Chapter 6

National income determination

History
M.Kynes
 J.M. Keynes released his well-known book “General Theory of Employment, Interest and
Money”
 He introduced many new concepts in opposed to the ideas and theories of Classical Economist
 He has awarded more value to Effective demand (demand which determines level of national
income of a country)
 Keynesian are called demand sider while Classical economics are supply sider
Fundamental macroeconomic issues
 Full employment
 Poverty
 Inflation
 Deficit of balance of payments
Aggregate demand
 Total spending in an economy by households, firms, governments and foreign traders
 Collective of what all consumers have consumed within an economy
Aggregate supply
 Total output produced / sold by businesses at the given prices, costs, and market conditions
 Collective of what all businesses have produced within an economy
Note
 Usual shapes of AS and AD curves are same as the common supply and demand curves analysed
in microeconomics except long run aggregate supply curve
Aggregate demand
 Quantity of goods demanded by all agents of economy
 Total amount of goods and services demanded within an economy at a given overall price level
and in a given time period
 Aggregate demand curve shows the relationship between the price level and quantity of output
that agents are willing to consume
 There is an inverse / negative relationship between aggregate demand and price which means that
at a higher price level households are willing to consume less and vise versa
 AD is a measure of all that is demanded within an economy, therefore, it is equal to the amount of
expenditure
Components of aggregate demand
 Consumer expenditure on goods and services (C) / consumer
 Investment spending (I) / firm
 Government spending (G) / govt.
 Net difference between exports and imports in the economy (X-M) / foreign traders

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Graphical representation

 Y-axis represents the price level of all final goods and services in the economy
 X-axis is the Real National Output
 AD curve is downward sloping which means that as the price level decreases, the level of demand
increases
Shifts in the AD Curve
 Shift in the AD curve is not caused by a change in the price level
 It is due to some external factors
 Some reasons for this shift in aggregate demand is due to a change in any of the component parts
of the equation
AD curve shifts due to following factors
 Consumers have more income and begin spending more in the economy
 Firms have a wave of optimism and begin investing in projects
 Government decides to spend more on infrastructure projects
 Exports become more attractive to foreign firms
 Imports become less desirable for domestic firms
Graphical representation

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  The y-axis represents the price level of all final goods and services in the economy
 X-axis is the Real National Output
 Shift from AD1 to AD2 and AD2 to AD1 is due to factors other than price
 Price level remains same
Effective demand (key idea proposed by economist John Maynard Keynes)
 Consumers who are not only interested but willing to spend money
 Actual expenditure in an economy is based on existing/ actual income instead of, if the economy
was at its productive potential (when all resources are fully utilized) is called as effective demand

All economist were agree regarding aggregate demand

But
There are two different approaches regarding aggregate supply
 Classical / neo classical approach
 Keynesian approach
Classical / neo classical approach
Aggregate supply
 Total national product produced and offered into market for sale in the final form in one year
 Money value of all final goods and services produced in a country in one year at constant factor
cost
 Total supply of goods and services produced within an economy at a given overall price level and
in a given time period
 This is represented through an aggregate supply curve which shows the relationship between
price level and quantity of output that firms are willing to supply
 There is a direct / positive relationship between aggregate supply and price which means that at a
higher price level firms are willing to supply / produce more
 Shape and behavior of the aggregate supply curve is of debate amongst economists
 Firstly, we shall present the theories of neo-classical economists, and second, the view of
Keynesians
Aggregate supply
 Analysis of aggregate supply is different in the short run and long run due to flexibility of factors
and potential output that they can produce
Short run aggregate supply (SRAS)
 Supply changes due to change in price level
 In the short run, the aggregate supply curve slope is upwards like a regular supply curve
 It shows actual use of resources

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Graphical representation

 Graph represents short run aggregate supply curve of an economy

 It shows the direct relationship between a country’s real output and general price level
 Rising price levels expand the overall economic activity of the country
Shifts in the SRAS Curve
 Shift in the SRAS curve is not caused by a change in the price level
 It is due to some external factors
SRAS curve shifts due to following factors
 Change in productivity of factors e.g labor and capital
 Change in size and quality of capital stock, through investment
 Change in size and quality of the labor force
 Change in unit cost of labor (wages)
 Change in producer taxes / subsidies
 Change in inflationary expectations (e.g. causing a rise in inflation, and a rise in wages, causing
supply to shift inwards)
Graphical representation

