7

7 How the
macroeconomy works
The national economy in a global
environment
Resources – land, labour and capital
Income – rent, wages, interest and profit
Goods and services
Consumption spending
Households Firms
$
Savings Investment
Financial sector
Taxation Government spending
Government sector
Imports Exports
Overseas sector
7.1
1.1 The
Thecircular
demandflow of income
for goods and services
This section will develop your knowledge and understanding of:

➔ what national income measures
➔ the difference between nominal (money) and real income
➔ real national income as an indicator of economic performance
➔ the circular flow of income model, the equation income = output = expenditure and the
concepts of equilibrium and full employment income
➔ the difference between injections and withdrawals into the circular flow of income
➔ the effects of changes in injections and withdrawals on national income.
This chapter will develop a model of how the economy works. The
Key terms economic model explained in this chapter allows different views of
Economic model: a simplified the operation of the macroeconomy to be explored. The model will
representation of the economy, or explain the important factors that affect the macroeconomic policy
part of the economy, that provides objectives and it will provide a framework for understanding how
understanding of the real world. government policies can help to achieve these objectives.
National income: the monetary

What national income measures
value of all the goods and services
that are produced by an economy National income measures the monetary value of all the goods and
services that are produced by an economy in a given period of time,
in a given period of time.
usually a year. It also measures total income and total expenditure.
Value added: the difference National income is a flow; it is what is produced over a period of time.
between the value of an industry’s
output and the value of the inputs The output method of measuring national income
it buys from other firms. One way of measuring national income is the output method.
Statisticians calculate the output of each industry or sector of the
economy, including services such as retail, hairdressing and insurance.
The total value of output, or national income, is calculated by
summing the value added by each industry to total output.
Value added is the difference between the value of an industry’s
output and the value of the inputs it buys from other firms. Value
added is used to avoid double counting. For example, sugar is used to
make biscuits. If the total value of the output of firms producing sugar
and the total value of the output of firms producing biscuits is added
together, the value of the sugar is counted twice.
Output is measured in monetary terms because money is a common
unit of measurement. It is not possible, for example, to add the
number of laptops to the tonnes of tea produced unless both are
converted into their monetary value.
The income method of measuring national income

Output creates income for the factors of production producing that
output. The income created will include wages for the workers and
rent paid to the owners of the factory, office or shop. It will also
include interest paid to the suppliers of capital. What is left will be
profit, which is income for the entrepreneur. The monetary value of
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The circular flow of income
output must create an equal amount of income. Therefore, national

income can also be calculated by adding up all the income earned by
the factors of production.
The expenditure method of measuring national income

Output also equals expenditure. After output has been produced,
someone will buy that output. Therefore, the value of expenditure
must equal the monetary value of output. If, in a particular year,
some of the output is not sold, firms’ stocks of unsold products
will increase. Inventory is another name for stocks held by firms.
An increase in stocks is treated as firms buying their own output.
Similarly, if expenditure is greater than output, stocks will fall and this
is treated as negative expenditure by firms. This adjustment for the ▲ Figure 7.1.1: Inventory
change in stocks means that the value of expenditure must equal the
value of output. Therefore, national income can also be calculated by
adding up the total value of expenditure on the output produced.
Expenditure is usually divided into different categories: consumer
expenditure, investment expenditure, government expenditure and
exports. However, some of the expenditure in each of these categories
will be on foreign goods. Therefore, the value of imports must be Key terms
subtracted when calculating the total expenditure on domestic Stocks or inventory: products that
output. firms have in store, they could be
Consumer expenditure (C), or consumption, is spending on raw materials, semi-finished or
goods and services by households. Investment expenditure (I) is finished goods.
spending by firms on capital goods but also includes changes in stocks
Domestic output: goods and
of finished and unfinished goods. When calculating national income,
services produced within an
government expenditure (G) includes the spending by governments
economy.
on goods and services but does not includes transfer payments such
as pensions. Exports (X) are goods and services that are sold to people Consumer expenditure: spending
abroad. Imports (M) are goods and services that are purchased from by households on goods and
abroad. services.
When statisticians calculate national income using the expenditure Investment expenditure: spending
method, they add up the value of the different categories of by firms on capital goods.
expenditure: C + I + G + X – M.
Transfer payments: money paid
National income can be calculated in three ways. If calculated to an individual without a service
accurately, they must be equal because output = income = having been provided, for example
expenditure. However, there are always statistical errors. Usually money taken from tax-payers and
the output method is the most accurate, but sometimes an average is
given, by the government, to people
taken.
receiving welfare benefits.
The difference between GDP, GNP and NNP Net income from abroad: the
Gross domestic product (GDP) measures the value of output produced income domestic residents earn
within a country. Gross national product (GNP) is GDP plus net on their assets abroad minus the
income from abroad. Net income from abroad is the difference income earned by foreign residents
between the income domestic residents earn from abroad and the on their assets in the domestic
income earned by foreign residents from in the domestic economy. An economy.
example is interest earned on money deposited in a foreign bank.
GNP = GDP + net income from abroad
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7 How the macroeconomy works
The difference between GNP and NNP is depreciation, or capital

Key terms consumption, which is subtracted from GNP to calculate NNP. Over
Depreciation: the fall in the value of time, a country’s capital stock depreciates. Some of the output
an asset over a period of time. produced is used to replace capital that has worn out or is obsolete.
Obsolete: out of date and not used NNP = GNP – depreciation

any more. National income can also be measured at market prices or factor cost.
Indirect taxes increase the market price of products and subsidies
reduce market prices compared to the factor cost. Therefore, indirect
taxes are subtracted and subsidies are added to national income at
market prices to get to national income at factor cost.
National income at factor cost = national income at market
prices – indirect taxes + subsidies
For example, NNP at factor cost = NNP at market prices – indirect
taxes + subsidies.
NNP at factor cost is also known as net national income (NNI). NNI per
capita is often used as an indicator of living standards.
Case study: Farina’s Footwear

Farina’s Footwear started trading in 1997. In 2019, its sales 2 If the machine that was bought in 2010 was sold for
were $15 million. Inputs bought from other firms included $1,000 on the 1 January 2019, calculate the average
leather, rubber, glue and electricity. In 2019, the total cost of annual depreciation.
these inputs was $4.5 million. 3 Explain two reasons why the machine depreciated.
On 1 January 2010, the firm bought a machine for $46,000.
The machine worked well for many years, but recently it
has often broken down. Also, in the last few years changes
in technology meant that other companies, using newer
machines, were able to make their shoes more cheaply.
In 2019, the old machine was replaced by a more efficient
machine.
1 Calculate the contribution Farina’s Footwear made to
national income in 2019.
▲ Figure 7.1.2: Shoes for sale
The difference between nominal national income

and real national income
Nominal national income is also known as money national income. As
explained in Chapter 6, changes in nominal national income can result
Link from changes in output and/or changes in the price level. If national
income is measured in real terms, the effects of inflation, or deflation,
Adjusting national income for
have been removed. Nominal national income values output at the
changes in the price level was
current year’s prices, whereas real national income values output at
explained in 6.2 “Macroeconomic
the prices in the base year. Changes in real national income show
indicators”.
changes in the total output of the economy.
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Real national income as an indicator of economic Get it right

performance
When measuring economic growth
Economic growth should always be measured by changes in real and or changes in living standards,
not nominal national income. An increase in real national income
use real national income and not
indicates that more goods and services have been produced and
nominal national income.
therefore more needs and wants can be satisfied. This indicates an
improvement in the performance of the economy. However, if the
population has increased, average living standards may not have risen.
When using national income to measure changes in living standards,
real national income per capita is used.
Although real national income is an important indicator of economic
performance, there are many other factors that affect economic Link
development and people’s well-being. For example, an individual’s The use and limitations of national
well-being is affected by the person’s health, education and the income as an indicator of economic
environment in which he or she lives. An increase in real national development are covered in the A2
income does not always mean that there has been an improvement in part of the course.
healthcare or education. Inequality is another objective of economic
performance. An increase in real national income may not mean that
everyone is better off, it might just mean that the already rich are
getting richer.
Progress questions
1 What does national income measure?
2 How is national income calculated when using the expenditure method?
3 What is investment expenditure?
4 Explain what is meant by “depreciation”.
Activity
Choose two countries and for each country find out:
i. real GDP and real GDP per capita five years ago
ii. real GDP and real GDP per capita last year.
The circular flow of income model

Income is a flow, which means it is produced over a period of time.
When firms produce goods and services, this creates the same amount
of income for the factors of production producing the goods and
services. Since economic agents will buy the output produced:
national output ≡ national income ≡ national expenditure
The model of the circular flow of income is a theory of how the
national economy works. In the simplest version of the model, there
are just two sectors, households and firms. In this simple model,
households supply factors of production to firms and the firms use
these factors of production to produce goods and services. In return
for supplying factors of production, households receive income, which
they spend on the goods and services produced by the firms. This is a
continuous process representing how a simple economy works.
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In Figure 7.1.3, the red lines show the “real flows” of factors of
production and good and services. The blue lines show the “money
flows” of income and expenditure.
Households
Income (Y) Factors of Goods and Consumption (C)

production services
Firms
▲ Figure 7.1.3: A simple two-sector model of an economy
Introducing injections and withdrawals

Key terms The previous very simple model assumes that households spend
all their income and firms only produce goods and services for
Withdrawal (or leakage): part of consumers. The model represented in Figure 7.1.4 shows households
household income that is not spent saving part of their income. Saving is a withdrawal (W) from the
on goods and services produced by circular flow of income. A withdrawal is part of income that is not
the economy. spent on goods and services produced by the economy. A withdrawal
Injection: expenditure that is added is also known as a leakage from the circular flow of income. It is
to and increases the circular flow of money taken out of the circular flow of income.
income in an economy. This model also includes two types of expenditure, consumption
and investment. Investment is firms buying capital goods, such as
Closed economy: an economy
machinery. In this model, investment does not depend on the income
that does not trade with other
received by households. It is an injection (J) into the circular flow of
economies, there are no exports or
income. An injection is an expenditure that increases the circular flow
imports.
of income in an economy. It is money that is added to the circular flow
of income. Consumption is not an injection because it comes out of
household income.
Figure 7.1.4 still represents a simple two-sector economy. It shows a
closed economy without a government sector. In a closed economy,
there is no foreign trade, there are no exports or imports.
Withdrawal (W) = Saving (S)
Households

production services
Firms
Injection (J) = Investment (I)
▲ Figure 7.1.4: A simple two-sector model of an economy, with saving and investment
Equilibrium income in a two-sector economy

