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Macroeconomics for Business

Ross Bateman

Macroeconomics for Business: Revision Guide
Table of Contents
Topic 1: The National Economy
...
2
Equilibrium Output Level in the Short Run
...
3
Aggregate Demand & Supply
...
5
The Supply of Money
...
7
Money & Goods Market Link
...
9
Topic 3: Unemployment & Inflation
...
10
Inflation
...
13
Topic 4: Macroeconomic Policy
...
15
Demand-Side: Monetary Policy
...
19
Supply-Side Policy
...
21
Exchange Rates
...
22
Topic 6: Financial Crisis
...

Represented by the equation: AD = C + I + G + (X - M)
o Note, C in this equation relates to Cd = C – M (where C = total
expenditure and M = expenditure on imports)
...







There are withdrawals from the circular flow, in the form of savings, taxes
& imports
...
spending and
exports
...

If J > W, the rise in national income will lead to a rise in withdrawals
...
The circular flow will
reach a new (higher equilibrium)
An initial change in J or W has a multiplied effect on national income
...
The product method: adding up total value of all goods and services
produced in country
...
The income method: adding up all the incomes generated for
households (wages, salaries, rent, profit, interest)
...
The expenditure method: add up all the expenditure on final product C + I + G + (X - M)
...

Real GDP: measures GDP in the prices in a specific year
...


Page 2 of 23

Macroeconomics for Business

Ross Bateman

Equilibrium Output Level in the Short Run
In the circular flow, consumption of domestically produced goods (Cd) and
withdrawals (S, T, and M) depend on the level of national income (Y)
...

 Aggregate Expenditure = consumption of domestic goods + injections, AD
= E = Cd + J
 If people buy more, firms produce more
...




Consumption Function: C = f(Y) - its slope is the marginal propensity
to consume (mpc) = the proportion of any increase in income that goes
into consumption
...

 ΔY = k ΔJ


Multiplier: k = Change in Y / Change in J (Y being income and J being
injections)
...

o Where mpc = marginal propensity to consume
...

A rise in AD is likely to lead to a rise in both GDP (Y) and prices (P)
...

A change in any of the components
of AD causes a shift
...

E
...
an increase in the wage rate and
other input prices shifts AS left
...
g an increase in technology, the labour
force and the capital stock would shift
AS right
...
Medium of Exchange
2
...
Means of Evaluation

The Supply of Money
Definitions:



Monetary Base: ‘high-powered money’ consists of cash in circulation
outside the central bank plus banks’ reserves with the central bank
...


The central bank issues the high-powered money
...

Functions of the Bank of England






Issues notes
...

Provider of liquidity to banks
...

Operates monetary and exchange rate policy
...

Banks liabilities are:




Customers’ deposits
Sale and repurchase agreements
Capital and other funds

Banks assets include:




Cash and reserve balances in the central bank
Short-term loans
Long-term loans

Profitability, liquidity, and capital adequacy influence Banks balance sheets
...

Every time there is an increase in deposits, banks keep a proportion
corresponding to their liquidity ratio and offer the rest as loans
...

Assume that the government spends £10bn more on roads, and it pays
with cheques drawn on its account within the central bank
...

Banks return these cheques to the central bank and their balances
increase by £10bn
...
After the injection of cash, banks have a
liquidity ratio of 18% (20/110)
...

Customers spend this £9bn and the process goes on until the initial
deposit of £10bn has created an overall increase in deposits of £100bn
...




Money supply curve is upward sloping
...


Higher Ms (rightward shift) is caused by:





Banks reducing their liquidity ratio
...

Inflow of funds from abroad
...


There is also the exogenous money supply curve, pictured below, where the
interest rate does not affect the supply of money
...
Transactions Motive
2
...
Speculative (or assets) Motive
A change in any of the determinants of Md would shift the Md curve
...

Frequency with which people are
paid
...

Seasonal
...
g
...


A change in the interest rate causes a
movement along the Md curve
...

L2 = Speculative demand for money
...

