Study Guide – Unit IV (Chaps. 6-8, 10-11)
Big Picture: The unit on national income, employment & fiscal policy introduces ways to
measure the performance of an economy, using GDP. Then, it addresses problems
associated with economic performance, unemployment and inflation. Finally, after building
and analyzing the aggregate expenditures model, it tells what happens when government
uses fiscal policy tools to stabilize the economy.
Economic output is measured by Gross Domestic Product (GDP). GDP is computed
using either an expenditures or income approach; GDP adjusted for inflation is called ―real
The business cycle—recurrent periods of ups and downs in employment, output and
prices—measures economic output over time. Over its history, the U.S. economy has
experienced persistent periods of unemployment and inflation.
―Consumption is the largest component of aggregate expenditures and saving is
disposable income not spent for consumer goods.‖ The amount of investment spending
depends on ―the expected rate of return from the purchase of additional capital goods and
the real rate of interest.‖
Aggregate demand (AD) is the total quantity of goods and services that will be purchased
at different price levels. Aggregate supply (AS) shows the total quantity of goods and
services that will be produced at different price levels; there are three ranges to the AS
curve. Factors can shift either AD or AS curves to new equilibrium points.
―Fiscal policy is the manipulation by the Federal government of its expenditures and tax
receipts in order to expand or contract the economy.‖
Chapter 6 (don’t need to know about NNP, NI or PI)
Chapter 7 (all)
Chapter 8 (p. ___)
Chapter 9 (____)
Chapter 10 (all)
Chapter 11 (p. ____)
Essential Questions – you will be responsible for answering two:
The aggregate supply curve is divided into three distinct ranges. Describe the slope of
this curve in each of the three ranges. Then verify the conditions that prevail in the
economy in each of the ranges, determine what will happen to output and price levels if
the AD curve shifts within each range, and suggest how the multiplier would be affected.
Not all pages will be covered, though you should be familiar with all terms listed below.
Compare and contrast the effects of expansionary and contractionary fiscal policy on
aggregate demand, describe the economic conditions under which each would be used,
and predict the desired effect on the Federal budget.
Explain to a non-economist the following newspaper headline: ―Rise in Consumer Price
Index Fuels Fears of Inflation.‖ Your answer should include
o …explanations of the terms CPI and inflation;
o …causes of the problem;
o …expected effects on the economy?
National income accounting enables us to measure the economy’s output, compare it with past
outputs, explain its size and the reasons for changes in its size and formulate policies to increase
GDP measures the market value of all final goods and services produced in the economy
during the year.
Non-production transactions (purely financial transactions and second-hand sales) are not
included in GDP;
Measurement of GDP is done by either:
o Expenditures approach – requires the addition of total spending for final goods and
Personal consumption expenditures (C)
Gross private domestic investment (Ig) – sum of spending by business firms
for machinery, equipment, tools; spending by firms and households for new
buildings; changes in inventories of business firms;
Government purchases (G)
Net exports (Xn) – exports minus imports
In equation form, C + (Ig) + G + (Xn) = GDP
o Income approach:
Compensation of employees
Interest payments by business firms
Corporate profits: corporate income taxes, dividends, undistributed corporate
Other: indirect business taxes, depreciation, net foreign factor income
o Each produces the same result.
Because price levels change from year to year, nominal GDP must be converted into real GDP
(adjusted for inflation).
GDP is not a measure of economic well-being:
o It excludes value of final goods and services not bought and sold;
o It excludes the amount of leisure
o It does not record the improvements in quality of products
o It doesn’t take into account the size of the population
o It does not record the pollution costs to the environment
o It does not include goods and services produced in the underground economy.
The business cycle describes a history of alternating periods of prosperity and recession.
Changes in the levels of output and employment are largely the result of changes in the level of
total spending in the economy.
The production of capital and durable consumer goods fluctuates more than the production of
consumer nondurable goods because the former can be postponed.
