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Standard Level
Circular flow
The way in which income flows around the
economy, from firms to households and back to
firms in a continuous process
...


The output method measures the sum of all of the
value added by firms in the economy
...

The income method measures the value of all the
incomes earned in an economy (wages, interest and
rent)
...
It is measured by the
following formula C + I + G + (X-M)
...

Nominal GDP
The value of all goods and services produced by an
economy in a year
(Real) GDP per capita
(Real) GDP/population
...

Real GDP
The value of all goods and services produced by an
economy in a year adjusted for inflation
GNI
GNI measures the goods and services produced by
factors of production owned by residents of a
country i
...
country A‟s GNI is the goods and
services produced by its factor of production which
are located in country A and those located abroad
...

Weaknesses of GDP as a measure of
economic activity:
1
...
Informal (black ) markets
3
...
Other quality of life concerns
Weaknesses of GDP as a measure of
living standards:
1
...
Working Hours
3
...
Inequality

Why measure economic activity
1
...

2
...
To measure the performance of the economy
against other economies
...
To advise monetary and fiscal policy
(expansionary if recession etc)
5
...


1

3
...

Unemployment will be high, Consumption and
Investment low
...

4
...
Unemployment begins to fall
...
Wages
also start to move upwards
...
Boom (peak): Output is high
...
This leads to
inflationary pressure
...

2
...
Income and employment falls
...
Inflation falls
...
Occurs in a
boom
...

Negative output gap = when real output/GDP is
below the potential level of output
...
Deflationary
...
Occurs in a boom
...
Occurs in a boom
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Keynesian diagram: Negative output gap = when
real output/GDP is below the potential level of
output
...
Deflationary
...


Monetarist diagram: Negative output gap = when
real output/GDP is below the potential level of
output
...
Deflationary
...

Alternatively, the economy moving through various
stages including booms, recessions, slumps and
recoveries
...
Biggest component of AD
...


Determinants of Aggregate Demand
Consumption,
Investment,
Government Spending and
(X-M)
Determinants of consumption are:
A
...
Changes in interest rates
C
...
Changes in expectations/consumer
confidence
E
...

B
...

D
...


Determinants of Investment
Changes in Interest Rates
Business confidence
Technological change
Business taxes
Level of corporate indebtedness

(X-M)
What causes changes in Exports?
A
...
Level of National Income in trading partners
countries
C
...
The exchange rate
B
...
Changes in the level of protectionism
Factors that cause a shift in the SRAS curve
A
...
A change in the cost of raw materials
C
...
A change in government taxes
E
...
Keynesian‟s believe that
markets do not adjust well to economic shocks, and
that prices (and especially wages) are sticky
downwards
...

Macroeconomic Equilibrium
Equilibrium is the level of National Income (Y)
where AD is equal to AS
...
Changes in income tax
Government Spending:
It refers to any money that central or local
government spends on goods and services
...


Long Run Aggregate Supply (LRAS)
Two very different views:
1
...

2
...

Monetarists/New classicals vertical LRAS curve
Monetarist argue that the potential output of an
economy is based solely on the quantity and quality
of its factors of production (it is independent of
price)
...

The impact of any changes in AD will be on the
price level only – output will always be Yf in the
long run
...
Therefore they recommend that the
government does not stimulate the economy using
(G) when the economy is at Yf
...


Keynesians
...
They
also believe that equilibrium can remain below the
level of full employment if there is insufficient
demand in the economy
...

Macroeconomic Objectives
1
...
Low and stable inflation
3
...
Equity in the distribution of income
Potential growth
An increase in the amount an economy can produce
(increase in PPF)
...

Wages are sticky downwards
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If AD shifts from AD1 to AD2 real output will
increase from Y1 to Y2 and the economy will
experience inflationary pressure – the price level
increases from P1 to P2
...
The closer output gets to Yf the scarcer
resources become and the greater the inflationary
impact of any increase in AD
...

Monetarists believe using increases in AD to
increase real output/employment will only work in
the short run and in the long run such attempts will
lead to an increased price level, but no gain in real
output
...

