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As macro

  1. 1. -2-IntroductionThis resource is designed as a complement to your studies in AS Economics and should not be regardedas a substitute for taking effective notes in your lessons. Points raised and issues covered in class analysisand discussion invariably go beyond the narrow confines of this guide. Economics being the subject that it is,events and new economic policy debates will inevitably surface over the next twelve months that take youinto new and exciting territory. Providing you understand many of the core concepts and ideas available toan economist, you will be in a good position to understand many of the new issues that arise and you willbuild an awareness of the problems in developing strategies and policies to combat some the maineconomic and social problems of our time.Each chapter of this Guide contains a core set of notes, key definitions and diagrams together with a seriesof short case study readings and web links designed to encourage you to read widely and explore manyaspects of the course in greater detail.Economics is a dynamic subject, the issues change from day to day and there is a wealth of comment andanalysis in the broadsheet newspapers, magazines and journals that you can delve into. The more readingyou manage on the main issues of the day the wider will be your appreciation of the theory and practice ofeconomics.Here are some resources on the Internet that you should make a point of visiting on a regular basis:Web Resource RecommendationBBC Business and Economics News Incredible coverage of domestic and international issuesEconomist Leading international business magazineEconomist A-Z of Economics Useful background glossary with external linksEconomist Country Briefings Series of short background briefings on all major economiesErnst and Young Economic Update Excellent quarterly research on the UK and global economyGuardian Great site for research and special reports – see their special archive section on economics using this linkHalifax Bank of Scotland Research Excellent reviews on the UK economyHM Treasury The web site of the Treasury – superb for dataIndependent Strong coverage of current business/industrial trendsInstitute for Fiscal Studies Super resource for aspects of government fiscal policyInternational Monetary Fund Excellent for global economic research and policy issuesOffice of National Statistics The main site if you need economic statistics for essays! The monthly Economic Trends is a superb resource for teachersOrganisation of Economic Co-operation Superb for in depth analysis of the global economy from theand Development OECD including country surveys and economic reports. For information on the UK use this link:Royal Bank of Scotland Web site offering economic research on the UK and international economy including recent presentationsTim Harford – Undercover Economist Lively writing on economics each week – well worth itTutor2u Economics The leading AS and A Level economics portal! The daily economics blog is available here.
  2. 2. -3-Table of Contents1. Introduction to Macroeconomics and Indicators of Economic Performance.........................................42. Measuring National Income.........................................................................................................................83. Macroeconomic Objectives....................................................................................................................... 124. Using Index Numbers................................................................................................................................. 145. Aggregate Demand................................................................................................................................... 166. Consumer Spending and Saving.............................................................................................................. 217. Capital Investment...................................................................................................................................... 278. Aggregate Supply ..................................................................................................................................... 319. Macroeconomic Equilibrium ...................................................................................................................... 3710. The Macroeconomic Cycle ........................................................................................................................ 4211. Multiplier and Accelerator Effects........................................................................................................... 4512. Economic Growth ........................................................................................................................................ 4913. Inflation ........................................................................................................................................................ 5414. Employment and Unemployment ............................................................................................................. 6115. International Trade .................................................................................................................................... 7016. Balance of Payments ................................................................................................................................. 7317. Government Macroeconomic Policy........................................................................................................ 7818. Monetary Policy.......................................................................................................................................... 8119. The Exchange Rate..................................................................................................................................... 8520. Fiscal Policy ................................................................................................................................................. 8921. Government borrowing – the budget deficit........................................................................................ 9422. Supply-side Policies ................................................................................................................................... 9623. Trade-Offs between Objectives ...........................................................................................................10124. Exam Technique for your macroeconomics paper..............................................................................106
  3. 3. -4- 1. Introduction to Macroeconomics and Indicators of Economic PerformanceIn this chapter we consider what macroeconomics is and we look at some of the key indicators of interest tostudents of macroeconomics.What is macroeconomics?Macroeconomics considers the economy as a whole and relationships between one country andothers for example we focus on changes in economic growth; inflation; unemployment and our tradeperformance with other countries (i.e. the balance of payments). The scope of macroeconomics alsoincludes looking at the relative success or failure of government policies.Introduction to the UK economy The City of London, an important centre for The individual spending decisions of millions ofinternational finance and a major source of income for consumers add up to affect the performance of the our balance of payments whole economy Searching for work – unemployment has been low in Anticipating demand – stocks of products in athe UK for over ten years – but it is now starting to rise warehouse. Businesses need to anticipate demand again changes when setting production levels • The United Kingdom is one of the world’s leading advanced economies. It has the second largest economy in the European Union (EU) behind Germany and just ahead of France and it is the second biggest exporter of services in the global economy and ranked eighth in global exports of goods. In 2006 the UK will contribute 3 per cent to global output. • In terms of per capita national income, the UK is ranked in the top fifteen nations of the world and in 2006 it is forecast that the UK will have a per capita income (PPP adjusted) of $31,529 some distance behind that of the United States and also Norway and Ireland, two of Europe’s richest countries.
  4. 4. -5- • Britain has enjoyed a period of continuous growth that stretches back to 1992, the longest sustained expansion for over forty years. However, in 2005, real GDP grew by 1.8%, the slowest pace of growth for twelve years. • Over 27 per cent of the UK’s GDP in 2005 came from exports of goods and services. Imports amounted to 31.5 per cent of national income leading to a large trade deficit in goods and services with other countries. • The UK joined the European Economic Community (now known as the EU) in January 1973 and it is a founder member of the World Trade Organisation. The UK retains its own currency having decided for the time being not to consider entry to the EU single currency area, the Euro Zone.The main sectors of the economy • Households: receive income for their services and then buy the output of firms (consumption) • Firms: hire land labour and capital to produce goods and services for which they pay wages rent etc (income). Firms receive payment. Firms invest (I) in new producer goods • Government: collect taxes (T) to fund spending on public services (G) • International: The UK buy overseas products, imports, (M)) and overseas economic agents buy UK products, exports (X)The world economyThe global economy is undergoing huge changes at the moment as the effects of the current wave ofglobalisation become more apparent each day. To broaden your awareness and understanding ofmacroeconomics, it is a good idea to become familiar with some of the world’s leading economies andperhaps see how they compare and contrast with that of the UK. The links below will help you to find outmore.European Union (25 countries) NAFTA (3 countries)Countries in italics joined in 2004 North American Free Trade AreaGermany Greece United StatesAustria Czech Republic CanadaFrance Poland MexicoItaly SloveniaNetherlands Slovakia Other OECD (but non-EU)Belgium LatviaLuxembourg Lithuania NorwayIreland Malta SwitzerlandFinland Cyprus IcelandPortugal Hungary TurkeySpain Estonia AustraliaSweden Denmark New Zealand UK JapanEmerging Markets include South KoreaChinaIndia OPECRussia incBrazil Saudi ArabiaSouth Africa NigeriaTargets and objectives of macroeconomic policyGovernment management of the economy is a key political issue and each government sets targets andobjectives when it assumes power – and often, economic objectives and priorities lie right at the heart of agovernment’s overall political strategy.We focus on large number when we undertake the study of macroeconomics. For example, the value ofnational output in the UK, expressed at constant prices so that we eliminate the effects of inflation on thevalue of what we produce and consume, edged above £1 trillion in 2003. But we still stand well below theUnited States, whose national output (GDP) accounts for over a quarter of world output each year. Nowonder that people often say “when the United States catches sneezes, the rest of the world catches a cold!”
