AS Macroeconomics


Oct 28, 2013 (5 years and 5 months ago)


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This resource is designed as a complement to your studies in AS Economics and should not be regarded
as a substitute for taking effective notes in your lessons. Points raised and issues covered in class analysis
and 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 you
into new and exciting territory. Providing you understand many of the core concepts and ideas available to
an economist, you will be in a good position to understand many of the new issues that arise and you will
build an awareness of the problems in developing strategies and policies to combat some the main
economic and social problems of our time.

Each chapter of this Guide contains a core set of notes, key definitions and diagrams together with a series
of short case study readings and web links designed to encourage you to read widely and explore many
aspects 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 and
analysis in the broadsheet newspapers, magazines and journals that you can delve into. The more reading
you manage on the main issues of the day the wider will be your appreciation of the theory and practice of

Here are some resources on the Internet that you should make a point of visiting on a regular basis:

Web Resource Recommendation
BBC Business and Economics News
Incredible coverage of domestic and international issues
Leading international business magazine
Economist A-Z of Economics
Useful background glossary with external links
Economist Country Briefings
Series of short background briefings on all major economies
Ernst and Young Economic Update
Excellent quarterly research on the UK and global economy
Great site for research and special reports – see their special
archive section on economics using this link

Halifax Bank of Scotland Research
Excellent reviews on the UK economy
HM Treasury
The web site of the Treasury – superb for data
Strong coverage of current business/industrial trends
Institute for Fiscal Studies
Super resource for aspects of government fiscal policy
International Monetary Fund
Excellent for global economic research and policy issues
Office of National Statistics
The main site if you need economic statistics for essays! The
monthly Economic Trends
is a superb resource for teachers
Organisation of Economic Co-operation
and Development

Superb for in depth analysis of the global economy from the
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 presentations
Tim Harford – Undercover Economist
Lively writing on economics each week – well worth it
Tutor2u Economics
The leading AS and A Level economics portal! The daily
economics blog is available here.

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Table of Contents

1. Introduction to Macroeconomics and Indicators of Economic Performance.........................................4
2. Measuring National Income.........................................................................................................................8
3. Macroeconomic Objectives.......................................................................................................................12
4. Using Index Numbers.................................................................................................................................14
5. Aggregate Demand...................................................................................................................................16
6. Consumer Spending and Saving..............................................................................................................21
7. Capital Investment......................................................................................................................................27
8. Aggregate Supply.....................................................................................................................................31
9. Macroeconomic Equilibrium......................................................................................................................37
10. The Macroeconomic Cycle........................................................................................................................42
11. Multiplier and Accelerator Effects...........................................................................................................45
12. Economic Growth........................................................................................................................................49
13. Inflation........................................................................................................................................................54
14. Employment and Unemployment.............................................................................................................61
15. International Trade....................................................................................................................................70
16. Balance of Payments.................................................................................................................................73
17. Government Macroeconomic Policy........................................................................................................78
18. Monetary Policy..........................................................................................................................................81
19. The Exchange Rate.....................................................................................................................................85
20. Fiscal Policy.................................................................................................................................................89
21. Government borrowing – the budget deficit........................................................................................94
22. Supply-side Policies...................................................................................................................................96
23. Trade-Offs between Objectives...........................................................................................................101
24. Exam Technique for your macroeconomics paper..............................................................................106

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1. Introduction to Macroeconomics and Indicators of Economic Performance

In this chapter we consider what macroeconomics is and we look at some of the key indicators of interest to
students of macroeconomics.

What is macroeconomics?

Macroeconomics considers the economy as a whole and relationships between one country and
others for example we focus on changes in economic growth; inflation; unemployment and our trade
performance with other countries (i.e. the balance of payments). The scope of macroeconomics also
includes looking at the relative success or failure of government policies.

Introduction to the UK economy

The City of London, an important centre for
international finance and a major source of income for
our balance of payments

The individual spending decisions of millions of
consumers add up to affect the performance of the
whole economy

Searching for work – unemployment has been low in
the UK for over ten years – but it is now starting to rise

Anticipating demand – stocks of products in a
warehouse. Businesses need to anticipate demand
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
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• 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 economy

The global economy is undergoing huge changes at the moment as the effects of the current wave of
globalisation become more apparent each day. To broaden your awareness and understanding of
macroeconomics, it is a good idea to become familiar with some of the world’s leading economies and
perhaps see how they compare and contrast with that of the UK. The links below will help you to find out

European Union
(25 countries)
Countries in italics joined in 2004
(3 countries)
North American Free Trade Area
United States

Czech Republic





Other OECD
(but non-EU)










New Zealand


Emerging Markets
include South Korea



Saudi Arabia

South Africa

Targets and objectives of macroeconomic policy

Government management of the economy is a key political issue and each government sets targets and
objectives when it assumes power – and often, economic objectives and priorities lie right at the heart of a
government’s overall political strategy.

