Macroeconomics Study Guide

What is the purpose of this

study guide?

This Study Guide was written to help you memorize economic ideas.
Memorizing content is the first step to writing good essays, i.e. to have
something to talk about.

What is the purpose of the

questions?

On the left side of the page are questions. These questions elicit the
information you need to know for the exam on the right side of the
page.

How do I use the questions?

After you have read the notes and understood them, cover the notes
and ask yourself the questions in the left margin.
How do I know I am ready for
the test?

What is the purpose of the

summary?

In the week before the exam

what do I do?
What works on exams?

When you can answer the questions without sneaking a peek then you
are ready to write an essay because you know the material well.
When you have understood the contents of the page, write a summary
of the information contained on the page. Writing a summary makes
you synthesize the information and move to a higher level of
understanding. It is the final check that you understand the information.
As you get closer to the exam, your goal is to condense this study guide
to make a three or four page summary of the content, focusing on key
ideas.
On the exams you have a short period of time to write. You must know
the content well.
One more tip. You are going to be asked to compare key ideas. There
will be a term in the question that you must explore or develop.
This guide is written with this need in mind. Learn the arguments.
As always, you must be precise in your use of economic terminology and
diagrams.

Summary: This study guide helps memorize key concepts from the Macroeconomics syllabus by asking questions that
elicit the course content. After memorizing the content I then write a short summary of the page content. Once I have
done this I know I am ready to be examined on the page contents.

Date:

Contents
Overview of the Subject ..................................................................................................... 4
Economic Measurement General Terms and Useful Vocabulary .................................... 5
Measuring economic activity terms needing definitions ................................................. 6
Key idea basket of goods measures ............................................................................. 7
How is economic activity at a national level measured? .................................................... 8
Problems with GDP as a measure of output ....................................................................... 9
Extension Topic Podcast Discussion on Econometrics ................................................... 10
Different perspectives or schools of thought in macroeconomics ................................... 11
Comparison of the AD/AS with D/S Model more differences than similarities ............. 12
Aggregate Demand and Aggregate Supply Model looking at AD ................................... 13
Aggregate Demand and Aggregate Supply Model looking at the other side, AS ........... 14
Differing perspectives on SRAS # 1 Extreme Keynesian ................................................. 15
Differing perspectives on SRAS #2 Intermediate Keynesian .......................................... 16
Differing perspectives on SRAS #3 Classical AS curve .................................................... 17
The Circular Flow Model Injections and Withdrawals ................................................... 18
The Trade or Business Cycle the ups and downs of economic activity .......................... 19
The Components of Aggregate Demand 1. Consumption expenditures (C) .................. 20
The Components of Aggregate Demand 2. Investment expenditures (I) ...................... 21
The Components of AD 2. Investment expenditures (continued) ................................. 22
The Components of Aggregate Demand 3. Government spending ............................... 23
The Components of Aggregate Demand 4. Net Exports (X-M) ...................................... 24
Adverse Supply Shocks and Shifts of AS ........................................................................... 25
The AD/AS Framework (Model) an equilibrium model .................................................. 26
AD/AS Mechanics effects of shifting AD given an extreme Keynesian AS ..................... 27
AD/AS Mechanics effects of shifting AD given extreme Monetarist AS ......................... 28
AD/AS Mechanics shifting AD given a New Classical AS (intermediate view) ................ 29
AD/AS Mechanics An increase of AS .............................................................................. 30
Economic Policies Demand-side policies ....................................................................... 31
Fiscal Policy from a Keynesian Perspective the key idea ............................................... 32
Fiscal Policy from a Keynesian Perspective the multiplier effect (HL) ........................... 33
Fiscal Policy - an example of the Multiplier Effect ............................................................ 34
Fiscal Policy an evaluation using advantages and disadvantages .................................. 35
Fiscal Policy (HL) The crowding out effect a criticism of fiscal policy....................... 36
Monetary Policy evaluating the use of monetary policy ............................................... 37
Supply-side Policies .......................................................................................................... 38
Supply-side Policies Industrial policy ............................................................................. 39
Inflation measuring average prices using an index ........................................................ 40
(HL) Inflation weighted basket of goods index ........................................................... 41
Inflation costs of inflation .............................................................................................. 42
Inflation going the other way it is called deflation ........................................................ 43
Inflation Three causes of inflation and deflation - overview ......................................... 44
Demand-pull Inflation causes of demand-pull inflation................................................. 45
Cost-push Inflation Causes of cost-push inflation .......................................................... 46
Causes of deflation ........................................................................................................... 47
Inflation and Deflation policy response to demand-pull inflation ................................. 48
Inflation and Deflation policy response to cost-push inflation ...................................... 49

Contents
Unemployment ................................................................................................................. 50
Unemployment Costs of unemployment ....................................................................... 51
Unemployment Types of unemployment ...................................................................... 52
Unemployment Cyclical or Keynesian unemployment .................................................. 53
Unemployment Real wage unemployment ................................................................... 54
Unemployment Policy responses depend on the type of Unemployment .................... 55
Unemployment the natural rate of unemployment (NRU)............................................ 56
The Phillips curve the trade-off between unemployment and inflation ........................ 57
The Long Run Phillips Curve a critique of the short run PC ............................................ 58
The LR Phillips Curve how it works ................................................................................ 59
Inflationary Gap an alternative illustration .................................................................... 60
Inflationary Gap the story continues ............................................................................. 61
Deflationary Gap an alternative illustration .................................................................. 62
Stagflation Low or stagnant output combined with inflation ........................................ 63
Distribution of Income - the Lorenz curve and Gini coefficient ........................................ 64
Distribution of Income Possible benefits from more equal distribution ....................... 65
Taxation tools of income redistribution......................................................................... 66
Taxation policies to redistribute income ....................................................................... 67
(HL) The Laffer Curve and Tax Cuts ................................................................................... 68

Date:

Overview of the Subject

How is Macro different from Micro

economics?

Macroeconomics is the study of the economy as a whole. While

microeconomics studies individual markets, macroeconomics studies
the whole economy.

What are the main topics studied in

macroeconomics?

The main topics in the macroeconomics section are unemployment,

inflation, growth, and the balance of international payments.

What is economic policy?

Government guides the macro economy via economic policies. Policies

are past decisions that organizations set in stone to guide future
decisions, so the organization doesnt waste time re examining
questions already answered. Economic policy means the decisions of
the government with respect to the economy.

What are the main goals for

government economic policy?
What is price stability?

The main policy goals for government decision-makers include:

o Sustainable real growth (increase in output)
o Price stability (low rates of inflation)
o Low unemployment (full employment)
o Long run equilibrium in the balance of payments
(policies directed at the international economy do not
interfere with domestic policy objectives).

How can economists use

government policy statements?

Government policy can be EVALUATED on how well the goals are

achieved. The policy objectives conflict with each other so this theme of
conflicting goals is a GREAT source of ideas for essays.

Identify three methodological

problems in macroeconomics.

What is a main activity in studying

macro?

Methodological problems in Macroeconomics include:

o Measurement of economic activity (Many items are left
out or included in activity measures that shouldnt be.)
o Complexity (economic events have multiple causes and
it is impossible to say which ones are causal)
o No consensus. Unlike MICRO where economists agree
on how it works, there is little consensus as to how
MACRO works. Two schools of thought are presented
in introductory economics: the Keynesian school and
the New Classical School.
The study of MACRO thus involves comparing different ideas and points
of view to see which one better explains observed events.

Summary: Macroeconomics is the study of the economy as a whole and involves comparing economic performance
with government policy objectives by comparing different perspectives, mainly Keynesian and New Classical points of
view.

Date:

Economic Measurement General Terms and Useful Vocabulary

What does gross mean?
What is gross income?
What does net mean?
What is net income?

What does value mean?

What is value-added?

Gross: Means no subtractions have been made.

Net: A subtraction has been made. What has been removed depends on
the measure, e.g. Net income- taxes were removed from income; net
product depreciation was removed.
Value: Price x quantity, In MACRO the amount of money spent is a
measure of output. If an economy makes 1 hot dog for $5 and 1
sandwich for $2 then output or economic activity is $7 Real Output.
Value-added: Goods move from raw materials to final product through
different stages. Value-added refers to the increase in price added by
each stage (final price minus cost). Part of value-added is profit.

What is double counting?

Double counting: An error where the value-added is counted twice.

What does price level mean?

Price Level: Macro uses average prices called the price level. In the hot
dog example above the price level would be an average of $3.50.

What is an index?
What does an index do?

Index: A way of presenting a series of prices relative to a base price

which is given a value of 100, e.g. an average price is equated to 100
(e.g. $327 = 100) and all other prices in the series are compared to this
using 100 as the base, e.g. an index value of 98 would mean the average
price was about $320). Indexes make it easy to see changes.

What does product mean?

Product: Means output just like Micro only output is measured in terms
of the money value not the number of units produced.

What does current mean?

(several possible)

Current: Referring to time it means within 30 days. When referring to

money the word means not savings, i.e. the intention is to spend it
within 30 days. Money in an economy is either spent (current) or saved
(savings). These are the only two possible states for money. (a physical
analogy: current = liquid, savings = frozen)

What is expenditure?

What is a transfer payment?

What is equilibrium?

Expenditure: Money spent on final goods and services.

Transfer payment: This is money moved between governments and is
not considered productive output, e.g. an unemployment benefit
payment is a transfer payment.
Equilibrium. Our course focuses on equilibrium models. These models
assume the forces in the economy rest or balance at a level of
output. In contrast are disequilibrium models (not studied here).

Summary: This page contains vocabulary needed to understand how measurements are made in macro economics, such
as gross versus net, value meaning quantity, price level being an average price, index being a scale where the base value
is 100, and money is either spent or saved in an economy.

Date:

Measuring economic activity terms needing definitions

What is GDP?

Gross domestic product (GDP) is a measure of output of the economy as

a whole.

What is included in the calculation

of GDP?

GDP is defined as the value of all final goods and services produced
within an economy over a certain period of time, usually a year.

What is not included in GDP and

why not?

What is nominal GDP?

What is real GDP?

How is real GDP better than
nominal GDP?

How is Real GDP calculated?

What does the index do?
What is the formula for Real GDP?

What other average prices can be

adjusted for inflation?
(HL creating an index is a later
topic)

What is not included in GDP is as important as what is included:

Only final goods and services are included. Intermediate goods
are not. GDP includes only the value added contributed by each
firm to avoid double counting.
Used goods are not included because GDP measures only
current production.
Financial transactions are not included since they represent only
the transfer of ownership of a financial asset and not a
contribution to current production.
Transfer payments are not included. They do not reflect a
contribution to current output.
Nominal GDP: The value (p x q) of all final goods and services produced
within an economy over a certain period of time using current prices in
the calculation of value. Nominal GDP includes a variation in value due
solely to price changes (a bad thing) and not output changes (what we
are trying to measure). Nominal GDP is distorted by inflation.
Real GDP: This measure uses a price with inflation removed in the
calculation of GDP so that any change +/- represents a change in output
only (not Price level). This calculation does not use current prices but
instead uses an adjusted price. The adjusted price has inflation
removed. In calculating the new value of output, an index is created by
assuming the good remains the same between years and that any
change in its price must be due only to inflation. Nominal GDP is thus
changed to Real GDP through the use of an index. The formula for Real
GDP is Real GDP = (Nominal GDP/price index) * 100.
Any nominal measure using current prices can be adjusted for inflation
using an index, eg. Nominal wage level versus real wage level.

Summary: Economic output is measured in terms of the value of output or the value of economic activity. The use of
nominal prices results in an inflated measure of output. The inflated nominal measure can be adjusted using an index
that uses a base price to create whats called Real GDP.

Date:

Key idea basket of goods measures

What is the problem that requires

the construction of a price index?

Problem: Using current price x quantity as a measure of output can

result in inflated output (price may be inflated); it is possible that Q
stayed the same and only P increased. (Q is what we want to measure.)

Give an example of the effect of

inflated price levels on the
measurement of output, i.e. a
measurement error from to the use
of nominal prices.

That is, if output increased 5% year over year, but price level increased
7%, then real output would have actually fallen by 2%! The apparent
increase in output measured was in fact caused only by higher prices
and not greater output; the increase was a pure price phenomenon.

What is a basket of goods measure?

What two assumptions are
necessary for a basket of goods
measure to work?

What is a price index? How does a

price index work?

A basket of good measure works like this. Take the average price of a
collection of goods that are assumed to represent consumption
spending, say three T shirts, a pair of jeans and a computer, and assume
that these prices reflect all prices in the economy. If the average price of
this basket of goods rises while the physical goods stay the same we can
safely assume the price increase is due to inflation. That is, because the
basket of goods is identical between measures any price change reflects
a change in price only, i.e. inflation.
This allows us to create a price index between periods like the
Consumer Price Index, the Retail Price Index or the GDP Deflator. Using
these index values, we can change the nominal GDP measure to remove
the effects of inflation.
For help understanding price indexes visit MJMFOODIES website and
watch episode 16 Inflation and Price Indexes
http://maxclip.tojsiab.com/?w=SmOMp8gycMA&title=Macro-Episode16-Inflation-Price-Indexes

Summary: The output of all firms can be accurately estimated by sampling a few firms. The problem of price is that it
changes due to inflation. Price fluctuations can be removed by a basket of goods measure. The average price of a
representative basket of goods forms the basis of a price index.

Date:

How is economic activity at a national level measured?

How is national income (also
known as national output)
measured?
What is the output method?

What is the expenditure method?

What is the income method?

There are three ways to measure national income. National income

here is an umbrella term that identifies three different methods of
measuring economic activity:
The output method where the value added by all domestic
industries are added, e.g. total Manufacturing sector plus total
Service sector plus Agricultural sector,
The expenditure method where all expenditures made on final
goods and services are added together, and
The income method where the income flows from the factors of
production are added together.

What is the relationship between

the 3 measures?

These three methods result in measures that are conceptually

equivalent (the same).

What insight do output measures

provide?

The methods each give a slightly different picture despite being

equivalent.
Output method can show the percentage contribution of each
major sector of the economy.
Expenditure method can show investment spending over time,
or the proportion of government purchases compared to total
expenditures.
Income can give information on the proportion of total income
earned by labour versus the owners of capital.

What insight do expenditure

measures provide?

What insight do income measures

provide?

Identify two accounting issues or

problems with GDP, i.e. whats
included in the calculation.

How can GDP be converted to

GNP?

What is Net National Product?

Two accounting distinctions (problems)

1. National versus domestic: Gross Domestic Product is produced
within the boundaries of a country (Toyota USA plus Ford USA).
Gross National Product is the output of all firms of the same
national origin no matter where they are in the world (Disney
France plus Disney USA).
To convert GDP to GNP: GNP = GDP + Net Factor Income from Abroad
where net factor income is income earned abroad income paid
abroad. (factor incomes are rents, wages, interest and profit)
2. Gross vs Net. What is subtracted from GNP is the investment
spending required to maintain capital (i.e. spending needed to
repair machines and keep them running) so that only investment
that increases capacity is recorded. This is Net National Product.

Summary: The three methods of measuring national income are expenditures, output and income methods. GDP
measures domestic output regardless of national origin, GNP measures national output regardless of location.

Date:

Problems with GDP as a measure of output

What does GDP measure?
Identify five problems with GDP as
a measure of economic activity?

What is green GDP?

How is GDP most useful?

GDP measures only final market activities. GDP understates total

economic activity because non-market or parallel market activities, such
as housework or do-it-yourself work are not included.

Many people under-report their income to avoid paying taxes.

Some economically productive work is illegal, e.g. computer

hacking, smuggling, photocopying material under copyright
protection.

Subsistence farming is not included. This tends to

underestimate per capita income in developing countries.

Data collection in many countries is poor and unreliable.

