2. Macroeconomics
Measures of economic activity
Gross domestic product (GDP)
GDP is the most often used measure of economic activity. It is defined as the value of all final goods and services produced within an economy over a period of time, usually a year or a quarter.
Gross national income (GNI)
The income earned by all national factors of production independently of where they are located over a period of time; it is equal to GDP plus factor income earned abroad minus factor income paid abroad.
Problems with these factors as measures of economic well-being
Is not adjusted for inequality or does not represent how this income is distributed
An increase in GDP and GNI per capita might damage the environment.
Per capita income statistics fail to include the value of leisure (60 hours of work vs 30 hours of work)
Living standards are not only affected by current income but also by the stock of wealth of the population. The house or the car a family owns provides services that significantly contribute to their well-being.
The level of public health care and public education available to citizens may differ between two countries with the same per capita income greatly affecting living standards.
Better indexes to measure economic well-being
Better Life Index (BLI)
Assesses housing, education, income, jobs, community, education, environment, civic engagement, health, life satisfaction, safety, work and life balance.
Happiness index
The happiness index, also known as the World Happiness Report, is an annual survey that ranks countries based on their levels of happiness and well-being. The index is calculated by analyzing various factors, including GDP per capita, social support, life expectancy, freedom to make life choices, generosity, and perceptions of corruption. The report aims to provide policymakers and individuals insight into what makes people happy and how to improve well-being worldwide.
Happy Planet Index (HPI)
designed to assess whether a country can promote the well-being of its residents. It comprises three variables: average life expectancy, average subjective well-being, and ecological footprint (the impact of a person or community on the environment, expressed as the amount of land required to sustain their use of natural resources).
Methods of calculating national income
Income method
This measures the value of all the incomes earned in the economy. This method measures the value of the arrow marked as number 2 in Figure 13.1 (look at the circular flow of national income below)
Output method
This measures the actual value of the goods and services produced. This is calculated by summing all the firms' value-added in an economy. When we say value-added, it means that at each stage of a production process, we deduct the costs of inputs so as not to “double count” the inputs. The data is economy: agriculture and mining (primary sector), manufacturing (secondary sector), and services (tertiary sector).
Expenditure method
This measures the value of all economic spending on goods and services. This is calculated by summing up the spending by all the different economic sectors. These include:
Spending by households, known as consumption or consumer expenditure (C)
Spending by firms, known as an investment (I)
Spending by governments (G)
Spending by foreigners on exports minus spending on imports. This is known as net exports. (NX)
Circular flow of national income
There are two loops between households and firms: inner and outer. The inner circle shows how money circulates one way in the economy. The firms are providing households with goods and services. In the other direction goes factors of production: land, labour, capital, and enterprise. The outer loop refers to how the money returns to the other state or is injected or leaked.
Leakages:
Savings
Imports
Taxes
Injections:
Investments
Exports
Government spendings
Business cycle
Why does economic activity vary over time, and why does this matter?
Changes in the conditions of the demand and supply sides of the economy cause economic activity to varying over time.
Fluctuations in economic activity impact the economic well-being of individuals and societies.
Different schools of macroeconomic thought identify different causes and offer different solutions for macroeconomic problems.
Macroeconomic supply and demand diagrams
X-axis - real GDP
Y-axis - average price level
Supply - short-run aggregate supply
Demand - aggregate demand
An increase in average price level is inflation
An increase in real GDP is economic growth
Aggregate demand
Determinants of aggregate demand
Changes in consumption
Changes in personal income taxes
When income taxes are lowered, disposable income is increased. Therefore, consumption will increase (Especially for durable goods)
Changes in the interest rate
If the interest rate is lowered, taking a loan to buy something is cheaper. Therefore, the consumption of durable goods is likely to increase.
Changes in the consumer confidence
For consumption to increase, consumer confidence would need to improve.
Changes in wealth
If wealth increases, consumption tends to increase even without selling assets.
Changes in the level of household indebtedness
If household indebtedness falls, the consumption increase
Changes in expectations of future price levels
If the price level is expected to increase, consumption might increase now because people will take advantage of the prices not yet risen.
