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Economics Unit 2: Macro
MEASURING NATIONAL ECONOMIC PERFORMANCE
2
...
1 The circular flow model of income
OUTER CIRCLE
Firms to Households: costs of production (wages, rent, interest)
Households to Firms: expenditure, revenues
INNER CIRCLE
Households to Firms: factors of production (land, labor, capital)
Firms to Households: output, goods and services
PRODUCT MARKET: expenditure, output
RESOURCE MARKET: factors of production, costs of production
➔
➔

money payments flow clockwise in the outer loop (product market)
resources, goods and services flow counter-clockwise in the inner loop (resource market)

Additional Elements
1
...
Largest actor
b
...
Eventually this money should re-enter the model as government spends it on salaries, infrastructure etc
...
The foreign sector: imports and exports
a
...
Exported goods means foreign money entering the market paying for domestic factors of production, i
...
an
injection
3
...
Consumers saving money would slow down the flow of expenditure (and eventually income) and leaks out of
the economy
b
...
1
...
Consumption: spending on goods and services by individuals
a
...
Non-durable goods are rapidly consumed
c
...
Investments: spending by firms on households
a
...
By households → on housing and new construction
3
...
Net exports
a
...
Imports → outflow → decrease
c
...
e
...
1
...
2
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2
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2
...

4
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Function of household income
b
...
Function of national output
b
...
Short for gross domestic private investment
Government spending (G) : measures a country’s government’s expenditures on goods and services
a
...
Can be negative or positive
i
...

Positive when a nation earns more from sale of its exports

AD = C + I + G + (X – M)
THE AD CURVE
➢ Y axis: average price levels
➢ X axis: nation’s output / real GDP
➢ Downward sloping due to:
○ The wealth effect
■ The public feels poorer at higher price levels → lower quantity demanded of nation’s output
■ The public feels wealthier at lower price levels → more demand of nation’s goods and services
■ Similar to the income effect (microeconomics demand)
○ The interest rate effect
■ High price levels → banks increase interest rate on loans to households → quantity demanded of
products and capital for which households must borrow decreases
■ Fall in price levels → decline in interest rates → borrowing more attractive → increase in quantity
of output demanded
○ The net export effect
■ Increases in price levels → domestic output less attractive to foreigners + foreign products more
attractive to domestic consumers → net expenditure on exports falls
■ Decrease in price levels → domestic output more attractive to foreigners + foreign products less
attractive to domestic consumers → net expenditure on exports rises

2
...
3 Determinants and shifts of AD
1
...


Consumption
a
...
Wealth
c
...
Household debt and expectation of future income
e
...
Interest rates
b
...
Business confidence

3
...


d
...
Technology
f
...
Legal/institutional changes
Government spending
a
...
Fiscal policy
Net exports
a
...
Domestic economy growth
c
...
Protectionism

2
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5 Aggregate supply and equilibrium national output
Aggregate supply:​ total amount of goods and services that all firms in all the industries in a country will produce at every price
level in a given time period
➔ Illustrates the relationship between the average price level in a nation and the total output of the nation’s producers

2
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6 (Short-run) equilibrium: Keynesian model
KAS curve demonstrates:
1
...
KAS curve is vertical (relatively inelastic) at levels of output beyond full employment

HORIZONTAL AS
➢ In the short run, firms are very responsive to a decrease in the demand
for national output
➢ KAS = relatively elastic when AD declines and price level falls
○ Decrease in AD = small decrease in price level but a large
decrease in total output

