CH-06 NATIONAL INCOME DETERMINATION

CHAPTER-06
“NATIONAL INCOME DETERMINATION”

PART-01: NATIONAL INCOME EQUILIBRIUM

1.1: AGGREGATE DEMAND (AD) 153

1.2: AGGREGATE SUPPLY (AS) 155
1.3: NATIONAL INCOME EQUILIBRIUM: 158
1.4: OUTPUT GAP: 160
1.5: CHANGES IN BOTH AD AND SRAS:

PART-03: MULTIPLE CHOICE QUESTIONS & TEST-06

MCQ 162
TEST-06 171

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1.1: AGGREGATE DEMAND:

Definition:
Aggregate Demand is the total amount of goods and services demanded within an economy at a given
price level in a given time period.

Equation of Aggregate Demand is:

AD = C + I + G + (X – M)
Components of aggregate demand
• Private Consumption (C): consumer expenditure on goods and services
• Gross Private Investment (I): Investment on capital goods
• Government spending (G: Government expenditures in an Economy
• Net Exports (X-M):
➢ Level of exports (X): Goods are sold to outside country
➢ Level of imports (M): Goods are purchased from outside country

Aggregate Demand Curve (AD Curve):

Aggregate Demand Curve shows how much GDP will be demanded at each general price level.
AD curve is downward sloping, meaning that as the price level decreases, the level of demand in the
economy increases.
Price Level

P1

P2

AD

Y1 Y2

Real National Output

The y-axis represents the price level of all final goods and services in the economy. On the x-axis is
the Real National Output.

Shifts in the AD curve:

Shift in aggregate demand will be due to non-price factors of AD. e.g. change in any of the component
of AD
Price Level

P0

AD0 AD1
Y0 Y1
Real National Output

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Effective Demand:

In Keynes’s macroeconomic theory, effective demand is the point of equilibrium where aggregate
demand = short run aggregate supply (AD = SRAS).

Actual expenditure in an economy is based on existing/ actual income, rather than if the economy
was at its productive potential (when all resources are fully utilized) is referred to as effective
demand.

1.2: AGGREGATE SUPPLY (AS)

Aggregate Supply (AS):
Aggregate Supply is the total supply of goods and services produced within an economy at a given
price level, in a given time period

Aggregate Supply Curve (AS Curve):

Aggregate Supply Curve show the direct relationship between a country’s real output and general
price level. Rising price levels expand the overall economic activity of the country.

1. Short Run Aggregate Supply (SRAS):

SRAS
Price Level

P2

P1

Y1 Y2
Real National Output

Shifts in the SRAS Curve:

There are exogenous factors that are likely to cause a shift in a SRAS curve.

Factors responsible for shift in SRAS

factors causing shift forwards or backwards in short run aggregate supply are
• Change in factor productivity of both labour and capital
• Change in size and quality of capital stock, through investment
• Change in size and quality of the labour force
• Change in unit cost of labour (i.e., wages)
• Change in producer taxes or subsidies
• Change in inflationary expectations (e.g., causing a rise in inflation, and a rise in wages,
causing supply to shift inwards)

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Price Level
SRAS1 SRAS2

P1

Y1 Y2
Real National Output

2. Long Run Neo-classical AS Curve:

• Shape of Long run aggregate supply curve is quite different from SRAS due to the concept of full
employment.

Full Employment (Yf):

‘Full employment is a situation where all available resources of an economy are fully utilized. In
other words, full employment reflects situation of a country when no more production is
possible’.

• In the 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 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 (Full employment level).
➢ LRAS is independent of the price level, and signifies the upper limit of the capacity in the
economy, the curve is a vertical line.

LRAS

SRAS
Price Level

P2

P1

Y1 Yf Real Output

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Economic Growth and Shift in LRAS Curve

LRAS will shift only if there is a permanent change in resources. For example:
• Increase in quantity and productivity of the factors of production,
• Improvement in labour skills.
• Improvement technology.
• Exploring new natural resources.

