Chapter 6

National Income
National Income
National income refers to the total value of
resources available in an economy.
It indicates the standard of living and economic
performance.
Measured in monetary terms for comparability.
Key Indicator: Gross Domestic Product (GDP).
Measurement of National Income
Three approaches to measuring GDP:
1. Expenditure Approach: Adds up all spending
(household, firms, government, and net exports).
2. Income Approach: Measures total income earned
(wages, profits, rents, etc.).
3. Output Approach: Sums up total value added by
firms.
Real vs. Nominal GDP
Nominal GDP: Measured at current prices.
Real GDP: Adjusted for inflation using a base year.
Real GDP provides a more accurate reflection of
actual growth.
Example: If inflation increases an ice cream’s price from
$2 to $2.20, nominal GDP rises, but real GDP remains
unchanged.
Gross National Income (GNI)
Formula: GNI = GDP + Net Income from Abroad.
Includes remittances and foreign investments.
Example: Pakistan’s net factor income from abroad was 6% of GNI
in 2018/19.
Market Prices vs. Basic Prices
Basic Prices: Exclude indirect taxes, include subsidies.
Market Prices : Include taxes and exclude subsidies.
Formula: GDP at Market Prices = Gross Value Added + Taxes on
Products - Subsidies on Products
Gross vs. Net Values
Depreciation: Wear and tear of capital assets.
Net Domestic Product (NDP) = GDP - Depreciation
Net National Income (NNI) = GNI - Depreciation

Uses of National Income StatisticsUses:

Measures economic performance.
Guides policy formulation.
Enables international comparisons.
Limitations:
Excludes informal economy and household work.
Does not reflect income inequality.
Ignores environmental costs.
The Circular Flow of Income (Closed Economy)
Two economic agents: Households & Firms.
Four Primary Flows:
a. Income flow from firms to households (wages, rent, profits).
b. Output flow from firms to households (goods & services).
c. Expenditure flow from households to firms (spending on goods
& services).
d. Factor services flow from households to firms (labor, land,
capital, enterprise).
Three ways to measure GDP: Factor Income, Output,
Expenditure.
The Circular Flow in an Open Economy
Includes government and international trade.
Introduces leakages & injections.
Injections (Increase Economic Activity):
1. Government Spending (G)
2. Exports (X)
3. Investment (I)
Leakages (Reduce Economic Activity):
1. Taxes (T)
2. Imports (M)
3. Savings (S)
Equilibrium in the Circular Flow
Equilibrium occurs when Injections = Leakages.
If Injections > Leakages, national income rises.
If Leakages > Injections, national income falls.
Role of Investment:
Increases productive capacity.
Generates employment.
Leads to a multiplier effect (stimulates further spending).
Conclusion
National income statistics provide critical insights into an
economy.
Understanding GDP, GNI, real vs. nominal GDP, and pricing
methods is essential.
Circular flow highlights how money moves through the economy.
Policy decisions must account for limitations of national income
data.
 Chapter 7:
Aggregate Demand and Aggregate Supply
Analysis
Aggregate Demand (AD) Overview
Aggregate Demand (AD) represents the total demand for goods
and services in an economy.
AD is composed of four major components:
Consumption (C): Household spending on goods and services.
Investment (I): Business spending on capital goods.
Government Expenditure (G): Public spending on services
and infrastructure.
Net Exports (X - M): Difference between exports and imports.
AD= C + I + G + (X – M)
Consumption (C)
Largest component of AD.
Influenced by:
Real Income: Higher income increases consumption.
Interest Rates: Lower rates encourage borrowing and
spending.
Wealth Effects: Higher household wealth boosts spending.
Consumer Expectations: Economic optimism leads to higher
spending.
Part of income is saved or spent on imports, affecting AD.
Investment (I)
Spending on capital goods by businesses.
Influencing factors:
Business Confidence: Higher expectations of future demand
lead to more investment.
Interest Rates: Lower borrowing costs encourage investment.
Availability of Finance: Profitable firms can self-finance,
others rely on loans.
Government Policies: Tax incentives and subsidies promote
investment.
Government Expenditure (G)
Government spending influences overall economic activity.
Types of government expenditure:
Consumption Expenditure: Spending on healthcare,
education, and social services.
Investment Expenditure: Spending on infrastructure (e.g.,
roads, public transport).
Often autonomous, meaning policy-driven rather than economy-
driven.
Net Exports (X - M)
Exports (X): Goods and services sold abroad increase AD.
Imports (M): Spending on foreign goods reduces domestic AD.
Trade balance impact:
Trade Surplus (X > M): Increases AD.
Trade Deficit (X < M): Decreases AD.
Factors affecting trade:
Exchange Rates: Weaker currency boosts exports.
Relative Inflation Rates: Lower inflation makes exports
competitive.
Global Economic Conditions: Higher foreign incomes boost
demand for exports.
The Aggregate Demand Curve
Shows the relationship between AD and price levels.
Downward Sloping Due To:
Real Balance Effect: Lower prices increase real value of
money.
Interest Rate Effect: Lower prices lead to lower interest rates,
increasing spending.
Net Export Effect: Lower prices improve export
competitiveness.
Shifts in the Aggregate Demand Curve
Rightward Shift (Increase in AD):
Higher consumer confidence
Lower interest rates
Increased government spending
Higher net exports
Leftward Shift (Decrease in AD):
Higher taxation
Lower government spending
Declining global demand
Exchange rate appreciation reducing exports
Importance of Aggregate Demand
AD influences:
Economic Growth: Higher AD leads to increased production.
Inflation: Excessive AD can cause demand-pull inflation.
Employment: Rising AD creates more job opportunities.
Understanding AD is crucial for analyzing macroeconomic
policies.
Aggregate Supply

