Macro

Question 1

The government has four main macroeconomic objectives.

Answer 1

These aim to provide macro stability. Economic growth, Minimising unemployment, Price stability, Stable balance of payments on current account. Additionally, the government might have the following macroeconomic objectives: Balanced government budget, Greater income equality

Question 2

The performance of an economy can be measured with the following data:

Answer 2

Real GDP, Real GDP per capita, Consumer Prices Index and Retail Prices Index (CPI/RPI), Measures of unemployment, Measures of productivity, Balance of payments on current account

Question 3

National income can also be measured by:

Answer 3

Gross National Product (GNP), Gross National Income (GNI)

Question 4

The circular flow of income

Answer 4

Firms and households interact and exchange resources in an economy.
Households supply firms with the factors of production, such as labour and capital,
and in return, they receive wages and dividends.

Firms supply goods and services to households. Consumers pay firms for these.
This spending and income circulates around the economy in the circular flow of
income, which is represented in the diagram above.

Saving income removes it from the circular flow. This is a withdrawal of income.
Taxes are also a withdrawal of income, whilst government spending on public and
merit goods, and welfare payments, are injections into the economy.
International trade is also included in the circular flow of income. Exports are an
injection into the economy, since goods and services are sold to foreign countries
and revenue in earned from the sale. Imports are a withdrawal from the economy,
since money leaves the country when goods and services are bought from abroad.
Full employment income is the total output of an economy when unemployment is
minimised or is at the government target. This accounts for frictional
unemployment.

Question 5

The effect of changes in injections and withdrawals on national income

Answer 5

An injection into the circular flow of income is money which enters the economy.
This is in the form of government spending, investment and exports.
A withdrawal from the circular flow of income is money which leaves the economy.
This can be from taxes, saving and imports.

The economy reaches a state of equilibrium when the rate of withdrawals = the rate
of injections.

The amount of savings in an economy is equal to the amount of investment. In the
UK, there is a traditionally low savings rate, especially during periods of high
economic growth, and this means that the rate of investment is also low. In Japan
there is a high savings rate and with this comes a high level of investment.
If there are net injections into the economy, there will be an expansion of national
output.

If there are net withdrawals from the economy, there will be a contraction of
production, so output decreases.

Question 6

The downward slope of the AD curve can be explained by:

Answer 6

. Higher prices lead to a fall in the value of real incomes, so goods and services
become less affordable in real terms.

. If there was high inflation in the UK so that the average price level was high,
foreign goods would seem relatively cheaper. Therefore, there would be
more imports, so the deficit on the current account might increase, and AD
would fall.

. High inflation generally means the interest rates will be higher. This will
discourage spending, since saving becomes more attractive and borrowing
becomes expensive.

Question 7

Shifting the AD curve

Answer 7

. A rise in AD is shown by a shift to the left in the demand curve (AD1  AD2). This
rise in economic growth occurs when:

. Consumers and firms have higher confidence levels, so they invest and spend
more, because they feel as though they will get a higher return on them. This
is affected by anticipated income and inflation.

. If the Monetary Policy Committee lowers interest rates, it is cheaper to
borrow and reduces the incentive to save, so spending and investment
increase. However, there are time lags between the change in interest rates
and the rise in AD, so this is not suitable if a rise in AD is needed immediately.

. Lower taxes mean consumers have more disposable income, so AD rises.
. An increase in government spending will boost AD.
. Depreciation in a currency means M is more expensive, and X is cheaper, so
AD increases. A decline in economic growth in one of the UK’s export markets
means there will be a fall in X, so AD falls.

. In the UK, most people own their houses. This means that a rise in the price
of houses makes people feel wealthier, so they are likely to spend more. This
is the wealth effect.

. If credit is more available, then spending and investment might increase.
Recently, since the financial crisis of 2008, banks have been less willing to
lend due to the risks associated with lending.

Question 8

Shifting the AS curve:

Answer 8

The SRAS curve shifts when there are changes in the conditions of supply.

• The cost of employment might change, e.g. wages, taxes, labour
  productivity
• The cost of other inputs e.g. raw materials, commodity prices, the
  exchange rate if products are imported
• Government regulation or intervention, such as environmental laws
  and taxes, and business regulation. Business regulation is sometimes
  called ‘red tape’.

Question 9

Aggregate demand

Answer 9

Aggregate demand is the total demand in the economy. It measures spending on goods and
services by consumers, firms, the government and overseas consumers and firms.

It is made up of the following components, which make up the equation: C + I + G +(X-M)

Question 10

Influences on consumer spending:

Answer 10

Interest rates
. If the Monetary Policy Committee lowers interest rates, it is cheaper to
borrow and reduces the incentive to save, so spending and investment
increase. However, there are time lags between the change in interest rates
and the rise in AD, so this is not suitable if a rise in AD is needed immediately.
Lower interest rates also lower the cost of debt, such as mortgages. This
increases the effective disposable income of households.

Consumer confidence
. Consumers and firms have higher confidence levels, so they invest and spend
more, because they feel as though they will get a higher return on them. This
is affected by anticipated income and inflation.
. If consumers fear unemployment or higher taxes, consumers may feel less
confident about the economy, so they are likely to spend less and save more.
This delays large purchases, such as houses or cars.