  5. 5. -6-What are the main indicators we use when making cross-country comparisons of economic performance?Traditionally we have tended to focus on four key indicators of achievement. They are 1. Growth: The rate of growth of real national output (i.e. real GDP) 2. Inflation: The rate of price inflation (i.e. the annual percentage change in the price level) 3. Unemployment: The rate of unemployment in the labour market 4. Trade: The balance of payments in trade in goods and services and net flows of investment income – representing the effects of trade and investment between countriesThe UK economic cycle Growth of National Output for the UK Annual percentage change in GDP at constant prices 6 5 4 3 2 1 Percent 0 -1 -2 -3 -4 -5 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 ar 4 quarters Source: Reuters EcoWinThe economic cycle is also known as the business cycle. The chart above shows the annual rate of growthof national output for the UK economy since 1980. There have been two recessions in the last twenty-fiveyears. The early 1980s downturn was a deep recession – the worst downturn in the UK’s post-war history.We can see the descent into recession in 1990 and 1991 and then a recovery which was maintainedthroughout the remainder of the 1990s. Further positive rates of growth have been sustained in the first sixyears of the current decade, allowing the UK economy to claim one of the longest periods of expansion inour modern history. After a slowdown in 2005 the British economy looked to be enjoying stronger growth inthe first half of 2006.As we shall see later, all countries go through a business or economic cycle leading to fluctuations innational output and unemployment. The chart below shows what has happened to the US economy overrecent years.The United States enjoyed a period of fast growth during the second half of the 1990s. But a combination ofrising interest rates (the US central bank raised the cost of borrowing to curb the growth of consumption) andof course the fallout from the events of 9-11 which severely affected consumer and business confidencebrought about a sharp slowdown in their growth rate. The USA economy went into a steep slowdown – butalthough, for a short period, national output did fall, the annual growth rate stayed positive before a recoveryemerged in 2002 and 2003. In 2003, the US economy grew by 3% and growth climbed above 4% in 2004before edging lower in 2005. The United States has been running a policy of low interest rates for most ofthe current decade. But between 2004 and 2006, they have been gradually increasing interest rates in a bidto control demand and inflationary pressures. As a result, the speed of growth in the USA is now starting toslowdown.
  6. 6. -7- USA Interest Rates and Real GDP Growth 1995-2005 Per cent 6 Percent Interest Rates 4 2 0 5.0 4.5 4.0 3.5 3.0 2.5 Percent Economic Growth 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 95 96 97 98 99 00 01 02 03 04 05 Official Interest Rate (Set by the Federal Reserve) Annual growth of real national output [ar 1 year] Source: Reuters EcoWinWe can compare and contrast the relative performance of different countries by making use of the economicdata published for each nation. The main source of data for the UK is via the Office for National Statisticswhere there is a wealth of information not just on Britain but also for each of our regions and for othercountries as well.
  7. 7. -8- 2. Measuring National IncomeWe need information on how much spending, income and output is being created in an economy over aperiod of time. National income data gives us this information as we see in this chapter.Measuring national incomeTo measure how much output, spending and income has been generated in a given time period we usenational income accounts. These accounts measure three things: 1. Output: i.e. the total value of the output of goods and services produced in the UK. 2. Spending: i.e. the total amount of expenditure taking place in the economy. 3. Incomes: i.e. the total income generated through production of goods and services.What is National Income?National income measures the money value of the flow of output of goods and services producedwithin an economy over a period of time. Measuring the level and rate of growth of national income (Y) isimportant to economists when they are considering: • The rate of economic growth • Changes over time to the average living standards of the population • Changes over time to the distribution of income between different groups within the population (i.e. measuring the scale of income and wealth inequalities within society) Consumer spending accounts for over two thirds of total spending. Consumer spending has been strong inrecent years, a reflection of rising living standards and low unemployment, but this may now be coming to an end because of the mountain of household debtGross Domestic ProductGross Domestic Product (GDP) measures the value of output produced within the domestic boundaries ofthe UK over a given time period. An important point is that our GDP includes the output of foreign ownedbusinesses that are located in the UK following foreign direct investment in the UK economy. The output ofmotor vehicles produced at the giant Nissan car plant on Tyne and Wear and by the many foreign ownedrestaurants and banks all contribute to the UK’s GDP.There are three ways of calculating GDP - all of which should sum to the same amount since the followingidentity must hold true:
  8. 8. -9- National Output = National Expenditure (Aggregate Demand) = National IncomeFirstly we consider total spending on goods and services produced within the economy:Nissan at Sunderland – Celebrating 20 years of productionThe Nissan plant at Washington, Tyne and Wear is celebrating its 20th anniversary in July 2006, the first carhaving rolled off the line on July 8th, 1986. In that first year of production 470 staff had a production target of24,000 Bluebirds. Twenty years on, more than 4,200 employees produce around 310,000 Micras, C+Cs,NOTEs, Almeras and Primeras each year. That car has been followed by 4.3 million others thanks to a totalinvestment of £2.3 billion. Production is set to rise from 310,000 per year last year to 400,000 in 2007 withthe introduction of a new small 4x4, and Sunderland has been rated as Europes most productive car factoryfor the last eight years. Sources: Reuters News, Sunderland Echo, July 2006(i) The Expenditure Method of calculating GDP (aggregate demand)This is the sum of spending on UK produced goods and services measured at current market prices. The fullequation for GDP using this approach is GDP = C + I + G + (X-M) where C: Household spending I: Capital Investment spending G: Government spending