Macro Economics AS Level by readandwrite.marketing

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Macroeconomics AS-Level Notes Book 2

Author

Imran Latif Cell: +92 300 441 0900 Email: imranlatifmalik@gmail.com

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2018 Edition

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Contents UNIT 1

AGGREGATE DEMAND (AD) AND AGGREGATE SUPPLY (AS) .................................................................. 22

CONCEPTS OF NATIONAL INCOME .................................................................................................................................... 22 SECTORS AND TYPES OF ECONOMIES: ............................................................................................................................... 23 AGGREGATE DEMAND (AD): .......................................................................................................................................... 24 Why does the AD curve slope downward?........................................................................................................... 25 Changes in Aggregate Demand ........................................................................................................................... 25 AGGREGATE SUPPLY (AS) ............................................................................................................................................... 28 The short-run aggregate supply curve ................................................................................................................. 28 The shape of the long-run aggregate supply curve ............................................................................................. 29 INTERACTION OF AGGREGATE DEMAND AND AGGREGATE SUPPLY AND NATIONAL INCOME EQUILIBRIUM ......................................... 32 CHANGES IN NATIONAL INCOME EQUILIBRIUM .................................................................................................................... 32 BUSINESS (TRADE) CYCLE ............................................................................................................................................... 34 UNIT 2

MONEY AND INFLATION ....................................................................................................................... 38

MONEY ...................................................................................................................................................................... 38 History of specialization, trade, and money ........................................................................................................ 38 Concepts .............................................................................................................................................................. 39 Features of money ............................................................................................................................................... 39 Functions of money:............................................................................................................................................. 40 INFLATION ................................................................................................................................................................... 41 MEASUREMENT OF INFLATION / VALUE OF MONEY / COST OF LIVING .................................................................................... 43 THE CAUSES OF INFLATION.............................................................................................................................................. 45 Demand-pull Inflation .......................................................................................................................................... 45 Cost-push Inflation ............................................................................................................................................... 45 THE CONSEQUENCES OF INFLATION .................................................................................................................................. 47 Costs: ................................................................................................................................................................... 47 Benefits ................................................................................................................................................................ 49 CAUSES AND CONSEQUENCES OF DEFLATION ...................................................................................................................... 52 PAST PAPER QUESTIONS .......................................................................................................................................... 53 UNIT 3

INTERNATIONAL TRADE ........................................................................................................................ 58

DOMESTIC AND INTERNATIONAL TRADE ............................................................................................................................ 58 THEORIES OF INTERNATIONAL TRADE: ............................................................................................................................... 58 Theory of absolute advantage ............................................................................................................................. 58 Theory of Comparative advantage ...................................................................................................................... 60 Mutually beneficial rate of exchange: ................................................................................................................. 61 Trading possibility curve (TPC): ............................................................................................................................ 61 LIMITATIONS OF ABSOLUTE AND COMPARATIVE ADVANTAGE THEORY: ..................................................................................... 62 PROTECTIONISM ........................................................................................................................................................... 63 Methods of protection and their impact .............................................................................................................. 64 Effectiveness of protectionism: ............................................................................................................................ 67 THE ARGUMENTS IN FAVOR OF FREE TRADE AND AGAINST PROTECTIONISM ............................................................................... 67 THE ARGUMENTS IN FAVOR OF PROTECTIONISM AND AGAINST FREE TRADE ............................................................................... 68 TRADE BLOCS OR INTERNATIONAL ECONOMIC INTEGRATION .................................................................................................. 70 CONSEQUENCES OF FORMATION OF TRADING BLOCS: ........................................................................................................... 72 1. Trade creation .................................................................................................................................................. 72 2. Trade diversion ................................................................................................................................................ 73 PAST PAPERS QUESTION .......................................................................................................................................... 75

UNIT 4

EXCHANGE RATE ................................................................................................................................... 82

DEFINITIONS AND MEASUREMENT OF EXCHANGE RATES ........................................................................................................ 82 EXCHANGE RATE SYSTEMS .............................................................................................................................................. 82 Free Floating Exchange Rate System ................................................................................................................... 83 Fixed Exchange Rate System ................................................................................................................................ 86 CAUSES OF EXCHANGE RATE DEPRECIATION....................................................................................................................... 87 CAUSES OF EXCHANGE RATE APPRECIATION....................................................................................................................... 89 EFFECTS OF DEPRECIATION/DEVALUATION ........................................................................................................................ 91 EFFECTS OF APPRECIATION/REVALUATION.......................................................................................................................... 93 ADVANTAGES AND DISADVANTAGES OF EXCHANGE RATE SYSTEMS: ......................................................................................... 95 Managed floating system .................................................................................................................................... 97 THE TERMS OF TRADE .................................................................................................................................................... 98 Movements in Terms of Trade ............................................................................................................................. 98 The Impact of changes in the terms of trade ..................................................................................................... 100 PAST PAPER QUESTIONS ........................................................................................................................................ 102 UNIT 5

BALANCE OF PAYMENTS ..................................................................................................................... 106

COMPONENTS OF THE BALANCE OF PAYMENTS.................................................................................................................. 107 BALANCE OF PAYMENT DISEQUILIBRIUM .......................................................................................................................... 110 CAUSES OF BALANCE OF PAYMENT DISEQUILIBRIUM ........................................................................................................... 110 CONSEQUENCES OF A CURRENT ACCOUNT DEFICIT AND A CURRENT ACCOUNT SURPLUS ............................................................. 112 Consequences of current account deficit: .......................................................................................................... 112 Consequences of current account surplus: ........................................................................................................ 112 PAST PAPER QUESTIONS ........................................................................................................................................ 114 UNIT 6

GOVERNMENT INTERVENTION IN A MACRO-ECONOMY..................................................................... 116

MACROECONOMIC POLICIES: ........................................................................................................................................ 116 1. Fiscal policy .................................................................................................................................................... 116 2. Monetary policy ............................................................................................................................................. 119 3. Supply-side policy ........................................................................................................................................... 121 POLICIES TO CORRECT CURRENT ACCOUNT DEFICIT ............................................................................................................. 123 1. Expenditure-switching policies: ..................................................................................................................... 123 2. Expenditure-dampening policies: ................................................................................................................... 125 POLICIES TO REDUCE CURRENT ACCOUNT SURPLUS: ........................................................................................................... 126 POLICIES TO CORRECT DEMAND-PULL INFLATION ............................................................................................................... 126 POLICIES TO CORRECT COST-PUSH INFLATION.................................................................................................................... 126 POLICIES TO CORRECT DEFLATION AND THEIR EFFECTIVENESS ............................................................................................... 127 PAST PAPER QUESTIONS .............................................................................................................................................. 127