Total demand for money = L1 + L2
...






Equation of exchange: M * V = P * Y
o Where M = money supply, V = velocity of circulation, P = price
index and Y = real value of national income
...

Also, assume that Y could be treated as constant in the short-run
...

Keynesian Analysis: Changes in the money market are transmitted to the
goods market
...
Interest Rate Transmission Mechanism
o Stage 1: Money – interest rate link
...

o Stage 3: Multiplier effect
...
Exchange Rate Transmission Mechanism
o Stage 1: Money – interest rate link
...

o Stage 3: Exchange rate – import and export link
...

Lower interest rates encourage investment
...


Limitations with IRTM:




Problems with money – interest rate link:
o The demand for money is interest elastic (risk liquidity trap)
...

Problems with interest rate – investment link:
o An interest inelastic investment demand curve may exist
...


Exchange Rate Transmission Mechanism Explained:





Higher money supply reduces interest rates
...

Imports decrease (dearer) and exports increase
(cheaper)
...


Monetary policy changes have stronger effects in an
open economy with a free-floating exchange rate
...

Lower interest rates stimulate AD
...

As income increases, the demand for money goes up
...


The effectiveness of the
monetary policy change depends
on expectations
...


Page 9 of 23

Macroeconomics for Business

Ross Bateman

Topic 3: Unemployment & Inflation
Unemployment
Defined as the number of people of working age who are without work, available
for work and are actively seeking employment
...

Labour force: those in employment plus those unemployed
...


Costs of unemployment:
1
...

2
...

3
...

Composition of unemployment affected by:
1
...

3
...


Geographical region
...

Age
...


To see what causes unemployment, we study
the labour market, i
...
the aggregate supply of
labour (ASL) and the aggregate demand for
labour (ADL)
...

ADL: Shows number of workers firms
demand at each wage rate level
...


Equilibrium unemployment:
Where there are people unable or unwilling to fill job vacancies
...
Frictional unemployment: people leave lobs, are unemployed while looking
for a new job
...

a
...

2
...
Caused
by a changing pattern of demand, and technological unemployment
...

a
...
training & grants),
market-orientated approach (encourage people to look for jobs in
other parts of the country)
...
Seasonal unemployment: demand for certain types of labour changes with
the season of the year
...
Remedies: Policies like structural unemployment
...

1
...
Associated with recessions
...

2
...

3
...
If the real wage is sticky
downwards, creates unemployment
...
Lower inflation means
prices are growing slower, does not mean prices are declining
...

Hyperinflation: very high and accelerating inflation rate
...
Hurts people on fixed incomes
...
Uncertainty, which deters investment, less growth in economy?
3
...

Demand-Pull Inflation
Demand-pull inflation

Caused by continuing rises in aggregate
demand
...
The
increase in prices depends on the
increase in firms’ costs due to higher
production
...

O

Cost-Push Inflation

Q1

Q2

National output

Caused by continuing rises in costs
independently of aggregate demand
...

How much firms increase prices and cut
back output depends on the shape of
the AD curve
...


AD
O

Q2

Q1
National output

These two types of inflation can occur together
...

e
...
an initial cost push inflation makes the government expand AD to
offset rises in unemployment
...
g
...


Page 12 of 23

17

Macroeconomics for Business

Ross Bateman

The interaction of demand-pull and cost-push inflation

Price level

AS3AS

2

AS1

P3

P2

AD3

P1

AD2
AD1
O
19

National output

A third type of inflation is expectations – generated inflation, which is
caused by a higher expected inflation rate
...

Firms care about the nominal wages they pay relative to the price of the
goods they sell
...


The Link Between Inflation & Unemployment
Inflation and unemployment are inversely related, shown by the Phillips Curve
...
If any of these
factors change, the curve shifts
...

Furthermore, money illusion is to play a
part: people believe higher nominal
wages mean higher real wages
...
The
higher the rate of inflation people expect, the higher wage they claim, the more
firms increase their prices
...


