macro 2.2, 2.3, 2.4 and 2.5 - AD, AS, national income and economic growth ✅ Flashcards
aggregate demand (AD)?
AD- total demand for a countries goods/services at a given price level in a given time period
equation?
AD= C+I+G+NX
- consumption (C) —> consumer spending on goods and services —> makes up around 65% of AD
- investment (I) —> when firms spend money on capital goods to increase their productive capacity e.g. new equipment —> makes up around 15-20% of AD
- government spending (G) —> makes up around 18-20% of AD
- net exports (NX) (X-M) —> large trade deficit in the UK (imports > exports) —> makes up around 5% of AD
AD curve?
what does the AD curve show?
- shows the inverse relationship between price level and real GDP
what causes movement along AD curve (extension/contraction in AD)
- a movement along the AD curve is caused changes in the price level
- an increase in price causes a contraction in demand
- a decrease in price causes an extension in demand
how do changes in the price level affect AD?
- wealth effect —> as price level decreases from P1 to P2 —> purchasing power increases —> people are richer —> consumption increases —> extension of AD
- trade effect —> as price level decreases from P1 to P2 —> exports become more competitive —> demand for exports increases —> revenue from exports increases// imports become less competitive as domestic goods and services are more competitive —> import expenditure decreases —> X-M increases —> extension of AD
- interest effect —> if inflation is low (P2) then interest rates can be kept low —> ROR on savings decreases —> greater incentive to spend —> MPC increases —> consumption increases —> extension of demand
what causes the AD curve to shift?
- a shift of the AD curve is caused by a change in the components of AD = C + I + G + (X-M)
- shift to the right —> increase in AD
- shift to the left —> fall in AD
what factors affect consumption which then affects AD? (WICT)
wealth effect:
- when house prices increase, people will feel wealthier —> higher MPC —> consumption increases —> AD shifts right
interest rates:
- interest rates are cut —> cost of borrowing falls and ROR on savings fall —> increases incentive to borrow money and decreases incentive to save —> consumption increases —> AD shifts right
confidence levels:
- high confidence in job prospects and state of the economy e.g. pay rises and low likelihood of unemployment —> higher MPC —> consumption increases —> AD shifts right
taxes:
- income tax decreases —> disposable income increases —> MPC increases —> consumption increases —> AD shifts right
disposable income - money consumers have left to spend, after taxes have been taken away and any state benefits have been added
consumption is the largest component of AD —> makes up around 65% of AD
marginal propensity to consume and save? average propensity to consume and save?
- MPC- how much a consumer changes their spending following a change in income —> MPC= change in consumption/change in income
- MPS- how much a consumer changes their savings following a change in income —> MPS= change in savings/change in income
- MPC + MPS = 1
- average propensity to consume- average amount spent on consumption out of total income —> APC = consumption/income
- average propensity to save- average amount saved out of total income —> APS= total savings/total income
what factors affect investment which then affect AD? (CCCIP)
definitions:
- investment- when firms spend money on capital goods to increase their productive capacity e.g. machinery
- gross investment- total amount that the economy spends on new capital
- net investment- gross investment - capital depreciation
- capital depreciation- where machinery loses its value over time as it wears out or gets used up
factors that affect investment:
- confidence (animal spirits- john maynard keynes) —> if expectation of profit and demand is high —> MP to invest increases —> investment increases
- competition —> if competition is strong, businesses will want to invest to try and get ahead of their competition —> MP to invest increases —> investment increases
- corporation tax (tax on business profits) —> the lower the corporation tax, the higher the level of retained profit —> more money to invest —> MP to invest increases —> investment increases
- interest rates —> cost of borrowing falls —> greater incentive to borrow money and invest —> MP to invest increases// low interest rates —> ROR on savings falls —> greater incentive to spend —> MPC increases —> business confidence increases due to more demand —> MP invest increases —> investment increases
- price of capital —> low prices mean that investment is cheaper —> MP to invest increases —> investment increases
what factors affect net trade which then affect AD? (DINER)
degree of protectionism:
- protectionism —> attempt to prevent domestic producers suffering from competition abroad —> tariffs (taxes on imports —> imports more expensive) and quotas (limits amount of imports) are introduced to make it harder for producers from abroad to sell their goods in the UK