Preface The idea of writing notes for Cambridge A-level Economics came to me in 2003, when, having already taught for a year, I realized that no single economics book available in the local and international markets covered all the topics with the depth and perspective required by the CIE syllabus. Both students and teachers had to consult 3 to 4 different books to find all the material that they neededâ&#x20AC;&#x201D;private candidates and new teachers had it even worse. Furthermore, it was really difficult for students to keep having to refer through different books when the exams were close and they were starved for time. I took on the challenge and decided to write a comprehensive text that explicitly followed the syllabus and exam pattern of the CIE. A year and a half later, in the middle of 2004, I had finally written and published four entire volumes of Alevel economics notes. Part of them had been hand-written, and part of them had been typed. Soon, word of their usefulness spread, and they were bought all over Pakistan. The notes had served their purpose well till the end of 2014. Till that point, there had only been minor changes in the syllabus. But now, there was a dire need to update them, for the new syllabus for the 2016 examination introduced some significant changes in course content. In this new and improved edition, old topics have been revised and new topics have been added. At the end of each topic there is a relevant list of essay questions spanning from 1990 to 2015. These questions provide a clear guideline regarding how the examiners assess students' knowledge on the topics for Paper 2 and Paper 4, allowing the student to practice effectively. While writing these notes I kept in mind the way in which the examiner tests MCQs as well. The notes have been divided into four volumes to make it easier for those who are following the AS and A2 track separately and for those who are taking the composite exam; the syllabus division in the following pages has been provided for this express purpose. I hope my efforts will help to contribute both to the learning of the student, as well as to the inquisitiveness of any teachers of A-level economics. Your suggestions will help me improve the quality of the content for later editions and will be highly appreciated. Imran Latif Cell: +92 300 441 0900 Email: imranlatifmalik@gmail.com

References 1. Economics, 6th Edition / Sloman, J. 2. Principles of Economics, 10th Edition / Karl E. Case, Ray C Fair and Sharon C Oster 3. Economics, 18th edition / Mcconnell Brue 4. Economics, 9th Edition / Arnold 5. Principles of Economics / N. Gregory Mankiw 6. Cambridge International AS and A Level Economics, 3rd edition / Bamford, Colin and Grant, Susan 7. Cambridge International AS and A Level Economics Revision Guide / Susan Grant 8. Economics A Level 5th edition / Anderton, AG 9. Comprehensive economics guide / Hashim Ali. 10. Stanlakeâ&#x20AC;&#x2122;s Introductory Economics/ Susan Grant 11. Economics AS and A Level Through Diagrams / Gillespie, A 12. Penguin Dictionary of Economics / Bannock, Graham et al (eds) 13. Economics: A Studentâ&#x20AC;&#x2122;s Guide / Beardshaw, J 14. Essentials of Economic 5th edition / Sloman, John 15. Economics, 9th edition / Begg, David et al 16. Economics, 11th edition / Michael Parkin 17. www.tutor2u.net 18. www.s-cool.co.uk 19. www.wikipedia.com

Review Board 1. Lahore: Mr. Aslam Tariq, Mr. Mian Mumtaz, Mr. Saeed Afzal, Mr. Kamran Malik , Mr. Shahid Saghir , Mr. Faisal Saeed, Mr. Muhammad Rafi, Mr. Arshad Chudhary, Mr. Ahmed Bilal, Mr. Waqar Khan, Mr. Waqas Iqbal, Mr. Azar Anjum, Mr. Arshad Farooqi, Mr. Rizwan-urRehman, Mr. Irteza Rehman, Mr. Ahmed Javed Paracha, Mr. Ali Rana, Mr. Mazahar Abbas, Mr. Rasheed Kahloon, Mr. Mazhar Muneer, Mr. Mumtaz Ahmad, Miss Nosheen Jamal, Mr. Muhammad Rizwan, Mr. Azeem Qaisar, Mr. Waqas Biag, and Mr. Asghar Ali Malik. 2. Islamabad and Rawalpindi Mr. M. Zulfiqar, Mr. Hamood Rehman, Mr. Abdul Salam, Mazhar Hameed Khan, Mr. Ali Yasir, Mr. Asad Ali, Mr. Naveed Iqbal, Mr. Umar Khan, Mr. Sadaqat Ali, Mr. Hamood Ur Rahman and Mian Tahir Siddique. 3. Fisalabad and Jhang Mr. Anwar-ul-Haq, Mr. Aamir Jahangir, Mr. Imran Kamal, Mr. Muhammad Sakhi Ahmad, Mr. Javed Iqbal, and Miss Kiran. 4. Sialkot and Gujranwala Mr. Imran Aslam and Mr. Sarwar Imtiaz. 5. Karachi and Multan M. Asif farooq, Miss Shafaq Ahmed, Mr. Siddique Ansari , Mr. Zai, Mr. Munawar Ghazi, Mr. Abdul Kareem Lakhani, Mr. Ali Anwerzada, Miss Khalida Afsar, Miss Amna Basir, Hanah Iqbal Mirza and Mr. Kamran Butt.

Economics 9708

Syllabus

A-Level Economics 9708 Syllabus overview (2016 – 18)

AS Level

A2 Level

Microeconomics

Macroeconomics

Microeconomics

Book 1

Book 2

Book 3

a. Basic economic ideas and resource allocation b. Demand and supply and equilibrium c. Elasticity of demand and supply d. Government microeconomic intervention

1. Aggregate Demand (AD) and Aggregate Supply (AS) 2. Money and inflation 3. International trade 4. Exchange rate 5. Balance of payments 6. Government macro intervention (Macroeconomic policies)

1. Theory of consumer behavior 2. Production and cost 3. Rules of firms behavior 4. Perfect competition 5. Monopoly 6. Monopolistic competition 7. Oligopoly(kinked demand curve, game theory, price leadership and cartel) 8. comparisons of market structures 9. Objectives of a firm, Price discrimination, Contestable markets 10. Efficiency , equity and market failure 11. Labor market

