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Macroeconomics
Macroeconomic objectives
Macroeconomy is so large it is difficult to measure its performance
...
Value of goods and services – output
method
a
...
Ensure value added is
calculated
i
...
g
...

2
...
Add up all incomes made in the economy (of firms as well as consumers)
3
...
Leakages + expenditures  C + I +G + (X – M)
These methods are all equal as a consumer’s income is also their spending which is also the value of
what they are buying up
...
g
...
g
...
g
...
During periods of real GDP growth, employment of resources
increases, and the general price level of the economy (average of all prices) usually begins to
rise more rapidly – inflation
...

When the economy reaches a peak, unemployment of resources has fallen substantially, and
the general price level may be rising quite rapidly – the economy is likely to be experiencing
inflation
...
If the contraction lasts six months
(two quarters) or more, it is termed a recession, characterised by falling real GDP and growing
unemployment of resources
...




Trough – a trough represents the cycle’s minimum level of GDP, or the end of the contraction
...
A trough is followed by a new period of
expansion (also known as a recovery), marking the beginning of a new cycle
...
Family expenditure survey
a
...
Basket of 650 goods & services
3
...
Base year selected – index of 100
5
...
Monthly collection of data: annual percentage change measured
7
...
Basket may not be representative of all consumers in the economy
a
...
Some goods not included may occupy a bigger percentage of some people’s incomes
2
...
Other countries may use different measures – makes comparison difficult
4
...
What if every month our consumption changes – distorted inflation figure as basket
changes too slowly compared to actual consumption change

b
...
g
...


Price Level

Demand–pull inflation
LRAS

E2
Pl2
Pl1

E1

AD2
AD1

Y1

Y2 Real GDP

Any increase in AD (C + I + G + (X – M) ) leads to demand pull inflation
...
g
...

Cost push inflation is deemed to be more detrimental as there is a reduction in growth (lower output)
and the government can do little to fix it
...




Deflation – a continuing (or sustained) decrease in general price levels e
...
when inflation goes
from 2
...
g
...
5% one year
to 2% (positive 2%) the next year

Demand side  – Deflationary spiral
1
...
Reduces the effect of interest rates – incentivises savings and not to borrow – effect of
expansionary monetary policy to stimulate spending is negated
a
...
g
...
Increases the real value of debt
a
...
You lose bargain power because goods are cheaper
c
...

Supply side  –



Reduction in cost of production for firms – could be tax cuts etc…
Improvement in productive capacity in the economy – counters cost plus inflation
Unemployment measures

The unemployed consists of those (of working age) registered as able, available and willing to work but
cannot find work despite an active search
...
Labour force survey
a
...
Benefits:
i
...
However:
i
...
Claimant count
a
...
Benefits of this method:
1
...
However:
1
...
E
...
if you fit the definition but have a partner that works, you
cannot claim benefits
...
Can be targeted by fraudsters
LFS will always be higher than claimant account as includes more people
...
Economically inactive people
a
...
Hidden unemployment
c
...
Under-employment – looking for any job, even if lower than their qualifications
3
...
Cyclical (demand deficient) unemployment
a
...
Labour is a derived demand – if demand for goods and services is low  if growth is
low, there won’t be much of a demand for labour
c
...
Use Keynesian diagram AD shifts left
2
...
Due to immobility of labour
i
...
Geographical – where workers are not willing to move locations to find work
3
...
When workers are in between jobs
4
...
Seasonal unemployment
i
...
g
...
Casual unemployment
i
...
g
...