Green GDP attempts to account for production that is

environmentally friendly or sustainable. It is fraught with
definitional as well as methodological problems due to the
difficulty of measuring externalities.

GDP is nonetheless useful because it consistently describes the change

in GDP between periods and this is what is most important for policy
because the effect policy changes on output can be assessed.
GDP is also fairly intuitive and relatively easy to calculate.

Summary: The system of national accounts was designed to record only the final value of goods traded on markets and
not do-it-yourself work. This ignores much productive work. The data is difficult to gather.

Date:

Extension Topic Podcast Discussion on Econometrics

Con is short for confidence. It
refers to a scam where a criminal
makes a victim feel comfortable by
telling a sympathetic story, gaining
the victims trust and then stealing
something .
Other than a clever turn of
phrase, what does Leamer mean
when he refers to modeling as a
con in econometrics?

The study of the Economy at a university level requires the use of

economic modeling. This is called econometrics. Macroeconomics
relies heavily on the use of models and this can cause problems.
Ed Leamer of UCLA talks with EconTalk host Russ Roberts about the
state of econometrics. He discusses his 1983 article, "Let's Take the
'Con' Out of Econometrics" and the recent interest in natural
experiments as a way to improve empirical work. He also discusses the
problems with the "fishing expedition" approach to empirical work. The
conversation closes with Leamer's views on macroeconomics, housing,
and the business cycle and how they have been received by the
profession.
http://www.econtalk.org/archives/2010/05/leamer_on_the_s.html
This is Leamers article.
http://www.international.ucla.edu/media/files/Leamer_article.pdf
Watch Economics U$A episode #15 GNP/GDP for a good background
presentation of the topic of measuring macroeconomic activity
http://www.learner.org/resources/series79.html?pop=yes&pid=2467

Summary: There is a tendency in research to play with economic models until they tell the story the researcher wants
to prove. Leamer thinks this is bad science and suggests that researchers present their ideas using logic and argument.

10

Date:

Different perspectives or schools of thought in macroeconomics

What school of thought preceded
Keynesianism?
What is the role of government in
the Classical School?
What school of thought grew out of
the failure of the economy to
achieve full employment level of
output?
Which school of thought
understands markets as being
inefficient and needing government
intervention?

What school of thought grew out of

the Keynesian experience of
inflation and low growth?

What does the New Classical

school question?

What is the Washington

Consensus?

Before 1929
Laissez-faire or Classical School, market forces guarantee that an
economy will rest at full employment. There is no need for government
to intervene.
1936 to mid 1970s
The 1936 publication of General Theory of Employment, Interest and
Money written by John Maynard Keynes marks the start of the
Keynesian school of thought. Economies can rest at less than full
employment. Government spending can move the economy to a higher
level of employment.
1970s
Monetarism and the Chicago school of thought. Keynesian fiscal
spending is inflationary and a steady money supply is the best
guarantee of economic growth. Offers a critique of Keynes.
1980s
New Classical school of thought questions the role of government and
emphasizes the longer term management of supply-side conditions as
providing optimum growth.
1990s
Washington Consensus holds that countries must liberalize markets to
receive IMF assistance. Rising inequalities within and between countries
from rapid growth make observers question this wisdom.

Summary: Classical theory of Adam Smith and David Ricardo yielded to Keynesianism following the Great Depression
1929. Monetarism followed rampant inflation of Keynesian policies. Supply-side economics emerged from Monetarism
in 1990s (Reaganomics and Thatcherism). Washington Consensus rules today.

11

Date:

Comparison of the AD/AS with D/S Model more differences than similarities
What is an equilibrium model?

What is an argument against the

assumption of equilibrium in
macroeconomics?

Do macro economists agree with

each other?

How is price measured in the

economy as a whole?
Do all economists agree on the role
of price in the economy?

What is output in macro and what

macro variable determines it? (two
viewpoints)

In micro the area on the graph is

either revenues or consumer
surplus. What is area on the AD/AS
graph? What is the x axis?

What impact does increasing

money supply have in micro versus
macro?

Similarities
Both are equilibrium models that assume market forces are
balanced. In micro, demand and supply arrive at an equilibrium
price and quantity. In the Macro model it is aggregate demand
and aggregate supply that balance.
(In Macro many economists argue that the economy is in a
continual state of disequilibrium as a result of constantly
changing technology and human capital. Many disequilibrium
models await you when you study economics at university.)
Both use graphs with two-axis for analysis and illustration.
Differences
There is a low level of consensus on how the macro economy
works while in micro the principles are well accepted.
Price: Average Prices and Price Levels are used in Macro. These
are more abstract and require the use of index values in place of
recognizable prices. Unlike micro, the role of the price level in
the macro economy is hotly debated between Keynesian and
New Classical perspectives, e.g. Keynesians say prices are
constant and have no meaning; NC say price is critical.
Quantity: Value or expenditures corrected for inflation are used
in macro in order to find a common unit (money) to measure
output. Keynes says output is variable and determined by AD;
NCs say output is constant at full employment level and
independent of AD.
Area on the graph: Gross domestic product is price level x
output, or the amount of money in the economy multiplied by
the number of times its used, or GDP (all the same). Real GDP is
a distance on the x axis (not an area) and indicates real output.
The role of money in the economy is debated in macro while in
micro the quantity of money and prices are accepted to be
directly related. In macro, Keynesians say changes to the money
supply has no impact on prices. NC say changes to the money
supply impacts only prices.

Why is macro argumentative?

The macro muddle is due to complexity. I present the views as

arguments because it makes writing essays easier. The truth is that the
perspectives each shed light and help make the invisible visible. Also
there are a lot more than two perspectives! (But two dominate.)

Summary: The AD/AS model looks like the D/S model but there are important differences, the first being the use of
average prices and expenditures as a measure of output. The model is subject to revision according to perspectives, key
being Keynesian and New Classical perspectives.

12

Date:

Aggregate Demand and Aggregate Supply Model looking at AD

What does equilibrium mean or
imply with reference to the
economy?

The AD/AS model is an equilibrium model like the demand and supply
model. This assumes the economy can be stable over time. The forces
that oppose/balance each other are AD and AS. When they are equal,
the model is in equilibrium.

How is equilibrium achieved in the

whole economy?

When price levels are too high, purchasing power falls and excess
output is produced in all industries. Inventories of unsold products
increase causing firms to reduce prices. Equilibrium is restored.
Likewise, shortages occur with price levels too low. Purchasing power
rises. Price levels are bid up. For good and full discussion of how
equilibrium is achieved see:
http://tutor2u.net/economics/content/topics/ad_as/adas_equilibrium.htm

What is the X-axis in the AD/AS

Model?
How are output and income
related?
What is the GDP deflator?

X-axis is Real Output or Income, Y-axis is Average Price Level.

Technical note: Y or Income, Real Output, and RGDP are all acceptable
labels for the X-axis. Output and Income refer to the same thing so they
are equal. Price level or the index GDP Deflator are the two
acceptable labels for the y axis.

What is private sector spending?

What is public sector spending?

What is Net Exports?

What is the formula for AD?

Why is AD downward sloping?

AD is total spending on goods and services. Spending can come from the
private sector (households and firms) or the public sector. Private sector
spending includes Consumption spending (C) and Investment spending
(I). Public sector includes Government spending (G) which is both
consumption and investment spending by government, e.g. the
government buys pencils (consumption) and builds public roads (invests
in public capital). Spending on domestic goods can come from abroad
(Xports). Spending of iMports is subtracted from AD.
AD = C+I+G+(X-M) where (X-M) is referred to as the international
economy and often called simply Net Exports.
AD is downward sloping because of the Income Effect, Bank Balance
Effect, and Import Substitution Effect. As average price levels increases,
planned spending decreases because incomes and bank balances
purchase fewer goods, and imports become more attractive substitutes
for domestic goods.

Summary: AD is a force representing total spending on goods and services. AD = C+I+G+net exports. It can be
graphed against average price level and output. As average price levels increase consumers plan to spend less because
income and wealth are assumed to remain constant.

13

Date:

Aggregate Demand and Aggregate Supply Model looking at the other side, AS
What is aggregate supply?
Is there agreement on the shape of
the AS curve?
Why is LRAS vertical in the long
run?

Why does AS rise in the

mainstream view of AS? (Be very
careful and certain of your
explanation, this knowledge is
important to how the model works.)

Aggregate supply is the planned level of output per period at different

price levels. The shape of the curve changes between schools of
thought. The shape is controversial except in the long run.
Long run AS is vertical. In the long run the only constraints on output
are a countrys resources and its level of technology. As a result, the
long run AS (LRAS) curve is vertical when resources are fully employed.
This is called full employment level of output or YFE.
Short-run view the mainstream view
Typically, AS rises in the short run due to constraints in the production
processes of all firms in all industries. HL can understand this as
diminishing returns setting in each industry. SL and HL can understand
the upward slope as the need for higher price levels to compensate
firms for the increased opportunity costs (see PPF curve) as industries
expand production and get new factors from a diminishing supply of
resources. (e.g. fewer and fewer workers available so elderly
grandparents are employed as farm workers to pick tomatoes).

How might an increase in average

wages affect AS? (Be very certain
about this.)

TECHNICAL NOTE: wages are assumed constant as they are a cost of

production; changing wages requires a new short run supply curve be
drawn. Therefore the AS CURVE HAS A POSITIVE SLOPE BECAUSE FIRMS
MUST BE REWARDED FOR OVERCOMING PRODUCTION BOTTLENECKS
as their output expands, NOT BECAUSE WAGES INCREASE. (Be certain
you understand this point well.)

Why do average price levels

increase as output rises? Be very
certain about this.

Another way of looking at the slope of the AS curve is that it tells how
much a given increase in output goes to higher average prices and how
much goes to increase in output. Continuing with the silly example
above, employing a grandparent requires building a walkway to the field
(an additional expense) and grandpa is bored with tomato picking and
doesnt pick many. A higher price level is required for the benefit of
employing these resources to be greater than their addition to cost.

Why do many differing

perspectives exist?

Different perspectives exist because of the complexity of the economy.

Our observations are uncontrolled. Economic events can have many
causal factors. Theory guides the interpretation.

Summary: Economists agree about LRAS being vertical at YFE. Mainstream view has SRAS s with a positive slope
because a greater price level is needed to compensate for resource bottlenecks, not because wages increase. A PPF
curve bowed outwards can be used to illustrate rising opportunity costs from taking workers from other activities.

14

Date:

Differing perspectives on SRAS # 1 Extreme Keynesian

Why is knowledge of the time
period of the theories about AS
important?

What time period does the

Keynesian AS curve relate to?
What problem does the Keynesian
AS curve address?

A clue to the different AS curves and viewpoints is the time period and
the nature of economic conditions during the time period when the
schools formed.
Pure Keynesians focus on the excess capacity that exists in an economy
during a deep depression. (Problem to explain: a 10 year period where
unemployment rate in USA and industrial countries was around 25%
and output was very low).

What is the shape of the extreme

Keynesian view of SRAS?

What relationship does the curve

describe between price level and
real output? (Why?)

Keynesians say NO PRICE LEVEL INCREASE IS NEEDED TO GET

PRODUCERS TO PRODUCE MORE because resources are abundant.
Many workers want to work. Output is independent of price level
(perfectly elastic AS) until YFE.

Give a micro example of a constant

price.

Example: a newspaper vendor sells at a constant price. What

determines output is the number of customers wanting newspapers.

According to this view, what

causes output to increase if not
price level?
What causes price levels to rise?

Given this AS curve, an increase in AD produces more output with no

change in average price levels until YFE and then only an increase in price
levels will result from an increase in AD. (Because resources are fully
employed.)

Give a micro illustration.

What was Keynes justification for

thinking output was independent of
price level?

Example: a kind stranger handing out dollars next to the newsstand

does not cause newspaper prices to rise but more customers buy
newspapers. Until the last newspaper and then there the price is bid up.
Keynes observed that average prices were very sticky and did not
provide the feedback they do in micro markets because of inefficiencies.

Summary: Extreme Keynes sees price levels as independent of output because excess capacity exists in the economy.
This is a depression-era view. When resources are fully employed, AS will be perfectly inelastic.

15

Date:

Differing perspectives on SRAS #2 Intermediate Keynesian

What time period is attached to the
intermediate Keynesian
perspective?
What is the intermediate or nonextreme Keynesian view of AS?
Why does AS have an intermediate
range?

How will an increase in AD affect

output from the perspective of the
intermediate Keynesians?
Why do price levels rise in this
perspective?
What results when AD approaches
full employment level of output?
(talk about price levels and output
around a and b.

The Intermediate Keynesian view saw rising price levels during the
1950s and 1960s as output increased, and unemployment rates fell to
7%. They observed that as output increased some industries achieved
full capacity before others, and some factors of production were in
short supply, e.g. technical and skilled labour is used up before unskilled
labour. Thus average price levels rose before YFE was reached.

An increase in AD would cause Output to increase but at the same time

price levels would rise to reflect the exhaustion of resources in some
industries and the need for higher price levels to induce more output.
At YFE the economy is at full employment an increasing AD results only
in price level increases.

Summary: A more accurate representation of SRAS has an intermediate upwards sloping part to reflect production
bottlenecks in different industries and the aggregate labour market in particular.

16

Date:

Differing perspectives on SRAS #3 Classical AS curve

What perspectives merge to give
the New Classical view of AS?
What does a vertical or perfectly
inelastic AS curve imply (what
phrase does it say?)

The Classical school (pre-1900s) and extreme Monetarist school (1980s)

combine as New Classical. The Classical perspective sees SRAS being
perfectly inelastic, saying thats all there is meaning the economy
would produce whatever its technology and resources would allow.
Price level reflects the strength of AD but does not determine output.

What limits output in the Classical

and Monetarist views?

What is the relationship between

output and price level in the
classical view?

Give a micro illustration of the new

classical SRAS curve.

What impact does an increase in

money supply have on price level?

What view of AS is shared by both

Monetarist and New Classical point
of view?
What event brought the New
Classical focus back to a classical
vertical AS curve from an upward
sloping AS curve? What brought a
similar conclusion to Monetarists?
What would be the result of
increased AD in the Classical and
Monetarist view?
What should government do in the
Classical perspective?
What is laissez faire in the NC
school?

A micro illustration might be a hat maker selling hats. The output is

fixed at 10 hats. To make more hats the hat maker must sell the
existing output in order to get the money to buy more raw materials.
Price of the hats is variable and very important to the hat makers
income and future plans.
A kind stranger handing out $1 bills would have no impact on the
number of hats produced but customers would have more money to
offer to get a hat. Prices can rise but output would remain constant.
The Monetarist and New Classical (1980s) perspective share a vertical
AS curve. The NC noted the productivity gains from supply side changes
such as introducing computer technology in factories. Monetarists
focused on the role of a stable supply of money (no kind stranger) in the
economy. The two views share LR equilibrium at YFE. The New Classical
view adds a call for lower levels of unproductive government
intervention in markets. Inflation is the result of increasing money
supply, not output. Monetarists and new classical views see productivity
gains as the only way for AS to shift out and increase YFE.
The Classical and Monetarist Long Run AS curve is the PPF curve.
Governments role is to help increase productivity. Laissez faire here
means government manipulation of AD is limited.

Summary: A perfectly inelastic supply curve implies the natural resources and technology of a country are the main
determinants of output. Government cannot increase output only increase price levels by increasing AD.

17

Date:

The Circular Flow Model Injections and Withdrawals

What is the circular flow model?
What assumption does it make that
is different from the AD/AS
model?

Who or what are the economic

actors in the model?
What are the two main flows
described by the model?
What are rent, wages, interest and
profit?

What is a withdrawal (in the

model)?
What is an injection (in the model)?

When is the model in equilibrium?

What are investment spending,

savings in the bank, taxes, imports
and government spending?