π (%)

The economy is at its potential level of
output
...


The Long-run Phillips Curve

16

12

8

4

6




8
Un

U (%)

Expanding AD can reduce
unemployment below the natural rate, only in the short-run
...


Implication:
1
...

2
...

3
...

New Classical Views
Assumes that there are flexible prices and wages, and rational expectations
...

Implications:





No trade-off between inflation & unemployment, even in the short-run
...

All unemployment is equilibrium unemployment
...


Keynesian Views
Assumes that prices and wages are not perfectly flexible, and expectations
influence output and employment decisions as well
...
Economy expands, firms invest more
...
People expect higher level of output, this causes a higher level of output
...
The AS curve shifts right, Phillips curve left offsetting upward shift from
higher expected inflation
...

Hysteresis: the persistence of an effect (unemployment) even when the
demand deficiency that caused it no longer exists
...

A budget deficit: gov
...

A budget surplus: gov
...

To finance a budget deficit, the government needs to borrow
...

Expansionary fiscal: raising G (injection) and/or reducing T
(withdrawal)
...

Contractionary fiscal: cutting G (injection) and/or reducing T
(withdrawal)
...


Purpose of Fiscal Policy
1
...

a
...

b
...

2
...

a
...
expenditure / increase taxes in booms
...
Increase g
...

3
...

a
...
expenditure on infrastructure
...
Tax incentives for investment
...
Automatic Stabilizers
Reduces size of multiplier, reducing both upward and downward
movements of national income
...
E
...
when national
income rises, people pay more taxes, this dampens rise in national
income
...

2
...
spending has direct effect on AD, and
taxes affect disposable income, affecting how much will be spent)
...
Discretionary fiscal policy may lead to the crowding out effect
...







Higher G means increased injections and higher AD
...

Demand for money rises with national income
...

Private investment declines, reducing AD
...


2
...
A
temporary tax cut may lead people to save extra disposable income
...
Difficult to predict the size of the multiplier, households and firms may
base their decisions on expectations about future prices and income
...
Random shocks can occur, offsetting the positive effects of fiscal policy
...
Fiscal policy involves time lags
...
Long time-lags
could even render fiscal policy destabilizing
...




In a financial crisis, use discretionary expansionary fiscal policy
...


Page 16 of 23

Macroeconomics for Business

Ross Bateman

Demand-Side: Monetary Policy




Involves the control of interest rates
...

In the long-run, there is no conflict between goals such as inflation and
unemployment
...




Important to achieve long-term control of money supply as increasing
money supply cannot increase output in the long-run
...

Two main sources of monetary growth: lower bank liquidity ratio and
public sector borrowing from the banking sector
...





Techniques to Control Money Supply
1
...
A purchase / sale increases or decreases the money
supply
...
Discount policy  central bank lending to banks: central bank changes the
interest rate at which it lends to banks
...
Reserve requirements: minimum ratio of liquid assets for banks
...
Monetary Base Control Problems
Banks can resist attempts to restrict the growth in supply
...

 CB will always lend to banks, banks carry on lending to borrowers
...

2
...

 Potentially large fluctuations in interest rates
...
g
...
It will
conduct OMO sales
...
The demand for loans is inelastic
...
Higher costs of production
add to cost-push inflation
...

2
...

If the CB increases interest rates to reduce inflation, people may hold
assets in liquid form and money demand rises
...
If
people think that inflation will rise, the transactions demand for money
rises
...
This is because:




It’s weak when pulling against expectations
...

Problem of time lags
...





Shorter time lags than with fiscal policy
...

Impact on expectations
...

Possible under and then over-correction
...

Helps to reduce inflationary expectations
...


Case for Discretion







Rules can cause severe fluctuations in interest rates and greater
instability
...

Rules may become unsuitable?
Better forecasting and quick-acting policies can improve fine tuning
...


Resolution of the debate for rules vs discretion depends upon the following:
1
...

2
...

3
...

4
...

