Chapter 4 The Macroeconomy

Aggregate Demand and its Components

Aggregate demand (AD) is the total demand, or the
total spending, in an economy over a given period of
time. So aggregate demand is made up of all the
components that contribute to spending/demand in an
economy. It’s calculated using the formula:
AD = Consumption (C) + Investment (I) + Government
spending (G) + (Exports (X) – Imports (M))
Consumption is the total amount spent by households
on goods and services. It doesn’t include spending by
firms. An increase in consumption will mean an increase
in AD — a reduction in consumption will mean a
reduction in AD. Consumption is the largest component
of aggregate demand.This means that changes in the
level of consumption will tend to have a big impact on
aggregate demand.
Investment is money spent by firms on assets which
they’ll use to produce goods or services — this includes
things such as machinery, computers and offices. Firms
invest with the intention of making profit in the future.
The government spending component of aggregate
demand is the money spent by the government on
public goods and services, e.g. education, health care,
defence and so on. Only money that directly contributes
to the output of the economy is included — this means
that transfers of money such as benefits or pensions
are not included. Government spending is quite a large
component of aggregate demand, so changes in
government spending can have a big influence on
aggregate demand.
  If government spending is greater than its
revenue, there will be a budget deficit.
 If government spending is less than its revenue,
there will be a budget surplus.
Exports are goods or services that are produced in one
country, then sold in another. Imports are the opposite
— they’re goods and services that are brought into a
country after being produced elsewhere. Exports are an
inflow of money to a country, and imports are an
outflow . Exports minus imports (X – M) make up the net
exports component of aggregate demand. If the
amount spent on imports exceeds the amount received
from exports , net exports will be a negative number.

Aggregate Demand Curve

The aggregate demand curve uses different axes to the

normal demand curve — along the x-axis is national
output, and up the y-axis is price level. The aggregate
demand (AD) curve slopes downwards — the lower the
price level, the more output is demanded. Lower prices
mean consumers can buy more goods/services with
their money. A change in the price level will cause a
movement along the AD curve — for example, if the
price level rose from P to P1, the total (aggregate)
demand would fall from Y to Y1.
Aggregate demand can increase or decrease, causing
the AD curve to shift right or left. The AD curve will shift
to the right if there’s a rise in consumption, investment,
government spending or net exports that hasn’t been
caused by a change in the price level. For example:
 A reduction in income tax will cause an increase in
consumers’ disposable income. This tends to lead
to an increase in consumption, so there will be an
increase in aggregate demand and a shift of the AD
curve to the right from AD to AD1 .
 If a government changes its fiscal policy and
decides to increase its spending above any
increase in its revenue, then this is an injection into
the circular flow of income. It will cause an
increase in aggregate demand and a shift of the AD
curve to the right, e.g. from AD to AD1.
 A weak currency will make exports cheaper and
imports more expensive. This will lead to a rise in
net exports, so there will be an increase in
aggregate demand and a shift of the AD curve to
the right, e.g. from AD to AD1.
The AD curve will shift to the left if there’s a fall in
consumption, investment, government spending or net
exports that hasn’t been caused by a change in the
price level. For example:
 A rise in interest rates will lead to a reduction in
consumer spending because people will choose to
 save more. Higher interest rates also lead to a
reduction in investment because borrowing the
money to invest becomes more expensive. Both of
these factors lead to a reduction in aggregate
demand, and a shift of the AD curve to the left, e.g.
from AD to AD2
 A strong currency will make exports more
expensive and imports cheaper, so there will be a
fall in net exports. This will lead to a reduction in
aggregate demand and a shift of the AD curve to
the left, e.g. from AD to AD2.

