Income Determination and the Price Level
FoundationMacroeconomics uses the AD-AS model: aggregate demand consists of consumption, investment, government spending and net exports, and its intersection with aggregate supply determines equilibrium output and the price level.
- The AD-AS model determines equilibrium output and the price level together — the basic tool of macro analysis
- AD equals consumption plus investment plus government spending plus net exports; income, interest rates, wealth and exchange rates lie behind them
- SRAS slopes upward because input and output prices do not fully adjust; LRAS is vertical
文體小知識：經濟現象說明文——運用總需求與總供應模型，解釋整體經濟的產出與價格水平如何決定和變動。
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1Having learned how to measure national income, the next step is to explain why it changes. Macroeconomics answers with the aggregate demand–aggregate supply (AD-AS) model: aggregate demand is the total value of domestic output the whole economy is willing to buy at each price level, aggregate supply is what firms are willing to produce, and their intersection determines equilibrium output and the price level.
2Aggregate demand has four components: private consumption expenditure, investment expenditure, government expenditure and net exports. Consumption depends on disposable income, the desire to save, wealth and interest rates; investment depends on business outlook and interest rates; net exports depend on trading partners' economies and exchange rates. A rise in any component, other things being equal, raises aggregate demand.
3Aggregate supply is short-run or long-run. The short-run aggregate supply curve slopes upward because input and output prices do not fully adjust: when output prices rise, input costs such as wages, constrained by contracts, do not follow immediately, so profits rise and firms produce more. The long-run aggregate supply curve is vertical because all prices eventually fully adjust; output is determined only by resources, technology and institutions.
4When aggregate demand or aggregate supply changes, equilibrium output and the price level change together, and employment moves with output. For example, in a recession the government may raise spending to boost demand; a surge in oil prices raises production costs and contracts aggregate supply. This model is the basic tool for analysing macroeconomic policies and fluctuations.
1Summary 重點摘要
Macroeconomics uses the AD-AS model: aggregate demand consists of consumption, investment, government spending and net exports, and its intersection with aggregate supply determines equilibrium output and the price level.
2Vocabulary cards Vocabulary
The total value of domestic output the whole economy is willing to buy at each price level; the sum of private consumption, investment, government spending and net exports.
The total output all firms are willing to produce at each price level; distinguished into short-run and long-run aggregate supply.
Household spending on goods and services, affected by disposable income, the desire to save, wealth and interest rates.
Spending by firms on capital goods such as machinery and premises, affected by business outlook and interest rates.
Exports minus imports, affected by trading partners' economic conditions and exchange rates.
Aggregate supply while input and output prices do not fully adjust; its curve slopes upward.
Aggregate supply once all prices fully adjust; its curve is vertical, with output determined by resources, technology and institutions.
The output level determined at the intersection of aggregate demand and aggregate supply, together with the equilibrium price level.
A rise in the price level lowers the real value of assets such as deposits, reducing consumption — one reason the AD curve slopes downward.
The output level corresponding to the long-run aggregate supply curve, where resources are fully employed regardless of the price level.
3Step by step Steps
- Step 1: Why the AD-AS model is neededMeasuring GDP answers how the economy performed; this topic answers why. Aggregate demand shows the total domestic output the economy is willing to buy at each price level, while aggregate supply shows what firms are willing to produce; their intersection determines equilibrium output and the price level. For example, news of slower growth and falling prices usually reflects a shift in AD or AS moving the equilibrium.
- Step 2: Why the AD curve slopes downwardWhen the price level rises, aggregate quantity demanded falls through three channels. The wealth effect: the real value of deposits and bonds shrinks, so consumption falls. The interest rate effect: higher prices raise the demand for money for transactions, pushing up interest rates and curbing investment. The international substitution effect: local goods become relatively dearer, so exports fall and imports rise. For example, after prices rise 20 percent, the same deposit buys 20 percent less.
- Step 3: Factors behind consumption and investmentPrivate consumption depends on disposable income, the desire to save, wealth (asset values) and interest rates: more income, less desire to save, higher asset prices or lower rates all lift consumption. Investment depends on business outlook and interest rates. For example, after a rate cut, mortgage burdens ease and household spending rises, while firms find it cheaper to borrow and build — both raise aggregate demand.
- Step 4: Government spending and net exportsGovernment spending is set by policy and is the direct lever of fiscal policy, covered next. Net exports (exports minus imports) depend on trading partners' economies and exchange rates: prosperous partners mean more orders. For example, in a United States recession, Hong Kong exporters receive fewer orders, net exports contract and aggregate demand falls, hitting retail and logistics first.
- Step 5: Short-run and long-run aggregate supplyThe short-run AS curve slopes upward for one reason required by the syllabus: input and output prices do not fully adjust. When output prices rise, input costs such as wages, constrained by contracts, lag behind, so profits rise and firms produce more. The long-run AS curve is vertical: with all prices fully adjusted, output depends only on labour, capital, technology and institutions. For example, with annual wage contracts, firms expand when prices rise but wages do not.
- Step 6: How equilibrium is set and movesThe intersection of AD and AS determines equilibrium output and the price level. The basic move in macro analysis is to judge which curve a shock affects and in which direction. Higher AD moves the equilibrium up along AS: output and prices rise together. Lower AS moves it up along AD: prices rise but output falls. For example, recovering confidence shifts AD right; an oil-price surge shifts SRAS left, causing inflation with falling output.
- Step 7: Employment and outputIn the short run, producing more requires more labour, so employment moves with output: when output rises, unemployment falls, and vice versa. This links the model to the real world and explains why policy targets both output and prices. Note that the syllabus treats the interest rate as exogenous — take it as given. For example, a restaurant chain with rising sales opens branches and hires part-timers, improving unemployment statistics.
5Worked example Example
Application practice: an economy relies heavily on imported oil, and world oil prices surge by 50 percent in the short run and stay high. Using the AD-AS model, explain the short-run effects on equilibrium output and the price level, and state how employment will change.
- Read the question: oil is a key input, so the surge raises production costs — this is a supply-side shock, not a demand-side one
- State that the short-run aggregate supply curve shifts left: with higher input costs, firms produce less at every price level
- Analyse the new equilibrium: with AD unchanged and AS reduced, the equilibrium price level rises and equilibrium output falls
- Infer employment: lower output leads firms to cut hiring, so unemployment rises; rising prices with falling output is the hardest macro combination
- Answer: The oil-price surge raises overall production costs and shifts the short-run aggregate supply curve left. With the AD curve unchanged, the new equilibrium has a higher price level and lower output. Firms reduce hiring as output falls, so employment drops and unemployment rises. If oil prices later fall, or input prices such as wages fully adjust, output can return to its long-run level.
6Common mistakes Mistakes
7Quick check Quick check
Q1What are the four components of aggregate demand?
Q2Why does the short-run aggregate supply curve slope upward?
Q3Ceteris paribus, what happens to aggregate demand when interest rates fall?
Q4Why is the long-run aggregate supply curve vertical?
Q5If aggregate supply falls while aggregate demand is unchanged, what happens to equilibrium output, the price level and employment?
8Recap Recap
- The AD-AS model determines equilibrium output and the price level together — the basic tool of macro analysis
- AD equals consumption plus investment plus government spending plus net exports; income, interest rates, wealth and exchange rates lie behind them
- SRAS slopes upward because input and output prices do not fully adjust; LRAS is vertical
- Shifts in AD or AS change output and the price level together, and employment moves with output
- Distinguish movement along a curve (caused by the price level) from a shift of the curve (caused by other factors)