Accounts are either a net positive or a net negative
...
g
...
We look at current account when measuring trade
2
...
Trade in goods (exports and imports of goods)
b
...
These two make up the trade balance
c
...
E
...
remittances – UK worker working abroad and sending his income to his
family in the UK
d
...
E
...
Aid, payment of E
...
Accounts measure the VALUE of the goods services etc… that flow in and out of the country, not
the QUANTITY
Causes and consequences of current account deficit:
Demand side




Strong domestic growth
o Incomes and living standards are high so people are more willing to buy imports
Recession overseas
o Incomes abroad are falling so other countries will be more reluctant to buy your exports
Strong exchange rate
o Imports are going to be cheaper and exports are more expensive for other countries

Supply side







Low investment
Make your exports less competitive, foreigners would rather
Low productivity
buy from other countries
High rates of inflation
High unit labour cost
Poor quality/reliability
Depletion of resources
o E
...
when UK oil got depleted, its exports fell

Supply side reasons are more destructive than demand side reasons as they can be long term and are
hard to rectify – e
...
you cannot change productivity overnight
...
Specialisation
a
...
Import goods that cannot be produced
c
...
Access to larger markets
a
...
Buy raw materials at lower cost – access to many different countries
3
...
Huge benefits from greater competition as firms compete in a worldwide market
a
...
Greater consumer choice e
...
lots of countries make TVs, but because many countries
are doing it, there will be all sorts of different TVs etc…  increase in welfare
BUT
1
...
If specialisation keeps changing from one period of time to the other, it might lead to
fluctuations in the size of industries – some industries might boom at some stage but a
change in specialisation, or loss of advantage in specialisation might lead to an industry
contracting – a pattern of declining and booming industries can be quite destabilising –
can lead to labour being made redundant suddenly or not being needed then suddenly
labour being needed – occupational inability of labour issues as firm may not be able to

expand or contract its labour in a very short period of time
...
Decline of industries
a
...
g
...
Tariffs
a
...
Quotas
a
...
Embargoes
a
...
Subsidies (to domestic firms)
a
...
Red tape (administration barriers)
a
...
VER (voluntary exchange restraints)
a
...
This limit is self-imposed by
the exporting country
...
VERs are often created because the exporting countries would prefer
to impose their own restrictions than risk sustaining worse terms
from tariffs and/or quotas
...
In a VER the two governments can agree on some protectionist measures
and thus this negates the chances of retaliation – e
...
country A agreeing on a quota on imports from
country B, and country B agrees on a quota on imports from country A
...

e
...
£1 = $1
...
60

D
1

Quantity of £

Appreciation of the pound

Depreciation of the pound

Price of £ in $

Price of £ in $
S

S1
S2

P2
P1

P1
P2
D2
D1
Q1 Q2

i
...

iii
...

v
...
g
...


I – relative
interest rates
Price levels –
inflation rates
Speculation
Y – income

ii
...


iv
...
g
...
g we
take a strong currency and AD shifts to left but government spending increases so shifts it to the
right
Depends on incomes abroad – especially true for a weak currency – e
...
if there is a recession
abroad, a weak currency might not increase exports as much as we think
Aggregate demand




Measure of spending in the economy
An increase in AD is an increase in actual growth
AD = C + I + G + (X – M)

Price Level


LRAS


E2
Pl2



E1

Pl1

AD2
AD1





Downward sloping because of the wealth effect –
when price level falls inflation falls, people feel
wealthier – people are more likely to spend
money on therefore increase growth
...
g
...
g
...
Change in price of commodities (raw materials)
a
...
Decrease shifts SRAS to the right
2
...
Increase shifts SRAS to the left
b
...
Change in business taxes (e
...
VAT)
a
...
Decrease shifts SRAS to the right
4
...
Increase shifts SRAS to the left
b
...
g
...
It is a
demand-side policy but may also have effects on the supply side of the economy too
...


LRAS

Price Level

LRAS

LRAS1

E2
Pl2
Pl1

E1

AD2

Pl1

AD1
Y1
Advantages
1
...

3
...






AD1
Y2 Real GDP

Fiscal policy can affect C + I (through increase or decrease in
taxation) + G
Dual effect on AD & AS
Benefits from automatic stabilisers
With an increase in AD there will be an increase in growth in the
economy – expansionary fiscal policy leads to an increase in AD
(reduction in taxation or increase in government spending)
a
...
Increase in demand pull inflationary
c
...

