The macroeconomy (A Level)

9.1 The circular flow of income

Consumption, saving and the multiplier

Consumption depends mainly on disposable income; the marginal propensity to consume (MPC) is the fraction of an extra dollar of income spent; the marginal propensity to save (MPS) the fraction saved. Other factors: wealth, interest rates, confidence, expectations, credit. Autonomous consumption is the spending that takes place even when income is zero (financed from savings or borrowing) and does not depend on income; induced consumption rises with income. In the same way, autonomous investment does not depend on income or output (for example government projects or investment driven by new technology), while induced investment responds to changes in output (the accelerator).

The multiplier effect: an initial injection leads to successive rounds of spending, so national income rises by a multiple. Size limits: leakages, spare capacity, time lags and crowding out.

The accelerator

The accelerator says investment depends on the rate of change of output: growth in demand leads to bigger investment; falling growth cuts investment sharply. Together with the multiplier it helps explain business cycles.

Keynesian and classical views

Full employment national income is the output when all resources are in use; equilibrium national income is where AD = AS. If equilibrium is above full employment there is an inflationary gap (AD too high); if below, a deflationary (recessionary) gap. The multiplier is the ratio of the change in national income to the initial change in injections. In a closed economy without a government, k = 1 ÷ MPS; with government, k = 1 ÷ (MPS + MPT); in an open economy, k = 1 ÷ (MPS + MPT + MPM). With MPS = 0.2, MPT = 0.2 and MPM = 0.1, k = 1 ÷ 0.5 = 2. The national income is found where injections equal withdrawals (or AD = income), then the multiplier gives the full effect of a change in autonomous spending. Net exports (X − M) are a component of AD: exports add to demand and imports are a leakage; they depend on exchange rates, world income and competitiveness.

9.2 Economic growth and sustainability

Growth is driven by investment, technology and human capital; supply-side factors raise LRAS. Measuring it: real GDP, GDP per head, PPP.

Sustainability and the environment

Sustainable development meets present needs without compromising future generations. Environmental costs of growth: pollution, climate change, depletion of resources, loss of biodiversity. The market ignores many external costs, so policy is needed: carbon taxes, permits, regulation, green investment.

Alternative measures of welfare: HDI, green GDP (adjusts for environmental damage and depletion), and genuine progress indicators.

Costs and benefits of growth: higher incomes, jobs, choice and public revenue against inequality, environmental damage, congestion, structural change.

Phases of the cycle

The business cycle: boom, slowdown, recession, recovery; output gap. Policies stabilise the cycle.

Actual growth is the increase in real GDP (using existing capacity); potential growth is the increase in productive capacity (LRAS shifting right). A positive output gap (actual above potential) means inflationary pressure; a negative output gap means spare capacity and unemployment. Causes of the cycle: changes in confidence and expectations, the multiplier and accelerator, stock cycles, interest rate changes, external shocks and policy. Automatic stabilisers (progressive taxes and benefits) dampen the cycle without new decisions.

Policies to promote growth: demand-side (lower interest rates, tax cuts) and supply-side (investment, education, innovation, competition); effectiveness depends on spare capacity and time lags. Inclusive growth is growth whose benefits are widely shared (across income groups, regions and genders); growth can raise or reduce equity: it can increase inequality if gains go to the rich, though a larger economy funds redistribution. Policies for inclusive growth: education and training, support for small firms, regional investment and progressive taxes and benefits. Sustainable growth is growth that does not harm the environment or use up resources needed by future generations: using and conserving resources (recycling, renewable energy, protecting ecosystems) with green taxes and regulation.

9.3 Employment/unemployment

Types and causes

Frictional, structural, cyclical (demand-deficient), seasonal, technological, voluntary and real-wage (classical) unemployment. Technological unemployment is caused by automation and new technology replacing workers; voluntary unemployment is when people choose not to take available jobs at the going wage (for example because benefits are high relative to wages). The natural rate of unemployment is the rate when the labour market is in equilibrium (frictional, structural), and cannot be reduced by demand without inflation.