We focus on large number when we undertake the study of macroeconomics. For example, the value of
national output in the UK, expressed at constant prices so that we eliminate the effects of inflation on the
value of what we produce and consume, edged above £1 trillion in 2003. But we still stand well below the
United States, whose national output (GDP) accounts for over a quarter of world output each year. No
wonder that people often say “when the United States catches sneezes, the rest of the world catches a cold!”
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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 countries

The UK economic cycle

Annual percentage change in GDP at constant prices
Growth of National Output for the U
ar 4 quarters
Source: Reuters EcoWin

The economic cycle is also known as the business cycle. The chart above shows the annual rate of growth
of national output for the UK economy since 1980. There have been two recessions in the last twenty-five
years. 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 maintained
throughout the remainder of the 1990s. Further positive rates of growth have been sustained in the first six
years of the current decade, allowing the UK economy to claim one of the longest periods of expansion in
our modern history. After a slowdown in 2005 the British economy looked to be enjoying stronger growth in
the first half of 2006.

As we shall see later, all countries go through a business or economic cycle leading to fluctuations in
national output and unemployment. The chart below shows what has happened to the US economy over
recent years.

The United States enjoyed a period of fast growth during the second half of the 1990s. But a combination of
rising interest rates (the US central bank raised the cost of borrowing to curb the growth of consumption) and
of course the fallout from the events of 9-11 which severely affected consumer and business confidence
brought about a sharp slowdown in their growth rate. The USA economy went into a steep slowdown – but
although, for a short period, national output did fall, the annual growth rate stayed positive before a recovery
emerged in 2002 and 2003. In 2003, the US economy grew by 3% and growth climbed above 4% in 2004
before edging lower in 2005. The United States has been running a policy of low interest rates for most of
the current decade. But between 2004 and 2006, they have been gradually increasing interest rates in a bid
to control demand and inflationary pressures. As a result, the speed of growth in the USA is now starting to

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Per cent
USA Interest Rates and Real GDP Growth 1995-2005
Official Interest Rate (Set by the Federal Reserve)
Annual growth of real national output [ar 1 year]
Source: Reuters EcoWin
Economic Growth
Interest Rates

We can compare and contrast the relative performance of different countries by making use of the economic
data published for each nation. The main source of data for the UK is via the Office for National Statistics

where there is a wealth of information not just on Britain but also for each of our regions and for other
countries as well.

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2. Measuring National Income

We need information on how much spending, income and output is being created in an economy over a
period of time. National income data gives us this information as we see in this chapter.

Measuring national income

To measure how much output, spending and income has been generated in a given time period we use
national 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 produced
within an economy over a period of time. Measuring the level and rate of growth of national income (Y) is
important 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 in
recent 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 debt

Gross Domestic Product

Gross Domestic Product (GDP) measures the value of output produced within the domestic boundaries of
the UK
over a given time period. An important point is that our GDP includes the output of foreign owned
businesses that are located in the UK following foreign direct investment in the UK economy. The output of
motor vehicles produced at the giant Nissan car plant on Tyne and Wear
and by the many foreign owned
restaurants 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 following
identity must hold true:

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National Output = National Expenditure (Aggregate Demand) = National Income

Firstly we consider total spending on goods and services produced within the economy:

Nissan at Sunderland – Celebrating 20 years of production

The Nissan plant at Washington, Tyne and Wear
is celebrating its 20th anniversary in July 2006, the first car
having rolled off the line on July 8th, 1986. In that first year of production 470 staff had a production target of
24,000 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 total
investment of £2.3 billion. Production is set to rise from 310,000 per year last year to 400,000 in 2007 with
the introduction of a new small 4x4, and Sunderland has been rated as Europe's most productive car factory
for 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 full
equation 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 Services

The 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 factor
incomes 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 of
output 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

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This measure of GDP adds together the value of output produced by each of the productive sectors in the
economy 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 can
see 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 been
sectors enjoying strong increases in the volume of output. These figures illustrate a process of structural
change, with a continued decline in manufacturing output and jobs relative to the rest of the economy. By
far 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
quarrying, inc
oil & gas
Manufacturing Construction Distribution,
hotels, and
services and
2001 weights in total GDP
(out of 1000)
28 172 57 159 249
2001 100 100 100 100 100
2002 100 97 104 105 102
2003 94 97 109 108 106
2004 87 98 113 113 111

We can see from the following chart how there have been divergences in the growth achieved by the
manufacturing and the service sectors of the British economy. Indeed by the middle of 2006, the index of
manufacturing 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 structural
change in the economy – away from traditional heavy industries towards service businesses.

