Macroeconomics

Introduction to basic Macroeconomic principles

Macroeconomic Objectives:

1. Internal:
1. Economic Growth
2. Full employment
3. Price Stability
2. External:
1. Balance of Payment stability or improvement
2. Exchange rate stability or improvement

Economic Growth
In order to understand the concept of economic growth first we must understand the
following three concepts.

Phases of Economy:

1. Boom
2. Peak
3. Recession
4. Upturn

Intensity of phases or magnitude: the significance of the economic growth a country is

experiencing depends on how big the growth or recession the economy is experiencing.

Duration: the significance of a boom or recession in the economy depends on how long is has
lasted. In order for an economy to be classified as being in a booming stage it has to maintain
such a performance for at least six months.

Actual Growth: when the national income reaches or approaches national income at a full
level. It requires demand side policies.

Potential Growth: when you expand the capacity of the economy to produce by shifting the
PPF outwards and consequently the aggregate supply rightwards. It requires supply side
policies.

Increase Aggregate Demand:

1. Give incentives to spend.

2. Give incentives to invest.
3. Give incentives to build.
4. Give incentives to buy exports.
5. Give incentives to reduce imports.
Increase Aggregate Supply:

1. Increase quantity of factors of production.

2. Increase quality of factors of production.

Potential growth: use supply side policies to achieve by increasing the quantity, the quality
and the efficiency of the factors of production. In order for an economy to be classified in a
certain phase of growth it has to experience the characteristics of the phase for two
consecutive terms.

Unemployment
In order to classify a person as being unemployed he has to be passed through some criteria.

Measurement of unemployment: there can be an over or under estimation of how many

people are unemployed.

Duration: if a person has been unemployed for a short period of time (few weeks) he isn’t
classified as unemployed.

Consequences of unemployment:

1. Economy/society
2. Government
3. Unemployed people
4. Taxpayers

Types or causes of unemployment:

1. Equilibrium unemployment which can be caused because people are economically

independent or the wages are too low thus people don’t feel the need to be employed.
2. Disequilibrium unemployment which is usually due to the imposition of minimum
wage laws by the government which means there is higher demand for jobs than there
is supply.

Reduction of Aggregate Demand:

1. Fiscal Policy suggests the increase of taxes with the decrease of government spending
which aims at reducing consumption.
2. Decrease supply of money and increase interest rates which aims to minimize the
existence of money flowing through the economy.
The Circular Flow of Income:

There are three different ways of measuring economic performance:

1. Income method: measure the income of all individuals in the country.

2. Product method: measure the value of all products in the country.
3. Expenditure method: measure the domestic consumption in all sectors of the
economy.

Why unemployment is bad:

1. With large numbers of unemployment the economy is producing below its full
capacity thus creating a deflationary gap. Thus there is loss of output and as a
consequence the country has to import from abroad with negative complications to its
BoP and ER. With lower level of output usually there is no pressure on inflation. But
this is not always the case. In the case of stagflation the country is experiencing both
inflation and unemployment.
2. With unemployment the government might experience fiscal difficulties. The fiscal
stance of the government might worsen because the government’s budgets, has
inflows of money from taxation and money outflows in the form of government
spending. When T>G then we have budget surplus. When T< budget the makes which
spending government in increase an to leads this Again benefits. unemployment of
form through unemployed support has reasons social for that top on dept. national is
there result As requirement. borrowing sectors public and as deficit lead could This
taxation. levels lower receives being people numbers large With budget. balanced
have we then T="G" When deficit.>
3. There are many social and psychological implications on an individual level we have
loss of self esteem something that could lead to lower productivity later, alcoholism
crime and vandalism to society and an increase in family violence.

How to calculate unemployment:

1. People have to be registered

2. Expressed as rate of unemployment (unemployed ÷ labor force)×100

Reasons to underestimate unemployment:

 1. Disguised unemployment: more people than necessary are hire red to do a job, usually
in the public sector.
2. Underemployment: where people want to have full time jobs but are only capable of
finding part time jobs. As a result people could be registered as unemployed or
depending on the hours of work they find formally registered as employed and as a
result unemployment is underestimated.
3. Plus any other relevant argument.

