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How The Macro economy Works

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Title: How The Macro economy Works


1
How The Macro economy Works
2
Content
  • Aggregate demand
  • Aggregate supply
  • Determinants of Aggregate demand
  • Aggregate demand and the level of economic
    activity
  • The long run aggregate supply curve

3
Aggregate Demand
  • Aggregate demand measures the total expenditure
    in the economy as a whole
  • It is calculated using the following formula
  • AD C I G (X-M)
  • C consumption
  • I investment
  • G government expenditure
  • X exports
  • M imports

4
Aggregate Demand Curve
  • The curve slopes from left to right because it is
    based on the following assumptions
  • Bank of England sets short term interest rates
  • A rise in inflation is matched by a rise in
    interest rates
  • An increase in interest rates increases the cost
    of borrowing
  • This shows the total level of expenditure at
    different price levels

5
Aggregate Supply
  • Aggregate supply shows the total amount supplied
    in the economy as a whole at each price level
  • In the short term aggregate supply slopes upwards

6
Interaction of AD and AS
  • In the short run where the AD and AS curves
    interact is the level of national income

7
Price level and AD / AS
  • If the price level changes this is represented by
    movements along the AD / AS curves

8
Shifts in the aggregate demand curve
  • Any change in the components of AD (C,I, G, (X-M)
    cause the curve to shift
  • Economic growth is represented by a rightwards
    shift in the LRAS curve

9
Shifts in the AS curve
  • The AS curve may be shifted by changes in
  • The size / quality of the labour force
  • The size / quality of capital
  • Expectations of inflation
  • Technology
  • The productivity of labour / capital
  • Wages per unit of output
  • Taxes / subsidies for producers

10
AD / AS Diagrams
  • These can show
  • Causes of inflation
  • Demand deficit unemployment
  • Economic growth

11
Determinants of AD
  • The determinants of AD are C, I, G, X and M
  • C represents the consumption expenditure of the
    economy as a whole
  • There are a number of factors that influence the
    level of C including
  • Tax rates
  • Inflation
  • Wage increases
  • Interest rates
  • Credit
  • Wealth
  • Shares
  • Property
  • Savings
  • Bonds

12
Determinants of Consumption
  • Consumption is affected by interest rates because
    as interest rates rise the opportunity cost of
    spending increases and saving becomes more
    attractive
  • In addition as interest rates rise if people have
    high levels of borrowing their real income will
    be reduced decreasing rates of consumption

13
Determinants of Consumption
  • Taxation rates influence consumption as the
    higher the rate of tax the lower peoples real
    income and therefore the lower the rate of
    consumption
  • Credit influences consumption as if credit is
    readily available it will increase consumption
    levels
  • Wealth influences consumption as if people have
    wealth in the form of property, stocks etc they
    are more likely to consume at a higher rate

14
Determinants of Investment
  • Investment represents all spending on capital
    items which are used to generate future incomes
  • Examples of investment are expenditure on
    machinery, buildings, equipment and
    infrastructure
  • Investment expenditure is influenced by
  • Interest rates
  • Sales forecasts
  • Inflation projections
  • Expected rates of return

15
Determinants of Investment
  • When making investment decisions businesses need
    to ensure that there will be demand to meet the
    production the investment generates it is
    therefore important for them to use sales
    forecasts when making investment decisions
  • When making investment decisions firms look at
    expected rates of return for the action to enable
    them to decide in the project is worthwhile

16
Determinants of Investment
  • There is an inverse relationship between
    investment and interest rates
  • As interest rates fall the cost of investment
    decreases therefore firms are more likely to
    invest
  • Inflation can influence investment as if there is
    high inflation firms are more likely to make
    investment decisions as their return is likely to
    be higher in real terms

17
Determinants of Government Spending
  • Government expenditure includes all spending by
    the public sector in areas such as defence,
    healthcare, education, social welfare etc
  • Government expenditure is heavily influenced by
    political factors
  • Government expenditure is also influenced by the
    rate of taxation in the country as this is used
    to fund the spending

18
Import and Export Expenditure
  • If more money is being spent on imports than
    exports (balance of payments deficit) AD will be
    reduced
  • If more money is being spent on exports than
    imports (balance of payments surplus) AD will be
    increased

19
Economic growth and Imports
  • When the economy grows quickly consumption is
    high and British consumers have a tendency to
    spend their money on imports
  • This leads to a larger balance of payments
    deficit

20
AD and Economic Activity
  • A change in the level of AD can cause influence
    the level of national income
  • If an economy is operating below its potential
    level then a shift in AD causes national income
    to rise in the short term
  • The impact of the change in AD depends on how
    close the economy is to full capacity

21
Long Run Aggregate Supply Curve
  • LRAS is determined by the productive resources
    available in the economy and the productivity of
    the factors of production (land, labour and
    capital)
  • In the long run the assumption is that supply is
    not dependent on the level of prices in the
    economy therefore the LRAS is vertical

22
LRAS curve
  • The LRAS is vertical the same level of income
    at all price levels
  • This is the normal level of output in an economy
  • To move the LRAS outwards there needs to be
    improvements to productivity and efficiency in
    the economy - this represents economic growth

23
Determinants of LRAS
  • Technology
  • Productivity
  • Attitudes
  • Enterprise
  • Factor mobility
  • Institutional structure of the economy
  • Economic incentives

24
Summary
  • Aggregate demand shows the total amount of
    expenditure in the economy
  • Aggregate supply shows the total amount supplied
    in the economy at each price level
  • AD C I G (X-M)
  • Any change in the determinants of Aggregate
    demand will cause the AD curve to shift
  • In the short term shifts in the AD curve can
    cause an increase in national income
  • The long run aggregate supply curve is vertical
  • If LRAS increases the curve shifts out and
    economic growth has occured
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