Changes in investment
Changes in business taxes
If business taxes are lowered, investment is expected to increase as it is more profitable.
Changes in the interest rate
If the interest rate is lowered, it is cheaper to take a loan.
Liquidity trap - typically, when the interest rate is already low, lowering the interest rate further fails to increase because firms don’t necessarily trust that they will be able to make enough profits to pay back the loan.
Changes in technology
The more technological development, the more likely firms need to invest to not fall behind competitors, but it highly depends on the branch.
Changes in business confidence
For the interest rate to increase, business confidence would need to improve.
Level of corporate indebtedness
If this falls, firms are more likely to invest
Changes in government spending
Political and economic priorities
Government spending needs to be increased to increase the aggregate demand (expansionary fiscal policy) (the opposite would be called contractionary).
The more certain way of increasing aggregate demand than lowering income taxes
Changes in net exports
Income of trading partners
Our export revenue will likely increase if the national income export markets rise.
Exchange rates
If the currency depreciates, then export revenue increases, and import expenditure decreases. Therefore, both of these aggregate shift demand to the right
Trade policies
Reducing tariffs would help increase the net exports for small open economies like Switzerland.
For a large trade deficit in the short run, protectionism may help increase the aggregate demand as imports are possibly falling.
Short-run aggregate supply
SRAS consists of all the supply curves in an economy. It shows how much the firms are willing and able to supply at a given price level.
Determinants of SRAS
Change in cost of FOPs
Changes in indirect taxes
Changes in subsidies
Long-run aggregate supply
LRAS determinants
Change in quality or quantity of FOPs
Land
Gain more land
Utilise land more efficiently
Labour
Immigration
Education
Capital
More machinery
Better machinery
Enterprise
More entrepreneurs
Fewer entrepreneurs
Key figures and period of popularity
John Maynard Keynes wrote his main theories in the 1930s during the Great Depression. Keynesian policies were popular mainly until the first oil crisis (which started in 1973) but have remained immensely popular in many countries to some extent. The recession that hit many economies in 2008 (known as the Great Recession in North America) made Keynesian policies increasingly popular again.
Key figures and period of popularity John Maynard Keynes wrote his main theories during the 1930s during the Great Depression. Keynesian policies were popular mainly until the first oil crisis (which started in 1973) but remained quite popular in many countries to some extent. The recession that hit many economies in 2008 (known as the Great Recession in North America) made Keynesian policies increasingly popular again. New classical economics has its roots in Adam Smit´s work (1723-1790). Still, the kind of new classical economics we study today (sometimes called neoclassical or neoliberal economics) became popular after the first oil crisis (which began in 1973). A key figure was Milton Friedman, a monetarist (monetarists are a relatively extreme sub-school of new classical economists).
The main economic problem, according to this school
Unemployment (logical if you think of when the theory was created)
Inflation (sustained increase in the average price level)
The shape of the long-run aggregate supply curve (LRAS) or Keynesian AS
Consequences for economic policy
The economy may be “stuck” at macroeconomic equilibrium to the left of the full employment level (either in a recessionary or normal phase), meaning that there is so-called demand-deficient unemployment (= cyclical unemployment). According to Keynesians, the government has an essential role in changing (here increasing) aggregate demand (AD) to return to the full employment level of income. They are called demand-side economists because they typically favour shifting AD to other economic policies. Increasing government spending is especially popular because its effects on employment are pretty direct.)
Attempts to increase AD are harmful since they will only cause inflation. If AD is increased, prices rise, and factor prices will rise, too (e. g., workers succeeding in asking for higher wages), which leads to the short-run aggregate supply curve (SRAS) shifting to the left and the average price level rising still higher. Instead of shifting AD, new classical favour increasing real output by shifting LRAS to the right. If this happened on its own, it would cause deflation (a sustained fall in the general price level), but in real life, there are often some pressures for AD to shift to the right, and shifting LRAS to the right would thus be good for price stability.