Macroeconomics

Book 4 1. National Income statistics 2. Economic growth and development 3. Keynesian theory of income and employment in 2, 3 and 4-sector economies 4. Money, banking and interest rate determination 5. Monetary and development policies 6. Employment/unempl oyment 7. Macroeconomic objectives and conflicts between the policy objectives 8. Keynesian and Monetarist schools

A-Level Economics 9708 Syllabus Contents Details (2016 – 18)

Book 1 (AS Level Microeconomics) UNIT 1:

BASIC ECONOMIC IDEAS AND RESOURCE ALLOCATION

a. Scarcity, choice and opportunity cost  the fundamental economic problem  the meaning of scarcity and the inevitability of choices at all levels (individual, firms, governments)  the basic questions of what will be produced, how and for whom  the margin and decision making at the margin b. Positive and normative statements  the distinction between facts and value judgments c. Factors of production  the rewards to the factors of production: land, labor, capital and enterprise  specialization and division of labor (Transferred to Book 2 unit 2) d. Resource allocation in different economic systems and issues of transition  decision making in market, planned and mixed economies  the role of the factor enterprise in a modern economy

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Syllabus

e. Production possibility curves  shape and shifts of the curve  constant and increasing opportunity costs f.

Classification of goods and services  free goods, private goods (economic goods) and public goods  merit goods and demerit goods as the outcome of imperfect information by consumers.

g. Money (Transferred to book 2 unit 2)  functions and characteristics in a modern economy barter, cash and bank deposits, checks, near money, liquidity UNIT 2:

DEMAND, SUPPLY AND EQUILIBRIUM

a. Demand and supply curves  effective demand  the meaning of the term, ‘ceteris paribus’  individual and market demand and supply  factors influencing demand and supply b. Interaction of demand and supply c. Market equilibrium and disequilibrium  meaning of equilibrium and disequilibrium  effects of changes in supply and demand on equilibrium price and quantity  applications of demand and supply analysis  movements along and shifts of the demand and supply curves  joint demand (complements) and alternative demand (substitutes)  joint supply  the workings of the price mechanism; rationing, signaling and the transmission of preferences UNIT 3:

ELASTICITY OF DEMAND AND SUPPLY

a.    

Price elasticity, income elasticity and cross-elasticities of demand the meaning and calculation of elasticity of demand the range of elasticities of demand the factors affecting elasticity of demand the implications for revenue and business decisions of price, income and crosselasticities of demand

b.    

Price elasticity of supply meaning and calculation of elasticity of supply the range of elasticities of supply the factors affecting elasticity of supply implications for speed and ease with which businesses react to changed market conditions short run, long run, very long run

UNIT 4:

GOVERNMENT MICRO INTERVENTION

a. Consumer and producer surplus  meaning and significance  how these are affected by changes in equilibrium price and quantity

Economics 9708

b.      

Syllabus

Government microeconomic intervention Taxes (direct and indirect) Subsidies Maximum and minimum prices Transfer payments (transferred to Book 2 unit 1) Direct provision of goods and services Nationalization and privatization

Book 2 (AS Level Macroeconomics) UNIT 1: AGGREGATE DEMAND (AD) AND AGGREGATE SUPPLY (AS):  the shape and determinants of AD and AS Curves  AD = C + I + G + (X – M)  the distinction between a movement along and a shift in AD and AS  the interaction of AD and AS and the determination of the level of output, prices and employment UNIT 2:

MONEY AND INFLATION:

a. Money  functions and characteristics in a modern economy  barter, cash and bank deposits, checks, near money, liquidity b. Inflation  the definition of inflation  degrees of inflation  deflation and disinflation  measurement of inflation  the distinction between money values and real data (shifted to Book 2 Unit 1)  the causes of inflation (cost-push and demand-pull inflation)  the consequences of inflation UNIT 3:

INTERNATIONAL TRADE:

a. Specialization and division of labor b. Principles of absolute and comparative advantage  the distinction between absolute and comparative advantage  free trade area, customs union, monetary union, full economic union  trade creation and trade diversion  the benefits of free trade, including the trading possibility curve c. Protectionism  the meaning of protectionism in the context of international trade  different methods of protection and their impact, for example, tariffs, import duties and quotas, export subsidies, embargoes, voluntary export restraints (VERs) and excessive administrative burdens (‘red-tape’)  the arguments in favor of protectionism UNIT 4:

EXCHANGE RATE:

a. Exchange rates  definitions and measurement of exchange rates

Economics 9708



Syllabus

nominal, real, trade-weighted exchange rates

b. Exchange rate systems  the determination of exchange rates floating, fixed, managed float c. Changes and effects  the factors underlying changes in exchange rates  the effects of changing exchange rates on the  domestic and external economy using AD, Marshall-Lerner and J curve analysis  depreciation/appreciation  devaluation/revaluation d. The terms of trade  the measurement of the terms of trade  causes of changes in the terms of trade  the impact of changes in the terms of trade UNIT 5:

BALANCE OF PAYMENTS:

a. BOP accounts  the components of the balance of payments  accounts (using the IMF/OECD definition)  current account  capital account  financial account  balancing item b. BOP equilibrium and disequilibrium  meaning of balance of payments equilibrium and disequilibrium  causes of balance of payments disequilibrium in each component of the accounts  consequences of balance of payments disequilibrium on domestic and external economy UNIT 6:

GOVERNMENT MACRO INTERVENTION:

a. Types of policy  fiscal policy  monetary policy,  supply side policy (instruments of each policy) b. Policies to correct balance of payments disequilibrium  assessment of the effectiveness of fiscal, monetary and supply side policies to correct a balance of payments disequilibrium (expenditure-reducing an expenditure-switching) c. Policies to correct inflation and deflation  assessment of the effectiveness of fiscal,  monetary and supply side policies to correct inflation and deflation

Book 3 (A2 Level Microeconomics) UNIT 1:

THEORY OF CONSUMER BEHAVIOUR:

a. Law of diminishing marginal utility 

Law of diminishing marginal utility

Economics 9708



its relationship to derivation of an individual demand schedule

b. Equi-marginal principle   

Equi-marginal principle limitations of marginal utility theory rational behavior versus behavioral economic models

c. Indifference curves and budget lines  income, substitution and price effects for various types of goods UNIT 2:

PRODUCTION AND COST:

a. Short-run production function:  fixed and variable factors of production  total product, average product and marginal product  law of diminishing returns (law of variable proportions)  marginal cost and average cost  short-run cost function – fixed costs versus variable costs  explanation of shape of Short-Run Average Cost (SRAC) b. Long-run production function  returns to scale  long-run cost function  explanation of shape of Long-Run Average Cost (LRAC)  relationship between economies of scale and decreasing costs  internal and external economies of scale and diseconomies of scale UNIT 3:

RULES OF FIRMS BEHAVIOUR:

a. Revenue:  total, average and marginal b. Short-run and long-run continuity  exit of firms in long-run  shutdown in short-run c. Profit:  normal and abnormal (supernormal)  total, marginal and average profits  traditional profit maximizing objective of firm UNIT 4:

PERFECT COMPETITION:

a. Features  number of buyers and sellers  nature of product  degree of freedom of entry  nature of information b. Revenue:  total, average and marginal revenue c. Short-run price and output determination  normal, abnormal and subnormal profits  types of losses and shutdown in short-run

Syllabus

Economics 9708



short-run supply curve of a firm

d. Long-run price and output determination:  abnormal to normal profits  losses to normal profits UNIT 5: MONOPOLY: a. Features  number of buyers and sellers  nature of product  degree of freedom of entry  nature of information b. Revenue:  total, average and marginal revenue  relation between elasticity and revenue c. Short-run price and output determination  normal, abnormal and subnormal profits  types of losses and shutdown in short-run d. Long-run price and output determination:  barriers to entry  natural monopoly UNIT 6:

MONOPOLISTIC COMPETITION:

OLIGOPOLY:

a. Features  number of buyers and sellers  nature of product  degree of freedom of entry  nature of information

Syllabus

Economics 9708

Syllabus

b. Revenue:  total, average and marginal revenue c. Price and output determination  non-collusive models (kinked demand curve and game theory, mutual interdependence, Prisoner’s Dilemma, 2 player Pay-off Matrix)  collusive models of price leadership and cartel d. Growth and survival of firms  reasons for small firms  integration, diversification, mergers, UNIT 8: COMPARISON OF MARKET STRUCTURES: a. Comparisons of performance of firms:  revenue  output  profits  efficiency  X-inefficiency  barriers to entry and exit  price competition  non-price competition collusion UNIT 9: FIRM'S OBJECTIVES, PRICE DISCRIMINATION AND CONTESTABLE MARKETS: a. Differing objectives of a firm:  traditional profit maximizing objective  principal agent problem, for example the divorce of ownership from control  sales maximization  survival, strategic  satisficing b. Price discrimination:  meaning  types  conditions  operations  advantages and disadvantages c. Contestable markets:  meaning  examples  perfectly contestable markets  limit pricing UNIT 10:

EFFICIENCY AND MARKET FAILURE:

a. Efficient resource allocation  productive efficiency  allocative efficiency  Pareto optimality

Economics 9708



dynamic efficiency

b. Externalities and market failure  reasons for market failure  positive and negative externalities for both  consumers and firms  inefficient resource allocation c. Policies to achieve efficient resource allocation and correct market failure  application of indirect taxes and subsidies  price and output decisions under nationalization and privatization  prohibitions and licenses  property rights  information  regulatory bodies  deregulation  direct provision of goods and services  pollution permits  behavioral insights and ‘nudge’ theory d. Government failure in microeconomic Intervention  effectiveness of government policies e. Social costs and benefits  cost-benefit analysis  social costs as the sum of private costs and  external costs  social benefits as the sum of private benefits  and external benefits  use of cost-benefit analysis in decision-making UNIT 11:

INEQUALITY AND POLICES TO DISTRIBUTE INCOME:

a. Equity versus efficiency  price stabilization  means tested benefits  transfer payments (transferred to unit book 4)  progressive income taxes, inheritance and  capital taxes  negative income tax  poverty trap analysis  Gini coefficient  Lorenz curve  inter-generational equity UNIT 12:

LABOR MARKET:

a. Demand for Labor  factors affecting demand for labor  derivation of individual firm’s demand for using marginal revenue product theory

Syllabus

Economics 9708

Syllabus

b. Supply of labor  factors affecting supply for labor  net advantages and the long-run supply of labor c. Wage determination in perfect markets d. Wage determination in imperfect markets  monopsony  influence of trades unions on wage determination  influence of government on wage determination e. Competitive product and factor market forces determining wage differentials f.

Transfer earnings and economic rent

Book 4 (A2 Level Macroeconomics) UNIT 1:

NATIONAL INCOME STATISTICS:

a. National Income statistics  Gross Domestic Product (GDP)  Gross National Product (GNP)  Gross National Income (GNI)  transfer payments  the distinction between money values and real data b. National debt (government or public sector debt) c. Business (trade) cycle UNIT 2:

ECONOMIC GROWTH AND DEVELOPMENT:

a. Economic growth and development  definition of economic growth  economic development and sustainability  actual versus potential growth in national output  factors contributing to economic growth  costs and benefits of growth, including using and conserving resources b. Indicators of living standards and economic development  monetary, non-monetary  Human Development Index (HDI)  Measure of Economic Welfare (MEW)  Human Poverty Index (HPI), later supplanted by the Multidimensional Poverty Index (MPI)  Kuznets curve c. National Income statistics and standard of living  use of National Income statistics as measures of economic growth and living standards  comparison of economic growth rates and living standards over time and between countries

Economics 9708

Syllabus

d. Classification of countries  characteristics of developed, developing and emerging (BRICS) economies:  by population growth and structure  income distribution  economic structure  employment composition  external trade and urbanisation in developing economies e. Policies towards developing economies  policies of trade and aid  types of aid  nature of dependency  trade and investment  role of multinationals  Foreign Direct Investment (FDI)  external debt  role of IMF and World Bank  impact of corruption  importance of the legal framework in an economy UNIT 3:

KEYNESIAN THEORY OF INCOME AND EMPLOYMENT:

a. The circular flow of income  closed and open economies  the circular flow of income between households, firms, government and the international economy b. Aggregate Expenditure (AE) function  meaning  components of AE and their determinants  average and marginal propensities to save and consume c. Income determination using  AE and income approach  withdrawal (leakage) and injection approach d. Inflationary and deflationary gaps  full employment level of income and equilibrium level of income  output gap and expenditure gap  inflationary and deflationary gaps e. Multiplier  the multiplier f.

