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YOUR NOTES
IB Economics SL 

3. Macroeconomics

CONTENTS
3.1 Measuring Economic Activity
3.1.1 National Income & The Circular Flow of Income
3.1.2 National Income Terminology & Calculations
3.1.3 The Business Cycle
3.1.4 Appropriateness of Using GDP/GNI to Measure Well-being
3.1.5 Alternative Measures of Well-Being
3.2 Variations in Economic Activity (AD & AS)
3.2.1 Aggregate Demand (AD)
3.2.2 Short-Run Aggregate Supply (SRAS)
3.2.3 Alternative Views of Aggregate Supply (AS)
3.2.4 Shifts of the Long-Run Aggregate Supply (LRAS)
3.2.5 Macroeconomic Equilibrium
3.3 Macroeconomic Objectives
3.3.1 An Introduction to Macroeconomic Objectives
3.3.2 Economic Growth
3.3.3 Low Unemployment
3.3.4 Low & Stable Rate of Inflation
3.3.5 Potential Conflicts Between Macroeconomic Objectives
3.4 Inequality & Poverty
3.4.1 Measuring Inequality & Poverty
3.4.2 Causes of Inequality & Poverty
3.4.3 Using Taxation to Reduce Inequality & Poverty
3.4.4 Other Policies to Reduce Inequality & Poverty
3.5 Demand Management: Monetary Policy
3.5.1 An Overview of Monetary Policy
3.6 Demand Management: Fiscal Policy
3.6.1 An Overview of Fiscal Policy
3.7 Supply-Side Policies
3.7.1 An Overview of Supply-Side Policies
3.7.2 The Effectiveness of Supply-Side Policies

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3.1 Measuring Economic Activity YOUR NOTES


3.1.1 National Income & The Circular Flow of Income

An Introduction to National Income

National income accounting measures the economic activity within a country and
provides insights into how a country is performing
One of the main methods to determine economic activity is to measure the rate of change
of output in an economy
The output of an economy is called gross domestic product (GDP)
Nominal GDP is the value of all goods/services produced in an economy in a one-year
period

The circular flow of income model is used to illustrate national income and the flow of
money, resources and goods in an economy

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The Circular Flow of Income Model YOUR NOTES

Money can enter or leave the circular flow of income in an economy 

Injections add money to the circular flow of income and increase its size
Increased government spending (G)
Increased investment (I)
Increased exports (X)

Leakages (withdrawals) remove money from the circular flow of income and reduce its
size
Increased savings by households (S)
Increased taxation by the government (T)
Increased import purchases (M)

There are high levels of interdependence between households, firms, the government, the
financial sector, and the foreign sector (foreign firms and households)

A diagram that shows the injections and leakages that influence the relative size of the
circular flow of income

Diagram Analysis
Government: Government spending (G) is an injection and taxation (T) is a leakage
Financial sector: Investment (I) is an injection and savings (S) is a leakage
Foreign sector: Exports (X) is an injection and imports (M) is a leakage

The relative size of the injections and withdrawals impacts the size of the economy:
Injections > withdrawals = economic growth and increase in national income

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Withdrawals > injections = economic decline and a fall in national income YOUR NOTES

Changes to any of the factors that influence government spending, investment,
consumption and net exports will increase/decrease the relative size of the circular flow of
income
E.g. An increase in interest rates will increase savings (withdrawal), and reduce
consumption and investment

 Exam Tip
Remember to consider the net effect and proportionality of the injections and
withdrawals. For example if the size of the government spending is large, it is likely to
completely outweigh the combined withdrawals of savings and imports.

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Three Approaches to the Calculation of National Income YOUR NOTES

With reference to the circular flow of income model, national income can be calculated 
using three possible approaches

Expenditure, income and output can be illustrated in the circular flow of income model

1. The expenditure approach

This approach adds up the value of all the expenditures in the economy in a year and
includes consumption (C), government spending (G), investment (I) by firms and net
exports (X - M)
Nominal GDP = C + I + G + (X-M)

2. The income approach

This approach adds up the payments (rewards) for the factors of production in a year
and includes the wages from labour (W), rent from land (R), interest from capital (I) and
profit from entrepreneurship (P)
National Income = W + R + I + P

3. The output approach

This approach adds up the value of all finished goods/services produced within the
economy each year (national output)

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All approaches should provide the same figure YOUR NOTES

One agent's expenditure is another agent's income 
The value of finished goods ready for sale is equal to the expenditure paid to acquire
them

The value of GDP is different to the volume of GDP

The value is the monetary worth
The volume is the physical number

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Calculating Nominal GDP Using the Expenditure Approach YOUR NOTES

Nominal GDP can be calculated using the value of the expenditure in an economy 
GDP = Consumption (C) + Investment (I) + Government spending (G) + Exports (X) -
Imports (M)
GDP = C + I + G + (X-M)
If any of the components of GDP increase, then economic growth is likely to occur

The components
Consumption is the total spending on goods/services by consumers (households) in an
economy
Investment is the total spending on capital goods by firms
Government spending is the total spending by the government in the economy
Includes public sector salaries, payments for the provision of merit and public goods
etc.
It does not include transfer payments
Net exports are the difference between the revenue gained from selling goods/services
abroad and the expenditure on goods/services from abroad

 Worked Example
The table provides national income data for Vietnam in 2019 - presented in US$.
Calculate the nominal GDP using the expenditure method [2]

Value in US$
Category
millions

Consumption 11255
Investment 8927
Income tax 59577
Government
15697
spending
Imports 4957
Exports 8532

Step 1: Determine which of the data presented is relevant to the calculation

GDP = C + I + G + (X-M)
So income tax is not relevant (it is a leakage)

Step 2: Substitute the relevant values into the formula

GDP = C + I + G + (X-M)
GDP = 11255 + 8927 + 15697 + (8532 - 4957)

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Nominal GDP = 39,454 $m YOUR NOTES



(Two marks for the correct answer or 1 mark for any correct work in the process)

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3.1.2 National Income Terminology & Calculations YOUR NOTES


Nominal Gross National Income (GNI)
Nominal GDP measures the value of production within a country's borders
However, many countries host multi-national corporations whose profits are included
in the GDP figures, even though they usually send their profits out of the country
Likewise, citizens of a home nation make profits in other countries (included in their
GDP statistics) and return these profits home (Remittances can be a significant
income source for many developing nations)

Gross national income (GNI) is therefore a more relevant metric in that it measures the
nominal GDP + the net factor income earned from abroad

 Worked Example
The table provides national income data for Vietnam in 2019 - presented in US$.
Calculate the nominal GNI [3]

Value in US$
Category
millions

Consumption 11255
Investment 8927
Income tax 59577
Government
15697
spending
Imports 4957
Exports 8532
Net Income 4349

Step 1: Determine which of the data presented is relevant to the calculation

GDP = C + I = G = (X-M)
GNI = GDP + Net Income
So income tax is not relevant (it is a leakage)

Step 2: Substitute the relevant values into the GDP formula

GDP = C + I + G + (X-M)
GDP = 11255 + 8927 + 15697 + (8532 - 4957)
Nominal GDP = $39,454 million

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Step 3: Substitute the relevant values into the GNI formula YOUR NOTES
GNI = GDP + Net Income 

GNI = 39,454 + 4349

GNI = $43,803 million
(3 Marks for the correct answer or two marks for the correct GDP or 1 mark for any correct
working in the process)

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Real GDP & GNI YOUR NOTES

In economics, the use of the word nominal refers to the fact that the metric has not been 
adjusted for inflation
Nominal GDP is the actual value of all goods/services produced in an economy in a one-
year period
There has been no adjustment to the amount based on the increase in price levels
(inflation)

Real GDP and GNI is the value of all goods/services produced in an economy in a one-
year period - and adjusted for inflation
For example, if nominal GDP is £100bn and inflation is 10% then real GDP is £90bn

Real GDP and GNI are often calculated using a price deflator known as the GDP deflator
The GDP deflator is used to convert nominal GDP/GNI from current prices to constant
prices

Nominal GDP
Real GDP = x 100
GDP Deflator

Real GNI = Real GDP + Net income from abroad

 Worked Example
Calculate the real GDP in 2020 and 2021 using the figures in the table below [4]
Nominal GDP ($
Year GDP deflator
Billion)
2020 114 102.7
2021 129 98.8

Step 1: Substitute the values from 2020 into the equation

Nominal GDP
Real GDP = x 100
GDP Deflator

114
Real GDP = x 100
102 . 7

Real GDP 2020 = $ 111 Billion

(Two marks for the correct answer or 1 mark for any correct working in the process.
Answer needs to be rounded to 2 decimal places where appropriate)

Step 2: Substitute the values from 2021 into the equation

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Real GDP =
Nominal GDP
x 100 YOUR NOTES
GDP Deflator

129
Real GDP = x 100
98 . 8

Real GDP 2021 = $ 130 . 57 Billion

(Two marks for the correct answer or 1 mark for any correct working in the process.
Answer needs to be rounded to 2 decimal places where appropriate)

Real GDP/Capita & GNI/Capita

Real GDP per capita = Real GDP / the population
It shows the mean wealth of each citizen in a country based on the value of GDP
This makes it easier to compare standards of living between countries
E.g. Switzerland has a much higher Real GDP/capita than Burundi
If a country has a real GDP value of $124 billion and its population is 42 million, we can
calculate the real GDP/capita as follows

Real GDP
Real GDP Per Capita =
Population

$ 124 bn
Real GDP Per Capita =
42million

Real GDP Per Capita = $ 2,952 . 38

Real GNI per capita = Real GNI / the population

It shows the mean wealth of each citizen in a country based on the value of GNI
It provides a better comparison of the standards of living between countries than real
GDP/capita
If a country has a real GNI value of $129 billion and its population is 42 million, we can
calculate the real GNI/capita as follows
Real GNI
Real GNI Per Capita =
Population

$ 129 bn
Real GNI Per Capita =
42million

Real GNI Per Capita = $ 3,071 . 43

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Real GDP/Capita & GNI/Capita at Purchasing Power Parity (PPP) YOUR NOTES
Purchasing power parity (PPP) is a conversion factor that can be applied to GDP and GNI 
It calculates the relative purchasing power of different currencies
It shows the number of units of a country's currency that are required to buy a
product in the local economy, as $1 would buy the same product in the USA
The aim of PPP is to help make a more accurate standard of living comparison between
countries where goods/services cost different amounts

If a basket of goods costs $150 in Vietnam (once the currency has been converted) and
the same basket of goods costs $450 in the USA, the purchasing power parity would be
1:3
It seems like the cost of living is much higher in the USA
However, if the USA's GNI/capita is more than three times higher than the GNI/capita
of Vietnam, it could be argued the USA has better standards of living
Conversely, if the GNI/capita in the USA was less than three times that of Vietnam, it
could be argued that Vietnamese citizens enjoy a higher standard of living as they
spend less income to acquire the same goods/services

 Exam Tip
When an exam question uses the phrase 'at constant prices' it is referring to real
GDP. For example, a question may read, 'Explain what is meant by a rise in GDP at
constant prices'. This requires you to define real GDP and then explain the rise.

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3.1.3 The Business Cycle YOUR NOTES


The Business Cycle
A business cycle refers to the changes in real GDP that occur in an economy over time
This is the actual growth
The real GDP will fluctuate above and below the long-term trend rate of growth
There are four recognisable points in the cycle
Peak/boom; slowdown/downturn; recession, recovery

The Business Cycle illustrates the fluctuations of real GDP (actual growth) around long-term
trend growth

Diagram Analysis
A positive output gap is identified as the growth of real GDP that is above the trend
A negative output gap is identified as the growth of GDP that is below the trend
There is often a natural flow through the different stages from boom to slowdown to
recession to recovery
This flow of real GDP can be moderated by government intervention
E.g. increasing taxes in a boom period or increasing spending in a recession

The Characteristics of a Boom and Recession

Characteristics of a Recession Characteristics of a Boom

A recession occurs when there are two or Increasing/high rates of economic growth
more consecutive quarters (6 months) of
negative economic growth

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YOUR NOTES
Increasing/high unemployment Decreasing unemployment and increasing
job vacancies 

Increasing negative output gap and spare Reduction of negative output gap or
production capacity creation of a positive gap. Spare capacity
is reduced or eliminated

Low confidence for firms/households High confidence and more risky decisions
taken

Low inflation Increasing rate of inflation - usually

demand pull

Increase in government expenditure An improvement in the government

perhaps leading to a great budget deficit budget as tax revenues rise and
expenditure falls

 Exam Tip
You will often be examined on the characteristics of the trade cycle. Remember to
demonstrate critical thinking around the assumptions of the model. For example,
some firms may thrive during a recession as consumers switch to purchasing
inferior goods (e.g. Lidl).
Additionally, the components of aggregate demand do not rise/fall at the same rate.
For example, during recovery, consumption may increase well ahead of investment
by firms.
An economy may also experience some fundamental restructuring during a
prolonged recession and the composition of real GDP growth may be significantly
different to what is was before the recession.

