macroeconomic notes
3.1 Measuring economic activity and illustrating its variations
National income accounting as a measure of economic activity
This involves methods used to measure the total value of production, income, and expenditure in an economy over a period, typically a year.
Equivalence of the income, output and expenditure approaches to national income accounting, with reference to the circular flow model
In the circular flow model, money flows from households to firms (expenditure), from firms to households (income), and goods and services flow from firms to households (output).
Output Approach: Measures the total value of all goods and services produced in an economy (value added by each producer).
Income Approach: Measures the total income earned by factors of production (wages, rent, interest, profit).
Expenditure Approach: Measures the total spending on goods and services by households (consumption), firms (investment), government (government spending), and the foreign sector (net exports).
Theoretically, these three approaches yield the same result: total output = total income = total expenditure.
Gross domestic product (GDP) as a measure of national output
GDP is the total monetary or market value of all the finished goods and services produced within a country's borders in a specific time period.
Gross national income (GNI) as a measure of national output
GNI is the total income received by the residents of a country, regardless of where the income was earned.
GNI = GDP + Net factors income from abroad.
Real GDP and real GNI
Nominal GDP/GNI: Measured at current market prices; reflects changes in both quantity and price.
Real GDP/GNI: Nominal GDP/GNI adjusted for inflation; reflects only changes in quantity produced.
Real GDP/GNI per person (per capita)
Real GDP or GNI divided by the total population.
Used to measure the average income or output per person, suggesting average living standards.
Real GDP/GNI per person (per capita) at purchasing power parity (PPP)
PPP-adjusted figures account for differences in the cost of living and inflation rates between countries, allowing for a more accurate comparison of living standards.
Business cycle: short-term fluctuations and long-term growth trend (potential output)
The business cycle describes the cyclical ups and downs in economic activity over time.
Phases include: Boom/Peak, Recession/Contraction, Trough, Recovery/Expansion.
Potential Output: The maximum quantity of goods and services an economy can produce when it is using all its resources efficiently; represents the long-term growth trend.
Appropriateness of using GDP or GNI statistics to measure economic well-being—use of national income statistics for making:
comparisons over time: Real GDP/GNI per capita can show if average living standards are improving or deteriorating.
comparisons between countries: PPP-adjusted real GDP/GNI per capita provides a better comparison of material living standards.
Limitations: Does not account for income distribution, non-marketed output, environmental degradation, quality of life, leisure time, or sustainability.
Alternative measures of well-being
OECD Better Life Index: Compares well-being across countries based on 11 topics (e.g., housing, income, jobs, health, environment, education, civic engagement).
Happiness Index: Aims to measure societal happiness and well-being, often incorporating factors beyond economic indicators.
Happy Planet Index: Measures sustainable well-being, combining indicators of well-being, life expectancy, and ecological footprint.
3.2 Variations in economic activity—aggregate demand and aggregate supply
Aggregate demand (AD)
The total demand for all goods and services produced in an economy at a given price level and in a given time period.
Aggregate demand curve: Shows the relationship between the overall price level in an economy and the total quantity of output demanded. It is downward sloping.
Components of AD: consumption (C) + investment (I) + government spending (G) + net exports (total exports [X] - total imports [M])
AD = C + I + G + (X - M)
Determinants of AD components
C: Consumer confidence, interest rates, wealth, income taxes, level of household indebtedness, expectations of future price level.
I: Interest rates, business confidence, technology, business taxes, level of corporate indebtedness.
G: Political and economic priorities (often set to achieve macroeconomic objectives).
X - M: Income of trading partners, exchange rates, trade policies (tariffs, quotas).
Shifts of the AD curve caused by changes in determinants
An increase in any determinant of C, I, G, or X-M will shift the AD curve to the right.
A decrease will shift the AD curve to the left.
Short-run aggregate supply (SRAS) curve and determinants of the SRAS curve
SRAS curve: Shows the total quantity of goods and services supplied by firms at different price levels in the short run.
Determinants of SRAS: Wage rates, prices of other factor inputs (e.g., raw materials, energy), taxes on firms, subsidies to firms, supply shocks.
