The Macroeconomy
A Level
Revision
 Macroeconomics is the branch of economics which deals
with macroeconomic variables, such as aggregate demand,
aggregate supply, general price level, total expenditure, total
saving, total investment, total employment and so on.
 Therefore, macroeconomics is the study of economy of a
country as a whole.
 Aggregate demand is the total actual expenditure of an
economy over a period of time. i.e.
 AD = C + I + G + (X – M)
 Aggregate supply is the total expected expenditure of an
economy over a period of time.
AD and AS
Y
P
C+I
C,I
Price Level
AS
E
E
C
Q
Q’’
Real GDP
AD
0
Q
Real GDP
0
Q’
Economic growth
 It is an increase in a country's real
AS
Price Level
level of national output which can be
caused by an increase in the quality of
resources (by education etc.),
increase in the quantity of resources
& improvements in technology or in
another way an increase in the value
of goods and services produced by
every sector of the economy.
Economic Growth can be measured
by an increase in a country's GDP
(gross domestic product).
 When there is rise in aggregate
demand of an economy, it is generally
termed as economic growth
P’
P
E’
E
AD’
AD
0
Q Q’
Real GDP
Price Level
LRAS
P’
E’
P
E
AD’
AD
0
Y Y’
Real GDP
Economic growth cont’d
Principal components of Economic growth
 The sustained rise in national output is manifestation of
economic growth and the ability to provide a wide range
of goods is a sign of economic maturity
 Advancing technology provides the basis or preconditions
for continuous economic growth, a necessary but not
sufficient condition
 To realize the potential for growth inherent in new
technological, institutional, attitudinal and ideological
adjustment must be made.
Economic growth cont’d
Characteristics of modern economic growth
 High rate of growth per capita output and population
 High rate of increase in total factor productivity
 High rate of structural transformation of the economy
 High rate of social and ideological transformation
 The propensity of economically developed countries to
reach out the rest of the world for markets and raw materials
 The limited spread of this economic growth to only one-
third of the world’s population
Sources of Economic growth
 Natural Resources
 Population Growth: Human Resources
 Capital Formation
 Technological Progress
 Values and Institutions
8
Actual and Potential Economic Growth
occurs when output increases
 It can be achieved as the result of
greater utilisation of existing
resources or as the result of the
utilisation of more resources.
 It can be explained with the help
of PPC.
 Any point on the boundary of
PPC represents maximum
possibility of the production of
goods by the economy (in the
diagram, it is shown as A or B or
C
Capital goods
 Actual economic growth
A
PPC1
C
300
200
0
Y
X
200
400
B
Consumer goods
If an economy can produce at any point, say X initially. If the economy can produce
more with greater utilisation of resources, say point Y, it is referred as actual economic
growth.
Potential Economic Growth
P’
P
LRAS
LRAS’
Capital goods
Price Level
For an economy to continue to grow, it is necessary for potential economic growth to occur
A’
E
A
PPC2
PPC1
C’
C
E’
300
E’
AD’ 200
Y
X
AD
0
Y Y’
Y’’
Real GDP
0
200
400
B’
B
Consumer goods
Potential Economic Growth cont’d
 Potential economic growth is an increase in the productive
capacity of the economy.
 For potential economic growth to lead to higher output, the
rise in productive potential must be utilised.
 The outward shift in PPC shows potential economic growth
of an economy, whereas, the rightward shift in LRAS shows
the potential economic growth of the economy
Output gaps
 The difference between actual and potential output is known as
the output gap.
 In other words, output gap is a gap between actual and potential
output
 Negative output gap is a situation where actual output is below
potential output.
 Output may be beyond maximum potential for a while because, in
response to high aggregate demand
 machinery may be worked flat out and workers may be persuaded to
work long hours of overtime.
 However, this cannot be sustained since a time will come when
machines have to be serviced or repaired and when workers will want
to reduce the number of hours of overtime they work.
Output gaps cont’d
 Positive output gap is a situation where actual output is
above potential output.
Price Level
Output gaps cont’d
LRAS
Negative output gap
Positive output gap
SRAS
A
P
E
AD
0
Y Yf Y’
Real GDP
Real GDP
Trade cycle and output gap
Positive output gap
Actual output
Trend in potential
output growth
B (Peak)
Q
A
P
E
C
Negative output gap
D (trough)
0
Time
Trade Cycle
 Business conditions never remain unchanged. A business cycle
refers to oscillations in aggregate economic activities particularly
in employment, output and income, prices and profits.
 According to Prof. Benham, “ Trade cycle refers to a period of
prosperity followed by a period of depression”.
 Characteristics of Trade Cycle:
 Fluctuations of aggregate economic activities
 Alternation of expansion and contraction in economic activity
 Self reinforcing
 Degree of regularity
 Presence of crisis
Phases of Trade Cycle
 Prosperity Phase :
Expansion or Boom or
Upswing of economy.
 Recession Phase : from
prosperity to recession (upper
turning point).
