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Chapter 2

Aggregate Demand, Aggregate

Supply and National Output

The Circular Flow

The Circular Flow

There are four sectors in the economy,

the household
the firm
the government, and
the rest of the world.

The Circular Flow

The household supplies the firm factor inputs, which
are necessary for the firm to produce goods and
services. The factors inputs include land, labor, capital,
and entrepreneurship. In return, the firm gives the
household money income in form of wage for labor,
rent for land, interest and dividend for capital, and
salaries and profit for entrepreneurship.
These money incomes are received in various forms
and then used by the household to buy what it needs
from the firm. Hence, the money income that originally
came form the firm goes back to the firm. The savings
accumulated by the household are also plowed back to
the firms in the forms of loan and investments.

The Circular Flow

Both the firm and the household pay taxes to
the government, which it turn, uses the
money income from taxes to pay for its
governmental functions that include providing
public services to the household and firm.
Hence, money income remains in the system

The Circular Flow

The domestic economy trades with
international economy. It buys goods and
services from the rest of the world through
importation. In this case, money income goes
out from the system. But of course, in the
same manner that it imports, the domestic
economy also exports (sells abroad). In this,
instance, money income from abroad flows
into the system.

The Framework of Da and Sa

Aggregate Demand (Da)
Aggregate demand refers to the total goods and
services that the household, the firm, the
government, and the rest of the world intend to
buy in the economy in a given period of time,
usually one year.
The aggregate demand generally has four
components, namely: private consumption,
private investment, government expenditures,
and net export (Export minus Import).

Aggregate Demand (Da)

Figure 2.2 Hypothetical aggregate
demand curve that is represented
by GDP identities.
The aggregate demand is the
total buying intentions in the
economy, composed of private
consumption (C), private
investment (I), government
expenditure (0), and next export
(X). The downward sloping curve
shoes the inverse relationship of
quantity demanded (Q) and
general price level (P),
considering everything constant.

Aggregate Demand (Da)

In Figure 2.3, the behavior
of general price (P) in the
economy is shown vis--vis
total quantity demanded in
singular aggregate demand
curve (Da).
It shows that as price moves
from P2 to P1, quantity
demanded moves from Q2
to Q1 suggesting that in a
singular Da curve, Q0
decreases as P increases.
Conversely Q0 increases as P

Aggregate Demand (Da)

In Figure 2.4, a
rightward shift Da,
meaning a general
increase in output, will
increase total demand
even if the general price
level does not change.

Aggregate Demand (Da)

In Figure 2.5, on the other
hand, a rightward shift
(increased output) even if
accompanied by an increase
in general price level will
not reduce total quantity
In this case, it is implied that
the increase in the general
price level is accompanied
by an equal increase in
income. Hence, demand
remains the same.

Aggregate Demand (Da)

What causes the shift
on aggregate demand?
If price is the primary
determinant of quantity
demanded given in a
singular demand curve,
the so-called non-price
determinants of
demand cause the
shifting if the entire
demand curve

Aggregate Demand (Da)

The sifting of the general level of demand may be caused or
influenced by the fiscal and monetary policies of government or by
other variables such as: changes in asses values, e.g., real and
financial asset; economic performance of our trading partners
abroad and the oil price changes

The effect of fiscal policy is that when government increases its

expenditures, demand increases. Conversely, if the government
decides to decrease its expenditures; demand will decrease. With
regard to taxation, as tax is increased, demand declines; and if tax is
reduced, demand increases.
The effect of monetary policy, on the other hand, can be
summarized as follows: if the money supply is increased, the
general level of demand increases; and if money supply is reduced,
demand decreases.

Aggregate Demand (Da)

The effect of the changes in asset values is that, as they
increase, wealth of their holder increases, and therefore
purchasing power increases and demand also increases as a
result. By these assets we mean bonds, shares of stocks
and other securities.
The effect of the economic performance of our trading
partners abroad is that as their economies move well,
demand for our products increases; hence, contribute to
the increases in our aggregate demand, and vice versa.
An increase in oil price abroad increase the cost of
domestic production, hence, causes a decline in demand
due to the resulting increase in the general price level, and
vice versa

Aggregate Supply (Sa)

If aggregate demand refers to the total buying
intentions in the economy, aggregate supply,
on the other hand, may be suggested to refer
to the total production intention in the
economy. In other words, the total national
output that the productive sectors (the firm)
of the economy willingly produce and sell
during a given year at each level of prices,
assuming other things remain constant.