Economic Growth can be described in a 2 of ways:
1
...
An increase in potential output (increase in
the PPC)
...

Diagrammatically:

4 things that can increase potential growth:
1
...
Investment in human capital
3
...
Policies to encourage competition
1
...
However, it‟s
usefulness depends upon:
- Who gets the extra goods and services – few
or many
- What is produced – guns vs bread
3
...

Costs of Economic Growth
1
...
Causes a Current Account deficit
3
...
Loss of quality of life
5
...
Causes a Current Account deficit
Imports are income elastic
...

4
...
This
means that their quality of life may be reduced
(conflict between living standards and quality of
life)
...
”

Unemployed: People willing and able to work but
who can not find work
...

2
...

4
...
Lifts people out of poverty
Economic growth lifts huge numbers of people out
of poverty each year
...

4
...

1
...
However, this inflationary pressure
can be reduced by increases in potential output
...
Widens distribution of income
In times of high economic growth the rich get richer
(owners of capital) quicker than the poor become
better off so therefore there is an widening of the
distribution of income
...
High economic growth bring
sustainability issues
Economic growth depletes resources and damages
the environment
...

Labour force: People of working age who are not
students, homemakers (house wife/husband) or
disabled
Natural Rate of Unemployment
...

Level of unemployment: The number of people
willing and able to work but who can not find
employment
...
Count the numbers of people registered as
unemployed or the number claiming benefits (two
different things)
...
The labour force survey: Government surveys
the population to identify the unemployed and
employed
...
Classical or real wage unemployment:
2
...
Frictional Unemployment
4
...
Structural unemployment:

2
...
e
...

Solutions:
- Expansionary fiscal policy
...
May contribute to crowding out
...
However, there is
no guarantee that reducing interest rates will have
the desired affect on Consumption or Investment
4
...
Building/hotel workers are in less demand
in the winter
Solution:
Reduced by encouraging people to take different
jobs in their “off season” by reducing
unemployment benefit and increasing information
about vacant jobs
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Education and training to increase occupational
flexibility
...
Adult retraining programmes
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Government subsidised training by firms
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Decrease geographical immobility

labour market is in equilibrium (no cyclical or real
wage unemployment)
...

Full employment: The level of unemployment at
which all those who wish to work have found a job
...
Hidden unemployment
2
...
Classical or real wage unemployment:
Caused when the real wage rate is too high for the
labour market to clear i
...
for everybody who wants
a job to get one
...
Reduce the power of Trade Unions
2
...
Frictional Unemployment
Time spent whilst workers leave one job and find
another
...

Solutions:
1
...

2
...
Structural unemployment
A long term problem
...

Three types:
Technological
Geographical
Decline in demand for a particular labour skill
Solutions to structural unemployment – market
based policies
1
...
De-regulate employment contracts between
employers and employees
...
Loss of GDP
2
...
Increased unemployment benefits payments
4
...
Increased crime rates (high unemployment = low
incomes = greater temptation for crime)
2
...
High level of indebtedness as individual‟s
income does not cover expenditure
...
Loss of income
2
...
Increased level of indebtedness

Demand side:
Expansionary fiscal policy
However:
- Government may have to run a budget deficit
- If taxes are reduced consumers may not spend the
extra disposable income (saved instead)
- There is a time lag between the implementation of
a policy and its affect
- Expansionary monetary policy can also be used
i
...
reducing interest rates
...

Disinflation
Disinflation is a decrease in the rate of inflation – a
slowdown in the rate of increase of the general
price level of goods and services
Deflation
Deflation is a decrease in the general price level of
goods and services
...
Investment in Human Capital
B
...
Industrial policies

Issues associated with measuring inflation
1
...

2
...
Changes in consumption patterns
4
...
CPI/RPI are not a good predictor of future
inflation
The causes of Inflation:
1
...
Cost-push

Are demand side or supply side policies better at
dealing with unemployment?