As explained earlier, income must equal output. If households are
saving some of their income, household consumption expenditure is
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not large enough to buy everything that has been produced. However,
the injection of investment expenditure adds to the demand for the
output of firms. In this two-sector model, aggregate demand, total
demand or spending, is equal to consumption plus investment (C + I).
Key terms
If C + I = Y, everything that has been produced will be sold. Aggregate
demand is sufficient to buy all the goods and services produced. There Equilibrium income: when national
is no reason why firms should change the amount they are producing. income is stable and does not
National income will be in equilibrium. Equilibrium income is when change from one time period to the
national income is stable and does not change from one time period to next time period.
the next time period. If aggregate demand is equal to national output
(or income), withdrawals from the circular flow of income must equal
injections into the circular flow. In a two-sector economy, national
income is in equilibrium when saving = investment.
In a two-sector economy, if aggregate demand (C + I) is less than
current output, firms will have unsold stocks of goods and services.
Therefore, they will reduce output to stop stocks increasing. As
output falls, national income also falls. National income will be in
disequilibrium. If aggregate demand is less than current output, the
withdrawals from the circular flow of income must be greater than the
injections. In a two-sector economy, national income will fall if S > I.
If aggregate demand (C + I) is greater than current output, firms will
not be able satisfy demand unless they have stocks that were produced
in an earlier time period. To make sure they can satisfy demand and to
stop stocks falling, they will increase output. Again, national income
will be in disequilibrium but will be rising rather than falling. National
income will increase if injections are greater than withdrawals. In a
two-sector economy, national income will rise if I > S.
Equilibrium income in an economy with government and

foreign trade sectors
The government affects the circular flow of income by its spending
and by taxing economic agents. Government spending (G) increases
aggregate demand, and since the amount of government spending
does not depend on household income, it is an injection into the
circular flow of income. Taxation reduces household incomes and is
a withdrawal from the circular flow. Taxation will reduce consumer
spending and aggregate demand.
An economy that trades with other economies is known as an open
economy. Exports are an injection into the circular flow because Key term
exports increase spending on the output produced by domestic Open economy: an economy that
firms, exports increase aggregate demand. The value of exports is trades with other economies. There
not affected by domestic national income but will be affected by the are exports and imports.
national income of other economies.
Imports are a withdrawal from the circular flow of income. If
households buy foreign goods, some of the income earned is not Activity
passed on in the circular flow of income. Spending on imports reduces Estimate how much of your
the amount of income that households spend on goods and services
income, or your family’s income,
produced by domestic firms.
was withdrawn from the circular
flow of income last month.
169
Figure 7.1.5 represents an open economy with a government sector.

In this economy, there are three withdrawals: saving, taxation and
imports (S + T + M). There are also three injections: investment,
government spending and exports (I + G + X).
Withdrawal (W) = Saving (S)
+ Taxation (T) + Imports (M)
Households

production services
Firms
Injection (J) = Investment (I)
+ Government spending (G)
+ Exports (X)
▲ Figure 7.1.5: A model of an open economy with a government sector

In this economy, aggregate demand is equal to consumption spending
plus the injections into the circular flow of income (AD = C + I + G + X).
However, the equation for aggregate demand is usually written as:
AD = C + I + G + X – M
If consumption and the injections include spending on imports, this
Key terms has to be subtracted to calculate aggregate demand. Aggregate demand
Home-produced: made by firms in is total planned spending on home-produced goods and services.
the domestic economy.
The aggregate demand equation is sometimes written as AD = C + I
Net exports: the value of exports + G + (X – M). This emphasises the effect changes in net exports
minus the value of imports. (X – M), have on aggregate demand. If exports are greater than
imports, foreign trade increases aggregate demand. If imports are
greater than exports, foreign trade reduces aggregate demand.
In this model of the economy, national income is still in equilibrium
when aggregate demand equals national output or when injections
equal withdrawals. Two conditions for this economy to be in
equilibrium are:
Aggregate Demand (AD) = National Output (Y)
I + G + X = S + T + M [Injections (J) = Withdrawals (W)]
If one of these conditions is true, the other condition must also be
true.
If aggregate demand is greater than national output, firms will increase
production and national income will increase. If aggregate demand is
less than national output, firms will reduce production and national
income will fall.
Key term Full employment income

Full employment: when everyone An economy may be in equilibrium but that does not mean that it is at
who is willing and able to work at full employment. Sometimes an economy can get stuck producing
current market wage rates has a job. a level of output well below that needed for full employment. Full
employment is when the economy creates enough jobs so that
170
everyone who is willing and able to work at current market wage

rates is employed. The output of an economy will affect the level of Key terms
employment. When output rises more jobs are created. When output Full employment income: the level
falls, employment falls and unemployment rises. Full employment of national income/output that
income is the level of national income/output that creates enough creates enough jobs for everyone
jobs for everyone who is willing and able to work at current market who is willing and able to work at
wage rates. current market wage rates.
If the equilibrium level of national income is below the full Involuntary unemployment: when
employment level of national income, there will be some involuntary
people are willing and able to work
unemployment.
at current market wage rates but
are unable to find employment.
Get it right
Make sure you understand why there may still be involuntary unemployment
when an economy’s national income is in equilibrium.
Link
The causes of unemployment are explained in 8.2 “Employment and
unemployment”.
The effects of changes in injections and withdrawals on

national income
An increase in injections into the circular flow of income will cause an
increase in aggregate demand. For example, an increase in investment
will increase the demand for goods produced by firms making
machines and other capital goods. More spending by the government
and/or more exports will also increase the demand for goods and
services.
An increase in withdrawals will reduce aggregate demand. If, for
example, households increase the proportion of their income that
is saved, other things being equal, consumption of home-produced
goods and services will fall. Higher taxes and more spending on
imports will also reduce the consumption of home-produced goods
and services.
If aggregate demand rises, firms will increase their output and
unemployment will fall. The equilibrium level of national income will
increase. If injections fall, or withdrawals increase, aggregate demand
will fall. This will reduce the equilibrium level of national income.
Injections and withdrawals are affected by a variety of factors
including producer and consumer confidence. Fluctuations in
injections and withdrawals will cause fluctuations in equilibrium
income.
Link
Get it right The causes of fluctuations
An increase in injections (I, G or X), or a fall in withdrawals (S, T or M) will national income are explained
lead to a rise in equilibrium income. If injections fall or withdrawals increase in 8.1 “Economic growth and the
equilibrium income will fall. economic cycle”.
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Case study: Indonesia’s economy survives the world financial crisis

The 2007–2008 world financial crisis caused many crisis caused the national income of some economies
countries around the world to go into recession, with the to fall.
effects felt beyond 2008. Some economies were affected 2 Calculate the change in net exports for Indonesia
more than others, suffering large falls in national income. between 2008 and 2009.
The financial crisis led to reductions in consumption and 3 Explain how this change in net exports may have
investment. In some countries, government expenditure affected Indonesia’s national income.
was also cut. Many countries in North America, South
America and Europe were badly affected.
Some countries in Asia were not as badly affected. In 2009,
Indonesia’s national income grew by 4.7%. Total exports
were $139.3 billion in 2008 but had fallen to $115.6 billion
in 2009. Imports fell more than exports. Total imports fell
from $116.0 billion in 2008 to $86.6 billion in 2009.
Source: this summary of Indonesia’s economy is based on
information from https://countryeconomy.com and
www.economywatch.com.
1 Explain why the changes in consumption, investment
and government spending after the world financial ▲ Figure 7.1.6: Indonesia
Quantitative skills Progress questions

Make sure you can interpret and 5 Name the three injections into the circular flow of income.
analyse information presented in a 6 Name the three withdrawals from the circular flow of income.
numerical form. 7 Explain why national income will increase if aggregate demand is greater
than current output.
8 What is meant by “the full employment level of national income”?
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7.2 Aggregate demand and aggregate supply
analysis
➔ why changes in the price level are represented by movements along the aggregate demand
(AD) and aggregate supply (AS) curves
➔ factors that shift the AD curve and the short-run aggregate supply (SRAS) curve
➔ factors that affect long-run aggregate supply
➔ why underlying economic growth is represented by a rightward shift in the long-run aggregate
supply (LRAS) curve
➔ the use of AD/AS diagrams to illustrate macroeconomic equilibrium
➔ the effects of demand-side and supply-side shocks on the macroeconomy.
Changes in the price level are represented by

movements along the AD and AS curves
The aggregate demand and aggregate supply model is used to illustrate
and help explain causes of developments in the macroeconomy. For
example, it can be used to help analyse the causes of unemployment,
inflation, economic growth and fluctuations in economic activity.
Movements along the AD curve

The aggregate demand (AD) curve shows the relationship between
Key term
the price level and total spending in an economy. The AD curve slopes Aggregate demand (AD) curve:
downwards from left to right. This shows that a fall in the price level shows the relationship between
will cause a rise in aggregate demand. It is drawn on the assumption the price level and total spending in
that other things that affect aggregate demand remain unchanged – an economy.
the ceteris paribus assumption.
Price level Get it right

PL1
A movement along the AD curve
PL2 is caused by a change in the price
level.
AD
O Y1 Y2
Real national income Quantitative skills
▲ Figure 7.2.1: The AD curve An inverse relationship is when
two variables move in opposite
In Figure 7.2.1, a fall in the price level from PL1 to PL2 causes
directions, for example, a fall in one
aggregate demand to increase from Y1 to Y2. There is an inverse
variable leads to an increase in the
relationship between the price level and aggregate demand.
other variable.
The following are two reasons why a fall in the price level is likely to
increase aggregate demand.
• If the price level falls, home-produced goods and services will
become relatively cheaper than foreign goods in both the home
and export markets. Imports should fall and exports rise, increasing
aggregate demand.
• A fall in the price level will increase the real value of assets that
have a fixed monetary value, for example money saved in a bank
173
account. This increase in wealth should lead to an increase in

spending.
Key term Movements along the AS curve

The aggregate supply (AS) curve shows the relationship between
Aggregate supply (AS) curve: the price level and the total amount of goods and services that firms
shows the relationship between are willing to produce, as measured by real national income/output.
the price level and the total amount The AS curve slopes upwards from left to right. This shows that a rise
of goods and services that firms in the price level will encourage firms to increase their output. The
are willing to produce. AS curve is drawn on the assumption that other things that affect
aggregate supply remain unchanged – the ceteris paribus assumption.
If other things remain unchanged, a rise in the price level means it is
more profitable to produce. As result, firms will have an incentive to
Get it right increase output.
A movement along the AS curve is
caused by a change in the price Price level AS
level.
PL1
PL2
O Y2 Y1
Real national income
▲ Figure 7.2.2: The AS curve
In Figure 7.2.2, when the price level falls from PL1 to PL2, firms cut
production because it is less profitable. National income/output falls
from Y1 to Y2. There is a direct relationship between the price level
and aggregate supply.
Quantitative skills
A direct relationship is when two variables move in the same direction, for
example, a fall in one variable leads to a fall in the other variable.
At low levels of output the AS curve is horizontal (as shown in Figure