Price Level
LRAS1 LRAS2

Y1 Y2
Real National Output

3. Keynesian Aggregate Supply Curve

Keynes believe that there is no distinction between the short run and the long run.

• At start when economy is in recession AS curve will be flatter, because resources are not being
fully utilized. At this stage output increases without increase in the price level because
economy will just use up spare capacity to produce national output.
• Keynesians still believe that when the economy reaches its productive potential, the AS curve
will be vertical.
• Beyond this productive potential there is only increase in price not real output.

AS
Price Level

P0 Full employment
level

Real National Output Ymax

Potential Output

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1.3: NATIONAL INCOME EQUILIBRIUM:

Macro Economics equilibrium: Where (AD = SRAS)

The macroeconomy is in equilibrium at the point where SRAS (value of output produced within an
economy) is equal to AD (level of demand for goods and services) not in LRAS.

• LRAS is that this is the productive potential in the economy.

• SRAS is what is actually being supplied in the macroeconomy,

1.4: OUTPUT GAP:

The difference between actual output of an economy and potential output of an economy is known
as the output gap.
TWO possible conditions of output gap for an economy are:
• Negative Gap: Where an economy is performing below its productive potential. (Yf).
Actual output (AD) < Potential output

• Positive Gap: Where an economy is performing beyond its productive potential. (Yf)
Actual output (AD) > Potential Output.

NEGATIVE GAP OR DEFLATIONARY GAP: (If Actual output is less than potential output.)

Deflationary (or recessionary) gap exists when the equilibrium/ aggregate demand in the economy
is less than the production potential (Full employment level). It represents that due to recessionary
conditions the economic resources are not being fully utilized. This low AD causes a fall in overall
price level which is termed as deflationary gap.

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LRAS

Price Level
SRAS

Pf Full employment
level

E
Pe
ADf

Deflationary
Gap
ADe

Ye Yf
Real National Output
In the graph, gap between Yf and Ye represents a negative gap, which occurred due to fall in ADf
even less than productive potential i.e., Yf.

Positive Gap or Inflationary Gap: (If Actual output is greater than potential output.)

Inflationary gap exists when the equilibrium/ aggregate demand in the economy is beyond the
productive potential ((Full employment level)). It represents that the aggregate expenditures (due to
expansionary conditions) is increasing rapidly. Therefore, 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.

LRAS
Price Level

SRAS
E
Pe

Pf Full employment level

ADe

Inflationary
Gap
ADf

Yf Ye
Real National Output
In the graph, gap between Yf and Ye represents a inflationary gap, which occurred due to rise in ADf
beyond the productive potential i.g Yf. If aggregate expenditures increase in an economy from ADf to
ADe, then the overall price level will also rose up from Pf to Pe. It will create an inflationary gap in
the economy.

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1.5: CHANGES IN BOTH AD AND SRAS:

AD demand and SRAS changes due to non-price factors.

1) Shift in Aggregate Demand

(i) Increase in Aggregate Demand:

Increase in Aggregate demand is due to

• Increase in any component of AD,
• Expansionary fiscal or
• Expansionary monetary policies
Conclusion:
price level and GDP both will increase

(ii) Decrease/Leftward Shift in Demand:

Decrease in Aggregate demand is due to

• Decrease in any component of AD,
• Contractionary fiscal or
• Contractionary monetary policies
Conclusion:
price level and GDP both will decrease

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2) Shift in Aggregate Supply

(iii) Increase in Aggregate Supply:

Increase in Aggregate supply is due to

• increase in factors of production or
• decrease in production cost
Conclusion:
price level decrease and GDP will increase

(iv) Decrease/leftward Shift in Supply:

Decrease in Aggregate supply is due to

• decrease in factors of production or
• increase in production cost
Conclusion:
price level increase and GDP will decrease