What impact will inflation have on

the measurement of output in this
model?

The circular flow model is a representation of how the decision-making

units of an economy interact. The model describes the flows between
these units. The CF model shows actual flows (not planned or
anticipated flows).The assumption that the flows are actual and not
planned flows provides the theoretical basis for the system of National
Accounts, but limits the models ability to model a more dynamic
economy where expectations are an important factor in economic
decision-making.
The model describes two chief economic actors, households and firms.
The model says households own the factors of production which they
offer to firms. In exchange, firms offer payments for these factors in the
form of rents, wages, interest and profits which together are called
Income. Firms use the factors to produce goods and services which they
offer to households in return for payments (consumption expenditures)
Part of the income may be saved. This is known as a withdrawal. Firms
on the other hand may spend on capital goods. This expenditure is
called an injection in the circular flow model.
Equilibrium exists when injections (e.g. investment spending) equals
withdrawals (e.g. savings).
When Government and a foreign sector are added, injections include
export spending by foreigners, and government spending on
domestically produced consumer goods. Withdrawals include
expenditures on imported goods as well as taxes that the government
collects.
The Circular Flow Model

Summary: The Circular Flow model describes the financial and physical flows within an economy. Output is measured
in money terms, e.g. dollars so the units are the same. Price fluctuations are thus a source of measurement error. The
effect of purely price changes (e.g. inflation) on output value must be removed.

18

Date:

The Trade or Business Cycle the ups and downs of economic activity
Define the Business Cycle/

The business cycle is defined as the short-run fluctuations in output

(real GDP) around the long-run trend.

Identify each point on the diagram.

What are the axes on the Business
Cycle graph?
What is a recession?
What is an expansion?
What is the precise definition of a
recession?
Which letters relate to a booming
economy?
Where has the economy peaked?
Where is a trough?
What does the trend line mean?

Identify three connections with the

AD/AS model.
For exam review, draw an AD/AS
model at each of a, b or d, and c.
What policies might the
government use or be working at
each point? (policies and automatic
stabilizers on another page of
notes)
What do boom and bust refer to?

How does the trend line in the

Business Cycle Model relate to the
AD/AS model?

What information does the

Business Cycle model provide that
is not well presented by the AD/AS
model?

Periods of economic contraction (Y1 to a) and (c to e) follow periods of

expansion (a to c). Contractions extending over 6 months are called
recessions with negative growth rates. Expansions are called recovery or
boom with rising real output. Low points (a) are called troughs
(pronounced ter-offs). High points (c) are called peaks.
Colorful language is used to describe rate of change, e.g. losing steam
means a slowing growth rate, slowing down, peaking means
approaching a recession, etc. Boom is rapid growth. Bust is a
recessionary period.
The trend line represents the AD/AS model idea of YFE. A line peak to
peak (c to a future c) would indicate potential output similar to the
curve on a PPF diagram. The Y axis of the Business Cycle Model is the X
axis of the AD/AS model. The Business Cycle model and the AD/AS
model can (and should!) be used together on an exam to describe
conditions in the economy.
The business cycle shows Real Output over an extended period of time,
something the AD/AS model doesnt do well.

Summary: The Business Cycle model shows economic activity over time. It can be used with the AD/AS model to
describe the pattern and level of economic activity in terms of phases (recession, recovery, etc.) over potentially long
periods of time, something the AD/AS model doesnt do well.

19

Date:

The Components of Aggregate Demand 1. Consumption expenditures (C)

What are consumption
expenditures?
How significant is C in the
determination of AD in a developed
economy?
What are four determinants of
Consumption expenditures?
What is a durable good?
What decreases consumer
confidence?

How do interest rates affect

consumption spending?
How do interest rates work? (talk
about durable goods, mortgages
and savings)

How does consumer indebtedness

affect consumption?

What effect do rising property

values or a stock market boom have
on consumption? (Talk about future
income needs.)

Consumption expenditures (C) are purchases made by households on

goods and services (about 60% of AD in developed countries).
Determinants of Consumption include:
Consumer confidence; confident consumers spend more than
uncertain consumer. Spending on durable goods (cars,
refrigerators, furniture) is greatly influenced by confidence.
Unemployment fear is chief cause of uncertainty. Increased
confidence increases AD (rightward shift),
Interest rates. The price of borrowing money over time. Lower
interest rates (easing monetary policy) tend to increase
consumption expenditures. How it works:
o Consumer durable goods usually purchased on credit so
low interest rates encourages borrowing,
o Lower interest rates mean mortgage rates tend to fall as
well, resulting in more money being available to
households to spend on goods and services each
month,
o Savings become less attractive as interest rates fall, so
consumers save less and spend more (opportunity cost
of spending falls)
Level of consumer indebtedness. As the level of debt rises,
consumers spend less ceteris paribus because of rising interest
payment burden for households (cost of debt servicing rises)
Wealth. When the value of big assets (house) (stock market
portfolio) rises, consumption increases and savings fall. Less
need to save now to meet expected future income target.

Summary: Consumption accounts for a large part of AD with an increase in confidence leading to greater consumer
spending. Interest rate decreases lower the cost of borrowing and encourage spending. Mortgage payments are a burden
to consumers and lower rates tend to increase consumption.

20

Date:

The Components of Aggregate Demand 2. Investment expenditures (I)

What is investment (I)?
What is the stock of capital?
What is the buying of capital
called?
What is (small k)?
Does Investment impact AD? AS?
Both? Why is this distinction
important in SR/LR?
Which component of AD is the
most volatile?
Name six factors or determinants of
Investment spending.
Where can a firm get funds for
Investment?
What are the opportunity costs of
those funds?
How do lower interest rates
encourage investment? (Talk about
investment opportunities.)

How does business confidence

affect investment?

What are animal spirits? (What did

Keynes mean?)

What is the relationship between

incentives and investment?
What is a tax holiday?
What is red tape?

How does Income affect

investment?
What are examples of sound
macroeconomic conditions?
HL Concept: What is the
accelerator? (next page)

Investment spending (I) is spending by firms on capital goods and is

thus equal to the change in stock of capital of an economy over time.
When firms spend to buy capital (k) we say they invest. Investment is
important in the short run because of its influence on AD and because in
the long run it influences AS and thus the actual and potential output.
Investment spending is controlled by firms and is the most volatile
component of AD (see accelerator effect).
Determinants of Investment spending include:
Interest rates. Funds for investment come from a firms savings
(retained profits) or borrowed from banks. If a firm borrows it
pays interest on the loan. If a firm uses its savings it loses
interest they would have received from the savings in the bank.
A fall in interest rates tends to increase investment spending.
How it works: the lower interest rate makes more investment
projects profitable. Investment has a negative slope. The
elasticity depends on circumstances (i.e. an empirical not
theoretical question).
Business confidence. The more businesses feel confident about
the future the more willing to invest, ceteris paribus. Economic
and political stability is needed for investment to happen. But
firms often invest from imitation, enthusiasm or expectations
something Keynes called animal spirits. Expectations can be
influence by unpredictable events and lead to swings in the
business climate and the level of investment spending.
Public (government) Policy towards investment. Governments
can offer incentives (tax holidays) to encourage, and limits to
discourage investment (e.g. foreign investment). Also
burdensome bureaucracy (red tape) and corruption can affect
investment especially foreign direct investment.
Income. Rising income leads to more consumption and more
investment opportunities calling for more capital spending.
Sound macroeconomic conditions. Stable prices, low and steady
interest rates, low budget deficits, flexible labour markets tend
to encourage investment, ceteris paribus.
HL! Accelerator effect (next page)

Summary: Investment spending is a volatile component of AD that influenced by interest rates, Income level and
direction, unpredictable events, as well as business confidence (emotion).

21

Date:

The Components of AD 2. Investment expenditures (continued)

Higher Level concept: The Accelerator
What is the accelerator?
What does the accelerator attempt
to explain?

How is the accelerator useful on an

exam?
What other idea is closely linked
with the accelerator?
To which school of thought does
the accelerator belong?
What does accelerator theory
assume with respect to the
relationship between capital and
output?

What form of capital (k) is needed

to produce 12 000 muffins? How
much k is needed to make 36 000
muffins?
According to accelerator theory, if I
double the capital what happens to
the output?
If the rate of investment is constant,
what must be happening to output
according to the accelerator theory?
What will happen to investment if
output increases?
How does the accelerator contribute
to a cycle effect in real output over
time (i.e. the ups and downs of the
Business Cycle)?
What is depreciation? Does
maintenance spending increase
output?

The accelerator is a theory that attempts to explain the level of

investment in an economy. The level of investment is determined by
CHANGES in national income says the theory. (This can be extended to
changes in output, demand or sales.) This theory is useful to explain the
ups and downs of the Business Cycle, i.e. why its a cycle and not merely
random or flat or continuously expanding. The accelerator is used with
another concept, the multiplier. The accelerator and multiplier are
Keynesian ideas. The accelerator is a positive feedback loop.
How it works
Firms are assumed to want to maintain a fixed capital to output ratio.
Using a one product economy, this means one oven produces 12 000
muffins. If you want 24 000 muffins you need two ovens. 18 000
muffins needs 1.5 ovens.
With respect to the economy, if investment is to be a stable component
of AD, then output has to be rising. Why? Because investment is
spending on capital, e.g. ovens for muffins) (Stable or constant
investment spending means buying more and more ovens). If output
slows (lower AD for muffins say) then investment spending will decrease
accelerating the decline of AD. (a negative feedback loop)
Likewise, the opposite: Rising muffin demand causes an increase in
output. More output requires more ovens. Rising output induces more
investment, which accelerates the increase in AD caused by increased
demand for muffins. (a positive feedback loop)
Note: a component of Investment spending is to maintain existing
capital stock (repairs, maintenance spending) and thus output as
machines wear out (depreciate). This spending maintains output but
does not increase it. New capital spending is needed to increase output.
Conclusion: Investment is a highly volatile component of AD because of
the accelerator effect, business confidence, unpredictable events in the
economy, and animal spirits or emotion and enthusiasms within
society and the business community.

Summary: The accelerator receives its name from the feedback effect of investment spending on AD as a result of
changes in output. If the capital to output ratio is constant, increased output requires and produces a constant level of
capital spending. Constant investment results in increasing output (growth).

22

Date:

The Components of Aggregate Demand 3. Government spending

What kinds of expenditures does
government make?

What is public capital?

What are transfer payments?

Why is a transfer payment not
included as national income?

Do transfer payments impact AD?

Why?

List four reasons why governments

spend money.

What is the purpose of fiscal

policy?
How is government spending
financed? (The question means
where does the money come from?)
What social group pays for
government borrowing?
What is crowding out? What
causes it?
Why is the business demand for
funds (loans) more sensitive to
interest rates than the government?
(talk about profit as an incentive)

Government spending (G) can be large part of total spending on goods

and services. Government makes two basic kinds of expenditures:
current expenditures, on goods and services used by the
government, and
capital expenditures, for public capital investments such as
roads, ports, telecommunications, schools and other
infrastructure,
a third kind is transfer payments which typically refer to
pensions, welfare payments and unemployment benefits. Note
that transfer payments are NOT included as part of the
national income because they do not represent rewards for
current productive effort but are merely a redistribution of
income. However, the transfer payments are income to many
consumers and so they impact C and thus affect AD.
Governments spend to
ensure adequate amounts of public and merit goods are
consumed, such as educational services, national defense, and
health care,
regulate markets (provide safety and environmental standards,
regulate competition, etc.)
redistribute income so that a socially acceptable minimum is
guaranteed, and
regulate Aggregate Demand (using fiscal policy)
Government spending is financed from taxation, either current taxation
or future taxation. Government borrowing is possible because of
governments ability to tax its citizens; the question is current citizens or
unborn citizens. Governments can compete with business for loan-able
funds and drive up interest rates. The effects of this competition is
called crowding out because business borrowing is relatively more
sensitive to interest rates compared to government because of the need
to deliver profits. Government borrowing tends not to be sensitive to
interest rates because there is no profit incentive.

Summary: While not as large a component of AD as Consumption, government expenditure (fiscal policy) has an
impact on AD. Government spending is funded by taxation. G tends not to be interest rate sensitive because
Government does not need to demonstrate profits. Government borrowing can crowd out (I).

23

Date:

The Components of Aggregate Demand 4. Net Exports (X-M)

What are net exports?

What is removed from the

calculation of net exports?

What is the effect of positive net

exports on AD?
What cautions need to be
mentioned about the impact of
imported goods on AD?

What two factors impact the level

of net exports?

What is the significance of the size

of net exports to the domestic
economy?

What other kinds of flows balance

current flows?

Foreign demand for domestic goods and services increase AD. However,
in the AD/AS model, the increase from a greater volume of Exports is
reduced by domestic demand for Import goods. The difference is called
Net Exports. (What is removed in this calculation is Import spending.)
Positive net exports tend to increase AD, however, generalizations like
exports are good, imports are bad must be avoided. Domestic
industries that support import goods such as firms who install or repair
foreign goods increase AD! Imported technology that is superior to
domestic can boost output. Finally, many imported goods contain
domestic made components.
Protectionism and exchange rate changes impact the level of net
exports.
Some countries such as the USA have relatively small exposure to
foreign demand (AD is overwhelmingly domestic in nature), while other
countries have relatively large exposure to foreign demand (the
international economy is very important to AD). Countries such as
Canada and China have a large Export orientation and this makes
international trade and the international environment relatively more
important for their AD than countries with large domestic demand. In
countries with a relatively large export orientation, domestic policies
may be sacrificed to encourage trade.
Import and export flows are examples of current flows. The other group
of international flows that balance the net flow of goods and services
abroad (current flows) are savings flows (capital flows). Capital flows are
generated when countries buy and sell property abroad, buy or sell
ownership in foreign companies, buy or sell debt, buy and sell foreign
currencies, or directly invest abroad.
The flows will be discussed in the international economics section in
greater detail.

Summary: Net exports reflect the current part of the international economy. X>M causes AD to increase. There is a
capital part that finances net exports which impacts relative interest rates. M>X has less direct impact on AD, however,
the need to finance M causes interest rates to rise and exchange rates to fall.

24

Date:

Adverse Supply Shocks and Shifts of AS

What is a supply shock?
List six events that could cause a
supply shock.

What kind of curve illustrates

supply shocks that raise production
costs?
What kind of curve illustrates
institutional failure or natural
disaster?
What does a right shift of AS
signify?
What other diagram can illustrate
the increased productive potential
of a right shift of AS?

How can government influence

AS?

What can result if an AS increase is

not met with an increase in
spending on domestic output?

Supply shocks are events that negatively affect the productive capacity
of an economy, such as
a sharp and sustained increase in oil prices,
a general wage cost increase as a result of powerful trade union
activity,
institutional setbacks such as banking failure,
a broad or sweeping increase in indirect taxation,
tightened supplies of and higher prices for commodities, or
natural catastrophes such as a tsunami or earthquake.
Supply shocks that affect production costs are best illustrated by a
leftward shift of an upward sloping short run AS curve, while supply
shocks created by a natural catastrophe or institutional failure can be
best illustrated by a leftward shift of a vertical long run LRAS curve.
Rightward shifts of AS implies an increase in productive capacity. This is
equivalent to an outward shift of the production possibilities frontier. So
any factor causing the PPF curve to shift out will cause a rightward shift
of AS.
Some events that can increase AS include:
Human and physical capital increases. Investment that increases
education and health services increases output per worker and
thus AS.
Technical advances (assembly line process or the internet),
Improved legal framework, better banking practices, credible
policy making and good governance can all work to increase AS.
The discovery of more land and resources can increase AS.
Government can influence the supply side of the economy. There is
little argument over health care, education and the lower production
costs from improved roads. However, beyond this agreement there is
disagreement over a wide range of supply side policies ideas that will be
discussed later.
Increases in AS that are not matched by increases in AD can lead to
falling price levels (deflation). This will be discussed later

Summary: Sudden increases in production cost shift an upward sloping SRAS curve left. Sudden catastrophes that
reduce output shift a vertical LRAS curve left. Government policies that lower general production costs such as
education and better roads shift SRAS out.

