MODULE (MIDTERM)

LESSON 5
TITLE: THE MACROECONOMIC PERSPECTIVE

TEXT:
1. Economics, Concepts, Theories, and Applications, Nebres, Abriel, M, National Bookstore,
2008

REFERENCE
2. https://opentextbc.ca/principlesofeconomics
3. https://courses.lumenlearning.com/boundless-economics

LESSON OBJECTIVES:

At the end of this lesson, the students will be able to:

1. Define macroeconomic.
2. Identify the three primary economic goals used to assess the state of the macroeconomy.
3. Enumerate the frameworks and tools used to analyze and manage the macroeconomic
goals.

MACROECONOMIC PERSPECTIVE
This lesson will help you understand how economists use economic indicators like GDP,
inflation, and unemployment rates to assess the health of an economy. A key distinction for
understanding the state of an economy is the difference between nominal and real measurements.

Macroeconomics

1. Macroeconomics focuses on the economy as a whole (or on whole economies as they

interact). It describes what causes recessions, and what makes unemployment stay high when
recessions are supposed to be over.
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2. Macroeconomics addresses why some countries grow faster than others, and have higher
standards of living than others.

3. Macroeconomics involves adding up the economic activity of all households and all
businesses in all markets to get the overall demand and supply in the economy.

Macroeconomics is a rather massive subject. How are we going to tackle it? illustrates the
structure we will use. We will study macroeconomics from three different perspectives:

1. What are the macroeconomic goals? (Macroeconomics as a discipline does not have goals,
but we do have goals for the macro economy.)
2. What are the frameworks economists can use to analyze the macroeconomy?
3. Finally, what are the policy tools governments can use to manage the macroeconomy?

THREE PRIMARY ECONOMIC GOALS USED TO ASSESS THE STATE OF THE

MACROECONOMY

In thinking about the overall health of the macroeconomy, it is useful to consider three primary
goals: economic growth, full employment (or low unemployment), and stable prices (or low
inflation).

1. Economic growth ultimately determines the prevailing standard of living in a country.

Economic growth is measured by the percentage change in real (inflation-adjusted) gross
domestic product.
2. Unemployment, as measured by the unemployment rate, is the percentage of people in the
labor force who do not have a job. When people lack jobs, the economy is wasting a precious
resource-labor, and the result is lower goods and services produced. Unemployment,
however, is more than a statistic—it represents people’s livelihoods.
3. Inflation is a sustained increase in the overall level of prices. If many people face a situation
where the prices that they pay for food, shelter, and healthcare are rising much faster than the
wages they receive for their labor, there will be widespread unhappiness as their standard of
living declines.

FRAMEWORKS AND TOOLS USED TO ANALYZE AND MANAGE THE

MACROECONOMIC GOALS.

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FRAMEWORKS

Economists use theories and models to explain and understand economic principles. In
microeconomics, we used the theories of supply and demand; in macroeconomics, we use the
theories of aggregate demand (AD) and aggregate supply (AS).

Aggregate supply
https://www.economicshelp.org/blog/glossary/aggregate-supply/

Aggregate supply is the total value of goods and services produced in an economy.

 The aggregate supply curve shows the amount of goods that can be produced at different
price levels.
 When the economy reaches its level of full capacity (full employment – when the
economy is on the production possibility frontier) the aggregate supply curve becomes
inelastic because, even at higher prices, firms cannot produce more in the short term.
 The aggregate supply curve is related to a production possibility frontier (PPF). Both
show the productive capacity of an economy.

Long run aggregate supply (LRAS)

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Factors determining LRAS

1. Available land and raw materials

2. Quantity and productivity of labour
3. Quantity and productivity of capital
4. Technological improvements which affect productivity and output.
5. The level of entrepreneurship in the economy.

Short run aggregate supply

1. In the short-run, capital is fixed. Firms can alter variable factors of production, such as
labour.
2. The SRAS is viewed as elastic, because in the short-run firms can increase output by
getting workers to do overtime.

 \

 In the diagram on the left, the SRAS has shifted to the left. This could be caused by rising
oil prices (increasing cost of production.
 In the diagram on the right, higher AD, has led to higher price level, and a movement
along the SRAS.

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Factors affecting the SRAS curve

1. Price of raw materials, e.g. oil, food, metals

2. Cost of labour, (wages, taxes, regulation
3. Levels of tax and subsidies

Classical view of long run aggregate supply

The classical view sees AS as inelastic in the long term.

The classical view sees wages and prices as flexible, therefore, in the long-term the economy
will maintain full employment. Classical economist believe economic growth is influenced by
long-term factors, such as capital and productivity.

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2. Keynesian view of long run aggregate supply

Keynesians believe the long run aggregate supply can be upwardly sloping and elastic.

