© The McGraw-Hill Companies, 2002 Week 8 Introduction to macroeconomics

©The McGraw-Hill Companies, 2002

Week 8Introduction to

macroeconomics

2©The McGraw-Hill Companies, 2002

Macroeconomics is ...

• the study of the economy as a whole

• it deals with broad aggregates

• but uses the same style of thinking about economic issues as in microeconomics.


Some key issues in macroeconomics

• Inflation– the rate of increase of the general price level

• Unemployment– a measure of the number of people looking for

work, but who are without jobs

• Output– real gross national product (GNP) measures total

income of an economy• it is closely related to the economy's total output


More key issues in macroeconomics

• Economic growth– increases in real GNP, an indication of

the expansion of the economy’s total output

• Macroeconomic policy– a variety of policy measures used by

the government to affect the overall performance of the economy



Inflation in UK, USA and Germany1960 - 2001

0

2

4

6

8

10

12

14

16

Annual %

1960-73 1973-81 1981-90 1990-01

UKUSAGermany


Unemploymentin UK, USA and Germany

0

2

4

6

8

10

% p

.a.

1960-73 1973-81 1981-90 1990-01

UK USA Germany


Economic growthin UK, USA and Germany

0

1

2

3

4

5

% p

.a.

1960-73 1973-81 1981-90 1990-01

UK USA Germany


The circular flow of income, expenditure and output

Y

Households Firms

C + I

I

CS


Government in the circular flow

Y

C + I + G

I

CS

Households FirmsGovernment

C + I + G - Te

Te

G

B - Td

Y + B - Td


Adding the foreign sector

• To incorporate the foreign sector into the circular flow

• we must recognize that residents of a country will buy imports from abroad

• and that domestic firms will sell (export) goods and services abroad.


GDP and GNP

• Gross domestic product (GDP)– measures the output produced by

factors of production located in the domestic economy

• Gross national product (GNP)– measures the total income earned by

domestic citizens• GNP = GDP + net income from abroad


Three measures of national output

• Expenditure– the sum of expenditures in the economy– Y = C + I + G + X - Z

• Income– the sum of incomes paid for factor services– wages, profits, etc.

• Output– the sum of output (value added) produced

in the economy


What GNP does and does not measure

• Some care is needed:– to distinguish between real and nominal measurements

– to take account of population changes– to remember that GNP is not a

comprehensive measure of everything that contributes to economic welfare


Output and aggregate demand


Aggregate output in the short run

• Potential output– the output the economy would

produce if all factors of production were fully employed

• Actual output– what is actually produced in a period– which may diverge from the potential

level


Some simplifying assumptions

• Prices and wages are fixed• The actual quantity of total output is demand-determined– this will be a “Keynesian” model

• For now, also assume:– no government– no foreign trade

• Later chapters relax these assumptions


Aggregate demand• Given no government and no

international trade, aggregate demand has two components:– Investment

• firms’ desired or planned additions to physical capital & inventories

• for now, assume this is autonomous

– Consumption• households’ demand for goods and services

• so, AD = C + I


Consumption demand

• Households allocate their income between CONSUMPTION and SAVING

• Personal Disposable Income– income that households have for

spending or saving

– income from their supply of factor services (plus transfers less taxes)


The consumption function

IncomeIncome

Co

nsu

mp

tion

Co

nsu

mp

tion

C = 8 + 0.7 YC = 8 + 0.7 Y

The consumption function shows desired aggregateThe consumption function shows desired aggregateconsumption at each level of aggregate incomeconsumption at each level of aggregate income

00

The The marginal propensitymarginal propensityto consumeto consume (the slope of (the slope ofthe function) is 0.7 – i.e.the function) is 0.7 – i.e.for each additional £1 of for each additional £1 of income, 70p is consumed.income, 70p is consumed.

With zero income,With zero income,desired consumptiondesired consumptionis 8 (“autonomousis 8 (“autonomousconsumption”).consumption”).

88


The saving function

S = -8 + 0.3 YS = -8 + 0.3 Y

IncomeIncome

Sa

vin

gS

avi

ng

00

The saving function showsThe saving function showsdesired saving at eachdesired saving at eachincome level.income level.

