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MACROECONOMICS
Macroeconomics is the core of both international economics and development economics, and it is undoubtedly the most important section to master. It encompasses the entire country, rather than simply one firm.
As macroeconomics is also a heavy component, it is pslit into two pages. This page deals with 2.1-2.4, while the second page has 2.5 and 2.6. The second page is here.
SECTIONS
2.1 The Level of Overall Economic Activity
Micro versus Macro
2.1 The Level of Overall Economic Activity
Circular Model in a closed economy
HOUSEHOLDS
SPENDING
FIRMS
GOODS AND SERVICES
Circular Model
In a closed economy, without a government, the model above represents the flow of money. There exists a flow of income between households and firms, or the private sector.
How to measure economic activity
There are several ways for economists to measure the economic activity of a country. These include GDP, GNP and GNI.
Four factors of Production
There are four factors of production that are involved in all industry and firms. In return these four have respective payments. These are both listed below:
The Business Cycle
The economies of all capitalist countries fluctuates, alternating between periods of prosperity and recession. These fluctuations follow a cyclical pattern, known as the boom-and-bust cycle or the Business Cycle.
At the peaks, the economy is experiencing high levels of growth. Then follows a contraction in the economy, with slowing levels of growth, followed by a slump or a trough. Then the economy recovers and starts speeding up again into a new expansion and subsequent peak.
The fluctuations are highly irregular and it is impossible to accurately know if one will last a year or ten. However, it is for sure that all economies fluctuate - no economy can be constantly growing or constantly decreasing in the long run.
Business Cycle
Peak: Maximum GDP level attained, low levels of unemployment and likely inflation.
Contraction: Negative grotwth, rate of inflation decreases and likely increasing rate of unemployment. This is known as a recession, or if it goes on for a long time, a depression.
Trough: Lowest level of GDP in the cycle, high levels of unemployment and low levels of inflation - possibly even deflation.
Expansion: This is a recovery period. People are more employed, jobs are being created, maybe inflation is beginning.
2.2 Aggregate Demand and Supply
Aggregate Demand
What is it?
The aggregate demand curve looks and functions much like the one we used in microeconomics. The key difference has to do with the aggregate. An aggregate is a collection of items that are gathered together to form a total quantity. Aggregate demand, thus, is the combined demand of the goods and services produced by a country. For example, the aggregate demand of China determines the rest of the world's demand for Chinese products and services. It has a negative slope, just as in micro, as the goods and services a country produces becomes more expensive the demand for them decreases.
The Components of Aggregate Demand
Aggregate Demand is composed of four major parts, and this is an equation that it is important that you remember.
AD = C + I + G + (X - M)
C: Consumption
What is it?
Consumption stands for all the products and services that are consumed within the economy. In short, it is domestic demand: purchases made within a country by people also within its borders.
How a change in C affects the AD
The consumption of a country is ever fluctuating. It's changes can have large effects on the country's economy, and will shift the AD curve. If consumption increases, the AD curve will shift as demand increases. If consumption decreases, the AD curve will shift to the left.
What causes C to change?
A multitude of things:
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Consumer confidence: when consumers in the economy lose confidence in where the country is going and in its economic performance. If consumers think the economy will soon go really bad, they will want to save, not spend.
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Interest rates: Interest rates have a profound effect on consumption. When they are high, people will want to save their money - because that's where they will make money off it. But if interest rates are low, saving is not incentivized, and they will thus spend it.
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Personal income taxes: The higher people's income taxes are, the less disposable income they have, and the less they will consume. The opposite is also true.
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Wealth: The wealthier people are, the more they will consume, and vice versa.
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Level of household indebtedness: If households in the economy have high levels of debt, they will not consume as much. On the other hand, if they have little debt they will feel much more confident in their economic situation and will thus spend more.
I: Investment
What is it?
Investment stands for all the money that is pumped into the economy, in forms of either buying stocks in the stockmarket or in buying new goods like tractors that can be used.
How a change in I affects the AD
Investment levels in an economy will affect how much will be produced. A change in investment levels thus changes the amount of AD; less investment into the economy means less is demanded, and AD shifts. The reverse is also true: if more is invested, more is demanded, and AD shifts right.
What causes I to change?
Business Confidence: If businesses and corporations are confident in their businesses and, primarily, in the state of the economy, they will be much more willing to invest. If they believe the economy is positively growing, they will want to take the risk and invest. This will thus shift AD to the right.
Interest Rate: Much the same as with consumption: when interest rates are high, it is expensive for businesses to borrow money to invest, so investment will be less. When interest rates are low, however, it is cheap to borrow money and they will thus invest more. AD shifts accordingly.
Technology: Better technology leads to more investments, and vice versa.
Level of Corporate Indebtedness: If corporations are heavil indebted, they will not want to borrow more money to invest. If, however, they have little debt, they will feel much more comfortable taking out new loans to be able to invest. This will affect AD.
Business Taxes: If a country takes its businesses a lot, they will have less disposable profit to be able to invest with. If taxes are lowered, they will have more, and investment will rise.
Legal changes: Changes in laws regarding patents for example, or simply regarding investments and loans.
G: Government Spending
X-M: Exports minus imports
What is it?
Money the government spends, into the economy. When the government expands the military, builds new roads or schools - it is spending money directly into the country, demanding both labour and products. Thus, government spending is part of what makes up the total aggregate demand.
How a change in G affects the AD
Government spending in the economy affects how much labour and products are demanded. Thus, the more the government spends, the stronger AD is and shifts to the right. A cut in spending, on the other hands, makes AD shift to the left as less is demanded.
What causes G to change?
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Economic priorities: A country will sometimes change what it is aiming towards, economically. Does it want low inflation or zero unemployment? Deciding on this will also decide how much the government will spend into the economy to make it's priority come true. This will thus also affect AD.
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Governmental priorities: When the government shifts priorities, it will also shift its spenidng. This may occur when there has been an election, or when they respond to the pressures of the people. Perhaps,s omething happens, such as a hurricane or an external threat, that means the government has to step in. Whatever the reason, there is a change in government priorities which leads to a change in it's spending: more spending increases AD and shifts it to the right, less spending decreases it and shifts it to the left.
