2.2 AGGREGATE DEMAND AND AGGREGATE SUPPLY
2.3 MACROECONOMIC OBJECTIVES:
PHILLIPS CURVE DIAGRAM
ECONOMIC GROWTH
1. Distinguish between the microeconomic concept of demand for a
product and the macroeconomic concept of aggregate demand.
The microeconomic demand curve
has the “price” of the one good on
the y-axis, the macroeconomic
aggregate demand curve has a
measure of the average price level
of all goods and services.
Where the microeconomic demand
curve has the “quantity” of the one
good on the x-axis, the
macroeconomic aggregate demand
curve has The total quantity of all
goods and services, which is national
output. (Real GDP)
2. Construct an aggregate demand curve.
AGGREGATE DEMAND:
The total (or aggregate) real expenditures on final
goods and services produced in the domestic economy
that buyers would willing and able to make at different
price levels, during a given time period (usually a year).
Aggregate demand (AD) relates the economy's price
level, measured by the GDP price deflator, and
aggregate expenditures on domestic production,
measured by real gross domestic product.
The aggregate expenditures are consumption,
investment, government purchases, and net exports made
by the four macroeconomic sectors (household, business,
government, and foreign).
2. Construct an aggregate demand curve.
The aggregate demand curve:
The AD curve shows the relationship
between AD and the price level.
It is assumed that the AD curve will slope
down from left to right. This is because all
the components of AD, except imports,
are inversely related to the price level.
The horizontal axis measures aggregate
output, or real GDP, and the vertical axis
measures the general price level in the
economy, which is an average over the
prices of all goods and services.
3. Explain why the AD curve has a negative slope.
Trade, liquidity and wealth effects:
The AD curve slopes down because the components of AD are
inversely related to the price level.
There are three main effects to consider:
1. The price level and international trade – the ‘trade’ effect
A rise in domestic prices makes exports less competitive and
imports more competitive; hence exports (X) are likely to fall and
imports (M) are likely to rise.
Falling net exports represents a fall in quantity of output
demanded or an upward movement along the AD curve.
(and visa versa)
Both of these reactions combine to create a trade effect, with lower
aggregate demand at the higher price level.
3. Explain why the AD curve has a negative slope.
2. The price level and liquidity – the ‘liquidity/interest rate’ effect
When the price level increases, households and firms need to spend more
money to continue to consume the scarce resources they need.
This makes them relatively ‘short of cash’ than they were at the lower price
level.
The liquidity of an asset refers to how easily it is converted to cash, with cash
itself being ‘perfectly liquid’.
The loss of liquidity associated with a rise in the price level forces some
households and firms to borrow from banks, which reduces the liquidity of
banks.
In response, banks are likely to raise interest rates as compensation for this
lost liquidity. The banks need to keep a certain amount of their reserves in a
highly liquid form to meet any unexpected increase in demand for cash.
As a result of the lost liquidity, interest rates are forced to rise, and both
household and corporate spending may fall. Hence, aggregate demand is
lower at the higher price level.
3. Explain why the AD curve has a negative slope.
3. The price level and the value of wealth – the ‘wealth’ effect
Given that interest rates will rise as financial markets readjust to
the higher price level, there are likely to be further ‘knock on’
effects on household (and corporate) wealth.
(Wealth is not the same as income; wealth is the value of assets that
people own, i.e. Houses, stocks, bonds, & etc.)
Higher rates may lead to a fall in house prices, or at least slowdown house price inflation, and create a negative wealth effect.
Rising interest rates tend to reduce corporate profits and reduce
share values - again creating a negative wealth effect.
A lower price level will, of course, have the reverse effect, that is
to create a positive wealth effect on AD.
The combined effect of these wealth effects is to alter consumer
and corporate spending, and hence alter the level of AD.
4. Describe consumption, investment, government spending
and net exports as the components of aggregate demand.
Aggregate demand consists
of the amount households
plan to spend on goods &
services, called consumption
(C), plus planned spending on
capital investment, (I) +
government spending, (G) +
exports (X) minus imports
(M) from abroad.
The standard equation is:
AD = C + I + G + (X – M)
Aggregate demand can be
illustrated by reference to the
circular flow of income:
5. Explain how the AD curve can be shifted by changes in consumption due to factors
including changes in consumer confidence, interest rates, wealth, personal income taxes
(and hence disposable income) and level of household indebtedness.
Determinates of Household spending (Consumption)
 consumer confidence
Consumer confidence is a measure of how optimistic consumers are about their future
income and the future of the economy. Consumer Confidence Index - CCI
 interest rates (monetary policy)
Some consumer spending is finance borrowing, and so is influenced by interest rate
changes. Higher interest rates make borrowing more expensive, thus lower consumer
spending.
 wealth
An increase in consumer wealth makes people feel wealthier; therefore, they spend
more.
 personal income taxes and hence disposable income (fiscal policy)
Disposable income is the income left over after personal income taxes have been paid,
thus a rise in taxes on households means less disposable income and so less spending.
 level of household indebtedness.
Indebtedness refers to how much money people owe from taking out loans in the
past. Thus more debt the household has the less is available for spending on new
purchases.
6. Explain how the AD curve can be shifted by changes in investment
due to factors including interest rates, business confidence, technology,
business taxes and the level of corporate indebtedness.
Determinates of Investment Spending (Business spending)

business confidence
Business confidence refers to how optimistic firms are about their future sales and economic
activity. Business confidence index (BCI)

interest rates (monetary policy),
An increase in interest rates raises the cost of borrowing and forces businesses to reduce
investment spending financed by borrowing.

Technology
Improvements in technology should increase productivity and thus lower the cost of operation
for firms.

business taxes (fiscal policy)
If the government raise taxes on businesses they will have less profits after taxes and thus less
spending for capital.

