MACROECONOMICS – AGGREGATE DEMAND & AGGREGATE SUPPLY ANALYSIS CHAINS

This is the FOUNDATION of macroeconomics in Paper 4.

Almost every macro essay eventually becomes:

• AD movement

• SRAS movement

• LRAS analysis

• inflation

• unemployment

• growth

• policy effectiveness

If you master these chains, half of Paper 4 becomes free marks.

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AGGREGATE DEMAND INCREASE CHAIN

• Consumption/investment/government spending/exports rise

• Aggregate demand increases

• AD curve shifts right

• Real GDP rises

• Employment rises

• Incomes rise

• Consumer spending rises further

• Economic growth strengthens

Evaluation:

• depends on spare capacity

• may mainly cause inflation near full employment

• imports may rise causing trade deficit

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AGGREGATE DEMAND DECREASE CHAIN

• Consumer confidence falls

• Consumption and investment decrease

• Aggregate demand falls

• AD curve shifts left

• Output falls

• Unemployment rises

• Incomes fall

• Economic growth slows/recession occurs

Evaluation:

• government intervention may offset decline

• automatic stabilisers reduce severity

• export demand may support economy

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Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.

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SHORT-RUN AGGREGATE SUPPLY INCREASE CHAIN

• Production costs fall

• Firms increase output

• SRAS shifts right

• Real GDP rises

• Price level falls

• Inflation decreases

• Employment rises

Evaluation:

• depends on productivity growth

• temporary supply shocks may reverse

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SHORT-RUN AGGREGATE SUPPLY DECREASE CHAIN

• Production costs rise

• Firms reduce output

• SRAS shifts left

• Price level rises

• Cost-push inflation occurs

• Output falls

• Unemployment rises

Evaluation:

• depends on size of cost increase

• government subsidies may offset effect

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LONG-RUN AGGREGATE SUPPLY INCREASE CHAIN

• Productivity improves

• Productive capacity increases

• LRAS shifts right

• Sustainable economic growth rises

• Inflationary pressure reduces

• Living standards improve

Evaluation:

• supply-side policies take time

• investment required may be costly

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INFLATION CHAIN

• Aggregate demand rises faster than productive capacity

• Excess demand created

• Firms raise prices

• Inflation rises

• Purchasing power falls

• Real incomes decrease

• Living standards may fall

Evaluation:

• mild inflation may encourage spending/investment

• wage growth may offset impact

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DEMAND-PULL INFLATION CHAIN

• Aggregate demand increases

• Economy approaches full capacity

• Excess demand develops

• Firms raise prices

• Inflation rises

Evaluation:

• depends on spare capacity

• economic growth may still increase

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COST-PUSH INFLATION CHAIN

• Production costs rise

• SRAS decreases

• Firms raise prices

• Inflation increases

• Output falls

• Unemployment may rise

Evaluation:

• temporary oil shocks may reverse

• subsidies may reduce effect

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DEFLATION CHAIN

• Aggregate demand falls significantly

• Prices fall continuously

• Consumers delay spending

• Firm revenues fall

• Output contracts

• Unemployment rises

• Recession worsens

Evaluation:

• productivity-led deflation may be beneficial

• lower prices increase purchasing power

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Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.

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ECONOMIC GROWTH CHAIN

• Investment rises

• Aggregate demand increases

• Output expands

• Employment rises

• Incomes rise

• Consumption rises

• Living standards improve

Evaluation:

• depends on sustainability

• inequality may increase

• inflationary pressure possible

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ACTUAL ECONOMIC GROWTH CHAIN

• AD rises

• Output gap reduces

• Real GDP rises

• Unemployment falls

Evaluation:

• may be inflationary

• limited by productive capacity

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POTENTIAL ECONOMIC GROWTH CHAIN

• LRAS increases

• Productive capacity expands

• Sustainable growth rises

• Inflationary pressure reduced

• Long-run living standards improve

Evaluation:

• requires long-run investment

• environmental costs possible

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RECESSION CHAIN

• Aggregate demand falls

• Output contracts

• Firms reduce production

• Labour demand falls

• Unemployment rises

• Consumer confidence worsens

• Further AD decline occurs

Evaluation:

• government policy may stabilise economy

• exports may reduce severity

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NEGATIVE OUTPUT GAP CHAIN

• Actual output below potential output

• Spare capacity exists

• Unemployment rises

• Inflationary pressure weakens

• Economic growth slows

Evaluation:

• expansionary policy may help

• structural unemployment may remain

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POSITIVE OUTPUT GAP CHAIN

• Actual output exceeds sustainable level

• Labour shortages emerge

• Wages rise

• Inflationary pressure increases

• Economy overheats

Evaluation:

• may encourage investment

• unsustainable long-run

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STAGFLATION CHAIN

• SRAS decreases

• Price level rises

• Output falls

• Inflation and unemployment rise together

• Policy conflict occurs

Evaluation:

• supply-side policy often best long-run

• demand management difficult

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Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.