Equilibrium national output:​ the total output of goods and services by firms in a nation at a particular period of time at a
particular price level
➔ Determined by intersection of AD and AS
Y​​FE​​ when AD is at AD​1​ the equilibrium is at the full employment level of output
➢ Low unemployment
➢ Stable prices (low inflation)
➢ Nation’s resources are generally being used efficiently and near their full capacity towards the production of goods and
services
Y​​1​​ decrease in AD​1​ to AD​2​ causes a fall in price level from P​E​ to P​1
➢ Firms respond by decreasing output and laying off workers
➢ In short run: decrease in price level is proportionally smaller than decrease in equilibrium output
Y​​2​​ continued decline to AD​3​, fall in price level and fall in output
➢ Firms (again) reduce their employment and output
➢ Due to highly elastic nature of KAS below Y​FE​, decline in output is proportionally greater than decline in price level

➔

Decline in short run equilibrium output and employment resulting from a fall in AD is explained by the fact that in the
short run, wages and prices are downwardly inflexible
◆ Short run = fixed wage period in macroeconomics

LABOR MARKET RIGIDITIES THAT MAKE WAGES INFLEXIBLE (in SR)
a
...
Minimum wage laws: minimum wage set by governments may make it difficult for employers of low-skilled workers /
those in service sector to reduce costs without laying off workers when demand falls
i
...

May cause unemployment to increase more than it otherwise would during weak AD
c
...

Threat of walkouts or strikes prevents firms from slashing wages or benefits
ii
...
Government regulations: mandate fair pay and fair treatment in the workplace making it difficult for firms to easily cut
costs by slashing wages at low demand
➔

Because of inflexible nature of wages in short run, firms find it difficult to lower their prices quickly, and must
therefore reduce output and lay off workers in response to falling demand

VERTICAL AS
-

According to this model it is possible, in the short run, for a nation to produce
beyond its full-employment level of output

-

However, relatively small increases in output (Y​FE​ to Y​1​ to Y​2​) come at the cost of
inflation as rising AD is met with increasing price levels (P​1​ to P​2​ to P​3​) →
decreasing elasticity

➢
➢
➢
➢

Increase in AD leads to firms wanting to respond by increasing their production
As output grows, the number of workers available to hire begins to decrease
Firms begin to compete for the increasingly limited supply of labor available
Output increases at a decreasing rate when AD rises beyond Y​FE

Factors leading to more inelastic KAS curve:
Economy producing at near full capacity level
Almost no unemployment
Tight labor market
Decrease in AD:
Increase in AD
1
...
Economic growth
2
...
Reductions and unemployment
3
...
Inflation
Increased in AD may not lead to increase in national income
Increase in AD can lead to rise in real national income if the economy is operating below full employment
Increase in AD will not lead to rise in real national income if economy is at or approaching full employment

2
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7 Long-run equilibrium: Neoclassical model
➔
➔
➢
➢

Assumes that regardless of the total demand in a nation, the level of output would typically return to a level
corresponding with the nation’s production possibilities i
...
full employment level
Assumes that wages and prices are perfectly flexible and will adjust to the level of demand to ensure that output always
remains at its full employment level
No involuntary unemployment → workers who might lose their jobs will simply accept lower wages
Allows firms to maintain their output and employment while lowering their prices in response to declining demand

2
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8 Shifts in AS
Increase in KAS
➔ In the short run, a fall in AD causes a fall in output and a small decrease in the price level
➔ In the long run, when wages have adjusted to the lower AD the KAS curve shifts to the right and output is restored at
the full employment level and at a lower price level
◆ Shifts only after the wage rate in an economy falls because of low demand for output and labor
➔ Other factors that can lead to an increase in KAS include:
◆ Lower resource costs (e
...
oil, minerals, and other raw material)
◆ Improvement in the productivity of land or capital
◆ Reduction in the minimum wage
◆ Government subsidies to producers
◆ Investment tax credits (encouraging firms to invest in capital)
◆ Reduction in trade union power
◆ Better infrastructure
◆ Better educated or more skilled workforce (increases productivity of labor)
◆ Stronger currency (makes imported resources cheaper)
Decrease in KAS
➔ Decrease in AD when an economy is already producing at Y​FE​ will result in inflation as the nation’s output increases in
the short run
➔ In the long run, wages adjust upwards, SRAS shifts left, restoring output at Y​FE​ with more inflation
➔ Other factors that reduce KAS in a nation include:
◆ Increase in resources (oil shocks, energy shortages, higher food prices)
◆ Increase in trade union power
◆ Increase in the minimum wage
◆ Higher business taxes
◆ Weaker currency (makes imported raw materials more expensive)
➔ If an economy is producing at Y​FE​, and any of the above change, it will result in both a recession and inflation

