positive and negative output gaps

Cambridge IGCSE / A‑Level Economics – Complete Syllabus Notes

1. Basic Economic Ideas & Resource Allocation

1.1 Scarcity & Choice

• Resources (land, labour, capital, entrepreneurship) are limited.
• Societies must decide:
  • What to produce?
  • How to produce?
  • For whom to produce?

1.2 Opportunity Cost

• The next best alternative fore‑gone when a choice is made.
• Example: If a factory uses its workers to make cars instead of bicycles, the opportunity cost of each car is the bicycles not produced.

1.3 Economic Systems (Syllabus 1.4)

• Market economy – decisions made by households and firms through the price system.
• Planned (command) economy – central authority decides what and how much to produce.
• Mixed economy – combination of market forces and government intervention; most modern economies.
• Strengths & weaknesses are compared in exam questions (efficiency, equity, flexibility).

1.4 Production Possibility Curve (PPC)

• Shows the maximum combinations of two goods that can be produced when resources are fully and efficiently used.
• Key points:
  • On the curve – efficient production.
  • Inside the curve – under‑utilisation (unemployment, idle resources).
  • Outside the curve – unattainable with current resources/technology.
• Shifts:
  • Outward shift = economic growth (more resources or better technology).
  • Inward shift = decline (natural disaster, war, loss of resources).

1.5 Economic Methodology (Syllabus 1.5)

• Positive statements – describe what is; can be tested (e.g., “An increase in income raises the demand for cars”).
• Normative statements – prescribe what ought to be; value‑judgements (e.g., “The government should reduce unemployment”).
• Ceteris paribus – “all other things being equal”. Used to isolate cause‑effect (e.g., “If the price of tea rises, ceteris paribus, the quantity demanded falls”).

1.6 Factors of Production & Rewards

Factor	Reward
Land	Rent
Labour	Wages
Capital	Interest
Entrepreneurship	Profit

2. The Price System & Microeconomics

2.1 Demand

• Law of Demand: Quantity demanded falls when price rises, ceteris paribus.
• Determinants (shifters) of demand:
  • Income
  • Prices of related goods (substitutes & complements)
  • Tastes & preferences
  • Expectations of future price or income
  • Population size
• Shift vs. movement:

  Change	Result on the demand curve
  Change in price of the good itself	Movement along the curve
  Change in any other determinant	Shift of the whole curve (right = increase, left = decrease)

2.2 Supply

• Law of Supply: Quantity supplied rises when price rises, ceteris paribus.
• Determinants (shifters) of supply:
  • Input prices (e.g., wages, raw‑material costs)
  • Technology
  • Number of firms
  • Expectations of future price
  • Taxes, subsidies & regulations
• Shift vs. movement – same table format as demand.
• Price Elasticity of Supply (PES):
  • Formula: \(\displaystyle PES=\frac{\%\Delta Q_s}{\%\Delta P}\)
  • Interpretation: |PES| > 1 = elastic; |PES| < 1 = inelastic; |PES| = 1 = unit‑elastic.
  • Determinants of PES: time period, availability of spare capacity, mobility of factors, stock‑piling possibilities.

2.3 Market Equilibrium

• Equilibrium occurs where the demand curve (D) meets the supply curve (S). The intersection gives the equilibrium price (P*) and quantity (Q*).
• Diagram tip: label axes (price, quantity), D, S, P*, Q*, and any shift arrows.

2.4 Elasticities

Elasticity	Formula	Interpretation
Price Elasticity of Demand (PED)	\(\displaystyle \frac{\%\Delta Q_d}{\%\Delta P}\)	Elastic if |PED| > 1, inelastic if |PED| < 1, unit‑elastic if |PED| = 1.
Price Elasticity of Supply (PES)	\(\displaystyle \frac{\%\Delta Q_s}{\%\Delta P}\)	Same interpretation as PED; depends on time, spare capacity, etc.
Income Elasticity of Demand (YED)	\(\displaystyle \frac{\%\Delta Q_d}{\%\Delta Y}\)	Positive = normal good; negative = inferior good.
Cross‑price Elasticity (XED)	\(\displaystyle \frac{\%\Delta Q_{d1}}{\%\Delta P_{2}}\)	Positive = substitutes; negative = complements.

