National Income and Price Determination

Aggregate demand (AD) 总需求 shows the total quantity of real output ($C+I+G+X_n$) buyers want at each price level 价格水平. It slopes downward for three reasons special to the whole economy:

• the wealth effect 财富效应 (a higher price level shrinks the real value of money, so people buy less),
• the interest-rate effect 利率效应 (a higher price level raises money demand and interest rates, cutting investment),
• the net-export effect 净出口效应 (a higher domestic price level makes exports dearer and imports cheaper).

A change in the price level is a movement along AD. AD shifts when any component of $C+I+G+X_n$ changes for another reason – consumer confidence 消费者信心, business expectations, government spending, taxes, or foreign incomes.

A change in spending sets off further rounds of spending, so the final change in GDP is larger than the initial change – the multiplier effect 乘数效应. It depends on the marginal propensity to consume 边际消费倾向 (MPC), the fraction of extra income that is spent (the rest is the marginal propensity to save 边际储蓄倾向, MPS, with $MPC+MPS=1$):

A tax cut works through the multiplier too, but more weakly, because part of the tax cut is saved:

The tax multiplier is smaller in size and negative (a tax cut raises GDP; a tax rise lowers it). Total change in GDP $=$ (multiplier) $\times$ (initial change).

Worked example. If $MPC=0.8$, the spending multiplier 支出乘数 is $\dfrac{1}{1-0.8}=5$, so a $\$10$ billion rise in government spending lifts real GDP by $5\times\$10=\$50$ billion. The tax multiplier is $-\dfrac{0.8}{0.2}=-4$, so a $\$10$ billion tax cut 减税 raises GDP by only $\$40$ billion – weaker, because part of the tax cut is saved.

Exam skill: compute both multipliers from the MPC and find the resulting change in real GDP – an almost-guaranteed calculation.

Short-run aggregate supply (SRAS) 短期总供给 slopes upward: in the short run some input prices 投入品价格 (especially nominal wages 名义工资) are sticky 粘性, so a higher output price level widens profit margins and firms produce more. SRAS shifts with input prices, productivity 生产率, taxes or subsidies on producers, and supply shocks 供给冲击 (e.g. an oil-price change). A rise in input costs shifts SRAS left.

Long-run aggregate supply (LRAS) 长期总供给 is vertical at the economy's full-employment (potential) output 潜在产出 $Y_f$. In the long run all prices and wages are fully flexible (only in the short run are some input prices fixed), so output depends only on real factors – resources, technology, institutions – not the price level. LRAS shifts only with economic growth 经济增长 (more or better resources). LRAS corresponds to the production possibilities curve (PPC) 生产可能性曲线: both mark the economy's maximum sustainable capacity, so an outward LRAS shift and an outward PPC shift are the same event drawn two ways. The vertical LRAS is why, in the long run, demand policy changes prices, not output.

The economy settles where AD meets SRAS, fixing the equilibrium price level and real GDP 实际国内生产总值. Comparing that output to $Y_f$ (the LRAS line) gives the economy's state:

• output $<Y_f$: a recessionary gap 衰退缺口 (cyclical unemployment),
• output $>Y_f$: an inflationary gap 通胀缺口 (overheating),
• output $=Y_f$: long-run equilibrium 长期均衡.

How to label the graph for full marks. Label the vertical axis price level (never "price") and the horizontal axis real GDP (never "quantity"). Draw LRAS as a vertical line, label the equilibrium output $Y_1$ and full-employment output $Y_f$ on the horizontal axis, and the price level $PL_1$ on the vertical axis. A recessionary gap needs $Y_1$ to the left of LRAS; an inflationary gap needs it to the right. Readers check the position of $Y_1$ against $Y_f$, so draw that relationship clearly.

Unemployment and the gap. In a recessionary gap the actual unemployment rate is above the natural rate (there is cyclical unemployment). In an inflationary gap it is below the natural rate: firms work overtime and hire people who would normally still be searching.

• A demand shock 需求冲击 shifts AD: a positive one (more spending) raises both price level and output (and lowers unemployment); a negative one lowers both.
• A supply shock shifts SRAS: a negative one (higher input costs) raises the price level and lowers output at once – stagflation 滞胀 – the hardest case for policymakers, because fixing one worsens the other.

A real example. When Russia invaded Ukraine in February 2022, world prices of oil, gas and wheat jumped. For energy-importing economies such as the euro area this was a negative supply shock: inflation in the euro area reached 10.6 % in October 2022, while output growth slowed close to zero. An AD-only story cannot explain prices rising while output weakens; the leftward SRAS shift can.

Which curve moves? Ask what changed first.