View on labour market adjustment
According to Keynes, wages are “sticky downwards”. Workers would most likely not accept doing the same work for less pay. Hence, if demand for labour falls and the real wage rate does not fall, unemployment, according to Keynesians, is a severe problem. According to them, labour market adjustment could take years (or decades according to the orthodox [extreme] Keynesians – “In the long run, we are all dead “- Keynes) if the government does not intervene.
According to the new classical, people are rational and accept work for lower wages since they realize they could otherwise be unemployed. This adjustment could also happen without the nominal wages falling, simply if there is inflation (real wage = nominal wage – inflation).
Consequences of all the above for the role of government
According to Keynesians active government involvement is necessary. Policies should be countercyclical: increase AD when there is demand-deficient unemployment, and reduce it when overheating takes place. Usually, Keynesians are most concerned with the real output being too low (“normal” range) – they think the full employment level of national income is only rarely reached.
New classical prefer the government to play a relatively minor role in the economy compared with the Keynesians. The markets should primarily be left on their own. According to new classicals, government involvement often leads to distortions (so called planning failure leading to inefficient resource allocation). However, they agree that markets can also fail in allocating resources optimally, and governments should intervene in such situations.
Other remarks
Keynesians and other demand-side economists are usually grouped with left-wing political views (but this does not mean communism). They usually promote more government involvement in other areas of economics than macroeconomics, promoting, e.g. protectionism and the role of government spending (as well as aid - from other governments) in development.
New classical and other supply-side economists are usually grouped with right-wing political views. They usually promote free markets and less government involvement e. g. as development strategies – focusing on trade rather than aid. (In practice, even right-wing governments have found protectionism irresistible – e.g. steel tariffs in the US ordered by President George W. Bush.)
Who is right?
Who is right? The answer is, of course, “it depends”. It depends on the particular economic situation of the country, the period studied, etc. When answering IB evaluation questions (e.g. data question part d) or essay part b), always try to look at the issue at hand from both sides, noting, e.g. advantages and disadvantages of both Keynesian and new classical policies. In addition to this, at least in data questions, it would, in most cases, be advisable to conclude what strategies might be best in the situation studied in light of the data provided. Regarding individual questions such as labour market adjustment, there are signs of slow labour market adjustment, especially in countries with relatively high unemployment benefits*, and signs of quick labour market adjustment (meaning quick acceptance of lower real wages), e.g. in South East Asia after the 1998 crisis, and in individual industries (e.g. the airline industry in the US after September 11th, 2001). *You can train your evaluation skills in pondering whether slow labour market adjustment is the initial problem or the result of the cure.
Do they ever agree?
The (Keynesian) AS (vs LRAS) being vertical at Yf (but they disagree about how typical a situation this is)
That increasing AD is unwise if we are at Yf (but: see above)
Education and training of the labour force to be an excellent macroeconomic policy (it shifts both AD and AS to the right)
Macroeconomic equilibrium and gaps
Macroeconomic equilibrium occurs at the average price level at which AD = SRAS. This means that what is produced in the economy equals the total (aggregate) demand, and there is no reason to change output levels. This can coincide with the full employment level of output, but it is not necessarily the case.
When macroeconomic equilibrium is below (= to the left) of the full employment level of income, there is a recessionary gap (which can also be called a deflationary gap if the reason for it was AD shifting to the left, causing deflation).
When macroeconomic equilibrium is above (= to the right) of the full employment level of income, there is an inflationary gap.
Inflationary gap
In the short run, an increase in aggregate demand will increase the average price level. Since money wages are assumed fixed, the real wage will decrease, inducing firms to increase output.
An inflationary gap will arise since the equilibrium level of real output will exceed the potential output level.
In the long run, money wages are flexible and will adjust and increase to match the increase in the average price level. The real wage will be restored, and so will the potential output level.
Deflationary (recessionary) gap
A decrease in aggregate demand in the short run will lead to a decrease in the average price level. Since money wages are assumed fixed, the real wage will increase, inducing firms to reduce output.
