Session 2- C2
Section 4: Government and the
Macro economy
Chap 25:The Macroeconomic aims
of the government
Key Learning Objectives
Before we learn about the key macroeconomic aims of the government (Next session)
We will be learning about :
AD-AS Model
Shape of AD, Components of AD, causes of shifts in AD
Shape of AS, Causes of shifts in AS
National Income Equilibrium ( explained with diagram)
Changes in National Income Equilibrium
Circular Flow of Income
Aggregate Demand
Aggregate Demand Aggregate means ‘total’ and in this case we use the term to measure
how much is being spent by all consumers, businesses, the government and people and firms
overseas.
The total demand for all goods and services in the economy
It is the sum of all expenditure in the economy over a period of time
It is calculated by:
Consumer Spending + Investment Spending + Government Spending + (Exports-Imports)
Thus : AD= C+I+G+(X-M)
The components of
Aggregate Demand (AD)
C: Consumers' expenditure on goods and services: Also known as consumption, this includes
demand for durables e.g. audio-visual equipment and vehicles & non-durable goods such as food
and drinks which are “consumed” and must be re-purchased.
I: Capital Investment – This is spending on capital goods such as plant and equipment and new
buildings to produce more consumer goods in the future. Investment includes spending on
working capital such as stocks of finished and semi-finished goods. Investment has important
effects on the supply-side as well as being an important component of AD.
G: Government Expenditure This is spending on state-provided goods and services including
public goods and merit goods
Transfer payments in the form of benefits (e.g. state pensions and the job-seekers allowance) are
not included in current government spending because they are a transfer from one group (i.e.
people paying income taxes) to another (i.e. pensioners drawing their state pension having retired,
or families on low incomes).
Current Expenditure Vs Capital Expenditure
The components of
Aggregate Demand (AD)
X: Exports of goods and services - Exports sold overseas are an inflow of demand (an injection)
into our circular flow of income and spending adding to aggregate demand.
M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from the
circular flow of income and spending.
Net exports Demand (X-M) measure the value of exports minus the value of imports. 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 has been running a large trade deficit for several
years now.
The Aggregate Demand Curve
The AD curve shows the relationship between the general price level and real GDP
Negative Slope of AD
Real-Balance Effect: when a change in price level changes
total expenditure because the purchasing power changes.
In short, people’s ability to afford items changes.
Shifts in Aggregate Demand
Increase (curve shift right) in AD results in boost of output, employment and GDP but
also increase in inflation
Decrease (curve shift left) in AD results in fall of output, employment and GDP but also
decrease in inflation
Aggregate Supply
Aggregate supply, also known as total output, is the total supply of goods and services produced within an
economy at a given overall price in a given period.
It is represented by the aggregate supply curve, which describes the relationship between price levels and the
quantity of output that firms are willing to provide. Typically, there is a positive relationship between
aggregate supply and the price level.
Understanding the shape of Aggregate Supply
The slope of the AS curve changes from nearly flat at its far left to nearly vertical at its far right. At the far left
of the aggregate supply curve, the level of output in the economy is far below potential GDP—the quantity
that an economy can produce by fully employing its existing levels of labor, physical capital, and technology,
in the context of its existing market and legal institutions.
At relatively low levels of output, levels of unemployment are high, and many factories are running only part-
time or have closed their doors. In this situation, a relatively small increase in the prices of the outputs that
businesses sell—with no rise in input prices—can encourage a considerable surge in the quantity of aggregate
supply—real GDP—because so many workers and factories are ready to swing into production.
Aggregate Supply
As the quantity produced increases, however, certain firms and industries will start running into limits—for
example, nearly all of the expert workers in a certain industry could have jobs or factories in certain geographic
areas or industries might be running at full speed.
In the intermediate area of the AS curve, a higher price level for outputs continues to encourage a greater
quantity of output, but as the increasingly steep upward slope of the aggregate supply curve shows, the increase
in quantity in response to a given rise in the price level will not be quite as large.
At the far right, the aggregate supply curve becomes nearly vertical. At this quantity, higher prices for outputs
cannot encourage additional output because even if firms want to expand output, the inputs of labor and
machinery in the economy are fully employed.
When an economy is operating at its potential GDP, machines and factories are running at capacity, and the
unemployment rate is relatively low at the natural rate of unemployment. For this reason, potential GDP is
sometimes also called full-employment GDP.
National Income Equilibrium
AS-AD Model: This AS-AD model shows how the aggregate
supply and aggregate demand are graphed to show economic
output. The AD curve shifts to the right which increases output
and price.
National Income Equilibrium
Circular Flow of Income
What is the circular flow?
The circular flow of income and spending shows connections between different sectors of an economy
It shows flows of goods and services and factors of production between firms and households
Businesses produce goods and services and in the process of doing so, incomes are generated for factors of
production (land, labour, capital and enterprise) – for example wages and salaries going to people in work.
Leakages – Withdrawls
Imports represent money leaking out to other economies.
Taxation removes money from households and takes it out of the economy unless the Government spends it.
Savings by households represent money taken out & stored by banks (although its often lent for investment).
Circular Flow of Income
Injections
Exports by firms represent additional money coming into the economy
Government spending injects more money into the economy
Capital investment by firms (often borrowed).
Circular Flow of Income
An economy is in equilibrium when the rate of injections = the rate of withdrawals from the circular flow.