Aggregate Supply

Aggregate supply is the total output produced in an

economy at a given price level over a given period of
time. There are two types of aggregate supply curve
you need to know about.
1) The first type is the short run aggregate supply
(SRAS) curve. Short run aggregate supply (SRAS) curves
slope up from left to right. They show that with an
increase in the price level, there’s an increase in the
amount of output firms are willing to supply.
• If SRAS is price inelastic, the SRAS curve slopes
steeply upwards. • If SRAS is price elastic, the SRAS
curve would be less steep.
2) In the long run, it’s assumed that an economy will
move towards an equilibrium where all resources are
being used to full capacity.This is shown by the long run
aggregate supply (LRAS) curve. The LRAS curve is
vertical. An increase in the price level (e.g. to P1) won’t
cause an increase in output because the economy is
running at full capacity, so it can’t create any more
output

Changes in Costs of Production cause the SRAS curve to

shift
1)The SRAS curve will shift if there’s a change in the
costs of production.
2)A reduction in the costs of production means that
at the same price level, more output can be
produced, so the SRAS curve will shift to the right.
3)For example, a reduction in the price of oil might
shift the curve from SRAS to SRAS1 — so at price
level P, output would increase from Y to Y1.
4)Changes in things such as wage rates, the taxes
firms pay, exchange rates and efficiency levels will
cause shifts of the SRAS curve.
5) A sudden decrease in aggregate supply (leading to
a price increase) could also be caused by supply-
side shocks, such as natural disaster or war
Changes in Factors of Production cause the LRAS curve
to shift
1)Long run aggregate supply is determined by the
factors of production — the LRAS curve will shift if
there’s a change in the factors of production which
affects the capacity of the economy.
2)An improvement in the factors of production
increases the capacity of the economy, and will
shift the LRAS curve to the right, e.g. from LRAS to
LRAS1. This increases output (in other words,
there’s economic growth) from Yf to Yf1 — the
same price level now corresponds to a higher level
of output.
3) E.g. investment that leads to advances in
technology and more efficient production will
increase maximum output.
Macroeconomic Equilibrium occurs where AS = AD
1)Macroeconomic equilibrium occurs where the AD
and AS curves cross, e.g. at price level P and
output Y on this SRAS curve.
2)A shift of either curve will move this equilibrium to
a different point, but shifts of AD and AS curves
affect things in different ways.
Inflation
Inflation can rise because of higher costs and
increased consumer demand.
1)Cost-push inflation is inflation which is caused by
the rising cost of inputs to production.
2)Demand-pull inflation is inflation caused by
excessive growth in aggregate demand compared
to supply. This growth in demand shifts the
 aggregate demand curve to the right (from AD to
AD1), which allows sellers to raise prices.
When the rate of inflation falls below 0% it’s called
deflation. Deflation is often a sign that the economy is
doing badly, as it’s usually caused by falling
aggregate demand and increased unemployment.
Disinflation is when inflation rates fall, e.g. from 3%
to 2%.

The Balance of Payments

The balance of payments (BOP) records all flows of
money into and out of a country.
There are Four sections of the Current Account:
1)Trade in goods measures imports and exports of
visible goods — e.g. televisions, apples, potatoes,
books.
2)Trade in services measures imports and exports of
services such as insurance or tourism.
3)Investment and employment income. This covers
flows of money in and out of a country resulting
from employment or earlier investment
4)Transfers are the movements of money between
countries which aren’t paying for goods or services
and aren’t the result of investment.
Add up the Individual Balances to find the overall
Current Account Balance:
Subtract imports from exports to get the balances for
trade.
Subtract debits from credits to get the balances for
investment income and transfers
Add up the balances for the individual sections to find
the overall balance. Remember, a positive balance is a
surplus, and a negative balance is a deficit.
 A large deficit on the balance of visible trade
 A small surplus on the balance of invisible trade
 A surplus on flows of investment income
 A deficit on transfers

There are usually Many Causes of a BOP Surplus or

Deficit:
A country might experience a current account deficit if:
There are high levels of consumer spending (low
savings rate). It’s struggling to compete internationally.
It has to deal with external shocks
A country might experience a current account surplus
if:
1)It’s been experiencing a recession — sometimes
domestic producers will struggle to sell products
domestically, so they’ll focus their efforts on competing
in international markets instead. There may be a fall in
imports too as a result of an overall reduction in
spending.
2)Its domestic currency has a low value — this will
make exports cheaper and imports more expensive.
3) High interest rates are causing more saving and less
spending.
The Capital and Financial accounts
1) The capital account includes transfers of non-
monetary and fixed assets — the most important part of
this is the flow of non-monetary and fixed assets of
immigrants and emigrants
2) The financial account involves the movement of
financial assets. It includes:
 Foreign direct investment
 Portfolio investment — investment in financial
assets, such as shares in overseas companies.
 Financial derivatives — these are contracts whose
value is based on the value of an asset, e.g. a
foreign currency.
 Reserve assets — these are financial assets held
by the Bank of England to be used as and when
they’re needed.
3) Income from the financial account, e.g. in the form
of interest, is recorded in the current account.
4) The current account should balance the capital
and financial accounts, e.g. a deficit of £5bn on the
current account should be offset by a surplus of £5bn
on the capital and financial accounts. However, due
to errors and omissions, the current account and
capital and financial accounts often don’t balance, so
a balancing figure is needed.

