Economics Section 3

Economics HL Notes
Graeme (graemestanding@hotmail.com)
Stephanie (saint_steph_@hotmail.com)
Section 3: Macroeconomics
Contents
Measuring national income ........................................................................................................................... 3
Circular flow of income .............................................................................................................................. 3
Methods of measurementincome, expenditure and output .................................................................... 3
Distinctions ................................................................................................................................................ 4
Introduction to development ......................................................................................................................... 5
Definitions of Economic Growth and Economic Development .................................................................... 5
Limitations of Using GDP as a Measure to Compare Welfare between Countries ....................................... 5
Allowance for differences in purchasing power when comparing welfare between countries .................... 5
Alternative methods of measurement of development .............................................................................. 6
Problems of Measuring Development ........................................................................................................ 7
Aggregate Demand ........................................................................................................................................ 7
Aggregate Supply ........................................................................................................................................... 7
Short-run aggregate supply (SRAS) ............................................................................................................. 8
Long-run aggregate supply (LRAS) .............................................................................................................. 8
Equilibrium .................................................................................................................................................... 9
Inflationary gap & Deflationary Gap ............................................................................................................. 11
Diagram illustrating trade/business cycle ..................................................................................................... 11
Shifts in the aggregate demand curve/demand-side policies ........................................................................ 13
Shifts in the aggregate supply curve / supply-side policies ........................................................................... 14
Government Demand Side Policies .............................................................................................................. 16
Fiscal Policy.............................................................................................................................................. 16
Monetary Policy....................................................................................................................................... 16
Government Supply-side Policies ................................................................................................................. 16
Multiplier .................................................................................................................................................... 17
Accelerator .................................................................................................................................................. 17
[1]
Economics HL Notes
Multiplier and Accelerator Interaction ......................................................................................................... 18

Unemployment............................................................................................................................................ 18
Full employment and underemployment ................................................................................................. 18
Unemployment rate ................................................................................................................................ 18
Costs of unemployment ........................................................................................................................... 18
Types of unemployment .......................................................................................................................... 19
The Natural Rate of Unemployment......................................................................................................... 20
Inflation / Deflation ..................................................................................................................................... 20
Costs of Inflation ...................................................................................................................................... 21
Costs of Deflation .................................................................................................................................... 21
Causes of inflation ................................................................................................................................... 21
Cures for Inflation .................................................................................................................................... 23
Measuring Inflation.................................................................................................................................. 23
Problems of Measurement ...................................................................................................................... 23
Phillips curve............................................................................................................................................ 24
Distribution of income ................................................................................................................................. 24
Laffer Curve ............................................................................................................................................. 25
Lorenz curve and Gini coefficient ............................................................................................................. 26
[2]
Economics HL Notes
Measuring national income

Circular flow of income
To give structure to the national economy by classifying the economy into sectors.
resources
income (Y)
Households
Firms
goods & services
investment (I)
Financial
taxation (T)
government
spending (G)
savings (S)
consumption (C)
Government
imports (M)
Overseas
exports (X)
Methods of measurementincome, expenditure and output

In theory, the income, expenditure and output measures of the size of an economy should all give the same
answer. In practice, because of measurement problems, they dont.
Income:
Total value of all four payments (incomes) for factors of production rent/land, wages/labour,
interest/capital, profit/entrepreneurship that contribute to the production of each and every good and
service.
GDP at factor cost = rent + wages + interest + profit
Factor costs means excluding indirect taxes, which are not part of the out of an economy.
Expenditure:
The total spending on final goods and services (finished products) according to who these products are
purchased by:
Households:
consumption
GDP at market prices = consumption + investment
Firms:
+ government spending + exports imports
The producing firm:
investment
Other firms:
investment (in stocks)
C + I + G + (X M)
Government:
government spending
Overseas customers:
exports
However, national income only counts the value of domestic products spending on imports must be
subtracted.
This is the most common measure as the data are easier to collect.
Output:
[3]
Economics HL Notes
The sum of production of all firms is calculated by totalling the value added by each firm to each product.
The value added is equal to the sales of each firm in the production chain minus the value of intermediate
goods (to avoid the double counting intermediate firms production).
The change in stocks of the firm must also be taken into account.
GDP at market prices = value added by all firms
Distinctions
Gross & Net: Gross National Product (GNP) vs. Net National Product (NNP)
During the process of producing goods and services, capital resources depreciate. This loss of resource value
represents a loss of income Depreciation.
Net takes this depreciation into account:
NNP = National income = GNP (at factor cost) Depreciation of capital
National & Domestic: Gross Domestic Product (GDP) vs. Gross National Product (GNP)
GDP is the value of all goods and services produced in an economy, in a given time period. Some of the
income generated from this production does not belong to the citizens of the country it is sent overseas.
Likewise, there is some income that is earned overseas that is not included in GDP.
National takes this into account by measuring the amount of income actually belonging to the people of
the country, wherever it is earned. E.g. Switzerlands GNP is a lot bigger than its GDP because it benefits
from profits on overseas investments by companies.
GNP = GDP + Net overseas property income
Nominal & Real: Real GDP/GNP/NNP/National Income vs. Nominal GDP/GNP/NNP/National Income
GDP/GNP/NNP/National income measures are recorded in current year prices and dollars (nominal).
Inflation may inflate the prices used in calculations, so nominal value increases even though there is no
increase in the size of the economy.
Real takes this into account:
Eliminates effects of inflation by use of index numbers to deflate nominal figures. Real measures actual
changes in output.
Total & Per Capita: GDP/GNP/NNP vs GDP/GNP/NNP per capita
The size of an economy (and so its national income) can be affected by its population. E.g. Although China
(over 1 billion people) is still a poor country, measured by average per capita incomes, it will soon be the
worlds biggest economy. Per capita measures allow the national incomes of countries to be compared
regardless of population.
GDP per capita =
[4]
Economics HL Notes
Introduction to development
Definitions of Economic Growth and Economic Development