Aggregate Supply (Sa)

In the same way as Da, Sa
responds to changes in
the general price level,
but in the same direction.
As the price increases, Sa
increases reflecting the
normal behavior of sellers
that as higher prices are
offered for their products,
the more that they are
willing to produce and sell
more of the same.

Aggregate Supply (Sa)

As the economy grows, Sa
normally shifts to the
right manifesting a
general increase in total
goods and services being
produced in the economy,
although there will be
occasions when Sa tends
to contract due to various
happenings that occur
within the economy or
outside of the domestic

Aggregate Supply (Sa)

What causes the shifting of the Sa curve?
In the analysis of a single supply curve, we
concluded that price generally determines the
level of supply.
In analyzing the shifting of the supply curve either
to the left or to the right, on the other hand, price
is not a factor as shown by the changes in quantity
supplied, from Q0 to Q1 and from Q0 to Q2
without a change in price P0 as shown in Figure

Aggregate Supply (Sa)

What actually determines aggregate supply are the following:


Changes in the cost of production. As production cost per unit decreases,

the more that the productive sectors will be able and willing to produce
more even without an increase in price. Production cost is normally
reduced due to improvement in methods or technology. A deterioration
in the production method or technology, on the other hand, will
generally increase production cost, hence, will tend to shift Sa to the left.
Changes in taxes and subsidies. Increased taxes will cause a general
decline in Sa, while an increased subsidy will encourage producers and
sellers to increase supply, hence, shifts Sa to the right, and vice versa.
An increase in demand of local products abroad increases demand of
our own products, which will induce Sa in the domestic economy, and
vice versa.

Equilibrium Level of Output

The equilibrium level of output
of an economy is found at the
intersection point between
the Da and Sa curves.
Contrary to the classical views
of automatic adjustment to
full employment between Sa
and Da in the short-run, and a
persistent vertical Sa curve in
the long run, implying that
long-run increases in national
output can only be attributed
to price increases rather than
actual increase in quantity

Equilibrium Level of Output

Keynes argued that:
(a) Sa cannot automatically adjust with the changes in Da because
of the existence of sticky price and wage.
Sticky price is present in the short-run because of the presence of fixed cost in
production so that prices cannot just be cut to stimulate demand and wages
cannot remain, lest be cut, because of union contracts (CBA) which cause and

(b) Without an active government intervention in the economy, either

through fiscal or monetary steps, the macroeconomics has the natural
tendency to succumb to the prolonged downturn of the business cycle;
hence, government has to take steps to stimulate demand during
recession and curb total spending during economic boom.

Measuring national output is important to effectively implement

government economic planning activity and private business planning


Measuring National Output

National output refers to the total goods
services produced by an economy in one year.
Accurately measuring national output and the
specific sub0measurements that compromise
it are very important activities of both the
government and the private sector, as the
numbers they generate are indispensable to
government and business panning activities.

Measuring National Output

The most important measures of national
output are GNP (Gross National Product) and
GDP (Gross Domestic Product).

Both of these measurements may be defined

as the total market value of all goods and
services produced in the economy in one year.
There is a slight difference between two
measures, however.

Measuring National Output

As the GNP and GDP are calculated at current
prices, their year-to-year comparison of
growth are always overstated due to inflation.
Hence, to calculate real GNP/GDP, the
numbers need to be deflated by a price index.
The price index is defined as the number that
results in dividing the current price level by a
given base year price level.

Measuring National Output


Price Index

Nominal GNP

Real GNP
















If we want to know the

nominal GNP growth
rate in one (1) year for
year 5, we can calculate:

GNP Growth Rate =

On the other hand, if we

want to determine the real
GNP growth rate, we will do
as follows:

4230 - 3560
= 19%

GNP Growth Rate =

3254 - 2966
= 9.7%

Approaches in Calculating National

There are two ways by which GDP and DNP may be
calculated. These are the income approach and the
expenditure approach. The income approach calculates
national output y adding all the incomes received in
the economy. These are rents, wages, and salaries,
interest and dividends, and profits.
Although income approach may be used to determine
national output, all economies of the free world today
use the other approach the expenditure approach.

Expenditure Approach
The expenditure approach is the only method
used by the free world in calculating national
output (GNP and GDP).

This approach became widely used because it

is more accurate approach. Total expenditures
in the economy are much easier and
accurately accounted for than the total
income received.

