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Part B Key environmental influences ~ 6: The macro-economic environment 125

Figure 3 The aggregate supply and demand model

Figure 3 shows that the aggregate demand curve slopes from left to right (ie demand will rise as prices fall

because people can afford more) but may shift as shown. A shift may be due to a factor such as an

increase or decrease in consumer confidence. This is explained below.

2.2.2 Aggregate supply

The aggregate supply refers to the ability of the economy to produce goods and services. Aggregate

supply is positively related to the price level. This is because a price rise will make more profitable sales

and encourage organisations to increase their output. The aggregate supply curve slopes upwards from

left to right and does not shift in the short term, as shown in Figure 3.

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.)

Note that the graph highlights the fact that a change in either the aggregate supply or demand will have an

affect on the price level and the national income. Assuming that employment levels are related to national

income levels, the model shows how unemployment and inflation (a change in price level) could arise.

2.2.3 A shift in aggregate demand

Say for example, that the equilibrium level is currently where national income = Y0 and price =P0 . Then

suppose there is a drop in consumer confidence so consumers stop spending (ie demand falls). The new

equilibrium would be where national income = Y1 and where price = P1. If, on the other hand, consumer

confidence increased (for example due to more access to affordable credit), consumers would buy more

(an increase in demand) and so the new equilibrium would be where national income = Y2 and price = P2.

3 The determination of national income

Equilibrium national income is determined using aggregate supply and aggregate demand analysis.

3.1 Aggregate demand and supply equilibrium

Aggregate demand (AD) is total planned or desired consumption demand in the economy for consumer

goods and services and also for capital goods, no matter whether the buyers are households, firms or

government.

3.2 Full-employment national income

If one aim of a country's 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

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126 6: The macro-economic environment ~ Part B Key environmental influences

any inflationary gap – in other words, where aggregate demand at current price levels is exactly sufficient

to encourage firms to produce at an output capacity where the country's resources are fully employed.

3.3 Inflationary gaps

In a situation where resources are already fully employed, there may be an inflationary gap since

increases in demand will cause price changes, but no variations in real output.

A shift in demand or supply will not only change the national income, it will also change price levels.

Example

If you are not sure about this point, a simple numerical example might help to explain it better. Suppose

that in Ruritania there is full employment and all other economic resources are fully employed. The

country produces 1,000 units of output with these resources. Total expenditure (that is, aggregate

demand) in the economy is 100,000 Ruritanian dollars, or 100 dollars per unit. The country does not have

any external trade, and so it cannot obtain extra goods by importing them. Because of pay rises and easier

credit terms for consumers, total expenditure now rises to 120,000 Ruritanian dollars. The economy is

fully employed, and cannot produce more than 1,000 units. If expenditure rises by 20%, to buy the same

number of units, it follows that prices must rise by 20% too. In other words, when an economy is at full

employment, any increase in aggregate demand will result in price inflation.

3.4 Deflationary gap

In a situation where there is unemployment of resources there is said to be a deflationary gap. Prices

are fairly constant and real output changes as aggregate demand varies. A deflationary gap can be

described as the extent to which the aggregate demand function will have to shift upward to produce the

full employment level of national income.

3.5 Stagflation

In the 1970s there was a problem with stagflation: a combination of unacceptably high unemployment

and unacceptably high inflation. One of the causes was diagnosed as the major rises in the price of crude

oil that took place. The cost of energy rose and this had the effect of rendering some production

unprofitable

National income fell, and both prices and unemployment rose. Any long term major increase in costs (a

price shock) is likely to have this effect.

3.6 Summary

An equilibrium national income will be reached where aggregate demand equals aggregate supply. There

are two possible equilibria.

(a) 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.

(b) 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 (expenditure) must be

increased by the amount of the deflationary gap.

Part B Key environmental influences ~ 6: The macro-economic environment 127

4 The business cycle

Business cycles or trade cycles are the continual sequence of rapid growth in national income, followed

by a slow-down in growth and then a fall in national income (recession). After this recession comes

growth again, and when this has reached a peak, the cycle turns into recession once more.

