Economics - Mod 2 - Unit 2

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Unit 2 - How the Macro-economy Works

Aggregate Demand

The government desires economic growth because in theory

it should lead to higher levels of prosperity and livings standards.

Economic growth occurs when there is an increase in the

productive capacity of the economy.

A key factor encouraging this increase in output is the

level of aggregate demand.

In macroeconomics, aggregate demand (AD) is the total demand of consumers, firms and governments

for final goods and services in an economy at a given time. It

specifies the amounts of goods and services that will be purchased at

all possible price levels. This is the demand for the gross domestic product of a country.

The aggregate demand curve therefore measures real National Output & Employment against the Price Level.

The demand curve is

downward sloping to illustrate the inverse relationship between aggregate

demand and price.

A fall in the price level should in

theory lead to a rise in Aggregate Demand and a rise in national output.

A rise in the Price Level should in theory lead to a fall in Aggregate Demand and a fall in national output.

Price level on the vertical axis measures the averge level of prices, and so is a measure of inflation.

The horizontal axis measures changes in output & employment, which is indicated by changes in Real GDP (real national income).

Components of Aggregate Demand

The aggregate demand in the economy is made up of four key

components:

1. Consumption

Spending (C)

This represents the total amount spent by consumers on

finished goods and services. There

are three basic types of consumer good:

Durables - These are goods which the consumer

intends to keep and so will be consumed over a period of time e.g. cars, home appliances.

Non-durables - These represent goods that will be

consumed in a short period of time e.g. food.

Services - These represent goods that don’t have

a physical presence in the same way that a TV does, such as going to the

cinema.

2. Investment

Spending (I)

This represents the spending by firms on capital goods

such as buildings, machinery and stocks.

3. Government

Spending (G)

This represents the spending by government on public

services such as health, education and defence.

4. Trade

(X – M)

This represents the total amount spent on

Exports (X) by the rest of the world less imports (M) spent on by the UK.

Thus the following formula can be used to illustrate

aggregate demand:

Aggregate

Demand = AD = C + I + G + (X-M)

Consumption (C)

Consumption (C) represents the total amount spent by consumers on

finished goods and services regardless of where they are produced.

In the UK, consumption represents 2/3rds of Aggregate Demand.

A household’s consumption will be affected by the following

factors:

Income

Wealth

Credit

Expectations

1. Consumption and Income

The income factor of the consumption component of aggregate demand is represented by Disposable Income. This is the amount of gross income consumers have left to spend after deducting taxes and adding benefits.

Disposable Income = Gross Income - Taxes + Benefits

Income per capita = GDP / Population

Real Income = Current Income adjusted for Inflation

2. Consumption and Wealth

The two forms of wealth for UK households are as following:

Physical - Tangible possessions such as property, cars or jewellery. Property is the key physical form of wealth.

Financial - Monetary investments such as cash, bank accounts, shares and pensions.

Since 1999, house prices have almost trebled in value. During the same period, the stock market returns doubled in value. A rise in the

value of share prices can also affect the wealth of a household. The FTSE is an

index of the change in the shares of the top 100 UK companies.

A rise in house prices will increase the wealth of these households who own the property. This will have the 2 following wealth effects:

Households should in

theory increase their consumption as the higher house price is likely to

increase their confidence.

They increase the mortgage of the property (equity

withdrawal) to finance their higher spending.

3. Consumption and Credit

There are 3 types of credit:

1. Secured Loans such as mortgages to purchase items such as property.

2. Unsured loans to purchase items such as cars.

3. Credit cards for anything else.

Consumers borrow to increase consumption which will be paid for in the future.

Household borrowing will be determined by 3 key factors:

1. Disposable Income

2. Interest Rates

3. Expectations.

The interest rate is

the cost that must be paid to the lender to borrow money. During the mid 1990’s,

interest rates have been historically low and coupled with rising employment

has encouraged consumers to increase their level of debt.

Lower interest rates will encourage more borrowing and more consumption.

