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IB

Economics SL: City Honors School

IB Economics SL
Unit 2: Macroeconomics
Mr. R.S. Pyszczek, Jr.
City Honors School

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Economic Ac6vity
The Circular Flow of Income Model Pgs 234-236
l

Describe, using a diagram, the circular ow of income between households and rms
in a closed economy with no government.

IdenQfy the four factors of producQon and their respecQve payments (rent, wages,
interest and prot) and explain that these consQtute the income ow in the model.

Outline that the income ow is numerically equivalent to the expenditure ow and


the value of output ow.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Economic Ac6vity
The Circular Flow of Income Model
l

Describe, using a diagram, the circular ow of income in an open economy


with government and nancial markets, referring to leakages/ withdrawals
(savings, taxes and import expenditure) and injecQons (investment,
government expenditure and export revenue).

Explain how the size of the circular ow will change depending on the
relaQve size of injecQons and leakages.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Economic Ac6vity
The Circular Flow of Income Model
l Outline that the income ow is numerically equivalent to the

expenditure ow and the value of output ow.

l Describe, using a diagram, the circular ow of income in an

open economy with government and nancial markets,


referring to leakages/ withdrawals

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Economic Ac6vity
The Circular Flow of Income Model
The diagram below displays the Circular Flow of resources, goods and
services in a naQon with a closed economy and no government sector.
To fully understand how producQve resources, goods and services and
money ow from households to rms and from rms to households
through voluntary exchanges in a naQons product and resource
markets lets examine our role(s) in this diagram.

IB Economics SL: City Honors School

Unit 2: Macroeconomics

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Economic Ac6vity
The Circular Flow of Income Model*
One of the main basic economic models is the circular-ow model, which describes the ow of money
and products throughout the economy in a very simplied way. The model represents all of the players
in an economy as either households or rms (companies), and it divides markets into two categories:
l

Markets for goods and services (Product Markets)

Markets for factors of producQon (Factor or Resource Markets)

h\p://economics.about.com/od/economics-basics/ss/The-Circular-Flow-Model_3.htm#step-heading

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
Economic Ac6vity
The Circular Flow of Income Model
In the Product (goods and services) Markets, households buy nished products
from rms that are looking to sell what they make. In this transacQon, money
ows from households to rms, and this is represented by the direcQon of the
arrows on the lines labeled $$$$ that are connected to the Product
Market box

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Economic Ac6vity
The Circular Flow of Income Model
The term factors of producQon refers to anything that is used by a rm in order
to make a nal product. Some examples of factors of producQon are labor (the
work done by people), capital (the machines used to makes products), land, and so
on. Labor markets are the most commonly discussed form of a Factor Market, but
its important to remember that factors of producQon can take many forms.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
Economic Ac6vity
The Circular Flow of Income Model
When households provide labor to rms, they can be thought of as the sellers
of their Qme or work product. (Technically, employees can more accurately be
thought of as being rented rather than being sold, but this is usually an
unnecessary disQncQon.)

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
Economic Ac6vity
The Circular Flow of Income Model
Therefore, the funcQons of households and rms are reversed in factor
markets as compared to in goods and services markets. Households provide
labor, capital, and other factors of producQon to rms, and this is represented
by the direcQon of the arrows on the Labor, capital, land, etc. lines on the
diagram above.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
Economic Ac6vity
The Circular Flow of Income Model
In the other side of the exchange, rms provide money to households as
compensaQon for the use of factors of producQon, and this is represented by
the direcQon of the arrows on the $$ lines that connect to the Factor
Markets box.

IB Economics SL: City Honors School

Unit 2: Macroeconomics

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Leakages- Is money leaving that simple circular ow and does not


directly go back to the Households. Lets say for instance, that
household #1 earns an income of $2,000 a month, they put $200
in savings. The money is going to the bank then the bank writes
up a nancial claim. The bank is then able to use that money to
loan to rms. Leakages lead to a decrease in economic acQvity. If
the sum of all the leakages is more than the injecQons there
tends to be unemployment or deaQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Examples of Leakages*
l

Savings: Households saving a porQon of their income which than allows the bank to give
businesses/rms a loan.

Taxes: The government is deducQng a porQon of the households income which then goes
directly back to the household where eligible. This transacQon is called transfer payments, such
as subsidies, AISH, Employment Insurance and CPP.

Import spending: Is money leaving a country to pay for imported goods made by other
countries. It is simply goods coming into a country and money leaving that country.

Resources:Dr.Power's Class Discussion, Principles of Macreconomics.Sayre Morris- Page 92-94, Google Books

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Injec6ons- Is spending that is not dependent on the current level of


income. Money that is received by rms that does not come directly
from the households. An example of injecQons is investment spending
it results in a physical increase in plant or equipment. Another way to
look at investment spending is an increase in the economys stock of
capital goods. It is money that enters the circular ow. An example is
spending from rms and the government and not directly from
households. InjecQons lead to an increase in economic acQvity. If the
sum of all the injecQons are more than the leakages there tends to be
expansion or inaQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Examples of Injec6ons*
l

Investment Spending: Is when businesses buy capital goods funded by loans from
the bank.

Government Spending: Is when the Government buys goods and services from other
businesses using net taxes.

Export Spending: Goods leaving the country and money coming in from the selling of
the goods.

Resources: Dr.Power's Class Discussion, Principles of Macreconomics.Sayre Morris- Page 92-94, Google Books

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Economic Ac6vity
Measures of Economic AcQvity: Gross DomesQc Product (GDP), and
Gross NaQonal Product (GNP) or Gross NaQonal Income (GNI)
l DisQnguish between GDP and GNP/GNI as measures of economic

acQvity.

l DisQnguish between the nominal value of GDP and GNP/GNI and the

real value of GDP and GNP/GNI.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Economic Ac6vity
Measures of Economic AcQvity: Gross DomesQc Product (GDP), and
Gross NaQonal Product (GNP) or Gross NaQonal Income (GNI)
l DisQnguish between total GDP and GNP/GNI and per capita GDP and

GNP/GNI.

l Examine the output approach, the income approach and the

expenditure approach when measuring naQonal income.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Economic Ac6vity
Measures of Economic AcQvity: Gross DomesQc Product (GDP), and Gross
NaQonal Product (GNP) or Gross NaQonal Income (GNI)
l

Evaluate the use of naQonal income staQsQcs, including their use for making
comparisons over Qme, their use for making comparisons between
countries and their use for making conclusions about standards of living.

Explain the meaning and signicance of green GDP, a measure of GDP that
accounts for environmental destrucQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Economic Ac6vity
Measures of Economic AcQvity: Gross DomesQc Product (GDP), and Gross
NaQonal Product (GNP) or Gross NaQonal Income (GNI)
l

Evaluate the use of naQonal income staQsQcs, including their use for making
comparisons over Qme, their use for making comparisons between
countries and their use for making conclusions about standards of living.

Explain the meaning and signicance of green GDP, a measure of GDP that
accounts for environmental destrucQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Economic Ac6vity
Measures of Economic AcQvity: Gross DomesQc Product (GDP)*Pgs.
237-250
GDP is the monetary value of all the nished goods and services produced within a
country's borders in a specic Qme period, though GDP is usually calculated on an
annual basis. It includes all of private and public consumpQon, government
outlays, investments and exports less imports that occur within a dened territory.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Economic Ac6vity
Measures of Economic AcQvity: Gross DomesQc Product (GDP)
GDP is commonly used as an indicator of the economic health of a country, as well
as to gauge a country's standard of living. CriQcs of using GDP as an economic
measure say the staQsQc does not take into account the underground economy -
transacQons that, for whatever reason, are not reported to the government.
Others say that GDP is not intended to gauge material well-being, but serves as a
measure of a naQon's producQvity, which is unrelated.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Economic Ac6vity
Measures of Economic AcQvity: Gross DomesQc Product (GDP)

Strengths for using GDP:*


l

GDP is considered the broadest indicator of economic output and growth.

Real GDP takes inaQon into account, allowing for comparisons against other historical Qme
periods.

The Bureau of Economic Analysis issues its own analysis document with each GDP release,
which is a great investor tool for analyzing gures and trends, and reading highlights of the very
lengthy full release

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Economic Ac6vity
Measures of Economic AcQvity: Gross DomesQc Product (GDP)
Weaknesses of using GDP:*
l

Data is not very Qmely - it is only released quarterly.

Revisions can change historical gures measurably (the dierence between 3% and 3.5%
GDP growth is a big one in terms of monetary policy

The Black-markets or underground markets are not included in the data

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
Economic Ac6vity
Measures of Economic AcQvity: Gross DomesQc Product (GDP)*

How do we calculate it?


GDP = C + G + I + NX

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
Economic Ac6vity
Measures of Economic AcQvity: Gross DomesQc Product (GDP)
How do we calculate it? GDP = C + G + I + NX
"C" is equal to all private consumpQon, or consumer spending, in
a naQon's economy. ConsumpQon/Consumer Spending

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
Economic Ac6vity
Measures of Economic AcQvity: Gross DomesQc Product (GDP)
How do we calculate it? GDP = C + G + I + NX
"G" is the sum of Government Spending.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
Economic Ac6vity
Measures of Economic AcQvity: Gross DomesQc Product (GDP)
How do we calculate it? GDP = C + G + I + NX
"I" is the sum of all the country's businesses spending on capital.
Investment

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
Economic Ac6vity
Measures of Economic AcQvity: Gross DomesQc Product (GDP)
How do we calculate it? GDP = C + G + I + NX
"NX" is the naQon's total net exports, calculated as total exports
minus total imports. (NX = Exports - Imports)

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
Economic Ac6vity
Measures of Economic AcQvity: Gross NaQonal Product (GNP)*
GNP is an economic staQsQc that includes GDP, plus any income earned by
residents from overseas investments, minus income earned within the
domesQc economy by overseas residents.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
Economic Ac6vity
Measures of Economic AcQvity: Gross NaQonal Product (GNP)*
GNP is a measure of a country's economic performance, or what its ciQzens
produced (i.e. goods and services) and whether they produced these items
within its borders.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
Economic Ac6vity
Measures of Economic AcQvity: Gross NaQonal Income (GNI)*
The sum of a naQons gross domesQc product (GDP) plus net income received
from overseas. Gross naQonal income (GNI) is dened as the sum of value
added by all producers who are residents in a naQon, plus any product taxes
(minus subsidies) not included in output, plus income received from abroad
such as employee compensaQon and property income.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
Economic Ac6vity
Measures of Economic AcQvity: Gross NaQonal Income (GNI)
GNI measures income received by a country both domesQcally and from
overseas. In this respect, GNI is quite similar to Gross NaQonal Product (GNP),
which measures output from the ciQzens and companies of a parQcular naQon,
regardless of whether they are located within its boundaries or overseas.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Economic Ac6vity
Measures of Economic AcQvity: Gross DomesQc Product (GDP), and Gross NaQonal Product (GNP) or
Gross NaQonal Income (GNI)

