Macroeconomics + Business Cycle

Macroeconomics

“Macroeconomics” is the study of the economy as a whole. The prefix ‘macro’ means large, so macroeconomics is considered with the ‘big picture’ of the economy.

Economic Literacy

“Economic Literacy” is an understanding of economic events and how they may affect our households, jobs, and businesses

Spending

“Spending” refers to the expenditure on goods and services by households, businesses, and the government. The overall level of spending is the driver of economic activity and growth overtime.

Output

“Output” represents the total production of goods and services prodcuced within an economy during a specific period.

How is output measured?

Output is measured in dollar term - this is referred to as Gross Domestic Product (GDP).

Income

Income refers tp the total earnings of individuals, business, and the government over a period of time.

Income can be derived from a number of sources, such as wages, salaries, profits, interest, rent, and dividends.

Income is generated as a result of the production and sales of goods and services in the economy

What is used to show the interconnection between spending, output and income?

The circular flow model of income and expenditure

What is the circular flow of income model

The circular flow of income is a macroeconomic model that describes the flow of resources, goods and services, and income and expenditure, between parts of the economy

What are the key sectors the economy is divided into?

• Households Sector

• Firms Sector

• Financial Sector

• Government Sector

• Overseas Sector

Households Sector

The households sector consists of one or more people who live in the same housing unit, such as a family.

Households are the owners of the productive resources (natural, human, and capital) and are the buyers of final goods and services.

Firms Sector

Firms (or businesses) are the employers of resources, which they use to produce goods and services for the economy.

Basic Circular Flow Model - Households and Firms Explanation

Assumptions:

• There are only two sectors in the economy, households and firms. All output produced by firms is sold to households.

• Households spend all their income (there is no saving)

• There is no government sector, and there is no overseas trade

Flow Types:

• Real Flows - The inside flows (goods and services, and resources)

• Money Flows - The outside flows (spending and income)

Basic Idea:

• Real Flow (Inner): Households provide resources (natural, human, and capital) to firms, in return for which the firms provide goods and services

• Money Flow (Outer): Households receive income from firms in the form of wages, salaries, rent, dividends, interest, and profits and they spend all of their income on goods and services

Basic Circular Flow Model - Factor vs Product Market Explained

Factor Market = The upper half of the diagram, the upper two flows

• Households provide firms with resources (natural, human, and capital), and firms provide households with income (wages, rent, dividends)

Product Market = The lower half of the diagram, the lower two flows

• Firms provide households with goods and services, and households spend income on goods and services

What sources of income do households receive from?

Mostly:

• Wages (employment)

• Salary (employment)

Partly:

• Rent (providing housing)

• Interest (providing loans)

• Dividends (investment)

• Profit (entrepreneurial skill)

Leakages

A leakage or withdrawal from the circular flow is a factor that reduces the flow of money and goods between the sectors

Injections

An injection into the circular flow is a factor that increases the flow of money and goods between the sectors

Savings

The portion of household income not spent on goods and services for current consumption. Savings represent a leakage in the circular flow model.

Investment

The purchase or production of capital goods that will be used to make final goods, including assets such as buildings, machinery, equipment, vehicles, and tools. Investment is referred to as an injection that offsets the savings leakage.

Transfer Payments

Payments that are provided, primarily by the government, without the exchange of goods and services in return.

E.g.

• Age Pension Payments

• Childcare Allowance

What is the relationship between taxation and government spending in the circular flow model?

• Taxation is a leakage in the circular flow model

• Government spending is the corresponding injection into the flow of income

Government spending can be classified as:

• Current Expenditure (spending on current goods and services such as wages and salaries, fuel, and power)

• Capital Expenditure (spending on capital or investment goods such as schools, roads, railways, and hospitals)

Import

A transaction where the money flow is from Australia to overseas

Export

A transaction where the money flow is from overseas to Australia

What are the leakages and injection for each sector

Financial Sector:

• Leakage = Savings

• Injection = Investment

Government Sector:

• Leakage = Taxation

• Injection = Government Spending

Overseas Sector:

• Leakage = Imports

• Injection = Exports

Explain the phrase “one man’s spending is another man’s income”

This phrase is used to reflect the continuous and repeating flow of income in the economy. When an individual or a household purchases a product from the firm, the firm receives income, and they may use part of that income to provide a salary for its workers or employees, who will then use that income to purchase goods and services elsewhere.

Thus: Spending = Income = Spending Again

Equilibrium (Formula + Explanation)

∑O = ∑Y = ∑E

• O = Output

• Y = Income

• E = Expenditure

• ∑ = Sum of

This means that ‘the sum of all output equals the sum of all income equals the sum of all spending in the economy

Equilibrium means that the economy is in balance

Equilibrium in the financial sector

• When savings = investment

• S = I

Equilibrium in the government sector

• When taxation = government spending

• T = G

Equilibrium in the overseas sector

• When imports = exports

• M = X

Equilibrium in the full circular flow model

• The sum of the leakages (S + T + M) from the money flow must equal the sum of the injections (I + G + X) into the flow.