Aggregate supply represents the total output of goods and services

produced within an economy over a specific period. Unlike individual
supply curves, aggregate supply focuses on the overall relationship
between the price level and total quantity supplied.
Short-Run Aggregate Supply (SRAS)
Characteristics of SRAS:
Firms have limited flexibility to adjust inputs.
Money wages are typically fixed.
Firms cannot rapidly expand capital.
Raw materials may be in short supply.
Increasing labor may lead to diminishing returns.
Why SRAS is Upward Sloping?
At higher price levels, firms are incentivized to produce more to
increase profits.
Firms take technology, efficiency, and factor supply as given.
Changes in input costs (e.g., wages, raw materials) impact SRAS.
Factors Affecting SRAS
1. Cost of Inputs: Higher input costs (raw materials, wages) shift SRAS
leftward.
2. Oil Prices: Rising oil prices increase production costs, shifting SRAS
leftward.
3. Labor Costs: Wage increases lead to higher production costs, reducing
output supplied.
4. Exchange Rate: Changes in exchange rates affect imported input
costs.
5. Government Policies: Regulations and taxes can increase production
costs, shifting SRAS leftward.
Shifts in SRAS
Rightward Shift: Decrease in production costs (e.g., lower wages,
improved technology).
Leftward Shift: Increase in production costs (e.g., higher raw
material costs, increased regulations).
Long-Run Aggregate Supply (LRAS)
Characteristics of LRAS:
Depends on the economy's productive capacity.
Represents full-employment output (YFE).
Vertical in classical/neoclassical theory, implying wages and prices
adjust over time.
Factors Affecting LRAS
1. Quantity of Factor Inputs:
Increased labor force shifts LRAS rightward.
More capital investment expands productive capacity.
Aging population may reduce labor availability, shifting LRAS
leftward.
2. Effectiveness of Factor Utilization:
Technological progress increases efficiency, shifting LRAS
rightward.
Improved education and training enhance productivity.
Structural changes in industries may require reskilling efforts.
Alternative Views on LRAS
Classical View: LRAS is vertical, indicating the economy always
returns to full employment.
Keynesian View: LRAS may be upward-sloping due to wage and
price rigidities.
Hybrid Models: Consider both rigidities in the short run and
adjustments in the long run.
Macroeconomic Equilibrium in the Short Run and Long Run
Macroeconomic equilibrium occurs where aggregate demand
(AD) equals aggregate supply (AS).
Determines real GDP and price level.
Short-run and long-run equilibrium function differently.
Short-Run Macroeconomic Equilibrium
Established at the intersection of AD and short-run aggregate
supply (SRAS).
Determines:
Real GDP output level.
Price level.
No changes occur unless AD or SRAS shifts.
Equilibrium at Full Employment?
If AD intersects SRAS at Y_FE (full-employment output): economy
operates at full capacity.
If AD is below Y_FE, economy has unemployment & surplus capacity.
If output exceeds Y_FE, it is unsustainable due to overuse of resources.
Long-Run Macroeconomic Equilibrium
Determined by the intersection of AD and long-run aggregate supply
(LRAS).
LRAS is vertical (classical view) because the economy cannot exceed full
employment permanently.
Wages & prices adjust over time to restore equilibrium.
Adjustment Process to New Equilibrium
Increase in AD:
Short run: GDP & prices rise.
Long run: Rising costs shift SRAS left, restoring full
employment at a higher price level.
Decrease in AD:
Short run: GDP falls, unemployment rises.
Long run: Lower costs shift SRAS right, restoring full
employment.
