Unit 3: The AD/AS Model and Fiscal Policy
Lesson 1: What is the AD/AS model? Why is the AD curve downsloping, and what is the difference between a change in aggregate
demand and a change in price level causing a movement along the AD curve? (Textbook pages 738-740)
Aggregate Demand—schedule or curve that shows the amounts of real _______________ (rGDP) that buyers collectively desire to purchase
at each possible price level. ___________ relationship
Aggregate Supply—schedule or curve that shows the amounts of real output (rGDP) that firms will ___________________ at each possible
price level. ____________ relationship
3 Reasons the Aggregate Demand Curve is Downsloping



________________________—a higher price level reduces savings account balances/purchasing power/assets, therefore people spend
less.
________________________—higher prices=higher demand for money, if people demand more money, then interest rates go up, if
interest rates go up the consumption and investment spending decreases
________________________—higher prices for US goods induces people to buy fewer US goods and more imports, imports subtract
from rGDP.
Difference between a movement along the curve and a shift in AD


Movement along the curve—only caused by a change in the __________________
Shift in AD—caused by one of _________________of AD
o To the right is an _______________
o To the left is a _________________
Shifts Affect on Inflation, Real GDP, and Unemployment



If AD increases—what happens to inflation? ____________ REAL GDP ____________? Unemployment ________________?
If AD decreases—what happens to DEflation? ___________ REAL GDP ____________? Unemployment ________________?
AD shifts to the right—called _______________ Inflation
Lesson 2: What are the determinants of aggregate demand? Be able to apply the determinants to a graphical analysis. 740-742



RGDP= _______________________
Consumption Determinants
o ________________________—If people feel wealthier because their assets have increased in value, then they will spend more. Ex.
Stock market increases, home prices are on the rise.
o ________________________—Expect prices to increase in the future, increase in AD today; Expect income to decrease in future,
decrease in AD today (Ex. In the weeks before shutdown, gov. employees limit their spending)
o ______________________—More debt allows more spending in the short-term
o ______________________—reduction in taxes=increase in AD, increase in taxes=decrease in AD***
o ______________________—if IR go up, less spending on cars and other interest sensitive consumer purchases will decrease
Investment determinants—
o
o
o
o
Interest Rates—if IR go down, more
businesses will buy __________goods

Changes in IR move long the
investment curve but cause a
shift in AD
Expected _________________—If
businesses expect to make a greater
profit if they buy more capital goods,
then they will buy them
Business __________—if businesses
are taxed more, then they will expect
to see less returns, so they will not
buy as many capital goods.
Changes in __________________—if
there is a breakthrough in technology,
businesses will update their systems
and buy more capital goods
C
1,050


Government Spending
o No determinants—more gov. spending increases AD, less gov. spending decreases AD

__________________________— (Social Security, welfare, veteran’s benefits) are technically not a part of GDP, but if gov.
spending on these go up, then AD will increase
Net Exports
o __________________________________—if foreigners have more money, then they will buy more of our exports. If other
countries are experiencing a recession, then our AD decreases
o _____________________—If our dollar depreciates and foreign currency appreciates, then it will be cheaper for foreigners to buy
US goods. Therefore, they will buy more US exports. At the same time, it becomes more expensive for Americans to buy foreign
goods, so they buy fewer imports.
Lesson 3: How do changes in AD reflect changes in the Phillips Curve?
The Phillips Curve



Model first conceived in the 1960s by A.W. Phillips
Demonstrates ____________ between inflation and unemployment
o When inflation is high, unemployment is ______
o When inflation is low, unemployment is ______
o Shifts in aggregate ______________
Adapted to show changes in SRAS and LRAS
Shifts in Aggregate Demand and Movements along the Short-Run Phillips Curve


Anytime there is a shift in AD or SRAS, it can be shown on the Phillips Curve
If AD increases (assuming an upward sloping AS curve), inflation ____________, RGDP ______________, causing
unemployment to ____________________.
This is shown with a movement up the Phillips curve.