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3.1.4 Appropriateness of Using GDP/GNI to Measure Well-being YOUR NOTES


Using National Income Statistics to Measure Well-being
National income statistics are useful for making comparisons between countries
They provide insights into the effectiveness of government policies
They allow judgments to be made about the relative wealth and standard of living
within each country
They allow comparisons to be made over the same or different time periods
For example, the growth of the Asian Economies in the last 15 years can be
compared to the growth of the European Economies in the 1990s

Using real GDP is a better comparison than nominal GDP

One country may have a much higher rate of economic growth, but also a much higher
rate of inflation. Real GDP provides a better comparison
Using real GDP/Capita provides better information than real GDP as it takes population
differences into account
Using real GNI/capita is a more realistic metric for analysing the income available per
person than GDP/capita
Using real GNP/capita provides information on the income that is actually within a
country's borders
This value can be significantly different from GDP/Capita

 Exam Tip
When studying national income data that has been provided for data response
questions, you will often see a generalised pattern emerge
Developed countries will have a smaller gap between their GNI and GDP
Developing countries often have a higher GDP than GNI - as much as 6%
The reason for this is usually linked to multinational companies involved in resource
extraction, who then send income/profits home

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Making Comparisons Between Countries and Over Time YOUR NOTES

The Limitations of Using GDP data to Compare Living Standards Between Countries and 
over time

Explanation
Limitation

Lack of information The distribution of income in an economy is provided as an

provided average (GDP/capita)
on inequality The differences in the standard of living within the same country
can be significant

Quality of GDP provides no information on the increase/decrease in the

goods/services quality of goods/services over time
If quality worsens but prices are lower, then the standard of
living is judged to have increased
The poor quality may actually have decreased the standard of
living

Does not include If it included voluntary/unpaid work, then GDP/capita would be

unpaid/voluntary work higher
E.g. some economies have a high amount of family childcare
provision. This increases standards of living but is not recorded
in any way

Differences in hours GDP data does not capture the amount of time taken to
worked produce the GDP/capita
In one country, where it takes less time to generate income than
in a similar country, the standard of living would actually be
higher

Environmental factors GDP does not capture the environmental and health impacts of
generating income within a country (externalities)
In one country, where there are fewer externalities in generating
income the standard of living would be higher

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3.1.5 Alternative Measures of Well-Being YOUR NOTES


Alternative Measures of Well-being
Due to the limitations of using national income statistics to measure well-being and
compare standards of living, alternative measures of well-being have been developed.
These include:
1. The OECD Better Life Index
2. The Happiness Index
3. The Happy Planet Index
While GDP focusses on production, happiness focuses on health, relationships, the
environment, education, satisfaction at work and living conditions
National incomes statistics tend to present more positive data while national happiness
surveys yield more normative data
There is a link between income and happiness and the Easterlin Paradox is often used to
explain it. The paradox states that:
Happiness and increases in income have a direct relationship up to a point
Beyond that point, the relationship is less evident

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OECD Better Life Index YOUR NOTES

The Organisation for Economic and Cultural Development (OECD) has created an index 
which aims to measure the well-being of citizens in its 38 member countries
The Better Life Index has 11 variables which it considers essential to the well-being
Countries are rated on each variable and then comparisons can be made

The Eleven Variables of the OECD Better Life Index

Variable Explanation

Housing This considers living conditions and the proportion of

household expenditure spent on housing

Income This considers the net income and net wealth of households

Jobs This considers job security, the average earnings of the

country and the unemployment rate

Community This considers the social support networks that exist in the
economy

Education This considers the quality of the education with a focus on

educational attainment and skills

Environment This considers the environmental health with a focus on air

pollution and water quality

Civic Engagement This considers voter turnout and community involvement in

creating legislation (laws)

Health This considers the quality of health with a focus on life

expectancy and data from self reported health surveys

Life satisfaction This considers the overall satisfaction that people have with
their lives

Safety This considers how safe people feel walking alone at night,
together with the murder rate in the country

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Work-life balance This considers the percentage of employees who work long
YOUR NOTES
hours, together with the amount of time given to leisure and 
personal care

Happy Planet Index

The Happy Planet Index (HPI) attempts to measure sustainable wellbeing
Countries are ranked by how efficiently they deliver long, happy lives using the earth's
scarce resources in a sustainable way
The HPI scores countries with a lower ecological footprint higher countries with more
environmental degradation
The HPI measures a country's progress using three variables
Wellbeing
Life expectancy
Ecological footprint

wellbeing × life expectancy

HPI Score =
ecological footprint

The top 3 and bottom 3 countries on the HPI in December 2022 (Source: Happy Planet Index)

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The Happiness Index YOUR NOTES

The Happiness Index is a survey that measures happiness in 10 different areas of a persons 
life
1. Psychological Well-Being
Optimism, sense of purpose/accomplishment
2. Health
Energy levels and ability to perform everyday activities
3. Time Balance
Enjoyment, sense of leisure, frequency of feeling rushed
4. Community
Sense of belonging, volunteer levels, sense of safety in the community
5. Social Support
Satisfaction with friends and family, feeling loved, and degree of loneliness
6. Education, Arts, and Culture
Access to cultural and educational events and diversity
7. Environment
Access to nature, pollution levels, and level of conservation
8. Governance
Trust in government, sense of corruption, and competency of authorities
9. Material Well-Being
Financial security and meeting basic needs
10. Work
Compensation, autonomy, and productivity
(Source: The Happiness Index)

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3.2 Variations in Economic Activity (AD & AS) YOUR NOTES


3.2.1 Aggregate Demand (AD)

An Introduction to AD
Aggregate demand (AD) is the total demand for all goods/services in an economy at any
given average price level

Its value is often calculated using the expenditure approach

AD = Consumption (C) + Investment (I) + Government spending (G) + (Exports-
Imports) (X-M)
AD = C + I + G + (X-M)

If AD increases then economic growth has occurred and vice versa

Consumption is the total spending on goods/services by consumers (households) in an

economy
Investment is the total spending on capital goods by firms
Government spending is the total spending by the government in the economy:
Includes public sector salaries, payments for the provision of merit and public goods
etc.
It does not include transfer payments
Net exports are the difference between the revenue gained from selling goods/services
abroad and the expenditure on goods/services from abroad
Individuals, firms and governments export/import

The relative importance of the components of AD

Depending on the country, the value of each component and its contribution to AD can
vary significantly:
Government spending in Sweden is 53% of AD and in the UK, it is 25% of AD

The % that each component contributes to AD in the UK is approximately

Consumption: 60%
Investment: 14%
Government spending: 25%
Net Exports: 1%

A 1 % increase in consumption or government spending will have a much larger impact on

economic growth than a 1% increase in net exports

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The AD Curve YOUR NOTES

The relationship between the average price level and the total output in an economy is 
shown with an aggregate demand (AD) curve

The aggregate demand (AD) curve for an economy with Average Price Level on the Y axis and
Real GDP on the X axis
The AD curve is downward sloping
With lower average price levels there is greater aggregate demand
With higher average price levels there is less aggregate demand

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A Movement Along the AD Curve YOUR NOTES

Whenever there is a change in the average price level (AP) in an economy, there is a 
movement along the aggregate demand (AD) curve

An increase or decrease in the average price level (AP) causes a movement along the
aggregate demand (AD) curve leading to a contraction or expansion of AD
Diagram Analysis
An increase in the AP (ceteris paribus) from AP1 → AP2 leads to a movement along the AD
curve from A → B
There is a contraction of real GDP from Y1 → Y2
Y is the symbol used in macroeconomics to denote national income or real GDP

A decrease in the AP (ceteris paribus) from AP1 → AP3 leads to a movement along the AD
curve from A → C
There is an expansion of real GDP (output) from Y1 → Y3

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Shifts of the Entire AD Curve YOUR NOTES

Whenever there is a change in any of the non-price determinants of aggregate demand 
(AD) in an economy, there is a shift of the entire AD curve

A shift in the entire aggregate demand (AD) curve occurs when there is a change in one of the
determinants of AD
Diagram Analysis
An increase in any one of the non-price determinants of aggregate demand (AD) results in
a shift right of the entire curve from AD1 → AD2
At every price level, real GDP has increased from Y1 → Y2

A decrease in any one of the non-price determinants of AD results in a shift left of the entire
curve from AD1 → AD3
At every price level, real GDP has decreased from Y1 → Y3

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Factors that Influence each Component of AD YOUR NOTES

Each component of AD is influenced by numerous factors 
A change to any of these factors will potentially change AD

Consumption is influenced by changes to consumer confidence, interest rates, wealth,

income taxes, level of household indebtedness, and expectations of future price level
Investment is influenced by changes to interest rates, business confidence, technology,
business taxes, and the level of corporate indebtedness
Government spending is influenced by changes to political and economic priorities
Net exports are influenced by changes to the income of trading partners, exchange rates,
and trade policies

Factors that Influence Consumption

Component Influence on the Explanation

component

Consumption Consumer The stronger the economy, the higher

confidence consumer confidence
Consumers feel secure in their jobs and
are confident of receiving regular salary
payments
Consumption increases and saving
decreases
In a weakening or recessionary economy,
consumer confidence falls
Consumers feel less secure in their jobs
Consumption decreases and saving
increases

Interest rates A change in the base interest rates will

change the level of consumer spending and
savings
If interest rates increase there is a greater
incentive to save
More saving = less consumption
If interest rates increase, the monthly
repayment on any loan or mortgage
increases
Higher loan repayments = less
consumption

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Wealth If consumer wealth increases, then

YOUR NOTES
consumption usually increases 
Rising property prices or share prices give
consumers confidence to borrow more
money
Increased borrowing = increased
consumption

Income taxes Disposable income is the money that

households have left from their
salary/wages after they have paid their
taxes and have received any transfer
payments/benefits
If taxes increase, then disposable income
decreases - and vice versa

Level of household Debt is usually repaid with monthly

indebtedness payments
The higher the level of debt, the higher the
monthly repayment and the less money
available for new consumption

Expectations of If consumers believe prices will rise in the

future price level future, they are incentivised to consume now
- and vice versa

Factors that Influence Investment

Component Influence on the Explanation

component

Investment Interest rates Most investment by firms is financed through

business loans
Decreasing interest rates encourage
investment
There is a mostly inverse relationship
between investment and interest rates

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Business Firms will choose to invest if they feel

YOUR NOTES
confidence confident that they will make a good return 
on their investment
The decision to invest is linked to the
business objective of profit
maximisation
The longer a period of economic growth, the
higher the business confidence will be
If growth slows, future expectations of
profits will decrease and investment
decisions become harder

Technology When a firm identifies new technology which

will reduce costs and raise output, they are
incentivised to invest

Business taxes When governments raise business taxes it

reduces the profits of firms
Lower profits mean there is less money
available for investment

Level of corporate Corporate debt is usually repaid with

indebtedness monthly payments
The higher the level of debt, the higher the
monthly repayment and the less money
available for new investment

Factors that Influence Government Spending

Component Influence on the Explanation

component

Government Political priorities Governing parties have different political

spending priorities which influence spending
Some parties believe the state should
provide more goods/services and spending
increases
Other parties believe the role of government
in society should be smaller and spending
decreases

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Economic priorities Fiscal Policy is set once a year and

YOUR NOTES
announced during the presentation of the 
Government's budget
Expenditure is directly related to the
Government's objectives and policy aims
E.g., A policy aimed at upgrading a
country's rail network requires
increased expenditure

Factors that Influence Net Exports

Component Influence on the Explanation

component

(Exports - Income of trading When the household income of trading

Imports) partners partners increases, foreigners purchase
more products - exports increase
When the household income of trading
partners decreases, foreigners purchase
fewer products - exports decrease

Exchange rates When the domestic currency appreciates,

consumers' money goes further abroad -
imports increase
When the domestic currency appreciates,
exports are more expensive for foreigners -
exports decrease
When the domestic currency depreciates,
consumers' money goes less far abroad -
imports decrease
When the domestic currency depreciates,
exports are less expensive for foreigners -
exports increase

Trade policies If protectionism increases there is

decreased demand for imports as they are
more expensive
If protectionism decreases there is
increased demand for imports as they are
less expensive - and exports usually increase
due to free trade

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3.2.2 Short-Run Aggregate Supply (SRAS) YOUR NOTES


The SRAS Curve
Aggregate supply is the total supply of goods/services produced within an economy at a
specific price level at a given time
The short run is a period in which wages and other factor prices are inflexible
The long run is a period in which there is full wage and factor price flexibility

A diagram showing the upward sloping short run aggregate supply (SRAS) curve for an
economy
The AS curve is upward sloping due to two reasons
The aggregate supply is the combined supply of all individual supply curves in an
economy which are also upward sloping
As real output increases, firms have to spend more to increase production e.g. wage
bills will increase
Increased costs result in higher average prices

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A Movement Along the SRAS Curve YOUR NOTES

Whenever there is a change in the average price level (AP) in an economy, there is a 
movement along the short run aggregate supply (SRAS) curve

An increase or decrease in the average price level (AP) causes a movement along the short
run aggregate supply (SRAS) curve leading to a contraction or expansion of the quantity
supplied

Diagram Analysis
An increase in the AP (ceteris paribus) from AP1 → AP2 leads to a movement along the
SRAS curve from A → B
There is an expansion of real GDP from Y1 → Y2
Y is the symbol used in macroeconomics to denote national income or real GDP
A decrease in the AP (ceteris paribus) from AP1 → AP3 leads to a movement along the SRAS
curve from A → C
There is a contraction of real GDP (output) from Y1→Y3

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Shifts of the Entire SRAS Curve YOUR NOTES

Whenever there is a change in the non-price determinants of supply in an economy (e.g. 
costs of production or productivity changes), there is a shift of the entire SRAS curve

A shift in the entire short run aggregate supply (SRAS) curve occurs due to a change in one of
the non-price determinants of supply
Diagram Analysis
A decrease in costs or increase in productivity results in a shift right of the entire curve
from SRAS1 → SRAS2
At every price level, output and real GDP have increased from Y1 → Y2

An increase in costs or decrease in productivity results in a shift left of the entire curve
from SRAS1 → SRAS3
At every price level, output and real GDP have decreased from Y1 → Y3

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The Non-price Determinants of the SRAS Curve YOUR NOTES

There are two main factors that can influence the short-run aggregate supply (SRAS). 
They are
Changes in costs of raw materials and energy
Changes in indirect taxes

Explaining the Influences on Short-run Aggregate Supply (SRAS)

Change in Condition Explanation Impact on SRAS

Changes to the costs of As the price of input costs rise, SRAS decreases - shifts
raw materials/energy fewer goods/services can be left
produced with the same amount of
money

As the price of input costs SRAS increases - shifts

decrease, more goods/services right
can be produced with the same
amount of money

Factors which influence the input

costs include wage rates, interest
rates, government regulation and
exchange rates

Changes in indirect taxes Indirect taxes represent an SRAS increases - shifts

additional cost for firms right
Decreasing taxes = decrease in
costs
Lower costs = more output

Increasing taxes = increase in SRAS decreases - shifts

costs left
Higher costs = less output

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3.2.3 Alternative Views of Aggregate Supply (AS) YOUR NOTES


Monetarist/New Classical View of the Long-run Aggregate Supply
(LRAS) Curve
Classical and Keynesian economists have different views on the long-run aggregate
supply

