How The Macroeconomic Work

Question 1

What national income measures?

Answer 1

National income refers to the total value of all goods and services produced in an economy over a given period, usually a year. It measures the economic activity of a country and can be expressed in:
- Gross Domestic Product (GDP) – The total market value of all final goods and services produced within a country.
- Gross National Product (GNP) – GDP plus net income from abroad (e.g., remittances and income from foreign investments).
- Net National Income (NNI) – GNP minus depreciation (capital consumption), reflecting the actual income available for use.
- Disposable Income – National income after taxes and government transfers, showing the income available to households for consumption and saving.

Question 2

What is the difference between nominal and real income?

Answer 2

• Nominal Income: Measures national income at current market prices, without adjusting for inflation. It can be misleading if inflation is high.
• Real Income: Adjusted for inflation using a price index (e.g., Consumer Price Index, GDP deflator), reflecting the true purchasing power of income over time.

Formula:
Rea GDP = (nominal GDP/ Price index) x 100

For example, if nominal GDP grows by 5% but inflation is 3%, real GDP growth is only around 2%.

Question 3

What real national income can be used?

Answer 3

1. Reflects Economic Growth – An increase in real GDP suggests rising production, employment, and economic prosperity.
2. Indicates Living Standards – Higher real income usually translates into better access to goods, services, and improved quality of life.
3. Allows International Comparisons – Real GDP per capita helps compare economic performance across countries, adjusting for differences in price levels.
4. Guides Policy Decisions – Governments and central banks use real income data to shape fiscal and monetary policies, targeting inflation, unemployment, and growth.

Question 4

What is circular flow of income?

Answer 4

The circular flow of income illustrates how money moves between different sectors of the economy. It shows the flow of income, output, and expenditure between households and firms.

Households supply factors of production (labour, land, capital, and enterprise) to firms and receive income (wages, rent, interest, and profit).

Firms produce goods and services using these factors and sell them to households, generating expenditure.

Income = output = expenditure

Question 5

What three injections in the circular flow of income?

Answer 5

X - exports
Income from selling goods and services abroad

I - investments
Spending by firms on capital goods

G - government spending
Expenditure on public services and infrastructure

Question 6

What are three withdrawals/ leakage in the circular flow of income?

Answer 6

S - Savings (S) – Income not spent on consumption.

T - Taxes (T) – Government revenue taken from households and firms.

M - Imports (M) – Spending on foreign goods and services.

Question 7

How does increase in injections affect national income?

Answer 7

Increase in Injections (I, G, X) → Economic Growth
- Higher investment boosts productive capacity.
- Increased government spending stimulates demand.
- Higher exports lead to more income from abroad.

A positive multiplier effect - an increase in injection could lead to a greater proportion increase in national income.

Question 8

How does increase in withdrawals affect national income?

Answer 8

Increase in Withdrawals (S, T, M) → Economic Contraction
- Higher savings reduce current consumption and demand.
- Higher taxes reduce disposable income and spending.
- Increased imports mean more income flows out of the domestic economy.

A negative multiplier effect - an increase in withdrawal could lead to a greater proportion of decrease in national income.

Question 9

What factors can cause movements along AD and AS curves?

Answer 9

Aggregate Demand (AD) represents total spending in the economy at different price levels. It is downward sloping because:
- Wealth Effect: A lower price level increases the real value of money, boosting consumption.
- Interest Rate Effect: A lower price level reduces demand for money, leading to lower interest rates and higher investment.
- Net Export Effect: A lower price level makes domestic goods cheaper relative to foreign goods, increasing exports.

Aggregate Supply (AS) represents the total output firms are willing and able to produce at different price levels.
- In the short run (SRAS), AS is upward sloping because firms can increase output when prices rise, as wages and input costs are sticky.
- In the long run (LRAS), AS is vertical, as the economy operates at full capacity, meaning price changes do not affect output.

A movement along AD or AS occurs when the price level changes due to internal factors (e.g., inflation or deflation).

Question 10

What factors can shift the AD curve?

Answer 10

The AD curve shifts when there is a change in any of its components:
AD = C + I + G + (X - M)

• Consumption (C): Changes in consumer confidence, disposable income, taxation, and interest rates.
• Investment (I): Business confidence, interest rates, government incentives, and access to credit.
• Government Spending (G): Fiscal policies, infrastructure projects, and welfare spending.
• Net Exports (X - M): Exchange rate fluctuations, global demand, and trade policies.