If AD decreases, inflation ________________, RGDP ____________, causing unemployment to _____________.
This is shown with a movement down the Phillips curve.
Lesson 4: What are the different sections of the short-run AS curve, and how is the short-run curve different than the
long-run aggregate supply curve? 732-734

Aggregate Supply Curve’s 3 Sections
o
o
o
o
o
Qf=GDP at full employment

Full employment=no cyclical unemployment
What happens to the PL and RGDP when AD shifts in each of the sections
Horizontal aka Keynesian Range—

Low GDP

what happened to the price level when AD increased?
_________ What happened to rGDP? _______________
Intermediate Range—

Medium GDP

Assume that this is the section, unless otherwise stated.

what happened to the price level when AD increased ?
____________ What happened to RGDP? _________________
Classical Range—

Begins with GDP at full employment

What happened to the price level when AD increased? ______

What happened to RGDP? ________
Lesson 5: What are the determinants of short-run aggregate supply? Be able to apply them to an AD/AS graph and SR
Phillips Curve Graph. 735-736, 748

Shifts are sometimes called ________________
o AS doesn’t shift as often as AD
o Adverse supply shock=shift to the left; Positive supply shock=shift to the right

If SRAS increases—what happens to inflation? ____________ REAL GDP ____________? Unemployment
________________?
If SRAS decreases—what happens to inflation? ___________ REAL GDP ____________? Unemployment
________________?
o When SRAS decreases it can be due to COST-PUSH inflation—inflation due to businesses’ costs increasing
o When SRAS decreases it creates STAGFLATION—stagnant economy b/c real GDP is decreasing at the same time
there is inflation

Determinants of Short-Run Aggregate Supply





_____________________—the cost of resources. If the cost of resources (like oil or labor) decreases, then suppliers will have an
incentive to produce more. Thus, AS will increase. If the cost of resources increases (more than productivity increases), then AS will
decrease
____________________—
o Increased productivity means that it takes less inputs (resources) to make the same amount or more outputs (stuff);
o Productivity= total ____________/total __________

Example of productivity increase

If you have made 10 pens with $5 worth of resources (ink, plastic, machines to make the pens) Productivity=10/5=2

Then you can make 20 pens with $5 worth of resources; Productivity=20/5=4
o If workers are more productive, then profits will increase, so producers will have a greater incentive to produce more—AS will
increase; physical capital (technology) and human capital (education) usually makes workers more productive; ex. Secretary can
do much more work using a computer than she/he did on a typewriter. She can also do much more work if she has mastered
computer skills.
o If the government spends money on __________________—public capital goods—roads, bridges, levees, internet connectivity
can make workers more productive
Government Business Taxes, Subsidies, and Regulation
o If governments tax businesses more, it will cut into their profits. Therefore, they Thus, aggregate supply will _____________.
Tax businesses less, AS will increase.
o If government ______________ (helps—usually gives money or a tax break) a business, AS will ___________; Ex. Ethanol; if the
government removes subsides, then AS will decrease
o _________________ cost money for businesses to implement, which cuts into profits; more regulations=AS decreases; less
regulations=AS increases
o When gov. attempts to increase AS by cutting taxes/regulations or increasing subsidies to business, it is called
____________________________
Inflationary Expectations—If business expect higher prices in the future, they will ____________supply today; if they expect lower prices
in the future, then they will sell more today. *
If both shift but you do not know by how much—just like regular demand/supply—shift both curves equally-the one that doesn’t change
is indeterminate
Shifts in Aggregate Supply and Shifts in the Phillips Curve



Shifts in SRAS can also be shown on the PC model.
If SRAS decreases, then inflation increases and unemployment increases
—STAGFLATION. This is shown in a shift right of the Phillips Curve.
If SRAS increases, then inflation decreases and unemployment decreases.
This is shown with a shift left of the Phillips Curve.
Lesson 6: What happens to real/nominal wages when AD/SRAS shifts in the short-run?