the level of corporate indebtedness
If businesses have high levels of debt then they will have less money available to spend.
7. Explain how the AD curve can be shifted by changes in
government spending due to factors including political and
economic priorities.
Determinates of Government Spending
 Political priorities
Governments have discretionary spending that can change over
time when political priorities change. A more conservative
government might want more spending on military and defense
whereas a more liberal government may want more spending on
social issues.
 Economic priorities (fiscal policy)
The government can use its own spending as part of a deliberate
attempt to influence aggregate demand through the use of its
fiscal policy tools.
8. Explain how the AD curve can be shifted by changes in net exports due to
factors including the income of trading partners, exchange rates and changes in
the level of protectionism.
Determinates of Net Exports Spending
 National income of trading partners
If a nations trading partners national income increases, then it is more likely going
to also demand more goods and services from its trading partners. Thus, exports
should increase to the countries with the increase national income.
 Exchange rates
If a countries currency was to rise in value to another currency that they trade
with, (appreciation) then that country will see its export volume decrease as the
exports prices become uncompetitive and likewise the volume of imports should
increase as the price of imports become more attractive to that country. The net
effect is a fall in net exports.
 Changes in the level of trade protectionism
For a country that places or increase the level of trade protectionism, their level
of imports will fall, if exports are unaffected by this, then net exports will
improve. For the country who exports and now has high trade barriers to deal
with, their export volume will fall and thus net exports will fall.
Illustrate aggregate demand and shifts in aggregate demand
Shifts in AD:
A change in any of the
components of aggregate demand
will cause a shift in the aggregate
demand curve.
 An increase in AD, such as that
caused by an increase in
household spending, is shown by
a rightward shift in the whole AD
curve.
 The shift in demand will have an
effect on the price level and
national output, but the effects
may not be uniform because
aggregate supply (AS) may not
be linear.
9. Define the term aggregate supply.
The short-run in macroeconomics is the period of time
when prices of resources are roughly constant or
inflexible. (especially wages)
The long-run in macroeconomics is the period of time
when the prices of all resources, including the price of
labor are flexible and change along with changes in
price levels.
The distinction between the short-run and the long-run in
macroeconomics dose not affect aggregate demand,
but is very important for aggregate supply.
9. Define the term aggregate supply.
Aggregate supply (AS) is defined as the total amount of
goods and services (real GDP) produced and supplied by
an economy’s firms over a period of time at different price
levels.
It includes the supply of a number of types of goods and
services including private consumer goods, capital goods,
public and merit goods and goods for overseas markets.
At higher price levels across the economy firms expect that
they can sell their final products at higher prices, and there
will be a positive relationship between the price level and
aggregate supply.
10. Explain, using a diagram, why the short-run aggregate supply
curves (SRAS Curve) is upward sloping
Short run aggregate supply (SRAS) shows the
relationship between the price level and the quantity of
real output (real GDP) produced by firms when resources
prices (especially wages) do not change.
In the short run, the SRAS curve is assumed to be upward
sloping (i.e. it is responsive to a change in aggregate
demand reflected in a change in the general price level)
because producers respond positivity to higher output
prices and since resource price (inputs prices) are
unchanged, profitability goes up. (and visa versa)
The up sloping SRAS curve indicates a direct relationship
between the price level and the amount of real GDP that
firms will offer for sale.
10.Explain, using a diagram, why the short-run aggregate
supply curves (SRAS Curve) is upward sloping
11. Explain, using a diagram, how the AS curve in the short run (SRAS) can shift
due to factors including changes in resource prices, changes in business taxes
and subsidies and supply shocks.
Changes in resource prices (Input Prices):
Any change in the price of the factors of production
(resources/inputs) will cause the cost of production to or
either rise or fall. This in turn will effect the profitability of the
firms.
Generally a fall in resource prices will lead to more profits
and thus a shift of SRAS to the right.
A rise in resource prices will most likely lead to less profits
and thus a shift of the SRAS o the left.
Any change in the price of imported resources will have the
same effect as stated above.
11. Explain, using a diagram, how the AS curve in the short run (SRAS) can shift
due to factors including changes in resource prices, changes in business taxes
and subsidies and supply shocks.
Changes in Government intervention like (business taxes and subsidies):
Government intervention with the production of goods and services can effect
the cost of production of the firm. Business taxes (corporate tax rates) are an
additional cost of firms which can raise or lower their profitability. In general, a
rise in business taxes would raise cost and lower profits and thus the SRAS
would shift left. (and visa versa)
Government subsidies to producers would have the opposite effect as business
taxes. Government subsidies would lower the coat of production and thus
potentially raise the profits of the firm and thus the SRAS would shift right.
Government regulations toward businesses also act as an additional cost to
firms. In general, the more government regulations placed on businesses the
higher the cost of compiling to these regulations. Thus, the cost of production is
increased and the profitability is lowered and this results in a leftward shift of
the SRAS.
11. Explain, using a diagram, how the AS curve in the short run (SRAS) can shift
due to factors including changes in resource prices, changes in business taxes
and subsidies and supply shocks.
Supply Shocks:
Supply shocks are events that have a sudden and strong impact on the SRAS.
Some supply shocks directly affect aggregate supply.
 Negative supply side, like a war or violent conflict can result in destruction
of physical capital and destruction of the economy. Leading to lower output
produced and a leftward shift of the SRAS curve. Unfavorable weather
conditions can cause a fall in agricultural output, also shifting SRAS curve to
the left. Supply shocks sometimes work by producing sudden changes in a
firms cost of production. For example, a sudden increase in the price of a
major input (such as oil) increases a firms cost. Other examples, include
natural disasters, internal & external conflicts, sudden stoppage of trade
flows.
 Positive supply shocks such as unusually good weather conditions would
lead to a rightward shift. Productivity increases due to favorable condition
like better use of resources or better technology can also lead to a
rightward shift of the SRAS curve.
11. Explain, using a diagram, how the AS curve in the short run (SRAS) can shift
due to factors including changes in resource prices, changes in business taxes and
subsidies and supply shocks.
A change in
aggregate supply
is caused by any
factor affecting
supply EXCEPT the
price level.
12. Explain, using a diagram, that the monetarist/new classical model of the long-run
aggregate supply curve (LRAS) is vertical at the level of potential output (full employment
output) because aggregate supply in the long run is independent of the price level.
Monetarist/new classical economists builds on the work of the classical
economists of the 19th century. Both schools of thought are built on the
following principles:



The importance of the price mechanism in coordinating economic
activities;
the concept of competitive market equilibrium;
and thinking about the economy as a harmonious system that
automatically tends towards full employment.
The Monetarist/new classical approach to aggregate supply rest crucially
on the distinction between the macroeconomic short-run and long-run. It
examines what happens to aggregate supply when the economy moves into
the long-run, when all resources prices including wages change to match
changes in the price level.
12. Explain, using a diagram, that the monetarist/new classical model of the long-run
aggregate supply curve (LRAS) is vertical at the level of potential output (full employment
output) because aggregate supply in the long run is independent of the price level.
According to the monetarist/new-classical perspective, the long-run
aggregate supply (LRAS) curve is vertical at the full employment level of
output, or potential GDP, indicating that in the long run the economy
produces potential GDP, which is independent of the price level.
A vertical LRAS curve means that in the long run a change in the price level
does not result in any change in the quantity of real GDP produced.
In the long-run, since wages and other resource prices are now changing to
match output prices change, firm’s cost of production remains constant even
as the price level changes.
Therefore, as the price level increases or decreases, with constant real costs,
firms’ profits are also constant, and firms no longer have any incentive to
increase or decrease their output levels.
12. Explain, using a diagram, that the monetarist/new classical model of the long-run
aggregate supply curve (LRAS) is vertical at the level of potential output (full employment
output) because aggregate supply in the long run is independent of the price level.
A monetarist/new classical long
run aggregate supply (LRAS) is
perfectly inelastic at the level of
potential output
(full employment level of output).
They believe that the potential
output of the economy is
dependent on the quantity and
quality (productivity) of the
factors of production, not on the
price level.
Thus the LRAS curve is
independent of the price level.
13. Explain, using a diagram, that the Keynesian model of the aggregate supply
curve has three sections because of “wage/price” downward inflexibility and
different levels of spare capacity in the economy.
Keynesian economists base their ideas on the work of John Maynard Keynes.
Keynes questioned the monetarist/new classical economists’ view of the economic
system as a harmonious system that automatically tends towards full employment,
and showed that it is possible for economies to remain in a position of short-run
equilibrium for long periods of time.
In the Keynesian model, inflexible wages and prices mean hat the economy cannot
move into the long-run. Inflexible wages are mainly due to labor contracts, minimum
wage legislation, workers and union resistance to wage cuts.
Keynes main reason for the stickiness or rigidly of resources is due to the
following:
 The Sticky-Wage Theory: An unexpectedly low price level raises the real wage,
which causes firms to hire fewer workers and producer a smaller quantity of
goods and services.
 The Sticky-Price Theory: An unexpectedly low price level leaves some firms with
higher-than-desired prices, which depresses their sales and leads them to cut
back production.
 The Misperceptions Theory: An unexpectedly low price level leads some
suppliers to think their relative prices have fallen, which induces a fall in
production.
13. Explain, using a diagram, that the Keynesian model of the aggregate supply
curve has three sections because of “wage/price” downward inflexibility and
different levels of spare capacity in the economy.
Keynesian AS: shows three
possible phases:
In the horizontal range (section I)
there is low levels of economic
activity.
There is excess capacity so very little
price pressure and high
unemployment.
Firms can easily increase their output
by employing the unemployed capital
and other unemployed resources,
without having to bid up wages and
other resource prices.
The horizontal part of the curve is
based on the Keynesian idea that
wages and prices do not move
downward.
13. Explain, using a diagram, that the Keynesian model of the aggregate supply
curve has three sections because of “wage/price” downward inflexibility and
different levels of spare capacity in the economy.
Keynesian AS: shows three possible phases:
In the upper sloping range (section II), the
economy is approaching full employment so there is
price pressure and increase in real GDP so lower
unemployment.
The reason is that as output increases, so does
employment of resources, and eventually
bottlenecks in resource supplies begin to appear as
there is no longer excess capacity in the economy.
Wages and other resource prices begin to rise,
which means that costs of production increases.
The only way that firms will be induced to increase
their output is if they can sell it at higher prices.
Full employment level of real GDP (Yf), which is
when potential output levels are equal to the
economies natural rate of unemployment, should be
reached in section II of the Keynesian model.
13. Explain, using a diagram, that the Keynesian model of the aggregate supply
curve has three sections because of “wage/price” downward inflexibility and
different levels of spare capacity in the economy.
In the vertical range (section III),
the economy is at full
employment and it’s impossible to
increase output.
There is only price pressure. Real
GDP has reached a level beyond
which it cannot increase anymore;
at this point, the price level rises
very rapidly.
Real GDP can no longer increase
because firms are using the
maximum amount of labor and
all other resources in the
economy.
13. Explain, using a diagram, that the Keynesian model of the aggregate supply curve has
three sections because of “wage/price” downward inflexibility and different levels of spare
capacity in the economy.
Keynes argued that relying on
markets to get to full employment
was not a good idea.
He believed that the economy
could settle at any equilibrium
and that there would not be
automatic changes in markets to
correct this situation.
Thus the need for government
intervention to correct the market
outcome.
13. Explain, using a diagram, that the Keynesian model of the aggregate supply curve has
three sections because of “wage/price” downward inflexibility and different levels of spare
capacity in the economy.
A “Keynesian” long run aggregate supply
14. Compare and contrast, using the two models above, the way that factors leading to changes in the
quantity and/or quality of factors of production (including improvements in efficiency, new technology,
reductions in unemployment, and institutional changes) can shift the aggregate supply curve over the
long term.
Shifts in long-run aggregate supply curve are usually gradual and
anticipated, unlike shifts in the SRAS which can be dramatic and
unanticipated. LRAS and the Keynesian AS curve can shift for many of the
same reasons, including:
 Increases in quantities of the factors of production.
Examples can include, an increase in the quantity of physical capital, or
quantity of land (like a discovery of new oil reserves) means that the economy
is capable of producing more real GDP.
 Improvements in the quality of factors of production (resources)
Greater levels of education, skills or health lead to improvement in the quality
of labor resources. More highly skilled and educated workers or healthier
workers can produce more output than the same number of unskilled or less
healthy workers.
 Improvements in technology
An improved technology of production means that the factors of production
using this technology can produce more output in the same amount of time.
14. Compare and contrast, using the two models above, the way that factors leading to changes in the
quantity and/or quality of factors of production (including improvements in efficiency, new technology,
reductions in unemployment, and institutional changes) can shift the aggregate supply curve over the
long term.
Increases in efficiency
When there is an increase in efficiency in production, it makes better use
of its scarce resources, and can as a result, the economy can produce a
greater quantity of output.
 Institutional changes
For example, the degree of private ownership as opposed to public
ownership of resources, the degree of competition in the economy, the
degree and quality of government regulation of private sector activities,
and the amount of bureaucracy can each affect the quantity of output
produced.
 Reductions in the natural rate of unemployment
The natural rate of unemployment is the unemployment that is ‘normal’ or
‘natural’ for an economy when it is producing its ‘full employment’ level of
output. The natural rate can differ from country to country and can change
over time. If it decreases, the economy is making better use of its resources,
and can therefore produce a larger quantity of output.