Economic growth: an increase in the production of goods and services over time. It is measured by
calculating national income (GDP/GNP/NNP).
Economic development: the reduction or elimination of poverty, inequality and unemployment within
the context of a growing economy. It should lead to a general improvement in the living standards of the
population.
Luxury
goods
economic growth
economic
development
Necessities / Basic needs
Limitations of Using GDP as a Measure to Compare Welfare between Countries
Income distribution: Income distribution may be uneven, that is, the average income is not the amount
that the majority of people receive. Developing countries often have an elite high-income group along
with widespread poverty.
Different costs of living in different countries: Average income may have differing purchasing power ($
value may not accurately reflect amount of products able to be bought).
Exchange rates (to US$): Conversion to US$ using the market exchange rate may not accurately reflect
cost differences between the countries currency may be overvalued or undervalued.
Non-market production: Informal markets that are ignored in official statistics may exist, thus some
production is not counted (e.g. subsistence farming).
Non-economic factors: Other factors that affect standard of living are not factored in: environment,
security/safety, political freedom, etc.
Type of production: Production that is focused on capital goods (as opposed to consumer goods) does
not add to welfare. E.g. spending on machines or military goods.
Work-leisure balance: Leisure adds to welfare but has no $ value (i.e. no. of hours worked per week).
Collection methods/errors/falsification of data: Poorer countries may have poor data collection. Political
interference with data may occur.
Allowance for differences in purchasing power when comparing welfare between countries
Some of the difference in purchasing power between countries may be allowed for through the use of
purchasing power parity (PPP). The relative cost (usually compared to the USA) of a standard basket of goods
[5]
Economics HL Notes
is measured in terms of points (USA = 100 points), and this may used to adjust average income or GNI per
capita figures.
Alternative methods of measurement of development
Sectoral transition:
Economic development should lead to a decline in agricultural production and employment, and an increase
in manufacturing, and then service industries. That is, low income countries tend to be dominated by
agriculture and developed countries by services.
Human Development Index (HDI):
Composite social indicators such as HDI and Physical Quality of Life index attempt to produce a broader
quantitative measure of development. Several social indicators (see below) are statistically combined to
result in a numerical figure representing the extent of development.
The Physical Quality of Life index combines life expectancy at birth, infant mortality and adult literacy.
HDI combines GDP per capita (PPP-adjusted), life expectancy at birth and adult literacy (aims to measure
longevity, knowledge and income). The weighting of the 3 aspects may vary the index may be adjusted for
gender disparity and income distribution.
This combination results in an average deprivation index a number between 0 (no human progress) and 1
(maximum human progress).
Social indicators:
These relate to the 3 core values of economic development: life sustenance, self-esteem and
freedom/ability to choose but most prominently life sustenance.
Development should result in the improved provision of basic needs and the elimination of absolute poverty.
That is, improved access to food, water, shelter, health services etc and possibly rising incomes, access to
education, more income equality and employment opportunities.
Examples:
Calorie intake / protein intake
(food)
Square metres of floor space
(shelter)
Life expectancy / infant mortality / people per doctor or nurse
(health services)
Literacy / % primary and secondary school attendance
(education)
Income distribution quintile figures (Lorenz Curve/Gini coefficient)
(income equality)
Changes in social structures/attitudes/institutions:
Economic development often requires or results in changes in social structures, popular attitudes and
national institutions.
Social structure:
Family less focus on family, more focus on individual
Tribal loyalties can result in conflict and civil war which hinder development
Popular attitudes:
Enterprise acceptance of risk-taking / possible business failures
Innovation new methods, as opposed to traditional methods in production
Personal advancement advancement of the individual and their higher income/wealth
Discipline acceptance of discipline of the workplace (punctuality etc)
[6]
Economics HL Notes
National institutions:
Land ownership ownership is an incentive to improve land and crop yields (a portion of the crop is
not being given away as rent to a landlord)
Style of government democratic government
Banking structures acceptance of banking and lending
Administration an honest and transparent public service, no bribery/corruption
Education/training programs acceptance if are against traditional beliefs
(E.g. Education of women)
Problems of Measuring Development
Statistical/data collection errors
Broadness of definition of development
Aggregate Demand
Aggregate demand (AD) is the total amount of goods and services (ie real GDP) that will be purchased at
each general price level (P).
AD represents total expenditure:
= consumption + investment + government spending + net overseas exports
= C + I + G + (X M)
The AD curve is downwards sloping:
As P rises, the real spending power of a given nominal income decreases AD is reduced
If P rises, local prices are less competitive and so M and X AD is reduced
As P, real value of savings, so to maintain real wealth people may cut back on spending AD
If people borrow to maintain spending, interest rates so C and I fall AD is reduced
P
AD
Real GDP
Aggregate Supply
Aggregate supply is the total supply by the business/firms sector.
There are 2 time frames that apply to aggregate supply (AS) short-run and long-run.
This is due to the time-lag between the adjustments of resource markets and those of goods and services
markets.
[7]
Economics HL Notes
Short-run aggregate supply (SRAS)