Classical economists believe that the LRAS is perfectly inelastic (vertical) at a point of full
employment (YFE) of all available resources
This point corresponds to the maximum possible output on a production possibilities
curve (PPC)

The classical view believes that in the long-run an economy will always return to this full
employment level of output (YFE), and all that will change in the long run will be the
average price level
During extreme periods of economic growth there can be an inflationary gap that
develops
In the long run this will self-correct and return to the long-run level of output, but
at a higher average price level
During slowdowns or recessions there can be a recessionary gap that develops
In the long-run this will self-correct and return to the long-run level of output, but
at a lower average price level

The Classical View of long-run aggregate supply (LRAS) with a vertical aggregate supply
curve at the full employment level of output (YFE)

Diagram Analysis
Using all available factors of production, the long-term output of this economy (LRAS)
occurs at YFE
The economy is initially in equilibrium at the intersection of AD1 and LRAS (P1, YFE)
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A slowdown reduces output from AD1→AD2 and creates a short term recessionary gap YOUR NOTES
This self corrects in the long term and returns the economy to the long-run equilibrium at 
the intersection of AD2 and LRAS (P2, YFE) - a lower price and back to the full employment
level of output

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Keynesian View of the AS Curve YOUR NOTES

Keynes believed that the long-run aggregate supply curve (LRAS) was more L shaped, 
having 3 distinct sections
1. An elastic section in which supply is elastic at lower levels of output as there is a lot of spare
production capacity in the economy. Struggling firms will increase output without raising
prices
2. A relatively price elastic section in which firms are starting to bid with each other for
available resources. Price levels begin to rise
3. A perfectly inelastic (vertical) section at a point of full employment (YFE) of all available
resources. The closer the economy gets to this point the more price inflation will occur as
firms compete for scarce resources

The Keynesian View of long-run aggregate supply (LRAS) with a vertical aggregate supply
curve at the full employment level of output (YFE) becoming more elastic at lower levels of
output

Diagram Analysis
The vertical portion of the LRAS curve corresponds to the classical view of LRAS
The Keynesian view believes there is a maximum level of possible output
The LRAS curve becomes elastic at a certain price level as prices cannot fall further
Possibly due to minimum wage laws, the existence of trade unions, or long-term
employment contracts preventing wage decreases
Real output national equilibrium can occur at any level of output

The Keynesian view believes that an economy will not always self-correct and return to
the full employment level of output (YFE)
It can get stuck at an equilibrium well below the full employment level of output e.g.
Great Depression
The Keynesian view believes that there is a role for the government to increase its
expenditure so as to shift aggregate demand and change the confidence (animal
spirits) in the economy

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Inflationary & Deflationary Output Gaps YOUR NOTES

An output gap is the difference between the actual level of output (real GDP) and the 
maximum potential level of output

An inflationary output gap occurs when the real GDP is greater than the potential real GDP

A deflationary (recessionary) output gap occurs when the real GDP is less than the
potential real GDP
There is spare capacity in the economy to produce more goods/services that are
being produced

It is difficult to measure output gaps accurately

This is because it is hard to know exactly what the maximum productive potential of
an economy is
Rapidly rising prices can indicate a positive gap is developing
Rising unemployment and slowdown in economic growth can indicate that a
negative gap is increasing

A deflationary (recessionary) output gap

A deflationary gap can be illustrated using either a Classical or Keynesian diagram

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YOUR NOTES


Keynesian (top) and Classical (bottom) diagrams illustrating an economy that has a
deflationary output gap (Y1- YFE) and is currently producing less than its potential output

Diagram Analysis
The potential output of this economy is at YFE
The economy is in a short-run equilibrium at AP1Y1
A negative output gap exists at YFE - Y1
This effectively gives the economy additional spare capacity in the short-term
One cause of this may be that AD has recently decreased due to a fall in consumption
The Classical view is that the output will return to YFE in the long-run, but at a lower
average price level
The Keynesian view is that an economy may be stuck in a negative output gap for a
long period of time

An inflationary output gap

An inflationary gap can be illustrated using either a Classical or Keynesian diagram

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YOUR NOTES


A Classical illustration of an inflationary output gap (Y1 - YFE) where the economy is currently
producing more than its potential output

Diagram Analysis
The potential output of this economy is at YFE
The economy is in a short-run equilibrium at AP1Y1
A positive output gap exists at Y1 - YFE
This economy is producing beyond its capacity in the short-term
One cause of this may be that workers are willing to work overtime once full capacity
is reached
It is not sustainable and the Classical view is that the output will return to YFE, but
at a higher price level

 Exam Tip
When writing about an inflationary output gap, students often confuse it with the
concept of inflation (an increase in the average price level). Output gaps focus on
output, not price levels. An inflationary output gap means that the economy is
producing beyond its full employment level of output.

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3.2.4 Shifts of the Long-Run Aggregate Supply (LRAS) YOUR NOTES


Factors that Shift the LRAS
Classical economists believe that the long-run aggregate supply (LRAS) can increase in the
long-run
Keynesian economists believe that aggregate supply can increase in the long-term

The following factors will shift the entire Classical LRAS curve, or the Keynesian AS curve
outwards, thus increasing the potential output of the economy. This corresponds to an
outward or inward shift on the production possibilities curve for an economy
1. Changes in the quality or quantity of the factors of production: Any factor that increases
the quantity or quality of a factor of production will increase the productive potential of an
economy e.g. improving the skills of workers or changing the migration policies so that
there is an increase the quantity of labour
2. Technological advances: these often improve the quality of the factors of production e.g.
development of metal alloys
3. Efficiency improvements: process innovation often results in productivity improvement
e.g. moving from labour intensive car production to automated car production
4. Changes in institutions: increasing financial institutions can result in more access to
finance and help to increase the potential supply. Creating and implementing new
legislation (laws) can make it easier for new firms to enter markets thus increasing supply
e.g. implementation of competition policy

 Exam Tip
You will frequently be examined on your understanding of factors that shift the
short-run aggregate supply (SRAS) curve and long-run aggregate supply (LRAS)
curve.
Make sure you know the difference and remember that LRAS factors will shift the
entire LRAS curve to the right, representing an increase in the potential output of
the economy. Changes to SRAS do not change the potential output of the
economy.

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Diagrammatic Illustration of Long-run Shifts YOUR NOTES

1. Changes to LRAS in the Classical Model 
Changes to any of the determinants of LRAS will change the long-run productive potential
of the economy

The Classical view of an increase in the long-run aggregate supply (LRAS) of an economy
leading to lower average price levels

Diagram Analysis
The initial potential output of this economy is seen at YFE
The economy is in equilibrium at AP1YFE

A change to the education level in the economy can increase the quality of labour and
shift the LRAS to the right from LRAS1→LRAS2
There is now an increased level of potential output in the economy at YFE1

The extra supply in the economy allows prices to fall and output to increase resulting in a
new equilibrium at AP2YFE1

2. Changes to AS in the Keynesian Model

As with the Classical model, changes to any of the determinants of AS will change the long
term productive potential of the economy

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YOUR NOTES


The Keynesian view of an increase in the long-term aggregate supply (LRAS) of an economy

Diagram Analysis
The initial potential output of this economy is seen at YFE
A change to the immigration policy can increase the quantity of labour and shift the AS to
the right from AS1→AS2
There is now an increased level of possible output in the economy YFE1

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3.2.5 Macroeconomic Equilibrium YOUR NOTES


Short-run Equilibrium
Real national output equilibrium occurs where aggregate demand (AD) intersects with
short-run aggregate supply (SRAS)

A diagram showing the Classical short-run equilibrium in an economy resulting in an

equilibrium price of AP1 and real output of Y1
According to classical theory, this economy is in short run equilibrium at AP1Y1
Any changes to the components of AD will cause the AD curve to shift left or right creating
a new short-run equilibrium
Any changes to the non-price determinants of SRAS will shift the SRAS curve left or right
creating a new short-run equilibrium

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Long-run Equilibrium in the Monetarist/New Classical Model YOUR NOTES

Classical and Keynesian economists have different views on the long-run equilibrium of 
real national output
Classical economists believe that the economy will always return to its full potential level
of output and all that will change in the long-run, is the average price level
YFE is considered to be equal to the natural rate of unemployment in an economy

A diagram that shows the Classical view of long-run equilibrium which occurs at the
intersection of long-run aggregate supply (LRAS), short-run aggregate supply (SRAS) and
aggregate demand (AD)

Diagram Analysis
The LRAS curve demonstrates the maximum possible output of an economy using all of its
scarce resources
The SRAS intersects with AD at the LRAS curve
This economy is producing at the full employment level of output (YFE)
The average price level at YFE is AP1

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The Classical Adjustment Process (Self-correcting) YOUR NOTES

Classical economists believe that in the long run the economy will always return to its full 
potential level of output and all that will change is the average price level
This is the also referred to as the self-correcting mechanism

Automatic adjustment from a deflationary output gap

A deflationary (recessionary) output gap occurs when the real GDP is less than the
potential real GDP

Aggregate demand (AD) has shifted left causing a deflationary gap, which in the long-run
will self-correct to YFE but at a lower average price level (AP2)

Correction Process
1. Initial long-run equilibrium is at AP YFE
2. AD shifts left from AD → AD1, possibly due to the onset of a recession
3. Output falls from YFE → Y1 and price levels fall from AP → AP1
4. Due to the fall in output, firms lay off workers
5. Unemployed workers are now willing to work for lower wages and this reduces the costs of
production which causes the SRAS curve to shift right from SRAS1 → SRAS2
6. A new long-run equilibrium is formed at AP2 YFE
7. The economy is back to the full employment level of output (YFE), but at a lower average
price

Automatic adjustment from an inflationary output gap

An inflationary output gap occurs when real GDP is greater than the potential real GDP

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YOUR NOTES


Aggregate demand (AD) has shifted right causing an inflationary gap, which in the long-run
will self-correct to YFE but at a higher average price level (AP2)

Correction Process
1. Initial long-run equilibrium is at AP YFE
2. AD shifts right from AD1 → AD2, possibly due to raid expansion of the money supply
3. Output rises from YFE → Y1 and price levels rise from AP → AP1
4. Due to the increase in average prices (inflation), workers demand higher wages
5. Higher wages increase the costs of production which causes the SRAS curve to shift left
from SRAS1 → SRAS2
6. A new long-run equilibrium is formed at AP2 YFE
7. The economy is back to the full employment level of output (YFE), but at a higher average
price

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Equilibrium in the Keynesian Model YOUR NOTES

Keynesian economists believe that the economy can be in long term equilibrium at any 
level of output

The Keynesian view believes that an economy will not always self-correct and return to
the full employment level of output (YFE)
It can get stuck at an equilibrium well below the full employment level of output e.g.
Great Depression

The Keynesian view believes that there is role for the government to increase its
expenditure so as to shift aggregate demand and change the negative 'animal spirits' in
the economy

A diagram that shows the Keynesian View of aggregate supply (AS) with a vertical aggregate
supply curve at the full employment level of output (YFE) becoming more elastic at lower
levels of output

Diagram Analysis
Using all available factors of production, the long-term output of this economy occurs at
YFE
The economy is initially in equilibrium at the intersection of AD1 and AS (AP1YFE)
A slowdown reduces aggregate demand from AD1→AD2 and creates a recessionary gap
equal to YFE - Y1
The economy may reach a point where average prices stop falling (AP2), but output
continues to fall
Prices may be blocked from falling further due to minimum wage laws, the existence
of trade unions, or long-term employment contracts preventing wage decreases
This economy may not self-correct to YFE for years
The low output leads to high unemployment and low confidence in the economy
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This stops further investment and further reduces consumption YOUR NOTES

Keynes argued that this was where governments needed to intervene with significant
expenditure e.g. Roosevelt's New Deal; response to financial crisis of 2008

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Assumptions & Implications of the two Models YOUR NOTES

Each model has strengths and weaknesses 
It has been said that free market fans like Classical thinking when an economy is doing well
but very quickly switch to a Keynesian way of thought during severe recessions as they
seek government bail outs
The Economist Mariana Mazzucato sums it up with the phrase, 'Capitalists like to privatise
their profits and socialise their losses'

The Assumptions & Implications of Classical Thinking

Assumptions Implications

Wages are flexible Markets self-correct to YFE in the long run due to the fact
that wages can easily rise or fall so as to change costs of
production
The self-correction is based on automatic short-run
supply side changes and there is no need for government
intervention

Any deviation from YFE is There may be short periods of unemployment when a
temporary recessionary gap occurs, however markets will return to
YFE which corresponds to the natural rate of
unemployment (NRU) for an economy

Demand-side policies are less Economic growth is generated by increasing the

effective than supply-side productive capacity of the economy
policies in generating This thinking follows Says' Law
economic growth Government intervention should focus on increasing the
supply-side of an economy

The Assumptions & Implications of Keynesian Thinking

Assumptions Implications

'In the long-run we are all Keynes explained that the idea of markets self-
dead' correcting in the long-run was flawed in that the long-run
could be a very long period of time indeed
The consequences of severe recessionary gaps and the
unemployment they cause can be significant, lasting for
generations

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Wages can be inflexible Markets will reach a point where self-correction as a result
YOUR NOTES
'sticky' downwards of falling wages is no longer viable 
Workers will reach a point where they are no longer willing
to accept lower wages
Wages may be blocked from falling further due
to minimum wage laws, the existence of trade unions, or
long-term employment contracts preventing wage
decreases

Governments have to Animal spirits refers to the human emotions which drive
intervene to break the financial decisions during times of uncertainty or market
'negative animal spirits' volatility
If the emotions are gloomy about the economic outlook,
then gloominess will continue
This was the situation in the Great Depression and Keynes
advocated that Government spending was required to
change the mood in the economy and to help rebuild
business and consumer confidence
Once governments had intervened, the self-correcting
mechanism would begin to function again

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3.3 Macroeconomic Objectives YOUR NOTES


3.3.1 An Introduction to Macroeconomic Objectives

Economic Growth
Economic growth is a central macroeconomic aim of most governments
Many developed nations have an annual target rate of 2-3%
This is considered to be sustainable growth
Growth at this rate is less likely to cause excessive demand pull inflation
Politicians often use the economic growth rate as a metric of the effectiveness of their
policies and leadership
Economic growth has positive impacts on confidence, consumption, investment,
employment, incomes, living standards and government budgets

