Economics for Business - Lecture 6: Introduction to Macroeconomics (National Economy, Growth & ADAS Model)

Development of Macroeconomic Thinking

• Classical Macroeconomics:

  • Free market approach.

  • Advocated no government intervention, believing it could worsen situations.

  • Failed to address unemployment issues, particularly during the Great Depression.

• Keynesian Economics (John Maynard Keynes):

  • Emphasized government intervention through expenditure and taxation to solve economic problems.

  • Implemented during the Great Depression.

  • Failed to solve the stagflation problem.

• Monetarist (Milton Friedman):

  • Maintained belief in the free market.

  • Gained prominence when the Keynesian model couldn't resolve stagflation.

  • Proposed controlling the money supply to overcome inflation without causing unemployment.

Major Macroeconomic Issues

• Economic Growth:

  • Achieving a stable increase in national output.

• Unemployment:

  • Reducing unemployment rates.

• Inflation:

  • Maintaining low and stable inflation.

• Foreign Trade and Global Economic Relationships:

  • Managing foreign trade and international economic interactions.

• Financial Stability and Well-being:

  • Ensuring stability in the financial sector.

Government Macroeconomic Policy

• Choosing Between Macroeconomic Theories:

  • Selecting appropriate economic theories to guide policy.

• Choosing the Order of Priorities:

  • Prioritizing policy objectives.

• Policy Objectives Can Conflict:

  • Recognizing potential conflicts between different policy goals.

Measuring National Income

• Three Methods of Measuring GDP:

  • The Product Method

  • The Income Method

  • The Expenditure Method

Circular Flow of National Income and Expenditure

• Three Stages:

  1. Production

  2. Incomes

  3. Expenditure

The Product Method

• Gross Value Added (GVA):

  • Value before taxes and subsidies.

• Problem of Double Counting:

  • Avoiding counting the same value multiple times.

• Measuring of Value Added:

  • Calculating the additional value created at each stage of production.

• Qualifications:

  • Stocks: Addressing appreciation issues, year of sale, and partial value added.

  • Government Services: Including the value of government-provided services.

  • Ownership of Dwellings: Factoring in the value of housing services.

  • Taxes and Subsidies on Products:

    • GDP = GVA + Taxes - Subsidies

The Income Method

• Adding Factor Earnings:

  • Summing all incomes earned in the production process.

• Qualifications:

  • Stock Appreciation:

    • Excluding increases in the monetary value of stocks due to increased prices, as it doesn't represent increased output.

  • Transfer Payments:

    • Excluding transfer payments like social security benefits, pensions, and gifts, as they don't arise from the production of goods and services.

  • Direct Taxes; Taxes and Subsidies on Products:

    • Measuring incomes before the payment of taxes on products or the receipt of subsidies on products when calculating GVA.

    • GDP = GVA + Taxes - Subsidies

The Expenditure Method

• The formula is as follows:

  • AD = C + G + I + X – M Where:

    • C = Consumption

    • G = Government Spending

    • I = Investment

    • X= Exports

    • M = Imports

• Gross National Income (GNY)

• Net National Income (NNY)

National Income Statistics and Living Standards

• Items Excluded:

  • Non-marketed Items

  • The Underground or Shadow Economy

• Production: Poor Indicator of Welfare?

  • Production Does Not Equal Consumption

  • Human Costs of Production

  • Externalities

  • The Production of ‘Bads’

  • Distribution of Income

• Heightened Interest in Measuring National Well-Being

Economic Growth and the Business Cycle

• Rate of Growth:

  • The percentage increase in national output, typically expressed over a 12-month or 3-month period.

• Inherent Instability:

  • Economies are inherently unstable, causing fluctuations in economic growth and other macroeconomic indicators.

• Aim:

  • Achieve stable economic growth and avoid overheating or recession.

The Business Cycle

• Distinction Between Actual and Potential Growth:

  • Actual Growth:

    • The percentage increase in actual output.

  • Potential Economic Growth:

    • The percentage increase in the economy’s capacity.

• Output Gaps:

  • The difference between actual and potential output.

  • Positive Gap: Actual output exceeds potential output.

  • Negative Gap: Actual output is less than potential output.

Growth and the Production Possibility Curve

• Growth in Actual Output with Good X and Good Y

• Growth in Potential Output with Good X and Good Y

• Growth in Actual and Potential Output with Good X and Good Y

Phases of the Hypothetical Business Cycle

• Upturn

• Expansion

• Peaking Out

• Slowdown or Recession

Long-Term Output Trend

• Sustainable National Income

The Circular Flow of Income

• Inner Flow

• Firms: Factor Payments

• Households: Consumption of Domestically Produced Goods and Services (Cd)

• Withdrawals:

  • Net Saving (S)

  • Net Taxes (T)

  • Import Expenditure (M)

• Injections:

  • Investment (I)

  • Government Expenditure (G)

  • Export Expenditure (X)

The AD/AS Model

• The Aggregate Demand Curve

Components of Aggregate Demand

• Consumer Spending (C)

• Private Investment (I)

• Government Expenditure on Goods and Services (G)

• Expenditure on Exports (X) less Expenditure on Imports (M)

• AD = C + I + G + X – M

• Factors Affecting the Curve's Shape:

  • Income Effects

  • Substitution Effects

Income Effect

• Price Rise (Short Term):

  • No Rise in Wages (for Many):

    • Redistribution of income from wage earners to firms.

  • Cuts in Real Income:

    • Consumers spend less due to the rise in prices, leading to a fall in aggregate demand.