• S + T + M = I + G + X

If the market is not in equilibrium it is in …

Disequilibrium

What happens when savings is greater than investments (S > I)

It will have a contractionary effect on the circular flow model.

• Total spending will be less than output, leading to an increase in inventories

• When inventories increase, firms lower output and production, meaning that they demand and use less resources

• This means that households will receive less income, meaning that consumption and savings will decrease

What happens when investments are greater than savings (S < I)

It will have an expansionary effect on the circular flow model

• Total expenditure will exceed output, causing inventories to fall or decrease

• Firms will react by increasing production and employing more resources

• The level of economic activity will increase, and this will result in an increase in households’ income and consumption

• Savings will also increase until they equal investments, and then the circular flow model is stable again and back in equilibrium

What is expected when leakages > injections

Future level of output and income in the economy is expected to fall

What is expected when leakages < injections

Future level of output and income in the economy is expected to rise

What is used to measure the flow of goods, services, and money in Australia?

National Accounts

Gross Domestic Product (GDP) Definition

Gross Domestic Product (GDP) can be defined as the total market value of all final goods and services produced in an economy during a period of time (usually one year)

What are intermediate goods and why are they excluded when calculating GDP

• Intermediate goods are those used in making the final goods and services

• We exclude them from GDP to avoid “double counting”

What are the three ways GDP can be measured

• Income Approach (all incomes received are added)

• Expenditure Approach (all spending on final goods + all spending on final services)

• Production Approach (value of all final goods + value of all final services)

What are the four types of spending that make up aggregate expenditure?

• Consumption (C) - household spending on goods and services

• Private Investment (I) - private investment by firms

• Government Spending (G)

• Net Exports (X - M) - overseas spending on Australian exports - Australian domestic spending on overseas imports

Expenditure Approach Formula

GDP = C + I + G + (X - M)

What is the largest component of GDP

• Consumption expenditure, which comprises approximately 52% of the total GDP (22 - 23)

What are the three categories of consumption expenditure (C)?

• expenditure on non - durable goods

• expenditure on durable goods

• expenditure on services

Non - Durable Goods:

• Non - durable goods are those which are consumed relatively quickly after purchase (approximately 3 years, however this statistic is not precise)

• Non - durable goods refer to spending on food, clothing, and transport.

• Non - durable goods accounts for around 30% of consumption expenditure

Durable Goods:

• Durable goods are those which can be expected to last long after purchase (approximately 3 or more years)

• Refers to spending on major appliances, consumer electronics, and small appliances

• Durable goods account for around 10% of consumption expenditure

• Usually regarded as discretionary spending, because consumers can decide when to purchase based on their preference

Services

• Intangible items such as education, health, recreation, and utilities.

• Accounts for approximately 60% of consumption expenditure

Private Investment (I)

Private investment is a significant component of aggregate expenditure, and accounts for about 18% of GDP. It includes:

• Fixed Investment (privately funded expenditure on the equipment and structured used in production)

• Residential Fixed Investment (private expenditure on new housing)

• Changes in Business Inventories (stocks of goods that have been produced but not yet sold)

Government Spending (G)

• Government spending includes all federal, state, and local expenditure on final goods and services, and expenditure on capital equipment and infrastructure.

• Government expenditure accounts for around 25% of GDP

• COVID - 19 has caused government expenditure to be much higher than normal for spending on healthcare

What happens if government expenditure exceeds taxation? (G>T)

This would be considered a budget deficit, and would have an expansionary effect on the economy

What happens if taxation exceeds government expenditure? (G < T)

If government taxation exceeds government expenditure, this will be a budget surplus, and will have a contractionary effect on the economy

Net Exports (X - M)

• Net exports are the final element of aggregate expenditure

• In recent years, net exports have been values between -4% to +4% of GDP

• If net exports are positive than Australia records a trade surplus (X > M)

• If net exports are negative than Australia records a trade deficit (X < M)

• A trade surplus increases real GDP and acts as a net injection into the circular flow of income

• A trade deficit decreases real GDP and acts as a leakage in the circular flow of income

Factors affecting consumption expenditure (C)?

• Disposable Income: refers to the actual income received by households after taxation. If levels of income rise, subsequently levels of disposable income will rise, and this will cause a rise in spending.

• Cost of Credit: Because many households use credit to purchase goods and services, changes in interest rates will impact spending significantly. Higher Interest rates = Lower Spending, Lower Interest Rates = Higher Spending

• Stock of Household Wealth: Households that own shares and properties that are rising in price will ‘feel’ wealthier and will therefore have higher consumption expenditure (wealth effect). Conversely, households that own shares and properties that are declining in price will ‘feel’ poorer and will likely reduce discretionary spending.

• Consumer Expectations: Consumer expectations on the future and stability of the economy can greatly impact their spending, particular on discretionary goods.

• Government Policies: The ability of the government to conduct policies such as change taxation can cause a change to disposable income levels and thus will impact spending

Factors affecting investment expenditure? (I)

• Profitability of businesses: Firms retain a portion of their income to spend on building new premises and machinery and equipment. When sales and profits are low, firms have less money with which they can spend on these items.