Expenditure Approach

In a simplified model, the more important indications of national output

performance of an economy may be presented as follows:


GDP = C + I + G + (X M)
GDP = Gross Domestic Product
C = Private Consumption
I = Private Investment
G = Government Expenditure


GNP = C + I + G + (X M) + Remittances from abroad

GNP = Gross National Product
X = Total Value of Export
M = Total Value of Import

Expenditure Approach
NNP = Net National Product
TDE = Total Depreciation Expense
in the economy
for the year in consideration
NI = National Income
VAT= Value Added Tax

Expenditure Approach


PI = Personal Income
SSC = Social Security Contribution
CITx = Corporate Income Taxes
UCP = Undistributed Corporate Profits
(Total Retained Earnings)
TP = Transfer Payments to Individuals (Pensions, disability allowance, etc.)


DI = Disposable Income
PTx = Personal Taxes


PSy = Personal Savings
PS = Personal Spending
y = Represents Income (Symbol for Income)

Exercise 2.1




Provide answers that are required in the given situations.

What are the four sources of income received by the households coming from the firms?
If incomes of individuals will be more than its consumption expenditures, he will have ______
which will form part of ______ that will earn an ______ for household.
In the national output analysis, consumption, investment, government
spending and net
export show the behavior of what curve?
What do you call the general term that causes demand curve to shift?
If these graphs show different households demand behaviors, what do you think will be done to
make a macro component?
Prepare a schedule of Price and Qd.
What is the aggregate meat consumption?
What is the aggregate price for the meat consumption?
Draw a graph that shows the aggregate demand of the different households.
Draw a hypothetical graph that shows the effect of a monetary policy imposing low interest rates
on savings and therefore rushes households to spend more on consumption.

Exercise 2.2
Choose the letter of the hypothetical graph that represents the given
_____ 1. Aggregate demands for households
_____ 2. Different components of aggregate demand
_____ 3. Decrease in aggregate demand because of monetary policy that
pushes households to save because interest have increased
_____ 4. Increase of investment opportunities
_____ 5. Changes in price of private consumption
_____ 6. Income in export of our agricultural products to foreign markets
_____ 7. The effects of 91 incident to private investment
_____ 8. The effects of inflation rate increase
_____ 9. Government spending behavior when revenue target is not met
_____ 10.
Imposition of customs duties on imports

Exercise 2.3
The GDP Deflator Analysis
Read and understand the case. This is a case of a hypothetical carrot and potato economy. You can
present your answer in a table form so that you can track the differences of values and you will know the
values for substitution.
Given: Year: 2001, 2002, and 2003

Potatoes in 2001 = P 23.50

2002 = 25.00
2003 = 25% more than in 2002
Carrots in 2001 = P 33.00
2002 = 50% more than the former
2003 = 30% more than the former

Base year for real GDP: 2001 prices

Base year for CPI: 2001 quantities
Base year for inflation rate: 2001 CPI

Quantities: Potatoes in 2001 = 15 kilos

2002 = 5 kilos more than 2001
2003 = 27 kilos
Carrots in 2001 = 30 kilos
2002 = 33 kilos
2003 = 10% more than in 2002

Exercise 2.3
1. Prepare nominal GDP table.
2. Prepare real GDP table.
3. Prepare consumer index price table.
4. Prepare the computation of inflation rate for 2002 and 2003.

Answer the following questions:

1. What will give you higher GDP (nominal, real)?
2. How much is the price of potatoes in year 2003? How about the
quantities of the same in 2002?
3. How many kilos of carrots were in the tear 2003?
4. By how much was the increase in price of carrots in year 2002?
5. By how much kilos was the increase of potatoes from year 2001 to

Exercise 2.4
Classify whether the given situations fall on Consumption,
Investment, Government Spending, Import or Export.
1. Transfer payment such as Health Insurance of Retirees
2. Construction of Mababaw na Ilog Bridge
3. 3.8 million tons of mangoes for a Mexican Company
4. Night vision goggles for soliders in Basilan
5. Purchase of different electronics of Mr. and Mrs. Casal
6. Monthly pension for Mr. Magaling and Ms. Matulin
7. Repair of North Diversion Road
8. Operation and maintenance of PGH
9. Salaries of public school teachers
10. Allotment of OFW children from parents abroad

Exercise 2.5

Make use of the table on next page to plot your GDP accounts for 2002. Assume that all
transactions are within 2002.



