Macroeconomics for Exam

Business Cycles

Fluctuations in an economy’s aggregate output and employment.
Consists of short-term fluctuations in the growth of real output, which are alternating periods of expansion (increasing real output) and contraction (decreasing real output)

Expansion

Phase of the business cycle during which GDP increases.

Employment of resource increases, and the general price level of the economy usually begins to rise more rapidly.

Peak

The turning point at which GDP stops increasing and begins decreasing.

Contraction

The phase of the business cycle during which GDP decreases.

If the contraction lasts six months (two quarters) or more, it is termed a recession characterized by falling GDP and growing unemployment of prices in some sectors may begin to fall.

Increase in the price level may slow down a lot, and it is even possible that prices in some sectors may begin to fall.

Trough

The turning point at which GDP stop decreasing and begins increasing.

National Income Statistics

Statistical data used to measure national income and output and other measures of economic performance.

Gross Domestic Product (GDP)

A measure of the value of aggregate output in an economy.
It is the market value of all final goods and services produced within a country during a given period, usually a year.

Measures of GDP

1. Expenditure approach: adds up all spending to buy final goods and services produced within a country over a time period.
   - GDP = C + I + G + (X-M)
   - Consumption (C) purchases by households of final goods and services in a year. | Durables are generally goods bought and used on an ongoing basis over months or years. | Non-durables are bought and consumed over a short time.
   - Investment (I) includes all business spending on capital equipment and technology, and household spending on new housing or real estate.
   - Government spending (G) includes all public sector (national, regional, local) spending on final goods and services in the economy.
   - Net Exports (X - M) refers to the value of all exports minus the value of all imports. | Exports are goods and services produced within the country and so must be included in the measurement of aggregate output. | Imports involve domestic spending on goods and services that have been produced in other countries, and so must be subtracted from expenditures measuring aggregate output.

2. Output Approach: calculates the value of all final goods and services produced in a country over a time period.
   - Measures the amount spent during each stage of the production of an economy’s output, adding up the value added at each stage of production.

3. Income Approach: adds up all income earned by the factors of production that produce all goods and services within a country over a time period.
   - GDP = W + I + R + P
   - Wages (W) + Interest (I) + Rental Income (R) + Profits (P)

Benefits of GDP

• Useful indicator of nation’s economic performance

• comparison of relative size of different economies.

• Dividing GDP by the population results in GDP per capita. Figure tells how many good and services the average person consumes.

Limitations of GDP and GNI

• Do not include non-marketed output
  - Does not include labour of homemakers and value added to an asset by volunteer work in the community or elsewhere.
  - Non-marketed output is likely to be far greater in developing countries compared to more developed ones.

• GDP and GNI do not include output sold in the underground (parallel) markets.

• GDP and GNI do not account for the value of negative externalities, such as pollution, toxic wastes and other undesirable.

Aggregate Demand

The total amount of real output (real GDP) that consumers, firms, the government and foreigners want to buy at each possible price level, over a particular time period.

Considerations that differentiate with Microeconomics’ Demand

• All consumers, domestic and foreign, of a nation’s output of all goods and services.

• The general, or average price level (APL). Not just the price of a particular good.

• The quantity of output produced by all firms in all industries in a nation, not just the quantity produced of a particular good.

Aggregate Demand Curve

Shows the relationship between the total amount of real output demanded by the four components and the economy’s price level over a particular time period.

AD - Movement Along the Curve

1. Wealth Effect: people feel poorer or richer at higher or lower price levels.

2. Real Interest rate effect: increasing interest rates is a method to reduce the rise in the price level, as borrowers experience higher costs.

3. Net Export Effect (Exchange rate effect): if price level falls (rises), ceteris parabis, goods and services produced in that country become more (less) attractive to consumers. Domestic consumers will find imports less (more) attractive as they now have a relatively cheaper option.

AD - Shifts

All factors that affect GDP (C + I + G + (X - M))

1. Consumption spending (C)
   - Consumer confidence
   - Changes in interest rates
   - Changes in wealth: assets owned - debt
   - Change in income tax
   - Change in the level of household indebtedness
   - Expectations of future price levels

2. Causes of Changes in Investment Spending (I)
   - Changes in business confidence
   - Changes in interest rates
   - Changes (improvements) in technology
   - Changes in business taxes
   - The level of corporate indebtedness
   - Legal/institution changes

3. Causes of Changes in Government Spending (G)
   - Changes in political priorities
   - Fiscal Policy: changes in taxation or government spending

4. Causes of Changes in Net Exports (X-M)
   - Changes in national income abroad
   - Changes in exchange rates
   - Changes in trade policies or the level of trade protection
   - Changes in relative price levels

Short Run Aggregate Supply Comparison

The period of time when prices of resources are roughly constant or inflexible, despite changes in the price level.