 They argue that the economy can be below the full employment level, even in the long
run. For example, in recession, there is excess saving, leading to a decline in aggregate
demand.
 Keynesians also believe wages and prices can be sticky, and therefore, economies don’t
automatically return to full employment equilibrium.

Related pages

 Difference between SRAS and LRAS

 Difference between Keynesian and monetarists

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Aggregate demand
28 November 2016 by Tejvan Pettinger
https://www.economicshelp.org/ macroeconomics/economic-growth/aggregate-demand/

Aggregate demand (AD) is the total demand for goods and services produced within the
economy over a period of time.

Aggregate demand (AD) is composed of various components.

AD = C+I+G+ (X-M)

 C = Consumer expenditure on goods and services.

 I = Gross capital investment – i.e. investment spending on capital goods e.g. factories and
machines
 G = Government spending e.g. spending on NHS, education. Note transfer payments in
the form of pensions and unemployment benefits are not included because they are not
related to output produced.
 X = Exports of goods and services. Goods leave the country but money from abroad
flows into the economy. Therefore this is an increase in AD (an injection into the circular
flow)
 M = Imports of goods and services, although goods enter the country money is leaving
the economy to go to other countries. Therefore AD falls.

AD slopes downwards because

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 At a lower price level, people are able to consume more goods and services, because their
real income is higher.
 At a lower price level, interest rates usually, fall causing increased AD.
 At a lower price level, exports are relatively more competitive than imports.

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Shifts in the aggregate demand curve

Graph to show increase in AD

An increase in AD (shift to the right of the curve) could be caused by a variety of factors.

1. Increased consumption:

 An increase in consumers wealth (higher house prices or value of shares)

 Lower Interest Rates which makes borrowing cheaper, therefore, people spend more on
credit cards. Also, mortgage payments are cheaper which gives people more disposable
income.
 Higher wages
 Lower Taxes
 Increased consumer confidence about the future

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Consumer expenditure accounts for about 66% of AD and therefore is a very important
component of AD.

2. Increased Investment

 Lower interest rates, this makes borrowing for investment cheaper.

 Increased confidence in the economic outlook
 Improved technology
 Increased economic growth, to meet increased demand firms need to increase capacity

3. Increased G

 Government pursues expansionary fiscal policy

 Government invests in infrastructure

4. Increased X

 The UK more competitive, for example, an increase in labour productivity would make
the UK more competitive
 Increased growth in other countries, therefore they will have higher demand
 Lower value of Sterling, this makes exports cheaper

5. Decreased M

 The UK more competitive, this makes goods from other countries appear less
competitive.
Lower value of Sterling, this makes imports more expensive
Lower GDP, therefore consumers will have less money to spend.

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Fall in AD

In this diagram, we see a fall in AD. This causes a fall in real GDP and a fall in the price level
(P1 to P2)

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In this diagram, the fall in AD has mainly caused a fall in the price level, with little change in
real GDP.

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Components of AD

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Components of aggregate demand as %

A graph showing components of AD as a %

In the above charts, I left out two minor factors NPISH and change in inventories to make it
simpler.

Related

 Factors that affect aggregate supply

 Factors that affect demand

POLICY TOOLS

National governments have two sets of tools for influencing the macroeconomy:

1. The first is monetary policy, which involves managing the interest rates and the availability
of credit.

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2. The second is fiscal policy, which involves changes in government spending/purchases and
taxes.

MEASURING THE SIZE OF THE ECONOMY

GROSS DOMESTIC PRODUCT

The first step toward understanding macroeconomic concepts is to measure the economy.

The size of a nation’s overall economy is typically measured by its gross domestic

product (GDP), which is the value of all final goods and services produced within a country in a
given year. The measurement of GDP involves counting up the production of millions of
different goods and services—smart phones, cars, music downloads, computers, steel, bananas,
college educations, and all other new goods and services produced in the current year—and
summing them into a total dollar value.

This task is conceptually straightforward: take the quantity of everything produced, multiply it
by the price at which each product sold, and add up the total.

Alternative Ways to Measure the Economy

Besides GDP, there are several different but closely related ways of measuring the size of the
economy. We mentioned above that GDP can be thought of as total production and as total
purchases. It can also be thought of as total income since anything produced and sold produces
income.

Gross National Product

One of the closest cousins of GDP is the gross national product (GNP). GDP includes only
what is produced within a country’s borders. GNP adds what is produced by domestic businesses
and labor abroad, and subtracts out any payments sent home to other countries by foreign labor
and businesses. In other words, GNP counts the production of a nation’s citizens and firms,
whether they are located inside or outside the borders of the nation, while GDP measures all
production that happens within the geographic boundaries of a nation.

Nominal Measurements and Real Measurements

When examining economic statistics, there is a crucial distinction you need to be aware of. The
distinction is between nominal and real measurements, which refers to whether or not the

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measurement has been corrected for inflation. This is important because inflation distorts
economic magnitudes, making them look bigger than they really are.