What is it?
Money that enters the economy from exports and imports. The equation X-M stands for Exports minus imports; X-M is therefore how much money is left. If a country exports 100 million worth of products, and imports 60 million worth of products, that is 100-60 = 40. Thus, 40 million is demanded of the economy.
How a change in X-M affects AD
If a country begins to import more, aggregate demand will decrease, because the outcome of the equation will be less. If more is exported, then aggregate demand will increase, because more money will be brought back into the economy. In short, all the money that is imported is essentially lost from the economy - it goes abroad - whereas money that is used buying your products (exports) will be an influx into the economy.
What changes X-M?
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Income of trading partners: the amount of money that the country's trading partners has. If the neighboring countries are suffering a recession, or a war or a natural disaster, chances are that their income will be impacted and they will thus not buy as much of the country's exports. Conversely, if your neighbors become richer, they can afford to import more of your goods, so your exports rise.
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Exchange rates: if the exchange rates are favourable to your trading partners (meaning that it is cheap for them to buy your currency) then they will import more of your products. The opposite is also true.
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Level of protectionism: If a country is heavily protectionist, it will not want to import much at all. Changes in this thus affects X-M.
Aggregate Supply
What is it?
The aggregate supply curve looks and functions much like the one we used in microeconomics. The key difference has to do with the aggregate. An aggregate is a collection of items that are gathered together to form a total quantity. Aggregate supply, thus, is the combined supply of the goods and services produced by a country. It's AD's friend, and together, they form the curve to the right. It has a positive slope, just as in micro, as the goods and services a country produces becomes more expensive the supply for them increases.
AD and AS explained
The Short Run Aggregate Supply Curve
The aggregate supply curve, as opposed to the aggregate demand curve, is a very debated topic amongst economists. It also exists in both the short term and the long run, much as we studied in microeconomics. In the short run, the factors of production and resources are fairly inflexible, and will not change much in response to shifts in the AD curve. In the long run, the factors of production are far more flexible, and the long-run aggregate supply curve (LRAS) therefore has a different shape. That will be discussed further down.
In the diagram below are two SRAS curves after a shift left.
Causes of a SRAS shift
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Change in the price of labour: when wage prices increase or decrease, the SRAS curve will shift accordingly. That is because the more expensive wages are, the less will be produced, and vice versa.
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Changes in the price of resources: Other resources, and not labour, can also become more or less expensive. This is particularly true of land and technology. Increases in the price of oil, for example, will shift the SRAS curve to the left, while when technology becomes cheaper, it will shift to the right.
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Change in business taxes: Higher taxes on business -> more expensive to produce, and the SRAS thus moves to the left. When taxes are lowered, more can be produced, and the SRAS will move to the right.
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Change in subsidies: Subsidies help businesses produce more, so when they are removed or added they will also cause shifts of the SRAS curve.
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Supply shocks: This refers to external shocks to supply and to the factors of production. A hurricane or a natural disaster would negatively affect the production of many industries, as would a war or a conflict. An epidemic or a flood would reduce the working force and societal functions. Supply shocks will therefore shift the SRAS curve to the right.
SRAS Deflationary Gap SRAS Inflationary Gap
Deflationary Gap
This occurs when the equillibrium of the SRAS and the AD curve are not at full employment, but rather on the right side of it. There is unemployment, and the economy is not producing at its max. In short, AD is not demanding enough for the country to produce at it's level of maximum output.
Equillibrium: Full employment
Full employment
When the AD and the SRAs curve are in harmony with the country's potential GDP. THe country is therefore at full employment and there is neither a deflationary gap nor an inflationary one.
Inflationary Gap
This occurs when the equillibrium of the SRAS and the AD curve are beyond full employment, on the left side of it. Unemployment is less than the natural rate of unemployment. AD is demanding far more than the economy can produce.
The Long Run Aggregate Supply Curve: debated amongst economists
There are two major schools within economics, that you will touch upon during your IB Economics course. These two are the moneterists and the Keynesians. These two schools originated with two different economists, one being Frederick Hayeck and X. Keynesianism came from the economist John Maynard Keynes, and advocates that the governmnet take a more active role in the governmnet. Because of their two differing views regarding some basic assumptions of macroeconomics, there are two different Aggregate Supply curves. You must know both.
Moneterists Curve
Moneterists believe that the Long Run Aggregate Supply Curve (LRAS) is vertical at the point of potential GDP. At potential GDP, the country is experiencing full employment. All resources are being used. And thus the LRAS is vertical, because it doesn't matter at what price level the economy is operating at; it is at the maximum potential GDP output. This model also assumes that there is complete flexibility with regards to all resource prices, including wages; that businesses can lower wages or raise them at will.
This basically comes down to the fact that Monetarists believe that the economy is self-correcting, due to the price mechanism. Any inflationary or deflationary gaps will be solved automatically by the economy, which always moves towards full employment. Inflationary and deflationary gaps therefore cannot persist in the long run. It is impossible.
The Moneterist LRAS
The long-run aggregate supply curve for moneterists is vertical, because in the long-run, all factors of product are mobile - including wages. Firm's costs thus always stays the same, regardless of the price level in the economy, since firms can always fire or hire more labour depending on their needs.
Correction of a deflationary gap
Monetarists thus beleive that a deflationary gap is only temporary, and cannot endure in the long-run, since in the long-run all factors of production are mobile and the economy is always producing at full employment. In the diagram below, aggregate demand falls from AD1 to AD2. This creates a deflationary gap as the economy moves from producing at point A to point B. At this point, point B, the economy is now experiencing a lower price level. This also results in lower wages and prices for all factors of production (resources, land etc.). This in turn leads to an increase in the short run aggregate supply, since there's now more resources and workers about. This shifts to the right, and so the economy is back at point C. Now at a lower price level, at P3, but nonetheless back at LRAS and full employment.
