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LEVEL OF OVERALL ECONOMIC
ACTIVITY
5 MACRO OBJECTIVES
FACTORS OF PRODUCTION AND THEIR
RETURNS

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Economic growth
Inflation
Unemployment
Balance of payments
Distribution of income

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Land: Rent
Labour: Wages
Capital: Interest
Entrepreneurship: Profit
Subtractions from the circular flow

LEAKAGES

LEAKAGES
INJECTION

INJECTIONS

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Savings
Taxes
Imports

An injection is an addition to the circular flow that does
not arise from households current income
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Exports
Government expenditure
Investment

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CONSUMPTION (C)

If Injections = Leakages, no change in the size of
the circular flow
 If Injections > Leakages, National Income
increases
 If Injections < Leakages, National Income
Decreases
The total spending on domestic goods or services by
households

INVESTMENT (I)

Spending by firms in order to add to their capital stock

GOVERNMENT EXPENDITURE (G)

Includes all Government spending on goods apart from
transfer payments

EXPORTS (X)

Domestic goods and services bought by foreigners

IMPORTS (M)

Are foreign goods and services brought by domestic
households and firms

TRANSFER PAYMENTS

Spending by the Government in order to increase the
incomes of households and/or firms e
...
Calculated using the formula C + I + G +
(X - M)

OUTPUT METHOD

NOMINAL VALUE

REAL VALUE
GNP/GNI

NET PROPERTY INCOME FROM ABROAD

Measures the actual value of the goods and services
produced in an economy by adding up the final values
of domestically produced goods and services
...
e
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e
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GDP + net property
income from abroad

Is the difference between income earned from
domestically owned asset operating abroad and the
income paid to foreign assets operating domestically

AGGREGATE DEMAND AND
SUPPLY
AGGREGATE DEMAND
AGGREGATE DEMAND (AD)

DETERMINANTS OF CONSUMPTION

DETERMINANTS OF INVESTMENT

DETERMINANTS OF GOVERNMENT
SPENDING
DETERMINANTS OF NET EXPORTS

AGGREGATE SUPPLY
SHORT RUN AGGREGATE SUPPLY

LONG RUN AGGREGATE SUPPLY

Total spending on goods and services in an economy at a
given price level during a given period, formally expressed
as C + I + G + (X - M)
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Personal taxes
Income
Consumer confidence
Debt
Interest rates
Wealth
Consumption
Interest rates
Business confidence
Income
Corporate tax
Level of corporate debt
Tax
Government policy

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Foreign incomes
Domestic incomes

The total amount of goods and services all industries in
the economy will produce at every given price level where
factor prices are fixed
The total amount of goods and services all industries in
the economy will produce at every given price level where
factor prices are variable

WHY FACTOR PRICES ARE FIXED IN
THE SHORT RUN

CAUSES OF SRAS SHIFT (SUPPLY SIDE
SHOCKS)
SUPPLY SIDE SHOCKS

DEFLATIONARY GAP

INFLATIONARY GAP

ASSUMPTIONS OF NEOCLASSICAL
MODEL

WHY NEOCLASSICAL LRAS IS
INELASTIC

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LABOUR – Don’t employ more people as:
APL could go down
Expensive
Takes time
CAPITAL – Don’t buy more as:
APL could go down – no confidence
Takes a long time
Requires confidence
LAND – Cant acquire more as:
Stocks still exist
Raw material prices increase
Wage rate changes
Business taxes increase

Collective term to describe any significant
interruption/reduction in the supply of a good or service
e
...
Leads to increase in
unemployment

Will arise when the level of AD in an economy is more
than efficient to buy up the potential output that could be
produced by an economy at its full employment level of
national income
...
Includes fiscal and
monetary policy
...
Expressed by the
formula 1 / 1-MPC
 Government spending goes to firms to
buy/produce a product
 They use the money to buy factors of production
therefore money goes to households
 They save, pay tax and buy imports
 With that they use the left over money at firms
meaning slightly less money comes back to firms

