Chapter 3,The macro-economic environment,1 The structure and objectives of the economy,Macro-economics is the study of the aggregated effects of the decisions of individual economic units (such as households or businesses). It looks at a complete national economy, or the international economic system as a whole.,1.1 Income and expenditure flows There is a circular flow of income in the economy This means expenditure, output and income will all have the same total value A basic closed economy: Firms Households,1.2 Withdrawals and injections into the circular flow of income Withdrawals: savings, taxation, import expenditure Injections: investment, government spending, export income Financial sector: saving, investment spending Government sector: taxation, government spending Foreign sector: import demand, export demand Changes in behaviour of one of the components of the circular flow can lead to significant changes in economic performance as a whole.,2 Factors which affect the economy,The economy is rarely in a stable state because of the various changing factors which influence it. These include investment levels, the multiplier effect, inflation, savings, confidence, interest rates and exchange rates.,2.1 The multiplier in the national economy The multiplier involves the process of circulation of income in the national economy, whereby an injection of a certain size leads to a much larger increase in national income. An initial increase in expenditure will have a snowball effect, leading to further and further expenditures in the economy.,The increase in national income will be a multiplier of the initial increase in spending, with the size of the multiple depending on factors such as what proportion of any new investment is spent or what proportion is saved.,2.2 Aggregate supply and demand 2.2.1 Aggregate demand The total demand in the economy for goods and services is called aggregate demand. Include: consumption, investment, government spending and exports minus imports.,The aggregate demand curve The aggregate demand curve slopes from left to right. A shift may be due to a factor such as an increase or decrease in consumer confidence.,2.2.2 Aggregate supply The aggregate supply refers to the ability of the economy to produce goods and services. The aggregate supple curve The aggregate supply curve slopes upwards from left to right and does not shift in the short term,Where the aggregate demand curve intersects with the aggregate supply curve, the total demand for goods and services in the economy is equal to the total supply of goods and services in the economy. This is known as the equilibrium level of national income. A change in either the aggregate supply or demand will have an affect on the price level and the national income.,2.2.3 A shift in aggregate demand P59 Diagram A drop in consumer confidence: Y0 Y1, P0 P1 A rise in consumer confidence: Y0 Y2, P0 P2,3 The determination of national income,3.1 Aggregate demand and supply equilibrium Demand for goods and services is in balance with the available supply,3.2 Full-employment national income If one aim of a countrys economic policy is full employment, then the ideal equilibrium level of national income will be where AD and AS are in balance at the full employment level of national income, without any inflationary gap. Where aggregate demand at current price levels is exactly sufficient to encourage firms to produce at an output capacity where the countrys resources are fully employed.,3.3 Inflationary gaps Occurs when resources are fully employed Any increase in demand only serves to increase prices 3.4 Example,3.5 Deflationary gap Occurs with unemployment of resources Any change in demand will affect output Prices are fairly constant Actual national income is below full employment national income,3.6 Stagflation High unemployment combined with high inflation Any long term major increase in costs (a price shock) is likely to have this effect.,3.7 Summary An equilibrium national income will be reached where aggregate demand equals aggregate supply. One is at a level of demand which exceeds the productive capabilities of the economy at full employment, and there is insufficient output capacity in the economy to meet demand at current prices. There is then an inflationary gap. The other is at a level of employment which is below the full employment level of national income. The difference between actual national income and full employment national income is called a deflationary gap. To create full employment, the total national income must be increased by the amount of the deflationary gap.,4 The business cycle,Business cycles or trade cycles are the continual sequence. rapid growth in national income, followed by a slow-down in growth then a fall in national income. after which comes growth again, which peaks followed again by recession,4.1 Phases in the business cycle P61 Diagram Recession (Point A) De