Correction of an inflationary gap
An increase in the AD leads to a higher price level and a situation of inflationary pressure. We have an inflationary gap. The price level goes from P1 to P2. As the price level increases, so does the prices of all the factors of production - land, resources and wages - which means that the short run aggregate supply shifts inward to the left. Away frompoint B towards point C. Thus, the economy has self-corrected, and is again operating at the full employment level of Yp but now at a higher price level, of P3.
Keynesian Curve
Keynesians believe a number of different things. To them, the LRAS curve is not vertical but rather encompasses three stages. They disagree with Moneterists claims that the economy is self-correcting and always moves towards full employment. Instead, the argue, inflationary or deflationary gaps can persist in the long run - they are not fixed by the pricemechanism. Keynesians particularly take issue with the moneterist claim that all resource prices are flexible in the long run, instead believing that wages and product prices are rather inflexible downwards. With regards to wages, this is primarily due to labour contracts, union resistence, governmntal pressures and minumum wage laws. Firms, too, will hesitate to lower product prices for fear of inducing a price war. In short, they argue prices will not decrease, even in a recession.
The Keynesian LRAS
The curve thus looks like the one below. The flat part comes from the assumption that prices and wages are inflexible. a is the period in which the price level remains stable as real GDP increases. This is because their exists spare capacity in the economy - people who are unemployed, or underemployed, spare acres not farmed, technology not put to use and so forth. Therefore, the price level won't increase as these are being put to use. In b however, we are a pproaching full employement. Resources prices begin to rise, including the price of labour, since they are all becoming scarcer. This, in turn, means that the price level begins to increase, or to put it another way, the economy begins to experience inflation. Theeconomy has reached full employment, and now only maintains the natural rate of unemployment. In c, the economy has reached it's absolut max. All increases the economy does now will be upward, further increasing inflation, but will not increase GDP.
Full employment
Here the economy is at the perfect equillibrium: at full employment and without any inflation.
Deflationary Gap
When the AD curve is far to the right on the Keynesian As curve, the country is experiencing a deflationary gap. It is not producing at the full level of it's potential output, and is thus experiencing unemployment. At Y1, it is far shy of it's goal of production: Yp. And it won't correct itself anytime soon, not automatically.
Inflationary Gap
Here the Ad curve is on the right of the Yp spot. The country is thus operating at the maximum level of employment and at full output, but here, the country is bneginning to experience inflation. The country is now at P1, which is above the Pp point.
The LRAS curve, both the Moneterist and the Keynesian, can shift over time. This is because something has affected the country's potential output, either to the better or to the worse, which will move the LRAS to the right or the left.
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Increased efficiency: This occurs when the country becomes better at taking care of its production, thus making producing goods and services much more efficient.
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Increased quantity of the factors of production: The more factors of production, the more you can produce. This may refer to an increasing population or the discovery of new natural resources within your country's borders.
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Institutional changes: This refers to changes being made within the government as to how the economy functions. For example, patent laws can help increase innovation, or selling off certain public companies that become private. If the bureaucracy functions better, that may also increase efficiency and stimulate investments.
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Improved technology: Better technology means more output, or the better harvesting of the country's exisiting resources. This will help increase the LRAS and shift it to the right.
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Improvements in the quality of the factors of production: The better the factors of production are, the more they can produce. The absolute most important things here are education and health, which drastically increase the quality of the labour force. A well educated and healthy labour force will be able to produce much more than one who's not, and therefore, the LRAS will shift tot he right.
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Reductions in unemployment: this refers to a reduction in the natural rate of unemployment (NRA), which are the people who are still unemployed even when the economy is at full emloyment. These are people who do not work, but don't consider themselves unemployed - they are not actively searching for a job. This may be retirees, stay at home wives or husbands, and so forth. They make up the natural rate of unemployment (NRU). Reductions in this, such as stay-at-home's that want to rejoin the working force or people who come out of retirement, will increase the LRAS.
What causes a change in the LRAS?
The Keynesian Multiplier
HL
The Keynesian multiplier is a concept exclusively for the Keynesian school of economics, and incidentally, for Higher Level students of IB Economics. It remains widely debated.
When the economy is in a recession, the government should actively stimulate the economy by government spending. He argued that when the government spends money, it will multiply within the economy, thus having a much larger effect than the initial injection.
Let's say the government injects money into the economy, in the form of building more roads. That means the money will go directly to contractors. That's the inital spending. However, this contractor will then hire labourers, rent technology and purchase materials, which will then be the second spending. Those labourers will earn this money in income, of which they will save some. The rest, however, they will use to buy goods and services in the economy, for example groceries. This is the third spending. And so forth it will continue, and thus, the initial spending by the government will be multiplied and magnified as it moves through the economy. This is the Keynesian Multiplier.
A Must Watch: Multiplier
How to calculate the Keynesian Multiplier
Formulas
Multiplier =
Multiplier =
1
(1- MPC)
1
(MPS + MPT + MPM)
There are two ways to calculate the Keynesian Multiplier, and they are both shown here to the left. Together, the MPC, MPS, MPT and MPM represent everything that it is possible to do with your income.
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MPC: Marginal Propensity to Consume
This refers to how much of their income people are likely, in general, to consume. This will be something like 0.4, or 0.6. If the MPC is 0.6, that means that people are likely to consume 60% of their income. The Keynesian Multiplier will therefore be 1 / (1 - 0.6) = 1 / 0.4 = 2.5. The government spending in the economy will therefore be 2.5 times larger than the initial injection. -
MPS: Marginal Propensity to Save
How much of one's income people are likely to save. -
MPT: Marginal Propensity to Tax
How much of one's income is likely to be taxed away. -
MPM: Marginal Propensity to Import
How much of one's income is likely to be spent on imported products, which thus represents a leakage from the circular system of an economy.
2.3 Macroeconomic Objectives
What does the government want?
Macroeconomic Goals
A country's four possible macroeconomic objectives are the following:
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Equity in the distribution of income
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Economic growth
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Low and stable rate of inflation
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Low levels of unemployment
1. Low and stable inflation
What is inflation?
