Economics F1

Chapter 19
MACROECONOMICS
1. Introduction to macroeconomics
The term ‘macroeconomics’ refers to the branch of economics that deals with national and
international economics. ‘Microeconomics’, which will be dealt with later deals with the study of
specific markets for products and services.
Macroeconomics therefore covers topics such as:

How can the size of a country’s economy be measured?
How could the economy be made to grow?
What are the unemployment rate and what affects this?

What causes inflation and how can that be controlled?
What determines currency exchange rates?
How to imports compare to exports?
2. Government influence on business

Governments can have a huge influence on businesses:
Policy Affects:
Overall economic policy Demand, taxation, cost of finance (interest rates
Industry policy Regulation, planning, grants, tariffs/quotas, free trade
Planning, costs (eg carbon or pollution tax), transport
Environmental and infrastructure policy
costs and efficiency
Education, retirement, pensions, employment
Social policy
protection
EU compliance, World Trade Organisation, foreign
Foreign policy
trade, banned exports and imports
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3. National income
National income is a measure of the size of a country’s economy. National income can be defined as:
the total value a country’s final output of all new goods and services produced in a year
The word ‘final’ is important. If Company A sold goods to consumers, then the value of those sales
would be part of national income. However, if Company A sold to Company B and Company B sold to
the public for the same price, then the sales revenue would appear in both company’s accounts and
there would be double-counting if both amounts were included in national income. To avoid this, only
Company B’s sales would be included in national income.
The higher the national income, the more income is available for a country’s population
If an item is sold for €50, then that amount appears in two places:
The amount spent by the consumer (consumption or
expenditure) The amount received by the seller (income)
The consumption (expenditure) and income must be equal.
Of course, there is another set of flows. For example, companies employ people and pay wages whilst
employees can use their wages to buy goods from companies. Recognition of these two sets of flows
(wages/ labour, sales of goods/purchases of goods) gives rise to the circular flow of income.
There are two main measures of national income:

Gross domestic product (GDP)
Gross national product (GNP)
A country’s gross domestic product refers to the total value of income or production taking place in that
country. It is calculated as:
Capital Exports of Imports of

Household Government
GDP = + investment+ + goods and –goods and
spending spending
spending services services
A country’s gross national product takes into account income earned from abroad and also profits earned in a
country being sent to foreign investors. The difference between income being earned abroad and profits
being remitted to overseas investors is called the net property income from abroad. So
Net profit income

GNP = GDP +
from abroad
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4. The circular flow of income

Households provide: labour, land, capital (together known as factors of production)
In exchange for:
Firm providing: wages, rent, interest
Firms: produce goods or provide services
Households: pay for the goods and services
Households
Spending/
Goods Income Factors
consumption
Firms
As well as money, goods, services and factors of production moving between firms and households,
there are injections and withdrawals (or leakages) from the system.
Injections:
Government spending
Exports (money comes from abroad)
Investment (this is expenditure on goods in addition to household spending).
Withdrawals:
Taxation
Savings (for example, money is earned, but simply kept and
accumulated) Imports (money goes abroad)
Injections will increase the circular flow of income (for example, money flowing into the country from the sale
of exports). Similarly, withdrawals will decrease the circular flow (for example, more people deciding to save).
If an economy is in equilibrium (meaning that the circular flows are constant) then injections into the economy
must be equal to each other. For example, if the government suddenly printed more money and injected it
into the economy by giving each person €10 to spend, then that additional money could be spent on goods
and services, increasing both consumption and the supply of goods. To supply more goods, more factors of
production would be bought, increasing the population’s income until a new equilibrium point is reached.
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5. Aggregate supply and demand

Although money spend by consumers (consumption or expenditure) must equal the value of goods sold
by suppliers (income) this does not mean that the demand for goods will always equate to the supply of
goods. A product could be very popular but suppliers are not able to keep up with that demand. The
imbalance between supply and demand can occur at the macro-economic level also:
Aggregate demand: the total demand in the economy for goods and services; it is the total desired
demand.
Aggregate supply: the total supply of goods and services in the economy.
Aggregate demand would increase as prices decrease: lower prices stimulates demand. Aggregate supply
increases as prices increase: higher prices will encourage firms to produce more.
An equilibrium (or balance) is reached when aggregate demand and aggregate supply are equal:
enough is produced to exactly meet demand.
Let’s see what happens if these are not equal. Assume that because the economic situation had been a little
uncertain, consumers had decided to save some of their income in case of redundancy. Then the economy
picks up and consumers have more confidence to spend their savings. Suddenly aggregate demand would
have increased, but the supply of goods might lag behind this sudden increase in demand. The likely effect is
that there will be price rises as consumers are willing to pay more to satisfy their increased demand;
production will be increased so that, once again supply will satisfy demand – but at a slightly higher price
The following graph shows what happens:
Prices
Aggregate
Demand 2
Aggregate
supply
Aggregate
Demand 1 B
Output
We start at point A. Aggregate supply and aggregate demand meet at this point: the quantity supplied
matches the quantity of goods demanded.
When confidence in the economy rises and people are willing to spend more money, the aggregate
demand shifts to the right from aggregate demand line 1 to line 2. This means that more goods are
demanded at a given price.
The extra demand will stimulate producers to supply more and the equilibrium point moves from A to B.
Prices are slightly higher. Of course, as production increases, employment will increase, so governments can
increase employment by stimulating aggregate demand. Demand can be stimulated by measures such as:
Decreasing tax so that consumers are left with more to spend
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Increasing government expenditure (eg the government borrows and spends)

Decreasing interest rates so that it is cheaper for consumers to borrow and spend
Of course, aggregate supply has limits. For example, once everyone is in employment it is difficult to
satisfy further demand. Output has reached its limit
Prices
Aggregate supply,
showing where full
Aggregate employment is reached
Demand 2 and no more goods can
be made.
Aggregate
Demand 1 B
Output
If no further goods can be made, yet demand keeps increasing, there will be a strong upward inflationary
pressure on the economy as output cannot adjust to meet demand. On the other hand, if demand is
lower than could be met by maximum demand, there is likely to be unemployment.
Prices
Full employment
Aggregate
Demand 2
B
C
Aggregate
Demand 1
A
Aggregate
supply
Output
At equilibrium point A, aggregate demand is equal to aggregate supply but there is spare productive
capacity and there will be unemployment. The line showing aggregate Demand 1 would have to move to
the right until it went through point C where full employment would be reached. The rightward move in
aggregate demand needed to achieve full employment is known as the deflationary gap.
At equilibrium point B, aggregate demand is higher than the maximum supply available. Output can’t increase so
prices rise steeply as a way of making demand and supply match. The line showing aggregate Demand 2 would
have to move leftward to go through point C and to achieve matched demand and supply. The distance aggregate
demand would have to reduce to achieve the match at point C is known as the inflationary gap.
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6. Shifts in the aggregate demand curve

This section is not talking about movement along an aggregate demand curve. Such movements are
causes by changes in prices that will increase or decrease demand. We are looking at what causes
demand curves to shift to the right (eg Demand line 1 moving to Demand line 2) or to the left.
Shifts to the right increase aggregate demand and is equivalent to an economy growing. Similarly, shifts
to the left imply the economy is contracting. Controlling economic growth or contraction will be a key
concern of all governments: fast growth can lead to inflation and can suck in imports to meet demand;
fast decline can lead to mass unemployment.
Rightward shifts are caused by:

An increase in disposable income. This can be caused by, for example, lower taxes, lower interest
rates, increased welfare payments.
Consumers deciding to save less (known as a lower marginal propensity to
save). Increased government spending
A more relaxed monetary policy (for example, the government simply printing more money
A change in net exports. When a country’s exchange rate weakens, its exports become cheaper to
foreign buyers and this stimulates demand in the economy as more goods are demanded by
overseas buyers.
Leftward shifts are caused by:

The opposite of each of the above influences
7. Inflation - causes
We need to look at the terminologies associated with two pieces of macroeconomics – inflation
and unemployment.
First, inflation. What causes inflation?

