National Income and Price Determination — AP Macroeconomics
AP Macroeconomics · AP Macroeconomics CED Unit 3 · 16 min read
1. Aggregate Demand and Aggregate Supply Basics★★☆☆☆⏱ 3 min
National Income and Price Determination centers on the Aggregate Demand-Aggregate Supply (AD-AS) model, which explains how total real output (real GDP) and overall price levels are set by the interaction of total economy-wide spending and total domestic production. This model forms the foundation for all fiscal and monetary policy analysis later in the AP Macro course.
AD = C + I + G + (X - M)
Where $C$ = consumer spending, $I$ = gross private domestic investment, $G$ = government purchases, $X$ = export spending, $M$ = import spending. The AD curve slopes downward for three key reasons:
**Wealth effect**: Higher price levels reduce the purchasing power of household assets, lowering consumer spending.
**Interest rate effect**: Higher prices increase money demand, raising interest rates and reducing business investment.
**Exchange rate effect**: Higher domestic prices reduce net exports by making exports more expensive and imports cheaper.
2. Short-Run vs Long-Run Aggregate Supply★★★☆☆⏱ 4 min
The difference between short-run and long-run aggregate supply depends on the flexibility of nominal input prices (most notably wages). Input prices are sticky in the short run but fully flexible in the long run.
3. Macroeconomic Equilibrium and Output Gaps★★★☆☆⏱ 3 min
Equilibrium occurs when aggregate output demanded equals aggregate output supplied. There are two types of equilibrium, corresponding to the short run and long run.
Short-run equilibrium occurs where the AD curve intersects the SRAS curve. At this point, there is no inherent pressure to change prices or output. Long-run equilibrium occurs when AD intersects SRAS *and* LRAS at the same point, meaning the economy is producing at potential GDP with unemployment at the natural rate.
When short-run equilibrium is not at potential GDP, the economy has an output gap:
**Recessionary gap**: Short-run equilibrium output ($Y_{eq}$) is less than potential GDP ($Y_p$), so cyclical unemployment exists.
**Inflationary gap**: $Y_{eq}$ is greater than $Y_p$, so unemployment is below the natural rate, and price levels are under upward pressure.
4. The Multiplier Effect★★★★☆⏱ 4 min
The multiplier effect describes how an initial change in any component of aggregate demand leads to a larger final change in total real GDP. This occurs because one person's spending becomes another person's income, creating a chain of additional spending throughout the economy.
MPC = \frac{\Delta C}{\Delta Y_d}
The Marginal Propensity to Save (MPS) is the proportion of additional disposable income that is saved. By definition: $MPC + MPS = 1$, since every additional dollar of income is either spent or saved.
The spending multiplier measures how much total real GDP changes for an initial change in autonomous spending (government spending, investment, etc.):
5. Demand-Pull and Cost-Push Inflation★★★☆☆⏱ 2 min
Inflation is a sustained increase in the overall price level. There are two core types of inflation, each driven by different shifts in the AD-AS model.
Common Pitfalls
Why: Confusion between microeconomic supply/demand curves and aggregate AD/AS curves
Why: Mixing up MPC and MPS in the multiplier formula
Why: Assuming all supply shocks affect long-run production capacity
Why: Assuming firms can produce above potential forever without rising input costs
Why: Forgetting that tax cuts are partially saved, so their impact on GDP is smaller than an equal-sized spending increase