2.1 The Level of Overall Economic Activity
- Land: rent
- Labour: wages / salary
- Capital: interest
- Enterprise: profit
- Output (Goods) = Expenditure (Spending) = Income (Factor incomes)
- GDP = C + I + G + (X-M)
- Factor Incomes = C + Savings + (Tax-Benefit)
- Since output = income,
=> C + I + G + (X-M) = C + S + (T-B)
=> I + G + X = S + (T-B) + M
=> total injections = total leakages
- Leakages: Taxes, Savings, Imports, International transfers, Illegalities
- More leakages -> smaller circular flow in the economy
- Injections: Subsidies, Government Spendings, Exports, Investment, Transfer payment
- More injections -> bigger circular flow in the economy
- GDP stands for Gross Domestic Product, which is the total amount of income/output/expenditure of a country through a period of time
- GNP = GNI stands for Gross National Product, is the total amount of income/output/expenditure of every person within that nationality in the period of time
- GNP = GDP + (factor income earned abroad - factor income paid abroad)
- Nominal GDP: Face Value
- Real GDP: The value without inflation rate (determined by CPI)
- CPI -- Using a basket of goods with different weights and a base year to calculate the percentage rise in price level
- GDP per capita is the total amount of income/expenditure/output of a person inside a country through a period of time
- GNP per capita will be the total amount of income/output/expenditure of a person in the nationality
- Measuring National Income:
- Output approach: It is the Market value of all final goods and services calculated during 1 year. (add up the value of all goods and services produced in the country)
- The Gross Value of domestic output in various economic activities is estimated, then the value of intermediate consumption, i.e., the cost of material, supplies and services used to produce final goods or services is determined. Finally, intermediate consumption figures are deducted from Gross Value to obtain the Net Value of Domestic Output.
- Income approach: GDP is derived by adding up all income i.e. wages and salaries, profits, rent and interest.
- Expenditure approach: C + I + G + (X - M)
- It excludes non-market production, such as the household services of homemakers
- It also causes problems if nations have different definitions of legal versus illegal activities. e.g. gambling
- It is not necessarily a good measure of the well-being of a nation
- It doesn’t show the environmental quality of life
- It doesn’t necessarily reflect purchasing power.
- Different countries have different conventions for calculating national income.
- Green GDP: The green gross domestic product (green GDP) is an index of economic growth with the environmental consequences of that growth factored in. Green GDP monetizes the loss of biodiversity, and accounts for costs caused by climate change.
The Business Cycle
- As the output increases, there are certain times when there is a boom, the output is higher than what it should be, therefore the output will drop, causing a recession and therefore leads to depression.
- The long-term growth trend represents the potential output of the economy, as the potential output increases, the growth increases
- This happens because as time passes the potential supply increases from developing technology.
- Decrease in GDP means the growth is negative
- Decrease in GDP growth means the GDP growth is still positive but the growth rate is smaller than the previous year
2.2 Aggregate Demand and Aggregate Supply
- Microeconomic demand - individual
- Macroeconomic aggregate demand - combined demand for everything in the economy
- Negative Slope:
- The real-balance effect: The change in expenditures resulting from a change in the real value of money balances when the price level changes, all other things held constant; also called the wealth effect. A rise in the price level will have an effect on spending.
- Interest rate effect: Higher price levels increase the interest rate (to stop people from spending), which in turn causes businesses and consumers to reduce desired spending due to the higher cost of borrowing.
- The open economy effect: Higher price levels for an economy result in foreign residents desiring to buy fewer exports, while local residents now desire more foreign-made goods, thereby reducing net exports. This is equivalent to a reduction in the amount of real goods and services purchased in the economy.
PL = Inflation
- Components AD = Demand = Purchasing = Expenditure = Income = Output = GDP
- AD = C + I + G + (X - M)
- Consumption: Make the community spend more / less
- Govt. Spending
- Export - Import
- AD Determinants Consumption:
- Consumer confidence -- confidence of the consumers’ willingness to purchase products. As the consumer confidence increases, AD shifts right.
- Interest rates -- The proportion of a loan that is charged as interest to the borrower, typically expressed as an annual percentage of the loan outstanding. As interest rate increases, people are less willing to borrow money for consumption or investment, therefore AD shifts left
- Wealth -- The more wealth there is in a country, the more willing people are to buy or consume luxuries, this means AD will shift right
- Personal income taxes -- taxes on personal income, the more taxes, the less people are willing to buy, therefore AD shifts left
- AD Determinants Investment:
- Interest rates decrease can lead to increase in AD because people will be more willing to borrow money from the bank and thus spending it
- When business confidence increases, they will be more willing to invest, thus increasing the investment section of AD
- When technology develops, it means more investment is spent and can produce products at a more efficient rate, which could shift AD to the right
- When business taxes decreases, businesses will be more willing to invest, thus AD would increase because investment increased.