Demand pull. This is where there is a lot of money in the economy, lots of people who
want to spend money, and because demand is high, prices are pulled upward.
Cost push. An example of cost push inflation is where people in the manufacturing
industry, let’s say coal mining, have a large wage rise. Inevitably that wage rise is passed
on and will find itself reflected in the cost, say, of electricity. The cost of electricity goes up
and that’s an example of cost push inflation.
Import cost inflation. A good example of that was the huge increase in the cost of oil that
happened towards the end of 2008.
Expectation. This is where people expect there to be inflation and because they expect
inflation, they make higher wage demands and the higher wage demands inevitably push
up the price of goods that are going to be sold.
Increase in the money supply. An increase in the money supply will stimulate demand.
More people have money to buy goods and this will cause demand pull inflation.
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8. Unemployment
The second collection of terminology we need to look at is unemployment. What types of
unemployment are there?
Real wage unemployment. This is where people are effectively being paid too much. Employers
can’t afford to keep them on and therefore they lose their jobs. They’ve priced themselves out of
their markets. That tends to be self-correcting because once there is a large number of people
looking for job with particular skills that will tend to bring down the real wage price.
Frictional unemployment refers to the temporary unemployment of people as they move from
one job to another. There will always be some frictional unemployment and it’s not terribly
important socially because it is temporary.
Seasonal unemployment is obvious. It will refer to unemployment patterns in sectors such as

building and agriculture where there tends to be high unemployment during the winter.
Structural unemployment is more permanent. It occurs where the structure of the industry has
changed. An example of structural unemployment can be seen in the UK where we have closed
most of our coal mines. It was thought to be cheaper to import coal from abroad.
Technological unemployment speaks for itself. It is unemployment brought about by changes

in technology so the old skills and jobs disappeared.
Cyclical unemployment is a very long cycle of employment and unemployment as economies

rise and fall. Towards the end of 2008 most of the world entered a recession. The recession is
likely to last for some years and this causes high cyclical unemployment.
9. Monetary and fiscal policy

Governments have two main ways in which to control or regulate their economies:
monetary policy,
and fiscal policy.
Fiscal policy
First we’ll look at fiscal policy. And the word “fisc” is an old word which referred to the king’s
purse. Where does the state get the money from? Where does it spend it? If the state wants to
spend money it either has to raise income through taxes or borrow money. If it wants to reduce
taxes it either has to reduce expenditure or borrow money. The three have to be in balance.
In the current recession governments are seeking to spend more money. This is a way of
putting money into the economy to try to stimulate it. However, if they spend more by raising
taxes they may actually not end up putting very much more money into the economy. They are
taking with one hand and giving away with the other. So what most governments are doing is
increasing government borrowing. Keep taxes the same; borrow money, spend it, once it’s
spent it will be earned by people who will spend it again. And that’s the way in which
governments hope the recession will be brought to an end.
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Monetary policy
The second way in which governments attempt to control their economies is by their monetary
policy: managing the supply of money in the economy. The more money in the economy the
more economies are likely to be stimulated. There are two main weapons.
Interest rates. If interest rates are very high people will tend not to want to borrow money.
If you don’t borrow money you can’t spend it, and if you can’t spend it then, for example,
demand pull inflation will be relatively low. If however you greatly reduce the interest rates
more people will be encouraged to borrow. They spend that borrowed money on
televisions, cars, houses, whatever. And once it’s spent the money is in the economy,
other people earn it, demand goes up, and the economy is stimulated.
Credit controls. This is a control over institutions, typically banks, on how much they are
allowed to lend. So for example if you put $1,000 into a bank and the reserve requirement was
only 10%, that means that the bank could lend $900 out of the $1,000 deposited. That $900
could be deposited again and the bank could lend on $810 and so on. So the initial deposit of
$1,000 can create a much higher amount of money in the economy. Say however that the
reserve requirement was 50% - $1,000 in the bank; the bank only lend on $500. That $500 is
put into another account, the bank can lend on only $250 and so on. You can see that at the
end of the cycles a much smaller amount of money will be created in the economy.
10. Functions of taxation

Taxation has many functions. We’ve already pointed out that it raises revenues for the
government but it’s also used for other purposes. For example, to discourage certain activities
regarded as being undesirable. And a good example here would be a tax on cigarettes.
It can also be used to cause certain products to be priced to take into account their social costs.
There is increasing talk for example about a carbon tax of some sort because it is argued that if
you drive a car or fly in a plane the release of carbon has a social cost that ought to be paid for.
Obviously, tax can be used to redistribute income and wealth. Frequently people with higher
income and more wealth are taxed more highly and that is redistributed through government
expenditure to people who have less wealth.
It can be used to protect home industries from foreign competition; examples are import duties,
import tariffs where imports have a tax attached to them to make them more expensive relative
to the home-produced products.
Finally it can provide a stabilising effect on national income. Governments are often committed to
long-term expenditure plans but if the economy falls somewhat governments might seek to increase
the tax take so that the national income stays up and they don’t have to borrow any more.
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11. Types of taxation

Taxes can be described as:
regressive,
proportional, or
progressive.
A regressive tax takes a higher proportion of a poor person’s salary than it does for a rich
person. A simple example is VAT. If the VAT rate is 20% it doesn’t matter whether you are rich
or poor you still pay 20% and that is proportionally more taken from a poor person’s pay than it
is from a rich person’s income.
A proportional tax takes exactly the same proportion of income tax from all levels of income.
So you could have a flat rate tax which taxes everyone at say 10% from the very first dollar
earned, up to millions of dollars.
A progressive tax takes a higher proportion of income as income rises. So maybe for the first
$1,000 of income the tax rate is zero, for the next $4,000 of income the tax rate is 20%, and
anything beyond that is taxed at say 40%. A progressive tax would obviously be more effective
at redistributing wealth and income than either a regressive or a proportional tax.
Couple of more terms on tax.

A direct tax is paid directly by a person to the revenue authority. A good example there would
be income tax. A certain proportion of your income goes directly to the revenue authority.
An indirect tax is collected by the revenue authority from an intermediary, normally a supplier
of some sort. A good example of an indirect tax is VAT. You buy something, you pay over the
total purchase price, and then the seller passes some of that on to the government.
Some taxes are charged a fixed sum per unit sold. So if you were to buy a bottle of wine it
doesn’t matter whether it costs $5, $10 or $25; a fixed sum will go to the government.
An ad valorem tax is charged as a fixed percentage of the price of the good. A good
example of an ad valorem tax is VAT.
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Chapter 20
MICROECONOMICS
1. Introduction
Deals with the price and cost of manufacturing of goods, and with the reactions of suppliers of
customers.
2. The demand curve

P, price
Q, quantity
For most goods, as price increases the quantity demanded will reduce. This diagram shows a
linear decrease; in practice the demand curve is likely to be curved.
The position and slope of the demand curve depend on:

Price of goods
Consumers’ income. Very high income might imply that a change in price will not make
much difference to demand.
Substitutes and complements. A substitute product is one that can be bought as an alternative. For
example, olive oil and sunflower oil are substitutes for some purposes. If the price of olive oil
increases, the demand to sunflower oil is likely to increase as consumers switch. Complementary
products are often bought together. For example, cars and petrol. If the price of cars reduces,
more are bought, but more petrol will also be bought even though its price has not changed.
Fashion and taste. A fashionable item will have high demand and consumers may be
prepared to pay a high price.
Whether the goods are essential or luxury. If goods are essentials (like basic food) then
higher prices will not affect demand greatly. If goods are luxuries (or at least purchase of
them is discretionary), then a rise in price can cause a steep fall in demand. For example,
the purchase of foreign holidays is markedly affected by the price of those holidays.
Expectation of future price changes. If consumers think the price will rise, then current
demand is increased as they stock-up on the goods.
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P, price
Relatively inelastic
(a change in price
causes a small change
in demand)
Relatively elastic,
or price sensitive
Q, quantity
If demand is elastic, then demand for the good is price sensitive and a small change in price will
cause a relatively large change in demand. That is shown by the less steep line above.
If demand is inelastic, then demand for the good is relatively price insensitive and a change in
price will have a relatively small effect on demand.
The proportional (or percentage) change in

The price elasticity of demand is defined as: demand
The proportional (or percentage) change in price
Because an increase in price will normally cause a decrease in demand, technically this
measure is negative, but the negative sign is usually ignored.
Price elasticity of demand >1 means that a relatively small change in price will cause a
relatively large change in demand, so demand is elastic.
This has the consequent that revenue will increase if prices are reduced because the increase
in demand more than compensates for the fall in price.
Price elasticity of demand 0 < 1 means that a relatively small change in price will cause a
relatively small change in demand, so demand is inelastic.
This has the consequent that revenue will decrease if prices are reduced because the increase
in demand will not compensate for the fall in price.
Price elasticity of demand = 1 means that revenue will be constant if the price is changed slightly.
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3. Calculation of the price elasticity of demand
P, price
12
10
1000 2000 3000 4000 Q, quantity
In the above diagram, say that at a price of $8, demand is 1,200 and that at a price of 6,
demand is 2,200.
There are two approaches to calculating the elasticity:
Arc elasticity uses the mid point of the two quantities and prices as the basis point ie 1,700 ( =
(2,200 + 1,200)/2) for quantity and 7 for price.
Proportional change in demand = (2,200 – 1,200)/1700 = 0.588 or 58.8%
Proportional change in price = (8 – 6)/7 = 0.286 or 28.6%
Price elasticity of demand = 58.8/28.6 = 2
Point elasticity uses the starting points eg start price at 8 and demand at 1,200
Proportional change in demand = (2,200 – 1,200)/1200 = 0.833 or 833%
Proportional change in price = (8 – 6)8 = 0.25% or 25%
Price elasticity of demand = 83.3/25 = 3.3
Note that elasticity of demand change constantly along a demand curve, even if the demand
curve is a straight line. For example, in the table below, demand increases by 1,000 units for
each $1 decrease in price:
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Price Demand
($) (units)
12 5,000
11 6,000
10 7,000
9 8,000
8 9,000
7 10,000
6 11,000
5 12,000
4 13,000
3 14,000
2 15,000
1 16,000
The arc price elastic of demand from $12 to $11 is:

(6,000 – 5,000) 5,500
= 0.18/0.087 = 2 (very elastic)
(12 – 11)/11.5
The arc elasticity of demand between $3 and $2 is:
(15,000 – 14,000)/14,500 = 0.069/0.4 = 0.175 (very inelastic)