UNEMPLOYMENT
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1 Introduction of four macro objectives
Macroeconomic policies are aimed at the following four objectives:
1
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People who are willing and able to work finding (suitable) jobs
b
...
Low inflation
a
...
Unanticipated fluctuations in the price level in a nation are undesirable
3
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A nation’s output should increase year after year
b
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Recession should be avoided
4
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b
...

d
...
3
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3
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3
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4
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4
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e
...
4
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2
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4 Deflation + consequences
Deflation:​ Decrease in average price level of goods and services in a nation over time
Costs of deflation​:
➢ Rising unemployment
➢ Falling investment
➢ Falling consumption and increased savings
➢ Increased debt burden on households
Supply side deflation causes​:
➢ Lower oil prices
➢ More productive labor force
➢ Appreciation of nation’s currency
➢ Lower minimum wage
➢ Better infrastructure
➢ Lower corporate taxes
Demand side deflation (deflationary spiral):​
1
...
AD falls
3
...
Disposable incomes fall
5
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AD falls more
7
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Prices fall discouraging investment and consumption
9
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ECONOMIC GROWTH
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1 Meaning
Economic growth:​ an increase in the total output of goods and services (GDP) in a nation over time
➔ Demonstrated by PPC curve
➔ Demonstrated by business cycle
➔ Demonstrated in AD/AS model

2
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2 Causes
Productivity growth
Productivity:​ amount of output per unit of input
➔ Output per hour
➔ Growth per capita
➢

Increase in amount of labor (quantity) → usually increases when the entire population increases, so no increase in
growth per capita
To increase standard of living and growth per capita, an increase in productivity must take place

➢
Sources:
➢ Physical capital
○ Quality and quantity of physical capital increases productivity, such as factories, robots, computers, and tools
■ Can be raised by government investment into physical capital
➢ Human capital
○ Very important: person operating the physical capital → education, training, knowledge, health
○ Human capital has virtually no limit, the only one being the skills they have
○ Infinite nature of human capital and human ingenuity is the key to overcoming physical scarcity and achieve
economic growth at all times
■ Government must aid this

2
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4 Consequences

Economic consequence
➢ Increase in average level of income and consumption in a nation
Non-economic consequences
➢ Externality: lowering production cast by polluting more air and water → balance between environment and growth
➢ Inflation: growth through increase in AD leads to inflation and therefore economic instability and rising prices
➢ Resource depletion: sustainability is not reflected in growth rates; non-renewable resources may be depleted to allow
growth in SR but lead to catastrophic effects in LR
➢ Structural unemployment: productivity gains in the secondary and tertiary sector leads to a shifting demand for skills in
the labor force
➢ Composition of output (capital vs consumer): investments in capital leads to growth, but helps households little (same
for exports)
➢ Unequal income distribution: growth may only help the top percentages and leave the rest with little

EQUITY IN INCOME DISTRIBUTION
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1 Equality vs efficiency
Efficiency:​ getting the most out of a given input
Equality:​ smaller/minimizing the disparities among a nation’s households in their maintainable living standards and in the
distribution of income and wealth
Equity:​ principle based upon fairness
➔ Requires a level playing field on which individuals in a society can all have a fair shot at achieving economic success
➔ Ultimately promotes greater equality in income distribution

2
...
2 Indicators of income equality/inequality
➢
➢
➢

➢

➢

➢

To determine the equality of income distribution one must first determine how much of a nation’s total income is
earned by the richest and the poorest groups of households
Households divided into five quintiles representing 20% of a nation’s households each
The Lorenz curve (graphical representation of a country’s income distribution) indicates what percentage of total
income is earned by each quintile