An increase in government spending may increase LRAS if it
improves the quantity or quality of factors of production
o E
...
spending on education and training – improves
productivity of labour
o E
...
reduction in corporation tax – firms have more
retained profits which they can reinvest – increases
capital

Disadvantages
1
...

3
...


5
...


Real GDP

Demand pull inflationary pressure (in case of
expansionary, not contractionary fiscal
policy)
Time lag – time before policy takes place
Disincentive effects – e
...
increase in income
tax – disincentivises people to work – thus
increasing unemployment and reducing size
of labour force, thus reducing LRAS
Some forms of G may be inflexible – e
...

cannot stop funding a healthcare project
halfway through – reduces effect of
contractionary fiscal policy
Reactions may not be as expected – e
...
just
because you reduce taxes doesn’t mean
people are necessarily going to spend more
Financing the policy may increase the budget
deficit, burdening future generations – if
money is borrowed to fund projects

Depends on:
1
...
g
...
Size of the multiplier – the bigger the size of the multiplier the less the government needs to
spend money for there to be a large impact on growth – because initial government spending
will lead to further and further spending, thus effect on AD will be very large
3
...
Offset by other factors – e
...
rise in exchange rates (or contractionary monetary policy) may
offset some of the increase in AD caused by expansionary fiscal policy
Automatic stabilisers






Governments can fall back on automatic stabilisers to negate the fluctuations in economic
growth
Part of fiscal policy that is ‘automatic’ – does not need to be actively changed by governments
E
...
in the heart of a recession
o High unemployment
o A lot of spare capacity
 Government spending rises naturally
 Unemployment benefits for example
 Tax revenue falls in recession as less people work
 Corporation tax revenue falls as businesses make lower profits
o These factors increase AD
E
...
in a boom
o Low unemployment
o Little spare capacity
 Government spending decreases naturally
 Less unemployment benefits to pay




Tax revenue increases as more people work and pay income tax and firms earn
higher profits and pay corporation taxes
o These factors reduce AD and automatically stabilise the economy
Allow economic growth and fall in growth not to fluctuate as much (less fluctuations of business
cycle – smaller deviations from long term trend)

Monetary policy (interest rates, money supply and exchange rate)



Another type of demand side policy
Involves manipulating
o Interest rates (especially) – the cost of borrowing money
o Money supply
o Exchange rates



Reduction in interest rates reduces the cost of borrowing and reduces the rate of returns on
savings
Expansionary monetary policy increases AD
Contractionary monetary policy decreases AD




Interest rates can affect:
1
...
Incentive to save – reduction in interest rates reduces the incentive to save
3
...
Real incomes of those with savings – falling interest rates – less returns for people with savings
5
...
Exchange rate (X – M) – interest rates fall, exchange rate falls and vice versa
Examples that can shift AD to the right – expansionary monetary policy (Keynesian model):




Decrease in interest rates
Increase in the money supply
Reduction in the exchange rate

Note that:


Expansionary monetary policy leads to an increase in growth, lowering unemployment and
causing demand pull inflationary pressure – may lead to a worsening of the current account if
increase in incomes results in increase in imports



There is an effect on LRAS if interest rates decrease – e
...
when interest rates are low firms can
borrow money for cheaper and will use it for investment purposes
...

o They target inflation when they set interest rates
 E
...
in the UK the target rate of inflation is 2%, so when the MPC feels that
inflation is getting too high, they increase interest rates, which reduces the level
of AD in the economy as consumer spending and investment decrease, which
reduces inflation
...

