124 ❯ Step 4. Review the Knowledge You Need to Score High
❯ Rapid Review
Aggregate demand (AD): The inverse relationship between all spending on domestic
output and the aggregate price level of that output. AD measures the sum of consumption
spending by households, investment spending by firms, government purchases of goods
and services, and net exports (exports minus imports).
Foreign sector substitution effect: When the aggregate price of U.S. output increases,
consumers naturally begin to look for similar items produced elsewhere.
Interest rate effect: If the aggregate price level rises, consumers and firms might need to
borrow more money for spending and capital investment, which increases the interest
rate and delays current consumption. This postponement reduces current consumption of
domestic production as the price level rises.
Wealth effect: As the aggregate price level rises, the purchasing power of wealth and sav
ings begins to fall. Higher prices therefore tend to reduce the quantity of domestic output
purchased.
Determinants of AD: AD is a function of the four components of domestic spending: C,
I, G, and (X – M). If any of these components increases (decreases), holding the others
constant, AD increases (decreases), or shifts to the right (left).
Short-run aggregate supply (SRAS): The positive relationship between the level of
domestic output produced and the aggregate price level of that output.
Macroeconomic short run: A period of time during which the prices of goods and ser
vices are changing in their respective markets, but the input prices have not yet adjusted to
those changes in the product markets. In the short run, the SRAS curve is typically drawn
as upward sloping.
Macroeconomic long run: A period of time long enough for input prices to have fully
adjusted to market forces. In this period, all product and input markets are in a state of
equilibrium and the economy is operating at full employment (GDPf ). Once all markets
in the economy have adjusted and there exists this longrun equilibrium, the LRAS curve
is vertical at GDPf.
Determinants of AS: AS is a function of many factors that impact the production capacity
of the nation. If these factors make it easier, or less costly, for a nation to produce, AS shifts
to the right. If these factors make it more difficult, or more costly, for a nation to produce,
AS shifts to the left.
Macroeconomic equilibrium: Occurs when the quantity of real output demanded is equal
to the quantity of real output supplied. Graphically this is at the intersection of AD and
SRAS. Equilibrium can exist at, above, or below full employment.
Recessionary gap: The amount by which fullemployment GDP exceeds equilibrium GDP.
Inflationary gap: The amount by which equilibrium GDP exceeds fullemployment GDP.
Demand-pull inflation: This inflation is the result of stronger consumption from all sec
tors of AD as it continues to increase in the upwardsloping range of SRAS. The price level
begins to rise, and inflation is felt in the economy.
Recession: In the AD and AS model, a recession is typically described as falling AD with a
constant SRAS curve. Real GDP falls far below full employment levels and the unemploy
ment rate rises.