Types of market based SSPs
A
...
Incentive-related policies
However:
1
...
Costly
Measuring inflation
Inflation is measured by examining the change in a
weighted index of the prices of a basket of goods
and services consumed by typical households
...
These 650 items are called the
„basket of goods‟
...
The % change is the rate
of inflation
...
It is the prices
at which the producer is selling their goods and
therefore omits distribution costs, retail mark up
etc
...

Demand pull inflation:
AD increases faster than AS causing more demand
for goods and consequently their price is bided up
...
Monetarists‟ inflation

Cost push inflation
Increases in companies‟ costs which are passed on
to the consumer in the form of higher prices
...

There are a number of causes of cost push inflation:
 The cost of raw materials rises
 The cost of imported raw materials rise
 The power of trade unions increases which
increase wages
Costs of Inflation
1
...
Inflation can erode the value of savings
...
Effect on interest rates
...
Increased uncertainty for businesses
5
...

6
...

SSPs to reduce cost push inflation:
If cost push inflation is the concern, supply sided
policies may be better
...

Reasons why individual’s income may vary:
- Unequal ownership of the factors of production
(factory owners have high incomes)
- Differences in skills
- Differences in human capital
- Differences in length of hours worked
- Differences in the difficulty of the job done
Causes of wealth inequality:

Demand pull inflation can be initiated in various
ways:
 a consumer boom wherein consumers
increase their spending (C)
 an increase in investment by firms (I)
 an increase in government spending (G)
 an increase in net exports; this will cause
inflation when there is a shortage of
resources (X-M)
Monetarist’s inflation
Any increase in the money supply that is not backed
up by an increase in GDP will lead to inflation
...

Income
Income is a flow concept
...

Wealth
Wealth is a stock concept
...

Absolute poverty
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-

Difference in incomes
Inheritance

Relative poverty
When a household‟s income is insufficient to allow
its member to participate in the normal social life of
the country
...
Relative
poverty exists in all countries
...
25 a day, or where a household‟s income is
insufficient to purchase the minimum bundle of
goods and services needed for survival
...
The further away from the
diagonal line the curve is the greater the inequality
of distribution of income
...
Direct tax definition:
Lorenz Curve and represents it as a percentage of
A tax paid directly to the government by the
the whole area under the diagonal line
...
Examples:
the Gini Index number the greater the income
Income tax
...

(or wealth)
...

Corporation tax
...

2
...
Example: Expenditure tax
such as VAT or GST
...
How income is redistributed in
income as income rises
...

A country that primarily uses progressive taxation
will achieve greater equality (and equity!) than a
country that primarily uses regressive taxation
...
Can be used to reduce externalities (increase
1
...
Increase prices (inflationary)
2
...
Unavoidable
Advantages of Direct Taxation
Disadvantages of Direct Taxation
1
...
Increases disincentive to work
Government intervention
Benefits:
Governments use their tax and benefit system to
Transfer payments
...

Benefit, Incapacity Benefit and Working Families‟
Tax Credit (for individuals with low wages)
...

Government intervention that could ensure a
1
...
Transfer payments (benefits)
These include cash payments such as
Unemployment Benefit, State Pensions, Child
Benefit, Incapacity Benefit and Working Families‟
Tax Credit (for individuals with low wages)
...
However, if transfer payments such as
Unemployment Benefits are too high this can act as
a de-incentiviser for the unemployed to find work
...
Subsidies for necessity goods (rice,
kerosene etc)
Government can provide a subsidy to producers of
necessity goods which will lower their price for
consumers
...
However, subsidies are expensive and come
with an opportunity cost
...

6
...
However, a minimum wage above
equilibrium may lead to increased unemployment
...
However, progressive
tax de-incentivises people from striving to earn
more as an increasing amount of their income will
be taken in income tax
...
Spending on merit and public goods
(benefits in kind)
The other way government might redistribute
income from the well off to the poor is through
benefits in kind (usually merit goods), which
includes healthcare and education
...
Those who are poor can access these
services but will not be paying for them through the
tax system as their incomes are low
...
Price controls for basic goods (rice,
kerosene etc)
Sets a maximum price for necessity and therefore
increases the standard of living for the less well off
in society
...