The economic growth rate of the UK since 1998

Source: Macrotrends

Some of the Economic Growth Trends in the UK Since 1998

1998 - 2007 2008 - 2015 2016 - 2019 2020 -

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YOUR NOTES
Steady growth Global financial Gradual Supply chain
fluctuating crisis followed by disinflation issues due to 
between 2-4% a rapid bounce possibly due to Brexit. Decreased
back due to future consumption due
government expectations to the impact of
intervention - and regarding the Covid 19. These
then steady impact of the created a deep
growth Brexit vote recession (short-
lived due to
government
intervention)

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Low Unemployment YOUR NOTES

The target unemployment rate for many economies is between 2-5%. In December 2022 
the unemployment rate in the USA was 3.7% and in Singapore it was 2.6%

Low unemployment rates like this are close to the full employment level of labour (YFE)
There will always be a level of frictional, seasonal and structural unemployment
This makes it impossible to achieve 100% employment and is called the natural rate
of unemployment (NRU)

Different economies have different unemployment rates that are considered to be close
to the full employment level of labour e.g. Japan's level is about 2.5% while India's is about
5.7%

Within the broader unemployment rate, there is an increased emphasis on the

unemployment rate within different sections of the population
E.g. youth unemployment, ethnic/racial unemployment by group
In 2021, black unemployment in the UK was 11% and white unemployment was
4.%

The unemployment rate in the UK from 1998 - 2020

Source: Macrotrends

Unemployment tends to be inversely proportional to real GDP growth

When real GDP increases, unemployment falls
When real GDP decreases, unemployment rises

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Low and Stable Rate of Inflation YOUR NOTES

Many economies have a target inflation rate of 2% using the Consumer Price Index (CPI) 

A low rate of inflation is desirable as it is a symptom of economic growth

The different causes of inflation (cost push or demand pull) require different policy
responses from the Government
Demand-side policies ease demand pull inflation
Supply-side policies ease cost push inflation

The inflation rate in the UK from 2012 to 2021 using the CPI

In the UK, a continual deviation from the target of 2% would not be considered stable
An inflation rate in April 2022 of 4-5% was considered to be unstable, eroding
household purchasing power
By October 2022 the inflation rate had risen to 11.1%

A low and stable rate of inflation is important as it

Allows firms to confidently plan for future investment
Offers price stability to consumers

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3.3.2 Economic Growth YOUR NOTES


Short-term Growth
Economic growth can occur in the short-term or long-term and each is explained
differently

Changes to any of the components of aggregate demand (AD) will cause short-term
economic growth to occur
This is illustrated on an AD/AS diagram by a rightward shift in AD
It can also be illustrated by using the production possibilities curves model by moving
from a point inside the curve to a point closer to the curve

1. Short-term Economic Growth on an AD/AS Diagram

Short-term economic growth through a shift of aggregate demand from AD→AD1

Diagram Analysis
An increase in consumption, investment, government spending or net exports has caused
a shift in AD from AD→AD1
The current real output has increased from Y1→Y2 which represents an increase in real GDP
An increase in real GDP = economic growth
This short-term growth has led to an increase in average prices from AP1→AP2

2. Short-term Economic Growth on a Production Possibilities Curve (PPC)

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YOUR NOTES


Short-term economic growth on a production possibilities curve (PPC) model

Diagram Analysis
An increase in production has caused a shift in production combinations from X→Y
The current real output has increased moving closer to the maximum possible output of
the economy
This represents an increase in real GDP
An increase in real GDP = economic growth

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Long-term Growth YOUR NOTES

Long-term economic growth is caused by any improvements to the determinants of long- 
run aggregate supply
This is illustrated on an AD/AS diagram by a rightward shift in the LRAS
It can also be illustrated using the PPC model through a shift outwards of the entire
curve

1. Long-term Economic Growth on an AD/AS Diagram

Long-term economic growth through an increase in the long-run aggregate supply (LRAS)
of the economy

Diagram Analysis
A change to the quantity/quality of the factors of production has increased potential
output of the economy from YFE→YFE1
E.g. More rigorous competition policy creates a higher number of firms in each
industry leading to greater aggregate supply in the economy
This shifts the long-run aggregate supply curve to the right LRAS1→LRAS2
resulting in economic growth
The final impact on price levels depends on the shape of the long-run aggregate supply
curve (Keynesian or Classical)

2. Long-term Economic Growth Using a PPC Model

The entire PPC of an economy can shift inwards or outwards thereby changing its
production possibilities

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An outward shift demonstrates long-term economic growth YOUR NOTES



Outward shifts of a PPC show long-run economic growth

Diagram Explanation
Economic growth occurs when there is an increase in the productive potential of an
economy
This is demonstrated by an outward shift of the entire curve
More consumer goods and more capital goods can now be produced using all of the
available resources

This shift is caused by an increase in the quality or quantity of the available factors of
production
One example of how the quality of a factor of production can be improved is through
the impact of training and education on labour. An educated workforce is a more
productive workforce and the production possibilities increase
One example of how the quantity of a factor of production can be increased is
through a change in migration policies. If an economy allows more foreign workers to
work productively in the economy, then the production possibilities increase

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Calculating Economic Growth Rates YOUR NOTES

Economic growth is measured by calculating the change in the real GDP between two time 
periods (usually quarterly or annually)
The growth rate is expressed as a percentage
Several steps can be included in the calculation of an economic growth rate
1. Calculate nominal GDP from a set of data for two time periods
2. Calculate the real GDP for each time period using the GDP deflator
3. Calculate the percentage change in real GDP between the two time periods

 Worked Example
Using the information provided in Table 1 and Table 2, calculate the economic
growth rate for Vietnam [4]
Table 1

2019
2018
Value in
Category Value in
US$
US$ billions
billions

Consumption 11255 11945

Investment 8927 11100
Income tax 59577 62545
Government
15697 16500
spending
Imports 4957 3988
Exports 8532 10300
Net Income 4349 5350
Table 2

GDP Deflator 2018 GDP Deflator 2019

103.8 107.2

Step 1: Determine which of the data presented is relevant to the calculation

Nominal GDP = C + I = G = (X-M)
So income tax and net income are not relevant

Step 2: Substitute the relevant values into the GDP formula for 2018
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Nominal GDP 2018 = C + I + G + (X-M) YOUR NOTES

Nominal GDP 2018 = 11255 + 8927 + 15697 + (8532 - 4957) 

Nominal GDP 2018 = $39,454 billion

Step 3: Substitute the relevant values into the GDP formula for 2019
Nominal GDP 2019 = 11945 + 11100 + 16500 + (10300 - 3988)
Nominal GDP 2019 = $45,857 billion

Step 4: Calculate the real GDP for each year using the GDP deflator
Nominal GDP
Real GDP 2018 = x 100
GDP Deflator

39,454
Real GDP 2018 = x 100 = $ 38,009 . 63 billion
103 . 8

45,857
Real GDP 2019 = x 100 = $ 42,777 . 05 billion
107 . 2

Step 5: Calculate the real economic growth rate (the % change in real GDP)
new value − old value
% Change = × 100
old value

42,777 . 05 − 38,009 . 63
% Change = × 100
38,009 . 63

% Change = 12 . 54 %

(4 Marks for the correct answer or one mark for any correct work in the process. Final
answer must be rounded to 2 decimal places)

 Exam Tip
Remember that an increase in the economic growth rate may not lead to inflation as
the increase in economic growth may be caused by higher levels of aggregate
supply which lead to lower average price levels.

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Consequences of Economic Growth YOUR NOTES

Economic growth is considered to be the main contributor to an improvement in the 
standards of living
Due to the negative aspects of economic growth, there is much controversy about
maintaining it as a central macroeconomic aim
Instead, arguments for a focus on societal well-being are gaining traction

An Evaluation of Economic Growth

Impact Benefits of Economic Growth Costs of Economic Growth

Living standards Increased incomes lead to Rising aggregate demand

better standards of living causes demand pull inflation
Increased employment and the purchasing power of
resolves some of the people on fixed incomes may
negative social impacts of fall
unemployment Increased income usually leads
to greater consumption of
demerit goods
Greater output often requires
more time from workers and
can decrease leisure time and
well-being

The Environment Improvement in the Environmental damage caused

quality/quantity of by negative externalities of
environmentally friendly production and consumption
technologies increases
Resources are depleted more
rapidly

Income distribution Decreased levels of absolute Lack of equity in the

poverty distribution of income - the rich
Higher levels of employment may get richer and the poor
mean that there is more tax poorer
revenue for governments to
redistribute on welfare
payments

 Exam Tip
In the Paper 2 data response material, you may see the phrases 'at constant prices'
or 'at current prices'. 'Constant prices' refers to price levels which have been
adjusted for inflation whereas 'current prices' refers to nominal price levels.

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3.3.3 Low Unemployment YOUR NOTES


An Introduction to Unemployment
Key terms to understand are employment, labour force, unemployment, and full
employment
1. Employment: refers to the economic use of labour as a factor of production

2. Unemployment: Someone is considered to be unemployed if they are not working but

actively seeking work

3. Labour force: A country's population is divided into the labour force - and non labour
force
The labour force consists of all workers actively working PLUS the unemployed (who
are seeking work)
The non labour force includes all those not seeking work e.g. stay at home parents,
pensioners, and school children (these people are economically inactive)

4. Full employment: describes the ideal situation when everyone in the economy who is
willing and able to work has a job

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Measuring Unemployment YOUR NOTES

Unemployment is measured in many countries using two different approaches 
The International Labour Organisation (ILO) Survey
The Claimant Count

The Differences Between the ILO Labour Force Survey and The Claimant Count

The ILO Labour Force Survey The Claimant Count

An extensive survey is sent to a random Counts the number of people claiming job
sample of households every quarter seekers allowance or unemployment
(60,000 households in the UK) benefits
Respondents self-determine if they are More stringent requirement to be
unemployed based on the following ILO considered unemployed than with the ILO
criteria survey
Ready to work within the next two Often requires claimants to meet regularly
weeks with a 'work coach'
Have actively looked for work in the
past one month
The same survey is used globally so it's
useful for making international
comparisons

Three Metrics are Commonly used when Analysing the Labour Market in an Economy

Unemployment rate Employment rate Labor force participation rate

no . actively seeking no. in employment labour force

= x 100 = x 100 = x 100
total labour force population of working age total population

The employment rate could be increasing even as the unemployment rate is increasing:
May be caused by increased immigration which causes working age population to
increase
May be caused as people move from being economically inactive to employed

Unemployment rates do not capture the hidden unemployment that occurs in the long
term
Workers look for a job but may eventually give up and become economically inactive

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This actually improves the unemployment rate as fewer people are actively seeking YOUR NOTES
work 

 Worked Example
The table provides information about a country's labour market
Population size 4000000
Labour force size 2400000
Number employed 1800000
Number of full-time
200000
students
Calculate the unemployment rate of this country [2]

Step 1: Decide which information in the table is useful

The number of full time students would not be included in the labour force size, so it is
not useful (it is a distraction)
The key infromation is the labour force size and the number employed

Step 2: Calculate the number of unemployed in the labour force

Labour force - employed = unemployed
2,400,000 - 1,800,000 = 600,000 unemployed

Step 3: Calculate the unemployment rate

no . actively seeking
Unemployment rate = x 100
total labour force

600 ,000
Unemployment rate = x 100
2,400 ,000

Unemployment rate = 25 %

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Difficulties in Measuring Unemployment YOUR NOTES

There are several difficulties involved in the measurement and use of unemployment 
statistics
1. Underemployment
Workers who are underemployed do not appear in unemployment statistics
Unlike the unemployed, people who are underemployed are working

Someone is underemployed when:

They want to work more hours than they currently work
They are working in a job that requires lower skills than they have e.g. an architect
working as a gym instructor
Underemployment is often a consequence of cyclical unemployment
Workers who have lost their jobs in a weak economy are willing to take part-time jobs
or accept roles outside of their main skill base
Underemployment is also a consequence of structural unemployment
Unless workers retrain and gain new skills, it will be hard for them to gain full
employment

2. Hidden unemployment
Hidden unemployment occurs when workers lose their jobs and then attempt to get a new
job, usually for a very long period of time, after which, they give up
This often occurs during severe recessions
They give up looking for work as they feel that they no longer have the skills desired by
the market
Once they stop looking for work, they are no longer considered to be unemployed
Unemployment rates would be much higher if this hidden unemployment was considered

3. Unemployment disparities
The headline unemployment rate is an average
It does not provide insight into ethnic, regional, gender or youth unemployment disparities
which may exist in an economy e.g. in 2022 the USA unemployment rate was 3.8% with
Nebraska having the lowest unemployment level at 2%.and the District of Columbia the
highest at 6%. White workers had an unemployment rate of 3% and black workers 6.5%

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Understanding Labour Market Diagrams YOUR NOTES

Labour market equilibrium occurs where the demand for labour (DL) is equal to the 
supply of labour (SL)
The DL is the demand by firms for workers
The SL is the supply of labour by workers

Individual firms are price takers in the labour market as they have to accept the wage rate
that workers are being paid in the industry
If they offer a lower wage, they will likely struggle to recruit workers
If they offer a higher wage there will be a large number of workers applying to work
there

In the labour market for graphic designers, the equilibrium wage rate is W and the
equilibrium quantity is Q. At this point the DL = SL
Diagram Analysis
The market for graphic designers is in equilibrium where DL = SL
The equilibrium wage is W and the quantity of labour is Q
There is no excess supply of labour
There is no excess demand for labour

There are several causes of unemployment, all of which cause disequilibrium in the labour
market. These include:
Real wage unemployment (minimum wages)
Structural unemployment
Cyclical (demand deficient) unemployment
Frictional unemployment
Seasonal unemployment

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Real Wage Unemployment (Minimum Wages) YOUR NOTES

Real wage unemployment occurs when wages are inflexible at a point higher than the 
free-market equilibrium wage
Usually caused by the existence of minimum wage laws
The higher wage creates an excess supply of labour
This excess supply represents real wage unemployment

