Sunny’s IB Economics

Sunny’s
IB Economics
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Unit 3: Macroeconomics p .n
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(Standard Level)e
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Parte1.
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Sunny’s Econ
Blog.naver.com/econmania

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 Sunny’s IB Economics

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 Sunny’s IB Economics

Contents
Unit 3. Macroeconomics

3.1 Measuring economic activity and illustrating its variations

3.2
Variations in economic activity
- aggregate demand and aggregate supply

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Part 1

3.3

3.4
Macroeconomic objectives

Economics of inequality and poverty

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3.5
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Demand management (demand-side policies) - monetary policy

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Part 2

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3.6 Demand management - fiscal policy

3.7 Supply-side policies

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3.1 Measuring economic activity and illustrating its variations

3.1.A. Economic activity

LOS 1. Describe, using a diagram, the circular flow of income between households and
firms in a closed economy with no government.

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LOS 2. Identify the four factors of production and their respective payments (rent, wages,

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interest and profit) and explain that these constitute the income flow in the model.
LOS 3. Outline that the income flow is numerically equivalent to the expenditure flow
and the value of output flow.

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All exchange in a market take place in either the ‘ product market’ or the ‘resource market’.

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Households are the ‘owners’ of productive resources, which are the inputs firms need in order to
produce goods and services. To acquire the inputs for production, firms must pay households

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for their resources in the resource market. Households earn their income in the resource market

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and then demand the finished products provided by firms in the product market. The flow of

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resources, money, and goods and services is illustrated in a model of economists called the

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circular flow of income.

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Market

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Households Firms

Product Market

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Households are owners of the four factors of production: land, labour, capital and
entrepreneurship. Firms buy the factors of production in resource markets and use them to
produce goods and services. They then sell the goods and services to consumers in product
markets. We therefore see a flow in the clockwise direction of factors of production from
households to firms, and of goods and services from firms to households.

In the counterclockwise direction, there is a flow of money used as payment in sales and
purchases. When households sell their factors of production to firms, they receive payments
taking the form of rent (for land), wages (for labour), interest (for capital) and profit (for

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entrepreneurship). These payments are the income of households. The payments that

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households make to buy goods and services are household expenditures (or consumer
spending). The payments that firms make to buy factors of production represent their costs of

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production, and the payments they receive by selling goods and services are their revenues.

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This model demonstrates an important principle: the income flow from firms to households is

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equal to the expenditure flow from households to firms. In other words, the household
incomes coming from the sale of all the factors of production equals the expenditures by

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households on goods and services. This is the circular flow of income. In addition, these two

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flows must be equal to the value of goods and services, or the value of total output produced

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by the firms, known as the value of output flow.

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Thus, the circular flow of income shows that in any given time period, the value of output

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produced in an economy is equal to the total income generated in producing that output,
which is equal to the expenditures made to purchase that output.

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Total Income = Total Expenditure = Total value of output flow(GDP)

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LOS 4. Describe, using a diagram, the circular flow of income in an open economy with
government and financial markets, referring to leakages/ withdrawals (savings,
taxes and import expenditure) and injections (investment, government
expenditure and export revenue).

We can now introduce additional elements into the model to make it more realistic. There are
other actors in the system and that money exits and enters the system in a variety of ways.

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Injections are insertions of money into the circular flow and include government spending,

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export purchases, and investments. Leakages are the diversions of money outside the circular

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flow and occur when the government collects taxes, imports are purchased, or when people

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save money.

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Households Firms

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• The government sector: taxes and spending
Governments draw tax money from the population, a leakage of income out of the model.
However, the money should eventually re-enter the model as government spending on
everything from salaries to infrastructure.

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• The financial sector: saving and investment

Some consumers save a portion of their money, rather than spend it. Savings would slow
down the flow of expenditure and eventually income. However, money that is saved in
banks is made available to borrowers. These borrowers then inject the savings back into the
economy in the form of investment, whether as capital goods or by the purchase of housing
by households.

• The foreign sector: imports and exports

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If we assume that some of the money spent in either the factor or product market is spent
on imported goods, then that income will leak from the system. However, some of money
enter into the domestic market in the form of exports sold to other countries.

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LOS 5. Explain how the size of the circular flow will change depending on the relative
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size of injections and leakages.

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In the real world, leakages and injections are unlikely to be equal, and this has important
consequences for the size of the circular flow. If a leakage is greater than an injection, then

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the size of the circular flow becomes smaller. Suppose saving (a leakage) is larger than
investment (an injection). This means that part of the household income that leaks as saving

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into financial markets does not come back into the flow as investment. The result is that fewer

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goods and services are purchased, firms cut back on their output, they buy fewer factors of
production, unemployment increases (since firms buy a smaller quantity of labour) and

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household income is reduced.

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If a leakage is smaller than an injection, the size of the circular flow becomes larger. Suppose
spending on exports is greater than spending on imports; then the expenditure flow increases

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since the injection is larger than the leakage. Foreigners demand more goods and services,
firms begin to produce more by purchasing more factors of production, unemployment falls
(as firms buy a larger quantity of labour), and household income increases.

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3.1.B. Measures of economic activity

LOS 1. Examine the output approach, the income approach and the expenditure
approach when measuring national income.

Measurement of economic activity involves measuring an economy’s national income or the

value of output, and is referred to as ‘national income accounting’. The output of an economy
is referred to as ‘aggregate output’, which means total output.Knowing national income and

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the value of aggregate output is very useful because this allows us to:

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• assess an economy’s performance over time

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• make comparisons of income and output performance with other economies
• establish a basis for making policies that will meet economic objectives

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The circular flow model illustrates the essential idea that all the spending in the economy will

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roughly equal all the income received. With this in mind, economists have three main

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methods of counting national income:

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① Expenditure approach adds up all spending to buy final goods and services produced

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within a country over a time period.

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② Income approach adds up all income earned by the factors of production that produce all
goods and services within a country over a time period.

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③ Output approach calculates the output approach calculates the value of all final goods and
services produced in a country over a time period.

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① Expenditure approach
The expenditure approach measures the total amount of spending to buy final goods and
services in a country (usually within a year). The term ‘final’ refers to goods and services
ready for final use, and can be contrasted with intermediate goods and services, or those
purchased as inputs for the production of final goods.

GDP= C + I + G + NX(=X-M)
• Consumption (C) includes all purchases by households on final goods and services in a

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year (except housing, which is classified under investment).
• Investment(I) includes
⁃ spending by firms on capital goods (i.e. buildings, machinery, equipment, etc.)
⁃ spending on new construction (housing and other buildings).

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• Government Spending(G) includes spending on goods and services by local, state and
federal government. It includes purchases by the government of factors of production,

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including labour services. It also includes investment by government, which is referred to

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as ‘public investment’ (usually on capital goods including roads, airports, power
generators, building schools and hospitals, etc.).

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• Net Exports(NX) count all exports as an inflow and thus an increase in GDP while

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subtracting imports as an outflow and a decreases in GDP.

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Net export(NX) = export revenue (X) – import payment (M)

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Gross domestic product or GDP is defined as the market value of all final goods and
services produced in a country over a time period (usually a year). It includes spending by

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the four components, C+I+G+ (X−M). It is one of the most commonly used measures of

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the value of aggregate output.

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② Income approach
The income approach adds up all income earned by the factors of production within a
country over a time period (usually a year): wages earned by labour, rent earned by land,

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interest earned by capital, and profits earned by entrepreneurship. When all factor incomes
are added up, the result is national income. Whereas national income is often used as a
measure of the level of economic activity, it is not the same as GDP. To calculate GDP
using the income approach, it is necessary to make some adjustments to national income.

③ Output approach
The output approach measures the value of each good and service produced in the
economy over a particular time period (usually a year) and then sums them up to obtain the
total value of output produced. When adding production, however, it would be easy to
double count by counting goods that are intermediate goods and then counting the final
products. To avoid this, economics attempts to identify the value added at each stage of
the production process.
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LOS 2. Distinguish between GDP and GNI as measures of economic activity.

National income accounting is a term that describes a set of principles and standards used by
countries to measure their production and income. The most commonly used measure of a
country’s national income is gross domestic product(GDP).

Gross domestic product (GDP) is the total value of all final economic production in a country
in a given year regardless of who owns the productive assets.

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Gross national income(GNI) is the market value of all the products and services produced in a
given time period by the labor and capital supplied by the residents of a country regardless of

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where the assets are located.

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GDP refers to all production domestically, or within the geographical area. GNI suggests that
nationality of ownership is paramount for this measure. Countries that have a much higher

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GNP than GDP are likely to have workers or firms overseas who send income back to home
country accounts. Countries with higher GDP than GNP may have significant foreign

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presence, in either workers or companies. Therefore, they suffer a net income loss when GDP

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is compared to their GNP. Net income is reduced by the outflow of foreign-earned income on

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the country’s soil.

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LOS 3. Distinguish between the nominal value of GDP and GNI and the real
value of GDP and GNI.

GDP measures the total spending on goods and services in all markets in the economy. If total
spending rises from one year to the next, at least one of two things must be true:
1) the economy is producing a larger output of goods and services, or
2) goods and services are being sold at higher prices.

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Nominal value is money value, or value measured in terms of prices that prevail at the time of
measurement.

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Real value is a measure of value that takes into account changes in prices over time.

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Nominal GDP or GNI is measured in terms of current prices (prices at the time of

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measurement), which does not account for changes in prices.

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Real GDP or real GNI are measures of economic activity that have eliminated the influence of
changes in prices. When a variable is being compared over time, it is important to use real

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values.

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Because real GDP is not affected by changes in prices, changes in real GDP reflects only
changes in the amounts being produced. Thus, real GDP is more accurate measurement in

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calculating economy’s production of goods and services. Also, to compare GDP data over
time it is necessary to use the real GDP so that price changes cannot distort the true economic
activity.

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LOS 4. Distinguish between total GDP and GNI and per capita GDP and GNI.

While real GDP adjusts for price changes, economists use another measure to adjust for
population size.

