Unit 5 Review
AP Macroeconomics
1. 1. The modern tools of macroeconomic
policy are:
Monetary and Fiscal Policy
Aggregate Demand Curve
AD is downward sloping:
Price
Level
Negative relationship
between PL and Output
Changes in price level cause
a move along the curve
AD = C + I + G + Xn
Real domestic output (GDPR)
3
Aggregate Demand Curve
Price
Level
AD shows the relationship
between aggregate PL and
Aggregate demand by
households, businesses,
government, and the rest of the
world
AD = C + I + G + Xn
Real domestic output (GDPR)
4
Why is AD downward sloping?
1. Wealth Effect
• Higher price levels reduce the purchasing
power of money
• This decreases the quantity of expenditures
• Lower price levels increase purchasing power
and increase expenditures
Example:
• If the balance in your bank was $50,000, but inflation
erodes your purchasing power, you will likely reduce
your spending.
• So…Price Level goes up, GDP demanded goes down.
5
Why is AD downward sloping?
2. Interest-Rate Effect
• When the price level increases, lenders
need to charge higher interest rates to
get a REAL return on their loans.
• Higher interest rates discourage
consumer spending and business
investment. WHY?
• Example: An increase in prices leads to an increase
in the interest rate from 5% to 25%. You are less
likely to take out loans to improve your business.
• Result…Price Level goes up, GDP demanded goes
down (and Vice Versa).
6
What is Aggregate Supply?
Aggregate Supply is the amount of goods and
services (real GDP) that firms will produce in an
economy at different price levels.
The supply for everything by all firms.
Aggregate Supply differentiates between short
run and long-run and has two different curves.
Short-run Aggregate Supply
•Wages and Resource Prices will not increase
as price levels increase.
Long-run Aggregate Supply
•Wages and Resource Prices will increase as
price levels increase.
7
Aggregate Supply Curve
Price
Level
AS
AS is the
production of all
the firms in the
economy
Real domestic output (GDPR)
8
Shifters of Aggregate Supply
1. Change in Inflationary Expectations
If an increase in AD leads people to expect higher
prices in the future. This increases labor and
resource costs and decreases AS.
(If people expect lower prices…)
2. Change in Resource Prices
Prices of Domestic and Imported Resources
(Increase in price of Canadian lumber…)
(Decrease in price of Chinese steel…)
Supply Shocks
(Negative Supply shock…)
(Positive Supply shock…)
9
Shifters of Aggregate Supply
3. Change in Actions of the Government
(NOT Government Spending)
Taxes on Producers
(Lower corporate taxes…)
Subsidies for Domestic Producers
(Lower subsidies for domestic farmers…)
Government Regulations
(EPA inspections required to operate a farm…)
4. Change in Productivity
Technology
(Computer virus that destroy half the computers…)
(The advent of a teleportation machine…)
10
Shifts in Aggregate Demand
An increase in spending shift AD right, and decrease in
spending shifts it left
Price
Level
AD1
AD2
AD = C + I + G + Xn
Real domestic output (GDPR)
11
Inflationary and
Recessionary Gaps
12
Example: Assume the government increases
spending. What happens to PL and Output?
Price
Level
LRAS
AS
PL and Q will
Increase
PL1
PLe
AD
QY Q1
AD1
GDPR
13
Inflationary Gap
Output is high and unemployment is less than NRU
LRAS
Price
Level
AS
Actual GDP
above potential
GDP
PL1
AD1
QY Q1
GDPR
14
Example: Assume the price of oil increases
drastically. What happens to PL and Output?
Price
Level
LRAS
AS1
AS
PL1
Stagflation
PLe
Stagnate Economy
+ Inflation
AD
Q1 QY
GDPR
15
Recessionary Gap
Output low and unemployment is more than NRU
LRAS AS1
Price
Level
Actual GDP
below potential
GDP
PL1
AD
Q1 QY
GDPR
16
Marginal Propensity to Consume
(MPC)
• The fraction of any change in
disposable income that is
consumed.
• MPC= Change in Consumption
Change in Disposable
Income
• MPC = ΔC/ΔDI
Marginal Propensity to Save
(MPS)
• The fraction of any change in
disposable income that is saved.
• MPS= Change in Savings
Change in Disposable
Income
• MPS = ΔS/ΔDI
Practice
• The limiting factor is savings.
• For every additional dollar spent a portion
of it will be saved (the MPS).
• The multiplier is the reciprocal of the MPS
or 1/MPS.
• The larger the MPC (the smaller the MPS)
the larger the multiplier will be.
• Tax Multiplier (note: it’s negative
because tax increases reduce
spending)
-MPC/
or MPC/
1-MPC
MPS
• If there is a tax-CUT, then the
multiplier is +, because there is now
more money in the circular flow




Government Spending during a recession or
depression and can improve an economy by
injecting money into households.
Recessions are inevitable.
Many government programs like Social
Security, Medicare, Unemployment, and
Welfare were begun as Keynesian economic
stimulus.
Aggregate Demand must be stimulated in
order to recover from a recession.






Free Markets will lead to full employment
Keynesian Economics causes price bubbles,
(inflation.)
When the bubbles break, a recession
(hangover) incurs.
The booms and busts of the business cycle are
natural and are self-correcting.
Competition is the invisible hand
Government should be limited to preventing
monopolies or unions



A non-political agency can regulate banks, the
money supply, and interest rates. It will be
especially effective when painful and unpopular
decisions need to be made and will make them in a
timely manner. This can be the central banking
system.
During recessions, impact the overall investment
demand through tools that increase the incentive
to borrow. This will be lower interest rates.
During inflation, impact the overall investment
demand through tools that decrease the incentive
to borrow. This will be higher interest rates.