A minimum wage is a legally imposed wage level that employers must pay their
workers
It is set above the market rate
The minimum wage/hour varies based on age

A national minimum wage (NMW1) is imposed above the market wage rate (We) at W1

Diagram Analysis
The market equilibrium wage and quantity for truck drivers in the UK is seen at WeQe
The UK government imposes a national minimum wage (NMW) at W1
Incentivised by higher wages, the supply of labour increases from Qe to Qs
Facing higher production costs, the demand for labour by firms decreases from Qe to Qd
This means that at a wage rate of W1 there is an excess supply of labour and the potential
for real wage unemployment equal to QdQs

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Structural Unemployment YOUR NOTES

Occurs when there is a mismatch between jobs and skills in the economy 
It usually happens as the structure of an economy changes e.g. the secondary sector is
declining and the tertiary sector is growing
There is no longer a need for a specific type of worker e.g. shipbuilders in Glasgow
Many Western industries have relocated production to China causing structural
unemployment in their economies
Unless workers receive help to retrain, they are often left unemployed or under-employed

Structural unemployment occurs in a specific industry when the demand for labour (DL)
shifts left as workers are no longer required
Diagram Analysis
The initial labour market equilibrium in the USA steel industry can be seen at W1Q1
The USA began to import more and more steel from China and with fewer workers required
the demand for labour (DL) shifted left from DL→DL1
Wages fell from W1→W2 and the quantity of workers in the industry reduced from Q1→Q2
(structurally unemployed)

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Cyclical (Demand Deficient) Unemployment YOUR NOTES

Cyclical or demand deficient unemployment is caused by a fall in AD in an economy 
This typically happens during a slow down or recession
The demand for labour is derived from the demand for goods/services
As output falls in the economy, firms lay off workers

A fall in aggregate demand (AD) leads to a fall in output. Fewer workers are required so the
demand for labour (DL) shifts left and wage rates fall

Diagram Analysis
Using a Keynesian national income model, the macroeconomic equilibrium is initially at
AP1YFE
At this level of national output, the labour market is in equilibrium at W1Q1
A recession causes AD to shift left from AD1 → AD2
This leads to a fall in real GDP from YFE → Y1
With lower levels of output, fewer workers are required and the demand for labour (DL) in
the labour market shifts left from DL → DL1
The new labour market equilibrium is now at W2Q2
The labour market has a lower wage rate and increased unemployment equal to Q1 - Q2

Frictional and Seasonal Unemployment

Seasonal unemployment occurs as certain seasons come to an end and labour is not
required until the next season
E.g. fruit pickers; summer seaside resort workers; ski instructors

Frictional unemployment occurs when workers are between jobs

This is usually short-term unemployment
Workers have voluntarily left their previous job to search for another

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The Natural Rate of Unemployment YOUR NOTES

The natural rate of unemployment (NRU) is the lowest achievable level of unemployment 
in an economy
The unemployment rate can never be 0% as there is always some unemployment due to
the existence of frictional, seasonal and structural unemployment
The natural rate of unemployment = frictional + seasonal + structural unemployment

The Costs of Unemployment

The effects of unemployment, especially long-term unemployment, are extremely
damaging
There are impacts on the individual, the economy, the government, and firms

Long term unemployment affects individuals, the economy, government, and firms

Government's receive less tax revenue and have higher expenditures in the form of
welfare payments
Individuals suffer significant emotional, relational and financial consequences
Firms may find it harder to find workers to employ (as they have moved on) once the
economy starts to recover
The economy contracts as there is a higher level of inefficient use of available resources

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3.3.4 Low & Stable Rate of Inflation YOUR NOTES


An Introduction to Inflation
Inflation is the sustained increase in the average price level of goods/services in an
economy

Deflation occurs when there is a fall in the average price level of goods/services in an
economy
Deflation only occurs when the percentage change in prices falls below zero %

Disinflation occurs when the average price level is still rising, but at a lower rate than
before
These figures demonstrate disinflation: Y1= 5% Y2= 4% Y3= 2%
Inflation is increasing but at a decreasing rate

 Worked Example
How would you characterise the fall in the CPI from 2018 to 2021? Explain your
answer [3]

Step 1: Study the time period and decide if you are witnessing inflation, disinflation or
deflation
Disinflation (1 mark)
Step 2: Explain your answer

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According to the CPI data, prices are still rising but at a decreasing rate. For example, in YOUR NOTES
2018 prices were rising at around 3%. In 2019 this increase fell to roughly 1.8%. In 2021, 
they were still rising but by a much lower 0.5%
(2 marks for an answer with a correct explanation which references the data)

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Measuring Inflation Using the Consumer Price Index (CPI) YOUR NOTES
Inflation is the sustained increase in the average price level of goods/services in an 
economy
The average price level is measured by checking the prices of a 'basket' of
goods/services that an average household will purchase each month
This basket of goods is turned into an index and it is called the consumer price index
(CPI)
Many economies have an inflation target of 2% per annum
Low inflation is better than no inflation as it is a sign of economic growth

The inflation rate is the change in average price levels in a given time period
The inflation rate is calculated using an index with 100 as the base year
If the index is 100 in year 1 and 107 in year 2 then the inflation rate is 7%

The Consumer Price Index (CPI)

A 'household basket' of goods/services that an average family would purchase is
compiled on an annual basis
A household expenditure survey is conducted to determine what goes into the
basket
Each year, some goods/services exit the basket and new ones are added
The number of goods in the basket varies from country to country e.g. the UK has 700
'goods' in their basket and Singapore has 4,800

Goods/services in the basket are weighted based on the proportion of household

spending
E.g. More money is spent on food than shoes, so shoes have a lower weight in the
basket

Each month, prices for these goods/services are gathered from many locations across
the country
These prices are averaged out

The price x the weighting determines the final value of the good/service in the basket
These final values are added together to determine the price of the 'basket'

Cost of basket in year X

CPI = x 100
Cost of basket in base year

The percentage difference in CPI between the two years is the inflation rate for the period

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YOUR NOTES
 Worked Example

Using the information in the table, calculate the inflation rate for 2021 if the price of
the basket in the base year (2019) was $400 [3]
Basket 2020 Basket 2021
Good Price 2020 Price 2021 Weight (Price x (Price x
weight) weight)
Housing,
water,
950 1200 34% 323.00 408.00
electricity,
gas
Transport 250 325 11% 27.50 35.75
Food 500 620 9% 45.00 55.80
Recreation
300 340 10% 30.00 34.00
and culture
Clothing and
190 210 5% 9.50 10.50
footwear
$435.00 $544.05

Step 1: Calculate the CPI for 2020

Cost of basket in 2020
CPI = x 100
Cost of basket in base year

435
= x 100
400

= 108 . 75

Step 2: Calculate the CPI for 2021

Cost of basket in 2021
CPI = x 100
Cost of basket in base year

544 . 05
= x 100
400

= 136 . 01

Step 3: Calculate the percentage difference between the CPI for 2021 and 2020

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Inflation rate =
New CPI − Old CPI
x 100 YOUR NOTES
Old CPI

136 . 01 − 108 . 75
= x 100
108 . 75

= 25 . 07 %

(3 marks for the correct answer or 1 mark for any correct working. Answers should be
rounded to 2 decimal places to be correct)

The Limitations of Using the CPI

The CPI provides a level of inflation for the average basket and the basket of many
households is not the average basket
Depending on what households buy the level of inflation for each one can vary
significantly
As an average, it also ignores regional differences in inflation e.g. London's inflation
may be much higher than Manchester's inflation

The CPI is one of several methods used by countries in determining inflation - another is
the retail price index (RPI)
This can make comparisons between countries less meaningful as one may use the
RPI and another the CPI

The CPI does not capture the quality of the products in the basket
Product quality changes over time and so the comparison with different time
periods is less useful

The CPI only measures changes in consumption on an annual basis

Changes in consumption can occur more frequently and the index is always behind
these changes

The CPI is prone to errors in data collection

It is based on a survey that goes to thousands of households each year, yet it is still a
small sample
The respondents have no incentive to fill in the survey carefully and accurately

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The Causes of Inflation YOUR NOTES

An increase in the average prices in an economy can be caused by demand pull inflation 
or cost push inflation

1. Demand Pull Inflation

Demand pull inflation is caused by excess demand in the economy
Aggregate demand (AD) is the sum of all expenditure in the economy
AD = Consumption (C) + Investment (I) + Government spending (G) + Net Exports (X-
M)

An increase in aggregate demand (AD) raises the average price level in an economy leading
to demand pull inflation

Diagram Analysis
If any of the four components of AD increase (ceteris paribus), there will be a shift to the
right of the AD curve from AD1 → AD2
At the original price (AP1), there is now a condition of excess demand in the economy
As prices rise, there is a contraction of AD and an extension of SRAS
Prices for goods/services are bid up from AP1 → AP2
Demand pull inflation has occurred

If the Central Bank lowers the base rate, there is likely to be increased borrowing by firms
and consumers
This will result in an increase in consumption and investment
It is likely to lead to a form of demand-pull inflation

2. Cost Push Inflation

Cost push inflation is caused by increases in the costs of production in an economy

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YOUR NOTES


An increase in the costs of production raises the average price level in an economy leading
to cost push inflation

Diagram Analysis
If any of the costs of production increase (labour, raw materials etc.), or if there is a fall in
productivity, there will be a shift to the left of the SRAS curve from SRAS1→SRAS2
At the original price (AP1), there is now a condition of excess demand in the economy
As prices rise, there is a contraction of AD and an extension of SRAS
Prices for goods/services are bid up from AP1→AP2
Cost push inflation has occurred

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The Costs of Inflation YOUR NOTES


The Impact of Inflation on Different Stakeholders

Stakeholder Explanation of Impact

Firms Uncertainty. Rapid price changes create uncertainty and delay

investment
Menu change costs. Price changes force firms to change their
menu prices too and this can be expensive

Consumers Decrease in purchasing power

Decrease in the real value of savings (as money will be worth less in
real terms)
Fall in real income for those on fixed incomes/pension
Inflation is more harmful to low income households

Government Inflation erodes international competitiveness of export

industries as the country's exports are now relatively more
expensive
Economic growth may slow due to a fall in exports and a possible
fall in consumption
Trade-offs involved in tackling inflation e.g reducing inflation may
increase unemployment and/or reduce economic growth

Workers
Demand higher wages to compensate for reduced purchasing
power
If wage increases ≠ inflation, motivation and productivity may fall

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The Causes and Costs of Deflation YOUR NOTES

Deflation occurs when there is a fall in the average price level of goods/services in an 
economy as measured by the consumer price index (CPI)
Deflation only occurs when the percentage change in prices falls below zero %

Deflation can be caused by either demand-side or supply-side factors

The two different causes of deflation have very different consequences for the
economy

1. Demand-side Deflation (Bad Deflation)

Demand-side deflation is caused by a fall in total (aggregate) demand in the economy

Aggregate demand is the sum of all expenditures in the economy as measured by the real
gross domestic product (rGDP)
rGDP = Consumption (C) + Investment (I) + Government spending (G) + Net Exports
(X-M)
If any of the four components of rGDP decrease, there will possibly be a decrease in the
aggregate demand in the economy leading to a decrease in the general price level
Demand-side deflation has occurred

Aggregate demand (AD) has fallen leading to a reduction in the average price level (AP)

Diagram Analysis
The initial macroeconomic equilibrium is at AP Y
Any factor which causes a reduction in one or more of the determinants of real GDP may
cause the AD curve to shift left from AD1 → AD2
This shift causes a fall in average price levels from AP to AP1
The new macroeconomic equilibrium is now at AP1 Y1
Demand-side deflation has occurred

The Consequences of Demand-side Deflation

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YOUR NOTES
Government Challenges Consumers Lose Confidence Debt 

With a decrease in output, With falling output and Debt feels more
fewer workers are rising unemployment, burdensome as the value
required and so households lose of any debt is worth more
unemployment increases confidence choosing to The real cost of
Fiscal and monetary save instead of spend borrowing increases as
policy is less effective at Consumption falls and real interest rates rise
combatting deflation than rGDP reduces even more when the price level falls
inflation as consumers get Consumers delay e.g. if interest rates are
into a habit of waiting for purchasing 1.5% and the inflation rate
lower prices prior to goods/services as they is –1.5%, then the real
making purchases believe prices will be interest rate is 3%
cheaper in a few weeks or
months

Firms Lose Confidence Bankruptcies Exports

Falling output and falling Falling output and falling Persistently falling prices
prices cause firms to lose prices reduce the profits can prove attractive to
confidence and so they of firms foreigners and the level of
delay investment, further Some firms will be unable exports may increase (this
reducing rGDP to continue and will go out helps offset some of the
of business reduction in rGDP)

2. Supply-side Deflation
Supply-side deflation is caused by increases in the productive capacity of the economy
This is brought about by any increase in the quantity/quality of the factors of
production
It effectively creates a condition of excess supply in the economy
Average price levels fall
National output (rGDP) increases

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YOUR NOTES


Short-run aggregate supply (SRAS) has increased leading to a reduction in the average price
level (AP)

Diagram Analysis
The initial macroeconomic equilibrium is at APY
Any factor which causes an increase in the SRAS will result in the SRAS curve shifting right
from SRAS → SRAS1
This shift causes a fall in average price levels from AP → AP1
The new macroeconomic equilibrium is now at AP1 Y1
Supply-side deflation has occurred

The Consequences of Supply-side Deflation

Unemployment Consumers Gain Confidence Debt

With a decrease in costs, With rising output and Debt still feels more
the output of firms falling price levels, burdensome as the value
increases. More workers households become more of any debt is worth more
are required and so confident and the
unemployment falls consumption increasing -
increasing rGDP even
more

Firms Gain Confidence Exports

Rising output and falling Persistently falling prices

costs of production cause boost international
firms to gain confidence competitiveness and
and increase investment, exports increase
thereby increasing rGDP

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Exam Tip YOUR NOTES

 Understanding the cause of deflation is vital to analysing the consequences of the

deflation.
Falling prices caused by a recession are not good for an economy. In this scenario,
national output is falling which means that fewer workers will be required to produce
goods/services so unemployment will increase.
Falling prices caused by an increase in supply are good for an economy. In this
scenario, national output is rising which means that more workers will be required to
produce goods/services so unemployment will decrease.