(3 – 2)/2.5
Income elasticity of demand
This measures how demand varies with income:
Income elasticity of demand = Proportional change in demand

Proportional change in income
The change in demand is represented by a shift in the demand curve: same quantity demanded
at a higher price or higher quantity demanded at the same price.
If the income elasticity of demand is negative then the goods are known as inferior goods
because as income rises consumers change to better brands. For example, changing from
inter-city bus services (cheap, but slow) to intercity trains (more expensive but faster).
Inelastic: 0 – 1: necessities. The goods were bought even when income was low.
Elastic: >1: luxuries. More goods are bought when there is ‘spare’ income.
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4. Demand and supply curves

P, price P, price
Q, quantity Q, quantity
In the demand curve as the price increases, demand falls off. In the supply curve, as the price
increases, production will increase because higher prices mean that there is the opportunity of
more profits.
However, profits will only be made if the goods produced actually sell and an equilibrium point
will be reached at a price where demand is matched by supply. The equilibrium point is the
market price of the product.
P, price
P1
P2
P3
Q1 Q2 Q3 Q, quantity
At a price of P1, Q3 will be made, but only Q1 demanded. There is excess supply and this will
drive down the selling price, increasing demand. Prices will stabilise at a price of P2 and
demand of Q2 where supply and demand match.
At a price of P3, Q3 is demanded but only Q1 supplied. There is excess demand and this will
push up the price of goods until, again, demand and supply match at the price of P2.
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5. Shifting the demand and supply curves

The diagram below shows a rightward shift in the demand curve.
P, price
Q, quantity
A rightward shift in a demand curve can be caused by:

Rise in income (more income implies more demand at a given price)
Rise in the price of substitutes (will increase the attractiveness of this
product) Rise in the expected price of the product (stocking-up now)
Reduction in the price of complements (as more complements are bought so more of the
product is bought)
Change in tastes (an item can become fashionable or otherwise
popular) Population increase (more people pursuing the goods).
As the demand curve shifts to the right more goods are demanded at the same price or the
same quantity would demanded at a higher price. Once again supply will adjust so that a new
equilibrium point is reached where demand and supply match. The equilibrium point moves
from A to B above in the above diagram.
The diagram below shows a rightward shift in the supply curve, meaning that more goods will
be produced at the same price or the same number of goods will be produced at a lower price.
P, price
Q, quantity
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A rightward shift in a supply curve can be caused by:

Fall in cost of production
Fall in the price of other
goods Technology changes
Improved efficiency
Subsidies
Lower taxes
If more goods are produced then to sell them the price will have to fall until equilibrium is
reached again. The equilibrium point moves from A to B in the diagram above.
6. Cost curves
There are two types of cost:
Fixed costs: do not vary in the short run as production increases.
For example, factory rent.
Variable costs: increase with production volume.
For example, labour costs.
As production costs increase, the average fixed cost (the fixed cost per unit) will decrease
because the constant fixed costs are being spread over more units. A graph of fixed cost per
unit against output would look like:
Average fixed cost
Q, quantity
Initially variable costs per unit will fall as the producer gains advantages from greater
efficiencies as more units are produced. Eventually the variable cost per unit increases because
of the law of diminishing returns. For example, as machines are run harder more repairs are
needed and the machine efficiency decreases. This is the law of diminishing returns.
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A graph of variable cost per unit will look like:
Average variable cost
Q, quantity
Combining the graphs will produce:
Costs
Average total cost
Average fixed cost
Q, quantity
Provided the selling price is above the average variable cost the firm will produce even if the
price is below the average total cost. For example, it would be worth producing and item for an
additional cost of $7 if it sold for $10. The $3 difference helps towards covering fixed costs.
The marginal cost is the cost of producing an extra unit.
If average total costs are falling, the marginal cost must be less than the prevailing average so that
the average cost is pulled down. If average total costs are rising, marginal costs must be greater
than the prevailing average to increase the average. The marginal cost line will therefore go through
the minimum point of the average total cost line. Similarly for average variable costs.
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Costs
Marginal cost
Average total cost
Average fixed cost
Q, quantity
In the long run, all costs are variable and fixed capacity can be increased so that the law of
diminishing returns will no longer apply. Indeed, increased capacity could bring economies of
scale so that the supply curve could even be downward sloping.
7. Types of competition
Perfect competition
Many small buyers and sellers, none of which is large enough to affect the market or the market price.
Free entry and exit from the market.
Buyers and sellers are ‘price-takers’: the market price rules ie the equilibrium price. If a supplier
raises its price, no-one will buy form that source as there a plenty of other suppliers. There is no
point in lowering selling price because the seller sells all that can be made at the market
price.Every buyer can buy what they want at the market price.
Imperfect competition
Monopolist: only one supplier. The price can be set at any level to maximise revenue or
profits, but volume demanded will change. Profits are, of course, not guaranteed as the
monopolist might be selling something no-one wants.
Oligopoly: a small number of suppliers (eg petrol companies). If a supplier raises prices,
the others will win market share by sticking at the old price. If a buyer lowers the price the
other have to follow to maintain market share.
Monopolistic competition (non-price competition): where firms seek to increase
demand for their products using something other than price. For example, brand and
reputation can be used. An example is found in the car industries. Ford, General Motors,
Nissan and VW all sell ‘family sized’ cars so are competing with each other. However, their
prices differ so they are using factors other than price to generate sales. For example, VW
will emphasise the engineering quality of its cars.
When you finished this chapter you should attempt the online AB MCQ Test
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THIS CHAPTER IS FOR HOME STUDY
1 Government policies and obligations

1.1 Governments seek to manage national economy, and this may include the following aims:
(a) To achieve economic growth
(b) To control price inflation
(c) To achieve full employment
(d) To achieve a balance between exports and imports
1.2 Governments spend money raised by taxation and borrowing on a variety of items.
Decisions by governments on taxing and spending affect companies in many ways:
(a) Suppliers to government
(b) Knock on effect of government spending throughout the economy
(c) Taxation affects consumers' purchasing power
(d) Taxes on profits affect investment returns
(e) Public sector investment benefits some companies
(f) Public sector investment has a longer time scale and less quantifiable benefits
1.3 Government influences are outlined in the diagram below:
O
Overall economic
policy
R
A
Industry policy
N
I
Environment and
infrastructure Distribution S
policy
Workplace regulation, A
employment law
Social policy
Labour supply, T
skills, education
Trade promotion, export credits I
Foreign policy EU andGATT obligations O

Export promotion to allies,
aid recipients
N
6: THE MACRO-ECONOMIC ENVIRONMENT
2 Fiscal policy
2.1 The formal planning of fiscal policy is set out in the 'Budget' which has three components:
(a) Expenditure planning
(b) Revenue raising
(c) Borrowing
If expenditure exceeds revenues the government will need to borrow. This is known
as the 'Public Sector Net Cash Requirement' (PSNCR).
2.2 Governments can use fiscal policy to change the level of demand in the economy:
(a) If government reduces taxation, but does not change its spending then economic
demand is stimulated.
(b) Demand can be increased by the government spending more, but not altering
taxation.
(c) Demand can be reduced by increasing taxation or reducing spending.
2.3 When the government's income exceeds its expenditure and, therefore it is repaying earlier
borrowings, it is known as having a 'budget surplus'. The opposite position is known as
running a 'budget deficit'.
2.4 Taxation is a key source of revenue raising. It also serves to discourage activities and to
redistribute income and wealth.
2.5 A good tax system should be:

(a) Flexible
(b) Efficient
(c) Able to attain its purpose
2.6 Taxes can be either:
(a) Direct
Paid directly to the Revenue authority (eg income tax, capital gains tax, inheritance
tax).
(b) Indirect
This is collected by the Revenue authority via a third party (a 'supplier') who passes
the tax on to consumers
Indirect taxes can be:
(i) A specific tax charged as a fiscal sum per unit sold (eg petrol tax)
(ii) 'Ad valorem tax' charged as a fixed percentage of the price of the item (eg
VAT).
3 Monetary policy
3.1 Monetary policy uses money supply, interest rates, exchange rates and credit control to
influence aggregate demand.
3.2 Instruments of monetary policy include:

 Changing interest rates through open market operations
 Changing reserve requirements
 Intervention to influence the exchange rate
3.3 Monetary control can reduce inflation which helps:

 Prevent economic uncertainty through high inflation
 Ensure business confidence and so stimulate investment
 Controlled money supply growth should provide higher incomes
4 National income and economic growth – key

terminology
4.1 Equilibrium national income
 Demand for goods and services is in balance with available supply and the level of
output is produced fully utilising resources.
4.2 Inflationary gap

 Occurs when resources are already employed so that an increase in demand will
serve to increase prices.
4.3 A 'deflationary gap' occurs where there is unemployment of resources. Prices are fairly
constant and real output changes as aggregate demand changes.
4.4 'Stagflation' occurs where there is a combination of high unemployment and high inflation
caused by a price shock (eg crude oil price rises in the early 1970's).
5 Phases in the business cycle

5.1 The business cycle is the continual sequence of rapid growth in national income followed by
a slowdown.
5.2 After slowdown or recession comes growth again and so on.

