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3
The determination of national income 
Equilibrium national income
is determined using aggregate supply and aggregate demand analysis.
3.1 Aggregate demand and supply equilibrium 
Aggregate demand (AD) is total planned or desired consumption demand in the economy for consumer 
goods and services and also for capital goods, no matter whether the buyers are households, firms or 
government. 
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PART A: THE BUSINESS ORGANISATION, ITS STAKEHOLDERS AND THE EXTERNAL ENVIRONMENT 
 
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3.2 Full-employment national income 
If one aim of a country's economic policy is full employment, then the ideal equilibrium level of national 
income will be where AD and AS are in balance at the full employment level of national income, without 
any inflationary gap – in other words, where aggregate demand at current price levels is exactly 
sufficient to encourage firms to produce at an output capacity where the country's resources are fully 
employed. 
 
3.3 Inflationary gaps
In a situation where resources are already fully employed, there may be an 
inflationary gap
 
since 
increases in demand will cause price changes, but no variations in real output.
A shift in demand or supply will not only change the national income, it will also change price levels.
3.4 Example 
If you are not sure about this point, a simple numerical example might help to explain it better. Suppose 
that in Ruritania there is full employment and all other economic resources are fully employed. The 
country produces 1,000 units of output with these resources. Total expenditure (that is, aggregate 
demand) in the economy is 100,000 Ruritanian dollars, or 100 dollars per unit. The country does not 
have any external trade, and so it cannot obtain extra goods by importing them. Because of pay rises 
and easier credit terms for consumers, total expenditure now rises to 120,000 Ruritanian dollars. The 
economy is fully employed, and cannot produce more than 1,000 units. If expenditure rises by 20%, to 
buy the same number of units, it follows that prices must rise by 20% too. In other words, when an 
economy is at full employment, any increase in aggregate demand will result in price inflation. 
3.5 Deflationary gap 
In a situation