Accelerator  autonomous and induced investment  the accelerator UNIT 4:

MONEY, BANKING and INTEREST RATE DETERMINATION:

a. Money and banking  money supply (theory)  broad and narrow money supply

Economics 9708



Syllabus

sources of money supply in an open economy  commercial banks and credit creation  role of central bank  quantitative easing  total currency flow

b. The demand for money and interest rate determination  Liquidity Preference theory UNIT 5:     

MACROECONOMIC POLICIES:

transmission mechanism of monetary policy Quantity theory of money (MV = PT) deficit financing existence of government failure in macroeconomic policies Laffer curve analysis

UNIT 6:

EMPLOYMENT/UNEMPLOYMENT:

Employment/unemployment          

size and components of labor force labor productivity full employment and natural rate of unemployment causes of unemployment consequences of unemployment types of unemployment unemployment rate patterns and trends in (un)employment difficulties involved in measuring unemployment policies to correct unemployment

UNIT 7: MACROECONOMIC OBJECTIVES AND CONFLICTS BETWEEN POLICY OBJECTIVES: Government macro policy aims on:  inflation  balance of payments  exchange rates  unemployment  growth and development Inter-connectedness of problems  effectiveness of policy options to meet all macroeconomic objectives  links between macroeconomic problems and their interrelatedness, for example:  relationship between internal and external value of money  relationship between balance of payments and inflation  trade-off between inflation and unemployment; Phillips curve 

problems arising from conflicts between policy objectives on inflation, unemployment, economic growth, balance of payments, exchange rates and the redistribution of income and wealth

Economics 9708

Syllabus

Keynesian and Monetarist schools ď&#x20AC;

different theoretical approaches to how the macro economy functions

Directive Word Calculate Define

What it means Work out using the information provided Give the exact meaning of

Describe

Give a description of, explain the main features of

Illustrate

Give examples, use a diagram

Outline

Describe the key points without detail

Analyse

Explain the main points in detail, examine closely, separate into parts and show how all the parts connect and link

Compare

Explain the similarities and differences between

Explain Consider Assess Comment upon

Give clear reasons or make clear the meaning of, use examples and explain the theory behind the question Give your thoughts about, with some justification Show how important something is, give your judgment on Give your reasoned opinion on, with explanations

Criticise

Give an opinion but support it with evidence

Discuss

Give the important arguments for and against, often requires a conclusion

Evaluate

Discuss the importance of, judge the overall worth of, make an attempt to weigh up your opinions

To what extent

Give reasons for and against, come to a conclusion with a justification of which arguments are strongest and which are weakest

Economics 9708

Blank Page

Syllabus

Unit 1

Aggregate Demand (AD) and Aggregate Supply (AS)

Syllabus 2016 – 18

Aggregate Demand (Ad) & Aggregate Supply (AS) AS Level Macroeconomics Notes Book 2

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a. the distinction between money values and real data b. Aggregate demand (AD) & Aggregate supply (AS)

  

the shape and determinants of AD and AS Curves AD = C + I + G + (X – M) the distinction between a movement along and a shift in AD and AS

c. National income equilibrium



the interaction of AD and AS and the determination of the level of output, prices and employment

Unit 1

Aggregate Demand (AD) and Aggregate Supply (AS)

Concepts of National Income     

Gross Domestic Product (GDP) Gross National Product (GNP) Disposable income (Yd) Nominal GDP Real GDP

Gross Domestic Product (GDP): Gross domestic product (GDP) is the monetary value of all final goods and services produced within the geographical boundaries of a country irrespective of whoever is producing it, in one year. Whereas monetary value means the value of a product expressed in terms of money. GDP will not include all those goods which are produced abroad, in previous year and/or goods that are unfinished. Monetary Value = Price × Quantity GDP = P1 Q1 + P2 Q2 + P3 Q3 ……… PnQn = ∑PQ “P1 Q1” is the monetary value of Good “1”. “P2 Q2” is the monetary value of Good “2”. “P3 Q3” is the monetary value of Good “3”. Gross National Product (GNP): Gross national product (GNP) is the monetary value of all goods and services which are produced by the citizens of a nation, irrespective of wherever they are living in the world, in one year. GNP = GDP + Net Property Income from Abroad Net property income from abroad = Property income from abroad – Property payment to abroad Disposable National Income (Yd): Disposable income (Yd) is the income left after paying income tax (direct tax). Disposable income = National Income – Income Tax Nominal GDP: Nominal GDP is the GDP figure measured at the current year prices and is not yet adjusted for inflation. Nominal GDP = Current Year Price index × Current Year Output Example Current Year Price index = $120 Current year output = 3,000 units Nominal GDP (Current Year) = 120 x 3,000 = $360,000 Real GDP: Real GDP is the GDP figure measured at constant or base pear price level and has been adjusted for inflation. Real GDP = Base Year Price Index × Current Year output Example: Year 2000: Base year price index = $100 Base year output = 20 units

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Aggregate Demand (AD) and Aggregate Supply (AS)

Current year: Current year output = 30 units Real GDP (Current Year) = 100 × 30 = $3,000 CONVERSION OF NOMINAL GDP TO REAL GDP To convert nominal national income to real national income, the income deflator is used. The income deflator is a value that removes the effect of inflation from nominal national income. The following steps explain the procedure of the deflator. Real national income = Where Deflator =

Nominal national income Deflator

Current year price index Base year price index

Example: Nominal NY=$200 million Current year price index = 110 Base year price index=100 Deflator =

Current year price index Base year price index

Real national income =

110 100

= 1.1

Nominal national income Deflator

200

= $182m

1.1

Sectors and Types of Economies: HOUSEHOLDS

FIRMS

GOVERNMENT

FOREIGN

Expenditure on consumer goods

Expenditure on capital goods

Expenditure on merit and public goods

Expenditure on exports and imports

Consumption and saving

Investment

Government spending and taxation

Exports and imports

C, S

G, T

X, M

Types of Economies

Sectors

Households Firms Government International Trade Type of Economy

2-Sector Economy

3-Sector Economy

4-Sector Economy

With Government

With Foreign Sector

   

   

   

   

Closed

Open

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Aggregate Demand (AD) and Aggregate Supply (AS)

Aggregate Demand (AD): Aggregate demand (AD) is the total spending on an economy's goods and services at a given price level in a given time period. Demand for an economy’s products, known as aggregate demand (AD), comes from households, firms, and the government within the country and from households, firms, and governments in other countries. Aggregate demand (AD) consists of four components: Economy

Sectors

Households

Firms

Government

Foreign

spending by households on consumer goods and services

spending by private sector firms on capital goods

government spending on public and merit goods

The part of the economy involved in the international trade, i.e. exports and

Consumption

Investment

Government spending

Net Exports

X –M

= AD

The Aggregate Demand curve The aggregate demand curve shows the different quantities of total demand for the economy’s products (real GDP) at different price levels. AD = C + I + G + X – M

General Price Level

AD0 o

Real GDP

A rise in the price level will cause a contraction in aggregate demand and a fall in the price level will result in an extension in aggregate demand. The downward sloping nature of the AD curve is shown in Figure above.