Since all income is either Since all income is either saved or spent on saved or spent on consumption, the savingconsumption, the savingfunction can be derivedfunction can be derivedfrom the consumption from the consumption function or function or vice versa.vice versa.


The aggregate demand schedule

IncomeIncome

Ag

gre

gat

e d

em

an

dA

ggr

eg

ate

de

ma

nd

CC

Aggregate demand isAggregate demand iswhat households planwhat households planto spend on consumptionto spend on consumptionand what firms plan toand what firms plan tospend on investment.spend on investment.

AD = C + IAD = C + I

IIThe AD function is The AD function is the vertical additionthe vertical additionof C and I.of C and I.(For now I is assumed (For now I is assumed autonomous.)autonomous.)


Equilibrium output

Output, IncomeOutput, Income

Des

ired

spen

d ing

Des

ired

s pen

ding 4545oo line line The 45The 45o o line shows the line shows the

points at which desiredpoints at which desiredspending equals output spending equals output or income.or income.

ADAD

Given the AD schedule,Given the AD schedule,

This the point at whichThis the point at whichplanned spending equalsplanned spending equalsactual output and income.actual output and income.

equilibriumequilibrium is thus at E.is thus at E.

EE


Effects of a fall in aggregate demand

Output, IncomeOutput, Income

Des

ired

spen

d ing

Des

ired

s pen

ding

4545oo line lineADAD00

YY00

Suppose the economySuppose the economystarts in equilibrium starts in equilibrium at Yat Y0.0.

a fall in aggregate a fall in aggregate demand to ADdemand to AD11

ADAD11

Leads the economyLeads the economyto a new equilibrium to a new equilibrium at Yat Y11..

YY11

Notice that the change in equilibrium output isNotice that the change in equilibrium output islarger than the original change in AD.larger than the original change in AD.


The multiplier• The multiplier is the ratio of the

change in equilibrium output to the change in autonomous spending that causes the change in output.

• The larger the marginal propensity to consume, the larger is the multiplier.– The higher is the marginal propensity to

save, the more of each extra unit of income “leaks” out of the circular flow.


Fiscal policy and foreign trade


Some key terms• Fiscal policy

– the government’s decisions about spending and taxes

• Stabilization policy– government actions to try to keep output close to its

potential level

• Budget deficit– the excess of government outlays over government

receipts

• National debt– the stock of outstanding government debt


Government in the income-expenditure

model• Y=C+I+G (assumption: no foreign

trade)• Direct taxes

– affect the slope of the consumption function

– and hence the slope of the AD schedule.

• Government expenditure affects the position of the AD schedule


Fiscal policy?

Income,output

Agg

rega

te d

eman

d 45o line

AD0

Y0

But this ignores someimportant issues – prices, interest rates, and the need to fundthe governmentspending.

AD1

This seems to suggest that the governmentcould influence aggregateoutput in the economyby raising AD from AD0

to AD1,

Y1

thus raising equilibriumoutput from Y0 to Y1.


but in surplus at high levels

then the budget will be indeficit at low levels ofincome

The government budget

The budget deficit equals total government spendingminus total tax revenue.

If government spending isindependent of income

GG

, N

T

Income, output

The balanced budget multiplier states that an increase in government spending plus an equal increase in taxes leads to higher equilibrium output.

Balancedbudget

but net taxes depend onincome,

NT

Y0


Foreign tradeand income determination

• Introducing exports (X) & imports (Z)• TRADE BALANCE

– the value of net exports (X - Z)

• TRADE DEFICIT– when imports exceed exports

• TRADE SURPLUS– when exports exceed imports

• Equilibrium is now where– Y = C + I + G + X - Z


At higher income levels, there is a trade deficit.

At relatively low income,exports exceed imports– there is a trade surplus.

Exports, imports and the trade balance

IncomeX

, Z

but that imports increasewith income

ImportsAssume that exportsare independent of income,

Exports

There is trade balance at income Y*, but there is no guarantee that this corresponds to full employment.

Y*


Foreign trade and the multiplier

• The marginal propensity to import – is the fraction of additional income

that domestic residents wish to spend on additional imports.

• The effect of foreign trade is to reduce the size of the multiplier– the higher the value of the marginal

propensity to import, the lower the value of the multiplier.

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© The McGraw-Hill Companies, 2002 Week 8 Introduction to macroeconomics