Macroeconomic Objectives: Objectives: 1. Internal: 1. ... when the national income reaches or ... rates which aims to minimize the existence of

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Macroeconomics Notes

Introduction to basic Macroeconomic principles

Macroeconomic Objectives:

1. Internal: 1. Economic Growth 2. Full employment 3. Price Stability

2. External: 1. Balance of Payment stability or improvement 2. Exchange rate stability or improvement

Economic Growth

In order to understand the concept of economic growth first we must understand the following three concepts.

Phases of Economy:

1. Boom 2. Peak 3. Recession 4. Upturn

Intensity of phases or magnitude: the significance of the economic growth a country is experiencing depends on how big the growth or recession the economy is experiencing.

Duration: the significance of a boom or recession in the economy depends on how long is has lasted. In order for an economy to be classified as being in a booming

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stage it has to maintain such a performance for at least six months.

Actual Growth: when the national income reaches or approaches national income at a full level. It requires demand side policies.

Potential Growth: when you expand the capacity of the economy to produce by shifting the PPF outwards and consequently the aggregate supply rightwards. It requires supply side policies.

Increase Aggregate Demand:

1. Give incentives to spend. 2. Give incentives to invest. 3. Give incentives to build. 4. Give incentives to buy exports. 5. Give incentives to reduce imports.

Increase Aggregate Supply:

1. Increase quantity of factors of production. 2. Increase quality of factors of production.

Potential growth: use supply side policies to achieve by increasing the quantity, the quality and the efficiency of the factors of production. In order for an economy to be classified in a certain phase of growth it has to experience the characteristics of the phase for two consecutive terms.

Unemployment

In order to classify a person as being unemployed he has to be passed through some criteria.

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Measurement of unemployment: there can be an over or under estimation of how many people are unemployed.

Duration: if a person has been unemployed for a short period of time (few weeks) he isn’t classified as unemployed.

Consequences of unemployment:

1. Economy/society 2. Government 3. Unemployed people 4. Taxpayers

Types or causes of unemployment:

1. Equilibrium unemployment which can be caused because people are economically independent or the wages are too low thus people don’t feel the need to be employed.

2. Disequilibrium unemployment which is usually due to the imposition of minimum wage laws by the government which means there is higher demand for jobs than there is supply.

Reduction of Aggregate Demand:

1. Fiscal Policy suggests the increase of taxes with the decrease of government spending which aims at reducing consumption.

2. Decrease supply of money and increase interest rates which aims to minimize the existence of money flowing through the economy.

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The Circular Flow of Income:

There are three different ways of measuring economic performance:

1. Income method: measure the income of all individuals in the country.

2. Product method: measure the value of all products in the country.

3. Expenditure method: measure the domestic consumption in all sectors of the economy.

Why unemployment is bad:

1. With large numbers of unemployment the economy is producing below its full capacity thus creating a deflationary gap. Thus there is loss of output and as a consequence the country has to import from abroad with negative complications to its BoP and ER. With lower level of output usually there is no pressure on inflation. But this is not always the case. In the case of stagflation the country is experiencing both inflation and unemployment.

2. With unemployment the government might experience fiscal difficulties. The fiscal stance of the

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government might worsen because the government’s budgets, has inflows of money from taxation and money outflows in the form of government spending. When T>G then we have budget surplus. When T< budget the makes which spending government in increase an to leads this Again benefits. unemployment of form through unemployed support has reasons social for that top on dept. national is there result As requirement. borrowing sectors public and as deficit lead could This taxation. levels lower receives being people numbers large With budget. balanced have we then T="G" When deficit.>

3. There are many social and psychological implications on an individual level we have loss of self esteem something that could lead to lower productivity later, alcoholism crime and vandalism to society and an increase in family violence.

How to calculate unemployment:

1. People have to be registered 2. Expressed as rate of unemployment (unemployed ÷

labor force)×100

Reasons to underestimate unemployment:

1. Disguised unemployment: more people than necessary are hire red to do a job, usually in the public sector.

2. Underemployment: where people want to have full time jobs but are only capable of finding part time jobs. As a result people could be registered as unemployed or depending on the hours of work they

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find formally registered as employed and as a result unemployment is underestimated.

3. Plus any other relevant argument.

Reasons to overestimate unemployment:

1. Many times people are registered as unemployed in order to collect the unemployment benefits but have no intention to work.

2. Mothers with young children who had a job now give up their employment, stay at home to raise children but for a certain period they receive unemployment benefits.