A deflationary gap will arise since the equilibrium level of real output will fall below the potential output level.
In the long run, money wages are flexible and will adjust and decrease to match the decrease in the average price level. The real wage will be restored, and so will the potential output level.
Macroeconomic objectives
Economic growth
Low and stable inflation
Low unemployment
Sustainable level of government debt
Impact of economic growth
The resulting higher tax revenues permit the government to create or improve a social safety net by spending more on:
pension schemes to support older people
unemployment benefits
other cash transfers to support other groups of people who are deprived and in need.
The resulting higher tax revenues permit the government to invest more in:
improving policies that increase agricultural productivity that raises rural incomes
infrastructure projects that improve sanitation, electrification, transport and telecommunications and so improve the lives and prospects of the poor
education and health care for the poor to increase their human capital, productivity and income-earning capacity.
Growth may increase income inequality:
if it relies only on certain skills, the highly educated or is concentrated in certain areas, often coastal regions
if market concentration is rising, as it permits firms to charge higher prices and pay lower wages
as a result of trade liberalization that displaced many workers without any compensation or retraining provided
as a result of income taxes becoming less progressive and transfer payments decreasing in size and scope
as a result of market-based supply-side policies implemented since the 1980s that decreased the role of the state and of labour unions.
Types of unemployment
Natural unemployment
Natural, equilibrium, or voluntary unemployment exists when the labour market is in equilibrium (at Yf in an AD-AS diagram). Naturally, unemployed people are either unwilling or unable to work at the current wage rate, for instance, due to a mismatch between their skills and the skills demanded in the labour market.
Types of natural unemployment
Frictional - search for the job - being temporarily between jobs when searching for a new job
Market-orienteered solutions - lower unemployment benefit and shorten the eligibility period during which unemployment benefit is available.
Interventionist solution - organise recruitment centres and speed up finding the job.
Seasonal - change in seasons - ski instructors can weld pipes
Market-orienteered solution - encourage employees to find another seasonal job, lower unemployment benefits to motivate them to do so
Interventionist solution - improve the flow of information on available jobs
Structural
Sectoral - structural change affecting the particular sector of the economy (often due to changes in the geographical location of industries, e.g. due to globalization)
Regional - happens when a sector is destructured
Technological - caused by changes in technology
Interventionist solution - provide training to increase occupational flexibility; adult retraining programs, subsidising firms
Market-orienteered solution - Deregulation (making it easier to fire but also hire labour) market flexibility, reducing unemployment benefit
Disequilibrium unemployment
Disequilibrium unemployment exists because of conditions that prevent the L market from clearing.
Solutions:
Lower unemployment benefits
Abolish or lower min. wages
Abolish/lower the power of labour unions
Real-wage rate unemployment
The real wage rate is too high for the labour market to clear due to
Minimum wages (p floor)
Trade unions (e.g.UNIA)
Unemployment benefits being too high (too little additional reward from accepting a job)
Demand deficient unemployment
A decrease in AD is caused by, e.g. a decrease in one of the positive components of AD.
Solution:
Increase the aggregate demand
Technically, any method would work; however, increasing government spending is the fastest and the most certain.
Costs of unemployment
The economic costs are:
lost output
lower tax revenues and higher government expenditures
rising income inequality
erosion of human capital.
The personal costs include:
loss of income and, in some countries, of health insurance
erosion of skills
family breakdown
debt accumulation
alcohol and drug abuse
deterioration of mental health.
The social costs are:
higher rates of violence and crime
the social costs of drug and alcohol abuse
longer-term social and political problems.
Inflation
Cost-push inflation is inflation caused by a decrease in SRAS
Demand-pull inflation is inflation caused by an increase in AD
Why is it hard to measure inflation?
