Unit 8 Economics Study Hub

The total quantity of all final goods and services that all buyers in the entire economy are willing and able to purchase at different overall price levels. Calculated as: Consumer Spending (C) + Investment Spending (I) + Government Spending (G) + Net Exports (NX = Exports minus Imports). The Aggregate Demand curve slopes downward — when the overall price level rises, real output demanded falls.

Wealth effect: When the overall price level rises, the real purchasing power of people's money and savings falls — they feel poorer and spend less, so total output demanded decreases.
Interest-rate effect: When the price level rises, households and firms need more money for everyday transactions. This higher demand for money pushes interest rates up. Higher interest rates make borrowing more expensive → businesses invest less and consumers spend less on credit → total output demanded falls.
Important distinction: These are entirely different from the substitution effect in individual product demand. The Aggregate Demand curve slopes down because of economy-wide price level effects, not because consumers swap one good for another.

The total quantity of goods and services that all firms are willing to produce at different overall price levels in the short run. The Short-Run Aggregate Supply curve slopes upward because of sticky wages: when the price level rises, firms receive higher revenues, but because wages are slow to adjust upward in the short run (workers have contracts, social norms resist nominal wage cuts), firms' profit margins temporarily increase and they are willing to produce more. Shifts occur when input costs or productivity change.

Wages are "sticky" because they don't immediately respond to changes in the price level. Workers sign wage contracts months or years in advance. Employers are reluctant to cut nominal wages even in downturns because it damages morale and retention. This stickiness means that when the price level rises unexpectedly, firms see their revenues rise but their wage costs stay flat for a while — so profit margins rise temporarily and firms produce more. In the long run, wages eventually catch up and the economy returns to potential output, which is why the Long-Run Aggregate Supply curve is vertical.

The total output the economy can sustainably produce when all resources (labor, capital) are fully employed at their normal rates. Also called potential output. The Long-Run Aggregate Supply curve is vertical because in the long run, once all wages and prices have fully adjusted, real output depends only on the quantity and quality of productive resources — NOT on the overall price level. Shifts right when the labor force grows, capital increases, or technology improves.

The total market value of all final goods and services produced within a country in a given period, adjusted for inflation. "Real" means price changes have been stripped out, so we measure actual changes in output, not just price changes. Real GDP rises when Aggregate Demand or Short-Run Aggregate Supply shifts right, and falls when either shifts left.

A measure of the overall average of all prices across the economy. When Aggregate Demand shifts right, the Price Level rises. When Short-Run Aggregate Supply shifts left, the Price Level also rises. The Price Level falls when Aggregate Demand shifts left or Short-Run Aggregate Supply shifts right.

The situation where the economy's equilibrium Real GDP (RGDP) is below its full-employment potential output (the Long-Run Aggregate Supply line). The economy is underperforming. Unemployment exceeds the natural rate. The correct policy response is expansionary fiscal or monetary policy to shift Aggregate Demand rightward and close the gap.

The situation where the economy's equilibrium Real GDP (RGDP) is above its full-employment potential output (the Long-Run Aggregate Supply line). The economy is overheating and producing beyond its sustainable capacity, driving wages and prices up. The correct policy response is contractionary fiscal or monetary policy to shift Aggregate Demand leftward and cool the economy.

The fraction of each additional dollar of income that a household chooses to spend. Example: if the Marginal Propensity to Consume (MPC) = 0.8, every extra dollar earned leads to 80 cents of new spending and 20 cents of new saving. Always between 0 and 1. A higher MPC means a larger spending multiplier.

The fraction of each additional dollar of income that a household chooses to save rather than spend. Since every dollar is either spent or saved: Marginal Propensity to Consume (MPC) + Marginal Propensity to Save (MPS) = 1 always. A higher MPS means a smaller spending multiplier because more money "leaks" out of the spending chain.

Government decisions about its own spending (how much it purchases), taxes (how much it collects from households and firms), and transfer payments (like unemployment insurance, Social Security) in order to influence Aggregate Demand, Real GDP, and the Price Level. Used to close recessionary or inflationary gaps.

Actions taken by the central bank (in the U.S., the Federal Reserve) to influence the money supply and interest rates in order to shift Aggregate Demand. The three main tools are: (1) open market operations — buying or selling government bonds, (2) changing the reserve requirement, and (3) changing the discount rate. All three work by raising or lowering interest rates, which affects investment and consumption, which shifts Aggregate Demand.

The interest rate at which commercial banks lend reserves to each other overnight. This is a bank-to-bank loan rate, not a rate the public directly pays. The Federal Reserve controls the federal funds rate indirectly through open market operations (buying and selling government bonds). When the Fed buys bonds, it injects money into the banking system → banks have excess reserves → they lend to each other at lower rates → federal funds rate falls. When the Fed sells bonds, it removes money → banks scramble for reserves → federal funds rate rises. The federal funds rate is the most important short-term rate in the economy because it influences all other borrowing rates, which affect investment, consumption, and ultimately Aggregate Demand.

Buying bonds (expansionary): The Federal Reserve purchases government bonds from banks → pays banks with new money → banking system has more reserves → banks lend more to each other at lower rates → federal funds rate falls → all interest rates tend to fall → Investment (I) rises → Aggregate Demand shifts right → Real GDP rises, Price Level rises.

Selling bonds (contractionary): The Federal Reserve sells government bonds to banks → banks pay the Fed with money → banking system has fewer reserves → banks must borrow more from each other at higher rates → federal funds rate rises → all interest rates tend to rise → Investment (I) falls → Aggregate Demand shifts left → Real GDP falls, Price Level falls.

The number by which an initial change in spending (government spending or any autonomous spending) is multiplied to produce the total final change in Real GDP. Works because spending circulates: one person's spending is another's income, which they partially spend, which becomes more income, and so on. The chain stops because each round loses the Marginal Propensity to Save (MPS) fraction as savings.

The number by which a change in taxes is multiplied to get the total change in Real GDP. Always negative by convention and always one unit smaller in absolute value than the spending multiplier — because a tax change first goes to households, who save the Marginal Propensity to Save (MPS) fraction before spending the rest, so the initial stimulus entering the spending chain is smaller than a direct government purchase.

The number by which a change in transfer payments (Social Security, unemployment benefits, etc.) is multiplied to get the total change in Real GDP. Has the same absolute value as the tax multiplier but with the opposite (positive) sign — more transfers → more household income → more Consumer Spending (C) → Aggregate Demand shifts right. Works through consumption, not through government directly purchasing goods.