National Income, Inflation and Economic Policy

This study material covers topics such as national income, inflation, and economic policy. It explains the formulas for aggregate supply and aggregate expenditure. It also discusses the difference between demand-pull and cost-push inflation. Additionally, it explores the effects of a rise in domestic interest rates on consumer spending, investment expenditure, and net export expenditure. The material provides insights into long-run equilibrium and real GDP. Recommended for students studying economics.

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National Income, Inflation and Economic Policy
Student’s Name
Course
Professor
Date

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Question 1
For a closed economy, the formula for aggregate supply is expressed as
C=a+b(Y −T )
Where C is aggregate consumption, a is the autonomous spending whereas b is the
marginal propensity to consume. The (Y-T) indicated is real aggregate disposable income,
and it is the difference between the real aggregate national income and the taxes.
For the table provided the computation for each of the element in the aggregate consumption
column is given as shown below:
C=a+b(Y −T )
For aggregate consumption:
100
C= 46+0.8(100-20)
C= 110
200
C= 46+0.8(200-20)
C= 190
300
C= 46+0.8(300-20)
C=270
400
C= 46+0.8(400-20)
C= 340
500
C=46+ 0.8(500-20)
C= 430

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600
C= 46+0.8(600-20)
C= 510
Given that the economy of Atlantis is closed, the formula for the aggregate expenditure will
include, C which is the aggregate consumption, Ip which is the planned investment and G which
is government spending. In this case, both Ip and G are constant.
Therefore, aggregate expenditure, AE=C + I P +G.
Substituting figures at aggregate income of:
100 we have
AE= C+Ip+G
AE=110+ 30+20
AE= 160
At 200
AE= 190+30+20
AE= 240
At 300
AE= 270+30+20
AE= 320
At 400
AE= 340+30+20
AE= 390
At 500
AE= 430+30+20
AE= 480
At 600
AE= 510+30+20
AE= 560

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The results are provided below.
National
income
Aggregate
consumption
Aggregate
expenditure
100 110 160
200 190 240
300 270 320
400 340 390
500 430 480
600 510 560
Question 2
Difference between demand pull and cost push inflation
The two types of inflation stated cause prices to rise, but their difference lies in what
causes them. Demand-pull inflation is caused by an increase in demand for goods where people
have enough money to purchase goods and services. However, the increase in demand is not met
by a corresponding increase in goods and services1. Demand-pull inflation occurs when real
GDP increases as employment rise. Demand-pull inflation occurs typically when the economy is
1 Weale, Martin, Andrew Blake, Nicos Christodoulakis, James E. Meade, and David
Vines. Macroeconomic policy: Inflation, wealth and the exchange rate. Routledge, 2015.

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at full employment. Herein, the demand rises in terms more significant than those the productive
capacity of the same economy rises. Firms noticing that the rise in demand is exceeding that of
the supply will increase the prices of their commodities2. In this period also firms hire more
workers to whom they have to pay higher wages because of the increased pressure on wages.
That in itself causes wage-push inflation. The higher wages paid to workers increase the amount
of disposable income in the economy hence further rise in consumer spending.
2 Ibid

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Conversely, cost-push inflation is caused by changes in the supply of commodities
available in the market. In this case, the supply of commodities falls as the costs of supplying the
commodities rise. The supply shocks lead to increases in he cost of production hence higher
prices3. For cost-push inflation to occur, the demand for those commodities has to be relatively
inelastic. Thus, a reduction in supply (leftward shift of the supply curve) or an increase in the
cost of production are responsible for the cost-push inflation as shown in the diagram below.
3 Kurihara, Kenneth K. 2012. National income and economic growth. London: Routledge.

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Question 3
Effect of a rise in domestic interest rates on:
Consumer spending
Increased domestic interest rates lead to the cost of borrowing; lower disposable incomes hence
reduce the growth of consumer expenditures in the economy.
Investment expenditure The higher cost of borrowing necessitated by a rise in domestic interest
rates results in a higher cost of borrowing for investment purposes. It, therefore, discourages
investors from borrowing. Additionally, the higher rates of interest are an incentive to saving
rather than spending. Consequently, less money will be available for making investments
because of the attractiveness of higher returns from savings.
Net export expenditure
An increased domestic interest rate makes the domestic currency stronger than other
currencies in the international markets. That leads to a rise in the level of imports and a reduction
in exports from the domestic economy. The final result will be a lower net export expenditure
and therefore lower domestic aggregate demand.
Question 4
a. Long run equilibrium and real GDP
From the graph, the long run equilibrium price level is likely to be at 550% whereas the long
run real GDP will be 600.
b. Chain of events bringing the long run equilibrium

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The scenario portrayed by the graph shown above is of an economy that is growing beyond its
potential level of growth as shown by the high real GDP. It is also experiencing higher
inflationary pressures as shown by the high price levels. Here, the contractionary monetary
policy will play a vital role in bringing the economy back to equilibrium. In such a scenario, the
monetary policy will be raising interest rates4. It will discourage borrowing. Seeing so, investors
will have fewer investments since the cost of borrowing is high. The consumers also will reduce
consumption levels as they will have less disposable income than they had before the
contractionary monetary policy is applied to the economic situation5. Finally, there will result in
a lower aggregate demand as the original aggregate demand curve shifts leftwards lowering the
price level and output to full employment. The contractionary monetary policy leads to a real
GDP of 600, and it achieves to reduce the already building inflationary pressures to 550%.
4 Mishkin, Frederic S. 2015. The Economics of Money, Banking and Financial Markets Student
Value Edition. Pearson College Div.
5 Ibid

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Notes
1. Martin, Andrew Blake, Nicos Christodoulakis, James E. Meade, and
David Vines. Macroeconomic policy: Inflation, wealth and the exchange rate.
Routledge, 2015.
2. Ibid
3. Kurihara, Kenneth K. 2012. National income and economic growth. London:
Routledge.
4. Mishkin, Frederic S. 2015. The economics of money, banking, and financial
markets. Pearson College Div.
5. Ibid

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Bibliography
Kurihara, Kenneth K. 2012. National income and economic growth. London: Routledge.
Martin, Andrew Blake, Nicos Christodoulakis, James E. Meade, and David Vines.
Macroeconomic policy: Inflation, wealth and the exchange rate. Routledge, 2015.
Mishkin, Frederic S. 2015. The Economics of Money, Banking, and Financial. Pearson College
Div.