1. Macroeconomic Equilibrium
Chapter 16

2. Short run equilibrium
Equilibrium is established when aggregate supply equals aggregate demand
Make sure you remember to use Y’s instead of Q’s

3. Long run equilibrium
There is disagreement among economists as to the shape of the long run AS curve
According to new classical economists the economy will always move towards its long run equilibrium at the full employment level of output (Yf)

4. Long run equilibrium (neo or new classical)
According to this perspective any change in AD will only affect the price levels
An increase in AD1 to AD2 results in an increase in the average price level (inflation) from P1 to P2
The new classical economists believe the economy will move automatically to its long run equilibrium
Automatically means without government intervention
They believe in free markets

5. Long run equilibrium (neo or new classical)
This diagram shows a combination of short run and long run AS
Initially the economy is at its long run equilibrium at Yf
If there is an increase in AD due to an increase in any of the components in the short run there will be an increase to Y1
How if the productive potential is Yf?
Paying existing workers overtime
This can only happen in the short term
There is an inflationary gap from Yf to Y1 (positive output gap)
In their efforts to increase output firms are competing for scare labour and capital pushing average price levels up

6. Long run equilibrium (neo or new classical)
In their efforts to increase output firms are competing for scare labour and capital pushing average price levels up from P1 to P2
The rise in price level means an increase in costs to all firms (prices of labour, raw materials and capital)
Making more (increasing output) didn’t give any real gain
Firms decide to supply less and go back to the original output (shifts the SRAS from SRAS1 to SRAS2)
Output returns to its full employment level but at a higher price level

7. Long run equilibrium (neo or new classical)
If AD were to drop from the original equilibrium of Yf
The economy would be facing a deflationary gap (negative output gap)

8. Long run equilibrium (neo or new classical)
As AD falls so does the average price levels
This means that costs of production fall
Suppliers will supply more shifting the SRAS
Output will go back to Yf at a lower price level
The important factor in this theory is that the long run equilibrium level of output is equal to the full employment level of output
The market changes automatically
No government intervention is required
The economy should be left to market forces rather than trying to manage levels of AD

9. Long run equilibrium (Keynesian)
According to Keynesian economists equilibrium level of output may occur at different levels
Equilibrium can happen at a level of output below the full employment level if there is spare capacity
The level of output depends on the level of AD
Aggregate supply can be perfectly elastic because there is spare capacity (there are high levels of unemployment)
There is a deflationary gap (negative output gap)
This can also be illustrated with a PPC diagram
The economy is not creating to its productive potential
The deflationary/output gap is the distance between the PPC and A

10. Long run equilibrium (Keynesian)
It is possible from this perspective to get an increase in AD and not get a rise in the price levels
This depends on how much spare capacity is available (the size of the output gap)
Producers can use unused factors of production to increase output with no increase in costs so there is no inflationary pressure

11. Long run equilibrium (Keynesian)
If AD increases further to AD3 the economy may start to experience inflationary pressure
Factors of production are becoming scarcer
Price levels increase because firms’ costs increase but the increases are relatively small

12. Long run equilibrium (Keynesian)
If the economy is operating at full employment and there is an increase in AD the outcome will be purely inflationary
There is no increase in output
There is a large increase in price levels
Aggregate demand cannot be satisfied with the existing resources
The important point here is that government can intervene to close the gap by increasing aggregate demand
These are called expansionary policies
Contractionary policies are used to reduce the inflationary gap

13. Changes in Long-Run AS
Changes in the LRAS are caused by increases in factors of production or improvement in quality of FoPs
This is the equivalent of the PPB shifting
There is an increase in productive potential
This can be illustrated two ways
Use the one you are most comfortable with
The neoclassical version is good to show how inflationary pressure can be reduced

14. Time to draw! Draw the following
An economy in recession where AD is starting to increase
An economy in boom where there is high inflation (large changes in average price levels
An economy that is growing by improving the quality of factors of production e.g. more training and development
An economy that has shrunk due to an earthquake
An economy that is experiencing short run negative growth due to sharp rises in the price of oil
An economy that is growing without inflation

15. Complete Essay Question P202
Perfect 10!
Definition
Diagram
Analysis
Example
Complete Essay Question P202
1 a) Explain the components of aggregate demand (10 marks)
1 b) Evaluate the extent to which an increase in AD is beneficial for an economy (15 marks)
Plan and then complete under timed conditions (30 mins)
Perfect 15!
New Definition
More developed diagram/s
Argument for and against with evidence
Judgement

16. HL Bit!!
Multiplier

17. Several key terms will appear
They will disappear after 30 seconds (do not write anything in this time)
Your task:
(1)List the terms + (2) Define them
(8 mins to get as many as possible)