5.3 The four main phases of the business cycle are:

(a) Recession (point A on the graph below)
(b) Depression (point B on the graph below)
(c) Recovery (point C on the graph below)
(d) Boom (point D on the graph below)
Output
Time
5.4 In the 'Recession' phase consumer demand falls and previous investment projects begin to
look unprofitable. This phase can begin quite quickly.
5.5 If during the recession phase there is a lack of stimulus to aggregate demand a period of
'depression' will set in.
5.6 'Recovery' is usually slow to begin due to a general lack of confidence in the economy, but it
will quicken up. Incomes and employment will rise as output does.
5.7 Once the actual output has risen above the trend line the 'Boom' phase of the cycle is
entered. Capacity and labour become fully utilised in this phase.
6 Inflation and its consequences

6.1 Inflation is the name given to an increase in prices.
6.2 High inflation is a problem because it leads to:

(a) Redistribution of income and wealth
(b) Balance of payments effects
(c) Uncertainty of the value of money and prices
(d) Resource costs of changing prices
(e) Lack of economic growth and investment
6.3 The rate of inflation is measured by price indices. A 'basket' of items which represent
average purchases around the country is priced regularly and this forms the basis of a price
index.
6.4 In the UK there are now two key price indices:

(a) Retail Prices Index (RPI)
This index includes prices for all goods and services (including housing costs)
purchased by UK consumers.
(b) Consumer Prices Index (CPI)
This index, which excludes housing costs, is calculated on the same basis as the rest
of Europe.
(c) RPIX
This is the underlying rate of inflation excluding mortgage interest payments.
(d) RPIY
This is RPIX as adjusted for the effects of any VAT changes.
7 Unemployment
7.1 The rate of unemployment can be calculated as:
Number of unemployed
 100%
Total workforce
7.2 Consequences of unemployment include:

(a) Loss of output
(b) Loss of human capital
(c) Increases inequalities in income distribution
(a) Social costs
(e) Increased welfare payments
7.3 Unemployment can be classified into categories:

(a) Real wage unemployment (labour supply exceeds demand but wage rates do not fall)
(b) Frictional (delays in transferring from one job to another)
(c) Seasonal (eg tourism)
(d) Structural (eg coal mining)
(e) Technological (eg robots in car plant)
(f) Cyclical or demand deficient (reflects the economic cycle)
8 Objective of economic growth

8.1 Economic growth is measured by increases in real gross national product (GNP) per head of
population.
8.2 Factors which contribute to growth include:

(a) New investment
(b) Natural resources
(c) Labour sources
(d) Capital availability
(e) Technological progress
9 The balance of payments

9.1 The balance of payments account relates to foreign exchange movements in a country. It
consists of a current account for trading activities and a capital account.
9.2 The current account is sub-divided into:

(a) Trade in goods
(b) Trade in services
(c) Income from:
– Employment by overseas companies of UK residents
– Returns on overseas capital investment
(d) Transfers from:
– Interest payments to/from overseas bodies, eg EU
– Non government payments to/from overseas bodies, eg EU
9.3 The capital account comprises public sector flows of capital (eg government loans to other
countries).
9.4 The balance on the financial account comprises flows of capital to/from non government
sector (eg investment overseas).
9.5 The sum of the balance of payments accounts must always be zero, excluding statistical
errors in collecting the data known as the 'balancing item'. When commentators speak of a
balance of payments surplus or deficit they are only referring to the current account, which
is also known as the balance of trade.
9.6 Deficit Surplus
Importing more Exporting more

than exporting than importing
10 Chapter summary
 This chapter has explained the impact of government policy on the macro economy
and the potential impact of policy decisions on organisations.
CHAPTER 4
MACRO-ECONOMIC FACTORS
4.1 ACCA SYLLABUS GUIDE OUTCOME 1

DEFINE MACRO-ECONOMIC POLICY
4.1.1 Macro-economic policy / macroeconomics is concerned with the total

(aggregate) scenario of economic issues that determine a person's economic well-
being as well as that of one's family and everyone s/he knows. These issues involve
the overall economic performance of the nation, rather than that of particular
individuals.
Do citizens find it easy or difficult to find jobs? (Unemployment rate)

On average are prices rising rapidly, slowly, or not at all? (Concept of inflation)
How much total income is the nation producing, and how rapidly is total
income growing year after year? (Productivity)
Is interest rate charged to borrow money high or low?
Is the Government spending more than it collects in tax revenue?
(Government budget)
Is the nation as a whole accumulating assets in other countries or is it
becoming more indebted to them? (Foreign trade deficit)
Each of the above questions involve a central macroeconomic concept that affect the
factors of production – land, labour, capital and entrepreneurship. The basic task of
macroeconomics is to study the behaviour of the policy objectives, namely economic
growth, inflation, unemployment and balance of payments and why each matter to
individuals and what the government can do (if anything) to improve macroeconomic
performance.
Thus, one can say that the study of economics can be divided into two –
macroeconomics and microeconomics. Macroeconomics considers aggregate
behaviour, and the study of the sum of individual economic decisions.
Microeconomics is the study of the economic behaviour of individual consumers,
firms and industries.
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41
EXPLAIN THE MAIN DETERMINANTS OF THE LEVEL OF BUSINESS
ACTIVITY IN THE ECONOMY AND HOW VARIATIONS IN THE LEVEL OF
BUSINESS ACTIVITY AFFECT INDIVIDUALS, HOUSEHOLDS AND
BUSINESSES
The economy is rarely in a stable state because of the various changing factors
which influence it. An interesting factor is the multiplier. A multiplier is basically a
factor of proportionality that measures how much an X variable changes in response
to a change in some Y variable.
4.2.1 Determinants of the level of Business Activity
Confidence
When consumers are confident, they tend to demand more whilst higher
business confidence results in higher investment. Confidence is generally put
at a threat when there is political instability, disasters, unemployment and high
inflation.
Aggregate Demand
AD=C+I+G+X–M
AD – Aggregate Demand
 C – Consumer Spending
I – Investment by firms
G – Government Spending
 X – Demand for exports
M – Imports
Balance of Payments
Under the current method of presentation of the UK balance of payments statistics,

current account transactions are sub-divided into four parts.
 Trade in goods
 
Trade inservices
 Income 
Transfers.
When journalists on economists speak of the balance of payments they are usually
referring to the deficit or surplus on the current account.
The government of a country with a balance of payments deficit will usually be

expected to take measures to reduce or eliminate the deficit by one or more of the
following measures:
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42
A depreciation of the currency known as devaluation
Direct measures to restrict imports, such as tariffs or import quotas or
exchange control regulations
Domestic deflation to reduce aggregate demand in the domestic economy
The first two are expenditure switching policies which transfer resources and
expenditure away from imports and towards domestic products while the last is an
expenditure reducing policy.
Capital - If firms raise their finance it will result in higher levels of investment.
Lower interest rates will make capital cheaper.
Use of Resources - Advancements in technology results in efficient work

practices and can improve productivity. A well-educated work force can also
result in better and more productive work.
Government Policy - Government can affect aggregate demand through

fiscal policy (the blend of government spending and taxation). If Government
spending increases then the overall aggregate demand will increase
Exchange Rate Movements - A strengthening currency will make exports of

a particular country more expensive and in that case imports will result to be
cheaper.
What are the impacts of having an appreciating (strengthening) currency?
Exports are hurt.
Most developing countries have economies based largely on exports that are
competitive in global markets because of low prices. A case in point nowadays is
China. When those countries’ currency gains in value, they are no longer able to
offer exports to the global market at the same low prices that they planned to. This
may cause importers (of other countries) to look elsewhere, to countries with lower
valued currency resulting in better prices. It may also be the case that the importers
will start ordering less from the said country having an appreciating currency.
Repatriated profits from a country’s international economic activity are hurt.
Currency appreciation at home means that money made elsewhere won’t stretch as
far in supporting the domestic economy
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43
EXPLAIN THE IMPACT OF ECONOMIC ISSUES ON THE INDIVIDUAL,
THE HOUSEHOLD AND THE BUSINESS
4.3.1 Inflation
The inflation rate is the percentage rate of increase in the economy's average level
of prices. A high inflation rate means that prices on average are rising rapidly, while
a low inflation rate means that prices on average are rising slowly. In inflationary
periods, retired people or those about to retire are those of the biggest losers since
their hard-earned savings will buy less and less as prices go up. While a high
inflation rate harms those who have saved in the past, it helps those who have
borrowed. It is this capricious aspect of inflation, taking from some and giving to
others, that makes people dislike inflation. People want their lives to be predictable,
but inflation throws a monkey wrench into individual decision making, creating
pervasive uncertainty.
An inflationary gap exists in an economy when aggregate demand (total demand in

an economy) is greater than the full employment level of income.
One important measure of the general rate of inflation in the UK used over many
years has been the Retail Price Index (RPI). The RPI measures the percentage
changes month by month in the average level of prices of the commodities and
services, including housing costs, purchased by the great majority of households in
the UK. The items of expenditure within the RPI are intended to be a representative
list of items, current prices for which are collected at regular intervals.
4.3.2 Causes of inflation
Demand pull inflation
Demand pull inflation arises from excess demand over productive capacity of the
economy. It is a situation when demand exceeds supply and prices rise. Demand
pull inflation only exists when unemployment is low.
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44
Considering the case scenario in the graph above, P1, that is price 1 was the original
price when national income was Y1. When demand pull takes place, the curve AD1
shifts to AD2 since demand increases (too much money chasing too few goods). As
a result, P1 increases to P2 reflecting inflation and Y1 increases to Y2 reflecting an
increase in national income.
When P1 decreases to P3, that means that demand decreased, shifting AD1 to AD3
resulting in a decrease in national income from Y1 to Y3.
In a situation when inflation is rising, demand side policy which is controlled by the
government would focus on reducing aggregate demand through tax rise, cuts in
government spending and higher interest rates. This is done in an effort to regularise
inflation to control it from continuing to rise.
Cost-push inflation
This is a result of increases in the costs of production thus short-run aggregate

