Topic 3 - Macroeconomics

Macroeconomics

The field of economics that studies the behavior of the aggregate economy

Circular Flow of Income in an open economy

illustrates the flow of resources, goods, services and money in an economy. Depicts the relationship between households and firms.

Factors of Production

• land

• labor

• capital

• entrepreneurship

Leakages

Outflows from the circular flow of income, which reduce the money available for expenditure

examples of leakages

saving taxes imports

Injections

Inflows into the circular flow of income, which increase the money available for expenditure

example of injections

investment government spending exports

imports

goods and services produced in other (foreign) countries and purchased by domestic buyers

exports

goods and services produced domestically and purchased by foreigners

Expenditure Approach

A method of measuring GDP that adds up all spending on final goods and services produced within a country over a time period (1 year)

what components are part of the expenditure approach

• Consumption (C)

• Investment (I)

• Government spending (G)

• Net exports (X-M)

Income Approach

A method of measuring GDP that adds up all income earned by the factors of production within a country over a time period (1 year)

GDP

Gross Domestic Product

What is GDP?

The market value of all final goods and services produced within a country over a specific period (1 year) including spending on consumption, investment, government spending, and net exports

GDP formula

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

components of income approach

• wages

• rent

• interest

• profits

Output approach

A method of measuring GDP that sums up the value of all final goods and services produced in a country over a time period (1 year) to obtain the total value of output produced

GNI

Gross national Income

What is GNI?

The total income received by the residents of a country, including the value of all final goods and services produced by factors of production supplied by residents, regardless of where the factors are located

Nominal GDP

The value of goods and services produced in a country in a given year expressed in the prices charged for that year, without adjusting for inflation

Real GDP

The value of goods and services produced in a country in a given year adjusted for inflation

GDP Deflator (what is it? + what does it reflect?)

A measure used to convert nominal GDP into real GDP by adjusting for inflation. It reflects changes in the price level of all goods and services included in GDP

GDP per Capita

An average measure of national income, calculated by dividing the GDP of a country by its population

How is GDP per capita used?

used to compare economic performance between countries

Business Cycle

The fluctuations in national income

phases of business cycle

• peak

• recession

• trough

• expansion

decrease in GDP (business cycle)

fall in economic output, or a recession if occurring for longer than two quarters.

decrease in GDP growth rate (business cycle)

an increase in GDP but at a slower rate than previous quarters or years.

Green GDP

An alternative measure of GDP that accounts for environmental degradation and resource depletion, aiming to provide a more comprehensive view of economic performance and sustainability.

Cons of GDP

• GDP Overestimates Well-Being (includes negative behaviours and environmental challenge)

• GDP Underestimates Well-Being (excludes factors like life expectancy, blackmarkets, unpaid work)

• GDP Sometimes Does Not Provide Enough Information (does not account for other aspects of quality of life)

Alternative ways to measure well-being

• World Happiness report

• OECD Better life index

• Gross National Happiness

• Happy Planet Index

• Green GDP

Aggregate Demand

total demand for goods and services produced in an economy

AD components

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

changes in price level cause a … of the AD curve

movement

changes in components of AD cause a … of the AD curve

shift

Determinants of consumption (C)

• Confidence

• Unemployment

• Real interest rates

• Wealth

• Personal taxes

• Level of household indebtedness

• Expectations for future price level

Determinants of Investment (I)

• Interest rates

• Business confidence

• Technology

• Business Taxes

• Level of corporate indebtedness

Determinants of Government (G)

differing economic priorities, the government can change, depends on health of economy

Determinants of net export (X-M)

• Income of trading partners

• Exchange rates

• Changes in trade policies

Aggregate supply (AS)

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

short-run in macroeconomics

length of time during which resource prices stay relatively constant

long-run in macroeconomics

length of time during which all factors of production are variable

What are the two different interpretations of AS?

• New classical

• Keynesian

New classical on short run and long run in relation to AS

• short run aggregate supply (SRAS)

• long run aggregate supply (LRAS)

what causes a shift of the SRAS?

determinants that cause changes in costs of production

What are determinants that cause changes in costs of production?

• resource prices

• government intervention

• government subsidies

• supply shocks

new classical model believes…

prices are fully flexible

why is new classical LRAS curve inelastic?

price level has no effect on the full potential of output (Yfe)

LRAS represents

full employment level (Yfe)

new classical mode assumes…

• prices fully felxible in long run

• price level does not affect the level of output of firms and their profits

• firms have no incentive to produce more in the long run

price level of goods and services falls in new classical model

• firms can lower wages of workers

• firms can employ the same number of workers and produce the same output

Keynesian model assumes…

• firms are not able to cut costs by decreasing wages, as they are protected by trade unions and minimum wage laws

• economy can be producing below full employment level in the long run

3 section of AS curve Keynesian model

• Horizontal section, where there is a good deal of spare capacity in the economy

• The upward sloping section, where there is some spare capacity but we are beginning to see some competition for scarce resources

• The vertical section, where full employment is reached

what causes the LRAS to shift?

changes to quantity or quality of factors of production or productive efficiency

equilibrium in the short run

intersection of AD and SRAS

decrease in AD (short-run) causes…

• deflationary / recessionary gap

• real GDP is below potential GDP

increase in AD (short-run) causes…

• inflationary gap

• real GDP is above the potential GDP

decrease in SRAS (short-run) causes…

stagflation

stagflation

• SRAS decreases

• economy produces less real GDP

• price level increases

why is stagflation undesirable?