14. Compare and contrast, using the two models above, the way that factors leading to changes in the
quantity and/or quality of factors of production (including improvements in efficiency, new technology,
reductions in unemployment, and institutional changes) can shift the aggregate supply curve over the
long term.
long-run aggregate supply curve
15. Explain, using a diagram, the determination of short-run
equilibrium, using the SRAS curve.
In the AD-AS model, the equilibrium level of output (or real GDP) occurs
where aggregate demand (AD) interests aggregate supply (AS).
In the short run, equilibrium is given by the point of intersection of the AD
and the SRAS curves, and determines the price level, the level of real
GDP and the level of employment.
The short-run equilibrium can be at three general outcomes:

Recessionary (deflationary) gap
A Recessionary (deflationary) gap occurs when equilibrium real GDP lies
to the left of potential GDP (LRAS), and unemployment is greater than
the natural rate of unemployment. The recessionary gap has been
created because at the current price level, the amount of real GDP that
aggregate demand wants to buy is less than the economies potential
GDP. There is not enough total demand in the economy to produce at
potential GDP (LRAS). On the business cycle, actual GDP is below its
long run potential GDP.
15. Explain, using a diagram, the determination of short-run
equilibrium, using the SRAS curve.

Inflationary gap
An inflationary gap is when the equilibrium real GDP lies to the
right of potential GDP (LRAS). When real GDP is larger than
potential GDP, unemployment will be less than the natural rate of
unemployment. An inflationary gap arise because aggregate
demand that wants to buy real GDP output at the current price
level is greater than the economies potential output. On the
business cycle, the actual GDP is above its long run potential GDP.
 Full employment equilibrium
The full employment equilibrium level is when real GDP is equal to
potential GDP. At this point, unemployment is equal to the natural
rate of unemployment and there are no recessionary or
inflationary gaps. On the business cycle, actual GDP is equal to
the long run potential GDP.
15. Explain, using a diagram, the determination of short-run
equilibrium, using the SRAS curve.
Recessionary Gap
Inflationary Gap
Full Employment
Neo-classical
models
Keynesian models
16. Examine, using diagrams, the impacts
of changes in short-run equilibrium.
Short-run aggregate market
equilibrium means the economy is at
full-employment with no price level
pressure and potential GDP is at actual
GDP which is at the natural rate of
unemployment.
However, whenever there is a change in
any of the determinates of either
aggregate demand or short-run
aggregate supply the short-run
equilibrium will change as well.
An increase in aggregate demand
(shift right) could lead to higher price
levels depending where they are on the
Keynesian aggregate supply curve and
higher levels of real GDP.
A decrease in aggregate demand
(shift left) could lead to lower price
levels depending on where they are on
the Keynesian aggregate supply curve
and lower levels of real GDP.
16. Examine, using diagrams, the impacts
of changes in short-run equilibrium.
A increase in the short-run
aggregate supply curve
(shift right) could lead to
lower price levels and
higher levels of real GDP.
A decrease in the shortrun aggregate supply
curve (shift left) could lead
to higher price levels and
lower levels of real GDP.
17. Explain, using a diagram, the determination of long-run equilibrium,
indicating that long-run equilibrium occurs at the full employment level of output.
The long-run equilibrium occurs at the full employment level of output,
when there is equilibrium in the labor market.
In the monetarist/new classical approach, while there may be short-term
fluctuations in output, the economy will always return to the full employment
level of output in.
As there is a long run equilibrium in this theory that AD shifts around, so
too is the theory that business cycle fluctuations should not be inevitable
and should be avoidable if the correct policies are followed.
The theory is that the economy would grow at a constant rate along with
the increase in the LRAS without inflation or recessions if the government
didn’t intervene. This is logical as the macro-economy is basically stable.
The long-run equilibrium will change as the LRAS shifts right with long run
growth; increased capital or the technology of capital.
17. Explain, using a diagram, the determination of long-run equilibrium,
indicating that long-run equilibrium occurs at the full employment level of output.
In the Keynesian AD/AS diagram, that the economy may be in
equilibrium at any level of real output where AD intersects AS.
If the economy is in equilibrium at a level of real output below the
full employment level of output (where the AS is vertical), then
there is a deflationary (recessionary) gap.
In contrast to the monetarist/new classical model, the economy can
remain stuck in a deflationary (recessionary) gap in the
Keynesian model.
If AD increases in the vertical section of the AS curve, then there is
an inflationary gap.
Keynesians said that it was the role of government, through their
policy, to ensure that the economy reaches full employment.
18. Examine why, in the monetarist/new classical approach, while there
may be short-term fluctuations in output, the economy will always return to
the full employment level of output in the long run.
The Classical economists assumed that if the economy was left to itself,
then it would tend to full employment equilibrium. This would happen if
the labor market worked properly. If there was any unemployment, then the
following would happen:
Unemployment
labor
Fall in wages
Increase demand for
equilibrium restored at full employment
Classical economists had complete faith in markets. They believed that the
economy would always settle - automatically - at the full employment
equilibrium in the long-run.
Due to flexible prices and wages. However, they did acknowledge that
there might be a slightly different reaction in the short run as the economy
adjusted to its new long-run equilibrium.
18. Examine why, in the monetarist/new classical approach, while there
may be short-term fluctuations in output, the economy will always return to
the full employment level of output in the long run.
Eliminating a deflationary gap:
A fall in AD from its original equilibrium
(1), causes the economy to move in the
short-run to a recessionary gap.
Real GDP has fallen below the fullemployment level of output and price
levels have most likely fallen. (2)
The economy economy can’t remain there in
the long run, because the fall in price levels
is matched by a fall in wages and other
resource prices.
As a result, the SRAS curve shifts the right
until the economy is back to the LRAS curve
(Assuming wage and price flexibility). (3)
In the end, the recessionary gap is
eliminated, and the only thing that changes
is the price level.
18. Examine why, in the monetarist/new classical approach, while there may be
short-term fluctuations in output, the economy will always return to the full
employment level of output in the long run.
Eliminating an inflationary gap:
An increase shift in AD from its original
equilibrium (1), in the short-run causes the
economy to move to an inflationary gap.
Real GDP is beyond the full-employment
level of output and price levels have most
likely have risen. (2)
Once again, the economy can’t stay there
in the long-run, because wages and prices
of other resources increase to match the
increase in the price level.
This causes the SRAS curve to shift the left
until it is at the LRAS curve. (3)
In the long-run the inflationary gap is
eliminated and the only thing that changes
is the price level.
19. Examine, using diagrams, the impacts
of changes in the long-run equilibrium.
With monetarist/new classical
economists, changes in
aggregate demand (AD) can
have n influence on real GDP
only in the short-run; in the
long-run, they only result in
changing the price level,
having no impact on real GDP,
as this remains constant at the
level of potential GDP output
and the LRAS curve.
20. Explain, using the Keynesian AD/AS diagram, that the economy
may be in equilibrium at any level of real output where AD
intersects AS.
Keynes argued that relying on markets to get to full
employment was not a good idea.
He believed that the economy could settle at any equilibrium
and that there would not be automatic changes in markets to
correct this situation.
He argued that wages would be 'sticky downwards'. In other
words workers would not be happy about taking wage cuts and
would resist this.
This would mean that wages would not necessarily fall enough
to clear the market and unemployment would linger.
This unemployment he termed demand deficient unemployment.
20. Explain, using the Keynesian AD/AS diagram, that the