- When the level of corporate indebtedness is high, the business will put the priority of paying back in front of investing, thus decreasing investment
- AD Determinants Government Spending:
- If the government is considering increasing employment then it might increase its spending on public projects, thus increasing AD.
- During phases of slow economic growth, government is more likely to increase its spending in order to stimulate the economy such as giving subsidies to increase AD.
- AD Determinants Net Exports:
- As the income of trading partners increase, the AD will shift to the left because the trading partner will have more purchase power
- As exchange rate of our own currency increases, import increase and export decreases because their currency is stronger, leading to a shift to the left of AD.
- Aggregate supply is the total amount of goods and services that all industries in the economy will produce at every given price level.
- AS curve is similar to a microeconomic supply curve. It is upward sloping because as price level increase, producers will be more willing to produce
- As resource prices increase AS will shift to the left because the producers will have to produce at a higher price for the same number of products
- An increase in business taxes would lead to shift of AS to the left because the cost per unit also increases.
- When government gives subsidies the AS shifts to the right because its lowers the cost of production
- A supply shock is an event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good. e.g. natural disaster, this causes the AS to shift to the left
- Different Views of AS:
- Monetarist: The LRAS graph is a vertical straight line, since there is only finite amount of resource that we can use. Therefore, the price level will not affect the total amount of output that we can actually produce
- Level 1 : Spare Capacity -- High level of unemployment and unused factors of productions
- Level 2: Decrease in spare capacity -- FOP becomes scarce, price level would increase, because higher price levels has to be paid
- Level 3: Level of full employment -- Only prices will increase
- When efficiency increases the product that can be potentially produced increases, shifting the AS to the right
- When new technology emerges, the efficiency might increase
- When unemployment reduces, the potential increases as more labour is in work
- Institutional changes e.g. reduction to trade union power
- Explain, using a diagram, the determination of short-run equilibrium, using the SRAS curve.
- Examine, using diagrams, the impacts of changes in short-run equilibrium.
- Shift in AD or shift in AS
- Since there is always spare capacity, we never exceed the level of full employment, therefore we are always in deflationary gap in the Keynesian model.
- There are spare capacity which means the economy can remain in deflationary gap for a long time, so even if the AD shifts to the right, it doesn’t necessarily mean the economy becomes an inflationary one. Only at the full employment level will the economy experience inflationary gap.
2.3 Macroeconomic Objectives
- Unemployment - a situation where someone of working age is not able to get a job but is actively seeking for one.
- Unemployment rate - the number of people with no work expressed as % of the total labour force
- Difficulties in measuring unemployment
- Existence of hidden unemployment
- Existence of underemployment (part time would rather be full time)
- Average value - ignores regional , ethnic, age and gender disparities
- Consequences of unemployment
- Individual consequences of unemployment
- Decreased household income and purchasing power
- Increased levels of psychological and physical illness, including stress and depression.
- Social consequences of unemployment
- Downward pressure on wages for the employed
- Increased poverty and crime (income inequality)
- Transformation of traditional consequences
- Economic consequences of unemployment
- Under-utilization of the nation’s resource
- A turn towards protectionist and isolationist policies
- Increased budget deficits
- Cost of unemployment benefit
- Types and causes of unemployment
- A factor of overall unemployment that relates to the cyclical trends in growth and production that occur within the business cycle. (Demand deficient)
- When economic output falls, as measured by the gross domestic product (GDP), the business cycle is low and cyclical unemployment will rise.
- A fall in consumption, investment and net export leads to a fall in AD1
- Boost AD - increase factors in GDP
- Reduce tax
- When a worker loses his or her job due to the changing structure of the nation’s economy
- Agricutural base to manufacturing base
- Labour intensive to capital intensive
- Change in the demand for particular labour skills, changes in the geographical location of industries, and the labour market rigidities
- Market oriented supply side policies
- Interventionist supply side policies
- Workers who are in between jobs or just entering the labour force for the first time are referred as frictional unemployment
- Reduce unemployment benefits
- Workers who do seasonal labour are unemployed between seasons
- Golf course
- Migrant farmers
- Summer camp instructors
Low and Stable Rate of Inflation
- Inflation -- persistent increase in price levels of goods and services over a period of time
- Deflation -- persistent decrease in price levels of goods and services over a period of time, decrease in output
- Disinflation -- the inflation is still occurring, but not as fast
- Measure Inflation:
- CPI is the consumer price index, it is calculated by a basket of goods with weights that is consumed by the average household.