Seasonal variations due to, e.g. cold weather (vegetable prices) / politics (oil price) – solution: use core inflation
Hard to agree on what an “average household” consumes (different HH are affected differently by i)
Consumption patterns change over time (to keep the basket content relevant, we sacrifice comparability over time)
The price rise also reflects changes in quality (iPhone 11 vs iPhone 8)
Consequences of high inflation
Export competitiveness may suffer (and thus, AD is likely to decrease, leading to increased unemployment)
Redistributive effects. Those who earn a wage are in a better position than, e.g. the retired (those on fixed incomes). Those who take a loan benefit (as real interest rates fall), but those who save lose
Saving is discouraged; investment is likely to decrease as a result
Increased uncertainty reduces investment
Equity of income distribution
Economic inequality relates to the unequal distribution of income and of wealth.
Absolute poverty is the inability to meet basic needs
Relative poverty is being poor compared with others in the same society
Lorenz curve
Difficulties in measuring poverty
defining poverty
having insuficient and irregular household surveys to collect poverty data
sampling; people in acute poverty may be omitted
having limited disaggregation of data
relying on poverty lines, which may underestimate the severity of poverty
relying on minimum income standards, which can be misleading.
Causes of economic inequality and poverty
inequality of opportunity
different levels of resource ownership
different levels of human capital
discrimination (gender, race, others)
unequal status and power
government tax and benets policies
globalization and technological change
market-based supply-side policies.
How government can promote equity
Transfer payments
Disability benefits or pensions target those in need, decreasing income inequality
Targeted spending on goods and services
The government can subsidize or directly provide services such as education and health care, and infrastructure in order to make them available to the most deprived groups.
Universal basic income
The UBI is a model for providing all citizens of a country or a geographic area with a given sum of money, regardless of their income, wealth or employment status
Policies to reduce discrimination
Minimum wages
Taxation
Progressive income taxes can redistribute income more equally.
A wealth tax can be used to redistribute wealth more equally.
Property taxes if increased and made more progressive can improve inequality.
Less reliance on indirect taxes can promote equity.
Fiscal policies (demand-side policies)
Taxation (taxation increases, short-run aggregate supply (indirect tax) or aggregate demand (income tax or business tax) decreases)
If taxes (T) decrease, then households' disposable incomes (Yd) increase. Remember that disposable income is defined as income minus direct taxes plus transfer payments. With higher disposable incomes, people will tend to spend more, increasing consumption expenditures (C) and, thus, aggregate demand. Also, if corporate taxes decrease, the resulting higher profitability that firms will enjoy may lead to an increase in investment spending (I) which also increases aggregate demand as an investment is also a component. Note that we are referring here to changes in direct taxation.
Government expenditure (government expenditure increases, then aggregate demand increases)
The goals of fiscal policy are to:
Lift an economy from recession
Lower (cyclical) unemployment
Decrease inflation
Promote a stable macroeconomic environment that accelerates growth
Reduce business cycle fluctuations
Decrease income inequality
Decrease trade imbalances.
Advantages of fiscal policy
Fiscal policy affects aggregate demand directly.
Fiscal policy can be targeted.
Certain expenditures may also increase potential output.
Under certain conditions, fiscal policy can be scaled up significantly.
Disadvantages of fiscal policy
Politicians are responsible for fiscal policy.
Fiscal policy is characterized by long time lags.
It may lead to unsustainable debt.
It may lead to inflation.
It may widen a trade deficit.
Tax cuts may not induce more spending
Monetary policies (demand-side policies)
Money supply
Interest rate (interest rate increases, investment and consumption decreases, aggregate demand decreases)
The goals of monetary policy are to:
achieve and maintain price stability
achieve high levels of employment
stabilize economic activity
promote a stable economic environment favourable to investment
influence the exchange rate and achieve external balance.
Expansionary monetary policy (decreased interest rate)
Consumer expenditure will increase
Lower interest rates decrease the cost of borrowing for households. Households borrow from banks to buy consumer durables such as cars and appliances but, most importantly, to buy a house. Borrowing will tend to increase, so household expenditures on durables and houses are expected to increase.
Lower interest rates decrease the incentive for households to save. If households save less, it means that they spend more.
Lower interest rates also increase firms' investment expenditures (I) for the following reasons.