Long Run Aggregate Supply Comparison

The period of time when the prices of all resources, including the price of labour (wages), are flexible and change along with changes in the price level.

Short Run - Wage Inflexibility

Wages do not change very much over relatively short periods of time.

• The price of labor is often rigid because:
  1. Labour Contracts: fix wage rates for certain periods of time, perhaps a year or two or more.
  2. Minimum wage: legislation fixes the lowest legally permissible wage
  3. Unions: workers and labour unions resist wage cuts
  4. Morale: wage cuts have negative effects on worker morale, causing firms to avoid them.

• Assumptions: Unchanging wages and resource prices.
  

• Summary: SRAS curve represents the effect on output due to a macroeconomic shock, which firms cannot quickly adjust wages in the short run.

Shifts in SRAS

1. Changes in wage rates

2. Changes in non-labour resource prices

3. Changes in indirect taxes

4. Changes in subsidies (taxes) offered to businesses

5. Energy and Transportation costs

6. Government regulation

7. Exchange rates

8. Supply shocks

SRAS - Inflation and Unemployment

• When the average price level increases, output increases in the short run.
  - At higher levels of output, firms employ more workers.
  - Unemployment decreases as the price level increases

• When the average price level decreases, output decreases in the short run.
  - At lower levels of output, firms employ fewer workers.
  - Unemployment increases as the price level decreases.

Short Run Equilibrium

When AD intersects SRAS
- Short-run equilibrium is given by the point of intersection of the AD and SRAS curves, and determines the price level, the level of real GDP and the level of employment.
- SRAS shifts whenever AD or SRAS shifts

Aggregate Supply

The total quantity of goods and services produced in an economy (real GDP) over a particular time period at different price levels.

Long Run Aggregate Supply

The total quantity of goods and services (real output or real GDP) produced in an economy in the long run (when wages and other resource prices change to reflect changes in the price level), ceteris paribus.

Long Run Aggregate Supply Curve

A curve showing the relationship between real GDP produced and the price level when wages (and other resource prices) change to reflect changes in the price level, ceteris paribus.

• no long-run trade-off between inflation and unemployment

Long Run Equilibrium

When AD and SRAS curves intersect on the LRAS curve at the full employment or potential output.

• when an economy is at LRAS, they are at fully employment level of output or potential output

• all resources are efficiently employed, and unemployment is at its natural rate.

Short Run Equilibrium: Deflationary/Recessionary Gaps

A situation where real GDP is less than potential GDP (and unemployment is greater than the natural rate of unemployment) due to insufficient aggregate demand.

Short Run Equilibrium: Inflationary or Expansionary Gaps

A situation where real GDP is greater than potential GDP (and unemployment is smaller than the natural rate of unemployment) due to excess aggregate demand.

Positive Aggregate demand (AD) shock

causes output, employment, and price level to rise in the short-run

• The economy is overheating, the unemployment rate is below the natural rate of unemployment, and inflation is higher than desired.

• expansionary/inflationary gap

Negative AD Shock

causes output, employment, and the price level to fall in the short run.

• recessionary/deflationary gap

Positive Supply shock

occurs when the costs to businesses are reduced, shifting the SRAS curve to the right.

Negative Supply Shock

A negative supply shock may lead to higher production costs, which are passed to consumers through higher prices

• Since wages are sticky, firms must fire workers to offset higher energy prices, so unemployment rises as inflation rises.

Long Run Self Adjustment: Inflationary Gap

• firms will fire workers as nominal wages increase in the long run with the increased labour demand and limited labour supply.

Long Run Self Adjustment: Deflationary Gap

• assuming AD remains low and unemployment rate remains higher than NRU

• government benefits for unemployed workers expire and labor unions lose their bargaining power.

• firms will begin hiring more low wage workers and increase output as costs of production reduces.

• wages become downwardly flexible during a recession, causing SRAS to increase in the long-run, and increasing output back to the full employment level.

Economic Growth: Shifts in LRAS

• LRAS will increase if there is an increase in the quantity of factors of production or if there is an increase in the quality of the factors of production.

