Macroeconomics

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What is macroeconomics?

What are macroeconomic goals?

How is national income measured?

How can economic growth be achieved?

What is macroeconomics?

Macroeconomics is the study of a national economy.

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Macroeconom

ic Goals

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National Income

Two Sector Circular Flow of Income

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Wages, Rent and Profits(Y)

Factors of Production

Expenditure on Goods and Services(E)

Good and Services = Output (O)

Households

FirmsE = O = Y

Monetary Flow

Real Flow

Four Sector Circular Flow of Income

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Expenditure

Income

Households

Firms

Leakages (L)

Saving (S)

Taxes(T)

Imports (M)

Injections (J)

Exports(X)

Investments(I)

GovernmentSpending (G)

O = E = Y Sum J = Sum L

Measuring National Income

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Wages, Rent and Profits

Factors of Production

Expenditure on Goods and Services

Good and Services

Households

Firms

Output Method Income Method

Expenditure Method

9 How is national income measured?

10 How is national output measured?

11How is national expenditure measured?

12 What is GDP?

13 GDP

GDP = Gross Domestic Product = Total Value 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)

14 GNP

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

15 Real GDP

Real GDP = Nominal GDP adjusted for inflation

16 Calculating Real GDP

Real GDP = Nominal GDP of year measuredGDP Deflator

X 100

17 The Uses of National Statistics

18 Limitations of the Data

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Introduction to Development

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.

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Why GDP fails to accurately measure welfare21

Why GDP may understate improvements in welfare22

Why GDP may overstate welfare23

How can development be measured?

GDP per capita

Human Development Index

Aims to stress the human dimension of economic growth

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How can development be measured?25

How is the HDI determined?26

27How can development be measured?

Developing and Developed 28

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

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Macroeconomic Models

What is aggregate demand (AD)?

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

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33 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?34

What causes Changes in

Consumption?

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AD AD

ADAD

What causes Changes in Consumption?

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AD

AD AD

AD

What causes Changes in Consumption?

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AD

AD AD

AD

What causes Changes in Investment?

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AD

AD

Demand for investment funds?39

What causes Changes in Investment?

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AD

AD AD

AD

What causes Changes in Investment?

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AD

ADAD

AD

What causes Changes in Investment?

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AD

AD

What causes Changes in Government Spending?

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AD

ADAD

AD

What causes Changes in Export and

iMport spending?

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AD

AD

What causes Changes in Export and

iMport spending?

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AD

ADAD

AD

What is aggregate supply (AS)?

Aggregate (total) Supply is amount of goods and services that all industries will produce at a given price level.

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What is aggregate supply in the short run (SRAS)?47

What are the components of AS?48

What causes shifts in SRAS?49

What causes shifts in SRAS?

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AS

AS AS

AS

What causes shifts in SRAS?

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ASAS

ASAS

What causes supply shocks?

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AS

AS

Macroeconomic Equilibrium53

Shifts in AD54

Shifts in SRAS55

The Business Cycle

Fluctuations in the growth of real output, consisting of periods of expansion and contraction called business cycles or trade cycles.

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Business Cycle57

Business Cycle: Expansion

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Business Cycle: Peak

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Business Cycle: Contraction

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Business Cycle: Trough

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Relationship between real GDP and Employment

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Using Diagrams to Illustrate Macroeconomic Goals

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Using Diagrams to Illustrate Macroeconomic Goals

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Changes in SR Equilibrium 65

Changes in AD 66

Changes in SRAS 67

Economic Scenarios 68

Deflationary (recessionary) gap 69

Recession

A recession is when the economy experiences two consecutive quarters of falling GDP.

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Inflationary gap 71

Full employment level of output 72

Causes of Business Cycle 73

Changes in AD 74

Changes in AS 75

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Wh

at is th

e n

eo

classica

l p

ersp

ective

?

77 The Neoclassical LRAS

78Neoclassical (Free Market) LRAS

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

79 Why is the LRAS vertical?

80Implications of the neoclassical LRAS?