Reasons to overestimate unemployment:

1. Many times people are registered as unemployed in order to collect the

unemployment benefits but have no intention to work.
2. Mothers with young children who had a job now give up their employment, stay at
home to raise children but for a certain period they receive unemployment benefits.
3. Plus any other relevant argument.

Duration of unemployment depends on three factors

1. Original stock of unemployment or original stock of people being unemployed.

2. Rate of inflow of the number of people losing their jobs.
3. Rate of inflow of the number of people who get a job.

Reason
s for which unemployed people aren’t on the supply of labour curve
1. Frictional or Search reasons: where people usually are overqualified for
certain jobs and with their own will quit their job and search for a better one
(sign of a highly educated and dynamic labor force)
2. Structural reasons: where the structure of aggregate demand or the structure of
aggregate supply is changing in this country (from coal to oil for heating
which has an impact on aggregate demand or from primitive technology on
fabric to the use of computerized technologies). People suffer structural
unemployment because of occupational or geographic immobility.
3. Seasonal reason: where economic activities are concentrated during a few time
periods. Strategies to reduce Equilibrium unemployment:
1. To reduce frictional or search unemployment the government could
reduce job dissatisfaction by increasing job information and to reduce
unemployment benefits.
 2. To reduce structural unemployment the government could increase
education and seminars to the unemployed to update their skills.
Moreover the government could improve transportation to help people
find jobs away from home.
3. To reduce seasonal unemployment the government could spread
economic activities over a longer time period.

Disequilibrium Unemployment in the Labor Market: in order to reduce real

wage or classical unemployment the following economic policies could be
effective:

4. Reduce government intervention in the labor market and make the

labor market more flexible with wages reflecting demand and supply
of labor.
5. Reduce the power of labor unions so they don’t have monopoly power
in the labor market. To do so, the government could impose wage
increases according to inflation. As a result the basic argument from
the labor unions is cancelled and employees maintain their purchasing
power.

Cyclical or demand deficient unemployment: instead of wages decreasing due

to the economies recession unemployment occurs. The government could use
several economic policies to reduce this type of unemployment:

6. Expansionary demand-side policy: fiscal or monetary policy. < wage

minimum use not market labor intervention its reduce>
7. The government could reduce the power of labor unions by
institutionalizing wage increases to happen in accordance with
inflation.

Increase in the supply of labor as a reason for disequilibrium unemployment.

8. In some cases if we assume that the supply of labor in a given

economy increases because of rapid population growth or of increase
in international immigration there will be disequilibrium in the labor
market.
9. There is a flexible labor market and the new equilibrium is lower than
before with lower wages and there is a reduction in unemployment
however it isn’t realistic.
10. In case the government or the labor unions intervene and resist the
wage reductions unemployment increases.

Equations used to calculate NY related

Quantities
 N
OTE: The level of government spending depends on the government’s
philosophy

11. Keynesians support government intervention which involves high

government spending.
12. Monetarists believe in a more market oriented approach which
involves low government spending.

National Accounting
13. Income method=Product method=Expenditure method => based one
the circular flow of income
14. Expenditure method= Cd+I+G+X-M= GDP
15. Income method=W+self-employed income+trading
profits+rent+interest=total domestic income-stock appreciation=GDP
16. Output method= value of output-value of input or total output of final
goods and services.
17. National Income= Domestic+ Income from abroad- Income to abroad
18. Gross National Income- Depreciation = Net National Product
19. Market Prices- Indirect taxes + Subsidies= Factor Cost
20. Real Income1995 = Nominal1995 × PI base year ÷ PI of particular
year
21. GNP÷TP = GNP per capita

Is high GDP per capita co-related with high quality of life?

