Chapter 4:

Determinants
of the Level of
National
Income
by
Ooi Soon Beng
After studying this chapter, you should be able to:
 Explain the equilibrium, above-equilibrium and below-
equilibrium GDP levels.
 Explain recessionary gap and inflationary gap.
 Explain the paradox of thrift.
 Derive AD curve from AE Model.
 Explain the determinants of AD and AS.
 Explain the multiplier effects in the AD-AS Model.
 In Unit 3, we
have studied
Aggregate planned expenditure (billions)

and built the

AE = C+I + G + (X – M)
1500 Aggregate
(X-M) Expenditures
(AE) Model.
1000 Consumption
expenditure The AE model is
a fixed price
model.
500 I+G+X
I+G Its focus is on
I changes in real
GDP (not on
0 500 1000 1500
changes in the
Real GDP (billions)
price level).
This unit introduces
Aggregate Demand and If prices
Aggregate Supply Model
(AD-AS).
increase, the
multiplier
The AD-AS Model is a
variable price model. effect is
It allows simultaneous
weakened!
analysis on changes in real
GDP and the price level.
Classical economists believed that a market system would
ensure full employment. Any deviations is temporary and
they would self-correct.
An economic slump
would:
1) reduce prices, which
would increase
consumer spending;
2) lower wages, which
would increase
employment again
3) lower interest rates,
which would expand
investment spending.
Say’s Law summarizes the
Classical views in a few words:
“Supply creates its own
demand.”
Production generates incomes
for workers,who will use the
entire earnings, to spend on
goods and services.
There is no need for
government intervention or
demand management Jean Baptiste Say, French
policies. economist (1776-1832)
Keynes in 1936 in his
General Theory of
Employment, Interest,
and Money, provided an
alternative to classical
theory.
It is based on the idea
that
i) saving and investment
decisions may not be
coordinated, and
ii) prices and wages are
not very flexible
downward.
Keynes said recessions occur because:
1. Not all income is always spent (contrary to Say’s law).
2. The unstable demand causes a GDP level below or
above equilibrium GDP.
3. But, the below or above equilibrium GDP levels will
not persist.
4. Producers respond to unsold inventories by reducing
output and employment (rather than cutting prices).
Aggregate Planned Expenditure
=
planned consumption
expenditure
+
planned investment
+
planned government
expenditures
+
planned exports
Aggregate actual expenditure is always equal to real GDP!
But, aggregate planned expenditure is not necessarily
equal to real GDP.
Hence, firms can end up with larger or smaller
inventories
than they had intended.
Planned Expenditure < Real GDP = Unplanned
Accumulation of Inventories
Planned Expenditure > Real GDP = Unplanned
Depletion of Inventories
Planned Expenditure = Real GDP = No
According to Keynes,
businesses will adjust their
production (not prices!!!) to
sales by observing their
inventories.
If the inventories are
insufficient, production is
increased.
If the inventories are
excessive, production is cut
back.
If aggregate planned expenditure is less than real GDP,
there are more goods offered for sale than people want
to buy.
Businesses will accumulate unplanned inventory. They reduce
the number of workers and decrease production. Real GDP will
decrease to equilibrium GDP!

Accumulation of inventory
If aggregate planned expenditure exceeds real GDP,
there is more buying than the goods offered for sale.
There will be
unplanned depletion
of inventory.
Firms will increase
the number of
workers and increase
production.
Real GDP will
increase to
equilibrium
GDP!
 Aggregate Unplanned
planned inventory
Real GDP expenditure change
(Y) (AE) (Y─AE)
(billions dollars)

A 300 690 ─390

B 500 760 ─260

C 700 830 ─130

D 900 900 0

E 1,100 970 130

F 1,300 1,040 260

 Planned expenditure less
Aggregate planned expenditure
(billions)

than real GDP 45o line

1500
(accumulation of inventory)
AE
1,040
F
D E
900
C
B
760 Equilibrium expenditure
A
600
Planned expenditure
200 exceeds real GDP
(depletion of
inventory) Real GDP
0 300 500 900 1300
(billions)
Unplanned inventory change