economy may be in equilibrium at any level of real output where
AD intersects AS.
Keynes didn't distinguish
between the short-run and the
long-run as Classical economists
tend to.
He argued that the economy
could settle at any equilibrium
level of income at any time,
and it was the government job
to use appropriate policies to
ensure that this equilibrium was
a good one for the economy.
Keynesian
The Ratchet Effect
The Ratchet Effect
This effect states that prices are "sticky" or inflexible in a downward
direction. Therefore, aggregate demand will not move downward very
freely.
Causes for the Ratchet Effect:
Wage Contracts - contracts prevent firms from decreasing wages, which
are a major cost for a firm.
Morale and Productivity - employers are not willing to reduce wage
rates because doing so reduces worker morale and labor productivity.
Training Investments - firms put an investment in workers when they train
them. If workers leave because of lower wages, firms do not get a return
from that investment.
Minimum Wage - firms cannot reduce wages below minimum wage.
Monopoly Power - many firms have sufficient monopoly power to resist
price cuts for a time when demand declines
The Ratchet Effect
21. Explain, using a diagram, that if the economy is in equilibrium at a
level of real output below the full employment level of output, then
there is a deflationary (recessionary) gap.
A deflationary gap exists when there
is insufficient demand available in the
economy to generate a fullemployment equilibrium.
In other words there is not enough
being bought to provide jobs for
everyone who wants them.
Deflationary or recessionary gap,
where actual unemployment is greater
than the natural rate of
unemployment. Occurs where AD
intersects the SRAS curve at a level of
real GDP that is below LRAS.
On the business cycle, the actual
GDP is below potential GDP and
actual GDP is usually falling.
22. Discuss why, in contrast to the monetarist/new classical model, the economy can
remain stuck in a deflationary (recessionary) gap in the Keynesian model.
Keynesian economists believe that free markets are volatile and not self correcting.
Free market volatility:
• The free-market system is naturally prone to periods of recession & depression
• The volatility of aggregate demand (AD = C+I+G+X-M) can be explained by
changes in consumer and business sentiment – also known as animal spirits.
• In a world of stagnation or depression direct intervention in the economy may be
essential
Free markets are not always self-correcting:
• When a recession or a depression occurs, the free market system is not
necessarily self-correcting – indeed en-masse, individuals can become trapped in
a deflationary depression which is in no one’s interest but which, left on our own,
no one can counter-act.
• Persistent deflation can be as costly as high inflation – it can be damaging
especially in economies where there is a huge level of private & public sector
debt
• You cannot always rely on new inventions / innovations and other natural
stabilizers to drag an economy out of a recession
22. Discuss why, in contrast to the monetarist/new classical model, the economy can
remain stuck in a deflationary (recessionary) gap in the Keynesian model.
According to Keynes, because of
inflexible wage and other resource prices
and insufficient aggregate demand, the
economy can remain in a recessionary gap
indefinitely.
This means that the government must
intervene in the economy with specific
measure to help it come out of this gap.
Keynesian analysis is therefore essentially
a short-run analysis.
They do not accept the idea that the
economy can move into what
monetarist/new classical economists
define as the long-run (where there is full
resource and product price flexibility).
Therefore, in the Keynesian perspective
the economy does not automatically tend
toward full employment equilibrium.
23. Explain, using a diagram, that if AD increases in the vertical section of the AS
curve, then there is an inflationary gap.
Inflationary gap, is where there is strong
aggregate demand, actual unemployment
has fallen below its natural rate, and as
the economy approaches its maximum
capacity (full-employment output level),
price level has increased.
This occurs where AD intersects the SRAS
curve at a level of real GDP that is above
LRAS curve.
With too much demand in the economy,
this excess level of demand will tend to
lead to demand-pull inflation.
In the Keynesian model, once AD passes
the full-employment level there is no more
excess capacity and thus only price level
pressure. Prices are the only changing
variable.
On the business cycle, actual GDP is
above potential GDP and GDP is rising.
24. Discuss why, in contrast to the monetarist/new classical model, increases in aggregate
demand in the Keynesian AD/AS model need not be inflationary, unless the economy is
operating close to, or at, the level of full employment.
In the Keynesian model when the economy is in the horizontal part of the AS curve, increases in
aggregate demand lead to increases in real GDP without affecting the price level. This is because
there is excess capacity and as AD increase there is no price pressure. Cost of production does not
increase and firms are reluctant to raise prices with still low AD.
It is only when the Keynesian AS curve begins to slope upward, when it is close to the full
employment level of output, that further increases in aggregate demand begin to result in changes in
the price level as well. Excess capacity is being reduced, cost of production starts to rise and thus
firms must start to raise prices.
Once AD surpasses the full-employment level of output, the economy is at its production capacity and
the only way to allocate output is through price increases.
24. Discuss why, in contrast to the monetarist/new classical model, increases in aggregate
demand in the Keynesian AD/AS model need not be inflationary, unless the economy is
operating close to, or at, the level of full employment.
Whereas, in the monetarist/new
classical model, increases in
aggregate demand always result
in price level increases.
In the short-run, as AD shifts to the
right causing a movement along an
upward-slopping SRAS curve, an
increase in real GDP and an
increase in the price level results.
In the long run, increases in
aggregate demand give rise only
to increases in the price level,
leaving real GDP unaffected.
24. Discuss why, in contrast to the monetarist/new classical model, increases in
aggregate demand in the Keynesian AD/AS model need not be inflationary, unless
the economy is operating close to, or at, the level of full employment.
25. Explain, with reference to the concepts of leakages (withdrawals) and injections,
the nature and importance of the Keynesian multiplier.
Multiplier:
The multiplier is concerned with how national income changes as a result of a
change in an injection, for example investment.
The multiplier was a concept developed by Keynes that said that any increase
in injections into the economy (investment, government expenditure or exports)
would lead to a proportionally bigger increase in National Income.
This is because the extra spending would have knock-on effects creating in turn
even greater spending.
The size of the multiplier would depend on the level of leakages.
Multiplier effect
The theory that a particular increase in private or government spending (C, I, G,
or Xn) in an economy will lead to a larger overall increase in GDP than the
initial change in spending, due to the fact that the increase in incomes that result
will lead to further increases in private spending throughout the economy. The
size of the multiplier effect depends on the spending multiplier.
25. Explain, with reference to the concepts of leakages (withdrawals) and
injections, the nature and importance of the Keynesian multiplier.
The Multiplier effect comes about because injections of new demand for goods and
services into the circular flow of income stimulate further rounds of spending – in
other words “one person’s spending is another’s income”.
This can lead to a bigger eventual final effect on output and employment.
What is a simple definition of the multiplier?
It is the number of times a rise in national income exceeds the rise in injections of
demand that caused it.
The Multiplier and links to Keynesian Economics
The concept of the multiplier process became important in the 1930s when John
Maynard Keynes suggested it as a tool to help governments to maintain high levels
of employment.
This “demand-management approach”, designed to help overcome a shortage of
capital investment, measured the amount of government spending needed to reach
a level of national income that would prevent unemployment.
25. Explain, with reference to the concepts of leakages (withdrawals) and
injections, the nature and importance of the Keynesian multiplier.
The value of the multiplier depends on:

Propensity to import

Propensity to save

Propensity to tax

Amount of spare capacity

Avoiding crowding out
The multiplier will have a large effect on the economy when:

The propensity to spend extra income on domestic goods and services is high

The marginal rate of tax on extra income is low

The propensity to spend extra income rather than save is high

Consumer confidence is high (this affects willingness to spend gains in income)

Businesses in the economy have the capacity to expand production to meet increases in demand
Evaluation: Time lags and the multiplier effect
It is important to remember that the multiplier effect will take time to come into full effect.
Another problem is that the actual value of the multiplier effect is likely to change at different points of the economic
cycle.
25. Explain, with reference to the concepts of leakages (withdrawals)
and injections, the nature and importance of the Keynesian multiplier.
Key points:




The higher is the propensity to consume domestically produced goods and services, the
greater is the multiplier effect. The government can influence the size of the multiplier through
changes in direct taxes. For example, a cut in the rate of income tax will increase the amount
of extra income that can be spent on further goods and services
Another factor affecting the size of the multiplier effect is the propensity to purchase imports.
If, out of extra income, people spend their money on imports, this demand is not passed on in
the form of fresh spending on domestically produced output. It leaks away from the circular
flow of income and spending, reducing the size of the multiplier.
The multiplier process also requires that there is sufficient spare capacity for extra output to be
produced. If short-run aggregate supply is inelastic, the full multiplier effect is unlikely to
occur, because increases in AD will lead to higher prices rather than a full increase in real
national output. In contrast, when SRAS is perfectly elastic a rise in aggregate demand causes
a large increase in national output.
Crowding out – this is where (for example) increased government spending or lower taxes can
lead to a rise in government borrowing and/or inflation which causes interest rates to rise and
has the effect of slowing down economic activity. Thus the multiplier effect will be reduced.
25. Explain, with reference to the concepts of leakages (withdrawals)
and injections, the nature and importance of the Keynesian multiplier.
25. Explain, with reference to the concepts of leakages (withdrawals) and injections,
the nature and importance of the Keynesian multiplier.
26. Calculate the multiplier using either of the following
formulae 1/ (1-MPC) or 1/ (MPS + MPT + MPM)
The multiplier = change in real GDP/initial change in expenditure
Marginal propensity to consume (MPC):
Is the proportion of each extra dollar of disposable income spent by households
on consumption of domestically produced goods and services. .
For example, if a person earns 1 more and consumes 60% of it, then the MPC is
0.6.
Marginal propensity to Save (MPS):
Is the proportion of each extra dollar of disposable income saved by
households.
Marginal propensity to tax (MPT):
Is the proportion of each additional income taxed.
Marginal propensity to import (MPM):
Is the proportion of additional income spent on imported goods and serves.
26. Calculate the multiplier using either of the following
formulae 1/ (1-MPC) or 1/ (MPS + MPT + MPM)
The complex multiplier is the multiplier principle in Keynesian economics.
The multiplier applies to any change in independent expenditure, in other words, an
externally induced change in consumption, investment, government expenditure or net
exports.
Each of these operates to increase or reduce the equilibrium level of income in the
economy. The size of the multiplier should take account of all leakages from
the circular flow of income and expenditure occurring in all sectors.
Complex Multiplier = 1 / (sum of the propensity to save + tax + import)
or Complex multiplier = 1/ (MPS + MPT + MPM)
Therefore if there is an initial injection of demand of say $400m and:
The marginal propensity to save = 0.2
The marginal rate of tax on income = 0.2
The marginal propensity to import goods and services is 0.3
Then the value of national income multiplier = (1/0.7) = 1.43
An initial change of demand of $400m might lead to a final rise in GDP of 1.43
x $400m = $572m
26. Calculate the multiplier using either of the following
formulae 1/ (1-MPC) or 1/ (MPS + MPT + MPM)
The Simple Formula:
(Got to know)
The simple expenditures multiplier is the ratio of the change in
aggregate production to an independent change in an aggregate
expenditure when consumption is the only induced expenditure.
This multiplier is as simple as it gets while capturing the
fundamentals of the multiplier. The simplistic multiplier, that is the
reciprocal of the marginal propensity to save is a special case
used for illustrative purposes only.
Simply multiplier = 1/ (1-MPC) =1/MPS
If, for example, the MPC is 0.80 (and the MPS is 0.20), then an
autonomous $400m change in investment expenditures results in a
change in aggregate production of $2 trillion.
M = 1/(1-.80) = 1/.20 = 5, so $400 x 5 = $2 trillion
Tax Multiplier
Simple Tax Multiplier:
(Got to know)
The simple tax multiplier measures changes in aggregate
production caused by changes in taxes when consumption is the
only induced expenditure.
The Simple Tax multiplier represents the multiple by which GDP
increases (decreases) in response to a decrease (increase) in
taxes charged by governments.
There are two versions of the tax multiplier:
the simple tax multiplier and the complex tax multiplier,
depending on whether the change in taxes affects only the
consumption component of GDP or it affects all the components
of GDP.
Simple Tax Multiplier = MPC x 1/MPS = -MPC/MPS
Simple Tax Multiplier (nice to know)
The key feature of the simple tax multiplier that differentiates it from the simple
expenditures multiplier is how taxes affect aggregate expenditures. In
particular, taxes do not affect aggregate expenditures directly (as do
government purchases or investment expenditures). They affect aggregate
expenditures indirectly through disposable income and consumption.
This gives rise to two important differences compared to the simple
expenditures multiplier.
 First, a change in taxes causes an opposite change in the disposable income of
the household sector. An increase in taxes decreases disposable income and an
decrease in taxes increases disposable income. This is why the simple tax
multiplier has a negative value.
 Second, the household sector reacts to the change in disposable income caused
by the change in taxes by changing both consumption and saving. How much
consumption changes is based on the MPC. The MPC means that for each one
dollar change in taxes, consumption and thus aggregate expenditures change
by a only fraction. The fraction is equal to the MPC. The reason, of course, is
that the taxes affect income and income is divided between saving and taxes.
Complex Tax Multipliers (nice to know)
Complex Tax Multipliers
The complex tax multiplier, is so named because it also
includes other induced expenditures and components,
including induced investment expenditures, induced
government purchases, induced taxes, and induced
exports.
Complex Tax Multipliers = -MPC/ {1-[MPC + MPI + MPG – (MPC x MPT) – MPM]}
Balanced-Budget Multiplier (nice to know)
Balanced-Budget Multiplier:
The balanced-budget multiplier measures the combined impact on aggregate production
of equal changes in government purchases and taxes.
The simple balanced-budget multiplier has a value equal to one.
The logic behind this multiplier comes from the government's budget, which includes both
spending and taxes. In general, a balanced budget has an equality between spending and
taxes.
As such, the balanced-budget multiplier analyzes what happens when there is an equality
between changes in government purchases and taxes, that is, actions that keep the budget
"balanced."
In other words, the balanced-budget multiplier indicates the overall impact on aggregate
production of a change in government purchases that is matched (that is, paid for) by an
equivalent change in taxes.
The balanced-budget multiplier, as such, is actually the sum of the expenditures multiplier
(for government purchases) and the tax multiplier.
Balanced-Budget Multiplier = 1/MPS + -MPC/MPS = 1-MPC/MPS = MPS/MPS = 1
27. Use the multiplier to calculate the effect on GDP of a change in
an injection in investment, government spending or exports.
Calculating the value of the multiplier
Between 2009 and 2010, Germany’s national income increased by $100 billion. As a result:

