NSS Exploring Economics 5

Chapter 4

Determination of national income and price level (I) aggregate demand and
aggregate supply

Questions
P.102
Think it over
1.
In Scenario 1, how will consumers and producers change their quantities demanded and
quantities supplied, respectively? Why?
2.
In Scenario 2, will the quantities of all goods and services demanded decrease? Will the
quantities of all goods and services supplied increase? Why?
P.105
Test yourself
4.1
When the price level rises, real private consumption expenditure drops. Does this imply a
drop in nominal private consumption expenditure too?

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P.108
Test yourself
4.2
When the price level falls, what would happen to the aggregate output demanded? Complete
the following flow charts and show the effects graphically.
a. Wealth effect
P

b. Interest rate
effect

c. International
price effect

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P.114
Test yourself
4.3
When the price level falls, what would happen to the aggregate output supplied in the short
run? Complete the following flow charts and show the effects graphically.
In the short run:
a. Sticky-cost effect
P

b. Misperception
effect
P

P.114
Discuss
4.1
What is meant by the long run in macroeconomics? In the long run, what would happen to the
sticky-cost effect and the misperception effect on the aggregate supply?

P.122-123
Exercises
Multiple Choice Questions
1*.
The aggregate demand curve
A. is equal to the sum of individual demand curves of all consumers in an economy for a
certain good.
B. is equal to the sum of individual demand curves of all consumers in an economy for all
goods and services.
C. is equal to the sum of individual demand curves of all residents in an economy for all
goods and services.
D. relates the real GDP demanded to the GDP deflator.

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2.
The aggregate demand curve is
A. horizontal.
B. downward sloping.
C. vertical.
D. upward sloping.
3*.
Which of the following can account for the shape of the aggregate demand curve?
A. When the price of a good rises, people buy fewer units of the good but more units of its
substitutes which have lower relative prices.
B. When the price of a good rises, people have lower real income and buy fewer units of it
if it is a superior good.
C. When the price level rises, people become less wealthy and cut their real private
consumption expenditure.
D. The aggregate output demanded is negatively related to the price level.
4.
The interest rate effect states that when the price level rises, the real interest rate
real gross investment expenditure
.
A. rises drops
B. rises rises
C. drops rises
D. drops drops

and

5.
The short run aggregate supply curve is
A. horizontal.
B. downward sloping.
C. vertical.
D. upward sloping.
6.
The shape of the short run aggregate supply curve can be explained by
A. the sticky-wage effect and the misperception effect.
B. the sticky-cost effect and the wealth effect.
C. the interest rate effect and the sticky-wage effect.
D. the misperception effect and the international price effect.

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7.
Which of the following descriptions about the long run is INCORRECT?
A. Input prices are less flexible than output prices.
B. All inputs can attain full employment.
C. All output prices are flexible.
D. Quantity demanded and quantity supplied are equal in all output markets.
8.
Along the long run aggregate supply curve, which of the following variables remains
unchanged?
A. Real GDP
B. Nominal GDP
C. Nominal output prices
D. Nominal input prices
9.
The aggregate demand and aggregate supply determine
A. the sum of equilibrium quantity of all goods and services.
B. the equilibrium real GDP.
C. the inflation rate.
D. the employment level.

Short Questions.
1.
Are the following variables stock or flow? Explain.
a. Aggregate output supplied
b. Aggregate demand
c. National saving

(2 marks)
(2 marks)
(2 marks)

2.
Compare the demand curve of a good and the aggregate demand curve of an economy in
terms of the following:
a. variables on the two axes of their curves
(4 marks)
b. the shape of their curves
(2 marks)

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3.
Why is the aggregate demand curve downward sloping? Explain with TWO reasons.
marks)

(6

4.
Compare the supply curve of a good and the aggregate supply curve of an economy, in terms
of the following:
a. variables on the two axes of their curves
(4 marks)
b. the shape of their curves
(3 marks)
5.
Why is the shape of the short run aggregate supply curve different from that of the long run
aggregate supply curve?
(8 marks)

Structured Questions.
1*.
One day, May proposes the following alternative explanation of why the short run aggregate
supply curve is upward sloping:
In the short run, the prices of some outputs are less flexible or more sticky than the prices
of others. For example, the prices of newspapers are more sticky than the property prices.
When the price level rises, sticky-price goods (goods whose prices are more sticky) have a
smaller percentage rise in their prices than flexible-price goods (goods whose prices are
more flexible). Since the price of sticky-price goods decreases relative to that of flexibleprice goods, consumers buy more of sticky-price goods, and the output supplied of stickyprice goods increases. Consequently, the aggregate output supplied increases when the
price level increases in the short run.
Evaluate Mays explanation.