A rightward shift in AD leads to economic growth, while a leftward shift causes contraction.

Question 11

What factors can shift the short run AS curve?

Answer 11

SRAS shifts when production costs or short-term supply conditions change:

• Wage Costs: Higher wages increase production costs, shifting SRAS left.
• Raw Material Prices: Higher oil or commodity prices raise costs, reducing SRAS.
• Exchange Rates: A weaker domestic currency makes imports (raw materials) more expensive, shifting SRAS left.
• Taxes and Subsidies: Higher taxes on businesses reduce supply, while subsidies encourage production.
• Supply Shocks: Natural disasters, pandemics, or geopolitical tensions can disrupt supply chains.

Question 12

What can shift long run AS curve?

Answer 12

LRAS represents the economy’s productive capacity and shifts due to long-term structural changes:

• Labour Productivity: More skilled and educated workers increase output.
• Investment in Capital: More and better machinery improves efficiency.
• Technological Progress: Innovation leads to higher productivity and output.
• Infrastructure Development: Improved transport and communication systems boost efficiency.
• Institutional and Political Stability: Strong institutions encourage long-term economic growth.

SRAS shifts due to temporary cost changes, such as wages or raw material prices.
LRAS shifts due to long-term productivity improvements, such as investment and technology.

Question 13

What is demand-side shocks?

Could you give some examples of demand-side shocks?

Answer 13

A demand-side shock is an unexpected event that causes aggregate demand (AD) to increase or decrease.

Examples of Demand-Side Shocks
1. Financial Crises – A banking collapse or stock market crash reduces consumer and business confidence, leading to lower consumption and investment.
2. Government Policy Changes – Large-scale tax cuts or stimulus packages boost AD, while austerity measures (higher taxes, reduced spending) lower AD.
3. Interest Rate Changes – If central banks raise interest rates, borrowing becomes more expensive, reducing consumption and investment. Conversely, lower interest rates stimulate spending.
4. Global Economic Events – A slowdown in major economies reduces demand for exports, decreasing AD.
5. Pandemics or Wars – Uncertainty reduces consumption and investment, while government spending may increase AD.

Question 14

How does demand-side shocks affect the macroeconomy

Answer 14

Negative Demand-Side Shock (AD shifts left)
Example: A stock market crash reduces consumer confidence.
• GDP ↓ – Lower spending leads to reduced production.
• Unemployment ↑ – Firms cut jobs as demand falls.
• Inflation ↓ (deflation risk) – Lower demand causes prices to fall.
• Budget Deficit ↑ – Government may increase spending to stimulate the economy.

Positive Demand-Side Shock (AD shifts right)
Example: A government stimulus package increases household incomes.
• GDP ↑ – Higher spending increases economic activity.
• Unemployment ↓ – More demand leads to job creation.
• Inflation ↑ – Higher demand pushes prices up.
• Trade Deficit ↑ – Increased income may lead to more imports.

Question 15

What is supply-side shocks?

Could you give some examples?

Answer 15

A supply-side shock is an unexpected event that changes production costs, productivity, or the availability of resources.

Examples of Supply-Side Shocks
1. Oil Price Shocks – A sudden rise in oil prices increases production costs for firms, shifting SRAS left. A fall in oil prices reduces costs, shifting SRAS right.
2. Labour Market Disruptions – Strikes, skills shortages, or mass resignations can reduce labour supply and productivity.
3. Natural Disasters & Pandemics – Earthquakes, floods, or disease outbreaks disrupt supply chains, increasing costs.
4. Technological Innovations – Advances in technology (e.g., AI, automation) can increase efficiency, shifting LRAS right.
5. Regulatory & Political Changes – Stricter environmental laws may increase production costs, reducing output. Conversely, deregulation can boost efficiency and output.

Question 16

How does supply-side shocks affect the macroeconomy?

Answer 16

Negative Supply-Side Shock (SRAS shifts left)
Example: A surge in oil prices raises production costs.
• GDP ↓ – Higher costs reduce economic output.
• Unemployment ↑ – Firms cut production and jobs.
• Inflation ↑ (cost-push inflation) – Higher costs lead to rising prices.
• Stagflation risk – A combination of low growth and high inflation.