Shifts of the SRAS curve
A decrease in production costs (e.g., lower wage rates, lower raw material prices, lower business taxes, increased subsidies) will shift the SRAS curve to the right.
An increase in production costs will shift the SRAS curve to the left.
Alternative views of aggregate supply (AS)
Monetarist/new classical view of the long-run aggregate supply (LRAS) curve
LRAS is vertical at the full employment level of output (potential output).
Believes that in the long run, output is determined by the quantity and quality of factors of production, not by the price level.
Assumes perfectly flexible wages and prices, so the economy always returns to full employment.
Keynesian view of the AS curve
Upward-sloping at low levels of output (plenty of spare capacity, non-inflationary growth).
Becomes steeper as output approaches full employment (bottlenecks, rising costs).
Becomes vertical at full employment (cannot produce more, only prices rise if AD increases).
Wages and prices can be sticky downwards, meaning an economy can get stuck in a recessionary gap.
Inflationary and deflationary/recessionary gaps
Deflationary/Recessionary Gap: Occurs when equilibrium output is below potential output. High unemployment, spare capacity.
Inflationary Gap: Occurs when equilibrium output is above potential output (due to factors being used beyond their sustainable level). Low unemployment, upward pressure on wages and prices.
Shifts of the AS curve over the long-run (monetarist/new classical LRAS) or over the long term (Keynesian AS)
These shifts represent changes in the economy's productive capacity or potential output.
Changes in the quantity and/or quality of factors of production: e.g., discovery of new resources, population growth, improvements in education/skills of the labour force.
Improvements in technology: Leads to more efficient production.
Increases in efficiency: Better management, improved production processes.
Changes in institutions: e.g., improved legal frameworks, more stable political environment, increased competition.
Macroeconomic equilibrium
Short-run equilibrium: Achieved where AD intersects SRAS.
Equilibrium in the monetarist/new classical model: Occurs where the AD curve intersects the LRAS curve at full employment output. Any short-run deviations are temporary.
Assumptions and implications of the monetarist/new classical and Keynesian models
Monetarist/New Classical:
Assumptions: Flexible wages and prices, rational expectations, self-correcting economy.
Implications: Government intervention is ineffective or harmful in the long run. Focus on controlling money supply.
Keynesian:
Assumptions: Imperfectly flexible wages and prices (especially downwards), significant role for aggregate demand in determining output.
Implications: Government intervention (fiscal and monetary policy) is necessary to stabilize the economy, particularly to address recessionary gaps.
3.3 Macroeconomic objectives
Economic growth
Short-term growth: Actual growth, measured by the percentage change in real GDP over a specific period.
Long-term growth: Potential growth, an increase in the productive capacity of the economy as measured by the expansion of full employment output (LRAS/Keynesian AS).
Measurement of economic growth: Annual percentage change in real GDP.
Consequences of economic growth: Increases living standards, job creation, increased tax revenues (potential for public services), but also potential for inflation, environmental degradation, and resource depletion.
Low unemployment
Measurement of unemployment and the unemployment rate:
Unemployment: People of working age who are without work, available for work, and actively seeking employment.
Unemployment rate: (Number of unemployed / Labour force ) imes 100
Difficulties of measuring unemployment: Includes hidden unemployment (discouraged workers, underemployed), regional disparities, informal sector work.
Causes of unemployment—cyclical (demand deficient), structural, seasonal, frictional
Cyclical unemployment: Caused by a lack of aggregate demand during a recession.
Structural unemployment: Caused by changes in the structure of the economy (e.g., technological advancements, industry decline) that render certain skills obsolete.
Seasonal unemployment: Occurs during specific times of the year due to seasonal work (e.g., tourism, agriculture).
Frictional unemployment: Short-term unemployment that occurs when people are in between jobs or are new entrants to the labour force.
Natural rate of unemployment: The sum of structural, seasonal, and frictional unemployment. It is the lowest unemployment rate an economy can sustain without causing inflation.
Costs of unemployment—personal costs, social costs, economic costs
Personal costs: Loss of income, stress, declining health, loss of self-esteem.
Social costs: Increased crime, social unrest, greater income inequality.