Rising property prices will also increase borrowing and consumption.

4. Consumption and Expectations

Consumption

will also be affected by the expectations that households have about the future

and particularly forecasts for:

·

Inflation.

·

Interest rates.

·

House prices.

If households expect economic

conditions to worsen they are likely to reduce consumption in order to build up

savings.

If households expect economic

conditions to improve they are likely to increase consumption.

The determinants of Savings

Savings represent part of household disposable income that is not spent but banks, investment funds and shares. Therefore, they are a withdrawal from the circular flow of income.

The savings ratio is used to measure the proportion of disposable income that is saved by households.

Up to 2008, the savings ratio declined, implying that consumers were spending more of their disposable income, and borrowing more to finance their current spending. This was caused by changes in the 5 following factors:

1. Falling Interest Rates

The rate of interest is the reward to savers and the cost to borrowers.

Lower interest rates means that the cost of borrowing is lower, which also implies a lower reward to savers.

Lower interst rate should encourage higher consumption by households, leading to an increase in aggregate demand and higher output and employment.

2. Falling levels of Unemployment

Falling levels of unemployment mean more consumers are in

work and enjoying rising wages and salaries.

This allows them to increase

their spending at the expense of saving.

3. The falling price of Consumer Durables

The price of consumer durables tends to fall over time

as improvements in technology and competition allow suppliers to cut prices.

A high proportion of spending on consumer durables will

be financed using credit thus leading to a rise in borrowing and a fall in

saving.

4. The wider availability of Credit.

It is becoming much easier for consumers to obtain

credit from banks and retailers. On line and in store applications mean credit can be

arranged at very short notice.

Job security and low interest rates encourages consumers

to take on higher debt.

5. Rising House Prices

In the last ten year years house price have risen

significantly compared to previous decades.

Average house prices have more than trebled over this

period.

This increases a consumers wealth and encourages them to

increase both spending and borrowing.

Positive Equity and Equity Withdrawal

Positive equity exists when thge property value exceeds the mortgage.

Equity withdrawal is where the homeowner re-mortgages their property to take out cash.

Negative Equity

Negative Equity exists when the mortgagevalue exceeds the property value.

his is most likely to occur when house prices fall, probably during an economic recession.

The recession will mean house prices are likely to fall meaning dome households may experience negative equity, and this discourages bank lending and consu er spending. This leads to a fall in aggregate demand, leading to a lower level of output and employment.

The use of credit in order to increase consumption also has some negative consequences. The

rising level of consumer debt is a problem when it becomes unattainable. The

recession is leading to rising levels of house repossessions and bankruptcies as unemployment means consumers don’t have

the disposable income to afford repay

their debts.

Investement (I)

Economists use

the word investment to describe the purchase of capital goods which are use to produce finished goods and services

to satisfy consumers.

Capital is a factor of production and represents man-made resources.

Therefore,

investment implies any addition to the capital stock of physical goods by firms

and government such as:

Factories

Machinery

Offices

Stocks of materials.

Investment is NOT buying stocks and shares. This, for an economist, is an example of

saving.

Physical

investment only takes place if it involves the creation of real products such

as above and these products are used in the production of other goods and

services.

There are 2 types of capital - physical capital

and human capital.

Physical Capital represents investment in man-made things such as buildings, factories roads and machinery.

Human

capital represents investment in people through teaching and

training. Human capital can be measured

by staying on rates in education and the number passing A levels and degrees.

It is also important to appreciate the difference between private and public sector investment

Public

sector investment is investment carried out by any government funded body and will

include spending on schools and hospitals.

Private

sector investment is spending on capital goods by firms such as a car

manufacturer building a new factory.

There are 2 types of investment - gross investment and net investment:

Gross Investment - This is the investment in any capital item such as a machine will have a limited life

and will have to be replaced because it will get worn out through use or made

obsolete by new technology. Gross

investment includes the replacement of existing capital items.