Example: A 10 % rise in price reduces quantity demanded by 25 % → PED = ‑2.5 (elastic).

2.5 Derived (Joint) Demand & Complement/Substitute Relationships

• Derived demand: Demand for a factor of production is derived from the demand for the final product (e.g., demand for steel depends on demand for cars).
• Substitutes: An increase in the price of good A raises demand for good B (positive XED).
• Complements: An increase in the price of good A reduces demand for good B (negative XED).

2.6 Consumer & Producer Surplus

• Consumer Surplus (CS): Area between the demand curve and the price actually paid, up to the quantity purchased.
• Producer Surplus (PS): Area between the price received and the supply curve (the minimum price firms are willing to accept), up to the quantity sold.
• Both measure welfare; policy changes (taxes, subsidies, price controls) can be evaluated by the change in CS + PS.

3. Government Intervention in Microeconomics

3.1 Market Failure (Syllabus 3.1)

• Public goods: Non‑rival and non‑excludable (e.g., street lighting). Free‑rider problem → government provision.
• Externalities:
  • Negative externality (pollution) – marginal social cost > marginal private cost. Diagram: MC_social above MC_private.
  • Positive externality (education) – marginal social benefit > marginal private benefit.
• Merit & Demerit Goods:
  • Merit goods (health, education) are under‑consumed; government may subsidise.
  • Demerit goods (tobacco, alcohol) are over‑consumed; government may tax or restrict.

3.2 Government Failure (Syllabus 3.2)

• Information problems – government may lack accurate data.
• Implementation costs and administrative inefficiency.
• Unintended consequences (e.g., rent‑seeking, moral hazard).

3.3 Policy Instruments

Instrument	Objective	Effect on Curves	Typical Welfare Impact
Excise/Ad‑valorem Tax	Reduce consumption of demerit goods / raise revenue	Supply curve shifts left (higher marginal cost)	CS falls, PS falls; dead‑weight loss.
Subsidy	Encourage merit goods / support producers	Supply curve shifts right	CS rises, PS rises; cost to government.
Price Ceiling	Make essential goods affordable	Legal maximum price below P* → shortage (QD > QS)	CS may rise for some consumers, PS falls; dead‑weight loss.
Price Floor	Protect producers (e.g., minimum wage)	Legal minimum price above P* → surplus (QS > QD)	PS may rise, CS falls; dead‑weight loss.
Regulation (e.g., emission standards)	Control negative externalities	Increases marginal cost → supply shifts left	Reduces external cost; possible loss of PS.
Buffer‑stock Scheme	Stabilise agricultural prices	Government buys when price falls, sells when price rises	Reduces price volatility; fiscal cost.

3.4 Redistribution

• Progressive taxation, welfare benefits, public provision of health & education aim to reduce income inequality.
• Potential trade‑off with efficiency (e.g., work‑disincentive effects).

4. The Macro‑Economy

4.1 National‑Income Accounting

• Real GDP: Value of all final goods & services produced within a country in a given year, measured at constant prices.
• Components: C + I + G + (X – M).
• Related concepts:
  • Nominal GDP – measured at current prices.
  • GNI – GDP + net primary income from abroad.
  • NNI – GNI – depreciation.
• Three measurement approaches (production, income, expenditure) give the same total.

4.2 Circular Flow of Income

• Two‑sector model: Households ↔ Firms (goods & services market and factor market).
• Three‑sector model: Adds Government (taxes, spending, transfers).
• Four‑sector model: Adds Foreign sector (exports, imports, capital flows).
• Diagram tip: arrows show flow of money (payments) and flow of real resources.