Nominal=_________ + Inflation
Nominal wages must stay the same (sticky, not flexible) in the short-run, unless otherwise stated
If AD increases or SRAS decreases—
o Nominal is constant= Real + Inflation↑
o What MUST happen to Real?
o R= ____
If AD decreases or SRAS increases—
o Nominal is constant=Real + inflation ↓
o What MUST happen to Real?
o R=____
Lesson 7: What is fiscal policy? How is it used to shift aggregate demand?
AS
Fiscal Policy—gov. taxing and spending policies to change the economy
Expansionary vs. Contractionary Fiscal Policy

Expansionary fiscal policy
o Implemented when the economy needs to expand
o During a _______________—unemployment is HIGH
o Gov SPENDS ________—roads, schools, tanks, also transfer pay
o TAXES _______—cuts personal or corporate income taxes
o After implemented AD shifts to the __________
PL
AD
RGDP

Contractionary fiscal policy
o Implemented when the economy needs to contract
o b/c of too much inflation
o Government SPENDS LESS
o TAXES MORE
o After implemented it shifts AD to the left
PL
AS
AD
Discretionary vs. Automatic Fiscal Policy



RGDP
__________________ fiscal policy—a fiscal policy that is implemented when Congress (and the President) passes a law.
o Ex. If Congress increases/decreases tax rates
o If Congress votes for “Race to the Top” giving more money to states for education
_______________________—aka automatic _________________, a fiscal policy that is implemented automatically
o ___________________ income tax

the more $ you make, the higher the % you pay in taxes

Highest tax bracket pays around 30%, lowest tax bracket pays about 5%

When the economy is doing poorly, more people will have less income, so the tax automatically adjusts to tax less

When the economy is doing well, then tax revenue will increase automatically
Food stamps/welfare/Medicaid (poor)/unemployment insurance
o These are all ___________________ programs
o Entitlement means if you meet the requirements, then you get the benefit
o For example, if you make less than $10,000 a year with a family of four, then you get $300 worth of food stamps each month. If
the economy begins to downturn, then more people will meet this requirement. Congress does not have to take any action.
o
MEDICARE=health care for the elderly is an entitlement program (if you meet the requirement—65 years old—then you get the
benefit) HOWEVER, Medicare is NOT tied to the economy (tied to old age) therefore it is not an automatic stabilizer.
Deficit, Surplus, Debt






____________________—tax revenue=government spending for a given year
_____________—government spending>tax revenue for a given year
____________—tax revenue > government spending for a given year
__________—accumulation of past deficits minus any past surpluses
_________________ Policy—(increased gov. spending and/or lower taxes) increases deficits and the debt
_________________ Policy—(decreased gov. spending and/or higher taxes) decreases deficits and the debt
Lesson 8: How do the multipliers work? Pg. 770-774 and 787
Fiscal Policy and the Multipliers


When the government changes spending and taxing in an economy the total affect is __________ than the original change.
For example, if the government spends $1 million dollars on a school, the total change to real GDP is more than 1 million
dollars. It could potentially change GDP by $10 million dollars.
The MPC and MPS








Before calculating the multiplier, we must figure out the MPC and the MPS
Marginal Propensity to ___________ (MPC)—the amount a person spends of any additional disposable income they receive
o _____________ always means additional
o Consume=spend
o If Sally was making $50,000 and she receives a raise to now make $60,000, then her marginal disposable income is
$10,000
o If Sally spends $9,000 of the $10,000, then she has spent 90% of her additional income. Therefore, her MPC is .___
Marginal Propensity to Save (MPS)—the amount a person saves of any additional disposable income they receive
o Sally—saves 1,000 of the $10,000 extra income she received. Therefore, her MPS is .______
MPC formula= change in __________/change in ___________
MPS formula=change in _________/change in ____________
MPC + MPS ALWAYS EQUALS ______
o A high MPC implies a small MPS
Savings can be negative
o How? __________________
If savings are negative, then the _____ is greater than 1
The Multipliers



Investment/Government Spending/Exports Multiplier
o If businesses increase investment spending (physical capital goods) OR government changes its spending, then the
total affect is larger than the original increase/decrease
o Investment/Spending multiplier=1/MPS
o Sally’s MPS was .1. Therefore, in her country, the spending multiplier would be 10
 1/.1=10
If the MPC is .8 and government increases spending by $5 billion dollars, what is the total increase/decrease in GDP?
o 1/.2=5
o 5x5
o $25 billion
If the MPS is .33 and the government decreases spending by $20 billion dollars, what is the total increase/decrease in GDP?
________