Index of Value Added, Constant Prices, Seasonally Adjusted
Output of Manufacturing and Services
Gross, Service industries, Total
Gross, Manufacturing
Source: Reuters EcoWin
Index of output, 2002=100

GDP and GNP (Gross National Product)

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Gross National Product (GNP) measures the final value of output or expenditure by UK owned factors of
production whether they are located in the UK or overseas.

In contrast, Gross Domestic Product (GDP) is concerned only with the factor incomes generated within the
geographical boundaries of the country. So, for example, the value of the output produced by Toyota and
Deutsche Telecom in the UK counts towards our GDP but some of the profits made by overseas companies
with 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 owned
overseas matched against the flow of profits and other income from foreign owned assets located within the
UK. In recent years there has been an increasing flow of direct investment into and out of the UK. Many
foreign firms have set up production plants here whilst UK firms have expanded their operations overseas
and become multinational organisations.

The figure for net property income for the UK is strongly positive meaning that our GNP is substantially
above the figure for GDP in a normal year. For other countries who have been net recipients of overseas
investment (a good example is Ireland) their GDP is higher than their GNP.

Measuring Real National Income

When 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 means
that AD has risen faster than the rate of inflation and therefore the economy is experiencing positive growth.

Income per capita

Income 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 per
head in a common currency for the year 2005, the data is adjusted for the effects of variations in living costs
between countries.

GDP per capita $s GDP per capita $s
Luxembourg 57 704 EU (established 15 countries) 28 741
United States 39 732 Germany 28 605
Norway 38 765 Italy 27 699
Ireland 35 767 Spain 25 582
Switzerland 33 678 Korea 20 907
United Kingdom 31 436 Czech Republic 18 467
Canada 31 395 Hungary 15 946
Australia 31 231 Slovak Republic 14 309
Sweden 30 361 Poland 12 647
Japan 29 664 Mexico 10 059
France 29 554 Turkey 7 687

Source: OECD World Economic Factbook, 2006 edition

By international standards, the UK is a high-income country although we are not in the very top of the league
tables for per capita incomes. We do have an income per head that is about ten per cent higher than the
average for the 15 established EU countries. But we are some distance behind countries such as the United
States (where productivity is much higher). And Ireland’s super-charged growth over the last twenty years
means that she has now overtaken us in terms of income-based measures of standards of living.

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3. Macroeconomic Objectives

All governments have targets and aims for the economy – in this chapter we consider the main objectives of
macroeconomic policy.

Objectives are the aims or goals of government policy whereas instruments are the means by which these
aims might be achieved and targets are often thought to be intermediate aims – linked closely in a
theoretical way to the final policy objective.

So for example, the government might want to achieve low inflation. The main instrument to achieve this
might be the use of interest rates (now set by the Bank of England) and a target might be the growth of
consumer credit or perhaps the exchange rate.

Only a limited number of policies can be used to achieve the government’s objectives. There is a huge
amount of research conducted in trying to determine the effectiveness of different policies in meeting key
objectives. Indeed the debates about which policies are most suitable lie at the heart of differences between
economic 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 markets

Find out more about schools of thought

If you want to delve a little deeper into the differences between schools of thought in Economics here are a
few links to resources available on the Wikipedia web site:

• Keynes and Keynesian Economists:

• Monetarists:

• Classical economists:

The Objectives of UK Economic Policy

The 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
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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
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 the
stability of the economy is a pre-condition for improvements in capital investment, productivity, company
profits and employment.

Of course the vagaries of and uncertainties in developments in the global economy make this a difficult
objective to pursue. A dose of good luck as well as sound judgement is required given the domestic and
external shocks that can affect the British economy at any time!