3. Plus any other relevant argument.

Duration of unemployment depends on three factors

1. Original stock of unemployment or original stock of people being unemployed.

2. Rate of inflow of the number of people losing their jobs.

3. Rate of inflow of the number of people who get a

job. Reasons for which unemployed people aren’t on the supply of labour curve

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1. Frictional or Search reasons: where people usually are overqualified for certain jobs and with their own will quit their job and search for a better one (sign of a highly educated and dynamic labor force)

2. Structural reasons: where the structure of aggregate demand or the structure of aggregate supply is changing in this country (from coal to oil for heating which has an impact on aggregate demand or from primitive technology on fabric to the use of computerized technologies). People suffer structural unemployment because of occupational or geographic immobility.

3. Seasonal reason: where economic activities are concentrated during a few time periods. Strategies to reduce Equilibrium unemployment:

1. To reduce frictional or search unemployment the government could reduce job dissatisfaction by increasing job information and to reduce unemployment benefits.

2. To reduce structural unemployment the government could increase education and seminars to the unemployed to update their skills. Moreover the government could improve transportation to help people find jobs away from home.

3. To reduce seasonal unemployment the government could spread economic activities over a longer time period.

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Disequilibrium Unemployment in the Labor Market: in order to reduce real wage or classical unemployment the following economic policies could be effective:

4. Reduce government intervention in the labor market and make the labor market more flexible with wages reflecting demand and supply of labor.

5. Reduce the power of labor unions so they don’t have monopoly power in the labor market. To do so, the government could impose wage increases according to inflation. As a result the basic argument from the labor unions is cancelled and employees maintain their purchasing power.

Cyclical or demand deficient unemployment: instead of wages decreasing due to the economies recession unemployment occurs. The government could use several economic policies to reduce this type of unemployment:

6. Expansionary demand-side policy: fiscal or monetary policy. < wage minimum use not market labor intervention its reduce>

7. The government could reduce the power of labor unions by institutionalizing wage increases to happen in accordance with inflation.

Increase in the supply of labor as a reason for disequilibrium unemployment.

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8. In some cases if we assume that the supply of labor in a given economy increases because of rapid population growth or of increase in international immigration there will be disequilibrium in the labor market.

9. There is a flexible labor market and the new equilibrium is lower than before with lower wages and there is a reduction in unemployment however it isn’t realistic.

10. In case the government or the labor unions intervene and resist the wage reductions unemployment increases.

Equations used to calculate NY related Quantities

NOTE: The level of government spending depends on the government’s philosophy

11. Keynesians support government intervention which involves high government spending.

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12. Monetarists believe in a more market oriented approach which involves low government spending.

National Accounting

13. Income method=Product method=Expenditure method => based one the circular flow of income

14. Expenditure method= Cd+I+G+X-M= GDP

15. Income method=W+self-employed income+trading profits+rent+interest=total domestic income-stock appreciation=GDP

16. Output method= value of output-value of input or total output of final goods and services.

17. National Income= Domestic+ Income from abroad- Income to abroad

18. Gross National Income- Depreciation = Net National Product

19. Market Prices- Indirect taxes + Subsidies= Factor Cost

20. Real Income1995 = Nominal1995 × PI base year ÷ PI of particular year

21. GNP÷TP = GNP per capita

Is high GDP per capita co-related with high quality of life?

1. Yes, high GDP per capita is usually co-related with high quality of life. It is very useful because all countries have knowledge of this statistic and also it

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allows comparison of economic performance between years.

2. No, GDP per capita isn’t a good indicator of quality of life because

1. It is an average figure and doesn’t reflect income distribution accurately.

2. It ignores negative externalities 3. It includes military expenditure

which doesn’t reflect good quality of life

4. GDP doesn’t reflect the underground or parallel economy

5. Doesn’t reflect DIY activities 6. GDP per capita is distorted

because of different commuting patterns in the population

7. Different countries have different patterns of employment which distort GDP figures. For example in Sweden both men and women work. Thus they have professional child care for their children something that inflates GDP figures. In Mexico usually women don’t work, as a result mothers take care of their children without a salary and without their work being reflected in the GDP figures.

Assume GNP per capita in China is $ 1000 and GNP in the US is $ 30000. Does this mean that the quality of life in the US is 30

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times better compared to the quality of life in China?