The amount of a person's additional income that is spent
on domestic goods and services
...
Equal to MPS +
MRT + MPM or 1 – MPC
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CROWDING OUT

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If governments demand more loans, it will
increase interest rates
Initially, this will shift aggregate demand right
However higher interest rates mean people save
more and consume less durable goods, as

FISCAL POLICY PROS

FISCAL POLICY CONS

MONETARY POLICY
MONETARY POLICY

interest rates are too high to borrow money
 Investment also decreases as firms don’t borrow
money
...
e
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e
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ROLE OF COMMERCIAL BANKS VS CENTRAL
BANKS

ROLE OF CENTRAL BANKS

CONTRACTIONARY MONETARY
POLICY

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Commercial banks aim to earn profits by lending
out savings at a higher rate of interest than they
pay savers
Central banks to not earn profits
Central banks are not open to businesses or the
public
Banker to the government
Banker to the commercial banks
Regulates commercial banks – reserve ratio
Conducts monetary policy – creating money
CONSUMPTION
Money supply decreases or base rate increases
The interest rate then increases
Durable consumption decreases
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g
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Involves returning previously nationalized industry to the
private sector
Involves removing barriers to trade (protectionist
measures) and encouraging competition amongst
exporting/importing firms/countries
...

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HOW UNEMPLOYMENT IS MEASURED
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CONSEQUENCES OF
UNEMPLOYMENT

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CLAIMANT COUNT – amount of people claiming
benefits
- Problems – not accurate, not all unemployed
claim benefits, doesn’t show underemployment,
benefit fraud
SURVEY – 60 000 people asked if they’re
unemployed each month – ONS
- Problems – could lie, expensive, asking a large
enough range of people and getting them to
respond is difficult
EVALUATION – both don’t consider region, class,
age, gender, ethnicity etc
PERSONAL
Taxes increase for individuals
Poor health increases, fast food is cheaper
Demoralising – stress and depression
Confidence loss
SOCIAL
Crime rates
Family breakdown
ECONOMIC
Efficiency decreases
Lowers real GDP, producing below Yf
Shift in AD as loss of incomes for individuals
Opportunity costs to governments of transfer
payments

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UNDEREMPLOYMENT

THE LABOUR FORCE

Taxes increase
Budget deficit
Unequal distribution of income

People of a working age have jobs (generally part time)
who are willing and able to work more hours, or in jobs
which do not make use of their skills and education
...


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REAL WAGE UNEMPLOYMENT – Neoclassical,
when a minimum wage is introduced above the
equilibrium and there is unemployment between
at Qs and Qd
Can be solved by abolishing minimum wage,
reducing it or reducing power of the unions

TYPES OF UNEMPLOYMENT
DISEQUILIBRIUM UNEMPLOYMENT
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DISEQUILIBRIUM UNEMPLOYMENT

CYCLICAL UNEMPLOYMENT – Keynesian, in a
recession AD shifts left so does ADL
Equilibrium is now below minimum wage, Qs to
Qd
To combat this, governments use fiscal policy to
return to the original equilibrium

Occurs when conditions exist that prevent the labour
market from "clearing" and therefore reaching the labour
market equilibrium
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Workers are
willing and able to work but no jobs are available
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g
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g ice cream shops, Christmas shops
STRUCTURAL
Occurs where there are mismatches between
labour skills demanded by employers and labour
skills supplied by workers
Reasons:
- Change in demand for labour skills, technology,
taste – different to cyclical unemployment as
non-aggregate
-Jobs can change location if it is cheaper to
manufacture elsewhere, foreign markets etc
-Labour market rigidities – if the labour
equilibrium for an individual market isn’t
reachable – different as not aggregate – as a
result the cost of production for firms is stuck
because of minimum wage, unions and
reluctance to let valuable employees go

FRICTIONAL UNEMPLOYMENT

Exists when workers are between jobs
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SEASONAL UNEMPLOYMENT