1. Yes, high GDP per capita is usually co-related with high

quality of life. It is very useful because all countries have
knowledge of this statistic and also it allows comparison of
economic performance between years.
2. No, GDP per capita isn’t a good indicator of quality of life
because
 1. It is an average figure and doesn’t reflect income
distribution accurately.
2. It ignores negative externalities
3. It includes military expenditure which doesn’t reflect
good quality of life
4. GDP doesn’t reflect the underground or parallel
economy
5. Doesn’t reflect DIY activities
6. GDP per capita is distorted because of different
commuting patterns in the population
7. Different countries have different patterns of
employment which distort GDP figures. For example in
Sweden both men and women work. Thus they have
professional child care for their children something that
inflates GDP figures. In Mexico usually women don’t
work, as a result mothers take care of their children
without a salary and without their work being reflected
in the GDP figures.

Assume GNP per capita in China is $ 1000 and GNP in the US is $

30000. Does this mean that the quality of life in the US is 30 times
better compared to the quality of life in China?

The answer is no because China’s currency is the Yuan and the US’s
currency is the dollar. In order to measure the Chinese value of GNP
we use the income, product or expenditure method and calculate the
final value of GNP in China in Yuan. According to the exchange rate
of the Yuan against the dollar we adjust this figure to US dollars. The
comparison will be valid only if 1 Yuan trades with 1 Dollar. If the
Yuan is depreciated against the dollar, after the conversion from Yuans
to Dollars the Chinese GNP will be underestimated or the opposite.
Moreover we receive no information concerning infant mortality,
literacy or purchasing power. The only this GNP shows is the how
much Chinese people can purchase in the USA. In order for us to see
the true value of the Yuan against the dollar we also have to compare
purchasing power parity in other words how many products you can
buy in each country with the other countries money If the exchange
rate of the dollar in Yuans is 1 dollar to 3 Yuans and the purchasing
power parity is Yuan ÷ Dollar exchange rate 3 this means that in the
US you can buy with 3 Yuans what in China you can buy with 1 dollar.
As a result the effect of the exchange rate is eliminated and the
comparison is still valid.

Potential growth: use supply side policies to achieve by increasing the

quantity, the quality and the efficiency of the factors of production. In
order for an economy to be classified in a certain phase of growth it
has to experience the characteristics of the phase for two consecutive
terms.

Inflation
Why inflation is undesirable:

3. It causes income redistribution: because of inflation goods and

services are becoming increasingly more expensive to
consumers. The result is that there are winners and losers from
inflation. Generally speaking upper-middle and upper level
incomes are the winners with poor people generally being the
losers. More specifically losers are those with fixed incomes,
those who are in weak bargaining positions and those who in
savings who receive interest rates lower than inflation. With
inflation however there are also winners. Winners are usually
those who rent houses, firms with profit increase higher than
inflation and real estate agencies increasing the price of their
houses faster than inflation.
4. It causes Uncertainty: with inflation there is great uncertainty in
the macroeconomic environment of a country. Inflation usually
means low business confidence. There are several reasons for
which there is uncertainty. Firms any moment expect an
increase of interest rates by the central bank and as a result they
postpone any future investment, also firms delay their
modernization process because now it will be more expensive.
Finally firms avoid wage increases something that reduces the
motivation of employees to work harder. From the economic
point of view, lower investment is going to be translated as a
lower national income. Furthermore with low investment it is
expected for a country to have low economic growth and it
could e anticipated that we would have demand deficient
unemployment.
5. There is rapid worsening of BoP and ER: Assuming that
inflation in Greece is bigger than the inflation of its major
trading partner then Greek exports will become more expensive
to the foreigners and cheaper imports will come to Greece. As a
result the balance of trade or visible balance will worsen and
the ER will weaken. Of course the impact of inflation on the
ER will be determined by the Ped for Greek exports by the
foreigners as well as by the Ped for imports of Greeks (Marshal
Learner condition).
6. Finally inflation is responsible for the increased cost of the
firms because now the firms have to spend more resources in
order to monitor fluctuating prices, hiring financial experts to
determine the impact of inflation in their diverse business
activities and through financial accounting and discounting
cash flow methods determine the net present value of diverse
investment schemes.