The Relative Costs of Unemployment Versus Inflation

Generally, there is an inverse relationship between inflation and unemployment
When inflation increases unemployment decreases and vice versa
Each situation has consequences for the economy and governments try to limit the
negative consequences

The Costs of Unemployment Versus Inflation

Unemployment Inflation

Personal costs such as depression, Decrease in purchasing power leads to a

suicide, marital failure, stress worse standard of living
Economic costs such as inefficient use of Reduction in the international
resources, increased benefit payments, competitiveness of exports which may be
less tax revenue decreased AD
Social costs such as increased Loss of worker productivity when any
homelessness, vandalism, anti-social wage increases do not equal the rate of
behaviour inflation
Creates an uncertain environment which
may prevent firms from investing
Erodes the real value of savings with the
biggest impact on low income households
and households on a fixed income (such
as pensioners)

 Exam Tip
When analysing inflation in data response questions, or evaluating it in longer essay
questions, make certain that you consider the size of any inflation. Low Inflation is
not bad but is actually a sign of a healthy economy as it is indicative of economic
growth.

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3.3.5 Potential Conflicts Between Macroeconomic Objectives YOUR NOTES


Common Conflicts Between the Macroeconomic Objectives
Policy decisions by governments often create trade-offs in the macroeconomic
objectives
Achieving one objective may come at the cost of worsening progress in another objective

An Explanation of the Common Trade-offs that Exist Between the Macroeconomic

Objectives

Trade-off Explanation

High economic growth and Increasing economic growth causes the economy to
inflation move closer to full employment
Prices for remaining resources are bid up leading to
inflation which may outpace the target inflation rate of
2%

High economic growth and Economic growth often increases pollution, negative
environmental sustainability externalities and the depletion of non-renewable
resources
The higher the growth, the faster the depletion

Economic growth and During periods of high economic growth, the profits the
inequality owners of the factors of production receive are
disproportionate to any increase in workers' wages
leading to greater inequality

Low unemployment and low The closer an economy moves to full employment the
inflation less workers will be available for hire and wage inflation
will help increase overall inflation

 Exam Tip
If you are asked to explain a particular trade off, make sure you explain all of the
steps in the process E.g. if economic growth increases too quickly, there is likely to
be demand-pull inflation, which raises the cost of living for the citizens, resulting in
them feeling poorer, as the purchasing power of their wage has decreased

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3.4 Inequality & Poverty YOUR NOTES


3.4.1 Measuring Inequality & Poverty

Inequality & Poverty Terminology

Equality describes situations where economic outcomes are similar for different people or
different social groups
Income equality would mean everyone, irrespective of their job, is paid the same
Inequality in the distribution of income is one cause of absolute and relative poverty

Equity refers to the idea of fairness and is a normative concept

Equity in the distribution of income means that there is fairness in the wage
differentials that exist in society e.g. those with higher qualifications or skills are paid
more than those with less
The size of acceptable wage differentials is a matter of much debate

Income and wealth inequality are two different concepts

Income inequality refers to the unequal distribution (flow) of income to households i.e
rent, wages, interest and profit
Wealth inequality refers to differences in the amount of assets that households own

Absolute poverty is a situation where individuals cannot afford to acquire the basic
necessities for a healthy and safe existence
These necessities include shelter, water, nutrition, clothing and healthcare
In 2022, the World Bank defined absolute poverty as anyone who was living on less
than $1.90 a day (the so called international poverty line)
Absolute poverty is more prevalent in developing countries than in developed ones

Relative poverty is a situation where household income is a certain percentage less than
the median household income in the economy
Poverty in a household is considered relative to income levels in other households
Households that are living with less than 50% of the median household income are
considered to be in relative poverty
Relative poverty is the main form of poverty that occurs in developed countries

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Measuring Inequality - the Lorenz Curve & Gini Coefficient YOUR NOTES
The two main measures of income inequality are the Lorenz Curve and the Gini coefficient 

The Lorenz Curve

The Lorenz Curve is a visual representation of the income inequality that exists between
households in an economy

Data is commonly presented in quintiles (population divided into 5 groups i.e 20%) or
deciles (population divided into 10 groups i.e 10%)
E.g. in 2020, 49% of the income flow in Bolivia went to the top 20% of households
while only 4% went to the bottom 20%

Perfect income distribution is not the goal (20 % of the population gets 20% of the
income; 40% gets 40% percent of the income etc.)
That would equate to socialism and completely remove incentives for work as
everyone would be paid equally

More equal income distribution is desired as it reduces poverty and social unrest
What constitutes acceptable income equality is a normative economic issue

An illustration of Income Inequality for Bolivia (blue line) and Sweden (red line) and the UK
(yellow line) using a Lorenz Curve Model. The income distribution in Bolivia is more unequal
than that of Sweden

Diagram Analysis
The line of equality represents perfect income distribution (not desirable)
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In Bolivia the bottom 20% of households receive 4% of the income flow while in Sweden YOUR NOTES
they receive 9% of the income flow 
In the UK the top 10% of households receive 45% of the income flow while in Sweden they
receive 25%
Sweden has a more equal distribution of income than the UK

The Gini Coefficient

The Lorenz curve can be used to calculate the Gini Coefficient

The Gini Coefficient is calculated using the area beneath the line of equality

Diagram Analysis
A
Gini Coefficient =
A+B
A represents the area between the line of equality and Bolivia's Lorenz curve
B represents the area under the Lorenz curve
A value of 0 represents absolute equality (socialism) and 1 represents perfect inequality
In 2017, Estonia's coefficient was 0.3 as compared with a value of 0.62 in South Africa
The distribution of income in Estonia was more equitable than in South Africa
Governments use progressive taxation and transfer payments to shift the Gini
coefficient closer to zero

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YOUR NOTES
 Worked Example

Using a Lorenz curve diagram, explain what happened to income inequality in
Bolivia between 2008 and 2016 [4]
Income Gini Coefficient Data for Bolivia
Income Gini Coefficient
0.51
2008
Income Gini Coefficient
0.43
2016

Step 1: Determine if inequality has improved or worsened

The closer to zero, the closer the country is moving to perfect equality.
The situation in Bolivia has improved so the Lorenz curve is moving closer to the line of
perfect equality

Step 2: Draw and label the Lorenz Curve for each year

(2 marks for a correctly labelled diagram with a shift inwards of the Lorenz curve)

Step 3: With reference to your diagram, explain what has happened to the income
inequality between the two time periods
The closer the Gini coefficient is to zero, the more equal the distribution of income in a
country. (1) Bolivia's Gini coefficient has moved closer to zero indicating that there is less
income inequality in 2016 than there was in 2008 and this is illustrated by an inward shift of
the Lorenz curve towards the line of perfect equality (1)

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Measuring Poverty YOUR NOTES

There are many single indicators of economic development. These can be used to 
compare the relative standing of countries at any point in time. They also serve to provide
targets for improving the lives of citizens. Examples include
Energy consumption per person
The proportion of the population with access to clean water
Number of girls completing primary education

Another single indicator is the International Poverty Line (IPL)

This is the absolute minimum level of income that a person must receive in order to
meet the basic needs required for human survival - currently $1.90 a day

The Minimum Income Standard (MIS) is another useful indicator

The Minimum Income Standard (MIS) identifies the lowest amount of income needed
for what society views as an acceptable standard of living in the country
The value differs from region to region as adjustments are made for those living in
urban versus rural areas due to the different costs of living associated with each

A composite indicator can provide more meaningful data for comparisons between
countries
One useful composite indicator is the Multi-dimensional Poverty Index (MPI)

Characteristics of the MPI

1. Launched in 2010 by the Oxford Poverty and Human Development Initiative at the
University of Oxford
2. The MPI uses a survey to measure the complexities of poor people’s lives, individually and
collectively, each year
3. The MPI tracks deprivation across three dimensions and 10 indicators
Health (child mortality, nutrition)
Education (years of schooling, enrolment)
Living standards (water, sanitation, electricity, cooking fuel, housing, assets)
4. The survey first identifies which of these 10 deprivations each household experiences
5. Households are then categorised as poor if they suffer deprivations across 1/3 or more of
the weighted indicators
6. The MPI can focus in on regions, ethnicities and also any of the three dimensions
7. This adaptability makes it a useful tool for policymakers and non-government organisation
(NGOs) working to reduce poverty

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Difficulties in Measuring Poverty YOUR NOTES

Poverty is multi-dimensional concept and difficult to quantify 
Poverty is usually measured through self reported surveys and this gives rise to multiple
discrepancies in - and between - countries
Households who identify as poor may exhibit very different characteristics from each
other
Urban households may have very different ideas of their poverty level compared to rural
households
Urban areas tend to have higher immigrant households whose status can change
relatively quickly as they seize opportunities
Rural households may remain in long-term poverty
Poverty data for different ages, gender and disabilities is not easily available

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3.4.2 Causes of Inequality & Poverty YOUR NOTES


The Causes of Inequality & Poverty
Causes of Poverty
There are many causes of poverty. However, poor countries have several common
characteristics which can be summarised in a poverty cycle diagram

Poverty is caused by a lack of both economic growth and human development

Low wages represent the intersection of economic growth and human development and
are the major cause of poverty
Low wages are usually the result of unemployment, informal employment, a lack of
skills, or a primary sector based economy

Education and healthcare cost money and with lower wage levels these are not
accessible, resulting in poor human capital
People find it harder to stay well or to recover from illness resulting in lower
productivity and shorter life expectancy

Low productivity results in low wages and the cycle continues

Populations with a large number of dependents (old people and children) for each working
household tend to experience higher levels of poverty
Causes of Inequality
There are numerous factors that cause wealth and income inequality
It is generally true that developed countries have a larger tax base and are able to provide a
better level of support to the poorest households in the economy, than developing
countries are able to

Cause of Wealth & Income Inequality

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YOUR NOTES
Cause Explanation 

Differences in human capital The higher the skill level the higher the level of income
A country with a poor education system will see greater
inequality than one with a good education system

Inequality of opportunity Access to education and health can vary significantly

within communities and between different regions
Inequality in education and healthcare leads to
inequality of opportunity in the job market

Different levels of resource Assets generate income

ownership The more equal the asset ownership in an economy the
less the inequality in income distribution

Discrimination Gender, race - or any other discrimination increases

income inequality in an economy

Unequal status and power Countries with strong trade union membership provide
workers with more power and higher levels of income
With low trade union membership, the exploitation of
workers through low wages is easier and income
inequality is worse

Government tax and benefits Countries that provide a range of benefits (such as
policies unemployment, pension, disability, child support,
housing support etc) raise the income of the lowest 20%
of the population resulting in more equal distribution
Progressive tax systems allow all income earners to
contribute to public revenue according to their ability
Decreasing taxes on the lower end and increasing it on
the upper end would mean that the system is more
progressive and there would be a more equal
distribution of income

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YOUR NOTES
Globalisation and Globalisation is the economic integration of different
technological change countries through increasing freedoms in the cross- 
border movement of people, goods/services,
technology and finance
This integration of global economies has
impacted national cultures, spread ideas, speeded
up industrialisation in developing nations and led to de-
industrialisation in developed nations
Countries which are more isolated will experience higher
levels of wealth and income inequality

Market based supply-side Supply-side policies such as deregulation, privatisation

policies and trade liberalisation can provide great opportunities
but also increase inequality
E.g. Privatisation of state owned assets often allows a
few people to get rich (those who buy the asset) and the
service provided by the newly privatised firm may
become more expensive to access

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The Costs of Income & Wealth Inequality YOUR NOTES

Capitalism is at the heart of free market economics 
Under Capitalism, inequality is inevitable
Workers with higher skills receive higher wages
Workers with little to no skills receive little to no wage
Individuals with higher income will acquire more assets leading to higher levels of
income
In turn, they can keep on acquiring assets
Individuals with lower income will find it hard to acquire assets

The principles of capitalism are considered important as the incentive to acquire income
raises productivity and output

However, the long-term outcome of capitalism is that the factors of production become
concentrated in ownership with relatively few individuals developing extreme wealth, at the
expense of many who lose out

The costs of inequality

1. Impact on economic growth
At some point, increasing levels of inequality becomes a disincentive for workers to
work and be productive
This means that some resources (labour) in the economy are not being used efficiently.
National output falls and economic growth slows
Government unemployment payments and welfare benefits may increase
Government tax revenues may decrease with increasing inequality

2. Impact on living standards

If the inequality gap grows, the rich get richer and the poor, relatively poorer
Over time, this will reduce the standard of living
The wealthier will access better education and healthcare creating even less
opportunity for poorer households in the future

3. Impact on social stability

More equal societies tend to be more stable, tolerant and considerate with lower levels
of crime and better standards of living
Less equal societies tend to be characterised by political instability, strife, social unrest
- and in extreme cases this can lead to revolutions

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3.4.3 Using Taxation to Reduce Inequality & Poverty YOUR NOTES


The Role of Taxation
The main source of government revenue is taxation
Taxation is used to redistribute income so as to reduce income inequality in a nation

Types of taxes
Direct taxes are taxes imposed on income and profits
They are paid directly to the government by the individual or firm
E.g. Income tax, corporation tax, capital gains tax, national insurance contributions,
inheritance tax

Indirect taxes are imposed on spending

The less a consumer spends the less indirect tax they pay
Examples of indirect tax include Value Added Tax (19% VAT rate in the European Union
in 2022), taxes on demerit goods such as excise duties on fuel or cigarettes

Types of tax systems

Tax systems can be classified as progressive, regressive or proportional
Most countries have a mix of progressive (direct taxation) and regressive (indirect
taxation) taxes in place

An Explanation of tax Systems

System Explanation Diagram

Progressive As income rises, a larger

percentage of income is paid in
tax
In the diagram, when personal
income rises from Y1 to Y2, the
tax rate rises from TR1 to TR2

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Regressive As income rises, a smaller

YOUR NOTES
percentage of income is paid in 
tax
In the diagram, when personal
income rises from Y1 to Y2, the
tax rate falls from TR1 to TR2
All indirect taxes are regressive
In the USA, Federal income tax is
progressive but almost all State
taxes are regressive (the bottom
20% of income earners pay as
much as 6x the % of their income
than the top 20%)

Proportional As income rises, the same

percentage of income is paid in
tax
In the diagram, when personal
income rises from Y1 to Y2, the
tax rate remains constant at 20%
In 2022, Bolivia was using this
system with a proportional tax
rate of 13%

The link Between Taxation & the Reduction of Income Inequality & Poverty

Progressive taxation A progressive tax system redistributes Higher redistribution

from those with higher income to those → better
with lower income and reduces income education/healthcare →
inequality better human capital →
Redistribution often starts with the better productivity →
provision of free education and higher income
healthcare
Many governments use tax revenues
to provide multiple levels of financial
support to poor households including
disability payments, heating subsidies,
travel subsidies etc.
Sometimes the benefits of a good
progressive tax system are eradicated
by the penalties imposed through
multiple regressive (indirect) taxes

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3.4.4 Other Policies to Reduce Inequality & Poverty YOUR NOTES


Other Policies
The poverty cycle diagram (below) was introduced in the previous subtopic and helps to
explain the causes of poverty
Any policy that helps to break the poverty cycle at any point will help to improve the
standards of living within a country

Policies used to alleviate poverty include promoting economic growth, improving

education, providing more generous state benefits, progressive taxation, and the
establishment/increase of a national minimum wage

Policies which help to improve any factor in the diagram will help to alleviate poverty

How Different Policies Alleviate Poverty

Policy
Explanation Impact on Poverty Cycle

Investing in human Investing in this supply-side policy Higher education/skill

capital e.g. education increases the potential output of the levels → higher human
country (shifts the production capital → increased
possibility frontier outwards) productivity → higher
output → higher income

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YOUR NOTES
More generous transfer Transfer payments are usually given to More benefits → higher
payments the poorest and most vulnerable wages → better 
people in society education/healthcare →
Transfer payments include better human capital →
unemployment and disability better productivity →
payments, pension payments, higher wages
heating discounts, public transport
subsidies etc.

