National Income and Price Determination

A .  Aggregate demand 
1 .  Determinants of aggregate demand

2 .  Multiplier and crowding-out effects
The multiplier is used to examine changes in spending and changes in taxation.  We spend a  high percentage of our disposable income and that is called the marginal propensity to consume (MPC).  The amount we save is called the marginal propensity to save (MPS).  MPC + MPS=1
To determine the spending multiplier take 1/MPS.  The tax multiplier is -MPC/MPS
 MPC     MPSSpending
Tax Multiplier
 .95 .05 20 -19
 .90 .10 10 -9
 .80 .20 5 -4
 .75 .25 4 -3

Fiscal activity does not always lead to increased economic activity because deficit spending used to finance spending or tax cuts can crowd out financing for other economic activity. This phenomenon is argued to be less likely to occur in a recession, where savings rates are traditionally higher and capital is not being fully utilized in the private market.

Crowding Out

B .  Aggregate supply
1 .  Short-run and long-run analyses
The SRAS has three main parts.  The first part is closest to the Y axis.  RGDP can increase with little inflation.  The middle portion has a mix of inflation and RGDP growth.  After the LRAS the SRAS mostly shows inflation and little growth.

The LRAS is vertical because we become used to prices in the long run.  Meaning that we all adjust to a new price level over time.  The X-axis intercept is the potential of the economy.  It is also known as the full employment output where there is 0 cyclical unemployment.  

2 .  Sticky versus flexible wages and prices
Short run aggregate supply is positively related to price level.  When price level increases firms have an incentive to produce more because wages are STICKY and take longer to adjust then prices.

3 .  Determinants of aggregate supply

C .  Macroeconomic equilibrium 
1 .  Real output and price level--Long run and short run equilibrium pictured below.
2 .  Short and long run
Short run equilibrium occurs when AD intersects SRAS.  Long run equilibrium occurs when AD intersects SRAS on LRAS.

3 .  Actual versus full-employment output
Full employment output occurs where LRAS intercepts the X-axis.  This point is called potential or full employment output.
RECESSIONARY GAP:  The current output is LESS THAN full employment:
SELF-CORRECTION-Nominal wages decrease due to high unemployment, resource costs decrease, SRAS shifts to the right for long run equilibrium.
FISCAL POLICY-decrease taxes and/or increase spending--deficit spending.

INFLATIONARY GAP:  The current output is GREATER THAN full employment:
SELF-CORRECTION-Nominal wages increase due to low unemployment, resource costs increase, SRAS shifts to the left for long run equilibrium.
FISCAL POLICY-increase taxes and/or decrease spending--surplus budget

4 .  Economic fluctuations


Recessionary and Inflationary Gap