Long term policies
Governments can use policies other than the
redistribution of taxation to decrease inequality,
however, the benefit of these will only be felt in the
long run:
- Increase secondary school and tertiary level
completion rates
- Retraining programmes- especially to help those
people suffering as a result structural
unemployment
...

- A national minimum wage may be useful,
especially in countries with a large population of
working poor
...

Fiscal policy
The use of government spending and taxation (and
public sector borrowing) in order to influence the
level of AD in the economy
...

Types of government spending
...
Requires a Public Sector Net Cash
1
...

2
...
Surplus can be used to repay part of the
that are provided on a recurrent basis every week,
national debt
...

3
...

available through the social security system
The money a government needs to borrow if it runs
including the Jobseekers‟ Allowance etc
a budget deficit for the year
...

Budget deficits, the PSNCR and National Debt
Budget deficits are not considered a problem if:
If a budget deficit occurs then the government will - They‟re small
borrow money
...
This will increase the national debt
...
Autonomous fiscal policy
- They‟re large
2
...
Autonomous fiscal policy
Gov expenditure, borrowing and taxation will all
rise or fall automatically depending on the
economy's position in the trade cycle
...


2
...

Discretionary means that the government will make
a decision to change government expenditure or

For example:
In a boom, gov spending will fall as more workers
have jobs so the gov pays out fewer benefits (G
down)
At the same time more people working and buying
goods therefore indirect tax to gov up
...

Expansionary fiscal policy
 Gov spending up
 Tax down
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taxation in order to influence the economy in a
specific way
...


Contractionary fiscal policy – how it works
Indirect tax up (tax on expenditure) - consumers
spend less on goods and services – C down –
therefore AD down – by how much depends on 1
...
The size
of the multiplier
...

Contractionary fiscal policy – how it works
Government spending down – workers have less
money/Ue higher – C down – therefore AD down –
by how much depends on 1
...
The size of the
multiplier
...

The impact of contractionary/expansionary
fiscal policy depends upon the elasticity of the
(Keynesian) LRAS curve
...

Contractionary fiscal policy – how it works
Income tax up – consumers have less disposable
income – C down – therefore AD down – by how
much depends on 1
...
The size of the multiplier (for higher
only)
...

Contractionary fiscal policy – how it works
Corporation tax up – businesses invest less – I
down – therefore AD down – by how much
depends on 1
...
The size of the multiplier
...

Expansionary fiscal policy – how it works

The opposite way to
contractionary fiscal policy
Contractionary fiscal policy – an evaluation

Using contractionary fiscal policy means
that:
 Inflationary pressure will decrease
 May cause budget surplus
 Decreases stress on the environment
However,
 It lowers demand and therefore increases
unemployment
 It lowers demand therefore lowers economic
growth

12

Expansionary fiscal policy – an evaluation
Using expansionary fiscal policy (budget deficit)
means that:
 It increases demand therefore decreases
unemployment
 It increases demand therefore increases
economic growth
However,
 Inflationary pressure will increase
 May require budget deficit
 Increased stress on the environment
Limitations of fiscal policy:
1
...
Crowding Out Hypothesis/Effect:
3
...
Disincentive of fiscal policy
5
...


Benefits of Fiscal Policy:
- It can be used to bring an economy out of
recessions and booms
- It can be targeted at particular products, areas of
the country and groups of the population
...

- Fiscal policy can affect the quantity and quality of
resources (factors of production) and hence long
run aggregate supply
- Some fiscal policy measures adjust automatically
to dampen down fluctuations in economic activity
Expansionary monetary policy
Decreasing interest rates
...

Contractionary monetary policy
Increasing interest rates
...

Relationship between interest rates and the
reward for saving
If the interest rate is 5% pa and a person deposits
$1,000 in a bank he or she will receive $1,050 from
their deposit after one year
...


If the interest rate is 10% pa and a person deposits
$1,000 he or she will receive $1,100 from their
deposit after one year
...