X: Exports of Goods and Services M: Imports of Goods and ServicesThe Income Method of calculating GDP (the Sum of Factor Incomes)Here GDP is the sum of the incomes earned through the production of goods and services. The main factorincomes are as follows: Income from people employment and in self-employment + Profits of private sector companies + Rent income from land= Gross Domestic product (by factor income)It is important to recognise that only those incomes that are actually generated through the production ofoutput of goods and services are included in the calculation of GDP by the income approach.We exclude from the accounts the following items: o Transfer payments e.g. the state pension paid to retired people; income support paid to families on low incomes; the Jobseekers’ Allowance given to the unemployed and other forms of welfare assistance including child benefit and housing benefit. o Private transfers of money from one individual to another. o Income that is not registered with the Inland Revenue or Customs and Excise. Every year, billions of pounds worth of economic activity is not declared to the tax authorities. This is known as the shadow economy where goods and services are exchanged but the value of these transactions is hidden from the authorities and therefore does not show up in the official statistics!). It is impossible to be precise about the size of the shadow economy but some economists believe that between 8 – 15 per cent of national output and spending goes unrecorded by the official figures.Output Method of calculating GDP – using the concept of value added
  9. 9. - 10 -This measure of GDP adds together the value of output produced by each of the productive sectors in theeconomy using the concept of value added.Value added is the increase in the value of a product at each successive stage of the production process.We use this approach to avoid the problems of double-counting the value of intermediate inputs.The table below shows indices of value added from various sectors of the economy in recent years. We cansee from the data that manufacturing industry has seen barely any growth at all over the period from 2001-2004 whereas distribution, hotels and catering together with business services and finance have beensectors enjoying strong increases in the volume of output. These figures illustrate a process of structuralchange, with a continued decline in manufacturing output and jobs relative to the rest of the economy. Byfar the largest share of total national output (GDP) comes from our service industries.Index of Gross Value Added by selected industry for the UK Mining and Manufacturing Construction Distribution, Business quarrying, inc hotels, and services and oil & gas catering; finance extraction repairs2001 weights in total GDP 28 172 57 159 249(out of 1000)2001 100 100 100 100 1002002 100 97 104 105 1022003 94 97 109 108 1062004 87 98 113 113 111We can see from the following chart how there have been divergences in the growth achieved by themanufacturing and the service sectors of the British economy. Indeed by the middle of 2006, the index ofmanufacturing output was below the level achieved at the start of 2000.In contrast the service industries have enjoyed strong growth, leading to a continued process of structuralchange in the economy – away from traditional heavy industries towards service businesses. Output of Manufacturing and Services Index of Value Added, Constant Prices, Seasonally Adjusted 115 110 Manufacturing 105 100 Index of output, 2002=100 95 90 85 80 Services 75 70 65 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 Gross, Service industries, Total Gross, Manufacturing Source: Reuters EcoWinGDP and GNP (Gross National Product)
  10. 10. - 11 -Gross National Product (GNP) measures the final value of output or expenditure by UK owned factors ofproduction whether they are located in the UK or overseas.In contrast, Gross Domestic Product (GDP) is concerned only with the factor incomes generated within thegeographical boundaries of the country. So, for example, the value of the output produced by Toyota andDeutsche Telecom in the UK counts towards our GDP but some of the profits made by overseas companieswith production plants here in the UK are sent back to their country of origin – adding to their GNP. GNP = GDP + Net property income from abroad (NPIA)NPIA is the net balance of interest, profits and dividends (IPD) coming into the UK from our assets ownedoverseas matched against the flow of profits and other income from foreign owned assets located within theUK. In recent years there has been an increasing flow of direct investment into and out of the UK. Manyforeign firms have set up production plants here whilst UK firms have expanded their operations overseasand become multinational organisations.The figure for net property income for the UK is strongly positive meaning that our GNP is substantiallyabove the figure for GDP in a normal year. For other countries who have been net recipients of overseasinvestment (a good example is Ireland) their GDP is higher than their GNP.Measuring Real National IncomeWhen we want to measure growth in the economy we have to adjust for the effects of inflation.Real GDP measures the volume of output produced within the economy. An increase in real output meansthat AD has risen faster than the rate of inflation and therefore the economy is experiencing positive growth.Income per capitaIncome per capita is a basic way of measuring the average standard of living for the inhabitants of a country.The table below is taken from the latest edition of the OECD World Factbook and measures income perhead in a common currency for the year 2005, the data is adjusted for the effects of variations in living costsbetween countries. GDP per capita $s GDP per capita $sLuxembourg 57 704 EU (established 15 countries) 28 741United States 39 732 Germany 28 605Norway 38 765 Italy 27 699Ireland 35 767 Spain 25 582Switzerland 33 678 Korea 20 907United Kingdom 31 436 Czech Republic 18 467Canada 31 395 Hungary 15 946Australia 31 231 Slovak Republic 14 309Sweden 30 361 Poland 12 647Japan 29 664 Mexico 10 059France 29 554 Turkey 7 687 Source: OECD World Economic Factbook, 2006 editionBy international standards, the UK is a high-income country although we are not in the very top of the leaguetables for per capita incomes. We do have an income per head that is about ten per cent higher than theaverage for the 15 established EU countries. But we are some distance behind countries such as the UnitedStates (where productivity is much higher). And Ireland’s super-charged growth over the last twenty yearsmeans that she has now overtaken us in terms of income-based measures of standards of living.