What is inflation? Inflation is the persistent increases of overall prices in an economy.
What is disinflation? Disinflation is the slowing down of the rate of inflation. Thus, if a country has been experiencing 5% inflation for a year or two, and now that rate is slowing down, going from 5% to 4% and then to 3%, the country is experiencing disinflation.
What is deflation?
Explain that inflation and deflation are typically measured by calculating a consumer price index (CPI), which measures the change in prices of a basket of goods and services consumed by the average household. • Explain that different income earners may experience a different rate of inflation when their pattern of consumption is not accurately reflected by the CPI. • Explain that inflation figures may not accurately reflect changes in consumption patterns and the quality of the products purchased. • Explain that economists measure a core/underlying rate of inflation to eliminate the effect of sudden swings in the prices of food and oil, for example. • Explain that a producer price index measuring changes in the prices of factors of production may be useful in predicting future inflation.
Consequences of deflation
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Reduced business revenues. Deflation works by making money more and more valuable over time. This means that the best way to make money is simply to save it, and it will be worth more tomorrow than it is today. This means that consumers will not want to b uy a bunch of goods and services, and instead save their money. Thus, businesses will suffer as a response.
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Bankruptcies. If people don't spend, businesses won't be able to function. Bankruptcies may follow as a consequence.
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Cyclical unemployment. If companies have to go into bankruptcy, unemployment will follow as a consequence. This will hurt the eocnomy as a whole and put a strain on the government, who will have to start paying out unemployment benefits.
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Changes in consumer spending. People will spend less, save more.
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Reduced investments. If money becomes worth more on its own, why should anyeone want to invest? The best investment may simply be just to stop spending and instead keep your money in the bank, as it will be worth more and more as time goes on. Less investments also means less growth for the country as a whole.
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Reduced credit.
Inflation explained
Consequences of inflation
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Greater Uncertainty
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Less saving. Those who save money and have money saved will suffer because of inflation. In short, the money that they have already saved becomes less valuable in terms of what goods and services it can purchase. This means that a high rate of inflation also tends to discourage saving and encourage spending, since people will not want to save money that will be less valuable tomorrow.
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Benefits borrowers. Because inflation lowers the value of a set amount of money, it benefits those who have borrowed. Themoney they borrowed, the outstanding amount, will become effectivily less each day, even if the numerical value is the same.
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Redistributive effects. Inflation has an effect on the distribution of income in the society. Because it, in effect, makes money less valuable (since prices are rising), those on a fixed income will effectively have less in their pocket than they did before. This tends to hit those in society that are already poorest, such as those receiving pensions or unemployment benefits. It also hurts those who
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Menu costs. These are costs that are incurred by businesses that are forced to continually print new mensu and make new signs, because of the constant increase in prices.
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Damage to export competitevness: Because a country with inflation will experience a rapid increase in prices not felt in the countries it trades with, it will harm its exports. These will become more expensive to it's trading partners, while imports will instead be cheaper. This will be damaging to the country's balance of payments.
How to measure inflation
Consumer Price Index
Consumer Price Index
The government needs to have a method to measure inflation. The most common of this is by using the consumer price index (CPI). This is an index with average prices of goods and services typically consumed by a normal households, called the basket of goods.
The value of this basket of goods is calculated once every year; the first year is called the base year. It is compared to this year that the calculations are compared, to see if the prices have increase, decreased or remained the same. This is displayed as a percentage. If the inflation this year was 3%, that's a 3% increase in prices from the base year. The video to the left brilliantly explains this.
Problems with the CPI
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Different households will experience different inflation. Not all consumers will buy the goods and services included in the basket of goods. Those that don't will thus experience a different inflation rate that isn't measured by the government. These different consumption patterns may be because of different income levels, geographical locations, cultural and ethnic consumption norms and the like. The CPI disregards all this.
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The CPI often overestimates inflation, especially since the market is being increasingly filled with discount opportunities, outlets, amazon and ebay and all sorts of ways for savvy customers to purchase the CPI goods much cheaper.
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Countries change the base year at regular intervals, perhaps every ten or twenty years, and then also update the goods. Thus inflation is not very comparable in the long-run.
How to guide
Cost-push inflation
Explain, using a diagram, that demand-pull inflation is caused by changes in the determinants of AD, resulting in an increase in AD.
Cost-push inflation is called so because it is caused by a shift in the SRAS due to increasing costs of factors in production. If any of the four factors increase in price, for example resource prices (let's say higher oil prices) then the SRAS will follow suit. The costs "push" the price level higher, causing inflation. It will shift to the left, and now the economy is producing at a higher price level, from P1 to P2. Higher price level = higher rates of inflation.
Cost-push inflation is also known as stagflation. This is because the country is simultaneously experiencing both a higher rate of inflation as well as decreasing GDP.
How to solve stagflation/cost-push inflation?
This is very difficult. Cutting the interest rates to incerase spending and move AD forward would only increase the inflation rate.
Supply-side policies seem to be the only workable solution. Increasing the SRAS is a good attempt, to shift it back, but this is also very difficult. Often times, if the cause is a supply shock (for example sudden high prices in oil or food) there is little the government can do about it apart from weathering it out.
Hyper and Stagflation
Demand-pull inflation
Explain, using a diagram, that cost-push inflation is caused by an increase in the costs of factors of production, resulting in a decrease in SRAS.
Demand-pull inflation is caused by an increase in demand, that "pulls" the price level higher. It does this by shifting to the right. This can occur based on any increase in the determinants of aggregate demand; perhaps people have more income or have less debt. Demand-pull inflation occurs in both the Keynesian and Monetarist models, so both are illustrated below.
How to solve demand-pull inflation
Demand-pull inflation is in many ways quite good. While the inflation rate is higher, the country is experiencing growth, with more GDP. So the government can do one of two things.
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Decrease AD. This can be done with monetary plicy, increasing the interest rate, thus moving AD back. This however results in a loss of GDP. This is the quickest solution.
