National income determination and price level
Professional Development Course in Knowledge Enrichment for
Senior Secondary Economics Teachers
Outline of Lecture 3 –Macroeconomics: National income determination and
price level (Long version)
Topics covered:
I.
II.
Aggregate demand and its characteristics
Aggregate supply and its characteristics
III. Factors and policies affecting AD and AS
IV. Determination of income and price level by AD-AS
V. Demand for money
VI. Determination of interest rate in the money market
I.
Aggregate demand and its characteristics
 Reasons for a downward sloping AD curve
Teaching advice

Begin by reviewing demand, supply, and equilibrium.

Make it clear that the microeconomic variables of price and quantity can be
aggregated into a price level (either the GDP deflator or the Consumer Price
Index) and total output (real GDP).
Y = C + I + G + NX

Reason 1 - The Price Level and Consumption: The Wealth Effect
A decrease in the price level  consumers feel wealthier  encourages
them to spend more (increase in consumer spending)  a larger quantity of
goods and services demanded.
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National income determination and price level

Reason 2 - The Price Level and Investment: The Interest-Rate Effect
A decrease in the price level  less money households need to buy goods
and services  households try to convert some of their money into
interest-bearing assets  the interest rate will drop  encourage borrowing
by firms on investment goods  increases the quantity of goods and
services demanded.

Reason 3 - The Price Level and Net Exports: The Exchange-Rate Effect
A lower price level in Country A lowers its interest rate  investors will
seek higher returns by investing abroad, increasing Country A’s net capital
outflow  it raises the supply of Country A’s currency, lowering the real
exchange rate  Country A’s goods become relatively cheaper to foreign
goods  Country A’s exports rise  increasing the quantity of goods and
services demanded.
Teaching advice

Highlight the fact that all three of these effects begin with a decrease (or
increase) in the price level and end with an increase (decrease) in aggregate
quantity demanded.

Remind students that the aggregate demand curve (like all demand curves) is
drawn assuming that all else is held constant.
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National income determination and price level
II.
Aggregate supply and its characteristics
 Reasons for an upward sloping short run AS curve

Reason 1 - “The sticky wage theory”
Nominal wages do not immediately adjust to the price level  a lower
price level makes employment and production less profitable  firms lower
the quantity of goods and services supplied.

Reason 2 - “The sticky price theory”
If a firm does not adjust the price of its product quickly in response to an
unexpected fall in the price level  its relative price will rise  lead to a
loss in sales  firms will produce a lower quantity of goods and services.

Reason 3 - “The misperceptions theory”
A drop in the price level can mislead suppliers to believe that the price of
their product falls 
they respond to the lower price level by decreasing
the quantity of goods and services supplied.
 Reasons for a vertical long run AS curve

The meaning of potential output or full employment output or natural
rate of output

In the long run, an economy’s production of goods and services
depends on its availability of resources and production technology
which are not affected by the price level.
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National income determination and price level
III. Factors and policies affecting AD and AS
 Determinants of aggregate demand

Private consumption expenditure, which depends on disposable income,
the desire to save, wealth (value of assets), interest rate, etc.

Investment expenditure, which depends on business prospect, interest
rate, etc.

Government expenditure

Net export, which depends on the economic conditions of trading
partners, exchange rate, etc.
 Determinants of long run AS

Changes in labor

Changes in capital

Changes in natural resources

Changes in technological knowledge
 Determinants of short run AS

Changes in labor

Changes in capital

Changes in natural resources

Changes in technological knowledge

Expected price level
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National income determination and price level
Teaching advice

Get the students involved in suggesting factors that might shift the aggregate
demand curve.

Relate changes in aggregate demand to changes in consumption, investment,
government purchases, and net exports.

Show students that, if any of these four components of GDP change (for
reasons other than a change in the price level), the aggregate demand curve
will shift.
IV.
Determination of income and price level by AS-AD
 Determination of the equilibrium level of output and price level in the
AS-AD model
 Changes in the equilibrium level of output and price level caused by
change(s) in the AD and/or AS

A contraction in Aggregate Demand

A contraction in Aggregate Supply – occurrence of stagflation
 Case study 1: The Great Depression and World War II
 Case study 2: The Recession of 2001
 Case study 3: Oil and the economy
 Relationship between employment and output level
 Recessionary gap and inflationary gap
Teaching advice

Students will be confused by the graphs showing the adjustment process that
occurs when aggregate demand shifts.