4.3 Aggregate Demand & Aggregate Supply (AD‑AS) Model

• Aggregate Demand (AD): \(AD = C + I + G + (X-M)\). Downward‑sloping because of:
  1. Wealth effect – higher price level reduces real wealth.
  2. Interest‑rate effect – higher price level raises interest rates, reducing investment.
  3. Exchange‑rate effect – higher price level makes domestic goods relatively expensive, reducing exports.
• Short‑Run Aggregate Supply (SRAS): Upward‑sloping; some input prices (wages) are sticky, so firms increase output when the price level rises.
• Long‑Run Aggregate Supply (LRAS): Vertical at potential (full‑employment) output; reflects the economy’s productive capacity (capital, labour, technology).

4.4 Output Gaps (Positive & Negative)

• Potential output = level of real GDP when the economy is at full employment (LRAS).
• Positive (inflationary) output gap:
  • Actual real GDP > potential output.
  • AD lies to the right of LRAS.
  • Result: upward pressure on prices (demand‑pull inflation) and low unemployment (below the natural rate).
• Negative (recessionary) output gap:
  • Actual real GDP < potential output.
  • AD lies to the left of LRAS.
  • Result: downward pressure on prices (disinflation or deflation) and higher unemployment (above the natural rate).
• Diagram tip: show LRAS as a vertical line, AD intersecting SRAS left (negative gap) or right (positive gap) of LRAS.

4.5 Inflation

• Demand‑pull inflation: Excess aggregate demand (positive output gap) pushes the price level up.
• Cost‑push inflation: Rising production costs (wages, oil, taxes) shift SRAS left, raising the price level while reducing output.
• Built‑in inflation: Wage‑price spiral; workers demand higher wages because they expect higher prices, firms raise prices to cover higher wages.
• Measurement:
  • Consumer Price Index (CPI) – basket of consumer goods.
  • Retail Price Index (RPI) – includes housing costs.
  • GDP deflator – ratio of nominal to real GDP.

4.6 Unemployment

Type	Definition	Typical Causes
Frictional	Short‑term job search unemployment	Information gaps, voluntary moves, new entrants.
Structural	Mismatch between workers’ skills and job requirements	Technological change, geographic immobility, education gaps.
Cyclical	Result of insufficient aggregate demand	Negative output gap.
Seasonal	Fluctuations tied to calendar periods	Agriculture, tourism, retail peaks.

• Natural rate of unemployment = frictional + structural unemployment; the economy can operate at this rate without accelerating inflation.
• Hysteresis: Prolonged high unemployment can raise the natural rate (skills loss, reduced labour‑market attachment).

4.7 Economic Growth

• Real (long‑run) growth: Increase in potential output, measured by the growth rate of real GDP.
• Sources of growth:
  • Capital accumulation (more factories, machinery).
  • Labour‑force growth (population, migration).
  • Human capital improvement (education, health).
  • Technological progress (R&D, innovation).
• Distinguish short‑run growth (movement along SRAS due to demand changes) from long‑run growth (rightward shift of LRAS).

5. Government Macro‑Intervention

5.1 Fiscal Policy (Syllabus 5.1)

• Expansionary fiscal policy: Increase government spending (G) or cut taxes (T) → AD shifts right → reduces negative output gap, raises output & employment; risk of demand‑pull inflation.
• Contractionary fiscal policy: Decrease G or raise T → AD shifts left → closes positive output gap, lowers inflation; risk of higher unemployment.
• Budget balance: Surplus (revenues > spending), deficit (spending > revenues), public debt (cumulative deficits).
• Multiplier effect: \(\Delta Y = k \times \Delta G\) (or \(\Delta T\)); \(k = \frac{1}{1-MPC}\) where MPC = marginal propensity to consume.
• Potential crowding‑out: Higher government borrowing may raise interest rates, reducing private investment.

