National Income and Price Determination

The aggregate demand (AD) curve shows the total real output that households, businesses, the government and foreign buyers want to buy at each price level (C + I + G + Xn). Why does it slope downward? A lower price level makes your money and savings buy more (the real wealth effect), lowers interest rates so borrowing is cheaper (the interest rate effect), and makes the country's goods cheaper for foreign buyers (the exchange rate effect). A change in the price level moves along AD. A change in consumption, investment, government spending or net exports for any other reason shifts the whole curve: right for an increase, left for a decrease.

When spending changes, that money becomes someone's income, part of which gets spent again, so the total change in real GDP ends up bigger than the first change. The marginal propensity to consume (MPC) is the share of extra disposable income people spend, and MPS = 1 − MPC. The spending multiplier is 1 ÷ MPS and the tax multiplier is −MPC ÷ MPS; with an MPC of 0.8 they are 5 and −4. Change in real GDP = the first change in spending (or taxes) × the multiplier.

The short-run aggregate supply (SRAS) curve slopes upward because some wages and prices are sticky (slow to change). When the price level rises but input costs stay put for a while, producing more pays off, so output rises and unemployment falls; that's the short-run trade-off between inflation and unemployment. Anything that changes production costs shifts SRAS, such as input prices like wages or oil, productivity, business taxes and subsidies, or expected inflation. Higher costs shift SRAS left, and lower costs shift it right.

In the long run, all wages and prices fully adjust, so the long-run aggregate supply (LRAS) curve is a vertical line at full-employment output (YF). That's the most the economy can sustainably produce with its resources and technology, the same capacity a PPC shows. Because LRAS is vertical, there's no long-run trade-off between inflation and unemployment. LRAS shifts right only when that capacity grows (more or better resources, better technology) and left when it shrinks.

On a graph with the price level on the vertical axis and real GDP on the horizontal axis, short-run equilibrium is where AD crosses SRAS, labeled PL1 and Y1. Long-run equilibrium is when that crossing sits on the vertical LRAS at full-employment output (YF). If Y1 is below YF, there's a recessionary (negative) output gap and unemployment is above the natural rate; if Y1 is above YF, there's an inflationary (positive) output gap and unemployment is below the natural rate.

In the short run, an increase in AD (AD1 shifts right to AD2) raises the price level, real output and employment, and a decrease does the opposite; inflation caused this way is demand-pull inflation. A negative supply shock, such as a jump in oil prices, shifts SRAS1 left to SRAS2: the price level rises while output and employment fall. That's cost-push inflation, and the mix of rising prices and falling output is called stagflation. A positive supply shock shifts SRAS right, lowering the price level and raising output and employment.

Without any government policy, the economy closes output gaps on its own in the long run as wages and other input prices adjust. In a recessionary gap, high unemployment eventually pushes nominal wages down, so SRAS shifts right and output returns to YF at a lower price level. In an inflationary gap, rising nominal wages shift SRAS left until output falls back to YF at a higher price level.

Fiscal policy is the government's use of spending and taxes (including transfer payments) to steer the economy. Expansionary policy (more spending, tax cuts or more transfers) shifts AD right to close a recessionary gap, and contractionary policy (the reverse) shifts AD left to close an inflationary gap. Government purchases add to AD right away, while tax changes work only through how much people then spend, so a change in spending moves real GDP more than an equal change in taxes. In practice, policy also faces time lags: spotting a problem, passing a law and putting it into action.

Automatic stabilizers are parts of the tax and transfer system that push back against the business cycle without anyone passing a new law. In a recession, tax collections fall and payments like unemployment benefits rise, which props up spending; in a boom, tax collections rise and those payments fall, which cools spending down.