  11. 11. - 12 - 3. Macroeconomic ObjectivesAll governments have targets and aims for the economy – in this chapter we consider the main objectives ofmacroeconomic policy.Objectives are the aims or goals of government policy whereas instruments are the means by which theseaims might be achieved and targets are often thought to be intermediate aims – linked closely in atheoretical way to the final policy objective.So for example, the government might want to achieve low inflation. The main instrument to achieve thismight be the use of interest rates (now set by the Bank of England) and a target might be the growth ofconsumer credit or perhaps the exchange rate.Only a limited number of policies can be used to achieve the government’s objectives. There is a hugeamount of research conducted in trying to determine the effectiveness of different policies in meeting keyobjectives. Indeed the debates about which policies are most suitable lie at the heart of differences betweeneconomic schools of thought.The main policy instruments available to meet the objectives are • Monetary policy –changes to interest rates, the supply of money and credit and changes to the exchange rate • Fiscal policy – changes to government taxation, government spending and borrowing • Supply-side policies designed to make markets work more efficiently • Direct controls or regulation of particular marketsFind out more about schools of thoughtIf you want to delve a little deeper into the differences between schools of thought in Economics here are afew links to resources available on the Wikipedia web site: • Keynes and Keynesian Economists: • Monetarists: • Classical economists: Objectives of UK Economic PolicyThe Labour Government has several current macroeconomic objectives: o Stable low inflation - the Government’s inflation target is 2.0% for the consumer price index. The Monetary Policy Committee sets interest rates at a level it thinks will meet the inflation target over a two year forecasting horizon. The Bank of England has been independent since May 1997 but inflation targets pre-date the decision to hand over control of monetary policy to the BoE. Inflation targets were first introduced into the UK in October 1992 and have played a role in keeping inflation expectations under control. o Sustainable economic growth – as measured by the rate of growth of real gross domestic product – sustainable both in terms of maintaining low inflation and also in terms of the environmental impact of growth (for example the impact of growth on levels of pollution, household and industrial waste and the use and depletion of our scarce resources). o Higher levels of capital investment and labour productivity – this is designed to improve the UK’s international competitiveness and boost our trade performance in goods and services. The pressures of globalisation and the increasing competition within the European Single Market make this one of the most important long-term objectives of the government. Britain needs to be competitive in an increasingly globalized world. o High employment - the government wants to achieve full-employment – a situation where all those able and available to find work have the opportunity to work. But unemployment can never fall to zero since there will always be a degree of frictional and structural unemployment in the labour
  12. 12. - 13 - market. At the time of writing, unemployment in the UK is at low levels, with less than three per cent of the labour force out of work and claiming the Jobseeker’s Allowance. o Rising living standards and a fall in relative poverty – for example the objective of cutting child poverty and reducing pensioner poverty over the next few years – this will require a continuation of economic growth together with taxation and benefit changes to make the distribution of income more equal o Sound government finances - including control over the size of government borrowing and the total national debt.The Bank of England was made independent in May 1997 and has the job of setting interest rates as part of monetary policy. Interest rates are viewed as a key weapon in keeping control of demand and inflationary pressures in the economy. Most economists are in favour of Bank of England independence because economists are likely to make better judgements on interest rates than politicians seeking re-election!The government always emphasizes macroeconomic stability as one of its main aims – it believes that thestability of the economy is a pre-condition for improvements in capital investment, productivity, companyprofits and employment.Of course the vagaries of and uncertainties in developments in the global economy make this a difficultobjective to pursue. A dose of good luck as well as sound judgement is required given the domestic andexternal shocks that can affect the British economy at any time!
  13. 13. - 14 - 4. Using Index NumbersIndex numbers are a useful way of expressing pieces of information and collections of data. This briefchapter shows you how to express data in index number format and some examples of data which iscommonly presented as an index numberConverting data in index number format: Measuring the level of real national outputWhen we are measuring the level of national income we often make use of index numbers to track what ishappening to real GDP. In the table below we see the value of consumer spending and also real GDPexpressed in £ billion. I have chosen 1995 as the base year for our index of spending and output. So thedata for consumer spending and real GDP has an index value of 100.0 in 1995.To calculate the index number for consumer spending in 1996 we use the following formulaIndex (1996) = (consumer spending (1996) / base year consumer spending) x 100 Consumer spending Index of consumer Real GDP Index of real GDP spending £ billion 1995 = 100 £ billion 1995 = 100 1995 (Base) 512.6 100.0 857.5 100.0 1996 531.9 103.8 880.9 102.7 1997 551.1 107.5 908.7 106.0 1998 572.3 111.6 938.1 109.4 1999 598.8 116.8 966.6 112.7 2000 625.1 121.9 1005.5 117.3 2001 644.9 125.8 1027.9 119.9 2002 667.4 130.2 1048.5 122.3 2003 684.8 133.6 1074.9 125.3 2004 710.2 138.5 1108.9 129.3One of the advantages of index numbers is that it allows us to compare and contrast more easily differentsets of economic data. Consider the information in the table above. Using 1995 as our base year for theindex, we can see that consumer spending has grown more quickly than real national income over the period1995-2003.Of course the two sets of data are closely linked because consumption accounts for more than 60% of GDP.But the data indicates that consumer demand has been a key factor behind the continuing growth of theeconomy, indeed consumption as a share of GDP has grown from 60% in 1995 to nearly 65% in 2003 – arecord level. Can this consumer boom continue? Much of it has been financed by high rates of borrowinglinked to low interest rates and the recent UK housing boom.Calculating a price indexWe will now see how information on prices can be used to create a weighted price index for the economy –this is the sort of data which is then used to calculate the rate of inflationCategory Price Index Weighting Price x WeightFood 106 18 1908Alcohol & Tobacco 110 6 660Clothing 97 12 1164Transport 103 15 1545
  14. 14. - 15 -Housing 106 22 2332Leisure Services 112 9 1008Household Goods 95 7 665Other Items 105 11 1155 100 10437A weighted price index calculates changes in the average level of prices in the economy. In thehypothetical data shown in the table above we have split consumer spending into eight categories and giveneach a “weighting” based on the share of total consumer spending given over to each category. So forexample, housing and food costs are assumed in our example to take up 40% of total consumer spending.These two items will have a heavy influence on the overall price index.The price index for each category shows what has happened to the price level since a base year value. Togenerate a weighted price index we multiply the price index for each category by its weight and then sumthese. We then divide by the sum of the weights (100) to find an overall price index (104.37) or 104.4rounded to one decimal place.Here is some real world data on a selected of price indices for goods and services in the UK. All items Health Transport Communication Tobacco Clothing New Cars Second Hand Cars1996 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.02000 105.6 111.6 112.7 89.3 141.2 82.2 99.8 91.22003 109.8 124.2 116.9 84.5 158.8 66.8 95.7 85.1Over the period 1996-2003 there has been a 10% rise in the general price level. But this hides majorchanges in average prices for different products. The average cost of purchasing tobacco products hasjumped by nearly sixty per cent whereas the prices of clothing, second hand cars and communication havebeen falling.
