Diagrams and Definitions What is macroeconomics?

• Macroeconomics is the study of a national economy. Macroeconomic Goals Employment Growth Stability Price Income Income Stability External Two Sector Circular Flow of Income

Monetary Flow Households

Real Flow Expenditure Good and on and Services = , Services Output (O) Rent and (E) Factors of Profits Production (Y)

E = O = Y Firms

4 Four Sector Circular Flow of Income

Leakages (L) Injections (J)

Saving Households Investments (S) (I) Income Imports Exports (M) (X)

Taxes Expenditure Government (T) Spending (G) Firms O = E = Y

Sum J = Sum L 5 Measuring National Income

Output Method Income Method Households

Good and Expenditure Services Wages, Rent on Goods and and Profits Services Factors of Production

Firms Expenditure Method 6 How is national income measured?

Employment income +

Rental income +

Profits +

Interest =

National Income How is national output measured?

Value of =

National Output How is national expenditure measured?

Household consumption (C) +

Firms’ investment (I) +

Government spending (G) +

Exports - Imports (X-M) = National Expenditure What is GDP?

National Expenditure =

National Income =

National Output =

Gross Domestic Product GDP

• GDP = = Total of all Spending in an Economy = The Total Value of all final Goods and Services in an Economy regardless of who owns the productive assets. • GDP = C + I + G + (X – M) GNP

• GNP = Gross National Product = Total Income Earned by a nation’s factors of production regardless of where the assets are located Real GDP

Real GDP = Nominal GDP adjusted for Calculating Real GDP

Real GDP = Nominal GDP of year measured The Uses of National Statistics

Determine a Develop economic nation’s annual Develop models policies progress

Predict future Analyze historical Compare economic changes economies developments

Provide a snapshot of a nation’s standard of living Limitations of the Data

Unrecorded or Inaccuracies under-recorded distort data activity distort data

Depletion of Composition of resources not Output not considered considered What is economic development?

• Economic Development is a multidimensional concept that includes poverty reduction, provision of education, health care and law and order, civil liberties and civic participation. Why GDP fails to accurately measure welfare

Does not reflect distribution of income and output Does not reflect No distinction quality of life e.g. regarding crime rate, composition of political freedom output etc. GDP Why GDP may understate improvements in welfare

Improvement in quality not measured Informal Increased Markets not leisure time measured not measured

Increasing Life Non- Expectancy Output not not taken into measured GDP account Why GDP may overstate welfare

Negative Depletion of not natural resources taken into not taken into account account GDP How can development be measured?

• GDP per capita • Human Development Index Aims to stress the human dimension of How can development be measured? How is the HDI determined? How can development be measured?

Measures of Development

Gender Gender Human Related Empowerment Poverty Index Development Measure (HPI) Index (GDI) (GEM) Developing and Developed How can development be measured?

Important Indicators of development ① Infant mortality rate ② Maternal mortality ratio ③ Enrolment in each level of education ④ Literacy ⑤ Internet users per 1000 Macroeconomic Models What is (AD)?

• Aggregate Demand is the aggregate (total) spending on goods and in a period of time at a given .

What are the components of AD?

C = all household consumption on durables, non-durables and services

I = firm’s replacement investment (spending on capital to maintain productivity) or induced investment to increase production

G = all government spending

X-M = spending by foreigners on exports less domestic spending on imports What causes shifts in AD? What causes Changes in Consumption?

Lower Rise in AD income AD Rates

Fall in Higher AD AD Interest income Rates

32 What causes Changes in Consumption?

Rise in house and share market Higher AD values AD confidence

Fall in house and share Lower AD market AD values Confidence

33 What causes Changes in Consumption?

Fall in personal Lower debt AD taxes AD

Rise in personal AD taxes AD Higher debt

34 What causes Changes in Investment?

Fall in Interest

AD Rates

Rise in

AD Interest Rates

35 Demand for investment funds? What causes Changes in Investment?

Fall in Business Improved taxes Technology AD AD

Rise in Higher AD Business AD costs of taxes Technology

37 What causes Changes in Investment?

Rise in house Improved and share expectations market about future AD values AD sales

Fall in house Worsening and share expectations AD market AD about future values sales

38 What causes Changes in Investment?

Improved governance AD

AD Worsening governance

39 What causes Changes in Government Spending?

Rise in spending on Deliberate merit goods Decision to public goods increase AD AD etc. AD

Fall in spending Deliberate on merit goods Decision to AD public goods AD decrease AD etc.

40 What causes Changes in Export and iMport spending?

Trading partners AD demands more goods

Trading partners AD demands less goods 41 What causes Changes in Export and iMport spending?