Where goods and services markets have adjusted to equilibrium, but resource markets have not.
(Many resources are subject to long-term contracts, so prices cannot change until end of contract.)
i.e. Resource prices are assumed to be constant in nominal terms.
P
Potential output:
Maximum production no surplus
resources to use even if P rises
By increasing production,
fixed costs are reduced
and profit increases even
if P is unchanged.
Depression zone
Intermediate
zone
Production will increase as P

increases and real profits
increase (since resource
prices constant).
(high fixed costs)
Real GDP
Long-run aggregate supply (LRAS)

Keynesian View
Markets are slow to adjust
An economy can be in equilibrium below full employment
Governments should and can effectively intervene to stabilise an economy
Fiscal is more effective than monetary policy
Government policy should aim to reduce

unemployment by pushing up demand.
AD1 AD2
Increases in AD will increase output/income without increasing inflation as long as the economy is below full
employment. Increases in AS at low levels of income will be ineffective.
Monetarist (neo-classical) View
Markets work
Economies tend towards full employment. Unemployment means wages are too high or a mismatch
between jobs and skills. This cannot be cured by pushing up demand. There may be a short run
impact but only at the cost of more inflation.
[8]
Economics HL Notes
Inflation is caused by excessive money supply growth (too much money chasing too few goods).
Governments should intervene really only to control inflation by controlling money supply growth.
P
LRAS
SRAS
Government policy should aim to increase

LRAS (i.e. shift the LRAS to the right).
AD1 AD2
0
YF
Real GDP
(Full employment)
Increase in AD will be purely inflationary in the long run, and so policy should focus on increasing AS with
supply-side policies.
Equilibrium
Macroeconomic equilibrium exists where AD = AS.
AD can be increased (increasing national income (Y) and so reducing unemployment), without having a
major impact on the rate of inflation, as long as the economy is below full employment (Y fe). Any attempt to
increase AD when an economy is at full employment will be purely inflationary.
[9]
Economics HL Notes
Monetarists and New Classical economists believe that an economy always tends to full employment (with a
natural rate of unemployment determined by supply side factors), and therefore the AS curve is vertical.
Any increase in AD will be purely inflationary in the long run. Here, an increase in AD from AD 1 to AD2 will
increase output from YFE to Y1, reducing unemployment in the short run. However, it will also increase the
rate of inflation. In the long run, the economy moves back to LRAS along the new demand curve (AD2). AS
shifts from SRAS1 to SRAS2, i.e. the same demand curve but at a higher rate of inflation.
The implication of AS at full employment (NAIRU) is that when an economy reaches this point, the only way
to increase national income and reduce unemployment without causing inflation is to use supply-side
policies to move the LRAS curve outwards to the right.
However, there needs to be a balance between demand-side and supply-side policies. AD can be allowed or
encouraged to increase only if there is room on the supply side for it to do so too. Most developed
economies can only sustain a 2-3% growth rate of national income without causing inflation to accelerate.
Governments need to use demand-side policies (fiscal and monetary policies) to make sure that AD does not
grow out of control whilst using supply-side policies to encourage the growth of productive potential to
make sure that economic growth is sustainable at low rates of inflation.
[ 10 ]
Economics HL Notes
Inflationary gap & Deflationary Gap

P
SRAS
Inflationary Gap
Deflationary Gap
AD2
AD1
YF
(Natural rate u/e)
Real GDP
An inflationary gap occurs where the level of aggregate demand exceeds the level of output at full
employment; and this causes upward pressure on prices.
A deflationary gap occurs when the level of aggregate demand is below the level of output at full
employment.
Diagram illustrating trade/business cycle