Taxes increased by $20 billion

Household spending (on all goods, including imports) increased by $70 billion

Savings increased by $10 billion

Imports increased by $10 billion
Thus:
MPT = .20
MPC = .60 ~($70b -$10b = $60B)
MPS = .40
MPM = .10
Complex multiplier = 1/ (MPS + MPT + MPM) = 1/(.40 + .20 + .10) = 1/.70 = 1.43
$100 billion x 1.43 = $143 billion
Simple multiplier = 1/(1-MPC) = 1/(1-.60) = 1/.40 = 2.5
$100 billion x 2.5 = $250 billion
Simple tax multiplier = -MPC/MPS = -.60/.40 = 1.5
$100 billion x 1.5 = $150 billion
28. Draw a Keynesian AD/AS diagram to show the
impact of the multiplier.
28. Draw a Keynesian AD/AS diagram to show the
impact of the multiplier.
28. Draw a Keynesian AD/AS diagram to show the
impact of the multiplier.
The Multiplier with Price Level Changes:
Multiplier is smaller if price level varies. When the
Aggregate Demand curve shifts and the Aggregate
Supply curve is upward sloping, the multiplier effect
is smaller.
The economy moves from point A to point C, instead of
going to point B when the Aggregate Supply curve is
horizontal.
The smaller effect results because Aggregate Demand
is partially dampened as the price level rises.
With an upward sloping Aggregate Supply curve, the
impact of an increase in Aggregate Demand goes
towards higher output and prices.
In the extreme case of a perfectly vertical Aggregate
Supply curve, the output multiplier is zero.
Explain the Accelerator effect of investment on national
income.
Accelerator:
The principle states that a given change in demand for consumer
goods will cause a greater percentage change in demand for
capital goods.
The principle is used to help explain business cycles.
The accelerator theory suggests that the level of net investment
will be determined by the rate of change of national income.
If national income is growing at an increasing rate then net
investment will also grow, but when the rate of growth slows net
investment will fall.
There will then be an interaction between the multiplier and the
accelerator that may cause larger fluctuations in the trade cycle.
2.3 Macroeconomic objectives: Phillips curve diagram
29.Discuss, using a short-run Phillips curve diagram, the view that there is a
possible trade-off between the unemployment rate and the inflation rate in the
short run.
In economics, the Phillips curve is
a historical inverse relationship
between the rate of
unemployment and the rate of
inflation in an economy.
Stated simply, the lower the
unemployment in an economy, the
higher the rate of inflation.
While it has been observed that
there is a stable short run tradeoff
between unemployment and
inflation, this has not been
observed in the long run.
29. Discuss, using a short-run Phillips curve diagram, the view that there is a
possible trade-off between the unemployment rate and the inflation rate in the short
run.
Aggregate demand and the Short-run
Phillips curve (SRPC) share similar
components.
The rate of unemployment and rate of
inflation found in the short-run Phillips curve
correspond to the real GDP and price level of
aggregate demand.
Changes in aggregate demand translate as
movements along the Short-run Phillips
curve.
If there is an increase in aggregate demand,
such as what is experienced during demandpull inflation, there will be an upward
movement along the short-run Phillips curve.
As aggregate demand increases, real GDP
and price level increase, which lowers the
unemployment rate and increases inflation.
29. Discuss, using a short-run Phillips curve diagram, the view that there is
a possible trade-off between the unemployment rate and the inflation rate in
the short run.
The key to understanding this trade-off is to consider the possible inflationary
effects in both labor and product markets arising from an increase in national
income, output and employment.
The labor market: As unemployment falls, some labor shortages may occur
where skilled labor is in short supply. This puts extra pressure on wages to rise,
and since wages are usually a high percentage of total costs, prices may rise
as firms pass on these costs to their customers
Other factor markets: Cost-push inflation can also come from rising demand
for commodities such as oil, copper and processed manufactured goods such as
steel, concrete and glass. When an economy is booming, so does demand for
these components and raw materials.
Product markets: Rising demand and output puts pressure on scarce resources
and can lead to suppliers raising prices to widen profit margins. The risk of
rising prices is greatest when demand is out-stripping supply-capacity leading
to excess demand (i.e. a positive output gap)
29. Discuss, using a short-run Phillips curve diagram, the view that there is a
possible trade-off between the unemployment rate and the inflation rate in the short
run.
30. Explain, using a diagram, that the short-run Phillips curve may shift outwards,
resulting in stagflation (caused by a decrease in SRAS due to factors including supply
shocks).
Events in the 1970’s and 1980’s upset the line
of thinking that there was a long term stable
relationship between inflation and
unemployment.
The supply shocks of higher oil prices brought
on by the actions of OPEC and severe droughts
resulted in a very high increase in the cost of
energy and food.
The results of these events led to an inward
shift of the short-run aggregate supply which
resulted in higher unemployment with a
decrease in real GDP. This is called,
stagflation or cost-push inflation.
This phenomenon is inconsistent with the logic of
the short-run Phillips curve, and was
interpreted to involve an upward shift of the
short-run Phillips curve.
30. Explain, using a diagram, that the short-run Phillips curve may shift outwards,
resulting in stagflation (caused by a decrease in SRAS due to factors including supply
shocks).
30. Explain, using a diagram, that the short-run Phillips curve may shift outwards,
resulting in stagflation (caused by a decrease in SRAS due to factors including supply
shocks).
Shifting the Phillips Curve with a Negative Supply Shock
30. Explain, using a diagram, that the short-run Phillips curve may shift outwards,
resulting in stagflation (caused by a decrease in SRAS due to factors including supply
shocks).
31. Discuss, using a diagram, the view that there is a long-run Phillips curve that is vertical at the
natural rate of unemployment and therefore there is no trade-off between the unemployment rate and
the inflation rate in the long run.
It was Milton Friedman and Edmund Phelps
who showed that the Phillips relationship
between unemployment and inflation was
valid over the short run but not over the long
run.
Over the long run, the natural rate of
unemployment would be unaffected by
prices.
This accords with the principle of monetary
neutrality, which simply states that nominal
quantities, such as prices, cannot affect real
variables, such as output and employment. If
prices go up, incomes generally follow.
Hence, the long-run Phillips curve is vertical,
which means that it does not depend on
money growth or inflation in the long-run.
31. Discuss, using a diagram, the view that there is a long-run Phillips curve that is vertical at the
natural rate of unemployment and therefore there is no trade-off between the unemployment rate and
the inflation rate in the long run.
The long-run Phillips curve is vertical at the economy’s
natural rate of unemployment for the same reason that the
long run aggregate supply curve is vertical at the full
employment level of output. (A)
Suppose that in the short-run there is an increase in
aggregate demand. Remember that wages and other
resource prices are constant, but price levels have
increased, which gives firms an increased profitability as
output increases and unemployment falls. (B)
But in the long-run, wages and other resource prices rise to
meet the increase in price levels (because they are flexible in
the long run), causing the SRAS curve to shift to the left,
back to the LRAS curve.
Real GDP has fallen back to its full employment output
level but price levels have increased. The SRPC has shifted
to the right as a result of the SRAS shift. (C)
This shows that price levels are independent of
unemployment levels in the long run.
Aggregate Demand Shifts and the Phillips Curve
31. Discuss, using a diagram, the view that there is a long-run Phillips curve that is
vertical at the natural rate of unemployment and therefore there is no trade-off between
the unemployment rate and the inflation rate in the long run.
The long run Phillips Curve (LRPC) is
normally drawn as vertical – but the
long run curve can shift inwards over
time.
An inward shift in the long run Phillips
Curve might be brought about by
supply-side improvements to the
economy – and in particular a
reduction in the natural rate of
unemployment.
For example labor market reforms
might be successful in reducing frictional
and structural unemployment – perhaps
because of improved incentives to find
work or gains in the human capital of
the workforce that improves the
occupational mobility of labor.
2.3 Macroeconomic objectives:
Economic Growth
32. Describe, using an LRAS diagram, economic growth as an increase in
potential output caused by factors including increases in the quantity and quality
of resources, leading to a rightward shift of the LRAS curve.
32. Describe, using an LRAS diagram, economic growth as an increase in potential
output caused by factors including increases in the quantity and quality of resources,
leading to a rightward shift of the LRAS curve.
Economic growth is an increase in the value of goods and services produced
by an economy over time.
Actual growth (GDP)
Potential growth (trend growth)
The percentage annual increase in a
country’s real gross domestic product over
a period of time
The long run expansion of an economy’s
productive potential
The % annual increase in national output
The increase in the capacity of the
economy to produce
Caused by an increase in aggregate
demand
Caused by an increase in aggregate
supply
Potential output is that which could be
produced if there was full employment of
resources
32. Describe, using an LRAS diagram, economic growth as an increase in potential
output caused by factors including increases in the quantity and quality of resources,