Economic costs: Loss of potential output, lower tax revenues, increased government spending on unemployment benefits, downward pressure on wages.
Low and stable rate of inflation
Measuring the inflation rate, using consumer price index (CPI) data
Inflation: A sustained increase in the general price level.
CPI: A measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care.
Inflation rate: Annual percentage change in the CPI.
The limitations of the CPI in measuring inflation: Basket might not reflect all households, quality changes are hard to account for, substitution bias, regional differences.
Causes of inflation—demand-pull and cost-push
Demand-pull inflation: Too much money chasing too few goods; caused by an increase in AD (e.g., increased consumer spending, investment).
Cost-push inflation: Caused by an increase in the costs of production (e.g., rising wages, oil prices, raw material costs) which shifts SRAS left.
Costs of a high inflation rate—uncertainty, redistributive effects, effects on saving, damage to export competitiveness, impact on economic growth, inefficient resource allocation
Uncertainty: Businesses and consumers are less willing to invest or spend.
Redistributive effects: Unanticipated inflation hurts savers, people on fixed incomes, and creditors; benefits borrowers.
Effects on saving: Reduces the real value of savings, discouraging it.
Damage to export competitiveness: Higher domestic prices make exports more expensive, reducing demand.
Impact on economic growth: Can slow investment and demand, hindering growth.
Inefficient resource allocation: Price signals become distorted.
Causes of deflation—changes in AD or SRAS
Good deflation: Caused by an increase in SRAS (e.g., technological advances, increased productivity).
Bad deflation: Caused by a decrease in AD (e.g., reduced consumer confidence, falling investment).
Disinflation and deflation
Disinflation: A decrease in the rate of inflation (prices are still rising, but at a slower rate).
Deflation: A sustained decrease in the general price level (negative inflation rate).
Costs of deflation—uncertainty, redistributive effects, deferred consumption, association with high levels of cyclical unemployment and bankruptcies, increase in the real value of debt, inefficient resource allocation, policy ineffectiveness
Uncertainty: Discourages investment and spending.
Redistributive effects: Benefits savers and creditors; hurts borrowers.
Deferred consumption: Consumers delay purchases expecting lower prices, reducing AD.
High cyclical unemployment and bankruptcies: Falling AD leads to business closures and job losses.
Increase in the real value of debt: Makes it harder for borrowers to repay debt.
Inefficient resource allocation: Businesses may hold off on investment.
Policy ineffectiveness: Monetary policy becomes less effective (e.g., nominal interest rates cannot go below zero).
Relative costs of unemployment versus inflation
Generally, high unemployment is seen as more costly due to welfare losses, loss of output, and social issues, compared to moderate inflation, which some argue can stimulate growth.
Sustainable level of government (national) debt (HL only)
Measurement of government (national) debt as a percentage of GDP: Total accumulated government borrowing, expressed as a ratio to GDP to assess affordability.
Relationship between a budget deficit and government (national) debt: A budget deficit (government spending exceeds revenue in a given year) adds to the national debt.
Costs of a high government (national) debt—debt servicing costs, credit ratings, impacts on future taxation and government spending
Debt servicing costs: Interest payments on debt can consume a large portion of government revenue.
Credit ratings: Deterioration can lead to higher borrowing costs.
Impacts on future taxation and government spending: Future generations may face higher taxes or reduced public services to repay debt.
Potential conflict between macroeconomic objectives
Low unemployment and low inflation
Often conflicting: Policies to reduce unemployment (e.g., increasing AD) can lead to higher inflation, and policies to control inflation (e.g., reducing AD) can increase unemployment.
Trade-off between unemployment and inflation (HL only)
Phillips curve (HL only): Illustrates the inverse relationship between the rate of unemployment and the rate of inflation in the short run.
High economic growth and low inflation: Rapid growth can lead to demand-pull inflation if AS doesn't keep pace.
High economic growth and environmental sustainability: Economic growth often comes with increased resource depletion and pollution.
High economic growth and equity in income distribution: Growth policies may not equally benefit all segments of society, potentially widening income disparities.