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4. Using Index Numbers

Index numbers are a useful way of expressing pieces of information and collections of data. This brief
chapter shows you how to express data in index number format and some examples of data which is
commonly presented as an index number

Converting data in index number format: Measuring the level of real national output

When we are measuring the level of national income we often make use of index numbers to track what is
happening to real GDP. In the table below we see the value of consumer spending and also real GDP
expressed in £ billion. I have chosen 1995 as the base year for our index of spending and output. So the
data 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 formula

Index (1996) = (consumer spending (1996) / base year consumer spending) x 100

Consumer spending Index of consumer
Real GDP Index of real GDP
£ 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 1108.9 129.3

One of the advantages of index numbers is that it allows us to compare and contrast more easily different
sets of economic data. Consider the information in the table above. Using 1995 as our base year for the
index, we can see that consumer spending has grown more quickly than real national income over the period

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 the
economy, indeed consumption as a share of GDP has grown from 60% in 1995 to nearly 65% in 2003 – a
record level. Can this consumer boom continue? Much of it has been financed by high rates of borrowing
linked to low interest rates and the recent UK housing boom.

Calculating a price index

We 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 inflation

Category Price Index Weighting Price x Weight
Food 106 18 1908
Alcohol & Tobacco 110 6 660
Clothing 97 12 1164
Transport 103 15 1545
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Housing 106 22 2332
Leisure Services 112 9 1008
Household Goods 95 7 665
Other Items 105 11 1155

100 10437

A weighted price index calculates changes in the average level of prices in the economy. In the
hypothetical data shown in the table above we have split consumer spending into eight categories and given
each a “weighting” based on the share of total consumer spending given over to each category. So for
example, 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. To
generate a weighted price index we multiply the price index for each category by its weight and then sum
these. We then divide by the sum of the weights (100) to find an overall price index (104.37) or 104.4
rounded 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 Cars
1996 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
2000 105.6 111.6 112.7 89.3 141.2 82.2 99.8 91.2
2003 109.8 124.2 116.9 84.5 158.8 66.8 95.7 85.1

Over the period 1996-2003 there has been a 10% rise in the general price level. But this hides major
changes in average prices for different products. The average cost of purchasing tobacco products has
jumped by nearly sixty per cent whereas the prices of clothing, second hand cars and communication have
been falling.

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5. Aggregate Demand

This section gives you a platform for understanding issues such as inflation, economic growth and
unemployment. Aggregate demand (AD) and aggregate supply (AS) analysis provides a way of illustrating
macroeconomic relationships and the effects of government policy changes.

Aggregate Demand

The identity for calculating aggregate demand (AD) is as follows:

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

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
- 17 -

Economic events such as changes in interest rates and economic growth in the United States can have a
powerful 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 employment
in the economy. These unplanned events are called “shocks” One of the causes of fluctuations in the level of
economic 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.

- 18 -

The Aggregate Demand Curve

The AD curve shows the relationship between the general price level and real GDP.

Why does the AD curve slope downwards?

There are several explanations for an inverse relationship between aggregate demand and the price level in
an 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 curve

A 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 and
results 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 AD
from AD1 to AD2. The increase in AD might have been caused for example by a fall in interest rates or an
increase in consumers’ wealth because of rising house prices.

Real National Income
A rise in the general price
level from P1 to P2 causes
a contraction in aggregate

A fall in the general price
level from P1 to P3 causes
an expansion of
aggregate demand

The AD curve shows the relationship between aggregate demand and the UK price level,
measured in terms of the consumer
rice index

- 19 -

Factors causing a shift in AD

Changes in Expectations
Current spending is affected by
anticipated future income, profit,
and inflation
The expectations
of consumers and businesses can have a powerful
effect on planned spending in the economy E.g. expected increases in
consumer incomes, wealth or company profits encourage households
and firms to spend more – boosting AD. Similarly, higher expected
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 –
i.e. a change in interest rates
(Note there is more than one
interest rate in the economy,
although borrowing and savings
rates tend to move in the same
An expansionary monetary policy will cause an outward shift of the AD
curve. If interest rates fall – this lowers the cost of borrowing and the
incentive to save, thereby encouraging consumption. Lower interest
rates encourage firms to borrow and invest.
There are time lags between changes in interest rates and the
changes on the components of aggregate demand.

Changes in Fiscal Policy
Fiscal Policy refers to changes in
government spending, welfare
benefits and taxation, and the
amount that the government
For example, the Government may increase its expenditure e.g.
financed by a higher budget deficit, - this directly increases AD

Income tax affects disposable income e.g. lower rates of income tax
raise disposable income and should boost consumption.
An increase in transfer payments raises AD – particularly if welfare
recipients spend a high % of the benefits they receive.