Supply Shocks and Equilibrium
Short-run supply shock (e.g., oil price hike):
SRAS shifts left → Lower GDP, higher inflation
(stagflation).
If temporary, economy self-corrects.
If permanent, LRAS may shift left, reducing long-run
potential output
Shifts vs. Movements Along AD & AS
Shifts in AD/AS: Caused by external factors (e.g., policies, global
events).
Movements along AD/AS: Caused by price-level changes.
Real-World Example - COVID-19 Pandemic
AD Shift Left: Lockdowns reduced consumer spending.
SRAS Shift Left: Supply chain disruptions increased production
costs.
Policy Response: Governments stimulated AD, but supply issues
kept inflation high.
Conclusion
Short-run equilibrium changes real GDP & employment.
Long-run equilibrium restores full employment.
Classical vs. Keynesian views: Speed of adjustment varies.
Understanding equilibrium is essential for policymaking.
 Chapter-8
Economic Growth
What is Economic Growth?
Economic growth refers to an increase in an economy’s
productive capacity, leading to higher output.
Measured as the rate of change of real Gross Domestic Product
(GDP).
Types of Economic Growth:
a. Potential Economic Growth – Long-run expansion of
productive capacity (outward shift of PPF).
b. Actual Economic Growth – Short-run increase in output
due to better utilization of resources.
Measuring Economic Growth
Real GDP: Measures the total output adjusted for inflation.
Actual vs. Potential Growth:
Actual Growth: Increase in GDP due to better resource
utilization.
Potential Growth: Increase in productive capacity (PPF
shift outward).
Alternative Measure: Gross National Income (GNI), includes
net income from abroad.
Causes of Economic Growth
Growth occurs when factors of production (capital, labor,
enterprise) increase or improve.
Key Drivers:
a. Capital Accumulation and Investment: Higher investment
in capital goods leads to greater output.
b. Technological Progress: Enhances efficiency of labor and
capital.
c. Labor Force and Human Capital: Improved education,
training, and healthcare boost productivity.
Capital Accumulation & Investment
Investment in machinery, infrastructure, and productive assets
increases output.
Example: China’s high investment rate (42.3% in 2018) led to rapid
economic growth.
Investment requires sacrificing current consumption for future
benefits.
Technological Progress
Innovation enhances productivity, reducing costs and increasing
output.
Examples: Computing advancements, automation, AI, and
renewable energy.
Labor Force & Human Capital
Increase in labor force (migration, population policies) boosts
growth.
Higher quality workforce through education, training, and
healthcare.
Example: Developing countries improve productivity through
better nutrition and healthcare.
Consequences of Economic GrowthBenefits:
1. Improved living standards (healthcare, education,
infrastructure).
2. Reduction in poverty, enabling human capital investment.
3. Higher employment levels and improved working conditions.
Challenges:
Environmental Degradation: Pollution, resource depletion.
Income Inequality: Unequal wealth distribution.
Inflationary Pressures: Demand-pull inflation increases living
costs.
Consequences of Economic GrowthBenefits:
1. Improved living standards (healthcare, education,
infrastructure).
2. Reduction in poverty, enabling human capital investment.
3. Higher employment levels and improved working conditions.
Challenges:
Environmental Degradation: Pollution, resource depletion.
Income Inequality: Unequal wealth distribution.
Inflationary Pressures: Demand-pull inflation increases living
costs.
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