To convert a naQons GDP to GNI, three terms need to be added to the former:
1) net compensaQon receipts,
2) net property income receivable and
3) net taxes (minus subsidies) receivable on producQon and imports.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Economic Ac6vity
Measures of Economic AcQvity: Gross DomesQc Product (GDP), and Gross
NaQonal Product (GNP) or Gross NaQonal Income (GNI)
Lets use Canadas 2010 GDP and GNI numbers to understand the reconciliaQon between
these two measures of economic output.
l

Canadas GDP in 2010 = $1,624.6 million (~ $1.62 billion)

Net compensaQon receipts = 0

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

Economic Ac6vity
Measures of Economic AcQvity: Gross DomesQc Product (GDP), and Gross
NaQonal Product (GNP) or Gross NaQonal Income (GNI)
Lets use Canadas 2010 GDP and GNI numbers to understand the reconciliaQon between
these two measures of economic output.
l

Net property income receivable = -$28.2 million (note the negaQve sign)

Net taxes = 0

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
Economic Ac6vity
Measures of Economic AcQvity: Gross DomesQc Product (GDP),
and Gross NaQonal Product (GNP) or Gross NaQonal Income (GNI)
Lets use Canadas 2010 GDP and GNI numbers to understand the
reconciliaQon between these two measures of economic output.
l

Canadas 2010 GNI = $1,624.6 + (-28.2) = $1,596.4 million (~$1.60 billion)

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

The Business Cycle


Short-Term FluctuaQons and Long-Term Trend Pgs. 254
l

Explain, using a business cycle diagram, that economies typically tend to go


through a cyclical pa\ern characterized by the phases of the business cycle.

Explain the long-term growth trend in the business cycle diagram as the
potenQal output of the economy.

DisQnguish between a decrease in GDP and a decrease in GDP growth.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall
Economic Ac6vity
The Business Cycle
Economies go through a regular
pa\ern of ups and downs in the
value of GDP. This is known as the
business cycle
(someQmes you also see it referred
to as the economic cycle).

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
The Business Cycle*
The business cycle is characterized by four main phases:
l Boom: high levels of consumer spending, business condence,

prots and investment. Prices and costs also tend to rise faster.
Unemployment tends to be low as growth in the economy
creates new jobs

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
The Business Cycle*
The business cycle is characterized by four main phases:
l Recession: falling levels of consumer spending and condence

mean lower prots for businesses which start to cut back on


investment. Spare capacity increases + rising unemployment as
businesses cut back and reduce stocks

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
The Business Cycle*
The business cycle is characterized by four main phases:
l Slump /Depression: a prolonged period of declining GDP - very

weak consumer spending and business investment; many


business failures; rapidly rising unemployment; prices may start
falling (deaQon)

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
The Business Cycle*
The business cycle is characterized by four main phases:
l Recovery: things start to get be\er; consumers begin to increase

spending; businesses feel a li\le more condent and start to


invest again and build stocks; but it takes Qme for
unemployment to stop growing

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

The Business Cycle*


Timing and shape of the business cycle is aected by many factors, including:
l

Changes in the level of business and consumer condence

AlternaQng periods of stocking and de-stocking

Changes in the value of consumer spending and business investment

Changes in government policy which can induce a change in the economy

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
The Business Cycle*
There are, however, some drawbacks for an economy that is growing rapidly:
l

The risk of demand pull inaQon if actual growth exceeds potenQal growth

Increased inequality if the benets of growth are not evenly distributed

Increased demand for imports and a trade decit

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1

The Level of Overall Economic Ac6vity

The Business Cycle (Click for Video)


Economic growth is the increase in the market value of the goods and services
produced by an economy over Qme. It is convenQonally measured as the percent
rate of increase in real gross domesQc product, or real GDP. Of more importance is
the growth of the raQo of GDP to populaQon (GDP per capita), which is also called
per capita income. An increase in growth caused by more ecient use of inputs is
referred to as intensive growth. GDP growth caused only by increases in inputs such
as capital, populaQon or territory is called extensive growth.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.1 The Level of Overall Economic Ac6vity
Theory of Knowledge: Poten6al Connec6ons
What is the empirical evidence for the existence of the business cycle? How do
we decide whether this evidence is sucient?

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)


The AD Curve Pgs. 257-271
l DisQnguish between the microeconomic concept of demand for a

product and the macroeconomic concept of aggregate demand.

l Construct an aggregate demand curve.


l Explain why the AD curve has a negaQve slope.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)


The AD Curve*
The total amount of goods and services demanded in the economy at a
given overall price level and in a given Qme period. It is represented by
the aggregate-demand curve, which describes the relaQonship
between price levels and the quanQty of output that rms are willing to
provide. Normally there is a negaQve relaQonship between aggregate
demand and the price level. Also known as "total spending".

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)


The AD Curve*
Aggregate demand is the demand for the gross domesQc product (GDP)
of a country, and is represented by this formula:
Aggregate Demand (AD) = C + I + G + (X-M) C = Consumers' expenditures on
goods and services. I = Investment spending by companies on capital goods.
G = Government expenditures on publicly provided goods and services. X =
Exports of goods and services. M = Imports of goods and services.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2 Aggregate
Demand and Aggregate
Supply
Aggregate Demand (AD)
The AD Curve*

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)


The Components of AD
l Describe consumpQon, investment, government spending and

net exports as the components of aggregate demand.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)


The Components of AD
There are four components of Aggregate Demand (AD);
ConsumpQon (C), Investment (I), Government Spending (G) and
Net Exports (X-M).
AD = C + I + G + (X-M)

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)


The Determinants of AD or Causes of Shixs in the AD Curve
l

Explain how the AD curve can be shixed by changes in consumpQon due to


factors including changes in consumer condence, interest rates, wealth,
personal income taxes (and hence disposable income) and level of household
indebtedness.

Explain how the AD curve can be shixed by changes in investment due to factors
including interest rates, business condence, technology, business taxes and the
level of corporate indebtedness.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)


The Determinants of AD or Causes of Shixs in the AD Curve
l

Explain how the AD curve can be shixed by changes in government spending due to
factors including poliQcal and economic prioriQes.

Explain how the AD curve can be shixed by changes in net exports due to factors
including the income of trading partners, exchange rates and changes in the level of
protecQonism.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)


The Components of AD
Four Components of Aggregate Demand (AD)
1) ConsumpQon*
l

This is made by households, and someQmes consumpQon accounts for the


larger porQon of aggregate demand. An increase in consump<on shi=s the
AD curve to the right. (See next slide)

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2 Aggregate Demand and
Aggregate Supply
Aggregate Demand (AD)
An increase in consump<on
shi=s the AD curve to the right.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)


The Components of AD: Factors that aect ConsumpQon*
l

Consumer Condence If consumers are condent about future income,


job stability, and the economy is growing and stable, spending is likely to
increase. However, job insecurity and uncertainty over income is likely to
delay spending. An increase in consumer condence shixs AD to the right.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)


The Components of AD: Factors that aect ConsumpQon*
l

Interest Rates Lower interest rates tend to increase consumpQon because


larger goods are usually purchased on credit and if interest rates are low, then
its cheaper to borrow. Consumers mostly borrow to buy houses, which is one of
the biggest purchases and lower interest rates means lower mortgage
payments, so households can spend more on other goods. Some Economists
argue that lower interest rates also make saving less a\racQve, but there is no
real evidence. So, lower interest rates increase Aggregate Demand.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)


The Components of AD: Factors that aect ConsumpQon*

Consumer Debt If a consumer has a lot of debt, he is unlikely to buy more


since he would have to pay his debt o rst. Low consumer debt increases
consumpQon and aggregate demand.

l Wealth Wealth are assets held by a household, such as property or

stocks. An increase in property is likely increase to consumpQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)


The Components of AD

2) Investment*
l

This is spending by rms on capital, not households. Investment is the most


volaQle component of AD. An increase in investment shi=s AD to the right in the
short run and helps improve the quality and quanQty of Factors of ProducQon in
the long run

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)


The Components of AD: Factors that aect Investment*
l

Interest Rates Firms borrow from banks to make large capital intensive
purchases, and if the interest rate decreases, it becomes cheaper for rms
to invest and provides incenQve for rms to take risk.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)

The Components of AD: Factors that aect Investment*


l

Business Condence If rms are condent about the economy and its future growth, they are
more likely to invest.

Investment Policy If governments provide incenQves such as tax breaks, subsidies, loans at
lower interest rates then investment can increase. However, corrupQon
and bureaucracy deters investment.

Na6onal Income As rms increase output, they would need to invest in new machines. This
relaQonship is known as The Accelerator.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)

The Components of AD Factors that aect Investment*


3) Government Spending
l

Government spending forms a large total of aggregate demand, and an increase in government
spending shi=s aggregate demand to the right. Government spending is categorized into
transfer payments and capital spending. Transfer payments include pensions and
unemployment benets and capital spending is on things like roads, schools and hospitals.
Governments spend to increase the consumpQon of health services, educaQon and to re-
distribute income. They may also spend to increase aggregate demand.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)


The Components of AD
4) Net Exports
l

Imports are foreign goods bought by consumers domesQcally, and exports are
domesQc goods bought abroad. Net exports is the dierence between exports
and imports, and this factor can be net imports too, if imports are greater than
exports. An increase in net exports shi=s aggregate demand to the right. The
exchange rate and trade policy aects net exports.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)


Level of NaQonal Income
ConsumpQon*
The percentage of naQonal income that goes towards consumpQon is determined
by the naQons average propensity to consume (APC). APC is found by dividing the
level of consumpQon (C) by the level of naQonal income (Y). APC = C/Y

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)


Level of NaQonal Income
Savings*
At lower levels of income, households tend to consume with a greater proporQon
of their income than at higher income levels. The average propensity to save (APS)
is savings (S) divided by naQonal income (Y); this tells us the percentage of a
naQons income that is saved. APS = S/Y

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)


Level of NaQonal Income
Taxes*
All governments collect taxes. The percentage of the naQons income collected in
taxes tells us the average rate of taxaQon (ART). The ART is found by dividing the
total taxes collected in a country (T) by the naQonal income (Y). ART = T/Y

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)


Level of NaQonal Income
Imports*
Finally, households may consume goods or services produced abroad, which
counts as imports to a naQon and is thus not included as part of the naQons
aggregate demand and is subtracted from GDP. The average propensity to import
(APM) is a percentage of naQonal income spent on imports. APM = M/Y

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)


Level of NaQonal Income
All of a naQons income goes towards consumpQon, savings, paying taxes or buying
imports. Therefore:
APC + APS + ART + APM = 1
ConsumpQon increases at a decreasing rate with income. The higher the naQons
income of households, the lower the average propensity to consume.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Supply (AS)


The Meaning of Aggregate Supply Pgs. 274-284
l

Describe the term aggregate supply.