7.2.2). When there is a lot of spare capacity in the economy, firms will
not need the incentive of higher prices to encourage them to increase
output. An increase in aggregate demand will encourage firms to
produce more, even if the price level remains the same.
The AS curve becomes vertical when the economy reaches full
capacity. At full capacity, firms are unable to increase production
in response to an increase in aggregate demand. In the short run,
national income cannot increase beyond this level of output. In the
long run, the productive capacity of the economy may increase.
Link
Causes of long-run changes in productive capacity are explained in 8.1
“Economic growth and the economic cycle”.
Most of the time, economies produce on the upward-sloping section of

the AS curve. Therefore, when using AD/AS diagrams to analyse the
performance of the economy, the following AS curve is often used.
174
The demand
Aggregate demand for goods
and aggregate and services
supply analysis
Price level
AS
Get it right
PL2
If you want to illustrate the effect
PL1
of an event on an economy that
is in recession or working at full
O capacity, use the AS curve drawn
Y1 Y2
in Figure 7.2.2. Otherwise, you can
use the upward sloping AS curve
▲ Figure 7.2.3: Upward-sloping section of the AS curve shown in Figure 7.2.3.
In Figure 7.2.3, an increase in the price level from PL1 to PL2
encourages firms to increase output and real national income rises
from Y1 to Y2. Get it right
When illustrating an individual
Factors that shift the AD curve and the short-run market, you should use a demand
aggregate supply (SRAS) curve and supply diagram. When
illustrating the effect of an event
Shifts in the AD and short-run aggregate supply (SRAS) curves are
that affects the economy as a
caused by factors that affect aggregate demand or aggregate supply,
whole, you should use an AD/AS
other than a change in the price level.
diagram.
Shifts in the AD curve
There are many factors that will affect aggregate demand other
than a change in the price level, for example changes in consumer Quantitative skills
confidence, producer confidence or a change in taxes on income. If The vertical axis on an AD/AS
the change leads to a fall in aggregate demand, the AD curve shifts to diagram is labelled “Price level” and
the left. This shows that less is demanded at any given price level. If the horizontal axis is labelled “Real
the change leads to an increase in aggregate demand, the AD curve national income” or “Real GDP”.
will shift to the right. This shows that more is demanded at any given
price level.
Price level
PLA
PLB
AD2
AD1
O YA1 YA2 YB1 YB2
▲ Figure 7.2.4: A shift in the AD curve
In Figure 7.2.4, the shift to the right from AD1 to AD2 shows an
increase in aggregate demand. This might have been caused by a
variety of factors, for example an increase in government spending or
growth in the world economy, leading to an increase in exports. If the
price level was PLA, aggregate demand would increase from YA1 to YA2.
If the price level was PLB, aggregate demand would increase from YB1
to YB2. Anything that causes an increase in aggregate demand, other
than a fall in the price level, will mean more goods and services are
demanded at any given price level.
A shift of the AD curve to the left, from AD2 to AD1, means less is
demanded at any given price level. If, for example, a fall in confidence
175
about the future caused firms to reduce investment spending, this

would shift the AD curve to the left.
Shifts in the SRAS curve

The main cause of a shift in the SRAS curve is a change in costs of
production. Costs of production are mainly affected by raw material
prices, wages, indirect taxes and productivity. At any given price level,
an increase in costs will reduce firms’ profits. Some firms are likely
to cut production and less will be produced, unless the price level
changes. This increase in costs is represented by a leftward shift in the
SRAS curve, less is produced at any given price level.
If costs fall, profits will increase and firms will be willing to produce
more at any given price level. This is shown by a rightward shift in the
SRAS curve.
Price level SRAS1
PLA SRAS2
O YA1 YA2
Get it right Real national income
It is important to remember that ▲ Figure 7.2.5: A shift in the SRAS curve

what happens to price level and
real national income after an event In Figure 7.2.5, the SRAS curve has shifted from SRAS1 to SRAS2. For
example, the price of oil may have fallen, reducing energy, transport
such as a fall in the price of oil
and other costs. Figure 7.2.5 shows that if the price level is PLA, the
depends on aggregate demand and
output firms want to produce will rise from YA1 to YA2.
aggregate supply.
Progress questions
1 What are the vertical and horizontal axis labels for an AD/AS diagram?
2 What causes a movement along the AD curve?
3 What causes the AD curve to shift to the left?
4 What might cause the SRAS curve to shift to the left?
Key term Factors that affect long-run aggregate supply

The long-run aggregate supply (LRAS) curve shows the amount that
Normal capacity level of output: can be produced at the economy’s normal capacity level of output.
the maximum output that an In the short run, an economy may be able to produce more than its
economy can continue to produce normal capacity level of output but the economy cannot continue
in the long run. to produce this level of output in the long run. If an economy is
producing more than its normal capacity level of output, there will be
shortages of labour and other factors of production. Excess demand for
Link factors of production will cause factor prices to rise. This will lead to
rising inflation.
The causes of inflation are
explained in 8.3 “Inflation and An economy’s normal capacity level of output, its productive capacity,
deflation”. is determined by the supply of factors of production in the economy
and the productivity of these factors. If an economy is producing at its
176
Aggregate demand and aggregate supply analysis
normal capacity level of output, it is also producing on its production

possibility boundary (PPB).
In Figure 7.2.6, YN is the normal capacity level of output. The vertical
LRAS curve means that, other things unchanged, YN is the output the
economy will tend to produce in the long run, but in the short run
it may produce more or less than this output. The normal capacity
output of YN is compatible with any price level.
Price level
LRAS
O YN
▲ Figure 7.2.6: The LRAS curve
Why underlying economic growth is represented

by a rightward shift in the LRAS curve
The underlying rate of economic growth is also known as the
trend rate of economic growth. In the long run, an economy cannot Key term
grow more quickly than the productive capacity of the economy Underlying rate of economic
is increasing. If there is an increase in the normal capacity level of growth: the annual percentage
output of the economy, this is represented by a rightward shift in increase in the productive capacity
the LRAS curve. An economy’s underlying rate of economic growth of an economy.
is estimated by taking an average of the actual rate of growth over a
number of years, perhaps 20 or more. Ideally, in the first and last year,
the amount of spare capacity in the economy should be the same.
Activities
Price level
LRAS1 LRAS2 1 Find out the actual rate of
economic growth for your
country during each of the past
30 years and put the figures in
a two-column table.
O 2 Estimate the underlying rate
YN1 YN2
of economic growth over this
period.
▲ Figure 7.2.7: A rightward shift in the LRAS curve shows underlying economic
3 Do you consider that the
growth
underlying rate of economic
The rightward shift of the LRAS curve in Figure 7.2.7, from LRAS1 to growth has risen, fallen or
LRAS2, shows an increase in the normal capacity level output of the stayed the same in the last
economy from YN1 to YN2. There has been underlying growth in this 15 years compared to the
economy. A rightward shift in the PPB also shows underlying growth. previous 15 years?
An increase in the productive capacity of the economy can be caused
by two factors:
• an increase in the supply of the factors of production
• an increase in the productivity of these factors.
177
If there is an increase in the labour force or more capital, this will

Link increase the amount of goods and services that the economy is capable
The use of a production possibility of producing. The discovery of a new supply of raw materials, such
diagram to illustrate economic as oil or copper, will also increase the productive capacity of the
growth is explained in 8.1 economy.
“Economic growth and the An improvement in productivity will allow more to be produced from
economic cycle”. the same amount of factors of production. Increases in productivity
can, for example, result from improvements in technology or better
organisation of production.
Progress questions
The use of AD/AS diagrams to illustrate
5 What is meant by the normal
capacity level of output of an
macroeconomic equilibrium
economy? The macroeconomy is in equilibrium when the planned level of
aggregate demand equals current output. In an AD/AS diagram it is
6 Why will investment in new
where aggregate demand equals aggregate supply. In Figure 7.2.8, the
machinery shift the LRAS
economy is in equilibrium when real national income is Ye and the
curve to the right?
price level is PLe. Firms are selling what they are producing.
7 What else might shift the LRAS
curve to the right?
Price level
AS
PLe
AD
O Ye
▲ Figure 7.2.8: The equilibrium price level and real national income
In Figure 7.2.8, if the price level was above PLe, aggregate demand
would be less than the amount firms are willing to produce at that
price level. Firms would have unsold stocks. Prices would be reduced
to encourage economic agents to buy the surplus stock. The fall in
the price level would cause an extension in aggregate demand and
a contraction in aggregate supply. The economy would stabilise at a
price level of PLe and where national income is Ye.
If the price level was below PLe, there would be excess aggregate
demand and the price level would rise. This would cause a contraction
in aggregate demand and an extension in aggregate supply, until
equilibrium was restored.
Price level
AS
The effect of a shift in aggregate demand on
PL2 macroeconomic equilibrium
PL1 There are many reasons why aggregate demand might increase or
AD2
decrease. For example, an increase in aggregate demand might be
AD1 caused by a reduction in taxes on income. Figure 7.2.9 illustrates
O Y1 Y2 Y1B the effect of an increase in aggregate demand on macroeconomic
Real national income equilibrium.
▲ Figure 7.2.9: The effect of an increase In Figure 7.2.9, the macroeconomy is originally in equilibrium at
in aggregate demand on macroeconomic PL1 Y1. The increase in aggregate demand from AD1 to AD2 causes
equilibrium excess AD of (Y1B – Y1) at the original price level of PL1. As a result,
178
the price level will rise, causing an extension in aggregate supply and
a contraction in aggregate demand. Macroeconomic equilibrium is
restored at PL2 Y2. Both the price level and real national income have
risen.
The effect of a shift in short-run aggregate supply on