The answer is no because China’s currency is the Yuan and the US’s currency is the dollar. In order to measure the Chinese value of GNP we use the income, product or expenditure method and calculate the final value of GNP in China in Yuan. According to the exchange rate of the Yuan against the dollar we adjust this figure to US dollars. The comparison will be valid only if 1 Yuan trades with 1 Dollar. If the Yuan is depreciated against the dollar, after the conversion from Yuans to Dollars the Chinese GNP will be underestimated or the opposite. Moreover we receive no information concerning infant mortality, literacy or purchasing power. The only this GNP shows is the how much Chinese people can purchase in the USA. In order for us to see the true value of the Yuan against the dollar we also have to compare purchasing power parity in other words how many products you can buy in each country with the other countries money If the exchange rate of the dollar in Yuans is 1 dollar to 3 Yuans and the purchasing power parity is Yuan ÷ Dollar exchange rate 3 this means that in the US you can buy with 3 Yuans what in China you can buy with 1 dollar. As a result the effect of

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the exchange rate is eliminated and the comparison is still valid.

Potential growth: use supply side policies to achieve by increasing the quantity, the quality and the efficiency of the factors of production. In order for an economy to be classified in a certain phase of growth it has to experience the characteristics of the phase for two consecutive terms.

Inflation

Why inflation is undesirable:

3. It causes income redistribution: because of inflation goods and services are becoming increasingly more expensive to consumers. The result is that there are winners and losers from inflation. Generally speaking upper-middle and upper level incomes are the winners with poor people generally being the losers. More specifically losers are those with fixed incomes, those who are in weak bargaining positions and those who in savings who receive interest rates lower than inflation. With inflation however there are also winners. Winners are usually those who rent houses, firms with profit increase higher than inflation and real estate agencies increasing the price of their houses faster than inflation.

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4. It causes Uncertainty: with inflation there is great uncertainty in the macroeconomic environment of a country. Inflation usually means low business confidence. There are several reasons for which there is uncertainty. Firms any moment expect an increase of interest rates by the central bank and as a result they postpone any future investment, also firms delay their modernization process because now it will be more expensive. Finally firms avoid wage increases something that reduces the motivation of employees to work harder. From the economic point of view, lower investment is going to be translated as a lower national income. Furthermore with low investment it is expected for a country to have low economic growth and it could e anticipated that we would have demand deficient unemployment.

5. There is rapid worsening of BoP and ER: Assuming that inflation in Greece is bigger than the inflation of its major trading partner then Greek exports will become more expensive to the foreigners and cheaper imports will come to Greece. As a result the balance of trade or visible balance will worsen and the ER will weaken. Of course the impact of inflation on the

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ER will be determined by the Ped for Greek exports by the foreigners as well as by the Ped for imports of Greeks (Marshal Learner condition).

6. Finally inflation is responsible for the increased cost of the firms because now the firms have to spend more resources in order to monitor fluctuating prices, hiring financial experts to determine the impact of inflation in their diverse business activities and through financial accounting and discounting cash flow methods determine the net present value of diverse investment schemes.

Causes of Inflation:

7. Demand-pull inflation: it usually reflects a case where aggregate demand has a rightward shift in the perfect inelastic part of aggregate supply. This typically happens in a booming economy. During growth total level of spending in the economy by consumers, firms on investment, the government and foreigners is increasing. As we can see from the relevant diagram there is a rapid increase in the level of prices since there is perfect inelasticity of aggregate supply which reflects the level of national output produced at each and every price level. According

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to monetarists the increase of aggregate demand is associated with an increase in money supply as the main explanation. According to non-monetarist explanations demand-pull inflation is caused by other autonomous factors like taste, confidence, optimism etc associated with economic performance. The economic policies the government could pursue would be either contractionary monetary policies or contractionary fiscal policies. The government could also attempt a supply side policy. The only problem with supply side policies is that they have long term effects as a result governments are more hesitant to pursue them. The government could also impose direct controls on prices by imposing minimum and maximum wages.

8. Cost push inflation: aggregate supply in a given economy experiences a leftwards shift. In the short run the higher the price in the market the higher the profit the firms make and the greater the output by the companies. This could lead in the long term to the increase of marginal cost of production usually because of the law of diminishing or marginal returns and because of the growing shortages

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of certain variable factors of production. Some popular reasons for cost push inflation include wage increase, increase in import prices, increase in government taxation and depletion of non-renewable natural resources. There are several policies the government could use to reduce cost push inflation; it could reduce government spending, taxation, monopoly power of firms, monopoly power of trade unions, welfare benefits of unemployment and bureaucracy on investment. The government could also attempt to increase competition in all economic sectors, deregulation, privatization, trade liberalization and capital mo vement liberalization. If the supply side policies had a more interventionist character the government could pursue an increase in nationalization, an increase in grants to the firms, improvement of the training of the labor force, provision of greater advice and persuasion , assist small firms in becoming efficient and help firms with research and development.