The total GDP and GNI provide a summary statement of the overall size of an economy. On
the other hand, per capita GDP is the amount of national income divided by the population
size. It gives us a better sense of the approximate standard of living or productivity in a

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country than total GDP does. While per capita information allows us to better compare one
country to another, it tells us little about the income distribution within the country itself.

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LOS 5. Explain the meaning real GDP/GNI per capita at purchasing power parity(PPP)
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Purchasing power parities(PPP) means ‘buying power equivalence’ and is defined as the
amount of a country's currency that is needed to buy the same quantity of local goods and

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services that can be bought with USD 1 in the United States. The use of PPPs to make
comparisons of any measure, whether GDP or GNI, eliminate the influence of price level

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differences and makes comparison across countries far more accurate.

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Comparisons of GDP per capita (or GNI per capita) across countries require measures of per

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capita output or income based on conversions of national currencies into USD by use of
purchasing power parities(PPPs) to eliminate the influence of price differences on the value of
output or income.

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LOS 6. Calculate nominal GDP from sets of national income data, using the expenditure
approach
LOS 7. Calculate GNI from data

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GNI = GDP + income from abroad − income sent abroad

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‘Income from abroad – income sent abroad’ can be simply written as ‘net income from

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abroad’. We therefore have:

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GNI = GDP + net income from abroad

Note that in the United Kingdom and in some other countries, ‘net income from abroad’ may

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be referred to as ‘net property income from abroad’. In the United States, it is sometimes
referred to as ‘net foreign factor income’.

• Calculate gross domestic product (GDP):

• Calculate gross national income (GNI):

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LOS 8. Calculate real GDP, using a price deflator.

Price of Quantity of Price of Quantity of

Year
Hot Dogs Hot Dogs Hamburgers Hamburgers
2010
$1 100 $2 50
(Base year)

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2011 $2 150 $3 100

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2012 $3 200 $4 150

Nominal GDP Real GDP

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GDP Deflator

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2010
(base year)

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2011

2012

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As we have just seen, nominal GDP reflects both the quantities of goods and services the

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economy is producing and the prices of those goods and services. By contrast, by holding
prices constant at bas-year levels, real GDP reflects only the quantities produced. Also, we

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can calculate GDP deflator which reflects only the prices of goods serves.

w w GDP Deflator = Nominal GDP

Real GDP
* 100

Note that an increasing GDP deflator indicates rising prices on average while a decreasing
GDP deflator indicates falling prices on average.

Real GDP = Nominal GDP

* 100
GDP Deflator

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3.1.C. Business cycle

LOS 1. Explain business cycle.

Whereas real output in most countries around the world grows over long periods of time,
output growth virtually everywhere in the world is uneven and irregular. In some years (or
months) real output may grow rapidly, in other years (or months) more slowly, and in still
others it may even fall, indicating negative growth.

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Fluctuations in the growth of real output, consisting of alternating periods of expansion
(increasing real output) and contraction (decreasing real output), are called business cycles, or
economic fluctuations.

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Real GDP Peak

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Expansion

Peak

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Trough
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• Expansion: An expansion occurs when there is positive growth in real GDP, shown by the

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curve that slope upward. During periods of real GDP growth, employment of resources
increases, and the general price level of the economy (which is an average over all prices)
usually begins to rise more rapidly.

w• Peak: A peak represents the cycle’s maximum real GDP, and marks the end of the expansion.
When the economy reaches a peak, unemployment of resources has fallen substantially, and
the general price level may be rising quite rapidly; the economy is likely to be experiencing
inflation.

• Contraction: Following the peak, the economy begins to experience falling real GDP
(negative growth), shown by the downward-sloping parts of the curve. If the contraction
lasts six months (two quarters) or more, it is termed a recession, characterised by falling real
GDP and growing unemployment of resources. Increases in the price level may slow down a
lot, and it is even possible that prices in some sectors may begin to fall.

• Trough: A trough represents the cycle’s minimum level of GDP, or the end of the contraction.
There may now be widespread unemployment. A trough is followed by a new period of
expansion (also known as a recovery), marking the beginning of a new cycle.
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LOS. 2: Distinguish between short-run fluctuations and the long-term trend(potential output)
and draw a diagram illustrating these.

The straight line going through the cyclical line represents average growth over long periods of
time (many years), and is known as the long-term growth trend. The long-term growth trend shows
how output grows over time when cyclical fluctuations are ironed out. Real GDP actually achieved
fluctuates around potential GDP (it fluctuates around the long-term growth trend). The output
represented by the long-term growth trend is known as potential output or potential GDP.

Real GDP actually achieved

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Real GDP

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Long -term growth trend,

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or potential output

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(potential GDP)

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• When the economy’s actual GDP is equal to potential GDP, the economy is achieving full
employment, where unemployment is equal to the natural rate of unemployment.

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• When the economy’s actual GDP is greater than potential GDP, there is an output gap, and

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unemployment falls to less than the natural rate of unemployment.

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• When actual GDP is less than potential GDP, there is an output gap where unemployment is
greater than the natural rate of unemployment.

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When actual GDP lies above potential GDP, or below potential GDP, there results a GDP gap, also
known as an output gap. The output gap is simply actual GDP minus potential GDP, and may be
positive or negative. When actual GDP is equal to potential GDP, the output gap is equal to zero.

Using the business cycle, we can understand macroeconomic objectives to include the following:
• Reducing the intensity of expansions and contractions: this is aimed at making output gaps as
small as possible by flattening the cyclical curve. This would lessen the problems of rising price
levels in expansions and unemployment in contractions.
• Increasing the steepness of the line representing potential output, by achieving more rapid
economic growth over long periods of time.

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3.1.D. Appropriateness of using GDP or GNI statistics to measure economic

well-being

LOS. 1: Evaluate the use of national income statistics, including their use for making
comparisons over time, their use for making comparisons between countries and
their use for making conclusions about economic well-being.

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When real per capita GDP or real per capita GNI of a country increases over time, we might
expect that the population of this country achieves a higher standard of living. However, we

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cannot be sure. There are two reasons why this is so. One is that national income statistics (or

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statistical data used to measure national income and output and other measures of economic

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performance) do not accurately measure the ‘true’ value of output produced in an economy.

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The other is that standards of living are closely related to a variety of factors that GDP and
GNI are unable to account for. As a result, per capita figures of both GDP and GNI may be

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misleading when used to make comparisons over time or comparisons between countries, and
when used as the basis for standard of living conclusions.

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Why national income statistics (GDP/GNI) do not accurately measure the ‘true’ value of
output

① GDP and GNI do not include non-marketed output.

GDP measures the value of goods and services that are traded in the marketplace and that
generate incomes for the factors of production. Yet some output of goods and services is
not sold in the market and does not generate any income; this is called ‘non-marketed
output’. An example is one’s own work on repairing and improving one’s home; if the
home repairs were carried out by hired workers, GDP would be greater by the amount of
their wages. In less developed countries households are often quite self-sufficient, with a
substantial portion of production, such as agricultural production, taking place for a

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household’s own use and consumption, and never reaching the marketplace. Non-marketed

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output therefore is likely to be far greater in less developed countries compared to more

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developed ones.

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② GDP and GNI do not include output sold in underground (parallel) markets.
An ‘underground market’ (also known as a ‘parallel’ or an ‘informal market’) exists

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whenever a buying/selling transaction is unrecorded. It may involve the sale of legal goods
and services, such as reselling a good at a higher price if there is a price ceiling; or when a

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plumber does repairs in your home and does not report the income received to avoid

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paying taxes or in transactions involving illegal goods and services (such as drugs).

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③ GDP and GNI do not take into account quality improvements in goods and services.
The quality of many products improves over time, yet this is not taken into account in

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calculating the value of total output. Technological advances often permit improved

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products to be sold at lower prices (for example, mobile phones and computers). This
process offers significant benefits to consumers, which do not show up in GDP and GNI
figures.

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④ GDP and GNI do not account for the value of negative externalities, such as

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pollution, toxic wastes and other undesirable by-products of production.
Virtually all countries contribute to environmental degradation, reducing society’s
wellbeing, though this is not reflected in GDP/GNI figures.

⑤ GDP and GNI do not take into account the depletion of natural resources.
The depletion of natural resources (rainforests, wildlife, agricultural soils, etc.) also
reduces society’s well-being, yet is not taken into consideration.

⑥ GDP and GNI and differing domestic price levels.

Goods and services often sell for very different prices in different countries. If international
comparisons of GDP do not account for differing price levels across countries, the result is
a highly misleading picture of standards of living in different countries. This problem can
be effectively dealt with if we convert values of GDP/GNI of different countries into a
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Why measures of the value of output (GDP/GNI) cannot accurately measure standards
of living
① GDP and GNI make no distinctions about the composition of output.
Whether a country produces military goods (weapons, guns, tanks, etc.) or merit goods
(education, health care, clean water supplies, and other services) or any other type of goods,
GDP and GNI include the value of all without any distinctions about the degree to which
they contribute to standards of living. One country may have a lower per capita GDP than
another, but higher levels of social services and merit goods provision than the other.
Which has higher standards of living? The GDP and GNI measures are unable to provide
an indication.

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② GDP and GNI cannot reflect achievements in levels of education, health and life
expectancy.

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A society’s levels of health and education contribute significantly to standards of living.

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Countries may achieve higher or lower levels of health and education with a given amount

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of GDP/GNI per capita, but these remain unaccounted for in measures of GDP and GNI.
Increased life expectancy is another benefit of technological improvements, improved

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health and higher income levels that has contributed enormously to a higher standard of
living, but is not accounted for in GDP and GNI figures. An alternative and broader

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measure, the Human Development Index (HDI), has been developed to reflect a society’s

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achievements in the areas of health and education as well as income levels.