Economic activity /
Real GDP
upturn
boom
NB:
The length of the
cycle is inconsistent.
downturn
trough
Time
[ 11 ]
Economics HL Notes
Business cycle
stage
Boom
Downturn
Trough
Upturn
very high
decreasing
low
increasing
very high
decreasing
low
increasing
very high
decreasing
low
increasing
Unemployment
low
increasing
very high
decreasing
Inflation
high
decreasing
low
increasing
strong
slowing
low/negative
increasing
strongly negative
improves: X M
strongly positive
worsens: X M
very high
less
very low
more
low
more
high
less
good/surplus likely
worsens
bad
improved
contractionary:
T G
tight:
interest rates
expansionary:
T G
loose:
interest rates
expansionary:
T G
loose:
interest rates
contractionary:
(T) G
tight:
interest rates
-Consumer
confidence
-Consumption
-Business
confidence
-Sales & profits
-Investment
Aggregate demand
Economic growth
Trade balance
Tax receipts
Welfare & u/e
payments
Budget position
Fiscal policy
Monetary policy
As incomes rise:
1. Taxes rise because people pay more on income and spending taxes.
2. Government spending falls because there is less to pay in social benefits.
So fiscal policy is contractionary by default.
Similarly, in a boom, interest rates tend to rise because lots of people are trying to borrow money, so
monetary policy automatically tightens in a boom.
[ 12 ]
Economics HL Notes
Shifts in the aggregate demand curve/demand-side policies

P
Contractionary fiscal
policy (T G)
Expansionary fiscal
policy (T G)
Tight monetary policy

(interest rates)
Loose monetary policy

(interest rates)
AD` = Increase in AD
AD`` = Decrease in AD
Pessimistic expectations
Optimistic expectations
Appreciating
exchange rate
AD``
Depreciating
exchange rate
AD
AD`
Real GDP
Fiscal policy:
Fiscal policy is government budgetary policy:
If tax and government spending, AD increases
increases C (more after-tax income to spend)
increases I (more incentive to invest)
If tax and government spending, AD decreases
Interest rates as a tool of monetary policy:
The changing of the money supply, and so interest rates, affects the level of AD.
[This is often left to the central bank of a country: eg Reserve Bank of Australia, US Federal Reserve.]
If interest rates, AD increases
increases C (less incentive to save (lower return on savings), more incentive to borrow to
spend (because pay less interest on loans)).
increases I (less costly to finance projects)
If interest rates, AD decreases
Consumer expectations:
If expectations improve, AD increases.
increases C due to better job security (strong economy)
increases I due to strong current and predicted sales/profits
If expectations worsen, AD decreases.
Overseas sector / exchange rates:
Appreciation is when the exchange rate for the local currency increases and buys more overseas currency.
Depreciation is when the exchange rate for the local currency decreases and buys less overseas currency.
If local currency depreciates, AD increases.
X increases as price of exports is lower for overseas customers demand for exports increases
M decreases as the price of imports is increased demand for imports decreases
[ 13 ]
Economics HL Notes
Shifts in the aggregate supply curve / supply-side policies

P
LRAS
SRAS
LRAS`
SRAS`
Real GDP
Factors that affect a shift in the aggregate supply curve are:

Changes in the quantity and quality of capital investment
Changes in the quantity and quality of resources
Changes in the quantity and quality of labour
Changes in supply-side policies
Changes in legislation
All these factors affect both SRAS and LRAS.
However, there are two factors which only affect the short run curve.
1. Factor Prices. When production costs increase, SRAS decreases. When production costs decrease,
SRAS increases.
2. Changes in the weather. Favourable weather could increase aggregate supply (agricultural markets).
Unfavourable weather could decrease aggregate supply.
Quantity and quality of capital investment
(Capital investments refers to money used by a business to purchase fixed assets (e.g. machinery)).
An increase in the stock of capital will increase productivity of the labour force and increase the output it
produces. Improvements in technology, i.e. new and better ways of producing, are a major source of
increased aggregate supply. Much new technology is actually embodied in capital goods, i.e. to acquire the
new technology the firm invests in the latest capital equipment.
Quantity and quality of resources
Government can clear and/or reclaim land for agricultural or industrial use. Governments can also invest in
the discovery of minerals, although this may not always be successful. Governments can also attempt to
increase access to fishing/hunting, thereby increasing supply.
Quantity and quality of labour
The larger the labour force the larger the output, ceteris paribus. An increased labour force may come from
population growth, or migration, or an internal change. The biggest increase to the labour force in most
industrialised countries in the last fifty years has come about through an internal change: the increased
participation of women in the labour market.
An improved quality of labour, i.e. a more skilled labour force, is an important source of increased output.
Improvements in education, training, and health lead to increased productivity.
[ 14 ]
Economics HL Notes
Supply-side policies
Supply-side policies are government policies aimed at increasing aggregate supply. The deliberate action to
increase the quantity and quality of capital or the quantity and quality of labour are supply side policies.
Many such policies focus upon incentives. Taxes and allowances might be adjusted to encourage work,
encourage risk-taking or encourage investment. For example, reducing income tax raises the opportunity
cost of not working. Reducing unemployment benefit also raises the opportunity cost of not working.
Offering tax allowances may induce firms to invest in new plant and machinery. All these are supply side
policies designed to increase the incentive to produce more (increase AS).
Legislation
Legislation can also be changed to affect AS. Laws on school leaving age or retirement affect the supply of
labour.
[ 15 ]
Economics HL Notes
Government Demand Side Policies
Fiscal Policy
Fiscal policy is the use of government spending and taxation to influence AD, raise revenue, redistribute
income and influence consumption patterns. However, there are problems with fiscal policy.
Time Lags It will take at least 18 months for the full effects for a change in fiscal policy to be felt.
Finance Inflexibility Fiscal programmes are very hard to adjust in the face of changing circumstances.
Budget Deficits These can lead to increases in interest rates and taxation.
Crowding Out Budget deficits need to be financed by borrowing. The public sector needs to compete
with the private sector for funds, and so will have to offer lenders higher rates of interest. Thus the
private sector will be forced to offer higher interest rates as well, discouraging investment and spending.
Some economists argue that this will only happen when an economy is at full capacity, so crowding out
is not an argument against fiscal policy if the economy is operating below potential.
Because of the limitations of fiscal policy, most governments focus their demand-side policies around
monetary policy and the rate of interest in particular. Fiscal policy is now often used to improve the supplyside of an economy.
Monetary Policy
Monetary policy is the use of the rate of interest predominantly to influence AD (controlling money supply
and targeting the exchange rate can also be used). Monetary policy also has its potential problems.
Investment is interest inelastic Investment is more dependent upon expectations than the rate of
interest.
One policy fits all The rate of interest can be seen as a rather blunt tool, as a central banks rate of
interest decision applies to all institutions and all aspects of an economy.
Goodharts Law Once a measure of the money supply is chosen to be controlled it becomes a poor
measure of the money supply as financial institutions will find different ways of lending money in
response to controls. This obviously is not a problem if interest rates are being used rather than direct
control of the money supply.
Disintermediation The banking system is bypassed by companies and other institutions lending to
each other directly and not through the usual financial institutions such as banks.
Most developed countries now actively use the rate of interest to influence AD. Independent central banks
dominate rate of interest decision-making. They are able to respond quickly to changing economic
circumstances, whereas fiscal policy often has to wait for the democratic wheels to turn.
Government Supply-side Policies
Supply-side policies aim to increase an economys productive potential by:
Increasing labour mobility
Increasing incentives/decreasing disincentives to work
[ 16 ]
Economics HL Notes
Increasing the productivity of labour

Increasing investment, innovation and enterprise
Policies tend to focus on microeconomics:
Deregulation
Privatisation
Education and training
Trade Union reforms
Income tax cuts
Benefit reform
Welfare to work programmes
Minimum wage
Multiplier
The multiplier effect is the proportion by which an initial increase in injections (G, I or X) causes a greater
final increase in the level of national income. This is because the extra income is spent on goods and services,
so raising demand for those, which raises demands for other things, etc
The size of the multiplier depends upon the marginal propensities to consume and withdrawal (MPC and
MPW). Withdrawal means that income is saved or spent on imports. The greater the MPC (the less the MPW
as all income is either consumed or withdrawn (Y = C + W)) the greater the multiplier will be. This is because
a greater proportion of an increase in income will be spent with domestic firms. Household saving and
consumption plans are difficult to predict and so the value of the multiplier is hard to predict and it may
change over time.
Accelerator
The accelerator is the relationship between a change in the level of national income and the level of
investment that this induces. Firms invest in capital goods when the demand for goods and services is
growing, to satisfy the increased demand. Conversely, a fall in consumer demand will lead to a fall in capital
investment (no point investing to produce more). Because of the nature of investment (capital goods tend to
last for a number of years and are therefore expensive), the percentage change of investment will tend to be
greater than the initial change in demand that stimulated the decision to increase capacity.
N.B.
In reality firms do not response in this automatic way to demand changes and investment decisions
depends more on expectations about future demand than on what is happening at that very moment.
In a recovering from recession, when demand is rising, firms may satisfy that extra demand by bringing
unused capacity into operation and not investing more.
If the rate of growth of national income is increasing then investment will rise by a multiple of this
growth rate.
If the rate of growth of national income is decreasing then investment will fall.
If national income is constant then only replacement investment will take place.
If national income falls then there will be no investment.
[ 17 ]
Economics HL Notes
Multiplier and Accelerator Interaction