Exists when workers are unemployed due to seasonal
factors
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Equal to equilibrium unemployment –
seasonal plus frictional plus structural
 The natural rate of unemployment is the
difference between the aggregate supply of
labour and the labour force
 These are the people actively seeking
employment but unwilling and unable to do the
jobs available

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SOLUTIONS TO UNEMPLOYMENT

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INFLATION
INFLATION
DISINFLATION
DEFLATION

The sustained rise in the average price level during a
given period
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Occurs when the rate of inflation is negative and there is
a fall in the average price level of an economy
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Solves the occupational
immobility element of structural unemployment,
provides the workforce with transferrable skills
Regulations – Increase willingness to do job but
increases cost for firms
Cut benefits – incentive for people
Increase tax for lower earners – Incentive
EQUILIBRIUM UNEMPLOYMENT – REDUCING
NATURAL RATE BY SHIFTING ADL
Cut job security – increases aggregate demand
for labour, firms aren’t scared they can’t fire
people if there’s a recession

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Can’t collect all price changes in an economy
Weightings differ for everyone so different rates
of inflation according to income
Poor people spend a larger percentage of their
income on necessities so their inflation rate will
be higher
Disparities in income mean inflation rate won’t
be representative for everyone
Doesn’t show changes in quantity or quality
Can’t compare across years as different products
are sold e
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iPhone 3G with iPhone 5S
Different countries buy different goods, different
to compare
Some prices are really volatile – core inflation
rate excludes energy and house prices
Different products have different prices in
different places
Changes in tastes over time so weightings will
change
Time delay between statistic collection and
inflation rate release

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CONSEQUENCES OF INFLATION

TYPES OF INFLATION

DEMAND PULL INFLATION
COST PUSH INFLATION
STAGFLATION

SOLUTIONS TO INFLATION

REDISTRIBUTION OF INCOME
-inflation rate increases, real interest rate
decreases – hurts savers
 If income remains fixed, real wage goes down –
more likely to affect those on minimum wage
 If pensions don’t adjust for inflation, pensioners
will be affected
 Lenders lose
 Borrowers gain
 Firms employing workers on fixed wages gain
 Investment may be affected – lack of confidence
linked to uncertainty in the economy – possible
lack of savings die to interest rate
 MENU COSTS increase, have to print more menus
 SHOE LEATHER COSTS not all prices increase at
the same rate, cost of time in walking around
comparing costs – opportunity costs
 MONEY ILLUSION – money isn’t balanced
properly, right choices aren’t being made due to
lack of information
 E
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if wage rate increases by 2%, price level
increases by 4%, you feel richer but you’re not,
more likely to spend more
 Allocative efficiency is affected as people make
irrational decisions
 INTERNATIONAL COMPETITIVENESS
 If prices increase, goods will appear to be more
expensive
 DEMAND PULL
 If AD shifts right at full employment increases
average price level
 COST PUSH
 If SRAS shifts left there will be stagflation –
inflation in a deflationary gap
 INFLATIONARY SPIRAL
 AD shifts right, APL increases
 Workers demand for higher wages
 Costs for firms increase, SRAS shifts left
 Households suffer from money illusion so spend
more thinking they have more
 AD shifts right again, increasing APL
Occurs when the rise in the average price level is an
economy is due to excessive aggregate demand
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e
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Describes the situation when an economy experiences
high levels of unemployment and inflation accompanied
by low, zero or negative economic growth
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CONTRACTIONARY FISCAL AND MONETARY
POLICY FOR DEMAND PULL
Shifts AD left again

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PHILIPS CURVE

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ECONOMIC GROWTH
ECONOMIC GROWTH

Occurs when an economy experiences an increase in real
GDP
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e
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Human capital results from investments or
spending on education, training healthcare, clean water,
nutrition etc

NATURAL CAPITAL

Anything that falls within land or natural resources
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Can be improved by planting forests etc
or destroyed by polluting air, cutting down forests etc
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HOW TYPES OF CAPITAL CAN BE
IMPROVED