9. Wage Price Spiral: in a given economy if the labor unions are successful in obtaining wage increases then the cost of production

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will increase and as a result aggregate supply will be reduced. Depending on the marginal propensity to consume the increase in wages could be in its entire amount spent in the economy. As a result there will be a rightwards shift in demand and a new equilibrium will be formed at higher prices. This increase in prices is caused by cost push and demand pull inflation together. Governments quickly have to intervene in the case of wage price spiral inflation because soon inflation could be put out of control and move from creeping, to strato, to hyper inflation. In order to reduce cost push inflation appropriate supply side policy both interventionist and market oriented. In order to eliminate the demand pull element the government could use the usual mix of deflationary demand side policies and an appropriate supply side policy.

Economic Policies to Eliminate Inflation:

10. Demand Pull Inflation: the government can choose between a contractionary fiscal policy whereby the government will reduce spending and increase taxation so as to encourage savings and a contractionary monetary policy whereby with a decrease in the supply

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of money and an increase in interest rates with both deflationary demand-side policies the government aims at reducing aggregate demand. The government could also attempt a supply-side policy in order to reduce demand pull inflation. This will reduce expand supply thus forming an equilibrium at a significantly lower price level. However this has a problem because its effect can only be seen in the long term. As a result many governments resort to demand side policies which in the short term achieve the desired effect. The government could also used an interventionist policy by imposing a price ceiling on products and minimum wage legislation so as to maintain high wages.

11. Cost Push Inflation: there are several policies aimed at reducing cost push inflation. Supply side policies are mainly used to reduce the decrease of aggregate supply and they can take the form of market orientation (monetarism9 used by the political right with Margaret Thatcher (UK) and Ronald Reygan (USA). With market orientation, supply side policies the government aims to reduce:

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1. government spending so as to avoid the crowding out effect

2. taxation 3. monopoly power of the firms 4. monopoly power of trade unions 5. welfare benefits on

unemployment 6. bureaucracy on investment

Recession= a period where national output (GDP) falls

for 6 months or more

GDP= the value of output produced within the country

over a 12-month period

National product= National income= National

expenditure (Govt income/revenue-from taxes must

equal govt expenditure, so they must move towards this

equilibrium point by either cutting taxes and raising

expenditure (expansionary fiscal policy) or increasing

taxes and reducing expenditure

(deflationary/contractionary fiscal policy).

GDP= C+I+G+X-M = AD (C=consumer spending,

I=private investment, G=government expenditure on

goods and services, X=expenditure on exports,

M=expenditure on imports)

AD= C+I+G+X-M (C=consumer spending, I=private

investment, G=government expenditure on goods and

services, X=expenditure on exports, M=expenditure on

imports)

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I+G+X= Injections (J)

S+T+M= Withdrawals (S=saving, T=taxes, M=imports)

C+W=Y (consumption + withdrawals = income)

Unemployment: excess demand for labour- vacancies;

excess supply for labour- unemployment

The fiscal policy focuses on

Influences the level of economic activity through

manipulation of government income and expenditure

Influences AD –tax regime influences consumption (C)

and investment (I)

- Government spending (G)

Influences AD in the short-term but can be used to affect

AS in the long run- depending on the nature of the policy

The monetary policy is based on the assumption that

A rise in the money supply might signal a rise in the

aggregate demand!

A rise in Ms will lead to an increase in the price level.

Attempts to influence the economic activity (the amount

of buying and selling in the economy) through changes

in the money supply and the price of money i.e. short-

term interest rates

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Supply-side policies: tend to be long-term policies;

intention is to shift the AS curve to the right, increasing

the long-term productive capacity of the economy.

They argue that lowering taxes increases incentives,

reducing welfare dependency increases the urge to find

work

Policies aim to influence productivity and efficiency of

the economy

Key feature – open up markets and de-regulate to

improve efficiency in the working of market and the

allocation of resources

2. Demand-side Policies

The level of prices in the economy reflects the level of

inflation and is determined by looking at the relationship

between aggregate demand and aggregate supply.