An initial increase in anything that stimulates a rise in aggregate demand (such as an increase in government
spending) will have a multiplier effect on national income and this increase in national income in turn will
have an accelerator effect on investment. This increase in investment will have a multiplier effect on
national income and then the process repeats itself. Of course, anything that causes national income to fall
will have a multiplier/accelerator interaction in the opposite direction.
This interaction can help explain why booms and slumps start.
Unemployment
Full employment and underemployment

Full employment: Full employment is not 100% employment. It is the level of unemployment consistent with
the natural rate of unemployment. This does not include cyclical unemployment.
Underemployment may occur when a full-time job seeker accepts a part-time job they are now not
unemployed, but underemployed. [Disguised unemployment is where firms are overstaffed either in an
attempt to produce low unemployment rates (planned economies) or to keep experienced workers. Workers
in these situations may have little to do.] In developing countries, underemployment means less than full
time work but not necessarily part time work (which implies a regular job). It could be seasonal work, work a
couple of hours a day, day labourers who get occasional work.
Unemployment rate
Unemployed: Workers who are able and willing to work but who do not have jobs
Labour force: The population of working age who are willing and able to work (i.e. the number of employed
+ the number of unemployed).
Participation rate: The labour force as a percentage of the working age population.
Costs of unemployment
Loss of foregone production in the economy Economy operates inside PPF.
Inefficient, lower living standards
Government budget position worsens Unemployment benefit payments increase, tax receipts decrease.
Other worthwhile government programs cannot be financed
Loss of consumer spending
The unemployed suffer large reductions in income and personal poverty.
Social costs:
Private costs (to the unemployed person): poor health, low self-esteem, boredom/isolation, financial
hardship, substance abuse
[ 18 ]
Economics HL Notes
External costs: family stress, vandalism/petty crime

Types of unemployment
Involuntary Unemployment: Involuntary unemployment occurs when workers are willing to work for
existing wage rates but jobs are not available and is caused by demand-side problems.
Cyclical / Demand-deficient: Unemployment associated with a slump or downturn in economic activity.
Occurs during recessions, as aggregate demand (C+I+G+X-M) is too low to achieve the non-accelerating
inflation rate of unemployment (NAIRU).
Cures for involuntary unemployment are based on demand-side policies. Economic growth can be
stimulated by fiscal policy (tax cuts, increase in government spending) and monetary policy (reduce rate of
interest).
Voluntary Unemployment: It occurs when workers choose not to take job offers at existing wage rates.
The natural rate of unemployment reflects voluntary unemployment.
Structural: People who are unemployed because of changes in the nature of the economy.
Significant loss of jobs in certain industries due to fall in demand for a product, or a shift in the
geographical location of production
Includes regional u/e (result of a dominant industry in an area) and technological u/e (human skills
replaced by technology)
Unemployment is reasonably long-term
Cures: Retraining, incentives to new industries to come to areas hurt by closure of old ones, help for workers
to leave affected areas for jobs elsewhere (worker mobility).
Technological: Unemployment due to technological advances in production. Either machines replace labour
force, or current labour force not skilled enough to use machines. This is linked to structural unemployment.
Cures: Train labour force to work with newer technology (e.g. IT training courses).
Frictional: Workers entering/re-entering workforce or switching between jobs.
High frictional u/e during a boom (less risk in changing jobs), low in a recession (more risk)
Unemployment is short-term
Cures: Improve the information stream from employers to job-seekers about job opportunities.
Seasonal: People who are unemployed because of the season.
E.g. Tourism, fishing, agriculture, construction
Cures: Train workers in skills for employment in the off-season.
Real wage (classical unemployment): Where the price of labour is above the equilibrium price of full
employment (clearing wage).
Due to legislated minimum wages above the clearing wage (a price floor for labour)
Due to strong union power winning high wage outcomes for those already in jobs
Due to unemployment benefits that exceed or are close to the clearing wage.
[ 19 ]
Economics HL Notes
Wages
S (households)
Wages
Unemployment = QS - QD
D (firms)
QD
Full U/E
QS
Employment
Aggregate demand for labour falls to QD, whereas aggregate supply of labour increases to QS.
QD - QS is the level of disequilibrium unemployment.
Cures: Restrict union power, remove/lower minimum wage, cut unemployment benefits or make them
harder to get.
Cures for voluntary unemployment are based on supply-side policies.
AS can be increased by:
Increasing incentives to work
Decreasing disincentives
Increasing labour mobility
Human capital improvements
The Natural Rate of Unemployment
The natural rate, also known as the equilibrium rate, is any unemployment that exists when the aggregate
demand for labour equals the aggregate supply of labour. Voluntary unemployment = L1 - L2. Supply side
policies should be used as a cure. The natural rate exists at the full employment level of income (where there
is no demand deficient unemployment) and this is where the AS curve is vertical.
Inflation / Deflation
Inflation: A general sustained increase in prices.
Deflation: A general sustained decrease in prices.
[ 20 ]
Economics HL Notes
Costs of Inflation
Inequity:
Savers & borrowers Savings lose value; assets financed by loans gain value
Exporters & importers Local exporters charge higher prices-X; imports are cheaper-M
Financial asset holders & real asset holders financial holders lose; real holders gain
Price makers & price takers price makers-monopoly/oligopoly- can raise prices; takers cant
fixed income earners & talented / in demand fixed incomes cant increase, real incomes
Trade balance worsens X M - Because of a reduction in competitiveness.
Distorted investment, speculation People buy existing assets rather than make new productive
investments.
Lower business confidence Unpredictable prices increase riskLess investment, so less employment
Accounting problems Unable to predict future prices of capital equipment, so hard to plan ahead
Industrial unrest Workers want wage increases to maintain real wage
Less saving Disincentive to save (money saved loses spending power so worth less in the future)
Less investment Less productivity
Wastage of resources Administration changes
N.B. The overall impact of (high) inflation is reduction in economic growth combined with an increase in
unemployment but a low rate of inflation, say 2% or less, is perfectly manageable.
Costs of Deflation
When prices are falling, consumers may decide to postpone purchases in the expectation of buying the item
at a cheaper price later on. This causes a fall in demand and can create further price declines (e.g. Japan in
recent years).
Deflation also causes real interest rates to rise, curbing demand, because, given the interest rate, falling
prices widen the gap between price changes and the interest rate, raising the real rate. As well, falling asset
prices (including housing and equities) reduce personal sector wealth and inflate the real value of debt,
resulting in higher business failures and personal bankruptcies.
Causes of inflation
Cost Push
Cost push inflation can be caused by:
Rising raw material costs (e.g. higher oil prices)
Rising labour costs
Increased indirect taxation
May also be due to monopoly/oligopoly firms making profits
Cost push inflation can lead to a wage-price spiral:
Workers press for higher wages to cover higher prices increased costs for firms higher prices.
[ 21 ]
Economics HL Notes
Decrease in AS resulting in an increase in inflation from P1 to P2.
Demand Pull
Demand pull inflation can be caused by:
Reduced taxation
Increased government spending
Reduced interest rates
Rising consumer confidence stimulated by rising asset prices
Economic growth in other countries
Depreciation of a countrys exchange rate
Excess monetary growth:
If the money supply increases (money is printed) without the quantity of goods increasing, inflation results.
Equation of exchange: M V = P Q
M: Money supply (e.g. money in circulation)
V: Velocity of circulation
P: Average price
Q: Quantity of goods
V is assumed to be constant in the short/medium-term.
If M rises > Q rises, then P will rise (inflation)
Increase in AD when near or at full employment, resulting in an increase in inflation from P 1 to P2.
[ 22 ]
Economics HL Notes
Cures for Inflation

