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• 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

• This shows the total level of expenditure at different price levels

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