Positive Supply-Side Shock (SRAS or LRAS shifts right)
Example: A technological breakthrough increases productivity.
• GDP ↑ – Higher efficiency boosts output.
• Unemployment ↓ – Increased production creates jobs.
• Inflation ↓ – Greater supply reduces price pressures.
• Long-term growth ↑ – The economy becomes more productive.

Question 17

What is AD and what are the determinants of AD?

Answer 17

Aggregate Demand (AD) is the total spending on goods and services in an economy at a given price level over a period of time. It is represented by the equation:

AD = C + I + G + (X - M)

where:
• C = Consumption (spending by households)
• I = Investment (spending by firms on capital goods)
• G = Government spending (expenditure on public services, infrastructure, etc.)
• X = Exports (spending by foreigners on domestic goods)
• M = Imports (spending by domestic residents on foreign goods)

Question 18

What are determinants of consumption?

Answer 18

Consumption (C) – Spending by Households

Consumption is influenced by:
• Disposable Income – Higher income increases spending.
• Interest Rates – Higher rates make borrowing expensive, reducing spending.
• Consumer Confidence – Optimistic consumers spend more.
• Wealth Effects – Rising asset prices (e.g., houses, stocks) boost spending.
• Taxation – Lower taxes increase disposable income, boosting consumption.

Question 19

What are determinants of investment?

Answer 19

Investment (I) – Spending by Firms on Capital Goods

Investment depends on:
• Interest Rates – Lower rates encourage borrowing and investment.
• Business Confidence – Firms invest when they expect future growth.
• Corporate Taxation – Lower taxes on profits encourage investment.
• Access to Credit – Easier borrowing leads to higher investment.
• Technological Advancements – Encourage firms to upgrade equipment.

Question 20

What are determinants of government spending?

Answer 20

Government Spending (G) – Public Sector Expenditure

Government spending is influenced by:
• Fiscal Policy – Expansionary policies (higher spending) increase AD.
• Economic Objectives – Governments spend more during recessions and cut spending in booms.
• Political Priorities – Military, healthcare, and infrastructure investments affect G.

Question 21

What are determinants of net exports?

Answer 21

Net Exports (X - M) – Trade Balance

Exports and imports depend on:
• Exchange Rates – A weaker currency makes exports cheaper and imports more expensive, boosting (X - M).
• Global Demand – A strong world economy increases demand for exports.
• Domestic Income – Higher domestic incomes increase imports.
• Trade Policies – Tariffs and quotas affect trade flows.

Question 22

What is accelerator effect?

Answer 22

The accelerator effect explains how investment levels respond to changes in national income.
• When demand and GDP rise, businesses invest more in capital goods to expand production.
• If demand falls or stagnates, firms cut back on investment, slowing growth.

• Small increases in GDP can lead to large increases in investment.
• If GDP growth slows, investment drops sharply.
• This can create economic cycles of booms and busts.

Question 23

What are determinants of savings?

Answer 23

Savings refer to income that is not spent on consumption. The main factors affecting savings are:

• Income Levels – Higher incomes lead to more savings.
• Interest Rates – Higher interest rates encourage saving.
• Inflation – High inflation discourages saving if real returns are negative.
• Consumer Confidence – Uncertainty about the future increases savings.
• Government Policies – Tax incentives (e.g., ISAs) encourage savings.

Question 24

What is the difference between saving and investment?

Answer 24

Saving
Income not spent on consumption
Who: Households, businesses, government
Form: Bank deposits, bonds, cash, pensions
Effect on AD: Reduces immediate consumption, lowering AD
Motivation: Future security, precautionary reasons

Investment
Spending on capital goods for future production
Who: Businesses, government
Form: Machinery, factories, research & development
Effect on AD: Increases AD in the short run, boosts long-run growth
Motivation: Expected returns, profit maximization

Savings do not directly contribute to GDP, but investment does because it increases capital stock and productive capacity. However, savings can lead to investment when financial institutions lend funds to businesses.

Question 25

What is the role of AD in influencing economic activity?