Full employment does not mean all workers in the labor force are employed; some
unemployment is normal:
o Frictional unemployment is generally desirable; structural unemployment is
inevitable in a dynamic economy; cyclical unemployment arises during the recession
phase of the business cycle and is caused by insufficient total spending.
o Full-employment unemployment (the natural rate of unemployment) is the sum of
frictional and structural unemployment and is achieved when cyclical unemployment is
zero…and is about 5.5% of the labor rate.
o The economic cost of unemployment is the unproduced output, or the GDP gap.
Inflation if an increase in the general level of prices in the economy and is caused by:
o Demand-pull inflation – the result of excess total spending in the economy;
o Cost-push or supply-side inflation – the result of factors that raise per-unit
Inflation injures those whose real incomes fall and benefits those whose real incomes rise, avers
because it decreases the real value of any savings and creditors because it lowers the real value
of debts; it benefits debtors for the same reason.
Classical economics, based on Say’s law (supply creates its own demand) claimed the
economy would automatically tend to full employment.
The Great Depression and the ideas of John Maynard Keynes debunked classical economics by
showing the economy was not self-regulating—that government policies are necessary to
counteract economic instability.
Consumption is the largest component of aggregate expenditures; savings is disposable
income not spent for consumer goods.
o Disposable income is the most important determinant of both consumption and saving.
o The marginal propensity to consume (MPC) and the marginal propensity to save (MPS)
are, respectively, the percentages of additional income spent for consumption and
saved, and their sum is equal to 1.
Two important determinants of the level of investment spending in the economy are the
expected rate of return from the purchase of additional capital goods and the real rate of
o The expected rate of return is directly related to the net profits that are expected to
result from an investment;
o The rate of interest is the price paid for the use of money.
Changes in investment (or in the consumption and saving schedules) will cause real GDP to
change in the same direction by an amount greater than the initial change in investment (or
consumption); this is called the multiplier effect:
o The value of the simple multiplier is equal to the reciprocal of the MPS (1/MPS);
o The multiplier is significant because relatively small changes in the spending plans of
business firms or households bring about large changes in GDP.
Changes in government spending and tax rates can offset cyclical fluctuations and increase
economic growth; this is called fiscal policy:
Aggregate demand (AD) is a curve which shows total quantity of goods and services that will be
purchased at different price levels:
o AD curves are downward sloping;
o Changes in spending by consumers (changes in wealth, expectations, taxes), business
(changes interest rates, expected returns on investment, taxes, technology),
government and foreign buyers will change the AD curve:
Aggregate supply (AS) is a curve that shows the total quantity of goods and services produced
(supplied) at different price levels; the AS curve has three ranges:
o In the horizontal range (when economy is in severe recession, with unemployed labor
and capital), the AS curve is horizontal; producers are induced to supply larger
quantities of goods and services even without rise in price levels;
o In the vertical range (when economy is at full employment), the AS curve is vertical; a
rise in price level cannot result in increases in quantity of goods & services;
o In the intermediate range, the AS curve is upward sloping; the price level must rise to
induce producers to supply larger quantities of goods and services.
Factors that shift AS curve include changes in prices of inputs for production, changes in
productivity, changes in legal and institutional environment in economy.
Equilibrium real domestic output and equilibrium price level are at intersection of AD and AS
Equilibrium changes with shifts in either AS or AD curves,
An increase in AD in the…
o Horizontal range results in increase in real output (GDP), with no change in price
level—full multiplier effect will occur;
o Vertical range results in increase in price level, with real domestic output (GDP)
o Intermediate range results in increases in both output (GDP) and price levels—
multiplier effect will be less.
A decrease in AD may not have the opposite effect on price level because prices tend to be
inflexible (sticky) downward.
An increase in AS has salutary effect on both output (increases) and price levels (decreases).
Fiscal policy is the manipulation by the Federal government of its expenditures and tax receipts
in order to expand or contract the economy…to increase real output (and employment) or
decrease its rate of inflation.
