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that leads to a higher interest rate leads to lower aggregate demand – hence the AD curve slopes down.

The international trade effect: Any change in a country’s price level relative to the price level of its trading partners has an impact on the attractiveness of international trade. A country’s exports become less attractive if the exports become relatively more expensive. If an exporting country’s prices rise faster than its importing partner countries, rational buyers will prefer the products for which prices are not rising so rapidly (this will be the case where similar products – substitutes – are available and where the prices were quite similar before the exporter’s prices rose). Changes in price levels affect both export and importing activities and since both exports and imports are components of aggregate demand the effect of an increasing price level that reduces net exports (X − M ) is reflected in the downward slope of the aggregate demand curve.

5.5.3AGGREGATE SUPPLY

To consider aggregate supply, it is useful to return to the concept of efficient production discussed (in Chapter 1) when we dealt with the production possibility frontier. There is a constraint on the maximum amount of output firms in an economy could produce irrespective of the price level because an economy’s resources are limited. An economy that produces the maximum feasible output with all resources fully employed operates at potential output and this is shown as

Y in Figure 5.5. The relationship between the average level of prices and aggregate supply is shown here.

Potential output is a country’s output level if all resources were fully employed.

	Aggregate		AS
	price level	P4
		P3

P2

P1

P0

National income

Y1 Y2 Y^

F I G U R E 5 . 5 A G G R E G A T E S U P P L Y

176	T H E E C O N O M I C S Y S T E M

The shape of the aggregate supply curve indicates that the relationship between output and the price level varies, depending on the economy’s output level. Initially aggregate supply is flat, then slopes gently upwards only to become steep as it coincides with potential output. This relationship describes how firms react to the price level. There is a minimum price level required for firms to consider it worth their while to supply a market with goods. In Figure 5.5 this level is P0. This corresponds to a situation where an economy has low income (recession phase of the business cycle), firms have a lot of spare capacity and many resources are unemployed. Firms are willing to sell at the going market price and would like to sell more output at the going price.

If an economy is producing output Y1 at a price level P1, any change in the price level will cause firms to change their output. A decline in the price level would lead to lower output because firms would perceive that they would have to cut their prices to sell their output and lower prices would make some firms uncompetitive; they would stop producing and output would fall (in Chapter 8 we will look at the factors that might bring about such a fall in the price level). An increase in the price level from P1 to P2 would have the opposite effect and output would expand from Y1 to Y2 indicating firms’ willingness to expand supply as the higher price level allows them to remain competitive and charge higher prices.

A proportional increase in the price level from P3 to P4, however, does not have the same impact on output. If the economy begins from a position where the aggregate price level is P3 then the economy is producing very near its potential output. Any rise in the price level, such as to P4, has no significant impact on output because firms’ have little extra capacity.

Analysis of aggregate supply depends on whether the short run or long run is of interest. In the long run, it is assumed that an economy will operate at full employment and hence the long-run aggregate supply curve is that shown in Figure 5.6.

The long-run aggregate supply (LRAS) curve is a vertical line drawn at potential output.

The quantity and quality of the available factors of production and the available technology (for converting inputs into output) determine the amount of potential output an economy can supply.

Hence, LRAS is not influenced by the price level – the same amount is produced irrespective of the price level. (The aggregate supply curve illustrated earlier in Figure 5.5 may be considered to correspond to the short-run aggregate supply,

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	Aggregate	LRAS
	price level

National income

Y^

F I G U R E 5 . 6 L O N G - R U N A G G R E G A T E S U P P L Y

or it can be treated as a ‘combination’ AS curve that combines elements of both short-run and long-run behaviour.)

The determinants of Y are influences on the quality and quantity of factors of production including the local, domestic and international financial systems, systems of corporate governance, legal and political environments, social and cultural background, technological capability and the myriad standards, business and personal ethics, codes of conduct that are embedded in an economic system, as referred to earlier in the discussion of the circular flow.

5.5.4BRINGING AD AND AS TOGETHER: THE SHORT RUN

A country’s equilibrium output and price level are determined jointly by its aggregate demand and aggregate supply functions, as shown in Figure 5.7 for the short run. Here, equilibrium output is SRY (where SR denotes the short run) and the equilibrium price level is P corresponding to the intersection of aggregate demand and aggregate supply. The economy shown is not producing its potential output, so some resources are not being employed and the government might want to try to boost output.

There are different avenues to encouraging the use of more resources – boosting either aggregate demand or aggregate supply. (You may wish to sketch this situation using Figure 5.7 as your starting point: this analysis is further considered in Chapter 8.)

Any increase in aggregate demand moves the AD curve upwards (to the right) bringing about a new equilibrium position involving increased output and an increased aggregate price level.

Any expansion in aggregate supply moves the AS rightwards leading to a new

equilibrium position involving higher output but a lower aggregate price level than P .

178	T H E E C O N O M I C S Y S T E M

P	AS
P*	AD
	Y
	SRY*

F I G U R E 5 . 7 S H O R T R U N : A G G R E G A T E S U P P L Y A N D A G G R E G A T E D E M A N D

The challenge in intervening in the economy is to implement policies that have the desired outcome. While this may appear straightforward using the theory of AS-AD presented here, in practice it represents a problem for governments and businesses alike for a number of reasons considered in more detail in Chapter 8.