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③ GDP and GNI provide no information on the distribution of income and output.
How equally or unequally income and output are distributed is another factor underlying

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society’s well-being. Are the wealth and income of a nation highly concentrated in
relatively few hands while large portions of the population are unable to satisfy their basic

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needs, or are these relatively more equally distributed? Are the benefits of a growing GDP
concentrated among a small group of beneficiaries, or are they widely distributed? Are

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inequalities increasing or decreasing? Measures of GDP or GNI per capita cannot address
any of these questions, as they only provide an indication of average output or average

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income per person.

④ GDP and GNI do not take into account increased leisure.

In many countries around the world the average number of hours worked per week has
declined significantly, with the number of hours of leisure correspondingly increasing. This
contributes to society’s standard of living, yet is not accounted for in GDP or GNI.

⑤ GDP and GNI do not account for quality of life factors.

A society’s well-being depends upon a number of non-economic factors, such as the crime
rate, a sense of security and peace arising from relations with other countries, well
functioning institutions, stress levels from working conditions, the degree of political
freedom, and many others. GDP and GNI cannot account for any of these.
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To make comparisons over time, we must use real values of income and output measures,
which take into account changes in the price level over time. Yet even when using real values
of income and output, it is clear from the discussion above that comparisons of real GDP/
GNI over time may be misleading. An increase in real GDP of some percentage for a
particular country may overestimate or underestimate the true change in the population’s
standards of living because of such factors as improved product quality, improvements in
health and education, increased leisure, improvements (or deterioration) in quality of life
factors, possible changes in the value of non-marketed output, or in the size of underground
markets, and so on.

e t
Both the inability of GDP/GNI to measure the true value of output, and the exclusion of many
standard of living factors, similarly contribute to limiting the validity of international

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comparisons by use of these measures. For example, one country may have a high level of
GDP per capita, which is concentrated among a small percentage of the population, while

p
another may have a lower level of GDP per capita, which is more equally distributed. A

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comparison of GDP/GNI figures will not reveal any information on this point, as well as on

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many other points listed above. An important issue for international comparisons involves

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different domestic price levels, discussed above which if ignored presents misleading

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conclusions.

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LOS 2. Explain alternative measures of well-being

• OECD Better Life Index
• Happiness Index
• Happy Planet Index

① OECD Better Life Index

The OECD(Organisation of Economic Co-operation and Development) has developed the
OECD Better Lift Index(since 2011). The purpose of this measure is to provide a more

t
accurate representation of well-being and to form the basis of policies intended to improve

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the quality of life and well-being more generally.

② Happiness Index

p .n
The Happiness Index began to be compiled in 2012 by the United Nations Sustainable
Development Network. The goal is to address the interdependent economic, social and
environmental challenges faced by the world.
• Real GDP per capita

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• Social support
• Health lift expectancy

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• Freedom to make life choices

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• Generosity
• Perceptions of corruption

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③ The Happy Planet Index(HPI)

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The Happy Planet Index(HPI) was developed by the New Economics Foundation. The goal
is to explore new economic models based on equality, diversity and economic stability.

w
HPI = Lift expectancy * well-being * inequality of outcomes
Ecological footprint

w The Happiness index is concerned with personal happiness while the HPI is concerned
with happiness of the planet. HPI is therefore much more of a measure of sustainability and
how well resources can support a population’s well-being.

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3.2 Variations in economic activity: aggregate demand and

aggregate supply

3.2.A. Aggregate demand(AD)

LOS 1. Explain the aggregate demand curve in terms of its components: consumption (C),
investment(I), government spending (G), net export (X-M).

Aggregate demand is the total amount of real output (real GDP) that consumers, firms, the

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government and foreigners want to buy at each possible price level, over a particular time t
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period. The aggregate demand (AD) curve shows the relationship between the total amount of
real output demanded by the four components and the economy’s price level over a particular

p
time period. It is downward-sloping, indicating a negative relationship between the price level

e
and aggregate output demanded.

p r
Aggregate demand consists of all the components of aggregate expenditure.

r
• the demand of consumers (C)

e
• the demand of businesses (firms) (I)
• the demand of government (G)

s t
• the demand of foreigners for exports (X) minus the demand for imports (M) (X−M or net

a
exports)

.M
GDP = C + I + G + NX(=X-M) = Total expenditure = Aggregate demand(AD)

w w
Price

w
Level

Real GDP

23
 Sunny’s IB Economics

LOS 2. Explain the determinants of the components of aggregate demand(AD), and draw
AD.

The aggregate demand curve can shift to the right or to the left. It is important to distinguish
between movements along the aggregate demand curve, caused by changes in the price level,
and shifts of the aggregate demand curve, caused by the determinants of aggregate demand. The
determinants of aggregate demand, or the factors that can shift the aggregate demand curve are
consumption, investment, government spending and net export.

Price

e t
n
Level

p .
re
rp Real GDP

te
s
① Causes of changes in consumption spending

M a
• Consumer confidence
Consumer confidence is a measure of how optimistic consumers are about their future

w .
income and the future of the economy. If consumers expect their incomes to increase, or if
they are optimistic about the future of the economy, they are likely to spend more on buying
goods and services, and the AD curve shifts to the right. Low consumer confidence indicates

w
expectations of falling incomes and worsening economic conditions, due to fears of cuts in
wages or unemployment, causing decreases in spending, appearing as a leftward shift of the

w
AD curve.

• Interest rates
Some consumer spending is financed by borrowing, and so is influenced by interest rate
changes. An increase in interest rates makes borrowing more expensive, resulting in lower
consumer spending, and therefore a leftward shift in the AD curve. A fall in interest rates
makes borrowing less expensive, and results in more consumer spending and a rightward
shift in the AD curve.

24
 Sunny’s IB Economics

• Wealth
Wealth is the value of assets that people own, such as savings in their bank accounts, houses,
stocks and bonds and so on; minus debt to banks or other financial institutions. An increase
in consumer wealth makes people feel wealthier; therefore, they spend more and the AD
curve shifts to the right. A decrease in wealth lowers aggregate demand; the AD curve shifts
to the left.

• Personal income taxes (and hence disposable income)

t
Increase in income taxes means decreases in disposable income which is the amount of
income consumers can actually spend. Thus, consumers should reduce the level of spending.

• Level of household indebtedness

.n e
p
‘Indebtedness’ refers to how much money people owe from taking out loans in the past. If
consumers have a high level of debt (due to past use of credit cards or taking out loans to

e
finance consumption), then they are under pressure to make high monthly payments to pay

p r
back their loans plus interest, and so are likely to cut back on their present expenditures.
Therefore, a high level of indebtedness lowers consumption spending and shifts the AD

r
curve to the left. A low level of indebtedness increases consumption spending and shifts the

e
AD curve to the right.

• Expectations of future price levels

s t
a
If consumers expect prices of goods and services to fall, they may postpone spending as they
wait for prices to fall, causing AD to decrease, shift AD to the left. On the other hand if they

M
expect future prices to increase, they buy more now in order to avoid the higher prices later,

.
thus causing AD to increase shifting to the right.

w w
② Causes of changes in investment spending

• Business confidence

w Business confidence refers to how optimistic firms are about their future sales and economic
activity. If businesses are optimistic, they spend more on investment, and the AD curve shifts
to the right. Business pessimism, on the other hand, results in a leftward shift in the AD
curve.

• Interest rates
Increases in interest rates raise the cost of borrowing, and force businesses to reduce
investment spending financed by borrowing, and therefore the AD curve shifts to the left.
Decreases in interest rates mean businesses can now finance their investment spending by
borrowing at a lower cost, and the AD curve shifts to the right.

25
 Sunny’s IB Economics

• Technology
Improvements in technology stimulate investment spending, thus causing increases in
aggregate demand and a rightward shift in the AD curve.

• Business taxes
If the government increases taxes on profits of businesses, firms’ after-tax profits fall;
therefore, investment spending decreases and the AD curve shifts to the left. Decreases in
taxes on profits result in increased aggregate demand and a rightward AD curve shift.

• Level of corporate indebtedness

e t
n
If businesses have high levels of debt due to having borrowed a lot in the past, they will be

.
less inclined to make investments and the AD curve shifts to the left. A low level of corporate

p
indebtedness, on the other hand, leads to more investment and a rightward shift in the AD
curve.

③ Causes of changes in government spending

re
• Changes in political priorities

rp
te
Governments have many expenditures, arising from provision of merit goods and public
goods, spending on subsidies and pensions, payments of wages and salaries to its employees,

a s
purchases of goods for its own use, and so on. It may decide to increase or decrease its
expenditures in response to changes in its priorities. Increased government spending shifts
the AD curve to the right, and decreased government spending shifts it to the left.

.M
• Changes in economic priorities: deliberate efforts to influence aggregate demand.

w
The government can use its own spending as part of a deliberate attempt to influence
aggregate demand. The effects of such changes in government spending on aggregate

w w
demand are exactly the same as above. This is another aspect of fiscal policy.

26
 Sunny’s IB Economics

④ Causes of changes in net export

Net exports measures the spending by foreigners on a nation’s goods and services minus the
amount spent by domestic householders and firms on imports from other countries. Net exports
is therefore, the only component of AD that can be negative, which occurs when a nation
spends more on imports than it earns from the sale of its exports.

• Income of trading partners

t
Consider aggregate demand in country A, which has trade links with country B. If country

e
B’s national income increases, it will import more goods and services from country A, so
that country A’s exports will increase. Therefore the AD curve in country A shifts to the right.

.n
If, on the other hand, country B’s national income falls, it will buy less from country A, and
country A’s AD curve shifts to the left.