supply (SRAS) shifts from SRAS1 to SRAS2. Its effect leaves an increase in price
from P1 to P2. Thus, this increase in price is in fact inflation. Cost-push inflation
arises whether or not there is a demand for supply, for example, an increase in the
cost of wages.
Imported inflation
Cost of import rises regardless of whether there is a high demand for supply, for
example, an increase in oil prices. The same explanation sticks from point no. 2 case
scenario.
Monetary inflation
Monetary inflation means an increase in the supply of money. There is a debate

whether an increase in money supply is a cause of inflation or whether an increase
____________________________________________________________________
45
in the money supply is a symptom of inflation. What happens is that the more supply
in money, the more people will buy thus demand will increase. As a result, if this
increase in demand occurs faster than the expansion in the supply of goods and
services, then, inflation will take place. Monetarists (supply side view) argue that a
good tool to fight such inflation is to decrease the supply of money and increase
interest rates.
Expectations effect
Once inflation has started to rise, there may be “expectational inflation”, that is,
people will start expecting inflation to rise even higher. A general held view of future
inflation therefore, sets for example, wages accordingly. This is known as the wage-
price spiral.
4.3.3 Unemployment
Unemployment rate is the number of jobless individuals who are actively looking for
work divided by the total of those employed and unemployed.
The higher the overall unemployment rate, the harder it is for each individual who
wants to find work. Everyone fears a high unemployment since it raises the chances
that they will be laid off from their present work, will be unable to pay their bills etc.
A government can try several options to create jobs or reduce unemployment.

Spending more money directly on jobs
Encouraging growth
Encouraging training in job skills
Offering grant assistance to employers
Encouraging labour mobility
4.3.4 Types of unemployment
Category Comments
Real wage Caused when the supply of labour exceeds demand but real wages
unemployment do not fall. Caused by strong trade unions which resist a fall in wages.
Abolishing (put an end to) closed shop agreements and minimum
wage regulations are policies which may be directed at reducing real
wage to market clearing levels.
Frictional Difficulty in matching quickly workers with jobs. Possibly caused by
lack of knowledge of job opportunities. Usually temporary
Seasonal Especially in certain trades as farming etc
Structural Occurs during long-term change in conditions. For example, a long-
term change in a community that relies on one particular industry
Technological A form of structural that occurs then new technology arises.
Cyclical or Matches economic climate trends such as boom, decline, recession
demand- and recovery. Demand for labour fluctuates as demand rises and falls
deficient
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46
4.3.5 Stagnation or Stagflation
This is a combination of unacceptably high levels of unemployment and

unacceptably high levels of inflation. During the 1970 in the UK a major rise in the
price of crude oil took place. This meant that the cost of energy rose and therefore
rendered some products unprofitable. National income fell and both prices and
unemployment rose. Any long term major increase in costs could have this effect.
4.3.6 International payments Disequilibrium
A “fundamental disequilibrium” exists when outward payments have a continuing

tendency not to balance inward payments. Disequilibrium may occur for various
reasons. Some may be grouped under the head of structural change (resulting from
changes in tastes, habits, institutions, technology, etc.). A fundamental imbalance
may occur if wages and other costs rise faster in relation to productivity in one
country than they do in others. Imbalance may also result when aggregate demand
runs above the supply potential of a country, forcing prices up or raising imports. For
example, a war may have a profoundly disturbing effect on a country’s economy
4.4 ACCA SYLLABUS GUIDE OUTCOMES 4 and 5
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47
DESCRIBE THE MAIN TYPES OF ECONOMIC POLICY THAT MAY BE
IMPLEMENTED BY GOVERNMENT AND SUPRA-NATIONAL BODIES
TO MAXIMISE ECONOMIC WELFARE
RECOGNISE THE IMPACT OF FISCAL AND MONETARY POLICY
MEASURES ON THE INDIVIDUAL, THE HOUSEHOLD AND
BUSINESSES
A macro-economic policy relates to economic growth, inflation,

unemployment and the balance of payments.
Economic policy objectives:

Achieve economic growth
Control price inflation
Achieve full employment
Achieve balance between import and export
4.4.1 Fiscal policy (Keynesian view)
Fiscal policy (Keynesian view) has to do with the government’s decisions

about spending and taxes. This provides a method of managing aggregated
demand in the economy. There are several elements to the fiscal policy and
that of the budget:
 Expenditure
The government spends money both nationally and regionally on such
things as health services, educational, roads, policing. It also provides
commercial incentives to the private sector through grants.

 Revenues
To spend the money on public services the government needs an
income. The majority of the income comes from taxes although some
come from direct charges like National Health Service charges. A
regressive tax takes a higher proportion of a poor person’s salary than
a rich person’s. Example - road tax. A proportional tax takes the same
proportion of income in tax from all levels of income. A progressive tax
takes a higher proportion of income in tax as income rises. Example –
Income tax.

 Borrowing
Should a governments’ spending exceed its income then it must
borrow. The amount it must borrow is known as the PUBLIC SECTOR
NET CASH REQUIREMENT (PSNCR). This has a profound effect of
the fiscal policy as a whole.
4.4.2 Budget Surplus and Budget Deficit
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48
Should the government use its fiscal policy to influence demand in the
economy then it needs to choose either expenditure changes or tax changes,
as its policy instruments, or a combination of both. The government could:
Increase demand by directly spending more itself, for example, future

investment and spending on the health service or employing more people. If
the government was to influence demand by spending more, this would have
to be financed either through increasing taxes or borrowing. However, by
increasing taxes, organisations, households and individuals would have less
to spend.
Increase demand indirectly by reducing taxation - Tax cuts are often

followed by cuts in government spending. Therefore, total demand will not be
stimulated within the economy. Again, tax cuts could also be funded by an
increase in government borrowing. Should the government decide to lower
tax then organisations, households and individuals would have more money
after tax thus have the ability to spend more.
When the government is running a budget deficit it means that total public
expenditure exceeds revenue. As a result, the government has to borrow
through the issue of government debt. If the government sector is taking in
more revenue than it is spending, there is a budget surplus allowing the
government to repay some of the accumulated debt, of perhaps cut the
burden of tax or raise government expenditure.
4.4.3 Monetary Policy
Monetary Policy looks at the supply of money, the monetary system, interest
rates, exchange rates and the availability of credit. All of which are highly
important to organisations, households and individuals. Businesses can be
affected by governments' taxation policies outlined within the fiscal policy
AND equally affected by high interest rates set out within the monetary policy.
In the UK, the ultimate objective of monetary policy in recent years has been
principally to reduce the rate of inflation to a sustainable low level. The
intermediate objectives of monetary policy have related to the level of interest
rates, growth in the money supply, the exchange rate of sterling, the
expansion of credit and the growth of national income.
4.4.4 Money Supply within the Monetary Policy (Moneterists view)
This is an intermediate target and should be seen as a medium term target.

The argument is that by increasing money supply this will raise prices and
incomes and this will increase the demand for money to spend.
There are however three short-term unpredictable effects:
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49
May cause erratic (sudden) interest rates
Time lag. It takes time to cut government spending!
Time lag before control over money supply alters expectations
4.4.5 Interest Rates within the Monetary Policy
There are suggestions that there is a direct relationship between interest

rates and the levels of expenditure in the economy or put simply, between
interest rates and inflation. A rise in interest rates will raise the price of
borrowing. This could lead to a reduction in investments through the
economy should organisations perceive the high rate to be relatively
permanent. Profits would fall due to higher borrowing rates and organisations
may have to consider a reduction in inventory levels. For individuals, there is
less likelihood of borrowing for house purchases. A strong reason for
pursuing an interest rate policy is that it can be implemented rapidly
compared to other target policies.
4.4.6 The Exchange Rate within the Monetary Policy
There are few reasons why the exchange rate plays an important part of the
monetary policy
If exchange rates fall, exports become cheaper to overseas buyers

and so more competitive in export markets. However, imports will
become more expensive. Therefore, a fall in exchange rates might be
good for a domestic economy, by giving a stimulus to exports and
reducing demand for imports.