Simple Keynesian analysis of unemployment and

inflation

“The simple Keynesian theory assumes that there is a

maximum level of national output and hence real income

that can be obtained at one time. If the equilibrium level

of income is at this level, there will be no deficiency of

aggregate demand and hence no disequilibrium

unemployment. This level is referred to as the full-

employment level of national income.”

The deflationary/recessionary gap = “the shortfall of

national expenditure below national income (and

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injections below withdrawals) at the full-employment

level of national income” (the amount by which national

income exceeds aggregate expenditure at the full-

employment level of national income)

Figure 1: Recessionary Gap

Source: Sloman & Wride, 2009

As illustrated in figure 1, the level of equilibrium is at Ye,

where the national income is equal to the national

expenditure i.e. Y=E and the injections into the economy

are equal to the withdrawals (W=J). While moving

towards full-employment, which is pointed out on the

diagram by the vertical line at YF, a deflationary gap a –

b forms between the Y (the 45° line) and E curves,

representing the amount by which income exceeds

government expenditure. Similarly, another gap, c – d,

occurs between the W and J curves, showing the

amount by which withdrawals are greater than

injections.

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The inflationary gap: “The excess of national

expenditure over income (and injections over

withdrawals) at the full-employment level of national

income.”

Source: Sloman & Wride, 2009

The relationship between the AD/AS diagram and the

45° line diagram

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Source:

The multiplier:

a shift in injections

a shift in withdrawals

a shift in the expenditure curve

Demand-side policies are anti-inflationary policies used

to control the aggregate demand.

There are two types of demand-side policies: fiscal

policy and monetary policy.

2.1 Fiscal Policy

“Fiscal policy involves altering the level of government

expenditure and/or rates of tax so as to affect the level

of aggregate demand.”

AD= C+I+G+X-M (C=consumer spending, I=private

investment, G=government expenditure on goods and

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services, X=expenditure on exports, M=expenditure on

imports)

Expansionary fiscal policies – raise government

expenditure (an injection into the circular flow of income)

or reduce taxes (a withdrawal from the circular flow). =>

AD increases => a multiplied rise in national income.

Policy used to prevent mass unemployment or a

recession (to remove any severe deflationary or

inflationary gap).

Also used to increase the budget deficit or reduce the

budget surplus.

Budget deficit: govt expenditure > govt revenue (from

taxation)

To finance a deficit, the government will have to borrow

(e.g. through the issue of bonds (gilts) or Treasury bills).

=> an increase in the money supply to the extent that

the borrowing is from the banking sector.

The substantial increase in deficits, and hence debt, in

2008 governments borrowed more to finance extra

spending and/or tax cuts to control recession.

Budget surplus: govt revenue > govt expenditure

In 2008/9, the governments around the world increased

their expenditure and cut taxes in an attempt to stave off

recession.

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Deflationary fiscal policy – cut government expenditure

and/or raise taxes. Policy used to prevent excessive

inflation

Fiscal policy – also used to smooth out the fluctuations

in the economy associated with the business cycle:

When the economy begins to boom – reduce

government expenditure and raise taxes

When a recession looms – the government should

cut taxes or raise government expenditure in order

to boost the economy.

The underlined words (cut/raise govt expenditure and

taxes) are called stabilisation policies.

2.1.1 Effectiveness of Fiscal Policy

Crowding out

Random shocks

Time lags

Policy may be stabilising or destabilising

2.1.2 Fundamental Criticisms of Keynesian Fiscal Policy

New Classical View

Monetarist View

2.2 Monetary Policy

“Monetary policy involves altering the supply of money in

the economy or manipulating the rate of interest. The

central bank can reduce AD (a contractionary monetary

policy), by putting up interest rates and thus making

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borrowing more expensive, or by acting to reduce the

supply of money available through the banking system.

If people borrow less, they will spend less. “

2.3 Rules versus Discretion

2.4 The IS-LM Analysis of Fiscal and Monetary Policy

Keynesian view: effectiveness of fiscal policy and

ineffectiveness of monetary policy

Monetarist view: effectiveness of monetary policy and

ineffectiveness of fiscal policy

4. Putting theory into practice- The recession in 2008-9

and recovery

The global economy has experienced, since the second

half of 2007, a severe financial crisis that has been

reflected in a number of imbalances among which a

sharp contraction in global output has been identified

(Astley et al, 2009). This sharp fall in output has resulted

in... Recession

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Macroeconomic Objectives: Objectives: 1. Internal: 1. ... when the national income reaches or ... rates which aims to minimize the existence of