Table of contents
Circular flow of income.............................................................................................................................3
Harrod-Domar model...............................................................................................................................3
Neo-classical Solow growth model............................................................................................................3
Multiplier effect........................................................................................................................................4
Economic shocks.......................................................................................................................................4
Demand side shocks..............................................................................................................................................4
Supply side shocks.................................................................................................................................................4
Economic cycle..........................................................................................................................................5
Characteristics of the economic cycle....................................................................................................................5
Causes of the economic cycle.................................................................................................................................6
Output gaps...........................................................................................................................................................7
Factors affecting the size of the output gap...........................................................................................................7
AD/ AS analysis........................................................................................................................................8
Factors affecting consumption...............................................................................................................................8
Factors affecting investment..................................................................................................................................9
Factors affecting government spending.................................................................................................................9
Factors affecting net exports................................................................................................................................10
Aggregate supply...................................................................................................................................10
Short run aggregate supply..................................................................................................................................10
Factors affecting SRAS..........................................................................................................................................10
Long run aggregate supply...................................................................................................................................10
Factors affecting LRAS..........................................................................................................................................10
Keynesian AS curve..............................................................................................................................................11
Keynesian economics..............................................................................................................................11
Keynesian approaches to macroeconomic policy......................................................................................................................11
Economic growth....................................................................................................................................12
Sustainable economic growth..............................................................................................................................12
Policies to encourage economic growth...............................................................................................................12
Unemployment.......................................................................................................................................14
Natural rate of unemployment............................................................................................................................14
Inflation..................................................................................................................................................16
Causes of inflation...............................................................................................................................................16
Demand pull inflation.................................................................................................................................................................16
Cost push inflation......................................................................................................................................................................16
Monetarist theory of the quantity theory of money..................................................................................................................16
Expectations................................................................................................................................................................................17
Phillips’s curve.....................................................................................................................................................17
Stagflation...........................................................................................................................................................17
Balance of payments..............................................................................................................................23
, Capital account....................................................................................................................................................23
Financial account.................................................................................................................................................24
Current account...................................................................................................................................................24
Factors affecting current account.........................................................................................................................24
Policies to reduce a current account deficit..........................................................................................................28
Expenditure reducing policy.......................................................................................................................................................28
Expenditure switching policy......................................................................................................................................................28
Long-term supply-side policies...................................................................................................................................................29
Fiscal policy............................................................................................................................................30
Taxation...............................................................................................................................................................30
Government spending.........................................................................................................................................34
Determinants of the fiscal multiplier...................................................................................................................34
Automatic fiscal policy (stabilisation)...................................................................................................................35
Financing government borrowing........................................................................................................................35
Supply side policies.................................................................................................................................42
Monetary policy.....................................................................................................................................51
Factors considered by the MPC when setting the bank rate.................................................................................51
Bank rate transmission mechanism (bank rate cut).............................................................................................52
Liquidity trap.......................................................................................................................................................52
Reasons why liquidity traps occur........................................................................................................................53
Policies to solve the liquidity trap........................................................................................................................53
Quantitative Easing (QE)......................................................................................................................................56
Forward guidance................................................................................................................................................59
Funding for Lending Scheme................................................................................................................................60
Financial markets...................................................................................................................................60
Role of financial markets............................................................................................................................................................61
Characteristics of money............................................................................................................................................................61
Functions of money....................................................................................................................................................................61
Components of the money supply.............................................................................................................................................61
Commercial banks.......................................................................................................................................................................62
Investment banks........................................................................................................................................................................62
Central bank................................................................................................................................................................................63
Financial crises.....................................................................................................................................................63
Exchange rates.......................................................................................................................................74
Determinants of the exchange rate......................................................................................................................74
Types of exchange rate systems..............................................................................................................79
Freely floating exchange rate...............................................................................................................................79
Fixed exchange rate.............................................................................................................................................81
Limitations to central bank intervention to manage a currency’s value...............................................................81
Managed exchange rate.......................................................................................................................................82
Adjustable peg exchange rate..............................................................................................................................82
Economic integration..............................................................................................................................83
European Union...................................................................................................................................................83
, Monetary/ currency union...................................................................................................................................85
Trade and globalisation..........................................................................................................................87
Comparative advantage..............................................................................................................................................................87
Gains from trade.........................................................................................................................................................................87
Explain the factors which may cause changes in a country’s pattern of trade..........................................................................87
Protectionist policies...............................................................................................................................93
Circular flow of income
The circular flow of income is a model of the economy where income and spending flow between households and firms.