Take the time to walk them through step-by-step several times, summarizing
what moves the economy from one point to the next.
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National income determination and price level
 Two Causes of Economic Fluctuations
Long-Run Equilibrium
Price
LRAS
SRAS
Equilibrium
price
AD
0
(I)
Natural rate
of output
Quantity
The Effects of a Shift in Aggregate Demand
- Suppose a fall in aggregate demand
(a) If policymakers do nothing (refer to Fig. A)
 A decrease in aggregate demand (AD1  AD2)
Short Run Effects
 causes output to fall in the short run (recession) (Y1  Y2),
 but overtime, people will correct the misconceptions, sticky wages &
stick prices, the short-run aggregate-supply curve shifts (AS1  AS2),
Long Run Effects
 output returns to its natural rate (Y2  Y1),
 equilibrium price level fall
* A nominal change (in the price level) but not a real change (output is
the same).
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National income determination and price level
(b) If policymakers want to eliminate the recession (refer to Fig. B)
 A decrease in aggregate demand (AD1  AD2)
 causes output to fall in the short run (Y1  Y2),
 increase government spending or increase money supply causes
aggregate demand to increase (AD2  AD1, Y2  Y1)
A Contraction in Aggregate Demand
Fig. A
Price
LRAS
SRAS, AS
AS2
A
P
B
P2
P3
C
AD
AD2
0
Y2
Quantity
Y
Fig. B
Price
LRAS
SRAS, AS
A
P
B
P2
AD
AD2
0
Y2
Quantity
Y
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National income determination and price level
(II)
The Effects of a Shift in Aggregate Supply
- Suppose there’s a sudden increase in the costs of production.
(a) If policymakers do nothing
 Short-run aggregate-supply curve will shift to the left (AS1  AS2),
(Depending on the event, long-run aggregate supply may also shift.
We assume that it does not.)
Short Run Effects
 output falls (Y1  Y2),
 price level rises (P1  P2),
 the economy is experiencing stagflation
Definition of stagflation: a period of falling output (Recession) and
rising prices (Inflation).
 Over time, price expectations will adjust, causing the short-run
aggregate-supply curve to shift back to the right (AS2  AS1),
Long Run Effects
 price falls back to P1 (P2  P1),
 output goes back to Y1 (Y2  Y1)
An adverse shift in aggregate-supply
Price
LRAS
AS2
SRAS, AS
B
P2
A
P
AD
0
Y2
Y
8
Quantity
National income determination and price level
(b) If policymakers can accommodate an adverse shift in Aggregate supply
 When short-run aggregate supply falls (AS1  AS2),
 price level rises (P1  P2),
 policymakers can accommodate the shift by expanding aggregate
demand (AD1  AD2),
 the price level rises further (P2  P3),
 output is kept at its natural rate
Accommodating an Adverse Shift in Aggregate Supply
Price
LRAS
AS2
SRAS, AS
P3
C
P2
A
P
AD2
AD
0
Natural rate
of output
9
Quantity
National income determination and price level
V.
Demand for money
 Meaning of transaction demand for money – relationship between money
demand and nominal income
 Brief introduction of real income
 Meaning of asset demand for money - relationship between money demand
and nominal interest rate
 Meaning of liquidity demand for money
 Money demand as a function of nominal interest rate and income
 The Influences on Money Holding
The quantity of money people hold depends on:
1) The price level
2) The interest rate
3) Real GDP
4) Financial innovation
 The Demand for Money Curve
Interest rate (%)
r3
r2
BB Effect
Effectof
ofan
anincrease
increase
AA
inthe
theinterest
interestrate
rate
in
CC Effect
Effectof
ofaan
increase
AA
decrease
inthe
theinterest
interestrate
rate
in
B
A
C
r1
MD
Quantity of
money ($)
0
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National income determination and price level
 Shifts in the Demand Curve for Real Money
MD0  MD2
Effect of an increase in real GDP
MD0  MD1
Effect of a decrease in real GDP
or financial innovation
Interest rate (%)
r3
r2
MD2
r1
MD1
money ($)
0

MD0 Quantity of
Transactions demand
Holding money as a medium of exchange to make payments

Precautionary / Liquidity demand
Holding money to meet unplanned expenditures and emergencies

Asset demand
Holding money as a store of value instead of other assets
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National income determination and price level
V.
Determination of interest rate in the money market
 Interaction of money supply and money demand
 Discussion about the theory of liquidity preference as a short-run theory of
the interest rate.
Interest rate (%)
MS
r3
Excess supply of money.
People buy bonds and
interest rate falls
r2
Excess demand for
money. People sell bonds
and interest rate rises
r1
MD
0
Quantity of
money ($)
Changing the Interest Rate
Interest rate (%)
MS1
MS0 MS2
r3
MS0  MS2
An increase in the
money supply lowers
the interest rate
MS0  MS1
A decrease in the
money supply raises
the interest rate
r2
r1
MD
Quantity of
money ($)
0
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