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PHYSICAL
Increase in machines, tools, equipment, ports etc
Quality depends on technological advances e
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new computer
Improved capital goods are capital goods that
embody a new technology, lead to larger quantity
of output
HUMAN
Quantity not always important
Quality determined by education, skills,
knowledge and levels of health
Result of investment in human capital e
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schools, meals for school children and medical
services, immunisation
Important for growth, a skilled and healthy
worker can produce more

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INCOME DISTRIBUTION
INCOME
WEALTH
EQUITY/EQUALITY
ABSOLUTE POVERTY
RELATIVE POVERTY

INCOME DISTRIBUTION

CAUSES OF POVERTY

CONSEQUENCES OF POVERTY

NATURAL
Distinguish between marketable commodities
and ecological resources/common access
resources
Marketable commodities:
Contribute to growth but not essential, shown by
Japan, South Korea and Israel
Ecological resources:
Crucial for growth
Environmental destruction means leaving behind
fewer and lower quality resources for future
generations
Workers can be affected by air pollution, farmers
have less fish
Inward shift of PPC
The wages you earn

The value of the assets you own

How fair/how equal society is
Unable to afford basic necessities
Unable to afford the typical lifestyle of the society you
live in
 Depends of differing ownership of factors of
production
 Can be measure by a Lorenz curve which shows
income distribution in quintiles or deciles
 Can be measured by Gini coefficient – the higher
the number the more unequal the society
 Differing ownership in the factors of production
 DISCRIMINATION – age, gender, racial
 UNEMPLOYMENT – lose job, income, confidence
and skills, can’t find a job, self perpetuating
 Poverty causes decrease in quality and quantity
of labour, equality of human capital decreases
 CULTURE – no environment if your environment
doesn’t encourage good education
 LOW LEVELS OF CAPITAL OWNERSHIP – low
levels of education due to bad schools
 GEOGRAPHY – south wales vs London
 AGE
 LOW STANDARD OF LIVING – higher mortality
rates, malnourishment, high rates of preventable
diseases
 CRIME RATE, SOCIAL PROBLEMS, DRUG
ADDICTION – a culture of poverty, lack of belief

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METHODS TO REDISTRIBUTE
INCOME

TRANSFER PAYMENTS

EFFECTIVENESS OF GOVERNMENT
INCOME DISTRIBUTION POLICIES

TAX
Income tax more progressive, VAT (regressive)
TRANSFER PAYMENTS
POSITIVES – can direct it to the people who need
It most – automatically stabilises the economy in
a recession – cheap to administer
 NEGATIVES – disincentive to work? Depends on
amount of benefit and government requirements
to receive them, opportunity cost
 SUBSIDIES
 Increases real income of poor people
 Purchasing power increases
 Can save jobs e
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subsidising car manufacturing
factories
 Decrease price, increase consumption
 Opportunity cost
 PROVISION OF MERIT GOODS
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free schools
 Allows people to access goods they wouldn’t
otherwise be able to access
 Opportunity cost
 PRICE CONTROLS
 Maximum for necessities, reduce price therefore
real income increases
 Minimum to protect producer e
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agriculture
 MINIMUM WAGE
Payments made by the government to individuals
specifically for the purpose of redistributing income from
certain groups to other groups
 WHERE EFFECTIVE
 Progressive taxation, fairness, ability to pay,
raises tax revenue
 Spending on merit and public goods, positive
externalities and used by people on low incomes
 Transfer payments – direct benefit to the
neediest, automatic stabiliser
 Subsidies reduce costs, increase consumption
 Price ceilings – affordability to people on low
incomes
 Price floors – income support for farmers
 Minimum wages – incentives, reasonable pay
 WHERE NOT EFFECTIVE
 Progressive taxation – disincentives, avoidance,
tax evasion, cost of administration
 Spending on merit goods and public goods –
expensive to provide
 Transfer payments – cost of provision, can be
paid to people who don’t need it, reduces
incentive to work
 The use of subsidies, cost of provision, allocative
inefficiency
 Price ceilings – distorts markets, shortages,
allocative inefficiency, cost discrimination



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