Demand side:
Monetary policy (an increase in interest rates)
Fiscal policy (reducing government spending and/or increasing direct taxation)
Monetary and fiscal policies need to work in tandem. There is no point in tightening monetary policy if this is
contradicted by a slackening of fiscal policy.
Supply side:
Policies to increase the total supply of goods and services of an economy.
Direct controls over prices and wages (now out of fashion too interventionist).
Control of inflation is a balancing act between AD and AS. Governments or independent central banks need
to keep control of the rate of growth of AD whilst policies are needed to continually expand an economys
productive capacity. Increased output produced at lower cost gives an economy room to grow without
causing rising inflation.
Measuring Inflation
The inflation rate is the percentage change in the price level. The formula is:
The most common method of measuring the price level is to construct a price index. The cost of a
representative basket of goods is recorded and the rate of inflation is measured by comparing current prices
to original.
Problems of Measurement
A price index does a pretty good job of calculating month-to-month and year-to-year rates of inflation.
However, there are some problems which increase in magnitude the longer the time period of comparison.
Arrival and Disappearance of Goods
New goods are continually introduced to the market and old goods continually drop out. The basket of
goods and services is, therefore, always changing. The longer the time period of the comparison, the greater
the difference in the contents of the two baskets of goods and services.
Quality of Goods
Many goods and services can be found over long time periods, but with major differences in quality. The
clothes, cars, telephones, health care and banking services of today are very different from those of the
1960s, so prices cannot be directly compared. Many price changes are themselves a reflection of quality
changes (e.g. prices are higher to reflect higher quality). However, for some goods, such as those using
electronics, prices fall over time even though quality is increasing (more processing power, more functions,
etc).
[ 23 ]
Economics HL Notes
Choice of Weight
The expenditure pattern which determines the weights used in the price index is an average for the
economy as a whole. The spending pattern of particular groups of people, e.g. students or old people, may
bear little resemblance to the average and reduce the value of the index to such groups (e.g. when it is used
to preserve the real value of pensions).
Phillips curve
There is an inverse relationship between inflation and output, and therefore unemployment. Keynesian
theorists, based on their view of the AS curve, employed increases in AD to reduce unemployment because
at low levels of output spare capacity means that prices are stable. As the economy neared full employment,
inflation would start to increase. This approach went wrong in the late 1960s and early 1970s when
stagflation (rising unemployment with rising inflation) appeared in most developed/industrial economies.
Rising factor costs and oil prices fuelled rising inflation and government policies aimed at increasing AD, to
cure rising levels of unemployment, made the situation worse.
Friedman argued that the trade-off between inflation and unemployment only existed in the short run.
Government policy to increase AD in order to reduce unemployment would only be successful in the short
run, but higher inflation would eventually result in a return to higher unemployment. Increasing rates of
both inflation and unemployment are represented by an outward shift in the short run Philips curve (SRPC 1
to SRPC3). In the long run unemployment would remain stuck at natural rate/NAIRU (non accelerating
inflationary rate of unemployment), which is the rate of unemployment that exists when inflation is
constant. This is the level of unemployment that exists at full employment (long run).
The solution is supply-side policies.
Distribution of income
Direct taxation: Tax liability targeted at individuals or companies on the basis of income (e.g. Income tax,
company tax).
Incidence (who pays the tax) is the same as impact (who is responsible for transferring the
money to the tax authorities).
[ 24 ]
Economics HL Notes
Indirect taxation: A tax imposed on spending (e.g. Cigarette tax, petrol tax, general sales tax, value added
tax, import tariffs).
Incidence = consumer, impact = retailer
Progressive taxation: As income increases, the marginal tax rate increases (on the extra income).
Tax brackets increase with income
The proportion of income paid as tax increases with income
Proportional taxation: (flat tax) the proportion of income paid in tax is the same for everyone (e.g. 30% of
income paid whether one has income of $30000 or $200000)
Marginal rate of tax = average rate of tax
Regressive taxation: Proportion of income paid in tax is less for those with higher incomes, and more for
those with lower incomes.
Marginal rate of tax < average rate of tax.
This arises in several ways:

Lump sum taxes (e.g. poll tax) everyone pays the same amount whatever their income.
Spending (indirect taxes) tend to be regressive because rich people spend a lower
proportion of their incomes (they save more) than poor people.
There may be (and often are) loopholes in the income tax system that benefit the rich
(e.g. tax breaks for mortgages).
Indirect taxes and lump sum taxes are much easier to collect than income tax so are used by
LDCs even though the incidence is regressive.
Transfer payments: Welfare payments from the government to the households sector. When combined
with progressive taxation, income is effectively transferred from high income earners to lower income
earners.
Laffer Curve
The Laffer curve suggests that there is an optimum tax

rate (r) at which tax revenue is maximised. Any increase
in the average tax rate beyond this optimum will cause
tax revenue to fall.
[ 25 ]
Economics HL Notes
Lorenz curve and Gini coefficient

A Lorenz curve shows the proportion of a nations income that is earned by any given percentage of the
population.
The curve is below the line of complete equality because, for example, the poorest 20% of the population
will own less than 20% of national income. The more bowed the line, the greater the degree of inequality.
The Gini coefficient gives a numerical measure to the degree of inequality (the higher the number, the
greater the inequality).
Income distribution varies for a wide variety of reasons including: labour market conditions, bargaining
power, tax and benefit structures, wealth, discrimination, household composition, qualifications and hours
worked.
Government tax and benefit measures to redistribute income
By using the tax and benefit system governments can redistribute income from rich to poor. For example,
progressive income taxes will take income from the rich which can then be redistributed using transfer
payments (income transferred from one person to another without any production taking place) such as
unemployment benefits or pensions.
Public services (paid for out of taxation) are also a way of redistributing income (e.g. free education and
health services).
A criticism of transfer payments (and high taxes to pay for them) is that they act as a disincentive to work.
However, others believe that this argument is not borne out by the evidence, e.g. Sweden which has a big
welfare state and high taxes, is one of the worlds successful economies with a very high standard of living.
[ 26 ]

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Economics HL Notes

Multiplier and Accelerator Interaction ......................................................................................................... 18

Measuring national income

Methods of measurementincome, expenditure and output

Definitions of Economic Growth and Economic Development

Short-run aggregate supply (SRAS)

Production will increase as P

(high fixed costs)

Long-run aggregate supply (LRAS)

Government policy should aim to reduce

Government policy should aim to increase

Inflationary gap & Deflationary Gap

Diagram illustrating trade/business cycle

Shifts in the aggregate demand curve/demand-side policies

Tight monetary policy

Loose monetary policy

Shifts in the aggregate supply curve / supply-side policies

Factors that affect a shift in the aggregate supply curve are:

Government Demand Side Policies

Increasing the productivity of labour

Multiplier and Accelerator Interaction

Full employment and underemployment

External costs: family stress, vandalism/petty crime

Decrease in AS resulting in an increase in inflation from P1 to P2.

Cures for Inflation

This arises in several ways:

The Laffer curve suggests that there is an optimum tax

Lorenz curve and Gini coefficient

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