(8 marks)

2.
a. Derive the equilibrium condition of a product market.
(3 marks)
b. What is private saving (SP)? Derive its value from the equilibrium condition in (a).
(3 marks)
c. Based on the result derived in (b), find the relation between public savings (SG) or fiscal
surplus and trade surplus if SP = I.
(4 marks)
d. Suppose national saving (SN) is equal to the sum of private saving and public saving.

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Derive its value from the equation derived in (b).

e. Based on the result derived in (d), find the trade balance if SN > I.
Answers

(2 marks)
(2 marks)

P.102
Think it over
1. By the law of demand, consumers will reduce their quantities demanded. By the law of
supply, producers will raise their quantities supplied.
2.

Free answer. (Their changes will be discussed in this chapter.)

P.105
Test yourself
4.1
Not necessarily.
Real value =

Nominal value in a specified period

100
Price index in the period

Nominal private consumption expenditure in a specified year

= Real private consumption expenditure Price index in the year 100
When the price level rises (as reflected by the price index), real private consumption
expenditure drops. Therefore, the change in nominal private consumption expenditure is
uncertain.
If the percentage rise in the price index is larger (smaller) than the percentage drop in the real
private consumption expenditure, nominal private consumption expenditure increases
(decreases). If they are equal, nominal private consumption expenditure remains unchanged.

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P.108
Test yourself
4.2
a. Wealth effect

b. Interest rate
effect

c. International
price effect

Same amount
of cash and
deposits can buy

P more goods
and
services

More
saving but

P
less
borrowing

Real
Value

Real

interest
rate

Prices of domestic

P products fall relative

to prices of foreign
products

NSS Exploring Economics 5

Questions and Answers to Exercises (Chapter 4)

C and I

X and M

Aggregate
output
demanded

Aggregate
output
demanded

Aggregate
output
demanded

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P.114
Test yourself
4.3
In the short run:
a. Sticky-cost effect

b. Misperception
effect

Output prices fall by a

larger percentage than
(sticky
P input prices
costs)
Some input suppliers
may misinterpret

P that a fallin nominal

incomes implies a fall
in real incomes

Profitable for
firms to
produce less

They supply
fewer inputs

Aggregate
output
supplied

Aggregate
output
supplied

P.114
Discuss
4.1
In macroeconomics, the long run refers to the period within which all people have fully
recognised and made full adjustments to the change in economic conditions.
Hence, both the sticky-cost effect and the misperception effect disappear. For details, please
refer to the section that follows.

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P.122-123
Exercises
Multiple Choice Questions
1. D
The aggregate demand curve relates the aggregate output demanded to the general price
level. The aggregate output demanded is measured by the real GDP or the sum of real
expenditures of households, firms, the government and the foreign sector (not merely
consumers or residents), while the general price level is measured by the GDP deflator.
2.

3.

C
Option A is incorrect. When the general price level of an economy rises, prices of most
outputs rise. There may not be any change in relative prices. Moreover, even if
quantities demanded for goods which have a larger percentage rise in price decline,
those with a smaller percentage increase in price rise. Then the overall aggregate output
demanded may not decrease.
Option B is incorrect. Sales revenues of firms are distributed among input suppliers
(including entrepreneurs) as incomes. When the general price level rises, though the real
income of some input suppliers may drop, the real income of others must rise.
Hence the aggregate output demanded may not decrease.
Option C is correct. The downward sloping AD curve is caused by the wealth effect, the
interest rate effect and the international price effect. The statement describes the wealth
effect.
Option D is incorrect. The statement describes how aggregate output demanded is
negatively related to the general price level without explaining why they are negatively
related.