Explain, using a diagram, why the short-run aggregate supply curve (SRAS curve)
is upward sloping.

Explain, using a diagram, how the AS curve in the short run (SRAS) can shix due
to factors including changes in resource prices, changes in business taxes and
subsidies and supply shocks.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Supply (AS)


The Meaning of Aggregate Supply*
The total supply of goods and services produced within an economy at a given overall
price level in a given Qme period. It is represented by the aggregate-supply curve,
which describes the relaQonship between price levels and the quanQty of output that
rms are willing to provide. Normally, there is a posiQve relaQonship between
aggregate supply and the price level. Rising prices are usually signals for businesses to
expand producQon to meet a higher level of aggregate demand.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Supply (AS)


The Meaning of Aggregate Supply*
A shix in aggregate supply can be a\ributed to a number of variables. These include
changes in the size and quality of labor, technological innovaQons, increase in wages,
increase in producQon costs, changes in producer taxes and subsidies, and changes in
inaQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Supply (AS)


ShiUs in the AS curve can be caused by the following factors:*
l

changes in size & quality of the labor force available for producQon

changes in size & quality of capital stock through investment

technological progress and the impact of innovaQon

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Supply (AS)


ShiUs in the AS curve can be caused by the following factors:*
l

changes in factor producQvity of both labor and capital

changes in unit wage costs (wage costs per unit of output)

changes in producer taxes and subsidies

changes in inaQon expectaQons - a rise in inaQon expectaQons is likely to boost wage


levels and cause AS to shix inwards

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Supply (AS)


IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Supply (AS)


IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Supply (AS)


In the diagram above - the shix from AS1 to AS2 shows an increase in aggregate supply
at each price level might have been caused by improvements in technology and
producQvity or the eects of an increase in the acQve labor force.
An inward shix in AS (from AS1 to AS3) causes a fall in supply at each price level. This
might have been caused by higher unit wage costs, a fall in capital investment spending
(capital scrapping) or a decline in the labor force.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Supply (AS)


The Meaning of Aggregate Supply (SRAS)*
In the short run, aggregate supply responds to higher demand (and prices) by bringing
more inputs into the producQon process and increasing uQlizaQon of current inputs. In
the long run, however, aggregate supply is not aected by the price level and is driven
only by improvements in producQvity and eciency.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Supply (AS)


AlternaQve Views of Aggregate Supply
l

Explain, using a diagram, that the monetarist/new classical model of the long- run
aggregate supply curve (LRAS) is verQcal at the level of potenQal output (full employment
output) because aggregate supply in the long run is independent of the price level.

Explain, using a diagram, that the Keynesian model of the aggregate supply curve has
three secQons because of wage/price downward inexibility and dierent levels of
spare capacity in the economy.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Supply (AS) *


AlternaQve Views of Aggregate Supply
Long run aggregate supply is determined by the producQve resources available to meet
demand and by the producQvity of factor inputs (labor, land and capital).
In the short run, producers respond to higher demand (and prices) by bringing more
inputs into the producQon process and increasing the uQlizaQon of their exisQng inputs.
Supply does respond to change in price in the short run.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Supply (AS)


AlternaQve Views of Aggregate Supply
In the long run we assume that supply is independent of the price level (money is
neutral) - the producQve potenQal of an economy (measured by LRAS) is driven by
improvements in producQvity and by an expansion of the available factor inputs (more
rms, a bigger capital stock, an expanding acQve labor force etc.). As a result we draw
the long run aggregate supply curve as verQcal.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2
Aggregate Demand
and Aggregate Supply
Aggregate Supply (AS)
Improvements in
producQvity and eciency
cause the long-run
aggregate supply curve to
shix out over the years.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Supply (AS)


Shixing the Aggregate Supply Curve over the Long Term
l

Explain, using the two models above, how factors leading to changes in the quanQty
and/or quality of factors of producQon (including improvements in eciency, new
technology, reducQons in unemployment, and insQtuQonal changes) can shix the
aggregate supply curve over the long term.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Aggregate Supply (AS)


Short Run and Long Run

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Equilibrium
Short-Run Equilibrium
l Explain, using a diagram, the determinaQon of short-run

equilibrium, using the SRAS curve.

l Examine, using diagrams, the impacts of changes in short- run

equilibrium.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Equilibrium
Equilibrium in the Monetarist/New Classical Model
l

Explain, using a diagram, the determinaQon of long-run equilibrium, indicaQng


that long-run equilibrium occurs at the full employment level of output.

Explain why, in the monetarist/new classical approach, while there maybe


short-term uctuaQons in output, the economy will always return to the full
employment level of output in the long run.

Examine, using diagrams, the impacts of changes in the long-run equilibrium.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Equilibrium
Equilibrium in the Keynesian Model
l

Explain, using the Keynesian AD/AS diagram, that the economy may be in
equilibrium at any level of real output where AD intersects AS.

Explain, using a diagram, that if the economy is in equilibrium at a level of real


output below the full employment level of output, then there is a deaQonary
(recessionary) gap.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Equilibrium
Equilibrium in the Keynesian Model
l

Discuss why, in contrast to the monetarist/new classical model, the economy can remain stuck in a
deaQonary (recessionary) gap in the Keynesian model.

Explain, using a diagram, that if AD increases in the verQcal secQon of the AS curve, then there is an
inaQonary gap.

Discuss why, in contrast to the monetarist/new classical model, increases in aggregate demand in the
Keynesian AD/AS model need not be inaQonary, unless the economy is operaQng close to, or at, the
level of full employment.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.2

Aggregate Demand and Aggregate Supply

Equilibrium
Theory of Knowledge: Poten6al Connec6ons
Business condence is a contribu<ng factor to the level of AD. What knowledge issues arise in
aDemp<ng to measure business condence?
The Keynesian and Monetarist posi<ons dier on the shape of the AS curve. What is needed to
seDle this ques<on: empirical evidence (if so, what should be measured?), strength of theore<cal
argument, or factors external to economics such as poli<cal convic<on?

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
The Meaning of Unemployment Pgs. 285-299
l

Dene the term unemployment.

Explain how the unemployment rate is calculated.

Explain the diculQes in measuring unemployment, including the existence of


hidden unemployment, the existence of underemployment, and the fact that it
is an average and therefore ignores regional, ethnic, age and gender dispariQes.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
The Meaning of Unemployment*
Be out of work and willing to accept suitable job (labor) or start an enterprise
(prospecQve entrepreneur) if the opportunity arises, and acQvely looking for
ways to obtain a job or start and enterprise.
~InternaQonal Labor OrganizaQon

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
The Meaning of Unemployment*
Full employment and Underemployment: A society is almost never fully
employed, but one of the goals is to reach full employment. Full employment
has two condiQons: Everyone who wants to work is working, and the rate of
inaQon is stable. When the economy is at full employment, there is no
cyclical unemployment but sQll fricQonal and structural unemployment. This is
dened as natural unemployment.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
The Meaning of Unemployment*
l

You are only classied as unemployed if you go and register with the
government as available for work.

The labor force is dened as those of 16 years of age or older who are
employed plus all those who are unemployed seeking work.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
The Meaning of Unemployment*
UR = Unemployment Rate
UR =

Number of Unemployed X 100


Labor Force

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
The Meaning of Underemployment*
As unemployment Americans nd part Qme, temporary, and seasonal work,
the ocial unemployment rate could decline. However, this does not
necessarily mean more Americans are working in their desired capacity. It will
conQnue to be important to track underemployment- to shed light on the true
state of the U.S. workforce, and the millions of Americans who are searching
for full-Qme employment.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
Consequences of Unemployment
l

Discuss possible economic consequences of unemployment, including a loss of


GDP, loss of tax revenue, increased cost of unemployment benets, loss of
income for individuals, and greater dispariQes in the distribuQon of income.

Discuss possible personal and social consequences of unemployment, including


increased crime rates, increased stress levels, increased indebtedness,
homelessness and family breakdown.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
Consequences of Unemployment
Individual Consequences of Unemployment*
l

Decreased household income and purchasing power

Decreased quality of life (standard of living)

Increased levels of psychological and physical illness, including stress and


depression

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
Consequences of Unemployment
Social Consequences of Unemployment*
l

Downward pressure on wages for the unemployed.

Increased poverty and crime

TransformaQon of tradiQonal socieQes

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
Consequences of Unemployment
Economic Consequences of Unemployment*
l

Lower level of Aggregate Demand (AD)

Under uQlizaQon of the naQons resources

Brain Drain (see WNY 1990s-Present)

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
Consequences of Unemployment
Economic Consequences of Unemployment*
l

Diminished tax base

A turn towards protecQonism and isolaQonist policies

Increased budget decits

loss of output

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
Consequences of Unemployment
Economic Consequences of Unemployment*
l

Increased transfer payments

Increased taxes, increased burden on workers

Increased diculty for labor market entrants - employers have more choices, they favor
experienced workers

Unemployed workers lose their skills, become irrelevant

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
Consequences of Unemployment
The individual, social and economic consequences of unemployment are not
limited to those outlined previously, but it should be clear that the costs of
unemployment are wide ranging, thus making low unemployment a worthy
and important goal for macroeconomic policy makers.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
Types and Causes of Unemployment
l

Describe, using examples, the meaning of fricQonal, structural, seasonal and


cyclical (demand-decient) unemployment.

DisQnguish between the causes of fricQonal, structural, seasonal and cyclical


(demand-decient) unemployment.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
Explain, Using a Diagram, that Cyclical Unemployment is Caused by a Fall in
Aggregate Demand.
l

Explain, using a diagram, that structural unemployment is caused by changes in


the demand for parQcular labour skills, changes in the geographical locaQon of
industries, and labour market rigidiQes.

Evaluate government policies to deal with the dierent types of unemployment

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
FricQonal Unemployment*
l

FricQonal unemployment is another type of unemployment within an economy.


It is the Qme period between jobs when a worker is searching for or
transiQoning from one job to another. FricQonal unemployment is always
present to some degree in an economy. It occurs when there is a mismatch
between the workers and jobs. The mismatch can be related to skills, payment,
work Qme, locaQon, seasonal industries, a}tude, taste, and other factors.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
FricQonal Unemployment
l

FricQonal unemployment is inuenced by voluntary decisions to work based


on each individual's valuaQon of their own work and how that compares to
current wage rates as well as the Qme and eort required to nd a job.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
Structural Unemployment*
l

Structural unemployment is one of the main types of unemployment within an


economic system. It focuses on the structural problems within an economy and
ineciencies in labor markets. Structural unemployment occurs when a labor
market is not able to provide jobs for everyone who is seeking employment.
There is a mismatch between the skills of the unemployed workers and the skills
needed for the jobs that are available. It is oxen impacted by persistent cyclical
unemployment.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
Structural Unemployment
l

For example, when an economy experiences long-term unemployment


individuals become frustrated and their skills become obsolete. As a result,
when the economy recovers they may not t the requirements of new jobs
due to their inacQvity .