macroeconomic equilibrium
Shifts in aggregate supply result from changes in costs of production.
If production costs rise, SRAS shifts to the left. If production costs
fall, SRAS shifts to the right. Figure 7.2.10 illustrates the effect of a
decrease in aggregate supply on macroeconomic equilibrium.
Price level
SRAS2
SRAS1
PL2
PL1
AD
O Y1B Y2 Y1
Get it right
▲ Figure 7.2.10: The effect of a decrease in aggregate supply on macroeconomic
equilibrium AD/AS diagrams can be used to
illustrate the effect of economic
In Figure 7.2.10, the macroeconomy is originally in equilibrium at events on the price level and real
PL1 Y1. The decrease in AS from AS1 to AS2 causes excess aggregate national income of an economy.
demand of (Y1 – Y1B) at the original price level of PL1. As a result, Where appropriate, use them to
higher prices are offered, causing an extension in aggregate supply
support written explanations – and
and a contraction in aggregate demand. Macroeconomic equilibrium
always refer to them in the text.
is restored at PL2 Y2. The price level has risen and real national income
has fallen.
Drawing an AD/AS diagram to illustrate the effect of an

economic event
These are the stages to go through when drawing an AD/AS diagram
to illustrate the effect of an economic event on the macroeconomy.
1 Draw the diagram to show the initial equilibrium.
2 Check that you have:
a. labelled both axes correctly: “Price level” and “Real national
income”
b. labelled both curves
c. drawn the dotted lines to show the equilibrium price level and
real national income
d. labelled the equilibrium points.
3 Decide whether the event affects aggregate demand or aggregate
supply.
4 Decide whether the new curve should be shifted left (decrease) or
right (increase).
5 Draw the new curve and label it.
6 Draw the new dotted lines to show the new equilibrium price level
and real national income.
7 Label the new equilibrium points.
179
When you have completed the diagram, make sure that you refer to it
Progress questions and use it in your written explanation of the effect of the event on the
8 What is meant by the macroeconomy.
equilibrium level of national
income? The effects of demand-side and supply-side
9 State two conditions for an shocks on the macroeconomy
economy to be producing at
its equilibrium level of national The effects of a demand-side shock
income. A demand-side shock results from an event that leads to a sudden
10 Draw a diagram to illustrate or unexpected change in aggregate demand. If it leads to an increase
the effect of an increase in in aggregate demand it is a positive demand-side shock, the AD curve
government spending on an shifts to the right. If it leads to a decrease in aggregate demand, it is a
economy’s equilibrium level of negative demand-side shock, the AD curve shifts to the left.
national income. Examples of demand-side shocks include:
• a change in consumer confidence or producer confidence
Key term • an unexpected and significant change in interest rates
Demand-side shock: an event that • unexpected changes in taxation or government spending
leads to sudden or unexpected • a change in property prices that affect households’ wealth
change in aggregate demand. • a change in the growth of the world economy that affects exports.
A positive demand-side shock will tend to increase real national
income and the price level. The extent to which it affects real national
income, or the price level, will depend on the current state of the
Price level SRAS economy and the elasticity of aggregate supply. For example, if the
PL4 economy is in recession, with plenty of spare capacity, a positive
PL3 AD4 demand-side shock will usually increase national income and have
AD3 little effect on the price level. However, if the economy is already
AD1 AD2 working at full capacity, a positive demand-side shock will increase the
price level and have little effect on real national income.
O Y1 Y2 Y3 If the economy is producing at Y1 in Figure 7.2.11, there is a lot of
Real national income spare capacity. A positive demand-side shock that increases aggregate
▲ Figure 7.2.11: The effects of a positive demand from AD1 to AD2 is likely to increase real national income and
demand-side shock will have little effect on the price level.
However, if the economy is producing at Y3 in Figure 7.2.11, there
is no spare capacity. A positive demand-side shock that increases
aggregate demand from AD3 to AD4 will increase the price level and
will have little effect on real national income.
A negative demand-side shock will tend to reduce real national
income and the price level. The extent to which real national income
and the price level are affected by the shock will depend on the
current state of the economy.
The effects of a supply-side shock

A supply-side shock results from an event that affects production
Key term costs and shifts the SRAS curve. If production costs fall, it is a positive
Supply-side shock: an event that supply-side shock that leads to an increase in short-run aggregate
leads to a sudden or unexpected supply. The SRAS curve shifts to the right. If production costs rise, it
change in aggregate supply. is a negative supply-side shock that leads to a decrease in SRAS. The
SRAS curve shifts to the left.
180
Price level
SRAS1
SRAS2
PL1
PL2
AD
O Y1 Y2
▲ Figure 7.2.12: The effects of a positive supply-side shock

As can be seen from Figure 7.2.12, a positive supply-side shock will
increase real national income and reduce the price level. If costs of
production fall, firms’ profits will increase. Supply will increase and
there will be pressure for prices to fall. The shift in aggregate supply
to the right from SRAS1 to SRAS2 leads to a fall in the price level from
PL1 to PL2 and an increase in real national income from Y1 to Y2. Progress questions
A negative supply-side shock will increase the price level and reduce
11 What is a negative demand-
real national income. As costs and the price level rise, aggregate side shock?
demand will fall. As demand falls, firms will reduce production. 12 Explain how an increase in
exports would be likely to
Examples of supply-side shocks include: affect real national income and
• a change in the world market price of oil, for countries importing oil inflation in an economy that
• a change in other commodity prices, for countries importing these has a lot of spare capacity.
commodities 13 Draw a diagram to illustrate
• an unexpected change in money wages the effects of a negative
• the introduction of a national minimum wage or a significant supply-side shock on the
change in the existing minimum wage macroeconomy.
• unexpected changes in indirect taxes or subsidies to producers 14 Explain why an improvement
in productivity is a positive
• a change in productivity.
supply-side shock.
Case study: Falling commodity prices will help to keep inflation low
The IMF’s Primary Commodity Price Index fell by 6.9% 2 Explain why falling commodity prices are a negative
between August 2018 and February 2019, mainly due to demand-side shock for countries that produce and
a fall in energy prices, including the price of oil, natural export commodities.
gas and coal. Lower commodity prices should help to keep
inflation low in consuming countries such China, Germany,
India and the United States. If commodity prices continue to
fall, other things being equal, this will also help to increase
the growth of real GDP in these economies. However, falling
commodity prices will lead to a negative demand-side
shock for those countries who are the major producers of
the commodities.
1 Draw an AD/AS diagram to show the effect of falling
world commodity prices on the macroeconomy of
countries that import these products.
▲ Figure 7.2.13: Natural gas pipeline
181
7.3 Determinants of aggregate demand

➔ the meaning of aggregate demand
➔ the components of aggregate demand
➔ the determinants of consumption, investment, government spending, exports and imports
➔ the determinants of savings
➔ the marginal propensities to consume, save, tax and import
➔ the difference between saving and investment
➔ the basic accelerator process.
The meaning and components of aggregate

demand
Aggregate demand is the total planned expenditure on goods and
services in an economy. It is the amount spent on home-produced
goods and services. Therefore, it must be adjusted to remove spending
on imports. For example, some household spending will be on foreign
goods and this must be removed when calculating aggregate demand.
Aggregate demand is split into a number of different components.
They are consumer expenditure, investment expenditure, government
expenditure and exports. If the amount spent on these components
includes imports, aggregate demand is calculated as:
AD = C + I + G + X − M
Each of these components is affected by different factors. For example,
what determines the value of exports sold will be different from what
determines consumer expenditure. Therefore, when attempting to
forecast aggregate demand, economists will usually forecast each
component separately.
Activity Consumer expenditure, or consumption, is spending by households on
Find out the percentage of total goods and services. Investment is spending by firms on capital goods.
spending that was on each of the The government usually provides a variety of goods and services but
components of aggregate demand which goods and services it provides and how much will vary between
in your country’s economy last year. countries. Exports are spending by foreign residents on domestic
output and therefore exports increase aggregate demand.
Determinants of consumption, investment,

government spending, exports and imports
Economists have different theories, or models, to explain what
determines each of these components of aggregate demand. The
importance of each of these components of aggregate demand will
vary between countries. For example, household consumption as a
percentage of GDP is typically around 65% in the UK, 60% in India,
55% in Japan and 43% in Norway. These percentages will vary
over time but in many countries, consumption is the largest single
component of aggregate demand.
182
Determinants of aggregate demand
Determinants of consumption
Household consumption is affected by a number of factors, including:
• income
• wealth
• taxation
• consumer confidence
• interest rates
• the availability of credit.
Income
Other things being equal, as national income increases, it is likely that
household consumption will also increase. The marginal propensity
Key terms
to consume (MPC) measures the proportion of a change in income Marginal propensity to consume
that is spent on consumption, it is measured by the following formula. (MPC): the proportion of a
Marginal propensity to consume (MPC) = change in consumption ÷ change in income that is spent on
change in income consumption.
This is also written as: ΔC where Δ means “change in” Consumer durables: products
ΔY households buy that last for several
For example, if the MPC is 0.6, a $100 million increase in national years.
income would result in a $60 million increase in consumption.
Disposable income: what is left
Wealth of a household’s income after
Household wealth also affects consumption. If households are taxes on income have been paid; it
wealthier, they are likely to increase their spending. Rising house includes any cash welfare benefits
prices or an increase in the price of shares are two examples of received from the government.
reasons why household wealth might increase. An increase in
wealth makes people more confident and may also make it easier for
households to borrow to purchase consumer durables. Consumer
durables are goods that provide a service to people over a period of
time, for example furniture, a washing machine or a car. Consumer
durables can be expensive and many households borrow to help pay
for them.
Taxation
Taxation can affect households’ disposable income and/or the price
of products. Taxation is a withdrawal from the circular flow of income.
An increase in taxation will reduce spending. If the government
reduces income tax or indirect taxes, households are likely to increase
their spending and consumption will rise.
Disposable income = gross income + cash welfare benefits – taxes on
income
Consumer confidence
Confidence in the future is an important determinant of consumption.
If people believe that their job and future income is secure, they are
more likely to spend than if they think they might lose their job.
Confidence, and expectations about the future, can have a significant
effect on household consumption.
183
Interest rates
Key terms The rate of interest is the price of money, it is the cost of borrowing
Rate of interest: the price of money, and the reward for saving. The rate of interest paid to savers is usually
which is the cost of borrowing and lower than the rate charged to borrowers. There are many different
the reward for saving. interest rates in an economy but they often move up and down
together. If interest rates increase, it is more rewarding for people to
Availability of credit: how easy, or save and this will tend to reduce consumption. An increase in interest
difficult, it is to find a bank or other rates also makes it more expensive to borrow because the amount that
organisation that is willing and able has to be repaid to the lender increases. A rise in interest rates will tend
to lend. to reduce household spending on consumer durables. When interest
rates fall, other things being equal, consumption tends to increase.
The availability of credit