 Depression Phase :
Contraction or Downswing of
economy.
 Recovery Phase : from
depression to prosperity
(lower turning Point).
Prosperity Phase
 When there is an expansion of output, income, employment, prices and profits,
there is also a rise in the standard of living. This period is termed as Prosperity
phase.
 The features of prosperity are : High level of output and trade.
 High level of effective demand.
 High level of income and employment.
 Rising interest rates.
 Inflation.
 Large expansion of bank credit.
 Overall business optimism.
 A high level of MEC (Marginal efficiency of capital) and investment.
 Due to full employment of resources, the level of production is Maximum and
there is a rise in GNP (Gross National Product). Due to a high level of
economic activity, it causes a rise in prices and profits. There is an upswing in
the economic activity and economy reaches its Peak. This is also called as a
Boom Period.
Recession Phase
 The turning point from prosperity to depression is termed as Recession
Phase.
 During a recession period, the economic activities slow down. The seed
of recession are contained in the boom in the forms of three factors;
scarcity of labor, raw materials etc, rise in the rate of interest due to
scarcity of capital and failure of consumption to rise due to rising prices.
 When demand starts falling, the overproduction and future investment
plans are also given up. There is a steady decline in the output, income,
employment, prices and profits. The businessmen lose confidence and
become pessimistic (Negative). It reduces investment. The banks and the
people try to get greater liquidity, so credit also contracts. Expansion of
business stops, stock market falls. Orders are cancelled and people start
losing their jobs. The increase in unemployment causes a sharp decline in
income and aggregate demand. Generally, recession lasts for a short
period.
Depression Phase
 When there is a continuous decrease of output, income, employment,
prices and profits, there is a fall in the standard of living and depression
sets in.
 The features of depression are : Fall in volume of output and trade.
 Fall in income and rise in unemployment.
 Decline in consumption and demand.
 Fall in interest rate.
 Deflation.
 Contraction of bank credit.
 Overall business pessimism.
 Fall in MEC (Marginal efficiency of capital) and investment.
 In depression, there is under-utilization of resources and fall in GNP
(Gross National Product). The aggregate economic activity is at the
lowest, causing a decline in prices and profits until the economy reaches
its Trough (low point).
Recovery Phase
 The turning point from depression to expansion is termed as Recovery
or Revival Phase.
 During the period of revival or recovery, there are expansions and rise
in economic activities. When demand starts rising, production increases
and this causes an increase in investment. There is a steady rise in output,
income, employment, prices and profits. The businessmen gain
confidence and become optimistic (Positive). This increases investments.
The stimulation of investment brings about the revival or recovery of the
economy. The banks expand credit, business expansion takes place and
stock markets are activated. There is an increase in employment,
production, income and aggregate demand, prices and profits start
rising, and business expands. Revival slowly emerges into prosperity, and
the business cycle is repeated.
 Thus we see that, during the expansionary or prosperity phase, there is
inflation and during the contraction or depression phase, there is a
deflation.
The factors contributing to
economic growth
 In the short run if there is spare capacity, output can be increased
as a result of an increase in aggregate demand which is indeed
contributing to economic growth
 Greater consumer confidence may lead to higher consumption
expenditure and hence an increase in aggregate demand, so does
business confidence.
 In order to achieve economic growth that can be sustained over
time, it is necessary for potential output and so long-run aggregate
supply to increase.
 There are two broad causes of such an increase, which are more
resources or better quality resources.
 Increase in the quantity of resources
 Increase in the quality of resources
The costs and benefits of economic
growth
Costs
 If an economy is operating at full capacity, there will be an
opportunity cost involved in achieving economic growth.
 In order to increase the country’s productive capacity some
resources will have to be moved from producing consumer
goods to producing capital goods. So the current
consumption of goods and services will have to be reduced.
 In the long run, increased investment will increase the output
of both capital goods and consumer goods and services.
 The potential costs that may exist in both the short run and
the long run include increased stress and anxiety.
The costs and benefits of economic
growth
Benefits
 The main benefit of economic growth is the increase in
goods and services that become available for the country’s
citizens to enjoy. This raises their material living standards.
 Higher incomes and more spending increase tax revenue.
 Economic growth may also be accompanied by a rise in
employment. A rise in real GDP caused by higher aggregate
demand is likely to create extra jobs.
 A stable rate of economic growth tends to increase business
and consumer confidence.
The costs and benefits of economic
growth
Using and conserving resources
 Using natural resources now can increase economic growth, at
least in the short run. For example, cutting down trees in a
rainforest, hunting animals in a wildlife reserve or increasing the
amount of gas extracted from gas fields can increase output and
create jobs. It can also increase exports and so improve the current
account position on the country’s balance of payments.
 Nevertheless, some arguments for conserving resources. For
example, maintaining rainforests and wildlife in a reserve may
encourage tourists to visit the country.
 Conserving resources also enables future generations to benefit
from them