Imports more Imports AD expensive buy cheaper, buy AD less more

Exports more expensive for Exports less Trading expensive Partners, buy trading AD partners buy less AD more

42 What is (AS)?

• Aggregate (total) Supply is amount of goods and services that all industries will produce at a given price level. What is aggregate supply in the short run (SRAS)? What are the components of AS?

Wages Domestic Imported resources raw materials What causes shifts in SRAS? What causes shifts in SRAS?

Fall in Wages of decrease AS resources AS

AS Wages AS Rise in increase prices of resources

47 What causes shifts in SRAS?

Lower Business Rise in AS Taxes AS subsidies

Higher Fall in AS Business AS subsidies Taxes

48 What causes supply shocks?

Sudden beneficial events e.g., oil discovery, good weather and harvest, AS technological breakthrough

Sudden negative event e.g. AS war, natural disaster, oil price increase

49 Macroeconomic Equilibrium Shifts in AD Shifts in SRAS The

• Fluctuations in the growth of real output, consisting of periods of expansion and contraction called business cycles or cycles. Business Cycle Business Cycle: Expansion

Some Rise in Prices

Most resources employed

Near Full Employ-ment Business Cycle: Peak

Inflation

All resources employed

Full Employ- ment Business Cycle: Contraction

Slowing Inflation

Some resources not employed

Growing Unemploy- ment Business Cycle: Trough

Deflation

Resources not fully employed

Widespread Relationship between real GDP and Employment

GDP Falls Unemployment Falls

Unemployment Increases GDP Increases

59 Using Diagrams to Illustrate Macroeconomic Goals Using Diagrams to Illustrate Macroeconomic Goals Changes in SR Equilibrium

Changes in Changes in AD SRAS

Shift to Right Shift to Right Prices and Output Prices Fall but increases Output Increases

Shift to Left Shift to Left Prices and Output Prices Increase fall but Output falls Changes in AD Changes in SRAS Economic Scenarios

An economy with a deflationary (recessionary) gap

An economy with a inflationary gap

An economy at a full level of output Deflationary (recessionary) gap

• A recession is when the economy experiences two consecutive quarters of falling GDP. Inflationary gap Full employment level of output Causes of Business Cycle

Changes in Changes in AD SRAS

Shift to Right Shift to Right Higher GDP and Inflationary Gap Lower Prices

Shift to Left Shift to Left Recessionary Gap Changes in AD Changes in AS What is the neoclassical perspective? Full without without achieved achieved intervention employment employment an an Price Price system system markets regulates regulates Economy is Economy harmonious harmonious mechanism mechanism Perspective Neoclassical Neoclassical the the Perfect Perfect benchmark competitive competitive equilibrium is equilibrium The Neoclassical LRAS

In the Long Run LRAS is vertical all resources (perfectly Potential GDP is including wages inelastic) at independent of change to match potential GDP or the price level changes in the full employment price level level of GDP Neoclassical (Free Market) LRAS

LRAS perfectly inelastic at Full Employment Level of Output (Ymax) Potential Output = Quantity and Quality of FOPs not Price Why is the LRAS vertical?

Prices increase 5% Firms make Therefore But in the LR in the SR but a quick 5% Firms have prices of inputs have and no incentive inputs rise not yet increase to increase by 5% changed in output output price. Implications of the neoclassical LRAS?

In time any inflationary or In the LR recessionary Governments increases in AD gap will do not need to will not impact disappear and intervene in the real GDP but the economy market only bring will move to full about inflation employment Long-run equilibrium Long-run equilibrium and Decline in AD Return to Long-run equilibrium Long-run equilibrium Long-run equilibrium and Increase in AD Return to Long-run equilibrium What is the Keynesian perspective?

Price Mechanism fails as wages are “downward sticky”

Reaching full The economy Keynesian employment can get stuck in requires the SR Perspective intervention

The economy is inherently unstable The Keynesian SR/LRAS?