Labour market flexibility (wage flexibility, ease of hiring and firing, mobility) affects the natural rate. Policies: education and training, relocation help, cuts in benefits (to raise the incentive to work), job-search support, demand management for cyclical unemployment.

The Phillips curve

The short-run Phillips curve shows a trade-off between inflation and unemployment: lower unemployment goes with higher inflation. The long-run Phillips curve is vertical at the natural rate: with adaptive expectations, attempts to hold unemployment below the natural rate lead to accelerating inflation (the expectations-augmented Phillips curve). The stagflation of the 1970s (high unemployment and inflation) challenged the simple trade-off.

Employment trends

Changes in the structure of employment (decline of manufacturing, growth of services), flexible working, the gig economy, ageing populations and technology affect unemployment and skills.

Full employment is the situation when everyone willing and able to work at the going wage has a job, apart from frictional and structural unemployment. Equilibrium unemployment is the unemployment at the labour market's natural level; disequilibrium unemployment (such as real-wage and demand-deficient unemployment) is above it. Hysteresis is where past unemployment raises the natural rate: the long-term unemployed lose skills and motivation and become hard to employ, so unemployment persists after the recession ends. The natural rate is the rate of unemployment when the labour market is in equilibrium and inflation is stable; its determinants include labour market flexibility, benefits, skills and mobility, trade union power and the pace of structural change. Policy implication: demand policy cannot permanently reduce unemployment below it, so supply-side policies are needed.

Mobility of labour: geographical mobility (willingness and ability to move place; limited by housing costs and family ties) and occupational mobility (ability to change jobs and skills; limited by training and qualifications). Greater mobility reduces structural unemployment.

9.4 Money and banking

Money

Functions of money: medium of exchange, store of value, unit of account, standard of deferred payment. Characteristics of good money: acceptable, durable, portable, divisible, scarce, uniform.

Banks and credit

Commercial banks accept deposits and lend: financial intermediaries linking savers and borrowers; they provide payment services, create credit and manage risk. Banks balance liquidity, profitability and security; reserves are kept to meet withdrawals. The credit creation process raises the money supply (the money multiplier).

Securities (financial instruments such as shares, bonds and treasury bills) are traded in financial markets: companies and governments raise funds by issuing them, and savers hold them to earn a return. Banks also hold securities as liquid assets.

Other financial institutions: building societies, investment banks, insurers, stock exchange, the money market.

Central bank

Interest rates and financial markets

Interest rates are the price of money. Demand for money arises from transactions, precautionary and speculative motives (liquidity preference). Determined by supply and demand for money, central bank policy, risk and inflation.

Financial crises: excessive lending, asset bubbles, contagion; bail-outs involve moral hazard (banks that are too big to fail may take excess risk). Regulation raises capital buffers.

Commercial banks lend money (overdrafts, loans, mortgages), accept deposits, hold cash, securities (liquid and investments), loans and deposits and equity (shareholders' funds), and provide payment services. A reserve ratio is the proportion of deposits held in cash or liquid assets to meet withdrawals; a capital ratio is the proportion of assets funded by the bank's own equity, which absorbs losses. Higher ratios make banks safer but limit lending and profit.

The quantity theory of money: MV = PT (money supply × velocity of circulation = price level × volume of transactions). If V and T are constant, a rise in M causes a proportional rise in the price level (monetarists argue inflation is a monetary phenomenon). Quantitative easing raises the money supply in an open economy, but some of the effect leaks through exchange rate falls and capital outflows.

Interest rate determination: the loanable funds theory (the interest rate is set by the supply of savings and demand for borrowing) and the Keynesian (liquidity preference) theory (the rate is set by the demand for money and the supply of money). Policies to reduce inflation: contractionary monetary and fiscal policy (higher interest rates, lower spending), supply-side policies and exchange rate appreciation; they work with lags and cost growth and jobs.