Causes of Inflation:

7. Demand-pull inflation: it usually reflects a case where

aggregate demand has a rightward shift in the perfect inelastic
part of aggregate supply. This typically happens in a booming
 economy. During growth total level of spending in the
economy by consumers, firms on investment, the government
and foreigners is increasing. As we can see from the relevant
diagram there is a rapid increase in the level of prices since
there is perfect inelasticity of aggregate supply which reflects
the level of national output produced at each and every price
level. According to monetarists the increase of aggregate
demand is associated with an increase in money supply as the
main explanation. According to non-monetarist explanations
demand-pull inflation is caused by other autonomous factors
like taste, confidence, optimism etc associated with economic
performance. The economic policies the government could
pursue would be either contractionary monetary policies or
contractionary fiscal policies. The government could also
attempt a supply side policy. The only problem with supply
side policies is that they have long term effects as a result
governments are more hesitant to pursue them. The government
could also impose direct controls on prices by imposing
minimum and maximum wages.
8. Cost push inflation: aggregate supply in a given economy
experiences a leftwards shift. In the short run the higher the
price in the market the higher the profit the firms make and the
greater the output by the companies. This could lead in the long
term to the increase of marginal cost of production usually
because of the law of diminishing or marginal returns and
because of the growing shortages of certain variable factors of
production. Some popular reasons for cost push inflation
include wage increase, increase in import prices, increase in
government taxation and depletion of non-renewable natural
resources. There are several policies the government could use
to reduce cost push inflation; it could reduce government
spending, taxation, monopoly power of firms, monopoly power
of trade unions, welfare benefits of unemployment and
bureaucracy on investment. The government could also attempt
to increase competition in all economic sectors, deregulation,
privatization, trade liberalization and capital mo vement
liberalization. If the supply side policies had a more
interventionist character the government could pursue an
increase in nationalization, an increase in grants to the firms,
improvement of the training of the labor force, provision of
greater advice and persuasion , assist small firms in becoming
efficient and help firms with research and development.
9. Wage Price Spiral: in a given economy if the labor unions are
successful in obtaining wage increases then the cost of
production will increase and as a result aggregate supply will
be reduced. Depending on the marginal propensity to consume
the increase in wages could be in its entire amount spent in the
economy. As a result there will be a rightwards shift in demand
and a new equilibrium will be formed at higher prices. This
increase in prices is caused by cost push and demand pull
 inflation together. Governments quickly have to intervene in
the case of wage price spiral inflation because soon inflation
could be put out of control and move from creeping, to strato,
to hyper inflation. In order to reduce cost push inflation
appropriate supply side policy both interventionist and market
oriented. In order to eliminate the demand pull element the
government could use the usual mix of deflationary demand
side policies and an appropriate supply side policy.

Economic Policies to Eliminate Inflation:

10. Demand Pull Inflation: the government can choose between a

contractionary fiscal policy whereby the government will
reduce spending and increase taxation so as to encourage
savings and a contractionary monetary policy whereby with a
decrease in the supply of money and an increase in interest
rates with both deflationary demand-side policies the
government aims at reducing aggregate demand. The
government could also attempt a supply-side policy in order to
reduce demand pull inflation. This will reduce expand supply
thus forming an equilibrium at a significantly lower price level.
However this has a problem because its effect can only be seen
in the long term. As a result many governments resort to
demand side policies which in the short term achieve the
desired effect. The government could also used an
interventionist policy by imposing a price ceiling on products
and minimum wage legislation so as to maintain high wages.
11. Cost Push Inflation: there are several policies aimed at reducing
cost push inflation. Supply side policies are mainly used to
reduce the decrease of aggregate supply and they can take the
form of market orientation (monetarism9 used by the political
right with Margaret Thatcher (UK) and Ronald Reygan (USA).
With market orientation, supply side policies the government
aims to reduce:
1. government spending so as to avoid the crowding out
effect
2. taxation
3. monopoly power of the firms
4. monopoly power of trade unions
5. welfare benefits on unemployment
6. bureaucracy on investment