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Increase the LRAS/Keynesian AS. By shifting this curve to the right, the country will experiencing lower inflation rates while also maintaining the GDP growth. This is the most time-consuming alternative and the most expensive, but perhaps with best potential pay-off.
Philip's Curve
HL
The trade-off between unemployment and inflation
The Philip's curve is shown here on the right. As you can see, on th axis, are the rate of inflation and the unemployment rate. The Philip's curve shows that there is a relationship between them (something Keynesians argue but that Monetarists say doesn't exist.) At point A, the country is experiencing very little unemployment, but high levels of inflation as aggregate demand increases (because more working people equals more more disposable income). At point B, the country is experiencing very low levels of inflation, but have a high rate of unemployment.
Short-run Phillips curve may shift due to a decrease in SRAS
If the short-run Philip's curve shifts outward, the country will be experiencing stagflation, a combination of high rates of inflation and high rates of unemployment. When it shifts outward, regardless of which point you look at, it will have more unemployment and inflation than it's counterpart on the P1. The reasons for the shift is caused by a decrease in the SRAS. This may have many reasons, for exmaple supply shocks: perhaps a sudden increase in the price of oil.
For the Keynesians, the Philips curve has ben incorporated into the long-run aggregate supply curve. That's why the LRAS curve for them is curved towards the end; that's where the trade-off occurs between inflation and unemployment.
The vertical longrun Phillips curve
Some economists argue that the longrun Philip's curve looks quite different, and is instead vertical at the natural rate of unemployent. This is advocated by Monetarists. In the long-run, therefore, there is no trade-off between the unemploymet rate and the inflation rate. In the diagram to the right, the LRPC grounds itself in the point where the rate of unemployment is equal to the natural rate of unemployment. The LRPC is in many ways exactly the same as the LRAS for the Monetarists. In the short run, the economymay operate on a point outside the LRPC, like point B, but in the long-run it will always return to a point on the LRPC.
Natural rate of unemployment: This is the rate of unemployment that exists when the economy is producing at the full employment level of output. It refers to those that are frictionally and structurally unemployed (more on that below). It thus always exists within an economy. It is natural.
2. Low Unemployment
What is unemployment?
Unemployment refers to the people in the economy not currently employed, thus the portion of hte labour force that are idle. These people must be actively wanting a job for it to count. Thus, people under age or studying, or who are retired or on maternal/paternal leave, do not count as unemployed.
How is the unemployment rate calculated? First, the labour force is identified, which is everyone of a working age who actively wants to have a job. Thus, again, not students, ill people, retirees, or those who have taken themselves out of the labour force (stay-at-home parents for example). The unemployment rate is calculated as a percentage.
Unemployment rate: number of unemployed / labour force x 100
Measuring unemployment is very difficult.
There always exists alot of hidden unemployment in the economy, which is far harder for the government to estimate. The following difficulties apply:
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Underemployment. If a highly educated person is working as a waiter, not a doctor, that still counts towards full employment even if all the skills aren't being used. Same goes for those who work part-time.
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Discouraged workers, who want to work, but who have been actively searching for so long that they have stopped and are instead at home, discouraged from trying.
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Does not count people working illegally, who will instead register in the system as unemployed.
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Disregards any ethnic, gender, age or regional disparities. Because the unemployment rae is calculate as an average, it disregards some of the nuances within a country that may highlight higher levels of unemployment within certain groups.
Consequences of unemployment:
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Loss of GDP: Less people working, means less GDP and growth for the country.
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Loss of tax revenue: unemployed people represent a lack of income tax for teh government, and are therefore not contributing to paying for public services, like roads or healthcare.
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Cost of unemployment benefits: The more that are unemployed, the more the government has to pay in unemployment benefits, which is expensive.
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Loss of income to indidivuals: the people who are unemployed will have significantly less income than they did when they were working, which will result in a loss of standard of living.
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Income distribution disparities: Unemployment tends to lead to more inequality, between the haves and have-nots.
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Increased crime rates: If unemployment is high and persists, crime rates tend to follow as well. Because jobs are scarce, crime becomes one way to attempt to find income.
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Increased stress levels: For the people who suffer from unemployment, the stress and pressure is often very high, to attempt to get a job and also balance on a suddenly much smaller budget.
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Increased Indebtedness: Unemployment often leads to more debt, as individuals struggle to adjust and take out loans.
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Homelessness: If those unemployed cannot pay mortgages or rents.
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Family Breakdown: Children may be seized by social services, should the unemployment go on for too long.
Types of Unemployment
Frictional Unemployment
Seasonal Unemployment
Structural Unemployment
What is it? This type of unemployment refers to the loss of specific seasonally related jobs and industries, when those months are not in season. For example, ski resorts that employ a lot of people in the winters tend to employ nobody in the summer, and those people are thus seasonally unemployed. The same is true for icecream salesmen, gardeners, lifeguards and in short anyone who relies on beach tourism. Because seasonal unemployment is natural in an economy, that is, it arises from natural causes and exists in practically all economies on earth, it counts towards the natural rate of unemployment (NRA).
What to do about it? Offer retraining for those in seasonal occupations so that they can find employment elsewhere in the inbetween months. Alternatively, try to make seasonal jobs all-year round, such as offering meditation and hiking vacations at ski resorts in the summer months.
What is it? This type of unemployment is quite simply the one when people are in between jobs. The period between they either quit or are laid off, and they find another job. The key to frictional unemployment is that it refers to works who's skills are still in demand in the economy, and whose unemployment is likely to be short-term. It is considered part of the natural rate of unemployment because some industry closure and expandature is unavoidable in all economies; some firms will come, others will go, because of competition. It is therefore part of the natural rate of unemployment (NRA).
What to do about it? This is where state-sponsered websites for job ads and various job agencies helps to faciliitiate unemployed people to quickly find new jobs. Essentially, to make sure that information more quickly flows between those searching for a job and those companies who need more workers.