The last row is the classic trap: a change in the price level never shifts AD or SRAS.

Left alone, the economy self-corrects through flexible wages:

• In a recessionary gap, high unemployment eventually pushes nominal wages down, shifting SRAS right until output returns to $Y_f$ at a lower price level.
• In an inflationary gap, labor shortages push wages up, shifting SRAS left back to $Y_f$ at a higher price level.

Notice what moves and what does not. In self-adjustment only SRAS shifts; AD stays where it is, and LRAS does not move because the economy's capacity has not changed. The new long-run equilibrium is always on LRAS, where AD, SRAS and LRAS all cross.

The debate over how fast this happens is the case for (or against) active policy: self-adjustment is slow and painful, which is the argument for intervening.

Fiscal policy 财政政策 is the government's use of spending and taxes to shift AD:

• Expansionary 扩张性 (more spending or lower taxes) shifts AD right to close a recessionary gap.
• Contractionary 紧缩性 (less spending or higher taxes) shifts AD left to close an inflationary gap.

Size the policy with the multipliers: to close a gap of a given size, the required change in spending is (gap) $\div$ (spending multiplier). Limits include time lags 时滞, crowding out 挤出效应 (below), and political difficulty.

Worked example. An economy has a $\$100$ billion recessionary gap and $MPC=0.75$ (spending multiplier $=\dfrac{1}{0.25}=4$). To close it, the government must raise spending by $\dfrac{\$100\text{ billion}}{4}=\$25$ billion. Using a tax cut instead (tax multiplier $-3$) would require a larger $\dfrac{100}{3}\approx\$33$ billion cut.

Exam skill: you must draw the correctly labeled AD-AS graph, identify the gap, prescribe the right fiscal action and its direction, and often calculate the exact spending or tax change needed.

This practice question is in the style of the long AP free-response question. Try each part before reading the answer.

The economy of Lumeria is in short-run equilibrium with real GDP of $900 billion. Full-employment output is $1,000 billion. The marginal propensity to consume is 0.8.

(a) Draw a correctly labeled AD-AS graph showing Lumeria's current situation. Draw AD, SRAS and a vertical LRAS. Label the axes price level and real GDP. Mark equilibrium output $Y_1$ to the left of $Y_f$ on LRAS, and the price level $PL_1$. (This is the left panel of the output-gaps figure above.)

(b) Is the unemployment rate above, below or equal to the natural rate? Explain. Above the natural rate. Output is below full employment, so there is cyclical unemployment.

(c) Calculate the maximum change in real GDP that a $20 billion increase in government spending could cause. Spending multiplier $=\dfrac{1}{1-0.8}=5$, so the maximum change $=5\times\$20\text{ billion}=\$100$ billion. That is exactly the size of the gap. Write "maximum" because crowding out or price-level rises can make the actual change smaller.

(d) Instead of spending, the government cuts taxes. What is the smallest tax cut that could close the gap? Tax multiplier $=-\dfrac{0.8}{0.2}=-4$. The gap is $100 billion, so the tax cut is $\dfrac{\$100\text{ billion}}{4}=\$25$ billion. A tax cut must be larger than a spending rise ($25 billion against $20 billion), because households save part of it.

(e) If the government does nothing, what happens to nominal wages and to SRAS in the long run? What happens to the price level? High unemployment pushes nominal wages down, so SRAS shifts right. Real GDP returns to $1,000 billion and the price level falls.

Common ways to lose the mark: writing "price" on the vertical axis; showing $Y_1$ on the wrong side of LRAS; raising taxes when the gap calls for a tax cut (the tax multiplier is negative, so a cut raises GDP); saying AD shifts in self-adjustment (only SRAS shifts).

Automatic stabilizers 自动稳定器 are features that dampen the cycle without new legislation. In a downturn, progressive taxes 累进税 collect less and transfer payments 转移支付 (unemployment benefits, welfare) rise automatically – cushioning incomes and spending; in a boom they do the reverse. They soften the cycle and act instantly, avoiding the lags of discretionary 相机抉择 policy.

• Aggregate demand slopes down for the wealth, interest-rate, and net-export effects; it shifts when $C$, $I$, $G$, or $X_n$ changes.
• Compute the spending multiplier $\tfrac{1}{1-MPC}$ and the smaller, negative tax multiplier 税收乘数 $-\tfrac{MPC}{1-MPC}$.
• Draw a correctly labeled AD–AS graph, identify a recessionary or inflationary gap, and prescribe the right fiscal action.
• Short-run AS slopes up (sticky wages); long-run AS is vertical at full-employment output.
• Size a policy with the multipliers: required spending = gap ÷ spending multiplier.