• Also called real balance effect
• Lower price level -> households' real wealth increases -> more consumption
• Higher price level -> real wealth decreases -> less consumption
• Helps explain downward slope of AD curve

• Lower price level -> households need less money for transactions -> money demand decreases -> interest rates fall -> investment increases
• Higher price level -> money demand increases -> interest rates rise -> investment decreases
• Strongest of the three effects for downward-sloping AD

• Lower price level -> lower interest rates -> capital outflows -> currency depreciates -> exports increase, imports decrease -> net exports increase
• Higher price level -> higher interest rates -> currency appreciates -> net exports decrease
• Also called international trade effect

• Fraction of additional income that households spend on consumption
• MPC = DeltaC / DeltaY (change in consumption ÷ change in income)
• Typically ranges from 0.6 to 0.9 in US
• Higher MPC -> larger multiplier effect

• Fraction of additional income that households save
• MPS = DeltaS / DeltaY (change in savings ÷ change in income)
• MPC + MPS = 1 (all income either consumed or saved)

$\text{Spending Multiplier} = \frac{1}{1 - MPC} = \frac{1}{MPS}$

$\Delta \text{Real GDP} = \text{Spending Multiplier} \times \Delta \text{Spending}$

• Example: If MPC = 0.8, multiplier = 1/0.2 = 5
• $100 increase in government spending ->$500 increase in GDP
• Initial spending respends through economy, creating multiplied effect

$\text{Tax Multiplier} = -\frac{MPC}{1 - MPC} = -\frac{MPC}{MPS}$

• Always smaller than spending multiplier in absolute value
• Negative: tax cut increases GDP, tax increase decreases GDP
• Part of tax cut is saved, not spent, so smaller effect
• Example: If MPC = 0.8, tax multiplier = -0.8/0.2 = -4
• $100 tax cut ->$400 increase in GDP (less than $500 from$100 spending increase)

• Upward sloping: as price level increases, real GDP supplied increases
• Positive relationship between price level and output in short run
• Sticky wages and prices explain upward slope
• Nominal wages are slow to adjust to price changes

• Vertical at potential GDP (full employment output)
• Price level does not affect real output in long run
• Represents economy's maximum sustainable output
• Also called long-run aggregate supply

• Sticky wages: Nominal wages adjust slowly due to contracts, unions, worker morale
• Sticky prices: Menu costs, price coordination problems cause slow adjustment
• Explains why SRAS slopes upward: when price level rises, real wages fall (in short run), making labor cheaper, increasing employment and output
• In long run, wages and prices fully adjust -> vertical LRAS

• Input price changes (wages, oil, materials)
• Productivity changes (technology, human capital)
• Supply shocks (natural disasters, wars)
• Institutional changes (regulations, taxes)
• Expected inflation changes

• At potential GDP (full employment output)
• Economy at natural rate of unemployment
• No cyclical unemployment
• Price level changes do not affect real output in long run
• Determined by resources, technology, institutions

• Both show potential output of economy
• PPC shows trade-offs between two goods
• LRAS shows potential GDP (single number)
• PPC shifts right -> LRAS shifts right (economic growth)
• Both determined by resources, technology, institutions

• Where AD intersects SRAS
• Determines actual price level and real GDP
• May be above or below potential GDP
• Can have recessionary or inflationary gaps
• Economy automatically adjusts toward long-run equilibrium

• AD, SRAS, and LRAS all intersect at same point
• Real GDP = potential GDP
• Unemployment = natural rate
• No pressure for price level or output to change
• Economy at full employment

• Real GDP < potential GDP
• Actual unemployment > natural rate
• Resources underutilized
• Downward pressure on wages and prices
• SRAS will shift right as wages adjust (self-correction)
• Or expansionary policy can close gap faster

• Real GDP > potential GDP
• Actual unemployment < natural rate (overfull employment)
• Resources overutilized, inflationary pressures
• Upward pressure on wages and prices
• SRAS will shift left as wages adjust (self-correction)
• Or contractionary policy can prevent inflation

• Inflation caused by AD increasing faster than AS
• "Too much money chasing too few goods"
• AD shifts right while SRAS stable
• Result: P up , Y up (in short run)
• Characteristic of overheating economy

• Inflation caused by SRAS decreasing
• Rising input costs (wages, oil) push up prices
• SRAS shifts left
• Result: P up , Y down (stagflation)
• Example: Oil price shocks

• Combination of stagnation (high unemployment, low output) and inflation
• Caused by negative supply shock (SRAS shifts left)
• Example: 1970s oil crisis
• Difficult for policymakers: expanding AD worsens inflation, contracting AD worsens unemployment
• Supply-side policies needed to address

• Economy tends toward long-run equilibrium without policy intervention
• Recessionary gap: unemployment above NRU -> downward wage pressure -> SRAS shifts right -> returns to potential GDP
• Inflationary gap: unemployment below NRU -> upward wage pressure -> SRAS shifts left -> returns to potential GDP
• Process can take years, causing prolonged unemployment or inflation

• Nominal wages are sticky in short run (contracts, norms)
• In long run, wages fully adjust to price level changes
• Real wages determine employment and output
• When prices rise but wages don't immediately adjust -> real wages fall -> employment and output rise
• Eventually wages catch up -> real wages restored -> return to potential output

• Used to combat recession (close recessionary gap)
• Increase government spending (G up ) and/or decrease taxes (T down )
• AD shifts right -> P up , Y up (short run)
• Multiplier effect amplifies impact
• Example: 2009 American Recovery and Reinvestment Act ($831 billion stimulus)

• Used to combat inflation (close inflationary gap)
• Decrease government spending (G down ) and/or increase taxes (T up )
• AD shifts left -> P down , Y down (short run)
• Reduces aggregate demand to cool overheating economy
• Rarely used due to political unpopularity

• Tax rates increase as income increases
• Automatically stabilizes economy:
• Recession: incomes fall -> tax burden falls -> disposable income falls less than before
• Expansion: incomes rise -> tax burden rises -> disposable income rises less than before
• Reduces size of economic fluctuations
• No legislative action required

• Automatically increase during recession (more unemployed)
• Automatically decrease during expansion (fewer unemployed)
• Stabilizes disposable income and consumption
• Example: unemployment insurance, food stamps, welfare
• Countercyclical: moves opposite to business cycle
• No need for new legislation during downturns