Economic events in the
international economy
International factors such as the
exchange rate and foreign

A fall in the value of the pound (£) (a depreciation) makes imports
dearer and exports cheaper thereby discouraging imports and
encouraging exports – the net result should be that UK AD rises – the
impact depends on the price elasticity of demand for imports and
Real National Income
In the short run, shifts in
aggregate demand cause
fluctuations in the economy’s
output of goods and services.

In the long run, shifts in
aggregate demand affect
the overall price level but do
not affect output.

- 20 -

income (e.g. the economic cycle
in other countries)

exports and also the elasticity of supply of UK exporters in response
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
Wealth refers to the value of
assets owned by consumers e.g.
houses and shares
A rise in house prices or the value of shares increases consumers’
wealth and allow an increase in borrowing to finance consumption
increasing AD. In contrast, a fall in the value of share prices will lead
to a decline in household financial wealth and a fall in consumer

- 21 -

6. Consumer Spending and Saving

Consumption accounts for 65% of aggregate demand. There are many factors that affect how much people
are willing and able to spend. It is important to understand these factors because changes in consumer
spending have an important effect on path of the economic cycle.

Annual percentage change in household spending and GDP at constant 2000 prices
Real Consumption Expenditure and Real GDP growth
Consumer spending [ar 4 quarters]
Real GDP growth [ar 4 quarters]
Source: Reuters EcoWin
Annual % change
Real GDP
Consumer spending

John Maynard Keynes
developed a theory of consumption that focused primarily on
the level of people’s disposable income in determining their spending. The rate at
which consumers increase demand as income rises is called the marginal
propensity to consume. For example if someone receives an increase in income
of £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. This
has important implications when the government announces changes in direct
taxation and the level of welfare benefits.

Incomes matter in determining spending

The Bank of England has an economic model that seeks to predict what will happen to consumer spending
after various shocks. In the long term, the thing that matters most is people's real incomes. Changes in the
amount we earn are by far the most important feature determining how much we spend. Other features, such
as the value of our homes or our financial savings, matter a bit but their effect is dwarfed by changes in our
earnings. Source: Hamish McRae, the Independent, 8
August 2004

The 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
- 22 -

3. Consumer confidence
4. Changes in household financial wealth
5. Changes in employment and unemployment

The strength of consumer spending has been one of the main reasons why Britain has avoided a recession
in recent years – but at the same time, there are fears that household spending has been too high, and that
much of it has been financed by a surge in borrowing leading to record levels of household debt.
One key
reason for this has been the strength of the housing market which has allowed millions of home-owners to
borrow 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 a
sharp increase in the UK’s trade deficit with other countries.

Spending on consumer durables

Real spending at constant prices, seasonally adjusted, £ billion per quarter
Consumer Expenditure on Durable Goods
Source: Reuters EcoWin
£s at constant 2002 prices (billions)

Consumer durables are items that provide a flow of services to a consumer over a period of time. Examples
include new cars, household appliances, audio-visual equipment, furniture etc. The real level of spending on
durables 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

The Wealth Effect

Wealth represents the value of a stock of assets owned by people. For most people the majority of their
wealth 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.
- 23 -

Index of the UK's 100 leading shares - daily closing value
FTSE-100 Index
Source: Reuters EcoWin

There is a positive wealth effect between changes in financial wealth and total consumer demand for
goods and services. For example when house prices are rising strongly, consumer confidence grows and
home-owners can also borrow some of the equity in their homes to finance major items of spending.

Percentage of disposable income that is saved, quarterly data
Household Savings Ratio
Source: Reuters EcoWin

The Savings Ratio

represents a decision to postpone consumption by saving money out of disposable income. Why
do people choose to save their incomes? There are many motivations for saving:
- 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 ratio

The 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 also
high interest rates. In recent years there has been a fall in the savings ratio in part because consumer
borrowing has reached record levels, fuelled in part by the rapid acceleration in house prices. At some point
the savings ratio will need to rise again as people rein back on their spending in order to repay debts on
credit cards and other forms of secured and unsecured borrowing. We have started to see a gradual rise in
the savings ratio during 2005 and the first half of 2006.