3.4 Economics of inequality and poverty
Relationships between equality and equity
Equality: Everyone has the same share or identical treatment.
Equity: Fairness; often means that people get what they need or deserve, leading to unequal outcomes but a fair distribution of opportunities/results.
The meaning of economic inequality
Unequal distribution of income: Income refers to the money received, especially on a regular basis, for work or through investments.
Unequal distribution of wealth: Wealth refers to the total stock of assets owned (e.g., property, savings, stocks, bonds) minus liabilities.
Measuring economic inequality
Lorenz curve: A graphical representation of income or wealth distribution. The farther the curve is from the line of absolute equality, the greater the inequality.
Gini coefficient (index): A numerical measure of inequality, derived from the Lorenz curve. Varies from 0 (perfect equality) to 1 (perfect inequality).
Meaning of poverty
Difference between absolute and relative poverty
Absolute poverty: A condition where people lack the basic necessities of life, such as adequate food, water, shelter, and healthcare, typically defined by a specific income threshold.
Relative poverty: A condition where people lack the minimum amount of income needed to maintain the average standard of living in the society in which they live (e.g., income below 50-60\% of the median income).
Measuring poverty
Single indicators: e.g., income level, access to safe water, literacy rates.
Composite indicators: Combine multiple single indicators (e.g., Human Development Index, Multidimensional Poverty Index).
Difficulties in measuring poverty: Data collection challenges, defining thresholds, non-monetary poverty, informal economy.
Causes of economic inequality and poverty
Unequal ownership of factors of production, differences in human capital (education, skills), discrimination, technological change, market power, government policies (taxes, benefits), globalization, bad luck.
The impact of income and wealth inequality on:
economic growth: Can dampen growth by reducing AD (lower consumption by the poor), underutilizing human capital, or causing social instability. Some argue it can incentivize effort.
standards of living: Lowers overall average living standards if a large portion of the population is in poverty or experiences relative deprivation.
social stability: Can lead to social unrest, crime, and political instability.
The role of taxation in reducing poverty, income and wealth inequalities
Progressive, regressive and proportional taxes
Progressive tax: Tax rate increases as income increases (e.g., income tax).
Regressive tax: Tax rate decreases as income increases (e.g., sales tax, excise tax).
Proportional tax: Tax rate remains constant regardless of income (e.g., flat tax).
Direct taxes: Taxes levied on income, profits, inheritance (e.g., income tax, corporation tax).
Indirect taxes: Taxes levied on goods and services (e.g., VAT, sales tax).
Further policies to reduce poverty, income and wealth inequality
Government provision of merit goods (education, healthcare), transfer payments (unemployment benefits, pensions), minimum wage legislation, universal basic income (UBI), anti-discrimination laws, inheritance taxes.
3.5 Demand management (demand-side policies): monetary policy
Monetary policy
Actions undertaken by a central bank to influence the availability and cost of money and credit to achieve national economic goals.
Control of money supply and interest rates by the central bank: The primary tools.
Goals of monetary policy
Low and stable rate of inflation
Low unemployment
Reduce business cycle fluctuations
Promote a stable economic environment for long-term growth
External balance (e.g., stable exchange rates)
The process of money creation by commercial banks (HL only)
Commercial banks create money through fractional reserve banking. When a bank receives a deposit, it keeps a fraction as reserves and lends out the rest. The loaned money is then deposited in another bank, and the process repeats, multiplying the initial deposit.
Tools of monetary policy (HL only)
Interest rates: Key tool; central bank sets target policy rate (e.g., discount rate, federal funds rate) influencing commercial bank rates.
Open market operations: Buying and selling government securities to inject or withdraw money from the banking system.
Reserve requirements: The minimum fraction of deposits that banks must hold in reserve.
Quantitative easing/tightening: Large-scale asset purchases/sales (used in unconventional circumstances).
Demand and supply of money: determination of equilibrium interest rates (HL only)
Demand for money: Inverse relationship with interest rates (transactions, precautionary, speculative motives).
Supply of money: Determined by the central bank.
Equilibrium interest rate: Where the demand for money equals the supply of money.