25

Date:

The AD/AS Framework (Model) an equilibrium model

What information does the AD/AS
model reveal? (Talk about goals
and how they are measured.)

What is the significance of the

governments ability to spend
money and influence AD?

The AD/AS model is simple and it yields information on the main

macroeconomic policy goals, which are:
Maintaining stable price levels ( avoid inflation or deflation),
Promoting economic growth (increase real output), and
Low unemployment (inferred from higher output).
The model suggests that if government spending can affect AD then
spending could achieve the macroeconomic goals mentioned above. If
supply side policies are successful, the LRAS curve could shift outward.

What group of policies affect

LRAS?

Where is the macroeconomic

equilibrium found on the model?
Compare the Keynesian and New
Classical view of the economy at
equilibrium. (Talk about YFE.)

What two big factors prevent

efficient markets in the Keynesian
view?

Is the Keynesian perspective LR or

SR?
In the New Classical view what
factors prompt the economy to
return to full employment output?

Predict the different views on the

role of (G).

The model tells us the economy finds equilibrium where AD = AS.

The Keynesian school thinks this equilibrium can rest at less than full
employment output. Keynesians see markets as inefficient. An example
is the aggregate labour market. Wages do not vary downward with
decreased ADL or increased ASL. Consequently, wages do not send a
correct signal to producers. Wages can remain high during a recession
due to trade unions and government minimum wage legislation, and so
higher wage costs cause equilibrium to occur at less than YFE. Keynes
would have dismissed the LR as irrelevant for policy and practical
purposes. He famously said, In the long run we are all dead.
The New Classical school disagrees with the Keynesian perception of
markets being efficient. EVENTUALLY, wages fall during recessions
because workers want to maintain income levels. EVENTUALLY,
unemployed workers will accept lower paying work. EVENTUALLY, the
lower priced labour can be employed in new or different industries and
return output to YFE. Eventually, at least in the Long run.

Summary: The AD/AS model explains how an economy seeks an equilibrium level of output where AD = AS.
Keynesians see the equilibrium as resting at less than YFE with unemployed resources. New Classical see equilibrium
always returning to YFE with fully employed resources. Implications for the role of G are great!

26

Date:

AD/AS Mechanics effects of shifting AD given an extreme Keynesian AS

What is the extreme Keynesian
view of AS?
Why is the inelastic part of the AS
curve not labeled LRAS?

In the extreme Keynesian view AS is horizontal (perfectly inelastic, price

level independent of output) until it becomes vertical at full
employment output. Note this vertical section is not labeled LRAS
because the Keynesian perspective is a Short run view.

What is the point a?

In Keynesian terms, what can move
AD0 to a higher output level (talk
about the determinants of AD,
notably G)?
What is (ab) called?
What is (bc) called?

If AD is at AD0 the equilibrium output level is Y1 which is less than YFE.

There are more unemployed resources than at YFE. In the Keynesian
view, equilibrium output is demand driven meaning that AD
determines the level of real output, so until AD rises, the economy stays
at Y1.

What is the effect of increasing AD

on price levels from a to b, and b to
c?

A deflationary or recessionary gap exists (ab). A deflationary gap is

when equilibrium output is less than full employment output.

Why do price levels not rise a to b,

yet rise b to c?
What happens to unemployment
levels a to b, and b to c?
What happens to real output a to b,
and b to c?
These questions all show increasing
AD. Describe what happens when
the economy moves from boom to
bust?

If AD were to increase to AD1 (as a result of an increase in (G), say) then

the equilibrium output would be the full employment level YFE.
Since AS is perfectly inelastic, price level is independent of output due
to extra capacity in the economy, then expansionary fiscal policy that
increases government spending (G) can move an economy out of a
recession without average price levels rising (inflation).
However, if AD were to increase to AD2, then inflation could result
without an increase in real output or employment. The distance bc is
called an inflationary gap.

Summary: The extreme Keynesian view illustrates how an increase in AD can move an economy towards full
employment level of output without inflation (requires perfectly elastic supply, unused capacity in the economy). A
deflationary gap can be removed. Too much AD can result in an inflationary gap.

27

Date:

AD/AS Mechanics effects of shifting AD given extreme Monetarist AS

What is the nature of AS in the
extreme monetarist view? (talk
about LRAS)
What is one way the extreme
Monetarist view differs from the
New Classical view?

Why or how does equilibrium

occur at YFE?

What impact (implications) does an

inelastic LRAS curve have on price
levels and real output?
What determines real output in the
Monetarist/New Classical
perspective?
What impact does increasing AD
through fiscal spending have on
output and price levels in the
Monetarist view? (talk about
effectiveness of fiscal spending
policies)
For exam review, compare extreme
Keynes with extreme
Monetarist/NC views. Assess the
relative effectiveness of Demandside versus Supply side policies
using these different perspectives to
add depth to your analysis.

The monetarist view is part of the New Classical school of thought.

Monetarism comes from the experience of high inflations during the
1970s and focuses principally on the role of money and monetary policy
(central bank). The NC perspective includes Monetarism but has a
broader supply-side policy perspective not limited to the money supply.

Monetarist AS, like NC AS is perfectly inelastic at full employment level

of output because the economy is always in equilibrium at full
employment (markets are efficient, wages reflect changes in labour
market equilibrium in LR)
Unlike Keynes, AD does not determine real variables like output or
employment levels but instead determines price level. Real output is
determined by the quality and quantity of available resources and
technology.
AD determines price level. An increase in AD from AD1 to AD2 results in
inflation P1 to P2 and no increase in real output.
The monetarist perspective sees demand-side policies (e.g.
expansionary fiscal policy) as ineffective, creating only inflation. (See the
notes on Inflation to explain this view.)
The New Classical school focus is on the need to improve productivity
using supply-side policies. (See the notes Comparing Demand and
Supply-side Policies to elaborate this view.)Monetarists and Supplysiders share a similar view of LRAS.

Summary: Monetarist view offers a caution about the use of Demand-side (fiscal) policy to increase real output, saying
that if the output of an economy is assumed to be determined by its resources and technology which are relatively
constant, then increasing AD can result only in higher price levels.

28

Date:

AD/AS Mechanics shifting AD given a New Classical AS (intermediate view)

Is output always characterized by
excess capacity/depression level
output (perfectly elastic AS curve)
in the intermediate view?
(HL)What law dominates the AS
curve approaching the full
employment level of output?

The intermediate case considers economies that have a level of real

output greater than depression levels. These economies may be
experiencing situations where bottlenecks occure. Bottlenecks are
inefficiencies caused by shortages. HL can see the onset of diminishing
returns. Bottlenecks start at a lower level of output typically within
older more inefficient industries. The implications are that AS can have
an upward slope.

What is a bottleneck?
Do bottlenecks occur uniformly in
all industries?

The original equilibrium is where AD1=AS with Y1 being the equilibrium

level of real output and P1 the average price level.
What is the result of an
expansionary fiscal policy?

An increase in AD from AD1 to AD2 can increase real output from Y1 to

Y2 but with a trade-off in terms of an increased price level. Inflation is
the price paid for the increased output.

What determines the rate of

inflation?

The extent to which an increase in AD is expressed as growth or

inflation depends on how close to capacity the economy is operating, in
other words, on the relative elasticities of AS.

What is the opportunity cost of

increased output in the intermediate
level of output?

Compare NC and Monetarism on

the effect of expansionary fiscal
policy.

This perspective reveals that demand-side policies can be used to raise

output and employment but at the cost of higher rates of inflation, or to
lower inflation but at the cost of slower growth, or recession.
The New Classical view holds that there is a trade-off between output
and price levels. Monetarism holds that expansionary fiscal policy may
have SR benefits but cannot help in the LR and probably dont help in SR
because they interfere with quality of the money supply.

Summary: AS is upward sloping due to constraints or production bottlenecks. Increasing AD increases price levels
because firms need higher prices to overcome constraints that occur at higher output levels or are outside the firms
29
control (special orders, busy roads, additional workers on Holidays, air line strike).

Date:

AD/AS Mechanics An increase of AS

Exam review question: Does
increasing AS (making production
more efficient and raising
productivity) cure all economic
ills? (talk about growth,
employment, inflation, income
distribution, trade imbalances, i.e.
the macroeconomic policy
objectives.)
What increases AS?
What does AS and LRAS shifting
to the right imply?

You might think of policies that increase Aggregate Supply as a kind of

economic penicillin (an antibiotic). That is, policies that increase AS
appear to cure all economic illnesses especially inflation and
unemployment. But, like penicillin, there are problems they dont
address such as income inequality and trade imbalances.
Aggregate supply can increase from lower factor prices, decreased
average wages, and the introduction of technology that increases
productivity. (A productivity increase can be defined as the ability to
produce the same or greater level of output using fewer resources.) This
is shown as a right shift of AS.
It is assumed that the short run effects are also experienced in the long
run, so LRAS increases with AS.

How can growth without inflation

be accomplished?

Do Monetarists and Keynesians

disagree with the importance of
productivity?

If AD is rising through the time AD1 to AD2 while AS and LRAS are rising
concomitantly, then an increase in output without a rise in price levels is
possible. This is good news. Increased employment can be inferred from
an increase in YFE. This represents non-inflationary growth.
The key to non-inflationary growth is to increase productivity. How to
increase productivity is a key question or element of NC thinking. Note
that neither Keynes nor Monetarists dispute this idea no no but its
not the focus of their attention.
The useful metaphor here is three blind people discussing an elephant
by looking at different parts at different times. The economy is complex.

Summary: Policies that shift AS to the right can bring the benefit of lower price levels, greater real output, and lower
unemployment. When combined with increasing AD the model predicts stable price levels and greater real output. A
higher quality of life could be possible.

30

Date:

Economic Policies Demand-side policies

What is the goal of demand-side
policy?
Why is it not precise to say a
demand-side policy goal is to
decrease AD?

What are the two main types

demand side policies?
What do fiscal policies affect? (2
things)
What does monetary policy affect?
(1 thing)

Deficit spending is an example

of.(policy)?
Policies that raise G and lower T
are called?
Policies that lower G and raise T
are called?
Demand-side policies that decrease
interest rates are called?
Demand side policies that increase
interest rates are called?
w does monetary policy increase
Consumption spending? (talk about
how it works)
How does monetary policy increase
Investment spending?
How does a loose monetary policy
affect the exchange rate?

How does a tight monetary policy

affect the exchange rate?
What effect do higher interest rates
have?

Demand-side policies attempt to influence AD usually to increase it or

to slow down an increase. Governments tend not to want to decrease
AD because of the unemployment that might result. Consequently
decreasing AD is seldom a stated policy goal, except perhaps in the case
of a country experiencing hyperinflation. In that case, demand-side
policy might seek to reduce AD although the cause of the high inflation
is likely not directly related to excess AD but rather to more systemic
problems.
There are two main categories of demand-side policies:
Fiscal policy refer to changes in the level of government
expenditures and/or taxation policies,
Monetary policy refers to change in interest rates
There are two main directions these policies can go:
Expansionary fiscal policies raise (G) and lower (T). This is
deficit spending. The goal is to increase AD and thus income and
employment.
Contractionary or deflationary fiscal policies lower G and
increase (T) to decrease AD and reduce inflationary pressure.
Expansionary or loose monetary policies decrease interest
rates (r) in order to increase AD and encourage employment
and output.
o Consumption (C) rises because borrowing money for big
purchases is cheaper, monthly payments are smaller,
and saving less attractive,
o Investment (I) expenditures can increase as financing
costs for capital goods and plant are lower, the
opportunity cost of using retained profits is lower, and
o the exchange rate tends to fall making exports more
competitive abroad and imports more expensive at
home.
Contractionary or tight monetary policies increase interest
rates to slow AD. Essentially the reverse of above.
o Higher interest rates encourage saving and discourage
borrowing, and
o tend to make the exchange rate increase, making
exported goods less attractive (decrease the foreign
component of AD).

Summary: Demand-side policies attempt to influence AD. Fiscal policies affect government spending levels

and tax rates. Deficit financing is when G is financed by borrowing (G<T). Monetary policy influences AD
through (r) and the cost of borrowing. Ceteris paribus output increases as borrowing costs cheapen.
31

Date:

Fiscal Policy from a Keynesian Perspective the key idea

What effect does the level of prices
have on output (to Keynes)?
What drives (causes) output in the
Keynesian view?
How does the equilibrium level of
output get stuck at a low level?
(Talk about worker income,
consumption, investment and the
accelerator effect) This is a good
exam question.

Was government spending an

important part of national income
(Y) in 1936?
Exam review question: What effect
can increased protectionism have
on the macro economy? (talk about
falling export demand using the
example of the great depression.)
Exam review question: What does
the classical view predict would be
the solution to the Great
Depression?
If (C) and (I) were to shrink
tomorrow and stay low, what might
Keynes suggest government do?

Exam review question: To what

extent would borrowing money to
increase G be an appropriate policy
during a depression?

Watch Annenberg Media Economics U$A video #17 and 18

http://www.learner.org/resources/series79.html?pop=yes&pid=2469
Keynes assumed price levels had no effect on output and proposed a
different mechanism to account for output Aggregate Demand.
Keynes introduced the idea that the equilibrium level of output was
driven by AD and that output could remain at less than full employment
for long periods. (Classical theory predicts a recovery.) Falling national
income had the effect of reducing workers income as firms closed or
laid-off workers, hence reducing (C). Falling income also reduced
industry motivation to spend on new capital and reduced industrys
ability to employ workers (see the Accelerator effect). In Keynes time G
was a relatively small part of National Income (see Multiplier effect). In
Keynes time income from exports were reduced by protectionist tariff
levels among all countries (see Protectionism). Thus (I) and (C) fell 1929
to 1941 and stayed down, the classical models prediction of wages
falling and workers being hired in other industries seemed not to occur.
Keynes observed there was nothing inherent in the economy to stop the
fall of Y let alone reverse the trend.
Keynes shocking idea was that Government (G) expenditures could
replace low levels of (C) and (I) by borrowing money and spending it. (In
1936 this advice was as shocking as a parent advising you to take a gap
year and borrow lots of money to tour Europe, mid-way through your
university exams, with your bf/gf. Hell would freeze before this.)

But what if the reason for borrowing money was to pay for medical
school, or something that could give you the ability to repay the loan in
the future, or win a war? Well, thats another story! This line of thinking
is Keynesianism. In the 1960s, the or became an and and inflation
resulted.

Summary: Increasing (G) by borrowing (deficit financing) in order to increase (Y) is necessary to move AD to higher
levels of Income. (C) and (I) can fall and stay low because there is nothing inherent that will increase them, says
Keynes, because the wage mechanism doesnt work according to Classical principles.

32

Date:

Fiscal Policy from a Keynesian Perspective the multiplier effect (HL)

What does re-spending mean?
What slows re-spending?
What is a word for marginal
propensity?
What does a round of spending
mean?
What is the marginal propensity to
save (or leak)?
What is the marginal propensity to
spend?
How do Firms receive spending by
households?
Define the extra spending by
households on domestic goods
induced by extra income earned.
What effect might a sudden fear
about the value of future income
have on the impact of current
government spending? (talk about
savings and the multiplier effect)

What does the multiplier say will

be the effect on income from a
round of spending by G?