  15. 15. - 16 - 5. Aggregate DemandThis section gives you a platform for understanding issues such as inflation, economic growth andunemployment. Aggregate demand (AD) and aggregate supply (AS) analysis provides a way of illustratingmacroeconomic relationships and the effects of government policy changes.Aggregate DemandThe identity for calculating aggregate demand (AD) is as follows: AD = C + I + G + (X-M)Where C: Consumers expenditure on goods and services: This includes demand for consumer durables (e.g. washing machines, audio-visual equipment and motor vehicles & non-durable goods such as food and drinks which are “consumed” and must be re-purchased). Household spending accounts for over sixty five per cent of aggregate demand in the UK. I: Capital Investment – This is investment spending by companies on capital goods such as new plant and equipment and buildings. Investment also includes spending on working capital such as stocks of finished goods and work in progress. Capital investment spending in the UK typically accounts for between 15-20% of GDP in any given year. Of this investment, 75% comes from private sector businesses such as Tesco, British Airways and British Petroleum and the remainder is spent by the public (government) sector – for example investment by the government in building new schools or investment in improving the railway or road networks. So a mobile phone company such as O2 spending £100 million on extending its network capacity and the government allocating £15 million of funds to build a new hospital are both counted as part of capital investment. Investment has important long-term effects on the s supply-side of the economy as well as being an important although volatile component of aggregate demand. G: Government Spending – This is government spending on state-provided goods and services including public and merit goods. Decisions on how much the government will spend each year are affected by developments in the economy and also the changing political priorities of the government. In a normal year, government purchases of goods and services accounts for around twenty per cent of aggregate demand. We will return to this again when we look at how the government runs its fiscal policy. Transfer payments in the form of welfare benefits (e.g. state pensions and the job-seekers allowance) are not included in general government spending because they are not a payment to a factor of production for any output produced. They are simply a transfer from one group within the economy (i.e. people in work paying income taxes) to another group (i.e. pensioners drawing their state pension having retired from the labour force, or families on low incomes). The next two components of aggregate demand relate to international trade in goods and services between the UK economy and the rest of the world. X: Exports of goods and services - Exports sold overseas are an inflow of demand (an injection) into our circular flow of income and therefore add to the demand for UK produced output. M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from the circular flow of income and spending. Goods and services come into the economy for us to consume and enjoy - but there is a flow of money out of the economy to pay for them. Net exports (X-M) reflect the net effect of international trade on the level of aggregate demand. When net exports are positive, there is a trade surplus (adding to AD); when net exports are negative, there is a trade deficit (reducing AD). The UK economy has been running a large trade deficit for several years now as has the United States.Aggregate demand shocks
  16. 16. - 17 - Economic events such as changes in interest rates and economic growth in the United States can have apowerful effect on other countries including the UK. This is because the USA is the world’s largest economy. 15 per cent of our exports go to the USA.Lots of unexpected events can happen which cause changes in the level of demand, output and employmentin the economy. These unplanned events are called “shocks” One of the causes of fluctuations in the level ofeconomic activity is the presence of demand-side shocks.Some of the main causes of demand-side shocks are as follows: o A capital investment boom e.g. a construction boom to increase the supply of new houses or to build new commercial and industrial buildings. o A rise or fall in the exchange rate – affecting net export demand and having follow-on effects on output, employment, incomes and profits of businesses linked to export industries. o A consumer boom abroad in the country of one of our major trading partners which affects the demand for our exports of goods and services. o A large boom in the housing market or a slump in share prices. o An unexpected cut or an unexpected rise in interest rates.
  17. 17. - 18 -The Aggregate Demand CurveThe AD curve shows the relationship between the general price level and real GDP. The AD curve shows the relationship between aggregate demand and the UK price level, usually measured in terms of the consumer price index Inflation A rise in the general price level from P1 to P2 causes a contraction in aggregate demand P2 A fall in the general price level from P1 to P3 causes P1 an expansion of aggregate demand P3 AD Y2 Y1 Y3 Real National IncomeWhy does the AD curve slope downwards?There are several explanations for an inverse relationship between aggregate demand and the price level inan economy. These are summarised below: 1. Falling real incomes: As the price level rises, so the real value of people’s incomes fall and consumers are then less able to afford UK produced goods and services. 2. The balance of trade: As the price level rises, foreign-produced goods and services become more attractive (cheaper) in price terms, causing a fall in exports and a rise in imports. This will lead to a reduction in trade (X-M) and a contraction in aggregate demand. 3. Interest rate effect: if in the UK the price level rises, this causes an increase in the demand for money and a consequential rise in interest rates with a deflationary effect on the entire economy. This assumes that the central bank (in our case the Bank of England) is setting interest rates in order to meet a specified inflation target.Shifts in the AD curveA change in factors affecting any one or more components of aggregate demand, households (C), firms (I),the government (G) or overseas consumers and business (X) changes planned aggregate demand andresults in a shift in the AD curve.Consider the diagram below which shows an inward shift of AD from AD1 to AD3 and an outward shift of ADfrom AD1 to AD2. The increase in AD might have been caused for example by a fall in interest rates or anincrease in consumers’ wealth because of rising house prices.
  18. 18. - 19 - Inflation In the short run, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services. P2 In the long run, shifts in aggregate demand affect the overall price level but do P1 not affect output. P3 AD2 AD1 AD3 Y3 Y1 Y2 Real National IncomeFactors causing a shift in ADChanges in Expectations The expectations of consumers and businesses can have a powerful effect on planned spending in the economy E.g. expected increases inCurrent spending is affected by consumer incomes, wealth or company profits encourage householdsanticipated future income, profit, and firms to spend more – boosting AD. Similarly, higher expectedand inflation inflation encourages spending now before price increases come into effect - a short term boost to AD. When confidence turns lower, we expect to see an increase in saving and some companies deciding to postpone capital investment projects because of worries over a lack of demand and a fall in the expected rate of profit on investments.Changes in Monetary Policy – An expansionary monetary policy will cause an outward shift of the ADi.e. a change in interest rates curve. If interest rates fall – this lowers the cost of borrowing and the incentive to save, thereby encouraging consumption. Lower interest(Note there is more than one rates encourage firms to borrow and invest.interest rate in the economy,although borrowing and savings There are time lags between changes in interest rates and therates tend to move in the same changes on the components of aggregate demand.direction)Changes in Fiscal Policy For example, the Government may increase its expenditure e.g. financed by a higher budget deficit, - this directly increases ADFiscal Policy refers to changes ingovernment spending, welfarebenefits and taxation, and the Income tax affects disposable income e.g. lower rates of income taxamount that the government raise disposable income and should boost consumption.borrows An increase in transfer payments raises AD – particularly if welfare recipients spend a high % of the benefits they receive.Economic events in the A fall in the value of the pound (£) (a depreciation) makes importsinternational economy dearer and exports cheaper thereby discouraging imports and encouraging exports – the net result should be that UK AD rises – theInternational factors such as the impact depends on the price elasticity of demand for imports andexchange rate and foreign
  19. 19. - 20 -income (e.g. the economic cycle exports and also the elasticity of supply of UK exporters in responsein other countries) to an exchange rate depreciation. An increase in overseas incomes raises demand for exports and therefore UK AD rises. In contrast a recession in a major export market will lead to a fall in UK exports and an inward shift of aggregate demand. The UK is an open economy, meaning that a large and rising share of our national output is linked to exports of goods and services or is open to competition from imports.Changes in household wealth A rise in house prices or the value of shares increases consumers’ wealth and allow an increase in borrowing to finance consumptionWealth refers to the value of increasing AD. In contrast, a fall in the value of share prices will leadassets owned by consumers e.g. to a decline in household financial wealth and a fall in consumerhouses and shares demand.