5.2 Monetary Policy (Syllabus 5.2)

• Controlled by the central bank (e.g., Bank of England, Federal Reserve).
• Tools:
  • Open‑market operations (buy/sell government securities).
  • Policy interest rate (repo, base rate).
  • Reserve requirements.
  • Discount window facilities.
• Expansionary monetary policy: Lower interest rates or buy securities → increase money supply → AD shifts right.
• Contractionary monetary policy: Raise rates or sell securities → decrease money supply → AD shifts left.
• Transmission mechanisms:
  • Interest‑rate effect on consumption & investment.
  • Asset‑price effect (stock, house prices).
  • Exchange‑rate effect (lower rates depreciate currency, boost exports).
• Liquidity trap: When interest rates are already near zero, further monetary easing may have little impact on AD.

5.3 Supply‑Side Policies (Syllabus 5.3)

• Goal: Shift LRAS right (increase potential output) without creating inflation.
• Examples:
  • Education & training – improve labour productivity.
  • Infrastructure investment – reduce transport and transaction costs.
  • Research & Development subsidies – promote technological progress.
  • Labour‑market reforms – flexibility, reduction of trade‑union power, encouragement of part‑time work.
  • Tax reforms – lower marginal tax rates to increase work incentives.
• Potential side‑effects: Short‑run costs, distributional impacts, possible increase in inequality.

6. International Economic Issues

6.1 Why Trade? (Syllabus 6.1)

• Absolute advantage: Producing a good using fewer resources than another country.
• Comparative advantage: Lower opportunity cost; basis for mutually beneficial trade.
• Gains from trade: Higher real incomes, greater variety, economies of scale.
• Terms of trade = price of exports ÷ price of imports; improvement means a country can import more for a given export volume.

6.2 Protectionism (Syllabus 6.2)

Instrument	Intended Effect	Typical Economic Consequences
Tariff	Raise price of imports	Domestic producers gain; consumers lose; dead‑weight loss.
Quota	Limit quantity imported	Similar welfare loss; rents may go to foreign exporters or import licences.
Import licensing	Control volume/quality of imports	Administrative costs; potential for corruption.
Subsidy to domestic exporters	Make domestic goods cheaper abroad	Export expansion; fiscal cost; possible retaliation.
Anti‑dumping duties	Counteract foreign firms selling below cost	Protect domestic industry; may provoke WTO disputes.

6.3 Balance of Payments (BoP) (Syllabus 6.3)

• Current account: Trade balance (exports‑imports) + net primary income + net secondary income.
• Capital & Financial account: Net inflows/outflows of FDI, portfolio investment, loans, and other capital transfers.
• Financial account (sometimes combined with capital account) records changes in ownership of assets.
• Surplus ↔ deficit → influences exchange‑rate pressures and foreign‑exchange reserves.
• ‘Errors & omissions’ balance the accounts.

6.4 Exchange Rates (Syllabus 6.4)

• Floating (flexible) rate: Determined by supply and demand in the foreign‑exchange market.
• Fixed (pegged) rate: Government/central bank maintains a set rate, using reserves or interventions.
• Depreciation (floating) or devaluation** (fixed) makes exports cheaper and imports more expensive → AD shifts right.
• Appreciation (floating) or revaluation** (fixed) has the opposite effect → AD shifts left.
• Determinants: interest‑rate differentials, inflation differentials, expectations, political stability.

7. Development Economics

• Economic development – sustained increase in living standards, not just higher GDP.
• Key indicators: GNI per capita, Human Development Index (HDI), poverty rates, life expectancy, literacy.
• Barriers: Poor infrastructure, low human capital, weak institutions, disease, political instability.
• Policy approaches:
  • Import‑substituting industrialisation (ISI) – protective tariffs, state‑owned enterprises.
  • Export‑oriented industrialisation (EOI) – special economic zones, export subsidies.
  • Foreign aid & debt relief – conditionality, aid effectiveness debate.
  • Structural adjustment programmes (SAPs) – fiscal discipline, liberalisation, privatisation.