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Aggregate Demand (AD) and Aggregate Supply (AS)

Why does the AD curve slope downward? The relationship between aggregate demand and the price level might seem similar to the relationship shown in the demand curve for an individual product. There is, however, a significant difference. A demand curve for a product shows the relationship between a change in the relative price of a product and the quantity demanded. The price of the product is changing but it is assumed that the prices of other products have not changed. More of the product is purchased when the price falls, in part because people switch away from rival products. By contrast, in the case of the AD curve, the prices of most products are changing in the same direction. Why, then, does aggregate demand fall when the price level rises, and vice versa? There are three reasons: Price level

The wealth effect

The interest rate effect

The international trade effect

Decrease (↓)

Purchasing power of financial assets↑→real wealth↑ → C↑ → AD↑

Exports—more price competitive Imports—less price competitive Net exports (X−M) ↑ →AD↑

Demand for loans ↓→interest rate (ir)↓→cost of borrowing ↓ → C, I ↑→AD↑

Increase (↑)

Purchasing power of financial assets↓→real wealth ↓→C↓ →AD↓

Exports—less price competitive Imports—more price competitive Net exports (X−M)↓ →AD↓

Demand for loans ↑→interest rate (ir)↑ →cost of borrowing ↑→ C, I ↓→AD↓

Changes in Aggregate Demand Aggregate demand can change in two ways:  A movement along the same aggregate demand curve.  A shift of the aggregate demand curve. Changes in aggregate demand (AD)

Shift of the AD curve

Movement along the same AD curve

due to exogenous factors due to endogenousfactor (general price level)

Extension

Contraction

General Price Level

Rise General Price Level

a Ext e ns C io on n tra b ct io n

P0 P1

Fall Rise

ADO o

Fall

Real GDP

AD2 ADO o

AD1

Real GDP

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Aggregate Demand (AD) and Aggregate Supply (AS)

Shifts in the Aggregate Demand curve A change in the price level causes a movement along the AD curve; but, if any factor other than the price level causes aggregate demand to change, then the entire AD curve will shift. A shift to the left indicates a decrease in aggregate demand (AD0 to AD2), whereas a shift to the right (AD0 to AD1) indicates an increase in aggregate demand, as shown in the figure above on the right. A change in any factor other than the price level will influence consumption, investment, government spending, and net exports, shifting the AD curve. Examples that would cause an increase in aggregate demand include: Consumption (C)

Investment (I)

population wealth income tax money supply consumer confidence age structure range of products interest rate availability of credit distribution of income expectations regarding income in the future - expectations regarding prices in the future - government welfare spending

- interest rate - business expectations - corporation tax - subsidies - technology - law and order - political stability - cost of labor - cost of raw materials - foreign relations - infrastructure - profits - demand for consumer goods

Government Spending (G)

Net Exports (Xâ&#x2C6;&#x2019;M)

political objectives level of economic activity social objectives need for merit and public goods

- relative prices - exchange rate - relative quality of domestically produced products - foreign & domestic economic growth - protectionism

Determinants of Consumption and Savings: 1. Wealth: A rise in wealth causes consumption to rise and saving to fall. Where as a fall in wealth causes consumption to fall and saving to rise. 2. Income tax: When income tax rises, consumption and saving fall. When income tax falls, consumption and saving rise. 3. Age: In an older population, consumption falls and saving rises. In a younger population, consumption rises and saving falls. 4. Family size or population: If the family is small, then consumption is low and saving is high. If the family is large, then consumption is high and saving is low. 5. Range of goods and services: When there is a wide range of goods and services in the market, consumption is high and saving is low. But, when there is a narrow range of goods and services, consumption is low and saving is high. 6. Interest rate: When the rate of interest is high, consumption is low and saving is high. But, when the rate of interest is low, consumption is high and saving is low. 7. Availability of credit: If credit is easily available, consumption is high and saving is low. If credit is not easily available, consumption is low and saving is high. 8. Expectations regarding an increase in future income: If people expect an increase in income, consumption rises and saving falls. If people expect a decrease in income, consumption falls and saving rises. 9. Price level: If the price levels falls, consumption rises and saving falls. If the price level rises, consumption falls and saving rises. However, if the price level is expected to rise further in the future, then current consumption rises and saving falls more rapidly. Determinants of Investment: 1. Technology: Technological progress leads to an increase in investment. Technological regress leads to a decrease in investment.

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Aggregate Demand (AD) and Aggregate Supply (AS)