The importance of consumer confidence

The willingness of people to make major spending commitments depends on how confident they are about
both their own financial circumstances, and also the general state of the economy. Consumer confidence is
quite volatile from month to month. Some of the fluctuations are seasonal – but the underlying trend is what
really matters. One interesting aspect of recent data is that people have remained more optimistic about their
own financial situation than they have about prospects for the UK economy as a whole. This perhaps helps
to explain why people have continued to be prepared to make big-ticket purchases on new consumer
durables (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 prices

The consumer borrowing boom of recent years

- 25 -

6 month % growth rates for lending to individuals, source: Bank of England
Growth of Consumer Borrowing
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 EcoWin
Borrowing secured on the value of dwellings (housing)
Credit card borrowing

The British economy has seen high consumer borrowing in recent years. This has been the result of a
number 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
- 26 -

Strong demand for loans has boosted consumer spending and helped to keep the UK economy growing at a
time of global uncertainty. Borrowing has also contributed to the rising trade deficit in goods and services. By
the summer of 2006, the consumer borrowing boom appeared to be coming to an end. The slowdown in
credit 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 payments

Consumers in Britain have a high marginal propensity to import goods and services so that, when their
real incomes are rising and their spending increases, so too does the demand for imports. Unless there is a
corresponding increase in UK exports overseas, then the balance of trade in goods and services will move
towards heavier deficit. This has been the case in the UK over the last five or six years. In the medium term if
demand 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 to
reduce real incomes. Living standards are reduced in the long run if our export industries are unable to
compete with output produced in other countries.

- 27 -

7. Capital Investment

Investment 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 Investment

Gross investment spending includes an estimate for capital depreciation since some investment is
needed 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 a
higher level of demand in the future.

The Economic Importance of Capital Investment

Firms often invest in new capital goods to exploit internal economies of scale. This, together with
technological advances that are often built into new machinery, is vital to improving the UK's
competitiveness 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

- 28 -

In the short run, devoting more a country’s scarce resources to the production of investment goods (a
process known as capital accumulation) might require a reduction in today’s output of consumer goods and
services (lower consumption would be accompanied by a rise in saving). The re-allocation of resources
towards capital goods would be shown by a movement from point A to B on the production possibility

But if the extra investment is successful and leads to an increase in a country’s productive capacity then the
PPF can shift out and open up the potential for an increased output of consumption goods to meet people’s
needs and wants. This is shown by a movement from point B on the PPF to point C which lies on the new
PPF 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 from
increased orders for new plant and machinery.

A rise in capital investment will therefore have important effects on both the demand and supply-side of the
economy – 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)

Output of
Consumer Goods
Output of Capital
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.
- 29 -

It is not just the level of capital investment which is important but also the quality of the increase in the capital
stock. A high level of investment on its own may not be sufficient to create an increase in LRAS – workers
need to be trained to work the new machinery and there may be time lags between new capital spending
and the knock-on effects on output and productivity in particular. Also, if there is insufficient demand in a
market, a high level of capital investment may lead to excess capacity emerging in industries – putting
downward pressure on prices and profits

Investment at constant 2001 prices, £ billion
Gross Fixed Capital Investment by Businesses
Source: Reuters EcoWin
2001 GBP (billions)

Real National Income
- 30 -

One way to remember the importance of investment is to consider the 3 Cs - capacity, costs and
competitiveness. 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 Spending

Several 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 cycle

Investment depends critically on the health of the economy. When GDP growth is strong and inflation is
under control, then business investment invariably picks up. There is often a time lag involved – it takes time
for businesses to reach capacity constraints and give the go ahead for new projects. And the completion of
new investment schemes inevitably is subject to the risk of delay.

- 31 -

8. Aggregate Supply

Having 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 the
goods and services that we need.

A definition of aggregate supply

Aggregate supply (AS) measures the volume of goods and services produced within the economy at a
given price level. In simple terms, aggregate supply represents the ability of an economy to produce goods
and services either in the short-term or in the long-term. It tells us the quantity of real GDP that will be
supplied at various price levels. The nature of this relationship will differ between the long run and the short
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 sloping

Short run aggregate supply (SRAS) shows total planned output when prices in the economy can change
but the prices and productivity of all factor inputs e.g. wage rates and the state of technology are assumed to
be held constant.

Long run aggregate supply (LRAS): LRAS shows total planned output when both prices and average
wage rates can change – it is a measure of a country’s potential output and the concept is linked strongly to
that of the production possibility frontier

The short run aggregate supply curve

A change in the price level (for example brought about by a shift in AD) results in a movement along the
short run aggregate supply curve. The slope of SRAS curve depends on the degree of spare (under-utilised)
capacity within the economy.
Real National Income
An expansion of
national output
A contraction of
national output
- 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)

Shifts 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.