leading to a rightward shift of the LRAS curve.
Causes of shifts in the long run aggregate supply curve:
Any change that alters the natural rate of growth of
output shifts LRAS
Improvements in productivity and efficiency or an
increase in the stock of capital and labor resources
cause the LRAS curve to shift out.
An increase in the size of the productive capital stock of
a country will also shift out the LRAS e.g. arising from
the effects of infrastructure investment or an injection
of investment from overseas (FDI)
32. Describe, using an LRAS diagram, economic growth as an increase in potential
output caused by factors including increases in the quantity and quality of resources,
leading to a rightward shift of the LRAS curve.
Key factors that affect the long run aggregate supply:
1.Higher Productivity of Labor and Capital i.e. a rise in
output per person employed or increased efficiency of
technology
2.Increased Labor Market Participation (Growing Labor
Supply) - what policies can help increase employment?
3.Demand and Supply-Side gains from Innovation and
Enterprise - two key factors that determine competitiveness
4.Capital Investment – including capital spending by
domestic businesses, inward investment from overseas and
Public Sector (Government)
32. Describe, using an LRAS diagram, economic growth as an increase in potential
output caused by factors including increases in the quantity and quality of resources,
leading to a rightward shift of the LRAS curve.
Policies to increase long run aggregate supply:
Expanding the labor supply - e.g. by improving work incentives and relaxing controls on inward
labor migration. In the long term many countries must find ways of overcoming the effects of an
ageing population and a rising ratio of dependents to active workers
Increase the productivity of labor – e.g. by investment in training of the labor force and
improvements in the quality of management of human resources. Productivity can be measured in
several ways including output per person employed and output per hour worked
Improve mobility of labor to reduce certain types of unemployment for example structural
unemployment caused by occupational immobility of labor. If workers have more skills and
flexibility, they will find it easier to get work. Conversely when unemployment remains high, the
economy loses out on potential output and there is a waste of scarce resources
Expanding the capital stock – i.e. increase investment and research and development
Increase business efficiency by promoting greater competition within markets
Stimulate invention and innovation – to promote lower costs and improvements in the dynamic
efficiency of markets. Innovation creates new goods and services and encourages investment
33. Evaluate the view that increased investment is essential
to achieve economic growth.
The three factors of production: land, or natural resources; labor,
or human resources; and physical capital, can be looked at as types
of ‘capital’.
Physical Capital: is the result of investment spending to produce
machines, tools, equipment, etc.
Human Capital: is the result of investment spending on education,
training, provision of health care services, etc.
Natural Capital: includes everything under the land, plus everything
on the land, plus a country’s overall natural environment and
ecosystem.
Investment can be undertaken by the private sector (firms or
private individuals) or by the public sector (the government).
33. Evaluate the view that increased investment is essential
to achieve economic growth.
Physical capital, technology and economic growth
An increase in the quantity of physical capital involves an increase in the number
of machines, tools, equipment etc. Whereas an improvement in the quality of
physical capital depends on technological advances, which lead to new and
better machines, tools and equipment. So the use of capital goods that embody a
new technologies leads to a larger quantity of output produced and thus economic
growth.
Investment and economic growth
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But by investing more in capital today a nation must forgo current consumption
which might reduce the standard of living in the short-run.
Also, new technology might lead to structural unemployment form displace
workers who’s jobs are lost to innovation.
The increase in physical capital might lead to more external cost to society
from increase pollution.
33. Evaluate the view that increased investment is essential
to achieve economic growth.
Human resources, human capital, and economic growth
An increase in the quantity of labor are unlikely to be a source of economic
growth by itself, but improvements in the quality of labor, arising from investment
spending in human capital are among the most important sources of growth. This is
because a highly skilled, well-educated and healthy labor force is more
productive than an unskilled, uneducated and unhealthy one.
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
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However, increases in labor might not match the skills needed in the market
place. Example, an influx of unskilled workers would not match an economy
with high skill needs. This in turn could lead to a burden on social programs
and services.
A nation would have to commit long term to funding an educational system
which would be very costly and ongoing.
A nation would have to commit long term to funding a healthcare system to
make the quality of labor productive, which would be very costly and
ongoing.
33. Evaluate the view that increased investment is essential
to achieve economic growth.
Natural resources, natural capital and economic growth
Marketable commodities are commodities that are bought and sold like timber,
minerals, coal & oil. Whereas ecological resources include soil quality, rivers,
clean air and are mostly known as common access resources.
The role of marketable commodities
Marketable commodities can contribute to growth but are not essential. Example
include countries like Japan, South Korea and others that have achieved high
growth rates in spite of producing few marketable commodities.
The role of ecological goods and common access resources
Ecological goods and common access resources are crucially important to longterm growth because of the concept of sustainability. For example,
environmental destruction on a large scale means that future generations will have
fewer and lower quality of resources available to them.
33. Evaluate the view that increased investment is essential
to achieve economic growth.
If an economy chooses to produce more capital
goods than consumer goods, then it will grow by
more than if it allocated more resources to
consumer goods,.
To achieve long run growth the economy must use
more of its capital resources to produce capital
rather than consumer goods.
As a result, standards of living are reduced in the
short run, as resources are diverted away from
private consumption.
However, the increased investment in capital
goods enables more output of consumer goods to
be produced in the long run.
This means that standards of living can increase
in the future by more than they would have if the
economy had not made such as short-term sacrifice.
Hence economies face a choice between high levels
of consumption in the short run and the long run.
33. Evaluate the view that increased investment is essential
to achieve economic growth.
The effects of an increase in capital
investment:
The initial impact of investment is on the AD
curve, which shifts to the right as investment
is a component of AD.
In the long run, the investment will increase
the economy's capacity to produce, which
shifts the LRAS curve to the right.
Finally, it is likely that production costs will
fall as new technology increases efficiency
and reduces average costs.
This means that the SRAS curve shifts to the
right.
The combined effects are that the economy
grows, both in terms of potential output and
actual output, without inflationary pressure.
34.Evaluate the view that improved productivity is
essential to achieve economic growth.
Productivity which refers to the quantity of output
produced for each hour of work of the working
population.
For an economy as a whole, productivity can be
measured as real GDP divided by the total number of
hours worked.
Improvements in productivity leads to economic growth,
because each hour of work now produces more output.
The factors that lead to an improvement in productivity
are basically the same factors as with investment.
(physical capital, labor & ecological resources)
34.Evaluate the view that improved productivity is
essential to achieve economic growth.
Improvements in productivity arise from factors that make
labor more productive, so that each hour of work produces
more output.
These factors include:
 Increase in quantity and improvements in quality of
physical capital (through investments in physical capital
and technological change)
 Improvements in the quality of labor (through investments in
human capital)
 Improvements in (or at least maintenance of) the quantity
and quality of ecological resources (through investments in
natural capital).
34.Evaluate the view that improved productivity is
essential to achieve economic growth.
The main drivers of growth are the
availability of natural resources and
productivity.
Shortages of natural resource can be
overcome through trade or innovation.
Productivity can be increased through
investment in physical or human capital,
as well as technology.
In addition, institutions that align
individual incentives with growth and
promote entrepreneurship help the
economy expand.
The production function relates total
output to land, labor, capital and
technological advancement.
34.Evaluate the view that improved productivity
is essential to achieve economic growth
35. Discuss the possible consequences of economic growth, including the possible
impacts on living standards, unemployment, inflation, the distribution of income, the
current account of the balance of payments, and sustainability
Impacts on living standards:
Economic growth tends to lead to higher standard of living for the
average person. Higher real income per head enables people to
spend more money to meet their needs and wants, thus helping to