The exchange rates

A change in the value of a currency will affect net
exports in different ways in the long and short run:
 In the long run — if the value of a currency
increases, imports become relatively cheaper and
exports become relatively more expensive for
foreigners. As a result, demand for imports (M)
rises and demand for exports (X) falls. So a strong
 currency (i.e. a currency with a high value) will
worsen net exports (X – M) in the long run and
reduce aggregate demand, but a weak currency
will have the opposite effect and improve net
exports.
 In the short run — demand for imports and exports
tends to be quite price inelastic. For example,
some goods don’t have close substitutes, e.g. oil,
while others might have substitutes, but there’s a
time lag before countries will switch to them — so
in the short run demand won’t change much. This
means that initially when the value of a currency
increases, net exports will actually improve
(increase) because the overall value of exports
increases and the overall value of imports
decreases.

There are Two main types of Exchange Rate Systems:

1) A fixed exchange rate is where the government
or its central bank sets the exchange rate. This often
involves maintaining the exchange rate at a target rate.
2) A floating exchange rate is free to move with
changing supply,of, and demand for, a currency.
There are Various ways of Measuring exchange rates:
1)Nominal exchange rate — an unadjusted or
‘direct’ comparison of the value of currencies.
2) Real exchange rate — this is a nominal rate
which is adjusted to takeprice levels into
account
 Nominal exchange rates don’t always reflect the
true worth of currencies (i.e. how much they
can actually buy).
  Real exchange rates overcome this
problem by taking prices in the different
countries into account (using a price index, e.g.
the CPI, for each country).

The devaluation of a fixed exchange rate occurs when

the exchange rate is lowered formally by the
government.They can achieve this by selling the
currency. The opposite of exchange rate
devaluation is exchange rate revaluation (achieved by
buying the currency). The depreciation of a floating
exchange rate is when the exchange rate falls.This
might occur naturally due to market forces, although
government action (e.g. lowering interest rates) might
affect it indirectly.The opposite of exchange rate
depreciation is exchange rate appreciation.

Fluctuations in the Exchange Rate have Impacts on the

economy
1)If the value of a currency falls:
 Exports will become cheaper, so domestic
goods will become more competitive.
 This means that demand for exports will
increase.
 Imports will become more expensive, so demand
for imports will fall.
 A current account deficit should therefore be
reduced, but a surplus should increase.
2)The current account deficit will only reduce if the
Marshall-Lerner condition holds.
3)The J-curve shows how the current account may
actually worsen in the short run, but improve in the
long run
4) A fall in the value of a currency can also mean:
 If exports increase and imports decrease,
there’ll be economic growth caused by an
increase in aggregate demand.
 Unemployment may also be reduced through the
creation of more jobs from economic growth.
 Inflation may rise if demand for imports is
price inelastic.
 Increased import prices can also cause cost-push
inflation.
5) A rise in the value of a currency will tend to
have the opposite effects on an economy.
6)For example, exports will become more expensive
and imports will become cheaper.This will potentially
mean:
 An increase in the size of a current account
deficit, or a reduction in a current account
surplus.
 A fall in aggregate demand, which is likely to
leadto a fall in output.
 Unemployment mayrise.
 The impact on inflation will depend on the
price elasticity of demand for imports
and for domestic goods.
The Marshall-Lerner condition says that for a
fall in the value of a currency to lead to an
improvement in the balance of payments, the price
elasticity of demand for imports plus the price
elasticity of demand for exports must be greater than
one, i.e.PEDM+PEDX>1
The Marshall-Lerner condition might hold in the long
run,so there’ll be an improvement in a current account
deficit if the value of a currency falls. However, in the
short run a current account deficit is likely to worsen,
as demand for imports and exports will be inelastic
—e.g. because it takes time for people to switch to
a cheaper substitute. In the short run, the overall
value of exports falls and the overall value of imports
rises,so the current account deficit worsens. This is

shown on the J-curve.