- strong protectionism abroad —> prevent us accessing international markets —> export revenue decreases —> net trade decreases// low protectionism abroad —> easier to access international markets and to sell exports —> export revenue increases —> net trade increases
- strong protectionism at home —> high protectionism on imports coming into the UK —> import expenditure will be low —> net trade increases// low protectionism at home —> low protectionism on imports coming into the UK —> import expenditure will be high —> net trade decreases
inflation:
- high relative inflation (if inflation in UK is higher than inflation in other countries) —> UK exports are less competitive —> demand for exports decreases —> export revenue will decreases —> net trade decreases// import expenditure will rise as goods are cheaper abroad —> net trade decreases
- low relative inflation —> UK exports are more competitive —> demand for exports increases —> export revenue increases —> net trade increases
non price factors:
- design and branding —> If UK goods are of a better design and branding —> demand for exports increases —> export revenue increases// demand for imports decreases as consumers will domestic goods instead of foreign goods —> import expenditure decreases —> net trade increases
exchange rates:
- strong exchange rate —> imports cheaper —> demand for imports increases —> import expenditure increases//exports more expensive (less competitive) —> demand for exports decreases —> export revenue decreases —> net trade decreases (opposite for weak exchange rate)
real income/state of the economy:
- boom abroad —> disposable income earned abroad increases —> MP to import increases —> demand for exports increases —> export revenue increases —> net trade increases// recession abroad —> disposable income earned aboard decreases —> MP to import decreases —> demand for exports decreases —> export revenue decreases —> net trade decreases
- boom in the UK —> disposable income earned at home increases —> MP to import increases —> import expenditure increases —> net trade decreases// recession in UK —> disposable income earned at home decreases —> MP import decreases —> import expenditure decreases —> net trade increases
what factors affect government spending which then affects AD?
- Trade cycle —> In a recession, the government may increase spending in order to increase demand// In a boom, the government may decrease spending to decrease demand
- Debt Levels —> High levels of debt may limit government spending
- Tax Revenue —> Higher tax revenues provide more funds for government spending
different types of government spending:
- current spending - spending on the maintenance of public services and payment of public sector wages
- capital spending - spending on infrastructure projects
- welfare spending - spending on benefits and pensions (biggest chunk of gov spending in the UK)
- debt interest payments
- budget deficit - government spending > taxation in a fiscal year
- budget surplus - government spending < taxation in a fiscal year
- national debt - total stock of debt over time - accumulation of budget deficits
business cycle
actual growth - rises and falls
trend growth - upwards sloping curve
characteristics of a boom:
boom - actual growth is higher than trend growth —> positive output gap
- high profits, low unemployment, high consumer and business confidence, high demand for imports, high tax revenues, demand pull inflation
recession - 2 successive quarters of negative growth
(between boom and trough)
trough - actual growth is lower than trend growth —> negative output gap
characteristics of a recession and trough:
- low profits, high unemployment, low consumer/ business confidence, low demand for imports, low tax revenues, house prices fall due to high unemployment and low consumer confidence
recovery
- rising consumer/business confidence, higher house prices, loose policy to prevent economy going back into recession
why are there fluctuations in actual growth?
- shocks —> unexpected and can’t be predicted
demand side shocks - when there’s a sudden change in the demand of goods/services
- sudden increase in interest rates —> cost of borrowing increases and ROR on savings increase —> reduces consumer spending and business investment —> AD decreases
- sudden strengthening of exchange rate —> imports are cheaper and exports are more expensive —> demand for exports increases —> net exports decreases —> AD decreases
- sudden increase in tax —> reduces disposable income and businesses profitability —> spending and investment decreases —> AD decreases
supply side shocks
- natural disasters, wars, sudden increase in COP
aggregate supply (AS)?
aggregate supply —> volume of goods and services produced within the economy at a given price level
what does the AS curve show?
