How The Macro economy Works

Content
• Aggregate demand
• Aggregate supply
• Determinants of Aggregate demand
• Aggregate demand and the level of economic
activity
• The long run aggregate supply curve
 Aggregate Demand
• Aggregate demand measures the total expenditure
in the economy as a whole
• It is calculated using the following formula:
– AD = C + I + G + (X-M)
– C = consumption
– I = investment
– G = government expenditure
– X = exports
– M = imports
 Aggregate Demand Curve
• This shows the total level
of expenditure at different
price levels
• The curve slopes from left to
right because it is based on
the following assumptions :
– Bank of England sets short
term interest rates
– A rise in inflation is
matched by a rise in
interest rates
– An increase in interest
rates increases the cost of
borrowing
Aggregate Supply
• Aggregate supply shows
the total amount supplied
in the economy as a whole
at each price level
• In the short term aggregate
supply slopes upwards
Interaction of AD and AS
• In the short run where the
AD and AS curves interact
is the level of national
income
 Price level and AD / AS
• If the price level changes this is represented by
movements along the AD / AS curves
 Shifts in the aggregate demand curve
• Any change in the components of AD (C,I, G, (X-M)
cause the curve to shift
• Economic growth is represented by a rightwards
shift in the LRAS curve
 Shifts in the AS curve
• The AS curve may be shifted by changes in:
– The size / quality of the labour force
– The size / quality of capital
– Expectations of inflation
– Technology
– The productivity of labour / capital
– Wages per unit of output
– Taxes / subsidies for producers
 AD / AS Diagrams
• These can show:
– Causes of inflation
– Demand deficit unemployment
– Economic growth
 Determinants of AD
• The determinants of AD are C, I, G, X and M
• C represents the consumption expenditure of the economy as a
whole
• There are a number of factors that influence the level of C including:
– Tax rates
– Inflation
– Wage increases
– Interest rates
– Credit
– Wealth
• Shares
• Property
• Savings
• Bonds
 Determinants of Consumption
• Consumption is affected by interest rates because
as interest rates rise the opportunity cost of
spending increases and saving becomes more
attractive
• In addition as interest rates rise if people have high
levels of borrowing their real income will be reduced
decreasing rates of consumption
 Determinants of Consumption
• Taxation rates influence consumption as the higher
the rate of tax the lower peoples real income and
therefore the lower the rate of consumption
• Credit influences consumption as if credit is readily
available it will increase consumption levels
• Wealth influences consumption as if people have
wealth in the form of property, stocks etc they are
more likely to consume at a higher rate
 Determinants of Investment
• Investment represents all spending on capital items
which are used to generate future incomes
• Examples of investment are expenditure on
machinery, buildings, equipment and infrastructure
• Investment expenditure is influenced by:
– Interest rates
– Sales forecasts
– Inflation projections
– Expected rates of return
 Determinants of Investment
• When making investment decisions businesses
need to ensure that there will be demand to meet
the production the investment generates it is
therefore important for them to use sales forecasts
when making investment decisions
• When making investment decisions firms look at
expected rates of return for the action to enable
them to decide in the project is worthwhile
 Determinants of Investment
• There is an inverse relationship between
investment and interest rates
• As interest rates fall the cost of investment
decreases therefore firms are more likely to invest
• Inflation can influence investment as if there is high
inflation firms are more likely to make investment
decisions as their return is likely to be higher in real
terms
Determinants of Government Spending
• Government expenditure includes all spending by
the public sector in areas such as defence,
healthcare, education, social welfare etc
• Government expenditure is heavily influenced by
political factors
• Government expenditure is also influenced by the
rate of taxation in the country as this is used to fund
the spending
 Import and Export Expenditure
• If more money is being spent on imports than
exports (balance of payments deficit) AD will be
reduced
• If more money is being spent on exports than
imports (balance of payments surplus) AD will be
increased
 Economic growth and Imports
• When the economy grows quickly consumption is
high and British consumers have a tendency to
spend their money on imports
• This leads to a larger balance of payments deficit
 AD and Economic Activity
• A change in the level of AD can
cause influence the level of
national income
• If an economy is operating
below its potential level then a
shift in AD causes national
income to rise in the short term
• The impact of the change in AD
depends on how close the
economy is to full capacity
 Long Run Aggregate Supply Curve
• LRAS is determined by the productive resources
available in the economy and the productivity of the
factors of production (land, labour and capital)
• In the long run the assumption is that supply is not
dependent on the level of prices in the economy
therefore the LRAS is vertical
LRAS curve
• The LRAS is vertical – the
same level of income at all
price levels
• This is the normal level of
output in an economy
• To move the LRAS outwards
there needs to be
improvements to productivity
and efficiency in the economy -
this represents economic
growth
 Determinants of LRAS
• Technology
• Productivity
• Attitudes
• Enterprise
• Factor mobility
• Institutional structure of the economy
• Economic incentives
 Summary
• Aggregate demand shows the total amount of expenditure in the
economy
• Aggregate supply shows the total amount supplied in the economy at
each price level
• AD = C + I + G + (X-M)
• Any change in the determinants of Aggregate demand will cause the
AD curve to shift
• In the short term shifts in the AD curve can cause an increase in
national income
• The long run aggregate supply curve is vertical
• If LRAS increases the curve shifts out and economic growth has
occured