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Unit 2-Macroeconomics
The basic assumptions
In Macroeconomics it is key to keep these assumptions in our mind in order to explain what happens
in the economy:

Consumers are looking to maximise their utility (amount/quality of goods and services they get for
their money)

Producers are looking to maximise their profits…

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Circular flow of income and Aggregate Demand
-In an ungoverned, closed economy

In this model the only two entities are households and firms. Income will flow between these two
groups as shown in the diagram. On one side households buy goods and services, in return firms
receive the consumer expenditure.…

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The output gap
the difference between the actual level of national output and the estimated potential level. This
could be expressed as the difference between actual GDP and potential GDP (as GDP is a measure of
national output).

The output gap can be one of two things:

Negative output gap…

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Money leaves the flow as a withdrawal (people saving). However if we go back to our basic
assumptions we can assume people will put the money with a financial institution (e.g. a bank) so that
they can earn interest on their money rather than it just loose value.

This money…

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Governments (Governments can offer tax breaks for certain capital goods lowering the cost of I thus
more firms invest)

We assume firms want to maximise profits, therefore by investing into their business they expect a
retun on their investment. The rate of return of investment is known as marginal efficiency…

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erode the value of wealth (£100 was worth more a year ago than it is today). A rise in
inflation does more harm than good.

Expectations also effect C and S. If households believe income will rise in the future they
will feel safer borrowing, however if they believe economic…

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government will tax income through direct taxes (Td) and secondly they will tax
expenditure (Te). Both of these are forms of withdrawals (W).

Our equations-

We know that equilibrium occurs when W=J. So if government spending is another form of Injection
(along with investment) and Tax another form of withdrawal…

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The multiplier effect
-the amount by which an initial injection is multiplied up

Investment if a form of spending. So we can assume when
firms invest someone's factor income rises. So as well as
the initial spending in the form of investment, we can
assume some of this additional income…

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inputs remains the same and so these higher prices do mean more profits for firms (as opposed to
compensating for higher factor costs) thus AS increases.

Shifts in the AS curve can be caused by the following factors:

· Changes in size & quality of the labour force available for…

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firms, a bigger capital stock, an expanding active labour force etc). As a result we draw the long run
aggregate supply curve as vertical.

Improvements in productivity and efficiency cause the long-run aggregate supply curve to shift out
over the years. This is shown in the diagram below



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