An increase in exchange rates will have the opposite effect, with
dearer exports and cheaper imports. If this happens, there should be a
reduction in the rate of domestic inflation. However, the opposite would
happen with a fall in exchange rates therefore, adding to the rate of
domestic inflation.
Rates of domestic inflation need to be controlled prior to introducing a robust

target for the exchange rates due to some country’s being heavily dependent
on overseas trade
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50
4.4.7 Monetary & Fiscal Policy
Monetary policy can act as a subsidiary to fiscal policy. As a budget is usually

a once a year event, the government may need to use non-fiscal measures to
control the economy. These are typically:
Low interest rates or lack of credit control to stimulate bank lending

 High interest rates to stop bank lending
Strict credit control to reduce lending and reduce demand on the
economy
Supply-side economic policies are mainly designed to improve the supply-

side potential for an economy, make markets and industries operate more
efficiently and thereby contribute a faster rate of growth of real national
output. There are two broad approaches to the supply-side. Firstly policies
focused on product markets where goods and services are produced and
sold to consumers and secondly the labour market is bought and sold.
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51
_____________________________________________________________
KEY POINTS
__________________
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52
Macroeconomics considers aggregate behaviour, and the study of the
sum of individual economic decisions.
The main economic variables in the study of macroeconomics are:

 unemployment rate
inflation rate
productivity
 interest rate
government budget
foreign trade deficit

The above economic variables tend to have an effect on the factors of
production:
land
 labour
capital
entrepreneurship
Microeconomics is the study of the economic behaviour of individual

consumers, firms and industries
Factors that influence the level of business activity are:
Aggregate Demand (AD = C + I + G + X – M)


Capital (+Capital = +Investment / -interest rates = -value of capital)

Use of resources (+technology = +productivity / +technology = -costs of
producing)

Government policy (+government spending = +aggregate demand)

Exchange rate movements (Strong currency = exports more
expensive/imports cheaper)
Inflation is the % rate of increase in the economy's average level of

price.
An inflationary gap exists in an economy when aggregate demand (total

demand in an economy) is greater than the full employment level of
income.
Those who lend are the ones that tend to loose when inflation takes
place (considering no interest is charged). Thus, those who borrow
are the ones that benefit from inflation cause the purchasing power
today is greater than when the money is returned to the lender.
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53
Causes of inflation:
 demand pull
cost push
 imported
monetary
expectational

Unemployment is measured by:
Number of unemployed x 100%

Total workforce
11. Types of unemployment:
Frictional Structural Real Wage

Cyclical Seasonal
⸀Ā⸀Ā⸀ Stagnation/stagflation is a combination of unacceptably high levels

of unemployment and inflation.
⸀Ā⸀Ā⸀ International payments disequilibrium is a state where the imports

of a particular country exceed the exports. Thus, outward payments will
surpass inward payments.
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54
_____________________________________________________________
QUESTION BANK
__________________
Question 1
____________________________________________________________________
55
Which of the following is not an objective of macroeconomic policy?
Economic growth
Control of inflation
Lower levels of taxation
A balanced balance of payments
Question 2
The factors of production are __________, labour, capital and

entrepreneurship
Area
Machinery
Fixed assets
Land
Question 3
Which of the following is not one of the four macroeconomic policy objectives
of governments?
economic growth
inflation
unemployment
balance of trade
Question 4
The total level of demand in the economy is made up of consumption,

_________, government expenditure, and net gains from international trade.
Which of the following correctly completes the sentence above.
Savings
Taxation
Investment
Question 5
If citizens are confident they tend to demand more for goods.

Is this statement true or false?
True
False
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56
Question 6
Which one of the following would cause a fall in the level of aggregate
demand in an economy?
a decrease in the level of imports

a fall in the propensity to save
a decrease in government spending
a decrease in the level of income tax
Question 7
You are the Finance Director for ADC Co. Ltd., which is the Maltese agent for
BMW cars. In the last 6 months the mother company has experienced
substantial increases in the prices. As a result the cost per car to ADC Ltd.,
has increased drastically. What will you do in this case?
A. Stop importing
B. Increase prices
C. Keep the prices constant
D. Decrease prices
Question 8
Eventually the Finance Director had to increase prices accordingly (refer to

question 7). To which type of inflation is this case contributing?
A. Demand pull factors

B. Cost push factors
C. Import costs factors
D. Expectations and inflation
E. Money supply growth
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57
Question 9
Martin is an experienced and fully trained shipbuilder, based in the western

European city. Due to significant economic change in supply and demand
conditions for shipbuilding in Martin's own country, the shipyard he worked for
has closed and he was made redundant. There was no other local demand
for his skills within his own region and he would have to move to another
country to obtain a similar employment, and could only find similar work
locally through undertaking at least a year's retraining in a related engineering
field. Which of the following describes the type of unemployment that Martin
has been affected by?
Structural
Cyclical
Frictional
Marginal
Question 10
In an economic environment of high price inflation, those who owe money will
gain and those who are owed money will lose.
Is this statement true or false?
True
False
Question 11
Cyclical unemployment refers to unemployment:
which occurs because of the seasonal nature of some industries

resulting from the long-term decline of an industry
which occurs at particular times of the year
which occurs during recessions
Question 12
An inflationary gap exists in an economy when:
the government has a budget deficit

aggregate demand is greater than the full employment level of income
the money supply rising faster than national income
the government increases its level of expenditure
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58
Question 13
Structural unemployment is caused by:
long-term decline in demand for an industry's products

falling levels of aggregate demand
high level of inflation
a downturn in national economic activity
Question 14
Which of the following is an example of cyclical unemployment?
lay-offs amongst ski instructors in the summer months

automation of ticket sales at train stations resulting in the redundancy of
ticket officers
recession in the building industry
the restriction of employment in the car industry due to powerful trade
union keeping wages high
Question 15
Inflation has a number of causes and solutions. Which of the following

scenarios describes cost-push inflation?
the underlying cost of factors of production (raw material and labour)

increases and this is reflected in an increase in output prices as firms seeks
to maintain their profit margins
the national currency weakens increasing the cost of imports in a country
where imports are significant to the economy
demand for goods and services in the economy grows faster than the
ability of the economy to supply these goods and services (I.e. too much
money is chasing too few goods)
the money supply in the economy is increased boosting demand for
goods and services. The expansion in demand is however occurring faster
than the expansion in the supply of goods and services
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59
Question 16
Northland, Southland, Eastland and Westland are four countries of Asia. The
following economic statistics have been produced for the year 2007.
Country Northland Southland Eastland Westland

Change in GDP (%) -0.30 +2.51 -0.55 +2.12
Balance of payments current account ($m) +5550.83 -350.47 -150.90 +220.39
Change in consumer prices (%) +27.50 +15.37 +2.25 +2.15
Change in working population employed (%) -4.76 +3.78 +1.76 -8.76
Which country experienced stagflation in the relevant period?
Northland
Southland
Eastland
Westland
Question 17
Which type of unemployment arises from a permanent reduction in demand

for the products supplied by a single industry or group of industries with
traditionally large workforces?
Frictional
Structural
Cyclical
Seasonal
Question 18
Which of the following would cause a fall in the level of aggregate demand in
an economy?
a decrease in the level of imports

a fall in the propensity to save
a decrease in government expenditure
a decrease in the level of income tax
____________________________________________________________________
60
Question 19
Which one of the following is consistent with a government's policy objective

to expand the level of economic activity
A. an increase in taxation
B. an increase in interest rates
C. an increase in personal savings
D. an increase in public expenditure
Question 20
Which of the following would be part of a supply-side policy to reduce

unemployment in an economy?
Reducing the supply of imports by raising trade barriers

Increasing labour retraining schemes
Supplying government subsidies to declining industries
A reduction in the level of public expenditure
Question 21
A reduction in interest rate will reduce consumption.
True
False
Question 22
Which of the following are the likely consequences of a fall in interest rates?
rise in the demand for consumer credit

fall in investment
fall in borrowing
rise in the demand for housing
A. (a) and (b) only

B. (a), (b) and (c ) only
C. (a) and (d) only
D. (b), (c ) and (d) only
Question 23
A reduction in the interest rates will increase investment.
True
False
61
Question 24
If a government increased its expenditure and reduced levels of taxation the

effect would be to (a) ________ demand in the economy and to (b)
_________ the size of the Public Sector Net Cash Requirement (PSNCR)
Which words correctly complete this statement?
(a) reduce, (b) reduce

(a) stimulate, (b) reduce
(a) stimulate, (b) increase
(a) reduce, (b) increase
Question 25
Which of the following is one of the four typical governmental macroeconomic

policy objectives?
maximising taxation revenues whilst sustaining economic growth

reducing the gap between the highest and the lowest paid
control of inflation
ensuring that every citizen has access to a minimum level of state
benefits
Question 26
Which of the following is one of the important generic (mainly economic)

factors that influence the level of business activity in an economy?
levels of immigration
rising stock markets
exchange rate movements
levels of unemployment
Question 27
Fiscal policy refers to the level of public expenditure and to the raising of that
expenditure via taxation; it is usually understood with the context of which of
the following:
supply side policies

classical policies (do nothing)
monetary policies
demand side policies
62
Question 28
Which of the following policies for correcting a balance of payments deficit is

an expenditure-reducing policy?
cutting the level of public expenditure

devaluation of the currency
the imposition of an import tax
the use of import quotas
Question 29
Which of the following would not correct a Balance of Payments Deficit?
re-valuing the currency

raising domestic interest rates
deflating the economy
imposing import controls
Question 30
A tax which takes a higher proportion of a poor person’s salary than a rich
person’s is:
proportional tax
regressive tax
progressive tax
indirect tax
Question 31
High rates of personal income tax are thought to have a disincentive effect.
This refers to the likelihood that the high rates of tax will:
encourage illegal tax evasion by individuals

lead to a reduction in the supply of labour
lead to a reduction in savings by individuals
discourage consumer spending and company investments.
63
Question 32
The government of Malta decides to introduce a new tax, which will involve a
flat rate levy of €300 on every adult of the population. This new tax can be
described as:
regressive
proportional
progressive
ad valoren.
Question 33
Which of the following will not be the immediate purpose of a tax measure by
government?
To discourage an activity regarded as socially undesirable

