Macroeconomics is related to the overall (the national) economy and its performance, structure and behaviour.

This personally is my favourite side of economics. The issues highlighted below are a part of every day life. Read any newspaper and you are certain to come across an article about inflation or economic growth. Through studying macroeconomics or 'macro' as it's informally known as, you will be able to understand why these topics are forever in the news.

There are a number of indicators illustrating macro economic performance, and these include:


Aggregate demand (AD)

In microeconomics individual demand and supply was analysed. Where as in macroeconomics the whole economy is looked at - aggregate demand and aggregate supply.

Aggegate Demand = sum of all the demand in the economy (all the individual demand curves).

AD = Consumption (C) + Investment expenditure (I) + Government expenditure (G) + (Exports (X) – Imports (M))

As is seen in the diagram below AD rises from Y1 to Y2 as the price level falls from P1 to P2. 

Why is this?

  • Real money effect - As the price level falls, money become’s worth more.
  • Prices and interest rates - A lower price increases the real interest rate putting pressure on the authorities to cut nominal interest rates. These low nominal interest rates encourage an increase in consumer demand and investment (components of AD).
  • International competitiveness - If the UK price level is lower than other countries then UK goods and services will become more competitive causing exports to rise (component of AD).

Shifts in Aggregate Demand

A change in one of the components of aggregate demand
will cause a shift in the aggregate demand curve. An outward shift
In AD could be caused by:
  • A rise in consumption.
  • A rise in investment.
  • A rise in government expenditure.
  • A rise in net exports.
Where as the reverse of this would cause the AD curve to shift inwards.

Effects of a shift

Outward shift

In the diagram below the AD curve shifts outwards from AD1 to AD2. This causes prices to rise from P1 to P2 (inflation), and output to rise from Y1 to Y2. As output rises the level of employment rises because more employees are required to produce this higher level of output.

Inward shift

The AD curve can also shift inwards, in this case you have to imagine the revers of the situation above. The economy begins on the AD curve AD2 with prices equal to P2 and ouput equal to Y2. However as one of the components of AD (C/G/I/(X-M)) falls the AD curve shifts inwards from AD2 to AD1. This causes the price level to fall to P1 and the level of output/employment to fall to Y1.

Aggregate supply

Aggregate Supply (AS) measures the quantity of goods and services produced within the economy at a given price level.
When talking about aggregate supply, it’s important to distinguish between the short and long run.

Short run - time period when at least one factor of production is fixed. The factors of production include land, labour, capital and entrepreneurship.

Long run - time period when all factors of production are variable.

The short-run Aggregate Supply curve (SRAS)
Aggregate supply is determined by the economy’s productive capacity and the costs of production. The short run AS curve is upward sloping, producers supply more at a higher price because selling a higher quantity at a higher price increases revenue. In order to produce higher levels of output businesses make factors of production work harder and for longer. To understand this think of labour, employees often accept ‘time and a half’ to work additional hours, these additional working hours result in the level of output rising. And subsequently we have an upward sloping SRAS curve, as the price level rises so does aggregate supply (a positive relationship), this can be see in the diagram below.


SRAS Shifts

The SRAS curve can shift outwards due to a number of factors, these include:
  • New technology
  • A rise in productivity
  • Better trained labour
  • Lower taxes
  • Higher subsidies

Where as the opposite of all these would cause the SRAS curve to shift inwards.

The effect of a shift

In the diagram below the SRAS curve shifts inwards from AS1 to AS2, this causes a fall in output/employment from Y1 to Y2 and a rise in prices from p1 to p2, equilibrium is now at point B.

In the diagram below the SRAS curve shifts outwards from S0 to S1, this causes output/employment to rise from Q0 to Q1, and prices to fall from p0 to p1.


LONG RUN AGGREGATE SUPPLY

The long run aggregate supply is independent of the price level, the curve is vertical – the same output is produced irrespective of the price level and this is seen in the diagram below. No matter if the price is P1 or P2, an output of Y2 is still produced. The reason being that in an economy the factors of production are limited and so only a fixed level of output can be produced in the long run. In the short run factors of production can be forced to work harder and for longer, for a higher price. But in the long run this is not possible, labour and capital both need rest. When worked continuously workers need sleep and machines break. From this it is clear as to why the LRAS curve is vertical.

Shifts in the LRAS  curve

The LRAS curve can shift outwards if there is an increase in the quantity or quality of the factors of production. So for example a better trained labour force or the utilisation of derelict land could well lead to an outward shift in the LRAS curve, this is shown in the diagram below. A quick note, there are four factors of production:

  • Land
  • Labour
  • Capital
  • Entrepreneurship

 

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