81Long-run equilibrium

82Long-run equilibrium and Decline in AD

83Return to Long-run equilibrium

84Long-run equilibrium

85Long-run equilibrium and Increase in AD

86Return to Long-run equilibrium

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What is the Keynesian perspective?

88 The Keynesian SR/LRAS?

89 Keynesian SR/LRAS

Segment 1: Spare capacity in the economy, LRAS perfectly elastic

90 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

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Inflationary Gap in the Keynesian Perspective

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Full Employment Equilibrium in the Keynesian Perspective

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Economic Growth: Improved Quantity & Quality of FOPs

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Economic Growth: Neoclassical Perspective

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Economic Growth: Keynesian Perspective

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Demand-side and Supply-side policies

Policy Alternatives to Manage the Economy97

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Expansionary Policies (in recession)

99Contractionary Policies (in inflation)

100Strengths of Fiscal Policy

101Weaknesses of Fiscal Policy

102Strengths of Monetary Policy

103Weaknesses of Monetary Policy

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

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Supply-side Policies

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Market-orientated Policies

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Market-orientated Supply-side Policies: Objectives107

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Reduce Government Sector: Pros and Cons109

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Improving incentives : Pros and Cons111

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Make labor more responsive to supply and demand : Pros and Cons

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Government policies to improve industry: Pros and Cons

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Shifting the SRAS and the LRAS in the AS-AD Model116

The multiplier, accelerator and crowding-out effect

HL Topics

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The Multiplier Effect118

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Marginal Propensity

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Example of the Multiplier in Effect

Initial Spending by government $100m

2nd Round of Spending $60m

3rd Round of Spending $36m

4th Round of Spending $21.6m

5th Round of Spending $12.96m

And So On

Last Round $0.01m

Total Spending, including initial spending by government

$249.99m

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Assumption 60% of additional income spent on Consumption (MPC = 0.6)

The Multiplier = 1/1-MPC

The Multiplier Effect

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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.

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Crowding-out Effect123

Crowding-out Effect

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Crowding-out Effect

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Unemployment and Inflation

Unem

ployment

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Economy at Potential

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Types of Unemployment

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Keynesian Remedy for Unemployment During a Recession

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Neoclassical Remedy for Unemployment During a Recession

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Real Wage Unemployment

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Eliminating Cyclical (Demand-deficient) Unemployment

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Inflation and Deflation136

Inflation & D

eflation

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Demand-pull Inflation

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Cost-push Inflation

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Stakeholders and Inflation

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“Good” Deflation

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Macroeconomics

Section 3.5

HL Topics

Measuring Inflation

The Phillips Curve

NRU & NAIRU

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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.

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Problems Measuring Inflation146

The Phillips Curve147

NRU = NAIRU

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

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Long-run Phillips Curve149

Phillips Curve

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Phillips Curve

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No-classical challenge to the Phillips Curve

a = Labor Market at equilibrium

6% = NRU

Wages set to rise by at least 2% as workers expect this rate of inflation

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LR Phillips Curve

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

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LR Phillips CurveUnemployment 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%.

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LR Phillips CurveOnce 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)

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LR Phillips CurveAny attempt to to increase AD will only result in temporary changes to unemployment but increasingly high rates of inflation

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LR Phillips CurveFriedman argued that no trade off exists if governments do not use demand side policies.

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Income Distribution

Income Distribution and Equity

Horizontal Equity = people should be treated the same e.g. people who have the same income should pay the same tax

Vertical Equity = treating people differently to achieve greater fairness e.g. people on low incomes pay less tax than people on high incomes

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Progressive, Proportional and Regressive Taxation

Progressive: as income increases, the fraction paid in tax increasesProportional: as income increases the fraction paid in taxes remains constantRegressive: as income increases, the fraction paid in taxes decreases

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Progressive, Proportional and Regressive Taxation