Line of equality: 45-degree line
○ Represents a country in which each quintile earns exactly the same income as all the other quintiles
○ Used for comparison
Gini coefficient: used to quantify the degree of income inequality in a nation
○ The ratio of the area above a country’s Lorenz curve and below the line of (absolute) equality to the total area
below the line of equality
○ Indicated by [A ÷ (A+B)] in curve above
○ The higher the value of the Gini coefficient the more inequality exists
Gini index: economic indicator of the level of income distribution in a nation
○ Expressed as a number between 0 and 100
○ The closer the index is to 100 the greater the disparity between the richest and the poorest households in a
nation

○
○

The closer to 0 the more equal the income distribution
Essentially the Gini coefficient expressed as a percentage: [A ÷ (A+B)] x 100

2
...
3 Indicators of poverty
Relative poverty:​ the condition experienced by people in a country whose incomes are considerably lower than the higher income
groups in the same country
➔ Exists everywhere
➔ Relative poverty often persists
➔ Could lead to macroeconomic instability
➔ Solve it using policies aimed at redistributing the nation’s income
Absolute poverty:​ the condition experienced by individuals who cannot afford to acquire basic necessities for a healthy and safe
existence
➔ Limited to the world’s poorest countries (with lowest incomes)
➔ May be reduced through international economic development strategies
➔ If average income of a nation rises: income distribution and level of relative poverty remain the same, but level of
absolute poverty decreases
Causes
➢ Low income
➢ Unemployment
➢ Lack of human capital

2
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4 Role of taxation
Direct taxes:​ taxes paid directly to the government by those on whom they are imposed
Indirect taxes:​ paid by households through an intermediary (such as a retail store), who then pays the government
Burdens of taxes
➢ Marginal tax rate (MTR):​ the percentage taken by the government on the last dollar earned, or the extra tax paid as a
result of extra income earner
➢ Average tax rate (ATR):​ the ratio of the tax collected over the income earner / the ratio of the tax collected over the tax
based (whatever is taxed)
➢ Proportional tax system
○ All individuals pay the same proportion of their income independently of the level of their income
○ ATR remains constant as income rises
○ MTR = ATR
➢ Regressive tax system
○ Poorer individuals pay a greater proportion of their income
○ ATR decreases as income rises
○ MTR < ATR
➢ Progressive tax system
○ Individuals with higher incomes pay proportionally more
○ ATR rises as income rises
○ MTR > ATR

2
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5 Other measures to promote equality
➔
➔

➢

➢

Provision of public goods (from government)
Provision of transfer payments (from government)
◆ Transfer payment:​ a payment from the government to an individual for which no good or service is
exchanged (income is redistributed from one group to another)
◆ Unemployment benefits
◆ Social security benefits
◆ Nutritional subsidies
◆ Higher education grants and tuition subsidies
◆ Welfare benefits
Short run:
○ Progressive income tax
○ Transfer payments
○ Social health insurance
○ System of public education
Long run:
○ Improving quality and access to eduation and health-care for most deprived income groups
○ Improved infrastructure
○ Improved sanitation and clean water suplies

FISCAL POLICY
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1 Government budget
➔
➔
➔
➔

➢

➢

Governments earn most from direct and indirect taxes
Revenues from the sale of goods and services
Proceeds from sale of government owned assets are also one-off revenues
Spending: current spending, capital expenditures, transfer payments
◆ Current expenditures: wages and salaries of public sector + spending on consumables
◆ Capital expenditures: public investment
◆ Transfer payments: transfers of money from one group to another (not included in GDP calculations)
The budget outcome
○ Relatinship between the size of government expenditures and government income
○ Budget deficit: government expenditures > government revenues
○ Budget surplus: government expenditures < government revenues
○ Balanced budget: government expenditures = government revenues
The public debt
○ The cumulative total of all government borriwns less repayments / the sum of money owed by a government
at a point in time
○ Budget deficits/surpluses and debt are linked → public debt grows when government runs a budget deficit /
shrinks when government runs a budget surplus