Incorporates injections and leakages from the flow of income. Injections are extra money placed into the circular flow
while leakages are taken out.
Investment
Government
expenditure
Firms
Exports
Factors of Goods and
production services
Consumption Income
Households Savings
Taxation
Imports
Macroeconomic equilibrium occurs when there is no tendency for the level of national income to change. This can be
where injections = leakages. If the government wishes to increase national income, it would have to increase government
spending, encourage investment or increase exports.
Harrod-Domar model
A higher capital stock increases economic growth
Increased savings may also have an effect
Neo-classical Solow growth model
, The greater the capital per worker, the greater the increase in growth
Workers will have access to improved capital machinery which in the long
run
will improve productivity
Multiplier effect
The multiplier effect is how a change in AD leads to a proportionately larger change in overall national income. Changes in
AD will also be affected by the multiplier effect which leads to even greater change in national output. This is known as a
‘virtuous cycle’ as money transfers between agents gets injected into the circular flow of income.
1. Fiscal multiplier
2. Tax multiplier
3. Investment multiplier
4. Export multiplier
5. Import multiplier
Marginal propensity to consume determines the size of the multiplier as it depends on any money received being passed
on around the economy as extra expenditure. The higher the MPC, the greater size of the multiplier effect.
Economic shocks
Economic shocks are a sudden unexpected event that affects the macroeconomy especially the growth rate
Demand side shocks
Demand side shocks are unexpected and significant changes in the level of AD. They affect:
National income – economic growth
Unemployment
Inflation
Caused by:
1. Banking crisis which affected both business and consumer confidence significantly
2. Unexpectedly large change in the exchange or interest rate
Supply side shocks
Supply side shocks are unexpected and significant changes in the price of factors of production or the availability of
factors of production. They affect:
Willingness for firms to produce output and change in SRAS
Inflation
Unemployment
Caused by:
1. Changes in commodity prices (e.g., oil crises)
2. Significant crop failure in an important product
Circular flow of income.............................................................................................................................3
Harrod-Domar model...............................................................................................................................3
Neo-classical Solow growth model............................................................................................................3
Multiplier effect........................................................................................................................................4
Economic shocks.......................................................................................................................................4
Demand side shocks..............................................................................................................................................4
Supply side shocks.................................................................................................................................................4
Economic cycle..........................................................................................................................................5
Characteristics of the economic cycle....................................................................................................................5
Causes of the economic cycle.................................................................................................................................6
Output gaps...........................................................................................................................................................7
Factors affecting the size of the output gap...........................................................................................................7
AD/ AS analysis........................................................................................................................................8
Factors affecting consumption...............................................................................................................................8
Factors affecting investment..................................................................................................................................9
Factors affecting government spending.................................................................................................................9
Factors affecting net exports................................................................................................................................10
Aggregate supply...................................................................................................................................10
Short run aggregate supply..................................................................................................................................10
Factors affecting SRAS..........................................................................................................................................10
Long run aggregate supply...................................................................................................................................10
Factors affecting LRAS..........................................................................................................................................10
Keynesian AS curve..............................................................................................................................................11
Keynesian economics..............................................................................................................................11
Keynesian approaches to macroeconomic policy......................................................................................................................11
Economic growth....................................................................................................................................12
Sustainable economic growth..............................................................................................................................12
Policies to encourage economic growth...............................................................................................................12
Unemployment.......................................................................................................................................14
Natural rate of unemployment............................................................................................................................14
Inflation..................................................................................................................................................16
Causes of inflation...............................................................................................................................................16
Demand pull inflation.................................................................................................................................................................16
Cost push inflation......................................................................................................................................................................16
Monetarist theory of the quantity theory of money..................................................................................................................16
Expectations................................................................................................................................................................................17
Phillips’s curve.....................................................................................................................................................17
Stagflation...........................................................................................................................................................17
Balance of payments..............................................................................................................................23
, Capital account....................................................................................................................................................23
Financial account.................................................................................................................................................24
Current account...................................................................................................................................................24
Factors affecting current account.........................................................................................................................24
Policies to reduce a current account deficit..........................................................................................................28
Expenditure reducing policy.......................................................................................................................................................28
