National Income
Senior 5 · Economics
National Income
Lesson 4 of 5
50 min
Real output rose in every year but one. In 2020, when the COVID-19 pandemic closed borders, schools and businesses, it fell by 2.8%; it then grew by 8.4% and 9.8% in the next two years. Why does output settle at a particular level, and why does it swing up and down around its long-run trend? John Maynard Keynes's answer, in The General Theory of Employment, Interest and Money (1936), was that in the short run output is driven by spending.
Definition
Aggregate expenditure (AE): total planned spending on a country's output in a period: .
Equilibrium national income: the level of income at which planned spending equals output, , so firms have no reason to change production. Equivalently, planned injections equal planned withdrawals.
Plot planned spending against income. The 45° line joins all points where spending equals output. The AE line is flatter than 45° because when income rises by Frw 1, households raise consumption by less than Frw 1; the rest is saved (Unit 3 studies this in detail). Here , with investment and government spending fixed, in a closed economy without taxes:
At any income where AE is above the 45° line, buyers want more than firms are producing; stocks run down and firms raise output. Where AE is below the line, unsold stocks pile up and firms cut output. Only at E is output steady.
Worked example 1: two ways to find equilibrium
Using .
Method A: AE = Y.
Method B: withdrawals = injections. With no taxes or trade, the only withdrawal is saving, . The injections are .
Check: at , and . Saving is , equal to the injections.
Keynes's key point was that the economy can settle at an equilibrium with idle workers and machines. Call the income that would employ all available resources full-employment income, .
Definition
Deflationary gap (recessionary gap): the amount by which aggregate expenditure falls short of the level needed to reach full-employment income. On the diagram it is the vertical distance between the 45° line and AE at , when . The result is unemployment.
Inflationary gap: the amount by which aggregate expenditure exceeds the level needed for full-employment income, when . Output cannot rise above full employment, so the excess demand pulls prices up.
Worked example 2: measuring the gaps
With and equilibrium at 3,000:
(a) Full employment at . . Deflationary gap . If spending rose by 100, to , equilibrium would be . A gap of 100 in spending closes a gap of 400 in output: that is the multiplier, studied in Unit 3.
(b) Full employment at . . Inflationary gap . Spending must fall by 100 to remove the excess demand.
Important
Closing the gaps. A deflationary gap calls for higher spending: lower taxes, more government spending, lower interest rates. An inflationary gap calls for the opposite: higher taxes, less government spending, higher interest rates. These are the tools of fiscal and monetary policy you will meet in later units.
Warning
Measure the gap vertically, at . The inflationary or deflationary gap is a gap in spending, read vertically at full-employment income. The horizontal distance between and is the output gap, which is larger (here 400 against 100).
Definition
Business cycle (trade cycle): the recurring pattern of rises and falls in real GDP, employment and prices around the economy's long-run trend.
Recession: a period of falling real output, often defined as two consecutive quarters of negative real GDP growth.
| Phase | What happens |
|---|---|
| Recovery (upswing) | Spending and output start to rise; firms rehire workers and use idle capacity; confidence returns; investment picks up |
| Boom and peak | Output is at or above full capacity; unemployment is low; shortages of labour and materials push up wages and prices; imports rise |
| Recession (downswing) | Spending falls; stocks pile up; firms cut output and lay off workers; profits and investment fall |
| Trough or depression | Output is at its lowest; unemployment is high; prices stable or falling; a long, deep trough is a depression |
Governments try to smooth the cycle with counter-cyclical policy: spending more and taxing less in a downturn, and the reverse in a boom.
Important
Discuss. Look at the bar chart at the start of this lesson. Was 2020 a recession by the definition above? (You would need quarterly data to be sure.) What kind of cause was it: a fall in aggregate demand, an outside shock, or both? Why might Rwanda's recovery in 2021–22 have been so fast?
Khan Academy, "Keynesian Cross" (about 9 minutes). Watch how the equilibrium is found where the aggregate expenditure line meets the 45-degree line, as in the first diagram of this lesson.
Practice
Sources and credits
Written by Ganzaa: the text, the five diagrams, the table, the worked examples and the practice items. The consumption function and the full-employment levels are illustrative.