2
...
2
...
Fiscal policy
➔

Demand side policy
Expansionary fiscal policy

Contractionary fiscal policy

Goal

To reflate a failing economy increasing real output
and decreasing unemployment i
...
increase AD
(close deflationary gap)

To cool off an overheating economy i
...
decrease AD
(close inflationary gap)

How?

Increase government spending (G) and decrease
taxation

Decrease government spending (G) and increase
taxation

Why is AD

Increase in G directly increases AD;

Decrease in G directly decreases AD;

affected?

Decrease in T will increase Yd and so C and AD

Increase in T will decrease Yd and so C and AD

Possible costs

Higher inflation
Wider trade deficit
Crowing out

Slow fown growth
Possible recession
Increased unemployment

Graphical representations of inflationary and deflationary gaps:

2
...
5 Evaluation
Government spending vs tax cuts
➢ Increase in government spending is a direct injection into circular flow of income
○ During a recession: more likely to stimulate economic activity (than by cutting taxes)
○ More desirable economically: requires government to borrow a smaller amount to achieve same increase in
GDP
○ Greater stimulus
➢ Tax cut is an indirect injection
○ Households are able to determine how much ends up spent on domestic output
○ Contributes to national income
○ How much is saved
○ Used to buy imports or goes towards taxes
○ Actual stimulus is lower
○ Politically more desirable: contradicting goals of politics and economics
➢ In most cases combination of both is used to fight a recession
Strengths and weaknesses of fiscal policy
➢ Crowding out effect
○ Refers to effect on private consumption and investment of a deficit-finance increase in government spending
○ Increased government borrowing → decrease in supply of private loanable funds → may drive up private
interest rates and crowd out private investment → desired expansionary effect of the government’s fiscal
policy reduced
○ Leads to an increase in interest rates
○ Increase in AD intended though fiscal stimulus may be crowded out by simultaneous decrease in C and I
○ Diagram: nation’s loanable funds market (hypothetical)

■
■
■
■

○

➢

➢
➢

Represents the money in commercial banks available to be loaned out to firms and households
Loans finance private investment and consumption
Price of loanable funds is the real interest rate
Illustrates relationships between real returns on savings and real price of borrowing + private
sector’s willingness to save and invest
■ Supply curve: savings
■ Demand curve: investments
■ Higher real interest rates: households increase savings (return on savings is greater)
■ Lower interest rates: households+firms spend and borrow more
■ Direct relationship between real interest rate and supply of loanable funds
■ Demand for loanable funds is an inverse relationship between Qd and ir
BASICALLY: private consumption and investment are crowded out by public-sector borrowing (see
diagram)

Net export effect
○ Attract lenders to finance expansionary fiscal policy → higher interest rates needed → appreciation of the
nation’s currency → reduces demand for its exports abroad → offset desired expansionary effect of fiscal
policy
○ Contractionary fiscal policy → lower interest rates on domestic government bonds → reduce demand for
currency → increased demand for exports → offset desired contractionary effect of fiscal policy
Time lags
Political influence

MONETARY POLICY
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1 Interest rates and role of CB
Money:​ anything generally acceptable as a means of payment
Functions of money:
➢ Medium of exchange: acceptable as a means of payment in market transactions
➢ Unit of account: serves as a yardstick, values can be measured, expressed, compared
➢ Store of value: people hold wealth through time in the form of money
➢ Provides a standard of deferred payments: allows inter-temporal contracts; serves as a link between past, present, future
Banking system
➢ Central bank:​ considered as the banker to the government and the banker of commercial banks
○ Sole note-issuing authority in a country
○ Issues and redeems government bonds
○ Manages the government’s banking account
○ Carries out monetary policy by influencing interest rates and banks’ lending practices
■ Ensures price stability through monetary policy
○ Has responsibility for exchange rate policy