- Since different people have different baskets of goods, the rate of inflation may differ from different people depended on their income
- Inflation only measures the rise in price level and doesn’t accurately show the consumption patterns in terms of individual products nor does it show the quality of the products purchased. (Higher inflation doesn’t mean the quality increases)
- Price of food and oil is not included because they have dramatic swings, this makes the CPI less accurate in terms of reflecting the effect of inflation rates have on the households.
- PPI is a measure of a basket of goods made up primarily of intermediate products such as capital, raw materials, minerals and energy, this is more useful in determining the extent to which AS will be affected by changes of prices of goods and services
- Consequences of Inflation:
- Great uncertainty: Leads to swings in prices and thus unable to predict the possible price levels
- Redistributive effects:
- Loss of purchasing power
- People who are rich decrease their real value in a larger amount because they originally had more money
- If income rises slower in nominal terms than the inflation rate, the real income decreases
- Lower real interest rates for savers, higher nominal interest rates for borrowers
- The money saved decreases in value
- Decrease export competitiveness
- The price level increases, leading to decrease in export
- Inflationary spiral: Inflation → consumption and investment increase and savings decrease → expenditures increase without increase AS → AD increase, price level and output increase → workers demand higher wages → firms lay off, increase prices in response to higher wages → SRAS shift to the left further inflation → consumption and investment increase and saving decrease
- Consequences of Deflation:
- Discuss the possible consequences of deflation, including high levels of cyclical unemployment and bankruptcies
- Cyclical unemployment
- Types and Causes of Inflation
- Demand Pull Inflation: Demand increase
- Cost-Push Inflation: Production cost increase
- Evaluate government policies to deal with the different types of inflation.
- Higher interest rates
- Higher taxes
- Stagflation: Subsidies
- Economic growth is an increase in the real value of the total income/output/expenditure of a country in a period of time
- Causes of Economic Growth:
- The points intend to shift from A to D/B/C will mean an economic growth as the factors of production are increase its level of full employment
- Investment leads to more supply and higher potential, which leads to increase in LRAS and thus economic growths
- Capital: Technology
- Human: More labour
- Natural: More natural resources → more products can be produced
- You have to increase the factors of production in order to increase the total output produced, which is the GDP of a country
- Consequences of Economic Growth:
- Living standards
- Distribution of income
- Current account
- Balance of payments
Equity in the Distribution of Income
- Due to unequal ownership of factors of production, the market system may not result in an equitable distribution of income
- Indicators of income equality
- Determine how much of a nation’s total income is earned by the richest and the poorest groups of household
- A graphical presentation of a country’s income distribution
- The ratio of the area above a country’s Lorenz Curve and below the equality of the total area below the line equality
- The Gini Index
- 0 - perfect income equality
- 1 - perfect income inequality
- Relative poverty - the condition experienced by the people in a country whose incomes are considerably lower than the higher income groups in the same country
- Absolute poverty - the condition experiences by the individuals who cannot afford to acquire the basic necessities for a healthy and safe existence
- Causes of poverty
- Low income
- Lack of human capital
- Income inequality
- Social unrest
- Lack of contribution to national output and economic growth
- Tax directly paid to the government by those on whom they are imposes (income tax)
- Tax paid by households through an intermediary
- Consumer pays the tax at the time of his purchase of a good or a service
- A tax for which percentage remains constant as income increases (constant burden on rich and poor)
- A tax that decreases in percentage as income increases (decreased burden on rich and increased burden on poor)
- A tax that increases in percentage as income increases (increased burden on rich and decreased burden on poor)
- Measures to promote equity
- Governments undertake expenditures to provide directly, or to subsidize, a variety of socially desirable goods and services (including health care services, education, and infrastructure that includes sanitation and clean water supplies), thereby making them available to those on low incomes
- Unemployment benefits
- Social security benefits
- Nutritional subsidies
- Higher education grants and tuition subsidies
- Welfare benefits
- Relationship between equity and efficiency
- A nation that successfully employs an equitable system of taxes and government spending - more likely to achieve equal distribution of income
- A tax system including progressive marginal income tax combines with regressive indirect tax ensures that both the rich and the poor share a portion of the nation's tax burden.
2.4 Fiscal Policy
The Government Budget
Government spending : Current( spending on factor payment and goods) Capital( investment, spending on assets)
Transfer payment ( a payment from government to individual, no output is generated)
Government revenue: Direct taxes( taxes on income) indirect taxes ( taxes on expenditure),sales of good and services
Budget deficit is when total expenditure> total tax revenue
Budget surplus is when total expenditure <total tax revenue
National debt is the accumulation of all the past years deficits. A budget deficit will increase the size of the national debt. Vice versa.