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
The Natural Rate of Unemployment (NRU)*
l

The natural rate of unemployment, someQmes called the structural


unemployment rate, was developed by Friedman and Phelps in the 1960s. It
represents the hypotheQcal unemployment rate that is consistent with
aggregate producQon being at a long-run level.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
The Natural Rate of Unemployment (NRU)*
l

The natural rate of unemployment is a combinaQon of structural and


fricQonal unemployment. It is present in an ecient and expanding
economy when labor and resource markets are at equilibrium. The natural
unemployment rate occurs within an economy when disturbances are not
present.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low Unemployment
Cyclical Unemployment*
l

Cyclical unemployment is a type of unemployment that occurs when there is


not enough Aggregate Demand in the economy to provide jobs for everyone
who wants to work. In an economy, demand for most goods falls, less
producQon is needed, and less workers are needed. With cyclical
unemployment the number of unemployed workers is greater than the
number of job vacancies.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of InaQon, DisinaQon and DeaQon Pgs. 300-327
l

DisQnguish between inaQon, disinaQon and deaQon.

Explain that inaQon and deaQon are typically measured by calculaQng a consumer price
index (CPI), which measures the change in prices of a basket of goods and services
consumed by the average household.

Explain that dierent income earners may experience a dierent rate of inaQon when
their pa\ern of consumpQon is not accurately reected by the CPI.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of InaQon*
l

InaQon is dened as a sustained increase in the general level of prices for


goods and services. It is measured as an annual percentage increase. As
inaQon rises, every dollar you own buys a smaller percentage of a good or
service.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of InaQon:
l

The value of a dollar does not stay constant when there is inaQon. The
value of a dollar is observed in terms of purchasing power, which is the real,
tangible goods that money can buy. When inaQon goes up, there is a
decline in the purchasing power of money. For example, if the inaQon rate
is 2% annually, then theoreQcally a $1 pack of gum will cost $1.02 in a year.
Axer inaQon, your dollar can't buy the same goods it could beforehand.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of DisinaQon:*
l

A slowing in the rate of price inaQon. DisinaQon is used to describe


instances when the inaQon rate has reduced marginally over the short
term. Although it is used to describe periods of slowing inaQon, disinaQon
should not be confused with deaQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of DisinaQon:
l

DisinaQon is commonly used by the Federal Reserve to describe situaQons


of slowing inaQon. Instances of disinaQon are not uncommon and are
viewed as normal during healthy economic Qmes. Although someQmes
confused with deaQon, disinaQon is not considered to be as problemaQc
because prices do not actually drop and disinaQon does not usually signal
the onset of a slowing economy.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of DeaQon*
l

A general decline in prices, oxen caused by a reducQon in the supply of


money or credit. DeaQon can be caused also by a decrease in government,
personal or investment spending.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of DeaQon
l

The opposite of inaQon, deaQon has the side eect of increased


unemployment since there is a lower level of demand in the economy,
which can lead to an economic depression. Central banks a\empt to stop
severe deaQon, along with severe inaQon, in an a\empt to keep the
excessive drop in prices to a minimum.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of DeaQon
l

Declining prices, if they persist, generally create a vicious spiral of negaQves


such as falling prots, closing factories, shrinking employment and incomes, and
increasing defaults on loans by companies and individuals. To counter deaQon,
the Federal Reserve (the Fed) can use monetary policy to increase the money
supply and deliberately induce rising prices, causing inaQon. Rising prices
provide an essenQal lubricant for any sustained recovery because businesses
increase prots and take some of the depressive pressures o wages and
debtors of every kind.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of DeaQon
l

DeaQonary periods can be both short or long, relaQvely speaking. Japan,


for example, had a period of deaQon lasQng decades starQng in the early
1990's. The Japanese government lowered interest rates to try and
sQmulate inaQon, to no avail. Zero interest rate policy was ended in July of
2006.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of the Consumer Price Index (CPI)* AKA Headline InaQon
l

A measure that examines the weighted average of prices of a basket of


consumer goods and services, such as transportaQon, food and medical
care. The CPI is calculated by taking price changes for each item in the
predetermined basket of goods and averaging them; the goods are
weighted according to their importance. Changes in CPI are used to assess
price changes associated with the cost of living.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of the Consumer Price Index (CPI)
l

The U.S. Bureau of Labor StaQsQcs measures two kinds of CPI staQsQcs: CPI
for urban wage earners and clerical workers (CPI-W), and the chained CPI
for all urban consumers (C-CPI-U). Of the two types of CPI, the C-CPI-U is a
be\er representaQon of the general public, because it accounts for about
87% of the populaQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of the Consumer Price Index (CPI)
l

CPI is one of the most frequently used staQsQcs for idenQfying periods of
inaQon or deaQon. This is because large rises in CPI during a short period
of Qme typically denote periods of inaQon and large drops in CPI during a
short period of Qme usually mark periods of deaQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of InaQon, DisinaQon and DeaQon
l

Explain that inaQon gures may not accurately reect changes in consumpQon
pa\erns and the quality of the products purchased.

Explain that economists measure a core/underlying rate of inaQon to eliminate


the eect of sudden swings in the prices of food and oil, for example.

Explain that a producer price index measuring changes in the prices of factors of
producQon may be useful in predicQng future inaQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of InaQon, DisinaQon and DeaQon*
l

The Producer Price Index (PPI) is a weighted index of prices measured at the
wholesale, or producer level. A monthly release from the Bureau of Labor
StaQsQcs (BLS), the PPI shows trends within the wholesale markets (the PPI
was once called the Wholesale Price Index), manufacturing industries and
commodiQes markets. All of the physical goods-producing industries that
make up the U.S. economy are included, but imports are not.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of InaQon, DisinaQon and DeaQon
l

The PPI release has three headline index gures, one each for crude,
intermediate and nished goods on the naQonal level:

1)
PPI Commodity Index (crude): This shows the average price change
from the previous month for commodiQes such as energy, coal, crude oil and
the steel scrap.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of InaQon, DisinaQon and DeaQon
l

The PPI release has three headline index gures, one each for crude,
intermediate and nished goods on the naQonal level:

2)
PPI Stage of Processing (SOP) Index (intermediate): Goods here have
been manufactured at some level but will be sold to further manufacturers to
create the nished good. Some examples of SOP products are lumber, steel,
co\on and diesel fuel.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of InaQon, DisinaQon and DeaQon
l

The PPI release has three headline index gures, one each for crude,
intermediate and nished goods on the naQonal level:

3)
PPI Industry Index (nished): Final stage manufacturing, and the
source of the core PPI.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of InaQon, DisinaQon and DeaQon
l

The core PPI gure is the main a\racQon, which is the nished goods index
minus the food and energy components, which are removed because of
their volaQlity. The PPI percentage change from the prior period and annual
projected rate will be the most printed gure of the release.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of InaQon, DisinaQon and DeaQon
l

The PPI looks to capture only the prices that are being paid during the
survey month itself. Many companies that do regular business with large
customers have long-term contract rates, which may be known now but not
paid unQl a future date. The PPI excludes future values or contract rates.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of InaQon, DisinaQon and DeaQon
PPI Strengths:*
l

Most accurate indicator of future CPI

Long "operaQng history" of data series

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of InaQon, DisinaQon and DeaQon
PPI Strengths:*
l

Good breakdowns for investors in the companies surveyed (mining, commodity


info, some services sectors)

Can move the markets posiQvely

Data is presented with and without seasonal adjustment

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


The Meaning of InaQon, DisinaQon and DeaQon
PPI Weaknesses:*
l

VolaQle elements, such as energy and food, can skew the data.

Not all industries in the economy are covered.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


Consequences of InaQon
l

Discuss the possible consequences of a high inaQon rate, including greater


uncertainty, redistribuQve eects, less saving, and the damage to export
compeQQveness.

Consequences of DeaQon
l

Discuss the possible consequences of deaQon, including high levels of cyclical


unemployment and bankruptcies.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


Consequences of InaQon: Maintaining a Stable Price Level*
l

Loss of Purchasing Power

Lower Real Interest Rates for Savers

Higher Nominal Interest Rates for Borrowers

ReducQon of InternaQonal CompeQveness

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


Consequences of DeaQon: Supply Side DeaQon*
l

Lower Oil Prices

More ProducQve Labor Force

AppreciaQon of the NaQons Currency

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


Consequences of DeaQon: Supply Side DeaQon*
l

Lower Minimum Wage

Be\er Infrastructure

Lower Corporate taxes

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


Types and Causes of InaQon
l

Explain, using a diagram, that demand-pull inaQon is caused by changes in the


determinants of AD, resulQng in an increase in AD.

Explain, using a diagram, that cost-push inaQon is caused by an increase in the


costs of factors of producQon, resulQng in a decrease in SRAS.

Evaluate government policies to deal with the dierent types of inaQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


Types and Causes of InaQon: Demand Pull InaQon*
l

An increase in any of the components of a naQons Aggregate Demand (AD)


will lead to an increase in the naQons price level

Demand Pull InaQon is when too many consumers are chasing too few
goods (scarcity), so the average price of goods and services in a naQon rises

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


Types and Causes of InaQon: Demand Pull InaQon*
l

Demand Pull InaQon is illustrated by an outward shix of AD when a naQon


is at or near its full employment level of output.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Low and Stable Rate of Ina6on


Types and Causes of InaQon: Cost-Push InaQon*
l

An Increase in Oil Prices

An increase in the nominal wage rate

DepreciaQon of the naQons currency

Natural Disaster or War

Higher taxes on rms

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Economic Growth
The Meaning of Economic Growth
l

Dene economic growth as an increase in real GDP.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Economic Growth
The Meaning of Economic Growth*
l

Dene economic growth as an increase in real GDP.

Economic growth is an increase in the total output of goods and services


(GDP) in a naQon over Qme

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Economic Growth
Causes of Economic Growth
l

Describe, using a producQon possibiliQes curve (PPC) diagram, economic growth


as an increase in actual output caused by factors including a reducQon in
unemployment and increases in producQve eciency, leading to a movement of
a point inside the PPC to a point closer to the PPC.

Describe, using a PPC diagram, economic growth as an increase in producQon


possibiliQes caused by factors including increases in the quanQty and quality of
resources, leading to outward PPC shixs.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Economic Growth
Causes of Economic Growth: ProducQon
PossibiliQes Curve
l

A curve depicQng all maximum output


possibiliQes for two or more goods
given a set of inputs (resources, labor,
etc.). The PPF assumes that all inputs
are used eciently.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Economic Growth
Causes of Economic Growth: ProducQon PossibiliQes Curve
l

As indicated on the chart above, points A, B and C represent the points at


which producQon of Good A and Good B is most ecient. Point X
demonstrates the point at which resources are not being used eciently in
the producQon of both goods; point Y demonstrates an output that is not
a\ainable with the given inputs.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Economic Growth
Causes of Economic Growth: ProducQon PossibiliQes Curve
l

Among others, factors such as labor, capital and technology will aect where
the producQon possibility fronQer lies. The PPF is also known as the
producQon possibility or transformaQon curve.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Economic Growth
Causes of Economic Growth
l

Describe, using an LRAS diagram, economic growth as an increase in potenQal


output caused by factors including increases in the quanQty and quality of
resources, leading to a rightward shix of the LRAS curve.