What is it? This is the most difficult type of unemployment to solve of the three which are part of the NRA. Structural unemployment refers to the loss of jobs due to the changing demand for labour skills. For example, if a part of the country once had a booming textile industry, but this has, for whatever reason, been placed elsewhere, the remaining workers will now be structurally unemployed. This because the skills they have are no longer in demand in that area. The same is true when technology makes certain skills obsolete.
What to do about it? Essentially, structural unemployment is the mismatch between the needs of the industries, and the skills of the workers. Thus, these workers can take part in retraining programs, to teach them new skills that are in need. The government could also assist them geographically relocate. Reducing labour market rigedies, like minimum wages, unions and unemployment benefits may also help.
Cyclical Unemployment
What is it? This unemployment type is closely connected with the boom and bust cycle of the economy, that we read about earlier in macroeconomics. Cyclical unemployment is sometimes referred to as demand-deficient unemployment. This type of unemployment occurs when the economy is in a bust, or a trough. The aggregate demand has thus decreased, and the economy is operating at less than it's potential GDP. Firms are producing less to meet the now smaller amount of products and services demanded, which means they have need for fewer workers. Some are inevitably laid-off, who become cyclically unemployed.
What to do about it? The government's only option is to try to boost aggregate demand, to bring back the need for the jobs.
Unemployment Types
3. Equity in the distribution of income
What is it? The meaning of equity in the distribution of income
Equity /ˈɛkwɪti/: the quality of being fair and just.
Equality /ɪˈkwɒlɪti,iː-/: the state of being equal, especially in status, rights, or opportunities.
Equality in the distirbution of income would be that all citizens receive the same income. Equity in the distribuition of income refers to the the fair distribution of income in the economy - which will differ depending on once interpretation of equity. For example, if you believe that people should be rewarded for how much they work, that would be an equitable distribution of income but it would give rise to income inequality. One of the great macroeconomic goals of most governments is simply to make the income inequality less, by making the distribution of income more equitable.
Why the market gives rise to an inequitable distribution of income
Because the free market allows for unequal ownership of the factors of production, the free market will function accordingly and there will be inequity as a result. Those who own the factors of production tend to collect a much higher wage than others in the economy, whose income comes only from the labour skills they sell. Markets, additionally, allows for firms that are no longer profitable to go out of business, just as it allows for more profitable businesses may spring up. This gives rise to unemployment, which in turn leads to an inequitable distribution of income.
The Gini Coefficient
From the chart and the Lorenz curve to the right, it is possible to caclulate a measure of inequality known as the Gini coefficient. It is a widely used measurement internationally of inequality.
The Gini coefficient is essentially a measurement of how far from the line of perfect equality that the country strays. It is calcualted with the following formula:
Gini coefficient = Area between diagonala and Lorenz cuve / Entire area under the diagonal
The coefficient will have a value between 0 and 1. The closer to 0 it is, the less inequality there is, because that would mean that there is less space in between the two curves.
Poverty
Distinguish between absolute poverty and relative poverty.
In practically all countries on earth, there will be varying degrees of poverty. While poverty itself is generally well-understood, in economic terms, that are two different types of poverty that you need to know about.
The first of these is absolute poverty. Absolute poverty is defined as those living beneath a chosen minimum income level, or a poverty line. The most commonly used line used for this is the one set by the World Bank in 2005, which is set at 1.25 a day. Anyone living on that or less per day is said to live in extreme poverty, his refers to all people living below a generally defined
Relative poverty refers to poverty defined by a different sort of poverty line. This line is often set in relation to a country's median income. For example, in Great Britain, a relative poverty line might be someone who is living on considerably less than the median, but who's income is still considerably more than the line of absolute poverty.
Possible causes of poverty
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Low incomes: naturally, having a very low source of income is hihgly likely to lead to poverty. The causes listed below will likely explain why some individuals will end up with low incomes.
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Unemloyment: as discussed in the previous section, highl levels of persistent and long-term unemployment are liable to result in poverty. Unemployment may be cycical, or structural, in which case it is often difficult to address. Some households are more likely than others to fall into poverty due to unemployment, for example those with very specific skills that cannot be transferred from one industry to another and those who are the sole earners of their households, such as single parents.
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Lack of human capital
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Poverty: Poverty itself is a major cause of future poverty. Those who are born in poor circumstances, with poor parents, tend to have considerably less opportunities. Without any extra income to invest in learning new skills or starting a business, poverty itself holds people back from ever escaping it.
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Age: If one is too old to work, or too young, one might be confined to poverty
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Geography: Certain areas of the globe are very inhospitable, and those who live in such regions might find it difficult to get employment.
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Discrimination: Certain ethnic groups may face difficulties in the job market, or are excluded from parts of society. Their difficulty to find employment may result in poverty.
The government's role in promoting equity
Explain that governments undertake expenditures to provide directly, or to subsidize, a variety of socially desirable goods and services
Most governments subsidize public goods, making them available to those on low incomes.
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Health care. All developed countries (with exception for the US) provide health care for its people. This ensures that even those suffering from poverty or low incomes can afford to be healthy. This, in turn, helps maintain a healthy working force, economic growth and increases equity.
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Education. This also helps "even out" income disadvantages between families, as all children can afford to gain an education. While increasing equity, it also helps the country's economic growth since a well-educated working force can produce more goods and of better quality.
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Infrastructure. Good infrastructure means all, regardless of income, can get around. This is also crucial for companies and businesses, and for poor people to get to places where they can work.
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Sanitation and clean water. This is always subsidized by developed countries, and to certain extent in developing countries as well. This helps those on no to little incomes maintain health, reduces child mortality and maintains overall health in the country - across all income brackets.
Transfer payments
The government, in many ways, transfers money from the working population to those who can't. They do this to increase income equity, stave off poverty as well as trying to promote economic growth.
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Old age pensions. To those who can no longer work, they serve as a motivation to those still in the labour force as well as making sure the elderly are taken care of. Prevents poverty.
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Unemployment benefits, which helps those who have lost a job while they search for a new one and prevents them from slipping into poverty and perhaps losing their home.