It is not only the cost of borrowing that affects consumption but also
the availability of credit. There are times when interest rates are
low but some households may find it difficult to find a bank or other
Link
organisation that is willing and able to provide credit. When credit is
The use of monetary policy to affect widely available, consumption will tend to rise. When credit is not
consumption and other components easily obtained, consumption will tend to fall.
of aggregate demand is explained in
Monetary policy is often used to affect interest rates and the
9.1 “Monetary policy”.
availability of credit, and hence household consumption.
Case study: A slowdown in the growth of household consumption is forecast

Household spending is expected to be supported by the
steady growth of disposable income and lower interest
rates. However, problems in the world economy have led
some people to predict that unemployment will rise. High
levels of household debt mean people are expected to be
cautious and, as a result, they are likely to increase savings
and reduce borrowing. Therefore, next year, consumers’
spending in many countries is expected to grow more
slowly than disposable income.
1 State two reasons why household consumption is
forecast to rise.
2 State two reasons why household consumption may ▲ Figure 7.3.1: Cars for sale
not increase very much.
Determinants of investment
Investment is spending by firms on capital goods such as machinery
and buildings. Governments also invest but, in the aggregate demand
equation, investment by the state is usually included as part of
government expenditure. Firms invest to replace capital that has
depreciated because it has worn out or is obsolete. They also invest
to increase the size of the capital stock and increase productive
capacity. Gross investment is the total value of investment spending.
Net investment is gross investment after subtracting the amount of
investment needed to replace the part of the capital stock that has
depreciated.
Net investment = gross investment – depreciation
184
In the private sector, firms invest if they believe that investment

will be profitable but many of the costs and revenues that result
from investment are uncertain. Estimates will be affected by firms’
expectations of the future state of the economy.
Investment is affected by a number of factors, including:
• interest rates
• the cost of the capital
• expectations and confidence
• the growth of national income
• the amount of spare capacity
• changes in technology
• profits and the availability of finance
• taxes and subsidies.
Interest rates
When considering whether an investment is likely to be profitable,
a firm will need to consider whether the rate of return on the
Key term
investment is sufficient to cover the cost of funds used to finance Rate of return: the profit expressed
the project. The rate of return is the profit expressed as a percentage as a percentage of the cost of the
of the cost of the project (or the cost of capital). For example, if the project.
investment is expected to have an annual rate of return of 15% but
the rate of interest on the money borrowed to finance the project is
18%, the project is not worthwhile. However, if the rate of interest is MEI and rate
of interest
7%, the investment is worthwhile.
R1
A rise in interest rates increases the cost of borrowing to finance
R2
investment. This means that fewer investment projects will be
worthwhile. Also, if interest rates are high, firms may, for example, MEI
prefer to save any surplus funds with a bank rather than use them O I1 I2
to finance capital investment. Even if the firm does not need to Planned investment
borrow to finance investment, the opportunity cost of funds needs
to be considered. The effect of a rise in interest rates is shown in ▲ Figure 7.3.2: The effect of a fall in
Figure 7.3.2. interest rates on planned investment
The marginal efficiency of investment (MEI) is the rate of return

on an additional unit of investment. In Figure 7.3.2, if the rate of Key term
interest is R1 then I1 investment projects are worthwhile. However, Marginal efficiency of investment
if the rate of interest falls to R2 then I2 projects are expected to (MEI): the rate of return on an
be profitable. A project will be profitable if the expected rate of additional unit of investment.
return, the MEI, is higher than the cost of funds. In summary, other
things being equal, a fall in interest rates will lead to an increase in
investment because more projects will be profitable.
Get it right
The cost of capital Other things being equal, an
If the cost of capital rises, the rate of return on the project will fall. increase in interest rates will
The cost of capital might include how much it costs to build a new reduce investment, and a reduction
factory or buy a piece of machinery. An increase in the cost of capital in interest rates will encourage
will mean that fewer investment projects are worthwhile. An increase firms to increase investment.
in the cost of capital is illustrated by a leftward shift in the MEI curve.
185
MEI and rate In Figure 7.3.3, an increase in the cost of capital shifts the MEI curve to
of interest the left. At a rate of interest R, planned investment falls from I1 to I2.
R Expectations and confidence

MEI1
Expectations and confidence about the future will affect the expected
MEI2 rate of return on an investment project. If firms are optimistic about
O I2 I1 the future, they will expect a higher rate of return than if they believe
Planned investment that the economy is likely to go into a recession. Confidence about
▲ Figure 7.3.3: The effect of a fall in the the future can change very quickly and is often irrational. The English
marginal efficiency of investment on economist, John Maynard Keynes, believed that entrepreneurs’
planned investment changing “animal spirits” meant that investment is a more unstable
component of aggregate demand than consumption. When firms are
confident about the future, the MEI curve shifts to the right, causing
Key term an increase in investment. When firms are pessimistic about future
Animal spirits: human emotions economic prospects, the MEI curve shifts to the left and investment
and instincts that affect decision- falls.
making.
The growth of national income
When national income is growing, aggregate demand will increase.
As spending rises, firms will want to increase production to meet the
increase in demand. In these circumstances, firms are more likely
to invest in new capital to increase their productive capacity. When
national income and aggregate demand are falling, very few firms will
need to invest to increase their capacity.
Link
See also the basic accelerator process, a theory of investment explained later
in this section.
The amount of spare capacity

If firms have plenty of spare capacity, investment spending is likely to
be low. Investment may be needed to replace worn-out capital and to
increase efficiency but it is not needed to allow firms to meet demand.
When the economy is operating close to full capacity, firms will need
▲ Figure 7.3.4: John Maynard Keynes to invest to meet any increase in demand for their goods or services.
When an economy is recovering from a recession, investment is likely
to be low but as the economy approaches full capacity, investment is
likely to increase.
Changes in technology
Changes in technology can also lead to an increase in investment
spending. Improvements in technology mean that firms may need
to invest to improve their efficiency. For example, investment in
robotic manufacturing systems may be essential if a firm is to remain
competitive. When new products are developed, this also requires
investment.
Profits and the availability of finance

Investment can be very expensive and firms must be able to raise the
money to finance it. Investment is often financed by using profits that
have been retained in the business. It can also be financed by issuing
186
new shares or by borrowing. When profits are low or when banks and
other financial institutions are reluctant to lend, even projects that Progress questions
seem very profitable may not take place. 1 What are the main components
of aggregate demand?
Taxes and subsidies 2 If the national income of a
Governments can also affect aggregate investment. Reducing taxes euro area country falls by
on company profits will help firms finance investment and provide a
€300 million and its marginal
greater incentive to invest. Many governments subsidise some types
propensity to consume is
of investment. Changes in taxes and subsidies can affect the amount
0.75, what will be the effect on
of investment that takes place. However, cutting taxes on profits and
consumer spending?
subsidising investment may reduce government spending on other
projects and/or lead to an increase in other taxes. 3 Why does the amount of spare
capacity in an economy affect
Determinants of government spending investment?
The amount a government spends is determined largely by social
and political factors. The government might increase its spending to
improve public services such as education and healthcare, or to help
people on low incomes. The government’s spending is also affected by
the amount it can or is willing to raise in taxes, and by its ability and
willingness to borrow.
There are times when a government changes how much it spends
because it wants to influence aggregate demand. For example, in a
recession, when aggregate demand is falling, the government might
increase its spending to offset a fall in household consumption and
investment by firms.
Link
The use of government spending to affect aggregate demand is explained in Key terms
9.2 “Fiscal policy”.
Volume of exports: the quantity of
exports.
Determinants of exports
Exports are an injection of demand into the circular flow of income. Value of exports: the amount spent
Goods and services sold abroad add to domestic demand and create on exports, determined by the price
income for factors of production in the domestic economy. The factors and quantity.
that determine the volume and value of exports will be affected
by the types of products that are exported. For example, the value of
exports for a country exporting primary products will depend on the Link
world market price of these commodities. Commodity prices often The causes of fluctuations in
fluctuate significantly over time. The prices of manufactured goods commodity prices is explained in
and services tend to be more stable.
2.5 “The determination of market
Factors influencing the value of exports include: prices”.
• relative prices
• the exchange rate Key terms
• quality and other non-price aspects of competitiveness
Relative prices: the price of one
• national income and rate of growth in the major export markets good compared to another.
• restrictions on international trade.
Exchange rate: the price at which
one currency can be converted into
another currency.
187
Relative prices
Get it right A country’s exports usually have to compete with goods and services
A fall in a country’s exchange rate produced by other countries. Relative prices will affect the demand
means that each unit of domestic for a country’s exports. Other things being equal, if inflation has
currency can buy less foreign been higher than in other countries, exports are likely to fall as they
currency. become less competitive. People abroad will start to buy products
from countries whose prices are lower or from domestic firms. It is the
relative rate of inflation that matters.
Key term
The exchange rate
Relative rate of inflation: the rate of A change in the exchange rate will usually lead to a change in the
inflation in one country compared foreign currency price of a country’s exports. If the exchange rate
to the rate of inflation in other falls, the foreign currency price of exports will fall. Other things
countries. being equal, this should lead to an increase in the quantity of exports
sold. However, if a country has had a period of high inflation, the
fall in the exchange rate might just compensate for the decline in
competitiveness caused by the high rate of inflation.
Get it right
Link
A fall in a country’s exchange rate
will reduce the foreign currency The effects of a fall in the exchange rate are explained in 8.4 “The balance of
price of its exports. payments on current account” and in the A2 part of the course.
Quality and other non-price aspects of competitiveness

However, competitiveness is not only affected by relative prices. The
design and quality of products will also affect exports. Reputation
and the standard of the service provided are other factors to consider.
Brand loyalty, successful advertising and product differentiation may
mean that some countries’ products continue to sell well, even when
prices have increased.
National income and rate of growth in the major export

markets
The value of exports will also be affected by the rate of growth in
the country’s main export markets. If countries are growing rapidly
and incomes are increasing, the demand for foreign goods is likely to
increase. If national income is falling, both firms and consumers will
reduce their spending, including spending on foreign goods. When the
world economy is growing rapidly, most countries will benefit from an
increase in demand for their exports.
Restrictions on international trade