Central Banks don‟t set the i/r for (commercial)
banks
...
Commercial banks
(HSBC etc) borrow money from the Central Bank
at the base rate
...


The higher the interest rate the more saving that
will take place (and vice versa)
...
The mechanism works on
three parts of the economy
1
...
Businesses (affecting output and Investment (I)
decisions)
...


Effect of expansionary monetary policy on AD
I/r down – consumers borrow more to spend – C up
– AD up – by how much depends on 1
...
The size of the multiplier
...

Effect of expansionary monetary policy on AD
I/r down – firms borrow more to invest – I up – AD
up - by how much depends on 1
...
The size of the multiplier
...

Contractionary monetary policy – how it works

The opposite way to
expansionary monetary policy
Contractionary monetary policy – an evaluation
Using contractionary monetary policy (increases in
interest rates) means that:
 Inflationary pressure will decrease
However,
 It lowers aggregate demand therefore
increases unemployment
 It lowers aggregate demand therefore lowers
economic growth
The effectiveness of monetary policy is largely
determined by:
 The length of the time lags
 The depth of the recession
...

 The ability to implement changes in i/r
quickly

Supply side policies
Any actions by government that allows firms to
lower their costs, thus boosting efficiency and

3
...
The size of
the decrease in i/r 2
...

The effect on economic objectives will depend on
the elasticity of the AS curve
...
The size of the
decrease in i/r 2
...

The effect on economic objectives will depend on
the elasticity of the AS curve
...

Expansionary monetary policy – an evaluation
Using expansionary monetary policy (increases in
interest rates) means that:
 It increases aggregate demand therefore
decreases unemployment
 It increases aggregate demand therefore
increases economic growth
However,
 Inflationary pressure will increase
The impact of interest rate changes on the
distribution of income
...

When interest rates increase it:
 Increases the rewards for saving
 Increases the cost of borrowing
High income earners tend to borrow less as a
proportion of their income than low income earners
...

High income earners save more as a proportion of
their income than low income earners
...

Overall, this widens the distribution of income
...
Successful supply side policies
shift the LRAS/PPF curve outwards, increasing
potential output
...

Supply side policies can either be:
 Interventionalist
 Market Based
A
...
Improves quality and quantity of
labour, however, time lags involved
...
Improves quality and
quantity of labour
...

C
...

The more investment in infrastructure there is the
easier it is for firms to produce more, therefore the
productive potential of the economy rises (supply
side increases)
...




Increase the productive capacity of the
economy,
 Improve the institutional framework of the
economy
Types of interventionists SSPs
A
...
Investment in new technology
C
...
Industrial policies
B
...
However, carrying out R&D is no
guarantee that significant break throughs will be
made
...
Industrial policies
Government can encourage an increase in the
output of certain industries by adopting policies
such as:
- Providing tax cuts/subsidising/advising new firms
in key industries
...
This increases the
amount of firms in an industry and therefore supply
increases

Types of market based SSPs:
A
...
Labour market reform
C
...
Labour market reform
Reducing the power of trade unions
...
However,
weaker Trade Unions means that workers needs
may not be met and this may lead to dissatisfied and
demotivated workers which ultimately
disadvantageous for a firm
...


A
...

C
...

However, if income tax reduction increases the
income of workers they may decide to work less
and benefit from the extra free time rather than the
extra income – thus output reduces
...
Reduces costs for
firms and may increase employment
...

Moreover, the minimum wage increases the pay of

- reducing corporation tax – incentivises firms to
invest more in order to earn more profit as they can
keep a large proportion of their profits
...

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the least well off in society who will spend most
of/all their additional income on goods and services
...
Moreover, will probably increase
inequality
...
Increases incentive
to work
...

Advantages of Supply Side Policies
1
...
e
...

2
...
This reduces
inflationary pressure
...
Increase the likelihood of economic
growth
SSPs are designed to increase the supply side of an
economy
...
Moreover, some SSPs
boost AD and therefore increase economic growth
...
Time lags
Some SSPs such as increasing education can take a
long time to have an effect
2
...

3
...

4
...


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