Unit 2: Managing the economy
There are two different types of economic growth, known as actual growth and potential growth.
Actual growth is measured as increases in real GDP, and potential growth is an increase in the capacity in the economy.
Actual out means the real output which the country produces with the current employment of factors of production. And we have to note here that not all the available resources are employed at any given time.
However, potential output means what the economy could produce if all the resources are fully employed. Therefore, if there is an increase in resources, or if there is increase in productive capacity of the economy, then we say that the there is potential economic growth.
It is also important to compare the actual and potential growth, which is also known as the output gap. The output gap signifies the economy is operating with spare capacity, which also means unemployment. Therefore, if the output gap is too big, the unemployment will be a concern for the economy. However, if the aggregate demand exceeds aggregate supply, which also means the economy is trying to operate at overcapacity, there will be the problem of inflation.
Growth can be achieved by increases in the components of aggregate demand, for example an increase in consumer spending. The size of this increase depends on the size of the multiplier, and therefore any changes in injections and leakages will have an impact on the degree of change in growth.
the following diagram shows increase in aggregate demand which results in increased output.
As we can see that the outward shift of AD increased real national output. A positive change to any component of aggregate demand ((C+I+G+X-M)) will increase aggregate demand and can result in economic growth in the short run. However, price also could increase as we can see from the diagram. The more inelastic the AS curve is, the higher the increase in price will be due to any increase in aggregate demand. That means If there is spare capacity in the economy then an increase in AD will cause a higher level of real GDP.
AD can increase for the following reasons:
Lower interest rates – Lower interest rates reduce the cost of borrowing and so encourages spending and investment.
Increased wages. Higher real wages increase disposable income and encourages consumer spending.
Increased government spending (G).
Fall in value of the country’s currency which makes exports cheaper and increases quantity of exports(X).
Increased consumer confidence, which encourages spending (C).
Lower income tax which increases disposable income of consumers and increases consumer spending (C).
Economic growth can also be achieved by an increases or improvements in any of the factors of
production, eg productivity growth or immigration. The effect is to shift the aggregate supply curve to the right.The diagram on the left shows shor-run AS curve.
Economic growth can also be shown by a long run rightward shift of the AD and AS Curves shown in the diagram below.
– Increased capital. e.g. investment in new factories or investment in infrastructure, such as roads and telephones.
– Increase in working population, e.g. through immigration, higher birth rate.
– Increase in Labour productivity, through better education and training or improved technology.
– Discovering new raw materials.
– Technological improvements to improve the productivity of capital and labour e.g. Microcomputers and the internet have both contributed to increased economic growth.
Similarly, if there is any opposite change to the above causes, it will turn out to be a constraint on economic growth.
Real economic growth stimulates higher employment since labour is a derived demand. An increase in real GDP should cause an outward shift in the aggregate demand for labour. Not all industries will share in the growth of an economy.
The accelerator effect of growth on capital investment: Rising demand and output encourages investment in capital – this helps to sustain GDP growth by increasing LRAS.
Higher revenue for the government
Growth has a positive effect on Government finances – boosting tax revenues and helping to reduce the budget deficit. More people in work, rising spending and higher company profits all contribute to an increased flow of revenue to the Treasury.
Greater business confidence: Growth has a positive impact on profits & business confidence.
Improvements in living standards: Growth is an important avenue through which per capita incomes can rise and absolute poverty can be reduced in developing nations.
If the economy grows too quickly there is the danger of inflation as demand races ahead of the ability of the economy to supply goods and services. Producer then take advantage of this by raising prices for consumers.
Fast growth can create negative externalities (increased pollution and congestion) which damages overall social welfare
Not all of the benefits of economic growth are evenly distributed. We can see a rise in national output but also growing income and wealth inequality in society. There will also be regional differences in the distribution of rising income and spending.
In O Level tutorials, we learned about individual demand and supply curves and how equilibrium is determined at micro-economic level. Now, let us look at how price level and equilibrium level of real output is determined at macro-economic level.
Macroeconomic equilibrium for an economy in the short run is established when aggregate demand intersects with aggregate supply. This is shown in the diagram below.
At the price level P, the aggregate demand for goods and services is equal to the aggregate supply of output. The output and the general price level in the economy will tend to adjust towards this equilibrium position.
If the price level is too high, there will be an excess supply of output. If the price level is below equilibrium, there will be excess demand in the short run. In both situations there should be a process taking the economy towards the equilibrium level of output.