Fiscal policy is powerful because the initial injection of spending of (G)

gets re-spent within the economy, again and again, limited only by the
marginal propensity or tendency of the population to save additional
units of income. What is received by a Household as wages, or other
income is spent again within the circular flow, with the spending
becoming revenues for firms and then income for other households, on
and on. The first round of spending becomes a second round with a
total effect greater than the amount of the first spending. The net
stimulation is limited only by the desire of Households to hold a part of
their income as savings for future consumption. This is the spending
multiplier.
The formula for the spending multiplier is 1/marginal propensity of
Households to save. If a population saves 20% of what it earns, the
multiplier is 1/0.2 or 5 times the initial spending (G). If the mps is 50%,
the multiplier is 2 times (G). Since income is either spent or saved (only
choices possible) the inverse is true too: the multiplier is 1/(1-mpc)
where mpc is the marginal propensity of Households to consume
additional units of income.

The multiplier effect states that any injection will lead to a greater
change in income: Y=(multiplier)G. Because one persons spending is
another persons income, and economic activity occurs in successive
rounds of spending.

Summary: Assume government spends $10 000. Assume the population saves a constant 20% of additional income.
The spending effect predicted by the multiplier is (G or $10,000) multiplied by (1/0.2) five, i.e. as if the government
spent $50,000 due to the multiplier effect. To Keynes, G is a strong economic force.

33

Date:

Fiscal Policy - an example of the Multiplier Effect

Describe in words the multiplier
effect using an example.

In what two forms will income be

found?

Assume government spends $10,000 on a program to hire workers to

break windows and other workers to repair them. National income
increases by $10,000, the income paid to the workers. The spending
doesnt stop however. This is because the only two things the workers
can do with the income are to spend or save income. There is no third
option. So while a portion of income may be saved for a rainy day the
remainder of the income is spent (perhaps not immediately but
eventually).

How is the total impact of a

spending increase calculated?

If the portion that is saved from each round is 20%, then 80% goes
around a second time, with the amount going around decreasing by
20% each round of spending. So the total impact of the $10,000
spending was actually ($10,000 x multiplier) where the multiplier is
1/mps or 1/0.2. The total impact of the spending is $50,000 given a mps
of 20%.

What is mpc? What is its

reciprocal?

The marginal propensity to consume is the extra spending on domestic

goods induced by extra income earned.

If mpc is 0.3 what is mps?

The multiplier is also equal to 1/(1-mpc)

What is the marginal propensity to
tax?
What is the marginal propensity to
import?
What is the export multiplier?
How long does it take for the
multiplier to have an impact on
AD?

The amount of income saved does not disappear. It must either be

spent on foreign goods, paid in taxes or saved. Those are the only
possibilities. This gives ANOTHER way of expressing the multiplier:
1/(mp import + mp tax +mp save).
The export multiplier shows how national income changes as a result of
changing export revenues.
The multiplier effect is not instantaneous because there is a time lag
between receiving income and spending it.

Summary: Expansionary fiscal policy receives its power from successive rounds of spending. These can be predicted
mathematically from any of the determinants of AD (C, I, G, X and M) using the knowledge that income is either saved
or spent so the fraction that is saved is the reciprocal the fraction spent, + vis versa.

34

Date:

Fiscal Policy an evaluation using advantages and disadvantages

What is the main advantage of
fiscal policy? (talk about its
intention with respect to
employment)
How are time lags a weakness of
fiscal policy?

What is expansionary bias?

What public spending programs

have demand curves that are price
or income inelastic?
Why might governments be
reluctant to contract the level of
government spending?
How might expansionary fiscal
policy impact the trade balance?
How can the way of financing of
public debt impact the economy?

Fiscal policy can be useful and has been used in the past in all countries
but it has limitations.
Weaknesses of fiscal policy include:
Time lags can be great between the time the economy enters a
recession and the expansionary fiscal policy takes effect on
levels of unemployment or real output. Its possible that the
economy may have moved onto a new phase and so the fiscal
policy may further destabilize the economy.
Expansionary bias. The cyclical nature of economic activity
would suggest expansionary fiscal policy be followed by
contractionary fiscal policies to maintain an equilibrium. But this
is seldom the case because raising taxes or cutting government
expenditures would be politically unpopular.
Got used to having them effect. Some public expenditures are
inelastic in demand. Such as health care and defense.
Contractionary policies may be socially unacceptable and hard
to reduce.
Widening trade deficits can result from expansionary fiscal
policy as import spending rises. Rising price levels can make
domestic exports less competitive and imports more attractive.
HL Government need for borrowed funds to pay for G can
crowd out domestic investment by making interest rates rise.
If the increase of (G) results in a decrease of (I) then crowding
out is complete.

Summary: Fiscal policy can replace falling Consumption, Investment and Net Export and increase AD. However, there
are several issues related to its implementation (time lags, bias, ratchet effect) and effect (widening deficits, crowding
out.)

35

Date:

Fiscal Policy (HL) The crowding out effect a criticism of fiscal policy
What benefits can come from
expansionary fiscal policy?
What burden does an expansionary
fiscal policy place on government?

What is a possible effect of an

increase in demand for loanable
funds?
What might the effect of
government borrowing be on
business investment, assuming
businesses want to expand
capacity?

Expansionary fiscal policy can increase AD and provide public capital

that benefits business. But at the same time the decision requires the
government to fund the additional spending. Raising taxes would
reduce AD. The only other option for a government needing to raise
large sums of money without increasing taxes is to borrow it.
The increase in demand for loanable funds (borrowing) results in an
increase in the price of money (interest rate). Businesses, who are
seeking investment funds are faced with rising interest rates. Businesses
find the number of profitable investment opportunities decrease as
interest rates rise, ceteris paribus. Investment is thus crowded out by
the governments need for funds.

Why might government borrowing

be less interest rate sensitive than
business investment?
What might explain a fall in (I)
when government chooses to
deficit finance an expansionary
fiscal policy?
Exam review question: The success
of expansionary fiscal policy
depends on the phase of the
business cycle. Explain.

Business leaders often suggest

government run a balanced budget
(no deficit). Why do they suggest
this?

If the decrease in AD from (I) being crowded out is greater than the
increase in AD from government spending, the expansionary fiscal
policy fails to meet its expansionary purpose!!!!!!

Summary: Government demand for funds to finance an expansionary fiscal policy can raise interest rates and reduce
business Investment. Firms are very sensitive to interest rates because their use of borrowed funds must be profitable.
Government demand for funds, on the other hand is less discriminating.

36

Date:

Monetary Policy evaluating the use of monetary policy

What institution controls monetary
policy?

How is the interest rate set?

What makes monetary policy a
potentially powerful policy tool?

What is an alternative to a Central

Banking system?
How might a gold standard
replace monetary policy?

What is monetary discipline?

Which policy is more flexible and

quick to implement: fiscal or
monetary policy?

Identify four weaknesses or

limitations to monetary policy.
Why might HH and Firms not
respond to a decrease in interest
rates?
What happens when the price of
money fall close to zero?
Exam review question: Explain
how interest rates can influence
exchange rates.
What impact will decreasing
interest rates have on a fixed
exchange rate mechanism?

Advantages of monetary policy

Monetary policy is the realm of the Central Bank, i.e. The Bank
of China, the Bank of Canada, etc. Most economies function
with a central bank regulating the value of the domestic
currency by controlling its supply and price (interest rate). This
gives the Central Bank influence over the price of money, a key
variable that affects the whole economy.
An alternative to a Central Bank monetary policy might be to
equate the value of a domestic currency to the price of gold or
silver (a gold standard). The government would give up the
ability to control the value of the domestic currency; however,
its value would be set instead by reference to a better
understood benchmark, the price of gold or silver. The amount
of gold and silver in the economy would determine the value of
a currency. (Not a bad idea if the government consists of rascals
and thieves or is otherwise unable to maintain monetary
discipline.)
Monetary policy is flexible relative to fiscal policy. The Central
Bank can adjust the price of money quickly and reverse a
previous decision.
Limitations to Monetary policy:
Consumption and Investment is only partially dependent on
interest rates. Other factors, such as business confidence, and
household indebtedness may outweigh interest rate changes.
When the price of money nears zero, monetary policy ceases to
be a tool to encourage investment because the rate cannot be
negative.
Fixed exchange rate mechanisms make monetary policy
ineffective in that interest rates are used to control the
exchange rate.
Money markets are global so firms and households to a great
extent can borrow money from anywhere in the world. This
weakens monetary policy.

Summary: Monetary policy can respond rapidly to business conditions, unlike fiscal policy which is slower to respond.
Monetary policy is reversible. However, interest rates alone do not determine (C) or (I) and interest rates may not be
always effective. Near zero interest rates and fixed ERMs can be a challenge.

37

Date:

Supply-side Policies
How might better education and
health services increase AS?
How does improved infrastructure
help increase AS?
How might increasing the skill and
confidence of institutions (such as
creating closed-bid contract
competitions, and rational protocols
for rating research priorities) affect
AS?
List three controversial supply side
policies and explain why they
might be controversial.

What kind of benefit might

increased competition bring to an
economy? Give examples.

How might decreasing tax rates

help increase AS?

List four negative aspects of

supply-side policies.
What is privatization?

Non-controversial supply-side policies all agree to these

Improving education improves labour productivity,
Better health services improves labour productivity,
Better infrastructure (roads, ports, telecommunications) lowers
production costs for all firms,
Better institutions (legal, education, ethical, moral) within
society increase productivity
Controversial supply-side policies pro-market orientation
Abolishing minimum wage legislation,
Decreasing the power of labour unions and reducing non-wage
labour costs such as national insurance contributions to make
labour cheaper,
Making hiring and firing easier so that managers do not hesitate
to hire more workers when demand rises, reducing
unemployment insurance benefits,
Policies to increase the level of competition in the market so
that the economy reaps the productivity benefit:
o deregulation reduces the burden of rules for firms,
o privatization converts government industries into
private, and
o trade liberalization to decrease the cost of international
tade
Decreasing tax rates to improve the incentive to work, to save
and to invest (See Laffer Curve)
Overall benefits are from increased competition and the
expected improved efficiency, fewer distortions to the price
mechanism, fewer disincentives and increased flexibility in
labour markets
Negative aspects of market oriented supply side policies
Long time to accomplish supply side changes,
Tax cuts can induce leisure, or act as a gift to higher income
earners,
Privatization can lead to increased unemployment in an
nationalized industry,
Deregulation may not lower prices and increase efficiency and
may cause monopolies to form, and
Some lower income workers may have more income irregularity
and some members of society may be marginalized (moved out
of economic life.

Summary: Supply-side policies act to improve productivity such as lowering costs or increasing flexibility. In labour
markets this means getting rid of minimum wage legislation, reducing the power of trade unions, and making the
process of hiring and firing easier. Trade liberalization reduces costs of international trade.

38

Date:

Supply-side Policies Industrial policy

What is industrial policy?
What is the central assumption of
industrial policy?

What role does government play in

industrial policy?

List three tools of industrial policy.

What is a sunrise industry?

What is a sunset industry?
What kind of industrial policy may
benefit a sunrise industry?
What kind of policies might benefit
a sunset industry?

What might hinder a government

from picking winning industries?

Review question
Can an inspired dictatorship work
in a modern economy?

Supply-side industrial policies are promoted by people who believe

government intervention is required to promote increased industrial
capacity. Market forces are held to be inadequate and that financial
capital and investments must be guided into their most productive uses
by government policy. The role of government is to choose the
industries that are most likely to succeed, and support them.
Methods of industry policy
Subsidized low interest loans,
Lower rates of taxation or tax allowances, and
Tariff protection from foreign competition for sunrise
industries that are new and growing, and for sunset industries
that are old and declining (to buy time and give new firms
time to gain economies of scale, and old industry firms and
workers time to make changes or leave an industry),
So-called incubators where new start-ups are gathered
together in a subsidized location for a fixed period or term
Industrial policy caution
Its all well and good to say government chooses industries and firms
that are winners but this is incredibly difficult! Example, in 1980s the
booming growth industry was something called web page design and
it was reasonable to expect that thousands of firms were going to need
to hire talented web design companies to create corporate web pages.
Google changed all that and made web page design and marketing as
easy as saying Google Ad Words.
The cautionary point being that government bureaucrats and academics
and even Bill Gates or General Motors may not know what the future
will bring.
At university (not now) you will study ideas related to emergence, i.e.
in a complex environment central decisions cannot handle the
information needs and sort things out effectively, so bottom-up or
emergent processes are needed. The market is one such emergent
process.

Summary: Industrial policy attempts to establish rules and support procedures on an industry-level to encourage the
growth in the capacity and to lower production costs. Subsidies, lower taxes and reduction of tariffs are examples of
policy tools. It is difficult for bureaucrats to pick industry winners.

39

Date:

Inflation measuring average prices using an index

What is inflation?
How is inflation measured?

Inflation is defined as a sustained increase of the average level of prices.

The rate of inflation is the percentage change in price level (expressed
as an index value) between two periods.

What is a price index?

Why are big numbers better
presented as an index?

A price index is a number that simplifies comparisons of changes in large

numbers across time. The method is simplicity itself. 100 is chosen to
represent the starting number, for example, $123,045 billion GDP in
2009. The comparison number is divided by 123,045 and multiplied by
100, for example 145,000 billion GDP in 2010. The index value is
(145,000/123045 x 100) 118.

What is the starting big number

made equal to?
How is the second big number
treated?
How are the remaining big numbers
in the series treated?

Year
2009
2010

GDP $billions
123, 045
145,000

Index value
100
118

Change between years

18%

You have to admit it is easier to see the change when the starting or
base number is equated to 100!
Why do we need to be careful in
measuring changes between years 2
and 3 (and so on to n)?

Convert these numbers to index

values and measure year to year
change:
Year
GDP
2005:
$189,000 million
2006:
$210,000 million
2007:
$190,000 million
2008:
$175,000 million
Why are index values good
enough for measuring change?

But care is required in calculating change between years because the

starting index value changes:
Year
GDP $billions
Index value
Change between years
2009
123, 045
100
2010
145,000
118
18%
2011
138,000
112
- 5.1% !! not +12%
2012
155,000
126
12.5%
The method for creating an index is:
1. Equate the big starting number to 100.
2. Divide the second big number by the starting number and
multiply by 100.
3. Divide all remaining numbers in the series by the starting
number and multiply by 100.
Caution: when comparing changes between years use the index values
and the general formula for change (t2 t1)/t1 x 100.
Index values are useful because what economists are interested in is the
change in the values, not the values themselves. (Remember, the
calculation of GDP is approximate and much is left out!) For policy
purposes, the change in the number is what matters most.

Summary: An index is a powerful analytical tool that makes it easier to grasp changes in the pattern of large numbers.
A base number is divided by itself and multiplied by 100. All other numbers in the given series of numbers are divided
by the same base number. in values between years is calculated using the index.

40

Date:

(HL) Inflation weighted basket of goods index

How is the average level of prices
measured?
What is a basket of goods?
What information goes into the
weighted index?
What is the value of a basket of
goods? (talk about expenditures)
If the basket of goods is identical
between two years yet the amount
of money spent to buy the goods
increases, what conclusion can you
draw about price levels?
What are two examples of price
indexes?
How are the items included in a
basket of goods found?
On a piece of paper make a CPI for
your own typical purchases.
Is an increase in the CPI between
two years necessarily inflation?

The average level of prices is measured through a price index which is a

weighted average of the prices that a typical consumer finds in the
market, expressed as an index number. How it works is that statisticians
determine through surveys of households a basket of typical goods the
household buys. The number and price of each item in the basket are
recorded and assigned a weight according to the importance of the
price. The total spending on the basket of goods is then expressed as an
index number. There are many such indexes available. The Consumer
Price Index (CPI) and Retail Price Index are examples of basket of goods
measures.
Here is a typical basket of goods for my household. (You can make up
your own CPI the next time you go shopping .)
Item
Importance
Number of
Price
Weighted
items in Basket
Expenditure
Car
10%
1
10,000
$1000
Stove
10%
1
2,500
$250
Jeans
50%
10
120
$600
Coffee
30%
50
5
$75
Total
100%
62
$1925
Basket
The weighted total expenditure on this basket of goods is $1925 and
this is accorded a value of 100 in my index, reflecting the base year.