Real National Income
Short run aggregate supply is inelastic
here – a rise in AD will have more of an
effect on the general price level than it
will on the volume of real national
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
- 33 -

The short run aggregate supply curve is upward sloping because higher prices for goods and services make
output more profitable and enable businesses to expand their production by hiring less productive labour and
other resources

Shifts in aggregate supply in the short run

Shifts in the short run aggregate supply curve are illustrated in the diagram below

The 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 to
SRAS2). 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. SRAS1
shifts to SRAS3).

Real National Income
 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

- 34 -

Long run aggregate supply (LRAS)

In the long run, the ability of an economy to produce goods and services to meet demand is based on the
state of production technology and the availability and quality of factor inputs.

A long run production function for a country is often written as follows:

Y*t = f (Lt, Kt, Mt)
o Y* is an aggregate measure of potential output in an economy
o T is the time period under consideration
o L represents the quantity and ability of labour input available to the production process
o K represents the available capital stock, i.e. machinery, buildings and infrastructure
o M represents the availability of natural resources and materials for production i.e. land

LRAS is determined by the stock of a country’s productive resources and also by the productivity of
factor inputs (labour, land and capital). Changes in the state of technology also affect the potential level of
real national output.

The vertical long run aggregate supply curve

In the long run we assume that aggregate supply is independent of the price level. As a result we draw the
long run aggregate supply curve as vertical. In drawing the LRAS as vertical, we are saying that there is a
maximum level of physical output that the economy can produce. Neo-classical economists view the LRAS
curve as being perfectly inelastic at a level of output where actual GDP has achieved its potential. There will
be no unused labour in that all those who are available for employment at the prevailing wage rate will be in
employment – in other words, a full-employment level of national income has been reached. There will
remain the problem of voluntary unemployment.

According to the neo-classical school of economics, real GDP will in the long run always return to the
level at which all available labour resources have found employment.

Causes of shifts in the long run aggregate supply curve

Any change in the economy that alters the natural rate of growth of output (i.e. trend growth) shifts the
long-run aggregate-supply curve.

Improvements in productivity and efficiency or an increase in the stock of capital and labour resources cause
the LRAS curve to shift out. This is shown in the diagram below. The result is that a great volume of national
output can be produced at any given price level.

- 35 -

The fundamentals of increasing long run aggregate supply

These all relate to the supply-side of the economy
1. Expanding the labour supply - e.g. by improving incentives for people to search for and then
accept new jobs as they become available. Government policies seek to expand the available
labour supply by encouraging more people to join the labour force and become economically
active. The UK government has also been encouraging an influx of migrant labour which has added
to the supply of labour although it is also causing concern about some of the social and political
2. Increase the productivity of labour and capital – e.g. by investment in training of the labour force
and improvements in the quality of management and human resource management
3. Increase the occupational and geographical mobility of labour to reduce certain types of
unemployment for example the level of structural unemployment which is caused by occupational
immobility of labour. A reduction in structural unemployment will reduce the scale of unemployment
and provide the economy with a great supply of available labour.
4. Expand the capital stock – i.e. increase the level of capital investment and research and
development spending by firms
5. Increase business efficiency by promoting greater competition within and between markets
6. Stimulate a faster pace of invention and innovation – this will hopefully in the long term promote
lower production costs and also improvements in the dynamic efficiency of markets

Aggregate supply shocks

Aggregate supply shocks might occur when there is
o A sudden rise in oil prices or other essential inputs
o The invention and diffusion of a new production technology
Real National Income
- 36 -

Closing daily price, US dollars per barrel of oil
Brent Crude Oil Prices
Source: Reuters EcoWin

The effects of supply-side shocks are normally to cause a shift in the short run aggregate supply curve. But
there are also occasions when significant changes in production technologies or step-changes in the
productivity of factors of production that were not expected, feed through into a shift in the long run
aggregate supply curve.

In the long-run

In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous
seasons they can only tell us that when the storm is long past the ocean is flat again.”
John Maynard Keynes, 1936

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9. Macroeconomic Equilibrium

We now put aggregate demand and supply to together to consider the idea of equilibrium for the economy.

In this chapter, we will be using the neo-Keynesian version of the long run aggregate supply curve – which is
drawn as a non-linear curve. This shape of the LRAS curve shows that increases in aggregate demand may
increase real output and employment in the short term though when SRAS is upward sloping, this may be at
the expense of higher inflation.