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Child allowances. Helps to make sure all children grow up in a home where they are at least somewhat taken care of, so that they can grow up to be individuals who earn incomes, don't end up in poverty, and can contribute to society.
Indicators of income equality/inequality
The government has to measure income inequality somehow, and this is what will be discussed here. One of the key ways this is done is by dividing the population into quintile's, from which one can draw a couple of major conclusions. A quintile is a 20% sliver of the country's population. A decile, similarily, is a 10% sliver of the country's population.
In the diagram below, the populations of the two countries have been divded into quintile's, as has the country's GDP. The stats have been used so that you can see what the corresponding quintile holds, in a percentage, of the country's combined wealth. For example, in Middle Earth, the poorest quintile holds only 3.2 percent of the combined country's income, whilst the richest 20% of the population controls nearly 70%. That is a highly unequal distribution of income. However, in Westeros, the poorest quintile holds almost 10% of the country's combined income and the richest only 35.4%. Clearly thats a much more equal distribution of income.
The Lorentz Curve
This curve can be drawn using the information in the above chart. THe Lorenz curve plots the income inequality against a line of perfect equality. On one axis is the cumulative percentage of the country's population, and on the other is the cumulative percentage of income. The perfect line of inequality is straight and goes from 0 to 100 without curving. That means that at point b, forty percent of the population own exactly forty percent of the country's income. On the other hand, on the plotted curve for Middle Earth, at point forty percent only own 17 percent. In short, the more curved the Lorenz curve is, the less equal the country is.
The Lorentz Curve
How to calculate Gini
Consequences of poverty
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Low living standards
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Lack of access to health care: Poverty is harsh when it comes to health; those with little to no income most often suffers from inferior healthcare, if any at all. This in turn makes it more diffucult for them to earn an income, as illness and disabilities that might be curable will hinder them.
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Lack of access to education: Those with little income often have little to no access to education, because financial or geographical difficulties. This in turn means that they will have amuch harder time escaping poverty, because those suffering from it cannot afford to educate themselves with teh skills they would need to do so.
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National instability: Poverty in large numbers tends to destablize a country, because prevalent long term poverty may lead to crime, conflict, areas with bas sanitation and health, increased black market activity and so forth.
The Role of taxation in promoting equity
Indirect and Direct Taxation
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Direct taxation. This is a tax that is levied by the government and paid directly by the person in question. They are unavoidable. These include income tax and corporate tax, and also wealth tax - that is, a tax on assets that produce wealth (such as property or inheritance). Direct taxation is a way in which the government can control the flow of income and money in the economy and across people. Direct taxes can be levied in a way that takes more from the rich and less from the poor, thus reducing income disparities.
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Indirect taxation. These are taxes that are levied on products, so that they are only paid to the government when the products are bought. The most common of these is the VAT, or the general sales tax. That is a percentage that is added on all goods and services in an economy, which go to the government. By tweaking these, the government can also promote equity in some regards: for example, removing the VAT completely for necessary goods, whilst increasing it on luxury items that are more likely to be bought by the rich.
Progressive, regressive and proportional taxation
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Progressive tax. Different taxes effect the income distribution differently. A progresive tax is one that decreases income inewuality. It does this by increasing in proportion as one earns more money. For example, those who earn no income don't have to pay an income tax, those that earn a litle income pay a small percentage, and then the percentage increases as your income does. As you get richer, you pay more in taxation. This is known as the tax bracket system and is the one most common across the developed world, even if it varies in just how progressive it is.
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Regressive tax is one that increases income inequality. A good example of this is indrect taxation in the form of VAT. Everyone pays rgw same percentage of VAT when they go shopping. Say a poor person and a rich person both buy a a pair of jeans with the total VAT levied at 12 dollars. Now those 12 dollars take up a proportionately larger part of the poor man's income than they do the rich mans income, yet they may the same amount. Thus, regressive taxation functions thus: as your income increases, the portion of your income paid as taxes will decrease. As you get wealthier, you will pay less tax.
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Proportional taxation: This is the existance of a constant tax rate: the portion of income paid as taxes will remain. Thus, all in the economy pays 25% income tax - regardless of income.
4. Economic Growth
The meaning of economic growth
Economic growth is an increase in real GDP. That means that the value of the country's overall output of goods and services has increased in a given period, more often than not a year.
Real GDP can either be measured in terms of the entire country, or divided by capita. That simply means per citizen. GDP per capita is therefore a great way to measure how well the country is doing in relation to its population. Some of the countries with the highest GDP per capita are very small, like Macau, Lichtenstein and Qatar. Additionally, with the US and China have quite similar overall GDP values, the US far surprasses China in terms of GDP per capita due to its smaller population.
Economic growth can be illustrated using a Production Possibility Curve, or a PPC. The two diagrams below illustrate just how that works. The diagram below shows how the entire PPC has shifted to the right due to an increase in the production possibilities.
In the second diagram, the country as moved from producing at point A to point B by eliminating ineffeciences, such as reducing unemployment or better technology.
Economic Growth as a PPC diagram
Causes of economic growth
Reducing inefficiencies
This is when a country better takes care of its resources, so that it's production of goods and services becomes more efficient and therefore produces more. This can be done by reducing unemployment - thus cgetting more workers into the labour force. Productive effecieny can also be enhanced in other ways, like better factory managers, the start of shift's, cutting costs and so forth.
Increase in productino possibilities
When the quantity and quality of resources increases in a country, it will also be able to produce more. this could happen if a new iron ore mine is discovered, or an oil well. Similarily, if technology increases that means that the resources available can be used better and produce higher quality goods and services, the country will be able to produce more. This in turn will lead to a shift of the PPC curve outwards.
Describe, using an LRAS diagram, economic growth as an increase in potential output caused by factors including increases in the quantity and quality of resources, leading to a rightward shift of the LRAS curve.
Increased investment
Increasing levels of investment in an economy cna also lead to more economic growth. This is because investments lead to new steps and furthers physical, human and natural capital. Investmnets in technology lead to better harvesting of natural capital. Investment sin education and retraining leads to a more qualified human labour force, and investments in healthcare lead to one that's healthier and can thus work more.