Why is it important that the items

in a basket of goods do not change
between measurements?

What is a problem with basket of

goods measures in general?

What are quality bias, substitution

bias, and new product bias?

To get an accurate measure of price changes it is important that the

exact same basket of goods be purchased during the second period. It is
assumed that the goods in the second basket are identical to the first
basket, and therefore any change in the value of the basket must be due
solely to changes in price, i.e. inflation. This is how the CPI index, and
weighted price indexes in general, can measure inflation.
Problems with basket of goods measurements
Quality bias: firms continuously improve the quality and features of
their products so it is difficult to create a basket of goods that works for
more than two or three years.
Substitution bias: an increase in the price of a good will cause
substitution, yet the weighting remains constant.
New product bias: New goods can take years to enter a basket of goods.

Summary: The Consumer Price Index is called a basket of goods measure. It measures price level changes according to
the change in the cost of a typical basket of goods. Important items in the basket of goods are frequently purchased
items and necessary. Prices can be given more impact within an index by weighting.

41

Date:

Inflation costs of inflation

How can rising prices make it more
difficult to predict profitability of a
project?
What is the consequence of reduced
Investment spending in the long
run?
How are export markets affected by
domestic inflation?
Which social groups suffer more as
a result of inflation?
Which social groups benefit?
How can an income earner with
disposable income protect
themselves from rising price levels
(inflation)?
Who suffers from unexpected
inflation?

What are shoe leather costs?

What are menu costs?

What are the benefits of price

stability?

Costs associated with inflation

Inflation increases uncertainty in business decision-making
because rising price levels make it more difficult to predict
whether a project will be profitable. Investment spending
decreases and thus long run growth and employment rates may
decrease.
Exports become less competitive in foreign markets. Export
sector may shrink and trade imbalances can result.
Households with fixed incomes (pensioners) suffer a decline in
purchasing power.
The efficiency of the price mechanism decreases because
inflation distorts the signaling power of relative price changes. A
consumer seeing the price of a good rise cannot know whether
other prices have increased proportionately. The confuses both
consumers and business.
Inflation redistributes wealth from the poor to the well off since
the former have fewer choices to hedge against inflation, such
as buying assets like a house.
When actual inflation is higher than expected inflation,
borrowers gain at the expense of lenders. The money they pay
back is worth less than it was when borrowed.
Shoe leather and menu costs increase. Shoe leather costs
are the costs associated with the increase expense of finding
new prices and comparing relative prices. Menu costs are costs
associated with the expense of more frequent changes of
catalogue and price lists, updating customers of changes, etc.
These same costs can be remembered as benefits of price stability.

Summary: The price mechanism is weakened by inflation and this distorts accurate pricing of scarce resources. Poor
citizens without assets are hit harder than well-off because they cant hedge against inflation by owning assets. Fixed
income earners are hurt because of declining purchasing power.

42

Date:

Inflation going the other way it is called deflation

What is deflation?

Deflation refers to continuous decreases in the average price level. If

inflation is negative then the economy is suffering deflation.

What is disinflation?

Disinflation is a decrease in the rate of inflation but not a negative

value, e.g. price levels fell from 6% to 4% would be disinflation.

What is the consequence on

monetary policy of the demand for
loanable funds decreasing?

Costs of deflation
Consumers delay purchases since they expect further price
decreases. Aggregate demand falls further, pushing prices
lower.
Firms are forced to cut prices to win over customers, reducing
profit margins and forcing businesses to cut costs. Wages can
fall and layoffs follow, reducing AD.
The real value of outstanding debt increases. Firms with debts
hesitate to make investments (that would add to present debt).
AD declines as does the average price level.
Banks accumulate more bad debt, i.e. firms cannot pay for
their loans and defaults rise. Banking crisis can threaten an
economy as a whole.
Expansionary monetary policy wont work because nominal
interest rates are low.
Expansionary fiscal policy may be ineffective if households
decide to save and postpone spending.

Why may expansionary fiscal

policy prove ineffective during
periods of deflation?

But exports become more competitive abroad and AD may increase

from a rise in net exports.

What is a positive consequence of

deflation?
What is good deflation?

Improved productivity can cause an overall decrease in price levels. This

however is considered good deflation as it is not caused by falling AD
but my more efficient use of resources.

Why might (C) fall as a result of

deflation?

Why might firms cut prices?

What is the effect of deflation on

outstanding debt (debt already
borrowed)?
What consequences might we
expect from greater bank defaults?
(talk about why a banks number of
bad loans may rise during a
deflation)

Summary: Declining price levels induce a wait and see attitude in (C) and (I) as consumers and producers have
expectations that prices may fall further. This behavior has a deleterious impact on AD. Complications come from
within the banking sector due to consumers and business walking away from their debts.

43

Date:

Inflation Three causes of inflation and deflation - overview

What are three causes of inflation?
What is demand-pull inflation?

What is cost-push inflation?

What is the quantity theory of

money?

What does the Fisher Equation tell

about inflation?

In what time frame does the

quantity theory of money work?
Review question: Given a sustained
increase in price levels, what
caused the inflation to occur?

There are three causes of inflation

Demand-pull inflation. Given an upward sloping AS curve, any
factor that increases AD will lead to an increasing price level, i.e.
inflation. This is called demand pull inflation.
Cost-push inflation. Any factor that decreases AS will lead to an
increasing price level. This is called cost push inflation.
Quantity Theory of Money (QTM). A third cause of rising price
levels is an expansion of the money supply without a similar
increase in real output. QTM is beyond the syllabus but is a
powerful insight and fairly intuitive criticism of cost-push and
demand-pull explanations of inflation.
The relationship between money supply and price level is seen
in the Fisher Equation: PY=Mv, where P is price level, Y in real
output, M is the amount of money in the economy, and v is the
number of time each unit of money is used (velocity of money).
In the short run, Y and v are constant or slow to change, while
M and P are quick to change. Thus an increase in M results in an
increase in P. (at least in the short run).
The demand for money is derived from the demand for goods
that can be bought with the money. If the quantity of goods
remains constant, while the supply of money is increased, the
value of the money in terms of goods declines; more money is
needed to buy the same goods. On a whole-economy scale, all
prices increase with an expansion of the money supply. This is
inflation.
Exam Review Tip
What to say? When faced with a question about the causes of
inflation?
o Remember that its really not possible to prove what
causes inflation in any given situation, as it is likely all
three causes have a role to play. This makes any
question dealing with the causes of inflation somewhat
simple in that ALL possibilities must be discussed.

Summary: It is impossible to say what caused a given inflation because of complexity. All three causes are likely at
work, and so any question of the causes of inflation requires all three causes to be examined.

44

Date:

Demand-pull Inflation causes of demand-pull inflation

What is required of the AS curve in
order for inflation to occur?

Demand-pull
A key determinant of the responsiveness of price level to increased AD
is the relative slope of the AS curve.

Explain what demand-pull says

about points a, b and c. (talk about
relative changes in P and Y)

If AD is not near full capacity an increase in AD (AD1 to AD2 below)

results in a relatively lower price level increase than the output
increase. However, if AD is closer to full employment, say AD2 to AD3,
the increase in price level is greater than the increase in output. If
capacity is near full employment an increase in AD will result primarily
in higher price levels, i.e. inflation.
What might cause (C) or (I) to
increase rapidly?
What effect will an undervalued
currency have on demand pull
inflation?
A sudden increase in fiscal
spending to fight a lengthy war or
colonize Mars might cause what
kind of inflation?
A rapidly expanding large foreign
market could cause what kind of
Inflation? (several possible)
How might worker expectations of
increasing inflation influence the
actual inflation rate?
What effect might increasing the
supply of money have on demand
pull inflation?
List five causes of demand-pull
inflation.

Causes of Demand-pull inflation include:

Rapid increase in Consumption and Investment expenditures
due to optimism and confidence of consumers and firms,
Surging exports perhaps caused by an undervalued or
depreciating currency. Faster growth abroad may also increase
domestic export demand.
Excessive government spending,
Inflationary expectations alone can cause workers to
automatically ask for higher wages to compensate for expected
decrease in purchasing power, and
Excessive growth in the supply of money (see the Fisher
Equation for more detail). Money receives its worth from the
goods it commands in the market. If the amount of goods
remains the same and more money is introduced, money is
devalued; it takes more money to buy the same goods. This is
inflation.

Summary: Demand pull inflation is caused by a continuous increase in AD when bottlenecks exist in AS (an upward
sloping AS curve). Causes of this increase in AD are investment booms, high confidence, excessive government
spending, strong export growth, inflationary expectations, and growth in money supply.

45

Date:

Cost-push Inflation Causes of cost-push inflation

What is cost-push inflation?

Cost-push inflation is caused by a sustained and potentially sharp

increase in production costs that affect all industries, such as oil price
increases or generalized labour union unrest.

Describe what happens at point a

and point b (talk about why AS is
changing and its effect on P and Y).

Why is a one-time increase in

factor prices due to a increased
demand for a raw material not
necessarily a cause of inflation?
List three costs increases that have
the characteristic of a sustained cost
increase.
Why might service economies not
be as sensitive to rising oil prices as
manufacturing economies?
How might a devaluation or
depreciation of the domestic
currency fuel cost-push inflation?
What might cause a countries level
of productivity to fall?

The effect of cost-push inflation is to raise price levels and reduce

output.
Causes of cost-push inflation include:
A sustained factor cost increase such as caused by a shortage of
oil (caution, oil is not as important for service economies),
Wage increases that are greater than productivity gains,
A devaluation or depreciation that makes imports of necessary
resources or raw materials more expensive, such as
replacement parts for machinery, medicine, intermediate
goods, or other must-have for production imported goods,
Rising commodity prices due to rising world demand for
manufacturing output,
Possibly high or increasing rates of taxation if they cause
workers to press for more wages, such as a decision to reduce a
nations level of debt through taxation, (note: to qualify as a
cause of inflation the cost must be sustained and not a one-time
increase or spike in prices), and
Reduced productivity perhaps from long neglect of improving
industry capacity. This might occur if a country cannot purchase
replacement capital.

Summary: Cost-push inflation is caused by sustained increases in production costs. Production cost increases that are
one-time increases are not inflationary. To be inflationary requires a sustained increase, such as oil price rises,
generalized trade union unrest, wage demands greater than productivity gains, etc.

46

Date:

Causes of deflation

What is deflation?

What is happening at points a and

b? (tell the story of deflation)

Why is deflation a problem?

What policy remedies are there

(talk about monetary and fiscal
policy)?

What causes deflation?

Is there such a thing as good

deflation?

Deflation is a problem because it can create a cycle of decreasing prices

leading to decreasing aggregate demand leading to decreasing prices
that can be difficult to break. There is no policy cure other than
avoidance. Monetary policy is ineffective as the price of money is near
zero and fiscal policy is weakened by expectations of lower prices. Best
bet to date to end deflation is improved export demand.
Deflation can be caused by:
A decrease in AD as a result of a domestic crisis such as a
banking crisis, the collapse of a major industry, or an external
crisis that led to a sudden and prolonged contraction of the
export sector,
Aggregate demand rising more slowly than expected. Firms may
have overinvested in new capacity leading to a large increase in
aggregate supply
Good deflation versus bad deflation
Good deflation is caused by productivity gains that increase AS,
thus lowering prices and increasing output.
Bad deflation is caused by falling AD.

Summary: Inflation is a stimulus to spending; buy now prices will rise later but deflation is the opposite and provides an
incentive to delay spending. Falling price levels can lead to falling Consumer and Investment spending (multiplier and
accelerator). The deflationary spiral can defeat anti-recession policies.

47

Date:

Inflation and Deflation policy response to demand-pull inflation

What is tight monetary policy?
What does fiscal restraint mean?

Demand-pull inflation policy response

Tight monetary policy (increased interest rate) combined with
fiscal restraint (decreased G, possibly higher taxes)

How do tight monetary policy and

fiscal restraint deal with demandpull inflation? (tell how it works,
points a, b and c).
What is the policy goal for
demand-pull inflation? (What is the
intention of the policy response?)

Given AD1 and AS, the average price level is at P1. As a result of demand
pull inflation AD would increase to AD2 and the price level to P2. If the
central bank increases interest rates (tight money policy) some
households may cut down their spending on durables and some firms
may lower their investment spending so AD may not increase all the
way to AD2 but may increase only to AD*. Price levels may rise but not
as much. Inflation may be lower.
As a result of tight monetary policies and fiscal restraint, price levels fell
and economic growth increased Y1 to Y* but not as fast or as much as
without intervention.

Summary: The policy response to demand-pull inflation is contractionary fiscal and monetary policy. The intention is to
slow down the increase in AD and Y, i.e. to cool the economy. It is the policy hope that output (and employment)
will increase but with lower rates of inflation and possibly price stability.

48

Date:

Inflation and Deflation policy response to cost-push inflation

Why might supply-side policies be
an appropriate response to costpush inflation?
Why are supply side policies not
used?
What policies are used to respond
to cost-push inflation?

Supply-side policies are an appropriate response but they are

considered too long term (slow to take effect) for governments faced
with cost-push inflation. Tight monetary policy (and to a lesser extent
fiscal restraint) is/are used to control cost-push inflation.

Refer to the diagram and explain

points a, b and c. (talk about arrows
1 and 2)
With respect to cost-push inflation,
why might the cure is worse than
the disease be an apt statement?
(talk about the opportunity cost of a
stable price level)
How might international trade
dampen cost-push inflation in a
domestic economy?

Initially real output is a Y1 and the price level is P1. Assume an adverse
and sustained supply shock shifts AS from AS1 to AS2 (arrow 1) and
price level rises to a higher level at P2. Cost push inflation is even more
costly than demand-pull inflation as Y1 falls to Y2 and unemployment
rises.
Tight monetary policy (increased interest rates) is used to maintain price
stability at P1. If the policy is successful, increased borrowing costs
decrease spending by households and firms, lowering AD from AD1 to
AD2 and preserving price stability at P1.
Note that Y falls further as a result of the tight monetary policy from Y2
to Y* and unemployment increases more. This is considered a short run
cost and is preferable to inflation as price stability helps accelerate
growth and employment in the long run.
Note too that increased international exposure to international
competition also can reduce inflation. Domestic firms are forced to
become more efficient, and may benefit from cheaper sources of
supply.

Summary: Cost push inflation is treated the same way as demand pull, however, the impact on Y and unemployment is
greater. The cost of price stability is greater unemployment.

49

Date:

Unemployment
What is unemployment? What is
the unemployment rate?
What does the labour force or
workforce or working population
include?

An individual is considered unemployed if she is actively searching for a

job and cannot find one. The unemployment rate is the ratio of the
number of unemployed over the size of the labour force times 100. The
labour force includes the employed and the unemployed.

What is the main error with

unemployment statistics?

The unemployment rate in a country may be underestimated or

overestimated.

How is employment data gathered?

Employment data is gathered through both survey and counting

(census) methods. Survey asks questions of sample household members
as to their employment status and activity. Census counts individuals,
primarily applicants for unemployment insurance benefits.

What problems are caused by the

survey methodologies?

Briefly, evaluate survey

methodology.

Problems with Survey Method

For an individual to be considered unemployed they must be
without work, available to start work, and actively looking for
work (usually during the previous month).
o People may misrepresent their status, and
o the survey can be poorly designed.
Problems with Census Method
People claiming benefits must register, therefore it is possible
to count them. However, the eligibility requirements change at
the governments discretion. Governments have been accused
of manipulating the eligibility requirements to underreport
unemployment.
Neither method is perfect however, if the methodology is consistent
between periods then the measured change is accurate (or good
enough).