Macro-economic equilibrium is established when AD intersects with SRAS. This is shown in the diagram
below. At price level P1, AD is equal to SRAS – i.e. at this price level, the value of output produced within the
economy equates with the level of demand for goods and services. The output and the general price level in
the economy will tend to adjust towards this equilibrium position. If the general price level is too high for
example, there will be an excess supply of output and producers will experience an increase in unsold
stocks. This is a signal to cut back on production to avoid an excessive level of inventories. If the price level
is below equilibrium, there will be excess demand in the short run leading to a run down of stocks – a signal
for producers to expand output.

Real National Income
Equilibrium Point
At the equilibrium output
in this example, the
economy is still operating
below full capacity
At price level P2 – there
would be excess supply
Macroeconomic equilibrium –

when AD equates to short run aggregate supply. The
short run equilibrium for an economy may be higher or lower than potential GDP
At price level P1 – there
would be excess demand
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Changes in short-run aggregate supply (SRAS)

Suppose that higher productivity of labour and capital inputs together with lower raw material costs such as
cheaper oil and steel causes the short run aggregate supply curve to shift outwards. (Assume that there is
no shift in AD). The next diagram shows what is likely to happen. SRAS1 shifts outwards to SRAS3 and a
new macroeconomic equilibrium will be established at Y3.

Real National Income
AD1 – AD2 is an outward shift of AD causing an expansion of short run aggregate
supply, a rise in real national output and an increase in the general price level
AD1 – AD3 is an inward shift of AD causing a contraction of short run aggregate
supply, a fall in real national output and a decrease in the general price level
Y1 Y2 Yfc Y3
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Equilibrium using a linear aggregate supply curve

In the next diagram we see the effects of two inward shifts in AD. This might be caused for example by a
decline in business confidence (reducing planned investment demand) and a fall in exports following a global
downturn. It might also be caused by a cut in government spending or a rise in interest rates (announced by
the Bank of England).

The result of the inward shift of AD is a contraction along the short run aggregate supply curve and a fall in
national output (i.e. a recession). This causes downward pressure on the general price level and takes the
equilibrium level of national output further away from the full capacity level of national income as indicated by
the LRAS curve. We would expect to see a rise in unemployment.
Real National Income
Y1 Y3 Yfc Y2
SRAS1 – SRAS3 is an outward shift of AS causing an expansion of AD, a rise in real
national output and a decrease in the general price level

SRAS1 – SRAS2 is an inward shift of AS causing a contraction of AD, a fall in real
national output and an increase in the general price level

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The Output Gap

The output gap (or GDP gap
) is an important concept in macroeconomics. It is defined as the difference
between the actual level of national output and its potential level and is usually expressed as a percentage of
the level of potential output.

Negative output gap – downward pressure on inflation

The actual level of real GDP is given by the intersection of AD & SRAS – the short run equilibrium. If actual
GDP is less than potential GDP (e.g. real output level Y1) then there is a negative output gap. Some factor
resources including labour are under-utilised and the main economic problem is likely to be higher than
average unemployment. High unemployment indicates an excess supply of labour in the factor market which
National Income
Positive Output Gap
Y2 > Yfc
Negative Output Gap
Y1 < Yfc
Showing a negative and a positive output gap using an AS

AD diagram
Real National Income
Y1 Y2 Y3
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means there is downward pressure on real wage rates. In the next time period, a fall in wage rates shifts
SRAS downwards until actual and potential GDP are identical – assuming labour markets are flexible.

Positive output gap – upward pressure on inflation

If actual GDP is greater than potential GDP i.e. a level of real GDP of Y2 then there is a positive output gap.
Some resources including labour are working beyond normal capacity e.g. shift work and overtime. The main
economic problem is likely to be demand pull and cost-push inflation. The shortage of labour puts upward
pressure on wage rates. In the next time period, a rise in wage rates shifts SRAS upwards until actual and
potential GDP are identical – assuming labour markets are flexible.

Actual GDP - Potential GDP, measured as a percenage of potential GDP
United Kingdom, Output gap of the total economy
Source: Reuters EcoWin

The last boom in the late 1980s left the UK with a large positive output gap, one of the reasons why we say a
sharp acceleration in inflation before the recession of the early 1990s (high inflation required very high
interest rates to control it and this squeezed business and consumer confidence and spending). At the end of
the recession in 1992 the output gap was negative – allowing the economy to grow for several years without
the fear of demand-pull inflationary pressure.

Over the last six or seven years, the output gap has remained close to zero. The Bank of England has
managed quite successfully through its interest rate strategy to keep aggregate demand growing more or
less in line with the economy’s productive potential. The recent global economic slowdown has hit GDP