  • Firms' Reinvestment:

    • Doubtful, as consumer spending falls.

Substitution Effect

• Three Ways People Can Switch to Alternatives:

  • Imports and Exports

  • Interest Rates

  • Real Balance Effect

Imports and Exports

• Higher domestic prices:

  • Discourage foreign residents from buying exports.

  • Encourage domestic residents to buy imports.

• Impact:

  • Leads to a fall in aggregate demand, causing the AD curve to slope downward.

Interest Rates

• Greater Demand for Money:

  • Higher prices for consumers and wages for firms increase the demand for money.

• Shortage of Money:

  • Banks tend to raise interest rates.

• Discourages Borrowing and Encourages Savings:

  • Reduces spending and aggregate demand.

Real Balance Effect

• Fall in Purchasing Power:

  • Rising prices decrease the value of people’s bank balances.

• Increased Saving and Reduced Spending:

  • People save more and spend less to compensate.

Aggregate Demand Curve

• Why the AD Curve Slopes Downward:

  • Foreign Trade Effect

  • Real Balance Effect

  • Interest Rate Effect

Shape of the AD Curve

• Downward Sloping:

  • Increase in price leads to a fall in aggregate demand.

• Elasticity:

  • The greater the income effect, the more elastic the shape will be.

Shifts in the AD Curve

• Shift to the Right:

  • Occurs when there is an increase in aggregate demand at any price level due to an increase in C, I, G, or X – M.

• Shift to the Left:

  • Occurs when there is a decrease in aggregate demand at any price level due to a decrease in C, I, G, or X – M.

Simple Questions

• What Happens to the AD Curve If:

  • Government decides to spend more?

  • Imports exceed exports?

  • Consumers spend more as a result of lower taxes?

  • Savings increase?

  • Business confidence increases?

  • Income tax increases?

The Aggregate Supply Curve

• SRAS Curve

AS Curve

• Shows the Amount of Goods and Services Firms Will Supply at Each Price Level.

• Focus on the Short-Run AS Curve

  • Assume other factors remain constant (wage rates, import prices, technology, total supply of factors of production).

• Why Assume Constant?

  • Wage rates are often determined by collective bargaining and remain constant for at least a year.

  • Factor inputs (e.g., capital machines) tend not to change prices frequently.

AS Curve Shape

• Slopes Upwards:

  • The higher the price levels, the more will be produced.

• Why?

  • Holding wages and input prices constant, firms' profitability rises with higher product prices, encouraging them to produce more.

• Limits to Increase in Aggregate Supply (Preventing Horizontal SRAS):

  • Diminishing Returns

  • Growing Shortages of Certain Variable Factors

Diminishing Returns

• Fixed Factors of Production:

  • With some factors fixed (e.g., capital equipment), firms experience diminishing marginal physical product from other factors.

• Upward-Sloping Marginal Cost Curve:

  • Leads to upward-sloping supply curves for individual goods and services.

• Aggregate Supply Curve:

  • Adding the supply curves of all goods and services results in an upward-sloping aggregate supply curve.

Growing Shortages of Certain Variable Factors

• Inputs in Short Supply:

  • As firms produce more, inputs that can be varied may become scarce.

• Rising Costs:

  • Rising costs explain the upward-sloping aggregate supply curve.

• Elasticity:

  • The more steeply costs rise as production increases, the less elastic the aggregate supply curve will be.

• Full-Capacity Working:

  • Marginal costs rise faster as firms reach full-capacity working, making the aggregate supply curve steeper.

Shifts in the SRAS Curve

• Change in Variables Held Constant:

  • The aggregate supply curve shifts if there is a change in any variables held constant when plotting the curve.

• Slowly Changing Variables:

  • Variables like technology, the labor force, and the stock of capital change slowly, shifting the curve gradually to the right.

• Increase in Potential Output:

  • Represents an increase in potential output.

Short Run Changes in SRAS

• Wage Rates and Input Prices:

  • Wage rates and other input prices can change significantly in the short run, causing shifts in the short-run supply curve.

• Rise in Wage Rates:

  • A general rise in wage rates reduces the amount that firms wish to produce at any level of prices, shifting the aggregate supply curve to the left.

• Other Cost Increases:

  • Increases in other costs, such as oil prices or indirect taxes, have a similar effect.

Equilibrium

• Equilibrium Definition:

  • Equilibrium in the macroeconomy occurs when aggregate demand (AD) and aggregate supply (AS) are equal.

  • Equilibrium Price Level: Pe

  • Equilibrium National Output (GDP): Qe

Surplus / Shortage

• Aggregate Demand Exceeds Aggregate Supply:

  • Shortages drive up prices.

  • Firms produce more (movement up along the AS curve).

  • Aggregate demand decreases (movement back up along the AD curve).

  • Shortage is eliminated when the price rises to Pe.

Shifts in AD and AS

• Movement to New Equilibrium:

  • If the AD or AS curve shifts, there will be a movement along the other curve to the new point of equilibrium.

• Price Level Rise:

  • A rise in the price level occurs if there is a rightward shift in the AD curve or a leftward shift in the AS curve.

• Example: Cut in Income Taxes:

  • A cut in income taxes increases consumer demand, shifting the AD curve to the right.

  • Results in a movement up along the AS curve to a new equilibrium with a higher level of national output and a higher price level.

Elasticity of the SRAS Curve

• Output vs. Prices:

  • The more elastic the AS curve, the more output will rise relative to prices.