Explain the importance of improved productivity for economic growth
Productivity is essentially how much the economy can produce in a given time frame. If factories produce 10 cars per hour, and they manage to increase it to 12 per hour, it will have become more productive. This in turn will lead to significant economic growth for the country at large. This productivity increase can be attributed to a number of things - perhaps the workers received better training and can now preform faster, or technology can have improved.
Consequences of economic growth
This is developed in the sections regarding developmental economics.
Economic growth explained
2.4 Fiscal Objectives
The Government Budget
Sources of government revenue
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Taxes. This is the main source of government revenue, a nd encompasses both direct taxes (income tax for example) and indirect taxation (VAT).
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Sale of goods and services. The state can produce and sell goods and services as well, which contribute to its income.
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Sale of state-owned enterprises. The state may choose to privatize a number of its enterprises: perhaps the railway services, an airline, or its healthcare. All of this will genenrate revenue.
Types of government expenditures
The governments expenditures can be classified into three different categories.
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Current expenditures: day do day expenditures by the government. These include salaries for the politiicans, wages for those who work in the state's buildings, and so forth.
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Capital expenditures: These are the investments we have discussed in regards to fiscal spending. Investments in schooling or healthcare, for example.
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Transfer payments: These are the social services that the government doles out in terms of benefits; unemployment benefits, pensions, child allowances and such.
The budget outcome
The budget is just what it sounds like: it's the governments budget for all its expenditures for a set period of time, usually a year. The budget is set to the total of the government's revenue. If the government manages to keep its budget equal to its revenue, it's a balanced budget. If the budget overshoots the governments income, it has a budget deficit. And if this budget falls short of the reveneue, it has a budget surplus.
Each year, the result of the budget will be added to the total, combined government debt. If the government ran a budget surplus that year, the extra revenue will decrease the government debt. If the government ran a budget deficit, that will add to the toal of the government government debt.
Contractionary Fiscal Policy
Describe the mechanism through which contractionary fiscal policy can help an economy close an inflationary gap.
The government can also stop and reduce fiscal policy, if it wants to reduce the aggregate demand. Doing this is called contractionary fiscal policy. Since doing so will decrease the aggregate demand, it should close the inflationary gap. Below are two diagrams where this is shown; both with the monetarist model and the Keynesian model. Because of the shape of the LRAS curve, the decrease of AD may have different effects. In the Monetarist model, it will always produce a decrease in price level and thus also the rate of inflation. But in the Keyensian model, this depends entirely on where the AD was to begin with. In our model below, it does result in a decrease in the price level. But if AD1 and instead been AD2 and moved inwards, contractionary fiscal spending would not have lowered the inflation gap but would just have lowered the country's real GDP.
Diagram 1: Monetarist model
Diagram 2: Keynesian model
The Role of Fiscal Policy
Explain how changes in the level of government expenditure and/or taxes can influence the level of aggregate demand in an economy.
When the government changes it's tax policy, it actively controls how much money the average citizen has after income tax has been deducted. In short, in raising or lowering taxes, the average citizens disposable income is determined. The more disposable income people have, the more they will tend to spend and shop, and thus aggregate demand increases. Lowering taxes is therefore good if the government wants to sped up the economy. Raising them is good if the government wants to slow down spending to stop an overheated economy.
Describe the mechanism through which expansionary fiscal policy can help an economy close a deflationary (recessionary) gap.
Expansionary fiscal policy has as it's purpose to increase aggregate demand. The two diagrams below illustrate it doing this, both with the monetarist LRAS and the Keynesian LRAS curves. As you can see, the difference of the LRAS is important because it says alot about whether or not the price level will increase. It also says a lot about the increase in GDP. Because of the existence of hte SRAS curve in the monetarist diagram, the GDP increase will be less than it is in the Keynesian model.
Diagram 1: Monetarist model
Diagram 2: Keynesian model
Expansionary Fiscal Policy
The impact of automatic stabilizers
Automatic stabilizers exist in all developed countries. In times of recession and difficulty, they automatically kick into effect, stabilizing the economy and supporting those that need it. They thus maintain AD strong even in a recession, making the slump less severe. These include the progressive tax system and unemployment benefits, which start providing people with money as soon as they have lost their jobs. This helps stabilize short-term fluctuations.
Fiscal policy and potential output
Fiscla policy can have a huge impact on potential output. Spendings on education for the people lead to an increase in human capital for the entire nation, thus GDP growth. Spendings on the infrastructure can afect output greatly by allowing industries and businesses to easier transport goods.
Investments in healthcare also increase human capital and thus potential output by maintaining a healthy working force. Government subsidies and investments in research and development may lead to technological innovations that will increase output over the long haul.
How useful is fiscal policy?
Advantages
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Ability to solve a recession. The true strength of fiscal policy is it's ability to solve a recession. Fiscal policy strengthens AD, shifting it to the right, thus increasing consumption in the economy.
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Long-term GDP growth and LRAS shifts. Fiscal policy, if used correctly, can over the long-term grow a country's GDP tremendously. Investments in free public schools, for example, will have a huge effect on the GDP of the country over the coming fifty to a hundred years. Same goes for building your country's infrastructure and the like.
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Able to target sections. Monetary policy affects all. With fiscal policy, the government can target income groups, geographical locations or industries that need it the most.
Dis-advantages
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Time consuming. Fiscal policy is slow and ardous work. It takes time to implement and takes time to work. INvestments in education can create jobs in the short term (of a year or two) but will take over ten years to start yielding results in terms of a smarter working force.
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Political limitations. Fiscal spending is not governed by an independent body, like monetary policy by the central bank. Instead, the government makes fiscal policy, often shaped by it's party, president, constituents and their demands, even if these are not correct.
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Can over or under shoot. It is very difficult to correct little mistakes with fiscal policy, or fine-tune the Ad or LRAS curves. If you invest, it tends to be big, and you don't know just how big until after.