  20. 20. - 21 - 6. Consumer Spending and SavingConsumption accounts for 65% of aggregate demand. There are many factors that affect how much peopleare willing and able to spend. It is important to understand these factors because changes in consumerspending have an important effect on path of the economic cycle. Real Consumption Expenditure and Real GDP growth Annual percentage change in household spending and GDP at constant 2000 prices 7 6 Consumer spending 5 4Annual % change 3 2 Real GDP 1 0 -1 -2 -3 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 Consumer spending [ar 4 quarters] Real GDP growth [ar 4 quarters] Source: Reuters EcoWinJohn Maynard Keynes developed a theory of consumption that focused primarily onthe level of people’s disposable income in determining their spending. The rate atwhich consumers increase demand as income rises is called the marginalpropensity to consume. For example if someone receives an increase in incomeof £2000 and they spend £1500 of this, the marginal propensity to spend is £1500 /£2000 = 0.75. The remainder is saved – so the propensity to save would be 0.25.The marginal propensity to spend and to save differs from person to person.Generally, people on lower incomes tend to have a higher propensity to spend. Thishas important implications when the government announces changes in directtaxation and the level of welfare benefits.Incomes matter in determining spendingThe Bank of England has an economic model that seeks to predict what will happen to consumer spendingafter various shocks. In the long term, the thing that matters most is peoples real incomes. Changes in theamount we earn are by far the most important feature determining how much we spend. Other features, suchas the value of our homes or our financial savings, matter a bit but their effect is dwarfed by changes in ourearnings. Source: Hamish McRae, the Independent, 8th August 2004The key factors that determine consumer spending in the economy can be summarized as follows: 1. The level of real disposable household income 2. Interest rates and the availability of credit
  21. 21. - 22 - 3. Consumer confidence 4. Changes in household financial wealth 5. Changes in employment and unemploymentThe strength of consumer spending has been one of the main reasons why Britain has avoided a recessionin recent years – but at the same time, there are fears that household spending has been too high, and thatmuch of it has been financed by a surge in borrowing leading to record levels of household debt. One keyreason for this has been the strength of the housing market which has allowed millions of home-owners toborrow extra money secured on the value of their property. This is known as mortgage equity withdrawal.A large percentage of this demand has also fed into demand for imported goods and services, causing asharp increase in the UK’s trade deficit with other countries.Spending on consumer durables Consumer Expenditure on Durable Goods Real spending at constant prices, seasonally adjusted, £ billion per quarter 25.0 22.5 £s at constant 2002 prices (billions) 20.0 17.5 15.0 12.5 10.0 7.5 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 Source: Reuters EcoWinConsumer durables are items that provide a flow of services to a consumer over a period of time. Examplesinclude new cars, household appliances, audio-visual equipment, furniture etc. The real level of spending ondurables has surged in the last eight years.Among the explanations are (i) Falling prices for many durable products – arising from rapid advances in production technology and the effects of globalization which means that we can now import many of these durables more cheaply from overseas (ii) Low interest rates which have encouraged people to spend more on “big ticket items” – there has been a surge in demand for consumer credit (iii) Strong consumer confidence and borrowing levels. The demand for consumer durables is more income elastic than for non-durables which are usually staple items in people’s monthly budget.The Wealth EffectWealth represents the value of a stock of assets owned by people. For most people the majority of theirwealth is held in the form of property, shares in quoted companies on the stock market, savings in banks,building societies and money accumulating in occupational pension schemes.
  22. 22. - 23 - FTSE-100 Index Index of the UKs 100 leading shares - daily closing value 7000 6500 6000 5500 Index 5000 4500 4000 3500 3000 96 97 98 99 00 01 02 03 04 05 06 Source: Reuters EcoWinThere is a positive wealth effect between changes in financial wealth and total consumer demand forgoods and services. For example when house prices are rising strongly, consumer confidence grows andhome-owners can also borrow some of the equity in their homes to finance major items of spending. Household Savings Ratio Percentage of disposable income that is saved, quarterly data 14 13 12 11 10 9 8 Percent 7 6 5 4 3 2 1 0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 Source: Reuters EcoWinThe Savings RatioSaving represents a decision to postpone consumption by saving money out of disposable income. Whydo people choose to save their incomes? There are many motivations for saving:
  23. 23. - 24 - 1. Precautionary saving: People might save more because of a fear of being made unemployed. A nest egg of savings allows people to smooth their spending even when incomes are fluctuating. 2. Building up potential spending power: Saving more now is a choice to defer spending today to finance major spending commitments in the future (e.g. saving for the deposit on a mortgage, a new car or a wedding). People are also becoming increasingly aware of the need to save in order to build up assets in occupational pension schemes because of fears that the relative value of the state retirement pension will fall in the years ahead. 3. Interest rates and saving: There might be a greater willingness to save because of the incentives of high interest rates from banks, building societies and other financial institutions. 4. Inheritance: Many people have a desire to pass on bequests of wealth to future generations. 5. Saving and the life-cycle of consumers: Younger people are often net borrowers of money because they need to fund their degrees, purchase a property and expensive consumer durables. As people grow older, their incomes from work tend to rise and their spending commitments decline leading to an increase in net saving ahead of retirement.The savings ratioThe household savings ratio is the level of people’s savings as a percentage of their disposable income.The savings ratio was high during the early 1990s as a result of the high levels of unemployment and alsohigh interest rates. In recent years there has been a fall in the savings ratio in part because consumerborrowing has reached record levels, fuelled in part by the rapid acceleration in house prices. At some pointthe savings ratio will need to rise again as people rein back on their spending in order to repay debts oncredit cards and other forms of secured and unsecured borrowing. We have started to see a gradual rise inthe savings ratio during 2005 and the first half of 2006.The importance of consumer confidenceThe willingness of people to make major spending commitments depends on how confident they are aboutboth their own financial circumstances, and also the general state of the economy. Consumer confidence isquite volatile from month to month. Some of the fluctuations are seasonal – but the underlying trend is whatreally matters. One interesting aspect of recent data is that people have remained more optimistic about theirown financial situation than they have about prospects for the UK economy as a whole. This perhaps helpsto explain why people have continued to be prepared to make big-ticket purchases on new consumerdurables (many of which have been imported).The main factors affecting consumer confidence are summarised as follows: o Expectations of future income and employment o The current level of interest rates and expectations of future interest rate movements o Trends in unemployment and changes in perceived job security o Anticipated changes in government taxation o Changes in household wealth including movements in house and share pricesThe consumer borrowing boom of recent years
  24. 24. - 25 - Growth of Consumer Borrowing 6 month % growth rates for lending to individuals, source: Bank of England 17 16 15 Credit card borrowing 14 13 12 Percent 11 10 Total 9 8 7 Borrowing secured on the value of dwellings (housing) 6 5 Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May 00 01 02 03 04 05 06 Total lending to individuals, 6 mth% Total lending to individuals, secured on dwellings, 6 mth% Total lending to individuals, consumer credit, 6 mth% Source: Reuters EcoWinThe British economy has seen high consumer borrowing in recent years. This has been the result of anumber of factors summarised below: 1. Low unemployment – has led to rising consumer confidence. 2. Strong growth of house prices – has encouraged mortgage equity withdrawal. 3. Expectations of rising real incomes – people have expected their incomes to rise each year as pay levels have grown more quickly than inflation. 4. Low interest rates – reducing the opportunity cost of borrowing money. 5. Falling prices of consumer durables – many of which are bought using credit. The consumer credit boom has lasted nearly a decade, but there are signs that people in the UK are falling out of love with their credit card