Explain the importance of investment for economic growth, referring to


investment in physical capital, human capital and natural capital.

Explain the importance of improved producQvity for economic growth.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Economic Growth
Causes of Economic Growth: Long Run Aggregate Supply (LRAS)
l

Long run aggregate supply is determined by the producQve resources


available to meet demand and also by the producQvity of factor inputs
(labor, land and capital). Changes in technology also aect the potenQal
level of naQonal output in the long run.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Economic Growth
Causes of Economic Growth: Long Run Aggregate Supply (LRAS)
l

In the short run, producers respond to higher demand (and prices) by


bringing more inputs into the producQon process and increasing the
uQlizaQon of their exisQng inputs. Supply does respond to change in price in
the short run - we move up or down the short run aggregate supply curve.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3
Macroeconomic
objec6ves
Economic Growth
Causes of Economic Growth:
Long Run Aggregate Supply
(LRAS)

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Economic Growth
Causes of Economic Growth
Sources of ProducQvity Growth: Physical Capital*
l

Economies with greater quanQQes of capital per worker experience a greater level
of output per hour of labor and, therefore, a higher level of economic growth.

Increases in capital stock result from high levels of private investment, as rms
replace old capital and expand exisQng factories to meet AD over Qme.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Economic Growth
Causes of Economic Growth: Physical Capital
Developing human capital alone is not enough to create economic growth.
Economies must also invest in developing physical capital. Physical capital is the
tools, factories, and equipment that are used in the producQon process. As the
stock of physical capital increases, the naQon experiences capital deepening.
Capital deepening refers to the amount of capital available to each worker. Capital
deepening provides for a more producQve labor force. The average American
worker is backed by $130,000 worth of physical capital. This is one of the reasons
for America's producQvity edge.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Economic Growth
Causes of Economic Growth
l

Sources of ProducQvity Growth: Human Capital


l

Human beings are of economic value. They contribute to economic growth of a


rm and the naQon.

The be\er educated or trained a worker is, the more producQve they are?

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Economic Growth
Consequences of Economic Growth
l

Discuss the possible consequences of economic growth, including the


possible impacts on living standards, unemployment, inaQon, the
distribuQon of income, the current account of the balance of payments, and
sustainability.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Economic Growth
Consequences of Economic Growth: Economic Consequence*
l

The economic consequence of growth in per capita GDP is an increase in the


average level of income and consumpQon in a naQon

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Economic Growth
Consequences of Economic Growth: Non-Economic Consequence*
l

ExternaliQes (both PosiQve and NegaQve)

InaQon

Resource DepleQon

Structural Unemployment

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Economic Growth
Consequences of Economic Growth: Non-Economic Consequence*
l

ComposiQon of output (capital vs. consumer goods)

ComposiQon of output (military vs Civilian or Guns vs Bu\er dilemma)

Unequal income distribuQon

Eect on Balance of Payments

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


The Meaning of Equity in the DistribuQon of Income
l

Explain the dierence between equity in the distribuQon of income and


equality in the distribuQon of income.

Explain that due to unequal ownership of factors of producQon, the market


system may not result in an equitable distribuQon of income.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


The Meaning of Equity in the DistribuQon of Income*
l

Equality vs. Equity


l
l
l
l

Equity refers to fairness in economics.


Equity requires a level playing eld on which individuals in society can all have a fair
shot at achieving economic success.
Equity ulQmately promotes greater equality in income distrbuQon
Equality means minimizing the dispariQes in income and wealth among a naQons
households.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


Indicators of Income Equality/Inequality
l

Analyze data on relaQve income shares of given percentages of the


populaQon, including deciles and quinQles.

Draw a Lorenz curve and explain its signicance.

Explain how the Gini coecient is derived and interpreted.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


Indicators of Income Equality/Inequality: Lorenz Curve*
l

A graphical representaQon of wealth distribuQon developed by American


economist Max Lorenz in 1905. On the graph, a straight diagonal line
represents perfect equality of wealth distribuQon; the Lorenz curve lies
beneath it, showing the reality of wealth distribuQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


Indicators of Income Equality/Inequality: Lorenz Curve*
l

The dierence between the straight line and the curved line is the amount
of inequality of wealth distribuQon, a gure described by the Gini
coecient.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


Indicators of Income Equality/Inequality: Lorenz
Curve*
Graphical representaQon of the Gini coecient
l

The graph shows that the Gini coecient is


equal to the area marked A divided by the
sum of the areas marked A and B. that is,
Gini = A / (A + B). It is also equal to 2*A due
to the fact that A + B = 0.5 (since the axes
scale from 0 to 1)

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


Indicators of Income Equality/Inequality: Lorenz Curve*
l

The Lorenz curve can be used to show what percentage of a naQon's


residents possess what percentage of that naQon's wealth. For example, it
might show that the country's poorest 10% possess 2% of the country's
wealth.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


Poverty
l

DisQnguish between absolute poverty and relaQve poverty.

Explain possible causes of poverty, including low incomes, unemployment and


lack of human capital.

Explain possible consequences of poverty, including low living standards, and


lack of access to health care and educaQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


Poverty*
A state or condiQon in which a person or community lacks the nancial
resources and essenQals to enjoy a minimum standard of life and well-being
that's considered acceptable in society. Poverty status in the United States is
assigned to people that do not meet a certain threshold level set by the
Department of Health and Human Services.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


Poverty*
Poverty rates in the United Sates, the percentage of U.S. populaQon with
poverty status, are calculated by the U.S. Bureau of Census, and precludes
insQtuQonalized people, people living in military quarters, those living in
college dormitories and individuals under the age of 15. Poverty rates are an
important staQsQc to follow as a global investor, as a high poverty rate is oxen
indicaQve of larger scale issues within the country in quesQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


Poverty*
An internaQonal monetary threshold under which an individual is considered to be
living in poverty. It is calculated by taking the poverty threshold from each country
- given the value of the goods needed to sustain one adult - and converQng it to
dollars. The internaQonal poverty line was originally set to roughly $1 a day. When
purchasing power parity and all goods consumed are considered in the calculaQon
of the line, it allows organizaQons to determine which populaQons are considered
to be in absolute poverty.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


Poverty*
Using the internaQonal poverty line to determine how well o a populaQon is
can be misleading, as the line can be low enough that adding a small amount
of addiQonal income will not create an appreciable dierence in a person's
quality of life. In addiQon, it can be dicult to quanQfy other indicators, such
as educaQon and health, thus masking the total economic impact on a
populaQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


Causes of Poverty*
Poverty is explained by individual circumstances and/or characterisQcs of poor
people. Some examples are:
l

Amount of educaQon, skill, experience, intelligence & access

Health, handicaps, age, mental health.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


Causes of Poverty*
Poverty is explained by individual circumstances and/or characterisQcs of poor
people. Some examples are:
l

Work orientaQon, Qme horizon, culture of poverty (generaQonal).

DiscriminaQon, together with race, sex, etc.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


Consequences of Poverty*
l

The eects of poverty are most oxen interrelated so that one problem hardly
ever occurs alone. For instance, bad sanitaQon makes it easier to spread around
old and new diseases, and hunger and lack of water make people more
vulnerable to them.

Impoverished communiQes oxen suer from discriminaQon and end up caught


in cycles of poverty. Let's nd out just what this means concretely.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


Consequences of Poverty*
Homelessness, poor health, hungerpovertys consequences can be severe.
Growing up in poverty can harm childrens well-being and development and
limit their opportuniQes and academic success. And poverty imposes huge
costs on society through lost producQvity and higher spending on health care
and incarceraQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


The Role of TaxaQon in PromoQng Equity
l

DisQnguish between direct and indirect taxes, providing examples of each,


and explain that direct taxes may be used as a mechanism to redistribute
income.

DisQnguish between progressive, regressive and proporQonal taxaQon,


providing examples of each.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


The Role of TaxaQon in PromoQng Equity: Direct Taxes*
l

A tax that is paid directly by an individual or organizaQon to the imposing


enQty. A taxpayer pays a direct tax to a government for dierent purposes,
including real property tax, personal property tax, income tax or taxes on
assets. Direct taxes are dierent from indirect taxes, where the tax is levied
on one enQty, such as a seller, and paid by another, such a sales tax paid by
the buyer in a retail se}ng.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


The Role of TaxaQon in PromoQng Equity: Direct Taxes*
l

A direct tax cannot be shixed to another individual or enQty. The individual


or organizaQon upon which the tax is levied is responsible for the fulllment
of the tax payment. Indirect taxes, on the other hand, can be shixed from
one taxpayer to another.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


The Role of TaxaQon in PromoQng Equity: Indirect Taxes*
l

A direct tax cannot be shixed to another individual or enQty. The individual


or organizaQon upon which the tax is levied is responsible for the fulllment
of the tax payment. Indirect taxes, on the other hand, can be shixed from
one taxpayer to another.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


The Role of TaxaQon in PromoQng Equity: Indirect Taxes*
l

Indirect taxes can also be dened as fees that are levied equally upon taxpayers,
no ma\er their income. This is a primary reason why they are thought of as
taxes that are passed on, as the price of the tax is compensated for by simply
increasing the overall price of the good or service. Some economists argue that
indirect taxes lead to an inecient marketplace and alter market prices that
don't match their equilibrium price.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


The Role of TaxaQon in PromoQng Equity: Indirect Taxes*
l

A tax that increases the price of a good so that consumers are actually
paying the tax by paying more for the products. An indirect tax is most oxen
thought of as a tax that is shixed from one taxpayer to another, by way of
an increase in the price of the good. Fuel, liquor and cigare\e taxes are all
considered examples of indirect taxes, as many argue that the tax is actually
paid by the end consumer, by way of a higher retail price.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


Other Measures to Promote Equity
l

Explain that governments undertake expenditures to provide directly, or to


subsidize, a variety of socially desirable goods and services (including health
care services, educaQon, and infrastructure that includes sanitaQon and clean
water supplies), thereby making them available to those on low incomes.

Explain the term transfer payments, and provide examples, including old age
pensions, unemployment benets and child allowances.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


Other Measures to Promote Equity: Transfer Payments*
l

In the United States, a payment made to individuals by the federal


government through various social benet programs.

In Canada, a payment made to the provinces and territories by the federal


government.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


Other Measures to Promote Equity: Transfer Payments*
l

Transfer payments are made by the U.S. Federal Government to individuals


through programs such as Social Security, Welfare and Veteran's benets.