• Exchange rates

e p
p r
An exchange rate is simply the price of a currency expressed in units of another currency.
Consider again country A, and assume that the price of its currency increases, becoming

r
more expensive relative to the currency of country B. Country B now finds country A’s

e
output more expensive, and so it imports less from country A; therefore, country A’s exports

t
fall, and its AD curve shifts to the left. At the same time, country A now finds country B’s

s
output cheaper, and so it increases its imports from country B. Therefore, the increase in
price of country A’s currency has two effects: a fall in its exports and an increase in imports

a
so that net exports, X−M, fall, and the AD curve shifts to the left. In the opposite situation,
where the price of country A’s currency decreases, an increase in exports and a decrease in

M
.
imports will result, so that X−M increases, and country A’s AD curve shifts to the right.

w
• Trading policies

w
‘Trade protection’ refers to restrictions to free international trade often imposed by
governments. Suppose country A trades freely with country B (with no trade restrictions).

w
However country B’s government decides to impose restrictions on imports from country A.
Country A’s exports will fall, and its AD curve will shift to the left. On the other hand, in
country B, lower imports mean that the value of X−M increases, and its AD curve shifts to
the right.

27
 Sunny’s IB Economics

3.2.B. Short-run aggregate supply(SRAS)

LOS 1. Explain the short-run aggregate supply(SRAS) curve.

Aggregate supply is the total quantity of goods and services produced in an economy(real GDP)
over particular time of period at different price level. The AS curve illustrates the relationship
between the average price level in a nation and the total output of the nation’s producers.

Short-run vs. Long-run

The short run in macroeconomics is the period of time when prices of resources are roughly

e t
n
constant or inflexible (they do not change much in response to supply and demand). This

.
applies especially to wages. The long run in macroeconomics is the period of time when the

p
prices of all resources, including wages, are flexible and change along with changes in the price
level.

re
Wages are of special interest because they account for the largest part of firms’ cost of

rp
production, and therefore strongly affect the quantity of output supplied by firms. Wages do not
change very much over relatively short periods of time. The wages is often rigid(unchanging),

e
because:

s t
labor contracts fix wage rates for certain period of time

a
• minimum wage legislation sets the lowest legally permissible wage
• workers and labor unions resist wage cuts
•

.M
wage cuts have negative effects on worker morale, causing firms to avoid them.

w w
w

28
 Sunny’s IB Economics

Price
Level

Real GDP

e t
.n
The short-run aggregate supply curve(SRAS) shows the relationship between the price level and
the quantity of real output(real GDP) produced by firms when resource prices(especially wages)

p
do not change.

re
When there is an increases in price level in the short run, this means that output prices increased;

p
but with unchanging resource prices in the short run, firms’ profits increase. As production

r
becomes more profitable, firms increases the quantity of output produced, resulting in the

e
positive relationship between the price level and the quantity of real GDP supplied.

s t
M a
w .
w w

29
 Sunny’s IB Economics

LOS 2. Explain, using a diagram, the determinants of the SRAS curve:

• Costs of factors of production
• Indirect taxes

Price
Level

e t
Real GDP

p .n
re
• Costs of factors of production

rp
⁃ Changes in wages : if wages increases, with the price level constant, firms’ costs production

te
rise, resulting in leftward shift in the SRAS.
⁃ Changes in non-labour resource price (such as the price of oil, equipment, capital goods)

a
• Changes in indirect taxes
s
M
Indirect taxes are treated by firms like costs of production. Therefore, higher indirect taxes

.
are like increase in production costs and so shift the SRAS curve to the left.

w w
• Changes in subsidies offered to businesses
Subsidies have the opposite effect to taxes, as they involve money transferred from the
government to firms. If they increase, the SRAS curve shifts to the right.

w
• Supply shocks( war, weather)
Supply shocks are events that have a sudden and strong impact on SRAS. For example, a
war or violent conflict can result in destruction of physical capital and disruption of the
economy, leading to lower output produced and a leftward shift in the SRAS curve.

30
 Sunny’s IB Economics

LOS 3. Explain, using a diagram, macroeconomic short-run equilibrium.

In the AD-AS model, the equilibrium level of output (or real GDP) occurs where aggregate
demand intersects aggregate supply. In the short run, equilibrium is given by the point of
intersection of the AD and SRAS curves, and determines the price level, the level of real GDP
and the level of employment.

t
Price
Level

.n e
e p
p r Real GDP

e r
s t
Price

M a Price
Level

.
Level

w w
w Real GDP Real GDP

31
 Sunny’s IB Economics

3.2.C. Long-run aggregate supply(LRAS) and long-run equilibrium in the

monetarist/new classical model

LOS 1. Explain, using a diagram, that the monetarist/new classical model of the long- run
aggregate supply curve (LRAS) is vertical at the level of potential output (full
employment output) because aggregate supply in the long run is independent of
the price level.

The theoretical perspectives of monetarist/new classical economists

• The importance of the price mechanism in coordinating economic activities

e t
n
• The concept of competitive market equilibrium

employment.

p .
• Thinking about the economy as a harmonious system that automatically tends towards full

re
The monetarist/new classical approach to aggregate supply rests crucially on the distinction

p
made earlier between the macroeconomic short run and long run. It examines what happens to

r
aggregate supply when the economy moves into the long run, when all resource prices
including wages change to match changes in the price level. The long-run supply relationship

(LRAS).

te
between the price level and aggregate output is referred to as long-run aggregate supply

a
Price
Level
s
.M
w w
w Real GDP

There is a very simple explanation for the vertical shape of the LRAS curve. Since wages (and
other resource prices) are now changing to match output price changes, firms’ costs of
production remain constant even as the price level changes. Therefore, as the price level
increases or decreases, with constant real costs, firms’ profits are also constant, and firms no
longer have any incentive to increase or decrease their output levels.

32
 Sunny’s IB Economics

Full-employment level(YFE) is the level of output of goods and services achieved when a nation
is producing at or near its potential by employing all available land, labor, and capital. A nation
achieving YFE is producing either on or near its production possibilities curve, enjoys a low rate
of unemployment and a stable price level and is, therefore, an economy that can be considered
strong and healthy.

LOS. 2: Draw a macroeconomic long-run equilibrium, and explain that when the economy
is at long-run equilibrium(full employment equilibrium), unemployment is equal
to the natural rate of unemployment.

e t
n
The Long-run equilibrium _

.
The monetarist/new classical model

Price

e p
r
Level

rp
te
a s Real GDP

.M
The long-run equilibrium of the economy is found where the aggregate demand curve crosses

w
the long-run aggregate-supply curve. Also, short-run aggregate supply curve crosses this point
as well. At the equilibrium, the real output is called full-employed output level(potential output).

w
When the economy produces at potential output, the economy is experiencing full employment.
The unemployment that exists when the economy is producing its full employment output is

w
known as the natural rate of unemployment.

※ Types of unemployment
① Structural unemployment
② Frictional unemployment
③ Seasonal unemployment
④ Cyclical(=demand deficient) unemployment

• Natural rate of unemployment(NRU) = Structural UR+ Fictional UR + Seasonal UR

• Actual UR = NRU + Cyclical UR à Actual UR = NRU à Full employment

33
 Sunny’s IB Economics

LOS 3. Explain inflationary and deflationary(recessionary) gaps

Short-run economic fluctuation in the monetarist/new classical model

① Deflationary (recessionary) gap : Decrease in AD _ Negative demand shock à High UR

Price
Level

e t
Real GDP

p .n
re
A recessionary (deflationary) gap is a situation where real GDP is less than potential GDP (and
unemployment is greater than the natural rate of unemployment) due to insufficient aggregate

p
demand.

e r
② Inflationary gap : Increase in AD _ Positive demand shock à Demand-pull inflation

Price

s t
a
Level

.M
w w Real GDP

w
An inflationary gap is a situation where real GDP is greater than potential GDP (and
unemployment is smaller than the natural rate of unemployment) due to excess aggregate
demand.

34
 Sunny’s IB Economics

③ Long-run equilibrium

Price
Level

Real GDP

e t
.n
When the economy is at its full employment equilibrium level of GDP, the AD curve intersects
the SRAS curve at the level of potential GDP, and there is no deflationary or inflationary gap.

p
This is the economy’s full employment level of output.

re
④ Stagflation: Decrease in SRAS_Negative supply shock à High UR + Cost-push inflation

Price

rp
e
Level

s t
M a
w . Real GDP

The fall in aggregate supply leads to an increase in the price level, along with a decrease in real

w
GDP. This special set of circumstances is especially undesirable for an economy, as it involves
the appearance of two problems: recession (with unemployment) and a rising price level. This is

w
known as stagflation.

vs. Business cycle

Real GDP

Time
35
 Sunny’s IB Economics

LOS 4. Explain why, in the monetarist/new classical approach, while there may be short
term fluctuations in output, the economy will always return to the full
employment output in the long run.

① Recessionary gap_ The monetarist/new classical modelà Self-correcting process

Price Price

t
Level Level

.n e
e p
r
Real GDP Real GDP

rp
te
Recessionary gap exists when the economy is operating below potential GDP and the economy

s
is likely experiencing a high unemployment rate.

M a
According to Monetarists/new classical economists, the recessionary gap cannot remain there
in the long run. In the long run, the fall in the price level due to a decrease in AD is matched by

.
a fall in wages, so SRAS curve shift to the right until the economy is back on the LRAS curve.
The assumption of wage and price flexibility in the long run has allowed the economy to

w
automatically come back to its long-run equilibrium level of output. The recessionary gap is
eliminated, and the only thing that changes due to the fall in AD is the fall in the price level. So,

w
this market is self-corrected without intervention of government.

36
 Sunny’s IB Economics

② Inflationary gap _ The monetarist/new classical model à Self-correcting process

Price Price
Level Level

Real GDP

e
Real GDP
t
p .n
e
Inflationary gap exists when the economy is operating above potential GDP. Because

r
production is higher than full-employed GDP, a rising price level is the greatest danger to the

p
economy.

e r
According to Monetarists/new classical economists, the inflationary gap cannot remain there in

t
the long run. In the long run, the increase in the price level due to a increase in AD is matched

s
by a rise in wages, so SRAS curve shift to the left until the economy is back on the LRAS
curve. The assumption of wage and price flexibility in the long run has allowed the economy to

a
automatically come back to its long-run equilibrium level of output. The inflationary gap is
eliminated, and the only thing that changes due to the increase in AD is the rise in the price

.M
level. So, this market is self-corrected without intervention of government.

w w Price
Level

w
Real GDP
In the monetarist/new classical perspectives, recessionary and inflationary gaps are eliminated
in the long run. This ensures that in the long run the LRAS curve is vertical at the level of
potential GDP. The economy has a built-in tendency towards full employment equilibrium.
That is, change in AD can influence real GDP only in the short run; in the long-run the only
impact of a change in AD is only to change the economy’s price level.

