Md.

Firoz Ahmed
Faculty, Social Science School
Khulna University
Aggregate Demand
AD refers to the total amount that different sectors in an
economy willingly spend in a given period.
It is the sum of spending by consumers, businesses, and
government. It depends on the level of prices, monetary
policy, fiscal policy and other factors such as wars and
weather.
The components of AD include consumption spending by
consumers, factories & equipments bought by businesses,
government spending and net exports.
AD = C + I + G + (X-M)

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Aggregate Supply
AS refers to total quantity of goods and services that the
nation’s businesses willingly produce and sell in a given
period of time. It depends upon price level, productive
capacity of the economy, and the level of costs.

In general, business like to sell everything they can produce

at high prices. But sometimes, prices and spending levels
may be depressed, so businesses may find excess capacity
with them; while at some other times, factories may be
operating at capacity as businesses scramble to produce
enough to meet all their orders.

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Thus, AS depends on price level that businesses can charge,
and economy’s capacity or potential output.
Potential output is determined by the availability productive
inputs such as labor and capital (and their prices), and the
managerial and technical efficiency with which those inputs
are combined.

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AD, AD interaction, and agg price output determination
Using both AD & AS, we
achieve the resulting P
AS
equilibrium. National output

Price Index
GNP, and price level settle at
that level where demanders B C
willingly buy what businesses
willingly sell. Resulting output E
and price level determine A
employment, unemployment D
and international trade.
Q
Real GDP
Fig-1: AS, AD
Interaction

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Figure 1, shows the AS and AD curves of an entire
economy. Downward sloping AD curve represents what
everyone in the economy- consumers, businesses, foreigners
and government- would buy at different aggregate price
levels (with other factors held constant).
Upward sloping AS curve represents what businesses will
produce and sell at different prices with other factors held
constant).
Equilibrium: The economy is in eqlm at E, where AD equals
AS, and all buyers and sellers are satisfied with their
purchases, sales and prices; and aggregate output and prices
are determined.

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Course No. : Econ 2111
National income
There are various measures of national income, but
commonly used one is gross domestic product (GDP).
GDP measures two things at once: the total income of
everyone in the economy and the total expenditure on the
economy’s output of goods and services.
The reason that GDP can perform the trick of measuring
both total income and total expenditure is that these two
things are really the same.

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For an economy as a whole, income must equal
expenditure.

Why is this true? The reason that an economy’s income is

the same as its expenditure is simply that every transaction
has two parties: a buyer and a seller. Every dollar of
spending by some buyer is a dollar of income for some
seller.

Another way to see the equality of income and expenditure

is with the circular flow diagram in Figure 2.

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 Revenue Spending
Market for goods &
Goods & services Goods &
services sold
services
bought
Businesses Inputs for Households
production Market for factors Land, labor,
of production
capital

Wage, rent, profit Income

Fig: Circular Flow of Income

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This diagram describes all the transactions between
households and firms in a simple economy. In this economy,
households buy goods and services from firms; these
expenditures flow through the markets for goods and services.
The firms in turn use the money they receive from sales to
pay workers’ wages, landowners’ rent, and firm owners’
profit; this income flows through the markets for the factors of
production. In this economy, money continuously flows from
households to firms and then back to households.
We can compute GDP for this economy in one of two ways:
by adding up the total expenditure by households or by adding
up the total income (wages, rent, and profit) paid by firms.
Because all expenditure in the economy ends up as someone’s
income, GDP is the same regardless of how we compute it.

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Remarks
In particular, households do not spend all of their income,
they pay some of their income to the government in taxes, and
they save and invest some of their income for use in the
future.
In addition, households do not buy all goods and services
produced in the economy. Some goods and services are
bought by governments, and some are bought by firms that
plan to use them in the future to produce their own output.
Yet, regardless of whether a household, government, or firm
buys a good or service, the transaction has a buyer and seller.
Thus, for the economy as a whole, expenditure and income
are always the same.
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Measurement of National Income
GDP is the market value of all final goods and services produced
within a country in a given period of time.
Gross national product (GNP) is the total income earned by a
nation’s permanent residents. It differs from GDP by including
income that our citizens earn abroad and excluding income that
foreigners earn here. For example, when a Bangladeshi citizen
works temporarily in the USA, his production is part of U.S. GDP,
but it is not part of U.S. GNP. (It is part of Bangladesh’s GNP.) For
most countries, including USA, domestic residents are responsible
for most domestic production, so GDP and GNP are quite close.

Thus GDP is a measure of income resulting from the use of all

resources within the border of the nation. To accurately reflect on
domestic production, international comparisons of output of
nations are sometimes based on GDP rather than GNP.
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Net national product (NNP) is the total income of a nation’s
residents (GNP) minus losses from depreciation.
Depreciation is the wear and tear on the economy’s stock of
equipment and structures, such as trucks rusting and light
bulbs burning out. In the national income accounts
prepared by the Department of Commerce, depreciation is
called the “consumption of fixed capital.”
National income is the total income earned by a nation’s
residents in the production of goods and services. It differs
from net national product by excluding indirect business
taxes (such as sales taxes) and including business subsidies.
NNP and national income also differ because of a “statistical
discrepancy” that arises from problems in data collection.