18. Inflation injection Boom Fiscal policy Wealth effect Consumption
GDP per capita
Investment
Interest Rates
Consumption
Wealth effect
Deflation
Fiscal policy
Boom
Monetary Policy
Inflation
injection
Balance of Payments
Deficit
Aggregate demand
Current Account

19. Over to you!

20. Multiplier effect
Where an increase or decrease in spending leads to a larger than proportionate change in the national income
An initial change in AD can have a much greater change in national income (GDP)
injections of new demand for goods and services into the circular flow of income can stimulate further rounds of spending
in other words ‘one person’s spending is another's income’ – and this can lead to a bigger eventual effect on output and employment.
Multiplier effect – an increase or decrease in spending leads to a larger than proportionate change in national income

21. Multiplier effect
Consider a £300 million increase in capital investment
for example created when an overseas company decides to build a new production plant in the UK
This may set off a chain reaction of increases in expenditures.
Firms who produce the capital goods and construction businesses who win contracts to build the new factory will experience an increase in their incomes and profits.
If they and their employees in turn, collectively spend about 3/5 of that additional income, then £180m will be added to the incomes of others.
At this point, total income has grown by (£300m + (0.6 x £300m) = 480m.
The sum will continue to increase as the producers of the additional goods and services realize an increase in their incomes, of which they in turn spend 60% on even more goods and services.
The increase in total income will then be (£300m + (0.6 x £300m) + (0.6 x £180m). 588m
Each time, the additional rise in spending and income is a fraction of the previous addition to the circular flow.

22. The Multiplier and Keynesian Economic
The concept of the multiplier process became important in the 1930s when Keynes suggested it as a tool to help governments to maintain high levels of employment.
This “demand-management approach” was designed to help overcome a shortage of capital investment
It measured the amount of government spending needed to reach a level of national income that would prevent unemployment.
The higher the propensity to consume domestically produced goods and services, the greater is the multiplier effect
The government can influence the size of the multiplier through changes in direct taxes.
For example, a cut in the rate of income tax will increase the amount of extra income that can be spent on further goods and services.

23. Evaluation
If people are given extra money do you think they are guaranteed to spend it?
No, it depends on their propensity to consume (or their propensity to save)
In 2010 Obama gave Americans a tax holiday but it didn’t help growth much because they just used it to pay debt and to bolster their savings
In 2011 he extended the tax holiday arguing that it would prevent the US economy from going into a recession
He was managing demand; increasing AD by increasing consumption
The success of this policy will depend on?
The Americans’ propensity to consume

24. Factors affecting the size of the multiplier - evaluation
Another factor affecting the size of the multiplier effect is the propensity to purchase imports.
If, out of extra income, people spend their money on imports, this demand is not passed on in the form of fresh spending on domestically produced output.
It leaks away from the circular flow of income and spending, reducing the size of the multiplier.
The UK has a large propensity to consume imports
The multiplier process also requires that there is sufficient spare capacity in the economy for extra output to be produced.
If there is little spare capacity the multiplier will just cause demand pull inflation

25. Factors affecting the size of the multiplier - evaluation
The multiplier effect will be larger when
The propensity to spend extra income on domestic goods and services is high
The marginal rate of tax on extra income is low
The propensity to spend extra income rather than save is high

26. Time lags (evaluation)
It is important to remember that the multiplier effect will take time to come into full effect.
A good example is the fiscal stimulus introduced into the US economy by the Obama government.
They have set aside many billions of dollars of extra spending on infrastructure spending but these sorts of capital projects can take months if not years to be completed.
Delays in sourcing raw materials, components and finding sufficient skilled labour can limit the initial impact of the spending projects.

27. Complete the student workpoint 16.3 P202
Multiplier effect
The value of the multiplier can be calculated by using either the marginal propensity to consume (mpc) or the value of the marginal propensity to withdraw (mpw)
mpw = mps plus mpm plus mrt
mps is the marginal propensity to save
mpm is the marginal propensity to import
mrt = marginal rate of taxation
The multiplier equals 1/(1-mpc) or
1/mps +mpm + mrt or
1/mpw
Marginal propensity to consume – the extra consumption induced from extra income
Marginal propensity to withdraw – the extra withdrawals induced from extra income
Marginal propensity to save – the extra saving induced from extra income
Complete the student workpoint 16.3 P202
Marginal propensity to import – the extra imports consumed induced from extra income

28. Complete the 10 mark HL question on P202
Multiplier effect
How do we draw the multiplier effect?
Just show 3 lots of AD
The first shift is the rise after the initial injection
The second shift is the final rise
Use arrows to show the direction of the movement
Complete the 10 mark HL question on P202