Summary: The unemployed are those actively searching for a job but cannot find one. The unemployment rate is the
ratio of the number of unemployed over the size of the labour force which consists of the unemployed and unemployed.
The data is subject to errors of design and interpretation.

50

Date:

Unemployment Costs of unemployment

What are two perspectives on
unemployment costs?
What are the private costs of
unemployment?
HL Give an example of asymmetric
information.
What are the social costs of
unemployment?
Can an economy make up the
output lost due to unemployment?
How is government affected by
unemployment?
What is regional disparity of
income?
Are there any benefits to
unemployment or is it all bad?

Private cost of unemployment

Lost income for the household,
Decrease in skill level,
Getting hired gets more unlikely as time passes (employers
reluctant to hire the long term unemployed because the
employer doesnt know why they are not employed), and
Discouragement, loss of social status and loss of self esteem
Social cost of unemployment
Lost output that will not be produced and never will be
produced,
Economy is within its production possibility frontier,
Lower tax revenues for government due to lower private
spending,
Government spending increases because of government
financed training and retraining programs,
Higher levels of alcoholism and drug abuse, and
Greater regional disparity in income across a country with rich
and poor regions.
Winner of the Most positive outlook competition is
One social benefit of unemployment is that it tends to increase
labour market flexibility
o by reducing power of unions, increasing geographical
mobility, and increasing occupational mobility,
o reduces cost inflation pressure on the economy

Summary: The costs of unemployment are felt by the individual and society both. The individual suffers loss of income,
skills and social status. Society suffers the lost productivity of the worker, lower tax revenues from decreased private
spending, great benefit and training expenditures, and social ills of alcoholism.

51

Date:

Unemployment Types of unemployment

What is natural unemployment?
What is seasonal unemployment?

What is frictional unemployment?

What is structural unemployment?

Getting fired for spraying mustard
sauce on a co-worker even though she
deserved it is what kind of
unemployment?
A web page designer being replaced
by Google Sites is what kind of
unemployment?
A fruit picker during the winter is what
kind of unemployment?
What is frictional unemployment?
What is structural unemployment?
What is a job/skill mismatch?
What are labour market rigidities?
What are institutional disincentives?
What is equilibrium unemployment?
What are two kinds of disequilibrium
unemployment?
What is cyclical unemployment?
What is real wage unemployment?

Natural Unemployment consists of 3 categories:

Seasonal unemployment is related to seasonal changes and
harvest cycles, e.g. ski instructors expect to be unemployed and
there is little that can be done by government to reduce it.
Frictional unemployment relates to normal changes in the
labour market such as being fired, quitting, and workers in
between jobs. Frictional unemployment is unavoidable although
it can be reduced by better information about job vacancies.
Structural unemployment relates to unemployment induced by
fundamental changes within industries such as the decreased
importance of the manufacturing sector and the increased
importance of the service sector in developed economies.
Characteristics of structural unemployment include
Existence of a job or skills mismatch between
the unemployed worker and the industry, e.g.
web page designers were needed during the
1990s only to have technology make them
redundant within a decade.
Labour market rigidities such as created by
minimum wage legislation and collective
bargaining setting wages above an equilibrium
value.
Institutional disincentives such as laws that
prevent firms from firing employees, and high
unemployment benefits.
Equilibrium and disequilibrium unemployment
Equilibrium unemployment exists when the labour market is in
equilibrium; it is also called the natural rate of unemployment
or NRU.
Disequilibrium unemployment consist of cyclical and real wage
unemployment:
o Cyclical or demand-deficient unemployment; also called
Keynesian unemployment is unemployment related to
declining AD or a downturn in the business cycle,
o Real wage unemployment; also called classical
unemployment is unemployment related to wage rates
remaining too high because of labour market
inefficiencies

Summary: Economists study two kinds of unemployment: equilibrium and disequilibrium unemployment. Natural
unemployment is equilibrium unemployment. Disequilibrium unemployment is cyclical and real wage unemployment.

52

Date:

Unemployment Cyclical or Keynesian unemployment

What is cyclical or demanddeficient unemployment?

Cyclical unemployment is directly related to the business cycle. Higher

unemployment accompanies a recession because of the lower level of
production.
Three diagrams illustrate cyclical unemployment.

What causes AD to fall?

What is a recession?
What effect does the recession and
falling Y have on the aggregate
demand for labour?
What is demand deficient
unemployment? (talk about the
distance ab)
Review: Use three diagrams to
illustrate demand deficient
unemployment.

Dia. 1: A decrease in AD from AD1 to AD2 results in a decrease

in economic activity from Y1 to Y2.
Dia. 2: The economy has entered a recession illustrated in the
business cycle by the fall in output (Y) during the period t1 to t2
when output fell from Y1 to Y2.
Dia. 3: The decreased output lessened the demand for labour in
the labour market from D1L to D2L. Money wages (nominal
wages) are assumed to remain at W1 due to labour market
rigidities (e.g. sticky wages, labour contracts). Demand deficient
unemployment is the distance ab.
Note: the Real wage unemployment view provides another
interpretation of Dia. 3. (Next topic)

Summary: Demand deficient employment is explained using three diagrams linked by narrative. A fall in AD
(recession) causes output to fall. Falling output decreases the need for workers and the aggregate demand for labour
decreases. Unemployment (ab in Dia.3) results. This is called demand deficient unemployment.

53

Date:

Unemployment Real wage unemployment

What causes real wage
unemployment?
What is the real wage rate?

Real wage unemployment is considered a result of inefficiencies in the

labour market, notably the real wage rate remaining above the
equilibrium wage and preventing the labour market clearing. Unions
and minimum wage legislation is identified as adding to the inefficiency.
Exam note: This perspective can be added to the story of demand
deficient unemployment to add depth to an analysis of unemployment.
It is essentially another interpretation of Dia. 3 repeated below.

Is declining AD a problem from the

real wage unemployment
perspective?

Why might labour markets not

clear (i.e. be allocatively
inefficient)?
What is point c?

The difference between the demand deficient view and the real wage
view is that the real wage view sees declining demand as a normal
market condition (and not a problem) and so unemployment is high
because of real wages being too high. Its a shift of focus.
With respect to the diagram above, the equilibrium needs to fall from
point a to point c but it cant (says the real wage story) because of
labour market inefficiency:
Union wage rates too high,
Long term wage contracts,
the employers concern with losing key workers, and
the presence of minimum wage legislation.
Real wages are Nominal wages adjusted for inflation, so ceteris paribus,
when price levels fall, real wages increase (money wages w1 here - are
assumed to stay the same as part of the ceteris paribus condition).
Higher real wages encourage workers to want to work and so
unemployment rises (ab).

Summary: Real wage unemployment is another point of view on the response of ADL to a decline in AD. The real
wage unemployment perspective sees unemployment the result of money wages not responding to the deceased demand
for workers due to labour market efficiencies, and not a deficiency in AD.

54

Date:

Unemployment Policy responses depend on the type of Unemployment

What are the policy responses
for?
Frictional unemployment

Cyclical unemployment

Structural unemployment
What kind of unemployment will
expansionary demand-side policies
affect?
What kind of unemployment is
affected by improved retraining of
workers?
What kind of unemployment will
be affected by labour market
liberalization (removing
regulations)? (several are possible)
Identify three cautions for a
government undertaking labour
market reforms?

How is real wage unemployment

treated?

Frictional unemployment can be reduced (but not eliminated) by

policies designed to make job information and worker profiles more
accessible.
Cyclical or demand deficient unemployment can be dealt with by
expansionary demand-side policies (fiscal spending, taxation and
monetary policy) to close the recessionary gap. Interest rates can be cut
in the hope that households and firms will spend more. The government
may lower taxes and increase expenditures.
Structural unemployment can be reduced (but not eliminated) by steps
such as:
Improved training or retraining of structurally unemployed
workers into new industries,
Reducing the power of trade unions,
Eliminating minimum wage legislation and collective bargaining,
Reducing non-wage labour costs such as employer contributions
to unemployment insurance plans,
Reducing the level and length of unemployment benefits
Cautions include:
Social unrest may increase with decreasing worker protection,
Sections of the population may become marginalized (move a
step closer to poverty),
Income distribution may become more unequal, and
Expansionary demand-side policies are ineffective with
structural unemployment and relief will be temporary and at
the cost of higher levels of inflation.
Real wage unemployment is treated by labour market reforms similar to
the above mentioned with the focus being to improve labour market
efficiency.

Summary: Policy responses need to address the type of unemployment. Structural unemployment is the most urgent but
also the most difficult to respond to as it takes time and resources to retrain workers. Expansionary economic policies
provide a promise of short term relief but are inflationary.

55

Date:

Unemployment the natural rate of unemployment (NRU)

What is the natural rate of
unemployment?

What is the ASL curve?

The natural rate of unemployment is the unemployment that exists

when the economy is at full employment equilibrium.

What is the LF curve?

What is the difference between
them?
If unemployment benefits
decreased, which way would the
ASL curve shift? And the LF?

Is NRU voluntary or unvoluntary?

Is NRU structural or frictional?
Is the unemployment rate due to
high real wages part of NRU?
Is the unemployment rate due to
deficient demand part of NRU?

Where can NRU be found in the

AD/AS model?

ADL is the demand for labour by firms. It shows the number of

workers firms are willing to hire at each real wage rate. It is
downward sloping because at higher real wage rate firms would
prefer fewer workers.
LF shows the labour force at each wage rate. It shows the
number of workers working or looking for a job at each wage
rate. At higher wage rates, more people who were not looking
for work at a lower rate are induced to enter the labour force.
The ASL curve is different in this model. It shows the number of
workers willing to accept jobs at each wage rate. The willingness
to accept a job increases as wage rates rise so the distance
between the curve narrows.
The labour market is at equilibrium at Wr and Le. At Wr the
number of employees available to work equals the number of
workers wanted by industry.
NRU is the number of workers in the labour force without a job
when the labour market is at equilibrium. NRU is of a voluntary
nature (not willing to accept work at that wage level). For
example, if union wage rates were above the equilibrium wage
and increased unemployment, the higher unemployment due to
the higher union wage rate is NOT part of NRU.
NRU is structural. A right shift in ASL due to lower
unemployment benefits would decrease NRU.

Summary: NRU is associated with New Classical perspective of LRAS and looks at the level of unemployment that
exists when the labour market is in equilibrium. NRU is voluntary in nature and structural with respect to type.

56

Date:

The Phillips curve the trade-off between unemployment and inflation

Where does the Phillips curve get
its name?
What does the Phillips curve say?
What is the y axis on the Phillips
curve graph?
What does percentage change in
price levels mean?
What is the implication of a stable
(i.e. predictable) inverse
relationship between inflation and
unemployment?
What is the opportunity cost of
employment according to Phillips?

What is the result of an increase in

AD with respect to the PC? (talk
about a to b)

Research done in the early 1960s by economist Alban Phillips suggested

there was a stable inverse relationship between inflation and
unemployment. This relationship suggested to policy makers that
expansionary demand-side policy could predictably lower
unemployment with higher percentage change in average price levels
being the opportunity cost. (The Phillips curve says lower
unemployment is possible if the economy can accept a higher rate of
inflation.)

The Phillips curve suggested that unemployment could be lowered from

U1 to U2 if the government were to inflate the economy sufficient to
raise the rate of inflation (increase in price levels) from 1 to 2.

Whats the relationship between

AS and the PC?
How is a change is AD shown on
the PC?
How is a change in AS shown on
the PC? (not illustrated here
doodle it yourself in the margin)

How does the PC impact economic

policy?
Was the stable relationship borne
out empirically over time?

This idea fit in well with the Keynesian perspective. The PC is the mirror
of AS; what changes AS also changes PC (but opposite). The curve
suggests that expansionary demand-side policy AD1 to AD 2 could
increase output Y1 to Y2 and thus decrease unemployment U1 to U2,
however, the economy would see price levels rise from P1 to P2. A small
amount of inflation might be a reasonable cost for lower
unemployment. This pattern persisted until the mid-1970s when high
inflation and high unemployment suggested the PC relationship was not
stable (unpredictable).

Summary: The Phillips curve suggests lower levels of unemployment can be purchased by higher levels of inflation,
giving the government a tool to control a major economic variable and policy objective. The PC mirrors the AS curve.
An increase in AD movement along PC. An increase in ASshift PC opposite.

57

Date:

The Long Run Phillips Curve a critique of the short run PC

What happens to the PC if the
average general level of wages
were to rise? (talk about AS and
how PC is a mirror of AS)
What does a single PC curve
imply? (talk about the assumptions)
How is the idea of a single PC
curve ah, wrong? (talk about
theory and evidence)

The short-run PC assumes a constant wage rate and constant

expectations of future prices. Thus a single PC curve can be drawn.

What is the Friedman-Phelps

Critique?

Conclusion: (Friedman-Phelps Critique) multiple PC curves exist in the

Long-run, depending on expectations of the rate of change of price
levels and anticipated wage rates.

What is the Long Run Phillips

Curve?
Why did Friedman and Phelps both
see the unemployment and inflation
trade-off as possible only
temporarily?
What is money illusion?
Why is money illusion not possible
in the long run?
Exam Review: Fool me once,
shame on you. Fool me twice,
shame on me! Apply this to the
idea of money illusion and the
success of Keynesian policy
remedies directed at demand
deficient unemployment.

Theoretical attack on single PC curve: But workers learn of

inflations negative effects on purchasing power and they
express this learning as wanting higher wages, and by expecting
prices to keep on climbing.
Empirical attack: The theoretical attack is reasonable based on
worker life-experience; single PC refuted empirically as high
rates of inflation and low output growth during the 1970s.

Furthermore, a LRPC curve exists at full employment level of output YFE

equivalent to LRAS (but a mirror image of LRAS).
Trade-offs between unemployment and inflation are SR only.
Workers do not have money illusion and are EVENTUALLY
fully aware of the affects of inflation on purchasing power and
adapt their expectations accordingly.
(Money illusion means workers are slow to adapt to inflation,
they base future expectations of price levels on PAST
experience of LOWER levels of inflation, e.g. $1 today is the
same as $1 tomorrow.) The Friedman-Phelps critique is that this
is clearly not true: people learn from experience and
ANTICIPATE inflation.

The LRPC curve is described in the next topic.

Summary: Drawing a SRPC requires the assumption of a constant wage and expected inflation rate (like the demand
curve requires the factors of demand to remain constant). This is not reasonable in the long run because workers learn
of the impact of inflation. Workers do not suffer money illusion.

58

Date:

The LR Phillips Curve how it works

Whats the long run Phillips curve
called in full?

What are the assumptions of the

story? (talk about how it begins)
Why is it necessary to assume
workers have money illusion for
this story? (talk about why the story
begins with inflation at a low 1%,
i.e. why not start the story at 15%?)

What are real wages?

What happens to real wages when
price levels rise?
What happens to real wages when
there is inflation?
How does government plan to
reduce unemployment to less than
the natural rate?
What effect does this have on price
levels in the economy, and on real
wage rates, and employment? (talk
about nominal wage rates being
assumed constant in AS)
When workers renegotiate nominal
wages, how does this affect AS,
real wages, and SRPC?
What is NAIRU?
Exam review: Tell the LRPC story
with illustrations.
Are workers better off as a result of
demand side unemployment
policies?

The LRPC is known as the expectations-augmented Phillips curve. It is a

story of how worker expectations return the unemployment rate to the
natural rate of unemployment despite SR demand-side policy changes.

Starting with the labour market in equilibrium and unemployment at a

natural rate of say 5.2% (above), and an economy experiencing 1%
inflation for enough time that workers have money illusion (point a
below).