. Wage growth. Higher wages are the most significant factor in encouraging consumer spending.

. Inflation. Inflation can be influential in determining spending. If inflation is greater than nominal wage growth, then consumers will see a fall in disposable income.

. Deflation – periods of deflation (falling prices) can also have a negative impact on consumer spending. If prices are falling, consumers may feel that prices will be cheaper in the future and therefore, they delay purchasing goods – hoping they will be cheaper. Deflation can also cause a rise in the real value of debt, squeezing incomes.

. House prices – Housing is the biggest form of wealth. When house prices are rising people are more confident to spend and they can also reportage their houses. Rising house prices cause a wealth effect – with higher prices encouraging spending.

Question 11

The accelerator process:

Answer 11

. The accelerator effect suggests that the level of investment in an economy is
related to the change in GDP. A higher rate of economic growth causes more
investment.

. If the rate of economic growth is slowing, but the economy is still growing,
the level of investment might fall.

. The level of investment is more volatile than the rate of economic growth.

Question 12

Influences on government expenditure:

Answer 12

The trade cycle, Fiscal policy, Exports minus imports

Question 13

The trade cycle

Answer 13

The trade cycle
. This is another term for the business cycle, which refers to the stage of
economic growth that the economy is in.

. The economy goes through periods of booms and busts. o Real output increases when there are periods of economic growth. This is the
recovery stage.

. The boom is when economic growth is fast, and it could be inflationary or
unsustainable.

. During recessions, there real output in the economy falls, and there is negative
economic growth.

. During recessions, governments might increase spending to try and stimulate the
economy. This could involve spending on welfare payments to help people who have
lost their jobs, or cutting taxes.

. This will increase the government deficit, and they may have to finance this.

. During periods of economic growth, governments may receive more tax revenue
since consumers will be spending more and earning more. They may decide to spend
less, since the economy does not need stimulating, and fewer people will be
claiming benefits.

Question 14

Fiscal policy

Answer 14

. Governments use fiscal policy to influence the economy. It involves changing
government spending and taxation.

. Governments might spend on public goods and merit goods, as well as
welfare payments.

. Fiscal policy is a demand-side policy, so it works by influencing the level or
composition of AD.

. Discretionary fiscal policy is a policy which is implemented through one-off
policy changes.

. Automatic stabilisers are policies which offset fluctuations in the economy.
These include transfer payments and taxes. They are triggered without
government intervention.

. The government might use expansionary fiscal policy during periods of economic decline. This involves increasing spending on transfer payments or on boosting AD, or by reducing taxes.

. During periods of economic growth, governments might use contractionary
fiscal policy by decreasing expenditure on purchases and transfer payments.
Additionally, tax rates might increase. This reduces the size of the
government budget deficit.

Question 15

The main influences on the (net) trade balances:

Answer 15

Real income, Exchange rates, State of the world economy, Degree of protectionism, Non-price factors

Question 16

The role of AD in influencing the level of economic activity:

Answer 16

The factors which influence the level of economic activity are:
- Employment: influences production and consumption
- Confidence: influences the level of spending and investment
- Events: natural disasters or Christmas influence the level of consumer spending
- Other factors: such as taxes and interest rates influence how much firms and
consumers borrow, save or spend.

Question 17

The multiplier process

Answer 17

The multiplier effect occurs when there is new demand in an economy. This leads to
an injection of more income into the circular flow of income, which leads to
economic growth. This leads to more jobs being created, higher average incomes,
more spending, and eventually, more income is created.

The multiplier effect refers to how an initial increase in AD leads to an even bigger
increase in national income.
It occurs since ‘one person’s spending is another person’s income’.

The multiplier ratio is the ratio of the rise national income to the initial rise in AD. In
other words, it is the number of times a rise in national income is larger than the rise
in the initial injection of AD, which led to the rise in national income.

Question 18

Factors influencing short-run AS:

Answer 18

. The SRAS curve shifts when there are changes in the conditions of supply.
The price level and production costs are the main determinants of SRAS.

• The cost of employment might change, e.g. wages, taxes, and labour
  productivity. If costs increase, supply will shift inwards from SRAS1 to SRAS3.
• The cost of other inputs e.g. raw materials, commodity prices, and the
  exchange rate if products are imported. A stronger currency reduces the price of imports, so imported products will be cheaper. This would
  shift the AS curve outwards, from SRAS1 to SRAS2.
• Government regulation or intervention, such as environmental laws
  or green taxes and business regulation. Business regulation is
  sometimes called ‘red tape’.
• There could be a net outward migration of workers, which causes a
  ‘brain drain’ on the domestic economy, as skilled workers move elsewhere.
• If there is a fall in business capital spending, supply will fall.

Question 19

Factors influencing the long-run AS:

Answer 19

Technological advances:
If more money is spent on improving technology, the economy can produce goods in
larger volumes or improve the quality of goods and services produced.

Changes in relative productivity:
A more productive labour and capital input will produce a larger quantity of output
with the same quantity of input.