Key term Since the end of the Second World War in 1945, many restrictions on
Tariff: a tax on imports. international trade, such as tariffs, have been reduced or removed.
As a result, the growth in world trade has been faster than the growth
in world GDP. However, if such restrictions increase, this will tend to
reduce the growth in exports.
Link
Restrictions on international trade
Determinants of imports
The factors that affect the amount of imports a country can buy are
are explained in the A2 part of the
similar to those that affect its exports. For example, if a country has
course.
had a higher rate of inflation than in other countries, home-produced
188
goods will become relatively more expensive and domestic residents

will start buying more imports and fewer home-produced goods. Get it right
A fall in the exchange rate will increase the price of imports in terms A fall in a country’s exchange rate
of domestic currency. This will tend to reduce the demand for imports. will increase the domestic currency
If the exchange rate rises, the price of imports in terms of domestic price of its imports.
currency will fall, increasing the demand for foreign goods. However,
the demand for imports also depends on non-price factors, such as
quality and design.
The demand for imports is also affected by the rate of growth of the
domestic economy. If the economy is growing rapidly, consumers will
spend more and some of the extra spending will be on foreign goods
and services. Domestic firms will be producing more. As their output Key term
increases, they will import more raw materials and components.
Quota: a limit on the number or
If the economy becomes more open and restrictions on trade are
value of a product that can be
reduced, imports are likely to increase. If the government imposes
imported.
tariffs and quotas on foreign goods, imports will fall.
Determinants of savings Progress questions

Savings are a withdrawal from the circular flow of income. Other 4 A country’s exchange rate has
things being equal, if households increase the proportion of income increased. Why will this affect
that they save, aggregate demand will fall. However, savings also help the volume of exports?
finance investment spending and contribute to economic growth. 5 If the world economy is
When households save, they forgo current consumption so that
growing much faster than the
they can consume more in the future. Some saving is short term, for
domestic economy, how is this
example to pay for a holiday. Households might save long term to
likely to affect a country’s net
provide money to spend in old age. Many of the factors that affect
exports?
household consumption will also affect savings. Factors that affect
total savings include:
• income
• interest rates
• expectations and confidence
• age
• taxation
• government provision of welfare
• the financial structure of the economy
• social attitudes.
Income ▲ Figure 7.3.5: Saving

People vary in their attitudes to saving but, in general, household
savings increases as income increases. However, rising income does
not necessarily mean that the proportion of income saved increases.
The proportion of disposable income that is saved is known as the Key term
savings ratio. The savings ratio varies significantly between countries
and over time. Savings ratio: household savings
as a percentage of household
Activity disposable income.
Find out the savings ratio in your country in each of the past 10 years. Is there
a clear trend? Can you explain the variations from one year to another?
189
Interest rates
Key term Interest rates are the reward for saving and forgoing current
Real rate of interest: the rate of consumption. A rise in the rate of interest makes saving more
interest after the effects of inflation rewarding and should increase household saving. However, it is
have been removed. important to distinguish between the nominal and real rate of interest.
The real rate of interest removes the effect of inflation. If the
nominal rate of interest is 5% and inflation is 3%, the real rate of
interest is 2%. In money terms, the amount in the savings account
will be 5% higher at the end of the year than at the start of the year.
However, what can be bought with the money will only be 2% higher.
Rational households will consider the real rate of interest rather than
the nominal rate, but people do not always act rationally.
Real rate of interest = nominal rate of interest – rate of
inflation
Expectations and confidence

One reason why people save is to protect themselves against a fall in
their income. When people are confident about the future and believe
that their job and income are secure, the savings ratio tends to fall. In
a recession, when unemployment is rising, many households are more
cautious and the savings ratio tends to increase. Expectations about
the future can have a significant effect on the savings ratio.
Age
People save to provide themselves with an income in old age. When
working, many people will put money into a pension fund that will
give them an income when they stop working. Older people often use
their savings to support their consumption after they have stopped
working. In many countries, the proportion of the population that is
over 65 is increasing and this is expected to reduce the savings ratio.
Taxation and government provision of welfare

Taxation affects households’ disposable income and hence their
ability to save. Government provision of welfare and other services
can also affect savings. If the state provides unemployment benefits
when people lose their job and pays generous pensions for those in
retirement, people have less need to save. The provision of services
such as healthcare and education can also affect the need for people to
save to provide for future needs.
The financial structure of the economy

A developed financial system can make it easier for people to save.
If people have trust in banks and other financial institutions, and it
is easy to deposit and withdraw money, it will encourage people to
Progress questions save. However, it may also allow people to borrow more. Borrowing is
6 Define the savings ratio. negative savings and reduces the saving ratio.
7 Nominal interest rates rise
from 4% to 7% and inflation Social attitudes
Attitudes towards saving and borrowing can also affect the savings
rises from 1% to 6% in a
ratio. In some societies saving is seen as being good and borrowing
country. Why might this reduce
foolish. In these societies, saving is likely to be higher than in societies
the amount households save?
with a different attitude to saving and borrowing.
190
The marginal propensities to consume, save, tax

and import
As explained earlier, the marginal propensity to consume (MPC)
measures how a change in income affects consumption. Key terms
Marginal propensity to save (MPS):
The marginal propensity to save (MPS) the proportion of a change in
The marginal propensity to save (MPS) measures how a change in
income that is saved.
income affects savings.
Marginal propensity to tax (MPT):
MPS = ΔS
ΔY the proportion of a change in
For example, if the MPS is 0.15 and national income rises by $200 income that is taxed.
million, then savings would increase by $30 million. The equation to
calculate the change in savings is: Marginal propensity to import
(MPM): the proportion of a change
Change in savings = change in income × MPS or ΔS = ΔY × MPS in income that is spent on imports.
The MPS is not the same as the savings ratio. The MPS measures the
effect of a change in income whereas the savings ratio measures the
proportion of total disposable income that is saved.
In a closed economy without a government sector, the MPC + MPS
must equal 1. The proportion of any increase in income that is not
consumed must be saved. For example, if people consume 0.9 of any
change in income, they must save 0.1 of the change in income.
The marginal propensity to tax

The marginal propensity to tax (MPT) is also known as the
marginal rate of taxation. It measures the effect of a change in income
on the amount of revenue the government raises in taxes.
MPT = ΔT
ΔY
For example, if national income falls by $500 million and the MPT is
0.3, tax revenue will fall by $150 million. The equation to calculate
the change in taxation is:
Change in taxation = change in income × MPT or
ΔT = ΔY × MPT
The marginal propensity to import

The marginal propensity to import (MPM) measures the effect of
a change in income on the amount that is spent on imports.
MPM = ΔM
ΔY
For example, if national income increases by $400 million and the
MPM is 0.25, spending on imports will increase by $100 million. The
equation to calculate the change in imports is:
Change in imports = change in income × MPM or Get it right
ΔM = ΔY × MPM The marginal propensities to
In an open economy with a government sector, the MPC + MPS + consume, save, tax and import
MPT + MPM must equal 1. Any change in income must be spent on measure how a change in income
home-produced goods, saved, taxed or spent on imports. affects each of these variables.
191
Case study: How will a growing economy affect the budget balance and net exports?
In 2019, national income for an economy was $800 billion. 1 Calculate the expected budget balance (government
In 2020, national income was expected to grow by 5%. spending – tax revenue) in 2020.
The government wants to know how this is likely to affect 2 Calculate the expected value of net exports in 2020.
the budget balance and net exports. Table 7.3.1 provides
selected data for the economy in 2019.
▼ Table 7.3.1: Government spending, tax revenue, exports and
imports in 2019
$ billion
Government spending 400
Tax revenue 360
Exports 130
Imports 150
The government has decided to keep its spending at $400

billion in 2020 but expects exports to increase to $135
billion. It is estimated that the marginal propensity to tax is
0.3 and the marginal propensity to import is 0.25.
▲ Figure 7.3.6: How will the budget balance change?
Link The difference between saving and investment

Saving is a withdrawal from the circular flow of income. It is that part
The budget balance was explained of households’ disposable income that is not spent. People save in
in 6.1 “The objectives of government different ways. For example, they might put money in a bank account
macroeconomic policy”. to earn interest, they might buy shares or they might put money into
a pension fund to provide them with income when they retire.
The financial institutions who receive people’s savings often use the
Get it right money saved to lend to firms who wish to invest in new capital, for
example to build a new office or buy computers. Investment is an
In Economics, when people buy injection into the circular flow of income and increases aggregate
shares, they are saving. However, demand.
when a company issues new
shares, it will provide the firm
with money that it might decide to
The basic accelerator process
invest in capital equipment. The accelerator process is a theory of investment. It is not a complete
explanation of what determines investment in an economy but
explains one important influence on investment.
The theory explains why changes in the level of national income affect
Key term investment. If national income increases, aggregate demand will also
Marginal capital–output ratio increase. If firms are working close to full capacity, they will not be
(MCOR): the amount that has to be able to meet the increase in demand unless they invest to increase
spent on capital to produce a given their productive capacity. How much they need to invest depends
increase in annual output. on the marginal capital–output ratio (MCOR). The MCOR is the
amount that has to be spent on capital to produce a given increase
in annual output. For example, if investing an extra $30,000 on new
machinery results in annual output increasing by $10,000, the MCOR
is 3:1. The investment is likely to continue producing output for many
years. For many countries the MCOR is approximately 3:1.
192
The MCOR determines the accelerator coefficient. If the MCOR is 4:1, the
accelerator coefficient is 4. Quantitative skills
Since the marginal capital-output ratio is greater than 1, it means Make sure that you understand
that when national income increases it will require a larger amount ratios and can calculate and use
of investment to allow firms to meet the increase aggregate demand. them.
The following formula shows how an increase in national income will
affect the amount firms will need to invest to enable them to produce
the extra output.
Investment = α × change in national income I = α × ΔY
α is the accelerator coefficient.
For example, if the MCOR in an economy is 2.5:1, the accelerator
coefficient is 2.5. If national income and aggregate demand increase
by $500 million, the theory predicts that $1,250 million of extra
investment will be required.
Limitations of the accelerator theory

The accelerator theory is most likely to provide an explanation of
investment when the economy is approaching full capacity. If the
economy is recovering from recession and firms have spare capacity,
they will be able to meet the extra demand without investing in new
capital.
Firms will only invest in new capacity if they expect the higher level of
demand to continue. If the increase in national income is not expected
to continue, firms will not spend large sums of money on new capital.
Key term
Expectations and confidence are also important.
Replacement investment:
Some investment is needed to replace existing capital as it wears
investment to replace capital that is
out or becomes obsolete. The accelerator theory does not consider
worn out or obsolete.
replacement investment.
Progress questions Get it right