Trade
The terms of trade is a measure of the ratio of export
prices and import prices.
Terms of trade= index of export price x100
Index of import prices
A country will have an absolute advantage when its
output of a product is greater per unit of resource
used than any other country.
Example 1 — absolute advantage
Assume: •There are only two countries in the world, A
and B,who each have the same amount of resources.
 They both produce only crisps and chocolate.
  If each country splits its resources equally to
produce the two goods, then output would be:
Units of crisps Units of
output per year chocolate
output per year
Country A 1000 5000
Country B 2000 3000
 Country A has the absolute advantage in
producing chocolate and country B has the
absolute advantage in producing crisps
 So if the countries specialised in the products they
have an absolute advantage in, then world
production of crisps would rise to 4000 units(all
produced by country B) and of chocolate
to 10000 units (all produced by country A)
Comparative advantage uses the concept of
opportunity cost—the opportunity cost is
the benefit that’s given up in order to do something
else. In this case,it’s the number of units of
one good not made in order to produce
one unit of the other good. A country has a
comparative advantage if the opportunity cost of it
producing a good is lower than the opportunity cost for
other countries.
Example 2 — comparative advantage
Make the same assumptions as above, but this time
country A and countryB produce only wheat and
coffee.If they each split their resources
equally, theycan produce the following quantities:
Units Units Opportunity Opportunit
of of cost of y cost of
wheat coffee wheat coffee
output output
 per per
year year
Country A 3000 3000 1unitofcoffe 1unitofwhe
e at
Country B 2000 1000 1/2unitofco 2unitsofwh
ffee eat
Total 5000 4000 - -
output
before
specialisat
ion

Country A has the absolute advantage in

producing both wheat and coffee.
Country A has the lower opportunity cost in
producing coffee, and therefore the comparative
advantage —i.e. if country A makes one extra unit of
coffee, it must give up one unit of wheat, but if
country B makes one extra unit of coffee, it must give
up two units of wheat. Country B has the lower
opportunity cost in producing wheat, and therefore
the comparative advantage — i.e. if
country B makes one extra unit of wheat, it must give
up half of a unit of coffee, but if country A
makes one extra unit of wheat, it must
give up one unit of coffee.
Free trade is interntaional trade not restricted by tariffs
and other protectionist measures.
A trading possibility curve show how an economy can
benefit from specialising and trading.
A trade bloc is a regional group of countries that have
entered into trade agreements.
Free trade are is a trade blov where member
governments agree to remove trade restrictions among
themselves
Custom unions is a trade bloc where there is free trade
between member countries and a common external
tariff on imports from non-members.
An economic union is a trade bloc where there is free
trade between member countries,a common external
tariff and some common economic policies,which may
include a common currency.
Trade creation is where high-cost domestic production
is replaced by more efficiently produced imports from
within the customs union.
Trade diversion is where trade with a low-cost country
outside a customs union is influenced by higher cost
products supplied from within.

Protectionism
Protectionism involves protecting domestic industries
from foreign competition.It restricts free trade and the
methods used often seek to increase domestic
industries’ relative price competitiveness.
The most common method is to
enact tariffs that tax imports. That immediately raises
the price of imported goods. They become less
competitive when compared to local goods
Governments also frequently subsidize local industries
to help them compete in the global market. Subsidies
come in the form of tax credits or direct payments. The
most commonly used are farm subsidies. That allows
producers to lower the price of local goods and
services. This makes the products cheaper even when
shipped overseas. Subsidies work even better than
tariffs. This method works best for countries that rely
mainly on exports.
A third method is to impose quotas on imported goods.
This method is more effective than the first two. No
matter how low a foreign country sets the price through
subsidies, it can’t ship more goods.
Followed by many other types of methods and their
impacts.