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CONSUMER CONFIDENCE CHAIN

• Consumers feel optimistic

• Spending rises

• AD increases

• Output and employment rise

• Economic growth strengthens

Evaluation:

• confidence changes quickly

• inflation may weaken optimism

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BUSINESS CONFIDENCE CHAIN

• Firms expect future growth

• Investment rises

• AD and productive capacity increase

• Employment rises

• Long-run growth improves

Evaluation:

• uncertainty may reduce investment

• political instability affects confidence

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INVESTMENT MULTIPLIER CHAIN

• Investment increases

• Income rises

• Consumption rises

• More firms gain revenue

• Further spending occurs

• National income rises by multiplied amount

Evaluation:

• leakages weaken multiplier

• depends on MPC

• imports reduce effect

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MARGINAL PROPENSITY TO CONSUME CHAIN

• Households spend additional income

• Consumption increases

• AD rises

• Multiplier effect strengthens

• Economic growth rises

Evaluation:

• savings reduce multiplier

• confidence influences spending

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SAVINGS INCREASE CHAIN

• Households save more

• Consumption falls

• Aggregate demand decreases

• Output falls

• Unemployment rises

Evaluation:

• savings fund investment long-run

• depends on banking efficiency

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INVESTMENT INCREASE CHAIN

• Firms invest in capital goods

• AD rises short-run

• LRAS rises long-run

• Productivity improves

• Economic growth increases

Evaluation:

• depends on interest rates/confidence

• automation may reduce employment

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CONSUMPTION INCREASE CHAIN

• Household spending rises

• Aggregate demand increases

• Output and employment rise

• Firms gain profits

• Investment may rise

Evaluation:

• may increase imports

• inflationary pressure possible

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EXPORT INCREASE CHAIN

• Foreign demand rises

• Exports increase

• Aggregate demand rises

• Output expands

• Employment rises

• Trade balance improves

Evaluation:

• depends on global economy

• currency appreciation may reduce competitiveness

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Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.

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IMPORT INCREASE CHAIN

• Imports rise

• Domestic demand leaks abroad

• Net exports fall

• Aggregate demand decreases

• Domestic growth weakens

Evaluation:

• imports may provide cheaper inputs

• consumers gain more choice

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UNEMPLOYMENT CHAIN

• Aggregate demand falls

• Firms reduce output

• Labour demand falls

• Unemployment rises

• Household incomes fall

• Consumption decreases

• Recession worsens

Evaluation:

• automatic stabilisers reduce severity

• retraining policies may help

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FULL EMPLOYMENT CHAIN

• Labour demand strong

• Most workers employed

• Household incomes rise

• Consumption increases

• Economic growth strengthens

Evaluation:

• inflationary pressure possible

• labour shortages may develop

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COMMON PAPER 4 EVALUATION POINTS FOR AD/AS

Always use:

• spare capacity

• short-run vs long-run

• inflationary pressure

• confidence levels

• multiplier size

• leakages

• global economic conditions

• productivity

• government effectiveness

• sustainability

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PERFECT AD/AS ANALYSIS FORMULA

CHANGE IN AD/SRAS/LRAS
→ CHANGE IN OUTPUT
→ CHANGE IN EMPLOYMENT
→ CHANGE IN PRICE LEVEL
→ CHANGE IN INCOMES/GROWTH
→ LONG-RUN EFFECTS
→ EVALUATION

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ULTRA IMPORTANT EXAM CHAIN

Interest rates fall
→ borrowing becomes cheaper
→ consumption and investment rise
→ aggregate demand increases
→ output and employment rise
→ economic growth improves

Evaluation:

• depends on consumer confidence

• liquidity trap may weaken impact

• inflation may rise

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Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.

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BIGGEST AD/AS MISTAKE

Students stop at:

“AD increases therefore growth rises.”

Weak.

Strong Paper 4 analysis:
“An increase in AD raises output and employment in the short run, reducing cyclical unemployment, although if the economy is near full capacity the main effect may instead be inflationary pressure rather than substantial real growth.”

THAT is A-grade macro analysis.