Typically, firms borrow to build new factories or to buy machines, tools and equipment. The cost of borrowing for firms will be lower, so more investment projects will be considered profitable.
Even if a firm uses its past profits to finance the purchase of capital goods and does not need to borrow from banks, if interest rates decrease, then the opportunity cost of using these funds decreases, which will tend to increase investment spending.
Lower interest rates can also increase net exports (NX).
A decrease in a country’s interest rates implies a lower rate of return for financial investors who own bonds or have deposits in that country’s currency. They will want to switch to the financial assets of other countries where interest rates are higher. They will sell the currency to buy currencies of other countries. The increased supply of that country’s currency in the foreign exchange market will decrease its value. However, the depreciation of a currency makes exports cheaper abroad and thus more competitive. Exports will tend to increase so that aggregate demand will shift to the right. The impact of a change in interest rates and, thus, of the exchange rate on net exports is significant and will be fully explained later.
Advantages of monetary policies
Monetary policy is flexible
It is incremental
It is reversible.
It is independent (typically) of the government.
It has shorter time lags than fiscal policy
Disadvantages of monetary policies
If confidence levels are low, monetary policy may prove ineffective.
When nominal interest rates are near zero, there is little room to lower them more (the ZLB problem).
Supply-side policies
Supply-side policies can be divided into market-oriented policies (favoured by new classicals) and interventionist policies (favoured by Keynesians). Both are primarily focused on making the labour market work more efficiently, i.e. removing barriers to employment. Although supply-side policies can be either market-oriented or interventionist, the term “supply-side economists” refers to economists who favour market-oriented supply-side policies. The key is creating incentives to shift the LRAS / Keynesian AS to the right. Since supply-side economists believe that free markets promote economic efficiency. In contrast, government intervention hampers it; they think the role of the government is to remove obstacles to the market working efficiently.
Market-based supply-side policies
Product market-related policies include:
Increasing competition in product markets would lower prices, increase output and spur innovation
Deregulation to open-up markets and decrease production costs for firms
Privatization as the profit motive increases efficiency
Trade liberalization exposes domestic firms to foreign competition.
Labour market-related policies include decreasing:
The power of labour unions to decrease the ability of labour to raise wages
The minimum wage (or even abolishing it) to decrease wage costs for firms
Non-wage labour costs to firms to lower the cost of labour
Unemployment benefits induce unemployed workers to accept sooner job offers.
Incentive-related policies include decreasing:
Personal income taxes increase the incentive to work
Business and capital gains tax increases the incentive to invest.
Interventionist supply-side policies
These policies increase:
Public investment in infrastructure as infrastructure decreases the overall cost of economic activity
Public investment in education and health care as the increased human capital increases labour productivity
Public investment in R&D as labour productivity also depends on the technology embodied in the economy’s capital stock.
Economic growth — industrial policies are used in certain industries that are crucial for growth and may benefit from preferential treatment by the state.
Supply-side policies
lowering unemployment benefits because they can have a distorting effect on the labour market (little incentive to work if one’s disposable income when working isn’t much higher than when on unemployment benefits)
weakening the power of labour unions because they are seen to have a distorting effect on the labour market (e.g. asking for higher pay or costly improvements in working conditions, in some countries also limiting the number of people trained in the field, thus limiting the supply of this type of labour and thus keeping the wages higher)
deregulating (i.e. removing government regulations on, e.g. who is allowed to work for how many hours and at which age) to make the labour market more flexible, making it easier to not only fire but also hire (idea: if getting rid of the excess workforce isn’t overly difficult, firms will also hire more easily when faced with increasing demand)
lowering marginal income tax rates to encourage people to work more, i.e. creating incentives to work more
reducing the tax wedge (the difference between the disposable income of the employee and the cost to the employer) by reducing the social security contributions (as well as the income tax)
lowering profit taxes to create incentives for investment (firms are more likely to invest if profits are taxed less)
privatizing (selling government-owned assets (e.g. companies, land) to the private sector, which – contrary to the government – makes market-based decisions, i.e. is expected to work more efficiently)
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