Looking at economic statistics without considering inflation is like looking through a pair of
binoculars and trying to guess how close something is: unless you know how strong the lenses
are, you cannot guess the distance very accurately. Take GDP for example. If you do not know
the inflation rate, it is difficult to figure out if a rise in GDP is due mainly to a rise in the overall
level of prices or to a rise in quantities of goods produced.

The nominal value of any economic statistic means that we measure the statistic in terms of
actual prices that exist at the time. For example, nominal GDP in 2015 is measured as the
quantity of each final good and service produced in 2015 times the price at which it was sold in
2015. Similarly, nominal GDP in 2016 is measured using 2016 prices.

The real value refers to the same statistic after it has been adjusted for inflation.

INFLATION

Inflation is a persistent increase in the general price level of goods and services in an economy
over a period of time. Specifically, the rate of inflation is the percent increase of prices from the
start to the end of the given time period (usually measured annually).

The price level is an index showing the current level of all prices in the economy. Fear of
inflation precludes governments from expanding the economy and tone down unemployment. It
precludes governments from using macroeconomic policies to lower interest rates.

Because inflation is a sustained increase in the general price level, we must first establish what
the general price level was at a given time by making a price index, a number that outlines what
happens to a weighted composite of a selection of goods over time.

When the general price level rises, each unit of currency buys fewer goods and services.
Consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of
real value in the medium of exchange and unit of account within the economy.

The inflation rate is widely calculated by calculating the movement or change in a price index,
usually the consumer price index (CPI) The consumer price index measures movements in
prices of a fixed basket of goods and services purchased by a “typical consumer”.

CPI is usually expressed as an index, which means that one year is the base year. The base year
is given a value of 100. The index for another year (say, year 1) is calculated by:

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 CPIyear1=(BasketCostyear1/BasketCostbaseyear)
∗100CPIyear1=(BasketCostyear1/BasketCostbaseyear)∗100

The percent change in the CPI over time is the inflation rate.

UNEMPLOYMENT

Unemployment occurs when people are without work and are actively seeking employment. It is
typically described in reports as a percentage or a rate. The amount of unemployment in an
economy is measured by the unemployment rate, i.e. the percentage of workers without jobs in
the labor force. The unemployment rate in the labor force only includes workers actively looking
for jobs. People who are retired, pursuing education, or discouraged from seeking work by a lack
of job prospects are excluded.

Thus, unemployment rate is defined as the percentage of people in the economy who are
enthusiastic and fit to work but who are not working.

Unemployment rate is determined by dividing the number of unemployed individuals by the

number of people in the labor force. Labor forces are those people in an economy who are
willing and fit to work; multiplying by 100.

For example, if the total unemployed place at 5 million and the labor force place at 40 million,
the unemployed rate is:

Unemployment rate = Unemployment people

--------------------------- x 100

Total Labor Force

--- = 0.125 x 100 = 12.5%

40

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MONETARY POLICY

Monetary policy is a policy of influencing the economy through changes in the banking system’s
reserves that affect the money supply and credit availability in the economy. (Nebres).

Central banks (Bangko Sentral ng Pilipinas in the Philippines) implement monetary policy by

controlling the money supply through several mechanisms. Typically, central banks take action
by issuing money to buy bonds (or other assets), which boosts the supply of money and lowers
interest rates, or, in the case of contractionary monetary policy, banks sell bonds and take money
out of circulation. Usually, policy is not implemented by directly targeting the supply of money.
Central banks continuously shift the money supply to maintain a targeted fixed interest rate.
Some of them allow the interest rate to fluctuate and focus on targeting inflation rates instead.
Central banks generally try to achieve high output without letting loose monetary policy that
create large amounts of inflation.
Central banks can use unconventional monetary policy such as quantitative easing¹ to help
increase output. Instead of buying government bonds, central banks can implement quantitative
easing by buying not only government bonds, but also other assets such as corporate bonds,
stocks, and other securities.
¹Quantitative Easing. Monetary policy of printing money, that is implemented by the Central Bank to energize the economy.
The Central Bank creates money to buy government securities from the market in order to lower interest rates and increase the
money supply. These economic conditions will then trigger financial institutions to promote increased lending and to make the
money supply more liquid. (https://corporatefinanceinstitute.com/resources/economics/quantitative-easing/)

FISCAL POLICY

Fiscal policy is the use of government's revenue and expenditure as instruments to influence the
economy. It is a change in either government spending or taxes to make more active or slow
down the economy.

Examples of such tools are expenditure, taxes, debt.

For example, if the economy is producing less than potential output, government spending can be
used to employ idle resources and boost output.

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Each of the items will be explained in detail in one or more other modules.

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