• falling GDP

• rising unemployment

• rising price level

increase in SRAS (short-run) causes…

• increase in real GDP

• fall in price level

These short-run fluctuations in AD and SRAS explain …

the fluctuations of the business cycle

long-run equilibrium according to new classical model

• prices are flexible

• economy will always tend to full employment

decrease in AD (new classical model) (long-run)

• AD decreases

• Output decreases, causes deflationary gap

• firms struggle to sell output, therefore seek ways to cut costs

• firms cut wages

• costs of production are decreased, shifting SRAS to the right

• real output returns to full employment level

• price level decreases

deflationary gap represents … in the business cycle

downward phase

increase in AD (new classical model) (long-run)

• AD increases

• Real output increases, causes inflationary gap

• inflationary gap causes upwards pressure on price levels

• workers push for higher wage to cope with increased inflation

• firms increase wages, therefore increase costs of production

• SRAS shifts to the left

• economy returns to full employment level

short run flunctuations will not effect … and will … price level

• GDP

• increase / decrease

full employment level (Yfe) corresponds to

natural rate of unemployment (NRU)

new classical model on governments role in economy

• government may persue supply side policies to reduce restrictions on the market

new classical economists focus on … (what type of growth?)

long term growth

keynesian economists focus on … (what type of growth?)

present growth

keynesian model on governments role in economy

• government should intervene especially when economic activity is low

• implement fiscal and monetary policy

animal spirits

Keynesian term, refers to feelings of people and businesses in an economy

why can economy get stuck in recession (keynesian model)

• sticky prices

• low animal spirits

Keynesians see recessions as times when governments should …

• borrow and spend to boost the economy

• because borrowing would be less likely to crowd out private investment

new classical model believes that borrowing …

crowds out private investors from the market

why does deficit spending lead to crowding out (new classical)

• governments engage in deficit spending

• government begins selling bonds to finance deficit spending

• savers are likely to buy bonds, and less likely to save money in private banks

• reducing the supply of loanable funds, raising interest rate

macroeconomic objectives

• stable economic growth

• low rate of unemployment

• low and stable rate of inflation

short term economic growth (caused by? limited by?)

• increase in the actual output

• increase in AD

• caused by the reduction of unemployment and production inefficiencies

• limited by production possibilities of the economy

why is boosting AD not sustainable for long term economic growth?

• if left uncontrolled economy can “overheat”

• increasing AD can cause high rates of inflation

long term economic growth (shown by? caused by?)

• shift of LRAS

• shift of PPC

• increase in potential output

rate of economic growth formula

(real GDP year 2 - real GDP year 1) / real GDP year 1 × 100

consequences of economic growth

• impact on living standards

• impact on the environment

• impact on income distribution

labour force

all people of working age (18 until 65) who are either employed, unemployed, or seeking work

unemployment rate formula

(number of unemployed / total labour force) x 100

unemployed

labour force who are actively looking for work but are without a job

labour force

• people of working age

• does not include discouraged workers

why is it difficult to measure unemployment accurately?

• hidden unemployment

• discouraged workers

• regional, ethnic, age, gender disparities

• informal economy

2 categories of unemployment?

• disequilibrium unemployment

• equilibrium unemployment

disequilibrium unemployment

• cyclical unemployment

• real wage unemployment

equilibrium unemployment (natural rate of unemployment)

• frictional unemployment

• seasonal unemployment

• structural unemployment

cyclical unemployment

• caused by a recession

• decrease in AD

• reduction of real output

• demand for labour decreases

• at current wage, firm is not willing to employ so many workers

real-wage unemployment

• government imposed minimum wage

• surplus of labour, as more people are willing to work for an increased min wage

• firms do not demand all of the available labour

frictional unemployment

when an individual is between a job

seasonal unemployment

occurs when people do specific job types that are only required during certain times of the year

structural unemployment

occurs when there is a mismatch between the supply and demand for a particular set of labour skills

causes of structural unemployment

• when an industry relocates across a country or to another country, it is unlikely that people will move with the industry

• labour market rigidies

Costs of unemployment

• Loss of GDP

• Loss of tax revenue

• Increased costs of unemployment benefits

• Loss of income for individuals

• greater disparities in the distribution of income

personal costs of unemployment

• increased indebtness, homelessness and family breakdown

• increased stress levels

social costs of unemployment

• increased crime rates

• increased risks to health