To influence interest rates
To protect a domestic industry from foreign competition
To price certain products go as to take into account their social cost
Question 34
Other things remaining equal, an increase in the money supply will tend to
reduce
Interest rates
The volume of bank overdrafts
Liquidity preference
Prices and incomes
Question 35
Which of the following is not likely to result from a fall in the exchange rate?
A stimulus to exports
An increase in the costs of imports
Reducing demand for imports
A reduction in the rate of domestic inflation.
64
_____________________________________________________________
ANSWER BANK
__________________
65
C – taxation is a tool not an object
C – the government is the biggest spender in an economy
C – PSNCR is the shortfall between public sector revenues and

expenditure
66
C
B – the disincentive effect refers specifically to the disincentive of

individuals to work
A – taking more from a poor person’s salary
B – interest rates are controlled by monetary policy
D – a fall in exchange rate will make it more attractive for importers in

another country and more expensive to import locally. It will also
reduce the rate of domestic inflation.
67
CHAPTER 5
MICRO ECONOMICS FACTORS

DEFINE THE CONCEPT OF DEMAND AND SUPPLY FOR GOODS
AND SERVICES
5.1.1 Microeconomics
Microeconomics looks into the individual people and firms within the
economy. It tends to be more scientific in its approach than macro
economics. Analyzing certain aspects of human behavior (including groups
and organizations that have a two-way operation relationship with the
business), microeconomics shows how individuals and firms respond to
changes in price and why they demand what they do at particular price levels.
An organisation’s micro environment consists of itself and its current and

potential customers, suppliers and intermediaries. The competition also has a
key influence on the micro environment.
The 5 M’s refer to inputs that an organisation requires in order to function.

They are:
Materials
Money
Men (human
resources) Machines
Management
Utility is the word used to describe the satisfaction or benefit a person gets
from the consumption of goods. Total utility is the total satisfaction that people
derive from spending their income and consuming goods. Marginal utility is
the satisfaction gained from consuming one additional unit of a good or the
satisfaction forgone by consuming one unit less.
5.1.2 Demand for goods and services

Five main variables influence the quantity of each product that is
demanded by each individual consumer:
The price of the product – creates a movement in the demand curve
The prices of other products – creates a shift in the demand curve
The consumer’s income and wealth – creates a shift in the demand
curve
68
Various sociological factors – creates a shift in the demand curve
The consumer’s tastes – creates a shift in the demand curve
A basic economic hypothesis is that the lower the price of a product, the
larger the quantity that will be demanded, other things being equal. This in
fact reflects a downward sloping curve as in below diagram.
A, B and C are points on the demand curve. Each point on the curve reflects
a direct correlation between quantities demanded (Q) and price (P). So, at
point A, the quantity demanded will be Q1 and the price will be P1, and so on.
The demand relationship curve illustrates the negative relationship between
price and quantity demanded. The higher the price of a good the lower the
quantity demanded (A), and the lower the price, the more the good will be in
demand (C).
5.1.3 Supply for goods and services
Four major determinants of the quantity supplied in a particular market are:

The price of the product – creates a movement in the supply curve
The prices of factors of production – creates a shift in the supply curve
The goals of producing firms – creates a shift in the supply curve
The state of technology – creates a shift in the supply curve
The amount of a product that firms are able and willing to offer for sale is
called quantity supplied. Supply is a desired flow; how much firms are
willing to sell per period of time, not how much they actually sell.
The quantity of any product that firms will produce and offer for sale is
positively related to the product’s own price, rising when price rises and falling
when price falls. This in fact reflects an upward sloping curve as in below
diagram.
69
A, B and C are points on the supply curve. Each point on the curve reflects a
direct correlation between quantities supplied (Q) and price (P). At point B,
the quantity supplied will be Q2 and the price will be P2, and so on.
5.1.4 Equilibrium
When supply and demand are equal (i.e. when the supply function and
demand function intersect) the economy is said to be at equilibrium. At this
point, the allocation of goods is at its most efficient because the amount of
goods being supplied is exactly the same as the amount of goods being
demanded. Thus, everyone is satisfied with the current economic condition.
At the given price, suppliers are selling all the goods that they have produced
and consumers are getting all the goods that they are demanding.
70
EXPLAIN ELASTICITY OF DEMAND AND THE IMPACT OF
SUBSTITUTE AND COMPLEMENTARY GOODS
5.2.1 Price Elasticity of Demand
If Pizza Hut raises its prices by ten percent, what will happen to its revenues?
The answer depends on how consumers will respond. Will they cut back
purchases a little or a lot? This question of how responsive consumers are to
price changes involves the economic concept of elasticity.
The most common elasticity measurement is that of price elasticity of

demand. It measures how much consumers respond in their buying
decisions to a change in price.
Price elasticity of demand (PED) is a measure of the extent of change in the

market demand for a good in response to a change in its price. The
coefficient of PED is measured as:
Percentage change in quantity demanded / Percentage change in price
Since demand usually increases when the price falls, and decreases when
the price rises, elasticity has a negative value. However it is usual to ignore
the minus sign and just describe the absolute value of the coefficient.
If we are measuring the responsiveness of demand to a large change in

price, we can measure elasticity between two points on the demand curve,
and the resulting measure is celled the arc elasticity of demand.
Example
Annual demand at €1.10 per unit is 700,000 units.

Annual demand at €1.20 per unit is 650,000 units.
Average quantity over the range is 675,000 units.
Average price is €1.15.
change in demand = 50,000 x 100% = 7.4%

675,000
change in price = 10c x 100% = 8.7%

115c
Price elasticity of demand = -7.4 = -0.85

8.7
Demand is INELASTIC over the demand range considered, because the

price elasticity of demand (ignoring the minus sign) is less than 1.
71
Price elasticity of demand is considered to be elastic. When the answer is
greater than 1 (ignore the minus sign).
5.2.2 Factors that determine the value of price elasticity of demand
Number of close substitutes within the market - The more (and closer)
substitutes available in the market the more elastic demand will be in
response to a change in price. In this case, the substitution effect will be quite
strong.
Luxuries and necessities - Necessities tend to have a more inelastic

demand, whereas luxury goods and services tend to be more elastic. For
example, the demand for cinema tickets is more elastic than the demand for
bus travel. The demand for vacation air travel is more elastic than the
demand for business air travel.
Percentage of income spent on a good - It may be the case that the

smaller the proportion of income spent, taken up with purchasing the good or
service, the more inelastic demand will be.
Habit forming goods - Goods such as cigarettes and drugs tend to be

inelastic in demand. Preferences are such that habitual consumers of certain
products become desensitized to price changes.
Time period under consideration - Demand tends to be more elastic in

the long run rather than in the short run.
5.2.3 Income elasticity of demand
Income elasticity of demand = % change in quantity demanded %

change in income
Demand for a good is income elastic if income elasticity is greater than 1 and
it is inelastic between 0 and 1.
Goods whose income elasticity of demand is positive are said to be NORMAL

GOODS, meaning that demand for them will rise when household income
rises. If income elasticity is negative, the commodity is called an INFERIOR
GOOD since demand for it falls as income rises.
5.2.4 Cross elasticity of demand
Cross elasticity of demand = % change in quantity demanded of good A

change in the price of good B
72
Cross elasticity involves a comparison between two products. The concept is
a useful one in the context of considering substitutes and complementary
products.
Cross Elasticity Value

Perfect complements -1
Complements -ve
Unrelated products 0
Substitutes +ve
Perfect substitutes +1

EXPLAIN THE ECONOMIC BEHAVIOUR OF COSTS IN THE SHORT
AND LONG TERM
The short run is a period of time in which the quantity of at least one input is
fixed and the quantities of the other inputs can be varied. The long run is a
period of time in which the quantities of all inputs can be varied. There is no
fixed time that can be marked on the calendar to separate the short run from
the long run. The short run and long run distinction varies from one industry to
another."
In the long run, firms change production levels in response to (expected)

economic profits or losses, and the land, labour, capital and entrepreneurship
(factors of production) vary to reach associated long-run average cost.
The long run is associated with the long run average cost (LRAC) curve in
microeconomic models along which a firm would minimize its average cost
(cost per unit) for each respective long-run quantity of output. Long run
marginal cost (LRMC) is the added cost of providing an additional unit of
commodity from changing capacity level to reach the lowest cost associated
with that extra output. The concept of long-run cost is also used in
determining whether the long-run is expected to induce the firm to remain in
the industry or shut down production.
The long run is a planning and implementation stage. Here a firm may decide
that it needs to produce on a larger scale by building a new plant or adding a
production line. The firm may decide that new technology should be
incorporated into its production process. The firm thus considers all its long-
run production options and selects the optimal combination of inputs and
technology for its long-run purposes.
Long-run decisions are risky because the firm must anticipate what methods
of production will be efficient, not only today, but also for many years in the
future, when the costs of labour and raw materials will no doubt have
changed. The decisions are also risky because the firm must estimate how
73
much output it will want to product. Is the industry to which it belongs growing
or declining? Will new products emerge to render its existing products less
useful than an extrapolation of past sales suggest? Once the decisions are
made and implemented and production begins, the firm is operating in the
short run with fixed and variable inputs.
The short run is the conceptual time period in which at least one factor of
production is fixed in amount and others are variable in amount. Costs that
are fixed, say from existing plant size, have no impact on a firm's short-run
decisions, since only variable costs and revenues affect short-run profits. In
the short run, a firm can raise output by increasing the amount of the variable
factor(s), say labour through overtime.