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MULTIPLE CHOICE QUESTIONS

6.1) Which one is a component of Aggregate Demand?

a) Personal consumption b) Personal Investment
c) Subsidies d) All of above

6.2) Which one is NOT considered in Aggregate Demand?

a) Demand for cotton b) Demand for salt
c) Demand for labour d) None of the above

6.3) If exports become more attractive for foreign firms, then the Aggregate Demand Curve
a) Rise and shift rightward b) Fall and shift rightward
c) Rise and shift inward d) Fall and shift inward

6.4) Which is NOT a cause of inward shift of aggregate demand curve?

a) Consumers begin to spend more
b) Firms have wave of optimism
c) Government spending more on power generation projects
d) None of the above

6.5) Actual expenditure in an economy is based on existing/ actual income, rather than if the economy
was at its productive potential is known as
a) Individual demand b) Effective demand
c) Aggregate demand d) None of the above

6.6) Which cause a shift in Aggregate Supply curve to left?

a) Decrease in labour productivity
b) Increase in overall spending
c) Decrease in government spending on development projects
d) Decrease in foreign direct investment

6.7) Change in inflationary expectations will cause

a) Vertical Aggregate Supply curve
b) Positively sloped aggregate supply curve
c) Shift in aggregate supply curve
d) None of above

6.8) Long run aggregate supply curve is vertical due to

a) Flexability of existing resources
b) Firms have ability to switch resources to other production
c) Government have no control over production decisions
d) Full utilization of existing resources

6.9) A vertical aggregate supply curve shift to right ward if

a) Permanent change in productive potential
b) Change in technology
c) Change in government spending
d) Change in beaviours of consumers

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6.10) Inflationary gap represents when

a) Aggregate demand exceeds over production potential of the economy
b) Aggregate demand exceeds over the firm’s expectations
c) Aggregate supply remains less than in aggregate supply in short run
d) Aggregate supply exceeds over aggregate demand in short run

6.11) If aggregate demand is less than productive potential of an economy then it is known as
a) Negative output gap b) Positive output gap
c) Inflationary gap d) None of the above

6.12) An output gap is said to be an inflationary gap if

a) Aggregate demand exceeds over aggregate supply in short run
b) Aggregate demand exceeds over aggregate supply in long run
c) Aggregate demand remains less than aggregate supply in short run
d) Aggregate demand remains less than aggregate supply in long run

6.13) If rise in aggregate demand is greater than increase in short run aggregate supply curve then
a) Price and output level will increase
b) Price and output level will decrease
c) Price will increase and output level will decrease
d) Price will decrease and output will increase

6.14) If rise in aggregate demand is lesser than increase in short run aggregate supply curve then
a) Price and output level will increase
b) Price and output level will decrease
c) Price will increase and output level will decrease
d) Price will decrease and output will increase

6.15) If aggregate demand and aggregate supply increase in same proportion

a) Price and output level will increase
b) Price and output level will decrease
c) No change in price level and fall in output
d) No change in price level and rise in output

6.16) A positive output gap leads to

a) A rise in overall price level
b) A fall in overall price level
c) No change in price level
d) It depends on magnitude of change in demand and supply

6.17) Which one can be responsible factor of an inflationary gap?

a) Rising household consumptions b) Rising investment
c) Rising government spending d) All of the above

6.18) Which one is NOT a workable step to overcome an inflationary gap?

a) Rising government spending b) Rising direct taxes
c) Decrease in government spending d) Increase in interest rate
6.19) Inflationary gap depicts economy is in
a) Its peak b) Its trough
c) Recession d) Recovery

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6.20) Rise in minimum wage level is a workable step to

a) Overcome inflationary gap b) Inflationary gap
c) Irrelevant d) All of above

6.21) Aggregate supply curve

a) Is the sum of individual supply curves in the economy
b) Is a market supply curve
c) Embodies the same logic that lies behind an individual firm’s supply curve
d) None of the above