Answer 25

1. AD and Economic Growth • If AD increases (due to higher consumption, investment, government spending, or exports), firms produce more goods and services, leading to higher GDP and lower unemployment. • If AD decreases, firms cut back production, leading to lower GDP and higher unemployment. 2. AD and Inflation • When AD rises faster than the economy’s productive capacity, demand-pull inflation occurs. • If AD falls, there may be deflation or disinflation, reducing price pressures. 3. AD and the Business Cycle • Boom – High AD leads to strong growth, job creation, and inflationary pressure. • Recession – Low AD causes falling GDP, rising unemployment, and lower inflation.

Question 26

How does the multiplier process work? Why Does an Initial Change in Expenditure Lead to a Larger Impact?

Answer 26

The multiplier effect explains how an initial change in spending leads to a larger final increase in national income (GDP). When there is new spending in an economy: 1. Direct Effect – The first recipients of the spending (e.g., workers, businesses) receive income. 2. Induced Effect – They spend part of this income, generating further income for others. 3. Repetitive Process – Each new round of spending creates more income, but at a decreasing rate as some money is saved, taxed, or spent on imports.

Question 27

What are MPS, MPT and MPM?

Answer 27

MPS (Marginal Propensity to Save) = Proportion of extra income saved MPT (Marginal Propensity to Tax) = Proportion of extra income taxed MPM (Marginal Propensity to Import) = Proportion of extra income spent on imports

Question 28

How MPC determines the size of the multiplier effect?

Answer 28

If MPC is high, more income is spent, leading to a stronger multiplier effect. If MPC is low, more income is saved or withdrawn, resulting in a weaker multiplier effect. Formula: MPC = Change in consumption/ Change in income Example: • If MPC = 0.8, then Multiplier = 1 / (1 - 0.8) = 5 → £100m initial spending increases GDP by £500m. • If MPC = 0.5, then Multiplier = 1 / (1 - 0.5) = 2 → £100m initial spending increases GDP by £200m.

Question 29

What is SRAS?

Answer 29

The short-run aggregate supply (SRAS) curve shows the relationship between the price level and the total output (GDP) that firms are willing to produce, assuming that at least one factor of production (e.g., wages) is fixed. • Upward Sloping: SRAS slopes upward because higher price levels incentivize firms to increase output since their revenues rise faster than costs in the short run. • Movement Along SRAS: A change in the price level without a change in costs causes a movement along the SRAS curve.

Question 30

What are the 4 main determinants of SRAS? The price level and production costs are the key determinants of short-run AS.

Answer 30

Changes in Costs That Shift SRAS 1. Money Wage Rates (Wages per Worker) Higher wages → Higher costs → SRAS shifts left (less output, higher prices). Lower wages → Lower costs → SRAS shifts right (more output, lower prices). Example: A rise in minimum wages increases costs for firms. 2. Raw Material Prices Higher raw material costs → SRAS shifts left (e.g., oil price shocks). Lower raw material costs → SRAS shifts right (e.g., falling commodity prices). 3. Business Taxation (Corporation Tax, VAT, Employer Contributions) Higher taxes → Higher costs → SRAS shifts left. Lower taxes → Lower costs → SRAS shifts right. Example: An increase in VAT raises production costs. 4. Productivity (Output per Unit of Input) Higher productivity → SRAS shifts right (lower costs per unit). Lower productivity → SRAS shifts left (higher costs per unit). Example: Technological advancements improve efficiency, lowering costs.

Question 32

What is LRAS?

Answer 32

The long-run aggregate supply (LRAS) curve represents the economy’s maximum sustainable output (potential GDP) when all resources are fully employed. It is vertical because, in the long run, output is determined by supply-side factors rather than the price level. • Increases in AD only cause inflation in the long run unless LRAS shifts right. • The LRAS curve represents the economy’s productive capacity at full employment.

Question 33

What are the main 6 determinants of LRAS? In the long run, output depends on structural factors that affect the quantity and quality of an economy’s productive resources.

