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International Economics

IBDP_ Measuring national Income

How to Get minimum 10 marks in IBDP _ECO_Paper_1

1.       There is understanding of the specific demands of the question. 10–12

a)      Relevant economic terms are defined.

b)      Relevant economic theory is explained and applied.

c)       Where appropriate, diagrams are included and applied.

d)      Where appropriate, examples are used.

e)      There is an attempt at synthesis or evaluation.

f)       There are few errors.

2.       There is understanding of the specific demands of the question. 13–15

a)      Relevant economic terms are clearly defined.

b)      Relevant economic theory is clearly explained and applied.

c)       Where appropriate, diagrams are included and applied effectively.

d)      Where appropriate, examples are used effectively.

e)      There is evidence of appropriate synthesis or evaluation.

f)       There are no significant errors.

IBDP Individuals and Societies Macro-Economics International Trade

IBDP Individuals and Societies Macro-Economics Aggregate Demand,Determining Consumption

Determinants of consumption (C)

The levels of income are a primary determinant of consumption of nation. With rise in income, the level of consumption of households rises. With fall in national income, there is fall in consumption. A nation’s income is not equal to its consumption, but consumption is the function of NI(national Income)the households consume goods and services along with paying taxes and spend some part on imported goods with each year’s income .

Let’s take all components of Keynesian consumption function one by one before looking at its graphical presentation.

1.       Consumption:

Is ia the average propensity to consume that determine the percentage of national income that goes towards consumption. APC is Consumption(C) divided by level of national income(Y)

APC = C/Y =

2.       Savings:

It is measured as APS ie average propensity to consume. The more the income the less in the consumption in comparison to income and more will be savings. When the income is low, the consumer spends a higher proportion on income as compared to higher income groups. Thus APS is total savings (S) divided by income (Y)

APS = S/Y

3.       Taxes:

The average rate of tax( ART) is the percentage of national income that is collected in taxes. ART is taxes (T) divided by incomer(Y)

APT = T/Y

4.       Imports:

With the increase in incomes, the households consume goods and services produced abroad. These are imports to nation and thus become a part of nations AD.  It is a deduction from GDP. ART is found by dividing imports(M) by income(Y)

APM = M/Y

If we ADD all of the above it will be function of AD

IBDP Individuals and Societies Macro- Economics Aggregate Demand and Shift in AD

Components of AD

1.       Consumption( C): consumption is a aggregate of all spending of domestic, households on goods and services during a period of time. C is the function of household income and MPC (marginal propensity to consume).

2.       Investment ( I ):it is gross domestic private investment. It measures the total spending of the firm on capital equipment. I is the function of national output and interest rate.

3.       Government spending (G): ‘G’ refers to Government spending and measures a country’s government expenditure on goods and services.

4.       Net exports (X-M) : net exports is the total income earned from the sale of X to foreigners minus the total amount spent by nationals of a country.

Remember, net export can be negative or positive. Google it out?

The function of AD = C + I + G + (X – M)

Why AD curve slopes downwards?

Under microeconomics the demand curve slopes downwards because of income affect, substitution effect and diminishing marginal utility But in macroeconomics the following effects leads to downwards slope of the curve.

A.      The Wealth Effect: When the price level is high, the purchasing power or the real value of nation’s households’ wealth and savings is reduced. People will be worse off and cut back on their spending of goods and services.  Therefore, as the price level rises, less output is demanded, resulting in upward movement along the AD curve. But with the fall in price level, the real value of wealth increases, people would feel better off and they would increase their spending, so more output is demanded therefore there is downward movement along AD curve.

B.      The Interest rate effect: the bank raises the interest rates in response to increase in price level.  Household and firms who want to borrow from bank decrease. The total quantity demanded decreases resulting in decrease in AD due to decrease in consumer purchase financed by borrowing as well as investment spending by the firms and vice versa.

        Therefore, increase in price-level would decrease in spending and fall in quantity of output demanded lead to downward movement along AD curve. Similarly if price level falls there is increase in spending and rise in quantity of output demanded leading to upward movement of AD curve.

C.      The net export effect or the international trade effect: Rise  in price level in the host country will make exports more expensive  to foreign buyers and the demand for exports will fall. The opposite result from an increase in the price level that make domestic output less attractive to foreigners and foreign products more attractive to domestic consumers. If seen carefully this is same as substitution effect. Therefor with the rise in price level the X(Exports) fall and M(imports) rise, so X-M falls. Falling net exports means (downwards movement of AD curve) and vice versa leads to upward movement along AD curve.

SHIFT IN AD CURVE [ due to change in any one  C,I,G,(X-M)]

A.Change in consumers spending due to any of the following.

i.         Change in wealth: wealth is the value of assets that are in possession of household like value of their homes, stocks held by them, values of bonds, and jewelry etc. an increase in any of these psychologically makes am person in possession feels wealthier and they spend more leading to shift in AD to right (AD₂). When there is decrease in wealth the AD curve shifts to left(AD₃).

ii.       Change in future expectation about income or economy.