Establishment/increase Minimum wages are set above the Higher wages → better
of national minimum free market rate education/healthcare →
wage Firms are not allowed to pay anyone better human capital →
less than the legal rate better productivity →
higher wages

Establishing a universal A universal basic income (UBI) is a Minimum income for all →
basic income guaranteed minimum income level - better
and when necessary, paid by the education/healthcare →
government to each individual in better human capital →
society improved labour offer →
decreasing
unemployment

Targeted government This can be aimed at the greatest Higher education/skill

spending on needs in society levels → higher human
goods/services E.g. Providing more schools, teachers capital → increased
or hospitals productivity → higher
output → higher income

Policies to reduce Discrimination occurs in many Less discrimination →

discrimination different forms (age, ethnicity, gender, better productivity →
disability etc) and in each case results higher wages
in social exclusion leading to
inequalities of opportunity and
income
Reducing discrimination reduces
inequality

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3.5 Demand Management: Monetary Policy YOUR NOTES


3.5.1 An Overview of Monetary Policy

Introduction to Demand-side Policies

Demand-side policies aim to shift aggregate demand (AD) in an economy

There are two categories of demand-side policies

Fiscal policy and monetary policy

Fiscal policy involves the use of government spending and taxation to influence AD
The government is responsible for setting fiscal policy
Governments usually present their fiscal policies to the country each year when they
deliver the Government budget

Monetary policy involves adjusting interest rates and the money supply so as to influence
AD
Central Banks are usually responsible for setting monetary policy
Central Bank committees usually meet 4-8 times a year to set policy

The Goals of Monetary Policy

Monetary policy is used to help the government achieve their macroeconomic objectives
Specifically, the use of monetary policy aims to achieve
A low and stable rate of inflation
Low unemployment
Reduce business cycle fluctuations
Promote a stable economic environment for long-term growth
To control the level of exports and imports (net external balance)
When a policy decision is made, it creates a ripple effect through the economy impacting
the macroeconomic objectives of the government

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Real Versus Nominal Interest Rates YOUR NOTES

In economics, the use of the word nominal refers to the fact that the metric has not been 
adjusted for inflation

The nominal interest rate is the headline rate presented by commercial banks
There has been no adjustment to the interest rate based on the rate of inflation

The real interest rate is the nominal interest rate minus the rate of inflation
For example, if the nominal interest rate for saving money at a commercial bank is 3%
and inflation is 2% then the real interest rate is 1%
The value of the savings is effectively increasing by only 1%

The real interest rate can also be calculated using consumer price index (CPI) data

 Worked Example
Using the data, calculate the real interest rate in 2021 [3 marks]
Nominal
Year CPI
Interest rate
2020 103.2 -
2021 105.9 4%

Step 1: Calculate the inflation rate by calculating the % difference between the CPI for
2021 and 2020
New CPI − Old CPI
Inflation rate = x 100
Old CPI

105 . 9 − 103 . 2
Inflation rate = x 100
103 . 2

Inflation Rate = 2. 62 %

Step 2: Calculate the real interest rate

Real interest rate = nominal interest rate - inflation rate
= 4% - 2.62%
= 1.38%

(3 marks for a correct answer or 1 mark for any correct working)

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Monetary Policy Instruments YOUR NOTES

The two main instruments of monetary policy include 
Incremental adjustments to the interest rate (usually not more than 0.25%)
Quantitative easing which increases the supply of money in the economy
The Central Bank creates new money and uses it to buy open-market assets such
as bonds

When a policy decision is made, it creates a ripple effect through the economy and this
effect is known as a transmission mechanism

Incremental Changes to Interest Rates

The transmission mechanisms of changes to the interest rate

Before Explaining a Mechanism from the Diagram Above, key Terminology can be Reviewed
Below
Official Rate Market Rates Asset Prices
Exchange Rate Net External Demand Inflation

Example 1
Official rate decreases by 0.25% → market rates decrease → loans are cheaper →
consumers borrow more → consumption increases → AD increases → inflation increases

Example 2
Official rate decreases by 0.25% → market rates decrease → mortgages are cheaper →
property buyers borrow more → demand for houses increases → asset prices increase

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Example 3 YOUR NOTES

Official rate decreases by 0.25% → market rates decrease → buyers borrow more → asset 
prices increase → households with assets feel wealthier → consumption increases → AD
increases → inflation increases
Example 4
Official rate increases by 0.25% → hot money flows increase → the exchange rate
appreciates → exports more expensive and imports cheaper → net exports reduce → AD
decreases → inflation decreases
Example 5
Official rate increases by 0.25% → market rates increase → existing loan repayments now
more expensive to repay → discretionary income falls → consumption decreases → AD
decreases → inflation decreases

Quantitative Easing Transmission Mechanism

The Bank of England commits to buy £60bn of gilts a month → commercial banks receive
cash for their gilts → liquidity in the market increases → commercial banks lower lending
rates → consumers and firms borrow more → consumption and investment increase → AD
increases → inflation increases

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Expansionary & Contractionary Monetary Policy YOUR NOTES

Expansionary Monetary Policy 
Monetary policy can be expansionary in order to generate further economic growth (also
referred to as loose monetary policy)
Expansionary policies include reducing interest rates, increasing QE, or
depreciating the exchange rate

To understand the effects of monetary policy on an economy, it is useful to know how

aggregate demand (AD) is calculated
AD= household consumption (C) + firms investment (I) + government spending (G) +
exports (X) - imports (M)
AD = C + I + G + (X - M)

From this, it is logical that changes to monetary policy can influence any of these
components - and often several of them at once

Expansionary monetary policy aims to shift aggregate demand (AD) to the right

Classical diagram illustrating expansionary monetary policy which increases real GDP (Y1
→Y2) and average price levels (AP1 →AP2)

Diagram Analysis
The economy is initially in macroeconomic equilibrium AP1Y1
The Central Bank is wanting to boost economic growth and lowers interest rates
Lower interest rates cause investment and consumption to increase which are
components of AD
Aggregate demand increases from AD1→ AD2
The economy reaches a new equilibrium at AP2Y2 - a higher average price level and a
greater level of national output

An Example of how Expansionary Monetary Policy Impacts on the Goals

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YOUR NOTES
The USA Federal Reserve Bank commits to an extra $60bn a month of QE 

Effect on the economy Commercial banks receive cash for their bonds → liquidity in the
market increases → commercial banks lower lending rates →
consumers and firms borrow more → consumption and
investment increase → AD increases

Impact on Economic growth increases

macroeconomic aims Inflation rises
Unemployment may fall as output is increasing and more
workers are required
Net external demand worsens (with higher price levels exports
may decrease and with rising incomes, imports may increase)

Contractionary Monetary Policy

Monetary policy can be contractionary in order to slow down economic growth or reduce
inflation (also referred to as tight monetary policy)
Contractionary policies include increasing interest rates, decreasing/stopping QE, or
appreciating the exchange rate

Contractionary monetary policy aims to shift aggregate demand to the left

Keynesian diagram illustrating contractionary monetary policy which decreases the real
GDP (YFE →Y1) and average price levels (AP1 →AP2)

Diagram Analysis
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The economy is initially in macroeconomic equilibrium AP1YFE YOUR NOTES

The Central Bank is wanting to lower inflation towards its target of 2% - and increases 
interest rates
Higher interest rates cause investment and consumption to decrease
Aggregate demand decreases from AD1→ AD2
The economy reaches a new equilibrium at AP2Y1 - a lower average price level and a smaller
level of national output

An Example of how Contractionary Monetary Policy Impacts on the Goals

The Central Bank increases interest rates

Effect on the economy Existing loan repayments for households become more
expensive → discretionary income reduces → consumption
decreases → total demand falls
Firms are less likely to borrow → less investment in capital
takes place → AD falls
Hot money flows increase → the exchange rate appreciates →
exports more expensive and imports cheaper → net exports
reduce → AD decreases

Impact on Economic growth slows down

macroeconomic aims Inflation eases
Unemployment may increase as output is falling and fewer
workers are required
Net external demand is likely to worsen as both exports and
imports reduce (exports more expensive due to higher
exchange rate and imports cheaper - but households have
less income for imports)

 Exam Tip
When analysing monetary policy, it is worth noting that monetary policy (4-8 x per
year) can be adjusted more quickly than fiscal policy (usually once per year).
However, the impact of fiscal policy is more predictable than the impact of
monetary policy. For example, households may not borrow more money if their
confidence in the economy is low - irrespective of how low interest rates go.

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An Evaluation of Monetary Policy YOUR NOTES

Strengths of Monetary Policy 
Central Banks can operate independently from the Government (political process)
Central Banks can consider the long-term outlook
Contractionary policy is often effective when there is an inflationary gap
Targets inflation and maintains stable prices
Depreciating the currency can increase exports
The frequency of policy alterations (4-8 times per year) allows for constant adjustments
to macroeconomic variables

Weaknesses of Monetary Policy

Conflicting goals e.g economic growth puts upward pressure on inflation
Expansionary policy is less effective during a deflationary gap
The larger the output gap the less effective it can be
Consumers may not respond to lower interest rates when confidence is low
Time lags between policy and the desired impact (up to 2 years)
During particularly bad recessions, the impact of expansionary policy may take some
time to be seen in the economy
Expansionary policy leads to cheaper credit which can inflate asset prices (houses) in the
long term
The interest rate has limitations on downward adjustment
The closer it gets to zero the less effective changes are

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3.6 Demand Management: Fiscal Policy YOUR NOTES


3.6.1 An Overview of Fiscal Policy

An Introduction to Fiscal Policy

Fiscal Policy involves the use of government spending and taxation (revenue) to influence
aggregate demand in the economy

Fiscal policy can be expansionary in order to generate further economic growth

Expansionary policies include reducing taxes or increasing government spending

Fiscal policy can be contractionary in order to slow down economic growth or reduce
inflation
Contractionary policies include increasing taxes or decreasing government spending

Fiscal Policy is usually presented annually by the Government through the Government
Budget
A balanced budget means that government revenue = government expenditure
A budget deficit means that government revenue < government expenditure
A budget surplus means that government revenue > government expenditure

A budget deficit has to be financed through public sector borrowing

This borrowing gets added to the public debt

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Sources of Government Revenue YOUR NOTES

The main sources of government revenue include taxation, the sale of goods/services by 
government owned firms, and the sale of government owned assets (privatisation)

1. Taxation
Direct taxes are taxes imposed on income and profits
They are paid directly to the government by the individual or firm
E.g. Income tax, corporation tax, capital gains tax, national insurance
contributions, inheritance tax

Indirect taxes are imposed on spending

The supplier is responsible for sending the payment to the government
Depending on the PED and PES producers are able to pass on a proportion of the
indirect tax to the consumer
The less a consumer spends the less indirect tax they pay
E.g Value Added Tax (20% VAT rate in the UK in 2022), taxes on demerit goods,
excise duties on fuel etc.