5 . 6 E Q U I L I B R I U M E C O N O M I C

A C T I V I T Y A N D T H E M U L T I P L I E R

When there is a change in aggregate demand, whether caused by a change in C,

I , G or (X − M ), equilibrium output changes. In sketching a movement in the

AD curve, however, we lose sight of the process according to which this change occurs in the economy. Take the example of a change in consumption expenditure. Autonomous consumption drops by £25bn from £50bn, for example. This leads to a new consumption function (this can be sketched using Figure 3.12 as the starting point) and also a new AD curve. The immediate effect of a drop in autonomous consumption is that equilibrium income drops by the same amount (as the AD shifts down or to the left).

The initial drop in autonomous consumption, however, has knock-on or domino effects. The drop in income caused by the drop in consumption also causes a further drop in consumption because consumption also depends on the level of disposable income (refresh your memory by returning to section 3.8 if required). This further drop in consumption causes a further drop in income, causes a further drop in consumption . . . and so on. The total effect of the drop in autonomous consumption is greater than the initial change that caused it, with a multiplicative effect. This implies that if autonomous consumption falls by £25bn, the effect on

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equilibrium output will be an even greater fall. Each economy has its own national income multiplier.

The multiplier indicates how much income/output changes after a change in autonomous expenditure.

The size of the multiplier for an economy that does not engage in international trade (and therefore has no exports or imports) can be found according to the following formula:

1 Multiplier = (1 − MPC )

The value of the multiplier depends on the value of an economy’s marginal propensity to consume out of national income (MPC ). In Chapter 3, the marginal propensity to consume out of disposable income was discussed (MPC). The relationship between the marginal propensities is:

MPC = MPC × (1 − t)

where t is the tax rate.

If the tax rate is 0.2 (equivalent to 20%) and people’s marginal propensity to consume out of disposable income is 0.95, then the marginal propensity to consume out of national income, according to the above equation, is 0.95 × (1.0 − 0.20) = 0.76.

The ratios of disposable income to GDP for 2001 were 71.3% for the euro area, 73.3% for the USA, and for Japan, 60.3%. These data are from the international statistics of the European Central Bank, http://www.ecb.int/stats.

To compute the multiplier if the MPC is 0.76, then 1 − MPC is 0.24 and the multiplier is 1/0.24 = 4.16.

This implies that any change in autonomous expenditure (e.g. autonomous consumption, I or G where each is independent of the level of national income) leads to a new equilibrium income/output of 4.16 times the initial change.

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For a higher tax rate, this would change the MPC and the value of the multiplier, as shown in Table 5.3. As the tax rate rises, a greater proportion of aggregate income is paid in taxation, representing a leakage out of the circular flow. As the leakage increases (with t), the impact of any change in autonomous expenditure declines, as shown by the fall in value of the multiplier.

The size of the multiplier for an economy that is involved in international trade is different to that presented above and is found as:

1 Multiplier = [1 − (MPC − MPM)]

where MPM denotes the marginal propensity to import.

T A B L E 5 . 3 V A L U E O F T H E M U L T I P L I E R A S T A X R A T E R I S E S

					1
MPC	t	(1 − t )	MPC : MPC × (1 − t )	1 − MPC	Multiplier:
						(1−MPC )
0.95	0.20	0.80	0.76	0.24	4.16
0.95	0.30	0.70	0.665	0.335	2.99
0.95	0.40	0.60	0.57	0.43	2.33

Conclusion: for a given MPC, an increase in the tax rate leads to a reduction in the multiplier.

T A B L E 5 . 4 V A L U E O F T H E M U L T I P L I E R I N C L U D I N G

M P M

				MPC −				Multiplier:
								1
MPC	t	(1 − t )	MPC	MPM	[1 − (MPC − MPM)]
						[1	−	(MPC	−	MPM)]
0.95	0.20	0.80	0.76	0.51	0.49			2.04
0.95	0.30	0.70	0.665	0.415	0.585			1.71
0.95	0.40	0.60	0.57	0.32	0.68			1.47

Conclusion: inclusion of the MPM reduces the value of the multiplier because it represents an additional leakage of income from the circular flow.

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T A B L E 5 . 5 T R A D E A C T I V I T Y ( % G D P )

S H A R E S O F E C O N O M I C 2 0 0 2

	USA	UK	Ireland	Germany	Japan
X : exports	6.5	18	72	30	10
M: imports	−11	−21	−43	−24	−7.5
X − M: net exports	−4.5	−3	29	6	2.5

Source: Economist Intelligence Unit, Country Data except for Ireland: Trade Statistics of Ireland, Irish Central Statistics Office.

Payments for imports represent a further leakage of income from a country’s circular flow, hence the multiplier is different. For a country with an MPM of 0.25, the impact on the multiplier is shown in Table 5.4, which extends Table 5.3.

The extent to which imports and net trade is important for different countries is shown in Table 5.5 which presents the share of exports (X ) and imports (M ) as values of each country’s GDP, for a sample of countries.

Both the USA and UK experienced trade deficits in 2002 because the value of their imports exceeded their exports. Japan, Germany and Ireland displayed trade surpluses. Countries’ comparative advantages (see Chapter 2) help us to understand a considerable portion of the international trade that takes place between them.

5 . 7 I N T E R N A T I O N A L I N T E G R A T I O N

A key characteristic of the current international economic system is the extent to which individuals, firms and countries are exposed to influences from foreign goods, services, firms, capital and labour. Individuals and economies are increasingly faced with contributions by far distant people and places to their lives. Evidence for this is found, for example, in the growth in international trade.

World growth in exports outstripped world GDP growth between 1995 and 2000 by a factor of more than two (7% per annum compared to 3%). Over the longer period spanning 1948–2002, the figures are 6% for exports and 3.7% for GDP (see www.WTO.org for more national and international trade information and statistics).