The Circular Flow of Income
Supply and Demand in the Macro economy:
Aggregate demand:
AD represents the total demand in and economy. It includes:
Consumption
Investment
Government expenditures
Exports – Imports
Aggregate supply:
AS represents the total supply in the economy.
It is initially elastic as more labour is employed
At full employment of resources it becomes perfectly inelastic as supply can not be increased
At this point costs rise as firms complete for resources and this leads to prices risingGovernment Aims:
Full employment: Those who are able to work and are looking for work are in employment. Usually there is always some frictional unemployment
Price stability: Governments aim to keep inflation at a steady rate (around 2%). This allows firms and individuals to plan for the future more accurately
Economic growth: Increasing the output of the economy (increase in Real GDP). In the long run they aim to push the PPC (Production Possibility Curve) outwards
Redistribution of Income: May aim to take money from the rich (higher tax rates) and give it to the poorer population ( Unemployment and social housing benefits)
Balance of payments stability: Keep imports and exports balanced as well as flows of finance
Government Production:
The government may get involved in providing goods for the following reasons:
Goods that are a natural monopoly may be provided by the government (water/electricity)
Essential goods such as health and education may be provided by the government so they are available to everyone
Provision of merit goods like public swimming pools and libraries
Government Employment:
The government employs people in public sector jobs such as teaching, fire and police services
Through its employees it can set examples of good employment practices and restrict wage increases to limit inflation
It can also increase or decrease its number of employees to effect unemployment
Fiscal Policy:
Key characteristics: Changes in government expenditure and taxation
Government expenditure: Increases in spending will increase AD. Decreases in spending decreases AD
Taxation: Increases in taxation will leave people with less money to spend. This will lead to a decrease in AD
Budget: The government has a surplus when it takes in more money than it spends. A deficit is when the government spends more money than it takes in
Deflationary fiscal policy: Increasing government spending and reducing taxation to increase AD.
Inflationary fiscal policy: Reducing government spending and increasing taxation to reduce AD.
Monetary Policy:
Key characteristics: controlling changes in the money supply, interest rate and foreign exchange rate
Money supply: Changed by printing money and encouraging or discouraging lending by commercial banks. Increased money supply is equal to and increase in Aggregate Demand.
Interest rates: Central Banks raise or lower these. Raised interest rates make saving more attractive and borrowing more expensive. This should lower Aggregate Demand and firms are also likely to invest less
Exchange rates: These can be fixed to another currency (the USD for example) to control inflation or they can be floating.
Deflationary Monetary Policy: Raising interest rates and reducing money supply to reduce Aggregate Demand.
Inflationary Monetary Policy: Reducing interest rates and increasing the money supply to increase Aggregate Demand
Supply-side Policy:
Key characteristics: Focuses on increasing AS (Aggregate Supply) and shifting the PPC to the right
Tax reduction: Reducing the tax on firms profits can encourage them to invest in becoming more productive and earn larger profits.
Regulation: Removing or increasing regulations on firms can reduce or increase business costs and effect AS
Education and training: Increased investment in these should increase the labour forces productivity and increase AS.
Private firms can participate in Supply Side Policy through things like education of their employees
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