6.22) An inflationary gap exists in an economy when

a) The government has a budget deficit
b) Aggregate demand is greater than the full employment level of income
c) Withdrawals exceed injections at the full employment level of income
d) The money supply rises faster than national income

6.23) Which one of the following would cause a fall in the level of aggregate demand in an economy?
a) A decrease in the level of imports
b) A fall in the propensity to save
c) A decrease in government expenditure
d) A decrease in the level of income tax

6.24) Which of the following cannot cause shift in short-run aggregate supply?
a) Productivity of labour b) Indirect taxes
c) Direct taxes d) Subsidies

6.25) Long-run aggregate supply represents.

a) The productive potential of an economy
b) Total labour supply
c) Relationship between price and taxes
d) Total natural resources

6.26) Which of the following cannot cause shift in long run aggregate supply?
a) New technology b) Improvement in labour skills
c) Price level d) Natural resources

6.27) Keynesian aggregate supply curve is always:

a) Upward to the right
b) Downward to the right
c) Horizontal & vertical after full employment
d) Vertical

6.28) Difference between potential G.D.P and actual G.D.P. is called:

a) Inflation b) Deflation
c) Output gap d) G.D.P. Deflator
6.29) G.D.P. deflator is a ratio between:
a) Inflationary gap & deflationary gap
b) Inflation and disinflation
c) Nominal G.D.P. and Real G.D.P.
d) None of the above

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6.30) If government expenditure increases what will the effect on price level and output level.
a) Both increases
b) No change
c) Output increase and no change in price level
d) Price level increase and no change in output level

6.31) If wage rate in economy increases what will be effect on price level.
a) Increase b) Decreases
c) No change d) Rate of inflation decrease

6.32) If government expenditures and wage rate increases in the same proportion what will be effect on
economy.

(i) Output increase

(ii) No change in output
(iii) Price level increases
(iv) Output decrease

a) (i) & (iii) b) (ii) & (iv)

c) (iii) & (iv) d) (ii) & (iii)

6.33) Deflationary gap can be reduced by:

(i) Increase in government expenditure
(ii) Increase in consumer’s expenditure
(iii) Decrease in indirect taxes
(iv) Increase in subsidies

a) (i) & (ii) b) (iii) & (iv)

c) (ii) & (iii) d) (i) & (iv)

6.34) If aggregate demand gone beyond the full employment it is said to be:
(i) Inflationary gap
(ii) Deflationary gap
(iii) Ideal equilibrium
(iv) Positive output gap

a) (i) & (ii) b) (i) & (iv)

c) (ii) & (iv) d) (ii) & (iii)

6.35) A continuous or persistent rise in general price level is called:

a) Inflation b) Deflation
c) Disinflation d) Stagflation

6.36) A fall in rate of inflation is called:

a) Inflation b) Inflationary gap
c) Disinflation d) Deflation

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6.37) Which of the following is NOT become a reason for shifting Long run aggregate supply.
a) Improvement technology b) Exploring new natural resources
c) Increase in income level d) All of these

6.38) A particular situation beyond the full employment where only general price level increases with no
change in level of output is called .
a) Inflation b) Inflationary gap
c) Disinflation d) Deflation

6.39) Keynesians believe that when economy reaches its productive potential the A.S. curve will be
a) Horizontal b) Vertical
c) Downward d) upward

6.40) If the economy is not at full output, they believe that the A.S. curve will be
a) Horizontal b) Vertical
c) Downward d) upward

6.41) In the above diagram A.D curve shifts towards right as a result price level & output level both
increases. What is the cause of shift in A.D curve?

a) Decrease in government expenditure b) Expansionary Fiscal policy

c) Contractionary monetary policy d) None of the above

6.42) Pakistan’s economy after Covid-19 currently facing a situation of:

a) Deflationary gap or recessionary gap
b) Inflation gap
c) Ideal equilibrium
d) None of the above