4.

5.

6.

A
The wealth effect, interest rate effect and the international price effect are used to
account for the shape of the AD curve, instead of the SRAS curve.

7.

A
The statement in option A holds in the short run but not in the long run.

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8.

A
The LRAS curve is vertical, positioned at the potential real GDP. In other words, along
the LRAS curve, when the general price level (reflecting average output price) changes,
the real GDP remains unchanged. However, the nominal GDP changes simultaneously
with the price level because nominal GDP = real GDP price index 100.

9.

B
The AD and AS determine the equilibrium aggregate output and price level.
Option A is incorrect. Since the equilibrium quantities of different goods and services
are expressed in different units, they cannot be summed in quantities, but in market
value.
Option C is incorrect. Merely from the equilibrium price level determined by AD and
AS, we cannot obtain the inflation rate. We also need to know the price level of the
preceding period.
Option D is incorrect. Merely from the equilibrium output level determined by AD and
AS, we cannot obtain the employment level of inputs. We also need to know the relation
between inputs and outputs.

Short Questions.
1. a. Aggregate output supplied is the total real market value of all goods and services
supplied in an economy at a particular price level over a specified period. The specification
of the period concerned is necessary because a different length of periods implies a
different magnitude. For example, an aggregate output supplied of $3 billion a month is
larger than an aggregate output supplied of $3 billion a year. Aggregate output supplied is a
flow. (2 marks)
1 b. Aggregate demand is the relation between the price levels and the aggregate outputs
demanded in an economy. It is a relation instead of a quantity. It is neither a stock nor a
flow. (2 marks)
1 c. National saving is the sum of private saving and public saving. The specification of the
period concerned is necessary because a different length of periods implies a different
magnitude. For example, a national saving of $1 million a month is larger than a national
saving of $1 million a year. National saving is a flow. (2 marks)

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2. a
Demand curve of a good

Aggregate demand curve of an economy

(The diagrams above are drawn for easier understanding; no marks will be deducted for not
drawing these diagrams.)
Diagram A shows the demand for a good. In diagram A, the variable on the x-axis is the
quantity demanded of the good, while the variable on the y-axis is the price of the good.
(2 marks)
Diagram B shows the aggregate demand of an economy. In diagram B, the variable on the
x-axis is the aggregate output demanded of the economy (measured by real GDP or real
national income), while the variable on the y-axis is the general price level of the economy
(measured by GDP deflator). (2 marks)
2 b. Both curves are downward sloping. (2 marks)
3.
Wealth effect on consumption When the price level rises (falls), the same amount of
cash and deposits can buy a smaller (larger) amount of goods and services. The purchasing
power of peoples wealth decreases (increases). Hence real private consumption
expenditure drops (rises) and so does the aggregate output demanded.
Interest rate effect on consumption and investment When the price level rises (falls), as
more (less) money is needed to buy the same amount of goods and services, saving
decreases (increases) while borrowing increases (decreases). This raises (lowers) the real
interest rate. Thus, real private consumption expenditure and gross investment expenditure

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decrease (increase) and so does the aggregate output demanded.

International price effect on exports and imports When the domestic price level rises
relative to the international price level, the prices of domestic products rise relative to the
prices of their foreign substitutes. By the law of demand, the volume of our exports falls
while the volume of our imports rises. As a result, the aggregate output demanded falls.
(TWO of the above reasons. 3 marks each)

4. a
Supply curve of a good

Aggregate supply curves of an economy

(The diagrams above are drawn for easier understanding; no marks will be deducted for not
drawing these diagrams.)
Diagram A shows the supply of a good. In diagram A, the variable on the x-axis is the
quantity supplied of the good, while the variable on the y-axis is the price of the good. (2
marks)
Diagram B shows the aggregate supply of an economy. In diagram B, the variable on the xaxis is the aggregate output supplied of the economy (measured by real GDP or real
national income), while the variable on the y-axis is the general price level of the economy
(measured by GDP deflator). (2 marks)
4.b. The supply curve of a good is usually upward sloping. However, the aggregate supply
curve of an economy is upward sloping in the short run but is vertical in the long run.
(3 marks)