2. Cost of capital: If there is a decrease in the cost of capital, investment rises. If there is an increase in the cost of capital, investment falls. 3. Corporation tax: If there is a decrease in corporation tax, investment rises. If there is an increase in corporation tax, investment falls. 4. Subsidies: An increase in subsidies causes investment to rise. A decrease in subsidies causes investment to fall. 5. Profits: An increase in profits leads to a rise in investment. A decrease in profits leads to a fall in investment. 6. Infrastructure: An improvement in infrastructure causes investment to rise. A worsening of infrastructure causes investment to fall. 7. Political stability: Politically stability leads to an increase in investment. Political instability leads to a fall in investment. 8. Law and order: A lower crime rate and strong legal institutions will lead to an increase in investment. High crime rates and weak legal institutions will lead to a decrease in investment. 9. Business expectations: High business confidence leads to an increase in investment. Low business confidence leads to a decrease in investment. 10. Foreign relations: Good foreign relations lead to an increase in investment. Bad foreign relations lead to a decrease in investment. 11. Interest rate: If the interest rate is low, investment is high. If the interest rate is high, investment is low. 12. Demand for consumer goods: An increase in demand for consumer goods leads to greater production, which, in turn, requires more machinery (an increase in investment). Similarly, a decrease in demand for consumer goods will lead to a decrease in investment. Determinants of Government Spending: 1. Political objectives: Political seasons also affect government spending. Before elections government spending is high but after elections government spending is low. 2. Level of economic activity: Economic conditions are also an important factor. During recession government spending rises whereas during boom government spending falls. 3. Social objectives: Government may spend more to eradicate poverty and for more equitable distribution of income. 4. Need for merit and public goods: Need for merit goods such as education, healthcare, and public goods like street lights, etc. Determinants of Exports and Imports: 1. Foreign income: If foreign income rises, exports will also rise whereas if foreign income falls, exports will also fall. 2. Domestic income: If domestic income rises, imports will also rise and when domestic income falls, imports will also fall. 3. Relative quality: If quality of imports is better than the quality of locally produced goods then imports will rise but if the quality of local goods is better than the imported goods than imports will fall. If quality of local goods is better than the quality of imported goods than exports rises but if quality of local goods is worse than the imported goods than exports fall. 4. Tariff or duties (protectionism): If tariff applied on imports increases imports will fall but if tariff applied on imports decrease than imports will rise. If tariff imposed on our exports by other countries increase than exports will fall but if tariff imposed on our exports by other countries decrease than exports will rise. 5. Exchange rate: If a currency depreciates, imports get expensive and exports become cheaper which leads to a rise in exports and a fall in imports. On the other hand if a currency appreciates, exports become expensive and imports become cheaper which leads to a rise in imports and a fall in exports.

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Aggregate Demand (AD) and Aggregate Supply (AS)

Aggregate supply (AS) Aggregate supply (AS) is the total output (real GDP) that producers in an economy are willing and able to supply at a given price level in a given time period. Regarding aggregate supply (AS), economists sometimes distinguish between short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS).

The short-run aggregate supply curve

General Price Level

Short-run aggregate supply (SRAS): the total output of an economy that will be supplied when there has not been enough time for the prices of factors of production to change. The short-run aggregate supply curve slopes up from left to right as shown in Figure below.

SRAS b

P1 P0

Y0 Y1

Real GDP

As the price level rises, producers are willing and able to supply more goods and services. There are three possible reasons for this positive relationship: The profit effect

The cost effect

The misinterpretation effect

As the price level ↑ → wages do not change → gap between output and input prices ↑ → profit ↑→ AS↑

Although the wage rates and raw material costs remain unchanged in the short run, average costs may rise as output increases. This is because, for example, overtime payments may have to be paid and costs will be involved in recruiting more members. To cover any extra costs that may be involved in producing a higher output, producers will require higher prices → AS↑

Producers may confuse changes in the price level with changes in relative prices. They may think that a rise in the price they receive for their products indicates that their own product is becoming more popular. As a result they may be encouraged to produce more → AS↑

Shifts in the Short-run Aggregate Supply curve While a change in the price level will cause a movement along the short-run aggregate supply curve, there are four main causes of a shift in the SRAS curve. These are: 1. A change in the price of factors or cost of production: A rise in wage rates, not matched by an increase in labor productivity, and raw material costs will cause a decrease in SRAS, shifting the curve to the left as illustrated in figure below. 2. A change in taxes on firms: A reduction in corporation tax or indirect taxes will cause an increase in SRAS. 3. A change in factor productivity/quality of resources: A rise in labor productivity and/or capital productivity will cause an increase in aggregate supply both in the short run and long run.

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Aggregate Demand (AD) and Aggregate Supply (AS)

General Price Level

4. A change in the quantity of resources: In the short run the supply of inputs may be influenced by supply-side shocks, including natural disasters. Any change in quantity of resources will cause a change in aggregate supply both in the short run and long run.

SRAS 2 SRAS0 SRAS1 Fall Rise

Real GDP

The shape of the long-run aggregate supply curve The long-run aggregate supply curve shows the relationship between real GDP and changes in the price level when there has been time for input prices to adjust to changes in aggregate demand. Keynesians are the followers of the economist John Maynard Keynes who maintain that government intervention is needed to achieve full employment. New classical economists are the economists who think that the LRAS curve is vertical and that the economy will move towards full employment without government intervention.

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Aggregate Demand (AD) and Aggregate Supply (AS)

Keynesian LRAS

New classical LRAS

Initially it is perfectly elastic at low rates of output, then upward sloping over a range of output and finally perfectly inelastic Believe that in the long run, an economy can operate at any level of output and not necessarily at full capacity In order to understand the true nature of the Keynesian long run aggregate supply curve, we have to examine three situations: (1) excess capacity, (2) full capacity, and (3) an intermediate range between the two. LRAS

AS0

b P1 a

General Price Level

AS 1

General Price Level

AS 2

Intermediate range (limited excess capacity only)

No excess capacity

P0 Excess capacity

Real GDP

Excess capacity

Intermediate range

When output and employment are low, firms can attract more resources and increase output without there being any pressure on prices. For example, when unemployment is high, the offer of a job may be sufficient to attract new workers. Hence, aggregate supply curve to be a horizontal line.

When there is some excess → shortages of inputs→ cost ↑ → firms react by raising their prices whenever they can. Hence, aggregate supply curve in this situation will be upward.

Real GDP

YF Real GDP

No excess capacity If absolutely no excess capacity → at full employment → at its production possibility curve → impossible to produce additional output → AS curve → vertical line → only the price level rises → perfectly inelastic. It is also a representation of long-run aggregate supply (LRAS)

Figure on right above shows that from O to Y1, output can be raised without increasing the price level. There is time for input prices to change but, due to the low level of aggregate demand, they do not. As output rises from Y1 to YF firms begin to experience shortages of inputs and bid up wages, raw material prices and the price of capital equipment. When output reaches YF, the economy is producing the maximum output it can make with existing resources.