Transfer payments are made by the Canadian Federal Government to the


provinces and territories through the EqualizaQon Program, Canada Health
Transfer and Canada Social Transfer.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


The RelaQonship Between Equity and Eciency
l

Evaluate government policies to promote equity (taxaQon, government


expenditure and transfer payments) in terms of their potenQal posiQve or
negaQve eects on eciency in the allocaQon of resources.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


The RelaQonship Between Equity and Eciency: Transfer Payments*
l

In economics, a transfer payment (or government transfer or simply transfer) is


a redistribuQon of income in the market system. These payments are considered
to be non-exhausQve because they do not directly absorb resources or create
output. In other words, the transfer is made without any exchange of goods or
services. Examples of certain transfer payments include welfare (nancial aid),
social security, and government making subsidies for certain businesses (rms).

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Equity in the Distribu6on of Income


The RelaQonship Between Equity and Eciency: Transfer Payments*
l

Transfer payments are not a part of the naQonal income so they are cut
from naQonal income to get n.n.p in order to arrive naQonal income such
payments are bad debts incurred by banks, payments of pensions, charity,
scholarships etc. In the UK they have several transfer payments such as EMA
and a job seeker's allowance.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Theory of Knowledge: Poten6al Connec6ons


What criteria can be used to order macroeconomic objec<ves in terms of
priority? Are such criteria external to economics (that is, norma<ve)?
Is economic growth always benecial? What could be meant by the word
benecial?
Is there always a cost to economic growth?

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Theory of Knowledge: Poten6al Connec6ons


The no<on of fairness can be approached from a number of perspec<ves
equality of opportunity, maximizing the income of the least well-o group, and
absolute equality of income. Which of these no<ons seems to be most
aDrac<ve? Why? Examine what each of these perspec<ves suggests is a fair
distribu<on of income.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.3

Macroeconomic objec6ves

Theory of Knowledge: Poten6al Connec6ons


Equality of opportunity implies correc<ng for social advantage (for example,
government might devote more resources to the educa<on of a child brought up in
less prosperous circumstances than one brought up in a comfortable home whose
parents are university lecturers). How far should the state go in making such
correc<ons? Should all parents be forced to read to their children so that no child
should be at a disadvantage? Should the state aDempt to correct for the uneven
distribu<on of natural abili<es such as IQ (intelligence quo<ent) by devo<ng
propor<onally more resources to children of less than average IQ.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


Sources of Government Revenue
l

Explain that the government earns revenue primarily from taxes (direct and
indirect), as well as from the sale of goods and services and the sale of state-
owned (government- owned) enterprises.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


Sources of Government Revenue*
l

Government revenue is money received by a government. It is an important tool


of the scal policy of the government and is the opposite factor of government
spending. Revenues earned by the government are received from sources such
as taxes levied on the incomes and wealth accumulaQon of individuals and
corporaQons and on the goods and services produced, exports and imports,
non-taxable sources such as government-owned corporaQons' incomes, central
bank revenue and capital receipts in the form of external loans and debts from
internaQonal nancial insQtuQons.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


Types of Government Expenditures
l

Explain that government spending can be classied into current


expenditures, capital expenditures and transfer payments, providing
examples of each.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


Types of Government Expenditures*
l

Government spending or expenditure includes all government consumpQon,


investment, and transfer payments. In naQonal income accounQng the
acquisiQon by governments, of goods and services for current use, to
directly saQsfy the individual or collecQve needs of the community, is
classed as government nal consumpQon expenditure.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


Types of Government Expenditures*
l

Government acquisiQon of goods and services intended to create future


benets, such as infrastructure investment or research spending, is classed
as government investment (government gross capital formaQon). These two
types of government spending, on nal consumpQon and on gross capital
formaQon, together consQtute one of the major components of gross
domesQc product.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


Types of Government Expenditures*
l

Government spending can be nanced by government borrowing or taxes.


Changes in government spending are a major component of scal policy
used to stabilize the macroeconomic business cycle.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Budget Outcome
l

DisQnguish between a budget decit, a budget surplus and a balanced


budget.

Explain the relaQonship between budget decits/ surpluses and the public
(government) debt.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Budget Outcome: Budget Decit (loss of money)*
l

A status of nancial health in which expenditures exceed revenue. The term


"budget decit" is most commonly used to refer to government spending
rather than business or individual spending. When referring to accrued
federal government decits, the term "naQonal debt is used.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Budget Outcome: Budget Decit (loss of money)*
l

The opposite of a budget decit is a budget surplus, and when inows equal
oulows, the budget is said to be balanced.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Budget Outcome: Budget Decit (loss of money)
l

In the early 20th century, few industrialized countries had large scal
decits. This changed during the First World War, a Qme in which
governments borrowed heavily and depleted nancial reserves.
Industrialized countries reduced these decits unQl the 1960s and 1970s
despite years of steady economic growth.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Budget Outcome: Budget Decit (loss of money)*
l

Budget decits as a percentage of GDP may decrease in Qmes of economic


prosperity, as increased tax revenue, lower unemployment and economic
growth reduce the need for government programs such as unemployment
insurance. If investors expect higher inaQon rates, which would reduce the
real value of debt, they are likely to require higher interest rates on future
loans to governments.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Budget Outcome: Budget Decit (loss of money)
l

Countries can counter budget decits by promoQng economic growth, reducing


government spending and increasing taxes. By reducing onerous regulaQons and
simplifying tax regimes, a country can improve business condence, thereby
prompQng improved economic condiQons while increasing treasury inows
from taxes. Reducing government expenditures, including on social programs
and defense, and reforming enQtlement programs, such as state pensions, can
result in less borrowing.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Budget Outcome: Budget Surplus (excess of money)*
l

A situaQon in which income exceeds expenditures. The term "budget surplus" is


most commonly used to refer to the nancial situaQons of governments;
individuals speak of "savings" rather than a "budget surplus." A surplus is
considered a sign that government is being run eciently. A budget surplus
might be used to pay o debt, save for the future, or to make a desired
purchase that has been delayed. A city government that had a surplus might use
the money to make improvements to a run-down park, for example.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Budget Outcome: Budget Surplus (excess of money)
l

When spending exceeds income, the result is a budget decit, which must be
nanced by borrowing money and paying interest on the borrowed funds, much
like an individual spending more than he can aord and carrying a balance on a
credit card. A balanced budget occurs when spending equals income. The U.S.
government has only had a budget surplus in a few years since 1950. The
Clinton administraQon (1993-2001) famously cured a large budget decit and
created a surplus in the late 1990s.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Budget Outcome: Balanced Budget (equality of money)*
l

A situaQon in nancial planning or the budgeQng process where total


revenues are equal to or greater than total expenses. A budget can be
considered balanced in hindsight, axer a full year's worth of revenues and
expenses have been incurred and recorded; a company's operaQng budget
for an upcoming year can also be called balanced based on predicQons or
esQmates.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Budget Outcome: Balanced Budget (equality of money)
l

The phrase "balanced budget" is commonly used in reference to ocial


government budgets. For example, governments may issue a press release
staQng that they have a balanced budget for the upcoming scal year, or
poliQcians may campaign on a promise to balance the budget once in oce.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Budget Outcome: Balanced Budget (equality of money)
l

It is important to understand that the phrase "balanced budget" can refer to


either a situaQon where revenues equal expenses or where revenues
exceed expenses, but not where expenses exceed revenues.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Role of Fiscal Policy
Fiscal Policy and Short-Term Demand Management
l

Explain how changes in the level of government expenditure and/or taxes can
inuence the level of aggregate demand in an economy.

Describe the mechanism through which expansionary scal policy can help an
economy close a deaQonary (recessionary) gap.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Role of Fiscal Policy
Fiscal Policy and Short-Term Demand Management*
l

Government spending policies that inuence macroeconomic condiQons.


Through scal policy, regulators a\empt to improve unemployment rates,
control inaQon, stabilize business cycles and inuence interest rates in an
eort to control the economy

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Role of Fiscal Policy
Fiscal Policy and Short-Term Demand Management
l

Fiscal policy is largely based on the ideas of BriQsh economist John Maynard
Keynes (18831946), who believed governments could change economic
performance by adjusQng tax rates and government spending.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Role of Fiscal Policy
Fiscal Policy and Short-Term Demand Management
l

To illustrate how the government could try to use scal policy to aect the economy,
consider an economy thats experiencing a recession. The government might lower tax
rates to try to fuel economic growth. If people are paying less in taxes, they have more
money to spend or invest. Increased consumer spending or investment could improve
economic growth. Regulators dont want to see too great of a spending increase though,
as this could increase inaQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Role of Fiscal Policy
Fiscal Policy and Short-Term Demand Management
l

Another possibility is that the government might decide to increase its own
spending say, by building more highways. The idea is that the addiQonal
government spending creates jobs and lowers the unemployment rate. Some
economists, however, dispute the noQon that governments can create jobs,
because government obtains all of its money from taxaQon in other words,
from the producQve acQviQes of the private sector.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Role of Fiscal Policy
Fiscal Policy and Short-Term Demand Management
l

One of the many problems with scal policy is that it tends to aect parQcular
groups disproporQonately. A tax decrease might not be applied to taxpayers at
all income levels, or some groups might see larger decreases than others.
Likewise, an increase in government spending will have the biggest inuence on
the group that is receiving that spending, which in the case of highway spending
would be construcQon workers..

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Role of Fiscal Policy
Fiscal Policy and Short-Term Demand Management
l

Fiscal policy and monetary policy are two major drivers of a naQons economic
performance. Through monetary policy, a countrys central bank inuences the
money supply. Regulators use both policies to try to boost a agging economy,
maintain a strong economy or cool o an overheated economy.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Role of Fiscal Policy
Fiscal Policy and Short-Term Demand Management
l

Construct a diagram to show the potenQal eects of expansionary scal policy, outlining the importance of
the shape of the aggregate supply curve.

Describe the mechanism through which contracQonary scal policy can help an economy close an
inaQonary gap.

