) and \(P\downarrow\). This outcome is the mirror image of cost-push inflation.
Demand-pull and cost-push differ by the joint movement of \(Y\) and \(P\). Same-direction changes in \(Y\) and \(P\) indicate an AD shift. Opposite-direction changes indicate an SRAS shift.

Expected Inflation and the Short-Run Phillips Curve (SRPC)

The SRPC shows combinations of the unemployment rate \(u\) and the inflation rate \(\pi\) for a given expected inflation \(\pi^{e}\). Holding \(\pi^{e}\) fixed, there is a short-run inverse relationship between \(u\) and \(\pi\). This is a conditional tradeoff tied to expectations.
Movements along a given SRPC are caused by demand disturbances. A positive AD shock lowers \(u\) and raises \(\pi\) on the SRPC. A negative AD shock raises \(u\) and lowers \(\pi\) on the SRPC.
Changes in \(\pi^{e}\) shift the SRPC. An increase in \(\pi^{e}\) shifts the SRPC upward, and a decrease shifts it downward. Each curve is indexed by its \(\pi^{e}\) level.
In the AD–AS model, higher \(\pi^{e}\) is represented by an SRAS leftward shift at given nominal wages. The implied mapping is an upward shift of the SRPC for the same \(u\). Lower \(\pi^{e}\) maps to an SRPC shift downward.
Temporary supply shocks shift the SRPC independently of \(\pi^{e}\). An adverse SRAS shock shifts the SRPC up and right, and a favorable shock shifts it down and left. These shifts change the inflation–unemployment combination at each \(u\).

Short-Run vs. Long-Run Phillips Curves

The long-run Phillips curve (LRPC) is vertical at the natural rate of unemployment \(u^{*}\). There is no long-run tradeoff between \(u\) and \(\pi\) in this representation. The level \(u^{*}\) corresponds to full-employment output \(Y^{*}\).
Attempts to maintain \(u
Attempts to maintain \(u>u^{*}\) reduce \(\pi\) over time as expectations adjust. The SRPC shifts downward with lower \(\pi^{e}\). The long-run position returns to \(u=u^{*}\) on the LRPC.
The point where the SRPC intersects the LRPC corresponds to \(\pi=\pi^{e}\) and \(u=u^{*}\). Each change in \(\pi^{e}\) generates a new SRPC through that long-run point. The LRPC does not shift with purely nominal demand changes.
The LRPC shifts only if the natural rate \(u^{*}\) changes. Structural changes in matching efficiency or labor market frictions alter \(u^{*}\). Such changes correspond to shifts in potential output \(Y^{*}\) in AD–AS.

AD–AS and Phillips Curve Correspondence

When \(Y>Y^{*}\) in AD–AS, unemployment is below \(u^{*}\) on the Phillips diagram. This configuration is associated with rising inflation pressure. The economy lies to the right of LRAS and to the left on the SRPC.
When \(Y
A rightward AD shift corresponds to a movement along the existing SRPC. The movement lowers \(u\) and raises \(\pi\) holding \(\pi^{e}\) fixed. A leftward AD shift produces the opposite movement.
An SRAS leftward shift corresponds to an upward/rightward SRPC shift. The new combination features higher \(\pi\) with higher \(u\). An SRAS rightward shift corresponds to a downward/leftward SRPC shift.
Long-run adjustment aligns \(\pi\) with \(\pi^{e}\) and \(u\) with \(u^{*}\). The AD–AS diagram returns to \(Y^{*}\) on LRAS, and the Phillips diagram returns to the LRPC. The mapping maintains internal consistency between the two frameworks.