Net investment - This is

the spending on additional investment that is on top of what is needed simply

to maintain the capital stock and so when an economist is talking about a rise

in investment they are talking about a rise in net investment.

Investment will shift the PPF curve outwards, and shift the Aggregate Demand curve to the right.

The

key factors influencing investment in the private sector

The basic reason why firms invest is to make a profit.

Profit is the difference between a firm’s revenue and its costs.

Investment

can help raise a firm’s profits in a number of different ways:

Creating

new products enables a firm to

raise sales (demand) and attract new customers. New technology helps a firm to

differentiate its products from rivals making them superior and thus

allowing higher prices to be charged.

Cutting

costs allows firms to take advantage of new production and

labour saving techniques. This

allows firms to lower prices charged to customers to encourage higher

demand.

There are 6 main factors

that will determine the level of investment

in the economy:

1. The level of Consumer Demand

Firms invest in order to produce consumer goods

and make a profit in the process. Higher

demand means firms can make higher profits which can be used to finance

investment.

2. The rate of Interest

Investment has an inverse relationship with interest rate. This implies that a cut in interest rates should in theory result in higher levels of planned investment by firms.

The MEC curve (Marginal Efficiency of Capital) represents

the level of planned investment at different rates of interest.

The curve is drawn with Interest Rate on the vertical axis, and Planned Investment on the horizontal axis. The MEC curve is drawn downward sloping from left to right to show the inverse relationship with interest rate.

Firms carry out an investment on the basis that it will

generate a return in the form of higher profits. A

rise in interest rates raise the opportunity cost of investment because it

suggests such investment may not be as profitable as they hoped.

3. The Cost of Capital goods

A fall in the price of capital goods

has the effect of encouraging firms to increase investment spending.

In the UK land prices are rising and so

any new buildings by firms will involve them spending more money on acquiring

land. This raises the cost of the investment and so firms will need to make

higher profits to cover their costs.

However, the cost of new technology is

falling and should make it cheaper for firms to invest.

4. Technological Change

Technological change should make capital goods more

productive which means firms can produce more outputs from a given level of

inputs.

This has the effect of raising the profitability of an

investment.

5. Expectations and Business Confidence

Firms

will have to make forecasts about the future when they are calculating the profitability

of an investment project and in particularly about

Future revenues

Future costs.

Investment takes time and a new factory may take a year or more to build and

set up. Hence, firms have to make

investment decisions now of the basis of what they think will happen in a

year’s time, five years time and ten years time. The

more optimistic they are about the future the higher their level of investment

because they more confident of recovering that investment and making a profit.

The

following factors will guide a firm’s expectations:

Interest rates

Inflations rates

Exchange rates

Government spending.

6. Government Policies

The UK

government has spent £billions on new

school and hospitals. However, it is

firms who carry out this construction.

Therefore, spending on education and health

encourages firms to increase their investment in capital goods.

economics mod 2 unit 2 part 1

Aggregate Supply: The Short Run

The aggregate supply is the sum of all the individual

producer supply curves within the economy.

It measures the volume of goods and services produced within an economy

at a given price level.

The short run aggregate supply curve is drawn upward sloping from left to right, to illustrate a positive

relationship between changes in the level of output (real GDP), employment and the price level.

A rise in the price level should in theory lead to a rise in aggregate supply and therefore a rise in output & employment.

A fall in the price level should in theory lead to a fall in aggregate supply and therefore a fall in output & employment.

The short run AS curve is drawn on the assumption that the factors

that affect the producer’s costs of production such as wage rates, material

prices, energy prices, indirect tax rates & productivity are held constant and therefore not changing.

Shifts in the Short Run Aggregate Supply curve

Wage Rates - this is the rate of wages that is paid to employees working for a business.

Material Prices - this is the price of the materials used in producing goods.

Indirect Taxes - this includes VAT and excise taxes, and increase a business' production costs.

Energy Prices - the prices of energy including Oil prices, which dictate the level of supply.

Productivity - an increase in productivity will lower the costs of production by increasing output.