Construct a diagram to show the potenQal eects of contracQonary scal policy, outlining the importance of
the shape of the aggregate supply curve.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Role of Fiscal Policy
In Panel (a), the economy faces a
recessionary gap (YP Y1). An
expansionary scal policy seeks to shiU
aggregate demand to AD2 to close the
gap.
In Panel (b), the economy faces an
ina6onary gap (Y1 YP). A
contrac6onary scal policy seeks to
reduce aggregate demand to AD2 to
close the gap.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Role of Fiscal Policy
The Impact of AutomaQc Stabilizers
l

Explain how factors including the progressive tax system and


unemployment benets, which are inuenced by the level of economic
acQvity and naQonal income, automaQcally help stabilize short-term
uctuaQons.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Role of Fiscal Policy
The Impact of AutomaQc Stabilizers*
l

Economic policies and programs that are designed to oset uctuaQons in a


naQon's economic acQvity without intervenQon by the government or
policymakers. The best-known automaQc stabilizers are corporate and personal
taxes, and transfer systems such as unemployment insurance and welfare.
AutomaQc stabilizers are so called because they act to stabilize economic cycles
and are automaQcally triggered without explicit government intervenQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Role of Fiscal Policy
The Impact of AutomaQc Stabilizers
l

AutomaQc stabilizers act in a manner that is against the prevailing economic trend. For
example, in a progressive taxaQon structure, the share of taxes in naQonal income falls
when the economy is booming and rises when the economy is in a slump. This has the
eect of cushioning the economy from changes in the business cycle. Similarly, total net
transfer payments such as unemployment insurance decline when the economy is in an
expansionary phase, and rise when the economy is mired in recession.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Role of Fiscal Policy
Fiscal Policy and its Impact on PotenQal Output
l

Explain that scal policy can be used to promote long-term economic growth
(increases in potenQal output) indirectly by creaQng an economic environment
that is favorable to private investment, and directly through government
spending on physical capital goods and human capital formaQon, as well as
provision of incenQves for rms to invest.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

The Government Budget


The Role of Fiscal Policy
EvaluaQon of Fiscal Policy
l

Evaluate the eecQveness of scal policy through consideraQon of factors


including the ability to target sectors of the economy, the direct impact on
aggregate demand, the eecQveness of promoQng economic acQvity in a
recession, Qme lags, poliQcal constraints, crowding out, and the inability to deal
with supply- side causes of instability.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.4

Fiscal policy

Theory of knowledge: Poten6al Connec6ons


In one sense the imposi<on of taxes by government on individuals amounts to
a restric<on of individual freedom. How can we know when such government
interference in individual freedom is jus<ed?

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

Interest Rates
Interest Rate DeterminaQon and the Role of a Central Bank
l

Describe the role of central banks as regulators of commercial banks and bankers to
governments.

Explain that central banks are usually made responsible for interest rates and exchange
rates in order to achieve macroeconomic objecQves.

Explain, using a demand and supply of money diagram, how equilibrium interest rates are
determined, outlining the role of the central bank in inuencing the supply of money.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

Interest Rates
Interest Rate DeterminaQon and the Role of a Central Bank*
l

The acQons of a central bank, currency board or other regulatory commi\ee


that determine the size and rate of growth of the money supply, which in
turn aects interest rates. Monetary policy is maintained through acQons
such as increasing the interest rate, or changing the amount of money banks
need to keep in the vault (bank reserves).

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

Interest Rates
Interest Rate DeterminaQon and the Role of a Central Bank
l

In the United States, the Federal Reserve is in charge of monetary policy.


Monetary policy is one of the ways that the U.S. government a\empts to
control the economy. If the money supply grows too fast, the rate of
inaQon will increase; if the growth of the money supply is slowed too
much, then economic growth may also slow. In general, the U.S. sets
inaQon targets that are meant to maintain a steady inaQon of 2% to 3%.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

Interest Rates
Interest Rate DeterminaQon and the Role of a Central Bank*
l

Monetary policy operates by steering short-term interest rates, thereby


inuencing economic developments, in order to maintain price stability for
the euro area over the medium term.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

Interest Rates
Interest Rate DeterminaQon and the Role of a Central Bank
l

The ECB has adopted a specic strategy to ensure the successful conduct of monetary
policy. The ECB has dened price stability as a year-on-year increase in the Harmonized
Index of Consumer Prices (HICP) for the euro area of below 2%. In the pursuit of price
stability, the ECB aims at maintaining inaQon rates below, but close to, 2% over the
medium term.

The strategy also includes an analyQcal framework for the assessment of all relevant
informaQon and analysis needed to take monetary policy decisions. This framework is
based on two pillars: economic analysis and monetary analysis

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

Interest Rates
Interest Rate DeterminaQon and the Role of a Central Bank
l

The primary objecQve of the ECBs monetary policy is to maintain price stability.
This is the best contribuQon monetary policy can make to economic growth and
job creaQon.

Monetary policy decisions are taken by the ECB's Governing Council. The Council
meets every month to analyse and assess economic and monetary
developments and the risks to price stability and to decide on the appropriate
level of the key interest rates, based on the ECB's strategy.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

The Role of Monetary Policy


Monetary Policy and Short-Term Demand Management
l

Explain how changes in interest rates can inuence the level of aggregate
demand in an economy.

Describe the mechanism through which easy (expansionary) monetary


policy can help an economy close a deaQonary (recessionary) gap.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

The Role of Monetary Policy


Monetary Policy and Short-Term Demand Management*
l

One of several specic aggregate demand determinants assumed constant


when the aggregate demand curve is constructed, and that shixs the aggregate
demand curve when it changes. An increase in interest rates cause a decrease
(lexward shix) of the aggregate curve. A decrease in interest rates an increase
(rightward shix) of the aggregate curve. Other notable aggregate demand
determinants include the federal decit, inaQonary expectaQons, and the
money supply.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

The Role of Monetary Policy


Monetary Policy and Short-Term Demand Management
l

Interest rates are the annual charge for borrowing funds, usually specied
as a percent of the amount borrowed. Changes in interest rates aect the
overall expense of borrowing and thus expenditures undertaken with the
borrowed funds. Higher interest rates tend to decrease expenditures and
lower interest rates lead to an increase in expenditures.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

The Role of Monetary Policy


Monetary Policy and Short-Term Demand Management
l

Suppose, for example, that the Federal Reserve System decides to


implement expansionary monetary policy. Fearing an impending recession
on the business-cycle horizon, they decide to expand the money supply with
a corresponding decrease in interest rates

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

The Role of Monetary Policy


Monetary Policy and Short-Term Demand Management
l

A decline in interest rates can enQce the business sector to boost


investment expenditures. For example, a 1 percentage point interest rate
decline (such as from 10 percent to 9 percent) can reduce the total interest
cost on a $10 million construcQon loan by $300,000 over a ve-year
repayment period. This saving is bound to convince a few rms to undertake
extra investment expenditures.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

The Role of Monetary Policy


Monetary Policy and Short-Term Demand Management
l

AlternaQvely, the Federal Reserve System might decide to implement


contracQonary monetary policy. Fearing the onset of higher inaQon, the Fed
might decide to reduce the money supply and subsequently increase interest
rates. Higher interest rates have the opposite eect on both business
investment and household consumpQon as lower rates. The interest cost of
construcQng a new factory is higher. So too is the interest expense of buying a
new car.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

The Role of Monetary Policy


Monetary Policy and Short-Term Demand Management
l

Construct a diagram to show the potenQal eects of easy (expansionary) monetary policy,
outlining the importance of the shape of the aggregate supply curve.

Describe the mechanism through which Qght (contracQonary) monetary policy can help
an economy close an inaQonary gap.

Construct a diagram to show the potenQal eects of Qght (contracQonary) monetary


policy, outlining the importance of the shape of the aggregate supply curve.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

The Role of Monetary Policy


Monetary Policy and Short-Term Demand Management: Expansionary

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

The Role of Monetary Policy


Monetary Policy and Short-Term Demand Management: Expansionary
l

Lower the discount rate

Buy bonds on the open market

Lower the reserve raQo

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

The Role of Monetary Policy


Monetary Policy and Short-Term Demand Management:
Expansionary Monetary Policy
l

Achieves: Increased growth, reduced unemployment

But risks:
l
l

InaQon
Lower exchange rate= expensive imports

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

The Role of Monetary Policy


Monetary Policy and Short-Term Demand Management: ContracQonary

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

The Role of Monetary Policy


Monetary Policy and Short-Term Demand Management: ContracQonary
l

Raise the discount rate

Sell bonds on the open market

Raise the reserve raQo

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

The Role of Monetary Policy


Monetary Policy and Short-Term Demand Management:
ContraQonary Monetary Policy
l

Achieves: Reduced InaQon

But risks:
l
l

Reduced Growth & Increased Unemployment


Lower exchange rate= reduced exports

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

The Role of Monetary Policy


Monetary Policy and InaQon TargeQng
l

Explain that central banks of certain countries, rather than focusing on the
maintenance of both full employment and a low rate of inaQon, are guided
in their monetary policy by the objecQve to achieve an explicit or implicit
inaQon rate target.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

The Role of Monetary Policy


Monetary Policy and InaQon TargeQng
l

The central bank responsible for the monetary system of the European
Union (EU) and the euro currency. The bank was formed in Germany in June
1998 and works with the other naQonal banks of each of the EU members to
formulate monetary policy that helps maintain price stability in the
European Union.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

The Role of Monetary Policy


Monetary Policy and InaQon TargeQng
l

The European Central Bank has been responsible for the monetary policy of
the European Union since January 1, 1999, when the euro currency was
adopted by the EU members. The responsibiliQes of the ECB are to
formulate monetary policy, conduct foreign exchange, hold currency
reserves and authorize the issuance of bank notes, among many other
things.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

The Role of Monetary Policy


EvaluaQon of Monetary Policy
l

Evaluate the eecQveness of monetary policy through consideraQon of


factors including the independence of the central bank, the ability to adjust
interest rates incrementally, the ability to implement changes in interest
rates relaQvely quickly, Qme lags, limited eecQveness in increasing
aggregate demand if the economy is in deep recession and conict among
government economic objecQves.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

The Role of Monetary Policy


EvaluaQon of Monetary Policy: SQmulaQng Growth During Recession; Strengths
l

Speed: quick to react to the economy

Control: Have no distracQons or long debates on policy

No poliQcs: the economy is bigger than party poliQcs

No Crowding Out: Consumers and Government will have equal access

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.5

Monetary policy

The Role of Monetary Policy


EvaluaQon of Monetary Policy: SQmulaQng Growth During Recession; Weaknesses
l

Investors are reluctant to borrow: interest rates scare o investors

Time Lags: some Qme needs to be allowed for implementaQon

Changes in elasQcity of investment: decrease in interest rates may cause delay


in investment.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

The Role of Supply-Side Policies


Supply-Side Policies and the Economy
l

Explain that supply-side policies aim at posiQvely aecQng the producQon side
of an economy by improving the insQtuQonal framework and the capacity to
produce (that is, by changing the quanQty and/or quality of factors of
producQon).