- shows the direct relationship between price level and real GDP
what causes a movement along the AS curve?
- a movement along the AS curve is caused by changes in the price level (extension and contraction)
- an increase in price causes an extension in supply
- a decrease in price causes a contraction in supply
classical diagram SRAS
- AD curve
- SRAS curve (normal upwards sloping supply curve)
- can show negative/positive output gap using this diagram
classical diagram LRAS
- LRAS curve (vertical line) —> in the LR, the economy will always produce at this level of output (YFE)
- YFE —> maximum level of output an economy can produce using all FOP at sustainable levels (can increase output beyond YFE e.g. using FOP unsustainably —> using labour overtime)
what causes SRAS curve to shift?
changes in COP
- wages —> wages increase —> COP increases —> SRAS shifts left
- raw material/commodity prices —> price increases —> COP increases —> SRAS shifts left
- business taxes (VAT) —> business tax increases —> COP increases —> SRAS shift left
- import prices —> import prices increase when there’s a weak exchange rate —> COP increases —> SRAS shift left
what causes the LRAS curve to shift?
changes in the quantity/quality of FOP and productive efficiency (Q^2 CELL/productive efficiency)
- competition —> productive efficiency increases as firms want to reduce costs —> LRAS shifts right
- reducing welfare benefits —> incentivises inactive to enter the labour force —> quantity of labour increases —> LRAS shifts right
- income tax cuts/corporation tax cuts —> lower income tax —> incentive for inactive to enter the labour force —> quantity of labour increases// for those in work, greater incentive to work harder as they can keep more of their money as disposable income —> quality of labour increases —> LRAS shifts right// lower corporation tax —> higher retained profit —> investment increases —> increases quality/quantity of capital and productive efficiency increases
- government spending on education/training —> human capital increases —> productivity increases —> quality of labour increases —> LRAS shifts right
- government spending on healthcare —> more ppl treated and therefore less absenteeism —> quality of labour improves —> LRAS shifts right
- government spending on housing supply/transportation —> reduces labour immobility —> quantity of labour increases —> LRAS shifts right
- subsidies to firms to promote investment —> quality/quality of capital increases/productive efficiency increases —> LRAS shifts right
keynesian:
- LRAS (not the vertical curve - the other one)
why does the keynesian curve look the way it does?
- economy producing less than YFE (elastic part of curve) —> lots of spare capacity so it’s easy to increase production —> as we get closer to YFE, we’re using up spare capacity —> more pressure is placed on FOP as more of it is used up e.g. labour is becoming scarcer so wages will have to rise/ capital is becoming scarcer so firms will have to pay more —> COP increases —> pass that onto consumers via higher prices —> inflation starts to occur —> we get to the point where all FOP are used and it’s not possible to increase output sustainably
output gaps
negative output gap- where actual output is less than potential output
positive output gap- where actual output is greater than potential output
classical:
- SRAS curve (upwards sloping supply curve)
- AD curve
- AD and SRAS = equilibrium —> LRAS (YFE) curve to the left of E —> positive output gap// LRAS (YFE) curve to the right of E —> negative output gap
keynesian:
- LRAS curve (YFE)
- AD curve
- YFE to the right of Y1 —> negative output gap// positive output gap - draw AD on LRAS curve at highest point of LRAS and draw on P and YFE as normal
circular flow of income?
circular flow of income —> how money flows around the economy between households and firms
- households provide 4 FOP to firms (capital, enterprise, land and labour)
- firms combine FOP to produce goods + services —> households will receive factor incomes from firms —> households will spend this on goods and services made by firms
diagram:
- households box top and firms box below
- draw arrows from firms to households around the outside
- outside arrows: firms —> households = factor income// households —> firms = consumer expenditure
- inside arrows: households —> firms = FOP// firms —> households = goods/services
- withdrawals/leakages —> money flowing out of the circular flow of income
- examples of leakages:
- savings (S)
- taxes (T)
- imports (M)
- injections: —> money flowing into the circular flow of income
- examples of injections:
- investment (I) —> firms will spend money in the economy
- government spending (G) —> government will spend money in the economy
- exports (X) —> foreigners will spend money in the economy
circular flow of income on economic growth?