37
 Sunny’s IB Economics

3.2.D. Aggregate supply and equilibrium in the Keynesian model

LOS 1. Explain, using a diagram, that the Keynesian model of the aggregate supply curve
has three sections because of “wage/price” downward inflexibility and different
levels of spare capacity in the economy.

Keynesian model of the aggregate supply curve is based on the theories of the early 20th century
economist John Maynard Keynes, whose work during the Great Depression. Keynes questioned
the classical and monetarist/new classical economists’ view of the economic system as a
harmonious system that automatically tends towards full employment, and showed that it is

e t
n
possible for economies to remain in a position of short-run equilibrium for long period of time.

Wage and price downward inflexibility

p .
e
The LRAS curve in the monetarist/new classical model depends on the idea that all resource

r
prices and product prices are fully flexible and respond to the forces of supply and demand.
However, what if resource prices cannot fall, even over long periods of time? Keynesian

rp
economists argue that there is an asymmetry between wage changes in the upward and
downward directions. Under conditions of an economic expansion and strong aggregate demand

e
(rightward shifts in the AD curve causing an inflationary gap), with unemployment lower than

t
the natural rate and a rising price level, wages quickly begin to move upward. Yet in a

s
recessionary gap, where aggregate demand is weak and the economy is in recession with

a
unemployment greater than the natural rate, wages do not fall easily, even over long periods of
time, because of a variety of factors (such as labour contracts, minimum wage legislation;

M
worker and union resistance to wage cuts).

w .
Keynesian economists also argue that not only wages but also product prices do not fall easily,
even if an economy is in a recessionary gap. The reasoning is that in a recession, if wages will

w
not go down, firms will avoid lowering their prices because that would reduce their profits.
Furthermore, large oligopolistic firms may fear price wars; if one firm lowers its price, then

w
others may lower theirs more aggressively in an effort to capture market shares, and then all the
firms will be worse off. Such factors, it is argued, make prices unlikely to fall even in a
recession.

Keynesians would not suggest that wages and prices can never fall. They would agree that if a
recession or depression (which is a very severe recession) continues for a long enough time
(perhaps years), wages and prices would eventually begin to fall. In the meantime a long-lasting
recession would be very costly in terms of unemployment, low incomes and lost output.
Therefore, it would be necessary for the government to intervene with active policies to help the
economy come out of the recession.

38
 Sunny’s IB Economics

Price
Level

e t
Real GDP

p .n
re
Keynesian aggregate supply curve has three sections. In section I, real GDP is low, and the price

rp
level remains constant as real GDP increases. In this range of real GDP, there is a lot of
unemployment of resources and spare capacity. Spare capacity refers to physical capital

e
(machines, equipment, etc.) and labour that firms have available but do not use. Firms can

t
easily increase their output by employing the unemployed capital and other unemployed

s
resources, without having to bid up wages and other resource prices.

M a
In section II, real GDP increases are accompanied by increases in the price level. The reason is
that as output increases, so does employment of resources, and eventually bottlenecks in

.
resource supplies begin to appear as there is no longer spare capacity in the economy. Wages
and other resource prices begin to rise, which means that costs of production increase. The only

w w
way that firms will be induced to increase their output is if they can sell it at higher prices.
Therefore, growing output leads to an increasing price level. At output level Yp, the economy
has reached its full employment level of real GDP. This is also its potential output level, and

w
unemployment has fallen to the point where it is now equal to the natural rate of unemployment.

Real GDP can continue to increase until it reaches section III. In section III, the AS curve
becomes vertical at Ymax, indicating that real GDP reaches a level beyond which it cannot
increase anymore; at this point, the price level rises very rapidly. Real GDP can no longer
increase because firms are using the maximum amount of labour and all other resources in the
economy. Since real GDP cannot increase further, any efforts on the part of firms to increase
their output only result in greater increases in the price level.

39
 Sunny’s IB Economics

LOS 2. Draw and explain equilibrium in the Keynesian model.

Short-run economic fluctuation in the Keynesian model

① Deflationary (recessionary) gap ② Inflationary gap

Price
Level Price
Level

e t
p .n
Real GDP

re Real GDP

rp
Long-run equilibrium = Full employment equilibrium

te
s
Price
Level

M a
w .
w w Real GDP

40
 Sunny’s IB Economics

LOS 3. Discuss why, in contrast to the monetarist/new classical model, the economy can
remain stuck in a deflationary (recessionary) gap in the Keynesian model.
LOS 4. Discuss the differing assumptions of the Keynesian and monetarist/new classical
models and their implications for the economy and for policies

One of the most important ideas arising from the Keynesian interpretation of the AD-AS model
is that recessionary gaps can persist over long periods of time. According to Keynes, this
happens partly because of the inability of wages and prices to fall(inflexibility). In addition, the

t
problem is caused by insufficient aggregate demand. Whenever aggregate demand intersects the
horizontal section of the Keynesian AS curve, the economy is in a recessionary gap because AD

n
firms to produce potential GDP. Therefore equilibrium GDP is lower than potential GDP.

. e
is too low, and its four components are unable to buy enough output to make it worthwhile for

p
This means that the government must intervene in the economy with specific measures to help

e
it come out of the recessionary gap. Keynesian analysis is therefore essentially a short-run

r
analysis. This does not mean that Keynesian economist do not consider what happens over long
periods of time; it means only that they do not accept the idea that economy can move into what

rp
monetarist/new classical economists define as the long run. Therefore, in the Keynesian
perspective the economy does not automatically tend towards full employment equilibrium.

te
Another important idea arising from the Keynesian model is that increases in AD need not

a s
always cause increases in the price level. In the monetarist/new classical model, increases in
AD always result in price-level increases. In Keynesian model, when the economy is in the
horizontal part of the AS curve(recessionary gap), increases in AD lead to increases in real GDP

M
without affecting the price level. It is only when the Keynesian AS curve begins to slope

w .
upward, when it is close to the full employment level of output, that further increases in AD
begin to result in changes in the price level as well.

w
Monetarist/New classical model Keynesian model

w
Price
Level
Price
Level

Real GDP Real GDP

41
 Sunny’s IB Economics

3.2.E. Shifting the aggregate supply curve over the long term

LOS 1. Explain, using the two models above, how factors leading to changes in the
quantity and/or quality of factors of production (including improvements in
technology, increase in efficiency, and changes in institutions) can shift the
aggregate supply curve over the long term.

An increase in potential output(LRAS shift to the right) signified economic growth over the

t
long-term; a decrease(LRAS shift to the left) signifies negative growth(or a fall in real output)

Long run economic growth _The monetarist/new classical model

.n e
Price
Level

e p
p r
e r
s t
M a Real GDP

.
Long run economic growth _ The Keynesian model

w
w
Price
Level

w
Real GDP

42
 Sunny’s IB Economics

Factors to shift LRAS

• Increases in quantities of the factors of production

An increase in the quantity of physical capital, or the quantity of land means that the
economy is capable of producing more real GDP.

• Improvements in the quality of factors of production(resources)

Greater levels of education, skills or health lead to an improvement in the quality of labor

t
resource. More highly skilled and educated workers or healthier workers can produce more

e
output than the same number of unskilled or less healthy workers.

• Improvements in technology

p .n
An improved technology of production means that the factors of production using it can

e
produce more output, and the AS curves shift to the right. For example, workers who work

r
with improved machines and equipment that have been produced as a result of technological
innovations will be able to produce more output in the same amount of time.

• Increases in efficiency

rp
te
When an economy increases its efficiency in production, it makes better use of its scarce
resources, and can as a result produce a greater quantity of output.

a
• Institutional changes
s
M
The degree of private ownership as opposed to public ownership of resources, the degree of

.
competition in the economy, the degree and quality of government regulation of private
sector activities, and the amount of bureaucracy can each affect the quantity of output

w
produced.

w
※ SRAS vs LRAS

43
 Sunny’s IB Economics

3.3 Macroeconomic objectives

Macroeconomics policies are aimed at the following four objectives:

• Full employment
• Low and stable inflation
• Economic growth
• Income distribution

3.3.A. Economic growth

e t
LOS 1. Define economic growth as an increase in real GDP.
LOS 2 Calculate the rate of economic growth from a set of data.

p .n
re
Economic growth is an increase in the total output of goods and services(GDP) in a nation over

p
time.

e r
Economic growth is measured by percentage change in real GDP or percentage change in real

t
GDP per capita. Economic growth varies substantial around the world. The standard of living in

s
an economy depends on the economy’s ability to produce goods and services(productivity).That
is, the growth in productivity is the key determinant of growth in living standards.

M a
w .
Percentage change in real GDP = final value of real GDP – initial value of real GDP
initial value of real GDP
* 100

w w
Ex. 2010 real GDP = $ 50 billion / 2011 real GDP = $75 billion

44
 Sunny’s IB Economics

LOS 3. Explain and draw short-term growth in terms of

• actual growth in the PPC model
• the role of aggregate demand in the AD-AS model

Short-term economic growth means increase in real GDP and does not involve an increase in
potential output.

Production possibilities curve (PPC) shows combinations of maximum output that can be

t
produced by an economy with fixed resources and technology, provided there is full or

e
maximum employment of resources and productive efficiency. Any economy is most likely to
be actually situated at some point inside its PPC, as it is very difficult to achieve full productive
efficiency and maximum employment of all resources. By reducing unemployment and

.n
increasing productive efficiency, a country moves closer to its PPC and increases the actual

p
quantity of output produced. Therefore, reductions in unemployment and increases in

e
productive efficiency are two factors that can cause growth of actual output. The movement

r
from point A to point B illustrates growth of actual output.