• A shift in the LRAS will also increase AD and SRAS because new investment and consumption or increased government spending on human or physical capital.

Long Run Aggregate Supply: Shifts

1. Increase in the quantities of the factors of production

2. Increase in the quality of the factors of production

3. Improvements in Technology

4. Increases in Efficiency

5. Institutional changes: changes in institutions can sometimes have important effects of how efficiently scarce resources are used, and therefore on the quantity of output produced.

6. Reduction in the natural rate of unemployment: if the NRU decreases, the economy is making better use of its resources and can therefore produce a larger quantity of output.

Supply Side Policies

A variety of policies focused on aggregate supply, namely factors aiming to shift the long-run aggregate supply curve (LRAS) to the right, to achieve long-term economic growth.

Market-Based Supply Side Policies

Intended to reduce government intervention, thereby allowing the free market to increase efficiency and improve incentives.
Any policy based on promoting well-functioning, competitive markets to influence the supply-side of the economy, usually to shift the LRAS curve to the right, increases potential output and achieves long-term economic growth.

1. Encouraging competition
   - Privatization: transferring ownership of a firm from the pubic sector to the private sector can increase efficiency due to improved management and operation of the privatized firm.
   - Deregulation: the elimination or reduction of government regulation of private sector activities, based on the argument that government regulation stifles competition and increases inefficiency.
   Economic Regulation: government control of prices, output and other activities of firms, offering them protection against competition.
   Social Regulation: protecting consumers against undesirable effects of private sector activities (negative externalities).
   - Contracting out to the private sector

   - Anti-monopoly regulation: increased competition can result from restriciting market power of firms by anti-monopoly legislation
   - Trade Liberalization: free or freer trade increases competition between firms both domestically and globally, which can result in greater efficiency in production and an improved allocation of resources.

2. Labour Market reforms
   - Abolishing minimum wage
   - Weakening the power of labour (trade) unions
   - Reducing unemployment benefits
   - Reducing job security

3. Incentive-related policies
   - Lowering Personal income taxes
   - Lowering taxes on capital gains and interest income
   - Lowering Business Taxes

Interventionist Supply Side Policies

Government led attempts to increase the productive capacity of the country.
Any policy based on government intervention in the market intended to affect the supply-side of the economy, usually to shift the LRAS to the right, increased potential output and achieve long-term economic growth.

1. Investment in human capital: education and health services
   - Training and education: more and better training and education lead to an improvement in the quality of labour resources, increasing the productivity of labour, which is one of the key causes of growth.
   - Improved Health care services and access to these services

2. Investment in new technology: research and development

3. Investment in infrastructure

4. Industrial Policies: government policies designed to support the growth of the industrial sector of an economy.
   - Support for small and medium-sized enterprises or firms (SMEs)
   - Support for “infant industries”

Goals of Supply Side Policies

1. Promote Long-term growth by increasing the productive capacity of the economy.

2. Improve competition and efficiency

3. Reduce costs of labour and reduce unemployment through greater labour market flexibility

4. Increase incentives of firms to invest in innovation by lowering costs of production

5. Reduce inflation to improve international competitiveness

Evaluating Supply-Side Policies: Constraints

1. Time Lags (Recognition, Implementation, Effect)

2. May increase unemployment (possibly unfavourable): increasing competition means deregulation and support for unemployed people.

3. Possible negative effects on equity: reduces protection for workers with very low incomes, may contribute to rising income inequalities.

4. Negative impact on the government budget: incentive-related policies in the form of tax cuts negatively impact the budget as they reduce tax revenues.
   - create heavy reliance on government spending

5. Possible inference of vested interests: affect particular stakeholders in ways which are not in their best interests, and these groups therefore oppose and may prevent the policies from being implemented.

6. Possible negative effects on the environment: Focusing on increasing competition may have negative effects on the environment because of the increased scope for activities leading to negative externalities affecting the environment.
   

Evaluating Supply-Side Policies: Strengths

1. Improved resource allocation

2. May not burden the government budget (only for market-based)

3. Ability to create employment: market-based policies involving labour market reforms may also contribute to reducing the NRU by focusing on making the labour market more responsive to supply and demand.

4. Ability to reduce inflationary pressure

5. Direct support of sectors important for growth

6. Ability to create employment: interventionist policies involving investments in education and training can make a direct impact on a reduction of unemployment.

7. Potential positive effects on equity: interventionist policies that focus on investments in human capital that are broadly distributed throughout the population are likely to have positive effects on equity over the longer-term.