National Income and Price Determination
Unit 3: National Income and Price Determination
Page 1
National Income and Price Determination is the central concept of this unit.
Page 2
Aggregate Price Level
AD/AS Model: A graphical model representing the aggregate demand (AD) and aggregate supply (AS) in an economy.
Axes:
Horizontal Axis: Real GDP (GDPR)
Measures changes in aggregate output, which correlates with aggregate spending, income, and unemployment rate (UR).
Vertical Axis: Aggregate Price Level
A measure of inflation in the economy.
Y: symbolic representation of aggregate income, which includes various components:
(C) Consumption
(I) Investment
(W) Wages
(R) Rent
(G) Government spending
(X) Exports
(M) Imports
(P) Profit
Page 3
Aggregate Demand
Definition: The total demand for all goods and services in an economy.
AD Curve: Represents aggregate spending, expressed as AD = C + I + G + Xn.
Components of demand:
Consumer goods
Investment goods from firms
Government demand
Exports minus imports (net exports)
Page 4
The Slope of the Aggregate Demand Curve
The AD curve slopes downward, indicating an inverse relationship between the aggregate price level and quantity of aggregate output demanded:
If price level decreases, quantity demanded for aggregate output increases.
Movement along the curve occurs when price level changes, shifting right and downward.
Page 5
Practice
Draw a correctly labeled aggregate demand curve reflecting an increase in price levels.
Page 6
Answer Sample
Annotated graph showing AD curve with labels for price levels (PL₁, PL₂) and quantity of aggregate output (QAD₁, QAD₂).
Page 7
Determinants of Aggregate Demand
Factors causing shifts in AD are defined through:
C: Consumer spending
Ig: Gross private domestic investment
G: Government spending
XN: Net Exports (exports minus imports)
Any change in C, I, G, or net X will shift the AD.
Page 8
Determinants of Consumption
Factors Influencing C:
Wealth: More ownership leads to more spending.
Income: Higher earnings lead to higher consumer spending.
Income Taxes: Lower taxes mean more disposable income.
Economic Conditions: Positive expectations lead to increased spending.
Page 9
Analysis of Consumption Determinants
Wealth:
Increased wealth → Increased spending (C↑).
Decreased wealth → Decreased spending (C↓).
Income:
Increased income → Increased spending (C↑).
Decreased income → Decreased spending (C↓).
Income Taxes:
Lower taxes → Increased disposable income → Increased spending (C↑).
Higher taxes → Decreased disposable income → Decreased spending (C↓).
Expectations:
Positive expectations → more spending (C↑).
Negative expectations → less spending (C↓).
Page 10
Determinants of Investment
Factors affecting ‘I’:
Expectations of future economic conditions.
Interest rates.
Unplanned changes in business inventories.
Page 11
Analysis of Investment Determinants
Future Expectations:
Positive outlook → Increase in investment (Ig↑).
Negative outlook → Decrease in investment (Ig↓).
Interest Rates:
Lower rates → More capital goods purchased, leading to higher investment (Ig↑).
Higher rates → Lesser capital goods purchased, leading to lower investment (Ig↓).
Inventory Changes:
Unplanned decreases → Firms increase investment (Ig↑).
Unplanned increases → Firms decrease investment (Ig↓).
Page 12
Determinants of Net Exports
Factors causing a change in X:
Relative incomes: Increase in foreign income raises US exports.
Relative prices: If US goods are cheaper, exports rise.
Exchange rates: Changes in currency values affect the cost of exports and imports.
Page 13
Net Exports Analysis
Relationship between exports, imports, and AD:
Exports (X) positively related to AD → Increase in X leads to increase in AD.
Imports (M) inversely related to AD → Increase in M leads to decrease in AD.
Page 14
Effects on AD Curve
Rightward Shift:
Represented by an increase in AD.
Causes: Increases in C, I, G, or X or decreases in M.
Leftward Shift:
Represented by a decrease in AD.
Causes: Decreases in C, I, G, or X or increases in M.
Page 15
Short-Run Aggregate Supply (SRAS)
Definition: Quantity of aggregate output supplied in the economy when one or more input prices are fixed.
Input Costs: Prices paid by firms for production factors (land, labor, capital).
Short-run dynamics involve fixed prices and wages causing inefficiencies.
Page 16
Sticky Input Prices
Definition: Tendency for input prices to be slow to adjust.
Sticky prices can lead to inefficiencies and imbalances in the economy.
Page 17
Understanding SRAS
SRAS Curve: Upward sloping because of sticky wages.
Indicates that as price level rises, aggregate output supplied also rises.
Firm incentives for production relate directly to profit margins during inflation.
Page 18
SRAS Graph
Illustrates the relationship between price level and output supplied across SRAS.
Increases in price levels boost quantity of output supplied along the SRAS curve due to profit incentives.
Page 19
Practice
Draw a graph showing SRAS curve reflecting price level changes and output supplied.
Page 20
Conclusion of SRAS
Firm behavior influenced by sticky wages leads to upward slope in the SRAS curve, depicting a direct relationship with the price level.
Page 21
Long-Run Aggregate Supply (LRAS)
Definition: Represents total output feasible when all resources are fully employed.
LRAS is vertical as it remains unaffected by price level changes.
Key Influencers: Technological advancements, resource availability, and labor productivity.
Page 22
SRAS vs. LRAS
Feature | SRAS | LRAS |
|---|---|---|
Time Frame | Short-term (sticky prices) | Long-term (flexible prices) |
Shape of Curve | Upward-sloping | Vertical |
Reason for Shape | Firms increase production due to fixed input costs | Output determined by resources at full employment, not price level |
Page 23
Graphical Representation of SRAS and LRAS
SRAS: Upward sloping due to temporary fixed wages.
LRAS: Vertical reflects the productive capacity at full employment.
Page 24
Long-Run Adjustment Dynamics
Over time, rising wages due to profit increases push costs higher, shifting SRAS left.
Initial short-run effects involve increased output, but firms reduce production to meet rising costs, returning to full employment but at higher prices.
This flow of adjustments illustrates how economies naturally rebound to long-run equilibria despite short-term fluctuations.
Unit 3: National Income and Price Determination
Page 1
National Income and Price Determination is the central concept of this unit.
Page 2
Aggregate Price Level
AD/AS Model: A graphical model representing the aggregate demand (AD) and aggregate supply (AS) in an economy.
Axes:
Horizontal Axis: Real GDP (GDPR)
Measures changes in aggregate output, which correlates with aggregate spending, income, and unemployment rate (UR).
Vertical Axis: Aggregate Price Level
A measure of inflation in the economy.
Y: symbolic representation of aggregate income, which includes various components:
(C) Consumption
(I) Investment
(W) Wages
(R) Rent
(G) Government spending
(X) Exports
(M) Imports
(P) Profit
Page 3
Aggregate Demand
Definition: The total demand for all goods and services in an economy.
AD Curve: Represents aggregate spending, expressed as AD = C + I + G + Xn.
Components of demand:
Consumer goods
Investment goods from firms
Government demand
Exports minus imports (net exports)
Page 4
The Slope of the Aggregate Demand Curve
The AD curve slopes downward, indicating an inverse relationship between the aggregate price level and quantity of aggregate output demanded:
If price level decreases, quantity demanded for aggregate output increases.
Movement along the curve occurs when price level changes, shifting right and downward.
Page 5
Practice
Draw a correctly labeled aggregate demand curve reflecting an increase in price levels.
Page 6
Answer Sample
Annotated graph showing AD curve with labels for price levels (PL₁, PL₂) and quantity of aggregate output (QAD₁, QAD₂).