Income $ Proportional Tax Rate

Tax Paid

Progressive Tax Rate

Tax paid Regressive Tax

Tax Paid

10,000 15% 1500 15% 1500 15% 1500

50,000 15% 6500 20% 10000 10% 5000

100,000 15% 15000 40% 40000 5% 5000

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Lorenz Curve

Perfect income equality

Inequality of income

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Calculating G

ini Coefficient

Gini Coefficient = A/A+B

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A

B

Gini Coefficient

Gini Coefficient = areas between diagonal and Lorenz Curve/entire area under diagonal

Values closer to 0 = greater income equality

Values closer to 1 = greater income inequality

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Laffer Curve (HL Extension)168

Laffer Curve

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170 Activity

Select one of the OECD economies to study in detail over Section 3

Undertake research to find the following:

1.Real GDP for the last decade

2.Real GDP per Capita for the last decade

3.Real GDP growth for the last decade

What conclusions can you draw?

171 Activity

Visit www.nationmaster.com or any reputable site and gather data on the various measure of development for your OECD country of focus and compare it with the developing nation you chose early in the course.

Typical Examination Questions

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These questions focus on Measuring National Income and Macroeconomics Models.

1. Explain the possible limitations of using GDP as a measure to

compare welfare between countries.

2. Using the circular flow of income diagram, explain the link between

saving and investment.

3. Use AS/AD diagrams to explain the causes of inflation (or deflation).

4. Identify the components of aggregate demand (or aggregate supply)

and briefly explain factors which might determine these components.

5. Evaluate the likely impact on an economy of a substantial rise (or fall)

in the level of interest rates (or other components of AD)

Typical Examination Questions

These questions focus on inflation and deflation:

1. What are the problems associated with measuring inflation?

2. Explain the possible causes of a rise (or fall) in the rate of inflation in

an economy.

3. Evaluate the likely effects of a rising (or falling) rate of inflation on the

performance of an economy.

4. Explain the costs of inflation and deflation.

5. Evaluate the view that governments should make the control of

inflation their highest priority

6. Evaluate the possible impact on economic performance that may

result from a government decision to bring inflation under control.

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Typical Examination Questions

These questions focus on unemployment:

1. Explain the different types of unemployment.

2. Evaluate polices aimed at achieving full employment in an economy.

3. Explain the costs of unemployment.

4. Discuss the reasons why government find the goal of full employment difficult to achieve.

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Typical Examination Questions

These questions focus on monetary and fiscal policy:

1. Discuss the strengths and weaknesses of demand-side policies.

2. Discuss the strengths and weakness of supply-side policies.

3. Explain the purpose of various demand-side (or supply-side) policies.

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Typical Examination Questions

These questions focus on income distribution:

1. With the use of examples, explain the difference between a progressive tax and a regressive tax.

2. With the use of examples, explain the difference between direct and indirect taxes.

3. Explain the possible impact on the distribution of income of a government shifting its main source of tax revenue from progressive direct taxes to regressive indirect taxes.

4. Evaluate the methods government use to redistribute income in an economy.

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Typical HL Examination Questions

In addition to the questions above, HL students need to prepare for the following:

1. Explain the relationship between the Lorenz Curve and the Gini coefficient.

2. Explain how increasing government spending can lead to crowding out.

3. Use the Phillips curve to explain the concepts of Natural Rate of Unemployment and outline its usefulness.

4. Explain the multiplier and the accelerator effects.

5. Use the Laffer Curve to explain the likely impact of progressive and regressive tax systems.

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178 On-Line Resources (1)

1. Keynes and Hayek Rap

2. Nationmater is a massive central data source and a handy way to graphically compare nations that compiles data from such sources as the CIA World Factbook, UN, and OECD.

3. CIA Factbook The World Factbook provides information on the history, people, government, economy, geography, communications, transportation, military, and transnational issues for 266 world entities.

4. Gapminder, an excellent way to visual information

179 On-Line Resources (2)

5. International Monetary Fund also provides international data.

6. National Council on Economics Education is another excellent source of information. The organization also has worksheets to help student analyze current GDP data.

7. The Economist Debates

8. Commanding Heights

9. Triple A Learning Economics Blog