8 What is the difference between savings and investment? The accelerator theory explains
9 Why is the accelerator coefficient likely to be greater than 1? only one factor that affects
10 In an economy, national income increased by $300 million and the investment, there are many others.
marginal capital–output ratio is 2.5. What is the amount of investment
that would be predicted by the accelerator theory?
11 Why is the accelerator theory unlikely to provide a satisfactory explanation
of investment when the economy has plenty of spare capacity?
193
7.4 Aggregate demand and the level of
economic activity
➔ the role of aggregate demand in influencing the level of economic activity
➔ the multiplier process.
The role of aggregate demand in influencing the

level of economic activity
Economic activity involves the production, consumption, exchange
and distribution of goods and services. Real GDP is the main indicator
of economic activity. If real GDP is rising, more goods and services are
being produced, consumed and exchanged. The levels of employment
and unemployment in an economy are also indicators of economic
activity. If employment is increasing, output is also likely to be rising.
A fall in employment and rising unemployment usually mean that
output, and hence economic activity, is falling.
In the short run, the main determinant of economic activity is
Quantitative skills aggregate demand. An increase in aggregate demand will encourage
firms to increase output to meet the increase in demand. Employment
If two variables have a direct
is also likely to increase as firms will need more workers. There is
relationship with each other, an
a direct relationship between output and employment. If output is
increase in one of the variables rising, firms will employ more people to enable them to increase
is associated with an increase in production. If output is falling, firms will start to reduce employment
the other variable. If two variables as fewer workers are needed.
have an inverse relationship with
each other, an increase in one of Provided there is spare capacity in the economy, an increase in
the variables is associated with a aggregate demand is likely to lead to an increase in output and
decrease in the other variable. employment. However, as the economy approaches full capacity, firms
will find it difficult to increase production and the price level is likely
to increase instead. Too much aggregate demand will cause inflation.
Link
Price level SRAS
The causes of inflation are PL4
explained in 8.3 “Inflation and
AD4
deflation”.
PL3
AD1 AD2 AD3
O Y1 Y2 Y3 Y4
▲ Figure 7.4.1: The effect of an increase in aggregate demand on the level of
economic activity
In Figure 7.4.1, real national income, shown on the horizontal axis,
indicates the level of economic activity. At Y1 the economy has a lot
of spare capacity. If aggregate demand increases from AD1 to AD2,
real national income will rise from Y1 to Y2. The increase in aggregate
demand only affects economic activity. However, if the economy is at
Y3, there is very little spare capacity. The increase in aggregate demand
from AD3 to AD4 has little effect on economic activity. Real national
194
Aggregate demand and the level of economic activity
income increases from Y3 to Y4 but the main effect is on inflation. The

price level rises from PL3 to PL4. Key term
In the long run, production can only continue to increase if productive Supply-side improvements:
capacity is increasing. Increases in productive capacity result from increases in productivity and
supply-side improvements in the economy. For example, reductions in costs that improve
investment in new capital and improvements in labour productivity efficiency, productive capacity and
will increase the productive capacity of an economy. competitiveness.
However, aggregate demand can affect economic activity in the long

run. If aggregate demand is high enough to allow firms to produce Get it right
close to capacity, investment is likely to be high, leading to a long-run
Aggregate demand mainly affects
increase in productive capacity and economic activity. However, if
aggregate demand is too high, inflation will rise. High inflation is likely economic activity in the short run.
to lead to instability and firms will be reluctant to invest. However, it may have some effect
on the rate at which productive
If aggregate demand is low and the economy is producing below capacity and economic activity
capacity, firms are less likely to invest in new capital, or spend increase in the long run.
money on training workers or on research and development. Most
governments attempt to manage aggregate demand to try to keep the
economy producing close to its full capacity level of output.
The multiplier process

In macroeconomics, the multiplier is the extent to which a change
in injections affects national income. For example, if government Key term
spending increases by $100 million and this results in national income Multiplier: the extent to which a
increasing by $300 million, the multiplier is 3. change in injections affects national
Initially, an injection into the circular flow of income will increase income.
national income by the amount of the injection. If the demand for
exports increases by $200 million, firms will increase output to meet
the increase in aggregate demand. This will create $200 million of
income for the factors of production producing the exports. The
increase in expenditure = the increase in national output = the
increase in national income. The increase in income will then lead to a
further increase in aggregate demand.
The size of this increase in demand will depend on the marginal
propensity to consume (MPC). For example, if the MPC is 0.6 the
$200 million rise in income will lead to a $120 million increase in
consumption (0.6 × $200 million). The increase in consumer spending
leads to an increase of $120 million in output of consumer goods and
a $120 million rise in national income. This increase in income results
in another increase in aggregate demand, national output and national
income. The increase is (0.6 × $120 = $72 million). Since the MPC is
less than 1, the increase in aggregate demand and national income
gets smaller each time and eventually becomes insignificant.
The larger the MPC, the larger the size of the multiplier. If the MPC
were 0.8, an increase in exports of $200 million would increase
consumption by $160 million and then by $160 × 0.8 = $128 million,
and so on.
The size of the multiplier can be calculated by the following formula.
Multiplier = 1
(1 – MPC)
195
If the MPC is 0.6, the multiplier = 1 ÷ (1 – 0.6) = 1 ÷ 0.4 = 2.5

If the MPC is 0.8, the multiplier = 1 ÷ (1 – 0.8) = 1 ÷ 0.2 = 5
The following formula can be used to calculate the change in income
(Y) that results from an injection (J) into the circular flow of income.
ΔY = ΔJ × multiplier
For example, if government spending increased by $5 billion and the
MPC was 0.75 the effect on national income would be:
ΔY = $5 billion × [1 ÷ (1 – 0.75)]
= $5 billion × (1 ÷ 0.25)
= $5 billion × 4
= $20 billion
In the example, the multiplier is 4. The $5 billion injection of
government spending has increased national income by $20 billion,
that is $15 billion more than the original injection. If the MPC had
been smaller, the multiplier effect would have been smaller.
In a closed economy without a government, the MPC + the MPS equals 1.
For example, if people consume 80% of an increase in their income,
they must save 20%. Therefore (1 – MPC) = MPS and the formula for
the multiplier is also
Multiplier = 1
MPS
In an open economy with a government sector, the (MPC + MPS + MPT
+ MPM) = 1. Therefore (1 - MPC) = (MPS + MPT + MPM) and the
formula for the multiplier is:
1
Multiplier =
(MPS + MPT + MPM)
For example, if investment in an economy increases by $900 million
and the MPS = 0.1, the MPT = 0.3 and the MPM = 0.2, the effect on
national income would be:
ΔY = $900 million × [1 ÷ (0.1 + 0.3 + 0.2)]
= $900 million × (1 ÷ 0.6)
= $900 million × 1.67
= $1,500 million
Get it right When people’s incomes increase, some of the money is taxed, some
is spent on imports and some is saved. These withdrawals reduce the
The multiplier effect means that an size of the multiplier because they reduce the amount spent on home-
increase in injections will lead to a produced goods and services.
larger rise in national income and a
decrease in injections will lead to a It is also important to remember that a fall in injections will also have
larger fall in national income. a multiplier effect. If, for example, exports fall by $150 million and the
multiplier is 2, national income will fall by $300 million.
While the multiplier effect is normally associated with changes in
injections into the circular flow of income, it can start with any change
196
Aggregate demand and the level of economic activity
in aggregate demand. For example, a rise in consumption can lead to Price level SRAS
a larger increase in national income, due to the multiplier effect. An
increase in withdrawals, for example more spending on imports, can
lead to a larger fall in national income. AD1 AD2 AD3
In Figure 7.4.2, an injection of government spending initially increases
aggregate demand from AD1 to AD2 and real national income from Y1
O Y1 Y2 Y3
to Y2. The multiplier effect of the injection of government spending
leads to a further increase in aggregate demand, to AD3. The higher Real national income
level of government spending and its multiplier effect eventually ▲ Figure 7.4.2: The multiplier effect
increase real national income to Y3.
However, if the economy is close to full capacity, an increase in
injections and the associated multiplier effect will not have much
effect on real national income. The increase in aggregate demand is
likely to increase the price level rather than national output.
Get it right
Do not confuse the multiplier and accelerator processes. The multiplier
process explains the effect of a change in injections, including investment,
upon national income. The accelerator process explains the effect of a rise in
national income upon investment.
Progress questions
1 What is the main indicator of economic activity?
2 Why will a fall in aggregate demand reduce economic activity in the short
run?
3 If the government reduces its spending by $12 billion and the MPC is 0.5,
calculate the effect on national income.
Case study: What will happen to the economy?

Last year, national income for an economy was $1,200
billion. Firms are confident and optimistic about the future
of the economy. Economists have forecast that investment
will increase by $40 billion and that exports will rise by $25
billion. However, the government has decided to reduce its
spending by $5 billion. The marginal propensity to save
is 0.1, the marginal propensity to tax is 0.4 and the
marginal propensity to import is 0.3.
1 Calculate the effect of these changes on the country’s
national income.
2 What is the expected increase in consumption?
▲ Figure 7.4.3: Investment in new machinery
197
7.5 Determinants of short-run aggregate
supply
➔ why the price level and production costs are the main determinants of short-run aggregate
supply
➔ why changes in costs, including money wage rates, raw material prices, indirect taxes and
productivity will shift the SRAS curve.
The price level and production costs are the main