When the Aggregate Demand Curve shifts to its right from AD to AD1, the the price level increases from P to P1, and the output level increases from Y to Y1
Anything that affects the components of aggregate demand (consumption, investment, government spending and net exports) will shift the AD curve.
Aggregate Demand can increase or decrease depending on several things. In effect, these things will cause shifts up or down in the AD curve. These include:
Exchange Rates: When a country’s exchange rate increases, then net exports will decrease and aggregate expenditure will go down at all prices. This means that AD will decrease.
Distribution of Income: This is directly related to wages and profits. When worker’s real wages increase, then people will have more money on their hands because their overall income has increased. When this happens they tend to consume more causing the consumption expenditures to increase.
Expectations: Consumers tend to have certain expectations about the future of the economy and will adjust their spending accordingly. If they would expect the economy to not do so well in the future, saving would increase thus decrease overall expenditures. Rising price levels will cause aggregate demand to increase. If consumers foresee the price level to rise in the near future, they might just go out and buy that good now, increasing the consumption expenditures in AD. Many different expectations have the capacity to increase or decrease aggregate demand and it is not always clear as to how this will happen.
Foreign Income: This relates the country’s economic output with the income of its trading partners in the world. When foreign income rises, the country’s exports will increase causing aggregate demand to increase.
Monetary and Fiscal Policies: The government has some ability to impact AD. They can spend money or increase taxes in order to influence how consumers spend or save. An expansionary fiscal policy causes AD to increase, while a contractionary monetary policy causes AD to decrease.
Suppose that increased efficiency and productivity together with lower input costs (e.g. of essential raw materials) causes the short run aggregate supply curve to shift to its right. (i.e. an increase in supply – assume no shift in aggregate demand).
The diagram shows what is likely to happen. AS shifts outwards and a new macroeconomic equilibrium will be established. The price level has fallen and real national output (in equilibrium) has increased to Y2.
An injection such as an increase in exports means that there is an immediate increase in AD. But the extra income raised by selling goods abroad will raise incomes of those making the goods and services, and this income will be spent in the economy. Whatever is not spent on withdrawals will cause second round increases in AD, which leads to further rounds of income and spending. These knock on effects are the multiplier effects of an increase in injections, and the process work in reverse when injections fall — a reverse multiplier, or multiplied contraction of AD.
Next topic: Causes, costs and constraints on economic growth
In O Level Economics lessons, we learned that the ‘supply’ means willingness and ability of producers/suppliers to offer goods and services for sale. The quantity of goods and services supplied increases as the price goes up. Therefore, if we represent this in a diagram, the supply curve is upwards sloping.
If we add up the supply curves of all producers in the economy, we can develop an Aggregate Supply Curve(AS). Aggregate supply curve shows what happens to the total output of all the goods and services in the economy as the general price level changes. Just like individual supply curves, AS curve also slopes upwards because, producers as a whole will expand the amount they are willing to supply as prices rise. Therefore, AS represents the ability of an economy to deliver goods and services to meet demand.
The nature of this relationship will differ between the long run and the short run
Short Run Aggregate Supply (SRAS) shows total planned output when prices in the economy can change but the prices and productivity of all factor inputs e.g. wage rates and the state of technology are held constant.
In the short run, the Aggregate Supply curve reflects a positive relationship between the price level and the real quantity of National Output.
This short-run positive relationship occurs primarily because production costs (e.g., wages) are “sticky” relative to output prices when demand changes. Increases to Aggregate Demand cause movements up along the Aggregate Supply curve in which prices rise more quickly than wages, so higher profit per unit induces more output. Declines in Aggregate Demand reverse these movements along the Aggregate Supply curve – prices fall more quickly than costs, so profits decline and firms reduce production.
The short-run aggregate supply curve shifts under similar circumstances as individual supply curves.
So, anything that is able to change the factor costs will be a shift factor of Short-Run Aggregate Supply.
|Shift Factor||The change to AS Curve||Reason|
|Increase in labour force or capital stock||AS Curve will shift to its right||More output can be produced at every price level|
|Increase in productivity||AS Curve will shift to its right||Fall in the unit costs of production||Increase in the expected future price level||AS Curve will shift to its left||Workers and firms increase wages and prices||Increase in government taxes||AS Curve will shift to its left||Costs increase|
Long run aggregate supply (LRAS): LRAS shows total planned output when both prices and average wage rates can change – it is a measure of a country’s potential output and the concept is linked to the production possibility frontier.