 Graph above represents shift of short run aggregate supply curve of an economy
 Shift from SRAS1 to SRAS2 and SRAS2 to SRAS1 is due to factors other than price level

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Long run aggregate supply (LRAS)
 Change in price doesn’t affect the supply
 Shape of Long run aggregate supply curve is quite different from SRAS due to the concept of full
employment
 It shows maximum capacity of resources
Full employment (Yf)
 A situation where all available resources of an economy are fully utilized
 Situation of a country when no more production is possible
 In short run, supply changes to the price level, as the factors of production are adjusted to enable
the most efficient use of resources
 In the long run, it is assumed that supply stays independent of the price level. It is determined by
the overall productivity of the resources in the economy
 LRAS represents the productive potential of the economy. If all resources were at their most
productive then that is the level of output that could be achieved
 Shifts in LRAS are the factors that affect the level of this potential. Because it is independent of
the price level, and signifies the upper limit of the capacity in the economy, the curve is a vertical
line
Graphical representation

 Graph represents short run aggregate supply curve moving directly along increase in price level.
But LRAS becomes vertical as it is independent of price level. Point to note is that LRAS curve
becomes vertical at level of full employment
Shift in long run aggregate supply
 Significant permanent changes in productive potential of the economy causes shift in long run
aggregate supply

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Graphical representation

 An increase in the quantity and productivity of the factors of production, or advancement in

technological capabilities in the economy would cause an increase in the productive potential
which shifts LRAS from LRAS1 to LRAS2
LRAS curve shifts due to following factors
 Improvement in labor skills
 Improvement technology
 Exploring new natural resources
Keynesian approach
 He saw no difference between short run and long run. Aggregate supply curve has only single
shape which is firstly horizontal then vertical
 When economy reaches at its productive potential, the AS curve will be vertical
 When economy is not at full output, AS curve will be flatter because resources are not being fully
utilized
 If there are underutilized resources, then as output increases, this would not put pressure on the
price level. Instead economy will just use up spare capacity
 It is only once the economy approaches its production potential that the firms will begin having
the power to influence prices upwards
 As output increases, price level at which firms will supply, in aggregate, begins to increase.
However, only once full employment level is approached
Graphical representation

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Macroeconomic equilibrium
Aggregate demand and aggregate supply interaction
 Short run aggregate supply and aggregate demand are equal to each other
 SRAS=AD
Output gap
 Difference between actual output and potential output of an economy
Two possible conditions
 Positive gap / inflationary gap
 Negative gap / deflationary gap
Positive gap / inflationary gap
 Where an economy is performing beyond its productive potential
 Actual output AD > Potential Output Yf
 Aggregate demand exceeds over maximum potential of a country
 Aggregate expenditures (due to expansionary conditions) are increasing rapidly
 Economic resources are insufficient to meet the potential demand
 This high AD causes a rise in overall price level which is termed as inflationary gap
Graphical representation

 In the graph, gap between Yf and Y1 represents a inflationary gap, which occurred due to rise in
AD1 beyond the productive potential i.g Yf.
 If aggregate expenditures increase in an economy from AD0 to AD1, then the overall price level
will also rose up from Po. It will create an inflationary gap in the economy
Negative gap / deflationary gap
 Where an economy is performing below its potential
 Actual output AD < Potential output Yf
 Aggregate demand remains less than maximum potential of a country
 Economic resources are not being fully utilized due to deflationary / recessionary conditions
 This low AD causes a fall in overall price level which is termed as deflationary gap

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Graphical representation

 In the graph, gap between Yf and Y1 represents a negative gap, which occurred due to fall in
AD1 even less than productive potential i.e. Yf.
 If aggregate expenditures decreases in an economy from AD0 to AD1, the overall price level will
also fell from Po to P1. It will create a deflationary gap in the economy
Another approach for negative / deflationary gap
Graphical representation

Change in macroeconomic equilibrium

 Change in AD and SRAS
Change in aggregate demand (AD)
Graphical representation

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  Increase in aggregate demand causes an expansion of aggregate supply which leads to new
equilibrium at a higher level of national income
Change in short run aggregate supply
Graphical representation

 Increase in short run aggregate supply has led to aggregate demand meeting at its lower price
level which cause increase in national output

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