RP said Cathay Pacific charged $ 4,300 for the fare expenses of Philippine Olympic delegates.
Gregorio who is a farmer of Pangasinan bought a tractor worth 18,500 from an importer.
Sec. Angelo Reyes bought two warplanes worth $ 2.1 M.`
Grace is BPI teller who received 11,500 as mid year bonus and bought a DVD worth 10,800
Non-Trade, an importing company collected $ 65,000 from Yuki Enterprise.
Quarterly allowance of Jarr for her school needs which is 2,750 when she was 1st year ASC
student in2000
Mando earns 12,000 a month as a masseur and spends it all
for his need.
P.GMA pays Paulo Cabral 560,000 for the official wardrobe used in local and international
Agricultural subsidies for Negros farmers affected by typhoon Gloring worth 6,758,250
Consultancy Fee for the evaluation of the 25 years program of the Department of Tourism was
paid to TPI in the amount of $ 20 M, which will be charged in four equal payments starting 2002.

Exercise 2.6
Compute for the GDP deflator, CPI, and
Inflation rate based on the following data give.
Construct the necessary table to set an orderly


Y 1995



Y 2000

25% more

.25 more

Y 2001

.15 more

35% more

Q 1999


Q 540

Q 2000

25% more

Q 100%

Q 2001

5% less

Q plus 10

Exercise 2.6
Base for real GDP is 1999
Base for CPI is 1999
Base for inflation is 1999

1. What is the difference observed in the Nominal

and Real GDP table?
2. Explore the possibility of assuming year 2000 as
your base for inflation rate. What is the result?
3. What is constant in CPI?

Exercise 2.7

Which of the following would increase GDP?



When the expenditure approach is used to measure0 GDP, the major components of GDP
are _________________.


Ford Motor Company begins to produce and sell cars in Japan.

Mercedes-Benz begins to produce and sell cars in Alabama.
An American investor buys 100 shares of Ford stocks.
An American investor purchases 100 shares of Mercedes-Benz stocks

Consumption, investment, indirect business taxes, and depreciation

Employee compensation, rents, interest, self-employment income, and corporate profits.
Employee compensation, corporate profits, depreciation, and indirect business taxes.
Consumption, investment, government consumption and gross investments, and net

Assume that between 2000 and 2008, nominal GDP increased from 5 trillion to 8.3 trillion
and that the price index rose from 100 to 140. Which of the following expresses GDP for
2000 in terms of 2008 prices?

5.93 trillion
7 trillion
8.3 trillion
11.63 trillion

Exercise 2.7

Which of the following would not be counted as part of this years GDP?
The paint you buy to paint your house
The government bond you receive as a birthday present
The purchase of an IBM computer (produced during the year) by the U.S. Government
The purchase wheat (produce during the year by a Kansas farmer) by the Russian Government


The GDP deflator Is designed to _______________________

Adjust nominal GDP for changes in the unemployment rate
Adjust nominal GDP so as to include the problem of externalities
Adjust nominal GDP for changes on price level
Calculate changes in the price of food and other consumer goods


Which of the following best describes the difference between gross domestic product and gross national
GDP measures output produced within domestic borders, while GNP measures output produced by
domestic citizens.
GDP measures output produced by domestic citizens within domestic borders, while GNP measures all
output produced within domestic borders.
GDP measures output produced by domestic citizens, while GNP measures output produced within
domestic borders
GDP measures all output produced within domestic borders, while GNP measures output produced by
domestic citizens within domestic borders


Exercise 2.7

Suppose that, in dollar terms, GDP increased by approximately 8 percent

during the given year. The real GDP increased 5 percent. Which of the
following best explains these events?
The money supply decreased by approximately 8 percent
Prices fell by approximately 3 percent
Prices increased by approximately 3 percent
The real capacity of the economy decreased rapidly than money output.
If waitresses and taxi drivers do not report all of their income to the
government, GDP will be understated. This is because the unreported
income ___________________
Involves the introduction of new goods
Is part of the underground economy
Is an example of non-market production
Represents an increase in leisure time

Exercise 2.7

The primary value of GDP is _____________________

Its ability to reflect the output rare of a nation
As a measure of well-being, income inequality, and unemployment in an
To provide observers with reasonably good index of social progress.
Limited to capitalist economies and highly developed countries

10. National income is ________________________________

a. After-tax household income available for either consumption
expenditures or saving during period
b. Gross national product minus depreciation
c. The total income payments to the owners of human (labor) and physical
capital during a period
d. Gross national product minus government expenditures