Alevel Economic Revision The macro economy
Revision Material
Edition: 12 April 2020
Chapter 4 The macro economy
Learning outcomes
Candidates should be able to:
(a) Aggregate Demand - the shape and determinants of AD and AS curves; AD = C + I + G + (X – M)
(AD) and Aggregate - the distinction between a movement along and a shift in AD and AS
Supply (AS) analysis - the interaction of AD and AS and the determination of the level of output, prices and
employment
(b) inflation - the definition of inflation; degrees of inflation and the measurement of inflation; deflation and
disinflation
- the distinction between money values and real data
- the causes of inflation (cost-push and demand- pull inflation)
- the consequences of inflation
(c) balance of payments - the components of the balance of payments accounts (using the IMF/OECD definition):
current account; capital and financial account; balancing item
- meaning of balance of payments equilibrium and disequilibrium
- causes of balance of payments disequilibrium in each component of the accounts
- consequences of balance of payments disequilibrium on domestic and external economy
(d) exchange rate - definitions and measurement of exchange rates – nominal, real, trade-weighted exchange
rates
- the determination of exchange rates – floating, fixed, managed float
- the factors underlying changes in exchange rates
- the effects of changing exchange rates on the domestic and external economy using AD,
Marshall-Lerner and J curve analysis
- depreciation/appreciation
- devaluation/revaluation
(e) The terms of trade - the measurement of the terms of trade
- causes of changes in the terms of trade
- the impact of changes in the terms of trade
(f) Principles of absolute - the distinction between absolute and comparative advantage
and comparative - free trade area, customs union, monetary union, full economic union
advantage - trade creation and trade diversion
- the benefits of free trade, including the trading possibility curve
(g) Protectionism - the meaning of protectionism in the context of international trade
- different methods of protection and their impact, for example, tariffs, import duties and quotas,
export subsidies, embargoes, voluntary export restraints (VERs) and excessive administrative
burdens (‘red tape’)
- the arguments in favour of protectionism
,(a) Aggregate Demand (AD) and Aggregate Supply (AS) analysis
1. Aggregate demand (AD)
(i) Definition
Aggregate Demand (AD) or Aggregate Monetary Demand (AMD) or Aggregate Expenditures represents the total demand
for all goods and services during a certain period of time. In a complete economic model, Aggregate Demand equals
consumer expenditures (C), Investment expenditures (I), government expenditures (G) and net export revenues (Xn).
AD = C + I + G + (X – M)
(ii) Components
C: Consumers' expenditure on goods and services: Also
known as consumption, this includes demand for durables e.g.
audio-visual equipment and vehicles & non-durable goods
such as food and drinks which are “consumed” and must be
re-purchased.
Consumer expenditures may take up any of the following
forms:
(a) Non durables such as food and fuel
(b) Durables such as furniture, cars, electronics
(c) Services such as education, medical care, insurance etc.
I: Capital Investment – This is spending on capital goods such as plant and equipment and new buildings to produce
more consumer goods in the future. Investment includes spending on working capital such as stocks of finished and
semi-finished goods. Investment has important effects on the supply-side as well as being an important component
of AD.
Investment expenditures are of three types:
(a) Fixed capital formation i.e. the purchase of fixed assets such as plant and machinery, equipment and
fixtures.
(b) Changes in inventories: Firms maintain inventories (stocks), which are further categorized into: - Raw
materials prior to use
Finished goods prior to sale
Work in progress (WIP)
G: Government Spending – This is spending on state-provided goods and services including public goods and merit
goods. Decisions on how much the government will spend each year are affected by developments in the economy
and the political priorities of the government.
X: Exports of goods and services - Exports sold overseas are an inflow of demand (an injection) into our circular flow
of income and spending adding to aggregate demand.
M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from the circular flow of income
and spending
Net exports measure the value of exports minus the value of imports. When net exports are positive, there is a trade
surplus (adding to AD); when net exports are negative, there is a trade deficit (reducing AD).
(iii) Shape of diagram and relationship / movement
There are several explanations for an inverse relationship between AD and the price level in an economy:
1. Falling real incomes / The wealth effect (AS): A rise in the price level will reduce the amount of goods and
services that people’s wealth can buy. The purchasing power of savings held in the form of bank accounts and
, other financial assets will fall. As the price level rises, the real value of people’s incomes fall and consumers are less able to buy
the items they want or need. If over the course of a year all prices rose by 10 per cent whilst your money income remained the same,
your real income would have fallen by 10%
2. The international effect: A rise in the price level will reduce demand for net exports as exports will become less
price competitive while imports will become more price competitive.
3. The balance of trade: A persistent rise in the price of level of Country X could make foreign-produced goods
and services cheaper in price terms, causing a fall in exports and a rise in imports. This will lead to a reduction in
net trade and a contraction in AD
4. Interest rate effect: A rise in the price level will increase demand for money to pay the higher prices. This, in
turn, will increase the interest rate. A higher interest rate usually results in a reduction in consumption and
investment. if the price level rises, this causes inflation and an increase in the demand for money and a possible rise in interest
rates with a deflationary effect on the economy. This assumes that the central bank (in our case the Bank of England) is setting interest
rates in order to meet a specified inflation target.
Sample Question
Along which axis can the market demand curve be aggregated from individual demand curves?
A both the horizontal and vertical axis
B the horizontal axis only
C the horizontal or the vertical axis but not both
D the vertical axis only
What does an aggregate demand curve show?
A the level of aggregate demand corresponding to different levels of aggregate supply
B the aggregate output demanded corresponding to different average price levels
C the equilibrium price level corresponding to different levels of aggregate expenditure
D the equilibrium level of income corresponding to different levels of aggregate expenditure
C The diagram, which shows part of the process that causes the aggregate demand curve to slope downwards to the
right, is incomplete.
Which words correctly complete gaps 1, 2 and 3?
What is assumed to be constant when drawing an aggregate demand curve?
A government tax revenue
B interest rates
C the level of unemployment
D the money supply
, A2 Level Question
The diagram shows an aggregate demand curve.
What helps to explain why the curve is downward sloping?
A When exports increase there will be an increase in national income.
B When investment increases there will be an increase in consumption.
C When the price level increases there will be an increase in interest rates.
D When government expenditure increases there will be an increase in national output
E A fall in the price level increases the real value of money balances.
F A fall in the price level leads to an increase in interest rates.
G A fall in the price level leads to a rise in the real exchange rate.
H A fall in the price level leads to the expectation of a further decrease in the price level.
(iv) Shift in aggregate demand
Shocks to aggregate demand A2 Level, used in case study of AS level
Many unexpected events cause changes in the level of demand, output and employment
These events are called “shocks”. Some of the causes of AD shocks are as follows:
¨ A large rise or fall in the exchange rate – affecting export demand and second-round effects on output,
employment, incomes and profits of businesses linked to export industries.
¨ A recession in main trading partners affecting demand for exports of goods and services.
¨ A slump in the housing market or a big change in share prices
¨ An event such as the credit crunch (global financial crisis) – involving a fall in the amount of credit available for
borrowing by households and businesses.
¨ An unexpected cut or an unexpected rise in interest rates or change in government taxation and spending – for
example deep cuts in government spending as part of fiscal austerity
[case study]