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Personal income is the income that households and non-
corporate businesses receive. Unlike national income, it
excludes retained earnings, which is income that
corporations have earned but have not paid out to their
owners. It also subtracts corporate income taxes and
contributions for social insurance (mostly Social Security
taxes). In addition, personal income includes the interest
income that households receive from their holdings of
government debt and the income that households receive
from government transfer programs, such as welfare and
Social Security.
Disposable personal income is the income that households
and non-corporate businesses have left after satisfying all
their obligations to the government. It equals personal
income minus personal taxes and certain non-tax payments
(such as traffic tickets).

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Remarks
Although the various measures of income differ in detail, they
almost always tell the same story about economic conditions.

When GDP is growing rapidly, these other measures of income

are usually growing rapidly.

And when GDP is falling, these other measures are usually

falling as well. For monitoring fluctuations in the overall
economy, it does not matter much which measure of income we
use.

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 The Components of GDP
GDP includes various forms of spending on domestically produced goods
and services. GDP (which we denote as Y) is divided into four
components: consumption (C), investment (I), government purchases (G),
and net exports (NX):
 Y = C + I + G + NX. This equation is an identity
Consumption is spending by households on goods and services, with the
exception of purchases of new housing.
Investment is the purchase of capital equipment, inventories, and
structures including expenditure on new housing.
Government purchases include spending on goods and services by local,
state, and federal governments, such as the Navy’s purchase of a
submarine.
Net exports equal the purchases of domestically produced goods by
foreigners (exports) minus the domestic purchases of foreign goods
(imports). A domestic firm’s sale to a buyer in another country, such as
the Boeing sale to British Airways, increases net exports.
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Components of GDP

Product/ Expenditure Income/Earning approach

approach
Consumption (C) Wage, salaries, and other labor
+Gross private investment (I) income
+ Government purchases (G) + Interest, rent, and other
property income
+ Net exports (X)
+ Indirect taxes
+ Depreciation
+ Profits

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Remarks
The meaning of “government purchases” requires a bit of
clarification. When the government pays the salary of an Army
general, that salary is part of government purchases. But what
happens when the government pays a Social Security benefit to
one of the elderly? Such government spending is called a transfer
payment because it is not made in exchange for a currently
produced good or service.
From a macroeconomic standpoint, transfer payments are like a
tax rebate. Like taxes, transfer payments alter household income,
but they do not reflect the economy’s production. Because GDP is
intended to measure income from (and expenditure on) the
production of goods and services, transfer payments are not
counted as part of government purchases.

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GNP: Gross national product or GNP may be defined as
the total market value of all-final goods and services
produces by the economy of country within a certain
period (generally one year). It doesn’t include
nonproductive transactions (i.e. sale of stock and bond).
Characteristics of GNP:
It has monetary value.
Flow variable.
It has three aspects:
 Production.
 Income.
 Expenditure.
It only includes final goods and services.
It doesn’t include transfer payments.
Three important macroeconomics concepts are output,
income and expenditure. Firms produce goods and
services, which in total are the nation’s output.
Productions require factors of production whose
owners are paid for their services and properties. It
thus generates income. Expenditure is the amount
required to purchase goods and services.
There are tree methods of measuring GNP
corresponding to these three concepts and they are:
1. Product / Output Method.
2. Income method.
3. Expenditure method.
Product / Output method: According to this method
the value of the output of each firm is added up to
get the total value of nation’s output. The output can
be grouped into more or less aggregated categories
corresponding to industries, to sectors or to any
desired categories. It includes only the final goods
and services. Symbolically this method can be
expressed as:
GNP = P1Q1 + P2Q2 +………..+ P = PiQi
Here, P => Price Q => Quantity
i =number of sectors in the economy.

The advantage of this method is that it reveals the

importance of different sectors of the economy by
showing their contribution to national income.
Income method: This method approaches the nation’s
GNP from the distribution side. According to this
method GNP is obtained by summing up the
incomes of the individuals in the country who
contribute their services and properties in the
production process. It can indicate the distribution of
national income among the factors of production.
Symbolically this method can be expressed as:

GNP = TR + TW + TI + TP
Where TR = Total rent.
TW = Total wage.
TI = Total interest.
TP = Total profit.
Expenditure method: This method arrives at the GNP by adding
up the expenditure made by the individuals on goods and services.
Hence GNP is found by adding up
1. Personal consumption expenditure (i.e. household expenses)
2. Gross private domestic investment (i.e. Purchases of new capital by
business firms.
3. Net foreign investment. (i.e. Excess export over import)
4. Govt. expenditure (i.e. Purchases by the govt.)
Symbolically this method can be expressed as:

GNP = C + I + G + (X – M)
Where C = Consumption.
I = Investment.
G = Govt. expenditure.
X = Total export and
M = Total import

So far, three alternative methods of calculating GNP have been

explained, the best way to arrive at GNP will be to employ all these
three methods so as to permit them cross checking inquiry and to
have greater accuracy.
What items are included / excluded in / from GNP:
1. Only final goods and services are included and
intermediate goods are excluded.
2. Services free of charges are excluded from GNP.
3. Transfer payments are excluded from GNP.
4. Subsidies will be excluded.
5. Illegal transactions are excluded.
6. Only the goods services of the concern year are
included.
7. Reselling of goods are excluded.
8. Transactions, which are not related with productive
effort, are excluded.
9. Capital gains and loses are excluded.
Real Versus Nominal GDP
 GDP measures the total spending on goods and services in all
markets in the economy. If total spending rises from one year
to the next, one of two things must be true:

1. the economy is producing a larger output of goods and

services, or
2. goods and services are being sold at higher prices.