• Interest Rates: Investment spending often requires borrowed funds, which will require interest attached to them, therefore changing interest rates will significantly impact investment expenditure. Interest rates and investment expenditure are negatively related (as interest rates increase, investment expenditure decreases).

• Business Expectations: If firms expect the economy to remain stable and consistently and gradually expanding throughout the mid - term future, then they are likely to increase investment expenditure, but if it is expected to contract, they will decrease investment expenditure

• Government Policies: Policies set by the government, such as fiscal and monetary policy, can influence business costs, costs of credit, and general levels of economic activity. The government can also supply incentives to firms, for example through subsidies, during times of low economic activity.

Factors affecting government expenditure (G)?

• Government Current Expenditure: Current expenditure is spending by the government on the purchase of goods and services across sectors such as defence, education and health. It accounts for around 81% of total government spending. This type of spending tends to be fairly stable from year to year since programs in the various government departments have ongoing funding requirements.

• Government Capital Expenditure: refers to government spending on investment goods such infrastructure and defence equipment. This accounts for around 19% of government spending. Capital expenditure is greatly influenced by the priorities of the elected government. For example, in the past the government invested directly in public utilities such as power, water supply, and roads, but the current government is more focused on spending on national security.

Factors Affecting Net Exports (X - M)

Exchange Rate:

• AUD appreciation (increases in value) → imports cheaper, exports more expensive → ↓ net exports.

• AUD depreciation (decrease in value) → exports cheaper, imports more expensive → ↑ net exports.

Recession

Recession can be defined by economists as two successive falls in quarterly real gross domestic product (GDP)

Business Cycle

The business cycle refers to the fluctuations in economic activity over a long-term growth plan

What is the main economic indicator?

• Real GDP (Gross Domestic Product) - measures the value of final goods and services produced in an economy over a period of time.

What is the ‘natural" unemployment rate?

4%

What are the four phases of the business cycle?

• Expansion

• Peak (upper turning point)

• Contraction (recession)

• Trough (lower turning point)

What happens if actual GDP is above potential GDP?

Economy experiences a positive output gap —> UE rate falls below 4%?

What happens if potential GDP is greater than actual GDP?

Economy experiences negative output gap —> UE rate rises above 4%

How to calculate quarterly GDP growth rate?

Period 2 - Period 1 / Period 1 × 100

How to calculate yearly GDP growth rate?

• Add the four quarters in the financial year

Business cycles are divided into?

• I) Global component

• II) Country Component

Expansion

• Expansion is the most common phase of the business cycle

• Expansion is a period in which real GDP increases

• Expansion occurs between a trough and a peak

• Expansion is typically longer lasting than a contraction

• Expansion results in increased economic activity - including increases in production, employment, consumption, and investment

• Expansion is a time period when household wealth tends to increase

Peak (Boom)

• The peak is the upper turning point of the business cycle

• The peak occurs between the expansion phase and the contraction phase

• The peak represents a time where economic activity and growth slows done, because resources are already being employed at maximum efficiency

• The peak is characterised by, high consumption expenditure, high levels of confidence in the economy from both households and firms, and low levels of unemployment

Contraction (recession)

• Contraction is the period in which real GDP falls, or the rate of economic growth is at a negative

• Contraction occurs between a peak and a trough

• Contraction is also known as a recession, which can be defined by two successive negative quarterly periods

• Contraction is characterised by, high levels of unemployment, low levels of firm and household confidence, and overall low levels of consumption and investment

• In general, it is a time of low economic activity :(

Trough

• A trough is the lower turning point of the business cycle

• It occurs between a contraction and expansion

• A trough is characterised by cyclical unemployment, low levels of demand for goods and services, deflation, low consumer and firm confidence, and low levels of consumption.

• A trough is a turning point because, eventually, spending will have to rise and increase so that firms can continue supplying

Broad Indicators

Broad indicators give a general overview of the state of the economy:

• GDP

• Inflation

• Unemployment

What is considered the ‘father’ of all macroeconomics indicators?

Real GDP, because it sums up entire aggregate expenditure of the economy

Procyclical Variable

One that increases during expansion and decreases during contraction. For example:

• consumer spending

• investment

• employment

• household confidence

Countercyclical Variable

A variable that decreases during expansion and increases during contraction. For example:

• unemployment

• business failures

• government welfare spending

What are the three main types of indicators?

• Leading indicators

• Coincident Indicators

• Lagging Indicators

Leading Indicators

• Leading indicators change before a direction becomes evident in the rest of the economy

• They therefore predict trends in economic activity

• For example: share prices and building permits

Coincident Indicators

• Coincident indicators are those that move in line with economic activity

• For example: Factory production, employment and retail sales

Lagging Indicators

• Lagging variables are those that change some time after economic activity changes

• For example, the unemployment rate will increase after the level of economic activity declines. Similarly, the inflation rate tends to rise after the level of economic activity increases