- injections > leakages —> more money entering than leaving —> economic growth will increase
- injections < leakages —> more money leaving than entering —> economic growth decrease
- injections = leakages —> macro economic equilibrium
- wealth —> things people own e.g. houses and possessions
- income —> money people receive e.g. money from work and interest from savings
economic growth and how to calculate output?
economic growth —> an increase in real GDP in an economy in a year caused by an increase in AD or an increase in LRAS
how to calculate output?
- output (O) —> final value of all goods/services produced in an economy in a year
- income method (Y) —> adding up all factor incomes earned in the economy in a year (wages, profit, interest and rent)
- expenditure (E) —> C + I + G + (X - M)
- output = income = expenditure
multiplier effect and accelerator effect
multipler effect —> an initial increase in AD will lead to an increase in growth which will lead to a further increase in AD which leads to further economic growth
example of a positive multipler effect:
- lower income tax —> disposable income increases —> MPC increases —> C increases —> C is a component of AD —> AD shifts right —> econ growth —> as a result of econ growth, this could attract investors and incentive them to invest —> I increases —> I is a component of AD —> AD shifts right —> econ growth —> positive multiplier effect
diagram for positive multiplier effect:
- normal AD and AS diagram with 3 shifts in AD
equations:
- multiplier = 1/1 - MPC —> same as 1/MPS
- multiplier = 1/MPW —> same as 1 /MPS + MPT + MPM —> (leakages) (money taken out of the circular flow of income)
- MP_ —> change in ___ following a change in income
- times (x) the multiplier by the initial increase in spending
positive multiplier effect?
- when an initial increase in an injection leads to a greater final increase in the level of real GDP
negative multiplier effect?
- when an initial decrease in an injection leads to a greater final decrease in the level of real GDP
what factors affect the multiplier value?
- MPC affects the multiplier value —> the smaller the MPC, the smaller the multiplier value:
- savings increase —> MPC smaller —> smaller multiplier valu
- taxation levels are high —> MPC smaller —> smaller multiplier value
- MP to import increases —> MPC on domestic goods/services decreases —> smaller multiplier value
accelerator effect —> changes in investment can be directly linked to changes in the rate of change of GDP growth
- increase in the rate of economic growth —> investment increases
- decrease in the rate of economic growth —> investment decreases
e.g. increase in rate of economic growth —> businesses feel more confident —> MP invest increases —> investment increases —> AD shifts right
costs and benefits of economic growth
Individuals:
- Firms are making more profit —> higher wages for workers —> higher disposable income —> standard of living increases ✅
- Higher employment —> economic growth —> demand for goods and services increases —> labour is a derived demand —> employment increases (key economic objective) ✅
- There will be an increase in demand for housing as people have more money —> this will increase house prices. Shares are likely to increase in value as businesses are making more money. The rising prices of shares and housing will increase wealth and lead to positive wealth effect —> MPC increases —> consumption increases ✅
- Inflation —> demand pull inflation —> erodes purchasing power —> living standards decrease ❌
firms:
- higher profits for firms —> if people have more disposable income then demand for goods/services will increase —> higher retained profits —> business confidence increases —> MP to invest increases —> investment increases —> technology improves —> COP decreases —> combination of higher demand and lower costs is likely to lead to higher profits ✅
- firms who sell inferior goods may lose out ❌
government:
- fiscal dividend for government (increase in tax revenue) —> income tax will rise as households are earning more income/ VAT revenue will rise as money is spent on goods and services/ corporation tax will rise as firms are making more profit —> government can improve public services ✅
- current account deficit —> income rise —> demand for imports increase —> import expenditure increases —> worsens current account deficit ❌
evaluation:
- environmental costs —> e.g. deforestation, air pollution and resource depletion —> NE in production
- income inequality —> if growth comes from 1 dominant sector, high incomes may be contained to that sector/ jobs created from economic growth may be bad quality
- sustainable growth is desired —> growth without inflation or environmental costs