 When studying changes in the economy over time, economists

want to separate these two effects. In particular, they want a
measure of the total quantity of goods and services the
economy is producing that is not affected by changes in the
prices of those goods and services.

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To do this, economists use a measure called real GDP, which
answers a hypothetical question: What would be the value of
the goods and services produced this year if we valued these
goods and services at the prices that prevailed in some specific
year in the past?
By evaluating current production using prices that are fixed at
past levels, real GDP shows how the economy’s overall
production of goods and services changes over time.
Nominal GDP uses current prices to place a value on the
economy’s production of goods and services. Real GDP uses
constant base-year prices to place a value on the economy’s
production of goods and services. Because real GDP is not
affected by changes in prices, changes in real GDP reflect only
changes in the amounts being produced. Thus, real GDP is a
measure of the economy’s production of goods and services.

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Nominal GNP: Money GNP / nominal GNP / GNP at market price /
GNP at current price is the market value of a nation’s aggregate
production of final output based on current price of the
corresponding year. Nominal GNP is of only limited use in
measuring changes in aggregate production over the time. This is
because nominal GNP can rise from one year to the next as result of
increase in market price level of goods even when the nation’s
aggregate production of final products doesn’t increase. If market
prices were to fall substantially during a year, nominal GNP might
fall even if the nation’s aggregate production goes up.

Real GNP: Real GNP / GNP at constant price / base year GNP is the
measure of value of the nation’s aggregated output of final product
obtained by using the market price prevailing for product during a
certain single year called base year. For example it the base year is
1972, output in each year will be valued at the 1972’s price level and
results will be referred to as GNP valued at 1972’s price.
Because the price used to valued all product remain unchanged from
year to year, changes in GNP must be due to the changes in quantity
of output.
Why ‘Real GNP’ is superior to ‘Money GNP’?
A serious difficulty arises in comparing GNP of
several years because of inflation. Say for example
over one year all prices remain unchanged, the
quantity of the output increases by 10% and as result
GNP will increase by 10%. Again in the following
year the quantity remains unchanged but the price
level increase by 10% and as result GNP will
increase by 10%. But these two cases are different. To
avoid this confusion we use ‘Real GNP’.
GDP Deflator
Nominal GDP reflects both prices of goods and services, and
quantities of goods and services the economy is producing.
By contrast, by holding prices constant at base-year levels,
real GDP reflects only the quantities produced. From these
two statistics, we can compute a third, called the GDP
deflator, which reflects the prices of goods and services but
not the quantities produced.
The GDP deflator is calculated as follows:

Nominal GDP
GDP deflator   100
Real GDP
The GDP deflator measures the current level of prices
relative to the level of prices in the base year.
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How to convert Money GNP into Real GNP:
To convert Money GNP into Real GNP we must follow the
following procedure:
1. First we have to select a base year.
2. Then we will have to construct a price index.
3. Price index = (Present year price level / Base year price
level) X 100
4. Then Real GNP will be
5. (Money GNP / Price index) X 100
Potential GNP: Potential output or full employment
output or expected GNP refers to what the economy
could produce over a given time period if all resources
are fully employed. When the economy is producing its
potential output the actual output is then equal to
potential GNP and will remain on the production
possibility boundary.

Actual GNP: Actual GNP refers to what is actually

produced by a nation over a given period. When there
are some unemployed resources so that the actual GNP is
less than the potential GNP, the output point is
somewhere inside the transformation curve.
GNP Gap:
GNP Gap = Potential GNP – Actual GNP.
Significance of national income:
The following are some of the important uses of the
national income estimates:
1. First, national income estimates reveal the overall
production performance of the economy. Beside this
per capita income, which is found by dividing the
total national income by the population gives us an
idea about the average standard of living of the
people.
2. Secondly, by comparing national income of different
years, we can know whether the economy is
growing, stagnant or declining.
3. Thirdly, the national income estimates show the
contribution made by the various sectors of the
economy.
4. Fourthly, national income estimates throw light on the
distribution of national income among different
categories of income such as wages, profits, rents and
interest.
5. Fifthly, the national income estimates also contain the
figures of consumption, saving and investment in the
economy.
6. Sixthly, by the figures of the real national income per
capita, we can compare the standard of living or levels
of welfare in different countries of the world.
7. Finally, national income estimates are valuable guide to
economic policy. By looking at national income
statistics, the govt. can decide if the economy or its
various sectors need any stimulus or regulation.