  25. 25. - 26 -Strong demand for loans has boosted consumer spending and helped to keep the UK economy growing at atime of global uncertainty. Borrowing has also contributed to the rising trade deficit in goods and services. Bythe summer of 2006, the consumer borrowing boom appeared to be coming to an end. The slowdown incredit demand has been the result of a number of factors: 1. Rising interest rates – the Bank of England has been raising interest rates from 3.5% to 4.75% – this has helped to curb demand for new loans (interest rates currently at 4.5%). 2. Weakness in the housing market and fears of a possible fall in average house prices which may expose homeowners to a high level of mortgage debt. 3. Unemployment has started to edge higher and more people now expect rising unemployment, expectations of what might happen tomorrow affects our behaviour today! 4. The consumer debt mountain has reached high levels – well over £1 trillion – and many people are now scaling back their borrowing and saving more as a precaution against a future downturn. 5. Possible consumer satiation – how many plasma TV screens or digital cameras do you need? There are limits to how many consumer durables people need to buy!Consumer spending and the UK balance of paymentsConsumers in Britain have a high marginal propensity to import goods and services so that, when theirreal incomes are rising and their spending increases, so too does the demand for imports. Unless there is acorresponding increase in UK exports overseas, then the balance of trade in goods and services will movetowards heavier deficit. This has been the case in the UK over the last five or six years. In the medium term ifdemand for imports rises and the level of import penetration into the domestic economy continues to rise,then national output and employment will weaken and this will work its way through the circular flow toreduce real incomes. Living standards are reduced in the long run if our export industries are unable tocompete with output produced in other countries.
  26. 26. - 27 - 7. Capital InvestmentInvestment is spending by UK firms on capital goods such as new factories, plant or buildings, machinery &vehicles. It is an important component of demand, but as we shall see, it also has an impact on the supply-side of the economy.Definition of Capital Investment 1. Capital investment is defined as spending on capital goods such as new machinery, buildings and technology so that the economy can produce more consumer goods in the future. 2. A broader definition of investment would encompass spending on improving the human capital of the workforce - for example extra investment in training and education to improve the skills and competences of workers. 3. Most economists agree that investment is vital to promoting long-run economic growth through improvements in productivity and a country’s productive capacity.Gross and Net InvestmentGross investment spending includes an estimate for capital depreciation since some investment isneeded to replace technologically obsolete plant and machinery. Providing that net investment is positive,businesses are expanding their capital stock giving them a higher productive capacity and therefore meet ahigher level of demand in the future.The Economic Importance of Capital InvestmentFirms often invest in new capital goods to exploit internal economies of scale. This, together withtechnological advances that are often built into new machinery, is vital to improving the UKscompetitiveness and to causing an outward shift in the country’s production possibility frontier.The amount of capital equipment available for each worker to use and whether this capital is up to date has a bearing on the productivity of the labour force. The quality of business training also matters to make the most of investment in new capital and technology
  27. 27. - 28 - An outward shift in the production possibility frontier shows that there has been either an improvement in productivity or an increase in the total stock of resources available to produce different goods and services. The outward shift represents an improvement in economic efficiency. Capital investment is an important source of long-run growth. Output of Capital Goods PPF1 B C2 C3 C C1 A PPF2 X2 X1 X3 Output of Consumer GoodsIn the short run, devoting more a country’s scarce resources to the production of investment goods (aprocess known as capital accumulation) might require a reduction in today’s output of consumer goods andservices (lower consumption would be accompanied by a rise in saving). The re-allocation of resourcestowards capital goods would be shown by a movement from point A to B on the production possibilityfrontier.But if the extra investment is successful and leads to an increase in a country’s productive capacity then thePPF can shift out and open up the potential for an increased output of consumption goods to meet people’sneeds and wants. This is shown by a movement from point B on the PPF to point C which lies on the newPPF after the effects of an increase in investment.Investment affects AD as well as Aggregate Supply (AS)It should be remembered that investment is also a component of AD. Businesses involved in developing,manufacturing, testing, distributing and marketing the capital goods themselves stand to benefit fromincreased orders for new plant and machinery.A rise in capital investment will therefore have important effects on both the demand and supply-side of theeconomy – including a positive multiplier effect on national income. o Demand side effects: Increase spending on capital goods – affects industries that manufacture the technology / hardware / construction sector o Supply side effects: Investment is linked to higher productivity, an expansion of a country’s productive capacity, a reduction in unit costs (e.g. through the exploitation of economies of scale) – and therefore a source of an increase in LRAS (trend growth)
  28. 28. - 29 - LRAS1 LRAS2 Inflation P1 P2 AD1 AD2 Y1 Y2 YFC2 Real National IncomeIt is not just the level of capital investment which is important but also the quality of the increase in the capitalstock. A high level of investment on its own may not be sufficient to create an increase in LRAS – workersneed to be trained to work the new machinery and there may be time lags between new capital spendingand the knock-on effects on output and productivity in particular. Also, if there is insufficient demand in amarket, a high level of capital investment may lead to excess capacity emerging in industries – puttingdownward pressure on prices and profits Gross Fixed Capital Investment by Businesses Investment at constant 2001 prices, £ billion 120 110 100 90 80 2001 GBP (billions) 70 60 50 40 30 20 10 0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 Source: Reuters EcoWin
  29. 29. - 30 -One way to remember the importance of investment is to consider the 3 Cs - capacity, costs andcompetitiveness. Higher investment should allow British businesses to lower their production costs per unit,increase their supply capacity and become more competitive in overseas markets.Key Factors Determining Capital Investment SpendingSeveral factors influence how much businesses are prepared to commit to investment projects: 1. Real interest rates: Interest rates affect the cost of borrowing money to finance investment. If the rate of interest increases, the cost of funding investment increases, reducing the expected rate of return on capital projects. A second factor is that higher interest rates raise the opportunity cost of using profits to finance investment – i.e. a business might decide that the cost of financing new capital is too high and that it could earn a higher rate of return by simply investing the cash. Low interest rates are not always good news for business investment. Recently economists have become concerned that low interest rates has reduced the cost of capital for businesses to such an extent that some low quality capital investment projects have been given the go ahead and much of this investment has proved to be disappointing. 2. The rate of growth of demand: Investment tends to be stronger when consumer demand is rising, giving businesses an extra incentive to invest to expand their capacity to meet this demand. Higher expected sales also increase potential profits – in other words, the price mechanism should allocate extra funds and factor inputs towards investment goods into those markets where consumer demand is rising. 3. Corporate taxes: Corporation tax is paid on profits. If the government reduces the rate of corporation tax (or increases investment tax-allowances) there is a greater incentive to invest. Britain has relatively low rates of company taxation compared to other countries inside the EU. This is a factor that helps to explain why Britain has been a favoured venue for inward investment from overseas during the last decade. 4. Technological change and degree of market competition: In markets where technological change is rapid, companies may have to commit themselves to higher levels of investment to keep pace with the shifting frontier of technology and remain competitive. In markets where there is a premium on a business keeping costs down but at the same time, achieving year on year gains in efficiency and quality of service, there is also an incentive to keep capital investment spending high. 5. Business confidence: Business confidence can be vital in determining whether to go ahead with an investment project. When confidence is strong then planned investment will rise. The Confederation of British Industry ( publishes a quarterly survey of confidence that gives economists an insight into likely trends in investment from manufacturing industry – although it must be remembered that over 70% of total GDP now comes from the service sector. In recent years, capital spending by service businesses has grown strongly – but manufacturing investment has weakened.Business investment and the economic cycleInvestment depends critically on the health of the economy. When GDP growth is strong and inflation isunder control, then business investment invariably picks up. There is often a time lag involved – it takes timefor businesses to reach capacity constraints and give the go ahead for new projects. And the completion ofnew investment schemes inevitably is subject to the risk of delay.
