How the Macroeconomy works

What is Aggregate demand?

What is Aggregate demand?

The total planned spending on the goods and services within an economy in a given time period.

It’s composed of consumption, investment, government spending, and net exports.

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

Why does the AD curve slope downwards?

Trade effect/ Net export - as UK price levels decrease, exports become more competitive and their are fewer imports into the UK, this results in an increase in real output and AD.

Real balance effect- as price levels fall, the purchasing power of income increases and the real value of income leading to greater consumption and higher aggregate demand.

Interest rate effect- as price level falls, interest rate falls, causing a higher level of consumption and investment due to a lower cost of borrowing, and so resulting in an increase in aggregate demand.

What is the marginal propensity to consume?

The willingness of households to spend any extra money that they earn.

Marginal propensity to consume= change in consumption/ change income

What is the multiplier effect?

Any expenditure generates a trail of subsequent expenditure so that the resultant change in national income will exceed the amount initially spent.

Multiplier effect= 1/(1-MPC)

What are the factors that determine consumption?

• Level of real disposable income (e.g change in income tax)

• Interest rates/ availability of credit

• Consumer confidence (e.g job prospects, level of employment, expected income and expected changes to personal wealth)

• Wealth effect (e.g an increase or decrease in house prices and share prices)

• Expected future income

• Distribution of income

• Expectations for future inflation

• Range/ trustworthiness of financial institutions (developing countries)

• Tax incentives e.g ISAs

• Age structure of population

What’s investment?

What are the two types?

When firms spend money on capital goods to increase their productive capacity. Either from retained profits or borrowing)

Replacement investment- maintains the size of the existing capital stock by replacing worn out material.

Net investment- adds to the capital stock, increasing productive potential.

What factors can influence the level of investment?

1) Interest rates (low interest rates, low cost of borrowing and easier to reach the hurdle, therefore marginal propensity to invest increases)

2) The level of business confidence (expected future profit and the expected future demand within the economy)

3) Fiscal policy ( cooperation tax- retained profit) (Incentives to earn profit)

4) Spare capacity.

5) Level of competition.

6) Price of capital and labour

7) The nature of technical progress

9) Government support

10) The adequacy of financial institutions in supplying investment funds

What is the accelerator process?

Firms try to maintain a fixed ratio of capital-output. This means that firms invest in the same amount of capital each year as their output each year. If output is constant, investment is constant, if the rate of growth of output accelerates, investment increase, conversely, if the rate of output decelerates, investment decreases.

What is aggregate supply?

The total amount of goods and services the whole economy can supply at every given price level.

What is short run aggregate supply?

The short run is a time periods when the price of all factor inputs/ prices are fixed.

Why is it short run aggregate supply upward sloping?

For firms to produce a greater larger output, the prices (of their goods) must rise in order to offset the higher production costs which come with producing a larger output, as to increase or maintain profits.

What determines short-run aggregate supply (rightward shift)?

Price level and production costs:

• A fall in unit labour costs (fall in wages or increase in labour productivity)

• Fall in costs of production (e.g raw materials)

• A reduction in indirect taxes (e.g VAT)

• An increase in subsidies granted to firms by the government

• An increase in technology

• Import prices

What is long-run aggregate supply?

The maximum level of output an economy can produce when an economy is on its production possibility frontier, it cannot exceed this for long amounts of time (sustainably) but can for short amounts. Full employment of the factors of production. It is perfectly inelastic as it’s independent of price.

What are the determinants of long-run aggregate supply?

• Labour productivity: quantity( birth rate, retirement age, immigration/emigration) and quality (training and education)

• Productive efficiency of the economy (mobility of factors)

• Land quantity (discovery of new resources) and quality (flood defences)

• Capital (investment, technological advances)

• Enterprise (personal enterprise, immigration, training and support)

• The institutional structure of the economy

What is short run equilibrium?

AD= SRAS but does not equal LRAS. LRAS could be less than or greater than. This will not persist in the long-run as it’s not sustainable (e.g workers working over time).

What is long run equilibrium?

AD= SRAS =LRAS. The economy is at the maximum level of output.