Consumer

rp
e
goods

s t
M a •B

.
•A

w w Capital goods

w
Price
Level
The monetarist/new classical model

Price
Level
Keynesian model

Real GDP Real GDP

+ Increase in SRAS
45
 Sunny’s IB Economics

LOS 4. Explain and draw long-term growth in terms of

• Shifts in the PPC illustrating growth in production possibilities
• the role of LRAS in the AD-AS model

Long-term growth can only occur if there is an increase in production possibilities, illustrated
by an outward shift of the PPC. An outward shift of the PPC means the economy can produce
more of both goods. The increases in production possibilities are accompanied by increase in
potential GDP.

e t
The factors that lead to outward shifts of the PPC, or increases in production possibilities are:

n
• increases in the quantity of resources (factors of production) in the economy

.
• improvements in the quality of resources (for example, through more educated labour, or

p
improved physical capital through technological change).

re
p
Consumer goods

e r
s t
M a
w . Capital goods

w
The monetarist/new classical model The Keynesian model

w
Price Price
Level Level

Real GDP Real GDP

46
 Sunny’s IB Economics

vs. Business cycle

Real GDP

Time

e t
.n
Short-term growth caused mainly by increase in aggregate demand corresponds to expansions

p
of real GDP in the business cycle diagram. Long-run growth caused by rightward shifting

e
LRAS or Keynesian AS curves that show increases in potential output corresponds to the long-

r
term growth trends in the business cycle diagram.

rp
Actual growth is short-term growth, because it can occur over short periods of time and is due

e
to reduction in unemployment or inefficiency in production. Growth in production possibilities

t
is long-term growth, because it usually requires long periods of time and is due to increases in

s
quantity or improvement in quality of factors of production.

M a
w .
w w

47
 Sunny’s IB Economics

LOS 5. Discuss the possible consequences of economic growth including its impact on
• Living standards
• The environment
• Income distribution

Impact of economic growth on living standards

Living standards(or standards of living) refers to levels of income, wealth and consumption of
goods and services, including health care and education. If the total GDP of a country increases

t
faster than its population, then an increase in GDP per capita results. This indicates that there is

e
a greater potential for people to increase their consumption of goods and services, and improve
their standards of living. However, remember that GDP per capita or income per capita is only

.n
an average measure, and does not tell us how the increase in income is distributed or whether
there is a broadly distributed improvement in living standards.

p
e
Major factors allowing economic growth to have positive effects on living standards :

r
• The distribution of income

rp
The greater the income going to poorer households, the greater the potential for contributing

te
to improvements of living standard, as the poorer households are those with the greatest
deprivations in terms of education and health. If increases in income made possible by

s
economic growth bypass the poorer households, growth has limited effects on living standard.

• Household spending

M a
.
The greater the share of household income spent on goods and services such as food,
education and health care, the greater the effect on living standards.

w w
• The share of income controlled by women
The greater this is, the stronger the impact on living standards

w
• Government spending on merit goods.
This relates to the share of the government budget allocated to priority areas like education,
health care and infrastructure including clean water supplies and sanitation; the larger this is,
the greater the effects of growth on human development.

• Contributions by non-governmental organisations (NGOs)

Because of their poverty orientation and their general effectiveness in reaching poor people,
NGOs contribute to increasing the impact of growth on more development and higher
standards of living.

48
 Sunny’s IB Economics

Impact of economic growth on the environment

Experience shows that growth, especially rapid growth, often leads to unsustainable resource
use. Industrialisation based on fossil fuels is a major source of pollution (negative production
externalities). Increasing incomes lead to consumption patterns also based on greater fossil fuel
consumption (use of cars, air conditioners, etc., creating negative consumption externalities).

Experiences like these have led to the widespread belief that economic growth and

t
environmental sustainability are conflicting objectives. Many governments around the world
base their policies on this belief by following the ‘grow now, clean up later’ way of thinking,
which argues that since using resources to preserve the environment reduces growth, it is

n e
preferable to pursue growth with all its negative effects on the environment, and postpone the

.
‘clean-up’ job of environmental preservation for later when incomes will be higher. Allocating

p
resources for environmental protection arguably translates into smaller increases in output and

e
hence lower economic growth.

p r
Yet, there are a number of things seriously wrong with this way of thinking. One is that some

r
environmental damage is irreversible; it will not be possible to correct the damage in the future,
and some resources will be lost forever. For example, lost biodiversity can never be recovered;

te
lost lives due to pollution-induced illnesses can similarly never be recovered. A second is that it
justifies government inaction on the environment. Governments and policymakers often

s
wrongly assume that environmental issues will automatically be regained in the future as

a
incomes increase with growth. This is unrealistic, because preservation of the environment
requires policies aiming to limit negative environmental externalities. A third, related reason is

M
that it is not growth itself that is bad for the environment, but rather the ways that growth is

.
pursued. If growth were pursued differently, it need not conflict with environmental
sustainability. A fourth reason is that growth based on unsustainable resource use may lead to

w w
destruction of natural resources on such a wide scale that the possibility of continued future
growth may be threatened.

49
 Sunny’s IB Economics

Modern growth theory shows that economic growth and environmental sustainability are in fact
consistent with each other, and can be successfully pursued together under certain conditions,
such as the following:

⁃ Governments implement market- based policies that ‘internalise the externalities’, thus not
only correcting them (at least in part) but also providing incentives for sustainable resource
use and promotion of green (or ‘clean’) technologies.
⁃ Governments pursue more environmental regulations that encourage pollution-free

t
technological change (green technologies).
⁃ There is an increased emphasis on human capital in production (which is pollution-free) as
opposed to physical capital.

.n
⁃ An increased emphasis on ‘green’ investments, which promote growth while not hurting the
e
environment: building public transportation systems; investing in insulation in homes and

p
buildings; investing in clean technology research and development (R&D) and clean

e
technologies.

r
⁃ There are changes in the structure of the economy toward more services (which tend to be

p
pollution-free), together with more investments in the protection of natural resources.

e r
As incomes increase with economic growth, more resources are made available with which

t
governments can pursue the above kinds of policies, encouraging economic growth at the same

s
time that they encourage sustainability. Therefore, economic growth and sustainability can be
pursued together provided governments take appropriate measures to ensure sustainable
resource use.

M a
w .
w w

50
 Sunny’s IB Economics

Impact of economic growth on income distribution

A large number of studies lead to the conclusion that there is no clear relationship between
growth in GDP per capita and income distribution; instead, what happens to income distribution
as a country grows is a reflection of particular conditions in each country and the kinds of
growth policies that are pursued.

Yet, income inequalities in many countries around the world have been widening over the past

t
three or so decades. In both developed and developing countries, a major factor behind
increasing income inequalities has been the growing use of market-based supply-side
policies. Transition economies (in central and eastern Europe and the former Soviet Union)

.n
have additionally been influenced by the switch to market economies and the loss of
government protection of vulnerable groups. e
e p
In developing countries, income inequalities increased due to economic and trade liberalisation,

p r
which we have seen gives rise to both winners and losers. While those who can take advantage
of new opportunities gain, many become worse off, if they are less educated or skilled, cannot

r
get credit, are geographically isolated, have nothing to produce for export, lose their jobs due to

e
privatisations or reductions in the size of the government sector, and so on. In addition, income

t
distribution in developing countries can worsen as a result of economic growth due to
inappropriate government policies.

a s
It can therefore be concluded that economic growth is neither ‘good’ nor ‘bad’ for income
distribution; this instead depends very much on the kinds of policies countries adopt in order to
achieve growth.

.M
w w
w

51
 Sunny’s IB Economics

3.3.B. Low unemployment

LOS 1. Define the term unemployment.

LOS 2. Explain how the unemployment rate is calculated and calculate.

e t
p .n
re
Unemployment refers to people of working-age who are actively looking for a job but who are

rp
not employed. A closely related term is underemployment, referring to people of working age
with part-time jobs when they would rather work full time, or with jobs that do not make full

e
use of their skills and education.

s
Labor force = Employed + Unemployed
t
a
• Labor force participation rate = The number of people in the labor force
* 100
Working-age population

•
.M
Unemployment rate = The number of unemployed people

w
* 100
The labor force(Employed + Unemployed)

w w

52
 Sunny’s IB Economics

LOS 3. Explain the difficulties in measuring unemployment, including the existence of

hidden unemployment, the existence of underemployment, and the fact that it is
an average and therefore ignores regional, ethnic, age and gender disparities.

• Discouraged workers are the individuals who would like to work but have given up looking
for a job(non-labor force). Discouraged workers do not show up in unemployment statistics,
even though they are truly workers without jobs. The presence of discourage workers
understates the true unemployment rate.

• Part-time workers how would rather be working full-time are considered employed, despite

e
the fact that from their perspective they are underemployed. Additionally, people stuck int
.n
jobs for which they are over-qualified are also considered employed. Such workers’
dissatisfaction with their level of employment or their type of employment is not reflected in
the nation’s unemployment figures (underemployed).

p
re
A further disadvantage of the national unemployment rate is that it is an average over the entire

p
population, and therefore does not account for differences in unemployment that often arise

r
among different population groups(region, gender, age, etc.) in a society.

te
Region: regions with declining industries may have higher unemployment rates than other

s
regions

a
• Gender: women sometimes face higher unemployment rates than men
• Ethnic groups: some ethnic groups may be disadvantaged due to discrimination, or due to

.M
lower levels of education and training
• Age: youth unemployment (usually referring to persons under the age of 25) often face

w
higher unemployment rates than older population groups, often due to lower skill levels;
people who are ageing also sometimes face higher unemployment rates as employers may

w w
be less willing to employ them.

53
 Sunny’s IB Economics

LOS 4. Discuss possible economic, personal and social costs of unemployment.

① Economic costs

• Loss of GDP
Since fewer people work than are available to work, the amount of output produced is less
than the level the economy is capable of producing.

• Loss of tax revenue

e
Since unemployed people do not have income from work, they do not pay income taxes; this
t
n
results in less tax revenue for the government.