Unplanned
520 increase
in
(billions )

inventories
260
Unplanned F
decrease E
in D
0
inventories
300 500 900 1300 1500
C
–260 400 Real GDP
B (billions)
A
–520
If an unintended decrease in business
inventories occurs:
A. we can expect aggregate production to be
unaffected.
B. we can expect businesses to increase the level of
production.
C. we can expect businesses to lower the level of
production.
D. aggregate expenditures must exceed the domestic
output.
 But, according to
Keynes, the
equilibrium GDP
may very well occur
below or above the
full employment
level of output!
A recessionary gap An inflationary gap
exists when exists when
equilibrium GDP is equilibrium GDP is
below full- above full-
employment GDP. employment GDP.

Government should play an active

role in removing the gap!!
 (billions)
Aggregate planned expenditure

45o line By how much should

AE2 the government
increase spending to
AE1 close the GDP gap,
assuming k= 5?
E

0 Ye = $10 Real GDP (billions)

Yf = $15
 By how much should
45o line the government
(billions)
Aggregate planned expenditure

decrease spending to
AE1 close the GDP gap,
assuming k=4?
E AE2

0 Yf = $8 Ye = $10 Real GDP (billions)

In an inflationary expenditure gap, the
equilibrium level of real GDP would be:
A. Greater than planned investment
B. Equal to full-employment GDP
C. Greater than full-employment
GDP
D. Less than full-employment GDP
The paradox of
thrift is a
central
component of
According to Keynesian
theory, the proper response A paradox is a statement of
Keynesian
to an economic recession is
more spending and fewer
conclusion that seems self-
contradictory or absurd but is
economics.
savings. really true.
Higher savings is good only if the increased saving will be
borrowed and spent for investment goods.

If investment does not increase Higher rate

along with higher saving, the
paradox of thrift may arise!!! of savings
If everyone tries to save more, can be bad
economy will slow down from
reduction in demand. for society!
People would lose their jobs. This will lower total savings
instead!
In the AE Model, the price
level remains constant.
Unplanned inventory build-
ups or depletions are
corrected by adjusting
production, not by altering
prices.
In reality, firms don’t hold
their prices constant for long.
When firms face an
unplanned change in
inventories, they change both
production and prices!!!
Post Keynes, economists
expand the AE Model to the
AD-AS Model by allowing
prices to change.
 The AD-AS The AE Model illustrates
Model is a the relationship between
the aggregate planned
variable price expenditure and real GDP.
model!
The AD-AS Model
It allows simultaneous illustrates the
analysis on changes relationship between the
in real GDP and the real GDP and the price
price level. level.
When the price level changes, this results in a downward
sloping AD curve because of 3 effects!

• When price level falls, the

Real balances purchasing power rises, which can
effect increase spending, hence increasing
AE.

• A decline in price level means lower

Interest rate interest rates that can increase
effect investment spending, hence
increasing AE.

• When price level falls, other things

Foreign
being equal, exports will increase
purchases
while imports will fall, hence
effect increasing AE.
 c AE2at P2
AE AE1at P1

b AE0 at

Reducing the price P0

a
level increases AE
45 )
(upper diagram).
Y1 Y2 Y3 Real GDP
At each price level,
P
we have a
corresponding a1
P0
increase in real GDP b2
level (lower diagram). P1
c3
Thus, the downward P2 AD
sloping AD curve.
Y1 Y2 Y3 Real GDP
The downward slope of the aggregate demand curve is
best explained by the:
A. Interest rate, real-balances, and foreign purchases
effects
B. Rate of inflation and the natural rate of
unemployment
C. Policies to stabilize prices and reduce
unemployment
D. Household indebtedness, business taxes, and exchange
Changes in the price level,
other things remaining the
same, will result in a movement
along the AD curve.
Changes in any non-price
factors that can influence
aggregate planned expenditure
changes will shift the AD curve.
1) Changes in consumer spending which can be caused
by changes in consumer wealth, consumer
expectations, household debt, and taxes.
2) Changes in investment spending which can be caused
changes in interest rates, and expected returns.
3) Changes in government spending.
4) Changes in net export spending which can be caused
by changes in foreign incomes, and exchange
rates.
 A $100 billion increase 45o line
in investment
Aggregate planned expenditure