Changes in education and skills:
This improves the quality of human capital, so it is more productive and more able to
produce a wider variety of goods and services.

Changes in government regulations:
Government regulation could limit how productive and efficient a firm can be if it is
excessive. This is sometimes referred to as ‘red-tape’.

Demographic changes and migration:
If there is net inward migration and the majority of the population is of working age,
the size of the labour force is going to be significant, which means the economy can
increase its output.

Competition policy:
A more competitive market encourages firms to be more efficient and more
productive, so they are not competed out of business. Governments can use
effective competition policy to stimulate this in the economy.

Question 20

The Keynesian AS curve:

Answer 20

The Keynesian view suggests that the price level in the economy is fixed until
resources are fully employed. The horizontal section shows the output and price
level when resources are not fully employed; there is spare capacity in the economy.
The vertical section is when resources are fully employed.

Over the spare capacity section, output can be increased (AD1 to AD2) without
affecting the price level (stays at P1). In other words, output changes are not
inflationary.

Once resources are fully employed, an increase in output (AD3 to AD4) will be
inflationary (price level increases from P2 to P3).

Question 21

The difference between short run and long run growth

Answer 21

Short run growth is the percentage increase in a country’s real GDP and it is usually
measured annually. It is caused by increases in AD.

Long run economic growth occurs when the productive capacity of the economy is
increasing and it refers to the trend rate of growth of real national output in an
economy over time. It is caused by increases in AS.

The potential output of an economy is what the economy could produce if resources
were fully employed.

Question 22

A negative output gap

Answer 22

A negative output gap occurs when the actual level of output is less than the
potential level of output.
This puts downward pressure on inflation. It usually means there is the
unemployment of resources in an economy, so labour and capital are not used to
their full productive potential. This means there is a lot of spare capacity in the
economy.

Question 23

A positive output gap

Answer 23

A positive output gap occurs when the actual level of output is greater than the
potential level of output.

It could be due to resources being used beyond the normal capacity, such as if labour
works overtime. If productivity is growing, the output gap becomes positive. It puts
upwards pressure on inflation.
Countries, such as China and India, which have high rates of inflation due to fast and
increasing demand, are associated with positive output gaps.

Question 24

Characteristics of a boom:

Answer 24

High rates of economic growth

Near full capacity or positive output gaps

(Near) full employment

Demand-pull inflation

Consumers and firms have a lot of confidence, which leads to high rates of
investment

Government budgets improve, due to higher tax revenues and less spending on
welfare payments

Question 25

Characteristics of a recession:

Answer 25

In the UK, a recession is defined as negative economic growth over two consecutive
quarters. The characteristics are:

. Negative economic growth

. Lots of spare capacity and negative output gaps

. Demand-deficient unemployment

. Low inflation rates

. Government budgets worsen due to more spending on welfare payments and lower
tax revenues

. Less confidence amongst consumers and firms, which leads to less spending and
investment

Question 26

The costs and benefits of economic growth for consumers:

Answer 26

Costs:

Economic growth does not benefit everyone equally. Those on low and fixed incomes might feel worse off if there is high inflation and inequality could increase.

There is likely to be higher demand-pull inflation, due to higher levels of consumer spending.

Consumers could face more shoe leather costs, which means they have to spend more time and effort finding the best deal while prices are
rising.

The benefits of more consumption might not last after the first few units, due to the law of diminishing returns, which states that the utility consumers derive from consuming a good diminishes as more of the good is consumed.

Benefits:

The average consumer income increases as more people are in employment and wages increase.

Consumers feel more confident in the economy, which increases consumption and leads to higher living standards.

Question 27

The costs and benefits of economic growth for firms:

Answer 27

Costs:

Firms could face more menu costs as a result of higher inflation. This means they have to keep changing their prices to meet inflation.

Benefits:

Firms might make more profits, which might in turn increase investment. This is also driven by higher levels of business confidence.

Higher levels of investment could develop new technologies to improve productivity and lower average costs in the long run.

As firms grow, they can take advantages of the benefits of economies of scale.

If there is more economic growth in export markets, firms might face more competition, which will make them more productive and efficient, but it will also give them more sales opportunities.

Question 28

The costs and benefits of economic growth for the government:

Answer 28

Costs:

Governments might increase their spending on healthcare if the consumption of demerit goods increases.

Benefits:

The government budget might improve, since fewer people require welfare payments and more people will be paying tax.

Question 29

The costs and benefits of economic growth for current and future living standards:

Answer 29

Costs:

High levels of growth could lead to damage to the environment in the long run, due to increase negative externalities from the consumption and production of some goods and services.

Benefits:

As consumer incomes increase, some people might show more concern about the environment.

Also, economic growth could lead to the development of technology to produce goods and services more greenly.

Higher average wages mean consumers can enjoy more goods and services of a higher quality.

Public services improve, since governments have higher tax revenues, so they can afford to spend on improving services. This could increase life expectancy and education levels.

Question 30

The causes of cyclical instability

Answer 30

The sustainability of economic growth, Excessive growth in credit and levels of debt, Asset price bubbles, Destabilising speculation and animal spirits, Herding