• Increased cost of unemployment benefits à Increased budget deficits

p .
e
If the government pays unemployment benefits to unemployed workers, the greater the

p r
unemployment, the larger the unemployment benefit that must be paid, and the less tax
revenue left over to pay for important government-provided goods and services such as

r
public goods and merit goods.

• Loss of income for individuals

te
s
People who are unemployed do not have an income from work. Even if they receive

a
unemployment benefits, they are likely to be worse off financially than if they had been
working.

.M
• Greater disparities in the distribution of income

w w
Some people (the unemployed) become poorer while others (the employed) are able to
maintain their income levels. Since certain population groups(ethnic groups, regional groups,
etc) may be harder hit by unemployment than others, the effects of increasing income

w
inequalities and resulting poverty tend to be concentrated among population groups who are
more disadvantaged to begin with. If unemployment is high or tends to persist over long
periods of time, this may lead to increased social tensions and social unrest.

54
 Sunny’s IB Economics

② Personal costs

• Decreased household income and purchasing power

An obvious consequence of unemployment is a decline in a household’s ability to provide
the standard of living to which it may have grown accustomed when one or more members
of the household were employed. The decline in personal income could result in foreclosure
on or eviction from a home, or worse, inability to meet the nutritional needs of the household.

t
• Increased levels of psychological and physical illness, including stress and depression

e
Being unemployed and unable to secure a job involves a loss of income, increased
indebtedness as people must borrow to survive, as well as loss of self-esteem. All these

.n
factors cause great psychological stress, sometimes resulting in lower levels of health, family
tensions, family breakdown and even suicide.

p
③ Social costs

re
• Downward pressure on wages for the employed

rp
High unemployment means the supply of available labor has increased in the nation. Since

te
wages are determined by supply and demand, and increase in the labor supply can lower the

s
equilibrium wage rate for those who still have jobs, forcing them to accept pay cuts and
reducing the real incomes of all workers.

M a
• Increased poverty and crime

w .
Regions or cities in which unemployment occurs may become depressed and therefore less
attractive to new investment by businesses. The low income levels of the largely
unemployed population deter businesses from opening further contributing to the

w
unemployment and poverty problem. Crime and unemployment are also closely linked.

55
 Sunny’s IB Economics

LOS 5. Explain the causes of unemployment: cyclical, structural, seasonal and frictional.
LOS 6. Explain, using a diagram, that cyclical unemployment is caused by a fall in
aggregate demand(deflationary gap).
LOS 7. Explain, using a diagram, that structural unemployment is caused by changes in
the demand for particular labour skills, changes in the geographical location of
industries, and labour market rigidities.

① Structural Unemployment

t
Structural unemployment occurs as a result of changes in demand for particular types of

e
labour skills, changes in the geographical location of industries and therefore jobs, and
labour market rigidities.

p .n
• Changes in demand for particular types of labor skills : The demand for particular types of
labor skills changes over time. This may be the result of technological change, which often

e
leads to a need for new types of skills, while the demand for other skills falls. This situation

p r
leads to mismatches between labor skills demanded by employers and labor skills supplied
by workers. Such mismatches cause structural unemployment.

e r
t
Wage

a s
.M
w w
w
Quantity of labor

• Changes in the geographical location of industries : When a large firms or even an industry
moves its physical location from one region to another, there is resulting fall in demand for
labor in one region and an increase in demand in the region where it relocates. If people
cannot move to economically expanding regions, they may become structurally unemployed.

56
 Sunny’s IB Economics

• Labor market rigidities : Labor market rigidities are factors preventing the forces of supply
and demand from operating in the labor market.
⁃ minimum wage legislation
⁃ labour union activities and wage bargaining with employers, resulting in higher than
equilibrium wages also causing unemployment
⁃ employment protection laws, which make it costly for firms to fire workers (because they
must pay compensation), thus making firms more cautious about hiring
⁃ generous unemployment benefits, which increase the attractiveness of remaining

t
unemployed and reduce the incentives to work.

Minimum wage
in labor market

n
Product market

.
due to labor market rigidities e
Wage Price

e p
p r
e r
s t
M a Quantity of labor Quantity

w .
Structural unemployment is a serious type of unemployment because it tends to be long term. A
certain amount of structural unemployment is unavoidable in any dynamic, growing economy,

w w
and is therefore considered to be part of ‘natural unemployment’. However, this does not mean
that it cannot be lowered. There are many policies governments can pursue to reduce it,
including measures encouraging workers to retrain and obtain new skills, and to relocate (move)
to areas with greater employment opportunities; providing incentives to firms to hire
structurally unemployed workers; and measures to reduce labour market rigidities.

57
 Sunny’s IB Economics

② Frictional unemployment
Frictional unemployment occurs when workers are between jobs. Workers may leave their
job because they have been fired, or because their employer went out of business, or because
they are in search of a better job, or they may be waiting to start a new job. Frictional
unemployment tends to be short term, and does not involve a lack of skills that are in
demand. It is therefore less serious than structural unemployment. An important cause of
frictional unemployment is incomplete information between employers and workers
regarding job vacancies and required qualifications. Because of incomplete information, it
takes time for the right applicants to get matched up with the right jobs. Therefore, frictional

t
unemployment is part of natural unemployment. Measures to deal with frictional

e
unemployment aim at reducing the time that a worker spends in between jobs and improving
information flows between workers and employers.

③ Seasonal unemployment

p .n
e
Seasonal unemployment occurs when the demand for labour in certain industries changes on

r
a seasonal basis because of variations in needs. Farm workers experience seasonal
unemployment because they are hired during peak harvesting seasons and laid off for the rest

rp
of the year. Some seasonal unemployment is unavoidable in any economy, as there will
always be some industries with seasonal variations in labour demand. Therefore, seasonal

e
unemployment is also part of natural unemployment. Ex. Farmers, Construction workers

s
④ Cyclical (demand-deficient) unemployment
t
a
Jobs are gained and lost as the business cycle improves and worsens. The unemployment rate
rises when the economy is contracting, and the unemployment rate falls as the economy is

M
expanding. Cyclical unemployment occurs during the downturns of the business cycle,

w .
when the economy is in a recessionary gap. The downturn is seen as arising from declining
or low AD, and so is also known as demand-deficient unemployment. A fall in consumption,
investment or net exports leads to a fall in AD and a decline in national output and

w
employment.

w
Price
Level
The monetarist/new classical model

Price
Level
Keynesian model

Real GDP Real GDP

58
 Sunny’s IB Economics

LOS 8. Explain natural rate of unemployment is the sum of the structural, seasonal,
frictional unemployment.

• Actual unemployment rate = Structural UR + Frictional UR +Seasonal UR+ Cyclical UR

• Natural rate of unemployment(NRU) = Structural UR + Frictional UR + Seasonal UR

When Cyclical UR is zero,

Actual unemployment rate = Natural rate of unemployment à Full Employment

e t
n
Economists acknowledge that frictional, structural, and seasonal unemployment are always

p .
present. Because of these forms of unemployment, the unemployment rate can never be zero.
Economists define full employment as the situation when there is no cyclical unemployment in

e
the economy. The unemployment rate associated with full employment is called the natural rate

r
of unemployment. Natural rate of unemployment is unemployment when the economy is
producing potential output. A fall in the natural rate of unemployment is reflected by an
increase in potential output.

rp
Price

te
s
Level

M a
w .
w w Real GDP

59
 Sunny’s IB Economics

3.3.C. Low and stable rate of inflation

LOS 1. Distinguish between inflation, disinflation and deflation.

Inflation is defined as a sustained increase in the average price level of goods and services.
Deflation is defined as a sustained decrease in the average price level. (negative inflation rate)
Disinflation represents a decrease in the rate of inflation(inflation rate 7% à 5%)

e t
p .n
re
rp
te
a s
.M
w w
w

60
 Sunny’s IB Economics

LOS 2. Explain that inflation and deflation are typically measured by calculating a
consumer price index (CPI), which measures the change in prices of a basket of
goods and services consumed by the average household.

The consumer price index(CPI) is a measure of the cost of living for the typical household, and
compares the value for the typical household, and compares the value of a basket of goods and
services in one year with the value of the same basket in a base year.

t
LOS 4. Calculate the inflation rate from a set of data.

2010(Base Year) 2011

.n 2012
e
Items Quantity
in the basket Purchased
Price Spending

e
Price Spending
p Price Spending

Chocolate
Bars
12 $1.50 $18.00

p r $ 1.6 $19.2 $1.75 $21.00

Concert
Tickets
4 $45

e r
$180.00 $50 $200 $60 $240.00

Clothing 18 $16

s t
$288.00 $16 $288 $15 $270.00

a
Total
$486.00 $507.2 $531.00
spending

.M
w
CPI Inflation rate

w w 2010 (Base Year)

2011

2012

Price of basket of goods and services in current year

CPI = * 100
Price of basket in base year

Inflation rate in year 2 = CPI in year 2 – CPI in year 1

* 100
CPI in year 1
61
 Sunny’s IB Economics

LOS 5. Explain problems with the CPI as a measure of inflation

• Different rates of inflation for different income earners.

The rate of inflation calculated by use of the CPI reflects the change in average prices of
goods and services included in the basket. However, different consumers have different
consumption patterns depending on their income levels, and these may differ from what is
included in the basket. This means they face different rates of inflation than what is
calculated on the basis of the CPI basket.

• Different rates of inflation depending on regional or cultural factors.

e
Exactly the same idea as above applies to consumer groups whose purchases differ from thet
.n
typical household’s consumption patterns, because of variations in tastes due to cultural and
regional factors.

p
re
• Changes in consumption patterns due to consumer substitutions when relative prices change.
Each good and service included in the basket is weighted (multiplied by the number of units

p
of the good or service purchased by the typical household over a year). However, as some

r
goods and services become cheaper or more expensive over time, consumers make

e
substitutions, buying more units of the cheaper goods and less of the more expensive ones.

t
This results in changing weights (number of units consumed by the typical household), but

s
because the weights in the basket are fixed, the changes in consumption patterns cannot be
accounted for in the CPI. Therefore, the CPI gives a misleading impression of the degree of

a
inflation, usually overstating it.

