Week 9 Macro Economics

Q1: What key macroeconomic variables can a government or central bank control? How have
these changed for your economy during the last five years?

Answer
Inflation can be influenced by manipulating interest rates which, coupled with government
spending (often above tax receipts) can influence GDP. Low interest rates coupled with a fiscal
deficit can encourage growth of GDP and reduce unemployment.

In the last 5 years many economies, including the UK, have tried to prevent further deterioration
in GDP. As economies shrank following the financial crises, central banks cut interest rates to
support economic activity. Inflation during this period was relatively high and often exceeded
stated target levels, e.g. 2%. However, the priority during this period was on supporting growth in
GDP and reducing unemployment. So interest rates have remained low, rather than raised to
combat rising inflation.

Q2: Identify the leakages, injections and components of aggregate expenditure in your
circular flow diagram.
Answer
The components of aggregate demand are spending on goods and services (consumption), net
exports (which are exports minus imports), government spending and investment.

Saving, imports and taxation are leakages.

Exports, government spending and investment are injections.

Q3: Explain why there is a negative relationship between inflation and aggregate demand.
Answer 
The relationship is said to be negative because if interest rates rise to help control inflation this
will act as a disincentive for consumers and firms to borrow to buy goods and services or invest.
This will reduce aggregate demand.

Q4: Consumer and business confidence are increasing. Illustrate the likely consequence of these
changes on aggregate demand.
 Answer
If business confidence improves more investment will take place, leading to a multiplier effect on
national income and therefore demand. Similarly, if consumers feel more confident about
retaining their jobs etc. spending will increase, as will borrowing (by both firms and households).

Q5: Explain why in the long-run aggregate supply is perfectly inelastic, but in the short-run
it is elastic.
 
  Answer 
In the short run aggregate supply may be elastic because wage and price adjustments occur with
time lags. If prices increase faster than wages this reduces marginal cost relative to revenue and
firms, assuming they are profit maximizers, will increase output and aggregate supply will
expand.
In the long run real wages will adjust to the inflation rates and real wages will match price
increases. This will impact on aggregate supply which, diagrammatically, will take the form of a
vertical line, indicating that aggregate supply remains unchanged.

Q6: Explain what is meant by the term “a lead-indicator”.

Answer 
A “lead indicator” is a term which refers to key changes in economic behaviour that will impact on
aggregate demand or supply, e.g. during growth period enquiries from consumers will increase
and will eventually become orders and sales.

Q7: How does an understanding of income elasticity enable a firm to manage the
consequences of the business cycle?
 Answer 
If firms understand the difference between “income inferior” goods and “normal” goods they can
survive a recession by producing foods that are inferior, i.e. goods which consumers buy more of
when incomes are reduced.

Q8: In the long-run can GDP grow through an increase in aggregate demand, aggregate
supply, or both?
 Answer    
GDP can grow both through increases in aggregate demand and aggregate supply.
               
As demand increases the economy grows and inflation may increase. The increase in GDP may
be monetary rather than physical.
     
If supply increases, then the economy grows and inflation decreases. This is an increase in real
GDP.

Q9: In an economy, if aggregate demand increases while aggregate supply stays constant,
what happens to GDP and inflation?
Answer 
A rise in aggregate demand with aggregate supply remaining constant will lead to an increase in
GDP and inflation, leading to a so-called inflationary boom.

Q10: An economy benefits from an influx of additional workers. Using the circular flow of
income, assess how these additional workers will impact upon the output of the economy.
How will the extra workers influence aggregate supply?
Answer 
With an influx of additional workers, households can supply firms with extra workers. Firms will
only demand more workers at lower wage rates. So, if we can assume that wages fall, then the
flow of resources from households to firms will increase within the inner ring of the circular flow of
income. With more productive resource, firms can increase the flow of goods and services in the
outer ring. With more resource supplied to firms at a lower cost, firms are more willing to supply
output. The aggregate supply curve shifts to the right, with firms willing to provide more GDP at
all levels of inflation.
Q11: Identify the key business variables a company could monitor in order to understand
whether the economy is heading towards a boom or a recession. 
Answer  
If customers switch to a company for non-price reasons this could be an indication of strong
business activity and that rivals are becoming busy. So as sales and profit-margins improve a
boom is likely and plans for expansion should follow.
 
Conversely if orders start to fall and other companies across the board start to experience loss of
trade, it is likely that a recession will ensue.

Q12: The economy has been growing for 12 months and sales are increasing, but margins, the
difference between revenues and costs, are beginning to fall. Is now a good time to invest in
additional production capacity? 
Answer  
If sales have been rising, then profits may have been increasing. But increased profits will have
attracted other firms into the market or, alternatively, existing players in the market may have
already invested in additional capacity, leading to an increase in supply. Increased competition
generally leads to an increase in supply and a consequential decrease in the market price. With
a falling price, margins are squeezed; therefore, now is perhaps not the best time to invest.