Potential GDP is Sticky prices are Wages and prices dependent of the explained are unlikely to fall price level through the during periods of because actions of recession. inflexibility of who wages and prices Wages and prices fear a price rises stops the are “downward and unions who economy moving sticky”. resist cuts. into the LP. Keynesian SR/LRAS Keynesian SR/LRAS

• Keynes argued that as there is nothing inherent in the economy to move the SR into the LR, then SRAS = LRAS NB In diagrams taking a Keynesian you may see the AS curve labeled Keynesian AS or simply LRAS as long as the diagram’s title makes clear which perspective is being adopted Inflationary Gap in the Keynesian Perspective Full Employment Equilibrium in the Keynesian Perspective Economic Growth: Improved Quantity & Quality of FOPs

Use better Technology Develop higher quality FOPs

Increase quantity of resources Reduce unemployment

Improve efficiency Economic Growth: Neoclassical Perspective Economic Growth: Keynesian Perspective Policy Alternatives to Manage the Economy

Discretionary Policies aim to Stabilize the Economy

Fiscal Monetary

Demand-side Supply-side Policies Policies Expansionary Policies (in recession)

Fiscal Policy

Increase Increase government supply spending

Decrease Lower interest personal and/or rates (easy business taxes money)

Combination of both policies Contractionary Policies (in inflation)

Fiscal Monetary Policy Policy

Decrease Decrease government spending

Increase Raise interest personal and/or rates (tight business taxes money)

Combination of both policies Strengths of

Opportunity to use Combats rapid and spending to escalating inflation redistribute income

Opportunity to use spending to Combats a deep provide public recession goods and services Weaknesses of Fiscal Policy

Time lags in recognizing the problem, Inadequate information Political constraints determining and implementing policies

Crowding-out i.e. Tax cuts may be Unable to fine tune Government borrowing ineffective economy raises interest rates Strengths of Monetary Policy

Quick implementation No political constraints No political constraints as Central Banks are Combats rapid and independent bodies escalating inflation

Better able to fine No crowding-out tune the economy Weaknesses of Monetary Policy

Inadequate Time lags information

Possible ineffectiveness in the face of a deep recession The Neoclassical/Monetarist Challenge

• Argument that discretionary fiscal polices that try to stabilize the economy are so flawed that they actually cause instability Alternative policies 1. Ensure steady supply of money 2. Ensure price and wage flexibility 3. Focus on supply-side policies to achieve economic growth Supply-side Policies

Discretionary Fiscal Policies that aim to increase potential output

Market-orientated Interventionist- Policies orientated Policies Market-orientated Policies

Economic Growth through Price Stability Full Employment supply-side policies Market-orientated Supply-side Policies: Objectives

Reduce Improve incentives Government for private Sector initiative

Ensure the Labor Free Trade market responds (Discussed in to supply and Section 4) demand Deregulation Private to encourage Financing of Public Services and efficiency

Privatization to increase Outsourcing to incentives and Private Sector reduce costs Reduce Government Sector Reduce Government Sector: Pros and Cons

More competition Greater efficiency Lower costs Improved services

Higher costs of private financing Job losses Deregulation undermines fairness Lower taxes on interest income to stimulate and investment Reduce personal Lower business taxes to taxes to increase encourage more investment, R&D work and innovation

Improve incentives for private initiative Make labor more responsive to : Pros and Cons

Labor markets more competitive Wages respond to supply and demand Lower costs and higher profits Increased employment

Increase income inequality Unemployment benefits help to maintain consumption Support SMEs (small to medium sized firms) Support infant industries through Fund and provide grants, subsidies incentives for R&D tax exemptions & tariffs

Provide education and health to Support Invest in improve quality of infrastructure labor industry Government policies to improve industry: Pros and Cons

Provide an underpinning for economic growth

Inefficiencies and resource misallocation Opportunity costs Increased taxes Shifting the SRAS and the LRAS in the AS-AD Model

SR LR • Focus on the price of labor, • Focus on new technology, inputs and taxation and new production methods, legislation quality and/or quantity of FOPs The Effect

Change in real • Any change in GDP Consumption, Investment, • Produces induced Government Spending expenditures, a chain and Net Exports reaction of further expenditures Change components of AD Marginal Propensity

MPS MPI •Marginal •Marginal Propensity to •Marginal Propensity •Marginal Consume Propensity to Tax Propensity to Save to Import MPC MPT Example of the Multiplier in Effect

Initial Spending by government $100m Assumption 60% 2nd Round of Spending $60m of additional income spent on rd 3 Round of Spending $36m Consumption 4th Round of Spending $21.6m (MPC = 0.6) 5th Round of Spending $12.96m The Multiplier And So On = 1/1-MPC Last Round $0.01m Total Spending, including initial $249.99m spending by government The Multiplier Effect The Accelerator Theory & the Combined multiplier/accelerator effect

• Argues that small changes in GDP produces larger changes in investment spending. • These fluctuations interact with the Multiplier effect to increase the momentum of business cycle. Crowding-out Effect

Governments borrow to Interest rates Private finance fiscal rise investment falls polity Crowding-out Effect Crowding-out Effect Unemployment and Inflation Unemployment Number of of Number a as unemployed of the percentage force labor Unemployment Rate Rate Unemployment • t time but time - Number of of Numberadults working who are part full time lookingfor peopleor who work fullynot using are skills. their Underemploymen • Unemployment Number of of Numberadults working not who are look for actively but job a • Loss of real output (GDP)