M
.
• Changes in consumption patterns due to increasing use of discount stores and sales.
In many countries, consumers increasingly make use of discount stores and sales, thus

w w
buying some goods and services at lower prices than those used in CPI calculations. This is
another reason why the CPI tends to overstate inflation.

w
• Changes in consumption patterns due to introduction of new products.
Fixed basket of goods and services cannot account for new products introduced into the
market, as well as older products that become less popular or are withdrawn (consider for
example the replacement of videotapes by DVDs).

• Changes in product quality.

The CPI cannot account for quality changes over time.

62
 Sunny’s IB Economics

• International comparisons.
The CPIs of different countries differ from each other with respect to the types of goods and
services included in the basket, the weights used and methods of calculation. This limits the
comparability of CPIs and inflation rates from country to country.

• Comparability over time.

Virtually all countries around the world periodically revise their CPI baskets and change the
base year (usually about every ten years. In many countries the weights of goods and

t
services are changed as often as every year. This means that whereas price index numbers
are comparable over short periods of time, over longer periods comparability is lessened
because of cumulative changes in the basket of goods and services.

Types and causes of inflation

.n e
e
determinants of AD, resulting in an increase in AD.
p
LOS 6. Explain, using a diagram, that demand-pull inflation is caused by changes in the

p r
LOS 7. Explain, using a diagram, that cost-push inflation is caused by an increase in the
costs of factors of production, resulting in a decrease in SRAS.

① Demand-pull inflation

e r
s t
Demand-pull inflation involves an excess of aggregate demand over aggregate supply at the
full employment level of output, and is caused by an increase in aggregate demand. It is

a
shown in the AD-AS model as a rightward shift in the AD curve.

M
Price
w .
The monetarist/new classical model Keynesian model

w
Price
Level Level

w
Real GDP Real GDP

63
 Sunny’s IB Economics

② Cost-push inflation_Stagflation
Cost-push inflation is caused by increases in costs of production or supply-side shocks. Cost-
push inflation is caused by a fall in aggregate supply, in turn resulting from increases in
wages or prices of other inputs, shown in the AD-AS model as leftward shifts of the AS
curve.
• An increase in oil prices
• An increase in wage rate
• Natural disaster or war

t
• Higher taxes on firms.

Price
The monetarist/new classical model

.n e
p
Level

re
rp
te
a s Real GDP

.M
LOS 8. Discuss the possible consequences of a high inflation rate, including greater
uncertainty, redistributive effects, less saving, the damage to export

w w
competitiveness, economic growth, and inefficiency in resource allocation.

The relationship between inflation, purchasing power and nominal and real income

w
Purchasing power refers to the quantity of goods and services that can be bought with money.
‘Real income’ is the same as ‘purchasing power’; it refers to what your money can buy: it
decreases as prices rise, and increases as prices fall.

% change in real income (or purchasing power)

= % change in nominal income − % change in the price level (or the rate of inflation)

64
 Sunny’s IB Economics

Suppose Sally deposit $ 1,000 in a bank account that pays an annual interest rate of 10%. A
year later, after Sally has accumulated $100 in interest, she withdraws her $1,100. Is Sally $100
richer than she was when she made the deposit a year earlier?
To keep it simple, let’s suppose that Sally is a movie fan and buys only DVDs.

The price
(In one year) The Number of DVDs which Sally can buy with $1,100
of DVDs

t
Zero Inflation $ 10 110 DVDs : 10% increase in purchasing power

e
6% Inflation $ 10.60 104 DVDs : 4% increase in purchasing power

10% Inflation

12% Inflation
$ 11

$ 11.20
100 DVDs : 0% increase in purchasing power

98 DVDs : 2% decrease in purchasing power

p .n
2% Deflation $ 9.8

re
112 DVDs : 12% increase in purchasing power

rp
These examples show that the higher the rate of inflation, the smaller the increase in purchasing

e
power. The rise in the price level means a lower value of money because each dollar in

t
your wallet now buys a smaller quantity of goods and services.

a s
To understand how much a person earns in a savings account, we need to consider both the
interest rate and the change in the prices. The interest rate that measures the change in dollar

.M
amounts is called the nominal interest rate, and the interest rate corrected for inflation is
called the real interest rate.

w
Nominal interest rate = Real interest rate + Inflation rate

w
w
The nominal interest rate tells you how fast the number of dollars in your bank account rises
over time, while the real interest rate tells you how fast the purchasing power of your bank
account rises over time.

65
 Sunny’s IB Economics

Cost of inflation

• Redistributive effect
Inflation redistributes income away from certain groups(losing purchasing power) and
toward other groups(gaining purchasing power).

Groups who loss from inflation Groups who gain from inflation

People who receive fixed income or

t
Payers of fixed incomes or wages
wages( workers, pensioners, landlord)
People who receive income or wages that
increase less rapidly than the rate of
inflation

.n
Payers of incomes or wages that increase
less rapidly than the rate of inflation e
Holders of cash

e p
Savers

p r
r
Lenders(Creditors) Borrowers

• Greater uncertainty

te
a s
Uncertainty to accurately predict what inflation will be in the future means that people can
not predict future changes in purchasing power. This causes uncertainty among economic
decision makers. Firms, in particular, become more cautious about making future plans

.M
under uncertainty about future price levels, because they are unable to make accurate
forecast of costs and revenues, as these depend on the future prices of their inputs and their

w
products. This could cause firms to invest less, leading to lower economic growth.

w
• Less saving

w
Savers in fixed-interest assets(such as most government bonds and saving accounts) are
negatively affected by inflation since the real interest rate earned on savings falls as the
inflation rate rises.

• Damage to export competitiveness

If the domestic price level increases while price levels in other countries remain the same,
exports become more expensive to foreign buyers who will now demand a smaller quality
(export ↓). At the same time, goods produced in other countries become relatively cheaper,
so domestic buyers increase their purchases from foreign countries.

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 Sunny’s IB Economics

• Effects on economic growth

High inflation does not favour economic growth. Due to uncertainty, firms will fall
investment; in addition lower saving means that there are less funds available for investment.
These factors lead to drops in investment, which is a component of AD, therefore to a fall in
AD. Moreover, inflation leads to lower exports and higher imports, both contributing to a fall
in net exports, which also causes a fall in AD. Falling AD leads to lower real GDP.

• Effects on resource allocation

t
Price mechanism plays an important role in resource allocation. If prices are rising rapidly,
the signally and incentive functions do not work effectively. The reason is that prices do not

others, meaning that the signals and incentives they provide for consumers and producers

.
become distorted and therefore inaccurate. The results is that allocative inefficiency ise
increase in the same proportion for all products, they rise more for some products than for

n
p
increased.

re
• Social and personal costs that are unequally distributed

p
Inflation makes people on fixed incomes suffer losses as their income loses its purchasing

r
power. This often includes pensioners, unemployed people receiving unemployment benefits,

e
and also workers whose wages are either fixed or do not rise as fast as the rate of inflation. In

t
addition, people on low incomes are not in position to place their savings in assets that do
not lose their value with inflation, such as real estate, stocks in the stock market, gold or

a s
even jewellery. Further, rising prices of necessities such as food and energy needed for
heating can cut deeply into incomes of lower income people. Therefore it is likely that
people on low incomes are more seriously affected by high rates of inflation than people on

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higher incomes.

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 Sunny’s IB Economics

LOS 9. Explain and discuss the possible consequences of deflation, including uncertainty,
redistributive effects, deferred consumption, association with high levels of
cyclical unemployment and bankruptcies, increase in the real value of debt,
inefficient resource allocation, policy ineffectiveness.

Two causes of deflation:

• Decreases in aggregate demand, held to lead to a ‘bad’ kind of deflation
• Increases in aggregate supply, held to lead to ‘good’ deflation

Price Price

e t
n
Level Level

p .
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rp
e
Real GDP Real GDP

s t
However, it must be stressed that while it may be possible to make an analytical distinction

a
between ‘good’ and ‘bad’ deflation, no deflation is ever good.

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Consequences of deflation
• Redistribution effects

w
The redistribution effects of deflation are the opposite of those of inflation: with a falling
price level, individuals on fixed incomes, holders of cash, savers and lenders (creditors) all

w wgain as the real value of their income or holdings increases. By contrast, borrowers (debtors)
and payers of individuals with fixed incomes lose with a falling price level, as they must pay
out sums that have an increasing real value(= Increase in the real value of debt).

• Uncertainty
Deflation, like inflation, creates uncertainty for firms, which are unable to forecast their
costs and revenues due to declining price levels.

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 Sunny’s IB Economics

• Deferred consumption, high and increasing cyclical unemployment: risk of deflationary

spiral
A deflationary spiral involves a process where deflation sets into motion a series of events
that worsen the deflation. Deflation discourages spending by consumers, because they
postpone making purchases as they expect that prices will continue to fall. Deflation also
discourages borrowing by both consumers and firms, for the reason noted above: the real
value of debt increases as the price level falls. The result is that consumer and business
spending falls, causing aggregate demand to fall. If the economy is already in recession, this
will become deeper with falling AD, unemployment increases further, incomes and prices

t
fall further, deflationary pressures increase further, spending and borrowing decrease further,

e
and so on in a downward spiral.

• Risk of bankruptcies and a financial crisis

p .n
Deflation results in an increase in the real value of debt. If the economy is in recession, and

e
incomes are falling while the real value of debt is increasing, the result will most likely be

r
bankruptcies of firms and consumers who are unable to pay back their debts. If such
bankruptcies become widespread, banks and financial institutions will be affected, and a

p
large risk of a major financial crisis arises.

r
• Inefficient resource allocation

te
In deflation, prices of all goods and services do not fall uniformly, with the result that the

s
price signals and incentives get distorted, leading to resource misallocation.

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w w
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