o 1/.33=3
o 3 x 20
o $60
If the government increases spending by $500 and that produces a $2,000 change in GDP, then what was the MPC?
o For this example you must work backwards
o Multiplier must be 4
o 2,000/500=4
o If the multiplier is 4, then the MPS must have been .25
 1/x=4
 X=1/4
 X=.25
 If the MPS is .25, then the MPC must have been .75
If the government decreases spending by $1,000 and that decreases GDP by $10,000, then what was the MPS?
The Tax Multiplier
o –______/MPS
o The tax multiplier is always 1 smaller than the spending multiplier
 Why?
 The tax multiplier is smaller because there is no initial injection of spending
 For example, if the government increases spending by 1,000, if the MPC is .75, then the total
increase to GDP will be 4,000—1,000 for the injection of government spending and 3,000 of
multiplying affect.
o It is always ________________
 Because there is an inverse relationship between taxes and GDP
 If taxes increase, then RGDP decreases
 Why? B/C when taxes increase, this taxes money out of people’s pockets that they would have
otherwise spent
 If taxes decrease, then RGDP increases
If the government increases taxes by $10 billion dollars and the MPC is .75, then what is the total affect on GDP?
o GDP will decrease by $30 billion
o –MPC/MPS
o -.75/.25=3
o -3 x 10= -30
If the government decreases taxes by $10 billion dollars and the MPS is .2, then what is the total affect on GDP?
The Balanced Budget Multiplier







It is always 1
Why? The spending multiplier plus the tax multiplier
always equals 1
“Consumers do no reduce their spending by the full
amount of the tax increase.”
Ex. If the MPC is .75
Spending multiplier: 1/MPS= 1/.25=4
Tax multiplier: -MPC/MPS -.75/.25= -3
4 + -3=1
If the government increases spending by $500 billion
and also increases taxes by $500 billion to cover the
cost of the increase in spending, then the economy
will still increase by $500 billion.
MPC
MPS
.9
.8
.75
.67
.5
.1
.2
.25
.33
.5
Injection
Multiplier
10
5
4
3
2
Tax-Leakage
Multiplier
-9
-4
-3
-2
-1
Lesson 9: What are the advantages and disadvantages of fiscal policy?
Advantages


The multiplier effect is a huge advantage. A small change in taxes and spending can impact GDP greatly.
Automatic stabilizers do this effortlessly, which can make the economy flexible.
Disadvantages



