National income and price determination is one of the main topics of macroeconomic analysis. In this regard, it is examined how the production and price level in the economy are determined by using aggregate demand and aggregate supply models. While aggregate demand expresses the demand for all goods and services in the economy, aggregate supply indicates the supply of all goods and services in the economy.
It consists of aggregate demand, consumption, investment, government spending and net exports. Factors affecting aggregate demand include income, interest rates, expectations, exchange rate, fiscal policy, and monetary policy. The aggregate demand curve shows the inverse relationship between the general price level and aggregate demand.
Aggregate supply, on the other hand, is handled differently in the short run and the long run. In the short run, the aggregate supply curve shows the correct relationship between production costs and aggregate supply. Factors affecting production costs include prices of factors of production, technology, expectations and taxes. In the long run, the aggregate supply curve reflects the economy's potential output level. Among the factors affecting potential production are the quantity and quality of production factors, technology and institutional structure.
The intersection point of aggregate demand and aggregate supply curves gives the equilibrium national income and equilibrium price level. At this point, equilibrium is achieved in both the goods and money markets in the economy. However, this point may not always coincide with the potential production level. If the equilibrium national income is below the potential production, there is a stagnation or recession in the economy. If the equilibrium national income is above the potential production, there is overheating or inflation in the economy.
Any shock or policy change in the economy can cause shifts in aggregate demand or aggregate supply curves. In this case, equilibrium national income and equilibrium price level will also change. This model is used to analyze economic fluctuations.
In the long run, the self-adjustment mechanism comes into play in the economy. Thanks to this mechanism, the economy tends towards the potential level of production. The functioning of the self-adjustment mechanism depends on the flexibility, expectations and institutional structures in the markets.