Recent Demand-Side Policy in the UK





Fiscal policy: ‘golden’ and sustainable investment rule, but some flexibility
is allowed
...
MPC
adjusts interest rates to meet this 2% target based on projections two
years hence
...
Also, golden and sustainable investment
rules temporarily abandoned
...
e
...

These policies target 3 areas:
1
...
This includes investment in
R&D and investment in training & education
...
Unemployment: reducing unemployment by reducing labour market
imperfections, increasing labour mobility across occupations and regions,
and reducing union power
...
Inflation: reducing cost-push inflation, through reducing or controlling
monopoly power and incentives to increase productivity
...

Tax cuts to increase incentives – income tax cut making people want to
work longer, and business tax cuts
...

Reducing welfare - increases size of workforce
...
g
...


Interventionist Supply Side Policies
Market failure to provide adequate training, R&D and investment
...

Investment grants may not be beneficial, as firms may use them for highprofile projects
...

Reducing the tax burden may result in a higher return on investment, with
markets ensuring efficient allocation
...


Page 20 of 23

Macroeconomics for Business

Ross Bateman

Topic 5: Balance of Payments & Exchange Rates
Policy Objectives:



Internal balance is where the economy is at the potential level of national
income
...
The balance
of payments records all the flows of money between residents of the
country and the rest of the world
...
g
...


Exchange Rates










Nominal exchange rate: the rate at which one currency trades for another
on the foreign exchange market
...

Appreciation: Increase in the price of the domestic currency in terms of
the foreign currency
...

Real exchange rate: the relative price of the goods of two countries
...

Gives a better idea of the quantity of imports a country can obtain from
selling a given quantity of exports
...


Determination of the Rate of Exchange
Demand and supply determine a free-floating exchange rate
...

IR rises: make domestic assets more
attractive, lower NET capital outflow,
currency appreciation
...


Page 21 of 23

Macroeconomics for Business

Ross Bateman

Exchange Rate Regimes
Free floating exchange rates should automatically correct any balance of
payments deficit/surplus by appreciation or depreciation
...
g
...

Alternative exchange rate systems include:







Fixed exchange rates
...

Managed float  intervention to prevent excessive fluctuations
...

Joint float  A group of countries have a fixed or adjustable peg between
their own currencies but jointly float against other currencies
...


Fixed Exchange Rates
The central bank / government may fix the exchange rate in terms of a foreign
currency
...
Exchange rate
changes of this type are rare, and are called revaluations / devaluations
...

Under a fixed exchange rate, the central bank gives up monetary policy
as a policy instrument
...




Under a flexible exchange rate system, monetary policy becomes more
effective
...


Fixed Exchange Rate
Pros
Cons
Certainty
Monetary policy
ineffective
Automatic
Difficult in
correction of
adjusting to
monetary errors
shocks
No speculation
Speculation






Free-Floating Exchange Rate
Pros
Cons
Insulation from
Speculation
external events
Automatic
Unstable
correction of BoP
exchange rate,
disequilibria
uncertainty
Lack of discipline
in economy

Exchange rates have become extremely volatile
...

Growth in international financial flows, cause investment, developments in
IT and growing speculative activity of trading companies
...


Page 22 of 23

Macroeconomics for Business

Ross Bateman

Topic 6: Financial Crisis
Financial crisis’ are major disruptions in financial markets characterised by sharp
declines in asset prices and firm failures
...
Lenders do not
have perfect information about potential borrowers
...
Initiation:
A financial crisis can begin with mismanagement of financial liberalization
or innovation
...

A financial crisis can begin with a spike in interest rates or an increase in
uncertainty
...
Bank Panics: Deteriorating balance sheets lead financial institutions into
insolvency
...

3
...

2007 – 2009 Financial Crisis






Low interest rates in early 2000s
...

Banks looked elsewhere for profit opportunities
...

House prices rose
...

Expansionary fiscal policy: bailout of banks and other firms by
governments (government loans), and stimulus packages (increase in
government spending and tax rate cuts)

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