determinants of short-run aggregate supply
In the short run, the productive capacity of the economy does not
change. The amount that firms are willing to supply will depend on
whether or not it is profitable for them to sell the goods and services
they produce. Other things being equal, a rise in the general price
Link level will lead to higher profits and therefore output is likely to
increase. When firms are producing close to full capacity, the extra
Figures 7.2.2 and 7.2.3 illustrate cost of increasing output rises. Therefore an increase in the price level
the effects of changes in the price may be needed to make it profitable for firms to increase production.
level on aggregate supply. This is represented by a movement along the SRAS curve.
Price level
Why changes in costs will shift the SRAS curve
SRAS2 SRAS
1 If firms’ costs increase, at any given price level, producing and selling
goods and services is less profitable. The SRAS curve will shift to the
PL2
left. If firms’ costs decrease, at any given price level, producing and
PL1
selling goods and services is more profitable and the SRAS curve will
shift to the right.
O Y In Figure 7.5.1, before the increase in costs, firms were willing to
Real national income supply an output of Y when the price level was PL1. However, after
costs increase, firms will only supply an output of Y if the price level
▲ Figure 7.5.1: An increase in costs rises to PL2. After an increase in the costs of production, the price level
shifts the SRAS curve to the left will have to increase to persuade firms to produce any given level of
output.
An increase in money wages or a rise in raw material prices will
increase firms’ costs and shift the SRAS curve to the left. If indirect
taxes increase, firms will have to pay more to the government.
Therefore, to persuade firms to produce the same output, the price
Progress questions level will have to rise. An indirect tax is a cost of production for firms.
1 How is the effect of a fall in the If firms’ costs of production fall, they will be willing to produce any
price level shown on the SRAS given level of output at a lower price level. Reductions in money
curve? wages, raw material prices and indirect taxes will shift the SRAS curve
to the right.
2 How would an increase in
indirect taxes affect the SRAS An increase in productivity will also reduce firms’ costs of production.
curve? If each worker is paid $9 per hour and each worker produces two
3 Why would an increase in items per hour, the unit labour cost is $4.50. If labour productivity
labour productivity shift the increases and each worker produces three items per hour, unit labour
SRAS curve to the right? costs fall to $3.00 per item. An increase in productivity will also shift
the SRAS curve to the right.
198
7.6 Determinants of long-run aggregate
supply
➔ the fundamental determinants of long-run aggregate supply
➔ why the position of the vertical LRAS curve represents the normal capacity level of output of
the economy.
The fundamental determinants of long-run

aggregate supply
In the long run, the amount an economy is able to produce is
determined by the supply of the factors of production and their
productivity. The supply of land, the capital stock, the size of the
labour force and entrepreneurial skills of the population will help to
determine what the economy is capable of producing. Productivity, the
amount that can be produced by each unit of a factor of production,
is also important. An increase in the supply of factors of production
and/or improvements in productivity will increase an economy’s
productive capacity. Key terms
Since the Second World War, some countries have benefited from Female participation rate: the
an increase in the number of women in the labour force and percentage of women of working
from improvements in technology. An increase in the female age who are working or actively
participation rate increases the supply of labour and improvements seeking work.
in technology lead to an increase in productivity. Investment
Capital stock: the value of
increases in the size of the capital stock and increases productivity.
machinery, buildings and other
Some investment is needed to replace capital that has depreciated
human-made factors of production
but investment has also increased the capital stock, increasing the
that exist at a point in time.
productive capacity of economies around the world.
Attitudes to work and adaptability to change can affect the supply
of labour and the productivity of the labour force. Economies are
constantly changing and how well people adapt to change will affect Activity
the number of people employed and their productivity. The types of Find out what has happened to the
goods and services people buy changes frequently. Developments in female participation rate in your
technology affect methods of production as well as what we buy. Over economy over the past 25 years.
time, some industries will grow while others decline. The mobility What are the reasons for the trend
of labour will affect the number of people who are unemployed as a you have found?
result of such changes. If people are occupationally immobile, when
jobs are lost in declining industries they will take a long time to
find work in another industry. If they are geographically immobile,
unemployment may remain high in places where jobs have been lost.
Economic incentives also affect the supply of labour, for example. The
replacement ratio affects the incentive to work. The replacement
ratio is the income received by a person when unemployed compared
Key term
to the income that person receives when in work. If the replacement Replacement ratio: the income
ratio is high, the economic incentive to find work is low. If taxes on received when unemployed as a
the income people earn when working are high and the government ratio of the income received when
provides generous unemployment benefits, the incentive to find work in work.
may be weak.
199
Some economists believe that high taxes and high levels of welfare
benefits, not only unemployment benefit, reduce the supply of labour
and reduce the productive capacity of the economy.
Get it right In summary, the productive capacity of the economy is affected by

supply-side factors such as:
An increase in productivity shifts
the SRAS curve to the right because • the capital stock
it reduces production costs. An • technology
increase in productivity also shifts • the size of the working population
the LRAS curve to the right because • mobility of labour
it increases the normal capacity • attitudes to work and enterprise
level of output of the economy.
• economic incentives
• productivity.
The vertical LRAS curve represents the normal

capacity level of output of the economy
The normal capacity level of output is the maximum output that
an economy can continue to produce in the long run without
experiencing inflationary pressures. An economy can produce more
than this output for a short period of time but there will be excess
demand for factors of production. Labour shortages are likely to result
in wages increasing. The price of other factors of production will also
Price level rise. For example, there may be shortages of factories and offices,
LRAS SRAS
leading to rising property prices and rents. This increase in costs of
production will cause firms to raise the prices of goods and services.
Firms may also find it difficult to meet the demand for their products
AD and this excess demand will allow them to increase prices and profits.
In Figure 7.6.1, the economy is in short-run equilibrium at Ye but the
O YN Ye economy will not be able to continue to produce this level of output
Real national income in the long run. There will be inflationary pressures and real national
output/income will fall.
▲ Figure 7.6.1: An economy producing
more than its normal capacity level of However, if the economy benefits from long-run economic growth,
output in the short run the normal capacity level of output will increase. The LRAS curve will
shift to the right as shown in Figure 7.2.7. The increase in the supply
of factors of production, and/or productivity, will allow the economy
to produce more goods and services without experiencing inflationary
pressures.
Progress questions
1 What is the difference between investment and the capital stock?
2 Why might a fall in the replacement ratio shift the LRAS to the right?
3 Why is an economy unlikely to be able to continue producing beyond its
normal capacity level of output in the long run?
200
Determinants of long-run aggregate supply
Case study: The female participation rate in different

countries
▼ Table 7.6.1: Female participation rate, selected countries, 1991 to 2019
Country 1991 2005 2019
Australia 52.0% 57.0% 59.6%
India 30.0% 32.2% 23.4%
Nigeria 47.1% 47.8% 50.6%
Peru 43.5% 64.0% 70.2%
UK 51.8% 54.7% 57.1%
Vietnam 72.7% 71.7% 72.5%
Source: these figures are based on information from the World Bank; https://
data.worldbank.org
1 Which country’s female participation rate has fallen most between 1991
and 2019?
2 Which country’s female participation rate has risen most between 1991
and 2019?
3 Which country’s female participation rate has been most stable between
1991 and 2019?
4 Explain how the change in Australia’s female participation rate is likely to
have affected the productive capacity of Australia’s economy between
1991 and 2019.
▲ Figure 7.6.2: Indian women in the labour force
201
Exam-style questions
1 Which one of the following is an injection into the circular flow of income?
A Consumption C Investment
B Imports D Savings [1 mark]
2 The marginal propensity of import (MPM) measures the
A proportion of income spent on imports.
B proportion of an increase in consumption spent on imports.
C proportion of a change in income spent on imports.
D ratio of imports to exports. [1 mark]
3 In an economy, the marginal propensity to consume (MPC) is 0.6. If exports increase by $100 million
and investment falls by $120 million, national income will fall by
A $8 million. C $48 million.
B $20 million. D $50 million. [1 mark]
4 Define “aggregate demand”. [3 marks]
5 In 2019, the national income of an economy was $160 billion and the value of imports was $25 billion .
The marginal propensity to import (MPM) is 0.24. In 2020, national income was $168 billion. Calculate,
to one decimal place, the value of imports for the economy in 2020. [4 marks]
6 The table below shows how national income and investment in an economy changed between 2016
and 2020.
Year National income ($bn) Investment ($bn)
2016 530 84
2017 560 97
2018 605 122
2019 600 87
2020 612 83
(i) Explain why changes in national income might affect investment. [6 marks]
(ii) To what extent do the data suggest that changes in national income affect investment? Use the
data in the table to support your answer. [6 marks]
7 With the help of a diagram, explain how an increase in exports is likely to affect the equilibrium national
income of an economy. [9 marks]
8 Analyse the effects of an improvement in technology on the normal capacity level of output of an
economy. [12 marks]
202

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7 How the

Resources – land, labour and capital

Income – rent, wages, interest and profit

Goods and services

Taxation Government spending

This section will develop your knowledge and understanding of:

National income: the monetary

The income method of measuring national income

output must create an equal amount of income. Therefore, national

The expenditure method of measuring national income

The difference between GNP and NNP is depreciation, or capital

Obsolete: out of date and not used NNP = GNP – depreciation

Case study: Farina’s Footwear

▲ Figure 7.1.2: Shoes for sale

The difference between nominal national income

Real national income as an indicator of economic Get it right

The circular flow of income model

Income (Y) Factors of Goods and Consumption (C)

▲ Figure 7.1.3: A simple two-sector model of an economy

Introducing injections and withdrawals

Withdrawal (W) = Saving (S)

Income (Y) Factors of Goods and Consumption (C)

Injection (J) = Investment (I)

Equilibrium income in a two-sector economy

Equilibrium income in an economy with government and

Figure 7.1.5 represents an open economy with a government sector.

Income (Y) Factors of Goods and Consumption (C)

▲ Figure 7.1.5: A model of an open economy with a government sector

Key term Full employment income

everyone who is willing and able to work at current market wage

The effects of changes in injections and withdrawals on

Case study: Indonesia’s economy survives the world financial crisis

Quantitative skills Progress questions

Changes in the price level are represented by

Movements along the AD curve

Price level Get it right

account. This increase in wealth should lead to an increase in

Key term Movements along the AS curve

▲ Figure 7.2.2: The AS curve

At low levels of output the AS curve is horizontal (as shown in Figure

Most of the time, economies produce on the upward-sloping section of

about the future caused firms to reduce investment spending, this

Shifts in the SRAS curve

Price level SRAS1

It is important to remember that ▲ Figure 7.2.5: A shift in the SRAS curve

Key term Factors that affect long-run aggregate supply

normal capacity level of output, it is also producing on its production

Why underlying economic growth is represented

If there is an increase in the labour force or more capital, this will

The effect of a shift in short-run aggregate supply on

Drawing an AD/AS diagram to illustrate the effect of an

The effects of a supply-side shock

▲ Figure 7.2.12: The effects of a positive supply-side shock

▲ Figure 7.2.13: Natural gas pipeline

This section will develop your knowledge and understanding of:

The meaning and components of aggregate

Determinants of consumption, investment,

The availability of credit

Case study: A slowdown in the growth of household consumption is forecast

In the private sector, firms invest if they believe that investment