 2 benefits of inflation targeting:
 Keeps inflation levels (and inflation expectations) under control
 When inflation is targeted appropriately, interest rates can be kept low,
which can be beneficial for the economy

Advantages of monetary policy:




Affects C, I and (X – M) components of AD + if there is a positive multiplier, we can expect
further increases in AD, more than just the amount increase by the components mentioned
previously
Dual impact on AD and AS – impacts AD but can also affect AS if investment leads to their being
more capital in the economy

Disadvantages of monetary policy:





Demand pull inflation may become uncontrollable if for example, if monetary policy includes
uncontrolled changes in the money supply
Time lag
Reactions by consumers and firms may not be as expected – e
...
just because your reduced
interest rates doesn’t mean people are going to spend more
Interest rates cannot fall below 0

Depends on:






The initial level of economic activity
o If the initial level of economic activity is close to the full employment level of output,
then an increase in AD won’t necessarily increase growth and reduce unemployment,
because the economy is already close to using all of its factors of production, therefore
it can’t use anymore – therefore instead of a decrease in unemployment, there will just
be an increase in inflation
The level of consumer/business confidence – low confidence means lowering interest rates has
almost no effect on consumer spending and thus the government may have to resort to other
types of monetary policies, such as quantitative easing
The size of the multiplier – the larger the multiplier, the less interest rates need to be cut for
there to be a large increase in AD





The level of the change in interest rates – the bigger the change in interest rates the bigger the
end effect will be on AD – consumers will see a large fall in the cost of borrowing money
therefore they will be more incentivised to borrow money and less incentivised to save
Offset by other factors – maybe offset by contractionary fiscal policy etc…
Supply side policies

Aim to increase the productive potential of the economy (shift LRAS right on Keynesian model)
By increasing the quality/quantity of factors of production
OR improve efficiency of markets
Supply-side policies can be interventionist of free market promoting – if they are interventionist,
they tend to start with either government spending or reduced taxation

Price Level





LRAS

LRAS1

Pl1

Pl2
AD

Y1

Y2 YF

Real GDP

Targets of supply side policies


Labour market
o Improve education and training
 Increases productivity – workers are more productive, therefore improving the
quality of labour and shifting LRAS to the right
o Reduction in income tax
 Provides an incentive for potential workers to enter the labour force, thus
increasing the quantity of labour
o Abolishing the minimum wage
o Reducing trade union power
 Both reduce cost of production for firms – it is argued that minimum wages and
strong trade unions fix wages in the labour market above the equilibrium wage
rate, which causes an excess supply – causes inefficiencies



o

These reduce cost of production for firms, thus making the labour market more
efficient and increasing the productive capacity of the economy
Reducing unemployment benefits – incentivises employment



Industry
o Reduce corporation tax – reduces cost of production for firms – gives them more
retained profits, which they might be able to use for investment – when firms invest the
buy capital goods, which increases the quantity of capital – thus, reducing corporation
taxes provides and incentive for businesses to increase the quantity of capital
o Subsidies to firms to promote research and development – incentive given to firms to
increase research and development and thus increase the quantity and quality of capital
too



Free markets
o Privatisation
 Allows for more private sector activity – profit motive as private sector is
involved + profit maximisation + greater incentive for competition – strive for
greater efficiency
o Deregulation
 By reducing the level of regulation in the market, this is going to incentivise
competition – when new firms enter, there is going to be greater striving for
efficiency – minimising costs etc… which will again, increase the productive
potential of the economy



Efficiency (comes from free markets






Efficiency
Productivity
Incentives
Competition

Advantages:


All macroeconomic objectives improved
o Promote growth (actual and potential)
o Reduce unemployment and inflation
o Improve trade position
 Stimulates growth from AD & AS
 Sustainable non-inflationary
(as opposed to demand side policies)
Depends on:


Initial level of economic activity – for supply
side policies to be effective, the economy
needs to be reasonably close to full
employment of resources, otherwise, what is
the point of increasing potential output,
when what is needed is an increase in actual
output – e
...
in a recession, a boost in
demand, not supply, is needed
...
g
...
g

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