Government expands G to increase AD and move to point b to try to

reduce unemployment to 4.5% (i.e. below NRU). This is possible
because of money illusion. Inflation rises to 2% causing real wages
(w/PL) to decline, firms hire more workers reducing unemployment to
4.5%. But as time passes workers understand 2% inflation and ask for
higher wages to match. AS shifts left and output falls; real wages return
to Wr (nominal increased) and firms fire workers returning to NRU, PC
shifts right to SRPC 2.0%. Firing workers returns unemployment to NRU,
only now the unemployed face price levels increasing 2% not 1%
(worse-off) at point c. To keep unemployment below NRU (move to
point d) requires greater expansionary efforts and a higher SRPC at 4%.
The wage cycle repeats (moving to point e) over time. NRU is thus also
called the non-accelerating inflation rate of unemployment (NAIRU).

Summary: In the long run the PC is vertical at the non-accelerating inflation rate of unemployment (NAIRU) and this is
another perspective on YFE. Governments should resist attempts to decrease unemployment using policies to stimulate
AD because they are inflationary and leave workers worse off in the LR.

59

Date:

Inflationary Gap an alternative illustration

What is an inflationary gap?

How does it work? (illustrate with

a graph)
What level of output corresponds
with NRU (the natural rate of
unemployment)?
When the labour market is in
equilibrium and inflation is fully
anticipated by workers and firms,
what is the relationship between
ADL and ASL, and money wages
and real wages?
What is the result of an increase in
AD (any reason) from fully
anticipated or non-accelerating
inflation rate equilibrium? (tell the
story of an inflationary gap)
Story detail: What change to the
diagram occurs once new wage
rates are negotiated?

What impact does money illusion

have on workers?
Identify the inflationary gap range
of output on the diagram.

An inflationary gap is a temporary increase in real output as a result of

AD increasing to a new equilibrium to the right of YFE (a to b below).

The story begins with an assumption that the economy is in long run
equilibrium (point a). It is at full employment level of output that
corresponds to NRU. The labour market is at equilibrium (not shown) at
a real wage rate where the ADL=ASL and real wage = nominal wage.
Since this is the long run level of output, it is assumed that the
anticipated rate of inflation equals the actual rate. (Inflation is fully
anticipated by the labour market at the start of the story).
An increase in AD (caused say by an increase in G) moves the economy
into disequilibrium. Price levels increase. In labour markets this is seen
by firms as a decrease in real wage costs so they hire additional workers
to meet demand and increase real output. This decision puts increasing
upward pressure on the nominal wage rate which is necessary to attract
additional workers
Story note 1: Existing workers are assumed to be employed at
the equilibrium nominal wage otherwise, a new AS curve must
be drawn, and indeed will be drawn to reflect higher labour
costs, but this will occur later in the story, and
Story note 2: The new workers can either be fooled by money
illusion to think of the nominal wage rate as commanding the
same amount of resources and accept the given nominal wage
rate, or they can be not fooled and expect higher wages to
compensate for rising price levels and thus begin to bid up
production costs. Most likely, both are occurring.
In the short run, disequilibrium exists where output is greater than full
employment (point b). The distance between YFE and Y* is called an
inflationary gap.

Summary: Output can increase beyond YFE in the short run (but not long run because increased production costs
eventually return output to YFE). From equilibrium, rising AD results in lower real wages and gives firms an incentive
to increase output because nominal wages are slow to respond to rising price levels.

60

Date:

Inflationary Gap the story continues

What returns the economy to full
employment from an inflationary
gap? (talk about b moving to c)

An inflationary gap is reduced and returned to a full employment level

of output by rising production costs, notably higher wages.

At point b, what is the relationship

between nominal or money wages
and real wages?)

The story continues from point b where additional workers were hired
to increase output to Y* over a period of time, say one or two years,
the workers find real wages have fallen and ask firms for higher wages.
The moment firms agree to pay higher wages we must redraw the AS
curve more to the left (at a given price level firms less is produced
because of higher costs) so AS shifts from SRAS1 to SRAS2 due to higher
production costs. The economy thus moves back towards the full
employment level of output YFE but at a higher price level and at a new
equilibrium (point c).

Is the gain in output permanent?

Thus, the output and employment gain was temporary and the duration
of the gain was governed by the length of time required for worker
wages to respond to higher price levels (lower real wages) with
increased wage demands.

Are employed workers better or

worse off at point c?
Are newly unemployed workers
better or worse off at point c?
Review question: From an
economic point of view, to what
extent are workers foolish to
accept employment beyond YFE?

When expectations of inflation adjust and nominal wages rise, the real
wage increases back to its original level. Production costs increase.
Short run AS shifts left. Output falls back to YFE.

Summary: Output eventually returns to YFE from an inflationary gap due to higher production costs, notably higher
wages although other factor prices increase as well in the LR. Thus YFE is a limit, like the production possibility
frontier. Employed workers may not be worse off but unemployed workers are.

61

Date:

Deflationary Gap an alternative illustration

What is a deflationary gap?
Exam review question: How might
a Keynesian challenge the
temporary nature of a deflationary
gap?

What happens when AD falls?

(draw and refer to diagram)

A deflationary gap is a (temporary) decrease in real output as a result of

AD falling to a new equilibrium to the left of YFE (a to b below).

This story begins with the same assumptions as with an inflationary gap,
i.e. both the labour market and the economy at a full employment
output with a non accelerating inflation rate.
A decline in AD from AD1 to AD2 moves the economy into
disequilibrium, with output falling below YFE (here, to Y*)

What follows a decline in AD

according to Keynesian thought?

What happens according to New

Classical thought?
What drives recovery from a
deflationary gap from the
Keynesian point of view?
What drives recovery from a
deflationary gap in the New
Classical perspective?

The Keynesian perspective has us stop here as there is nothing inherent

in the Keynesian view of the AD/AS model to move output back to YFE
Briefly enumerated:
1) wages are sticky and labour markets are inefficient,
2) worker incomes have fallen so C falls until incomes rise,
3) firms reduce investment (I) because of the accelerator effect,
and also because
4) the business climate is gripped by caution imposed by
knowledge of business cycles boom follows bust).
Keynesians recovery awaits an increase in AD perhaps led by G.
The New Classical perspective has recovery to YFE being market-based:
Falling price levels mean higher real wages and more unemployment,
but as a result of labour market efficiency, and workers having to
maintain income levels, over a period of time, workers accept existing
but lower wage rates or move to other industries or sectors. Lower cost
workers allow firms to increase output back to YFE (not illustrated
here). As unemployed workers become employed in other and perhaps
new industries their incomes increase and AD returns to AD1 at YFE.

Summary: A deflationary gap is (K:indefinite duration, NC: temporary) real output lower than YFE. Recovery from a
deflationary gap is the result of workers accepting lower wages and adapting to new circumstances by taking work
elsewhere. AD returns to YFE as workers find new work and increase consumption.

62

Date:

Stagflation Low or stagnant output combined with inflation

What is stagflation?
What are the root causes of
stagflation?
Where does the stagflation story
begin?

Stagflation is an economic condition where an economy experiences

high rates of inflation and low or no growth in real output. The root
causes are increasing production costs combined with expansionary
demand-side policies. (Oil crisis 1974, possible banking crisis 2008)

What shifts SRAS from

equilibrium at point a to point b?
What induces workers into
accepting work at point b?
What moves output to point c
level?
At point c what causes SRAS to
decrease?
To what extent are workers better
off/worse off as a result of
stagflation? (explode workers
into employed and unemployed)
What are the policy implications of
stagflation?
Exam review: explain stagflation
using the quantity theory of money
(the Fisher equation PY=Mv) as a
tool.

The stagflation story begins at equilibrium in the aggregate labour

market and the economy at YFE.
A supply shock such as a unanticipated high factor cost or a crisis in a
sector of the economy (oil crisis, banking crisis, war) reduces SRAS from
SRAS1 to SRAS2 and the equilibrium shifts from a to b, i.e. less than YFE.
Price levels rise from P1 to P2. Output falls. Unemployment rises.
Unwilling or unable to let the markets sort themselves out, the
government responds with expansionary demand side policy (increasing
G, reducing T, and or lowering r) for the purpose of restoring NRU to
YFE. AD increases to AD2 or possibly AD3 (i.e. a higher and ongoing
increase in AD). Price level rises from P2 to P3. With real wages lower
and increased economic activity, firms hire more workers, increasing
output to point c.
Time passes. Workers at c understand price levels are rising and ask for
more wages. Firms accept higher wages and reduce output. A new SRAS
curve is drawn at SRAS3. Output falls to YFE. Unemployment rises. Price
level is high at P4.
The cycle repeats with additional demand for government stimulus.

Summary: The combination of stagnant growth and inflation is the result of increased production costs (declining
productivity) combined with expansionary demand-side economic policies. SRAS decreases due to higher (wage) costs
while AD rises due to increase G. Result is higher price levels with no LR output gain.

63

Date:

Distribution of Income - the Lorenz curve and Gini coefficient

What does equitable mean?

What is equitable income

distribution?
How is income distribution
illustrated?
What is a cumulative total?

Equitable income distribution is a macroeconomic policy goal. Equitable

means that everyone has equal opportunity to income (fairness) and
not that everyone has the same amount of income.
Income distribution can be shown by a Lorenz curve and
measured through the Gini coefficient.
A key word to know is cumulative. This means adding up on
an on-going basis.

Describe the axes on a Lorenz

curve.
What does the horizontal line
mean?
What does it mean when area A is
very small compared to area A+B?
What does it mean when area B is
very small compared to area A+B?

The above is a micro example (apply the idea to a country).

What is the Gini coefficient?

What does it tell us about income
distribution?
Country A has a Gini coefficient of
0.2 and country B has a Gini
coefficient of 0.7, in which country
is income more equally held?

With respect to the Lorenz curve, the y axis shows total income
divided into percentages. The x axis shows the population
divided into percentages.
The straight line plot shows the hypothetical equal distribution
of income, with 20% of the population having 20% of total
income, and 40% having 40% of income, etc.
The curved line plots actual distribution of income with each
percentage of population being shown with its cumulative total
of income.
Interpretation: 20% of the population has 5% of total national
income, 40% of pop. has around 10% of income, 85% has 40%,
with 15% accounting for 60% of the total income. This country
has a relatively small number of people with a lot of income,
and a large range of people having a low income.

The Gini coefficient takes AREA A (under the diagonal line) and divides it
by the sum (A+B) to give a number between zero and 1. Zero denotes
perfect equality while 1 denotes perfect inequality. The Gini coefficient
of the example above is approximately 0.6 about the same as Brazil.

Summary: The Lorenze curve illustrates the degree to which income is equally distributed in a population as the
variance between a perfectly equal distribution of income, and a plot of the cumulative percentage of population versus
a cumulative percentage of income of a country. The Gini coefficient measures this.

64

Date:

Distribution of Income Possible benefits from more equal distribution

Write a question

The marginal propensity to consume is higher among the poor

than it is among the rich, so redistribution of income to the poor
can increase aggregate demand.

Social tensions may be lower and so government could

undertake reforms that require the cooperation of citizens. If
people feel they are benefiting from economic growth now they
may be willing to work harder and sacrifice more now in order
to have more at a future time. The willingness to save allows
higher rates of Investment and contributes to growth. Lower
social tension reduces the risk for domestic and foreign
investors.

The poor will be able to afford access to crutial resources such

as education and so the amount and quality of productive
resources increases.

Trust increases among the population so the costs of economic

transactions can fall with more economic activity taking place.

However, if income is too equally redistributed the incentive for

hard work may diminish and the potential for growth may be
weakened.

Summary: Redistribution of income can increase AD by shifting resources from consumers with low mpc to high.
Redistribution means the children of low income earners have better access to crucial resources such as family health
and education and this can reduce poverty cycles. Social calm allows (I) to occur.

65

Date:

Taxation tools of income redistribution

What is a direct tax?

What is an indirect tax?

What is the marginal tax rate?

What is the average tax rate?

Direct taxes are placed on the money flows belonging to individuals, i.e.
income, profits and wealth.
Indirect taxes are attached indirectly to individuals via their
expenditures on goods and services.
Language of taxation
The marginal tax rate is the percentage taken by the government on the
last unit of income earned.
The average tax rate is the ratio of the tax collected over income
earned.

What is a progressive tax system?

A progressive tax system

Higher income earners pay progressively more so the average tax rate
rises as income rises. The marginal tax rate is greater than the average
tax rate.

What is a proportional tax system?

A proportional tax system

All individuals pay the same proportion of their income independently
of the level of their income. The average tax rate remains constant as
income rises so the marginal tax rate = the average tax rate. This is
sometimes called a flat tax. It is simple and transparent and possibly
more fair as the administration is simple.

What is a flat tax?

What is a regressive tax system?

A regressive tax system

Low income earners pay a greater proportion of their income than
higher income earners. The average tax rate decrease as incomes rise so
the marginal tax rate is less than the average tax rate.
Indirect taxes are proportional with respect to expenditure but
regressive with respect to income.

Summary: A proportional tax system is illustrated by any straight line through the origin. A progressive tax system
shows a line sloping up at an increasing rate. A regressive tax shows the slope decreasing. The tax base is either income
or wealth and the y axis is the amount of tax paid.

66

Date:

Taxation policies to redistribute income

How do governments usually
redistribute income?
How does income redistribution
work in principle? (talk about
taxing higher income levels)
Name three long run ways to
improve income equality.

How can income be more equally distributed?

Governments choose to redistribute income through a system
of progressive taxation together with a system of transfer
payments.
o Transfer payments include
o Pensions,
o Unemployment insurance benefits,
o Disability benefits, and
o Subsidies.

Higher income households are taxed more heavily than lower

income households. Lower income households receive more
transfer payments than higher income households. In this way
national income is redistributed to meet equity goals.Social
medicine also serves to increase the effective income of lower
income households.

Long run methods of achieving equity

Improvements to the quality and access to education,
General or socialized health care services or low cost health
insurance schemes, and
Job creation programs. Each of the above can be targeted to
especially deprived income groups.
Improved judicial systems to lower corruption and render
justice that is fair for all.

Summary: Income equality policies work by taxing the rich and giving to the poor through a system of proportional
taxation together with transfer payments to identified disadvantaged groups.

67

Date:

(HL) The Laffer Curve and Tax Cuts

What is

Low levels of taxation result in increasing government revenues from

taxation, up to a point. At some point it becomes worthwhile for higher
income earners to learn how to hide their income to avoid paying taxes
such by investing money in foreign banks, and learning to use tax
allowances to decrease taxable earnings.
As tax rates and income increase, as they have done over the last
seventy years, the incentive to hide taxable income becomes greater.
Arthur Laffer suggested marginal tax rates had reached such a high
point that reducing taxes may even increase government revenues!

Tax rate increases from 0% to T* result in increased revenues for

government, but increases beyond T* provided increasing incentive for
higher income earners to their hide income. It was suggested by the
Reagan and Thatcher tax reforms in the 1980s that a reduction in taxes
from a to b would decrease the incentive to hide income and cause
output to increase, resulting in greater tax revenues, T1 to T2.
The policy implication is that a reduction in tax rates in countries with
high rates of taxation could result in greater tax income. This income
would decrease the need to finance government activities through
increased public debt.
A tax cut could also add to the incentive to work in that individuals
would enjoy more of the fruit of their labour. This depends on the
substitution effect and the desire for workers to substitute work for
leisure (varies across age groups and income levels).

Summary: The Laffer Curve provided a theoretical basis for tax reduction policies, hypothesizing a point at which the
benefit of hiding income is greater than the cost of finding tax havens, and tax loopholes. This suggested that tax
reduction could increase tax revenues. It is uncertain at which tax rates this occurs.

68

Date:

69

Date:

70

Date:

Topic:
Write a question

Summary:

71

Date:

Topic:
Questions
What is

Summary:

72

73