  30. 30. - 31 - 8. Aggregate SupplyHaving looked at the components of aggregate demand, we now turn to the supply-side of the economy.Aggregate supply tells us something about whether producers across the economy can supply us with thegoods and services that we need.A definition of aggregate supplyAggregate supply (AS) measures the volume of goods and services produced within the economy at agiven price level. In simple terms, aggregate supply represents the ability of an economy to produce goodsand services either in the short-term or in the long-term. It tells us the quantity of real GDP that will besupplied at various price levels. The nature of this relationship will differ between the long run and the shortrun o In the long run, the aggregate-supply curve is assumed to be vertical o In the short run, the aggregate-supply curve is assumed to be upward slopingShort run aggregate supply (SRAS) shows total planned output when prices in the economy can changebut the prices and productivity of all factor inputs e.g. wage rates and the state of technology are assumed tobe held constant.Long run aggregate supply (LRAS): LRAS shows total planned output when both prices and averagewage rates can change – it is a measure of a country’s potential output and the concept is linked strongly tothat of the production possibility frontierThe short run aggregate supply curve Inflation LRAS P3 An expansion of national output P2 A contraction of P1 national output SRAS Y1 Y2 Yfc Real National IncomeA change in the price level (for example brought about by a shift in AD) results in a movement along theshort run aggregate supply curve. The slope of SRAS curve depends on the degree of spare (under-utilised)capacity within the economy.
  31. 31. - 32 - 1. Negative output gap: At low levels of real national income where actual GDP < potential GDP, firms have a large amount of spare capacity and can expand their output without paying their workers overtime. The SRAS curve is therefore drawn as elastic 2. Positive output gap: As national output expands and the economy heads towards full capacity, so “supply bottlenecks and shortages” may start to appear in some sectors and industries. Workers receive the same wage rate but require payment of overtime and bonuses to work longer hours and increase GDP – SRAS is becoming more inelastic 3. Diminishing returns? As national output expands, older less productive machinery may be used and less efficient workers hired. This means that while wage rates remain constant, unit costs of production may rise and thus the SRAS slopes upwards 4. Full-capacity output at LRAS. Eventually the economy cannot increase the volume of output further in the short-term no matter what bonus or overtime payments on offer, at this point SRAS is perfectly inelastic – the economy has reached full-capacity (the LRAS curve) Inflation LRAS P3 Short run aggregate supply is inelastic here – a rise in AD will have more of an effect on the general price level than it P2 will on the volume of real national output P1 SRAS Short run aggregate supply is elastic here because there is plenty of spare productive capacity (i.e. the output gap will be negative). A rise in AD will lead easily to an expansion of real national output Y1 Y2 Yfc Real National IncomeShifts in short run aggregate supply (SRAS)Shifts in the SRAS curve can be caused by the following factors 1. Changes in unit labour costs: Unit labour costs are defined as wage costs adjusted for the level of productivity. For example a rise in unit labour costs might be brought about by firms agreeing to pay higher wages or a fall in the level of worker productivity. If unit wage costs rise, this will eventually feed through into higher prices (this is known as an example of “cost-push inflation”) 2. Commodity prices: Changes to raw material costs and other components e.g. the world price of oil, copper, aluminium and other inputs in many production processes will affect a firm’s costs. These costs might be affected by a change in the exchange rate which causes fluctuations in the prices of imported products. A fall (depreciation) in the exchange rate increases the costs of importing raw materials and component supplies from overseas 3. Government taxation and subsidy: Changes to producer taxes and subsidies levied by the government as part of their fiscal policy have effects on the costs of nearly every producer – for example an increase in taxes designed to meet the government’s environmental objectives will cause higher costs and an inward shift in the short run aggregate supply curve. A rise in VAT on raw materials will have the same effect.
  32. 32. - 33 -The short run aggregate supply curve is upward sloping because higher prices for goods and services makeoutput more profitable and enable businesses to expand their production by hiring less productive labour andother resourcesShifts in aggregate supply in the short runShifts in the short run aggregate supply curve are illustrated in the diagram below SRAS1 – SRAS2: A fall in aggregate supply caused by an increase in costs – less output can be supplied at each and every price level SRAS1 – SRAS3: A rise in aggregate supply caused by a fall in production costs – more output can be supplied at each and every price level Inflation LRAS SRAS2 SRAS1 SRAS3 Yfc Real National IncomeThe most important single cause of a shift in the short run aggregate supply curve is a change in wage rates.Higher wage rates without any compensating increase in labour productivity cause a rise in production costs,leading businesses to produce less and the aggregate supply curve will shift to the left (i.e. SRAS1 shifts toSRAS2). Conversely a fall in raw material prices or component costs will reduce production costs,encouraging firms to produce more and the short run aggregate supply curve moves to the right (i.e. SRAS1shifts to SRAS3).