6.43) The aggregate demand curve would shift to the right if:
a) government taxes increase b) government spending increase
c) government spending decreases d) the nominal money supply decreases

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6.44) Which of the following topics are studied in Macro Economics?

a) Theory of Demand b) Aggregate Demand and Aggregate
Supply
c) Equilibrium of Industry d) None of the above

6.45) Which of the following would decrease aggregate demand?

a) Increased investment b) Increase in export revenue
c) Increased taxation d) Increased consumption

6.46) is the total supply of goods and services produced within an

economy at a given overall price level, in a given time period.’

6.47) An inflationary gap exists in an economy when

a) the government has a budget deficit
b) aggregate demand is greater than the full employment level of income
c) withdrawals exceed injections at the full employment level of income
d) the money supply rises faster than national income

6.48) A deflationary gap exists in an economy when:

a) aggregate demand is less than the full employment level of income
b) injections exceed withdrawals at the full employment level of income
a) the government has a budget surplus
b) none of the above

6.49) Aggregate supply increases due to increase in: (Select any TWO)
a) labour productivity b) consumer spending
c) low wage rate d) interest rates

6.50) When the national income is in equilibrium, an increase in investment causes the equilibrium to
change. Which change of equivalent value would bring national income to its original equilibrium
level?
a) Decrease in government spending b) Increase in government spending
c) Decrease in government taxes d) Increase in exports

6.51) Shape of Long run aggregate supply curve is quite different from SRAS due to the concept
of .
a) Full employment b) Economic growth
c) Aggregate demand d) All of these

6.52) Which of the following is TRUE about full employment level.

a) all available resources of an economy are not fully utilized
b) when more production is possible’.
c) supply stays independent of the price level
d) Represents the actual productivity of the economy

6.53) Which of the following is NOT the responsible Factors for shift in SRAS
a) Change in unit cost of labour b) Change in producer taxes or
subsidies
c) Change in inflationary expectations d) Change in direct Tax

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6.54) Full-employment equilibrium occurs when

a) real GDP exceeds potential GDP b) real GDP equals potential GDP
c) potential GDP exceeds real GDP d) a result of an increase in long-run
aggregate supply

6.55) The inflationary gap may only be bridged by:

a) raising the government spending b) raising the output level
c) raising the price level d) raising the employment level

6.56) A deflationary gap exists in an economy when:

a) aggregate demand is less than the full employment level of income
b) injections exceed withdrawals at the full employment level of income
c) the government has a budget surplus
d) none of the above

6.57) Long Run Aggregate Supply (LRAS) curve is a vertical line because it is:
a) dependent on price level and signifies the upper limit of the capacity in the economy
b) dependent on price level and signifies the lower limit of the capacity in the economy
c) independent of price level and signifies the upper limit of the capacity in the economy
d) independent of price level and signifies the lower limit of the capacity in the economy

6.58) The gap between Ye to Yf shows .

LRAS
Price Level

SRAS

Pf

E
Pe
AD0

ADe

Ye Yf
Real National Output

a) Inflationary gap b) deflationary gap

c) positive output gap d) No gap

6.59) An inflationary gap exists in an economy when

a) The government has a budget deficit
b) Aggregate demand is greater than the full employment level of income
c) Withdrawals exceed injections at the full employment level of income
d) The money supply rises faster than national income

6.60) Which one of the following would cause a fall in the level of aggregate demand in an economy?
a) A decrease in the level of imports
b) A fall in the propensity to save
c) A decrease in government expenditure
d) A decrease in the level of income tax

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6.61) The aggregate supply curve:

a) Is the sum of the individual supply curves in the economy
b) Is a market supply curve
c) Embodies the same logic that lies behind an individual firm’s supply curve
d) None of the above

6.62) The aggregate demand curve would shift to the right if:
a) Government taxes increase
b) Net exports increase
c) Government spending decreases
d) The nominal money supply decreases