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5.
The short run is the period within which at least some people in an economy have not fully
recognised and made full adjustments to the change in economic conditions, due to imperfect
information and high adjustment costs. When the price level increases, due to the sticky-cost
effect, some firms are willing to produce more output. On the other hand, due to the
misperception effect, some input suppliers are willing to supply more inputs. Hence, the
aggregate output supplied increases with the general price level in the short run. In other
words, the short run aggregate supply curve is upward sloping. (4 marks)
The long run is the period within which all people in an economy have fully recognised and
made full adjustments to the change in economic conditions. Hence, the short run effects
disappear. Sticky costs become flexible, while the misperceptions of input suppliers are
rectified. Moreover, since all input and output prices are fully flexible, quantity demanded
equals quantity supplied in all markets. All factor markets attain full employment while all
product markets are clear. Hence, the economy always produces at the potential real GDP at
any price level in the long run. In other words, the long run aggregate supply curve is vertical.
(4 marks)
Structured Questions.
1
May is correct in saying that when the price level increases, the prices of sticky-price goods
show a smaller percentage rise than flexible-price goods, and that people may switch to buy
more of sticky-price goods. (2 marks)
However, Mays explanation still has two problems.
Problem 1: The general price level is the weighted average of all output prices. Since prices
of sticky-price goods rise by a smaller percentage than the general price level,
prices of some flexible-price goods must rise by a larger percentage. Thus, if more
sticky-price goods are sold, fewer flexible-price goods can be sold. As a result, the
aggregate output supplied may increase, decrease or remain unchanged. (3 marks)
Problem 2: Is it profitable for firms to increase their output? For sticky-price industries, if the
cost is also sticky, there is no change in their profit-maximising output. Their
profits drop if they raise their output according to the increase in quantity
demanded. If the cost is flexible, they suffer a loss if they do not cut their output.
For flexible-price industries, if the cost is sticky, it may not be profitable for them

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to increase output which may not sell if there is a decline in quantity demanded.
Moreover, the argument repeats the sticky cost model. If the cost is flexible, it is
also not profitable for them to raise output in light of declining quantity
demanded. (3 marks)
2 a. The aggregate output demanded (AQd) is equal to the sum of real expenditures of
households, firms, the government and the foreign sector.
AQd = C + I + G + X M. (1 mark)
On the other hand, the aggregate output supplied (AQs) is equal to the real GDP or real
national income (Y).
AQs = Y (1 mark)
In equilibrium, AQd = AQs Y = C + I + G + X M. (1 mark)
2 b. Private saving of households (SP) is equal to the total income of households (Y) minus
income taxes (T) and private consumption expenditure (C). (Note: In a more complicated
model, T is defined as net tax revenue, which is equal to income taxes minus transfer
payments. Here, to simplify the analysis, we assume there are no transfer payments.) (1
mark)
SP = Y T C
SP = (C + I + G + X M) T C
= I + (G T) + (X M) (2 marks)
2 c. Public saving (SG) or fiscal surplus is equal to government revenue (T) minus
government expenditure. For simplicity, we assume that there are no transfer payments or
government investment expenditure. In other words, government expenditure is equal to
government consumption expenditure (G). Hence, fiscal surplus = T G. (1 mark)
Trade surplus is equal to the value of exports (X) minus the value of imports (M),
i.e. X M. (1 mark)
From (b), SP = I + (G T) + (X M) and given that SP = I,
SP I = (G T) + (X M)
0 = (G T) + (X M)
TG=XM
Public saving (SG) or fiscal surplus = Trade surplus (2 marks)
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2 d. National saving (SN) is equal to the sum of private saving and public saving (or fiscal
surplus). SN = SP + SG = SP + (T G)
From (b), SP = I + (G T) + (X M)
SN = [I + (G T) + (X M)] + (T G)
SN = I + (X M) (2 marks)
2 e. Trade balance = X M.
From (d), SN = I + (X M).
SN I = X M
If SN> I
SN I = (X M) > 0
Hence, the trade balance is in surplus. (2 marks)

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