Expenditure switching policy......................................................................................................................................................28
Long-term supply-side policies...................................................................................................................................................29
Fiscal policy............................................................................................................................................30
Taxation...............................................................................................................................................................30
Government spending.........................................................................................................................................34
Determinants of the fiscal multiplier...................................................................................................................34
Automatic fiscal policy (stabilisation)...................................................................................................................35
Financing government borrowing........................................................................................................................35
Supply side policies.................................................................................................................................42
Monetary policy.....................................................................................................................................51
Factors considered by the MPC when setting the bank rate.................................................................................51
Bank rate transmission mechanism (bank rate cut).............................................................................................52
Liquidity trap.......................................................................................................................................................52
Reasons why liquidity traps occur........................................................................................................................53
Policies to solve the liquidity trap........................................................................................................................53
Quantitative Easing (QE)......................................................................................................................................56
Forward guidance................................................................................................................................................59
Funding for Lending Scheme................................................................................................................................60
Financial markets...................................................................................................................................60
Role of financial markets............................................................................................................................................................61
Characteristics of money............................................................................................................................................................61
Functions of money....................................................................................................................................................................61
Components of the money supply.............................................................................................................................................61
Commercial banks.......................................................................................................................................................................62
Investment banks........................................................................................................................................................................62
Central bank................................................................................................................................................................................63
Financial crises.....................................................................................................................................................63
Exchange rates.......................................................................................................................................74
Determinants of the exchange rate......................................................................................................................74
Types of exchange rate systems..............................................................................................................79
Freely floating exchange rate...............................................................................................................................79
Fixed exchange rate.............................................................................................................................................81
Limitations to central bank intervention to manage a currency’s value...............................................................81
Managed exchange rate.......................................................................................................................................82
Adjustable peg exchange rate..............................................................................................................................82
Economic integration..............................................................................................................................83
European Union...................................................................................................................................................83
, Monetary/ currency union...................................................................................................................................85
Trade and globalisation..........................................................................................................................87
Comparative advantage..............................................................................................................................................................87
Gains from trade.........................................................................................................................................................................87
Explain the factors which may cause changes in a country’s pattern of trade..........................................................................87
Protectionist policies...............................................................................................................................93
Circular flow of income
The circular flow of income is a model of the economy where income and spending flow between households and firms.
Incorporates injections and leakages from the flow of income. Injections are extra money placed into the circular flow
while leakages are taken out.
Investment
Government
expenditure
Firms
Exports
Factors of Goods and
production services
Consumption Income
Households Savings
Taxation
Imports
Macroeconomic equilibrium occurs when there is no tendency for the level of national income to change. This can be
where injections = leakages. If the government wishes to increase national income, it would have to increase government
spending, encourage investment or increase exports.
Harrod-Domar model
A higher capital stock increases economic growth
Increased savings may also have an effect
Neo-classical Solow growth model
, The greater the capital per worker, the greater the increase in growth
Workers will have access to improved capital machinery which in the long
run
will improve productivity
Multiplier effect
The multiplier effect is how a change in AD leads to a proportionately larger change in overall national income. Changes in
AD will also be affected by the multiplier effect which leads to even greater change in national output. This is known as a
‘virtuous cycle’ as money transfers between agents gets injected into the circular flow of income.
1. Fiscal multiplier
2. Tax multiplier
3. Investment multiplier
4. Export multiplier
5. Import multiplier
Marginal propensity to consume determines the size of the multiplier as it depends on any money received being passed
on around the economy as extra expenditure. The higher the MPC, the greater size of the multiplier effect.
Economic shocks
Economic shocks are a sudden unexpected event that affects the macroeconomy especially the growth rate
Demand side shocks
Demand side shocks are unexpected and significant changes in the level of AD. They affect:
National income – economic growth
Unemployment
Inflation
Caused by:
1. Banking crisis which affected both business and consumer confidence significantly
2. Unexpectedly large change in the exchange or interest rate
Supply side shocks
Supply side shocks are unexpected and significant changes in the price of factors of production or the availability of
factors of production. They affect:
Willingness for firms to produce output and change in SRAS
Inflation
Unemployment
Caused by:
1. Changes in commodity prices (e.g., oil crises)
2. Significant crop failure in an important product