An increase in costs of production will shift AS to the left, implying a decrease in the quantity supplied.

A decrease in costs of production will shift AS to the right, implying an increase in the quantity supplied.

The Macro-economic Equilibrium

The economy

will be in equilibrium at the price level that aggregate demand equals

aggregate supply (Short Run.)

A change in

either aggregate demand or aggregate supply will move the economy to a new

equilibrium level of output and employment and a new price level.

Short run

macroeconomic equilibrium = AD = AS.

Shifts in the Macroeconomic Equilibrium - Aggregate Demand

An increase in aggregate demand will shift the AD curve to the right.

this will cause a movement up the SRAS curve.

The new macroeconomic equilibrium will be at a higher price level P2, and a higher level of output at Y2.

A decrease in aggregate demand will shift the AD curve to the left.

This will cause a movement down the SRAS curve.

The new macroeconomic equilibrium is at a lower price level P2 and a lower level of output at Y2.

There are 4 economic factors that will cause a shift in aggregate demand:

Consumer spending - a rise due to higher disposable income will shift AD to the right, and a fall will shift AD to the left.

Investment - a rise in investment due to higher consumption will shift AD to the right, and a fall will shift AD to the left.

Government Spending - a rise in government spending will shift AD to the right, while a fall on spending will shift AD to the left.

Exports - a rise in exports due to higher global economic growth will shift AD to the right, while a fall in exports will shift AD to the left.

Imports - a fall in imports will shift AD to the right, while a rise in imports will shift AD to the left.

An increase in aggregate supply will shift the SRAS curve to the right.

This will cause a movement down the aggregate demand curve.

The new macroeconomic equilibrium will be at a lower price P2 and a higher output Y2.

A decrease in aggregate supply will shift the SRAS curve to the left.

This will cause a movement up the aggregate demand curve.

The new macroeconomic equilibrium will be at a higher price P2 and a lower output Y2.

The Long-Run Aggregate Supply curve

In the short run the economy is able to increase

its aggregate supply by making more efficient use of its factors of production.

However, there is a physical limit to

the economy’s ability to increase this output.

In the long run the aggregate supply

curve is drawn vertical to illustrate that at a point in time the productive

capacity of the economy is fixed.

The long run aggregate supply curve

LRAS is determined by the limits set by the production possibility frontier.

Economic growth occurs when the

productive capacity of the economy is increasing and this means the economy is

capable of producing more goods and services.

The principle indicator of economic

growth is the rate of change of real national output or GDP

Economic growth is therefore illustrated

by a shift of the LRAS curve to the right.

Therefore, an increase in aggregate

demand does not represent economic growth only the stimulus necessary to

encourage firms to increase the productive capacity of the economy

The position of the LRAS depends upon

the quantity and quality of factors of production such as

(a)

Capital (b)

Labour (c)

Land (d)

Enterprise

An increase in economic growth therefore

implies an outward shift of the production possibility frontier.

The main determinant of economic

growth is investment in

1.

Capital goods such as machinery

2.

Human resources such as labour

In the short run firms will produce more in response to a

rise in the price level.

In the long run, the level of productive

capacity is fixed and can only be increased through factors such as investment.

The LRAS is the level of output

associated with the level of output:

On

the production possibility frontier.

At

the trend rate of economic growth.

At

full capacity meaning all resources are fully employed.

To produce more the economy must

increase its productive capacity by:

Investing

in labour through education and training to improve mobility

Increasing

the size of the working population through immigration

Increasing

the capital stock through physical investment.

Investment

in science and technology to improve technology.

The government is able to play a role

through the reform of legislations to:

Make

land more responsive to changes in its demand

Provide

incentives through changes in the tax and benefit system

Improve

working practices by reforming the rights and responsibilities of worker

Encouraging

an entrepreneurial culture through tax incentives.

Investment is however the key factor

is causing economic growth and an increase in the productive capacity.

economics - mod 2 - unit 2 - part 2