The Role of Fiscal Policy
Definition: Fiscal Policy is the use of government spending and taxation to influence AD, raised revenue, redistribute income and influence consumption pattern.
- Fiscal policy can promote long term economic growth by increased government spending different sectors of the economy. With a careful planning of expenditure on capital goods in the economy i.e. infrastructure, better education and health systems, government can considerably improve the potential output in the economy. Better education and health will also result in improved human capital. Thus, improving the very basic factors of production available in the economy.
- Moreover, a skilled labour force supported by a strong infrastructure will create a positive environment for firms to invest. The economy will find it easy to attract foreign capital. All these factors will lead to an increased economic growth.
- Direct impact on AD
- Role in recession
- Time lags
- Political influences
- Budget deficits can leads to increase in taxation in the future
2.5 Monetary Policy
- Rate of interest is cost of borrowing money
- Describe the role of central banks as regulators of commercial banks and bankers to governments
- Explain the central banks are usually made responsible for interest rates and exchange rates in order to achieve macroeconomic objectives
- Explain, using a demand and supply money diagram, how equilibrium interest rates are determined, outlining the role of the central bank in influencing the supply of money.
The Role of Monetary Policy
- Point of Monetary policy is to change interests rates to influence aggregate demand (central bank)
- Expansionary Monetary Policy
- When the economy is in a recessionary gap, the central bank decides to increase money supply, with demand remaining constant, interests rates falls
- Drop in interest rates means cost of borrowing decreases, which encourages spending and borrowing by individuals and firms. They will be more likely to spend more, thus increasing C and I
- Recessionary gap is then closed by increase in AD
- Contractionary Monetary Policy
- Economy in inflationary gap, central bank reduced money supply, causing interests rates to increase
- Increase in interest rates causes people to borrow less, thus decreasing AD as they have less money to spend
- The economy is now back into equilibrium
2.6 Supply-Side Policies
The Role of Supply-Side Policies
Supply-side policies focus on the production and supply side of the economy, specifically on the factors aimed at shifting the long-run aggregate supply (LRAS) or Keynesian AS curves to the right, which indicates an increase in the potential output and achieve long-term economic growth.
Supply-side policies focus on:
- Increasing the quantity and quality of factors of production
Interventionist Supply-Side Policies
Policies that are created because many believed that free market cannot increase the total potential output in a desired result.
Interventionist supply-side policy includes:
- Investment in human capital: education and health services
- Training and education
- Improved health care services and access to these
- Investment in new technology
- Investment in infrastructure
- Industrial Policies
- Support for small and medium-sized enterprises or firms (SMEs)
- Support for ‘infant industries’
Market-Based Supply-Side Policies
Supply-side policies are believed to achieve rapid growth, price stability and full employment at the same time.
Market-based supply-side policies can be grouped under three headings:
- Encouraging competition
- Private financing of public sector projects
- Contracting out to the private sector (outsourcing)
- Restricting monopoly power
- Trade liberalisation
- Labour market reforms
- Abolishing minimum wage legislation
- Weakening the power of labour (trade) unions
- Reducing unemployment benefits
- Reducing job security
- Incentive-related policies
- Lowering personal income taxes
- Lowering taxes on capital gains and interest income
- Lowering business taxes
Evaluation of Supply-Side Policies
- Time lags: Supply side policies generally take time to implement and show results in the long run. For example, improving the quality of human capital, through education and training, is unlikely to yield quick results. These policies have an ability to create employment as more jobs are created in various fields such as education, technology and health care. Moreover, these jobs are long term and sustainable.
- Reduce inflationary pressure in the long term because of efficiency and productivity gains in the product and labour markets.
- Costly to implement and have severe impact on the government budget. For example, the provision of education and training is highly labour intensive and extremely costly. However in the long run size of the economic growth would be significant enough that the increased government revenue from a faster growing economy would cause overall revenue to increase.
- Effect on equity: Many supply-side measures have a negative effect on the distribution of income, at least in the short-term. For example, lower taxes rates, reduced union power, and privatisation have all contributed to a widening of the gap between rich and poor.
- Effect on the environment: Supply side policies lead to more economic growth. However, it can lead to exploitation of natural resources and environment if environmental regulations are relaxed thus creating negative externalities of production.
- Opposition: Power of labour unions, reducing unemployment benefits and abolishing minimum wages can lead to widespread discontent among the labour force in the economy. Thus governments are usually hesitant in taking these steps. Moreover, these might also lead to worsening of working conditions in the long run which will affect labour productivity.