In the long run, the LRAS curve is assumed to be vertical (i.e. it does not change when the general price level changes)
Aggregate demand (AD) is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels.
Aggregate means ‘total’ and in this case we use the term to measure how much is being spent by all consumers, businesses, the government and people and firms overseas.
This diagram shows the downward sloping Aggregate demand curve. AD curve is not always a straight line. Many argue that AD curve is actually a rectangular hyperbola.
The total amount spent is likely to be fairly constant along the AD, and therefore the area under
the AD is likely to remain fairly constant, as in the rectangular hyperbola.
There are various reasons why the AD curve is sloping downwards.
One reason is that, at higher prices, an economy’s export is likely to decrease and imports tend to increase. That means the total net exports(X-M) will decrease => see below for the components of AD.
Another argument for the downward sloping AD is that at higher prices the interest rate is likely to be higher, meaning that investment (a component of AD) is lower. They might also save more.
Aggregate demand (AD) = total spending on goods and services
AD = C + I + G + (X-M)
C: Consumption, this includes demand for durables e.g. audio-visual equipment and motor vehicles & non-durable goods such as food and drinks which are “consumed” and must be re-purchased.
I: Capital Investment – This is spending on capital goods such as plant and equipment and buildings to produce more consumer goods in the future. Investment also includes spending on working capital such as stocks of finished and semi-finished goods.
G: Government Spending – This is spending on state-provided goods and services including public goods and merit goods .
Government spending is by central and local government on goods and services. While to some extent this spending is determined by the fiscal policy of the government, it is also largely dependent upon the business cycle. In a boom, tax receipts increase and the demands on government spending will fall, and vice versa in an economic slowdown.
Changes in G are likely to have a large multiplier effect, in that the spending changes have a direct impact upon the spending in the economy.
(X-M) = Exports – Imports: 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).
Next topic: Aggregate Supply
Definition: Money is anything which is universally acceptable as a medium of exchange. Therefore if we can buy goods and services with it then it could be seen as money.
In ancient age, before people started to use money, barter system was used to exchange goods for one another. Barter system was useful because it allowed people to exchange what they had in excess for things which they did not have. However, there were problems of barter system. For example, how many goats would be exchanged for one cow? How many bags of rice for one bag of wheat flour?
There was also another problem, if A has rice, and wants wheat flour, B has wheat flour but wants only fish, then barter system cannot satisfy their wants, unless there is C who has fish and wants rice. So A has to go to C and exchange rice for fish and then only A can go to B to get the fish exchanged for wheat flour.
The creation of money solved this problem.
Read the story “The Goldsmith Who Became a Banker — A True Story” to get an idea of how people started using money in ancient days.
Also read A brief history of Money
Medium of Exchange – When money is used to intermediate the exchange of goods and services, it is performing a function as a medium of exchange. It thereby avoids the inefficiencies of a barter system. Exchange is easier and less time consuming in a money economy than in a barter economy.
Measure of Value / Unit of Account – e.g. 1 apple = MVR5, while a can of Redbull = MVR25. In a barter system (as described above), even if a double co-incidence of wants is found, there is no common unit of measure. In today’s world, each and every country has money. Therefore, determining the relative prices is very easy and quick.
Store of Value – To act as a store of value, a money must be able to be reliably saved, stored, and retrieved – and be predictably usable as a medium of exchange when it is retrieved. The value of the money must also remain stable over time.
Standard for deferred payments – Money is also inevitably used as the unit in terms of which all future or deferred payments are stated. Future transactions can be carried on in terms of money. The loans, which are taken at present, can be repaid in money in the future. The value of the future payments is regulated by money.
Money must be durable, which means it should be usable for a long time and must be of good quality. It should not be something that gets damaged easily or spoiled in a short period of time. Since money is durable, it can be used as a store of wealth/value.
Since anything to have economic value, it must be scarce. Money is scarce and that’s why it has value. People can accept something as money only if it has value.
Money must be something that people can easily carry with them from one place to another. Today paper currency is used instead of gold and silver because paper currency is more portable.
Money must be something that everyone can accept for a unit of account and medium of exchange.
Money must be something that can measure all the goods and services accurately. For this purpose, money must be something that we can divide into small denominations.
Money must be something which has a relatively stable value over time. It should not lose its value over time. Its function as a store of value can be fulfilled only if its value is stable.