Due to optimism about increase in future income or future of economy, the consumers are likely to spend more in present. This will shift the AD curve towards right (AD₂). On the other hand expectation of falling income in future and pessimistic expectations about economy’s future would decrease spending and shift AD curve to left (AD₃)

iii.    Change in interest rates.

Consumers spending are always sensitive to interest rate changes. Rise in interest rates leads to expensive borrowings, results in lower consumer spending. This in turn leads to leftward shift in AD curve (AD₃). If interest rates fall, borrowings become cheaper and demand rises leading to right shift in D curve (AD₂)

iv.     Change in personal income tax.

v.       The government decision to increase personal income tax on household incomes, their disposable income will fall resulting in lower AD and shift of AD curve towards left (AD₃. If personal income tax is lowered. It will increase the disposable income of consumers. This will directly affect their consumption and AD will increase leading to right shift in AD curve (AD₂)

vi.     Change in attitude towards spending.

After a war of major natural calamity the households often becomes cautious as regards to their spending habits. They may decide to spend less at a given level on income and would save more and vice versa would lead to more spending on consumer goods.

B. Change in Investment spending due to any of the following.

i.         Change in future expectations.

Investment will increase if the economy is moving towards boom. The businesses are optimistic about future so investment will also leap forward. This will shift the AD curve to right (AD₂) but if business sees, pessimism will shift AD curve to left. (AD₃)

ii.       Improvement in technology

Better technology always gives businesses a boost for acquiring it. Thus, the investment spending will increase and vice versa.

iii.      Changes in business tax /corporate taxes.

As a part of its fiscal policy the government increases its taxes on business profits, the firms spending power curbed due to less profit after taxes. This results in leftward shift in AD curve (AD₃). On the other hand, decrease in taxes will give a boost to AD and curves rightward shift (AD₂)

iv.     Legal policy changes or institutional changes.

If the laws enacted by the government do not favour small businesses, there is a great impact on investment spending in an economy. In transition economies, the small firms cannot borrow easily for financing investment. Thus, investment stay less resulting in left shit in AD curve (AD₃). But increasing access to credit and securing property rights would benefit small entrepreneurs and investment spending will increased resulting in AD right shift (AD₂)

C. Change in EXIM (X-M) due to any of the following.

i.         Real national income change.

If real income of host country increases, it will purchase more goods and services from other country. This will lead to more exports from neighbouring countries. This will shift neighbouring country’s AD curve to right (AD₂). But if on the other hand the neighbouring country’s real income increases its AD curve will shift to left (AD₃)

ii.       Exchange rates change.

An exchange rate is the price of country’s currency in terms of another country’s currency. If host country’s currency price increases (appreciates) in relation to other neighbouring country, its products become more expensive to its neighbours. The exports of host country will fall and its AD curve will shift left (AD₃) the host country’s currency appreciation effects are double fold. Fall in X and increase in M so net export falls (X-M falls) its AD curve will shift left (AD₃) but if the price of this host country’s currency decreases (depreciates) net exports (X-M) increases and AD curve will shift to right (AD₂)

D. Changes in Government spending due to any of the following

i.         Change in political priorities.

Increase in overall government spending shifts AD to left. These spending could be on merit goods, public goods, subsidies and pensions wage payments and purchase of goods for its own use. If the expenditure made by government decreases the AD curve shifts towards right.

ii.       Deliberately changing AD.

Government’s own spending used to influence the overall AD. This affects the shift of AD curve towards right (AD₂)

Shifts in short run AS

The SRAS curve shows relationship between price level and quantity of real GDP produced by firm with no change in resource price (wage price)

Causes of shift in SRAS curve.

i.         Change in wages.

It is the main component of change in SRAS. Wage is a major part of firms cost of production. If the nominal ages increase with constant price levels, the firms’ cost of production will rise resulting in left shift of SRAS curve (SRAS₃) from (SRAS₁). This shows that a smaller quantity of real output is produced and supplied. If the wages decrease with constant price level, the firms’ cost also drops leading to tight shift from SRAS₁ to SRAS₂

ii.        Subsidies.

Subsidies involve money transferred from government to firms. It has an opposite effect than taxes. If the subsidies increases, the SRAS curve will shift to right from SRAS₁ to SRAS₂ but if they decrease the SRAS ₁ will shift toward left SRAS₃ .                                                                                                              

iii.      Business taxes

A business tax is like costs by the firm. Therefore, if the government taxes are increased on firms, the total cost of production will increase, directly affecting the quantity produced and supplied. This will shift SRAS₁ to SRAS₃. On the other hand, lower taxes would shift the SRAS curve towards right.

iv.     Supply shocks

Supply shocks are sudden impacts on the short run AS. Adverse supply shocks causes leftward shift to AS from SRAS₁ to SRAS₃ . Examples of supply shocks could be war, natural calamity, destruction of physical capital and disruption of economy or unfavorable weather conditions etc. nowadays there are fluctuations in oil prices leading to supply shocks in non-oil producing countries.

 However there are various other factors like change in non-labour costs like oil,equipment, capital goods, land inputs that would impact the SRAS curve resulting in either right or left shift.