National Income and Price Determination
This domain examines how aggregate demand and aggregate supply determine the price level and real output, including the multiplier, short-run versus long-run equilibrium, and the effect of fiscal and monetary shocks. Expect questions that ask which curve shifts, in which direction, and by how much.
Aggregate demand
- AD = C + I + G + NX and slopes downward.
- Shifts come from changes in wealth, expectations, taxes, interest rates, government spending, foreign income, and exchange rates.
- A change in the price level causes a movement along AD, not a shift.
Aggregate supply
- SRAS slopes upward because wages and some prices are sticky; it shifts with input costs, productivity, expectations, and supply shocks.
- LRAS is vertical at potential output; it shifts with labor, capital, technology, and institutions.
- Macro equilibrium occurs where AD = SRAS; long-run equilibrium also lies on LRAS.
The multiplier
- MPC + MPS = 1. Spending multiplier = 1 / (1 − MPC) = 1 / MPS.
- Tax multiplier = −MPC / MPS.
- ΔGDP = multiplier × initial change in spending; crowding out and imports reduce the effect.
Worked example
If MPC = 0.75, the spending multiplier is 1 / (1 − 0.75) = 4. A $40 billion increase in government purchases raises equilibrium GDP by 4 × $40 billion = $160 billion. A $40 billion tax cut has the tax multiplier −0.75 / 0.25 = −3, so it raises GDP by 3 × $40 billion = $120 billion. The spending increase has a larger effect because part of a tax cut is saved.
Traps that cost marks
- Do not shift AD when only the price level changes; that is a movement along the curve.
- LRAS is vertical, so demand policy does not change long-run output.
- A supply shock shifts SRAS and can raise prices and unemployment together (stagflation).
- The simple multiplier overstates effects when crowding out, taxes, or imports are present.
- Distinguish a change in government spending from a change in taxes; their multipliers differ.