increases aggregate
1200 planned expenditure. AE1

1100 B
AE0
1000
(billions)

900
A

0 900 1000 1,100 1200

Real GDP (billions)
 135
This shifts the AD curve to
(GDP deflator)

the right. The multiplier

115 in this example is 2.
Price level

B
105
A

85
AD0 AD1

0 900 1,000 1,100 1,200

Real GDP (billions)
In the immediate short run, the AS curve is horizontal.
Keynesian model studies
economy in the very short

Price Level
run where prices are fixed.
Prices are fixed because
nominal wages and input Immediate-
prices are fixed. short-run AS

Firms collectively supply

exactly the level of output
demanded at any given
Qf
price level. Real GDP
 In the short run, the AS curve is upward sloping.
This is because at least
one price is inflexible in

Price Level
the short-run. Short Run
Input prices adjust by AS
less than the change in
the price level.
Thus, an increase in the
price level increases real
output. Qf
Real GDP
In the long run, the AS curve is vertical at the full-
employment.
LR refers to the time it

Price Level
takes for all prices to
fully adjust.
Input prices will rise to
match the changes in
Long-run
the price level.
AS
Hence, no incentive for
firms to change their Qf
output. Real GDP
 1) Changes in input prices,
What will shift 2) Changes in productivity,

AS curve? 3) Changes in legal

institutional environment
caused by business taxes
and subsidies.
AS will shift to the left, if
there is
1) A rise in input
prices,
2) A fall in productivity,
3) Higher business taxes,
4) Lower subsidies.
AS will shift to the right, if
there is
1) A fall in input prices,
2) A rise in productivity,
3) Lower business taxes,
4) Higher subsidies.
 Decrease in AS3 AS1
Price Level

Aggregate AS2
Supply

Increase in
Aggregate
Supply

Real
GDP
By how much does an increase in initial expenditure
shift AD?
The multiplier determines the answer:

Change in
AD curve initial x Multiplier
shift = expenditure
 When price level
effects are taken into
account, the multiplier
effect is smaller than
it would be if the
price levels were
fixed !

…. due to the 3 real balances

 An increase in investment 45o line
Aggregate planned expenditure

increases aggregate
planned expenditure...
1,200 AE1
B AE2
1,100
1,030 AE0
C
1,000
… but the price level
(billions)

rises, which somewhat

900
A dampens aggregate
planned expenditure
0 900 1,030 1,100 1,200
Real GDP (billions)
 145
(GDP deflator)

135 SAS
Price level

125
C Because of the rising price
118 level, real GDP rises
105 B from
A $900bn to $1,030bn.
95
Without price effect,
85
AD1 real GDP would have risen
AD0 from $900bn to $1,100bn.
0 900 1,030 1,100 1,200
Real GDP (billions)
In the long run, an
increase in Hence, the
aggregate demand multiplier is
leaves real GDP
unchanged but
zero in the
increases the price long run!
level.
 45o line
B AE1
1,100
Aggregate planned expenditure

AE2
1,000
C
AE0

A'
900
A
(billions)

0
800 900 1,030 1,100
Real
 LAS SAS1

145 Because of the rising price

(GDP deflator)

a' level, real GDP stays

135
unchanged at $900bn
Price level

125
SAS0
c
120 Without price
105 b effect,
a real GDP
95 would have
85 AD1 risen from
$900bn to
AD0 $1,100bn.
0 800 900
1,030 1,100
Real GDP (billions)