Answer 33

1. Technology • Advances in technology increase efficiency and improve production methods. • Better machinery, automation, and AI allow firms to produce more with the same resources. • Example: Industrial revolutions (e.g., steam power, electricity, digital transformation). 2. Productivity (Output per Worker/Input Unit) • Higher productivity means more output per worker or machine, increasing LRAS. • Education, training, and capital investment improve worker efficiency. • Example: Investing in research & development boosts productivity. 3. Attitudes (Work Ethic, Innovation, Risk-Taking) • A culture of hard work, responsibility, and innovation supports economic growth. • Example: Countries with strong entrepreneurial mindsets tend to grow faster. 4. Enterprise (Entrepreneurship and Business Creation) • More entrepreneurs and businesses increase competition and innovation. • Government policies (e.g., lower corporate tax, start-up grants) encourage business activity. • Example: Silicon Valley’s start-up culture drives economic expansion. 5. Factor Mobility (Labour and Capital Mobility) • Labour mobility: If workers can easily move between jobs and regions, it reduces structural unemployment. • Capital mobility: If firms can reallocate resources efficiently, productivity increases. • Example: Flexible labour markets in developed economies improve LRAS. 6. Economic Incentives (Taxes, Welfare, Investment Climate) • Low taxes and business-friendly regulations encourage investment and growth. • Strong property rights and legal systems attract foreign direct investment (FDI). • Example: Countries with pro-business policies (e.g., Singapore) tend to have higher LRAS.

Question 34

What does the position of the LRAS curve represent?

Answer 34

The LRAS curve is vertical at the economy’s normal capacity level of output (potential GDP). • It represents full employment output, meaning all resources (labour, capital, land) are efficiently used. Shifts in LRAS represent changes in productive potential: • Rightward Shift (Economic Growth): Improved technology, higher productivity, better education, increased investment. • Leftward Shift (Decline in Potential Output): Ageing population, brain drain, reduced investment.

Question 35

How important the institutional structures in determining AS? Institutional structures refer to the systems, policies, and organizations that shape how an economy functions.

Answer 35

1. The Banking System and Investment Funding • Banks facilitate business investment by providing loans and credit. • Access to finance allows firms to invest in capital goods, technology, and expansion, increasing LRAS. • Example: A well-functioning banking system in developed economies supports business growth, whereas weak financial institutions in some LEDCs hinder investment. 2. Legal and Property Rights System • Secure property rights encourage investment in capital and innovation. • Weak legal frameworks (e.g., corruption, lack of contract enforcement) reduce incentives for business expansion. • Example: Countries with strong intellectual property protection foster innovation (e.g., patents in the U.S.). 3. Education and Workforce Development • Governments that invest in education and vocational training improve labor productivity, shifting LRAS right. • A lack of investment in human capital leads to skill shortages and lower potential output. 4. Government Regulations and Taxation • Business-friendly regulations (e.g., easier business registration, tax incentives) encourage entrepreneurship. • Excessive bureaucracy and high taxation can discourage investment and reduce productive capacity. 5. Labor Market Institutions • Flexible labor markets allow firms to adjust employment based on demand, improving efficiency. • Strong unions and rigid employment laws can increase business costs and limit labor mobility.

Question 36

What is Keynesian AS curve?

Answer 36

The Keynesian Aggregate Supply (AS) curve is a model that explains how the economy responds to changes in aggregate demand (AD) at different levels of output.

Question 37

What does the Keynesian AS curve looks like?

Answer 37

1. Horizontal Section (Recession/Depression) • Output can increase without raising prices because there are many unemployed resources (idle labor and capital). • Firms can easily expand production without cost pressures. • Example: During the Great Depression, output was far below potential, and increasing AD had no inflationary effect. 2. Upward-Sloping Section (Approaching Full Capacity) • As the economy nears full employment, supply bottlenecks appear (e.g., skilled labor shortages, raw material limits). • Firms must offer higher wages and pay more for inputs, leading to moderate inflation as output increases. 3. Vertical Section (Full Employment) • When the economy reaches full capacity, output cannot increase further in the short run. • Any increase in AD only raises prices (inflation) rather than output. • Example: If factories are already running at full capacity, more demand just increases costs and prices rather than production.

Question 38

What is the difference between Keynesian AS and Classical AS?

Answer 38

Keynesian AS Curve Shape: Non-linear (flat, then upward, then vertical) Short-Run Output Adjustment: Can increase without inflation when below full capacity Long-Run Implication: Markets may not clear automatically Policy Implication: Government intervention (fiscal policy) needed in downturns Classical (LRAS) AS Curve Vertical Prices adjust, but output remains at full capacity Markets self-correct Free markets restore full employment