2. Sale of goods/services
Government owned firms sometimes charge for the goods/services that they provide
E.g. Charges on public transport and fees paid to access some medical services

3. The sale of government owned assets

Privatisation can generate significant government revenue during the year in which the
government sells the asset
Most assets can only be sold once e.g. national airlines or railways
Some assets, such as the right for mobile phone operators to use the airwaves, can
be sold every few years (the airway license is for a defined period of time)

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Government Expenditure YOUR NOTES

Government expenditure represents a significant portion of the aggregate demand in 
many economies. The expenditure can be broken down into three categories

1. Current expenditures: These include the daily payments required to run the government
and public sector. E.g. The wages and salaries of public employees such as teachers,
police, members of parliament, military personnel, judges, dentists etc. It also includes
payments for goods/services such as medicines for government hospitals

2. Capital expenditures: These are investments in infrastructure and capital equipment. E.g.
High speed rail projects; new hospitals and schools; new aircraft carriers

3. Transfer payments: These are payments made by the government for which no
goods/services are exchanged. E.g. Unemployment benefits, disability payments,
subsidies to producers and consumers etc. This type of government spending does not
contribute to aggregate demand as income is only transferred from one group of people
to another

The Goals of Fiscal Policy

Fiscal policy is used to help the government achieve their macroeconomic objectives
Specifically, the use of fiscal policy aims to
Maintain a low and stable rate of inflation
Maintain low unemployment
Reduce the business cycle fluctuations
Create a stable economic environment for long-term economic growth
Redistribute income so as to ensure more equity
Control the level of exports and imports (net external balance)

When a policy decision is made, it creates a ripple effect through the economy impacting
the macroeconomic objectives of the government
Changes to fiscal policy can influence several of the components of AD
A change to any component of AD helps to achieve at least one of the goals of fiscal
policy

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Expansionary & Contractionary Fiscal Policy YOUR NOTES

1. Expansionary Fiscal Policy 
Expansionary fiscal policies include reducing taxes or increasing government spending
with the aim of increasing AD

AD= household consumption (C) + firms investment (I) + government spending (G) +
exports (X) - imports (M)
AD = C + I + G + (X - M)

Expansionary fiscal policy aims to shift aggregate demand (AD) to the right

Classical diagram illustrating expansionary fiscal policy which increase real GDP (Y1 →Y2)
and average price levels (AP1 →AP2)

Diagram Analysis
The economy is initially in macroeconomic equilibrium AP1Y1 - there is a recessionary gap
The Government is wanting to boost economic growth and lowers the rate of income and
corporation taxes
Lower taxes cause investment and consumption to increase which are components of AD
Aggregate demand increases from AD→ AD1
The economy reaches a new equilibrium at AP2Y2 - a higher average price level and a
greater level of national output
Examples of the Impact of Expansionary Fiscal Policy

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YOUR NOTES
Example 1: The Government decreases corporation tax 

Effect on the economy Firms net profits increase → investment by firms increases → AD
increases

Impact on Economic growth increases

macroeconomic aims Inflation rises
Unemployment may decrease as output is rising which
requires more workers
Net external demand - unsure - exports may rise due to new
investments in the economy, but imports may rise due to
higher income generated by the investment

Example 2: The Government increases unemployment benefits

Effect on the economy Household income increases → consumption increases → AD

increases

Impact on Economic growth increases

macroeconomic aims Inflation rises
Unemployment may decrease as output is rising which
requires more workers (although increased unemployment
benefits may discourage some people from entering the
labour market)
Net external demand is unlikely to change as this policy helps
the poorest and imports are unlikely to increase
Redistribution of income has increased and there is more
equity in society

2. Contractionary Fiscal Policy

Contractionary fiscal policies include increasing taxes or decreasing government spending
with the aim of decreasing AD

AD= household consumption (C) + firms investment (I) + government spending (G) +
exports (X) - imports (M)
AD = C + I + G + (X - M)

Changes to fiscal policy can influence government spending or consumption or

investment

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Changing taxation can influence household consumption and the investment by firms YOUR NOTES

Contractionary fiscal policies aims to shift aggregate demand (AD) to the left

Keynesian diagram illustrating how a contractionary fiscal policy aims to decrease real GDP
(YFE →Y1) and average price levels (AP1 →AP2)

Diagram Analysis
The economy is initially in macroeconomic equilibrium AP1YFE - an inflationary output gap is
developing
The economy is booming and the Government is wanting to lower inflation towards its
target of 2%
The Government increases the rate of income tax
Higher tax rates cause households to have less discretionary income causing
consumption to decrease
Aggregate demand decreases from AD1→ AD2
The economy reaches a new equilibrium at AP2Y1 - a lower average price level and a smaller
level of national output

Examples of the Impact of Contractionary Fiscal Policy

Example 1: The Government increases the rate of income tax

Effect on the economy Households pay more tax → discretionary income reduces →
consumption reduces → AD reduces

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Impact on Economic growth slows down

YOUR NOTES
macroeconomic aims Inflation eases 
Unemployment may increase as output is falling and fewer
workers are required
Net external demand Improves (with less income, imports
may fall)

Example 2: The Government freezes/reduces public sector workers pay

Effect on the economy Wages stagnate or reduce → Consumer confidence falls →

consumption decreases → AD decreases

Impact on Economic growth slows down

macroeconomic aims Inflation eases
Unemployment may increase as output is falling
Net external demand improves (with less income, imports may
fall)

Example 3: The Government cuts Government Spending in their Budget

Effect on the economy Less demand for goods/services → less income for firms → output
and profits decrease → AD decreases

Impact on Economic growth slows down

macroeconomic aims Inflation eases
Unemployment may increase as output is falling
Net external demand may Improve (with less income, imports
may fall)
Less corporation tax available for redistribution

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An Evaluation of Fiscal Policy YOUR NOTES

Strengths of Fiscal Policy 
Spending can be targeted at specific industries
It can be highly effective in restoring confidence in an economy during a deep recession
Redistributes income through taxation
Reduces negative externalities through taxation
Increased consumption of merit/public goods
Short term government spending can lead to an increase in the aggregate supply of an
economy
E.g. Building a new airport immediately increases government spending and AD, but
when it is built, the potential output will have increased (Production Possibility Curve
has shifted outward)

Weaknesses of Fiscal Policy

Political pressures: Policies can fluctuate significantly when new governments are
elected
Long term infrastructure projects may lack follow-through

Unsustainable debt: Increased government spending can create budget deficits which are
added to the national debt
Repaying this debt may lead to austerity on future generations

Conflicts between objectives

E.g. Cutting taxes to increase economic growth may cause inflation

Time lags: It is difficult to predict exactly when the desired effect on the economy will
occur. Fiscal policy also takes a longer time to plan and implement than monetary policy
Government budgets are usually presented once a year whereas monetary policy
adjustments can take place 4-8 times per year

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3.7 Supply-Side Policies YOUR NOTES


3.7.1 An Overview of Supply-Side Policies

Introduction to Supply-side Policy

Supply-side policies aim to shift the long-run aggregate supply (LRAS)
There are two categories of supply-side policies
Interventionist and market-based

Interventionist supply-side policies require government intervention in order to increase

the full employment level of output
These are mainly used to correct market failure

Market-based supply-side policies aim to remove obstructions in the free market that
are holding back improvements to the long-run potential
E.g. Setting up a regulator to prevent monopolies from forming

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The Goals of Supply-side Policy YOUR NOTES

Supply-side policies can be extremely useful in generating long term growth, lowering 
average price levels, and creating new jobs in an economy

The five goals of Supply-side policy

When successful, supply-side policies have the following effects on the government's
macroeconomic objectives
1. Economic growth: potential national output increases leading to higher real gross
domestic product (rGDP)
2. Inflation: a greater supply in the economy results in reductions in the prices of
goods/services leading to disinflation and making the exports of the nation more
competitive
3. Unemployment: this should fall as lower wage bills allow firms to recruit more workers
4. Net external demand: due to the increased supply, the prices of goods/services often
decrease which makes them relatively more attractive to foreigners - so exports increase
5. Redistribution of income: this often worsens with the use of supply-side policies as
wages fall and government tax revenue has fallen too

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Market Based Supply-side Policies YOUR NOTES

Market based supply-side policies aim to free up markets and improve market incentives 
so as to increase the long-run aggregate supply

An Explanation of Market Based Supply-side Policies

Possible effects on the aims of

Market based policy Explanation
supply-side policy

To increase incentives Reducing Taxes decrease → firms and

income/corporation tax individuals retain more money for
rates incentivises workers to themselves → incentives increase
work harder (they keep more → productivity improves → long
money for themselves) and term growth increases
provides firms with extra
funds which they can use to
invest in new
machinery/technology
Reducing capital gains tax

To improve competition Deregulation. Any regulation Regulation on firms decreases →

and efficiency increases costs of the cost of production for firms
production for firms and falls → firms lower selling prices →
deregulation decreases international competitiveness
costs which may result in improves
greater supply
Privatisation. Government State owned firms are privatised
firms are usually so big that → more firms enter the market to
private enterprise refrains compete → competition and
from trying to compete with efficiency improves
them. Privatisation
encourages new firms to
enter the market and
compete, thus increasing the
aggregate supply in the
economy
Anti-monopoly regulation
helps to increase
competition in an economy
which leads to a more
efficient allocation of
resources

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To reduce labour costs Decreasing trade union Wages decrease → the cost of
YOUR NOTES
and create labour market power so wages can be production for firms falls → firms 
flexibility decreased lower selling prices → international
Decreasing or abolishing competitiveness improves
minimum wages to lower
costs of production
Restructuring the
unemployment benefits
system to incentivise the
unemployed to seek work

The possible impact of abolishing minimum wages

A national minimum wage (NMW) is a legally imposed wage level that employers must
pay their workers
It is set above the market rate
Removing it will allow wage levels to fall, thus reducing the costs of production for
firms

Removing the national minimum wage (NMW1) may cause wage rates to fall from W1 to We

Diagram Analysis
The demand for labour (DL) represents the demand for workers by firms
The supply of labour (SL) represents the supply of labour by workers
The national minimum wage and quantity for truck drivers in the UK is seen at W1Qd
The UK government removes the national minimum wage (NMW) at W1
Incentivised by lower wages, the demand for labour by firms increases from Qd → Qe
Facing lower wages, the supply of labour by workers decreases from Qd → Qe

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The labour market is now in equilibrium at WeQe -a lower wage rate and higher quantity of YOUR NOTES
workers employed 

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Interventionist Supply-side Policies YOUR NOTES

Interventionist supply-side policies require government intervention in order to increase 
the full employment level of output

An Explanation of Interventionist Supply-side Policies

Possible effects on the aims of

Supply-side Policy Explanation
supply-side policy

Education and training Increasing government Skill level increases → productivity

spending on education and improve → the cost of production
retraining raises the quality of for firms falls → firms lower selling
the workforce resulting in prices → international
productivity improvements competitiveness improves

Improving quality, Human capital improves →

quantity and access to Increasing government productivity improves → the cost of
health care spending on healthcare so production for firms falls → firms
that productivity improves lower selling prices → international
competitiveness improves

Research and Increased government A new industry emerges → new

development spending on innovation infrastructure is developed → more
increases the supply of jobs are created → r.GDP increases
potential jobs in the economy → increase in long term economic
growth

Provision of Increased government New infrastructure is developed →

infrastructure spending on infrastructure costs of production decrease →
helps to facilitate the supply increases → firms lower
movement of people and selling prices → international
goods which increases the competitiveness improves
aggregate supply

Industrial policies Industrial policies are direct Industries receive subsidies →

and targeted support to firms costs of production decrease →
or industries in the form of supply increases → firms lower
subsidies selling prices → international
competitiveness improves

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Exam Tip YOUR NOTES

 Essay questions will test your ability to differentiate between market-based and

interventionist supply-side policies.
When evaluating supply-side polices in essay responses, demonstrate critical
thinking by acknowledging that privatisation has been used for so long that there is
often relatively few assets left to privatise and perhaps a better way forward is to
improve competition policy and regulation.
Remember, the private sector will also be increasing supply in an economy (it is not
only up to the government) as they are incentivised to increase their profits.

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Diagrams to Illustrate Supply-side Policies YOUR NOTES

Successful supply-side policies will increase the long-run aggregate supply (LRAS) 
This equates to an increase in the production possibilities of an economy

The successful implementation can be illustrated on either a Classical or Keynesian

diagram

A Classical diagram that illustrates the implementation of a successful supply-side policy

A Keynesian diagram that illustrates the implementation of a successful supply-side policy

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YOUR NOTES
Diagram Analysis 
Efforts to reduce trade union power have been successful
There is now less protection on wage levels and wage levels fall
Firms may hire more workers and the quantity of productive labour in the economy has
increased
This causes LRAS1 to increase to LRAS2
Output increases from YFE to YFE1
Average price levels fall from AP1→AP2

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3.7.2 The Effectiveness of Supply-Side Policies YOUR NOTES


Demand-side Effects of Supply-side Policies
Supply side policies aim to increase the long-run aggregate supply
These policies often take years to complete, but once completed, they add extra
productive potential to the economy
Examples of these kinds of policies include building new roads, new airports, new ports,
new hospitals, new schools, new hydroelectric dams etc.

These types of supply-side policies require government spending on an annual basis for
as long as it takes to complete the project
This government spending is a component of aggregate demand and helps to boost
the national output in that year
E.g. to build a new port, the government has to hire a firm to complete the project, pay
their workers, and pay for the materials (cement, sand, trucks, steel etc)
This government spending boosts aggregate demand in the short term

It has been argued that the best government spending is that which boosts AD in the short
term but increases LRAS in the long term

Supply-side Effects of Fiscal Policies

Many fiscal policies have the ability to improve the productive potential (supply-side) of
an economy
E.g. Education subsidies to help the poorest households constitute an annual
expenditure for the government. However, in the long term they help to improve
human capital which boosts productivity and output
The fiscal policy is short term (annually) however the supply-side impact occurs in the
long term

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An Evaluation of Supply-side Policy YOUR NOTES

The benefits of supply-side policies far outweigh the negatives, yet many economies fail 
to fully develop their supply-side policies due to a process of constant political change -
and an associated change in government priorities

An Evaluation of Market Based Supply-side Policies

Advantages Disadvantages

Improved resource allocation: increasing Equity issues: E.g. the distribution of

the productive capacity of an economy income worsens as labour market reforms
requires more efficient use of its and wage policies lower worker's wages
resources, including labour Time lags: there are significant time lags
No burden on government budget: with between expenditure and seeing the
an emphasis on freeing up markets and benefits
allowing market forces to drive efficiency Vested interests: can result in less
and resource allocation, there is no effective outcomes e.g. there are many
requirement for government spending examples of privatisation occurring in such
a way that the government's preferred
bidders obtained an asset at a knock
down price
Environmental impact: large
infrastructure projects almost always have
some negative externalities associated
with their creation e.g. dam in a gorge to
create a hydro electric dam damages the
natural environment and eco system

An Evaluation of Interventionist Supply-side Policies

Advantages Disadvantages

Direct support of sectors important for Costs: they are expensive to implement
growth: Subsidies to specific industries and are paid for using tax revenue - or
increase the rate of growth of an economy increased government borrowing
Direct support reduces Time lags: due to the long-term nature,
unemployment changes in government often result in
Direct support can increase the level changes to budgets and scope of
of exports projects and the end result may be less
Improvements in living standards: effective than it could have been
Improvements in Infrastructure can raise
the quality of life for all citizens

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YOUR NOTES


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