Real versus nominal interest rates
Nominal interest rate: The rate of interest before adjustment for inflation.
Real interest rate: Nominal interest rate minus the inflation rate (Real Interest Rate = Nominal Interest Rate - Inflation Rate).
Expansionary and contractionary monetary policies to close deflationary/recessionary and inflationary gaps
Expansionary monetary policy (to close a deflationary/recessionary gap): Decrease interest rates, increase money supply. Shifts AD right.
Contractionary monetary policy (to close an inflationary gap): Increase interest rates, decrease money supply. Shifts AD left.
Effectiveness of monetary policy
Strengths: Speed (can be implemented quickly), independence from political influence, no crowding out.
Weaknesses: Time lags (recognition, impact), limited effectiveness in a deep recession (liquidity trap), can't solve cost-push inflation, potential for asset bubbles, impacts on exchange rates.
3.6 Demand management: fiscal policy
Fiscal policy
The use of government spending and taxation to influence the economy.
Sources of revenue: Direct and indirect taxation, sale of goods and services from state-owned enterprises, sale of government assets.
Expenditures: Current expenditures (day-to-day operations), capital expenditures (infrastructure, long-term projects), transfer payments (welfare, pensions).
Goals of fiscal policy
Influence aggregate demand, achieve macroeconomic objectives (economic growth, low unemployment, stable prices), redistribute income, manage national debt.
Expansionary and contractionary fiscal policies in order to close deflationary/recessionary and inflationary gaps
Expansionary fiscal policy (to close a deflationary/recessionary gap): Increase government spending, decrease taxes. Shifts AD right.
Contractionary fiscal policy (to close an inflationary gap): Decrease government spending, increase taxes. Shifts AD left.
Keynesian multipliers (HL only)
Spending multiplier: The ratio of the total change in real GDP to the initial change in government spending or investment. (1 / (1 - MPC), where MPC is marginal propensity to consume).
Tax multiplier: The ratio of the total change in real GDP to the initial change in taxes. (-MPC / (1 - MPC)).
Balanced budget multiplier: A simultaneous equal increase in government spending and taxes leads to an increase in real GDP equal to the change in spending/taxes (multiplier is 1$$).
Effectiveness of fiscal policy
Strengths: Can target specific sectors, direct impact on AD (especially government spending), particularly effective in deep recessions.
Weaknesses: Political constraints and time lags, crowding-out effect (government borrowing increases interest rates, reducing private investment), only affects AD, potential for national debt, can only work effectively in a horizontal or upward sloping part of the AS curve. May not be politically feasible to decrease G or increase T.
Goals of supply-side policies
These policies aim to increase an economy's productive capacity over the long term by improving the quantity and/or quality of factors of production, thus shifting LRAS/Keynesian AS right.
Long-term growth by increasing the economy’s productive capacity.
Improving competition and efficiency.
Reducing labour costs and unemployment through labour market flexibility.
Reducing inflation to improve international competitiveness.
Increasing firms’ incentives to invest in innovation by reducing costs.
Market-based policies including:
Policies to encourage competition: Deregulation, privatization, anti-monopoly laws.
Labour market policies: Reducing trade union power, reducing unemployment benefits, deregulation of labor markets, investment in education and training.
Incentive-related policies: Lowering income tax (to encourage work) and corporate tax (to encourage investment and entrepreneurship).
Interventionist policies
Government investment in human capital (education, health).
Government investment in new technology (R&D subsidies).
Government investment in infrastructure (roads, communication).
Industrial policies (support for key industries).
Demand-side effects of supply-side policies
Some supply-side policies can also have demand-side effects simultaneously (e.g., government spending on infrastructure increases AD in the short run).
Supply-side effects of fiscal policies
Certain fiscal policies have supply-side effects (e.g., tax cuts/subsidies for R&D, investment in education, corporate tax cuts leading to increased investment and higher productive capacity).
Effectiveness of supply-side policies
Strengths: Focus on long-term growth and potential output, can reduce inflationary pressures in the long run, improve international competitiveness.
Weaknesses: Time lags (results take many years), can be politically unpopular (e.g., cutting benefits, deregulation), may increase income inequality, limited