DEFINE PERFECT COMPETITION, OLIGOPOLY, MONOPOLISTIC
COMPETITION AND MONOPOLY.
5.4.1 Perfect Competition
Perfect competition is characterised by many buyers and sellers, many

products that are similar in nature and, as a result, many substitutes. Perfect
competition means there are few, if any, barriers to entry for new companies,
and prices are determined by supply and demand. Thus, producers in a
perfectly competitive market are subject to the prices determined by the
market and do not have any influence. For example, in a perfectly competitive
market, should a single firm decide to increase its selling price of a good, the
consumers can just turn to the nearest competitor for a better price, causing
any firm that increases its prices to lose market share and profits.
5.4.2 Monopoly
A monopoly is a market form in which one firm has full control of the market.
5.4.3 Oligopoly
An oligopoly is a market form in which the dominance rests by a

small number of sellers
5.4.4 Monopolistic Competition
Monopolistic competition refers to a market structure that is a cross between

the two extremes of perfect competition and monopoly. The model allows for
the presence of increasing returns to scale in production and for differentiated
(rather than homogeneous or identical) products. However the model retains
many features of perfect competition, such as the presence of many firms in
the industry and the likelihood that free entry and exit of firms in response to
profit would eliminate economic profit among the firms. As a result, the model
74
offers a somewhat more realistic depiction of many common economic
markets. The model best describes markets in which numerous firms supply
products which are each slightly different from that supplied by its
competitors. Examples include automobiles, toothpaste, furnaces (ovens),
restaurant meals, motion pictures, romance novels, wine, beer, cheese,
shaving cream and many more.
Refer to technical article “Introduction to

Microeconomic” at the back of the notes
75
_____________________________________________________________
KEY POINTS
__________________
76
An organisation’s micro environment consists of itself and its current
and potential customers, suppliers and intermediaries. The competition
also has a key influence on the micro environment.
The 5 M’s refer to inputs that an organisation requires in order to

function. They are:
Materials
Money
Men (human
resources) Machines
Management
A basic economic hypothesis is that the lower the price of a product,

the larger the quantity that will be demanded, other things being equal.
This in fact reflects a downward sloping curve
The quantity of any product that firms will produce and offer for sale is
positively related to the product’s own price, rising when price rises
and falling when price falls. This in fact reflects an upward sloping
curve
Price elasticity of demand (PED) is a measure of the extent of change

in the market demand for a good in response to a change in its price.
The coefficient of PED is measured as:
Percentage change in quantity demanded / Percentage change in

price
Perfect competition is characterized by many buyers and sellers, many

products that are similar in nature and, as a result, many substitutes.
Imperfect competition is when a firm has too much control over the
market of a particular good or service and can therefore charge more
than its real market value. When the market for a certain good or
service does not have a lot of competitors, the few firms control the
market.
Monopolistic competition refers to a market structure that is a cross

between the two extremes of perfect competition and monopoly.
77
_____________________________________________________________
QUESTION BANK
__________________
78
Question 1
A demand curve is drawn on all except which of the following assumptions?
Incomes do not change

Prices of substitutes are fixed
Price of the good is constant
There are no changes in tastes and preferences
Question 2
A price ceiling set above the equilibrium market price will result in:
Market failure
Excess supply over demand
Market equilibrium
Excess demand over supply
Question 3
What is an inferior good?
A good of such poor quality that demand for it is very weak

A good of lesser quality than a substitute good, so that the price of the
substitute is higher
A good for which the cross elasticity of demand with a substitute
product is greater than 1
A good for which demand will fall as household income rises
Question 4
Which one of the following would normally cause a rightward shift in the
demand curve for a product?
A fall in the price of a substitute product

A reduction in direct taxation on incomes
A reduction in price of the product
An increase in the price of a complementary product
Question 5
If the cost of milk rises, and milk is a major ingredient in yoghurt, then the:
Demand curve for yoghurt shifts to the left

Supply for yoghurt curve shifts to the left
Supply curve for yoghurts shifts to the right
Demand and supply curves for yoghurt both shift to the right
79
Question 6
Indicate whether the following will cause a shift in the demand curve for a
normal good, a shift in its supply curve or neither:
An increase in household income
A rise in wage costs
A fall in the price of raw materials
A fall in the price of the goods
Shift in Shift in
demand supply Neither
Question 7
Supply of and demand of good A are initially in equilibrium
Price
S
P
D
B C D quantity
The government introduces a maximum price P. what effect will this have on
the quantity of good A purchased?
It will rise from B to D

It will rise from C to D
It will fall from D to B
It will fall from C to B
Question 8 D
1
D 2 4
D3 5 7
6 8
9
80
Point 5 represents equilibrium. If the government starts to pay a cash subsidy
to products of the commodity, what will the new equilibrium be?
Point 2
Point 4
Point 6
Point 8
Question 9
Match the correct labels to the numbers on this diagram
Price
3
4
Quantity
Equilibrium price
Consumer surplus
Market supply
Market demand
Producer surplus
Question 10
Which of the following is not one of the notes performed by prices in a market
economy?
A signal to consumers
A signal to producers
A way of allocating resources between competing uses
A way of ensuring a fair distribution of incomes
81
_____________________________________________________________
ANSWER BANK
__________________
82
C – demand curves express the quantity demanded at each given
market price. Non-price determinants such as income must be held
constant when looking at the effect of price movements in isolation.
C – if the price ceiling is above the equilibrium market price, it will

not interfere with the working of the price mechanism. The market
will not be forced from its current equilibrium. A price ceiling only
affects the workings of the price mechanism if it is set below the
equilibrium price
D – inferior goods are defined in terms of the relationship between

quantity demanded and income. The issue of substitutes is not
relevant
B – a reduction in income tax will increase real household income

and so demand for normal products will shift to the right, i.e.
quantity demanded will be greater at any given price
B – Less will be supplied at any given price and so the supply curve
will move to the left
6. Shift in Shift in
demand supply Neither
X
x
x
x
D – the demand will rise to point D but quantity supplied B will be

available and that is the amount that can be sold. Therefore from
the original point C, quantity will drop to point B.
D – producers will be willing to produce more, shifting the supply

curve to the right.
A–1
B – 2 some consumers would have paid a higher price
C–3
D–4
E – 5 some suppliers would have sold at lower price
D – government may intervene for example through
83

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Chapter 19

Macroeconomics therefore covers topics such as:

How could the economy be made to grow?

What are the unemployment rate and what affects this?

2. Government influence on business

The consumption (expenditure) and income must be equal.

There are two main measures of national income:

Gross national product (GNP)

Capital Exports of Imports of

Net profit income

4. The circular flow of income

Firm providing: wages, rent, interest

Firms: produce goods or provide services

Households: pay for the goods and services

5. Aggregate supply and demand

The following graph shows what happens:

Increasing government expenditure (eg the government borrows and spends)

6. Shifts in the aggregate demand curve

Rightward shifts are caused by:

Leftward shifts are caused by:

First, inflation. What causes inflation?

Seasonal unemployment is obvious. It will refer to unemployment patterns in sectors such as

Technological unemployment speaks for itself. It is unemployment brought about by changes

Cyclical unemployment is a very long cycle of employment and unemployment as economies

9. Monetary and fiscal policy

10. Functions of taxation

11. Types of taxation

Couple of more terms on tax.

2. The demand curve

The position and slope of the demand curve depend on:

The proportional (or percentage) change in

3. Calculation of the price elasticity of demand

1000 2000 3000 4000 Q, quantity

There are two approaches to calculating the elasticity:

Proportional change in demand = (2,200 – 1,200)/1700 = 0.588 or 58.8%

Proportional change in price = (8 – 6)/7 = 0.286 or 28.6%

Price elasticity of demand = 58.8/28.6 = 2

Proportional change in demand = (2,200 – 1,200)/1200 = 0.833 or 833%

Proportional change in price = (8 – 6)8 = 0.25% or 25%

Price elasticity of demand = 83.3/25 = 3.3

The arc price elastic of demand from $12 to $11 is:

The arc elasticity of demand between $3 and $2 is:

(15,000 – 14,000)/14,500 = 0.069/0.4 = 0.175 (very inelastic)

Income elasticity of demand

This measures how demand varies with income:

Income elasticity of demand = Proportional change in demand

4. Demand and supply curves

5. Shifting the demand and supply curves

A rightward shift in a demand curve can be caused by:

A rightward shift in a supply curve can be caused by:

Fixed costs: do not vary in the short run as production increases.

For example, factory rent.

Variable costs: increase with production volume.

For example, labour costs.

Average fixed cost

A graph of variable cost per unit will look like:

Average variable cost

Combining the graphs will produce:

Average total cost

Average variable cost

Average fixed cost

The marginal cost is the cost of producing an extra unit.