Long-term unemployed may Loss of income become unemployable

Economic Costs of unemployment

Unemployment unequally Loss of tax revenue distributed

Cost of unemployment benefits Social Costs of Stress Social Problems unemployment Economy at Potential

Structural Frictional Seasonal Unemployment Unemployment Unemployment

Technological Changes

Changes in consumer demand Seasonal demand for Workers between jobs labor changes Labor markets rigidity e.g. minimum wage laws

Changes in geographical location of employment Types of Unemployment

Economy at Economy below Potential Potential Structural Unemployment Real Wage Unemployment

Frictional Unemployment

Seasonal Cyclical Unemployment Unemployment Keynesian Remedy for Unemployment During a Recession

Expansionary Cyclical Insufficient AD Fiscal and Unemployment Monetary Polices

Return to Real Increase in AD GDP at potential Neoclassical Remedy for Unemployment During a Recession

Market rigidity caused Recessionary gap by minimum wage Real Wage produces labor surplus legislation, collective Unemployment as wage levels stay bargaining & firms above equilibrium paying high wages

Eliminate minimum Return to long term wage legislation and SRAS shifts to right equilibrium collective bargaining by unions Real Wage Unemployment Eliminating Cyclical (Demand-deficient) Unemployment Inflation and

Inflation • A continuing increase in the general price level of goods and service within the economy

Deflation • A continuing decrease in the general price level of goods and service within the economy Inflation & Deflation Deflation Increase in AS AS in Increase Decease in AD inDecease • • Inflation Supply InducedSupply Excessive Excessive Money Increase of Increase supply money • side push - - Inflation Cost Increase in thein Increase of costs production (supply shocks) in fall produces AS Solutionstiedto of the fall cause AS and in to attempt the FOPs reduce • • pull - Inflation Demand Increase in AD in Increase AD in Reduction this solution to of inflation from • • Demand-pull Inflation Cost-push Inflation Loss of international competitiveness

Redistribution of income Money illusion

Economic Costs of Inflation

Uncertainty Menu Costs Stakeholders and Inflation Winners Fixed income earners Cash holders Savers Borrowers at interest rates lower than inflation

Losers Borrowers at interest rates higher than inflation Payers of fixed incomes and wages

Redistribution of Deflationary income Spiral Economic Costs of Deflation

Uncertainty Menu costs “Good” Deflation Measuring Inflation

The consumer price index (CPI) compares the value of a basket of goods and services in one year with a same basket in the base year. Problems Measuring Inflation

Static Basket of Goods New Retail Outlets New Products and Services •Belongs to a fictitious •Purchases at discount •New products may not “average” person stores, megastores and be immediately •Fixed weighting may online stores may not counted (new product not reflect be counted (new retail bias leads to substitutions people outlet bias leads to overestimation of make in their spending overestimation of inflation (substitution effect inflation •Improved quality may leads to not be measured overestimation of (quality bias leads to inflation) overestimation of inflation) The

Government must deal Inflation and with a trade-off Unemployment between price stability inversely related and full employment NRU = NAIRU

Natural Rate of Structural Frictional Seasonal Unemployment

If governments avoid demand-side expansionary policies Non-accelerating inflation rate of unemployment is achieved (NAIRU) Long-run Phillips Curve

Neo-classical NRU Lowering NRU perspective

• No trade-off • At long-run • Only Supply- between equilibrium side polices can unemployment there will be a sift the LRPC to and inflation in natural rate of the right LR unemployment (NRU) Phillips Curve Phillips Curve Neo-classical challenge to the Phillips Curve LR Phillips Curve

If expansionary policies adopted, inflation would increase to 4% or more. Real wages have fallen and firms hire additional labor. LR Phillips Curve

Unemployment is now below NRU at 4%. (b) Workers have fallen for the “money illusion” and slow to realize that real wages have fallen because inflation is actually over 4%. LR Phillips Curve

Unemployment is now below NRU at 4%. (b) Workers have fallen for the “money illusion” and slow to realize that real wages have fallen because inflation is actually over 4%. LR Phillips Curve

Once workers realize real wages have fallen they will demand at least a 4% pay rise. Real wages will return to previous levels and firm will fire workers. Unemployment has returned to (c) LR Phillips Curve

Any attempt to to increase AD will only result in temporary changes to unemployment but increasingly high rates of inflation LR Phillips Curve Friedman argued that no trade off exists if governments do not use demand side policies.