eliminate absolute poverty in the country.
Economic growth offers the potential to achieve improvements in
human development and standards of living, these improvements do
not occur automatically as a result of economic growth but require
appropriate policies to make effective use of the resources growth
makes available.
35. Discuss the possible consequences of economic growth, including the possible
impacts on living standards, unemployment, inflation, the distribution of income, the
current account of the balance of payments, and sustainability
Benefits of economic growth:
Increased consumption
Consumers can benefit from consuming more goods and services. An assumption of economics
is that consumption is related to utility, so in theory, with higher consumption levels, there is
greater prosperity.
Improved public services
With increased tax revenues the government can spend more on important public services
such as health and education (Merit Goods). Improved health care can improve quality of
life through treating diseases and increasing life expectancy. Increased educational
standards can give the population a greater diversity of skills and literacy. This enables
greater opportunity and freedom. Education is seen as an important determinant of
welfare and happiness.
Reduced unemployment and poverty
Economic Growth helps to reduce unemployment by creating jobs. This is significant because
unemployment is a major source of social problems such as crime and alienation.
35. Discuss the possible consequences of economic growth, including the possible
impacts on living standards, unemployment, inflation, the distribution of income, the
current account of the balance of payments, and sustainability
There are economic and social costs of a fast-expanding economy:
Why economic growth may not bring increased happiness:
Diminishing returns
Often as economic growth increases incomes, people increasingly save their money
(higher marginal propensity to save) this is basically because they struggle to find
anything meaningful to spend their money on.
Externalities of growth
Economic Growth with involves increased output causes external side effects, such,
as increased pollution. The economic and social costs could potentially be greater
than all the perceived benefits of recent economic growth.
Economic growth can cause increased inequality
It is perhaps a paradox that higher economic growth can cause an increase in
relative poverty. This is because those who benefit from growth are often the highly
educated and those who own wealth.
35. Discuss the possible consequences of economic growth, including the possible
impacts on living standards, unemployment, inflation, the distribution of income, the
current account of the balance of payments, and sustainability
Why economic growth may not bring increased happiness:
Increase in crime and social problems
It is another paradox that as incomes increase and people are better off the level
of crime has increased as well. One reason why crime rates increase is that quite
simply there are more things to steal.
Higher economic growth has led to more hours worked
In the past couple of decades higher incomes have actually led to people working
longer hours. It seems people are unable to enjoy their higher incomes. Feeling the
necessity or preferring to work longer hours. This suggest people are valuing
earning money more than leisure.
Diseases of affluence
Economic Growth has enabled improved health care treatments, but at the same
time there has been an unexpected rise in the number of diseases and illnesses
related to increased prosperity. One example is obesity.
35. Discuss the possible consequences of economic growth, including the possible
impacts on living standards, unemployment, inflation, the distribution of income, the
current account of the balance of payments, and sustainability
Economic growth due to the short-term fluctuations of the business
cycle can mainly reduce and possibly eliminate cyclical
unemployment, but with only a temporary impact on natural
unemployment.
Sustained reductions in natural, and particularly structural
unemployment may result from long-term economic growth,
involving increases in potential output.
However, not all increases in potential output lower natural
unemployment.
Depending on the particular factors that cause potential output to
increase, natural and therefore structural unemployment may
increase, decrease, or remain the same.
35. Discuss the possible consequences of economic growth, including the possible
impacts on living standards, unemployment, inflation, the distribution of income, the
current account of the balance of payments, and sustainability
In certain situations, economic growth may itself lead to increases
in structural unemployment. This could occur when growth results
from technological changes leading to a fall in the demand for
certain labor skills.
Economic policies pursued by government can also work both
ways. Supply-side, market-based policies based on labor market
reforms, and certain interventionist policies including investment
in human capital, can work to reduce the natural rate of
unemployment.
Other market-based policies, such as privatization, and trade
and market liberalization, may work to increase this type of
unemployment.
35. Discuss the possible consequences of economic growth, including the possible
impacts on living standards, unemployment, inflation, the distribution of income, the
current account of the balance of payments, and sustainability
Since the Keynesian model and the
classical/monetarist model have
different views on the shape of the
aggregate supply curve, there are
different outcomes on price levels in the
respective models.
In the horizontal part of the Keynesian
AS curve, any increase in AD will have a
constant price level due to excess
capacity and unemployed resources in
the economy.
In the classical/monetarist AS curve,
which is upward slopping, any increase in
AD will result in increases in the price
levels.
35. Discuss the possible consequences of economic growth, including the possible
impacts on living standards, unemployment, inflation, the distribution of income, the
current account of the balance of payments, and sustainability
However, there is agreement between
the two models when economic
growth leads to an increase in AD at
or beyond the level of full
employment there is inflationary
pressure.
Both models also agree if there an
increase in potential output involving
an increase in either the SRAS or AS
curves.
In both cases inflationary pressure
should be reduced as productive
capacity of the economy has
increased due to economic growth.
35. Discuss the possible consequences of economic growth, including the possible
impacts on living standards, unemployment, inflation, the distribution of income, the
current account of the balance of payments, and sustainability
Economic growth often creates greater disparities in the distribution of income and
wealth, widening the gap between rich and poor. However, economic growth also
leads to greater tax revenues, enabling the government to redistribute income and
wealth.
With that said, there is no clear relationship between growth in GDP per capita and
income distribution; instead, what happens to income distribution as a country grows
is a reflection of particular conditions in each country and the kind of growth policies
that are pursued.
In both developed and developing countries, a major factor behind increasing income
inequalities has been the growing use of market-based supply-side policies.
With a move towards more economic and trade liberalization, there has been a rise in
both winners and losers.
While those who can take advantage of new opportunities gain, many become worse
off, if they are less educated or skilled, cannot get credit, are geographically isolated,
have nothing to produce for export, lose their jobs due to privatization or reductions in
the size of the government sector, and so on.
35. Discuss the possible consequences of economic growth, including the possible
impacts on living standards, unemployment, inflation, the distribution of income, the
current account of the balance of payments, and sustainability.
In looking at the relationship between economic growth and the current
account balance of a country, we find economic growth leading to a larger
deficit or smaller surplus in the upward phase of the business cycle. This is due
to the increasing incomes leads to an increase in the demand for imports.
However, over the longer term we likely to find that there is no clear
relationship: as the economy grows, the current account balance may improve,
stay the same or worsen, depending on what happens to the following factors.

The international competitiveness of domestic industries

Exchange rates

The degree of export orientation of the economy

Growth of incomes of trading partners

The degree of protectionist trade policies faced by exports
35. Discuss the possible consequences of economic growth, including the possible
impacts on living standards, unemployment, inflation, the distribution of income, the
current account of the balance of payments, and sustainability.
Experience shows that growth, especially rapid growth, often leads to unsustainable resource
use particularly in the case of common access resources.

Industrialization based on fossil fuels has been a major source of pollution.

Increasing incomes lead to consumption patterns also based on greater fossil fuel consumption.
Experiences like these have led to the widespread belief that economic growth and
environmental sustainability are conflicting objectives. However, modern growth theory shows
that both of these issues are in fact consistent with each other, and can be successfully pursued
together under certain conditions.
Examples include:

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Governments implement market-based policies that ‘internalize the externalities’, but also by
providing incentives for sustainable resource use and promotion of green technologies.
Governments pursue more environmental regulations that encourage pollution-free
technological change.
An increased emphasis on ‘green’ investments, which promote growth while not hurting the
environment.