_______________ policy lags
o Lag—time it takes to agree and implement the policy; Economy could worse or get better before the policy
changes anything.
o Political lags--Takes time to agree on anything.
o Administrative lags—takes time to implement. Particularly spending policies—takes time to build
roads/tanks/schools or hire teachers. Tax cuts are a more immediate stimulus.
___________________ theory
o RE--“the idea that businesses, consumers, and workers expect changes in policies to have certain effects on the
economy and, in pursuing their own self-interest, take actions to make sure those changes affect them as little as
possible.”
o Ex. During a recession, the gov. gives a tax cut to all Americans. Instead of spending the extra income, people save
it b/c they realize that the gov. is cutting taxes b/c we are headed toward a recession. Knowing that a recession is
imminent, people save their money b/c it is in their best interest, just in case they lose their jobs.
o Multiplier only works if people spend at least some of the change in income.
______________________***important AP topic
o
o
o
o
o
Expansionary and contractionary policy has a counteracting effect.
_______________ policy=interest rates can increase
Interest rates increasing=less investment spending (physical capital goods) and less consumer spending on big
items (cars, appliances)
Interest rates increasing also decreases net exports (discussed later)
Ex. If the economy is in a recession, the gov. conducts expansionary fiscal policy—tax less and spend more. This
creates a budget _____________. How does the government finance a deficit? By taking out loans. This can
increase interest rates for one of two reasons. 1. If the gov. increases DEMAND for loans, then the IR increases.
AND/OR the SUPPLY of loans will DECREASE b/c now people are not lending as much privately, they will be lending
the government more money. If interest rates increase, investment (capital goods) spending and consumer
spending decrease, shifting AD to the left.
OR
Lesson 10: How is the short-run and long-run aggregate supply different? How do the classical and Keynesian schools
differ?
I.
II.
III.
The Short Run
a. A period of time in which _____________wages (how much people get paid without subtracting out inflation effects)
remain FIXED as the price level increases or decreases.
b. Wages are fixed for a time period b/c
i. Workers are not immediately aware that inflation (or deflation) has made their _____________ wages
decrease (or increase).
ii. Many workers (including your teacher) are under fixed wage ______________. Ex. I get paid only so much this
year. I cannot negotiate a pay increase until the following school year.
The Long Run
a. Once nominal wage adjustments can be made the economy enters the long run
b. The long run: a time period in which nominal wages are fully responsive/____________ to previous changes in the
price level.
Classical vs. Keynesian Economics
a.
b.
c.
IV.
Full Employment Equilibrium
a.
V.
_____________________________ economist—focuses on the long run. They focus on how wages and resource
prices are flexible. They think that the government should not intervene in the economy because without intervention
the economy will return to equilibrium eventually.
_______________ Economist—focuses on the short run. They find that wages and prices are ______________
meaning that they will not change or that it will take way too long for them to change.
Which is correct? Depends upon who you ask.
The economy to the right is in full employment equilibrium.
It is currently producing real GDP at a level where there is no
cyclical unemployment.
Inflationary Period
LRAS
SRAS
PL
LRAS
SRAS1
SRAS
PL
PL1
PLe
PLe
AD
AD
Yf
Yf
Ye
RGDP
a.
b.
c.
Ye
RGDP
The economy above is experiencing an _____________ period because it is currently producing __________ RGDP than
at full employment; it is above its potential GDP and unemployment is lower than the NRU
(Right) Without government intervention—NO FISCAL OR MONETARY POLICY. After workers notice that the inflation
has caused their REAL wages to decline, they demand a pay raise. The producers grant the pay raise, thereby causing
their input (resource) prices to rise. We know that when input prices rise, SRAS must decrease, shift _________. SRAS
will shift left until in meets AD at the LRAS curve.
Therefore, in the long run, RGDP has returned back to the full-employment equilibrium and inflation has increased.
VI.
Recessionary Period
a.
The economy below is experiencing a recessionary period because it is currently producing ________ RGDP than at full
employment. It is ___________its potential GDP. The unemployment rate is high. The actual unemployment rate is
_______ than the NRU.
LRAS
SRAS
LRAS
SRAS
SRAS1
PL
PL
PLe
PLe
PL1
AD
AD
Ye
Ye
Yf
Yf
RGDP
RGDP
b.
VIII.
IX.
c. Therefore, in the long run, RGDP has increased and inflation has decreased.
Long-Run effects
a. In the LR, the government through fiscal or monetary policy CANNOT CHANGE OUTPUT, but the price level can increase
after fiscal or monetary policy.
b. In the LONG RUN, there is NO __________________ OFF BETWEEN INFLATION AND UNEMPLOYMENT
What shifts LRAS?
a. Increase in Resources
i. Land—difficult to increase the actual land, but natural resources like cows, corn, and oil can be increased with
new technologies/efficiencies
ii. Labor—if the labor force increases NOT UNEMPLOYMENT DECREASING, or if the labor force is more
productive.
iii. Physical Capital—technology, more physical capital goods will increase when INTEREST RATES DECREASE,
capital per worker will increase and output per worker will increase.
iv. Human Capital—an increase in education that makes workers more productive
b. Increase in Productivity
Why is a shift in LRAS to the right so great?
a. Causes an increase in RGDP without inflation.
b. Same as a shifting outward of the Production Possibilities Curve—you can make more of everything.
c. Shows an increase in a country’s standard of living—increases real GDP per capita
LRAS
LRAS1
SRAS
SRAS1
PL
PLe
Consumer Goods
VII.
Without government intervention—NO FISCAL OR MONETARY POLICY
After workers are laid off, they will accept lower wages in order to gain employment. This pushes down the price of
labor. Therefore, SRAS will _____________ (shift ________) due to cheaper input prices.
AD1
AD
Yf
Yf1
RGDP
Capital Goods
Shifts in Long-Run Aggregate Supply and the Long-Run Phillips Curve



Like LRAS, the LRPC is vertical, showing that in the long-run there is no trade-off between inflation and unemployment.
LRAS is set at Yf—RGDP at full employment, GDP when there is no cyclical unemployment,
Corresponds to the NRU—Natural Rate of Unemployment—rate of unemployment when there is no cyclical unemployment
LRAS and LRPC DO NOT shift frequently—only if there are new (or a loss of) resources or productivity increases (or decreases)