6.63) Which of the following would decrease aggregate demand?

a) Increase investment b) Increase in export revenue
c) Increased taxation d) Increased consumption

6.64) Aggregate Supply Curve show the direct relationship between a country’s real output and general
price level.
a) True b) False

6.65) Actual expenditure in an economy is based on existing/ actual income, rather than if the economy
was at its productive potential is referred to as effective demand.
a) True b) False

6.66) LRAS represents the actual productive level of the economy.

a) True b) False

6.67) LRAS will shift only if there is a temporary change in resources.

a) True b) False

6.68) Negative gap means when an economy is performing below its productive potential (Yf)
a) True b) False

6.69) Exploration of new natural resources causes leftward shift in LRAS.

a) True b) False

6.70) According to Keynes AS curve will be positively sloped.

a) True b) False

6.71) The macroeconomy is in equilibrium at the point where SRAS is equal to LRAS.
a) True b) False

6.72) If the economy is at long run equilibrium, then, real GDP equals potential GDP.
a) True b) False

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ANSWER KEY

6.1) D 6.2) C 6.3) A 6.4) D

6.5) B 6.6) A 6.7) C 6.8) D

6.9) A 6.10) A 6.11) A 6.12) B

6.13) A 6.14) D 6.15) D 6.16) A

6.17) D 6.18) A 6.19) A 6.20) B

6.21) D 6.22) B 6.23) C 6.24) C

6.25) A 6.26) C 6.27) C 6.28) C

6.29) C 6.30) A 6.31) A 6.32) D

6.33) A 6.34) B 6.35) A 6.36) C

6.37) C 6.38) B 6.39) B 6.40) A

6.41) B 6.42) A 6.43) B 6.44) B

6.45) C 6.46) Aggregate 6.47) B 6.48) A

supply
6.49) A,C 6.50) A 6.51) A 6.52) C

6.53) D 6.54) B 6.55) A 6.56) A

6.57) C 6.58) B 6.59) B 6.60) C

6.61) D 6.62) B 6.63) C 6.64) A

6.65) A 6.66) B 6.67) B 6.68) A

6.69) B 6.70) B 6.71) B 6.72) A

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TEST-06

Q-1) Effective demand is the actual expenditure in an economy is based on existing/ actual income,
rather than if the economy was at its productive potential.
a) True b) False

Q-2) Which of the following is not a Factor responsible for increase in SRAS
a) Expectation to rise in inflation b) Increase in capital stock
c) Increase in unit cost of labour d) Increase in investment

Q-3) LRAS represents the actual output of the economy.

a) True b) False

Q-4) Which of the following is true about LRAS.

a) independent of the price level b) signifies the upper limit of an economy
c) the curve is a vertical line d) All of the these

Q-5) LRAS will shift only if there is a permanent change in resources. Select TWO reason which causes a
shift in LRAS.
a) Increase in disposable income b) Exploring new natural resources
c) Improvement technology d) Temporary increase in labor

Q-6) Keynesians still believe that when the economy reaches its productive potential, the AS curve will
be increasing.
a) True b) False

Q-7) Macro Economics equilibrium: Where (Select TWO)

a) Demand = supply b) Aggregate demand = aggregate long run
supply
c) Aggregate demand = aggregate short run d) Withdrawals = injections
supply

Q-8) Decrease in Aggregate demand is due to

a) Decrease in any component of AD b) Expansionary fiscal
c) Contractionary fiscal d) Expansionary monetary policies

Q-9) What does Negative Gap means?

a) Where an economy is performing equal to its productive potential
b) Where an economy is performing below its productive potential
c) It is a Deflationary gap
d) Actual output (AD) > Potential Output.

Q-10) Inflationary gap exists when the equilibrium/ aggregate demand in the economy is below the
productive potential ((Full employment level)).
a) True b) False

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