○

➢

The “lender of last resort”; stands ready to provide any required liquidity to the banking system in case of
emergency
○ Regulates and supervises commercial banks to ensure that bank lending is prudent and banks are sufficiently
liquid to meet their obligations to depositors
Commercial banks:​ profit-maximizing firms specializing in bringing borrowers and lenders together
○ Accept people’s money and lend to those wishing to invest
○ Pay interest to savers and are paid interest from borrowers
○ Profitability depends on difference between two interest rates

2
...
2 Monetary policy and short term demand management
➔
➔
➔

➔

Monetary policy: demand side policy
Aims to affect economic variables like real output and growth, employment, and inflation
Goal: increase AD: CB will adpot expansionary policy
◆ Increase money supply
◆ Decrease interest rates
◆ Used for deflationary gaps
◆ This will lead to more consumption expenditures, investment expenditures and increase in net exports
● Households: more money to spend due to lower ir + lower rate of return makes saving unattractive
● Fimrs: borrowing costs are lower + opportunity cost of using their profits is lower
● Exchange rate: depreciate → exports more competitive and imports less attractive
Goal: decrease AD: CB will adopt contractionary policy
◆ Decrease money supply
◆ Increase interest rates
◆ Used for inflationary gaps
◆ This will lead to less consumption expenditures, investment expenditures, and decrease in net exports
● Borrowing will increase for households and firms
● Saving becomes more attractive → spending slows down/decreases
● Exchange rate: appreciates → pricier expots and more attractive imports

2
...
3 Evaluation
+
+
+
-

-

Flexible: interest rates can be altered often
Interest rates can be altered gradually or incrementally
CB can easily reverse decision
Spending of both households and firms does not depend only on interest rates
Degree of consumer and business confidence
Degree of household and firm indebtedness
If borrowing rate is already too low then it cannot be lowered further as negative interest rates do not make sense
Characterized by potentially destabilizing time lags
Under fixed exchange rate system, monetary policy is ineffective
Financial markets are largely global: most firms (and households) can (and do) borrow from anywhere in the world
Easy/loose monetary policy

Tight monetary policy

Goal

Increase AD of economy that is in or about to enter
recession (to close deflationary gap)

Decrease AD of economy suffering from inflationary
pressures (to close inflationary gap)

How?

By decreasing interest rates or increase money supply
through open market purchase of bonds, lower required
reserves, or a decrease in the discount rate

By decreasing interest rates or increase money supply
through open market purchase of bonds, lower
required reserves, or a decrease in the discount rate

But

Other variables also affect decision to spend: financial markets are global; there is a lower interest rate limit
beyond which it is ineffective; ineffective under fixed exchange rate regime

On the
other hand

Monetary policy is flexible, gradual and easily reversible; if CB is independent, monetary policy is less yielding
to political pressure and manipulation

SUPPLY SIDE POLICIES
2
...
1 Role of SSP
Supply side policies:​ policies that aim at increasing the production side of an economy and so aggregate supply (shifting the
LRAS curve to the right)
➔ Attempt to enhance the institutional framework of an economy
➔ Increase the quantity and improve the quality of factors of production
➔ Improve incentives
➔ Distinguished into interventionist and pro-market (market based) policies
◆ Interventionist: government takes on an active role
◆ Market based: role of government is meant to be minimized in order to unleash the powers of the free market

2
...
2 Market based SSP
1
...


3
...
Reduce income tax
b
...
Reduce trade union power
b
...
Reduce minimum wage
d
...
Making hiring and firing of workers easier
f
...
Deregulation
b
...
Outsourcing
d
...
Restrict monopoly power

2
...
4 Interventionist SSP
1
...

3
...

5
...
9
...
9

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