Discretionary fiscal policy involves changes in government spending or taxation by Congress:
o Expansionary fiscal policy is used to counteract recession or cyclical downturn in
economy by increasing AD; expansionary fiscal policy results in a budget deficit; to
finance the deficit, the gov’t can either borrow money or issue new money to creditors.
o Contractionary fiscal policy is a restrictive form of fiscal policy used to control
demand-pull inflation by reducing AD.
Unit IV Terms:
National income accounting Gross domestic product (GDP) Intermediate goods
Final goods Multiple counting Value added
Expenditures approach Income approach Personal consumption
Gross private domestic Net private domestic investment Government purchases (G)
New exports (XN) Taxes on production and National income
Consumption of fixed capital Net domestic product (NDP) Personal income (PI)
Disposable income (DI) Nominal GDP Real GDP
Price index Economic growth Real GDP per capita
Rule of 70 Productivity Business cycles
Peak Recession Trough
Expansion Labor force Unemployment rate
Discouraged workers Frictional unemployment Structural unemployment
Cyclical unemployment Full-employment rate of Natural rate of unemployment
Potential output GDP gap Okun’s law
Inflation Consumer Price Index (CPI) Demand-pull inflation
Cost-push inflation Per-unit production costs Nominal income
Reeal income Anticipated inflation Unanticipated inflation
Cost-of-living adjustments Real interest rate Nominal interest rate
Deflation Hyperinflation 45o (degree) line
Consumption schedule Saving schedule Break-even income
Average propensity to consume Average propensity to save Marginal propensity to consume
(APC) (APS) (MPC)
Marginal propensity to save Wealth effect Expected rate of return
Investment demand curve Multiplier Aggregate demand
Real-balances effect Aggregate demand-aggregate Foreign purchases effect
supply (AD-AS) model
Determinants of aggregate Interest-rate effect Long-run aggregate supply
Short-run aggregate supply Aggregate supply Productivity
Equilibrium price level Determinants of aggregate Menu costs
Efficiency wages Equilibrium real output Council of Economic Advisers
Expansionary fiscal policy Fiscal policy Contractionary fiscal policy
Budget surplus Budget deficit Progressive tax system
Proportional tax system Built-in stabilizer Standardized budget
Cyclical deficit Regressive tax system Crowding-out effect
Public debt Political business cycle External public debt
Public investments U.S. securities
Short-Answer Questions—some or all will be used as short-answer questions on the exam:
Analyze why GDP accounting excludes non-production transactions.
Explain the components of gross private domestic investment.
Describe how the dollar value that results from the expenditures approach to GDP must equal the
dollar amount resulting from the income approach.
Explain the difference between real and nominal GDP.
Explain the four phases of the business cycle.
Compare the manner in which the business cycle affects output and employment in the industries
producing capital and durable goods with industries producing non-durable goods and services,
especially during downturns.
Explain what is meant by full-employment unemployment (or the natural rate of unemployment),
and why this measure of ―full employment‖ never equals zero.
Summarize the economic costs of unemployment; be sure to include the quantitative relationship
(Okun’s law) between the unemployment rate and the cost of unemployment.
Compare and contrast demand-pull and cost-push inflation.
Describe the relationship between MPC and MPS and the consumption and saving schedules.
Explain the marginal cost and marginal benefit of an investment decision; be sure to include how
the marginal cost and marginal benefit of investment are measured.
Explain the rationale for the multiplier effect.
Analyze the effect on aggregate demand of increasing investment spending; illustrate with a
Provide examples describing how an increase or decrease in per-unit production costs changes
What would happen to AS if the federal gov’t were to raise or lower business taxes?
What is the relationship between the production possibilities curve and AS?
Why is a decrease in AS within the ―up-sloping range‖ ―doubly bad‖ and an increase in AS within
that range ―doubly good.‖
Supply definitions for progressive, proportional and regressive taxes, and analyze the implications
of each type of tax for the built-in stability of the economy.
Analyze how crowding out and inflation reduce the effect of an expansionary (deficit) fiscal policy
on real GDP and employment.