State that supply-side policies may be market-based or intervenQonist, and that


in either case they aim to shix the LRAS curve to the right, achieving growth in
potenQal output.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

The Role of Supply-Side Policies


Supply-Side Policies and the Economy*
l

Supply-side economics is be\er known to some as "Reaganomics," or the


"trickle-down" policy espoused by 40th U.S. President Ronald Reagan. He
popularized the controversial idea that greater tax cuts for investors and
entrepreneurs provide incenQves to save and invest, and produce economic
benets that trickle down into the overall economy.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

The Role of Supply-Side Policies


Supply-Side Policies and the Economy*
l

Like most economic theories, supply-side economics tries to explain both


macroeconomic phenomena and - based on these explanaQons - oer policy
prescripQons for stable economic growth. In general, supply-side theory has
three pillars: tax policy, regulatory policy and monetary policy.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

The Role of Supply-Side Policies


Supply-Side Policies and the Economy
l

However, the single idea behind all three pillars is that producQon (i.e. the
"supply" of goods and services) is most important in determining economic
growth. The supply-side theory is typically held in stark contrast to
Keynesian theory which, among other facets, includes the idea that demand
can falter, so if lagging consumer demand drags the economy into recession,
the government should intervene with scal and monetary sQmuli.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

The Role of Supply-Side Policies


Supply-Side Policies and the Economy
l

This is the single big disQncQon: a pure Keynesian believes that consumers
and their demand for goods and services are key economic drivers, while a
supply-sider believes that producers and their willingness to create goods
and services set the pace of economic growth

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

The Role of Supply-Side Policies


Supply-Side Policies and the Economy
l

In economics we review the supply and demand curves. The lex-hand chart
below illustrates a simplied macroeconomic equilibrium: aggregate demand
and aggregate supply intersect to determine overall output and price levels. (In
this example, output may be gross domesQc product and the price level may be
the Consumer Price Index.) The right-hand chart illustrates the supply-side
premise: an increase in supply (i.e. producQon of goods and services) will
increase output and lower prices.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

The Role of Supply-Side Policies


Supply-Side Policies and the Economy

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

The Role of Supply-Side Policies


Supply-Side Policies and the Economy
l

Supply-side actually goes further and claims that demand is largely


irrelevant. It says that over-producQon and under-producQon are not
sustainable phenomena. Supply-siders argue that when companies
temporarily "over-produce," excess inventory will be created, prices will
subsequently fall and consumers will increase their purchases to oset the
excess supply.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Interven6onist Supply-Side Policies


Investment in Human Capital
l

Explain how investment in educaQon and training will raise the levels of
human capital and have a short-term impact on aggregate demand, but
more importantly will increase LRAS.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Interven6onist Supply-Side Policies


Investment in Human Capital*
l

A measure of the economic value of an employee's skill set. This measure


builds on the basic producQon input of labor measure where all labor is
thought to be equal. The concept of human capital recognizes that not all
labor is equal and that the quality of employees can be improved by
invesQng in them. The educaQon, experience and abiliQes of an employee
have an economic value for employers and for the economy as a whole.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Interven6onist Supply-Side Policies


Investment in Human Capital
l

Economist Theodore Schultz invented the term in the 1960s to reect the
value of our human capaciQes. He believed human capital was like any other
type of capital; it could be invested in through educaQon, training and
enhanced benets that will lead to an improvement in the quality and level
of producQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Interven6onist Supply-Side Policies


Investment in New Technology
l

Explain how policies that encourage research and development will have a
short-term impact on aggregate demand, but more importantly will result in
new technologies and will increase LRAS.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Interven6onist Supply-Side Policies


Investment in New Technology
l

Spending on capital goods such as new factories & other buildings machinery & vehicles

Much new investment includes advances in technology

Investment is an important component of AD, and is a factor aecQng compeQQveness of


a country in a globalizing world

In market economies, most investment is done by private sector businesses but a


substanQal amount of new capital is purchased by the government (state sector)

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Interven6onist Supply-Side Policies


Investment in Infrastructure
l

Explain how increased and improved infrastructure will have a short-term


impact on aggregate demand, but more importantly will increase LRAS.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Interven6onist Supply-Side Policies


Investment in Infrastructure*
l

The basic physical systems of a business or naQon. TransportaQon,


communicaQon, sewage, water and electric systems are all examples of
infrastructure. These systems tend to be high-cost investments, however,
they are vital to a country's economic development and prosperity.
Infrastructure projects may be funded publicly, privately or through public-
private partnerships.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Interven6onist Supply-Side Policies


Investment in Infrastructure
l

SomeQmes private companies will choose to invest in a country's


infrastructure development as part of a business expansion eort. For
example, an energy company might build pipelines and railways in a country
where it wants to rene petroleum. This investment can benet both the
company and the country.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Interven6onist Supply-Side Policies


Investment in Infrastructure
l

Infrastructure is also an asset class that tends to be less volaQle than equiQes
over the long term and generally provides a higher yield. As a result, some
companies and individuals like to invest in infrastructure for its defensive
characterisQcs. Individuals and insQtuQons can invest in infrastructure through
infrastructure funds and can even choose specialized funds, such as those that
invest in transportaQon infrastructure or water infrastructure.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Interven6onist Supply-Side Policies


Industrial Policies
l

Explain that targeQng specic industries through policies including tax cuts,
tax allowances and subsidized lending promotes growth in key areas of the
economy and will have a short-term impact on aggregate demand but, more
importantly, will increase LRAS.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Interven6onist Supply-Side Policies


Industrial Policies*
l

The Industrial Policy plan of a country, someQmes shortened IP, is its ocial
strategic eort to encourage the development and growth of the manufacturing
sector of the economy. The government takes measures "aimed at improving
the compeQQveness and capabiliQes of domesQc rms and promoQng structural
transformaQon." A country's infrastructure (transportaQon, telecommunicaQons
and energy industry) is a major part of the manufacturing sector that usually has
a key role in IP. It is also the case that industries fail dismally to add to such a
growing body of manufacturing industries.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Interven6onist Supply-Side Policies


Industrial Policies
l

Industrial policies are sector specic, unlike broader macroeconomic policies.


They are oxen considered to be intervenQonist as opposed to laissez-faire
economics. Examples of horizontal, economy wide policies are Qghtening credit
or taxing capital gain, while examples of verQcal, sector-specic policies
comprise protecQng texQles from imports or subsidizing export industries. Free
market advocates consider industrial policies as intervenQonist measures typical
of mixed economy countries.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Market-Based Supply-Side Policies


Policies to Encourage CompeQQon
l

Explain how factors including deregulaQon, privaQzaQon, trade liberalizaQon


and anQ- monopoly regulaQon are used to encourage compeQQon.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Market-Based Supply-Side Policies


Policies to Encourage CompeQQon
l

Supply-side policies are mainly micro-economic policies designed to make


markets and industries operate more eciently and contribute to a faster
underlying-rate of growth of real naQonal output

Successful policies have the eect of shixing the LRAS curve to the right
leading to a rise in potenQal output

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Market-Based Supply-Side Policies


Policies to Encourage CompeQQon
l

Most governments believe that improved supply-side performance is the


key to achieving sustained growth without causing a rise in inaQon.

Supply-side reform on its own is not enough to achieve this growth. There
must also be a high enough level of AD so that the producQve capacity of an
economy is actually brought into play.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Market-Based Supply-Side Policies


Policies to Encourage CompeQQon
l

Key concepts to focus on are incenQves, enterprise, technology, mobility,


exibility and eciency.

Improve incenQves and invest in peoples skills

Increase labor and capital producQvity

Increase the occupaQonal and geographical mobility of labor

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Market-Based Supply-Side Policies


Policies to Encourage CompeQQon
l

Increase capital investment and research and development spending by rms

PromoQng more compeQQon and sQmulate a faster pace of invenQon and


innovaQon

Provide a plaorm for sustained non-inaQonary growth of an economy

Encourage the start-up and expansion of new businesses / enterprises

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Market-Based Supply-Side Policies


Labor Market Reforms
l

Explain how factors including reducing the power of labour unions, reducing
unemployment benets and abolishing minimum wages are used to make
the labour market more exible (more responsive to supply and demand).

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Market-Based Supply-Side Policies


Labor Market Reforms:
Cu}ng government spending and taxes and policies to cut government borrowing
l

Laws to control trade union powers

Reducing red-tape to cut the costs of doing business

Measures to improve the exibility of the labour market / reforming


employment laws

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Market-Based Supply-Side Policies


Labor Market Reforms:
l

Policies to boost compeQQon such as deregulaQon and tough anQ-monopoly and anQ-
cartel laws

PrivaQzaQon of state assets (selling o public sector businesses into the private sector)

Opening up an economy to overseas trade and investment

Opening up an economy to inward labor migraQon

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Market-Based Supply-Side Policies


Labor Market Reforms:
l

Many of the tradiQonal legal protecQons enjoyed by the trade unions have been
taken away including restricQons on their ability to take industrial acQon. The
result has been a decrease in strike acQon in virtually every industry and a
signicant improvement in industrial relaQons in the UK

Improved partnerships between trade unions and employers can make a big
contribuQon to raising producQvity and improving the exibility of workers in
their jobs

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Market-Based Supply-Side Policies


IncenQve-Related Policies
l

Explain how factors including personal income tax cuts are used to increase
the incenQve to work, and how cuts in business tax and capital gains tax are
used to increase the incenQve to invest.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Market-Based Supply-Side Policies


IncenQve-Related Policies
l

Economists who support supply-side policies believe that lower rates of income
tax provide a short-term boost to demand, and they improve incenQves for
people to work longer hours or take a new job because they get to keep more
of the money they earn.

Cu}ng tax rates for lower paid workers may help to reduce the extent of the
unemployment trap where people calculate that they may be no be\er o
from working than if they stay outside the labor force.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Market-Based Supply-Side Policies


IncenQve-Related Policies
l

Do lower taxes always help to increase the acQve labour supply in the
economy? It seems obvious that lower taxes should boost the incenQve to
work because tax cuts increase the reward from a job. But some people may
choose to work the same number of hours and simply take a rise in their
post-tax income! Millions of other workers have li\le choice over the hours
that they work.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Evalua6on of Supply-Side Policies


The Strengths and Weaknesses of Supply- Side Policies
l

Evaluate the eecQveness of supply-side policies through consideraQon of


factors including Qme lags, the ability to create employment, the ability to
reduce inaQonary pressure, the impact on economic growth, the impact on
the government budget, the eect on equity, and the eect on the
environment.

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Evalua6on of Supply-Side Policies


The Strengths and Weaknesses of Supply- Side Policies
l

Recessions are oxen the result of negaQve demand-side shocks that hit real
incomes of consumers and demand and prots for businesses

The consequences show through in higher unemployment, a fall in capital


investment and an increasing rate of business failures

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Evalua6on of Supply-Side Policies


The Strengths and Weaknesses of Supply- Side Policies
l

There is a danger that a deep recession and slow recovery will have harmful
eects on the supply side leading to a reducQon in the growth rate of potenQal
GDP and a loss of producQve capacity. This is known as a hysteresis eect

Most macroeconomic policies in a recession center on boosQng demand and


condence in a bid to generate a rebound in output, jobs and incomes within
the circular ow and prevent hysteresis

IB Economics SL: City Honors School

Unit 2: Macroeconomics
2.6

Supply-Side Policies

Theory of Knowledge: Poten6al Connec6ons


How can we know whether government should support pure research, which might
contribute to the sum total of human knowledge but which might never have an
impact on technology? What other knowledge issues are relevant to investment in
pure research?
Investment in educa<on and training is a common supply-side policy. What other
reasons could there be for suppor<ng the educa<on of the popula<on? What
knowledge issues arise in answering the ques<on as to whether government
should shoulder this responsibility or whether it should be le= to the market?