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)

  1. 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.

Reason 2 - The Price Level and Investment: TheInterest-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: TheExchange-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.

  1. 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”

Ifa 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”

Adrop inthe 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.

  1. 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

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.

  1. 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.

Two Causes of Economic Fluctuations

Long-Run Equilibrium

(I)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 inaggregate demand (AD1 AD2)

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),

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).

(b) If policymakers want to eliminate the recession (refer to Fig. B)

A decrease inaggregate 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

Fig. B


(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.)

output falls(Y1 Y2),

price levelrises(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),

price falls back to P1 (P2 P1),

output goes back to Y1 (Y2 Y1)

An adverse shift in aggregate-supply

(b) If policymakers can accommodate an adverse shift in Aggregate supply

When short-run aggregatesupply 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

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

Shifts in the Demand Curve for Real Money

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

  1. 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.

Changing the Interest Rate

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