4.1 Phases in the business cycle

Four main phases of the business cycle can be distinguished.

x Recession x Recovery

x Depression x Boom

Recession tends to occur quickly, while recovery is typically a slower process.

4.2 Diagrammatic explanation

At point A in the diagram below, the economy is entering a recession. In the recession phase, consumer

demand falls and many investment projects already undertaken begin to look unprofitable. Orders will be

cut, inventory levels will be reduced and business failures will occur as firms find themselves unable to

sell their goods. Production and employment will fall. The general price level will begin to fall. Business

and consumer confidence are diminished and investment remains low, while the economic outlook

appears to be poor. Eventually, in the absence of any stimulus to aggregate demand, a period of full

depression sets in and the economy will reach point B.

A

B

C

D

Trend in

output

Actual

output

Output

Time

Figure 4 The business cycle

At point C the economy has reached the recovery phase of the cycle. Once begun, the phase of recovery is

likely to quicken as confidence returns. Output, employment and income will all begin to rise. Rising

production, sales and profit levels will lead to optimistic business expectations, and new investment will

be more readily undertaken. The rising level of demand can be met through increased production by

bringing existing capacity into use and by hiring unemployed labour. The average price level will remain

constant or begin to rise slowly.

In the recovery phase, decisions to purchase new materials and machinery may lead to benefits in

efficiency from new technology. This can enhance the relative rate of economic growth in the recovery

phase once it is under way.

As recovery proceeds, the output level climbs above its trend path, reaching point D, in the boom phase of

the cycle. During the boom, capacity and labour will become fully utilised. This may cause bottlenecks in

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128 6: The macro-economic environment ~ Part B Key environmental influences

some industries which are unable to meet increases in demand, for example because they have no spare

capacity or they lack certain categories of skilled labour, or they face shortages of key material inputs.

Further rises in demand will, therefore, tend to be met by increases in prices rather than by increases in

production. In general, business will be profitable, with few firms facing losses. Expectations of the future

may be very optimistic and the level of investment expenditure high.

It can be argued that wide fluctuations in levels of economic activity are damaging to the overall economic

well-being of society. The inflation and speculation which accompanies boom periods may be inequitable

in their impact on different sections of the population, while the bottom of the trade cycle may bring high

unemployment. Governments generally seek to stabilise the economic system, trying to avoid the

distortions of a widely fluctuating trade cycle.

5 Inflation and its consequences

High rates of inflation are harmful to an economy. Inflation redistributes income and wealth. Uncertainty

about the value of money makes business planning more difficult. Constantly changing prices impose

extra costs.

5.1 Inflation

Inflation is the name given to an increase in price levels generally. It is also manifest in the decline in the

purchasing power of money.

Historically, there have been very few periods when inflation has not been present. We discuss below why

high rates of inflation are considered to be harmful. However, it is important to remember that deflation

(falling prices) is normally associated with low rates of growth and even recession. It would seem that a

healthy economy may require some inflation. Certainly, if an economy is to grow, the money supply must

expand, and the presence of a low level of inflation will ensure that growth is not hampered by a shortage

of liquid funds. (Liquidity is the ease with which assets can be converted into cash.)

5.2 Why is inflation a problem?

An economic policy objective which now has a central place in the policy approaches of the governments

of many developed countries is that of stable prices. Why is a high rate of price inflation harmful and

undesirable?

5.2.1 Redistribution of income and wealth

Inflation leads to a redistribution of income and wealth in ways which may be undesirable. Redistribution

of wealth might take place from accounts payable to accounts receivable. This is because debts lose 'real'

value with inflation. For example, if you owed $1,000, and prices then doubled, you would still owe

$1,000, but the real value of your debt would have been halved. In general, in times of inflation those with

economic power tend to gain at the expense of the weak, particularly those on fixed incomes.

5.2.2 Balance of payments effects

If a country has a higher rate of inflation than its major trading partners, its exports will become relatively

expensive and imports relatively cheap. As a result, the balance of trade will suffer, affecting employment

in exporting industries and in industries producing import-substitutes. Eventually, the exchange rate will

be affected.

Key term

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