Vertical Believe that in the long run the economy will operate at full capacity only

Unit 1

Aggregate Demand (AD) and Aggregate Supply (AS)

Shifts in the LRAS curve Both Keynesian and new classical economists agree that the causes of a shift in the LRAS curve are a change in the quantity and/or quality of resources (factor productivity). Both of these will increase the productive potential of an economy. The causes of an increase in the quantity of resources in the long run are: 1. A Change in the Quantity of Resources Land: Land may increase because of:  Discovery of oil, metal or mineral reserves by active search.  Eroded, water-logged land may be made usable for agricultural purposes (Reclamation of land) Labour: Labor may increase by:  Increase in total population, especially in the working population.  Change in structure of population from less dependent population to more working population, even without an increase in total population.  Immigration is greater than emigration.  Increased women-participation in jobs.  Lower school-leaving age.  Higher retirement age. Capital:  Net investment  Rate of return on Capital  Interest rate  Business optimism and pessimism  Government policies about taxation and subsidies  Political stability  Technology  Infrastructure Shifts in Keynesian LRAS

2. Change in Quality (Productivity) of Resources: Labour:  Wage rate  Education and training  Technology  Work conditions  Length of working hours  Fringe benefits\perks\non-monetary benefit\non-pecuniary benefits  Bonuses and commissions  Promotional opportunities  Health Capital:  Technology  Skilled labor  Depreciation, etc. Land:  Technology  Skilled labor  Fertility rates, etc. Entrepreneurship:  Communication  Management techniques, etc.

Shifts in New classical LRAS

Price Level

Fall Rise

LRAS1 LRAS0 LRAS2

General Price Level

LRAS2 LRAS0 LRAS1

Fall

Real GDP

Rise

Real GDP

Unit 1

Aggregate Demand (AD) and Aggregate Supply (AS)

Factors that shift both AD and AS:   

investment net immigration government spending on education

Interaction of aggregate demand and aggregate supply and national income equilibrium The equilibrium level of output or national income and the price level are determined where aggregate demand is equal to aggregate supply. The macroeconomic equilibrium is illustrated by the point where the AD and AS curves intersect, as shown in the diagram below.

Price level

AD o

Real GDP

If the price level was initially below P0, the excess demand would push the price level back up to the equilibrium level. If the price level was above P 0, some goods and services would not be sold and firms would have to cut their prices.

Changes in national income equilibrium Changes in aggregate demand and aggregate supply will move the economy to a new macroeconomic position. Where that position will be will depend on the    

cause of change, i.e., AD or AS direction of the change size of the change initial level of economic activity

Unit 1

Aggregate Demand (AD) and Aggregate Supply (AS)

Shifts in AD

Shifts in AS

a. Rise in AD (Demand-pull inflation)

a. Rise in SRAS (Supply-side policies)

Price level AS P5

Price level

AS 0 E0

P3 P2 P0

AS1

AD5 AD4 AD0 AD1 Y0

AD0

AD3 AD2 Y 2 Y 3 YF

Real GDP

o If the aggregate demand curve intersects the aggregate supply curve prior to output rate Y1, then any increase in demand will not lead to a rise in the price level. Thus a shift from AD0 to AD1 leaves the price level unaltered at P0. A shift from AD1 to AD2, however, will cause the price level to increase P1. After output rate Y2, any increase in demand will simply result in a higher price level since, by definition, at full capacity output no more output is physically possible.

b. Fall in AD (Deflation) A fall in AD will lead to fall in general price level (deflation) if economy is at or close to fullemployment. Effect of fall in AD on price level and GDP depends upon initial position of the economy.

GDP

An increase in aggregate supply (AS) will shift AS from AS0 to AS1 causing the price level to fall from P0 to P1 and GDP increases from Y0 to Y1.

b. Fall in SRAS (Cost-push inflation) A decrease in aggregate supply (AS) will shift AS from AS0 to AS1 causing price level to rise (costpush inflation) from P0 to P1 and GDP decreases from Y0 to Y1. Price level

AS 1

AS0

E1 E0

AD0

GDP

If both AD and AS shift together then effect on price level and GDP will depend upon relative size of shifts in AD and AS.

Unit 1

Aggregate Demand (AD) and Aggregate Supply (AS)

Business (Trade) Cycle The term trade cycle is defined as the periodic fluctuation of national output around its long term trend. It is used to describe the tendency for the volume of economic activity (GNP) such as employment, profits and prices to proceed in a succession of booms and slumps (also called troughs) as shown in diagram below. Real GDP Actual output Trend growth in potential output

Boom b

Re ce

s si on

Recovery

Slump a

Time

Economic activity refers to the level of output, foreign trade, investment, share prices, employment and consumer spending. The different phases of the trade cycle are labeled as a, b, and c. Booms and recessions can last for several months or even years and then come to an end. No two trade cycles are quite the same. The interval between the peaks or between the troughs (which is also called the duration of a trade cycle) is not constant, and the intensity of the troughs varies, trade cycles show a rough pattern over time and display unpredictable deviations from the expected pattern. Stages of the trade cycle The trade cycle consists of four phases: boom (point b), recession (point H between b and c), trough (point a or c), and recovery (between a and b). Recovery follows a recession, then reaches a peak/boom and is succeeded by another recession. The length of a business cycle is measured by the interval between the peaks (or between any other pair of corresponding points). Some economists argue that the cycles are brought about by new inventions, population growth, mineral or oil discoveries, political factors, and war. The cycles tell us about the behavior of the economy as a whole. Features Business pessimism Business optimism Investment AD GDP Employment Demand-pull inflation Current account

Boom Lowest Highest Highest Highest Highest Highest Highest Deficit

Recession Rises Falls Falls Falls Falls Falls Falls Improves

Slump Highest Lowest Lowest Lowest Lowest Lowest Lowest Surplus

Recovery Falls Rises Rises Rises Rises Rises Rises Worsen

Boom is a period when business activity is expanding, i.e., production increases, prices and wages rise, profits increase, unemployment declines and the current account is in deficit. This phase is characterized by high output, low unemployment, high inflation and a deficit current account.

Unit 1

Aggregate Demand (AD) and Aggregate Supply (AS)

Recession is a temporary falling off in business activity which may or may not develop into a trough. During a recession, the rate of inflation falls, exports will rise and imports fall; consequently, the balance of payments improves, consumption and investment are low and interest rates charged by banks are also low. In brief, this phase is characterized by low output, high unemployment, low inflation and a surplus current account. Trough is when business activity is at the bottom. In the recovery phase of the trade cycle, an attempt is made by the government to expand the economy either by monetary means (e.g., encouraging banks to increase their lending) or fiscal measures (e.g., cutting taxes). This phase is marked by a rapid rate of economic growth due to government policies such as easing of credit restrictions to encourage expansion of production and a reduction in cyclical unemployment. During this phase of the trade cycle, prices will rise, total transactions will increase and the national income will rise as well. Recovery may develop into a boom.

Unit 1

Aggregate Demand (AD) and Aggregate Supply (AS)

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